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January 20, 2015
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A Small Borough Closes on a Big Lease of its Water and Sewer System: Lessons for Other Municipalities

by Timothy J. Horstmann and Adam L. Santucci

Reprinted with permission from the January 20, 2015 issue of The Legal Intelligencer
© 2015 ALM Media Properties, LLC.
Further duplication without permission is prohibited. All rights reserved.

On December 30, 2014, the Borough of Middletown, Dauphin County closed on a 50-year lease of its water and sewer system. Pursuant to this public-private partnership, United Water will operate, maintain and manage the system, but Middletown will retain ownership of the assets even after the contract term. Middletown’s lease of the system – often referred to as a “concession” in the industry – is the culmination of a years-long process to fashion a novel solution to the Borough’s substantial pension shortfall and avoid painful property tax increases or electric rate increases on Borough residents. The Borough’s selection of United as its system operator followed an open bidding process which attracted multiple suitors.

Pursuant to the terms of the lease, Middletown received an up-front payment of $43 million, and will receive substantial annual lease payments thereafter during the lease term. The total aggregate value of the deal is approximately $60 million. Using the up-front payment, the Borough resolved not only its pension deficit, but also retired all of its outstanding debt. For the first time in decades, the Borough greets a new year debt-free.

The Middletown concession is a model for how similar transactions can work for other Pennsylvania municipalities. We expect more public-private partnerships to be explored in 2015 as a means to address pension and other liabilities, to avoid painful tax increases or even simply as a means to generate revenue for key initiatives, such as redevelopment. For municipalities interested in exploring such a transaction, lessons can be learned from Middletown – most notably in the areas of labor, utility system infrastructure, and finance.

Labor. A primary consideration for decision-makers and deal makers in these transactions is the labor issue. Employees are a key stakeholder group and their concerns must be addressed early to ensure a transaction succeeds. Because in most cases the employees will be represented by a labor union, we focus our discussion on the issues associated with transitioning union-represented employees.

A municipality could consider furloughs for affected employees, but this approach is difficult if not impossible for several reasons. First, layoffs would be met with stiff opposition from a key and vocal stakeholder group. In addition, this approach likely would result in the subcontracting of bargaining unit work, which may be specifically prohibited by the applicable collective bargaining agreement. Even if the agreement does not address subcontracting, however, the municipality would be required to engage in bargaining, because under the Pennsylvania Public Employe Relations Act (“PERA”), subcontracting is a mandatory subject of bargaining. As a practical matter this means the municipality would need the union’s agreement prior to assigning the bargaining unit work to non-bargaining unit employees. Obviously, it is highly unlikely that a union would sign off on a plan resulting in wholesale layoffs.

Alternatively, the municipality could require the concessionaire to make offers of employment to all of the affected employees. In this scenario, the concessionaire likely would be considered a successor employer under PERA. As a successor employer, the concessionaire would be required to recognize the union as the representative of the employees and to bargain collectively with that union regarding the terms and conditions of employment of the employees. In addition, while bargaining, the parties would be obligated to maintain the status quo with respect to the terms and conditions of employment of the employees until a new agreement is reached or until the parties reach impasse.

In addition, a municipality may wish to go further than what the law requires in addressing the concerns of affected employees. Additional protections and/or benefits for employees could be required of the concessionaire as a term of the agreement between the concessionaire and the municipality. Although satisfying the concerns of affected employees may be difficult, the ability to offer job security, continued union representation, and consistency with respect to wages and benefits for a period of time are significant benefits that should go a long way in addressing the concerns of this key stakeholder group.

Infrastructure and Operations. Another prime focus in these transactions is the preservation and improvement of utility system infrastructure. This is accomplished through the preparation of operating standards, which set forth the municipality’s required methodology for system operation, upgrades and planned capital improvements, and an estimate of their annual cost. Well-drafted standards will address a variety of matters affecting the utility’s operations, including, in the water and sewer context, water quality management, annual pipeline rehabilitation and replacement, water loss and leak detection, valve and hydrant exercising, system pressure and flow parameters, sludge management controls, and meter testing, repair and replacement. Rigorous reporting requirements may also be included to ensure compliance with the benchmarks set forth in the standards, as well as applicable state and federal regulatory requirements. The ability to assess damages may also be included to effect remedial action and full compliance.

Tied closely to system preservation and improvement are guidelines that govern customer rates for the utility service. Decision makers can expect to hear loudly and clearly concerns from ratepayers. The good news is, these concerns can be addressed. For example, the agreement may provide for an initial “frozen” rate term and/or capped rate increases. Further, rate increases may be tied to a specified percentage plus an objective index. These provisions provide customer protection from rate shock and also provide certainty through a set framework for any necessary rate increases.

Finance. Finally, because in many cases municipal assets leased to a concessionaire were initially acquired using tax-exempt bond proceeds, a key focus of these transactions will be evaluating the use of transaction proceeds to ensure no detrimental tax impact. Under the Internal Revenue Code, a concessionaire’s use of municipal assets initially acquired using tax-exempt bonds may result in the bonds being declared taxable “private activity bonds” by the IRS. This determination is retroactive to the date the bonds were issued, and violates the covenants made by the municipality in the underlying bond documents.

In a public-private partnership where the concessionaire is a for-profit business, the transaction will generally run afoul of the Code’s private activity bond rules. Municipalities needn’t despair, however, as the IRS forgives otherwise “bad” use arising from such a transaction, if the municipality takes a “remedial action” with respect to the affected bonds. To be eligible to take a “remedial action,” the municipality must meet five requirements: (1) the municipality must have reasonably expected at the time the bonds were issued that they would not be private activity bonds; (2) the weighted average maturity of the bonds must not be greater than 120% of the expected economic life of the assets; (3) the terms of the transaction must be bona-fide and on an arms’ length basis; (4) any proceeds from the transaction must be treated as gross proceeds subject to arbitrage and rebate; and (5) the bond proceeds must have been originally spent on a valid governmental purpose.

If all five requirements are met, the municipality may then take a “remedial action” to avoid an adverse tax determination as to its affected bonds. In this context, the “remedial actions” generally available to municipalities are the “redemption” option and the “alternative use of proceeds” option.

A municipality electing the “redemption” option must use transaction proceeds to redeem the affected outstanding bonds. To qualify, the redemption must occur within 90 days of closing. If the bonds are not callable for redemption within that period, the municipality must instead establish a defeasance escrow into which it must deposit funds in an amount sufficient to redeem the bonds on the earliest call date and to pay any interest and principal due in the interim.

A municipality may instead elect the “alternative use of proceeds” option. Under this option, the municipality must use transaction proceeds for a tax-exempt purpose (e.g., the construction of a new fire station). The municipality must expect to spend the proceeds within two years. Any proceeds not spent must instead be used to redeem the bonds.

For municipalities in fiscal distress, a new year brings familiar tough choices and the prospect of increased taxes and dwindling services. A public-private partnership similar to the recent Middletown concession might be a viable path back to fiscal stability, and may help a small municipality address big problems. Municipal officials should talk with their financial advisors and attorneys to determine if such an option is right for them.

Timothy J. Horstmann and Adam L. Santucci are attorneys with the law firm of McNees Wallace & Nurick LLC in Harrisburg, and practice in the Firm’s Municipal Recovery group. The group advises fiscally-challenged municipalities in Pennsylvania, and calls on the experience of its attorneys in public finance, business, tax, labor, energy and infrastructure in crafting novel solutions to a municipality’s financial problems. The group’s attorneys represented Middletown in connection with the lease of its water and sewer system. Tim can be reached at thorstmann@mwn.com, and Adam at asantucci@mwn.com.