In June, 2012, Stockton California filed a bankruptcy case under chapter 9.  While businesses and individuals are entitled to file bankruptcy petitions without bankruptcy court approval, the same is not true for municipalities.  They can only be debtors if, among other things, the majority of their creditors agree; they negotiate in good faith and fail to obtain majority agreement; negotiation is impracticable; or a creditor is attempting to obtain a voidable preference.  In addition, the bankruptcy court can dismiss a municipality’s petition if it was not filed in “good faith.”

In the Stockton case, the city argued that it was entitled to be a debtor because of the second test described above: that it had negotiated in good faith but failed to obtain majority consent.  At the beginning of the case, the bankruptcy judge deferred decision on the issue, instead directing that the objecting creditors and the city engage in mediation. 

Following that long mediation process, the bankruptcy court on April 1, approximately 10 months after the original filing, determined that Stockton was indeed an appropriate municipal debtor.  The court focused on the municipality’s “financial distress,” subject to “fiscal emergencies,” to stop the “hemorrhage of funds.”    

The court determined that Stockton had negotiated in good faith.  It had participated in a pre-filing mediation process under California law, which authorizes municipalities to file chapter 9 petitions either after undergoing such a process or after the declaration of a fiscal emergency followed by a vote of the governing board.  The court specifically found that the bondholders had not negotiated in the process in good faith, so that they had no right to complain.  Because negotiation is a “two-way street,” the court did not allow the bondholders to successfully argue that the city was not negotiating in good faith, when they themselves had first declined to negotiate.  One fact that the court pointed to that supported the city’s good faith was that they did reach substantial agreements in the process on the collective bargaining agreement.  Another fact pointed to by the judge was that the city desperately needed to negotiate in good faith because of its fiscal needs, so that it makes no sense to believe the city is playing some kind of game.

Finally, the court addressed the argument of the bondholders that the city was in bad faith because it had determined that its restructuring would not reduce its pension obligations to CalPERS.  The court said that it was not appropriate for the bondholders to stop negotiating just because the city’s position was that it would not consider impairing CalPERS.  The protection for the bondholders will be in the plan confirmation process that is the next step, where the issue will be whether creditors are being treated fairly.  At that time, the CalPERS issue will come to the forefront in the bankruptcy case.

The bankruptcy judge’s recent decision is important mostly for what it did not do.  It did not send Stockton out of bankruptcy.  The judge himself said that what has happened in the case to date is merely “a qualifying round” leading to what is to come: that is, the city’s attempt to achieve approval of a plan of adjustment under chapter 9.  The court’s view of the future of the case is that there will be a continued “substantial litigation process” with the court to resolve issues of whether the creditors are being dealt with fairly and not unreasonably discriminated against.

Under Ohio law, an Ohio municipality must petition and obtain the approval of the state tax commissioner before it is authorized to file for federal bankruptcy protection.