ALBANY, N.Y., Oct. 13 (Reuters) - The state's top court on Wednesday heard arguments in a case claiming that New York's economic development policies are unconstitutional because they allow taxpayer money to be used for the purely private benefit of businesses.

A group of 50 individuals and small businesses coordinated by James Ostrowski, a Buffalo attorney and vocal member of the Tea Party, claim in Bordeleau v. New York State that certain economic-development initiatives tucked into the budget for the fiscal year 2009, including grants to agriculture trade associations and subsidies for technology firms and a hotel, violate a provision of the state constitution that prohibits the state from giving gifts or loans to private entities.

An investigative report last week by the Albany Times Union found that GlobalFoundries, a semiconductor manufacturer and one of the defendants in the case, spent some of the $665 million cash grant it received in 2008 -- the largest such grant in U.S. history -- on luxury apartments, flat-screen TVs and catering for private parties. Overall, the company received $1.4 billion in subsidies after pledging more than $7 billion to build a new plant outside Albany.

Wednesday's arguments, before the Court of Appeals in Albany, focused largely on the role of public authorities, which are quasi-public entities created to foster economic development, and whether the powers afforded to those authorities are constitutional.

Public authorities, whose boards are appointed by the legislature, wield a number of extraordinary powers not afforded to state agencies, such as the ability to issue tax-exempt bonds and overrule local zoning ordinances. New York's largest such authority, the Empire State Development Corporation, is also a defendant in the case.

AKIN TO 'MONEY-LAUNDERING OPERATION'

Ostrowski, who represents the plaintiffs, likened the authorities to a "money-laundering operation" that allows the governor and lawmakers to steer economic development money to favored projects.

"If you're going to say 'A can't give money to B,' then it is only logical that A can't give money to C to give to B," Ostrowski said.

Ostrowski is the founder of Free New York, a nonprofit group that advocates for smaller government and claims the state's economic-development policies have done more harm than good, particularly to upstate communities.

Under the "gift and loan" provision of the New York constitution, the state must show the grants in question not only provided a public benefit, but that any private benefits were "merely incidental," according to the ruling by the Appellate Division, Third Department, currently on review.

The defendants argued that because the state does not directly fund public authority projects, the "gift and loan" argument does not apply. The state does provide funding to some public authorities, but it falls to the groups to decide how to spend the money.

"Public authorities were designed to do indirectly what the state cannot do directly," said Deputy Solicitor General Barbara Underwood, who pointed to a number of Court of Appeals decisions that strengthened the powers of public authorities.

'INSANE' FOR COURT TO REVIEW ALL GRANTS

Underwood and attorneys for the defendant companies, which include IBM, also said grants given directly to private groups by the state, such as those given to trade groups to promote New York agriculture, are not "gifts" because they are conditioned on the performance of the recipient in creating jobs and otherwise realizing economic growth.

"If we violate that contract, the state has extensive remedies, including the right to claw back some of the money," said Harold Iselin of Greenberg Traurig, who argued on behalf of GlobalFoundries.

Some legal experts said a decision in favor of the plaintiffs -- which would send the case to trial -- would upset decades of case law and state policy, as well as open the floodgates for legal challenges to any individual grant doled out by the state.

Paul Finkelman, a constitutional law expert at Albany Law School, said that because grant-making discretion has traditionally been left to the legislature, "the notion that the courts should review every economic development grant by the legislature is insane."

But Ostrowski argued Wednesday that the legislature's policies have been failing for more than four decades, pointing to the steady decline of manufacturing and other industries in New York despite public authorities steering billions of dollars into development projects.

"We are here to put an end to this type of illegal spending moving forward," he said.

The case is Bordeleau, et al v. New York State, et al, New York State Court of Appeals No. 190.

For the plaintiffs: James Ostrowski.

For the state: Deputy Solicitor General Barbara Underwood.

For GlobalFoundries: Harold Iselin of Greenberg Traurig.

(Reporting By Dan Wiessner)

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