CHICAGO – Fiscally distressed Harvey and its public safety pension funds and revenue bondholders officially ended the first test of Illinois’ new pension intercept law on Monday with a settlement that divvies up the city’s share of state-collected tax funds.

The agreement allows the Chicago suburb to keep a chunk of its state collected funds and protects revenues pledged to bondholders, while leaving open questions over the intercept’s future use and the priority afforded to pension claims that could interfere with bondholder rights.

Bob Fioretti of law firm Roth Fioretti LLC ia former Alderman in the Chicago City Council.
Attorney Bob Fioretti represents Harvey.

“This settlement saves Harvey from a de facto bankruptcy that threatened critical services and could have put citizens in jeopardy,” said Harvey’s attorney Bob Fioretti, of Roth Fioretti LLC. “It’s a good settlement all around after tough negotiations and it also allows the city to meet its pension obligations.”

An often divided Harvey City Council unanimously approved the settlement July 23. The final documents were presented to Cook County Circuit Court Judge Raymond Mitchell Monday and he signed an order dismissing the pending litigation. The city had filed a lawsuit in April in an effort to block Comptroller Susana Mendoza from sending $2.3 million of diverted funds to the police pension fund.

Going forward, the agreement frees up revenues — such as sales and motor fuel taxes and the local share of income taxes — Mendoza’s office would have intercepted under a process put in place earlier this year under a 2011 public safety pension funding law that currently applies to all but Chicago’s public safety funds.

About $649,000 was set for distribution this week. The $2.3 million was previously distributed under an interim settlement.

Harvey settlement chart
Harvey settlement chart

The city will keep 65% of the pool of state funds, the police fund will receive 25% until a $7.3 million 2015 court judgment is paid off, and the firefighters fund will receive 10% to cover a $12.4 million 2015 judgment. Once the police claim is retired, the 25% would then go to the firefighters.

The settlement also protects holders of $6 million of 2008 hotel-motel/sales tax bondholders who under city ordinance had long enjoyed a priority claim on state sales tax and home rules sales tax. It also safeguards the agreement in the event state lawmakers alter the intercept law and ensures the city remain current on payments to a third pension fund — the statewide Illinois Municipal Retirement Fund — which also now has similar intercept powers.

The settlement leaves open a series of legal questions raised by the comptroller’s office, lawyers, and market participants over the future use of the intercept including the prioritization of claims among funds and whether pension claims are superior to existing liens enjoyed by bondholders.

Another legal position left on the table is the city’s argument that state law bars the diversion of its revenues to cover a judgment or to cover payments owed before fiscal 2016 when the intercept took effect, although the diversion process was not put in place until this year.

The questions are material, investors and rating agency analysts as well as lawyers in the case say as local governments are behind on payments owed to dozens and possibly hundreds of the more 600 public safety pension funds in the state.

“The judge will bless the settlement but it doesn’t resolve any of these legal issues,” said one attorney in the case.

Other fiscal issues also abound over the heavy weight of pension obligations on local government balance sheets and potential solutions as the collective funded ratios of all 671 Illinois public pension funds falls under 50% and grew $17 billion to $185.2 billion in fiscal 2016 from $168.2 billion. Illinois makes nearly $130 billion of the figure.

SETTLEMENT

Parties to the settlement include the public safety funds, bond trustee Amalgamated Bank, Harvey, and the comptroller’s office, which is represented by the state attorney general. The settlement calls on the city to annually levy for the amount needed to meet ongoing pension contribution requirements. The two funds can file new claims with the comptroller should the city fall behind. The city waives most of its rights to contest the claims.

The settlement calls for the exclusion of home rule taxes and local share tax sales taxes which will go to the trustee and be distributed after debt service is paid. Personal property replacement taxes and any state funds subject to competing claims by the Illinois Department of Transportation or any federal or state agencies from the pot to be distributed. The PPRT taxes will go into an escrow with 12.2% directed to the police fund and the same amount to firefighters.

If both the police fund and the firefighters fund submit future claims for overdue payments, the new claims will be paid in equal amounts, until one of the claims is paid in full, reads the settlement.

“This puts us in much better shape,” said police fund attorney Michael Moirano, of Moirano Gorman Kenny LLC. The system is 51% funded.

“Our expectation is that there will be enough to keep the firefighters fund solvent until the police are satisfied, at which point our share will increase,” said fund attorney Andrew Schwartz, of Schwartz & Kanyock LLC. The system is 22% funded.

The dispute began in February when the police fund took first crack at the city’s state collected funds by filing a claim against a pool of funds that totaled about $7 million last year. The firefighters’ fund followed by filing a claim in April, arguing that it had rights to share in diverted revenues that came to total $2.3 million. The courts initially denied Harvey’s request for an injunction blocking the continued withholding.

The case became public in April when Mayor Eric Kellogg announced public safety layoffs due to the withheld funds. The bondholder trustee intervened in May seeking to protect its rights under the 2008 ordinance to the home rule sales taxes and local share of state sales taxes.

The case came to a head in late May as the comptroller completed a certification review process of the police claim and city’s objection and was prepared to release the funds in accordance with the law.

Brenton 'Brent' Vincent, partner at Bryan Cave Leighton Paisner LLP
Attorney Brent Vincent represents the trustee for Harvey's revenue bondholders.

As part of its review, the comptroller concluded that home rule sales taxes did not meet the definition of “state funds” under the state legislation and would continue to flow directly to the bond trustee but local share state sales taxes did and were subject to diversion – a position objected to by bondholder lawyer Brent Vincent of Bryan Cave Leighton Paisner.

The city and firefighters’ fund joined forces to win a temporary restraining order preventing distribution of the $2.3 million and negotiations continued on an interim settlement that would allow for distribution of the funds the city said it desperately needed to meet payroll.

Negotiations then focused on a global settlement going forward but negotiations were fraught with complications.

With various lawmakers saying they would press for changes in the 2011 law to push off the intercept or limit the diversion levels, the parties needed to ensure that any change in law wouldn’t impair the agreement. If future legislation changes the intercept mechanism, the Illinois Department of Revenue has agreed to bypass the comptroller’s office and direct the various state fund to an escrow agent that would manage distribution.

Another issue arose when the comptroller’s office concluded that the well-funded statewide fund — the Illinois Municipal Retirement Fund — would now join the public safety pension in the diversion claims’ process.

Previously, the IMRF had rights as a “state agency” to garnish a single revenue stream for a local government behind on contributions.

The IMRF has recently filed four diversion requests under the new process, according to comptroller spokesman Abdon Pallasch.

The Harvey parties also worried that a future IMRF claim against the city could get in way of the settlement’s distribution allocations, so the settlement requires the city to remain current on IMRF payments. If the comptroller receives a claim, the office will notify the bond trustee and it would pay the claim from excess revenues on hand before they are distributed to the various parties.

BIGGER PICTURE

While the 2011 law gives pension funds the right to intercept funds, it lacks language calling the claim a lien. That leaves open the question of priority. If “lien” were used the first fund to file a claim would have priority status. The lack of such language raises question over how to deal with competing claims and that needs to be settled by the legislature or the courts.

The comptroller’s office had been seeking court direction on the distribution as the “pension code does not explicitly provide for the manner in which the comptroller is to distribute the withheld state funds to the police fund and the firefighters fund that have both certified delinquencies,” reads the settlement.

Other issues left on the table include Harvey’s argument that property can’t be garnished to satisfy a judgment under state law and law does not allow pension funds to divert revenues for contributions owed before fiscal 2016. “We are shooting in the dark, there is no case law” on many of the issues that surfaced in the case but were not litigated as the settlement resolved the dispute, one attorney said.

Some market participants have worried that a flood of funds could follow Harvey’ lead straining coffers. The intercept also has sparked worries from rating agencies and investors that bondholders’ legal claims will fall behind pensioners and could lead to impairment as distressed governments look for ways to preserve funding for critical services.

Harvey attorney Fioretti said he expects others will follow, though he noted that political dynamics will play a role as pension fund board members include both retirees and current employees.

The former may take an aggressive stance in demanding payment, while the latter may look to avoid any actions that result in job losses as they did in Harvey. There’s also the chance that the Harvey mess might prompt some local governments to step up funding to avoid a similar quagmire.

The settlement could serve as a “precedent in terms of a settlement” for future governments that find themselves embroiled in a similar dispute, but the state needs to take the lead on a long term fix, Fioretti said.

“There’s no question that the state need to intervene so that local governments can meet their obligations and pension funds can reach the goal of 90% funding without bankrupting” city coffers, Fioretti said. “The Illinois model of ignoring the problem does not work.”

Fioretti supports some form of intervention as current state intervention laws fall short of helping cities like Harvey. The Chicago Civic Federation and restructuring expert Jim Spiotto’s has pitched a quasi-state intervention board that would help struggling communities manage their debt before reaching distressed levels. Fioretti thinks lawmakers should convene a special panel and take testimony to come up with fix.

Harvey’s fiscal woes run deep due to a dwindling tax base, population and job losses, and fiscal mismanagement that led to Securities and Exchange sanctions on the 2008 bond sale, general obligations defaults, and an ongoing dispute with Chicago on overdue water payments.

Fioretti said the city is tightening its belt to address the 35% revenue loss.

Gov. Bruce Rauner has endorsed adding a Chapter 9 statute to state law. Others believe a constitutional amendment ending the state constitutional's ban on benefit cuts is part of a fix, though it could face a legal challenge as unions believe benefits in place at the time of hiring are protected. Others say public safety funds should be consolidated.

Pension strain has been a primary driver in 31 downgrades of Illinois municipalities by Moody’s Investors service since January 2017.

A new funding source to bolster funding would go a long way toward a fix, though it’s a tough political sell after the state last year raised income tax rates to cut red ink and stabilize its near-junk ratings.

Nuveen said in a recent report it doesn’t expect a wave of fund intercepts, but it does see others facing similar struggles. “Illinois taxpayers shoulder the fiscal burden of both state and local pension obligations," the report said. "Investors should evaluate the capacity of local tax bases to absorb growing pension costs when assessing credit quality across the state.”

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.