The Chapter 9 bankruptcy case of Stockton, California has come to an unexpectedly quick and consensual resolution. The outcome here, which will see the city’s pension obligations maintained, is particularly surprising given the vehement opposition of Stockton’s bond insurers at the outset of the case. The bond insurers, who backstopped approximately $240 million of the city’s debt, contested Stockton’s eligibility for Chapter 9 protection. They claimed that the city’s failure to engage in negotiations with Calpers, the California public employee pension system, prior to filing its petition demonstrated a lack of “good faith” that required the dismissal of Stockton’s bankruptcy case. Although they lost that battle, comments made at the time by Judge Christopher Klein suggested that Stockton would have difficulty obtaining approval of a plan of adjustment unless it directly confronted its pension obligations.

Uncertainty regarding the proper appropriate legal treatment of pension obligations has become a crucial overhanging issue in Chapter 9 municipal bankruptcy cases. Plans of adjustment for municipal debtors, similar to plans of reorganization for corporate debtors, prohibit “unfair” discrimination among classes of similarly situated creditors. The Stockton case looked to be an excellent opportunity for the bond insurers to 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 has been equally eager for this battle in order to establish that such discrimination is not “unfair”, as the protections for public employee pension obligations under California law mandate such different treatment. The bondholders argue that this type of state law preferential treatment is trumped by federal law under the Bankruptcy Code, while Calpers contends that the preference under California law for public employee pension obligations is protected under the Tenth Amendment.

The anticipated bare-knuckled courtroom brawl has given way, however, to a settlement that will keep in place the current pension benefits while terminating health insurance for most of Stockton’s retirees. Stockton’s bond insurers are accepting reduced recoveries on the bonds. The key to the settlement is an increase in the sales tax in Stockton from 8.25 percent to 9 percent that is intended to raise about $300 million over 10 years, and will allow the city to rehire police officers and public safety workers. The tax increase was approved by Stockton voters last week.

The showdown between the bond insurers and Calpers has been averted for the time being. However, similar issues are brewing in the Chapter 9 bankruptcy of San Bernadino, California, and other California cities may also seek Chapter 9 protection in order to challenge Calpers. After that looms Detroit, whose unions are claiming similar pension protections under Michigan law. The good news for aficionados of legal contretemps is that it remains highly probable that battle will be joined on this front sooner rather than later.