The Olympics may be over, but a potential clash of titans is gearing up in the Chapter 9 bankruptcy case of Stockton, California. Municipal bond insurer National Public Finance Guarantee Corporation (“National”) has challenged Stockton’s eligibility to be a debtor under Chapter 9 of the Bankruptcy Code, and is focusing expressly on the city’s alleged failure to seek concessions of its pension liabilities from Calpers, the California public employee pension system. Section 109(c) of the Bankruptcy Code mandates that a municipality seeking protection under Chapter 9 must show either that it has negotiated in good faith with its creditors, or that such negotiations were “impractical”. National contends that Stockton’s failure to engage in negotiations with Calpers prior to filing its petition requires the dismissal of Stockton’s bankruptcy case under Section 109(c).
Stockton listed Calpers as its single largest unsecured creditor in its petition, with a claim of $147.5 million. California state law conditions a municipality’s ability to seek bankruptcy protection under Chapter 9 on its participation in a 60 day negotiation process with its major creditors. National asserts that during such process, Stockton sought major concessions from its bondholders, but none from Calpers. Stockton can be expected to argue in its response to National that public employee pension liability protections under California law rendered negotiations with Calpers “impractical”.
National’s challenge to Stockton’s eligibility aims directly at those protections for public employee pension liabilities, protections which Calpers seeks to enforce rigorously. To date no bankruptcy court has ruled on whether such protections can provide Calpers with a priority over other unsecured creditors. Employee pensions were not challenged in previous Chapter 9 cases of California municipalities, but bondholders did not suffer major losses in those cases either. Such will probably not be the case in Stockton. Moreover, numerous other California cities and towns are experiencing similar financial distress due at least in part to public employee pension liabilities, and are likely to seek bondholder concessions as well. A showdown between Calpers and bond insurers and investors clearly looms, and National has now fired the first salvo.