By Paula Dwyer When Time Warner (TWX) announced on July 28 that net income for the second quarter had shrunk 27% from the same period a year ago, that wasn't the only bad news from the media giant. Buried in a news release was Time Warner's announcement that it had launched an internal investigation into how it had accounted for America Online's European subsidiary, AOL Europe, in 2001 -- just after completing its merger with AOL. The announcement contained only the slimmest of details, and even they were cryptic: The probe "related to the consolidation of, and equity accounting for, its interest in AOL Europe prior to 2002."
So what's really going on with this self-examination? Time Warner is peeling back the onion on actions that AOL took in the last quarter of 2000, when it was in a frenzy to complete the merger. As first reported by BusinessWeek (see 6/28/04, "Goldman's 1% Solution"), AOL and German media conglomerate Bertelsmann, which together ran AOL Europe as a 50-50 joint venture, each needed to bring their ownership to below 50%.
HIDING LOSSES. Bertelsmann needed to cut back because it had promised Europe's competition czar that it wouldn't have control over AOL Europe -- as a condition of letting AOL and Time Warner merge. But AOL also needed to reduce its stake because it didn't want to consolidate AOL Europe's books -- including large losses -- with its own.
That's where Goldman Sachs Group (GS) stepped in. The Wall Street bank agreed to buy 1% of AOL Europe -- half a percent from each parent -- for $215 million. AOL Europe, in return, agreed to a "put" contract promising Goldman that it could sell back the 1% stake by a specific date and at a set price. That simple transaction solved Bertelsmann's EU problem and AOL's accounting issue.
However, the deal also raises securities-law questions. The U.S. Securities & Exchange Commission and the Justice Dept. have construed some deals involving promises to buy back assets at a specific time and price as share-parking arrangements designed to mislead investors.
WHAT'S MATERIAL? Andreas Schmidt, former chief executive of AOL Europe, says the Goldman deal may have kept up to $200 million in 2000 losses off the combined AOL-Time Warner financials. That's enough, he says, that Time Warner might have tried to change the terms of the $120 billion merger if it had known about the losses since AOL wouldn't have looked as healthy.
Another issue: The deal was never disclosed. Goldman maintains that it didn't need to be because the amount wasn't material. Why? Because it didn't involve at least 3% of AOL Europe's assets. But 1999 SEC guidelines state that materiality cannot be reduced to a numerical formula. Instead, companies are supposed to consider other factors that could be important to investors, such as whether a subsidiary played a significant role in a company's profitability. Goldman says that was considered.
The SEC hasn't brought charges over the 1% solution, and an SEC spokesman wouldn't comment on whether the agency is probing the deal. Time Warner won't comment further, and Goldman Sachs denies wrongdoing. But with Time Warner now probing the transaction on its own, you can expect more shoes to drop on whether the 1% solution followed the letter and spirit of accounting rules and securities laws. Dwyer is senior writer in BusinessWeek's Washington bureau