(Reuters) - A unit of insurer MBIA Inc challenged Stockton,Calif.'s eligibility for bankruptcy, saying the city's decision notto ask for concessions from the California Public Employees'Retirement System pension fund undermined its case.

The filing in bankruptcy court sets up a battle betweencreditors and the city which could determine whether Stockton isallowed court protection and could set precedent over whether andhow cities, counties and the state can cut retirement benefits.

A federal judge must approve Stockton's eligibility for Chapter9 protection before the city can reorganize its debts under courtprotection from creditors, and a primary criterion is whether thebankruptcy petition was filed in good faith.

“The city has not presented evidence that it negotiated with itscreditors equitably and thus, in good faith,” National PublicFinance Guarantee Corp wrote.

The company, which insured nearly $94 million of the city'srevenue bonds, said Stockton had not negotiated at all withCalpers, and that its initial proposal to creditors, called 'theAsk,' showed a financial shortfall even after bond payments werecut. The insurer said that was due to retirement fund payments.

“The terms of the Ask itself are fatal to the City's argumentfor eligibility,” it wrote, adding that city officials with Calperspensions benefited from the pension fund treatment.

“The protection of Calpers benefits for the Mayor, city counciland other city employees is clearly not in good faith,” itsaid.

Bond insurer Assured Guaranty Ltd has also questioned Stockton'seligibility for bankruptcy in public statements and has until theend of the day on Thursday to file a motion with the court.

The case is In re: City of Stockton, California, debtor,U.S. Bankruptcy Court, Eastern District of California, No.12-32118.