One month ago, Judge Christopher Klein ruled in the city of Stockton, CA bankruptcy case that public employee pension obligations can be impaired in municipal bankruptcy cases under Chapter 9 of the Bankruptcy Code.  Last week, however, Judge Klein approved the plan of adjustment for Stockton that left public pension obligations intact over the vociferous objection of Franklin Investments, a major city bondholder whose claim was substantially reduced.  The confirmation of the Stockton plan underscores that even as there now appears to be a sound legal foundation for distressed municipalities to utilize Chapter 9 to reduce public pension claims, achieving such a result will remain an arduous process. 

 Judge Klein ruled that sufficient differences exist between public pension obligations and the debt evidenced by the city’s bonds to justify the disparate treatment.  He found that the city had proposed the plan in good faith, that it was feasible, and overall in the best interests of the city’s creditors, and accepted the city’s judgment that maintaining the pension obligations was necessary in order not to lose key employees.  He also noted that city employees were being affected in other ways, as the plan eliminated retiree medical benefits and certain cost of living adjustments.  Painfully aware that a contrary decision could put the parties back to “square one” and  lead to months if not years of additional litigation at a cost of millions of dollars, Judge Klein reluctantly concluded that the plan “is the best that can be done in terms of the restructuring and adjustments of the debts of the city of Stockton.”

The impact of Judge Klein’s earlier ruling nevertheless should not be disregarded.  Up until now, many practitioners and legal scholars believed that state law preferential treatment for public pension obligations would be insulated in Chapter 9 bankruptcy cases.  The key question has been whether state laws protecting public employee pension obligations are protected under the Tenth Amendment, which reserves to a state rights not granted to the federal government under the Constitution, or are pre-empted and superseded by Congress’s Article I, Section 8 authority to establish uniform laws regarding bankruptcy.   

Judge Klein unequivocally found that Congress’s Article I power controls here.  While there was a similar decision one year ago by Judge Stephen Rhodes in the Detroit bankruptcy case, that ruling was more limited, as it relied on a detailed parsing of Michigan statutes and the Michigan state constitution.  Judge Klein took a broader view, stating that  because the State of California had expressly authorized municipalities to seek protection under Chapter 9, it “open[ed] the gate” and was approving a process that it knew would be governed by federal law.   “Once the city passes through the gate, it’s what’s specified in the United States Bankruptcy Code.  Otherwise, you come to the conclusion that the California Legislature can edit . . . federal law.”

 Judge Klein’s decision will significantly affect negotiations between distressed municipalities and advocates for public employee pension rights.  Until now, for municipalities that wished to impair their pension obligations, there was nothing but uncertainty as to whether a Chapter 9 bankruptcy proceeding could succeed.  That uncertainty has now been effectively eliminated.  At the same time, the takeaway from the final outcomes of both the Stockton and Detroit cases is that if public employee pensions are to be impaired, it will require a lengthy, expensive and determined effort.