Sleepless in Stockton

My family's first house was one of those post-World War II starter homes that sprouted by the hundreds through the late 1940s and early '50s from farmland north of Stockton. With three bedrooms and a big yard, it went for $5,600: $50 down and a VA loan. Back then, kids could safely walk to the local grocer to buy candy, front doors stayed unlocked all day, and a big night out was a movie at the ornate Fox Theater downtown.

Ten years later our house fetched nearly $8,000. But that was nothing compared with the boom-and-bust real estate cycles to come. In the decades that followed, I would see developers plow up rich delta soil to plant new subdivisions and shopping malls, as families arrived in Stockton by the thousands.

In the 1980s the once-bustling port began to decay, as shoppers abandoned downtown. I've watched Stockton's leaders destroy the best parts of the old city core for short-term profits. In one of many ill-conceived revitalization schemes, the 1898 domed courthouse - an architectural gem that figured prominently in the final scenes of All the King's Men - was torn down to make way for a Bauhaus box that quickly became an outdated eyesore.

Then came a new housing boom, prompted by cheap financing and Bay Area commuters' migrating to the Central Valley. From 2000 to 2007, row after row of homes sprouted in asparagus and tomato fields, the builders and lenders spurred on by Wall Street's thirst for securitized mortgages. At the top of the bubble, Stockton was issuing 3,000 residential construction permits a year.

Property values soared, from an average of $110,000 to more than $400,000. Tax revenues doubled, and the city, counting on the growth to continue indefinitely, embarked on a construction spree, borrowing heavily to build a marina, a convention hall, and a sports arena.

With the paint on those projects barely dry, the bubble burst. The riverfront city in California's heartland became ground zero in the nation's foreclosure crisis. Residents were losing their homes, and many lost their jobs as well.

Stockton's city council reacted in 2008 with furloughs, then two years later began to slash and burn. It cut into basic protections, reducing the police force by 25 percent and the number of firefighters by 30 percent.

Watching my hometown unravel has been like seeing its open spaces and historic architecture bulldozed all over again, but this time the wreckage is human.

Nick Garcia, a 58-year-old retired Stockton cop, says that before the financial crisis, "we were beating the bad guys - we felt like we were making a difference." Garcia spent 26 years on the force, half of them in the narcotics unit.

Now Stockton has no narcotics unit. Its robbery-homicide detail investigates only the homicides, which hit a record of 58 last year and are on pace to exceed that in 2012. And with only three burglary detectives in a city of 290,000 people, few home break-ins receive attention.

In crisis negotiations with the city, public employee unions gave up $90 million in wages and benefits. Then the city unilaterally took $20 million more - prompting three separate lawsuits - before it quit paying retirees' health insurance premiums altogether.

Even that didn't work. Stockton defaulted on $2 million in bond payments and endured the humiliation of having its new office building and a parking garage repossessed by Wells Fargo Bank. But it was too late to stop the hemorrhaging.

In June, facing a $26 million budget deficit and $800 million in unfunded liabilities, Stockton became the largest U.S. city ever to file for protection under Chapter 9 of the federal bankruptcy code. (In re City of Stockton, No. 12-32118 (Bankr. E.D. Cal. filed June 29, 2012).)

Under a so-called pendency plan, the Stockton city council adopted a balanced budget for fiscal year 2012-13 - but only by using measures that, outside of bankruptcy, would otherwise violate state law or its contractual obligations.

Now Stockton's attempt to emerge from bankruptcy under a plan of adjustment has become a defining legal battle. The contest pits the city against a laundry list of disgruntled creditors, including current employees, retirees, banks, bond insurers, and the California Public Employees' Retirement System (CalPERS) - the biggest public employee pension fund in the nation with assets of more than $230 billion.

Legal briefs for the claimants have put federal bankruptcy law on a collision course with the U.S. and state constitutions over whether pension benefit debts to CalPERS are subject to impairment in a restructuring plan.

Karol K. Denniston, a municipal restructuring and bankruptcy specialist at Schiff Hardin in San Francisco, says that if Stockton's other unsecured creditors can convince the court that state pension benefits are subject to impairment under the bankruptcy code, "that will lay down a precedent that would affect every city in California."

When the City of Vallejo, 70 miles west of Stockton on San Pablo Bay, filed for bankruptcy in 2008, its four public sector unions challenged the city's eligibility. Chapter 9 requires that the debtor municipality must be insolvent, must have tried in good faith and failed to negotiate an agreement with creditors, and must seek a plan of adjustment. (11 U.S.C. § 109(c).) U.S. Bankruptcy Judge Michael S. McManus found that the city had satisfied those requirements, and a year later the Ninth Circuit's bankruptcy appellate panel affirmed. (In re City of Vallejo, 408 B.R. 280 (B.A.P. 9th Cir. 2009).)

The unions also challenged Vallejo's authority to cancel retirees' health care coverage, unilaterally abrogating collective bargaining agreements in violation of state labor laws. Judge McManus found that under bankruptcy law the city could do so, and U.S. District Judge John A. Mendez affirmed his ruling. "This court declines to legislate from the bench and create a new exception to federal preemption," Mendez wrote. "If California had desired to restrict the ability of its municipalities to reject public employee contracts in light of state labor law, it could have done so as a pre-condition to seeking relief under Chapter 9." (Int'l Bhd. of Elec. Workers, Local 2376 v. City of Vallejo (In re City of Vallejo), 432 B.R. 262, 270 (Bankr. E.D. Cal. 2010).)

"Unions learned a lot of hard lessons" in that case, Denniston says. Vallejo also exposed the precarious standing of public sector retirees, who are unrepresented in bankruptcy proceedings under collective bargaining agreements. Nor are retirees represented individually or collectively by CalPERS, according to a June 2008 memo sent by a CalPERS attorney to a former Vallejo employee.

The U.S. trustee in Vallejo's bankruptcy appointed an official unsecured creditors committee of retirees. That committee sued for minimum health care benefits - a life and death matter for retirees in some job classifications, since the city wasn't required to pay into either Social Security or Medicare on their behalf.

Vallejo asserted that the creditors committee lacked standing to represent individual retirees; the bankruptcy court agreed and dismissed the suit.

In January 2011, Vallejo announced a plan of adjustment that only paid unsecured creditors between 5 and 20 cents on the dollar. Under the amended plan approved by the court later that year, retirees would have to stand in line with all of Vallejo's other unsecured creditors. Officials in Stockton - and that city's main unsecured creditors - were paying close attention to the result.

Barely a month after Stockton filed its bankruptcy petition in June, things again went sour for city retirees. An association of retired employees had sought a temporary restraining order, or in the alternative, permission from the bankruptcy judge to challenge the constitutionality of impairments to their health benefits. The retirees alleged violations of the contracts clauses of both the U.S. and California constitutions, as well as provisions of state law.

But in early August, U.S. Bankruptcy Judge Christopher M. Klein in Sacramento dismissed the complaint, stating that section 904 of the Bankruptcy Code "forbids the court from using any of its powers to 'interfere with' property or revenues of a chapter 9 debtor."

Judge Klein continued, "Accordingly, although the city's unilateral interim reduction of retiree health benefit payments may lead to tragic hardships for individuals in the interval before their claims are redressed in a chapter 9 plan of adjustment, the motion for injunctive relief must be denied."

Klein's ruling devastated the retirees' constitutional arguments. "While the Contracts Clause is a key navigational star in the firmament of our Constitution and economic universe," he wrote, "it is subject to being eclipsed by the Bankruptcy Clause. ... Significantly, the Contracts Clause bans a state from making a law impairing the obligation of contract; it does not ban Congress from making a law impairing the obligation of contract. This asymmetry is no accident."

Klein found that the Constitution's bankruptcy clause necessarily authorized Congress to make laws that impair contracts. "In sum," he wrote, "even if the plaintiffs' benefits are vested property interests, the shield of the Contracts Clause crumbles in the bankruptcy arena." (Ass'n of Retired Employees of the City of Stockton v. City of Stockton, 2012 WL 3193588 at *1-3 (Bankr. E.D. Cal.).)

Stockton's bankruptcy puts CalPERS - and its billions of dollars in trust assets - directly in the crosshairs.

Within days of Judge Klein's ruling, the city's bond insurers, Assured Guaranty and National Public Finance Guarantee, separately challenged Stockton's eligibility to file. They alleged that prior to petitioning for bankruptcy, Stockton had failed to negotiate with creditors in good faith by sheltering CalPERS at the expense of other similarly situated creditors.

The bond insurers, on the hook for the city's missed pension benefit payments to CalPERS, were staring at projected obligations of $17 million in 2012-13 alone, and potentially the need to make up all debt payments on $124 million in pension obligation bonds if the city followed through with its proposal to default.

In their objection, the insurers pointed out that the city's pendency plan didn't include CalPERS - Stockton's largest unsecured creditor at $147.5 million - as a candidate for concessions. In fact, the insurers alleged, Stockton never even asked CalPERS to accept concessions during the mediation period.

As a secondary argument, the insurers asserted that Stockton had failed to demonstrate it is insolvent. Failure to make timely payment on bonds isn't enough when the city - pre-bankruptcy - still funded payroll and retiree health premiums, they claimed.

Kevin J. Lyons, deputy general counsel for Assured Guaranty's public finance business group, contends that CalPERS is not protected by the state constitution. Echoing Judge Klein's reasoning, he argues that under the supremacy clause of the U.S. Constitution, federal bankruptcy power, "trumps any purported state law priority for public worker pension benefits. As a result, the obligations owed to public employees will be treated like any other general unsecured claim."

Lyons adds, "The legal standard for [confirming an adjustment plan] is that it has to be fair and show no favoritism. Not adjusting the CalPERS obligation does not meet that standard, so the plan will not be confirmed, and the case should be dismissed."

The first hearing on the bond insurers' eligibility objection is scheduled for January. If their arguments fail, Stockton would become the first American city since the Great Depression to force bondholders to accept concessions in a bankruptcy proceeding. If they prevail, it could align the insurers' interests with the city's - and give Stockton the legal cover to impose lower pension benefits on employees and retirees.

Marc A. Levinson, Stockton's bankruptcy lawyer and a partner at the Sacramento office of Orrick, Herrington & Sutcliffe, contends that the city "does not intend to alter pension benefits." But in the shifting alliances that roil bankruptcy cases, that promise may not mean much.

The significance of the bond insurers' challenge wasn't lost on CalPERS, which has 1.6 million members - 500,000 of them retirees. The fund is counting on an estimated $245 million from Stockton over the next decade.

California law treats public retirement benefits as deferred compensation and part of an employment contract, earned as the employee works. As contractual obligations they are protected by the state constitution's contracts clause, meaning the vested rights may not be impaired except in rare circumstances.

But what constitutes those rare circumstances? "There is a whole school of legal thought that retirement benefits are guaranteed by the state constitution," says Schiff Hardin's Denniston.

Peter Mixon, CalPERS general counsel, certainly thinks they are. In an address to his administrative board in September, Mixon summarized the pension fund's legal position. He emphasized that CalPERS is an arm of the State of California, which has sovereign powers reserved by the Tenth Amendment. And because Congress reserved for states the power to control municipalities, he asserted, it "determined that Chapter 9 ... would not preempt state laws that control the political and governmental powers of municipalities and arms of the state." (See 11 U.S.C. § 903.)

Bolstering his case, Mixon argued that contracting municipalities are "bound by the constitutional and statutory provisions governing the system and the decisions of the CalPERS Board of Administration." Because the Legislature created CalPERS as a trust fund, he added, it has a fiduciary duty to beneficiaries and therefore "does not have the right to 'forgive' or reduce employer contributions." Moreover, it is precluded by state law "from lowering the benefit formula for existing employees who are members of the system."

In a statement posted on its website this fall, CalPERS asserted, "Under federal law, the Bankruptcy Court may not interfere with the relationship between the State and a City. Accordingly, remedies available to CalPERS include not only seeking relief from Bankruptcy Court, but also exercising CalPERS's governmental powers."

But CalPERS's legal strategy was challenged in October in yet another municipal bankruptcy when the City of San Bernardino took the unprecedented step of suspending its regular contributions to CalPERS. Compton - not yet in bankruptcy but citing a short-term cash-flow problem - also suspended payments the same month, and CalPERS filed suit.

The giant pension fund, however, may have an ace up its sleeve - a virtual poison pill against impairment in bankruptcy court. State law allows the CalPERS board to put a lien on the assets of any agency terminated for nonpayment, and those claims rank second only to wages. (Cal. Gov't Code § 20574.) As Mixon told his board in September, "Because termination of the relationship essentially closes the pension plan, any unfunded liabilities as of termination must be fully paid by the employer. ... Termination by a municipal debtor would create a much larger obligation to CalPERS, which would impair the ability of the debtor to make payments to its unsecured creditors and severely dilute the return to such creditors."

Lyons of Assured Guaranty disagrees. "Once the state consents to federal bankruptcy jurisdiction" by permitting a municipal filing, he says, "that trumps state law priority."

Ultimately, Stockton's exit from bankruptcy may come down to which prevails: Chapter 9, or the constitutional guarantee that states have the right to manage their own affairs. In August, Judge Klein warned that although a state may set the terms for its municipalities to file a Chapter 9 case, "it cannot revise Chapter 9. For example, it cannot immunize bond debt held by the state from impairment." But he also noted, "The overall goal is a balance that does not offend the Tenth Amendment." (Stockton, 2012 WL 3193588 at *4.)

To that end, the judge appointed U.S. Bankruptcy Judge Elizabeth L. Perris of Portland, Oregon, to open negotiations between Stockton and its creditors. Perris had helped Vallejo and Mammoth Lakes reach deals that ended their Chapter 9 cases. As Klein put it, "The real remedy for the plaintiffs lies in participating in the process of formulating a plan of adjustment." (Stockton, 2012 WL 3193588 *11.)

Of course, Stockton's core financial troubles can't be fixed in a courtroom. Cities all across the country have promised their workers benefits they cannot provide, but are legally prevented from reducing. The public safety unions in particular feel cheated.

"The employees, and specifically the police, have been hit much harder and for a longer period of time than the bond market," says David E. Mastagni, attorney for Stockton's police union. "I believe [city officials] knew they were going to file bankruptcy," he says. "Look, what they are going after [for concessions] is bonds, and scapegoating the employees."

There are no easy answers. Chronic underestimation of liability for retirees' health care and pensions - and the failure to properly set aside current funds for those benefits - has as many as 20 California municipalities teetering on the brink of bankruptcy. Last June two major cities sought a way around Chapter 9 - reducing pension obligations through a ballot initiative rather than in bankruptcy court.

In San Jose, 70 percent of voters approved a plan to give current employees the option of switching to lower defined benefits or paying more into the city's independent pension system. The measure also cuts retirement benefits for future hires.

As soon as the votes were tallied, San Jose sought a preemptive ruling in federal court that the measure did not violate the U.S. and state constitutions. The unions shot back with five state court lawsuits raising a variety of claims. By October, the parties had stipulated to dismiss the federal case and proceed in a consolidated case before the Santa Clara superior court. (See San Jose Police Officers Ass'n v. City of San Jose, No. 112CV225926 (lead case).)

In San Diego - which also operates an independent public pension system - voters approved a measure to freeze the pay formula used to calculate pensions for current employees, and switch future hires to a 401(k)-style defined contribution plan. Both measures drew lawsuits.

The unions asked the state Public Employment Relations Board to invalidate the initiatives as an unfair labor practice, on the ground that the city had refused to bargain before placing them on the ballot. The city won an injunction blocking the board's proceedings, but it lost the jurisdictional issue on appeal. (See San Diego Mun. Employees Ass'n v. Superior Court, 206 Cal. App. 4th 1447 (2012).) At the core of the dispute is whether city council members, acting as citizens, have the right to avoid collective bargaining by going directly to the voters on key issues.

While the courts weighed the legality of those ballot measures, I was drawn back home to witness Stockton's announcement of municipal bankruptcy. Outside a city council meeting, satellite TV trucks jostled for parking space alongside the Ionic columns of City Hall. Built in 1926, the Renaissance revival building betrayed the city's cash-strapped status with peeling paint and a crumbling foundation.

Inside, city workers - many of them retired cops and firefighters - crammed the council's tiny chambers in a last-ditch effort to forestall the inevitable. The crowd spilled through open double doors into an anteroom, and more watched on monitors from a downstairs lobby.

I watched as people at the end of their careers were "asked" to bear the burden of fiscal recklessness so the city could retrench and survive. But these employees, each individually a small creditor, are hopelessly overmatched in a bankruptcy system geared to long-term survival of the debtor.

During an extended open-mic session, retirees recounted heroic struggles to pay medical bills that had piled up, in hope the city would reverse itself and maintain their health benefits. Some testimony was angry, some tearful, and some accusatory.

With eight TV cameras trained on him, Gary Jones, a cop's cop with a small goatee and a shaved head, limped toward the podium. He wore the white shirt and blue "retiree" name tag worn by many in the room. In a slightly slurred voice, he told the council members he'd spent 15 years on the Stockton force before an inoperable brain tumor forced him to take medical retirement in 2006. Jones blamed his speech difficulties on medication and his tumor, imploring the council not to end his health coverage. "If I lose this medicine," he told them, "it is a life sentence."

As he spoke, many in the crowd wiped away tears. Through two hours of testimony others said they were too ill to work, too old to find new jobs, or too young to qualify for Medicare. All of them realized they would be paying for the years of poor choices by Stockton's leaders.

But the council had already made its decision to file for bankruptcy. Mayor Ann Johnston said Stockton had no options. Severe layoffs had left the city facing a public safety crisis. "We have cut our police force so drastically we cannot cut any more. We will not cut anymore," she said. "We have exhausted all possible solutions."

With one dissenting vote, the Stockton council kicked its retirees to the curb, leaving them without health insurance. Now the remaining question is whether their pension benefits will be spared.

As the meeting adjourned, Mayor Johnston tried to lift the mood, telling the gathering, "We will survive this. We will come out of it stronger and healthier."

For Gary Jones, probably not.

Pamela A. MacLean is a contributing writer at California Lawyer.

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