The 38 Studios Bond Payment: Expecting a Penalty is Reasonable; Expecting Punishment is Not

Justin nailed the high-level issue. Let’s go through some of the nuts and bolts.

 

1. Article VI, section 16 of the Rhode Island constitution says the General Assembly cannot authorize debt over a certain amount “without the express consent of the people”, i.e. through a voter referendum…

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.

The 38 Studios bonds were authorized under a law that permitted the former Economic Development Corporation to issue bonds without a voter referendum, but that is in compliance with the state constitution, because it states that such bonds…

…shall not constitute a debt, liability or obligation of the state or of any political subdivision of the state other than the Rhode Island commerce corporation or a pledge of the faith and credit of the state or any political subdivision other than the corporation but shall be payable solely from the revenues or assets of the corporation.

Advocates for repaying the 38 Studios bonds have taken a position that the text of the constitution and state law don’t have any real meaning.

Now, let’s look at another Rhode Island law. In 2011, the general assembly passed a law, signed by Governor Chafee, regarding municipal debt…

Annual appropriations for payment of financing leases and obligations securing bonds, notes or certificates (“other financing obligations”), shall also have a first lien on ad valorem taxes and general fund revenues commencing on the date of each annual appropriation.

If it ever becomes necessary for bondholders to assert their first lien on local revenues, will there be any doubt about whether this law really counts, or an explanation of why the first lien law is self-evidently meaningful, while constitutional and statutory limits on incurring debt are merely “boilerplate“?

Here is one way not to answer questions about the two laws being regarded differently:  Going to private organizations outside of government — even ones with the worldwide prestige of “ratings agencies” — and letting them be final judges of what laws are real. Private organizations, even those in the orbit of financiers with lots of money, do not create a higher-law that overrides the real law.

 

2. During his House Oversight Committee testimony on Thursday, John Simmons of the Rhode Island Public Expenditures Council asked, if the RI legislature does not appropriate the money for the 38 Studios bonds, how future investors would be able to make a “judgment about what [else] you would willfully not pay?”.

Answering this question is simple, because of – not in spite of — the clarity of the state constitution and the law under which the 38 Studios bonds were authorized. General obligation debts that are 1) approved with the constitutionally required voter assent and 2) not approved under a process that says obligations of the state are not being created, will continue to have the same public support they’ve always had.

If RI continues to make all of its GO payments on time and in full, it will be direct evidence that Rhode Island’s payment of true state obligations continues to be “predictable”, and that non-payment of the 38 Studios bonds only means that Rhode Island differentiates between debt backed by the full-faith and credit of the state and debt that expressly isn’t.  The hit to that state’s GO credit rating should be minimal — if the purpose of such ratings is to be maximally informative, and the business of the ratings agencies is to provide objective analysis.

And if ratings agencies say that non-payment of non-voter approved bonds means that Rhode Island’s non-GO rating status must be reduced to World War Z, possibly for a long period of time, this is also an outcome that’s fair and rational.

 

3. As Mike Riley and others have pointed out, it is not ratings agencies that decide the price of debt for Rhode Island. Ultimately, that falls upon bond buyers themselves.

Bond buyers, I am told, are in their business to make money. That means if the interest rates that the usual buyers of Rhode Island bonds are willing to offer shoot way up, opportunities open for new players to get into the game, offer a better deal, and reap bigger rewards than they otherwise would — assuming that the business of bond buyers is to make money through actual investing.

John Simmons told the House Oversight Committee on Thursday that Rhode Island is “susceptible to being penalized or punished fairly substantially by the ratings agencies or the market itself, as an example of what should not happen”. Does punishment here mean punishment by individual decisions in a legitimate marketplace, or punishment through collusive action?  If the answer to this question is based upon a fear that investors may decide amongst themselves to turn down money-making opportunities, to impose a boycott or to fix prices above a certain interest rate in order to make Rhode Island into an “example”, then the answer is headed towards an allegation of illegal activity.

Those who have expressed concerned about “punishment” should be absolutely clear with the public about the mechanisms by which they expect individual, profit-seeking bond holders to leave money on the table, in order to make an example of Rhode Island, because it will never be cost-efficient, or moral, or in the best interests of the people of this state to accept either illegal collusion or leaders who would tolerate it.

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