2015 in Review: Chapter 9

Global Publication February 22, 2016

Chapter 9 of the Bankruptcy Code provides financially-distressed municipalities protection from their creditors as they develop and negotiate a plan for adjusting or restructuring debts. These municipalities include state agencies, school districts and public improvement districts, as well as cities and counties which have issued substantial amounts of public debt. 

While Chapter 9 cases have traditionally been rare, a spike in such cases since the “Great Recession” beginning in 2007 has put the spotlight on municipalities in distress and the effect on various constituencies such as government employees, retirees and, of course, bondholders. This article summarizes significant developments in several of the large Chapter 9 cases that were closely followed during 2015 in both the bankruptcy courts and the appellate courts. Finally, this article concludes with a brief review of new legislation enacted or proposed in 2015 by certain states in reaction to legal developments in municipal bankruptcy. 

I. The “Pension Wars” Continue

2015 saw developments in the continuing saga of municipal pensioners versus bondholders in Chapter 9. Prior to the Chapter 9 cases of the City of Detroit, Michigan and City of Stockton California, discussed below, the great debate among bankruptcy professionals and scholars was whether pension rights protected by state constitutions and/or state statutes were subject to impairment in bankruptcy. The argument against impairment was that because the Tenth Amendment of the United States Constitution prohibits any federal intrusion on state sovereignty, no federal bankruptcy court may order the impairment of rights that are otherwise protected by state law. Consequently, as Detroit and Stockton and other large municipalities filed for bankruptcy, labor and retiree creditors were directly pitted against bondholders, who argued for reductions in pensions to deflect any impairment of their bonds and to help solve the municipality’s
financial issues.  

Detroit, Michigan

Detroit was the largest, and arguably, the most contentious municipal bankruptcy ever filed as it reported liabilities of over $18 billion when it commenced its Chapter 9 case on July 18, 2013. As with all Chapter 9 cases, the first fiercely litigated issue involving almost all of Detroit’s creditors was whether the city was eligible to be a Chapter 9 debtor under the Bankruptcy Code and whether it filed its petition in good faith. In arguing against eligibility and that the city did not file its petition in good faith, a myriad of labor and retiree constituencies asserted that the Michigan Constitution’s prohibition of impairment or diminution of pension rights must be respected in Chapter 9. 

On December 3, 2013, in a landmark ruling contained in a 143 page opinion, Judge Steven W. Rhodes, the bankruptcy judge assigned to the case, ruled that Detroit was eligible to be a Chapter 9 debtor. Interestingly, he also took the opportunity to rule that pension rights are contract rights under the Michigan constitution, and therefore subject to impairment in federal bankruptcy proceedings where it has long been held that bankruptcy law permits the impairment of contracts. Addressing Tenth Amendment concerns, Judge Rhodes reasoned that because the State of Michigan authorized Detroit’s federal bankruptcy filing, it implicitly acquiesced to any impairment of the city’s debts that may be impaired under federal bankruptcy law, including
pension liabilities. 

After months of extensive litigation and mediation, Detroit’s plan of adjustment was confirmed by Judge Rhodes, ultimately with the consent of almost every creditor constituency other than a number of the city’s retirees. The city revised its plan at least eight times, with several revisions occurring during the confirmation trial itself, to incorporate the many settlements with creditors, including all of its bondholder constituencies. Detroit’s final confirmed plan allowed it to shed $7 billion out of its reported $18 billion in debt and invest $1.7 billion into city service and infrastructure improvements over the next decade. In addition, it provided for, among other things, reductions of 4.5% of general service retiree pensions, elimination of cost of living adjustments and additional reduction in retiree health benefits. Detroit’s settlement with the overwhelming majority of its creditors was made possible by the “grand bargain,” a name given to a collection of several interconnected settlements, creating an $816 million fund contributed by state funds, private foundations and donors, to bolster the city pensions and prevent the sale of any of Detroit Institute of Art’s valuables during the bankruptcy. 

Nonetheless, as discussed in detail in Section II below, a few retirees and labor associations continue to contest Detroit’s plan in the appellate courts and seek full restoration of their pension benefits. 

Stockton, California

2015 was a monumental year for the City of Stockton, California, as on February 25, 2015, almost three years after filing its Chapter 9 case, Stockton’s plan of adjustment became effective and the city finally emerged from bankruptcy. Stockton’s Chapter 9 case was not without controversy. From the case’s inception in June of 2012, Stockton declared that it would not impair employee pensions administered by the California Public Employees’ Retirement System, also known as CalPERS, which makes pension payments to retired city workers. Rather, the city proposed to substantially impair employee health care claims and capital market creditors’ claims. Not surprisingly, intensive litigation ensued. However, in the Fall of 2013, after extensive negotiations and with the assistance of mediators appointed by Judge Klein (the presiding bankruptcy court judge), several large capital markets creditors settled on the treatment of
their claims under the city’s proposed plan of adjustment.  

Two funds managed by Franklin Templeton Investments, however, continued to contest Stockton’s proposed treatment of their claims. Franklin was the holder of approximately $35 million of bonds that Stockton issued to fund various city projects. Under terms of Stockton’s plan of adjustment, Franklin would receive approximately $4.35 million, the value of the collateral as determined by Judge Klein which would translate into a twelve percent recovery on their claim. However, Franklin argued that on the $30 million portion of its claim that was not secured by collateral, it was receiving a recovery of less than one percent. Franklin contended that such treatment was unfair and discriminatory under the Bankruptcy Code, given that Stockton had not provided for any impairment of CalPERS’ unsecured claims. Conversely, CalPERS and Stockton asserted that California state law prohibited any impairment of employee pensions in Chapter 9. 

Toward the end of 2014, in a series of what many viewed as landmark municipal bankruptcy decisions, Judge Klein rejected all of CalPERS’ contentions and concluded that the United States Constitution and federal bankruptcy law override any attempts by a state to limit the scope of Chapter 9. Essentially, Judge Klein ruled that once a state authorized its municipalities to utilize federal bankruptcy law to restructure its debts, it cannot then pick and choose which parts of Chapter 9 apply. Nevertheless, after holding that Stockton could have impaired the pensions of its employees and retirees, Judge Klein confirmed Stockton’s plan of adjustment in 2015, without requiring Stockton to do so. Rather, Judge Klein agreed that the city’s reasons for not impairing pensions, including the impact on employee morale and the questionable financial benefit, were supported by the evidence and made in good faith. 

Soon thereafter, Franklin appealed Judge Klein’s confirmation order to the Ninth Circuit’s Bankruptcy Appellate Panel (BAP). Franklin raised three principal arguments. First, Franklin asserted that Stockton’s plan of adjustment was not proposed in good faith, as evidenced by the considerable disparity of treatment among similarly situated unsecured creditors. Second, Franklin argued that the city improperly classified Franklin’s bond claims along with dissimilar creditors. Finally, Franklin contended Stockton’s plan was not fair and equitable and in the best interests of creditors as required by the Bankruptcy Code, arguing that “no bondholder has ever received so little in the history of municipal bankruptcy.” 

On December 11, 2015, the BAP unanimously affirmed Judge Klein’s order confirming Stockton’s plan of adjustment and disposed of Franklin’s three arguments in less than three pages of its 51-page opinion. Notably, the BAP upheld the bankruptcy court’s determination that notwithstanding the disparity in recovery for CalPERS and Franklin, the plan as a whole was proposed in good faith, and was fair and equitable and in the best interest of creditors. The bulk of the BAP’s opinion, however, was devoted to whether Franklin’s appeal was “equitably moot” and should be
dismissed, as discussed in detail in Section II below. 

San Bernardino, California

On May 29, 2015, almost three years after its bankruptcy filing in August of 2012, San Bernardino finally proposed a plan of adjustment that has engendered considerable controversy. Under the plan, the city proposed to pay certain bondholders a penny on the dollar on over $50 million in outstanding pension obligation bonds, while at the same time assuming its employee pension obligations without any impairment. Specifically, the city proposed to continue making full payments into its pension fund administered by CalPERS. Notably, the bankruptcy judge had already ruled that although the pension obligation bonds were issued to reduce the city’s underlying retirement obligations, San Bernardino’s plan of adjustment need not provide similar treatment for the pension bond claims as those of retirement obligation claims, as they are each separate and distinct legal obligations based on different types of contracts. In its proposed disclosure statement, a requisite first step in the plan confirmation process, San Bernardino noted that it carefully considered severing its relationship with CalPERS, which it may readily do under California law, but ultimately decided against it because of its desire to retain and attract quality employees. 

Unsurprisingly, several large creditors asserted that the bankruptcy court should not approve San Bernardino’s disclosure statement because the underlying proposed plan was not confirmable and was missing adequate disclosures under the Bankruptcy Code. Arguing that the plan was not confirmable, objectors primarily pointed to the large disparity in treatment of CalPERS’ claims, i.e., payment in full versus those of the holders of pension obligation bonds, i.e., a penny on the dollar. In addition, the objectors contended that the disclosure statement did not adequately explain why the city could not raise taxes or other revenues to provide a greater recovery for pension obligation bondholders. 

After two rounds of objections and bankruptcy court hearings and an amended plan and disclosure statement, on December 23, 2015, the bankruptcy court overruled the objectors’ threshold allegations that the proposed plan was not confirmable, but notably ruled in favor of the objectors that San Bernardino must revise its disclosure statement. In particular, the court required the city to provide additional information and clarify why it had arrived at a decision that it was unable to raise additional taxes or otherwise increase revenues to provide greater recoveries for pension bond claimants.

To the extent this proposed plan of adjustment moves forward in 2016, the city will have to persuade the bankruptcy court that the plan is “fair and equitable” under the Bankruptcy Code, notwithstanding the one cent on the dollar recovery for pension obligation bondholders and other unsecured creditors. 

II. In Chapter 9 Appeals, “To Moot or Not to Moot” Is the Question

A frequent issue in bankruptcy appeals is the extent to which an appeal of an order confirming a debtor’s plan is rendered moot by events that occurred subsequent to confirmation. Unless the confirmation order is stayed, it is generally effective when issued, and the plan’s proponents will typically take steps to immediately begin implementing its terms. The doctrine of “equitable mootness” requires the appellate court to consider whether “effective relief” can be granted on appeal or whether subsequent events, such as distribution of property, transfer of title to assets or other actions taken in consummating the confirmed bankruptcy plan, have occurred that would make it impossible or unfair for the appellate court to alter the bankruptcy court’s order of confirmation. The equitable mootness doctrine which is typically adhered to in Chapter 11 bankruptcy cases is important because it gives consummated plans a finality designed to reinforce confidence to creditors and new investors that a confirmed plan will not be altered after the fact. 

Jefferson County, Alabama

Although Jefferson County, Alabama, emerged from bankruptcy in December of 2013, its Chapter 9 case is still being litigated in the appellate courts. The county was able to exit bankruptcy after completing a $1.8 billion refinancing of its sewer debt - the cornerstone of its plan for restructuring debts of over $4.23 billion. A group of sewer ratepayers appealed the bankruptcy judge’s decision confirming Jefferson County’s 2013 plan of adjustment to the district court, arguing that certain covenants of the new sewer warrants issued under the plan impermissibly granted the bankruptcy judge sewer ratemaking authority that otherwise exclusively belonged to the county’s commissioners. In addition to arguing that the bankruptcy judge would have such ratemaking authority for over forty years, i.e., the last maturity date of the new sewer warrants, the ratepayers loudly complained that the plan would result in unreasonably higher rates for sewer customers for decades to come. Jefferson County promptly filed a motion with the district court requesting dismissal of the ratepayers appeal as “moot” because, among other things, the county’s plan had long since been consummated.  

In the Fall of 2014, the district court denied the county’s motion to dismiss the ratepayers appeal, ruling that while Jefferson County’s plan of adjustment had been consummated and new sewer warrants issued in the public marketplace, the constitutionality of the plan provisions that ceded the county commissioners’ authority to set sewer rates to the bankruptcy court could be reviewed and reconsidered in the appellate courts. In addition, the district court also ruled that the doctrine of equitable mootness does not apply in Chapter 9 cases, reasoning that the Chapter 11 finality concerns were inapplicable in municipal bankruptcy cases. However, the district court allowed Jefferson County to immediately appeal its ruling to the United States Court of Appeals for the Eleventh Circuit, effectively staying any consideration of the ratepayers’ appeal in the district court. 

In early 2015, the Eleventh Circuit agreed to hear Jefferson County’s appeal of the district court’s refusal to dismiss the ratepayers appeal. The county filed briefs arguing that the plan is not only “equitably” and “constitutionally” moot but also “statutorily” moot, as section 364(e) of the Bankruptcy Code provides finality for consummated post-petition financings, i.e., the new sewer warrants issued under the plan, notwithstanding, any subsequent appeals. In addition, Jefferson forcefully argued that finality concerns are even more of an issue in Chapter 9 cases, particularly under Jefferson County’s plan which provided for $1.8 billion of newly issued public debt. In an amicus brief filed with the Eleventh Circuit, the Securities Industry and Financial Markets Association (SIFMA) wrote that the district court ruling threatens the stability of the municipal bond market because it departs from accepted law regarding Chapter 9 cases and traditional interpretations of mootness. 

Watch for the Eleventh Circuit’s decision expected in early 2016 which may be the first circuit level appellate court to opine on whether the doctrine of equitable mootness applies in Chapter 9. 

Detroit, Michigan

As with Jefferson County, Alabama, the Chapter 9 case of the City of Detroit, Michigan, is still being litigated in the appellate courts. Detroit emerged from bankruptcy on December 10, 2014, ultimately with the consent of almost every creditor constituency, other than a number of the city’s retirees. As discussed above in Section I, Detroit’s plan to some extent impaired pensioners’ benefits by providing for, among other things, reductions of 4.5% of general service retiree pensions, elimination of cost of living adjustments and additional reduction in retiree health benefits. Objecting retirees, including members of the Detroit Active and Retired Employee Association (DAREA), sought full restoration of their pension benefits, even though a majority of the 20,000 retirees in the city’s pension system voted to accept the city’s plan of adjustment.  

Immediately after Detroit emerged from bankruptcy, the objecting retirees appealed the bankruptcy court’s confirmation of Detroit’s plan to the district court. In their briefing, the retirees argued that parts of the treatment of pension claims in the bankruptcy violated the Bankruptcy Code and the Michigan Constitution. Detroit, on the other hand, filed a motion in the district court requesting dismissal of the retirees’ appeal as equitably moot, as the plan had already been consummated, and that requiring the city to amend the plan would undo the city’s entire restructuring, detrimentally affect third parties and create chaos in the bankruptcy court and confusion among its citizenry. 

On September 29, 2015, Judge Bernard A. Friedman of the district court ruled in favor of the city, specifically rejecting the district court’s reasoning in the Jefferson County case and holding that the doctrine of equitable mootness does indeed apply in Chapter 9. Further, he ruled that the appeal was equitably and constitutionally moot, and that exempting pensions from the plan would “unravel the grand bargain.” Judge Friedman wrote that “the court disagrees with appellant’s suggestion that requiring the city to unimpair approximately $1.9 billion in GRS pension claims would not ‘produce a “perverse” outcome — ‘chaos in the bankruptcy court’ from a plan in tatters and/or significant ‘injury to third parties.’” In addition, the district court found that, “the relief appellant requests — sending the city back to square one to keep pensions intact — would require ‘nothing less than a wholesale annihilation of the plan.’ … Any argument to the contrary simply cannot be credited.”

The objecting retirees were not deterred and appealed Judge Friedman’s ruling to the United States Circuit Court of Appeals for the Sixth Circuit. The retirees submitted their brief essentially reiterating the arguments that they made to the district court. Detroit’s Sixth Circuit brief was supplemented with the additional precedent of the Stockton district court decision which ruled that equitable mootness applied in Chapter 9. Further briefing in the Sixth Circuit is due in January.  

Stockton, California

As discussed in Section I above, as soon as Stockton’s plan of adjustment was confirmed in early 2015, Franklin appealed Judge Klein’ confirmation order to the to the Ninth Circuit’s Bankruptcy Appellate Panel (BAP), a panel of three judges, one of whom is Judge Meredith Jury, the presiding bankruptcy court judge in San Bernardino’s Chapter 9 case discussed above. Soon thereafter, Stockton filed a motion with the BAP for dismissal of Franklin’s appeal, arguing that its plan had been fully consummated and it would be impossible to reconstruct the bankruptcy case if confirmation of the plan were reversed.  

As mentioned above, late last year, the BAP issued a 51 page opinion unanimously affirming Judge Klein’s confirmation order of Stockton’s plan of adjustment. The bulk of the BAP’s opinion was devoted to whether Franklin’s appeal was “equitably moot” and should be dismissed, as Stockton had argued. The BAP first noted that there was sparse case law on the question of equitable mootness in Chapter 9, and that two recent district courts in the cases of Jefferson County, Alabama, and the City of Detroit, Michigan, took opposite positions. The BAP decided that the Detroit decision, ruling that equitable mootness did apply in Chapter 9, was correct and further observed that cases in the Ninth Circuit Court of Appeals (the controlling appellate court over the BAP) in Chapter 11 cases also supported a finding of mootness in the Stockton case. Notably, the BAP took issue with the reasoning of the Jefferson County district court decision and agreed with Judge Friedman in Detroit that “if the interests of finality and reliance are paramount to a Chapter 11 private business entity... then these interests surely apply with greater force to [a municipality’s] Chapter 9 plan ...,” which affects countless creditors and several hundred thousand city residents. The BAP, therefore, held that the appeal was indeed moot in the sense that it was too late to undo the entire Stockton Chapter 9 plan without creating chaos in the Stockton case itself and in the larger municipal bond market.

Although many observers predicted that Franklin would appeal the BAP’s decision to the United States Circuit Court of Appeals for the Ninth Circuit and then ultimately, to the Supreme Court, it declined to do so, finally ending its lengthy battle with the City of Stockton. 

III. States Reaction to Chapter 9 - Statutory Lien Legislation 

Historically, general obligation bonds backed by a municipality’s pledge of its full faith and credit were viewed by investors as among the safest securities that municipalities could issue. However, recent Chapter 9 cases demonstrate that in bankruptcy, less than full recovery of such general obligation bonds may be a real possibility, as municipal debtors continue to argue (but have not established any precedent to date) that such bonds should be treated as unsecured claims.  Some states have reacted to these legal arguments by proposing or enacting legislation granting “statutory lien” protection to certain municipal bonds. These statutes aim to ensure that bankruptcy courts treat such bonds as secured claims. 

In bankruptcy, creditor claims are either secured or unsecured. Unsecured claims are those that are unsupported by a lien or exceed the collateral’s value and often receive among the lowest recoveries. In contrast, secured claims supported by a lien typically receive full recovery. Yet not all secured claims are created equal. Bankruptcy “cuts off” consensual liens—they do not apply to revenues received by the debtor postpetition. Statutory liens are not cut off and continue to attach to postpetition revenues. This difference is critical in Chapter 9 cases because applicable state law often forbids municipalities from pledging their physical assets to bondholders. Municipalities therefore often secure debts with liens on specified future revenues, and if the lien is a statutory lien, it continues to apply to revenues acquired postpetition, leaving bondholders relatively protected. If the lien is consensual, it is “cut off,” leaving bondholders secured only by pledged funds already on hand on the day the case is commenced. Statutory lien-based claims are thus superior to unsecured claims and claims secured by a consensual lien.

On July 13, 2015, California enacted Senate Bill 222, which declares that all general obligation bonds issued by California municipalities are protected by a statutory lien on future ad valorem property tax revenues. New general obligation bonds issued by California municipalities after January 1, 2016, will be secured by a statutory lien which automatically arises and is perfected without any required filings. Unfortunately, SB 222 is ambiguous as to whether it affects preexisting bonds. Expect litigation on that point if SB 222 is not clarified.

On August 10, 2015, New Jersey enacted its own statutory lien bill. Rather than focusing on general obligation bonds, the New Jersey law grants statutory liens to certain municipal bonds that were already “secured” by a pledge of state aid revenues appropriated for local municipalities. As with California’s SB 222, New Jersey’s statutory lien automatically arises and is perfected. Moreover, in an improvement over SB 222, New Jersey’s law “appl[ies] to all qualified bonds whether issued prior to or following enactment of that act.” That unambiguous retroactivity clause should prevent disputes over whether preexisting bonds are secured.

Late last year, the Michigan State Senate considered “House Bill 4495” which would provide for a statutory first lien on bonds that are subject to an unlimited tax pledge, and require a portion of the taxes collected to be held in trust for the owners of the municipal securities. The statutory lien would apply to any unlimited tax general obligation bonds, even those issued prior to the bill’s enactment. However, as of the date of this publication, no action on the new bill was taken by the Michigan State Senate. 

Expect more responses at the state level as legal issues under Chapter 9 are litigated and clarified.

Lawrence A. Larose is a partner in Chadbourne & Parke’s New York Office in the firm’s bankruptcy and financial restructuring group. Samuel S. Kohn is a partner in Chadbourne & Parke’s New York Office in the firm’s bankruptcy and financial restructuring group.

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