Salary Cap Smoothing Is As Complicated As It Is Necessary

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Update 2 (3/11/15): The National Basketball Players Association informed the NBA that it will not agree to “smoothing” in the increases in the salary cap that will result from the new national media agreements beginning in the 2016-17 season.

Update (2/13/15): The National Basketball Players Association officially rejected the NBA’s salary cap “smoothing” proposal on Friday. NBPA executive director Michele Roberts said the union hired two forensic economic teams to evaluate the league’s proposal and both recommended the union not accept it.

The league’s proposal apparently contained some elements of artificially suppressing the salary cap (the second scenario described below) and increasing the salaries in all existing contracts (the third scenario described below). The union is opposed to artificially suppressing the salary cap.

The league and union can still negotiate, but time is running increasingly short.

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“At first glance, [it] is not that attractive, I won’t lie. But we’re studying it to figure out if there really is some advantage for players.”

That was NBA players’ union executive director Michele Roberts last week, describing her aversion to salary cap “smoothing” in the wake of the league’s massive new national TV rights deals.

The new deals with Disney and Turner will pay out $23.4 billion over nine seasons, starting with 2016-17 and running through 2024-25, an average of $2.6 billion per year. That’s a huge increase from the current deals, which pay out $7.44 billion over eight seasons, an average of $930 million per year.

The new deals escalate over time, starting at $2.1 billion and climbing to $3.1 billion. The current deals will pay out just over $1.0 billion in their final season in 2015-16, which means the league’s national TV revenue will jump by nearly $1.1 billion in 2016-17.

The salary cap is tied directly to league revenues, and this will be the largest injection of revenues in NBA history. It alone will cause a $16 million spike, above and beyond any increases from sources other than national TV money. 

The cap is set at $63 million this season after having hovered at around $58 million for the previous six years. The league is projecting a $66.5 million cap for 2015-16. If left unchecked, it could jump by around $20 million in 2016-17, to as high as $86 million or more.

This abrupt influx of spending power would produce a windfall for the free-agent class of 2016.

But it could cause some big-time trouble as well:

  • It could magnify any perceived lack of competitive balance across the league. A huge influx of spending power allocated exclusively toward one summer could cause NBA teams to gut their rosters in preparation. There are only so many quality free agents whom will come available that summer, and only so many teams that can grab them. Those who get them could become powerhouses. Those who get shut out will be left to pick up the pieces.
  • It could leave past free-agent classes in the lurch. When the salary cap increases, so too do minimum team spending requirements and maximum salaries. Players whose contracts are up in 2016 could see a substantial increase in salary based solely on timing, so much so that an average player could wind up making substantially more money than, say, a superstar player who locked in a full maximum salary contract in 2015.
  • It could leave future free-agent classes in the lurch. If so much cap space is being spent on long-term contracts for the 2016 free-agent class, there may not be much cap space left over for the summers that follow. This could have a particularly damaging effect for higher-priced free agents in 2017 and beyond – right up until the point where the contracts of the highly paid summer of 2016 free agents burn off.
  • It could cause wild, unexpected swings in future salary cap levels. Teams will certainly not be able to ramp up their spending on player salaries quickly enough to accommodate the elevated salary cap levels produced by the new TV deal (even if every team in the NBA were to spend $10 million more on player salaries than wherever the salary cap will be set in 2016-17, the players still wouldn’t get their guaranteed share of revenues). That, in turn, will leave the players with less than the share of league-wide revenues to which they are entitled. The players would still get their money on the back end through the escrow process, but it would still pose massive problems. That’s because the salary cap calculation contains an adjustment mechanism whereby if the league doesn’t pay the players their guaranteed share of revenues in any one season, then the shortfall, divided by the number of teams in the league, is added to the salary cap in the following season. Alternatively, if the players were paid more than their guaranteed share of revenues (pre-escrow) and the system is getting close to exceeding what the league can get back through the escrow system, then the salary cap in the following season may be reduced in order to put on the brakes. Ultimately, since it will be virtually impossible for teams to ramp up their spending quickly enough to accommodate the elevated 2016-17 salary cap, the current salary cap calculation methodology will cause a huge one-time upward spike in the cap in 2017-18 as well, which will then cause a huge drop in the 2018-19 salary cap as the one-time spike is burned off(1).

The league wants to avoid such instability. It is pushing to “smooth out” the effects of the TV deal.

The possibilities for doing so are limited only by the mind’s imagination. But such scenarios are fraught with complications.

Players are entitled to a guaranteed 51 percent share of league-wide revenues(2). The split of league revenues is the single most critical collectively-bargained element of the CBA. Neither the players nor the owners will allow any salary cap “smoothing” mechanism to alter the integrity of the split. Therefore, smoothing inherently creates a diversion between what players are being paid and the salary cap levels which largely determine their salaries.

But smoothing is necessary.

Three of the more prevalent alternatives for salary cap smoothing (each of which containing countless permutations) include:

  • The league could take some of the $23.4 billion in TV money that kicks in for the 2016-17 season and push it back into 2015-16, thus raising next year’s cap from the its current $66.5 million projection. For example, the league could reallocate $550 million toward 2015-16, causing the 2015-16 cap to increase to a projected $74 million. If the remaining $22.8 billion were then to be allocated normally, the 2016-17 cap could increase to $85 million (vs. the $86 million projection from above). The league would achieve its desire for smoothing in the form of cap increases from $63 million (this year) to $74 million (2015-16) to $85 million (2016-17), with steady growth thereafter.

This approach could be problematic for owners. Increasing the 2015-16 salary cap (the year prior to the TV money kicking in) would cause the players to receive more than their 51 percent share of revenues for that season (because the cash that underlies the cap increase would actually be paid out by the networks in future seasons). While the situation would resolve itself over time, the owners would in effect be funding an interest-free loan to the players that isn’t returned in full for nearly a decade.

The CBA has an established mechanism for dealing with this issue: 10 percent of each player’s paycheck is withheld and placed into escrow until the end of each season; if the players have made more than their fair share, the overage is given back to the owners, and the rest is returned to the players. But with such a large artificial increase in the 2015-16 salary cap, withholding 10 percent of players’ paychecks would not come anywhere close to resolving the massive overage. The league would need to dramatically increase the size of the escrow to wipe out the interest-free loan. That’s unlikely to be something the players would approve. And even if the players did approve, it would still effectively mean that the owners would be fronting a large sum of cash (not necessarily to be given directly to the players but rather to be placed into escrow) that they would only receive back at the end of the season.

Even if the owners were to move past these structural issues, the approach could create dissension within the owner ranks as to how funds returned from escrow would be disseminated. The current CBA requires that the excess funds be returned to the owners in equal shares. But we would be dealing with a substantially larger overage to be returned than is normally the case, and distributing those funds in equal shares would essentially be taking money from higher-spending teams (who contributed more to the escrow account) and giving it to lower-spending teams (who contributed less to the escrow account).

Also problematic is that teams have been planning around a $66.5 million 2015-16 cap for many months now. Vaulting it higher as the result of a concession on smoothing would undermine those planning efforts.

  • The league could gradually phase in the $23.4 billion in TV money that kicks in for the 2016-17 season across multiple future seasons. For example, the league could phase it in over two years by artificially removing $550 million of the TV money from the 2016-17 cap calculation, causing it to reduce to $78 million. The league would achieve its desire for smoothing in the form of cap increases from $66.5 million (next year) to $78 million (2016-17) to maybe somewhere in the neighborhood of $90 million (2017-18), with steady growth thereafter(3).

This approach would be problematic for the players. Artificially decreasing the salary cap would cause the players to receive less than their 51 percent share of revenue for the seasons that are being smoothed (because the increase in cash paid out by the networks would not cause a corresponding increase in the salary cap, which would reduce teams’ spending power).

The CBA has an established mechanism for dealing with this issue: if the players receive less than their 51 percent share of revenue, the league simply cuts them a check for the difference at the end of the season. But think about what would be happening here. This approach effectively amounts to artificially decreasing the salary cap in future seasons with no corresponding increase thereafter. It also means the players would effectively be giving the owners an interest-free loan for each season which has an artificially depressed salary cap (i.e., a significant portion of the money they are owned for the services they perform throughout the season would only be paid after the season is over). Why would the players ever agree to that?

Even if the players were to moved past these structural issues, the approach could create dissension within the player ranks as to how any check(s) cut by the league at the end of the season would be disseminated. When this situation last occurred in 2010-11, the $26 million shortfall was distributed to the players pro rata. But we could be dealing with a substantially larger shortfall this time around, and distributing those funds pro rata would essentially be taking money from higher-paid players and giving to lower-paid players. It is also possible that the union could hold some of the funds back, as a war chest of sorts for what’s expected to be a labor fight in 2017.

  • The league could make no adjustments to future salary cap levels at all. Instead, it could artificially increase the salaries (and cap hits) of all players already under contract for the 2016-17 season by a predetermined amount — the TV money will increase roughly 100 percent in 2016, at which point it will represent roughly 1/3 of league-wide revenues — with corresponding increases to the values of certain salaries and exceptions that do not rise in conjunction with the salary cap, so as to spread the benefit of the increasing salary cap around to all players.

This approach has its problems for both owners and players. For owners, it undermines their cap planning efforts and reduces their potential spending power in the summer of 2016. For players, it could cause dissension in that it takes money from the 2016 free agent class and gives it to others. Despite the problems, such an approach would seem to like it has the potential to be the least controversial to all parties but, thus far, has apparently not been discussed as a possibility.

The league could take any of the above approaches. Or a combination. Or any number of other alternatives. But any change to the salary cap calculation requires consent of the players’ association.

Commissioner Adam Silver recently acknowledged that discussions with the players’ union have already begun. He has discussed a concept with Roberts on a plan to phase in the salary cap increases. In the plan, the league would “artificially lower the cap and tax down to a lower number,” Silver said.

“We are not to the point of looking for agreement with a specific proposal. We have presented a concept to them. It is the league’s position that it will be a more equitable distribution of the money if we smooth in, rather than having one enormous windfall for the particular class of free agents that year. Just to be clear, the players in totality will still get 51 percent of BRI in ’16-17. It’s just a question of how it’s distributed among the players and where the level of the cap is set.”

Silver has reportedly pitched several versions of his concept to Roberts, including some that set the 2016-17 salary cap at anywhere from $78 million to $82 million (presumably the second approach above).

But here’s the thing: Phasing in the new TV money over multiple seasons in an effort to “smooth out” the cap increases could ultimately do the exact opposite, particularly if Roberts and the players’ union are to have their way.

Back in 2011, the league opted out of the previous CBA and locked out the players. Silver declared the then-current system to be “broken,” claiming that most teams were losing money and vowing to secure the concessions necessary to create a “sustainable business model that… provides teams, if well-managed, with an opportunity to be profitable.”

Following a contentious negotiation, the sides eventually agreed upon on a new CBA that reduced the players’ share of revenues from 57 percent to 50 percent (but could range from 49 percent to 51 percent). This massive give-back by the players salvaged a shortened 2011-12 season, and helped bring about what is now record profitability for the league.

Owners who once leveraged $300 million or so in annual losses from their $1.6 billion cut of league-wide revenues prior to the lockout (43.0 percent of a $3.8 billion pie) replaced it with a $2.3 billion cut this past season (49.9 percent of a $4.5 billion pie), presumably driving $300 million or so in profits(4). When the new media rights deal kicks in two years from now, the owners’ cut could nearly double to $3.1 billion, which could potentially drive annual profits for owners into the billion-dollar range. That’s a billion dollars of profit.

The players’ concessions have helped make that happen. Over the past three seasons, $812 million has been redistributed from players to owners as a result of the adjusted revenue split. Over the next two years, it figures to redistribute another $660 million or so. By the time the new TV deal kicks in, the players will be conceding around $400 million every year. And by the time a new CBA would expire, it would exceed $500 million every year.

The players are bound to want to renegotiate. They’re bound to want to get a little back on the revenue split. They’ll get their chance in 2017, by exercising their right to terminate the current CBA.

The league should be generating nearly $7 billion in revenue by then(5). At those levels, every percentage point give-back would equate to a re-allocation of roughly $140 million — $70 million less for the owners and $70 million more for the players – and, in turn, would cause future salary cap levels to rise by $2 million.

For purposes of the cap calculation, the players should get at least one percentage point back without league objection. That singular point will not cause any reallocation of monies between players and owners but rather correct for an “error” in the salary cap calculation itself.

The current cap calculation is based on the presumption of a 50-50 split of league-wide revenues. It was designed that way because it represents the midpoint of what the players are guaranteed to receive (between 49 to 51 percent). The calculation is working fine for now because the actual split over the past three years has consistently been quite close to 50-50. The new TV deal, however, will ensure the players receive the maximum 51 percent. At that point, you’ll have a salary cap calculation that is based on a presumption of a 50-50 split of revenues when in fact the players will be receiving a 51 percent share. That’s an “error,” on that perhaps should have been caught and accounted for, and it will cause the 2016-17 salary cap (and luxury tax) to be unfairly low(6). Any new CBA to come would surely correct for this issue.

Roberts, however, is gearing up to push for more than just to keep the 51 percent share the players will already have. She and the players she represents would surely love to see the previous 57– 43 split restored. However, despite their new-found riches, owners aren’t likely to simply relent.

We could be in for another epic battle. But for illustrative purposes, let’s simplify. If the starting point is 51 percent and the union is pushing for as much as 57 percent (or more), perhaps a compromise is ultimately struck at the midpoint, 54 percent. That alone would vault the 2017-18 salary cap by about $8 million. An assumed $90 million salary cap (from above) could instead reach $98 million.

Which brings us back to the concept of smoothing.

Why would the players agree to artificially lower the 2016-17 salary cap to between $78 million and $82 million if they’re gunning for a post-lockout salary cap of $98 million or more the very next season? Wouldn’t such “smoothing” create the type of massive jolt it is being tasked to prevent – going from $66.5 million next season, to between $78 million and $82 million after the TV deal kicks in, to $98 million after the lockout?

No one knows how high the cap will go over the next several years. The figures presented in this post are merely illustrative. But the point is simple: If the players plan to fight for a larger share of league-wide revenues, a corresponding jolt in the salary cap would follow. If that is what you are gunning for as a union, then why would you accept a plan – in whatever form it comes – that (significantly) lowers the cap for the season prior? Wouldn’t it in effect be creating the very wild fluctuations that such “smoothing” was purporting to eliminate(7)?

The players would likely reject any proposal that artificially reduces future salary cap levels (alternative two above), while owners would likely reject any proposal that artificially increases prior salary cap levels (alternative one above). That leaves the issue very much locked in uncertainty.

Salary cap smoothing is an extremely complex issue – so complex, in fact, that the league has retained economists and other professionals to assist in navigating the matter(8).

Don’t expect a resolution on the issue anytime soon. The NBPA recently issued a memo to its members, letting them know that the matter of salary cap smoothing will be discussed and analyzed at upcoming player representative meetings, as well as with a larger audience at All-Star Weekend.

Notes:

1. To be fair, the subsequent spikes in the salary cap of which I speak would happen in the seasons after the current CBA is likely to be terminated, so this probably really isn’t an issue. Any new CBA to come will surely address this issue so as not to allow for such wild multi-season fluctuations as a result of this one-time event. 

2, According to the terms of the CBA, the players are guaranteed to receive between 49 percent and 51 percent of the league’s revenues — the exact percentage is tied to the league’s financial performance. The new TV deal should ensure the players receive the full 51 percent for the remainder of the agreement.

3. This example assumes the TV money is smoothed out over three years for purposes of symmetry but an example over more years would be equally plausible. See footnote 7 below for my ramblings as to why the maximum, in my humble opinion, should only be four. 

4. And let’s be honest here. Even this impressive number should be substantially higher. No team needs to spend as recklessly as did the Brooklyn Nets last season. 

5. Remember also that CBA negotiations will concern themselves only with the future, so they’d be negotiating the revenue split for seasons during which total revenues would top $7 billion, and possibly even exceed $8 billion! 

6. Ironically, this what I call “error” will have the effect of “smoothing” things out, by lowering the 2016-17 salary cap by around $2 million. This “error” will cause the 2016-17 cap to decline by $2 million, which could in turn cause players not to receive their 51 percent share of revenues, which would in turn cause a check to be cut by the league for the difference, which would in turn cause a spike in the salary cap the following season, which in turn would create huge spikes in the salary cap, which is what the league is trying to prevent. This is another factor that would cause the current CBA to be terminated and be corrected for in any subsequent negotiations. 

7. You could make the argument that smoothing is still beneficial (particularly plans which place the 2016-17 in the higher end of the range being discussed) even if the 2017-18 were to rise to nearly $100 million. But I could make the argument right back at you that the $100 million figure was only if players receive concessions to a split of league-wide revenues at 54 percent; they’d clearly be gunning for more. Then you’d argue back at me that I am being short-sighted because I am only considering how best to smooth things out when one year is altered. Then we’d get into a debate as to how many years should be smoothed out. My logic would go something like this: Smoothing purports to artificially alter the salary cap levels in any particular season(s) such that it creates a more natural flow with the unaltered salary cap levels in the season(s) that surround it. Since most NBA contracts last no longer than four years (up to five, for players who leverage full Bird rights), only between one and two cap levels need to be artificially altered. In that way, cap levels will be smoothed over a three to four year period. And so, I’d have to conceded that you were right and consider alternatives that would alter two years. And so continue the ramblings of an idiot. But it’s okay, because nobody ever reads footnotes anyway. 

8. You can’t just pick a number and go with it. The cap calculation is at the core of every financial metric utilized by the league. This is a much larger undertaking than it would seem. I promise. 

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