BILL ANALYSIS Ó SENATE GOVERNANCE & FINANCE COMMITTEE Senator Lois Wolk, Chair BILL NO: AB 506 HEARING: 7/6/11 AUTHOR: Wieckowski FISCAL: Yes VERSION: 6/29/11 TAX LEVY: No CONSULTANT: Weinberger LOCAL GOVERNMENT BANKRUPTCY Prohibits a local agency from petitioning for bankruptcy protection unless it starts a neutral evaluation process and meets other conditions. Background and Existing Law Federal bankruptcy law for public agencies (Chapter 9) gives government debtors time to come up with repayment plans, providing them a breathing spell from creditors' collection efforts. Only a municipality, which federal law defines as a political subdivision, public agency, or instrumentality of a state, can initiate a Chapter 9 proceeding. The municipality must be insolvent and desire to effect a plan to adjust its debts. To qualify as insolvent, a municipality must demonstrate that it: Has obtained the agreement of creditors holding at least a majority of the amount of the claims of each class that such entity intends to impair under a plan in a case under Chapter 9; or , Has negotiated in good faith with creditors and it has obtained the agreement of creditors holding at least a majority in amount of the claims of each class that the municipality intends to impair under a plan of adjustment of claims; or , Is unable to negotiate with creditors because negotiation is impracticable; or , Reasonably believes that a creditor may attempt to obtain a transfer that is avoidable under federal bankruptcy law. Unlike private bankruptcy law (Chapter 11), municipal bankruptcy law must respect the states' sovereign powers. Consequently, the states can control their local agencies' access to federal bankruptcy protection. Like 11 other states, California grants its local public agencies the AB 506 - 6/2911 -- Page 2 broadest possible access to federal bankruptcy available. The state statutes broadly authorizing bankruptcy filings by local governments were first enacted in 1939 (SB 338, Phillips, 1939) and codified in 1949 (SB 768, Cunningham, 1949). In 2001, after studying the state statutes authorizing bankruptcy filings by local public entities, the California Law Revision Commission recommended revisions to conform the statutes to changes in federal bankruptcy law and to reaffirm the intent of the statute to provide the broadest possible access to municipal debt relief under federal law. Legislators approved the Commission's recommendations the following year (SB 1323, Ackerman, 2002). Because one municipality's bankruptcy may have a negative effect on other local governments' borrowing power, some states limit or prohibit their local governments to access federal protections. Local governments in 22 states do not have access to municipal bankruptcy, while 16 other states impose some conditions on municipal bankruptcy filings. The conditions imposed by other states range from a requirement that a local entity's legislative body must pass an ordinance or resolution before filing for bankruptcy to a requirement that a state commission grant approval before a local government may file for bankruptcy. After the 1994 Orange County bankruptcy, the Legislature tried to establish state oversight for municipal bankruptcy filings. The bill passed, but Governor Pete Wilson vetoed it (SB 349, Kopp, 1996). The Law Revision Commission's 2001 study also considered proposals to require prefiling approval by the Governor or a governmental committee, but did not recommend any substantive reforms. Last year, AB 155 (Mendoza, 2010) would have required either the approval of a state commission or the completion of a state audit before a local public entity could file for bankruptcy. That bill died on the Senate Floor. The California Debt and Investment Advisory Commission provides information, education, and technical assistance on debt issuance and public fund investments to local public agencies. The Bureau of State Audits conducts performance, financial, and compliance audits that are either mandated by statute or requested by the Legislature through the Joint Legislative Audit Committee. Information relating to any audit conducted by the Bureau of State AB 506 - 6/2911 -- Page 3 Audits cannot be released to the public until the audit is completed. In 2008, the City of Vallejo filed a Chapter 9 bankruptcy petition. The City subsequently asked the bankruptcy court for permission to reject collective bargaining agreements with four unions representing city employees. After more than three years, Vallejo remains under the bankruptcy court's protection, although it may emerge from bankruptcy soon. In response to the length, cost, and consequences of Vallejo's bankruptcy and the potential for additional municipal bankruptcy filings, labor unions and others want local officials to participate in a neutral alternative dispute resolution process before filing for bankruptcy. Proposed Law Assembly Bill 506 prohibits a local public entity from filing a petition and exercising powers under federal bankruptcy law unless it participates in a neutral evaluation process, and meets certain conditions. I. Requirements for seeking bankruptcy protection . Specifically, AB 506 prohibits a local public entity from filing for bankruptcy protection unless it participates in a neutral evaluation process, receives a good faith certification from the neutral evaluator, and: Reaches an out-of-court agreement with all interested parties regarding a plan of adjustment; or , Is unable to reach an out-of-court agreement and the neutral evaluator certifies in writing that the parties have participated in the neutral evaluation process in good faith; or , Interested parties did not participate in the neutral evaluation process. AB 506 prohibits a local public entity from filing a petition and exercising powers under federal bankruptcy law if the neutral evaluator determines that the local entity failed to participate in the neutral evaluation process in AB 506 - 6/2911 -- Page 4 good faith. Failure to participate in good faith includes the failure to provide accurate and essential financial information, the failure to attempt to reach settlement with all interested parties to avert bankruptcy, or evidence of manipulation to delay and obstruct a timely agreement. ÝSee §3 of the bill.] Alternatively, AB 506 allows a local public entity to file a petition and exercise powers under federal bankruptcy laws if: The State Auditor determines that the local public entity is insolvent, as defined in federal law; and , The local public entity has been participating in a neutral evaluation with interested parties for at least 90 days. Ý§12] For these purposes, AB 506 states that the term "local public entity" does not include a school district. Ý§3] II. Neutral evaluation process . When a local public entity is or likely will become unable to meet its financial obligations when those obligations are due or become due, AB 506 allows a local public entity to initiate a neutral evaluation process. The neutral evaluation must be conducted through an alternative dispute resolution program within the state and in accordance with state law. Ý§5] AB 506 requires each interested party to provide at least one representative to attend all neutral evaluation conferences. Each party's representative must have authority to settle and resolve disputes or be in a position to present any proposed settlement or plan of readjustment to the governing body or membership for approval and implementation. The local public entity must provide a representative who must represent the local public entity's interest and who must be in a position to propose any settlement or plan of readjustment to the local public entity's governing body. AB 506 allows an interested party to be represented by legal counsel, but requires it to inform all parties of the representation. Ý§9] AB 506 requires the parties to maintain the confidentiality AB 506 - 6/2911 -- Page 5 of the neutral evaluation process and prohibits them from disclosing statements made, information disclosed, or documents prepared or produced, during the neutral evaluation process unless all parties consent in writing to the disclosure. The confidentiality requirement does not apply to documents that were not confidential before the start of the neutral evaluation process. Ý§9] AB 506 requires the parties to a neutral evaluation process to exchange all documents including current financial information and projections addressing future financial obligations affecting the local public entity or that may hinder a resolution of the issues before the neutral evaluator. The neutral evaluator may request the submission or exchange of memoranda on issues, including the underlying interests, and the history of the parties' prior negotiations. Information that a party wishes to keep confidential may be sent to the neutral evaluator in a separate communication clearly marked "CONFIDENTIAL." Ý§8] AB 506 requires the neutral evaluation process to end if: The parties execute an agreement of settlement. The parties reach an agreement or proposed plan of readjustment that requires the approval of a bankruptcy judge. The neutral evaluator certifies that one or more of the parties has not participated in good faith, that no resolution has been reached, and that further efforts at the neutral evaluation process would not contribute to a resolution of the parties' dispute. The neutral evaluator certifies that the parties have participated in good faith, but the parties have reached an impasse and further efforts at the neutral evaluation process would not contribute to a resolution of disputes. The neutral evaluator certifies that a neutral evaluation was initiated by the local public entity but that no interested parties participated. Ý§10] III. Neutral evaluator selection and removal . AB 506 requires the parties to a neutral evaluation process to select a neutral evaluator through a mutually agreed upon process. If at any time during the neutral evaluation AB 506 - 6/2911 -- Page 6 process, the public entity and a majority of interested parties wish to have the neutral evaluator replaced, AB 506 allows the public entity or a member of the interested parties to request that the neutral evaluator be removed. If the public entity and the majority of the interested parties agree that the neutral evaluator should be removed, then a new neutral evaluator must be selected in a mutually agreed upon selection process. Ý§7] If a neutral evaluator is informed of the existence of any facts that a reasonable individual would consider likely to create a potential or actual conflict of interest, AB 506 requires the neutral evaluator to disclose those facts to the local public entity and all interested parties involved in the neutral evaluation. If any party to the neutral evaluation objects to the neutral evaluator, that party must notify all other parties, including the neutral evaluator, within 15 days of receiving the notice from the neutral evaluator. The neutral evaluator must withdraw and a new neutral evaluator must be selected. Ý§6] IV. Neutral evaluator requirements . AB 506 requires a neutral evaluator to oversee the neutral evaluation process, and facilitate the following requirements: The local public entity must completely disclose of all documentation necessary to clearly demonstrate whether the local public entity is solvent, including financial reports, expenditures, assets, and any other relevant documentation. The local public entity and any interested party must present information to each other, including the status of funds of the local public entity that clearly distinguishes between general funds and special funds. The local public entity and any interested party must present its proposed plan of readjustment. The local public entity and any interested party must negotiate in good faith. Ý§4] AB 506 requires a neutral evaluator to assist all interested parties in reaching an equitable settlement to avert a Chapter 9 filing. The neutral evaluator must also assist the parties in identifying the anticipated legal costs associated with a Chapter 9 filing relative to the AB 506 - 6/2911 -- Page 7 local public entity's budget shortfall. The neutral evaluator may consult with alternate dispute resolution service providers, the California Debt and Investment Advisory Commission, the California State Mediation and Conciliation Service, the Executive Office for U.S. Trustees, retired bankruptcy judges, or other appropriate entities in establishing and administering the neutral evaluation regarding issues that are not confidential. Ý§5] AB 506 requires the California Debt and Investment Advisory Commission, when requested by a local public agency or a neutral evaluator, to serve as a neutral third party to provide technical assistance in any neutral evaluation process conducted pursuant to state law governing municipal bankruptcy. Ý§2] AB 506 requires a neutral evaluator to meet all of the following qualifications: At least 10 years of high level business or legal practice involving bankruptcy. Experience and training in conflict resolution and alternative dispute resolution. Completion of a mandatory training program in municipal organization, municipal debt restructuring, Chapter 9 bankruptcy, public finance, taxation, California constitutional law, California labor law, federal labor law, and municipal finance dispute resolution, provided through an alternative dispute resolution program within the state. Ý§6] AB 506 provides that a neutral evaluator: Must be impartial, objective, independent, and free from prejudice. May not act with partiality or prejudice based on any participant's personal characteristics, background, values or beliefs, or performance during the neutral evaluation process. Must avoid a conflict of interest or the appearance of a conflict of interest during the neutral evaluation process and must make a reasonable inquiry to determine whether there are any facts that a reasonable individual would consider likely to create a potential or actual conflict of interest. May not, before the neutral evaluation process, AB 506 - 6/2911 -- Page 8 establish another relationship with any of the parties in a manner that would raise questions about the integrity of the neutral evaluation, except that the neutral evaluator may conduct further neutral evaluations regarding other potential local public entities that may involve some of the same or similar constituents to a prior mediation. Must conduct the neutral evaluation process in a manner that promotes voluntary, uncoerced decisionmaking in which each party makes free and informed choices regarding the process and outcome. May not impose a settlement on the parties. Must use his or her best efforts to assist the parties to reach a satisfactory resolution of their disputes. The neutral evaluator may make oral or written recommendations for settlement or plan of readjustment to a party privately or to all parties jointly. Must instruct and inform the local public entity and all parties of the limitations of Chapter 9 relative to other chapters of the bankruptcy codes. This instruction must highlight the limited authority of United States bankruptcy judges in Chapter 9, such as the lack of flexibility available to judges to reduce or cram down debt repayments and similar efforts not available to reorganize the operations of the city, that may be available to a corporate entity. May request documentation and other information from the parties that the neutral evaluator believes may be helpful in assisting the parties to address the obligations between them. Must provide counsel and guidance to all parties and is prohibited from being a legal representative of any party or having a fiduciary duty to any party. Must maintain the confidentiality of all the information he or she obtained in the neutral evaluation process, unless otherwise agreed to by the parties. Ý§6] If a complete settlement of all or some issues in dispute is not achieved within the scheduled neutral evaluation sessions, the neutral evaluator may continue to communicate with the parties in an ongoing effort to facilitate a AB 506 - 6/2911 -- Page 9 complete settlement in order to avoid a Chapter 9 filing. Ý§6] In the event of a settlement with all interested parties, the neutral evaluator may assist the parties in negotiating a prepetition, preagreed plan of readjustment in connection with a potential Chapter 9 filing. Ý§6] V. Confidentiality requirements . AB 506 requires the neutral evaluation process to meet extensive confidentiality requirements. Ý§13] Specifically, the bill requires that: No evidence of anything said or any admission made for the purpose of, in the course of, or pursuant to, a neutral evaluation is admissible or subject to discovery, and disclosure of the evidence cannot be compelled, in any arbitration, administrative adjudication, civil action, or other noncriminal proceeding in which testimony can be compelled to be given. No writing, as defined in state law, that is prepared for the purpose of, in the course of, or pursuant to a neutral evaluation is admissible or subject to discovery, and disclosure of the writing cannot be compelled, in any arbitration, administrative adjudication, civil action, or other noncriminal proceeding in which testimony can be compelled to be given. All communications, negotiations, or settlement discussions by and between participants in the course of a neutral evaluation must remain confidential. Evidence otherwise admissible or subject to discovery outside of a neutral evaluation cannot be inadmissible or protected from disclosure solely by reason of its introduction or use in a neutral evaluation. Neither a neutral evaluator nor anyone else may submit to a court or other adjudicative body, and a court or other adjudicative body may not consider, any report, assessment, evaluation, recommendation, or finding of any kind by the neutral evaluator concerning a neutral evaluation conducted by the neutral evaluator, unless the information is deemed necessary by a judge presiding over a Chapter 9 bankruptcy proceeding to determine eligibility of a AB 506 - 6/2911 -- Page 10 municipality to proceed with a Chapter 9 case or unless all parties to the neutral evaluation expressly agree otherwise. A communication or a writing, as defined in state law, that is made or prepared for the purpose of, or in the course of, or pursuant to a neutral evaluation is not made inadmissible, or protected from disclosure, by provisions of this chapter if either: o All persons who conduct or otherwise participate in the neutral evaluation expressly agree in writing, or orally, to disclosure of the communication, document, or writing. o The communication, document, or writing was prepared by or on behalf of fewer than all the neutral evaluation participants, those participants expressly agree to its disclosure, and the communication, document, or writing does not disclose anything said or done or any admission made in the course of the neutral evaluation. A written settlement agreement prepared in the course of, or pursuant to, a neutral evaluation, is not made inadmissible, or protected from disclosure, if the agreement is signed by the settling parties and any of the following conditions are satisfied: o The agreement provides that it is admissible or subject to disclosure, or words to that effect. o The agreement provides that it is enforceable or binding or words to that effect. o All parties to the agreement expressly agree to its disclosure. o The agreement is used to show fraud, duress, or illegality that is relevant to an issue in dispute. An oral agreement made in the course of, or pursuant to, a neutral evaluator is not made inadmissible, or protected from disclosure, if any of the following conditions are satisfied: o The oral agreement is recorded by a court reporter or reliable means of audio recording. o The terms of the oral agreement are recited on the record in the presence of the parties and the mediator, and the parties express on the record that they agree to the terms recited. AB 506 - 6/2911 -- Page 11 o The parties to the oral agreement expressly state on the record that the agreement is enforceable or binding, or words to that effect. o The recording is reduced to writing and the writing is signed by the parties within 72 hours after it is recorded. o The agreement is used to show fraud, duress, or illegality that is relevant to an issue in dispute. Anything said, any admission made, or any writing that is inadmissible, protected from disclosure, and confidential before a neutral evaluation ends, must remain inadmissible, protected from disclosure, and confidential to the same extent after the neutral evaluation ends. If a person subpoenas or otherwise seeks to compel a neutral evaluator to testify or produce a writing, as defined in state law, and the court or other adjudicative body determines that the testimony or writing is inadmissible under this section, or protected from disclosure under this section, the court or adjudicative body making the determination must award reasonable attorney's fees and costs to the neutral evaluator against the person seeking the testimony or writing. Any reference to a neutral evaluation during any subsequent trial is an irregularity in the proceedings of the trial for the purposes of state law. Any reference to a neutral evaluation during any other subsequent noncriminal proceeding is grounds for vacating or modifying the decision in that proceeding and granting a new or further hearing on all or part of the issues, if the reference materially affected the substantial rights of the party requesting relief. VI. State Auditor . After a local entity has initiated the neutral evaluation process, to help ensure that a local public entity meets the insolvency requirement in federal law and to assist the local entity and the interested parties in the neutral evaluation process, AB 506 authorizes a local public entity to submit information to the State Auditor describing the public entity's current financial position, including analyses of: The local public entity's revenues and estimated AB 506 - 6/2911 -- Page 12 revenues for the relevant time period. The local public entity's anticipated ongoing expenses. The local public entity's proposed plan for restoring the soundness of the local public entity's financial position if they have one. An itemized list of creditors that may be impaired or may seek damages as a result of the proposed plan. Any additional information the auditor deems necessary to complete the audit in a timely manner. Ý§13] The State Auditor must audit the analyses and financial position of the local public entity and must work with the local public entity to establish a deadline for the audit work. AB 506 requires that this audit must take precedent over any pending audit requested by the Joint Legislative Audit Committee. The auditor's report must become public at the time of filing for bankruptcy or prior to filing, at the public entity's discretion. Ý§13] AB 506 requires, if a local public entity requests an audit, that the State Controller must transfer sufficient funds from the General Fund to the State Auditor to reimburse the State Auditor for the audit activities. The State Controller must use General Fund revenues that are payable to the state from local public entities during the fiscal year in which the audit is performed. AB 506 specifies that it does not create an additional fiscal obligation to the local public entity. Ý§13] AB 506 contains legislative findings declaring that the duties of the State Auditor that arise under the bill's provisions must be initially funded from the State Audit Fund, pursuant to state law, which meets the requirements of specified Legislative Joint Rules. Ý§15] VII. Definitions . AB 506 defines numerous terms used in the bill. Ý§14] VIII. Findings and declarations . AB 506 contains extensive legislative findings and declarations supporting the need to establish a neutral evaluation process for municipalities in fiscal distress. Ý§1] As constitutionally required by Proposition 59 (2004), AB 506 AB 506 - 6/2911 -- Page 13 also includes legislative findings and declarations regarding the necessity of maintaining the confidentiality of neutral evaluation proceedings. Ý§16] State Revenue Impact No estimate. Comments 1. Purpose of the bill . Because local and state finances are inextricably linked, the state has a direct interest in the fiscal health of its local governments. A municipal bankruptcy can have statewide repercussions, including higher borrowing costs for other local entities and the state. The state also has a compelling interest in ensuring the validity and enforceability of contracts negotiated through the collective bargaining process, which forms the foundation for positive and stable labor relations. These state interests justify a state role in prescribing conditions under which local entities may seek Chapter 9 protection. The neutral evaluation authorized by AB 506 helps local officials find alternative strategies to address short-term fiscal challenges in ways that avoid the broad and lasting spillover effects of municipal bankruptcy. By providing an opportunity for good faith negotiation over a restructuring plan, the neutral evaluation process expedites the Chapter 9 process for local entities that eventually file for bankruptcy. AB 506's state audit process produces an independent and public assessment of a local entity's financial position, which may either support the local entity's bankruptcy claim or identify alternatives to bankruptcy. AB 506 offers municipalities facing financial distress a faster, cheaper, better alternative to the path recently taken by Vallejo and protects the interests of a broad coalition of stakeholders who are affected by municipal bankruptcies. 2. Local control . By imposing conditions on a local officials' access to bankruptcy protection, AB 506 critically undermines their discretion in responding to fiscal crises. Local elected officials are directly accountable to residents within communities affected by a municipal bankruptcy. As a result, a decision to enter AB 506 - 6/2911 -- Page 14 bankruptcy is a last resort that those officials do not take lightly. High legal costs, damaged credit ratings, and a lasting stigma that can deter investment and growth in a community all weigh heavily against a decision to petition for bankruptcy protection. The principal benefit of federal bankruptcy is the automatic stay of financial obligations which allows a local entity some breathing space to formulate a debt readjustment plan that is consistent with the fiscal interests and priorities of the local community. The neutral evaluation process and optional audit process proposed by AB 506 could delay a local government's ability to obtain protection under the stay of financial obligations. The Committee may wish to consider whether AB 506 is an unjustified state intrusion into local affairs. 3. What's changed ? Local officials have used municipal bankruptcy protection sparingly during the 70 years that it has been available to local public entities in California. Only three general purpose governments have filed for municipal bankruptcy protection: Orange County (1994), the City of Desert Hot Springs (2001), and the City of Vallejo (2008). Since 1991, 24 local public entities have filed for bankruptcy; more than half were small health care districts. This recent average of fewer than two municipal bankruptcy filings per year from among the thousands of local public entities in California may reflect the substantial, inherent disadvantages of resorting to bankruptcy. Despite the Great Recession and additional state-imposed burdens on local finances, the Sierra Kings Health Care District is the only California local government that has filed for bankruptcy protection in the three years since Vallejo entered bankruptcy. Vallejo's experience may serve as a cautionary example, encouraging fiscally distressed local governments to find alternative approaches to fiscal restructuring. The Committee may wish to consider whether the recent frequency and purpose of municipal bankruptcy filings justify the changes that AB 506 makes to the state's long-standing municipal bankruptcy statute. 4. What happens next ? It is unclear what might happen if a local entity that is participating in a neutral evaluation process becomes unable to pay its obligations before the process is completed. As mentioned in Governor Wilson's veto of the 1996 Kopp bill, some opponents of AB 506 - 6/2911 -- Page 15 state oversight of municipal bankruptcy argue that a denial of eligibility for bankruptcy "could raise questions of liability of the state to creditors of the public agency." However, there is no evidence that this theoretical concern has become a problem in the other states that block access to municipal bankruptcy. Regardless of whether the state may incur legal liability, it may face heightened political pressure to provide fiscal assistance to a local entity that can't seek bankruptcy protection because it has not completed the neutral evaluation process. Legislators may feel obligated to intervene to ensure that an insolvent county, city, or district doesn't stop providing vital public services. The Committee may wish to consider whether the conditions imposed by AB 506 to protect limited state interests could result in expanded state obligations to struggling local entities. Assembly Actions Assembly Local Government Committee: 5-3 Assembly Appropriations Committee: 12-5 Assembly Floor: 48-27 Support and Opposition (6/30/11) Support : California Professional Firefighters; California Conference Board of The Amalgamated Transit Union; California Conference of Machinists; California Dispute Resolution Council; California Labor Federation; California Official Court Reporters Association; California Nurses Association; California Teamsters Public Affairs Council; Estero Municipal Improvement District; International Longshore and Warehouse Union; Police Officers Research Association of California; Professional and Technical Engineers; IFPTE Local 21; United Food and Commercial Workers Region 8 States Council; Unite Here!; Utility Workers Union of America, Local 132. Opposition : Association of California Healthcare Districts; California Chamber of Commerce; California Contract Cities Association; California Special Districts Association; California State Association of Counties; Howard Jarvis Taxpayers Association; League of California Cities; Long Beach Area Chamber of Commerce; Los Angeles AB 506 - 6/2911 -- Page 16 County Business Federation; Marin County Council of Mayors and Councilmembers; Regional Council of Rural Counties; Urban Counties Caucus. Cities of: American Canyon; Antioch; Apple Valley; Atherton; Azusa; Bellflower; Beverly Hills; Burlingame; Campbell; Ceres; Clayton; Cloverdale; Culver City; Danville; Diamond Bar; Encinitas; Fontana; Foster City; Fountain Valley; Fresno; Goleta; Gustine; Half Moon Bay; Healdsburg; Hermosa Beach; Highland; Huron; Lakewood; Lathrop; Livingston; Lodi; Long Beach; Los Altos Hills; Madera; Merced; Monterey Park; Moreno Valley; Mountain View; Murrieta; Newman; Norwalk; Pasadena; Pinole; Placentia; Rancho Cucamonga; Red Bluff; Redding; Redwood City; Santa Clara; Santa Rosa; Signal Hill; South San Francisco; Stockton; Sunnyvale; Tracy; Tulare; Upland; Vista; Wasco; West Hollywood; Whittier; Yucaipa. Counties of: Monterey; Orange; Sacramento; Santa Clara.