Take-Two Reveals Subpoenas Over Hidden Sex Scenes in Video Game

Shares of video game producer Take-Two Interactive Software (Nasdaq: TTWO) plunged to new lows Tuesday after the company revealed it had been served with grand jury subpoenas as part of an apparent investigation into a host of company activities. At issue is whether company executives knew about explicit sex scenes hidden in its "Grand Theft Auto: San Andreas" game.

Take-Two said it had been served with subpoenas from the District Attorney of the County of New York asking for various documents from the company dating to October of 2001.

Other Issues Raised

The New York City-based firm said the subpoenas seek documents relating to the programming of "Grand Theft Auto: San Andreas," the subsequent submission of the title to the Entertainment Software Rating Board for rating determination, as well as internal documents related to the decision to terminate PricewaterhouseCoopers as its auditor.

Also being sought are documents related to compensation of current and former officers and those relating to the interactions between the company's Board of Directors and management. Suggesting additional issues being raised by the investigation is the inclusion of the documents related to acquisitions the company made in 2005 in the request.

"The Company has not been advised that it or any specific individual is presently a target of the investigation," Take-Two said in a statement. "The Company is fully cooperating and providing the requested documents."

The subpoenas appear to be aimed at determining whether company executives and directors were aware of the inclusion of sexually explicit material in hidden scenes in the game title. The scene, often referred to as "hot coffee" after a line of dialogue in the hidden scene, was hidden in the original game but could be unlocked with downloadable patches, which were widely available on the Internet.

Bad News Travels Fast

Take-Two disclosed the subpoenas in a press release and a filing with the Securities and Exchange Commission (SEC) late Monday. By Tuesday afternoon, the company's shares had lost some 18 percent and were trading at US$10.56. That price would represent a new 52-week low for the stock, more than a full dollar below the previous low price for the past year.

The San Andreas version of "Grand Theft Auto" has become a double-edged sword for Take-Two. It is one of the best selling titles is has ever produced, but the resulting "hot coffee" scandal forced it to offer to buy back thousands of copies and to re-issue the game without the hidden scenes -- at a cost of more than $20 million. It also helped put the company under the glare of white-hot regulatory spotlights.

Earlier this month, Take-Two and Rockstar Games -- which developed the title -- reached a settlement with the Federal Trade Commission (FTC). The FTC agreed to drop charges that the companies made deceptive claims about the content of its games in order to get more favorable ratings.

"We allege that Take-Two and Rockstar's actions undermined the industry's own rating system and deceived consumers," said Lydia Parnes, Director of the FTC's Bureau of Consumer Protection. "This is a matter of serious concern to the Commission, and if they violate this order, they can be heavily fined."

Regulators have dogged Take-Two in the past as well. In June of 2005, the company agreed to pay $7.5 million in fines to settle an SEC investigation into its accounting practices, which also led to a restatement of earnings from 2002 to 2004.

More recently, Take-Two found itself dealing with the fallout from the resignation of a board of directors member. Barbara A. Kaczynski, who chaired the board's audit committee, resigned in January and cited mis-management as her reason for leaving.

Kiss of Death

What most hurt Take-Two immediately after the hot coffee scandal was the decision by the ratings board to rate the title as "Adults Only," according to JupiterResearch analyst Joseph Laszlo. Not only did that limit its natural audience of teenagers, it also meant the title would not be carried by many important retailers, notably Wal-Mart (NYSE: WMT), which immediately pulled it from its shelves.

Though it may help titles appeal to older gamers, in terms of overall sales , "that rating can be the kiss of death," he added.

Laszlo said the controversy prompted cries for changes in the game-title rating system, but that has yet to happen, even though game publishers say the system hurts them by limiting access to their games and that decisions are often arbitrary.

The Grand Theft series is largely responsible for Take-Two's success as a game publisher, with an estimated $50 million in revenue from the franchise since it first appeared in the late 1990s.

What was most troubling about the subpoenas is that they seem to cover a range of areas, including "anything and everything over the last five years," said UBS Investment Research analyst Michael Wallace. He said the cloud of potential criminal investigations could also cause the company to lose focus, something it can't afford to do in a bitterly competitive game publishing market.