10 Practical Lessons for Cities Facing Bankruptcy – From a New Ninth Circuit Ruling

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Pointing the way

By: Donald L. Swanson

The Ninth Circuit Court of Appeals, in a new ruling, helps point-the-way for cities facing the complexities of Chapter 9 bankruptcy.

The Facts

On March 28, 2003, three citizens of Vallejo, California, have a violent encounter with two of Vallejo’s police officers.  A lawsuit ensues.

Then, the City of Vallejo files Chapter 9 bankruptcy and achieves a confirmed bankruptcy plan.

Then, the lawsuit results in a judgement for one of the plaintiffs.

The New Ninth Circuit Ruling

Legal wranglings about the judgment result in a September 8, 2016, ruling by the Ninth Circuit Court of Appeals in a case captioned Deocampo v. Potts (Case No. 14-16192).

The Ninth Circuit’s Deocampo v. Potts ruling addresses a narrow issue.  Yet, practical lessons for cities facing Chapter 9 bankruptcy can be gleaned from it.

10 Practical Lessons

Here are ten of such practical lessons.

Lesson # 1.  Mediation is an essential tool for resolving Chapter 9 cases.  As in other Chapter 9 cases, mediation plays a central role in achieving a confirmed plan in the City of Vallejo’s bankruptcy.

Lesson # 2.  There is no such thing as an “involuntary” Chapter 9 bankruptcy.  A Chapter 9 case can begin only by the municipality filing a voluntarily Chapter 9 petition, with authorization from the state and with a desire “to effect a plan to adjust” its debts (11 U.S.C. §§ 109(c)(4), 301 & 921).

Lesson # 3.  A city in bankruptcy, unlike a business debtor, cannot resolve its financial problems by liquidating its assets and terminating operations.  A city must continue operating and meeting the needs of its citizens.

Lesson # 4.  A city in bankruptcy can confirm it’s Chapter 9 plan without the consent of its creditors (11 U.S.C. §§ 109(c)(5) & 943).

Lesson # 5.  The primary plan confirmation standard in Chapter 9 is this: the plan must be, (i) “in the best interests of creditors,” and (ii) “feasible” (11 U.S.C. § 943(b)(7)).  This standard provides neither precision nor clarity.   The Ninth Circuit explains such imprecision and lack of clarity like this in Deocampo v. Potts:

“Our case law construing Chapter 9 is scant, and this appeal confronts us with a novel legal issue, of the kind that often surfaces when changing social and economic conditions awaken dormant statutes. But Chapter 9 has awakened, and we do not presume further disputes over its interpretive and practical complexities will remain long at rest.”

Lesson # 6.  When a Chapter 9 plan is confirmed, the City is discharged from debts that aren’t “excepted from discharge”  by the confirmed plan (11 U.S.C. § 944(b), (c)(1)).

Lesson # 7.  At least two large municipalities, Detroit and San Bernardino, have expressly discharged  the claims of citizens against their police officers for misconduct.

Lesson # 8.  If a city wants to make an attempt at discharging its police officers from misconduct liability, the city must make explicit provision for such a discharge in its Chapter 9 plan.

Lesson# 9.  An ambiguity in a bankruptcy plan drafted by the city is construed against the city.

Lesson # 10.  A city’s commitment, made after confirmation of its Chapter 9 plan, to defend and indemnify a police officer is unimpaired by the terms of its confirmed plan.

Conclusion.

Thanks to the Ninth Circuit for pointing-the-way on various complexities of the newly-awakened Chapter 9 statutes.

Links to prior articles on this Chapter 9 city-bankruptcy subject are:

Part 1:  Police Abuse Claims and Municipal Bankruptcy — A New Report

Part 2:  Will Police Misconduct Liability Allow a City to File Bankruptcy? — “Insolvent” Eligibility Standard

Part 3:  Can a City File Bankruptcy to Deal With Police Misconduct Liability? — “Good Faith” Requirement

 

Can a City File Bankruptcy to Deal With Police Misconduct Liability? — “Good Faith” Requirement (Part 3 of 3)

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11 U.S.C. Sec. 921(c) — “Good Faith” Requirement for Municipal Debtors

By Donald L. Swanson

“[I]t is unlikely that a city could file for bankruptcy solely for the purpose of shedding liability associated with unconstitutional police practices.”

–Conclusion in a Report, dated 8/21/2016 and titled: “Who Pays for Police Misconduct in Bankruptcy Cities?

This conclusion is undoubtedly accurate when a City is capable of paying the judgment. In such a context, a City’s bankruptcy filing would violate the “good faith” requirement of 11 U.S.C. § 921(c).

But this conclusion seems unlikely to prevail in the context of an exceedingly-large judgment amount against a City that can’t be paid.

Hypothetical

Imagine this hypothetical:

A City and its police officers are sued by a group of plaintiffs for violating the plaintiffs’ civil rights.
Jury verdicts are for many-millions of dollars—amounts that are multiple times the City’s annual budget.
Plaintiffs start executing on the judgements: garnishing the City’s checking accounts, attaching and selling the City’s office furniture, computers, police cars and fire trucks, etc.
The City has been trying for many months to pay the judgments:  seeking loans, seeking buyers for non-essential assets, raising taxes — but nothing works. The City, simply, cannot find enough money to pay the judgments.
So . . . in addition to the judgments remaining unpaid, the City is now unable to provide the basic services its citizens require.

In this hypothetical, it’s difficult to imagine how any court could find the City’s bankruptcy filing to lack “good faith.”

“Good Faith” in Chapter 11

The “good faith” standard is well-worn in the Chapter 11 context. Like Chapter 9, a Chapter 11 case can be dismissed because of the debtor’s lack of “good faith.”

In re Mense and Cottonsmith, LLC

For illustration and analogy, the 2014 Chapter 11 case of In re Mense and Cottonsmith, LLC,  seems helpful. In Mense and Cottonsmith, a business and its owner filed Chapter 11 bankruptcies to stop execution on a $3 million judgment. The debtors had appealed the judgment but couldn’t post a supersedeas bond to stop collection efforts during appeal.

The Bankruptcy Court’s discussion of “good faith” in Mense and Cottonsmith includes the following:

The “Good Faith” Standard:

–“The majority of bankruptcy courts tackling this issue have held that the filing of a chapter 11 petition as a litigation tactic to circumvent the requirement of an appeal bond in state court litigation is in bad faith.”

–“When a debtor files chapter 11 to dodge the requirement for an appeal bond, a court’s determination of good faith typically hinges on the following factors:

1. Whether the debtor is a viable business which would suffer severe disruption if enforcement of the judgment was not stayed; and the chapter 11 petition was filed to preserve its status as an ongoing concern and to protect its employees and creditors;
2. Whether the debtor had financial problems on the petition date, other than the adverse judgment;
3. Whether the debtor has relatively few unsecured creditors, other than the holder of the adverse judgment;
4. Whether the debtor has sufficient assets to post a bond to stay the judgment pending appeal;
5. Whether the debtor acted in good faith to exhaust all efforts to obtain a bond to stay the judgment pending appeal;
6. Whether the debtor intends to pursue an effective reorganization within a reasonable period of time, or whether the debtor is unwilling or unable to propose a meaningful plan until the conclusion of the litigation; and
7. Whether assets of the estate are being diminished by the combined ongoing expenses of the debtor, the chapter 11 proceedings, and prosecution of the appeal.”

Applying the “Good Faith” Standard:

The Court rules that neither Mense nor Commonsmith, LLC, filed bankruptcy in “good faith” and dismisses their bankruptcy cases. The Mense and Cottonsmith court explains its dismissal decision like this:

“Cottonsmith is not an operating business . . . has no employees, no cash flow, and no sources of income . . . no reasonable prospects for the conduct of business in the future . . . only 1 unsecured creditor besides Kayne . . . [T]he balance in the [bank] account has decreased from $1,400,000 to $1,118,082.70 . . . Cottonsmith’s bankruptcy was filed for the purpose of preventing Kayne . . . from seizing Cottonsmith’s cash which Mense is now using to pay his personal expenses and to fund the appeal.

“Mense does not operate [or manage] a business . . . He did not list any gross receipts or business expenses . . . and he admits that he has no employees. Mense invests in real estate projects and businesses while collecting social security. . . . It is undisputed that Mense is solvent. His schedules reveal a net worth in excess of $13.4 million. Other than Kayne’s judgment, Mense had no financial problems.

In re Ford

The 1987 case of In re Ford  provides a helpful contrast. Richard Ford files Chapter 11 bankruptcy after a $165,000 judgment is entered against him. He also files an appeal of the judgment but can’t post a supersedeas bond.

The Ford Court concludes that “the debtor did not lack good faith when he filed this petition under Chapter 11.” And the Court provides the following explanations:

–“[T]he debtor has several tracts of land which can be liquidated over a period of time to pay the Canton judgment should such payment become necessary. . . . the plan filed by the debtor proposes to pay the Canton judgment in full in an orderly manner.

–“This Court is impressed that the debtor has filed a Plan of Reorganization . . . offering to pay his creditors in full with an orderly liquidation of assets. . . . Ford’s assets are not immediately liquid, but liquidation of a portion of these assets is possible given a reasonable period of time.”

–“There is little to be gained by allowing a forced liquidation of the debtor’s one-third undivided interest in real property which this Court believes would result in chaotic dismemberment of the debtor’s assets with resulting damage to the debtor, his co-owners and creditors alike.”

–”Ford did not and does not now have sufficient cash presently available to him to pay the judgment or to post a supersedeas bond. . . . The Chapter 11 petition was not filed solely to avoid posting a supersedeas bond, but only to give the debtor time to liquidate his assets.”

Editorial Comments:

In the hypothetical above, a City might file a Chapter 9 bankruptcy Petition in “good faith.” Or it might not. The “good faith” of a City’s filing depends on all the circumstances.

I suggest that a City, whose circumstances are much like those of the In re Ford case, is likely to stay in bankruptcy. However, the closer the facts of a city’s bankruptcy get to those of Mense and Cottonsmith, the likelihood of a dismissal for lack of “good faith” becomes greater.

Note:  The first article in this series reviews the new study report linked above and explains the mediation connection.  The second article in this series considers the “insolvency” element for Chapter 9 eligibility.  A fourth article is “10 Practical Lessons for Cities Facing Bankruptcy.”

Will Police Misconduct Liability Allow a City to File Bankruptcy? — “Insolvent” Eligibility Standard (Part 2 of 3)

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11 U.S.C. Sec. 101(32)(C) — definition of municipal insolvency

By Donald L. Swanson

Hypothetical:

A City has been struggling for years to provide adequate services.
Then, the City and its police officer are sued for violating the plaintiff’s civil rights.
A jury verdict is for many-millions of dollars—an amount multiple times the City’s annual budget. Defendants appeal.
Plaintiff starts executing on the judgement. So the City files bankruptcy.

Question:

Does the City meet the “insolvent” element of eligibility for bankruptcy filing, under § 109(c)(3) of the Bankruptcy Code?

Statutory Standard:

“Insolvent” for a municipality is defined in § 101(32)(c) of the Bankruptcy Code as follows:

(32)The term “insolvent” means—  . . .

(C) with reference to a municipality, financial condition such that the municipality is—

(i) generally not paying its debts as they become due unless such debts are the subject of a bona fide dispute; or
(ii) unable to pay its debts as they become due.

The difference between sub-parts (C)(i) and (C)(2) of § 101(32) is this:

–(C)(1) deals with whether debts are currently being paid when due.
–(C)(2) deals with whether debts will be paid when due in the future.

Applying the Standard:

How these two standards are applied can be an interesting study.

An early case is In re City of Bridgeport, a 1991 ruling in Connecticut. The Bankruptcy Court says the § 101(32)(C) insolvency analysis is made as of the bankruptcy filing date. On that date, the City, (i) was paying its debts as they came due, and (ii) had sufficient cash for the foreseeable future. Therefore, the Bankruptcy Court dismisses the bankruptcy case because the City was solvent on the bankruptcy filing date.

In re City of Stockton, California, is a 2013 case dealing with municipal insolvency. The court examines three types of insolvency under part (C)(2) of § 101(32) (cash insolvency, budget insolvency, and service insolvency) and finds the City to be “insolvent” under all three types:

(i) Cash:

“[T]he City would run out of cash within a matter of weeks after the case was filed.”
“While cash insolvency — the opposite of paying debts as they become due — is the controlling chapter 9 criterion under § 101(32)(C), longer-term budget imbalances (budget insolvency) and the degree of inability to fund essential government services (service delivery insolvency) also inform the trier of fact’s assessment of the relative degree and likely duration of cash insolvency.”

(ii) Budget:

“Budget insolvency focuses on the ability of a municipality to create a balanced budget that provides sufficient revenues to pay for its expenses that occur within the budgeted period. . . . The projections . . . demonstrate imbalances that would persist for decades without some radical surgery.
Nor do there appear to be untapped resources that would make a material difference. Few fixed assets are available to be sold or otherwise monetized. . . .
Nor will normal property tax revenues improve enough to make a material difference. . . .
It follows that the extra revenues needed to fund a plan of arrangement probably will have to come from tax increases. The difficulty is that local tax increases in California generally require a vote of the people.

(iii) Service:

“The evidence demonstrates that the police department has been decimated. The crime rate has soared. Homicides are at record levels. The City has among the ten highest rates in the nation of aggravated assaults with a firearm. Police often respond only to crimes-in-progress. That is a paradigm example of service delivery insolvency that confirms that the cash insolvency is no chimera.”

The Standard and the Hypothetical:

Part (C)(1) would not apply to the hypothetical above because the judgment is on appeal and is, therefore, “the subject of a bona fide dispute.”

Part(C)(2) could apply and might demonstrate insolvency because:

–the judgment is currently due and payable (and can be enforced) in its entirety, despite the appeal; and
–the magnitude of the judgment amount, and its immediately-due status, might enable the City to prove it is “unable to pay its debts as they become due.”

Note: The first article in this series reviews a new report of a study (titled “Who Pays for Police Misconduct in Bankruptcy Cities?”) and explains the mediation connection to the subject.  The third article in this series will address the “good faith” requirement for a municipality in bankruptcy.  A fourth article is “10 Practical Lessons for Cities Facing Bankruptcy.”

Police Abuse Claims and Municipal Bankruptcy — A New Report (Part 1 of 3)

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11 U.S.C. Sec. 109(c) — Chapter 9 Eligibility

By Donald L. Swanson

Detroit’s mediated settlements are “an extraordinary accomplishment in bankruptcy and an ideal model for future municipal debt restructurings.

–Judge Steven W. Rhodes, from Detroit Bankruptcy’s Plan Confirmation Ruling

A new report

Who Pays for Police Misconduct in Bankrupt Cities” is the title for the report of a study, published on August 21, 2016.  The report is most helpful–and well worth reading in its entirety!

Here’s how the report begins:

“In March 2015, the United States Department of Justice released a report finding racial bias and discrimination pervading police and court practices in Ferguson Missouri. When asked to comment shortly thereafter, Ferguson’s mayor suggested that an unduly aggressive stance by DOJ could push Ferguson into bankruptcy.”

Given the developing role of mediation in resolving municipal bankruptcy cases, this report warrants our consideration.

Who pays the misconduct claims?

Here is empirical information cited in the report:

“[A] recent empirical study . . . found that governments, rather than individuals, pay the vast majority of § 1983 judgments—even in the absence of an indemnification mandate. In large departments, officers contributed to the settlements or judgments in only .41% of the actions. In small departments, officers did not contribute at all to settlements or judgment payments.”

Municipal bankruptcy eligibility

The report identifies and discusses a “conjunctive list” of the following statutory requirements (contained in 11 U.S.C. § 109(c)) for a city’s bankruptcy filing under Chapter 9 of the Bankruptcy Code:

1. The city must meet the definition of a “municipality” in 11 U.S.C. § 101(40).

[Editorial Comment. This item should not be a significant hurdle for a city.]

2. State law must authorize the city to file. The report says some states already authorize such action; while other states require more. There is, for example, “no express authorization in Illinois law for the City of Chicago to file.”

[Editorial Comment. A state statute where I reside, for example, says: “Any county, city . . . is hereby permitted, authorized, and given the power to file a petition . . . under 11 U.S.C. chapter 9.” Neb. Rev. Stat. § 13-402.]

3. The city must be insolvent, as defined in § 101(32)(c). The report says this requirement “is enforced quite rigorously” and “prevents a city in stable financial condition from filing for bankruptcy solely as leverage to manage one particular type of debt, such as civil rights liability.”

4. The city must be genuinely pursuing a plan confirmation, rather than merely seeking delay.

5. The city must have negotiated in good faith prior to bankruptcy (or meet an alternative requirement).

6. The bankruptcy Petition must be filed in good faith.

Debt restructuring and discharge

Regarding “debt restructuring and discharge,” the report provides the following information:

–“In a municipal bankruptcy, only the debtor can propose a plan to restructure debts, although it requires substantial creditor support, as well as compliance with a long list of statutory requirements; the list is conjunctive and thus all must be satisfied.”

–If a court confirms a municipality’s plan as adhering to all statutory requirements, “the debtor is discharged from all debts as of the time when the plan is confirmed.”

–“There is no explicit exception to discharge for civil rights debts in municipal bankruptcy.” Exception to discharge for “willful and malicious injury by the debtor to another entity or to the property of another entity” applies “only to individuals“ and not to “entities.”

The article then cites and discusses various “key cases.” Here are two items on the City of Detroit case:

–“Detroit classified claims arising from § 1983 litigation as general unsecured claims and proposed . . . an estimated recovery of ten to thirteen cents on the dollar.” The Court approved this proposal.

–“Detroit’s restructuring plan also sought to release the individual capacity liability of . . . individual officers, to whom the city had indemnification obligations. The court . . . refused to approve this part of the plan.”

Conclusions

The report’s conclusion contains these four opinions:

First: “[K]ey details of the law remain unsettled.”

Second: “[T]here is case law support for the proposition that a discharge of debt in bankruptcy can include a release of a city’s liability stemming from police misconduct claims.”

Third: “Due to the other requirements associated with municipal bankruptcy, including the eligibility threshold and good faith, it is unlikely that a city could file for bankruptcy solely for the purpose of shedding liability associated with unconstitutional police practices.”

Fourth: “On the other hand, it is entirely possible that a city facing lawsuits for widespread police misconduct is also in dire straits financially and thus far more likely to be eligible for the extraordinary relief offered by the federal bankruptcy system.”

[Editorial Comment: Three of these four opinions appear to be well-supported. However, the “Third” conclusion is probably subject to significant exceptions.]

Note: The second article in this series  considers the “insolvency” element for Chapter 9 eligibility.  The third article will consider “good faith” requirements and exceptions mentioned in the Editorial Comment immediately above.  A fourth article is “10 Practical Lessons for Cities Facing Bankruptcy.”