Stockton Bankruptcy Sets Stage for Pension Battle

Some say the ruling in Stockton, Calif.'s case could lead to a U.S. Supreme Court decision on how bankrupt cities deal with their pension liabilities.
by | April 1, 2013 AT 4:30 AM
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A federal judge ruled Monday that Stockton, Calif.’s bankruptcy could go forward, an order that some court watchers say could eventually lead to a U.S. Supreme Court decision on how bankrupt cities deal with their pension liabilities.

In an oral ruling that took nearly two hours, including a short break, U.S. Bankruptcy Judge Christopher Klein found that Stockton had practiced due diligence in declaring its bankruptcy, making it the largest U.S. city to gain Chapter 9 status. The Northern California city of 300,000, which filed for bankruptcy last June, was being challenged by its bond insurer, Assured Guaranty. The company argued that Stockton did not attempt to renegotiate its pension debt with the California Public Employees’ Retirement System (CalPERS) and therefore did not exhaust all possible outlets before filing for Chapter 9.

The ruling means that in the immediate future, Stockton will start working on its restructuring plan, one which will almost certainly include just partial repayments to creditors. But in the longer term, Assured Guaranty is expected to continue challenging the notion that CalPERS is exempt from being treated like any other creditor.

“Looking to the horizon, capital market creditors will say this [Stockton’s restructuring plan] can’t be fair because it discriminates against creditors in that it’s disproportionate,” said Karol Denniston, a San Francisco-based bankruptcy attorney. Denniston added she suspects the bond insurer’s challenge to Stockton’s bankruptcy status was a strategic move to set the stage for making that argument in an appellate court in the future.

“That’s a dog fight [that’s] coming,” she said.

Frank Shafroth, director of the George Mason University Center for State and Local Government Leadership, said he expects the issue to work its way to the national stage. “I’m assuming it would go to the 9th Circuit [Court of Appeals] and then to the Supreme Court,” he said. “This is not the end. I don’t even think it’s the beginning of the end. I think it’s the end of the beginning.”

Indeed, the issue of pensions, their legal status as contracts and whether they should be subject to change has been dotting state and federal courts across the country in recent years. In Southern California, the city of San Bernardino is arguing that CalPERS should be treated like any other of the city’s creditors (essentially the same argument Assured Guaranty is making in Stockton’s case). The pension system, says San Bernardino (which declared bankruptcy last July), should take a haircut right alongside the city’s bondholders and other shareholders. A judge has yet not ruled on that case’s eligibility.

In January, the Florida Supreme Court ruled that public employees’ pension contracts can be adjusted, when it upheld in a split decision a 2011 state law requiring public employees to contribute 3 percent of their salaries to the state's pension fund. The Florida Education Association had sued the state, arguing that the required contribution amounted to a pay cut and was subject to negotiation, according to their collective bargaining agreement. However the court ruled in a 4-3 decision that such a restriction on the state’s pension structure, that “could never be amended or repealed irrespective of the fiscal condition of this state,” could lead to fiscal irresponsibility.”

In August 2011, the city of Central Falls, R.I., declared bankruptcy after failing to renegotiate its pension and labor contracts. The city immediately moved in bankruptcy court to cut the amount it owed on those liabilities; eventually, it reached new agreements with labor and retirees in court that cut pensions by 55 percent. (Funding from the state’s General Assembly reduced that cut to 25 percent for the first five years.)

Although Monday’s ruling on Stockton sets the stage for a larger battle regarding the city’s CalPERS obligations, Denniston notes Klein offered a view into his thinking when he stated that municipalities allow bankruptcy under federal law because that law grants the ability to impair contracts. Under the California constitution, pensions are a protected contract.

“One could interpret from that, that Judge Klein doesn’t see CalPERS as any different from any other contract,” Denniston said.