On 14 April 2011, the US online poker market was thriving. At any time, over 55,000 players sat at virtual tables, gambling with their real dollars. The market was dominated by three players – Full Tilt Poker, PokerStars and Absolute Poker (the 'Poker Companies').1
This industry was brought to a shuddering halt on Friday 15 April 2011, when US Department of Justice ('DoJ') seized control of the companies' websites and accused them of bank fraud, illegal gambling and money laundering.2
In this article, we analyse the events since 'Black Friday' (as it became known in the poker world) to try to make sense of the allegations and answer the question: Were these legitimate businesses or elaborate frauds?
The events of the last year
Whilst operations outside the US continued, the DoJ actions led to an immediate stop in online play in the US and removed access to hundreds of millions of dollars held in US players' accounts. The Poker Companies had made assurances about the security of the player funds. However, despite an agreement with the DoJ to refund US players, Full Tilt did not refund any players.
The likelihood of players receiving refunds diminished on 29 June 2011, when Full Tilt closed down worldwide after its licence was suspended by the Alderney Gambling Control Commission. 3 Then on 20 September, the DoJ issued new allegations that Full Tilt had operated "as a massive Ponzi scheme against its own players". The DoJ release 4 alleged that, in March 2011, Full Tilt had held $60 million in cash whilst owing its players $390 million and that it had made distributions to its directors and owners of more than $443 million over the four years to April 2011.
As of June 2012, the Full Tilt players had still not received any money. With massive liabilities to its own customers, no licence to operate and serious allegations of fraud made against it by the DoJ, it would not appear that Full Tilt has much value. It was therefore surprising to hear in April 2012 that an offer to purchase Full Tilt has been put forward valuing the company at $750 million.
The events leave several key questions that we will discuss in turn:
- Was online poker in the US a legitimate business?
- Was Full Tilt really a "Ponzi Scheme" as alleged?
- How is Full Tilt apparently worth $750 million?
Was online poker in the US a legitimate business?
In 2006, the US Federal Government passed the Unlawful Internet Gambling Enforcement Act (UIGEA) which made it a crime to process payments for illegal online gambling. 5 This caused the largest company at the time to withdraw from the market.
Since 2001, credit card companies had required banks that processed credit card transactions to apply a particular transaction code to all internet gambling transactions. By the time the UIGEA had passed in 2006, most banks routinely declined such transactions.
It is at this point that the Poker Companies had an issue – how could they transfer funds from a player to themselves if the banks declined the transaction?
As shown in the diagram, cash is extracted from the mini-economy of online poker by the poker site and winning players. As a result, losing players must be able to add to their accounts, because otherwise the games would die out as funds diminish over time. It was this reality that the Poker Companies faced in 2006.
A simplified view of the money flows in online poker
In response to the UIGEA, the Poker Companies allegedly adopted a variety of strategies with the aim of processing transactions without alerting the US banks that they were for internet gambling. The DoJ allegations state that the methods included:
- Setting up front companies (often using third party processors), such as online flower shops and pet supply stores to process transactions. After a period of time, these were often detected by the banks and shut down. However, the Poker Companies simply opened up new front companies.
- Creating pre-paid debit cards that could be 'loaded' without attracting a gambling transaction.
- Deceiving the US ACH e-check system.6 This required a US based originating bank and account. The Poker Companies found third parties willing to open bank accounts for them to process the transactions whilst not informing the bank of the true nature of the transaction.
Notwithstanding the potential legal difficulties, these arrangements created significant operational difficulties for the Poker Companies in that:
- It was hard to keep track of which front company was being used and where.
- They had no control of the actual cash that was being processed.
- Customers would complain to their bank because their statements would contain
- the front company name which they wouldn't recognise.
It is the disguise of the nature of the transactions that formed the basis of DoJ bank fraud allegations. Whilst the allegations against the Poker Companies are just allegations, by May 2012, six of the 11 people named in the indictment had reached plea agreements with the DoJ. If the allegations are tested in court, it will be interesting to see what arguments are made in defence. The actions of those who entered into plea agreements certainly suggest that the Poker Companies thought that they were operating in a legally grey area.
The Australian Connection
Daniel Tzvetkoff ran an Australian company called Intabill 7 which processed internet transactions. He was arrested in Las Vegas in April 2010 and has been accused of processing $543 million of transactions on behalf of the Poker Companies. At one time facing a possible 75 year jail sentence, he is reported to have struck a deal to be a prosecution witness in the trials of other accused payment processors and is reported as being in witness protection in New York. Whether his services will be required after the guilty pleas of other accused remains to be seen.
Was Full Tilt a 'Ponzi Scheme'?
As discussed earlier, Full Tilt did not refund players after Black Friday. It subsequently transpired that this was because it could not pay the players. At the end of March 2011, Full Tilt held around $60 million in cash, whilst owing players around $390 million. This was despite repeated assurances from Full Tilt that player funds were kept separate from cash used to fund operations.
There was much head scratching in the poker world as to where the money had gone, especially given the DoJ's allegations that Full Tilt had operated as "a massive Ponzi scheme". As in many fraud situations, we believe a 'follow the cash' analysis assists. In this case, there were two central problems:
- 'cash in' wasn't real cash; and
- cash reserves were depleted by large distributions to owners and the Board.
'Cash in' wasn't cash
During 2010, Full Tilt was suffering significant difficulties with its payment processing as the US banks continued to close down front companies and it had not received payments from some processors. Additionally, when some players tried to transfer funds to their Full Tilt account, their account was credited (allowing them to play with those credits), but those funds were not removed from the players' bank accounts.
According to the DoJ, this resulted in $130 million being credited to players' accounts (and available to use for play) which was not correctly removed from those players' bank accounts, creating a massive shortfall in cash. These phantom funds would be gambled and lost to other players who were, of course, unaware that the funds were not real. This wash of funds between players meant that it would be a practically impossible task to unravel all the transactions to identify whether funds were correctly owed to players.
Cash was being distributed to owners and the Board
The second problem was that cash was depleted by distributions to Full Tilt's owners and directors. The DoJ indicates that this totalled over $443 million in the four years to April 2011.
Usually, such distributions would only be made in the form of salaries, bonuses or dividends on profits. As Full Tilt was a private enterprise, accounts are not publically available. With no information as to its profit levels, it is not possible to state with certainty that these payments were in excess of profits that were earned. However, the financial situation of the company – in which it owed players nearly $400 million but only held cash of $60 million – suggests, in our view, that the profits earned from the Full Tilt business were not sufficient to warrant such large distributions.
Do the distributions constitute a Ponzi scheme?
Ever since the Madoff Scandal, the term Ponzi scheme has been in widespread use. The SEC definition 8 includes the following key attributes to a Ponzi scheme:
- a promise to invest funds claimed to generate high returns with little or no risk;
- a focus on attracting new money to make promised payments to earlier investors;
- using funds for personal expenses; and
- a lack of legitimate investment activity.
It is questionable whether Full Tilt fits this definition. If you strip away the issues of deposits from players not being processed properly and the high level of distributions to owners, the underlying business of Full Tilt certainly had value – it operated virtual card rooms and was licensed outside the US as a legitimate business. Its fundamental business model was similar to that of PokerStars, which has continued to have financial success outside the US.
If the DoJ allegations that Full Tilt simply paid its owners and directors money that belonged to the players are correct, this appears to be more of an act of theft, rather than a Ponzi scheme.
An alternative view is to say that Full Tilt was, in some sense, operating as a bank for its players. As no bank retains sufficient cash reserves to pay back to its customers all of the deposits it holds, one might argue that Full Tilt did not need to keep all its deposits available in cash. It would only be necessary to hold this much cash if there was a 'run on the bank', which Full Tilt unfortunately experienced when it was forced to refund all its US customers in April 2011.
However, a clear distinction needs to be made between how a bank might treat cash reserves and Full Tilt – a bank doesn't have the cash reserves because it has invested the cash elsewhere to earn a return (for example loaning it to other customers and getting paid interest); Full Tilt didn't have the cash because it had already been distributed to its board and owners.
The result is, in our view, that Full Tilt does not appear to have been a Ponzi scheme, as defined. However, the DoJ allegations suggest that player funds were not kept secure and were inappropriately paid to owners and directors. It is not clear what assurances Full Tilt gave to the Alderney Gaming Commission regarding the security of player funds or what steps the Commission took to satisfy itself that a licence should be issued.
How is Full Tilt apparently worth $750 million?
With massive liabilities to its own customers, no licence to operate and serious allegations of fraud made against it by the DoJ, Full Tilt would not appear to have any value. Therefore, it was surprising to hear in April 2012 of an offer to purchase Full Tilt valuing the company at $750 million.
Whilst surprising, this demonstrates that the value of something is not just its innate nature, but what somebody is prepared to pay for it.
As accountants, when undertaking a valuation, the common definition of value we adopt is that of 'fair market value', which is defined as:
"The price that a willing but not anxious buyer, acting at arm's length, with adequate information, would be prepared to pay; and a willing but not anxious seller would be prepared to accept."9
However, we believe that the value of $750 million for Full Tilt is not fair market value. This is because the offer is from a specific buyer, PokerStars (one of the other Poker Companies), and is in the context of an apparent deal with the DoJ to settle the actions against PokerStars. As such, the value of $750 million is better defined as the 'special value' of Full Tilt to a specific buyer, namely to PokerStars.
This 'special value' is confirmed by the reports that of the $750 million that PokerStars will reportedly pay to 'acquire' Full Tilt, around $300 million will be used to pay back the US Full Tilt players, whilst the DoJ will take the rest in settlement with PokerStars.
Unlike the game of poker, this appears to be a win-win situation for everybody – the players get their money refunded, the DoJ receives a substantial settlement sum and PokerStars settle their issues. It has not been reported whether this would settle the actions against the individuals at PokerStars as well, but we doubt that they will be booking flights to the US in the near future.
There are several lessons to be learned from the events of poker's Black Friday. These include:
- Despite the long reach of the DoJ, there are always people willing to take a risk if there are the potential rewards.
- Without proper regulation, companies such as Full Tilt are able to present a front of financial stability that isn't as reliable as first appears.
- The value of an entity to a particular party can be very different to the value of that entity to anybody else.
Whilst the story is not yet complete, there are several important questions that have yet to be answered:
- Who knew exactly what was going on at Full Tilt?
- How much regulatory involvement did the Alderney Gaming Commission have in relation to Full Tilt and how did it get comfortable that a licence could be issued?
- Did the payment processors and the poker companies really think that they could continue to deceive the US banks and why would they risk this when the potential penalties were so great?
1 The major players were Full Tilt and
PokerStars. We only consider these companies in the balance of the
2 The DoJ press release is available here: http://www.justice.gov/usao/nys/pressreleases/April11/scheinbergetalindictmentpr.pdf
3 A licensing authority based in Alderney in the Channel Islands, which had issued several electronic gambling licences to Full Tilt.
4 The full amended complaint is available here: http://blogs.reuters.com/felix-salmon/files/2011/09/FullTiltPokerComplaint.pdf
5 Poker is 'illegal online gambling' because it is considered by the authorities to be a 'game of chance'.
This is something many players (including the author!) disagree with.
6 An electronic clearing house for financial transactions in the United States which processes large volumes of credit and debit transactions in batches.
7 We note that KordaMentha was appointed the liquidator of Intabill.
9 Spencer v Commonwealth (1907) 5 CLR418
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