SAN FRANCISCO - A federal appeals court late last week unanimously upheld a lower court ruling that Vallejo, Calif., is eligible for bankruptcy protection.

The ruling, published by the U.S. Bankruptcy Appellate Panel of the Ninth Circuit Friday afternoon, said the city was insolvent when it declared bankruptcy. The panel also certified the case for appeal to the Ninth Circuit Court of Appeals, saying the law on municipal bankruptcy remains unsettled.

The court ruled for the city on the major question - whether it's eligible for Chapter 9 bankruptcy protection - but it ruled against the city on the question of whether the law requires a debtor to propose a plan to adjust its debts before filing bankruptcy.

"We conclude that, based on the admissible evidence, the bankruptcy court correctly found that Vallejo was insolvent," the panel said in its 33-page affirmation of the lower court ruling.

Vallejo, a San Francisco Bay Area city of 117,000, declared bankruptcy in May 2008, saying it could no longer afford its labor contracts. Public employee unions opposed the filing, saying the city had money to meet its obligations if it wanted to.

Two of the city's four unions - representing police and managerial employees - agreed to new contracts after the lower court ruled that Vallejo was bankrupt, but unions for the firefighters and miscellaneous employees continue to fight the bankruptcy.

Lawyers for the employee unions could not be reached for comment.

The question before the appellate panel was whether U.S. District Bankruptcy Court Judge Michael McManus properly applied the legal test for municipal bankruptcy in finding that Vallejo was eligible for Chapter 9. The test includes a series of steps, including proving that the debtor is insolvent, has tried to negotiate a resolution outside of bankruptcy, and desires to negotiate a plan to adjust its debts.

The appellate panel found that the lower court was right to accept the city accountant's conclusion that Vallejo could not tap other funds to balance the general fund and avoid bankruptcy. The unions argued that the city's comprehensive annual financial reports showed it had $137 million at the end of fiscal 2008 to meet its obligations to city workers.

"According to the unions, Vallejo should have pillaged all of its component agency funds, ignoring bond covenants, grant restrictions, and normal GASB and GAAP practices, to subsidize its general fund," the appellate panel said, referring to the Governmental Accounting Standards Board and generally accepted accounting principles.

It also agreed with the lower court's ruling that the test of bankruptcy in Chapter 9 is a cash-flow test - whether the city can pay its bills as they come due, not a balance sheet test - whether the city's assets outweigh its liabilities.

While the panel found that Vallejo showed it wanted to negotiate a plan of adjustment, it ruled that the city hadn't negotiated with creditors on an actual plan of adjustment before seeking bankruptcy protection.

The city argued that the law didn't require it to present creditors a formal plan before filing. Instead, it simply needed to negotiate toward such a plan. The lower court agreed with the city, but the appellate panel said that was an error.

"While a complete plan is not required, some outline or term sheet of a plan, which designates classes of creditors and their treatment, is necessary," the panel said.

Notwithstanding that error, the panel upheld the lower court ruling, saying Vallejo had met a separate test, which allows bankruptcy if the debtor shows it's not practical to negotiate a plan outside of court.

The panel also found enough merit in the unions' argument to suggest that a higher court might want to take a look at the case.

"There is no controlling decision from the Ninth Circuit Court of Appeals or the Supreme Court of the United states that addresses the parameters of Chapter 9 eligibility requirements for municipalities," the court said in its certification allowing an appeal to the court of appeals.

The certification means the court allowed its decision to be appealed to the next higher court, which wouldn't normally be permissible after an appeals panel had upheld a trial court's ruling.

It's unclear if the unions will exercise that option, and if they did, the Ninth Circuit Court of Appeals is not obligated to hear the case.

Vallejo and its unions are currently negotiating with a court-appointed mediator to try to reach a conclusion of the case. The city's finances have continued to deteriorate since the bankruptcy filing, and it continues to slash staff and salaries. It has asked Judge McManus for permission to reject its labor contracts, but the trial judge ordered the two sides into mediation with another bankruptcy judge before he rules on the motion to reject the contracts.

"While the city is pleased with the ruling, it is unfortunate that both the city and the labor unions have devoted valuable resources and time that could have been better spent developing a plan of adjustment to exit bankruptcy," the city said in a release.

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