Judge: Stockton can go belly up

April 2, 2013

By John Seiler

It’s official: The city of Stockton is bankrupt. On April 1, U.S. Bankruptcy Judge Christopher Klein ruled that Stockton’s bankruptcy can proceed. “It’s apparent to me the city would not be able to perform its obligations to its citizens on fundamental public safety as well as other basic government services without the ability to have the muscle of the contract-impairing power of federal bankruptcy law,” he wrote.

Opinions were divide on whether the ruling helped the private bondholders, which wanted the court first to reduce the city’s generous pensions for retired public employees; or whether it helped the public-employee unions, which insist that the bondholders first take a “haircut” on their claims on city funds (which funds, of course, are provided by taxpayers).

The bottom line: “This was a preliminary round,” Dan Pellissier told me; he’s the president of California Pension Reform, which has been working to change state pension laws. “It didn’t get to the question people wanted to hear. It was more of an administrative decision.”

That wasn’t how it was seen by some. “In the context of going through the findings of fact, [the judge] made some comments about how Chapter 9 is all about giving them the ability to impair contracts because the only place you can do that is bankruptcy court,” bankruptcy lawyer Karol Denniston told the Inland Valley Daily bulletin. “He’s correct with all that, but it’s interesting that he chose to emphasize that.”

The contracts to be “impaired” would be those between Stockton and the unions concerning pensions. The California Constitution widely is interpreted as precluding the breaking of such contracts. However, this is a federal bankruptcy court. So it depends on whether the U.S. Constitution and federal law allow a federal judge to break such contracts.

“The ruling never addressed whether federal bankruptcy code trumped constitutional protection,” Pellissier said.

Pension problem

A different view from Denniston’s came from the Wall Street Journal’s editorial page, which wrote:

“The San Joaquin Valley city of 300,000 intends to use bankruptcy to stiff capital market creditors in order to pay for its workers’ rich pensions, which will merely encourage other insolvent municipalities to do the same.

“Stockton filed for bankruptcy last summer after a three-month confidential mediation with creditors failed to substantially reduce its long-term liabilities or close its $25 million deficit. Assured Guaranty and National Public Finance Guarantee, which insure about $260 million of the city’s bond debt, pulled out of negotiations after the city council refused to haircut the city’s single largest creditor, the California Public Employees’ Retirement System (Calpers).

“Meanwhile, the city was proposing to slash by 80% the $125 million in principal on pension obligation bonds that it had issued in 2007 to pay an overdue bill to Calpers. Never before has a bankrupt city reduced principal on its debt. In its Chapter 9 eligibility trial, Stockton nonetheless blamed bond insurers for negotiating in bad faith—an argument Judge Klein echoed in his ruling.”

‘Over-interpreting’

“Everyone is over-interpreting,” Pellissier observed. “This was just Stage 1, whether the city is eligible for bankruptcy. They said, ‘We’re out of money after a perfunctory attempt to balance the budget.'”

As to the operation of the court, he said, “The role of a federal bankruptcy court is impairing contracts,” meaning the court decides which contracts are modified or voided. For example, in the 2009 General Motors bankruptcy, the federal court decided that the United Auto Workers union had precedence over bondholders, dealers and investors.

However, Pellissier said that federal court dealings with municipalities is different than those with private companies because of constitutional issues governing federal and state powers. “In the private sector, a judge can divide the assets himself,” Pellissier said. “For a municipality, he can only approve what the city wants to do.”

The problem is that if the pensions are the city’s No. 1 priority, then the only way to pay for them is to cut city services even more than they already have been. The Huffington Post reported that, since recent budget cuts that have reduced the number of police, murders in Stockton have soared. If taxpayers’ money mainly goes to the pensions of retirees no longer working for the city, it’s a good question why the city government even should exist.

Bond prices

Another factor with not only statewide importance, but national importance, is how slamming the bondholders first would affect municipal bond prices. If bondholders are more vulnerable than retirement funds, then bond interest rates would rise, making it harder for municipalities to borrow, in turn raising the costs for taxpayers.

Although given the foolish projects funded by many cities — such as the $47 million Stockton blew on a sports arena, which contributed to the bankruptcy — higher interest rates might cancel such follies in other cities. That would be a good thing.

The Stockton bankruptcy approval has implications for San Bernardino, which also declared bankruptcy last year. (Mammoth Lakes declared bankruptcy as well. But its problem was losing a lawsuit, not pensions.)

According to the Daily Bulletin, Stockton’s successful argument in court is “the same basic argument San Bernardino has been making since it filed for bankruptcy protection in August, and other cities might soon find themselves in similar situations.” Which means San Bernardino’s lawsuit also has a good chance of advancing.

The Stockton court decision also is a sharp warning to other municipalities and school districts — and to the state itself — to get their financial acts together. The state, in particular, needs to enact pension reforms much stronger than the weak “reform” enacted last fall to gull voters into supporting Proposition 30, the $6 billion tax increase.

Rhode Island, which is even more dominated than California by Democrats, bravely has undertaken pension reforms after the city of Central Falls went bankrupt.

Taxpayer funds are not unlimited. Spiking pensions more than a decade ago, as this writer warned many times back then, inevitably would lead to governments going belly up. Unless reforms are made soon, the bankruptcies are just starting.