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All Eyes on Stockton as Judge OKs Bankruptcy

The Stockton Record
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The Stockton Record

A U.S. bankruptcy judge's decision Monday cleared the way for indebted Stockton, Calif., to seek relief through Chapter 9 bankruptcy. Experts say the precedent-setting case has implications for other financially struggling cities such as Detroit, as well as municipal bondholders, public workers and retirees.

"The fact of the matter is, the city can't pay its bills," said Marc Levinson, lead bankruptcy counsel for the city of Stockton. With the judge's ruling, "We have a forum to try to discuss the city's debts."

Judge Christopher Klein agreed, according to the Associated Press. "It's apparent to me the city would not be able to perform its obligations to its citizens on fundamental public safety as well as other basic government services without the ability to have the muscle of the contract-impairing power of federal bankruptcy law," he said.

(Watch More: Judge OKs Cali City to File Bankruptcy)

That forum will have an audience. "Everyone's watching this case," said John Pottow, a law professor at the University of Michigan who specializes in bankruptcy law. "We're finally having the moment of reckoning. … The more cities that do it, the more other cities will feel comfortable doing it."

The ruling "raises the specter of doing it in other places," said Alicia Munnell, director of the Center for Retirement Research at Boston College.

This could be problematic for the municipal bond market. Jessalynn K. Moro, managing director of U.S. public finance for Fitch Ratings, said via email that the increasing interest in Chapter 9 has prompted bond traders "to re-evaluate the fundamental assumption that local governments will seek to repay their bonded debts at virtually all costs."

Judge Klein's decision also could have big ramifications for Detroit. Last week, an emergency financial manager with expertise in bankruptcy took on the troubled city's books. Stockton's path through Chapter 9 could prove to be a road map if other attempts to fix Detroit's finances fail.

"We're very hopeful that Detroit can avoid bankruptcy," said Bettie Buss, senior research associate at the Citizens Research Council of Michigan. Having a bankruptcy expert handle the city's books and negotiate with creditors, however, "gives the discussions … more urgency," she said. If creditors know bankruptcy is an option, they could be more motivated to negotiate.

(Read More: Judge Makes Decision)

Bondholders in the Stockton case are expected to mount a legal challenge to state legislation that protects pensions, arguing that pension obligations shouldn't be shielded from the financial fallout other creditors face. "Pensions will be the battleground," Levinson said. "The battle lines have already been drawn."

"There's two antithetical legal propositions," Pottow said. "A bankruptcy plan of reorganization has to comport with generally applicable law. On the other hand, the bankruptcy code can preempt laws that directly conflict with a bankruptcy plan" if the court determines that those laws were set up to shield certain groups at the expense of others, he said.

If pensions are preserved and bondholders take a significant haircut, the typically staid municipal bond market could face turbulence. Moro said that although "continued attempts by defaulting governments to restructure or even reduce debts could further erode confidence" among bond-buyers, "we are all in a bit of wait-and-see mode."

Pottow called that the less likely outcome, though. "I think those state laws are probably superseded under bankruptcy code," he said.

If this is the case, retirees—not only those in Stockton but in other fiscally shaky cities—could lose out. "There are lots of cities that have overextended retiree benefits," Pottow said. "It's much easier to offer a union greater health benefits than to offer them more money."

In Michigan, pensions that have already been earned are protected by the state's constitution, Buss said. But if Stockton bondholders' challenge leads a judge to decide that bankruptcy law supersedes state protection, city workers in Detroit could see their pensions shrink should the city end up in Chapter 9.

"If this is used as a tool, it certainly reduces the power of unions and employee groups" in municipalities where filing for Chapter 9 protection is a legal option, Munnell said. She added that California law surrounding pension funding lacks flexibility but suggested that public workers would be better off if state legislatures addressed issues like this rather than leave retiree benefits vulnerable in bankruptcy court.

"It's just such a terrible way to do business," Munnell said. "The pension system did not bring Stockton to this point, but pensions are being affected by this decision."

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