By: John Boersma
St. John’s Law Student
American Bankruptcy Institute Law Review Staff
In a proceeding requiring the municipality of Stockton (the “City”) to establish its eligibility for chapter 9 relief under sections 109(c) and 921(c) of the Bankruptcy Code, the Bankruptcy Court of the Eastern District of California held that the City met its requirement of negotiating in good faith with its creditors.[1] When the City was set to end the fiscal year with a deficit of over $8,000,000,[2] the City manager, “ask[ed] the City Council to initiate the neutral evaluation process under California [law],” which the City needed to complete before it filed for Chapter 9 relief.[3] This request was approved, and the City began the neutral evaluation process by presenting a proposed adjustment plan describing how it would deal with the affected parties.[4] In response to this proposal, two capital creditors refused to negotiate unless the City include in its plan an impairment of its pension obligation to the California Public Employees’ Retirement System (“CalPERS”).[5] Upon the completion of the neutral evaluation process, the City filed a chapter 9 petition.[6] Four creditors objected to the petition granted, alleging the City was ineligible to be a debtor under chapter 9, arguing that the City failed to negotiate in good faith.[7] Rejecting this argument, the court not only held that the City had satisfied the requirement to negotiate in good faith, but also concluded that the City’s creditors had a reciprocal duty to negotiate in good faith.[8]
The requirement for a California municipality to negotiate in good faith in order to be eligible for chapter 9 relief is found in two statutes. The first place the requirement is found is under the California statute authorizing a municipality to be a debtor.[9] California law authorizes its municipalities to be chapter 9 debtors after undergoing a neutral evaluation process, which involves good faith negotiations by all parties involved.[10] The Stockton court interpreted this to mean that “good faith negotiation in the California neutral evaluation process is a two-way street.”[11] Because the capital creditors had refused to negotiate, the court reasoned that they could no longer complain about the City’s failure to negotiate in good faith.[12] As a result, the Court held that the City met its good faith requirement under California law.[13]
The second requirement for a municipality to negotiate in good faith is found in section 109(c)(5)(B) of the Bankruptcy Code.[14] Unlike the California statute, section 109(c)(5)(B) does not explicitly require that “all interested parties” are to negotiate in good faith. Rather, it merely requires the municipality seeking chapter 9 relief to negotiate in good faith.[15] The Stockton court, however, reasoned that “good faith negotiations contemplate reciprocity.”[16] As a result of this reciprocity, if creditors decline “to respond in good faith to a good faith proposal by [a] municipality,”[17] the court will likely find the municipality has met its requirement of good faith negotiations under section 109(c)(5)(B).[18] Accordingly, the court, found that the City had satisfied section 109(c)(5)(B), because the City’s offer to the capital creditors who refused to negotiate was made in good faith.[19]
In holding that the City satisfied its requirement of negotiating in good faith with its creditors, the Stockton court imputed upon the creditors a reciprocal duty, under section 109(c) of the Bankruptcy Code, to negotiate in good faith.[20] This reciprocal duty is a novel one that had previously existed only under California law.[21] In effect, the Stockton court applied California’s requirement of reciprocal good faith negotiations to all municipalities filing for chapter 9 relief. While §109(c)(5)(B) does not, by its terms, require the creditors to negotiate in good faith, the court reasoned that the City’s requirement to negotiate in good faith imputes upon the City’s creditors the duty to negotiate in good faith as well.[22] As such, creditors should ensure that they also negotiate with municipal debtors in good faith, which likely requires that the creditors respond to any and all proposed plans to adjust a municipality’s debts.
[1] In re City of Stockton, 493 B.R. 772, 777 (Bankr. E.D. Cal. 2013) (noting “that the City carried its burden to establish the elements required for an order for relief”); While there are five requirements that must be met under 11 U.S.C. § 109(c), this note will focus exclusively on the section 109 requirement dealing with good faith.
[2] Id. at 780-81 (noting that Deis’s memorandum explained that while service reductions are an easy target in order to bridge the deficit gap, further service cuts “simply pose too much of a safety risk to [Stockton’s] citizens”).
[3] Id. at 780 (stating that “the neutral evaluation process is one of two alternatives preliminary to filing a municipal debt adjustment case under chapter 9 of the Bankruptcy Code”).
[4] Id. at 782. Under the proposed plan, the City promised to eventually make whole two of its capital creditors, National Public Finance and Assured Guaranty, but refused to pay debt service after varying amounts of time.
[5] Id.
[6] Id. at 783.
[7] Id. at 783-4 (documenting objectors two arguments that City failed to negotiate in good faith: First, “any proposal that would impair the rights of capital markets creditors without simultaneously impairing CalPERS is not made in good faith. Second, … the City’s proposal was made on a take-it-or leave-it basis without the intention of actually negotiating”).
[8] In re City of Stockton, 493 B.R. at 793 (asserting that the “good faith negotiation obligation is satisfied with respect to any class of putatively impaired creditors that declines to respond in good faith to a good faith proposal by the municipality”).
[9] While Chapter 9 eligibility is governed by the federal Bankruptcy Code, §109(c)(2) of the Bankruptcy code states that “[a]n entity may be a debtor under chapter 9 of this title if and only if such entity is specifically authorized … to be a debtor under such chapter by State law.”
[10] Cal. Gov’t Code §53760.3(o) (requiring “[t]he local public entity and all interested parties participating in the neutral evaluation process [to] negotiate in good faith”).
[11] In re City of Stockton 493 B.R. at 785.
[12] Id. at 787 (stating that the creditors failure to negotiate in good faith constituted a “waive[r] of the right to complain about the City’s performance during the California pre-filing negotiation process”)
[13] Id. (holding that “the City has proved by a preponderance of the evidence that it honored the requirements of the California neutral evaluation process”).
[14] 11 U.S.C. § 109(c)(5)(B) (requiring that in order to be eligible for Chapter 9 relief the party must engage in good faith negotiations that “fail[] to obtain the agreement of creditors holding at least a majority in amount of the claims of each class that such entity intends to impair under a plan in a case under such chapter”).
[15] Id. (stating that “[a]n entity may be a debtor under Chapter 9 of this title if and only if such entity has negotiated in good faith…”).
[16] In re City of Stockton 493 B.R. at 793.
[17] Id.
[18] Id. (stating that because “good faith negotiations contemplate reciprocity … [i]t follows that, as a matter of law, a municipality’s §109(c)(5)(B) good faith negotiation obligation is satisfied with respect to any class of putatively impaired creditors that declines to respond in good faith to a good faith proposal by the municipality”).
[19] Id.
[20] Id. (noting that “[j]ust as it takes two dancers to tango, good faith negotiations contemplate reciprocity).
[21] Cal. Gov’t Code §53760.3(o)
[22] In re City of Stockton 493 B.R. at 793, (noting that at trial the creditors had asserted that the §109(c)(5)(B) good faith obligation is only applicable to the City, and responding that this assertion was incorrect because “good faith negotiations contemplate reciprocity”).
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