Municipal Bankruptcy: Understanding the Limited Powers of the Judiciary

From two students at our Harrisburg campus (Julia Skinner (Class of 2013) and Corey Dietz (Class of 2014)), the following post presents some insights into uncertainty about the operation of municipal bankruptcy proceedings:

Municipalities contemplating filing for bankruptcy are met with resistance because of the fear of rogue judges taking over a city’s finances and making cuts to wherever they see fit. The deteriorating financial condition of many municipalities is bringing these fears to the forefront of the minds of city employees, officials, and citizens. Because municipal bankruptcy filings are rare, many people are uninformed about exactly how municipal bankruptcy works. Unlike individuals and business entities that file for bankruptcy, municipalities that file under chapter 9, the municipal bankruptcy chapter, maintain the freedom to control their finances and property, with judicial interference being permitted only when the municipality consents. The sometimes-stated fear of a judicial takeover of a city is far from the truth of how a chapter 9 bankruptcy works. Section 904 of the Bankruptcy Code imposes limits on the federal court to assure that powers reserved to the states are honored. The section states:

[n]otwithstanding any power of the court, unless the debtor consents or the plan so provides, the court may not, by any stay, order, or decree, in the case or otherwise, interfere with- (1) any of the political or governmental powers of the debtor; or (2) any of the property or revenues of the debtor; or (3) the debtor’s use or enjoyment of any income-producing property.

11 U.S.C. § 904. This limitation bars the possibility of rogue judges and judicial control over the city functions. The case law reinforces the concept of judicial limitations and municipal freedoms.

One of the opinions in Stockton, California’s bankruptcy case illustrates these limitations. Stockton has a population of approximately 300,000 people and on June 28, 2012, it became the largest city to ever file for bankruptcy. Stockton owes more than $350 million to bond insurers. Stockton has stopped paying some bondholders and creditors have been contesting the city’s payments to state pension fund and the California Public Employees’ Retirement System, or CalPERS. California’s Stockton can pay claim opposed by bond insurers, Reuters (Jan. 30, 2013, 7:35 PM). The retired employees of Stockton brought suit as a class action by the Association of Retired Employees of the City of Stockton (ARECOS) and 8 retirees on July 10, 2012, together with an Application for Temporary Restraining Order in order to continue the payment of the retiree health benefits. In re City of Stockton, Ca., 478 B.R. 8 (2012). The city created a new budget that reduced payments to the plaintiffs. The retirees brought suit seeking an injunction prohibiting the City from implementing the retiree health benefit reduction as part of its annual operating budget. The plaintiffs filed suit claiming that they had vested contractual rights protected by the Contracts Clause of the United States Constitution to continue the payments. Id. at 13. Judge Klein noted that “the Contracts Clause bans a state from making a law impairing the obligation of contract; it does not ban Congress from making a law impairing the obligation of contract.” Id. at 15. Therefore, the Bankruptcy Clause authorizes Congress to make such laws that would impair contracts. Specifically, § 904 forbids the court from granting such an injunction, allowing a city to control their finances without judicial interference under the Bankruptcy Clause.

Although the retirees feel that they have been wronged by having their payments reduced, § 904 prevents the court’s ability to issue an injunction whether it is fair or not. Section 904 is so comprehensive that it “functions as an anti-injunction statute- and more.” Id. at 20. In short, the § 904 limitation on the court’s authority is absolute unless a city either consents or a provision in a plan of adjustment has already been proposed. Id.

The only real remedy for the retirees is to participate in the process of formulating a plan of adjustment (a plan of adjustment is the chapter 9 equivalent to chapter 11’s plan of reorganization). According to settled bankruptcy law, Stockton may “implement interim contractual modifications before the confirmation of a chapter 9 plan of adjustment but such revisions do not, as a matter of law, become permanent unless and until made part of a confirmed plan of adjustment or otherwise voluntarily agreed.” Id. at 30. Therefore, no matter how unfair it may seem to the retirees or plaintiffs in general, the judiciary’s hands are tied under § 904.

Jefferson County, Alabama, filed the largest municipal bankruptcy measured by outstanding debt in November, 2011. The court in Jefferson County’s case applied § 904 in the same manner. Jefferson County was in a dire financial state and was seeking ways to save money. The Cooper Green Hospital operated by the county was continuously spending over budget and operating at a loss. In re Jefferson County, 484 B.R. 427, 435 (2012). The county was no longer able to fund the hospital’s deficits Id. at 434. Jefferson County decided to close the Cooper Green hospital emergency room as well as end inpatient procedures. Id. at 435. Several parties, including the city of Birmingham, employees, inpatients and the mayor, sought an injunction to prevent the county from closing the hospital. Id. at 437.

In refusing the injunction, the court discussed the powers of a municipal debtor. The court found a chapter 9 debtor retains full title over property and retains control over the properties operations. Id. at 462. The freedom of the chapter 9 debtor was incorporated in § 904 along with a restriction on the bankruptcy court’s ability to interfere with a municipal bankruptcy. Id. at 462. Without a municipal debtor’s consent a bankruptcy court may not interfere with any political or governmental powers, any of its property or revenues, or its use and enjoyment of income-producing property. Id. at 463.

In a more recent Stockton opinion the court consistently applied § 904. In In re City of Stockton, the issue was whether a Chapter 9 municipal debtor must obtain court approval under Federal Rule of Bankruptcy Procedure 9019 of any compromise or settlement the municipality makes during the course of the bankruptcy. In re City of Stockton, California, 486 B.R. 194, 195 (2013). The City of Stockton had agreed to settle a lawsuit for $55,000. Id. The capital market creditors claimed that the city must make a motion under Rule 9019 for court approval of the settlement. Id. The city’s contention was that Rule 9019 did not apply in chapter 9 cases unless the city sought court approval. Id. The court held that Rule 9019 applies to municipal bankruptcy cases only if the municipality consents to the court considering approval of a settlement or compromise. Id. at 197. However, when a chapter 9 debtor files a Rule 9019 motion to have a court approve a compromise the municipality can consent to judicial interference. Id. The court also held the city can expend its property and revenues during the chapter 9 case in any way it wants. Id. at 198. The court in this Stockton opinion maintained that the judiciary could only interfere with a municipal bankruptcy when the municipality consents to the interference.

The courts are steadfast in their interpretation of § 904 prohibiting judicial interference with a municipal bankruptcy unless the municipality consents to the interference. The fears that are prevalent among city leaders and the general public of judicial control and dominance are unfounded. Judges may not step in and control the city’s finances directly after a city has declared bankruptcy. Through § 904, Congress ensured the judiciary’s hands are tied allowing the municipality to maintain control over its property and revenues.

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