On April 1, 2013, a federal judge granted the city of Stockton, California’s request for federal bankruptcy protection after a three-day evidentiary hearing. Stockton’s bankruptcy could result in municipal bond investors losing millions of dollars. Those investment losses could result in arbitration claims against the brokerage firms that sold the bonds to investors.

Bankrupt cities must come up with a plan for creditors to forgive some of the debt. That means that holders of Stockton’s municipal bonds likely will not get all of their money back. Those would include holders of $165 million in bonds the city issued in 2007. Incidentally, Stockton issued those bonds to keep up with payments that the city owed to the California Public Employees Retirement System (CalPERS) as Stockton property taxes plummeted during the recession. Stockton reportedly owes CalPERS about $900 million to cover pension promises.

A host of questions arise out of the bankruptcy, including whether Stockton will fund the retirement pensions of its employees before paying other debts that it owes, including its municipal bond obligations. A constitutional question to be answered is whether federal bankruptcy law overrides California law that says that money owed to the state pension fund must be paid.

Stockton has tried to restructure some debt by slashing employment, re-negotiating labor contracts, and cutting health benefits for workers. Library and recreation funding also have been slashed, and Police Department-funding reportedly has decreased to the extent that Stockton police only respond to emergencies in progress. This could be what has led to Stockton’s crime rate ranking among the highest in the nation.

Investors who purchased Stockton municipal bonds may have claims against the brokerage firms that sold the municipal bonds if the brokerage firms failed to understand and inform investors of Stockton’s shaky financial position, i.e., the likelihood that Stockton would not be able to repay its debts.

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