California has had two major municipal bankruptcies in the past year, and both are being watched very closely by “interested parties” throughout the country. Novel legal issues are at stake in both Stockton and San Bernadino, with federal bankruptcy judges likely to issue rulings that will have significant ramifications for public pensions as well as the municipal bond market.

The question of what happened to these two cities before bankruptcy is a critical one, but not where we are going to start. Both cities have filed for federal bankruptcy protection, and both have had opposition to those filings. Within those filings lay some difficult legal questions that ultimately will be determined by federal bankruptcy courts.

Stockton has continued to pay its pension obligations (to calPERS), leading bondholders to file in opposition to that city’s bankruptcy petition. San Bernadino, on the other hand, stopped its pension payments (to calPERS), which has led to calPERS creating significant legal obstacles for the City, including strong opposition to the bankruptcy filing. As of this date a federal judge has allowed Stockton to proceed into federal bankruptcy protection over the objection of bondholders, while San Bernadino has not as of yet been approved for the same. The consensus appears to be that Stockton has been better managed through the bankruptcy process, with the City Manager asserting control over the process, and delivering results. But the legal positioning, placing bondholders and calPERS on a collision course, will not be solved by good management. Ben Feder of the “Bankruptcy Law Insights Blog” summed up the legal issues involved in that battle:

“The issues at stake — whether California state laws protecting public employee pension obligations are pre-empted and superseded by Congress’s Article I, Section 8 authority to establish uniform laws regarding bankruptcy, or are protected under the Tenth Amendment — implicate fundamental issues of federalism, and in all likelihood the Supreme Court will eventually need to resolve the questions being raised regarding the proper balance between state and federal power … .

“The [most] complicated question is whether priorities for unsecured claims created under state law — particularly regarding obligors that are themselves governmental units — can trump the distribution mechanisms of the U.S. Bankruptcy Code, and the Code’s underlying purpose of providing similar treatment for similarly situated creditors. Numerous states in addition to California have varying degrees of protection for public employee pension obligations. (Rhode Island, on the other hand, recently took the opposite tack and enacted a law that gave priority to bondholders in the Central Falls Chapter 9 cases.)

“Calpers will argue that the preference under California law for public employee< pension obligations is protected under the Tenth Amendment. San Bernardino’s bond investors will argue that the Bankruptcy Code expressly sets forth the priority of certain types of unsecured claims, that no other unsecured claims are entitled to more favorable treatment, and that California law regarding public employee pension obligations is pre-empted by the Supremacy Clause of the Constitution.”

And so the battle is joined, with calPERS, if you judge by the rulings, appearing to have the upper hand. San Bernadino has added to that perception by filing an FY 14 budget that will begin paying calPERS again. The full FY13 obligation of San Bernadino to calPERS is $25.5 million, 21% of total revenue for the City. No word from the City on how they plan to pay back the arrears, which could total over $15 million by the time they start paying into the fund again. That obligation is going to be vigorously contested, as calPERS will attempt to prevent the City from entering bankruptcy and applying a haircut to that unpaid pension obligation.

The decision in the case of Stockton, to allow the City to proceed into Chapter 9 bankruptcy proceedings, has been analyzed by many, with all looking to read the tea leaves as to what Judge Christopher Klein really thought about the ultimate status of calPERS. Many who are looking to the federal bankruptcy proceedings to bring “pension reform” to Stockton were encouraged by some of the verbiage in Judge Klein’s ruling. Some of the reports I read claim that Judge Klein, in his decision, referred to calPERS as a “garden variety creditor.” That is simply not true, and it is a very important point.The Judge pointed out that one of the objectors would like to classify calPERS in that fashion. Judge Klein highlighted some of the financial issues that compelled Stockton to seek Chapter 9 protection, and he did not exempt pension practices.

And some of the problems were also rooted in generous retirement practices. The pensions, of course, are
themselves a form of implicit compensation. Pensions were allowed to be based on the final year of compensation, and
only the final year of compensation, and that compensation could include essentially an unlimited accrued vacation and sick leave. So it was possible to engage in the phenomenon that’s become known as “pension spiking,” in which a pension can wind up being substantially greater than the annual salary that the retiree ever had. And there’s been a number of those situations that have come into public view,generally, not entirely from Stockton, as part of a debate
that seems to be going on in the larger community. In any event, pension spiking was an issue in Stockton because Stockton’s obligations to CalPERS were based on the amount of pensions that were having to be paid out. So projected pension expenses in particular were soaring.

So Judge Klein recognized that poor pension practices were part of the problem. Judge Klein also took note of the some of the pension changes made through modifications to existing collective bargaining agreements that benefited the City through the mandatory pre-Chapter 9 mediation process. That process was ignored by bondholders, which ultimately undercut their legal position in opposition to Chapter 9 for the City. But what did he say about the Stockton obligation to calPERS, and the position of bondholders (more specifically bond insurers) that the City ought to immediately haircut this obligation?

This does not mean that there’s not potentially a serious issue involving CalPERS. But at this point, I do
not know what that is. I do not know whether spiked pensions can be reeled back in. There are very complex and difficult questions of law that I could see out there on the horizon, but no plan of adjustment can be confirmed unless — no plan of adjustment can be confirmed over the rejection by a particular class unless that plan does not discriminate unfairly and is fair and equitable with respect to each class of claims that is impaired under or has not
accepted a plan. That’s section 1129(b)(1) of the Bankruptcy Code, which, by virtue of section 901, applies in
chapter 9 cases. So the protection for the Capital Market Creditors is in the plan confirmation process. If a plan is proposed that does not deal with CalPERS and if the Capital Market Creditors reject their treatment under the proposed plan, then I will have to focus on the question of unfair discrimination. And the gravamen of the argument that the Capital Markets Creditors make is one of unfair discrimination. But that is not an eligibility question to be a problem at this stage of the case. To the contrary, it is a plan confirmation problem. And the City is going to have a difficult time confirming a plan over an objection and claim of unfair discrimination without being able to explain that problem away. And that problem is probably going to require me to get down into the nitty-gritty of the CalPERS situation. And I, at this point, have no clue how that’s going to come out, but that is the protection.

(emphasis added)

So Judge Klein acknowledges the difficult legal issues involved with attempts to modify the City obligation to calPERS. Judge Klein had made a strong point in his decision to highlight the legal principle that federal bankruptcy proceedings are all about modifying contractual obligations, and certainly supersede state law:

….what chapter 9 brings to the table that is not in state law is the exclusive power of the Congress under the Constitution to make uniform laws concerning bankruptcy. And uniform laws concerning bankruptcy mean impairment of contracts. The contracts clause of the United States Constitution says that no state may make a law impairing the obligation of contracts. And that limitation does not apply to Congress. And, for the reasons I explained in that decision, the asymmetry is absolutely intentional on the part of the founders, the framers of the Constitution, because bankruptcy is nothing but the impairment of contracts. I’ve been doing this job for more than 25 years. I’ve had more than 138,000 bankruptcy cases. I’ve been party to impairment of millions of contracts and it’s all constitutional. And I explained in that decision also that a parallel contracts clause in the state constitution must give way to the Bankruptcy Code, to the power of the Congress under the Supremacy Clause of the Constitution;
perfectly straightforward, garden variety constitutional law proposition.

For those on either side of this issue to cite Judge Klein’s decision to allow Stockton to go forward into Chapter 9 as a victory would simply be, in my opinion, overly optimistic. It is the beginning of the process, and these issues are complex and not easy to untangle. One thing that comes through to me, after reading the decision, is the victory by Stockton City Manager Bob Deis, who produced the complex documents and plans necessary to get Stockton into Chapter 9. A thoroughly professional job. A second item of note is the poor legal work of lawyers representing bond insurers. The Judge was not overly impressed with their arguments as to why Stockton should be stopped from entering Chapter 9, and their position on mandatory mediation badly undercut their own position.

The last issue to be discussed in this overly long post is the modification, by Stockton, of payments by the City to fund retiree health care costs. The City, in its pendency plan, modified (lowered or eliminated)payments for retiree health care costs. The retirees sought injunctive relief from the terms of the City plan before Judge Klein, who ruled last year that the City could in fact move forward with the modification(s), denying the petition for relief. The retirees will have to participate in the Chapter 9 proceedings in order to protect this claim, but it should be noted that the legal argument that these collective bargaining contracts will be sacrosanct in a federal bankruptcy proceeding did not hold up in an initial legal test. (Association of Retired Employees of the City of Stockton v. City of Stockton).

Lots more to come on these very important cases. While each state is different (Chapter 9 allowed by some and not others)there will be critical legal issues determined by federal bankruptcy judges that will likely end up before the Supreme Court. Those determinations will have some major impacts not just on the legal status of pension obligations but on municipal bond markets as well.

The three page Stockton restructuring proposal here.

The full Stockton restructuring plan submitted through mediation. (File 1 of 3)

Stockton Restructuring Proposal submitted through mediation. (File 2 of 3)

Stockton restructuring proposal submitted through mediation (File 3 of 3).

San Bernadino Press Release on Stopping Payments to calPERS.

City of San Bernadino Pendency Plan.