By Gary Kaplan

On April 1 Judge Christopher Klein of the U.S. Bankruptcy Court for the Eastern District of California ruled that the city of Stockton is eligible for relief under Chapter 9 of the U.S. Bankruptcy Code, rejecting challenges by "Capital Markets Creditors" that insured hundreds of millions of dollars in bonds issued by the city. The bankruptcy case, the largest ever by a U.S. city, was initiated in June 2012 in the face of Stockton's $26 million budget deficit, even after the city of 300,000 slashed spending by $90 million over three years, drastically cutting pay for police officers, firefighters and other public employees, and cutting public services.

The next step in the bankruptcy case is Stockton's preparation of a proposed "plan of adjustment" to restructure more than $1 billion owed to creditors. This is anticipated to raise unprecedented issues in municipal bankruptcy, including Stockton's efforts to slash payments on its bond debt of about $300 million, as well as possible reductions in its $900 million liability to the California Public Employees' Retirement System (CalPERS), the city's largest creditor. These issues involve uncharted waters, and if Stockton is able to cut these debts, it will likely embolden other cities facing comparable daunting liabilities to consider a bankruptcy filing.

Potential Reduction In Stockton's Bond Debt

Based on Stockton's pre-bankruptcy negotiations with creditors, which were required before it could seek bankruptcy relief, the city's plan of adjustment is expected to include significant write-downs in its bond obligations. This would be unprecedented in a municipal bankruptcy case (although such reductions are being contemplated in the pending bankruptcy cases of the city of San Bernardino and Jefferson County, Ala.) and presents a number of legal and practical challenges.

On the legal side, in the absence of a consensual restructuring of the bond debt with Capital Markets Creditors, Stockton could confirm a "cramdown" plan of adjustment if it satisfies applicable provisions of the Bankruptcy Code, including that the plan (1) "is in the best interests of creditors and is feasible" pursuant to §943(a)(7), and (2) is "fair and equitable" and "does not discriminate unfairly" with respect to objecting creditors in accordance with §1129(b).

The limited body of relevant case law suggests that Stockton's compliance with the "best interests of creditors" and "fair and equitable" standards will require that the city demonstrate its plan is balanced and that it has taken reasonable steps to increase revenue and cut expenses before proposing major debt reductions. A lack of unfair discrimination mandates that disparate treatment of a particular class of creditors is reasonable, necessary, proposed in good faith and proportionate to its rationale. Thus, Stockton would have difficulty providing inferior treatment of the claims of the Capital Markets Creditors as compared to other creditors in the absence of appropriate justification.

Even if Stockton can overcome the legal obstacles to cram down a plan of adjustment that cuts its debt to Capital Markets Creditors, it will still face practical hurdles in doing so. Stockton (and other distressed cities) may find themselves unable to fund ongoing operations by issuing bonds in the future, or may be forced to pay higher interest rates to obtain such financing, as investors seek compensation for the risk of future nonpayment through bankruptcy or the threat of a Chapter 9 filing to accomplish such objective. Thus, any economic benefit that the city may realize in reducing its bond debt may be tempered by the higher costs it pays on future bonds.

If Stockton is successful in slashing its bond obligations, it will likely provide other distressed cities with leverage to restructure their bond debt, based on the threat of compelling such write-downs through bankruptcy. Not surprisingly, major participants in the multitrillion-dollar municipal bond market are keeping a wary eye on the Stockton case.

Possible Modification of Stockton's Pension Debt

The other shoe that may drop in its bankruptcy case is Stockton's potential restructuring of its pension obligations. Although Stockton has kept up with pension payments to CalPERS to date, there is increasing speculation that it will seek to reduce these obligations through its plan of adjustment.

Under applicable provisions of California's Public Retirement Law (Cal. Gov. Code, §20000 et seq.), CalPERS sets contribution rates for municipalities with which it contracts to provide retirement benefits to their employees, based on the municipality's chosen benefits for its retirees. If the municipality does not pay the amounts owed under the agreement, then CalPERS may terminate the contract and demand the amount deemed necessary to fund future benefits. If the municipality fails to pay such amount, then CalPERS has the right to reduce benefits accordingly. Thus, if Stockton fails to honor its agreement, CalPERS could be justified in cutting pension payments to retired employees consistent with the city's prior contributions. While this would leave retirees with claims for the city's breach of its obligations to pay pension benefits, those claims probably would be paid at a fraction of their face amount under Stockton's plan of adjustment.

While Klein rejected the Capital Markets Creditors' argument that the city was required to negotiate with CalPERS to reduce its pension debt in order to be eligible for bankruptcy relief, the court observed that if such a restructuring is not part of Stockton's plan of adjustment, then "the city is going to have a difficult time confirming a plan over an objection and claim of unfair discrimination" by other creditors.

While no municipality has slashed its pension debt through a Chapter 9 plan, the trend appears headed in that direction. For example, the city of San Bernardino halted contributions to CalPERS (along with other creditors) in August 2012 upon filing for Chapter 9 bankruptcy, although it is planning to resume payments in July.

Both Stockton and CalPERS have argued in court filings that the city must pay CalPERS the full amount owed under California law. However, the legal answer on this point is far from clear. On the one hand, the Bankruptcy Code generally recognizes the sovereignty of the states (and their political subdivisions) under the 10th Amendment to the U.S. Constitution. For example, Bankruptcy Code §943(b)(4) provides that "the court shall confirm the plan if ... the debtor is not prohibited by law from taking any action necessary to carry out the plan." Stockton and CalPERS have both argued that the city may not impair the vested pension benefits of employees and retirees pursuant to the contract clauses in each of the United States and California Constitutions.

On the other hand, the Bankruptcy Code authorizes a plan to be confirmed even if certain terms are inconsistent with nonbankruptcy law. For instance, Bankruptcy Code §1123(a)(5) provides that "notwithstanding any otherwise applicable non-bankruptcy law ... a plan shall provide adequate means for the plan's implementation." Indeed, in an earlier ruling in the Stockton case, Judge Klein rejected retired employees' efforts to require the city to continue paying their health benefits during the bankruptcy case in accordance with applicable state law, stating "even if the plaintiffs' benefits are vested property interests, the shield of the Contracts Clause crumbles in the bankruptcy arena." Assoc. of Retired Employees v. City of Stockton (In re City of Stockton), 478 B.R. 8 (Bankr. E.D. Cal. 2012). Likewise, in the city of Vallejo's recent Chapter 9 case, the court ruled that employees' collective bargaining agreements protected by California's labor laws could be cancelled under bankruptcy law, which generally supersedes conflicting state laws. Int'l Bhd. of Elec. Workers, Local 2376 v. City of Vallejo (In re City of Vallejo), 403 B.R. 72 (Bankr. E.D. Cal. 2009). (By way of disclosure, the author's law firm represented two of the unions in the Vallejo bankruptcy case.)

It remains to be seen whether Stockton's plan of adjustment will seek to alter the city's pension funding obligations to CalPERS. Even if it can legally do so, a number of practical constraints may prevent Stockton from moving forward on such a drastic course. CalPERS has asserted that if the city alters its existing pension obligations, the city will be unable to provide employees with further pension benefits for at least three years under applicable law. Cal. Gov. Code §20460. In addition to provoking a harsh political backlash, this would likely result in Stockton having difficulty retaining and hiring qualified employees.

In light of the potentially tremendous ramifications from Stockton cutting its pension obligations, cities and counties throughout California and across the United States are closely watching the possible reduction of pension debt in the Stockton case as their stagnant receipts are unable to keep pace with ever-increasing retiree and employee benefit costs.

Gary M. Kaplan is a certified bankruptcy specialist and is special counsel in the San Francisco office of Farella Braun & Martel. He co-chairs the firm's restructuring, insolvency and creditors rights group and represents debtors, secured and unsecured creditors, creditors' committees, trustees and receivers in a wide range of bankruptcy and nonbankruptcy matters. He can be reached at [email protected].

Reprinted with permission from the April 26, 2013 edition of the The Recorder © 2013 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382 or [email protected] or visit www.almreprints.com.