The battle in California municipal bankruptcies between bond investors and Calpers, the California public employee pension system, began in the Stockton Chapter 9 bankruptcy case and continues unabated in the bankruptcy case of San Bernardino. The issues at stake – whether  California state laws protecting public employee pension obligations are pre-empted and superseded by Congress’s Article I, Section 8 authority to establish uniform laws regarding bankruptcy, or are protected under the Tenth Amendment — implicate fundamental issues of federalism, and in all likelihood the Supreme Court will eventually need to resolve the questions being raised regarding the proper balance between state and federal power.           

In San Bernardino, Calpers filed a motion asserting that public employee pension obligations have priority status under California law and that it is entitled to full and immediate payment of all such obligations owed by the city, notwithstanding the pendency of its Chapter 9 filing and the existence of the automatic stay under Section 362 of the U.S. Bankruptcy CodeJudge Meredith Jury of the U.S. Bankruptcy Court for the Central District of California rejected the motion. This ruling itself is not particularly controversial; even assuming that Calpers is correct in its argument that it is entitled to preferential treatment in the bankruptcy case, the exception to the automatic stay that it is seeking to invoke – pertaining to the exercise of a state’s “police and regulatory power” – does not extend as far as Calpers contends. (That exception has consistently been interpreted by courts as intended to allow governmental entities to maintain and protect public safety, and not, as Calpers is trying to do, to collect moneys owed to them.) 

The far more complicated question is whether priorities for unsecured claims created under state law – particularly regarding obligors that are themselves governmental units – can trump the distribution mechanisms of the U.S. Bankruptcy Code, and the Code’s underlying purpose of providing similar treatment for similarly situated creditors. Numerous states in addition to California have varying degrees of protection for public employee pension obligations. (Rhode Island, on the other hand, recently took the opposite tack and enacted a law that gave priority to bondholders in the Central Falls Chapter 9 cases.)   

Calpers will argue that the preference under California law for public employee pension obligations is protected under the Tenth Amendment. San Bernardino’s bond investors will argue that the Bankruptcy Code expressly sets forth the priority of certain types of unsecured claims, that no other unsecured claims are entitled to more favorable treatment, and that California law regarding public employee pension obligations is pre-empted by the Supremacy Clause of the Constitution. 

This question will not be definitively answered in the near future. Assuming no consensual resolution in either the San Bernardino or Stockton cases (and neither side appears ready to concede an inch), a judicial decision will probably not be rendered until one of these cities seeks approval of a plan of adjustment, which is still probably months and possibly years away. Appeals thereafter will take even longer. The issues raised here will remain an overhang over municipal bankruptcies in California and in other states that have established specific creditor priorities for governmental entity obligors.