"There hasn't been a Chapter 9, as far as I'm aware, of this size at which these issues have been tried in front of a judge," said Robert Christmas, a financial restructuring and bankruptcy partner at Nixon Peabody LLP.

LOS ANGELES — If all goes according to plan, Stockton could receive approval of its plan of adjustment as soon as next week and begin its emergence from Chapter 9 bankruptcy.

But it still has to overcome the objections of one major bondholder and prove itself to the bankruptcy judge.

The second-largest city to file for Chapter 9 bankruptcy is gearing up for its four-day confirmation hearing, starting on Monday, during which time it will have to demonstrate to U.S. Bankruptcy Judge Christopher Klein that it has a recovery plan that will work.

Stockton, which filed for bankruptcy protection in June 2012 and received eligibility approval in April 2013, has reached agreements with most of its major creditors, including bond insurers Assured Guaranty and National Public Finance Guaranty.

However, the city will go into its hearing next week with one creditor, Franklin Advisers, Inc., still holding out.

Franklin, which under the city's plan would receive single payment of $94,000 for $35 million of Stockton Public Financing Authority lease revenue bonds issued in 2009, filed an objection to the plan in February. It argues that Stockton has not made a reasonable effort to provide a reasonable recovery and that the city discriminates against Franklin by treating other creditors more favorably.

"The city has made no meaningful response to those points," Franklin said in an emailed statement. "While our goal is to be a productive partner in the city's restructuring on equal footing with the city's other creditors, the meager recovery that the city is attempting to cram down through the plan leaves us with no choice but to object so that we can deliver a fair recovery for our investors."

Franklin's bonds were structured as a lease of a city park and two city golf courses that can't be redeveloped.

Their treatment in the city's plan contrasts with other bonds backed by leases on parking garages, an office building, and a sports arena, which received much higher recoveries.

The investment firm, which holds 100% of the 2009 lease revenue bonds in its Franklin High Yield Tax-Free Income Fund and California High Yield Municipal Fund, has raised a lot of issues that Stockton will have to address during the hearing, most notably the city's treatment of its pension obligations, which remain untouched under the plan.

The hearing should be interesting, as most of the issues that will be discussed haven't really been addressed by a bankruptcy judge, according to Marc Levinson, Stockton's bankruptcy attorney and a partner at Orrick, Herrington & Sutcliffe LLP.

"There really aren't confirmation decisions. The ones we do have were rendered in the 30s and 40s-a really long time ago," Levinson said. "Usually by the end, everyone made a deal. So we don't really have any recent, well-written decisions."

For example, he pointed to the relatively recent bankruptcies in Vallejo, Calif., Central Falls, R.I. and Orange County, Calif., which all had consensual confirmations.

Stockton will have just four days to get through these issues, but Levinson said it has been working with Franklin's counsel to come up with a time-efficient procedure to have an orderly trial.

The confirmation hearing had been scheduled for the beginning of April, but was pushed back a month because the city took longer to respond to discovery requests than anticipated.

"Where the judge is going to have to make a real decision, and there's not really a lot of guidance in case law about this, is whether the plan is fair and equitable and doesn't discriminate unfairly against those parties who have not settled," said Robert Christmas, a financial restructuring and bankruptcy partner at Nixon Peabody LLP. "There hasn't been a Chapter 9, as far as I'm aware, of this size at which these issues have been tried in front of a judge."

Franklin is arguing that the plan unfairly discriminates against its claim by classifying its bonds with a dissimilar retiree health benefit claim. In addition, it says the plan provides the retirees with a combined recovery of 70%, while proposing a ¼% recovery for Franklin.

Another issue — which is likely to take the spotlight next week — will be the city's treatment of its obligations to the California Public Employees' Retirement System.

"If pensions are somehow put into play, then I think this all of a sudden this gets very interesting for people," said Michael Sweet, a bankruptcy partner at Fox Rothschild LLP.

Franklin says the plan fails to provide it with a reasonable recovery because the city's refusal to confront its pension problem provides no justification for Franklin's "meager" proposed recovery.

"The city's willingness to pay tens of millions of dollars every single year for the next thirty or more years to satisfy the pre-petition pension claim completely undercuts its assertion that it cannot make any future payments in any amount to Franklin," the firm said in its objection.

In a response, Stockton said Franklin's criticisms of the city's pension projections are misplaced. The city said it has already taken steps to lessen its pension obligations and that its plan provides a path for the city to absorb short-term increases in its pension obligations while maintaining its feasibility.

It also argues that retirees bore their share of the pain with the elimination of their once-generous health benefits.

Stockton also said that impairment of its CalPERS obligations would not only result in a massive termination fee of $1.6 billion, but would also make it very difficult to attract or retain public workers going forward.

While a federal bankruptcy court can overrule labor contracts, CalPERS has said that it is an arm of the state and a sovereign function in which the federal government should not interfere.

"CalPERS' argument has never been tested in a bankruptcy court," Christmas said. "So whether or not CalPERS is effectively an arm of the state and gets a special position is not something that's been litigated or decided, so that's a completely open question in my view."

Judge Klein has indicated that he is prepared to rule on whether or not pensions can be impaired. He has in the past rejected a contract impairment argument, noting that the constitutional prohibition against contract impairment does not apply in the bankruptcy arena.

"The concern that I would think people are going to have is in five years are they going to be looking back saying we didn't solve the problem because we didn't address the pensions," Sweet said. "So it's a question of whether or not the analysis they've done is sufficient to satisfy that they're not going to be back in the same position a few years down the road."

In a recent report, Moody's Investors Service compared Stockton to Vallejo, which exited bankruptcy nearly three years ago and is still struggling with mounting pension obligations.

Moody's said that Vallejo, which has a persistent structural budgetary imbalance, triggering speculation about a second bankruptcy filing, could serve as a warning sign for Stockton if it, too, fails to modify its pension liabilities.

Judge Klein has said he has seen reports on Vallejo's budget problems and wants to be sure that if Stockton exits bankruptcy without addressing pensions, it would not face a second insolvency.

"The important thing is, you want a permanent fix, not a temporary fix," said James Spiotto, managing director of Chapman Strategic Advisors LLC. "If pension payments are not affordable and sustainable in the long run and you don't address them now, that obviously will be a problem later."

Levinson, who also represented Vallejo in its bankruptcy proceedings, said the comparison between the two cities is unfair and the bankruptcies are two very different cases.

"The press reports about Vallejo sinking because of its pension obligations are unfair and untrue because Vallejo is not in bankruptcy and has maintained that it doesn't intend to file a second bankruptcy case," Levinson said. "It's dealing with its budget issues."

What the city will have to do is show its pension obligations will not be a problem in the future and that it take care of them under the recovery plan, Spiotto said.

"The best interest to creditors is a long-term success and growing of the community so that there are more taxpayers and revenues," he said. "And it is not the best interest of creditors not to address systemic problems that exist today."

How these issues get resolved will play out next week in the U.S. Bankruptcy Court's Eastern District of California in Sacramento.

The judge has flexibility on when he gives his decision, so it could happen as soon as the fourth day of the hearing or after several days or even weeks.

During the eligibility hearing, Klein concluded the trial on a Thursday and asked the parties to come back for the ruling on a Monday.

"I would suspect that since there are a number of really interesting legal issues here that Judge Klein will not rule at the end of the trial, but may call as back the following week to announce a ruling," Levinson said.

If the plan is approved, as Levinson and the city believe it will be, then Stockton will implement its plan, adhering to its agreements, paying claims, and meeting all of the conditions under its plan, and officially emerge from bankruptcy.

If it's not approved, it's back to the drawing board for Stockton, which would have to modify its plan and go through the whole process again.

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.