Considerations for a Casino Boat in Texas

Ethics and Compliance Plan for a Casino

Abstract

This ethics and compliance plan for a casino in Texas provides background information on the industry, regulations to be considered, and the nature of the proposed organization. Because of state regulations, the proposed organization is for a waterway casino that will operate gambling activities outside state jurisdiction in international waters off the Texas coast. This plan further discusses how regulations will influence business activities, and what the roles and responsibilities of the compliance professional will be for the casino. It provides a detailed description of the governance structure of the business as well as the importance of maintaining an audit committee to oversee compliance. Furthermore, the process of interfacing with compliance is described by defining economic capital and measures for assessing and managing risk, including quantitative and qualitative approaches. Risk mitigation strategies are explained using stress tests, extreme value theory, and measuring operational risk. Finally, the establishment of a culture of ethics through the application of authentic leadership is discussed before a summation of information is provided in the conclusion.

Background

The casino industry produces revenues of $70 billion a year globally (FATF, 2009). It is a cash-intensive industry, and as such there a number of risks involved that have to be managed. Casinos are widely known, for instance, as hubs for money laundering, and the financial activities of casinos are similar to financial institutions, which is why vulnerabilities receive a great deal of attention when it comes to compliance. Casinos differ from financial institutions in the respect that they operate within an entertainment context, providing shows, dining and other experiences for guests. Thus, while they are considered non-financial institutions, financial activities make up a bulk of the enterprise. Casinos must accept funds on account, engage in money exchange, proceed with money transfers, provide cashing facilities, and service other financial transcations, similar to what would be found in a financial institution. Maintaining transparency of the movement of funds, operating the casino with respect to regulations, and managing internal controls within the casino are all essential aspects of operations. One inherent risk in the business is that of criminality. The FATF (2009) warns that “casinos represent the greatest risk for money laundering activities and this was reflected in the revision of the FATF 40 Recommendations 2003, with obligations on casinos being significantly enhanced in relation to Customer Due Diligence (CDD), record keeping, reporting of suspicion, and comprehensive regulation and supervision” (p. 9). For this reason, ownership structure, integrity within the organization, the implementation and management of internal controls, and corporate governance of casino/gaming institutions are central to the success of the business. Compliance plays a vital role in ensuring that the casino operates within its legal scope. Gaming must be conducted honestly, using surveillance techniques as well as security systems to ensure the protection of the business operations and its clientele and investors.

Regulations

The casino industry is regulated at the state level. Under US federal law, gambling is legal. States have the right, however, to regulate the industry and typically do so through a gaming control board (GCB). In Texas, state law prohibits all forms of gambling. However, the Kickapoo Lucky Eagle Casino operates in Texas under federal law because it is located on an Indian reservation in Eagle Pass, Texas (500 Nations, 2021a). Currently, the Texas House is considering a joint resolution bill HJR 133 that “would let voters decide in November whether or not to allow commercial casinos in the state. The bill proposes a limit of four destination casinos to be built in Austin, Dallas-Fort Worth, Houston and San Antonio” (500 Nations, 2021b). The bill is in committee at this time and proposes “a constitutional amendment to foster economic development and job growth and to provide tax relief and funding for education and public safety by creating the Texas Gaming Commission, authorizing and regulating casino gaming at a limited number of destination resorts and facilities licensed by the commission, authorizing sports wagering, requiring occupational licenses to conduct casino gaming, and requiring the imposition of a tax” (HJR 133, 2021). Until this bill is passed and signed into law, gambling casinos will remain prohibited in Texas.

However, one workaround solution that has been adopted by casinos in states that prohibit gambling is to establish themselves on waterways. One day cruise ship that operates out of Galveston, Texas, is Jacks or Better. It is a 155-foot yacht that provides gambling games, such as poker, blackjack, roulette and slot machines to guests (Amico, 2018). By taking guests out of Texas state jurisdiction into international waters, the casino boat is able to operate legally (Davis, 2017). The boat must travel nine miles over the course of an hour-and-a-half before it reaches international waters, whereupon gambling games commence for four hours before the boat must return to dock (Davis, 2017). While state legislation is pending, the boat casino is the best option for operating a casino in Texas. Galveston is an ideal choice because local regulators there pushed for a repeal of the state mandate “prohibiting the docking of ships with gambling equipment unless they first stopped at a foreign port of call” (Gambling in Texas, 2021). Since 1989, the requirement to dock at a foreign port of call has been lifted with the blessing of the US Attorney’s office, on the condition that less than half the boat’s space is devoted to gambling games and that emphasis is given to non-gaming activities (Gambling in Texas, 2021).

In order for the Texas-based casino boat to be in compliance with the US Attorney’s office it must therefore provide alternative forms of entertainment for guests and must not exceed use of 50% of its space reserved for gambling. This places constraints on the organization, but as Jacks or Better shows the proposition is possible.

Proposed Organization

The proposed organization is for a casino boat to sail out of Galveston into international waters. The casino boat will offer slots, gambling tables that include poker, blackjack and roulette in 45% of its space, and it will also provide entertainment and dining services in the other 55% of its space.

Differentiation is important in any industry. In Texas, there are few casino options, but one does exist in Galveston already. However, Jacks or Better is only a day cruise, providing guests with only four hours of gambling per cruise. Our organization aims to provide a longer cruise time, by providing guests with rooms onboard so that the cruise can stay 2-3 days in international waters before returning to dock. Two to three voyages. Another option, however, is to have multiple cruises per day, with a separate day and night cruise each totaling seven hours.

How Regulations Influence the Organization

Regulations in Texas currently prohibit land-based gambling. For that reason, the casino must operate only in international waters off the coast of Texas. These waters are nine miles from Galveston and can be reached in under two hours. During the time of travel to reach these waters, guests will enjoy alternative entertainments and dining. Gambling operations may commence once international waters are reached.

Roles and Responsibilities of Compliance

It is the duty of compliance officers to coordinate with federal and state regulators, to oversee risk management, to manage the organization’s compliance program, and to coordinate reporting channels for addressing compliance issues. For a casino boat, the job of the compliance officer is to ensure that internal gaming controls align with regulations and that security and compliance issues are addressed in a timely manner. For this organization, it will be important to contact the US Attorney’s office to ensure that the conditions approved are still applicable regarding less than 50% of the boat’s space dedicated to gambling.

Additionally, the development of internal casino procedures is one of the main priorities of the compliance professional. This includes providing training programs for staff and observing gaming activities so that any problems with gaming are addressed immediately. Audit programs are instrumental in maintaining a safe, secure, and regulated environment.

Compliance officers are not tasked with making managerial corrections: their duty is to observe and report, and for this reason surveillance is essential. Surveillance of gaming spaces, monitoring of gaming machines to make sure they are in compliance with technical standards, and monitoring of game play are all part of the purview.

A necessary component of compliance is the establishment of an organizational culture that facilitates compliance. As Frasher (2013) indicates, attitudes affect the extent to which an organization responds to problems of compliance. Implementing a culture of compliance begins with training employees and educating stakeholders on the importance of adhering to regulations. Integrity has to be valued from top to bottom, and part of the compliance professional’s job is to ensure that integrity is the standard for all operations related to gaming.

Self-regulation is critical to the success of the compliance professional (Omarova 2011). This includes monitoring accounting, transactions, and that gaming operations are conducted appropriately. To this end, regulatory technology (RegTech) has come a long way to facilitate self-regulating operations. In fact, RegTech has advanced to such an extent that it currently possesses “the potential to enable a nearly real-time and proportionate regulatory regime that identifies and addresses risk while facilitating more efficient regulatory compliance” (Arner et al., 2016, p. 371). An IT-based regulatory monitoring system will assist in the compliance program implemented in the organization. This way, day-to-day operations and transactions can be safely and effectively monitored by using data-based analytics systems.

Ethical behavior is expected at all times among compliance officers, as their job depends upon a total commitment to moral conduct. Ethics training will be a priority for employees so that it is clear to all what right and wrong courses of action are. One area that will have to receive special focus is the monitoring for criminal activity, as casino operations are cash intensive and vulnerable to criminal exploitation (FATF, 2009).

Governance Structure

Governance is provided by a board of directors, which directs the managers in the company (Bukhvalov & Bukhvalova, 2011). The Board is responsible for overseeing the entirety of operations, but its role is mainly to provide guidance and direction—not to police or to manage. The Board delegates the authority to manage to the management team. The management team is responsible for implementing the vision and strategy developed by the Board.

The management team must assemble the appropriate working party and reference groups, for supplying training materials and tutorials, models and supplies, and monitoring systems. Reporting systems are critical to the success of the organization, and a hierarchical assembly of authority is needed so that information flows up to the Board and back down through management to the assembled teams and workers. Communication between management and the Board and between management and the working parties should involve a two-way flow so that directives are not lost, oversight is maintained, and performance goals are met.

The audit committee should be comprised of an independent group capable of auditing systems and reporting to the Board. This committee is of particular importance in the realm of compliance. Without this committee, compliance standards may not be met; thus, the audit committee deserves special focus.

The Audit Committee

One of the most important elements of governance structure is the audit committee. The audit committee should consist of individuals who are independent from the company board. The Sarbanes-Oxley Act of 2002 mandates that this be so for public companies, but it is good governance practice for any organization, as it puts investors at ease and avoids conflicts of interest. The audit committee is responsible for auditing IT, security, controls systems and operations. The audit committee is separate and distinct from anyone involved in upper management and whenever an auditor is used within the organization, the auditor reports directly to the audit committee. The audit committee should be given its own budget and should pay for external auditing out of this budget. This ensures that an ethical system of governance is in place.

There are three principles that should guide the audit committee. First, it must have absolute independence from the company’s board and managers and must not be constrained in any way, by any gesture, or by any input when it comes to auditing the company’s operations. Second, it must know that its purpose is to ensure the integrity of the company’s accounting by conducting a truly effective audit. Third, its members must refrain from establishing close ties with other members of the company, at any level. The audit committee is in charge of protecting the honesty of the company, and for that reason separation from the company’s employees and managers is crucial.

Roles and Responsibilities

The role of the Board is to determine the vision of the organization, the strategy to be implemented, and the goals that must be obtained. The Board passes on to management the responsibility of implementing this vision. Management directs operations and polices actions internally so as to keep the business operations in line with the goals of the Board. Workers report to management, and management reports to the Board.

Because of the need for transparency, honesty and integrity in the casino business, the audit committee is responsible for auditing and overseeing the integrity of operations. It is independent of every member of the organization and operates on its own budget. It reports its findings to the Board, which then proceeds with making whatever adjustments are necessary to address situations. The Board reports to investors upon the state of the organization, similarly to what is found in a public company: quarterly reports comprised of audited financials, forward guidance, and going concerns will be made available to investors.

Interfacing with Compliance

The Federal Reserve Bank of San Francisco defines economic capital as “the amount of risk capital, or equity, needed to cover possible unexpected losses that might arise from an institution’s risk exposures” (Lopez, 2010). Measuring exposure to risk requires a consistent and perpetual assessment of the business’s internal capital. Unexpected losses have to be delineated as part of a risk management strategy. Expected losses do not figure into these assessment processes, as they are part of the overall calculations of business activities. For the casino, operations should be managed in the same way operations are managed in a financial institution: “economic capital measures can be used to generate risk-adjusted profitability measures. They can also serve as inputs to decisions regarding whether to expand or contract specific business lines” (Lopez, 2010).

For that reason, economic capital should be based on exposure to risk. Proper risk management ensures that “economic capital models encompass possible losses arising from defaulted loans (credit risk), financial market fluctuations (market risk), and business operations (operational risk)” (Lopez, 2010). Two methods of measuring risk are quantitative approaches and qualitative approaches. Quantitative approaches are useful for managing economic risk. Qualitative approaches are useful for monitoring and managing concentration risk and legal risk (Lopez, 2010). According to the Federal Reserve Bank of San Francisco, “quantitative approaches attempt to characterize the entire distribution of potential losses and can generate several risk measures. The most common are value-at-risk (VaR) and expected shortfall (ES)” (Lopez, 2010). VaR helps management to determine a measure of the potential for losses with a certain degree of confidence. ES provides a measure of potential losses beyond that confidence threshold, i.e., extreme losses—and “both measures have advantages for business-line risk analysis” (Lopez, 2010). However, neither can ensure aggregation across business lines. To compensate, individual risk measures can be applied to facilitate more complete organization-wide capital calculations: “aggregation using weights derived from a correlation matrix of the various risk types provides greater flexibility for measuring diversification benefits” (Lopez, 2010). Nonetheless, data quality will always be a deciding factor in determining risk.

Validating economic capital calculations is the next step in interfacing with compliance. The audit committee will be instrumental in this process. But managers must be able to understand the limitations of economic capital calculations and how to document these calculations for review. Supervisors will be tasked with overseeing internal validation processes, using quantitative and qualitative reviews. The audit committee provides support as it represents the organization’s ability to conduct “internal audits by institutional staff not involved in design and implementation of economic capital models” (Lopez, 2010).

Quantitative approaches that will be used with the casino include comparison of model inputs, by identifying correlations between historical data or industry-wide benchmarks. Industry surveys can be used in benchmarking to enable the casino to compare its own internal economic capital calculations with data from industry surveys, studies, and third-party vendor models. Backtesting will enable the casino to compare observed losses with forecasts of potential losses according to the economic capital model applied.

Qualitative approaches that will be used with the casino include content analysis of documents pertaining to legal regulations, applications within the casino’s own internal regulatory surveillance system, and assessment of concentration risk. Concentration risk is a banking term, but it applies for the casino in terms of not allocating too much capital to one single enterprise. Because the casino boat must dedicate less than 50% of its space to gambling, concentration risk should be offset by allocating sufficient capital towards providing a majority of its space to alternative forms of entertainment, dining, and other activities.

Risk Mitigation Strategies

Stress Tests

Stress tests are an important component of managing risks. These are conducted regularly to ensure that the organization has sufficient capital for operations during times of economic or financial stress. The Federal Reserve (2020) provides a model stress test, which assesses “capital adequacy, internal capital adequacy assessment processes, and their individual plans to make capital distributions.” To this end, the casino must adhere to the following points:

First, the casino must assess the anticipated uses of capital and the sources from which capital will be obtained for all four quarters of the fiscal year. The plan for this capital must consider assets on hand, the risk profile developed for compliance, and the degree to which operations are expected to develop in terms of scope and complexity. Given the nature of the entertainment, dining and gambling business of the casino boat, these operations will contain a high degree of complexity.

Second, the casino must clearly provide definition of its capital adequacy.

Third, the casino must clearly define the capital policy that the Board chooses to pursue, including allocation of funds for assets, for reserves, for costs of operations, and so on.

Fourth, the casino must clearly describe alterations to business operations planned for the foreseeable future as these alterations will impact liquidity and may require capital adjustments.

The casino’s financial data, management procedures and processes, and policy requirements will all factor into the stress test assessment. A baseline will be developed for assessing the degree to which stressful scenarios affect the casino’s planned operations for the upcoming fiscal year. The test will incorporate four full quarters’ worth of projected revenues, losses, and capital ratios for every scenario tested throughout this assessment.

Extreme Value Theory

Extreme Value Theory (EVT) will provide the casino with a way to assess extreme events and develop proper mitigation techniques so as to better prepare for them (Gilli & Kellezi, 2006). EVT makes it possible for the casino to calculate extreme risk measures through analysis of probability distributions. A random sample of variables is used to determine whether potential events may be discerned as more or less extreme than other events. The purpose of EVT is to calculate breaking points for the casino.

In EVT, it is critical to define accurately what might constitute an extreme nature event. Because of the complexity of operations in a casino boat, numerous variables must be identified and used in EVT assessments. By ordering a set of vectors, subjective interpretations of the parameters of distribution are inevitably necessitated. Controls can be applied to limit the degree to which subjective analysis is conducted. Nonetheless, EVT is useful for assessing loss distribution, catastrophe modeling, capital management and operational risk management in extreme scenarios.

Measuring Operational Risk

Operational risk focuses on people risk, systems risk, process risk, external events risk, and legal/compliance risk. People risk refers to risk associated with human capital performance and human resources management. Proper hiring, training, monitoring, evaluating, and managing is used to mitigate people risk. Process risk refers to risk associated with internal business processes that might lead to financial loss or negative performance. This risk may be mitigated by monitoring of internal business processes via the audit committee as well as active engagement of consumers via social media, which represents a method of maintaining strong consumer relations. Systems risk refers to risk associated with internal systems, such as IT, security, surveillance, backup systems, and so on. Mitigation of this risk is conducted by stress testing systems routinely. External events risk refers to events outside the control of the casino, including natural disasters, robberies, attacks, and so on. Mitigation is conducted by developing a disaster plan and response system. Legal/compliance risk refers to risk associated with non-compliance with both internal and external regulations. The audit committee and compliance officers are responsible for mitigating risk in this department, by assessing finance operations, tax laws, ethical conduct, anti-money laundering laws, etc.