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Stockton, California bankruptcy eligibility trial begins

Shuttered and padlocked businesses line Main Street in Stockton, California in this June 27, 2012 file photo. REUTERS/Kevin Bartram/files
Shuttered and padlocked businesses line Main Street in Stockton, California in this June 27, 2012 file photo. REUTERS/Kevin Bartram/files

By Jim Christie

SACRAMENTO, California (Reuters) - Lawyers for Stockton and its creditors kicked off a courtroom battle on Monday over whether the California city is eligible for bankruptcy protection to force its bondholders to swallow losses while leaving pensions intact.

The closely-watched case has broad implications for other local governments seeking protection in bankruptcy court from creditors and for struggling municipalities that may pursue a similar path.

The outcome in the case of Stockton, the biggest city to declare bankruptcy, also is an important test case for the $3.7 trillion municipal debt market, which provides financing for various public capital projects, from school construction to sidewalk repairs.

Unlike in corporate bankruptcies when all debt holders absorb some losses, bondholders in major municipal bankruptcies consistently have been repaid all of their principal since at least the 1930s.

Now Stockton and at least two others municipalities are challenging that premise: Jefferson County in Alabama and San Bernardino, California, also expect to ask bondholders to take losses in their bankruptcies.

The Stockton hearing is expected to last most of this week.

Bondholders and insurers, which will have to repay investors for any capital losses, argue the decision by Stockton to keep paying its largest creditor, the California Public Employees' Retirement System, shows a lack of good faith and should block Stockton's request for bankruptcy protection under federal bankruptcy law.

Stockton pays a yearly contribution of about $30 million to the $254 billion retirement system. The largest U.S. pension fund, known as Calpers, manages pension accounts for the city's employees and retired employees.

"The city ignores the 800-pound pension gorilla in the room," Guy Neal, one of the lawyers for the capital markets creditors, said in his opening remarks.

Bond insurers contesting Stockton's eligibility for bankruptcy protection have more than $300 million of exposure to the city's debt. Assured Guaranty Corp, Assured Guaranty Municipal Corp and National Public Finance Guarantee Corp were joined by Wells Fargo Bank, the Franklin California High Yield Municipal Fund and Franklin High Yield Tax-Free Income Fund.

Marc Levinson, a lawyer for Stockton, defended the city's right to go bankrupt. He argued Stockton had attempted to negotiate in good faith with its creditors as required by California law before demanding protection from creditors.

The city of 300,000 in California's Central Valley, which filed for bankruptcy last year, fell on hard times when its revenue plunged after its once-torrid housing market went bust. Two decades of generous employee benefits, poor fiscal management and too much debt also caught up with the city, which is 85 miles east of San Francisco.

Stockton's general fund-supported payroll has dropped to 972 positions from 1,360 in 2008-2009. The city has about 2,400 retirees, 1,100 of them affected by the city scrapping its retiree medical program. Savings from shedding retiree medical spending is helping bolster Stockton's finances while it presses its bankruptcy case, city manager Bob Deis said.

"These guys aren't giving us credit for that," Deis told Reuters after his testimony at the hearing.

Deis defended Stockton's pension contributions, saying they are "inextricably" tied to the crime-plagued city's ability to retain and recruit police officers.

Stockton's budget provides for 340 sworn police officers, compared with 401 in 2008-2009. If Stockton had done differently impairing its pensions after wiping out its retiree medical program police officers would have simply quitted.

"If it appears we'll impair retirement benefits, we'll have a mass exodus of police officers," Deis said.

By contrast, San Bernardino, which also filed for bankruptcy protection last year, is not making contributions to the state's pension fund as it contends with its financial troubles.

In other municipal bankruptcy cases, bondholders have been protected.

Central Falls, a tiny, poor Rhode Island city, had its bankruptcy plan approved by a judge in September. It slashed retirees pension payments in half and raised taxes, but left bondholders unscathed.

A Rhode Island law, passed as Central Falls' insolvency reached a crisis point, gave bondholders a lien on property tax revenue.

The Central Falls case, along with sweeping public pension changes at the state level, prompted labor unions and retirees in other struggling Rhode Island cities - including Providence, the state capital - to renegotiate retirement benefits and collective bargaining agreements.

Though Central Falls has exited bankruptcy, its case will remain open for several years so the court can step in if elected officials veer from the restructuring plan. Officials must give quarterly statements about the city's finances.

Because of the Central Falls case, "I don't think we're ever going to need a Chapter 9 again" in Rhode Island, said Theodore Orson at a distressed municipalities conference this month in Providence. Orson was the attorney for the state-appointed receiver who oversaw Central Falls' return from insolvency.

(Reporting by Jim Christie; Additional reporting by Michael Connor in Miami and Hilary Russ in New York; Editing by Tiziana Barghini, Mary Milliken and Chizu Nomiyama)

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