The star litigator David Boies of Boies, Schiller & Flexner, who has a knack for ending up in the middle of the most pressing issues of the day, told me recently that the next great American crisis is $5 trillion in unfunded pension liability for city and state governments. Boies just signed on to defend Rhode Island from state workers' challenges to the sweeping pension overhaul legislation passed in 2011, and he predicts that if elected officials in other states don't take similar action, the United States faces an unprecedented wave of government bankruptcies.

That prediction underscores the significance of the bankruptcy proceeding of San Bernardino, California, a Los Angeles exurb undone by swollen salaries and retirement benefits for city workers. In August, San Bernardino filed for protection from its creditors under Chapter 9, the rarely invoked Bankruptcy Code provision for municipalities. In late November, the city council passed a proposal to resolve its $46 million budget deficit. The plan called for San Bernardino to continue deferring pension contributions to the California Public Employees' Retirement System, which it stopped paying in August. As of the end of last month, the city owed Calpers, its biggest creditor, more than $5 million.

San Bernardino isn't the only California city in deep financial trouble because of pension obligations, as Calpers and its lawyers at K&L Gates know all too well. On Nov. 27, the pension fund took pre-emptive action. As I reported, Calpers asked U.S. Bankruptcy Judge Meredith Jury of Riverside to lift the automatic stay on litigation against San Bernardino so it could bring a state court enforcement action to recover what the city owes the fund. Calpers asserted that pension contributions are a component of employee compensation, which is entitled to priority in federal bankruptcy. The pension fund said it's entitled to sue San Bernardino not only because it's exempt from the automatic stay as an arm of the state but also because San Bernardino's deferral of retirement payments violates state labor and pension laws.

On its face, the Calpers motion was merely administrative, but I had a feeling the bond insurers that are also creditors of San Bernardino would read the pension fund's muscle-flexing as a provocation. On Monday, that suspicion was confirmed. Whether or not Calpers meant to incite a full-on battle over its prerogatives under the U.S. and California constitutions, that's what the pension fund is now facing, by dint of a 44-page brief filed jointly by Ambac and National Public Finance Guarantee (a wing of MBIA).

The bond insurers, represented by Arent Fox (for Ambac) and Winston & Strawn (for National), argue in notably aggressive language that Calpers needs a lesson in constitutional law. "Purportedly to avoid a phantom harm from the (San Bernardino's) proposed deferral of certain obligations to Calpers, Calpers contends that because it is an 'arm of the state,' the court should ignore the Supremacy Clause of the United States Constitution and over 70 years of legal precedent to elevate Calpers' pecuniary interest above the interest of the city and its other unsecured creditors," the new brief said. "Calpers distorts the fundamental principles of bankruptcy law and omits or ignores governing constitutional, statutory and judicial authority establishing that the Bankruptcy Code pre-empts and supersedes inconsistent state law."

According to the bond insurers, Calpers isn't an arm of the state, and even if it were, it is not permitted to proceed with an action just to recover money. States are exempt from the automatic stay granted in Chapter 9 only to exercise political and governmental power under the 10th Amendment, not to jump ahead of other creditors as Calpers proposes, the brief said. "Calpers' task of pension administration is neither a sovereign activity nor an exercise of police or regulatory powers," the bond insurers argued. "In fact, any state action that conflicts with the bankruptcy court's control of the property of the debtor is necessarily outside the scope of the governmental power exception."

Moreover, they said, Calpers is flat wrong about the enforceability in bankruptcy of state laws on municipal pension obligations. According to the brief, precedent dating back to 1940 dictates that once a state has granted a municipality permission to enter federal bankruptcy protection -- as California did for San Bernardino -- the Supremacy Clause of the U.S. Constitution subordinates state law to the federal bankruptcy code. "The State of California, of which Calpers claims to be an arm, may not authorize the city to file for bankruptcy protection and then cherry pick, through Calpers or otherwise, the (bankruptcy) code provisions that it would prefer to apply to state-related claims," the brief said. "Such cherry picking has been uniformly rejected," most recently in the Chapter 9 bankruptcy of Stockton, another California city.

The bond insurers' brief called Calpers's motion to lift the stay "an undisguised and unfounded attempt by (the pension fund) to undermine the purposes of Chapter 9 ... and obtain grossly preferential treatment over all other general unsecured creditors." They're asking the bankruptcy judge not only to deny the pension fund's motion but to issue an order specifically declaring that Calpers is bound by Chapter 9's stay on litigation.

On Tuesday, a Calpers spokesman escalated the war of words with the bond insurers. "This is a case of Wall Street's big bond firms versus Main Street," he said in an email response to a request for comment on the insurers' filing. "We will champion our members who have relied on the retirement promises made by the City of San Bernardino. These big bond firms from Wall Street are sophisticated investors. They knew the risks of issuing or insuring those bonds and they should be ashamed for trying to be paid before the retirees who have earned their retirement benefits. San Bernardino's hard-working public employees spent their careers serving our fellow Californians; those employees live here, work here, retire here and pay taxes here, and they should be paid their promised retirements long before San Bernardino's politicians pay out-of-state speculators and big Wall Street firms."

(This post has been corrected. A previous version misspelled National Financial's full name.)

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