by Barbara Altimus Shreero
Judge Christopher M. Klein's decision to accept the
City of Stockton's petition for bankruptcy on April 1, 2013 set the stage for a
battle over whether public workers' pensions can be reduced through municipal
Stockton's public revenues tumbled dramatically when the
recession hit, leaving Stockton unable to meet its day-to-day obligations.
Stockton slashed its police and fire departments, eliminated many city
services, cut public employee benefits and suspended payments on municipal
bonds it had used to finance various projects and close projected budget gaps.
Stockton continues to pay its obligations to California Public Employees'
Retirement System ("CalPERS") for its public workers' pensions.
Pension obligations are particularly high because during the years prior to the
recession, city workers could "spike" their pensions-by augmenting
their final year of compensation with unlimited accrued vacation and sick
leave-in order to receive pension payments that grossly exceeded their annual
When Judge Klein accepted Stockton's petition April 1, 2013,
he reasoned that Stockton could not perform its basic functions "without
the ability to have the muscle of the contract impairing power of federal
bankruptcy law." Judge Klein noted that his decision to "grant an
order for relief ... is merely the opening round in a much more complicated analysis."
The question looming is whether the contract-impairing power of federal
bankruptcy law is strong enough to adjust state pension obligations.
Stockton will have the opportunity to present a plan of
adjustment, which must be approved through the confirmation process. No plan of
adjustment can be confirmed over rejection by a particular class of creditors
unless the plan (1) does not discriminate unfairly, and (2) is fair and
equitable with respect to each class of claims that is impaired under or has not
accepted a plan. Judge Klein said that if Stockton "makes inappropriate
compromises, the day of reckoning will be the day of plan confirmation."
Stockton's plan of adjustment will likely propose periods
of debt service relief and interest-only payments for some municipal bonds,
followed by amortization. Stockton intends to actually impair other municipal
bonds, potentially paying only cents on the dollar. However, Stockton does not
intend to reduce its pension obligations to CalPERS under the plan. Provisions
of the California Constitution and state statutes prohibit the reduction of
public workers' pensions, even in bankruptcy proceedings. These California
state law provisions were thought to make public pensions virtually
untouchable. Yet, the plan may not be confirmable if it impairs Stockton's
obligations to bondholders but not its obligations to CalPERS. Bondholders and
insurers will surely vote against and object to the plan, claiming it unfairly
discriminates against them, and Judge Klein will have to decide whether the
treatment constitutes unfair discrimination. The unfair discrimination claim
may have merit, because an overarching goal of federal bankruptcy law is to
equitably allocate losses among competing creditors. Federal bankruptcy law
often trumps state laws, but there is no precedent for how federal bankruptcy
law applies to California's pension provisions.
For now, cash-strapped municipalities around the
country-and their creditors-are watching to see just how Stockton will
restructure its obligations.
This article is not intended
to provide legal or other advice or to create an attorney-client relationship.
Read other articles at Sheppard Mullin Finance &
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