Casino Enterprise Management

The quickest route to an embarrassing comeuppance for professionals is to stray outside the area of their expertise. As regulators, our comfort zone is bounded by the rules and internal controls related to things like asset protection and game integrity. We should hesitate—even if asked—to issue edicts or make decisions that intrude on the prerogatives of the owner or operator of a gaming enterprise to exercise their business judgment. Regulators should stick to refereeing the industry and let the operators score the economic touchdowns or commit the game-changing fumbles. (Since "owner/operator" is awkward, we'll use "operator" herein to refer to the person or entity that is licensed to run the casino enterprise and that makes the business decisions.)

But what happens when an economic downturn tosses the proverbial monkey wrench into all the grandiose optimism that prompted extensive borrowing to finance more hotel rooms, larger gaming floors and new "can't miss" expansions into more jurisdictions? Despite the reputation of being "recession proof," the casino industry is clearly not immune to economic downturns, business failures and bankruptcies, of which there have been many much-publicized and notable examples just in the past year. Could—or should—regulators have taken some action to curb the enthusiasm of some of their more daring licensees, who blithely leveraged their assets to create more capacity on the assumption that discretionary gaming dollars would always be there?

Even attempting to answer this question requires us to enter unfamiliar territory. We prefer to leave esoteric matters such as debt-to-equity ratios and DuPont Analysis to the MBAs. But some critics have contended that regulators should be concerned about the debt taken on by their licensees and either enact, or enforce, regulations designed to ensure financial stability. So, ignoring our own advice and taking a deep breath, we bravely take the plunge into a commentary on these contentions.

Warning Signs
At the recent International Conference on Gambling and Risk-taking, held in Lake Tahoe, a principal partner in a private equity firm argued that regulators ignored clear warnings that operators were taking on too much debt, especially mortgage-backed equity, and failed to consider the consequences if economic conditions deteriorated. Two historic examples were offered as object lessons that should have been heeded. First, the 1988-1989 collapse of Drexel Burnham that precipitated a wave of restructuring and bankruptcies among Atlantic City casinos, which were unable to refinance their substantial debt. The second example was the bankruptcy of the Aladdin Casino, which had the misfortune to face its financial crisis coincident with the economic downturn that followed the events of Sept. 11, 2001. Though other factors were involved in these examples, the effect was similar to the current situation where restricted access to credit combined with a recessionary economy is negatively impacting cash flows.

The present situation, it was argued, might have been less traumatic had more regulators followed the approach taken by the New Jersey Casino Control Commission after the Drexel Burnham debacle: Look more closely at the balance sheets of licensees and insist on demonstrations of financial stability.

As we understand the argument, regulators should monitor the debt structure of their licensees and intervene in cases where the amount of leverage could put the business at some level of unreasonable risk. Presumably, this could be accomplished by regulations requiring approval of any new debt transaction that could impact financial viability or by requiring the licensee to demonstrate that its cash flow projections are adequate to meet its financial obligations.

A Philosophic Digression
Purely as a matter of regulatory philosophy, we have no problem with considering the financial suitability of the operator as a factor in a licensing decision. Regulators should look at the business acumen and past commercial practices of an applicant to assess its ability to profitably manage a complex casino enterprise. Such an inquiry properly weighs the business judgment of the applicant in the context of the totality of experience. The question is not whether the applicant always makes the correct (i.e., most profitable) decisions, but whether it has the capacity for prudent judgment as evidenced by past practices.

The licensing inquiry into financial suitability should also consider the overall adequacy of financing for the proposed project. Here, the regulator is not attempting to gauge the probability of ultimate success or failure or the likely degree of profitability as would an investment bank seeking to maximize returns. Instead the goal of the regulator is to merely obtain an assurance that there are sufficient funds to launch the endeavor. Regulators, in short, should not attempt to substitute their judgment for that of the applicant. Doing so creates a potential barrier to entry into the market that may be grounded in unreasonable or unrealistic assumptions.

Licensing, of course, is not simply a one-time determination. Licensees have a continuing duty to remain suitable, and most jurisdictions require renewal of licenses at periodic intervals, at which time a reassessment of suitability is in order. In the very dynamic and highly competitive casino industry, most licensees are constantly making numerous decisions intended to expand, or at least protect, market share. From changing the floor mix to promotions to adopting new technology, operators endeavor to reduce costs and increase net win within the context of existing regulations. Major decisions concerning expanding existing properties, adding properties or venturing into new jurisdictions invariably requires complex assessments of potential gain balanced against identified risks. Financing these projects involves making certain assumptions about projected cash flows and the overall economic situation. These are business judgments that are essentially predictions about the future.

Unlike a licensing decision that focuses on capacity, a regulatory review of decisions that involve taking on more debt in order to seize a potential economic opportunity or advantage necessarily entails a substitution of the regulator's opinion or prediction for that of the operator. It basically places the regulator into the position of a board of directors and requires them to second-guess management's decision with an independent assessment of risk.

Slippery Slope
Of course, there are strong arguments supporting regulatory intervention where the risks associated with financing or debt acquisition could threaten the viability of the casino enterprise. Regulated casinos pay a portion of their revenue to various levels of government through taxes and other assessments. Depending on the circumstances, a bankruptcy or other financial crisis could interrupt or reduce these payments. At a minimum, as we saw with the recent Tropicana case in Atlantic City, stress on financial resources can affect critical staffing levels at key areas of the casino, thus exposing assets and gaming activity to unacceptable risk. Jurisdictions therefore have a legitimate interest in the financial health of their licensed casinos. The question is how best to protect this interest.

Regulators, by nature and inclination, are conservative creatures. Not in the political sense, but rather in the sense of wanting to reduce risk as much as possible. The fear, which is often grounded in painful experience, is that they will be blamed, fairly or not, if something goes wrong. Hence, the overwhelming likelihood is that if regulators take action on an issue, they will take a most cautious approach.

Regulatory intervention, as with any artificial overlay on market forces, can have unintended and not always beneficial consequences. The relatively recent example of the bankruptcy of Greektown Casino in Detroit serves as a complex and controversial example.

Without attempting to relate all the intricacies of this incident, the following is a brief history of events leading up to the Greektown Casino's June 2008 Chapter 11 filing.

Greektown was the third of three casinos to open in Detroit following the 1996 vote initiative approval of casino gaming for that city. Part of the delay in opening was the result of licensing issues concerning the suitability of two of the principal owners. The matter was resolved through a buyout agreement in which the Sault Ste Marie Tribe of Chippewa Indians acquired a 90 percent interest in exchange for an installment payment of $268 million to the departing owners. Greektown thus started the race for market share in last place and with substantially more debt than its competitors.

Greektown's circumstances were complicated by a development agreement with the city of Detroit that, similar to its other competitors, required Greektown to build a permanent casino that met specified design and quality standards. It was estimated that construction of such a facility would cost in the range of $400 million to $800 million. Obviously, this project required Greektown to go to the capital market for financing. The fly in the proverbial ointment was that Michigan regulations mandated board approval of debt transactions. In 2005, the board did grant approval of $500 million in proposed financing but demanded that Greektown agree to a set of conditions, including returning to the board for approval of allocation of funds prior to drawing on any of the financing.

Among the conditions that the board insisted on was the requirement that Greektown maintain a debt-to-earnings ratio of 6.25-to-1, meaning that for every $6.25 in debt, the casino must show $1 in earnings. Neither of the other Detroit casinos were subject to such restrictions, which some analysts claimed put Greektown at a competitive disadvantage. It was also claimed that the ratios and conditions made it more difficult, and expensive, for Greektown to obtain the financing that it needed.
Ultimately the casino failed to meet the financial projections and covenants required by the board. This basically forced the operator to choose between a forced sale by the board or seeking bankruptcy protection under Chapter 11.

The irony of the Greektown situation was that it remained a profitable operation throughout the above ordeal and arguably could have avoided the need for bankruptcy but for the board's conditions. In fact, the board intransience in refusing to modify the restrictions, according to some analysts, was the precipitating factor in the bankruptcy.

While in bankruptcy, Greektown managed to complete and open its new casino hotel property, though the wrangling over the financing delayed the project and no doubt contributed to the increased cost of the development.

As of May 2009, Greektown remains before the bankruptcy court seeking either to reorganize its debt or to obtain a favorable sale of the property. It is also seeking a rollback of the state gaming tax from 24 percent to 19 percent—relief that was previously granted to the other two Detroit casinos.

The Greektown situation illustrates the problematic nature of regulatory intervention. There are certainly no guarantees that the judgment of the regulator will be either correct or helpful and, as noted, may well have negative unintended consequences.

One Size Doesn't Fit All
Some casino jurisdictions, like Nevada, have no restrictions on the number of licensed casinos, while others, like New Jersey and Michigan, limit the number. Some jurisdictions have fairly large casino operations, while others, like Colorado and some riverboat states, have relatively small ones. Tax rates also vary among jurisdictions. Thus, the consequences of a single casino failure will vary from jurisdiction to jurisdiction.

The nature of the failure can vary as well. In some cases, the operation can simply shed debt, acquire a new owner and continue to generate cash and tax payments. In others, failure means the shuttering of a business, loss of employment and the end of tax payments.

Each jurisdiction's regulators, therefore, must assess the impact of potential casino failures against the possible risks inherent in second guessing business judgments. No doubt the calculus will ultimately depend on local conditions.

Final Thoughts
No one wants to stand by while Rome burns, but responsible regulation does not necessarily require intervention to prevent businessmen from reaping the consequences of their own folly or the vagaries of an unforgiving market. There are many reasons for business failure, and not all of them are preventable. The current economic situation has negatively impacted businesses that were acting reasonably and conservatively. Unless there is a clear basis for regulatory intervention and demonstrable evidence that intervention will help rather than hinder, our approach would be to leave well enough alone and let the market determine the winners and losers.

Pat Leen, co-owner of Gaming Regulatory Consultants, was a founding member of the Michigan Gaming Control Board. He can be reached at (517) 256-8619 or pleen[at]grcgaming.com.

Tom Nelson, co-owner of Gaming Regulatory Consultants, was the first Director of Licensing and Enforcement for the MGCB and served for 22 years as Michigan's Assistant Attorney General. He can be reached at (719) 440-6611 or tnelson[at]grcgaming.com.