New California Law Will Restrict Cities' Access To Bankruptcy Under Chapter 9

Like many other states, California is in the midst of a financial crisis often referred to as "the next Greece." California's fiscal crisis has heightened fears that its other cities or municipal agencies will follow the City of Vallejo into federal bankruptcy protection under Chapter 9 ("Chapter 9") of Title 11 of the United States Code (the "Bankruptcy Code"). In response to such concerns, the State, with the support of organized labor, whose contracts are at risk for rejection in the event of local government bankruptcies, enacted Assembly Bill No. 506 ("AB 506") into law on October 9, 2011. The new law places certain limitations on a municipality's ability to file for bankruptcy. California has now followed a number of other states that have recently enacted laws designed to limit or restrict localities from filing for bankruptcy.

The Bankruptcy Code requires explicit state approval before a municipal entity can file for bankruptcy protection under Chapter 9. Prior to the enactment of AB 506, California law granted municipalities a general blanket approval to file for bankruptcy protection under Chapter 9. The new law, however, places certain procedural restrictions on a local public entity's1 ability to file for bankruptcy protection. Specifically, AB 506 requires that as a prerequisite for state approval of the filing (i) the local public entity must participate in a "neutral evaluation process"2 or (ii) the governing board of the local public entity must declare a fiscal emergency and adopt a resolution authorizing the filing (by a majority vote) after a noticed public hearing.3

The question that will naturally arise from this legislation is can California, or any other state for that matter, do this? That is, can a state like California, or Pennsylvania in the case of the City of Harrisburg, limit or proscribe a municipality's "right" to file for bankruptcy? Based on existing case law, the answer appears to be yes.

Municipalities are political subdivisions of the states, from which they derive their rights and powers. Chapter 9 expressly honors this arrangement. It does not give a municipal agency any independent authority to file a bankruptcy petition. Rather, each state itself must determine whether to permit its local public entities to avail themselves of Chapter 9 protection.4 In other words, Chapter 9 permits municipalities to reorganize under federal bankruptcy law, but delicately balances Congressional authority to make and...