SACRAMENTO – If Stockton, Calif. is granted eligibility for bankruptcy protection, the next big fight ahead may be with its whale of a creditor, the California Public Employees’ Retirement System, the largest pension fund in the country.

One of the main arguments the so-called capital market creditors made during the three-day trial over the city’s eligibility for Chapter 9 bankruptcy, which ended Wednesday, was that Stockton never attempted to seek concessions from CalPERS.

“What doesn’t make sense is that the city has failed to negotiate at all with CalPERS, its single largest creditor. CalPERS is number one on its list of 20 largest creditors,” said Assured Guaranty’s attorney Guy Neal, a partner with Sidley Austin LLP.

The capital markets firms’ lawyers argued during the trial that the city would remain insolvent even if it got the $350 million of concessions it sought from bondholders during pre-bankruptcy mediation, and that Stockton needs to seek liability reductions from CalPERS for future financial stability.

CalPERS, with assets of approximately $237 billion, is the largest public pension fund in the U.S.

The city’s bankruptcy attorney Marc Levinson, a partner with Orrick, Herrington & Sutcliffe, said that a battle with the pension fund giant could only happen, if at all, in bankruptcy court, saying during his closing, “let’s get it on.”

Another attorney for Stockton, Norman Hile, also a partner at Orrick, said during final arguments that CalPERS isn’t technically a creditor, but rather a trustee for the employees, saying an impairment to the pension system would hurt employees.

“The city has reduced its pension obligations where it legally could,” Hile said.

That could change in bankruptcy court.

Even U.S. bankruptcy Judge Christopher Klein seemed to nod to that fact. He made several comments when the topic of CalPERS was raised during the trial, including that the question of whether the pension obligations should or should not be part of a reorganization of the Stockton’s debts could happen if he granted relief. 

“I know that issue is down the stream, and we may end up going down the stream,” Klein said.

During the whole trial, an attorney from CalPERS sat on the sidelines and tried several times unsuccessfully to address the judge over characterizations of the system made during the hearing.

Stockton’s liability to CalPERS, which the city pegs at nearly $250 million, is expected to grow 94% over the next decade. The city said during the trial that it would have to pay around $1 billion to CalPERS if it pulled out of the system.

CalPERS also has a lien on all city assets and revenue, with the exception of payroll.

Stockton has already made cuts to its retiree medical plans as part of trying to rein in benefits that handed to city employees in previous years, one of several causes of its current financial problems.

The main arguments made by lawyers for bond insurers Assured Guaranty Corp. and National Public Finance Guarantee, investor Franklin Advisors, and trustee Wells Fargo N.A. is that Stockton never negotiated in “good faith” as defined in the federal bankruptcy code or met the definition of insolvency, meaning cash poor.

The city has countered that it is insolvent: it doesn’t have the cash to pay its bills, and that its laborious negotiations with creditors during the state directed Assembly Bill 506 mediation process proved it negotiated in good faith.

The bond firm attorney’s pointed to the fact that the city refused to seek haircuts from CalPERS as evidence of a lack of good faith, adding that those who created the city’s negotiating proposal enjoy CalPERS pensions.

The bond creditor lawyers also said the city’s “ask” presented during mediation negotiations would have had them take a $350 million hit, around 44% of concessions, despite the related debt service being only 7.5% of base line expenditures. That included permanently ceasing payments from the general fund toward $124 million in outstanding Assured Guaranty Corp. insured pension obligation bonds.

The city’s defaults on lease revenue bonds have already cost it control of parking garages and an office building.

Experts say that if, during bankruptcy, the city is able to force bond firms to take such haircuts to principal, it would be unprecedented.

The capital market lawyers also said the city could have reduced expenses and enhanced revenues — such as by asking voters to approve higher taxes — to solve its cash flow problems without jeopardizing public safety, which the city has put front and center as a reason to refrain from further cuts.

Klein is expected to rule on Stockton’s Chapter 9 bankruptcy eligibility Monday.

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