The findings of the UK's Immersive and Addictive Technologies Inquiry may significantly impact the economics of video game companies.
On 12 September 2019, the UK government's Digital, Culture, Media and Sport Committee ("DCMSC") published the findings of its investigation into immersive and addictive technologies (the "Report"). The Report recommended that the UK government regulate loot boxes, which may lead to a requirement for gaming companies to hold gambling licences. The Government is expected to respond to the Report in 2020. Sponsors entering the gaming space should adjust their commercial and legal diligence to determine whether investments are subject to future policy risk. Sponsors with portfolio companies in this space should analyse the extent of the portfolio's reliance on loot boxes as a revenue stream and assess the viability of alternative income models.
What are loot boxes?
A loot box is a virtual container which a player can purchase in a video game for a small sum of real money, known as a microtransaction. Once activated, the single use loot box awards the player with a randomised in game item (which is usually cosmetic or provides gameplay advantages). The rarity of the contents of loot boxes are often a closely held secret; however, the developer of a particularly popular game disclosed odds of 10,000/1 for their most sought-after items.
With randomised odds and the ability to trade items for real money, loot boxes have come under pressure from international regulators, governments and the mainstream media — with accusations that they constitute a gambling activity. The Report sought to assess whether these arguments carried weight, both in terms of the applicable legislation and the associated harms of gambling addiction.
Gaming or gambling?
The Report examined the gambling regulatory framework, namely the Gambling Act 2005 (the "Act"). The Act states that a regulated form of gambling means playing a game of chance for a prize which means "money or money's worth" and includes both a prize provided by a person organising gaming and winnings of money staked. The UK Gambling Commission provided evidence to DCMSC that the Act in its current form does not apply to loot boxes, as in game items have no real world monetary value, and therefore do not fall within the meaning of "money's worth" in the Act. Whilst the Report acknowledged that the Act was not neatly applicable to the economics of the gaming industry, it concluded that loot boxes should in future be considered as games of chance played for "money's worth", and recommended that the Government should specifically bring loot boxes into section 6 of the Act through new regulations or commission research to counter the Report's view.
Why does it matter?
As Internet and mobile gaming have grown in popularity, the economics of the gaming industry have fundamentally changed. Though the industry was originally built upon a premium business model, whereby the sole monetisation point was the sale of physical games to consumers, there has been a prominent shift towards the freemium (or free to play) model, whereby the end user initially downloads the base game for free, but subsequently purchases additional content through in game microtransactions. The additional content may be purely cosmetic or may withhold player progress until the payment is made, effectively creating a paywall to the rest of the game. These microtransactions form the basis of business models for some of the most popular games in the market, and loot boxes are one of the most widespread forms.
The Report found that the wider video gaming industry is increasingly moving towards the freemium model. In evidence given before the DCMSC, Dr Jo Twist (chief executive of Ukie, the UK trade body for the video game industry) stated that 43 per cent of revenue from games released in Europe came from in game microtransactions in 2018. The regulation of loot boxes as envisaged by the Report would therefore pose a threat to this revenue stream. In particular, the Report further recommended that loot boxes should be not be sold to children playing the games, and that the government petition the Pan European Game Information Council to apply gambling content labelling and corresponding age limits to games containing loot boxes.
Developing your strategy guide
Whilst the government has yet to respond to the Report, it is likely that the recommendations will inform the tenor of future policy. Consequently, gaming companies and their corporate owners must continue to monitor developments in this space closely, and be reactive to changing legislation and trends.
Sponsors entering this space should adjust their commercial and legal diligence in order to flag targets' exposure to potential future policy risk. They should request that the financial statements provided clearly identify revenues generated by loot boxes, or ask the management team to confirm the overall percentage of revenue that is derived from them. If the target is heavily reliant on loot boxes, diligence should be focussed around the impact of the Act to the target's business (including a potential duty of care to players), or whether the target's financial position could withstand the removal of the loot box-generated revenues. Sponsors should also ensure that any investments or potential investments would not be affected by fund documentation restrictions or excuse rights in relation to gambling or similar activities.
If sponsors determine that holding gambling licences is either inappropriate from a fund perspective or undesirable from a portfolio perspective, they should also assess alternative income models and consider how receptive the target and its games would be to a change of revenue model. In game advertising, for example, is one alternative model. However, its inclusion is controversial among players, and the difficulty associated with measuring its effectiveness may impact placement negotiations with advertising agencies. The target could also consider moving from a freemium to a premium model. This may help mitigate against lost loot box revenue but again carries the risk of alienating consumers. The most viable alternative appears to be the subscription model, which has increasingly been adopted in well known video game franchises such as Fortnite and Call of Duty as the controversy around loot boxes deepens. Care will, however, still need to be employed around any pricing considerations, to avoid negatively influencing a distractible consumer base.
The next level
The DCMSC launched its inquiry at a time when regulatory authorities around the world have been taking a heightened interest in loot boxes. The Belgium Gaming Commission and the Dutch Gaming Authority have separately found that loot boxes in a number of popular titles were in violation of their respective gambling laws. Failure to change the games so that they comply with the applicable legislation may result in a prison sentence of up to five years and a fine of up to €800,000 in Belgium and a fine of up to €830,000 or 10 per cent of the gaming company's worldwide revenue, whichever is higher, or even a ban on the game, in the Netherlands. The Children's Commissioner for England has recently published a report calling for more stringent rules to protect children and, specifically, for the government to regulate loot boxes, after revealing children's gambling fears. In the US, the Federal Trade Commission held a workshop in 2019 with industry figures and academics in order to assess the risk to consumers and the strength of player protections. Japan, the originator of the loot box mechanic, has approached the issue with a blend of consumer laws and self regulation.
In response to these regulatory developments, several leading gaming companies have already implemented new policies in relation to the disclosure of odds for loot boxes and more are following suit. The publishers of popular video games such Fortnite and Rocket League have also pledged loot box transparency whilst the developers of the Call of Duty franchise, amongst others, have abandoned loot boxes in their entirety in favour of new systems where functional content will be unlocked only through free gameplay. In addition, certain leading gaming companies have parental controls that offer further protection over in game purchases by children.
The Report has been released at a time when the games industry is under increasing regulatory pressure amidst a wider examination of the technology sector. The growing visibility of video games in mainstream media has been accompanied by a number of other developments, which offer both opportunities and challenges to industry entrants and incumbents alike. The formalisation of eSports, increased workers unionisation, privacy and data protection concerns around use of customer data analytics, and increasing M&A activity characterise a maturing industry which is receiving an increased level of consumer and business interest and industry players must remain alive to legislative and economic changes in the sector.