Vermont's biggest city is a prosperous place, but its government's credit woes don't reflect that.

Moody's Investors Service gives speculative ratings to two of Burlington's certificate of participation issues, and it gives the city government's senior debt a barely investment grade Baa3, with a negative outlook.

The primary problem Burlington faces stems from a city controlled telecom operation that went awry, leaving the city in a major dispute with lender Citibank.

In the last few weeks talks between the parties have broken down, upping the financial ante for Burlington.

Citibank is determined to hold the city's feet to the fire, according to its lawyer.

With an unemployment rate of just 3.4% as of March, Burlington has a vigorous economy. But its struggle with Citibank could have a profound negative impact on the city's finances.

In the middle of the past decade Burlington built a high speed internet, television and telephone network, initially for city government buildings and schools. The city owned enterprise overseeing the network, Burlington Telecom, BT for short, then branched out to commercial users.

Burlington financed the first two phases of building with a lease-purchase agreement with Koch Financial.

In a lease-purchase agreement, a financial institution pays to build infrastructure up front. A municipality makes lease payments each year for a number of years until the money is paid off, at which time the municipality has the option to take ownership. However, if the municipality misses a payment the agreement is cancelled, it is required to disassemble the infrastructure and return it to the financial institution.

In this case the lease was for 20 years. In 2007 Burlington put out a request for proposals to refinance its $22 million arrangement with Koch. The government requested additional money to expand the system to a variety of residential and commercial users.

Citibank Municipal Finance paid off Koch and gave an additional $11.5 million to Burlington for the build-out, said Kevin Fitzgerald, attorney for Citibank.

Fitzgerald said Burlington misrepresented its circumstances to Citibank Municipal Finance, which has since been succeeded by Citibank.

But city officials, including Mayor Miro Weinberger, dispute Citibank's account of the situation.

"There is no 'BT debt' to Citibank," the mayor said.

In the middle part of the decade, without the approval of the city council, city leaders had used $16 million of general fund money for a variety of city expenses, Fitzgerald said. The leadership used $7 million of the $11.5 million from Citibank loaned for expanding the network to reimburse the general fund, Fitzgerald said.

"They were just chasing money," Fitzgerald said. "Sort of in the nature of a Ponzi scheme."

In the agreement that Burlington signed with Citibank in 2007, Fitzgerald said the city said it could use its general fund to support Burlington Telecom, though in 2005 the Vermont Public Service Board had told the city government that it could not do so.

In 2010 the public service board reiterated Burlington was not to use any general fund money to support Burlington Telecom.

BT was not bringing in enough money to make the lease payments. After making a partial lease payment in the third quarter of 2010, the city council decided to stop making payments on the lease.

Citibank moved to exercise what it saw as its rights under the original lease-purchase agreement, launching a process that involved mediation. In mid-May the mediator declared that the process was completed without an agreement having been reached, said Burlington city attorney Eileen Blackwood.

The judge in the United States District Court for Vermont currently expects the case to go to trial in January, Blackwood said.

The breakdown of the mediation is a credit negative for Burlington, Moody's analyst Nicholas Lehman wrote on May 20.

Based on what it claims were Burlington's misrepresentations to it, Citibank is seeking the return of the money it gave to Burlington for the network build-out. It is also asking the city to de-install the network and return it to Citibank. Finally, it wants Burlington to pay it a fair rental payment for its use of the equipment since the agreement was terminated in 2010.

In total it is seeking more than $40 million, equivalent to 30% of the total fiscal 2012 government activities expenditures for the city of 42,000.

"We need to stick to our guns about disassembly," Fitzgerald said. "To not do so would destroy the fundamentals of the municipal marketplace."

As Fitzgerald portrays it, Citibank has no choice.

"You can't not enforce the leases as Citibank is trying to do," Fitzgerald said. "Otherwise you've created a precedent where other borrowers would be incentivized to do the same thing [as Burlington]."

The city government has repeatedly made clear that it does not want to disassemble the network.

"I think the fiber optics that Burlington Telecom put down is a vital economic development asset for us," said Burlington Councilwoman Jane Knodel. "It's a competitive advantage for us…. My overall goal is to preserve that asset."

Knodel said she also wanted to retain a meaningful level of public ownership of the asset.

Burlington Mayor Miro Weinberger strongly disputes Citibank's portrayal of the dispute.

"In stark contrast to a general obligation bond, the annual appropriation lease executed between Burlington and Citibank explicitly stated that it was not backed by the full faith and credit of the city," he said. "Fundamentally, when the deal was struck, Burlington taxpayer dollars were not to be used to pay for operating losses of BT. This was a basic tenet of the agreement …. The fact that the terms of that original deal still govern the city's interactions with Citibank and greatly limit what payments the city can lawfully make to Citibank is in no way an indication of the city's lack of creditworthiness."

While the recent mediation process failed, Burlington is still open to the possibility of a settlement, he said.

Burlington has lots of financial pluses, Knodel said. Once the city can put the Burlington Telecom mess behind it, the rating will reflect the strong fundamentals.

If a court orders Burlington to pay Citibank money, Knodel said she could not rule out voting for higher taxes for Burlington.

The city's water and wastewater funds have drawn money from the General Fund in recent years. Moody's noted this as a credit negative for the city.

Weinberger said that the city has increased its water and wastewater rates. The city plans to greatly reduce their draw from the General Fund by the end of fiscal 2014, Weinberger said.

In April the city sold a $9 million long-term bond that will eliminate its recent dependence on the sale of tax anticipation notes, Weinberger said.

Burlington has about $106 million debt outstanding.

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