In Ruling on California Town's Bankruptcy, Judge Challenges Sanctity of Pensions

A federal bankruptcy judge on Wednesday upended the widely held belief that public workers' pensions have a special status in California that makes them impossible to cut, further chipping away at the idea that pensions are sacrosanct in a municipal bankruptcy.

The ruling, which came during a hearing on a plan by the City of Stockton to exit bankruptcy, did not order the city to cut its pension plan or take any specific action. The judge said that he needed more time to reflect on Stockton's situation and that he would decide Oct. 30 whether the city could emerge from its two-year bankruptcy or whether it still had more work to do.

But the decision, by Judge Christopher M. Klein of the Eastern District of California, dealt a blow to California's giant state-led pension system, known as Calpers, which has been leading efforts to preserve defined-benefit pensions nationwide.

Stockton has gone through what Detroit faces and hopes to emerge from bankruptcy protection in the spring. But its biggest problem, pension payments, still looms.

It echoed a decision made last year by Detroit's bankruptcy judge, but went even further. While Detroit's pension system was a struggling local entity with few friends in the state capital, Calpers is a powerful arm of the state, with statutory powers that include liens allowing it to foreclose on the assets of a city that fails to pay its pension bills.

Calpers had argued that if Stockton stopped making payments and dropped out of the state pension system, the lien would let it claim $1.6 billion of its assets. But Judge Klein said those statutory powers were suspended once a California city received federal bankruptcy protection.

'Why should I take that lien seriously?' he asked a lawyer for Calpers, Michael Gearin. 'I may avoid it as a black-letter matter of bankruptcy law,' he said, referring to well-established legal principles.

He did not dispute that Stockton would be billed $1.6 billion to leave Calpers and said such a termination fee 'can be seen as a golden handcuff.' But in bankruptcy, he said, Stockton could legally refuse to pay the bill because it arose from the city's contract with Calpers, and contracts are broken routinely in bankruptcy.

'The bankruptcy code provides that the lien can be avoided and be treated as an unsecured claim,' Judge Klein said.

Judge Klein also said that Stockton had many options other than Calpers for retirement benefits: a private provider, like an insurance company; a multiemployer pension plan affiliated with a union; one of California's county-run pension plans; or it could even offer no pensions at all.

'There are lots of permutations and combinations out there with respect to the art of the possible,' he said, adding that nothing in the law required any city to give its business to Calpers. 'The whole world is out there.'

Judge Klein's ruling went beyond anything that Stockton was seeking.

In oral arguments on Wednesday, Stockton's lawyer, Marc A. Levinson, said that for Stockton to switch to another retirement plan administered by a different entity would probably take two years, and in the meantime all the city's workers were likely to quit. Their first choice would be to seek similar jobs in cities that were still part of Calpers, he said, adding that he thought Calpers was a more efficient plan administrator than any other entity Stockton might try.

Mr. Levinson said Stockton wanted to use its 'business judgment' to keep its existing relationship with Calpers, something bankruptcy law permits.

The issue of cutting pensions was raised by a holdout creditor, Franklin Templeton Investments, a mutual fund company that had previously bought about $36 million of Stockton's debt. In mediation, the city had initially proposed to settle the entire debt for less than a penny on the dollar, but Franklin managed to improve its position somewhat by showing that about $4 million of the debt was secured and had to be paid. That helped, but the city was still offering less than a penny on the dollar for the unsecured portion.

That left Franklin to argue that Stockton's exit strategy could not be approved by the court because it unfairly discriminated among creditors because Calpers was not going to lose a penny and Franklin would receive so little. A bankruptcy plan of debt adjustment is supposed to treat similar creditors more or less the same; it allows for some discrimination as long as there is a reason for the different treatment. Stockton said its treatment of Franklin Templeton constituted 'fair discrimination.'

In court proceedings in July, Judge Klein said it was not clear to him that Calpers was even a creditor. He adjourned the hearings until the city and other parties could brief him on Stockton's relationship with Calpers.

Calpers responded by saying it was part of 'a triangular relationship,' in which the city, its past and present workers and Calpers worked together, with some interactions governed by contract but the most important activities governed by statute.

But Judge Klein said that he had been studying the state law that governs public retirement benefits in California, which he said was 'like a jigsaw puzzle.' Once he put the pieces together, he said, he realized that what he saw in the statute was different from what had been described to him.

Much of Judge Klein's analysis revolved around subtle federalist issues like whether an arm of the state could still enforce the laws of that state once a city has taken shelter in federal bankruptcy court. California's public pension law has a provision that anticipated these issues and specifically says that the contract a city enters into with Calpers cannot be impaired, no matter what other laws might say.

Judge Klein said legislative history showed that California lawmakers were responding to the increased possibility of a municipal bankruptcy that grew out of New York City's bankruptcy near miss in 1975.

He said that California's lawmakers had also enacted laws that specified exactly the steps cities had to take to obtain authorization from the state to file for federal bankruptcy protection. He said that when the legislature enacted that law, it tacitly agreed that if the city earned the authorization for bankruptcy, it would be governed by the federal bankruptcy code.

'Those conditions are the opening of the gate,' he said. 'Once the city passes through the gate, it's what's specified in the United States Bankruptcy Code. Otherwise, you come to the conclusion that the California Legislature can edit the federal law.'

In a statement, Calpers said: 'We disagree with the judge's opinion on the issue of pension impairment. This ruling is not legally binding on any of the parties in the Stockton case or as precedent in any other bankruptcy proceeding and is unnecessary to the decision on confirmation of the city of Stockton's plan of adjustment.'