A bankruptcy judge's ruling last week declaring the city of Stockton insolvent sets the stage for a possible legal showdown over whether financially destitute municipalities can alter employee pension benefits.

City officials don't want to make those cuts for fear of losing competitiveness when trying to recruit and retain employees. They say workers have already made other major cost-saving concessions.

But unhappy capital market creditors, including holders and insurers of city bonds, could force the issue by insisting that, if they must absorb economic losses to resolve the bankruptcy, payments to the pension program should be trimmed, too.

The legal showdown could be avoided if the city and those creditors reach a compromise. But if they don't, Judge Christopher Klein warns, promised pension benefits could be amended.

That threat undermines claims by California's retirement systems that benefits are inviolable and could leave the California Public Employees' Retirement System to defend their sanctity.

The genesis of the Stockton case dates back over the past decade as the city dug a huge financial hole by providing salaries and benefits more generous than what most California cities offer, and recklessly borrowing to fund new public facilities and downtown improvements.


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The financial commitments anticipated steadily increasing property values that would continually boost tax revenues. But when the city became a center of the foreclosure crisis, the municipal budget imploded.

By 2012, Stockton could not pay all of its bills and began the long march toward the bankruptcy protection Klein granted Monday. Now, the city must put together a financial plan fair to all creditors that also provides long-term fiscal stability.

The judge can approve the plan or reject it. He can suggest changes, but he cannot mandate them. On the other hand, the city must eventually craft a solution that earns Klein's blessing.

Klein warned that if Stockton does not make pension changes or reach an agreement with the financial-industry creditors, then he will probably have to "get down into the nitty-gritty of the CalPERS situation."

He said he had "no clue how that's going to come out," but even raising the possibility of pension alterations throws this case into uncharted territory.

That's because most California pension attorneys have insisted that once public employees start working, the rate at which they accrue retirement benefits cannot be reduced.

For example, an employee who started working under a pension plan that pays, say, 2 percent of top salary for every year on the job would be entitled to at least that rate for all future years of employment. The accrual rate could be increased during a worker's career, but never decreased, the pension attorneys claim.

They defend their position by pointing to the state and federal constitutions, which bar government impairment of contracts. But Judge Klein last week and in a ruling last summer was clear: That protection doesn't apply to bankruptcy court.

He notes that the federal Constitution only bars state impairment of contracts. Meanwhile, it grants Congress authority to establish rules for bankruptcy, which typically involves altering contractual commitments.

As for the state constitutional protection, Klein said, "it must give way to the Bankruptcy Code, to the power of the Congress under the Supremacy Clause of the Constitution."

While the judge says it's theoretically possible to alter pension benefits in bankruptcy court, it's uncertain how that would be done. Lowering the benefit accrual rate would reduce Stockton's future costs. But it's not clear that CalPERS, which operates under state laws, has the authority to make those changes.

Then there's Stockton's debt to CalPERS, $322 million at last count, for the past underfunding of its pension plan. Trimming that in bankruptcy would also lower future city costs. But it would leave less money available in Stockton's CalPERS account to pay for benefits workers have already earned.

"There are very complex and difficult questions of law that I could see out there on the horizon," the judge said.

If the city and capital market creditors compromise, they will save Klein a lot of work. If they don't, this could turn into a very interesting case.

Contact columnist and editorial writer Daniel Borenstein at 925-943-8248 or dborenstein@bayareanewsgroup.com.