Oregon State Lottery Director's Paper Video

OREGON STATE LOTTERY DIRECTOR’S PAPER

VIDEO LOTTERY COMPENSATION RATES and RETAILER CONTRACT 2015

JANUARY 29, 2015

I. BACKGROUND

On June 28, 2015, the current retailer contracts expire. By this date, the Oregon State Lottery must have in place new retailer contracts to provide for the sale of Lottery products to the public. Without the Lottery’s network of retailers, the Lottery cannot sell its products, either traditional or Video Lottery. Thus the continuation of our contractual relations with our retailers is essential to generating revenue and meeting the Lottery’s constitutional and statutory mandates.

II. LEGAL REQUIREMENTS

(a) Balance of Goals: The Oregon Lottery Commission is required by law to maximize revenue for the state while providing a reasonable rate of return for the retailers who sell Lottery products on behalf of the Lottery.

“In establishing its schedule of payments to contractors, the Oregon State Lottery Commission shall undertake to develop a system that maximizes the net revenue to the state for the public purpose consistent with providing a reasonable rate of return for contractors.” (emphasis added) ORS 461.445

In litigation brought by individuals seeking to maximize Oregon Lottery revenues available for education, the Oregon Supreme Court had the opportunity to interpret this statutory language and provide guidance on how the Oregon Lottery Commission is to accomplish this task.

“Under ORS 461‐445, the Lottery is to “undertake to develop a system” that has two goals, viz., ‘maximiz[ing] the net revenue to the state” and “providing a reasonable rate of return” to the retailers. In that context, the

outcome—a “system”—is to be the result of a process— “develop[ment]”—by the Lottery that harmonizes two competing goals. Moreover, interplay of those two goals will differ to some degree for each of the hundreds of retailers with whom the Lottery deals. (Each has different costs in rent, taxes, personnel, and physical facilities, to name only the most obvious examples. Moreover, each of those factors may vary to some degree for each retailer from year to year.) Yet the Lottery’s “system” is to be imposed by a set of rules, which are quasi‐legislative policy choices of general applicability. See ORS 183.310(9) (defining “rule”). Such rules will, of necessity, affect some retailers differently than others. No system is possible that precisely strikes the statutory balance as to every retailer.” (emphasis added) Wolf v. Oregon Lottery Com’n, 344 Or. 345 (2008).

(b) Statewide Lottery: ORS 461.300 also requires the Lottery to provide convenient locations throughout Oregon with a statewide network in both rural and metropolitan locations.

“The Oregon State Lottery Commission shall adopt rules specifying the terms and conditions for contracting with lottery game retailers so as to provide adequate and convenient availability of tickets or shares to prospective buyers of each lottery game as appropriate for each such game.” (emphasis added) ORS 461.300(1).

These provisions require the Lottery to ensure that the contract structure— presumably including the commission rate structure—allow for locations throughout the entire state, not just large metropolitan areas.

III. HISTORY:

(a) HISTORICAL REVIEW OF VIDEO LOTTERY COMPENSATION RATES AND CONTRACT LENGTH:

(1) Video Lottery Compensation Rates prior to the 2004 Contract: Video Lottery began in 1992 and the compensation rate was a flat 35% of net sales. In July of 1995, the Commission adopted a tiered compensation rate structure of 35% on the first $200,000 in sales and 30% on sales above that, which resulted in an overall rate of approximately 33%. In July 1999, the Commission expanded the tiered rate structure and the overall compensation rate declined to about 32%.

(2) 2004 Contract: In 2004, the Commission adopted a revised tiered rate structure that required retailers to choose Option A or Option B each business year, with Option A favorable for low volume retailers and Option B favorable to high volume retailers. Overall, the compensation rates adopted were lower and the overall compensation rate declined from about 32% to about 28.3%.

Advocates for still lower compensation rates filed a petition in the Oregon Court of Appeals for review of the administrative rule that adopted the compensation rates, claiming the Commission had misapplied its statutory responsibility in establishing the compensation rates and arguing the rates adopted were too high. The Oregon Supreme Court ultimately resolved this case, upholding the validity of Lottery’s administrative rule, the compensation rates adopted by the Commission, and the process by which the Lottery Commission determined the appropriate compensation rates. Wolf v. Oregon Lottery Commission, 344 Or. 345 (2008), referenced in section II(b) above.

(3) 2005 Contract Amendment for the Sale of Line Games: When Lottery began selling line games in May of 2005, the Commission adopted an alternative compensation rate structure for those retailers who opted to sell both line games and video poker games. Under this new rate structure, the overall compensation rate dropped to about 25%.

(4) 2007 Look Back Rule: In 2007, in accordance with the “Look Back Rule” which was adopted in 2005, the Lottery Commission lowered video compensation rates for those retailers selling line games. The overall compensation rate dropped to about 23%. It was anticipated that these new rates would result in an overall rate reduction to approximately 22% by 2010, but due to the smoking ban and the economic recession there was a drop in Oregon Lottery sales and therefore, the overall compensation rate did not decrease as low as expected. Ordinarily, the design of the rate structure operates to reduce the overall compensation rate for retailers as Oregon Lottery sales increase.

(5) 2010 Contract: When the Video Lottery contracts came up for renewal in 2010, there was strong division of opinion between education activists who continued to believe that commission rates were still too generous to retailers and retailers who believed that fifteen years of

commission rate reductions, coupled with the no smoking ban and a severe economic recession, justified an upward adjustment in commission rates, particularly in the lower ranges. In effect, retailers believed that continual reductions in commission rates while sales volumes were growing—including the “look‐back” mid‐contract in 2007—now justified a “look‐back” for retailers to receive some relief from the significant revenue decline which they were already experiencing.

Faced with continuing economic uncertainty, the Commission decided to leave rates unchanged for the next contract, the first time since Video Lottery began in 1992 that there had not been a downward adjustment in at least some of the rates.

(6) Length of Retailer Contract: When Video Lottery began in 1992, the term of the retailer contract was three years. In 1998 the Lottery went to a six‐year contract to comply with business practices for leases, financing, and planning. This was followed by another six‐year contract in 2004 after review and discussion. In 2010, the Lottery Director argued that stability of a six‐year contract benefits both the Lottery and its statewide network of Lottery retailers and it comports with business practices in the industry. However, given the uncertainties facing the Lottery, the Commission approved a 5‐year contract, with the unintended effect of placing deliberations on the next contract within the election year of 2014.

(b) REVIEW OF LOTTERY SALES AND NUMBER OF RETAILERS:

(1) Under the direction and guidance of the Lottery Commission, there was a tremendous increase in Oregon Lottery sales from fiscal year 2000 through fiscal year 2008, averaging 9.6% per year. In 2009, however, the statewide smoking ban and the economic recession reduced video sales by 12% in FY 2009 and 10% in FY 2010. Since then, revenues have only grown by an average of 1.2% per year.

Fiscal Total Video Year Lottery Sales 2000 $436,531,650 2001 $462,398,035 2002 $480,201,739 2003 $498,712,314 2004 $530,996,187 2005 $579,650,266 2006 $732,888,437 2007 $853,505,565 2008 $895,111,696 2009 $786,746,726 2010 $706,981,950

2011 $720,510,190 2012 $727,124,878 2013 $737,370,280 2014 $742,730,503

(2) While total sales peaked in FY 2008, the number of retailers didn’t begin to decline until after FY 2010, the point at which the two‐year plunge in sales was followed by a period of stagnant sales growth. The decline in retailers, while less severe than the sales drop, has continued at a slow pace throughout the current contract period.

One might expect that the decline in number of retailers would help offset the effect of a decline in sales for surviving retailers. However, since sales dropped by 21% then largely leveled off at the same time that the number

of retailers declined by 7%, the result is that sales per retailer have also declined 18% since the peak in FY 2008. Consequently, retailers have seen a significant drop in their lottery revenue since 2010 with very little recovery since the end of the recession.

These developments have contributed to a demoralized retailer base that makes it difficult to sustain growth even as the overall economic climate is recovering from our worst economic decline since the Great Depression. The modest increase in sales per retailer and per Video Lottery terminal has been accompanied by a slow, but fairly persistent reduction in Video Lottery retailers.

Sales per Sales per Fiscal Year Retailers VLTs Retailer VLT

2005 1,998 10,275 $290,115 $56,414 2006 2,044 10,560 $358,556 $69,402 2007 2,143 11,315 $398,276 $75,431 2008 2,258 11,918 $396,418 $75,106 2009 2,354 12,270 $334,217 $64,120 2010 2,377 12,414 $297,426 $56,950 2011 2,362 12,288 $305,042 $58,635 2012 2,314 12,093 $314,229 $60,128 2013 2,306 12,160 $319,762 $60,339 2014 2,271 11,989 $327,050 $61,951

Even though Lottery revenues have been stagnating, there are some positive signs. This fiscal year, the Oregon Lottery has embarked upon a three‐year replacement of all its Video Lottery terminals and, near the end of that period, will be updating its Video Lottery network with a new Intelligen system, which will operate as a LAN‐based network tying all Oregon Lottery terminals together rather than the data cable system it has had for the last two decades.

To properly capitalize on these investments, however, requires a strong distribution system which, in the case of the Oregon Lottery, starts with an effective and motivated corps of Lottery retailers.

IV. CURRENT OUTLOOK:

As we enter 2015, the economic recovery finally appears to have taken hold, even if it is still not very robust. Nationally, the unemployment rate for December 2014 was 5.6% while Oregon’s was 6.7%. In fact, while the national unemployment rate fell by a full percentage point during 2014, Oregon’s remained fairly steady.

Thanks in large part to the first round of delivery and installation of the new Video Lottery Terminals, Video Lottery sales for the first half of FY 2015 increased by 4.7% after growing just 0.7% during the previous fiscal year.

The Video Lottery Terminal Modernization Program (VLTMP) won’t be completed until FY 2017. The total cost of the new VLTs, including installation and the new network, is estimated at $227 million. Of this, $130 million is being withheld from the scheduled Video Lottery transfers to the state over three consecutive fiscal years, starting in FY 2014. The balance is being self‐funded from Lottery proceeds outside of the scheduled transfers to the state of Oregon.

The Oregon Lottery would have been able to fully fund the Video Lottery Terminal Modernization Program without withholding transfers if the Lottery had not made additional transfers from administrative savings (excess funds held by the Oregon Lottery in uncommitted reserves in excess in the amount normally transferred to the state according to the formula used to calculate such transfers) during the recession years of FY 2008 through FY 2012, totaling $140 million.1

Whether increased Video Lottery play will continue once players have tried the new Video Lottery terminals and new games associated with them remains to be seen. One of the most important factors in leveraging the opportunity presented by new Video Lottery terminals and new games is how energized and motivated the Lottery’s retailer base is.

Lottery retailers have been demoralized in recent years for several reasons, only some of which are within the Oregon Lottery’s ability to influence or control. The

1. Such transfers have been commonly made during past recessions which allow lottery funds to serve as a quasi‐ rainy day fund, particularly for education but also indirectly benefiting other programs that compete with education for general funds.

7 prolonged economic decline centered largely on depressed consumer spending obviously contributed to stagnant Oregon Lottery sales. The statewide smoking ban, adopted Jan. 1, 2009, is widely believed to have had a further negative impact on Video Lottery revenues although the ban itself remains widely popular and is in no risk of being modified or repealed.

Because Lottery retailers are required to be OLCC licensees, they are also food and beverage retailers. Consequently, Oregon’s high minimum wage coupled with no tip credit—a condition common to all of the West Coast states—remains a source of discontent, particularly at a time when their business is depressed.

Although none of these factors are directly related to the Oregon Lottery, when coupled with a pattern of more than two decades in which Lottery commissions were consistently reduced when Oregon Lottery revenues increased but which were not increased when Lottery revenues declined or remained stagnant, it is understandable that many retailers are frustrated by their current situation.

Adding to their frustration is a complex and seemingly counterproductive system of commission rates that forces retailers to select a rate schedule that anticipates at the beginning of the fiscal year what their total volume is likely to be for the balance of the year, then reduces their commissions as their sales volume increases in any event.

While the existence of retailer dissatisfaction has been evident for some time, it became particularly apparent during the five retailer forums that were held throughout the state last September. Each Lottery commissioner attended at least one of the forums which were held in Bend, Albany, Medford and east and west Multnomah County.

While there were valuable discussions at each forum across a range of issues, a common thread running through all of the meetings was a feeling that retailers have been constantly squeezed by increased costs and declining incomes over the last five years, with the Lottery blamed for either contributing, or at least being indifferent, to their situation.

V. DIRECTOR’S RECOMMENDATION

In order for the Oregon Lottery to take advantage of the improving state economy and the opportunity presented by the Video Lottery Terminal Modernization Program, as well as to reinvigorate the morale of Lottery retailers, I believe the 2015‐2010 retailer contract should:

1. Eliminate the Option A and Option B commission rate schedules and instead create a single rate schedule that applies to all Video Lottery retailers. 2. Flatten out the rate schedule so that instead of declining by 60% from the highest to lowest rate as today, the overall decline is less than 30%. 3. Eliminate rates lower than 20%.

The easiest way to accomplish the three principles above without pitting one group of retailers against another is to take the top two tiers from Option A—a 27.5% commission rate for the first $175,000 of Video Lottery sales and a 23% rate on sales over $175,000 up to a maximum of $475,000—then adopt a flat 20% rate on all sales above $475,000.

Under this rate schedule and based on FY 2014 data, no one would receive lower commission payments than under the current system and fewer than one‐fourth of all retailers would receive more, split about evenly between the current Option A and Option B retailers.

Applying this rate schedule to retailers in FY 2014 would have resulted in $5.6 million more in commissions for retailers collectively, with a corresponding reduction in net income to the Oregon Lottery. However, this calculation ignores any net growth resulting from the removal of the disincentives associated with commission rates below 20% that are currently present in both the Option A and Option B rate schedules.

A $5.6 million increase in total commissions represents less than eight‐tenths of one percent (0.8%) of total Video Lottery sales last year. To put it another way, sales would only have to increase by a little over 1% in order to net the same gross sales minus commission that we experienced in FY 2014.

A rate schedule that reduces the disincentive to grow will also support our plan to hold retailers more accountable for improving their facilities, diversifying their menus and activities consistent with the Lottery’s casino prohibition policies, and

9 helping implement our recently adopted Problem Gambling Code of Conduct with improved training and player engagement practices.

It is my belief that the adoption of this rate schedule will encourage some existing retailers to open new Video Lottery locations, others to extend operating hours that have been artificially curtailed and still others to upgrade their operations in a way that will increase their total sales volume, including but not limited to Video Lottery revenue. I am also convinced that a single rate schedule with a moderate decline in commission rates will be far more attractive to prospective lottery retailers than the current confusing and seemingly punitive rate system and hence help us start expanding our retailer base again after half a decade of decline.

Consequently, I am confident that the adoption of this new schedule will increase, rather than reduce, Lottery revenues to the state and therefore recommend adopting this proposed rate schedule.

At the same time, I understand that commissioners and other state officials may be concerned that even a modest increase in commission rates after several years of fairly stagnant Lottery revenues may be a risky proposition. I also recognize that there would be vocal opposition from groups and individuals that have long felt that Oregon’s Video Lottery commission rates are too generous to retailers and who believe that commission rates should be cut further, not increased.

If the Oregon Lottery Commission chooses not to adopt this new rate schedule, I recommend that the Commission simply retain the current rate schedules. This will not require a rule change and could be accomplished by a simple renewal of the current contracts.

Whatever the Commission decides to do about rates, I strongly recommend a contract period of five years, extending until the end of June, 2020. Even though I know that some commissioners may wish to revisit some of the concerns raised by retailers earlier than that date, I am convinced that a renewal period for anything less than five years will be interpreted by most retailers as lack of certainty going forward and remind many of them of past commission rate reductions enacted between contract periods when revenues were growing.

If the commissioners wish to consider a new commission schedule within the 5‐ year period, that option will still be available. But a shorter contract period