38 Studios and the 'Gift Clause'

38 Studios and the 'Gift Clause'

July 05, 2012
Originally published in The Providence Journal

Rhode Island's $75 million loan guarantee to former baseball star Curt Schilling, like most government subsidies, promised to fulfill certain public objectives. Supporters of the deal cited economic growth, good paying long-term jobs, and increased tax revenue to justify pledging taxpayer funds and risking the state's credit. However, Curt Schilling's 38 Studios never brought the economic growth and long-term jobs its supporters promised. Rhode Island citizens found out the hard way, government and private enterprise do not mix.

Taxpayer money spent in the interest of politically connected private entities rarely benefits the public. Yet somehow, Schilling, someone with no prior programming or business experience off the baseball diamond, convinced state officials to invest enthusiastically his venture. After striking out with Wall Street venture capitalists and the Massachusetts government, Schilling scored a hit with the Rhode Island Economic Development Corporation (RIEDC) in 2010.

Presumably star-struck, the RIEDC agreed to expand its funding commitment from $50 million to $125 million in order to accommodate a $75 million loan guarantee for the retired pitcher's firm. The agency did this with the expectation that 38 Studios would create 450 permanent jobs in Rhode Island and help kick-start a thriving technology industry.

These expectations were not met. Last month Schilling's 38 Studio's filed for bankruptcy and was forced to lay off its entire staff of over 400 without warning. Bankruptcy court documents indicate Schilling's video game venture owes more than $150 million, mostly to the RIEDC, and smaller sums to over 1,000 different companies and individuals.

The reasons for 38 Studios' demise are many, but elected officials and bureaucrats moonlighting as venture capitalists share a great deal of the blame. REIDC officials overlooked the fact that private investors, dating back to 2009, had declined investing in Schilling's company deeming the venture too risky.

Many professional venture capitalists strike out on investments, but also stand to reap rewards based on merit; whereas government officials risk taxpayer dollars, not their own. The success or failure of 38 Studios didn't bear the same consequences on the bureaucrats as it would for individual investors.

In addition, REIDC officials appeared to have acted in haste and failed to uphold the agency's own standards. The procedure and regulations to qualify for a REIDC loan guarantee had not even been finalized before 38 Studios received its check.

If there is a silver lining to all this, it is that a solution is readily at hand, if politicians are willing to use it. Rhode Island's constitution contains a provision known as the "Gift Clause" that prohibits incurring state debt for private gain.

The Rhode Island provision states that the "general assembly shall have no powers, without the express consent of the people, to incur state debts... nor shall it in any case, without such consent, pledge the faith of the state for the payment of the obligations of others." Rhode Island is not alone; another 47 state constitutions contain similar provisions--that are often neglected or subverted.

The purpose of the Gift Clause is to protect taxpayers from public financing fiascos like 38 Studios, but Rhode Island elected officials circumvented its prohibition on subsidies by issuing "moral obligation bonds," which are issued at higher interest rates due to the fact Rhode Island can default on the loan. These moral obligation bonds deny taxpayers a say on how their money is invested. As a result, Rhode Island taxpayers will be paying off 38 Studios' debt for years to come.

As The International Business Times reported, "Bondholders say that the state sold moral obligation bonds to skirt voters' approval."

Rhode Island policy makers, as well as those of other states, have an opportunity to put an end to this abuse of taxpayer money to benefit private interests. If the state were to actually abide by its gift clause, taxpayers would be free to choose whether they want to subsidize the 300 plus private companies or back the $357 million in moral obligation bonds they currently support. This would reinstate fair competition for all Rhode Island businesses and create an environment where businesses are rewarded for their quality rather than their connections. Ultimately, that would benefit all residents of the state.