The city of Stockton, California declared bankruptcy a month ago and is in the process of sorting out its financial affairs. Now it has been hit with a fresh indignity in the form of a threatened lawsuit from Assured Guaranty, a company based in Bermuda which provides insurance against defaults on municipal bonds.

In 2007, Stockton borrowed $125 million in the bond market to pay for enhanced pension benefits and invested the money in its California Public Employees’ Retirement System (CalPERS) acount, where it lost about one-third of its value in the economic crash. Stockton still owes $124 million in payments on the bonds, but its bankruptcy plan calls for it to pay only $21 million.

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Assured Guaranty finds it unacceptable that Stockton is giving top priority to paying its own employees’ pensions. It calls this “a contortion of the bankruptcy process” and insists that it is unacceptable for the city to “prefer one class of similarly situated creditor over another.”

The “similarly situation” part is what’s in question, though. According to the general counsel of CalPERS, under California law “the obligations owed to the public workers of the city have priority over those of general unsecured creditors.”

When the city of Vallejo declared bankruptcy in 2008, for example, and officials considered scaling back pension obligatons, pressure from CalPERS forced them to back down.

The Sacramento Bee points out, however, that pension obligations are no longer as ironclad as they once were. In California, the cities of San Diego and San Jose have approved ballot initiatives — which are being challenged in unions — to scale back the promised benefits for current employees. Other states have reduced cost-of-living increases for retirees, and when Central Falls, Rhode Island declared bankruptcy last year, police and firefighters agreed to accept at 25% cut in their pensions.

Meanwhile, Assured Guaranty has been struggling with its own financial problems. Last December, S&P downgraded its credit rating, and in May it posted a first quarter loss on derivatives losses.

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There is thus reason to believe that the lawsuit is intended quite seriously — and there is a chance that it could lead to a revision of the laws involving bankruptcy and retirement plans.

Photo by Montyofarabia (Own work) [CC0], via Wikimedia Commons