UPDATE 3-Stockton eligible for bankruptcy protection-U.S. judge

Mon Apr 1, 2013 5:51pm EDT

By Jonathan Weber

SACRAMENTO, Calif., April 1 (Reuters) - Stockton, California, is eligible for bankruptcy protection, a federal judge ruled on Monday, turning aside creditors' arguments the city was not truly insolvent when it sought protection and improperly failed to seek pension concessions.

U.S. Bankruptcy Court Judge Christopher Klein's ruling permits Stockton to proceed with a Chapter 9 municipal bankruptcy case after it became the largest U.S. city ever to file for bankruptcy.

The decision is likely to increase scrutiny of how the city will handle its pension obligations, managed by the California Public Employees Retirement System (Calpers).

Stockton is being closely watched by the $3.7 trillion municipal bond market and by other cash-strapped cities.

Creditors have claimed a lack of good faith by Stockton in its decision to fully pay its obligation to the $254 billion Calpers system but impose losses on bondholders and bond insurers.

The expected move by the California city of 300,000 - along with Jefferson County in Alabama and San Bernardino in California - breaks with a long-standing tradition to fully repay bondholders the principal in most major municipal bankruptcies.

CALPERS ISSUE LOOMS

In a lengthy preamble to his ruling, Klein delivered a stinging rebuke to the so-called capital market creditors - mainly the insurers for bondholders who own hundreds of millions of dollars of Stockton debt - who had opposed the bankruptcy filing.

Klein said capital market creditors had failed to negotiate in good faith in a pre-bankruptcy mediation, as required by law, and also criticized their refusal to foot part of the bill for mediation. He dismissed their arguments that the city wasn't really broke, stating that Stockton was "by any measure insolvent" prior to its filing.

The judge also rejected the argument that city had improperly exempted the $254 billion Calpers from concessions during the pre-bankruptcy mediation. He did, however, suggest that the issue of how pension payments are treated will be a central issue in the case going forward.

"This does not mean there is not potentially a serious issue involving Calpers," Judge Klein said in reference to his ruling. "But at this point I do not know what that is." He added that there were "very complex and difficult questions of law that I can see out there on the horizon," relating to Calpers.

But those issues are properly addressed as part of the effort to finalize a so-called "plan of adjustment" for emerging from bankruptcy.

"SCORCHED EARTH" TACTICS

Bob Deis, the Stockton city manager who is largely responsible for managing the bankruptcy process, called the judge's verdict a "vindication" of the city's position. He criticized the "scorched-earth" legal strategy of the bond creditors as a waste of time and money and said the city had already spent $6 million to $7 million on the mediation and legal costs.

Assured Guaranty Ltd., one of the bond insurers, said in a statement that it "disagrees" with the Judge's ruling but that it looked forward to working with the city on a "consensual approach" to resolving its debts.

Bond insurers Assured Guaranty Corp, Assured Guaranty Municipal Corp and National Public Finance Guarantee Corp were joined by Wells Fargo Bank, the Franklin California High Yield Municipal Fund and Franklin High Yield Tax-Free Income Fund in contesting Stockton's bid for bankruptcy eligibility.

They argued that the city could have done more to cut spending and raise taxes, and that it was unfair to demand concessions from bondholders without also demanding cuts in payments to Calpers.

But Judge Klein, citing crime statistics and the city's extensive cost-cutting pre-bankruptcy, agreed that further cuts in public safety and other services were not options.

He also rejected bondholder arguments that they were not required to negotiate in good faith in the mediation, noting that it was impossible to negotiate with a "stone wall."

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