SACRAMENTO (CBS/AP) -- The people of Stockton will feel financial fallout for years after a federal judge ruled Monday to let the city become the most populous in the nation to enter bankruptcy.
But the case is also being watched closely because it could answer the significant question of who gets paid first by financially strapped cities—retirement funds or creditors.
"I don't know whether spiked pensions can be reeled back in," U.S. Bankruptcy Judge Christopher Klein said while making the ruling. "There are very complex and difficult questions of law that I can see out there on the horizon."
The potential constitutional question in the Stockton case is whether federal bankruptcy law trumps a California law that says money owed to the state pension fund must be paid.
In making his ruling, Klein disagreed with creditors who argued that Stockton failed to pursue all avenues for straightening out its financial affairs.
"It's apparent to me the city would not be able to perform its obligations to its citizens on fundamental public safety as well as other basic government services without the ability to have the muscle of the contract-impairing power of federal bankruptcy law," Klein said.
A statement released by creditors said the group "respectfully disagrees with the court's ruling." The legal team for those creditors declined to say whether it would ask Klein for permission to appeal his decision—a requirement of bankruptcy code.
Stockton has tried to restructure some debt by slashing employment, renegotiating labor contracts, and cutting health benefits for workers. Library and recreation funding have been halved, and the scaled-down Police Department only responds to emergencies in progress. The city crime rate is among the highest in the nation.
Since cities can't liquidate assets, those that declare bankruptcy must come up with a plan for creditors to forgive some of the debt.
Holders of the biggest portion of Stockton's debt insured $165 million in bonds the city issued in 2007 to keep up with payments to the California Public Employees Retirement System as property taxes plummeted during the recession.
Stockton now owes CalPERS about $900 million to cover pension promises, far the city's largest financial obligation. Many struggling cities across California are in the same situation.
So far, Stockton has kept up with pension payments while reneging on other debts, maintaining it needs a strong pension plan to retain its pared-down workforce.
Attorneys for creditors argued that it was unfair for their clients to accept reduced payments while the pensions negotiated in flush times went untouched. They argued that employees who shared the wealth during good times should bow have to endure some of the pain with cuts to their pensions.
Legal observers expect the creditors to aggressively challenge the repayment plan presented by Stockton in the next phase of the process.
"That's where it will be precedent-setting," said Karol Denniston, a municipal restructuring expert who monitored the trial. "Does bankruptcy code apply to CalPERS or not? If bankruptcy code trumps state law, then that's huge and it has huge implications in terms of what happens next for other municipalities across California."
The state pension plan manages $255 billion in assets but was underfunded by $87 billion in 2011, the last time calculations were made. CalPERS is in the process of setting new rates to close the liability, said spokeswoman Amy Norris.
The changes could further strain at least two dozen other financially strapped cities, including San Bernardino, San Jose, Compton, Fairfield, Watsonville, Atwater.
"Just about everybody has an unfunded liability," Norris said.
Legal observers of the first-ever Chapter 9 bankruptcy case questioning state pension obligations expect an appeal to decide whether the 10th Amendment that gives rights to states is more powerful than federal bankruptcy code
Even Judge Klein, who was inclined at first to approve bankruptcy without a trial, said he was going forward with the hearing that ended Monday to create an appellate record.
Now the city of nearly 300,000 people begins a months-long process of negotiations over debt repayment. Already Stockton has spent $2 million on mediation and up to $5 million on the eligibility case, said Bob Deis, Stockton's city manager.
"There's nothing to celebrate about bankruptcy," he said. "But it is a vindication of what we've been saying for nine months."
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