Something Seems Amiss with the 38 Studios Lawsuit

The lawsuit that the state of Rhode Island filed against Curt Schilling, some of his former 38 Studios employees, and the top members of the Rhode Island Economic Development Corporation (EDC)—the quasi-public agency that approved the 38 Studios loan for the state—is nearly 100 pages long. But I think I can sum up the allegations in two bullet points:

1. Schilling, 38 Studios, and top EDC brass willfully deceived the EDC board of directors, the people who actually voted on whether or not to issue 38 Studios the loan.
2. The EDC board of directors are total morons.

The state actually only makes the first argument in the lawsuit, but the second is implicit. A little background on the downfall of 38 Studios and how such a company could get a $75 million loan: The EDC board of directors is a 13-member body made  of a handful of top Rhode Island leaders and business-people, volunteering their time to help improve the state’s economy. At the time that the 38 Studios loan was approved, “None of the board members were experts in law, lending, video gaming, or economic development,” the lawsuit helpfully points out. Despite not having any expertise that could have actually been useful in this situation, these people, in their own rights, were very successful. We’re talking about the president and CEO of Rhode Island Hospital, the chairman of a medical device company, the president of the University of Rhode Island—people like that. Presumably they are not idiots. And yet, Rhode Island’s lawsuit hinges on the notion that they believed everything that 38 Studios and the EDC’s professional staff told them and never even asked a single hard question in response.

For instance, it is standard EDC practice, when doing a deal, to prepare something called an “internal credit memoranda,” which essentially assesses how risky the deal is. But according to the lawsuit, while making the memo for 38 Studios, an EDC analyst had a hard time getting info from the company: “The only numbers I have seen to date are the hard copy of what they presented in the various meetings,” the analyst wrote in an email. “To be honest, I have more information on the typical $10k micro loan than I have on a $75 million request. This is a problem.”

Finally, the analyst told the EDC deputy director Michael Saul, “I don’t think I can support a $75 million guarantee to any single company in this industry due to the wide volatility in commercial success of game releases.” According to the lawsuit, from there, Saul put the kibosh on the internal credit memo and it was never delivered to the board.

Now hold the phone: The EDC board never received the basic document assessing whether or not the loan was a good idea and still went through with the vote to approve it? Something here doesn’t smell right. If the internal credit memo was as fundamental as the lawsuit would have you believe, it makes no sense that the EDC board would vote to direct $75 million to a company without seeing it.

Another case of this comes up with 38 Studios’ agreement with IBM to serve as a third-party monitor. Basically, in order to make sure Schilling’s company was on track, Rhode Island wanted to put in place a watchdog. That watchdog would be IBM. But according to the lawsuit, IBM would only agree to do it if it contracted directly with 38 Studios, not with the state of Rhode Island. You can see how that might lead to problems: it’s never a good thing when the watchdog is getting paid by the company it’s supposed to be watching (recall how this worked out for big banks and the credit rating agencies). The lawsuit alleges that EDC board members were surprised to find out that it was 38 Studios, and not Rhode Island, that would be paying IBM. That’s because, apparently, the language in the original bond documents misleadingly indicated that IBM would directly contract with the state. According to the suit, “On November 2, 2010, the Closings [on the bonds] took place without an Initial Assessment in hand and without an adequate third-party monitoring system in place.”

But here’s the thing, on the same day, November 2, EDC Director Keith Stokes (named as one of the defendants) also signed off on an agreement with 38 Studios over IBM. The document clearly states that 38 Studios would be paying IBM to keep watch on it. It is hard to believe that members of the EDC Board did not know about this agreement. It was on the public record, after all. Less than a year later, the EDC amended its agreement with 38 Studios, so that IBM no longer had to deliver written reports to the state, just oral briefings. Apparently 38 Studios was worried about secrets from their game leaking—either that or they figured, the less oversight, the better. Did the EDC board not know about that either? How asleep at the wheel were these guys?

Apparently, the answer is totally.