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On June 28, 2012, Stockton, California became the most recent
municipality to file for bankruptcy under chapter 9, after having
concluded a mandatory mediation process with its creditors.
See, In re City of Stockton, California, Case No. 12-32118
(Bankr. E.D. Cal.). Many parties affected by a potential filing by
other similarly situated California public entities are seeking to
understand the process that precedes a Chapter 9 filing and how to
plan for a possible filing. This summary provides an overview of
the protocol before a California entity may file for Chapter 9
protection.
To file for Chapter 9 bankruptcy
protection, a municipality must satisfy both federal and state
eligibility criteria. The federal eligibility rules are set forth
in § 109(c) of the Bankruptcy Code: The debtor must be a
municipality, must specifically be authorized to file a Chapter 9,
be insolvent and be willing to effect a plan to adjust its debts.
In addition, the municipality must satisfy one of the following
four requirements: (1) the debtor has obtained the agreement of
creditors holding at least a majority in the amount of claims of
each class that the debtor intended to impair through its plan; (2)
the debtor has negotiated in good faith but failed to obtain the
agreement of creditors holding at least a majority in the amount of
claims of each class that the debtor intended to impair under its
plan; (3) the debtor was unable to negotiate with its creditors
because such efforts were impracticable; or (4) the debtor
reasonably believes that a creditor may attempt to obtain a
preferential payment.
The Code's "specifically authorized to be a Chapter
9 debtor" requirement refers to state law eligibility rules.
In California, a new law requires that distressed municipalities
seeking bankruptcy protection must undergo a 60-day mediation with
creditors before they may file a Chapter 9
petition—though either the municipality or a majority of
creditors may extend the mediation for an additional 30 days.
Municipalities must participate in the mediations unless they are
facing a fiscal emergency. The City of Stockton, for example,
engaged in the required mediation process for 90 days without
success. This law was adopted with the hope that pre-filing
mediations would ease the length, cost and consequences of a
municipality's bankruptcy on all interested parties.
Together, the state and federal eligibility criteria shape the
process through which a municipality files for bankruptcy in
California.
The impact of the 60-day mediation requirement is largely felt
by those municipalities which are not yet insolvent but which are
fiscally distressed. Such municipalities must enter into the
mediation under California law and negotiate in good faith under
federal law. Because the municipality must spend at least 60-90
days in mediation, it cannot threaten to pull out of the mediations
during that time frame, absent the fiscal emergency referenced
above. Moreover, because of the federal good faith requirement, it
is unlikely that the municipality could simply initiate the
mediation process and then take no action; neither could it
initiate the mediation process but thereafter engage in conduct
which tended to thwart the purposes of the mediation.
The 60-day mediation requirement may obviously create certain
hardships for municipalities and their residents. Some
municipalities may need to drastically cut services to residents in
order to maintain solvency during the mediation process. The City
of Stockton, for instance, is reportedly operating its police force
at approximately 60% of suggested staffing levels. To address
residents' safety concerns, the City has adopted a
"Marshall Plan" to reduce crime and increase public
safety, despite the reduced police force. Other distressed
municipalities may likewise seek to turn to strategic alternatives
to alleviate the effect of service cuts.
While the municipality may find that it initially has less
leverage since it has no immediate recourse to bankruptcy, its
leverage will likely increase – and creditors'
leverage will likely decrease – as the mediation period
winds down. If the municipality ends up in bankruptcy, under the
Code it has the exclusive right to propose a plan of adjustment.
Neither creditors nor the court may control the daily affairs of a
municipality directly, and may not do so indirectly by proposing a
plan of adjustment of the municipality's debts that would
govern the municipality's future taxes and
expenditures.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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