Aquila shares tumbled nearly 7% Wednesday to $3.14 after a federal court ruling blocked the company from using $504 million in proceeds from the sale of its Canadian utility assets. The court ruled in favor of Chubb Insurance Corp., which had argued that additional collateral was needed to cover Aquila’s contractual obligations to supply gas to a group of Nebraska municipal utility companies.

“We are naturally disappointed in the outcome of the hearing today,” said Rick Dobson, Aquila’s CFO. “We will continue to pursue our repositioning and liability management plans, which we have been executing for the past year and a half, bearing this new development in mind.”

Following the ruling, Standard & Poor’s downgraded Aquila’s corporate credit rating to “CCC+” from “B-,” saying the injunction “significantly limits Aquila’s liquidity and hampers management’s efforts to stabilize its vulnerable credit profile.”

Fitch Ratings said the decision “constrains Aquila’s already tight liquidity position and further limits financial flexibility.” However, Fitch said it would not change Aquila’s existing “B-” senior unsecured credit rating nor its negative outlook. It said Aquila should have just enough cash on hand over the next 12 months to pay its debt maturities and fund operations.

The order on Tuesday by U.S. District Judge Gary Fenner of the U.S. District Court for the Western District of Missouri, Western Division, stems from an ongoing dispute between Aquila and Chubb regarding two surety bonds provided by Chubb to secure Aquila’s gas deliveries through 2012 to the American Public Energy Agency (APEA), which provides gas to a group of Nebraska municipalities. APEA prepaid for the gas.

Aquila has been in the process of divesting non-core assets to exit the volatile energy trading business and return to its roots as a domestic utility. Its sale in May of Canadian utility assets to Fortis Inc. for C$1.08 billion was the last major asset sale of its restructuring process. In the meantime, it also has been pledging its domestic utility assets to senior secured bank lenders.

Its tight financial condition and final restructuring moves, led Chubb to argue that Aquila would no longer be able to collateralize its contractual obligations if the recent proceeds from the Canadian asset sale were used to fund upcoming debt maturities.

Aquila assured the court that the posting of collateral was unnecessary because it has been delivering the gas and intends to continue to deliver it until 2012 or until its obligations are fulfilled.

On June 14, however, the court sided with Chubb and issued a temporary restraining order preventing Aquila from using the proceeds of the Canadian asses sales for any purpose. On Tuesday, a preliminary injunction was issued to prevent Aquila from using $504 million while the Chubb litigation is pending. The issue will go to hearing to consider whether the injunction should become permanent. No date has been set for the hearing.

Fitch said the inability of Aquila to access the asset sale proceeds is “clearly a negative event for creditors.” The agency estimated that Aquila has $800-900 million of cash available, excluding the $504 million. Fitch said Aquila is expected to have adequate cash on hand to retire the $250 million of senior notes due July 15 and $150 million of notes due Oct. 1.

Over the next 12 months, Fitch projects that cash on hand “should be roughly sufficient to fund debt maturities, the deficit of cash flow from operating activities and budgeted capital spending, but there will be almost no remaining cushion to fund any other unexpected liquidity needs if the $504 million remains unavailable.”

Fitch also added that Aquila’s cash flow generation is “weak relative to debt. The renegotiation of tolling and gas prepayment contracts that persistently drag on cash flow is viewed to be critical for financial recovery.” But renegotiation may be difficult because of the profitability concerns of Aquila’s counterparties.

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