* Decision is initial step in long, legal challenge
* Legal challenges to health reform loom in other states
* Health Secretary Sebelius says law is constitutional
(Adds Virginia officials' comments)
By Jeremy Pelofsky and Lisa Lambert
WASHINGTON, Aug 2 A U.S. judge ruled on Monday that the state of Virginia could proceed with its challenge to President Barack Obama's landmark healthcare law, a setback that will force the White House to defend its reforms in the middle of a tough congressional election campaign.
In the opening salvo of the legal fight, U.S. District Judge Henry Hudson refused to dismiss the state's lawsuit, which argued the requirement that its residents must have health insurance is unconstitutional and conflicts with state law.
Hudson, who noted that his ruling was only an initial step, decided the issue the state raised -- whether forcing residents to buy something, namely healthcare, is constitutional -- had not been fully tested in court and was ripe for review.
"The congressional enactment under review -- the Minimum Essential Coverage Provision -- literally forges new ground and extends (the U.S. Constitution's) Commerce Clause powers beyond its current high watermark," Hudson said in a 32-page ruling.
The new law is a cornerstone of Obama's domestic agenda and aims to expand health insurance for millions more Americans while curbing costs. Obama officials have vigorously defended it as constitutional and necessary to stem huge increases in costs for healthcare.
Health and Human Services Secretary Kathleen Sebelius said the ruling rejecting the Obama administration's motion to dismiss the case was a procedural step and the healthcare reform law has "full constitutional backing."
"We remain confident that the case is solid," she told reporters. Arguments on the merits are set for Oct. 18, two weeks before the Nov. 2 congressional elections.
The fight over the healthcare law is expected to be a major issue in those campaigns as Republicans have advocated repealing the measure and plan to attack Democrats for it.
"This healthcare bill is a monstrosity and will be a big issue in the fall," Senate Minority Leader Mitch McConnell told Reuters in an interview after the ruling. "We would repeal it and replace it were we given enough votes to do that."
McConnell's fellow Republicans are expected to pick up many seats in the House of Representatives and possibly in the Senate, although it is unclear whether they would take control of the two chambers.
MISSOURI TRIES TO FORBID PENALTIES
Missouri voters are expected to pass a measure on Tuesday to forbid the federal government from penalizing individuals for refusing to buy health insurance. But it could be symbolic because federal law typically supersedes state laws.
The federal penalty provision does not take effect until 2014 and the Obama administration has pointed to tax credits, subsidies and other mechanisms to help those who cannot afford to buy insurance. Some 46 million people in the United States lack healthcare coverage.
Virginia's lawsuit, filed shortly after Obama signed the health reforms into law, is one of several arguing that it is an unprecedented seizure of power by the federal government.
"This lawsuit is not about healthcare, it's about our freedom and about standing up and calling on the federal government to follow the ultimate law of the land -- the Constitution," said Virginia Attorney General Ken Cuccinelli.
The state said that penalizing someone for failing to buy health insurance coverage violates the Constitution's Commerce Clause and Tax Clause that allows the federal government to regulate commerce between the states.
"This portion of the complaint (by Virginia) advances a plausible claim with an arguable legal basis," wrote Hudson, who was appointed by George W. Bush in 2002.
Virginia also argued that because the Constitution does not allow the government to force a person to purchase something, therefore the federal government also would be powerless to levy a penalty or tax for failing to buy healthcare coverage.
The Obama administration has countered that the government always has the ability to levy taxes and that the Constitution places the federal government's powers over the states.
It has also said that Virginia does not have legal standing to sue on behalf of its citizens. Instead, Justice Department lawyers say, individuals purportedly affected would have to contest the law themselves in court.
Virginia's legislature approved its own measure saying its citizens cannot be required to buy health insurance, bolstering its case, the state's governor Bob McDonnell said. "It warrants a full and thorough hearing in our courts," he said.
Health insurance companies, which fought hard against the passage of the healthcare law, have moved on to accept it. Wall Street had already factored in the decision.
"Wall Street is not operating under the assumption that the healthcare reform law is stricken or components of it are stricken because of constitutionality concerns," said Collins Stewart analyst Brian Wright, who covers insurer stocks, adding that the case warrants closer scrutiny by Wall Street.
"We are focused on implementing the new law in a manner that holds down costs and minimizes disruption for the 200 million people our members serve," said Robert Zirkelbach, a spokesman for the industry's lobby group, America's Health Insurance Plans.
Arguments over the Obama administration's motion to dismiss a lawsuit by 20 other states are set for September in Florida.
Legal analysts say there is a good possibility the matter will reach the U.S. Supreme Court, but most say there is only a slim chance the states would prevail. (Additional reporting Lisa Richwine and Susan Heavey in Washington, Lewis Krauskopf in New York, editing by David Alexander and Chris Wilson)