A Cook County judge ruled Friday Chicago’s partial pension fund overhaul was unconstitutional.

CHICAGO - A Cook County Circuit Court judge declared Chicago's overhaul of two of its four pension funds unconstitutional and void in its entirety.

Friday's ruling sets back city efforts to tackle its $20 billion unfunded pension tab that has dragged one of its ratings down to junk.

Judge Rita Novak voided the city's 2014 overhaul the two funds, which cover laborers and municipal employees, in an opinion that agreed with fund members who sued arguing that the changes diminish benefits in violation of the state constitution's pension clause.

Chicago Mayor Rahm Emanuel's administration and a majority of impacted unions had settled on the changes, which were approved by state lawmakers in 2014 and took effect Jan. 1.

The city will appeal directly to the Illinois Supreme Court, which will have the final word.

Its justices sided with unions, employees, and retirees in a May opinion tossing out the state government's reforms to four of Illinois' five state employee pension funds approved in 2013.

"While we are disappointed by the trial court's ruling, we have always recognized that this matter will ultimately be resolved by the Illinois Supreme Court," said city Corporation Counsel Stephen Patton, who argued the case earlier this month.

"We continue to strongly believe that the city's pension reform legislation, unlike the state legislation held unconstitutional this past spring, does not diminish or impair pension benefits, but rather preserves and protects them," Patton said.

The ultimate outcome will have profound ramifications for the city.

The case is being closely followed by investors who view the city as a distressed borrower and in turn demand steep interest rate penalties on general obligation borrowing; rating agencies have warned the city's battered credit faces further deterioration if it fails to solve its pension mess.

The city's reforms cut some benefits while increasing employer and employee contributions to stabilize the two funds, which are headed toward insolvency in the coming decade.

If Friday's decision holds, it actually provides the city with near-term budget relief because the rejected plan called for the city to make $100 million in higher contributions in 2016. But the decision puts the funds back on an path to insolvency.

Moody's Investors Service, which dropped the city to junk-level Ba1 in May, called the ruling a credit neutral in special commentary Friday.

Standard and Poor's warned of the pressures the city faces if it fails before the high court.

"Ultimately, the loss of this case means more hurdles for the city in its attempt to address its growing pension liabilities. We will likely lower our GO rating within the next six months if the city fails to incorporate pension contributions in a structurally balanced manner," S&P analysts wrote in a special commentary Friday.

Novak's 35-page order draws widely from the high court's May opinion, despite the city's contention that its legal arguments differ from the state's rejected ones.

Novak writes that the high court's opinion "deals with closely parallel issues and provides crystal-clear direction on the proper interpretation of the law."

At the heart of the case is the state constitution's pension clause.

"Membership in any pension or retirement system of the state, any unit of local government or school district, or any agency or instrumentality thereof, shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired," the clause says.

Novak called "the reduction, elimination for certain years, and postponement" of annual cost-of-living adjustments "one of the critical changes" in the legislation. The COLA is additionally hit by the elimination of compounded annual increases with future hikes tied to a new less-generous formula.

"The changes to members' annuities … are the same type of changes that the Supreme Court invalidated" in the state case, Novak wrote.

"It follows then that here, as in the case before the Supreme Court, 'there is simply no way that the annuity reduction provisions….can be reconciled with the rights and protections established by the people of Illinois when ratified the Illinois constitution of 1970 and its pension protection clause,'" Novak wrote, quoting the high court.

The city's legal defense centered on two arguments that differed from the state's position that it was justified in cutting benefits under its sovereign powers to act in a fiscal emergency.

First, the city sought to prove that the overhaul didn't diminish benefits but "preserves" and "protects" them by rescuing the funds from the depletion of their assets. It further legally binds the city to actuarially based contributions to fully fund the system, and obligates the city on pension annuities, which the city argues prior statutes did not.

The city's second legal position argues that the new provisions afforded fund members provide consideration for the cuts, a legal theory in contract law that allows for detrimental changes to be made in exchange for some perk if parties agree. The city notes that 28 of 31 impacted unions signed off on the plan.

The idea of consideration had picked up steam as a possible means to get around the pension clause based on a footnote in the Illinois Supreme Court's opinion that suggested the court might look favorably on such an argument.

Novak rejected both city arguments.

On the city's contention that the changes preserve the funds and offer a net benefit, Novak called the theory "wholly inconsistent with constitutional teachings" saying "it disregards the settled distinction between pension benefits, which are constitutionally protected, and funding choices, which are not."

Novak rejected the city's position that it was not legally on the hook previously to make good on the actual payment of benefits, saying the pension clause establishes a contractual relationship that puts the onus on the employer to pay the benefits.

On the notion that the changes meet a fair and bargained-for exchange, Novak said the city failed to show it had authority for such an expansive interpretation of a "bargained-for exchange." She further found that argument fails in ignoring the individual rights of fund members who are not in the unions that were party to the negotiations.

The unions that agreed to the package "were not acting as agents in the collective bargaining process," Novak added.

Novak said the city's bargaining strategy failed to meet what the high court said it might consider constitutional as a bargained-for exchange in its footnote in the May opinion.

Attorneys for the fund members behind the lawsuits challenging the legislation known as SB1922 called the ruling a victory for employees and retirees and called on the city to shift its focus toward finding revenue solutions to funding its pensions.

"The opinion makes clear the protections in the pension clause are broad and clear in what they say," said attorney John Shapiro. "The benefits of retirees and employees cannot be cut as a way for the city solve its pension funding issues. It's unconstitutional. We look forward to arguing our position before the Illinois Supreme Court."

Chicago and the Emanuel administration face deep pension funding problems.

Separately, the city faces a $550 million scheduled spike in contributions to its police and fire funds next year under a 2010 state mandate to stabilize public safety funds across the state.

State lawmakers this year approved legislation that would ease Chicago's transition by phasing in the shift to an actuarially based schedule and extending the time to reach a 90% funded ratio by 15 years, which would lower the city's immediate contribution requirements by about $200 million.

It's unclear if Gov. Bruce Rauner will sign it.

Emanuel intends to release Chicago's 2016 budget a month early in September, outlining a revenue plan to tackle the pension contribution spike.

If the lower court ruling stands, the administration also must go back to the drawing board on the laborers' and municipal funds, finding a solution that likely relies in higher city contributions than SB1922 would have required.

The ruling emboldened the unions that fought the pension changes.

"We would urge the city not to waste further time and taxpayer dollars on an appeal," said Anders Lindall, spokesman for the American Federation of State, County and Municipal Employees Council 31. "The problem with pensions is a funding problem, it's not a benefit problem."

The rating agencies issued warnings over the city's need to solve its pension dilemma. The struggle for the city is in finding a path that meets the constitution's stringent protections of benefits without too heavily burdening a tax base that must also support Cook County and the Chicago Public Schools' pension fixes.

Analysts acknowledged that the opinion Friday is not the final word so no rating action was taken.

"The ruling is one step forward in the process of resolving outstanding questions on the constitutionality of the 2014 legislation," said Matt Butler, Moody's lead Chicago analyst.

"The decision is credit neutral for Chicago, as we expect it will be appealed to the Illinois Supreme Court, which will ultimately determine the constitutionality of the legislation," he wrote.

"We expect that the next six months will show how serious the city is about implementing both immediate and far-reaching plans to address the structural cracks in its budget, including creating its own pension solution," Standard & Poor's said Friday. "Given the uncertainties surrounding an appeal, however, we expect city management to consider contingency plans for addressing its liability regardless of the ultimate outcome. Without long-term structural fixes, the rating on the city' debt will continue to be pressured."

Fitch Ratings said the Friday action would not immediately impact the city's rating, given the likely appeal. Fitch's lead Chicago analyst Arlene Bohner said the agency expects a high court ruling by the end of the year if justices agree to the direct appeal, putting pressure on the city to come up with a backup plan should justices agree with the lower court.

"Implementation of pension solutions that move all the city's pension plans on a clear path toward adequate funding while preserving sustainable budgetary balance are a prerequisite to removing Fitch's negative outlook on the rating. Absent that, the rating is likely to be downgraded," Bohner said.

The city's more than $8 billion of GOs carry a BBB-plus rating and negative outlook from both Fitch Ratings and Standard & Poor's and A-minus and stable outlook by Kroll Bond Rating Agency. Moody's has a negative outlook on its Ba1 rating.

The city paid nearly 500 basis points over Treasuries on its recent taxable sale and more than 250 basis points over the Municipal Market Data's benchmark on the tax-exempt piece.

The Civic Federation of Chicago warned of the dire consequences posed by the ruling. "Without these reforms, the city reverts back to an inadequate funding formula that has resulted in such severe underfunding that actuaries expect the Municipal and Laborers Funds will run out of money within the next decade - an unthinkable prospect," said the federation's Sarah Wetmore.

"It is important to keep in mind that the city's pension funds are governed by state statute and the state of Illinois has been complicit in the severe underfunding of pension funds throughout the State," she added. "Any comprehensive solution will require both involvement and assistance from the state."



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