Rhode Island Faces an Investment Gone Awry
By the morning of June 7, officials at 38 Studios, a video game company started by major league baseball legend Curt Schilling, knew their enterprise was doomed. After a night of conference calls and meetings, executives came to a conclusion: Their task was now a salvage operation.
“It got to the point,” the company's former chief financial officer told creditors at a bankruptcy hearing last week, “where you had to protect what was left.”
By that afternoon, an emergency board meeting had moved to file for bankruptcy protection.
Just 18 months earlier, in November 2010, 38 Studios had secured a deal with the state of Rhode Island for a $75 million economic development loan to move its headquarters from Massachusetts to Providence. The deal was touted as a potential industry-starter for the economically depressed state.
But the arrangement soured. In early 2011, the company needed an additional $30 million to $50 million to survive. That money never arrived, leaving the state as primary backer. Cash-flow problems surfaced from disappointing sales of its first game. The release of its second, originally set for late 2012, was pushed into 2013.
In early May, 38 Studios faced a choice: Make a $1.125 million loan payment or meet payroll. For a time, the company did neither. The payment was eventually made, but by the end of May the company laid off all of its 400 employees, who hadn't been paid in three weeks.
Now, the company is facing liquidation in federal bankruptcy court. It lacked the funds to pursue a Chapter 11 restructuring, and its Chapter 7 filing has left creditors poring over its assets. The company's debt stands at about $150 million, with $20 million in assets.
The largest creditor – and arguably the entity with the most to lose – is Rhode Island. The state is on the hook for about $116 million – including interest and fees – stemming from the $75 million loan. How much it owes will be settled in court. The first hearing is next week.
But beyond the fiscal fallout, Rhode Island – with its 11 percent unemployment rate – is also struggling to make sense of what went wrong and how such a deal took shape in the first place. Some fear it could have a longer-term impact on future economic development.
“38 Studios was a risky business under every situation imaginable,” says Ed Mazze, professor of business administration at the University of Rhode Island's College of Business Administration. “The only reason that I believe we gave them the funds is that we were so desperate to create jobs.”
‘It only gets easier from here'
The 38 Studios deal stems from Rhode Island's Job Creation Guaranty Program, passed in 2010. The bill gave the Rhode Island Economic Development Corporation authority to dole out $125 million in economic development loans.
They would be backed by moral obligation bonds, meaning the state wouldn't be legally obligated to repay the loans. Still, a moral obligation is seen as a promise to pay, just a step below a full legal obligation.
“Moral obligation bonds have paid off in virtually the same proportion as standard general obligation bonds,” says Wilson White, a municipal bond expert with decades of experience in the market. “The state pledged its moral obligation.”
In November 2010, state officials and 38 Studios management struck a deal. Optimism was high, thanks in part to the project's high-profile connection with Schilling. The company set about moving its operations to Providence, recruiting and relocating employees from as far away as Germany.
Fred Hashway, an Economic Development Corporation official, wrote a mass e-mail to company and state officials the day the deal closed: “It only gets easier from here.”
‘A Hail Mary pass'
But despite the optimism, some questioned it from the beginning. Former Republican Governor Donald Carcieri was a supporter, but his successor, Lincoln Chafee, an independent, criticized it. The issue became heated enough that Carcieri released a statement in August 2010 critiquing the politicization.
“Businesses and the bond market should not be subject to political posturing,” Carcieri said. “The EDC has entered into a good faith agreement with 38 Studios, after months of due diligence and analysis.”
The state's first error, economic development experts say, was placing so much of its economic development fund in one venture, especially a risky video game company.
“It's the first time I've heard of a government giving away almost the entire store to one company,” says Anthony Figliola, the vice president of Empire Government Strategies and a familiar figure in economic development policy. “The state gave away most of its money to a start-up company. That's alarming.”
How the deal was struck in the first place has become as much a question in Rhode Island as what went wrong. Many point to Schilling's celebrity – and Republican political leanings – as an explanation.
“It's clear to me at least that had it not been Curt Schilling it would not have happened so quickly,” Marion Orr, a political science professor at Brown University, says. “There are a number of people who are saying why couldn't I, as a small business owner, tap into those funds? The fact of the matter is that that person is not Curt Schilling.”
Others point to simple desperation.
“You do a Hail Mary pass when you're desperate,” says Scott Wolf, executive director of Grow Smart Rhode Island, a nonprofit group. “We've been desperate for a long time.”
Running on Fumes
But no matter the explanation, it took about six months for problems to surface.
With less revenue than expected, a delay in getting additional tax credits and a lack of interest from investors, the company was running on fumes. Its operations were increasingly funded by Schilling while officials sought capital in the United States, Asia and elsewhere.
“There were a number of things on the precipice,” Bill Thomas, the present of 38 Studios, told creditors last week. “We were trying to look at every avenue.”
But nothing came. The tax credits were tied up in the state bureaucracy, and not having those funds proved a significant blow. But with a missed loan payment earlier in May – an episode that included writing, and later withdrawing, a bad check – those prospects dimmed further. Faced with unmet payroll, Schilling himself put the situation into stark relief with a May 15 e-mail.
“This ceases to become a viable company,” he wrote, “at 5pm when the employees are notified they will not be receiving their paychecks.”
The next week, 38 Studios laid off its employees. Three weeks later, it filed for bankruptcy. Now the courts, creditors, appointed trustees, state officials and law enforcement would sort through the fallout.
Rhode Island's options
The most important question may be what ill effects Rhode Island will suffer if it refuses to honor the bonds.
Since they're moral obligation bonds, there'd be little standing for bondholders to recoup their losses should the state walk away. The wild card is the market's reaction, and some say the backlash would be swift. “The market would treat it as tantamount to defaulting,” says Matt Fabian, managing director of Municipal Market Advisors. “They would be ostracized.”
But others say that's overstated. With more debtors facing accumulated red ink, the market could be more forgiving. “Bondholders knew what they were getting into,” argues Craig Chilton, an adviser with BondView. “If I were a taxpayer in Rhode Island, I'd be hard-pressed to want to make good on the obligation.”
Complicating the matter is Rhode Island's shaky fiscal picture. The state has $1.95 billion in debt, compared to its $8 billion annual budget. It has $357 million in moral obligation debt. The state recently closed a nearly 7 percent budget gap but has a more than $14 billion pension liability that is less than half funded.
That could make default on the 38 Studios bonds an attractive option, even if the $116 million the state owes isn't a budget-breaking figure in its own right. Still, the governor's office and state officials say there has been no consideration of default. In May, Moody's reaffirmed the state's credit rating, saying it expects the state to live up to its obligations.
In the end, though, for a state facing a number of tough choices, what to do with the 38 Studios debt could provide an easy one for Rhode Island officials. “This is something they can legally walk away from,” Chilton said. “It's a lot of money to not have to pay.”
Picking up the pieces
The longest-lasting effect, though, could be the damage done to the economic development program. The state's Economic Development Corporation has long been the subject of scrutiny. Some say a revolving door of leadership has left it rudderless, with no overarching strategy.
“Somebody says we ought to become the bioscience capital of the world, and the director likes that, we suddenly are going to become the bioscience capital of the world,” Mazze, the URI professor, said. “The entire focus of the Economic Development Corporation has been based on fads.”
Six members of the board have resigned or passed on reappointment. More broadly, there's a worry that the negative publicity could hinder economic development going forward. The governor's office has pledged a full airing, while saying the state will look to support businesses and job growth.
But Orr, the political science professor, says many are now questioning those plans.
“This 38 Studios issue really resonates with people,” he said. “It comes at a very, very difficult economic time for us.”