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Will the law tackle fantasy sports for a loss?

An employee in the software development department of DraftKings walks past screens displaying the company's online system stats in Boston in September. The legal landscape for daily fantasy sports is quickly getting complicated, with both states and members of Congress looking at ways to increase regulatory oversight.(Stephan Savoia/AP Photo)

An employee in the software development department of DraftKings walks past screens displaying the company’s online system stats in Boston in September. The legal landscape for daily fantasy sports is quickly getting complicated, with both states and members of Congress looking at ways to increase regulatory oversight.
(Stephan Savoia/AP Photo)

The fantasy sports industry is under siege. Almost every day another lawmaker or agency announces a hearing on its legal foundations or an investigation into its business practices. Last week, U.S. Rep. Frank Pallone Jr. and Sen. Robert Menendez, both New Jersey Democrats, argued for new safeguards. The Wall Street Journal reported that the FBI and Justice Department had opened an investigation into whether daily fantasy sports sites violate federal law. By the end of the week, Nevada had told daily fantasy sports companies they had to cease operations and seek gaming licenses.

This most recent round of scrutiny follows allegations of cheating at DraftKings, one of two leading sites, amping up the calls for regulation that have been mounting since DraftKings and FanDuel began a multimillion-dollar ad blitz in August. “Maybe we need to start treating online fantasy sports gaming like traditional sports betting, which has safeguards in place to protect the player,” said Menendez at a press conference outside of MetLife Stadium last week.

(On Monday, DraftKings said a law firm it hired to investigate claims an employee used valuable inside information to win a $350,000 second-place prize on FanDuel confirms that didn’t and couldn’t have happened because he didn’t receive the helpful data until 40 minutes after that site’s contest closed.)

The daily fantasy sports industry has its roots in the Unlawful Internet Gambling Enforcement Act of 2006. The law explicitly says that fantasy sports games don’t count as betting so long as they have a few key attributes, such as set prize pools, skill-based contests, and not relying on the outcome of any single sports events. FanDuel and DraftKings interpret this as an exemption from gambling laws and designed their games to adhere to this definition of fantasy sports.

‘Sheer chutzpah’

That strategy doesn’t sit well with Jim Leach, the congressman who drafted the initial law.

“It is sheer chutzpah for a fantasy sports company to cite the law as a legal basis for existing. Quite precisely, UIGEA does not exempt fantasy sports companies from any other obligation to any other law,” he recently told the Associated Press.

Menendez suggested that UIGEA has created a “regulatory vacuum” and said Congress should reexamine the lack of federal oversight. Along with Pallone, he has called for the Federal Trade Commission to examine how it might regulate fantasy sports. Rep. Dina Titus, D-Nev., recently wrote a letter to the House’s Energy and Commerce Committee citing experts who claim that daily fantasy sites already violate the 2006 law. (New Jersey and Nevada are among the handful of states with legalized gambling, and traditional casinos have howled about the exemption that daily fantasy sites enjoy.) The FBI and Justice Department, according to the Wall Street Journal,are also looking into violations of the current law. And if UIGEA no longer serves as a shelter for DraftKings, Fan Duel, and other daily fantasy sites, they would face an existential crisis.

Even without changes in the federal law or its interpretation, the legal landscape for these sites is quickly getting complicated. The main front is probably going to be state governments, not Washington, according to I. Nelson Rose, a leading expert on gambling law. UIGEA doesn’t prevent states from passing more restrictive measures, and fantasy sports were already outlawed in five states before Nevada’s action on Thursday. In that state, the existing gambling industry had been pushing for restrictions on what they saw as unfair competition for some time. There’s now movement to consider new legislation in a handful of others.

In Massachusetts, for instance, Attorney General Maura Healy has said that her office “has been reviewing the practices” of the daily fantasy operators. Healy’s office did not respond to request for comment about what might come of this review.

It seems increasingly unlikely, however, that states are going to continue to treat these companies as nothing more than online retail startups.

“No way,” said Richard McGowan, a professor in the finance department at Boston College’s Carroll School of Management who focuses on the gambling industry. “They have reputational issues right now.”

Heavily taxed

At the very least, according to McGowan, the states will want to tax daily fantasy operators they way they currently tax casinos, which is to say, heavily. FanDuel and DraftKings probably pay few if any taxes at the moment because most of their profits have been offset by monster marketing costs. But gambling taxes are levied against gross gaming revenue, not profit, at rates of up to 70 percent in some states. “When you legalize a form of gambling, the state looks around, finds out what the highest rate is in the country, and then goes higher,” said Rose.

Gaming licenses come with a number of other unwieldy burdens. Casinos have to pay for state overseers to watch them count money, which raises the possibility of 45 different sets of monitors looking over shoulders at DraftKings and FanDuel. Anti-money laundering regulations can be costly. Mondogoal, a daily fantasy sports site that is licensed in the Isle of Man and the United Kingdom, says that about 20 percent of its overall costs come from regulatory expenses. “We naively thought we could start this company for pretty cheap, but startup costs are high when you’re in a regulated jurisdiction,” said Daniel Feldman, one of the company’s founders.

A regulated fantasy market in the U.S. could force sites to deal with a different set of rules in each state. In one gloomy scenario, the operators might have to split themselves into dozens of state chapters that don’t share entry fees and prize pools, a consequence that would make it nearly impossible for a company such as DraftKings to offer single games with $2 million prizes.

Of course, new rules could also have a big upside for established industry players. They could force smaller players out of business, scare away new competitors, and confer an air of legitimacy and fairness.

“If I were them,” McGowan said of DraftKings and FanDuel, “I want the state to regulate me. The state is going to protect me.”

Profitable businesses?

DraftPot, founded in a dorm room at Columbia University earlier this year, is one of the little guys that might suffer. The company, which raised $2.2 million in a round of seed funding last summer, has only a dozen employees, none of whom are lawyers. Joey Levy, one of its co-founders, said he’s confident his business would survive the arrival of gaming-style licenses and tax rates, but he’s not eager for that day.

“It shouldn’t be an easy process for states to impose harsh measures,” he said, “because we are offering a product that a large portion of the population really wants.”

Justine Sacco, a spokeswoman for FanDuel, declined to comment on how new regulations would affect its business, saying that a discussion of hypothetical scenarios would be irresponsible. DraftKings hasn’t responded to interview requests. Investors in the two companies, both of which recently hired lobbyists, declined to comment or did not respond to calls.

Gambling companies have been able to live with onerous restrictions because their basic products are inherently quite profitable. The same may not be true of daily fantasy sports, where margins are already squeezed by prize payouts designed for maximal growth. Research by U.K.-based SuperLobby suggests that only the two leaders, DraftKings and FanDuel, are consistently making money on their guaranteed contests (accounting for the majority of prize money paid) with profits just below 10 percent. Newcomer Yahoo is routinely failing to fill its contests, while many of the small operators appear to be losing money at unsustainable rates.

Add steep taxes and a dizzying regulatory maze, and it’s hard to see how the current model makes money.

“Daily fantasy sports is a fantastic entertainment product, but it’s a pretty mediocre gambling product,” said Chris Grove, a consultant at Eilers Research and the publisher of the websites LegalSportsReport and OnlinePokerReport.

State gaming commissions might also decide to become competitors in the daily fantasy field, assuming they can find a way around rules that prohibit them from offering games of skill. Massachusetts Treasurer Deborah Goldberg told the Boston Herald last week that her state’s lottery should launch its own daily fantasy site. And a state-run operation, as McGowan points out, would not pay taxes and therefore should be able to offer sweeter pots.

It’s unlikely that all these variables will break against daily fantasy operators. The slog ahead for FanDuel and DraftKings could lead to sturdier positions in a more stable industry. But government attention could also smother two fairly young companies that have not yet firmed up profitable business models.

“It’s the death by a thousand cuts of compliance that will be the real threat to the bottom line,” said Grove.

Information from The Associated Press was used in this report.