Constitutionality of 2003 Deficit Bond Measure
(January 26, 2004)
By J. Clark Kelso
Professor of Law and Director,
Capital Center for Government Law and Policy
University of the Pacific, McGeorge School of Law
California ended its 2002-03 fiscal year with an accumulated deficit estimated at approximately $10.7 billion. To close that gap and balance the budget, the Legislature enacted and Governor Davis signed the "California Fiscal Recovery Financing Act" (2003 Cal. Stats., ch. 13; Gov't Code §§ 99000-99020). The Act authorizes the issuance of bonds to finance the accumulated deficit and temporarily dedicates a source of sales tax revenues for bond repayment. It is estimated that bond repayment will occur within five years. See Senate Floor Analysis of AB 7X (7/27/03); Assembly Floor Analysis of AB 7X (7/30/03).
Some critics of the Act contend that it violates the California Constitution by creating a debt in excess of the constitutional debt limit of $300,000. Cal. Const., Art. XVI, § 1. A legal challenge against the Act is still pending. If Propositions 57 & 58 are passed at the March 2004 primary election, there will be no need for the bonds authorized by the Act to be sold. However, if either of those propositions fails at the primary election, then the State may need to turn to the $10.7 billion in bonds authorized by this Act as an alternative.
It is unclear whether the bonds authorized by the Act are constitutional. Although the general structure of the financing authorized by the Act has been upheld under what has become known as the "appropriation doctrine," the five-year payback period under the Act (which is a significantly longer period than has been approved by courts considering previous financing mechanisms) and the failure to address the structural deficit in FY 2003-04, creates a significant risk that a court would decide the Act crosses the line between authorizing a constitutional "cash transaction" and establishing an unconstitutional debt.
Basic Constitutional Provisions Regarding the State Budget Process
In brief overview, the California Constitution contemplates an annual budget cycle, requires that the budget be balanced (while, as interpreted by the courts, permitting that balance to be achieved through financing mechanisms that may extend beyond a single budget cycle), and imposes certain limitations upon specific items within the budget (such as spending on education). The relevant provisions of the balanced budget requirement and permissible financing mechanisms are set forth in this section.
The Governor's Budget
The budget cycle begins each year with submission of the Governor's budget. Article IV, Section 12, of the California Constitution provides for the Governor's budget as follows:
"(a) Within the first 10 days of each calendar year, the Governor shall submit to the Legislature, with an explanatory message, a budget for the ensuing fiscal year containing itemized statements for recommended State expenditures and established State revenues. If recommended expenditures exceed estimated revenues, the Governor shall recommend the sources from which the additional revenues should be provided."
The last sentence of Section 12(a) requires, in effect, the Governor's budget to be balanced. The balance can be achieved either by reducing expenditures so that the recommended expenditures do not exceed estimated revenues, or by recommending sources for raising additional revenues to close the gap between recommended expenditures and estimated revenues.
Section 12(a)'s requirements are, in the overall budget process, relatively insignificant. In the first place, a close reading of Section 12(a) leaves some doubt about how precisely balanced the Governor's budget actually must be. The first sentence of Section 12(a) requires submission of "a budget for the ensuing fiscal year containing itemized statements for recommended State expenditures and established State revenues" (emphasis added). The first sentence does not require the budget to be balanced. That function is performed by the second sentence, which is triggered only if the "recommended expenditures exceed estimated revenues" (emphasis added). There is clearly a great deal of play in "estimating" revenues for the coming year. Moreover, even if the Governor determines that the recommended expenditures would exceed the estimated revenues, the second sentence only directs the Governor to "recommend the sources from which the additional revenues should be provided." This language is quite imprecise in its effect. Arguably, the Governor could satisfy this requirement simply by recommending that unspecified taxes be raised to supply the additional revenues.
Second, given the imprecision in Section 12(a) -- imprecision that apparently leaves the Governor with a great deal of discretion -- it is unclear whether Section 12(a)'s requirements could be enforced in a court of law. In submitting the annual budget bill, the Governor "acts in a legislative capacity." Veterans of Foreign Wars of the United States v. California (1974) 36 Cal.App.3d 688, 697. See also Jenkins v. Knight (1956) 46 Cal.2d 220, 223. Although Section 12(a) uses the mandatory "shall" in directing the Governor to submit what amounts to a balanced budget, in view of the discretion and judgment that necessarily goes into performance of what is essentially a legislative and political act, it is doubtful whether a court would issue of writ of mandate directing the Governor to modify a submitted budget that allegedly is not in balance. See Jenkins v. Knight (1956) 46 Cal.2d 220, 223; B.E. Witkin, 8 Cal. Proc., Extraordinary Writs, § 80 ("mandamus cannot be used to control the discretion of an administrative officer or agency").
Third, the Governor's budget does not itself have the force of law. Instead, the Governor's budget is simply a "bill" that does not become law until the Legislature approves the "budget bill," which it is constitutionally obligated to do by June 15 pursuant to a two-thirds vote of each house. Cal. Const., Art. IV, §§ 12(c)-(d).
While the legal impact of Section 12(a) may be minimal, it obviously has some significant political and practical implications. A Governor who submits an out-of-balance budget will be subject to political and public criticism. More important, as discussed below, there remain constitutional limitations upon the manner in which the State may finance a budget by incurring debt. This puts some practical limits upon how unbalanced the Governor's budget can be and still be viewed as a working document for the Legislature.
The $300,000 Debt Limit
The most significant limitation upon overall State indebtedness to finance General Fund obligations is found in Article XVI (Public Finance), § 1, which provides in pertinent part as follows:
"The Legislature shall not, in any manner create any debt or debts, liability or liabilities, which shall, singly or in the aggregate with any previous debts or liabilities, exceed the sum of three hundred thousand dollars ($300,000), except in case of war to repel invasion or suppression insurrection . . . ."
While the constitutional limitation on indebtedness seems to forbid any debts or liabilities that exceed $300,000 (whether standing alone or when aggregated with other borrowing), as interpreted by the courts, the State has significant flexibility in financing general fund obligations. The most important flexibility is created by the "appropriation doctrine." Under this doctrine, borrowing to meet an obligation or anticipated obligation does not fall under the constitutional limitation on indebtedness so long as the borrowing is accompanied by an appropriation of existing funds, or reasonably anticipated funds, and a provision is made for the repayment of the indebtedness. A detailed review of a few of the most significant appropriation cases is warranted since the constitutionality of the Fiscal Recovery Financing Act appears, in large part, to depend upon whether its provisions fit within the contours of the appropriation doctrine.
A good example of the constitutional limits upon borrowing is found in Veterans' Welfare Board v. Jordan (1922) 189 Cal. 124. The legislature had authorized the issuance of $10 million in interest-bearing bonds to aid veterans of World War I in the purchase of homes and farms through a loan program. The legislature had simultaneously appropriated funds to service the indebtedness. The court rejected the argument that by appropriating moneys, or otherwise providing ways and means, for payment of the bonds, a debt had not been created. Id., 189 Cal. at 135-36. The court's view is perhaps best expressed in the following sentence: "It is certainly a startling proposition that the issuance of $10,000,000 in interest-bearing bonds by the state does not create an indebtedness." Id., 189 Cal. at 128-29.
Notwithstanding Jordan's somewhat simplistic view of what constitutes a debt, other cases upheld a variety of short-term borrowing mechanisms. For example, in Riley v. Johnson (1933) 219 Cal. 513, the Supreme Court of California held that the limit on state indebtedness did not prohibit the issuance of interest-bearing, registered warrants. The State was facing a severe cash-flow problem as a result of the Great Depression. Chapter 605 of the statutes of 1933 provided for the registration and endorsement of interest-bearing warrants. The legislature passed this bill in contemplation of the fact that the general fund would be exhausted by the end of the fiscal period, and that it would become necessary to register warrants. There was in fact a shortfall in the general fund, and warrants totalling several millions of dollars were issued.
The treasurer contended that "the registration and indorsement of interest-bearing warrants at a time when there are no unapplied moneys in the general fund to meet either the principal or interest thereof, constitutes the creation of an indebtedness or liability in excess of $300,000, in violation of Article XVI, section 1, of the Constitution." Id., 219 Cal. at 520. The court rejected this contention, holding that registration and indorsement of the warrants did not create a debt or liability under Section 1. The court supported its holding as follows:
"It is our opinion that no indebtedness or liability is created, within the meaning of the constitutional provision in question, when, as here, the legislature, at the time of authorizing the obligation, appropriates money to meet such obligation. . . . It is well settled in this state that revenues may be appropriated in anticipation of their receipt just as effectually as when such revenues are physically in the treasury. The appropriation of such moneys and the issuance of warrants in anticipation of the receipt of revenues in effect operates in the nature of a cash payment and, therefore, does not create an indebtedness or liability within the meaning of the debt limitation clause." Id.
The appropriation doctrine was slightly expanded three years later with the decision in Riley v. Johnson (1936) 6 Cal.2d 529. Riley II raised the issue of whether registered warrants could extend beyond the fiscal period in which the warrants were issued. A special concern in this case was that a subsequent legislature might repeal appropriations made by a former legislature. The court rejected this possibility, however, holding that such a repeal would be forbidden by state law:
"The legislature is vested by our Constitution with the burden and responsibility of making appropriations, and may do so in anticipation of the receipt of the revenues necessary to pay them. It has long been the accepted law in this jurisdiction that when the state, through its legislature, makes a legal appropriation of so much money as will be necessary to pay the warrants from the general fund, as such moneys are received, the legislature cannot thereafter repeal or render ineffectual such appropriation as against the warrant holders. Therefore, the lapse of the present biennium presents an immaterial element for consideration in the case." Id., 6 Cal.2d at 532-33.
A more economical method of financing short-term cash-flow problems was upheld in Flournoy v. Priest, (1971) 5 Cal.3d 350. The statutory procedure upheld in Flournoy "was enacted to meet the practical problem created by the fact that the collection of state revenues within the fiscal year 1971-1972 will lag behind the expenditures required by appropriations for that year, thereby necessitating the borrowing of funds to be repaid when the anticipated revenues are collected. In the past the problem of dealing with temporary insufficiencies of the funds in the state treasury to meet current operating expenses of the state government has been solved by the use of registered warrants. The validity of the registered warrant procedure was established in" Riley and Riley II, supra. Id., 5 Cal.3d at 352.
The statutory procedure at issue in Flournoy, Gov't Code §§ 17300 et seq., authorized the controller to estimate in advance the anticipated cash flow shortage and draw demands in that amount against appropriations made from the general fund. Notes could then be issued in an amount sufficient to satisfy the demands, and Section 17310 of the Government Code "expressly appropriates the funds necessary to pay the principal and interest of the notes and necessary administrative expenses." Id., 5 Cal.3d at 353. According to the court,
"in this case as in the case of the statute considered in the Riley cases, the Legislature has appropriated revenues in anticipation of their receipt and provided for the issuance of notes in anticipation of such receipt. Such appropriation and issuance 'operates in the nature of a cash payment and, therefore, does not create an indebtedness or liability within the meaning of the debt limitation clause.'" Id., 5 Cal.3d at 353-54 (quoting Riley, 219 Cal. at 520-21).
The State's flexibility under the appropriation doctrine is not unlimited. In Pooled Money Investment Board v. Unruh (1984) 153 Cal.App.3d 155, the Third District Court of Appeal, with an opinion by Justice Puglia, struck down a particular form of borrowing under Article XVI, § 1. The legislation created the Pooled Money Investment Board and authorized it to raise funds by issuing commercial paper notes and bank credit notes up to 10 percent of the general fund revenues. Id., 153 Cal.App.3d at 156. Unlike the statutes upheld in the Riley cases and Flournoy, the statutes here were designed to meet "a 'continuing cash deficit,' not merely a temporary lag of incoming revenues behind required expenditures." Id., 153 Cal.App.3d at 165. Because of this difference, the statutes did not require that the notes be actually paid in the fiscal year of issuance, but instead required that the notes be only "payable." Id., 153 Cal.App.3d at 156 In addition, the statutes permitted the Board to issue notes irrespective of any anticipated shortfall in revenues, and did not require that sale of the notes be tied to any particular expenditures. In the first year, the Board adopted resolutions directing the Treasurer to issue and sell $150 million in commercial paper and $150 million in bank credit notes for fiscal year 1983-84. Id.
Justice Puglia's opinion synthesizes the Supreme Court's appropriation doctrine cases in the following two decisive paragraphs:
"In accord with the holding in Jordan, application of the appropriation doctrine in Riley I and II and in Flournoy was not dependent simply on an existing appropriation for paying back borrowed moneys. The statutes approved there in common required the existence of an underlying appropriation for expenditures and an actual or expected cash deficit in the general fund resulting in insufficient money to pay those expenditures when they came due. The registration of a warrant (see § 17221) or a demand (§ 17300) was conditional upon the existence of an underlying obligation for payment of which moneys had already been appropriated. Without the existence of a specific item to be paid for which an appropriation had been made, the equivalent of a cash transaction could not be posited.
Also necessary to the rationale of Flournoy and the Riley cases was the constructive presence of anticipated revenues in the state treasury. Logically, borrowing to pay for an outstanding obligation can be equated with a cash transaction only if the appropriation for retirement of the loan instruments is based on probable or reasonably anticipated revenues. While Riley II establishes that the loan instruments need not be paid in full during the fiscal year of issuance, it is nonetheless clear that appropriations therefor must be based on sound and reasonable estimates of revenues expected to be forthcoming within a short period of time. Furthermore, the statute considered in Flournoy authorizing issuance of short term notes specifically requires that appropriations for payment of the notes be based on estimates of probable income during the current fiscal year and that the notes 'be payable exclusively from moneys in the General Fund in the fiscal year of issuance,' except for 'recourse to internal borrowing funds in the event insufficient moneys are available from the General Fund.'" Id., 153 Cal.App.3d at 164.
The court in Pooled Money Investment Board held that the statutes at issue violated the debt clause because: (1) the statutes "impose virtually no limitations on when and in what amount borrowing is authorized," which meant that "there is no requirement there be any actual or anticipated cash deficit in the general fund before borrowing can take place" (Id., 153 Cal.App.3d at 164); and (2) the borrowing was not "in any way tied to specific underlying appropriations to ensure that the aggregate amount borrowed will not exceed existing appropriations for satisfaction of which there is a cash deficit" (Id., 153 Cal.App.3d at 164-65). As the court then explained,
"[t]he lack of any nexus to underlying appropriations or to a deficit in general fund cash to meet expenditures for which those appropriations have been made differentiate transactions under the statute in question from those under other statutes which have been equated with cash payments. Any cash transaction requires two sides -- an obligation and its payment. Since sections 17281-17294 provide only for the payment and do not identify the obligation or even require that one exist, an essential element of the equation is missing." Id., 153 Cal.App.3d at 165.
Finally, the court noted that there was no statutory requirement that the notes be paid in the fiscal year of issue. Since the statutes "permit[] borrowing unrelated to current fiscal year appropriations and to probable forthcoming revenues," it would have theoretically been possible to engage in a continuing pattern of rolling over debt with short-term borrowing.
In light of all the above considerations, the court concluded that "[d]espite the fact that the Legislature has appropriated funds to service the loans, the borrowing scheme contained in sections 17281-17294 lacks the elements of a cash transaction necessary to avoid creation of a constitutionally repugnant debt or liability." Id., 153 Cal.App.3d at 165-66.
Constitutionality of the Fiscal Recovery Financing Act
To those unfamiliar with the appropriation doctrine, the issuance of $10.7 billion in bonds repayable over a period of years would appear, on its face, to constitute a debt in violation of Article XVI, § 1. Veterans' Welfare Board v. Jordan (1922) 189 Cal. 124, 128-29 ("It is certainly a startling proposition that the issuance of $10,000,000 in interest-bearing bonds by the state does not create an indebtedness."). However, under the authorities reviewed above, the sale of bonds under the Act will not be held a debt or liability under Article XVI, § 1, if the sale has enough of the indicia of a "cash transaction" to fall within the purview of the appropriation doctrine. See Riley v. Johnson (1933) 219 Cal. 513, 520; Flournoy v. Priest, (1971) 5 Cal.3d 350, 353-54.
For purposes of this analysis, the key features of the Fiscal Recovery Financing Act are as follows:
· The Act establishes the "California Fiscal Recovery Financing Authority" in state government (Gov't Code § 99004(a)) and authorizes it to sell bonds "for the purpose of funding the accumulated budget deficit [as of June 30, 2003] and paying costs related thereto" (Gov't Code § 99005(b); see also Gov't Code § 99011(a));
· The Act provides that the "proceeds of the bonds . . . shall be deposited in the General Fund to fund all or a portion of the accumulated budget deficit" as of June 30, 2003 (Gov't Code § 99013);
· The Act establishes a "Fiscal Recovery Fund" as a "special fund in the State Treasury" (Gov't Code § 99008(a)) and provides that the moneys in the fund, upon annual appropriation, "shall be available solely for the purposes" of satisfying the bond obligations (Gov't Code § 99008(c); see also Gov't Code § 99002(c));
· The Act provides that the bonds provided for "are not a debt or liability of the state or of any political subdivision thereof or a pledge of the full faith and credit of the state or of any political subdivision thereof, and shall be payable by the [Fiscal Recovery Financing Authority] from available revenues" in the Fiscal Recovery Fund (Gov't Code § 99011(b));
· The Act eliminates one-half percent of the Bradley-Burns local sales tax authority (thereby reducing the Bradley-Burns rate from 1.25 percent to .75 percent), imposes a temporary one-half percent state sales and use tax, and provides that revenues from this new tax "shall be deposited in the State Treasury to the credit of the Fiscal Recovery Fund" (Rev. & Tax Code § 6051.5(b); see also Rev. & Tax Code §§ 6201.5; 7101.3
· The Act provides that its provisions shall effectively terminate when the Director of Finance determines that all of the obligations under the bonds have been paid or otherwise provided for (Gov't Code §§ 99006(b), 99010).
The sale of the bonds combined with the temporary creation of a special fund to repay the bond obligations, where the special fund receives a dedicated revenue stream irrespective of appropriation, shares many of the characteristics of the short-term financing upheld in the Riley cases and in Flournoy. Just as in those cases, the state issued the bonds at a time when there was an actual cash shortfall. In Riley and Flournoy, the Legislature made an appropriation in anticipation of having sufficient moneys in the general fund to satisfy the obligations. Under the Act, the Legislature has established a special fund with a dedicated, stable revenue source to satisfy the obligations, and it appears reasonably likely that the revenues will in fact be sufficient to satisfy those obligations. The creation of a special source of revenue to pay off the bonds is one the features which distinguishes the Act from the bond financing authorized by the "California Pension Obligation Financing Act" (2003 Cal. Stats., ch. 11), which was struck down by the Sacramento Superior Court in part because the pension bonds did not "identif[y] the source of revenue to pay off those bonds" (Transcript of Hearing with Statement of Decision, p. 126).
However, there are also some differences between the Act and the financing approved in Riley and Flournoy. First, the obligations in Riley and Flournoy were to be repaid within a two-year period, a relatively short period of time. By contrast, the obligations authorized under the Act are likely to be satisfied over a longer period of time, approximately five years. Second, the bonds authorized by the Act are not tied to any specific expenditures for which specific appropriations have been made. Third, the Legislature did not enact an appropriation this year to repay the bonds, or even authorize continuing appropriations to repay the bonds, instead relying upon subsequent Legislatures to enact annual appropriations from the Fiscal Recovery Fund. These differences may suggest that the financing mechanism established by the Act is less like a "cash transaction" and more like a debt.
Although there are some similarities between the Act and the financing system struck down in Pooled Money Investment Board, there are also some material differences. Whether the Act's provisions are unconstitutional under the holding in Pooled Money Investment Board is, ultimately, uncertain. The legislation in Pooled Money Investment Board anticipated a long-term method of financing by incurring debt unrelated to specific appropriations or cash shortfalls, and created a state board for that very purpose. By contrast, the Act does not, on its face, appear to create systemic, long-term borrowing to finance State operations and obligations. Instead, the Act's provisions are designed to meet a predicted cash shortfall this fiscal year. However, in view of the Legislature's failure to address the systemic budget gap and the near certainty that the State will experience a similar shortfall next fiscal year, the Act's provisions, if upheld, would seem to establish a rather simple way of repeatedly authorizing bonds to finance ongoing State operations. This is the essence of the defect identified in Pooled Money Investment Board, and this raises serious questions about the constitutionality of the financing mechanism authorized in the Act.
Conclusion
In summary, the Act's financing mechanism goes significantly beyond anything that the courts have previously upheld against constitutional attack. While the basic financing structure authorized by the Act has withstood constitutional challenge, by extending the payback period to five years, and in light of the failure to address the State's structural deficit, a court could easily declare the Act's provisions to be unconstitutional. There is, accordingly, significant legal risk associated with the sale of the bonds authorized by the Act.