Bankrupt Stockton says it does not want to cut its biggest debt, pensions promised employees, because the CalPERS plan is needed to be competitive in the job market, particularly for a short-handed police force in the crime-ridden city.

But despite Stockton’s wishes, during a hearing Oct. 1 on Stockton’s “plan of adjustment” to cut debt and emerge from bankruptcy, something else may emerge: a landmark ruling on whether CalPERS pension debt can be cut in bankruptcy.

Early last July, U.S. Bankruptcy Judge Christopher Klein, who has called the unclear status of pension debt in bankruptcy a “festering sore,” asked parties in the Stockton case for legal briefs on the pension issue before the Oct. 1 hearing.

This month the lone major holdout with no negotiated agreement with Stockton, two Franklin bond funds owed $35 million, gave the judge a 64-page brief arguing that CalPERS debt has no special protection in bankruptcy.

Stockton and CalPERS say the pension issue is “academic” and “hypothetical” because the exit plan does not cut pensions. Franklin contends that a ruling on pensions is needed to know whether all creditors are being fairly treated.

“The city’s ability to impair pension liabilities presents a live controversy that the court must resolve as a condition to confirmation of the proposed plan,” said the Franklin brief.

After Stockton filed for bankruptcy in June 2012, two bond insurers owed more than Franklin (Assured Guaranty $164 million and National Public Finance Guarantee $89 million) raised the pension issue while opposing Stockton’s eligibility.

Judge Klein said fair treatment of creditors, a requirement under federal law, would be considered in the exit plan. Stockton negotiated agreements with the two big insurers, a smaller insurer (Ambac $12 million), all unions and a retiree group.

In closed-door mediation, Franklin reportedly rejected a city offer to pay half its debt. The original Stockton plan of adjustment gave Franklin $135,000, a “cram down” or forced reduction in debt that triggered a trial in May.

After Klein set the value of Franklin’s collateral, two golf courses and a park, at $4 million, Stockton agreed to pay Franklin $4 million. Now Franklin wants payment for the remaining unsecured part of the loan.

“Can the court confirm a plan that provides full payment of the city’s massive prepetition liability for unfunded pensions, delivers recoveries ranging from 52 percent to 100 percent for all other material unsecured creditors, yet crams down a sub-1 percent payment on Franklin?” said the Franklin brief. “The answer is no.”

Stockton argues employees have more than their share of financial pain: pay cuts as high as 23 percent, workforce reduced an average of 25 percent, and a retiree health care debt of $545 million eliminated, replaced by a lump-sum payment of $5 billion.

With lower pensions for new hires under the governor’s reform, workers paying more toward their own pensions and other changes, Stockton estimates a 30 to 50 percent cut in retirement benefits for current workers, a 50 to 70 percent cut for new hires.

“The city urges the court to confirm the plan and to do so as promptly as possible,” said the Stockton brief. “During the two years of this bankruptcy case, businesses have been reluctant to invest in Stockton and the city has struggled with hiring and retaining personnel.

“Potential employees are hesitant to join the city so long as the future of the city’s pensions is uncertain, while current employees eyeing transfers to other agencies wonder if they need to leave while they have the chance.”

During the trial in May, Klein seemed to suggest a split ruling is possible while reportedly listing several options: “Or I might conclude the CalPERS contract can be impaired, but in this case the decision (by the city) not to do so made sense.”

Port of Stockton (Google Earth)

Stockton argues that cutting pension debt in bankruptcy would terminate the city CalPERS contract, triggering a $1.6 billion payment that would cut pensions 60 percent, cause an exodus of employees, and unwind deals negotiated with unions and creditors.

When a plan is terminated, CalPERS needs a big up-front payment because the obligation to pay the pensions, often running 50 years or more, shifts from the employer to CalPERS, which cannot get more money from the employer if funds fall short.

If the employer cannot make the full termination payment, CalPERS has the brief power, only as the pension obligation is being transferred, to evenly cut the pensions of current workers and retirees to an amount covered by the employer payment.

An expert said during the trial that Stockton could only pay about 40 percent of the current $1.6 billion “unfunded termination liability” calculated by CalPERS for the city’s two pension plans, hence the view that pensions would be cut 60 percent.

Whether a procedure like this can used to cut pensions in bankruptcy is one of the legal issues debated in the briefs requested by Judge Klein. He asked for views about the lien CalPERS has on employer assets to enforce payment of termination costs.

Franklin said CalPERS-sponsored legislation in 1982 imposed the lien after Congress broadened the bankruptcy law “to provide for rejection of collective bargaining agreements and adjustment of resulting claims and other employee obligations.”

To “clarify ambiguities” in the 1982 law, the CalPERS board in April last year approved a staff proposal to sponsor legislation that would “provide CalPERS with a present lien on all assets of a contracting public agency in the amount of all obligations owed to the system.”

The present-lien legislation apparently has not been introduced. Among a half dozen questions raised by the judge is whether a city’s CalPERS contract can be rejected in bankruptcy.

Under state law, said the CalPERS brief, an employer would no longer be eligible for bankruptcy if it attempted to reject its contract. Franklin said that state law is legislation sponsored by CalPERS after the Orange County bankruptcy in 1994.

In the Detroit bankruptcy, a judge ruled that pensions can be cut. Joining in an appeal, CalPERS argued that Detroit has a city-run plan and federal bankruptcy law does not allow an “arm of the state” like CalPERS to be impaired in a municipal bankruptcy.

Last week Detroit reached a tentative agreement with one holdout bond insurer, Syncora, owed about $200 million. Only one major opponent to the Detroit restructuring plan remains, Financial Guaranty Insurance Co., a bond insurer owed about $1 billion.

The Detroit plan cuts many pensions by 4.5 percent and trims or eliminates cost-of-living adjustments. An $816 million “grand bargain” among private donors, the state and the Detroit Institute of Arts reduced pension cuts and saved the city’s art collection.

In Rhode Island last week, state treasurer Gina Raimondo won the Democratic nomination for governor. In 2011 she pushed a pension reform that cut cost-of-living adjustments, raised retirement ages and created a hybrid pension-401(k) plan.

In a small bankrupt city, Central Falls, Rhode Island, population 19,000, retirees voted in 2011 to accept pension cuts of up to 55 percent, reduced for the first five years by a state supplement.