482438969Pension holders and other creditors of the City of Stockton, California (“Stockton”), as well as other interested parties following Stockton’s bankruptcy case (No. 12-32118, Bankr. E.D. Ca.), must wait until October for a resolution of the dispute surrounding Stockton’s treatment of the California Public Employees’ Retirement System (“CalPERS”) pension plan in its plan of adjustment.  During a hearing on Tuesday, July 8, 2014, Judge Christopher Klein shared his preliminary understandings of California’s Public Employees’ Retirement Law (“PERL”) and the status of CalPERS pension plan in bankruptcy.  Judge Klein hinted that he might be persuaded that Stockton’s CalPERS pension plan could be adjusted in bankruptcy despite CalPERS’s contrary assertions.  However, his views were not final rulings.  CalPERS, Stockton, and other parties in interest will each have an opportunity to weigh in prior to an October 1 hearing during which Judge Klein will determine whether the CalPERS pension plan can be altered.

What’s Before Judge Klein

Stockton filed for bankruptcy in June 2012 and was found eligible to become a chapter 9 debtor in April 2013.  Stockton has actively negotiated with its creditors to seek a consensual restructuring of its debt.  Despite reaching consensual deals with most of its creditors, Stockton has been engaged in litigation with creditor Franklin California High Yield Municipal Fund and Franklin High Yield Tax-Free Income Fund (together, “Franklin”) over the treatment of Franklin’s claims against Stockton in its plan of adjustment.  In both its First Amended Plan for the Adjustment of Debts, filed on November 15, 2013 and approved for disclosure on November 22, 2013, and its First Amended Plan for the Adjustment of Debts, as Modified, filed on June 2, 2014 (together, the “Stockton Plan”), Stockton has sought to impair Franklin while leaving its unfunded pension liabilities to the CalPERS pension plan unchanged.

Franklin has challenged the Stockton Plan particularly Stockton’s decision to leave its unfunded pension liabilities unchanged.  For example, Franklin has argued that the Stockton Plan fails the best interests of creditors test set forth in section 943(b)(7) of the Bankruptcy Code, which requires a plan of adjustment to provide creditors with at least what they could reasonably expect to receive outside of bankruptcy.  Franklin has asserted that Stockton’s claim that it is limited in its ability to make any future payments to Franklin is not credible because Stockton will continue to pay tens of millions of dollars in yearly pension liabilities for a thirty-year period.  Franklin has also argued that the Stockton Plan was not proposed in good faith as required by section 1129(a)(3) of the Bankruptcy Code because Stockton has left its unfunded pension liability—its single largest liability—unaltered.  Accordingly, Franklin has argued that Stockton has acted in bad faith by not seeking to impair its unfunded pension liabilities.

Both CalPERS and Stockton have responded to Franklin’s objections. CalPERS has argued that the only mechanism by which CalPERS or Stockton could reduce pension benefits is through complete termination of the CalPERS pension plan.  According to CalPERS, termination of the CalPERS pension plan would trigger an immediate obligation of Stockton to CalPERS of more than $1.6 billion secured by a senior lien on all of the Stockton’s property.  For these same reasons, CalPERS has also argued that Stockton’s decision to continue its relationship with CalPERS and not impair the unfunded pension liability was made in good faith.

The July 8 Hearing

While some speculated that CalPERS status would be determined during a July 8 hearing, Judge Klein began the hearing by emphasizing that he would not be issuing a final ruling.  Instead, he explained that he wished to provide the parties with an update as to how, in light of the evidence and briefing to date, he viewed the issues.  He expressed his hope that after revealing his preliminary thoughts, the parties would have an opportunity for further briefing to correct him, if necessary, from making, in his words, a “bonehead mistake.”

Notably, Judge Klein explained that his understanding of PERL is that the financial risk of a shortfall in pension payments is placed on the employees, such that the employees, and not CalPERS, are the actual creditors of Stockton.  Additionally, the validity of CalPERS’s alleged $1.6 billion lien on Stockton’s assets that would arise from the termination of Stockton’s CalPERS pension plan was called into doubt.  However, Judge Klein explained that the Stockton Plan could still be confirmable even if CalPERS’s lien is not enforceable.  Judge Klein also requested that the parties provide additional briefing on other issues including the sources of funds for CalPERS and the administrative barriers to Stockton of negotiating a move from its CalPERS pension plan to a different pension plan— notably, a California municipality is not required to participate in the CalPERS system.  A further hearing has been scheduled for October 1, 2014, during which Judge Klein is expected to finally resolve the pension dispute.


Although Judge Klein made clear that his statements and views were not final, he appears to be leaning toward ruling that Stockton’s CalPERS pension plan can be adjusted in bankruptcy.  With two months of additional briefing, however, Judge Klein’s views may very well change before final findings are issued on October 1.