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Municipal Technical Advisory Service (MTAS)

Original Author: Hemsley, Sid
Date of Material: 02/01/1999

Utilities--Extension policies
Utilities--Rates and charges

City and Developer Enter Agreement to Provide Sewer Extensions and Recover Cost Through Sewer Tap Fees

Reviewed Date: 04/26/2021
MTAS was asked whether the city and a developer may enter into an agreement to provide sewer extensions and recover the cost through sewer tap fees.

Can the city enter into an agreement with a developer whereby the developer pays for sewer extensions to his development, and the city either:

1. Imposes a sewer tap fee and pays all or a portion of it to the developer over a period of time until he has recovered all or a part of the cost of the sewer extensions?

2. Permits the developer to sell tap fees for connections to the extensions he has made until he has recovered all or a portion of the cost of the sewer extension?

Apparently, the city can enter into an agreement of either kind with the developer.
With respect to the first arrangement, in Chandler Investment Company v. Whitehaven Utility District, 311 S.W.2d 603 (Tenn. Ct. App. 1957), a utility district determined that it had no funds with which to make water main extensions to a proposed development. It made an agreement with the developer to make the water main extensions provided the developer would make an advance on the construction cost of $88,000, in return for which the developer would receive a refund against the advance of 50% of the gross charges received against each metered connection for a period of ten years. The developer made a deposit of $55,000, the city made the extensions, and the developer began receiving the 50% of the gross charges from each metered connection. Other subdivisions in the utility district had been financed in the same manner. The developer learned that he could get a better deal from the City of Memphis for his next development in the utility district. The Court held that better deal or not, the utility district was the exclusive provider of utility services inside its service area.

Although the Court did not directly address the question of whether the utility district’s sewer main extension agreement was legal, it seems that if the Court had questions on that point, it would have raised them, at least in passing.

It appears to me that in Whitehaven, the developer essentially lent money to the utility district to make the sewer line extension, and that the utility district repaid the loan from the revenues generated by the extension. By whatever name that arrangement is called, I have consulted with MTAS utility consultants and other utility practitioners and confirmed what I already knew: arrangements of that kind are widespread, and are reflected in the utility extension policies of several municipalities.

Such arrangements appear to be a form of "capital recovery charge," or "user contribution." Arthur Anderson’s Guide to Water and Wastewater Finance and Pricing, Chapter 4, "Capital Recovery Charges," Raftelis, George A., discusses those charges or contribution arrangements at length. I find no arrangements in the Guide where the developer recovers charges or contributions; however, there are probably no technical reasons why such arrangement could not provide for cost recovery; whether they are always financially wise is another matter.

The Guide does not put its legal imprimatur on any of the arrangements, but is useful for showing that capital recovery charges or user contributions are a generally acceptable financial technique to front-end the cost of utility extensions. In fact, MTAS finance consultants have in the past advised municipalities to consider such arrangement in financing utility extensions, sometimes without the cost recovery provision. As far as I can determine, the legal challenges in other jurisdictions to such arrangements have involved charges and contributions that were essentially impact fees.

With respect to the second arrangement, you pointed me to Trull v. City of Lobelville, 554 S.W.2d 638 (Tenn. App. 1977) (which I remembered as soon as I saw it). There the city entered into an agreement with a contractor for the latter to extend sewer, water and gas lines from the city’s mains, in return for which the contractor could charge tap fees to users of his line extensions. When he had recovered the cost of the extensions plus reasonable profits, he would convey the lines to the city. But before the developer had recovered the cost of the extensions, the city breached the agreement by itself tapping the extensions to provide service to certain customers and by claiming ownership to the lines. (Disputes over the gas lines were resolved ). Even though the contract between the developer and the city had not been properly approved by the city commission, the court held it to be an implied contract enforceable against the city. As in Whitehaven, there is no hint that the Court thought that the line extension financing arrangement itself "as opposed to the manner in which the city had entered into it" might have been ultra vires.

Johnson City v. Milligan Utility District, 276 S.W.2d 748 (Tenn. App. 1955), is similar to Trull. There Miller and Williams agreed with the City of Johnson City to extend a waterline though their proposed subdivision in Carter County, in exchange for which the city agreed to supply water in that area. The agreement provided that Miller and Williams were to keep the line in repair and could collect a tap fee from each new customer. The case does not indicate for how long they were to receive the tap fee. The Court had no negative comments about the agreement. In fact, the city itself had continued to pay the tap fee to the successors in title of Miller and Williams and recognized their right to receive them. The financial aspects of the agreement arose only in the context of the questions of title to the line, and which of the City of Johnson City and the utility district had the right to service the area.

It has also been held that cities in Tennessee operate their utilities in their proprietary, rather than their governmental, capacities. The significance of that doctrine is seen in Bybees Branch Water Association v. Town of McMinnville, 333 S.W.2d 815 (Tenn. 1960):

‘A municipal corporation engaged in the business of supplying public utilities and facilities is regarded as a public corporation transacting private business for hire, and, in that respect and to that extent, as a public or quasiprivate corporation.’ 62 C.J.S. Municipal Corporations, Sec. 3, p.73.

‘The city in its operation of utilities herein does so in its proprietary or individual capacity rather than in its legislative or governmental capacity. It is thus governed, for the most part, by the same rules that control a private, individual or business corporation. [206 Tenn. 375] City of Knoxville v. Heth, 186 Tenn. 321, 210 S.W.2d 326, 329.

[Also see City of Shelbyville v. State ex rel Bedford County,, 220 Tenn. 197, 415 S.W.2d 139 (Tenn. 1967); Batson v. Pleasant View Utility District, 592 S.W.2d 578 (Tenn. App. 1980); Maury County Board of Public Utilities v. City of Columbia, 854 S.W.2d 890 (Tenn. App. 1993)]

Batson is particularly instructive on the proprietary capacity issue. In that case a developer and the utility district entered into a contract under which the developer would entirely at his cost extend water lines from the utility districts mains to his new subdivision. The contract provided that the city would be entitled to charge a meter deposit for each meter it installed, and that after the lines had been installed and inspected, their ownership would vest in the utility district. After a majority of the lines had been installed and inspected the utility district imposed a $500 tap fee per residence. The developer argued that its contract with the utility district prohibited the latter from charging a tap fee, and the utility district argued that under Tennessee Code Annotated, sections 6-2610(f) [now 7-82-304(6)] and 6-2625 [now 7-82-403], the utility district had not only the authority but the duty to fix and revise rates and charges so that they would always be adequate to insure that the utility was self-supporting. In holding for the developer, the Court declared that the statutes cited by the utility district did not dispose of the question because, "A city operates it utilities in a proprietary or individual capacity and not in its legislative or governmental capacity. [Citation omitted] A contract made by a city in the course of its operation of a utility is in its proprietary capacity." [Citations omitted] It was true, continued the Court, that generally a city could not contract away its legislative or governmental functions, but:

T.C.A. section 6-2607 [now 7-82-301] states that an incorporated district shall be a municipality or public corporation. T.C.A. 6-2610(d) [now 7-82-304(4)] grants any district the power to make and enter into contracts.

As a ‘municipality’ operating its utility in a proprietary or individual capacity, the rules that control private individual or corporate business generally apply. [Citation omitted]

It has been held that state laws permitting a municipality to contract in its proprietary capacity suspend the municipality’s power to regulate rates during the contract period. St. Cloud Public Service Co. v. City of St. Cloud, 265 U.S. 352, 44 S. Ct. 492, 68 L.Ed. 1050 (1924).

By acting in its proprietary capacity, the defendant has obligated itself by contract to provide ‘tapping on’ without charge. This is not in abrogation of its statutory authority to fix or revise rates or charges in its legislative or governmental capacity.

The addition of ‘tapping on’ charge constitutes a unilateral modification of the contracts. Modification requires the mutual assent and meeting of the minds required by contract. [Citation omitted] [At 582]

Private corporations can enter into arrangements like or similar to those contemplated by your questions. For that reason, apparently so can public utilities, even to the extent of contracting away their rate-making powers with respect to tap fees.

The statutes under which utilities in Tennessee can be established and operated are replete with rules governing utility revenues and expenditures. But as far as I can determine, none of them operate to prohibit utility extension policies under which the developer front-ends the cost of the extension and is reimbursed, in whole or in part, that cost. Tennessee Code Annotated, section 7-34-115, provides that "Any municipality shall devote all revenues derived from a public works to or for"

(1) The payment of all operating expenses;
(2) Bond interest and retirement and/or sinking fund payments;
(3) The acquisition and improvement of public works;
(4) Contingencies;
(5) The payment of other obligations incurred in the operation and maintenance of public works and the furnishing of service;
(6) The redemption and purchase of bonds....
(7) The creation and maintenance of a cash working fund;
(8) The payment of an amount to the general fund of the municipality [of a certain percentage of equity invested from the general fund]

The city’s payment of the developer’s front end costs should fit under (5), if not (1) and (3).

Tennessee Code Annotated, section 7-34-115 is a part of the Revenue Bond Law, and arguably applies only to municipalities operating utilities under that Law [See Nashville Electric Service v. Luna, 204 S.W.2d 529 (Tenn. 1947)]. However, I have previously concluded that statute was probably intended by the Legislature to apply to all utility systems.

I have read every Tennessee Attorney General’s opinion I can find that remotely bears on your question. OAG 94-105 asks three questions relative to the cost of installing a sewer system infrastructure in a subdivision proposed for annexation. Question 1 was "Whether a municipality may subsidize the cost of installing a sewer system infrastructure in the rights-of-way and public easement aras of a subdivision proposed for annexation? Neither Question 1 nor its answer seem pertinent to your question because the former involves using tax revenues to subsidize the utility system, while the latter involves using sewer utility revenues to essentially pay for sewer extensions initially paid for by the developer. Because utility rates and charges are fees and not taxes, no tax revenues are involved in your question.

Question 2 is more relevant: "Whether the Knoxville Utilities Board may refund or forgive obligations for contributions in aid of construction or similar fee agreements that have been paid or are to be paid to the Board by residential customers for sewer infrastructure extension into the public rights-of-way and public easement areas of the residential areas." Unfortunately, the opinion does not answer the question, raising only the possibility that such refunds may run afoul of the city’s charter, noting that the utility system’s rates are set by the city council.

Utility systems in Tennessee can operate under various statutes, including their charter. I do not know under what statutory authority the sewer system operates. I have already pointed to the probability that Tennessee Code Annotated, section 7-34-115 applies to all utility systems in Tennessee. The City is chartered under the general law manager-commission charter, the same charter under which another City was chartered in Trull, above. Several provisions in Section 6-19-101 authorize cities operating under that charter to establish and operate utility systems, including sewer systems. None of those provisions prescribe utility revenue expenditures. In fact, Section 6-19-101(14) gives the city the authority to:

Prescribe reasonable regulations regarding the construction, maintenance, equipment, operation and service of public utilities and compel, from time to time, reasonable extensions of facilities for such service....

I am not sure what "compel, from time to time, reasonable extensions of facilities for such service....,," means [presumably it applies to privately-owned public utilities operating inside the city] but if reasonable extensions can be compelled, arguably the city can enter into agreements for the extension of such services.

But let me add a nervous cautionary note here. In Johnson City v. Milligan Utility System the court answered the question of which of the City of Johnson City and the utility district had the right to provide utility service in Carter County in favor of the utility district. It did so by concluding that the city never had a franchise to provide water service in Carter County, which led it into a distinction between the public and private undertakings of public utilities:

Whether a business operation may be classed as that of a public utility is controlled by the facts of a particular case. Generally, the question depends upon whether the service is in fact of a public character and whether it may be demanded on a basis of equality and without discrimination by all members of the public or obtained by permission only. [Citations omitted.]

A franchise may be defined as the grant of a right or of or a privilege by the sovereign power usually with respect to streets or highways primarily to enable the grantee to perform a public service or benefit. It is not associated in meaning with a strictly private undertaking.

The fact that a business or enterprise is, generally speaking, a public utility does not make every service performed or rendered by it a public service, with the consequent duties and burdens, but it may act in a private capacity, and in so doing is subject to the same rules as a private person. [Citation omitted.] [At 753]

That distinction itself points to a fundamental principle governing the provision of all utilities in Tennessee: they must be provided without discrimination to all applicants in the same class, and that class distinctions must generally be reasonable, generally based on the cost of providing service. [See J.W. Farmer v. Mayor and City Council of Nashville, 127 Tenn. 509 (1912); Watauga Water Co. v. Wolfe, 99 Tenn. 429 (1897); Crumley v. Watauga Water Co., 99 Tenn. 419 (1897); City of Parsons v. Perryville Utility District, 594 S.W.2d 401 (Tenn. App. 1979)] In fact, the courts have said that such is the law even where it is not stated in the utility’s enabling or governing legislation.

Municipalities generally have considerable discretion in the decision to extend utility services. [See 48 ALR222] In Tennessee, the dispositive case on the question of whether a utility must extend its service is Chandler Investment Co. v. Whitehaven Utility District, above. In that case the Court outlined the considerations that go into the question of whether a utility is required to make a main extension where the franchise or charter does not require the provision of utility services to all potential customers:

In the absence of an express provision in the franchise or charter obligation of a public service company requiring it to furnish the designated service to every inhabitant of such territory, the right of an inhabitant of such territory to demand an extension of service for his benefit is not absolute and unqualified but is to be determined by the reasonableness of the demand therefor under the circumstances involved. [At 611]

The Court at length then expounds on all the considerations upon which utility extension decisions can be made, including, the duty of the utility pursuant to its charter or other law, and the cost of making the extension in question.

The reason I point to the law generally requiring the nondiscriminatory provision of utility services, and of the factors that go into making utility extensions decisions is that they probably ought to hover over every decision a utility makes, including the effect of the agreements it makes with a developer on those principles. We have seen that because cities operate their utilities in their proprietary capacities they can probably enter into agreements of the nature contained in your question. But Johnson City v. Milligan Utility District and Whitehaven point to the part the utility’s charter and/or franchise may play in whether a utility’s service decisions have a public or private character, and the latter declares that in the absence of rules contained in those documents, utility extension decisions are governed by the rule of reasonableness. I do not know the terms of any franchise that might be an issue, but none of the laws under which sewer systems in Tennessee can be established operated, including the city’s charter, appear to prohibit agreements of that nature. However, if the agreement permits either the city or the developer to charge tap fees that are discriminatory or unreasonable, I suspect the governmental-proprietary distinction could find itself thrown out the window.