On June 29, 2012, Judge Thomas B. Bennett of the Bankruptcy Court for the Northern District of Alabama held that operating expenses as determined under Jefferson County's sewer warrants indenture do not include (i) a reservation for depreciation, amortization or future expenditures or (ii) an estimate for professional fees and expenses and that the monies remaining in the sewer system's revenue account after the payment of actual operating expense should be paid to the warrant holders in accordance with the Indenture. This decision represents an unequivocal win for special revenue lenders because it ensures that special revenue bonds will continue to be secured and serviced in accordance with the underlying indenture during a municipality's Chapter 9 case. The Bank of New York Mellon v. Jefferson Co., Ala. (In re Jefferson Co., Ala.), Case No. 12-00016-TBB (Bankr. N.D. Ala. June 29, 2012).
The County's financial problems stemmed primarily from approximately $3.6 billion in warrants the County issued to overhaul its sewer system. For a detailed account of the events leading to the County's Chapter 9 case, see Jefferson County: The Bankruptcy Court Always Wins.
The specific issues raised in this adversary proceeding relate to the Court's January 6, 2012 opinion, which found that the state court receiver lost jurisdiction over the sewer system when the County filed for Chapter 9. Following that decision, the County sent the Indenture Trustee for the holders of the special revenue sewer warrants a notification stating that the County was withholding sewer revenues that are asserted by the County to be included as operating expenses under the indenture or as necessary operating expenses under section 928(b) of the Bankruptcy Code. The County asserted that it would reserve the following expenditures from payments to the bondholders: (1) maintenance expenditures; (2) project expenditures; (3) professional fees and related costs; (4) depreciation, amortization and future expenditures and (5) extraordinary items. The Court estimated the these operating expenses could reduce payments to the Indenture Trustee by as much as $100,000,000 throughout the course of the County's Chapter 9 case.
In response, the Indenture Trustee filed a motion for declaratory judgment asking the Court to find (i) that the Indenture's distribution scheme for the County's sewer revenues governs the retention of necessary operating expenses, (ii) that section 928(b) of the Bankruptcy Code is inapplicable to the current dispute, and (iii) that the County may not withhold payment of monies on account of disputed categories of "operating expenses."
Judge Bennett's opinion touches on both the direct issue before him – what expenditures constitute operating expenses that the County can deduct from payment streams otherwise dedicated to the payment of principal and interest payments on the warrants – and the interplay between the Indenture and the provisions of the Bankruptcy Code related to special revenue bonds in Chapter 9 generally and section 928(b) specifically.
The Court holds that the expenses associated with maintaining the sewer system in good repair constitute "Operating Expenses."
The Court began by focusing its analysis on the provisions of the Indenture that permit the County to pay Operating Expenses prior to the payment of principal and interest. The Indenture defines Operating Expenses to include:
(a) the reasonable and necessary expenses of efficiently and economically administering and operating the [sewer] [s]ystem . . . (b) the expenses of maintaining the [sewer] [s]ystem in good repair and in good operating condition . . . and (c) the fees and charges of the Trustee.
Section 11.1 of the Indenture states that on the last day of each month, the County shall apply funds in the reserve account for payment of principal and interest, first to payment of all Operating Expenses "that are then due and were incurred during the then-current or in any preceding calendar month." Based on the plain language of the Indenture, the Court held that for an Operating Expense to be paid out ahead of principal and interest, the Operating Expense "must have been both incurred plus due for payment" at the time of the payment of principal and interest.
Here, the County sought to reserve funds for, among other things, future professional fees, depreciation, amortization and future expenditures, that, under GAAP, are chargeable to a fixed capital account when the sewer system is in good repair. Applying Section 11.1 of the Indenture, the Court held that these expenditures are not Operating Expenses under the Indenture because they have not yet been incurred.
The Court holds that "Necessary Operating Expenses" are narrower than the Operating Expenses in the Indenture.
The second dispute centered on the County's assertion that section 928(b) of the Bankruptcy Code permitted the County to reserve greater payment amounts from funds allocated to principal and interest payments than the Operating Expenses reserve provided for in the Indenture. Section 928(b) states that any lien on special revenues "shall be subject to the necessary operating expenses of such project or system. . . ."
The court analyzed the meaning of "necessary operating expenses" in section 928(b) and attempted to harmonize the term with the provisions requiring the payment of "Operating Expenses" under the Indenture. The Court focused on the history and nature of Chapter 9 and particularly on the amendments creating sections 922(d) and 928. Congress added these provisions in 1988 because the original Chapter 9 adopted in 1978 did not take into account the rise of special revenue municipal finance.
Section 928(a) creates consensual liens against special revenues, while subsection (b) provides a carve out for necessary operating expenses. Because the Bankruptcy Code does not define the term "necessary operating expenses," the Court looked to legislative history to determine the significance of this phrase. The legislative history indicated that the 1988 amendments were "designed to keep the framework of special revenue financing unaltered by the provisions addressed by the 1988 amendments. . . . What was envisioned to happen first is the use of special revenues to keep the system or project operating followed by payment of interest and principal to lenders." Based on this legislative history, the Court found that an expense is a "necessary operating expense" under section 928(b) if it keeps "the system or project operating to generate monies or repay the lenders and to deliver the intended service to customers." The Court also found that there is no indication "that municipal debtors were to be given the ability through §928(b) to significantly restructure the contractual agreements for the lien against special revenues or the distribution of monies to secured creditors."
In this case, the Court held that the definition of Operating Expenses in the Indenture included all "necessary operating expenses" under section 928(b). Consequently, the Court held that section 928(b) of the Bankruptcy Code did not modify the waterfall detailed in the Indenture, concluding that:
Recalling . . . the overall purpose of the 1988 Amendments and the standard set by §928(b) allows one to learn how they work in harmony. What this Court has identified as the overall purpose is leaving pledges of special revenues in municipal special revenue financing unaltered unless a pledge would cause a system or project to fail to meet the minimum for §928(b)'s subordination to be invoked. The standard is that which allows a project or system to be in good condition to enable it to keep going to generate revenues to repay bondholders and to provide the services to the system's or project's customers. It is not a standard that requires the best conditions, it is not one that contemplates that all possible costs of operation should be incurred and it is not one that was designed to supersede the overall purposes of the 1988 Amendments other than in a lowest denominator sort of way. [Internal quotations omitted]
Accordingly, the Court found that it should not interpret "necessary operating expenses" more broadly than the parties agreed under the Indenture because the Indenture reserves operating expenses sufficient to maintain the sewer system.
This case is a matter of first impression, and thus will have immediate influence in other Chapter 9 cases – including the Stockton, CA bankruptcy filed earlier this month and San Bernardino, CA's potential bankruptcy filing. Following this decision, municipal debtors likely will not be able to reserve cash for expenditures that is otherwise dedicated to the payment of special revenue bonds – except to the extent permitted in the applicable indenture.
More broadly, the Court made clear that the intent of sections 928(b) and 922(d) of the Bankruptcy Code is to protect the special revenue financing system and to ensure that it continues to operate during bankruptcy in the same fashion as it operates outside bankruptcy. The Court's sweeping pronouncements regarding the Chapter 9 "safe-harbors" for special revenue bonds are likely to hamper municipalities' efforts to reduce or alter payments to special revenue lenders during the pendency of a Chapter 9 case. For these reasons, this decision bolsters special revenue lenders in their efforts to collect principal and interest in bankruptcy and should give the municipal bond market comfort that courts will respect the terms of special revenue indentures – even when municipalities enter the uncharted waters of Chapter 9.
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