Regulation, Segregation, and a Cereus Case of Déjà Vu

By now, most poker players know the sordid details. Online poker site commingles player funds with its working capital. Poker site uses player money to fund daily operations. Poker site unexpectedly gets slammed with requests by players withdrawing money from their accounts. Poker site experiences cash flow problems and can't pay player withdrawal requests. Poker site sends out a series of misleading statements and emails to players assuring them their funds are secure and withdrawal requests will be processed in the near future. Poker site changes tune, blames a third-party payment processor for taking player funds. Poker site closes down its operation without reimbursing players the funds in their accounts. Poker site owner skips on his merry way without any financial consequences.

"Alex, What was Cereus (Absolute Poker / UB Poker) in 2011?"

"I'm sorry, we were looking for PokerSpot in 2001."

That's right, well before the Moneymaker boom and the heyday of Paradise Poker and Party Poker (remember them?), poker star Russell "Dutch" Boyd started a little online poker room called PokerSpot that became rather popular. Perhaps too popular. The site owners apparently commingled player funds with operational funds, and dipping into those funds had to be pretty tempting for an undercapitalized internet start-up business looking to expand its market share. When a shady third-party payment processor made off with player deposits (at least, that's the official company line), PokerSpot stalled and lied to its players in a futile attempt to cover up the cashflow problem. Eventually, PokerSpot simply shut down and stiffed its players, and owner Dutch Boyd skated off scot-free, at least financially.

Now the parallels between PokerSpot and Cereus are not completely identical. PokerSpot never had a cheating scandal, nor were there ever allegations that Dutch Boyd or other PokerSpot principals had absconded with player funds for personal gain. But some of the underlying poor business and financial practices adopted by PokerSpot are once again in play with Cereus, and to a lesser extent, Full Tilt Poker. In particular, the experiences players have had in getting funds repaid to them following Black Friday only proves that, in the decade since the Poker Spot scandal, online poker has yet to adopt appropriate player protection mechanisms. Frankly, the only difference between trusting customers and gullible suckers is a particular poker site's current cashflow position.

Last year as the Frank and Reid bills to legalize online poker on a federal level were debated in Congress, there was grumbling from some poker players who resisted any form of government regulation of the game. After Black Friday, however, some of the advantages of gaming regulation came into painful relief. While PokerStars appears to have been able to process player cashouts in fairly quick fashion, Full Tilt has struggled with player refunds, at least in part because player funds apparently are commingled with company operating funds in accounts seized by the federal government. Even worse off are players wanting refunds from Cereus; rumors are swirling that the company faces cashflow problems and is unable to pay back players, and some players fear the company may even simply refuse to pay U.S. players or declare bankruptcy.

Imagine the different situation players would face if online poker were legalized and regulated. Most financial industries—e.g., banking, securities and commodities trading, and insurance—are highly regulated with respect to certain financial requirements—e.g., working capital, financial ratios, permissible investments, reserves, and protection of client funds. Not surprisingly, brick and mortar gaming companies face similarly strict financial oversight. Imagine how things today would be different if online poker sites were subject to regulations requiring that:

• Client funds must be held in trust accounts, segregated from the company's accounts for operating, investment, and other funds;
• Client funds must be protected by adequate cash bond, insurance, reserves, and other security;
• Companies must maintain positive working capital and other key financial ratios at or above a minimum level; and,
• Investments by the company must be low-risk and relatively liquid, making them available as necessary to fund player withdrawal requests

Now each of the Big Three affected by the DOJ's Black Friday bank account seizures—PokerStars, Full Tilt, and Cereus—are currently licensed and subject to gaming regulations in foreign countries. But the regulatory requirements of the licensing authorities for the Big Three vary widely, and those regulatory differences essentially explain why PokerStars is nearing the finish line on its way to cashing out American players in full, while Full Tilt is still on the backstretch, and Cereus has barely made it out of the blocks.

Let's look first at PokerStars, licensed by the Isle of Man Gambling Supervision Commission. Essentially, there are a few key regulatory requirements that made it relatively easy for PokerStars to complete the cash out process once the DOJ agreed to allow payments to be sent to American players:

• Player account funds are required to be segregated in accounts separate from accounts holding non-player funds, such as operating or investment accounts, and each player account must be labeled with "client account" in its title. (Participants' Money Rules 3, 4)
• Player funds include "deposits, winnings, transfers, gratuities, and redeemed bonuses". This would seem to include any accrued rakeback, FPPs, or similar prizes, bonuses, and rewards with monetary value.  (Participants' Money Rule 3)
• Player account funds are held "on trust" for players. (This is significant because it imposes legal fiduciary duties on the person or company holding the funds.) (Participants' Money Rules 4, 6)
• Player funds not held in a player account must be covered by security deposits and reserves approved by the Commission. (Participants' Money Rule 4)
• Player funds held by a third-party payment processor must be covered by the poker site if the funds were credited to the player's account by the poker site. (Participants' Money Rule 5)
• Poker sites must maintain sufficient reserves and security deposits as the Commission deems necessary to allow the poker site to pay its debts—i.e., solvency testing. (Regulations 6(2), 13(5)) 

Because of these regulations, PokerStars did not commingle player funds with operating funds. So, when PokerStars accounts were seized, presumably the seized accounts either were not the player accounts, and/or PokerStars was able to document to the DOJ's satisfaction that the seized accounts contained player money rather than company funds, a task made easier by the requirement that every player account bear the phrase "client account" in its title. Also, because the funds were segregated and because of solvency rules requiring PokerStars to have sufficient liquid funds, security deposits, and reserves to meet its outstanding debts, PokerStars likely faced little or no impact on its operational cash flow from the rather significant volume of player cash outs. Given the circumstances, PokerStars deserves credit at least for its relatively quick and forthright handling of the player cash out process.

Now let's look at Full Tilt, licensed by the Alderney Gambling Control Orgaization (Alderney is one of the Channel Islands). Alderney's gaming laws comprise both regulations and internal control system (ICS) guidelines. There are some key differences that distinguish the Alderney regulations from the Isle of Man regulations:

• Player funds may be segregated or unsegregated. Segregated funds are those which are accounted for separately from a company's operational or other general funds. Segregated funds can be held in separate player accounts which are not labeled as "client accounts", or may simply be tracked as a separate entry in the company's internal accounting system without being held in separate player accounts. Unsegregated funds are commingled both in company bank accounts and in the company's internal accounting system—i.e., treated as company funds rather than player funds. (ICS Guideline 2.9.2)
• If segregated, player funds may be protected or unprotected. Protected funds are those held in player accounts separate from accounts holding operational or other company funds, and must be labeled as "client accounts". (ICS Guideline 2.9.2)
• If player funds are unsegregated or segregated but unprotected, the poker site is required to notify players of this status. If player funds are segregated and protected as validated by the Commission, the poker site is allowed to notify players of this status (presumably as a marketing point). (ICS Guideline 2.9.2)
• Player funds may be held by the poker site itself or an associate (which includes software licensees and third-party payment processors). The poker site technically cannot have "recourse" to the funds except to debit or transfer funds for certain approved purposes (e.g. player loses a wager, player buys in to a game, or player transfers funds to another player), while "associates" holding funds are only limited by the terms of the poker site's gaming license requirements. (Regulations 57, 231, 234)
• Poker sites are required to maintain certain financial ratios, including total assets of 25% in excess of total liabilities [(TA-TL) / TL > 25%], current assets greater than current liabilities, and cash greater than amounts due customers. (Regulation 243 & Schedule 20)

I have not been able to find any documentation of whether player funds at Full Tilt were segregated, and if so, whether those funds were protected or unprotected. I think a fair inference can be drawn from Full Tilt's reaction to the DOJ's seizure of its bank accounts, in which Full Tilt claimed that the accounts contained player funds, that at the very least the funds were unprotected; i.e., player funds were commingled with company funds in the accounts. Based on its progress in processing player cash outs, Full Tilt appears to have segregated the player funds by tracking them separately for accounting purposes; however, this definition of segregated is different than the definition used by the Isle of Man regulations. For a fair "apples to apples" comparison, the player funds held by PokerStars were segregated and protected while the player funds held by Full Tilt were segregated but not protected. Notice how dangerous this slippery definition of segregated can be to uninformed players; players hear "segregated" and think funds are held in trust in separate bank accounts, while in fact their money is commingled with company operational or investment funds, a practice which can be easily abused by unscrupulous company insiders. However, if Full Tilt segregated the funds with internal accounting, it is easy to see how in practice Full Tilt has lagged behind PokerStars in player cash outs because of the need to separate out commingled player funds from seized company funds. It appears highly likely that Full Tilt will be able to pay players in full if and when player funds can be recouped from the seized accounts.[FN1] If, however, Full Tilt needs to dip into operational or investment funds to pay players, Full Tilt's need to maintain the financial ratios mandated by the regulations may slow the repayment process, though ultimately repayment in full should be possible so long as the company maintains a healthy level of non-U.S. business.

One other interesting point arises from the Alderney regulations. The regulations permit a poker site to allow player funds to be held by an associate, which includes software licensees and third-party payment processors. The software licensee provision raises questions about the relationship between Full Tilt and Pocket Kings, the software company closely connected to Full Tilt. The third-party payment processor provision does not seem to apply to Full Tilt, at least at this time, but does raise some interesting issues to be discussed with respect to Cereus. [FN2]

Speaking of Cereus, we finally come to online poker's black sheep—the Cereus Poker Network, operator of the scandal-plagued poker sites, Absolute Poker and UB Poker (f/k/a Ultimate Bet). Weeks after Back Friday, well behind the efforts of PokerStars and Full Tilt, and after much foot-dragging and double-talking, Cereus today finally issued a press release indicating it had reached something of an agreement with the DOJ that will enable it to ... well, it's not entirely clear what Cereus will be doing, a point we'll return to in a moment.

Interestingly, despite the sale last summer of Cereus to Blanca Games—a gaming company based in Antigua—Cereus remains regulated by the Kahnawake Gaming Commission in Canada (note the references to Kahnawake regulation on the Blanca Games home website, as well as the still-operational European facing websites for Absolute Poker and UB Poker). This is especially curious considering Antigua has its own gaming commission, relies on gaming as a significant industry, and has loudly protested the DOJ's actions against Absolute Poker as a WTO trade violation. More intrigue arises from a June 2010 agreement between the Kahnawake and Antigua gaming commissions which allows reciprocal gaming licenses for companies based in either jurisdiction. According to the agreement, a company can be located in Antigua and be regulated by Kahnawake or vice-versa, so long as authorization is given by both gaming commissions. One of the gaming commissions provides the "Primary License" and has primary regulatory responsibility—Kahnawake in the case of Cereus. Given the rather questionable ties between former Cereus owner Tokwiro Enterprises and the Kahawake Gaming Commission (not to mention the rather unsatisfactory Kahnawake investigations of the Absolute Poker and Ultimate Bet scandals), the timing of the regulatory agreement a mere two months prior to Cereus' move to Antigua certainly raises suspicions of Cereus' motivations. One has to wonder if Cereus and its owners relocated to Antigua because of favorable laws related to taxation, business operations, or criminal extradition, not to mention its antagonism towards the United States on all matters gambling related.

Fortunately, there is no need to speculate about Kahnawake gaming regulations. Interestingly, they track in large degree with Antiguan gaming regulations, and seem to be based on the same model gaming code. Some Kahnawake gaming regulations of note with respect to player funds include:

• Poker sites are required to post security sufficient to cover their operational costs and expenses, "including but not limited to obligations owed to players". (Regulation 88). The security may be used by the Commission to satisfy poker site debts, so poker players may have some recourse against the Commission in the event Cereus stiffs its American players. (Regulation 89). However, whether a poker site is required to post security, as well as the amount and type of security, are ultimately left to the discretion of the Commission. (Regulations 90-94). So, it is an open question whether the Commission required Cereus to post security at all, and if so, in what type and amount. It should also be noted the type of security matters, since a lien on company property may be unenforceable or worthless due to foreign law or a bankruptcy filing, while a cash bond or insurance policy may be more easily accessible.
• Grounds for a suspension or revocation of a poker site's license include:  a) significant financial problems, including insolvency, bankruptcy, or receivership; b) "fail[ure] to discharge financial commitments to players ... or the Commission has reason to believe such failure is imminent"; and c) "in the Commission's sole discretion" the company "no longer has a good business reputation or sound financial position". (Regulation 118(a), (i)-(k)).
• Players' funds must be kept in separate accounts at a financial institution or other "body approved by the commission." (Regulation 2)
• Players must have "direct access to funds" in their player account, and must be able to "obtain the balance of funds in that account and close the account". (Regulations 2, 181).
• A poker site "must, at the request of a player in whose name a player’s account is established, once the player’s identity is established, remit funds in the player’s account to the requesting player as soon as practicable after receipt of the request." (Regulation 187).
• A poker site "must not have recourse to funds in a player's account except" to debit or credit the account for gaming transactions. (Regulation 193).

Compared to the sets of regulations which applied to PokerStars and Full Tilt, the regulations for Cereus seem fairly similar, and in some ways, more protective of players. However, the regulations are only as strong as the Commission enforcing them. When a regulatory agency lacks authority or political will to enforce its own rules, licensees will bend and even break rules. The Commission clearly could have suspended or revoked the Cereus license (or done so for either Absolute Poker or Ultimate Bet individually) after their past scandals, particularly if Scott Tom were still calling the shots behind the scenes (it would be unfathomable if the Commission knowingly permitted Scott Tom to serve as a "key person" post-scandals, and if the site hid his role, that alone is sufficient to revoke a gaming license under the regulations). Unfortunately, the Commission seems either too weak or too influenced to enforce its regulations against Cereus.

If Cereus fails to pay players back, again that would be grounds to revoke a gaming license. However, there is some wiggle room for Cereus, as payment need be made only "as soon as practicable". With Cereus dragging its feet since Black Friday in making a deal with the DOJ, Cereus might assert—and the Commission might endorse—a position that it is unable to pay players back at present.

Which brings us back to the Cereus press release from today (broken down nicely by Mark Gahagan on Sparta Poker). [FN3] In its statement, Cereus (technically Absolute Poker—how the DOJ missed the low-hanging fraud fruit at UB Poker is beyond me) announced:

Today's signing of the agreement with the DOJ is an important step towards the safe and efficient return of funds to our US players. We can now move as expeditiously as possible to collect player monies from third party processors as a prelude to establishing proper mechanisms for the return of funds to our US players. As previously announced, we have already taken specific actions to exit the US market by closing our US-facing operations. Blank Rome LLP will continue to engage in discussions with the SDNY in order to complete the necessary agreements for the final transfer of frozen fund balances to our US players. This remains our highest priority. We will continue to update our players and the poker community, as we move forward to resolve outstanding issues.

There is something of a disconnect here. At one point, Cereus blames its failure to pay U.S. players on the need to "collect player monies from third party processors", yet a few sentences later, Cereus shifts its explanation to needing to "complete the necessary agreements [with the DOJ] for the final transfer of frozen fund balances to our US players". What's going on here? Given Cereus' shady track record and the lack of transparency into both Cereus' operations and the actions of the Kahnawake Gaming Commission, we are left to conjecture based on the evidence available.

Cereus' complaint about the DOJ holding player funds in seized bank accounts is probably a relatively straightforward—and accurate—explanation. If so, it appears Cereus was most likely commingling player funds and operational funds in its corporate accounts, much like Full Tilt. Of course, commingling funds would be in violation of Commission regulations, but it's not much of a stretch to believe that Cereus was violating the player account regulations while the Commission either failed to detect the practice or tacitly endorsed it. Still, if this is the primary reason for the delay in paying U.S. players for account cash outs, then presumably Cereus, like Full Tilt, should be able to account for player funds in the frozen accounts and arrange for the return of those funds. However, if Cereus not only commingled the funds but failed to account for them separately and simply lumped player funds in with other corporate funds (a practice that would have been permitted under Alderney regulations as an "unsegregated" accounting practice), then Cereus may well face difficult obstacles in convincing the DOJ to release frozen funds as the DOJ will be reluctant to release funds that belong to the corporation rather than to players.

The third-party payment processor provision is potentially more troubling and more sinister. Clearly the most important business function for a poker site is to move money on and off the site; "on" to fund operations via game play and the rake, "off" to keep customers happy and coming back for more play. Given the difficulties online poker sites have faced with money transfers since passage of the UIGEA, it is possible (maybe even probable) that a poker site might use third-party payment processors as a quasi-bank for a portion of players' funds. A payment processor could hold incoming player funds and use them to process outgoing player withdrawals at the direction of the poker site, with regular "squaring up" between the poker site and payment processor as funds built up or diminished at the processor. The advantage to the poker site would be to minimize the number of transactions into or out of the poker site's bank accounts. In addition to legitimate business purposes, this arrangement would also make it harder for regulators or law enforcement officials to detect improper monetary transactions (e.g., violations of UIGEA or money laundering laws) as funds would be more difficult to trace back to a poker site. However, this arrangement would also require a poker site to be more involved in the third-party payment processor's operations, which might explain some of the conspiracy claims included in the Black Friday indictment which purport to connect the poker sites themselves to some of the third-party payment processors' questionable business practices (e.g., intentional miscoding of transactions and setting up phantom "legitimate" businesses).

A third-party payment processor holding player funds in this manner seems permissible pursuant to the Alderney and Isle of Man regulations discussed earlier (though the Isle of Man requires the poker site to credit the players' accounts for funds held in this manner; Alderney's regulation does not have such an explicit requirement). But such an arrangement would be a clear violation of Kahnawake gaming regulations, unless the Commission approved the use of a third-party payment processor in lieu of a bank (see Regulation 2), or Cereus simply ignored the rule or bypassed it by designating certain corporate accounts as "players' funds accounts" to satisfy the Commission on a technical basis, but on an operational basis used funds held by third-party payment processors as its de facto players' accounts. Of course, if Cereus did operate in this fashion, now that the U.S. river of milk, honey, and cash deposits has dried up, there's not a lot of incentive for any of those third-party processors to return a dime of player funds to Cereus.

Considering other newsworthy events at Cereus, how long will it be before they announce their new U.S. professional poker player spokesperson—Dutch Boyd?

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[FN1] ADDENDUM (10 May 2011):  In response to a valid criticism raised by someone close to the industry that Full Tilt has yet to begin player cash outs and has not adequately explained the reasons for the delay, I recognize I am giving Full Tilt a certain benefit of the doubt. It's also true there are indications Full Tilt funds in the seized bank accounts are still the subject of serious contention between Full Tilt and the DOJ, which could be expected if funds were commingled. It is entirely possible Full Tilt's financial issues are significantly closer to the Cereus situation than to PokerStars, with a combination of commingled funds being seized and player cash out requests causing serious (if hopefully temporary) cash flow issues given Alderney liquidity and reserving requirements. However, Full Tilt does seem to be at least communicating with players and attempting to answer player concerns (see HERE and HERE on the TwoPlusTwo forums for Full Tilt Q/A posts, along with player responses and criticisms), and Full Tilt has a much better non-U.S. player business operation (to better generate cash flow) as well as a stronger desire to protect its public image. So, for now, I still think Full Tilt is much more likely to pay back U.S. players sooner and in full than Cereus.


[FN2]  ADDENDUM (31 July 2011):  In retrospect, I clearly gave far too much credit to Full Tilt's management, or underestimated the seriousness of their financial troubles. As events unfolded after the original post, Full Tilt couldn't process player cash out requests, most likely because player funds were completely commingled with operating funds, and the cash flow from their European operations was not sufficient to fund operations and player cash out requests. It appears likely that, prior to Black Friday, Full Tilt was using player funds to finance operations, including expensive ad campaigns (such as the Poker After Dark TV show), player endorsement deals, and executive compensation for Ray Bitar and Howard Lederer. In any event, more than three months after Black Friday, Full Tilt has had its license suspended by the Alderney GCC, and prospects for cash outs for American players seem tied to some kind of outside buyout of Full Tilt.

[FN3] ADDENDUM (10 May 2011):  Literally moments after I hit "publish" for this post, Gary Wise of ESPN Poker reported that a revised statement was issued by Cereus/Absolute Poker. The critical difference I note is that the revised statement deletes any reference to issues with third-party payment processors. Whether the original statement was in error, or the original statement was accurate but raising too many uncomfortable questions, or it was considered better PR to just throw the DOJ under the bus rather than third-party processors who hold significant amounts of money they'd like to get back, is impossible to know.