CHICAGO — The fate of Minnesota’s proposed tobacco bond refunding is in the hands of the state’s high court, which is being asked to decide whether the use of an appropriation pledge constitutes a “public debt” that is subject to state limits on the uses of such debt.

The issue before the Minnesota Supreme Court, which is being asked to validate the bonds, stems from from the state’s plan to refund its November 2011 issue of $757 million of tobacco bonds. The original debt is secured by payments the state receives under its settlement with major tobacco companies.

Minnesota officials want to issue up to $800 million of state appropriation-backed bonds with the goal of cutting interest costs. The anticipated savings of the refunding are $65 million, according to court filings.

The November sale generated $640 million in net proceeds that were in turn used to cover debt service coming due on outstanding bonds during the 2012-13 biennium under a budget agreement that ended a state government shutdown.

The issue included an extraordinary optional redemption feature that allows the state to redeem the bonds in the event it sells appropriation-backed refunding bonds by a deadline of Dec. 1. The refunding bonds would formally be called state general fund appropriation refunding bonds.

Minnesota Attorney General Lori Swanson has contended that the bonds constitute a public debt and are an attempt by the state to bypass rules that don’t permit the use of public debt to balance the budget.

“This is a slippery slope if this court validates these bonds,” potentially opening new avenues to balance the budget and deficit spending, the attorney general’s solicitor general, Alan Gilbert, warned during oral arguments before the court last week.

Lawyers for Minnesota Management and Budget commissioner James Schowalter believe the attorney general is wrong on several fronts.

They say the bonds don’t constitute a public debt under the state’s definition since its “full faith and credit” is not pledged.

“As a practical matter there is no obligation to pay,” Kutak Rock LLP’s Angela Wilson said during oral arguments on MMB’s behalf. “The risk is on bondholders,” who would have no legal recourse against the state, unlike in the case of a general obligation pledge, should lawmakers fail to appropriate debt-service funding.

Wilson also argued that the bond proceeds won’t go to help eliminate a deficit but will refund debt issued for that cause.

Legislation authorizing the tobacco securitization or an appropriation bond issue was signed last year by Gov. Mark Dayton under a plan struck by the governor and lawmakers who had been deadlocked over how to fully eliminate a $5 billion deficit in the state’s fiscal 2012-13 budget. The stalemate forced a partial 20-day government shutdown last summer.

The legislation allowed for the use of the tobacco bond proceeds to cover debt-service payments owed in the new biennium.

The law, however, had a catch. The use of an appropriation pledge, though more affordable, was subject to a state Supreme Court validation process. With debt service payments coming up, the state moved on a securitization last November and in April the MMB’s Schowalter launched the validation process.

Swanson first raised concerns over the use of an appropriation pledge on tobacco bonds after former Gov. Tim Pawlenty floated a $1 billion issue to help balance the state’s fiscal 2010-11 budget. That action drove the decision to include the validation-process requirement in the new legislation.

In its written filings with the court, the MMB stresses that the state would clearly spell out that the refunding bonds are not a public debt of the state and its full- faith-and-credit and taxing powers are not pledged for repayment.

The bonds would be payable solely from amounts appropriated annually from the general fund by the Legislature and the state would have no contractual responsibility to repay the debt.

The state intends to use it tobacco settlement payments to repay the debt, but it makes clear that those funds are not pledged to the bonds.

“The bonds will be paid, if at all, each fiscal year from the general fund, based on a standing appropriation,” the court filings read.

Though the MMB filings stress the limitations of the pledge, they acknowledge that Minnesota’s failure to appropriate funds would “adversely affect the state’s credit rating and could therefore potentially affect the state’s to access capital markets in a cost-effective manner.”

“As a result, future Legislatures will experience economic and reputational pressure to annually appropriate sufficient funds to pay the principal and interest on outstanding appropriation bonds as they become due,” they acknowledge.

State officials outline for the high court how rating agencies typically assign a rating one to two notches below the state’s general obligation rating.

Minnesota currently carries ratings in the high double-A category.

The state lost its top credit marks in large part because of its use of one-shots, including the tobacco sale last year, to balance its budget.

The driving factor behind the state’s move is a reduction in interest costs with net present-value savings estimated at a minimum of 3%. The tobacco securities carry a true interest cost of 4.79% and carried credit ratings in the high triple-B and single-A category.

While the final rate on the refunding bonds is subject to market conditions, the state anticipates garnering a true interest cost of about 3.27%, according to court filings.

“Although these millions in savings will be free for the state to put to uses other than interest payments, the appropriation refunding bonds do not directly address any current projected budget deficit,” the MMB asserts in filings.

The state has never issued appropriation bonds but it has supported agency debt with an annual appropriation of funding under a master lease equipment financing program and certificates of participation. An annual appropriation of funds also goes to the University of Minnesota for its new football stadium.

The attorney general opposes the state’s position on several fronts.

Its filings argue that the appropriation bonds do qualify as a public debt based on statutory language, citing “any obligation payable directly in whole or in part from a tax of statewide application on any class of property, income, transaction or privilege but does not include any obligation which is payable from revenue other than taxes.”

Put more simply, the use of a general fund appropriation, no matter what the intended repayment stream is, makes the securities a “public debt” subject to limits on use.

Swanson, the attorney general, casts aside Minnesota’s arguments that because the government is not “technically” bound to repay the bonds, the securities don’t constitute a public debt, calling that argument a “subterfuge” to bypass state limits on the use of public debt to balance the budget.

“The court should not allow the use of appropriation bonds, referred to by some courts as moral obligation debt, to deficit spend in violation of the clear mandate of the state constitution,” the attorney general’s filings read. “Such funding is merely a subterfuge to evade the balance budget requirement of Minnesota’s constitution.”

“The practical effect of the bonds is that future Legislatures will have little choice but to pay off the bonds because failure to do so would have a significant adverse effect on the state’s credit rating and its ability to borrow money in the future,” Swanson argues.

In a second argument, the attorney general also contends that if the court accepts the state’s position that it has no legal obligation to repay the debt, then the bonds are still not valid under laws governing contracts.

Dayton is a member of the state’s version of the Democratic Party, known as the Democrat Farmer Labor Party as is Swanson.

The Legislature is controlled by the GOP and Pawlenty is a Republican.

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