Showdown At Time Warner

Problems with AOL accounting leave Dick Parsons in a tight spot: Settling with the SEC could fuel an investor lawsuit

It was late 2003, and Richard D. Parsons, chairman and chief executive of Time Warner Inc. (TWX ), had been at loggerheads with the Securities & Exchange Commission for more than 18 months. The issue: whether the company properly booked a slew of advertising deals negotiated by America Online Inc. before it merged with Time Warner. Parsons had already reduced AOL's reported ad revenues by $190 million over eight quarters. But he drew the line at SEC demands that he restate even more by marking down an unusual $400 million advertising contract AOL had struck with German media giant Bertelsmann in 2001.

So Parsons decided on a bold course, a source close to the case tells BusinessWeek. He promised SEC Enforcement Director Stephen M. Cutler that he would "restate immediately" if outside auditors and other financial experts said the accounting on the Bertelsmann deal was wrong. For months, a panel of hired guns pored over AOL documents, e-mails, and spreadsheets. In the end, they all concluded that, while the accounting fell into a gray zone, Time Warner's financial statements were probably correct.


Case closed? Not yet. Despite Parsons' gamble, the SEC isn't buying the experts' conclusions and still demands that Time Warner lower its revenues from the Bertelsmann contract. Unless Time Warner yields, the agency could notify the company this summer that it intends to sue, according to a source close to the SEC. The charge: misleading investors about the health of AOL ad revenues.

If the SEC brings charges, Time Warner is likely to settle, BusinessWeek has learned. But the standoff, as reconstructed through interviews with corporate, government, accounting, and legal sources, already has become the rarest of events in post-Enron Corporate America -- a monumental battle of wills between a regulator and a major corporation. With an aggressive SEC stressing the need for companies to cooperate with its probes, Time Warner's long-running resistance may have already exposed the company to heightened penalties. A Time Warner spokesman would not comment on the case or on any of the detailed charges except to say: "We continue to seek to cooperate fully with investigators." The SEC would neither confirm nor deny the investigation.

However it's resolved, the battle will leave scars. The SEC's hard-nosed tack will fuel complaints, already being voiced by defense lawyers, about overzealous enforcement. Time Warner's stubborn refusal to settle the accounting dispute, prolonging uncertainty about the company, has depressed its stock. And while company finances have improved over the past year, the SEC probe has impeded the issuance of stock or bonds, increasing pressure to sell assets instead.

In essence, sources close to the case say, the SEC suspects that AOL gave Bertelsmann money that it used to buy AOL ads. Such so-called round-trip deals violate securities laws unless disclosed because they mislead investors.


The pressure on Parsons is immense. No matter how the 56-year-old CEO resolves the SEC case, he could leave Time Warner vulnerable in other arenas. He could choose to settle the investigation, and the SEC probably wouldn't require Time Warner to admit wrongdoing. But shareholder lawyers would likely use the settlement documents -- containing the SEC's view of the Bertelsmann ad deal -- as fresh ammunition in a massive shareholder suit working its way through federal court in Manhattan. Investors charge that AOL inflated ad revenues by $1.7 billion from 1999 through July, 2002. Shareholders lost some $56 billion in market value between Jan. 11, 2001, when the merger was completed, and July 24, 2002, when the company disclosed the SEC probe.

Handing those unhappy shareholders an SEC settlement would be unpleasant. But Parsons' only other choice is to roll the dice and fight the SEC. The ensuing trial would give plaintiffs' lawyers a virtual road map for their case -- including much of the SEC's evidence.

Adding to Time Warner's legal jeopardy: Two AOL ad deals are under criminal investigation. Federal prosecutors in Virginia are probing, a now-bankrupt Las Vegas Internet firm, while the U.S. Attorney in Los Angeles is looking into Homestore Inc. (HOMS ), an online provider of real estate listings, now under new management, in Westlake Village, Calif. Pro-After Inc., the new name of Purchase-Pro, has agreed to cooperate with the feds, says Gregory Garman, a lawyer representing the company. A Homestore spokesperson says the company was cleared in 2002.

These cases threaten to involve former AOL officials -- and could open Time Warner to even more SEC charges of helping its ad clients commit securities fraud by falsely inflating the clients' revenues.

The Bertelsmann tangle stems from a friendship, forged in the tech boom, between AOL founder Stephen M. Case and ex-Bertelsmann Chairman Thomas Middelhoff. They formed a joint venture in 1995 to run AOL Europe. In March, 2000, the companies signed a contract that gave Bertelsmann the right to demand that AOL buy out Bertelsmann's 49.5% interest in AOL Europe for $6.75 billion. AOL could choose to pay in cash or stock. Case and Middelhoff declined to comment.

In March, 2001, Bertelsmann needed cash. It exercised its option to sell and tried to persuade Time Warner to pay in cash instead of stock. Time Warner agreed but demanded that the German company buy a large quantity -- $400 million worth -- of AOL ads in return for the more valuable cash payment. Bertelsmann agreed, and ads promoting its products began appearing online immediately.

So why the SEC dispute? One accounting source says that the SEC believes the ads were hurriedly grafted onto a buyout deal that had nothing to do with ads. Instead of booking $400 million in ad revenues, the SEC argues, AOL should have lowered the $6.75 billion it paid for AOL Europe by $400 million. That would reduce AOL's ad revenues of $3.6 billion in 2001 and 2002 by about 11% -- and take a chunk out of profits for those years.

The SEC also has AOL spreadsheets that give a wide range of values for the Bertelsmann option to sell its stake in AOL Europe. The agency could argue that AOL was gaming the price to adjust for whatever level of ads Bertelsmann committed to. Bertelsmann's accounting of the deal jibes with the SEC's view, says a source familiar with the case.

Who's right? Experts say the deal is so unusual that accounting principles don't specifically address it. The experts Parsons assembled agree with Time Warner's view, an accounting source says. They included Ernest L. Ten Eyck, a former SEC official with a King of Prussia (Pa.) forensic accounting company. Ten Eyck would not confirm that Time Warner had hired him or comment on any conclusions he might have drawn.


But some don't back the Time Warner findings. "I would tend to agree with the SEC," says Jack T. Ciesielski, an accountant who publishes the Analyst's Accounting Observer newsletter. While he has not seen any Time Warner documents, Ciesielski says, "the SEC probably believes that the payments were spread out over many quarters to make them look like ad revenues rather than a single payment to close out options as part of a transaction over a piece of property."

Another problem for Time Warner: A source close to the case says the SEC has interviewed Bertelsmann employees who say that the prices it paid for AOL ads were above the market rate. One former Bertelsmann exec says that Bertelsmann never used all the ad space to which it was entitled. In SEC filings, Time Warner has claimed it ran $400 million in ads.

The SEC considers its case strong, but Time Warner holds a few good cards, too. A source close to the company says AOL started negotiating to sell Bertelsmann online ads a year before the AOL Europe buyback. Bertelsmann's payment for the ads and Time Warner's payment for the buyback were separate -- evidence, accounting sources say, that the deals were distinct. The crux of Time Warner's argument, accounting and legal sources say, is that accounting rules allow it to recognize revenue as long as it delivers equal value in return. These sources say Time Warner argues that the SEC shouldn't be concerned with the underlying motivation for an ad deal.

Even if Time Warner manages to settle the Bertelsmann affair, it still must contend with the spreading PurchasePro and Homestore investigations. Eight officials from the two companies have pleaded guilty to criminal charges of inflating revenues through round-trip transactions with unnamed media companies. "It was a symptom of the times," says accountant Ciesielski. "Lots of Internet companies structured their deals to look like they had steady revenue growth."

One of those media companies, according to a criminal information filed in the PurchasePro case, is based in Dulles, Va., AOL's hometown. Government sources say that company is AOL, and AOL's pre-merger SEC filings confirm that it had contracted with PurchasePro to help the Las Vegas company find buyers for its software. The court filing alleges a secret side agreement: The media company helped buyers pay for the products, and in return PurchasePro gave the media company $30 million in warrants for PurchasePro stock. A government source says AOL booked $30 million in stock warrants as ad revenues in 2000.

After reports of PurchasePro's accounting problems surfaced in February, 2001, Time Warner retained William R. McLucas, SEC enforcement director from 1989 to 1998, to assess AOL's dealings with PurchasePro and Homestore. According to sources familiar with the internal investigation, McLucas looked at other ad deals, too -- and turned up ample evidence of improper accounting. These sources say that the company ended the relationship with McLucas in 2002. Time Warner later retained Williams & Connolly, a Washington law firm known for an aggressive approach to prosecutors. McLucas declined to comment.

PurchasePro and Homestore are among the AOL ad partners cited by the shareholder lawsuit in Manhattan. The suit alleges that current and former senior officials, including Robert W. Pittman, AOL's president before the merger, knew of the deteriorating outlook for ad revenues in the fall of 2000 yet continued to make optimistic forecasts. Pittman did not respond to several requests for comment.

A Manhattan federal judge on May 5 allowed the class action to proceed. She dismissed charges against Parsons, former Time Warner CEO Gerald M. Levin, and Case. But the judge saw enough evidence to continue scrutinizing Pittman and four other execs. Time Warner continues to pay Pittman's legal fees.

Parsons likes to call Time Warner's legal problems "legacy" matters inherited from its ill-fated combination with AOL. But the SEC is dealing with a legacy, too -- the massive mess left behind after Corporate America's orgy of accounting misdeeds. Time Warner may think it's just tussling over an accounting technicality. But the SEC sees something else: A company that played with boom-era accounting and still defends its practices. For an SEC determined to make sure the numbers game is over for good, that will never wash.

By Paula Dwyer and Catherine Yang in Washington, Jack Ewing in Frankfurt, and Tom Lowry in New York

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