stocktoncityhallOn Friday, December 11, the Ninth Circuit Bankruptcy Appellate Panel (BAP) unanimously affirmed the order confirming the plan of adjustment of the City of Stockton. Earlier this year, Bankruptcy Judge Christopher Klein of Sacramento had confirmed the plan in an order and opinion published as In re City of Stockton, 526 B.R. 35 (Bkrtcy. E.D. Cal 2015).

Both before and during the course of the municipal bankruptcy case, Stockton negotiated compromises with virtually all its creditors, including bondholders and organized labor. However, one bondholder, Franklin Funds, did not reach agreement with the city and opposed confirmation of the plan of adjustment. One of the most contentious issues was whether Stockton’s plan was proposed in good faith when the city paid 17% of Franklin’s claim, but did not impair the pension rights of its employees or retirees. Judge Klein’s published opinion cited above was primarily devoted to that issue. He concluded that, although the city could have impaired pensions under the Bankruptcy Code, its decision not to do so was made in good faith and supported by the facts. Nevertheless, ironically by the time the case was argued and decided on appeal, that issue had faded into the background.

Franklin raised three principal arguments: 1) that the Stockton plan was not proposed in good faith, 2) that Stockton improperly classified Franklin’s claim along with dissimilar other creditors, and 3) that the plan was not in the best interests of creditors. The BAP addressed each of these arguments and concluded that Judge Klein had correctly ruled in favor of Stockton on each of them.

The contention that the plan was not proposed in good faith, as required by the Bankruptcy Code, included the question whether it was fair to substantially impair Franklin’s claim while not impairing the pensions of employees and retirees. (The pension obligation was a major debt of the city.) In connection with that argument Franklin observed that, even though both obligations arose from the same collective bargaining agreements, retirees’ health benefits were eliminated and replaced with a one percent payout in the plan, while pensions were untouched. Franklin also argued that the city’s long-term business plan showed that the reserve funds provided for in the plan could have allowed Stockton to pay Franklin in full over time.

The BAP disposed of these arguments in less than three pages of its 51-page opinion. The court concluded that, although pensions were not directly impaired by the plan, the rights of employees and retirees were either directly or indirectly adversely affected either by the plan or by concessions made by the city’s unions that reduced compensation and benefits and changed the manner of funding pensions for new employees. The court also held that, even though pensions and health benefits arose out of the same collective bargaining agreements, the two obligations involved completely different legal and factual considerations and in good faith could be treated as separate claims. The BAP also pointed out the extensive negotiations that resulted in agreements with almost all other creditors as demonstrating the city’s good faith. Finally, the BAP chose not to second-guess the city’s decision as to the amount of reserve funds it should set aside, because the future is unpredictable.

The question whether Franklin was improperly classified along with the retirees’ claims (based on their eliminated health benefits) was primarily a legal question of interpreting the Bankruptcy Code, namely whether the two claims were so dissimilar as to require separate classification. (The classification scheme allowed the retirees to out-vote Franklin, and accordingly the class accepted the plan.) The BAP concluded that both the retirees and Franklin held legally indistinguishable unsecured claims.
Finally, on the question of whether the plan was in the best interests of creditors came down to the interpretation of that phrase under chapter 9 of the Code, the municipal bankruptcy chapter. Franklin argued that a plan had to be in the best interest of each and every creditor to satisfy that requirement. The BAP disagreed. It noted that in chapter 11 corporate reorganizations the Code did provide for an individualized best interest test. But it held that the wording in chapter 9 was different and provided for a collective best interest test, and the Stockton plan clearly was in the best interests of all the creditors viewed collectively.

A large portion of the BAP’s opinion was devoted to whether the appeal was “equitably moot” and should be dismissed. That issue arose because Stockton had filed a motion requesting that the appeal be dismissed as moot, arguing that the plan had been fully consummated and it would be impossible to reconstruct the case if confirmation of the plan were reversed. The BAP rejected Franklin’s argument that the equitable mootness doctrine did not apply in chapter 9 and went on to discuss whether the appeal was moot because the plan had been consummated.

The BAP noted that there was not much case law on the question of equitable mootness in chapter 9 and that two recent courts took opposite positions in the cases of Jefferson County, Alabama, and the City of Detroit. The BAP decided that the Detroit decision 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. The BAP therefore held that the appeal was indeed moot in the sense that it was too late to undo the entire Stockton plan without creating chaos. The BAP did suggest that a very limited decision was possible that would merely require Stockton to increase the payout to Franklin without changing any other part of the plan. However, the court did not go there, because it held that the plan met all the legal criteria of chapter 9, that Judge Klein’s factual findings in support of confirmation of the plan were not erroneous and that the plan would be affirmed in all respects.

John T. Hansen practices business and municipal bankruptcy in California. He represented three of the employee unions in the Stockton, Calif., bankruptcy case. © Copyright 2015, John T. Hansen, Esq. All rights reserved. Reprinted with permission.

Rose Law APC serves as labor counsel to several City of Stockton public employee unions including Stockton City Employees Association, and Operating Engineers Local Union No. 3. Attorney Joe Rose coordinated with Mr. Hansen on behalf of City of Stockton employees and their labor organizations throughout the entire municipal bankruptcy process from pre-bankruptcy mediation to the final order approving the plan of adjustment.

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