The perception that public employee pension obligations cannot be impaired in bankruptcy suffered a damaging blow several months ago in the City of Detroit bankruptcy case, and has now been fatally wounded by the recent ruling of Judge Christopher Klein in the Chapter 9 case of Stockton, California.  Although Judge Klein’s decision is not likely to lead to a spate of municipal bankruptcy filings in an effort to escape burdensome pension liabilities (indeed, it may not even lead to the actual diminishment of pension claims in the Stockton case itself), this is an important decision.  Unless reversed on appeal, it will alter the legal landscape for distressed municipalities.  Together with the similar Detroit decision, the Stockton ruling will affect negotiations among municipalities, employee unions, pension system representatives and financial creditors across the country. 

Issues regarding the appropriate legal treatment of public employee pension obligations, and the Tenth Amendment implications in connection therewith, have been a crucial overhang for distressed municipalities and in Chapter 9 municipal bankruptcy cases for several years.  The Tenth Amendment reserves to a state rights not granted to the federal government under the Constitution.  The key question has been whether state laws protecting public employee pension obligations are protected under the Tenth Amendment, or are pre-empted and superseded by Congress’s Article I, Section 8 authority to establish uniform laws regarding bankruptcy. 

In Stockton, the city proposed a plan that recognizes California’s pension protections and that does not seek to impair those obligations, while at the same time substantially reducing the claim of Franklin Investments, a major city bondholder.  Under the U.S. Bankruptcy Code, plans of adjustment for municipal debtors, similar to plans of reorganization for corporate debtors, prohibit “unfair” discrimination among classes of similarly situated creditors.  The City of Stockton and the California public employee pension system (“Calpers”) contend that the disparity between Franklin’s claims and Calpers’ claims is permissible, because the preference under California law for public employee pension obligations is protected under the Tenth Amendment.  Franklin has objected to the plan, claiming that the disparate treatment is impermissible, because California law regarding public employee pension obligations is pre-empted by the Supremacy Clause of the Constitution

Judge Klein agreed with Franklin: on this issue, the Supremacy Clause overrides state law.  There is no abrogation of the Tenth Amendment because the State of California has expressly authorized municipalities to seek protection under Chapter 9.  In Judge Klein’s view, when the California legislature enacted the authorization law, it “open[ed] the gate” and was approving a process that it knew would be governed by federal law. “Once the city passes through the gate, it’s what’s specified in the United States Bankruptcy Code.  Otherwise, you come to the conclusion that the California Legislature can edit . . . federal law.”

This decision may actually have more impact outside of the Stockton case than within it.  Judge Klein ruled that public employee pension obligations can be impaired, but he did not make a ruling on the Stockton plan and the proposed disparate treatment.  Stockton has proffered several other justifications for the different treatment between pension claims and Franklin’s claims, and one or more of those may be sufficient for Judge Klein to approve the plan.  The parties may also find a way to reach a settlement, which could moot Judge Klein’s ruling. 

Regardless of what happens in Stockton, however, the decision will reverberate in distressed municipalities throughout the country.  Because Chapter 9 is such an onerous and expensive process, it is unlikely that there will be a rush of municipalities into the bankruptcy courts.  But the Stockton decision will tilt the playing field.  It will provide leverage to parties that wish to impair pension obligations, which will significantly affect negotiations on these matters.  Until now, for municipalities that wished to impair their pension obligations, there was nothing but uncertainty as to whether a Chapter 9 bankruptcy proceeding could succeed.  That uncertainty has now been substantially reduced.