Wall Street banks shun online gaming floats

Online gaming IPOs are all the rage at the moment. Indeed, since Empire Online made its AIM debut in June, poker fever has swept the City. But with most Wall Street investment banks shying away from underwriting floats because of concerns over the legality of online gaming in the US, will the boom in the internet poker sector end in tears?
On 1 September, Gibraltar-based 888.com (formerly known as Cassava), which was advised by Freshfields Bruckhaus Deringer corporate head Tim Jones, became the latest online gaming business to confirm its intention to float on the London Stock Exchange (LSE).
888.com’s decision to launch a £700m-plus IPO comes hot on the heels of PartyGaming’s £4.6bn IPO in July. Like PartyGaming, the world’s largest internet gaming group, the lion’s share of 888.com’s revenues are generated from the US.

Internet casino operators are seeking to list on the LSE for a number of reasons. Listing not only gives selling shareholders an opportunity to realise their investments, it also helps to raise a company’s profile. Furthermore, it gives businesses a valuation, enabling them to go on an acquisition rampage. Nevertheless, the industry is still highly fragmented, with much of the sector still in private hands. Consequently, more IPOs are anticipated in the forthcoming months, with both Betfair and PokerStars reported to be plotting listings.

Indeed, the surge of deals in the online gaming sector is reminiscent of the dotcom boom witnessed in the City during the late 1990s. But unlike most of the online businesses that came to the market during the dotcom boom, online gaming companies have a trading history and are incredibly profitable. For instance, last year PartyGaming made $350m (£189.9m) in after-tax profits. However, there is one similarity that should not be forgotten – IPOs in both these sectors come with hefty health warnings.

PartyGaming’s prospectus, for instance, contains 27 pages of risk factors. The biggest of these is from the US, where it is unclear whether internet gambling is permissible. PartyGaming does not have a physical presence in the US, but the vast majority of the company’s clients reside there. The company also generates most of its revenues (approximately 87 per cent in the first quarter of 2005) from the US.

Consequently, in its prospectus, PartyGaming warns: “Any action by the US authorities that succeeds in prohibiting or materially restricting PartyGaming from online gaming in the US would have very serious consequences for the group and could result in investors losing all, or a very substantial part, of their investment.”

The principal legislation governing the legality of online gaming in the US is the Federal Wire Act. The US Department of Justice has adopted a conservative interpretation of this legislation and therefore considers that companies offering online gambling to US residents would be in breach of federal laws. However, in the MasterCard International case in 2002, a federal appellate court ruled that the Wire Act does not prohibit non-sports internet gambling.

There is also a question mark over whether US banks and financial services businesses which process online gaming transactions are in breach of the law. Three years ago, Citibank stopped processing card payments to internet gaming sites following pressure from Eliot Spitzer, the New York Attorney-General.

Against this backdrop it is no wonder that the lack of clarity in respect of the US regulatory position has sent jitters across Wall Street, with most US investment banks turning down lucrative mandates to underwrite IPOs in the gaming sector. For instance Credit Suisse First Boston decided not to underwrite 888.com’s float due to concerns over possible regulatory action in the US. Consequently, 888.com turned to HSBC, while PartyGaming instructed Germany’s Dresdner Kleinwort Wasserstein, which in turn were both advised by magic circle firm Linklaters.

Indeed, New York-based Skadden Arps Slate Meagher & Flom is believed to have advised several Wall Street banks not to underwrite listings in this sector because of fears about the legality of online gaming in the US. Commenting on Skadden’s position, one source argues: “This isn’t a clear-cut issue in terms of the Wire Act, so there’s a variety of views out there in terms of how closely you should sail to the wind. But I think this is something the banks should be avoiding.”

This view is shared by a number of lawyers, although it is unlikely that many firms will turn down such lucrative mandates. Indeed, according to one source close to the PartyGaming IPO, several law firms pitched against Freshfields to advise the company on its listing. But if that is genuinely the case, then why have the IPO mandates been shared by only a handful of firms?
Another source argues that most firms will conclude that they are further down the pecking order provided their legal opinions contain sufficient disclosures.

Aside from the US regulatory minefield, online gaming businesses also face fierce competition because of the lack of barriers to entry. The threat of competition has resulted in AIM-listed Sportingbet making an offer for Empire Online in a bid to deprive PartyGaming, its biggest rival, of the stream of customers that Empire puts its way (see page 10).

And, of course, there is the risk that the popularity of internet gaming may be just a passing fad which runs the risk of disappearing into the ether almost as quickly as it arrived.

Indeed, one source concedes that, because most online gaming sites are relatively young businesses, it is very difficult to predict by how much and how quickly these companies will grow. For instance, PartyGaming’s share price plummeted to below the float price of 105p last week after the company announced its interim results. Nevertheless, PartyGaming’s market capital is big enough to qualify the company for entry into the FTSE100.

The boom in the online gaming sector looks set to continue – for the moment at least. So those lawyers and bankers who are prepared to take a gamble on the legality of internet betting in the US may be in for a jackpot.

Recent online gaming IPOs
Issuer AIM/London Stock Exchange main list Legal adviser to the company Underwriter/ Nomad Legal adviser to Nomad/ underwriter(s) Market cap on date of admission
Empire Online AIM Nabarro Nathanson Numis Travers Smith £120m
PartyGaming Main List Freshfields Bruckhaus Deringer Dresdner Kleinwort Wasserstein Linklaters £4.6bn
888.com (formerly
Cassava) Main List Freshfields Bruckhaus Deringer HSBC Linklaters Not applicable
  Source: The Lawyer