* First step in a complex legal proceeding
* Lifting protection would leave the city without cash flow- judge
* $2 million cashout paid to employees "preferential" - Calpers
By Jonathan Weber and Tim Reid
RIVERSIDE, Calif., Dec 21 (Reuters) - A U.S. bankruptcy judge ruled on Friday against an attempt by the California Public Employees Retirement System to bypass the bankruptcy court and collect overdue pension payments from the bankrupt city of San Bernardino.
The decision, while only one step in a highly complex legal proceeding, was a blow to Calpers' argument that pension payments and California law should take precedence in a bankruptcy.
Calpers, the largest U.S. pension fund with $241 billion in assets, had been seeking to lift the automatic bar on payment collections that comes with a bankruptcy filing.
Calpers is concerned that if San Bernardino - a city of 210,000 east of Los Angeles - continues to withhold payments it could encourage other debt-strapped California cities to follow suit.
Calpers has long argued that under California state law the contract between Calpers and debtor cities is inviolate and the pension fund should be paid in full, even in a bankruptcy.
Two other California cities - Vallejo, which emerged from bankruptcy last year, and Stockton, which filed for bankruptcy protection this year - continued to make payments in full to Calpers. San Bernardino is the first city to halt payments to the pension fund and thus the first to potentially challenge Calpers' historic primacy as a creditor.
The motion by Calpers was denied without prejudice, Judge Meredith Jury said. While Jury said the bankruptcy court clearly had jurisdiction, a Calpers attorney said the pension fund may nonetheless ask a state court to intervene in the matter.
San Bernardino has not made its $1.2 million twice monthly payments to Calpers since it filed for bankruptcy in August. It now owes at least $8 million to the pension system in addition to a long term debt that the city pegs at $143 million.
"Unless I have been misled the city has limited funds on a daily and monthly basis, it is using the limited funds to pay salaries," Jury said in her opening remarks. She based her ruling largely on the potentially disastrous impact a state collection action could have on the struggling city.
Lifting the protection would leave the city without the cash flow to run daily operations, she said.
Calpers has also made a broader argument that San Bernardino should not be eligible for bankruptcy and that state law should prevail when it comes to pension payments.
Calpers officials have said that they are willing to argue a wider Constitutional point - the state law defending their right to be paid versus the federal municipal bankruptcy law - all the way to the U.S. Supreme Court.
The court decision may favor bondholders who sided with the city against Calpers.
Ralph Taylor, an attorney representing the holders of $50 million pension bond holders said they agreed with the judges' comments and "it was in the best interests of the city for the stay to remain in place".
If Calpers were allowed to sue the city and collect its payments, it would likely be "devastating on the city, its workforce...and other creditors because Calpers will take it all" he said.
San Bernardino has issued $50 million of pension obligation bonds to pay down part of its debt with Calpers.
At the Friday hearing, attorneys also argued about whether Calpers and other creditors should be entitled to extensive discovery as part the proceeding to determine whether the city is eligible for bankruptcy.
One reason for denying bankruptcy protection would be a finding that the city had not acted in good faith --and Calpers attorneys said the lack of information from the city and other factors suggested a lack of good faith.
Michael Lubic, an attorney with K&L gates representing San Bernardino, cited a Reuters article about $2 million in cash-outs of sick and vacation time to employees that were paid immediately prior to the bankruptcy filing.
Calling those payments "clearly preferential" and thus improper in a bankruptcy, Lubic argued that they showed the city was not acting in good faith in claiming that it had no money to pay its bills.
City lawyers said the city was required to make the payments, and chided union representatives for objecting to the cash-outs at the hearing even though many employees had demanded the payments. Jury expressed great surprise that the parties would learn about such payments from a news article.
Jury ultimately agreed that in light of the many unanswered questions about the current state of the city's finances, some discovery would be warranted. She had initially said she hoped to avoid a time-consuming and expensive discovery process.