A lawsuit that seeks to void $14.3 billion of Illinois' outstanding general obligation debt amounts to nothing more than a policy statement masked under a legal guise that lacks any merit, Illinois Attorney General Kwame Raoul’s office argues in the state’s
The complaint seeking taxpayer action status from the court claims the state violated its constitution when it sold $10 billion of GO pension obligation bonds in 2003 and again in 2017 with a $6 billion borrowing to pay down its unpaid bill backlog.
About $14.3 billion is still owed on the two issues, according to the complaint filed by the Illinois Policy Institute’s leader 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.
No effort was made to “enjoin the issuance of the allegedly unlawful bonds before they were issued,” says the state’s response, filed Friday, objecting to the request to file a taxpayer action complaint.
“Instead, petitioner seeks to call back ships put to sea years ago, many of which are nearing their decommission date, to maximum detrimental effect,” continues the state response. “Petitioner does so without naming any holder of the bonds for a proper adjudication of their rights, instead advancing the interests of one noncitizen investor in different bonds against other bondholders, and attempting to elevate certain appropriations over others.
“Because petitioner slept on his rights for years, because the essential premise of his proposed complaint is wrong as a matter of law, including under clear Illinois Supreme Court precedent, and because the remainder of the complaint states no cause of action whatsoever, but rather seeks to conduct a fiscal policy debate in a courtroom, there is no role for the court to play and no reasonable grounds for allowing its filing,” the state filing says, calling the lawsuit "a policy paper masquerading as a complaint” that seeks to make the case Illinois has not been wise in its fiscal decisions.
A hearing in the state’s Seventh Judicial Circuit for Sangamon County is scheduled for Aug. 15.
Spreads
Market analysts have voiced skepticism about the case’s legal merits, based on the approval granted by bond lawyers and the state attorney general and their read of state debt rules that give the state broad issuance powers as long as it names a general purpose for the bonds, method of repayment, and approval by a three-fifths legislative majority.
They also believe, if the policy group and hedge fund prevailed, the state would find a way to make bondholders whole to avoid any market consequences.
Those beliefs didn’t stop the market from driving state yield penalties up in trading and there’s an expectation now that the state may get stuck paying more to borrow during the course of the lawsuit if not resolved quickly.
The state’s 10-year and 25-year GO was trading at a 170 basis point spread to the Municipal Market Data AAA benchmark Monday compared to a 160 bp spread on July 10 and a 139/140 spread just before the lawsuit’s filing.
“Illinois GOs have moved in a downward fashion since the lawsuit,” said Daniel Berger, senior market strategist at MMD – Refinitiv. “I think it’s still in price discovery mode.”
“The legal merit may be weak and it’s a long shot, but it’s hard to handicap judicial risks especially when a judge may not be well-versed in municipal finance and this case could be around a while as either side will appeal,” said Brian Battle, director of trading at Performance Trust Capital Partners.
The bottom line is “the buyside gets to buy Illinois bonds at a cheaper” price in the secondary and if the case lingers it will be “more expensive for Illinois to borrow. It’s a cloud over the state,” Battle said.
Citi’s municipal analysts were among those that were skeptical of the case and its impact in their initial reaction but in a follow-up commentary the group said it would be “remiss of us to ignore the possibility of an unfavorable outcome for Illinois especially since it could have significantly negative fallout on the state GO sector. We have long been bullish on Illinois GOs and pointed to levers that the state can pull to correct its fiscal situation. But, we have also noted that the GO spreads are too tight vs. its fundamentals and at present, we see more downside than upside,” the report said.
“Let’s be clear, we do not believe that this litigation has any merit as we would posture that the underlying argument is baseless,” Oppenheimer market strategists wrote in a commentary. “For now, the greatest concern for bondholders is headline risk … the longer the litigation goes on, the greater the chances for a sustained hit to bond valuations.”
Market participants had been expecting a summer bond sale, but Pritzker’s administration said no deal is imminent. “There are sufficient funds available now for early costs” of the state’s new $45 billion capital program, said budget spokeswoman Carol Knowles. “We would expect to issue capital bonds this year, but will work with the construction agencies on the timing of the need.”
The size and timing of an authorized $1.2 billion unpaid bill backlog borrowing will depend on cash flow needs at the comptroller’s office and a decision on the need for additional pension buyout bonds likely will be made later this summer, Knowles said.
Arguments
The complaint argues the $10 billion 2003 deal and the $6 billion of 2017 borrowing that sold in two transactions amount 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 state’s filing argues “the laws authorizing the 2003 and 2017 bonds that petitioner contests plainly satisfy” the specific purposes requirement by naming the purpose of the 2003 bonds for pension contributions and the 2017 bonds for paying down overdue vouchers and so “the petition therefore presents no reasonable ground for filing the complaint.”
The state further argues that the complaint comes too late under legal precedent involving “unjustified interference” in the application of public funds and in the case of the 2003 deal general five-year statute of limitations on civil actions.
“In this case, petitioner seeks to unscramble eggs that were cracked, cooked, and eaten sixteen and two years ago, with no explanation as to why he did not bring suit before breakfast hit the pan,” the state filing says.
The state also picks apart at the complaint’s claims that the state’s balanced budget amendment is violated and so debt service should be halted, arguing under the State Debt Clause and the General Obligation Bond Act debt service is supported by the full faith and credit of the state which provides a contractual guarantee.
Warlander argues it has standing to bring the case because “the unconstitutional bonds lowered the state’s creditworthiness and have put the state at a significant risk of default.” Warlander holds about $25 million of GOs from deals in 2010, 2014, 2016, 2017, and 2018. The state is rated triple-B-minus and triple-B.
The state counters that such a position does not give Warlander any standing on a taxpayer action.
Tillman heads a conservative-leaning think tank that has been critical of state fiscal and tax policies and formerly had close ties to Bruce Rauner, who was defeated by Pritzker last November.
Market participants have attributed some concerns to Puerto Rico related rulings and actions.
The Puerto Rico Oversight Board in Puerto Rico's Title III case earlier this year moved to invalidate $6 billion of GOs on the argument that the commonwealth had exceeded state debt rules. The comparison is not direct as Illinois is fighting the lawsuit seeking to invalidate its bonds.
The appellate court also recently upheld a lower court ruling that the commonwealth may, but is not required, to continue paying some special revenue-backed bonds, a ruling that runs counter to the long-held position that such debt was insulated during bankruptcy proceedings and that’s added to uncertainty over how to value court risks.
