April 7 (Bloomberg) -- Alabama’s state school construction authority won’t make payments to JPMorgan Chase & Co. due under a derivative deal until a federal court rules on the state’s lawsuit seeking to have the contract thrown out.

Alabama Finance Director James Main said the state won’t make any payments to the New York-based bank -- or accept any -- under the interest-rate swap transaction until the status of the lawsuit is determined. The first exchange of payments under the contract is set for May 1.

“It would not be proper for me to authorize the use of taxpayer money for any payment due under the agreements until the court resolves those issues and determines our rights and obligations,” Main, also the authority’s secretary, said in a statement e-mailed to reporters.

Alabama in October filed a lawsuit in U.S. District Court in Montgomery, Alabama, saying that the sale of a so-called swaption, an option on an interest-rate swap, wasn’t allowed under state law. The deal was executed in connection with bonds sold by the Alabama Public School and College Authority.

JPMorgan spokesman Brian Marchiony declined to comment.

Derivative deals that local governments entered into with Wall Street banks backfired last year, saddling cities, states and school districts with skyrocketing bond payments and large fees to break the contracts. The contracts were purchased by governments seeking to save money on their financing costs.

Interest-Rate Swap

Under an interest-rate swap, two parties agree to exchange periodic payments based on an underlying bond, usually a fixed- rate for a variable one. Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities.

In 2002, the Alabama authority sold JPMorgan an option to enter into a swap with it beginning in November 1998. Once exercised, the authority was supposed to sell floating-rate bonds and begin exchanging payments with JPMorgan. Under the contract, the authority would have received payments based on the one-month dollar London interbank offered rate, known as Libor -- which was to cover the cost of its floating-rate bonds -- and pay the bank a fixed rate in return.

The Alabama school authority sued the bank days before the contract could be exercised by JPMorgan and never sold new bonds in connection with the transaction.

Main said Alabama will not miss any bond payments due investors, saying the dispute is limited to the derivative trade.

“I want to say as strongly as I possibly can, the state of Alabama and the APSCA have not and will not default on their debt obligations,” he said.

The case is Alabama Public School and College Authority v. JPMorgan Chase Bank, 2:08-cv-00863-WKW-CSC, U.S. District Court, Middle District of Alabama.

To contact the reporter on this story: William Selway in San Francisco at wselway@bloomberg.net.

Last Updated: April 7, 2009 18:58 EDT