U.S. Bankruptcy Court Judge Thomas Bennett last month upheld the Chapter 9 bankruptcy filing of Jefferson County, Alabama, the largest municipal bankruptcy case in history. As has been widely reported, the County’s financial woes were precipitated by the disastrous funding of upgrades to its sewer system. Not surprisingly, given the billions of dollars at stake and the lack of applicable Chapter 9 precedents, the Jefferson County case has already produced a torrent of briefs and two extensive opinions from Judge Bennett. The main antagonists in this case – the County one side, and a group comprised of the holders of the County’s sewer warrants (the “Sewer Warrants”), the Indenture Trustee for the Sewer Warrants, the monoline insurers of the Sewer Warrants, and the state court appointed receiver for the sewer system (the “Sewer Warrant Parties”), on the other – have already fought bitterly over the County’s eligibility to be a debtor under Chapter 9, and over which party – the County or the receiver – would maintain control of the sewer system during the Chapter 9 case. The County has prevailed in both battles.     

The two sides are now preparing to square off again next week on another crucial issue for which there exists no caselaw guidance. Section 922 of the Bankruptcy Code permits the holders of bonds or warrants that are secured by “special revenues”, such as those generated from the Jefferson County sewer system, to continue to receive payment from the application of such revenues during the course of a Chapter 9 case. However, Section 928(b) provides that the lien on such revenues is subject to the sewer system’s “necessary operating expenses”. With no governing definition as to what constitutes “necessary operating expenses” in the Bankruptcy Code and no previous court rulings on the scope of Section 928(b), the two sides predictably have staked out positions at opposite poles. 

The parties agree that “Operating Expenses”, defined in part under the Indenture governing the Sewer Warrants as “the reasonable and necessary expenses of efficiently and economically administering and operating the [Sewer] System”, should be deducted from the sewer revenues collected by the County before payment to the holders of the Sewer Warrants. The dispute centers on certain specific categories of additional expenditures that the County now wants to subtract, including what a Joint Statement filed by the parties describes as “maintenance expenditures”, “project expenditures”, “professional fees and related costs”, and “reserves for depreciation and amortization and for future operating and/or capital expenditures”. Prior to the Chapter 9 Case, the Indenture Trustee was receiving $9.6 million each month to pay over to the holders of the Sewer Warrants. According to the Sewer Warrant Parties, the additional deductions sought by the County would reduce this amount to $4.25 million.   

In an 83 page brief, the County forcefully argues that the statutory term “necessary operating expenses” in Section 928(b) must be read more broadly than the Indenture definition of “Operating Expenses”, and permits the County to withhold amounts evidencing the disputed expenditures. The Sewer Warrant Parties, with equal vigor and nearly equal length, assert that Section 928(b) must be read narrowly, that the statutory term “necessary operating expenses” encompasses what they describe as “the commonly used definition of ‘Operating Expenses’” under the Indenture, and that the County improperly seeks to use the Bankruptcy Code to reduce the payments properly due to the sewer warrant holders. 

The County’s argument regarding expenditures for “professional fees and related costs” provides an interesting twist, particularly given the contentiousness of the case so far. The County believes that such expenditures should include litigation costs incurred with respect to the Sewer Warrants in the Chapter 9 case. The County thereby wants to deduct as “necessary operating expenses” under Section 928(b) its own legal expenses from the sewer revenues otherwise payable to the holders of the Sewer Warrants. Because the holders of the Sewer Warrants have no recourse to any County revenues or assets other than the sewer revenues, they effectively would find themselves paying the County’s legal costs out of their own pockets.    

Corporate debtors in Chapter 11 cases typically must pay the legal costs and expenses of their secured lenders. This customary feature of loan documents acts to discourage debtors (or other parties acting on behalf of a debtor’s estate) from pursuing litigation against lenders, as the debtor’s estate funds the litigation costs of both sides. The County’s gambit, if successful, would turn this dynamic completely on its head, and could significantly alter the direction of the Chapter 9 case.