December 27, 2011, 1:50 PM EST

By Steven Church

(Updates with hearing begins in second paragraph.)

Dec. 15 (Bloomberg) -- The fate of the biggest municipal bankruptcy in the U.S. may depend on how judges in Alabama define the word 'bond.'

Alabama's Jefferson County is in court today defending its decision to file for bankruptcy. Creditors including Bank of New York Mellon Corp. and JPMorgan Chase & Co. objected to the filing, claiming state law bans Alabama counties from entering bankruptcy unless they have issued "refunding or funding bonds."

Jefferson County doesn't have any debt that is officially labeled as a bond; its bankruptcy was caused mainly by more than $3 billion in sewer warrants. One Alabama town, Prichard, had its bankruptcy petition thrown out because its debt didn't include funding bonds, according to court papers. That case is on appeal to the Alabama Supreme Court.

"If the creditors are right, the outcome will turn on the distinction, if any, between bonds and warrants," Dale Ginter, a lawyer who represented retired city workers in Vallejo, California's bankruptcy, said in an e-mail. "Financial instruments are occasionally given different names -- even if the economic impact is the same."

Jefferson County contends that limiting the bankruptcy option in Alabama to municipalities with bonds is "absurd."

"Were the objectors' argument the law, a county struggling to service $3 billion in bond debt would be authorized to declare bankruptcy, but a county struggling to pay the same $3 billion in warrant obligations would not," the county argued in court papers filed Dec. 13.

Explicit Law

Bondholders and other creditors claim the state law authorizing bankruptcy is explicit and should be applied to Jefferson County the same way it was applied to Prichard.

Bondholders have asked U.S. Bankruptcy Judge Thomas B. Bennett in Birmingham to dismiss the bankruptcy, which gives the county the right to stop paying some bills temporarily while it reorganizes its finances. Under Chapter 9 of the U.S. Bankruptcy Code, the county may seek court approval for a plan to reduce what it owes creditors.

Bennett scheduled a two-day hearing starting today to decide whether the county meets legal tests laid out in Chapter 9. Those tests include whether Jefferson County is insolvent, whether it negotiated with creditors before seeking bankruptcy and whether the filing was authorized by state law.

The dispute over the definition of the word 'bond' is part of the state law test and was the focus of court filings leading up to today's hearing. Both sides agree that the Alabama Supreme Court may need to answer the question of whether a public debt must be labeled as a bond before a municipality qualifies for bankruptcy.

Agreement Failed

Jefferson County filed last month after county, state officials, the receiver and bondholders failed to implement a tentative agreement that would have required the sewer debt to be cut by about $1 billion.

Jefferson County was the 13th entity to file a Chapter 9 bankruptcy this year. Three other filings were by municipalities: Boise County, Idaho; Central Falls, Rhode Island; and Harrisburg, Pennsylvania.

The rest were special-purpose districts and public-benefit corporations. A bankruptcy judge dismissed Harrisburg's case, saying it wasn't properly authorized under state law.

Jefferson County's bankruptcy is opposed by BNY Mellon, the trustee for the sewer debt, and creditors JPMorgan, which owns more than $1 billion of the sewer warrants, Bank of America Corp. and Assured Guaranty Municipal Corp. A group of taxpayers who are suing Jefferson County also seeks to dismiss the bankruptcy.

Chapter 9

"In light of the county's lack of funding or refunding bonds and the resulting failure of specific authorization to file its Chapter 9 petition, the county's Chapter 9 petition must be dismissed," BNY Mellon said in a court filing.

The county's sewer system doesn't collect enough money pay obligations on more than $3 billion in related debt. Since the Nov. 9 bankruptcy filing, the county has battled bondholders and the sewer system's receiver for control of the system and its finances. Bennett hasn't ruled on what limits, if any, the bankruptcy imposes on the receiver, John S. Young Jr.

The case is In re Jefferson County, 11-05736-9, U.S. Bankruptcy Court, Northern District of Alabama (Birmingham).

--With assistance from Michael Bathon in New York. Editors: Stephen Farr, John Pickering

To contact the reporter on this story: Steven Church in Wilmington at schurch3@bloomberg.net

To contact the editor responsible for this story: John Pickering at jpickering@bloomberg.net