RICHMOND — The Virginia Lottery has raised concerns that unregulated “skill” games that have appeared in bars and convenience stores across the state may be contributing to a slowdown in lottery ticket sales.

In an Aug. 15 financial report sent to Gov. Ralph Northam, the lottery called attention to the potential revenue threat from what it called “untaxed, unlicensed and unregulated machines,” many of them in stores that also offer lottery tickets.

“During the third and fourth quarters of FY19, we began to view with growing concern an aggressive expansion in the number of these machines installed at Lottery-selling retail locations,” Virginia Lottery Director Kevin Hall wrote in the report. “By our unofficial count, nearly 4,300 of these unregulated games-of-skill machines now operate in more than 1,350 Lottery licensed retailers — one-quarter of our licensed retail locations.”

The lottery, a state agency that generated a record $650 million for public education in its last full year of operations, has long been one of just a few legal gambling options available in Virginia. As the state considers loosening its gambling laws to allow casinos and sports betting, lottery officials are keeping a close eye on potential impacts to their operations. Hall said the lottery expects to have a better estimate of the skill machines’ fiscal impact in “the coming weeks.”

In a presentation to General Assembly budget writers Tuesday, Secretary of Finance Aubrey Layne said he’s heard anecdotally that some businesses have moved lottery machines out to replace them with skill games.

“We’re going to have to come to grips with this,” Layne said. “We had a great year in the Lottery, which is fantastic. But the last three months have not been what they were.”

In its report, the lottery also noted that its “softening in sales activity” has coincided with the arrival of slots-like historical horse racing machines operated by Colonial Downs Group after the General Assembly legalized the machines in 2018. The company that bought the horse racing track and reopened it this year has established mini-casinos in New Kent County, Richmond and the town of Vinton in Roanoke County. And more are on the way.

Unlike with the historical horse racing machines, the state hasn’t passed any legislation authorizing the skill machines, leaving uncertainty over whether they are or aren’t legal. While largely avoiding state-level regulatory scrutiny, Queen of Virginia Skill & Entertainment — a high-profile player in the industry — has given Virginia politicians from both parties a total of $224,000 since entering the state in late 2017, according to the Virginia Public Access Project. The company also claims to have donated more than $600,000 to Virginia charities since the fall of 2018.

“We agree that there are many gambling machines masquerading as skill devices across the Commonwealth and those illegal machines must be cleaned up,” Queen of Virginia spokesman Joel Rubin said in emailed statement. “Our Queen of Virginia skill games are legal and provide a valuable benefit for hundreds of small businesses across the Commonwealth.”

The company’s gaming terminals resemble slot machines. But they contain an element of skill that may be enough to get around Virginia’s ban on gambling devices.

The company’s games generate what they call a “tic-tac-toe style puzzle” featuring spinning reels and a three-by-three grid with randomly generated symbols. Players can solve the puzzle by picking a “wild card” square to make a line of three matching symbols. Solving the puzzle doesn’t always result in a prize greater than the amount played. If the user doesn’t win back 104% of the money they played, they can proceed to a memory game that allows them to recoup their money by successfully repeating a 25-step sequence of lighted dots in perfect order.

In June, Charlottesville Commonwealth’s Attorney Joe Platania announced he had determined the Queen of Virginia machines are illegal. He ordered establishments in his city to remove them or risk prosecution.

The company responded by suing Platania, arguing that its games are lawful because a “perfectly skillful” player can always win at least 104% of what they put in.

“For this reason, the Game is not an illegal gambling device, and playing it does not constitute illegal gambling under Virginia’s gambling statutes,” the company said in its lawsuit.

The company has also filed a federal lawsuit against an apparent competitor operating in Virginia, claiming patent infringement and breach of contract.

To avoid exposing bars and convenience stores to punishment by the Virginia Alcoholic Beverage Control Authority, the company obtained a letter from ABC in 2017 that said the agency — after conferring with Attorney General Mark Herring’s office — did not consider the games to be illegal gambling devices. On its website, Queen of Virginia boasts it has “the only games in Virginia which have been reviewed for use by [ABC] with an accompanying written letter.”

But the ABC letter concluded on a cautionary note, stating that the agency’s opinion was “obviously not binding” on other agencies or officials who may come to a different conclusion on the devices’ legality.

In April, ABC updated its stance. In a bulletin to its licensees, the agency said Herring’s office had offered “additional guidance” suggesting it is up to local prosecutors to decide whether the games are legal. The agency said it would work with local law enforcement should questions about potentially illegal games arise.

House Appropriations Chairman Chris Jones, R-Suffolk, voiced dismay at ABC’s initial letter appearing to sanction the machines, saying the machines seem to have proliferated with little state control.

“I am very surprised by that interpretation,” Jones said in an interview. “We need to potentially revisit that in the coming year.”

The state is conducting a wide-ranging gambling study ahead of possible legislative action in 2020.

Herring spokesman Michael Kelly said it has been the “longstanding position” of the attorney general’s office to defer to local prosecutors what games do or don’t constitute illegal gambling. Kelly said the Charlottesville lawsuit — which asks the court to essentially declare the games legal — could “provide some clarity in the near term.”

In a legal analysis attached to its lawsuit, Queen of Virginia said its games were further bolstered by earlier legal opinions on claw machines and coin pushers. In 1988, then-Attorney General Mary Sue Terry said both games would not qualify as gambling devices under state law.

At Tuesday’s budget meeting, Senate Majority Leader Tommy Norment, R-James City, asked Layne, the finance secretary, if the General Assembly could consider a “taxation adjustment” to protect the lottery from “other gaming alternatives.”

“You guys appropriate the money, so I think you’re the ones who control the purse strings,” Layne said.

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