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ALL EYES ON THE MAIN EVENT IN STOCKTON BANKRUPTCY

Dan Pellissier, President, California Pension Reform

April 12, 2013

[Publisher's Note: As part of an ongoing effort to bring original, thoughtful commentary to you here at the FlashReport, I am pleased to present this column from Dan Pellissier of California Pension Reform - Flash]

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The Great Recession of 2008 placed a major financial strain on all California school districts and government agencies. While budget officials estimate future taxes and spending on a smooth, straight line basis, the huge drop in economic activity and sputtering recovery has stressed all government agencies, regardless how well managed.

Although most California governments are struggling and have tightened their belts, three cities have gone to federal bankruptcy court because their slumping revenue and increasing employee costs created unsustainable structural deficits. Vallejo, Stockton and San Bernardino have proven to be the weakest municipalities, all seeking a bankruptcy judge’s unique power to break costly contracts and write down mounting debts.

Our Founding Fathers recognized the importance of giving debtors an orderly process to cancel unbearable contracts, divvy up their limited assets between creditors and start over. Debtor prisons were not very effective and the states wanted to be sure their citizens would be treated fairly throughout the nation. Through the US Constitution’s “Enumerated Powers” (Article 1, Section 8) they gave Congress the power “to establish uniform Laws on the subject of Bankruptcies throughout the United States.”

For more than a century, the powers of bankruptcy court were only available to individuals and corporations. The Great Depression proved government agencies also needed to break contracts and adjust their debts, so Congress gave municipalities access to bankruptcy court by establishing Chapter 9 in 1937. The depth of the economic distress made the previous remedy of judicially imposed tax increases ineffective. To date, more than 600 insolvent municipalities have found relief in bankruptcy court.

In all but Chapter 9 cases, a federal bankruptcy judge has tremendous power to impose a settlement on creditors and debtors. Yet the 10th Amendments’ limit on federal powers keeps federal judges from stepping in and operating local agencies through appointed trustees as allowed elsewhere in the bankruptcy code. Indeed, states must specifically authorize their municipalities to file for bankruptcy, though California offers blanket permission after following a pre-filing process.

It was after that fact finding and mediation process that Stockton entered bankruptcy court last summer and presented a Pendency Plan to operate the city while the court considered its case. The plan ended the City’s lifetime retiree health care benefits, a move that was immediately challenged by the retirees claiming the benefit was a vested right protected by the California Constitution’s Contracts Clause. Bankruptcy Judge Klein promptly dismissed their case, reminding the retirees that even if their benefits are vested, any protection provided under the state contracts clause "crumbles in the bankruptcy arena."

Two weeks ago, Judge Klein issued another ruling, confirming that the City of Stockton met the qualifications for Chapter 9, including being both a city and insolvent. Although the outcome was no surprise, the lawyers for the Wall Street Creditors facing $165 million bond insurance losses used this opportunity to highlight the main question now on the table, whether Stockton employees’ state contractual rights to their pensions have priority over bond holders claims for repayment.

It is a foundational principle of bankruptcy law that all creditors of the same class shall be treated equally. It is so important, that in private sector cases judges can impose a fair solution over the objections of the debtors and creditors. Judges do not have that power in Chapter 9 cases. They can only approve a Plan of Adjustment proposed by the municipality.
Stockton proposes to keep paying on its $900 million unsecured debt to CalPERS and stop paying the bondholders' unsecured claims. The Wall Street Creditors are particularly upset that they money they loaned to Stockton was used to pay CalPERS. To help explain this glaring inequity, Stockton says the Wall Street Creditors knew about their financial condition and debt to CalPERS when they made the loan, so they should bear all of the cost of its failure. It is like that classic scene in the movie Animal House, where fraternity President Otter tells pledge Flounder whose brother’s car has been destroyed, “You (messed) up, you trusted us.” Clearly Animal House ethics should not be a guide for important public policy decisions.

While Judge Klein’s recent ruling did not resolve this conflict, he said it would be addressed at the proper time and that Stockton “is going to have a difficult time confirming a Plan of Adjustment over the objection of unfair discrimination.” He also confirmed that CalPERS is a “garden-variety creditor” without the special protection it has been asserting. This position is consistent with Klein’s strong ruling on the retirees’ claims for special status.

There are two major reasons why people outside Stockton should care about this bankruptcy case. First, if bond issuers believe their repayment will always come after pension debt payments, they may stop doing business with weak municipal governments or charge them substantially higher interest rates to compensate for the additional investment risk. This increased risk profile could have a dramatic impact on many debt stressed California communities that will need some type of financing to address their own fiscal problems in the years ahead.

More importantly, if Judge Klein refuses to accept a Plan of Adjustment that protects all past and future pension earnings, it will set the stage for a serious conversation about how those contractual pension obligations can be modified to save a community from fiscal ruin, the real purpose of Chapter 9 bankruptcy.

Stockton’s five percent annual cost of living adjustment for retirees is one of the most generous in the state, doubling their monthly pension payment after just 14 years of retirement. Reducing that scheduled increase to the much more common two percent annually would instead make retirees wait 36 years before their benefit would double.

Changing the amount of pension benefits current employees earn in the future could also save a tremendous amount of money, but it will take the power of the bankruptcy court to break the implicit contract some believe government workers have to those future earnings. While this could happen outside of bankruptcy court through collective bargaining, it is a concession government employees will never make so long as they believe their future benefits are beyond the reach of even a bankruptcy judge.

In the big picture, California communities need some way to adjust their very costly obligations to generous government employee retirement benefits or they will continue to see the erosion of the government services upon which they depend. Bankruptcy is an expensive, time consuming and divisive process that should be used only as a last resort. Yet the Stockton case has the potential to change the key assumptions that make resolving these conflicts out of court so difficult.

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Dan Pellissier is the President of California Pension Reform, a citizens group dedicated to establishing fair and sustainable retirement benefits for government employees. You can contact Pellissier, via the FR, here.

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