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Key test looms for Stockton, California, bankruptcy bid

By Jim Christie

SAN FRANCISCO (Reuters) - The city of Stockton, California, has a strong case heading into court next week in a bid to establish eligibility for bankruptcy protection, a move contested by bond insurers of more than $350 million of its debt, lawyers watching the case predicted.

At the February 26 hearing in Sacramento, Chief Bankruptcy Judge Christopher Klein is likely to schedule a fight in court over eligibility - a battle that bankruptcy law experts predict the city of 300,000, the largest in the United States to have ever filed for municipal bankruptcy, will win.

Michael Sweet of the law firm Fox Rothschild, who helped Richmond, California, avoid filing for bankruptcy, said Stockton has an upper hand because of its orderly approach to California's and the federal Chapter 9 municipal bankruptcy codes.

"The way this case appears to be going, Stockton should be able to convince Judge Klein it's eligible," Sweet said.

Hard times set in for Stockton when its revenue plunged after its once red-hot housing market went bust. Two decades of generous employee benefits, too much debt and poor fiscal management also caught up with the city located 85 miles east of San Francisco.

Stockton City Manager Bob Deis last February urged the city council to initially suspend about $2 million in bond payments as a part of a larger overhaul of the city's finances.

The council embraced the plan, paving the way for Stockton's bankruptcy filing in June and a plan the next month to impair nearly $200 million of its debt, which has pit the city against its capital market creditors in a fight that has become increasingly bitter as the showdown over eligibility nears.

BOND INSURERS UP IN ARMS

Stockton is in several aspects an opposite of San Bernardino, another sizeable California city that filed for bankruptcy last year.

Stockton planned its move well ahead of its bankruptcy filing. San Bernardino rushed into a hasty filing after its city council learned that spending would exceed revenue by $45 million and the city had no reserves.

Additionally, Stockton has targeted bondholders for losses while San Bernardino is skipping out on payments to the state pension fund, the California Public Employees' Retirement System.

Bond insurers National Public Finance Guarantee Corp and Assured Guaranty have more than $350 million of exposure to Stockton's debt and have loudly complained about the city continuing payments to the pension fund, best known as Calpers, while halting payments to some bondholders.

"Unless the City is willing to tackle its pension liabilities and obligations to Calpers there is no legitimate purpose served by permitting it to remain in Chapter 9," lawyers for Assured and its Assured Guaranty Municipal Corp said in court filing in December.

Calpers recently dismissed such attacks, saying "The city's obligations to Calpers are not negotiable."

GOOD FAITH, INSOLVENCY AT ISSUE

The insurers also contest Stockton's claim of insolvency and claim the city did not negotiate with creditors in good faith. Two requirements for debtors to establish Chapter 9 eligibility are they negotiate in good faith and prove they are broke.

Stockton's meticulous planning and its extensive record of talks and financial troubles should allow it establish eligibility to remain in bankruptcy court.

"It's pretty stitched up," said Karol Denniston of the law firm Schiff Hardin, who helped draft California's law for how municipalities may file for bankruptcy.

Stockton's lawyers have honed in on compelling arguments for why the city should be deemed eligible to advance its Chapter 9 case, said Denniston, who is not involved in the case.

Dropping retiree medical coverage to eliminate liabilities of more than $400 million helps Stockton's case for eligibility and counters calls for the city to pare its pension spending, said Dale Ginter of the Downey Brand law firm who represented the retirees' committee in another famous California's bankruptcy case, Vallejo, which lasted from 2008 to 2011.

"The city has a good argument in that they've already clipped the retirees for a good chunk of money," said Ginter who squared off in the Vallejo case against lawyers now working for Stockton.

(Reporting by Jim Christie; Editing by Tiziana Barghini and Bob Burgdorfer)

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