Oct. 12 (Bloomberg) -- An Alabama agency that sued JPMorgan Chase & Co. last year over the legality of derivative contracts tied to bonds it sold a decade ago plans to refinance the debt.

The Public School and College Authority, which accounts for more than two-thirds of Alabama’s total debt, intends to borrow $776 million next week to refund bonds sold in 1998 and 1999.

Alabama may owe New York-based JPMorgan more than $122 million if the derivatives are found legal after a trial scheduled for next October, according to a preliminary official statement for the bond issue. If the state agency wins the dispute, it would have to return $12.6 million in premiums it got from the contracts with JPMorgan.

“They’re waiting for the court to tell them what to do,” said Edward Hampton, a Moody’s Investors Service analyst. “Part of what this refinancing does is allow flexibility in the next couple of fiscal years so they can make those cash payments.”

The Alabama authority sued JPMorgan last year over a “swaption,” or option on an interest-rate swap, from 2002. Under the contract, the school agency received $2.2 million in exchange for giving JPMorgan the right to swap interest payments with the agency on $283 million of bonds starting in November 2008. In all, Alabama received $12.6 million for swaptions on bonds issued in 1998 and 1999.

Debt Savings

JPMorgan pitched the deals as a way to refinance fixed-rate bonds with floating-rate debt while protecting against the risk of rising interest rates, according to a complaint in federal court in Alabama.

The school authority alleged the contracts weren’t a “legitimate hedging transaction,” under Alabama law because the risk of “an extraordinary and historically unprecedented increase in long-term rates” was remote.

The state also said that money it received from JPMorgan was less than 1 percent of the outstanding amount of the bonds. Alabama law requires debt refinancings to save 3 percent.

The bond sale next week will reduce debt service costs for fiscal 2010 through 2012 by $135 million, according to Moody’s. The savings would come through a combination of lower debt service costs for the new bonds, and pushing debt payments into later years.

The Public School and College Authority’s bonds are backed by certain excise taxes that are required to be paid into the state’s Education Trust Fund. The fund’s revenue totaled $2.1 billion in fiscal 2009, after falling 11 percent from 2008, according to Moody’s. Moody’s rates the bonds Aa2, its third- highest investment grade rating.

Alabama selected Morgan Stanley to lead a group of banks in underwriting the bonds after a June competitive bond issue failed to attract bids from securities firms. At the time, Alabama’s acting finance director said the court dispute with JPMorgan may have affected the sale.

To contact the reporter on this story: Martin Z. Braun in New York at mbraun6@bloomberg.net

Last Updated: October 12, 2009 14:03 EDT