Contributed by Lee Jason Goldberg
Compromises and settlements form an integral part of the bankruptcy process and are favored as a matter of public policy. Bankruptcy Rule 9019, rather than an explicit statutory provision, establishes bankruptcy courts’ oversight role for compromises and settlements, requiring debtors to seek approval on motion and after notice and a hearing. Bankruptcy courts exercise their oversight role by only approving compromises and settlements that are fair and equitable, in the best interest of the debtor’s estate, and not beneath the “lowest point in the range of reasonableness.” This oversight role is well accepted in chapter 11 cases, but is it identical in chapter 9 cases? No, according to the California bankruptcy court presiding over the City of Stockton’s chapter 9 case.
The bankruptcy court’s decision is notable: it propounds a distinct rule for chapter 9 cases regarding compromises and settlements while sounding a cautionary note aimed at limiting debtor overreach. In addition, the decision provides an interpretive roadmap for chapter 9 jurisprudence and explicates a fundamental rule of construction for the Bankruptcy Code.
In its chapter 9 case, Stockton agreed to settle a pending damages lawsuit for $55,000. Capital markets creditors argued that Stockton was required to seek approval of the settlement under Bankruptcy Rule 9019, even though the creditors conceded that the settlement was unlikely to flunk judicial scrutiny under that rule. The bankruptcy court rejected the creditors’ argument, holding that section 904 of the Bankruptcy Code gives a chapter 9 debtor freedom to decide whether to ignore or follow the compromise-approval procedure of Bankruptcy Rule 9019. Notwithstanding the optional nature of Bankruptcy Rule 9019, the court left the door open for oversight of compromises and settlements by observing that a municipal debtor may still need to account for prior compromises during plan confirmation proceedings.
Did Congress Intend to Change the Procedure Governing Settlements by Municipal Debtors Under the Former Bankruptcy Act?
The bankruptcy court began by examining the current chapter 9 law in the context of the Bankruptcy Code’s predecessor bankruptcy statute, the Bankruptcy Act of 1898. The Bankruptcy Act of 1898 contained an explicit statutory provision governing settlements, but a rule of procedure clarified that it did not apply to chapter IX (municipal debt adjustment) cases. The court deduced, based on its review of the history and plain language of the statutory provisions and rules of procedure governing settlements and municipal debt adjustment cases, that the argument that a municipality must obtain court approval of settlements would have seemed “dubious” when the Bankruptcy Code was enacted in 1978.
With the enactment of the Bankruptcy Code, certain omitted Bankruptcy Act provisions were left to procedural rules or interpretive doctrine, and the U.S. Supreme Court adopted a rule of construction for the Bankruptcy Code that doctrines established under the Bankruptcy Act were presumed to have been carried forward except to the extent Congress indicated a contrary intent.
The court concluded that basic bankruptcy settlement doctrine was carried forward into the Bankruptcy Code even though the express statutory provision was deleted. As Congress did not indicate a contrary intent regarding settlements, settlement procedure was left to a combination of procedural rule and nonstatutory judicial doctrine. Bankruptcy Rule 9019 was modeled on a former bankruptcy rule and adopted to prescribe a procedure for settlements. As to substantive standards, the court noted that courts have consistently followed the settlement precedents established under Bankruptcy Act decisions requiring that settlements be “fair and equitable.”
Based on this elemental rule of construction for the Bankruptcy Code, the court found that it followed that if judicial scrutiny of compromises was not required in chapter IX cases under the Bankruptcy Act, then none was required in chapter 9 cases under the Bankruptcy Code. It did not constitute a change in substantive law that the rules issued under the Bankruptcy Code abandoned the prior format under the Bankruptcy Act of separate rules for separate chapters. The court also found that Bankruptcy Rule 9019 could not trump section 904 of the Bankruptcy Code as a matter of law. The court held, therefore, that Bankruptcy Rule 9019 only applies in chapter 9 cases if the debtor elects to “consent” under section 904 to have the court consider approval of a compromise.
Examining a Municipal Debtor’s Settlement Authority Within the Construct of the Current Bankruptcy Code
Turning to the question before it from a constitutional perspective, the bankruptcy court called the extent to which bankruptcy settlement doctrine applies in the chapter 9 context a puzzle because much of the Bankruptcy Code does not apply. Pursuant to section 103(f), only chapters 1 and 9 apply in chapter 9 cases, except as provided in section 901, which designates select provisions from chapters 3, 5, and 11 that also apply. The court noted that this patchwork chapter 9 incorporation necessitates caution when considering bankruptcy concepts that are virtually axiomatic in cases under other chapters. Context shifts in the chapter 9 arena, the court observed, and, context can be crucial in municipal debt adjustment cases, including as to compromises.
In chapter 9 cases, section 904 limits the jurisdiction and powers of the bankruptcy court by prohibiting its interference, unless the debtor consents or the plan so provides, with (1) any of the political or governmental powers of the debtor, (2) any of the property or revenues of the debtor, or (3) the debtor’s use or enjoyment of any income-producing property. Section 904, the court remarked, is a keystone in the constitutional arch between federal bankruptcy power and state sovereignty.
The court explained that the Supreme Court held the first federal municipal debt adjustment statute to be unconstitutional in 1936 in part because the precursor of section 904 qualified the prohibition on federal judicial interference with municipal property or revenues to revenues “necessary in the opinion of the judge for essential government purposes.” Through a combination of Supreme Court decisions and Congressional action, this qualifier was ultimately removed in its entirety, leaving an outright prohibition on any judicial interference with any of the property or revenues of a municipal debtor (unless the debtor consented or the plan so provided).
As a result, the court concluded that it could not prevent a chapter 9 debtor from spending its money for any reason, even foolishly or in a manner that disadvantaged other creditors, unless the municipality consented to such judicial oversight. The court reasoned that the power to approve a compromise entails the power to disapprove one, and the power to disapprove is the power to interfere, which, without consent, is precisely what Congress withheld in chapter 9 cases. Thus, the court found that section 904 meant that Stockton could expend its property and revenues during the chapter 9 case as it wished, including by paying any debt in full or settling a lawsuit for $55,000 without permission from the court. Such permission would imply a power to disapprove and thereby to interfere with Stockton’s property or revenues, which would offend section 904.
The court clarified that Bankruptcy Rule 9019 motions filed by debtors in other chapter 9 cases demonstrated that those municipalities had consented for purposes of section 904 to judicial interference with the property or revenues that were needed to accomplish the proposed transactions. The court also suggested reasons as to why a municipality may provide such consent to judicial approval, including the insistence of a counterparty as a condition precedent, a strategy of transparency designed to forestall later challenges to plan confirmation, and satisfaction of a requirement of nonbankruptcy law with which the municipality also must comply. In those and other situations, the chapter 9 debtor is free to consent to judicial approval under bankruptcy settlement-review standards by filing a Bankruptcy Rule 9019 motion or by including such a review as a plan provision.
Limitations on a Municipal Debtor’s Settlement Authority
Notwithstanding the seemingly unfettered discretion municipal debtors have to enter into settlements and compromises, the bankruptcy court did articulate an important limiting principle: the plan confirmation process. Because a chapter 9 debtor has the exclusive right to propose a plan, the burden of proving the essential elements for confirmation is on the debtor in its capacity as plan proponent. Acknowledging that unconstrained settlements may amount to a creeping plan of arrangement (and that such creep may be legitimate and sensible or that it may be nefarious), the court nonetheless made clear that the day of reckoning arrives at the plan confirmation hearing.
Section 901(a)(1) of the Bankruptcy Code incorporates certain of the plan confirmation requirements of section 1129, including the cramdown standards of section 1129(b)(1) (requiring that the plan “does not discriminate unfairly” and is “fair and equitable” with respect to each non-accepting class of impaired claims). According to section 1129(a)(3), the plan must have “been proposed in good faith and not by any means forbidden by law.” The court noted that it was not difficult to imagine arguments that evidence of untoward settlements could be probative of section 1129(b)(1) and section 1129(a)(3) issues.
Thus, the court concluded that Stockton’s capital markets creditors had in effect given notice that they reserved the right to litigate the debtor’s conduct and management and spending choices during the case at the time of plan confirmation. The court found this to be the limiting principle and the protection to which the capital markets creditors were entitled.
While headlines involving this decision have focused on the court’s observation that the answer to the question of whether a chapter 9 debtor must obtain court approval of compromises is “shrouded in mists of time,” the court ably navigated its way through those mists by providing an interpretive roadmap for chapter 9 jurisprudence that took into account the history and plain language of the statutory provisions and rules of procedure governing settlements and municipal debt adjustment cases as well as the constitutional considerations at work in chapter 9 cases. In addition, the case vividly illustrates the application of an essential rule of construction for the Bankruptcy Code, namely that doctrines established under the Bankruptcy Act were presumed to have been carried forward except to the extent Congress indicated a contrary intent.
The court’s answer to the question before it – a chapter 9 debtor is not required to seek approval of compromises pursuant to Bankruptcy Rule 9019 – is significant. The decision should not be seen, however, as a wholesale abdication of the court’s oversight role of compromises and settlements in the chapter 9 context. As the court cautioned, a municipality’s day of reckoning will come at plan confirmation, where the court may be called upon to determine whether the chapter 9 debtor’s plan is “fair and equitable” to creditors who were displeased with an earlier settlement entered into by the debtor. Accordingly, before a municipality decides that it can enter into any settlement it wishes merely because it need not seek contemporaneous judicial approval, the municipality should bear in mind that it may need to account for that same settlement down the road.
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