In re City of Stockton, Case No. 12–32118–C–9

• Court: United States Bankruptcy Courts. Ninth Circuit. U.S. Bankruptcy Court — Eastern District of California
• Writing for the Court: KLEIN, Bankruptcy Judge
• Citation: 526 B.R. 35
• Parties: In re: City of Stockton, California, Debtor
• Docket Number: Case No. 12–32118–C–9
• Decision Date: 27 February 2015

526 B.R. 35

In re: City of Stockton, California, Debtor

Case No. 12–32118–C–9

United States Bankruptcy Court, E.D. California.

Signed February 27, 2015

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Marc A. Levinson, Orrick, Herrington & Sutcliffe LLP, Sacramento, California, for Debtor.

Michael J. Gearin, K & L Gates LLP, Los Angeles, California, for California Public Employees' Retirement System.

James O. Johnston, Jones Day, Los Angeles, California, for Franklin High Yield Tax–Free Income Fund and Franklin California High Yield Municipal Fund.

AMENDED¹ OPINION REGARDING CONFIRMATION AND STATUS OF CALPERS²

KLEIN, Bankruptcy Judge:

Resolving the single objection to confirmation of the chapter 9 plan of adjustment of debts by the City of Stockton necessitates answering the threshold question whether, as a matter of law, pension contracts entered into by the City, including the pension administration contract, may be rejected pursuant to Bankruptcy Code § 365. 11 U.S.C. § 365.

After answering that question of law in the affirmative, we come to the main question: whether, as matters of law and fact, the City's chapter 9 plan should be confirmed even though the plan does not directly impair the City-sponsored pensions.

Franklin Templeton Investments (“Franklin”) objects to confirmation, contending that the City's failure to modify pensions means that the plan (1) is not proposed in good faith and (2) that Franklin's unsecured claim should be separately classified so that Franklin can be deemed to be a separate, non-accepting class as to which the plan may be confirmed only if, with respect to Franklin, it is fair and equitable and does not unfairly discriminate against it. 11 U.S.C. §§ 1122(a), 1129(a)(3) & 1129(b).

If Franklin's unsecured claim is not separately classified, then the fair-and-equitable-and-not-unfairly-discriminatory analysis of § 1129(b) would not apply to this plan because Franklin's claim is dwarfed and out-voted in the single class of unsecured claims. The value given up by retirees who accepted the plan is on the order of ten times the value lost by Franklin.

The California Public Employees' Retirement System (“CalPERS”), which by contract administers the City-sponsored

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pensions, says that California law insulates its contract from rejection and that the pensions themselves may not be adjusted. Although, as will be seen, it is doubtful that CalPERS even has standing to defend the City pensions from modification, CalPERS has bullied its way about in this case with an iron fist insisting that it and the municipal pensions it services are inviolable. The bully may have an iron fist, but it also turns out to have a glass jaw.

This decision determines that the obstacles interposed by CalPERS are not effective in bankruptcy. First, the California statute forbidding rejection of a contract with CalPERS in a chapter 9 case is constitutionally infirm in the face of the exclusive power of Congress to enact uniform laws on the subject of bankruptcy under Article I, Section 8, of the U.S. Constitution—the essence of which laws is the impairment of contracts—and of the Supremacy Clause. U.S. Const . art. I, § 8 & art. VI. Second, the $1.6 billion lien granted to CalPERS by state statute in the event of termination of a pension administration contract is vulnerable to avoidance in bankruptcy as a statutory lien. 11 U.S.C. § 545. Third, the Contracts Clauses of the Federal and State Constitutions, as implemented by California's judge-made “Vested Rights Doctrine,” do not preclude contract rejection or modification in bankruptcy. Finally, considerations of sovereignty and sovereign immunity do not dictate a different result.

Hence, as a matter of law, the City's pension administration contract with CalPERS, as well as the City-sponsored pensions themselves, may be adjusted as part of a chapter 9 plan.

But, when one turns to the question of plan confirmation, pensions must be viewed as but one aspect of total compensation.

The City's plan achieves significant net reductions in total compensation (including lower pensions for new employees and elimination of up to $550 million in unfunded health benefits) that employees accepted in exchange for preserving existing pensions.

All capital markets creditors, except Franklin, accepted a package of restructured bond debt in impairments reflecting their relative rights in collateral. Franklin did not fare as well because its bargain was backed by poor collateral.

Viewing compensation as a whole package, and comparing those net reductions with the net reductions for capital markets creditors, the plan is, in law and fact, appropriate to confirm.

Jurisdiction

Jurisdiction is founded on 28 U.S.C. § 1334. The question whether to confirm a chapter 9 plan of adjustment is a core proceeding that a bankruptcy judge may hear and determine. 28 U.S.C. § 157(b)(2)(L).

The premise of Franklin's objection to confirmation is its theory that the City's pensions administered by CalPERS may be modified and that the plan should not be confirmed unless the pensions are modified. The City's plan does not propose to adjust the CalPERS pension.³ The ferocity

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of CalPERS' resistance to Franklin's position (and of other financial creditors who have since compromised) throughout this case belies its assertion that the question is moot.⁴ Since the answer to the question is essential to resolve Franklin's objection, it is not moot.

I

Structure of City's Pensions

In addition to acting as the pension system for employees of the State of California, CalPERS contracts with California municipalities in competition with other pension administrators to administer local pensions for municipalities. Public Employees' Retirement Law, Cal. Gov't Code § 20460 (“PERL”).⁵ The Stockton-sponsored pension plan is such a plan.

A

The City's pension obligation is established by contract between the City and its employees. The terms of the City-sponsored pension conform to a template that CalPERS is willing to administer by contract. The City could also select a different administrator in the public or private sector or establish its own administration system.

If one were to diagram the relevant relationships, one would draw a triangle in which the corners are the City, CalPERS, and City employees. There are three distinct relationships. First, the City agrees with its employees to provide pensions. Second, the City agrees with CalPERS that CalPERS will administer City pensions by collecting payments from the City and investing those funds so as to produce enough to pay the pensions, and then paying on behalf of the City. Third, CalPERS promises City employees that it will pay the pensions.

From the viewpoint of the law of contract, there are three connected bilateral relationships. Two legs of the triangle are contracts: between City and employees and between City and CalPERS. The third leg is a third-party beneficiary relationship according to which pensioners are intended third-party beneficiaries of the City's contract with CalPERS. See CalPERS' Brief in Support of Stockton's Petition, Dkt. No. 711, at 5.

B

CalPERS does not bear financial risk from reductions by the City in its funding payments because state law requires CalPERS to pass along the reductions to pensioners in the form of reduced pensions. Rather, it is the pensioners, present and

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future, themselves who are at risk of loss.⁶

As noted, a municipality is free to establish its own self-funded, self-administered pension system, commonly funded by individual or group life insurance or annuity contracts.⁷ It may join a county pension system or another municipality's pension system. It may contract with a private entity to administer its pensions. Nor does there appear to be an impediment to agreeing in collective bargaining to pay into a union-administered pension plan. Or, it may contract with CalPERS.

A municipality is entitled to shift from one pension administrator to another. If it shifts away from CalPERS, it cannot enter into a new CalPERS contract for three years. Cal. Gov't Code § 20460.

The key legal point to draw from this structure is that the authority of CalPERS to interject itself into the potential modification of a municipal pension in California under the Federal Bankruptcy Code is doubtful. As CalPERS does not guaranty payment of municipal pensions and has a connection with a municipality only if that municipality elects to contract with CalPERS to service its pensions, its standing to object to a municipal pension modification through chapter 9 appears to be lacking.

Nevertheless, the reality is that CalPERS has captured a substantial portion of the local pension servicing market in California. As of June 2014,⁸ it services pensions sponsored by 1580 local public agencies and 1513 school districts under a variety of benefit formulas with optional contract provisions. Only 32 percent (552,888 employees) of its members are state employees,...