UPDATE 2-San Bernardino, California, gets bankruptcy protection

* Judge: city was clearly insolvent

* Calpers considering options for appeals

By Tim Reid

RIVERSIDE, Calif., Aug 28 (Reuters) - A U.S. federal judge on Wednesday granted bankruptcy protection to the California city of San Bernardino, paving the way for a precedent-setting battle between bondholders and California's giant public pension system.

The case is being closely watched by other U.S. cities, including Detroit, which declared the biggest U.S. municipal bankruptcy last month, where budgets are burdened by soaring pension costs.

Judge Meredith Jury of the U.S. Bankruptcy Court for the Central District of California ruled that San Bernardino was eligible for Chapter 9 bankruptcy protection despite opposition by the California Public Employees' Retirement System, or Calpers. The $260 billion pension fund is the city's biggest creditor and America's largest pension fund.

"I am ruling as a matter of law that the city is eligible," Jury said. "I don't think anyone in this courtroom seriously thought the city was anything but insolvent."

A city must be insolvent and have proof to have negotiated in good faith with creditors to be eligible for Chapter 9 municipal bankruptcy.

Michael Gearing, an attorney appearing for Calpers, called Jury's decision a "dangerous precedent" that will encourage other cities to "create a crisis because they have a large number of creditors."

Amy Norris, a Calpers spokeswoman, said in an emailed statement: "Calpers is considering its options for appeals."

San Bernardino, a city of 210,000 located 60 miles east of Los Angeles, filed for bankruptcy protection in August 2012, citing a $46 million deficit and arguing that it had effectively run out of cash to meet its daily obligations.

The city must negotiate with its creditors and produce a final bankruptcy plan on which the judge will ultimately have to rule. Whether pension and other debt payments, including to holders of $50 million in pension obligation bonds, will have to be treated equally or not will remain a key issue - one that could eventually reach the U.S. Supreme Court.

LIKE OTHER CREDITORS?

Calpers argues that it should not be treated like other creditors and must be paid in full because California state law says the fund must always be fully paid, even in a bankruptcy. Bondholders argue that federal bankruptcy law trumps state statutes and say Calpers should be forced to fight with other creditors over how much they are paid under an exit plan.

Another California city, Stockton, which was also found eligible for municipal bankruptcy protection in April, is expected to present an exit plan in September. Creditors will be asked to vote on the plan.

The judge overseeing that case said dealing with Stockton's obligations to Calpers will probably be unavoidable under an exit plan.

In an unprecedented move, San Bernardino stopped paying its $1.2 million bimonthly employer payments to Calpers for a year after declaring bankruptcy, the first California city to halt payments to the fund.

It resumed paying Calpers last month but continues to renege on payments to other creditors, including holders of $50 million in pension obligation bonds.

Calpers said the city still owes the fund $14.3 million in arrears and that it will "aggressively pursue all past due contributions, resulting interest and penalties."

"These payments are statutorily required and necessary to deliver on the pension benefits promised to San Bernardino employees as a form of deferred compensation," the powerful pension system said.

But the judge questioned who will provide for those payments.

"If Calpers gets all the money they want, under what they say is their statutory right, who isn't going to get paid? All the employees? How is that going to help Calpers?" she said.

The case is In re San Bernardino, 12-bk-28006, U.S. Bankruptcy Court, Central District of California (Riverside).