Revived Illinois GO legal challenge poses credit risks

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An appellate court decision that reopens a legal challenge to $14.3 billion of outstanding Illinois general obligation bonds is a credit negative for the state, Moody’s Investors Service said.

“The ruling is credit negative because it prolongs a legal challenge that, while unlikely to prevail, carries severe risk and could limit the government's financial options at a time when the coronavirus pandemic is weighing on revenue,” Moody’s wrote in a comment Friday.

Ted Hampton, Moody's lead Illinois analyst, is one of the authors of an outlook piece that labels last week's appellate court opinion a credit negative.

Moody’s rates the state at the lowest investment grade of Baa3 with a negative outlook. Fitch Ratings and S&P Global Ratings assign ratings at the same level, also with negative outlooks.

“We still view an ultimate ruling in favor of the plaintiff as highly unlikely, in view of the state's constitutional power to borrow for statutorily defined needs,” Moody’s said. “But an appellate court ruling at this stage supporting the lower court could have settled questions on the state’s ability to use statutorily authorized debt for pension or bill-payment purposes and potentially alleviated some of the investor concern that has driven up Illinois' borrowing costs compared with other issuers.”

The appellate court did not comment on the merits of the case, instead concluding that the lower court had erred in ruling that it couldn't proceed as a taxpayer action.

"Nothing in the appellate court opinion signals support for the plaintiff’s stated goal of forcing the state to stop paying debt service," Moody's wrote.

The lawsuit challenges the legal validity of the state’s $10 billion 2003 pension issue and $6 billion 2017 bill backlog borrowing. About $14.3 billion remains outstanding. In addition to the debt being challenged, the state has another $13 billion issued for capital projects and another $1.2 billion of one-year GO notes issued under state law allowing borrowing for unexpected deficits.

The state’s fiscal year 2021 general fund budget includes the potential sale of about $1.3 billion in additional backlog bonds if budget pressures intensify in the second half of the fiscal year.

“The existence of litigation against the backlog bonds would likely keep the state from using this option even if voters in November defeat a proposal to allow the state to raise revenue by imposing a progressive income tax,” Moody’s wrote.

The state budget also counts on up to $5 billion of borrowing through the Federal Reserve’s short-term lending program if the federal government doesn’t approve aid to make up for tax losses. The state has cut fiscal 2020 and 2021 revenue projections by more than $7 billion due to the economic shutdown and recession caused by the COVID-19 pandemic.

The Thursday opinion from the appellate panel came in a case first launched in July 2019 by Illinois Policy Institute head John Tillman and the New York-based hedge fund Warlander Asset Management LP. Tillman heads a conservative group that is a frequent critic of state fiscal policies. Warlander is no longer a named plaintiff.

They sought the court’s permission to file a taxpayer action lawsuit that argues the financings ran afoul of the state constitution and repayment of the remaining balance of $14.3 billion should be blocked.

After oral arguments last summer, Sangamon County Circuit Court Jack D. Davis II in an August 2019 opinion rejected Tillman’s request for leave to file the case and the potential litigation ground to a halt. Tillman’s lawyers appealed to the Fourth District Appellate Court, arguing that Davis’ ruling went too far in considering the legal merits when the decision should have been limited to whether the lawsuit was “frivolous” or “malicious.”

“Tillman’s complaint sets forth a colorable reading of the Illinois Constitution that does not appear to be frivolous on its face. While we express no opinion on the ultimate merits of Tillman’s claims, we conclude that the petition and complaint state reasonable grounds for filing suit,” reads the appellate court’s 12-page opinion.

“We conclude that because Tillman’s complaint was not frivolous or malicious, the trial court erred by denying his petition for leave to file it. Accordingly, we remand the case for further proceedings,” reads the opinion. “We repeat that we express no opinion on the merits of Tillman’s claims.”

The Tillman lawsuit argues that deficit financing is not a “specific purpose” allowed under the state constitution. The state can borrow to cover a deficit under statutory provisions that allow for a term limited to one year due to a failure of revenues. The state recently borrowed $1.2 billion through a MLF loan under that provision.

Many market participants thought the challenge was a long shot given the state’s bond review process and the wide latitude of the statutory language, but secondary market spreads on Illinois paper widened by about 35 basis points after the initial filing, reversing improvements as market participants had been buoyed by a newfound political calm in the state with the 2018 election of Pritzker.

Spreads recovered after the trial court’s refused to allow the complaint to proceed and the state was further aided by the market’s thirst for higher yielding credits.

The new ruling lands as the state’s spreads have recovered from peak levels of more than 400 basis points to the Municipal Market Data’s top benchmark. They spiked amid market turmoil dating back to March as the COVID-19 pandemic accelerated and worries grew over the state’s ability to preserve its investment-grade ratings.

Many market participants have said they believe if Tillman eventually prevails the state would pass legislation making good on repayment of the debt in question to preserve its market access.

Warlander withdrew its name from the lawsuit after Davis expressed concerns over the New York-based fund’s involvement during oral arguments last summer. During oral arguments, the firm disclosed in the courtroom that it stood to benefit if the bonds were ruled illegal because of credit default hedges it had entered into involving the challenged bonds.

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