By Tim Reid, Cezary Podkul and Ryan McNeill

LOS ANGELES, Dec 20 (Reuters) - The California city of San Bernardino paid $2 million in cash-outs to employees for unused vacation and sick time in the three months before declaring bankruptcy on August 1, data reviewed by Reuters show.

City officials chalked up the payment spurt to coincidence and other factors. Still, the payments may run afoul of a core provision of the bankruptcy code that imposes strict rules on the types of payments that can be made immediately prior to a bankruptcy, according to bankruptcy lawyers who are not involved in the case.

In a court hearing scheduled for Friday, the city is expected to argue that it is so penniless that it needs bankruptcy protection and relief from payments owed to the California Public Employees Retirement System and other creditors.

Yet in July alone, the city paid $1.2 million to 33 employees for unused sick and vacation time, with more than half of that paid out the day before the bankruptcy filing. The next highest similar total for a recent July was $471,149, in 2010. Reuters analyzed city data from 2008 to this year obtained through a public-records request.

In the three months before the bankruptcy, 51 city workers received sick and vacation time payouts totaling $2 million. Most of the workers received the payments as part of their retirement, as provided for in union contracts, city officials said.

Rhonda Haynes, the city's acting human-resources director, said the timing of the payouts was a coincidence. July 31 is the normal cash-out payment date for employees who retired and received their final wage check on July 15, she said. Other city officials also suggested that general anxiety among older workers over the city's finances led to a blip in retirements.

Legal analysts said the cash-outs immediately prior to bankruptcy filing were troubling and could be a breach of the federal bankruptcy code. Payments made by a debtor 90 days prior to a filing can be subject to clawback if they are found to be "preferential." Preference payments violate the bankruptcy code, a civil statute that does not provide for criminal sanctions.

"It looks really bad and it needs to be investigated," 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.

"If you want to say you can't make payroll, but can pay $2 million to your employees while not paying other creditors, those are questions all creditors will be asking," Denniston said.

Michael Sweet, a bankruptcy attorney with Fox Rothschild who is not involved in the San Bernardino case, said: "This looks like they are were trying to take care of certain employees, and that is precisely what the bankruptcy code is designed to protect - preferring one creditor over another."

OTHER EXPLANATIONS

City officials said there were good reasons for the spike. Asked why the number of cash-out payments in May, June and July were abnormally high, acting HR director Haynes said in an email provided by the city clerk's office: "My guess is because you have a lot of retirements at the end of the fiscal year."

Haynes said the city has no formal written policy governing cash-outs. "Normal practice" was that once an employee retired and received their final paycheck, the retiree would automatically receive a cash-out payment for unused sick and vacation time under the terms of their employment with the city, she said.

The retirement spike could also have been a result of some older employees' choosing to retire in light of the city's well-known financial woes.

"People were sensitive to how the city's finances could affect them," said Gigi Hanna, the city clerk. "There were certainly discussions in my department over whether it was better to retire now or wait it out."

The city was trying to reduce its workforce to cut costs. City attorney James Penman told the city council on November 5 that in his department, "we urged several people to retire, which they did and weren't necessarily ready to do so."

Penman was arguing in that council session for the re-hiring of Henry Empeno Jr.

Empeno, senior deputy in the city attorney's office, retired from the workforce with cash-out payments of $89,583 shortly before August 1 bankruptcy filing. On November 5, the city council approved Empeno's re-hiring on a monthly salary of $11,307 a month, and total annual salary and benefits of $161,140. The effective date for his reinstatement is December 26, according to the city clerk's office.

San Bernardino's acting city manager and the city's finance director did not respond to emails asking who authorized the cash-outs.

TOP RECIPIENTS

Haynes said cash-outs can only be paid when a city employee retires from the workforce. The city data reviewed by Reuters, however, showed that seven employees who received cash-out payments in the three months prior to the filing also received wage checks afterward.

Gigi Hanna, the city clerk, said some retired workers - such as Empeno - had been hired back as contractors, but could not provide further detail.

The city council voted to suspend cash-outs to its workers shortly after it filed for bankruptcy and to award them on a case-by-case basis.

Hanna, the city clerk, said in an email: "The city manager has the ultimate authority to approve cash-outs for all employees. As for the large number of retirements during that three month period...the budget discussions began in April and it was clear from what was being discussed in open session that the city was in serious financial straits."

The city of 210,000, about 60 miles east of Los Angeles, filed for Chapter 9 bankruptcy protection citing a $46 million deficit for this fiscal year.

The amount of cash-outs in May, June and July of this year was the highest for any three-month period in the data reviewed by Reuters.

The pre-bankruptcy cash-outs included David Harp, a police lieutenant, who walked away with $123,156, the third-highest amount during the period. Theodis Henson Jr, a police captain, left with $234,907, while Brian Boom, another lieutenant, departed with $171,110.

Harp, 58, left after 35 years with the San Bernardino Police Department and said it was "time to go." He'd been planning to retire for two years, he said, and gave city officials two weeks' notice.

"People knew I was going to leave," he said. The bankruptcy had no effect on his decision, he said. He noted that San Bernardino's financial troubles were not new, and "you'd have to be a blind man not to see what was going on."

Empeno did not respond to a message left with the city attorney's office or an email sent to his work account. Attempts to contact Boom were not successful.

COURT SHOWDOWN

Friday's hearing will be the first time San Bernardino's biggest creditors - the California Public Employees' Retirement System (Calpers), and Wall Street bondholders and insurers - will meet to argue their case before the judge overseeing the city's bankruptcy application.

The case is emerging as a landmark legal battle over whether the pensions of government workers take precedence over other payments in a municipal bankruptcy, which could have ramifications for municipal creditors, including Wall Street bondholders, as more cities and towns have trouble meeting their obligations.

Calpers, San Bernardino's biggest creditor and America's biggest pension fund, is arguing that under California law it has primacy as a creditor and must continue to be paid in full, even in a bankruptcy. In its original bankruptcy filing, the city said its unfunded obligations to Calpers totaled $143.3 million.

Last week Calpers, which is opposing the city's request for protection, filed court papers denouncing what it called a "sham" bankruptcy. It accused the city of "criminal behavior" in withholding payments to the pension plan.

The city has failed to make its twice-monthly $1.2 million payments to Calpers since it filed for bankruptcy on August 1. City officials traveled to Calpers headquarters on December 5 to plead for more time to pay.

Calpers officials told Reuters they have little latitude to allow San Bernardino - or any other city that pays into its pension fund - to alter the payment schedule.

In its court filing last week, Calpers said the city had "buried its head in the sand", rather than deal with a long-standing financial crisis.

A Calpers spokesman said the cash-out payments were "something we will look at."

The city's second-largest creditor is Wells Fargo Bank, the trustee for nearly $50 million in pension-obligation bonds the city issued in 2005 to reduce its debt to Calpers.

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