City's Right to Reach Compromise Without Court OK 'Shrouded In Mists of Time'

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By Laura Mahoney

SACRAMENTO, Calif.--The City of Stockton's ability to settle a civil lawsuit without the bankruptcy court's permission stems from provisions in the Bankruptcy Law of 1898 that did not go away when the Bankruptcy Code displaced it in 1978, a federal judge said in a Feb. 5 written ruling (In re City of Stockton, Bankr. E.D. Calif., No. 2012-321118, opinion 2/5/13).

“The answer to the question whether a chapter 9 debtor must obtain court approval of compromises is shrouded in mists of time,” U.S. Bankruptcy Judge Christopher Klein said in a 14-page opinion that followed a ruling from the bench Jan. 30 (25 BBLR 175, 2/7/13).

The dispute between the city and its creditors likely would not have arisen before 1978, when the Bankruptcy Code displaced the Bankruptcy Act of 1898, Klein said. The Bankruptcy Code omitted some provisions from the former act because they were procedural and well established, not because they would no longer apply.

“It follows, then, that if judicial scrutiny of compromises was not required in Chapter IX cases, then none is required in Chapter 9 cases under the Bankruptcy Code,” Klein said. “The fact that the rules issued under the 1978 Bankruptcy Code abandoned the prior format of separate rules for separate chapters does not constitute a change in substantive law.”

A status conference is scheduled for Feb. 26 at the U.S. Bankruptcy Court for the Eastern District of California, in Sacramento. Klein is expected to set a schedule to hear objections to the city's eligibility for bankruptcy. 

City Can Choose to Ask For Court Approval

Klein's opinion confirms that Stockton, which filed a Chapter 9 bankruptcy petition in June (24 BBLR 890, 7/12/12), can finalize a settlement it reached with a man who sued the city alleging its police officers used excessive force on him. The ruling also applies to other city management decisions that arise during bankruptcy proceedings.

A municipal debtor can decide whether to ignore or follow Federal Rule of Bankruptcy Procedure Rule 9019 and ask the court for approval of settlements or compromises. Klein said. Either way, the debtor may need to account for such compromises during plan confirmation hearings, Klein said.

If the court required the city to get court approval for compromises or settlements, it would violate the Bankruptcy Code's prohibition on court interference with a municipality's control over its property or revenues, Klein said.

“The power to approve a compromise implies the power to disapprove a compromise,” the judge said. “And the power to disapprove is the power to interfere. And the power to interfere without consent with property or revenue is precisely what Congress has withheld in chapter 9 cases.” 

Plan Confirmation Is 'Day of Reckoning’

To address the creditors' arguments that unconstrained settlements could mean fewer resources to repay them during bankruptcy proceedings, Klein said the “day of reckoning” comes at the plan confirmation hearing.

The creditors, including Assured Guaranty Corp., Franklin High Yield Tax Free Income Fund, National Public Finance Guaranty Corp., and Wells Fargo Bank said in court filings that the city could evade Chapter 9 rules by “compromising” and paying disputed prepetition claims held by other, more favored creditors.

“In short, the capital market creditors have, in effect, given notice that they reserve the right to litigate the debtor's conduct and management and spending choices during the case at the time of the plan confirmation,” Klein said. “That is the limiting principle and the protection to which they are entitled.”

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