Judge's take on Prop 123 could impact ed funding

Local attorney Grady Gammage Jr. is a senior research fellow at Morrison Institute for Public Policy.
April 11, 2018

Proposition 123 is back in the headlines because it’s back in the courtroom.

The measure, approved by the voters in 2016, increased distributions from the “permanent fund” of proceeds from state trust lands to settle ongoing litigation with Arizona’s schools. Now, U.S. District Court Judge Neil Wake has ruled that Proposition 123’s distributions may have violated the Enabling Act.

According to Judge Wake, the State had to obtain Congress’ approval of Proposition 123 before its distributions could be made. Congress did approve Proposition 123, but nearly two years after the fact, on March 23 of this year. The question is now whether Congress’ consent applies retroactively to payments made under Proposition 123. If the answer is no, Judge Wake may invalidate hundreds of millions of dollars in payouts.

Cameron Artigue, Chris Hering and myself, from the law offices of Gammage & Burnham, filed an amicus brief (see document here) in the federal court case on behalf of various Arizona’s education interests (which, for the record, did not include or involve Morrison Institute or Arizona State University).

This Morrison Institute blog is intended to help Arizonans better understand the matter in terms of related background, legal questions and potential impact.

Background

For 86 years, it was simple to calculate annual distributions from the permanent fund: The fund could only invest in interest-bearing bonds, and only the earnings from those investments could be distributed. In 1998, however, Arizona voters approved Proposition 102 and authorized equity investments, creating uncertainty as to whether to distribute capital gains. Proposition 102 resolved that issue by establishing a variable formula for computing annual distributions, based on the fund’s rate of return over the preceding five years (including unrealized capital gains), multiplied by the fund’s average value over that five-year period. Congress consented to this formula by amending the Enabling Act in 1999.  

That formula had an unintended consequence when the stock market and real estate market crashed in 2008 and 2009. As a result of the crash, the formula yielded a distribution of literally zero in 2010—at a time when education funding was already under severe pressure. In response, the Legislature referred Proposition 118 to the ballot in 2012, which temporarily replaced the variable formula with a fixed annual distribution of 2.5 percent of the permanent fund’s average value over the preceding five years. Although the voters approved Proposition 118, Congress did not amend the Enabling Act to consent to the fixed annual payout.

Proposition 123

Back to Proposition 123. Governor Doug Ducey conceived of Proposition 123 as a way to use the permanent fund to settle a lawsuit challenging the Legislature’s reduction in voter-mandated inflation funding for K-12 education. Proposition 123 called for a one-time distribution of $259 million and a fixed annual distribution through 2025 of 6.9 percent of the permanent fund’s average value over the preceding five years. The voters approved Proposition 123 in May 2016.

Immediately after the election, a Phoenix resident named Michael Pierce filed a lawsuit, contending that Arizona could not implement Proposition 123’s distributions without congressional consent. Governor Ducey argued that congressional approval was not necessary. Judge Wake flatly disagreed, however, holding that congressional authorization was required.

Judge Wake’s ruling (see document below) went much further than that, however. He first concluded that Proposition 118’s fixed distribution of 2.5 percent also violated the Enabling Act. Citing then-Treasurer Ducey’s arguments in favor of Proposition 118, the judge stated that “[t]he whole point” of Proposition 118 was to invade the corpus of the permanent fund.   The result, according to Judge Wake, was “excess distributions” from the fund that failed to preserve “the entire principal … for future school children.”

As a lawyer with considerable knowledge of the subject matter, I believe this reasoning is flawed on a couple levels. The variable formula established in 1999 does not draw a precise distinction between “corpus” and “income.” Indeed, as a Morrison Institute for Public Policy prior briefing paper explained, the definition of the fund’s “corpus” is far from clear. Congress instead approved a particular formula for calculating annual distributions.

The correct question is not whether Proposition 118’s distributions invaded the fund’s corpus, but whether they exceeded the distributions allowed under that formula. As we explained to Judge Wake in our amicus brief, the answer to this question is almost certainly no.

The stock market bottomed in 2009. After 2012, the disastrous years of 2008 and 2009 began to cycle out of the variable formula’s five-year lookback period. As a result, Proposition 118’s 2.5 percent fixed distribution was actually less than what the distribution would have been under the variable formula. Our brief showed that Proposition 118’s fixed payout was too conservative and left as much as $500 million in the permanent fund, money that would have been distributed to schools under the variable formula.

Judge Wake applied the same line of reasoning to Proposition 123. Relying upon an affidavit provided by Governor Ducey, Judge Wake stated that up to $344 million in “excess funds” (corpus) was distributed before Congress consented to Proposition 123. This figure represents the difference between Proposition 123’s distributions and what would have been paid out under Proposition 118.

But that is the wrong comparison. The correct question to ask is whether Proposition 123’s distributions exceeded the distributions allowed under the variable formula approved by Congress, and the evidence strongly suggests that the answer is no. Stock market returns have been very strong since 2015. As we demonstrated in our amicus brief, the variable formula’s distributions would have been higher than the distributions actually made under Proposition 123.

So, even if Congress was required to consent to Proposition 123’s fixed distribution scheme, the distributions themselves were not invalid because they did not exceed the distributions Congress already authorized under the variable formula.

More Uncertainty for Public Schools

The Court directed the parties to brief whether Congress’ approval of Proposition 123 validates the “excess fund disbursements” in 2016 and 2017 under Proposition 123 and the “excess fund disbursements” from 2012 to 2015 under Proposition 118. If the approval was retroactive, the case ends. If the approval was not retroactive, Judge Wake strongly suggested that he could restrict “withdrawal of future fund disbursements” under Proposition 123 to recoup any improper distributions made from the fund.

But this approach is counterproductive at best. Schools rely upon distributions from the permanent fund in setting their yearly budgets. Any order that withholds distributions from the fund would blow a massive hole in their budgets, and it is not at all clear that the Governor and Legislature would appropriate additional funds to fill that hole.

On the other hand, Judge Wake’s suggestion may be the only remedy he can order. The federal Constitution bars him from entering a money judgment against the State or directly compelling the State to appropriate general fund monies to repay any excess distributions made from the permanent fund.

Education funding is certain to be a central issue in this year’s election. The final outcome of this litigation could raise the stakes dramatically.