News Analysis: Illinois jobs bill charts way for lottery deals(4)

Buried inside Illinois’ $31 billion jobs bill may be a solution to a problem faced by many others states: how to monetise their lotteries without running afoul of federal regulations.

Illinois’ House Bill 2424, the implementation act for the jobs bill, urges the state to outsource the management of the Illinois lottery to a private sector partner and remunerate them with a 5 percent share in the lottery’s profits. Those profits would likely get a lift from online sales of lottery tickets, which the state hopes to ok in the near future.

In recent years, at least a dozen of the 40 states that have state-run lotteries have considered leasing them out to private sector partners in return for large upfront payments. The private sector partners, in return, would gain access to monopolistic assets with steady, i.e. infrastructure-like, cashflows. It seemed like a match made in heaven.

Illinois Lottery: still a gold pot for Illinois, but not as big

So the pitchbooks went out and the states, eager to use gambling revenues for more respectable priorities like education spending, listened intently. In early 2007, for example, now cash-strapped California received an estimate from Lehman Brothers that its state-run lottery could be worth up to $37 billion, says Fred Klass, chief operating officer for the California Department of Finance. That proposal was for a pure privatisation, though, and the state did not want to pursue that path, he added.

Still, such a massive estimate raised eyebrows in other states. In the months that followed, Illinois, New York and Indiana made significant progress analysing similar deals. Indiana had even appointed a sell-side advisor, Morgan Stanley, to handle the process.

But in October 2008, virtually all of these sell-side processes came to a screeching halt. In response to an inquiry from Indiana and New Jersey on whether such sales would be allowed under federal law, the US Department of Justice’s Office of Legal Counsel (OLC) issued a legal opinion saying, essentially, that they would not.

That’s because lotteries in general are illegal under federal law. The only reason 40 states and the District of Columbia are able to operate them is because they were granted an exemption from this prohibition. Private lotteries do not get the exemption, and therefore a long-term concession that gives a private operator a controlling share of the profits of a state lottery would run afoul of the exemption, the OLC argued.

“We were surprised by the recent Office of Legal Counsel decision,” Indiana Governor Mitch Daniels said at the time. “The best legal advice available to us had suggested that the OLC would not interpret federal lottery statutes as preventing the long-term lease of state lotteries.”

Reluctantly, he dropped the idea, as did several other states pursuing such deals.

But the OLC’s opinion wasn’t absolute. As is often the case in these types of legal matters, there was some wiggle room.

“That said, we think it is permissible for a state to compensate private contractors with some portion of the lottery’s revenues,” the OLC said. But any such deal would have to be structured in such a way that “the [private] management company is not to receive more than a de minimis share of the lottery’s profits”. But, it added, “the state has to retain actual control over all significant business decisions”.

One can tell from reading Illinois’ $31 billion jobs bill that the person crafting it read the OLC opinion; indeed, portions of it are verbatim to the OLC memo. But this would be no Skyway or Indiana Toll Road lease: the term of the contract with a private sector partner would be no more than 10 years, and the state would “exercise actual control over all significant business decisions”, making it more of an outsourcing agreement than a brownfield asset lease, as per OLC’s wishes.

Structured this way, the deal may not run afoul of the OLC’s opinion, says Kirkland & Ellis partner Sean Maloney. Maloney, who worked on a potential lottery transaction for New York state while he was first deputy secretary to former Governor Eliot Spitzer, says that lotteries already outsource a significant portion of their activities to private enterprises anyway. So as long as a potential deal is structured more as an outsourcing contract than a sale, it is likely to get federal clearance.

Any such deal would have to happen soon: the bill sets 1 March, 2010 as the deadline, and the state is authorised to issue requests for qualifications and look for advisors for the deal at its leisure.

Meanwhile, Illinois legislators are back in Springfield for a special session to figure out how to balance the budget. While the lottery deal won’t plug the deficit, it will give the state one less thing to worry about and bring it a couple hundred million closer to meeting the $31 billion price tag of its jobs bill.

The countless other states facing special sessions over the same issues may want to follow Illinois’ footsteps.