Maine Advisory Opinions March 11, 2005: AGO 05-1 (March 11, 2005)

Maine Attorney General Opinions

2005.

AGO 05-1.

Dear Senator Strimling and Representative Smith:

You have asked several questions concerning the Governor's proposal to sell lottery revenues, proceeds from which are intended to be received by the State in fiscal years 2006 and 2007. As we understand this proposal, the Legislature would authorize the Commissioner of the Department of Administrative and Financial Services ("DAFS") to sell lottery revenues for a ten year period on terms that she deems appropriate, subject to certain general terms and requirements established by statute. While we can provide some general information concerning your questions, any legal analysis would be incomplete without a detailed proposal to evaluate. This is particularly true with respect to the applicability of federal tax provisions, which are quite complex and key to the success of such a transaction.

We address your questions in the order that you have raised them.

1. Would a proposal to securitize future State lottery revenue by issuing bonds require voter approval pursuant to the Maine Constitution? Or could the proposal legally involve the issuance of "Maine governmental authority bonds" rather than general obligation bonds, so that voter approval is not constitutionally required? The Committee would greatly appreciate an explanation of the difference between these types of bonds as well.

The term "bonds" is used to describe a number of different vehicles used by the State to borrow money. The State agrees to make periodic payments of principal, interest or both, to those who provide funds to the State by investing in the bonds. General obligation bonds are backed by the full faith and credit of the State, and are issued with voter approval pursuant to the terms of Me. Const. Art. IX, § 14.

In contrast, moral obligation bonds are commonly issued by distinct and separate public authorities created by the Legislature, and these bonds are not backed by the State's assets and taxing power. As a practical matter, however, if the source of repayment on such bonds fails or proves inadequate, the State's credit rating may be affected if payments are not made.

The question of whether voter approval is required for the proposal you reference (or for any given issue of bonds) depends upon whether they are to be backed by the full faith and credit of the State. If bonds are to be supported by the State's credit, voter approval is required under Article IX, § 14 of the Constitution. As we read the proposal, it would authorize the DAFS Commissioner to undertake the sale of lottery revenues using whatever financing vehicle brings the best return on the best terms, but without the authority to create a debt or liability on the part of the State.

The Law Court has upheld the Legislature's power to establish distinct and separate corporate bodies such as the Maine State Housing Authority, the obligations of which are not debts of the State in Maine State Housing Authority v. Depositors Trust Company, 278 A.2d 699, 707 (Me. 1971). In that case, the statutory authority given to the Housing Authority to issue bonds to fund Its activities was upheld against a challenge based on both the voter approval requirement and the debt limit contained in Article IX, § 14. Depending upon how the proposed transaction is ultimately structured, an argument might be made that a debt or liability of the State within the meaning of Art. IX, § 14 results if DAFS, rather than an independent governmental authority, is the contracting party. This risk could be significantly reduced if the legislation is drafted so that the transaction is entered into by such a governmental authority.

In summary, if the transaction is structured so that it is not backed by the full faith and credit of the State and it does not create a debt or liability of the State within the meaning of Art. IX, § 14, voter approval is not required.

2. Would a proposal to securitize future State lottery revenue unconstitutionally bind a future Legislature, by requiring that a future Legislature obey an obligation to transfer lottery revenue to another entity?

The United States Supreme Court stated more than a century and a half ago that "[i]t is a principle controverted by no one, that, on general questions of policy, one legislature cannot bind those which shall succeed it..." Woodruff v. Trapnall, 51 U.S. 190, 208 (1851)(n. 1). Maine's Law Court has also so held:

This bill, if enacted, will be on equal footing with every other law passed by the Legislature: subsequent sessions of the Legislature may choose to follow it, or they may choose to repeal it, either expressly or by implication. See Manigault v. Springs, 199 U.S. 473, 487, 26 S.Ct. 127, 133, 50 L.Ed. 274 (1905)(bill requiring Legislature to give direct notice to all interested parties and to publish the notice in a major newspaper, prior to the granting of a private right or privilege by special bill, could be "repealed, amended, or disregarded by the legislature" and was "not binding upon any subsequent legislature.")....To read this statute as binding upon future Legislatures is to read it as an attempt to amend the Constitution of the State of Maine through improper means. Such a bill would not be enforced by the courts against future Legislatures.

Opinion of the Justices, 673 A.2d 693, 695-696 (Me.1996). More specifically with reference to statutes that contemplate appropriation by a subsequent Legislature, the Court in Maine State Housing Authority, supra, concluded (at 708):

We consider that the Legislature, having positively stated its intention not to obligate the state [by. an express statement in the statute], and aware of its inability to bind future legislatures even if it wished to do so, intended only to express to its successors an expectation and aspiration that the project might be found worthy of financial assistance, if later needed.

Thus, legislation that provides for the sale of lottery revenues and concomitant payment of those revenues by future Legislatures would not bind subsequent Legislatures.

3. If the Maine State Retirement System were to purchase State bonds for future lottery revenue while maintaining a relationship with the State as an employer who pays into the retirement system, would the retirement system be "favoring" a participating employer in violation of section 503 of the federal Internal Revenue Code, or other federal law?

The Maine State Retirement System ("MSRS") is an employee retirement plan. Its trust income is exempt from federal taxation, and its employee contributions are tax deferred, as long as the plan complies with the qualification requirements of Sections 401(a) and 501(a) of the Internal Revenue Code ("the Code"). The prohibited transaction provisions of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), do not apply to governmental plans such as MSRS. However, a qualified governmental plan's ability to invest in, or make loans to, its creator or an entity that makes substantial contributions to the plan are clearly limited by certain provisions of the Code. Specifically, 401(a)(2) requires that the purpose of any loan or investment must be for the "exclusive benefit" of plan beneficiaries, and Section 503(b) sets forth prohibited transactions for qualified plans. Compliance with these requirements is necessary in order for the plan to retain its qualified status.

A determination of whether a MSRS loan to, or investment in, the State may violate Sections 401(a)(2) or 503(b) and thus jeopardize the qualified status of the MSRS trust, first requires a thorough understanding of the detailed terms and conditions of the loan or investment transaction. Second, such determination requires a careful application' of the provisions of Sections 401(a)(2) and 503(b) to the detailed facts and circumstances of the proposed transaction. Since the detailed terms and conditions of the proposed bond transaction that you reference between MSRS and the State are presently unknown, it is impossible to make a determination as to the effect of such transaction on the qualified status of the MSRS plan. This is a complex area of law and a thorough legal analysis requires familiarity with the relevant Code provisions as well as interpretive decisions from the Internal Revenue Service and federal courts.(fn1)

Regardless of whether such a transaction would pass muster under federal tax law, the decision to proceed with a transaction rests solely with the MSRS Board of Trustees ("Trustees"). In addition to the fiduciary duties placed on the Trustees by federal tax law, the Maine Constitution, Art. IX, Sec. 18, states that Trustees are obligated to invest MSRS funds in trust "for the exclusive purpose of providing for [retirement and related] benefits and [that such funds] shall not be encumbered for, or diverted to, other purposes." Additional duties are imposed on the Trustees by statute. 5 M.R.S.A. § 17153(3); 18-A M.R.S.A. § 7-302; 18-B M.R.S.A. § 802-07, 901-06.

Although we are presently unable to provide an answer to your question, we can explain the provisions of the Internal Revenue Code that would be relevant in analyzing the transaction once the detailed terms and conditions are known.

The exclusive benefit rule under Code section 401(a)(2)

In order for the System to remain qualified as a tax exempt plan under Section 401(a), all MSRS investments must be made "for the exclusive benefit" of MSRS beneficiaries. While there are no specific rules set forth in the Code or applicable regulations, the following criteria are relevant to a determination whether an investment satisfies the requirements of the exclusive benefit rule:

1.

The cost of the investment must not exceed its fair market value at the time of purchase.

2.

The investment must provide a fair rate of return commensurate with the prevailing market rate.

3.

The plan must maintain sufficient liquidity to permit distributions in accordance with plan terms.

4.

The safeguards and diversity that a prudent investor would adhere to must be present.

Revenue Ruling 69-494, 1969 C.B. 88; Winger's Department Store, Inc. V. Commissioner, 82 T.C. 869 (1984).

Although these criteria appear fairly self-explanatory, a number of federal court opinions provide additional guidance in applying the exclusive benefit rule to specific situations.

Prohibited transactions under Code section 503(b)

Section 503(b) prohibits a trust from engaging in certain transactions with, among others, its creator or an entity that has made a substantial contribution to it. Since the State created and has made substantial contributions to the MSRS trust, the MSRS Trustees must be alert to these prohibited transactions when considering a loan to the State or an investment in a State issued security.

Specifically, Section 503(b) prohibits the MSRS from:

1. Lending any part of its income or corpus to the State, without the receipt of adequate security and a reasonable rate of interest; * * *

3. Making any part of its services available to the State on a preferential basis;

4. Making any substantial purchase of securities or any other property from the State, for more than adequate consideration in money or money's worth;

5. Selling any substantial part of its securities or other property for less than an adequate consideration in money or money's worth to the State; or

6. Engaging in any other transaction that results in a substantial diversion of the MSRS' s income or corpus to the State.

With respect to e first prohibition referenced above, adequate security refers not to the State's creditworththiness, but rather to tangible security, "something in addition to and supporting a promise to pay, which is so pledged to the organization that it might be sold, foreclosed upon, or otherwise disposed of in default of repayment of the loan." Treas. Reg. §1.503(b)-1(b)(1). Code section 503 provides two special rules regarding subsection (b)(1) transactions. The first, in section 503(e), provides that under certain circumstances, debt obligations of an employer acquired by the trust that are part of an issue of debt obligations also owned by independent parties will satisfy the adequate security requirement. The second special rule, in section 503(f), provides an exception for cases in which employers are prohibited by federal law from pledging certain assets.

I hope this information is helpful.

Sincerely,

G. STEVEN ROWE

Attorney General

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1. Due to this complexity and in response to a request from the MSRS, I have approved that organization's request to seek legal counsel from a Washington, D.C. law firm that specializes in this area of federal tax law.