Immediately before and after AOL's merger with Time Warner in January 2001, executives at the internet company artificially inflated the value of AOL stock while liquidating their own shares in a selling frenzy to enrich themselves to the tune of $936 million, according to a lawsuit filed on Monday in a California court.
The lawsuit, filed by the University of California and Amalgamated Bank's LongView Collective Investment Fund, alleges that former AOL chairman Steve Case and other senior figures were primary beneficiaries of illegal insider trading. The complaint also names as defendants a number of other past and present officers and directors at AOL Time Warner Inc., along with the company itself and its auditor, Ernst & Young LLP.
Case and two of his AOL colleagues, Vice Chairman Kenneth Novack and President/COO Robert Pittman, are accused of carrying out a scheme to overstate the number of the company's internet subscribers and inflate its e-commerce advertising revenues, profits and backlog of future business to help secure a merger with Time Warner.
While the stock was still at an artificially high level, AOL and Time Warner executives used the closing of the merger in January 2001 to take advantage of a "change of control" proviso to cash in millions of stock options on an accelerated basis.
The merger triggered early vesting of 35 million shares valued at $1.7 billion for the five top AOL executives alone. In the subsequent five months, company executives sold off 10.7 million shares from personal portfolios. During the same period, however, they spent $1.3 billion of the company's cash reserves to repurchase 30.2 million shares on the open market – in effect, using corporate money to prop up the stock's value so they could benefit personally and shield themselves from a stock collapse, according to the suit. The lawsuit reports that repurchasing began on 1st February, 2001, and the personal stock sales began the very next day.
AOL executives Case and Pittman received the highest gain from vesting their shares, selling off $157 million and $94 million, respectively, between July 2000 and November 2002. AOL Time Warner's stock price ultimately plummeted from a high of $58.51 per share to a low of $8.60 per share, resulting in a combined loss of more than $500 million for the two parties bringing the action.
"Under the law, a company issuing new stock, as the merged AOL Time Warner did, is liable to the purchasers of that stock for material misstatements that inflate the stock's value," said James Holst, a lawyer for the University of California. "We believe that AOL Time Warner and its investment advisers must be held responsible for the admitted misstatement of AOL's financial condition."
The scheme began in the period leading up to the merger when AOL executives engaged in "falsifications" to create a "grossly distorted" e-commerce advertising business that pumped up AOL stock prices, according to the complaint. It adds that the advertising deals included swaps with other internet companies that AOL misleadingly counted as revenues or transactions involving AOL's own funds that were provided to purported customers. Many of the deals were also made with companies "that lacked the financial wherewithal to honor them."
Even as other internet competitors were reporting a slowdown in advertising, AOL continued to insist it was bucking the trend. Six months after the merger, former AOL chief executive officer Gerald Levin, who is also named a defendant, claimed ad revenues were "stabilizing" and that "we have several high growth areas." Levin left the company a few months later with a $625 million retirement package.
The lawsuit alleges that AOL revenues from 2000 - 2001 were overstated by almost $1 billion. AOL Time Warner has admitted that AOL may have overstated revenues by as much as $600 million, but the lawsuit argues that even this number is too conservative.
"The public may becoming numb to the stream of reports about accounting scandals and corporate fraud, but this case should fuel renewed concern about how America's big corporations do business and earn the trust of investors," said William Lerach, a partner at Milberg Weiss, the US law firm acting for the investors. "In this instance, had AOL truthfully reported its actual ad revenue at the time, the merger could never have taken place."
The merger has been called "a terrible deal" by Dow Jones, the "worst deal of the century" by Time and "one of the great train wrecks in corporate history" by Fortune. The New York Times has said that Case "pulled off one of the sweetest deals in business history...by managing to acquire Time Warner with AOL's inflated stock." Richard Parsons, AOL Time Warner's current CEO has called the merger "silly" and a "mistake" based on "overly ambitious" forecasts that were "not real." Due to overvalued assets, the merged company took a $100 billion loss in 2002, the largest in history.
Ernst & Young, the accounting firm that oversaw the auditing throughout the merger, has retained the account and is paid $52 million in annual fees. "The merger itself turns out to have been a contrivance intended to benefit an unscrupulous few at the top of the corporate hierarchy," said Bruce Raynor, Amalgamated Bank vice chairman.
"The University of California made a sound investment in a solid company when it invested heavily in Time Warner prior to its merger with AOL," said the University's treasurer, David Russ. "The value of that investment was significantly impaired as a result of the merger."
In addition to this lawsuit, a class action is being brought against the company, lead by the Minnesota State Board of Investments. It is also facing a class action securities suit and investigations by the Securities and Exchange Commission and US Department of Justice.