Federal Judge: Broke California Cities Can Slice Pensions

A federal judge rebuked the 'bully' CalPERS in the case of Stockton's bankruptcy.

"If you have the facts on your side, pound the facts," goes the old legal adage. "If you have the law on your side, pound the law. If you have neither on your side, pound the table." A newly published federal court decision found the California Public Employees' Retirement System was merely banging the legal table with its "iron fist" in the Stockton bankruptcy case.

Judge Christopher Klein rejected the pension fund's argument that California cities could not reduce pension benefits even in bankruptcy. The decision could dramatically change the way pensions are handled in future bankruptcy proceedings, even though the judge upheld the city's workout plan, which leaves existing pensions untouched while "impairing" creditors.

The judge was clear: When California cities go bankrupt, pensions can be cut. After Klein made that point in his verbal ruling in October,CalPERS shot back in a statement: "The ruling is not legally binding on any of the parties … or as precedent in any other bankruptcy proceeding …." Now it seems legally binding and precedential.

The rest of the ruling elaborates on that simple point, but Klein's dressing down of CalPERS makes for entertaining reading – and might keep it in its place when other cities face pension-driven fiscal ruin. It's been widely reported that when Vallejo and San Bernardino went into bankruptcy, city officials agreed not to reduce pension benefits out of fear of facing CalPERS' legal fist and bottomless bank account.

According to Klein, it is doubtful CalPERS, which administers municipal pension plans but doesn't guarantee any payouts, even has the authority to get involved in these proceedings. As the judge noted, CalPERS doesn't face much risk of loss in a bankruptcy. The agreement is between Stockton taxpayers and current and future retirees.

"Although … it is doubtful that CalPERS even has standing to defend the city pensions from modification, CalPERS has bullied its way about in this case with an iron fist insisting that it and the municipal pensions it services are inviolable," Klein explained. "The bully may have an iron fist, but it also turns out to have a glass jaw." The judge termed as "constitutionally infirm" CalPERS' argument that California law trumps the federal bankruptcy code.

CalPERS largely is governed by public employees, retirees, union members, and union-allied politicians — so it has taken a lead role in protecting pensions at any cost, even if it means higher costs to taxpayers and reduced quality of municipal services.

The most fascinating part of the ruling details one specific way CalPERS bullied Stockton officials. For instance, municipalities can switch to another administrator (or create their own system), but CalPERS makes it difficult for anyone to leave. The judge found it "has a policy of, by overt and passive aggression, resisting attempts to make such shifts."

The pension fund maintains a termination pool. When, say, a special district shuts down, CalPERS shifts its accumulated contributions to an investment fund with a much lower yield than the general fund — around 3 percent, rather than its typical 7.5 percent expected rate of return. In public pension funds the size of the unfunded liabilities, or debt to pay pension promises, is determined by the predicted rate of return. Higher returns obviously mean lower debt.

When Stockton went into bankruptcy and mulled cutting its pension obligations, CalPERS threatened to place the city in that termination pool — something the judge called a "poison pill" that would have increased the city's debt by $1.6 billion. Yes, that's billion. Instead of working with Stockton on a plan to help it reduce benefits and stay solvent, CalPERS threatened it with a massive debt.

This was the ultimate pounding of tables, given that the pension fund's legal arguments were so weak. "The judge confirmed that CalPERS' view of the bankruptcy code was uniquely held by CalPERS," said Dan Pellissier, president of California Pension Reform in Sacramento. "CalPERS and the unions were the only ones holding that pension debts are different. And it's not a big surprise that federal bankruptcy law trumps state law. Any first-year law student would know that."

Stockton went into the bankruptcy facing down CalPERS' "iron fist." But now that Klein put his ruling on paper, other cities know about the pension fund's "glass jaw." It will be a different legal game if other California cities go belly up.