INDIANAPOLIS | The Federal Transit Administration cut off funding Friday for the financially troubled Gary Public Transportation Corp., a disciplinary move that could shut down city bus service by the end of the year.

The Gary transit agency "lacks the technical, legal or financial capacity" to continue receiving grants and must repay $3.7 million in mismanaged federal funds, FTA Chief Counsel Severn Miller wrote in a scathing letter delivered late Friday.

The Federal Transit Administration said the city agency "fraudulently inflated" an energy-efficiency contract, "illegally spent" nearly $900,000 in infrastructure funds on operating expenses and further flouted federal rules by decommissioning working buses without prior approval.

Calls to Gary Mayor Rudy Clay and Daryl Lampkins, the bus agency's general manager, seeking comment were not returned to The Times, which learned of the pending reprimand on Thursday.

"I'm not saying anything," Cherokee Stanton, chairwoman of the Gary Public Transportation Corp. board, said when contacted Friday.

Federal dollars account for nearly a third of the bus agency's annual budget, so the FTA's decision to sever ties means "the Gary community may lose transit service by the end of the year," Miller wrote in his letter to Clay. The FTA also forwarded the letter to the Gary Common Council, Gov. Mitch Daniels and members of the Indiana congressional delegation.

"This affects the people of Gary. They depend on the city's busing service," said Justin Kitsch, spokesman for U.S. Rep. Pete Visclosky, D-Ind. "It's terrible that their transit services may be interrupted because the GPTC did not fully comply with its financial responsibilities."

The fiscal troubles stretch back to 2001, when the bus agency inked a $3.3 million energy-efficiency contract with Milwaukee-based Johnson Controls.

The Gary Public Transportation Corp. apparently lacked the local cash to seek federal funds, so it took a $300,000 loan from Johnson Controls, using the money to obtain $1.2 million from the FTA. Johnson Controls in January agreed to pay $2.4 million to settle a civil complaint brought by the U.S. attorney's office.

The diversion of $888,782 in federal infrastructure funds to operating expenses occurred in fiscal years 2005 and 2006, according to the FTA. The Gary Public Transportation Corp. owes the federal agency another $1.6 million after prematurely retiring natural-gas fueled buses and an accompanying fueling station.

The FTA told the city agency it could erase that debt by persuading another transit agency to begin using the alternative-fuel fleet or by purchasing new buses. On it's Web site, the Gary Public Transportation Corp. recently announced the purchase of eight new buses. But the FTA says "GPTC does not intend to purchase enough buses to entirely extinguish the debt in this manner."

The FTA has hired a private contractor, Jacobs Engineering Group, to work with Gary Public Transportation Corp. to craft a remediation plan to repay the $3.7 million debt and restore it eligibility for federal funding.

"We're not saying we're leaving them by the wayside. We're still going to be there," FTA spokesman Wes Irvin said Friday. "We just can't start giving them money again until they get their financial house back in order."

Gov. Daniels' office had not received the FTA letter late Friday, though a spokeswoman said the state is well aware of the unfolding situation.

"There's certainly no secret that there have been financial and management problems over time," said Jane Jankowski, the governor's press secretary. "Obviously, we're interested in ensuring that there's continued bus service for those who count on it."