Tuesday, April 2, 2013

More on Stockton's Bankruptcy ... Are the City's Creditors to be Treated Equally? ... If Not, How Unequally ... Is It 'Fair' for Pension Benefits of Public Employees to be Treated 'More Equally' Than the Rightful Claims of Bondholders? ... And What About Other Cities?

Bankruptcy is a proceeding whereby an entity's debts are restructured by the court in order that the institution can continue to operate with a reasonable chance at getting its act together and going forward as a solvent institution capable of paying its bills.

Municipal bankruptcies are rare, and defaulting on debts owed by cities simply doesn't happen. Not until now, that is. And that brings us to Stockton, California.

Stockton is broke. Stockton has incurred debts that it cannot repay and obligations that it cannot satisfy.

Stockton finances its city employees' pensions with the state agency Calpers (California Public Employees' Retirement System), as do other California cities. Calpers receives pension contributions from cities, invests those funds and then pays pension benefits to eligible retirees. Calpers is a huge big and politically powerful government entity.

The bondholders of  Stockton are seeking to be treated equally with Calpers, something the city officials evidently have no intention of allowing.

Of course, many of the Stockton city officials are also active participants in the city's pension plan. It's an obvious conflict of interest for them to favor the employee pensions over the rights of bondholders, but that's precisely where the situation stands.

Enter the bankruptcy court.

Ruling Sets Up Pension Battle in Bankrupt City provides the overview of the case:

Downtown Stockton, Calif. A bankruptcy judge said the city’s police force and fire department had been cut to their safe limit.

"A federal bankruptcy judge ruled on Monday that the city of Stockton, Calif., was eligible for court protection from its creditors, clearing the way for a battle over whether public workers’ pensions can be cut when the city they work for goes bankrupt.                                  

After declaring Chapter 9 bankruptcy last year, Stockton eliminated tens of millions of dollars in city services and said it would cut some bond payments in a way unseen before in municipal bankruptcy. But bondholders objected to Stockton’s effort to protect pensions while forcing losses on investors.       
Many states have statutes and constitutional provisions making it illegal to cut public workers’ pensions. Until now, there has not been a prominent test of those laws in bankruptcy — particularly not in California, where the big state pension system, known as Calpers, has been girding for battle on the issue, trying to avoid the precedent of a cutoff or shortfall in a city’s pension contributions.
Federal bankruptcy law often trumps state laws, but municipal bankruptcies are so rare that there is almost no precedent on how to apply the law to state pension provisions.
In the ruling, issued on Monday in Sacramento, which affirmed the legal status of Stockton’s bankruptcy, Judge Christopher M. Klein said he could see battle lines being drawn between Calpers — formally the California Public Employees’ Retirement System — and the city’s other major creditors, including several Wall Street companies that either bought Stockton’s bonds or insured them. But he ruled that it was still too early in the case for that battle to be joined.
“There are very complex and difficult questions of law that I can see out there on the horizon,” he said.
The judge said he would decide those questions during the next phase of Stockton’s bankruptcy, in which the city’s creditors will contest whether its so-called plan of adjustment is fair. A plan of adjustment in a municipal bankruptcy is comparable to a plan of reorganization in a Chapter 11 bankruptcy; a city cannot emerge from bankruptcy unless the judge confirms its plan of adjustment.
“The day of reckoning will be the day of plan confirmation,” Judge Klein said near the end of a two-hour session in which he read his decision. “The city is going to have a difficult time confirming a plan over the objection of unfair discrimination.”"
So exactly what's at stake in the Stockton case? California City's Bankruptcy Poses Risk to Pensions says this in part:

"Stockton, which had $700 million in bond debt and faced a $26 million annual budget shortfall when it filed for bankruptcy, also could become one of the first municipalities to use bankruptcy protection to force bondholders to take less than the principal they are owed. Two other areas operating under Chapter 9 protection, San Bernardino and Jefferson County, Ala., are also trying to negotiate such concessions from their bondholders.

Bondholder groups have argued that Stockton was unfairly trying to use bankruptcy to cut debt payments while leaving untouched its obligations to the California Public Employees' Retirement System, or Calpers, which holds city workers' retirement money.

Municipal experts and struggling cities in California and elsewhere have been closely watching the case to see whether a city's debt to its pension funds is immune from cuts imposed by a bankruptcy judge. A ruling against pension funds could inspire more cities to file for bankruptcy."


And a claim of 'unfair discrimination' will be made by every interested party in the bankruptcy proceeding, including pensioners, citizens who are being denied adequate city services, current employees, Calpers, and bondholders. But it's the bondholders who most likely will be shortchanged by the city in its 'plan of adjustment.'
Then the bankruptcy judge will be asked to approve that plan, and that's where the claims of 'unfair discrimination' will be adjudicated. In federal bankruptcy court.
Bondholders Beware takes the position that 'Stockton will use bankruptcy to skin lenders, not pensioners:'  
"That headline more or less sums up the message of federal bankruptcy Judge Christopher Klein's decision on Monday to allow Stockton, California, to proceed with Chapter 9 bankruptcy. 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.

The city claimed that its workers and residents had already paid their fair share, and now it was time for the capital creditors to chip in. Yet the most significant concessions from labor involved cutting bonus pay for things like handling a canine (which pays an extra 9%). Many of these fringe benefits and pay categories were incorporated in informal side letters with unions and never approved by the city council.

Pensions for new workers were trimmed modestly, and the "Lamborghini" retiree health benefits—that's city council member Kathy Miller's description—entitling workers who had worked for merely six months to free lifetime medical are to be phased out. Yet as city officials attested, all of these "concessions" have merely brought the city into line with comparable cities—which are also slouching toward bankruptcy because of public employee pay and benefits.

The truth is that the only way Stockton can solve its financial problems in or outside of bankruptcy is to trim its $147 million unfunded pension liability. Pensions equal about 40% of its annual payroll costs. The average firefighter can retire at age 50 with an annuity equal to 90% of his highest year's salary, which until recently included various bonus pay categories, plus a cost-of-living adjustment.

So even though the city has cut its workforce by roughly a third, it still faced a $25 million deficit last year. And even if it defaults on the $200 million it owes in principal and interest on its pension obligation bonds, it projects a $100 million deficit over the next decade. That will likely increase since Calpers recently approved a 50% rate hike in municipalities' pension bills to fill its own liabilities hole.

Calpers insists that pensions are contracts protected under state and federal law. When the Bay Area suburb of Vallejo filed for Chapter 9 bankruptcy in 2008, Calpers threatened to tie the city up in court if it even tried to cut pensions. Never mind that the express purpose of bankruptcy is to break and restructure contracts.

Stockton never sought to restructure pension benefits and never approached Calpers during mediation. Perhaps city officials figure union-dominated Calpers is too politically powerful to take on, but it's also true that their own pensions are at stake in any restructuring.

All of which leaves the city's bondholders as the likeliest targets. Creditors who thought that lending to cities was a risk-free exercise are learning the ugly reality of modern public-union politics. Unions have the power, and their view is that their benefits are forever and your contracts are negotiable."

Summing Up

There comes a time when federal bankruptcy laws, state constitutions, political judgments and financial practicalities collide.

Such a time has come to Stockton and is headed for lots of other American cities as well. For that matter, our federal government's system of unaffordable entitlements is at considerable risk as well.

We simply don't have enough money to make good on all the promises government officials have made in the past. And using 40% of Stockton's payroll for city workers' pensions doesn't make any sense at all.

But then, neither does it make sense to ruin the city's chances to borrow money in the future at anything approaching reasonable borrowing terms. And that's exactly what will happen if Calpers is left out of the inevitable "haircutting" and placed ahead of Stockton's bondholders.

So this case has a long and difficult road ahead.

And in the end, its resolution may well serve as a clear signal to other cities, public employees, unions, bondholders and state and federal legislators.

This leaves lots of problems for one federal bankruptcy judge to address. But Judge Klein will undoubtedly receive "lots of help" along the way by the various interested parties, including politicians, unions, employees, citizens and bondholders.

It's going to be a biggie and will say a whole lot about the power of public sector unions versus the rights of taxpayers and other providers of public funds, including bondholders.
Stay tuned.

Thanks. Bob.


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