Court Holds That Stockton Is Eligible To File For Chapter 9

April 3, 2013

On April 1, 2013, the U.S. Bankruptcy Court for the Eastern District of California ruled that the City of Stockton qualified to file for protection under chapter 9 of the Bankruptcy Code. The court's decision on this issue serves as an important milestone for chapter 9 jurisprudence, clarifying the requirements for “good faith” negotiations and being “insolvent” as conditions to filing for chapter 9 protection. Significantly, the court held that a municipal debtor need not negotiate with all of its creditors, only those that it intends to impair.

Statutory Background

The Bankruptcy Code enumerates various criteria with respect to a municipality's eligibility to file for chapter 9 protection. In pertinent part, section 109(c) of the Bankruptcy Code provides that an entity may be a debtor under chapter 9 only if such entity is (i) insolvent, (ii) is authorized to file for chapter 9 under applicable state law, and (iii) has “negotiated with its creditors in good faith and has failed to obtain the agreement of creditors holding at least a majority in amount of the claims of each class that such entity intends to impair under” its plan of adjustment. 11 U.S.C. § 109(c)(2)-(5) (emphasis added). Courts have previously interpreted the good faith negotiations requirement as mandating prepetition negotiations among the municipality and creditors that the municipality intends to impair under its plan of adjustment. See In re City of Vallejo, 408 B.R. 280 (9th Cir. BAP 2009). In addition, section 901 of the Bankruptcy Code, which incorporates other provisions of Title 11, requires that a debtor file its petition in good faith.

Further, section 921(c) provides that the bankruptcy court “may dismiss the petition if the debtor did not file in good faith or if the petition does not meet the requirements of this title.” 11 U.S.C. § 921(c)(emphasis added).

Facts

On June 28, 2012, the City of Stockton, a city with over 290,000 residents, filed for chapter 9 protection. Stockton was one of three California cities to file for chapter 9 in the summer of 2012— the others being San Bernardino and Mammoth Lakes. However, Stockton's filing represents the largest city to ever seek protection under chapter 9 of the Bankruptcy Code. Stockton's chapter 9 filing was precipitated by reliance on “bubble” economic assumptions to support significant debt obligations, spending to revitalize the city's downtown, and rising pension costs. The City was particularly hard hit by the subprime mortgage crisis and had one of the highest foreclosure rates in the nation (which, in turn, decreased tax revenues). In 2012, Stockton defaulted on its bond obligations, which resulted in the receivership of several properties owned by Stockton, including City-owned parking garages and a building intended to be the Stockton City Hall. In addition, Stockton's general fund had a $26 million deficit, which further inhibited the City's ability to service its debt obligations and continue to pay for basic municipal services.

Stockton had signaled for months that it was financially distressed and that a chapter 9 filing could be imminent. Indeed, in March 2012, Stockton commenced a neutral evaluation and mediation with certain of its creditors, as required under...