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SACRAMENTO, Calif., March 25 (Reuters) - Lawyers for Stockton and its creditors began their court battle on Monday over whether the California city may have bankruptcy protection in a closely followed trial hinging on the city leaving pensions intact while trying to force losses on bondholders.
As the biggest U.S. city to file for bankruptcy, the outcome for Stockton will be an important test case for the $3.7 trillion U.S. municipal debt market. The hearing is expected to last most of this week.
Stockton, along with Jefferson County in Alabama and smaller San Bernardino, California, has said its bondholders will be asked to take losses.
Since at least the 1930s no major city or county has forced a reduction in the principal of its debt during a municipal bankruptcy procedure.
Lawyers for bondholders and insurers, which will have to repay investors for any capital losses, argue the decision by Stockton to not seek to impair its largest creditor, the California Public Employees' Retirement System, shows a lack of good faith - a reason that should block Stockton's request for bankruptcy protection under federal bankruptcy law.
The retirement system, best known as Calpers, manages pension accounts for Stockton's employees and retired employees.
"The city ignores the 800-pound pension gorilla in the room," Guy Neal, one of the lawyers for the capital markets creditors, said in his opening remarks.
Bond insurers contesting Stockton's eligibility for bankruptcy protection have more than $300 million of exposure to the city's debt.
Assured Guaranty Corp, Assured Guaranty Municipal Corp and National Public Finance Guarantee Corp were joined by Wells Fargo Bank, the Franklin California High Yield Municipal Fund and Franklin High Yield Tax-Free Income Fund.
Marc Levinson, a lawyer for Stockton, defended the city's right to go bankrupt. He argued Stockton had attempted to negotiate in good faith with its creditors as required by California law before demanding protection from creditors.
The city of 300,000 in California's Central Valley, which filed for bankruptcy last year, fell on hard times when its revenue plunged after its once-torrid housing market went bust. Two decades of generous employee benefits, poor fiscal management and too much debt also caught up with the city, which is 85 miles east of San Francisco.
San Bernardino, which also filed for bankruptcy protection last year, is not making contributions to the state's pension fund as it contends with its financial troubles.
In other municipal bankruptcy cases, bondholders have been protected.
Central Falls, a tiny, poor Rhode Island city, had its bankruptcy plan approved by a judge in September. It slashed retirees pension payments in half and raised taxes, but left bondholders unscathed.
A Rhode Island law, passed as Central Falls' insolvency reached a crisis point, gave bondholders a lien on property tax revenue.
The Central Falls case, along with sweeping public pension changes at the state level, prompted labor unions and retirees in other struggling Rhode Island cities - including Providence, the state capital - to renegotiate retirement benefits and collective bargaining agreements.
Though Central Falls has exited bankruptcy, its case will remain open for several years so the court can step in if elected officials veer from the restructuring plan. Officials must provide quarterly statements about the city's financial health.
Because of the Central Falls case, "I don't think we're ever going to need a Chapter 9 again" in Rhode Island, said Theodore Orson at a distressed municipalities conference this month in Providence. Orson was the attorney for the state-appointed receiver who oversaw Central Falls' return from insolvency.