Article

Note: The Water Works Board of the U.S. City of Birmingham (Principal) decided to issue US$300 million in revenue bonds. The Revenue Bonds were governed by a trust indenture. The judge stated that:

Under the Trust Indenture, the [Principal] was required to establish and fund a Debt Service Reserve Fund (the "Reserve Fund") for the payment of the interest and principal on the Revenue Bonds. The [Principal] could satisfy the requirements for creating the Reserve Fund in a number of ways, including a direct cash payment, a letter of credit, or the purchase of a surety bond. Under the terms of the Trust Indenture, if the [Principal] elected to satisfy the Reserve Fund requirements through the purchase of a surety bond, the issuer of the bond had to have an investment grade credit rating of "AAA" by Standard & Poor's ("S & P"), or "Aaa" by Moody's (collectively the "AAA rating"). The Trust Indenture provided that if the rating of the surety bond issuer should fall below AAA, the [Principal] must either deposit in the Reserve Fund an amount of cash equal to the amount of all outstanding parity securities, or replace the original surety bond with another bond, letter of credit, or insurance policy from an issuer with a AAA rating.

Principal purchased a surety bond from Ambac Financial Group, Inc. and Ambac Assurance Corporation (Surety) in March 2007. The bond provided that Surety would pay the remaining principal and interest to U.S. National Bank Association (Beneficiary) on behalf of the bondholders if Principal defaulted on the revenue bonds issued by Beneficiary. The Judge stated:

At the time the [Principal] and [Surety] agreed upon the Surety Bond, and when the [Principal] and the [Beneficiary] executed the Trust Indenture, [Surety] was rated AAA by S & P and Aaa by Moody's. In June, 2008, S & P downgraded [Surety]'s rating to AA, and Moody's downgraded [surety bond]'s rating to Aa3. As a result of these downgrades, the [Principal], as an alternative requirement under the Trust Indenture, made a cash deposit of over $15 million into the Reserve Fund.

The bond, however, remained in effect.

Principal sued Surety for breach of contract, misrepresentation, deceit, suppression of truth, and negligence. Surety filed a motion to dismiss the complaint. The United States District Court for the Northern District of Alabama, Souther Decision, Acker, J., granted the motion.

Principal argued that the trust indenture and the surety bond are part of one overall contract, and that Surety breached an express term of this contract, found in the trust indenture, when its investment rating was downgraded. The Judge found that in order for two instruments to be part of one contract, they must be executed by the same parties. He reasoned that since Surety was not a party to the trust indenture, it could not be a part of the contract between Surety and Principal. The Judge ruled that Surety was not bound by the rating requirement in the trust indenture, and therefore it did not breach the contract. The Judge also explained that even if the trust indenture were part of the contract, Principal's breach of contract claims would still fail because the trust indenture required:

[T]he [Principal] must maintain a reserve fund, and that if the [Principal] chooses to purchase a surety bond to satisfy the Reserve Fund requirement and if a bond issuer subsequently has its credit rating down-graded, the [Principal] must replenish the Reserve Fund. [Surety] is not mentioned by name in those parts of the Trust Indenture here relied upon by the [Principal]. While the Trust Indenture contains provisions that refer to [Surety] as the issuer of the Surety Bond, the [Principal] could have satisfied its Reserve Fund requirement in a number of ways when [Surety] was downgraded, including the purchase of a surety bond from another insurer with a AAA rating, that is if one existed. The facts that the Trust Indenture only refers to the insurer's credit rating in the present tense, and calls for specific actions to be taken by the [Principal] if that credit rating should change in the future, demonstrates that the parties contemplated, and fully comprehended, that [Surety] was not promising that its credit rating would not go down in the future.

Principal also argued that Surety assumed an implied contractual obligation to maintain the AAA investment rating they held when they entered the contract. The Judge ruled that such an obligation must be an express condition of the contract.

Principal also claimed that Surety undertook a duty to maintain an AAA investment rating and that Surety was negligent because they breached this duty to Principal when their rating was downgraded. The Judge determined that:

[I]t is possible to allege a breach of contract, and, alternatively, to allege a tort that involves a breach of duty, but to do so the duty in tort must be independent of the duty in contract . . . . A contracting party cannot negligently breach its contract. He either breaches or does not breach. As the relationship between the [Principal] and [Surety] is purely contractual, it is impossible to conceive of [Surety]'s owing a duty to the [Principal] outside the terms of the contract.

Comment:

This case illustrates the consequences of permitting insurers or bonding companies to offer products (so-called "standbys") that competed with financial standbys without imposing the same regulatory scheme and requirements for capitalization as were imposed on standby letters of credit.

[JEB/sws]

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