[authors: Alan Martin and Matthew Holbrook]

The Stockton, California City Council has now authorized the filing of a Chapter 9 bankruptcy petition. Many parties affected by a potential filing by other similarly situated California public entities are seeking to understand the process that precedes a Chapter 9 filing and how to plan for a possible filing. This summary provides an overview of the protocol before a California entity may file for Chapter 9 protection.

To file for Chapter 9 bankruptcy protection, a municipality must satisfy both federal and state eligibility criteria. The federal eligibility rules are set for in § 109(c) of the Bankruptcy Code: The debtor must be a municipality, must specifically be authorized to file a Chapter 9, be insolvent and be willing to effect a plan to adjust its debts. In addition, the municipality must satisfy one of the following four requirements: (1) the debtor has obtained the agreement of creditors holding at least a majority in the amount of claims of each class that the debtor intended to impair through its plan; (2) the debtor has negotiated in good faith but failed to obtain the agreement of creditors holding at least a majority in the amount of claims of each class that the debtor intended to impair under its plan; (3) the debtor was unable to negotiate with its creditors because such efforts were impracticable; or (4) the debtor reasonably believes that a creditor may attempt to obtain a preferential payment.

The Code’s “specifically authorized to be a Chapter 9 debtor” requirement refers to state law eligibility rules. In California, a new law requires that distressed municipalities seeking bankruptcy protection must undergo a 60-day mediation with creditors before they may file a Chapter 9 petition. Municipalities must participate in the mediations unless they are facing a fiscal emergency. The City of Stockton, for example, engaged in this required mediation process without success. This law was adopted with the hope that pre-filing mediations would ease the length, cost and consequences of a municipality’s bankruptcy on all interested parties. Together, the state and federal eligibility criteria shape the process through which a municipality files for bankruptcy in California.

The impact of the 60-day mediation requirement is largely felt by those municipalities which are not yet insolvent but which are fiscally distressed. Such municipalities must enter into the mediation under California law and negotiate in good faith under federal law. Because the municipality must spend at least 60 days in mediation, it cannot threaten to pull out of the mediations during that time frame, absent the fiscal emergency referenced above. Moreover, because of the federal good faith requirement, it is unlikely that the municipality could simply initiate the mediation process and then take no action; neither could it initiate the mediation process but thereafter engage in conduct which tended to thwart the purposes of the mediation.

The 60-day mediation requirement may obviously create certain hardships for municipalities and their residents. Some municipalities may need to drastically cut services to residents in order to maintain solvency during the mediation process. The City of Stockton, for instance, is reportedly operating its police force at approximately 60% of suggested staffing levels. To address residents’ safety concerns, the City has adopted a “Marshall Plan” to reduce crime and increase public safety, despite the reduced police force. Other distressed municipalities may likewise seek to turn to strategic alternatives to alleviate the effect of service cuts.

While the municipality may find that it initially has less leverage since it has no immediate recourse to bankruptcy, its leverage will likely increase – and creditors’ leverage will likely decrease – as the mediation period winds down. If the municipality ends up in bankruptcy, under the Code it has the exclusive right to propose a plan of adjustment. Neither creditors nor the court may control the daily affairs of a municipality directly, and may not do so indirectly by proposing a plan of adjustment of the municipality's debts that would govern the municipality's future taxes and expenditures. Thus, it is generally in the creditors’ best interest to work with, and not against, the municipality during its mediation window to reach a non-bankruptcy solution.