Third-party Relief for Municipal Debtors: 'necessity' in the Chapter 9 Context

• Jurisdiction: United States,Federal
• Publication year: 2019
• Citation: Vol. 35 No. 1

Third-Party Relief for Municipal Debtors: 'Necessity' in the Chapter 9 Context

Christian Morbidelli

THIRD-PARTY RELIEF FOR MUNICIPAL DEBTORS: "NECESSITY" IN THE CHAPTER 9 CONTEXT

ABSTRACT

"Third-party releases" are a longstanding—although non-statutory—form of relief in chapter 11 bankruptcy cases. Bankruptcy courts use them to relieve non-debtors of liability for certain debts. For example, directors of a debtor corporation might propose to contribute assets to a settlement fund in exchange for tort plaintiffs giving up their claims against the directors. Although circuits are currently split on whether to allow third-party relief at all, the majority agree that it falls within bankruptcy courts' § 105(a) equitable authority in certain circumstances. Courts make this determination using a variety of tests, most notably the "Dow Corning factors."

With the recent uptick in municipal bankruptcy cases, some debtors have attempted to extend third-party relief to chapter 9 bankruptcy. These cases fall roughly into two categories. In the first, a state provides funds to assist in a reorganization in return for certain creditors giving up claims against the state. In the second, a city attempts to relieve its police officers of liability for civil rights violations by including injunctions against the plaintiffs in the city's plan of reorganization. If the officers themselves had filed for bankruptcy, these lawsuits would be nondischargeable claims arising from personal physical injury under § 523(a)(6). While courts have so far applied the Dow Corning factors correctly to the first category of cases, a series of decisions in the Fifth and Ninth Circuits have led to a much more lenient standard (the "necessity standard") for the second.

This Comment argues that the second series of decisions has ignored fundamental limitations on the permissibility of third-party relief. First, courts should not allow it to be used as a loophole for discharging otherwise non-dischargeable debts. Second, by removing substantive limitations on third-party relief the necessity standard both ignores the limits of a bankruptcy court's equitable powers and incentivizes over-reliance by municipalities. This Comment advocates discarding the necessity standard and returning to established standards that limit third-party relief to situations in which it is consistent with the Code.

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INTRODUCTION

In October 2016, Korey King, a San Bernardino, CA resident, filed suit against three city police officers.¹ In his complaint, King alleged that the officers had violated his civil rights, and King requested damages under 42 U.S.C. § 1983.² He did not include the city as a defendant.³ However, King soon received notice that his suit had been stayed pending the resolution of San Bernardino's chapter 9 bankruptcy case.⁴ The confirmation of the city's plan of reorganization several months later brought even worse news.⁵ Because San Bernardino had undertaken the officers' defense in King's case, California law obligated the city to indemnify them for any damages awarded.⁶

San Bernardino, accordingly, had proposed in its plan of reorganization to enjoin King and numerous other civil rights plaintiffs from collecting damages on their claims against indemnified police officers.⁷ The city claimed that this injunction—referred to as a "third-party release"—was necessary to free up funds for its continued operations, including a $56.5 million "Police Resources Plan" targeting the city's high crime rates.⁸ The bankruptcy court agreed with San Bernardino and approved its plan of reorganization.⁹ In October 2017 the district court affirmed that King's suit was subject to the plan injunction.¹⁰ King's right to receive compensation was effectively erased by the bankruptcy of a city that was not a party to his suit.

Chapter 9 of the United States Bankruptcy Code applies to municipalities.¹¹ While municipal bankruptcies have historically been rare,¹² the recent recession

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prompted several major cities,¹³ a county,¹⁴ and a host of other entities to seek relief under chapter 9.¹⁵ Many of these financially troubled municipalities entered bankruptcy bearing obligations to indemnify their employees against personal liability for acts committed in their professional capacities.¹⁶ Chapter 9 generally gives debtors great flexibility to modify their obligations in tailoring plans of reorganization, without balancing the interests of creditors.¹⁷ Accordingly, several of these municipalities, including San Bernardino, sought to extend the Code's protections to their indemnified employees.¹⁸

A bankruptcy court's ability to release non-debtor parties from debts is a powerful but infrequently-invoked measure.¹⁹ Debtors may offer what this Comment will refer to as "third-party relief to creditors in exchange for continued financing or consent to less-favorable terms,²⁰ or to their own officers who play an important role in reorganization.²¹ Circuits are currently split on whether this relief is permissible under chapter 11, with the majority allowing it in certain unusual circumstances.²² The seven Dow Corning factors form the

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most notable standard.²³ The Ninth Circuit, which has adopted the minority position, has also indicated that its prohibition of third-party relief in chapter 11 bankruptcy will not extend to chapter 9 cases.²⁴

In the recent wave of municipal bankruptcies, several cities unable to indemnify law enforcement officers for civil rights lawsuits instead sought third-party relief in the form of injunctions against the plaintiffs.²⁵ Drawing from chapter 11 case law, courts in these cases have converged on a standard basing the availability of third-party relief on its "necessity" to reorganization.²⁶ As a result, municipal debtors now enjoy a great degree of freedom to modify their employees' obligations to third parties. These decisions, however, have not addressed two important considerations that should limit the availability of third-party relief.

First, bankruptcy courts have failed to consider whether they possess the authority to release third parties from debts that would be nondischargeable in the third-party's own bankruptcies. These include debts listed under § 523(a) as "exceptions to discharge," such as those arising from "fraud . . . embezzlement, or larceny," "domestic support obligations," "willful or malicious injury" to another's person, or for benefits obtained under "false pretenses."²⁷ The § 523(a) exceptions reflect a Congressional policy of "not allowing a debtor to use the bankruptcy system to avoid debts when the debtor acted wrongfully in incurring those debts."²⁸

Second, courts have not justified the introduction of a new, necessity-based, standard for chapter 9. The constitutional status of municipalities precludes

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"failure" in the chapter 11 sense, removing any objective measure of necessity.²⁹ Furthermore, the ubiquity of indemnification obligations will lead most municipal debtors to request, and qualify for, third-party relief, destroying its status as a dramatic measure reserved for unusual circumstances.³⁰ This will invite abuse by allowing municipal officials to regularly avoid debts they could not discharge individually, extending municipal bankruptcy beyond the bounds contemplated by the Bankruptcy Code.

This Comment begins by outlining the structure and goals of chapter 9 bankruptcy, as well as several state-law alternatives available to municipalities. Next, it discusses the prevalence of municipal indemnification obligations and the circumstances which give rise to these obligations. This Comment then provides an overview of the case law governing third party relief in chapter 11, which courts have imported into chapter 9 cases. It continues by examining in detail the use of third-party relief to shield police officers from liability for civil rights violations in recent chapter 9 cases.

This Comment establishes that the § 523(a) exceptions to discharge overrule bankruptcy's general policy of giving the debtor a "fresh start," which is also the justification for third-party relief. Next, it argues that the necessity standard is not appropriate for chapter 9 because it removes crucial limiting factors from Dow Corning, and because a municipality's indissolubility precludes an objective measure of necessity. Combined with the ubiquity of municipal indemnification obligations, these omissions leave a municipal debtor with almost no substantive limitations on the availability of third-party relief.

Finally, this Comment examines the Dow Corning factors' suitability for municipal bankruptcy and conclude that they reflect basic Code requirements equally applicable to chapters 11 and 9. Because so little precedent exists, courts can easily resume restricting third-party relief to truly unusual circumstances. This Comment also notes possible legislative solutions. For instance, Congress could expand the scope of chapter 9 if it decides that protecting public employees is crucial to successful reorganization. States could also amend their

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indemnification laws to directly protect employees of financially-troubled municipalities.

I. BACKGROUND

A. Chapter 9 Bankruptcy and Municipal Alternatives

Chapter 9 bankruptcy "permit[s] a financially distressed public entity to seek protection from its creditors."³¹ It is primarily in this context that the necessity standard and the possibility of releasing third parties from nondischargeable debts arises. However, financially distressed municipalities have additional non-bankruptcy options, so this section will place chapter 9 in the context of state solutions, such as receiverships.

1. Overview of Chapter 9 Bankruptcy

In contrast to the other Code chapters, chapter 9 provides "systematic advantages for debtor municipalities,"³² such as limited control by the bankruptcy court,³³ little consideration of creditors' interests,³⁴ and the debtor...