WISHFUL THINKING
In terms of the value of public funds squandered, and the political fall-out from a succession of poor decisions, the 38 Studios bond issuance debacle which was proposed, approved, and funded by both the State of Rhode Island and the quasi-public Rhode Island Economic Development Corporation (hereafter, RIEDC), is a miraculous case study in public mismanagement. Within two years -- a relatively short amount of time in the equity market -- former Boston Red Sox pitcher Curt Shilling's gaming software enterprise failed in spectacular fashion. Unable to convince a single venture capital firm from the Boston area to invest in his company, out of roughly 200 firms, Shilling looked to the red-headed step-child of New England, Rhode Island, for support. In quick succession, a series of decisions were made at the highest levels of the Rhode Island executive and legislative branches, and allowed by omission by the judicial branch, that culminated in an unprecedented bond issuance to fund a loan package equal in value to $75 million to a singular project: 38 Studios' proposal to develop and release two video games, predicted by Shilling to generate a stream of profits equal to the success Bill Gates achieved with Microsoft.
Two years after that process began in 2010, 38 Studios filed for bankruptcy. Governor Lincoln Chafee is arguing today that the State of Rhode Island, while not legally obligated to do so, should nonetheless guarantee the outstanding debt owed to private bondholders by the RIEDC. This in spite of the fact that the RIEDC is an entity, "legally distinct" from the state of Rhode Island the latter of which granted the RIEDC its authority.
The threat of a credit downgrade and the ensuing difficulty the state will experience when trying to access credit markets should have both been judged as unacceptable risks. The state is required to receive public support via a popular referendum if bonds are to be issued to raise capital. Why wouldn't the RIEDC need to garner public support for its bond issuance? If the investment package for 38 Studios' proposal could not be guaranteed to succeed -- which was impossible -- then the State of Rhode Island was saddled with a de facto liability all along. Because the state and RIEDC were considered separate legal entities, as per authorizing legislation, then the RIEDC would have to prove that the state was never in danger of a credit downgrade if 38 Studios filed for bankruptcy. Anything short of that proof would mean that the state would have to either pay for the debt obligations of the RIEDC in order to maintain credit worthiness, or, refusing to pay those obligations, would be subject to higher interest rates in the capital markets. Both of these scenarios violate the Rhode Island constitution.
A SHADOWY ORGANIZATION
CREDIT RISK
Current debate is centered around the competing camps of pragmatism and idealism, two motivating ideologies that offer mutually exclusive scenarios both likely to punish Rhode Island taxpayers. Chafee, an emphatic critic of 38's plan from the beginning, is convinced that Rhode Island's borrowing costs would soar if RIEDC's outstanding debt owed is not paid to investors. And he's right to be worried, but his argument in favor of guaranteeing RIEDC's debt has failed to address a glaring constitutional dilemma: Rhode Island's constitution, specifically Article VI, Section 16, clearly prohibits the state from, "[pledging] the faith of the state for the payment of the obligations of others," in this case RIEDC. Moreover, the very creation of the RIEDC, and the legal authority given to that entity to fund capital programs through the issuance of bonds to private investors is unconstitutional.The threat of a credit downgrade and the ensuing difficulty the state will experience when trying to access credit markets should have both been judged as unacceptable risks. The state is required to receive public support via a popular referendum if bonds are to be issued to raise capital. Why wouldn't the RIEDC need to garner public support for its bond issuance? If the investment package for 38 Studios' proposal could not be guaranteed to succeed -- which was impossible -- then the State of Rhode Island was saddled with a de facto liability all along. Because the state and RIEDC were considered separate legal entities, as per authorizing legislation, then the RIEDC would have to prove that the state was never in danger of a credit downgrade if 38 Studios filed for bankruptcy. Anything short of that proof would mean that the state would have to either pay for the debt obligations of the RIEDC in order to maintain credit worthiness, or, refusing to pay those obligations, would be subject to higher interest rates in the capital markets. Both of these scenarios violate the Rhode Island constitution.
A SHADOWY ORGANIZATION
The existence of the RIEDC and its structure, while not necessarily unconstitutional, is undemocratic. The RIEDC's executive body, the Board of Directors, is composed of only 13 members. The ex officio chairman of the board is, surprisingly, also the current Rhode Island Governor, and he requests 11 more appointments for the board's membership to be evaluated and approved by the R.I. General Assembly. The entire process of staffing the RIEDC is overseen by public officials. This structure is troublesome because of the influence current public officials have over the corporation's powers. Even though the chairman can not vote, I would argue that to allow the state's chief executive to also serve as the chairman of a legal entity created by the state is unethical.
The U.S. Constitution explicitly prohibits Congressional members from serving in other offices of the U.S. upon entry into the legislature. "No Senator or Representative shall, during the Time [sic] for which he was elected, be appointed to any civil Office under the Authority of the United States... and no Person holding Office under the United States, shall be a Member of either House during his Continuance in Office" (Article I, Section 6.) This is not to suggest that state constitutions should mirror the U.S. Constitution. Rather, the Framers recognized the inherent danger of allowing public officials to occupy multiple offices. One officer enjoying the authority of multiple offices is contradicts the importance of a separation of powers between and among the separate branches of government, and the efficacy of a system of checks and balances.
"LET THEM EAT CAKE!"
The very creation of the RIEDC as a separate legal entity from the state was not only unnecessary, but, it could be argued, was an effort to bypass the referendum process required whenever the state sought to issue bonds or notes in excess of $50,000. The Department of Economic Development was already in existence when the RIEDC was created. Why create a second entity to fulfill the same purposes as an established state department? The answer can be found in R.I. Gen. Laws § 42-64-7.5., "Transfer of functions from the Department of Economic Development." Subsection (a) reads, "All functions formerly administered by the department of economic development are hereby transferred to the Rhode Island economic development corporation."
In addition to the functions transferred from the state department to RIEDC, the new entity was granted an exemption from seeking public approval for raising debt through referendums. The bonds and notes the RIEDC issues do not require approval from the public, whereas those of the Department of Economic Development had to satisfy that requirement. So, strictly stating the facts: in one move, the state eliminated the need to consult the public when seeking to risk their tax dollars, and vested that authority to issue debt instruments with a new entity answerable only to the 12 voting members of the Board of Directors.
Moreover, only five members of the Board of Directors are needed for a quorum. And only a simple majority of the Directors present at the consideration of business is sufficient to approve loans and the issuance of bonds to fund those loans. In other words, while the State of Rhode Island can not issue debt without the consent of the public via popular referendum, the RIEDC is so constructed that three people can issue debt to private investors with no need to consult the public. This would be of little concern to us if the State of Rhode Island had no fiduciary responsibilities to the RIEDC. But as is abundantly clear from recent developments, the health of Rhode Island finances is inextricably linked to the RIEDC.
The U.S. Constitution explicitly prohibits Congressional members from serving in other offices of the U.S. upon entry into the legislature. "No Senator or Representative shall, during the Time [sic] for which he was elected, be appointed to any civil Office under the Authority of the United States... and no Person holding Office under the United States, shall be a Member of either House during his Continuance in Office" (Article I, Section 6.) This is not to suggest that state constitutions should mirror the U.S. Constitution. Rather, the Framers recognized the inherent danger of allowing public officials to occupy multiple offices. One officer enjoying the authority of multiple offices is contradicts the importance of a separation of powers between and among the separate branches of government, and the efficacy of a system of checks and balances.
"LET THEM EAT CAKE!"
The very creation of the RIEDC as a separate legal entity from the state was not only unnecessary, but, it could be argued, was an effort to bypass the referendum process required whenever the state sought to issue bonds or notes in excess of $50,000. The Department of Economic Development was already in existence when the RIEDC was created. Why create a second entity to fulfill the same purposes as an established state department? The answer can be found in R.I. Gen. Laws § 42-64-7.5., "Transfer of functions from the Department of Economic Development." Subsection (a) reads, "All functions formerly administered by the department of economic development are hereby transferred to the Rhode Island economic development corporation."
In addition to the functions transferred from the state department to RIEDC, the new entity was granted an exemption from seeking public approval for raising debt through referendums. The bonds and notes the RIEDC issues do not require approval from the public, whereas those of the Department of Economic Development had to satisfy that requirement. So, strictly stating the facts: in one move, the state eliminated the need to consult the public when seeking to risk their tax dollars, and vested that authority to issue debt instruments with a new entity answerable only to the 12 voting members of the Board of Directors.
Moreover, only five members of the Board of Directors are needed for a quorum. And only a simple majority of the Directors present at the consideration of business is sufficient to approve loans and the issuance of bonds to fund those loans. In other words, while the State of Rhode Island can not issue debt without the consent of the public via popular referendum, the RIEDC is so constructed that three people can issue debt to private investors with no need to consult the public. This would be of little concern to us if the State of Rhode Island had no fiduciary responsibilities to the RIEDC. But as is abundantly clear from recent developments, the health of Rhode Island finances is inextricably linked to the RIEDC.
A PIPELINE FOR REALLOCATIONS
The RIEDC could not operate without direct support from the Rhode Island General Assembly. Specifically, the Rhode Island General Assembly provides annual appropriations to the RIEDC. These appropriations are used by the RIEDC to fund, inter alia, debt obligations. How is that constitutional? The money Rhode Island gives to the RIEDC is spent on RIEDC's obligations. Article VI, Section 16 of the Rhode Island Constitution prohibits this type of support: "The General Assembly shall have no powers, without the express consent of the people, to incur state debts to an amount exceeding fifty thousand dollars, except in time of war [sic]... nor shall it in any case, without such consent, pledge the faith of the state for the payment of the obligations of others."
However, R.I. Gen. Laws § 42-64-8.1., "Appropriation and expenses," simply disregards this constitutional prohibition. It says, "The general assembly shall annually appropriate any sums that it may deem necessary to carry out the provisions of this chapter; and the state controller is authorized and directed to draw his or her orders upon the general treasurer for the payment of that sum, or so much as may be required from time to time, upon receipt by the controller of proper vouchers authenticated." The constitution and this law contradict one another, but things get more weird.
Article VI, Section 17 of the constitution allows the state to borrow money when it anticipates fund receipts to be forthcoming from multiple sources. This would seem to invalidate my argument because this section seems to allow the state to borrow money, and transfer it to separate entities -- in this case the RIEDC -- so long as future receipts are expected. I'm simplifying the text, but that's the gist of the clause. There's a major flaw in that clause, however: receipts will always be expected from debtors up until the moment when they file for bankruptcy. 38 Studios was scheduled to repay the RIEDC directly, and the State of Rhode Island indirectly, up until May of 2012 when the company filed for bankruptcy. Both the RIEDC and the state had credited their accounts with the expected receipts from 38 Studios as if these were guaranteed. When 38 Studios defaulted, those receipts vanished and the RIEDC and state were in an awkward position where debt obligations owed by the RIEDC to private investors was no longer supported by future expected funds. In one fell swoop, Section 17 was invalidated, and Section 16 then dominated all constitutional considerations, if it wasn't supreme before.
However, R.I. Gen. Laws § 42-64-8.1., "Appropriation and expenses," simply disregards this constitutional prohibition. It says, "The general assembly shall annually appropriate any sums that it may deem necessary to carry out the provisions of this chapter; and the state controller is authorized and directed to draw his or her orders upon the general treasurer for the payment of that sum, or so much as may be required from time to time, upon receipt by the controller of proper vouchers authenticated." The constitution and this law contradict one another, but things get more weird.
Article VI, Section 17 of the constitution allows the state to borrow money when it anticipates fund receipts to be forthcoming from multiple sources. This would seem to invalidate my argument because this section seems to allow the state to borrow money, and transfer it to separate entities -- in this case the RIEDC -- so long as future receipts are expected. I'm simplifying the text, but that's the gist of the clause. There's a major flaw in that clause, however: receipts will always be expected from debtors up until the moment when they file for bankruptcy. 38 Studios was scheduled to repay the RIEDC directly, and the State of Rhode Island indirectly, up until May of 2012 when the company filed for bankruptcy. Both the RIEDC and the state had credited their accounts with the expected receipts from 38 Studios as if these were guaranteed. When 38 Studios defaulted, those receipts vanished and the RIEDC and state were in an awkward position where debt obligations owed by the RIEDC to private investors was no longer supported by future expected funds. In one fell swoop, Section 17 was invalidated, and Section 16 then dominated all constitutional considerations, if it wasn't supreme before.
A FAIT ACCOMPLI
The support provided to the RIEDC by the State of Rhode Island, while not legally obligatory, can be considered a de facto obligation for the state. This fact is exposed in detail within R.I. Gen. Laws § 42-62, The Rhode Island Economic Development Corporation Act:
"[Let it be] Resolved, that in order [to] assure any payments due on guarantees or bond obligations issued by the corporation in connection with the program pursuant to this authorization are made, to assure the continued operation and solvency of the corporation for the carrying out of its corporate purposes, and except as otherwise set forth in these authorizing resolutions in accordance with the provisions of chapter 64, title 42 of the [R.I.] general laws: (i) The cooperation shall create a reserve fund from which shall be charged any and all expenses of the corporation with respect to guarantee or bond obligations of the corporation pursuant to these resolutions resulting from a program borrower's default; and (ii) The corporation shall credit to the reserve funds no less than fifty percent (50%) of all program receipts of the corporation including guaranty fees, premiums and any other receipts or recoveries from collections received pursuant to the corporation's rights to recover payments as a guarantor; and (iii) To the extent the corporation's obligations as a guarantor or pursuant to its program bond obligations are not satisfied by amounts in its guaranty reserve fund, the executive director of the corporation shall annually, on or before December 1st, make a delivery to the [R.I.] governor a certificate stating the minimum amount, if any, required for the corporation to make payments due on such guarantees. During each January session of the general assembly, the governor shall submit to the general assembly, as part of the governor's budget, the total such sums, if any, required to pay any and all obligations of the corporation under such guarantees or bond obligations pursuant to the terms of this authorization. All sums appropriated by the general assembly for that purpose, and paid to the corporation, if any, shall be utilized by the corporation to make payments due on such guarantees or bond obligations."
So if the RIEDC is not able to maintain a balance in its reserve fund equal to
or greater than 50% of its total outstanding obligations, then there are only a
few funding options available to the corporation to boost its capital
requirements. Annual financial audits of the RIEDC's balance sheets reveal its
consistent reliance upon appropriations from the R.I. General Assembly to meet
its reserve fund requirements. The law is explicit: "All sums appropriated by the
general assembly for that purpose [to pay any and all obligations of the
corporation required by bond issuance agreements between RIEDC and bond program
borrowers], and paid to the corporation, if any, shall be utilized by the
corporation to make payments due on such guarantees or bond obligations." That is
a mind-blowing stipulation. Consider, again, this specific clause of Article VI,
Section 16 from the Rhode Island Constitution: "The General Assembly shall have
no powers, without the express consent of the people... [to] pledge the faith of
the state for the payment of the obligations of others." Constitutions always
supersede legislation and if the latter violates the former, then it is the job
of the judicial branch to invalidate that legislation.
THE STATE CONSTITUTION
Even if one were to argue that the State of Rhode Island is only required to honor its "moral authority" to guarantee the debt of a quasi-public entity like the RIEDC, Section 16 still prohibits "The General Assembly [from incurring] state debts... exceeding fifty thousand dollars," without the express consent of the people through a popular referendum. No, appropriations are not legally defined as debts; they are voluntary transfers of public funds. But that is a moot point, and here's the crucial insight that explains why that is the case: The purpose of these appropriations, as mentioned above, is to directly assist the RIEDC's efforts to maintain a reserve fund balance equal to, or in excess of, 50% of its outstanding bond receivables, or amount owed to the RIEDC. In other words, R.I. General Assembly appropriations given to the RIEDC are used for obligations that should have been subject to a public referendum before any appropriations were considered.
That requirement was bypassed recently during the Studios 38 fiasco, but many times before that incident as well. In fact, RIEDC's combined statement of net assets as of June 30, 2012 lists the total "Bonds payable" and "Loans payable" sub-categories as equal to $360,982,523. Again, the State is likely to exercise its "moral authority" to guarantee the bond payments are made to bondholders from the Studios 38 deal in order to protect Rhode Island's access to affordable credit. This guarantee is called a "Conduit Debt Transaction," and these transactions are the lifeblood of the RIEDC. To wit, "The total aggregate principal amount outstanding under all conduit debt obligations at June 30, 2012 was approximately $1,063,000,000" ("Rhode Island Economic Development Corporation: Financial Statements and Supplementary Information Year Ended June 30, 2012," (22 October 2012,) 37, Braver PC Accountants & Advisors.) Yes, that number is correct: billions.
That requirement was bypassed recently during the Studios 38 fiasco, but many times before that incident as well. In fact, RIEDC's combined statement of net assets as of June 30, 2012 lists the total "Bonds payable" and "Loans payable" sub-categories as equal to $360,982,523. Again, the State is likely to exercise its "moral authority" to guarantee the bond payments are made to bondholders from the Studios 38 deal in order to protect Rhode Island's access to affordable credit. This guarantee is called a "Conduit Debt Transaction," and these transactions are the lifeblood of the RIEDC. To wit, "The total aggregate principal amount outstanding under all conduit debt obligations at June 30, 2012 was approximately $1,063,000,000" ("Rhode Island Economic Development Corporation: Financial Statements and Supplementary Information Year Ended June 30, 2012," (22 October 2012,) 37, Braver PC Accountants & Advisors.) Yes, that number is correct: billions.
When officials, like Governor Chafee, claim that the State of Rhode Island is not technically liable for RIEDC's obligations, they are only correct in an abstract, legalistic sense. The consequences Rhode Island will experience if it doesn't guarantee RIEDC's debts would be devastating. The very threat of this occurring is the catalyst for the emergence of our constitutional dilemma. Access to capital in the private equity market would immediately vanish, or rather, would only be offered to the State at exorbitantly high interest rates. But why is that the case? After all, the authorizing law which created the RIEDC made it explicitly clear that the RIEDC was henceforth considered a "legal entity separate from the State of Rhode Island and Providence Plantations." That clause is a hollow one, however.
There is a slim chance that taxpayers will avoid either directly or indirectly paying for the RIEDC's obligations. If the legislature approves Chafee's idea to guarantee the corporation's liabilities, then the taxpayers will be asked to directly pay. If the state refuses to honor the bondholder's rights, and the equity and financial investment markets restrict the state's access to, or increase the cost of, financing, then a few negative effects could happen: higher interest rates would demand that a larger portion of the state's budget be set aside to pay those costs, thereby forcing the state to either cut services or raise taxes. The only other way to offset higher borrowing costs without cutting services or demanding higher taxes is to magically generate new economic growth with some concoction of "voodoo economics." The first two possibilities are unsavory and highly probable; the latter, an unlikelihood approaching wishful thinking.
There is a slim chance that taxpayers will avoid either directly or indirectly paying for the RIEDC's obligations. If the legislature approves Chafee's idea to guarantee the corporation's liabilities, then the taxpayers will be asked to directly pay. If the state refuses to honor the bondholder's rights, and the equity and financial investment markets restrict the state's access to, or increase the cost of, financing, then a few negative effects could happen: higher interest rates would demand that a larger portion of the state's budget be set aside to pay those costs, thereby forcing the state to either cut services or raise taxes. The only other way to offset higher borrowing costs without cutting services or demanding higher taxes is to magically generate new economic growth with some concoction of "voodoo economics." The first two possibilities are unsavory and highly probable; the latter, an unlikelihood approaching wishful thinking.
HISTORICAL LESSONS & CHAFEE'S CHOICE OF THE LESSER EVIL
The propensity of capital markets to punish bond issuers has repeatedly occurred in recent history. A global example will illustrate this point.
As was painfully shown during the 1980's throughout the Latin American community of emerging markets -- notably Argentina, Brazil, and Mexico -- equity and debt markets are just as likely, if not more likely, to be guided by psychological factors than they are by logical ones. In essence, as these states individually enjoyed access to affordable capital, provided by private investment firms, they progressively exposed themselves to more risk that slowly built up within their group. Seeking to feed their industrialization policies, these states quickly expanded the amount of debt on their balance sheets. Loans were denominated primarily in dollars but then lent to domestic borrowers in the national currencies. For a while this wasn't a problem because Latin America enjoyed a favorable exchange-rate balance between the national currencies of its member states and the U.S. dollar. However, that quickly changed following a cascading sequence of events that made it nearly impossible for these states to maintain fiscal credibility in the debt markets.
When the U.S. supported Israel in its struggle against the Arab world during the Yom Kippur War, the Organization of Petroleum Exporting Countries (OPEC) responded in turn by simultaneously restricting the supply of oil to the global market and raising prices. This triggered immediate inflation in the developed world, most notably in the United States. Paul Volker, the chairman of the Federal Reserve's Board of Governors, acted to combat this inflation in the early 1980's by raising the federal funds rate to 20.1%, while the Treasury Department sold bonds and notes to soak up cash in the economy. These efforts induced a recession, but popped the inflationary bubble.
When the U.S. supported Israel in its struggle against the Arab world during the Yom Kippur War, the Organization of Petroleum Exporting Countries (OPEC) responded in turn by simultaneously restricting the supply of oil to the global market and raising prices. This triggered immediate inflation in the developed world, most notably in the United States. Paul Volker, the chairman of the Federal Reserve's Board of Governors, acted to combat this inflation in the early 1980's by raising the federal funds rate to 20.1%, while the Treasury Department sold bonds and notes to soak up cash in the economy. These efforts induced a recession, but popped the inflationary bubble.
Unfortunately, these medicines crippled Latin America's ability to finance its debt. Faced with a dramatically unfavorable exchange-rate, these states struggled to collect enough of their national currencies to exchange for dollars which were now more expensive. They exhausted their capital reserves and soon exposed their financial weaknesses to the world. Mexico defaulted first, but in so doing doomed the other emerging economies as well because, as the markets reasoned, individual circumstances of each state were overshadowed by the group's collective risk. And so access to capital vanished, defaults ensued, and economic and social pain gripped these societies.
Similarly, the market won't distinguish between the State of Rhode Island and the RIEDC. The creditworthiness of each is seen as an inseparable whole. Moreover, at the institutional level the RIEDC is composed of R.I. public officials from the highest levels of government. The Governor sits on the corporation's Board of Governors and recommends eleven candidates for approval by the Rhode Island General Assembly to sit on the Board as well. What has happened since the RIEDC's creation is the selection of prominent business leaders within Rhode Island who almost invariably support the same policies that the State of Rhode Island currently supports. This duplicitous support is by nature both political and financial, wherein lies the danger.
Public officials do not have the luxury to hedge their bets as financial investors do, for to do so would be interpreted by the public as a public violation of ethical standards. The result is the expectation of financial institutions that poor mismanagement of either the state's finances, or those of the RIEDC, guarantees that the other is more than likely being mismanaged as well. Taken to an extreme conclusion, some analysts within the credit market would see the close relations between the state and RIEDC as indicative of corruption and, therefore, a highly risky credit option.
Public officials do not have the luxury to hedge their bets as financial investors do, for to do so would be interpreted by the public as a public violation of ethical standards. The result is the expectation of financial institutions that poor mismanagement of either the state's finances, or those of the RIEDC, guarantees that the other is more than likely being mismanaged as well. Taken to an extreme conclusion, some analysts within the credit market would see the close relations between the state and RIEDC as indicative of corruption and, therefore, a highly risky credit option.
The State of Rhode Island tried to create a quasi-public authority, providing it with the benefits available to these entities, while naively suggesting that the new corporation, and the State, were insulated from one another's risk. The legislators didn't realize that markets are rarely controlled by legal nuances. Credit rating analysts see the cross-over between the members of these two political bodies, and the murky, commingled flow of operating funds, and rightly conclude that, in spite of legislation, no de facto legal separation exists between the state and the corporation.
That is why Governor Chaffee is making the case that, while he doesn't agree with the state's options implied by reality, he must nonetheless ask the Rhode Island taxpayers to guarantee the obligations of the RIEDC. The public enjoyed neither the opportunity to evaluate the 38 Studios bond issuance nor the constitutional right to vote using that evaluation to inform their decision. But nonetheless, market realities will leave this 'dead-cat' on the door-steps of each and every taxpayer, whether they like it or not.
That is why Governor Chaffee is making the case that, while he doesn't agree with the state's options implied by reality, he must nonetheless ask the Rhode Island taxpayers to guarantee the obligations of the RIEDC. The public enjoyed neither the opportunity to evaluate the 38 Studios bond issuance nor the constitutional right to vote using that evaluation to inform their decision. But nonetheless, market realities will leave this 'dead-cat' on the door-steps of each and every taxpayer, whether they like it or not.
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