By Dave Warner and Edith Honan

HARRISBURG, Pennsylvania (Reuters) – Pennsylvania’s capital, Harrisburg, filed for bankruptcy on Wednesday in a desperate bid to resolve its debt crisis, setting up a showdown with the state over control of the city.

Harrisburg becomes one of the most-high profile cities to opt for the little used Chapter 9 of the U.S. bankruptcy code, most notably tapped nearly 20 years ago by Orange County, California.

The Pennsylvania capital’s crisis has been a year in the making as the city of about 50,000 struggles to pay for critical services as well as roughly $300 million in debt incurred from an expensive revamp of its incinerator.

While city services should continue uninterrupted, the move has caused confusion about how bills will be paid.

“We’re getting calls from vendors, wondering if they are going to get paid,” said Brenda Alton, the director of city’s department of parks, recreation and enrichment. “I feel it is a bad decision.”

Municipal bankruptcies are rare. But if Harrisburg is successful in winning concessions with bondholders, pensioners and other stakeholders, it could lead other financially troubled cities to seek bankruptcy.

Bankruptcy gives the city “bargaining power” with its creditors, municipal workers, retirees and the state, which is considering a takeover, said Mark Schwartz, an attorney for the council.

There have been only 629 municipal bankruptcies under Chapter 9 of the U.S. Bankruptcy Code since 1937, according to James Spiotto, a municipal bankruptcy expert at the law firm Chapman and Cutler.

“I think it’s more of an example of an aberration,” Spiotto told Reuters Insider. “It’s event-driven from a failed incinerator plant that’s unique to the Harrisburg situation. That isn’t a contagion that’s going to spread to other municipalities.”

Orange County, California, filed the largest Chapter 9 bankruptcy in U.S. history in December 1994 after it suffered more than $1 billion in investment losses on derivatives. Vallejo, California, with 120,000 residents, filed for Chapter 9 in 2008, and Central Falls, the smallest city in Rhode Island, the smallest U.S. state, filed earlier this year.

Harrisburg’s City Council approved the bankruptcy filing in a 4-3 vote. It was opposed by Mayor Linda Thompson, who in a news conference on Wednesday challenged the legality of the City Council’s vote.

Under city law, the mayor and the city solicitor must sign off on all hiring of outside counsel and the city solicitor must approve all ordinances and resolutions considered by the council, and neither was done in this case, Thompson said.

“They have been dishonest with the entire community for months,” Thompson said of the council. “I am ashamed of the behavior.”

The bankruptcy has the potential to stoke political passions as it will likely pit firefighters and police against municipal bond investors, who are often perceived to be wealthy retirees, said Peter Kaufman, president of Gordian Group and a financial restructuring specialist.

“It’s disgusting, it really is,” said Warren Jones, 68, a retired corporate manager. “I talk to people I know who are in business and they’re worried.”

Pennsylvania Governor Tom Corbett has said the city would be better off if it agreed to a rescue plan under the state’s Act 47 program for distressed cities — which has seen Philadelphia and other cities through crises — and his office stressed its opposition to the bankruptcy.

Pennsylvania’s state Senate will vote on a bill next week that calls for an eventual takeover of Harrisburg and the forced implementation of a fiscal rescue plan. The state’s lower house has already passed the bill.

“Rather than wasting precious time on illegal filings and engaging expensive attorneys, the majority of City Council should be about working with the mayor and the commonwealth to resolve this crisis via the Act 47 process,” said state Senator Jeff Piccola, who helped write the bill.

WALL STREET v. WALNUT STREET

The City Council has rejected rescue plans, one backed by the state and one by the city’s mayor. Those plans called on Harrisburg to renegotiate labor deals and sell or lease its most valuable assets — the incinerator and parking garages.

The City Council said those plans demanded too much of Harrisburg residents and did not ask enough of the county, bondholders and the bond insurer, Assured Guaranty.

City Councilman Brad Koplinski, who voted in favor of bankruptcy after opposing both of the rescue plans, said the council is looking for “a global solution with shared pain for all of the stake-holders.”

By selling its assets, and cutting off major revenue streams, the city could risk another fiscal crisis down the road, Koplinski said. If that happens, the city’s only options for addressing cash-flow problems would be to raise property taxes or further reduce benefits for public workers, he said.

Koplinski said he would not support a solution where “Wall Street gets paid in full and the people of Walnut Street have to pay for it many times over.”

In a statement, Assured questioned the vote’s legality, saying that as a distressed city of the third class of Pennsylvania cities, Harrisburg is “specifically prohibited from filing for bankruptcy.”

“Assured Guaranty realizes the complexity of the situation facing Harrisburg and continues to be eager to work with Harrisburg, Dauphin County and the Commonwealth in formulating solutions to address Harrisburg’s debt.”

The company “also strongly supports the efforts of the Governor and the Legislature to reach a prompt and fair resolution of Harrisburg’s debt obligations.”

However, City Controller Dan Miller said the filing was the right move for Harrisburg.

“I think it’s the only real option that we had,” said Miller, adding that the previous plans rejected by the City Council would have benefited creditors at the city’s expense.

Harrisburg’s bankruptcy filing wants to go where previous municipal bankruptcies have not: toward cutting the principal owed to bondholders, Kaufman said.

Daniel Berger, senior market strategist at Municipal Market Data, said there was very little trading in Harrisburg’s bonds on Wednesday. “Investors have written off these bonds for years as distressed credits,” he said.

WAVE OF MUNICIPAL BANKRUPTCIES?

Financial analyst Meredith Whitney, one of the few on Wall Street who foresaw the 2008 financial crisis, said last year she expected a wave of municipal bond defaults.

Chapter 9 bankruptcies remain uncommon, however. The process is very expensive, and not all states let local governments file for bankruptcy. Governments also have a power that ailing companies do not have: the ability to tax.

Alabama’s Jefferson County settled with its creditors last month to avoid what would have been the biggest-ever municipal bankruptcy.

Despite Harrisburg’s filing, municipal bankruptcies will likely remain rare, said Richard Ciccarone, chief research officer and municipal bond specialist with McDonnell Investment Management LLC.

(Reporting by Dave Warner in Harrisburg, Edith Honan in New York and Tom Hals in Wilmington, Delaware; Additional reporting by Chip Barnett and Michael Tarsala in New York; Editing by Kenneth Barry and Jan Paschal)