San Bernardino Becomes 3rd California City to Get Bankruptcy Protection

The ruling, which makes San Bernardino the third California city to get bankruptcy protection, could serve as a guide for other cities like Detroit that are in financial distress. Observers also say it's an important test for Chapter 9.
by | August 29, 2013 AT 3:00 AM

San Bernardino on Wednesday became the third California city in recent years to be awarded bankruptcy protection by a judge, setting the stage for a battle between the Southern California city's creditors and its retirees -- a fight that could provide a playbook for other cities facing similar financial burdens.

San Bernardino follows Vallejo, which was awarded Chapter 9 protection in 2008, and Stockton, which was granted protection in April of this year. (Mammoth Lakes, a California resort town, filed for bankruptcy in 2012, but won dismissal of its case after settling the $43 million development lawsuit that initially forced the city to seek protection from its creditors.)

The California Public Employees' Retirement System (CalPERS) remains the lone objector to San Bernardino's Chapter 9 claim -- the local union withdrew its objection last month after the city dropped its effort to reject collective bargaining agreements. As the nation's largest retirement system, the $260 billion CALPERS fund presents a formidable opponent. Vallejo did not attempt to reduce its pension obligations when it declared bankruptcy, a decision many believe was made to avoid a fight with CalPERS.

In her ruling, Judge Meredith Jury said it had been obvious for months that the city's finances were beyond rescue. "I don't think anyone in this courtroom seriously thought the city was anything but insolvent," she said, according to news accounts.

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San Bernardino, a city of 240,000 that is located one hour east of Los Angeles, has already gone where no city has gone before when it temporarily suspended its payments to CalPERS after declaring bankruptcy Aug. 1, 2012. It resumed payments this year, but the city's unfunded pension liability of about $143 million and the $50.4 million in bonds it issued in 2005 to help cover pension obligations and defaulted on, remain looming financial burdens. In its objection, CalPERS claimed that San Bernardino did not qualify for bankruptcy status largely because it ignored years of warnings about a looming financial crisis and was filing for Chapter 9 protection merely out of convenience.

Many observers believe that Wednesday's ruling is an important test for the federal law used by Detroit and other cities with overwhelming pension payment costs as any restructuring plan San Bernardino puts forth is expected to include cuts to retiree payments. Bankruptcy expert James Spiotto, a partner at Chapman and Cutler, notes that San Bernardino’s pension costs are so overwhelming they would “crowd out” the city’s ability to make a full recovery unless those costs become part of the restructuring along with creditor debt.

“If you just lower the debt and don’t solve the systemic problem, you’re just going to repeat it again – you’re not creating recovery,” he said, adding that a Chapter 9 plan must be structured in such a way that it gives a municipality the best chance to survive in the long term.

Detroit Emergency Manager Kevyn Orr has also called for cuts to current and future pension benefits in its bankruptcy plan, should it win Chapter 9 status. (Detroit filed for bankruptcy on July 18, becoming the largest U.S. city to do so.) Labor unions are fighting the bankruptcy on the claim that workers' benefits are protected by Michigan's state constitution – an argument that is echoed by their California counterparts facing similar threats in bankruptcy court.

It is precisely that question – do contractual obligations guaranteed by state law or state constitution still apply in federal bankruptcy court? – that some believe will make its way to a U.S. Supreme Court decision on how bankrupt cities deal with their pension liabilities. Karol Denniston, a bankruptcy attorney with Schiff Hardin in San Francisco, said that issue may be ruled on first in Detroit, where the judge has fast-tracked the city’s case.

“You can predict [a ruling that] bankruptcy code trumps state law,” Denniston said. And, she said, that precedent could send a signal to municipalities across the county with similarly burdensome retiree debt.

“If you get a clear ruling on that out of Detroit, the bankruptcy court will be open for municipalities where there’s no other way to restructure those pension obligations,” she added.

Pension liabilities are also an issue in Stockton's bankruptcy, which was given the green light by a judge in April to begin forming its restructuring plan. Stockton's Chapter 9 status was being challenged by its bond insurer, Assured Guaranty, which argued that the city of 300,000 did not attempt to renegotiate its pension debt with CalPERS and therefore did not exhaust all possible outlets before filing for Chapter 9.

By approving Stockton's bankruptcy protection, the judge essentially kicked that question to the restructuring hearings where Assured Guaranty can continue challenging the notion that CalPERS is exempt from being treated like any other creditor.