"Because Judge Klein provided this road map, parties are going to be asking more questions and have different expectations regarding restructuring pensions the next time a California city has to restructure," said Karol Denniston, a partner at Squire Patton Boggs.

SAN FRANCISCO — Stockton, Calif.'s bankruptcy confirmation hearing came to a conclusion on Thursday, but the final ruling did not bring much clarity about the treatment of pension obligations in Chapter 9 bankruptcy.

While U.S. Bankruptcy Judge Christopher Klein during Stockton's Chapter 9 case gave his view that pension obligations can be impaired in California, Stockton did not present him with a request to impair pensions, and he did not go beyond Stockton's request.

"What we do have is the court's analysis that will give cities and their employees, retirees, taxpayers and creditors pause the next time it is necessary to restructure a city's obligations," said Karol Denniston, partner in the San Francisco office of Squire Patton Boggs.

"Stated another way, because Judge Klein provided this road map, parties are going to be asking more questions and have different expectations regarding restructuring pensions the next time a California city has to restructure," she said.

At the final confirmation hearing Thursday, Klein approved Stockton's bankruptcy exit plan, which did not impair payments to the California Public Employees Retirement System, despite an earlier ruling from Klein saying it would be legal for the city to do so.

In his analysis at the beginning of October, Klein said under federal bankruptcy law Stockton could reject its contract with CalPERS. He also said the $1.6 billion termination fee that CalPERS said it would charge to break the contract would be avoidable in bankruptcy.

The city's plan did not include impairing its contract with CalPERS, and remained unchanged after Klein's statements.

City officials have said they don't want to walk away from the CalPERS system because they would be at a disadvantage in competing for employees with other jurisdictions with CalPERS or other pensions.

"While Stockton chose not to challenge pensions, other cities may see things differently," analysts at Moody's Investors Service said in a report released Thursday.

The analysts said local governments will now have more negotiating leverage with labor unions, who cannot count on pensions as ironclad obligations, even in bankruptcy.

Actual Chapter 9 filings will remain rare, Moody's said. The process is difficult and expensive, and California's improved economic climate makes bankruptcy filings less likely.

Standard & Poor's also said in report Thursday that Stockton's experience with municipal bankruptcy is unlikely to cause other municipalities to view Chapter 9 as an attractive option.

"I expected Klein to 'moot' his Oct. 1 ruling, in the face of the reality of what rejecting the pension obligations really would mean," said Harvey Leiderman, a partner at Reed Smith.

"Oct. 1 was an academic exercise, [Thursday] was a reality check," he said. "I did not believe he was going to fail to approve the plan on the basis of some theoretical possibility that the city was not proposing."

Leiderman currently serves as fiduciary, investment and litigation counsel to public pension funds in California, including CalPERS.

Fox Rothschild bankruptcy attorney Michael Sweet, said he wasn't surprised by Klein's decision, giving the signals he'd been sending and the fact that the city made it clear that it didn't want to impair pensions.

He said that the city to watch is San Bernardino.

"They haven't put their plan out yet and they showed that, unlike Stockton, they were willing to explore the possibility of reducing the CalPERS payments," Sweet said. "It'll be interesting to see if San Bernardino considers impairing pensions as part of their plan."

Jeff Snyder, vice president at Cammack Retirement, said he wasn't surprised by the outcome either. Eventually, however, Stockton will have to deal with its pension issues.

"The plan does not really address the issues around the underfunded liabilities," Snyder said. "They don't provide a solution really to eliminate or reduce those liabilities long term, so perhaps it's just kicking the can down the road."

He noted that the city did get some concessions as part of its collective bargaining agreements, including on employee salaries and the elimination of most retiree health benefits, but still has long-term unfunded liabilities that need to be addressed.

For now, Stockton must deal with bouncing back from bankruptcy.

Leiderman said he is optimistic about the city's future, saying Stockton will emerge with lower employee costs per capita, a higher tax base, and less outstanding debt to pay.

"As far as access to capital markets, despite its questionable reputation, from an underwriting point of view Stockton is a pretty good credit risk today," he said. "Its house of debt and payroll obligations is now in better order than any time in the last decade."

Moody's said the judge's ruling is generally credit negative for investors in California lease-backed obligations, but positive for investors in enterprise system debt.

"The disparate treatment of pension obligations and investor-owned obligations means that pensions are likely to enjoy better treatment than debt in California Chapter 9 cases," Moody's said.

Investors in the city's enterprise water and sewer system debt continued to timely debt service payments and, under the plan, will receive full repayment of their principal.

Sweet said Stockton's future will come down to "intangibles."

"A piece of paper from a judge doesn't bring a city back," he said. "The question is, do people want to do business in Stockton, are people going to buy homes in Stockton, do people feel safe in Stockton, do they have a flight of public safety officers who go somewhere else?"

Franklin Advisors, Inc., the remaining creditor with objections to Stockton's plan after the others settled, has 14 days after the judge files his order to revisit anything in the case.

"Under the city's plan, Franklin would take a significant loss on $35 million of bonds it holds, which would have amounted to a recovery rate of only 1%.

Klein, however, said Thursday that after taking into account a $4 million payment from the city on a secured claim, the recovery rate would be closer to 12%."

Franklin had objected to receiving such a large haircut when CalPERS was untouched.

A spokesperson for Franklin said the firm is disappointed with the decision and is currently evaluating next steps.

Denniston said she expects that Franklin will appeal.

"Because Judge Klein was so careful to provide clearly stated findings of fact and conclusions of law, Franklin faces a difficult challenge in changing anything in the court's ruling," she said.

Moody's said such an appeal could take months or even years, and a successful appeal would only be marginally significant since Franklin's investment was a small part of the city's outstanding debt.

"Were Franklin to win an appeal, the city would not necessarily have to renegotiate with all of its other creditors," Moody's analysts said. "Instead, Stockton likely would have to negotiate a higher recovery level with just Franklin. For now, Franklin faces an uphill battle."

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