SAN FRANCISCO — A ruling in the Stockton, Calif., bankruptcy case that pension obligations can be impaired could spur efforts among other cities to address pension costs, but won't lead to a rush to the courthouse, bankruptcy experts said.
U.S. Bankruptcy Judge Christopher Klein ruled Wednesday during a hearing on Stockton's proposed plan of confirmation to exit bankruptcy, calling state employee retirement law governing the California Public Employees' Retirement System "flat out invalid" in the face of the federal supremacy clause.
"Judge Klein's findings yesterday will reverberate throughout California cities as they evaluate their options," said Karol Denniston, partner in the San Francisco office of Squire Patton Boggs. "We can hope it will open the door for cities and CalPERS to work together to identify new ways to assist cities and their residents who are suffering through service insolvencies and avoid the need for a rash of Chapter 9 filings."
Fox Rothschild bankruptcy attorney Michael Sweet said he doesn't think the ruling will prompt municipalities to file for Chapter 9.
First, he said, many cities have been watching the Stockton case and have already had a sense of Klein's stance on pension obligations.
In addition, financial pressures have been letting up on cities and local governments, diminishing the need to file for bankruptcy protection.
"Filing for Chapter 9 is such an extraordinary step, I think cities are hard-pressed to do it, if they haven't found themselves there already, because the economy is getting better and things are looking up," Sweet said. "A lot of cities are working out solutions with their pension funds on their own, consulting with CalPERS or whoever else in order to avoid Chapter 9."
Denniston said bankruptcy is expensive and time consuming, and municipalities instead should be focusing on how to fairly deal with pension costs, since these are often a city's largest liability.
"Stockton should be a game changer, not an incentive for more Chapter 9 filings," she said.
Harvey Leiderman, a partner at Reed Smith, believes the ruling could encourage some municipalities to file for bankruptcy to try to reduce pension obligations if they don't understand the longer term implications to their fiscal health.
"Bankruptcy is not an economy ticket to Easy Street," he said. "Klein may have encouraged some to think that there is a convenient off-ramp from their ongoing pension obligations, but municipal employees will soon learn to vote with their feet if these promises are broken."
Leiderman currently serves as fiduciary, investment and litigation counsel to public pension funds in California, including CalPERS.
CalPERS has said it disagrees with Klein's ruling and that it was unnecessary to the decision on confirmation of Stockton's plan of adjustment.
"We disagree with the Judge's opinion on the issue of pension impairment," the pension system said in a statement. "This ruling is not legally binding on any of the parties in the Stockton case or as precedent in any other bankruptcy proceeding."
According to Sweet, the ruling is not binding because it was given in a trial court, and in order to have precedential authority, it needs to be an appellate court decision.
Moody's Investors Service called the ruling a positive sign for investors that pension obligations will not be given preferential treatment over debt in a municipal bankruptcy.
"This is a credit positive development regarding the treatment of debt versus pensions in California, though it could, if upheld, lead some other financially stressed municipalities to consider bankruptcy as a way of trimming unaffordable and growing pension burdens," analysts Eric Hoffmann and Greg Lipitz wrote Thursday.
"Still, we expect few if any new bankruptcy filings in the near term, now that municipal finances in California are generally improving with the state's economic rebound," they said.
In the long-term, however, the ruling could have a greater significance if another economic downturn were to occur, according to Sweet.
"If we see an environment like we saw in 2011 and 2012, I think cities that are looking at the possibility of filing for Chapter 9 will be emboldened by what Judge Klein said, which could cause them to be more disposed to file for Chapter 9 than they might otherwise have been."
The comments could also have broader legal implications, according to Leiderman. He said if the court's observations ever find their way into binding law, it would represent a "remarkable federal incursion into states' rights."
"Chapter 9 strikes a very delicate balance between federal and state power," Leiderman said. "A law based on the idea that a state's regulation of its political subdivisions is nothing more than a commercial contract, to be broken by either party without consequence, would ripple through the full faith and credit of our state and local governments."
Klein made the ruling in what marked the seventh day of Stockton's confirmation hearing, which has dragged on since May.
The hearings have focused on arguments between Stockton and Franklin Advisors, Inc., the only creditor with which Stockton has not reached agreement on its plan.
Franklin, which under the plan stands to take a significant loss on $35 million of bonds it holds, has argued that it is unfair to offer the firm only a 1% recovery rate when the city is proposing not to impair CalPERS in any way.
It's not clear if Klein will apply his opinion about CalPERS to the Stockton case.
Leiderman said he guesses Stockton will come back with a sweeter deal for Franklin and Klein's ruling will not be put in writing.
Klein acknowledged that he had not been asked to decide whether pension obligations could be impaired, but said it would be difficult to make a ruling on Stockton's confirmation plan without doing so.
At the end of Wednesday's proceeding, Klein said he was not ready to rule on the confirmation plan, and set another court date for Oct. 30.
