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Public Service Commission Warns of Substantial Civil Penalties for Water Utilities and Their Board Members for Unauthorized Debt
Recently the Kentucky Public Service Commission (“KPSC”) issued a warning to members of water utility governing boards: If your water utility issues evidences of indebtedness without the required KPSC authorization, you and your utility are likely to be assessed substantial civil penalties. The warning, issued in its Order of September 17, 2018 in Case No. 2017-00469, is a cogent reminder that the governing bodies of public water utilities must be familiar with the statutory requirement to obtain KPSC approval before issuing debt.
KRS 278.300 requires a public utility to obtain KPSC authorization before issuing “any securities or evidences of indebtedness” or assuming “any obligation or liability in respect to the securities or evidences of indebtedness of any other person.” “Evidences of indebtedness” includes all types of debt instruments, not only bonds, but also promissory notes, assistance and loan agreements, lease agreements, even an agreement with a local automobile dealer for the installment purchase of a vehicle.
Two exceptions to the requirement for prior KPSC approval exist. Firstly, KPSC approval is not required for notes that are payable in two years or less. Such notes, however, cannot be renewed for an aggregate term of more than six years. For example, a utility could issue a note for two years and then renew the note for two additional two-year periods without obtaining KPSC approval. If the utility wishes to renew the two-year note for a 3rd time, however, it must request KPSC authorization.
Secondly, KPSC authorization is not required if the debt instrument is subject to the supervision or control of a Federal Government agency. For example, the issuance of bonds to or a loan agreement with Rural Development does not require KPSC authorization since the bond issuance or loan agreement is subject to Rural Development’s supervision and Rural Development is an agency of the Federal Government.
The amount of the indebtedness is immaterial. It does not matter whether the note is for five million dollars or five thousand dollars. Any debt, except for the two exceptions noted above, requires KPSC authorization.
Failure to strictly comply with the terms of a KPSC order authorizing the issuance of an evidence of indebtedness will also subject the utility and its officers to possible penalty. In Case No. 2016-00338, a water district issued debt exceeding the authorized amount. Although issuance refinanced the existing debt at a lower rate of interest and produced significant savings to the water district, the KPSC assessed civil penalties against the water district’s commissioners for issuing debt in excess of the authorized amount.
What are the consequences of violating KRS 278.300? The most obvious consequence is civil penalties assessed against the utility and its officers and agents. KRS 278.990(1) permits the assessment of a civil penalty of no less than $25 and no greater than $2,500 for each violation of KRS Chapter 278 or for aiding and abetting a violation of KRS Chapter 278. KRS 278.990(1) also provides for a criminal penalty of imprisonment for no more than six months. (A court, not the KPSC, must impose a criminal penalty.)
In its Order of September 17, 2018, the KPSC made clear that non-profit water districts and water associations will be assessed civil penalties for violating KRS 278.300. Previously, it had expressed a reluctance to penalize such utilities because penalties deprive those utilities of revenue necessary to maintain or improve the quality of service. The increasing number of violations, however, had led the KPSC to reconsider this policy.
The KPSC has been less reluctant to penalize water district commissioners and general managers. While it is the utility that actually issues the evidence of indebtedness, KRS 278.990(1) permits the KPSC to penalize persons who “aid and abet” a violation of KRS Chapter 278. Water district commissioners have been found to aid the unauthorized issuance by voting to approve a resolution to issue the debt instruments or signing an unauthorized promissory note or loan agreement. The KPSC has also penalized general managers for their involvement in the unauthorized issuance of debt.
In addition to assessing penalties against him, the KPSC may initiate administrative proceedings to remove a water district commissioner from office for aiding and abetting a water district’s unauthorized debt issuance. The KPSC has also mandated that water district commissioners attend certified water management training as punishment for their actions.
Another consequence of violating KRS 278.300 is potential public embarrassment for the utility and its officers. The KPSC generally holds a public hearing on any allegation of unauthorized debt issuance and requires the utility’s officers and members of its governing board to appear and testify at such hearing. These hearings are streamed live on the KPSC’s website. The KPSC requires the utility to publish in the largest circulating newspaper in its service area notice of the hearing, the allegations giving rise to the hearing, and how the public may view the hearing.
The failure to obtain prior authorization does not affect the debt instrument. The water utility’s obligation to honor the instrument remains. In fact, most debt instruments now require the borrower to certify or represent that all required regulatory approvals for the loan or debt have been obtained. If the underlying debt instrument were deemed unenforceable, the borrower would still be subject to legal action for breach of contract.
The KPSC has previously held that the lack of authorization will deprive a utility of any right to recover through rates the interest payments associated with the debt instrument. In most cases, however, the KPSC has permitted recovery of the interest and principal payments through rates so long as the proceeds of the debt instrument are used for a reasonable purpose related to the provision of utility service and the debt was reasonably necessary and appropriate for the purpose. When they are not, however, the KPSC has denied recovery of the principal and interest payments through utility rates. For example, the KPSC will not allow recovery of principal or interest on a debt instrument whose proceeds were used solely to pay current operating expenses.
The available defenses to the assessment of a civil penalty are very limited. Ignorance of KRS 278.300 is not a defense. The KPSC has declared that “[i]gnorance is not a valid excuse . . . as it is the responsibility of the utility and its directors to comply with the laws of the Commonwealth . . . .” The KPSC has further held that reliance upon the advice of legal counsel does not prevent the finding of a violation.
How can violations be avoided? Utility officers should become familiar with the laws governing the utility’s operations. They should attend annually a course of instruction on the laws governing their utility’s operation. (The KPSC, the Kentucky Rural Water Association, and other entities regularly conduct such programs.) Knowledge of the law’s requirements will reduce the likelihood of a violation.
A water utility should adopt policies requiring legal review of the proposed agenda and minutes of all meetings of its governing board. It should require legal review of all evidences of indebtedness prior to their issuance. It should ensure that its legal counsel is familiar with the requirements of KRS Chapter 278. In many of the KPSC proceedings in which violations were found, the governing bodies acted without legal review of these documents or relied upon the assistance of counsel who were unfamiliar with the KPSC’s laws and regulations.
In summary, the KPSC is aggressively pursuing water utilities that fail to obtain KPSC authorization prior to issuing evidences of indebtedness. Water utilities and their governing boards should take steps to ensure a full and complete understanding of KRS 278.300 and make every effort to comply with its requirements. Failure to do so will likely subject them to significant civil penalties and public criticism.