Stockton Bankruptcy Sanctioned by Judge

April 8, 2013Alerts

On Monday, April 1, Judge Christopher Klein ruled Stockton eligible for Chapter 9 bankruptcy protection. The decision came nine months after the city filed for bankruptcy and followed a three-day evidentiary hearing pitting the city against the capital markets creditors who represented the holders of tens of millions of dollars in municipal bonds.

The bondholders had argued, among other things, that the city was not eligible for bankruptcy because it did not take all possible steps to reduce costs and it did not negotiate in good faith prior to filing bankruptcy because it had not sought a reduction of its obligation to make payments to CalPERS — the state’s employee pension fund.

Decision Comes Down

Judge Klein took two hours to present his detailed findings of fact and conclusions of law from the bench. First, he went through a lengthy description of the city’s financial state as far back as 2008, noting the difficulties plaguing the city in recent years. Despite several declarations of fiscal emergencies and numerous attempts to reduce costs through furloughs and reduction of staffing and benefits, the city still watched revenues drop so low that it was looking at over $8 million in deficit for the current fiscal year with a projected $20 million to $38 million deficit in the next fiscal year.

The city showed that it was insolvent by three different measures: (1) from a “service delivery” perspective (the city was unable to pay for all of the costs of providing services at the level necessary to maintain the health, safety and welfare of the community); (2) from a budgetary perspective (the city could not create a budget under which it would be able to have sufficient revenues to pay expenses that would occur over the budget period); and (3) on a cash basis (the city was not able to generate and maintain cash balances allowing it to pay expenditures as they become due).

Judge Klein concluded – by a preponderance of the evidence – that the city met each of the threshold eligibility requirements in Bankruptcy Code §109(c), specifically that it (1) is a municipality (2) is authorized by the state to be a debtor under Chapter 9; (3) is insolvent; (4) desires to implement a plan to adjust its debts and (5) has negotiated with its creditors to the greatest extent possible.

Judge Klein also noted that the petition was filed in good faith and therefore did not run afoul of Code §921(c).

What Happens Next?

With this decision in hand, the city must now formulate a plan of adjustment that can be confirmed by the court. In that vein, Judge Klein forewarned the city of potential difficulties it may face in attempting to present a plan of adjustment that impairs the bondholders but leaves CalPERS payments intact. He reminded the city that the “day of reckoning” would come at plan confirmation, noting that plan confirmation is governed by Bankruptcy Code §1129(b)(1) and that a plan could not succeed if it unfairly discriminates against a class of creditors.

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As this story progresses, Michael continues to provide commentary to national publications. Read or listen to more of his thoughts in a sampling of the press below: