Can Maine sell its future lottery revenues for an upfront payment without voter approval, and could the state retirement system buy the resulting bonds?

Plain-English summary

The Governor's 2006-2007 budget proposed selling ten years of future Maine lottery revenue to investors for an immediate cash payment. The Joint Standing Committee on Labor asked Attorney General G. Steven Rowe three questions: did this require voter approval; would it bind future legislatures; and could the Maine State Retirement System (MSRS) buy the resulting securities without losing its tax-qualified status?

On voter approval, the AG drew the standard distinction. General obligation bonds, backed by the State's full faith and credit, require voter approval under Article IX, § 14 of the Maine Constitution. Moral-obligation or "authority" bonds issued by separate corporate entities (such as the Maine State Housing Authority) do not, because they are not state debts. The AG read the Governor's proposal as authorizing the Department of Administrative and Financial Services Commissioner to choose whatever financing vehicle gave the best return without creating a state debt. Cited the Law Court's 1971 decision in Maine State Housing Authority v. Depositors Trust Company upholding bond authority for separate corporate bodies. The AG advised that if the deal were instead routed through DAFS rather than an independent authority, an argument that the State had taken on Article IX, § 14 debt would be plausible, and that risk could be reduced by drafting the legislation to make a separate governmental authority the contracting party.

On binding future legislatures, the AG was definitive. One Legislature cannot bind a successor on general questions of policy. Future Legislatures could repeal or amend the lottery-revenue program, expressly or by implication. The opinion quoted Opinion of the Justices, 673 A.2d 693 (Me. 1996), and Maine State Housing Authority, 278 A.2d at 708, for the proposition that statutes contemplating future appropriations express only an aspiration, not a binding obligation.

On the MSRS purchase question, the AG declined to give a final answer because the actual transaction terms were not yet drafted. The opinion explained the framework. To keep tax-exempt status under IRC § 401(a) and § 501(a), the plan had to satisfy the exclusive-benefit rule of § 401(a)(2). Under Revenue Ruling 69-494 and Winger's Department Store v. Commissioner, that meant the cost could not exceed fair market value, the return had to be commensurate with prevailing market rates, the plan had to keep enough liquidity for distributions, and prudent-investor diversification standards had to be met. Section 503(b) separately prohibits a qualified trust from lending corpus to its creator without adequate security and a reasonable interest rate, and from a list of related-party transactions: making services available preferentially, buying State property at inflated prices, selling MSRS property to the State at a discount, or any transaction substantially diverting income or corpus to the State. "Adequate security" under Treasury Regulation § 1.503(b)-1(b)(1) meant tangible security separate from the State's general creditworthiness, something the trust could foreclose on or sell. Sections 503(e) and 503(f) provided narrow exceptions when the bond was part of an issue independent parties also held, or when federal law forbade the State from pledging assets. The AG noted that he had separately approved an MSRS request to retain Washington, D.C. tax counsel to vet the transaction.

Currency note

This opinion was issued in 2005. Subsequent statutory amendments, court decisions, or later AG opinions may have changed the analysis. Treat this page as historical context, not current legal advice. Verify current law before relying on any specific rule, deadline, or remedy mentioned here.

Background and statutory framework

State lottery proceeds in 2005 flowed into the General Fund as ordinary receipts. The Governor's proposal would convert that future income stream into a one-time lump sum by selling the rights to future receipts to investors, structured as a bond or securitization. This kind of transaction had been used by other states (notably for tobacco settlement payments) and is conceptually similar to a pension-fund "factoring" transaction.

The Maine constitutional question turned on Article IX, § 14, which restricts the State from creating debt without voter approval. The Law Court had repeatedly upheld separate authority structures, like the Maine State Housing Authority, that issue revenue bonds backed only by their own income and not by the State's general taxing power. The price of that work-around was that the State could not formally promise the bondholders payment, so investors would be looking only at the income stream itself plus whatever credit-enhancement the structure provided.

The federal qualified-plan rules existed to keep public employee retirement trusts honest. ERISA's prohibited-transaction rules do not apply to governmental plans, but the IRC's § 401(a)(2) exclusive-benefit requirement and § 503 prohibited-transaction list do, and a violation can disqualify the trust and trigger immediate taxation of trust earnings. The exclusive-benefit rule existed precisely to prevent governments from using their pension funds as cheap captive lenders. A state pension fund buying state-issued debt is not automatically prohibited, but the burden is on the trustees to document that the price, yield, security, and diversification all stand on independent-investor terms.

Common questions

Q: Was Maine actually proposing to sell its lottery to a private buyer?
A: No. The proposal contemplated securitizing the revenue stream, meaning investors would own the right to receive payments equal to lottery proceeds for a fixed period, typically backed by a separate trust or authority. The State would still operate the lottery.

Q: Why does the form of bond matter for voter approval?
A: Maine's Constitution requires voter approval before the State commits its full faith and credit to debt. If the transaction is structured so the State has no obligation to pay if the lottery income falls short, it is not state debt within the meaning of Article IX, § 14, and voter approval is not required.

Q: Could the Legislature lock in payments to bondholders so future legislatures could not cut them?
A: No. The AG cited the long-standing principle, traced back to Woodruff v. Trapnall (1851), that one legislature cannot bind another on policy questions. Bond covenants typically address this commercial risk through credit-enhancement structures, not by claiming a constitutional ability to bind successors.

Q: What is the "exclusive benefit" rule the AG mentioned?
A: It is a federal tax-code requirement (26 U.S.C. § 401(a)(2)) that the assets of a qualified retirement plan can be used only for the exclusive benefit of plan participants and their beneficiaries. Investing pension assets in employer-issued securities is allowed but has to clear the same fairness, diversification, and adequate-security tests an independent investor would apply.

Q: What kind of "tangible security" does § 503(b) require?
A: Under Treasury Regulation § 1.503(b)-1(b)(1), pledging the borrower's general credit is not enough. There has to be a specific asset, separately identified, that the trust could foreclose on or sell if the borrower defaulted. Lottery revenue securitization could potentially satisfy this if the bonds were structured as secured by the revenue stream itself.

Citations and references

Constitutional provisions:
- Me. Const. Art. IX, § 14 (voter approval for state debt)
- Me. Const. Art. IX, § 18 (MSRS exclusive purpose)

Federal tax statutes:
- 26 U.S.C. § 401(a) (qualified plan requirements)
- 26 U.S.C. § 503(b) (prohibited transactions)
- Treas. Reg. § 1.503(b)-1(b)(1) (adequate security)
- Revenue Ruling 69-494, 1969 C.B. 88

Cases:
- Maine State Housing Authority v. Depositors Trust Company, 278 A.2d 699 (Me. 1971), upholding revenue-bond authority for separate corporate bodies
- Woodruff v. Trapnall, 51 U.S. 190 (1851), one legislature cannot bind successors
- Opinion of the Justices, 673 A.2d 693 (Me. 1996), legislative enactments equal to one another regardless of how passed
- Winger's Department Store, Inc. v. Commissioner, 82 T.C. 869 (1984), application of exclusive-benefit rule

Source

• Landing page: https://www.maine.gov/legis/lawlib/lldl/agops/agops.htm
• Original PDF: https://lldc.mainelegislature.org/Open/AG/Opinions/2005/ag_20050311.pdf

Original opinion text

Best-effort transcription from a scanned PDF. Minor errors may remain, the linked PDF is authoritative.

05-1

REGIONAL OFFICES:
84 Harlow St., 2nd Floor, Bangor, Maine 04401, Tel: (207) 941-3070, Fax: (207) 941-3075
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128 Sweden St., Ste. 2, Caribou, Maine 04736, Tel: (207) 496-3792, Fax: (207) 496-3291

G. STEVEN ROWE
ATTORNEY GENERAL

State of Maine
Office of the Attorney General
6 State House Station
Augusta, Maine 04333-0006
Telephone: (207) 626-8800
TDD: (207) 626-8865
Fax: (207) 287-3145

March 11, 2005

Senator Ethan Strimling, Senate Chair
Representative William J. Smith, House Chair
Joint Standing Committee on Labor
100 State House Station
Augusta, ME 04333-0002

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.

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;

2. [omitted in source]

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 the first prohibition referenced above, adequate security refers not to the State's creditworthiness, 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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