A federal bankruptcy judge ruled on Monday that the city of Stockton, Calif., was eligible for court protection from its creditors, clearing the way for a battle over whether public workers' pensions can be cut when the city they work for goes bankrupt.
After declaring Chapter 9 bankruptcy last year, Stockton eliminated tens of millions of dollars in city services and said it would cut some bond payments in a way unseen before in municipal bankruptcy. But bondholders objected to Stockton's effort to protect pensions while forcing losses on investors.
(Read More: Judge: Stockton, Calif., Can File for Bankruptcy)
Many states have statutes and constitutional provisions making it illegal to cut public workers' pensions. Until now, there has not been a prominent test of those laws in bankruptcy—particularly not in California, where the big state pension system, known as Calpers, has been girding for battle on the issue, trying to avoid the precedent of a cutoff or shortfall in a city's pension contributions.
Federal bankruptcy law often trumps state laws, but municipal bankruptcies are so rare that there is almost no precedent on how to apply the law to state pension provisions.
In the ruling, issued on Monday in Sacramento, which affirmed the legal status of Stockton's bankruptcy, Judge Christopher M. Klein said he could see battle lines being drawn between Calpers—formally the California Public Employees' Retirement System—and the city's other major creditors, including several Wall Street companies that either bought Stockton's bonds or insured them. But he ruled that it was still too early in the case for that battle to be joined.
"There are very complex and difficult questions of law that I can see out there on the horizon," he said.
(Read More: US Municipalities That Went Bankrupt)
The judge said he would decide those questions during the next phase of Stockton's bankruptcy, in which the city's creditors will contest whether its so-called plan of adjustment is fair. A plan of adjustment in a municipal bankruptcy is comparable to a plan of reorganization in a Chapter 11 bankruptcy; a city cannot emerge from bankruptcy unless the judge confirms its plan of adjustment.
"The day of reckoning will be the day of plan confirmation," Judge Klein said near the end of a two-hour session in which he read his decision. "The city is going to have a difficult time confirming a plan over the objection of unfair discrimination."
The Wall Street creditors had been trying, until now, to persuade Judge Klein to throw out the case, arguing that the city was not truly insolvent and had not treated them fairly. Specifically, they argued that they were being forced to take big haircuts while Calpers was not asked to give up a single dollar of what Stockton owed it, an estimated $900 million. Those creditors included Assured Guaranty and the National Public Finance Guarantee Corporation, which insured some of Stockton's bonds, and two high-yielding mutual funds, led by Franklin Advisors, which invested in the bonds. Wells Fargo Bank also objected, in its role as bond trustee.
But Judge Klein found that the group, which he called "the capital markets creditors," had raised the fairness issue prematurely. He also said he found their claims that the city was feigning insolvency unpersuasive. Municipalities must clear several legal hurdles before they can qualify for bankruptcy court protection, and Judge Klein said Stockton had done more than necessary to demonstrate its eligibility.
For example, he said the city had already made big cuts in its work force and had wrung painful concessions out of the workers who remained. He cited rising drug trafficking and gang violence and said the police force and fire department had been reduced so much that any further cuts would put residents at an unacceptable risk. Even after all those cuts, he said Stockton had reached a point where the only way it could keep from running out of cash was by defaulting on its bonds.
The judge also said that California statute required all Chapter 9 candidates to go through a 60-day mediation period before declaring bankruptcy, and creditors were supposed to help pay the cost. But the capital markets creditors dropped out of mediation, he said, when they learned Stockton was not seeking any concessions from Calpers. That left the city to pay the whole bill.
"The capital markets creditors contend that the city gave them a take-it-or-leave-it proposition, and that that is not negotiation," Judge Klein said. "I'm sorry. I'm not persuaded. Negotiation is a two-way street. You can't negotiate with a stone wall. You cannot do it. It cannot be done. It is a contradiction in terms."
Stockton's city manager, Bob Deis, expressed satisfaction with Judge Klein's decision in a written statement. "After nine months and millions of dollars in legal fees, the judge validated what we have been saying from the beginning, that the city is insolvent and needs the protection of bankruptcy to adjust its debts."
Calpers' chief executive, Anne Stausboll, issued a statement saying that Stockton "has consistently acknowledged the importance of providing benefits to its employees through its existing relationship with Calpers, consistent with state law." She said that Calpers would continue to act as a fiduciary as the bankruptcy progressed, "and protect and defend the integrity and soundness of the pension plan."
A spokesman for Assured Guaranty, Robert Tucker, said the company "respectfully disagrees" with Judge Klein's decision on the question of eligibility. He said the insurer had made several proposals in mediation but Stockton did not yield. He said Assured Guaranty believed that "the real, substantive issues posed by the city's Chapter 9 filing" would still be addressed, in the next phase of the case.
Municipal finance specialists said one lesson they were drawing from Stockton's case was that Chapter 9 was not as effective as it ought to be, given the scope of the city's fiscal problems and how long it was taking Stockton just to bring Calpers, its biggest creditor, to the negotiating table.
"You can't restructure without dealing with your largest creditor," said Karol K. Denniston, a lawyer with Schiff Hardin whose practice includes advising financially troubled municipalities in California. She said some members of the California state Legislature were already watching Stockton's case and another in San Bernardino, with an eye toward new state laws that could help troubled cities avoid such expensive and debilitating struggles.
"I think we'll see legislation next year," Ms. Denniston said. One idea being considered, she said, was amending the state pension laws, to give Calpers the authority, but not the obligation, to restructure the debts that distressed cities owe it.