Lottery Contract Snafu Costs State Millions

The state’s mishandling of a lottery computer contract has added $44 million to the price tag for a new customer-friendly ticketing system--and may have cost California’s financially strapped schools as much as $113 million in anticipated revenue, legal documents and interviews show.

The computer snafu stems from a contract cancellation ordered by former Lottery Director Sharon Sharp that has resulted in a costly legal settlement and a two-year delay in the introduction of the new technology--now set for next June.

The contract was part of a long-range strategy to entice more people to play the lottery by making it more convenient. The idea was to create thousands of new ticketing outlets by developing low-volume terminals for mom and pop businesses that hadn’t had the customer traffic to justify the high cost of ordinary on-line telephone hook-ups.

In addition, for Scratcher players, the contract would provide for computerized validation that would allow small winning tickets to be cashed at any outlet in the state. Scratcher tickets now can be cashed only at the places they were purchased.

Lottery officials estimated that the Scratcher changes alone will increase Scratcher sales by about 30%. Using that percentage, they calculated that California schools would have reaped an additional $113 million had the new system been in effect for the last two years, as originally planned. At least 34% of lottery revenues must go to public schools. Another 16% goes to administration and the remaining 50% to prizes.

But one year after the contract was awarded to the Sacramento-based High Integrity Systems Inc. in March, 1992, Sharp suddenly announced its cancellation, contending the company had failed to deliver the system as promised.

Company officials angrily denounced the decision, saying it was lottery foot-dragging and constant change orders that had prevented it from going into operation. Both sides sued each other.

Now, after spending $7.2 million on legal expenses, the lottery has settled the lawsuits and reinstated the contract in an agreement that several lawyers see as a resounding victory for the company.

Costs Shifted to State

An examination of the settlement shows that not only did it give more favorable terms to High Integrity Systems, it also forced the state to pay $36.8 million in costs that it had not been required to pick up under the original agreement.

Officials said the new agreement requires the lottery to make an immediate payment of $25 million to the company for hardware, software and terminals; purchase two mainframe computers estimated to cost a total of $2.3 million; pay telecommunications costs expected to run $130,000 a month--or $8.5 million over the life of the contract--and reimburse the company an estimated $1 million for upgrades needed because of the two-year delay.

Lottery administrators acknowledged that all of these costs were absorbed by the company in the original contract. The original five-year contract required High Integrity Systems to absorb all costs for the 6,700 terminals and other computer equipment needed to run the new system and the installation costs. The company would recoup the costs and make a profit by earning a percentage of the sales.

But the administrators said they believed they had been right in accepting the settlement because it freed them from a costly, time-consuming lawsuit that had prevented the lottery from moving forward with technological advances that would increase its revenues.

“This decision makes the best sense for the lottery to meet its business needs and to fulfill its role to maximize revenues for public schools,” Interim Director Del Pierce said in a written statement. “We would rather spend our efforts on sales enhancements and providing better service and convenience to our players than on continuing to litigate this matter.”

Officials would not discuss the possible damages that might have been assessed against the state had the case gone to trial, but documents show they could have been substantial. “As I stand here, the lottery faces a potential liability to High Integrity Systems exceeding $100 million,” company President Tony Stefanis warned the lottery in May, 1994.

McGeorge School of Law professor Claude Rohwer, an expert in contracts, said the trial outcome would have been hard to predict because of the way the contract was written. He said it was impossible for him to determine the legal obligations of either side.

“This was the most poorly drafted document I have ever looked at in my professional career,” said Rohwer, who examined it several years ago for High Integrity Systems. “If a student turned in that document as some work product . . . I’d flunk them.”

The unexpected expenses have hit the lottery as it celebrates its 10th anniversary and struggles to rebound from a crushing drop in revenue. After soaring to an all-time sales record of $2.6 billion in 1988-89, revenues began to slide and finally hit bottom in 1991-92 when they fell to $1.3 billion. Since then they have slowly been increasing, rising to $2.1 billion in 1994-95.

The lottery is the latest agency to become enmeshed in computer contract problems that have ended up costing the state millions of dollars. A year ago technological problems forced the Department of Motor Vehicles to abandon a computer project after spending $50 million. Later, the state auditor issued a report warning that a new computer system at the Department of Social Services will ultimately cost about $1 billion--$455 million more than originally estimated--and may not be able to deliver all that was promised.

Two legislators familiar with the lottery’s computer problem said the settlement once again raises serious questions about an agency’s handling of a computer project and in this instance about the decision to cancel a contract.

“How can we become so numb that a $44-million cost overrun . . . goes un-addressed. This is unbelievable. They have spent almost as much on legal expenses as the government has spent to prosecute O.J. Simpson and at least that trial was televised,” said Sen. Tom Hayden (D-Santa Monica), a frequent critic of lottery operations.

Assemblywoman Debra Bowen, (D-Marina del Rey), a lawyer and chairwoman of the Budget Subcommittee on Information Technology, said the reinstated contract appears to be such a step backward for the lottery that she can only speculate that additional costs absorbed by the state are really an attempt to compensate the company for a wrongful termination.

“It’s possible that given the exposure from previous wrongful acts that this is better than the alternative of paying a cash settlement, but I object to dressing a lawsuit settlement in sheep’s clothing,” said Bowen, who examined the two contracts. “I think we need to be honest about what we’re doing here.”

She said the settlement is the kind of agreement that has gotten the state into problems with other computer systems because it requires the lottery to assume more risk and places no penalties on the company for late deliveries or failure to meet goals. “In other words, the vendor here has only an upside and no downside,” she said.

New Contract Criticized

Lottery spokesman Jeanne Winnick argued that the contract is not one-sided because the state by the $25-million payment would gain the advantage of being able to take early ownership of about 6,000 terminals provided by High Integrity Systems.

But Bowen said that was no advantage in the rapidly changing world of computer technology, where innovations become obsolete so quickly that “you’re better off if you don’t have title” to computer equipment.

She said the best contracts are those that require a company to pay all the upfront costs for equipment and technology and then enable it to earn its return through a percentage of sales--a concept the lottery used when it negotiated a $400-million contract for its GTECH on-line system and in its original contract with High Integrity Systems.

Under the new agreement, High Integrity continues to earn a percentage of sales--5% instead of the original 4.9%--but it also shares upfront costs with the state.

Lottery administrators refused to discuss the contract cancellation because it was a “decision of a previous administration.” Reached in Chicago, former Director Sharp also declined to discuss the contract, saying she was not aware of the latest developments and “I think common sense prevents me from commenting.”

However, Lottery Commission Chairman Daniel Apodaca, one of two commissioners who endorsed both the original decision to cancel the contract and the move to reinstate it, insisted the lottery’s actions were appropriate. The termination seemed the only option in 1993, he said, because High Integrity Systems had not performed even after several time extensions.

Asked why the lottery would reinstate the contract of a company that had not performed, he said High Integrity Systems officials have “promised us and guaranteed to us” that they can now meet the lottery’s requirements. He said “good business sense” almost forced the lottery to settle or face more delays and loss of revenue.

“There is no question if [the company] had come through and delivered the way the original contract called for,” he said, “they would have been in better shape and the lottery would have been in better shape.”

Ron Cohan, an attorney for High Integrity Systems, a subsidiary of the Georgia-based Equifax Inc., declined to reply to the criticism, other than to say his client was “very pleased . . . to have an opportunity to renew a relationship with the lottery.” He estimated that the new system would be operational by early summer.

Sharp made the decision to cancel High Integrity’s contract in April, 1993, and then six months later recommended that GTECH--the company that runs the lottery’s computer-operated games such as Super Lotto and Keno--be given a portion of the job. But that proposal was rejected by the Lottery Commission.

Two months later, Sharp resigned under pressure from the office of Gov. Pete Wilson, who expressed concern about the lottery’s contracting process. After her departure, the state’s auditor weighed in on the issue, finding that the bid specifications on another multimillion-dollar computer contract awarded during Sharp’s tenure were so restrictive that only GTECH could meet them.

After Sharp left the lottery, many of her top-level administrators, including those who drew up the original High Integrity contract, were replaced. Bob Silva--the official named by Sharp’s successor to take over management of computer operations--said he spoke with lottery officials who were there at the time to form his own opinion of how the contract was managed.

The lottery “had very poor project management at that point in time, that’s my interpretation,” he said. “I only hear stories of what happened in ‘92-’93 but it was a terrible way to run a ship. . . .”

But Silva said he was confident that under current lottery management the new system will work.

Lottery spokeswoman Winnick said the additional cost of the High Integrity contract will be paid out of administrative funds.

She said it is not expected to require cutbacks in other areas because lottery revenues have been increasing steadily in the last few years.

The introduction of new games and the accumulation of several big jackpots have caused sales to rise from the $1.3 billion all-time low to $2.1 billion for the 1994-95 year. In the fiscal year that began July 1, revenues are expected to climb to $2.4 billion.

Lottery Chairman Apodaca is pleased that work has begun under the new version of the contract. “Education was not getting what it should have been getting while the lawsuit was going,” he said. “. . . We figure there has certainly been a lost opportunity.”