Are You Exposed to Chapter 9 Bankruptcies in California?

If you have missed the many stories of failing California cities and municipalities, take a look at the city of Stockton’s continued unraveling, and bankruptcy proceedings.

It's fascinating to see how this will work out in practice. Having lived in California and paid into their ever-expanding programs, how Stockton’s Chapter 9 works out in the end will be most interesting. With so many of California’s cities having fiscal problems, this is a problem that can impact private sector suppliers that rely on the public sector.  Are you using any of them?

First of all, since I’m not a lawyer, I wanted to see some analysis of California-specific case law references in this area, and I came across the Legislative Analyst’s Office, California’s Nonpartisan Fiscal and Policy Advisor site from which I borrow a few details, in an abridged format:

  • Retirees - local government agreements with retirees to provide pension or health benefits may be subject to rejection under Chapter 9 – but case law (outside of health care benefit reductions) is limited
  • Collective Bargaining Agreementslocal governments may use Chapter 9 to nullify contracts with employee groups (aka collective bargaining agreements) if it can show that such agreement hinders its ability to achieve fiscal stability, along with some other requirements
  • Bonds and debtsdebt payments may be reduced by decreasing the total amounts owed, lowering the interest rates, and/or extending the length of time during which the debts are to be repaid

Read more here.

My informed (albeit layman) analysis suggests that likely outcomes can include:

  • Freeing California’s cities from onerous union requirements – for example, forcing rewrites of overly generous pension and healthcare benefits
  • Trigger a radical (to California especially) rethink around employment in the public sector – as a longer-term solution to address the problem rather than the symptom. For example, will the public sector finally start to outsource (i.e. retain control but privatize delivery) of most work to private sector providers via SOW contracting – in order to limit pension and healthcare obligations to core staff only? Note, the Brits call this "commissioning" rather than procurement with requisite different skill sets required. Interesting.

Speculation, yes, but if California wants to return to being a creative, trend-setting leader in innovation and business, it can’t have cities spending like tomorrow will never come. And it looks like the actions of the past (and present) have to come home to roost – with a vengeance.


Think through what developments in California means for your organization – here are a few tangible concerns:

  • Practitioners, if your firm supplies a municipality in California or relies on companies with large exposure to the State’s public sector – what is your exposure on the buy- and sell-side?
  • Solution providers, if you do business with the public sector in Cali – how good are those receivables?
  • Practitioners and solution providers, do you have the spend or CRM visibility to understand if you're shipping into – or otherwise rely on business with – a potential (or current) Chapter 9 sinkhole?

Finally, this is not confined to California. The stakes are too high, no matter how the current Stockton court case plays out in the first round, my bet is that this will go all the way up to SCOTUS (the Supreme Court of the USA). If that happens, it looks to me that this could have a nation-wide impact.

Who said contract management and supply (and customer) risk management wasn't a fascinating topic that we should all care about?

Voices (2)

  1. Thomas Kase:

    Andy Kessler: The Pension Rate-of-Return Fantasy

    “Stockton may expose the little-known but biggest lie in global finance: pension funds’ expected rate of return.”

    “There is almost zero probability that Calpers will earn 7.5% on its $255 billion anytime soon. The right number is probably 3%.”

    “Over time, returns are going to be subpar and the contributions demanded from cities across California and companies across America are going to go up and more dominoes are going to fall. San Bernardino and seven other California cities may also be headed to Chapter 9. The more Chapter 9 filings, the less money Calpers receives, and the more strain on the fictional expected rate of return until the boiler bursts.”

    “In the long run, defined-contribution plans that most corporations have embraced will also be adopted by local and state governments.”

  2. Thomas Kase:

    Contractor Risk Strategies

    So, what can California Contractors do to protect themselves from these risks? These are a few suggestions that can help avoid, mitigate and resolve these risks:

    1. Know who is the contracting party.
    If the contracting party is the State of California or a Joint Powers Authority, the solvent parties may be liable for the underlying debts, depending on the structure of the contracts.

    2. Determine whether the responsible public entity is likely to remain solvent.
    Contractors must become familiar with the bond rating agencies so they have a general understanding of the likelihood of the public entities’ current and future solvency. Investors in municipal bonds have been studying the risk of default for many years. In the U.S., most bond ratings are calculated and published by three major companies: Moody’s, Standard & Poor’s and Fitch IBCA. In addition to the three majors, the SEC has recognized several other Nationally Recognized Statistical Rating Organizations” (NRSROs).
    It is important to realize the ratings of particular types of debt are based on their security. As such, a general contractor should look to the lowest rating of any security, as it is probably the less secured. For example, Certificates of Participation in Sports Areas and similar projects are generally more secure than general obligation bonds. It is important for contractors to master these ratings and avoid cities who seem like they are on the brink.
    Of course, bear in mind that many of these rating agencies prior to 2008 gave high marks to a variety of mortgage debt issuers and public agencies that nevertheless encountered substantial financial setbacks.

    3. Request limiting or eliminating retention for risky public entities.
    There is nothing wrong with writing to a city or public agency and stating that you wish a reduced or zero retention due to their credit rating. They may not agree, but you will get your message across.

    4. Request reducing the payment cycle to 15 to 30 days.
    Similarly, there is nothing wrong with writing to a city or public agency and stating that you wish a 15 – 30 day payment clause placed into the final bidding materials. Again, this does not cost them anything, but greatly reduces the float that the general contractor, subcontractors and suppliers might face in the event of an insolvency.

    5. Provide invoices to the public entity in a timely manner.
    It is not a bright idea to slow down your invoice process when you have an unstable public client. It is best to get invoices into the client, clean and complete, as soon as is practical.

    6. Resolve Change Order and Claims disputes during the project.
    The adage time is money is even more important if the public entity is on the skids. It is better to settle early and often than to see a change order or claim slip into the bankruptcy category.

    7. Include a clause in subcontracts and supplier agreements that they will submit claims in bankruptcy along with the general contractor and allow the bankruptcy process to serve as the collection process.
    The Clark v Safeco case does not address the viability of this approach. However, as the bankruptcy process is not a forfeiture, an agreement to proceed with that federal process might be better for the subcontractors and suppliers than to engage in warfare with the general contractor and surety.

    8. Attempt to ascertain if the public entity intends to reject your contract at the earliest opportunity.
    In the event of a major ongoing project, it is very helpful to get a read from the public entity if they are going to cease work on the project. While this will generally require city council approval, it will be much better on the subcontractors and suppliers if they know what the Chapter 9 debtor is planning, as soon as possible.

    9. File a claim in bankruptcy soon after receiving notice that the public entity has filed Chapter 9.
    The Bankruptcy process is not for amateurs. A crisp and accurate bankruptcy claim will more likely be considered and paid than a sloppy or homegrown effort. If the claim is not made in a timely basis, the claim will be denied. Legal Counsel are able to log into the federal online claims websites and get regular updates on filings and hearings.

    10. For subcontractors, preserve Stop Notice and Surety Rights during the bankruptcy proceeding.
    This is a highly complex area of the law. While all lawsuits are stayed by Section 362 of the Bankruptcy Code, some steps are allowed to perfect the lien or claim. This is an evolving area of law that requires specialized legal counsel. “Exercising state law remedies within the confines of the Bankruptcy Code may be the best course of action for subcontractors and suppliers,” says Michael Weiland, Esq., Managing Partner of Weiland, Golden, Smiley, Wang Ekvall & Strok, a Costa Mesa-based bankruptcy boutique firm.

    11. Work with the AGC to get a contractor appointed to the creditor committee.
    Typically, a creditor’s committee is formed by the Office of the United States Trustee with various classes of creditors being represented. As contractors would generally fall into the same class of creditors, they are often represented by the largest creditor. In the Orange County Bankruptcy, the CFO of Sukut Construction, Inc., a major Orange County-based contractor, served on the Creditors Committee as the construction industry representative.

    12. Seek qualified bankruptcy counsel with contractor-specific experience.


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