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This blog post was authored by Paul D. Knothe

We are all aware of the ongoing discussion over the rising cost of public pension benefits and whether they are sustainable in the long run. However, one unanswered question was lurking in the background: Is Chapter 9 bankruptcy a way for struggling municipalities to shed these pension liabilities?  We now have a glimpse at what at least one bankruptcy judge would rule if faced with that situation:  those pension obligations can likely be impaired in a bankruptcy proceeding.

Published reports indicate that on October 1, 2014, Bankruptcy Judge Christopher Klein stated from the bench that he believed that, contrary to arguments made by CalPERS, the City of Stockton can impair its pension obligations to its employees and retirees as part of a Chapter 9 plan by terminating its contract with CalPERS.

To be clear, Judge Klein’s statements of October 1 do not constitute a finding that the City must or will impair its pension obligations.  The question before Judge Klein is whether to accept or reject the City’s proposed plan, which does not call for any reduction in its pension obligations.  Another City creditor opposed the plan, arguing that the City’s debt to it should not be reduced while pensioners face no reduction to their benefits.

California courts have regularly stated that pension benefits are vested and therefore have certain protections (although retiree medical benefits seem to be less protected).  But what does “vested” mean?  A vested benefit is based on contract principles.  The courts have stated that the promise made by a public employer to provide a pension benefit in the future is akin to the offer portion of a contract and, the employee accepts that offer by performing work.  Thus, according to the courts, a contract is formed and, given the prohibition on passing legislation impairing a contract, the public agency may not impair that contract.

In a bankruptcy, however, contracts are regularly modified, many times against the creditor’s will.  Those other creditors think that their contract is just as valid as any other contract, including pension obligations to public agency employees and retirees.  In fact, that was the assertion of one of Stockton’s creditors.  It argued it should not take a large loss while employees’ and retirees’ pension benefits go unscathed.  If the creditor is successful in blocking the plan and a future approved plan does require that the City terminate its contract with CalPERS, the results could be significant.   The City asserted numerous negative consequences of compelled termination of its CalPERS contract.  As an example, two of them are:

  • Accrued pension benefits would be cut to some degree.  CalPERS’ Deputy Chief Actuary and the City’s hired expert, as cited in the City’s brief, estimated this reduction at 60%.   A Termination Liability would be imposed on the City, and because it does not have the funds to pay that liability, benefits to employees must be reduced pro rata based on the amount of the Termination Payment that is not funded.
  • The City would not be allowed to rejoin CalPERS for at least three years.

These issues are far from settled.  We will continue to keep you updated with any new developments.