“Paying the pension obligations doesn’t bode well for the other parties in the case,” said attorney Karol Denniston, partner at Squire Patton Boggs.

RIVERSIDE, Calif. — If San Bernardino doesn't radically change course before filing a bankruptcy plan of adjustment next May, its bondholders could bear the brunt of the financial pain from its Chapter 9 filing.

The city placed bondholders last in line, after its pension fund and employee unions, during a 12-month confidential mediation process. It signed an interim agreement with the California Public Employees' Retirement System in which it essentially agreed to make the pension fund whole.

Then earlier this month, a charter amendment measure to free the city from a process that automatically pegs police and fire wages to a median of similar-sized cities failed on Nov. 4, giving the city little leeway on employee compensation.

"The city has whacked away at liabilities until there is nothing left to whack," said Karol Denniston, a partner at San Francisco-based Squire Patton Boggs. "Paying the pension obligations doesn't bode well for the other parties in the case."

Denniston said a general Wall Street versus Main Street theme has emerged in municipal bankruptcies, with bondholders as the Wall Street bad guys and pensioners as Main Street good guys.

"That is the wrong way to look at it, because Wall Street built Main Street," Denniston said.

How cities treat the credit markets in their bankruptcies could determine the kind of reception they receive when they exit and want to fund their next infrastructure project, she said.

That is something San Bernardino officials will have to consider over the coming months, because U.S. Bankruptcy Judge Meredith Jury at a hearing Tuesday set a May 30 deadline for the city to file a plan of adjustment. If the city doesn't turn its back on its interim agreement with CalPERS there could be a "battle royale" over the confirmation plan, Denniston said.

Attorneys representing bondholders and insurers for $50 million in pension obligation bonds wanted an earlier deadline.

In courtroom arguments supporting a March deadline, Mark Angelov, an attorney for Ambac Assurance Co., said no feasible plan can be adopted with the CalPERS plan in effect and the city's inability to restructure city salaries.

"Filing a plan, sooner rather than later, we will be able to see if the city is willing to file a feasible plan," Angelov said.

The mediation has not been successful, according to Vincent J. Marriott, III, a partner with Ballard Spahr, who represents Erste Europäische Pfandbrief- und Kommunalkreditbank.

"The only participant an agreement has been struck with has been CalPERS - and that deal was really a surrender," Marriott said. "Mediation is not needed for a city to surrender."

The CalPERS agreement "was so generous that now the tail is wagging the dog as to the future health of the city," Marriott said.

The city strenuously disagrees with both of the pension bondholders' essential points, said Paul Glassman, the city's attorney, a partner with Stradling Yocca Carlson & Rauth.

Those points were that the city had not made progress in the case and that the city had not provided enough information on the term sheet that laid out the terms of negotiation, Glassman said.

"The city may not have made progress with the pension bondholders, but it has made progress with other creditors," Glassman said.

Jury, however, took the city to task for not providing a more detailed term sheet, which she hasn't seen because of the confidentiality restrictions in the mediation.

"What the city seems to miss is they never put out in detail how all the pieces would work together in the same way that Stockton did," Jury said. "That was what I was trying to direct by asking that there would be a term sheet before the mediation started."

The city began mediation with its creditors in November 2013.

Jury said she now wishes in hindsight that she had asked for a more comprehensive term sheet to provide a road map for the mediation talks.

"I don't know why it took nine months to agree to pay CalPERS in full," Jury said. "I can't tell you how surprised I am that the city put all of its balls in the charter amendment basket and hadn't considered any of the other things up until the election."

She added that that was never going to be enough, because its attorney's fees will exceed whatever they would have saved through the charter amendment.

In Stockton and Detroit, the judges both affirmed the theoretical ability to impair pensions in a municipal bankruptcy, but pensions were untouched in Stockton and only lightly impaired in Detroit, where many bonds took large haircuts.

Despite the rulings in those two cases, the discussion on whether pensions can be impaired in municipal bankruptcy is far from over, according to Michael Sweet, a bankruptcy attorney with Fox Rothschild.

Stockton chose to not go down that road, but Denniston said in that case U.S. Bankruptcy Judge Christopher Klein laid out a detailed road map as to how a city could chose to impair CalPERS, and why federal bankruptcy law would trump state law if it did.

"I don't think we are done by a long shot on the discussion as to whether pensions can be impaired," Denniston said.

Although San Bernardino is 28 months into its bankruptcy case, little progress has been made, according to Ron Oliner, an attorney for the San Bernardino Police Officers Association. The police union reached an agreement with the city, but it fell apart a few weeks later. No agreement has been reached with the San Bernardino City Firefighters Union.

San Bernardino received clearance from U.S. Bankruptcy Judge Gregg Zive, the mediator in the case, to release limited details about the interim agreement with CalPERS prior to the Nov. 18 hearing, according to Glassman, the city's attorney. The city and CalPERS agreed on a Sept. 1, 2015 deadline for a plan of adjustment, and that the plan will not impair the city's obligations to CalPERS, and the city will not reject the city's relationship with CalPERS, according to that filing.

It also provided that the city shall repay the deferred amount owed to CalPERS in full, with interest, in 24 equal installments beginning on July 1, 2014, and ending on the earlier of June 1, 2016 or a Chapter 9 plan effective date.

Michael Lubic, a partner with K&L Gates, who represented CalPERS in the hearing, said in an interview that the pension fund made concessions to the city, but he couldn't comment on the specifics until the city and judge agree to lift the gag order. Lubic said he would be amenable to the entire agreement being opened for public review.

Sweet said he found the idea that CalPERS would make any concessions surprising given its sabre-rattling and the strong positions the pension fund was taking in the early days of the Stockton bankruptcy filing in July 2012.

According to statements Klein put on the record during Stockton's final confirmation hearing, it's the retirees and employees who would actually be impaired rather than the pension fund, Denniston said. CalPERS testified during the Stockton bankruptcy that if there was a shortfall and the city were not able to make the payments, the pension fund is not legally obligated to make up the difference, she said.

"A key takeaway from Stockton is that unless there is a miracle or a grand bargain in San Bernardino - the discussion is not really CalPERS, but the retirees and employees," Denniston said.

In San Bernardino, there is also a question as to whether the city can craft a feasible plan without impairing the pension funds, she said.

"In the best interest of all the creditors, I think they need to take a look," Denniston said.

Denniston said she is certain Klein's statements, while not precedential, will be used by the capital markets creditors to say "it's not that you can't impair the pensions, it is that you are choosing not to, and that could impact confirmation."

According to Sweet, it behooves the city to meet the deadline set by Jury, because the only recourse she has in municipal bankruptcy would be to dismiss the case. In Chapter 11, the creditors can propose alternative plans of adjustments, but that isn't an option in municipal bankruptcy.

A problem in San Bernardino that wasn't a factor in the other two cities' bankruptcies was volatility, because of the change in leadership, Denniston said.

Shortly after the city entered bankruptcy, its finance director and assistant finance director left. The City Council faced a recall election. It has a new mayor, new city attorney and new finance director.

One thing California state government might want to consider, Denniston said, is emulating Michigan by setting up a situation where an emergency manager is appointed to handle any future bankruptcies, because it frees the process from politics, she said.

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.