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.

Even the debt of financially troubled California, which has the lowest bond rating of any state, had an interest rate last week of as little as 1.4% on five-year debt and 4.18% on 30-year bonds. These government bonds are popular among wealthy investors because the interest earned is free from federal taxation and state taxation in the state where they're issued.

Stockton's financial health has been a victim of both the real estate collapse and mismanagement, say current city officials. Home values fell more than 50%, slashing property tax revenues. The city made ill-fated investments at the peak of the real estate boom in a new city hall that was never used and a sports stadium. Financial records were a mess. Parking fines were tallied daily by one police department employee and monthly by another department employee — then counted twice in the city budget, a $500,000-a-year error.

Stockton owes about $700 million to bondholders, including $125 million it borrowed in 2007 in a poorly timed bet to buy investments for its pension fund. The city plans to stop $12 million in debt payments immediately and reduce pension payments by $13 million a year. The elimination of retiree health care could save $19 million.

Stockton's bondholders — represented by bond insurance companies — have held firm about collecting what they are owed, confident that they can do well in bankruptcy court. The city plans to stop making millions in bond payments when the bankruptcy is officially filed, no later than Friday.

"Bondholders voluntarily taking a haircut would set a precedent for the billions of similar California debt outstanding," says Matt Fabian, managing director of Municipal Market Advisors, a research firm.

The bankruptcy of Vallejo, Calif., in 2008 had similar issues to those in Stockton and bondholders lost virtually nothing, he says. In addition, that bankruptcy dodged the issue of labor contracts and retirement benefits.

"The city went through years of expensive litigation and had little to show for it," Fabian says. If Stockton reverses that — a quick and effective restructuring, from the city's perspective — then other California cities may follow it into bankruptcy court.

Former Stockton city manager Dwane Milnes, now president of the Association of Retired Employees of the City of Stockton, says Vallejo shows that bankruptcy isn't a good path for financially troubled cities. "You somehow have to find millions of dollars within that broke budget to finance bankruptcy," he says.

Federal law lets local governments file for bankruptcy only if state law permits. About half of states allow it. States cannot file for bankruptcy.

Even states that permit bankruptcy often make it hard to file, except as a last resort. Stockton went through 90 days of extra negotiations, required by a new state law, before it could file.

Michigan passed a law in March 2011 that lets the state appoint emergency financial managers to run governments in financial trouble. The managers have the power to replace elected officials, sell assets and change union contracts — the latter power not yet tested in court. Four cities and three school districts are under emergency managers.

Detroit finances scrutinized

Detroit is trying to prevent the appointment of an emergency manager and possible bankruptcy. Now, a state-appointed financial advisory board is examining the city's finances. Mayor David Bing said Monday he will lay off 164 firefighters to save money in the arson-plagued city.

Stockton thinks it has a clear legal right to end retiree health care, which generally has less legal protection than pensions. There is no chance retiree medical benefits will be restored, says Johnston, the mayor, although retirees can keep the insurance if they pay for it.

Gerri Ridge, 56, who retired after 26 years with the police department, worries the change will shorten her life. She's had two heart attacks. Without city insurance, she plans to reduce doctor visits and shop for the least expensive of seven heart medications she takes.

"I know for a fact that I might not make it to 65," she says. Her pension is $1,895 a month.

Milnes, city manager from 1991 to 2001, says the city waited too long to fix its financial problems: "You have to start early enough if you see a freight train over on the other side of the hill."