Dragnet

By National Journal and Graeme Browning

May 21, 1997

Island Casino is every gambler's dream. One of a thriving new breed of gambling enterprises launched in the last year, it offers roulette, craps, video poker, slot machines, sports betting--on football, baseball, basketball, hockey and boxing--and a bingo game billed as "one of the world's largest." It's quick, it's open round the clock and, best of all, it's available on any computer screen.

That's right. Island Casino operates through the Internet.

The computers that create it are located on Curacao, in the Netherlands Antilles, a group of Caribbean islands almost 1,200 miles south of Miami. The company that runs it is licensed under Dutch law, which permits gambling. And its games take place in the borderless world of cyberspace, where anyone armed with a computer, an Internet hookup and a credit card can play--for real money.

For gambling opponents and state law enforcement officials, that's a nightmare. They want Uncle Sam to police the likes of Island Casino. Although states have always decided whether to allow gambling--and how to regulate it--only federal law enforcement agencies can operate across state lines, as the Net does.

On-line gambling isn't the only Internet-based activity that officials want to regulate.

Fifteen states and the District of Columbia have considered cyberspace taxes, which could hit home computer users and big corporations that do business on line. And some federal agencies are looking to extend 19th-century laws that regulate banking and commerce to cover the financial scams that threaten to flourish in the Information Age.

Every time a new technology has arrived on the American scene, policy makers have wrung their hands about regulation. Universal access to telephones, dividing up the radio spectrum, television licensing--each of these principles, now taken for granted, first required lengthy discussion in Washington. Now that's happening with the Internet.

But there's a sense of urgency in this debate that didn't exist before. The Internet is growing faster than anyone expected: 57 million people worldwide are now connected, compared with 1.1 million in 1991. And the Net's financial clout is growing apace. In the year 2000, more than $70 billion in sales will be transacted over the Net worldwide, the Commerce Department predicts. Estimates from other sources range widely and are unscientific; some suggest sales in the $150 billion-$600 billion range by decade's end.

Regulators, lawmakers and the on-line industry may differ over how much this new electronic universe really needs to be regulated, but with the Internet mushrooming as it is, advocacy groups say, there's not much time left to search for the answers.

Controlling the Card Sharps

Take Internet gambling, a growth industry if there ever was one. About 25 "wagering sites" now exist on the World Wide Web, and at least 100 more are in the works, according to Sue Schneider, who chairs the Interactive Gaming Council, a group of on-line gambling companies that was created late last year by the Interactive Services Association, a Silver Spring (Md.)-based trade group.

"In the last 18 months, the on-line segment of the gaming industry has reached critical mass," said Schneider, who also publishes Rolling Good Times, an electronic magazine about on-line gambling. She said the number of gambling sites that are under construction "could easily double by the end of the year."

These "virtual" casinos last year captured $3.4 billion of the almost $25 billion that Americans spent on casino-based gambling, according to financial analyst Sebastian Sinclair of Christiansen/Cummings Associates Inc., a New York City management consulting firm.

By the end of next year, annual on-line gambling expenditures will reach nearly $16 billion, predicted Dennis Mills, a member of Parliament in Canada who's championing a bill to legalize Internet gambling. On-line gambling "appears to be the first Internet application that has the potential to make other investments pale by comparison," Mills wrote in a statement on the subject.

If Island Casino and other popular Internet gambling services are any indication, however, the technology may first need a big upgrade. Most of these graphics-heavy sites load up so slowly onto a computer screen that one bettor recently complained he could catch a cab to a nearby racetrack in the time it takes to place an Internet bet. Also, most of the sites are now set up to be played only "for fun," not for real money. And those that do take money wagers have complicated registration procedures that can involve delays lasting days.

While the gambling industry eagerly anticipates the prospect of making big bucks from the Internet, anti-gambling groups and state law enforcement officials fear that virtual casinos will create a host of problems.

Incidents of gambling addiction increase as casinos become accessible to a larger share of the population, according to Bernard P. Horn, communications director of the National Coalition Against Legalized Gambling, a Washington-based organization that represents state and local anti-gambling groups.

"Also, how do you know whether someone playing casino games on the Internet is an adult or not?" Horn asked. "If you put casinos on the Net, you have to understand that you are making gambling accessible to millions of people, and creating millions of addicts and underage gamblers." Think of the potential for a 16-year-old to swipe his parents' credit card and run up huge gambling debts on the Net before Mom and Dad notice.

Fraud is also inherent in on-line gambling, opponents say. How would a bettor sitting at a computer terminal in Idaho know that the roulette wheel being "spun" by a computer in Antigua isn't fixed? "On the Internet, if people get hold of your Social Security number or your credit card number, away they go" to make fraudulent purchases, said Sen. Jon L. Kyl, R-Ariz. "There's an extra potential for fraud here that doesn't exist as much in a regulated environment."

Kyl is pushing a bill that amends the 1934 Wire Communications Act to make on-line gambling a crime. Similar legislation he sponsored during the 104th Congress died in committee, but Kyl believes the bill has better chances this time around because the National Association of Attorneys General backs it, as does the National Coalition Against Legalized Gambling. "Our only opposition comes from those people who have spent a lot of money to create these casinos," he said. "They see a huge source of revenue going out the window."

Faced with criticism like Kyl's, Schneider of the Interactive Gaming Council counters that strict betting limits will help control compulsive gamblers, while "filtering" software designed to protect children from Internet pornography will also screen out underage players. "The whole argument here really boils down to the fact that the Internet is a global medium that defies legislation by one particular country," she said.

Kyl's bill attempts to address that problem by adding a clause expressing the "sense of the Senate" that the federal government should have jurisdiction over any company, no matter where it's located, that transmits wagers via the Net into or out of the United States. "But if a casino company is legally licensed in one country, it's hard for another country to come in and say, `You can't do that,'" Schneider contended.

In the long run, the make-or-break issue for on-line gambling will be whether consumers find the games trustworthy, both supporters and opponents say. Americans wagered $80 billion-$85 billion last year on sports, according to gambling industry estimates. Because they have confidence in the underlying bookmaking system, gamblers are also flocking to sports betting on the Internet, even though it's specifically illegal under U.S. law, Schneider said.

The Justice Department could prosecute on-line "sportsbook" operators now, but chooses not to, said Horn of the anti-gambling coalition. "That's a shame because on-line gambling operations are in such a fragile state. You could go after all the gambling sites that exist today and knock them down," he said. "And what we're seeing now is just a fraction of the problem we'll see if we don't take action soon. The more that people become accustomed to gambling this way, the more demand there will be for it down the road."

Taxing Questions

If casino operators are enthusiastic about their potential take from the Internet, state and local taxing authorities are even more raring for a windfall. Colorado, Connecticut, the District of Columbia, Louisiana, Massachusetts, Ohio, Pennsylvania, Tennessee, Texas, Washington and Wisconsin now tax some Internet services, while California, Illinois, Iowa, Maryland and West Virginia are considering similar taxes.

Most of these taxes are based on a percentage--from 2.5 per cent to 6 per cent--of the monthly fee that a computer owner pays a company for an Internet hookup. The taxes are added to the computer owner's monthly bill, just as telephone access charges are added to telephone bills. But there are also proposals to tax electronic purchases of computer software programs, books, magazines and other items popular among on-line shoppers.

The states argue that they are simply extending existing tax laws to a new technology, as they have a sovereign right to do. "As more and more sales take place on the Net, that will eventually have an impact on sales tax collections in a number of states. And the sales tax does finance a lot of state programs," said Neal M. Osten, director for commerce and communications in the Washington office of the Denver (Colo.)-based National Conference of State Legislatures. "That's the way the system was supposed to work, and it's working."

Computer users and the on-line industry haven't taken kindly to their tax-inflated bills, however. In August 1996, shortly after the city of Tacoma, Wash., imposed a 6 per cent tax on the fees that people pay to an Internet service provider, angry citizens forced the city to repeal it. Buoyed by widespread public support, a bill to exempt all Internet uses from state taxation passed both houses of the Florida Legislature and is awaiting Gov. Lawton Chiles's signature. Earlier this year, New York Gov. George E. Pataki announced that his state will also exempt Internet service providers from state taxes.

Many state tax officials are chafing over such policies because they create a burden on businesses that aren't operating on the Internet, Osten said. "This hits small independent businesses, the ones that are the backbone of a lot of state revenue, especially hard," he added. "They're the people who have a physical location, like a store, that's generating sales taxes. We know where they are, and we can tax them. But if a business that exists primarily on somebody's computer and operates on the Internet isn't paying sales tax, then you really have unfair competition."

Nevertheless, the regulators could be outvoted on this issue. The Treasury Department last November issued a policy paper rejecting new federal taxes on the Net. Early this year, an executive branch interagency working group--chaired by Ira C. Magaziner, senior adviser to President Clinton for policy development--issued a draft proposal to "establish cyberspace as a duty-free zone."

"The Administration believes that widespread competition and increased consumer participation in marketplace choices, not government regulation, should be the defining features of the new digital age," the draft paper concluded.

Congress seems to agree. Rep. Dave Weldon, R-Fla., introduced a bill in early March to exempt the Internet and on-line services from federal taxes. Soon after, Rep. C. Christopher Cox, R-Calif., and Sen. Ron Wyden, D-Ore., introduced the Internet Tax Freedom Act, which would impose a moratorium on new state and local taxes, including sales taxes, aimed at the Net.

In any business transaction--whether on the Internet or through more old-fashioned means--a state can tax out-of-state sellers of goods or services only if the sellers have "sufficient physical contact" with the taxing state, the U.S. Supreme Court has ruled. But applying that standard to business that's conducted on the Net poses problems.

Wyden suggests that because the Internet is so decentralized, and Net-based transactions could be routed through hundreds of different computers, as many as 30,000 state and local taxing authorities could argue that they have the right to place levies on electronic commerce.

If a California company sells a computer software program manufactured in Oregon to a computer owner in Florida, who downloads the program onto his hard disk using an Internet service provider located in Virginia, Wyden said, then who has the right to tax what? "It's no longer just a matter of one state taxing the manufacturer and another the reseller," he added. "Electronic commerce via the Internet doesn't fit into those neat little categories any more."

State tax authorities themselves appear to be struggling with the question of how and where to apply levies to the Net. Alone among the states, Minnesota taxes digital information services such as Lexis-Nexis, for example. The state of Utah has decided not to tax the Internet, but some cities within the state are considering doing just that. Louisiana and Colorado tax only Internet users located within the state, while Washington taxes out-of-state users as long as their Internet service provider has a Washington address.

The only way to bring fairness to the current hodgepodge is for the states to decide on a single set of laws and a uniform tax rate to apply to the Internet, the Interactive Services Association argued in a recent white paper. "We're not fighting taxation, but we are asking for uniformity of language," said Brian A. O'Shaughnessy, director of public policy for the association, which represents some 350 computer software and hardware manufacturers, Internet service providers and on-line companies. "If we're going to have taxation in this new environment, let's not have patchwork."

One proposed solution, the Cox-Wyden bill, would maintain the tax moratorium for two years while a panel composed of representatives from the Treasury, Commerce and State Departments, state and local governments, and consumer and business groups studies the issue of taxing the Net and prepares a report for Congress. The states point out that they're already working with the on-line industry to develop uniform tax standards. "Wyden's office says the moratorium is a way to get us to the table, but we've been at the table for a year," Osten said.

Meanwhile, the technology of the Internet is changing so quickly that state officials worry that new tax laws will be outdated before they even pass. "When we're trying to define various aspects of the Net, the question always is, will that technology still be there in a few years?" Osten said. "But it's important that we sit down with industry anyway. Whatever's going to happen in the future will be based on what happens now."

Cops in Cyberspace

How and when to tax the Internet is a perplexing question, but federal regulators consider the Net's potential for money-laundering, consumer and banking fraud, invasions of privacy and forgery a far more pressing issue.

"Electronic commerce is probably inevitable, [but] it's not without its risks and dangers," Peter J. Toren, deputy assistant attorney general in the Justice Department's Computer Crimes and Intellectual Property division, warned at a conference on regulating electronic cash, sponsored by American University's law school in mid-April. "History has taught us that as soon as any technology arrives, some individuals will try to misuse and abuse it."

Internet users were convinced that Reed Elsevier Inc.'s Lexis-Nexis subsidiary was doing just that last year, when it added Social Security numbers to "P-Trak," the database it sells to lawyers. After thousands of computer owners complained, the numbers were deleted from the database. More recently, the Social Security Administration itself was forced to back down hurriedly from its plan to put taxpayers' Social Security numbers in its interactive database.

"Consumers are becoming increasingly concerned about the power of technology to collect and distribute information about them," Lucy Morris, assistant director for credit practices at the Federal Trade Commission (FTC), said at the American University conference.

The FTC has also been homing in on Internet-based business frauds. Late last year, the commission's Bureau of Consumer Protection coordinated a daylong surveillance of the Internet by federal, state and local law enforcement officials and unearthed more than 500 Web sites promoting pyramid schemes, which are illegal.

In a similar "Business Opportunity Surf Day" that the FTC organized on April 24, officials from the commission, from the North American Securities Administrators Association, from the U.S. Postal Service, Canada and Norway, as well as attorneys general from 24 states, discovered more than 215 Web sites offering outrageous earnings from business opportunities that amounted to little more than scams.

The Treasury Department is so concerned about the potential for financial fraud related to the Internet and computer-based currency that it established the Financial Crimes Enforcement Network (FinCEN) three years ago to bolster the anti-money-laundering efforts of the Justice Department and the Federal Bureau of Investigation.

The Internet's speed, efficiency and global nature, which allow businesses to do billions of dollars' worth of sales worldwide, also help criminals launder money in the blink of an eye, Stephen Kroll, FinCEN's legal counsel, said at the American University conference. "The problem is that everything that's good about these [computer] systems for everyone else is bad for financial-crime enforcement," he noted.

AT&T, for example, recently announced that it would begin testing a system this summer in which consumers can download funds from their bank accounts, via the Internet, to a "smart card," a device that resembles a credit card and contains a computer chip.

Once the funds are stored on the smart card, the consumer could purchase goods over the Internet by clicking on the item at a merchant's Web site and running the smart card through a "reader" attached to the consumer's computer. Prompted by the magnetic strip on the smart card, the "reader" subtracts funds from the card and transmits them, in the 0s and 1s of computer language, over the Net to a smart card owned by the merchant. At the end of the day, the merchant uploads his or her proceeds to the bank, using the same devices.

While smart cards could revolutionize electronic commerce, they also offer the threat of the "perfect counterfeit," Kroll and Toren warned. "Smart cards are only a string of computer bits that someone, somewhere, can make a perfect copy of," Toren said.

Regulation of the Internet is imperative if law enforcement is going to get a handle on financial crime, Kroll added. "We've been trying to end bank secrecy for the last 50 years, but we will have lost the fight if the Internet bypasses the banks and renders them no longer key to financial transactions," he contended.

Several other federal regulatory agencies, however, oppose loading the Net up with a host of rules. In a significant speech given last October, William J. McDonough, president of the Federal Reserve Bank of New York, urged that regulators "monitor" development on the Net but not attempt to restrain it.

The U.S. Office of the Comptroller of the Currency (OCC) takes the position that "supervision, not regulation, is the key word," James Gillespie, assistant chief counsel in the Comptroller's office, said at the American University conference. And last year, the Office of Thrift Supervision chartered the Security First Network Bank, the first "thoroughly Internet bank in the country," according to OTS special counsel Paul Glenn.

For all their concerns about crime, the banking and financial industries support this hands-off approach. "The majority of the new technologies we're talking about are essentially new configurations of established financial products. And powerful models already exist to guide policy makers as they deal with these issues," said Brian W. Smith, a partner in the Washington offices of Mayer, Brown & Platt, a Chicago-based law firm, and formerly chief counsel at the OCC. "I advocate taking a deep breath, and letting the system function on its own."

Debates about regulating cyberspace are sure to balloon along with the Internet's popularity. Trouble is, the technology is changing so rapidly that decisions made this year could turn out to be ill-advised only a few years down the road. Perhaps that's why many policy makers, at least for now, are choosing the easy way out: They're calling for "moratoriums," as the on-line world races past them toward the 21st century.


By National Journal and Graeme Browning

May 21, 1997

http://www.govexec.com/federal-news/1997/05/dragnet/2960/