The Contracts Clause versus the Bankruptcy Clause: Bankruptcy Court Holds Bankruptcy Clause Reigns Supreme

Contributed by Cristine Pirro
Shortly after the City of Stockton, California filed for chapter 9 protection in June, a group of retired employees commenced an adversary proceeding to prevent termination of their benefits on the theory that the Contracts Clause of the United States Constitution prevented the City from reducing retiree health benefits.  After an extensive review of various versions of the statute and the interaction of those versions with the Constitution, the Bankruptcy Court for the Eastern District of California affirmatively held that the Contracts Clause did not eclipse the Bankruptcy Clause and that the “lawsuit rest[ed] on infirm constitutional ground.”
The dispute began in July of 2012, when Stockton adopted a new budget.  California law requires state and local budgets to be balanced.  Stockton balanced its budget by cutting costs, including retiree health benefits.  The Association of Retired Employees of the City of Stockton and eight additional retirees commenced an action in the bankruptcy court seeking, among other things, (i) a temporary restraining order or preliminary injunction prohibiting Stockton from implementing the retiree health benefit reduction, (ii) a declaration that the changes are unlawful, and (iii) an order compelling Stockton to pay for the retiree health benefits.  The retirees’ primary argument in support of these requests was that Stockton was unilaterally changing the terms of the retiree benefits, thereby impairing contractual obligations in direct violation of the Contracts Clause of the U.S. Constitution.  Their theory was health benefits are a form of deferred compensation that, in this case, Stockton’s retirees already had earned.  Because the retirees had earned these benefits, the retirees’ interest was vested and protected by the Contracts Clause.
The bankruptcy court first reviewed the Contracts Clause, which provides that “no State shall . . . pass any . . . Law impairing the Obligation of Contracts.”   The bankruptcy court focused on the word “State,” explaining that the Contracts Clause does, in fact, ban a state from making a law that impairs the obligation of a contract.  The Contracts Clause does not, however, ban Congress from making such a law.  Indeed, by virtue of the Bankruptcy Clause, the U.S. Constitution actually authorizes Congress to make laws that would impair contracts:  “[T]he Contracts Clause . . . is subject to being eclipsed by the Bankruptcy Clause: ‘The Congress shall have Power to . . . establish . . . uniform laws on the subject of Bankruptcies throughout the United States.’”  Citing a 1936 U.S. Supreme Court decision, the bankruptcy court reasoned that the purpose of bankruptcy legislation is to interfere with relations between parties, which includes altering their contractual obligations.  When a state authorizes a municipality to file a chapter 9 case, that state invites the intervention of the bankruptcy power to do what the state can’t – impair the obligation of contracts to rescue the municipality.
The bankruptcy court also discussed the state-federal relationship in detail, determining that chapter 9 is premised on multiple levels of state consent.  For example, a chapter 9 case must be voluntary, and requires the consent of both the state and the municipality.  Consent is also included in section 904 of the Bankruptcy Code, which limits the court, absent the debtor’s consent, from interfering with the political or governmental powers of the debtors, any property or revenues of the debtor, or the debtor’s use or enjoyment of any income-producing property.  Consent also is implicit in the restriction in section 941 of the Bankruptcy Code that only the municipality can propose a “plan of adjustment.”  These provisions assuage the concern that the federal government may be overstepping its bounds by governing an unwilling state.
The states are further able to exercise control over municipalities by virtue of section 903 of the Bankruptcy Code, which reserves to the state the power to control municipalities.  According to the Court, the overall goal is to maintain the balance imposed by the Tenth Amendment to the U.S. Constitution, which provides that “the powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States, or to the people.”  The Court was careful to note, however, that despite the control a state may exercise by virtue of these provisions, once the state permits a municipality to file a chapter 9 case, it cannot revise or pick and choose which provisions of chapter 9 it wants to apply.
The retirees put forth several other arguments that the bankruptcy court rejected summarily.  First, they argued that the relief requested was a mere preservation of the status quo, and as such would not directly interfere with Stockton’s property or revenues in contravention of section 904 of the Bankruptcy Code.  The bankruptcy court found that section 904(2) of the Bankruptcy Code, which limits a court’s power over any property or revenues of the debtor, expressly bars the bankruptcy court from interfering with Stockton’s choice to suspend the payments.
Second, the retirees argued that the parties should be required to meet and work out their differences, as was required in Orange County’s chapter 9 case.  The bankruptcy court noted the differences between the Stockton and the Orange County chapter 9 cases – Orange County did not interfere with property or revenue of the estates, and the collective bargaining agreements in Orange County (unlike the retiree benefits in Stockton) were executory – and also noted that the retirees admitted at oral argument that they wanted the bankruptcy court to impose the equivalent of section 1114 of the Bankruptcy Code.  The bankruptcy court concluded that, because section 1114 of the Bankruptcy Code (which relates to the payment of insurance benefits to retired employees in a chapter 11 case) is not specifically applicable in a chapter 9 case, the court did not have the authority to impose the relief requested.
Third, the retirees argued that Stockton imposed a plan of adjustment by circumventing confirmation standards without meeting certain fundamental requirements of due process.  The court found to the contrary, explaining that a formal plan of adjustment had not yet been filed and that Stockton had the ability to suspend payment of various obligations to allow essential governmental services to continue as a routine aspect of the reorganization process.