With a population of approximately 300,000, Stockton, Calif., is the largest city in the United States to seek bankruptcy protection. Since its filing last June, municipal advisers have closely monitored the city of Stockton’s Chapter 9 bankruptcy proceeding in In re City of Stockton, Calif., Case No. 2012-32118 (U.S. Bankr. E.D. Cal. 2012), because its problems, including substantial bond debt and outsized pension obligations, are far from unique.

Although there are sure to be many significant developments during this case, U.S. Bankruptcy Judge Christopher M. Klein of the Eastern District of California on April 1 resolved a key threshold question through an order that confirmed that Stockton is eligible for protection under Chapter 9. Klein entered findings of fact and conclusions of law orally on the record and a short time later issued the order, which provides some insight into the practical application of Chapter 9 and may encourage other similarly situated municipalities to move forward with their own bankruptcy filings.

Chapter 9 provides municipal debtors with flexibility not available to debtors under other chapters of the Bankruptcy Code, including: the ability to operate in bankruptcy with minimal judicial oversight while still protected by the automatic stay; freedom from the risk of a competing plan, liquidation or the appointment of a trustee; the ability to settle pre-bankruptcy claims without court approval; and the absence of many other controls that normally act as a check upon a debtor during a bankruptcy reorganization case. Nevertheless, Chapter 9 cases are infrequently filed as compared to other cases under the Bankruptcy Code. The limited use of Chapter 9 is attributable to a myriad of factors, one of which is that eligibility for Chapter 9 is a threshold issue, and, as was seen in the Stockton matter, often hard-fought between creditors and the municipal debtor.

In order to qualify for protection under Chapter 9, the debtor must be a municipality and it must also: (1) be specifically authorized by the state to be a debtor under Chapter 9; (2) be insolvent; (3) desire to effect a plan to adjust its debts; and (4) be able to demonstrate either that it (i) has obtained agreement from creditors holding a majority of the claims in each class intended to be impaired, (ii) has negotiated in good faith to obtain the agreement of creditors holding at least a majority in amount of claims in each class the entity intends to impair, (iii) was unable to negotiate with creditors because such negotiation is impracticable, or (iv) reasonably believes that a creditor may try to obtain a preferential payment.

In the four years preceding its Chapter 9 filing, Stockton implemented a number of cost-saving measures to address its budget deficit, including employee compensation and job cuts, municipal service and maintenance reductions, and retiree payment deferrals. Although these efforts reduced its deficit by $90 million, according to briefs filed by the city, a projected $26 million shortfall remained in the 2012-13 fiscal year budget. In addition, a bond default had occurred.

In compliance with California’s recently enacted law authorizing municipalities to file a Chapter 9 petition, Stockton engaged in pre-bankruptcy negotiations and subsequently mediation with creditors. During mediation, Stockton produced a detailed restructuring plan and proposed budget, both of which would become important later during the bankruptcy eligibility fight. The mediation process failed, thus leading to Stockton seeking Chapter 9 protection.

After Stockton filed, a group of creditors, largely composed of those who had insured the bonds on which the city had defaulted, challenged Stockton’s Chapter 9 eligibility, arguing that the city had failed to prove insolvency, failed to satisfy the requirement of pre-bankruptcy creditor negotiations, and failed to file in good faith.

The creditors argued within their briefs that the city was not insolvent and that nonbankruptcy solutions such as serious budget reform and revenue enhancements were a viable alternative to bankruptcy. The creditors also contended that the city had not exhausted these nonbankruptcy alternatives prior to filing. In response, Stockton argued that any deeper cuts would have harmed the health, safety and welfare of the community, and that tax increases were not a realistic option. Perhaps the most contentious issue stemmed from the proposed less favorable treatment of the bond insurer’s claims as compared to that of Stockton’s pension-related obligations. The California Public Employees’ Retirement System (CalPERS), administrator of California’s public employees’ retirement system, is the city’s largest creditor. The voluminous and detailed proposed restructuring plan put forth by Stockton was central to the city’s argument that pre-petition negotiations had been in good faith. In contrast, the creditors claimed that the contents of the plan revealed a lack of good faith in those negotiations, contending that Stockton had not negotiated with CalPERS, and that the restructuring plan failed to seek any concessions from CalPERS. CalPERS and Stockton each responded, stating that negotiations would have been fruitless, because the contract between Stockton and CalPERS was executory, and moreover, applicable state law prohibits any alteration of the CalPERS obligations.

The bankruptcy court found that the city was eligible for Chapter 9 protection. In his oral findings of fact and conclusions of law placed on the record, Klein concluded that the city was insolvent and had undertaken sufficient pre-petition good-faith negotiations even though there were apparently no negotiations with CalPERS. The court also noted that an objecting group of creditors themselves failed to negotiate in good faith as evidenced by their refusal to negotiate with Stockton unless and until the claim of CalPERS was likewise impaired (a finding that has since been challenged by the objecting creditors). The court, however, while finding that disparate treatment among creditors is not an eligibility issue, stated that this issue could well become relevant when a Chapter 9 plan is presented for confirmation.

The Stockton matter is significant on a number of fronts. It reaffirms the importance of a well-developed plan as a basis for pre-petition negotiations. In addition, it shows that serious steps must be taken before bankruptcy to reduce expenses and increase revenue. With those steps taken in advance and assuming pre-bankruptcy negotiations fail, then Chapter 9 offers relief not otherwise available under the laws of most states, including the ability to alter and reduce certain contract obligations. Whether Chapter 9 can be used, however, to alter statutory statewide pension programs remains a key question that is yet to be answered. •

Francis J. Lawall, a partner in the Philadelphia office of Pepper Hamilton, concentrates his practice in national bankruptcy and reorganization matters. He recently co-authored A Collier Monograph: Debt Adjustments for Municipalities Under Chapter 9 of the Bankruptcy Code.

Justin C. Esposito is an associate in the Philadelphia office of the firm, concentrating in estate and business succession planning. He was also a contributing author on A Collier Monograph.