A federal judge ruled yesterday that CalPERS pensions can be cut in bankruptcy like other debt. He rejected the argument that the giant system is an “arm of the state” with pensions protected by federal law and two state laws on contracts and liens.

U.S. Bankruptcy Judge Christopher Klein, who has called the issue of whether CalPERS pensions can be cut in bankruptcy a “festering sore,” delayed until Oct. 30 a ruling on whether Stockton can exit bankruptcy without cutting pensions.

Stockton does not want to cut pensions, arguing they are needed to be a competitive employer, particularly for police. The city reached agreements with three bond insurers owed $265 million, all labor unions, retirees and other major creditors.

But Stockton could not negotiate an agreement with a lone holdout, two Franklin bond funds owed $36 million, triggering a trial in May on the Stockton “plan of adjustment” to cut debt and emerge from the bankruptcy filed two years ago.

Franklin argues that an exit plan that provides full payment of the city’s “massive” pension liability, while paying Franklin a penny on the dollar, cannot be confirmed under the federal bankruptcy code requiring fair treatment of creditors.

Klein issued his CalPERS decision after receiving extensive written briefings from both sides he requested at the May trial. His lengthy oral ruling, covering the disputed legal points in detail, may be followed by a written decision.

“We have a plan that proposes not to adjust pensions,” Klein said. “I have concluded that pensions could be adjusted, at least the CalPERS contract could be adjusted, and by inference the pensions could be adjusted.”
A federal judge ruled in the Detroit bankruptcy last fall that pensions can be cut. CalPERS joined in the appeal, arguing that Detroit has a city-run plan and that CalPERS is an arm of the state whose operations are protected under federal bankruptcy law.


“We disagree with the judge’s opinion on the issue of pension impairment,” CalPERS said in a news release. “This ruling is not legally binding on any of the parties in the Stockton case or as precedent in any other bankruptcy proceeding and is unnecessary to the decision on confirmation of the City of Stockton’s plan of adjustment.

“CalPERS will reserve any further comment until such time as the court renders its final written decision. What’s important to keep in mind is what the City of Stockton stated in court today: that they can’t function as a city if their pensions are impaired.”

Matthew Jacobs, CalPERS general counsel, said in a separate news release: “The real precedent of today’s proceedings is that even if municipalities are allowed to impair pensions in the rare situation of bankruptcy, cities like Stockton can make the smart decision to protect the pension promises for their public employees.

“The city has made a choice to protect pensions for its public employees and find a reasonable path forward to a more fiscally sustainable future. This is the right decision. While we disagree with today’s ruling on pensions, we are hopeful that Judge Klein will approve Stockton’s plan. Providing great services to a city requires great employees and Stockton said today in court that it can’t function as a city if pensions are impaired.”

CalPERS has taken several steps, some going back decades, to avoid a ruling like the one Judge Klein made yesterday.

Vallejo officials said they considered cutting pensions in bankruptcy, but chose not to try after CalPERS threatened a lengthy and costly legal battle. Vallejo cut deals with all creditors, avoiding a rare trial as on Stockton’s plan to “cram down” debt.

The Vallejo bankruptcy prompted public employee unions to back legislation requiring cities to get permission from a state panel to file bankruptcy. Some union officials said the threat of “pulling a Vallejo” could affect labor contract bargaining.

The bill, AB 506 in 2011, was altered to require an attempt in neutral mediation to reach an agreement with creditors before filing bankruptcy. Stockton failed to get an agreement during a 90-day mediation before filing for bankruptcy on June 26, 2012.

A month later San Bernardino made an emergency filing for bankruptcy without first trying mediation. Then San Bernardino, saying it was in danger of not making payroll, took an unprecedented step: skipping payments to CalPERS for a year.

The failure to make payments gave the California Public Employees Retirement System grounds to terminate its contract with the city, probably triggering a deep cut in pensions for San Bernardino current workers and retirees.

Last June San Bernardino announced an undisclosed agreement with CalPERS, reached in closed-door mediation, to pay the $13.5 million in skipped payments, plus several million more in penalties and interest.

San Bernardino is still struggling to reach agreements with labor unions, receiving court approval to modify a firefighter contract. City officials have said they do not expect to have a debt-cutting plan of adjustment until early next year or later.

In the Stockton bankruptcy, Judge Klein said during the trial in May that one of his options was ruling on whether CalPERS pensions could be cut without necessarily finding that Stockton pensions should be cut.

Part of his analysis yesterday that CalPERS pensions are not state “governmental or political powers” protected under federal bankruptcy law is that while state workers are in CalPERS by statute, cities choose to join CalPERS.

Klein said California cities have the option of forming their own pension systems, joining a county pension system, hiring a private pension provider or withdrawing from CalPERS, if they can afford to do so.

He concluded that benefits not prescribed by state law are not “governmental or political” powers protected by the federal bankruptcy law, but instead are unprotected “business powers.”

Klein said a CalPERS-sponsored state law preventing cities from rejecting their CalPERS contracts in bankruptcy is “flat-out invalid” under the constitutional “supremacy clause” giving federal law priority over state law.

The judge said another CalPERS-sponsored state law that gives CalPERS a lien on all city assets, except wages, when they declare insolvency is an invalid attempt by the state Legislature to “edit” the federal bankruptcy law.

Stockton argues that its employees and retirees have a fair share of the bankruptcy burden with pay cuts, workforce reductions and the elimination of retiree health care, a $545 million long-term debt replaced with a $5 million lump sum.

Klein’s ruling on Stockton may hinge on the city’s decision to place Franklin in the same class of debtors as retirees, who voted to accept the big cut in health care with the promise that their pensions would not be cut.

The low payment to Franklin is similar to the retiree health care cut. Franklin argues that it was “punished” for rejecting a city offer in closed-door mediation and unfairly placed in the debtor class to be “swamped” by the retiree approval of their health care cut.

The city argues that Franklin is properly in the class because most of its debt is unsecured. After the judge ruled that Franklin’s collateral (two golf courses and a park) were valued at $4 million, Stockton amended its plan to pay that amount.

But Franklin wants payment for the remaining $32 million of unsecured debt.

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune.

Cross-posted at CalPensions.