A Tale of Two (Bankrupt) Cities
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A Tale of Two (Bankrupt) Cities

June 2013

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After delivering his findings at a hearing last April in Stockton's Chapter 9 proceeding, U.S. Bankruptcy Judge Christopher M. Klein announced that he would take a brief recess. But before he did so, the judge teed up the issue the city's creditors had been waiting for him to address: the legal status of the California Public Employees Retirement System (CalPERS).

"If I accept the Capital Market Creditors' view at face value, CalPERS is just a garden-variety creditor who bears the financial risk of loss, kind of as a guarantor or something," Klein said. "I know that CalPERS has vociferously ... contested those kind of assertions. And it is no secret that the Capital Markets Creditors have CalPERS in the crosshairs for a dispute over that." (In re City of Stockton, No. 12-BK-32118 (Bankr. E.D. Cal. transcript of proceedings April 1, 2013).)

They certainly do. The bond insurers had forced a three-day trial to determine whether the city was even eligible for bankruptcy - and hundreds of thousands of public pensions statewide would rise or fall depending on the answer. With that teasing comment, Klein excused himself. When he returned, the judge cut through the contentious briefs of opposing creditors.

"The gravamen of the argument that the Capital Market Creditors make is one of unfair discrimination," Klein said. "But that is not an eligibility question. ... [T]o the contrary, it is a plan confirmation problem." And that problem, he predicted, "is probably going to require me to get down into the nitty-gritty of the CalPERS situation."

On this day, CalPERS had gotten what it wanted, and more. Klein rejected the objectors' contention that Stockton was not eligible for bankruptcy protection because it had failed to negotiate with creditors in good faith. Then he turned the objectors' argument on its head, finding that the Capital Market Creditors themselves could not justify refusing to participate during the mandatory mediation process - "voting with their feet and choosing to act as the stone wall" - on grounds that the city hadn't even asked CalPERS for reduced payments.

"Judge Klein is a believer in the mediation process and made it clear that all parties have to participate in good faith," says Michael B. Lubic, outside counsel for CalPERS and a partner in the Los Angeles office of K&L Gates. "With that ruling, he was sending a message to all creditors that might be involved in prefiling mediations."

The message could have been directed at San Bernardino, which also declared bankruptcy last summer. That city avoided meeting with creditors by declaring a fiscal emergency - a loophole in the mediation requirement - and filed immediately under Chapter 9. (In re City of San Bernardino, No. 12-BK-28006 (Bankr. C.D. Cal. filed Aug. 1, 2012).)

"San Bernardino was unprepared for bankruptcy," says Karol K. Denniston, a partner in the San Francisco office of Schiff Hardin whose practice focuses on municipal restructurings. "The case is underfunded, and there has been no cooperation from the stakeholders. Chapter 9 is a terrible place for a city without liquidity."

In San Bernardino, CalPERS opposed bankruptcy when the city unilaterally halted its pension obligation payments. CalPERS then moved for relief from the automatic litigation stay to pursue those debts.

"It's really a tale of two cities," says Michael A. Sweet, a financial restructuring partner at the San Francisco office of Fox Rothschild who has helped clients avoid municipal bankruptcy. "These two cases are potentially precedent-setting, so both CalPERS and the bond insurers are spending big money on the litigation."

In his San Bernardino brief, Lubic contended that CalPERS is "an arm of the state" that falls within the "police power" exception to the automatic stay. He argued that the city's failure to make contributions violated the state's Public Employees' Retirement Law (PERL, Cal. Gov't Code §§ 20000-21765) and provisions of the state Labor Code, which require it to make pension contributions according to existing collective bargaining agreements. And he invoked Proposition 162, passed by voters in 1992, which prohibits "tampering with public pension funds."

Pointedly, Lubic also argued that payments to pension funds constitute wages, and that prompt payment of wages is the public policy of the state. For authority he cited a state Supreme Court opinion holding that wages may be preferred over other debts because they "are not ordinary debts ... because of the economic position of the average worker and, in particular, his dependence on wages for the necessities of life for himself and his family." (Ex parte Trombley, 31 Cal. 2d 801, 809 (1948).)

The bond insurers responded aggressively, laying out their own case for why CalPERS should stand in line with other creditors. Matthew M. Walsh, a partner in the Los Angeles office of Winston & Strawn, noted that Judge Klein had ruled last year in the Stockton case that federal bankruptcy law trumps both state statutes and state constitutional protection of contracts. Klein, he contended, had "found that state laws like the PERL and the California Labor Code are ineffective and preempted in a Chapter 9 case."

Behind those competing arguments is a classic contest between labor and capital - one party a trust holding billions of dollars in deferred wages, the other the insurers for fixed-income investors. But as Gov. Jerry Brown said about education funding in his State of the State message, "Equal treatment for [those] in unequal situations is not justice."

Late last year U.S. Bankruptcy Judge Meredith A. Jury denied CalPERS relief from the litigation stay in San Bernardino. But the pension fund didn't give up. In April a committee at CalPERS proposed amending the Government Code to provide it with "a present lien on all assets of a contracting public agency in the amount of all obligations owed to the System." That same month the San Bernardino city council told the pension fund it would resume payments, while the city continues to renege on payments to bondholders.

Both CalPERS and the bond insurers are seeking extensive discovery into San Bernardino's finances, delaying an eligibility trial for months. "Right now the two sides are throwing rocks at each other," Denniston says. "But they haven't decided what this fight is going to be about."

Sweet believes CalPERS is trying to avoid a ruling in either bankruptcy case on the big issues - the Supremacy Clause and preemption of state laws. "The worst thing for CalPERS would be a court ruling that it is a 'garden-variety creditor,' " he says. "They don't want to run that risk. The status quo works well for them. If the economy recovers, people may forget all about the pension crisis."

But Sweet cautions, "Judge Klein planted the seed for a ruling, warning that he will not allow a plan of adjustment to go forward with discriminating treatment between equally situated creditors."

As Klein gets "into the nitty-gritty" of conflicting arguments, however, he may be forced to choose sides. Is impairing pension benefits necessary to avoid unfair discrimination - or is it just another form of wage theft dressed up as equality before the law?


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