Trial over Stockton's bid for bankruptcy nears end in California

SACRAMENTO, Calif., March 26 Tue Mar 26, 2013 8:40pm EDT

SACRAMENTO, Calif., March 26 (Reuters) - A federal court trial set to rule whether Stockton, California, is eligible for bankruptcy is nearing an end with closing arguments scheduled for Wednesday, a day earlier than expected.

Judge Christopher Klein in U.S. bankruptcy court in Sacramento, California, gave no indication on when he would rule. But observers said a decision could come sooner rather than later in a case closely watched for its broad implications for other struggling municipalities considering bankruptcy.

At issue is whether bondholders and bond insurers can be forced to swallow losses while leaving pensions of workers and retirees intact.

Bondholders in major municipal bankruptcies consistently have been repaid their entire principal since at least the 1930s but Stockton is expected - along with Jefferson County in Alabama and San Bernardino in California - to break that streak, said lawyers familiar with the case.

Bondholders and bond insurers, which will have to repay investors for capital losses, argue that Stockton's decision to maintain payments to the California Public Employees' Retirement System shows a lack of good faith - a reason to block its request for eligibility for bankruptcy protection under federal bankruptcy law.

Bond insurers contesting Stockton's eligibility for bankruptcy have more than $300 million of exposure to the city's debt. Assured Guaranty Corp, Assured Guaranty Municipal Corp and National Public Finance Guarantee Corp are joined by Wells Fargo Bank, the Franklin California High Yield Municipal Fund and Franklin High Yield Tax-Free Income Fund in objecting to the city's bid to adjust its debt under bankruptcy court protection.

Stockton pays a yearly contribution of about $30 million to the $254 billion California Public Employees' Retirement System, best known as Calpers. It is the largest U.S. public pension and manages pension accounts for the city's employees and retired employees.

The creditors told Klein that Stockton was not insolvent at the time it filed for bankruptcy last summer, saying the city could have imposed deeper spending cuts or proposed tax measures.

Stockton officials say deeper cuts would endanger public safety, following $90 million in cuts over three years and a sharp decline in payroll, in their crime-plagued city. The officials also say they must keep paying Calpers to be able to retain and recruit employees, especially police officers.

If Klein finds Stockton is eligible for creditor protection under Chapter 9 of the U.S. bankruptcy code, the city could begin drafting a so-called plan of adjustment for its debts right away, said Karol Denniston, an attorney with the Schiff Hardin law firm in San Francisco who helped draft California's law guiding municipal bankruptcies.

Denniston said that the process will require some time. In Alabama, Jefferson County filed in November 2011 and has not yet filed a workout plan for the country's largest municipal bankruptcy. And any plan would eventually require a court finding that it is fair and equitable to all creditors.

Denniston noted that a workout plan could put the matter of impairing payments to Calpers back in play.

Creditors will also be able to appeal a finding of eligibility to U.S. District Court or a bankruptcy appellate panel, Denniston said.

If Klein instead finds Stockton is not eligible for bankruptcy protection, the city could operate under its current spending plan while implementing concessions it has won from its employees and negotiating concessions from other creditors.

Creditors would be able to press their respective claims against the city in state or federal court, Denniston said. But in that case, the creditors would not be able try to impair Stockton's payments to Calpers, Denniston said.

Denniston expects Klein to decide Stockton's eligibility quickly, noting he prides himself on clearing his desk of cases before him by the end of the workweek.

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