* Cities part with redevelopment funds under protest
* Local budgets hit by elimination of agencies
* Funds re-routed to schools
* Some cities may challenge legality of state reclaiming the funds
By Ronald Grover and Jim Christie
LOS ANGELES/SAN FRANCISCO, July 16 (Reuters) - California cities, including many facing severe budget problems, are struggling to comply with an order issued last week to return millions of dollars of economic development funds as Governor Jerry Brown's controversial shutdown of the state's redevelopment agencies moves forward.
As many as 400 cities were notified by e-mail on July 9 of their bills for repayment of funds that they had earmarked to repair streets, apartment buildings or for other projects through now-defunct redevelopment agencies. Cities that do not pay up face having tax revenue withheld beginning this week.
Redevelopment agencies were originally established to help restore blighted areas. They were funded by the increased tax revenue from property they helped to improve or rebuild. But over the years redevelopment money has made up an increasing percentage of local property tax revenue and city programs.
Many cities had grown accustomed to using redevelopment funds for a variety of purposes and have complained bitterly about the shutdown of the agencies. The city of San Bernardino cited the loss of $6 million in redevelopment funds as one reason behind its recent move to seek bankruptcy protection.
Last week, many of the cities repaid the funds under protest, including some that say they are contemplating legal action.
San Diego paid $89 million to San Diego County "to avoid penalties that would further burden taxpayers," Mayor Jerry Sanders' office said in a statement on Friday, adding that the payments were made "under protest and with reservation of all rights to challenge the legality of the mechanism used by the State to calculate the demanded payment."
"We've done a good job managing the wind-down of redevelopment and paying our bills on time," Sanders said in the statement. "Now the State has changed the rules and is trying to plug the budget holes that they have created."
In June, Moody's Investors Service downgraded to Ba1 $11.6 billion in California tax allocation bonds rated Baa3 or higher, citing increased uncertainty regarding timely debt service payments. Outstanding redevelopment bonds are now the responsibility of "successor agencies," which in many cases are the cities themselves.
Twelve cities unsuccessfully sought a restraining order to block the state from collecting their remaining redevelopment funds, arguing that it would restrict their ability to pay their obligations on bonds.
The Orange County city of Westminster returned nearly $9 million "under protest," the city council said after a special meeting on July 12.
Westminster, which last year received $38 million in redevelopment tax revenue, laid off 49 staffers in February, mostly from its building codes and inspection unit, after the legislature initially passed legislation to abolish the agencies.
The Northern California city of Pittsburg fared better, even though it paid $3.3 million. It successfully disputed its initial $7.3 million bill by pointing out mistakes the state made in calculating its bill.
The city of Pinole, near San Francisco, borrowed $1 million to send the state and intends to repay that from general funds, city manager Belinda Espinosa told the San Jose Mercury News.
The city, which has 95 full-time positions, cut 53 slots over the last three years.
"The real story is that some cities can no longer charge off staff costs to that money, and that could mean layoffs," said La Mirada City Manager Tom Robinson, whose city returned $64,000.
The city of 48,000 south of Los Angeles is not facing a budget crisis but the city will ask voters on Nov. 6 to increase its 8.75 percent sales tax to 9.75 percent to help fund future capital improvements.