When U.S. Bankruptcy Judge Christopher Klein confirmed the city of Stockton's plan of adjustment in February, most of the city's creditors expressed relief. The largest group, Stockton's employees and retirees, had conceded their lifetime health benefits - worth hundreds of millions of dollars - during Chapter 9 negotiations in return for the city honoring $412 million of unfunded pension obligations. (In re City of Stockton, 526 B.R. 35 (Bankr. E.D. Cal. 2015).) But two funds managed by Franklin Templeton Investments objected. Stockton had defaulted on a $35 million bond obligation to the Franklin California High Yield Municipal Fund and the Franklin High Yield Tax-Free Income Fund, $30.5 million of which was unsecured bonds for capital improvements. Franklin contended that it lost about $32 million, which it said in court filings was unfair and discriminatory when the city had not even requested pension cuts. Just one month after Klein announced he would confirm the city's plan, Franklin appealed to the Ninth Circuit's Bankruptcy Appellate Panel, which has not yet scheduled argument. (In re City of Stockton (Franklin High Yield Tax-Free Income Fund v. City of Stockton, No. EC-14-1550 (B.A.P. 9th Cir. notice of appeal filed Nov. 12, 2014)).) Franklin and others in the bond industry were dismayed that although Klein had ruled Stockton's contract with the California Public Employees' Retirement System (CalPERS) can be impaired in bankruptcy, he failed to rule that the city must adjust that contract. CalPERS, Stockton's pension administrator, came away unscathed when Klein confirmed a plan that left pension obligations intact. CalPERS also handles pensions for Vallejo and San Bernardino, which are in separate bankruptcy proceedings. In all three cities, lawyers representing CalPERS had effectively engaged in a two-front war: In court they argued that pension contracts are inviolable under the state Constitution, while during mediation they negotiated deals that ultimately persuaded judges to leave pension obligations alone. Following a Stockton confirmation hearing in October, CalPERS wasn't exactly gracious about its impending victory. Responding to a Sacramento Bee editorial, CalPERS CEO Anne Stausboll wrote, "Contrary to the belief of many pension critics, CalPERS is no Goliath. Franklin Templeton Investments - the last bondholder standing in the way of the city of Stockton's plan to rebuild - is no David." Franklin, she continued, "is a sophisticated Wall Street investor that did its due diligence, analyzed the risks, and decided to make a $36 million investment in Stockton. As it turns out, the investment did not pay off. That's how the investment world works. Franklin needs to move on." But Franklin didn't move on, and now the legal issues in Stockton could be determined by an appellate panel, with consequences for every municipal government within the Ninth Circuit's jurisdiction. Judge Klein's order in February had made clear that the U.S. Constitution and federal bankruptcy law (11 U.S.C. § 545) gave him the power to impair public pensions. "[I]t is doubtful that CalPERS even has standing to defend the city pensions from modification," Klein wrote. "CalPERS has bullied its way about in this case with an iron fist insisting that it and the municipal pensions it services are inviolable. The bully may have an iron fist, but it also turns out to have a glass jaw." (In re City of Stockton, 526 B.R. at 39.) Klein first ruled that state law forbidding rejection of a CalPERS contract in Chapter 9 bankruptcies is "constitutionally infirm" under the Supremacy Clause (U.S. Const., Art. I, § 8). Second, the judge held that the $1.6 billion lien granted to CalPERS by state statute in the event its pension administration contract with Stockton is terminated is vulnerable to avoidance in bankruptcy. And third, Klein ruled that California's judge-made "vested rights doctrine" does not preclude contract rejection or modification in bankruptcy. But Klein declined to force the issue. Instead, he approved the city's plan to eliminate $2 billion in public debt by cutting out unfunded employee-health benefits, raising sales taxes, and reducing payments to bondholders. "This plan has huge implications for the financial market players in the bond community," says Michael A. Sweet, a bankruptcy partner at Fox Rothschild in San Francisco. "The bond guys were the only ones hanging out there who were impaired. They are thinking about the precedent." Lack of recent authority may be key to Franklin's appeal. Its lawyers are relying on a 75-year-old Supreme Court case that calls for "equality of treatment of creditors." (American United Mut. Life Ins. Co. v. City of Avon Park, 311 U.S. 138, 147 (1940). Stockton "defied that bedrock principle," Franklin argued in its opening brief, "through a plan of adjustment that reinstated $412 million of unfunded pensions, delivered recoveries between 52% and 100% to creditors holding half a billion dollars in other claims, but discharged Franklin's $30.5 million unsecured claim in a single payment of less than 1% - far less than any other material stakeholder. No bondholder has ever received so little in the history of municipal bankruptcy." Franklin asked the panel to set aside Stockton's plan of adjustment and return the case so Klein can give "fair, reasonable and nondiscriminatory treatment to Franklin's unsecured claim." Central to Franklin's appeal is securing designation as a separate, nonaccepting class. It accused Stockton of "gerrymandering" the creditor classes so that Franklin would be lumped together with pensionholders, who overwhelmingly supported keeping their pensions intact: Some 1,100 retiree votes to approve the plan swamped Franklin's dissent. Franklin's attorneys cried foul, claiming that the city "neutered Franklin's 'no' vote" by classifying retiree pension claims separately from retiree health-benefit claims. "Each retiree's claim for retirement benefits is a single claim that cannot be split into two in order to assist the city's gerrymandered classification scheme," wrote James O. Johnston of Jones Day in Los Angeles. "This plainly violates the 'same treatment' requirement of section 1123(a)(4)." As authority in his pleading, Johnston relied on two precedents from the 1940s. In the first, the U.S. Supreme Court held that "minorities under the various reorganization sections of the Bankruptcy Act cannot be deprived of the benefits of the statute by reason of a waiver, acquiescence or approval by the other members of the class." (Kelley v. Everglades Drainage Dist., 319 U.S. 415, 419 (1943).) In the second, the Ninth Circuit reversed a confirmed plan after finding it was not in the "best interests" of the creditors - despite acceptance by 90 percent of the bondholders. (Fano v. Newport Heights Irrigation Dist., 114 F.2d 563 (9th Cir. 1940).) Johnston insists that Franklin isn't targeting employee pensions for impairment, but simply wants equality of treatment among all creditors. "If Stockton serves as precedent to allow debtors to pick and choose the level of recovery among creditors," he said in an interview, "that is a bad result." Marc A. Levinson, Stockton's lead bankruptcy attorney at Orrick, Herrington & Sutcliffe in Sacramento, says he finds it hard to believe the two sides attended the same trial. Regarding the classification claim, Levinson comments, "This is not a rocket-science issue - Judge Klein deals with it every day in Chapter 11 plans. It wasn't gerrymandering." In papers filed earlier with Klein, Levinson pointed out that debtors have considerable discretion to classify claims under 11 U.S.C. section 1122. "One of the great challenges of doing this case is that there were no recent Chapter 9 precedents in the Ninth Circuit, or anywhere," Levinson says. "In the 1930s and 1940s there were a lot of key cases involving a series of bonds with a total value of $80,000. The question for the court is how those cases compare to the situations today in Stockton, Detroit, or San Bernardino." In the city's answering brief, Levinson asserted, "Franklin failed to adduce a shred of evidence suggesting that the City classified creditors as it did for the purpose of rigging the vote." He continued, "Franklin's complaint that other creditors fared better through negotiation and that it fared worse by abandoning negotiations does not show bad faith. It shows why parties negotiate in the first place." As to fairness, Levinson says Franklin will recover about 17.5 percent of its $35 million in bonds - far more than the 1 percent it asserts in court filings. Franklin, he says, fails to acknowledge that the city had no choice but to satisfy its pension obligations. "The City could not 'trim' its pension obligations and remain in CalPERS - it faced an all-or-nothing choice," Levinson wrote in his May briefing. "Termination would immediately give rise to an "unfunded termination liability" of $1.6 billion." If unpaid, he contended, the massive liability "would result in a 60 percent pro rata cut to existing pensions of both retired and current employees." The options of either self-funding pensions or joining the Social Security system, Levinson argues, aren't realistic if the city wants to retain its employees. Stockton he says simply refused to play chicken with its workforce. Steven H. Felderstein, managing partner of Felderstein Fitzgerald Willoughby & Pascuzzi in Sacramento, is the attorney for the official committee of retirees in Stockton's bankruptcy. He points out, "CalPERS benefits are portable to other cities that are members of CalPERS. So why would the best employees stay in Stockton if they can go down the road and get pensions elsewhere? CalPERS is the market standard." Still, retirees paid a steep price, losing the future value of health benefits that they and their families had been promised - estimated at $550 million-in return for a one-time payment of $5.1 million. "While Franklin bemoans its treatment, it ignores the fact that almost all of the approximately 1,100 retiree health benefit claimants ... voted to give up lifetime health benefits," Levinson pointed out to Judge Klein. "This is a real and meaningful sacrifice to allow confirmation of a feasible plan." However, worker and retiree pensions in Stockton may not be safe just yet. Klein's ruling that he has the legal authority to cut pension benefits - even though Stockton chose not to ask him to - has attracted the attention of the capital markets because it could provide a road map for other cities to impair pension obligations. Karol K. Denniston, a partner in the public finance practice at Squire Patton Boggs in San Francisco, says, "Franklin is doing the market a huge service by raising painful questions about how bondholders are treated when they are lined up against pensioners." With corporate bankruptcies, she says, everyone gets tough love, but similarly situated creditors get similar treatment. "There is a developing perception that pensionholders receive better returns than bondholders. That may be better on an emotional level, but technically they are both unsecured claimholders." If bondholders lose out, she adds, it will be more difficult for cities to get bonds, and the cost of the unsecured bonds they do get will go up. But those who are watching to see if Franklin will win a precedent from the bankruptcy appellate panel may be disappointed, Denniston suggests. Much of Stockton's reorganization plan, in place since October 2014, has been implemented, she notes. That raises the question of "equitable mootness" - a doctrine developed by the appellate courts that provides for dismissal of appeals from consummated plans if it would be inequitable to grant relief. In Stockton's case, Denniston says, the city might be able to shield itself from all or part of Franklin's appeal with a showing that the confirmed plan is substantially underway. Attorney Sweet of Fox Rothschild declined to predict how far appeals in Stockton might go, or the case's final outcome. But given that "the law was not in favor of pensions going into this," Sweet gives CalPERS credit for "very craftily" handling the situation. "CalPERS, one might say, has really pulled a rabbit out of a hat here." Pamela A. MacLean is a contributing writer at California Lawyer.