Investment houses question motives of hedge fund behind Illinois GO lawsuit

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Two investment powerhouses with a $2 billion stake in Illinois bonds claim the hedge fund behind a lawsuit to block the state’s repayment of $14.3 billion of general obligation debt may be positioned to profit from a default.

Nuveen Asset Management LLC and AllianceBernstein LP put forth the claim in a joint brief filed Friday asking the court to allow it to file an amicus brief in support of Illinois’ position that the bonds were legally issued and should continue to be paid.

The investment firms’ brief lays out a series of arguments, some of which echo state Attorney General Kwame Raoul in asking the court to deny a petition from Warlander Asset Management LP and John Tillman to proceed with a taxpayer action lawsuit. Tillman is head of the Illinois Policy Institute, a conservative think tank that’s been critical of the state’s financial management.

The brief offers a new wrinkle.

“On information and belief, Warlander has bought credit default swaps well in excess of its nominal $25 million in GO bonds” from money-center financial institutions and “if swaps are Warlander’s undisclosed ‘separate financial interest in the litigation,’ then Warlander stands to reap an extraordinary profit from the mere pendency of this litigation,” the amicus brief argues.

The firms are referring to a footnote on page six of the original complaint that reads “in addition to the bondholdings referenced above, Warlander also has a separate financial interest in this litigation.”

While most municipal market analysts have shrugged off the lawsuit’s legal merits based on reviews of the deals conducted by the AG’s office and bond and underwriters’ counsel, a threat to state GO payment is still posed and Warlander stands to potentially benefit, the brief claims.

The brief lays out a scenario under which Warlander could profit in the event of a default if it in fact does hold those credit default swaps, although no firm evidence is offered.

“If public officers ‘for their own protection’ refuse to pay principal and interest on the challenged bonds until petitioners’ lawsuit is finally adjudicated, the result will be catastrophic — the bonds will default, Illinois will immediately lose its credit rating and the trading price of the challenged bonds will drop sharply,” warns the filing.

“If Warlander holds swaps, it can then buy GO bonds at bargain basement prices and tender them to the swap-seller at 100 cents — realizing an enormous profit from the catastrophic default it has manufactured,” it continues.

The brief includes data from the International Swap Dealers Association that is publicly available at showing credit default swaps on Illinois exceed $300 million.

Illinois, however, is fighting the lawsuit and market analysts believe the state would take any action required to continue making bond payments during the lawsuit and in the event the petitioners prevailed in order to preserve market access and its weak investment grade ratings.

“The court must determine Warlander’s true financial interest in the litigation in order to determine whether the petition has been filed for a malicious or ulterior purpose,” the brief urges.

A Warlander representative declined to comment, as did a spokeswoman for Tillman.


The brief also outlines the damage already inflicted since the lawsuit was filed in early July with a loss of more than $500 million in value for holders of the 2003 and 2017 bonds being challenged.

“Obviously, an injunction barring Illinois from paying principal and interest on the GO bonds threatens the Amici [reference to the two firms] and their clients with substantial economic harm. Not only does it jeopardize the state’s ability to pay principal and interest on the Amici’s bonds, but the filing of this action has already impaired the trading prices of those bonds,” reads the brief.

The petitioners are seeking to block any further repayment on the premise that the state failed to meet the legal threshold for issuing the bonds, including a requirement that the “special purpose” for the bonds be documented. The lawsuit was filed against Gov. J.B. Pritzker and other state constitutional officers.

A hearing with oral arguments scheduled on whether the case should be allowed to proceed as a taxpayer action is set for 11 a.m. Thursday in the state’s Seventh Judicial Circuit for Sangamon County, in the state capital of Springfield. Judge Jack D. Davis II is presiding over 2019-CH-000235.

Nuveen and AllianceBernstein represent clients who hold $2 billion of Illinois GOs, including $600 million of bonds from the 2003 and 2017 issues being challenged. “These holdings dwarf the $25 million in GO bonds that Warlander claims to hold,” according to the brief.

The brief’s warnings on the potential harm extend beyond Illinois’ borders. “Permitting activist investors to litigate against the validity of widely held municipal bonds based on their credit default swap bets could introduce a significant destabilizing force into the municipal markets and harm investors and government entities alike,” the brief contends.

The brief also lays out the toll already imposed on the bonds’ trading value simply from the filing of the lawsuit and the negative headlines that have ensued.

Spreads on bonds from the three deals — $10 million of taxable GOs sold in 2003 and $6 billion of GOs sold in two transactions in 2017 — have risen by about 36% to 182 basis points from 134 bps to the Municipal Market Data top benchmark scale, according to the brief.

“This movement represents a loss of $574 million in value to the holders of all of the challenged 2003 and 2017 GO bonds,” says the brief. The 2003 bonds paid down the state’s pension tab and covered near-term contributions while the 2017 deals paid down the state’s bill backlog built up over a two-year budget impasse.

The state’s maturities at 10 years and further out remained at a 175 basis point spread to MMD on Monday compared to 140 bps just before the lawsuit’s filing.

The firms also blame the state’s delay in selling $1.5 billion of GOs to pay down a bill backlog — it stood at $6.6 billion Monday — on the lawsuit’s filing because it’s now “more expensive for the state of Illinois to issue new GO Bonds, harming every citizen of the state.”

The state had intended to sell the bonds this summer, but the deal has been pushed off until at least the fall, according to market participants. “Trade creditors are still waiting for payment,” the brief reads. The borrowing is aimed at reducing the state’s interest costs because it will pay less on the bonds than on the overdue bills some of which accrue at 12% annually.

The amicus brief cast further questions on Warlander’s assertion that the value of its bonds are at risk of impairment if the state continues to repay the outstanding $14.3 billion because of its weak, barely investment grade condition. The brief alleges that Warlander’s bonds are trading at levels of 107 cents to 119 cents on the dollar. “This lawsuit cannot make them worth materially more,” the brief says.

On the merits of the lawsuit’s legal interpretations, the amicus brief challenges the position that the bond legislation falls short of adequately establishing a legal special purpose.

“First, petitioners are incorrect when they assert … the Illinois Constitution uses ‘specific purpose’ as a limitation on the incurrence of long-term debt. Rather, the section requires a ‘specific purpose’ not as a limitation on power to incur long-term debt but as a description of the purpose for which that power is used,” the brief says.

The brief also turn to constitutional convention dialogue to argue that “not only do they misread the plain language…of the constitution, but also they disregard its drafting history to seek a result that is plainly at odds with the intent of the delegates who formulated this provision.”

The two investment houses are represented by Sorling Northrup and Kramer Levin Naftalis & Frankle LLP.


Citi municipal analyst Vikram Rai in the team's Municipal Weekly report last week reported having received “countless questions on the prognosis of the lawsuit” ahead of the Aug. 15 hearing as spreads have “slowly but steadily” widened. The team warns that investors should be prepared “for a lengthy legal battle due to the process of appeals.”

“Even though at least one rating agency has revised its outlook on the state to stable from negative citing better tax collections, investors continue to approach the state’s GO debt with trepidation” and because the case could take some time to make it through the appeals process “spreads are likely to stay under pressure as long as the overhang of the lawsuit exists.”

State GOs could rally “significantly” if the case is dismissed for a lack of standing Thursday as the petitioners’ appeals process would face a tougher road, but Citi doesn’t anticipate that outcome and doesn’t see spreads narrowing to levels seen before the lawsuit’s filing.

The report considers a scenario where Illinois loses an investment grade rating, although Citi stresses it does not expect such action. “In the unlikely event that the GOs are downgraded by either of the key rating agencies, we do not expect a sharp move in spreads in either direction, though we do expect that spreads will continue to widen over time,” the report says.

The petitioners’ lawyers argue in their latest filing that the question over whether the bond issues satisfy constitutional language on specific purposes requires judicial consideration. Tillman and Warlander are represented by Webber & Thies PC and White & Case LLP.

The Illinois attorney general in its July 19 response to the complaint, argues the bond legislation met the state’s broad authorizing language, that Warlander lacks standing to pursue a taxpayer action, and that the attack on the 2003 bonds comes too late based on a general five-year statute of limitations policy.

An Industry source familiar with the investment firms' decision to file the brief said the CDS issue came up as they began exploring among market participants a motive for Warlander to back the complaint given its Illinois holdings were limited to $25 million.

"Why is a hedge fund spending all this money to protect $25 million? That doesn't makes sense," the source said. The firms "started talking to people and there were rumors out there that they were short on Illinois bonds."

The firms lack documented evidence on the depth of Warlander's alleged CDS position but say it's well known by key market participants and should be disclosed to the court even if Warlander has since sold off the position the investment firms' allege Warlander holds. "Let's have it out there in the open," the source said. The motive, too, for the firms in filing the brief was to inform the judge of their support for Illinois' position based on their clients' holdings. The firms "think Illinois will win the case at the end of the day but they felt it was important to stand up for their clients who are being harmed by the lawsuit and the judge should have the perspective of long-term investors," the source said.

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Lawsuits Buy side General obligation bonds Secondary bond market State of Illinois Nuveen AllianceBernstein Illinois