Federalism fight in Stockton’s Chapter 9

August 11, 2012

Municipal bankruptcies under Chapter 9 of the federal bankruptcy code are such rarities that every case seems to pose issues of first impression. There was the question of who bore the burden of showing Bridgeport, Connecticut, was insolvent in 1991; the breaking of a collective bargaining agreement in Vallejo, California, in 2009; and being too big for bankruptcy protection in a botched bid by Harrisburg, Pennsylvania, last fall. The same is true of the doozy of a legal fight brewing between the California Public Employees’ Retirement System and the bond insurers MBIA and Assured Guaranty in Stockton, California. Before this case is over, we should know whether the federal bankruptcy code trumps state constitutional protection for pension benefits.

This week, both MBIA and Assured filed objections to Stockton’s Chapter 9, arguing that the city is not eligible for protection from its creditors under the plan it has filed with the federal bankruptcy court in Sacramento. The bond insurers, which are responsible for making good on any shortfalls between what certain municipal bondholders were promised and what Stockton delivers, made slightly different but substantially overlapping arguments. MBIA’s lawyers at Winston & Strawn asserted in a 23-page brief that Stockton did not negotiate in good faith with its creditors and did not file its Chapter 9 petition in good faith. Assured, represented by Sidley Austin, added an argument in its 25-page brief that Stockton does not meet the definition of insolvency.

At the heart of both insurers’ objections is CalPERS, the pension system that is Stockton’s biggest unsecured creditor. According to MBIA, Stockton’s obligation to CalPERS totals $245 million over the next 10 years. Yet Stockton made no attempt to negotiate a reduction in that obligation with CalPERS before filing its bankruptcy petition, according to both bond insurers. Nor does the city’s proposed plan for resolving its financial shortfall call for any reduction in what Stockton owes CalPERS. Instead, the bond insurers argue, Stockton wants to shift a disproportionate share of the pain of its financial problems onto bondholders (and, by extension, to the insurers). That not only makes Stockton’s Chapter 9 filing an exercise in bad faith, according to MBIA and Assured, but also means the city won’t be able to solve its problems through bankruptcy. The $10 million or so Stockton will save on the backs of bondholders, plus other savings the plan proposes, won’t be enough to satisfy the city’s pension obligations, the insurers argued.

CalPERS’s general counsel, Peter Mixon, put out a statement last week on the Stockton bankruptcy, before the bond insurers filed their formal objections but after Assured threatened to do so. “The obligations owed to the public workers of [Stockton] have priority over those of general unsecured creditors, including bondholders,” Mixon said. On Friday, in response to the MBIA and Assured filings, CalPERS told the Sacramento Bee that the pension rights of public employees are “constitutionally protected.” Mixon didn’t respond to my email asking about the statutory basis of that protection, but in a prescient article in March, Mary Williams Walsh of the New York Times reported that CalPERS believes the California state constitution bars any reduction in what municipalities owe in pension obligations.

That faith puts California state law on a collision course with the federal bankruptcy law cited by Assured and MBIA. Their position is that Stockton has not met its federal law obligations under Chapter 9. CalPERS will presumably respond that Stockton may not cut its pension fund obligation under the California constitution. Expect to see the bond insurers unleash the Supremacy Clause of the U.S. Constitution, and Stockton and CalPERS to counter with the Contracts Clause and its analog in California state law.

The fight may turn on the intersection of Chapter 9 and the 10th Amendment. That amendment, you may recall, reserves the management of state internal affairs for state governments, not the federal government. Chapter 9 is a sort of carve-out that gives municipal governments the benefits of bankruptcy protection under the federal law. The power of the federal judges overseeing Chapter 9 cases are not as broad as corresponding powers in other sorts of bankruptcies because of 10th Amendment limits, but, on the other hand, municipalities seeking Chapter 9 protection have to show that they’re eligible for federal protection. (Orrick, Herrington & Sutcliffe offers a handy explanation of the 10th Amendment issue; coincidentally, Orrick is counseling Stockton in its Chapter 9, but the lead Orrick partner on the case was unavailable and his partner didn’t return my call.)

I’m betting that the bond insurers will assert that when Stockton filed for federal Chapter 9 protection, California implicitly ceded to federal authority, so the good-faith requirements of the federal law supersede state law protection of pension obligations.

Meanwhile, a ruling earlier this week by U.S. Bankruptcy Judge Christopher Klein of Sacramento in the Stockton case seems to anticipate the looming constitutional showdown over the CalPERS obligation – and to bode well for the bond insurers. Klein was ruling on a motion for a temporary restraining order by Stockton retirees, who claimed that the city was violating the Contracts Clause and California law by reducing their contractual health benefits via Chapter 9. Klein disagreed. The Contracts Clause, he said, bans a state from passing a law that interferes with contract obligations but doesn’t block the U.S. Congress from such action. “This asymmetry is no accident,” wrote Klein, who proceeded to explain that the whole purpose of federal bankruptcy laws is to permit the impairment of contracts or, more specifically, to permit the debtor to get out from under contractual obligations. (He goes all the way back to 1819 to make that point.)

“It follows, then, that contracts may be impaired in this Chapter 9 case without offending the Constitution,” Klein wrote. “The Bankruptcy Clause gives Congress express power to legislate uniform laws of bankruptcy that result in impairment of contract; and Congress is not subject to the restriction that the Contracts Clause places on states.”

That would seem to undercut any CalPERS and Stockton argument that Stockton is not permitted to reduce its contractual obligation to CalPERS – especially because Klein goes on to tackle the question of whether state law prevails over federal law in Chapter 9. It does not, the judge said flatly. “The federal bankruptcy power also, by operation of the Supremacy Clause, trumps the similar contracts clause in the California state constitution,” he said. “In sum, even if the plaintiffs’ benefits are vested property interests, the shield of the Contracts Clause crumbles in the bankruptcy arena.”

Granted, Klein was ruling on an incomplete record with different facts. And, as Reuters muni bond columnist Cate Long wrote Thursday, CalPERS is very good at intimidating litigation foes: When Vallejo was in Chapter 9, Long wrote, it caved to the pension fund after being threatened with litigation. But Assured and MBIA are apparently prepared to match CalPERS brief for brief. And with Klein’s temporary restraining order ruling already in the record, the pension fund and Stockton have some explaining to do.

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