On January 30, 2013, Judge Christopher Klein of the
Bankruptcy Court for the Eastern District of California held that, pursuant to
section 904 of the Bankruptcy Code, a municipal debtor is not required to seek
court approval to enter into settlements with and make settlement payments to prepetition
creditors during the pendency of its chapter 9 case. The decision demonstrates
the broad scope of section 904 and the free reign that a municipal debtor
enjoys under that section during the pendency of its chapter 9 case. In re
City of Stockton, Cal., Case No. 12-32118 (Bankr. E.D. Cal. Jan. 30, 2013).
The dispute at issue centered on a proposed settlement
with a citizen who had a tort claim against the city's police department for
alleged police brutality. The City agreed to pay that citizen $55,000 and, in
exchange, the citizen would drop the lawsuit. In October 2012, the City filed a
motion requesting that any settlement reached between a debtor and
creditor need not be approved by the bankruptcy court.
The bondholders challenged the debtor's motion, arguing
that Rule 9019 of the Federal Rules of Bankruptcy Procedure applies to chapter
9 and requires that a debtor seek court approval to enter into settlements with
creditors. Among other things, the bondholders argued that chapter 9 "is not a
one way street," that a debtor should be required to act in good faith during
the pendency of its case, and that creditors should have a right to object to
these settlements prior to the debtor's filing of its plan of adjustment.
Absent such a policing mechanism, the bondholders contended that a municipal
debtor would be free to pay its favored creditors prior to even proposing its
plan of adjustment, and that unfavored creditors could potentially be left
impaired under the plan of adjustment. According to the bondholders, such a
result would be inequitable because the debtor could potentially spend all of
its revenues to satisfy its favored creditors' claims.
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