UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF NEW YORK
02 MDL Do cket No . 1500 (SWIG) ) 02 CIV. 5575 (SWK) IN RE AOL TIME WARNER, INC. ) SECURITIES & "ERISA" LITIGATION )
SECOND AMENDED CONSOLIDATED CLASS AC ION COMPLAINT OF LEAD PLAINTIFF MINNESOTA STATE BOARD OF INVESTMENT
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MEREDTflI COHEN GREENFO GEL HENS MILLS & OLSON, P .L.C. & SE`IRN1CI , -P.C. 3554 IDS Center - . Oane Liberty Plaza, 35th Floor - 80 South Eighth Street ~K :. :; •~ New York, N . :,10006 :fir.., ,. :•~ ~(212]240-0020 . ., 3384505
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48184 TABLE OF CONTENT S
1. INTRODUCTION _ ...... 1 U . NATURE OF THE ACTION ...... 11 III . JURISDICTION AND VENUE...... 13 IV . PARTIES ...... 14
A. Plaintiffs ...... 14
1 . Lead Plaintiff ...... 14 2. Additional Plaintiffs...... 1 5 B . Defendants...... 15 1 . AOL Time Warner, Inc...... 15 2 . America Online, Inc ...... 16 3. Time Warner, Inc ...... 16 4. The Individual Defendants...... 1 7
a. Stephen M. Case...... 17 b. Robert W. Pittman ...... 18 c. J. Michael Kelly...... 18 d. David M. Colburn...... 19 C. Eric Keller ...... 19- f Joseph A. Ripp...... 19 g- Steven Rinder ...... 20 h. Gerald M. Levin ...... 20 k. Wayne H. Pace ...... 20
5 . Additional Individual Defendants ...... 23
a. Paul T. Cappucio ...... 23 b. Kenneth J. Novack...... 23 6. E rnst & Young LLP ...... 23 V . CLASS ALLEGATIONS ...... 24 VI . SUBSTANTIVE ALLEGATIONS ...... 27 A . The Growth of AOL and Its Emphasis on Increasing Advertising Revenue...... 27 B . The Constant and Increasing Pressure to Falsify Advertising Revenue ...... 32
I C. The Creation of AOL Time Warner and the Additional Pressure to Report Growing Adve rtising Revenue ...... 3 6
D . AOL's Pattern and History of Accounting Improprieties ...... 37
E. Fraudulent Transactions and Improper Accounting Used to Artificially Inflate AOL and AOL Time Warner Advertising Revenue ...... 40
I . Use of Sham Transactions and Improper Accounting Practices Regarding Round -Tripping, Back-to-Back, and Boomerang Deals ...... 47
2. Barter Transactions ...... 48
a. Exchange of Advertising for Goods and/or Services ...... 50
b. Warrants or Stock (equity) Received in Barter o r Partial Barter Transactions ...... 52
c. Exchange of Advertising - "In Kind" Advertising ...... 54
(i) Homestore, Inc...... 56 (ii) Sun Microsystems, Inc...... 60 (iii) Veritas Software Corporation ...... 62 (iv) Bertelsmann AG ...... 64 (v) Gateway Inc. RoundtripfFree Internet Service ...... 66 (vi) WorldCom Inc ...... 67 (vii) Qwest Communications ...... 69 `iii) Hughes Electronics Corporation ...... 70 (ix) Homestore-The 2000 House and Home Deal ...... 72 (x) Gateway Inc Stock Purchase ...... 74 (xi) Oxygen Media Inc . Stock Purchase ...... 75 (xii) PurchasePro .com, Inc. Advertising Swap ...... 77 (xiii) Monster.com ...... 78
3. "Front Loading" or "Jackpotting" t o Record Advertising Revenue ...... 79
(i) Catalina Marketing Corporation ...... 80 (ii) Telefonica SA ...... 8 1
4. Converting Legal Disputes into Advertising Revenue ...... 82
(i) 24dogs.com Arbitration Award ...... 82 (ii) Ticketrnaster Legal Action ...... 84
ii 5. Booking Sales on a Gross Rather Than Net Basis to Inflate Advertising Revenue ...... 85
eBay...... 86
6. Counting Repricing of Equity Stock Rights as Advertisin g Revenue...... 89
PurchasePro ...... 89
7. Converting Contract Termination Fees into Advertisin g Revenue...... 90
Dr.Koop.com ...... 92
8. "Cross-Platform" Deals to Inflate Advertising Revenue ...... 93
(i) The Golf Channel ...... 94 (ii) Oxygen Media-Carriage Deal ...... 95
F. The Company's Admissions of Materially Overstated Advertising Revenue and Violations of the Securities Laws ...... 97
G. The Materially False and Misleading Statements, Omissions of Material Fact and Devices, Schemes or Artifices to Defraud Regarding Artificially Inflated Advertising Revenue ...... 99
a. The Fiscal Quarter Ended December 31, 1998 ...... 100 b. The Fiscal Quarter Ended March 31, 1999 ...... 102 c. The Fiscal Quarter and Year Ended June 30, 1999 ...... 105 d. The Fiscal Quarter Ended September 30, 1999 ...... 109 C. The Fiscal Quarter Ended December 31, 1999 ...... 112 f. The Fiscal Quarter Ended March 31, 2000 ...... 11 6 g. The Fiscal Quarter and Year Ended June 30, 2000 ...... 12 1 h. The Fiscal Quarter Ended September 30, 2000 ...... 126 i. The Fiscal Quarter and Year Ended December 31, 2000 ...... 132 j . The Fiscal Quarter Ended March 31, 2001 ...... 142 k. The Fiscal Quarter Ended June 30, 2001 ...... 15 1 1 . The Fiscal Quarter Ended September 30, 2001 ...... 156 M. The Fiscal Quarter and Year Ended December 31, 2001 ...... 158 n. The Fiscal Quarter Ended March 31, 2002 ...... 16 1 a. The Fiscal Quarter Ended June 30, 2002 ...... 162
H. The Materially False and Misleading Statements, Omissions of Material Fact and Devices, Schemes or Artifices to Defrau d
ill Regarding AOL Time Warner's Goodwill ...... 166
1. Defendants' Course of Conduct is Revealed ...... 18 1 J . Scienter of the Individual Defendants ...... 187
The Individual Defendants Knew, or Recklessly Disregarded, that AOL and AOL Time Warner Were Engaged in Fraud and Were Motivated to Use and Cover Up the Use of Improper Accounting and Sham Transactions to Artificially Inflate Advertising Revenue ...... 187
a. The Individual Defendants Were Actively Engage d in the Company's Daily Activities Such That They Were Aware Of, Recklessly Disregarded, Controlled and/or Culpably Participated in the Fraudulent Activities of th e Business Affairs Division ...... 188
b. The Nature of the Accounting Improprieties an d Sham Transactions ...... 193
c. Whistleblowers Provide Further Evidence of Individual Defendants' Knowledge ...... 195
d. The Prior Pattern of Improper Accountin g Practices...... 197
e. Defendants ' Restatement of AOL's Advertising Revenu e and GAAP Violations Provide Evidence of Scienter ...... 198
f. The Individual Defendants ' Awareness of Improper Deals and Continued Denial of Any Wrongdoing After the Truth is Revealed...... 199
2 . Motive and Opportunity of the Individual Defendants to Engage in Improper Accounting, Sham Transactions and Reporting of Inflated Advertising Revenue ...... 200
a. Salaries, Bonuses, Stock Sales - The Culture of Greed Begins ...... 200
b. The Shift to Flat Rate Pricing and the Increased Importance of Advertising Revenue to AOL's Bottom Line ...... 201
c. A Culture of Recklessness and Greed ...... 202
iv d. The Importance of Initiating, Consummating an d Successfully Implementi ng the Merger ...... 206
e. Defendants' Financial Incentives Related to the Merger ...... 209
f. The Individual Defendants Deny and Cover Up Problem s Associated with Shrinking Advertising Revenue ...... 21 0
3. Individual Defendants' Compensa tion Incentives ...... 213
4. Additional Allegations and Discussions Regarding Scienter and § 10(b ) Violations of Stephen M . Case ...... 21 7
5. Additional Allegations and Discussions Regarding Scienter and § 10(b) Violations of Gerald M . Levin...... 224
6. Additional Allegations and Discussions Regarding Scienter and § 10(b) Violations of Joseph A . Ripp and Steven E. Rindner ...... 228
K. Scienter of Ernst & Young ...... 232
I . Ernst & Young's Work for AOL, Time Warne r and AOL Time Warner ...... 232
2. Ernst & Young's Close Relationship with AOL Time Warner ...... 233
3 . Ernst & Young's Auditing Expertise and Industry Knowledge ...... 234
4. Ernst & Young's Actual Knowledge of Specific Transactions and Accounting Thereof ...... 235
5 . The Restatement of AOL's and AOL Time Warner's Financial Statements ...... 237
6. Ernst & Young's Past Involvement with Previou s Accounting Frauds ...... 238
7. Ernst & Young's Responsibilities as AOL's and AOL Time Warner's Independent Auditor ...... 239
8. Ernst & Young's Violations of Accounting and Auditing Standards...... 240
a. Ernst & Young Failed to Properly Consider Fraud ...... 242
b. Ernst & Young Failed to Maintain Independence ...... 249
v c. Ernst & Young Violated GAAS by Reporting that the Financial Statements Were Presented i n Accordance with GAAP When They Were Not ...... 250
d. Ernst & Young Failed to Obtain Sufficient and Competent Evidential Matter ...... 251
C. Ernst & Young Fa iled to Exercise Due Professiona l Care and Professional Skepticism ...... 253
f. Ernst & Young Failed to Properly Plan and Supervise ...... 253
g. Ernst & Young Failed to Properly Evaluate Audit Findings ...... 255
h. Ernst & Young Failed to Properly Consider AOL and AOL Time Warner's Lack of Internal Control ...... 256
L. The Materially False and Misleading Statements and Omissions of Material Facts In the Merger Registration Statement and Joint Proxy Statement-Prospectus ...... 257
VII. APPLICABILITY OF PRESUMPTION OF RELIANCE : FRAUD-ON-THE-MARKET DOCTRINE ...... 264
VIII. NO SAFE HARBOR ...... 265
IX. COUNTS ...... 266
COUNT ONE...... 266
Against AOL Time Warner for Violations of § I 1 of th e Securities Act in Connection With the Merger Registration Statement ...... :. .266
COUNT TWO ...... 268
Against Defendants Case, Levin, Kelly, Cappuccio, Novack and Pittman for Violation of Section 1 I of the Securities Act in Connection with the Merger Registration Statement ...... 268
COUNT THREE...... 269
Against Ernst & Young for Violations of § 11 of the Securities Act in Connection With the Merger Regis tration Statement ...... 269
N COUNT FOUR ...... 272
Against Defendants Case , Pittman, Kelly, Colburn, Ripp and Levinfor Liability Under § 15 of the Securities Act For Violations of § 11 of the Securities Act ...... 272
COUNT FIVE ...... 274
Against AOL, Time Warner, and AOL Time Warner For Violations of § 14(a) of the Exchange Act, and Rule 14a-9 Promulgated Thereunde r In Connection With the Joint Proxy Statement-Prospectus ...... 274
COUNT SIX ...... 275
Against Defendants Case, Levin, Kelly, Cappuccio, Novack and Pittman For Violations of § 14(a) of the Exchange Act, and Rule 14a-9 Promulgated Thereunder In Connection With the Joint Proxy Statement-Prospectus ...... 275
COUNT SEVEN ...... 277
Against Ernst & Young For Violations of § 14(a) of the Exchange Act, and Rule 14a-9 Promulgated Thereunder In Connection With the Joint Proxy Statement-Prospectus ...... 277
COUNT EIGHT ...... 278
Violations Of Section 10(b) OfThe Exchange Act And Rule lOb-5 Promulgated Thereunder Against Defendants AOL Time Warner, AOL and Case, Pittman, Kelly, Colburn, Keller, Ripp , Binder, Levin and Pace ...... 278
COUNT N NE ...... 282
Against Ernst & Young for Violations of § 10(b) of the Exchange Act and Rule I Ob-5 ...... 282
COUNT TEN ...... 286
Against Defendants Case, Kelly, Pittman, Colburn, Ripp, Levin and Pace for Liability Under § 20(a) Of The Exchange Act For Violations Of § I0(b) Of The Exchange Act And Rule IOb-5 Promulgated Thereunder...... 286
X. PRAYER FOR RELIEF ...... 288
XI. JURY TRIAL DEMANDED ...... 289
vii EXHIBIT A - AOL Advertising and Commerce Revenue (overstated (as originally reported) vs . Actual Advertising and Commerce Revenue)
EXHIBIT B - Additional Plaintiffs and Their Respective Counsel
viii I. INTRODUCTION
This action is brought on behalf of Lead Plaintiff Minnesota State Board o f
Investment ("Plaintiff' or "MSBI") and all other persons and entities who purchased, exchange d or otherwise acquired publicly traded stock of America Online, Inc . ("America Online" or
"AOL") and/or bought or sold options on AOL stock during the period January 27, 1999 through
January 11, 2001, and persons or entities who purchased, exchanged or otherwise acquire d publicly traded stock of AOL Time Warner, Inc. {"AOL Time Warner" or "Company") and/o r bought or sold options on AOL Time Warner stock during the period January 12, 2001 throug h
and including July 24, 2002 . The "Class Period" therefore runs from January 27, 1999 through
and including July 24, 2002, and the "Class" is comprised of all persons and entities who purchased, exchanged or otherwise acquired the stock referenced above or bought or sold option s
on such stock during the Class Period, and were damaged thereby . The illegal conduct detailed in this Second Amended Consolidated Class Action Complaint ("Complaint") was committed by,
among others, senior officers and directors of AOL and AOL Time Warner and their outside
auditor, Ernst & Young, LLP ("Ernst & Young"), in violation of the Securities Act of 1933 (the
"Securities Act") and the Securities and Exchange Act of 1934 (the "Exchange Act") .
2. The MSBI brings this securities class action to redress numerous violations of th e federal securities laws. Defendant AOL Time Warner, Defendant AOL, and other Defendant s named herein, have engaged in, inter alia, a systematic and fraudulent scheme to materially inflate advertising revenue reported in the companies' publicly disclosed financial statement s
and, in turn, the value of AOL and AOL Time Warner stock. To that end, during the Clas s
Period, Defendants overstated AOL's reported advertising revenue by at least a staggering $1 .7 billion through the use of sham transactions and improper accounting practices. This illegal
48184 conduct was designed to capitalize on the "dot-corn" stock market phenomenon and ensure th e
consummation of the merger between AOL and Time Warner, Inc. (` Time Warner"), announced in January 2000.
3. In 1985, AOL began as a small start-up company called Quantum Computer
Services. After going public in 1992, AOL grew rapidly and was one of "the nation' s fastest-
growing commercial computer networks" by the end of 1993 . The AOL business consists principally of interactive services, web properties, internet technologies and electronic commerce
services. As of September 34, 2002, AOL had 26.7 million subscribers to its domestic AOI- branded internet services, and 6 .1 million subscribers to its European internet services . Time
Warner was created by multiple mergers over 75 years, including the combination in .1996 of
Time Warner Companies, Inc. and Turner Broadcasting System, Inc. Time Warner's principal
business is to create and distribute branded information and entertainment throughout the world .
Its business interests include cable networks, publishing, music, filmed entertainment, cable and
digital media .
4. Investor expectations of the future prospects of publicly traded companies had
historically been based largely on reported corporate earnings and cash flows . However, during
the 1990s "Internet boom", many Internet companies had significant losses and negative cash
flow, and were not expected to generate earnings or positive cash flow for some time. As a
result, investors principally based their expectations for the probable future prospects of Interne t
companies, like AOL, on multiples of reported revenue. These revenue multiples were
extraordinarily high by historical standards due to the perceived potential of businesses in this
new industry .
48184 2 5. AOL's stock price experienced a meteoric rise during the Internet boom of the
1990s, with a resulting beneficial impact on the value of Individual Defendants' substantial personal holdings of AOL stock and stock options and their AOL employee compensation. Due in large part to huge increases in reported AOL revenue, in 1998 alone, the value of AOL stock jumped 552%. From 1993 to 1998 the stock price increased by an annual compounded rate o f
135%. However, early in the Class Period , a key source of AOL's recurring advertising revenu e
- Internet companies -- were facing significant concerns with, and eventually a fatal downturn in , their business condition. In turn, AOL's advertising revenue from these sources was leveling off, with future advertising revenue from Internet companies looking increasingly bleak for AOL. In a deliberate attempt to hide that fact and continue its previous extraordinary gains in stock price , and thereby create even greater wealth for themselves, the Individual Defendants devised a n illegal scheme to report materially inflated advertising revenue, a number which had becom e increasingly important to the market in the late 1990s as AOL's subscription revenue waned .
6. AOL and Time Warner announced with much fanfare on Janua ry 10, 2000 their agreement to merge the two companies (the "Merger"), valuing the deal at $200 billion.
However, the value placed on AOL's stock for purposes of the Merger was based primarily on
AOL's purported advertising revenue, and the tremendous growth AOL touted as to this revenue source. Indeed, Salomon Smith Barney Inc., the investment banking firm advising AOL on the
Merger, valued the "advertising and e-commerce" segment ofAOL's business at a multiple of between 44 and 171 -times the reported estimates for fiscal year 2000 revenue, far greater than the multiples attached to the other parts of AOL's business. In other words, it was AOL's historical and projected advertising revenue and e-commerce which were driving its value.
48]84 7. Consummation of the Merger, which the media described as "the deal of the
century," was delayed until January 11, 2001 (one year) due to its complexity and a review of th e
transaction by the Department of Justice ("DOJ") for antitrust purposes. During that time, the
advertising market was continuing to soften and the dot-corn bubble burst for many Interne t
companies . Analysts questioned whether AOL' s advertising revenue was immune from this
development. In response, the AOL Individual Defendants assured the market that, unlike th e rest of the industry, AOL was unaffected. At the same time, however, internal AOL documents
and discussions between Defendants during the pendency of the Merger apprised Individua l
Defendants to the contrary : AOL was at ri sk to lose at least $140 million in advertising revenu e
for calendar year 2001 alone !
To avoid the fate of a rising number of other Internet companies, Individual
Defendants were intent on making sure the merger went through . As one AOL Senior Manager
was quoted by The Washington Post on July 18, 2002, in an article entitled "Unconventional
Transactions Boosted Sales, Amid Big Merger, Company Resisted Dot-Corn Collapse:"
The bubble had clearly burst, but senior management was under enormous pressure to hit the- [financial] numbers and close the Time Warner transaction, which would diversify the revenue base and lower the risk profile of the Company .
Accordingly, during the one year period before the Merger was finalized , AOL's publicly
reported advertising revenue was artificially inflated not only to boost the value of AOL stock , but also to ensure the Merger . After the Merger, Individual Defendants continued to overstat e
AOL Time Warner' s advertising revenue to bolster the Company's stock price and make it
appear that both the Merger and the value of AOL stock exchanged in the Merger were justified.
Even when the advertising market eventually became so weak that the Company was forced t o report decreases in advertising revenue, it nonetheless continued to artificially inflate it s
48184 4 advertising revenue to soften the stock market's reaction to the reported revenue numbers.
Largely as a result of declining advertising revenue figures, AOL has been forced to write-down over $100 billion in goodwill -- the largest write-down in corporate history.
9. On July 18 and 19, 2002, The Washington Post published a two-part article reporting allegations that AOL before the Merger, and AOL Time Warner after the Merger, had substantially overstated publicly reported advertising revenue. Within hours after The
Washington Post first reported the story, Defendant Robert Pittman, AOL Time Warner's Chie f
Operating Officer, a member of the Company's Board, the head of operations for the AOL division of the Company, and formerly the President and Chief Operating Officer of AOL prior to the Merger, abruptly resigned from the Company. At the same time, the Company and
Defendant Ernst & Young, AOL's and AOL Time Warner's independent auditing firm, emphatically denied any wrongdoing and reaffirmed the accuracy of AOL's and AOL Time
Warner's financial statements.
10. Soon thereafter, the Company began to trickle out information confirming its illegal conduct . After the close of the stock market on July 24, 2002, the Company acknowledged that the Securities and Exchange Commission ("SEC") was investigating AOL and the Company's accounting practices, driving AOL Time Warner's stock price down by almost 15.4% overnight. On July 31, 2002, the Company confirmed that the DOJ had commenced a criminal investigation of AOL and the Company's accounting practices .
11 . Two weeks later, in an August 14, 2002 press release and in its SEC Form 1 O-Q filing, the Company acknowledged that advertising revenue "may" have been overstated for
AOL in the amount of $49 million with respect to three transactions covering a period of six
48184 quarters. The Company also stated that it was "continuing its review of these and othe r transactions at the AOL division."
12. On October 23, 2002 , after the filing of the initial complaint in this matter, the
Company restated the financial statements of AOL and AOL Time Warner for eight consecutive quarters (July 1, 2000 to June 30, 2002) during the Class Period, a clear admission of repeated violations of the securities laws. In fact, in its October 23, 2002 Form 8-K filing with the SEC,
AOL Time Warner not only restated the companies' advertising revenue by reducing it in the
amount of $190 million, it also stated :
As a result of the restatement announced on October 23, 2002 by AOL and AOL Time Warner Inc. (the "Company "), the Company' s financial statements for the affected periods should no longer be relied upon, including the audited financial statements for 2000 and 2001 contained in the Company's annual report on Form I O-K for the year ended December 31, 2001 .
(Emphasis added.) The largest quarterly restatement of AOL's advertising revenue, a reductio n
of $66 million, was for the last publicly reported fiscal quarter prior to the consummation of the
Merger that Individual Defendants wanted to be effectuated at all costs.
13. On March 28, 2003, just prior to the filing of the amended Complaint, th e
Company reported in its SEC Form 10-K filing that it may further restate AOL advertising
revenue by reducing it in an additional amount of up to $400 million for the years 2001 and 2002 .
According to the Company, this possible restatement is attributable to two transactions with
Bertelsmann AG, which are a subject of the SEC's investigation . The Company also stated that,
in addition to the Bertelsmann transactions, "it is possible that further restatement of the
Company's financial statements may be necessary," with respect to "the range of other
transactions" being investigated by both the SEC and the DOJ.
48184 6 14. In the aggregate, the Company has thus far restated or acknowledged th e
possibility of restating advertising revenue for the Class Period by reducing the revenue in the
amount of at least $477 million, with essentially all of the reduction attributable to AOL
advertising revenue. However, this figure does not come close, either in magnitude or timeframe ,
to all of the advertising revenue that was previously overstated by AOL and AOL Time Warner
during the Class Period . By Plaintiff's calculation set forth in detail in this Complaint,
Defendants have overstated ADL's advertising revenue during the Class Period by at least $1 .7
billion. A chart reflecting the significant difference between the artificially inflated AO L
advertising revenue reported during the Class Period and the actual amounts ofAOL advertising
revenue is set forth below . (A full-size chart is attached hereto as Exhibit A .)
AOL Advortialnp and Commorco Revenue (Ovarsta ta d ( as Or1 Inalty Reported) vs. Actual Advertlaing and Commerce Revenue)
Boo
700
600
500
400
300
200
10 0
0
Quarters ende d These numbers may decrease as knowledge about AOL's Improper oceounting praetFces Increases with formal discovery.
48184 7 The Company claims that it continues to review the propriety of previously reported financia l
statements. The SEC and DOJ investigations, which according to the Company, "have focuse d
on transactions involving the Company's America Online unit that were entered into after July 1 ,
1999," are continuing and include numerous transactions referenced in this Complaint an d people named as Defendants in this action.
15. Examples of Defendants' illegal conduct during the Class Period include, but are not limited to, the following:
Sixteen separate sham transactions involving AOL and then AOL Time Warner, Homestore, Inc . and various third parties, whereby AOL Time Warner improperly reported significant advertising revenue. At least four Homestore executives have already plead guilty to criminal charges in connection with such transactions and AOL Time Warner executives are targets of the ongoing criminal investigation. In a related civil proceeding brought by Homestore shareholders, the court characterized the sham transactions as "a massive conspiracy driven by pure avarice ;"
b. Various other sham transactions, including one with PurchasePro.com, Inc., which was referred to in the July 19, 2002, Washington Post article as "science fiction ." This sham deal involved a purported revision of the terms of AOL's equity interest in PurchasePro, and AOL and the Company fraudulently accounted for the transaction by reporting $27 .5 million in advertising revenue;
c. So-called "round-trip" deals with various companies such as Bertelsmann AG, Veritas Software Corporation, WorldCom, Inc., Qwest Communications, Hughes Electronics Corporation, Gateway, Inc., Homestore, Inc., PurchasePro .com, Inc., Sun Microsystems, Inc., Monster.com and Oxygen Media Inc., with respect to which AOL or AOL Time Warner improperly reported at least $1 .4 billion dollars in advertising revenue during the Class Period;
d. So called "jackpotting" where AOL and the Company impermissibly "squeezed" multiple on-line advertising banners purchased by the same customer onto the same screen and did so repeatedly during a short period of time at the end of a reporting
48184 8 period in order to record the revenue in that particular reporting period;
C. Converting an arbitration award against MovieFone, Inc . and the settlement of litigation with Ticketmaster into $36 .7 million of advertising revenue;
f Booking gross, rather than net, revenue for advertising which AOL and AOL Time Warner sold on behalf of eBay as a broker, thereby allowing AOL and AOL Time Warner falsely to report substantially more advertising revenue than permitted by applicable accounting rules ;
g. Improperly converting contract termination fees from failing "dot- com" companies into advertising revenue;
h. Improperly accounting for cross-platform adver tising deals (advertising services provided by more than one AOL Time Warner division), including the double-booking of advertising revenue;
i. Reporting materially overstated AOL advertising revenue in numerous AOL and Company press releases and financial statements;
j. Failing to disclose the true current and anticipated condi tion of AOL's advertising revenue and business, both before and after the Merger;
k. Misrepresenting as part of the Merger, AOL's advertising revenue and the value of "goodwill";
1 . Failing to properly account for the vastly inflated goodwill associated with the AOL and Time Warner Merger ; and
m. Falsely representing that AOL and AOL Time Warner's financial statements were prepared in conformance with Generally Accepted Accounting Principles ("GAAP") and fairly represented the financial operation of the companies, and that certain of those financial statements were audited in compliance with Generally Accepted Auditing Standards ("GAAS").
16. Defendants' illegal actions during the Class Period artificially propped up th e price ofAOL and AOL Time Warner stock when they were purchased , exchanged or otherwise
48184 9 acquired by the MSBI and other Class members, causing the MSBI and the Class to lose billion s
of dollars.
17. While AOL and AOL Time Warner investors lost huge amounts of money due to
Defendants' fraudulent scheme, Individual Defendants reaped billions of dollars in proceed s selling their own AOL and AOL Time Warner stock at artificially inflated prices . For instance,
Defendant Pittman sold at least $262 million of AOL and Company stock during the Class
Period, and in the year preceding consummation of the Merger was awarded options for 4 million shares of stock . Defendant Case, the Company's Chairman of the Board, who
announced his resignation in January 2003, sold at least $555 million of AOL and AOL Time
Warner stock during the Class Period and, in the year prior to completion of the Merger, wa s
awarded options for about 5 million shares of stock. Moreover, a large portion of the insider selling by Defendants was conducted during a four-month period just after consummation of the
Merger, during which time the Company was engaged in a $5 billion repurchase of its own stock , serving to further inflate the stock while these Defendants sold millions of their own AOL Time
Warner shares. For instance, Defendants Pittman and Case sold 1 .5 and 2 million AOL Time
Warner shares, respectively, in early 2001, while the Company was mid-flight in its massive stock buy-back program .
18. Even prior to the wrongful acts complained of here, which cover approximately a
31/2-year period beginning Janua ry 27, 1999, AOL's accounting practices had come under SE C scrutiny. At least as early as 1997, the SEC determined that AOL had improperly inflated advertising revenue of the company . The SEC action resulted in AOL's restatement of the financial reporting for its 1997 fiscal year third quarter, transforming an alleged p rofit into a loss.
In response to the SEC action, Defendant Case promised the inves ting public that AOL would
48184 10 adopt "new gold-standard accounting policies ." However, in the very next fiscal quarter,
through improper accounting, AOL reported a $10.9 million profit. The SEC again require d
AOL to restate that quarter's results to reflect proper accounting standards, turning the reported profit into an $11 .8 million loss. In the fall of 1998, the SEC identified further accounting
improprieties of AOL and required AOL to revise its accounting for $316 million in acquisition
costs related to internet companies .
19. On May 15, 2000, the SEC issued an Order against AOL finding that it had improperly accounted for $385 million in costs associated with AOL revenue production for the period spanning July 1, 1994-June 30, 1997 and required AOL to cease and desist from further improper accounting practices and violations of the securities laws . As part of the SEC Cease and Desist Order, AOL paid a $3 .5 million fine and restated its earnings for the company's fiscal year 1995, 1996 and 1997 financial reports, again converting previously reported profits into losses.
20. Instead of complying with the SEC's Order, the Individual Defendants and Ernst
& Young chose to continue the illegal conduct to ensure consummation of the Merger and fo r their own sho rt-term personal gain to maximize the value of their AOL or AOL Time Warner securities holdings, options, bonuses, etc ., or fees to be made from the companies . As one
Company employee described the corporate mentality in the July 19, 2002 Washington Post article, "The sheer arrogance, the feeling of being untouchable, was amazing ."
II. NATURE OF THE ACTION
21 . The schemes alleged herein entailed , inter alia the dissemination of materially false and misleading information, and omissions of material facts, in AOL and AOL Time
Warner financial statements, press releases , and filings with the SEC; the AOL Time Warner, Inc.
49184 11 Registration Statement, filed with the SEC in connec tion with the Merger of AOL and Time
Warner consummated on January 11, 2001 ("Merger Registration Statement"); the Joint Proxy
Statement-Prospectus filed with the SEC by AOL and Time Warner, distributed to thei r
respective shareholders and incorporated into the Merger Registration Statement ("Joint Proxy
Statement-Prospectus"); and in statements of individual Defendants .
22. The material misrepresentations and omissions were designed to and did, inter
alb inflate artificially AOL's and AOL Time Warner's publicly reported advertising revenue.
In turn, this created the illusion during the Class Period that such revenue -- the most significant
qualitative measure by which the market evaluated the current and future financial health and
prospects of AOL and its touted synergies with Time Warner - was, as desc ribed by one stock
market analyst, the Company's "fastest growing revenue stream and a key element of growth
going forward." The material misrepresentations and omissions were also designed to and di d
hide from the public the schemes used to falsely inflate advertising revenue, including th e
creation of sham transactions and use of improper accounting practices .
23. Defendants were well aware that advertising revenue was material to th e
marketplace. During the Class Period , it became increasingly important for AOL and AOL Time
Warner to set themselves apart from the rest of an industry experiencing growing concerns ove r
declining advertising revenue and difficulties in meeting analysts' expectations . Motivated by the desire to ensure consummation of the Merger and enhance their own wealth through personal
AOL and AOL Time Warner securities holdings, salaries , bonuses and stock options, or fees t o be earned from the companies, Defendants violated repeatedly the federal securities laws durin g the Class Period. Indeed, the recent restatement of AOL's and AOL Time Warner's financial statements constitutes admissions of numerous violations of the securities laws.
48194 12 24. Defendants' schemes were intended to, and in fact did, artificially inflate the prices of AOL and AOL Time Warner stock purchased or acquired by the MSBI and the Class
causing them to suffer billions of dollars in losses.
25. The financial fraud described herein could not have been accomplished withou t the knowing participation of Ernst & Young, the supposed "independent" auditor of AOL and
Time Warner and later, of AOL Time Warner . Ernst & Young received millions of do llars in
auditing, consulting and other fees from the companies.
26. As the longstanding auditor of AOL and Time Warner, and after the Merger ,
AOL Time Warner, Ernst & Young had knowledge of, or recklessly disregarded, the fraudulen t
accounting practices and schemes engaged in by AOL and AOL Time Warner during the Class
Period, and lent its considerable reputation and credibility to AOL and AOL Time Warner's financial statements. Those financial statements were materially misstated starting in 199 8 through and including 2002, as a direct result of false advertising revenue which Ernst & Youn g allowed AOL and AOL Time Warner to recognize.
M. JURISDICTION AND VENUE
27. Certain claims asserted herein arise under Sections 10(b), 14(a) and 20(a) of th e
Securities Exchange Act, 15 U.S.C. §§ 78j(b), 78n(a) and 78t(a), and the rules and regulations promulgated thereunder, including SEC Rule 1Ob-5, 17 C .F.R. § 240.1Ob-5. Certain other claims asserted herein arise under Sections 11, 12 and 15 of the Securities Act, 15 U.S.C. §§ 77k,
771(a)(2) and 77o. Claims asserted against any Defendant under Sections 11, 12 and 15 of the
Securities Act and Sections 14 and 20 of the Exchange Act are not based in fraud, and should no t be construed to be based in fraud .
481 84 13 28. The Court has jurisdiction over this action pursuant to Section 27 of the Exchange
Act, 15 U.S.C. § 78aa, and 28 U. S.C. § 1331 and Sec tion 22 of the Securi ties Act, 15 U .S.C. §
77v.
29. Venue is proper in this District pursuant to Section 27 of the Exchange Act, an d
28 U.S.C. § 1391(b) and'Section 22 ofthe Securities Act, 15 U.S.C. § 77v. Defendant AOL
Time Warner is a corporation with its principal place of business in this District and many of th e acts, practices and transactions complained of herein, including the preparation, issuance an d dissemination of materially false and misleading statements, occurred in substantial part in this
District.
30. In connection with the acts alleged in this Complaint, Defendants, directly o r indirectly, used the means and instrumentalities of interstate commerce, including, but no t limited to, the United States mails, interstate telephone communications and the facilities of th e national securities markets .
IV. PARTIES
A. Plaintiffs
1. Lead Plaintiff
31 . Plaintiff MSBI purchased, exchanged or otherwise acquired stock ofAOL, and
AOL Time Warner during the Class Period and has suffered damages caused by Defendants ' violations of the federal securi ties laws. The MSBI is an agency established by Article XI of the
Minnesota Constitution and laws of the State of Minnesota for the purpose of administering and directing investment of all state funds and pension funds . The funds managed by the MSB I include: the Basic Retirement Funds, the Post Retirement Fund, the Supplemental Investmen t
Fund, the Permanent School Fund, the Environmental Trust Fund, the Assigned Risk Plan, and
48184 14 the State Cash Accounts . As of June 2002, the MSBI had approximately $44.6 billion in funds
under management. The MSBI purchased or otherwise acquired approximately 3,073,050 share s
of AOL stock during the Class Period, exchanged approximately 2,610,780 shares of Time
Warner stock for AOL Time Warner stock pursuant to the Merger, and purchased approximately
5,769,839 shares of AOL Time Warner stock during the Class Period . On January 8, 2003, the
Honorable Shirley Wohl Kram, United States District Court Judge for the Southern District of
New York, appointed the MSBI as Lead Plaintiff for this litigation and directed the MSBI to file an Amended Consolidated Complaint .
2. Additional Plaintiffs
32. The persons and entities listed on Exhibit B attached hereto are addi tional
Plaintiffs in this consolidated action. During the Class Period, each purchased, exch anged or otherwise acquired stock of AOL and/or AOL Time Warner, and/or bought or sold options on
AOL and/or AOL Time Warner stock, and suffered damages as a result of Defendants ' violations of law.
B. Defendants
1. AOL Time Warner. Inc.
33. Defendant AOL Time Warner is a Delaware corpora tion with its headquarters in
New York, New York. AOL Time Warner claims to be the world's first fully integrated,
Internet-powered media and communications company . The Company was formed in connection with the Merger of AOL and Time Warner, Inc . As a result of the Merger, AOL and
Time Warner each became wholly owned subsidiaries of AOL Time Warner. AOL Time
Warner is named as a Defendant in its own right for all liabilities of AOL Time Warner arising in conjunction with or after the Merger and for all liabilities of AOL and Time Warner arising in
48184 15 conjunction or after the Merger. AOL Time Warner is also named as a successor-in-interest for all liabilities of AOL and Time Warner arising prior to or in conjunction with the Merger. On
October 16, 2003, AOL Time Warner officially changed its name to Time Warner, Inc. in an effort to "better reflect the portfolio of our investors." To avoid confusion in this Complaint ,
Plaintiff will refer to the merged entity as AOL Time Warner or the Company.
2. America Online. Inc.
34. Defendant AOL is a Delaware corporation with its principal place of business i n
Dulles, Virginia. It is a wholly owned subsidiary of AOL Time Warner. AOL began its existence on May 24, 1985 as a small company called Quantum Computer Services . AOL went public on March 19, 1992 and, by the end of 1993, was one of "the nation's fastest-growin g commercial computer networks ." The AOL business, based both before and after the Merger in
Dulles, Virginia, consists principally of interactive services, web properties, internet technologies and electronic commerce services . Before the Merger, AOL operated on a fiscal year ended Jun e
30. Following the Merger, AOL has operated on AOL Time Warner' s fiscal year, which ends on
December 31 . Currently, AOL operates two worldwide internet services. As of September 30,
2002, AOL had 26.7 million subscribers to its domestic AOL-branded internet services, including America Online, CompuServe, AOL MovieFone, Net Center, AOL .com, ICQ an d
Digital City. As of the same date, there were 6.1 million subscribers to its European internet services. AOL is responsible for its liabilities resulting from this lawsuit, whether arising before, in conjunction with, or after the Merger.
3. Time Warner Inc.
35 . Defendant Time Warner, Inc. (now known as Histo ric TW, Inc.) is a Delaware corporation with its headquarters in New York, New York . Time Warner is a wholly owned
48194 16 subsidiary of AOL Time Warner. Time Warner was created in 1996 as a result of the acquisitio n
of Time Warner Companies, Inc. and Turner Broadcasting System, Inc. by TW, Inc., renamed
Time Warner Inc. Time Warner's principal business is to create and distribute branded
information and entertainment throughout the world. Its business interests include cable
networks, publishing, music, filmed entertainment, cable and digital media. Prior to the Merger,
Time Warner functioned as a holding company deriving its operating income and cash flow from
its investments in its subsidiaries, including Time Warner Entertainment Company, L.P., or
"TWE," a Delaware limited partnership formed in 1992 that owns a majority of Time Warner' s
interests in filmed entertainment and cable television systems and a portion of its interests i n
cable networks. Before the Merger, Time Warner operated on a fiscal year ended December 31 .
Following the Merger, Time Warner operates on AOL Time Warner's fiscal year, which als o
ends on December 31. Time Warner is responsible for its liabilities resulting from this lawsuit ,
whether arising before, in conjunction with, or after the Merger. On October 15, 2043, Time
Warner, Inc., the then subsidiary of AOL Time Warner, Inc., officially changed its name to
Historic TW, Inc. For purposes of this Complaint, Plaintiff will refer to this Defendant as Time
Warner.
4. The Individual Defendants
36. The following Defendants were Officers and/or Directors of AOL prior to the
Merger with Time Warner :
a. Stephen M. Case. Defendant Stephen M . Case {"Case") co-founded AOL in 1985 and served as its Execu tive Vice President from September 1987 to January 1991 and
Vice President of Marketing from 1985 to September 1987 . He became a Director of AOL when it first became a public company in September 1992, Chief Executive Officer in April 1993 and
48194 17 Chairman of the Board in October 1995, holding all of these positions until the Merger wa s
consummated on January 11, 2001 . Case was a signatory to the Joint Proxy Statement-
Prospectus incorporated into the Merger Registration Statement . Upon the Merger, Case becam e
an Affiliated Director and Chairman of the Board of AOL Time Warner. Case is also a member
of the Board of Representatives of Time Warner Entertainment Company, L.P. On January 12 ,
2003, Case announced his resignation from the Company effective May 2003, noting that ,
among other things, the Merger had been a "disappointment, "
b. Robert W. Pittman. Before joining AOL, from 1990 to September 1995 ,
Defendant Robert W. Pittman ("Pittman") was President and Chief Executive Officer of Time
Warner Enterprises, a division of Time Warner Entertainment Company . Pittman moved to
AOL in November 1996, where he was President and Chief Executive Officer of AOL Networks ,
a division of AOL, until February 1998. From February 1998 until the Merger, Pittman wa s
President and Chief Operating Officer of AOL. He was a Director of AOL from 1995 until th e
Merger. Upon the Merger, January 11, 2001, Pittman became Co-Chief Operating Officer o f
AOL Time Warner and an Affiliated Director of the AOL Time Warner Board of Directors . On
April 19, 2001, Pittman also resumed his previous responsibilities for operations of the AOL subsidiary of AOL Time Warner. In May 2002, Pittman became the sole Chief Operating
Officer of AOL Time Warner. On July 18, 2002, the day The Washington Post reported on various accounting improprieties regarding AOL advertising revenue, Pittman abruptly resigned his position as Chief Operating Officer with AOL Time Warner and announced his intent t o resign as acting head of AOL "after a new CEO is in place." He resigned from his AOL position shortly thereafter in July 2002.
J. Michael Kelly. From June 1998 until the Merger, Defendant J . Michael
48184 18 Kelly ("Kelly") was Senior Vice President, Chief Financial Officer and Assistant Secretary of
AOL. Kelly was a signatory to the Merger Registra tion Statement. Upon the Merger, Kelly became Chief Financial Officer and Execu tive Vice President of AOL Time Warner. On or
about November 1, 2001, Kelly was appointed Chief Operating Officer of the AOL subsidiary of
AOL Time Warner. Kelly is now Chairman and Chief Executive Officer of AOL International
and Web Services.
d. David M. Colburn. From 1995 until the Merger, Defendant David M.
Colbum ("Colbum") was Senior Vice President of Business Affairs for AOL, who reported
directly to Defendant Pittman. Following the Merger, Colburn became Executive Vice-Presiden t
and President of Business Affairs and Development for AOL Time Warner and continued to report directly to Pittman . Colburn was AOL's, and then AOL Time Warner's chief deal-maker.
Colbum was terminated in August 2002 after he was identified as a subject of the SEC and DOJ investigations.
e. Eric Keller. Defendant Eric Keller ("Keller") was Senior Executive Vice
President of Business Affairs and Development under, and reported directly to, Defendan t
Colburn at AOL. After the Merger, Keller remained Senior Executive Vice President of
Business Affairs and Development and continued to work under, and report directly to, Colbwrn .
Keller was the number two deal-maker at AOL and AOL Time Warner. Various media reports have identified Keller as a subject of the SEC and DO] investigations.
f. Jos h A. Ri . Defendant Joseph A. Ripp ("Ripp") was Executive Vice
President, Chief Financial Officer and Treasurer of Time Inc . until 1999. He then became the
Executive Vice President and Chief Financial Officer of Time Warner from 1999 until th e
Merger. On October 16, 2000, Ripp was named Executive Vice President, Chief Financia l
48184 19 Officer and Treasurer of AOL subsidiary, effective upon the Merger. In September 2002, Ripp
became Vice Chairman of AOL, a position he currently maintains.
g. Steven Rindner. Defendant Steven Rindner ("Rindner") was Senior Vic e
President of Business Affairs & Development in 2001 for the Company .
37. Defendants Case, Kelly, Pittman, Colburn, Keller, Ripp, Rindner and Novack ar e
sometimes collectively referred to herein as the "AOL Individual Defendants ."
38. The following Defendants were Officers and/or Directors of Time Warner prior t o
the Merger with AOL:
h. Gerald M. Levin. From 1983 until January 1987 and from 1988 unti l
the Merger, Defendant Gerald M . Levin ("Levin") was a Director of Time Warner . From
January 1993 until the Merger, Levin was Chairman and Chief Executive Officer of Tim e
Warner. He served in multiple executive positions with Time Warner prior to 1993 . Upon the
Company's incorporation in February 2000, Levin was appointed Chief Executive Officer o f
AOL Time Warner. Levin also became an Affiliated Director of AOL Time Warner's Board of
Directors. Levin was a signatory to the Merger Registration Statement and the Joint Proxy
Statement-Prospectus incorporated therein . He is also a member of the Board of Representative s
of Time Warner Entertainment. Levin retired from the Company in
May 2002.
Wayne H. Pace. From July 1993 to March 2001, Defendant Wayne H .
Pace {"Pace"} held multiple executive posi tions with Time Warner, including that of Chief
Financial Officer. Following the Merger, in March 2001, Pace became Vice Chairman and Chie f
Financial and Administrative Officer of Turner Broadcasting System, Inc . In November 2001 ,
48184 20 Pace became the Company's principal financial officer as the Executive Vice President an d
Chief Financial Officer of the Company, a position he maintains at the present time.
39. Defendants Case, Kelly, Pittman, Colburn, Keller, Ripp, Rindner, Levin, an d
Pace, are sometimes collectively referred to herein as the "Individual Defendants."
40. Due to the Individual Defendants' positions with AOL and/or AOL Time Warner, they directly participated in management, and the day-to-day operations, of one or both of th e
companies during the Class Period. In addition, they had access to and/or were provided the
adverse undisclosed information, including the adverse information detailed herein, about th e business, opera tions, products, operational trends, financial statements, markets and present and
future business prospects of AOL and AOL Time Warner. They had such access via internal
corporate documents (including the Company's and AOL's operating plans, budgets and
forecasts and reports of actual operations compared thereto), conversations with other AOL and
AOL Time Warner corporate officers and employees , attendance at management and Board of
Directors meetings and committees thereof, and reports and other information provided to them
in connection therewith.
41 . The Individual Defendants, because of their positions of control and authority a s
officers and/or Directors of the Company and/or AOL, were able to and did control the conten t
of the various SEC filings, press releases and other public statements pertaining to the Company
and AOL during the Class Period . Each Individual Defendant was provided with copies o f
documents alleged herein to be misleading prior to or shortly after their issuance and/or had th e
ability and/or opportunity to prevent their issuance or cause them to be corrected. Accordingly,
each of the Individual Defendants is responsible for the accuracy of such public reports an d releases detailed herein and is therefore primarily liable for the representations contained therein.
48184 21 42. As Officers and controlling persons ofpublicly-held companies whose common
stock was, and is, registered with the SEC pursuant to the Securities Exchange Act, and traded
on the New York Stock Exchange, and governed by the provisions of the federal securities laws,
the Individual Defendants had a duty to disseminate promptly, accurate and truthful information
with respect to the Company's and AOL's financial condition and performance, growth,
operations, financial statements, business, products, markets, management, revenues, earnings
and present and future business prospects, and to correct any previously-issued statements tha t
had become materially misleading or untrue, so that the market price of the Company's an d
AOL's publicly-traded stock would be based upon truthful and accurate information . The
Individual Defendants' misrepresentations and omissions during the Class Period violated thes e
specific requirements and obligations .
43 . The Individual Defendants par ticipated in the drafting, preparation, and/or
approval of the public statements, press releases, shareholder repo rts and other communications
complained of herein, and were aware of, or recklessly disregarded, the misstatements containe d
therein and omissions therefrom, and were aware of their materially false and misleading nature.
Because of their board membership and/or executive and managerial posi tions with AOL Time
Warner and/or AOL each of the Individual Defendants had access to the adverse undisclosed
information about AOL Time Warner's and/or AOL's business prospects and fin ancial condition
and performance as particularized herein and knew (or recklessly disregarded) that these advers e
facts rendered the representations made by or about AOL, AOL Time Warner and their business
materially false and misleading.
44. It is appropriate to treat the Individual Defendants, and the AOL Individua l
Defendants, respectively, as groups for pleading purposes and to presume that the false ,
48184 22 misleading and incomplete information conveyed in the Company's and AOL's SEC filings , press releases and other publications and communications alleged herein, are the collective actions of the narrowly defined group ofDefendants identified above.
45. Each of the above-referenced Individual Defendants is liable as a participant in a fraudulent scheme and course of business that operated as a fraud or deceit on the Class b y disseminating materially false and misleading statements and/or concealing material adverse facts.
5. Additional Individual Defendants
46. The following are additional Individual Defendants :
a. Paul T. Cappucio. Defendant Paul T . Cappuccio ("Cappuccio") was an
Associate Deputy Attorney General at the U.S. Department of Justice from 1991 to 1993 . He was Senior Vice President and General Counsel of AOL from August 1999 until the Merger.
Upon the Merger, Cappuccio became Executive Vice President, General Counsel and Secretary of the Company. Cappucaio was a signatory to the Merger Registration Statement .
b. Kenneth J . Novack. Defendant Kenneth J. Novack ("Novack") was Vice
Chairman of AOL from May 1998 until the Merger . He was a Director of AOL from January
2000 until the Merger. Upon the Merger, Novack was appointed an Affiliated Director of the
Company and became its Vice Chairman . He is also a member of the Board of Representatives of Time Warner-Entertainment .
6. Ernst & Young LLP
47. Defendant Ernst & Young is a firm of certified public accountants that maintain s its headquarters in the Southern District of New York . At all times relevant to this action, Erns t
& Young provided auditing and accounting services to AOL and AOL Time Warner, including
48194 23 but not limited to, conducting audits of AOL and AOL Time Warner 's year-end financial statements and, beginning no later than the quarter ended March 31, 2000, reviewing AOL's and the Company's quarterly financial statements . In connection therewith, Ernst & Young issued unqualified audit reports related to AOL and AOL Time Warner's financial statements, for
inclusion in each of AOL's annual reports for the fiscal years 1999 and 2000 and transi tion period ended December 31, 2000 on SEC Forms 10-K, in the Merger Registration Statement .
Ernst & Young also issued an unqualified audit repo rt for inclusion in AOL Time Warner's
annual report for the years 2000 and 2001 on SEC Forms 10-K .
V. CLASS ALLEGATION S
48. Plaintiff brings this action on its own behalf and as a class action pursuant to
Rules 23(a) and (b)(3) of the Federal Rules of Civil Procedure on behalf of a Class of all person s
and entities who purchased, exchanged, or otherwise acquired publicly traded stock of AOL or
bought or sold options on AOL stock during the period January 27, 1999 through January 11 ,
2001, and all persons or entities who purchased, exchanged or otherwise acquired publicly trade d
stock of AOL Time Warner or bought or sold options on AOL Time Warner stock during the
period January 12, 2001 through and including July 24, 2002, and were damaged thereby.
Excluded from the Class are Defendants, Defendants' immediate families, and the legal
representatives, heirs, successors or assigns of any Defendant, and any entity in which an y
Defendant has or had a controlling interest, and the senior Officers and Directors of AOL and th e
Company. Also excluded from the Class are Homestore, Inc., PurchasePro .com, Inc., and
Veritas Software Corporation, their successors or assigns and any entity in which Homestore ,
PurchasePro or Veritas has a controlling interest; and the senior executives of Homestore,
48184 24 PurchasePro, and Veritas, their legal representatives and heirs, successors or assigns, and th e immediate families of the senior executives of Homestore, PurchasePro and Veritas .
49. The members of the Class are so numerous that joinder of all members is impracticable. Throughout the Class Period, AOL and AOL Time Warner common shares were actively traded on the New York Stock Exchange (AOL through January 11, 2001, and AO L
Time Warner starting January 12, 2001), which was an efficient market . Currently, AOL Time
Warner has over 4 billion shares of common stock issued and outstanding and is reported to be the third most widely held stock in the United States . While the exact number of Class members is unknown to Plaintiff at this time and can only be ascertained through appropriate discovery , there are many thousands of members in the proposed Class . Record owners and other members of the Class may be identified from records maintained by AOL Time Warner or its transfer agent and may be notified of the pendency of this action by mail, using the form of notice similar to that customarily used in securities class actions .
50. Plaintiffs claims are typical of the claims of the members of the Class as all members of the Class are similarly affected by Defendants' wrongful conduct in violation of federal law complained of herein-
51 . Plaintiff will fairly and adequately protect the interests of the members of th e
Class and has retained counsel competent and experienced in class and securities litigation .
52. Common questions of law and fact exist as to all members of the Class and predominate over any questions solely affecting individual members of the Class . Among the questions of law and fact common to the Class are :
a. whether the federal securities laws were violated by Defendants' acts as
alleged herein;
48184 25 b. whether statements made by Defendants to the investing public during th e
Class Period misrepresented, or omitted, material facts about the business, operations an d
prospects of the Company and AOL;
c. whether AOL and AOL Time Warner's reported financial results during
the Class Period were materially misstated;
d. whether AOL and AOL Time Warner's reported financial results during
the Class Period were in accordance with GAAP;
e. whether the Merger Registration Statement contained material
misstatements or omitted to state material information ;
f. whether the Joint Proxy Statement-Prospectus contained material
misstatements or omitted to state material information ;
g. whether Defendants acted with the requisite state of mind in
misrepresenting or omitting material facts;
h. whether the market price of AOL and AOL Time Warner publicly traded
stock was artificially inflated due to the material omissions and misrepresentation s
complained of herein;
i. whether Defendant Ernst & Young's unqualified reports issued on AO L
and AOL Time Warner's financial statements during the Class Period materially
misstated that Ernst & Young's audits thereon were conducted in accordance with GAAS;
and
whether members of the Class have sustained damages and, if so, the
appropriate measure thereof.
48184 26 53 . A class action is superior to all other available methods for the fair and efficien t
adjudication of this controversy since joinder of all members is impracticable. Furthermore, as the damages suffered by individual Class members may be relatively small, the expense and burden of individual litigation make it impossible for members of the Class to individually redress the wrongs done to them . There will be no difficulty in the management of this action as
a class action.
VI. SUBSTANTIVE ALLEGATIONS
A. The Growth of AOL and Its Emphasis on Increasing Advertising Revenue
54. AOL, since its inception, has been a revenue-driven company . The stock market
historically valued companies based on earnings and free cash flows . Beginning in the 1990s, however, there was an explosion of start-up Internet companies which reported net losses an d negative cash flows . Traditional valuation methods were not applied to determine the value o f
these companies. Rather, due to the potential presented by the Internet, the market began t o
value high-tech companies based upon revenues . As a result, there was an increasing pressur e
on Internet companies , like AOL, to report substantial growth in revenue each reporting pe riod to maintain or increase stock market value.
55. Companies reporting revenue that disappointed the market's expectations, eve n narrowly, saw their share prices plummet. Given these circumstances, AOL and later AOL Time
Warner, and the Individual Defendants, have continually looked for ways to increase AO L revenue in order to increase its market valuation, and the value of the Individual Defendants ' substantial personal holdings of AOL and AOL Time Warner stock and/or options . The focus on revenue growth became even more acute when concern over the viability of dot-corn companie s surfaced in late 1999 and early 2400.
48184 27 56. During the dot-com boom AOL's stock price skyrocketed due to its reported revenue growth. For example, a $100 investment in AOL stock in 1993 was worth $16,972 by the end of 1998, a 135% compounded annual return . In turn, AOL employees became fantastically wealthy. As reported by The Washington Post on July 19, 2002, in an article titled
"Creative Transactions Earned Team Rewards": "Everyone [at AOL], it seemed was becoming an instant millionaire at the Company's Dulles headquarters . There were a lot of Ferraris and twenty somethings and secretaries retiring with seven-figure bank accounts after a few years o n the job, thanks to the incredible windfall from stock options ."
57. However, for AOL stock to continue its extraordinary increase in value, it was imperative that company revenue continue to show impressive growth. Any weakness in AOL revenue growth would mean that the company's phenomenal ri se in its stock price could not continue. Accordingly, the Individual Defendants, first at AOL, and later at AOL Time Warner, devised various fraudulent schemes to artificially enhance advertising revenue to fraudulently induce continued substantial increases in the companies' stock prices .
58. Historically, AOL has reported three main types of revenue: (1) subscription services revenues; (2) advertising and e-commerce revenues ; and (3) enterprise solution revenues.
Subscription services revenue is generated from customers subscribing to AOL's internet services. Advertising and c-commerce revenue are non-subscription based and are, generated from the company's base of subscribers and users as well as businesses who advertise on AO L internet sites. Enterprise solution revenues consist principally of product licensing fees and fees from technical support, consulting and training services . Of the three revenue sources, AOL initially depended primarily on its subscription service revenue for the bulk of its revenue an d revenue growth.
48184 28 59. . As a result of increased competition, the increased use of the World Wide Web
and increased popularity of browser software, AOL was forced to continually reduce prices for
its online services and in December 1996 dropped its pay-by-the-hour method of chargin g
subscribers and adopted a "flat-rate" pricing plan .
60. Following the introduction of the flat rate plan for the AOL subscriber service in
December 1996, the company experienced a significant increase in both (1) subscriber usage ,
which was mainly due to the growth of the subscriber base, and (2) the average monthly usage per subscriber as subscribers spent more and more time online. As the average usage level s
increased, the company faced further pressures on its operating margins due to increased networ k
costs on both an absolute dollar basis, as well as a percentage of revenue basis . The increase in
cost of revenues was primarily attributable to increase in data network costs, as well as personne l
and related costs associated with operating the data centers, data network and providing custome r
support, consulting, technical supportltraining and bi lling. According to AOL's SEC Form 1O-Q
for the quarter ended March 31, 1997, the company reported that overall average monthly onlin e
service revenue per AOL subscriber in fiscal 1997 was expected to be lower than in fiscal 1996, primarily due to the adoption of the flat-rate pricing plan in fiscal 1997. As AOL began seeing its subscription revenue for the online service drop, the company looked for ways to increas e
advertising revenue.
61 . The growth of higher margin advertising revenue became increasingly important to AOL's business objectives. Advertising revenue grew in importance as the compan y continued to leverage its large, active and growing user base . This user base not only included the paying subscribers of the AOL and CompuServe services, it also included users of the
48194 29 company's other branded services such as AOL MovieFone, Net Center, ACL.com, ICQ and
Digital City.
62. AOL's SEC Form 10-K for the fiscal year ended June 30, 1997, described the
importance of advertising revenue to AOL's success :
An important component of the company's business strategy is to increase nonsubscription based revenues, including from advertising sales and transaction fees associated with electronic commerce, and the sale of merchandise, which the company believes are increasingly im ortant to its growth and success. The company continues to estab lish a wide variety ofrelationships with advertisin and electronic commerce partners in order to grow its non-subscription based revenues and to provide AOL subscribers with access to a broad selection of competitively priced, easy to order products and services .
(Emphasis added.)
63 . Many ofAOL's advertising deals involved various forms of partnerships o r alliances. According to AOL's SEC Form 10-K for the fiscal year ended June 30, 1999:
The company offers its advertising and commerce partners a variety of customized programs, which may include premiere placement or select sponsorship of particular online areas or web pages for designated time periods . As merchants recognized the value in reaching the company's large, growing and active subscriber base and users of its web-based properties, the company has been able to earn additional revenues by offering selected merchants exclusive rights to market particular goods or services within one or more of the company's online services and properties . In those transactions, the company provides its commerce partners certain marketing and promotional opportunities and in return receives cash payments, the opportunity for revenue sharing, cross promotions and competitive pricing and online conveniences for subscribers. Certain of the transactions with partners also include an equity component for the company . The company may receive a warrant to purchase stock or may purchase or acquire a direct equity interest in the partner. These equity investments are accounted for in accordance with company accounting policies . In addition, these equity investments can also represent an additional potential source of income or loss to the company upon their disposition .
(Emphasis added.)
64. Beginning at least as early as May 1998, many of these alliances and partnership s enabled AOL, and later AOL Time Warner, to artificially inflate revenue through , among other
48194 30 means, the use of improper accounting practices regarding "round-trip" and barter transactions .
This was accomplished , in large part, through the emergence of AOL "portal" deals. A "portal"
can be viewed as a website playing the role of a "gate" that welcomes the user onto the interne t
and guides the user towards the information he or she is seeking .
65 . As reported in an October 30, 2000 article in the Industry Standard entitled
"AOL's Rough Riders:"
Never was [AOL's Senior Vice President of Business Affairs David] Colburn more valuable to AOL than when the portal deal was born, the offspring of necessity and opportunity. In December 1996, AOL, following the lead of its competitors, dropped its pay-by-the-hour method of charging customers in favor of a flat monthly fee, precipitating one of the many crises that AOL has faced in its relatively short life as a publicly traded company . The price change may have been great news for the company's millions of subscribers, but it meant a huge hit for AOL's bottom line and also its stock price . Deals with the company's many content providers, which had been based on AOL's per hour fees, needed to be renegotiated, and alternative revenues had to be found. Back then there was plenty of talk about a wondrous new business model dubbed the "portal," but how a company might cash in on all those eyeballs they had attracted remained to be seen.
That's what David was responsible for doing," says a former Colburn lieutenant. "It largely fell on him to restructure all the existing deals and figure out, more importantly, how the company could make money as a portal ." The plan for dealing with content providers was a radical departure from the old model ; most would now have to pay for the privilege of providing news and information to AOL users. "It's not like an edict was handed down one Thursday and that was that," says David Ellington, CEO of NetNoir, an AOL stalwart since 1995 . "But on the other hand, it's not like they left us much room to negotiate." Yet finessing relations with a few pissed-off content providers was hardly AOL's main concern .
Terms such as "anchor tenancy" had been invented, or reinvented for the Web, and a new paradigm adopted : AOL was no longer a diverse community of users but an enormous online shopping mall visited by tens of millions of consumers .
(Emphasis added.)
66. In addition to acquiring an equity stake in its advertisers, other alliance partner s agreed to share revenue realized from deals, and online brokerages like E-Trade agreed to shar e
48194 31 commissions from every trade initiated by all AOL secured customers . The need to strike deals with AOL was particularly apparent with regard to sta rt-up Internet companies, many of whom, believing their companies' survival depended on an AOL deal, made enormous upfront payments to AOL and gave up large portions of their companies . According to a former AOL
Vice President, fledgling companies that had just gone public or were on the verge of going public and were in need of financing, were finding that in order to get the financing, investors were asking "What sort of deal do you have with AOL?" If a company did not have a deal wit h
AOL, the investors refused to take the company seriously, saying they could not invest un til the company had an AOL -deal.
67 . According to a former AOL Chief Technology Officer, Product Manager and
Senior Business Manager, as AOL became a portal with an increasing number of millions of subscribers, the company had more power to demand what it wanted . It insisted that some of its advertisers and content providers give AOL performance warrants or shares of their companies for as little as a penny a share. According to this source, "[i]nternally, the thinking at AOL was that when we sign a deal with a company, the stock will go up, so we would try to capture th e full value of our deal."
68. According to the same source , AOL used creative accounting when the company began charging other companies for exposure to its subscribers.
B. The Constant and Increasing Pressure to Falsify Advertising Revenue
69. Within AOL, and later AOL Time Warner, there was enormous pressure to show increasing revenue each quarter and meet or exceed revenue targets . This was especia lly true with respect to advertising revenue following AOL's shift in its business model to emphasize thi s revenue source. A former AOL dealmaker in the October 30, 2000 Industry Standard article
48184 32 entitled, "AOL's Rough Riders," confirmed that no matter how many advertising deals AOL was generating, it was never enough "Working there you were under pressure all of the time to make your quota, especially at the end of the quarter." "Colburn would be screaming at people `Why the f _ _ _ aren't we hitting our numbers?"" Defendant Colbum was AOL's top dealmaker and chief architect of many of the transactions making up AOL's fraudulent advertising revenue .
According to a former AOL senior executive also quoted in the Rough Riders" article, "Colbur n is the driver when it comes to deals at AOL.. .. He oversees all of the dealmaking the Company does."
70. According to a former Senior Manager in AOL Time Warner's Interactiv e
Marketing Unit responsible for developing sales programs and strategic partnerships, a deal was
structured, it was designed to help AOL make its quarterly numbers . According to this source,
meeting quarterly revenue goals was the driving force behind the various accountin g
manipulations and fraudulent transactions undertaken by the Company. As this source stated :
"We were congratulating ourselves for being creative . In the long run, we are ultimately
providing value to our customers and our investors wanted to see revenue at all costs."' But, the
source added: "Deep down we knew our accounting practices were not that secure . We knew
what we were doing wasn't conventional ." The Washington Post reported on July 19, 2002, in,
an article titled "Creative Transactions Earned Team Awards", that another AOL sourc e
described the culture at AOL as follows: "The lavish parties, the crazy antics - - it really
socialized you. You had to toe the line." (Emphasis added .)
71 . According to a former AOL Vice President, the pressure was always on for
making deals that would catch Wall Street's attention . AOL executives wanted to do deals tha t
would give them a "big fat press release" that would cause AOL's stock to go up. For this
48184 33 reason, as the same source stated , AOL entered into several deals that were not significant from a
cash flow standpoint, or, in fact, were a wash, but that ended up artificially inflating advertisin g revenue and impressing shareholders . This witness described the pressure to impress Wall Stree t
as a predominant factor in AOL' s corporate culture created primarily by Defendants Pittman and
Colburn. The pressure "was something that was always there, and it got even more intense " during the period before the Merger was completed and a week or two before the end of every quarter. According to this witness, Colbum regularly told his people "you had better do it o r else." According to a former Senior Manager in AOL Time Warner's Interactive Marketing Unit,
Colburn's Business Affairs Division developed the improper deals in order to book revenue an d make quarterly sales goals . The former Senior Manager said "The idea in the back of their mind was to show revenue as ad revenue . Our value as a company hinged on ad revenue and revenu e growth. We were sales and revenue driven. There was a lot of pressure to make quarterl y numbers. We had a core number to hit."
72. The pressure to maintain continually impressive revenue growth and the need t o artificially inflate that revenue through the improper methods described herein, increased eve n more as many of the Internet companies that had given up enormous sums in dollars and equity to partner with AOL were achieving disappointing results. Many overvalued Internet companies which took advantage of the Internet bubble were seeing their stock prices drop well below thei r
Initial Public Offering {"IPO') prices . Other Internet companies were seeing their stock price s fall precipitously on concerns of not only declining advertising revenue, but on concerns that a majority of Internet companies would disappear altogether. Individual Defendants knew that an y indication of weakness in AOL' s advertising revenue growth would swiftly and severely impact its stock price.
48184 34 73 . Due to the critical importance of advertising revenue to AOL, this revenue source was tracked closely by the companies and their top execu tives. According to a former AOL Vice
President, reports prepared by Robert O'Connor, Vice President of Finance for the Busines s
Affairs Unit, both before and after the Merger, showed every advertising deal that AOL had an d the amount of annual revenue recognition expected from the deal . These reports indicated th e
amount of revenue initially expected on a deal and the revised- lower amount of anticipate d revenue if that advertiser was experiencing financial difficulty. Additionally, AOL utilized a periodic "pipeline report" prepared by the Interactive Services unit, which report describe d
advertising deals in the pipeline and anticipated to generate revenue . The Individual Defendants had access to such reports . Also, weekly business meetings were attended by "Colburn' s people," including Colburn, Bob O'Connor and Eric Keller. During these meetings variou s
advertising deals, including the significant financial problems of existing customers tha t jeopardized continuing revenue from those contracts were discussed.
74. According to this same source, every Sunday morning, Colbum had telephone
conference calls with top executives .in which they discussed the status of advertising deals an d revenue recognition. During the Sunday morning calls, Colburn would frequently ask Ja y
Rappaport, who did many of the major deals, in the Business Affairs unit, which "BA Specials" were on the list. The "BA Specials", which consisted of deals that caused AOL's advertisin g revenue to be improperly inflated, made up a substantial portion of AOL's advertising revenue, especially at the end of a quarter. These Sunday calls also involved discussions of problems with dot-corn companies that had advertising deals with AOL and the restructuring of advertising deals in order to maximize advertising revenue for AOL.
48184 35 75. By at least August 2000, internal company documents showed that AOL was a t
risk to lose substantial advertising revenue from existing customers the following fiscal year. In
September 2000, AOL documents estimated that AOL was at risk to lose $108 million in
advertising revenue in the 2001 fiscal year (July 1, 2000-June 30, 2001) due to the financial
difficulties of its advertising customers . In early October 2000, Defendant Pittman and other
AOL executives were told that as a result of many failing dot-com customers of the Company,
AOL was at risk to lose $140 million in advertising revenue the following calendar year.
C. The Creation of AOL Time Warner and the Additional Pressure to Report Growing Advertising Revenue
76. AOL's need to demons trate substantial and continuing revenue growth took o n
even greater importance when AOL and Time Warner discussed merging the two companies.
77. The proposed Merger was jointly announced by AOL and Time Warner with
much fanfare on January 10, 2000 . The media described the Merger as "the deal of the century ."
78. On January 11, 2000, The Los Angeles Times reported that the deal came to fruition when Time Warner was convinced that AOL's stock value was "real":
Levin and Case said they had worked carefully to strike a reasonable compromise on the values of their two companies.
"One of the creative breakthroughs was in the valuation," Case told The Times in a joint interview with Levin . He said the key to coming to a final deal was Time Warner's "recognition that these Internet values are real ." ...
79. The value of AOL's stock for purposes of the Merger was based primarily on
AOL's reported advertising revenue and histo rical growth in that revenue source. Salomon
Smith Barney, for example, which advised AOL on the Merger, valued AOL's "advertising and commerce" business at a multiple of between 44 and 171 of estimated revenue for fiscal year
2000, far greater than the multiples applied to the other segments ofAOL's business.
48184 36 80. The pressure to report impressive advertising revenue and growth became eve n
more intense after the Merger was announced . During the one year period between the Merger
agreement and the deal's consummation, Individual Defendants were desperate to ensure that the
deal went through, especially since the advertising market was weakening and the stock prices of
many dot-com companies were plummeting. Indeed, at least months before the Merger was
consummated, Individual Defendants were aware that AOL was at risk to lose substantia l
amounts of advertising revenue in the current fiscal year and the next calendar year. As reported
in the July 18, 2002 issue of The Washington Post, James Patti, who during the pendency of th e
Merger was a Senior Manager in AOL' s Business Affairs division, stated, "The bubble had
clearly burst, but senior management was under enormous pressure to hit the [financial] numbers
and close the Time Warner transaction, which would diversify the revenue base and lower th e
risk profile of the Company."
81 . On June 23, 2000, AOL and Time Warner announced that their respective
shareholders had voted to approve the Merger with AOL common shareholders to receive I share of AOL Time Warner common stock for each share of AOL they owned (then having a market price of $54.62 per share) and Time Warner common shareholders to receive 1 .5 shares of AOL Time Warner common stock for each share of Time Warner they owned (then having a market price of $79.50 per share). The Merger was finalized on January 11, 2001 .
D. AOL' s Pattern and History of Accounting Improprieties
82. The schemes described herein follow a familiar pattern for AOL. Even prior to the start of the Class Period, AOL engaged in accounting improprieties, resulting in SE C investigations, and restatements of previously reported financial results .
48194 37 83 . For example, in early 1997, after AOL reported a profit for its fiscal year 199 7
third quarter, the SEC conducted an investigation into AOL's accounting practices . Specifically,
the SEC alleged that AOL had improperly inflated advertising revenue regarding an AOL deal
with Tel-Save Holdings, Inc. AOL improperly recorded as revenue $12 million from the
agreement with Tel-Save and the SEC required AOL to record $ 7 million of that sum over th e
remaining term of the contract. The Company restated its 1997 fiscal year third quarter earnings,
which changed the previously reported profit to a loss . In response to the SEC action, Defendant
Case promised the public that AOL would adopt "new gold-standard accounting practices ."
84. However, the very next fiscal quarter (ended June 30, 1998) AOL reported a
profit of $10.9 million based on more accounting improp rieties. The SEC again required AOL to
restate the quarterly results, which caused AOL to report an $ 11 .8 million loss.
85. In 1998, AOL attempted to immediately write-off two acquisitions totaling $31 6
million to avoid a drag on future earnings . In accordance with proper accounting standards, th e
SEC forced AOL to write-off the acquisition over a period of six years. The next business day
after the SEC decision, then-Chairman of the SEC, Arthur Levitt, stated publicly his concern s
with "earnings management ." As reported by A e Washington Post on October 5, 1998, Levitt referred to the "gray area where the accounting is being perverted" and earnings reports tha t
"reflect the desire of management rather than the underlying financial performance of th e
company." According to The Washington Post article, Levitt also said, in a not-so-veile d reference to AOL, that these accounting improprieties are not limited to small companies, bu t also occur "in companies whose products we know and admire."
86. The SEC separately investigated other AOL accounting practices that took place during fiscal years 1995-1997. This SEC investigation involved the Company's improper
48194 38 allocation of hundreds of millions of dollars of costs associated with obtaining new subscribers over a period of years rather than accounting for the costs as they were incurred. This improper accounting had the effect of inflating AOL's earnings for fiscal years 1995, 1996 and 1997 . If
AOL had properly accounted for the expenses, it would have posted losses rather than profits in each of the years.
87. Based on its investigation, on May 15, 2000, the SEC ordered AOL to "Cease and
Desist" from further violations of the securities laws and required AOL to comply with accounting rules in the future. As part of the SEC's action, AOL also paid a $3 .5 million fine and restated its prior financial results for the repo rting periods in'question, again converting alleged profits to losses. AOL agreed to abide by the SEC Order, including compliance with the securities laws and applicable accounting standards .
88. When the SEC disclosed the issuance of its Cease and Desist Order and $3 .5 million fine against AOL in May 2000, then-SEC Enforcement Chief, Richard H . Walker, publicly stated that "[t]his case underscores the importance we attach to financial reporting and should serve as a warning to others not to stretch the rules through aggressive accounting."
89. Notwithstanding the SEC actions in 1997, 1998 and 2000, as well as AOL' s agreement to abide by accounting rules and cease and desist from securities violations in the future, Defendant Steve Case's promise on behalf of AOL to adopt "new gold-standard accounting practices", SEC Chairman Levitt's comments regarding "perverted" accounting and other SEC warnings regarding improper accounting practices, as detailed herein, AOL and AOL
Time Warner, and the Individual Defendants , with the blessing of the Company's auditor,
Defendant Ernst and Young, continued during the Class Period to violate the securi ties laws by reporting artificially inflated advertising revenue through the use of sham transactions and
48184 39 improper accounting practices. This was done in order to make sure the Merger went through and to increase the value of the companies' securities for their own short-term personal financia l benefit with respect to their holdings of the companies' securities and options, salaries, bonuses, etc.
E. Fraudulent Transac tions and Improper Accounting Used to Artificially Inflate AOL and AOL Time Warner Advertising Revenue
90. At all relevant times during the Class Period , AOL and AOL Time Warner represented that their financial statements were prepared in conformity with GAAP, the uniform rules, conventions and procedures that define accepted -accounting practice . As set forth in
Statement of Financial Accounting Concepts ("SFAC") No . 1, Objectives of Financial Reporting by Business Enterprises, one of the fundamental objectives of financial reporting is that it provide accurate and reliable information concerning an entity's financial performance during the period being presented . SFAC No. 1, 1 42 states:
Financial reporting should provide information about an enterprise's financial performance during a period. Investors and creditors often use information about the past to help in assessing the prospects of an enterprise . Thus, although investment and credit decisions reflect investors' and creditors' expectations about future enterprise performance, those expectations are commonly based at least partly on evaluations of past enterprise performance .
91 . GAAP is recognized and used by the accounting profession in order to define acceptable accounting practices. Both annual and interim Ce.g_, quarterly) financial statements must be prepared in accordance with GAAP. The same GAAP applies to interim financial statements that apply to annual financial statements. The SEC has also endorsed GAAP in
Regulation S-X, 17 C .F.R. § 210.401(a)(l), which provides that financial statements filed both annually and quarterly with the SEC must comply with GAAP, except quarterly statements are
48184 40 not required to have the same level of footnote disclosure. If the filings do not comply with
GAAP, they are presumed to be misleading and inaccurate, despite footnote or other disclosure.
92. GAAP is comprised of a hierarchy of authoritative literature. The highest
authority is comprised of FASB ("Financial Accoun ting Standards Board"} Statements of
Financial Accounting Standards ("SFAS"}, FASB Interpretations ("FIN"), APB Opinions
("APB'), and AICPA Accounting Research Bulletins {"ARB"). GAAP provides other
authoritative pronouncements including, among others, AICPA Statements of Position ("SOP"),
Consensus Positions of the FASB Emerging Issues Task Force ("ErTF T), and the FASB Concep t
Statements {"CON"}
93. Circumstances may require that analogies be drawn. AICPA Auditing Standards
{"AU") Section 411 .09 states, "Because of developments such as new legisla tion or the evolution
of a new type of business transaction, there sometimes are no established accounting principle s
for reporting a specific transaction or event. In those instances, it might be possible to report the
event or transaction on the basis of its substance by selecting an accounting principle tha t appears appropriate when applied in a manner similar to the application of an establishe d principle to an analogous transaction or event."
94. AU Section 625.08 also provides that to aid in forming a judgment , the reporting accountant should perform the following procedures : (a) obtain an understanding ofthe form and substance of the transaction(s); (b) review applicable GAAP; (c) if appropriate, consult with other professionals or experts; and (d) if appropriate, perform research or other procedures to ascertain and consider the existence of creditable precedent or analogies.
48184 41 95. The responsibility for preparing financial statements that conform to GAAP rest s with corporate management, as set forth in AU Section 110.03 of the AICPA Professional
Standards:
The financial statements are management's responsibility . . . . Management is responsible for ado tin sound accounting policies and for establishing and maintaining internal control, that will, among other things initiate, record, process, and report transactions (as well as events and condi tions) consistent with management's assertions embodied in the financial statements . The entity's transactions and the related assets, liabilities, and equity are within the direct knowledge and control of management . . . . Thus, the fair presentation of financial statements in conformity with [GAAP] is an implicit and integral part of management's responsibility.
(Emphasis added.)
96. Throughout the course of the quarterly and annual financial reporting during th e
Class Period , AOL, the Company and the Individual AOL and AOL Time Warner Defendants, materially overstated AOL's and AOL Time Warner' s advertising revenue through sham
transactions and improper accounting. Consequently, the financial statements were false an d misleading and constituted an extreme departure from GAAP, by violating the following GAAP
concepts and principles, among the many other principles identified herein :
a. APB 29. The principle that nonmonetary transactions should be
accounted for based on the fair value of the assets (or services) involved which is the same basi s
as that used in monetary transactions. As more fully discussed below, AOL and AOL Time
Warner violated this accounting principle repeatedly when reporting round-trip/barte r transactions, including deals with Homestore, Inc ., Sun Microsystems, Inc ., Veritas Software
Corporation, Bertelsmann AG, WorldCom, Inc., Qwest Communications, Hughes Elec tronics
Corporation, Gateway, Inc ., PurchasePro, Monster .com, and Oxygen Media Inc.
48184 42 b. EITF 99-17. The principle that exchanges of advertising services between two companies should be accounted for at fair value only if the fair value is determinable base d on the entity's own historical practice of receiving cash or cash equivalents for similar advertising from buyers unrelated to the counter-party in the exchange. If the fair value is not determinable within stated limits, "the transaction should be recorded at the carrying amount o f the advertising, which likely will be zero." AOL and AOL Time Warner violated these accounting requirements by overstating revenue in advertising "swaps" when there was no ultimate realization in cash, including deals with Homestore, Inc., PurchasePro and Monster.com.
c. EITF 99-19. The principle that revenue should be recognized in ne t amounts, rather than gross, when acting as an agent and not as principal . In circumstances where a company does not have the risks and rewards of a principal, earns a fixed amount or percentage , and does not have credit risk, the company is an agent and should not recognize revenue in a gross amount. AOL and AOL Time Warner violated this requirement in connection with at least an arrangement with eBay when they improperly recognized revenue for advertising, placed a s
an agent, at gross rather than at the net amount of the commission actually earned .
d. CON 2 1 63 . The concept of "representational faithfulness ," which is defined as the "correspondence or agreement between a measure or description and th e phenomenon it purports to represent . In accounting, the phenomena to be represented ar e economic resources and obligations and the transactions and events that change those resource s and obligations." AOL and AOL Time Warner repeatedly violated this GAAP requirement i n connection with all of the deals discussed herein .
C. CON 6 ¶ 79 and 82 . The concept that in order for revenue to be classified as revenue (versus gains), the company must deliver or produce goods, render service s
48184 43 or perform other activities that constitute its ongoing major operations . Gains are defined a s other events or circumstances which result from peripheral or incidental transactions to the company. AOL and AOL Time Warner violated this requirement when, for example, the y characterized as advertising revenue cash inflows that were from sham or round-trip transaction s
(kickbacks) and from real transactions such as litigation settlements, deal terminations and the modifications of terms of equity deals. As more fully discussed below, Defendants violated thi s standard with respect to several transactions, including those with Homestore, Inc ., Bertelsmann
AG, Gateway Inc., 24dogs.com, Ticketmaster, Dr .Koop.com, and PurchasePro .
f CON 5' 83 . The concept that in order to recognize revenue, it must b e earned, realizable or realized . In order to consider revenue to be earned, the company must hav e
"substantially accomplished what it must do to be entitled to the benefits represented by th e revenues." In order for revenue to be considered realizable or realized, "products (goods o r services), merchandise or other assets are exchanged for cash or claims to cash ." AOL and AOL
Time Warner violated this requirement, for instance, when it recognized revenue by
"jackpotting" (not earned) in deals with Telefonica and others and when it double -booked revenue (not realizable) in a deal with Oxygen Media Inc., in addition to deals with Homestore,
Inc., Gateway Inc., Dr.Koop.com, and PurchasePro.
g. SFAS 123; EITF 00.08 ; APB 29. The principle that companies which sel l goods and services in exchange for equity instruments issued by the purchaser should measure the transaction at the fair value of the consideration received (given) or the fair value of th e equity instruments issued, whichever is a more reliable measure. AOL and AOL Time Warner violated this principle when they failed to report transactions based on the fair value of the equity received (and held solely by AOL) by failing to adjust the amount of equity issued b y
48184 44 appropriate time value and marketability discounts. As more fully discussed below, thes e
standards were violated with respect to several deals, including transactions with Homestore, Inc.,
Hughes Electronics Corporation, Gateway, Inc ., PurchasePro.com and Oxygen Media Inc .
h. EITF 00.08; CON 2163 . The principle that changes in fair value of th e equity instruments received in exchange for goods or services may be recognized as additional revenue from the transaction, if, on the measurement date, the quantity or terms of the'equity are dependent on the achievement of the counterparty's performance and changes in fair value result from an adjustment to the instrument upon achievement of a performance condition. AOL and
AOL Time Warner improperly repo rted advertising revenue when, for instance, customers like
PurchasePro adjusted the fair value of equity granted AOL through pricing changes even though
AOL was not entitled to such an adjustment under the terms of the o riginal agreement and no further performance objectives were achieved .
APB 16,188. The principle that in an acquisition, the acquiring company record receivables of the acquired company at present values of amounts to be received determined at appropriate current interest rates, less allowances for uncollectibility and coll ection costs, if necessary (fair value). AOL violated this principle in accounting for the 24dogs.com deal when it failed to report litigation settlement proceeds owed to an acquired company as the satisfaction of a purchased receivable and instead reported the proceeds as advertising revenue.
SOP 97.2, % 14. The principle that if an arrangement includes Multiple- elements, the revenue should be allocated to the various elements based on evidence of fair value, regardless of any separate prices stated within the contract for each element. AOL and AOL
Time Warner violated this principle repeatedly when it improperly attributed revenue from cabl e deals to its online division in transactions with Qwest Communications, Golf Channel, and
49184 45 Oxygen Media Inc., and, in the case of Oxygen Media Inc., double-booked the same revenue in
more than one division.
k. CON 1 1 34. The concept that financial reporting should provid e
information that is useful to present and potential investors, creditors and other users in making
rational investment, credit and similar decisions . AOL and AOL Time Warner violated this requirement in connection with all the transactions discussed herein when it overstated
advertising revenue in its financial statements .
1 . CON 1 140. The concept that financial reporting should provide information about the economic resources of an enterprise, the claims to those resources, and matters that change such resources. AOL and AOL Time Warner repeatedly violated this requirement by overstating the value of several of its various round-trip, barter and other transactions.
m. CON 1 ¶ 42. The concept that financial reporting should provid e information about an enterprise's financial performance during a time period. This information is often used by investors and creditors in order to assess the prospects of the company . AOL and AOL Time Warner repeatedly violated this requirement when they overstated thei r advertising revenue.
n. CON 1 1 50. The concept that financial reporting should provide information about how management of an enterprise has discharged its stewardshi p responsibility to owners (stockholders) for the use of enterprise resources entrusted to it. AOL and AOL Time Warner violated this requirement numerous times when it overstated advertisin g revenue.
48184 46 o. CON 2 Z 58-59. The concept that financial reporting should be reliable and relevant so that it represents what it purpo rts to represent. AOL and AOL Time Warner violated this requirement as to at least each of the transactions discussed herein .
p. CON 2 1 79. The concept that financial reporting should be complete, in other words, nothing material is left out of the information that may be necessary to insure that i t validly represents underlying events and condi tions. AOL and AOL Time Warner violated this requirement as to at least all of the transactions discussed herein, because they failed to report th e underlying substance of the transactions.
q. CON 2% 95, 97. The concept that financial reports should be conservative. Preparers must adequately consider uncertainties and risks inherent in busines s situations, reflect those issues in reports and insure that what is reported represents what it purports to represent. AOL and AOL Time Warner violated this requirement as to each deal when they overstated advertising revenue .
97. AOL and AOL Time Warner improperly recognized revenue in violation o f
GAAP during the Class Period as a result of multiple schemes which were specifically designe d to and did artificially inflate advertising revenue. Certain of these advertising deals incorporated multiple approaches utilized by AOL and AOL Time Warner to artificially manufacture advertising revenue. However, these schemes are each best described by one of the followin g approaches conceived and commonly used by AOL and AOL Time Warner :
] . Use of Sham Transactions and Improper Accounting Practices Regarding Round-Tripping. Back-to-Back, and Boomerang Deals
98. One of AOL and AOL Time Warner's more creative ways of inflating advertising revenue was through the use of sham transactions and/or improper accounting in connection with
"round-trip," "back to back" or "boomerang" deals . These deals involved, in some instances,
48184 47 the participation of multiple parties in elaborate advertising revenue schemes relating to AOL' s
purchase of goods, services, equity or some combination thereof from another party with th e
requirement of a reciprocal purchase of AOL's advertising services . These circular "trades" or
"swaps", as accounted for by AOL and AOL Time Warner, frequently gave the appearance that
AOL or AOL Time Warner had entered highly profitable multi-year, multi-million dollar deals
to sell advertising. Rather, AOL or the Company had really funneled , or "round-tripped," the
entire value of the revenue it received from these sales directly back to the original customer
through simultaneous purchases of advertising, goods, services, or equity, resulting in no ne t
gain to AOL or AOL Time Warner .
99. In May 2001 , the SEC's former Chief Accountant, Lynn Turner, expressed the
SEC's concern over such inherently fraudulent transactions when it appears that a company ". . .
has taken $1 million out of its left pocket only to receive that $1 million back in its right pocket ,
and wants to record the $1 million in revenue . . . .The staff questions how these types of `round-
trip' arrangements result in revenue , and whether, in substance, they are sham transactions
engineered solely to inflate the revenue line in the income statement ."
2. Barter Transactions
100. Barter, a common practice of AOL and AOL Time Warner during the Clas s
Period, was one mechanism through which AOL conducted round-trip deals. Barter transactions were often used by AOL and AOL Time Warner to lend an appearance of legitimacy to those transactions. As described below, many of the improper transactions included aspects of bot h round tripping and barter. However, barter deals involve an even greater ability to manipulate the amount of advertising revenue ultimately reported .
48184 48 101 . The SEC has expressed great concern over the use of barter transactions to inflate revenue. For example, on December 7, 1999, then-SEC Director of Enforcements, Richar d
Walker, in a speech entitled `Behind the Numbers of the SEC's Recent Financial Fraud Cases " given to the American Institute of Certified Public Accountants ("AICPA"), stated:
[C]ompanies are also using novel and creative methods to cook the books . For example, we are beginning to see an increase in the use of "barter" transactions, especially among high-technology companies, where the assets received in exchange for goods and services provided are greatly overvalued . We brought 4 barter cases last year.
(Emphasis added.)
102. Similarly, on December 8, 1999, Jane B. Adams, Deputy ChiefAccountant of the
SEC, also spoke to the AICPA and stated:
With the emergence of Internet companies as a significant part of the economy and for which investment decisions have been based on revenues rather than earnings, income statement classification and presentation has become a critical area. The staff is seeing a number of accounting issues for which the underlying objective seerns to be the grossing pp of the income statement. . . . Barter transactions also are pretty hot. For example, two Internet companies agree to provide banner advertisements on each other's websites, and record the arrangements as revenue and marketing expense .
The sign ficant pressure to report larger revenues raises questions as to the quality of the information being provided . In the case of barter advertising, how has the value transferred or received been established? What evidence supported that amount? Was the amount recorded in the financial statements based on reliable and verifiable valuations? Did it meet a reality check that that amount could have been realized in a cash transaction?
(Emphasis added.)
103. In the case of AOL and AOL Time Warner, barter deals used to overstate advertising revenue took at least three forms:
48194 49 a. Exchange of Advertising for Goods and/or Service s
104. AOL and AOL Time Warner regularly bartered advertising for a variety of goods or services such as computers, telecommunication services and network devices . According to a former Vice President for Business Development , AOL would typically target companies for barter deals who sold equipment or services to AOL, and particularly companies selling network devices, telecommunications services or computer equipment. These exchanges often were consummated at the end of a fiscal quarter to meet analysts' expectations. An August 26, 2002
Wall Street Journal article discussing AOL's practice of "squeezing" its suppliers for advertisin g revenue quoted Defendant Pittman : "If we're one of their big customers, we expect them to b e one of our big customers " AOL's and AOL Time Warner' s accounting for these types of barter transactions often led to the artificial inflation of advertising revenues .
105 . Accounting for revenues and profits resulting from non-monetary transactions, including barter, has always been highly regulated and scrutinized by the accounting professio n and government through the FASB and SEC, respectively. The Emerging Issues Task Force has also issued several consensus positions on revenue recognition matters . The accounting principles applicable to corporate ba rter transactions are derived from APB 29. APB 29,
"Accounting for Non-Monetary Transactions," became effective for transactions occurring after
September 30, 1973.
106. APB 29, in effect, provides that non-cash transactions, which include barter transactions, be recorded at the fair value of the assets (or services) given up or received , whichever is more clearly evident . APB 29, 1 25 states that "fair value of a non-monetary asset transferred to or from an enterprise in a non-monetary transaction should be determined b y referring to estimated realizable values in cash transactions of the same or similar assets, quote d
48194 50 market prices, independent appraisals, estimated fair values of assets or services received in exchange, and other available evidence . If one of the parties in a non-monetary transaction coul d have elected to receive cash instead of the non-monetary asset, the amount of cash that coul d have been received may be evidence of the fair value of the non-monetary assets exchanged ."
Recording barter transactions based on the "full" or "list" price of assets received, violates AP B
29 if not adjusted for any discount that would normally be received.
107. In December of 1999, the SEC reiterated existing GAAP with the issuance of
Staff Accounting Bulletin 101,17 C.F.R. § 211 ("SAB 101"}, which summarized the proper recognition, presentation, and disclosure of revenues in financial statements . Pursuant to SAB
101, revenues may not be recognized until they are "realized or realizable and earned ." In order for revenues to be considered "realized or realizable and earned," they must meet all of the following criteria: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred o r services have been rendered, (iii) the seller's price to the buyer is fixed or determinable, and (iv ) collectibility is reasonably assured . As the SEC stated , SAB 101 "is not intended to change current guidance in the accounting literature ." For example, before recognizing advertising revenue from a barter transaction a company must complete the "earnings process" by providing services valued at the amount reported in the transaction .
108. In addition to being "earned," revenues must not be self-generated . In this regard, the characterization of the transactions must demonstrate "representational faithfulness" and not subordinate the substance of the agreement to its form. CON 21160. In the case of a barter transaction, this means both parties to the barter have purchased services, products or equity, a t arms-length for reasons other than to artificially inflate revenue for one or both of the parties. A
48184 51 company selling advertising as part of a legitimate barter transaction can then only recogniz e
advertising revenue in accordance with the requirements of APB 29 .
109. Further, "revenues" are earned through transactions which involve or reflect the
major ongoing operations and services of the entity. CON 6 ¶ 79 ; CON 5 ¶ 83 . By contrast,
"gains" are recognized when obtained through an entity's peripheral or incidental transactions
not arising from the core operations of the entity. CON 6 ¶ 82 .
110. The SEC has also expressed concern over both round-trip and complex barter
transactions in which revenues are generated only as a result of the counterparty's agreement to
reciprocate; i.e., but for the counterparty's agreement to pay for advertising services, the
company would not have purchased goods, services or equity from the counterparty . In such
instances both parties must report the net, rather than gross, value of revenue derived from th e
transaction.
111 . In this regard, former SEC Chief Accountant Lynn Turner, in a speech on May 18 ,
2001, stated: "When an entity would not have entered into one of the separate contracts withou t
all the contracts being negotiated and agreed to as a `package', it will often be difficult t o identify a separable benefit being received and to establish reliable and verifiable fair values fo r each element of the arrangement. In those instances, the facts and circumstances will ofte n dictate that the cash inflows and outflows be reported as a net revenue or cost amount, in th e appropriate periods."
b. Warrants or Stock (equity) Received in Barter or Partial Barter Transactions
112. AOL and AOL Time Warner also regularly bartered advertising for warrants or stock as one component of complex deals entered into with other companies . In several deals ,
AOL and AOL Time Warner entered into such deals under the guise of making an investment,
48184 52 yet required the counter-party to recycle the funds by purchasing advertisements . The companies would then report advertising revenue without using the underlying investment (the equity) as a basis for valuing the advertising revenue, resulting in revenue overstatements .
113. On March 16-18, 2000, the Emerging Issues Task Force of FASB reached consensus (thereby making it a GAAP requirement) on the issues surrounding exchange o f equity for services in accordance with APB 29 . In so doing, the Task Force issued EITF Issu e
No. 00-8, entitled "Accounting by a Grantee for an Equity instrument to be Received i n
Conjunction with providing Goods or Services ."
114. Pursuant to EITF 00-8, 1 4 and APB 29, in transactions where a company receive s
equity (e.g., warrants or stock) as consideration or partial consideration for the services rendered by the company, "the grantee should measure the fair value of the equity instruments using th e stock price and other measurement assumptions" on the earlier of the date that a mutua l understanding of the terms are established and a commitment to performance is reached or th e date the grantee's performance is complete .
115. In addition, EITF 00-8, ¶ 10, requires that "companies should disclose, in eac h period's financial statements, the amount of gross operating revenue recognized as a result of non-monetary transactions addressed by Issue 00-8" (those involving equity received i n conjunction with providing goods or services) . EITF 00-8, ¶ 10 goes on to state: "Furthermore, the SEC Observer reminded registrants of the requirement under Item 303(a)(3)(ii) of Regulatio n
S-K to discuss known trends or uncertainties that have had or that a registrant reasonably expect s to have a materially favorable or unfavorable impact on revenues ."
48184 53 c. Exchange of Advertising - "In Kind" Advertisin g
116. A typical barter transaction between internet companies involves trading advertising space and then assigning a value to both revenue and expense . No cash is exchanged between the parties .
117. AOL also improperly inflated its adver tising revenue by reporting revenues o n such "in kind" advertising whereby AOL would provide customers with advertising on its website and in return receive certain advertising services which usually consisted of rights to advertise "America Online Keyword : j I" on a customer 's product.
118. According to a former Company account manager , AOL and AOL Time Warner often made barter deals with their strategic partners towards the end offiscal quarters involving the exchange of banner advertisements which effectively served as the principal currency for such deals . The deals involved a swap of banners on each others' sites . Both parties booked the advertising impressions as revenue . If AOL and Company adverti sing customers complained about the value of the advertising for which they had originally contracted, AOL's and AOL
Time Warner' s response was typically to provide "bonus banners" to the client rather than renegotiate a contract, a practice known as "make good ." According to this source, such "banner swaps" also occurred between AOL Time Warner divisions following the Merger and the AO L online division frequently posted "family banners" for Time Warner channels, such as Turner
Broadcasting, and booked the advertisements as revenue for AOL.
119. In early 2000, FASB stated, with respect to barter : "To the extent that revenues include barter transactions for which there is no ultimate realization in cash and no overall effec t on net income, the practice may lead to overstated revenues and artificially inflated market capitalization ." (EITF 99-17, T 2). The FASB went on to rule that companies could book a
48184 54 barter advertisement as revenue only if they could compare it with a similar transaction wit h
another company in which cash was exchanged within the previous six months . AOL and AOL
Time Warner failed to comply with FASB requirements and in fact utilized improper accounting
for "in-kind" barter transactions to overstate advertising revenue .
120. Accounting for "in kind" advertising transactions is governed by EITF Issue No .
99-17, "Accounting for Advertising Barter Transactions" and APB 29 . EITF 99-17 becam e
effective for transactions entered into after January 20, 2000.
121 . The necessity for EITF 99-17 is stated in the text of the rule:
It has become increasingly popular for Internet companies to enter into transactions in which they exchange rights to place advertisements on each others' web sites. In some of these transactions, no cash is exchanged between the parties. In other transactions, similar amounts of cash are exchanged between the two parties.
122. EITF 99- 17, 14 states:
The Task Force reached a consensus that revenue and expense should be recognized at fair value from an advertising barter transaction only if the fair value of the advertising surrendered in the transaction is determinable based on the entity's own historical practice of receiving cash, marketable securities, or other consideration that is readily convertible to a known amount of cash for similar advertising from buyers unrelated to the counterparty in the barter transaction . An exchange between the parties to a barter transaction of offsetting monetary consideration, such as a swap of checks for equal amounts, does not evidence the fair value of the transaction. If the fair value of the advertisin surrendered in the barter transaction is not determinable within the limits of this Issue, the barter transaction should be recorded based on the carrying amount of the advertising surrendered, which likely will be zero.
(Emphasis added .) This historical practice must be for a similar transaction in the six months prior to the transaction in question, pursuant to the provisions of the EITF.
123. Examples of AOL and AOL Time Warner round -trip and barter deals that were improperly accounted for by AOL and AOL Time Warner include the following:
48194 55 (1) Homes tore Inc.
124. Sixteen separate sham transactions with Homestore, Inc. ("Homestore") and AOL
and then AOL Time Warner occurred in the latter part of 2000 and the first half of 2001 .
Although these Homestore deals are just some of the transactions devised by AOL or AOL Time
Warner to artificially inflate revenue, much is known about these deals because of an ongoing criminal investigation into the Homestore matter that has already resulted in publicly disclosed guilty pleas to criminal offenses by four Homestore executives .
125. The concept for the sham Homestore transactions was devised by Defendant E ric
Keller, and approved by at least the person at AOL Time Warner to whom he directly reported,
Defendant David M . Colburn. The sham deals were designed to work to the mutual benefit o f
Homestore and AOL Time Warner so that they could both report bogus advertising revenue . As discussed below, AOL Time Warner had a significant equity interest in Homestore, 3 .9 million shares of Homestore stock, and therefore the Company benefited from the sham deals when both it, and Homestore reported artificially inflated advertising revenue .
126. The Homestore deals involved "three legs". In the first leg Homestore paid a third-party for services and products that Homestore did not need , and for which it in fact, overpaid. The secret second leg required the third parties to purchase advertising from AOL
Time Warner with most or all of the money Homestore paid to the third parties . Under the third leg, AOL Time Warner purchased advertising from Homestore in the same amount that the third- party paid to AOL Time Warner for advertising. Accordingly, AOL Time Warner and
Homestore secretly round tripped or purchased advertising revenue from themselves in sham triangular transactions .
48184 56 127. As part of these sixteen fraudulent transactions, in 2001 the third pa rties paid
AOL a total of $45. 1 million for advertising, with the agreement that AOL would funnel the
monies back to Homestore, after deducting an approximate $9 million "commission ."
128. Homestore executives, and Keller and Colburn, agreed that the secret leg of th e
sham transactions would not be documented. The secret third parties included PurcbasePro, Inc .,
Investor Plus, FX Consultants, Classmates.com, Wizshop, and Easy Roomates.
129. In May 2001, Keller worked with Homestore's top dealmaker, Peter Tafeen, to
avoid detection by Homestore 's auditing firm of the sham transactions that were to take place in
the second quarter of 2001 . However, in June 2001, Keller was placed on administrative leave
by AOL Time Warner.
130. At that time, in June 2001, Defendant Joseph Ripp, then the Executive Vic e
President and Chief Financial Officer of AOL, who became AOL's Vice-Chairman on
September 13, 2002, and Defendant Steven Rindner, AOL's Senior Vice President for Business
Affairs and Development, handled the sham deals for AOL.
131 . Initially, Ripp and Rindner raised questions regarding documentation of the third-
party leg of the deal. During mid-to late June 2001, by phone and e-mail, Ripp and Rindner told
Homestore that they had concerns about the collectiblilty of money from the third parties . In
response, Homestore went to great lengths to resolve the collectibility issues, including
accelerating payments to the third par ties so that AOL received its money during the second
quarter of 2001 .
132. On June 29, 2001, the last business day of the second quarter, AOL told
Homestore that it had not received confirming letters from some of the third parties regardin g
48184 57 their purchase of advertising from AOL. Ripp and Rindner also said that Homestore could no t be paid unless the confirming letters were received .
133. After the final confirming letters were subsequently received later on June 29,
2001, Homestore 's Chief Executive Officer, Stuart Wolff, caused a phone call to be placed to
Colbum who was not available. A message was left to have Colburn call Wolff. Instead, late in the evening of June 29, 2001, Ripp returned the call to Wolff. Wolff and several Homestore
executives and Ripp and Rindner participated on the call . Wolff told Ripp and Rindner that
Keller had agreed to the deal long ago . Wolff threatened litigation . Ripp and Rindner said tha t
Keller was gone, but never denied that Keller agreed to the deal or that Keller did not have th e
authority to make the deal on AOL Time Warner' s behalf. Wolff suggested that they should get
Keller on the phone, but Ripp and Rindner declined the offer . Another Homestore executive sai d he confirmed that money had already been paid to certain of the third-party vendors and AO L had received the payments for the advertising.
134. That evening after the call, the Company sent to Homestore its confirmation o f the deal.
135. The Company, and at least Ripp, Rindner, Colburn and Keller, were all aware of the round-trip and fraudulent nature of the deals . Indeed, Keller and Colbum concocted th e scheme and Ripp and Rindner clearly knew of the details of the deals, including where th e money AOL Time Warner received was actually coming from and that it was round -tripped back to Homestore. Ripp and Rindner, however, covered up the sham deals to allow the Company t o inflate advertising revenue and avoid adverse publicity for both AOL Time Warner and
Homestore, in which the Company had a significant equity interest .
48184 58 136. The fraudulent Homestore transactions have been confirmed by the guilty pleas t o criminal offenses of four Homestore executives in an ongoing DOJ investigation into th e
Homestore matter. Although the criminal charges and guilty pleas do not identify AOL Time
Warner by name, they refer to the company that engaged in these transactions with Homestore as a "major media company." Furthermore, these documents describe the same three-legged transactions referred to above and refer to the total of sixteen transactions and receipt by th e
"major media comp any" of $45 .1 million in 2001 for advertising as pa rt of these sham transactions.
137. Numerous press reports have identified the Company, and its executives , including Colburn and Keller, as targets of the DOJ investigation. In addition, Colburn, Keller and AOL Time Warner were named as defendants in a securities class action brought by
Homestore shareholders in the United States Court for the Central District of Californi a regarding the sham transactions. On March 7, 2003, the Honorable United States District Judge
Marsha J. Pechman, issued an Order Regarding Motions to Dismiss. In re Hornestore.com, Inc.
Securities Litigation, No. COI-11 115 MJP, 2003 WL 1227643 (C .D. Cal. March 7, 2003). In her
Order, Judge Pechman recounted in substantially similar fashion the Homestore allegations set forth herein, and the sham three-legged transactions involving the Company, Homestore, and the third parties . The court reluctantly dismissed the Company, Colburn, Keller and the third parties because it concluded that no "aiding and abetting" liability of AOL as to Homestore shareholders existed under the securities laws . However, the court stated :
While this Court feels compelled to arrive at this result, it does so with reservation. The acts alleged in the [Complaint], which this Court must accept as true for purposes of this motion, describe a massive conspiracy driven byyure avarice. In particular. the detailed factual allegations describing the role of AOL and its agents in helping Homestore please Wall Street and in boostin its own revenues through bogus commissions give this Court great pause .
45184 59 This decision does not mean that the wrongs of these aiders and abettors w ill necessarily go unchecked ; the PSLRA expressly granted the SEC the authority to bring civil actions against alders and abettors of securities fraud, and it is this Court's understanding that some investigation is ongoing.
Id. at *24. (Emphasis added .)
138. On March 12, 2003, The Washington Post reported that the federal investigation
of AOL Time Warner had, indeed, been broadened to include the "aiding and abetting" of others by the Company, Colburn and Keller, both before and after the Merger.
139. The Company improperly reported advertising revenue from these phony deals .
The transactions were shams agreed to with Homestore in order to repo rt advertising revenue
that neither party "earned" as required by SFAC No. 5 ¶ 83 . In addition, the fraudulent transactions were not "representationally faithful" as required by SFAC No. 2 163 . Thus, even if the Company only reported its bogus $9 million "commission" as advertising revenue, and prorated it over the first two quarters of 2001, the Company's advertising revenue was overstated by $4.5 million for each of the quarters ended March 31, 2001 and June 30, 2001 . Of course, if the Company reported the entire $45.1 million as advertising revenue , the overstated amount is even larger.
(i) Sun Microsystems, Inc .
140. Ina barter transaction with Sun Microsystems, Inc. ("Sun"}, AOL overpaid for goods at list price when normally it would receive a discount, thereby overstating the consideration exchanged for AOL's services in violation of APB 29. This transaction continued for three years and ultimately resulted in approximately $150 million of overstated advertising revenue over the course of the deal .
48184 60 141 . The Sun transaction was announced on November 24, 1998 and involved the
swap of advertisements for computer equipment. A September 1, 2002, a New York Times
article entitled, "Ouster at AOL, but Where Does Trail End? ," reported that AOL agreed to buy
$500 million in computer equipment from Sun at list price, even though companies like AOL
typically buy at a discount of more than 30 percent . For its part, Sun agreed to pay AOL $35 0 million for advertising services . A contemporaneous agreement provided for Sun to pay AOL more than $310 million per year as part of a three-year partnership called "Iplanet" AOL treated these payments from Sun as recurring revenue. Through this partnership, AOL was in effect receiving back some of its own expenditures in order to artificially increase its own advertisin g revenue and overstate income as a result . Furthermore, AOL and Sun would not have entered into the transaction without the reciprocal purch ases. Accordingly, under APB 29 revenue resulting from the deal should have been reported net of the overpayment rather than on a gros s basis.
142. A former AOL Chief Technology Officer, Product Manager and Senior Business
Manager confirmed AOL's improper barter deal with Sun . According to this source, th e announcement reporting the deal, which was signed by Jay Rappaport, was misleading becaus e
AOL did not realize the amount of revenue it was reporting .
143 . At a minimum, AOL's overpayment for Sun's computer equipment, based on the equipment's fair market value, should have been recorded as a reduc tion of AOL's advertising revenue resul ting from the round-trip transaction. Instead, AOL recorded the transaction based on an inflated list purchase price for the computer equipment, resulting in at least a 3 0%, or $150 million, overstatement of advertising revenue . AOL therefore overstated its advertising revenu e by at least $4.2 million for December 1998 and at least $12 .6 million per quarter starting with the
48184 61 quarter ended March 31, 1999 through the quarter ended September 31, 2001, and $8.4 million for the quarter ended December 31, 2001 . AOL's relationship with Sun would serve as a template for numerous other deals in which AOL bartered with other companies, round-tripping money and reporting advertising revenue at greatly inflated values, in violation of GAAP.
{iii`) Verrtas Software Corporation
144. In a classic case of round-tripping reminiscent of the earlier Sun swap, AOL negotiated a deal in September, 2000 to pay $50 million dollars for $30 million dollars worth of
software it purchased from Veritas Software Corporation ("Veritas') according to a former
Senior Contract Specialist at AOL. The extra $20 million dollars was then round-tripped back to
AOL in a purported separate deal in which Veritas purchased online advertising from AOL.
145. AOL then overstated its advertising revenue by $20 million in violation of AP B
29. According to the above source, the Veritas deal came about after AOL's Business Affairs unit raised a "hue and cry" when it heard that AOL's network opera tions unit was planning to make a $30 million dollar purchase from Veritas without getting something in return. Veritas
said it did not want to advertise on AOL and was not going to spend any money to do so .
Consequently, Defendant Colburn and a Business Affairs Director, Jeffrey Tyeryar, instructed the appropriate personnel to raise the contract amount to $50 million dollars and then structure
another deal in which Veritas would spend the extra $20 million dollars it had received for it s software on AOL advertising . Business Affairs wanted the $20 million from Veritas so that it could be booked as revenue before the end of the last quarter of calendar year 2000, the las t quarter before the Merger. The source described the Veritas deal as being j "kick-back" arrangement.
48184 62 146. More specifically, according to the above source, AOL's Jeff Tyeryar negotiated
a new dual contract arrangement and Colburn signed off on it for AOL's Business Affairs Unit.
By using two different contracts, it was made to appear that the two transactions were unrelated
and that AOL had received $20 million dollars in advertising revenue when, in fact, AOL wa s just getting back the $20 million dollars it had overpaid for the Veritas equipment and software .
Veritas, for its part, agreed to the deal only because it was anxious to book revenue from the
AOL software sale before the end of 2000 . Mike Cahill, a Veritas Vice President, handled the deal for Veritas.
147. In a Reuters news release dated November 14, 2002, Veritas reported that, in connection with the SEC's investigation of AOL's accounting, the SEC had subpoenaed Veritas' records relating to transactions it entered into with AOL in September 2000.
148. On January 17, 2003, Veritas announced that, as a result of the SEC's investigation, it was restating its financial results for fiscal years 2000 and 2001, eliminating $2 0 million in revenue previously booked as licensing and support fees paid by AOL. Further, the
Company announced that it would no longer record as an expense the $20 million it paid AOL for advertising.
149. Then, on or about March 17, 2003, Veritas disclosed in an amended Form 10-K filing with the SEC that the restatement resulting from the AOL deal was based on a determination that the fair value of the goods and services purchased and sold in the deal coul d not be "reasonably determined." In addition, Veritas disclosed that it was further restating its financials based on "two additional contemporaneous transactions involving software license s and the purchase of on-line advertising services" to reflect additional reductions in revenue .
49184 63 Veritas' auditor at the time of these transactions, Defendant Ernst & Young, was replaced following the audit of the Company's year 2000 financial statements .
150. AOL's and AOL Time Warner's improper accounting for the Veritas dea l resulted in an overstatement of advertising revenue by at least $4 million per quarter from th e quarter ended December 30, 2000 through the quarter ended December 31, 2001 .
{1V) Bertelsmann AG
151 . Ina round-trip transaction with Bertelsmann AG ("Bertelsmann"), AOL overstated advertising revenue by nearly $400 million when it bought out Bertelsmann's interes t in a joint venture. Rather than take advantage of the discount being offered by Bertelsmann. on the buy-out price if paid in cash, AOL arranged to have Bertelsmann round-trip or rebate tha t portion ofthe buy out price which would have constituted the discount amount back to AOL through the purchase of advertising services . This transaction continued for two years an d ultimately resulted in AOL overstating advertising revenue by $400 million over the course of the deal in violation of APB 29.
152. In the first quarter of 1998, Bertelsmann paid AOL $75 million fora 50% interest in a joint venture to operate the CompuServe European online service . Each company investe d an additional $25 million in this joint venture. In August 1999, AOL Europe introduced
Netscape Online in England and in May 2000, AOL Europe introduced CompuServe Office in
Germany.
153 . In March 2000, AOL and Bertelsmann announced plans to restructure their AOL
Europe joint venture and to undertake a new strategic alliance. The restructuring consisted of a put and call arrangement for AOL to purchase, in two installments, Bertelsmann's 50% interest in AOL Europe for consideration approximating $6.7 billion.
48184 64 154. According to a March 31, 2003 Wall Street Journal article, "A person familiar with the situation said that when Bertelsmann initially asked AOL to be paid in cash for its AOL
Europe stake, it had offered a discount on the sale price in exchange. The person said AOL' s response was that it wasn't interested in a cash discount, but wanted a bigger ad deal.
Bertelsmanm accounted for the advertising as a cost of the sale, the person said ."
155. A March 29, 2003 article entitled, "AOL Says SEC is Challenging it s
Accounting," The New York Times reported:
In a filing with the S .E.C. yesterday, AOL Time Warner disclosed that S .E.C. investigators had told the company that they think it improperly reported $400 million in revenue from a two-way deal with the German media conglomerate Bertelsmann. In 2000, America Online agreed to pay Bertelsmann $6 .7 billion for its 50 percent stake in AOL Europe. As part of the deal, Bertelsmann agreed to buy $400 million in advertising from AOL, which acquired Time Warner in - January 2001 . The S .E.C. investigators contend, in essence, that the payment was more of a rebate on the larger payment than a genuine advertising sale and, thus, should have been deducted from the purchase price .
The article went on to state that "the agreement with Bertelsmann was negotiated at the top levels of both companies" and also noted that, "current and former Bertelsmann executives" ha d recently revealed that not only had they questioned the deal, but that they were instructed by
Bertelsmann 's headquarters "to buy online advertising from AOL at inflated prices to fulfill the purchase commitment made as part of the larger transaction ."
156. The article also pointed to a connection with the sham transactions between AOL and Homestore:
In a related investigation into accounting at the internet company Homestore, one of the AOL's division's business partners, some former Homestore executives have also told S.E.C. investigators that AOL executives talked about a pool of advertising spending from Bertelsmann, people involved in that investigation have said. The former executives of Homestore told investigators that their counterparts at AOL spoke of possibly allocating Bertelsmann's advertising spending to Homestore, which in turn paid money to AOL .
48184 65 157. Under the requirements of APB 29, AOL was obligated to report the deal at its
fair market value and any overpayment should have been recorded as a reduction of the revenu e
that was recognized in connection with this deal . Since AOL would have received the discount,
AOL overstated its advertising revenue during the Class Period by $ 16.3 million, $65.5 million,
$39.8 million, $0 .5 million, $80 .3 million and $84.4 million per quarter, starting with the quarter
ended March 31, 2001 through the quarter ended June 30, 2002, respectively . The fact that
Bertelsmann recognized the advertising purchase as a cost of the sale provides even further
evidence that the Company improperly reported advertising revenue in connection with th e
Bertelsmann deal .
(y) Gateway Inc. Round-tria/Free Internet Service
158. In yet another round-trip transaction, AOL improperly accounted for the bundling
of its internet services on Gateway Inc .'s ("Gateway") computers, thereby overstating
advertising revenue by $470 million in violation of the directives set forth in APB 29.
159. In or about late 1999 or early 2000, AOL and Gateway entered into an
arrangement pursuant to which Gateway agreed to promote AOL's internet service to purchasers
of its computers. Each time a Gateway computer purchaser subscribed to the AOL service,
Gateway would receive a fee or "bounty" from AOL. According to an April 2, 2003 Washington
Post article entitled "Gateway to Amend Financial Reports - SEC Had Raised Concerns Over
AOL Deal," at the same time AOL paid a `bounty". Gateway in turn paid AOL for providing a free year ofinternet service on its computers .
160. Since there was no substance to the transaction other than swapping checks, AOL should have reported the transaction at its zero value instead of improperly reporting the amount s as sales and corresponding costs of sales . As a result, AOL overstated its advertising revenue b y
48184 66 $340 million in 2000 and $130 million in 2001 by recognizing the fees paid by Gateway as revenue, despite the fact that AOL was cycling the same amount back to Gateway in the form o f
a "bounty" payment.
161 . On or about April 1, 2003, Gateway announced that it was restating previousl y reported revenue from its agreement with AOL in response to accounting concerns raised by th e
SEC, which had been investigating Gateway's accounting since at least November, 2002. An
April 2, 2003 Washington Post article reporting on the announcement stated:
In 2000 and 2001, Gateway's method of reporting its dealings with America Online artificially boosted revenue because it failed to deduct the payments it made to AOL from the revenue it received. Because money was moving back and forth between the companies, Gateway said it intends to restate its financial results by reducing its revenue , a change that will more appropriately reflect the net amount of cash it received .
The revision is related to how the company accounted for bundled AOL Internet services, which it previously had reported on a gross basis, Gateway said in a statement. Current management has determined that it is more appropriate to present such amounts on a net basis.
Gateway said the reduction of revenue on its books from restating deals with America Online would be about $340 million, or 3 .5 percent of revenue, in 2000, and $130 million, or 2.2 percent of revenue, in 2001 .
(Emphasis added.)
162. AOL and AOL Time Warner's improper accounting for the Gateway internet deal resulted in an overstatement of adver tising revenue, on a prorated basis, by at least $85 millio n per quarter beginning with the quarter ended March 31, 2000 through the quarter ende d
December 31, 2000, and $130 million for the quarter ended March 31, 2001 .
(n) WorldCom Inc.
163 . Beginning in 1998 , WorldCom Inc. {"WorldCom') and AOL entered into a
"multi-year, multi-million dollar agreement" pursuant to which AOL paid at least $900 million
48184 67 dollars a year to WorldCom to carry the bulk of its internet traffic, and AOL became
WorldCom's largest customer. In July 2001, WorldCom and AOL Time Warner struck a massive round-trip/barter deal in which WorldCom agreed to buy more than $200 million dollars in advertising across all AOL Time Warner properties in exchange for AOL Time Warner continuing to keep its network traffic on WorldCom's network. While not disclosed in the press releases announcing the deal , AOL Time Warner also agreed to buy internet capacity from
UUNet, a unit of WorldCom, to expand AOL Time Warner's online network . The reciprocal transactions were used by AOL Time Warner as a vehicle to improperly recognize advertising revenue of at least tens of mi llions of dollars in violation of APB 29.
164. An August 22, 2002 Wall Street Journal article entitled, "Questionable AOL
Revenue Has WorldCom Link," noted the close relationship between the two companies
(Defendant Case held a seat on WorldCom's Board of Directors and AOL was WorldCom' s largest customer) and pointed out that, according to people familiar with the SEC's investigation of AOL Time Warner, a substantial portion of the $49 million of overstated advertising revenu e initially reported by the Company involved revenue inappropriately booked from the WorldCo m deal:
The money stemmed from the particularly close relationship America Online and WorldCom developed during the past few years, in which AOL became WorldCom's biggest customer, paying the telecommunications inn at least $900 million a year to carry the bulk of its Internet traffic. Most recently, in July 2001, the two companies struck a massive deal in which WorldCom agreed to buy more than $200 million in advertising across AOL properties in exchange for AOL continuing to keep its network traffic on WorldCom's network .
People close to the situation said the latest deal was negotiated in part by David M. Colburn, a top AOL deal maker who was ousted two weeks ago, and Scott Sullivan, WorldCom's former chief financial officer, who has been charged with securities fraud after the company, now in bankruptcy-court proceedings, found a total of $7.2 billion in improper accounting .
48184 68 165. In its SEC Form 10-Q for the quarter ended June 30, 2002, AOL Time Warner revealed that the initial reported overstatement amount of $49 million impacted the quarter ende d
December 31, 2000 through the quarter ended March 31, 2002 . As a result, AOL Time Warner' s improper accounting for the WorldCom deal resulted in an overstatement of adver tising revenue by at least $12.7 million for the quarter ended December 31, 2000, $5 .3 million for each of th e quarters ended March 31, June 30 and September 30, 2001, $11 .8 million for the quarter ended
December 31, 2001 and $8.5 million for the quarter ended March 31, 2002 .
(vii) Owest Communica tions
166. In or about July, 2001 , AOL Time Warner entered into a reciprocal transaction with Qwest Communications ("Qwest"). Under the deal, AOL reportedly agreed to use Qwest's network and to purchase digital subscriber lines and network transport capacity . In return, Qwest agreed to advertise in the Company's media properties including magazines, television programming, and online services. In a related round-trip transaction , AOL agreed to buy network capacity in Europe from KPNQwest, a Qwest affiliate, in return for which Qwest agreed to purchase AOL advertising.
167. AOL Time Warner violated GAAP by failing to account for the transaction based on the fair market value of the underlying instruments, either the network services or th e advertising services, whichever was more reasonably and readily determinable . Thus, the reciprocal transactions were used by AOL as a vehicle to improperly recognize millions of dollars of advertising revenue in violation of APB 29.
168. On August 23, 2002, The New York Times reported that another of the three deal s being examined by AOL Time Warner in connection with the Company 's initial report of $49 million in improperly reported revenue was the swap deal between the Company and Qwest .
48184 69 (viii Hughes Electronics Corporation
169. AOL improperly accounted for a June 21, 1999 round -trip/barter transaction
involving AOL's receipt of restricted stock in Hughes Electronics Corporation {"Hughes") in
exchange for advertising which allowed AOL and AOL Time Warner to overstate advertising
revenue. By overvaluing the stock received, AOL artificially inflated its advertising revenue by
nearly $50 million per quarter over a 2 'A year period .
170. The June, 1999 transaction expanded upon a preexisting partnership, entered into
on May 11, 1999, by the two companies to develop a combination set-top box that would mak e
DirecTV and AOL TV available to customers. Under the expanded alliance, AOL invested $1 .5 billion in General Motors {"GM") Series H 6.25% automatically Convertible Preferred Stock .
GM immediately invested the $1 .5 billion received from AOL in the stock of its subsidiary,
Hughes. In return, Hughes committed to increase its sales and marketing expenditures to AOL
over the next three years by approximately $1 .5 billion dollars .
171 . As included in its June 29 , 1999 SEC Form 8-K, a GM press release regarding the
AOL and Hughes deal stated that "the investment would be non-dilutive to earnings ." Similarly, a June 21, 1999 Internetnews.com article reported that "AOL said the investment will not have a negative impact on its earni ngs." AOL made this statement because it knew the invested fund s were to be round-tripped back to AOL and accounted for by AOL as advertising revenue .
However, the bartered services (advertising revenue) were overstated in violation of GAAP, particularly APB 29, SFAS 123 and EITF 00-08, since AOL did not properly value the ba rter instrument (stock) exchanged for them. More specifically, while AOL entered into the round- trip/barter deal under the guise of making an investment, the underlying instrument, not th e money to be exchanged, should have provided the basis for valuation .
48184 70 172. Despite the amounts of money swapped (i.e., $1 .5 billion from AOL for GM
Series H preferred stock in exchange for Hughes' commitment to purchase $1 .5 billion in advertising from AOL), the underlying round-trip/barter deal was essentially an exchange of GM
Series H preferred stock for AOL advertising services. AOL's recognition of advertising revenue at the full purported value of the stock violated GAAP. Since the stock was no t publicly-traded but was a class of stock created only for AOL and was not convertible until June
2002 (three years later), the value of the stock at the time of the transaction was not $1 .5 billion, and thus the associated AOL advertising services recorded based on that inflated amount over the period of the deal was improper. Though the stock tracked Hughes' common stock (GM Serie s
H common stock), the stock's value three years in the future should, at a minimum, have had a time value and marketability discount applied to it . As a result, applying conservative factors for time value and a marketability discount, AOL's and AOL Time Warner's advertising revenue was overstated by at least $16 million for the quarter ended June 30, 1999, $48 million per quarter beginning in the quarter ended September 30, 1999 through the quarter ended March 31 ,
2000, and $32 million in the quarter ended June 30, 2000.
173. In its Form 10-K for the fiscal year ended December 31, 2001, filed on March 25 ,
2002, the Company reported a charge of "approximately $270 million to reflect an other-than- temporary decline in the carrying value of AOL Time Warner 's investment in Hughes
Electronics Corp. ("Hughes"), an available-for-sale investment." Three months after the close of the Class Period, AOL Time Warner acknowledged its material false statements relative to th e value of its investment in Hughes. In its SEC Form I0-Q for the quarter ended September 30,
2002, filed on November 14, 2002, the Company reported :
Included in the non -cash pretax charges for three and nine month periods ended September 30, 2002 are charges related to the writedown of AOL Time Warner's
48184 71 investment in Hughes Electronics Corp . ("Hughes") of $505 million for both the three and nine month periods .
174. Finally, in January 2003, AOL Time Warner sold its 8.4% stake (80 million
shares) in Hughes for approximately $800 million , resulting in a total writedown of $700 million ,
or approximately 47%. According to a Hughes SEC Form 8-K, filed on March 3, 2003, Hughe s
and AOL entered into an agreement terminating their entire strategic alliance. Under th e
termination, Hughes was released from its commitment to spend $1 billion in additional sales, market, development and promotion efforts to support the companies' joint products and services .
(ix) Homestore - The 2000 House and Home Dea l
175. In May 2000, AOL and Homestore entered into a five-year agreement whereby
AOL artificially inflated advertising revenue by approximately $26.5 million per year by
improperly accounting for the value of stock it received in the deal. As part of the agreement,
Homestore became the exclusive dis tributor of home-buying and moving services across AOL properties and AOL created the "House and Home" channel on its website. Homestore was the
exclusive content provider for the site. AOL and Homestore also agreed that they would share revenue generated from the House and Home channel . In return, AOL received 3.9 million shares of Homestore common stock, at a guaranteed value of $68 .50 per share, and $20 million in cash.
176. Just prior to the announcement of the AOUHomestore agreement, Homestore' s stock price was $18 .25 a share, and immediately after the announcement it rose to $22.875 a share, a 25% increase.
177. As part of the deal, AOL also received a $90 million letter of credit that
Homestore could draw upon up to a $50 million cap if Homestore's stock price did not reach the guaranteed price.
48184 72 178. On May 1, 2000, Business Wire reported on the Homestore/AOL alliance:
America Online, Inc. (NYSE: AOL), the world's leading interactive services company, and Homestore.com, Inc. (Nasdaq: HOMS), the world's leading home and real estate network on the Internet, today reached a new five-year multifaceted content, e-commerce and dist ribution alliance valued in excess of $200 million, to provide the most comprehensive source of home and real estate content to several key AOL brands .
Under the terms of the agreement, America Online, Inc. will receive approximately 3 .9 million shares of Homestore.com common stock, which Homestore.com is required to guarantee meet certain performance targets throughout the term of the agreement . As part of the guarantee, Homestore.com will issue a $90 million letter of credit, which will be drawn upon only if Homestore.com's common stock does not meet the performance targets . AOL will also receive $20 million in cash as part of the agreement .
179. This deal was orchestrated by Keller at AOL and Peter Tafeen at Homestore, with
Colburn having extensive involvement in the transaction.
180. Keller told Joe Shew , a Homestore executive, in March or April 2000 that AOL' s
auditors had looked at the deal and that the $20 million cash payment, the letter of credit an d
certain termination provisions, were included in the agreement so that AOL could recognize revenue. These provisions were not initially part of the agreement . Keller told Shew that
Colburn was directly involved in the negotiations of these terms . Keller also told Shew that
AOL would be recognizing $50 million per year in revenue from the agreement.
181 . When the agreement was implemented, Homestore was very disappointed with the deal. Homestore believed that it did not receive enough "hits" through the AOL interne t properties and Peter Tafeen regularly complained to Colburn about his disappointment with th e deal.
182. AOL reported the value of the deal to be $287 million, or about $57 million pe r year over the five-year term of the deal. AOL, however, failed to properly account for th e
48184 73 consideration at its fair value, and thus violated APB 29, SFAS 123 and EITF 00-08, which
would have included discounts for time value and marketabili ty (transfer) restrictions. As a
result, the Company improperly overstated advertising revenue by at least $4.4 million for the
quarter ended June 30, 2000 and $6.6 million per quarter for the quarter ended September 30,
2000 through the quarter ended June 30, 2002, the last reported quarter during the Class Period.
(x) Gateway Inc. Stock Purchase
183 . AOL again improperly accounted for a round-trip/barter transaction involving the
purchase of stock in a round-trip deal originally entered into with Gateway beginning on or about
October 10, 1999 . The stock was held only by AOL and unmarketable for three years .
184. According to a former AOL Vice President for Business Development, the deal
`vas not arm's length" and was misrepresented by AOL to the marketplace . AOL agreed to
invest approximately $800 million in Gateway, acquiring a 4.5% stake in the company in
Gateway stock and warrants . The source reported that, in return, the agreement provided that
Gateway would use the entire $800 million dollars it received from AOL for advertising and
other strategic partnerships on AOL's service. These Gateway investments included an online
retail store joint venture of AOL and Gateway in which Gateway invested $75 million. Both
AOL and Gateway's stock went up as a result of the publicity about this deal which was
presented in press releases as being mutually beneficial to the companies . According to the
source, the deal was, in fact, a round-trip/barter transaction in which AOL, through improper
accounting, overstated advertising revenue.
185. Similar to the Hughes and Homestore House and Home transactions described
above, AOL failed to use the underlying instrument (stock), as opposed to the money exchanged,
as a basis for valuing the amount of advertising revenue to be recognized in the deal . As was its
48184 74 practice, in or about December, 2001, AOL invested $200 million in a class of stock -50,000
shares of non-voting Series A convertible preferred stock - that o y AOL held . The Gateway
stock was thus restricted and would not convert until 2002 and beyond (usually three years from
the transaction date) depending on the trading prices on those dates . Consequently, proper
valuation of the stock was critical to AOL's recognition of advertising revenue in the Gateway
deal. APB 29 required that a fair market value calculation be applied upon issuance of the stock
and that the advertising revenue reported by AOL be discounted accordingly . AOL did not do so, thus violating APB 29, SFAS 123 and ETTF 00-08, which required that the transaction be valued at the fair value of the instruments swapped, including time value and marketability discounts.
By failing to properly value the Gateway stock, AOL and AOL Time Warner overstate d advertising revenue by at least $3 million in December, 2001 and $9 million per quarter for th e quarter ended March 31, 2002 through the quarter ended June 30, 2002, the last reported quarte r during the Class Period.
W) Oxygen Media Inc. Stock Purchas e
186. AOL Time Warner again improperly accounted for a round-trip/barter transactio n involving the purchase of stock in a deal entered into with Oxygen Media Inc . ("Oxygen Media") in April, 2001 . While not fully disclosed to the marketplace, AOL invested $30 to $50 million dollars in Oxygen Media which operates a cable channel . As part of the deal, Oxygen Media's cable channel would be carried on the Company's cable systems and Oxygen Media would purchase $100 million in advertising mostly from the AOL division of the Company. According to a former AOL account manager, the AOL deal with Oxygen Media was an instance of "round tripping" or a "reinvestment deal ."
48184 75 187. The deal itself was announced on April 4, 2001 , in a Wall Street Journal article
entitled, "AOL Time Warner Reaches Deal to Boost Stake in Oxygen Media" The a rticle stated :
AOL Time Warner inc. is boosting its minority stake in struggling Oxygen Media Inc., the closely held cable-television and online company, in a move that reflects the growing control ofAOL executives over Time Warner's far-flung operations.
AOL Time Warner also will send a certain amount of online traffic to Oxygen's four Web sites by weaving Oxygen's content into AOL's various online channels. AOL Time Warner declined to disclose the size of its cash investment in Oxygen or the size of its equity stake in the business.
188. On August 26, 2002, in an article entitled, "Officials Probe AOL's Actions With
Partners," The Wall Street Journal reported on the Company's round-trip/barter deal with
Oxygen Media:
For America Online, investing in companies that then advertised on the Internet service was about as crucial to its growth as taking in oxygen. Literally.
Last year, AOL invested $30 million to $50 million in Oxygen Media Inc. and arranged for the women-focused cable channel to be carried on parent AOL Time Warner Inc.'s cable systems . At the time, Oxygen agreed to buy about $100 million in ads that mostly ran on America Online--a hefty amount for a start-up media company.
The Oxygen trades were one of the many complex deals that were a way of life at the America Online unit--and many other technology companies-during the boom years. At AOL, these deals sometimes included an investment Other times, AOL squeezed its suppliers for advertising revenue . Either way, the deals weren't much of a secret--AOL was proud of its ingenuity in crafting the arrangements and expected AOL partner companies to buy ads on AOL . "If we're one of their big customers, we expect them to be one of our big customers," Robert Pittman, the since-departed chief operating officer, said in an interview last year.
189. The Oxygen Media carriage deal was unusual for not including a launch fee .
Networks like Oxygen Media routinely pay cable operators substantial launch fees to obtai n favorable channel positions on cable systems. Instead of paying the Company such a fee, which could have been as much as $100 million dollars, Oxygen Media purchased advertising ,
48184 76 principally from the Company's AOL online division . To compensate Time Warner's cable division for not receiving revenue from Oxygen Media in the form of a launch fee, the AOL online division bought advertising on Time Warner cable . According to a Wall Street Journal report on October 7, 2002 entitled, "SEC Probes AOL-Oxygen Pact For Double-Booking of
Revenue," Defendant Pace, AOL Time Warner's Chief Financial Officer, told a group of investors that the SEC inquiries into AOL's accounting included AOL's involvement with other
AOL Time Warner divisions and singled,out the Oxygen Media deal as an example. By failing to properly account for its round-trip deal with Oxygen Media, AOL Time Warner overstate d that AOL advertising revenue by at least $19.8 million per quarter for the five quarters ended
June 30, 2001 through the quarter ended June 30, 2002.
(xii) PurchasePyro.co Inc. Advertising Swap
190. AOL and AOL Time Warner improperly accounted for an "in kind" advertising deal with PurchasePro. com, Inc. ("PurchasePro "}, which AOL used as a vehicle to improperly inflate advertising revenue by at least $13 .9 million during the Class Period . At that time,
PurchasePro was a start-up business-to-business software fine . According to PurchasePro's SE C
Form 10-K for 2000 and its SEC Form 10-Q for the second quarter 2001, pursuant to th e marketing agreement, PurchasePro bought advertising space from AOL and, in two transactions,
AOL purchased promotional subscriptions for use with AOL customers for $13 .9 million.
AOL's purchase of $4.9 million (in 2000) and $9.0 million (in 2001 ) of PurchasePro's subscriptions for AOL's customers and PurchasePro ' s purchase of advertising from AOL were round-tripped revenues. Rather than earned, the revenues were effectively self-generated. Thus, the cash transactions failed to demons trate "representational faithfulness" and subordinated the
48184 77 substance of the agreement to its form in violation of Statement of Financial Accountin g
Concepts No. 2.
191 . Since AOL exchanged its advertising services for the PurchasePro subscriptions ,
AOL should have recognized the advertising revenue in accordance with the requirements of
APB 29. APB 29 states that the fair market value of the instruments (subscriptions and advertising services) should be used as the basis of the transaction . If unable to determine the fair market value, the recorded amounts (costs) should be used to value the transac tion (APB 29, par. 26), which would be minimal to zero. EITF 99-17 provides additional requirements as t o the valuation of advertising services using the past six months cash transaction for simila r amounts and similar terms as a basis. AOL overstated its advertising revenue by at least $4.9 million for the quarter ended December 31, 2000 and $9 million for the quarter ended June 30 ,
2001 because the fair value and cost of the virtually nothing . PurchasePro subscriptions and
AOL advertising was virtually nothing .
(du} Monster.com
192. AOL improperly accounted for another "in kind" advertising deal entered into with Monster.com in late 1999, used by AOL to overstate advertising revenue by over $2 9 million during the Class Period. On December 2, 1999, Business Wire reported on AOL's "$100 million relationship" with Monster.com:
America Online, Inc. (NYSE: AOL), the world's leading interactive services company, and Monster.com, the leading global careers network and the flagship brand of TMP Worldwide Inc. (NASDAQ: TMPW), today announced a four year, exclusive $100-million relationship to bring Monster.com's career management resources directly to cyberspace's largest consumer audience across seven America Online brands .
193. According to a former AOL Vice President for Business Development, the transaction entered into between AOL and Monster.com was a "profitless deal" in which AOL
48194 78 promoted Monster.com and Monster.com agreed to promote AOL by exchanging advertisements with each other.
194. Similar to the PurchasePro deal discussed above, because AOL exchanged or swapped its advertising services for the Monster.com advertising, AOL should have recognized the advertising revenue in accordance with the requirements set forth in APB 29 and EITF 99-17:
APB 29 states that the fair market value of the instruments (adver tising services) should be used as the basis of the transaction. If unable to determine the fair market value within the limits o f
ETTF 99-17, the barter should be recorded based on the carrying amount of the advertising surrendered, which would be zero . EITF 99-17 also provides additional directives as to the valuation of advertising services using the past six months cash transaction for similar amounts and similar terms as a basis . Further, applying the standards set forth in SFAC 2, the transaction would be properly characterized as a sham and the substance would be a net zero transactio n despite its form. No "real" revenue was reportable. By failing to comply with APB 29 and EITF
99-17, AOL and AOL Time Warner overstated advertising revenue by at least $2.08 million for the quarter ended December 31, 1999 and $6.24 million for each quarter beginning with th e quarter ended March 31, 2000 through the quarter ended June 30, 2002, the last quarter reporte d in the Class Period .
3. "Front Loading" or "Jackpotting" to Record Advertising Revenue
195. Another category of deceptive advertising deals involved the practice o f manipulating the timing and placement of advertisements to report the revenue generated fro m those advertisements in a particular quarter, thereby meeting internal goals or external earning s estimates. According to a former AOL Associate Project Manager in the Sales Planning
Operations Division, who was responsible for booking revenue and implementing sales o n
48194 79 AOL's website, the overall practice of flooding the website with advertisements at the end of the
month through this method of so-called "front loading" or "jackpotting" was common. Millions
of dollars were "fmntloaded" or "jackpotted" at the end of each quarter and many advertisers
were in the dark about this practice .
196. A Washington Post article dated July 19, 2002 said that interviews with former
AOL employees revealed that the term "j ackpotting" referred to gambling slot machines where,
for example, three cherries in a row wins. In AOL's case, jackpotting meant it would run the
same ad three times on a single web page, often on the bottom of the screen, where it was less
visible.
(i) Catalina Marketing Corporation
197. According to a former Chief Technology Officer, Product Manager and Senior
Business Manager who worked for AOL, the Company often engaged in "jackpotting", an
example of which took place in the first quarter of 1998, even before the Class Perio d
commenced, in connection with Catalina Marketing Corporation ("Catalina") . Catalina had
signed a $10 million dollar two year contract to run supermarket advertising online with AOL.
Even though the food section of AOL was not ready to run the advertising, AOL executives
made sure the ads ran before the end of the quarter and in advance of the contractual obligation
so AOL could book the revenue. According to this source, the rule of thumb at AOL at the time
was that AOL would book 25% of the value of the contract in the quarter the advertising began .
198. The fact that AOL generated numerous advertisements in a short time frame,
allegedly many times on the same page (to the point that some customers complained of
excessiveness), to an earnings process does not alleviate the requirement of CON 5, p . 83 which
states, "Revenues are not recognized until earned . An entity's revenue-earning activities involve
49184 80 delivering or producing goods, rendering services, or other activities that constitute its ongoin g major or central operations, and revenues are considered to have been earned when the entity ha s substantially accomplished what it must do to be entitled to the benefits represented by th e revenues." (Emphasis added.)
199. When AOL engaged in "jackpotting" in connection with, inter ali% Catalina
Marketing, it overstated advertising revenue - by "squeezing" or "jackpotting" multiple advertising impressions or banners, AOL did not perform under the contract . In other words, when the ads began to run in such a fashion under this, and other similar deals, there was n o
"earnings process" taking place with regard to the superfluous or excessive advertisements because AOL had not "substantially accomplished" the substance of the contractlagreements .
(ii) Telefonica SA
200. According to a July 19, 2002 article in The Washington Post, an example of
"jackpotting" occurred just prior to the Merger in connection with a Business Affairs deal to sell
$ 15 million dollars in online ads to Telefonica, SA, ("Telefonica") a large Spanish telecommunications company. Confirming the existence of the relationship between AOL and
Telefonica, the Dow Jones International News Service reported on December 19, 2000 that
Telefonica Datacorp, the business telecom unit of Spanish telecommunications company
Telefonica SA (TEF) had signed a "'multimillion dollar" strategic agreement with AOL fo r several years .
201 . In order to book revenue from the Telefonica deal in the quarter ended December
31, 2000, AOL needed to run the advertising during that month. According to the July 19, 2002
Washington Post article:
But with so little time left, AOL had to place the ads in high-traffic areas of AOL, such as its welcome screen, the first Web page people see when they use the
48184 81 service. More consumers saw ads on the welcome screen and AOL could get faster credit for running the promotions .
AOL officials didn' t care that the Telefonica link from AOL's English-language welcome screen took its users to a Spanish-language site, said AOL sources familiar with the deal. Nor did it matter to [AOL] that Telefonica's computer servers couldn't handle all of the customer traffic from AOL, they said.
AOL succeeded in running the Telefonica ads fast to book the revenue before December 31, as accounting rules required .
202 . Under GAAP, however, AOL did not substantially accomplish what it would b e required to do in order to recognize revenue. As a result, AOL's advertising revenue was overstated by $15 million for the quarters ended December 31, 2000 and March 3 1, 2001 , respectively.
203 . According to a former AOL Vice President for Business Development, AOL regularly engaged in this type of "jackpotting" towards the end of each quarter in order to meet targets similar to the "jackpotting" that occurred with respect to Telefonica . Specifically, this source stated that similar "jackpotting" also occurred with regard to transactions with Gateway and Cisco.
4. Converting Legal Disputes into Advertising Deals
204. Another impermissible accounting practice engaged in by AOL and AOL Time
Warner involved the improper conversion of a legal dispute into an advertising deal . To that end,
AOL demanded that its litigation opponent purchase advertising in settlement of a dispute . This revenue was then improperly reported as advertising revenue .
(i) 24dogs.com Arbitration Awar d
205. AOL improperly converted a $22.8 million arbitration award into advertisin g revenue. MovieFone Inc . (" MovieFone"), an online ticketing firm, had won an arbitratio n award against a Wembley PLC subsidiary. When AOL purchased MovieFone a year later in
48194 82 1999, it turned the $22 .8 million arbitration award, plus interest, into online advertising revenue ,
recognized in AOL's rascal quarter ended September 30, 2000 . In return, AOL agreed that this purchase of advertising would satisfy the prior arbitration award . In a deal reached just days before the end of the quarter ended September 30, 2000, when AOL knew it was short of its
targets for advertising revenue, Wembley agreed to purchase $23 .8 million in advertising for its
online greyhound racing website, 24dogs .com. The importance of meeting revenue targets wa s
even more critical because the consummation of the Merger with Time Warner was only months
away. Accordingly, AOL quickly put together advertisements and ran enough of them to book
$16.2 million of advertising revenue in the quarter ended September 30, 2000 .
206. However, to book the advertising revenue in that quarter under this improper
conversion scheme, AOL needed to run the advertising before September 30, 2000 . Without
Wembley's knowledge, AOL created banner and button advertisements out of Wembley's
24dogs.com website and started running advertisements . In this case of jackpotting" similar to
Telefonica, AOL ran as many as three or four Wembley advertisements on a single webpage .
According to the July 18, 2002 Wa hington Post article, within about an hour of posting the greyhound ads, Wembley's unfinished website crashed from an overload of customer traffi c from AOL. Such "jackpotting" overstated advertising revenue because there was no "earning s process" taking place with regard to the superfluous or excessive advertisements because AOL had not "substantially accomplished" the substance of the Wembley deal.
207. Even more significant from an improper accounting standpoint, applicable accounting standards do not allow for an arbitrary conversion of one type of revenue into another .
This is because the initial recording of income ( such as the MovieFone arbitration award) gave rise to the receivable in the first place. AOL's conversion of this receivable into advertisin g
49184 83 revenue is subordinating the substance of the transaction to its form . APB 16 ¶ 87 and SFAS
141 137 require that assets of an acquired company (MovieFone) be recorded on the opening
balance sheet at the time of the acquisition . The subsequent collection of that receivable would
therefore have no income statement impact. Here, the overall impact of AOL's accounting manipulations was to overstate advertising revenue by $16.2 million and $7.5 million for the
quarters ended September 30, 2000 and December 31, 2000, respectively .
(U) Ticketmaster Legal Action
208. In the same fiscal quarter ended September 34, 2400, AOL improperly converted another pending litigation, with Ticketmaster, into $13 million in advertising revenue. By settling its action against Ticketmaster in exchange for Ticketmaster buying advertising from
AOL, a settlement payment was made and should have been recorded as other income, not advertising revenue. CON 6 ¶ 82, and CON 5 ¶ 83 require that income resulting from peripheral or incidental transactions be treated as gains rather than revenue because they do not arise from a company's central operations. The settlement of the Ticketmaster litigation did not constitute
AOL's ongoing major or central operations . AOL's attempt to improperly characterize the litigation settlement as advertising revenue violates the requirements of CON 2 ¶ 160 which states, "The quality of reliability and, in particular, of representational faithfulness leaves no room for accounting representations that subordinate substance to form ." Here, the reporting of
Ticketmaster transaction failed to demonstrate "representational faithfulness" and subordinated the substance of the agreement to its form in violation of CON 2 . The impact of this accounting manipulation was to overstate advertising revenue by $13 million for the quarter ended
September 30, 2000.
48194 84 S. Bookie Sales on a Gross Rather Than Net Basis to Inflate Advertisin Revenue
209. Another deceptive prac tice of AOL and AOL Time Warner was its
misrepresentation to investors of the nature of its agency relationship with particular customers.
With respect to certain deals , AOL Time Warner served as an adver tising broker for a customer
and then represented all (gross amounts ) of the resulting revenue to be AOL's and AOL Time
Warner's own adver tising revenue, rather than reporting only the percentage of revenue properly
accruing to AOL and the Company as a commission from the sale.
210: Reporting gross revenue as a principal versus net revenue as an agent was
highlighted by ETTF Issue No. 99-19, which became effective for financial statements for fiscal
periods beginning after December 15, 1999 . EITF 99-19 is intended to resolve any issue about
whether a company should report revenue based on (a) the gross amount billed-to a customer
because it has earned revenue from the sale of the goods or services or (b) the net amount
retained (that is, the amount billed to a customer less the amount paid out, i.e., to a supplier who
has earned a commission or fee). As the FASB notes in EITF 99-19, "How companies report
revenue for the goods and services they offer has become an increasingly important issue
because some investors may value certain companies on a multiple of revenues rather than a
multiple of gross profit or earnings ." (Emphasis added.)
211 . The accounting requirements of EITF 99-19 are consistent with SAB 101 . SAS
101 states:
In asserting whether revenue should be reported gross with separate display of cost of sales to arrive at gross profit or on a net basis, the [SEC] staff considers whether the registrant :
1 . acts as principal in the transaction; 2. takes title to the products;
48184 85 3. has risks and rewards of ownership, such as the risk of loss for collection, delivery, or returns ; and 4. acts as an agent or broker (including performing services, in substance, as an agent or broker) with compensation on a commission or fee basis .
If the company performs as an agent or broker without assuming the risks and rewards of ownership of the goods, sales should be reported on a net basis.
eBay
212. AOL and AOL Time Warner had an agreement with the internet auction company ,
eBay, to broker advertisements on eBay's behal f
a. According to a Dow Jones News Service posting on March 25, 1999, Americ a
Online and eBay formed a four-year marketing alliance in which "America Online . . . may act as
the sole third-party advertising sales force for advertising sold on eBay's web site, www.ebay.com." This agreement was part of a broader relationship between the two companies contained in an agreement entitled "Interactive Marketing & Advertising Representation ." The
March 1999 agreement was actually an amendment of an earlier agreement which resulted in the previous contract being terminated in August 1999. Under the amended agreement in March
1999, eBay also expanded the scope of its strategic relationship with AOL under the followin g terms:
• eBay granted prominent presence on AOL's proprietary services, including
AOL, AOL.com, CompuServe, Netscape's Netcenter, ICQ and Digital City;
• eBay was to develop a co-branded version of its service for each AOL property
which will prominently feature each party's brand ;
• AOL entitled to all advertising revenue from the co-branded site;
• AOL continue to act as the sole third-party advertising sales force fo r
advertising sold on eBay's website, www.ebay.com; and
48184 86 • eBay to pay $75 million over the four-year term of the contract.
eBay SEC Form 14-Q for the quarterly period ended March 31, 2000 .
b. According to a Wall Street Journal article on August 14, 2001, AOL Time
Warner and eBay announced that AOL Time Warner would continue to serve as eBay' s
exclusive third-party advertising sales force for eBay. This announcement resulted from a n
August 2001 amendment to eBay's Interactive Marketing and Advertising Representatio n
agreements with AOL Time Warner . This amendment extended the term of the relationshi p
through March 2004 and "provide[d] additional exclusivity for AOL Time Warner." Under the
amended agreement, elay was obligated to pay $93.8 million over the Sve-year term of th e
contract in exchange for online advertising services .
eBay November 14, 2001 Form i 0-Q and eBay March 25, 2002 Form 10-K .
213 . Since AOL only served as an advertising broker or agent for eBay, it only earned
and received a commission on the sales it made for eBay. AOL, however, did not simply record
its earned commission, but recorded all of the eBay advertising revenue as if it were AOL' s
revenue. As a result of this improper recognition of revenue , AOL reported a larger amount of
advertising revenue than it was entitled to.
a. Indeed, according to Alec Klein's book Stealing Tame:
In the summer of 2001 , AOL deal makers boarded the company jet for the San Jose, California, headquarters of [eBayj . . .and returned a day later with a transaction that would help AOL meet its financial targets. AOL revised a deal in which it agreed to serve as an ad broker, selling eBay's on-line ad space, according to AOL's confidential executive summary of the deal . But AOL did not simply take the customary ad rep's commission . Instead, AOL counted all of the eBay advertising revenue as if it were AOL's own. "AOL recognizes all revenue generated from eBay inventory sales on a topline basis," AOL said in its internal documents. In this way, AOL booked $80 million in revenue in 2000 and 2001, the gross amounts from selling eBay's ads . The gross sales didn't change AOL's net income, because AOL counted the payments it forwarded to eBay-
48184 87 minus its broker's fee-as an expense elsewhere on its books. But with this accounting, AOL was able to report a larger amount of ad and commerce revenue .
Alec Klein, Stealing Time: Steve Case, Jerry Levin and the Collapse of AOL Time Warner 265 (Simon & Schuster ed . 2003).
b. GAAP, specifically EITF 99-19, requires that revenue earned by an agent (as
opposed to the principal) should be reported in its net amount, meaning the commission earned
by AOL rather than eBay's total advertising revenue. As reported in the July 18, 2002
Washington Post, however, AOL "sold ads on behalf of online auction giant eBay, Inc ., booking
the sale of eBay's ads as AOL's own revenue." The Washington Post further stated : "AOL did not buy eBay's advertising inventory," "AOL carried no financial penalty if it did not sell
eBay's ads" and "AOL would not explain how it shared that risk ." All of these terms and conditions indicate that AOL operated as an agent, not principal . Commenting on the deal in the
Washington Post, "Michael Sutton, the SEC's chief accountant from 1 995 to 1998, said, `This sounds more like an agency relationship than a principal relationship .' An agent should book a commission, he said, not the gross sale, as AOL did ."
c. Like most internet companies, AOL and AOL Time Warner's valuation was based on multiples of revenues rather than multiples of earnings. More specifically, AOL and
AOL Time Warner' s advertising was a key factor in the market's valua tion of the companies .
Consequently, accurate advertising revenue presentation for AOL and AOL Time Warner was o f paramount importance. However, AOL and the Company overstated AOL's advertising revenue from the eBay deal because AOL was acting as an agent and not the principal (by earning a commission on the sale of the advertising). As such, AOL and AOL Time Warner should have only recorded the commissions ea rned as the companies' revenue, not the gross revenue amounts .
AOL and AOL Time Warner' s failure to do so is a clear violation of GAAP, specifically CON 5
48184 88 ¶ 83, and EITF 99-19, which require that agents (in this case AOL and AOL Time Warner)
report only their commissions earned as revenue rather than the revenue earned by the seller (in
this case eBay) as their own. AOL and AOL Time Warner therefore overstated advertising
revenue by at least $16.8 million for each quarter beginning with the quarter ended September 30,
1999 through June 30, 2001 and $12.75- million for the quarter ended September 34, 2401 .
6. CountingRepricing of Equity Stock Rights as Advertising Revenue
214. AOL and AOL Time Warner also fraudulently reco gnized advertising revenue when they revised the terms of their respective equity investment in existing advertisin g
customers in violation of applicable accounting principles .
PurchasePro
215. AOL improperly accounted for its marketing deal with PurchasePro by recognizing advertising revenue with respect to stock rights AOL held in PurchasePro. A July
19, 2042 Washington Post article recounts Defendant Colburn arrogantly describing this
PurchasePro deal as "science fiction ."
216. Pursuant to an agreement entered into in or about March, 2000, AOL agreed to distribute software for PurchasePro and, in exchange, received tens of millions of dollars in performance warrants. The warrants, which are similar to stock options, gave AOL the right to buy PurchasePro stock for $63 .26 per share. PurchasePro subsequently accelerated the vesting schedule for three million of the warrants and adjusted the exercise price down to .01 a share.
Based upon the change in the vesting schedule for and pricing of these 3 million PurchasePro warrants, the Company improperly booked $20.5 million dollars as advertising revenue in the quarter ended December 31, 2000 and another $7 million in the quarter ended March 2001 .
48184 89 217. When PurchasePro reduced the exercise price of the warrants from $63 .26 to
$0.01, AOL should have recognized the change in value as a gain, rather than as advertising revenue. CON 6 ¶ 82 states that "gains are increases in equity (net assets) from peripheral o r incidental transactions of an entity and from all other transactions and other events an d circumstances affecting the entity except those that result from revenues or investments by owners." CON 6 ¶ 78 states that "revenues are in flows or other enhancements of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods , rendering services, or other activities that constitute the entity's ongoing major or central operations." Since the adjustment in price was not attributable to additional services provided b y
AOL or achieved milestones previously set in an agreement, as provided for in E1TF 00-8, the reduction in price has no correlation to performance. Thus, AOL and AOL Time Warner violated GAAP and overstated advertising revenue by at least $20.5 million for the quarter ended
December 31, 2000 and $7 million for the quarter ended March 31, 2001 .
7. Converting Contract Termination Fees into Advertising Revenu e
218. Another category of false reporting of advertising revenue involved th e renegotiation of certain long-term advertising contracts . This situation arose in cases where companies, especially internet companies, with long-term advertising agreements with AOL and
AOL Time Warner were facing financial difficulties and were at risk of not ful filling their contracts. Rather than taking these companies to court to enforce the contracts and risk attracting negative attention to the health of AOL's advertising business, AOL renegotiated the deals and required the companies to pay a fee for shortening the deal . AOL then improperly treated that fee--a renegotiation or termination fee-as advertising revenue.
48184 90 219. A former AOL Chief Technology Officer, Product and Senior Business Manager
confirmed that when a dot-corn company could no longer meet the terms of its contract ,
Defendant Colbum and others would put pressure on it to pay up and then restructure the deals.
220. According to a former Account Services Manager in the Interactive Marketin g
Division of AOL, approximately 60% of the dot-corn contracts that person was responsible for
were renegotiated in the aforementioned manner. According to this source, the contracts with
dot-com companies were renegotiated because the customers determined at some point durin g
the contract period that they would not be able to make payments to AOL. Account services
managers at AOL called customers who wanted to cancel their contracts customer "kills." If a
customer contacted an account services manager or sales representative, the customer file wa s
pulled and forwarded to Business Affairs, which would then establish new terms for the
customer in order to prevent a default on the contract .
221 . According to a July 18, 2002 Washington Post article:
In some instances, AOL said in its written response to the Post, it would renegotiate a struggling dotcoms ad deal to shorten the term of the contract . The dot.com would pay AOL a fee for breaking the deal early, and that fee would be incorporated into the new, shorter-term ad deal, effectively creating a balloon payment. AOL would count all of the revenue, including the fee for renegotiating a shorter-term deal, as ad revenue .
From July 2000 through March 2001, AOL said, it booked $56 million dollars from dot-corn deals that were terminated or restructured, about 3% of its $2 .1 billion dollars in overall ad and commerce revenue during that time . In each quarterly earnings report during the period, the terminated and restructured deals range from 1 .5 to 4.4% of AOL's advertising and commerce revenue.
(Emphasis added.)
49194 91 Dr.Koop.com
222. An example of a termination fee improperly recorded as advertising revenue by
AOL is the $9.625 million termination fee paid by Dr.Koop.com ("Dr.Koop") when it cancelled
its contract with AOL . Dr.Koop entered into an $89 million four-year deal with AOL in July
1999. In April 2000 the deal failed, and according to Dr.Koop's 2000 SEC Form 10-K, the
original agreement between Dr.Koop and AOL was amended. In exchange for 3 .5 million shares
of Dr.Koop common stock, Dr.Koop was, in turn, relieved of any further cash payment
obligations to AOL and all existing warrants (vested and unvested) were cancelled . AOL and
Dr.Koop agreed to reduce carriage on AOL for a twelve-month period subject to the terms of the
amended agreement. The value of the shares given to AOL to terminate the deal was placed at
approximately $9.6 million.
223; AOL and AOL Time Warner violated GAAP by improperly recording the fees received to sho rten or terminate these contracts, including the Dr .Koop deal, as advertising revenue from ongoing operations, rather than gains. More specifically, CON 6182, requires that income resulting from peripheral or incidental transactions be treated as a gain rather than revenue because it does not arise from the central operations of the company. AOL and AOL
Time Warner also violated CON 5, which requires that revenue be earned through major ongoing operations, and CON 2, which requires representational faithfulness. The termination or renegotiation fees did not result from the central operations of the Company. Consequently,
AOL and AOL Time Warner overstated adver tising revenue by at least $9.6 million by failing to properly treat contract cancellation fees as gains. The improperly reported Dr.Koop advertising revenue was reported for the quarter ended June 30, 2000.
49194 92 8. "Cross-Platform" Deals to Inflate AdvertlsinlZ Revenue
224. Time Warner clients soon learned that the "cross-promotions" and "synergies "
once touted as an inherent benefit of the Merger resulted in new deals with Time Warne r
divisions that now required the purchase by the customer of adver tising from the AOL division
as well . After the Merger of AOL and Time Warner, the two companies used their combined
strength to increase AOL's online advertising revenue by pressuring Time Warner clients to
convert purchases of, inter alia, cable programming into purchases of online advertising. And, in
at least one instance, the same advertising revenue was booked at more than one division .
225. In advertising deals involving so-called cross-platforms (including on-air, onlin e
and print media, or any combination thereof) the various elements must be recorded based on th e
relative fair value of each (as determined by "vendor specific objective evidence") . Though
AOL Time Warner 's cross-platform promotion/advertising transactions were not software sales,
accounting literature relative to SOP 97-2 entitled "Software Revenue Recognition" most closel y
and reasonably provides accounting standards for such multiple -element deals. In December
1998, the AICPA issued SOP 98-9, "Modification of SOP 97 -2, Software Revenue Recognition,
with Respect to Certain Transactions." SOP 98-9 clarifies certain provisions of SOP 97-2, and
effectively deferred the required adoption of those provisions until the fiscal year beginning
January 1, 2000.
226. SOP 97-2, 110 states:
"If an arrangement includes multiple elements, the fee should be allocated to the various elements based on vendor-specific objective evidence of fair value, regardless of any separate prices stated within the contract for each element . Vendor-specific objective evidence of fair value is limited to the following :
• The price charged when the same element is sold separately,
48184 93 • For an element not yet being sold separately, the price established by management having the relevant authority; it must be probable that the price, once established, will not change before the separate introduction of the element into the marketplace .
227. In cases where AOL Time Warner attributed revenue from cross-platform deals to
the AOL division, that revenue must be calculated in accordance with SOP 97-2 . "Vendor
specific objective evidence" for advertising must be cash or cash received historically in a
similar transaction (as defined in ETTF 99-17, ¶ 4-6) and even then, it must be further compared
with the relative fair values of the other elements bundled in the transaction, rather than th e
stated prices within the contract for each element .
228 . In those instances where the online advertising is not even desired, but added as a
required term of the deal, the relative fair market value of such online services would be very
low. At a minimum, the added online advertising would be a sales incentive for the actual
desired services, and would not constitute earned revenue .
(i) The Golf Channel
229. In June 2001, the Golf Channel agreed to pay AOL Time Warner $200 million for
advertising over five years in order to have its programming shown on Time Warner Cable .
After hearing about this deal, the AOL division weighed in and asked for a piece of the deal .
According to the July 18, 2002 Washington Post article, Time Warner cable successfully pressured the Golf Channel into spending about $15 million of the $200 million on online
advertising with AOL. This amount helped the online division to report increased advertising revenue for the quarter ended September 30, 2001 . According to The Washington Post, AOL
sources acknowledged that the Golf Channel had "few options" : "We told them where and
when" the ads ran . . . "They didn't have a choice-" The $15 million transferred from the $20 0
48184 94 million cable deal was not legitimate AOL advertising revenue under SOP 97 2, 110, because there was no relative fair value in the AOL advertising for the Golf Channel .
230. Ina May 18, 2001 speech at the 33rd-Rocky Mountain Securities Conference , then SEC Chief Accountant Lynn E. Turner stated, "... in order to report these types of arrangements on a gross basis, the company must receive from its customer a separatel y identifiable benefit that the company could have obtained from a third party, and there must be sufficient, competent and verifiable evidence of the fair value of the benefit received . When an - entity would not have entered into one of the separate contracts without all of the contracts bein g negotiated and agreed to as a `package,' it will often be difficult to identify a separable benefit being received and to establish reliable and verifiable fair values for each element of the arrangement. In those instances, the facts and circumstances will often dictate that the cash inflows and outflows be reported as a net revenue or cost amount, in the appropriate periods."
Because the Golf Channel would not have agreed to spend money on online advertising in the absence of the requirement that it do so as part of a larger advertising "package," AOL Time
Warner overstated AOL's advertising revenue by $15 million for the quarter ended September
30, 2001 .
{i) Oxyze Media -Carriage Deal
231 . Ina Wall Street Journal article dated October 24, 2002, concerning AOL Tim e
Warner's decision to restate its financial results for two years and reduce advertising revenue by
$190 million, it was disclosed that certain of the improper transactions involved divisions other than the AOL online unit. One of the deals identified in the article was AOL's deal with Oxygen
Media and the report of "double booking" the same revenue at more than one Company division .
According to the article :
43184 95 Oxygen's deal ca lled for Time Warner's cable systems to agree to carry the channel, and instead of paying a fee for this carriage, Oxygen spent about $100 million in advertising on AOL properties, mostly on the online service. People familiar with the situation say AOL engineered intercompany ad transactions so that the revenue was effectively reflected in the divisional numbers of both the online and cable units.
232. In the course of employing cross platform marketing to generate advertising revenue for the Company, AOL Time Warner overstated advertising revenue for its online division by including revenue from other media platforms . In addition, the Company, "double- booked" revenue received from Oxygen Media in more than one business segment, i .e., it recorded the same revenue in two sets of books beginning in the quarter ended rune 30, 200 1 through the quarter ended June 30, 2002 (the time period during which the advertising ran).
233 . In addition, like Golf Channel, Oxygen Media would not have agreed to spend th e
$100 million on advertising in the absence of the cable carriage agreement . As described above,
Oxygen's carriage deal was unusual for not including a launch fee, even though cable network s routinely pay significant launch fees to obtain favorable channel positions . Instead of paying the
Company such a fee, which could have been as much as $I00 .miiiion dollars, Oxygen Medi a purchased advertising, principally from the Company's AOL online division. To compensate
Time Warner's cable division for not receiving revenue from Oxygen Media in the form of a launch fee, the AOL online division bought advertising on Time Warner cable .
234. For AOL, the $100 million commitment represented 3.4% of ACL's advertising over the five quarters the deal ran - second quarter of 2001 through second quarter of 2002. For
Oxygen Media, the deal camejust four months after the Company had cut the number of we b
-sites it operated from more than a dozen to four. Following announcement of the deal, Oxygen
Media reduced its web presence even further, to just two sites and eventually acknowledged tha t
"Me deal was less lucrative than originally anticipated ." As reported in an August 26, 2002
48194 96 WallStreet Journal article discussing the deal, when asked whether Oxygen media would have
bought advertising if it was not seeking carriage, the company's chief operation officer stated i t
was a three-way deal and "I wouldn't separate" any of the elements. As stated above, Oxygen --
Media would-not have agreed to spend the $100 million on online advertising in the absence of
. the carriage deal being an inseparable part of the "package.' Accordingly, AOL Time Warner
overstated advertising revenue by at least $19 .8 million per quarter over the five quarter s
beginning with the quarter ended June 30, 2001 through the quarter ended June 30, 2002 .
F. The Company's Admissions of Materially Overstated Adver tising Revenue and Violations of the Securities Laws
235. Subsequent to the MSBI's filing of its initial complaint, the Company restated its
advertising and commerce revenue in the amount of $190 million for the eight consecutive
quarters ended September-30, 2000 through June-30, 2002, with the restatement reducing ACL' s
advertising revenue by $168 million. According to the Company, the remaining overstate d
amount of $22 million "represents a reduction in revenues from certain transactions related to th e
AOL segment in which the advertising was delivered by other AOL Time Warner segments."
236. According to the Company's SEC Form 8-K filed on October 23, 2002, the
restatement by quarter of AOL's advertising and commerce revenue is as follows:
QUARTER RESTATED Quarter Ended ($66 million) 9/30100 Quarter Ended ($22 million) 12131/00 Quarter Ended ($ 13 million) 3131101 Quarter Ended ($28 million) 6/30/01 Quarter Ended ($16 million) 9/30/01 Quarter Ended ($ 17 million) 12131/01 -
481" 97 Quarter Ended ($6 million) 3/31/02 Quarter Ended - 6/30/02 W-
237. In addition, at the same time the Company restated its financial results, it publicl y stated:
As a result of the restatement announced on October 23, 2002 by AOL and AOL Time Warner Inc . (the "Company"), the Company's financial statements for the affected periods should no longer be relied n including the audited financial statements for 2000 and 2001 contained in the Company's annual report on Form10-K for the year ended December 31, 2001 .
(Emphasis added.)
238 . Under GAA.P, restatement of previously issued financial statements is the most
serious step, reserved only for circumstances where no lesser remedy is available. Under APB
20, Accounting Changes, restatements are only permitted, and are required, to correct material
accounting errors or irregularities that existed at the time the financial statements were prepared .
By restating AOL and AOL Time Warner's financial statements, the Company admitted that
each document publishing the original financial statements contained untrue statements and/o r
omissions, of material fact. Similarly, by restating; the Company also conceded that each of the
press releases disseminated to the investing public and each of the annual and quarterly report s
on Form 10-K and Form 10-Q that were filed with the SEC, contained untrue statements o f
material fact, and/or failed to disclose material facts .
239. On March 28, 2003, the Company reported that it may have to restate up to
another $400 million in advertising revenue for the years 2001 and 2002, regarding transaction s
with Bertelsmann AG. The Company also reported on March 28 , 2003, that further restatement
of advertising revenue was "possible" due to the "range of other transactions" that were the
subjects of the continuing SEC and DOJ investigations.
48184 98 G. The Materially False and Misleading Statements, Omissions-of Material Fact and Devices Schemes or Artifices to Defraud Regarding Artlci Inflated Adverlis' Revenue
240. The sham transactions and improper accounting practices of the Company an d
AOL, and the Individual Defendants, which Ernst & Young permitted, caused the financial statements of AOL and the Company for various fiscal periods, the press releases related thereto , pro forma and statements of Individual Defendants, to be materially false and misleading, and to omit material facts. Such conduct, including the sham transactions, also constituted schemes, devices or artifices to defraud the public.
241 . These material misrepresentations and omissions and devices, schemes or artifices to defraud had the desired effect of manipulating stock market analysts to favorably comment on the companies and causing investors to purchase or otherwise acquire AOL, and later AOL Time
Warner, stock at artificially inflated prices.
242. During the .Class Period, AOL and AOL Time Warner reported tremendous growth in AOL advertising revenue based on phony numbers . Near the end of the Class Period, when the advertising market was so weak that the Company was forced to report decreasin g
AOL. advertising revenue, it still continued to artificially inflate the reported advertising revenue.
243. As detailed previously in this Complaint, AOL and the Company overstated AOL advertising revenue by at least $1 .7 billion during the Class Period . This artificially inflated
AOL advertising revenue was typically included as part of the companies' periodic reporting of
AOL "advertising and commerce", or AOL "advertising, commerce and other" revenue. Prior to the Merger, AOL also typically reported "advertising and commerce backlog" which represented
"the contract value of advertising and commerce agreements signed, less revenues alread y recognized from these agreements".
18184 99 a. The Fiscal Quarter Ended December 31, 1998
244. The Class Period begins on January 27, 1999, when AOL reported .arti$cially inflated advertising revenue for the quarter ended December 31, 1998. On January 27,1999, just prior to release ofAGL's quarterly results , the Dow Jones News Service reported on the high market expectations created by AOL:
America Online, Inc. (AOL) could beat the consensus estimate of 14 cents a share for its fiscal second quarter by a penny or two, but analysts said the company is unlikely to exceed projections by much more than that .
William Blair & Co. analyst Abhisbek Gami estimates AOL will post service revenue, which is revenue from the company's $21 .95-a-month subscription fee, of $765 million. He estimates the company will post "other" revenue, which includes revenue from advertising and elect ronic commerce on the service, of $163 million.
AOL reported service revenue of $483 million, and other revenue of $109 mi llion, in the year-ago quarter.
(Emphasis added.)
245. Later that day, January 27,1999, the AOL Individual Defendants caused AOL to issue a press release reporting its financial results for its fiscal quarter ended December 31, 1998, that exceeded analyst's projections of the company's advertising and commerce revenue and beat analysts' earnings predictions by 3 cents per share. As reported in BusinessWire:
America Online, Inc. (NYSEAOL) today announced results for its fiscal second quarter of 1999, ended December 31, 1998, setting new records in total revenues, advertising, commerce and other revenues, net income and membership growth.
The Company' s net income totaled $88 million, or $0.17 per diluted share, on a fully taxed basis for the 1999 second quarter, a 340% increase over last year's second quarter fully taxed net income of $20 million , or $0.04 per diluted share.
Total revenues increased by 62% over the same quarter last year to $960 million . Advertising, commerce and other revenues reached $181 million, up 66% over last year's second quarter.
48184 100 Steve Case, Chairman and Chief Executive Officer of America Online, said : 'With this quarter's record result& we continued to build excellent momentum throe out our ❑ erations and across our brands . In 1998, the Internet truly came of age and became even more integral to people's everyday lives . As the industry leader, America Online is better si tioned than ever to continue delivering strong profit growth on a consistent, predictable basis .""
Mr. Case added: "Electronic commerce is changing forever the way businesses sell and consumers buy goods and services . We're excited about the opportunities presented by our pending combination with Netscape as well as our alliance with Sun Microsystems to drive the growth of this new medium and serve new customers and markets in valuable and innovative ways." _
Bob Pittman, President and Chief Operating Officer, said : ".. . With advertising and commerce revenues more than doubling„ mainstream marketers increasingly see the superior value' of reaching cybersnace's biggest audience through our brands."
-- Advertising and Electronic Commerce Revenues : Revenues from advertising and commerce climbed to $126 million, an increase of 133% over the $54 million in last year's second quarter and 22% above the $103 million recorded duriniz th e first quarter
- Advertising and Electronic Commerce Backlog: The Company_ grew its backlog of advertising and electronic commerce revenues from $598 million on September 30, 1998 to $729 million on December 31, 1998 .
(Emphasis added.)
246. On January 27, 1999, the Dow Jones News Service reported that AOL declared a
two-for-one stock split.
247. On or about February 10, 1999, the AOL Individual Defendants caused AOL to file its SEC Form 10-Q for the company's fiscal quarter ended December 31, 1998 . The Form
Z 0-Q was signed by Defendants Case and Kelly . It contained substantially the same financial information as the January 27, 1999 press release, including $126 million in advertising and commerce revenue, an increase of 133% over the year ago quarter, and $729 million i n advertising and commerce backlog, up from $320 million in the year ago quarter. The Form 10-
48194 101 Q also stated that advertising and commerce revenue for the six month period ended December
31, 1998 was $229 million, an increase of 134% over the six month period ended December 31,-
1997. In addition, the Form I O-Q assured investors that the Company's financials were prepare
: d in accordance with GAAP
The accompanying unaudited condensed consolidated financial statements, which include the accounts of America Online, Inc . (the "Company") and its wholly and majority owned subsidiaries, have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Fonn 1 O-Q and Article 10 of Regulation S-X .
248. In fact, AOL's reported advertising and commerce revenue'for the quarter and six
months ended December 31, 1998 was overstated by at least $42 million as a result of AOL' s
improper accounting for the Sun deal, as discussed above. Further, AOL's representation to the
public in its press release and related SEC Form 14-Q filing that its advertising revenue backlog
as of December 31, 1998 was $729 million was false because, due to AOL's imprope r
accounting for the Sun deal, the actual backlog was overstated by at least $147 million, or by at
least 25%. Moreover, without this overstatement of the advertising backlog, the backlog would
have decreased from the prior quarter .
b. The Fiscal -Quarter Ended March 31, 1999
249. On February 25,1999 The Wall Street Journal reported that AOL's advertising
and commerce revenue was even more important to market analysts' views of the Company than
its earnings:
AOL be an r rtin consistent profits in 1997 and showed g -profit in evpry quarter of 1998. For its most recent full fiscal year, ended June 30, 1998, AOL reported net income of $91 .$ million, or 17 .5 cents a share adjusted fora two-for- one stock split earlier this week, on $2.6 billion in revenue. Analysts estimate AOL's fiscal 1999 earnings will amount to about 33 cents a share, according to a survey by First Call .
43184 102 But analysts say an even more pertinent indicator is AOL's revenue from advertising and electronic commerce, which totaled $126 million in the second quarter ended Dec. 31 , up from $54 million a year earlier. That revenue carries a substantially higher profit mar ' than the revenue from members' subscription fees.
(Emphasis, added .)
250. On April 27,1999, the AOL Individual Defendants caused AOL to issue a press release reporting its financial results for its fiscal quarter ended March 31, 1999. AOL announced `record" advertising and commerce revenue of $210 million for the quarter and advertising and commerce backlog of $1 .3 billion. As reported in Business Wire :
America Online, Inc. (SE:ADL) today announced results for its fiscal third quarter ended March 31, 1999, setting new records for total revenues, advertising and commerce revenues fully taxed net income before one-time events, and AOL membership growth .
Revenues reached nearly $1 .3 billion, representing a 66% increase over the combined AOL and Netscape revenues in last year's March quarter . Adverts ing, commerce and other revenues reached $275 million up 94% over last year's third quarter
Mr. Pittman added: "We have moved quickly to integrate Netscape and reorganized the Company to take advantage of new opportunities in this fastmoving environment. With virtually all companies seeking to put their businesses on the Internet, our strategic alliance with Sun will aggressively develop and market a full suite of e -commerce solutions for our partners and other customers . Both MovieFone and When.com will make the online experience of our members and other Internet consumers even more valuable to their everyday lives. We will continue to be opportunistic as our industry consolidates, taking advantage of our focus, efficiency and scale, and we are confident our business momentum will continue ."
Key operating metrics from the quarter include .. . Revenues from advertising and commerce climbed to $210 million, increasing 119% over last year's corresponding quarter .. .. The consolidated backlog of advertising and commerce revenues grew to approximately $1 .3 billion at the end of this quarter, from $804 million at the end of the last quarter.
48184 103 AOL also expanded its strategic relationship with eBay the largest online persan- to-person trading community. Through a mew $75 million. four-year agreement, eBay will have prominent presence across the Company's brands . . . . AOL will be entitled to all advertising revenues generated by these sites, and may act as the exclusive third-party advertising sales force for advertising sold on eBay's Web site.
(Emphasis added.)
251 . On April 28,1999, a Dow Jones News Service article reported that analysts were
extremely impressed by AOL's staggering reported growth in advertising revenue:
Coming off a "high quality" third quarter, America Online. Inc. LAQLJ appears to have a bright future, said Donaldson Lufkin & Jenrette Securities Corp Internet aniEst Jamie K gg en.
"They were ahead of our model on every key metric," Kiggen said during a CNBC interview Wednesday, referring to the Internet giant's fiscal third-quarter earnings results, posted late Tuesday.
America Online posted "tremendous" growth in advertising revenue, whic h - - - Kiggen said is the driving force,behind the'company's earnings model . America Online said its advertising and commerce backlog grew to about $1 .3 billion at the end of the latest third quarter from $804 million at the end of the second - quarter.
(Emphasis added.)
252. On or about May 7, 1999, the AOL Individual Defendants caused AOL to file its
SEC Form 1 O-Q for the fiscal quarter ended March 31, 1999 . The SEC Form 1 O-Q contained
substantially the same financial infvrmation as the April 24, 1999 press release, includin g
advertising and commerce revenue of $210 million, an increase of 119% from the year ago
quarter, and $1 .3 billion in advertising and commerce backlog. The Form 10-Q also reported
advertising and commerce revenue for the nine months ended March 31, 1999 as $530 millon,
an increase of 127% from the nine months ended March 31, 1998 . In addition, the Form 10-Q
assured investors that the Company's financials were prepared in accordance with GAAP:
48194 104 The accompanying unaudited condensed consolidated financial statements, which include the accounts of America Online, Inc . (the "Company") and its wholly and majority owned subsidiaries, have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.
253. In fact, AOL's reported advertising and commerce revenue for the qua rter and the nine-months'ended March 31, 1999 was overstated by at least $12.6 million and $16.8 million, respectively, as a result of AOL's improper accounting for the Sun deal , as discussed above.
Further, AOL's representation to the public in its press release andrelated SEC Form 10-Q filing that its advertising revenue backlog as of March 31, 1999 was $1 .3 billion was false because, due to AOL's improper accounting for the Sun deal, the actual backlog was overstated by at least
$134.4 million, or at least 12%.
c. The fiscal Quarter and Year Ended June 30,1999
254. On July 20, 1999, a Dow Jones News Service article, titled "America Online Seen
Beating 4Q Views By 10-2¢ a Share," reported that analysts had high expectations for the
Company's performance in the quarter, reflected in a "whisper number" two cents above th e consensus earnings estimate, and that the Company was under pressure to make the whisper number to keep share prices high:
America Online, Inc. (AOL) is expected to report earnings above the analysts' consensus earnings estimate of 11 cents a share when it releases fourth-quarter results after the markets close Wednesday.
Some analysts, while officially maintaining previous estimates, have suggested the top Internet service provider will exceed the consensus estimate . The so- called whisper number, or unofficial earnings estimate, is 13 cents a share for the quarter ended June 30 ....
The whisper numbers are significant because AOL has a history of beating analysts' estimates. Many investors expect the Dulles, Va ., company to do the same this quarter, and they could be disappointed if AOL falls short of the whisper number, even if it beats the official consensus.
48184 105 America Online exceeded Wall Street earnings expectations by 2 cents a share in the third quarter and by 3 cents a share in the second quarter, according to First Call Corp., which tracks earnings estimates .
255. On July 21, 1999, the AOL Individual Defendants caused AOL to issue a press
release announcing "record" financial results for its fiscal quarter and year ended June 30, 1999.
AOL's reported earnings of 13 cents for the quarter was equal to the "whisper" number, two
cents higher than the analysts' consensus estimate. AOL also reported $233 million of
advertising and commerce revenue for the quarter, $1 billion of advertising and commerce
revenue for the fiscal year, and $1 .5 billion in advertising and commerce backlog. As Business
)ire reported:
America Online, Inc. (NYSE: AOL) today announced results for its fiscal fourth quarter and full fiscal year ended June 30, 1999 - setting new records across the board for consolidated revenues, advertising and commerce revenues, operating income, and AOL membership growth.
Fourth quarter revenues rose to $1 .4 billion, or 46% over last year' s corn ndin period. Advertising, commerce and other revenues reached 306 million 87% over fiscal 1998's fourth arter.
Steve Case, Chairman and Chief Executive Officer, said: "Ms has been a year of tremendous owth and achievement. We added more than five million new members to our flagship AOL service , generated $1 billion in advertising and commerce revenues. and achieved record operating profits.
Key operating metrics from the quarter included : -- Advertising and Commerce Revenues: Revenues from advertisine and commerce climbed to $233 million, increasing 86% over last year' s corresponding quarter.
(Emphasis added.)
256. On July 21, 1999 a Dow Jones News Service article titled, "AOL's Strong
AdvertisingfE-Commerce Revs Boosts Results," reported that AOL's advertising and commerce revenue was its fastest growing revenue source and helped offset slowing subscriber revenue :
48184 106 A sharp increase in adver tising and electroni c-commerce revenues helped America Online Inc. (AOL~ beat analysts' earnings expectations for its fourth cru ear even as its European subscriber growth slumped.
The Dulles, Va., company reported fourth-quarter revenues of $1 .3 8 billion, up 46% from $943 million a year ago . The latest results included $233 million in advertising and c-commerce revenue, up 86% from a year ago, a sharper rate of increase than the other categories of revenue, subscriptions and enterpris e solutions.
(Emphasis added.)
257. On or about August 13, 1999, the AOL Individual Defendants caused AOL to file its SEC Form 10-K for the Company's fiscal quarter and year ended June 30, 1999 . The Form
10-K was signed by Defendants Case and Kelly . It contained substantially the same financia l information as the July 21, 1999 press release, including $1 billion in advertising, commerce and other revenue in the fiscal year, an 84% increase over the $543 million in such revenue in fiscal
1998, and $1 .5 billion in advertising, commerce and other backlog . The Form 10-K also reported $765 million in advertising and commerce revenue in fiscal 1999, an increase of 114 % over fiscal 1998 . The Form 10-K highlighted AOL's increasing dependence on advertising revenue and the reported astronomical growth in advertising and commerce backlog:
. . . An important component of the Company's business strategy in its Interactive Online Services business is an increasing reliance on advertising„ commerce and other revenues . These revenues include advertising and electronic commerce fees, the sale of merchandise, as well as other revenues. . .. The growth of advertising, commerce and other revenues is important to the Company's business objectives, as these revenues provide an important contribution to the Company's operating results. Advertising revenues are expected to grow in importance as the Company continues to leverage its large, active and g user base.... Affecting the growth in advertising, commerce and other revenues is the backlog balance as of June 30, 1999, 1998 and 1997 of $1,519 million, $511 million and $180 million, respectively. During fiscal 2000, approximately $680 million of revenue will be generated from the June 30, 1999 backlog .
(Emphasis added.)
48194 107 258. In addition, the Form 10-K assured investors that the Company's financials wer e prepared in accordance with GAAP : a- The management of America Online, Inc. is responsible for the integrity and objectivity of the financial and operating information contained in this Annual Report on Form 10-K, including the consolidated financial statements covered by the Report of Independent Auditors . These statements were prepared in conformity with generally accepted accounting principles and include amounts that are based on the best estimates and judgments of management, which it believes, are reasonable under the circumstances.
259. The Form 10-K also incorporated, with Defendant Ernst & Yonng's consent, the
July 21, 1999 report of Ernst & Young which assured investors that the financial statements wer e audited in accordance with GAAS and were in compliance with GAAP :
We conducted our audits in accordance with generally accepted auditing standards .... We believe that our audits provide a reasonable basis for our opinion.
In our [Ernst & Young] opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of America Online, Inc. at June 30,1999 and 1998, and the consolidated results of its operations and its cash flows for each of the three years in the period ended June 30,1999, in conformity with generally accepted accounting principles.
260. In fact, AOL's reported advertising and commerce revenue for the quarter and year ended June 30, 1999 was overstated by at least $28 .6 million and $45.4 mi lion, respectively.
The overstatement of $28.6 million for the quarter was due to AOL's improper accounting for the Sun ($12.6 million) and Hughes ($16 million) deals, respectively, as discussed above . The overstatement of at least $45.4 million for the year ended June 30, 1999 was also due to AOL's accounting improprieties in connection with the Sun ($29 .4 million) and Hughes ($16 million) deals, respectively, as discussed previously. Further, AOL's representation in its July 21, 1999 press release and the related SEC Form 10-K that its advertising revenue backlog as of June 30 ,
1999 was $1 .5 billion was false because the actual backlog was overstated by at least $686 .8
481" 108 million, or 84%, due to the improper accounting of the Sun ($121 .8 million) and Hughes ($565 million) deals.
d. The Fiscal Quarter Ended September 30, 1999 s-.
261 . On August 11, 1999, Dow Tones Business News reported that market analyst
Youssef Squall of Ladenburg Thalman & Co ., "expects [AOL] to post $329 million in ad and o- commerce revenue, up from $306 million in the fourth quarter ended June 30 ."
262. On October 19,1999, Dow Jones News Service reported:
Strong subscriber growth and an increase in advertisingaand electronic commerce revenue should help America Online, Inc. (AOL) beat analysts' expectations for its first fiscal quarter.
The Dulles, Va., Internet service provider is expected to report earnings of 13 cents a share for the quarter ended Sept. 30, up from 5 cents a share a year ago, according to a First Callfihomson Financial survey of analysts .. . . The unofficial estimate, or whisper number, puts America Online's first-quarter earnings at 15 cents a share ....
The report also said that securities analyst, Arthur Newman, "expects the company's revenue from advertising and e-commerce to rise to $325 million from $175 million a year ago.. . "
(Emphasis added.)
263. On October 20, 1999, the AOL Individual Defendants caused AOL to issue a press release announcing f nancial results for the quarter ended September 30, 1999, which met the "whisper" number for earnings and beat analysts' expectations for advertising and commerc e revenue. Business lire reported:
America Online, Inc. (NYSE: AOL) today announced results for the first quarter of fiscal 2000 ended September 30, 1999 -- setting new records for consolidated revenues, advertising and commerce revenues, operating income, and membership growth in the first quarter.
The Company's frilly taxed net income totaled $184 million, or $0 .15 per diluted share, up from $50 million, or $0.04 per diluted share, on the same basis in fiscal
48184 109 1999"s first quarter. Operating income for the quarter climbed 244% over the year ago quarter to $265 million.
First quarter revenues rose to $1 .5 billion, or 47% over last year's first quarter, and advertising. commerce, and other revenues reached $350 milli on, doubling over the fiscal 1999's September quarter .
Steve Case, Chairman and Chief Executive Officer of America Online, said : 'This quarter's results clearly demonstrate America Online's leadership and win power."
--- Advertising, Commerce and Other Revenues : Revenues from advertising commerce and other revenues climbed to $350 million, doubling from $175 million during the year ago quarter.
- Backlog: The Corn an brought its consolidated bacIdog of advertising and commerce revenue to over 2.0 billion at the end of the arter adding a net of more than $500 million since June 30,1999.-
(Emphasis added.)
264. Analysts commented very favorably on the company's financial results. For example, on October 21, 1999, PR Newswire reported:
"Yesterday, AOL reported Ql:O0 results ahead of consensus expectations," reported E*Ofering analyst Andrea Williams. "In our opinion, America Online continues to be the dominant force in interactive media today, with a compelling product offering a large and loyal customer base, robust advertising, and sponsorship demand. We believe that AOL remains the company best- -positioned for the long term on the Internet"
(Emphasis added.)
265. On October 28, 1999, Business Wire reported that AOL had again declared a two- for-one split of its common stock and Defendant Stephen Case, AOL's Chairman and Chief
Executive Officer, said :
"We are delighted that we are able to split our common stock for the second time this year. We are committed to making ownership of our Company accessible to the average investor, and we are very encouraged by the phenomenal growth in individual shareholder accounts in the past year. We hope that this latest split will make it possible for even more people to share in the promising growth of our Como an and our indus!ly as we enter the 21st Cen "
48194 110 (Emphasis added.)
266. On November 2,1999, the AOL Individual Defendants caused AOL to file its 0_
SEC Form 10=Q for the fiscal quarter ended September 30, 1999 . The Form 10-Q was signed by
Defendants Case and Kelly. It contained substantially the same financial information as th e
October 20,1999 press release, including advertising, commerce, and other revenue of $35 0 million, an increase of 100% from the year ago quarter, and advertising and commerce backlo g of $2 billion. It also reported advertising and commerce revenue of $272 million for the quarter.
In addition, the Form 10-Q assured investors that AOL's financials were prepared in accordance with GAAP:
The accompanying unaudited condensed consolidated financial statements, which include the accounts of America Online, Inc. (the "Company") and its wholly and majority owned subsidiaries, have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Reg lation S-X .
267. In fact, AOL's reported advertising and commerce revenue for the quarter ended
September 30, 1999 of $272 million was overstated by at least $77 .4 million, an overstatement of the actual advertising and commerce revenue by at least 40 %, as a result of AOL's improper accounting for the Sun ($12 .6 million), Hughes ($48 million) and eBay ($16 .8 million) deals, as discussed previously. Further, AOL's representation to the public in its October 20, 1999 press release and the related SEC Form 3 aQ that its advertising revenue backlog as of September 30,
1999 was $2 billion was false because the actual backlog was overstated by at least $726 million , or 57%, due to the improper accounting of the Sun ($109.2 million), Hughes ($517 million), an d
Monster.com ($100 million) deals.
49194 111 e. The Fiscal Quarter Ended December 31,1999
268. Analysts continued to be impressed with AOL's financial results and projected
exceptional growth in AOL advertising revenue, based on AOL 's reported results. For example,
on December 8, 1999, Business Wire reported:
Wit Capital Research Analyst Jordan Roban today increased estimates for America Online (NYSE : AOL). Rohan also reiterated a Buy rating on the shares of America Online, and increased his 12-18 month target price to $105 per share . In addition, Rohan indicated: "Applying the findings of the updated model, we arrived at a considerably higher (and, we think, still conservative) projection for the company's advertising and e-commerce revenues . We have increased our fiscal 2000 advertising and e-commerce revenue estimate to $1 .7 billion from $1 .6 billion. Accordingly, our total revenue estimate has increased to $6 .5 billion from $6.4 billion in 2000. Similarly, we have raised our 2001 revenue estimate to $8.2 billion from $7.8 billion based on more accelerated growth in e- commerce and advertising revenues than previously anticipated."
The analyst increased his fiscal 2000 and 2001 EPS estimates to $0 .35 and $0.53 per share, from $0.34 and $0.47, respectively.
(Emphasis added.)
269. On December 17, 1999 Merrill Lynch analyst Henry Blodget similarl y
commented favorably on AOL and, in particular, its growth in revenue from advertising :
He stated that "investors should focus on AOL's profit growth, not subscriber growth or access pricing. They should focus on how much advertising and e- commerce revenue AOL will ultimately be able to receive each month from its customers." Blodgett said that if advertisinglo-commerce increases to $20 of monthly revenues per subscriber, than AOL Stock is "under-valued." Blodget concluded that "it's reasonable to project that AOL's revenue from advertisingk- commerce will rise to $20 per customer each month in five years."
(Emphasis added.)
270. On January 10, 2000, the Individual Defendants caused AOL and Time Warner to
issue a joint press release announcing that the board of directors of both companies ba d unanimously approved a merger agreement to create a new company called AOL Time Warner.
48184 112 271 . On January 19, 2000, the AOL Individual Defendants caused AOL to issue a
press release announcing "record" financial results for the quarter ended December 31, 1999,
including record revenue of $1 .6 billion, 27% of which was advertising, commerce and other
revenue. Business Wire reported:
America Online, Inc. (NYSE: AOL) today announced results for the second quarter of fiscal 2000 ended December 31, 1999 -- setting new records for consolidated revenues, advertising and commerce revenues operating income and quarterly membership growth.
Second quarter revenues rose to $1 .6 billion, or 41 % over last year's second quarter, and advertising, commerce and other revenues reached $437 million, 79% over fiscal 1999's December quarter.
Steve Case. Chairman and Chief Executive Officer said: "This is a momentous time for America Online, as we're announcing the strongest results in our Company's history. During the quarter, we achieved record growth in revenues advertising and commerce, operating income and subscriber growth - attracting more than 2 .1 million new AOL and CompuServe members and millions more Web users to our family of brands ."
Mr. Case added : "With Time Warner, we are taking a bold step to extend our leadership as the Internet moves into its next wave of explosive growth. Our combined company will be uniquely equipped to take full advantage of the Internet's growth to create value for our shareholders, and we are committed to making the most of this opportunity."
Bob Pittman, President and Chief Operating Officer said : "Our operating performance this quarter demonstrates that we continue to build enormous value through the creation and development of powerful interactive brands that deliver unmatched benefits to consumers. While our flagship AOL service continues to set subscriber growth and advertising/commerce records in the premium mass market segment, we're also leading the value segment with CompuServe ."
- Advertising Commerce and Other Revenues : Revenues from advertising, commerce and other revenues climbed to $437 million, an increase of 79% from 244 million during the year-ago arter. -- Backlo : The Com an brought its consolidated backlog of advertising and commerce revenue to more than $2.4 billion at the end of the quarter.
48184 113 The Company also completed agreements with: Gateway, to accelerate distribution of each company's products and services including DSL access ....
The Company extended its advertising and o-commerce leadership through a series of agreements during the quarter. Ina four-year, $100-million partnership, Monster.com became the exclusive career-search resource across a range of America Online brands .
(Emphasis added.)
272. On January 20, 2000, the AOL Individual Defendants caused AOL to file with the
SEC its (parent Report on Farm 8-K dated January 19, 2000 which was signed by Defendan t
Kelly and incorporated AOL's press release ofJanuary 19, 2000 announcing AOL's financial results for the quarter ended December 31, 1999.
273. On January 20, 2000, The Wall Street Journal praised AOL's reported growth in
advertising revenue and stated that AOL executives had announced high earnings expectations for the Company following the planned Merger with Time Warner :
Analysts were impressed with AOL's performance in one closely watched area : advertising and commerce revenue. The company said that figure almost doubled to $437 million from $244 million a year earlier. Advertising and commerce fees tend to carry a higher profit margin than other areas ofAOL's business. "We knew it was going to be strong, but it was really, really strong," James Preissler, an analyst at PaineWebber Inc., said ofAOL's revenue in that category.
AOL offered bullish growth predictions for the new AOL Time Warner, saying the Companies' combined earnings before interest, taxes, depreciation and amortization could grow at a 30% annual rate .
(Emphasis added.)
274. On or about February 11, 2000, the AOL Individual Defendants caused AOL t o file with the SEC its Current Report on Form 8-K dated January 10, 2000 which was signed by
Defendant Kelly and incorporated AOL Time Warner's pro forma consolidated condensed
49184 114 financial statements for the three months ended September 30, 1999, the year ended June 30,
1999, the nine months ended September 30, 1999 and year ended December 31, 1998. The pro
forma consolidated condensed financial statements were materially false and misleading, 0 _ because they included AOL's fraudulently inflated advertising revenue reported for the respective fiscal periods as discussed herein at IN 248, 264 and 266 .
275. On or about February 14, 2000, the AOL Individual Defendants caused AOL to
file its SEC Form 10-Q for the fiscal quarter ended December 31, 1999. The Form 10-Q was
signed by Defendants Case and Kelly. It contained substantially the same financial information
as the January 19, 2000 press release, including advertising, commerce, and other revenue o f
$437 million, an increase of 79% from the year ago quarter, and an advertising and commerc e
backlog of $2.4 billion. The Form 10-Q also stated that AOL had $352 million in advertising
and commerce revenue for the quarter ended December 31, 1999, an 87% increase over the year
ago quarter, and commerce and advertising for the six month period ended December 31, 199 9
of $624 million, an increase of 94% over the six months ended December 31, 1998 . In addition,-
the Form 1 O-Q assured investors that America Online's financials were prepared in accordanc e with GAAP:
The accompanying unaudited condensed consolidated financial statements, which include the accounts of America Online, Inc. (the "Company") and its wholly and majority owned subsidiaries, have been prepared in accordance with accounting principles generally accepted in the United States for interim financia l information and with the instructions to Form 14-Q and Article 10 of Regulation S-X.
276. In fact, AOL's reported advertising and commerce revenue of $352 million fo r the quarter and $624 million for the six-months ended December 31, 1999 was overstated by at least $79.5 million, and $156.9 million, respectively, or in percentage terms, an overstatement of the actual adver tising and commerce revenue by at least 29% and 34%, respectively. AOL's
48184 115 reported advertising, commerce and other revenue was similarly overstated by $79.5 million and
$156.9 million for the three and six-month periods, respectively. The overstatement of $79.5
million during the quarter was due to AOL's improper accounting of the Sun ($12.6 million), a_
Hughes ($48 million), Monster com ($2 .1 million) and eBay ($16.8 million) deals, as discussed
above. In addition, the overstatement of at least $156 .9 million during the six-months ended
December 31, 1999 is att ributable to AOL's improper accounting for the Sun ($25 .2 million),
Hughes ($96 million), Monster .com ($2.1 million) and eBay ($33.6 million) deals, as discussed
above.
277. Further, AOL's representation to the public in its press release of January 19,
2000 and the related SEC Form 10-Q filing that its advertising revenue backlog as of Decembe r
31, 1999 was $2.4 billion was false because the actual backlog was overstated by at least $1 .2
billion, or at least an outrageous 101°/0, due to the improper accounting of the Sun ($96.6
million), Hughes ($469 million), Monster.com ($97.8 million), and Gateway ($541 .5 million)
deals.
f The Fiscal Quarter Ended March 31 .2000
278. On April 3, 2000, Dow Jones News Service again reported that ING Barings LLC
market analyst Youssef Squall, based on AOL' s prior financial results, predicted strong revenue
growth at AOL, driven by growth in the Company's advertising and commerce revenue:
America Online's subscription growth is remarkable .... But the growth story at erica Online is the way it takes advantage of its large customer : by charging other companies to advertise and conduct electronic-commerce on its proprietary network. Squali estimated that revenue from advertisinWe-commerce rose 71 % to $470 million from $275 million a year earlier .
Including sales of business software, overall revenue at America Online should rise 38% to $1 .72 billion in the third quarter from $1 .25 billion a year earlier, Squall said. America OnIine's earnings were expected to rise to 9 cents a share from 4 cents a share a year ago, excluding one-time items .
49184 116 (Emphasis added.)
279. On April 3, 2000, the AOL Individual Defendants caused AOL to file with th e
SEC its Current Report on Form 8-K dated April 3, 2000, that incorporated AOL Time warner pro forma consolidated condensed financial statements for the six months ended December 31 ,
1999, the year ended June 30, 1999, and the year ended December 31,1999 . The pro form a consolidated condensed financial statements were materially false and misleading, because the y included AOL's fraudulently inflated advertising revenue reported for the respective fiscal periods, as discussed herein at 11260, 276 and 277.
280. On April 18, 2000, the AOL Individual Defendants caused AOL to issue a press release, again announcing "record" financial results for the quarter ended March 31, 2000, an d soundly beating analyst predictions of advertising, commerce and other revenue by over $10 6 million. As reported by Business Wire:
America Online, Inc. (NYSE: AOL) today announced record results for the third quarter of fiscal 2000, ended March 31, 2000 -- reaching new highs for consolidated revenues, advertising and commerce revenues, operating income, and EBITDA .
The quarter's net income, fully taxed and excluding one-time items, totaled $271 million, or $0.11 per diluted share, up from $104 million, or $0 .04 per, diluted share, on the same basis last year. The Company reported net income of $438 million, or $0.17 per diluted share, up from $411 million, or $0 .16 per diluted share, in fiscal 1999's third quarter. Reported net income included one-time gains from the sale of investments totaling $275 million this quarter and $567 million in last year's third quarter. The year-ago quarter also includes one-time charges of $103 million . Excluding these items, operating income for the quarter climbed more than 155% over the year-ago quarter to $383 million .
Third quarter revenues rose to $1 .8 billion, or 47% over last year's March quarter . Advertising, commerce and other revenues climbed 103°/a over fiiscal 1999's third quarter to $557 million - marling a record $120 million increase, or 27% . over this year's second quarter.
48184 117 Steve Case, Chairman and Chief Executive Officer, said: 'This quarter 's results underscore the tremendous strength ofAmerica Online 's operations, and demonstrate that we are on a clearpath to continued strong growth and increased profitability. Since we announced our landmark merger with Time Warner, we haven't missed a beat"
Bob Pittman, President and Chief Operating Officer, said: "This quarter is an excellent example of how America Online is uniquely positioned in the Internet industry. We have built an unmatched collection of interactive brands, which will be further enhanced by the Time Warner merger, and we have an unparalleled connection to consumers . We're taking online advertising and commerce to new heights. yet we've barely scratched the surface in terms of the impact our medium can have."
Key operating metrics from the quarter included :
-- Backlog: The Company brought its consolidated backlog of advertising and commerce revenue to more than $2 .7 billion at the end of the quarter, up from $2.4 billion on December 31,19 9.
Working closely together in anticipation of their merger, America Online and Time Warner this quarter launched a number of cross-promotional agreements involving their world-class brands.
Extending its advertising and commerce leadership, the Company announced a series of significant advertising/commerce alliances this quarter with such market leaders as General Motors, American Airlines, Sears, Kinko's, Footlocker-corn, Oxygen Media, and PurchasePro.com.
(Emphasis added.)
281 . The press release was included in AOL's Current Report on Form 8-K dated April
18, 2000 and signed by Defendant Kelly that was filed with the SEC on April 21, 2000 .
282. On April 18, 2000, in commenting upon AOL's just released financial results,
Dow Jones News Service stated:
48184 118 Advertising and electronic-commerce activity soared in America Online, Inc.'s (AOL) third quarter, helping the company soundly beat analysts ' earnings expectations.
We saw across-the board, and across all brands, strong growth in advertising and commerce, revenue, said [Defendant) Michael Kelly, AOL's Chief Financial Officer.
283 . On April 21, 2000, a Dow Jones News Service article, titled "Tech Week in
Review", likewise reported AOL's very strong advertising and commerce revenue g rowth. It. also noted that a J.P. Morgan analyst warned investors to stay away from most internet stocks, but continued to rate AOL a top recommendation . .
Earnings reports were strong throughout the week . . . . .America Online, Inc.'s net income advanced 7% on growth in advertising and its electronic-commerce business, underlining its emergence as a media force.
I.P. Morgan Securities Inc. analyst Susan Walker White warned investors to stay away from consumer-oriented Internet stocks this summer. In a 50-page report released Friday, White lowered price targets for most of the stocks in he r coverage area.
White's too recommendations include America Online, Inc.. .. White maintained her 12-month price target of $90 million for America Online. ...
(Emphasis added.)
284. On or about May 15, 2000, the AOL Individual Defendants caused AOL to file its
SEC Form 10-Q for the fiscal quarter ended March 31 , 2400. On May 17, 2440, the AOL
Individual Defendants caused AOL to file a SEC Form 10-Q/A for the period ended March 31,
2000. Both the Form 10-Q and 14-Q/A were signed by Defendants Case and Kelly. Both the
Form 10-Q and Form 14-QIA contained substantially the same financial information as the Apri l
18, 2000 press release, including advertising, commerce and other revenue of $557 million, a
103% increase from the year ago quarter, and $2.7 billion in advertising and commerce backlog.
The Form I O-Q and Form 10-Q/A also stated that AOL had $463 million in advertising an d
48184 119 commerce revenue, a 119% increase over the year ago quarter, and $1,087 million in advertisin g and commerce revenue for the nine months ended March 31, 1999, a 104% increase over the nine months ended March 31, 1998 . In addition, both the Form 10-Q and the Form 10-Q/A assured investors that America Online' s financials were prepared in accordance with GAAP:
The accompanying unaudited condensed consolidated financial statements, which include the accounts of America Online, Inc. (the "Company' or "America Online") and its who lly and majority owned subsidiaries, have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form I 0-Q and Article 10 ofRegulation 5-X.
285. In fact, AOL's reported advertising and commerce revenue of $463 million for the quarter and $1.1 billion for the nine-months ended March 31, 2000 was overstated by at least .
$168.6 million, and $325.5 million, respectively, or on a percentage basis, an overstatement o f the actual advertising and commerce revenue by at least 57% and 43%, respectively, as a result of AOL's improper accounting. The overstatement of $168.6 million during the quarter was due to AOL's improper accounting for the Sun ($12.6 million), Hughes ($48 million), Monster.com
($6.2 million), Gateway ($ 85 million) and eBay ($16.8 million) deals, as discussed above. The overstatement of at least $325 .5 million during the nine months ended March 31, 2000 was du e to AOL's improper accounting for the Sun ($37.8 million), Hughes ($144 million), Monster.com
($8.3 million), Gateway ($85 million) and eBay ($50.4 million) deals, as discussed above .
286. Further, AOL's representation to the public in its press release dated April 18 ,
2000 and the related SEC Forms 10-Q and 10-Q/A filings that its advertising revenue backlog as of March 31, 2000 was $2 .7 billion was false. The actual backlog was overstated by at least $1 . 1 billion, or at least 73%, due to the improper accounting of the Sun ($84 million), Hughes ($42 1 million), Monster. com ($91 .5 million), Gateway ($456.6 million), DrKoop.com ($9.6 million) and Homestore.com ($79.4 million) deals.
48184 120 287. The SEC Form 14-QIA for the quarter ended March 31 , 2400 also reiterated th e advertising and commerce revenue and advertising backlog previously reported for the yea r ended June 30,1999, again overstating AOL's financial results for the period, as previously discussed herein in 1260.
288. On February 11, 2000 the Company filed the Merger Registration Statement as amended on March 24, 2000, April 25, 2000, May 18, 2000 and May 19, 2000, which containe d or incorporated by reference all items referenced in ¶¶ 648 and 652-660, including the Merger
Agreement, historical AOL financial data, pro forma consolidated financial data of AOL Time
Warner, including AOL Time Warner' s consolidated balance sheet as of March 31, 2000, and
Ernst & Young's unqualified audit reports as referenced in ¶ 657, all of which were materially false and misleading for the reasons set forth in 661-667 .
289. Unaware of the concealed adverse information discussed herein, the shareholder s of AOL and AOL Time Warner voted to approve the Merger of the two companies on June 23 ,
2000.
g. The Fiscal Quarter and Year Ended June 30, 200 0
290. On July 6, 2004, Dow Jones News Service reported that, despite the collapsing internet advertising market, AOL was expected to report another record-breaking quarter.
Many smaller Internet companies ran into cash problems during the quarter ended June 30, causing them to cut back on advertising spending . In turn, this had a domino effect on other Internet companies, in particular those that collect the bulk of their revenue by selling advertising on their Web sites .
But don't expect the cutbacks to have much of an effect on the leaders in the online advertising markeLAmerica Online Inc. GAOL) and Yahoo! Inc. (MOO). These corn anies have large and diversified rtfolios of ad customers, which absorbed the lost business from struggling "dot-corn" firms, analysts sax.
48184 121 America Online, Dulles, Va ., should report revenue from advertising and electronic-commerce of $557 million for its fourth quarter ended June 30, Newman estimated. That represents an 82% surge from the $306 million reported a year earlier. W- (Emphasis added)
291 . Two weeks later, on July 19, 2000, Dow Jones News Service reported that, based on AOL's prior financial results, expectations for AOL's advertising and commerce revenue an d earnings were very high, notwithstanding the weakness in the internet advertising market:
Buoyed by strong advertising and electronic-commerce revenue, America Online, Inc. (AOL) is expected to post fourth-quarter earnings ahead of the analysts' consensus estimate.
A First CaRrIhomson Financial survey of 30 analysts predicted that the Dulles, Va., Internet service provider would post earnings of 11 cents a share for the quarter ended June 30, up from 6 cents a share year ago . America Online, the world's largest ISP, is scheduled to report results after the market closes Thursday.
But analysts expect the company to continue its lengthy streak of beating analysts' expectations. Merrill Lynch analyst Henry Blodget, for example, says it's possible the company will post earnings of 12 cents a share. Some so-called "whisper number" estimates, which purport to be more accurate than formal estimates, put fourth-quarter net as high as 13 cents a share . In recent quarters, AOL has beaten estimates by at least a penny per share .
America Online, which plans to close its acquisition of media giant Time Warner Inc. {TWX) in the fall, had a strong quarter despite reports of softness in the online advertising, market, analysts say. The demise or near-demise of smaller Internet companies prompted many of them to slash their online advertising budgets. But top Web site operators like America Online were mostly immune to the crunch .... Squall estimated America Online's fourth-quarter revenue from advertising and e-commerce operations rose 96% from last year to $599 million. Overall revenue, which includes Internet-access subscriptions and business software sales, should come in at $1 .95 billion, up 42% from a year earlier.
(Emphasis added.)
292. On July 19, 2000, Associated Press Newswires reported that Ken Kiarash, a n analyst with Buckingham Research Group, said : "I don't think [AOL's] advertising revenue ha s
48184 122 peaked yet. The issue is how fast they will be able to grow that line, which I think i s crucial to this company's success." [Emphasis added.)
293. In July 20, 2000, the AOL Individual Defendants caused AOL to announce record financial results for the quarter ended June 30, 2000, again surpassing analysts' expectations fo r advertising, commerce and other revenue and meeting the `whisper" number for earnings per share. The Dow Jones News Service reported:
America Online, Inc.'s (AOL) fourth-quarter results beat analysts' expectations, helped by strong advertising revenue and lower network operation costs .
The Dulles, Va., Internet service provider reported earnings excluding charges of 13 cents a share for the quarter ended June 30, up from 6 cents a share a year earlier and ahead of the analysts' consensus estimate of 11 cents a share. Revenue rose to $1.93 billion from $1.38 billion a year ago.
The company's fourth-quarter revenue from advertising and electronic commerce jumped 95% from a year ago to $609 million, ahead of most analysts estimates .
The numbers showed that AOL weathered what some analysts expected would be a slump in online adver tising during the quarter.
America Online President and Chief Operator Officer Bob Pittman said the company's outlook for advertising revenue was strong. He pointed to AOL's recent deals with top advertisers like Target Corp . (TGT), Coca-Cola Co. (1(0) and Citigroup Inc. (C).
In addition, America Online's backlog of adyertising/e-commerce revenue rose to $3 billion at rune 30 from $2.7 billion at March 31 . The backlog represents the amount of revenue the company expects to receive in future quarters under the terms of contracts that have already been signed .
"We're getting more advertising dollars than anyone except the top four television networks." Pittman said during Thursday 's conference call.
Kelly said AOL and Time Warner were on pace to meet financial targets for the combined company. He said AOL Time Warner expects to post revenue of more than $40 billion in 2001, representing an annual growth rate of 12% to 15% .
*t *
48184 123 "Clearly, we are on our way to mating our financial objectives a reality," he said.
Pittman said AOL Time Warner would be an advertising behemoth. He said that only four advertisers are on both companies' respective lists of top 10O advertisers
.). (Emphasis added
294. On July 20, 2000, Dow Jones News Service reported that in an interview with
Defendant Case after AOL reported its fourth quarter earnings, Case emphasized that investors need not be concerned that the online advertising slump would lower AOL advertising revenue:
... Case said "all our-numbers were at or above consensus estimates ." AOL's earnings of 13 cents a share, excluding items, beat the consensus by 2 cents a share. Case said AOL's fourth-quarter results were helped by strong advertising and electronic-commerce revenue, a development that should reassure investors who had feared that a "dot com" shakeout would hurt the online advertising market. -
(Emphasis added.)
295. On or about September 22, 2000, the AOL Individual Defendants caused the
Company to file its SEC Form 10-K for the Company's fiscal quarter and year ended June 30,
2000. On October 30, 2000, the AOL Individual Defendants caused AOL to file a SEC Form
1 D WA for the fiscal quarter ended June 30, 2000. Both the Form 10-K and Form 10-KIA were signed by, inter alia, Defendants Case, Pittman and Kelly. Both the Forms 10-K and 10-K/A contained substantially the same financial information as the July 20, 2000 press release , including advertising, commerce, and other revenue of $609 million for the quarter, and advertising and commerce backlog of $3 billion. Both the Forms 10-K and 10-KIA also stated that AOL had $ 1.6 billion in advertising and commerce revenue in fiscal 2000, an increase of
107% over - scal 1999, as well as $1,986 million of advertising, commerce, and other revenue i n fiscal 2000.
48134 124 296. Both the Forms 10-K and 10-K/A also incorporated, with Defendant Ernst &
Young's consent, the July 20, 2000 report of Defendant Ernst & Young which assured investor s that the Company's financials were audited in accordance with GAAS and in compliance with 0-
GAA.P:
We conducted our audit in accordance with auditing standards generally accepted in the United States .... We believe that our audits provide a reasonable basis for our opinion.
In our [Ernst & Young] opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of America Online, Inc. at June 30, 2000 and 1999, and the consolidated results of its operations and its cash flows for each of the three years in the period ended June 30, 2000, in conformity with accounting principles generally accepted in the United States .
297. In fact, AOL's reported advertising and commerce revenue of $513 million for
the quarter and $1 .6 billion for the year ended June 30, 2000 was overstated by at least $166 .7 million, and $492.2 million, respectively, or in percentage terms, an overstatement of the actual
advertising and commerce revenue by at least 48% and 94%, respectively, as a result of AOL's
improper accounting . Likewise, AOL's advertising, commerce, and other revenue-for the quarter
and year ended June 30, 2000 of $609 million and $1 .986 billion, respectively, was overstated by
at least 38% and 33%, respectively. The overstatement of at least $166 .7 million for the quarter
was due to AOL's improper accounting of the Sun ($12 .6 million), Hughes ($32 million),
Gateway ($85 million), Homestore ($4.4 million), DrKoop.com ($9.6 million), Monster.com
($6.2 million) and eBay ($16.8 million) deals, as discussed above. The overstatement of at least
$492.2 million for the year ended June 30, 2000 was similarly due to AOL's improper
accounting of the Sun ($50 .4 million), Hughes ($176 million), Gateway ($170 million),
Homestore ($4.4 million), DrKoop .com ($9.6 million) Monster.com ($14.6 million) and eBay
($67.2 million) deals, as discussed above.
48194 125 298. Further, AOL's representation in its July 20, 2000 press release and its related
SEC Form 10-K and Form 10-K/A filings that its advertising revenue backlog as of June 30,
2000 was $3 billion was false because the actual backlog was overstated by at least $1 billion, or --
52%, due to the improper accounting of the Sun ($71 .4 million), Hughes ($389 million),
Monster.com ($85.3 million), Homestore.com ($75 million), Gateway ($371 .7 million),
Ticketmaster ($13 million) and 24dog s.com ($23.7 million) deals, as discussed previously.
299. Both the Form 10-K and 10-KIA incorporated by reference the Merger
Agreement between AOL and Time Warner, which contains false representation and warranties by AOL, as discussed herein at % 667
300. Both the Form 10-K and 10-KIA for the fiscal quarter and year ended June 30,
2000 also stated that the advertising, commerce and other revenue for the quarter ended Marc h
31, 2000 was $11 million more than originally reported due to a merger, again overstating
AOL's advertising, commeice and other revenue for the quarter ended March 31, 2000, a s discussed previously in 71285-286 .
h. The Fiscal Quarter Ended September 30, 200 0
301 . The Washington Post reported in an article of July 18, 2002, titled
"Unconventional Transactions boosted Sales," that by at least August 2000, AOL executives , including Defendant Colburn, knew that various advertising customers of the Company were experiencing financial problems that jeopardized existing AOL advertising agreements .
Sometime in September 2000, i nternal AOL documents showed that AOL was "at risk" to lose more than $108 million in advertising revenue for the 2001 fiscal year (July 2000-2001) due to the many failing dot- com companies. This estimate quickly increased within the Company.
Indeed, at the beginning of October 2000, Bob O'Connor, then AOL's Vice President of Finance
49384 126 for its advertising division , warned Defendant Pittman and several other Company executives that AOL was at risk of losing $140 million in advertising revenue in the 2001 calendar year because many internet companies which had advertising contracts with AOL were failing. the --
Washington Post article also reported that AOL considered suing the fai ling dot-com companies,
but chose not to do so "because the public filings would show some weakness in its business."
302. On October 18, 2000, the Dow Jones News Service reported that analysts were
concerned about the potential impact of the internet advertising slump on AOL's advertising
revenue, the Company's fastest growing and most profitable revenue source :
America Online, Inc. (AOL) is expected to meet, and possibly beat, analysts' earnings estimates when it reports first-quarter results Wednesday.
The Dulles, Va., Internet service provider, should post earnings of 13 cents a share, excluding special items, for the quarter ended Sept . 30, according to a First Calllxhomson Financial survey of 28 analysts....
AOL usually beats the analysts' consensus estimate by a penny or two a share . Some analysts, however, appear a little less certain that the results in the latest first quarter will beat estimates as soundly as in previous quarters .
Merrill Lynch analyst Henry Blodget said in a research note Tuesday that it's possible AOL would beat the consensus by a penny, but "it's not expected." ING Barings analyst Youssef Squall said "there's a good chance" AOL will beat the mean estimate. J.P. Morgan analyst Susan Walker White sees "slight upside."
Advertisingle-commerce is the segment that has generated nervousness among investors. While it represents a minority ofAOL's overall revenue, it is the company's fastest-growing, and most profitable, segment. In recent weeks, concerns about a slowdown in online advertising spending have hit Web portals such as Yahoo ! Inc. (YHOO). The concerns fnally caught up to AOL Tuesday, with its shares falling 17% .
(Emphasis added.)
303. However, once again, AOL's reported numbers beat analysts' estimates by a
penny a share. On October 18, 2000, the AOL Individual Defendants caused AOL to issue a
press release announcing "Record-Breaking Results for FY2401 First Quarter . . . Advertising,
48184 127 Commerce and Other Revenues Jump 80% to $649 Million ." These financial results were for the last publicly reported fiscal period prior to the consummation of the Merger . As the press release reported :
America Online, Inc. (NYSE: AOL) today reported results for its fiscal first quarter ended September 30, 2000 - reaching new highs for consolidated -revenues, advertising, commerce and other revenues , operating incom. EBITDA and first-quarter AOL membership growth.
The quarter's net income, fully taxed and excluding one-time items, totaled $350 million, or $0.14 per diluted share, up from $182 million, or $0 .07 per diluted share, on the same basis last year the Company reported net income of $345 million, or $0.13 per diluted share, up from $181 million, or $0 .07 per diluted share, in fiscal 2000's first quarter. Reported net income included onetime merger-related charges of $6 million . Excluding these items, operating income for the quarter climbed more than 86% over the year-ago quarter to $484 million.
The quarter's consolidated revenues climbed 34% to $2 .0 billion from $1.5 billion in last year's first quarter. Advertising, commerce and other revenues reached a record $649 million climbing 80% over fiscal 2000's corresponding quarter.
Mr. Pittman added: "Our distinctive strategy of focusing on large strategic marketing agreements with major mainstream companies is paving off in the continuing stren of our advertising and commerce revenues, which will substantially benefit from the merger. Our advertising and commerce growth prospects are underscored when you look at the top 100 advertisers each for Time Inc., Turner Networks and AOL, and find that only four out of the 300 are d licated on all three lists.
Other operating highlights from the quarter include: Revenues from subscriptions increased to $1 .2 billion, a 21 % rise over the fiscal 2000 first quarter, advertising commerce and other revenues climbed to $649 million, increasing more than 80% over last year's co ndin a rter and the consolidated backlog o advertising and commerce revenues grew to more than $3 .0 billion at September 30, 2000, from $2.0 billion a year earlier.
(Emphasis added .)
304. In a conference call with analysts on October 18, 2000 following the release o f the quarterly results, then AOL President, Defendant Pittman, responded to a question regarding
481S4 128 whether AOL was feeling the effects of an industry-wide slowdown in advertising as follows: "I don't see it and I don't buy it" (Emphasis added.) In the same telephone conference, Defendant
Stephen Case, AOL's Chairman and Chief Execu tive Officer at the time, said "AOL's advertising growth is right on target.. . The current advertising environment benefits us because it will drive a flight to quality." (Emphasis added..) Defendant Michael Kelly, then AGL's Chief
Financial Officer, similarly characterized AOL's advertising and commerce revenue growth as
"very healthy" and emphasized, "1 can't save that strongly enough." Kelly reiterated his prior predictions that AOL Time Warner's revenue will rise 12% to 15% annually and the merged company's EBITDA would rise 30% in the Company's first year. (Emphasis added.)
305. The market responded very favorably to the midday financial statements released by AOL on October 18, 2000, and the stock rose over 7% to $46.91 per share at the close of the market on October 18, 2000, up from a price of $43 .60 per share at the close of the market on
October 17, 2000.
306. In an October 19, 2000 research note, Mary Meeker, an analyst at Morgan Stanley , commented on ACL's advertising revenue : "This has developed quickly into AOL' s fastest growing revenue stream and a key element of growth going forward ." At about the same time,
Christopher Dixon, a PaineWebber Inc . analyst, wrote that AOL's strong advertising and commerce revenue "should alleviate some concerns about the health of the Internet advertising environment."
307. On October 19, 2040, ING Barings LLC analyst, Youssef H. Squall, reiterated his
"strong buy" rating noting the Company's "[s]olid advertising revenues .. . ."
308. On October 23, 2000, The Wall Street Journal reported that "[i]nitially, AOL shareholders wondered if the link [with Time Warner]would weigh down the company's risin g
48194 129 stock. Now, a solid affiliation with a traditional company seems a good bet for the future . Of course, AOL is also greatly helped by its reliable earnings and its sustained domination of online access." (Emphasis added.)
309. On or about November 2, 2000, the AOL Individual Defendants caused AOL to issue its 1999 Annual Report for the fiscal year ended June 30, 1999, in which Defendants Cas e and Pittmanf touted AOL's remarkable advertising revenue growth:
In short, we are pleased to say that America Online has never been stronger. Our fiscal 1999 highlights include .... Advertising, commerce and other revenues climbed 84% to $1 billion, with a backlog of committed revenue of $1.5 billion.
During fiscal 1999, we signed 58 multi-year advertising and commerce agreements, each worth in excess of $1 million.
The 1999 Annual Report also appended AOL's SEC Form I O-K for the fiscal quarter and yea r ended June 3% 1999 filed August 13, 1999. For the reasons discussed previously in 1250, the
Form I0-K and related statements regarding AOL's advertising revenue for the quarter and year ended June 30, 1999 were materially false and misleading.
310. On November 9,20-00, the AOL Individual Defendants caused AOL to file its
SEC Form 10-Q for the fiscal quarter ended September 30, 2000. The Form 10-Q was signed by
Defendants Case and Kelly. It contained substantially the same financial information as th e
October 18, 2000 press release, including $649 million in advertising, commerce and other revenue, an 80% increase over the year ago quarter, and a $3 billion advertising and commerce backlog. The Form I O-Q also stated that AOL had $534 million in advertising and commerce revenue, a 95% increase over the year ago quarter . In addition, the Form 10-Q assured investors that AOL's financials were prepared in accordance with GAAP :
The accompanying unaudited condensed consolidated financial statements, which include the accounts of America Online, Inc . (the "Company") and its wholly
48184 130 owned subsidiaries, have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S X.
311 . In fact, AOL's reported advertising and commerce revenue for the quarter ended '-
September 30, 2000 of $534 million was overstated by $156 million, an overstatement of the actual advertising and commerce revenue by at least 41 %, as a result of AOL's improper accounting for the Sun ($12 .6 million), Gateway ($85 million), 24dogs.com ($16.2 million),
Homestore ($6.6 million), Monster.com ($6.2 million), Ticketmaster ($13 million) and eBay
($16.8 million) deals, as, discussed above. For the same reasons , AOL's reporting of advertising, commerce and other revenue was likewise overstated by $156 million for the quarter. The
Company has already admitted overstatement of $66 mil lion of AOL advertising and commerce revenue for the quarter ended September 30, 2000, based on its restatement of the quarter's resul t in the SEC Form 8-K filed October 23, 2002 .
312. Further, AOL's October 18, 2000 press release and related SEC Form 10-Q filing stating that its advertising revenue backlog as of September 30, 2000 was $3 billion was false because the actual backlog was overstated by at least $1 billion, or by at least 51%, due to the improper accounting of the Sun ($58.8 million), Hughes ($389 million), Homestore.com ($68.4),
Gateway ($286 .8 million), 24dogs .com ($7.5 million), Veritas ($20 million), Telefonica SA ($15 million), PurchasePro ($41.4 million) and WorldCom ($48.9 million) deals.
313. The statements made by Defendants Case, Pittman and Kelly to market analysts on the conference call of October 18, 2000, as reproduced above, are also false and misleading for the same reasons, and were particularly egregious in light ofthe internal AOL informatio n showing that $140 million of AOL advertising revenue was "at risk" for the following calendar year.
48194 131 314. On October 30, 2000 the AOL Individual Defendants caused the Company to fil e a SEC Form 10-KIA for the quarter and fiscal year ended June 30, 2000 in which the Company reiterated the advertising and commerce revenue and advertising and commerce backlog a-- previously reported for the quarter and year ended June 30, 2000, again overstating AOL' s financial results for the period, as previously discussed in IN 296-297, herein.
The Fiscal Quarter and Year Ended December 31, 2000
315. On January 11, 2001, the Individual Defendants caused the Company to issue a press release announcing that the Merger between AOL and Time Warner bad been complete d that day, creating AOL Time Warner.
316. One day alter the Merger was consummated, on January 12, 2001, The Wall
Street Journal reported that despite the weakening advertising market, AOL Time Warner wa s standing by its revenue targets for the merged company and that advertising and e-commerc e would remain the fastest growing revenue source for the Company:
Mike Kelly, AOL's chief financial officer and holder of the same title at the new company, said yesterday that executives are sticking by their targets„ which call for revenue to g row by 12% to 15% to total more that $40 billion in 2001, and for earnings before interest, taxes, deprecia tion and amortization to rise about 30% to $1 I billion. He added that the new AOL Time Warnerhad alwa Tanned to aggressively look for cost savings and ways to generate extra revenue .
Analysts' concerns intensified last month after Time Warner warned that its fourth-quarter earnings would be hurt by weaker ad revenue . . . . At the AOL said its fourth-quarter advertising and online commerce revenues were "on -track" to meet Wall S treet expectations.
Mr. Kelly said yesterday he s till expected advertising and e-commerce "would be our fastest- owin revenue corn anent."
(Emphasis added.)
317. On January 12, 2001, the Individual Defendants caused the Company to file an
SEC Form 8-K dated January 11, 2001 and signed by Defendant Cappuccio that incorporated th e
48184 132 Merger Agreement between AOL and Time Warner, which contains false representations and
warranties by AOL as discussed herein at 1667.
318. On January 13, 2001, The Los Angeles dimes reported that AOL Co-Chief *-
Operating Officer, Defendant Pittman, indicated that softness in the advertising market woul d
not hurt AOL's advertising revenue . As The Los Angels Times quoted Defendant Pittman:
"In the advertising world, you hear people say there's a slowdown . But it's not across the board . When [buyers] cut back, they don't cut back on their primary ad buys, which provide a big reach. Turner Networks, WB and the Time magazine group all fit into that category.... Also, if you do have a slowdown in traditional media and there's open inventory on our existing media properties, we're a major advertiser ourselves. We're No. 7 in the country in advertising-sales. We have the -ability to.take our own ads and put them on our own properties, so we can fill. up the slack there."
(Emphasis added.)
319. On January 26, 2001, the Individual Defendants caused the Company to file an
SEC Form 8-K/A dated January 11, 2001 . The Form 8-K/A was signed by Defendant Kelly and
James Barge and incorporated the AOL Time Warner consolidated balance sheet as of
September 30, 2000 and AOL Time Warner's pro forma consolidated condensed financial-
statements for the three months ended September 30, 2000, year ended June 30, 2000 and yea r
ended December 31, 1999, which were materially misleading because they incorporated th e
fraudulently inflated AOL advertising revenue for the respective fiscal periods, as discusse d
herein at 11 276-277, 297-298 and 311-312 .
320. Similarly, on January 26, 2001, the Individual Defendants caused the Company to
file its SEC Form 8-K/A amending its SEC Form 8-K dated January 18, 2001 that updated the
financial results for the quarter ended September 30, 2000 and reiterated the advertising an d
commerce revenue and advertising and commerce backlog previously reported for the quarter ,
again overstating AOL's financial results for the period, as discussed herein in 11311-312.
48194 133 321 . On January 31, 2001, the Individual Defendants caused the Company to report th e first financial results since the Merger was constrnmated, including "all-time records" in AO L advertising revenue. The press release stated :
AOL Time Warner Inc . (NYSE: AOL) today reported record December quarter results for America Online, Inc. and pro forma results for the combined Company's December quarter and fu ll year. In addition, the Company released the results for Time Warner Inc.'s December quarter and full year.
As a result of the ACL Time Warner merger, the Company is reporting the results of America Online, Int.'s December quarter and AOL Time Warner's pro forma quarter and full year ended December 31, 2000.
In the December quarter, America Online reported all-time records in-revenues, advertising, commerce and other revenues a tin income EBITDA and AOL membership growth.
The Company's net income, fully taxed and excluding one-time events, climbed 67% to a record $365 million, or $0.15 per diluted share, up from $219 million, or $0.09 per diluted share, on the same basis last year. Including non-cash charges of $535 million related to write-downs of various investments, the Company's reported net income was $37 million, or $0 .01 per diluted share. On the same basis in the year-ago quarter, reported net income was $280 million, or $0 .11 per diluted share.
America Online's December quarter revenues climbed 27% to nearly $2 .1 billion from $1 .6 billion in the year-ago quarter. Advertising, commerce and other revenues reached a record $741 million, climbing 65% - over last year's corresponding quarter.
Further, AOL operating highlights from the quarter include :
Advertising & Commerce Revenues: Revenues from advertising and commerce climbed to $686 million, increasing 71 % over last year's corresponding quarter. . . .
AOL Time Warner Pro Forma Results:
Driven by strong performances at America Online, Cable, Publishing and Networks, AOL Time Warner' s pro forma 2000 revenues rose 11 % to $36.2 billion, and adjusted EBITDA increased 19% to $8.4 billion. That compares to 1999's $32.5 billion in revenues and $7.0 billion in adjusted EBITDA. AOL
48184 134 Time Warner's 2000 adjusted diluted cash earnings per common share climbed 32% to $0.94, compared to $0 .71 in 1999. The Company's subscription revenues increased 13% to $14.7 billion, and the Company finished the year with 130 million subscriptions, an increase of 16% over the prior year. Fa- advertising and commerce revenues increased 24% to more than $8.7 billion.
For the December quarter, AOL Time Warner's revenues rose 8% to $10 .2 billion, and adjusted EBITDA increased 14% to $2.4 billion. That compares to $9.5 billion in revenues and $2.1 billion in adjusted EBITT]A in last year's corresponding quarter. Subscription revenues increased 11% to $3 .8 billion, compared to $3.5 billion in 1999's December quarter, and advertising and commerce revenues increased-1414%% to $2.6 billions compared to the year-ago quarter's $2.3 billion. AOL Time Warner's December quarter adjusted diluted ,cash earnings per common share climbed 17% to $0.28, compared to $0 .24 in 1999.
(Emphasis added.)
322. On January 31, 2001, Dow Jones News Service reported that AOL Time Warner' s
first reported financial results included strong AOL advertising and commerce revenue, despit e
the depressed online advertising market :
AOL's revenue from advertising and electronic-commerce was strong-rising 55% to $741 million exceeding the expecta tions of many analysts. The performance showed that AOL was more than able to weather an overall soft market for online advertising.
"AOL's online advertising and commerce platform is alive and well ," said Wit Soundview analyst Jordan Rohan . "The unit 's 741'million in revenue implies that despite being more than twice the size of Yahoo, AOL is U~tw g more quickly, and gaining market share."
. . . AOL Time Warner Co-Chief Operating Officer Bob Pittman said the corn an can prosper even in a soft ad market and a broader economic slowdown .
(Emphasis added.)
323. On January 31, 2001, Dow Jones Business News reported that the strong revenue growth for the merged Company's first quarter was boosted by a remarkable increase in advertising, commerce and other revenue :
48184 135 Pro-forma revenue rose 8.1 % to $10.23 billion. AOL Time Warner attributed the increase to strong performances from its America Online cable, publishing and networks businesses.
"We are seeing exciting momentum in our subscription and advertisingJcommerce businesses across the company, " Bob Pittman, co-chief operating officer, said in a prepared statement.
AOL's revenue rose 27% to $2.06 billion, boosted in part by a 65% jump in revenue from advertisin% commerce and related ac tivities.
(Emphasis added.)
324. On January 31, 2001, Dow Jones News Service reported:
AOL Time Warner Inc. (AOL) Chief Financial Officer J. Michael Kelly reiterated the Company's ambitious 2001 owth targets Wednes d
In a meeting with analysts here after reporting fourth-quarter results, Kelly said the newly merged Internet and media company expects 2001 revenue of $40 billion, compared with pro forma revenue of $36.2 billion in 2000. It also expects earnings before interest, taxes, depreciation and amortization, or EBITDA, to rise about 30% to $11 billion from $8.4 billion in 2000. "Me guidance that we gave over a year ago remains unchanged," Kelly said .
Some analysts have questioned whether AOL Time Warner can meet such ambitious targets, particularly in light of Time Warner's weaker-than expected fourth quarter. Indeed, AOL Time Warner's fourth-quarter pro forma EBTTDA rose just 14% from a year earlier, less than half the targeted 2001 growth rate .
Kelly reiterated the company's overall revenue growth tar et of 12% to 15%.
"Look at the results that are out there " said AOL Time Warner Chief Executive Jerry Levin. "Look at the financial disci line in this c "man ."
In another sign of the company's optimism, Chairman Steve Case said he's focused on two numbers the company hopes to achieve someday: a market capitalization of $1 trillion and $100 billion in annual revenue.
(Emphasis added.)
48184 136 325. On January 31, 2001, Business Wire reported that Defendant Kelly, AOL Time -
Warner's Chief Financial Officer, said:
"Strong wth in subscription and advertising revenues will drive the Company's . performance. with the benefit of multiple revenue streams from a diverse array of world class brands and customer relationships. AOL Time Warner has all the financial strength necessary to back our vision for the future."
326. On February 1, 2001, The Los Angeles mimes reported that AOL Time Warner
again told investors they shouldn't worry about the newly merged company meeting its financial
targets because advertising revenue growth at AOL would continue to boost the Company's total revenues, despite the slowing advertising market:
AOL Time Warner tried to reassure Wall Street on Wednesday that the newly merged company-fueled largely by its fast-mowing America Online unit - remains on track to meet its financial targets, despite a slowing economy and softening advertising market.
The article continued:
They are in good control of the underlying operations and seem to have the integration process in hand,' said CIBC World Markets analyst John Corcoran. "I have more confidence in their ability to make their numbers .' Corcoran said he was particularly impressed by AOL's subscription base, which gained another 2 .1 million members in the fourth quarter to reach 26 .7 million worldwide, and by the online company's strong advertising and c-commerce revenue, which surged-65% over last year's fourth quarter. `Even though the outside environment is slowing down, AOL continues to do well ,' Corcoran said. `It's the engine that drives all the other parts of this business .'
According to Gerald Levin, chief executive at AOL Time Warner, `We are paying a lot of attention to top-line revenue growth.'
To help calm investor worries about the advertising slowdown, the company noted that it was already reaping the benefits of its larger size . It announced marketing deals with Nortel Network Corp., Cendant Corp., Compaq Computer Corp. and Purchase Pro, a business-to-business e-commerce company .
(Emphasis added.)
48154 137 327. On February 13, 2001, Dow Jones News Service reported that AOL Time Warner
again emphasized the AOL unit's advertising and commerce revenue to assure investors that the
merged Company's revenue growth would remain strong : a-
M ichael Kelly said the AOL side of the business would be the "catalyst for change across the whole company."
AOL Time Warner expects the fastest-growing; segment of its business to be advertisin ,and commerce revenue. Revenue in this area rose 29% last year, on a pro forma basis, with the AOL side posting the sharpest rowth. For 2001, AOL Time Warner expects advertising/commerce revenue to rise 18% to 22%.
(Emphasis added.)
328. On March 8, 2001, Dow Jones News Service reported that individual Defendants boasted that the increasing weakness in the adve rtising market would not affect AOL Time
Warner's advertising business:
Despite increasing signs of a weak advertising market, AOL Time Warner Inc. (AOL) Chief Operating Officer Bob Pittman reaffirmed the company's ambitious financial targets for 2001 .
Speaking at the Merrill Lynch Internet Conference in New York today, Pittman put it bluntly "our businesses are doing great."
While acknowledging that the overall advertising market has weakened, he said AOL Time Warner remains strong because its numerous properties make it a must-buy for advertisers.
"I want to assure you we gave The Street our guidance in January and we are sticking to it. Peri "he said.
Pittman said, "fin addition, the soft economy has sparked a "flight to ali ' among advertisers, who are shifting their spending to AOL Time Warner from its competitors."
(Emphasis added.)
329. On March 8, 2001, Lehman Brothers, Inc., issued an analyst report on AOL Time
Warner in which it rated the Company's common stock a "Buy." In making the recommendation,
48184 138 the analyst report relied heavily on the reported strength of the "AOL division's advertising business 23
330. On March 14, 2001, Merrill Lynch analyst Henry Blodgett similarly issued a favorable report on AOL's advertising business:
For Q2, we did not change any estimates, and in fact believe AOL will have a solid quarter, possibly even ahead of our estimates (which would be remarkable in this environment). We note that despite the disastrous state of the online ad market with blowups from Yahoo!, CNET, and other ad supported companies, we still expect AOL to increase adcom revenue slightly sequentiall y AOL is the least exposed to the weakness in advertising demand, and continues to sign large cross platform advertising deals with traditional advertisers .
(Emphasis added.)
331 . On March 27, 2001, the Individual Defendants caused AOL Time Warner to issue
its 2000 Annual Report in which Defendant Case and Levin touted AOL's phenomena l
advertising revenue growth :
The ability to monetize the fundamental building blocks of value that we possess is rooted in multiple revenue streams from subscriptions, advertising and commerce. and content. . . .Continuing to capitalize on its status as the premier Internet brand, America Online extended its industry leading position in advertising and commerce, growing its base by a remarkable 91% last year .
(Emphasis added.)
The Annual Report continued:
Advertising and commerce revenues increased by 91° o from $1 .240 million during the year ended December 31, 1999 to $2,369 million during the year ended December 31, 2000. This increase was primarily attributable to additional advertising and electronic commerce on America Dnline's AOL servi as well as its other branded services and portals.
(Emphasis added.)
332. On March 27, 2001, the Individual Defendants caused AOL Time Warner to file its SEC Form 10-K for the transition period from July 1, 2000 to December 31, 2000 . The Form
48184 139 10-K was signed by Richard Parsons and Defendants Case, Levin, Kelly and Pittman . It contained substantially the same financial information as the January 31, 2000 press release, including $686 million in advertising and commerce revenue at the AOL unit for the quarter -- ended December 31, 2000 . The Form 10-K also stated that AOL advertising and commerce revenue was $1 .3 billion for the six months and $2 .4 billion for the year ended December 31,
2000, a 91% increase over the year ended December 31, 1999 . Starting with this financial report, the Company discontinued the reporting of advertising and commerce backlog .
333 . In addition, the Form 10-K incorporated, with its consent, the January 31, 200 1 report of Defendant Ernst & Young, which assured investors that AOL's financials were audited in accordance with GAAS and found to be compliant with GAAP :
We conducted our audit in accordance with auditing standards generally accepted in the United States . . . . We believe that our audits provide a reasonable basis for our opinion.
In our [Ernst & Young LLP] opinion, the financial statements referred-to above present fairly, in all material respects, the consolidated financial position of America Online, Inc . at December 31, 2000 and 1999, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2000, in conformity with accounting principles generally accepted in the United States.
334. The Form 10-K farther stated that "An important component of America Online' s
strategy is to continue increasing revenues from advertisin . .. . ."
335. In fact, AOL's advertising and commerce revenue reported in its financial
statements of $686 million for the quarter, $1 .3 billion for the six months and $2 .4 billion for th e year ended December 31, 2000, was overstated by at least $186.8 million, $343 million and
$678.1 million, respectively, an overstatement of the actual advertising and commerce revenu e by at least 37%, 37%, and 40%, respectively, as a result of AOL's improper accounting. The overstatement of at least $ 186.8 million for the quarter was due to AOL's improper accountin g
48184 140 of the Sun ($12.6 million), eBay ($16.8 million), Gateway ($85 million), 24dogs.com ($7.5
million), Homestore .com ($6.5 million), Veritas ($4 million), Telefonica SA ($10 million),
WorldCom ($12 .7 million), Monster.com ($6.2 million) and PurchasePro ($25 .4 million) deals,
as discussed above. The overstatement of at least $343 million for the six months ende d
December 31, 2000 was due to AOL's improper accounting for the Sun ($25 .2 million),
Gateway ($170 million), eBay ($33 .6 million), 24dogs .com ($23.7 million), Veritas ($4 million),
Telefonica SA ($10 million), WorldCom ($12.7 million), Homestore.com ($13.2 million),
Monster.com ($12.5 million), PurchasePro ($25.4 million) and Ticketmaster ($13 million) deals,
as discussed above. The overstatement of at least $678 .1 million for the calendar year ended
December 31, 2000 was due to AOL's improper accounting for the Sun ($50 .4 million), eBay
($67.2 million), Homestore ($17.6 million), Hughes ($180 million), Gateway ($340 million),
24dogs.com ($23.7 million), Veritas ($4 million), Telefonica SA ($10 million), WorldCom
($12.7 million), Monster.com ($25 million), PurchasePro ($25 .4 million), Ticketmaster ($13 million) and Dr.Koop.com ($9.6 million) deals, as previously discussed .
336. The Company has already admitted overstatements of $22 million, $88 million and $88 million, ofAGL advertising and commerce revenue -for the quarter, six months and year ended December 31, 2000, respectively, in the SEC Form 8-K filed October 23, 2002 .
337. The oral statements made by Defendant Kelly as reported by The Wall Street
Journal on January 12, 2001, Defendant Pittman's statements as reported by The Los Angeles
7Ymes on January 13, 2001, Defendant Kelly's comments to market analysts on January 31, 2001 and Defendant Pittman's comments at the Merrill Lynch Internet Conference on March 8, 2001, as reproduced above, are also egregiously false and misleading . Indeed, these representations that the advertising market slowdown would not adversely affect the advertising revenue growt h
49184 141 at AOL were patently misleading and false for the reasons discussed above and in light o f internal information within AOL which showed that AOL was at risk to lose substantial advertising revenue. W-
j. The Fiscal Quarter Ended March 31, 2001
338. On April 2, 2001, he Wall Street Journal reported that AOL Time Wamer wa s one of a few large companies continuing to see sharp gains in stock price despite a softenin g economy and weak stock market :
In a rocky stock market. LAOL Time Wamerl is one of few big companies whose stock has shown a sharp gain so far this year, partly because it has stuck by aggressive revenue and earnings targets. The newly merged company, facing a weakening economy, is pulling out all,the stops to meet its original forecasts for 2001 : 12% to 15% growth in revenue, to $40 billion, and a 30% increase in earnings before interest, taxes, depreciation and amortization, to $11 billion . The company says not to worry, and many analysts and investors are confident it will deliver."
(Emphasis added.)
339. On April 3, 2001, AFXNews reported that Individual Defendants continued t o state that the Company could meet its financial goals notwithstanding declines in the economy :
AOL Time Warner Inc . chiefexecutive Gerald Levin said the company is "on track" to meet its 2001 sales and profit targets despite a less favorable economic environment.
Speaking at the Salomon Smith Barney/Broadcasting and Cable Magazine Big Picture Conference, Levin said business is very strong.
340. On April 12, 2001 , AFXNews reported:
Analysts are confident that AOL Time Warner's first-quarter numbers will not disappoint.
"AOL Time Warner is best positioned . . Ito weather, the on-going weakness in ad land and concerns about upcoming talent spikes," said UBS Warburg's Christopher Dixon .
48184 142 "America Online continues to attract additional marketing dollar from b i traditional advertisers, add new subscribers worldwide and produce metrics that blow the competition away," argued Lehman Brothers' Holly Becker. Becker . . . rates AOL Time Warner a `buy.' Dixon has a "strong buy" recommendation on the stock .
(Emphasis added.)
341 . On April 16, 2001, Barron's reported that Individual Defendants predicted strong advertising revenue for the Company' s fiscal quarter driven by the Company's AOL division:
Indeed, the folks at AOL Time Warner e t advertising and c-commerce revenues to grow nicely this ear despite the punk economy.
But the real owth engine for AOL Time Warner' s ad revenue w ill incontestably be AOL, which has seen its annual advertising and e-commerce revenues soar from zero to $2 billion in the last six years . Indeed, AOL may be immune to the down cycle in the media because what it sells to advertisers is somewhat different from traditional image or product advertising.
"We're renting out the eyeballs and increasingly the fingers of our subscribers, who are primed to buy products as a result of the adjacency, context and product information surfing the AOL service lends itself to," says Barry Schuler, chairman and CEO of America Online .
(Emphasis added.)
342. On April 18, 2401, the Individual Defendants caused the Company to issue a press release announcing its financial results for the quarter ended March 31, 2401, including strong revenue gains for the Company, driven by large gains in advertising and commerce revenue at the AOL unit As stated in the press release:
A OL Advertising and Commerce Revenues Climb 37% to $721 Million
AOL Time Warner Inc . (NYSE: AOL) today reported results for its first quarter ended March 31, 2401, posting strong gains in total revenues, EBITDA, cash earnings per share, and Free Cash Flow over pro forma results from last year's comparable quarter.
Total revenues rose 9% to $9.1 billion, compared to $8.3 billion in the 2000 first quarter. Excluding one-time events, EBITDA increased 20% to $2 .1 billion, from $1.8 billion in the corresponding 2000 quarter, cash earnings per common shar e
48184 143 were $0.23, versus $0 .19 in last year's first quarter, and Free Cash Flow climbed to $651 million, up 409% from the year-ago quarter's $128 million .
[AOL Time Warner] Revenue growth was driven by a 9% increase in subscription revenues to $3.9 billion, a 10% increase in advertising and commerce revenues to $2.1 billion, and an 8% increase in content and other revenues to $32 billion. This compares to $3.5 billion, $1 .9 billion and $2 .9 billion respectively in last year's March quarter.
In addition, the Company's press release stated that: "strong growth in advertising and commerce
revenues were led by year-over-year increases of 37% at America Online ." (Emphasis added.)
343. On April 18, 2001, AFX News reported that the strong revenue growth reported by
AOL Time Warner in its first quarter as a merged entity helped the Company significantly
exceed forecasts of earnings per share:
AOL reported a rise in first quarter cash earnings per share to 23 cents from a proforma 19 cents a year. ago, beating Wall Street consensus forecasts by 3 cents .
Speaking after the release of the figures, AOL Time Warner chief executive officer Gerald Levin said the company is "on track" to meet its fiilI year revenue and EBTTDA targets.
"1 think we have made an excellent start," Levin said during a conference call.
Analyft who had feared the slowdown in online advertising may have hit the grouy's performance, were buoyed by the figures .
In a note to clients, Merrill Lynch described the company' s results as "impressive ."
Salomon Smith Barney was equally upbeat .
(Emphasis added.)
344. On April 18, 2001, Dow Jones News Service reported that Individual Defendants
told the investing public that strong advertising and commerce revenue at the AOL division would be instrumental in achieving the Company's fiscal year goals :
AOL Time Warner Inc. expects the advertising market to improve in the second half of the year, Chief Financial Officer Michael Kelly said Wednesday.
48194 144 "I'd say we are assuming the second half of the year will see some streng1hening of the ad markets," Kelly said during a conference call Wednesday after AOL Time Warner reported better-than-expected first-quarter results.
An improving advertising market could be key to helping AOL Time Warner meet its ambitious financial targets for 2001 . Chief executive Jerry Levin said first-quarter results put the company "on track" to meet those targets.
Levin called AOL service the "jewel in the crown of the companx"
(Emphasis added.)
345. On April 19, 2001, Lehman Brothers, Inc., issued an analyst report on AOL Time
Warner in which it rated the Company's common stock a "Buy." In making the recommendation, the Lehman analysts noted that advertising revenue was "robust" and that online advertising had grown 37% makin& AOL' s "first quarter online advertising revenues of $721 million . . . equal to our full year revenue forecast of $725 million for Yahoo!" (Emphasis added.)
346. On April 19, 2001 , Merrill Lynch issued an analyst report on AOL Time Warner in which it stated that "[a]dvertising commerce segment results were :singjy strong, considering the widespread weakness across the in . Results were boosted by 37%o advertisinggrawth at AOL, which represents nearly 34°/% of total advertising revenue."
(Emphasis added.) The report concluded that "[w]ith an estimated 25% of revenue coming from advertising related business, AOL Time Warner is in an advantageous position relative to its peers in the current weak advertising environment" (Emphasis added .)
347. On April 19, 2001, The Los Angeles Times reported in an article titled, "Company
Town AOL Time Warner Restores Confidence with Strong First Quarter Earnings," that the
49184 145 surprisingly strong revenue growth in advertising and commerce had a significant positiv e impact on the market's confidence in the Company:
AOL Time Warner Inc. delivered surprisingly solid earnings Wednesday to a wary Wall Street, putting to rest for now-doubts about the media and entertainment giant's ability to hit its financial targets amid the advertising slowdown. Fueled by double-digit growth at its Internet and cable businesses, the New York-based company said first-quarter revenue rose 9% to $9 .1 billion. Quarterly earnings, before certain costs, soared 20% to $2.1 billion. The strong showing was in sharp contrast to those of other Internet and media companies, which have disappointed investors in recent weeks with rising losses and falling sales. Last week, Yahoo Inc. said it would fire 12% of its work force and report an $11 .5-million first-quarter loss.
Even with a solid first-quarter performance, the company will have to work . overtime to meet its ye ar-end goal of generating $40 billion in revenue and $11 billion in earnings. .AOL Time Warner' s chief executive, Gerald Levin, reiterated those targets Wednesday and said his company is not as vulnerable as others to the ad slowdown. `Our company rides above the normal market dynamics.' Levin said...Advertising and e-commerce revenue-a trouble spot at many Internet companies -rose 10% during the qua rter, thanks largely to increase at the flagship AOL Internet service and the Time Warner cable business.
(Emphasis added.)
348. On April 19, 2041, The Wall Street Journal reported that AOL Time Warner's growth in online advertising and its confidence in its previously stated goals for fiscal 2001 se t the Company apart from other companies in the online advertising business :
In its first quarter as a merged company, AOL Time Warner Inc. met most of its financial tar ets driven by strop wth at America Online and Time Warner Cable, and renewed its pledge to meet its aggressive full-year goals. The media conglomerate's projections assume a pickup in advertising in the second half of the year in areas that have endured an ad slowdown in recent months .
For the full year, AOL predicts EBITDA of about $11 billion, up about 34% . Wall Street applauded the results. `This sets the tone for a big year for the company,' said Frederick W . Moran, an analyst at Jeffries & Co . `It shows their resilience in the face of a difficult advertising market.'
AOL overcame softness in the advertising market to st a 10% higher ggarted advertisin revenue- $2.05 billion, in line with projections released in January. Mr. Kelly said AOL's online unit in particular had seen `very strong, performance
49184 146 in the advertising marketplace.' Advertising and commerce revenue at the unit rose 37% to $721 million from $528 million a year earlier. That helped drive America Online's Ebitda up 35% to $684 million.
Analysts said America Online 's success was noteworthy considering the striking •` Internet advertising slowdown at rival Yahoo! Inc. `They're clearly takin g massive market share in online advertising,' said Jamie Kiggen, analyst at Credit Suisse First Boston .
(Emphasis added)
349. On April 27, 2001, Salomon Smith Barney issued an analyst report by Jill S .
Krutick on AOL Time Warner which rated the Company's common stock a "Buy," an d highlighted the unusual strength in the Company's online advertising revenues compared to it s
competitors. In making the recommendation , the Salomon analyst noted that during AOL's first
quarter earnings conference "management exgressedconfidence in a s tren thening, [of the
advertising market in the second half of 2001 ." (Emphasis added .) The Salomon analyst also stated: "Despite the current challenges in the overall advertising market and the onlin e
advertising market in particular, we believe AOL has strong prospects in its advertising and commerce line in the next few years [and described AOL as] the most desirable advertising and marketing venue on the Internet at present." (Emphasis added.)
350. Salomon analyst Krutnick concluded that "AOL's stock should rise as earnings targets are met. AOL Time Warner's first quarter 2001 results were ahead of our expectations. . . " The report went on to do a detailed comparison of AOL and its peers, and noted that "AOL's ad/e-commerce revenues were $721 million. representing 5% sequential
owth and 37% ear-over- ear owth. In con arison Yahoo?'s ad/c-commerce revenues were down 28% ear-to- ear in the same quarters."' (Emphasis added.) The Salomon report stated that these " [healthy gains in ad/e-commerce revenues at AOL also contributed to margin improvement. . ." (Emphasis added .) For instance, AOL's adle-commerce revenues rose from
48184 147 29% of AOL's total revenues in first qua rter 2000, to 34% in first quarter 2001, with the total
ad/e-commerce dollars rising 37% year to year. "To put that number in some context," the
Salomon analysts wrote. ". . . both Yahoo! and DoubleClick recently reported steeper-than-20%
year-to-year declines in their first quarter online ad revenues. AOL is the online advertising
market's growth d river." (Emphasis added.)
351 . Comparing AOL's performance with Excite( Wome. Krutnick's report stated tha t
"[t]he difference between +37% year-to-year growth at AOL and a -41% decline in ad/commerc e
revenue at ExcitefalHome in first quarter 2001 is a wider performance gap than we have eve r
seen between these two companies. The Salomon report went on to compare AOL with
EarthLink and concluded that with respect to advertising revenue, "the race is not even close :
AOL produced healthy year-over-year adver tising revenue growth while EartbLink experience d
a steep year-over-year ad revenue decline ." The report noted the difference between AOL's
+37% year-to-year growth and EarthLink's -57% decline, and observed that while "others put
erasing losses ahead of growth, AOL accelerates ." In sum, the Salomon report concluded that
"fi}n the sea of uncertainty that is 2001 . we believe AOL Time Warner has ... the market share
growth of its advertising franchises..." (Emphasis added .)
352. On May 2, 2401, Salomon Smith Barney issued another analyst report on AOL
Time Warner which again rated the Company's common stock a "Buy." In making the
-recommendation, the Salomon report stated :
An area of obvious interest is the advertising market where AOL Time Warner made the point that tough economic times breed defensive spending and reversion to "core" ad vehicles like those Time Warner provides . In our judgment, solid first quarter results did much to chase away skepticism and we expect this to lift even further as the year unfolds and the company delivers .
(Emphasis added.)
48184 148 353. On May 4, 2001, the San Jose Mercury News reported that Defendant Cas e boasted of the unusually strong advertising and commerce revenue at the AOL unit:
As Internet stocks flounder around him, AOL Time Warner Chamuan Steve Case on Thursday boasted that his company is hitting Wall Street targets . . .The merged company announced financial results last month that were in line with expectations of most analysts . He Minted out that even as Internet advertisin has declined for others, AOL operations reported advertising and e-commerce had increased 37 percent .
(Emphasis added.)
354. On or about May 15, 2401, the AOL Individual Defendants caused the Company to file its SEC Form I aQ for the Company's first fiscal quarter as a merged entity ended March
31, 2001 and subsequently caused the Company to file a SEC Form 10-Q/A for the same period on May 16, 2001 . The Form 10-Q and Form 14-Q/A was signed by Defendant Kelly an d contained substantially the same financial information as the April 18, 2001 press release, including the 37% increase in advertising and commerce revenue for AOL, which means that although it was not broken out as such, the Form I aQ financial results of $2 .1 billion revenu e for the AOL business segment included $721 million in AOL advertising and commerce revenue.
In addition, the Form 10-Q and Form 10-Q/A assured investors that the Company's financials were prepared in accordance with GAAP:
The accompanying consolidated financial statements are unaudited but, in the opinion of management, contain all the adjustments (consisting of those of a normal recurring nature) considered necessary to present fairly the financial position and the results of operations and cash flows for the periods presented in conformity with generally accepted accounting principles applicable to interim periods.
355. In fact, AOL Time Warner's reported AOL segment advertising and commerce revenue for the quarter ended March 31, 2001 of $721 million was overstated by at least $214 .3 million, an overstatement of the actual advertising and commerce revenue by at least 42%, as a
48194 149 result of AOL's improper accounting. The $214.3 million overstatement was a result of AOL
Time Warner's improper accounting for the Sun ($12 .6 million), eBay ($16 .8 million),
Homestore.com ($11 .1 million), Gateway ($130 million), Veritas ($4 million), Telefonica S A
($5 million), WorldCom ($5 .3 million), Monster.com ($6.2) PurchasePro.com ($7 million), and
Bertelsmann ($16 .3 million) deals, as discussed above. Based on the restatement of th e
Company's financial results in its SEC Form 8-K filed on October 23, 2002, the Company has already admitted overstating at least $13 million of AOL advertising and commerce revenue for the quarter ended March 31, 2001 .
356. Defendant Levin's statements to market analysts on April 18, 2001 that the AO L unit was the crown jewel of the merged entity, as reproduced above, are egregiously false an d misleading. Again, not only w as the Company improperly recording AOL advertising revenue, but internal AOL information revealed that AOL was suffering from the same weak advertisin g market as the rest of the industry.
357. In addition, the Form 10-Q and Form 10-Q/A for the quarter ended March 31,
2001 contained a footnote reclassifying certain revenue amounts a year after they were firs t reported, resulting in a decrease in "advertising, commerce and other" revenue for the quarter ended March 31, 2000. The SEC Form 10-Q and Form 14-Q/A failed to specify the origin of the reclassified revenue, continued to inflate AOL' s advertising, commerce, and other revenue, and the reclassified revenue amount was substantially less than the amount of the allege d overstatement. Thus, the reclassified advertising revenue remained materially overstated, as set forth herein at U 285-286 .
48184 150 k. The Fiscal Quarter Ended June 30, 200 1
358. On dune 7, 2001, Merrill Lynch Capital Markets issued an analyst report on AOL
Time Warner in which it rated the Company's common stock a "Buy." In making the --
recommendation, the Merrill Lynch analyst stated: "We believe AOL continues to be the `crown
jewel' within the group, with the COO [Parsons] giving many examples of how the traditional
business had been able to plug into the AOL growth engine (and vice versa) ."
359. On June 20, 2001, The Wall Street Journal reported that concerns about online
advertising deals made with PurchasePro led AOL Time Warner to investigate, but the Company
stated that it bad accounted properly for all revenue related to PurchasePro:
America Online suspended top deal maker Eric Keller as part of an investigation into the company's involvement with PurchasePro .com Inc. Mr. Keller is a senior vice president for business affairs at America Online, a unit of New York's AOL Time Warner Inc. He runs a team of negotiators who hammer out deals such as the one with PurchasePro, a start-up business-to-business software fiun that this past year agreed to pay America Online $50 million for a marketing agreement and 20 million for a software agreement. America Online owns 5.7% of PurchasePro, Las Vegas, and is entitled to a cut of PurchasePro 's software revenue. . . . An America Online okesman said `All revenues related to PurchasePro have been accounted for appropriately and accurately by AOL.'
(Emphasis added.)
360. On June 21 , 2001, Dow Jones-News Service reported that AOL Time Warner
continued to advise the market that its advertising revenue was a reliable revenue source despit e
the continuing decline in the advertising market :
Offering a glimmer of good news for the struggling media industry. AOL Time Warner AOL) Chief Executive Jerry Levin said advertising revenue at the company has started to stabilize.
Earlier this week, a number of top newspaper publishers said that the state of the advertising market remains gloomy . Dow Jones & Co. (DJ), publisher of The Wall Street Journal and this and other newswires, said the company hasn't seen any improvement in the advertising climate this month .
49184 151 Knight Bidder Inc. (KRl), the U .S.'s second-largest newspaper publisher, expects advertising revenue to fall between 8% and 9% for the second quarter . Washington Post Co. (WPO) estimates its ad revenue dropped 8 .4% in the first five months of the year.
However, AOL has boasted that its diverse media properties have allowed it to sell lucrative ad packages, helping to cushion the blow of the weakened economy.
AOL closed its acquisition of Time Warner Inc. on Jan. 11 and reported its first quarter as a combined- company in April . At the time, the company said it overcame softness in the advertising market to post a 10% higher quarterly advertising revenue, $2.05 billion, in line withprojections released in January.
(Emphasis added.)
361. On June 25, 2001, Lehman Brothers, Inc. issued an analyst report on AOL Tim e
Warner in which it rated the Company' s common stock a "Buy." In mating the recommendation,
the Lehman analysts noted: "While the ad market in general sti ll remains in flux. . . .AOL
continues to do deals and remains committed to strong; ad/commerce revenue growth this year.
We are currently forecasting $3 .4 billion in ad/commerce revenues for America Online, up 45%0
over last year." (Emphasis added.)
362. In a Salomon Smith Barney report, dated June 27, 2001, the analyst stated:
Based MRon our ex ectation that industry-wide Online advertising revenue will be down 30% in 2001 vs. 2 40, AOL continues to dramatically outperform its competitors and grab market share in the near term . In particular, we note that AOL captured a 45%+ market share of online ad dollars in 1 Q01, up from 25- 30% in IQ00, and we believe AOL will control more than half of the online advertising market in 2Q01 .
(Emphasis added.)
363 . On July 18, 2001 , the Individual Defendants (except for Keller who wa s dismissed in June 2001) caused the Company to issue a press release stating its record financia l results for the fiscal quarter ended June 30, 2001, led by 26% growth in advertising and
48194 152 commerce revenues in the AOL business segment as compared to the year ago quarter. The
press release stated:
AOL Time Warner Inc. (NYSE: AOL) today reported results for its second quarter ended June 30, 2001, posting records in total revenues, EBITDA and cash earnings per common share .
Total revenues rose 3% to $9 .2 billion, up from $8.9 billion, on a pro forma basis, in last year's corresponding quarter, led by a 10% increase in subscription revenues to $4.1 billion. . . . Advertising and commerce revenues ew 1 % to $2.3 billion, with America Online and Time Warner Cable Rpsting, strong increases of 26%o and 19% r 'vel . . . .EBITDA increased 20% to $2.5 billion; cash EPS, climbed 28% to $0.32; and Free Cash Flow climbed 55% to $519 million, excluding merger-related costs. These compare to pro forma EBITDA of $2 .1 billion, cash EPS of $0 .25 and Free Cash Flow of $334 million in last year's corresponding quarter . . .
AOL Advertising and commerce revenues reached $706 million, climbing 26% over last year's June quarter. . .
(Emphasis added.)
364. On July 18, 2001, Dow Jones News Service reported that AOL Time Warner's
financial results increased dramatically, due to strong growth in AOL's advertising an d
commerce revenue:
In a prepared statement, chief execu tive Jerry Levin said, "We couldn't be more proud of what we accomplished this quarter. We achieved outstanding bottom- line results, dramatic improvement in profit margins and a huge increase in Free Cash Flow. Our record results are further proof that we are delivering on the promise ofthe AOL Time Warner merger."
*** America Online's revenue increased 13% to a record $2 .14 billion. AOL's EBITDA improved 37% to a record $ 801 million on higher advertising and commerce revenue, increased operating efficiencies, and reduced network costs per hour and selling, general and adminis trative expenses.
Levin added, "In just six months, we've made great progress integrating the Company."
(Emphasis added.)
49184 153 365. On July 18, 2001, a Dow Jones News Service article entitled, "AOL CEO : Co.
Was 2nd Largest U .S. Advertiser In 2Q," reported that AOL Time Warner was increasing its forecast of 2001 cash earnings growth by ten percent, asserting that the company could continue to grow advertising revenue:
' We are assuming only a sli t turn in the advertisin market in the second half of the year''' in the company's networks and publishing units, Ke lly said.
Kelly said AOL was lifting its forecast of 2001 cash earnings growth to a range of 35% to 40%, compared with 2000 levels, from a range of 25% to 30%. Kelly's remarks came as the New York media and entertainment company reported second-quarter cash earnings that beat analysts' expectations, but with revenue that fell short of estimates .
One way AOL has responded to the advertising market downturn is to step up its own adyertis€ng filling up unused ad inventory. Levin said AOL was the second- largest U.S. advertiser in the second gparter. normally, the company is somewhere in the top 10, he said .
366. On or about August 14, 2001, the Individual Defendants (except Keller) cause d the Company to file its SEC Form 10-Q for the Company 's second quarter ended June 30, 2001 .
The Form 1 O-Q was signed by Defendant Kelly and contained substantially the same financia l information as the July 18, 2001 press release, including a reported 26% increase in advertisin g and, commerce revenue for the AOL business segment over the year ago quarter, which means that although it was not broken out as such, the reported financial results of $2.1 billion AOL business segment revenue for the quarter included $706 million in AOL business segment advertising and commerce revenue. The Form 10-Q also asserted that the "growth in [AOL] advertising and commerce revenues was due to an overall increase in advertising ...... The Form
1 O-Q also reported a 31 % increase in AOL business segment advertising and commerce revenu e for the year ended June 30, 2001 over the year ended June 30, 2000 . In addition, the Form 10- Q assured investors that the Company's financials were prepared in accordance with GAAP:
48184 154 The accompanying consolidated f nandial statements are unaudited but, in the opinion of management, contain all the adjustments (consisting of those of a normal recurring nature) considered necessary to present fairly the financial position and the results of operations and cash flows for the periods presented in conformity with generally accepted accounting principles applicable to interim periods.
367. In fact, AOL Time Warner' s reported AOL segment advertising and commerce revenue for the quarter ended June 30, 2001 of $706 million was overstated by at least $150 .3 million, or an overstatement of the actual advertising and commerce revenue by at least 27% .
The overstatement of at least $150.3 million for the quarter was due to AOL Time Warner's improper accounting for the Sun ($12.6 million), eBay ($16.8 million), Homestore.com ($11.1 million), Veritas ($4 million), WorldCom ($5 .3 million), Monster.com ($6.2 million), Oxygen
Media ($19.8), PurchasePro ($9 million) and Bertelsmann ($65 .5) deals, as discussed above.
The Company has already admitted that at least $28 million for the quarter and $41 million for the six months ended June 30, 2001, respectively, of AOL advertising and commerce revenu e was overstated based on its restatement of the quarter' s results in the SEC form 8-K filed
October 23, 2002 .
368. In addition, the Form 10-Q for the quarter ended June 30, 2001 contained a footnote reclassifying certain revenue amounts, a year after they were first reported, resulting in a decrease in "advertising, commerce and other" revenue for the quarter ended June 30, 2000 .
The SEC Form I0-Q failed to specify the origin of the reclassified revenue, continued to inflate
AOL's advertising, commerce and other revenue, and the reclassified revenue amount was substantially less than the amount of the alleged overstatement. Thus, the reclassified advertising revenue remained materially overstated, as set forth herein at 11297-298.
48184 155 1. The Fiscal Ouarter Ended September 30, 2001
369. On September 24, 2001, aDow Jones News Service article titled, "AOL
Abandons Longstanding Financial Targets For Year" reported that AOL Time Warner, for the --
first time, acknowledged that the slowdown in the advertising market would affect its futur e
performance:
For more than 18 months, executives from AOL and its predecessor companies, America Online, Inc. and Time Warner inc., had insisted the merged entity would post cash flow growth of 30% and revenue growth of more than 10%. The projections were among the proposed merger's se lling points to Wall Street.
But AOL said late Monday its cash flow growth in 2001 will be in the 20% range and revenue growth between 5% and 7%. AOL cited the [September 11 terrorist] attacks and the advertising market slowdown, becoming the latest company to sound a note of caution in the wake of the attacks.
While many analysts had lowered their AOL estimates in recent weeks, some were surprised by the magnitude of the expected shortfall . . . . "These numbers are lower than what we had been projecting," said CIBC World Markets analyst John Corcoran. "Me magnitude of the shortfall might surprise the Street ."
"The bottom line is - despite this tragedy and the resulting economic effects - our unique mix of assets give us confidence that we can generate strong earnings growth next year and into the future." Chairman Steve Case said in the press release.
Still, there was no disclosure of the fact that advertising revenue had already dec lined significantly at AOL, and the illegal steps AOL had taken to artificially inflate its advertising revenue in order to mask that fact.
370. On October 17, 2001, the Individual Defendants (except Keller) caused the
Company to issue a press release reporting its financial results for the quarter ended Septembe r
30, 2001, including $624 million in AOL advertising and commerce revenue, a 5% increase over the year ago quarter.
48J84 156 371 . On November 14, 2001, the Individual Defendants (except Keller) caused the
Company to file its SEC Form 10-Q for the Company's fiscal quarter ended September 30, 2001 .
The Form laQ contained substantially the same financial information as the October 17, 2001 --
press release, including advertising and commerce revenue of $624 million at the AOL unit for
the quarter, a 5% increase over the year ago quarter. The Form 10-Q also reported advertising
and commerce revenue for the AOL business segment for the nine months ended September 30 ,
2001 of $2 .051 billion, a 22% increase over the nine months ended September 30, 2000 .
372. In addition, the Form 10-Q assured investors that the Company financials wer e
prepared in accordance with GAAP:
The accompanying consolidated financial statements are unaudited but, in the opinion of management, contain all the adjustments (consisting of those of a normal recurring nature) considered necessary to present fairly the financial position and the results of operations and cash flows for the periods presented in conformity with generally accepted accounting principles applicable to interim periods.
373 .. In fact, AOL Time Warner' s reported AOL segment advertising and commerc e
revenue of $624 million for the quarter and $2 .1 billion for the nine months ended September 30,
2001, was overstated by at least $ 122.1 million, and $486.7 million, respectively, or an
overstatement of the actual advertising and commerce revenue by at least 24 % and 31%, respectively, as a result of AOL Time Warner's improper accounting. The overstatement of at least $122. 1 million for the quarter was due to AOL Time Warner's improper accounting for the
Sun ($12.6 million), eBay ($ 12.8 million), Oxygen Media ($19 .8 million), Veritas ($4 million),
WorldCom ($5.3 million), Homestore ($6.6 million), Monster.com ($6.2'million), Golf Channel
($15 million) and Bertelsmann ($39.8 million) deals, as discussed above. The overstatement of at least $486.7 million for the nine months ended September 30, 2001 was due to AOL Time
Warner's improper accounting for the Sun ($37 .8 million), eBay ($46.4 million), Homestore.com
48184 157 ($28.8 million), Oxygen Media ($39 .6 million); Veritas ($12 million), Telefonica SA ($ 5 million), WorldCom ($15.9 million), Gateway ($130 million), Monster .com ($18.6 million),
PurchasePro ($16 million), Golf Channel ($15 million) and Bertelsmann ($121 .6 million) deals,
as discussed previously.
374. The Company has already admitted overstating $16 million,-and $57 million of
AOL advertising and commerce revenue for the fiscal quarter and nine months ended September
30, 2001, respectively, based on its restatement of financial results in the SEC form 8-K filed
October 23, 2002.
375-- In addition, the Form 10-Q for the quarter ended September 30, 2001 contained a
footnote reclassifying certain revenue amounts, a year after they were first reported, resulting in
a decrease in "advertising, commerce and other" revenue for the quarter ended September 30 ,
2000. The SEC Form 1D-Q failed to specify the origin of the reclassified revenue and continued
to inflate AOL's advertising, commerce and other revenue, and the reclassi fied revenue amount
was substantially less than the amount of the alleged overstatement. Thus, the reclassified
advertising revenue remained materially overstated, as set forth herein at 11311-312 .
M. The Fiscal Quarter and Year Ended December 31, 200 1
376. On November 27, 2001, a Dow Jones News Service article titled, "AOL Co-COO
Backs `02 Double-Digit Cash Flow Growth View" reported that despite the economic downturn,
AOL Time Warner was holding to its ambitious targets for the year ended December 31, 2002:
AOL Time Warner Inc . (AOL) Co-Chief Operating Officer Bob Pittman said he's comfortable with the company's previous estimate of posting a "double-digit-cash flow growth rate in 2002.
The media and Internet company said in late September it expected earnings before interest, taxes, depreciation and amortization, or EBITDA, to rise by a double-digit percentage in 2002_ At the same time, AOL lowered its forecasts for
43184 158 this year, citing the weak economy and advertising market . It expects EBITDA to rise 20% in 2001 .
"We're comfortable with the double'-digit EBITDA growth" i.n 2002, Pittman told investors at the Credit Suisse First Boston technology conference in Scottsdale, Ariz. "We have enough control of our destiny to be comfortable ."
(Emphasis added.)
377. On January 30, 2002, the Individual Defendants (except Kelle) caused th e
Company to issue a press release with financial results for the fiscal quarter and year ended
December 31, 2001, which included a year-over-year increase in AOL advertising and commerce revenue for the year of 13% to $2 .7 billion, and AOL advertising and commerce revenue of $637 million for the quarter.
378. On or about March 25, 2002, the individual Defendants (except Keller) caused th e
Company to file its Form 10-K for the fiscal quarter and year ended December 31, 2001 . The
Individual Defendants (except Keller) subsequently caused the Company to file a Form 10-K/A on March 26, 2002 for the fiscal quarter and year ended December 31, 2001 . The Form 10-K and Form 10-WA contained substantially the same financial information as the January 30, 2002 press release, including $637 mi llion and $2.7 billion in AOL advertising and commerce revenue, and $2.2 billion and $8.5 billion in AOL Time Warner advertising and commerce revenue, respectively, for the fiscal quarter and year ended December 31, 2001 . The Form 10-K and
Form 10-KJA was signed by, among others, Richard Parsons and Defendants Case, Levin, Pac e and Pittman.
379. The Form 10-K and Form 10-K/A further stated:
While advertising revenues declined overall, certain segments and businesses of AOL Time Warner experienced an increase in advertising revenues. Specifically, and as discussed in more detail below under Business Segment Results , advertising revenues increased at the AOL and Cable segments, and at The WB Network.
48194 159 380. The Form 10-K and Form 10-KA also incorporated, with the consent o f
Defendant Ernst & Young, the January 28, 2002 report of Ernst & Young which assure d
investors that the Company's financials were audited in accordance with GAAS and were
prepared in compliance with GAAP:
We conducted our audit in accordance with auditing standards generally accepted in the United States . . .. We believe that our audits provide a reasonable basis for our opinion.
In our [Ernst & Young] opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position ofAOL Time Warner at December 31, 2001- and 2000, and the consolidated results of its operations and its cash flows for each ofthe three years in the period ended December 31, 2001 , in conformity with accounting principles generally accepted in the United States. Also, in our opinion , the related financial statement schedule and supplementary information, when considered in relation to the basic financial statements taken as a whole, present fairly in a ll material respects the information set forth therein.
381 . On March 27, 2002, AOL Time Warner issued its 2001 Annual Report in which
Richard Parsons and Defendants Case and Pittman emphasized the growth in advertising revenu e
compared to the previous year, noting there was "a 13% increase in AOL advertising and
commerce revenues from $2.369 billion to $2 .688 billion."
382. In fact, AOL Time Warner's reported AOL segment advertising and commerce revenue of $637 million for the quarter and $2.7 billion for the year ended December 31, 2001 was overstated by at least $60 .3 million, and $547.2 million, respectively, or an overstatement of the actual adver tising and commerce revenue by at least 10% and 26%, respectively, as a result of AOL's improper accounting . AOL Time Warner's reported advertising and commerce revenue for the quarter and year ended December 31, 2001 was similarly overstated by at least
$60.3 million and $547.2 million, respectively, as a result of AOL Time Warner's improper accounting. The overstatement of at least $60.3 million for the quarter was due to AOL Time
48184 160 Warner's improper accounting for the Sun ($8.4 million), Oxygen Media ($ 19.8 million),
Gateway ($3 million), Veritas ($4 million), WorldCom ($11 .8 million), Homestore ($6.6
million), Monster.com ($6.2 million) and Bertelsmann ($0 .5) deals, as discussed above. The --
overstatement of at least $547.2 million for the year ended December 31, 2041 was due to AO L
Time Warner's improper accounting for the Sun ($45 .2 million), eBay ($46 .4 million),
Homestore.com ($35.4 million), Oxygen Media ($59 .4 million), PurcbasePro ($16 million),
Gateway ($133 million), Veritas ($16 million), Telefonica SA ($5 million), WorldCom ($27 .7
million), Monster.com ($25 million), Golf Channel ($15 million) and Bertelsmann ($122 .1
million) deals, as discussed above .
383 . The Company has already admitted overstating AOL advertising and commerc e
revenue for the quarter and year ended December 31, 2001 by $17 million, and $74 million ,
respcctively, based on its restatement of financial results in the SEC form 8-K filed October 23 ,
2002.
n. The Fiscal Quarter Ended March 31, 2002
384. By March 2002, the advertising market had become so bleak, that the Compan y
was forced to acknowledge a signi ficant impact on its AOL advertising business. Nevertheless,
AOL secretly continued to artificially inflate its advertising revenue.
385. Indeed, on or about May 5, 2002, the Individual Defendants (except Keller)
caused the Company to file its SEC Form 10-Q for the Company's fiscal quarter ended March 31 ,
2002. The Form l0-Q reported $501 million in AOL advertising and commerce revenue for the
quarter ended March 31, 2002 . In addition, the Form 10-Q assured investors that the Company's
financials were prepared in accordance with GAAP:
The accompanying consolidated financial statements are unaudited but, in the opinion ofmanagement, contain all the adjustments (consisting of those of a
48184 161 normal recurring nature) considered necessary to present fairly the financial position and the results of operations and cash flows for the periods presented in conformity with generally accepted accounting principles applicable to interim periods. 0- 386. In fact, AOL Time Warner's reported AOL segment advertising and commerce
revenue for the quarter ended March 31, 2002, of $ 501 million was overstated by $130.4 million,
or an overstatement of the actual advertising and commerce revenue by at least a stunning 35% ,
as a result of AOL's improper accounting, as discussed above. The $130.4 million
overstatement is due to AOL Time Warner's improper accounting for the Oxygen Media ($19.8
million), Gateway ($9 million), Monster .com ($6.2 million), Homestore ($6 .6 million),
WorldCom ($8.5 million)and Bertelsmann ($80 .3 million) deals, as discussed above. The
Company has already admitted an overstatement of at least $6 million in advertising an d
commerce revenue for the quarter in the SEC Form 8-K filed October 23, 2002 .
387. The Form 10-Q for the quarter ended March 31, 2002 also stated that th e
advertising and commerce revenue for AOL Time Warner the quarter ended March 31, 2001 was
$17 million less than originally reported a year previously, but failed to identify the origin of the
reduced revenue and whether the decrease related to AOL. The Form I0-Q again overstated the
Company's advertising and commerce revenue for the quarter ended March 31, 2001, a s previously discussed in 1355.
o. The Fiscal Ouarter Ended June 30 2002
388 . On July 24, 2002, the last day of the Class Period, Richard Parsons and Defendan t
Pace held a conference call with market analysts after the Company issued a press release announcing the Company's financial results for the quarter ended June 30, 2002 . The press release was issued and the conference call took place after the stock market had closed on Jul y
24, 2002. During the conference call, Defendant Pace stated that the AOL division had $412
48184 162 million in advertising and commerce revenue in the quarter ended June 30, 2002, $342 million of
which was advertising revenue. Pace also stated that the advertising and commerce backlog as
of June 30, 2002 was $860 million . Also during the call, Parsons stated that the SEC-was
conducting an investigation into the Company's accounting practices with respect to AOL
advertising revenue in reaction to allegations raised in articles published by The Washington Post
on July 18 and 19, 2402.
389. In fact, AOL Time Warner's reported AOL segment advertising and commerce
revenue of $412 million and advertising revenue of $342 million for the quarter ended June 30 ,
2002, were both overstated by at least $126 million, or in comparison with actual advertising and
commerce revenue, by at least 44% and 58%, as a result of AOL's improper accounting.
390. The overstatement of at least $126 million for the quarter was due to AOL Tim e
Warner's improper accounting for the Oxygen Media ($19 .8 million), Homestore ($6 .6 million),
Monster.com ($6.2 million), Bertelsmann ($84.4 million) and Gateway ($9 million) deals, as
discussed above . Further, Pace's statement in the July 24, 2042 press release that AOL Time
Warner's AOL segment advertising revenue backlog as of June 30, 2002 was $860 million was false because the actual backlog was overstated by at least $212 .8 million, or at least 33%, due to the improper accounting of the Homestore .com ($132 million), Monster.com ($35.4 million),
Gateway ($51 million), and Bertelsmana ($113 .2 million) deals. Accordingly, notwithstanding the extremely weak advertising market that left the Company no choice but to report decreased advertising revenue, and acknowledgement by the Company of the SEC investigation, the
Company still artificially inflated its reported advertising revenue and backlog.
48194 163 391 . On July 24, 2002, AOL Time Warner stock closed at $11 .40 per share. Following the Company's disclosure of the SEC investigation after the market closed on July 24, 2002, the stock fell 15 .4% to close at $9 .64 per share at the end of trading on July 25, 2002. a-
392. Based on the foregoing, during the Class Period the Company, AOL, the
Individual Defendants and Defendant Ernst & Young, have made material misrepresentations and omitted material facts, in SEC filings, press releases, financial statements, and AOL Tim e
Warner's consolidated pro forma financial statements referred to above, including the Merge r
Registration Statement, the Joint Proxy Statement Prospectus, and the financial statements an d pro forma financial statements incorporated by reference in the Merger Registration Statemen t and Joint Proxy Statement Prospectus as follows .
a. Materially overstated AOL and Company advertising and commerc e revenue, AOL advertising and commerce backlog, and percentage increases of such amounts in year over year comparisons in statements referenced above;
b. Materially overstated AOL advertising revenue in the conso lidated pro forma financial statements in the documents referenced above ;
c. Failed to disclose that AOL and AOL Time Warner had engaged in sham transactions and improper accounting, resulting in the overstated advertising revenue an d backlog, and percentage comparisons referenced above ;
d. Failed to disclose in the documents referenced above the true current an d anticipated condition of AOL's advertising revenue and advertising business, both before an d after the Merger;
C. Falsely represented in the documents referenced above that the subjec t financial statements were prepared in accordance with GAAP and Article 10 of Regulation S-X ;
48184 164 f Falsely represented in the documents referenced above that the audited
financial statements were audited in conformance with GAAS;
gn Falsely represented in the documents referenced above that the subjec
ht financial reports fairly presented the results of the companies' operations, particularly wit respect to the adver tising and commerce revenue of AOL, including the advertising and
commerce revenue of the Company's AOL business segment; and
h. Falsely represented in the documents referenced above that results of th e
companies' operations, particularly with respect to the advertising and commerce revenue o f
AOL, including the advertising and commerce-revenue of the Company's AOL business segment.
393. AOL, the Company and Individual Defendant made numerous statements
described above in the companies ' press releases , and otherwise to market analysts and the media, that materially overstated AOL and Company advertising revenue and falsely represented
or failed to disclose the effect on AOL and the Company of an industry-wide deterioration of th e
Internet advertising market. Such statements include those of Defendants Case, Pittman and
Kelly on October 18, 2000, to market analysts as detailed in IN 303-304 above. Other such false
and misleading statements include, as discussed above, the following :
1 . Kelly's statements reported by The Wall Street Journal on January 12, 2001, as set forth in 1 315 above;
2. Pitt van's statements as reported by The Los Angeles Times on January 13, 2001, as set forth in 1318 above;
3. Kelly's comments to market analysts on Janua ry 31, 2001 , as set forth in 11324-325 above;
4. Pittman's comments at the Merrill Lynch Internet Conference on March 8, 2401, as set forth in 1 328 above ;
5. Levin's statements to analysts on April 18, 2001, as set forth in ¶¶ 343- 344 above;
48184 165 6. Pace's statements to analysts on July 24, 2002, as set forth in ¶ 388 above; and
7. The statements of Case, Pittman, Kelly and others in the AOL and, Company press releases announcing financial results throughout the Class Period, as set forth above.
394. The longstanding and pervasive artificial inflating ofAOL's advertising revenue,
including various sham deals, constituted devices, schemes or artifices to defraud investors an d
the marketplace. Indeed, the systema tic practices of AOL and the Company to materially
overstate advertising revenue operated as a fraud on the market and investors resulting in th e
purchase or acquisition of AOL and AOL Time Warner stock at artificially inflated prices.
395. In addition, AOL's artificially inflated advertising revenue caused the value of th e
Company's goodwill, created as part of the Merger, to be vastly inflated. As discussed in the
following section, the Company materially overstated the value of goodwill prior to and i n
conjunction with the Merger and improperly accounted for the goodwill after the Merger ,
causing it to continue to be greatly overstated .
IT. The Materially False and Misleading Statements, Omissions of Material Fact and Devices, Schemes or Artifices to Defraud Regarding AOL Time Warner's Goodwill
396. AOL and AOL Time Warner created a grossly overstated goodwill value of $127 billion, comprised of $94.705 billion of new goodwill and approximately $33 billion ofexisting
goodwill, in connection with the Merger. The Company, AOL and Time Warner before and in
conjunction with the Merger, falsely reported the Company's goodwill created by the Merger.
After the Merger, the Company continued to falsely report its goodwill . The representations i n the Company's Merger Registration Statement, AOL's &Time Warner's-Joint Proxy Statement-
Prospectus in connection with the Merger, AOL's SEC Form 10-K filings for the year ended
June 30, 2000 and the six-month period ended December 31, 2000, AOL's SEC Form 8-K filings
48184 166 on February 11, 2000, April 3, 2400 and May 23, 2000 and AOL Time Warner's SEC Form 8-
K/A filings on January 26, 2001 and March 30, 2001 vastly overstated the value of the pro forma
goodwill. The postMerger representations in Company financial statements continued to report
a greatly inflated goodwill valuation and failed to take appropriate write-downs of the goodwill
as required by GAAP.
397. Goodwill is defined by APB 16 as the premium paid by one company to acquire
another when the purchase price exceeds the fair market value of the acquired company' s
underlying identifiable tangible and intangible assets. Goodwill is intended to be the
quantification of the real and actual value of the unidentifiable intangible assets of a company .
Such assets include primarily the value of a business' reputation and customer patronage and
loyalty to be derived therefrom .
398. With respect to the pre-Merger misrepresenta tions, AOL incorporated by reference in its SEC Fonn 10-K filed on September 22, 2000 for its fiscal year ended June 30,
2000, certain pro forma financial statements "which were presented to illustrate the effects of the
Merger." Those pro forma statements reported that, as a result of the Merger, an estimated amount of $94.705 billion would be allocated to goodwill due to the excess purchase price over identifiable tangible and other intangible assets. The pro forma statements also estimated a
`useful life" for the goodwill of 25 years .
399. AOL's SEC Form 10-K filed on March 27, 2001 for the period July 1, 2000 through December 31, 2000, incorporated by reference the same pro forma financial statements which again estimated new goodwill attributable to the Merger of $94.745 billion with a useful life of 25 years.
49194 167 400. AOL's SEC Form 8-K filed on February 11, 2000 contained a pro forma
consolidated condensed balance sheet of AOL Time Warner at September 30, 1999 to illustrate - 0- the effects of the Merger as if it occurred as ofthat date. That balance sheet estimated new
goodwill attributable to the Merger to be $95 .842 billion, with an estimated useful life of 2 5
years.
401 . AOL's SEC Form. 8-K filed on April 3, 2000 contained a pro forma consolidated
condensed balance sheet of AOL Time Warner at December 31, 1999 to illustrate the effects o f
the Merger as if it occurred as of that date. That balance sheet estimated new goodwill
attributable to the Merger to be $94 .736 million, with an estimated useful life of 25 years.
402. AOL's SEC Form 8-K filed on May 23, 2000 contained a pro forma consolidated
condensed balance sheet ofAOL Time Warner at March 31, 2000 to illustrate the effects of th e
Merger as if it occurred as of that date. That balance sheet estimated new goodwill attributable
to the Merger to be $94 .705 billion, with an estimated useful life of 25 years .
403 . AOL's 8-Ks filed on April 3 , 2000 and May 23, 2000 represented that :
AOL Time Warner will periodically review the carrying value of the acquired goodwill ... for acquired businesses to determine whether an impairment may exist. AOL Time Warner will consider relevant cash flow information, including estimated future operating results, trends and other available information, in assessing whether the carrying value of goodwill ... can be recovered. If it is determined that the carrying value of goodwill ... will not be recovered from the undiscounted future cash flows of acquired businesses, the carrying value of such goodwill ... would be considered impaired and reduced by a char a to operations in the amount of the impairment.
(Emphasis added .) In addition, the Form 8-Ks represented that an "impairment charge i s measured as any deficiency in the amount of estimated undiscounted cash flows of acquire d businesses available to recover the carrying value related to goodwill . . . ."
48184 168 404. The Company' s Merger Registration Statement which incorporated by reference
AOL's and Time Warner's Joint Proxy Statement-Prospectus was filed with the SEC o n
February 11, 2000, as amended on March 24, 2000, April 25, 2000, May 18, 2400 and May 19, 0-
2000. The Merger Registration Statement and Joint Proxy Statement Prospectus incorporated by
reference the same pro forma financial statements "presented to illustrate the effects of the merger" and previously referenced in 1398.
405. On or about May 23, 2000, the Joint Proxy StatementProspectus was mailed by
AOL and Time Warner, respectively, to their stockholders. The Merger Registration Statement
and Joint Proxy Statement-Prospectus represented that:
AOL Time Warner will eriodicall review the c value of the a uired goodwill for acquired businesses to determine whether an impairment may exist . AOL Time Warner will consider relevant cash flow information, including estimated future operating results, trends and other available information, in assessing whether the carrying value of goodwill can be recovered . If it is determined that the carrying value of goodwill will not be recovered from the undiscountcd future cash flows of acquired businesses, the carrying value of such goodwill would be considered impaired and reduced bya charge to operations in the amount of the impairment.
(Emphasis added .) In addition, the Merger Registration Statement and Joint Proxy Statement
Prospectus represented that an "impairment charge is measured as any deficiency in the amount of estimated undiscounted cash flows of acquired businesses available to recover the carrying value related to goodwill."
406. Following the Merger, on January 26, 2001, the Individual Defendants caused th e
Company to file its SEC Form 8-K!A amending its SEC Form 8-K filed January 12, 2001 . Form
8-K/A included as an exhibit the consolidated balance sheet of AOL Time Warner as of
December 31, 2000, which was subsequently updated as a pro forma consolidated condense d
48184 169 balance sheet in AOL Time Warner's SEC Form 8-K/A filed on March 30, 2001 and set forth th e amount allocated to goodwill as a result of the Merger.
407. The newly created $94.705 billion in goodwill was predicated upon AOL's overstated advertising revenue, and therefore a valuation of AOL that exceeded its true fair market value. Indeed, as discussed-in this Complaint in great detail, AOL's advertising revenue was artificially inflated to bolster the price of AOL's stock and to make certain the Merger that
Individual Defendants desperately wanted, was consummated. Accordingly, AOL's inflated advertising revenue essentially created "counterfeit money" with regard to the inflated value o f
AOL stock, which in tam vastly overstated the value of goodwill . Therefore, the pro form a financial statements incorporated by reference in AOL's Form 10-Ks for the year ended June 30,
2000, and the six-month period ended December 31, 2000 , AOL's SEC Form 8-K filings on
February 11, 2044, April 3, 2000 and May 23, 2040, the Company's Merger Registration
Statement, the Company's SEC Form 8-K/A filings on January 26, 2001 and March 30, 200 1 and AOL's and Time Warner's Joint Proxy Statement-Prospectus, falsely represented the tru e value of goodwill. The Form I0-Ks, the Form 8-K the Form 8-KIAs, the Merger Registration
Statement and the Joint Proxy Statement-Prospectus also falsely represented the useful life of th e goodwill to be an .estimated 25 years . As discussed below, the real useful life for the goodwill was, in fact at best, two years.
408. In addition, the grossly overstated goodwill was not properly accounted for by the
Company in its financial . statements for each of the fiscal 2001 quarters and the year ende d
December 31, 2401, as well as the first two quarters of fiscal 2002 . For the quarter ended March
31, 2001 and until the quarter ended September 30, 2002, goodwill was the largest asset on AOL
Time Warner's balance sheet . Because goodwill was such a significant part of AOL Time
48184 170 Warner's financial statements, comprising more than half of total reported assets, its accounting
treatment was crucial to the proper and accurate determination of AOL Time Warner's earnings
and shareholders' equity. By failing to write-down this inflated, asset and thereby properly value
goodwill, Defendants materially overstated the Company's goodwill, shareholders' equity (the
Company's net worth) and net income in its financial statements for each of the fiscal quarters in
2001, the year ended December 31, 2001, and the first two quarters 'of2002.
409. Goodwill and other intangible assets were recorded in AOL Time Warner's SEC
Form 10-Q for the quarter ended March 31, 2001 (filed with the SEC on May 15, 2001) a s
$127.907 billion, which included the goodwill] created by the Merger and other goodwill and intangible assets acquired by the Company after the Merger. The Company's reported goodwill reflected a reduction since the-Merger for pro rata amortization of the goodwill over what the
Company represented to be the goodwill's useful life of 25 years . However, the Company failed to take any write-downs of this vastly inflated asset. As a result of the inflated goodwill, the
Form I0-Q also contained a greatly overstated value of shareholders' equity in the amount of
$156.525 billion.
410. Goodwill and other intangible assets were recorded in AOL Time Warner's SEC
Form 10-Q for the quarter ended June 30, 2001 (filed with the SEC on August 14, 2001) as
$126.6 billion, reflecting a reduction since the Merger for pro rata amortization of the goodwill over what the Company represented to be the goodwill's useful life of 25 years . However, the
Company failed to take any write-downs of this vastly inflated asset. The Company also continued to report overstated shareholders' equity of $156 .1 billion.
411 . Goodwill and other intangible assets were recorded in AOL Time Warner's SEC
Form I0-Q for the quarter ended September 30, 2001 (filed with the SEC on November 14, 2001 )
48184 - 171 as $126.9 billion, including a reduction of the goodwill created by the Merger for pro rata amortization of the goodwill over what the Company represented to be the goodwill's useful life of 25 years. However, the Company failed to take any write-downs of this vastly inflated asset, and accordingly also reported inflated shareholders' equity of $154 billion .
412. The Company's SEC Form 10-Q for each of the above-referenced financial periods also stated:
The accompanying consolidated financial statements are unaudited but, in the opinion of management, contain all of the adjustments (consisting of those of a normal recurring nature) considered necessary to present fairly the financial position and the results of operations and cash flows for the periods presented in conformity with generally accepted accounting principles applicable to interim periods.
413 . The Company's SEC Form 10-K for the year ended December 31, 2001, (filed with the SEC on March 25, 2002) reported goodwill and intangible assets of $128 billion, which again reflects pro rata amortization of the original $94 .705 billion of goodwill over its supposed useful life of 25 years . However, no write-downs of the overvalued asset were taken and the
Company again reported overstated shareholders' equity of $152 billion .
414. Jo addition, the Form 10-K represented that the Company "periodically review s the carrying value of acquired intangible assets, including goodwill, to determine whether an impairment may exist." The Form l0-K also stated, with Ernst & Young's consent, that the financial statements therein were prepared in comp liance with GAAP and were audited by and given an unqualified opinion by Ernst & Young, who stated, "We conducted our audits i n accordance with auditing standards generally accepted in the United States " (GARS). Ernst &
Young further stated as part of the Form 10-K: "In our opinion, [the Company's] financial statements .._ present fairly, in all material respects, the consolidated financial position of AO L
Time Warner at December 31, 2001 and 2000, and the consolidated results of its operations and
48194 172 its cash flows for each of the three years in the period ended December 31, 2001, in conformit y
with accounting principles generally accepted in the United States ."
415. By failing to write-down the overstated goodwill in any of the fiscal 2001 quarters, +_
or the fiscal year ended December 31, 2041, the Company violated GAAP and thereby avoided substantially reducing the carrying value of goodwill and shareholders' equity and reporting a huge operating loss. GAAP, as set forth in FAS No. 121, which was applicable during the Class
Period, required that companies review long-lived assets, including goodwill, to determine whether the assets are impaired . FAS No. 121, IN 5-6:
5. The following are examples of events or changes in circumstances that indicate that the recoverability of the carrying amount of an asset should be assessed:
a. A significant decrease in the market value of an asset ;
b. A significant change in the extent or manner in which .an asset is used or a significant physical change in an asset;
c. A significant adverse change in legal factors or in the business climate that could affect the value of an asset or an adverse action or assessment by a regulator,
d. An accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset; and/or
e. A current period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with an asset used for the purpose of producing revenue.
6. If the examples of events or changes in cir cumstances set forth in paragraph 5 are present or if other events or changes in circumstances indicate that the carrying amount of an asset that an entity expects to hold and use may not be recoverable, the entity shall estimate the future cash flows expected to result from the use of the asset and its eventual disposition. Future cash flows are the future cash inflows expected to be generated by an asset less the future cash outflows expected to be necessary to obtain those inflows . If the sum of the expected future cash flows (undiscounted and without interest charges) is less than the carryin g
48184 173 amount of the asset, the entity shall recognize an impairment loss in accordance with this Statement. Otherwise, an impairment loss shad not be recognized; however, a review of depreciation policies may be appropriate .
(Footnote omitted.)
416. Individual Defendants were aware of several factors at the time of the Merger an d thereafter which established that the goodwill was materially overstated as recorded by AO L
Time Warner in the financial statements referred to above. Individual Defendants knew of the previously overstated AOL advertising revenue, which resulted in the inflated value of AO L stock and therefore a huge overstatement of goodwill when the Merger was consummated .
Individual Defendants were also aware of a material decline in the advertising market and th e increasingly dramatic decline in demand for AOL advertising, which had typically represente d
20%'of the Company's revenue. The fact that large amounts of existing AOL advertising revenue were at significant risk was known by AOL executives at least as early as August 2000 .
Indeed, in the months preceding the consummation of the Merger, ACL's senior management was advised that the company faced the risk of losing more than $140 million in advertisin g revenue the following calendar year.
417. Notwithstanding the material decline in the value of the previously inflated goodwill, AOL Time Warner and the Individual Defendants failed to take required write-downs so that the Company would not report a huge loss for thefiscal periods referenced above o r admit that the value of AOL stock was greatly overvalued as part of the Merger. Moreover, the
Company repeatedly reported to the public that the estimated useful life of the goodwill was 2 5 years, when in fact, as discussed below, it was less than two years .
48184 174 418. Due to the accounting improprieties related to goodwill, the Company presented its financial results and statements in a manner which violated GAAP, including the following fundamental accounting principles : ._
1 .1 . Interim financial reporting should be based upon the same accounting principles an d
practices used to prepare annual financial statements (APB No. 28, 110);
1 .2.'Financial reporting should provide information that is useful to present and potential
investors and creditors and other users in making rational investment, credit and simila r
decisions (CON 1 134);
1 .3 . Financial reporting should provide information about the economic resources of a n
enterprise, the claims to those resources, and effects of 'transactions ; events and
circumstances that change resources and claims to those resources (CON 1140);
1 .4. Financial reporting should provide information about how management of an enterpris e
has discharged its stewardship responsibility to owners (stockholders) for the use o f
enterprise resources entrusted to it . To the extent that management offers securities of
the enterprise to the public, it vohintarily accepts wider responsibilities for
accountability to prospective investors and to the public in general (CON 1150);
1 .5.-Financial reporting should provide information about an enterprise's financial
performance -during a period. Investors and creditors often use information about th e
past to help in assessing the prospects of an enterprise . Thus, although investment and
credit decisions reflect investors' expectations about future enterprise performance ,
those expectations are commonly based at least partly on evaluations of past enterpris e
performance (CON 17 42);
48384 175 1 .6. Financial reporting should be reliable in that it represents what it purports to represen t
That information should be reliable as well as relevant is a notion that is central t o
accounting (CON 2 7158-59);
1 .7. Completeness, which means that nothing is left out of the information that may b e
necessary to insure that it validly represents underlying events and conditions (CON 2 1
79); and
1 .8. 'Conservatism be used as a prudent reaction to uncertainty to try to ensure that
uncertainties and risks inherent in business situations are adequately considered. The
best way to avoid injury to investors is to try to ensure that what is reported represent s
what it purports to represent (CON 2 IN 95, 97).
419. The SEC's former Chief Accountant, Lynn Turner, remarked in a May 18, 200 1 speech that ". . . the staff wants to be very clear that if events occurring subsequent to th e acquisition result in impairment . . . an impairment charge should be recorded in the appropriat e period." (Emphasis added.) Clearly, the Company's knowledge of the 'gross overstatement of value both prior and subsequent to consummation of the Merger, as well as deteriorating marke t conditions and Company . performance, should have caused it to evaluate and write down the goodwill in the quarter ended March 31, 2001, and continue to do so in subsequent quarters t o reflect the real value of goodwill.
420. Further,.the undisclosed adverse information concealed by Defendants during th e
Class Period is the type of information which, because of SEC regulations, regulations of th e national stock exchanges and customary business practice, is expected by investors and securitie s analysts to be disclosed and is known by corporate officials and their legal aid financial advisors to be the type of information which is expected to be and must be disclosed.
48184 176 421 . On August 14, 2001, the Company's SEC Form 10-Q for the quarter ended rune
30, 2001 described changes in accounting standards for goodwill :
[t]hese standards change the accounting for business combinations by . . the prospective use of pooling-of-interests accounting and requirin. prohibiting g companies to stop amortizing goodwi ll and certain intangible assets with an indefinite useful life created by business combinations accounted for using the purchase method of accounting. Instead, goodwill and intangible assets deemed to have an indefinite useful life will be subject to an annual review for impairment. The new standards generally will be effective for AOL Time Warner in the first quarter of 2002 and for purchase business combinations consummated after June 30, 2001 . AOL Time Warner is in the process of quantifying the anticipated impact of adopting the provisions of FAS 142, which is deemed to be significant.
Upon adoption, AOL Time Warner will stop amortizing goodwill, including goodwill in the carrying value of certain investments accounted for under the equity method of accounting. Based on the current levels of goodwill, this would reduce amortization expense and, with respect to equity investees, it would reduce other expense, net, by approximately $5.3 billion and $600 million, respectively. Because goodwill amortization is nondeductible for tax purposes, the impact of stopping goodwi ll amortization included- in the carrying value of equi ty investees would be to increase AOL Time Warner's annual net income by approximately $5.9 billion. In addition, AOL Time Warner is in the process of evaluating certain intangible assets to determine whether they are deemed to have an indefinite useful life. As a result of this process, AOL Time Warner may stop amortizing an additional $25 billion to $40 billion of intangible assets. This could result in an additional reduction ofpretax amortiza tion of approximately $1 .0 billion to $1 .5 billion, which will have a corresponding after-tax increase in AOL Time Warner's net income of 600 to $900 million.
(Emphasis added.)
422. AOL Time Warner's representation that earnings would increase under the "new" accounting requirements for goodwill, FAS 142, by the amount of $5 .9 billion was materially misleading and omitted material facts because AOL Time Warner was well aware that th e goodwill figure was grossly overstated. The goodwill should have been adjusted due to it s impairment before 2002, thereby greatly reducing the "plug figure" of goodwill that was far in excess of the goodwill's true value. The required "impairment" test would have instantly
48184 177 revealed that an impairment loss had occurred which required reporting in the first quarter of
2001 and in the succeeding quarters to reflect the over-valuation of goodwill .
423. On January 7, 2002, Business Wire reported:
Effective January 1, 2002, all calendar year companies will be required to adopt the new accounting standard "Goodwill and Other Intangible Assets" ("FAS 142"). FAS 142 eliminates amortization of goodwill and other intangible assets with indefinite lives, which is expected to reduce AOL Time Warner' s annual amortization by over $7 billion.
FAS 142 provides new measurement techniques for goodwill and other intangible assets resulting from business combinations . While its revaluation has not been completed, the Company said it expects to record a one-time, non-cash charge in its income statement for the first quarter of2002 in the 0-$60 billion range to reflect overall market declines since the AOL Time Warner merger was ,announced in Jana of 2000. This charge wi ll reflect the cumulative'effect of adopting, the accounting change and does not affect the Company's operations.
(Emphasis added.)
424. In the Company's 2001 SEC Form 10-K, for the year ended December 31, 2001 , the Company stated that it would be implementing FAS 142,'which superseded FAS 121, in the first quarter of 2002 . FAS 142 requires an annual test for impairment in addition to interim test s similar to FAS 121 . AOL-Time Warner stated:
As a result of this initial review for impairment, AOL Time Warner expects to record a one-time, non-cash charge of approximately $54 bi llion upon adop tion of the new accounting standard in the first quarter of 2002. Such charge is non- operational in nature and will be reflected as a cumula tive effect of an accounting change.
(Emphasis added.)
425. Under GAAP, AOL Time Warner could not wait until the first quarter of 2002 to record any impairment of goodwill . In so doing, it improperly took advantage of a prospectiv e change in accounting principles under FAS 142 to avoid a charge against operating income.
Under the prior accounting directive (FAS 121) that, as discussed above, should have been
48184 178 applied to the Company' s financial statements for the fiscal quarters and the year ended
December 31, 2001, the impairment would have been charged to operating income.
426. - The first impairment was ultimately reported in the Company's March 31, 2002 --
SEC Form 14-Q (filed on May 5, 2002) when AOL Time Warner announced, as reported by the media, "the largest write-down in history." This write-down reduced the Company's value b y
$54 billion in a massive charge against assets in its 2002 first quarter financial report, and left a substantial remaining goodwill amount reported by the Company in the Form 1O-Q. The
Company represented in the Form 10-Q that the write-down of goodwill "is reflected as a cumulative'effect of an accounting change...."
427. The impairment, however, was neither caused by nor the result of new accountin g regulations because the "old" accounting standard clearly required the same action, but at a n earlier date. By ignoring the application of FAS. 121 (the "old" accounting directive), AOL Time
Warner did not acknowledge the immediate issue that the deal was improperly valued at th e
Merger date due to the artificially inflated advertising revenue, and thus the purchase price wa s improperly calculated and recorded .
428. The Company's write-down,of goodwill in the first quarter of 2002 wa s insufficient, resulting in a continued overstatement of goodwill value. Indeed, the Company's
SEC Form 1 il-Q for the quarter ended March 31, 2002 wrote down goodwill in the amount of
$54 billion, reducing outstanding goodwill to a reported $80.178 billion. The Form. 10-Q also stated:
The accompanying consolidated financial statements are unaudited but, in the -opinion of management, contain all the adjustments (consisting of those of a normal recurring nature) considered necessary to present fairly the financial position and the results of operations and cash flows for the periods presented in conformity with generally accepted accounting principles applicable to interim, periods.
48184 179 429. On July 24, 2002, the Individual Defendants (except Keller and Pittman) caused the Company to issue a press release announcing its financial results for the quarter ended June
30, 2002, which did not include a write-down of goodwill .
430. As discussed. above, the pro forma financial statements included as part of AOL' s
SEC Form 10--Ks for the year ended June 34, 2000, and the six month period ended December 31 ,
2000, AOL Time Warner's SEC Form 8-K/A filings on January 26, 2001 and March 30, 2001 , the Company's Merger Registration-Statement and AOL's and Time Warner's Joint Proxy
Statement-Prospectus were materially false and misleading and omitted material facts because :
The pro forma financial statements materially overstated the real fair market value of goodwill ;
b. The pro forma financial statements, failed to disclose that the goodwill was overvalued ; and
c. The useful life of the goodwill created by the Merger was far less than the 25 years represented in the pro forma financial statements. -
431 . Similarly, the Company's financial statements for the quarters ended March 31 ,
2001, June 34, 2001 and September 30, 2001, and the year ended December 31, 2001, and fo r the first fiscal quarter of 2002, as well as the Company's July 24, 2002 press release announcing the Company's 2002 second quarter fi nancial results, were materially false 'and misleading and/or omitted material facts because:
a. The failure to write-down or sufficiently write-down the goodwill, as discussed above, materially overstated the goodwill of the Company and its shareholders' equity,
b. The financial statements and July 24, 2002 press release failed to disclose that the goodwill was materially overstated; -
c. The financial statements did not comply with GAAP P-or fairly present the goodwill of the Company;
48184 - 180 d. The Company's Form 10-K for the year ended December 31, 2001 was not audited in conformity with GARS ; .
e. If the Company had properly written down the goodwill, it would have reported a huge operating loss, rather than the much smaller reported losses, for at least one of the fiscal 2001 quarters as well as for the entire 2001 fiscal year,
f. If the Company had properly written down goodwill in 2002, it would have reported a bigger net loss for the quarter ended March 30, 2402, and when it failed to do so, it would have reported a huge loss for the-second- quarter of 2002;
g: The useful life of the goodwill created by the Merger was far less than 25 years;
h. The Company's announcement that earnings would increase by $5.9 billion in 2002 following the effective date of SFAS 142 was misleading because the goodwill should have been written down in 2001 based on SFAS 121; and
i. The Company's representation that SFAS 142 caused the impairment in the value of outstanding goodwill was false because the prior accounting standard, FAS 121, required the same action, but at an earlier time.
432. The gross overstatement of the true value of goodwi ll created by the Merger an d failure to properly account for the goodwill also constitutes devices, schemes or artifices to defraud the public. Indeed, the overstated goodwill masked the inflated advertising revenue an d the real value of AOL stock and the Company.
I. Defendants' Course of Conduct Is Revealed
433 . On July 18, 2002, The Washington Post published the first of two articles, based on statements of former Company employees and confidential documents, which reporte d allegations that the Company and AOL artificially inflated AOL's advertising revenue, enabling
Defendants to report to the public materially false advertising revenue . The article reported that the Company denied the allegations and quoted from a lawyer retained by the Company :
The accounting for all these transactions is appropriate and in accordance with generally accepted accounting principles . . . . The disclosures in AOL' s financial
48184 181 statements are appropriate and accurate. AOL's statements provide our investors with all appropriate material information about our business.
(Emphasis added.) The article quoted Defendant Ernst & Young as stating that it "stands by its . _ original view that the accounting and disclosures were appropriate."
434. Within hours of the pub lication of The Washington Post article, Defendant
Pittman abruptly resigned from the Company .
435. The second of The Washington Post articles regarding the fraud, published the next day, July 19, 2002, further detailed allegations of prior improper reporting of AO L advertising revenues.
436. On July 24, 2002, the Company acknowledged that the SEC was investigating its accounting practices in connection with AOL's advertising revenue. As The Washington Post reported on July 25, 2402 :
AOL Time Warner Inc. disclosed yesterday that the Securities and Exchange Commission has launched a probe into its accounting practices after ques tions were raised about how the company generated revenue through a series of unconventional deals.
The world's largest media company said that its accounting was proper and that all the transactions were approved by its outside auditor. But its chief executive and chief financial officer vowed to give investors a better understanding of the business, beginning yesterday with more detailed disclosures about its online division, including its advertising and commerce revenue, as part of AOL Time Warner's announcement of second-quarter financial results .
Pace said he is comfortable with the company's accounting and disclosure practices, but he said he wants AOL Time Warner to be "on the leading edge" of disclosures.
(Emphasis added.)
437. On July 25, 2002, the San Jose Mercury News also reported on the Company' s disclosure that the SEC was looking into the Company's accounting practices. The Company's
48184 182 Chief Executive Officer, Parsons; was quoted in the article as stating "In the current environment , any such allegations will necessarily and appropriately draw inquiry from the appropriate regulatory authorities even where, as here, they are without merit ."
438. On July 25, 2002, after AOL Time Warner disclosed that the SEC had launched a civil-investigation into its accounting practices, several Wall Street analysts immediatel y downgraded the Company's stock.
439. Only after the existence of the SEC investigation regarding the imprope r
'recognition of AOL advertising revenue was revealed by the Company did Defendants' improper conduct and its effect become clear to the marketplace. After the Company' acknowledged the
SEC investigation, AOL Time Warner shares declined by 15 .4% to close at $9 .64. Thus, AOL
Time Warner common stock had plummeted in value by more than 77% from its trading price of
AOL common stock at the beginning of the Class Period ($41 .38) to the Company's trading price at the end of the Class Period ($9.64), as adjusted for stock splits and the Merger. The value of AOL Time Warner stock from when it first started trading until the end of the Clas s
Period decreased by 79.9%.
440. On July 31, 2002, the Company confirmed that the DO] had opened a criminal investigation into the Company's accounting practices .
441 . On or about August 9, 2002, the Company fired Defendant Colbum, the President
,of AOL's Business Affairs division, who had reported directly to Defendant Pittman .
442. On August 14, 2002, the Individual Defendants (except Keller, Pittman, and
Colburn) caused the Company to issue a press release, announcing the Company's certification o f its Annual Report on Form 10-K for 2001 and all reports on Form IO-Q, all reports on Form 8-K, all proxy materials and all amendments to the foregoing filed with the SEC subsequent to the
48184 183 filing of its Form IO-IC for 2001 . In that release, the Company noted that it had disclosed in its
SEC Form I 0-Q for the second quarter 2002, which was filed with the SEC on August 14, 2002 , that based on information it claims to have learned in the previous 10 days: 0-
the Company had identified three transactions involving its AOL unit with respect to which the Company may conclude, after further investigation, that consideration received by AOL from third parties may have been inappropriately -recognized as advertising and commerce revenues . The advertising and commerce revenues recognized in connection with-these three transactions totaled approximately $49 million occurring over a period of six quarters .
In the 10-Q filing, the Company noted that it may be necessa ry to restate the results of prior fiscal periods.
443. On October 23, 2002, AOL Time Warner publicly stated that its previously announced financial results for each of the quarters ended' September 30, 2000 through June 30,
2002 were incorrect and had to be restated . For the AOL division, the impact of the adjustments reduced advertising and commerce revenue by $168 million dollars over the eight quarterl y periods. The remaining $22 million dollars represented a reduction in revenues related to AO L in which the advertising was delivered by other AOL Time Warner divisions . The Company also announced that the review ofaccounting for advertising transactions was continuing.
444. On January 12, 2003, at the AOL Time Warner annual shareholder meeting,
Chairman Case announced that he would step down in May, 2003 .
445. On January 20, 2003, A e Wall Street Journal reported:
Veritas Software Corp., Mountain View, Calif.-said it will restate-some financial results to reflect changes in the accounting for two AOL Time Warner Inc_ transactions, which the Securities and Exchange Commission is reviewing. Regulators are looking at whether AOL's America Online Internet business and Veritas had entered into transactions in which they bought products from each .other for legitimate business purposes or whether the deals were simply designed to inflate revenue on both sides.
(Emphasis added.)
48184 194 446. On January 30, 2003, The Wall Street Journal reported:
In an astonishing end to a disastrous year, AOL Time Warner Inc . reported a 2002 net loss of $98.7 billion after taking a fourth-quarter charge of $45 .5 billion, mostly to write down the value of its troubled America Online unit. The write- down, creating the biggest annual corporate loss in history was more than twice what Wall Street had anticipated . AOL also announced the resignation of Ted Turner as vice chairman.
(Emphasis added.)
447. On February 5, 2003, The Wall Street Journal reported :
In an indication that federal authorities are expanding their criminal investigation of AOL Time Warner Inc.'s America Online wu the Federal Bureau of Investigation has sought to question several former PurchasePro.com Inc. officers in the past few weeks.
. . .People familiar with the situation said the Department of Justice and the Securities and Exchange Commission are focusing on America Online and some of its former executives, including Eric Keller and David M . Colbum. These people said the investigation, which was launched last summer, is continuing and prosecutors are expected to decide whether to bring charges later this year . Simultaneously, federal prosecutors in Los Angeles are probing America Online's relationship with Homestore Inc . Several former Homestore officials have pleaded guilty to fraud and are cooperating with prosecutors .
AOL declined to comment.
(Emphasis added.)
448. On March 12, 2003, The Washington Post reported:
The federal investigation of America Online Inc . and two of its former ke executives has been broadened to include alleged "aiding and abetting:'of schemes by other companies to artificially inflate reported revenue, sources familiar with the probe said yesterday.
Federal investigators are scrutinizing the roles that AOL and two dealrnakers David M. Colbwn and Eric Keller, may have played in enabling certain companies, including Homestore Inc., an online real estate firm, to im ro er1 pump up financial results . At the core of the inves tigation, sources said, Securities and Exch ange Commission investigators are ex amining allegtA quid pro qua schemes in which AOL and other companies exchanged cash through
49184 185 sham transactions to falsely boost revenue, both before and after America Online's merger with Time Warner Inc . in January 2001 .
The expansion of the probe increases the potential exposure of AOL Time Warner Inc. and the individuals involved , because the could be found culpable not only for the firm's own accounting irregularities but also for the financial misconduct of others. sources said.
AOL Time Warner has been cooperating extensively with inves tigators in the hope that the company can avoid criminal charges. Still, insiders expect the media giant to face civil sanctions from the SEC.
Investors in Homestore named AOL, Colbum and Keller as defendants in a lawsuit filed last year in California, alleging that the company and its executives made it easier for Homestore to falsify financial results . Last week, a federal judge said she was reluctantly removing the AOL defendants from the case, citing a Supreme Court decision that limits the ability of private parties to seek damages from those who aid wrongdoing rather than perpetrating it themselves .
At the same time, U.S_ District Jude Marsha J. Pechman lashed out at AOL. She noted that the SEC has the ex licit legal authority to brie char es of "aiding and abetting" wrongdoing. "Me acts alleged . . .. which this Court must accept as true for purposes of this motion, describe a massive conspiracy driven by pure avarice," Pechman wrote in her 41-page opinion .
***
While dropping the AOL defendants from the Homestore suit, Pechman said they remain in the cross hairs of a federal probe.
"This decision does not mean that the wrongs of these aiders and abettors will necessarily go unchecked : the law expressly ted the SEC the authori to bring civil actions against aiders and abettors of securities fraud, and it is this Court's understanding that some investigation is on oin " she wrote.
(Emphasis added.)
449. On March 28, 2003, the Company reported that it might have to restate as much as an additional $400 million in AOL advertising revenue as a result of transactions with
Bertelsmann AG that were part of the SEC's investigation. At the same time, the Company
48184 186 acknowledged that further restatement may be necessary with respect to other transactions being investigated by the SEC and DOJ.
450. On April 1, 2003, Reuters reported that Gateway "would delay filing its 2002 annual report by up to 15 days because of plans to restate 2000 and 2001 revenue and costs o f goods sold as it reviews transactions with AOL."
J. Scienter of The Individual Defendant s
451 . The history of AOL is that they have pushed the envelope ever since Steve Case has been running the Company . The first time I wrote about AOL accounting'was back in 1996 and then they were fessing up to playing accounting games in the years before that. They were hiding expenses just like WorldCom so that they could look profitable . They came clean, they straightened things out, Steve Case gave a speech back then in which he promised gold standard accounting. Three months later, he had to restate earnings again. There's a long history of this .
Jerry Knight, The Washington Post financial reporter, guest on CNBC television program Kudlow & Cramer, Jan . 21, 2003 .
The Individual Defendants Knew, or Recklessly Disregarded, that AOL and AOL Time Warner Were Engaged in Fraud and Were Motivated to Use and Cover Up the Use of Improper Accounting and Sham Tran sactions to Artificially Inflate Advertising Revenue
452. As alleged herein, the Individual Defendants acted with scienter in that they knew , or recklessly disregarded, that the public documents and statements issued or disseminated in th e name of AOL and AOL Time Warner were materially false and misleading and omitted material facts; were aware that such statements or documents would be issued or disseminated to th e
investing public; and knowingly, or recklessly, participated or acquiesced in the sha m transactions and improper accounting practices which led to the issuance or dissemination of such statements or documents .
453. The Individual Defendants as a group, and separately , either knew, or recklessly
disregarded, the false and misleading statements or material omissions referred to above. The
48184 187 types of accounting fraud engaged in during the Class Period were similar to earlier activit y engaged in by AOL. Notwithstanding prior SEC actions against AOL, AOL and AOL Time
Warner maintained a culture of arrogance and greed geared solely toward maximizing reporte d advertising revenue of AOL, inflating the value of AOL and the Company's stock, and ensuring the consummation of the Merger. In addition, the Individual Defendants had both motive an d opportunity to engage in the fraudulent activities Plaintiff alleges.
a. The Individual Defendants Were Actively Engaged in the Company's Daily Activities Such That They Were Aware Of, Recklessly Disregarded Controlled and/or Culpably Participated in the Fraudulent Activities of the Business Affairs Division
454. The organizational structures at AOL and AOL Time Warner were such that the companies ' improper dealmaking and accounting practices, as well as the downturn in AOL's advertising business, were known, or were recklessly disregarded , at the highest levels of AOI , including Stephen Case, its Chairman.
455. As a founder of AOL, its Chairman and Chief Executive Officer, and Chairman of
AOL Time Warner, Case had access to all significant corporate information possessed by th e two companies. In addition, all of the key participants in the transactions at issue reported either directly or indirectly to Case . According to a former Senior Manager in AOL's Interactive
Marketing division , David M. Colburn and Robert Pittman reported directly to Case at AOL.
456. According to a former AOL Vice President for business development, AOL's
"Operating Committee" or "Op Corn", consisting of nine top members of senior management chaired by Pittman, held weekly meetings to discuss matters of importance to the company . As a result of these weekly meetings, the Operating Committee knew about the "BA Specials", the restructuring of advertising deals for failing dot-corns, and the downturn in AOL's advertising business. Members of the Operating Committee during 2000-2001 included, among others,
48184 - 188 Defendants Pittman , Colbum and J. Michael Kelly. Case had the authority to sit in on the
Operating Committee's meetings.
457. As President and Chief Operating Officer ofAOL and Co-Chief Operating ,
Officer of AOL Time Warner, Robert Pittman was privy to all significant financial and
operational information at the two companies . According to an Advertising Age article dated
May 7, 2001 entitled , "Crunchtime; Bob Pittman is Promising the World . AOL Time Warner
Better Deliver," Pittman was deeply involved with AOL's and the Company's advertising
business. He admitted to being the "Account Executive" on the biggest accounts and to fielding
client calls at home after hours . In addition, Pittman was one of Colbum's primary mentors,
promoting Colbum several times. According to The New York Times, Pittman promoted Colburn
to the head of the Business Affairs unit at AOL and at AOL Time Warner and personally worked
to support Colburn's efforts to push through the combined Company's major advertising deals,
including the agreement to sell advertising from both the AOL division and Time Warner t o
WorldCom .
458 . According to The Washington Post, David M. Colbum, who ran the Business
Affairs division, reported to Pittman, who reported directly to Case . In addition, Colburn is
reported to have been particularly close to Pittman . Colburn was heavily involved in all of the
transactions at issue in this Complaint-he reviewed and signed off on all deals . In addition to
his hands-on involvement with the subject deals, according to numerous witnesses and press
accounts, Colburn was also a major force in instilling the culture of greed and arrogance that
drove others within the companies to make sham deals or to take steps to engage in and cover up
the improper accounting used in connection with-the deals .
48184 189 459. J. Michael Kelly served as Executive Vice President and Chief Financial Office r for AOL Time Warner and Senior Vice President and ChiefFinancial Officer for AOL. Kelly joined AOL in June 1998, and as its Chief Financial Officer, was the executive most directly responsible for the accuracy of the Company's accounting. According to AOL Time Warner executives, as reported in The New York Times article dated September 1, 2002 entitled "Ouster at AOL, but Where Does Trail End?," it was Colburn's job to try and do everything possible to post strong results , and Kelly's job to stop him at the limits of accounting rules . As Chief
Financial Officer, Kelly signed off on all of AOL and AOL Time Warner's major advertising deals and its financial reports until December 2001, when he was demoted to Chief Operatin g
Officer of the AOL division.
460. Every advertising deal was reviewed and signed off by Colburn. A former account manager in the account services unit of AOL's Interactive Marketing division stated tha t for big advertising deals, Meyer Berlow, Barry Schuler or Defendant Pittman also signed off.
According to the former employee, the bigger the deal the more significant the list of peopl e signing off on the deal. In anAdvertising Age article dated May 7, 2001, Pittman noted, with regard to crossmedia advertising deals : "We generally do these issues at the COO or CEO leve l within the Company ."
461 . Eric Keller, a Senior Vice President in the Business Affairs Division an d purported number two dealmaker to his boss Colburn, was deeply involved in the creation an d execution of the Company's advertising transactions, including the Homestore and PurchasePro stock warrant deals.
462. Joseph Ripp, as Executive Vice President and Chief Financial Officer of AOL Inc.
(the online subsidiary of AOL Time Warner), had access to and was involved with .financial
48184 190 matters relevant to the transactions. In August 2001, Ripp along with Steven Rindner, a Senior
Vice President in AOL's Business Affairs and Development division, took over hand ling the sham transactions with Homestore on behalf of the Company.
463 . Within Business Affairs, Keller and Rindner, as Vice Presidents, reported directl y to Colburn who signed off on all deals emanating from that division .
464. Since November 2001 Wayne Pace has served as Executive Vice President and
Chief Financial Officer of AOL Time Warner. In this capacity, he played a pivotal role i n driving value creation across AOL Time Warner and has overseen all of the Company's finance functions, including tax, financial planning, mergers and acquisitions, treasury, accounting and capital allocation. He has made numerous statements regarding the strength of the Company' s advertising revenue despite knowledge that such revenue was materia lly overstated. As Kelly' s successor, Pace took on Kelly's responsibilities and involvement in the Company .
465. Upon the Merger Date, Novack became Vice Chairman of the Company . As a member ofthe Office of the Chairman, he provided strategic counsel and handled special assignments for the Chairman, and assumed a leading role in major corporate transactions- including taking a leading role in AOL's joint venture with Bertelsmann. Formerly the Vic e
Chairman of AOL and a Director, Novack played a number of critical roles at that company. In addition to broad strategic responsibilities, he oversaw AOL's Legal Department, as well as
AOL Investments, and was a key architect of the Merger between AOL and Time Warner. Prior to joining AOL, Novack was outside counsel to the company.
466. Gerald Levin, as Chairman and Chief Executive Officer of Time Warner and
Chief Executive Officer of AOL Time Warner, had access to any and all corporate informatio n possessed by the two companies. Levin was one of the primary driving forces behind the Merger .
48184 191 After the Merger, Levin made numerous misrepresentations regarding the Company's financia l prospects and overruled internal efforts to disclose the true nature of the Company's advertising revenues.
467. As set out in detail below, the Individual Defendants were aware that AO L advertising revenue was artificially inflated through sham transactions and improper accountin g and that the advertising market was in a major downturn through regular company report s tracking such revenue and several whistleblowers communica ting such issues to senior management.
468. The Individual Defendants were insiders who were engaged in active daily role s at the companies and were involved with or were aware of the relevant transactions at issue i n this Complaint. Through their collective efforts, the companies issued pub lic filings, press releases, and other group-published information containing false and misleading information.
469. Even in cases where Defendants were not personally engaged in such transactions, they knew, individually or as a group, of the existence of improper accounting and eithe r approved of it or failed to act to prevent it despite their ability to control the actions of the ke y dealmakers.
470. As set forth elsewhere herein in detail , the individual Defendants, by virtue of their receipt of information reflecting the true facts regarding AOL and AOL Time Warner, their control over, and/or receipt and/or modification of AOL's and AOL Time Warner 's allegedly materially misleading misstatements and/or their associations with the AOL and AOL Tim e
Warner which made them privy to confidential proprietary information concerning AOL and
AOL Time Warner, participated in the fraudulent conduct alleged herein .
48184 192 b. The Nature of the Accounting Improprieties and Sham Transaction s
471 . Many of the subject transactions involved actions that demonstrate intentiona l misconduct as the actions had no legitimate business purpose in AOL and AOL Time Warner' s business other than to hide the true nature of the transactions so that advertising revenue could b e artificially inflated. For example, in the fraudulent Homestore deals, Defendants set up sixtee n separate sham transactions in which the two companies generated bogus advertising revenu e through the use of three-legged "round-trip" deals involving third parties. . As part of the deal s
Defendants agreed with Homestore executives not to document the secret leg of the sha m transaction in order to avoid their detection .
472. As set out more completely above, Keller was the architect of sixteen separat e sham transactions with Homestore--all approved by Colburn-in which the two companies generated bogus advertising revenue through the use of three-legged "round trip" deals involvin g third parties . Once the deals were in effect, Keller worked with Homestore's top dealmaker ,
Peter Tafeen, in May 2001 to avoid detection by Homestore's auditing firm of the sham deals that were to take place in the second quarter 2001 . Keller and Colburn also agreed with
Homestore executives not to document the secret leg of the sham transaction in order to avoi d detection. In addition, Keller was directly involved in the fraudulent Homestore-House and
Home Deal in 2000 .
473. With the end of the 2001 second quarter rapidly approaching, Ripp and Rindner participated in a conference call with Homestore CEO Stuart Wolff on June 29, 2001 and agreed to carry on with the sham transactions despite their knowledge that the deals were corrupt. By doing so, they were able to allow AOL Time Warner to inflate advertising revenue and avoid
48184 193 negative publicity for both AOL Time Warner and Homestore, in which AOL Time Warner ha d
a significant equity interest.
474. Similarly, Defendants' activities with regard to the PurchasePro warrants deal did
not serve any legitimate business purpose and shows intentional misconduct . That deal, which
according to The Washington Post was referred to as "science fiction" by Colburn, involved a
purported revision of the terms of AOL's equity interest in PurchasePro, and AOL and the
Company fraudulently accounted for the transac tion by reporting $27.5 million in advertising
revenue.
475. Keller was involved with the PurchasePro transaction in which AOL received
PurchasePro stock warrants in exchange for distribu ting PurchasePro software. According to
Charles E. Johnson, Jr., PurchasePro's CEO as reported by The Washington Post on July 19,
2002, "[tjhe warrants had nothing to do with ad revenue. They were directly related to selling
our marketplace software to our customers, supp liers and partners ."
476. Other types of fraudulently accounted for deals involved "round-tripping",
"jackpotting", conversion of settlement proceeds into advertising revenue, improperly booking
revenue in cases where AOL acted as an advertising broker, converting contract termination fees
from failing dot-corns into advertising revenue, and double-booking of advertising revenue
obtained in cross-platform deals .
477. In a classic "round-trip" transaction negotiated in 2000, AOL paid Veritas $50
million for $30 million in software. Veritas, in turn, used the excess money paid by AOL to purchase $20 million in AOL advertising. The Gateway deal also involved "round-tripping."
Both Gateway and Veritas have since restated their revenues based on the improper accounting involved in their transactions with AOL demonstrating the fraudulent nature of the deals .
48184 194 478. By its "jackpotting" practices, AOL would run inordinate, and wholly ineffective, amounts of advertising in the final few days before a quarter ended so that it could meet th e number of advertising impressions required to realize all of the advertising revenue in tha t quarter. Such behavior, which made no sense from an advertising or business standpoint, wa s only done to commit fraud and produce improperly inflated advertising revenue .
c. Whistleblowers Provide Further Evidence of Individual Defendants' Knowled e
479. Several AOL and AOL Time Warner whistleblowers raised concerns with uppe r management, including Pittman, about the propriety of the accounting methods being engaged i n by the Company with regard to advertising revenue only to be dismissed for their efforts . Some of these concerns were raised and summarily dismissed during the pendency of the Merger that the Individual Defendants so badly wanted to be effectuated . The Individual Defendants, particularly Case, Pittman, Kelly, Pace and Levin, in company press releases, continued t o misrepresent to investors critical information relating to advertising revenue with full knowledge that investors were relying heavily on such information.
480. Numerous employees questioned the improper recognition of the advertisin g revenue alleged herein, raising the matter with senior management. According to the July 18 ,
2002 Washington Post article entitled "Unconventional Transactions Boosted Sales: Amid Big
Merger, Company Resisted Dot-Corn Collapse" Robert O'Connor outlined his concerns in a series of meetings in 2001 and 2002 with Pittman, Colburn, Kelly and other AOL executives.
According to O'Connor, "Clearly, a lot of what they were living on was revenue that was not o f the highest quality. I don't know if they're still in denial, but there was some pretty big busines s issues they were not willing to face. For nine months I tried to get these guys out of denial. I
49184 195 tried to take the perfume off the pig ." O'Connor also told Company officials at some point that he was concerned that AOL's accounting practices might lead to another SEC investiga tion.
481 . According to the July 18, 2002 Washington Post article, another former employee, James Patti, a senior manager in AOL's business affairs division told senio r executives he was uncomfortable with some of the AOL advertising deals . He was laid off shortly thereafter in 2001 even though he bad recently received a merit promotion . Patti said he believes that his job termination was directly related to his unwillingness to go along with the advertising deals. Patti said, "I had been asked to paper many of these questionable deals an d was unwilling to cooperate, making my concerns known to management," and that "[t]he layoff came exactly one week later . Ultimately, f was happy to leave the company with my integrity and professional ethics intact ."
482. Recognizing that falling advertising rates would produce an inventory problem- i .e., AOL would be forced to sell so many additional ads to meet revenue targets that it woul d run out of space to post additional ads-Robert O'Connor warned Company executives that thi s would create a fundamental business problem . Told that he was not a team player, O'Connor left the Company on March 29, 2002 without negotiating a severance package because he was n o longer comfortable working in an environment where officials did not want to hear about interna l business issues. According to O'Connor, as reported in the July 19, 2002 Washington Post article entitled "Creative Transactions Earned Team Reward:" "Not only were they not willing to get out of denial, now they were going to actually punish those who were going to even rais e issues."
483. Berlow, President of Interactive Marketing, commented on O'Connor in a March
8, 2042 e-mail obtained by The Washington Post. The e-mail, sent to Barry Schuler, at the time
48184 196 President of AOL's Interactive Services Group, noted that "[t]he only reason you know that there is an inventory problem is that Bob [O'Connor] continued up the ladder with the inventor y problem (Bobby-Ripp-Kelly-Mayo) and shot his career out the window." Berlow was referring to Robert Friedman, then head of AOL's interactive marketing division ; Defendant Joseph A.
Ripp,,Chief Financial. Officer of the AOL division of the Company ; Defendant J. Michael Kelly, the ChiefOperating Officer for the AOL division; and Mayo Stuntz , Jr., executive vice president of AOL Time Warner's cross divisional ini tiatives.
484. Soon after the Merger, Individual Defendants boldly projected a quick 30 percen t profit increase. Defendants took this position despite fierce internal opposition from Joa n
Nicolais, Time Warner's chief contact with Wall Street . According to a December 9, 2002
Newsweek article entitled "How it All Fell Apart," one top executive stated that Nicolais criticized AOL's approach as "basically an elaborate spin machine. . . . She didn't think the numbers added up ."
d. The Prior Pattern of Improper Accountin Practice s
485. As noted in detail above, AOL has an extensive history of having engaged in, an d been disciplined for, accounting improprieties by the SEC. Past SEC investigations of and
actions against AOL occurred between 1997 and 2000 . On May 15, 2000, the SEC issued a
Cease and Desist Order against AOL requiring it to comply with accounting rules and the securities laws. AOL agreed to comply with the Cease and Desist Order . In the same SEC action, the SEC fined AOL $3 .5 million, the largest fine ever assessed at the time, and required
AOL to restate its financial statements for 1995-97.
486. As a result of the multiple SEC actions, the Individual Defendants were well aware of the importance of proper accounting and in fact Case had pledged to adopt "new gold-
48184 197 standard accounting practices ." Despite this knowledge, the Individual Defendants continued t o intentionally ignore or recklessly disregard applicable accounting regulations and the securitie s laws.
e. Defendants' Restatement of AOL's Advertising-Revenue- and GAAP Violations Provide Evidence of Scienter
487. Defendants' GAAP violations, as presented in detail above, were not technical violations of esoteric accounting rules, but conduct violative of basic GAAP principles that further demonstrates the Individual Defendants' dishonesty .
488. Since the filing of the initial complaint, the Company has admitted that improper accounting occurred over at least eight consecutive quarters with respect to almost $200 million of advertising revenue. The biggest quarterly period of artificially inflated advertising revenu e that the Company has admitted, $66 million, was for the quarter that commenced just one month after the SEC issued the Cease and Desist Order and imposed a $3 .5 million civil penalty against
AOL.
489. By issuing a restatement over eight consecutive quarters of almost $200 million i n advertising revenue, AOL Time Warner has admitted that its publicly-issued financial statements for each of the restated periods were not prepared in conformity with GAAP, and that AOL Time
Warner materially misstated its financial condition and results of operations. Under GAAP, the restatement of previously issued financial statements is reserved for circumstances where no lesser remedy is available . Under APB 20, Accounting Changes, restatements are only permitted, and are required only to correct material accounting errors or irregularities that existed at the time the financial statements were originally prepared and issued.
490. The restatement of a company's previously issued financial statements becomes necessary when it is discovered that previously issued financial statements contained errors o r
48184 198 irregularities in accounting which caused them to be materially misstated . Such misstatements can be the result of errors or fraud, and once discovered, the company is obligated to notify al l parties who may rely on the previously issuedfinancial statements that they should no longer place reliance thereon. The restatement of a company's previously issued financial statement is , in fact, an admission that such financial statements contained material misstatements that-caused them to be misleading to the reader.
f. The Individual Defendants'Awareness of Improper Deals and Continued Denial of Any Wrongdoing After the Truth is Revealed
491 . After the Company's accounting improprieties were revealed by The Washington
Post, the Individual Defendants admitted knowledge of the suspect deals but arrogantly denie d any wrongdoing. Only after the allegations persisted and the SEC and DOJ investigation s became public, did the Defendants acknowledge any wrongdoing .
492. According tone Washington Post July 18, 2002 article, a lawyer hired by the
Company responded : "The accounting for all of these transactions is appropriate and in accordance with generally accepted accounting principles . The disclosures in AOL's financial statements are approp riate and accurate. AOL's statements provide our investors with all appropriate material information about our business." The attorney added that The Washington
Post's investigation was "not only grossly unfair and unwarranted in light ofthe exhaustive facts we have presented to you, but is also reckless in the current highly-charged environment ."
493 . Within weeks of making these fervent denials, Pittman resigned, Colburn was fired and locked out of his office, and the Company disclosed that government agencies wer e conducting civil and criminal investigations into their accounting practices and that the Compan y
-itself was conducting an internal investigation of its accounting practices. As a result of this internal investigation, the Company has thus far restated its advertising and commerce revenue i n
48184 199 the amount of $190 million for the eight consecutive quarters ended September 30, 2000 throug h
June 30, 2002 . The government's investigations are ongoing and reportedly were recentl y broadened in scope. Most recently, the Company announced that it may further restate AO L
advertising revenue by reducing it in an amount of up to $400 million for 2001 and 2002 as a result of the SEC's investigation into the Bertelsmann AG transactions .
2. Motive and Op ortunity of the Individual Defendants to Engage in Improper Accounting, Sham Transactions and Reporting of Inflated Advertising Revenue
a. Salaries, Bonuses, Stock Sales -The Culture of Greed Begin s
494. Throughout the Class Period, the Individual Defendants all shared an overridin g motive to enrich themselves through the considerable wealth that flowed to them from thei r
generous salaries and bonuses and the sale of stock at inflated prices. During the Class Period, this motive became increasingly focused on the Merger between the two companies, the so-
called "deal of the century." Prior to the Merger, Individual Defendants engaged in fraud t o
inflate AOL's stock price and to initiate the Merger and ensure its ultimate consummation, alon g with the corresponding acceleration of vesting of stock options and lifting of restrictions o n restricted stock. After the Merger, the Individual Defendants engaged in fraud to keep the illusion of growth, profitability and synergy of the merged entity alive-rand, correspondingly , keep the stock price up . After the Merger, the Individual Defendants also recognized that if th e merger turned out to be a failure or was even perceived as such, they would be faced wit h removal from their positions of power and access to corporate riches . In the end, this became the reality for Individual Defendants Case, Levin, Pittman, Colbum and Keller. Such short- sightedness and greed helped to produce the facts that are the subject of this Complaint .
48184 200 495 . Faced with these motivations and the knowledge of a general downturn in the advertising market and a specific decrease in AOL advertising revenue, especially as a result o f dot-corn failures, Defendants, individually and as a group, were highly motivated to engage i n improper accounting and sham dealmakiug to inflate advertising revenue at the companies .
h. The Shift to Fiat Rate Pricing and the Increased Importance of Advertising Revenue to AOL's Bottom Lin e
496. Partly as a result of increased competition, in December 1996 AOL dropped its pay-by-the-hour method of charging subscribers and adopted a "flat-rate" pricing plan.
497. Following the introduction of the flat rate plan for the AOL subscriber service in
December 1996, the company experienced a significant decline in its profit margins for revenu e flowing from usage of its online service. As AOL began seeing its subscription revenue for the online service drop, the company looked for ways to increase advertising revenue .
498. The growth of higher margin advertising revenue became increasingly importan t to AOL's business objectives. Advertising revenue grew in importance as the company continued to leverage its large, active and growing user base . For fiscal years 1997, 1998, an d
1999 AOL reported advertising and commerce revenue of $147 million, $358 million, and $765 million, respectively. Advertising was the fastest growing part of AOL's business.
499. AOL's SEC Form 10-K for the fiscal year ended June 30, 1997, described th e importance of advertising revenue to AOL's success:
An important component of the company's business strategy is to increase nonsubscription based revenues, including from advertising sales and transaction fees associated with electronic commerce, and the sale of merchandise, which the company believes are increasingly important to its gEpwdi and success . The company continues to establish a wide variety of relationships with advertising and electronic commerce partners in order to grow its non-subscription based revenues and to provide AOL subscribers with access to a broad selection of competitively priced, easy to order products and services .
48184 201 (Emphasis added.)
500. Beginning at least as-early as mid-1998, many of these alliances and partnerships
enabled AOL, and later AOL Time Warner, to artificially inflate revenue through, among othe r
means, the use of improper accounting practices regarding "pound-trip" and barter transactions .
This was accomplished, in large part, through the emergence of AOL `portal' deals described in
detail above.
501 . According to a former AOL Chief Technology Officer, Product Manager and
Senior Business Manager, as AOL became a portal with an increasing number of mi llions of
subscribers, the company had more power to demand what it wanted . It insisted that some of its
advertisers and content providers give AOL performance warrants or shares of their companies
for as little as a penny a share .
502. According to the same source, AOL used creative accounting when the company began charging other companies for exposure to its subscribers .
c. A Culture of Recklessness and Gree d
503. The explosive growth in advertising revenue at AOL, brought about in large pa rt by the fraudulent accounting and dealmaking of the Business Affairs division, elevated tha t division's and Colbum's importance at the company. As subscription revenues fell, advertisin g growth was the only way the company could sustain its sky-high stock prices and ensure th e company's long-term viability . The inflated stock value allowed AOL employees to becom e increasingly wealthy as a result of stock options and large salaries. The Individual Defendants ' desire to maintain such wealth created a culture that expected and rewarded improper deal- making in AOL's Business-Affairs unit through the use of a mix of lavish perks and financial rewards and the threat of verbal abuse .
49184 202 504. For example, a September 1, 2002 New York Times article entitled "duster at
AOL, but Where Does the Trail End?" reported that Pisan "lavishly rewarded executives who did meet their quarterly goals." The article proceeds to note that Colburn earned enough fro m
AOL stock options to hire popular music groups `N Sync and the Dave Matthews Band to play at parties for his children.
505. Colburn, as the leader of the Business Affairs division, has been described as a
"larger than life figure." The Washington Post, in a July 19, 2002 article, described Colbum' s tactics as follows :
He burnished his imposing reputation on Sundays at 9 a.m. on the regulation basketball court outside his large, clapboard and stone country-style house in Potomac.
There, he gathered his loyalists-a group of deal makers who wanted to move up the corporate ladder. Attendance was de rigueur. What he taught his disciples was his way of playing sports-and doing business . He played a ferocious game, breaking down his opponents with rough elbows, blatant fouls and name-calling, attendees said .
"It's the way he gets people to love him and fear him," said an AOL official. "You don't go to play, you go there to be abused ."
Colbum could be rougher on his troops at work, said several sources, many of whom declined to speak for attribution for fear- it would hurt their career or jeopardize their benefits .
Once Colbum beckoned Ted Rogers, then a new member to his team- and a former Washington Redskins player and gave him a dressing down outside AOL's fifth-floor boardroom during a meeting of "Op Com," the operating committee of senior executives, chaired by Pittman .
Witnesses said Colbum screamed at Rogers for a paperwork mistake- getting the wrong AOL executive's signature on a particular deal . The berating became water-cooler legend : If Colburn could decimate Rogers, a 250 pound, 6- foot-2 112 former linebacker, what about the rest of his crew?
*** Every couple of weeks, AOL sources said, Colburn would pick other people, poke fun at them, yell at them, break them apart, and build them back up.
48184 203 "He'd put an arm around you, and say, `Things are going to be all right, I really love you,"' said an AOL source. "He'd say a kind word, and it'd make your day. It's like an abusive father."
Colburn also bestowed financial rewards on his minions . He would send favored underlings and their spouses on weekend getaways to places like New York, all expenses paid, including limousine service and lavish dinners, AOL sources said.
Colburn helped decide who got stock options, another powerful incentive to keep employees in line, especially when AOL shares were on the rise, sources said. During the height of the Internet boom, employees recalled logging on to their computers in the morning, checking their portfolio and staring in amazement at their growing assets.
"It was like, `Tow, I just made a few thousand dollars just by sleeping,"' said an AOL official .
But in exchange for such largess, Colburn demanded loyalty, AOL sources said, and .never was that more clear than when AOL was at the pinnacle of its power.
"He created these foot soldiers who went to war for him," said an AOL source. "These were heady times ."
506. Colburn's efforts to create loyalty in his Business Affairs division were successful.
As described in the Industry Standard article "AOL Rough Riders" dated October 30, 2000 :
[Colbum] has a posse of imitators at AOL who show up at work dressed in Hawaiian shirts and needing a shave. They'll plunk a pair of cowboy boots up on the table during a meeting no matter who's present because that's somethin g Colburn would do . Some even borrow his strange accent. "Every guy working on deals inside AOL wants to be just like Colburn," [ex-AOL dealmaker Phillip] Zakas says . "So you'd have these people walking around trying to sound like Colbum: `If you don't sign this deal, you're f*#ldng crazy; this is a great deal.' That kind of stuff happened all the time even though it was frowned upon-unless of course it was Colburn or a vice-president, because they .had the charisma to get away with it."
507. In January 2000, when AOL announced its anticipated merger with Time Warner,
Colburn's Business Affairs division was at the height of its power, making huge deals with start- up Internet companies desperately seeking the type of business legitimacy that only AOL could
48184 204 offer them. The Business Affairs division' s successes enriched those in the division and employees throughout the Company. The Washington Post reported on July 19, 2002 :
The transactions, in turn, helped enrich AOL. Everyone, it seemed, was becoming an instant millionaire at the company's Dulles headquarters . There were a lot of Ferraris . And twenty somethings and secretaries retiring with seven- figure bank accounts after a few years on the job, thanks to the incredible windfall from stock options .
At business affairs, almost anything seemed possible . Hard work begot wealth. Wealth begot parties. And parties, on occasion, became part of that work .
That included a spontaneous excursion from Dulles to San Francisco by a handful ofAOL officials on the corporate jet. They called it a "team-building trip.lp,
It took place in the Gold Club topless bar on Howard Street, said sources who were present, and both men and women from AOL attended.
"The lavish parties, the crazy antics-it really socialized you," said another AOL source. "You had to toe the line ."
508. The importance of the Company's stock price was instilled in every facet of corporate culture at AOL and AOL Time Warner. For example, according to. a former employee, even securi ty issues were presented in terms of stock value . At a security session, AOL's head of security, a former FBI agent, began his presentation by saying "Everything we do around her e is related to one word ." Then he stopped and wrote on the blackboard the word "stock" H e then went on to explain that "the main reason to practice good corporate security was .that security leaks and problems could affect AOL's stock price."
509. On a monthly basis, Colburn would present `Sammy Awards"-to the to p performers of the 100 or so employees of AOL's Business Affairs division. A takeoff on television's Emmy awards, the Bammys were presented by Colbum to those employees who had put together deals most favorable to AOL .
48184 205 510. At one such ceremony in December 2000, just prior to the Merger, Colburn awarded the Bammy gold star plaque to Kent Wakeford and Jason Witt, who had put togethe r the sham transaction with PurchasePro .Com described herein. According to The Washington
Post, Colburn praised Wakeford and Witt for what he called a "science fiction" deal to generat e advertising revenue, a comment some attendees took for the aggressive way the Company ha d constructed the transaction .
511 . One attendee at the ceremony said, "The sheer arrogance, the feeling of being untouchable, was amazing."
512. In light of the important role played by the Business Affairs division in helpin g
AOL and AOL Time Warner meet its revenue targets and the fact that its work was approved b y executives at the highest level, it is not surprising that Business Affairs employees believed they could do no wrong.
d. The Importance of Initiating, Consummating and Successful) Implementing the Merger
513 . Case and Levin may have had different motives in merging their two companies , but the strength of their desire to merge was the same .
514. "Case had been searching for a big acquisition for a year. Time Warner was exactly what he longed for, a traditional company rich in assets and history . Gerry Levin had been searching for something entirely different . In a career that encompassed the history of the modern media, Levin held fast to a vision of an interactive world . For him, AOL was the fulfillment of that vision." CNBC television program The Big Heist: How AOL Took Tim e
Warner, CNBC, January 9, 2003, transcript at 3 ("Big Heist Trans . at "D.
515 . According to John Malone, a longtime business associate of Steve Case and
Chairman of Liberty Media (one of AOL's largest shareholders) stated: "Case was ready to
48184 206 marry anybody that would have hard assets and liquidity ." Id. at 3. Richard Beanie. AOL's
lead deal attorney, confirmed this observation: "We spent a good amount of time, I believe in the spring and summer leading up to [the Merger], looking at a lot of different strategic choices ." Id. at8 .
516. The Newsweek article, dated December 9, 2002 entitled "How it All Fell Apart, " noted: "Case was also increasingly worried that customers would dump his snail's-pace dial-up service for faster connections offered by cable companies . His hot stock was burning a hole in his pocket."
517. In addition to a desire to meet the market's continued expectations of increased advertising revenue to keep the company's stock price artificially inflated, the Individual
Defendants were under tremendous pressure to keep advertising revenue up so as to no t jeopardize AOL's pending Merger with Time Warner.
518. After the Merger agreement was announced in Janua ry 2000, the pressure to generate advertising revenue became even more intense. According to the July 19, 2002
Washington Post article, in August 2000, employees in the Business Affairs division were meeting regularly in a conference room between the office of Case and Pittman to discuss wha t to do with a growing list of failing dot-com customers which were pleading with AOL to restructure their advertising deals. Colburn and Berlow conducted the meetings with their employees, oftentimes screaming at them to get AOL's business partners to pay up . According to AOL sources, Colbum was constantly reminding people that pressure was on because of the
Merger and would say "Are you guys crazy? Are you forgetting what we have to accomplish? "
519. As reported in The Washington Post article on July 18, 2002, according to former
AOL employee, James Patti : "The bubble had clearly burst, but senior management was under
48184 207 enormous pressure to hit the [financial] numbers and close the Time Warner transaction, whic h would diversify the revenue base and lower the risk profile of the company ."
520. Not surprisingly, the Company's largest quarterly restatement of advertisin g revenue was for the last publicly reported quarter prior to the co nsummation of the Merger.
521 . There was also a strong motive at Time Warner to consummate the Merger, especially on behalf of Levin. Michael Fuchs, former HBO Chairman and CEO who worked with Gerry Levin for nearly 20 years, stated that Levin "has an enormous drive to be seen as a visionary. It started back in 1975 when HBO went up on the satellite. It became Gerry's calling card . And replicating that visionary situation was driving motivation for him throughout hi s career. Every deal was the transforming deal." Big Heist Trans . at 4.
522. Levin was so intent on consummating the Merger that he reportedly told fe w
Time Warner colleagues of the deal's existence . According to a reporter who covered the story for Time, "People who reported directly to Levin, you know, heads of huge divisions who had no idea, they found out about it, I believe it was the Sunday night before the Monday mornin g announcement." Big Heist Trans. at 9.
523 . Once implemented, Time Warner individuals such as Levin were motivated to see the Merger succeed in order that they not be viewed as failures for having agreed to merge wit h an Internet company such as AOL.
524. Perhaps recognizing that his vision would not be fulfilled, Levin retired from the
Company unexpectedly in May 2002 . On January 12, 2003, Levin' s partner in the Merger, Case announced his resignation from the Company effective May 2003, noting that, among other things, the Merger had been a "disappointment ."
48184 208 e. Defendants' Financial Incentives Related to the Merge r
525. In addition, certain Individual Defendants had enormous financial incentives t o complete the merger due to the accelerated vesting of their stock options and lifting o f restrictions on stock sales . AOL Time Warner's 2002 Proxy Statement noted : "All options awarded prior to 2000 held by Messrs . Levin, Turner, and Parsons became immediatel y exercisable in full upon the approval of Time Warner's board of directors of the AOL-TW
Merger on January 9, 2000. All options awarded prior to 2000 held by Messrs . Case and Novack became immediately exercisable in full on the Merger Date and a ll such options held by Mr.
Pittman became immediately exercisable on the first anniversary of the Merger Date."
Restricted shares of stock at both companies similarly became vested and unrestricted .
526. Once the Merger was completed, part of Defendants' motivations for the Merger became clear. As set out in detail below, the Individual Defendants engaged in extensive inside r selling in the months immediately following the Merger with numerous sales taking plac e between January and May 2001, when the combined company's stock hit its all-time high .
During this period the Individual Defendants (whose information is publicly available) sold ove r
11 .4 million shares of AOL Time Warner stock for proceeds of nearly $270 million.
527. This massive insider sell-off occurred while the Company was engaged in a $ 5 billion repurchase of its stock . During the first six months of 2001, the Company repurchased 3 0 million shares of its stock for $1 .3 billion serving to further inflate the stock price while the
Individual. Defendants sold 11 .4 million of their own shares for proceeds of $270 million during the same period.
48184 209 f. The Individual Defendants Deny and Cover Uu Problems Associated with Shrinking Advertising Revenue
528. Due to the critical importance of advertising revenue to AOL, such revenue was tracked closely by the companies and their top executives . According to one former AOL Vice
President, Robert O'Connor (Vice President of Finance for the Business Affairs unit) prepared reports that showed "every advertising deal that AOL had and the amount of annual revenu e recognition expected from each deal ." The reports would show the amount of revenue initiall y expected from a deal and would show a lower amount than initially expected if that advertiser were experiencing financial difficulties. According to The Washington Post article dated July 18 ,
2002, AOL tracked on a weekly basis the health of the dot-corns, how much they owed AOL, what AOL was doing to get its money, how the dot-corns were responding and how much mone y
AOL could lose if the dot-corns did not pay their bills.
529. In addition, according to a former employee AOL used a "pipeline report" prepared by the Interactive Services unit that showed what advertising deals were in the pipelin e and could be expected to turn into revenue producers.
530. As reported in The Washington Post on July 18, 2002, according to sources at
AOL, the Company considered suing failing dot-corns in order to get them to pay for ads tha t they had agreed to buy. But sources said that AOL decided against such a strategy because the public court filings would publicize the weakness in the business .
531 . In September 2000, internal company documents indicated that AOL was "at risk" to lose more than $108 million in advertising revenue in fiscal 2001 (July 2000 to June
2001) with most of the jeopardized revenue coming from failing dot-corns .
532. According to the July 18, 2002 The Washington Post article, approximately two weeks before AOL released its first quarter results on October 18, 2000, Pittman and several o f
48184 210 the Individual Defendants were told in a meeting at-AOL's Dulles headquarters by Rober t
O'Connor that AOL faced the risk oflosing more than $140 million in advertising revenue in calendar year 2001 . This came at a time when the market-was aware of the downward trend facing the industry. For example, just a week before the AOL's October 18, 2000 statements, th e common stock of Yahoo Inc., plunged 21 % after the company reported that its advertising revenue growth could no longer be sustained.
533. According to the July 18, 2002 The Washington Post article, AOL's top executives were already holding weekly emergency meetings to discuss the status of advertisin g agreements with failing dot-corns.
534. Not only did Pittman, Case and Kelly not communicate the Company's advertising revenue problem to analysts during an October 18, 2000 conference call, the y actually touted the strength of AOL's advertising and commerce revenues .
535. When asked whether AOL was feeling a slowdown in advertising, Pittman responded "I don' t see it, and I don't buy it."
536. At the same conference, Case said "AOL's advertising growth is right on target" and noted that "[t]he current advertising environment benefits us because it will drive a flight t o quality "
537. Similarly, Kelly told analysts that AOL' s advertising and commerce revenu e growth was "very healthy" and emphasized, "I can't say that strongly enough ."
538. Despite his vehement denial of any problems with AOL advertising, J . Michael
Kelly later sought to disclose problems related to the decline in advertising revenue to investors just months after the Merger, but was overruled by Levin and Pittman. On October 14, 2002 ,
The New York Times reported the following:
48184 211 Six months after America Online bought Time Warner, the merged company's to executives rejected ar ents from its chief financial officer that the should back down from their ambitious promises to Wall Street, three senior executives involved in the company's deliberations now sa . . . . Instead, the executives waited two more months, until September 2001, to publicly acknowledge that the company would badly miss their financial projections made at the time of th e merger.
The chief financial officer, J. Michael Kelly, made his case while r arias AOL Time Warner's second-quarter earnings report in July 2001, arguing that a prolonged downturn in the advertising market was jeopardizing the company's promise of an annual operating profit, excluding certain charges, of $11 billion in the merger's first year, the senior executives said .
But Mr. Kelly's boss, Gerald M . Levin, the former chief executive, and Robert W. Pittman, the former co-chief operating officer, overruled him, arguing that the combination of new company-wide advertising deals and deep cost cuts could-still make up for any shortfalls, the senior executives said.
Mr. Kelly eventually signed off on the company's public statements . But his caution in July 2001 suggests that AOL Time Warner's top executives mgy have been more aware of the risks to the company's results than the have previously acknowledged.
Mr. Kelly was the execu tive most directly responsible for the company 's, financial reports and the chief financial officer of AOL before the merger, giving him a unique familiarity with its books as well as those of the merged company.
The Securities and Exchange Commission and the Justice Department are investigating the possibility that AOL temporarily inflated its advertising revenue around the time it acquired Time Warner, and one question they are asking is how much Mr. Kelly and his co lleagues knew about the precariousness of AOL's finances, people involved in the investigations have said.
New information emer ' in light of the investigations suggests that even by the time the merger was com lete . AOL's advertising and marketing revenue-the most crucial component of the combined com_R's an profits and growth-alLead d Mended on a varie of unusual deals creating the temporary but unsustainable appearance of strong demand for its services. More than $500 million of AOL's advertising, marketing and other revenue between June 2000 and July 2001 derived from anomalous soon-to-Mire deals.
A company spokesman said that the company consistently gave investors its best information and its executives worked hard to fulfill their promises.
48184 212 And yet, AOL had always declined to answer questions about who its biggest advertisers were or exactly where its revenue came from, even to other executives at its sister companies like AOL Europe, two executives involved said . After the merger closed in January 2001, AOL Time Warner disclosed even less . The com an for the first time stopped revealing AOL's backlog of future advertising revenue under contract. As a resuk investors had no way of knowing daring the next 18 months that the backlog was declining to $800 million, from $3 billion before themer er.
(Emphasis added .)
539. Despite his earlier denials of the possibility of a slowdown in advertising at AOL,
Pittman abruptly resigned from AOL Time Warner following the two Washington Post articles published on July 18 and 19, 2002.
540. Soon after publication of the same two articles, Colbum was fired and locked ou t of his offi ce .
3. Individual Defendants' Compensation Incentives
541 . Although scienter ofthe Individual Defendants is described in the immediatel y preceding paragraphs and throughout this Complaint, the following is a summary of publicly known compensation information regarding the Individual Defendants .
Stephen M. Case
542. According to publicly available data, Case made the most money from his inside sales of stock of all the Individual Defendants .
543 . All stock options awarded prior to 2000 and held by Case became immediatel y exercisable in full on the Merger Date, providing a s trong personal motive for him to ensure the
Merger went through at all costs . During the Class Period Case sold over 6 million shares of
AOL and AOL Time Warner stock for total proceeds of over $555 million. In the four months immediately following the Merger, Case sold 2 million shares for total proceeds of over $100 million.
48184 213 544. Case's eitecutive compensation during the Class Period provides further evidence of his motive. During 2001 and 2002 he received an annual salary of $1 million . In 2002, Case also received "other annual compensation" of $277,555 consisting of "financial services" of
$99,213 and transportation-related benefits of $178,342 . For July 1, 2000 through December 31 ,
2000 (the "Transition Period") Case received a salary of $383,333, for AOL fiscal year 2000
(July 1, 1999-June 30, 2000) he received a salary of $725,000 and a bonus of $1 .125 million, and for AOL fiscal year 1999 he received salary of $575,000 and a bonus of $1 million. Moreover,
Case received option grants of 4 million shares in 2001, 1 .75 million shares during the Transitio n
Period, 3 million shares for AOL fiscal year 2000, and 1 .8 million shares during AOL fiscal year
1999.
Robert W. Pittman
545. All stock options awarded prior to 2004 and held by Pittman became immediatel y exercisable on the first anniversary of the Merger Date providing a strong personal motive fo r him to-ensure the Merger went through at all costs . During the Class Period Pittman sold over
3 .3 million shares of AOL and AOL Time-Warner stock for proceeds of over $262 million . He sold 1 .5 million shares for over $72 million in the four months immediately following th e
Merger. Bloomberg, in a July 30, 2002 article entitled "AOL Time Warner Pay Dilemma Goe s
Beyond Pittman ," suggests that Pittman sold an unusually large percentage of his AOL and AOL
Time Warner stock: "Pittman seems to have been a far more savvy investor than an executive.
He clearly didn't believe in the notion that one ought to hold a lot of shares in one's company, a s he owned just 13,388 shares as of Jan. 31 [2002]."
546. Pittman's executive compensation during the Class Period provides further evidence of his motive. Up until his departure in July 2002, Pittman received a salary o f
49194 214 $769,230. During 2001 he received a salary of $1 million . In 2002, Pittman also received "other annual compensation" of $288,837 consisting of, inter alia "financial services" of $100,000 and
$161,192 for reimbursement for the payment of taxes related to life insurance coverage provided in 2001 . In 2001, Pittman also received "other annual compensation" of $399,611 consisting of, inter alia, $100,000 for financial services and $286,346 for the payment of taxes related to life inkwmee coverage. For July 1, 2000 through December 31, 2000 (the "Transition Period")
Pittman received a salary of $358,333 and a bonus of $550,000, for AOL fiscal year 2000 (July 1 ,
1999-June 30, 2000) be received a salary of $683,334 and a bonus of $1 .05 million, and for AO L fiscal year 1999 he received salary of $591,667 and a bonus of$1 million . In addition, Pittman received option grants of 210,000 shares in 2002, 3 .5 million shares during 2001, 1 .5 million shares during the Transition Period, 2 .5 million shares for AOL fiscal year 2000, and 1.44 million shares during AOL fiscal year 1999.
J. Michael Kelly
547. During the Class Period Kelly sold over $42 mi llion in AOL and AOL Time
Warner stock. Kelly sold 400,000 shares for proceeds of over $19 million in the three month s immediately following the Merger. Kelly's executive compensation provides further evidence of his motive. In 1999 Kelly received a base salary of $450,000 and a minimum bonus of 75% of base salary or greater if certain personal and corporate goals were met. In addition, he received a stock option package consisting of an initial reward of 250,000 shares vesting over 4 years an d the option to purchase 225,000 additional options per year during years 4, 5, and 6 .
David M. Colburn
548. During the Class Period Colbum sold at least 150,000 shares of AOL and AOL
Time Warner stock for proceeds of over $7.5 million-all during the four months following the
48184 215 Merger. Colburn's stock sales while an employee at AOL are not publicly available because he was not required to notify the SEC of sales due to his level of employment with the company .
However, according to the the Industry Standard article of Oct. 30, 2000 entitled "AOL' s
Rough Riders," it is likely that he had very substantial sales during this period as the article reported that he had an estimated net worth of $250 million .
Joseph A. Ripp
549. During the Class Period Ripp sold at least 20,000 shares ofhis AOL and AOL
Time Warner stock for proceeds of over $1 .7 million.
Gerald M.' Levin
550. All stock options awarded prior to 2000 and held by Levin became immediately exercisable in full upon the approval by Time Warner's board of directors of the Merger o n
January 9, 2000 providing a strong personal motive for Levin to ensure the Merger was approve d at Time Warner.
551 . Levin's executive compensation during the Class Period provides furthe r evidence of his motive. In 2002, Levin received a salary of $769,230 and other annual compensation of $285,058 consisting of, inter ali a, $100,000 in financial services and $178,342 in transportation-related benefits . During 2001 he received a salary of $1 million and other annual compensation of $237,602 consisting of, inter alia, of $97,500 in financial services and transportation related benefits of $127,446 . In 2000 Levin received a salary of $1 million, a bonus of $10 million, and other annual compensation of $226,620 from Time Warner . In addition, Levin received option grants for 4 million shares during 2001 and 750,000 share s during 2000.
48194 216 Wayne H. Pace
552. During a large portion of the Class Period Pace held positions that did not require
him to publicly report his insider transactions.
Eric Keller and Steven Rindner
553 . Due to these Defendants' positions with the companies, they were not required to
file forms with the SEC related to insider sales and therefore that information is not publicly
available.
4. Additional Allegations and Discussion ReiZarding Scienter and 10 Viola tions of Stephen M. Case
554. By at least November, 1999, Defendant Case was aware that AOL's real
advertising revenue was decreasing significantly . Alec Klein, Stealing Time: Steve Case, Jerry
Levin, and the Collapse of AOL Time Warner 105-106, 186 (Simon & Schuster ed. 2003)
(hereinafter "Stealing Time"). (The author of Stealing Time, Alec Klein, also investigated and
wrote the July 18 and 19, 2002 Washington Post articles that reported on the impropriety of AOL
advertising revenue). As a result, Case knew, no later than November 1999, that the AO L
advertising revenue stream was considerably more imperiled than was being reported to
shareholders and the public. In fact, investors had no idea that AOL advertising revenue was in
jeopardy. Rather, they were told of huge AOL advertising revenue growth . At the same time,
however, Case knew the substantially endangered condition of that critically important revenu e
source.
555. Indeed, by November 1999, "Case began receiving internal company reports
pointing to a stark reversal of fortune on the horizon . Investors didn't know it, but suddenl y
AOL's backlog - its pipeline of ad deals - was showing a disturbing downward trajectory ." Id.
at 186. The internal AOL advertising revenue reports received by Case include the following :
48194 217 A confidential report dated November 4, 1999, showed just how bad the situation was: The company had signed forty-seven deals valued at $694 million from July to September 1999, but in the next three- month period, from October to December, so far only fourteen deals had been signed, valued at $457 million. Less than a week later, on November 10, another internal report showed the same weakness . And by January 14, 2000, four days after the AOL-Time Warner merger was announced, a further report indicated there was still no pickup.
Id. The November 4 and 10, 1999 and January 14, 2000 internal confidential AOL reports received by Case were all entitled "Interactive Marketing Key Deals Summary ." Id. at 313 .
556. Not coincidentally, at the very time Case received the November reports revealing deteriorating AOL advertising revenue, he first approached Defendant Levin about a merger wit h
Time Warner. As Klein reveals in Stealing Time:
[Sligns of financial weakness were beginning to blip on AOL spreadsheets . Internal AOL documents show that as early as the fall of 1999, just as Case made his ini tial approach to Levin, AOL's pipeline of future, big advertising deals was projected to slow in volume and revenue. That, combined with AOL's greatest asset, its stock price, gave Case all the incentive he needed to pull off the Time Warner deal.
"It was," said a company executive, "Steve's masterstroke ."
Id. at 106.
557. Case, by his own admission, was able to strike the merger deal only afte r convincing Time Warner that the value of AOL stock was "real." ( supra ¶ 78.) As the
January 11, 2000 Los Angeles Times reported:
Levin and Case said they had worked carefully to strike a reasonable compromise on the values of their two companies .
"One of the creative breakthroughs was in the valuation" Case told The Times in a joint interview with Levin. He said the key to coming to a final deal was Time Warner's "reco 'lion that these Internet values are real ."
49184 218 (id .) (Emphasis added.) The extremely high value placed on AOL as part of the Merger was principally based on AOL' s reported advertising revenue and the huge historical and projected continued growth in the company's advertising revenue. ( supra ¶ 79.)
558. However, at the same time Case persuaded Time Warner that the value of AO L stock was "real," and publicly represented in the Los Angeles Times that the value of the company's stock was "real," Case knew that the purported value of AOL stock was not, in fact, real. Case knew by at least November 1999, and failed to disclose to the marketplace, tha t
AOL's advertising backlog was deteriorating substantially.
559. Case continued to sign AOL's SEC filings, including the following:
• SEC Form 10-Q for the fiscal quarter ended December 31, 1999 • SEC Form 10-Q for the fiscal quarter ended March 31, 200 0 ■ Joint Proxy Statement-Prospectus mailed to shareholders on or about May 23, 2000 • SEC Form 10-K for the fiscal quarter ended June 30, 200 0 ■ SEC Form 10-K/A for the fiscal quarter ended June 30, 2000 + SEC Form 10-Q for the fiscal quarter ended September 30, 200 0 SEC Form 10-K for the transi tion period from July 1, 2000 to December 31, 2000
Scree supra IN 275, 284, 405, 295, 310, & 332 .) All of these SEC filings reported substantially inflated AOL advertising revenue and backlog (see supra 11276-277,285-286,392,297-298 ,
311-312 & 335) and gave the false impression of huge continuing AOL advertising revenue increases on a quarter-to-quarter basis . Yet Case continued to fail to disclose to AOL shareholders and the investing public the adverse company information of which he ha d knowledge or, at the very least, recklessly disregarded, j, that the real AOL advertisin g revenue was decreasing significantly. Instead, he touted AOL's financial results to ensure that the Merger was consummated and to inflate the value of AOL's stock price. For example, on
April 18, 2000, the same day Case signed AOL's financial statement for the quarter ending
March 31, 2000, AOL issued a press release announcing "record" financial results and inflated
48184 219 AOL advertising revenue and backlog of at least 57% and 73%, respectively, for the quarter ending March 31, 2000 . See pra ¶¶ 285-285.) In that press release, Case stated :
This quarter's results underscore the tremendous strength of America Online's operations, and demonstrate that we are on a clear path to continued strop growth and increased rofiitabili . Since we announced our landmark merger with Time Warner, we haven't missed a beat .
(Lee su ra ¶ 280.) (Emphasis added.)
560. On May 15, 2000, Case, on behalf of AOL, agreed with the SEC to cease & desist from violating applicable accounting standards, and AOL paid a $3 .5 million fine to the SEC.
See, supra ¶ 19.) This SEC action came after previous SEC actions against AOL and Case's earlier commitment to scrupulously adhere to applicable accounting standards. ( supra ¶ 18 .)
Accordingly, Case was aware of the urgent need for AOL to comply with applicable accountin g practices.
561 . On or about May 23, 2000, the Joint Proxy Statement Prospectus, signed by Cas e and Levin, was mailed by AOL and Time Warner to their stockholders . The Joint Proxy
Statement-Prospectus was incorporated into the Merger Registration Statement, which in turn incorporated financial statements and pro forma financial statements that materially overstated
AOL advertising revenue and backlog and omitted material facts regarding the real condition o f
AOL advertising revenue.
562. On July 20, 2000, AOL's financial statement for the quarter ending June 30, 2000 , which was signed by Case, announced more "record" financial results and inflated advertising revenue and backlog by at least 48% and 52%, respectively . (S supra ¶¶ 297-298.) Also on
July 20, 2000, Case was interviewed by the Dow Jones News Service, which reported on that same day as follows :
48194 220 Case said "all our numbers were at or above consensus estimates." AOL's earnings of 13 cents a share, excluding items, beat the consensus by 2 cents a share . Case said AOL's fourth-quarter [for the quarter ending June 30, 2000] results were helped by strong advertising and electronic-commerce revenue, a development that should reassure investors who had feared that a "dot-com" shakeout would hurt the online advertising market.
(aee sum ¶ 294.) (Emphasis added .) Case again failed to tell the public the true condition o f
AOL's advertising revenue, backlog and growth, which he was aware of at least as early as
November 1999. Case continued to have access to_periodic AOL advertising revenue reports, including those titled "Interactive Marketing Key Deals Summary" dated March 21, 2000 ,
August 18, 2000 and August 24, 2000. See Stealing Time at 313 . Other AOL internal documents available to Case, which reported the true state of AOL's advertising revenue, such as an "Interactive Marketing FY02 Budget Analysis-Ad Forecast," dated September 26, 2000 and documents titled "Interactive Marketing Deal Restructuring," dated August 18 and 24, 2000.
Id. These reports in the fall of 2000 confirm the same information that Case was aware of in
November 1999 - AOL was continuing to lose substantial amounts of actual adver tising revenue. (eee supra % 7, 75, 301 & 313 .)
563 . On October 18, 2000, AOL again reported "record " financial results and inflated advertising revenue and backlog by at least 41 % and 51%, respectively, for the quarter endin g
September 30, 2000. (Lee supra IN 311-312.) The quarterly statement, signed by Case, covered the first full quarter after Case agreed to the SEC's Cease & Desist order and the last publicl y reported quarter before the Merger was consummated. This AOL financial statement involves the biggest quarterly restatement of AOL advertising made thus far by the Company . (See supra
¶ 236.) On October 18, 2000, following the release of these quarterly results, Case, along with
Levin, Pittman and Kelly, held a conference call with analysts to tout AOL's purported financial
48184 221 performance . (See supra ¶ 304); Stealing Time at 195. In response to an analyst's question o f whether AOL was affected by the industry-wide slowdown in advertising, Case stated that
"AOL's advertising growth is right on target . . . . The current advertising environment benefits us because it will drive a flight to quality." id.
564. The Dow Jones Business News also reported on October 18, 2000, as follows:
AOL's first-quarter ad revenue,' however, was "very much on tare " and should be strong in future qua rters, Chairman and Chief Executive Steve Case said Wednesday. In an interview after AOL reported first-quarter [for the quarter ending September 30, 2000] results, Mr. Case said the company 's advertising revenue showed it has weathered an overall slump in the online ad market.
As for AOL's sharp drop Tuesday [October 17, 2000], Mr. Case said, "I do not think people generally are concerned about Internet advertising. Our results show there's no reason to be concerned when it comes to AOL."
(Emphasis added.)
565. In addition, according to Nina Munk's book, Fools Rush In: Steve Case, Jerry
Levin, and the Unmaking of AOL Time Warner (HarperCollins ed. 2004) (hereinafter "Fools
Rush In"), Case and Levin spent the day on October 18, 2000 promoting the Merger wit h analysts, investors and journalists . Munk's book relates what Case told analysts, investors and journalists on October 18, 2000:
[F]ar from hurting AOL, he said, the so-called dot-corn shakeout was encouraging advertisers to spend more money on AOL. "Mere's a lot of swirl about the advertising market, [but] AOL's advertisin wth is right on tare" Case told everyone. "The current advertising market benefits us because it drives a flight to quality."
All day on October 18, reporters analysts, and investors kept baiting Levin and Case. One television reporter asked incredulously: "Everybody has been hurt by the crashing dot-corn advertising . You have not?" Case replied: "Maybe we're a little bit different than
48184 222 everybody else. We've always felt that we were, maybe, a cut above. I don't say that arrogantly, but we have been doing this for over fifteen years and we've kind of emerged as the blue-chip. And we have a little different business model - a different approach . I think we benefit from that."
Fools Rush In 204-205. (Emphasis added.)
566. Based on Case's knowledge dating back to at least November 1999 regarding the precipitous decline in AOL advertising revenue, on October 18, 2000 he knowingl y misrepresented the state of AOL advertising revenue in an effort to consummate the Merger and inflate the value of AOL stock. At a minimum, on October 18, 2000, Case was reckless in touting AOL's advertising revenue and fa iling to disclose the true state of AOL advertising revenue if, before making such statements, he failed to review the post-November 1999 an d
January 2000 internal AOL documents which revealed the real condition of that source o f revenue. (Lee supra IN 7, 75, 301 & 313 .) Indeed, in light of his prior knowledge of decreasing
AOL advertising revenue dating back to at least November 1999 , Case's misrepresentations on
October 18, 2000 regarding the condition of AOL advertising revenue were either knowingly or recklessly false.
567. Case continued to have access to AOL's periodic internal reports regarding AOL advertising revenue, including documents entitled "Interactive Marketing Key Deals Summary, " dated November 6 and 16, 2000 and January 4, 2001, and a report entitled "Interactiv e
Marketing Q2 Deals at Risk Potential Exposure," dated December 2000 . See Stealing Time at .
313 .
568. Nonetheless, AOL issued on March 27, 2000, and Case signed, AOL's SEC Form
10-K for the transition period from July 1, 2000 to December 31, 2000 . ( supra ¶ 332.) This
SEC Form 10-K continued to report substantially inflated AOL advertising revenue by at least 3 7
48184 223 % of the actual amount of AOL advertising revenue, and failed to disclose the declining condition of real AOL advertising revenue. {Id} Significantly, with the filing of the SEC Form
10-K for the transition period, AOL and the Company abruptly ceased the reporting of AOL advertising and commerce revenue backlog . (Id.)
569. With his knowledge of the actual condition of AOL advertising revenue, shortl y after the Merger was consummated on January 11, 2001, Case caused the Company to initiate a
$5 billion stock repurchase program that propped up the value of AOL Time Warner stock.
Fools Rush In at 214. At the same time, within a four-month period immediately after th e
Merger, Case sold 2 million shares of his Company stock for total proceeds of $100 million .
See supra 1543.) See also Fools Rush In at 229.
570. After the Merger, Case continued to sign SEC filings , including the SEC Form
IO-K for the fiscal quarter and year ended December 31, 2001 and SEC Form 10-K/A for th e fiscal quarter and year ended December 31, 2001 . [See supra ¶ 378.) These SEC filings reported substantially inflated AOL advertising revenue and did not disclose the true condition of thi s important revenue source . ( supra 382, 286-287.)
5. Additional Allegations and Discussion Regarding Scienter and & 10 (b) Violations of Gerald M. Levin
571 . Shortly after Case and Levin announced the Merger , AOL Time Warner was incorporated in February 2000, at which time Defendant Levin was appointed Chief Executiv e
Officer of AOL Time Warner. See supra ¶ 38(h).)
572. On or about May 23, 2000, the Joint Proxy Statement-Prospectus, signed b y
Levin and Case, was mailed by AOL and Time Warner to their stockholders . The Joint Proxy
Statement-Prospectus and the Merger Registration Statement which also was signed by Levin , incorporated financial statements and pro forma financial statements that materially overstate d
48184 224 AOL advertising revenue and backlog. In addition, these documents did not disclose material facts regarding the true condition of AOL advertising revenue. (ace supra ¶[ 36(a), 38(h), 392 &
405 .)
573. On October 18, 2000, AOL reported "record" financial results and inflate d advertising revenue and backlog by at least 41 % and 51%, respectively, for the quarter ending
September 30, 2000. (See supra IN 311-312.) This quarterly statement involved the bigges t restatement of AOL advertising revenue issued thus far by the Company . ( sum 1236.)
574. As indicated above , on October 18, 2044, Levin spent the day with Case promoting the Merger with analysts, journalists and investors . Levin, on October 18, 2000, described the condition ofAOL advertising revenue to analysts, journalists and investors a s follows: "There's been a lot of swirl around the advertising market, particularly related to the so- called dot-corn shakeout . I don't get it and I don't buy it." Fools Rush In at 205. (Emphasis added.) Levin also referred to any concern regarding a decline in AOL advertising revenue as "a kind of nervous Nellie, manufactured issue. . . ." Id. at 204.
575. According to an October 18, 2000 article in the Dow Jones News Service, during the conference call with analysts on that day Levin also stated, "[w]e think there is no dot-cam advertising issue as it relates to Time Warner or AOL."
576. Similarly, in an October 19, 2000 article in the Hollywood Report er, Levin-stated that fears of slowing advertising revenue from Internet companies were misguided . "There is no advertising issue," he said.
577. By his statements on October 18 and 19 , 2000, Levin misrepresented the real state of AOL's advertising revenue and failed to disclose the truthful information to the public. As
Chief Executive Officer of AOL Time Warner, Levin sought to dispel any concerns about AO L
48184 225 advertising revenue in an effort to promote the Merger. In so doing, Levin acted knowingly or
recklessly in making such false statements regarding the advertising revenue because he eithe r
knew the truth from AOL' s internal reports or recklessly disregarded AOL internal documents which showed the substantial deterioration of AOL advertising revenue. ( supra ¶f 7, 75,.301
& 313 .) Indeed, since Levin assumed responsibility to describe the state of AOL advertising revenue, he was, at a minimum, reckless in failing to first review pertinent internal company reports which disclosed the true condition of that important revenue source .
578. After the Merger, Levin signed company SEC filings including AOL's. SEC Form
10-K for the transition period from July 1, 2000 to December 31, 2000, AOL Time Warner' s
SEC Form 10-K for the fiscal quarter and year ended December 31, 2001, and SEC Form 10-
KJA for the fiscal quarter and year ended December 31, 2001 . (See supra ¶ 332.) These SEC filings reported substantially inflated AOL advertising revenue and did not disclose the rea l condition of AOL advertising revenue. Significantly, with the issuance of the AOL SEC Form
14-K for the transition period from July 1, 2000 to December 31, 2001, AOL and the Company discontinued the reporting of AOL advertising and commerce backlog . C&e supra ¶ 332.)
579. In July of 2001, Levin and Defendant Pittman rejected the efforts of their ow n
CFO to disclose the true nature of AOL's advertising revenue. While preparing the Company' s second-quarter earnings report, AOL Time Warner's Chief Financial Officer, J . Michael Kelly, finally sought to divulge publicly that the Company would be unable to meet financia l projections. As The New York Times reported on October 14, 2002:
The chieffinancial officer, J. Michael Kelly, made his case while pireparing AOL Time Warner' s second-quarter earnin r rt in Jul 2001, gKgWpg that a prolonged downturn in the advertising market was jeopardizing the company's promise of an annual operating profit, excluding certain charges, of $ 11 billion in the merger's first year, the senior executives said.
48184 226 But Mr. Kelly's boss, Gerald M. Levin, the former chief executive, and Robert W . Pittman, the former co-chief operating officer, overruled him . . . .
supra ¶ 538.) (Emphasis added.)
580. Levin refused, after his Chief Financial Officer's warning, to disclose the real condition of AOL advertising revenue:
[B]y July 2001, AOL Time Warner's situation was becoming untenable . Even with unconventional deals, the newly merged company could not reach the lofty financial goals it had set for itself in its first full year. The ad market was that bad. . . . Then the chorus began to mount [within AOL Time Warner],_becoming more hostile : Why is corporate sticking to these ridiculously high targets? Why is Levin working so hard to justify the merger to Wall Street? ** * Then an internal caution came from AOL Time Warner's top financial man, J . Michael Kelly. As he was preparing the public release of the company's second-quarter financial numbers that July, the chief financial officer could not ignore how the anemic ad market was threatening to scuttle AOL Time Warner's promises to Wall Street, including achieving a revenue increase of 12 to 15 percent in the merger's first year .
It was time, Kelly argued to his bosses, for the company to go bat in hand to Wall Street and publicly lower its financial goals . This was a matter of maintaining AOL Time Warner's credibility with investors . They deserved to know . It was a compelling argument. But Kelly was overruled [by Levin and Pittman] .
Stealing Time at 266. (Emphasis added.) Kelly's immediate boss at the time was Gerald Levin .
581 . Accordingly, by at least July 2001, Levin knew from the Company's own Chie f
Financial Officer that the industry-wide Internet advertising downturn was adversely affectin g
AOL and was not disclosed to the investing public . However, Levin refused to disclose such information to shareholders and the public so that the Merger looked like a success. Instead,
Levin caused the Company to issue a financial statement for the quarter ending June 30, 2001 which reported inflated AOL advertising revenue by at least 27 % compared to AOL's actual advertising revenue and did not reveal the subst antial deteriorating condition of AOL's real advertising revenue. See supra 1367.) Levin therefore knew by at least July 2001 that the AO L
48184 227 advertising revenue stream was considerably more imperiled than was being reported t o shareholders and the public.
6. Additional Allegations and Discussion Regarding Scienter and 14 Violations of Joseph A. Ripp and Steven E. Rindner
582. The void left in the wake of Keller's departure in June 2001 was quickly filled by two of AOL's senior officers . One was AOL's Chief Financial Officer, Defendant Ripp, whos e position gave him complete access to all of the accounting that reflected any transactions that brought AOL revenue, whether real or illusory, and imposed on him the duty to ensure that the transactions were properly documented and reported. ( su~ra ¶ 36(f).) The other was
Defendant Rindner, who succeeded Keller as AOL's Senior Vice President for Business Affairs and Development, a position that made him responsible for creating and monitoring the deal s that generated revenues for AOL. ( supra ¶ 36(g).)
583 . In tandem, Ripp and his accomplice Rindner immediately stepped in to shepher d the sham Homestore deal that Keller and Colburn had devised . In so doing, both of them knew about the fraudulent structure of the circular transactions that had brought AOL fictitious revenue during the first quarter of 2001 and the additional ones contemplated for the secon d quarter. The two men wasted no time ensuring that AOL captured the remaining revenue fro m the secret Homestore vendors before the second quarter ended .
584. Beginning in mid-June 2002, Rapp and Rindner had a number of phon e conversations with Joseph J . Shew, Homestore's Vice President of Finance, during which they made sure that AOL would actually receive its money from the secret par ties in time to artificially inflate its revenue for the then-current quarter. ( First Amended Consolidate d
Class Complaint $ 358, filed in In re Homestore.com Securities Litigation., 41-CV-11115 MJP,
U.S. Dist. Court, Central Dist. of Cal. ("Homestore Complaint"). They pushed Homestore to
48184 228 accelerate its payments to the secret parties so that AOL would receive its phony revenue by the quarter's end. See i They also told Homestore that unless those parties furnished letter s confirming they would purchase advertising, AOL would not feed any more money into the circuit of deceit. (Lee Lid.) In other words, Ripp and Rindner were so aware of how the sha m transactions worked, that they wanted written confirmation that AOL would receive its part o f the fraudulent funds .
585. Motivated by their desire to ensure receipt of the round-tripped payments, Ripp and Rindner asked Homestore to prepare a list of its secret vendors, ultimately titled "Potentia l
Referral Advertisers ." The purpose of the list was to document which vendors wer e participating-or, stated from Ripp and Rindner's perspective, from whom AOL would be receiving the money from . Ripp and Rindner's request for the list evinces their knowledge tha t the transactions were essentially circular between AOL and Homestore, and not independent deals between AOL and the secret vendors. See id. 11356-57.)
586. Homestore told Ripp and Rindner that it did not want to create a list identifyin g the secret vendors participating in the fraudulent scheme. However, in a phone conversation with Jeff Kalina, Homestore's Director of Transactions, and Stuart Kim, a member o f
Homestore's legal department, in the latter part of June 2002, Ripp and Rindner insisted that th e vendors be identified to ensure AOL would receive the money . When Homestore suggested as a compromise that the list also include names of vendors with whom it never intended to d o business, Ripp and Rindner agreed to a merged list having full knowledge of which named vendors actually participated in the triangular transactions and which names were merel y dummies. See, id. 1357.)
48184 - 229 587. To address AOL's desire to recognize advertising revenue during the then -current quarter, Shew had a series of meetings with Peter B . Tafeen, Homestore's Executive Vice
President of Business Development and Sales, and Jeff Kalina, its Director of Transactions . (See id. ¶ 358.) The outcome was Homestore's agreement to pay the secret vendors in time for them to buy advertising from AOL before the quarter expired . See id.) But by June 29, the final business day of the quarter, AOL still had not received all the confirmation letters, so Ripp and
Rindner withheld AOL's authorization of the transactions . Worried that the funds it advanced to the vendors would not come full circle, Homestore made sure that AOL had all the letters later in the day. See id. 1359; supra 1133.)
588. That evening Ripp and Rindner, now AOL's point men on the Homestore deal, participated in a conference call with Homestore's Chief Executive Officer, Stuart Wolff, which
consummated the transactions. See id. ¶ 359; supra ¶ 133 .) With Shew and Tafeen in his office,
Wolffsummarized the transactions and articulated Homestore's perspective, delving into detail
with the help of a written schedule of the transactions that Kalina and Taffeen had prepared for
him. (Stt Homestore Complaint ¶ 359.) Wolff and Taffeen both expressed their concern that
AOL might renege by not reimbursing Homestore for the front money it had already paid to the
hidden vendors . See i Shew also told Ripp and Rindner in no uncertain terms that because
Homestore had fronted money so AOL could get its purported advertising revenue, AOL was
obligated to complete the round trip by paying Homestore, less the commission due AOL on the
transactions. See id.) All three legs of the deal were laid out for Ripp and Rindner to see . If
they had lacked knowledge about any facets of the deal before that conference, after it they were
every bit as educated as Coeburn and Keller about the illicit workings of the transaction .
48184 230 589. Later that evening, AOL sent Homestore confirmation that it was going forward with the deal-in the precise manner discussed during the conference . See id. ¶ 360; supra ¶
134.)
590. In addition to the facts evidencing the actual knowledge Ripp and Rindner had about the Homestore transactions, the surrounding circumstances compel the conclusion that they must have known the deal was corrupt. The fraudulent nature of the transactions could not have been more transparent to AOL's Chief Financial Officer and the man in charge of developing business . There was no conceivable explanation for the deal's triangular structure other than using a clandestine leg that allowed AOL to derive illusory advertising revenue from the funds it then passed on to Homestore. At the very least, instead of vigilantly performing their duties, Ripp and Rindner recklessly allowed the illegal transactions to take place on their watch, turning a blind eye to what were, at the very least, red flags that clearly disclosed the fraudulent nature of the transactions. Instead, Ripp and Rindner let the transactions proceed, allowing AOL to claim $45.1 million of fraudulent revenue from these transactions during the-first two quarters of 2001 . (Lee supra ¶ 127.) All the while, Ripp and Rindner were keenly aware that they would benefit personally from stock price inflation caused by the fraud they helped perpetrate . (Lee supra IN 549, 553.)
591 . Despite their oversight of the deal they knew to be fraudulent, neither Ripp no r
Rindner did anything to expose it . Just as Keller had done before them, they concealed the deal's structure so that AOL could further inflate the advertising revenue it reported and avoid the consequences of bringing the facts to light. And like Keller, each of them was complicit in the fraud by doing what it took to make the deal work .
49194 231 592. In short, Ripp and Rindner knew of or recklessly disregarded the blatantl y
fraudulent nature of the Homestore scheme . Both were fully aware of how the scheme operate d
and that there could be no legitimate reason for its machinations . Indeed, the scheme has already
resulted in seven Homestore officers and management personnel, including the ones dealing wit h
Ripp and Rindner, pleading guilty to criminal charges stemming from the DOJ's investigation of
Homestore. (Heins Decl. in app. to Mot. to Dismiss, Exs. E, G-J.) The scheme is still being
scrutinized as part of the ongoing_ SEC and DOJ investigations of AOL's advertising revenue.
593. As recognized by the court presiding over the securities class action brought b y
Homestore's shareholders, the scheme Ripp and Rindner helped orchestrate was "a massiv e
conspiracy driven by pure avarice." In re Homestore Sec. Litig., No. C01-11115 MJP, 2003 WL
1227643, at *24 (C .D. Cal. March 7, 2043). (Lee supra ¶ 137.) Because of Ripp and Rindner's
acts, they were targeted, along with Colburn and Keller, by the Homestore court's apt commen t that "the detailed allega tions describing the role of AOL and its agents in helping Homestore please Wall Street and in boosting its own revenues through bogus commissions give this Court great pause." ld_ ( sera $ 137.)
K. Scienter of Ernst & Youn g
594. In addition to the facts alleged above, the following facts, among others, sho w that Ernst & Young acted with scienter.
1. Ernst & Young's Work for AOL, Time Warner and AOL Time Warner
595. Ernst & Young was retained by and had served as independent auditor to both
AOL and Time Warner for many years prior to the Merger, and AOL Time Warner since th e
Merger. Ernst & Young performed annual audits on AOL's and AOL Time Warner's financial statements during the Class Period, as well as quarterly review work for AOL since at least the
48184 - 232 first quarter 2000, and as to AOL Time Warner, for every quarter since the Merger, to date . As such, Ernst & Young was heavily involved in the regular accounting practices of the companies .
For each fiscal year 1999, 2000 and 2001 and transition period ended December 31, 2000, Ernst
& Young issued "clean" opinions as set forth in AOL and AOL Time Warner's SEC Form 10-Ks ,
-opining that AOL and AOL Time Warner' s financial statements were prepared in conformity with GAAP, that the financial statements "present fairly in all material respects" the financial condition of the companies and that Ernst & Young had planned and performed its audits i n accordance with GAAS. Each of these representations was untrue. Ernst & Young also consented to the incorporation of its reports containing its unqualified opinions, and to th e reference to itself as "Experts" in the Merger Registration Statement .
2. Ernst & Young's Close Relationship with AOL Time Warner
596. AOL and AOL Time Warner were huge clients for Ernst & Young. For example,
Ernst & Young billed AOL Time Warner $49 .05 million in 2002 and $52.7 million in 2001 . Of the 2002 amount, $32.5 million, or 66%, was for services other than AOL Time Warner's U.S.
Audit. Of the 2001 amount, $42.1 million, or 80%, was for services other than AOL Time
Warner's U.S . Audit. The additional fees in 2002 included $ 19.2 million for tax compliance and planning, $5.9 million for internal audit services, and $4.2 million for subsidiary an d international audits. The additional fees in 2001 included $25.9 million for tax compliance and planning, $8.2 million for internal audit services, and $3 .6 million for subsidiary an d international audits.
597. For 2000 (prior to the Merger), Ernst & Young was paid by the two companies a combined $59 million (AOL $3 .5 million and Time Warner $55.4 million). Of this amount, only
$8 million was for the U.S. audits of AOL and Time Warner. The rest was for consulting
48184 233 services provided by the Ernst & Young consulting group (prior to its sale on May 23, 2000 t o the French company, Cap Gemini).
598. In addition, former Ernst & Young alumni were employed at AOL and AOL Time
Warner during the Class Period. James W. Barge, a Senior Vice President and Controller at
AOL Time Warner, came from Ernst & Young. Barge is responsible for overall internal and external financial reporting functions, financial planning and analysis and Board-leve l communications. Barge came to Time Warner from Ernst & Young in March of 1995 as
Assistant Controller. At Ernst & Young, be was the Area Industry Leader of the Consumer
Products Group and a Partner in the West Region Accounting Auditing Department. During that period he had regional responsibility for consultations on a wide variety of accounting and auditing issues managing SEC related matters .
599. John Martin, AOL Time Warner's Vice President of Investor Relations and the
Company's principal day-to-day contact with the investment community, is also an Ernst &
Young alumnus. Before joining Time Warner in 1993 as a Manager of SEC financial reporting, he was a Senior Accountant in the Business Assurance Group at Ernst & Young in New York .
3. Ernst & Young's Auditing Expertise and Industry Knowled e
600. Ernst & Young is a sophisticated multinational accounting and tax firm ranking a s the fourth largest such firm in the world with annual revenues of $4.4 billion according to a 2002 survey.
601 . In addition, Ernst & Young promoted itself as having expertise specifically suited for internet and e-commerce companies through its Technology Communications an d
Entertainment division (TCE). In their brochure, Ernst & Young boasted "Ernst & Young helps
49184 234 technology, communications, and entertainment companies operate more efficiently, profitably , and successfully."
602. Ernst & Young, along with the Massachusetts Institute of Technology an d
Inter@a ctive Week, studies the companies involved in the internet economy to produce the
Internet 500 which ranks the top 500 businesses by their revenue generated from onlin e operations.
603. In addition to AOL Time Warner, Ernst & Young lists numerous technology companies on its roster of clients including several entities with which AOL had agreements a s to which it engaged in improper accounting practices . Such entities include eBay and Sun
Microsystems. Ernst & Young also served as auditor for Veritas before being replaced following that company's year 2000 audit.
4. Ernst & Young's Actual Knowledge of Specific Transactions and Accounting Thereof
604. In the wake of SEC actions against AOL Time Warner and in response to the July
18 and 19, 2002 Washington Post articles, the Company has stated that it had relied on Ernst &
Young's approval of not only the accounting methods used, but many of the particula r transactions at issue as well . In addition, Ernst & Young has stated that its audits were properly performed when it knew that they were not.
605. Prior to the July 18, 2002 Washington Post article, H. Stephen Hurst, Ernst &
Young partner, released a statement at AOL Time Warner' s request saying the firm stood by its original view that the accounting and disclosures were appropriate .
606. In July 2002, then AOL Time Warner CEO Richard Parsons said in a conference call following The Washington Post articles that "They [Ernst & Young] have confirmed in writing, without qualification, that the accounting for each and every one of the transaction s
48184 235 mentioned in [The Washington] Post articles and the related financial statement disclosures for those transactions were approp riate and in accordance with Generally Accepted Accounting
Principles."
607. In a July 29, 2002 article in Advertising Age, Defendant Pace also reassured investors that AOL Time Warner and its auditor Ernst & Young stood by the accounting .
608. Regarding the Homestore transactions in particular, AOL Time Warner spokesman John Buckley stated in an August 6, 2002 Los Angeles Times article that "AOL's accounting for all transactions with Homestore .com were appropriate and signed off by our outside auditors Emst & Youn ." (Emphasis added.)
609. One of the transactions described in The Washington Post articles involved
AOL's deal with PurchasePro in the fall of 2000, a deal AOL Time Warner said was approved by Ernst & Young.
610. However, PurchasePro's auditor, Arthur Andersen, disagreed with the way
PurchasePro accounted for revenue from reseller agreements . PurchasePro's SEC Form 8-K dated November 29, 2001 states:
During Andersen's review of the Company's interim financial statements for the three-month period ended September 30, 2000, Andersen expressed disagreement with prior members of the Company's management regarding propose d recognition of revenue derived from reseller agreements between the Company and its business partners . This issue was the subject of discussion between Andersen and the Company's Audit Committee and was resolved to Andersen's satisfaction.
As a result of this disagreement, Arthur Andersen resigned as PurchasePro 's auditor on
November 21., 2001 .
48194 236 5. The Restatement of AOL's and AOL Time Warner' s Financial Statements
611 . Despite Ernst & Young's immediate and unequivocal denial of any improper accounting when The Washington Post first reported on July 18, 2002 on the accountin g improprieties, both the Company and Ernst & Young acknowledged only three weeks later that at least $49 million of advertising revenue had been improperly reported when the allegations persisted and the SEC and DO] started their investigations . Two months later, the Company reported that $190 million in advertising revenue was improperly reported and that th e
Company's internal investigation was continuing. Then, on or about March 28, 2003, the
Company reported that the SEC may require it to restate an additional $400 million in revenue based on the Company's improper accounting for an advertising deal with Bertelsmann AG .
612. Ernst & Young issued unqualified audit reports, which were published in th e companies Forms 10-K and Annual Reports to shareholders for, inter alia, the years ended
December 31, 2001 and December 31, 2000.
613 . However, by restating its financial results, AOL Time Warner has admitted that its and AOL's publicly-issued financial statements for each of the restated periods were not prepared in conformity with GAAP, and that AOL and AOL Time Warner materially misstated its financial condition and results of operations. Thus, Ernst & Young's opinions that the financial statements for the years ended December 31, 2000 and 2001, had been prepared i n conformity with GAAP were false and misleading. Under GAAP, the restatement of previously, issued financial statements is reserved for circumstances where no lesser remedy is available .
Under APB 20, Accounting Changes, restatements are only permitted, and are required to: correct material accounting errors or irregularities that existed at the time the financial statement s were originally prepared and issued.
48184 237 614. The restatement of a company's previously issued financial statements becomes necessary when it is discovered that previously issued financial statements contained errors or irregularities in accounting which caused them to be materially misstated . Such misstatements can be the result of errors or fraud, and once discovered, the company is obligated to notify all parties who may rely on the previously issued financial statements that they should no longer place reliance thereon. The restatement of a company's previously issued financial statements is, in fact, an admission that such financial statements contained material misstatements that cause d them to be misleading to readers .
6. Ernst & Young's Past Involvement with Previous Accountinc Fraud s
615. Ernst & Young has been involved in accounting fraud in the past . Recently, Erns t
& Young paid $335 million to settle claims arising from its auditing role in a securities frau d case involving Cendant Corp., a record amount paid by an auditing firm in such a case .
616. On November 23,1992, The Office of Thrift Supervision filed a Notice of
Charges against Ernst & Young stemming from its improper audit practices with regard to som e of the most notorious failed financial institutions of the 1980's savings and loan crisis, including
Continental Illinois. To resolve these charges and numerous related lawsuits filed by the FDIC ,
Ernst & Young paid $400 million in settlement, and agreed to a cease and Desist Order restricting its future work for insured depository institutions.
617. In May 1999, Ernst & Young settled claims that it failed to publicly disclose accounting irregularities by paying $34 million in a securities case involving Informix .
618. In a complaint filed in 2002 by the Federal Deposit Insurance Corporatio n
("FDIC"), the FDIC alleged "Ernst & Young has a long history of breaching duties owed to the
FDIC and other regulatory agencies overseeing financial institutions."
48154 238 7. Ernst & Young's Responsibilities as AOL's and AUL__ Time Warner's Independent Auditor
619. The duty owed by an independent auditor to a company's shareholders is wel l established . As the United States Supreme Court explained in a case involving a predecessor firm of Ernst & Young:
By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public . This "public watchdog' function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust .
United States v Arthur Young & Co ., 465 U.S. 805, 817-18 (1984) .
620. In addition, the responsibilities and functions of an independent auditor includ e the following:
The objective of the ordinary audit of financial statements by the independent auditor is the expression of an opinion on the fairness with which they present, in all material respects, financial position, results of operations and cash flows, in conformity with generally accepted accounting principles . (AU § 110.01).
The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. (AU § 110.02).
The professional qualifications required of the independent auditor are those of a person with the education and experience to practice as such. (AU § 110.04).
621 . The independent auditor must also comply with professional training and proficiency rules, including the following:
The audit is to be performed by a person or persons having adequate technical training and proficiency as an auditor. (AU Section 150.02).
In the performance of the audit which leads to an opinion, the independent auditor holds itself out as one who is pro ficient in accounting and auditing. (AU § 210.03).
48184 239 The independent auditor's formal education and professional experience compliment one another, each auditor exercising authority upon an engagement should weigh these at tributes in determining the extent of his or her supervision of the subordinates and review of their work. It should be recognized that the training of a professional person includes a continual awareness of developments taking place in business and in his or her profession . (AU § 201 .04).
In the course of his or her day-to-day practice, the independent auditor encounters a wide range of judgment on the part of management, varying from true objective judgment to the occasional extreme and deliberate misstatement . He or she is retained to audit and report upon financial statements of a business because, through training and experience, he or she has become skilled in accounting and auditing and has acquired the ability to consider objectively and to exercise independent judgment with respect to the information recorded in books of account or otherwise disclosed by his or her audit. (AU § 21 0.05).
622. Ernst & Young, in contracting to perform its -audit of AOL's and AOL Tim e
Warner's financial statements, assumed all of the responsibilities and obligations set forth in the
preceding paragraphs .
8. Ernst & Young's Violations of Accounting and Auditing Standards
623 . As discussed below , Ernst & Young violated its professional responsibilities-and
knowingly or recklessly participated with AOL and AOL Time Warner in improper revenue
recognition practices, policies, and procedures in order to artificially boost AOL's and AOL
Time Warner's reported advertising revenue. Although Ernst & Young was aware that the
revenue recognition practices of AOL and AOL Time Warner were in violation of GAAP, Erns t
& Young provided unqualified audit opinions in order to continue earning lucrative fees for th e
auditing and other services that it provided for AOL and AOL Time Warner.
624. As part of its planning for and implementa tion of various audit engagements for
AOL and AOL Time Warner, Ernst & Young was required under GAAS to be thoroughly
familiar with the nature of AOL's and AOL Time Warner's business, the manner in which senio r
management ran the companies, the internal control environment at the companies, and the area s
48184 240 of audit risks at AOL and AOL Time Warner. As AOL and AOL Time Warner' s auditor, Ernst
& Young had unfettered access to the Company's books and records throughout the Class Period .
Ernst & Young, as a world-renowned "Big 4" public accounting firm, had knowledge of the requirements of GRAS, and, as described below, knew of the audit risks inherent in AOL, AOL
Time Warner and in the industry.
625. Ernst & Young knew, or except for its reckless disregard of the facts would hav e known, that (i) it had not performed its audits of AOL's and AOL Time Warner's financial statements in comp liance with GAAS ; (ii) it never should have issued an "unqualified" audit report on AOL's and AOL Time Warner's financial statements for the fiscal/calendar year s ended 1999, 2000, 2001 and the transition period for AOL ended December 31, 2000 ; and (iii) its audit reports on AOL's and AOL Time Warner's financial statements for the years ended
1999, 2000, 2001 and transition period for AOL ended December 31, 2000 were not in conformity with GAAS when opining that the financial statements were in accordance wit h
GAAP and that the "financial statements . .. present fairly in all material respects," the financial condition of the companies. This conclusion may be expressed only when the auditor has formed such an opinion on the basis of an audit performed in accordance with GAAS. (AU §
508.07). Ernst & Young failed to do so .
626. As set forth above, AOL and AOL Time Warner repeatedly violated GAAP with respect to its accounting for the deals at issue. Yet, Ernst & Young failed to identify and correc t those violations despite its admitted awareness of many of the deals. In fact, Ernst & Young' s audits of the financial statements were so woefully inadequate that Ernst & Young repeatedl y violated GARS. Ernst & Young utterly failed to perform the most fundamental of procedures to provide a basis for its unqualified reports . As described herein, Ernst & Young repeatedly an d
48194 241 materially violated GAAS in each of its audits of AOL and AOL Time Warner during the Class
Period, failed to plan or to perform its audits to obtain reasonable assurance that AOL and AOL
Time Warner's financial statements were free ofmaterial misstatement , and, therefore, had no basis on which to state that the financial statements were presented in conformity with GAAP,
GAAS violations include:
a. Ernst & Young Failed to Properly Consider Fraud .
627. Ernst & Young knowingly or recklessly failed to plan its audits to evaluate th e risk factors relating to management's characteristics, their influence over the contro l environment and the company's accounting and internal control policies. "The auditor should specifically assess the risk of material misstatement of the financial statements due to fraud an d should consider that assessment in designing the audit procedures to be performed ." AU §
316.12; AU § 316.05 {"The auditor should assess the risk that fraud may cause the financial statements to contain a material misstatement ."). When examining risk factors provided in AU
Section 316, it is obvious that Ernst & Young should have identified risks for fraudulen t reporting virtually everywhere. Among the conditions that should cause the auditor to consider that a client has attempted financial fraud are discrepancies in the accounting records, such as transactions not properly recorded as to amount, or unsupported or unauthorized balances o r transactions; conflicting or missing evidential matter, such as significant unexplained items o n reconciliations ; or denied access . to records . AU §§ 316.25, 317.09, AU §§ 316.21, 317.09. To limit the risk of financial statement misstatement as a result of fraud, the auditor should perform procedures, including a detailed review of the client's quarter-end and year-end adjusting journal entries and an investigation of.any entries that appear unusual as to nature or amount and of significant and unusual transaction, particularly those occurring at or near quarter-or year-end .
48184 242 AU § 316.29. Ernst & Young violated GAAS because it failed to properly consider the risk that
AOL and AOL Time Warner' s financial statements would be materially misstated as a result of
fraud.
628. In its role as auditor, starting at least as early as the quarter ended December 31 ,
1998, and throughout the Class Period, Ernst & Young knew of extraordinary audit risk factors
("red flags") at AOL and AOL Time Warner which Ernst & Young intentionally ignored or
recklessly disregarded, allowing AOL and AOL Time Warner to artificially inflate their
advertising revenue. Significant audit risk factors which existed at AOL and AOL Time Warne r
throughout the Class Period and Ernst & Young audit failures include the following :
a. Ernst & Young knowingly or recklessly failed to design its audits to
consider that a significant portion of management 's compensation was represented by bonuses,
stock options, or other incentives, the value of which was contingent upon AOL and AOL Time
Warner achieving. unduly aggressive revenue or earnings targets. Ernst & Young was aware of
the overwhelming motivation for management to engage in fraudulent financial reporting, which
included the personal motive that Individual Defendants had to maintain a high stock price,
AOL's need to maintain its stock price in order to consummate the Merger.
b. Ernst & Young knowingly or recklessly failed to properly consider the
excessive interest by management in maintaining or increasing AOL and AOL Time Warner' s
stock price or advertising revenue growth trends through the use of unusually aggressiv e
accounting practices . Ernst & Young was aware that AOL and AOL Time Warner entered int o
many complex and aggressive transactions, and that material amounts of the advertising revenu e
that came in at the end of the quarters which allowed AOL and AOL Time Warner to hit its
advertising revenue targets were based on such practices. Many deals entailed reciprocal or
48184 243 round-trip transactions whereby AOL and AOL Time Warner's own money was cycled back to them as revenues, or barter instruments that were difficult to value, while others, lik e
PurchasePro, improperly converted cash flows of an entirely different nature into advertising revenues
c. Ernst & Young was aware of the significant problems that AOL experienced with the SEC on several- occasions in connection with its accounting practices, including the May 2000 imposition of a cease and desist order and $3 .5 million fine against AOL and the requirements on several occasions that AOL restate prior financial statements. Ernst &
Young was therefore aware of the SEC's significant concerns with AOL's accounting practices, as well as with internet companies generally . Further, Ernst & Young knew of the importanc e the SEC attached to making sure that AOL and AOL Time Warner's financial statements did not
"reflect the desire of management rather than the underlying financial performance of th e company"' and did not "stretch the rules through aggressive accounting."
d. Ernst & Young knowingly or recklessly failed to design its tests or execute its audits properly to investigate the nature, timing and amount ofrevenues which Ernst &
Young knew were being recorded at the eleventh hour at AOL and AOL Time Warner . Ernst &
Young knew that AOL and AOL Time W arner management had a practice of promising analysts, creditors, and other third parties that the companies would achieve what appeared to be undul y aggressive or clearly unrealistic forecasts -- AOL and AOL Time Warner were touted as th e industry powerhouse primarily because of their ability to meet and generally exceed undul y aggressive forecasts. When the online advertising market was weakened , AOL and AOL Time
Warner communicated their superiority and insulation from any risk of loss . Ernst & Young knew the positive impact the announcement of a large advertising deal would have on the AOL
48184 244 and the AOL Time Warner share price, and knew that AOL and AOL Time Warner were extraordinarily intent on hitting adve rtising revenue targets. Ernst & Young knew that AOL' s
"BA Specials" that would come through near the end of a reporting period consistently aide d
AOL and AOL Time Warner in meeting or exceeding the market 's high expectations.
e. Ernst & Young did not adjust its audit procedures despite a failure b y
AOL and the Company's management to display and communicate an appropriate attitude regarding internal controls in the financial reporting process . As the long-term auditing and accounting firm of AOL and AOL Time Warner, Ernst & Young was very aware that AOL an d
AOL Time Warner placed signi ficant emphasis on hitting earnings targets and analys t expectations at the expense of fiscal responsibility and proper accounting practice . In this regard,
Ernst & Young knew of the high pressure and focused environment at the companies to report revenue, especially advertising revenue , as high as possible. This included AOL and AOL Time
Warner's senior management continuously setting unduly aggressive and unattainable revenu e targets and expectations for operating personnel, as opposed to targets and expectations based on the operational realities at the companies and within the intemnet industry, thereby setting up enormous pressure on the AOL and AOL Time Warner management to employ improper advertising revenue recognition practices. Despite this attitude and corporate culture, Ernst &
Young failed to address the risks of overstated revenues .
f. Ernst & Young knowingly or recklessly failed to inquire of all partie s involved in the complex barter/roundtrip transactions, did not perform substantive tests t o determine proper valuation (such as present value analyses or comparable market pricing t o estimate fair market value) and did not investigate whether advertising revenue was truly earne d or realizable. In order to determine such, investigations as to the value of deals touted in AOL
48194 245 and AOL Time Warner's SEC filings, specifically the collectibility of receivables or restricted stock transactions should have been examined .
g. Ernst & Young did not appropriately design or execute its audits t o properly address the impairment of AOL Time Warner's tangible and intangible assets. AOL
Time Warner ignored the requirements in the then present literature regarding goodwil l impairment, choosing to wait to apply subsequent standards and claim the impairment loss was a result of new accounting literature .
h. Ernst & Young knowingly or recklessly failed to increase its substantiv e testing to determine how or why AOL and AOL `Time Warner continued to show growth of large proportions when competitors and the industry as a whole was declining. Additional testing should have included comprehensive tracking of relationships (to expose the roundtripping/barter transactions, procedures should have been put in place to identify the reciprocal patterns of purchases and sales) and examina tion of pricing (including discounts) of counterparties' bartering instruments (AOL and AOL Time Warner paid inflated prices for customer goods or services to generate inflated sales for itself). Ernst & Young knew that AOL and AOL Time Warner faced a high degree of competition in a market facing declining margins .
Not only this, but the industry as a whole was suffering with increasing business failures and
significant declines in customer demand . Ernst & Young was aware that AOL and AOL Time
Warner faced the reality that their adver tising revenue was a critical indicator of performance, while the industry was experiencing declining advertising demand .
i. Ernst & Young knowingly or recklessly failed to audit the controls aroun d
the disclosures, classification and timing for advertising revenue, allowing classification a s
revenues rather than gains/losses on contracts . As AOL and AOL Time Warner's dot-corn
48184 246 customers were failing and the related revenue streams were drying up, Ernst & Young wa s
aware that AOL and AOL Time Warner began to reduce commitments and accelerate co llections from these customers and that AOL and AOL Time Warner would allow the dot-corns to pa y their way to a shortened or terminated deal, saving the dot corn years of payments and-generatin g immediate cash flow for the companies .
629. Ernst & Young was also aware of significant audit risks ("red flags") relating t o the operating characteris tics and financial stability of the AOL and AOL Time Warner, yet failed to plan and perform the nature, timing and extent of its audit procedures, including :
a. Ernst & Young was aware of and knowingly or recklessly failed to examine the nature, timing and classification of round-tripping and barter transactions . In order to appropriately account for the transac tions, further investigation beyond reading the contracts was required . Ernst & Young knew that AOL and AOL Time Warner regularly entered into roundtripping or barter transactions that generated gains or earnings growth while the amounts of cash transacted were simply exchanges of like amounts.
b. Ernst & Young knowingly or recklessly failed to plan its audits to consider the fact that AOL and AOL Time Warner' s financial reporting was based on significant estimates that involved unusually subjective judgments or uncertainties, or that were subject to potential significant changes in the near term that were financially disruptive on the entity (e.g. ultimate co llectibility of receivables, timing of revenue recogni tion, or realizability of financial instruments based on the highly subjective valuation of collateral or difficult-to-assess repayment sources). Ernst & Young knew that AOL and AOL Time Warner entered into barter transactions on a regular basis that included goods and services of an estimated value. Ernst & Young failed to design substantive tests to determine the reasonableness of these estimated values . Ernst &
48184 247 Young failed to examine the counterparties' competitive pricing and standard discounts for similar transactions - there were cases where AOL and AOL Time Warner overpaid for goods and services to provide incentive to the counter-party to purchase from AOL and AOL Tim e
Warner and valued the transactions at the inflated amounts .
c. Ernst & Young did not properly ascertain materiality as it related to AOL and AOL Time Warner and its transactions . Materiality applies to both the quantitative and qualitative factors Ernst & Young knowingly or recklessly failed to consider the impact o f overstated advertising revenue on the stock price and investors' decision-making . Ernst &
Young was aware that AOL and AOL Time Warner had significant, unusual, and highly complex transactions, especially those close to quarter or year end, that posed difficul t
"substance over farm" questions. Most of AOL and AOL Time Warner's barter/roundtrippin g transactions, in addition to advertising deals with companies who were obligated to remi t litigation settlements to the company, fell into this risk category.
d. Ernst & Young knowingly or recklessly failed to examine transactions fo r substance over form, proper valuation and business use. Ernst & Young was aware that AOL and AOL Time Warner bad contractual anangements without apparent business purpose. AOL and AOL Time Warner entered into deals with companies who had no business purpose for advertising online.
e. Ernst & Young knew, but knowingly or recklessly failed to ascertain why ,
AOL and AOL Time Warner outperformed everyone in the marketplace, accepting the easy answer that the proof was in the numbers. Ernst & Young had the responsibility to exercise skepticism in investigating the revenue recognition policies, including valuation, timing and
48184 248 collectibility of the barter transactions, and the "multi-million dollar" deals with companies with questionable futures. It did not carry out its responsibility.
630. Given Ernst & Young's actual knowledge and disregard of such significant audi t risk factors ("red flags") at AOL and AOL Time Warner, particularly in the context of ho w sensitive advertising revenue recognition issues were, and are, for internet-based companies ,
Ernst & Young either knew of or recklessly disregarded, the various sham and improperl y accounted for AOL and AOL Time Warner transactions described in this Complaint. Ernst &
Young's total abdication of professional skepticism in not challenging the economic substanc e and reality of the subject transactions resulted in the issuance of a "clean" or unqualified audi t opinion on financial statements that were known or would have been known had Ernst & Youn g conducted its audits in accordance with GAAS, to be materially misstated.
b. Ernst & Young Failed to Maintain Independence
631 . Ernst & Young violated GARS General Standard No . 2, which requires the auditor to maintain an independence in mental attitude in all matters relating to the aud it. The independent auditor must comply with the rules of independence, including AU § 150.02 which provides that. Similarly, AU § 220.02 states:
"In all matters relating to the assignment, an independence in mental attitude is to be maintaine d by the auditor or auditors." AU § 220.02 states:
[T]he auditor must be independent . . . .he must be without bias with respect to the client since otherwise he would lack that impartiality necessary for the dependability of his findings, however excellent his technical proficiency may be . However, independence does not imply the attitude of a prosecutor but rather a judicial impartiality that recognizes an obligation for fairness not only to management and owners of a business but also to creditors and those who may otherwise rely (in part, at least) upon the independent auditor's report, as in the case of prospective owners or creditors.
AU § 220.02.
45184 249 632. Ernst & Young knew that its various other business dealings with AOL and AOL
Time Warner through which it earned enormous fees presented conflicts of interest for Ernst &
Young, which motivated it to appease the companies rather than perform its auditin g responsibilities for the benefit of the companies' shareholders .
c. Ernst & Young Violated GARS By Reporting That The Financial Statements Were Presented in Accordance With GAAP When The Were Not
633. Standard of Reporting No . 1 states:
The report shall state whether the financial statements are presented in accordance with generally accepted accounting principles. AU § 150.02.
Professional standards set forth the following requirements with respect to this standard :
The term "generally accepted accounting principles" as used in reporting standards is construed to include not only accounting principles and practices but also the methods of applying them. AU § 410.02.
The phrase "generally accepted accounting principles" . . . includes not only broad guidelines of general application, but also detailed practices and procedures . . . AU § 411 .02.
The auditor' s opinion that financial statement present fairly an entity's financial position, results of operations, and cash flow in conformity with generally accepted accounting principles should be based on his or her judgment as to whether (a) the accounting principles selected and applied have general acceptance; (b) the accounting principles are appropriate in the circumstances . . . . (e) the financial statements reflect the underlying transactions and events in a manner that presents the financial position, results of operations, and cash flows stated within a range of acceptable limits, that is, limits that are reasonable and practicable to attain in fi nancial statements. AU § 411.04.
634. Ernst & Young violated GAAS Reporting Standard No. 1, which requires the audit report to state whether the financial statements are presented in accordance with GAAP, as
Ernst & Young's audit opinions falsely represented that the AOL and AOL Time Warner
48184 250 financial statements complied with GAAP when, in fact, those financial statements were materially misstated .
d. Ernst & Young Failed to Obtain Sufficient and Competent Evidential Matter.
635. "Most of the independent auditor's work in forming his or her opinion o n financial statements consists of obtaining and evaluating evidential,matter concerning th e assertions in such financial statements ." AU § 326 .02. "The independent auditor's direct personal knowledge, obtained through physical examination, observation, computation, and inspection, is more persuasive than information obtained ind irectly." AU § 326 .21 .
Representations from management "are not a substitute for the application of those auditing procedures necessary to afford a reasonable basis for an opinion regarding the financial statements under audit ." AU § 333.02; AU § 333 .02. "The books of original entry, the general and subsidiary ledgers, related accounting manuals, and records such as work sheets and spreadsheets supporting cost alloca tions, computations, and reconciliations all constitute evidence in support of the financial statements." "[W]ithout adequate attention to the propriety and accuracy of the underlyiig accounting data, an opinion on financial statements would not be warranted." AU § 326 .16, AU § 326 .15. Ernst & Young violated GARS by failing to obtain sufficient and competent evidential matter .
636. For example, Ernst & Young failed to obtain stifficient competent evidentia l matter with respect to AOL and AOL Time Warner's excessive valuation and comple tion of earnings process in connection with barter transactions. Ernst & Young failed to :
a. Perform an adequate test of the fair market value of the goods ,
services and equity exchanged for advertising;
48184 251 b. Inquire of lower level staff responsible for putting goods int o
service to determine the benefit received by AOL and AOL Time Warner, and
c. Inquire of customers as to the value received by the customer .
637. Further, Ernst & Young failed to obtain sufficient competent evidential matter with respect to AOL and AOL Time Warner's overpayments for goods or services in order to generate reciprocal sales. Ernst & Young failed to :
a. Obtain standard price lists, large customer and volume discounts,
etc. from vendors to determine the reasonableness of p rices being paid by AOL and AOL
Time Warner, and
b. Compare such transactions with similar purchases made in the pas t
to determine whether an overpayment was made .
638. Ernst & Young also failed to gather sufficient competent evidential matter t o corroborate AOL and AOL Time Warner's management representations as to the earnings process completed in connection with "jackpotting." Ernst & Young failed to :
a. Examine the times and sites on which ads ran which would have demonstrated the lack of a true earnings process and in turn revealed a mechanism used simpl y to generate revenue;
b. Inquire of lower level staff responsible for placing the advertisements on AOL's web site; and
c. Inquire of customers who expressed dissatisfaction ove r
"j ackpotting."
48184 252 e. Ernst &Young Failed to Exercise Due Professional Care and Professional Skepticism .
639. "Due professional care requires the auditor to exercise professional skepticism ."
This requires the auditor to "diligently perform, in good faith and with integrity, the gatherin g and objective evaluation of evidence." "In exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that management i s honest." AU §§ 230 .07-09, AU § 316.16-21 (professional skepticism is required in planning an d performing an audit). The auditor also "must be without bias with respect to the client sinc e otherwise he would lack [the] impartiality necessary for the dependability of his findings ." AU §
220.02. Notwithstanding these requirements, in connection with its planning and performing audit procedures concerning, among other things, recognition of advertising revenue, and certai n other matters described herein, Ernst & Young relied almost exclusively on representations fro m
AOL and AOL Time Warner management and failed to exercise professional skepticism, failed to maintain an independent mental attitude and failed to exercise due professional care in th e exercise of its audits.
C Ernst &,Young Failed to Properly Plan and Supervise.
640. The auditor must adequately plan its audit and properly supervise the work of associates so as to establish and carry out procedures reasonably designed to search for and direct the existence of fraud that could have a material effect on the financial statements . AU §§
310, 320, 327. The auditor must also obtain a level of knowledge of its clients' businesses sufficient to enable it to "obtain an understanding of the events, transactions, and practices that, in his judgment, may have a signi ficant effect on the financial statements ." AU § 311 .06.
. . . The auditor may decide to consider further management's selection and application of significant accounting policies , particularly those related to revenue recognition, asset valuations, or capitalizing versus expensing. In this respect, the
48194 253 auditor may have a greater concem about whether the accounting principles selected and policies adopted are being applied in an inappropriate manner to create a material misstatement of the financial statements. AU § 316A.27. (Emphasis added.)
641 . For example, Ernst & Young failed to obtain sufficient knowledge, and plan its audit accordingly, with respect to AOL and AOL Time Warner' s accounting and reporting systems to recognize, among other things :
a. The methods AOL employed to generate substantial advertising sales activities near the end of reporting periods along with any weaknesses of failures within th e internal control system that would ensure such sales' validity. AOL had "BA specials" - that were generated at the eleventh hour of a given reporting period and provided revenue figures necessary to hit earnings targets, but later would be deemed uncollectible or impaired ;
b. Weaknesses associated with AOL's accounting policies related to revenuetgain classification. AOL renegotiated deals for a buy-out or early termination with failing dot-cons which were construed as sales revenues rather than a gain or other revenues ; and
c. Litigation settlements that were converted to advertising revenu e on more than one occasion. There appeared to be little or no internal controls governing such classification practices, nor did Ernst & Young plan their audits accordingly based on thes e weaknesses within the internal control system . In connection with planning and supervising its audit procedures, Ernst & Young violated GAAS .
642. In addition, Ernst & Young failed to obtain sufficient knowledge upon which t o assess the environment under which AOL and AOL Time Warner's accounting data, wer e produced and processed:
48184 254 a. Revenues/profitability were not consistent with industry trends (AOL was able to show increased advertising revenues in an industry facing significant decline) ;
b. The rate of change within the indust ry was rapid;
c. AOL and AOL Time Warner operated within a highly competitive environment;
d. Direction of change within industry was declining with business failures ;
e. Management demonstrated an attitude toward financial reporting that wa s unduly aggressive;
f. Management placed undue emphasis on meeting revenue/earnings projections ;
g. Management's compensation was tied to meeting aggressive targets ;
h. Many contentious or difficult accounting issues were present; and
Significant difficult-to-audit transactions or balances were present .
g. Ernst & Young Failed to Properly Evaluate Audit Findings .
643. "The risk of material misstatement of the financial statements is generally greater when account balances and classes of transactions include accounting estimates rather tha n essentially factual data because of the inherent subjectivity in estimating future events."
Estimates are subject "to misstatements that may arise from using inadequate or inappropriat e data or misapplying appropriate data ." AU § 312.36. "Even when management's estimation process involves competent personnel using relevant and reliable data, there is potential for bia s in the subjective factors." Accordingly, the auditor should consider estimates "with an attitude of professional skep ticism." AU § 342.04. "{T]he auditor should obtain an understanding of how management developed the estimate ," AU § 342 .10, and should "obtain sufficient
48194 255 competent evidential matter to provide reasonable assurance" that, among other things , estimates
are reasonable in the circumstances and are presented in conformity with GAAP, AU § 342 .07.
Ernst & Young violated GAAS , because it failed to obtain sufficient competent evidential matter
concerning, and, therefore, failed to properly evaluate, AOL and AOL Time Warner's estimates
of, among other things, round-tripped transactions, bartered goods and services, and goodwill
impairments.
h. Ernst & Young Failed to Properly Consider AOL and AOL Time Warner's Lack of Internal Control.
644. "In all audits, the auditor should obtain an understanding of internal control
sufficient to plan the audit ." AU § 319 .02. The auditor should obtain sufficient knowledge of
the information system relevant to financial reporting to understand," among other things, the
classes of significant transactions, "the accounting records, supporting information and specific
accounts in the financial statements involved in the processing and reporting of transactions, the
accounting processing involved in recording , processing, accumulating and reporting
transactions, and the financial reporting process used to prepare financial statements." AU §
319.49. Ernst & Young violated GAAS because it knowingly or recklessly failed to learn or to
consider that AOL and AOL Time Warner had grossly deficient internal controls and procedures .
For example, Ernst & Young failed to develop or plan its audits to consider :
a. that AOL Time Wainer had grossly deficient revenue recognition
disclosure controls, including the lack of an appropriate system for determining amount,
timing and classification of revenues/gains, policies governing the calculation of fair
market value in the complex barter transactions, and integrity of revenue disclosures to
report the true substance of transactions rather than their form which were many time s
48184 256 quite different. This included a lack of control over a few key employees' ability to
influence the accounting for advertising revenue ; and
b. that efforts were not made to assure that all necessary adjustments to
correctly and fairly present AOL and AOL Time Warner's quarterly financial posi tion
and results of operations.
L. The Materially False and Misleading Statements and Omissions of Material Facts In the Merger Registration Statement and Joint Proxy Statement Prospectus
645. On February 11, 2000, AOL Time Warner filed with the SEC and disseminated to the public the Merger Registration Statement, which included the Joint Proxy Statement-
Prospectus. AOL Time Warner made four amendments to the Merger Registration Statement, the last of which was filed with the SEC on May 19, 2000 .
646. The Merger Registration Statement was signed by J. Michael Kelly, Executive
Vice President and Chief Financial Officer, Gerald M. Levin, Chief Executive Officer, and Pau l
T. Cappuccio, Vice President and Director.
647. The Joint Proxy Statement-Prospectus was signed by Defendant Case, as
Chairman and Chief Executive Officer of AOL, and Defendant Levin, as Chairman of Tim e
Warner, and sent to shareholders of both companies on or about May 23, 2000 .
648. The Merger Registration Statement and Joint Proxy Statement-Prospectus included the Second Amended and Restated Agreement and Plan of Merger (the "Merge r
Agreement"). The Merger Agreement was attached as Annex A to the Merger Registration
Statement and Joint Proxy Statement-Prospectus. In the Merger Agreement, AOL represented and warranted as follows:
4.1 Representations and Warranties of America Online . . .
48184 257 (d) Reports and Financial Statements .
(i) America Online has filed all required registration statements, prospectuses, reports, schedules, forms, statements and other documents required to be filed by it with the SEC since July 1, 1997 (collectively, including all exhibits thereto , the "America Online SEC Reports").... None of the America Online SEC Reports, as of their respective dates (and, if amended or superseded by a filing prior to the date of this Agreement, then on the date of such filing), contained or will contain any untrue statement of a material fact or omitted or will omit to state a material fact required to be stated therein or necessar t o to make the statements therein, in light of the circumstances under which they were made, not misleading. Each of the financial statements (including the related notes) included in -the America Online SEC Reports presents fairly, in a ll material respects, the consolidated financial position and consolidated results of operations and cash flows of America Online and its consolidated Subsidiaries as of the respective dates or for the respective periods set forth therein, all in conformity with United States generally accepted accounting principles "GAAP") consistently applied during the periods involved except as otherwise noted therein, and subject, in the case of the unaudited interim financial statements, to the absence of notes and normal year-end adjustments that have not been and are not expected to be material in amount. All ofsuch America Online SEC Reports, as of their respective dates (and as of the date of any amendment to the respective America Online SEC Report), complied as to form in all material respects with the applicable requirements of the Securities Act and the Exchange Act and the rules and regulations promulgated thereunder .
*** (e) Information Supplied .
(i) None of the information supplied or to be-supplied by America Online for inclusion or incorporation by reference in (A) the Form S-4 (as defined in Section 6.1) will, at the time the Form S-4 is filed with the SEC, at any time it is amended or supplemented or at the time it becomes effective under the Securities Act, contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary to make the statements therein in light of the circumstances under which they were made, not misleading and (B) the Joint Proxy Statement/Prospectus (as defined in Section 6.1) will, on the date it is first mailed to Time Warner stockholders or America Online stockholders or at the time of the Time Warner Stockholders Meeting or the America Online Stockholders Meeting (each as defined in Section 6 .1), contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary in order to make the statements therein,in light of the circumstances under which they were made, not misleading . The Form S-4 and the Joint Proxy Statement/Prospectus will, comply as to form in all material respects with the requirements of the Exchange Act and the Securities Act and the rules and regulations of the SEC thereunder .
481sa 258 (Emphasis added.)
649. The Joint Proxy Statement-Prospectus included the following message to
shareholders : "Me boards of directors of both America Online and Time Warner have approved
the merger and recommend that their respective stockholders vote FOR the merger proposal .
Information about the merger is contained in this joint proxy statement prospectus."
650. The Joint Proxy Statement-Prospectus continued :
Your vote is v important, regardless of the number of shares you own . Whether or not you plan to attend the special meeting, please vote as soon as possible to make sure that your shares are represented at the meeting . If you do not vote, it will have the same effect as voting against the merger . We strongly support this combination of our companies and join with our boards of directors in enthusiastically recommending that you vote in favor of the merger .
(Emphasis added.)
651 . The Joint Proxy Statement Prospectus explained that the record date of eligibility
to vote on the Merger was May 18, 2000, and that the Special Stockholder Meetings for AO L
and Time Warner shareholders would both take place on June 23, 2000.
652. The Merger required and received the affirmative vote of the AOL and Time
Warner shareholders at the respective Special Stockholder Meetings .
653. The Merger Registration Statement and Joint Proxy Statement-Prospectu s
included selected historical financial data of AOL, including the audited consolidated financial
statements of AOL for the year ended June 30, 1999 and unaudited consolidated financia l statements for the nine months ended March 31, 1999 and 2000 .
654. In addition, the Merger Registration Statement and Joint Proxy Statement-
Prospectus included unaudited pro forma conso lidated financial data of AOL Time Warner. The pro forma financial results were presented on two different bases due to AOL's and Time
48184 259 Warner's different fiscal years - a June 30 fiscal year basis and a December 31 calendar yea r
basis. The AOL Time Warner pro forma financial data included revenue data for the nine
months ended March 31, 2000, the year ended June 30, 1999, the three months ended March 31 ,
2000 and the year ended December 31, 1999 .
655. The Merger Registration Statement also included the pro forma consolidated
condensed balance sheet of AOL Time Warner as of March 31, 2000 which purported to reflect
the historical financial position ofAOL at March 31, 2000 and also set forth the amount
allocated to goodwill as a result of the Merger.
656. The Merger Registration Statement and Joint Proxy Statement -Prospectus also
incorporated by reference, inter alia, the documents set forth below, each of which included
some or all of the materially untrue and misleading financial statements and information referred
to herein:
a. America Online's Annual Report on Form 10-K for the fiscal year ended June 30, 1999 (filing date August 13, 1999) ;
b. America Online's Quarterly Report on Form 14-Q, for the quarterly period ended September 30, 1999 (filing date November 2, 1999) ;
G. America Online's Quarterly Report on Form 1 O-Q, for the quarterly period ended December 31, 1999 (filing date February 14, 2000) ;
d. America Online's Quarterly Report on Form 10-Q/A, for the quarterly period ended March 31, 2000 (filing date May 17, 2000), which contains financial statements and related information that restate and supersede the financial statements and related information in America Online's Annual Repo rt on Form 10-K for the fiscal year ended June 30, 1999, filed August 13, 1999 ;
e. America Online's Current Report on Form 8-K dated January 19, 2000 (filing date January 24, 2000) incorporating AOL's press release, dated January 19, 2000, announcing AOL's financial results for the quarter ended December 31, 1999;
f. America Online 's Current Report on Form 8-K dated January 10, 2000 (filing date February 11, 2000) incorporating AOL Time Warner pro forma consolidated condensed financia l statements for the three months ended September 30, 1999, the year
48184 260 ended June 30, 1999, nine months ended September 30, 1999 and year ended December 31; 1998;
g. America Online's Current Report on Form 8-K dated April 3, 2000 (filing date April 3, 2000) incorporating AOL Time Warner pro forma consolidated condensed financial statements for the six months ended December 31, 1999, the year ended June 30, 1999, and the year ended December 31, 1999 ;
h. America Online's Current Report on Form 8-K dated April 18, 2000 (filing date April 2 1, 2000) incorpora ting AOL's press release, dated April 18, 2000, announcing AOL's financial results for the quarter ended March 31 , 2000; and
i. The Joint Proxy Statement and Prospectus filed with the SEC on or about May 19, 2000 and sent to Time Warner and AOL shareholders on or about May 23, 2000 relating to the Merger of AOL and Time Warner .
657. Ernst & Young consented to the incorporation by reference in the Merge r
Registration Statement and Joint Proxy Statement-Prospectus of its unqualified audit report , dated July 21, 1999 , on AOL's 1999 consolidated financial statements as set forth in AOL's
1999 SEC Form 10-K for the year ended June 30, 1999 and consented to all references to Ernst
&Young in the Merger Registration Statement and Joint Proxy Statement-Prospectus, which included a reference to it under the caption "Experts ." In a subsequent amendment to the Merger
Registration Statement, Ernst & Young consented to the reference to itself as "Experts" and to the use of its report dated July 21, 1999, except for Note 3, which is dated May 12, 2000, wit h respect to the consolidated financial statements of AOL for the three years ended June 30, 1999 incorporated by reference as Exhibit 99 to AOL's SEC Form 10-Q/A for the quarterly period ended March 31, 2000 , incorporated by reference and made a part of the Merger Registra tion
Statement and Joint Proxy Statement Prospectus . In that amendment, Ernst & Young als o consented to the incorporation by reference in the Merger Registration Statement and Joint Prox y
Statement-Prospectus, and to the reference to itself as "Experts," of its May 19, 2000 report wit h respect to the consolidated balance sheet of AOL Time Warner as of March 31, 2000 . Finally,
48194 261 Ernst & Young consented to the incorporation by reference in the Merger Registration Statemen t and Joint Proxy Statement-Prospectus of its report dated July 20, 2000, with respect to th e consolidated financial statements of AOL included in its SEC Form 10-K for the year ended Jun e
30, 2000. These reports were incorporated in the Merger Registration Statement and Joint Prox y
Statement-Prospectus "in reliance on Ernst & Young's report, given on their authority as expert s in accounting and auditing."
658 . AOL Time Warner further represented in the Merger Registration Statement an d
Joint Proxy Statement-Prospectus that Ernst & Young had audited the consolidated balance shee t of AOL Time Warner at March 31, 2000 and audited the consolidated financial statements o f
AOL for the three years ended June 30, 1999 and that such fi nancials were incorporated in th e
Merger Registration Statement and Joint Proxy Statement-Prospectus under "Experts" "i n reliance on Ernst & Young LLP's report, given on their authority as experts in accounting an d auditing."
659. The pro forma consolidated condensed financial statements included in the
Merger Registration Statement and Joint Proxy Statement-Prospectus were "presented to illustrate the effects of the Merger ." The pro forma financial statements represented that as a result of the Merger an estimated amount of $94.705 billion would be allocated to goodwi ll due to the excess purchase price over identifiable tangible and other intangible assets . The pro forma financial statements also estimated a useful life of 25 years for the goodwill .
660. The Company ' s Merger Registration Statement and AOL's and Time Warner' s
Joint Proxy StatementProspectus represented that :
AOL Time Warner will periodically review the carrying value of the acquired goodwill for acquired businesses to determine whether an impairment may exist . AOL Time Warner will consider relevant cash flow information, including estimated future operating results, trends and other available information, i n
48184 262 assessing whether the carrying value of goodwill can be recovered . If it is determined that the carrying value of goodwill will not be recovered from the undiscounted future cash flows of acquired businesses, the carrying value of such goodwill would be considered impaired and reduced by a charge to operations in the amount of the impairment.
(Emphasis added.) In addition, the Merger Registration Statement and Joint Proxy Statement-
Prospectus represented that an "impairment charge" would be "measured as any deficiency in the amount of estimated undiscounted cash flows of acquired businesses available to recover th e carrying value related to goodwill ."
661 . All of the financial statements of AOL contained or incorporated by reference i n the Merger Registration Statement and Joint Proxy Statement-Prospectus were untrue becaus e they materially overstated AOL advertising and commerce revenue, and/or AOL advertising an d commerce backlog, and/or percentage increases in such amounts in year over year comparisons, for various fiscal periods as set forth in ¶J 240-357 and 392 .
662. All of the pro forma financial statements for AOL Time Warner, including the
Company's pro forma consolidated condensed balance sheet as of March 31, 2000, contained o r incorporated by reference in the Merger Registration Statement and Joint Proxy Statement-
Prospectus were untrue because they materially overstated AOL advertising and commerc e revenue, as set forth in $1235-357 and 392, and because they materially overstated the real valu e of goodwill and its useful life, as set forth in IN 395-432.
663 . All of the financial statements and pro forma financial statements contained o r incorporated by reference in the Merger Registration Statement and Joint Proxy Statement-
Prospectus failed to disclose the sham transactions and improper accounting that resulted in th e overstated advertising revenue and backlog, and percentage comparisons referred to above ; the
48184 263 true current and anticipated condition of AOL's adver tising revenue and business ; and the true
fair value of goodwill created by the Merger and its useful life was materially overstated.
664. All of the financial statements of AOL contained or incorporated by reference in
the Merger Registration Statement and Joint Proxy Statement-Prospectus falsely represented tha t
they were prepared in accordance with GAAP and Article 10 of Regulation S-X.
665. With respect to the audited financial statements of AOL included or incorporated
by reference in the Merger Registration Statement and Joint Proxy Statement Prospectus, Ernst
&Young falsely represented that they were audited in conformance with GARS.
666. All of the financial statements of AOL contained or incorporated by reference in
the Merger Registration Statement and Joint Proxy Statement-Prospectus falsely represented tha t
they fairly represented the results of AOL operations, particularly with respect to the advertising
revenue and business of AOL.
667. For the same reasons set forth above, AOL's representations and warranties in the
Merger Agreement attached as Annex A to the Merger Regis tration Statement and Joint Prox y
Statement-Prospectus that: (1) AOL's financial statements were prepared in conformity with
GAAP; and (2) AOL's SEC filings were free of material misstatements and omissions wer e
similarly untrue and misleading.
VII. APPLICABILITY OF PRESUMPTION OF RELIANCE : FRAUD-ON-TEDE-NLARIKET DOCTRINE
668. At all relevant times, the market for AOL and AOL Time Warner stock, was an
efficient market for the following reasons, among others:
a. AOL's and the AOL Time Warner 's stock met the requirements for listing,
and were listed and actively traded on the NYSE, a highly efficient and automated market;
48184 264 b. As regulated issuers , AOL and AOL Time Warner filed periodic publi c
reports with the SEC and the NYSE ;
c. AOL and AOL Time Warner regularly communicated with public
investors via established market communica tion mechanisms, including through regular
dissemination of press releases on the national circuits of major newswire services an d
through other wide-ranging public disclosures, such as communications with the financia l
press and other similar reporting services and regular periodic conferences with groups of
market analysts; and
d . AOL and AOL Time Warner were followed by numerous securities
analysts employed by major brokerage firms who wrote reports which were distributed to
the sales force and certain customers of their respective brokerage firms . Each of these
reports was publicly available and entered the public marketplace .
669. As a result of the foregoing, the market for AOL's and the Company's stock promptly digested current.information from all publicly available sources and reflected such information in AOL's and the Company's stock. Under these circumstances, all purchasers of
AOL and the Company's stock during the Class Period suffered similar injury through their purchase of such stock at artificially inflated prices and/or through their purchase or sale o f options on AOL and/or Company stock, and a presumption of reliance applies.
VIII. NO SAFE HARBOR
670. The statutory safe harbor provided for forward-looking statements under certain circumstances does not apply to any of the allegedly false statements pleaded in this Complaint.
Many of the specific statements pleaded herein were not identified as "forward-looking statements" when made, nor was it stated that actual results could differ materially from those
48194 265 projected, nor did meaningful cautionary statements identifying important factors that could
cause actual results to differ materially from those in the forward-looking statements accompany
those forward-looking statements. Alternatively, to the extent that the statutory safe harbor does
apply to any forward-looking statements pleaded herein, defendants are liable for those fals e
forward-looking statements because at the time each of those forward-looking statements was
made, the particular speaker knew that the particular forward-looking statement was false, and/or
the forward-looking statement was authorized and/or approved by an executive officer of
America. Online and/or the Company who knew that those statements were false when made. IX. COUNTS
COUNT ONE
(Against AOL Time Warner for Violations of § 11 of the Securities Act in Connection with the Merger Registration Statement)
671 . Plaintiffrepeats and realleges each and every allegation contained above as if
fully set forth herein, except that this Count does not sound in fraud, and Plaintiff does not
incorporate herein any allegations of fraud in connection with this Count . This Count is asserted
against AOL Time Warner for violation of Section 11 of the Securities Act, 15 U.S .C. § 77k, on
behalf of all Class members who acquired AOL Time Warner common stock pursuant and/or
traceable to the Merger Registration Statement, including in exchange for Time Warner common
stock.
672. The Merger Registration Statement contained untrue statements of mate rial facts
and omitted to state material facts necessary to make the statements made therein not misleading .
As referenced in this Complaint, the untrue statements of material fact contained in, and th e
material facts omitted from the Merger Registration Statement include :
48184 266 a. AOL's untrue financial statements which artificially inflated AOL advertising revenue;
b. AOL Time Warner' s untrue pro forma financial statements which contained artificially inflated AOL advertising revenue;
c. AOL Time Warner's untrue pro forma financial statements which falsely represented the true value of goodwill created in connection with the Merger, and the useful life of the goodwill;
d. Failure to disclose that the AOL advertising revenue in the financial statements and pro forma financial statements was based on sham transactions and improper accounting, the true current and anticipated condition of AOL's advertising revenue and business; and that the true fair value of goodwill created by the Merger and its useful life was materially overstated; -
C. The untrue representation that AOL's financial statements had been prepared in conformity with GAAP; and
f. . AOL's untrue representations and warranties in the Merger Agreement.
673 . AOL Time Warner is the registrant for the shares issued pursuant to the Merger and filed and signed the Merger Regis tration Statement as the issuer of its common stock. AOL
Time Warner is therefore absolutely liable under Section 1 I of the Securi ties Act, 15 U .S.C. §
77k, to Plaintiff and other members of the Class for the material misrepresentations or omission s contained in the Merger Registration Statement.
674. At the time Plaintiff and other Class members acquired AOL Time Warner common stock pursuant and/or traceable to the Merger Registration Statement, they did no t know of the facts concerning the untrue and misleading statements and omissions alleged herein .
675 . In connection with issuing the Merger Registration Statement, AOL Time Warner used the means and instrumentalities of interstate commerce and the U . S. mails.
676. By reason of the foregoing , AOL Time Warner is absolutely liable for violations of Section 11 of the Securities Act to Plaintiff and the other members of the Class who acquire d
AOL Time Warner common stock pursuant and/or traceable to the Merger Registratio n
48184 267 Statement, including in exchange for Time Warner common stock, each of whom has been damaged by reason of such violations .
COUNT TWO
(Against Defendants Case, Levin, Kelly, Cappuccio, Novack, and Pittman for Violation of Section 11 of the Securities Act in Connection with the Merger Registration Statement)
677. Plaintiffrepeats and realleges each and every allegation contained above as if fully set forth herein, except that this Count does not sound in fraud, and Plaintiffdoes not incorporate herein any allegations of fraud in connection with this Count . This Count is asserted against Defendants Stephen Case, Gerald M . Levin, J. Michael Kelly, Paul T. Cappuccio,
Kenneth J . Novack, and Robert W . Pittman for violations of Section I 1 of the Securities Act, 1 5
U.S .C. § 77k, on behalf of all Class members who acquired AOL Time Warner common stock pursuant and/or traceable to the Merger Registration Statement,, including in exchange for Tim e
Warner common stock .
678. The Merger Registration Statement contained untrue statements of material facts and omitted to state material facts necessary to make the statements made therein not misleading , as referenced in ¶ 672.
679. Defendant Stephen Case signed the Joint Proxy Statement-Prospectus which wa s incorporated into the Merger Registration Statement . Defendant Gerald Levin, signed the Join t
Proxy Statement-Prospectus and the Merger Registration Statement . Defendants J. Michael
Kelly and Paul Cappuccio signed the Merger Registration Statement. Defendants Stephen Case,
Kenneth J. Novack and Robert W. Pittman, all consented to being named in the Merger
Registration Statement as being or about to become directors of AOL Time Warner . All are therefore liable under Section 11 of the Securities Act, 15 U.S.C. § 77k(a)(1) and (3), to Plaintiff
48184 268 and other members of the Class for the material misrepresentations or omissions contained in th e
Merger Registration Statement .
680. At the time Plaintiff and the other Class members acquired AOL Time Warner common stock pursuant and/or traceable to the Merger Registration Statement, they did no t know of the facts concerning the untrue and misleading statements and omissions alleged herein .
681 . In connection with issuing the Merger Registration Statement, the individua l
Defendants named in this Count used the means and instrumentalities of interstate commerce and the U. S. mails.
682. By reason of the foregoing, the Defendants named in this Count violated Sectio n
11 of the Securities Act and are liable to Plaintiff and the other members of the-Class who acquired AOL Time Warner common stock pursuant and/or traceable to the Merger Registration
Statement, including in exchange for Time Warner common stock, each of whom has bee n damaged by reason of such violations .
COUNT THREE
(Against Ernst & Young for Violations of § 11 of the Securities Act in Connection with the Merger Registration Statement)
683. Plaintiff repeats and realleges each and every allegation contained above as i f fully set forth herein, except that this Count does not sound in fraud, and Plaintiff does no t incorporate herein any allegations of fraud -in connection with this Count . This Count is asserted against Ernst & Young for violations of Section 11 of the Securities Act, 15 U.S.C. § 77k, on behalf of all Class members who acquired AOL Time Warner common stock pursuant and/o r traceable to the Merger Registration Statement, including in exchange for Time Warner commo n stock.
48184 269 684. Ernst & Young consented to the incorporation by reference in the Merger
Registration Statement of its unqualified audit report, dated July21, 1999, on AOL's 1999 consolidated financial statements as set forth in AOL's 1999 Form 1 Q-K for the year ended June
30, 1999 and consented to all references to Ernst & Young in the Merger Registration Statement, which included a reference to it under the caption "Experts ." In a subsequent amendment to the
Merger Registration Statement, Ernst & Young consented to the reference to itself as "Experts" and to the use of its report dated July 21, 1999, except for Note 3, which is dated May 12, 2000, with respect to the consolidated financial statements of AOL for the three years ended June 30,
1999 incorporated by reference as Exhibit 99 to AOL's Form 10-Q/A for the quarterly period ended March 31, 2000, incorporated by reference and made a part of the Merger Registration
Statement and Joint Proxy Statement-Prospectus . Ernst & Young also consented to the incorporation by reference in the Merger Registration Statement of its report dated July 20, 2000, with respect to the consolidated financial statement of AOL included in its Form 10-K for th e year ended June 30, 2000. Ernst & Young opined that AOL's financial statements for fiscal year ended June 30, 1999 and 2000, which were incorporated in the Merger Registration Statement, were prepared in conformity with GAAP. Further, as set forth under the caption "Experts,"
AOL's financial statements were included "in reliance on Ernst & Young's report, given on their authority as experts in accounting and auditing ." Ernst & Young is therefore liable under
Section 11 of the Securities Act, 15 U.S.C. § 77k(a)(4) .
685. In the Merger Registration Statement, the parts that Ernst & Young prepared and incorporated within the document, specifically, its audit reports dated July 21, 1999, except Note
3 which is dated May 12, 2000 and July 20, 2000, and the parts that it audited, specifically,
AOL's annual financial statements, contained untrue statements of material facts and omitted to
48194 270 state material facts necessary to make the statements made therein not misleading . In particular,
as discussed in 240-357, 392 and 396-432 abode, the untrue statements include the
overstatement of advertising revenue, and backlog, and percentage increases in the amounts and
the overstatement of the value of goodwill created in the Merger for the various fiscal periods as
set forth in ¶ 657, and the statements in Ernst & Young's audit reports that: (i) it had audited
AOL's financial statements for each of the three years ended June 30, 1999 and the year ended
June 30, 2000 in accordance with GAAS ; (ii) it had planned and performed those audits "t o
obtain reasonable assurance about whether the financial statements are free of materia l
misstatements;" (iii) in its opinion , AOL's financial statements "present fairly, in all material
respects, the consolidated financial position" of AOL at June 30, 1999 and 1998 and June 30,
2000 in conformity with "generally accepted" accounting principles; and (iv) its audits provided
"a reasonable basis for [Ernst & Young's] opinions."
686. At the time Plaintiff and the other Class members acquired AOL Time Warner
common stock pursuant and/or traceable to the Merger Registration Statement, they did no t
know of the facts concerning the untrue and misleading statements and omissions alleged herein.
687. In connection with the issuance of the Merger Registration Statement, Ernst &
Young directly or indirectly, used the means and instrumentalities of interstate commerce and th e
U.S. mails.
688. By reason of the foregoing, Ernst & Young violated Section 11 of the Securities
Act and is liable to Plain tiff and the other members of the Class who acquired AOL Time
Warner common stock pursuant and/or traceable to the Merger Registra tion Statement, including
in exchange for Time Warner common stock , each of whom has been damaged by reason of such
violations.
48184 271 COUNT FOUR
(Against Defendants Case, Pittman, Ke11y, Coxbu rn, Ripp and Levin for Liability Under § 15 of the Securities Act For Violations of § 11 of the Securities Act )
689. Plaintiff repeats and realleges each and every allegation contained above as i f fully set forth herein, except that this Count does not sound in fraud, and Plaintiff does no t incorporate herein any allegations of fraud in connection with this Count. This Count is asserted against Defendants Stephen M . Case, Robert W. Pittman, J. Michael Kelly, David M. Colburn,
Joseph A. Ripp and Gerald M. Levin for violations of Section 15 of the Securities Act, 15 U.S .C.
§ 770, on behalf of all Class members who acquired AOL Time Warner common stock i n exchange for Time Warner common stock, pursuant to and/or traceable to the Merge r
Registration Statement.
690. As alleged in Count One, AOL Time Warner violated Section 1 I of the Securitie s
Act.
691 . The Defendants named in this Count acted as controlling persons of AOL Time
Warner within the meaning of Section 15 of the Securities Act as alleged herein . These
Defendants had the power and authority to cause the Company to violate Section I I of th e
Securities Act.
692. By virtue of their high-level positions as executives and/or directors at AOL and
AOL Time Warner during the Class Period and members of the Company 's management team, and/or their ownership and contractual rights, participation in and/or awareness of AOL's and
AOL Time Warner's operations, the Defendants named in this Count had the power to influenc e and control and did influence and control , directly or indirectly, the decision-making of AOL
Time Warner, including the content and dissemination of the various statements which Plaintif f contends are false and misleading . Each of the Defendants named in this Count, by virtue of hi s
48184 272 responsibilities and activities as a senior officer and/or director of AOL and/or AOL Tim e
Warner was privy to and participated in the creation, development and reporting of AOL's and
AOL Time Warner' s internal budgets, plans, projections and/or reports. These Defendants were provided with or had unlimited access to copies of the reports, press releases, public filings and other statements alleged by Plaintiff to be misleading prior to and/or shortly after thes e statements were issued and had the ability to prevent the issuance of the statements or cause the statements to be corrected.
693. Because of their positions of control and authority as senior officers and directors of AOL and/or AOL Time Warner, these Defendants were able to,-and did, control the contents of the Merger Registration Statement which contained materially false financial information and omitted facts necessary to make the facts stated therein not misleading.
694 . At the time Plaintiff and other Class members acquired AOL Time Warner common stock pursuant and/or traceable to the Merger in exchange for AOL and Time Warner common stock, they did not know of the facts concerning the untrue and misleading statement s and omissions alleged herein.
695. By reason of the foregoing, these Defendants are jointly and severally liable a s controlling persons pursuant to Section 15 of the Securities Act for the Company' s violations of
Section 1 i to Plaintiff and the other members of the Class who acquired AOL Time Warner common stock pursuant and/or traceable to the Merger Registration Statement, including in exchange for Time Warner common stock.
48184 273 COUNT FIVE
(Against AOL, Time Warner, and AOL Time Warner For Violations of § 14(a) of the Exchange Act, and Rule 14a-9 Promulgated Thereunder In Connec tion With the Joint Proxy Statement-Prospectus)
696. Plaintiff repeats and realleges each and every allegation contained above as if
fully set forth herein, except that this Count does not sound in fraud, and Plaintiff does no t
incorporate herein any allegations offraud in connection with this Count. This Count is asserted
against AOL, Time Warner, and AOL Time Warner in its own right and as successor to AO L
and Time Warner for violations of Section 14(a) of the Exchange Act, 15 U .S.C. § 78n(a), an d
Rule 14a-9 promulgated thereunder, 17 C.F.R'240.14a-9, on behalf of all Class members who
held Time Warner common stock at the close of business on May 18, 2000, the record date o f
eligibility to vote, and on June 23, 2000, the date of the Special Meetings in which the Merge r
was voted upon and approved .
697: The Joint Proxy Statement-Prospectus described herein was a "proxy solicitation"
within the meaning of Section 14(a) of the Exchange Act and Rule 14a-9 promulgated
thereunder.
698. The Joint Proxy Statement-Prospectus contained untrue statements of material
facts and omitted to state material facts necessary to make the statements made therein no t
misleading, as referenced in ¶ 672.
699. AOL and Time Warner sought to secure AOL and Time Warner shareholder
approval of the AOL Time Warner Merger by means of the materially false and misleading Joint
Proxy Statement-Prospectus and solicited proxies from Plaintiff and other members of the Class .
48194 274 700. AOL and Time Warner, at the time it issued the Joint Proxy Statement-Prospectus,
acted negligently and without due care in distributing or causing to be distributed the Joint Prox y
Statement-Prospectus containing the false and misleading statements and omissions .
701 . The Merger required and received the affirmative vote of the AOL and Time
Warner shareholders at the respective Special Stockholder Meetings held on June 23, 2000 .
Accordingly, the materially false and misleading Joint Proxy Statement-Prospectus was an
essential link in the accomplishment of the Merger.
702. In connection with issuing the Joint Proxy Statement-Prospectus , AOL Time
Warner used the means and instrumentalities of interstate commerce and the U.S. mails.
703 . By reason of the foregoing, AOL, Time Warner, and AOL Time Warner are liable
to Plaintiff and other members of the Class who held Time Warner common stock on May 18 ,
2000 and June 23, 2000 for violations of Section 14(a) of the Exchange Act and Rule 14a- 9
promulgated thereunder, each of whom has been damaged by reason of such violations. COTTN T SIX
(Against Defendants Case, Levin, Kelly, Cappuccio, Novack and Pittman For Violations of § 14(a) of the Exchange Act, and Rule 14a-9 Promulgated Thereunder In Connection With the Joint Proxy Statement Prospectus)
704. Plaintiff repeats and realleges each and every allegation contained above as i f
fully set forth herein, except that this Count does not sound in fraud, and Plaintiff does not
incorporate herein any allegations of fraud in connection with this Count. This Count is asserted
against Defendants Stephen Case, Gerald M. Levin, J. Michael Kelly, Paul T. Cappuccio,
Kenneth J. Novack, and Robert W. Pittman for violations of Section 14(a) of the Exchange Act,
15 U.S .C. § 78n(a), and Rule 14a-9 promulgated thereunder, 17 C .F.R. §240.14a-9, on behalf of
all Class members who held Time Warner common stock at the close of business on May 18 ,
48184 275 2000, the record date of eligibility to vote, and on June 23, 2000, the date of the Special
Meetings in which the Merger was voted upon and approved .
705. The Joint Proxy Statement Prospectus described herein was a "proxy solicitation" within the meaning of Section 14(a) of the Exchange Act and Rule 14a-9 promulgated thereunder.
706. The Joint Proxy Statement-Prospectus contained untrue statements of material facts and omitted to state material facts necessary to make the statements made therein not misleading, as referenced in 1672.
707. The Defendants named in this Count sought to secure AOL and Time Warner shareholder approval of the Merger by means of the materially false and misleading Joint Proxy
Statement-Prospectus and solicited proxies from Plaintiff and other members of the Class .
708. The Defendants named in this Count, at the time it issued the Joint Proxy
Statement Prospectus, acted negligently and without due care in distributing or causing to b e distributed the Joint Proxy Statement-Prospectus containing the false and misleading statement s and omissions.
709. The Merger required and received the affirma tive vote of the AOL and Tim e
Warner shareholders at the respective Special Stockholder Meetings held on June 23, 2000 .
Accordingly, the materially false and misleading Joint Proxy Statement-Prospectus was an essential link in the accomplishment of the AOL Time Warner merger.
710. In connection with issuing the Joint Proxy Statement-Prospectus, the means and instrumentalities of interstate commerce and the U.S. mails were used.
711. By reason of the foregoing, AOL, Time Warner, and AOL Time Warner are liable to Plaintiff and other members of the class who held Time Warner common stock on May 18 ,
48184 276 2000 and June 23, 2000 for violations of Section 14(a) of the Exchange Act and Rule 14a- 9 promulgated thereunder, each of whom has been damaged by reason of such violations .
COUNT SEVEN
(Against Ernst & Young For Violations of § 14(a) of the Exchange Act, and Rule 14a-9 Promulgated Thereunder In Connection With the Joint Proxy Statement Prospectus )
712. Plaintiff repeats and realleges each and every allegation contained above as i f fully set forth herein, except that this Count does not sound in fraud, and Plaintiff does no t incorporate herein any allegations of fraud in connection with this Count. This Count is asserted against Ernst & Young for violations of Section 14(a) of the Exchange Act, 15 U.S.C. §78n(a), and Rule 14a-9 promulgated thereunder, 17 C.F.R. § 240. 14a-9, on behalf of all Class members who held Time Warner common stock at the close of business on May 18, 2000, the record date of eligibility to vote, and on June 23, 2000, the date of the Special Meetings in which the Merge r was voted upon and approved .
713. The Joint Proxy Statement-Prospectus described herein was a "proxy solicitation" within the meaning of Section 14(a) of the Exchange Act and Rule 14a-9 promulgate d thereunder.
714. As set forth in 1657, Ernst & Young permitted the use of its name in the Joint
Proxy Statement-Prospectus to solicit proxies from Plaintiff and other members of the Class .
715. The Joint Proxy Statement-Prospectus contained untrue statements of material facts by Ernst & Young and omitted to state material facts necessary to make the statement s made therein by Ernst & Young not false and misleading, as alleged above in ¶ 685.
716. Ernst & Young acted negligently and without due care in making the false and misleading statements and omissions in the Joint Proxy Statement-Prospectus .
48194 277 717. The Merger required and received the affirmative vote of the AOL and Tim e
Warner shareholders at the respective Special Stockholder Meetings held on June 23, 2000.
Accordingly, the materially false and misleading Joint Proxy Statement-Prospectus was an essential link in the accomplishment of the Merger.
718. In connection with the issuance of the Joint Proxy Statement Prospectus, the means and instrumentalities of interstate commerce and the U.S. mails were used.
719. By reason of the foregoing, Ernst & Young is liable for violations of Section 14(a) of the Exchange Act and Rule 14a-9 promulgated thereunder to Plaintiff and the other member s of the Class, each of whom has been damaged by reason of such violations.
COUNT EIGHT
(Violations Of Section 10(b) Of The Exchange Act And Rule 10b-5 Promulgated Thereunder Against Defendants AOL Time Warner, AOL and Case, Pittman, Kelly, Colburn, Keller, Ripp, Rindner, Levin and Pace)
720. Except for the Counts not sounding in fraud, Plaintiff repeats and realleges eac h and every allegation contained above as if fully set forth herein . This Count is asserted against
Defendants Case, Pittman, Kelly, Colburn, Keller, Ripp, Rindner, Levin and Pace for thei r violations of Section 10(b) of the Exchange Act 15 U.S.C. 78j(b) and Rule lOb-5, 17 C.F.R.
240.10b-5, promulgated thereunder . This Count is also asserted against AOL Time Warner, a s successor to AOL, and AOL in its own right.
721 . During the Class Period, the Defendants named in this Count carried out a plan , scheme and course of conduct which was intended to and, throughout the Class Period, di d deceive the investing public, including Plaintiff and other Class members, as alleged herein an d caused Plaintiff and other members of the Class to purchase, exchange or otherwise acquire AOL and/or AOL Time Warner stock at artificially inflated prices, and/or to purchase or sell options
48184 278 on AOL and/or AOL Time Warner stock . In'furtherance of this unlawful scheme, plan and
course of conduct, Defendants, and each of them, took the actions set forth herein .
722. Defendants : (a) employed devices, schemes, and artifices to defraud; (b) made
untrue statements of material fact and/or omitted to state material facts necessary to make the
statements not misleading ; and (c) engaged in acts, practices, and a course of business which
operated as a fraud and deceit upon the purchasers of AOL's or the Company's stock in an effort
to maintain artificially high market prices for these securi ties in violation of Section 10(b) of the
Exchange Act and Rule 1 Ob-5. All Defendants named in this Count are sued as primary
participants in the wrongful and illegal conduct charged herein .
723. Defendants, individually and in concert, directly and indirectly, by the use, mean s
or instrumentalities of interstate commerce and/or of the mails, engaged and participated in a
continuous course of conduct to conceal adverse material informa tion about the business,
operations and future prospects of AOL and AOL Time Warner as specified herein.
724. Defendants employed devices, schemes and artifices to defraud, while in
possession of material adverse non-public information and engaged in acts, practices, and a
course ofconduct as alleged herein in an effort to assure investors of AOL's and AOL Tim e
Warner's value and performance and continued substantial growth, which included the making
of, or the participation in the making of, untrue statements of material facts and omitting to stat e
material facts necessary in order to make the statements made about AOL and AOL Time
Warner and their operating condition, advertising revenue, goodwill and future prospects in the
light of the circumstances under which they were made, not misleading, as set forth more particularly herein, and engaged in transactions, practices and a course of business which
operated as a fraud and deceit upon those who purchased, exchanged or otherwise acquired AO L
48184 279 or AOL Time Warner stock and/or those who bought or sold op tions on AOL and/or AOL Time
Warner stock during the Class Period .
725. As more fully described in the paragraphs relating to fraud (¶ 98-239,240-394
and 395-432), the violations of GAAP (J 90-97 and 98 -234) and the scienter of the Defendants
named herein (J 451-593), each of the Defendants' primary liability arises from the followin g
facts: (i) the Individual Defendants were high-level executives and/or directors at AOL and AOL
Time Warner during the Class Period and members of the Company's management team or had
control thereof; (ii) each of these Defendants, by virtue of his responsibilities and activities as a
senior officer and/or director of AOL and AOL Time Warner was privy to and pa rticipated in the
creation, development and reporting of AOL' s and the Company's internal budgets, plans,
projections and/or reports ; (iii) each of these Defendants enjoyed significant personal contact and
familiarity with the other defendants and was advised ofand had access to other members of
AOL's and the Company's management team, internal reports and other data and informatio n
about AOL's and the Company's advertising revenue, finances, opera tions, and sales at all
relevant times; and (iv) each of these Defendants was aware of, participated in or caused the
dissemination of information to the investing public of AOL and AOL Time Warner filings with
the SEC, press releases and regis tration statements . These statements and documents were
materially false and misleading in that, among other things, they misrepresented, and failed t o
disclose, AOL's and AOL Time Warner' s sham transactions, improper recognition of advertising revenue and improper accounting for goodwill, during the Class Period .
726. The Defendants had actual knowledge of the misrepresentations and omissions o f material facts set forth herein, or acted with reckless disregard for the truth, in that they failed t o ascertain and disclose such facts, even though such facts were available to them. Such
48184 280 Defendants' material misrepresentations and/or omissions were made knowingly or recklessly and for the purpose and effect of. (1) concealing AOL's and AOL Time Warner's operatin g condition, advertising revenue, goodwill and future business prospects from the investing public;
(2) consummating the Merger; and (3) supporting the artificially inflated prices of its stock. As demonstrated by Defendants' overstatements and misstatements of AOL's and the Company's business, operations, advertising revenue, goodwill, earnings and future business prospectus throughout the Class Period, Defendants, if they did not have actual knowledge of the misrepresentations and omissions alleged, were reckless in failing to obtain such knowledge by deliberately refraining from taking those steps necessary to discover whether those statement s were false or misleading.
727. As a result of the dissemination of the materially false and misleading information and failure to disclose material facts, as set forth above, the market price of AOL and AOL Time
Warner stock was artificially inflated during the Class Period . In ignorance of the fact that market prices of such publicly-traded stock was artificially inflated, and relying directly o r indirectly on the false and misleading statements made by Defendants, or upon the integrity o f the market in which the securities trade, and/or on the absence of material adverse informatio n that was known to or recklessly disregarded by Defendants, but not disclosed in public statements by Defendants during the Class Period, Plaintiff and other class members acquired such stock and/or bought or sold options on such stock during the Class Period at artificially high prices and were damaged thereby.
728. At the time of said misrepresentations and omissions, Plaintiff and other members of the Class were ignorant of their falsity, and believed them to be true. Had Plaintiff and the other members of the Class and the marketplace known the truth regarding the problems tha t
48194 281 AOL and AOL Time Warner were experiencing, which were not disclosed by Defendants,
Plaintiff and other members of the Class would not have purchased or otherwise acquired such
stock or bought or sold options on such stock, or, if they had acquired-such stock or bought or
sold options on such stock during the Class Period, they would not have done so at the ar tificially
inflated prices which they paid.
729. By virtue of the foregoing, Defendants named in this Count have violated Section
10(b) of the Exchange Act, and Rule lOb-5 promulgated thereunder. Asa direct and proximate
result of Defendants' wrongful conduct, Plaintiff and the other members of the Class suffered
damages in connection with their respective purchases or acquisitions of AOL and AOL Time
Wame?s stock and/or purchases or sales of options on such stock during the Class Period .
COUNT NINE
(Against Ernst & Young for Violations of § 10(b) of the Exchange Act and Rule lOb-5)
730. Except for the Counts not sounding in fraud, Plaintiff repeats and realleges each
and every allegation contained above as if fully set forth herein . This Count is asserted against
Ernst & Young for violations of Section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b), and Rule
lOb-5, 17 C.F.R. 244.IOb-5.
731 . Ernst & Young, individually and in concert with others, directly and indirectly, by
the use of means or instrumentalities of interstate commerce and/or of the mails, engaged and participated in a continuous course of conduct that operated as a fraud and deceit upon Plaintiff
and the other members of the Class ; made various untrue and/or misleading statements of material facts and omitted to state material facts necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading made the above statements with a severely reckless disregard for the truth; and employed devices, and artifices t o
48184 282 defraud in connection with the purchase and sale of AOL and/or AOL Time Warner stock,
and/or the purchase or sale of options on such stock, which were intended to, and did : (i) deceive
the investing public, including Plaintiff, regarding, among other things, AOL and AOL Time
Warner's sham transactions, improper recognition of advertising revenue and improper
accounting for goodwill; (ii) artificially inflate and maintain the market price of AOL and AOL
Time Warner stock; and (iii) cause Plaintiff and class members to purchase AOL and AOL Time
Warner stock at artificially inflated prices and/or purchase or sell options on such stock.
732. As more fully described in the paragraphs relating to the fraud , (% 98-239, 240-
394 and 395432), the violations of GAAP (J 90-97 and 98-234) and Ernst & Young 's scienter
(J 594-644), pursuant to the aforesaid plan and course of conduct, Ernst & Young participated ,
directly and indirectly, in the preparation and/or issuance of the statements and document s
referred to above, including in AOL and AOL Time Warner filings with the SEC, press releases ,
and registration statements. These statements and documents were materially false and
misleading in that, among other things, they misrepresented , and failed to disclose, AOL's and
AOL Time Warner's sham transactions, improper recognition of advertising revenue and
improper accounting for goodwill, during the Class Period .
733. Ernst & Young, among others, engaged in such a device, scheme or artifice to
misrepresent the financial condition and results of AOL and AOL Time Warner and to
consummate the Merger, and maintain and/or inflate the prices of AOL and AOL Time Warner's
stock to, among other things, gain lucrative auditing and other consulting services from AOL and
AOL Time Warner. Specifically, Ernst & Young knew or recklessly disregarded that AOL's
reported annual financial results for fiscal years 1999, 2000 and the transition period for the year
ended December 31, 2000 (including December 31, 1999) and AOL Time Warner's reported
48184 283 annual financial results for 2001 as filed with the SEC in AOL and AOL Time Warner's Forms
IO-K, in the Merger Registration Statement and other SEC filings, and disseminated to th e investing public, were materially overstated and were not presented in accordance with GAAP, that Ernst & Young's audits were not performed in accordance with GARS, and, therefore, that
Ernst & Young's unqualified audit reports, as included or incorporated by reference in those annual reports on Forms 1 O-K and other SEC filings, were materially false and misleading .
734. The SEC Form 1 d-Ks, the Merger Registration Statement and other SEC filings were materially false and misleading; contained untrue statements of material facts ; omitted to state material facts necessary to make the statements made in those filings, under the circumstances in which they were made, not misleading; and failed to adequately disclose material facts. As detailed herein, the misrepresentations contained in, or the material facts omitted from, those SEC filings included, but were not limited to, the overstatement o f advertising revenue through sham transactions and improper recognition of revenue and backlo g and percentage increases in the amounts and the overstatement of the value of goodwill create d in the Merger, as well as the representations in Ernst & Young's unqualified audit reports issued in connection with Ernst & Young's audits of AOL and AOL Time Warner 's financial statements and AOL Time Warner 's balance sheet for those years, in which Ernst & Young certified that: (i) it had audited AOL and AOL Time Warner' s financial statements in accordance with GAAS; (ii) it had planned and performed those audits "to obtain reasonable assurance abou t whether the financial statements are free of material misstatements"; (iii) in its opinion, AOL and
AOL Time Warner' s financial statements "present fairly, in all material respects, the consolidated financial position" of AOL and AOL Time Warner " in conformity with generally accepted accounting principles" or "accounting principles generally accepted in the United
48184 284 States;" and (iv) Ernst & Young's audits provided a "reasonable basis" for its opinions . As
detailed herein, Ernst & Young's audit reports were materially false and misleading . Ernst &
Young knew or recklessly disregarded, that the statements described above, which were
contained in the SEC Form 10-Ks, registration statements and incorporated by reference in other
SEC filings, were untrue, were made with omissions of material facts, and were misleading.
735. Ernst & Young, with knowledge or reckless disregard of the falsity and
misleading nature of the statements contained in its unqualified reports, and in reckless disregard
of the true nature of its audits, caused the complained of public statements to contain
misstatements and omissions of material facts as alleged herein . As described herein, Ernst &
Young's audit of AOL and AOL Time Warner's financial statements for 1999, 2000, the 2000
AOL transition period ended December 31, 2000 (including December 31, 1999) and the year
December 31, 2001 were not performed in accordance with GAAS, and, in fact, Ernst & Young had no basis for its unqualified opinions rendered in connection therewith . Ernst & Young's unqualified reports dated July 21, 1999, July 20, 2000, January 31, 2001 and January 28, 2002, issued in connection with those audits, as included in the SEC Form 10-Ks, registration statements and other SEC fillings, in which Ernst & Young opined, among other things, that its audits were performed in accordance with GAAS, were materially false and misleading .
736. As described in detail above, Ernst & Young acted with scienter throughout th e
Class Period, in that it either had actual knowledge of the misrepresentations and omissions of material facts set forth herein, or acted with reckless disregard for the truth, in that they failed to ascertain and to disclose the true facts, even though such facts were available to them . Ernst &
Young was AOL's and AOL Time Warner's auditor, and, therefore, was directly responsible for the false and misleading statements and omissions disseminated to the public th rough its
48184 285 unqualified audit reports .
737. As a result of the dissemination of the materially false and misleading informa tion and failure to disclose material facts , as set forth above, AOL and AOL Time Warner stock wa s sold in the public market, and the market prices of such stock was artificially inflated during the -
Class Period. In ignorance of the materially false and misleading nature of the reports and statements described above, Plaintiff and class members relied to their detriment on th e statements described above and/or on the integrity of the market prices as reflecting th e completeness and accuracy of the information disseminated in connection with their purchases o f the stock and/or options.
738. At the time of said misrepresentations and omissions, Plaintiff and the class were ignorant of their falsity, and believed them to be true . Plaintiff and the class members could not, in the exercise of reasonable diligence, have known the actual facts . Had Plaintiff and the class members known the truth, they would not have taken such ac tion.
739. By virtue of the foregoing, Ernst & Young has violated Section 10(b) of th e
Exchange Act and Rule lOb-5 promulgated thereunder . As a direct and proximate result of Erns t
& Young's wrongful conduct, Plaintiff and the other members of the Class suffered damages i n connection with their respective purchases or acquisi tions of AOL and AOL Time Warner' s stock and/or purchase or sale of options on such stock during the Class Period .
COUNT TEN
(Against Defendants Case, Kelly, Pittman, Colburn, Ripp, Levin and Pace for Liability Under § 20(a) Of The Exchange Act For Violations Of § 10(h) Of The Exchange Act And Rule 10b-5 Promulgated Thereunder)
740. Plaintiffrepeats and realleges each and every allegation contained above as if fully set forth herein, except that this Count does not sound in fraud, and Plaintiff does no t
48184 286 incorporate herein any allegations of fraud in connection with this Count. This Count is asserted against Defendants Case, Kelly, Pittman, Colburn, Ripp, Levin and Pace for their violations o f
Section 20 of the Exchange Act, 15 U.S .C. §78t(a), on behalf of all Class members who purchased, exchanged or acquired AOL and/or AOL Time Warner stock and/or bought or sold options on such stock during the Class Period and were damaged thereby .
741 . As alleged above in Count Eight, AOL Time Warner, AOL and the Individua l
Defendants violated Section IOb-5 of the Exchange Act and Rule IOb-5 promulgated hereunder .
742. The Defendants named in this Count acted as controlling persons of AOL and
AOL Time Warner within the meaning of Section 20 of the Exchange Act as alleged herein.
These Defendants had the power and authority to cause AOL and the Company to violat e
Section I0(b) of the Exchange Act and Rule I Ob-5 promulgated thereunder .
743 . By virtue of their high-level positions as executives and/or directors at AOL and
AOL Time Warner during the Class Period and members of AOL and the Company' s management teams, and their ownership and contractual rights, participation in and/or awarenes s of AOL's and the AOL Time Warner's operations, the Defendants named in this Count had th e power to influence and control and did influence and control, directly or indirectly, the decision- making of AOL and AOL Time Warner, including the content and dissemination of the various statements which Plaintiff contends are materially false and misleading . Each Defendant named in this Count, because of his responsibilities and activities as a senior officer and/or director of
AOL and/or AOL Time Warner, was privy to and participated in the creation, development and reporting of AOL's and the AOL Time Warner' s internal budgets, plans, projections and/or reports. The Individual Defendants were provided with or had unlimited access to copies of the reports, press releases, public filings and other statements alleged by Plaintiff to be misleadin g
48184 287 prior to and/or shortly after these statements were issued and had the ability to prevent the issuance of the statements or cause the statements to be corrected.
744. In particular, each of these Individual Defendants had direct and supervisor y involvement in the day-to-day operations of AOL and AOL Time Warner and, therefore, i s presumed to have had the power to control or influence the particular transactions giving rise to the securities violations as alleged herein, and exercised the same .
745. The Individual Defendants were culpable participants because they were aware of the dissemination of information to the investing public which they knew or recklessly disregarded was materially false and misleading. As a result, the Individual Defendants knew or recklessly disregarded that AOL and AOL Time Warner were engaging in fraudulent conduct in violation Section I0 (b) of the Exchange Act and Rule 1Ob-5 promulgated thereunder.
746. By reason of the foregoing, the Individual Defendants are jointly and severally liable as controlling persons pursuant to Section 20 of the Exchange Act for AOL's and AOL
Time Warner's violation of Section I0(b) of the Exchange Act and Rule 1Ob-5 promulgated thereunder. As a direct and proximate result of the Individual Defendants' wrongful conduct,
Plaintiff and other members of the Class suffered damages in connection with their purchases , exchange or acquisitions of AOL and/or AOL Time Warner stock and/or purchase or sale of options on such stock during the Class Period.
X. PRAYER FOR RELIEF
WREREFORE, Plaintiff prays for relief and judgment, as follows :
(a) Determining that this action is a proper class action, and appointing
Plaintiff as representative of the class under Rule 23 of the Federal Rules of Civil Procedure ;
48184 288 (b) Awarding compensatory damages in favor of Plaintiff and the other Clas s members against all Defendants, jointly and severally, for all damages sustained as a result o f
Defendants' wrongdoing, in an amount to be proven at trial, including interest thereon ;
(c) Awarding Plaintiff and the Class their reasonable costs and expense s incurred in this action, including fees for Plaintiff's counsel and experts ;
(d) Awarding extraordinary, equitable andlor injunctive relief as permitted b y law, equity and the federal statutory provisions sued hereunder, pursuant to Rules 64, 65, an d any other appropriate state law remedies; and
(e) Such other and further relief as the Court may deem just and proper.
XT. JURY TRIAL DEMANDED
Plaintiff hereby demands a trial by jury .
Dated.Al ~3
obert A. Skirnick RS (2636(2636)) Samuel f). He'vns MEREDITH CGH EN GREENFOGEL Stacey L. Mills & SKERNICK, F.C. Bryan L. Crawford One Liberty Plaza, 3511' Floor Alan 1. Gilbert New York, NY 10006 Daniel C. Hedlund (212) 240-0020 Lori A. Johnson (212) 240-0021 Fax HEINS MILLS & OLSON, P .L.C. 3550 IDS Center Attorneys for Lead Plaintiff Minnesota 80 South Eighth Street State Board of Investment and Local Minneapolis, MN 55402 Counsel for the Class (612) 338 -4605 (612) 338-4692 Fax
Attorneys for Lead Plaintiff Minnesota State Board of Investment and Lead Counsel for the Clas s
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