Illinois violated its constitution when it sold $10 billion of general obligation-backed pension obligation bonds in 2003 and again in 2017 with its $6 billion bill backlog borrowing, a hedge fund and state fiscal critic allege in a court filing that seeks to halt future payments.
“This complaint seeks a declaration that the debt … is unconstitutional and unenforceable, and seeks an injunction prohibiting defendants from disbursing public funds in service of this unconstitutional debt,” say the documents petitioning the state courts for approval to file a taxpayer action lawsuit.
About $14.3 billion is still owed on the two issues, according to the documents filed by Illinois Policy Institute head John Tillman, acting as a taxpayer, and the New York-based hedge fund Warlander Asset Management LP, a state bondholder. It names Gov. J.B. Pritzker, state Treasurer Michael Frerichs, and Comptroller Susana Mendoza, all acting in their official capacities, as defendants.
The documents equate both the $10 billion 2003 deal and the $6 billion of 2017 borrowing that sold in two transactions to deficit financings that its argues violated state rules including constitutional language that link issuance to a “specific purpose” as well as requirements under the state’s balanced budget act.
“Simply obtaining cash to finance the state’s structural deficits or to speculate in the market is not a ‘specific purpose,’ ” says the lawsuit.
The Pritzker administration dismissed the allegations and highlighted the string of legal advisors that signed off on the deals.
“This is simply a new tactic from the extreme right to interfere in capital markets. We’re done with the far right’s dangerous financial games to pull Illinois underwater. We saw this repeatedly under Bruce Rauner, who funded and executed on John Tillman’s pathological focus to drive Illinois into bankruptcy,” Pritzker spokeswoman Emily Bittner said in an emailed statement, referring to the former governor.
“Several layers of bond counsel and Attorney General Madigan were required to sign off on bond offerings, and these met those standards. This lawsuit is not worth the paper it’s written on,” Bittner added.
Several market participants said while they needed to digest the lawsuit’s arguments, the Illinois constitution grants the General Assembly broad bonding powers and they voiced skepticism that the various legal reviews conducted on the bonds would have allowed such violations to occur. They also suggested the “specific purpose” language is broad and that the bonds were issued with a GO pledge that allows for the sweeping use of the general fund for repayment purposes.
The purpose of the 2017 backlog bonds “was to pay various unspecified, unrelated bills that had gone unpaid in fiscal years 2016 and 2017 due to the state’s lack of funding. The debt was not incurred for a ‘specific purpose,’ … but to pay past-due operating expenses,” argues the lawsuit. “The debt is therefore unconstitutional.”
The pension bond proceeds were loaned to the pension system to bring down the unfunded liability with about $2.3 billion going to cover contributions owed over two fiscal years, a form of deficit financing. “Using bond money to cover general operating expenses or to speculate in the market in hopes of turning a profit is not a qualifying ‘specific purpose,’ ” the lawsuit argues. “The debt is therefore unconstitutional.”
The comptroller, like the governor's office, pushed back against the allegations in the pending litigation. "The media should waste no ink on a ridiculous lawsuit that misrepresents the Illinois Constitution and seeks to enjoin a state from spending money that was wisely spent years ago, approved by bond counsel. But this filing was never about the law. It was meant to generate headlines to scare investors in the bond market for political ends before the filing is laughed out of court...the markets should see this as nothing more than garbage that should be thrown out immediately by the courts," Susana Mendoza said in a statement.
The state will be represented by the Illinois Attorney General. The plaintiffs are represented by Webber & Thies PC and White & Case LLP.
About $8.85 billion of the 2003 POBs and $5.5 billion of the 2017 bonds remain outstanding with a total of $20 billion owed through 2033 when the bonds mature, according to the lawsuit. The POBs are retired in 2033 while the final tranche of backlog bonds maturing in 2029.
Market participants immediately drew comparisons to efforts by the Puerto Rico Oversight Board in Puerto Rico's Title III case to invalidate $6 billion of general obligation bonds on the argument that the commonwealth had exceeded its constitutional debt limit, and, contrary to the constitution, proceeds were used to finance deficit spending. Some hedge funds support the effort. The efforts remain pending.
Warlander and Tillman argue they have standing to bring the case and seeking the court’s permission to file a taxpayer action to block any further repayment of the bonds. They argue “the unconstitutional bonds lowered the state’s creditworthiness and have put the state at a significant risk of default” and “this risk of default will only grow as the state continues to make payments on the unconstitutional bonds.”
As a taxpayer, Tillman has the right to challenge the illegal distribution of taxpayer funds because of the harm it causes, the lawsuit asserts.
Warlander is the holder of $25 million of Illinois GO paper from issues in February 2010, February 2014, April 2014, May 2014, November 2016, December 2017, and May 2018.
“Because Warlander has been harmed by the state’s issuance of unconstitutional debt, and because it faces a significant risk of future harm from the state’s payments on that debt, an actual controversy exists between Warlander and the state regarding the proper interpretation of the Illinois Constitution,” the lawsuit continued.
Tillman, who is chief executive of the Illinois Policy Institute, a conservative-leaning think tank that has been critical of state fiscal and tax policies, said in a statement his motive in backing the lawsuit is to place a check on state borrowing that has “allowed overspending to go unchecked.”
The lawsuit lays out the state’s fiscal mess from its annual budget gaps to its $133.7 billion pension quagmire and the risks allegedly posed to taxpayers by using bonds to finance debt, taking to task lawmakers for “decades of fiscal mismanagement.”
The state’s ongoing fiscal ills coupled with a two-year budget impasse between 2015 and 2017 during the former Rauner administration dragged the state’s ratings down the lowest among states and they remain just barely in investment grade territory.
Moody’s Investors Service and S&P Global Ratings rate the state at the Baa3/BBB-minus level, one cut away from junk. Both assign a stable outlook. Fitch Ratings assigns a BBB rating to the state with a negative outlook that is expected to soon be resolved based on the results of the spring legislative session.
The state’s spreads remain the widest among states but have materially narrowed — to around 137 basis points over the Municipal Market Data’s AAA benchmark on Friday from 278 basis points two years ago at the end June.
The narrowing followed the end to the impasse, passage of an income tax hike, and more recently from improved legislative progress under Pritzker, a Democrat, who took office in January and enjoys legislative majorities. Investors are also bullish on the state’s prospects for raising more revenue should voters next year approve a graduated income tax structure. The state’s secondary market trading levels have also benefitted from market demand for higher yielding paper.
Barclays, Bank of America Merrill Lynch, Citi, JPMorgan, Loop Capital Markets LLC, and Siebert, Cisneros Shank & Co. LLC were senior managers on the $4.5 billion deal that was part of the backlog borrowing. The other $1.5 billion was competitively sold. Chapman and Cutler LLP and Charity & Associates PC served as bond counsel on the negotiated issue and Chapman and Burke, Burns & Pinelli Ltd.
The former Bear Stearns & Co. Inc. and former UBS Painewebber Inc. served as leads on the 2003 pension bonds. Mayer Brown LLP and Pugh, Jones & Johnson PC were bond counsel.
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