Online Gambling Gone Wild: U.S. Crackdown Sparks Offshore Boom

[Update, March 31, 11:30 am. On March 30, the World Trade Organization said that the United States had failed to comply with an earlier ruling, which mandated that the U.S. lift its ban on online gambling. Experts say the WTO decision could result in possible commercial sanctions.]

Daniel Negreanu tends to understand the odds pretty well. As one of the most successful poker tournament players in the world, "Kid Poker" was in 1998 the youngest player to win the World Series of Poker -- an honor he held until 2004 -- and he continues to dominate high-stakes games throughout the poker-playing world.

However, in December 2005, wary of increasing government hostility toward Internet gambling, he knew it was time to fold. "Clearly, it wasn't going to be possible to live in the U.S. and run an online poker operation," he said. So he sold his successful online poker site, Full Contact Poker, to Big Stack Enterprises, based in Curacao.

Negreanu, as usual, was ahead of the game. It wasn't until 10 months later -- Sept. 30, 2006 -- that the shot heard round the online gambling world was fired when Congress passed the Unlawful Internet Gambling Enforcement Act (UIGEA) as part of the larger Safe Ports Bill. In less than two weeks, President Bush signed the bill into law, and the global online gaming industry -- which derived as much as 60% of its revenue from the U.S. market -- took a devastating hit.

The event couldn't have been timed worse from the point of view of Jez San, the former director of 3-D game developer Argonaut Software and the founder of PKR.com, a United Kingdom-based online poker site that was still in beta test at the time the bill was approved. Congress passed the legislation just 24 hours after San had finalized his first round of financing -- and after he had sunk $1 million of his own money into his venture. "We had to make a decision, and we made it immediately not to launch into the U.S. market," said San, whose company has never allowed any U.S. citizens to play for money. "I like America. I want to be able to keep visiting without getting arrested. It was very important to me that we were legitimate."

At the same time, passage of the bill caused a host of companies that had previously been operating in the United States to withdraw. These included some of the largest and most successful online gambling sites in the world, including PartyPoker.com and 888 Casino-on-the-Net, both publicly traded and listed on the London Stock Exchange.But not everyone was so easily spooked. A large number of online gambling companies chose to keep their casinos open. Although now operating illegally according to U.S. Justice Department rules, they're reporting that business is pretty much as usual. Although there are fewer dollars overall, there are less gambling houses vying for those dollars, and the ones who agreed to talk concur that after a dip in the second half of 2006, revenue is already on its way back up.

"We were growing 300% last year, and although we lost some ground last summer, things have since rebounded, and we expect to be back up to our summer 2006 levels within the next month or so," said a senior executive at one of the top online gambling sites that has chosen to still accept U.S. customers, who declined to be identified for fear of prosecution.

Another executive who asked for anonymity said that revenue had already shot past mid-2006 levels and showed no sign of abating. "U.S. citizens still want to gamble, and we intend to keep allowing them to," he said. Indeed, a host of new online gambling establishments are expected to quickly fill the void left by the ones that decided to bow out.

"Some sites have no downward loss of patrons at all. Even those that have lost customers are still making money -- more than last year. It's a major blip, but still just a blip, and people will find ways of getting around it," said I. Nelson Rose, a professor of law at Whittier Law School in Costa Mesa, Calif., and an expert on online gaming laws. Joseph Kelly, a professor of business law at State University of New York College in Buffalo and co-editor of the Gaming Law Review agreed: "This is just a hiccup."

Along with many others, Kelly believes that online gambling will eventually be legal in the United States. "The panic created by the DOJ's actions will eventually subside, new legislation will be passed, and we'll see a regulated industry emerge," Kelly said. When that will happen is anyone's guess. But "the notion that you can put a definitive stop to online gambling is a ludicrous one," he said.San himself is characteristically ebullient about what lies ahead. His company -- which provides poker players with an immersive experience using the 3-D technology standard in video games and virtual worlds such as Second Life -- is growing at 50% per month. It will be profitable this year despite barring U.S.-based players. "Nothing is going to be able to stop this industry," he said. Numbers Racket
Getting accurate figures on what is happening in online gaming has always been difficult and is now almost impossible.

"Because the public companies left, and the ones stayed are the less transparent private ones, it's much harder to get those numbers," said Sue Scheider, publisher of the Interactive Gaming News. "The difficulty with the unlisted firms is that they are under no obligation to publish their results, so it's incredibly difficult to tell what is actually happening in the market," agreed Ed Barton, an analyst with Screendigest.com, a market research firm that tracks the online gambling industry based in London.

Before the U.S. crackdown, online gambling revenue was approximately $12 billion globally, according to London-based Global Betting and Gaming Consultants. Although still just a fraction of the $258 billion overall gambling market -- which includes land-based casinos and card rooms as well as government-sponsored lotteries -- Internet revenue was growing at high double-digit rates. Indeed, after pornography, online gambling was the second-highest Internet-based revenue generator, dwarfing global online retailing and e-commerce activities.

Today, although no one is quite sure how much revenue has evaporated because of fears of legal liability, "online gaming is still huge," said Dave Schwartz, director of the Center for Gaming Research at the University of Nevada, Las Vegas. "Depending on what numbers you believe it can easily be twice what the entire Las Vegas strip makes annually on all its activities, including food and hotel services in addition to gambling revenues."

Barton belongs to a set of analysts who believes that the volume of the U.S. market was so large as to be irreplaceable in the short term. "Although there are growth areas -- particularly in Asian markets, where many U.K firms are setting up shop -- "the rate of growth there is not event approaching the volumes we saw in the U.S. market," said Barton. "Make no mistake, the industry was hard hit."

Still, Scheider, like many other industry observers, believes that companies still hoping to stay in the U.S. market can expect to prosper -- albeit under a "Prohibition mentality." Other than that, she doesn't believe that the long-term effects will be all that significant. "It's very likely that revenues will just move from one person's pocket to another. The companies that have continued to take U.S. players are doing very well," she said.

Many of the companies that chose to withdraw from the United States simply changed their focus to non-U.S. venues. Other than in a few isolated countries -- notably, France and Israel, which are making noises about enforcing their own anti-gambling initiatives -- most governments have rolled out the welcome mat. And positive results are beginning to roll in. One of the world's largest gambling sites, 888 Holdings PLC, a U.K. company, announced in mid-February that its full-year net revenue rose 7% even after leaving the United States.

"It's very hard to believe that the revenues of online gaming providers will flat line," said Tom W. Bell, a professor at the Chapman University School of Law who is an adjunct scholar at the Cato Institute and who follows the legal issues of online gambling. "Although at a low point last fall, they almost immediately began to bounce back, and my guess they will continue to steadily increase over time."Double Trouble
Although the Safe Ports Bill that President Bush signed into law on Oct. 13 had a huge impact on the market, it wasn't the only step the U.S. government took to deter online gambling. Having an arguably more dampening effect were other actions by the Justice Department.

The United States has taken other steps to deter online gambling.The arrest of David Carruthers, CEO of BetonSports, at a Dallas airport in July -- before the Unlawful Internet Gambling Enforcement Act was passed -- put a chill on the industry. Carruthers was indicted, along with 10 other people, under federal racketeering laws and the Wire Act of 1961, which forbids using a "wire communication facility" for transmitting information about "bets or wagers."

Indeed, in late January 2007, despite the passage of the UIGEA, the DOJ continued making arrests based on the Wire Act of 1961. It charged two former executives of Neteller, a publicly traded U.K. online money transfer company, with moving billions of dollars of illegal gambling proceeds from U.S. citizens to Internet gambling companies located overseas. By far the largest online gaming transaction processing concern in the world, more than $7.3 billion in 2005 and $5.1 billion in the first half of 2006 went through Neteller's hands. Some estimates put that figure as representing as much as 50% of the global online bettor market. Also in January, there were press reports that the DOJ had issued subpoenas to a number of prominent global banks that had participated in the underwriting of the IPOs of overseas gambling sites. Upon this news, stock prices of online gambling concerns registered on the London stock exchange tumbled.Although Neteller promptly released a statement that it would no longer process gambling revenue from U.S. customers, other payment processing options abound, such as ePassporte, ATMonline, and Click2Pay. And industry observers point out that five years ago when PayPal withdrew from the online gambling payment processing market, the impact on the industry was temporary before other companies leaped into the market.

"What happens in the near term -- say the next 12 months to five years -- depends on several things, including what sorts of payment mechanisms remain and what new ones arise," said Bell, who believes it's very possible that new payment processes specifically designed to avoid the reach of U.S. regulators will be developed. Already, the most dedicated online gamblers are establishing offshore bank accounts and using phone cards to pay for their activities.

In addition, said Bell, "the killer application for the gambling industry, which is sure to eventually emerge, will be a perfectly anonymous and untraceable form of digital cash." In effect, such forms of payment will replace the legitimate businesses of highly regulated firms with much more dubious ones.

"This will prove of use to a number of unsavory characters and be a regulator's nightmare," said Bell. "It's very likely that the United States will very much regret the actions it is taking."Strange Bedfellows
Bell believes that one driving force between recent anti-gambling activities can be found within the U.S. land-based gaming industry. "It's the politics of the bricks-and-mortar gambling interests, who don't want to see their customers going to their more convenient gambling venues," said Bell.

Michael Pollock, managing director of the Spectrum Gaming Group, a research firm that tracks trends in the gaming industry, agreed. "The brick-and-mortar casinos have felt for many years that Internet gambling was a threat," he said. What will eventually happen, said Pollock, is that the U.S. industry will become regulated and legal, and the land-based casinos with the strongest brands will become the leaders in this domain.

There is ample evidence emerging that the brick-and-mortar casinos already are starting to test the online waters with an eye toward eventually bringing that experience back home. In December, the Sands launched an online casino in the U.K. market. In February, Playboy followed suit. "Over the next two years, we're going to see things like an Internet-based MGM and a Bicycle Casino, where there is a great deal of brand cross-promotion going on," said Aaron Todd, a gaming industry reporter with Casino City, an online gaming portal.

In the meantime, there's "reasonable cause" to worry that the only online gambling services that remain will be those of the less reputable sort, according Bell. "If regulators had consumers foremost in mind, if they were really attempting to protect consumers, they would recognize that people will continue to play online, and it doesn't make sense to drive out of the market the people who are the most credible and legitimate," he said.

"It's an unfortunate set of circumstances from consumers' standpoint," said Sue Scheider. "I don't think the federal government is acting in their best interest. And it's clearly not revenue driven, because for years the industry has been begging, 'Regulate me, tax me.' "

She's also heard all the speculation about how Las Vegas interests might be driving the agenda, but "ultimately, no one really knows who is behind this crackdown or why they are doing it."Tough Fight
Many companies have been anticipating the moves by the U.S. government for a long time. Cryptologic, a Toronto provider of software and networking infrastructure for online gambling sites, has been preparing for more than five years for the eventuality that the United States would make online gambling illegal. When the UIGEA was passed, it notified all its customers still allowing U.S. gamblers that they needed to find other vendors.

"We've been in this industry for more than a decade and have always lived with the uncertainty of what the United States might eventually do," said Steve Taylor, CFO of Cryptologic. "For that reason, years ago we started focusing more on Europe and other global markets."Business is good: Cryptologic recently signed deals with Playboy Enterprises as well as the government of the Netherlands to help them develop casino and poker sites. "We pride ourselves on being a legitimate player," said Taylor.

Indeed, Cryptologic just reported its strongest fiscal year ever, with revenue up 21% over 2006. Future growth rates look robust, says Taylor, who says he expects online poker to grow at a 20% compound rate over the next 20 years, and casino operations at 12%.

"As broadband and e-wallet solutions become more available and acceptable, we believe we can meet or exceed those numbers. We are very bullish on the industry," says Taylor, who points out that only 5% of revenue for the total global gambling market come from online activities. "We think there's an awful lot of room for growth even without the U.S. market," he added.

But those organizations still hoping that online gambling will eventually be legal in the United States aren't going away without a fight. The European Union is challenging the UIGEA through the World Trade Organization, charging that the United States has banned Internet gambling in a blatant attempt to protect domestic gambling revenues. Calling it protectionism and saying it's clearly against WTO regulations, the WTO brought suit against the United States on behalf of the Caribbean countries of Antigua and Barbuda.

In early February, the WTO ruled against the United States and said it plans to prove it guilty of breaking international trade laws elsewhere in the world. And in mid-February, The Poker Players Alliance, an industry lobbying group, named former New York Sen. Alfonse D'Amato as its chairman to spearhead plans to fight for an exemption for poker within the UIGEA.

Indeed, many legal scholars doubt whether the UIGEA forbids anything not already made illegal under the Wire Act passed in 1961. There's even controversy about how far the Wire Act itself can be used to prevent online gambling, as the U.S. Fifth Court of Appeals has ruled against the Justice Department's assertions that the Wire Act forbids all online betting. Instead, the court decided that the Wire Act pertains only to online betting on sports events.

"There are a number of court cases pending that are creating reasonable doubts about how far the current laws go in forbidding anything other than sports betting," said Kelly.Burgeoning Venues
Ironically, the UIGEA contained a provision that has actually legalized new online gambling venues within the United States by stating that individual states have the ability to regulate Internet gambling within their borders. "This clarified things considerably and has theoretically opened the door to a great deal of online gambling activity as long as companies can come up with ways to verify exactly where players are geographically located," said Todd.

Rose believes that ultimately the efforts of Bill Frist et al will backfire. "He'll be responsible for the greatest explosion of creativity and expansion of intrastate gambling than ever could have been anticipated," said Rose. "It's crystal clear now that you've made it legal, that just about every state will look into it. I fully expect that California, Nevada, and New Jersey will legalize, regulate, and tax Internet poker within the foreseeable future."

Schwartz, who has written a number of books on the history of gambling, said that in the past, "if there's a law against gambling, people have always found a way around it." He believes there's little logic in the current legislative attempts to curb it. "There are ways to provide geographic and age verification. In Utah, if you can prove that you are 21 years of age, there really isn't a compelling reason that you can't place a bet in the state of New Jersey. So why not place an online bet? There's really no reason not to allow it.""There's a clear trajectory of how existing industries view new technologies," said Pollock. "First they try to fight it, to kill it off. Then they move into acceptance. And finally, they embrace it."

The same pattern will play out here, said Pollock. "After efforts by the DOJ to put a lid on it, it will be highly regulated and controlled, and handled with integrity. No one can realistically put a lid on it. The economic case is too compelling."

This story was updated April 4 to reflect corrected information on which law was used in charges against gambling executives.