Now, though, officials in the Obama administration may be looking ahead to a rescue of the automakers, an enormous challenge that could be simplified, from the government’s point of view, if kept out of court and under tight administration control. That would make it easier to change the terms of contracts governing retiree benefits, said David L. Gregory, a law professor at St. John’s University in New York.
“The issue is, how can the government calibrate and contour and control the process of reorganization,” without the time, expense and compromise inherent in bankruptcy, Mr. Gregory said. “The executive branch is proposing to do what the bankruptcy courts have had the exclusive prerogative to do.”
This month, the town of Vallejo demonstrated not only that it was possible for a city to tear up its union contracts in bankruptcy, but that it was even easier for a city to do so than for a company. The precedent may matter.
Municipalities do not file for Chapter 11 bankruptcy protection; they use Chapter 9, which has different terms and a much smaller body of legal precedent. Municipal bankruptcies are so rare that until the Vallejo ruling, it was not clear whether a city could get out of its union contracts in Chapter 9.
Unions representing Vallejo’s public employees tried to argue that state labor laws protected the contracts. But the federal judge handling the bankruptcy, Michael S. McManus, wrote that federal bankruptcy law trumped the state labor law. He also observed that Congress could have set tougher standards for municipalities voiding their labor contracts — it did so for companies. But such bills died in committee.
After reaching his decision, the judge gave both sides one more chance to try to negotiate less-onerous concessions.
“The world is watching, and I don’t say that with pride, because we never wanted to file a Chapter 9,” said Marc A. Levinson, a partner with Orrick, Herrington & Sutcliffe who is representing Vallejo in the bankruptcy. The city ran out of money last year, after promising benefits that it could not afford when the recession drove down tax receipts.
Vallejo’s bankruptcy is being closely watched because its problems mirror those in many communities that have promised benefits that now look unsustainable. In many places the benefits have been locked in with statutory and constitutional guarantees.
“That’s why Vallejo is so important,” said James E. Spiotto, a Chapter 9 specialist with the firm of Chapman & Cutler in Chicago. “Chapter 9 and bankruptcy is the land of broken promises.” He said unions were better off negotiating concessions now than landing in bankruptcy court and ending up with no contract at all.
But entirely different rules apply to bonded debt, and to a related problem plaguing some communities: derivatives. Chapter 9 was never meant to be a place where governments could get out of their bonded debt, Mr. Spiotto said.
Derivatives are largely untested, but the issue may reach a decisive point in Jefferson County, Ala., which is entangled in interest-rate swaps. The swaps were intended to shield the county from rising interest rates after it issued a large amount of variable-rate debt to pay for a new sewer system.
The swap arrangements broke down amid last year’s turmoil in the credit markets, leaving Jefferson County with $3.2 billion in debt that it can neither pay nor refinance. Some officials are now calling for a Chapter 9 filing; others are against it.
Alabama’s governor, Bob Riley, has written to the Treasury secretary and the Federal Reserve chairman, asking for help in stretching out Alabama’s financial obligations, rather than repudiating them.
The Treasury secretary, meanwhile, is working on a much broader initiative to give the federal government the power to modify the contracts of the financial institutions it takes over. The proposal raises several new issues, because it would eliminate the judicial oversight of bankruptcy proceedings and the opportunity for affected parties to challenge the changes.
The goal is to speed up reaction time to crises, said Lisa Hill Fenning, a retired bankruptcy judge who now practices at Dewey & LeBoeuf in Los Angeles. “Traditional ways of dealing with these problems are too complicated and would take too long,” Ms. Fenning said. “They’re trying to cut through red tape.”