Round one of the fight between the City of Stockton, California and its creditors is finally over. On April 1, 2013, Bankruptcy Judge Christopher M. Klein held that Stockton satisfied the eligibility requirements for a Chapter 9 debtor.

Back on June 28, 2012, Stockton filed a petition seeking to adjust its debts under Chapter 9 of the United States Bankruptcy Code.

Stockton’s bond insurers (who guaranteed payment of pension obligation bonds) objected to Stockton’s petition. The bond insurers (joined by the indenture trustee for the Stockton Public Finance Authority bondholders) argued that Stockton failed to satisfy its burden of demonstrating that it: (i) is insolvent, (ii) complied with its pre-filing negotiation obligation, (iii) negotiated in “good faith,” and (iv) filed its bankruptcy petition in good faith. After conducting discovery, the bond insurers filed supplemental objections claiming that the “evidence demonstrated that the City entered bankruptcy intending to spread losses disproportionately among a subset of creditors so that it could protect its largest creditor, CalPERS, and the related pensions of the very City employees making this improper decision.”

In reply, Stockton argued that it had satisfied all of the requirements for bankruptcy protection and that the conclusions of the bond insurers’ experts were based upon flawed assumptions and sloppy methodology. Stockton further argued that its staffing, compensation and benefits reductions demonstrated its good faith, as did the agreements it reached with its unions, and that any further cutbacks or reductions would have jeopardized Stockton’s ability to provide needed services to its citizens.

CalPERS, touted as Stockton’s largest creditor, filed a brief in support of Stockton’s petition explaining that Stockton is in good standing and current on its payments to the system. According to CalPERS, “there is no debt to CalPERS that will be adjusted in the City’s plan.”

At the April 1, 2013 hearing, Judge Klein held that Stockton satisfied the eligibility requirements under Bankruptcy Code Section 109 because it: (i) is a municipality within the meaning of § 109(c); (ii) is authorized under California law to be a debtor; (iii) was insolvent at the time of the filing of its petition because it was unable to pay debts as they became due; (iv) is desirous of effecting a plan to adjust its debts, as demonstrated by its “Ask” at the court-ordered mediations; and (v) negotiated in good faith with its creditors in satisfaction of § 109(c)(5)(B), as demonstrated by the substantial agreements reached on the collective bargaining agreements.

The ruling makes Stockton the largest U.S. city to seek bankruptcy protection. Nonetheless, Judge Klein’s decision will not end the fight between Stockton and its bond insurers, as round two invariably will involve a major battle over the terms of Stockton’s forthcoming plan of adjustment. Stay tuned…