Is Zynga a Target for State Attorneys General?

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22516v1-max-250x250A few weeks ago a good source gave me a legal document written by a former federal prosecutor and senior Department of Justice official. It was arguing that social gaming company Zynga could be breaking multiple state and federal anti-gambling laws via its popular Texas HoldEm game.

A few things are striking about this. First off, Zynga is one a handful of companies building Facebook and iPhone apps that has found a way to make money. Lots of money. Close to $200 million in revenues to be precise. The fact that it could be the next target for an overzealous state attorney is a big story in and of itself. Second, the fact that competitors are this threatened by Zynga’s cash machine shows an ugly battle royale brewing in the application space. (More on that in a bit.)

Online gambling is illegal, according to the U.S. State Department and a handful of states, but there are still some gray areas. In June, the Feds started cracking down on gamblers in an attempt to clear things up. Meanwhile, others like Massachusetts representative Barney Frank are seeking to legalize and tax the $1 billion or more in annual revenues U.S. poker players are mostly sending to sites based overseas. Frank clearly faces a huge uphill battle from religious groups who see poker as a moral issue.

But a site like Zynga should be able to side-step all of this, because although you can buy chips for Zynga’s Texas HoldEm game you can’t redeem them for money, right? Maybe not.

According to the brief, the issue boils down to three factors:

• Is the activity otherwise authorized?
• Is poker a game of chance, as opposed to a game of skill?
• Does the user bet/win something of value?

The answers to the first two are pretty clear—and not contested by Zynga. Poker is clearly considered gambling in the offline world, and poker specifically has been proven in New York State court to be a game of chance not skill in the case of New York v. Turner. That decision read: “Games of chance range from those that require no skill, such as a lottery…to those such as poker, blackjack which require considerable skill in calculating the probability of drawing particular cards. Nonetheless, the latter are as much games of chance as the former, since the outcome depends to a material degree upon the random distribution of cards.”

The third question is where things get murky. Zynga liberally gives people free chips every time they log in. But you can also buy chips. That constitutes the user betting something of value. So what about the outcome? Do users win something of value?

A prosecutor could argue a few angles here: Within the game, there’s the case that the chips are of value because they can be used to buy virtual gifts for others or that extended game play and privileges given to players who win more chips constitutes something of value. There’s some precedent under New York State law (specifically entailing poker machines in Plato’s Cave Corporation v. State Liquor Authority) showing that continued play constitutes something of value. But Zynga could easily argue that there are so many opportunities for continued free play and so many free chips given away at every log in that players clearly aren’t motivated to win because of material gains.

The one place where Zynga chips do have a clear material value is on illegal secondary markets where chips are regularly bought and sold, and because Zynga allows Facebook friends to send chips to each other transferring chips to a black-market buyer isn’t hard. (Zynga only allows you to gift 100 chips per day, so it is time-consuming.) The brief argues that these illegal markets are readily found with a Google search and that “While Zynga does not support the black market, an argument could be made that they profit from it and do so knowingly.”

Zynga takes issue with that and argues that it has gone to great lengths to squash the secondary market for chips and enforce its Terms of Service. Zynga has filed numerous cease and desist letters to sites and ISPs, has taken down sites by enforcing legal protections surrounding its own copyrights and trademarks, daily monitors the Web looking for these illegitimate sites, worked with payment processors like PayPal to accelerate the take down of these sites and filed numerous legal actions.

There’s a demonstrable paper trail showing Zynga’s efforts to clamp down on these secondary markets. Cases have included: Zynga Game Network, Inc. v. Phillip Labrasca / Complaint Filed July 1, 2009, Zynga Game Network, Inc. v. Duc Doan /  Complaint Filed July 1, 2009, Zynga Game Network, Inc. v. Carmi Solak / Complaint Filed July 14, 2009, Zynga Game Network, Inc. v. Jason McCann / Complaint Filed: July 14, 2009, Zynga Game Network, Inc. v. Chris Sim II / Complaint Filed July 14, 2009 and Zynga Game Network, Inc. v. Moss Brothers / Complaint Filed July 14, 2009.

This all raises the question: Why doesn’t  Zynga just turn-off the ability to gift friends chips? I expect if prosecutors started to seriously circle, the company would shut it down.

It’s hardly a slam dunk that Zynga is breaking the law and a stretch to say going after them is in the public’s interest. The Feds certainly have much more explicit examples of online gambling to focus on first. But could I see an over-zealous legislator or state attorney general bringing a case against them for political reasons? Absolutely. These are people who believe that online dating sites lead to rape, MySpace leads to pedophilia and Twitter leads to terrorism. Crazier claims have certainly been made than saying a game called “poker” could be encouraging online gambling. And while you can argue that World of Warcraft, Second Life or any game operating in the virtual goods economy has the same issues, a game called poker would likely be a clearer target.

Now, back to the competitor who leaked us the brief. The person called the meeting under the condition of anonymity, so I can’t divulge who it was. But the source argued they commissioned the brief because they too had thought of building poker applications, having watched Zynga’s success and wanted to see if there would be legal implications down the line. The findings were enough to scare them away from it. The competitor then decided to leak it because it thought it was unfair that Zynga was using potentially illegal revenues to its own competitive advantage in other applications like Mafia Wars. The competitor alleged that Zynga spends some $500,000 a week on Facebook ads and another $2 million to $3 million per month on MySpace advertising.

Whether you find the leak a savvy or slimy business move, it was certainly ballsy: If Zynga is called out it will have a chilling effect on the entire virtual goods space which appears to be one of the most lucrative business models going on the Web.

Lastly, I was disappointed that Zynga chief executive Mark Pincus refused to address the claims on the record. I have a huge amount of respect for Pincus and as such gave him every opportunity, including sharing the brief itself nearly a week before publication of this post. The brief raises legitimate questions and if Zynga really believes its operating in the clear, why not just say so on the record?

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