California Prerequisites to Municipal Bankruptcy Filings: Working or Not?

Historically, a municipality could file for protection under Chapter 9 of the United States Bankruptcy Code without seeking prior state approval or satisfying any pre-conditions.  As a response to the City of Vallejo’s 2008 bankruptcy filing, the California state legislature passed AB 506, which became effective on January 9, 2012.  AB 506 permits a financially troubled city or agency to file for bankruptcy protection, but it must satisfy a prerequisite before doing so. 

The entity must either: (1) engage in a neutral evaluation process with its creditors with the help of a mediator for a minimum of 60 days, or (2) declare a fiscal emergency. 

By promoting the use of a neutral evaluator, the legislation encourages the municipality to work with its creditors to craft a settlement or readjustment plan that has the requisite support to be approved. 

The fiscal emergency alternative requires a resolution of the majority of the governing body of the agency or municipality.  It must be accompanied by findings that the financial status is jeopardizing the health, safety or well-being of the residents or constituents of the entity.  In addition, the resolution must state that the body is unable to pay its obligations within the next 60 days. 

In both cases, the goal is to promote a more efficient resolution that will accelerate completion of the bankruptcy process if it remains necessary.  But, is AB 506 working?

The City of Stockton chose to engage a neutral evaluator. After 60 days of working with former United States Bankruptcy Judge Ralph R. Mabey of Salt Lake City, the City of Stockton elected to extend the negotiation period for an additional 30 days.  In the end, the City filed for bankruptcy protection. 

The City of San Bernardino did not engage a neutral evaluator, instead opting to declare a fiscal emergency and then immediately filing for bankruptcy protection. 

Both cities’ bankruptcy plans are being challenged for a host of different reasons, implying that AB 506 may merely be a speed bump on the road to bankruptcy – slowing the process but not helping municipalities avoid bankruptcy or making the process more efficient.

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