Nearly nine months after it filed for protection under Chapter 9 of the Bankruptcy Code, a federal bankruptcy judge last week determined that the city of Stockton, California has satisfied the requirements of Section 109(c) of the Bankruptcy Code and may proceed with its efforts to adjust its massive bond, pension and employee obligations. Section 109(c) of the Bankruptcy Code mandates, among other things, 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”. Stockton’s bondholders had contended that the city’s failure to engage in negotiations with Calpers, the California public employee pension system, prior to filing its petition required the dismissal of Stockton’s bankruptcy case under Section 109(c).  

Judge Christopher Klein disagreed, and ruled that the fact that Stockton had sought major concessions from its bondholders but none from Calpers (even though Calpers is its single largest creditor) would not serve to disqualify Stockton from continuing its Chapter 9 case. He noted that that city was unequivocally insolvent, and determined that it had done everything it feasibly could to avoid resorting to Chapter 9 bankruptcy.  

While this might appear on the surface to be a defeat for the bondholders, it could turn out to be a loss worth experiencing. Stockton contends that negotiations with Calpers were impractical, given the strong public employee pension liability protections under California law. Judge Klein agreed, but only for the immediate purpose of determining whether Stockton was eligible to enter bankruptcy. Exiting bankruptcy will entail a completely different analysis. 

Judge Klein made clear that his ruling last week was only a first step. His comments suggest that Stockton will have difficulty obtaining approval of a plan of adjustment unless it confronts its Calpers obligations head on

Plans of adjustment for municipal debtors, similar to plans of reorganization for corporate debtors, prohibit “unfair” discrimination among classes of similarly situated creditors. The bondholders now have the opportunity to have a fight for which they have been spoiling, and show that any preferential treatment afforded Calpers in a Chapter 9 case is precisely the type of “unfair” discrimination that the Bankruptcy Code forbids. Calpers, which has been equally eager for this battle, will rejoin that such discrimination is not “unfair” as the protections for public employee pension obligations under California law mandate such different treatment. The bondholders undoubtedly intend to respond that such state law preferential treatment is trumped by federal law under the Bankruptcy Code.  Calpers will argue that the preference under California law for public employee pension obligations is protected under the Tenth Amendment.  

The issues have now been squarely set out on the table by Judge Klein. If he in fact rules that Stockton cannot justify preferential treatment of public employee pension obligations and that the Tenth Amendment is inapplicable here, the bondholders will not regret last week’s defeat in the slightest.