Stockton, Calif., tests legalities of city bankruptcies

— -- The bankruptcy of Stockton, Calif., could be the crucial test case that determines whether local governments can use the federal courts to shed burdensome retirement benefits in a way that corporations often do.

The struggling city of 291,000 has been firing police, firefighters and other workers for several years to reduce payroll costs so it can pay retirement benefits and debt. The City Council and city manager decided Tuesday — with regret but little disagreement — that it cannot cut more and, instead, the knife must be taken to pension and health care benefits of former workers.

"We have used every tool in our toolkit to try to resolve our financial situation without going into Chapter 9 (bankruptcy)," says Mayor Ann Johnston. "It truly is bad that we're in this position, but it's good that we have a way to resolve our financial situation."

What's significant about the Stockton bankruptcy is that a substantial-sized city is confronting head-on a multitrillion-dollar problem facing states, cities and school districts nationwide: unfunded promises for pensions and retiree health care. With unusual frankness, City Manager Bob Deis compares Stockton's strategy with that of General Motors and American Airlines, recent examples of a decades-old business technique to abandon costly retirement promises by filing for bankruptcy.

"This is a big test case," says University of Pennsylvania law professor David Skeel. "The conventional wisdom has been until very recently that you can't touch retirement benefits or labor contracts in bankruptcy court. That conventional wisdom has been rapidly eroding because of the horrendous financial conditions of some cities and the role pensions are playing in the trouble."

Headed to Supreme Court?

Skeel says two small towns — Central Falls, R.I., and Prichard, Ala. — made the same claim in bankruptcy court. But those cases didn't move forward enough to settle the issue. Other prominent bankruptcies — such as Jefferson County, Ala., last November and Orange County, Calif., in 1994 — dealt with more traditional debts to lenders, not retirement promises and labor agreements.

"It's quite likely this issue will have to go to the Supreme Court one day," Skeel says. "There are huge stakes and huge uncertainty."

Nationwide, there's been a small uptick in the number of local governments filing for bankruptcy: 13 filings last year. But that's a tiny fraction of the 89,500 local governments — counties, sewer districts, parking authorities — in the USA.

Fewer than 700 local governments have filed for bankruptcy since 1937, reports bankruptcy attorney James Spiotto. And many of those were for specific projects gone awry, such as a sports stadium or a trash incinerator. Adding retirement benefits to the list of debts that can be reduced could make courts — along with city councils and state legislatures — a routine way to reduce unfunded retirement liabilities.

Labor unions and local governments — until Stockton — have worked hard to avoid the issue of retirement benefits in bankruptcy court. This week, unions agreed to cut benefits $23 million next year to enable the city of Providence to avoid filing for bankruptcy.

Lending money to government is considered among the safest investments, even during tough times. The average interest rate on a 30-year municipal bond was just 3.15% Wednesday, reports Bloomberg.com. That's close to a historic low.