By Michael Connor and Tim Reid

MIAMI/LOS ANGELES, Nov 30 (Reuters) - America's rarely used municipal bankruptcy law is presenting unexpected risks for investors in the $3.7 trillion U.S. tax-free bond market.

The largest U.S. pension fund, the California Pension Retirement System (Calpers), this week sued a small, cash-strapped California city in a bid to halt its bankruptcy, creating fresh uncertainties for municipal bond buyers.

At stake is much more than the few million dollars that San Bernardino, a city of 210,000 people just east of Los Angeles, owes in arrears for pensions - a token amount in comparison with the $241 billion managed by Calpers.

But the courtroom face-off in California may help establish who feels the most pain in municipal bankruptcies under Chapter 9, a section of federal bankruptcy law that poses multiplying risks to bondholders and other creditors of ailing local governments.

Similarly, bankruptcy experts and bond investors are closely watching the judge handling the year-old $4.23 billion Chapter 9 case filed by Alabama's Jefferson County that may affect risk assessments and interest rates for tax-free revenue bonds.

Both cases could set important legal precedents that would weaken or change safeguards for bond investors and potentially raise borrowing costs for cities and other issuers of tax-free revenue bonds used to finance water works and other infrastructure.

"It is a huge concern," said David Manges, municipals trading manager at BNY Mellon Capital Markets in Pittsburgh. "Chapter 9 bankruptcies are so rare that there are few precedents for dealing with muni bonds. Every example is creating new tax law ad hoc."

ALABAMA CASE MAY STING REVENUE BONDS

Lawyers in the Alabama case have clashed over how much of sewer-system revenues should go to owners of some $3 billion of county sewer-system bonds. The dispute challenges decades-old assumptions that revenue bonds go untouched in Chapter 9 cases.

"Jefferson County has really opened a Pandora's Box," said Richard Larkin, senior vice president at investment firm H.J Sims.

Desperate for revenue to pay for basic government services, Jefferson County officials have aggressively claimed sewer-system fees and are forcing a rethink among investors about the safety and relative risk of revenue bonds backed by dedicated cash flows, such as tolls or water bills.

"A lot of people buy revenue bonds because they think they are safer than general obligation bonds," Larkin said. "They believe their payments would continue during any bankruptcy."

Calpers worries that San Bernardino, in halting bi-weekly payments of $1.6 million to the city's pension accounts until the 2014 fiscal year, is threatening its customary first-in-line status as a creditor in workouts by distressed governments.

Calpers' legal move may mean that bondholders and other creditors of San Bernardino could see their rights to payments hurt if Calpers wins its argument.

Historically, bondholders have fared better in Chapter 9 proceedings than those in corporate bankruptcies, though only a few large local governments with outstanding bonds have gone through Chapter 9 in recent years.

Twenty two states either do not authorize or have bans on municipal bankruptcy. Most Chapter 9 cases have involved entities such as special tax districts supporting arenas, ports or water utilities.

However, Chapter 9 was used in the two largest U.S. municipal bankruptcies to date: those of Jefferson County in Alabama and Orange County, in California.

No U.S. municipality in the past 30 years has used bankruptcy to pay anything less than the full principal due to bondholders, though some interest payments have been lost.

Only the Californian city of Vallejo, which emerged from bankruptcy in 2011, forced bondholders to take a haircut when its finances were restructured. Interest payments to a single major creditor, U.S. Bank, a unit of USBancorp, were reduced, though principal payments were met.

In Orange County, which declared bankruptcy in 1994, bondholders continued to be paid in full, although for some it took longer to get full interest and principal payments.

CHAPTER 9, AN UNUSUAL MIX OF FEDERAL, STATE LAWS

In practice a tangle of federal and state laws, Chapter 9 differs greatly from the Chapter 11 laws for corporate bankruptcies, under which companies reorganize their finances under court supervision. Chapter 9 offers troubled local governments the chance of a stronger bargaining position with creditors and labor unions, as well as continued control over their services.

"It has been the last resort," said James Spiotto, a prominent Chapter 9 specialist and a partner at Chapman & Cutler in Chicago. "Other methods have been viewed by policymakers as more acceptable, and the use of Chapter 9 by cities and towns has been small."

Unlike failed department stores or people overwhelmed by hospital bills, Chapter 9 cases leave managers of busted water systems and counties with more autonomy than a corporate boss would have under Chapter 11.

U.S. bankruptcy judges can order companies to liquidate assets or force a debtor to sell a home but have no power to tell a city to shop downtown parkland to property developers or hike trash-hauling fees as ways to satisfy debts.

"It's not like a retail enterprise," said bankruptcy lawyer George South of DLA Piper in New York. "Cities can't shut down. They provide vital services."

Chapter 9 cases, which have included three Californian cities that declared bankruptcy since June, also sting citizens by cutting services, put at risk government workers' jobs and retirement benefits and can deter business investment.

Alternatives to Chapter 9 have been financial control boards in New York, financial managers in Indiana, intergovernmental cooperation in Pennsylvania and receivers in Rhode Island.

"The goal of the municipalities is to be able to deliver essential services and right-size their governments," Spiotto said. "There's a lot of creativity out there beyond Chapter 9."

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