Setting the stage for a groundbreaking confrontation between Wall Street and retirees, a federal judge ruled Monday that the city of Stockton was, indeed, eligible for bankruptcy protection from its creditors.

Judge Christopher Klein found the creditors’ arguments for keeping the city out of bankruptcy as deficient as their behavior during negotiations leading up to his decision. The bondholders and insurers wanted Stockton to raise taxes, curtail city services, sell municipal property and reneg on its obligations to the California Public Employees’ Retirement System (CalPERS) before asking them to take a haircut on $900 million in debt.

In their zealous opposition to last June’s bankruptcy filing, the creditors refused to participate in a months-long negotiating period, drawing an admonishment from the judge who twice referred to them as acting in bad faith. The city was stuck with the entire tab for the mediation after the creditors dropped out, complaining that they wouldn’t negotiate while CalPERS was still being funded.

Judge Klein didn’t see it that way. “I’m sorry,” he told the creditors. “I’m not persuaded. Negotiation is a two-way street. You can’t negotiate with a stone wall. You cannot do it. It cannot be done. It is a contradiction in terms.”

But Klein did allow CalPERS obligations to remain on the table as he sorts through conflicting law ungoverned by precedent.

Stockton, a city of 300,000, is the largest municipality in the country to declare bankruptcy. The case sets U.S. bankruptcy law, which gives the judge vast authority to decide who gets dinged for a filer’s debts, against California state law that says funding for the pension plan cannot be monkeyed with.

Stockton has continued to make payments to the pension fund throughout the negotiations, unlike the city of San Bernardino, which filed for bankruptcy in August and, with Judge Meredith Jury’s blessing, suspended its payments to CalPERS. Seven cities in California have filed for bankruptcy.

–Ken Broder

To Learn More:

Ruling Sets Up Pension Battle in Bankrupt City (by Mary Williams Walsh, New York Times)

Judge Rules Stockton, Calif., to Enter Bankruptcy (by Tracie Cone, Associated Press)

Stockton Bankruptcy Clears Way for CalPERS Pension Fight (by Diana Marcum, Los Angeles Times)

Instead of Going Bankrupt, Insurer Says, Stockton Should be Going after Labor and Retirees (by Ken Broder, AllGov California)