By Jim Christie
SAN FRANCISCO (Reuters) - When Stockton, California, filed for bankruptcy last year, the stage was set for a precedent-setting battle with Wall Street over whether bondholders or retired public employees should pay the price when a local government goes broke.
But under the terms of recent settlements, bond insurers who are backing about $240 million in city debt will accept a "haircut" of as much as 50 percent on some bonds. Retirees will keep their full pensions, though 1,100 of them will lose their retiree health insurance.
On Tuesday, Stockton voters are likely to approve a sales tax increase that could all but seal a surprisingly speedy end to the city's bankruptcy case. With that, the much-anticipated showdown over pensions will move to Detroit or another city seeking court protection from creditors.
Massive cuts to Stockton's budget will remain. The sales tax increase will raise about $300 million over 10 years and likely enable the city to emerge from bankruptcy early next year.
"We got reform. We just got it a different way than everybody wanted," said City Manager Bob Deis, who recently retired and is credited with driving a tough but well-organized bankruptcy process.
He said polls showed 60 percent of voters supported the tax hike, which would raise Stockton's sales tax to 9 percent from 8.25 percent, which includes the state sales tax of 7.5 percent.
For troubled municipalities and their lenders, the lessons from Stockton are mixed.
From one perspective, the case suggests trying to force a showdown on pensions may not be a good strategy for Wall Street. Legal experts say Stockton's biggest bond insurers, Assured Guaranty and National Public Finance Guarantee, overplayed their hand by demanding that pensions be on the table before they would even negotiate.
Further, Stockton was reluctant to test a provision of the state constitution that its pension fund, the California Public Employees' Retirement System (Calpers), argues protects pension payments even in the event of a bankruptcy. Instead, retirees were asked to share the pain by losing their health insurance, a step the city could take without a protracted legal battle and one that slashed its long-term liabilities by $500 million.
"When you're in the middle of a restructuring, you tend to move to things that have clarity," said Karol Denniston, a San Francisco lawyer who helped write the California law guiding municipal bankruptcies.
Yet the question of whether pensions can be cut in the face of a municipal fiscal crisis is not likely to go away.
In Detroit's bankruptcy case, a similar battle is brewing over whether state law protecting pensions can be trumped in federal bankruptcy court. Given that city's massive pension liabilities, it is not clear that a Stockton-style solution would be possible.
In San Bernardino, California's bankruptcy, the city stopped making its bi-monthly payments to Calpers for a full year and is now $17 million behind on its current obligations. Calpers is fighting the city's bankruptcy tactics on every legal front.
In the meantime, the city of San Jose, California, is fighting a lawsuit over its move to alter how current employees earn pension benefits. San Jose Mayor Chuck Reed is spear-heading a state-wide ballot initiative to clear any legal roadblocks to such efforts.
NOT FOR 'SETTING THE TABLE'
Stockton filed its petition for bankruptcy protection last year after drastic cutbacks - including furloughs, pay cuts and a 40 percent reduction in its payroll - failed to keep its budget in balance. The city was reeling from a plunge in tax revenues caused by the recession and the implosion of a once-hot housing market, on top of ill-conceived spending on projects such as a downtown sports arena.
Deis, who arrived in 2010 after working as the administrator of Sonoma County, California, led the restructuring effort. Even after all the belt-tightening, Deis in early 2012 took more drastic actions, including defaulting on some debt and launching talks with creditors in hopes of staving off bankruptcy.
Negotiations failed, and on June 28, 2012 Stockton filed for bankruptcy -- the biggest U.S. city to do so until Detroit took away that dubious crown earlier this year.
Reflecting the concern that Stockton could set a precedent with broad implications for the municipal debt market, Stockton's bond insurers, Assured Guaranty and National Public Finance Guarantee, aggressively challenged the city's eligibility for bankruptcy. They insisted the city could simply cut services further - a position that led Deis to accuse them of advocating "anarchy in the streets," since police are the main cost in the crime-plagued city.
The attack on Stockton's eligibility backfired.
U.S. Bankruptcy Judge Christopher Klein had at one point suggested that it would be hard to resolve the case without pensions being part of the discussion. In his ruling in June affirming Stockton's eligibility, however, he hammered Assured and National on several fronts.
Klein said the bond insurers had not bargained in good faith by assuming a "we-have-nothing-to-talk-about position" when the city indicated it would not go after pension payments.
He also detailed Stockton's successful talks with other creditors and the painful measures, including dumping retiree health insurance, that it had agreed to take. He also noted that the city's deals with employees would indirectly reduce its pension obligations over the long run.
Any complaints about pensions would need to be raised later, in proceedings over the confirmation of the final plan to exit bankruptcy, Klein added.
The stinging loss gave the creditors an incentive to negotiate with Stockton, said David Mastagni, a Sacramento lawyer for Stockton's police officers who over the past year has struck deals with the city on officers' pay and pensions.
The creditors relied on "political theater," Mastagni said. "That's why the decision was so harsh."
Klein's decision marked an important lesson about Chapter 9 proceedings, said municipal bankruptcy expert Denniston: "The eligibility process is meant just for eligibility, not setting the table for other issues."
HEADING FOR THE EXIT
Tuesday's vote is the last key piece of Deis' plan for exiting bankruptcy. If voters balk, Stockton will have to close libraries, recreation centers and fire houses - and reopen talks with its creditors.
Even with new revenue, the city will need to keep a lid on most spending, though the measure specifically includes funding to hire more than 100 additional police officers.
A formal exit from bankruptcy does not mean the city's fiscal troubles are over. In Vallejo, a San Francisco Bay Area city that filed for bankruptcy in 2008 and pursued a restructuring similar to Stockton's, the budget is again out of balance just two years after the city emerged from Chapter 9.
Stockton is counting on a housing recovery and continued improvement in the economy to make it all work.
"Until we do get a full recovery, a lot of cities are going to be grasping at straws and gasping," said Steven Frates, research director at Pepperdine University's School of Public Policy.
For Stockton's residents, glimmers of hope are mixed with weary resignation.
Jodi Anderson, a 47-year-old retired police dispatcher, said she would vote for Stockton's tax hike even though she has already involuntarily helped the city's restructuring.
"The city won't get out of bankruptcy without it ... I don't want to start from scratch again," she said. Anderson has gone without health insurance for more than a year, along with her husband Mark, a 54-year-old retired police officer.
Both believed their medical coverage would be rock-solid despite the city's weakening finances.
"We knew there were drastic things on the horizon but we didn't envision bankruptcy," Anderson said.
(Editing by Jonathan Weber and Dan Grebler)