Stockton, California, Ruling: Bankruptcy Court Powerless To Prevent Retiree Benefit Reductions By Municipal Debtor

Amid the economic hardships brought upon us by the Great Recession, the plight of cities, towns, and other municipalities across the U.S. has received a significant amount of media exposure. The media has been particularly interested in the spate of recent chapter 9 bankruptcy filings by Vallejo, Stockton, San Bernardino, and Mammoth Lakes, California; Jefferson County, Alabama; Harrisburg, Pennsylvania; and Central Falls, Rhode Island. A variety of factors have combined to create a virtual maelstrom of woes for U.S. municipalities—a reduction in the tax base caused by increased unemployment; plummeting real estate values and a high rate of mortgage foreclosures; questionable investments; underfunded pension plans and retiree benefits; decreased federal aid; and escalating costs (including the higher cost of borrowing due to the meltdown of the bond mortgage industry and the demise of the market for auction-rate securities). Addressing any one of these issues is a challenge for a municipality. Together, the burden has been too great for some municipalities to bear.

One option available to certain municipalities facing potential financial catastrophe is to seek relief under chapter 9 of the Bankruptcy Code. Chapter 9 for a long time was an obscure and little used legal framework, but it has grown more prominent in recent years as an option for struggling municipalities. Chapter 9 allows an eligible municipality to "adjust" its debts by means of a "plan of adjustment," similar in many respects to a plan of reorganization in a chapter 11 bankruptcy case. However, due to constitutional concerns rooted in the Tenth Amendment's preservation of each state's individual sovereignty over its internal affairs, the resemblance between chapter 9 and chapter 11 is limited.

This inherent constitutional tension was the subject of a ruling recently handed down by a California bankruptcy court. In In re City of Stockton, California, 478 B.R. 8 (Bankr. E.D. Cal. 2012), the court held that: (i) the debtor city could unilaterally reduce the benefits of its retirees without offending the Contracts Clause of the U.S. Constitution (even where those benefits otherwise may be considered contractual in nature under state law); and (ii) the court was not permitted to enjoin the debtor from implementing the benefit reductions due to the express limitations on a bankruptcy court's jurisdictional mandate in chapter 9 cases. The court also affirmed the jurisdiction of bankruptcy courts to make such determinations and declined a request to cede jurisdiction of this dispute to state courts in California.

MUNICIPAL BANKRUPTCY LAW

Ushered in during the Great Depression to fill a vacuum that previously existed in both federal and state law, federal municipal bankruptcy law has been plagued by a potential constitutional flaw that endures in certain respects to this day—the Tenth Amendment reserves to the states sovereignty over their internal affairs. This reservation of rights caused the U.S. Supreme Court to strike down the first federal municipal bankruptcy law as unconstitutional in Ashton v. Cameron County Water Improvement Dist. No. 1, 298 U.S. 513 (1936), and it accounts for the limited scope of chapter 9, as well as the severely restricted role the bankruptcy court plays in presiding over a chapter 9 case and in overseeing the affairs of a municipal debtor.

The Supreme Court later validated a revised municipal bankruptcy statute in United States v. Bekins, 304 U.S. 27 (1938), concluding that revisions to the law designed to reduce the opportunity for excessive federal control over state sovereignty struck a constitutionally permissible balance. The present-day legislative scheme for municipal debt reorganizations was implemented in the aftermath of New York City's financial crisis and bailout by the New York State government in 1975, but...