SACRAMENTO – A Federal bankruptcy judge ruled Monday that Stockton, Calif. is eligible for Chapter 9 protection, rejecting the objections of bond market creditors.

U.S. bankruptcy Judge Christopher Klein said the city met all of the requirements of the Federal code to enter bankruptcy, cutting down the main arguments the so-called capital market creditors made during a three-day trial, which included that Stockton did not negotiate in good faith or wasn’t insolvent when it filed its petition.

“It makes no sense to think the city is playing some kind of game to target the capital market creditors,” Klein said during his more than hour-long ruling. “I reject that the city artificially crafted this situation.”

The next phase of bankruptcy process will be for the city to come up with a plan to reorganize its debts that will need to be confirmed by Judge Klein.

Stockton, a city in California’s Central Valley with a population of more than 300,000, filed for bankruptcy at the end of June. It is one of the largest municipalities, measured by outstanding debt and population, to file bankruptcy protection.

The consortium of creditors is made up of bond insurers Assured Guaranty Corp. and National Public Finance Guarantee, investor Franklin Advisors, and trustee Wells Fargo N.A.

The judge said he did not think the city “budgeted itself into this situation,” noting that if the city hadn’t defaulted on some of its debt, it wouldn’t have been able to meet its other debt service obligations.

Klein said he found the testimony of city employees credible during trial, including City Manager Bob Deis.

Deis said during a press conference after the ruling that nobody in the city was celebrating bankruptcy but there was a sense of validation.

The city manager said the bond firms “scorched-earth litigation strategy” fighting eligibility cost the city between $4 million and $5 million and time when they should have been working on their plan for adjusting its debts.

If negotiations went well, Deis said the city could exit bankruptcy protection in three to five months, adding he looked forward to negotiations with the bond creditors.

Assured Guaranty Corp., which is an insurer of a large amount of the debt of which the city had proposed to slash principal payments on, said it “respectfully” disagreed with the ruling.

The insurer said it “believes that the city’s current ask falls short of the fairness requirements mandated by Chapter 9,” reiterating what the judge said during his ruling that eligibility is very much a preliminary round.

The so-called ask proposed during pre-bankruptcy negotiations would have had bond firms take a $350 million hit in interest and principal, including permanently ceasing payments from the general fund toward $124 million in outstanding Assured insured pension obligation bonds.

Bond market experts have said, if during bankruptcy, the city is able to force bond firms to take a haircut to principal, it would be unprecedented.

National Public Finance Guarantee, another insurer with large exposer to the city’s debts, said the judge clearly indicated that the city will have a hard time confirming its plan of adjustment that discriminates against some creditors.

“Stockton’s significant fiscal problems can only be resolved when CalPERS works cooperatively with other interested parties to put the city on a path toward long-term financial stability,” Kevin Brown, a spokesman for National, said in an emailed statement.

Klein said the fact that the city did not try to impair the California Public Employees’ Retirement System, the largest pension fund in the country, did not show it didn’t negotiate in good faith.

The bond market creditors said during the trial that Stockton decided not to ask for concessions from the California Public Employees’ Retirement System, which has been listed as its largest creditor in court documents, and instead put the burden on bond investors and their guarantors.

“It is no secret that the capital market creditors have CalPERS in their cross hairs,” Klein said, adding that it is difficult to confirm a plan of adjustment during bankruptcy that discriminates against certain creditors, which was alleged by bond firms during the initial mediation process. They see CalPERS as the city’s largest creditor.  

CalPERS said in a press release that it was pleased with the ruling, saying it would continue to “protect and defend the integrity and soundness of the pension plan.”

“The day of reckoning will be the day of plan confirmation,” Klein said.

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