Cities, Bankruptcy Law and Pension Payments

When Central Falls, R.I., emerged from Chapter 9 bankruptcy a few weeks ago, it did so with a court-sanctioned plan that calls for, among a litany of tax increases and spending cuts, lower pension payments. In other words, the city will be sending less money to its pension plan, reducing its costs but also decreasing the benefits for a group of the city's retirees.

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Central Falls isn't the only city in the country having trouble funding its pension plan. Four cities in California have, will be or are contemplating filing for Chapter 9. But unlike Central Falls, the California jurisdictions -- Compton, San Bernardino, Stockton and Vallejo -- write their checks for pension contributions to the statewide pension plan, CalPERS. Public employee benefits are also protected by the state constitution. I talked to Mark Johnson, a pension expert on the Employee Retirement Income Security Act (ERISA), and to Jonathan Holtzman, one of the lead attorneys on Stockton's bankruptcy filing, about some of the issues that cities face regarding pension payments. Here are their edited comments.

What happens when the federal bankruptcy law crosses hairs with a state's constitution protecting employee pensions?

Mark Johnson (MJ): We are plowing through uncharted ground here. In general, we haven't had a lot of instances where cities have applied for bankruptcy. Typically, any government units that exist -- a city, county, water district -- were created by a state legislature and can do only what the state legislature lets them do. Some states don't allow their governmental units to file for bankruptcy. For those that do allow it, there's a conflict between a section of the federal bankruptcy code that says a city can file for bankruptcy and where a state says you can file but you can't touch pension obligations. Does the state control if and how a city can use the bankruptcy process? The question that needs to be answered is really fundamental: Who's the boss?

Jonathan Holtzman (JH): There's no real question that federal law trumps state law when they are inconsistent. The issue with respect to pensions arises because California law purports to limit what can be done to CalPERS obligations in bankruptcy. The extent to which that law is effective is a more nuanced question.



Stockton made a business judgment that in order to be a viable ongoing entity -- to be able to recruit and retain employees -- it has to be able to provide a pension like other jurisdictions. If Stockton had taken a different tack -- as other cities may -- would it have been able to alter the pension? That's the question San Bernardino may face. But, unless Stockton changes course, that issue is unlikely to be resolved in the Stockton case.

The way a Chapter 9 bankruptcy works, the city proposes a plan of adjustment, which then must to be approved by the bankruptcy court. Only the city can propose a plan of adjustment. Although the capital market creditors argue the city should abandon its CalPERS obligations, creditors don't have the right in Chapter 9 to propose a plan of adjustment.

With respect to retiree health benefits, Judge Christopher Klein's ruling [in Stockton's bankruptcy case] essentially says that "vested benefits" are a contractual obligation, and that one of the purposes of bankruptcy is to adjust contractual obligations. Judge Klein's opinion suggests that just because a benefit is "vested" does not mean it is untouchable in bankruptcy.

What does that mean for CalPERS?

JH: CalPERS argues that under state law, bankrupt agencies cannot reject their contracts with CalPERS and that CalPERS gets to stand in front of the creditor line. Remember, CalPERS holds money in trust. It doesn't have a giant chunk of money that doesn't belong to somebody. If a public agency doesn't pay, CalPERS won't pay benefits to the agency's employees. So, when the capital market creditors say, "Don't pay CalPERS," it's important to understand the real effect will be on employees and retirees.

Where will this showdown finally lead?

MJ: Ultimately, the Supreme Court is probably going to render a decision as to whether or not federal bankruptcy law trumps not merely state law, which it usually does, but also trumps the fact that a city in California or Texas or anywhere else is simply an operating unit of the state and gets to do what the state allows it to do. It's not merely a business that's headquartered in California or Michigan or Rhode Island that's filing for bankruptcy. It is a government unit that only exists because the state says it can exist. If a state says it must pay, must it pay? That's the question.

JH: The current thinking is that San Bernardino will be the first place where it gets litigated. All eyes are on what happens there.