Stem Cell Bonds, Royalties and Campaign Promises

The upcoming sale of California state bonds for its unprecedented stem cell research effort raises anew a $700 million question along with allegations of deceit in the campaign for Prop. 71, the measure that created the Golden State program.

On the surface, the matters involve an arcane financial issue. Can California sell non-taxable bonds to finance the activities of CIRM or must they be taxable. If they are taxable (meaning the dividends are taxable to buyers), the state will have to offer a higher interest rate to purchasers. That, according to one estimate, could mean as much as $700 million in additional costs to the state.

Such additional potential costs did not surface in the 2004 campaign. At the time, interest costs to the state were reported as $3 billion, rather than as much as $3.7 billion. Those amounts would be needed to borrow the $3 billion for the grants for stem cell research.

Nearly a year after Prop. 71 passed, reporter Bernadette Tansey of the San Francisco Chronicle wrote that California stem cell chairman Robert Klein knew before the election that taxable bonds might be needed but did not disclose the matter to the public. Klein was leading the effort on behalf of Prop. 71.

What triggers the use of taxable bonds is CIRM's requirement that royalties be paid to the state if state-funded research generates a significant amount of income.

Tansey reported,

"The potential problems have to do with a complex and unsettled question: how federal tax law will apply to a novel state research venture, supported by tax-exempt bonds, that involves a state split of private profits.

"But IRS rules largely forbid the states to use tax-exempt bonds to benefit specific private enterprises rather than serving a general public good -- and to share revenue from an enterprise to the extent that the state becomes like a business partner."

The issue of taxability was nearly invisible prior to Tansey's article, which subsequently generated allegations of bait-and-switch tactics and statements that Klein had a moral responsibility to be more forthright about the matter.

Stu Leavenworth, associate editor of The Sacramento Bee, interviewed Klein following the Chronicle report. Leavenworth wrote,

"The integrity of Prop. 71 is at stake in the royalty(taxable bond) debate. During the campaign, advocates of Prop. 71 mentioned royalties repeatedly, with Klein touting it on the PBS NewsHour with Jim Lehrer. This wasn't by accident. California was in the midst of a budget crisis, so Klein needed to create the impression - no matter how tenuous - that Californians would get some direct return on their investment."

Leavenworth described the conduct during the campaign at best misleading. "At worst, it was a cynical ruse," he wrote.

We queried both CIRM and the office of state Treasurer Bill Lockyer, which issues the bonds, concerning whether future stem cell bonds would be taxable.

Dale Carlson, chief communications officer for CIRM, replied,

"Bonds have never been used before to fund research, and so we want to be certain that the Prop 71 offerings are eligible for tax-exempt status. (See, for example, the transcript of the 11/05 IP task force meeting beginning at page 19 (http://www.cirm.ca.gov/transcripts/pdf/2005/11-22-05.pdf)) The Treasurer's office assumes that they'll qualify, but will be seeking guidance from the IRS to be sure. In the meantime, this first offering will be taxable."

The response from spokesmanTom Dreassler in the treasurer's office was similar:

"We want to complete the initial sale ASAP so we can pay back the bridge financing provided by the state General Fund and private foundations. At this point, however, we do not have an IRS determination that we can sell stem cell bonds as tax-exempt. So, we will issue this initial $250 as taxable. Then we hope to get a formal determination from the IRS that establishes the extent to which we can issue tax-exempt stem cell bonds. Once we get that ruling, we can refinance the $250 million as tax-exempt, thus cutting taxpayers' costs. Our long-term intent is to sell as much as possible of the $3 billion as tax-exempt, consistent with the IRS determination."

CIRM presumably could eliminate the cost of the added interest by withdrawing requirements that royalties be paid. However, that is extremely unlikely. Meanwhile, the IRS opinion could be some time in coming.

You can find all the coverage by the California Stem Cell Report and links to the stories mentioned above, plus much, much more by searching the label "bonds" below.