Review of the Contract for an
Automated Instant Ticket Gaming System

January 31, 1996

Hon. Debra Bowen
Assembly Member, 53rd District
Room 2158, State Capitol
Sacramento, California 95814

Dear Assembly Member Bowen:

This letter is in response to your October 2, 1995 request that our office review the contract for an Automated Instant Ticket Gaming System and litigation between the California State Lottery (CSL) and High Integrity Systems, Inc. (HISI).

We have attempted to answer all your questions about the contracts and litigation between the CSL and HISI with the information and documents released to us by the CSL. We made several document and information requests to the CSL over the past three months, and our efforts to respond to you sooner were hampered by the failure of the CSL to respond to our requests in a timely fashion. In addition, the CSL has indicated that the majority of documents related to the litigation are not subject to public disclosure on the basis of (1) protective orders which authorized the designation of documents as "secret" or "confidential" and (2) the attorney-client and attorney-work product privilege.

Due to the unavailability of some documents related to the litigation and the CSL's reluctance to provide comprehensive answers to several of our questions, we were unable to answer all your inquiries in full.

The enclosed response to your request contains a series of four attachments:

We would be happy to brief you on our findings at your convenience. If you have any questions, please contact Gerald Beavers of my staff at 322-8402.


Elizabeth G. Hill Legislative Analyst


Attachment I

Definition of Terms

In order to facilitate understanding of our answers and comments, we provide below definitions of terms as used by the California State Lottery and our office.

Figure A
Definition of Terms
Term Definition
As used by us, this term refers to the July 17, 1992 contract between the California State Lottery (CSL) and High Integrity Systems, Inc. (HISI).
Agreement As used by us, this term refers to two documents: (1) the "Confidential Agreement for Settlement and Mutual Release between the California State Lottery and High Integrity Systems, Inc., Telecredit, Inc., T.I. Holding Corp., and Equifax Inc.," executed on November 9, 1995; and (2) the "Reinstated Contract Between California State Lottery and High Integrity Systems, Inc.," executed on July 21, 1995.
Implementation term Refers to the first of two separate time periods in the agreement. It began on the effective date of the agreement (November 13, 1995). There is no fixed time period for implementation but the CSL expects it to run through May 1996. During this period, HISI and the CSL will complete work necessary for installing the new system, such as refurbishing existing Scratchers Network Access Processor (SNAP) terminals and locating retailer sites for the terminals.
Revenue term This refers to the second time period in the agreement. It will last 5.5 years during which time HISI will receive a share of sales revenues from the SNAP terminals as payment for its work. The CSL indicates that this term is anticipated to begin in May 1996, when either (1) at least 3,000 SNAP retailers have begun operating or (2) five weeks have passed since testing of the system has been completed and accepted by the CSL.
Games The CSL has two types of games--on-line games and off-line instant ticket games.
On-line games are the five draw games: Super LOTTO, Fantasy 5, KENO, Daily 3, and DECCO.
Off-line games are the instant Scratchers tickets (paper tickets with latex covered play areas that are scratched off). The CSL usually has 10 to 15 Scratchers games running at one time.
This is the vendor for the CSL's central gaming system and existing on-line game terminals.
Terminals On-line game terminals are electronically connected to the CSL's central gaming system. These terminals have two functions: (1) automated play for consumers and (2) dial-up connection via dedicated or regular commercial telephone lines to the CSL's central gaming system for retailers. There are two basic types of terminals:
High volume are currently in use and offer only on-line games and are connected via dedicated telephone lines to the central gaming system. There are two types of high volume terminals:
CAT (clerk-activated terminals).
SST terminals (stand-alone self-service terminals) that are consumer activated.
Low volume will be provided by HISI and will validate Scratchers tickets for prize redemption and offer on-line games. These are connected via regular commercial telephone lines to the central gaming system.
SNAP, LINK, and LVTs (low volume terminals) all refer to the low volume, on-line terminals that will be provided under the HISI contract. These terminals will provide on-line games and instant validation of Scratchers tickets. (Herein, we will refer to them as SNAP terminals, although the CSL is now referring to them as LINK terminals.)

Attachment II

Overview of Gaming Operations

In order to facilitate understanding of our answers to your questions in attachment 3, we provide below some background information on the CSL's gaming operations and the new automated instant ticket gaming system.

Current Gaming Operations. Approximately 21,000 retailers throughout the state form a network that offers on-line and off-line lottery games. Of these retailers, approximately 13,000 are on-line and off-line retailers (also referred to as high volume retailers) that do average weekly Scratchers sales of $900 or more and on-line sales of $750 or more. Of these 13,000 retailers, 12,000 have on-line game CAT terminals, and the remaining 1,000 have both on-line CAT and SST terminals. The on-line CAT and SST terminals are connected to the CSL's central gaming system via dedicated telephone lines. Approximately 8,000 retailers currently only offer Scratchers games and have average weekly ticket sales of $200. Because these retailers are not connected to the CSL's central gaming system, they cannot offer on-line games or instant validation of Scratchers tickets.

The current process for cashing winning Scratchers tickets requires the consumer to either (1) return to where the ticket was purchased for validation by the retailer or (2) mail the ticket to the CSL headquarters. Tickets with prizes under $25 can be visually validated and paid out by the retailer. To validate and cash tickets with prizes of $25 to $599, and to receive credit for doing so, retailers have to call in manually to headquarters for verification of ticket authenticity and prize level. Validation and prize claims of Scratchers tickets with winning payouts over $599, which are subject to taxation, can only be done by player mail-in.

Automated Instant Ticket Gaming System. The agreement with HISI will provide the CSL with a gaming support system with several interrelated gaming software applications and custom computer hardware that will allow it to place new on-line SNAP terminals at existing Scratchers-only retailers. Connecting to the central gaming system with dial-up technology over regular commercial telephone lines, these terminals will allow retailers to offer on-line games and on-line validation of Scratchers tickets. The CSL plans to place SNAP terminals with some of the existing 8,000 Scratchers-only retail sites and with newly recruited retailers. (According to the CSL, automation equipment will not be available for all retailers and some adjustments will be made to the size of the retailer network.) With the instant validation capability, consumers will be able to take their winning tickets, regardless of where the tickets were purchased, to any retailer with a SNAP terminal who can then instantly validate the ticket and pay prizes up to $599. Scratchers prizes of $600 or more will still require mail-in validation.

Once installed, the new SNAP terminals will dial-in to the CSL's central gaming system, which will use a multiple game router (MGR), a message switching device, to electronically route inquiries and transactions to the appropriate operating system. The MGR will determine if incoming transactions are on-line games or Scratchers validation inquiries to be routed to (1) the GTECH on-line gaming (OLG) host, which serves as the central nervous system for the CAT and SST terminals, or (2) to the new validation system, known as the Scratchers Back Office (SBO). The interface with the existing GTECH host will allow retailers with SNAP terminals to provide on-line games, such as Super LOTTO, DECCO, and Fantasy 5, for the first time. The SBO will instantly relay Scratchers validation and prize information to retailers over the telephone lines.

Automated validation of Scratchers tickets for the 13,000 existing on-line retailers will be provided through a separate contract with another vendor for bar code readers to be attached to the CAT terminals. In addition, the CSL is currently in the process of issuing an invitation for bid to provide validation-only terminals for those remaining retailers who will sell Scratchers tickets only. When the SNAP terminals, bar code readers, and validation-only terminals are operational, consumers will be able to redeem their winning Scratchers tickets up to $599 at any lottery retailer location.

Attachment III

Response to Questions

Your questions are shown below with our answers and comments directly beneath.

Question No. 1

The CSL and HISI entered into a contract in March, 1992. That contract was subsequently terminated by the CSL. In July, 1995, the two parties agreed to a course of action that I've seen described as a reinstatement of the 1992 contract with modified terms. Please compare the two contracts, point out the differences between the two documents, and comment on the significance of those differences.


With the information provided in the agreement, considered by the CSL to constitute a reinstated contract, we have identified 13 significant differences between the original contract and the agreement. We discuss most of the items identified here in greater detail in responses to your other questions.

1. Maximum Contract Amount. Normally, state contracts identify the maximum amount payable to the contractor. In the original contract, the maximum amount was not defined as a total dollar amount. Instead, it would have been determined by the fees paid the contractor based on a percentage of sales and other payments for specified services. The original contract does state that the total amount obligated equals $150 million, but that amount is characterized in the contract as being provided for CSL budgetary purposes only. Consequently, there was no payment cap in the original contract.

Our review of the agreement did not disclose a maximum amount payable to the contractor. Like the original contract, payment will be determined by a variety of factors, including fees as a percentage of sales, payment for work performed by subcontractors, where necessary, and possibly incentive payments.

2. Lump Sum Payment. The agreement includes a $25 million lump sum payment to HISI on the effective date of the new contract, with interest at the state's pooled money investment rate from July 14, 1995 until the date of payment. The CSL has indicated to us that the total payment made to HISI on November 15, 1995, in accordance with the terms of the agreement, was $25,490,949 ($490,949 in interest). In addition, the CSL is required to pay half of the sales tax related to the purchase of hardware. According to the CSL, the amount of the sales tax has not yet been determined. The original contract has no lump sum payments, up-front or otherwise.

Comment. Based on information we have been able to attain, it is not clear what the $25 million payment represents. It appears that the lump sum payment and

interest is payment for prior work by HISI and some form of a stipulated settlement award. We would note that this is not a normal state contracting practice.

3. Implementation Costs. Information provided by the CSL indicates that it will incur estimated expenses of $5 million associated with implementation of the agreement. The estimate is comprised of several components, including additional staff and the acquisition of computers to route and process game transactions. We asked the CSL whether the $5 million related to the $25 million up-front payment. The CSL's response suggests that it represents an additional expense. The CSL states, however, that a portion of this expense would have been required to implement the original contract--specifically, the hiring of additional staff to support new computer applications. Other portions of the estimate, such as the computers to process game transactions, are clearly additional costs the CSL would not have incurred under the original contract.

4. Time and Materials Payment. The new agreement calls for time and materials (T&M) compensation plus 10 percent for certain work done prior to commencement of the revenue term, or in other words, only during the implementation term of the contract. The rates for T&M compensation will be based on HISI's own rates and on rates negotiated by HISI with its subcontractors. There is no ceiling on the total T&M compensation during the implementation term, but certain contractor costs (such as completion of documentation and additional hours for correcting "bugs") are excluded.

Comment. We are unable to gauge the fiscal significance of this T&M plus 10 percent feature because the agreement does not provide a ceiling and the rates of compensation have not yet been identified.

5. Incentive Compensation. The agreement provides for incentive compensation of up to $4 million if work is completed within a certain time frame. Payments range from $1 million to $4 million.

Comment. Incentive payments are not usually found in state contracts, but have been made in some instances--for example, to repair freeway damage in the 1994 Northridge earthquake.

6. Number of Terminals. Under the agreement, HISI is to provide the CSL with 6,700 SNAP terminals, 700 of which are spare terminals to ensure that at least 6,000 retail locations are operational at all times and not down due to retailer turnover or maintenance problems. The HISI has already produced 5,700 of these terminals during work done under the original contract. In addition, HISI has an option, at its own cost, to place up to 4,000 "excess" terminals at retailer locations. The original contract called for 10,000 terminals with an option for an unspecified additional amount of terminals.

7. Percentage Share of Off-Line and On-Line Game Revenue. For 5.5 years after installation of a terminal, the HISI will receive the following under the agreement:

Comment. Under the original contract, HISI was to receive, within the five-year contract period, a 4.43 percent to 5.32 percent share of both off-line and on-line game revenue once the system was determined by the CSL to be operational, and up to 6.03 percent for an optional 3 years.

8. Guaranteed Revenue Term. The CSL guarantees 5.5 years of revenue to HISI for each of the 6,000 SNAP terminals (or a total of 1,716,000 terminal selling weeks [TSWs]). Excess TSWs or spare selling weeks from the 4,000 excess and 700 spare terminals, respectively, do not count toward fulfilling this guarantee. In addition, the CSL must provide automated validation of Scratchers transactions in order to fulfill the guarantee, which appears to be a modification to the original contract. To accomplish this, the CSL, through its contract with GTECH, must provide HISI access to technical information and hardware associated with the central gaming system so that the new system can tie-in with the existing GTECH system.

Comment. The original contract had none of the following provisions:

9. Equipment at State Cost. The CSL purchases and gains ownership of all terminals and associated equipment (printers, security devices, etc.), except for the 4,000 excess terminals, which HISI is obligated to provide at its cost.

Comment. In the original contract, HISI provided all hardware and software, with the exception of the wide area network (WAN), which was the CSL's responsibility. Ownership of HISI-provided hardware and software, however, would have transferred to the CSL upon contract termination or at the end of the five-year contract term. Under the agreement, the CSL (1) is responsible for all telecommunications costs and (2) acquires immediate ownership of equipment provided by HISI under the original contract, some of which will be refurbished to meet the CSL's current requirements. The original contract specified that all equipment had to be "new and free of defect."

10. Benchmarking. The benchmarking and acceptance testing requirements are better defined and more detailed in the agreement than in the original contract.

11. Performance Bonds. Although both documents contain performance bonds, the language in the agreement only provides for a performance bond "which secures Contractor's performance in accordance with the State Lottery Act, Section 880.69." This language does not specifically state that the CSL may make a claim against that bond, as the original contract did.

12. Personnel Guarantees. The agreement states on page 14 (IV.C.2.c.) that "A. A. Pierce shall be and remain involved in the oversight of CSL's performance of its obligations under the Contract through the end of the Implementation Term."

Comment. This is an unusual stipulation in the event that Mr. Pierce is not available to the CSL. It is common to have a provision for personnel replacements due to uncontrollable circumstances. For instance, the oversight committee named on page 13 of the agreement does contain a provision for member replacement. We would also note that in February 1995, the administration announced that Mr. Pierce was being appointed Chief Deputy Director of the Department of Transportation (Caltrans). While Mr. Pierce remains on the CSL's payroll, the July 1995 organization chart for Caltrans identifies him as one of the department's chief deputies.

13. Indemnity for Acts or Omissions. The agreement provides that HISI's aggregate liability under indemnification provisions relating to misconduct, error, subcontractor claims and ticket alteration resulting in a prize for a nonwinning ticket being paid shall not exceed $10 million for acts or omissions occurring in any one calendar year, except in cases where intentional acts or omissions cause physical injury to persons. The original contract did not specify any limit on the contractor's indemnification liability.

On January 24, 1996 the CSL, in response to our request for verification of the differences discussed above, identified the following additional differences:

We have not reviewed these differences between the contract and the agreement.

Question No. 2

Under what authority did the CSL modify and renew, without going out to competitive bid, a contract that was terminated more than two years ago?


The CSL asserts that it has "reinstated" the original contract pursuant to the court-sanctioned settlement agreement. The CSL states that it and HISI were able to design a settlement that recognized the terms of the original competitively bid contract but allowed for modifications that were necessary to resolve their dispute.

Question No. 3

Would you describe the 1995 contract as a 'modification' of the 1992 agreement or would you describe it as a new contract that should have gone out to competitive bid?


The CSL's statement to us that "the contract was terminated after CSL conducted a pre-acceptance review of development . . . " verifies that it did exercise its termination rights under the terms of the original contract. On the other hand, in the same response to us the CSL states that, through litigation, they have kept the original contract in effect, although in a highly modified form.

Comment. If the court had enjoined the CSL from terminating the original contract, then the agreement would seem to be a substantially amended contract. The CSL advises us, however, that no such court action occurred. Consequently, the agreement could be viewed as a new contract subject to the CSL's procurement policy and regulations, which do provide for sole-source award. Given the CSL's response, we believe that a legal interpretation is needed in order to authoritatively answer your question. You may want to ask the Legislative Counsel to address this issue.

Question No. 4

In my reading of the two contracts, the state would not have had to make any capital outlay for equipment under the 1992 contract. Yet under the 1995 contract, the state is purchasing $25 million worth of equipment. In your view, shouldn't this new $25 million purchase have gone out to competitive bid?


The CSL did not provide a direct response to our first request for a cost comparison of the original contract and the agreement. We recently restated our request for a cost comparison of the original contract and the agreement. The CSL has indicated that it will take some time to provide the requested information. Therefore, it is not possible at this time to determine if the $25 million represents the purchase price of equipment and software alone. The CSL documents and a joint CSL/HISI press release indicate that the CSL is paying $25 million to purchase 6,700 SNAP terminals, security hardware, and software applications. More importantly, the CSL financial statements of June 30, 1995 state that ". . . management has determined that the fair market value of these assets is $22 million." Thus, at least $3 million of the $25 million, and possibly the interest and tax payments, appears to be for something other than the assets named above.

Moreover, the financial statements further indicate that the $25 million may be for some equipment as well as a settlement award to HISI. As a result, we are unable to advise you regarding the portion of this amount which is software or equipment related. As noted above, the CSL's procurement policies do provide for sole-source awards.

Question No. 5

The CSL will spend $25 million on equipment under the terms of this contract. Exactly what equipment will the state be getting for this $25 million? How does that differ from what the state would have received had the CSL not terminated the 1992 contract?


Please refer to our responses to Question Nos. 1 and 4 above.

Question No. 6

The CSL is paying this $25 million in a lump sum at the front of the contract. Is that unusual? Is it, in your view, wise from a financial standpoint or a performance contracting standpoint?


Again, we reiterate that all the facts have not been made known to us. Without the Lottery Commission's rationale for "reinstating" the contract--which the CSL will not provide on the basis that it is inappropriate to discuss because of possible future litigation--it is impossible for us to comment on the wisdom of this payment. In response to our question on the shared-risk provisions of the agreement, the CSL stated that " . . . HISI has only recovered $25 million of the approximately $57 million expended in performing under the original contract." This leads us to believe that this is an abnormal situation where some portion of the $25 million should be viewed as a settlement payment and partial payment for work performed and equipment produced by HISI under the original contract, and not a payment per se for an equipment purchase. As explained in our answer to Question No. 4, at least $3 million of the $25 million appears to be for something other than what will be provided for by the agreement. In our opinion, an up-front lump sum payment cannot work as a performance guarantee.

Question No. 7

State agencies are subject to a number of procedures and controls when they purchase information technology. Do these same procedures apply to the CSL? If there are differences, please point them out and explain the basis for them.


We asked the CSL for the basis of their exemption from Department of General Services (DGS) and Department of Finance (DOF) review of their information technology projects. Their response regarding exemption from normal procurement requirements (DGS) is that a Legislative Counsel opinion confirms that the act creating the CSL provides them this exemption. As for the DOF feasibility study report (FSR) review, the CSL simply states that, as there is no annual budget appropriation, they are exempt from standard information technology project controls. The Lottery Act, however, requires that all procurement decisions be approved by the five-member Lottery Commission, the members of which are appointed by the Governor.

Comment. It is our opinion that the CSL has not sufficiently responded to our question regarding external information technology FSR review. It is important to note that the law did not prevent the CSL from adhering to state procurement law; it was the CSL's choice to establish its own procurement procedures. The Legislative Counsel opinion says nothing about an exemption from DOF review. (See Attachment No. 4, Legislative Counsel Opinion). Finally, we have asked the DOF for any documentation it may have confirming the CSL's exemption from normal FSR review requirements, but have not yet received a conclusive response.

In recent years, the commission has been a party to several large information technology contracts and amendments. For example, in 1993 the CSL signed a $203 million contract with GTECH for the OLG system and 13,000 on-line terminals, plus amendments for up to $71.5 million more to extend maintenance agreements and provide additional equipment. Furthermore, in 1992 the commission signed a $15 million contract with Lottery Enterprises Inc., plus an amendment of $31 million for 6,500 Scratchers vending machines. In our opinion, the high dollar value of these contracts should be subject to external review similar to that required of other state information technology contracts.

Question No. 8

The CSL will pay HISI a $4 million bonus if the system is up and running within six months, $2.5 million if it's up in six to nine months, or $1 million if it's up in nine to fifteen months. Are such completion bonuses normal in state contracts? When does the clock 'start ticking' on these time frames? How would you describe a performance bonus that's been inserted into a contract after the contract has been awarded, as appears to have happened here? Please compare the completion bonuses and penalties for lateness or non-performance in the 1995 CSL contract with HISI to the state's contract to re-build Interstate 10 in the wake of the Northridge Earthquake.


Completion Bonuses. These bonuses--as found in the "reinstated" HISI contract--are not normal for state information technology projects. Caltrans has used incentive/disincentive provisions in 18 contracts since 1992 for emergency response construction to earthquake (Northridge and Loma Prieta) and storm damage (flooding of Interstate 5 in 1995). Given the abnormal situation with the HISI contract, we believe that the completion bonus may also be part of a settlement payment.

While other state agencies are pursuing innovative information technology contracting, most of this is in the area of procurement, shared risk, and payment methods, not completion bonuses. The one information technology exception is the Board of Equalization's (BOE) contract for database migration to the Stephen P. Teale Data Center. This contract contains a withhold provision that allows for a 20 percent payment holdback until final project completion if there are late or unacceptable product deliverables. If deliverables are produced before individual project deadlines, the BOE withholds only 10 percent until project completion. Although this provision is not the same as a bonus payment, it is an example of a different type of payment program that functions as a contractor incentive.

Time Frames. In the few state contracts with completion bonuses, with the exception of the Interstate 10 (I-10) contract, a reasonable period is usually allowed for the contractor to obtain the resources to initiate the project before the clock starts.

Performance Bonuses. It is our understanding that a significant portion of the work to be done under the agreement had already been completed by HISI under the original contract. Under these circumstances, we would not consider the bonus in the agreement to be a true incentive provision. Again, without more complete information and a determination that a new contract has been awarded, it is difficult for us to comment on the wisdom of the performance bonus in the agreement. We would reiterate that these unusual provisions may be part of a settlement agreement.

A number of the changes in the original contract are of such a substantial nature that they would not normally be allowed under the state's regular contracting policies. The performance bonus is one example of such a change.

Comparison to the Caltrans I-10 Contract. Comparing the I-10 contract and the HISI contract is difficult because of the different nature of information technology contracts and construction contracts. The total incentive payment in the I-10 contract was $14.8 million. The bonus period began with the actual construction start date. The I-10 contract specified completion bonus and lateness penalty terms of the same amount--$200,000 a day. (According to Caltrans, lateness penalties or disincentives have become a standard feature of their construction contracts.) The contractor, C.C. Myers, opened the road 74 days ahead of schedule. Figure 1 highlights some of the comparison points between the two contracts.

Figure 1
Comparison of I-10 and HISI Contracts
  • $4 million within zero to six monthsa
  • $2.5 million within six to nine monthsa
  • $1 million within nine to fifteen monthsa
  • $200,000 a day for each day project completed under the 140 day contract period
  • Contract term
    • Implementation term: six months
    • Revenue term: 5.5 years
  • 140 days
  • Timeline
    • Contract reinstated: November 9, 1995
    • Implementation term:b November 13, 1995
    • Revenue term: 5.5 years after completion of implementation
  • Award: February 5, 1994
  • Start date: February 6, 1994
  • Completion date: April 12, 1994
  • Deadline: June 24, 1994

  • Standard
    • $25 million plus percent of sales for 5.5 years
  • $14.9 million for 140 days
  • Incentive
    • Up to $4 million
  • $14.8 million (74 days at $200,000 per day)
  • Penalty terms
    • None specified in contract
  • $200,000 a day for road opening delay
  • $5,000 a day for contract completion delayc
  • a The amount of the incentive payment is determined by when HISI completes all required work in the implementation period (estimated to be May 1996).
    b The agreement states that the implementation term "shall have no fixed duration." The CSL, however, has indicated that the revenue term is expected to commence in May 1996.
    c Delay of contract completion includes such things as not finishing landscaping and cleanup.

    Question No. 9

    If changes occur in the first twelve months of operation, the CSL shall compensate HISI at a rate of cost for time and materials, plus 10%. Are 'cost-plus' features such as these normal in state contracts?


    Cost-plus features are not normal in state contracts. The T&M provision is discussed further under Question No. 13.

    Question No. 10

    The CSL is required to supply all hardware to coordinate the HISI system with the GTECH system. The contract then permits the CSL to request HISI's assistance in 'procuring required hardware and operating system software from Tandem Computers should HISI be able to obtain a more favorable price form Tandem for such items.' What does this relate to?


    According to the CSL, HISI has a special marketing arrangement with Tandem Computers which the CSL believes may enable HISI to purchase Tandem equipment at less cost than if the CSL had to purchase equipment on the open market. The CSL indicates that HISI does not have such an arrangement with other manufacturers of the equipment to be used under the contract (for example STRATUS Computers).

    Question No. 11

    The CSL is required to supply the telecommunications network and to bear all telecommunications costs during the term of the contract. Can you please estimate what those costs will amount to? Are they one-time or ongoing? Can you determine how this system will interface with the state's Cal-Net system? Does this permit the CSL to purchase and install a system or to contract with a commercial vendor to provide the service?


    The CSL will incur both one-time and ongoing costs for telecommunications. The ongoing costs will be for maintenance and charges associated with the use of telecommunications lines. In November 1995, we asked the CSL for these estimates, but at that time the CSL declined to provide the estimates. We recently restated our request, and the CSL has replied that it will take some time to respond. The automated instant ticket gaming system will use regular commercial telephone lines, not the CALNET system, for the SNAP terminals to dial-in to the central gaming system.

    Question No. 12.

    The contract calls for the CSL to pay HISI $25 million, plus interest, for the equipment. Is this feature standard in other contracts? Do you find it unusual that the CSL is paying interest on a contractually agreed to amount of money that's being spent for a one-time equipment purchase?


    Please refer to our response to Question No. 4.

    Question No. 13.

    The contract calls on the CSL to pay for 'time and materials' on a 'cost-plus 10%' arrangement. Furthermore, the rates for the compensation are to be based on those rates negotiated by HISI with its subcontractors and are not to be subject to any ceiling. Please explain how you interpret what is to be included in 'time and materials,' whether this is a standard provision of other information technology contracts, and how significant or open-ended you believe this provision of the contract to be.


    Items Covered Under Time and Materials. Our review of the agreement indicates that the CSL is paying cost plus 10 percent for two categories of work to be completed prior to the beginning of the revenue term (anticipated start date of May 1996). These categories include (1) new tasks and (2) preparation of the acceptance test plan, including work performed prior to the signing of the agreement.

    New Tasks. The new tasks assigned to HISI include identifying, analyzing, and incorporating CSL requirements into the following baseline hardware and software:

    Preparing the Acceptance Test Plan. Preparation of the acceptance test plan entails specifying:

    Exclusions From Cost-Plus 10 Percent. Time and materials excluded from the cost plus 10 percent compensation are:

    Comment. The compensation rate for all T&M is undefined in the agreement papers released to us. Thus, we cannot comment on the fiscal significance of this provision beyond saying that we believe compensation is open-ended because, as noted in your October 2, 1995 request, there is no ceiling on the subcontractor rates.

    Question No. 14

    Please compare the benchmark testing requirements of the 1992 contract with those in the 1995 contract.


    The original contract contained sections on benchmarking and on acceptance testing, totaling approximately three pages. These sections provided for the development of specific test schedules and procedures. The agreement has combined the activities covered by these two sections into an acceptance test plan, totaling 22 pages. The acceptance test plan, which defines a schedule and procedures and also defines acceptance criteria in substantially more detail than the original contract, is a significant improvement because it provides definition lacking in the original contract.

    Question No. 15

    The Lottery Act specifies that 50% of the lottery revenue must be awarded in prizes, 34% must go to education, and 16% may be used for administrative overhead (6.5% retailer compensation, 9.5% game and operating costs). The highest sales year was 1988-89, which generated $2.6 billion in total revenues. At 16% that means $416 million was available for administrative expenses. The most recent figures are from 1993-94, in which the lottery generated $1.9 billion in total revenues. At 16% that means $304 million was available for administrative expenses. How common is it to tie administrative expenses to a percentage of a fluctuating revenue stream?


    We have been unable to identify any other state agency that has administrative expenses tied to a specified percentage of a fluctuating revenue stream. We have identified, however, two state agencies that are self-funding and depend on a fluctuating revenue stream for administrative expenses.

    California Exposition and State Fair (Cal-Expo) As a self-funded state program, Cal-Expo has depended on a fluctuating revenue stream for operating expenses since 1986-87. Cal-Expo has not received any General Fund or special fund support in the last nine fiscal years. Consequently, funding for administrative expenses has depended on fluctuating revenue amounts from ticket, commissions, and rental sales. While expenses are not tied to a percentage of the revenue stream, Cal-Expo has had to adjust its operating budgets as income fluctuates.

    California Housing Finance Agency (CHFA). The CHFA is the state's mortgage bank for low- and moderate-income individuals. The agency meets its operating expenses by revenues generated from its loan and insurance programs. The agency's two revenue sources are (1) loan interest rates set slightly above the interest cost of bonds and (2) administrative fees received as part of the loan interest paid. The agency receives no General Fund or special funds to finance its operations. The

    money available for administrative expenditures changes with the fluctuations in these two revenue sources.

    Other State Lotteries. In 1994, according to industry publications, operating expenses for the 36 state lotteries in the country ranged from 8 percent to 27 percent of sales revenues. In 1990, 5 percent to 8 percent of operations costs went to retailer commissions and 2 percent to 3 percent went to advertising. Over half of these lotteries had total administrative costs in the 15 percent to 18 percent range, with 12.5 percent as the average allocation of sales revenues to operating expenses. In comparison, the CSL in 1990 spent 15 percent of revenues ($322.6 million) on operating costs, including $135.4 million on retailer commissions and $61 million on advertising.

    The National Conference of State Legislatures provided us with information that indicates that, in addition to California, only three other states have set a limit on administrative expenses as a percentage of sales revenues (Georgia--20 percent, Minnesota and Texas--15 percent each). Clearly, it is not very common for state agencies in California or for other state lotteries to tie administrative expenses to a percentage of a fluctuating revenue stream.

    Question No. 16

    As noted above, the amount of money available for administrative expenses dropped by about 27 percent from 1988-89 to 1993-94. Please identify, to the extent you can, what cutbacks the CSL made in order to keep its books balanced.


    Annual revenues declined significantly between 1988-89 and 1991-1992 and then began to gradually increase. Figure 2 (see page 16) displays the CSL's operating budget from 1988-89 through 1994-95. As you note, the amount of funds available for administration declined by 27 percent (an annual average decrease of 4.5 percent) between 1988-89 through 1993-94. As shown in the figure, the major reductions were in the areas of professional services, advertising, other general expenditures, and off-line games. For most of these areas, expenditures reached a low in 1991-92 (the lowest point of the CSL revenue--$1.4 billion--in its ten-year history), and then began increasing the following year. Furthermore, the number of staff positions in 1993-94 was 920, compared to 1,162 in 1988-89 (a 21 percent reduction). Interestingly, the total expenditures on salaries increased by 4 percent over the same time period. This trend continues into 1994-95. Finally, as shown in Figure 2, since 1988-89, administrative expenditures generally have been increasing as a percentage of revenues.

    Figure 2
    California State Lottery Operating Budget
    (Dollars in Millions)
    1988-89 1989-90 1990-91 1991-92 1992-93 1993-94 1994-95
    CSL revenuesa $2,629 $2,480 $2,132 $1,359 $1,759 $1,931 $2,166
    16 percent available for administration 421 397 341 217 282 309 347
    Claimed prizes (50%) 1,314 1,240 1,062 669 881 964 1,075
    CSL expendituresb
    Operating expenses
    Salaries $41 $45 $46 $43 $40 $43 $44
    Professional services 19 21 25 7 8 13 13
    Advertising 60 73 61 41 48 42 44
    Amortization and depreciation 21 26 29 18 26 25 13
    Other general 19 21 18 13 15 14 17
    Subtotals ($160) ($186) ($179) ($122) ($137) ($137) ($131)
    Direct game costs
    Off-line $16 $12 $11 $7 $9 $13 $14
    On-line 11 11 12 28 30 39 50
    Subtotals ($27) ($23) ($23) ($35) ($39) ($52) ($64)
    Retailer commissions $135 $130 $121 $81 $105 $115 $141
    Totals $322 $339 $323 $238 $281 $304 $336
    Actual percent expended on administration 12.30% 13.69% 15.16% 17.50% 15.98% 15.66% 15.47%
    Positions 1,162 1,244 1,190 1,007 926 920 880
    Amount to educationc $991 $900 $747 $452 $597 $663 $755
    a Does not include interest income.
    b Totals differ from actual expenditures due to rounding and exclusion of interest expense for 1988-89 and 1989-90.
    c From lottery sales revenues only. Amendments to the Lottery Act in 1994 clarify that interest is above the required 34 percent.
    Source: California State Lottery Fund financial statements and Governor's Budget.

    As Figure 2 shows, the CSL was not in compliance with the statutory limitation on lottery expenses in 1991-92. Total operating expenses in that year represented 17.5 percent of revenues, or 1.5 percent ($20.4 million) above the statutory limit. The Lottery Act does not appear to specify any penalties or enforcement action against the CSL if it is out of compliance with the 16 percent limit on administrative expenses and is, in effect, spending some of education's share of lottery sales revenue.

    Question No. 17

    In April, 1993, HISI sued the CSL after the CSL canceled the 1992 contract that had been awarded to HISI. The CSL hired a private law firm to defend its decision. Please, to the extent you can, detail the chronology that led to the hiring of the law firm, the amount of money spent in legal fees, the money that may be spent in the future, and what the CSL received for the money it has paid and will pay to the law firm.


    Chronology. The following is a chronology of the CSL legal actions with regard to the HISI contract. (Dates listed are effective dates, not the dates the contract and amendments were entered into or signed.)

    Amounts Spent and Services Received. As reported to us, the CSL has spent $7.2 million on legal fees and costs associated with the HISI case. This amount paid for items such as expert testimony and consulting, out-of-state depositions, and document management. We asked the CSL for a line-item/categorical breakdown of the $7.2 million paid to DBSR for legal representation. The CSL's response was as follows:

    The CSL's response provides no detail supporting these four expenditure categories. Consequently, the information provided is not sufficient to allow us to assess what the CSL received for the money spent on DBSR legal services.

    In addition, $170,972 in currently disputed billings is outstanding. The CSL expects to spend less than $100,000 for current-year outside legal representation to conclude the remainder of the HISI litigation. Lastly, the CSL states that "DBSR provided no advice having any impact upon the decision to terminate the contract . . . ."

    Question No. 18

    Please determine how that contract was awarded to the individual law firm.


    The CSL indicates that it awarded the contract for legal representation to DBSR on a sole-source basis due to its belief in the firm's expertise and extensive experience in government contract law. The CSL's regulations do allow for sole-sourcing contracts that are "solely for private legal services." Moreover, Sections 1233 and 1235 of the State Administrative Manual exempt legal services contracts from competitive bidding requirements.

    Question No. 19

    Please compare the CSL-HISI contract to prior information technology contracts that the state has entered into. I'm interested in determining whether this contract repeats mistakes that we've seen in other technology-oriented contracts awarded by the state.


    The agreement documents we have reviewed contain several provisions not normally found in the state's information technology contracts, including (1) an up-front lump sum payment, (2) incentive bonuses, and (3) cost-plus payments. These features alone make the proposed agreement substantially different from a typical information technology contract. Procurement law has been amended in recent years to provide for "value-added" procurements, which could be thought of as including provisions similar to those agreed to by the CSL. Unlike most other state agencies, however, the CSL does not submit its procurements to external review. Consequently, provisions which the CSL might claim as being "value-added" may or may not be acceptable to external review agencies.

    Under the agreement, the CSL has already purchased some of the equipment required by the new system, and has committed to acquiring specific additional equipment, including computers--all for a gaming system for which HISI is providing the application software. (Software which the CSL apparently believed was incomplete when the CSL terminated the original contract.) Consequently, this situation is on the surface similar to the well-publicized problem the Department of Motor Vehicles (DMV) experienced when it acquired computing systems for which the application software had not been developed. On the other hand, the agreement provides, through acceptance testing, for the CSL to validate that the entire system--hardware and software--function according to the CSL's specifications, something which the DMV's approach lacked.


    We have responded to your questions to the best of our ability with the information we have been able to obtain from the CSL since October 1995. In a number of instances, however, the CSL would not provide us information on the basis that to do so would either compromise the CSL's legal position or violate the confidentiality or secrecy provisions of the agreement. Moreover, many of the CSL responses raised more questions than they answered.

    Our review of the CSL's actions regarding the termination of the contract with the HISI (and the subsequent litigation and agreement) suggests that the system developed by HISI under the original contract was nearly complete, given that the CSL now estimates that the system will be operational within six months (May 1996) of the effective date of the agreement. This in turn raises the question as to why the commission approved the termination of the original contract.

    We believe that state agencies have an obligation to hold contractors accountable and exercise termination rights only as a last resort. In this case, however, it is not clear based on the information we have had the opportunity to review that the situation on April 21, 1993, the date the CSL terminated the original contract, in fact warranted a last resort action.

    The delay resulting from the decision to terminate the contract has been costly for the state. It has been costly in terms of both the loss of anticipated additional revenue which would have accrued in part to the schools (we estimate this loss to be in the tens of millions of dollars), and the CSL expenditures related to the lawsuit and the new agreement (we estimate that these costs exceed $10 million).

    Notwithstanding any flaws in the original contract, that contract provided a means for identifying and addressing issues pertaining to performance of the contractor. Moreover, it appears from changes reflected in the agreement, that part of the performance problem may have been due to coordination issues between the CSL and HISI which made it difficult for the contractor to obtain (from other CSL contractors) technical support and information without which HISI would not be able to meet its contractual obligations.

    With respect to the agreement, whether it is a new contract or a reinstated contract is subject to interpretation. The CSL maintains, in essence, that despite the fact the CSL terminated the contract, the settlement agreement has kept the original contract alive, albeit in a substantially amended form. We cannot provide a legal opinion on the CSL's position, but whether the contract is new or reinstated may be moot however, because the CSL's procurement policies provide for sole-source awards. Our review did not include an assessment of whether the CSL followed its own procedures for sole-source justification in signing the agreement.

    We are disturbed by the position the CSL took with respect to providing specific information we requested of them in order to address the questions you posed to us. In many instances, the CSL declined to provide information on the grounds of attorney-client privilege. Some of the information requested was, we believe, so basic that it is difficult to comprehend how providing the information could compromise the CSL's position in the event litigation is resumed. An example of this is our request for a chart showing the major changes reflected in the agreement compared to the original contract. This is the kind of information one would assume the CSL staff would have provided to the lottery commissioners so that they would understand better what the CSL was buying in settling the litigation. The CSL would not

    provide us such a chart, however, citing the legal privileges noted above. Obviously, this comparative information would have expedited our review of the two documents.

    Finally, the Lottery Act has provided the CSL certain flexibilities not normally provided state agencies, such as the authority to establish its own procurement policies. In addition, the CSL has advised us that it has other exemptions from state practice--such as an exemption from external review of FSRs for information technology projects. (We have been unable to verify this exemption.)

    We believe that both the costly experience associated with the contract for the automated instant ticket gaming system and the difficulty we experienced attempting to obtain information from the CSL in order to respond to your questions suggest that a review of the Lottery Act is in order. We believe the Legislature should consider amendments which would improve accountability by providing legislative and executive branch oversight of the CSL's administrative budget. We believe that such amendments would be consistent with the Lottery Act's emphasis on benefiting schools. Such external oversight of the commission's administrative activities would likely improve their effectiveness.