SAN FRANCISCO - The U.S. Ninth Circuit Bankruptcy Appellate Panel late Thursday ordered Vallejo, Calif., to show that the $136 million in restricted funds on its balance sheet are legally restricted, as the panel considers a labor union appeal of the city's bankruptcy eligibility.

The city and its unions have been litigating for the past 10 months over whether Vallejo is unable to pay its bills or just unwilling. Federal Bankruptcy Judge Michael McManus ruled in September that the city's general fund was really insolvent and eligible for bankruptcy protection.

City workers appealed the ruling, saying Vallejo had failed to prove it could not access money outside its general fund. While McManus relied on testimony by the city's top accountant to determine that the non-general fund monies were restricted, the appeals court last week said in an order that it wants more specific proof.

Vallejo must show the court "copies of all applicable statutes, rules, ordinances or other legislative bases of such alleged restrictions," the three-judge panel said, adding that the city must also "exclude all references to contractual or other non-legislative bases of alleged restrictions."

Vallejo is the largest California city to declare bankruptcy and the largest U.S. municipality to go broke since Orange County in 1994. It has about $50 million of general fund bond debt outstanding, but its main liabilities are owed to current workers and retirees. Vallejo has asked McManus to allow it to reject its collective bargaining agreements because they are no longer affordable. The judge's ruling on that motion is pending.

Two of the city's four labor unions - the International Association of Firefighters and the International Brotherhood of Electrical Workers - are contesting the city's bankruptcy eligibility. Two other unions have renegotiated contracts and dropped their opposition to the bankruptcy.

"The city is made up of over 100 individual funds, but they're not separate legal entities," said union attorney Kelly A. Woodruff, of Farella Braun + Martel LLP in San Francisco. "The entire bankruptcy proceeding has focused on the general fund, and we argue that that is improper ... The city as a whole filed for bankruptcy."

The city downplayed the importance of the appellate panel's order, saying it was ready to give the court as much proof as it wanted.

"The city offered to present this evidence regarding the restricted funds in their last brief on the appeal," said Vallejo spokeswoman JoAnn West. "The panel has now asked the city to submit it."

Vallejo bankruptcy attorney Marc A. Levinson, of Orrick, Herrington & Sutcliffe LLP in Sacramento, argued in court that McManus had properly accepted the city accountant's testimony on fund restrictions, but he also offered to submit more proof if the judges disagreed.

He added that Vallejo had no reason to hide money, noting that it had been forced to entirely cut funding for community organizations and libraries, causes that are dear to both elected officials and residents. He said the city wouldn't have done that just to harm workers.

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