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(Bloomberg) — San Bernardino, the bankrupt California city, was sued for keeping up payments to the state’s powerful retirement system without giving equal treatment to pension-bond holders, a conflict facing other struggling U.S. municipalities.

The lawsuit presents a novel legal challenge for the California Public Employees’ Retirement System, which last year lost an argument in federal court over whether it deserved more protection than Wall Street.

Pension-bond holder Erste Europaische Pfandbrief- und Kommunalkreditbank AG sued San Bernardino yesterday in federal bankruptcy court in Riverside, California, claiming equal status with Calpers. The bank, which holds about $50 million in pension obligation bonds, didn’t name Calpers in the suit.

“Any payment of the Calpers pension obligation portion requires equivalent payment of the bondholder pension obligation portion,” the company, a unit of Frankfurt-based Commerzbank AG, said in the filing.

Ambac Assurance Corp., which insured part of the pension debt, joined Erste Europaische in suing the city.

Cities often issue bonds to raise money to bolster their pension obligations. In San Bernardino’s case, the money was used to fill a hole in its retirement fund, which is administered by Calpers. The city also makes regular payments on behalf of its employees to Calpers, which in turn pays retired city workers.

Public Services

City Attorney Gary Saenz defended the decision to treat the Calpers obligation differently from the pension bonds. The city must prioritize its debt payments while in bankruptcy in a way that guarantees the continuity of public services like police and fire protection, he said.

“To have a work force to provide those services, we need to have a stabilized pension system or a pension system that is unimpaired,” he said in an interview today.

San Bernardino and Stockton, California, filed for bankruptcy within weeks of each other in 2012, each partly blaming the high cost of union contracts.

San Bernardino initially quit paying Calpers, only to resume monthly payments after cutting a deal with the system. Stockton kept up payments and declined to fight Calpers’s legal claim that it must be paid before bondholders.

No Different

Investors challenged Stockton’s decision, and last year a federal judge agreed with one of their key arguments: that Calpers was no different from any other unsecured creditor.

Calpers has said it disagrees with that ruling. It’s reviewing yesterday’s lawsuit, said Brad Pacheco, a spokesman.

Detroit, which exited its record municipal bankruptcy last month, won court permission to cut pensions after unions argued that reductions violated a state law giving their retirement benefits more protection than other city debts.

Holders of Detroit pension bonds accepted pennies on the dollar in the bankruptcy, after first saying it was unfair that they were getting less than retirees.

The San Bernardino lawsuit is Erste Europaische Pfandbrief und Kommunalkreditbank AG v. City of San Bernardino 15-ap-01004, and the bankruptcy is In re San Bernardino, 12-bk-28006, U.S. Bankruptcy Court, Central District of California (Riverside).

Copyright 2018 Bloomberg. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.

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