By Aaron Kleven

The bankruptcy of the largest U.S. city to file a chapter 9 bankruptcy petition has yielded a decision with serious implications for municipal creditors. Specifically, the United States Bankruptcy Court for the Eastern District of California overruled the objections asserted by retired employees of the City of Stockton, California and authorized the City to suspend the retiree’s health benefits during the City’s Chapter 9 case. Ass’n of Retired Employees of the City of Stockton, et al. v. City of Stockton, California (In re City of Stockton), 56 Bankr.Ct.Dec. 250 (Bankr. E.D. Cal.). Bankrutcy Judge Klein acknowledged the potential hardship to the retirees, but citing Section 904 of the Bankruptcy Code stated that the court has no power to interfere with the property or revenues of the debtor during Chapter 9.

Stockton joined a growing trend by filing for Chapter 9 protection on June 28, 2012. During course of its bankruptcy case, the City implemented a new budget, which featured significant spending cuts, including a unilateral reduction of existing retiree health benefits. In response, the Association of Retired Employees of the City of Stockton, along with other retirees, filed an adversary proceeding as a class action with the Bankruptcy Court, seeking to enjoin the suspension of the retiree’s health benefits.

The retirees contended that retirement benefits are vested contract rights, protected from impairment by the Contracts Clause of the U.S. Constitution, which precludes a state from impairing contract obligations. However, the Bankruptcy Court held that the Contracts Clause does not protect contract obligations from federal interference. The Court explained that, although the suspension of benefits may have been a state action, the protection of the bankruptcy process amounts to federal action, thereby trumping the Contracts Clause.

The Court went on to describe the constraints of Sections 903 & 904 of the Bankruptcy Code, which restrict federal courts from interfering with the political or governmental powers of a municipal debtor, the property or revenues of the debtor, or the debtor’s use or enjoyment of income producing property, regardless of whether the debtor’s action is fair.

In reaching this decision, the Court distinguished the temporary restraining order issued in the Orange County bankruptcy, Orange Cnty. Emps. Ass’n v. Cnty. Of Orange (In re Cnty. Of Orange), 179 B.R. 177, 185 (Bankr. C.D. Cal. 1995), on the grounds that the TRO issued therein concerned the employment status of the County’s employees, rather than the County’s property or revenues.

The Court similarly rejected the retiree’s argument that Bankruptcy Code Section 1114, which requires a Chapter 11 debtor to pay insurance benefits to retired employees during the case, mandates continuation of the retiree’s health insurance benefits, explaining that such Code provision does not apply to a Chapter 9 debtor.

This decision gives Chapter 9 debtors a great deal of flexibility to modify the rights of contractual counterparties, making Chapter 9 potentially even more unfavorable to creditors than the more well-traveled chapters of the bankruptcy code. Though municipal debt has traditionally been stable, the creditor-hostile nature of Chapter 9 should give potential creditors pause. If municipal bankruptcies continue to become more commonplace, creditors of various stripes — including institutional lenders, contractors, individual bond-holders, and workers negotiating compensation and pensions — would be wise to reevaluate their investment strategies so as to account for the greater risk of payment default or non-consensual credit modification.

Geraldine A. Freeman, Practice Group Leader  
415.774.2966 (office)

Alan H. Martin, Practice Group Leader 
714.424.2831 (office)

Todd L. Padnos, Editor 
415.774.2938 (office)