38 Studios: The Broken Road to Bankruptcy

This letter was written by Sen. Jim Sheehan (Dist. 36, NK, Narr.).

There has been much said about the failed 38 Studios' deal.  In spite of this fact or because of it, the story deserves further clarification as to the specific events and issues which, in my estimation, led to the ill-fated 38 Studios' deal as well as to the company's subsequent bankruptcy. The following account is based upon committee testimony, news accounts, investigative reports, research and other sources of information.

Curt Schilling had an illustrious career as a pitcher for the Boston Red Sox. As a famous, albeit former, Red Sox player, Curt Schilling was possessed of great self-confidence, making him the ideal pitchman for his long held dream – to build a video gaming empire. However, while Schilling knew baseball, he admittedly was "out of his element" when it came to understanding the day-to-day operations of a business. By contrast, Donald L. Carcieri was a knowledgeable businessman for years prior to turning to politics when he decided to run for governor of RI in 2002. Once elected, Republican Governor Don Carcieri would task the Economic Development Corporation (EDC) with helping him transform Rhode Island into a more business-friendly state.

By the winter of 2010, Governor Carcieri was nearing the end of his two terms as governor. He was faced with a high unemployment rate (nearly 12 percent), small businesses starved for access to capital,  and an incomplete political legacy.  A chance meeting between Governor Carcieri and Curt Schilling led to discussions and eventually a prospective deal to bring 38 Studios along with many high tech jobs to R.I. The state had desired to build a technology sector in the "Knowledge District" of Providence. 38 Studios would help form the centerpiece of this new high tech development. For a small state, this was "thinking big." For the governor and the unemployed, this potentially could be a win-win scenario, a home run [While it is still unknown what role or to what extent, if any, legislative leaders played in bringing about the 38 Studios' deal, pending civil suits may shed some light on this question.].

Still, former Governor Carcieri must assume the lion's share of responsibility for the 38 Studios' deal given his leadership position as chairman of the EDC Board as well as the official who hand-picked its membership. In a retrospective interview in September of 2012 with WPRI News, the former governor did take "responsibility" for the deal being approved "on his watch," but explained that everyone "had high hopes that this could be the nucleus of something for a whole new industry in our state." Indeed, it was this "hope" that seemed to color and drive the decision-making process of 38 Studios' deal, in spite of a number of red flags which urged caution.

1. Venture capital firms repeatedly turned Curt Schilling down prior to pitching his dream idea to R.I.

The "word on the street" was that Massachusetts-based venture capitalists were fond of Curt Schilling personally, but were unwilling to invest in his 38 Studio's company. In short, it seemed that the "smart money" was not buying. Even future State Treasurer Gina Raimondo, herself a venture capitalist, weighed in on the prospective deal in a letter sent to then EDC Director Keith Stokes.  She warned, "I would proceed very carefully on [38 Studio's deal]...If [38 Studios] were in fact a compelling investment I would have to think it would be well funded already by venture capitalists; the fact that many have looked at it and passed is a red flag.”  Her warning went unheeded.

2. Investing a large sum of money in a single business in the already risky industry of video gaming is unwise.

A basic tenet of investment is diversification. As the old saying goes, you should not put all of your "eggs in one basket." When the $125 million Job Creation Guaranty Program came before the General Assembly, it was touted as a means to provide access to capital, particularly for small companies.  In turn, this would help them expand their businesses and hire new employees which could shorten the state's long unemployment lines. Unfortunately, this was not to be the case. $75 million of the $125 million appeared to be intended, at least from the EDC's perspective, for one company – 38 Studios. Further complicating matters, the EDC appeared to lack clear or definitive lending guidelines and requirements that banks and other financial institutions rely on to reduce risk and to assure more prudent and consistent investment practices.

3. The vetting process for the 38 Studio's deal was inadequate, hurried and possibly negligent in its lack of full risk disclosure.

EDC did not possess in-house expertise in either the video gaming industry or venture capital-like investment. Therefore, the EDC turned to an outside firm to vet the 38 Studio's prospects for success as a business venture. Timothy Cole, Senior Strategy and Research Manager, voiced concern about the outside firm that was selected to perform the due diligence on 38 Studios. Indeed, the company, Strategy Analytics of Boston, was not considered by Cole to be adequate to the task. Cole suggested a well-established, albeit more expensive, firm called Monitor Group of Cambridge. In spite of this recommendation, the EDC stuck with Strategy Analytics. Timothy Cole also believed that the due diligence was being rushed in completing its analysis before all major risks could be weighed.

When the due diligence was completed, Sean Easton, EDC Financial Portfolio Manager, was alarmed that the 38 Studios projections for its business seemed to rely on releasing a successful game every two years – a track record that most companies can only dream of (New York Times report).  Per an investigative report by WPRI News, Easton wrote to his superiors that he could not support a $75 million guarantee to any single company in the video gaming industry due to the wide volatility in commercial success of game releases. He further cautioned that he had more information on a $10,000 micro loan than he did on the $75 million 38 Studios deal, especially about the financial projections made by 38 Studios. He concluded,  "[t]his is a problem.... I am still not comfortable the opportunity is as strong as they'd like us to believe." Easton believed his analysis was buried when he was instructed by Deputy Director of EDC J. Michael Saul, that, "...we should stay away from any statements about financial projections" when briefing the EDC board. If such information was not disclosed or clarified to the EDC Board of Directors, it is conceivable that the board may have rejected the 38 Studio's deal.

4.  The Job Creation Guaranty Program was a wrong fit for 38 Studios at its stage of development.

The Job Creation Guarantee Program was conceived of as a way to provide capital to companies seeking to expand their businesses and hire new employees. A job creation program was a mismatch for 38 Studios. As a software start-up company, 38 Studios needed to spend its money on product development and getting its product to market.  Instead, the Job Creation Guaranty Program mandated that participating it increase and maintain a certain number of employees. Moreover, 38 Studios appeared to have a spending problem or "high burn rate." According to a July 2012,  Golocalprov article, records show that 38 Studios was spending between $4-$5 million per month and had spent some $133 million since 2006.

5. Third party monitoring or oversight of 38 Studios' management was imprudent at best.

A consulting arm of IBM was contracted to monitor and analyze 38 Studio's financial records and provide quarterly reports on the status of the 38 Studio's new video game "Copernicus" and provide them to the EDC. The EDC Board apparently operated under the false impression that IBM would police the EDC investment on the Board's behalf. To the contrary, IBM was being paid by 38 Studios as opposed to the EDC, creating an obvious conflict of interest with regard to providing proper oversight. According to an investigative report by GoLocalProv, IBM, in fact, never issued a single report to the EDC Board as to the financial health of 38 Studios. The same report further added that between September 2010 to May 2012, the EDC Board never formally discussed the financial health of 38 Studios either.

In spite of this lack of oversight, it is improbable that the 38 Studios could have survived even if the EDC had been aware of 38 Studio's financial problems, given the fact that it did not have nearly enough capital to launch its second video game.  According to the New York Times, 38 Studio's game Reckoning sold about 1.5 million units, which was a more-than-respectable debut for a gaming company, but nothing like the spectacular showing that Mr. Schilling had projected or needed to keep his company afloat.  At the same time, Schilling was unable to attract more private financing for his ailing 38 Studios.

On May 1, 2012, 38 Studios defaulted on its loan payment to EDC. While Governor Carcieri's successor, Governor Lincoln Chafee, made some effort to rescue the company, the company appeared to be at rope's end financially speaking. After a failed last ditch effort to secure state-sponsored film tax credits, 38 Studios had to lay-off all of its 400 employees in late May. On May 25, 38 Studios again defaulted on its loan payment to EDC. With its options exhausted, 38 Studios finally filed for bankruptcy on June 10, 2012.

Since 38 Studios declared bankruptcy, the ill-fated deal has been investigated by the FBI, the US Attorney, the RI Attorney General and the RI State Police.  With all of these investigations nearing an end or already concluded, no apparent criminal wrong-doing has been found.  Meanwhile, the State of Rhode Island has filed separate civil suits against those it believes were responsible for the 38 Studios deal in order to recover monetary damages on behalf of the state.  As these civil lawsuits go forward, I expect any lingering questions may be answered as the key players in the 38 Studios debacle finally break their silence and testify in the lawsuits against them.