Last week, Fiscal Watch wondered if the $3.2 billion in IOUs that the State of California is issuing in lieu of cash payments are Constitutional and legal. The answer is a complicated “yes” on both counts.

California began printing the IOUs last Thursday and is sending them out to people and businesses owed money, including taxpayers due refunds.

The IOUs mature on October 2 — meaning that’s when California is supposed to replace them with cash. They carry a 3.75 percent interest rate, annualized.

As FW noted last week, it’s unconstitutional for states to issue currency.

The IOUs are not currency, though. The test is “are they designed to circulate in the community as money,” says Allan Marks, a partner at Milbank, Tweed in Los Angeles.

The Golden State does not expect IOU recipients to transfer the paper freely at face value as payment for goods and services. Nobody is obligated to accept them as all creditors must accept legal tender.

The IOUs are, instead, negotiable instruments that represent a “promise to pay.” People are free to transfer them among themselves for a negotiated price.

Buyers and sellers of goods and services can negotiate the price of the IOU to be face value.

They could also negotiate a price below face value, if the buyers and sellers perceive that there’s a risk that the state won’t make good on the paper, or if they perceive that the interest rate is too low.

Traders could also negotiate the price to be above face value, if investors perceive that the interest rate is better than what they could earn in the market for a similar investment.

Specifically, the negotiable instruments are “a special class of instrument called a registered warrant,” says Marks of Milbank.

California has issued the warrants before: in 1933, when the state, like many states in the Depression, issued similar IOUs, and again as recently as 1992.

The warrants are legal investments for banks. Last week, Wells Fargo and Bank of America, among others, initially agreed to accept the warrants from customers as deposits, although both banks said that they would stop accepting them this week.

And the warrants are debt – evidence, again, of a specific “promise to pay.”

But there’s a hitch here. In a court case surrounding the state’s 1933 issuance of similar instruments, state court ruled that the warrants aren’t a debt when it comes to California’s Constitutional debt cap, if the state plans to repay the warrants with existing funds or funds that it reasonably anticipates, with both funding sources subject to appropriation (lawmaker approval).

Are the warrants securities under the federal definition, thus allowing the Securities and Exchange Commission to regulate them?

The SEC has never interpreted its statutory authority over securities markets to include state warrants.

But the definition of security is broad, and nothing would stop the SEC from asking Congress for such authority if it does not believe it possesses it and thinks that it needs it.

The SEC is making some noise here: Reuters reports that if the warrants “are deemed securities by the Securities and Exchange Commission, then those buying and selling them could be subject to federal law on broker-dealers. Currently, SEC officials are analyzing the issues involved.”

The fact that Wall Street firms want to trade the instruments on a secondary market could be giving the regulators a nudge.

Can the state use the warrants for any purpose? No. In 1992, California tried to use similar warrants to pay its state employees. State and federal courts ruled that such substitution of payment would violate the Federal Fair Labor Standards Act, which mandates that the workers be paid “promptly.”

What happens if someone doesn’t want to accept a warrant – or what happens if the state doesn’t pay the warrants back (with actual cash, not new warrants) when they mature?

Probably not much.

Warrant-holders cannot force the state into bankruptcy. It’s quite possible that nobody – even long-term bondholders – can force a state into bankruptcy.

“Federal bankruptcy courts lack jurisdiction over a state bankruptcy, as opposed to a municipal bankruptcy, and there are no precedents for an organized insolvency proceeding or reorganization of a bankrupt state,” Marks notes.

Of course, a vendor who provides services and feels he is owed money for his services can refuse to provide new services or can sue in state court. Similarly, a resident owed an income-tax refund could sue.

But even if that party won a favorable court judgment, he would not be assured of cash payment. Courts cannot attach liens to state assets, and the state could conceivably satisfy the judgment with another IOU.

Cold comfort for actual bondholders, too, maybe — but with no precedents, it’s hard to tell. (Update: Today’s Wall Street Journal notes that California’s constitution rates bondholders — not including warrant holders — second in payment priority, after aid to schools.)

Could New York State issue similar warrants as its own budget woes grow? Nothing in federal law or the Constitution stops it, as California’s experience shows.

So it all comes down to the state constitution and state statutory authority. New York did not attempt to issue IOUs in its early-nineties recession.

FW will learn more.

Like California, New York has the first prerequisite, which is a motive. It does not want to address the structural problems that bedevil its budget.