(Bloomberg News) The California Public Employees’ Retirement System is trying to rewrite the rules for bankrupt cities, claiming that it should get paid before almost everyone else, including bondholders.

The biggest U.S. public pension fund would set a legal precedent should courts adopt Calpers’s position that, as an arm of the state, it is exempt from rules that apply to other creditors in the Chapter 9 bankruptcy cases of San Bernardino and Stockton. A Calpers victory would threaten public services in a city trying to reorganize in bankruptcy, or in an extreme case, cause a city to disincorporate, attorney James E. Spiotto said in an interview.

“Chapter 9 was never intended to cause the liquidation of a municipality or the reduction of services,” said Spiotto, who isn’t involved in the San Bernardino and Stockton cases. “What Calpers is doing is threatening the basic tenet of Chapter 9.”

Pension costs for retired public employees are straining local governments from California to Rhode Island. In Southern California, San Bernardino says it is so strapped for cash it must put off $13 million in payments to Calpers or risk public safety. About 400 miles north, creditors of Stockton are fighting Calpers in court as well, arguing that the pension fund shouldn’t be given preferential treatment and urging the city to take an aggressive stance in negotiations.

San Bernardino will battle Calpers in a federal court in Riverside, California, on Dec. 21 over two related legal issues: whether Calpers can sue the city to force it to make about $7 million in missed payments and whether the city should be kicked out of bankruptcy.

Calpers blames elected officials for San Bernardino’s financial problems, saying in an e-mail that they made “irresponsible and short-sighted” decisions. Cutting back on what the city owes employees would make it hard to recruit qualified workers, Calpers spokesman Robert Glazier said.

“The city will be worse off if they choose not to fulfill their obligations,” Glazier, deputy executive director for external affairs, said an e-mailed response to questions. “We have a responsibility as fiduciaries to protect our members and the soundness of the retirement system just as our members were responsible in making their contributions, going to work and doing their jobs.”

In the private sector, when bankrupt corporations fall behind on such payments, the shortfall is considered an unsecured debt owed to the pension fund. Only part of the debt is given priority by bankruptcy courts, Spiotto said.

Administrative Claim
Calpers is arguing that all of its debt should be treated as an administrative claim, which means only a handful of creditors would be paid first, such as the lawyers and financial advisors working on the bankruptcy case, Spiotto said.

“What Calpers is trying to do is rewrite the priorities of the bankruptcy code,” Kenneth N.
Klee, who helped revise Chapter 9 of the U.S. Bankruptcy Code in the 1970s as a lawyer working for Congress, said in an interview. He isn’t involved in the California cases.