The move laid bare a high-stakes battle shaping up between Wall Street and state pension funds over how they are treated when cities run out of money.

The powerful California Public Employees' Retirement System (Calpers) filed a legal motion declaring its intention to sue San Bernardino for millions of dollars in pension arrears, a move that the fund has never before had to make in a municipal bankruptcy.

San Bernardino, a city of 210,000 about 60 miles east of Los Angeles, filed for bankruptcy protection on August 1. Since then, it has halted its bi-weekly, $1.2 million payment to Calpers, saying it wants to defer any payments to the fund until fiscal year 2013-2014. Calpers says the city is already $6.9 million in arrears since August 1.

The San Bernardino bankruptcy is fast emerging as a precedent-setting case over how creditors, especially Wall Street bondholders and insurers, are treated in a municipal bankruptcy, because never before has a city seeking bankruptcy halted payments to Calpers or threatened its historical primacy as a creditor.

Under Californian state law, the contract between Calpers and debtor cities is viewed as inviolate and has been treated as such by state courts. Unlike Calpers, other creditors have historically been forced to renegotiate or forgive debt to debtor cities.

The Californian city of Stockton, also seeking bankruptcy protection, decided to keep current on all payments to Calpers, as did the city of Vallejo, which emerged from bankruptcy in 2011.

San Bernardino's decision to halt its payments, and its move on Monday night to include in a new budget an attempt to renegotiate the terms of its debt with Calpers, is uncharted territory for the pension fund. Wall Street bondholders and insurers have already indicated their intention to test Calpers' primacy as a creditor in the San Bernardino case.

Calpers, one of the biggest pension funds in the world, serves many cities and counties in California. It is San Bernardino's biggest creditor. The city, which has a nearly $46 million deficit for the current fiscal year, lists its unfunded pension obligations to Calpers at $143.3 million. Calpers says if the city halted its relationship with the fund immediately, the debt would be $319.5 million.

Under the U.S. bankruptcy code, all legal actions against a debtor city by creditors are stayed until the bankruptcy has been approved, or thrown out.

In the legal motion filed to the bankruptcy judge overseeing the San Bernardino case shortly before midnight on Tuesday, Calpers asked for that stay to be lifted so it could redeem its debt in a state court. It also said even if the stay was not lifted, it would still seek redress in a state court.

Calpers expressly stated that it was "concerned about inappropriate preferential treatment that might be given to other creditors" in San Bernardino's bankruptcy. Calpers has long argued that pension contributions cannot be touched, even in a bankruptcy.

The move by Calpers is the opening battle that could see the case move all the way to the U.S. Supreme Court, America's highest court, said Karol Denniston, a Californian bankruptcy expert who authored part of the state's bankruptcy code.

All municipal bankruptcy cases, including San Bernardino's, are adjudicated in federal court. Calpers is in effect asking that the state law governing its contractual relationship with debtor cities not be trumped in federal court, Denniston said.

"We've never been here before," Denniston said. "This is the opening move in complex legal issue over how much power a federal bankruptcy court has over a state contract. The state statute, and Calpers, says Calpers always gets paid in full. This is the first time this has ever been tested."

Robert Glazier, a Calpers official, said: "This legal action would allow us to collect the employer contributions from San Bernardino which are required by state law, to maintain the integrity of the San Bernardino pension plan for its public employees and retirees and to avoid needless procedural disputes and additional legal costs."

(Reporting By Tim Reid; Editing by Pravin Char)

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