United States: Municipal Water And Sewer Authorities: When Wall Street Comes Knocking

Last Updated: June 18 2018
Article by Kevin Kent and Brittany Gigliotti

This article originally ran in The Legal Intelligencer on January 31, 2018.

It has been a year and a half since Pennsylvania's Fair Value Legislation, Act 12 of 2016, 66 Pa. C.S. Section 1329 (Act 12) went into effect in June 2016. Since Act 12's enactment, Pennsylvania has seen an uptick in investor-owned utilities' (IOUs) attempts to privatize municipal water authorities, and IOUs have publicized their plans to focus on "growth through acquisition." IOUs are seeking to convince municipalities—particularly cash-strapped municipalities—that liquidating the assets of their municipal water authorities provides money in the short-term that can be used in a municipality's general fund or to pay down debt.

The enactment of Act 12 followed the water crisis in Flint, Michigan. The act was touted as a way for municipal authorities facing mounting infrastructure upgrades to sell their assets to a private utility better equipped to finance necessary upgrades. Act 12 made it easier for private utilities to acquire municipal water authorities, because it allowed private utilities to offer higher prices for water system assets. Specifically, Act 12 permits IOUs and other entities regulated by the Pennsylvania Public Utility Commission (PUC) to value municipal water authorities' assets for rate-making purposes at the lesser of the fair market value or the negotiated purchase price. Under the previous rule, the value of a municipal water system for rate-making purposes was based on a depreciated original cost, which would generally result in a lower sale price than fair market value.

Although Act 12 gained support on the basis that it permits ailing municipal water authorities to sell aging infrastructure at a better cost, the act does not specify that a municipal authority must be struggling to consider a sale. Thus, since Act 12's passage, IOUs have been expanding their focus and setting their sights on purchasing the assets of viable water utilities that need little infrastructure upgrades or are well-equipped to finance them. Whether the water utility itself pushes for monetization, or the "incorporating municipality" threatens to terminate and monetize a water utility without the utility's approval, monetization of a water system is an attractive short-term option for a city seeking access to funds or struggling to balance its budget. It may not, however, be in the best interests of present or future utility ratepayers.

Notwithstanding Act 12, a sale of a viable municipal water authority risks costly litigation, separate and apart from the traditional PUC and regulatory approval process, due to changes to the Pennsylvania Municipality Authorities Act, 53 Pa. C.S.A. Ch. 56 (PMAA), which governs municipal authorities, and the interpretation of Article I, Section 27 of the Pennsylvania Constitution, also known as Pennsylvania's Environmental Rights Amendment (ERA). These changes have created uncertainty as to whether a proposed sale of a viable municipal authority is even valid, particularly if there is a perception that the sale is not in the public interest. Uncertainty surrounding the requirements of the ERA and the PMAA and could result in considerable regulatory and legal costs, have significant public relations impacts, and could tie up proceeds received from any proposed sale.

The ERA

If a commonwealth entity considers a proposed sale of a viable water authority under Act 12, it will likely have to account for its fiduciary obligations under the ERA.

The ERA states: The people have a right to clean air, pure water, and to the preservation of the natural, scenic, historic and esthetic values of the environment. Pennsylvania's public natural resources are the common property of all the people, including generations yet to come. As trustee of these resources, the commonwealth shall conserve and maintain them for the benefit of the people.

The ERA provides Pennsylvania citizens or municipal authorities with a private cause of action in the event a commonwealth entity—such as a municipality—breaches its terms.

The ERA was adopted in 1971, however, until recently, Pennsylvania courts' interpretation and enforcement of the amendment was largely deferential to the legislative and executive branches of government. For over 40 years, courts did not strike down a single government action as violative of the ERA.

Recently, the Pennsylvania Supreme Court breathed new life into the ERA, first with its plurality decision in Robinson Township v. Commonwealth, 83 A.3d 901 (Pa. 2013), and more recently with its June 2017, majority opinion in Pennsylvania Environmental Defense Foundation v. Commonwealth (PEDF), 161 A.3d 911 (Pa. 2017). Following Robinson Township and PEDF, the Pennsylvania Supreme Court interprets the ERA as establishing a public trust wherein public natural resources—i.e., pure water—are the corpus of the trust, commonwealth entities (including municipal authorities) are the trustees, and the people are the beneficiaries. Commonwealth entities have a fiduciary duty to "conserve and maintain" these resources for the benefit of the people, including "generations yet to come" and they "cannot be shortsighted." The Supreme Court further noted "the trustee may use the assets of the trust 'only for purposes authorized by the trust or necessary for the preservation of the trust; other uses are beyond the scope of the discretion conferred.'" The court further found that proceeds from sales of trust assets must remain part of the trust and be used only for conservation and maintenance purposes.

Viewing PEDF in light of a proposed sale of a viable municipal water authority to an IOU, government entities have Constitutional duties as trustees to preserve public natural resources and not to be shortsighted. A municipality seeking to sell the assets of a viable municipal authority may have to contend with a Constitutional challenge premised on arguments that a sale could lead to: higher rates to ratepayers, loss of revenue for the areas served by the water authority over the long term, a purchase price for the assets that is much less than the actual value of the system, no gains in efficiency following privatization, or a permanent loss of local control over a viable public resource.

Further, because PEDF states proceeds from a sale of the assets of natural resources, such as water, must remain part of the trust and be used only for conservation and maintenance purposes, placing proceeds from a sale in a municipality's general fund could constitute an ERA violation. Perceived ERA violations provide ratepayers with a direct cause of action, and the effect of an ERA challenge on the sale of a municipal authority is uncertain, as it has yet to be litigated. Such litigation could take years to proceed through the courts and, in the meantime, could halt a municipality's ability to use the monetized assets in its general fund.

The Pennsylvania Municipality Authorities Act

In 2016, Pennsylvania American Water purchased the assets of the Scranton Sewer Authority (SSA). Proceeds from the sale were divided, in part, between the city of Scranton and the borough of Dunmore. Following that transaction, Scranton has faced numerous lawsuits, including a lawsuit filed in October 2017, by ratepayers alleging that the SSA asset sale violated Section 5612(a.1) of the PMAA by providing proceeds of the sale to Scranton and Dunmore for their general funds.

The PMAA governs the creation, operations and dissolutions of municipal authorities, and Section 5612(a.1), codified in 2012, prohibits money of an authority being used for any purpose not directly related to that authority's mission or purpose. It also provides rate-payers with a cause of action against the recipient of that money to seek the return of funds expended in violation of Section 5612(a.1).

The SSA lawsuit seeks the return of all money from the SSA asset sale pursuant to Section 5612(a.1), arguing that monetizing the SSA's assets for use in Scranton and Dunmore's general funds was not part of the mission or purpose of the SSA. The suit seeks to have all funds from the sale placed in trust. Although it is uncertain whether the PMAA's provisions continue to apply following an agreement for a dissolution of an authority, this uncertainty does not necessarily preclude litigation. It is reported that the funds Scranton had earmarked to assist with balancing its budget could be tied up for years or depleted following this litigation.

Because the full implications of the ERA and Section 5612(a.1) on the sale of a viable municipal water authority remain to be seen, the arena is fraught with legal pitfalls. When considering IOU proposals under Act 12, government entities should keep in mind their fiduciary duties and the present and future public interest—and clearly articulate the public benefits and detriments of whether or not to sell—or risk costly litigation. Even if a government entity articulates a public benefit to the sale of a municipal authority's assets under Act 12, there is no guarantee litigation will be averted. Taking steps early to educate government entities, particularly members of their governing bodies, on their duties and obligations in this changing landscape, ahead of proposed offers, can mitigate these risks. Further, if it is determined that maintaining current operations is not feasible or optimal, these entities should consider alternatives to an outright sale, such as a lease of system assets or license arrangement that keeps control of system assets in the hands of the municipal authority on a long term basis.

Reprinted with permission from the January 31, 2018 issue of The Legal Intelligencer. © 2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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