…yeah right. These guys will never go to jail.
But AOL will go down in history as a Ponzi scheme that makes 80s Junk Bonds look like chicken feed. Actually, I found a good backgrounder on Ponzi schemes here: http://www.mark-knutson.com/thescheme.html
AOL TIME WARNER Why AOL’s Accounting Problems Keep Popping Up The online giant created ad ‘revenues’ out of thin air. Now, it’s got scandals! FORTUNE Monday, April 14, 2003 By Carol J. Loomis
When there’s bad corporate news to be disclosed, the wise say, “Get it out and get it over with.” But that message hasn’t visibly permeated AOL Time Warner (parent of FORTUNE’s publisher) when it comes to accounting problems. Since last July, when the Washington Post did a biting two-part article about unsavory behavior at AOL, the company’s online division, the news hasn’t stopped. First the SEC moved in to investigate, and then came the Justice Department. Next, in August, AOL Time Warner’s CEO, Richard Parsons, certified the company’s financial statements–except for $49 million in AOL “revenues” that the company said it had just discovered maybe shouldn’t have been claimed as such. By October, when a “review” of that matter and others had been completed, the $49 million of nonrevenues had ballooned to $190 million (for unenumerated sins, most attributed to AOL), which the company said it would expunge by restating eight quarters of its 2000-02 financial statements. In the restatements, of course, profits vanished along with the revenues.
Then, just as March ended, came the news that the company and the SEC were arguing over yet an additional $400 million of revenues that might not deserve the name. In short, the SEC is suggesting that the $190 million confession didn’t exhaust the bad stuff. Its investigation continues, as does the Justice Department’s. So AOL Time Warner has acknowledged that further restatements might become necessary.
There’s a stark explanation for this river of news, and it’s kin to an old saying: “To a man with a hammer, everything looks like a nail.” At the AOL division, the locus of the accounting troubles, the hammer was an insatiable desire to show growth in revenues–very particularly, in what AOL called “advertising and commerce”–and to book the Ebitda (earnings before interest, taxes, depreciation, and amortization) that tagged along. So to AOL every business deal, including the unlikeliest of candidates, looked like a way to get these revenues. AOL won an arbitration award that it negotiated into an advertising contract. A raft of dot-coms that AOL invested in round-tripped their money–and at least once, in the case of Homestore.com, apparently triangulated it–into advertising. Investing in a dot-com called PurchasePro, AOL bought warrants for $9 million, then marked up the investment to $27 million and booked the difference as revenues.
And in the latest revelation, AOL’s purchase of Bertelsmann’s half-interest in AOL Europe magically produced that $400 million in ad revenues that the SEC and AOL Time Warner are fighting over. Magically and invisibly, we might add. Outsiders never knew there was $400 million of advertising tied to the Bertelsmann deal until AOL Time Warner made that fact clear at the end of March.
So, yes, in Virginia, at AOL, there was an obsession to get advertising in the door. Consequently nobody there appears to have paid much attention to whether the business deals at issue were really producing ad “revenues” by any acceptable definition–or perhaps the insiders didn’t think outsiders would ever learn the details. Well, the outside world has now caught on, and so have a lot of plaintiffs lawyers. Besides tussling with Washington, AOL Time Warner is today the defendant in at least 40 shareholder suits, many of which sprang from the accounting legerdemain.
It is important to recognize that at AOL Time Warner, whose revenues last year were $42 billion, neither $190 million nor $400 million is a major figure. But in certain ways these tainted amounts (leaving aside other problems the regulators may still unearth) counted for a lot. That’s partly true because incremental advertising revenues at AOL don’t tend to be heavily burdened with costs. So these revenues generally cascade into profits. Specifically, AOL Time Warner has said that the $190 million in bogus revenues ($22 million of which went to company divisions other than AOL) produced $97 million of Ebitda and $46 million in net income. That net translated–until the restatements whisked it away–into a neat profit-to-revenues margin of 24%. As for the $400 million, what it produced in Ebitda and net income can’t be said, because the company has not disclosed that information.
The other reason that these incremental revenues mattered is that they helped AOL paint a deceptive picture of exactly what was happening in its advertising and commerce line of business. As 2000 began, bringing with it the amazing news that AOL and Time Warner were going to merge, this segment of operations was the bright hope for AOL. Its online subscription business, true, was significantly larger and still growing. It produced revenues in 2000 of $4.777 billion, against a reported, though now tainted, figure of $2.347 billion for advertising and commerce. But everyone expected that growth in subscriptions would eventually flatten out (which, in 2002, it did), and here was this advertising and commerce business whooshing up like crazy–roughly doubling every year, in fact.
We all know now that the Internet bubble burst in March 2000, but at the time that fact was not obvious. And at AOL, for sure, the announced ambitions for advertising and commerce were then still extraordinary. At a joint meeting of the AOL and Time Warner boards in July 2000, Robert Pittman, the highly confident chief operating officer of AOL (who is now gone from the company), said that by the year 2005, he expected this line of business to produce $7 billion in revenues!
In your dreams–including the ones that began exploding in 2001. That year’s picture was helped out by $88 million in revenues that AOL Time Warner now says were “inappropriately recognized” and by $122 million in contested Bertelsmann revenues. Even so, the advertising and commerce line grew that year only to $2.673 billion, a tepid rise of 14%. And in 2002 the trend rolled over abjectly–like a worn-out dog–and revenues fell by a huge 40%, to $1.606 billion. The amount would have been significantly lower still had it not included $6 million of inappropriately booked revenues and $274 million from the Bertelsmann deal. In any case, the punishing experience of 2002 proved the idiocy and uselessness of all the contortions that AOL had put itself through in its advertising business: It was trying to get from a place it never was to a place it never could be.
During all the accounting events that led up to the $190 million restatement, including those that took place after the consummation of the merger in early 2001, AOL people were in charge of what was happening at AOL. Steve Case was the boss; Bob Pittman was originally No. 2 and later was the AOL Time Warner executive who had responsibility for AOL; Michael Kelly was the hard-charging chief financial officer (first of AOL, then for a time of AOL Time Warner); and a man named David Colburn –fired last August–ran the business affairs department that negotiated many of the smelly deals. In the meantime, the old Time Warner executives–Gerald Levin, who became CEO of AOL Time Warner, and Richard Parsons, now CEO–were in New York City, sort of listening in. What they knew about the happenings at AOL is unclear.
But the $400 million deal done with Bertelsmann, the big German media company, is different from the $190 million in that it spanned a regime change, in which the AOL forces lost power and Time Warner gained it. So people like Levin and Parsons were on the Bertelsmann case at certain key moments. The deal’s strangeness therefore deserves special attention.
When AOL and Time Warner announced in January 2000 that they would merge, Bertelsmann and AOL had a skein of connections. Steve Case and Bertelsmann’s CEO, Thomas Middelhoff, were good friends; Middelhoff was on AOL’s board; Bertelsmann was a significant holder of AOL stock (though it had also been a significant seller in the late ’90s, reaping glorious profits at per-share prices ranging up to around $95); and the two companies jointly owned AOL Europe. After the merger announcement some of these things had to go, for the simple reason that Bertelsmann and Time Warner were competitive media giants and couldn’t be in bed together.
So Middelhoff resigned from AOL’s board. And then in March 2000 the two companies said they had agreed on a complex put-and-call deal by which AOL would potentially buy out Bertelsmann’s 49.5% interest in AOL Europe. This business was then, and is now, a losing operation. But the price negotiated by the CFO of AOL, Kelly, was a product of Internet frenzy and was to be a monster $6.75 billion (or under certain circumstances even more). One major investor in AOL Time Warner recently called that deal the “killer” for the merger, though it is probably wishful thinking on his part to believe that this one transaction could have made the difference in a coupling so fated to fail.
If a minimum price of $6.75 billion was set, the exact timing and terms were not. Most important, AOL Time Warner had the right to pay in cash, stock, or a combination. There was also a delay factor built into the deal, specifying that payment would not begin, at the earliest, until 2002.
By March 2001, though, with the merger completed, AOL’s Kelly and Bertelsmann were down to hard negotiations about just what kind of payment–cash or stock–would be made. Looking at AOL’s tumbling shares, then fluctuating around $40, Bertelsmann naturally wanted cash. You might think that AOL would want the opposite, since it was loaded with more than $20 billion in debt and sure to need more if it paid cash. But what AOL really cared about, above all things, was a quid pro quo. AOL offered cash if “in exchange” (words used in AOL’s recent disclosures about the deal) Bertelsmann would sign up for ads.
And in the end a kind of compromise was reached: AOL Time Warner would pay at least $2.45 billion in cash (with the form of payment for the remainder of the $6.75 billion to be settled later), and Bertelsmann would buy $125 million in ads. When the $2.45 billion arrangement was announced in AOL Time Warner’s first-quarter 10-Q filing with the SEC, nothing was said about a $125 million advertising deal tied to it.
Bertelsmann’s ads, for such things as music products and book clubs, began to run on AOL, in most cases dwarfing the amounts being spent in those categories by other advertisers. But one former Bertelsmann executive remembers behind-the-scenes dissension at his company about the deal. He, for one, saw no use in advertising on AOL but was forced to go out and do it. Fortunately for his bottom line, he says, headquarters absorbed the cost of the advertising on its books rather than allocating it down to the operating divisions.
By the end of 2001, most of Bertelsmann’s $125 million had been spent, and AOL and Bertelsmann were back to negotiating the next tranche of payment. Mike Kelly (who declined to talk to us) had at that point been moved out of the CFO’s job, becoming the operating head of AOL. But the word at AOL Time Warner’s offices in New York City is that he continued to be the negotiator on the Bertelsmann deal. And certainly the style of what developed looked familiar: This time AOL agreed that in 2002 it would pay the entire $6.75 billion in cash, and in exchange, Bertelsmann would buy $275 million more of advertising on AOL (almost all of which ran in 2002).
So, to sum up: To get cash, Bertelsmann was willing, in effect, to cut $400 million from the purchase price (and maybe more; who knows?). AOL could have accepted that cut straight out, reducing the price it had to pay to $6.35 billion–and thereby netting a crisp, clean saving of $400 million. Instead, it opted to get that much in advertising, which though it may not have carried much in costs, certainly carried some. So AOL Time Warner did not, in that arrangement, garner a full $400 million. It’s totally weird–unless you know that the only reason for doing things that way was to capture advertising and commerce revenues.
We come now to the role of Time Warner executives in all this. By late 2001 there had been a regime change, in which the Time Warner crew had taken power from AOL. Jerry Levin was retiring in May 2002 but had designated Dick Parsons, not Bob Pittman, as his successor. A new CFO, Wayne Pace, formerly at Turner Broadcasting, had been installed in November 2001 and had been widely accepted as an upright, tell-it-like-is executive. And this new team was stepping up to the job of reporting the company’s results.
So in the spring comes 10-K time, in which the company must file its annual report with the SEC. The Bertelsmann deal got a lot of ink in that 10-K: The company, the filing said, would pay $6.75 billion in 2002 and was borrowing to raise the cash needed. But was there any mention that the $6.75 billion was offset by a $400 million advertising deal? Absolutely not.
FORTUNE sought to ask AOL Time Warner management about this omission, as well as many other points having to do with the accounting problems. But management, pleading the Washington investigations, wouldn’t talk on the record, and this writer wouldn’t talk off the record. Company executives merely repeated what they had said before: “As we stated in our Form 10-K, the company and its auditors continue to believe that the Bertelsmann transactions have been accounted for correctly. But, as we disclosed, we are engaged in ongoing discussions with the SEC staff to consider their views and any additional information they may have as part of the company’s continuing efforts to cooperate with the SEC’s investigation.”
Because AOL Time Warner wouldn’t tell us why it had omitted the $400 million advertising deals from its SEC filings, we can only speculate about the reasons. Maybe management and its auditor, Ernst & Young, honestly thought there was no need to mention the advertising. Then again, maybe they recalled what had happened in the first-quarter 10-Q–no reference to the first advertising agreement–and thought it would be controversially inconsistent to suddenly be making admissions about the Bertelsmann ad deals.
Although investors might think AOL Time Warner had a duty to disclose the advertising deals, the SEC’s declared problem with the Bertelsmann matter is not about disclosure but rather about the accounting for the advertising. As AOL Time Warner has described things, the SEC has a “preliminary view” that at least some portion of the $400 million should not have become revenues but instead should have been recorded as a reduction in the price that the company paid Bertelsmann.
Neither AOL Time Warner nor Ernst & Young agree with this argument. How could they, given that they did not include the Bertelsmann deal in the bad stuff that they acknowledged in the $190 million confession? Indeed, FORTUNE has learned that when AOL Time Warner signed off on the $190 million in October, it did not know the SEC had any problems about Bertelsmann. The SEC, for that matter, didn’t then know it either, because only later did it become educated about the Bertelsmann affair.
AOL Time Warner and Ernst & Young are not only defending the accounting but have also explained to the SEC in writing why it was sound. FORTUNE asked to see a copy of the explanation but was refused. We then directly asked Ernst & Young to brief us about the accounting issues, and they refused that request as well, saying they could not “breach the confidentiality of client matters.”
So we turned to some outside accounting experts. One, Jack Ciesielski, publishes the highly regarded Analyst’s Accounting Observer and is also a member of the Financial Accounting Standards Board’s emerging-issues task force. To Ciesielski, there’s no gray area to this issue at all. “I agree with the SEC,” he says. “The timing of the advertising contracts indicates they were part of the deal.” So what he sees is a “rebate” that should never have been accounted for as revenues but rather as an offset to the cost of the deal.
A sharper opinion still comes from Walter Schuetze, a former KPMG partner who also served as a board member of FASB, chief accountant of the SEC, and chief accountant of its enforcement division. “I suspect,” he says, “that the SEC staff is saying to AOL that only the fair value of the advertising that Bertelsmann bought can be booked as revenue. But that is such a diaphanous number that I wouldn’t put much stock in it. I think the entire $400 million should be credited to the purchase price.”
He refers to Bertelsmann’s buy of advertising as a “forced purchase,” similar to many others that AOL had cranked onto its books. As for Ernst & Young, Schuetze is not respectful. He says that on AOL, it has been the “most pliable auditor” he’s ever seen: “AOL’s accounting has been rubbish,” he says, “and Ernst & Young agreed to rubbish accounting.”
It is hard to follow an act like that, so we won’t try.