SAN FRANCISCO - Vallejo, Calif.'s public employee unions have given up on getting the city tossed out of bankruptcy court.

Two unions - the International Brotherhood of Electrical Workers and the International Association of Firefighters - last week withdrew their appeal of rulings by the district bankruptcy court and Bankruptcy Appellate Panel ruling that the San Francisco Bay Area city was eligible for protection from creditors under Chapter 9 of the U.S. bankruptcy code.

After Vallejo declared bankruptcy in May 2008, the unions disputed the city's contention that it was insolvent. U.S. District Bankruptcy Judge Michael McManus ruled the city eligible for bankruptcy protection in September 2008.

The Ninth Circuit Bankruptcy Appellate Panel in Pasadena, Calif., upheld the ruling on June 26, but it gave the unions the right to appeal the decision to a higher court. The unions filed a notice of appeal before last week deciding not to continue the fight.

"After the bankruptcy court ruled one way and the BAP ruled the same way, it would have been very hard to convince the Ninth Circuit to overturn," said union attorney Kelly A. Woodruff of Farella Braun + Martel LLP. "We knew we were facing a very uphill battle."

Vallejo's bankruptcy case is being followed closely by lawyers, labor leaders and government finance officers across the country. It is the biggest municipal bankruptcy since Orange County, Calif.'s filing in 1994, and the deep economic downturn has spawned calls for other municipalities, including the Detroit Public Schools and Jefferson County, Ala., to declare bankruptcy.

The end of the eligibility fight moves the Vallejo bankruptcy battle back to the district court and to negotiations over new public employee labor contracts. The city has been paying workers less than their contracted wages for more than a year under the protection of the bankruptcy court.

The city has filed a motion to reject the union contracts altogether. McManus ruled that the bankruptcy court can allow labor contracts to be voided, but in April he ordered the two sides in to mediation with Chief Judge Elizabeth L. Perris of the U.S. Bankruptcy Court for the District of Oregon. Unions representing Vallejo's police and managerial employees reached revised labor agreements in early February.

"We're still in mediation," said city bankruptcy attorney Marc A. Levinson of Orrick, Herrington & Sutcliffe LLP. He said the abandonment of the eligibility appeal saved the city legal fees that probably would have run into the "low six figures."

Woodruff said Vallejo and the firefighters are "very close" to a settlement. She hopes the IAFF and the city can have an "agreement in concept this week."

She wouldn't comment on the contents of the agreement, but said negotiations have broken down over a new contract for the IBEW, which represents Vallejo's front-line, non-public-safety workers. Woodruff said the union last week offered to essentially freeze pay for the next three years, to require employees to contribute to health care premiums, and to reduce pensions for new hires.

"Settlement talks broke down completely on Thursday when the city's negotiators rejected the offer without taking it to City Council," she said.

Levinson said Vallejo has also been in preliminary negotiations with Union Bank of California, which is the holder of most of the city's general fund debt because it was the letter-of-credit provider on the certificates of participation. The city had $53 million of general fund debt outstanding when it declared bankruptcy.

It has reduced its payments on the debt to less than the contracted rates since June 2008. It deferred payments altogether during the final quarter of fiscal 2008-09, and it has capped interest payments at 2% for fiscal 2009-10.

Once new labor contracts are agreed, the city will negotiate a deal with Union Bank that allows it to either dismiss the bankruptcy or gain approval for a plan to adjust the city's debts.

"Not having to worry about this eligibility stuff does speed the process," Levinson said. He declined to comment on the city's negotiation positions.

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