Without admitting or denying the allegations in the complaint, Time Warner consented to the entry of a judgment that, among other things, orders it to pay $300 million in civil penalties, which the Commission will request be distributed to harmed investors. The penalties cannot be used to offset any judgment or settlement in any related shareholder suit. The judgment further orders the company to comply with the Commission's May 15, 2000 cease-and-desist order against AOL; enjoins the company from violating antifraud, reporting, books-and-records, and internal control provisions of the federal securities laws; and enjoins the company from aiding and abetting securities fraud. As part of the settlement, Time Warner agreed to restate its historical financial results to reduce its reported online advertising revenues by approximately $500 million (in addition to the $190 million already restated) for the fourth quarter of 2000 through 2002 and to properly reflect the consolidation of AOL Europe in the company's 2000 and 2001 financial statements. The company also agreed to engage an independent examiner to determine whether the company's historical accounting for certain transactions was in conformity with generally accepted accounting principles (GAAP).
In the separate administrative action, Pace, Barge, and Desroches consented, without admitting or denying the allegations, to the entry of a Commission cease-and-desist order that finds that they caused reporting violations by the company based on their roles in accounting for $400 million paid to the company by Bertelsmann AG in two sets of transactions.
Stephen M. Cutler, Director of the Commission's Division of Enforcement, said, "Our complaint against AOL Time Warner details a wide array of wrongdoing, including fraudulent round-trip transactions to inflate online advertising revenues, fraudulent inflation of AOL subscriber numbers, misapplication of accounting principles relating to AOL Europe, and participation in frauds against the shareholders of three other companies. Some of the misconduct occurred while the ink on a prior Commission cease-and-desist order was barely dry. Such an institutional failure calls for strong sanctions."
James T. Coffman, Assistant Director of the Commission's Division of Enforcement, added, "Accountants are gatekeepers to the capital markets. The actions against Pace, Barge, and Desroches demonstrate that the Commission will hold responsible executives and accountants who fail to take meaningful action when faced with significant evidence that the accounting is wrong. As our investigation continues, we will be turning our attention to those primarily responsible for the company's fraud and improper reporting."
The Commission's complaint against Time Warner, which was filed in the United States District Court for the District of Columbia, includes the following allegations:
Fraudulent Round-Trip Transactions to Inflate Online Advertising Revenue
Beginning in mid-2000, stock prices of Internet-related businesses declined precipitously as, among other things, sales of online advertising declined and the rate of growth of new online subscriptions started to flatten. Beginning at this time, and extending through 2002, the company employed fraudulent round-trip transactions that boosted its online advertising revenue to mask the fact that it also experienced a business slow-down. The round-trip transactions ranged in complexity and sophistication, but in each instance the company effectively funded its own online advertising revenue by giving the counterparties the means to pay for advertising that they would not otherwise have purchased. To conceal the true nature of the transactions, the company typically structured and documented round-trips as if they were two or more separate, bona fide transactions, conducted at arm's length and reflecting each party's independent business purpose. The company delivered mostly untargeted, less desirable, remnant online advertising to the round-trip advertisers, and the round-trip advertisers often had little or no ability to control the quantity, quality, and sometimes even the content of the online advertising they received. Because the round-trip customers effectively were paying for the online advertising with the company's funds, the customers seldom, if ever, complained.
Aiding and Abetting Frauds
Several of the counterparties to the round-trip transactions were publicly traded companies. Three of these counterparties-Homestore, Inc., PurchasePro.com, Inc., and a California software company- improperly recognized revenue on the round-trip transactions and reported materially misstated financial results to their own investors.
As a consequence, the company aided and abetted the frauds of three public companies.
Fraudulent Use of Bulk Sales to Inflate the Number of AOL Subscribers
The company artificially inflated the number of AOL subscribers in the second, third, and fourth quarters of 2001 so it could report to the investment community that it had met its new subscriber targets, an important metric the market used to evaluate AOL (both before and after its merger with Time Warner). Specifically, the company counted members from "bulk subscription sales" to corporate customers (for distribution to their employees) when the company knew that the memberships had not, and mostly would not, be activated. In at least one instance, the company entered into round-trip arrangements to fund the corporate customers' purchases of bulk subscriptions. Additionally, in last-minute efforts to meet the quarterly targets, the company on at least four occasions shipped non-conforming bulk subscription membership kits to the customers prior to quarter-end with the understanding that it would turn around and replace them at a later date with conforming kits, but it nonetheless counted new subscribers from these sales as of the quarter-end.
Failure to Consolidate AOL Europe
From March 2000 through January 2002, the company failed to properly consolidate the financial results of AOL Europe in its financial statements. AOL Europe was originally a 50/50 joint venture between AOL and Bertelsmann. In March 2000, AOL entered into a contingent purchase agreement relating to Bertelsmann's interest in AOL Europe. The agreement gave AOL broad and direct powers enabling it to control the operations and assets of AOL Europe, a fact that the company acknowledged in a letter to the European Commission (in the context of satisfying EC merger regulations). GAAP requires consolidation when one entity has a controlling financial interest in another entity. The company's failure to properly consolidate AOL Europe resulted in material misstatements of its financial results, including overstatements of operating income and free cash flow in 2000 and 2001, overstatements of net income in 2000, understatements of net losses in 2001, and understatements of total debt in 2000 and 2001.
Violations of the Commission's Cease-and-Desist Order
The Commission issued a cease-and-desist order against AOL on May 15, 2000 because AOL violated reporting and books-and-records provisions of the federal securities laws. Thereafter, the company violated the cease-and-desist order by artificially inflating its online advertising revenue and the number of AOL subscribers, as well as its failure to consolidate AOL Europe's financial statements.
