City Journal

Michael S. Gruen
Government by Subterfuge
New York officials routinely concoct complex financial schemes to evade the State Constitution and frustrate the will of the voters.
Winter 1995

Governing New York is an even more complicated business than it need be, because New York's leaders often resort to complexity as a stratagem for evading constitutional limitations on their authority. Both the State Constitution and the City Charter contain numerous provisions designed to ensure that government handles the people's finances fairly and responsibly, and that the people have ample opportunity to participate in decision making on important financing and landuse issues. The state can't go into debt without voter approval, for example; the city can't sell its real estate without a public auction; neither the city nor the state can grant special tax exemptions to favored corporations or institutions. But politicians have found devious ways to do all these forbidden things, and New York's courts have consistently, if sometimes reluctantly, acquiesced in their schemes.

Even though officials sometimes have the best intentions when they try to work around the law, the end never justifies the means in such matters. When politicians undermine the Constitution, even in pursuit of worthy goals, they invariably undermine public confidence in government.

Consider a representative selection of these subterfuges, most of which involve public authorities, nominally independent corporations created by the state, like the Urban Development Corporation (UDC). Typically, the UDC or another authority will act as middleman, conducting transactions that would be illegal if the city or state carried them out. These make a mockery of the legal protections that New York's voters have enacted to ensure that the business of government is conducted democratically.

Start with an example I know especially well, because I am a lawyer representing the East 13th Street Community Association, a group of neighbors who oppose construction of a homeless housing facility in Manhattan near Union Square. (The Manhattan Institute, which publishes City Journal, has filed a friend-of-the-court brief in opposition to the facility.) New York City and State and the UDC made an agreement under which the city invited the UDC to condemn a cityowned property and to pay the city $1 for it. The UDC then conveyed the property to a developer, which the city designated, again for $1. That developer is a nonprofit organization called Housing Enterprise for the Less Privileged (HELP), founded by Andrew Cuomo, the former governor's son, and now headed by the younger Cuomo's sister, Maria Cuomo Cole.

The city does not really want to give away a valuable piece of Manhattan real estate for only $1. So in exchange for the property, HELP has agreed to construct a commercial and retail building on an adjacent, cityowned lot at an estimated cost of $4 million.

Why didn't the city simply sell the property to HELP for $4,000,001, with the same result and much less paperwork and administrative expense? Because doing so would have violated the City Charter. The Charter generally requires the city to auction its property in order to avoid illconsidered or politically motivated sales below market value. It also requires an appraisal and a timeconsuming public review process, the Uniform Land Use Review Procedure.

If politicians want to make sure that a sale goes to a particular developer, allowing others to bid on it is risky. Hence the scheme of pretending that the whole matter is beyond the city's control by erecting the facade of UDC condemnation. Everyone involved refers to this as a "friendly condemnation," with the UDC being "invited" to condemn the property: it never would have occurred without the city's instigation.

One suspects that the city is losing money on the deal. Although the nominal price is $4,000,001, the city is contributing half the cost, making the real proceeds only $2 million and change. The property HELP is taking over constitutes half of a lot valued in 1987 at $18 million. Even HELP acknowledges that it may be paying less than fair market value for the property; without an auction, there is no way for taxpayers and voters to know for sure. And the UDC is involved in "friendly" condemnations in no fewer than 15 similar deals with the city for homelesshousing programs.

Thus far, the courts have approved this deal, designed to subvert not only the City Charter's protection against improvident sales of city property but also its guarantee of citizen participation through the landuse review process. An appellate court ruled that the UDC "condemnation" insulated the transaction from challenge under the Charter. The Court of Appeals (New York's highest court) affirmed the decision on procedural grounds, leaving the substantive issues unresolved.

Another example of government by subterfuge is the story of the old Commodore Hotel—now the Grand Hyatt—next to Grand Central Terminal. In the midseventies, the hotel had closed and was disintegrating. Its owner, a subsidiary of the bankrupt Penn Central Railroad, owed some $10 million in property taxes. Because of pending bankruptcy proceedings, the city could not foreclose on its tax lien, perhaps for years.

So the city hatched a plan, which the Court of Appeals later described, with some restraint, as "complex." A private developer, Wembley Realty, would buy the hotel from Penn Central for $10 million; Wembley would then sell the building to the UDC for $1; the UDC would lease the building back to Wembley for 99 years; the rent would be payable to the city rather than to the UDC; and, at the end of the lease, the city would get title to the property. Under the provisions of the law that created the UDC, the authority's title to the hotel would exempt it from city property tax. After 40 years, Wembley's annual rent payments to the city would reach the level the company would be paying in property tax if it owned the building. Why would Wembley pay $10 million for a hotel, then sell it for $1? Because a longterm exemption from property taxes, which the firm effectively received, made the upfront loss worthwhile.

One small problem: The State Constitution prohibits the city from granting special tax breaks like this. Any exemptions must be available to everyone meeting standard qualifications.

Yet the Court of Appeals upheld the scheme. Reason: "The property will obtain tax-exempt status not by any claimed or alleged invalid legislation enacted by the City Council," the court explained, "but rather by virtue of the purchase of the hotel by the UDC." The reality, however, is that the UDC could not have purchased the hotel for $1—Wembley would not have sold it—had the city not consented to waive its $10 million tax lien and to forgo taxes for 99 years. The city, in other words, sold a tax concession; the UDC's involvement was no more than window dressing for what would otherwise have been an unconstitutional transaction.

Soon after the Commodore Hotel deal was done, the State Legislature concocted another special tax exemption, this time to benefit the Museum of Modern Art, which faced financial problems and needed additional space. MoMA owned several brownstones west of the museum building. It wanted to acquire additional property and then develop the entire site to provide both exhibition space and a steady source of income. The city, state, and MoMA developed what the Court of Appeals described as a "highly intricate and imaginative scheme" to finance a 50story Museum Tower housing museum facilities on the first six stories and condominium apartments on the other floors.

But how to ensure a flow of income to the museum? Condominium owners don't pay rent after all—but they do pay property taxes. MoMA needed a way to tap the taxes for itself. The city obliged: it would exempt the property from taxes but require the condo owners to make tax-equivalency payments to the museum.

While the city was willing to allow the exemption in this particular case, neither it nor the State Legislature wanted to abolish the rule that even charitable organizations must pay taxes on property they use for commercial purposes. But, as in the case of the Commodore, officials came up against the constitutional prohibition against special tax exemptions. The government could not bestow a tax break upon this project alone.

Or could it? The Legislature passed a law authorizing the creation of local trusts to help cultural institutions build combined cultural and commercial facilities. The trusts may condemn the required property, construct the buildings, and sell them to the cultural institution and the cooperating commercial developer. Once a trust has held title, however briefly, the property is forever taxexempt. But the owners of the commercial part of the building must pay the trust the sum they would otherwise pay in taxes. The trust then gives the cultural institution enough of this money to defray its operating costs on the new structure, with the remainder going to lenders and the city.

To make certain that only MoMA would qualify, lawmakers strictly limited the creation of the new trusts to cultural institutions that, first, have owned contiguous taxexempt property in excess of 50,000 square feet for at least five years and, second, meet high minimum admissions requirementsin New York City, average annual admissions of at least 500,000 for at least five years.

The Court of Appeals held the scheme constitutional because other institutions might qualify in the future. Two dissenting judges, however, would have quashed the law as "gimmickry" designed to conceal a subsidy from the public and irrevocably commit longterm support to a single institution. The dissenters recognized that the "objective" qualifications were expressly designed to limit the benefit to a single institution.

Deals like these illustrate well the pervasive practice of cooking up elaborate schemes to subvert basic constitutional restrictions. But these examples look like child's play when compared with the way the state escapes legal limits on its ability to borrow money.

The State Constitution provides that no longterm debt may be contracted "by or in behalf of the state" without voter approval by referendum. But New Yorkers are often skeptical of the state's borrowing proposals. Of ten bond issues totaling $10.7 billion that have appeared on the ballot in the past 20 years, only five, amounting to $6.5 billion, won approval. But the state has managed to borrow another $20 billion, and plans to borrow an additional $7.1 billion, by evading the constitutional limitation.

The trick is "backdoor financing." A public authority, such as the UDC or the Thruway Authority, does the borrowing and declares that only it, not the state, is liable for the debt. Then, through a complicated set of transactions, the state actually pays off the debt. In one well-known scheme, the UDC and the Thruway Authority sold $230 million in bonds and used the proceeds to purchase Attica prison and Interstate 287 from the state. The authorities then leased the prison and the highway back to the state; the Legislature fixed the "rent" under the "leases" at an amount equal to the annual debt service obligation. In other words, the state is paying off the debt under the pretense of paying rent.

The courts have upheld such borrowing on the grounds that because the state is not legally obligated to pay, there is no incurrence of debt "by or in behalf of the state." The constitutional requirement of popular approval, therefore, does not apply. But if the state defaulted on its "rent" payments, bondholders would take over the prison and the highwaya practical impossibility. The state would never allow a default.

A variation on the theme earmarks certain tax revenues for repayment of bonds. In 1990, the Legislature created the Local Government Assistance Corporation and authorized it to borrow $4.7 billion to finance certain operating expenses of local governments. Again, the scheme relied on the fiction that public approval of the bonds was unnecessary because only the corporation, not the state, is responsible for repaying the debt. But where will the corporation get the money? From a fund consisting of onefourth of the revenues from the state's 4 percent sales tax.

Each year, in theory, the Legislature has the option of appropriating or not appropriating the money. But, in practice, everyone recognizes that a breach of faith with the bondholders—a failure to continue appropriating the fundswould destroy the state's credit rating. So, in reality, there is every bit as much assurance that the state will pay the debt as there would be if the state had incurred it directly.

From Albany's point of view, it makes no difference whether the debt service payments go directly to the bondholders or reach them through the Local Government Assistance Corporation. To the public, however, it makes a big difference. Had the deal been done in a straightforward manner, the voters would have had the opportunity to decide whether they wanted to burden their children and grandchildren with another $4.7 billion in debt.

Most recently, the Legislature has authorized the sale of $7.1 billion in bonds for improvement of transportation facilities, all through public authorities and without voter approval. In June 1994, the Court of Appeals upheld the plan.

New York City, too, has used similar subterfuges to evade limits on its debt. The State Constitution prohibits a municipality from incurring debt exceeding a given percentage of its property tax base—10 percent in the case of New York City. When the city ran up against that limit in the early seventies and faced an unprecedented fiscal crisis, the Legislature sought to evade the constitutional prohibition by establishing the New York City Stabilization Reserve Corporation (SRQ) whose sole function was to issue bonds, paying the proceeds to the city. Each year, the city would supposedly have the option of paying the debt service or not. But this choice was a fiction: if the city chose not to pay, the state would simply divert to the bondholders local support funds that would otherwise have gone to the city. Either way, the city was effectively liable for the debt. The use of the SRC as an intermediary to transfer funds was nothing but a pretext for evading the debt ceiling.

The Court of Appeals upheld the scheme because the enabling act declaredin denial of the practical reality—that the bonds of the SRC "shall not be a debt of either the state or the city, and neither the state nor the city shall be liable thereon." Therefore, the court held, the city could not be exceeding its constitutional debt limitation. Three of the seven judges, however, recognized that the plan was "a barely disguised technique for debt ceiling avoidance" that "violates the spirit and tenor" of the Constitution.

The SRC never sold any bonds—by the time the court upheld it in May 1975, the fiscal crisis had exploded. The Legislature created a new agency, the Municipal Assistance Corporation (MAC), whose structure was similar. But the amount of debt increased dramatically. The SRC had been authorized to borrow $520 million in 1974. MAC was initially authorized to borrow $3 billion, a figure that ballooned to $10 billion by 1980. As of 1980, MAC's legislatively established borrowing limit alone exceeded the city's constitutional debt limit by almost $2 billion. The limitation on municipal borrowing had lost its meaning.

Over and over, New York's public officials have seemed to view the State Constitution not as a limit on their power but as a challenge to their talents for evasion. When officials flout constitutional limits, they threaten the most fundamental principle of American democracy—that governmental authority comes from the people. When the people enact restrictions on governmental conduct, public officials and the courts should honor them—not in the breach by legalistic sleight of hand but by respecting the purpose for which they were adopted.

How can New York develop an honest government, one that respects the limits of the State Constitution and the City Charter? Nothing would help more than if Governor Pataki and Mayor Giuliani repudiate the idea of government by subterfuge, refusing to enter into deals that serve immediate political goals at the expense of the government's integrity.

Greater public awareness would help prevent future subterfuges. We should remember that the purpose of these Byzantine schemes is precisely to obfuscate. They succeed because the general public does not understandand the press does not spotlight—either the schemes or their consequences, and so the public is hardly in a position to fight them by voting out officials who adopt them.

The courts must become far more vigorous in carrying out their fundamental responsibility to enforce constitutional limitations on governmental authority. The subterfuges I have described would be impossible without judicial laxity. When it comes to individual civil rights like free speech and due process, courts are generally vigilant in defending the Constitution when the other branches of government seek to evade it. They should be no less so when the issue is the people's political right to control their government, limit its powers, and hold it accountable.

Sometimes judges succumb to the pretext that a crisis justifies extraordinary measuresthough it is precisely in times of crisis that constitutional limits on government are most crucial. Eventually judicial laxity becomes endemic: legal precedent from crisisinspired decisions and a natural reluctance to upset the ship of state combine to inhibit the judiciary from overruling the other branches of government when they act outside their legally defined roles.

Of late, New York's courts have at least begun to express some embarrassment at their willingness to allow the subversion of the Constitution. In upholding the recent $7.1 billion transportation bond issue, the Appellate Division acknowledged: "Undoubtedly, there is a certain intrinsic validity to plaintiffs' contentions that the challenged financing schemes are little more than carefully tailored mechanisms to circumvent the referendum requirements of [the] New York Constitution...Likewise, there is a disturbing correctness to their argument that...inasmuch as...default would affect the state directly by impairing its credit and hampering its ability to issue bonds in the future, the state practically and economically is obligated to make payment." The court nevertheless concluded that precedent forced it to uphold the borrowing.

The Court of Appeals agreed, adding: "If, as plaintiffs urge, modern ingenuity, even gimmickry, have in fact stretched the words of the Constitution beyond the point of prudence, that plea for reform in state borrowing practices and policy is appropriately directed to the public arena"—that is, the constitutional amendment process. But, in fact, the current limits on debt are contained in constitutional amendments passed in response to earlier subterfuges. If the courts continue shirking their responsibility to uphold the Constitution, further amendments will only tempt officials to brew new schemes to evade them.

But happily, in the 1993 case of Schulz v. State, the Court of Appeals dealt a potentially crucial setback to government by subterfuge, giving voters the power to file suits challenging backdoor financing through public authorities. Before this case, rules limiting "standing" all but precluded direct legal attacks on state financing methods.

In the Schulz case, the court ultimately allowed the borrowing to go through because the plan had already progressed so far that the judges believed overruling it would severely disrupt the financial markets. This suggests one solution: the courts could expedite cases challenging large capital projects or financing schemes so that judges can address the legal issues without fear that enforcing the Constitution would lead to financial or political chaos.

However they do it, the courts must get serious about enforcing the limits on government built into the State Constitution and the City Charter. Doing so would promote both the longterm health of the state's finances and public confidence in its institutions of government.

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