Dec. 12 (Bloomberg) -- The California Public Employees’ Retirement System is trying to rewrite the rules for bankrupt cities, claiming that it should get paid before almost everyone else, including bondholders.
The biggest U.S. public pension fund would set a legal precedent should courts adopt Calpers’s position that, as an arm of the state, it is exempt from rules that apply to other creditors in the Chapter 9 bankruptcy cases of San Bernardino and Stockton. A Calpers victory would threaten public services in a city trying to reorganize in bankruptcy, or in an extreme case, cause a city to disincorporate, attorney James E. Spiotto said in an interview.
“Chapter 9 was never intended to cause the liquidation of a municipality or the reduction of services,” said Spiotto, who isn’t involved in the San Bernardino and Stockton cases. “What Calpers is doing is threatening the basic tenet of Chapter 9.”
Pension costs for retired public employees are straining local governments from California to Rhode Island. In Southern California, San Bernardino says it is so strapped for cash it must put off $13 million in payments to Calpers or risk public safety. About 400 miles (644 kilometers) north, creditors of Stockton are fighting Calpers in court as well, arguing that the pension fund shouldn’t be given preferential treatment and urging the city to take an aggressive stance in negotiations.
San Bernardino will battle Calpers in a federal court in Riverside, California, on Dec. 21 over two related legal issues: whether Calpers can sue the city to force it to make about $7 million in missed payments and whether the city should be kicked out of bankruptcy.
Calpers blames elected officials for San Bernardino’s financial problems, saying in an e-mail that they made “irresponsible and short-sighted” decisions. Cutting back on what the city owes employees would make it hard to recruit qualified workers, Calpers spokesman Robert Glazier said.
“The city will be worse off if they choose not to fulfill their obligations,” Glazier, deputy executive director for external affairs, said an e-mailed response to questions. “We have a responsibility as fiduciaries to protect our members and the soundness of the retirement system just as our members were responsible in making their contributions, going to work and doing their jobs.”
In the private sector, when bankrupt corporations fall behind on such payments, the shortfall is considered an unsecured debt owed to the pension fund. Only part of the debt is given priority by bankruptcy courts, Spiotto said.
Calpers is arguing that all of its debt should be treated as an administrative claim, which means only a handful of creditors would be paid first, such as the lawyers and financial advisers working on the bankruptcy case, Spiotto said.
“What Calpers is trying to do is rewrite the priorities of the bankruptcy code,” Kenneth N. Klee, who helped revise Chapter 9 of the U.S. Bankruptcy Code in the 1970s as a lawyer working for Congress, said in an interview. He isn’t involved in the California cases.
Stockton filed for bankruptcy at the end of June. San Bernardino followed on Aug. 1. Both blamed the slowdown in the economy, which pushed down tax revenue, and rising costs for pensions, retiree health care and wages, especially for police officers and firefighters.
In the San Bernardino case, Calpers asked a judge to waive a restriction preventing the fund from suing the city in state court, where it would have the chance to force payment.
“The city’s failure to make these contributions is a violation of state law,” Calpers said in court papers.
While a city is in Chapter 9, creditors are barred from seizing assets or suing. One exception is for government agencies that are enforcing a law using their police or regulatory powers.
“Simply put, if the city is forced to pay Calpers, the city’s ability to continue to function would be seriously threatened,” San Bernardino officials said in court papers.
In Stockton, Calpers General Counsel Peter Mixon issued a statement arguing that pensions and other public employee benefits are protected by the California Constitution and have priority over other creditors.
Stockton has an unfunded pension liability of $147.5 million owed to Calpers, according to the city’s bankruptcy petition. The city also owes $124.3 million on pension obligation bonds and about $142 million for various public projects.
San Bernardino, about 60 miles east of Los Angeles, has an unfunded pension liability of about $143 million and is in default on $50.4 million in bonds issued in 2005 to help cover pension obligations, according to court documents and the city budget.
Central Falls, Rhode Island, exited bankruptcy earlier this year after cutting pensions and health-care benefits for retirees. The state sided with bondholders in that case, passing a law that allowed them to put a lien on city tax revenue. The city’s bondholders were paid in full, according to court documents.
Municipal bond investors are watching San Bernardino’s fight with Calpers, partly because so much of the city’s debt is tied to pensions, said Richard P. Larkin, director of credit analysis for Herbert J. Sims & Co., a municipal-bond underwriter in Iselin, New Jersey.
“If Calpers wins, I think people are going to look at bankruptcies for municipalities much more negatively,” Larkin said by telephone. “This is a precedent-setting case, not just in California but nationally.”
The California bankruptcies probably won’t have an immediate effect on the municipal-bond market, where prices are rising and yields are shrinking, Larkin said. Investors are more focused on the debates in Washington over the fiscal cliff and whether municipal bonds will remain tax-exempt, he said.
Should Calpers win, investors who buy municipal bonds will eventually demand higher interest rates from cities and counties to compensate for the increased risk, Richard A. Ciccarone of McDonnell Investment Management LLC said in an interview.
“It would put more bondholders at risk than would normally be at risk,” said Ciccarone, chief research officer at Oak Brook, Illinois-based McDonnell, which oversees about $8 billion in municipal debt.
Employee pensions should be paid ahead of sophisticated investors who understood the risks of buying municipal bonds, Calpers’ Glazier said in the e-mail.
“Calpers will champion our members who have relied on the retirement promises made by the City of San Bernardino,” he said.
The case is In re San Bernardino, 12-28006, U.S. Bankruptcy Court, Central District of California (Riverside).
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