Analysis: What To Make Of SEC, IRS Investigations Into DraftKings

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Before DraftKings announced its blockbuster acquisition of Golden Nugget Online Gaming, the company released its second-quarter results and mentioned an interesting development in its Securities and Exchange Commission (SEC) filings.

Following the earnings release this month, company CEO Jason Robins told Barron’s that the company is on the path to “profitability in a state in a two-year to three-year time horizon. And profitability will grow from here.”

While the prospect of future profitability undoubtedly has investors excited, there remain some dark clouds hanging over DraftKings.

Old problems back for DraftKings?

As reported in the company’s 10-Q, the quarterly report revealed the presence of two inquiries: the first was a subpoena from the SEC and the second is the declaration that the company is being audited by the IRS.

The company reports that the SEC investigation stems from the release of the June 15 report from short-selling focused Hindenburg Research.

The Hindenburg report was followed by several lawsuits from prominent plaintiffs’ firms filed in the Southern District of New York. The lawsuits alleged primarily that DraftKings violated sections 10(b) and 20(a) of the Securities Exchange Act.

What are those sections?

Section 10(b) is the securities law provision that is frequently associated with insider trading, though that is only one subsection of the rule. 10(b) effectively criminalizes a fraud associated with buying or selling securities.

Section 20(a) of the Securities Exchange Act allows private citizens (as opposed to the government) to bring an action against someone who acted on insider information.

The lawsuits remain at very early stages, having only been filed at the beginning of July.

The SEC investigation

The DraftKings 10-Q states that the SEC is seeking documents in association with some of the Hindenburg report’s allegations.

Amongst the allegations in the Hindenburg report that could be within the scope of the SEC inquiry are:

Should these acts be found to have occurred, it could make the sales of a reported $1.4 billion in shares by insiders problematic. Of course, none of these allegations have been proven and an SEC request for documents appears to be a preliminary fact-finding endeavor.

The DraftKings take

The company noted that they are cooperating with the SEC investigation. It is worth noting that it is not uncommon for allegations in short-seller reports to send regulators down a path to conduct a preliminary investigation.

However, the company did state that it:

cannot predict with any degree of certainty the outcome of these matters or determine the extent of any potential liabilities. The Company also cannot provide an estimate of the possible loss or range of loss. Any adverse outcome in these matters could expose the Company to substantial damages or penalties that may have a material adverse impact on the Company’s operations and cash flows.

They also noted they do not believe the outcome of the SEC investigation will have a serious impact on the company’s financial condition.

More about IRS investigation of DraftKings

Joining the discussion of the “Securities Matters” in the DraftKings 10-Q report was a one-paragraph note on an IRS audit for previous years’ taxes.

The company revealed that the primary issue is relating to the payment of the federal gambling excise tax as it relates to the company’s fantasy sports operations.

The company said

The final resolution of that audit, and other audits or litigation, may differ from the amounts recorded in these consolidated financial statements and may materially affect the Company’s consolidated financial statements in the period or periods in which that determination is made.

The IRS audit seemed to be a foregone conclusion after the tax agency released their memorandums detailing the organization’s belief that daily fantasy sports contests constitute gambling for purposes of the federal gambling excise tax of .25 percent on legal wagers and 2 percent on illegal wagers.

Unlike state taxes on gambling operators, the federal tax applies to handle, not revenue.

Why do these investigations matter?

While these investigations undoubtedly could have an effect on the companies share price or value because they would impact investor sentiment, the bigger impact could be felt if these allegations are substantiated and viewed negatively by state regulators.

The permissive nature of gambling licensure requires that companies maintain nearly spotless records. This has been one of the factors that keep offshore companies, even those who have renounced accepting American money, from getting licensed.

It is unclear just what action regulators would take in the event either of these investigations turns out poorly for DraftKings, but as we are often reminded, the fact that this is a state-by-state regulatory environment means different regulators could take different approaches.

The preliminary nature of these investigations means that we are a long way from knowing how things will turn out and various results including findings that no wrongdoing occurred are possible, but in the event that one or both agencies make negative findings the company’s licenses could face review.