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* Bankrupt city faces $15 million payment demand from state
* City calls move illegal and threatens to sue
* Dispute relates to wind-down of redevelopment agencies
By Tim Reid
March 12 (Reuters) - Bankrupt San Bernardino is threatening to sue the state of California over demands it owes millions of dollars in property taxes, the latest complication in the city's quest to fix its fiscal problems in federal bankruptcy court.
The bankruptcy of the city 65 miles east of Los Angeles is a national test case on whether the pensions of government workers take precedence over other payments in a municipal bankruptcy. It is a high stakes issue for pension plans and their beneficiaries, and for Wall Street bondholders who lend money to governments.
In letters dated February 21 and March 4, the California Department of Finance demanded the city pay $15.2 million in property taxes related to its former redevelopment agency. If the city does not pay the money by April 3, the state could dock the funds from San Bernardino's future sales and property tax revenues, the letters state.
In response, San Bernardino's city attorney said in a letter to California's state controller, John Chiang, that the threat to withhold tx revenue is "illegal" and a "willful violation" of federal bankruptcy law, which protects debtors from creditors' demands during proceedings.
If California does not withdraw its threat to dock future city revenue, "the city will have no choice but to institute proceedings" against the state controller and other state officials, James Penman, San Bernardino's city attorney, wrote in a March 8 letter.
San Bernardino filed for bankruptcy protection in August, citing a $46 million deficit for the current fiscal year. It continues to state that it can barely make payroll.
A federal bankruptcy judge has yet to rule on the city's eligibility for bankruptcy protection, but in the meantime bankruptcy court protections against collection actions remain in place.
The bankruptcy court proceedings are still in an early stage, with the city and its creditors -- notably Calpers, the public employee retirement system -- wrangling over the production of financial records.
San Bernardino halted its twice monthly pension payments to Calpers in August, an unprecedented step for a city. Calpers argues that it takes primacy over other creditors in the bankruptcy, something Wall Street bondholders dispute.
The judge overseeing the case has voiced sympathy with the city's argument that it has scant human resources to deal with voluminous record demands and has given the city more time to comply. The city's finance chief quit his post in February, and has not been replaced.
The state finance department move follows a letter last week from California's state controller, alleging that San Bernardino misdirected over $500 million in assets and cash after its redevelopment agency was dissolved.
San Bernardino's RDA was one of about 400 eliminated last year across California as a result of legislation spearheaded by Governor Jerry Brown. The goal was to free up property tax revenues controlled by the RDAs for use in funding schools and other services.
San Bernardino's dispute with the state over RDA funds is not an isolated case, said Karol Denniston, an expert in municipal bankruptcy at Schiff Hardin law firm in San Francisco who is not involved in the San Bernardino case.
Many cities have received demands from the state over the allocation of RDA funds and are disputing them, she said. What makes San Bernardino unique is that it is the only one of these cities in bankruptcy.
"The state coming after San Bernardino is consistent with it coming after everybody else - but San Bernardino is in bankruptcy and is gasping for air," Denniston said.
"For San Bernardino, this is impossible to address. There are cities not in bankruptcy having trouble dealing with this, in terms of the audits and the manpower involved."
H.D.Palmer, a spokesman at the California department of finance, said the department was aware that San Bernardino was seeking bankruptcy protection.
He said the state was willing to work out a structured payment with the city, but that under state law once an audit had determined the money was owed it had to be paid.
Michael Sweet, a bankruptcy attorney with Fox Rothschild who is not involved in the San Bernardino case, said the city had good grounds to dispute the state's financial demands, but they nontheless could complicate the process.
"This certainly makes it tougher for the city," Sweet said. "To the extent the city has to expend resources, be they monetary or staff hours dealing with the state, those are resources that can't be spent on creditors."