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
s a me 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
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 obli g ations.
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
judge s 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 supercede 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.
(Reporting by Alison Frankel)
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