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Market Waits for Jefferson County Receiver Ruling

BRADENTON, Fla. — The potential ouster of the Jefferson County, Ala., sewer system’s receiver in connection with the county’s bankruptcy case could derail the long-held legal precedent that bonds secured by a specific pledge of revenues will continue to be paid during a Chapter 9 proceeding, according to creditors and industry participants.

Federal bankruptcy Judge Thomas Bennett could decide any day whether to allow the receiver, John Young, to remain in place and continue making debt service payments while the county’s bankruptcy case proceeds.

Jefferson County’s attorneys argue that an automatic stay that went into place the moment the county filed its bankruptcy petition on Nov. 9 required the receiver to turn the sewer system over to the county along with the control of its revenues and the authority over whether to continue paying its $3.14 billion of sewer debt.

An Alabama circuit court judge appointed Young to take over the county sewer system in September 2010 after the trustee for the sewer warrants, Bank of New York Mellon, sued for the system to be placed into receivership.

Richard Ciccarone, managing director and chief research officer for McDonnell Investment Management, said that Jefferson County’s large and complex bankruptcy “could have severe implications on the way analysts and investors think about revenues.”

To date, the market and investors believed that Chapter 9 provisions were designed to protect secure bondholder obligations, he said.

“The challenge here is determining whether or not the special revenue pledge provided by the sewer rates fall under that [secured] category,” he said.

“The complex issues being dealt with here are potentially very important precedents for Chapter 9,” according to Ciccarone.

Some interested parties cited previous bankruptcy cases as a part of their arguments, to show that special revenues continued to support timely debt payments, including in the case of Vallejo, Calif., which filed for Chapter 9 in 2008 and emerged early last month.

In a supplemental brief filed following two days of hearings on the matter Nov. 21-22, the county’s attorneys said that under the bankruptcy code, “the lien on special revenues will be subordinate to the necessary operating expenses of the project or system,” and that sets a minimum standard for the payment of operating expenses ahead of debt service.

The county’s brief also said that the fact that the sewer warrants were insured demonstrates “that the market always perceived a meaningful risk that payment might cease, including during a Chapter 9 bankruptcy case.”

In response, creditors filed a joint brief that disagreed with the county’s assessment.

The county’s “limited reading of pledged special revenues runs afoul of Congress’ intent to enact a comprehensive statutory scheme to prevent a Chapter 9 bankruptcy from roiling the municipal bond market by requiring that net special revenues … be paid,” the creditor’s group, consisting of Bank of Nova Scotia, Société Genérale, State Street Bank and Trust Co., Lloyds TSB Bank plc, Regions Bank, Bank of New York Mellon, Bank of America NA, JPMorgan, Syncora Guarantee Inc., and Financial Guaranty Insurance Co., argued in its supplemental brief.

“Consistent with the clear congressional mandate, no bankruptcy court in a Chapter 9 case has ever found that special revenues can be taken and used by a municipality contrary to the pledges under state law and the contractual rights of warrant holders,” the creditors said.

Generally, a petitioner under Chapter 9 retains control over which creditors get paid as well as the timing of the payments, according to Karen Grande, a partner at Edwards Wildman Palmer LLP who is special counsel to Rhode Island’s municipal receivership program and involved in that state’s Central Falls bankruptcy case.

“The assumption has generally been that because payments to holders of special revenue bonds are not subject to the automatic stay, that payments on such bonds would not be interrupted to the extent that there are available pledged revenues,” Grande said.

However, an argument could be made that while the bankruptcy code permits special revenue bonds to be paid during the pendency of a bankruptcy, it does not require that special revenue bonds continue to be paid without interruption, she said.

“All of this raises 10th Amendment concerns about whether the bankruptcy court would continue to allow the receiver to operate the system and apply net revenues to the payment of its special revenue bonds, or permit the county to delay payment,” Grande said.

The 10th Amendment governs the principle of federalism. It states that powers not granted to the federal government and not prohibited to the states by the Constitution are reserved to the states.

Federalism has been cited as one argument by the receiver and BNY Mellon supporting the position that Bennett should honor the decision of the Alabama state court that appointed Young as the receiver to take over the sewer system and its finances.

The potential to overturn a precedent that has allowed special revenue bonds to be paid during bankruptcy cases in the past has far-reaching implications, according to Leslie Norwood, associate general counsel for the Securities Industry and Financial Markets Association,

“Key to the viability of infrastructure financing throughout the United States is the assurance under the bankruptcy code, to those who buy revenue bonds secured by special revenues, that the pledge of revenue will continue and will be paid, even if the municipality files a Chapter 9 proceeding,” Norwood wrote in a letter last month to Bennett.

Amendments to the bankruptcy code made in 1988 with respect to Chapter 9 were enacted to reassure the market that those who invest in revenue bonds will continue to see their pledged revenues collected and paid to the bondholders, she argued.

After reviewing the Alabama state court’s decision to appoint a receiver over Jefferson County’s sewer system, Norwood said that “any actions to diminish, impair, or alter the rights of a state to provide remedies for revenue bonds, or to limit the ability of the receiver to take the actions necessary to ensure payment of operation and maintenance cost and debt service, would have material consequences in the market.”

Also, any effort by a municipality to change the remedies it represented to the market when bonds were sold “would create uncertainty and confusion in the entire market,” she added.

In addition to the sewer revenue warrants, the county also placed into bankruptcy $814.07 million of school revenue warrants secured by a one-cent sales tax, $200.52 million of general obligation warrants, and $82.5 million of limited-obligation lease warrants.

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