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- The Lottery Has Not Provided Required Funding to Education
- The Lottery’s Procurement Practices Do Not Always Ensure That It Obtains the Best Value
- The SCO Has Not Effectively Overseen the Lottery’s Performance
- Other Areas We Reviewed
The Lottery Has Not Provided Required Funding to Education
- The Lottery failed to provide $36 million in funding to education in fiscal year 2017–18 because it did not budget to adhere to the proportionality requirement in the Lottery Act.
- Despite a requirement to maximize funding for education, the Lottery does not have an up‑to‑date analysis of the optimal balance between prize payouts and education funding. In other words, the Lottery does not know whether the prizes it offers result in the most possible funding for education.
The Lottery Failed to Meet a Critical Requirement for Education Funding
Lottery Act Requirements for
The Lottery must do the following:
- Increase funding in proportion to any increase in net revenue.
- Maximize total net revenue allocated to education.
- Provide at least as much funding to education annually as the average of the past five fiscal years.
Source: The Lottery Act.
As illustrated in Figure 1 in the Introduction, in 2010 the Legislature adjusted the requirement for how much of its revenue the Lottery is required to provide to education. Before these changes to the law, the Lottery Act required the Lottery to provide a specified percentage of its revenue to education. The 2010 changes placed the Lottery under less prescriptive requirements, which the text box describes. It is critically important that the Lottery adhere to these requirements because they are safeguards that ensure that the Lottery’s education funding increases as the Lottery’s revenues increase and that the education funding is at its highest possible level and does not decline sharply from one year to the next.
Despite their importance, the Lottery has not ensured that it follows all of these requirements, and as a result, it failed to provide $36 million to education. As we discussed in the Introduction, since fiscal year 2015–16 the Lottery Act has required the Lottery to increase its annual education funding in proportion to the increases in its net revenues—which we define as total sales revenue minus the Lottery’s administrative and operational expenses. If the Lottery had adhered to this proportionality requirement, it would have provided education with $36 million more than it actually provided during fiscal year 2017–18. We calculated this dollar value by reviewing the changes in the Lottery’s net revenues, determining the education funding that would have resulted from an increase in proportion to the change in net revenues, and then comparing that to the actual amount the Lottery provided to education. As Figure 2 shows, the Lottery exceeded its required education funding in two fiscal years where the proportionality requirement was applicable, but it also failed to provide the required funding in the other year.
The Lottery Has Not Met Required Education Funding Levels, Totaling $36 Million in Funds That Did Not Go to Education
Source: State law, audited financial statements from the Lottery fiscal years 2015-16 through 2017–18, and unaudited financial data from fiscal year 2018–19.
* The Lottery is required to match growth in total net revenue only in fiscal years where net revenue has increased from the previous fiscal year. In fiscal year 2016–17, net revenue had decreased so the Lottery did not need to match growth.
In response to our conclusion about its education funding, the Lottery’s deputy directors of finance and business planning stated that the Lottery does not believe that the 2010 changes to the Lottery Act require a direct proportional relationship between net revenue and education funding. We disagree with the Lottery’s interpretation and believe that the Lottery has not accepted the commonly understood meaning of proportionality. Under its interpretation, the Lottery could satisfy the proportionality requirement by simply raising the amount of education funding by a small fraction of the increase in its total net revenue rather than the maximum amount.
According to these deputy directors, the Lottery believes it has met the intent of the 2010 changes to the Lottery Act by increasing the gross dollar amount of its annual funding for education. They argued that the Lottery is able to provide this higher level of funding because of the larger percentage of its revenue it is now allowed to devote to prize payouts. These deputy directors shared their belief that if the Lottery reduced the amount of revenue it directs to prize payouts, players would reduce their spending on lottery products, and therefore total revenue and the amount available to direct to education would decline. Based on the experience of the Lottery and documentation we reviewed related to lotteries in other states, the relationship between increased prize payouts and increased sales revenue that the deputy directors shared with us seems correct. However, as we discuss in the following section, the Lottery has not determined whether its current prize payouts are at an optimal point.
Changes to the Lottery Act are needed to align the Lottery’s education funding with both the requirements and the intent of the 2010 amendments to the Lottery Act. Although it was initially passed by the voters as a ballot proposition, the Legislature can amend the Lottery Act under certain conditions. To amend the Lottery Act, the Legislature must approve a bill with at least a two‑thirds majority vote and the amendments must further the purpose of the Lottery Act. First, the Legislature could require the Lottery to pay the $36 million that it failed to provide to education. As described in the Introduction, the Lottery is allowed to allocate 13 percent of its revenue for operational and administrative costs. The Lottery does not carry a fund balance from year to year, and the only other categories of spending are its prize payouts and its education funding. Therefore, the Lottery has only two cost categories from which it can pay the $36 million: prize payouts and its administrative allowance. We believe a requirement to pay the $36 million from the administrative allowance provides the best balance between reimbursing education the funding it is owed and allowing the Lottery to continue managing its prize payout amounts in a way that maximizes its current year revenue. The Lottery’s operational and administrative costs include costs that are directly linked to overall sales, such as its retailer compensation. Because of this, the Lottery would likely need to repay the $36 million from the portion of its administrative allowance that it reserves for its own operations. In its fiscal year 2019–20 budget, the Lottery estimated that it would spend about $279 million on its operations.
Further, although we do not believe the proportionality requirement is unclear, to ensure that the Lottery understands its obligations under the law and adheres to the 2010 amendments, the Legislature could amend the Lottery Act to further clarify the proportionality requirement. As we previously indicated, the Lottery’s deputy directors believed that the 2010 amendments to the Lottery Act did not require a directly proportional relationship between its net revenue growth and its funding for education, a position that we do not agree with. A change to the Lottery Act to specify that education funding must grow at a rate identical to the rate of growth in total net revenue would make clear the expectations for how education funding should increase in response to such gains. The changes we recommend would be consistent with the earlier Legislative intent to increase and maximize the lottery net revenues that the Lottery provides to education. Because of that, in our view, such amendments to the Lottery Act would also be consistent with the purpose of the act.
The Lottery Has Not Prioritized Funding to Education When Setting Its Budgets
The Lottery has not funded education at the required level in part because it has not used a budgeting process that is designed around meeting the Lottery Act requirements. The Lottery Act requires the Lottery Commission to establish the percentage of its total annual revenues that it will allocate to education at a level that maximizes total net revenues for education. The Lottery Act also requires the Lottery to maximize education funding, which is a requirement that the Lottery can only meet by knowing that it is providing the most possible funding to education every year. Therefore, it is essential for the Lottery to annually determine what the optimal balance point is between prize payouts and education funding. Since the 2010 amendments to the Lottery Act, the Lottery’s total operating revenue has increased by 115 percent and its funding to education has increased by 66 percent. In addition, the Lottery has decreased the proportion of total sales revenue that it directs to education from 33 percent in fiscal year 2010–11 to between 24 and 25 percent in fiscal years 2016–17 through 2018–19. Given the requirements in the Lottery Act, as well as the significant decrease in the overall percentage allocated to education, we expected that the Lottery would be able to explain how it determined that between 24 and 25 percent was the portion of its total revenue that ensures that it maximizes education funding based on the optimal balance point.
When we asked the Lottery to provide its determination of the optimal balance point, the deputy directors stated that the Lottery contracted with a consultant to determine whether increased prize payouts would increase overall revenue. The consultant’s study concluded that increased prize payouts would increase revenue and also contained an estimated optimal balancing point between prize payouts and education funding. The consultant delivered the results of that study in January 2010—making it now a decade old. In the study, the consultant identified the optimal prize payout percentage as 62 percent of the Lottery’s total sales revenue, which at the time represented about a 10 percentage point increase to the percentage that the Lottery allocated to prize payouts. In addition to being 10 years old, the consultant’s determination about the optimal prize payout percentage is based on assumptions that are likely no longer valid. For example, when calculating the optimal prize payout percentage, the consultant assumed that the Lottery’s administrative costs would equal 13.5 percent of its total sales revenue—an amount that exceeds the current legal limits by one‑half of a percentage point. The deputy director of business planning shared with us a statement from that consultant that confirmed that the study would lose validity as it became older. In other words, the consultant acknowledged that the study would have less relevance as it aged.
Despite these problems with the consultant’s study, according to the deputy directors of finance and business planning, it is the only study of this type that the Lottery has performed to establish an optimal balance point between prize payouts and education funding. Accordingly, we assessed whether the Lottery had adhered to the consultant’s identified optimal prize payout percentage when setting its budgets since fiscal year 2015–16 and found that it has not. Specifically, in its budgets for fiscal years 2015–16 through 2019–20, the Lottery has held the percentage of its total annual revenue that it budgets towards prize payouts at about 64 or 65 percent, or approximately 2 to 3 percentage points higher than the optimal prize payout percentage identified by its consultant. In terms of dollars, this means that the Lottery had planned to pay out in prizes between about $110 million to $248 million more per year than the consultant’s study indicated it needed in order to maximize revenue for education. In fiscal years 2015–16 through 2018–19, the actual percentage of total revenue paid in prizes was within about 1 percent of the budgeted percentages.
Because of the significant difference between the consultant’s study and the Lottery’s actual planning, combined with the fact the study is outdated, the Lottery must perform a new analysis to know whether it is optimally balancing prize payouts and funding for education, and therefore fulfilling the mandate in the Lottery Act to maximize education funding. The deputy directors believe that the consultant’s study is still relevant to current economic conditions. However, as we describe earlier, the Lottery has not adhered to that study’s optimal prize payout percentage when setting its budgets. The deputy director of business planning also stated that it was difficult to apply an optimal balancing point in large part because of the unpredictable nature of large multistate jackpot games in which the size of prize payouts—and therefore player participation in the games—is not controlled. Although we acknowledge the unpredictable nature of these games, during its budget setting process the Lottery makes assumptions about the revenue it will receive in an upcoming fiscal year and the prizes it expects to pay out. Therefore, at a minimum the Lottery is able to plan to achieve a prize payout percentage that would provide the maximum amount of funding to education. Until the Lottery determines the correct percentage, California will not know whether education is receiving all of the funding from the Lottery that it should and the Lottery Commission cannot ensure that it is meeting the intent of the Act.
Further, the Lottery’s budget process does not ensure that it is adhering to the proportionality requirement because it does not budget its funding for education to increase in proportion with increases from the previous fiscal year’s net revenue. We expected the Lottery to be preparing its budgets in such a way as to identify any increases the Lottery expects to experience in net revenue from the previous fiscal year and then plan to increase the amount it provides to education in proportion with those net revenue increases. If the Lottery began its budget process with a review of the expected year‑to‑year changes in its net revenue, it could accurately determine how much it would need to provide to education in the upcoming fiscal year to satisfy the proportionality requirement. However, the Lottery’s budget process does not include such a step.
The Lottery’s deputy director of finance stated that the budgeting process begins with a discussion of the education funding goal the Lottery would like to meet for the upcoming fiscal year. However, the Lottery could not provide evidence that its goal is informed or determined by a review of the requirements in the Lottery Act. Further, this assertion contradicts the statements the deputy director made over the course of the past few fiscal years when he presented the Lottery’s budget to the Lottery Commission for consideration. In multiple years at Lottery Commission meetings, the deputy director explained to the commission that the Lottery’s budget development process begins with his budget team meeting with each of the Lottery’s divisions to develop a division‑specific budget for administrative expenditures. When we questioned the deputy director on the discrepancy between these statements, he explained that he did not see the two processes as mutually exclusive, and while the Lottery is establishing and refining its education goal for the coming year’s budget, his budget team is holding meetings with each Lottery division to discuss their estimated administrative expenditures.
Although it does not begin each fiscal year’s budgeting process with a goal for education funding, the Lottery has a long‑term goal to contribute $2 billion to education in fiscal year 2020–21, which is a 7 percent increase from the amount it provided in fiscal year 2018–19. The deputy directors of finance and business planning indicated the goal was not based on specific sales tactics that the Lottery expected would result in that amount of education funding nor on a specific formula that the Lottery uses when setting education funding goals. Rather, they explained that the Lottery’s staff selected the $2 billion amount because they believed it was a monumental goal that would inspire sales staff to increase revenue yet still be reasonable for the Lottery to meet in the given time period. Email correspondence from August 2018 shows that the Lottery believed this goal was achievable based on its recent performance. Specifically, the deputy director of business planning shared with others at the Lottery that based on the average growth in the Lottery’s gross dollar contributions to education, he believed that the goal of $2 billion in fiscal year 2020–21 was “not too far out of reach.” Although setting a goal for education funding is a positive step, the Lottery must ensure that it considers the Lottery Act’s requirements when it develops its goals. Moreover, the goal should be based on actual analysis rather than an inspirational goal without analytical support.
Because its budget process does not begin with the Lottery setting a specific target for education funding as would comply with the requirements of the Lottery Act, the Lottery is not properly planning to fulfill its sole purpose—to maximize the funding it provides to education. If the Lottery began by establishing a target for education funding that was informed by the Lottery Act requirements—to maximize funding for education and keep growth in education funding proportional with increases in net revenue—it would have a goal around which to plan when budgeting for its other expenses. For example, if the Lottery selected a funding target of $1.9 billion, it would plan its prize payouts to ensure that it meets that target. In addition to budgeting to meet the funding requirements, the Lottery would also need to regularly monitor its expenses and prize payouts to ensure that it is adhering to its budget and can meet the requirements by the end of each fiscal year. Until it adopts a budget process that includes setting a funding goal that is informed by the statutory requirements, the Lottery will likely continue underfunding education and undermining its own purpose for existing.
To ensure that the Lottery provides the required amount of funding to education, the Legislature should require that the Lottery pay—from its administrative expense category—the $36 million to education it should have provided in fiscal year 2017–18.
To ensure that the Lottery adheres to the meaning of the 2010 amendments to the Lottery Act, the Legislature should amend the act to specify that the relationship between increases in its net revenue and increases in its education funding should be directly proportional.
To ensure that it provides the maximum amount of funding to education in future fiscal years, the Lottery should do the following:
- By August 2020, determine the optimal amount of prize payouts that maximizes the funding for education.
- By August 2020, establish a policy to annually reconsider the optimal amount of prize payouts that maximizes funding for education.
- Use this optimal prize amount when setting its budgets, beginning with the budget for fiscal year 2021–22.
To adhere to the Lottery Act’s education funding requirements, beginning with fiscal year 2020–21, the Lottery Commission should require its staff to demonstrate that they have planned for education funding to be maximized and aligned with the proportionality requirement of the Lottery Act, and approve only those budgets that plan for such funding. It should then monitor actual education funding and ensure that it complies with the requirement.
The Lottery’s Procurement Practices Do Not Always Ensure That It Obtains the Best Value
- The Lottery did not ensure that it followed its regulations for noncompetitive agreements. In eight of the 15 procurements we reviewed—worth $5.7 million—the Lottery had inadequate justification for its decision to noncompetitively select its vendor.
- A lack of safeguards at the Lottery for noncompetitive procurements creates concern around all of the noncompetitive agreements it has entered into. Over the past three fiscal years, those agreements totaled $13.8 million in value.
- From fiscal years 2014–15 through 2017–18, the Lottery entered into 17 agreements with hotels—worth $720,000—for its retailer trade shows but cannot show that it evaluated other options before entering into these agreements. Several of these agreements contained excessive costs for food and beverages.
The Lottery Entered Noncompetitive Agreements Without Adequate Justification
Allowable Exceptions to the Lottery’s
Competitive Bidding Requirements
- An urgent and compelling need.
- An interagency or intergovernmental agreement.
- A master services agreement or multiple award schedule.
- After a good faith effort to identify vendors, a determination that only one viable source exists for the goods or services.
- Retention of legal counsel or a uniquely qualified expert.
Source: The Lottery Act.
The Lottery’s contracts development services unit (contracts unit) has not ensured that the Lottery follows its contracting regulations when it chooses to enter into agreements without competitive bids. As a result, the Lottery lacks a critical safeguard for ensuring that it always obtains competitive pricing, which is important because every dollar of its revenue that the Lottery spends on administrative costs is a dollar that it cannot provide to education. Lottery contracts must be approved by either the contracts unit manager, the Lottery’s executive director, or the Lottery Commission, depending on the dollar value of the agreement. The Lottery’s regulations generally require it to use a competitive bidding process for its procurements. For procurements valued at more than $100,000, the regulations require a formal process of publicly soliciting bids and announcing a selected vendor. For procurements valued at or under $100,000, the regulations prescribe an informal process but still require the Lottery to obtain multiple price quotes unless doing so is not possible. The Lottery’s regulations allow it to forgo these processes under certain circumstances regardless of the value of the agreement. In such circumstances, the Lottery must cite one of the allowable exceptions that we show in the text box. Before entering an agreement with a vendor, the Lottery’s divisions submit procurement justification memos to the contracts unit that explain the steps the division took to identify the preferred vendor and, if relevant, explain the reasons why an exception to competitive bidding is applicable.
We reviewed 15 of the Lottery’s purchase orders and contracts from fiscal years 2016–17 through 2018–19. Among these agreements were eight in which the Lottery did not use its formal or informal competitive bidding process. As Figure 3 indicates, we found that for all eight of these agreements—valued at a total of $5.7 million—the Lottery cited an exception to its competitive bidding requirements without adequate documentation showing that it had adhered to its regulations. The largest of these procurements was a $4.6 million contract with an existing IT vendor to upgrade the Lottery to a newer version of the vendor’s financial software. The Lottery did not use competitive bidding to identify the financial software it would use, and when it decided not to formally consider other software options, it cited two reasons why it believed that switching to another product was not cost‑effective: the cost of pursuing price quotes and the costs associated with switching to a different product. However, the presumption that other options will not be cost‑effective is not an allowable exception to competitive bidding under the Lottery’s regulations and is not a sound business practice. In fact, the Lottery’s regulations state that it will use competitive bidding to ensure that it obtains the best value. Further, efficiency, financial viability, and price are some of the elements that the regulations describe as factors that the Lottery will evaluate during a competitive process. Therefore, the Lottery should not have disqualified other vendors or products before engaging in a competitive review of its options.
The Lottery’s Inadequate Contracting Processes Do Not Always Ensure That It Obtains Best Value
Source: Lottery contract records.
The contract for financial software was significantly larger than the other seven contracts with which we found problems. However, most of the other contracts featured similar issues. We found that the Lottery often appeared to predetermine a product or service it wanted to purchase and then determined that there was only one vendor from which it could purchase that product or service. However, the documentation that supports these determinations usually showed only that the vendor was the proprietary owner of the selected product rather than that it was the only vendor that could provide a solution that met the Lottery’s needs. For example, the Lottery contracted for email distribution software from an IT vendor for $200,000 without seeking multiple bids. To exempt itself from the competitive bidding requirement, the Lottery stated that only one viable source existed for the software. However, the justification memo for this contract does not indicate that the Lottery’s decision to select the vendor was the result of a good faith effort to identify other vendors that could provide email distribution software. Instead, the memo noted that the Lottery would reassess its options for email distribution as part of a larger project that it would begin within the upcoming 12 months. Nevertheless, a preference to delay consideration of other viable options is not an allowable exemption from competitive bidding under the Lottery’s regulations.
The problems we identified with the Lottery’s procurement activity are the result of weak processes and a lack of formal guidance for its staff. The Lottery has a contracts unit that, according to its manager, is the central unit responsible for ensuring that its procurement activities align with applicable requirements. However, the contracts unit did not fulfill this role for any of the eight procurements with which we found issues. Although we expected to see that the contracts unit was requiring Lottery divisions to submit evidence that they had adhered to procurement requirements, it was not doing so. For example, when we asked for supporting documentation showing that the Lottery appropriately concluded that it had no other options besides noncompetitive procurement, for a few of the contracts with which we found problems the contracts unit manager responded that her unit did not maintain that documentation and referred us to the Lottery division that had originally requested the goods or services. Because it does not always require other divisions to demonstrate that they are following the Lottery’s procurement regulations, the contracts unit provides limited assurance that the Lottery is always obtaining the best possible value in its agreements.
Further, the Lottery lacks sufficient formalized guidance for its procurement staff. Although the contracts unit manager and the Lottery’s former chief counsel provided us with the Lottery’s policies and procedures for procurements, the contracts unit manager informed us that these documents were outdated. She stated that, when procuring goods and services, her unit and Lottery legal staff provide guidance to the program seeking to procure the good or service about how to justify a noncompetitive agreement. When we spoke with procurement staff from several Lottery divisions, one indicated that the Lottery has required different support for different contracting decisions and that consistency in required support could be better. Other procurement staff indicated they would find it beneficial if the Lottery provided its program units with procurement guidance. According to the Lottery’s deputy director of finance, the Lottery’s current executive director made it a top priority for members of executive management to update and unify all of the Lottery’s policies and procedures and to ensure that its staff are trained on them. The Lottery’s deputy director of operations indicated that discussions about the procurement guidance occurred only recently. Therefore, as of January 2020 the Lottery has not ensured that its staff have up‑to‑date and appropriate guidance for conducting procurement activities. Because obtaining the best possible rates on its procured goods and services will help the Lottery ensure that it is funding education at the maximum possible level, it is critical that it create and implement updated policies and procedures.
The frequency with which the Lottery uses certain exemptions from competitive procurement processes concerns us. We reviewed the Lottery’s procurement records to assess the significance of the noncompetitive procurements that it engaged in over the last three fiscal years. According to its records, the Lottery did not use a competitive process for about $40.6 million—or about 62 percent of its new agreement procurement activity from fiscal years 2016–17 through 2018–19.
We focused our analysis on new agreements or procurements because amendments to existing agreements are generally not subject to the same requirements as new agreements and are, by definition, noncompetitively sourced. Further, our analysis excludes one competitively bid contract that was an outlier because it skewed the summary level data about the Lottery’s procurement activity. That contract was over 30 times larger in value than the next highest valued contract.
Although, as shown in Figure 4, $26.8 million of this amount is from contracts and purchase orders that were entered into under master agreements or interagency agreements where the Lottery has some assurance that it is getting a good price, the Lottery did not competitively bid the remaining agreements, which were worth $13.8 million—or 21 percent of its overall procurement activity. Given that our review of a selection of the Lottery’s contracts found problems with the Lottery’s support for its decisions to not seek competitive bids, the proportion of the procurement activity that these agreements comprise is significant. Insufficiently vetted decisions to not seek competitive bids increase the risk that the Lottery will spend more than it needs to for goods or services and thereby reduce the revenue available for education.
21 Percent of the Lottery’s Procurement Activity Involved Noncompetitive Agreements
Source: Lottery contract records from fiscal years 2016–17 through 2018–19.
* The competitive agreements exclude one contract that was 30 times larger in value than the next highest contract.
The Lottery Did Not Minimize Retailer Trade Show Expenses and Spent Excessively on Food and Beverages
Requirements of the Lottery’s
Informal Competitive Bidding Process
When possible, the Lottery must do the following:
- Directly contact potential bidders with the goal of eliciting competition.
- Communicate contract terms to potential bidders.
- Document all contacts with potential bidders.
- Receive verbal or written bids.
- Accurately record and evaluate actual bids.
- Determine which bidder is qualified to perform the contract and submitted the best bid.
Source: Lottery regulations.
The problems we identified in our review of 15 procurements also extended into contracts the Lottery entered into with hotels for its retailer trade shows. Until Spring 2018, the Lottery hosted retailer trade shows in an effort to educate retailers about its products and services, such as training on how to sell lottery products. As we describe earlier, the Lottery’s regulations require it to use an informal competitive process for procurements at or under $100,000 in value. Specifically, the Lottery’s regulations require it to take all of the actions in the text box when possible.
We reviewed 17 contracts—worth about $720,000 in total—that the Lottery entered into with the hotels where it hosted its retailer trade shows, and the results of our review are summarized in figure 5. These contracts usually included expenses for food and beverage catering, event space, and lodging for Lottery staff. Each contract was under $100,000 in value, meaning that the Lottery was required to follow its informal competitive bidding process before it entered into them. However, the Lottery cannot demonstrate that it followed its regulations. It had no documentation showing that it accurately recorded and evaluated competing bids or determined the best value for any of the contracts. Only for one agreement—for a 2015 trade show in Ontario—could the Lottery provide a spreadsheet listing comparable hotels that included pricing information; however, this spreadsheet did not accurately record the pricing information and did not provide sufficient evidence that the Lottery had obtained best value for the agreement, as one of the comparable hotels on the spreadsheet had a lower listed price than the one the Lottery selected and there was no indication why the lower‑priced option was not selected. Therefore, the Lottery has no evidence that it followed its informal competitive bidding process and took reasonable steps to minimize trade show expenses.
The Lottery Entered Into $720,000 in Hotel Agreements for Trade Shows Without Ensuring That It Minimized Expenses
Source: Lottery contract records and hotel invoices.
As part of all but one of these agreements, the Lottery agreed to pay a food and beverage minimum to the hotel, but some of these minimums appear to have been excessive. For example, one agreement was for a 2014 trade show in Orange County that lasted one day and had about 320 registered attendees. The contract with that hotel required the Lottery to pay a $45,000 food and beverage minimum averaging $141 per guest per day. Another agreement for a 2016 single‑day trade show in Santa Clara contained a $40,000 food and beverage minimum for about 180 registered guests, which is an average of about $220 per guest per day. Although the targeted audience of these conferences was retailers and not state employees, to assess the reasonability of these food costs we used the standard state per diem meal rate of $41 per person per day. Even if we use double the state rate, the costs of some of these food and beverage minimums are very high in comparison. Further, although some of the food provided under these agreements was for meals, other food expenses were for unreasonably priced snacks. For example, for the trade show in Orange County, the Lottery agreed to pay $60 for a dozen granola bars and $45 for a dozen cookies. By obtaining multiple price quotes, the Lottery may have found more reasonably priced hotel packages or at least would have been better able to negotiate with hotels for these higher‑priced items. For example, some of the hotel agreements we reviewed contained food and beverage minimums closer to $10,000 with average per‑guest amounts of between $28 and $48 per day.
The Lottery’s sales and marketing division had the primary responsibility for planning the retailer trade shows. When we asked for bidding documentation demonstrating that the sales and marketing division obtained the best value for the agreements with hotels, a manager within the division stated that the division did not maintain this documentation and could not provide it. The manager provided us the spreadsheet we reference earlier, which he asserted the Lottery’s primary gaming vendor had provided to the Lottery as a list of hotels suitable for hosting the Lottery’s trade shows. However, as we explain earlier, although the spreadsheet listed pricing information for comparable hotels for a 2015 trade show in Ontario, it did not provide adequate proof that the Lottery obtained best value for this agreement. Additionally, the spreadsheet listed potential venues only for 2015 trade shows and also lacked critical pricing information for some venues, making it inadequate support for the remainder of Lottery’s hotel selections. Lastly, the deputy director of the sales and marketing division provided a justification memo for the three hotel agreements the Lottery entered into in 2018, which explained what factors the Lottery considered when entering into these agreements, such as available meeting space and the quantity of retailers in the surrounding area. However, these justification memos did not include any pricing information or similar documentation for alternative comparable hotels, which would have demonstrated that the Lottery contacted multiple bidders with the goal of eliciting competition. The Lottery was therefore unable to demonstrate that it followed its own contracting requirements and received the best value when selecting hotels for its events.
After the sales and marketing division decides to enter into an agreement with a hotel to host a trade show, the Lottery’s contracts unit must review the proposed agreement. According to the Lottery’s contracts unit manager, her unit’s regular practice is to require a justification memo for any procurements valued at more than $2,000. However, she confirmed that her unit did not require justification memos or other supporting documentation for any of the 17 hotel selections because these agreements were paid for by credit card and did not go through the Lottery’s regular procurement system. Because the contracts unit is responsible for ensuring that the Lottery adheres to its contracting regulations, it plays an essential role in controlling the Lottery’s costs and making sure that the Lottery directs all possible funding to education.
Amending the Lottery Act Would Create Greater Accountability for the Lottery’s Procurement Processes
The Lottery is not subject to General Services’ oversight with regard to its contracts and procurement activity. In 1984, when voters—through Proposition 37—approved the Lottery Act, the proposition granted the director of the Lottery the authority to purchase or lease goods and services that were necessary to achieve the purpose of the Lottery Act without generally being subject to specific provisions of state law that governed procurement. Less than two years later, the Legislature added language to the Lottery Act that more expressly stated that the Lottery’s contracts and procurements were not subject to General Services’ oversight. The Legislature prescribed specific requirements for the Lottery’s procurement activities, such as a requirement that the Lottery develop competitive bidding procedures for the awards it makes valued at more than $100,000. In 2008 the Legislature further amended the Lottery Act to specify that the Lottery was not subject to the requirements of the Public Contract Code.
However, the Lottery’s approach to its noncompetitive procurements provides little assurance that it is meeting the intent of the voters and the Legislature. In 1984 voters approved the creation of the Lottery on the basis that the Lottery would provide funding for education. When it amended the Lottery Act in 1986, the Legislature declared that its intent was to foster and promote full competition in contracting and that it expected that full competition in contracting would ensure that more of the funds generated by the Lottery Act would go directly to education. The results of our review—as well as a 2016 SCO review that concluded that the Lottery did not have limitations on the monetary and time increases for contract amendments, which means it had no limitations on how much it could increase a contract’s dollar value or duration—show that the Lottery has not applied enough safeguards to its procurement activities to enable it to direct the most funding possible to education.
Amending the Lottery Act in such a way as to subject the Lottery to regular reviews of its procurement processes would create necessary accountability by addressing a gap in the State’s oversight of the Lottery. As we describe in the Introduction, the SCO is the primary oversight entity over the Lottery. Although the Lottery Act assigns the SCO broad authority to conduct audits of the Lottery, it does not specify that the SCO must regularly conduct audits of the Lottery’s procurement processes. In contrast, the Public Contract Code requires General Services to conduct audits of the departments to which it delegates purchasing authority and specifies that these audits should occur at least once every three years. Therefore, a requirement that the SCO perform regular procurement audits of the Lottery would align the oversight of the Lottery with the oversight the State requires of other departments without disrupting the existing express exemptions from the regular state contracting requirements. To amend the Lottery Act through legislation, the Legislature must approve a bill with at least a two‑thirds majority vote, and the amendment must further the purpose of the act. The changes we recommend would create greater accountability for contracting decisions and be consistent with the earlier Legislative intent to encourage competition and thereby maximize the funding to education. As a result, they would also be consistent with the purpose of the act.
The Lottery Does Not Know Whether the Millions It Spends on Its Fairs Program Have Been Effective
The Lottery also cannot demonstrate that its spending for its fairs and festivals program (fairs program) is consistent with its mandate to maximize the amount of funding for education. The Lottery’s regulations allow it to sponsor activities or functions in furtherance of its mission when the value received by the Lottery in return for the sponsorship is commensurate with the expenditure. Further, the regulations also allow the Lottery to give away promotional items including free tickets and branded merchandise in an effort to maintain awareness of lottery products and motivate future purchases of lottery tickets. Under these provisions, the Lottery has maintained its fairs program for the past 20 years, attending events such as the Orange County Fair and the California Strawberry Festival, which connect it to local communities. During these fairs, the Lottery sells tickets and allows customers who purchase a certain number of its products to spin a wheel where they can win additional promotional lottery tickets. Attending these fairs is one of the marketing tactics that the Lottery uses to reach and interact with consumers.
However, the fairs program does not generate a direct profit, and the Lottery cannot demonstrate that the program leads people to play lottery games again in the future. In April 2019, the Lottery conducted an analysis of the fairs program that included evaluating the program’s profitability. Specifically, the Lottery identified that in 2017 the fairs program cost the Lottery $5.7 million but directly generated only $5.5 million in sales, leading to a loss of $200,000. Any Lottery expense that does not directly tie back to increased revenue may be an ineffective use of Lottery funds because that expense is money that otherwise would be available to fund education. Therefore, to justify the expenses of the fairs program, we expected that the Lottery would be able to demonstrate that it receives some other value commensurate with its expenses.
When we asked the Lottery how it measures whether it receives commensurate value, it could not show that it had performed such a measurement any time before our audit. After we asked the Lottery to demonstrate additional value, the sales and marketing deputy director provided us with an analysis that concluded that the Lottery would need to have purchased at least $1.3 to $3.7 million in advertising to reach the same number of consumers it did at the fairs. Regardless, the Lottery’s April 2019 analysis stated that the intention of the fairs program was to increase certain intangible benefits, such as brand strength, improved customer experience, and increased customer loyalty; and the Lottery could not demonstrate that participating in the fairs increased these intangible benefits. According to the sales and marketing deputy director, the Lottery participates in these events to connect with the community and increase brand awareness, which overall has impact on these intangible benefits. She explained that by increasing these intangible benefits, the Lottery will encourage infrequent Lottery players to play more frequently or attract new customers who may not have interacted with the Lottery previously, thereby increasing sales revenue. She also stated that the Lottery is not currently tracking these intangible benefits and that it is very difficult to directly attribute the effect of one fair and festival interaction on long‑term brand measures as the impact is not always realized immediately.
Notwithstanding those challenges, the Lottery is unable to demonstrate that it is receiving the benefits it hopes to get from its fairs program, which we agree would likely benefit education if the Lottery were to attain them. The Lottery must ensure that its activities, in aggregate, maximize its funding for education. Without the assurance that the fairs program generates additional funding for education, the Lottery does not know whether this money would be better spent on other activities. Every dollar the Lottery spends on the fairs program is a dollar that the Lottery can either provide directly to education or use to engage in activities that it knows generate additional funding for education. Therefore, the Lottery would be in a better position to justify its fairs program as essential to its mission if it could demonstrate a direct relationship between the two—for example, by surveying customers about their experience with and opinions about the Lottery after having attended the fair.
To ensure that the Lottery is subject to oversight of its procurement practices, the Legislature should amend the Lottery Act to direct the SCO to conduct audits of the Lottery’s procurement process at least once every three years.
To ensure that it conducts procurements in a way that preserves all possible funding for education, by August 2020, the Lottery should develop procurement procedures that, at a minimum, do the following:
- Provide examples of when products are truly available from only one source and examples of when the Lottery should consider whether alternative products can also fulfill its needs.
- Require its staff to collect and maintain documentation supporting any exception to competitive bidding and provide examples of adequate and inadequate documentation.
- Instruct its contracts unit to deny all procurement requests that do not demonstrate adherence to contracting requirements.
To ensure that it receives value for the funding it spends on its fairs program, by January 2021, the Lottery should determine whether the program has increased its brand strength, customer loyalty, customer satisfaction, ticket sales, and profits. If the analysis determines that the Lottery has not achieved these benefits, it should terminate the program.
The SCO Has Not Effectively Overseen the Lottery’s Performance
- The SCO inappropriately removed a finding from an April 2019 audit report after the Lottery requested changes to the report. That finding questioned the costs of $720,000 in hotel agreements, an issue we discuss earlier in this report.
- The SCO relied solely on the Lottery to prepare a report for the Legislature on the Lottery’s performance without assessing the thoroughness of the report, and therefore the Legislature has gone without independent analysis of whether the Lottery has fulfilled the purposes of the 2010 changes to the Lottery Act.
- To provide more effective oversight of the Lottery, the SCO will need to significantly adjust its approach to audits to focus on effectiveness and efficiency of the Lottery’s operations.
The SCO Inappropriately Removed a Significant Finding From a Recent Audit Report After the Lottery Requested Changes
The SCO inappropriately removed a finding questioning hotel costs of about $720,000 from an audit report in 2019. Figure 6 summarizes the timeline of events that led to this removal. The Lottery Act requires the SCO to conduct audits of the Lottery as the SCO deems necessary. Under this mandate, the SCO conducted an audit of the Lottery’s Office Revolving Fund and Travel Expenses and published the related report in April 2019. Before publishing its report, the SCO met with the Lottery in February 2019 to share the findings it planned to report. Included was a finding we describe earlier in this report: that the Lottery had insufficient justification to show that it had obtained the best value when entering into 17 hotel agreements worth about $720,000. The SCO informed the Lottery that it planned to report that the Lottery erred because it did not maintain documentation showing how it knew it had obtained the best value for these agreements—concerns that are essentially identical to those we raised earlier in this report.
The SCO Inappropriately Removed an Audit Finding After the Lottery Requested Changes to a Draft Audit Report
Source: SCO and Lottery email correspondence, and SCO audit records.
After that meeting, the SCO provided the Lottery with a final draft copy of its audit report so that the Lottery could prepare a written response to the audit. During its response period, in March 2019, an attorney for the Lottery emailed the SCO’s chief counsel and expressed concerns about the hotel agreements finding. Specifically, the attorney was concerned that the SCO’s audit team had based the finding on outdated requirements instead of the Lottery’s more up‑to‑date procurement requirements, which she indicated were found in the Lottery’s regulations. Over the course of several hours, the Lottery’s attorney sent emails sharing information with the SCO’s chief counsel about the effective date of the Lottery’s procurement regulations and her interpretation of the regulations. For example, the attorney argued that the regulations hold the Lottery to a less strict standard than the outdated requirements the SCO had relied on during its audit because the regulations stated that the Lottery would perform activities such as contacting multiple bidders and determining which bidder was best qualified, where possible—implying that it was not an absolute requirement to perform these activities in all cases. It was her belief that, as a result, the entire finding was questionable and she suggested modifications the SCO should make to its report. Less than one day after the attorney from the Lottery and the SCO’s chief counsel first communicated via email about these issues, the SCO told the Lottery that it would adjust its audit report as a result of the Lottery’s objections. Subsequently, the SCO removed this finding from its report entirely.
At a minimum, removing the finding related to the hotel agreements represents a significant lapse in analytical rigor. When we asked the chief of the SCO’s audits division why the SCO removed the hotel agreements finding, he stated that the procurement regulations did not support keeping the finding in the audit report. However, the SCO’s audit records do not include documentation or any analysis that explains why the regulations did not support the finding. To address this gap in the audit records, we asked the SCO’s audit chief to explain his reasoning. According to the audit chief, he decided the regulations did not support the audit finding because they contained the phrase “where possible,” which he believed meant that the Lottery was not always required to use competitive bidding. The SCO’s audit files contain no analysis or evidence showing that it was impossible for the Lottery to follow its regulations. Further, the audit chief could not explain to us what the SCO expects the Lottery to document to show compliance with the regulations. Moreover, the audit manager carefully documented her conclusion that the finding should stand. We question how the SCO could conclude that there was not a reportable finding if it cannot explain what it expected the Lottery would do to comply with its procurement regulations.
There is little meaningful difference between the outdated requirements that the SCO originally used to support its hotel agreement finding and the regulations it should have used as its standard. As we discuss earlier in this report, we have concluded that the hotel agreements were problematic. Both the old requirements and the regulations instruct the Lottery to seek multiple bids and keep a record of all contacts with bidders. Further, both require the Lottery to have recorded the bids submitted by potential vendors. The SCO had confirmed during its audit that the Lottery’s contracts division had no evidence that the Lottery had taken these steps. Therefore, we question why the audits division chief determined that he could no longer include this finding in the SCO’s report.
Further, the manner in which the SCO made its decision to remove the finding is troubling because neither the audit team nor the audits division chief responsible for removing the audit finding from the report directly communicated with the Lottery about its objections. If either the audit team or audits division chief had directly interacted with the Lottery, those conversations might have produced a different result, especially given the audit manager’s opinion that the finding should still be included. All communication related to the removed finding that we reviewed between the Lottery and the SCO took place between the Lottery’s attorney and the SCO’s chief counsel. Even though the audits division chief made the ultimate decision to remove the finding, he never communicated directly with the Lottery. Additionally, no member of the audit team communicated with the Lottery or had an opportunity to directly address the Lottery’s objections to the finding even though the audit manager in charge of that audit believed the Lottery had insufficient support to demonstrate that it had obtained best value when entering into the hotel agreements; therefore, she believed that the finding should have been included in the final report. Given that the audit team had a large amount of experience regarding the audit subject, SCO’s decision to remove the finding without allowing the audit team to respond directly to the Lottery’s concerns about the finding is troubling.
Finally, the changes the SCO made to its report before issuing it to the public raise concerns about it strictly adhering to auditing standards, including those pertaining to an audit entity’s independence. In its April 2019 report, the SCO stated that it conducted its audit in accordance with generally accepted government auditing standards. Those standards require the SCO to avoid any appearance of a compromise to its independence and that it perform its audits without being affected by influences that compromise its professional judgment. This independence is important because it gives reasonable assurance to informed third parties that the findings of an audit will be impartial. However, the emails exchanged between the SCO and the Lottery, the SCO’s decision to not involve the audit team in direct conversation with the Lottery, the lack of analysis of the regulations by the SCO, and the fact that the regulations the Lottery shared did not contradict the finding, create the appearance that the SCO removed these findings because of pressure from the Lottery and not because of its own independent judgment of the evidence it had collected. Such a deficiency in independence may cast doubt on the integrity of the SCO’s audits of the Lottery.
The SCO Did Not Adequately Assess the Lottery’s Performance After Changes to State Law
The SCO did not fulfill an important responsibility to report to the Legislature about the Lottery’s performance after significant changes to the Lottery Act. As we discussed previously, the Legislature amended the Lottery Act in 2010 to permit the Lottery to increase the proportion of its revenue it pays out as prizes. The 2010 amendments also required the SCO to convene a review group—consisting of the State Controller, the chair of the Lottery Commission, and the Superintendent of Public Instruction. Under the SCO’s lead, the Lottery Act required the lottery review group to report to the Legislature by no later than the end of March 2016 on whether the 2010 amendments furthered the purposes of the Lottery Act. However, the SCO—despite its position as the lead entity responsible for convening the lottery review group—did not submit this report to the Legislature until October 2019, after we determined that it had never submitted the report.
Because the SCO did not ensure that it submitted the review group’s report to the Legislature, the answer to a significant question about the 2010 amendments went unaddressed for more than three years. The intent of the 2010 amendments was to further the purpose of the Lottery Act by giving the Lottery the authority to determine the percentage of its total revenue to allocate to prize payouts so that it would maximize funding to support education. The expectation of the Legislature was that with this authority, the Lottery would be able to raise more funding for education. In requiring the review group report, the Legislature clearly indicated an interest in knowing whether its expectations were realized. The SCO coordinated a public meeting of the review group in March 2016, and the SCO’s records and statements made to us from the SCO’s chief counsel indicate that the review group approved a draft version of its report for final submission at that time. Because the 2010 amendments required the SCO to convene the lottery review group, it is reasonable to conclude that the SCO was responsible for submitting the report on the review group’s behalf. However, no record we reviewed shows that the SCO ever submitted the report to the Legislature in the period of time shortly following that meeting. The SCO agreed that it had no record of having submitted the report in 2016 or subsequently thereafter and stated that because it did not, it sent the report to the Legislature in October 2019—a claim that we validated.
However, as shown in figure 7, the report the SCO submitted was written by the Lottery. When we spoke with the Lottery's deputy director of finance at the beginning of our audit, he provided us a draft version of the review group report and indicated that he authored the draft of the report with the assistance of the Lottery's staff and the chair of the Lottery Commission. In subsequent conversations, the chief of the SCO’s audits division also stated that the Lottery drafted the report that the review group voted to send to the Legislature. We compared the report the SCO submitted to the Legislature in 2019 with a draft copy of the report the Lottery provided to us and confirmed that the reports are in all substantive ways identical. In other words, the SCO submitted a report written by the Lottery about whether the Lottery was adequately fulfilling its mandate, which raises clear concerns about the objectivity of the report. Further, the SCO could not demonstrate that it performed any due diligence to ensure that the report accurately reflected the Lottery’s performance after the 2010 amendments or that the report’s comments about the 2010 amendments were aligned with the legislative intent. We find it concerning that the SCO would submit a report to the Legislature—stating that the analysis in the report was prepared by the review group—that contained no third‑party analysis of the Lottery’s performance from either the SCO or the Superintendent of Public Instruction.
The SCO Submitted a Report on the Lottery’s Performance to the Legislature That Had No Independent Analysis and Was Three Years Late
Source: SCO email correspondence, interviews with SCO and Lottery staff, and draft and final versions of a report to the Legislature.
The content of the report demonstrates why a more objective review of the Lottery was essential. The report’s analysis and conclusions are very favorable toward the Lottery. According to the amendments, the Legislature’s purpose when it enacted the 2010 changes to the Lottery Act was to increase the total amount of net revenue available for the Lottery to supplement funding for education and to maximize the amount of net revenue that the Lottery directs to education. The report states that the changes to the Lottery Act clearly accomplished the first of these goals. However, when it discusses the second goal, the report states that making a determination about whether funding has been maximized can be difficult, and it reaches no conclusions about whether the Lottery achieved the goal. As we describe earlier, the Lottery has no analysis demonstrating that it has determined the optimal balance between education funding and its other expenses. Without such an analysis, the Lottery has no assurance that it is maximizing its contribution to education—an observation that is missing from the review group report.
Further, the review group report also discounts the importance of the proportionality requirement, wherein the Lottery must increase education funding in proportion to increases in its net revenues; and the proportionality requirement is one of the key safeguards that the Legislature added to the Lottery Act in 2010. Instead of determining that the Lottery has not met this requirement—a conclusion we presented earlier in this report—the review group report, drafted entirely by the Lottery, argues that such proportionality is not possible. Instead, the report states that to meet the intent of the 2010 changes to the Lottery Act, the Lottery would need to increase the share of its revenue allocated to prizes so that the gross dollar amount of funding for education would increase. The report concludes that increasing the share of revenue allocated to prizes disrupts the proportionality between sales revenue and growth in the funding for education. However, the report offers no evidence proving that increasing the percentage of sales revenue allocated to prizes precluded the Lottery from increasing education funding in proportion to increases in net revenue. Because it dismisses this requirement as impossible, the review group report is missing a critical conclusion about the Lottery’s adherence to the Lottery Act.
That the SCO did not participate in creating the content of the review group report is another indicator that it has not acted as an independent and objective oversight entity. Although the responsibility for the review group report collectively belonged to the SCO, the Lottery, and the Superintendent of Public Instruction, the SCO is arguably the most objective member of this group with respect to the Lottery’s performance. The Lottery cannot be an independent reviewer of its own performance, and the school system, overseen by the Superintendent of Public Instruction, is the largest beneficiary of the Lottery’s education funding. Therefore, the SCO’s failure to contribute an impartial analysis to the review group report represents a significant gap in effective oversight of the Lottery and the quality of the information the Legislature has about the Lottery’s operations.
The SCO’s Current Approach to Auditing the Lottery Will Not Identify Shortcomings in the Lottery’s Performance
The SCO’s current approach to its audits of the Lottery will not ensure that the SCO reviews the Lottery’s operations for efficiency or effectiveness. The Lottery Act requires the SCO to conduct quarterly and annual audits of the Lottery’s accounts and transactions and allows the SCO to conduct any other audits it deems necessary. Although on its own that authority is broad, for the past several years the SCO has also been subject to a provision in the annual Budget Act that prohibits it from conducting performance‑related audits—which are reviews of effectiveness and efficiency—unless given express statutory authority. We believe the SCO has that authority under the Lottery Act. The SCO’s audits division chief indicated that the SCO has never made a determination that the authority to audit in the Lottery Act is the type of express statutory authority to which the Budget Act refers. Therefore, the SCO has reviewed the Lottery only for compliance with narrow sets of laws or regulations. By their nature, these types of reviews will not identify all areas for improvement needed in an organization or address efficiency problems.
The SCO determines what elements of the Lottery to audit through a risk assessment process that it has conducted periodically every three to five years. This risk assessment identifies relatively small issue areas, such as individual contracts and the operations of a single unit within a larger division of the Lottery, as the potential topic for audits. The risk assessment also identifies areas that are larger in scale, such as the Lottery’s procurement process or management of its investments, as potential audit topics. To assess the depth of the SCO’s audits, we reviewed the audits during 2015 through 2018 that the SCO conducted of the Lottery for which it published a report. These audits generally had as their objectives determinations of compliance with applicable laws or regulations, rather than a broader assessment of operational effectiveness or efficiency, and none of the audits related their findings to the Lottery’s mission to provide supplemental funding to education. The SCO also conducts quarterly audits of the transfer of funds the Lottery makes to public education. Those audits verify whether the Lottery adheres to the requirement in the Lottery Act to spend no more than 13 percent of its annual revenue on its operational and administrative costs. However, these quarterly audits do not review whether the Lottery has maximized funding to education.
Although we acknowledge that the SCO’s audits have covered important subject matter—such as whether the Lottery has appropriately managed its retailer network or has adequate safeguards over its prize payment processes—the SCO’s recent audits have not reviewed whether the Lottery has maximized its contribution to education; this is significant in light of the fact that providing supplemental funding to education is the reason the Lottery exists. To fulfill its role as an effective oversight agency over the Lottery, the SCO must take significant corrective action. The Lottery Act exempts the Lottery from the oversight mechanisms that other state agencies are subject to, including General Services’ oversight over contracting and procurement practices and Finance’s oversight of the Lottery’s budgets. Therefore, the gaps in the SCO’s audit approach and general oversight of the Lottery that we note in this report have left the State without effective, independent, and ongoing monitoring of the Lottery’s performance. When voters approved the creation of the Lottery, oversight responsibility was assigned to the SCO. To provide effective oversight of the Lottery, the SCO will need to adjust its approach to its audits of the Lottery. As it does so, it will be important for the SCO to apply safeguards against threats to its independence and ensure that it reviews the Lottery for operational effectiveness and efficiency.
To ensure effective oversight of the Lottery, the SCO should immediately begin taking steps to improve its audits of the Lottery by doing the following:
- Develop and follow procedures that ensure that objections to audit findings are addressed by the audit team that worked on the audit. The procedures should provide the audit team sufficient time to interact directly with the Lottery about its objections and should direct the audit team to fully document its rationale for making any adjustments to the audit’s findings before the audit report is published.
- Revise its risk assessment of the Lottery to include issues of efficiency and effectiveness of the Lottery’s operations.
- Select high‑risk areas of the Lottery’s operations and conduct performance audits to assess the effectiveness and efficiency of those areas. In all audits of the Lottery, consider how the audit findings relate to the Lottery’s purpose of providing education with the maximum possible funding.
Other Areas We Reviewed
To address the audit objectives approved by the Joint Legislative Audit Committee (Audit Committee), we looked at three other issues. Specifically, we examined the Lottery’s overall spending in operational and administrative areas, including whether these expenses were for necessary purposes; we assessed its justifications for hiring additional staff; and we reviewed its processes for determining whether to pay prize claims and allocations of unclaimed prize money. The following sections show the results of our review of these areas.
Operational and Administrative Spending Levels
Since 2010 the Lottery Act has required the Lottery to keep its total administrative and operational costs to within 13 percent of its total annual revenue. The Lottery’s spending on operational and administrative costs remained within that limit during fiscal years 2016–17 through 2018–19. To assess the reasonableness of the Lottery’s spending in these areas, we compared the Lottery’s expenses to those of lotteries in Arizona, Florida, New York, North Carolina, and Texas. We selected these states because of either their comparable size or the similar nature of their lottery systems. Although the percentage of its overall revenue the Lottery spent on operational and administrative costs over the past three years was similar to those of North Carolina and Arizona, it was higher than those of Texas and Florida. However, the publicly available information on the Florida and Texas lotteries’ operations and administrative costs is not sufficient to identify why these lotteries had lower costs than California. In addition, we identified New York as an outlier to the other lotteries because the percentage of its revenue spent in all major cost categories was different from the others. Further, we reviewed evidence that the Lottery compared itself to other state lotteries in certain areas, including the reasonableness of advertising costs, the number of consumers who purchase lottery tickets, and the amounts individual consumers spend on tickets.
Finally, the major contributor to growth in the Lottery’s operational and administrative costs have been its gaming costs and retailer compensation. Because retailer compensation is linked to overall sales, including bonuses to retailers when they sell winning tickets, the increases in this cost category are attributable to the large increase in overall sales revenue and not to mismanagement by the Lottery.
To further assess whether the Lottery’s operational and administrative costs were justifiable, we reviewed 30 expenses from these cost categories from fiscal years 2016–17 through 2018–19. We found that all but one of these expenses were for justifiable purposes because they were reasonably tied to a necessary function the Lottery must perform. The one expense we question was an $8,300 purchase of training tools that the Lottery made for a retailer trade show. Although the justification for the purchase described these items as training tools, the items included lip balm, T‑shirts, and first aid kits. According to the deputy director of sales and marketing, the Lottery held its last retailer trade shows in spring 2018, and it is not currently a priority for the Lottery to resume them. Therefore, we have no recommendation for eliminating this type of spending in the future.
The Lottery has adequately justified additions to its staffing levels, which we reviewed in three key divisions over the past three fiscal years. From fiscal years 2016–17 through 2018–19, the Lottery increased its staff by 5 percent, or 37 employees, giving it a total of about 770 permanent employees as of June 2019. For all position requests made before September 2019, according to the deputy director of finance, when proposing to add new staff, each lottery division was required to prepare a budget revision proposal (budget revision). These budget revisions required approval from the deputy director of finance, the chief deputy director, and the executive director before Lottery staff presented them to the Lottery Commission, which has final approval authority. Budget revisions must have included a justification for the new staff positions, reasons why the problem cannot be resolved through current resources, and an analysis of all feasible alternatives. The deputy director of finance indicated that since September 2019, the Lottery divisions also have the option to bring new position requests to the Lottery Commission throughout the year as the business need arises rather than wait until Lottery staff present the annual budget to the Lottery Commission. In these instances, the requesting division prepares a justification document, which contains the same type of justification as the budget revision and requires the same approval as a budget revision before it is presented to the Lottery Commission.
We reviewed five Lottery budget revisions in which the operations, sales and marketing, and security and law enforcement divisions requested permission to add new staff positions. We determined that these divisions generally provided a reasonable justification for adding all of the positions they requested in those budget revisions. For example, the operations division requested a chief engineer position. The associated budget revision justified this position by indicating that the Lottery’s engineering and maintenance workload would increase beyond what the current manager could manage after the Lottery converted seven of its leased facilities to owned facilities. In addition, the Lottery indicated that it needed to add the chief engineer position because the minimum qualifications required for the current manager’s position did not require the knowledge necessary to manage and make decisions regarding the engineering and maintenance positions and their assigned duties. The Lottery believed that the leader of this section should have that knowledge, which further supported its decision to add the position.
Prize Claims and Unclaimed Prize Money
The Lottery’s security and law enforcement division investigates all prize claims over a specified dollar amount, all ticketless claims, and all prize claims that the Lottery has identified as questionable, such as late claims. The Lottery Act requires the Lottery to determine whether “substantial proof” exists for validating ticketless claims before payout. The Lottery’s policies and procedures for investigating prize claims appear reasonable for ensuring that the Lottery is performing appropriate actions to gather and evaluate evidence before paying investigated claims. We examined 30 investigated prize claims for which the Lottery approved payment, and we found that the Lottery’s investigators took reasonable steps to investigate the claims and used similar types of evidence and investigative approaches to support their recommendations to pay the claimant.
The Lottery directed about $286 million in unclaimed prize money to education from fiscal years 2016–17 through 2018–19. The Lottery Act requires the Lottery to distribute all unclaimed prize money to education 180 days after the conclusion of a Lottery game or, for multistate games, up to one year after a jackpot or grand prize drawing. Two primary mechanisms ensure that unclaimed prize money is distributed to education. First, according to the chief of the Lottery’s financial reporting branch, two supervisors at the Lottery who oversee accounting of prize money review the work of their employees to ensure that the Lottery has accounted for all unclaimed prize money that should go to education. Second, both the SCO and an outside accounting firm audit all of the Lottery’s unclaimed prize money. Neither of these entities has identified any issues with the Lottery’s contributions of unclaimed prize funds over the past three fiscal years.
We conducted this audit under the authority vested in the California State Auditor by Government Code 8543 et seq. and according to generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives specified in the Scope and Methodology section of the report. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.
ELAINE M. HOWLE, CPA
California State Auditor
February 25, 2020