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Minnesota City Broadband System Falters on $26M of Bonds

CHICAGO — A struggle for customers has dampened a small Minnesota city’s high-tech ambitions for its broadband network and put the bonds issued to build the network in default.

The broadband system was once envisioned as a potential model for other local governments to follow, but it’s failing to generate enough revenues to service $26.4 million of tax-exempt revenue bonds issued in 2008.

The system — aimed at enhancing the city of Monticello’s growth and appeal in attracting businesses and residents — faced stiff competition from private competitors that lowered their prices to keep customers.

With the system’s revenues falling short, the trustee has been drawing from various bond reserves to cover debt service payments. Between July 2011 and June 2012, the city, which issued the bonds and owns the system, covered debt service by loaning the project money generated by its liquor sales operations.

Under no obligation to make up the shortfalls, Monticello, located just north of the Twin Cities, informed the trustee of its intention to halt that practice in June as it sought out a restructuring.

Without any agreement between bondholders and the city on a restructuring and with the city in default on bond terms for failing to raise rates to a level sufficient to cover debt service, trustee Wells Fargo Bank NA went to court last month. It won an order allowing it to not make a Dec. 1 payment for $883,000.

The trustee is preserving existing reserves to cover various expenses which could include a potential legal battle with the city.

The payment owed next June includes a similar interest payment and a principal payment for $85,000.

“The project’s expenses currently exceed its revenues by a substantial margin, and there are no net revenues from which debt service payments on the bonds can be made. Debt service payments to date have been made from proceeds of the bonds that were set aside when the bonds were issued, and from other funds of the city,” a trustee notice reads.

The city’s decision to stop supplementing debt service prompted the trustee’s decision to undertake a trust instruction proceeding in Hennepin County District Probate Court.

It asked for an order instructing it not to make the December payment and future payments from surplus and reserve funds.

“The city’s intentions, and the nature and extent of the remedial and other actions the trustee may be required to take in this matter are unclear. However, the funds currently held in the Trust Estate are likely to be the only funds available for these purposes for the foreseeable future,” a notice read.

The court granted the order on Nov. 15.

The unrated revenue bonds were structured as term bonds due in 2023 and 2031 and carried original yields of 6.5% and 6.75%, respectively. They most recently were trading at 15 cents on the dollar, according to data posted on the Municipal Securities Rulemaking Board’s online EMMA disclosure website.

Oppenheimer served as underwriter and Faegre & Benson LLP as bond counsel on the issue.

Proceeds financed the city’s costs of acquiring and construction a fiber optics broadband communications network to provide cable television, internet access, and telephone services to businesses and residents.

The bonds are special, limited obligations of the city with principal and interest payable solely from the system’s operating revenues after operational and maintenance expenses.

The bonds do not benefit from a mortgage or security interest in the project assets.

The city owns and operates the system under the name FiberNet Monticello. The city had previously contracted management out to Hiawatha Broadband Communications Inc. but it resigned over the summer and the city then hired Cleveland-based FiberConnect Inc. to act as interim manager.

It also retained Gigabit Squared LLC as a broadband consultant. The consultant recently released a report with recommendations for future operations of the system but city officials are still reviewing it.

The system entered July with just one-third the number of customers projected in the bond offering documents. The system was mostly complete as of March, providing more than 1,000 voice lines, 1,000 video connections, and nearly 1,400 internet connections.

Private companies lowered their prices in response to the new competition, hurting the city’s ability to lure and keep customers.

While the city is not under obligation to repay the bonds from any source other than the system’s revenue, the indenture does require it to establish rates and charges from its users to cover debt repayment.

City financial reports note that the city failed to comply with that provision for the fiscal year ending Dec. 31, 2011. Such a move would likely cause more customers to turn to the competition. The reports showed the system’s expenses exceeded revenues by more than $2.6 million in fiscal 2011.

Monticello in March informed the trustee of the shortfalls and that it was considering halting supplemental payments. It raised the specter of a potential restructuring.

In June, the city posted an update on the project reporting that system revenues were insufficient to cover debt service and that it had decided to halt making its supplemental payments. It has made no payments from its own coffers or system revenues since May.

The trustee holds two reserves with $25,000 and $2.6 million and another $635,700 in a surplus account.

Under the indenture, the city must reimburse the trustee for fees and services and it gives the trustee a first-priority lien on the trust estate — which includes the reserves — to cover those expenses.

The trustee reported it has retained both a financial adviser and legal counsel and has requested reimbursement from the city for $200,000 in expenses.

Monticello reported in its own notices posted on EMMA earlier this year that it was “actively undertaking all reasonable actions and exploring all available options to make the system” financially successful while continuing to provide high quality services to its customers.

The city said it was exploring strategic options with the goal of reducing costs, improving revenues, restructuring or refinancing debt.

“The city will continue to work with you and keep you updated on the progress of its review and actions related to the operation of the system and debt restructuring efforts,” according to a city notice posted in June.

City finance director Wayne Oberg said Tuesday the city continues to explore “all available options” to repay the debt and keep the system viable.

In published reports, the city has defended its undertaking, which established the fastest internet system in the state, with affordable rates. Critics counter that broadband is not a core municipal service and might be best left to private companies.

For investors, the Monticello case presents a stark message.

“It’s a reminder to the investment community of the risks associated with a non-standard security pledge,” said Richard Ciccarone, chief research officer at McDonnell Investment Management. It enforces the need for assessing the soundness of a municipal pledge, the essentiality of a project, and the burden of honoring a pledge, he said. In the Monticello case, the pledge is to raise rates to cover debt repayment.

“Burden is in the eye of the beholder,” Ciccarone said of the difficulty in assessing such issues.

The city initially looked at establishing its own broadband network after complaints from businesses looking for improved and more affordable service, and initially hired a consultant to study its viability.

The subject was put to referendum in 2007 and it passed with a 74% majority in favor of the system.

The project hit its first major hurdle when Bridgewater Telephone Co., a subsidiary of TDS Telecom, filed a lawsuit seeking to have the bond issue voided.

Bridgewater, which was in the process of building its own fiber-optic network in Monticello, argued that the city had no authority under state law to issue bonds to fund a business that would provide Internet, cable television, and telephone services.

The company also argued that the use of an operating reserve fund to pay for current expenses violated state law. The courts dismissed the lawsuit.

About 150 communities across the country have created city-wide cable or fiber-to-the-home network, according to a recent article posted on Governing.com.

Such access may be critical for municipalities to compete for business and population but such systems face challenges in the form of private competition and financial hurdles. Some states also pose legislative hurdles to such publicly-owned systems. Some market participants said the best option is seeking a public-private partnership.

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