On June 29, 2012, the Bankruptcy Court in the Jefferson County, Alabama chapter 9 municipal bankruptcy case issued a decision in The Bank of New York Mellon, as Indenture Trustee, et al. v. Jefferson County, Alabama (Bankr. N.D. Ala. June 29, 2012) siding with creditors by limiting the County's use of revenues generated by its sewer system.
Bankruptcy Judge Thomas Bennett ruled that the County cannot deduct and set aside from the operating revenues of the sewer system reserves for estimated bankruptcy related professional fees and depreciation, amortization and capital expenditures.
The Bankruptcy Court let stand the parties' agreements in the Indenture as to the types of operating expenses that may be paid from the sewer system's revenues, which did not include the reserves sought by the County.
The Bankruptcy Court also held that section 928(b) of the Bankruptcy Code did not subordinate the pledge of the sewer system's revenues to these expenses. The decision is the first significant interpretation in chapter 9 of the meaning and scope of the "necessary operating expenses" under section 928(b) of the Bankruptcy Code that may be paid from "special revenues" ahead of the pledge to the creditors.
As a consequence, the Court has advanced the legal argument that, in chapter 9 municipal bankruptcies, bankruptcy courts should respect and protect a pledge of net special revenues.
In re Jefferson County, Alabama – Background
Jefferson County, Alabama filed for relief under chapter 9 of the Bankruptcy Code on November 9, 2011. Jefferson County's chapter 9 case is the largest municipal bankruptcy in U.S. history in terms of its liabilities.1
In large part, the chapter 9 filing resulted from the inability to pay the substantial debt incurred to finance the construction and repair of the County's sewer system. The sewer system debt took the form of a "special revenue" financing in which publicly traded warrants were secured by liens against the net revenues generated by the sewer system.2 The Indenture contains a net revenue pledge after payment of certain defined "Operating Expenses" of the sewer system. As is typical in these types of financings, the Indenture Trustee may look only to recover from the net revenues generated by the sewer system and has no recourse to the County or its general funds. The warrant holders are owed approximately $3.2 billion.
The Municipal Bankruptcy Amendments of 1988 (the "1988 Amendments") added several interrelated provisions to the Bankruptcy Code intended to provide for the uninterrupted payment of pledged "special revenues" to the secured lenders during a chapter 9 case. First, section 922(d) of the Bankruptcy Code provides that the automatic stay does not operate to stay the "application of pledged special revenues" to the debt obligations secured by the "special revenues." Second, section 928(a) provides that the revenues generated by the project or system post-bankruptcy remain subject to the pledge created in any pre-bankruptcy security agreement. Neither of these two features applies in a chapter 11 reorganization. The Bankruptcy Code, however, provides that a pledge of "special revenues" is "subject to the necessary operating expenses of such project or system…." 11 U.S.C. § 928(b) (emphasis added).
In the first skirmish early in the chapter 9 case, the Bankruptcy Court rendered a decision on January 19, 2012, ousting a state court appointed receiver from possession of the sewer system and its revenues.3 See In re Jefferson County, Alabama (Bankr. N.D. Ala. Jan. 6, 2012). At the same time, however, the Bankruptcy Court held that the net revenues remained subject to the Indenture Trustee's liens and the Indenture Trustee was entitled under sections 922 and 928 of the Bankruptcy Code to receive continued payment of the net revenues generated by the sewer system. The question of what types of expenses could be deducted by the County from the gross revenues was left open for consensual arrangement or later determination by the Court.
Almost immediately, a dispute arose between the County and the Indenture Trustee as to that issue. The County sought to deduct from the sewer revenues a reserve to cover estimated professional fees related to the bankruptcy and litigation with the warrant holders, as well as for depreciation, amortization and capital expenditures related to the sewer system. These deductions amounted to more than $4.5 million per month and would amount to $54 million per year. As a result, the Indenture Trustee commenced an adversary proceeding in the Bankruptcy Court seeking a declaration that these expenses could not be paid from the sewer system's revenues.
The Bankruptcy Court, therefore, was required to determine:
(a) whether the County's reserves for professional fees, depreciation, amortization and capital expenditures came within the definition of "Operating Expenses" in the Indenture such that they were permitted to be paid ahead of the amounts turned over to the Indenture Trustee, and
(b) if not allowed to be paid as a matter of the Indenture, whether these expenditures otherwise constitute "necessary operating expenses" that could be paid ahead of the Indenture Trustee by virtue of section 928(b) of the Bankruptcy Code.
Both the County and the Indenture Trustee argued that the matter could be resolved solely by reference to the Indenture and that there was no need to address the scope of section 928(b). To that end, the County took an expansive view of the definition of "Operating Expenses" in the Indenture such that the additional expenses were covered by the contractual agreements. As expected, the Indenture Trustee took a narrower view of the Indenture's terms. The Indenture Trustee further argued that section 928(b)'s priming of a "special revenue" pledge was applicable only to a gross pledge of all "special revenues" and had no application to a net pledge of "special revenues" left over after payment of contractually agreed operating expenses.
At the start of its Decision, the Court recognized that the result and analysis would have significant effect on larger issues in the case with respect to the County's likely use of the plan "cram down" provisions in the Bankruptcy Code, where the net present value of the warrant holders' collateral is of critical importance. The Bank of New York Mellon, as Indenture Trustee, et al. v. Jefferson County, Alabama, at 7. The Indenture granted the warrant holders what is commonly known as a "net revenue pledge" since the lien attached only to the sewer system's net revenues "that remain after payment of Operating Expenses." Id at 9. The pledge in the Indenture was not a pledge of all revenues, i.e. a gross revenue pledge. Given the net revenue pledge structure, the Bankruptcy Court noted that the amount of "Operating Expenses" that could be deducted by the County was significant beyond the immediate cash flow issue. Id. at p. 7. This is because the net present value of the warrant holders' collateral – the net revenue stream –for plan "cram down" purposes will be affected by the amount of "Operating Expenses" which act to reduce the extent of the collateral. The higher the Operating Expenses, the lower the amount of the monthly pledged net revenues, and vice-versa, which on a net present value basis can cause significant swings in the value of the net revenue stream. This is critical because the County ultimately may seek to invoke the "cram down" power and value the pledged net revenue stream, and thus the warrant holders' secured claim, under section 506 of the Bankruptcy Code at an amount that is less than the $3.2 billion owed and stretch out repayment of that lower amount in a chapter 9 plan of adjustment.4
The Terms of the Indenture – "Operating Expenses"
With that as a backdrop, the Court first embarked on a review of the terms in the Indenture. The Court found that the Indenture generally provided that the "Operating Expenses" under the Indenture were "made up of (a) reasonable and necessary expenses for the efficient and economical administration and operation of the sewer system, [and] (b) expenses of maintaining the sewer system in good repair and in good operating condition,…." Id. at p. 11. The Bankruptcy Court further found that the payment scheme in the Indenture requires that such "Operating Expenses" must be "due for payment in the current month or in a prior month." Id. at p. 14.
With respect to the County's reserves for depreciation, amortization and capital expenditures, the Bankruptcy Court held that such amounts could not be withheld because the definition of "Operating Expenses" expressly excluded "depreciation, [and] amortization" and such expenses were not payable in a current or prior month. Id. at pp. 14-16. The Bankruptcy Court further found that the parties' dealing confirmed this interpretation since (a) the County's pre-bankruptcy historical budgets and financial statements did not include reserves for depreciation, amortization or capital expenditures (or a proxy for such items) to be paid or withheld as "Operating Expenses" and (b) such items were never taken as deductions by the County out of the sewer system's revenues distributed to the Indenture Trustee. Id. at pp. 17-18.
The Bankruptcy Court came to a slightly different conclusion with respect to the reserve sought for professional fees. Here, the Court held that the County's reserve for estimated professional fees was not on account of any expenditures payable in the current or a prior month and, therefore, could not be deducted from the amounts turned over to the Indenture Trustee. Id. at pp. 18-19. At the same time, however, the Court declined to rule whether professional fees otherwise met the definition of "Operating Expenses" under the Indenture stating that such a ruling was unnecessary and there were insufficient details on the composition of the fees to make such a ruling. Id. at p. 19. The Court did state that the Indenture Trustee's contention that such professional fees were per se outside the definition was "too broad." Id.
In sum, the Bankruptcy Court held that the Indenture did not allow the County to deduct estimated reserves for depreciation, amortization and capital expenses and professional fees from the sewer system's revenues before turning such funds over to the Indenture Trustee. The ruling, however, appears to leave open the possibility that the County may be able to deduct professional fees actually incurred each month depending on the nature of such fees.
Section 928(b) – "necessary operating expenses"
Having decided the contractual matters under the Indenture, the Bankruptcy Court next turned to section 928(b) of the Bankruptcy Code to determine whether the County's requested reserves constituted "necessary operating expenses" that were senior under the statute to the Indenture Trustee's pledge of net revenues.
The Bankruptcy Court first rejected the Indenture Trustee's argument that section 928(b) was implicated only where there was pledge of gross special revenues. The Court held that section 928(b) applies to both net revenue pledges and gross revenue pledges. The Court noted that "what are Operating Expenses under the Indenture needs to achieve what § 928(b) was designed to ensure." Id. at p. 25. The Court found that the words "necessary operating expenses" were susceptible to multiple meanings or interpretations. Id. at p. 28. The language in the statute could mean only those expenses "absolutely required" to the operation of the system or those "important" to the system's operations, or something in between. Id. at p. 27. The Court, therefore, resorted to a review of the legislative history to determine the meaning of the statute.
As a general matter, the Court noted that the legislative history made clear that section 928(a) and other 1988 Amendments were intended to preserve the special revenue lenders' liens during the course of the bankruptcy case and "ensure that revenue bondholders receive the benefit of their bargain with the municipal issuer and that they will have unimpaired rights to the project revenues pledged to them." Id. at p. 30 (quoting the Senate Report for the 1988 Amendments). That "benefit of their bargain" must also be consistent with section 928(b), which provided that a pledge of special revenues is subordinate to certain operating expenses. Id. at p. 31. However, the Court held that there is nothing in the legislative history that would allow "municipal debtors ... 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." Id. at p. 33. That said, the Court expressly noted that this ruling did not impact a municipal debtor's ability to "alter aspects of pledged special revenues transactions" under other provisions of the Bankruptcy Code, including section 506 and the "cram down" provisions of section 1129. Id at n. 18. Thus, while section 928(a) generally mandated that the special revenue financing documents be respected during the bankruptcy case in order to maintain the status quo, the Court left open the very real possibility that a restructuring of special revenue debt could be achieved in a connection with confirmation of a plan of adjustment.
The Bankruptcy Court then delved into the legislative history surrounding the meaning of "necessary operating expenses" under section 928(b). According to the Court, the legislative history indicated that the standard is premised on "keeping the system or project operating to generate monies to repay the lenders and to deliver the intended service to customers" and such expenses represent a "minimum" that is "necessary and directly related to the project or system." Id. at pp. 34-35 (quoting and citing the Senate Report for the 1988 Amendments). The Court, therefore, held that "necessary operating expenses" under section 928(b) means expenses:
that are (1) expended to keep the system or project operating in the sense that the system or project is kept in good repair and generating special revenues, not improvements or enhancements, (2) directly related to the project or system, not unrelated, (3) some, but not all operating expenses, which flow from § 928(b) being a minimum standard, and (4) being paid, which is different from those that may be incurred and paid at a later time.
Id. (citing the Senate and House Reports for the 1988 Amendments).
As a result, the Court rejected the County's contention that capitalized expenses such as reserves for depreciation, amortization and capital expenses were "necessary operating expenses" under section 928(b). According to the Court, these are "not the sort of day to day expenses required to keep the sewer system operating for the relatively short time between the filing of the County's bankruptcy and a final resolution of the case." Id. at p. 37. The Court held that "adopting the County's view as the standard embedded in § 928(b) allows an end run around what was the overall purpose of the 1988 Amendments. This occurs because it would significantly alter the agreed scope of the lien against special revenues along with the contracted for distribution of pledged special revenues to a degree beyond what the legislative history indicates was the purpose of the 1988 Amendments." Id. at p. 38.
In the end, the Court held that it would not upset the net revenue pledge and the definition of "Operating Expenses" provided in the Indenture since the contractual terms at least met section 928(b)'s minimum requirements. Section 928(b) subordinates the lenders' pledge only to those expenses that allow:
a project to be in good condition to enable it to keep 'going' to 'generate revenues to repay bondholders' and to provide services to the system's or project's customers. It is not a standard that requires 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 supercede the overall purpose of the 1988 Amendments other than in a lowest denominator sort of way.
Id.at p. 39.
The Court went on to say that in the context of net special revenue pledges – as opposed to gross revenue pledges – the Court should generally defer to the "distributive design representing the business judgments of the parties that is expressed in the contract between them" since at the time the financing documents were executed both the interests of the lenders and the municipality were aligned in ensuring that adequate operating expenses were paid such that the system remained in good condition sufficient to generate the requisite revenue to repay the debt. Id. at p. 40. In sum, the Court held that "the Operating Expenses to be paid within any given month exceed the minimal standard of § 928(b)." Id. at p. 42 n. 24. Accordingly, the Court held that section 928(b) did not apply to subordinate the pledge of net special revenues to the reserves sought by the County.
In this and its earlier decision, the Bankruptcy Court in Jefferson County, Alabama confronted the structure and meaning of the "special revenue" provisions in the 1988 Amendments. There is little case law authority in chapter 9 generally and, therefore, the Court's rulings will have an impact in other chapter 9 cases. The Court's decision provides the following guideposts:
- The 1988 Amendments related to "special revenue" financings are designed to leave uninterrupted the lenders' right to the special revenues to maintain the status quo during the course of the chapter 9 case.
- While section 928(b) applies to both net and gross revenue pledges, the Court should defer to the parties' contractual arrangements where they provide for the payment of operating expenses out of special revenues.
- The "necessary operating expenses" in section 928(b) that prime a special revenue pledge represent a minimal standard constituting those expenses that are necessary to keep the system in good condition so that it may continue operating and generating revenue to pay the lenders and provide service to the customers.
- Most importantly, the 1988 Amendments do not override other provisions of the Bankruptcy Code that may be used by a municipal debtor to impair special revenue claims and liens in the plan process in connection with the debtor's exit from bankruptcy, i.e., the power to value the special lenders' secured claim downward under section 506 and use the "cram down" power in section 1129 to restructure the secured claim.
Finally, the Court's decision in Jefferson County, Alabama confirms the customary "bond opinion" given in public finance transactions. It is common for the political subdivision incurring or issuing the financial obligation to provide to the related lender or purchaser a legal opinion (often referred to as a "bond opinion") that covers, among other things, the instrument (e.g., an indenture or a bond resolution) that creates any pledge of security for the repayment of that financial obligation. The lender (or purchaser) often expects such an opinion to address not only the valid and binding nature of the instrument, but also to address whether the instrument creates a valid pledge. Of course, such opinions usually indicate they are qualified to the extent that enforceability is limited by applicable bankruptcy or similar laws affecting creditor rights generally. The Bankruptcy Court in Jefferson County, Alabama, in the context of a pledge of net special revenues, has gone a long way in advancing the legal argument that bankruptcy courts should respect and protect a pledge of net special revenues during the course of the bankruptcy case, thereby adding significance to bond opinions.
This article was prepared by David A. Rosenzweig (email@example.com or 212 318 3035) and Stanford G. Ladner (firstname.lastname@example.org or 212 318 3212) from Fulbright's Municipal Bankruptcy & Insolvency Practice.
 Stockton, California recently filed chapter 9, and it is being reported as the largest U.S. city in terms of population to have sought such relief. Jefferson County's population exceeds Stockton's population.
 "Special revenues" are defined in chapter 9 to include "receipts derived from the ownership, operation, or disposition of projects or systems … that are primarily used or intended to be used primarily to provide transportation, utility or other services…." 11 U.S.C. § 901(2).
 The Indenture Trustee secured the appointment of a receiver by an Alabama State Court in September 2010. The receiver had been operating the sewer system and maintaining control over the revenues for more than two years since his appointment.
 A special revenue lender would not have an unsecured deficiency claim for the difference since (a) special revenue financings usually are non-recourse and (b) in any event, the Bankruptcy Code provides that special revenue lenders shall not be treated as having recourse pursuant to section 1111(b) of the Bankruptcy Code, which applies in a chapter 11 case. 11 U.S.C. § 927.