Latest JeffCo Legal Strategy Could be Used by Others in Chap. 9

BRADENTON, Fla. — Jefferson County, Ala., has set the stage for yet another novel approach in its Chapter 9 bankruptcy with a proposal to reject a lease securing warrants that were sold to build a courthouse, a jail, and a 911 emergency communication system.

The strategy could backfire.

However, if successful, it could set a precedent for debt-secured leases to be rejected by other municipalities in Chapter 9.

The Jefferson County Public Building Authority sold $86.75 million of lease-revenue warrants in 2006 insured by Ambac Assurance Corp. About $82.5 million of the warrants are still outstanding with a final maturity in 2026.

The limited-obligation debt was secured by a pledge of revenues derived from leasing the facilities to the county, and the county’s payment of the lease is subject to annual appropriation, according to the official statement.

The funding source for the lease is described in the official statement as coming from a variety of revenues flowing into the county’s general fund, including the occupational tax that has since been struck down by Alabama courts.

In a motion filed last week with the court, the county said it does not have enough money to pay for the lease and essential government services. The county reportedly is in discussion to lease a vacant mall for some court facilities because it would cost less than the bond-finance facility.

“The Alabama Legislature has failed to lawfully enact a statute to replace the county’s lost revenue from that [occupational] tax,” according to the motion asking federal Judge Thomas Bennett to allow the county to use the bankruptcy code to reject the lease.

The proposed rejection appears to be an attempt to force the state to provide funds for the county, or risk having no place for the state court to sit in Jefferson County, said John Whitlock, a partner at Edwards Wildman Palmer LLP.

“Like so many issues in this case, it is really another facet of the fundamental political dispute over funding of government services in Jefferson County and the decisions by the state of Alabama,” Whitlock said. “Whether the bankruptcy code will be a solution or lead to a solution remains to be seen.”

In general, a debtor in reorganization under the bankruptcy code is given considerable leeway to exercise business judgment to reject leases, he said.

If the court finds that the lease is a true lease, the county would have a strong case to allow the rejection even though there may be strong policy arguments against essentially closing the local courthouse, according to Whitlock.

The county has said that it is not required to keep the courthouse, located in the city of Bessemer, open.

Most judges and court workers, who are employees of the state, would be moved to downtown Birmingham, which is the county seat.

Jefferson County already defaulted on the lease-revenue warrants in March by failing to make a $6.2 million debt-service payment.

Funds from the $8 million reserve account were used to make the payment.

The remaining $2 million in the reserve is expected to be used toward the October payment, with Ambac potentially making the remainder of the payment.

Attorneys said in court documents that they already negotiated “in good faith” with the bond insurer in an attempt to reduce Jefferson County’s obligation under the lease, but they were unsuccessful.

Ambac, whose parent company Ambac Financial Group Inc., filed for Chapter 11 bankruptcy in November 2010, has not responded in court filings to the county’s motion to reject the lease.

Ambac also insures a portion of the county’s defaulted school and sewer system warrants.

“We’re not going to comment on this case right now,” said Michael Fitzgerald, managing director of investor relations at Ambac. “As it relates to fulfilling our obligations, if we receive a valid claim under a general account policy we have been honoring and expect to continue to honor such claims with payment.”

While warrant holders appear to be protected by virtue of insurance, Whitlock said Ambac will be the “true economic party in interest” on the warrants, and the insurer would become an unsecured creditor if called upon to pay claims.

Ambac could contest the right of the county to reject the lease, saying that it is a form of capital lease instead of a true real estate lease, he said.

“One basis for such an argument would be the $1 purchase option at the end of the lease,” said Whitlock, who reviewed documents filed with the court. “Assuming the courthouse would be expected to have substantial value at the end of the scheduled term of the lease, the $1 purchase option would be a bargain purchase option, which is more typically associated with a capital lease rather than a true lease.”

If Bennett allows the debt-secured lease to be rejected, Ambac would become an unsecured creditor to be paid in accordance with the county’s plan of adjustment, he said.

The insurer could be looking at a loss if the value of the debt-secured lease is calculated similarly to the way the value is calculated for a true real-estate lease.

“The interesting thing about real estate…leases is that the bankruptcy claim for unpaid future rent is limited to the rent for the greater of one year, or 15%, up to three years of the remaining term of the lease,” Whitlock said. “It is interesting that the county chose to seek to reject the lease in bankruptcy rather than just moving out and giving notice of non-renewal.”

If the lease is rejected, calculating the damage claim will “also raise interesting issues of what the remaining term of the lease should be,” he said.

A potential source of recovery to pay Ambac, or the warrant holders if the bonds were not insured, is the lease termination damages claim against the county.

If the court allows the lease to be rejected, it would set a precedent, Whitlock said, adding that there is a substantial amount of case law on the rejection of leases typically used in Chapter 11 bankruptcy that should generally apply in situations involving Chapter 9.

Jefferson County is a pioneer, according to Matt Fabian, managing director at Municipal Market Advisors, referring to the potential impact its legal maneuver could have on other municipal debt-secured leases.

“You’d assume that the rating agencies and others would begin to require a different set of covenants and protections for lease bonds if they are seen as easily dischargeable in bankruptcy,” Fabian said.

Jefferson County filed for Chapter 9 bankruptcy last November after losing the occupational tax, which provided a significant source of revenue for the general fund, and after being unable to negotiate restructuring of $3.1 billion of sewer warrants. Lawmakers have refused for several years to replace the tax revenue. This week, the Jefferson County Commission voted to close the indigent care hospital as part of a cost-cutting strategy.

Bennett has scheduled a hearing in Birmingham on Sept. 13 to consider the county’s motion to reject the courthouse lease.

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