SACRAMENTO - Vallejo, Calif., and its unions continued to negotiate in earnest this week, even as they fought over the city's bankruptcy court motion to reject its collective bargaining agreement in a federal court here.

Negotiations have netted contract agreements with two of the city's four unions - the Vallejo Police Officers Association and the Confidential, Administrative, Management, and Professional Employees union - and a fresh offer to a third bargaining group, the International Brotherhood of Electrical Workers. But the city and the International Association of Firefighters remain at odds.

Vallejo last May filed for the nation's biggest municipal bankruptcy since Orange County, Calif., in 1994. The San Francisco Bay Area city of 117,000 claimed it could no longer afford contracts with its municipal employee unions, and in September U.S. Bankruptcy Court Judge Michael McManus agreed Vallejo was bankrupt.

McManus heard arguments and testimony on the city's motion to reject its union contracts this week. With this week's court proceedings hanging over negotiators like a sword of Damocles, they have begun to reach agreements that could allow the city eventually to exit bankruptcy with reduced labor costs. The agreements could clear the way for negotiations to begin with bondholders, who represent a much smaller claim on the city.

"I'm still hoping a deal will be made, but I doubt it can happen before Judge McManus rules" on the labor contracts, said Marc Levinson, the city's bankruptcy lawyer and a partner at Orrick, Herrington & Sutcliffe LLP in Sacramento. "We're much closer with IBEW than we are with the firefighters."

Until Vallejo and its workers reach a deal, their lawyers continue to battle in the federal court in a closely watched effort to reject the city's labor contracts. Other governments with financial woes are watching the case closely to see whether they can use the protection of a Chapter 9 bankruptcy - or the threat of it - to get out of wage and benefit promises that no longer seem realistic in a spiraling economy. Meanwhile, investors in local government debt are worried that such a temptation could expose them to the vagaries of the bankruptcy courts even if they aren't the main target of the action.

Vallejo's $53 million of general fund-backed debt has been in limbo since the Chapter 9 bankruptcy filing. Officials capped interest payments on the variable-rate debt under the protection of the bankruptcy court, but both the city and Union Bank of California - the letter of credit provider that now holds the vast majority of the debt - have said in court filings that they can't negotiate a plan to adjust the debts until they know what the city's labor costs will be.

The case law on municipal bankruptcies is thin because governments rarely go bankrupt, and lawyers for Vallejo and the holdout unions - which are backed by the state and national AFL-CIO - say the judge will have to choose between two very different interpretations of the law governing rejection of collective bargaining agreements.

Lawyers for the city said the government has to reduce its labor costs to supportable levels. In their filings, they say Section 365 of the Bankruptcy Code gives a debtor like Vallejo the authority to reject contracts, including collective bargaining agreements.

Levinson and the city's lawyers said McManus should look to the U.S. Supreme Court's 1984 case, National Labor Relations Board v. Bildisco & Bildisco, for guidance.

The Supreme Court said a bankrupt employer could reject labor contracts if it could show that the contracts were burdensome, that the competing interests the court is weighing - so called "equities" - balanced in favor of rejecting the labor contract, and that negotiations had been attempted but were unlikely to succeed.

After an outcry by labor groups in the wake of the Bildisco ruling, Congress changed the Bankruptcy Code to make it harder to reject collective bargaining agreements, but it did not amend Chapter 9, which applies to municipalities, with the extra labor protections.

To Vallejo's lawyers, that means Congress must have intended for Bildisco to remain the law for municipal bankruptcy, as the Bankruptcy Court ruled in the Orange County case. If lawmakers wanted to, they could have put the stricter standards for contract rejection into Chapter 9, lawyers for Vallejo said this week.

"Congress chose not to even though it had the opportunity to do that several times," Levinson said in court Tuesday.

But union attorneys said Judge McManus should look to California state law that controls municipal collective bargaining agreements in the absence of a clear federal preemption.

"What the city is asking this court to do has never been done, ever," said Kelly A. Woodruff, a union bankruptcy lawyer with Farella Braun + Martell LLP in San Francisco.

"The city blithely assumes that [the Bankruptcy Code] preempts otherwise applicable state law. It does not," Woodruff and union lawyers wrote in court filings.

Woodruff said California has specific laws that govern negotiations between local governments and their workers, and they don't allow a city to unilaterally reject labor contracts, even in bankruptcy. The state's right to govern its affairs is protected by the 10th Amendment to the U.S. Constitution, and those rights should not be preempted unless the Congress specifically overrules state law, according to union lawyers.

Given that Congress didn't update Chapter 9 municipal bankruptcy statutes when it passed standards for rejection of collective bargaining agreements in the corporate bankruptcy code, the issue must remain governed by California law, the attorneys contend.

With both sides facing the possibility that a ruling might go against them, they have been negotiating to reach an agreement that they can live with before the judge decides the issue.

The Vallejo City Council and the Police Officers Association last week approved contract changes that will reduce city labor costs and removed the union from the legal challenges to the bankruptcy filing.

The new contract cuts police staffing costs by 18% compared to the old contract, according to city manager Joseph M. Tanner. The deal will save the city's $77 million general fund about $6 million in fiscal 2009 and 2010.

Vallejo has been paying workers less than their contracted salaries under a court-approved pendency plan since shortly after it filed for bankruptcy.

The revised police contract caps salaries at the level the city has paid under the bankruptcy through June 2010 and ties future pay raises to the mean of seven Bay Area cities. It also limits health care payments for current and former employees, eliminates minimum staffing requirements, and reduces leave payouts.

In return for their concessions, the police will get a contract extension through 2012 and receive $1 million in damages to be paid between 2012 and 2015.

Vallejo's much smaller Confidential, Administrative, Management, and Professional Employees union this week agreed to a deal that included no bankruptcy damages, Levinson said. The two sides had not yet published the details of the new contract, which won't go before the City Council for approval until next week.

Levinson said the city also wrote up a new proposal for the IBEW this week and continues to actively negotiate with its firefighters. He said the city has offered the firefighters the same deal the police recently accepted.

As it reaches agreements with labor groups, Vallejo removes obstacles in the bankruptcy court. Three city unions have appealed McManus' ruling that the city was eligible for bankruptcy protection, and the Bankruptcy Appellate Panel of the Ninth Circuit Court of Appeals will hear the appeal Feb. 19.

The police contract agreement leaves two labor groups still contesting Vallejo's bankruptcy: the firefighters and the IBEW.

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