California Bankruptcy Judge Rules that State Law Does Not Protect Pension Fund from Municipal Bankruptcies

On October 1, a bankruptcy judge ruled that the pension agreement between Stockton, California and Calpers, California’s massive state-run pension fund for public employees, is an executory contract that can be rejected in bankruptcy. Judge Christopher Klein of the Eastern District of California found that California laws designed to protect Calpers from municipal bankruptcies could not be enforced once a city entered bankruptcy.  The ruling came during a portion of the confirmation hearing on Stockton’s plan to exit Chapter 9 bankruptcy, the remainder of which has been continued until October 30. Stockton, which declared bankruptcy in 2012, had spent millions to revitalize its downtown in the years before the recession but was hit hard by the foreclosure crisis. The city is attempting to reorganize more than $900 million of long-term debt.

Stockton proposed a plan that assumes its pension agreement with Calpers, and pays 100% of the pension liability that Stockton had incurred before filing its chapter 9 petition. The city’s proposed treatment of the Calpers agreement was predicated on its belief that California state law prevented it from impairing or rejecting its agreement with Calpers. Bondholder Franklin Templeton Investments, a mutual fund company that holds a $32.5 million unsecured claim, opposed the plan, arguing that the pension agreement was an executory contract, and that California state law did not constrain Stockton from rejecting the contract. In Franklin’s view, because the pension agreement could be rejected, a plan providing for full payment to Calpers would be unfair and could not be confirmed.

Under the plan, Stockton proposes to pay 100% of its obligations to Calpers, and assume its pension agreement, while paying Franklin approximately 1% of its claim. Other bondholders, all of whom have agreed to support Stockton’s plan, would stand to receive 52% to 100% recoveries. Franklin argued that, by fully funding the pensions and providing much higher recoveries to supporting bondholders than to Franklin, the plan unfairly discriminated among similarly situated creditors. While Franklin has raised several issues with its treatment under the plan, the October 1 hearing focused on the city’s relationship to Calpers.

Stockton and Calpers, which filed a brief in support of the plan, argued that under California state law, Stockton was required to pay Calpers in full because a city’s contract with Calpers cannot be impaired in bankruptcy.  If Stockton rejected the contract, the city would owe a $1.6 billion termination fee, which California law would grant Calpers a lien on city assets to collect.  According to Stockton and Calpers, those circumstances justified the assumption of the under the plan.

Judge Klein disagreed that the California statutes provided a basis for the assumption of the Calpers agreement, ruling that the Bankruptcy Code preempts the California statutes; California cannot “edit the federal law.”  According to Judge Klein, Stockton could reject its contract with Calpers under Section 365 of the Bankruptcy Code and avoid Calpers’ $1.6 billion lien under Section 545, which provides for the avoidance of statutory liens. Stockton would still owe Calpers a $1.6 billion termination fee, but this claim would be on equal footing with Franklin’s unsecured bond claim. Judge Klein did not order Stockton to rejec

Stockton also argued that the judge should defer to its business judgment and allow the city to maintain its existing relationship with Calpers by assuming the contract. Stockton alleged that transitioning to a new pension plan would take two years, which would endanger Stockton’s ability to retain employees. However, Judge Klein pointed out that Stockton had many options for retirement benefits, such as a multiemployer pension plan affiliated with a union, a county-run pension plan, or simply not offering pensions. The ruling has undermined one of the important justifications for paying Franklin less than Calpers and the other unsecured creditors.

The confirmation hearing has been continued until October 30, when Judge Klein will decide whether to confirm the plan over Franklin’s objection and resolve the treatment of Calpers’ claim. Judge Klein put the onus on Stockton, telling the city’s attorney, Marc A. Levinson, that “the ball is in your court” to show why the plan should be confirmed and assumption was proper. Judge Klein urged Stockton and Franklin to settle before the October 30 hearing, declaring “open season for some kind of adjustment to be made.”

The ability to reject Calpers contracts in bankruptcy will give municipal governments a stronger hand in negotiating with employees. Calpers, fearful of bankruptcy judges awarding it lower recoveries on its contracts, may also pressure governments and unions to come to the negotiating table to avoid bankruptcy. Judge Klein’s ruling may have a wide-ranging effect on California cities struggling under the weight of pension plans.



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