JEFFERSON CITY, Mo. — One of the Missouri Lottery's biggest contracts might not stand up in court if it was challenged by the company that runs its statewide network of ticket sales.
That means the state doesn't collect as much money as the contract allows when the company is penalized for breakdowns.
And, even when the Lottery does collect money for penalties, the proceeds are not directly funding public schools across the Show-Me state, according to a review by the Post-Dispatch. Rather, the cash is being rolled back into the Lottery's marketing budget to pump up future sales.
At issue is a provision in the Lottery's 2014 contract with Rhode Island-based IGT that calls for the state to assess penalties if there is an outage at a retailer or within the lottery ticket distribution system. In Lottery parlance, the penalties are known as "liquidated damages."
When the $16.1 million per year contract was awarded to IGT three years ago, it called for specific penalties to be assessed for various outages, ranging from major system problems to relatively minor breakdowns.
But, a review found few instances where the maximum penalty has been assessed. And, after the newspaper's inquiries, Lottery officials acknowledged that its contract with IGT may not withstand a legal challenge.
"If the Lottery were to assess the maximum potential liquidated damages at every opportunity without regard to the circumstances of the loss in question, it might run the risk that the validity of any particular assessment — or worse, the validity of the applicable liquidated damages provision in the contract — would be challenged in court, and that the Lottery might not win," Lottery spokeswoman Susan Goedde said in a statement.
The exact amount of money being left on the table by the Lottery is unclear, but examples provided by the Lottery through the state's Sunshine Law found that in some instances, the amount of money that could have been collected was significantly higher than what was actually charged.
Under one scenario outlined in a 2016 letter, the Lottery had sought to assess penalties worth $1.1 million, but IGT balked and argued that a fine of $138,146 would be more reasonable.
In the end, IGT provided 700 self-service lottery dispensing machines, to be placed around the state, as well as paid subsidies to the state worth $250 per machine in the first year and $100 in each year after.
In lieu of paying liquidated damages, IGT also agreed to create a mobile app for buying tickets on smartphones and buy a special vehicle to promote and sell Lottery products.
There's no way of telling whether that was a good deal for the Lottery because the provisions outlined in the settlement were not subject to competitive bidding procedures, which guide most of the other thousands of state government transactions made each year.
Despite acknowledging the faulty contract, Lottery officials contend they are following industry standards when it comes to assessing penalties.
"I believe we have been aggressive in pursuing liquidated damages," said Gary Gonder, the chief operating officer of the Missouri Lottery.
Launched in 1986, the Missouri Lottery funnels 23 cents of every dollar spent on tickets, scratch-offs and other games to the state's public education programs.
Two-thirds of the money goes back to the players as prizes, while 4.5 cents goes to administrative costs and 5.9 cents goes to retailers, according to Lottery figures.
For schools, the more than $300 million funneled from the Lottery amounts to about 4 percent of the total funding for Missouri's public elementary, secondary and higher education systems.
For the past decade, the state has contracted with IGT to oversee its lottery ticket distribution system. The contract has paid the company, formerly known as GTECH, between $13 million and $17 million per year.
The most recent contract with IGT was hammered out in 2014. The company was among three bidders for the seven-year agreement.
Under a handful of provisions in the 113-page contract, the Lottery can charge liquidated damages of up to $1,000 per minute for systemwide outages.
Problems such as a complete system shutdown rarely occur, said Judy Martin, chief financial officer of the Lottery.
Instead, liquidated damages are more typically assessed on problems with terminals at retailers.
In the contract, penalties for problems at retailers can be assessed at a rate of up to $150 per hour for the first hour.
But, according to a review of one week of penalties, the lottery assessed penalties at a rate closer to $60 per hour for many of the problems.
Martin said the maximum is charged in some situations, but the Lottery uses a sliding scale that costs the vendor less money if the repair is done in a timely manner.
Gonder said calculating liquidated damages is a challenge for lotteries across the nation.
Vendors like IGT acknowledge they must pay penalties when there are breakdowns, but they only want to pay for the actual loss in sales to the lottery.
The assessments take into consideration when a terminal might have gone down. For example, if it was at 5 a.m. on a day when there is a big jackpot, the financial loss might be larger than a day when there was no jackpot.
In other words, Martin said, the contract is only a guideline. "This is just a starting point for calculation," she said.
Added Goedde, "We determine liquidated damages on a case-by-case basis consistent with maximizing our revenues and profits for public education."
Why then did the Lottery raise the penalty thresholds when it wrote the contract proposal in 2014?
Goedde said the contract calls for higher liquidated damages than previous contracts because the cost of doing business has increased.
"Revenues are higher now than 13 years ago, so it would make sense that the damages cap would also increase," Goedde said.
The higher damage rates became a sticking point soon after IGT won the contract.
Records obtained by the Post-Dispatch show company attorneys began to prod the Lottery to lower what it was charging for liquidated damages.
In a February 2016 letter, IGT attorney Chuck Hatfield asked the Lottery to reconsider its decision to impose the $1.1 million in liquidated damages in the wake of a terminal breakdown.
According to the letter, the incident involved a period of nearly 40 hours in which some gaming devices were not operating.
Hatfield, who served as chief of staff to former Gov. Jay Nixon, said historical sales data shows that lost sales during that period would be much lower than the $1.1 million sought by the Lottery.
He cited case law noting that under Missouri statutes, damages must be reasonably related to the actual damages suffered.
"Liquidated damages clauses — even though contractually agreed to by the parties — are not enforceable if they are not reasonably related to the actual damages," Hatfield wrote.
Education or marketing?
On top of the legally dubious contract, the penalty money being collected from IGT is not going toward education.
Rather, the proceeds of liquidated damages are being spent on the Lottery's promotional marketing efforts.
In the case of the 2016 settlement, for example, the Lottery agreed to let IGT install 25 Samsung televisions in various retail locations in lieu of paying cash.
That practice of allowing for the purchase of Lottery equipment without a competitive bidding process continues today.
Gonder said an upcoming expansion into Buffalo Wild Wings will require the installation of 56-inch television screens for Keno players. The Lottery will use damage assessments to pay for the screens.
"We turn those liquidated damages dollars into marketing equipment. In the end we save budget," Gonder said.
The practice of using liquidated damages to pay for marketing programs has drawn attention in other states.
In North Carolina, a 2012 audit criticized the practice, saying it did not comply with the state's cash management policy.
In Connecticut, the Lottery had sought $4.2 million from its vendor for damages associated with problems with one of its games. According to the Hartford Courant, a 2016 settlement resulted in the vendor paying an estimated $500,000, with some of that coming in the form of the company providing training for lottery retailers.
A 2016 review of the Texas Lottery criticized the practice of allowing the company to pay its penalties via equipment or services, which has become the practice in Missouri.
"This allows the agency to utilize noncompetitive procurement methods for many of its projects, and gives the agency broad authority to award and manage its largest contracts outside of established contracting practices," the review says.
In Colorado, state law bars spending money from penalties without approval of the Legislature.
In addition, Colorado law says: "The division shall not receive any goods or services in lieu of an assessment of liquidated damages, nor shall the division require a vendor to purchase goods and services in lieu of an assessment of liquidated damages."
Martin said that in Missouri, lottery auditors and the state auditor have signed off on the system used by the Lottery to assess damages.
"Neither of them have a problem with how we're handling them," Martin said.