June 12, 2006

Taking a Gamble


It's hard to imagine Goldman Sachs or Merrill Lynch investing in a company that grows marijuana or scalps concert tickets. Yet the two firms, along with such houses as Morgan Stanley, JPMorgan and Fidelity, have invested hundreds of millions of dollars in shares of online casinos, even though those companies may be breaking US laws.

Most of these companies trade on the London Stock Exchange and are licensed in remote locations like Malta and Antigua, all of which deem Internet gambling to be perfectly legal. But the problem is, the users are largely Americans, who are placing bets on poker, blackjack or sporting events online from their homes. And as far as the US Department of Justice is concerned, in America, online gambling is illegal.

But that hasn't stopped Merrill Lynch Asset Management, Goldman Sachs Group, Fidelity Management and Blue Ridge Capital from taking stakes in Sportingbet, which, as the name suggests, allows people to bet on sporting events. Nor has it stopped Goldman and Morgan Stanley Securities from having sizable holdings in And several hold shares in the long-established, UK-listed bookmaking firms William Hill and Ladbrokes.

"Morgan Stanley, Fidelity, Goldman Sachs, JPMorgan, they're all major investors in the gambling industry," says Warwick Bartlett, lead partner at Global Betting & Gaming Consultants in the UK.

It's not hard to see why the gambling ban is ignored. The online gaming industry is going gangbusters. It has already grown from $3 billion in 2001 to $12 billion at the end of last year, and that figure is expected to rise to $24.5 billion by 2010, according to Christiansen Capital Advisors, a Maine firm that analyzes the gambling industry.

It's potentially also a lucrative source of investment banking and underwriting fees. Some $54.1 billion worth of M&A involving companies in the casino and gaming industry have been announced or completed since 2000. About $9 billion worth of deals have been announced this year alone. That's equal to the amount done for all of last year.

On the capital markets side, a little more than $40.3 billion in debt and equity transactions have been done by gaming companies since 2000. One of the most notable was PartyGaming's $1.6 billion IPO last year--underwritten by Dresdner Kleinwort Wasserstein, Calyon Securities, BBVA Securities and Mediobanca- which was the London Stock Exchange's biggest IPO in five years. About two months after flotation, the gaming group was included in the FTSE 100 Index of leading companies by market value. Last week, the founders sold an additional GBP232 million in shares.

"Anyone looking to invest in stocks would be well advised to consider gambling stocks, as they are one of the hottest stocks on the market globally," says Robert Winslow, an analyst with Wellington West Capital Markets.

And despite the prohibition, US consumers represent about 50% of the market. Indeed, the American Gaming Association recently released a report showing that US residents spent more than $4 billion last year on Internet gambling. And that segment is growing at a rate of 20% a year, the association says.

Treading Delicately

But for the US investment banks, Internet gambling is the investment that dare not speak its name. None of those contacted would respond to a request to be interviewed. Even analysts who wrote reports on the sector declined to speak on the record.

Wall Street is treading delicately because, while the US federal government has yet to prosecute anyone for investing in online gambling, it might be able do so under existing laws. The most relevant is the 1961 Wire Act, which prohibits the transfer of betting information across state lines using wire communications, such as the telephone.

It remains unclear whether the Wire Act applies to nonsports gambling or to the Internet, which was obviously not around when the legislation passed. The apparent intent of the law was to suppress organized crime by regulating gambling activities. Still, the Justice Department maintains that all Internet gambling is illegal, though it's unlikely that sites hosted and managed overseas by non-US citizens would fall within the reach of US law enforcement.

"The complicating factor is that US players engage in this activity," says Lawrence Walters, a partner with San Diego law firm Weston, Garrou, DeWitt & Walters who specializes in online gaming. "If the online gambling site was 100% Maltese players, licensed in Malta, and US investors decided to invest in that entity, I don't think there would be a question of whether that was legal."

Cory Aronovitz, founder of the Casino Law Group, which specializes in gambling-related issues, says a lot of gambling operators go public based on US investor interest, and yet they still have to list on the London Stock Exchange, beyond US regulators' radar. When PartyGaming went public in June of 2005, its offering statement expressly prohibited US investment.

"It was very difficult even to get your hands on a prospectus over here," Aronovitz says. "I had two clients that began the process for going public, and instead of talking to the houses here, they're looking offshore."

Aronovitz says he is constantly being asked by clients who want to launch Internet gambling businesses whether they can invest in existing operations. He tells them they can, provided the company engages only in casino-type games and does not take bets on sporting events. "I think I have a good-faith argument to tell the client that the Department of Justice would be hard pressed to go after them. However, if they want to be in Internet sportsbook, they could reasonably be served an indictment," says Aronovitz.

Jay Cohen found out the hard way just what the legal limits are in this arena. An American citizen, Cohen set up an offshore gambling enterprise that was licensed and based in Antigua, where such gambling is legal, but he solicited bets from people in the US. He was convicted of violating US law and sent to prison.

"The court says Jay Cohen was soliciting bets from individuals in New York, and that's where he ran afoul of US law," says Weston's Walters. "If that company had focused on customers in Antigua, what could US authorities have said? Not much."

In another case worrisome to Wall Street, the Department of Justice went after several media companies that had been accepting ads from sports betting companies and told them they were "aiding and abetting" criminal activity. Some investment banks fear a similar logic will be used for firms that are investing in, financing or even taking on these companies as clients. That's what happened to PayPal, which agreed to pay a $10 million fine in 2003 after regulators claimed the Internet banker aided offshore sports books and online casinos, which did business in violation of US law. PayPal also agreed to cease providing financial transfer services to such offshore entities.

Closing Loopholes

In an effort to close any remaining loopholes, several gambling opponents in Congress have sponsored new legislation aimed at stamping out the online gambling industry altogether. Rep. Bob Goodlatte (R-Va.) and Rick Boucher (D-Va.) sponsored the Internet Gambling Prohibition Act in February, which targets providers of online gambling services. The bill seeks to update the Wire Act by clarifying that prohibition relates to remote gambling over various communications media, and covers sports betting as well as lottery and games of chance.

The bill also seeks to prohibit a gambling business from accepting various forms of noncash payment, which could derail offshore operators with US-based bank accounts. Lastly, the bill allows law enforcement agencies to seek injunctions against any party to prevent violations of the act. That means Internet service providers could be forced to block access to certain Web sites.

Another piece of legislation introduced is the Unlawful Internet Gambling Enforcement Act, which was sponsored by Rep. James Leach (R-Iowa) last November. The bill seeks to prevent the use of credit cards and fund transfers for unlawful Internet gambling and would allow such transactions to be blocked. The bill is similar to one sponsored by Sen. Jon Kyl (R-Ariz.) in the Senate.

Both bills recently passed the House Judiciary Committee and are on their way to the full House for a vote. Although versions of the ban have been introduced in both houses of Congress for the past 10 years, and none has passed, some believe this year may be different. Some 131 members of Congress signed onto the Goodlatte bill as co-sponsors-about four times as many as previous antigambling bills-a sign of the political pressure currently being exerted in the House. But in the end, many believe it will stall in the Senate, given the competing gaming interests, conflicting regulations and shortened congressional calendar.

Many gambling proponents say the prohibition of online gambling would do more harm than good. As it is, Wall Street is losing investment-banking business as all the lucrative IPOs are listed in London, and with the industry offshore, Americans lose out on potential jobs and tax revenues.

"It's a matter of the extreme Christian conservative groups pushing their morals on the rest of the country when it comes to gaming. And because they think it's wrong, we all should think it's wrong. That's not the way this country is supposed to operate," says Frank Catania, president of North Haledon, NJ-based Catania Con- sulting Group and former direct- or of the New Jersey division of gaming enforcement.

Rather than an all-out prohibition, industry observers anticipate regulation, which is the "if you can't beat 'em, join 'em" route authorities in the UK have taken. While the country already allowed sports betting, it will now allow online casino games like poker, blackjack and roulette. British lawmakers passed the UK Gambling Act in April 2005, which established a Gaming Commission that could license and regulate online gambling operations. The first licenses are expected to be issued in 2007.

"The industry has grown and matured. With the UK choosing the regulation route and with many e-gaming companies having gone public in the UK, there is a much greater sense of legitimacy to the space, a far cry from the early days," says Spencer Churchill, an analyst with Clarus Securities in Toronto. "Overall, I would say there's a 25% chance legislation passes."

Profit Potential

Despite the legal uncertainty in the US markets for M&A and investment in online gaming, deals continue to get done, says Weston's Walters. "The profit potential is overshadowing most of those concerns," he explains. "When you look at how sure a bet these companies are, from a financial perspective, a lot of these academic and theoretical concerns go out the window."

Catania, whose consulting firm has considerable experience with gaming issues, pooh-poohs the notion that the investment banks are in any jeopardy by holding shares in these companies. "It's a passive investment. They're not operators. If I own shares in AT&T, and they're wiretapping or doing something wrong, does it mean I'm liable? No," he says.

But the problematic regulatory environment is shaping where those investments go. A stock like PartyGaming, for instance, whose customer base is about 80% American, is owned predominantly by individuals and hedge funds, according to Global Betting's Bartlett. But online gaming companies, such as William Hill and Ladbrokes, which have few--if any--US customers, have more mainstream investor support, Bartlett says.

"It's argued there's more quality to William Hill's and Ladbrokes' earnings because they don't trade in places where it's illegal to do so, like the US and Holland," he says. "A lot of William Hill's financing comes from the US, and there could be actions against those banks and financial institutions were William Hill to take bets from the US."

In general, investment banks have confined most of their investments to listed companies, even though many of the industry's operators are based in offshore jurisdictions, such as Antigua and the Netherlands Antilles, that have been more open to granting licenses to online gaming providers and that offer attractive tax schemes.

Weston's Walters says there's a lot more US investment than what shows up in the public filings of listed companies. Groups of investors are setting up online gambling companies in jurisdictions like Antigua that will offer gambling, poker and casino. They usually avoid sports betting, as that definitely sets off a violation of the Wire Act, Walters says. "That's where a lot of the private investment actions is," he says.

If the US antigambling legislation does pass, Clarus's Churchill says the sector would take a considerable hit, particularly in the capital markets. But the impact would be somewhat limited. Growth in the industry outside the US has been at a much faster pace, and most operators have succeeded in reducing their US exposure significantly-though it still remains at more than 50%, he says.

"Longer term, growth will continue. International market growth will be unaffected and strong, and the US player base will find ways to continue gambling online, just as they did when major credit cards companies stopped e-gaming transactions," Churchill says.

Wellington's Winslow agrees that the industry will only continue to grow, whether the US is on board or not. "The next legs of growth will be geographies like Asia and Eastern Europe," he says. "There's a propensity to gamble in many of those cultures."

Certainly, companies like, an online sports book and casino operator based in Costa Rica, aren't too worried. "As far as I'm concerned, the biggest challenge our industry faces is our ability to manage our own growth," says Calvin Ayre, the company's founder and CEO. "The online gambling market has grown at an exponential rate, and there's no sign of a slowdown."


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