SAN FRANCISCO - Alameda, Calif.'s venture into operating a cable television operation bond financed with tax-exempt debt comes to an end this week - except for ongoing litigation with bondholders angry at taking a substantial haircut, and permanent financial impacts to the city-owned electric utility.

The cable TV venture is a decade old. Initially, leaders of the San Francisco bayside city of 75,000 thought of it as a way to take advantage of the utility's plans for laying fiber-optic lines throughout the city by creating a revenue-generating operation.

But Alameda's cable TV business failed to pan out, and the City Council voted this week to sell the system to Comcast, its prime competitor.

The sale will generate about $15 million to pay holders of 2004 bond anticipation notes that financed the completion of the system and refinanced its outstanding debt at the time.

Unfortunately for the investors, the outstanding principal is $33 million, so they will take a serious haircut.

That has resulted in federal litigation in which major investors - two Nuveen Investments high-yield tax-exempt funds and Pacific Specialty Insurance Co. - are alleging the city and underwriter Stone & Youngberg LLC fraudulently concealed material information about the true condition of the cable TV enterprise when the notes were sold. They say they are owed at least $11 million more.

Alameda Power and Telecom electric ratepayers will pay an even steeper price over time, because the electricity side of the business will never recoup almost $44 million of interfund loans advanced to the telecom enterprise.

The cable system - which also offered high-speed Internet services - was launched in 1998, when city voters approved a charter amendment allowing the utility to offer telecommunication services.

There were several reasons officials were interested in entering such a nontraditional venture, according to staff reports prepared for the City Council and Public Utilities Board in advance of their votes this week to sell the cable system.

At the time, Alameda was underserved by its incumbent cable provider, and the utility wanted to diversify its business in the face of plans to deregulate California's electricity market - a process that was later dialed back after the rolling blackout fiasco of 2000.

The city's cable venture experienced higher-than-expected construction costs, rising costs for programming, stiff competition on price and service from Comcast, and uncompetitive labor costs, according to the staff reports.

Alameda launched construction of the cable system with a $10 million equity investment from the city utility, plus a $16 million issuance of tax-exempt certificates of participation in 2000, maturing four years later.

To complete the telecom system and refinance its outstanding debt, the city, through the Alameda Public Financing Authority, in 2004 issued $33 million of tax-exempt bond anticipation notes slated to mature with a full balloon payment in 2009.

The notes were not rated, and they were priced in April 2004 to yield 7.25% at a time when five-year maturities were at 2.56% on Municipal Market Data's triple-A curve.

Alameda's telecom network was completed in 2005, and trouble was afoot as early as 2006, according to the staff reports, when the city hired a consultant to review the cable system's operations. The resulting cost cuts helped it earn a small operating surplus in 2007.

That small surplus did not come anywhere close to providing the kind of revenue the system would need to successfully refinance the Bans in 2009, according to a subsequent report from financial advisory firm Northcross, Hill & Ach Inc., which was retained by the city to review its options for dealing with the pending maturity of the Bans.

"No underwriter would market a refinancing of the telecom debt without a pledge of either electric system revenue or the city's general fund," the financial adviser reported to the city in February.

Officials had begun exploring a sale of the system, a process that culminated this week in the vote to sell the system to Comcast, in a deal that closes today.

The short sale required consent from at least 75% of the noteholders. They received consent from 95%, according to the city staff report, with the stipulation that they retained the right to sue the city to recover their losses.

The holders of the other 5% get paid in full, it said.

The consenting noteholders include the Nuveen High Yield Municipal Bond Fund, the Nuveen High Income Municipal Opportunity Fund, and Pacific Specialty Insurance, according to the staff report. Those three investors owned a combined $20.55 million in notes. (The insurance company was advised by Nuveen Asset Management Inc., according to court filings.)

Other consenting noteholders were the Bernard A. Osher Trust, which owned $8.95 million, and two PIMCO municipal bond funds that owned $2 million.

Alameda actually went to court first, filing a complaint in U.S. District Court in San Francisco against the Nuveen entities in October, seeking declaratory relief because, "instead of negotiating with the city in good faith, the noteholders have threatened litigation, claiming without any basis that they were not informed of the risks involved in their investment in the notes."

Later in October, the Nuveen funds and Pacific Specialty filed a counterclaim against several Alameda city government entities as well as Uptown Services LLC, which prepared a financial feasibility study for the 2004 note issue, and underwriter Stone & Youngberg.

"The city did not provide full disclosure of the material facts," their suit alleges.

While the official statement for the notes contains a lengthy recitation of risk factors, Nuveen alleges that Alameda failed to disclose that city officials already believed that the system was not economically feasible, could not compete with Comcast and satellite TV providers, and was unwilling to raise rates.

Furthermore, Nuveen argues in its filing, the city was motivated to issue the 2004 notes - which have no recourse to anything but cable system revenue - because it feared the terms of the $16 million in COP debt the city incurred in 2000 for the telecom system would give the lender, Citibank, the ability to access the assets of the utility's electric division to satisfy the debt.

In this week's staff report, city manager Debra Kurita said the 2000 telecom financing did contain a "firewall" protecting the electric division.

A city spokesman did not respond to a request for comment. In an e-mail, Nuveen spokeswoman Kathleen Cardoza said "we have no comment on pending litigation."

Nuveen's suit further alleges that Stone & Youngberg was aware of the Alameda's "fraud" and "provided substantial assistance to advance the commission of the fraud."

"Personnel at Stone & Youngberg LLC devoted substantial time and effort in performing due diligence with respect to its role in the sale of the revenue bond anticipation note offering at issue," the firm's attorney in the case, Robert Charles Friese, said in a written statement responding to a reporter's query.

"Moreover there appear to have been many public representations prior to the issuance of the notes, as well as the disclosures in the offering materials, that would seriously call into question the inclusion of the company in this litigation," he said. "Based on our examination to date the allegations against Stone & Youngberg appear to have no merit."

Between 1999 and 2007, the utility's electric services fund advanced $43.6 million to its telecom communications fund, with repayment scheduled to commence in 2020, according to Kurita's staff report.

"With the sale of the system, the interfund advances will not be repaid," the report said. "Adjustments to the electric services fund balance sheet will be made in conjunction with future recommendations from the auditors."

The utility's outstanding electricity revenue bonds have underlying A-minus ratings from Standard & Poor's and Fitch Ratings.

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.