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Stanford University Law School
- Securities Class Action Clearinghouse
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RICHARDS McGETTIGAN REILLY
& WEST, P.C.
MICHAEL McGETTIGAN (VSB#13426)
CRAIG C. REILLY (VSB#20942)
Suite 700, King Street Station
225 Reinekers Lane
Alexandria, VA 22314
Telephone: 703/549-5353
MILBERG WEISS BERSHAD
HYNES & LERACH LLP
WILLIAM S. LERACH
600 West Broadway, Suite 1800
San Diego, CA 92101
Telephone: 619/231-1058
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KEITH M. FLEISCHMAN
SAMUEL H. RUDMAN
One Pennsylvania Plaza
New York, NY 10119-0165
Telephone: 212/594-5300
Attorneys for Plaintiffs
[Additional counsel appear on signature page.]
UNITED STATES DISTRICT COURT
EASTERN DISTRICT OF VIRGINIA
ALEXANDRIA DIVISION
DAVID ORMAN, TRUSTEE, GARY D. ) Civ. No. [97-CV-00264]
WALTER, SCOTT D. WALTER, JASON )
RAFFENAUD, BARBARA Y. WALTER, ) CLASS ACTION
TADRIC PAGE, BERNARD GOLDSMITH, )
GINA FLORENS, MIKLOS WECHTER, )
TIMOTHY BAKER and LEE ROSS, On )
Behalf of Themselves and All Others )
Similarly Situated, )
)
Plaintiffs, )
vs. ) CLASS ACTION COMPLAINT FOR
) VIOLATION OF THE SECURITIES
AMERICA ONLINE, INC., STEPHEN M. ) AND EXCHANGE ACT OF 1934
CASE, JAMES G. ANDRESS, JANICE ) [filed Feb. 24, 1997]
BRANDT, FRANK J. CAUFIELD, DAVID )
COLE, MICHAEL M. CONNORS, JOHN L. )
DAVIES, MILES GILBURNE, ALEXANDER )
M. HAIG, JR., RICHARD E. HANLON, )
JAMES V. KIMSEY, ELLEN M. KIRSH, )
MATTHEW KORN, LENNERT J. LEADER, )
THEODORE LEONSIS, MARC S. SERIFF, )
JEAN N. VILLANUEVA, AUDREY Y. WEIL )
and ERNST & YOUNG, LLP, )
)
Defendants. ) Plaintiffs Demand A
___________________________________ ) Trial By Jury
INTRODUCTION AND OVERVIEW
1. This is a class action on behalf of purchasers of the
stock of America Online, Inc. (the "Company" or "AOL") between
August 10, 1995 and October 29, 1996 (the "Class Period"), seeking
to pursue remedies under the federal securities laws. AOL provides
on-line services to personal computer users, in competition with
other on-line service providers and with direct Internet access and
service providers. During AOL's 1996 fiscal year ("F96"), ended
June 30, 1996, AOL reported strong growth in net income and
earnings per share ("EPS") totaling $29.8 million or $.38 per share
with shareholders' equity increasing to $512 million, based on
AOL's largest single asset -- " Deferred Subscriber Acquisition
Costs" -- of $314 million, resulting from AOL's vastly increasing
marketing expenditures to try to attract subscribers to its system.
AOL's interim F96 financial results were reviewed by Ernst & Young
LLP (" Eamp;Y" ) and represented by AOL as fairly presenting its
financial condition and results of operations. AOL's F96 results
were certified by its auditor Eamp;Y as being fairly presented in
conformity with Generally Accepted Accounting Principles (" GAAP" ),
after an audit by Eamp;Y in accordance with Generally Accepted
Auditing Standards (" GAAS" ). AOL and Eamp;Y justified AOL's deferral
of hundreds of millions of subscriber acquisition costs (basically
direct response advertising and marketing expenditures) and their
amortization over a 24-month period on the ground that the average
AOL subscriber stayed with AOL for over 40 months and had a
lifetime subscription value of over $700. In fact, however, AOL
had no reasonable basis for its public representations of a 40+
month average subscriber lifetime with a average value of $700+, or
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for its accounting of subscriber acquisition costs being an
amortizable asset in accordance with GAAP. Throughout the Class
Period, AOL knew, that despite increasingly large marketing
expenditures, it was suffering from slowing subscriber growth and
an increasingly acute problem with " churn," i.e., users not signing
up as subscribers after a free trial period and subscribers
cancelling their subscriptions, problems which rendered its
representations materially false and misleading when made. In
addition, AOL represented that its new direct internet access
service Global Network Navigator (" GNN" ) and its Booklink Web
Browser was very successful and attracting large numbers of
subscribers thus enabling AOL to effectively compete in the
Internet access market. Based on its purported success, positive
momentum and subscriber growth resulting from its increasing
marketing expenditures, AOL forecast increased F97 EPS of $1.00+
and that AOL would reach 10 million subscribers by June 1997. As
a result of these false statements and false financial reporting,
AOL's stock soared to an all-time high of $71 per share in May
1996.
2. However, during June through October 1996, AOL's stock
declined sharply, as AOL made partial and materially incomplete and
misleading disclosures that, despite its greatly increased
marketing expenditures, it was suffering from slowing subscriber
growth and increased subscriber cancellations. As a result, AOL
was forced to reduce its marketing expenditures and instead
concentrate on trying to increase subscriber retention. As the
defendants knew, subscriber revenue and retention problems had in
fact become increasingly acute in 1995, and, indeed, " churn" was a
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constant problem at AOL even before 1995. AOL initially addressed
its increasingly serious problems with churn by appointing a task
force, and, in or about March 1996, established an official Member
Retention & Loyalty Lab, or " Churn Lab."
3. Then, on October 29, 1996, just a few weeks after AOL had
issued its F96 financial statements, and Eamp;Y had certified its
assets, earnings and shareholders' equity, as well as the
appropriateness of AOL's accounting practices, AOL revealed that it
was taking huge write-offs of $460 million, principally consisting
of a $385 million write-off of all previously deferred or
(capitalized) subscriber acquisition costs, and further revealed
that it would end its practice of not expensing such costs. AOL
also announced a $75 million " restructuring" write-off which, inter
alia, would completely eliminate AOL's investment in GNN (which had
failed as an Internet access product) resulting in the firing of
over 300 employees; and that it was adopting flat rate pricing as
of December 1, 1996.
4. AOL thus instantly eliminated in its entirety the largest
single asset on its balance sheet (capitalized subscriber
acquisition costs), reduced its shareholders' equity by 80% and
wiped out by five times over the total pre-tax net income it had
ever reported. It is now clear that AOL had never earned any
profits and, in fact, had been incurring huge operating losses in
prior years rather than the profits it had claimed, and instead of
the profitable growth forecast by and for it in F97, AOL is
presently suffering huge losses. During mid-October 1996, AOL
stock collapsed to as low as $22-3/8 per share -- 70% below its
Class Period and all-time high of $71.
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5. However, before the truth about AOL's huge losses and
improper accounting practices, failed Internet access product and
inability to reach the 10 million subscribers mark by June 1997
were revealed, AOL and the 18 AOL insiders named as defendants in
this action took advantage of the artificial inflation in AOL's
stock, which their false and misleading statements had caused, to
sell off 4.9 million and 2.1 million shares of AOL stock,
respectively, at prices as high as $55-3/8 per share. This enabled
AOL to obtain $139 million in badly needed new capital and the 18
insiders to pocket over $95 million in illegal insider trading
profits.1 AOL's co-founder and Chairman Emeritus, defendant James
V. Kimsey (" Kimsey" ) sold 82% of his AOL stock -- 651,000 shares at
as high as $55-3/8 per share pocketing $24.5 million. AOL's co-
founder, Chairman and CEO, defendant Stephen Case (" Case" ), sold
76% of his AOL stock -- 575,000 shares at as high as $55 per share
pocketing $29.1 million. AOL's Chief Financial Officer, defendant
Lennert Leader, sold 66% of his AOL stock -- 210,800 shares at as
high as $54 per share, pocketing $10 million. Collectively, 18 AOL
insiders unloaded 72% of their AOL holding during the Class Period.
6. AOL went public in 1992 and became one of the most
rapidly growing on-line service providers. AOL's business appeared
to be a spectacular success as it reported obtaining millions of
subscribers and acquired several other companies during 1992-1996
-- all while reporting large revenue and operating profit gains.2
____________________
1 Unless otherwise noted, all shares and per share amounts have
been adjusted to reflect AOL's 2-1 stock split declared on October
31, 1995.
2 Excluding certain mandated one-time charges to write off
purchased research and development costs in connection with AOL's
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Because of AOL's apparent success it attracted attention as one of
America's new high-tech growth companies and its stock was a very
strong performer. Due to the strength of its stock, AOL was able
to raise millions in new capital via large secondary stock
offerings and to acquire several other companies by issuing
millions of shares of its stock. AOL's founders and top
executives, Kimsey and Case, received widespread favorable media
attention, with Case appearing on the cover the Business Week and
Kimsey testifying before Congress on behalf of the American
Electronics Association in favor of legislation making it more
difficult to sue such companies for fraud in class action suits
under the federal securities laws.
7. In fact the truth about AOL was quite different than AOL
and its accountants publicly represented. Thus, this suit involves
the misconduct of AOL's corporate insiders, who, in managing this
rapidly growing, capital-hungry company, along with its
accountants, made misrepresentations and used accounting
subterfuges to make it appear that AOL was profitable and would
achieve increasing profits in F97 when, in fact, properly accounted
for, AOL was incurring large losses which were increasing and was
unlikely to achieve any substantial profits in the foreseeable
future. AOL's insiders did this for several reasons:
• AOL was spending increasingly large amounts of cash
(up to approximately $250 per net subscriber) to try to
____________________
acquisitions of other companies. As required by accounting rules,
AOL periodically took one-time write-offs of purchased research and
development costs as a result of these acquisitions. Analysts
covering AOL customarily excluded such write-offs from their
appraisals of AOL's earnings, and AOL always reported its earnings
both including and excluding such write-offs, purportedly to show
the true earning power of its business.
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attract subscribers who provided only small monthly
revenues to AOL (about $18 per month on average) if they
subscribed. Thus, AOL was encountering a high cash " burn"
rate and was in a negative cash flow position, which
required AOL to sell stock to raise cash to support its
operations. This put pressure on AOL's insiders to make
it appear AOL was profitable so its stock would trade at
high prices and it could raise needed capital on
attractive terms.
• AOL was trying to rapidly grow its business by
continually making acquisitions of other companies.
Since AOL could not afford to pay for these acquisitions
in cash, it had to pay for them by issuing AOL stock.
This put pressure on AOL's insiders to make it appear AOL
was profitable, so that (i) AOL's stock would trade at
higher prices and thus fewer shares needed to be issued
to complete an acquisition; (ii) the controlling
shareholders of the companies AOL wanted to buy would be
willing to accept AOL stock in return for selling their
companies to AOL; and (iii) those persons would then be
able to sell off the AOL stock they obtained at high
prices in AOL stock offerings.
• AOL was under attack by short-sellers, who
criticized AOL's accounting practices, competitive
position and business outlook. AOL's insiders wanted to
" squeeze" the short-sellers of AOL stock and punish them
by pushing AOL's stock up much higher in price, forcing
the short-sellers to " cover" their positions, i.e., buy
in their short sales which would punish them and push AOL
stock even higher. This put pressure on AOL's insiders
to make it appear that AOL was profitable and succeeding,
i.e., the short-sellers were wrong, as AOL's stock could
not be pushed higher unless AOL appeared to be a
successful and profitable operation.
• AOL's insiders, who were intimately familiar with
its business and the inappropriateness of the accounting
practices being used to conceal its losses, and make it
appear profitable, knew AOL's prospects for achieving the
profit growth being forecast were non-existent, wanted to
sell off large portions of their holdings in AOL before
the truth about the impaired position of AOL's business
had to be admitted and AOL had to take huge write-offs
and report losses. Thus, they wanted to push AOL stock
higher so they could maximize their profits from selling
their AOL shares, which could only be accomplished by
making it appear that AOL was profitable, succeeding and
well-positioned to continue to grow profitably.
8. To increase its subscriber base, AOL was constantly
attempting to add subscribers who after a free trial subscription
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period paid a monthly fee plus usage fees over a certain number of
free use hours. To attract new subscribers, AOL had to make ever
larger marketing expenditures -- which escalated dramatically
during the Class Period, to as high as approximately $250 per net
new subscriber. Despite these huge expenditures by AOL, new
subscribers could only be obtained by giving them an initial free
trial membership and even if they signed up as paying subscribers,
they paid only a $10 per month subscription charge and, on average,
only about $18 per month total, including usage charges. Many
trial users never became subscribers, many others repeatedly signed
up for free trial subscriptions without ever becoming paying
subscribers, and a large number of persons who did become paying
subscribers terminated AOL's service quickly. As of June 30, 1995,
less than 25% of AOL's subscribers had been subscribers for one
year or longer.
9. In early 1995, before the beginning of the Class Period,
AOL's top management discussed with middle management the need to
keep AOL's stock price from declining, especially given AOL's
serious concerns, even at that early date, about churn rates and
subscriber retention. The impact of pricing plans, churn and
subscriber usage on AOL stock prices was not only recognized by
AOL's management, but the subject of numerous discussions within
AOL. At a meeting in late 1995 at the Sheraton Premiere Hotel, top
AOL officers encouraged AOL employees to focus on signing up
family, friends and neighbors as subscribers and to follow up to
ensure that the new subscribers did not cancel their memberships,
citing churn rates as high as 60% in 1995.
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10. To inflate its subscriber numbers and make it appear that
its churn rate was lower than it really was, AOL secretly extended
the trial (free) membership period of thousands of trial
subscribers who did not want to buy the AOL service, knowingly
permitted persons to repeatedly sign up for trial subscription
periods counting them as subscribers, and secretly gave
concessions, like extra hours of free usage time, special pricing
plans, credits and other incentives to keep subscribers from
canceling, even if the incentives meant that AOL would make no
money on a particular subscriber. Members enrolled on a free trial
basis were also included by AOL in their total membership figures,
despite the fact that AOL received no revenue from trial members
and knew that a substantial number of trial subscribers would not
become paying subscribers. The subscriber membership rate was also
inflated by fake accounts, which AOL knew about as early as 1994.
Within the Company, and particularly within the Community Action
Team (a unit established to address problems with member
retention), it was well known that fake accounts were out of
control, with thousands of fake accounts being set up every day
through " AOHell," a fraudulent mechanism set up by computer
hackers. To maintain inflated membership numbers, however, AOL
management between August and December of 1995 instructed the
Community Action Team not to terminate fake accounts.
11. By mid-1995, despite AOL's efforts to diversify its
revenue base, 90% of its revenues continued to come from monthly
subscriber fees -- a fee structure that was under increasing
competitive pressure as the growth of the Internet gave computer
users access to much of what AOL charged its subscribers for at a
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much lower cost. Notwithstanding these negative economics of AOL's
business, AOL did not expense its huge and increasing subscriber
acquisition costs, as was required by the accounting rules
regarding advertising costs. Instead, AOL deferred expensing most
of those costs, capitalizing them instead, recording these cash
expenditures as an asset on AOL's balance sheet and then amortizing
them over an increasingly long period of time, even though it had
little, if any, hope of recovering these costs out of subscription
fees. Certain analysts, financial writers and stock traders
criticized AOL and its accounting practices -- which AOL staunchly
defended, even falsely asserting they had been " blessed" by the
Securities and Exchange Commission (" SEC" ). As a result AOL became
a target of short-sellers who publicly criticized the Company and
its top management, while selling over 15 million shares of AOL
stock short -- the largest short position of any NASDAQ stock.
AOL's insiders hated the " shorts" and their criticism of the
Company and its accounting practices and asserted they had " not
made their case."
12. As AOL's F95 year (ended June 30, 1995) unfolded, AOL's
insiders realized that AOL was in trouble. AOL was encountering
increasing competition from both the Internet and from other
suppliers of on-line services, which was putting pressure on AOL to
cut its subscription fees and usage charges. AOL was vastly
increasing its marketing expenditures to get more subscribers but
was encountering a higher churn, higher numbers of customers
refusing or unable to pay their charges and stagnant average usage
charges as AOL was increasingly attracting more marginal
subscribers (low usage), while losing its more sophisticated
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heavier users to lower-cost Internet access providers. As a result,
AOL's cash " burn" rate was escalating, its competitive position was
deteriorating and it badly needed to raise additional capital.
Worse, yet, AOL had assured the entrepreneurs who controlled the
seven companies AOL had acquired during F95 for millions of shares
of AOL stock that they would be able to sell off the AOL stock they
had received in those transactions in a registered stock offering
that AOL would cause to occur. As a result, AOL was under
increasing pressure to accomplish a large public offering of its
stock to raise capital it needed to alleviate its cash flow squeeze
and to enable the sellers of their companies to AOL to sell off
their AOL shares.
13. To support AOL's stock price and accomplish such large
stock sales, AOL's insiders realized it was indispensable that AOL
continue to report profitable operations and forecast continuing
strong subscriber growth and profits. However, they knew that due
to the deterioration in AOL's business and the adverse impact on
earnings by the rising amortization expenses of AOL's rapidly
escalating net Deferred Subscriber Acquisition Costs, AOL's
operating earnings were going to decline sharply during F96. So,
even though by year-end F95 the actual economics of AOL's business
required AOL to stop deferring subscriber acquisition costs and
write off its millions in previously deferred costs, AOL's insiders
schemed to not only find a way to continue to defer those costs and
to avoid a huge write-down of AOL's deferred subscriber acquisition
costs at year-end F95, but also to actually lengthen the period
over which AOL wrote off such costs to 24 months, so AOL could
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forecast strong F96-F97 EPS and then report profits and EPS during
F96 instead of losses.
14. Defendants knew from the increasing competition from
other Internet service providers, evidenced by internal churn rates
and other changing market factors, that there was no legitimate
basis for concluding that AOL's deferred subscriber acquisition
costs would result in probable future economic benefits (i.e.,
revenue from user fees) as required by applicable accounting rules
(including Statement of Position 93-7), to justify deferring (and
capitalizing) dramatically increasing amounts of subscriber
acquisition costs, let alone increasing the amortization period
from 12 or 18 months to 24 months. Indeed, competition from other
on-line service providers was a major concern at AOL, which
continually monitored and evaluated its competition. AOL even
assigned specific personnel to forecast the future business
environment, and was thus well aware of the impact competition from
other on-line service providers had on AOL's retention rates, which
was a subject of frequent discussion by AOL's upper management.
AOL also internally recognized that changing market forces and
lower user fees charged by its competitors put the reliability of
AOL's budget projections in serious question. AOL's Accounting
Department knew that the changing business environment in the on-
line service provider industry made projections based on historical
results inherently unreliable. Also contributing to AOL's
deteriorating position vis-a-vis competing on-line service
providers was its use of technical products which did not meet the
needs of its subscribers, like its web browsers.
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15. Moreover, AOL's internal controls were in such disarray
that the Company had no reasonable basis from any of its data to
support its claim that the average subscriber was retained for 40+
months and generated $700+ in revenue. The " historic" studies upon
which this claim was based were in large part derived from the
Company's subscriber usage reports which were fatally flawed and
misleading because they were based on attenuated projections,
supposition and conjecture and included numerous free-trial
subscribers and fraudulent and/or cancelled accounts. AOL's Brand
Research Department generated the initial subscriber usage reports,
based on raw data about subscriber revenue, turnover and the costs
to maintain subscribers. The Brand Marketing Department, led by
defendant Jan Brandt, received those reports directly, and
manipulated them to reflect results in line with the defendants'
need to justify their public statements about, inter alia,
continuing growth and anticipated future revenues. The Brand
Marketing Department then communicated the data to the Accounting
Department, where it was further massaged. Only then did the
Accounting Department pass the data on for use by AOL's various
other departments, where it was used to make budgets and in
dealings with commercial clients such as advertisers.
16. Total membership figures were constantly misstated by at
least 500,000 subscribers. Revenue projections were also inflated
as a result of projecting membership rates based on current
membership numbers which included free trial members and
cancellations. Similarly, raw subscriber usage data indicated that
the publicly touted 40+ month average subscriber life had to have
been based on skewed data and projections taken from selected
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slices of the subscriber usage reports, and that the actual average
subscriber life, based on the raw data, was substantially shorter.
Subscriber usage reports went to Accounting only after having been
manipulated to include projections based on unsupported expected
future revenue, rather than an historical actual revenue; moreover,
as defendants knew, any revenue projections were especially
sensitive to churn rates, and AOL had no reliable consistent data
on actual churn rates.
17. AOL used this manipulated data to justify its
amortization of subscriber acquisition costs. Not surprisingly,
there were frequent conflicts between the actual data, reports
generated internally and AOL's public disclosures concerning
subscriber totals, expected revenue and retention rates. As a
result of the constant revisions and changes to the critical user
data, budget proposals from various AOL departments, such as the
Business Planning Department, were repeatedly returned to be
revised to reflect the constantly changing subscriber usage data,
and it was not unusual for AOL departments to generate four
different versions of budget projections in a matter of days
because of the continually changing statistics involving
anticipated subscriber usage.
18. AOL was able to obtain $139 million in badly needed
capital through a public offering of AOL common stock which was
completed on October 13, 1995. Over 7 million shares of AOL common
stock were sold in the offering, 4.9 million by AOL for over $139
million. In addition, a number of entrepreneurs who had sold their
businesses to AOL for AOL stock in the prior year sold their
shares, as AOL had assured them they would be able to do, and
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defendant James V. Kimsey sold 400,000 of his AOL shares in the
offering. In order to promote the offering, AOL's top officers,
including defendants Stephen M. Case and Lennert J. Leader,
conducted a " roadshow" in late September and early October, 1995,
with representatives of the lead underwriters. They met with
institutional investors, security analysts and brokers in major
cities throughout the country, where they repeated their false
representations about a 40+ month average subscriber life and
average lifetime membership revenue of $700+, and also represented,
among other things, that AOL's retention, or " churn," rate was
stable or improving. The defendants were careful, however, not to
disclose internal AOL information and statistics about retention
rates and churn. Internally, churn data was analyzed by category,
i.e., retention rates for subscribers who had been members 90 days
or more, 45 to 90 days and 30 to 45 days. Disclosures to
outsiders, including on AOL's roadshow for its October 1995 public
offering (as well as in AOL's periodic conference calls with market
analysts), about the churn rate never included explanations about
such distinctions and were instead based on misleadingly
incomplete, partial information. AOL insiders took advantage of
the misleading information communicated to the market in the
roadshows and the momentum the public offering gave to AOL's stock
price. Of the 2.1 million shares of AOL stock sold by AOL insiders
during the Class Period for a total of approximately $95.86
million, 860,000 shares were sold from October through December,
1995 for a total of $29.75 million, including 400,000 shares sold
by Kimsey in the offering itself for approximately $1.7 million;
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100,000 shares sold by Case for approximately $3.9 million; and
60,000 shares sold by leader for $2.4 million.
19. That the defendants were well aware throughout the Class
Period that the existing data about subscriber usage did not
support AOL's amortization of subscriber acquisition costs is also
evidenced by the fact that, in June 1995, to guard access to that
data, AOL began restricting the access of lower level AOL personnel
to subscriber usage information data. In or around the middle of
1995, shortly before AOL lengthened its amortization period to 24
months, the subscriber usage reports available to AOL personnel
internally also underwent dramatic changes in format. Prior to
that time, the reports were fairly detailed, with specific numbers
on usage hours, sessions per user, members per month, and turnover
(or churn) rates. After June 1995, however, the subscriber usage
reports were stripped of their detail as management in charge of
Brand marketing and Accounting became increasingly sensitive and
secretive about the data available on subscriber usage and about
sharing the data underlying the reports with AOL mid-level managers
and employees.
20. AOL not only continued to amortize subscription
acquisition costs during the Class Period, but increased the length
of the amortization Period despite changes in its business model,
which changed from depending on revenue from subscribers to other
revenue sources, such as advertisers, as early as 1995. Defendants
knew that AOL could not rely on user fees from subscribers to
generate sufficient revenue and that it desperately needed other
sources of revenue to survive. Shortly after Mayer Berlo was hired
as a Vice President to run the National Accounts Department in the
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fall of 1995, the focus of the National Accounts Department changed
to generating revenue from advertising, as opposed to its prior
focus on obtaining interesting content providers to attract as many
subscribers as possible. Indeed, the reduced reliance on
subscriber revenue was identified by AOL itself in its 10-Q for the
first quarter of fiscal 1997 (filed with the SEC after the Class
Period on or about November 15, 1996), as having caused AOL to " no
longer [have] an adequate accounting basis to support recognizing
deferred subscriber acquisition costs as an asset."
21. Sales executives were instructed that the main objective
in signing up large national accounts, such as Century 21 Realty,
TWR and ERA Realty, was to secure substantial up-front payments for
those companies to get onto the AOL system. In order to prop up
its stock price, AOL needed these large up-front fees to offset the
lower usage by subscribers, and hence subscriber revenue, AOL was
encountering in 1995 and 1996. Moreover, the up-front fees, which
were immediate revenue to AOL, were reduced by bounties, as high as
$25 per subscriber, AOL paid to the national accounts for each of
their employees who signed up as a subscriber with AOL.
22. Defendants not only intentionally ignored the fact that
its existing subscriber usage and membership data, its increasing
churn and the changing market factors made its practice of
amortizing (and capitalizing) subscriber acquisition costs improper
and contrary to applicable accounting rules, but also adopted an
internal policy of justifying the continued amortization of
subscriber acquisition costs until and unless there was clear and
convincing evidence that it had no basis to amortize its subscriber
acquisition costs. This internal policy was directly contrary to
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Statement of Position 93-7, the accounting rule upon which AOL
relied to amortize its subscriber acquisition costs, which puts the
burden on the company seeking to amortize advertising costs to show
that the advertising will " result in probable future economic
benefits," and similarly requires the company to have " persuasive
evidence" that the effects of the advertising to be amortized will
be similar to the effects of past similar advertising, taking into
account, inter alia, demographics and economic conditions. AOL had
no such " persuasive evidence," and, to the contrary, knew that the
subscriber acquisition costs it was amortizing would not result in
future revenues sufficient to justify its accounting practices.
Not surprisingly, there was dissent even within AOL about the
propriety of the Company amortizing subscriber acquisition costs,
dissent which AOL and the Individual Defendants intentionally
ignored in order to accomplish their fraudulent scheme.
23. By carrying subscriber acquisition costs as an
amortizable asset in public financial reports throughout the Class
Period, the defendants were able to successfully artificially
inflate the market price of AOL common stock by misleading the
investing public into believing that AOL had a reasonable basis,
based on material facts then in its possession, that substantial
future revenues from subscribers it had already acquired would more
than make up for the hundreds of millions of dollars in " deferred"
capitalized costs AOL incurred in acquiring new subscribers.
Defendants' continued representations to the investing public that
AOL had a reasonable factual basis for amortizing its subscriber
acquisition costs over a two year period were materially false and
misleading when they were made because of the defendants' knowledge
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throughout the Class Period that the amortized costs would not and
could not be reasonably anticipated to result in future subscriber
revenues equal to or in excess of the capitalized deferred costs,
given the undisclosed adverse facts about subscriber usage,
membership churn, and changing market conditions. Moreover, the
investing public had no access to the facts which were contrary to
Defendants' public representations because that information was in
the sole possession of Defendants. The investing public,
reasonably believing the truth of Defendants' representations,
continued to overvalue AOL common stock based on the false
representation that the ever increasing deferred subscriber
acquisition costs represented, and would result in within two
years, future revenues in an amount at least as great as the amount
of those " deferred" costs.
24. Due to AOL's improper and misleading accounting
practices, total net deferred, capitalized subscriber acquisition
costs increased dramatically during F95 and F96:
America Online, Inc.
Total Net Deferred Subscriber Acq Costs
- 18 -
Net Deferred Subscriber acquisition Costs were $314 million at
June 30, 1996, compared to $77 million at June 30, 1995, an
increase of 306%. By comparison , quarterly sales increased only
110% from $159 million at June 30, 1995 to $334 million at
June 30, 1996. Further, excluding the effects of amortization, the
gross additions to deferred subscriber acquisition costs went up
dramatically in F95 and F96 until the fourth quarter of F96, when
AOL was forced to cut back dramatically on its marketing and
advertising expenditures:
America Online, Inc.
Gross Additions to Def Subscriber Cost
Gross additions to Deferred Subscriber Acquisition Costs increased
significantly from the $46 million in the quarter ended June 30,
1995 to $71 million in the quarter ended Sept. 30, 1995 and to $123
million in the quarter ended March 31, 1996. As shown below, the
- 19 -
amount capitalized per new subscriber increased dramatically after
June 30, 1995:
America Online, Inc.
Additions to Deferred Subscriber
Acquisition Costs Per New Subscriber
25. To conceal the deterioration in AOL's business and
sustain AOL's false picture of profitable growth, as AOL's
subscriber acquisition costs escalated, its subscriber growth
slowed, its " churn" rate increased, its subscriber retention rate
declined, and its average monthly subscriber revenue stagnated --
factors that required AOL to immediately expense its subscriber
acquisition costs -- AOL improperly lengthened the period over
which AOL amortized those costs at the outset of F96 to 24 months.
By deferring these costs and amortizing them over a longer period
of time, AOL falsely represented to the investing public that AOL
had a reasonable factual basis for anticipating probable future
revenues would be generated within two years from subscribers
- 20 -
acquired as a result of the deferred costs of at least the full
amount of the deferred costs. On this basis, AOL fraudulently
reported net income and EPS in F96, instead of the losses it was
actually incurring, and inflated its F96 results, enabling it at
F96 year end to carry on its balance sheet an asset of $314 million
(Deferred Subscriber Acquisition Costs), while reporting
shareholders' equity of $512 million and forecasting F97 and F98
EPS of $1.00+ and $1.75+, respectively. The chart below shows how
this subterfuge allowed AOL to turn large losses into reported
profits:
America Online, Inc.
Amounts in thousands except EPS
EPS adjusted for 10/95 split
RESULTS AS REPORTED - EXCLUDING CHARGES FOR PURCHASED R&D
9/30/95 12/31/95 3/31/96 6/30/96 F96
Revenues $197,865 $249,145 $312,340 $334,467 $1,093,875
Operating Income 10,875 16,089 24,720 32,332 68,839
Net Income 6,719 10,590 15,127 16,066 47,805
Earnings Per Share 0.08 0.10 0.14 0.15 0.47
RESULTS IF SUBSCRIBER ACQUISITION COSTS NET DEFERRED/AMORTIZED
9/30/95 12/31/95 3/31/96 6/30/96 F96
Revenues $197,865 $249,146 $312,340 $334,487 $1,093,875
Operating Income -44,651 -40,558 -63,493 -4,234 -153,633
Net Income -24,209 -24,335 -38,096 -2,540 -89,180
Earnings Per Share -0.36 -0.23 -0.34 -0.02 -0.95
The following chart shows the difference between operating income
from reported amounts to that which would have been reported had
AOL not been capitalizing and amortizing the costs:
//
//
//
//
//
- 21 -
America Online, Inc.
Operating Income Comparison
Excluding Special Charges
26. AOL's and Eamp;Y's practice throughout the Class Period of
capitalizing AOL's subscriber acquisition costs and writing them
off over a 24-month amortization period was a fraudulent
contrivance to mislead the investing public about the Company's
increasingly acute problems with obtaining new subscribers,
retaining existing subscribers and generating revenues from
subscriber fees, and to allow AOL to report profits rather than
losses in F96 while its marketing expenses were ballooning out of
control and its competitive position and business position were
weakening. AOL had no basis to represent, nor could AOL
demonstrate, as required by applicable accounting rules and
principles, that these deferred subscriber acquisition costs would
clearly result in a probable future economic benefit to it. AOL's
accounting practice was unjustified, a violation of GAAP and caused
AOL's financial results to not be presented in an accurate or fair
manner, because:
- 22 -
• AOL had no historical basis to believe that its
aggregate deferred subscriber acquisition costs would be
recovered within 24 months, or, indeed, within any
reasonable period of time, from aggregate subscriber
revenues, given AOL's high "churn" rate, its low
subscriber fees, increasing competition, reduced
retention rates, the ability of an AOL subscriber to
cancel at will and without penalty and AOL's inability to
generate significant revenues from sources other than
subscriber fees, despite its recognition that subscriber
fees provided an insufficient source of revenue to
generate profits for the Company particularly given
increasing competition and changes in the market for on-
line services.
• AOL's usage fees were declining, being cut from
$3,50 per hour to $2.95 per hour in Jan. 1995, to as low
as $1 per hour by May 1996, which was eroding AOL's
revenue base d and the value or worth of a subscriber
lifetime membership.
• AOL's claimed average 40+ month average subscriber
life and lifetime subscription/usage revenue of $700+
were bogus figures, contrived by AOL to provide a
justification for its accounting practices. Only a tiny
fraction of AOL's subscribers stayed for 40 months or
longer and the purported average was based not on
historical experience, but "projections," which were made
without any reasonable basis, were unrealistic and were
inconsistent with AOL's actual experience, especially
since AOL counted as subscribers persons who wanted to
cancel (by secretly providing extended free trial periods
or additional free usage time) and persons who were not
paying for the service (either because they were
receiving the service on a free "trial" basis or were
improperly or fraudulently receiving service without
paying AOL) and because AOL had no reasonable basis to
predict the retention rate of new subscribers acquired in
F95 and F96.
• AOL's reported average subscriber life of 40+ months
was based on a premise that AOL knew was false, i.e.,
that the relatively tiny portion of its subscriber base
which had been with AOL for more than 18 months was
representative of the new subscribers AOL was acquiring
during F95 and F96. AOL knew that its newer subscribers
were not the heavy on-line service users who had earlier
signed up with AOL (and who generated significant monthly
fees) nor were the new subscribers as likely to spend the
same number of money hours of their lives on-line. AOL
also knew that many of these newer subscribers were most
interested in e-mail services which, after the initial
free trial period, these subscribers could obtain
elsewhere for much lower fees.
- 23 -
• Because AOL'S service was a month-to-month
arrangement where a subscriber could cancel at will
without penalty, i.e., there was no long-term subscriber
commitment (unlike a 36-month subscriber where a
subscriber pays $x for a 36-month subscription period),
AOL had no reasonable basis to believe, given increasing
competition, greater free Internet access, and the
increasing acute churn problem by 1995, that AOL
subscribers would on average remain as subscribers long
enough and spend enough to ever recover AOL's average new
net subscriber expenditures, let alone to recover it in
24 months as represented in AOL's public filings.
• AOL was concealing its true increasingly high
"churn" rate and falsifying its average subscriber life
and lifetime revenue through various secret practices.
AOL allowed thousands of subscribers to remain
subscribers even though they were delinquent in paying
their accounts or had established "free" accounts through
improper and fraudulent practices. Also, when trial
subscribers notified AOL they wanted to cancel the
service at the end of their free "trial period," AOL
permitted them to take additional free trial period and
offered various other incentives, including, among other
things, extending free usage time, even if as a result of
the incentives AOL would make no money on a particular
subscriber -- practices which were inconsistent with the
representations AOL made to justify AOL's deferral (and
capitalization) of hundreds of million in subscriber
acquisition costs.
• AOL however did not want to pay taxes on the phony
profits its bogus accounting practices were generating on
its publicly issued financial statements. Thus, on AOL's
tax returns, AOL expensed 100% of its subscriber
acquisition advertising and marketing expenditures as
incurred -- an accounting treatment that was inconsistent
with its accounting practice in its public financial
statements. as a result, AOL reported losses on its tax
returns and avoided paying taxes on the phantom profits
its accounting artifices created for its publicly
disseminated financial statements.
As detailed above and in ¶¶127-148, AOL's interim and full-year F96
financial statements did not accurately or fairly report AOL's
results of operations in conformity with GAAP, due to AOL's
deferring of its direct marketing expenses to acquire subscribers
and amortizing those costs over two years. Such costs should have
been expensed as incurred as AOL was unable to clearly project a
- 24 -
probable future economic benefit from these costs and knew it would
likely never recover those costs from subscriber fees. By this
contrivance, AOL inflated AOL's assets and net worth and turned
AOL's actual losses into reported profits.
27. After AOL had pulled off its huge secondary stock
offering in October 1995 and AOL's insiders had largely completed
their bail out of AOL stock in mid-1996, AOL began to reveal that
its subscriber growth had slowed, its "churn" rate had increased,
its revenue and profit growth were slowing and it was forced to
reduce its subscriber marketing expenditures to concentrate on
trying to improve the retention rate of its subscribers. AOL stock
fell sharply as these partial and misleadingly incomplete
disclosures occurred, but continued to trade at artificially
inflated levels as AOL continued to make false representations
including continuing to amortize increasing amounts of subscriber
acquisition costs, and report inflated EPS, assets and
shareholders' equity, while forecasting further income and EPS
gains in F97. Then, on October 29, 1996, AOL admitted that its
practice of deferring subscriber acquisition costs was not
justified, that "it no longer has an adequate accounting basis to
support recognizing deferred subscriber acquisition costs as an
asset" and that it would write-off an astonishing $385 million in
previously capitalized costs and immediately expense them in the
future, resulting in a huge loss of $353 million/$3.80 per share
for the first quarter of F97 and a loss for all of F97 as well.
AOL also admitted it was going to take an additional $75 million
write-off, in part due to the failure of its direct access Internet
product -- GNN. These huge write-offs wiped out the single largest
- 25 -
asset on AOL's balance sheet and reduced its shareholders' equity
to about $100 million -- an 80% reduction from the $512 million in
shareholders' equity certified by Eamp;Y as fair, accurate and in
conformity with GAAP in AOL's F96 Annual Report and Form 10-K
issues just a few weeks earlier. It also more than wiped out all
the profits AOL had ever reported, in fact, the write-off was five
times all of AOL's historic pre-tax earnings. As a result, it was
clear that AOL had, in fact, never made a profit, and the only
shareholders' equity remaining on AOL's balance sheet resulted not
from any profits AOL had ever earned, but rather, only from its
public sale of stock at artificially inflated prices, in excess of
the stock's par value. By mid-October 1996, AOL's stock fell to
$22-3/8 per share, less than one-third of its Class Period (and
all-time) high of $71.
28. As a result of AOL's announcement of its stunning write-
off and the reversal of its practice of amortizing subscriber
acquisition costs, it became clear to the public market that the
underlying basis for AOL's practice throughout the Class Period of
amortizing subscriber acquisition costs -- a present probable
expectation of ascertainable revenues matching the deferred costs
-- was untrue. In addition to announcing the enormous write-off
and reversal of its amortization accounting practice, AOL also
announced a change in its pricing for on-line services. As
reported by the Associated Press on October 29, 1996:
Embracing a tactic that has hammered it, America Online
Inc. on Tuesday began offering a new flat-rate price in
a bid to stem the defection of customers to cheaper
providers of access to the Internet.
The new $19.95 monthly fee, effective Dec. 1, offers
unlimited access to America Online's electronic services
- 26 -
and media as well as the Internet. It marks a turnaround
for America Online, which earlier this month offered the
$19.95 rate but for only 20 hours use tacking on $2.95
for each additional hour users spent on-line.
* * *
The company had previously stuck to charging per-hour
fees on top of a base rate even as it warned it was
having trouble keeping subscribers because of rivals
offering unlimited use of the Internet for a single fee.
* * *
And in an acknowledgment that its financial statements
may not have been accurately reflecting the company's
condition, America Online said it would account for its
high marketing costs as they are incurred, instead of
deferring the expenses among future financial reports.
29. Although continuing to insist its past practice of
amortizing subscriber acquisition costs was completely proper,
defendants also made statements which contradicted that assertion
by admitting the change in accounting methodology would give the
market "a clearer idea" of what was really going on in the Company
as a result of massive subscriber acquisition costs, and, in
addition, admitted having experienced a slowdown in subscriber
acquisitions and a decrease in subscriber retention rates. As
reported in Dow Jones News Service on October 29, 1996:
"People will have a much clearer idea of what is
happening [with the accounting change]," America Online
Chief Executive Steve Case said in a telephone conference
call with the media.3
For the December quarter, America Online's management now
is projecting a $32 million loss - excluding another
charge - almost exclusively because of cash expensing of
marketing costs, Merrill Lynch & Co. analyst Lauren Rich
Fine said in a research note.
* * *
____________________
3 Here as elsewhere emphasis has been added unless otherwise
noted.
- 27 -
Company officials said in the conference call that the
third-quarter should be breakeven under the new
accounting practice and that America Online should become
profitable in the fourth quarter and beyond. America
Online needed to make moves to keep its position as the
on-line service with the most subscribers. More than six
million people use America Online, but the company has
said its subscriber growth has slowed and that it has
been losing people to cheaper Internet access services.
30. On October 30, 1996, The Wall Street Journal reported
AOL's October 29, 1996 announcement and wrote:
The accounting charge is more than five times as
large as the total pretax earnings that AOL had reported
for the past five fiscal years combined. It underscores
just how massive the company's marketing efforts have
been -- and how illusory its profits may have been. The
change raises the question of whether AOL will be able to
report much profit at all in future quarters.
* * *
AOL had staunchly defended the accounting method it
will now abandon. As AOL spent huge sums on advertising
and free trials to lure newcomers, it spread each
quarter's expenses over up to two years rather than
deduct the costs immediately. Backed by its outside
accountants, the company had argued that spreading the
costs over two years was a justifiable way to match
expenses against revenue flows that would emerge later.
Mr. Case said scrapping this controversial method is
aimed at stemming Wall Street concerns that had dogged
the Company for years. . . . "We've decided it's best
not to spend all our time in this debate over accounting
practices. There will be no argument over the quality of
earnings."
* * *
AOL has been struggling with annual customer-churn
rates of 30% to 40% by some estimates, as some users quit
the on-line service to use cheaper Internet access
providers. . . .
"We've spent large amounts of cash to market a
product that arguably wasn't responsive to market needs,"
said Lennert Leader. AOL's chief financial officer.
31. After AOL's revelations and admissions of October 29,
1996, one analyst wrote "the stock has been a nightmare," that AOL
- 28 -
had to "bite the bullet on its smoking bomb of subscriber
acquisition costs" and "will finally clean up its balance sheet."
Other analysts wrote that this "move . . . makes the earning
numbers more indicative of what is really happening at AOL" and
"provides . . . a true earning story," "because . . . it better
reflects the true cost of acquiring subscribers." Analysts now
forecast F97 losses and far smaller future profits for AOL as
expensing subscriber acquisition costs "caused near-term earnings
expectations to be significantly reduced," i.e., "we are lowering
our estimates dramatically, primarily to reflect the move to
expense subscriber acquisition costs," Noted financial writer Allan
Sloan wrote an article in Newsweek entitled "Profits? What Profits?
AOL Reboots Its Books, And Its Earnings Disappear." The article
included a picture of Case, captioned "What, me worry? Chairman
Cases' quest for profits has so far proved illusory," and stated
that AOL had "wiped out most of AOL's net worth, plus all the
profits it claimed to have made in its entire 11-year history" and
"offers a classic example of how investors can be burned by taking
a company's utterances at face value," concluding:
In case you missed it, here's what the fuss is
about. Until last week AOL insisted on accounting for
its promotion expenses in an unrealistic way. Instead of
considering the costs a regular expense, as normal
companies do. AOL spread them over two years. This let
AOL report profits while spending much more money than it
took in.
Let's be specific. In its fiscal year ended June
30. AOL spent $363 million on promotion. That's a third
of its total revenues. However, AOL charged only $126
million of promotion costs against its profits. The
difference, $237 million, was lots more than the $65
million pretax profit AOL claimed. Thus, AOL was burning
cash even as it reported profits.
- 29 -
Now AOL has gotten accounting religion. The Company
says it will henceforth charge its promotion expenses to
earnings as it spends the money, the way a normal company
does. In addition, AOL will take a special charge of
$385 million for "deferred" promotion costs. That's
money AOL had spent but hadn't charge against profits,
and is counted as an asset.
You have to love this. By deferring those costs, AOL
over the years reported profits $385 million greater than
they would otherwise have been -- which would have been
far enough below zero as to make the Arctic seem
tropical. AOL then used these nonexistent "profits" to
bill itself as a money-making Company. That boosted its
stock price. Now AOL is taking a special charge,
suggesting that "it's just bookkeeping" and doesn't
really matter.
Nonsensical numbers: Forgive my gloating. But AOL
in essence is conceding that skeptics like me, who said
that AOL's accounting verged on fantasy, were right.
Please note that I'm not accusing AOL of illegality; its
outside accountants blessed everything. But the numbers
were nevertheless nonsensical.
32. As a financial columnist observed in a November 7, 1996
Wall Street Journal column:
Last week, AOL threw in the towel -- sort of -- by a one
time charge of $385 million, reducing to vapor what Ernst
& Young had certified as solid assets nine weeks earlier
and announced it would expense all future marketing.
According to accounting sleuth Howard Schilit, AOL is
gaming the numbers even now. "Instead of expensing when
they should have, AOL said, 'We'll expense it tomorrow,'"
he says. With the special charge "tomorrow never comes."
33. During the Class Period, AOL was able to sell 4.9 million
shares of stock to public investors in October 1995, raising $139
million in new capital it desperately needed, several entrepreneurs
who had sold their companies to AOL for AOL stock during F95 were
able to sell off the AOL stock they had taken in those acquisitions
as AOL had assured them they would be able to do and the 18 AOL
insiders named as defendants were able to sell 2.1+ million shares
of their AOL shares at as high as $55-3/8 per share on the open
market, pocketing $95+ million. These insiders sold off large
- 30 -
portions of their AOL holdings, often exercising options to acquire
the AOL stock at as little as $.25 per share -- pocketing almost
$96 million of risk-free, illegal insider trading profits. The
chart below summarized these massive stock sales:
% of Shares
Defendant/Position Shares Sold Prices Proceeds Owned Sold
Case - CEO 575,000 $38-1/2-$55 $29.1 million 76%
Kimsey - C/B 651,000 $29-1/8-$55-3/8 $24.5 million 82%
Leader - CFO 210,800 $38-1/2-$54 $10 million 66%
Connors -SVP 98,300 $36-1/8-$55 $4.3 million 60%
Brandt - VP 32,000 $39-1/2-$54-1/2 $1.4 million 89%
Cole - SVP 57,100 $39-3/4-$51 $2.5 million 77%
Davies - SVP 23,300 $53-1/2 $1.2 million 88%
Hanlon - VP 6,000 $50-7/8-$54-3/8 $308,780 100%
Kirsh - VP 27,250 $39-$53-1/2 $1.1 million 91%
Korn - VP 17,150 $40-7/8-$54-1/2 $798,475 86%
Leonsis - SVP 99,200 $35-1/2-$55 $4.5 million 38%
Seriff - SVP 40,000 $39-3/4 $1.5 million 36%
Villanueva - VP 17,000 $38-3/4-$52-7/8 $766,660 92%
Weil - VP 40,000 $35-5/8-$52-3/4 $1.7 million 37%
Andress - Dir 100,000 $50-3/8-$53-1/2 $5.2 million 99%
Caufield - Dir 48,200 $39-$46-7/8 $2.1 million 100%
Gilburne - SVP 41,000 $49-7/8-$51 $2 million 100%
Haig - Dir 47,200 $41-$54-5/8 $2.3 million 100%
Individual Totals: 2,130,500 $29-1/8-$55-3/8 $ 95,862,428 72%
AOL-Co. 4,963,266 $29-1/8 $139,500,000 N/A
GRAND TOTAL: 7,093,766 $29-1/8-$55-3/8 $235,362,428 N/A
These stock sales were unusual both in amount and timing compared
to these defendants' prior sales of AOL stock, as demonstrated by
the following charts:
//
//
//
//
//
//
//
- 31 -
America Online, Inc.
Defendants' Stock Sales-Dollar Volume
Quarterly Stock Sales - March 1992 to December 1996
America Online, Inc.
Defendants' Stock Sales-Share Volume
Quarterly Stock Sales - March 1992 to December 1996]
Includes stock sales by: Miles Gilburne, Alexander Haig,
Janice Brandt, Ellen Kirsch, Matthew Korn, Richard Hanlon,
James Andress, Lennert Leader, Theodore Leonsis, Stephen Case,
Michael Connors, Frank Caufield, James Kimsey, David Cole,
John Davies, Marc Seriff, Audrey Weil and Jean Villanueva.
- 32 -
Significantly, while these insiders unloaded 2.1 million share of
their AOL stock -- 72% of their total holdings during October 1995
through May 1996 when AOL sold at inflated prices, after the stock
collapsed in June 1996 they sold not one single share of AOL stock
through October 31, 1996.
34. The stock charts below demonstrate the price action of
AOL's stock during the Class Period, defendants' stock sales during
the Class period and before the collapse of AOL's stock price and
the performance of AOL's stock compared to an index of similar
companies, which shows that the action of AOL's stock was due to
company-specific events and not market forces:
America Online, Inc.
August 10, 1995 - October 29, 1996
Daily Stock Prices
- 33 -
America Online, Inc.
vs. H&Q Technology Services Group
August 10, 1995 - October 29, 1996
JURISDICTION AND VENUE
35. This Court has jurisdiction over this action pursuant to
§27 of the Securities Exchange Act of 1934 (the "1934 Act" or
"Exchange Act"), 15 U.S.C. §78aa, and 28 U.S.C. §1331. The claims
asserted herein arise under §§10(b) and 20(a) of the Exchange Act,
15 U.S.C. §§78j(b) and 78t(a), and Rule 10b-5, 17 C.F.R. §240.10b-
5, promulgated thereunder by the SEC.
36. Venue is proper in this District pursuant to §27 of the
Exchange Act and 28 U.S.C. §1391(b). Many of the acts giving rise
to the violations complained of, including the dissemination of
false and misleading information, occurred in this District.
- 34 -
37. In connection with the wrongs complained of, the
defendants used the instrumentalities of interstate commerce, the
U.S. mails and the facilities of the national securities markets.
THE PARTIES
38. (a) Plaintiff David Orman, Trustee for Kati Levine,
purchased 150 shares of AOL common stock on February 5, 1996 at
$44.97 per share and was damaged thereby.
(b) Plaintiff Gary D. Walter purchased 30 shares of AOL
common stock on February 8, 1996 at $49-1/4 per share and was
damaged thereby.
(c) Plaintiff Scott D. Walter purchased 30 shares of AOL
common stock on February 8, 1996 at $49-1/4 per share and was
damaged thereby.
(d) Plaintiff Jason Raffenaud purchased 20 shares of AOL
common stock on February 8, 1996 at $49-1/4 per share and 10 shares
of AOL common stock on March 1, 1996 at $47-3/8 per share and was
damaged thereby.
(e) Plaintiff Barbara Y. Walter purchased 32 shares of
AOL common stock on January 11, 1996 at $34-1/8 per share and was
damaged thereby.
(f) Plaintiff Tadric Page purchased 20 shares of AOL
common stock on March 12, 1996 at $54-1/8 per share and was damaged
thereby.
(g) Plaintiff Bernard Goldsmith purchased 400 shares of
AOL common stock on June 20, 1996 at $41.75 per share and was
damaged thereby.
(h) Plaintiff Gina Florens purchased 1000 shares of AOL
common stock on May 8, 1996 at $63.15 per share and 500 shares of
- 35 -
AOL common stock on May 10, 1996 at $59.14 per share and was
damaged thereby.
(i) Plaintiff Miklos Wechter purchased 50 shares of AOL
common stock on August 16, 1996 at $30.75 per share and was damaged
thereby.
(j) Plaintiff Timothy Baker purchased 130 shares of AOL
common stock on May 9, 1996 at $64 per share and 100 shares of AOL
common stock on July 19, 1996 at $31 per share and was damaged
thereby.
(k) Plaintiff Lee Ross purchased 100 shares of AOL
common stock on February 7, 1996 at $49 per share and was damaged
thereby.
39. (a) Defendant America Online, Inc. maintains its exec-
utive offices in Dulles, Virginia. The Company provides on-line
services. The Company's common stock was actively traded in
efficient markets on the NASDAQ National Market System and on the
New York Stock Exchange ("NYSE") during the Class Period. There
are over 90 million shares of AOL common stock outstanding.
(b) During F95, AOL acquired Redgate Communications,
Medior, Inc., WideArea Information Servers, Inc., NaviSoft, Inc.,
BookLink Technologies, Inc., Advanced Network & Services, Inc.
("ANS") and Global Network Navigator, Inc. During F96, AOL
acquired Johnson-Grace Co. and Ubique, Inc. Each of these trans-
actions was an acquisition which involved the use of AOL stock as
consideration. AOL issued about 6.8 million shares of its stock in
these acquisitions.
40. (a) Defendant James V. Kimsey ("Kimsey") was founder and
Chairman of AOL's Board until Oct. 1995, when he resigned as
- 36 -
Chairman, but remained a director of the Company. Because of
Kimsey's position with the Company he knew the adverse non-public
information about its business, finances, products, markets and
present and future business prospects via access to internal
corporate documents (including the Company's operating plans,
budgets and forecasts and reports of actual operations compared
thereto), conversations and connections with other corporate
officers and employees, attendance at management and Board of
Directors' meetings and committees thereof and via reports and
other information provided to him in connection therewith. During
the Class Period and as part of the fraudulent scheme, defendant
Kimsey sold 651,000 shares of AOL stock at artificially inflated
prices of $29-1/8-$55-3/8 per share based on inside information,
pocketing $24.5 million. These sales constituted 82% of the AOL
stock Kimsey actually owned.
(b) Defendant Stephen M. Case ("Case") was founder,
President, CEO and a director of the Company. Because of Case's
position with the Company he knew the adverse non-public informa-
tion about its business, finances, products, markets and present
and future business prospects via access to internal corporate
documents (including the Company's operating plans, budgets and
forecasts and reports of actual operations compared thereto),
conversations and connections with other corporate officers and
employees, attendance at management and Board of Directors'
meetings and committees thereof and via reports and other
information provided to him in connection therewith. During the
Class Period and as part of the fraudulent scheme, defendant Case
sold 575,000 shares of AOL stock at artificially inflated prices of
- 37 -
$38-1/2-$55 per share based on inside information, pocketing $29.1
million. These sales constituted 76% of the AOL stock Case
actually owned.
(c) Defendant James G. Andress ("Andress") was a
director of the Company. Because of Andress' position with the
Company he knew the adverse non-public information about its
business, finances, products, markets and present and future
business prospects via access to internal corporate documents
(including the Company's operating plans, budgets and forecasts and
reports of actual operations compared thereto), conversations and
connections with other corporate officers and employees, attendance
at management and Board of Directors' meetings and committees
thereof and via reports and other information provided to him in
connection therewith. During the Class Period and as part of the
fraudulent scheme, defendant Andress sold 100,000 shares of AOL
stock at artificially inflated prices of $50-3/8-$53-1/2 per share
based on inside information, pocketing $5.2 million. These sales
constituted 99% of the AOL stock Andress actually owned.
(d) Defendant Janice Brandt ("Brandt") was a Vice
President of the Company. Because of Brandt's position with the
Company she knew the adverse non-public information about its
business, finances, products, markets and present and future
business prospects via access to internal corporate documents
(including the Company's operating plans, budgets and forecasts and
reports of actual operations compared thereto), conversations and
connections with other corporate officers and employees, attendance
at management meetings and via reports and other information
provided to her in connection therewith. During the Class Period
- 38 -
and as part of the fraudulent scheme, defendant Brandt sold 32,000
shares of AOL stock at artificially inflated prices of $39-1/2 to
$54-1/2 per share based on inside information, pocketing $1.4
million. These sales constituted 89% of the AOL stock Brandt
actually owned.
(e) Defendant Frank J. Caufield ("Caufield") was a
director of the Company. Because of Caufield's position with the
Company he knew the adverse non-public information about its
business, finances, products, markets and present and future
business prospects via access to internal corporate documents
(including the Company's operating plans, budgets and forecasts and
reports of actual operations compared thereto), conversations and
connections with other corporate officers and employees, attendance
at management and Board of Directors' meetings and committees
thereof and via reports and other information provided to him in
connection therewith. During the Class Period and as part of the
fraudulent scheme, defendant Caufield sold 48,200 shares of AOL
stock at artificially inflated prices of $39 to $46-7/8 per share
based on inside information, pocketing $2.1 million. These sales
constituted 100% of the AOL stock Caufield actually owned.
(f) Defendant David Cole ("Cole") was a Senior Vice
President of the Company. Because of Cole's position with the
Company he knew the adverse non-public information about its
business, finances, products, markets and present and future
business prospects via access to internal corporate documents
(including the Company's operating plans, budgets and forecasts and
reports of actual operations compared thereto), conversations and
connections with other corporate officers and employees, attendance
- 39 -
at management meetings and via reports and other information
provided to him in connection therewith. During the Class Period
and as part of the fraudulent scheme, defendant Cole sold 57,100
shares of AOL stock at artificially inflated prices of $39-3/4 to
$51 per share based on inside information, pocketing $2.5 million.
These sales constituted 77% of the AOL stock Cole actually owned.
(g) Defendant Michael M. Connors ("Connors") was a
Senior Vice President of the Company. Because of Connors' position
with the Company he knew the adverse non-public information about
its business, finances, products, markets and present and future
business prospects via access to internal corporate documents
(including the Company's operating plans, budgets and forecasts and
reports of actual operations compared thereto), conversations and
connections with other corporate officers and employees, attendance
at management meetings and via reports and other information
provided to him in connection therewith. During the Class Period
and as part of the fraudulent scheme, defendant Connors sold 98,300
shares of AOL stock at artificially inflated prices of $36-1/8 to
$55 per share based on inside information, pocketing $4.3 million.
These sales constituted 60% of the AOL stock Connors actually
owned.
(h) Defendant John L. Davies ("Davies") was a Senior
Vice President of the Company. Because of Davies' position with
the Company he knew the adverse non-public information about its
business, finances, products, markets and present and future
business prospects via access to internal corporate documents
(including the Company's operating plans, budgets and forecasts and
reports of actual operations compared thereto), conversations and
- 40 -
connections with other corporate officers and employees, attendance
at management meetings and via reports and other information
provided to him in connection therewith. During the Class Period
and as part of the fraudulent scheme, defendant Davies sold 23,300
shares of AOL stock at artificially inflated prices of $53-1/2 per
share based on inside information, pocketing $1.2 million. These
sales constituted 88% of the AOL stock Davies actually owned.
(i) Defendant Miles Gilburne ("Gilburne") was Senior
Vice President, Corporate Development of the Company. Because of
Gilburne's position with the Company he knew the adverse non-public
information about its business, finances, products, markets and
present and future business prospects via access to internal
corporate documents (including the Company's operating plans,
budgets and forecasts and reports of actual operations compared
thereto), conversations and connections with other corporate
officers and employees, attendance at management meetings and via
reports and other information provided to him in connection
therewith. During the Class Period and as part of the fraudulent
scheme, defendant Gilburne sold 41,000 shares of AOL stock at
artificially inflated prices of $49-7/8 to $51 per share based on
inside information, pocketing over $2 million. These sales
constituted 100% of the AOL stock Gilburne actually owned.
(j) Defendant Alexander M. Haig, Jr. ("Haig") was a
director of the Company. Because of Haig's position with the
Company he knew the adverse non-public information about its
business, finances, products, markets and present and future
business prospects via access to internal corporate documents
(including the Company's operating plans, budgets and forecasts and
- 41 -
reports of actual operations compared thereto), conversations and
connections with other corporate officers and employees, attendance
at management and Board of Directors' meetings and committees
thereof and via reports and other information provided to him in
connection therewith. During the Class Period and as part of the
fraudulent scheme, defendant Haig sold 47,200 shares of AOL stock
at artificially inflated prices of $41 to $54-5/8 per share based
on inside information, pocketing $2.3 million. These sales
constituted 100% of the AOL stock Haig actually owned.
(k) Defendant Richard E. Hanlon ("Hanlon") was Vice
President Investor Relations of the Company. Because of Hanlon's
position with the Company he knew the adverse non-public
information about its business, finances, products, markets and
present and future business prospects via access to internal
corporate documents (including the Company's operating plans,
budgets and forecasts and reports of actual operations compared
thereto), conversations and connections with other corporate
officers and employees, attendance at management meetings and via
reports and other information provided to him in connection
therewith. During the Class Period and as part of the fraudulent
scheme, defendant Hanlon sold 6,000 shares of AOL stock at
artificially inflated prices of $50-7/8 to $54-3/8 per share based
on inside information, pocketing $308,780. These sales constituted
100% of the AOL stock Hanlon actually owned.
(l) Defendant Ellen M. Kirsh ("Kirsh") was Vice
President, General Counsel and Secretary of the Company. Because
of Kirsh's position with the Company she knew the adverse non-
public information about its business, finances, products, markets
- 42 -
and present and future business prospects via access to internal
corporate documents (including the Company's operating plans,
budgets and forecasts and reports of actual operations compared
thereto), conversations and connections with other corporate
officers and employees, attendance at management meetings and via
reports and other information provided to her in connection
therewith. During the Class Period and as part of the fraudulent
scheme, defendant Kirsh sold 27,250 shares of AOL stock at
artificially inflated prices of $39 to $53-1/2 per share based on
inside information, pocketing $1.1 million. These sales
constituted 91% of the AOL stock Kirsh actually owned.
(m) Defendant Matthew Korn ("Korn") was Vice President,
Operations of the Company. Because of Korn's position with the
Company he knew the adverse non-public information about its
business, finances, products, markets and present and future
business prospects via access to internal corporate documents
(including the Company's operating plans, budgets and forecasts and
reports of actual operations compared thereto), conversations and
connections with other corporate officers and employees, attendance
at management meetings and via reports and other information
provided to him in connection therewith. During the Class Period
and as part of the fraudulent scheme, defendant Korn sold 17,150
shares of AOL stock at artificially inflated prices of $40-7/8 to
$54-1/2 per share based on inside information, pocketing $798,475.
These sales constituted 86% of the AOL stock Korn actually owned.
(n) Defendant Lennert J. Leader ("Leader") was Senior
Vice President, Chief Financial Officer and Treasurer of the
Company. Because of Leader's position with the Company he knew the
- 43 -
adverse non-public information about its business, finances,
products, markets and present and future business prospects via
access to internal corporate documents (including the Company's
operating plans, budgets and forecasts and reports of actual
operations compared thereto), conversations and connections with
other corporate officers and employees, attendance at management
meetings and via reports and other information provided to him in
connection therewith. During the Class Period and as part of the
fraudulent scheme, defendant Leader sold 210,800 shares of AOL
stock at artificially inflated prices of $38-1/2 to $54 per share
based on inside information, pocketing $10 million. These sales
constituted 66% of the AOL stock Leader actually owned.
(o) Defendant Theodore Leonsis ("Leonsis") was a Senior
Vice President of the Company. Because of Leonsis' position with
the Company he knew the adverse non-public information about its
business, finances, products, markets and present and future
business prospects via access to internal corporate documents
(including the Company's operating plans, budgets and forecasts and
reports of actual operations compared thereto), conversations and
connections with other corporate officers and employees, attendance
at management meetings and via reports and other information
provided to him in connection therewith. During the Class Period
and as part of the fraudulent scheme, defendant Leonsis sold 99,200
shares of AOL stock at artificially inflated prices of $35-1/2 to
$55 per share based on inside information, pocketing $4.5 million.
These sales constituted 38% of the AOL stock Leonsis actually
owned.
- 44 -
(p) Defendant Marc S. Seriff ("Seriff") was Senior Vice
President, Product Research of the Company. Because of Seriff's
position with the Company he knew the adverse non-public informa-
tion about its business, finances, products, markets and present
and future business prospects via access to internal corporate
documents (including the Company's operating plans, budgets and
forecasts and reports of actual operations compared thereto),
conversations and connections with other corporate officers and
employees, attendance at management meetings and via reports and
other information provided to him in connection therewith. During
the Class Period and as part of the fraudulent scheme, defendant
Seriff sold 40,000 shares of AOL stock at artificially inflated
prices of $39-3/4 per share based on inside information, pocketing
$1.5 million. These sales constituted 36% of the AOL stock Seriff
actually owned.
(q) Defendant Jean N. Villanueva ("Villanueva") was Vice
President Corporate Communications of the Company. Because of
Villanueva's position with the Company she knew the adverse non-
public information about its business, finances, products, markets
and present and future business prospects via access to internal
corporate documents (including the Company's operating plans,
budgets and forecasts and reports of actual operations compared
thereto), conversations and connections with other corporate
officers and employees, attendance at management meetings and via
reports and other information provided to her in connection
therewith. During the Class Period and as part of the fraudulent
scheme, defendant Villanueva sold 17,000 shares of AOL stock at
artificially inflated prices of $38-3/4 to $52-7/8 per share based
- 45 -
on inside information, pocketing $766,660. These sales constituted
92% of the AOL stock Villanueva actually owned.
(r) Defendant Audrey Y. Weil ("Weil") was a Vice
President of the Company. Because of Weil's position with the
Company she knew the adverse non-public information about its
business, finances, products, markets and present and future
business prospects via access to internal corporate documents
(including the Company's operating plans, budgets and forecasts and
reports of actual operations compared thereto), conversations and
connections with other corporate officers and employees, attendance
at management meetings and via reports and other information
provided to her in connection therewith. During the Class Period
and as part of the fraudulent scheme, defendant Weil sold 40,000
shares of AOL stock at artificially inflated prices of $35-5/8 to
$52-3/4 per share based on inside information, pocketing $1.7
million. These sales constituted 37% of the AOL stock Weil
actually owned.
41. The individuals named as defendants in ¶40(a)-(r) are
sometimes referred to herein as the "Individual Defendants."
Defendants Case, Kimsey and Leader, because of their positions as
founders of AOL, their stock ownership, management position, and/or
membership on the Company's Board of Directors, were controlling
persons of the Company and had the power and influence, and
exercised the same, to cause AOL to engage in the illegal practices
complained of herein.
42. As officers, directors and/or controlling persons of a
publicly-held company whose stock is registered with the SEC under
the 1934 Act and traded on the NASDAQ National Market System and
- 46 -
NYSE, the Individual Defendants had a duty to promptly disseminate
accurate and truthful information with respect to the Company's
operations, business, products, markets, management, earnings, and
present and future business prospects, to correct any previously
issued statements that had become untrue and to disclose any
adverse trends that would materially affect the present and future
financial operating results of the Company, so that the market
price of the Company's stock would be based upon truthful and
accurate information.
43. The Individual Defendants, because of their positions
with the Company, controlled the contents of its quarterly and
annual reports, press releases and presentations to securities
analysts. Each Individual Defendant was provided with copies of
the Company's reports and press releases alleged herein to be
misleading prior to or shortly after their issuance and had the
ability and opportunity to prevent their issuance or cause them to
be corrected. Because of their positions and access to material
non-public information available to them but not the public, each
of these defendants knew or recklessly disregarded that the adverse
facts specified herein had not been disclosed to and were being
concealed from the public and that the positive representations
which were being made were then false and misleading. As a result,
each of the Individual Defendants is responsible for the accuracy
of the corporate reports, filings and releases detailed herein as
"group published" information and is therefore responsible and
liable for the representations contained therein.
- 47 -
44. AOL and the Defendants are also responsible and liable
for materially false and misleading representations made in analyst
reports, described herein, throughout the Class Period, because:
(a) At all times relevant to this action, AOL maintained
an investor relations department that widely distributed and
disseminated an investors relations package (the "Investor
Package") to interested investors and others. The Investor Package
-- which was updated periodically to reflect recent Company
developments -- contained, among other things, SEC filings, press
releases, analyst reports and general information on AOL and its
business.
(b) For example, an Investor Package circulated by the
Company on or around September 1996 included the following
documents, among others: (i) AOL Proxy Statement dated September
29, 1996; (ii) AOL's 1995 Annual Report; (iii) Form 10-K for the
fiscal year ended June 30, 1995; (iv) Prospectus dated October 10,
1995; (v) Form 10-Q for the fiscal quarter ended March 31, 1996;
and (vi) a package labeled "Analyst Reports" which contained
analyst reports from the following analysts: Merrill Lynch (dated
August 9, 1996); Goldman Sachs (same); Lehman Brothers (same and
July 1); Robertson Stevens (same and July 15, 1996); Morgan Stanley
(same and June 25, 1996); Bear Stearns (same); Chicago Corp.
(same); and Alex Brown (same and June 7, 1996).
(c) During the Class Period, AOL actively collected and
reviewed analyst reports concerning the Company and selected
certain reports for inclusion in the Investor Package and, thus,
dissemination by the Company to the public. By disseminating the
analyst reports, AOL adopted the statements as its own. All of the
- 48 -
analyst reports included in the Investor Package were of a positive
nature and negative reports about AOL were not included.
(d) In an effort to shield themselves from liability for
what they knew to be materially false and misleading statements
contained in the analyst reports, defendants sought to disclaim
responsibility for the reports by issuing the following boilerplate
warning on the cover of the "Analyst Reports" document:
These Reports are for informational purposes only.
You are urged to seek professional advice before
investing in America Online Stock. America Online makes
no guarantee of the accuracy or completeness of the
information provided here.
Yet, defendants were aware that the statements contained in the
Analyst Reports was materially false and misleading and therefore
their warning was meaningless and nothing more than a thinly-veiled
attempt to shield themselves from liability.
45. Defendant Ernst & Young, LLP is a firm of certified
public accountants. For several years Eamp;Y was engaged by AOL to
provide independent accounting, consulting and auditing services
and gave AOL accounting advice and consultation regarding AOL's
annual and quarterly reports filed with the SEC. As AOL grew, it
became one of the largest audit clients of Eamp;Y's Virginia/
Washington, D.C. offices and the Eamp;Y partners in charge of the
account benefited economically from the growth and success of AOL
and from the increasing fees the AOL account provided Eamp;Y, and thus
Eamp;Y was very eager to keep AOL happy and retain AOL as a client.
Eamp;Y consented to its opinions on AOL's F95 and F96 financial
statements being included in AOL's Oct. 1995 Prospectus and in
AOL's F95 and F96 Forms 10-K and Annual Reports. Eamp;Y directly
participated and worked with AOL to develop a rationale for AOL's
- 49 -
accounting practice of deferring its subscriber acquisition costs
knowing that AOL had no reasonable basis for that accounting
practice. Among other things, Eamp;Y helped AOL develop the
rationales and projections it used to justify its accounting
practice. As a result, Eamp;Y was not independent with respect to
auditing or reviewing AOL's financial statements or opining thereon
as Eamp;Y was, in effect, auditing its own work and had a stake in
justifying the correctness of an accounting practice that enabled
AOL to inflate its balance sheet, net income and EPS, and its
underlying justifications that Eamp;Y had helped create. Eamp;Y rendered
false opinions on AOL's F95 and F96 financial statements for the
F95 and F96 years ended June 30, 1995 and 1996, respectively. Eamp;Y
also reviewed the false statements about AOL's financial results
for each of the interim quarters of F96, ended Sept. 30, 1995,
Dec. 31, 1995 and March 31, 1996, by reviewing and approving AOL's
interim financial statements, knowing of or recklessly disregarding
their falsity, including the false statement that the amortization
period for deferred subscriber acquisition costs had been
lengthened to 24 months in F96 "[b]ased on the Company's historical
average customer life experience" and "to more appropriately match
subscriber acquisition costs with associated online service
revenues."
AOL INSIDERS' MOTIVE AND OPPORTUNITY
46. Each of the AOL defendants had the opportunity to commit
and participate in the fraud. The Individual Defendants were the
top officers and directors of AOL and they controlled its press
releases, corporate reports, SEC filings, the preparation of its
financial statements and its communications with analysts. Thus,
- 50 -
they controlled the public dissemination of, and could falsify, the
information about AOL's business, finances and future prospects
that reached the public and impacted the price of its stock.
47. Each of the Individual Defendants also had the motive to
commit and participate in the fraud. AOL's stock traded at a price
earnings multiple reserved for premier growth companies with track
records of meeting the investment community's expectations for high
profit growth. This stock performance enabled AOL's corporate
executives and directors to exercise stock options and sell stock
at large profits and enabled AOL to raise cash via public stock
sales and to grow by using its stock to make acquisitions of other
companies. AOL's apparent success and its stock's performance also
contributed to the high profile of Kimsey and Case, who acted as
spokespersons not only for AOL but for industry groups as well.
For all these reasons, maintaining AOL's image of strong profitable
growth and its high stock price was extremely important to AOL's
top executives and directors. Defendants also wanted to cover up
the problems with and deterioration in AOL's business (and their
own mistakes and acts of mismanagement) to make it appear that
AOL's business was succeeding, so that its stock price would trade
at artificially inflated levels, high enough so that they could
insider trade by selling off significant amounts of their AOL stock
in part by exercising stock options to acquire AOL stock and then
immediately selling off the AOL stock they acquired at artificially
inflated prices, pocketing large sums for themselves.
48. AOL's corporate officers and directors were operating,
managing and overseeing a capital-hungry company in an intensely
competitive industry. They were motivated to make it appear that
- 51 -
AOL was profitable and would achieve increasing profits in the
future for several reasons:
• AOL was spending increasingly large amounts of cash
(up to $250 per net subscriber) to try to attract these
subscribers who provided only small monthly revenues to
AOL (about $18 per month on average) if they subscribed.
Thus, AOL was encountering a high cash "burn" rate and
was in a negative cash flow position, which required AOL
to sell stock to raise cash to support its operations.
This put pressure on AOL's insiders to make it appear AOL
was profitable so its stock would trade at high prices
and it could raise needed capital on attractive terms.
• AOL was trying to rapidly grow its business by
continually making acquisitions of other companies.
Since AOL could not afford to pay for these acquisitions
in cash, it had to pay for them by issuing AOL stock.
This put pressure on AOL's insiders to make it appear AOL
was profitable, so that (i) AOL's stock would trade at
higher prices and thus fewer shares needed to be issued
to complete an acquisition; (ii) the controlling
shareholders of the companies AOL wanted to buy would be
willing to accept AOL stock in return for selling their
companies to AOL; and (iii) those persons would then be
able to sell off the AOL stock they obtained at high
prices in AOL stock offerings, as AOL had assured them
they would be able to do.
• AOL's insiders, who were intimately familiar with
its business and the inappropriateness of the accounting
practices being used to conceal its losses and make it
appear profitable and knew AOL's prospects for achieving
the subscriber membership and profit growth being
forecast were non-existent, wanted to sell off large
portions of their holdings in AOL before the truth about
the impaired position of AOL's business had to be
admitted and AOL had to take huge write-offs and report
losses. Thus, they wanted to push AOL stock higher so
they could maximize their profits from selling their AOL
shares, which could only be accomplished by making it
appear that AOL was profitable, succeeding and well-
positioned to continue to grow profitably.
STATUTORY SAFE HARBOR
49. The statutory safe harbor provided for forward-looking
statements under certain circumstances does not apply to any of the
allegedly false forward-looking statements pleaded in this Amended
Complaint because the statements pleaded at ¶¶53-55, 65, 72-76 and
- 52 -
80 were made prior to the enactment of the statutory Safe Harbor on
Dec. 22, 1995, via legislation that may not be applied retro-
actively. Alternatively, none of the forward-looking statements
pleaded at ¶¶53-55, 65, 72-76, 80-81, 85-88, 92-94, 100-102, 105-
111 and 115-119 was identified as a "forward-looking statement"
when made. Nor was it stated that actual results "could differ
materially from those projected." Nor did meaningful cautionary
statements identifying important factors that could cause actual
results to differ materially from that in the forward-looking
statements accompany those forward-looking statements. To the
extent that the statutory safe harbor does apply to any forward-
looking statements pleaded in ¶¶53-55, 65, 72-76, 80-81, 85-88, 92-
94, 100-102, 105-111 and 115-119, the AOL defendants are liable for
those false forward-looking statements because at the time each of
those forward-looking statements was made the speaker actually knew
the forward-looking statement was false and the forward-looking
statement was authorized and/or approved by an executive officer of
AOL who actually knew that those statements were false when made.
DEFENDANTS' FRAUDULENT SCHEME AND COURSE OF BUSINESS
50. Each of the defendants is liable as a participant in a
fraudulent scheme and course of business that operated as a fraud
or deceit on purchasers of AOL stock, by making false and
misleading statements and/or concealing material, adverse facts,
including certain fraudulent accounting practices and issuing or
certifying false financial statements. The scheme: (i) artifi-
cially inflated the price of AOL stock; (ii) caused plaintiffs and
other members of the Class to purchase AOL stock at inflated
prices; (iii) permitted the Individual Defendants to sell
- 53 -
approximately 2.1 million shares of AOL stock at prices as high as
$55-3/8 per share, pocketing over $95 million; and (iv) permitted
AOL to sell 4.9 million shares at $29-1/8 per share, raising $139
million in desperately needed cash.
BACKGROUND TO THE CLASS PERIOD
51. As AOL's F95 year to end June 30, 1995 unfolded, AOL's
insiders realized that AOL was in a troubled situation. It was
encountering increasing competition from both the Internet and from
competing suppliers of on-line services, which was putting pressure
on AOL to cut its charges. This was due in part to increasing use
by sophisticated computer users of free or low-cost Internet access
which provided most of the services AOL charged its subscribers
for. AOL was also vastly increasing its marketing expenditures to
try to get more subscribers but encountering more and more "churn,"
refusal of customers to pay their monthly subscription and use
charges, and low average usage charges of new subscribers as it was
attracting more marginal subscribers (low usage), while losing
sophisticated subscribers (heavy usage) to free or lower-cost
Internet access. As a result, AOL's cash "burn" rate was
escalating and its competitive position deteriorating -- a
dangerous situation. Worse yet, AOL had assured the entrepreneurs
who controlled the seven companies AOL had acquired during F95 for
millions of shares of AOL stock that they would be able to sell off
significant amounts of the AOL stock they had taken in those
transactions in an SEC-registered public offering that AOL would
cause to occur. As a result, as F95 unfolded, AOL was under
increasing pressure to do a large public offering to raise capital
it desperately needed to supplement its worsening cash flow
- 54 -
problems and to enable the sellers of companies to AOL to sell off
their AOL shares, as AOL had assured them they would be able to do.
However, to support AOL's stock price and absorb such large stock
sales, AOL's insiders realized it was necessary for AOL to continue
to report profitable operations and forecast continuing future
profits, and to persuade the market that AOL was succeeding and
would continue to achieve profitable growth. To do this, AOL
enlisted the help of certain investment banking firms -- Alex.
Brown, Morgan Stanley, Goldman Sachs and Merrill Lynch -- to serve
as underwriters of a huge stock offering to take place in the last
half of 1995. Those underwriters, in turn, issued very positive
research reports on AOL and served as conduits by and through which
AOL could distribute very positive information to the market, both
before the stock offering -- to condition the market for the stock
offering -- and after it -- to support AOL's stock price while its
insiders unloaded their shares.
52. Due to the deterioration in the economics of its
business, i.e., its rapidly escalating subscriber acquisition costs
and its weakening business position, AOL's insiders knew that
unless something was done, AOL's earnings would decline sharply
during F96 and it could suffer operating losses. So, even though
the actual economics of its business required AOL to stop
capitalizing or deferring its subscriber acquisition costs at year-
end F95 and write off its millions in previously deferred costs,
AOL's insiders, with the assistance of Eamp;Y, schemed to lengthen the
period of time AOL wrote off (amortized) its deferred subscriber
acquisition costs at the beginning of F96, to 24 months to cover up
the deterioration of AOL's success. To give credence to the longer
- 55 -
amortization period, AOL represented, concurrent with the release
of its 4Q F95 results that based on its studies of historic
subscriber behavior, i.e., retention, its average subscriber life
had increased to 41 months and the average lifetime value of a
subscriber was now $715 and the change was being done to more
accurately match marketing expenses with subscriber revenues. As
a result, AOL was able to avoid a huge write-down of its deferred
subscriber acquisition costs at year end F95, forecast strong F96
and F97 profits and EPS and report large and increasing shareholder
equity, profits and EPS during F96 instead of losses.
FALSE AND MISLEADING STATEMENTS
DURING THE CLASS PERIOD
53. On Aug. 10, 1995, AOL reported its 4Q F95 and F95
results, via a press release that stated:
America Online, Inc. reported today that its [fourth
quarter] revenues . . . increased . . . . Net income
grew more than six-fold to $6,189,000 from earnings of
$905,000 in the same period a year ago. The company said
earnings per share in the fourth quarter before merger
and amortization costs totalled $0.16 per share, while
reported earnings per share, inclusive of these expenses,
amounted to $0.13 on nearly 30 percent more shares
outstanding. This compares with $0.02 per share earnings
in fiscal 1994's fourth quarter.
* * *
The company noted that . . . anticipated member life
and lifetime value of membership both rose steadily over
the year, the company said, ending at 41 months and about
$715 respectively.
"Fiscal 1995 was a terrific year for America
Online," said President and CEO, Steve Case.
54. On Aug. 10, 1995, AOL held a conference call for
analysts, investors and AOL's shareholders during which Case and
Leader made presentations and answered questions. In that call and
- 56 -
in later one-on-one follow-up conversations with analysts, they
stated:
• While AOL was reporting a loss for F95, this was
only due to a mandatory write-off of millions of dollars
of purchased research and development costs arising from
the seven acquisitions AOL made in F95.
• AOL's actual operations were profitable and gaining
strength. AOL's business was enjoying very strong
momentum.
• AOL's "churn" rate was stable or declining.
Subscriber retention was improving.
• Due to these favorable "metrics," average subscriber
membership life had risen to 41 months and average
lifetime membership value had risen to $715.
• AOL expected to achieve strong earnings growth in
F96 and F97, excluding any charges for purchased research
and development from later acquisitions.
55. On Aug. 24, 1995, Alex. Brown issued a report on AOL,
written by S.L. Eskenazi, which was based on and repeated
information provided in the Aug. 10, 1995 conference call, and in
follow-up conversations Eskenazi had with Case and/or Leader. The
report forecast F96 and F97 EPS of $.425 and $.625, respectively,
for AOL, and stated:
Investment Highlights
* America Online reported F4Q (June) 1995
operating EPS results of $0.16 on $152 million in
revenue, ahead of our estimates of $0.14 in EPS on $139
million in revenue.
* [R]etention rates to 41 months (from 39 in
March); paid usage to 2.93 hours (from 2.73); and
lifetime revenues to $714 (from $667).
* * *
June Quarter Highlights
Based on continued strong momentum in the base business
. . . we are raising our FY 1996 EPS estimate to [$0.425]
. . . and establishing a FY 1997 EPS range of . . .
[$.625-.75].
- 57 -
56. On Sept. 19, 1995, AOL announced it would undertake a
secondary offering of 7+ million shares of its stock -- with shares
to be sold by AOL and by selling shareholders -- principally by
individuals and entities which became shareholders of AOL through
its acquisitions of seven businesses over the past year. The stock
offering was to be underwritten by Morgan Stanley, Goldman Sachs,
Alex. Brown, and Merrill Lynch. AOL's draft Registration Statement
for its stock offering filed on Sept. 18, 1995 with the SEC stated:
[E]ffective July 1, 1995, the Company changed the period
over which it amortizes subscriber acquisition costs from
twelve and eighteen months to twenty-four months. Based
on the Company's historical average customer life experi-
ence, the change in amortization period is being made to
more appropriately match subscriber acquisition costs
with associated online service revenues.
57. On Sept. 19, 1995, AOL issued its F95 Annual Report to
Shareholders which contained a letter signed by Case that stated:
Unprecedented Results
* * *
Average use per member climbed 30% to exceed 6.5 hours
per month. Average member life rose to 41 months in the
fourth quarter, contributing to an average lifetime
revenue of $715, up considerably from 32 months and less
than $500, respectively, in the same quarter a year ago.
For fiscal 1995 in total, our net income before charges
and expenses in connection with our acquisition of seven
companies during the year was nearly $20 million, as
compared with $2.6 million in fiscal 1994.
* * *
Leveraging the Internet Phenomenon
* * *
As we expanded our offerings to include the full suite of
Internet applications, we identified and acquired the
best technology and talent to rapidly accelerate our lead
in this segment of the market. In the Fall of 1994, we
announced the acquisition of BookLink Technologies
. . . . With the introduction of our easy-to-use
- 58 -
Internet "browser," we believe we have introduced a whole
new class of consumers to the Web.
Also on the Internet front, we acquired Global
Network Navigator (GNN), one of the most highly
trafficked sites on the Web. GNN has been heralded as a
leader in providing easy and intuitive navigation for
consumers who want to explore the many and varied
resources of the Web. It will play a critical role in
providing content and "context" for AOL's new standalone
Internet brand, expected to launch in the Fall of 1995.
58. Elsewhere, AOL's Annual Report stated:
Strategic Acquisitions
AOL acquired the talents and award-winning
technologies of several companies including BookLink
Technologies, . . . and GNN. The combined capabilities
represented by these companies have helped to strengthen
AOL's lead in the converging worlds of online services,
the Internet and multimedia.
* * *
Internet Lead Strengthened
AOL launched an award-winning "browser" in the
Spring, giving its members access to the vast resources
of the World Wide Web. In addition, the Company
announced plans for the launch of an Internet-only brand,
scheduled for Fall 1995.
59. AOL's F95 Annual Report discussed GNN:
In June, AOL acquired Global Network Navigator
(GNN). GNN has been widely heralded as a leader in
providing easy and intuitive navigation for consumers who
want to explore the many and varied resources of the Web.
GNN is expected to play a critical role in providing
content and "context" for AOL's new standalone Internet
brand, scheduled to launch in the Fall of 1995.
60. AOL's F95 Annual Report contained charts purporting to
show increasing "Average Customer Life" and "Lifetime Revenues Per
Subscriber," as set forth below:
//
//
//
- 59 -
61. AOL's F95 Annual Report to Shareholders included AOL's
F95 financial statements which reported total assets of $406
million and shareholders' equity of $217 million. One asset,
Deferred Subscriber Acquisition Costs of $77 million, represented
the largest single asset on AOL's balance sheet. AOL's F95 Annual
Report to Shareholders also stated in the Notes section and
Management's Discussion and Analysis section ("MD&A"), that:
The Company's services are sold on a monthly
subscription basis. Subscriber acquisition costs
incurred to obtain new subscribers are recoverable from
revenues generated by such subscribers within a short
period of time after such costs are incurred.
* * *
[E]ffective July 1, 1995 the Company changed the period
over which it amortizes subscriber acquisition costs from
twelve and eighteen months to twenty-four months. Based
on the Company's historical average customer life
experience, the change in amortization period is being
- 60 -
made to more appropriately match subscriber acquisition
costs with associated online service revenues.
62. The Notes to AOL's F95 financial statements in the F95
Annual Report stated:
Deferred Subscriber Acquisition Costs.
* * *
The Company's services are sold on a monthly
subscription basis. Subscriber acquisition costs
incurred to obtain new subscribers are recoverable from
revenues generated by such subscribers within a short
period of time after such costs are incurred.
63. AOL's F95 financial statements, included in AOL's F95
Annual Report to Shareholders, were audited by Eamp;Y, which issued an
unqualified "clean" opinion certifying those financial statements.
64. On Sept. 18, 1995, AOL filed its Annual Report on Form
10-K for F95 with the SEC. This report was signed by Case, Kimsey,
Leader, Caufield, Haig and Andress. The Form 10-K contained the
same financial statements, Notes and MD&A as AOL's F95 Annual
Report to Shareholders, including Eamp;Y's clean, unqualified opinion.
65. During late Sept. and early Oct. 1995, AOL's top
officers, inter alia, Case and Leader, went on a "Roadshow" with
representatives of the lead underwriters for the upcoming stock
sale. They visited institutional investors, security analysts and
brokers in several cities, including New York, Chicago, San
Francisco and Los Angeles. They told them that:
• While AOL had reported a loss for F95, this was only
due to a mandatory write-off of millions of dollars of
purchased research and development costs arising from the
seven acquisitions AOL made in F95.
• AOL's actual operations were profitable and gaining
strength. AOL's business was enjoying very strong
momentum.
- 61 -
• AOL's "churn" rate was stable or declining.
Subscriber retention was improving.
• Due to these favorable "metrics," average subscriber
membership life had risen to 41 months and average
lifetime membership value had risen to $715.
• AOL expected to achieve strong EPS growth in F96 and
F97 to approximately $.45-$.50 and $.75-$.80, respec-
tively, excluding any charges for purchased research and
development from later acquisitions.
66. On Oct. 10, 1995, AOL offered for sale over 7 million
shares of its stock (including the overallotment option) to the
public at $29-1/8 per share. AOL itself sold 4.9 million shares,
raising over $139 million in badly needed cash. Several
entrepreneurs who had sold their businesses to AOL for AOL stock in
the prior year sold their shares, as AOL had assured them they
could do, and Kimsey sold 400,000 of his AOL shares. AOL's
Registration Statement and Prospectus for this stock sale
incorporated AOL's F95 Form 10-K by reference and was signed by the
same defendants who signed AOL's F95 Form 10-K.
67. The Oct. 10, 1995 Prospectus stated:
[E]ffective July 1, 1995, the Company changed the period
over which it amortizes subscriber acquisition costs from
twelve and eighteen months to twenty-four months. Based
on the Company's historical average customer life
experience, the change in amortization period is being
made to more appropriately match subscriber acquisition
costs with associated online service revenues.
68. On Oct. 12, 1995, Merrill Lynch issued a report on AOL,
which included and repeated the following information which had
been provided to Merrill Lynch by Case and Leader as part of their
joint efforts to market the AOL stock in the Oct. 10, 1995 stock
offering:
* Rapid subscriber growth should continue. . . . We
project AOL will reach . . . 12.0 million in FY98.
- 62 -
* Robust subscriber dynamics is compounding revenue
growth. AOL's average hours of usage per subscriber is
climbing, driving increases in average revenue per
subscriber. Churn is also improving.
* * *
* AOL should benefit from the internet through 1) GNN,
its new Internet access service . . . .
69. In the Oct. 30, 1995 edition of Newsweek, an article by
Allan Sloan entitled "OnLine's Bottom Line -- How Creative
Accounting Makes AOL Look Great," appeared. The article included
a picture of Case, which was captioned "His Books Are Blessed By
The SEC." This article, and a nearly identical one by Sloan that
appeared in The Washington Post in late Oct. 1995, entitled "Look
Beyond The High-Tech Accounting To Measure America Online's Market
Risk," stated in part:
Accounting is terribly important to AOL. The better
its numbers look, the more Wall Street loves it and the
easier AOL can sell new shares to raise cash to pay its
bills. By my analysis, the company is running a cash
deficit of about $75 million a year -- a deficit it
covers with money from stock sales. Thus, if AOL can't
sell stock, it's got big trouble. At the least, it would
have to drastically scale back its expansion plans.
So what about the high-tech accounting that trans-
mutes AOL's operating losses into profits? "The SEC
reviewed our 10K (annual report) and blessed it," said
AOL's chief financial officer, Lennert Leader.
* * *
Leader said AOL is following standard accounting
procedures in matching the timing of expenses with the
period over which it will receive revenue. He said the
company's marketing and R&D expenses produce customer
accounts that last a long time. That, he said, makes it
appropriate for AOL to write off the costs over a period
of years, even though it has to shell out the cash
immediately.
* * *
- 63 -
Why change to 24 months from 15? Leader said it's
because the average life of an AOL account has climbed to
41 months from 25 months in 1992.
70. On Oct. 30, 1995, AOL issued two releases concerning GNN.
The releases were headlined and stated:
1) AMERICA ONLINE UNVEILS NEW INTERNET SERVICE; LAUNCH
OF NEW GNN BRAND TARGETS GROWING MARKET SEGMENT
America Online, Inc. today unveiled its Internet
service, GNN (Global Network Navigator) . . . .
GNN is designed to be a "Best of the Net" offering
that combines the content and context of GNN one of the
most highly trafficked sites on the World Wide Web, the
power and speed of the award-winning AOL web browser
technology and software suite, comprehensive web
directories and search tools, and customer support.
GNN's broad network access -- with local dial
availability in more than 600 cities -- makes it the
first truly national full-featured Internet service for
consumers.
2) GNN ANNOUNCES "BEST OF THE NET" FULLY-INTEGRATED
CONSUMER INTERNET SERVICE
GNN is a fully-integrated Internet solution offering a
vast array of features to make exploring the Internet
simple and productive for consumers.
GNN debuted today as a "Best of the Net" offering
that combines the content and context of one of the most
trafficked Web sites to date; the power and speed of an
award-winning Web browser . . . . GNN's broad network
access -- with local dial availability in more than 600
cities -- makes it the first truly national full-featured
Internet service for consumers.
71. On Nov. 7, 1995, AOL reported its results for the first
quarter of F96, i.e., the three months ended Sept. 30, 1995, via a
release that stated:
America Online said that operating earnings for the
quarter were $7,751,000, or $0.16 per share on approxi-
mately 49.9 million fully-diluted shares . . . .
* * *
"Our momentum continues," Chief Executive Steve Case
noted . . . .
- 64 -
Additionally, Case said "[w]e're extremely pleased with
the launch a week ago of our GNN brand . . . ."
72. On Nov. 7, 1995, AOL held a conference call for analysts,
investors and AOL shareholders during which Case and Leader made
presentations and answered questions. In the call and in later
one-on-one follow-up conversations with analysts, they stated:
• While AOL was reporting a loss for 1Q F96, this was
only due to a mandatory write-off of millions of dollars
of purchased research and development costs arising from
an acquisition AOL made in F95.
• AOL's actual operations were profitable and gaining
strength and momentum.
• AOL's "churn" rate was stable or declining.
Subscriber retention was improving. AOL had purged all
fraudulent accounts from its roles.
• Average subscriber membership life was at 40 months,
falling one month due to the purging of fraudulent
accounts. Average lifetime membership value was at
$715+.
• AOL's business was enjoying very strong momentum.
• GNN had been successfully launched. With its
BookLink browser, GNN was a great success, attracting
many new subscribers.
• AOL expected to achieve strong EPS growth in F96 and
F97, to $.45-$.50 and $.75-$1.05, respectively, excluding
any charges for purchased research and development from
later acquisitions.
73. On Nov. 8, 1995, Alex. Brown issued a report on AOL,
written by Eskenazi, which was based on and repeated information
provided him in the Nov. 7, 1995 conference call and follow-up
conversations with Case and Leader. The report forecast F96 and
F97 EPS of $.50 and $.80, respectively, for AOL, and stated:
-- America Online (AOL) reported F1Q (Sept) 1996
operating EPS of [$0.08] on $198 million in revenue and
3.714 million members, versus our expectation of $0.14 on
$195 million and 3.6 million members. . . .
- 65 -
-- We are raising our estimates to reflect the current
momentum in the base business . . . to FY (Jun) 1996 EPS
of [$.50] . . . to FY 1997 EPS of [$.775-.825] EPS
. . . .
74. On Nov. 8, 1995, Morgan Stanley issued a report on AOL,
written by Mary Meeker, which was based on and repeated information
given her in the Nov. 7, 1995 conference call and in follow-up
conversations with Case and Leader. The report forecast F96 and
F97 EPS of $.47 and $.875, respectively, for AOL, and stated:
AMER REPORTED STRONG CQ3 RESULTS -- AMER reported
CQ3 operating EPS of $0.16, in-line with our estimate
. . . .
75. On Nov. 14, 1995, Merrill Lynch issued a report on AOL
written by L.R. Fine, which was based on and repeated information
provided him in the Nov. 7, 1995 conference call and follow-up
conversations with Case and Leader. The report forecast F96 and
F97 EPS of $.50 and $1.00, respectively, for AOL, and stated:
* AOL's momentum is just partially reflected in its
first quarter results of [$0.08] per share vs. last
year's $0.04.
* * *
GNN provides additional opportunity for value
creation. Last year AOL acquired Global Navigation
Network (GNN), one of the most highly visited sites on
the Web, which provided easy and intuitive navigation of
the Web. On October 30th, AOL successfully relaunched
GNN as an Internet access provider, giving AOL a second
online service brand.
76. On Nov. 14, 1995, Alex. Brown issued a report on AOL
written by Eskenazi, which was based on and repeated information
provided him in the Nov. 7, 1995 conference call and follow-up
conversations with Case and Leader. The report forecast F96 and
F97 EPS of $.50 and $.80, respectively, for AOL, and stated:
* America Online (AOL) reported F1Q (Sept.) 1996
operating EPS of [$0.08] . . . versus our expectation of
- 66 -
[$0.07] . . . . During the quarter, AOL purged a number
of accounts (100,000-200,000), which made its normal
business metrics (paid usage, retention, lifetime
revenue) more difficult to compare sequentially.
* We are raising our estimates to reflect the current
momentum in the base business . . . to FY (June) 1996 EPS
of [$.50] . . . to FY 1997 EPS of [$.775-.825] EPS
. . . .
77. On Nov. 14, 1995, AOL filed its Report on Form 10-Q for
the quarter ended Sept. 30, 1995, i.e., the first quarter of F96,
with the SEC. The report was signed by Case and Leader. The 10-Q
reported that AOL had total stockholders' equity of $228 million
and an operating loss of $6.1 million. Excluding the charge for
acquired research and development AOL had operating income of $10.8
million for 1Q F96. The Form 10-Q stated:
Effective July 1, 1995, the Company modified the
components of subscriber acquisition costs deferred, and
changed the period over which it amortizes subscriber
acquisition costs. The period over which the Company
amortizes subscriber acquisition costs was changed from
twelve and eighteen months to twenty-four months, in
order to more appropriately match subscriber acquisition
costs with associated online service revenues.
78. On Dec. 5, 1995, AOL issued a release about GNN which
stated:
GNN is one of the most highly trafficked sites on
the World Wide Web.
GNN, the first fully integrated Internet service, is
widely cited as being the ideal launching pad for people
who want to navigate the vast resources of the Web.
79. The positive statements made by AOL both directly and
indirectly through securities analysts set forth in ¶¶53-78 during
Aug. 1995-Dec. 5, 1995 were each false and misleading when made and
failed to disclose the following material adverse facts, disclosure
of which was necessary to make the statements made not false and
misleading:
- 67 -
(a) AOL's profits, EPS, assets and shareholders' equity
for the period ended Sept. 30, 1995 were each improperly and
artificially inflated due to AOL's failure to write off its
previously deferred and capitalized subscriber acquisition costs
and failure to expense such costs in the current period, as
required by GAAP and necessary for a fair presentation of AOL's
actual results from operations;
(b) AOL's lengthening of the amortization period for
deferred subscriber acquisition costs was not undertaken to more
accurately match the expenses of obtaining subscribers with
revenues from obtained subscribers, as most subscribers to the AOL
service remained subscribers only a short period of time and, in
fact, this change was made for the purpose of permitting AOL to
conceal the deterioration of its competitive position in actual
earning power and to help it avoid reporting sharply declining
profits or even losses during F96;
(c) It was not true that AOL recovered the costs of
obtaining a new subscriber relatively quickly from subscribers, as
AOL's true net subscriber acquisition costs were so high that few
subscribers remained subscribers long enough to generate revenues
sufficient to cover AOL's true costs per net subscriber;
(d) AOL's accounting treatment for its deferred
subscriber acquisition costs had not been "blessed" or "approved"
by the SEC nor did the SEC "bless" AOL's F95 Form 10-K;
(e) AOL's claimed average subscriber life of 40-41
months and average lifetime subscriber value of $700+ were false
and artificial figures for which there existed no reasonable basis
in fact. Instead, they were bogus figures, contrived by AOL to
- 68 -
provide a justification for its accounting practices. Only a tiny
fraction of AOL's subscribers stayed for 40 months or longer and
the purported average was based not on historical experience, but
"projections," which were made without any reasonable basis, were
unrealistic and were inconsistent with AOL's actual experience,
especially since AOL counted as subscribers persons who wanted to
cancel (by secretly providing extended free trial periods or
additional free usage time) and persons who were not paying for the
service (either because they were receiving the service on a free
"trial" basis or were improperly or fraudulently receiving service
without paying AOL) and because AOL had no reasonable basis to
predict the retention rate of new subscribers acquired in F95 and
F96.
(f) AOL's reported average subscriber life of 40+ months
was based on a premise that AOL knew was false, i.e., that the
relatively tiny portion of its subscriber base which had been with
AOL for more than 18 months was representative of the new
subscribers AOL was acquiring during F95 and F96. AOL knew that
its newer subscribers were not the heavy on-line service users who
had earlier signed up with AOL (and who generated significant
monthly fees) nor were the new subscribers as likely to spend the
same number of money hours of their lives on-line. AOL also knew
that many of these newer subscribers were most interested in e-mail
services which, after the initial free trial period, these
subscribers could obtain elsewhere for much lower fees.
(g) Because AOL's service was a month-to-month
arrangement where a subscriber could cancel at will without
penalty, i.e., there was no long-term subscriber commitment (unlike
- 69 -
a 36-month subscriber where a subscriber pays $x for a 36-month
subscription period), AOL had no reasonable basis to believe, given
increasing competition, greater free Internet access, and the
increasing acute churn problem by 1995, that AOL subscribers would
on average remain as subscribers long enough and spend enough to
ever recover AOL's average new net subscriber expenditures, let
alone to recover it in 24 months as represented in AOL's public
filings.
(h) AOL was concealing its true increasingly high
"churn" rate and falsifying its average subscriber life and
lifetime revenue through various secret practices. AOL allowed
thousands of subscribers to remain subscribers even though they
were delinquent in paying their accounts or had established "free"
accounts through improper and fraudulent practices. Also, when
trial subscribers notified AOL they wanted to cancel the service at
the end of their free "trial period," AOL permitted them to take
additional free trial period and offered various other incentives,
including, among other things, extending free usage time, even if
as a result of the incentives AOL would make no money on a
particular subscriber -- practices which were inconsistent with the
representations AOL made to justify AOL's deferral (and
capitalization) of hundreds of million in subscriber acquisition
costs.
(i) AOL's retention rate was not improving, but rather,
was deteriorating due to increasingly effective competition from
Internet access providers which was siphoning off AOL's heaviest
users and because AOL's massive marketing campaign was increasingly
attracting far less sophisticated, i.e., marginal users, who were
- 70 -
much more likely to terminate the AOL service after the free trial
membership period, and thus, AOL's "churn" rates were much higher
than AOL had disclosed or confirmed;
(j) AOL's GNN (direct Internet access system) with its
BookLink "WebBrowser" was not one of the most highly trafficked
sites on the World Wide Web, was not the first fully integrated
Internet service and was not a success but rather a failure,
attracting only limited numbers of subscribers and failing against
the competition;
(k) There was no reasonable basis in fact for the
statement that AOL was on track to obtain 10 million subscribers by
mid-1997, as, in fact, due to AOL's declining retention rate,
escalating "churn" rate and increasing inability to compete
effectively with the Internet access providers, defendants knew
these statements were false when made; and
(l) As a result of the foregoing, there was no
reasonable basis in fact for defendants' forecasts that AOL would
be profitable during F97 or achieve EPS of approximately $.75-$1.00
in F97, as, in fact, those forecasts were inconsistent with the
adverse facts set forth above and thus were known by defendants to
have been false when made.
80. On Dec. 13-14, 1995, while appearing at an AOL "Partners"
Conference in Phoenix, Arizona, Case had a meeting with securities
analysts and forecast that AOL would reach 10 million subscribers
by year-end F97.
81. On Dec. 28, 1995, AOL issued a press release headlined
and stating:
- 71 -
AMERICA ONLINE ANNOUNCES 4.5 MILLION MEMBERS, SUBSCRIBER
GROWTH AT RECORD LEVEL
America Online, Inc. said today it now has more than
4.5 million members of its flagship AOL brand, and
indicated that it has added more new subscribers in this
past quarter than in any previous three month period in
its history. Based on the current level of momentum in
its business, the company expects its rapid growth to
continue into 1996 . . . .
"We're closing what's been a phenomenal year having
started with just over 1.5 million AOL members and we are
ending 1995 with three times that number," said Steve
Case, Chairman and CEO of America Online. "Not only are
consumers in the United States showing a strong
preference for AOL as their means of access to the
Internet and the world of online services, but initial
response to GNN, our new Internet-only service . . . has
been gratifying and we're excited about the prospects for
dramatic growth next year . . . .
82. On Jan. 16, 1996, Merrill Lynch issued a report on AOL,
written by Fine, which repeated information provided him by Case
and Leader in conversations over the past few days. The report
forecast F96 and F97 EPS of $.50 and $1.00, respectively, and
stated:
* GNN, AOL's direct internet access brand, was
successfully launched on October 24, and has already
added over 100,000 subscribers.
* * *
GNN, AOL's internet access brand . . . is already
the fastest growing internet access provider and as a
stand alone public company we estimate it would have a
market value based on the low end of the comparable
range, of $500 million.
83. On Feb. 6, 1996, AOL reported its results for the second
quarter F96, i.e., the quarter ended Dec. 31, 1995, via a release
that stated:
America Online, Inc. reported today that its
revenues for the three months ended December 31, 1995
more than tripled from fiscal 1995's second quarter to a
record $249,094,000, and net income was $10,590,000, or
$0.10 per share . . . .
- 72 -
84. In a February 6, 1996 news story about AOL's announcement
of its second quarter 1996 fiscal year results in the Associated
Press, AOL was reported to have touted continuing increases in
earnings, profits, revenues and subscribers; while minimizing
concerns about competition from the Internet:
America Online Inc. said Tuesday it earned $10.6 million
in the last three months of 1995 and now has 5 million
subscribers.
The profit amounted to 10 cents per share for the
period, which is American Online's second fiscal quarter.
A year ago, it lost $38.7 million, or 60 cents per share,
after charges for its acquisitions of BookLink
Technologies and Navisoft Inc.
Revenue was $249.1 million, up from $76.4 million a year
ago. The profit fell in line with Wall Street
expectations.
* * *
The company finished 1995 with 4.59 million subscribers
but has since added enough to pass 5 million.
In a prepared statement that accompanied the earnings
report, America Online chief executive officer Steve Case
suggested the Company's performance ought to quiet
critics who say on-line services are doomed by the growth
of the Internet.
"The fact that we've grown ten-fold in two years speaks
volumes about what consumers really want when they go on
line," Case said.
85. In a similar report in The Washington Post on February 7,
1996, the Company insisted that its 1996 second quarter results
confirmed its representations of unabated growth:
The company, among several local firms that reported
earnings yesterday, said it now has 5 million
subscribers, which is said represents a tenfold increase
in two years.
* * *
Company officials used the results to counter recent
reports that the on-line business could decline in the
future.
- 73 -
"The fact that we've grown tenfold in two years speaks
volumes about what consumers really want when they go on
line," said Steve Case, America Online's chairman.
"Entering 1996, we're more enthusiastic than ever about
our market position and the momentum in our business."
86. On Feb. 6, 1996, AOL held a conference call for analysts,
investors and AOL's shareholders during which Case and Leader made
presentations and answered questions. In the call and in later
one-on-one follow-up conversations with analysts, they stated:
• AOL's operations were profitable and gaining
strength. AOL's business was enjoying very strong
momentum.
• AOL's subscriber acquisition rate was accelerating.
• AOL's GNN was a great success, had attracted many
subscribers, and was the fastest growing domestic
internet access provider and would be the No. 1 or 2
brand within a year.
• AOL's "churn" rate was stable or declining.
Subscriber retention was improving.
• Average subscriber membership life had risen to 42
months. Average lifetime membership value had increased
to approximately $757.
• AOL expected to have 10 million subscribers by June
1997.
• AOL expected to achieve strong EPS growth in F96 and
F97 to levels even higher than earlier forecast, with F96
EPS of $.50 and F97 EPS between $.85-$1.00.
87. On Feb. 7, 1996, Morgan Stanley issued a report on AOL,
written by Meeker, which repeated information provided her by Case
and Leader in the Feb. 6, 1996 conference call and follow-up
individual conversations. The report forecast a 40% five-year EPS
growth rate for AOL and stated:
AMER REPORTED STRONG CQ4 RESULTS -- AMER reported CQ4 EPS
of $0.10, above our estimate of $0.09 . . . .
* * *
- 74 -
The momentum in AMER subscriber additions improves our
confidence level that the company can reach its 2-year
target 10MM+ subscribers by FY-end 1997 (Jun). . . .
- RAISING ESTIMATES, MAINTAIN OUTPERFORM RATING --
For F1996E (June), we now look for . . . operating
EPS (pre-goodwill amortization) of $0.50 . . . .
For F1997E, we look for AMER to end the year with
10.2MM subscribers (thus exceeding the 10MM target)
. . . and to post . . . reported EPS of $1.00
. . . .
88. On Feb. 8, 1996, Merrill Lynch issued a report on AOL,
written by Fine, which repeated information provided him by Case
and Leader in the Feb. 6, 1996 conference call and follow-up
individual conversations. The report forecast F96 and F97 EPS of
$.50 and $1.00, respectively, and stated:
INVESTMENT HIGHLIGHTS:
* AOL's subscriber acquisition rate is accelerating.
* * *
* Operating margins expanded 160 basis points to
41.4%, highlighting the operating leverage resulting from
AOL's rapid growth.
* AOL continues to make significant progress at GNN
(its direct internet access provider) . . . .
* The continued acceleration in AOL's momentum is
impressive.
* * *
GNN has added over 100,000 subscribers since its
inception. We believe this makes GNN the fastest growing
commercial domestic internet access provider. GNN's mere
existence is further evidence of AOL's ability to adapt
to a rapidly changing competitive landscape and to
leverage their dominant position in online services into
new markets.
89. On Feb. 13, 1996, Alex. Brown issued a report on AOL,
written by Eskenazi, which was based on information provided him by
Case and Leader in the Feb. 6, 1996 conference call and follow-up
- 75 -
individual conversations. The report forecast F96 and F97 EPS of
$.51 and $.83, respectively, and stated:
* Reported F2Q (Dec) 1996 operating EPS of $0.11
. . . . These results were driven by better-than-
expected gross margin (41.4% versus 39% expected) . . . .
[A]s a result, we are maintaining our recently revised
(upward) EPS and subscriber estimates.
* Key business metrics improved sequentially:
retention rates to 42 months, paid usage of 3.12 hours,
Internet usage of 16%, and average revenue capture per
member month of $17.99.
* * *
In addition, the key metrics . . . continued to improve
. . . retention rose to 42 months from 40+ . . . .
Finally, GNN (its Internet direct service) added 100,000
subscribers in the last 90 days (which was perhaps faster
than Netcom), and the Company stated that it expects the
service to be the #1 or #2 brand (along with Netcom)
within a year.
90. On Feb. 12, 1996, an article about AOL headlined "As
America Online's Share Price Has Soared, So Has The Growing Number
of Short-Sellers," appeared in The New York Times. It stated:
The share price of the king of conventional on-line
services, America Online, quietly rose to another record,
at $51 a share, up from less than $16 a share a year ago.
Is this a levitation act? The short-sellers of
America Online certainly think so, and there are plenty
of them. . . .
The bearish case on America Online rests on the
assumption that new rivals and the Internet will deal the
Vienna, Va. company a crushing blow. Its rapid growth,
skeptics say, was fueled by a costly marketing campaign
that the company will no longer be able to afford with
the advent of stiff price competition.
* * *
"There is a lot of elegance to the arguments of the
shorts," replied Richard Hanlon, vice president of
investor relations for America Online. "But the problem
for them is that those arguments have not proved to be
correct."
- 76 -
On the marketing-cost question, Mr. Hanlon explained
that the $45 cost for adding a subscriber is for "gross"
subscribers, totaling 1.9 million the most recent
quarter. During the period, he says, America Online
spent $86 million to entice those 1.9 million people to
sign up. The 877,000 new subscribers, Mr. Hanlon added,
is a net figure, meaning they were still subscribers by
the end of the quarter.
The difference is a high rate of turnover, raising
questions about America Online's assertion that its
average subscriber stays with the service for 42 months.
Mr. Hanlon says the 42-month figure is a projection,
based on the behavior of past subscribers. And he
insists that America Online's churn rates are not unusual
for the on-line business, and that they are improving.
91. On Feb. 14, 1996, AOL filed its Report on Form 10-Q for
the quarter ended Dec. 31, 1995, i.e., 2Q F96, which was signed by
Case and Leader. The 10-Q presented shareholders' equity of $406
million and net income of $10.5 million, or $.10 per share. The
Form 10-Q also stated, among other things:
Note 3. Change in Accounting Estimate.
Effective July 1, 1995, the Company modified the
components of subscriber acquisition costs deferred, and
changed the period over which it amortizes subscriber
acquisition costs. The period over which the Company
amortizes subscriber acquisition costs was changed from
twelve and eighteen months to twenty-four months, in
order to more appropriately match subscriber acquisition
costs with associated online service revenues.
92. On Mar. 12, 1996, AOL announced an agreement with
Netscape where AOL would license the Netscape Navigator, which
would enable AOL's members to access the World Wide Web through
AOL. In a conference call Case and Leader told analysts that:
Netscape's Navigator Strengthens GNN . . . . GNN
service members (100,000 strong) [would soon undergo a
transition] to the Netscape Navigator as the preferred
browser, giving [them] "browser parity" with such
competitors as PSINet and Netcom Online. . . . GNN could
have many more subscribers than the largest ISP, Netcom
(310,000), within 12 months. Bundling Netscape's
Navigator coupled with AOL's marketing and branding
- 77 -
muscle, makes management's GNN goals much more probable
. . . .
93. On April 17, 1996, Lehman Brothers "initiated coverage"
on AOL with a report written by Brian Oakes. Prior to writing this
report, Oakes communicated with Case and Leader and the report
contained and repeated information he obtained from them. The
Lehman report forecast F96 and F97 EPS of $.46 and $.95
respectively, for AOL. The report stated:
Accelerating Growth
As the clear industry leader in online services,
America Online is a must-own for investors looking to
capture the growth of millions of consumers going online.
Fundamentally, the company continues to outperform our
expectations and growth is actually accelerating.
* * *
Expanding Margins
We expect operating margins to double over the next
four years . . . .
94. On April 23, 1996, Bear Stearns initiated coverage on AOL
in a report written by J. Kiggen and S. Reamer. Prior to writing
this report, Kiggen/Reamer communicated with Case and Leader and
the report contained information they obtained from them. The
report stated:
We estimate earnings of $0.46 per share in fiscal 1996
(June year) . . . .
* * *
For fiscal 1997, we look for earnings to grow 119%,
to $1.00 per share . . . .
America Online Should Post 60%-70% 3-to-5 Year
Earnings Growth. We expect America Online to post at
least 60%-70% 3-to-5 year earnings growth, as the company
begins to leverage its enormous customer base (which we
estimate could be over 10 million subscribers by the
middle of next year), its lower cost AOLnet network
- 78 -
(gross margin expansion as more AOL traffic moves off of
sprint), its new GNN Internet service . . . .
95. On April 23, 1996, Everen Securities "initiated coverage"
on AOL in a report written by Kevin Dukesherer and Rob Nunez.
Prior to writing this report, Dukesherer/Nunez communicated with
Case and Leader and the report contained information they obtained
from them. The report forecast F96 and F97 EPS of $.50 and $.85
for AOL and stated:
Projected 5-year annual EPS growth of 74% driven by
subscriber growth and margin expansion as online services
become a mainstream consumer product.
96. As AOL's insiders disseminated this exceedingly positive
information to the market through securities analysts its stock
soared to its all time high of $71 per share on May 7, 1996.
97. The positive statements made by AOL both directly and
indirectly through securities analysts set forth in ¶¶80-95 during
Dec. 13, 1995-May 7, 1996 were each false and misleading when made
nd failed to disclose the following material adverse facts,
disclosure of which was necessary to make the statements made not
false and misleading:
(a) AOL's profits, EPS, assets and shareholders' equity
for the periods ended Dec. 31. 1995 and March 31, 1996 were each
improperly and artificially inflated due to AOL's failure to write
off its previously deferred and capitalized subscriber acquisition
costs and failure to expense such costs in the current period, as
required by GAAP and necessary for a fair presentation of AOL's
actual results from operations;
(b) AOL's lengthening of the amortization period for
deferred subscriber acquisition costs had not been undertaken in an
- 79 -
effort to more accurately match the expenses of obtaining
subscribers with revenues from obtained subscribers, as most
subscribers to the AOL service remained subscribers only a short
period of time and, in fact, this change was made for the purpose
of permitting AOL to conceal the deterioration of its competitive
position in actual earning power and to help it avoid reporting
sharply declining profits or even losses during F96;
(c) AOL's claimed average subscriber life of 40-41
months and average lifetime subscriber value of $700+ were false
and artificial figures for which there existed no reasonable basis
in fact. Instead, they were bogus figures, contrived by AOL to
provide a justification for its accounting practices. Only a tiny
fraction of AOL's subscribers stayed for 40 months or longer and
the purported average was based not on historical experience, but
"projections," which were made without any reasonable basis, were
unrealistic and were inconsistent with AOL's actual experience,
especially since AOL counted as subscribers persons who wanted to
cancel (by secretly providing extended free trial periods or
additional free usage time) and persons who were not paying for the
service (either because they were receiving the service on a free
"trial" basis or were improperly or fraudulently receiving service
without paying AOL) and because AOL had no reasonable basis to
predict the retention rate of new subscribers acquired in F95 and
F96;
(d) AOL's reported average subscriber life of 40+ months
was based on a premise that AOL knew was false, i.e., that the
relatively tiny portion of its subscriber base which had been with
AOL for more than 18 months was representative of the new
- 80 -
subscribers AOL was acquiring during F95 and F96. AOL knew that
its newer subscribers were not the heavy on-line service users who
had earlier signed up with AOL (and who generated significant
monthly fees) nor were the new subscribers as likely to spend the
same number of money hours of their lives on-line. AOL also knew
that many of these newer subscribers were most interested in e-mail
services which, after the initial free trial period, these
subscribers could obtain elsewhere for much lower fees;
(e) Because AOL's service was a month-to-month
arrangement where a subscriber could cancel at will without
penalty, i.e., there was no long-term subscriber commitment (unlike
a 36-month subscriber where a subscriber pays $x for a 36-month
subscription period), AOL had no reasonable basis to believe, given
increasing competition, greater free Internet access, and the
increasing acute churn problem by 1995, that AOL subscribers would
on average remain as subscribers long enough and spend enough to
ever recover AOL's average new net subscriber expenditures, let
alone to recover it in 24 months as represented in AOL's public
filings;
(f) AOL was concealing its true increasingly high
"churn" rate and falsifying its average subscriber life and
lifetime revenue through various secret practices. AOL allowed
thousands of subscribers to remain subscribers even though they
were delinquent in paying their accounts or had established "free"
accounts through improper and fraudulent practices. Also, when
trial subscribers notified AOL they wanted to cancel the service at
the end of their free "trial period," AOL permitted them to take
additional free trial period and offered various other incentives,
- 81 -
including, among other things, extending free usage time, even if
as a result of the incentives AOL would make no money on a
particular subscriber -- practices which were inconsistent with the
representations AOL made to justify AOL's deferral (and
capitalization) of hundreds of million in subscriber acquisition
costs;
(g) AOL's retention rate was not improving, but rather,
was deteriorating due to increasingly effective competition from
Internet access providers which was siphoning off AOL's heaviest
users and because AOL's massive marketing campaign was increasingly
attracting far less sophisticated, i.e., marginal users, who were
much more likely to terminate the AOL service after the free trial
membership period, and thus, AOL's "churn" rates were much higher
than AOL had disclosed or confirmed;
(h) AOL's GNN with its Booklink WebBrowser had not been
successfully launched and was, in fact, a failure and great
disappointment to AOL, attracting only limited numbers of
subscribers and failing against the competition;
(i) There was no reasonable basis in fact for the
statement that AOL would obtain 10 million subscribers by mid-1997,
as, in fact, due to AOL's declining retention rate, escalating true
"churn" rate and increasing inability to compete effectively with
the Internet access providers;
(j) As a result of the foregoing, there was no basis in
fact for defendants' forecasts that AOL would reach 10 million
subscribers by mid-1997, as those forecasts were inconsistent with
and contradicted by the above adverse facts and thus were known by
defendants to be false when made; and
- 82 -
(k) As a result of the foregoing, there was no
reasonable basis in fact for defendants' forecasts that AOL would
be profitable during F97 or achieve EPS of approximately $.80-
$1.00 in F97, as, in fact, those forecasts were inconsistent with
the adverse facts set forth above and thus known by defendants to
have been false when made.
98. After AOL's stock hit its Class Period and all-time high
of $71 on May 7, 1996 and AOL's insiders had completed the bulk of
their insider bailout, the stock began to decline on May 8, 1996 as
AOL's insiders began to partially disclose adverse information
about the Company in an attempt to gradually "manage" the stock
price lower and avoid the huge catastrophic immediate collapse that
would result if the full truth were disclosed, by making a series
of partial disclosures, coupled with continuing false reassurances.
As a result, while AOL stock declined during June-Oct. 1996, it
continued to trade at artificially inflated levels.
99. AOL's stock fell by $10 to as low as $61 during May 7-9,
1996, as AOL revealed in its May 8, 1996 conference call that its
churn rate was up in April, its subscriber growth had temporarily
slowed due to "seasonal factors" and it was cutting back
"temporarily" on its marketing expenditures to concentrate on
retaining subscribers. Then AOL stock fell from $56-1/2 to $42-3/4
between June 3, 1996 and June 6, 1996, when AOL revealed that
although it had reached 6 million subscribers, it had added only
200,000 subscribers in April-May 1996 versus the 500,000 forecast,
thus confirming that subscriber growth was slowing more than
earlier disclosed and the number of subscribers cancelling (churn)
was continuing to accelerate. However, AOL's stock price continued
- 83 -
to be artificially inflated in this time period due to AOL's false
statements.
100. On May 8, 1996, AOL issued a release reporting its 3Q F96
results, i.e., the quarter ended March 31, 1996, which stated:
Net income for the latest three months improved to
$15,127,000, or $0.14 per share . . . .
On May 15, 1996, AOL filed its Report on Form 10-Q for the third
quarter of F96 ended March 31, 1996, which was signed by Case and
Leader. The report presented AOL shareholders' equity of $439
million, as well as 3Q F96 net income of $15.1 million, or $.14 per
share. The Form 10-Q also stated, among other things:
Note 3. Change in Accounting Estimate.
Effective July 1, 1995, the Company modified the
components of subscriber acquisition costs deferred, and
changed the period over which it amortizes subscriber
acquisition costs. The period over which the Company
amortizes subscriber acquisition costs was changed from
twelve and eighteen months to twenty-four months, in
order to more appropriately match subscriber acquisition
costs with associated online service revenues.
101. On May 8, 1996, AOL held a conference call for analysts,
investors and AOL's shareholders during which Case and Leader made
presentations and answered questions. In the call and in later
one-on-one follow-up conversations with analysts, they revealed the
following:
• AOL's subscriber growth had slowed, due to "seasonal
factors."
• AOL's churn rate suddenly had increased in April,
but this was a temporary phenomenon.
• AOL going to temporarily reduce marketing
expenditures to attract new subscribers and concentrate
on retaining subscribers and improving its service.
However, they also stated:
- 84 -
• AOL expected its subscriber base to continue to grow
and still expected to have 10 million subscribers by
year-end F97, i.e., June 30, 1997.
• AOL still expected to earn approximately $.45-$.50
in F96 and to achieve strong EPS growth in F97 to
approximately $.95-$1.05, somewhat higher than earlier
forecast.
102. On May 8, 1996, Alex. Brown issued a report on AOL
written by Eskenazi which was based on and repeated information
provided him by Case and Leader in the May 8, 1996 conference call
and in follow-up conversations. The report forecast F96 and F97
EPS of $.49 and $.95, respectfully, for AOL, and stated:
-- America Online (AOL) reported solid F3Q (Mar) 1996
EPS results of $0.14 . . . .
-- No change to EPS estimates: FY (June) 1996 EPS of
$0.49 on $1.13 billion in revenue and 6.3 million
members, and FY 1997 EPS of $0.95 on $2.06 billion and 10
million members. While post-conference call concerns
were voiced regarding slowing member growth, it is
important to note that we are actually raising our member
growth forecast slightly.
103. On May 9, 1996, Morgan Stanley issued a report on AOL
written by Meeker which was based on and reported information
provided her by Case and Leader in the May 8, 1996 conference call
and in follow-up conversations. The report increased its
forecasted F96 and F97 EPS to $.54 and $1.05, respectively, for
AOL, and stated:
- AMER CQ1:96 EPS STRONG -- AMER reported CQ1:96 EPS
of $0.14, above our estimate of $0.12 -- the upside was
due to higher than expected revenue and gross margin.
* * *
- SUBSCRIBER GROWTH WAS GOOD -- AMER ended CQ1:96 with
5.5MM subscribers and the company believes it will have
6MM subscribers this week. We continue to believe that
the company can reach its 10MM+ subscribers target by FY-
end 1997 (Jun) . . . .
* * *
- 85 -
We are maintaining our F1996E revenue estimate of $1.1B
(up 182%) and increasing our operating income slightly to
$89MM (up 174%) with operating EPS of $0.54 (vs. our old
estimate of $0.53). F1997E revenue is $1.9B (up 73%) and
operating income $204MM (up 128%) with operating EPS of
$1.05. Note that, in general, we look for margins to
expand.
While management was upbeat on the conference call
and indicated that it is comfortable with street
financial estimates, it did caution about spring/summer
seasonality and a higher rate of churn than usual in the
month of April. . . .
AMER shares have been stoked by loads of good news
and positive momentum over the past 3 years, and while
the news is still great, we think it's gone from super-
great to just great.
104. The positive statements made by AOL both directly and
indirectly through securities analysts set forth in ¶¶99-102
between May 8 and 15, 1996 were each false and misleading when made
and failed to disclose the following material adverse facts,
disclosure of which was necessary to make the statements made not
false and misleading:
(a) AOL's profits, EPS, assets and shareholders' equity
for the period ended March 31, 1996 were each improperly and
artificially inflated due to AOL's failure to write off its
previously deferred and capitalized subscriber acquisition costs
and failure to expense such costs in the current period, as
required by GAAP and necessary for a fair presentation of AOL's
actual results from operations;
(b) AOL's lengthening of the amortization period for
deferred subscriber acquisition costs was not undertaken in an
effort to more accurately match the expenses of obtaining
subscribers with revenues from obtained subscribers, as most
subscribers to the AOL service remained subscribers only a short
- 86 -
period of time and, in fact, this change was made for the purpose
of permitting AOL to conceal the deterioration of its competitive
position in actual earning power and to help it avoid reporting
sharply declining profits or even losses during F96;
(c) AOL's claimed average subscriber life of 40+ months
and average lifetime subscriber value of $700+ were false and
artificial figures for which there existed no reasonable basis in
fact because, among other things, AOL was artificially inflating
its subscriber numbers and length of subscribership by secretly
extending free trial periods, letting persons sign up for repeated
trial subscription periods, by making other concessions to trial
subscribers who attempted to cancel AOL's service and by including
as subscribers material numbers of individuals who had not and/or
would not pay their monthly subscription costs;
(d) The increase in AOL's "churn" rate in Mar.-April was
not sudden or temporary and in fact AOL's "churn" rate was much
higher than AOL had disclosed or confirmed and AOL was concealing
the true high and escalating rate of "churn" of its subscribers by
secretly allowing trial subscribers to extend their trial
subscription period or by offering other inducements to existing
subscribers who wanted to cancel their AOL service in order to keep
them on AOL's subscriber roles;
(e) AOL's "churn" rate had been in fact escalating which
escalation was being concealed only through the artifice of
offering trial and regular subscribers secret inducements such as
extended trial membership periods or additional free usage time in
order to induce people not to terminate the AOL service;
- 87 -
(f) AOL's GNN (direct Internet access system) was a
failure and AOL's investment in GNN would have to be written off;
(g) Defendants had no reasonable basis in fact when they
represented that AOL would obtain 10 million subscribers by mid-
1997, as, in fact, due to AOL's declining retention rate,
escalating true "churn" rate and increasing inability to compete
effectively with the Internet access providers, and thus those
forecasts were inconsistent with and contradicted by the above
adverse facts and were known by defendants to be false when made;
and
(h) As a result of the foregoing, there was no
reasonable basis in fact for defendants' forecasts that AOL would
be profitable during F97 or achieve EPS of approximately $1.00 in
F97, as, in fact, those forecasts were inconsistent with the
adverse facts set forth above and thus were known by defendants to
have been false when made.
105. On June 5, 1996, Lehman Brothers analyst Brian Oakes
spoke with Case and Leader and then issued a report repeating
information given him by them. The report forecast F96 and F97 EPS
of $.47 and $1.00, respectively, for AOL, and stated:
We just talked with America Online, and everything
remains on track in revenues, earnings and subscriber
growth -- with the company ahead of schedule in other
areas.
The persons Oakes spoke to were Leader and Case.
106. On June 7, 1996, Alex. Brown issued a report on AOL
written by Eskenazi after he spoke to Case and Leader. The report
repeated information given him by them. The report forecast F96
and F97 EPS of $.49 and $1.00, respectively, for AOL, and stated:
- 88 -
[W]e are raising FY (June) 1997 EPS estimate to $1.00
from $0.95 . . . . This change in mix of sales reflects
AOL's focus on maximizing relationships with customers
("other revenue") from customer acquisition (online
service revenue).
* * *
-- With respect to churn, we calculate (based on
AOL's guidance that 3/4 of churn are trial conversion)
that existing member retention is roughly 4-5 years (20-
25% churn per year), a healthy figure based on the
newness of the online medium.
107. On June 12, 1996, Morgan Stanley issued a report on AOL
written by Meeker after she spoke to Case and Leader. The report
repeated information given her by them. The report forecast F96
and F97 EPS of $.54 and $1.05, respectively, for AOL, and stated:
Note however that we are not changing our EPS
estimates for F1996 and F1997. While the relative impact
of these adjustments, given the large size of AMER's
customer is not significant, we have also inched up our
CQ2 gross margin estimate from 41.6% to 42.0% and
increased our F1997E gross margin from 42.0% to 42.5%.
AMER management indicated that it is comfortable with
these changes.
- Churn -- Per the company, churn appears to have
stabilized since March/April.
108. On July 16, 1996, AOL via Case and/or Leader appeared at
the Wheat First Butcher Singer conference in Nantucket. According
to a July 17, 1996 report by Wheat First, at the conference AOL
forecast F96 and F97 EPS of $.47 and $.90:
-- AmericaOnline presented at the Wheat First Butcher
Singer Nantucket conference yesterday. Management
reiterated earlier-stated subscriber targets of eight
million by calendar year-end 1996 and 10 million by
fiscal year-end June 1997.
109. On July 17, 1996, Lehman Brothers issued a report on AOL
written by Oakes after Oakes had visited AOL and had discussions
with Case and Leader. Oakes' report repeated information given him
- 89 -
by them, forecasting F96 and F97 EPS of $.47 and $1.00,
respectively, for AOL. The report stated:
* Recent visit to America Online indicates that the
fundamentals at the company are fine.
* Problems at CompuServe yesterday led to weakness in
AOL as investors were overly concerned that AOL would
report a similar fall in earnings and no subscriber
growth.
* This is not the case, as we expect on August 8, AOL
will report earnings of at least $0.15 and subscriber
growth of about 800,000 during the quarter. We should
also see both gross margins and operating margins
continue to expand.
110. On July 19, 1996, AOL issued a press release headlined
and stating:
AMERICA ONLINE'S CASE SAYS MEMBERSHIP CONTINUES TO GROW
America Online, Inc. issued the following statement
from Steve Case, Chairman and CEO: "There has been
considerable confusion and speculation in recent weeks
about the online service market and AOL in particular.
This uncertainty was heightened this week when CompuServe
announced they were experiencing a decline in membership,
which led some short sellers to assert that this might be
a proxy for online services in general.
"AOL continues to grow members, revenues and
profits. We ended the quarter with 6.2 million worldwide
members, and we expect to add hundreds of thousands of
net new members in the September quarter, even though we
have slowed marketing expenses in recent months as we
gear up for the Fall. We expect to hit our stride in the
Fall with new marketing initiatives aimed at educating
consumers about the many unique attributes of AOL
including our new 3.0 software, new content, new
navigational aids, and new value pricing.
. . . [W]e are pleased to note that on August 8, we
expect to report earnings per share for the June quarter
that will meet or exceed the consensus Street expectation
which (before one-time legal charges) is $0.16.
111. On July 19, 1996, the following ran on Reuters:
AOL SEES MEETING OR BEATING Q4 WALL ST. EXPECTATIONS
Responding to fears it may be losing current and
potential members to the Internet, America Online Inc.
- 90 -
fought back Friday with a bullish series of announcements
designed to revive its ailing stock price.
* * *
In his statement Friday, Steve Case, chairman and
chief executive, said America Online (AOL) expected to
meet or exceed Wall Street expectations for fourth
quarter earnings.
112. On July 22, 1996, Newsbytes reported the following:
America Online's Case Says Membership Not Declining
In an apparent effort to halt a downward trend in its
stock, America Online Chairman and Chief Executive
Officer (CEO) Steve Case said the online services'
profits, revenues, and subscriber rolls "continue to
grow." Case's efforts seemed to work, too, because AOL
stock rose more than $4 on the NASDAQ exchange at midday.
* * *
Case said the company expects to meet or beat Wall
Street consensus earnings estimates of 16 cents per share
for AOL's fourth quarter 1996, before one-time legal
charges, AOL will release its earnings August 8.
* * *
Case also said the company intends to surpass 10
million members worldwide in mid-1997, "and we believe
that goal is achievable," he said.
113. Between July 17, 1996 and July 24, 1996, AOL's stock fell
from $34-3/4 to as low as $24-1/2, as AOL revealed the number of
subscribers actually added in the June 30, 1996 quarter was well
below expectations, and it was continuing to incur more churn from
established customers and less conversions from trial customers
into paying subscribers. In Aug. 1996 AOL revealed it had "purged"
350,000 subscribers who had taken "multiple free trials." In mid-
September 1996, an article appeared in The Washington Post that
reported alarming statements made by AOL executives at an AOL
employee meeting, e.g.:
- 91 -
"It's mortifying to me that every day, many times [the
number of people in] this room, that many people, cancel
AOL," Leonsis said.
Katherine Borsecnik, the vice president for content
development, drove home the point. "Members are
canceling every day in large numbers -- large enough to
make a significant and material difference in the bottom
line," she said.
Also in mid-Sept. Case admitted the Company had made mistakes in
recruiting new subscribers -- actually "'we kind of dropped the
ball here.'" In early Oct. 1996, AOL admitted in its F96 Annual
Report that it had encountered "lower overall retention rates" in
F96 due to increased competition from the Internet, pricing
competition from competitors and an increase in "less-qualified,"
i.e., marginal subscribers, retention rates were the worst for new
subscribers and, as a result, AOL could no longer predict the
overall future rate of retention -- meaning that its previously
projected 40+ month subscriber life and $700+ average subscription
lifetime value was invalid. As a result of these admissions, the
impropriety of AOL's prior practice of capitalizing subscriber
acquisition costs over 24 months to match revenues with expenses
was exposed and by mid-Oct. 1996, AOL stock sold as low as $22-3/8
per share. However, during this same time period, i.e., July-Oct.
96, AOL continued to make false and misleading statements to the
market to cushion the blow of these adverse disclosures and thus
AOL common stock continued to trade at inflate prices.
114. On Aug. 8, 1996, AOL issued a release reporting its
fourth quarter F96 and F96 results, which was headlined and stated:
AMERICA ONLINE BECOMES FIRST BILLION DOLLAR INTERACTIVE
SERVICES COMPANY
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Interactive Services Leader Posts FY96 Revenues of $1.1
Billion with 120% Leap in Fourth Quarter Revenues and
Operating Net Beating Analysts' Estimates
. . . The Company said that its results for the
fourth quarter hit new records for revenues, gross profit
margins and earnings per share from operations.
In the fourth quarter, AOL earned $21,026,000, or
$0.19 per share . . . which compares with net income of
$5,309,000, or $0.06 per share . . . .
AOL's gross margins rose to 46.6% in the last three
months of fiscal 1996, from 42.4% the previous year
. . . .
Operating income climbed over 200% to $32,332,000 in
the latest quarter, from $10,175,000 in fiscal 1995's
comparable period, while the operating margin of 9.7% for
fiscal 1996's last three months contrasts with margins of
6.7% for the same quarter last year.
* * *
Case also said the Company was improving its retention
rate.
115. On Aug. 8, 1996, Reuters ran the following:
AMERICAN ONLINE PROFITS RISE
America Online Inc., the world's largest online
service, reported a three-fold increase in quarterly
profits Thursday . . . .
The Dulles, VA-based company posted net income of
$16 million, or 14 cents a share, in its fiscal fourth
quarter ended June 30 vs. $5.3 million, or 6 cents a
share, a year ago.
* * *
The results surpassed expectations of Wall Street
analysts.
"The earnings were a blowout," said Lehman Brothers
analyst Brian Oakes.
* * *
The company . . . said it had begun to see
encouraging trends in member retention and usage.
* * *
- 93 -
Case said recent churn levels were at their lowest
in 13 weeks, with retention rates increasing . . . .
116. On Aug. 8, 1996, AOL held a conference call for analysts,
investors and AOL's shareholders during which Case and Leader made
presentations and answered questions. In the call and in later
one-on-one follow-up conversations with analysts, they stated:
• AOL's operations were very profitable and gaining
strength.
• Net subscriber acquisition costs were the lowest all
year.
• AOL's "churn" rate was declining. Subscriber
retention was improving.
• Average subscriber membership life had risen to 40
months.
• AOL's business was enjoying very strong momentum.
• AOL still expected to have 10 million subscribers by
year-end F97.
• AOL still expected to achieve strong EPS growth in
F97 to over $1.00 per share with further EPS growth in
F98.
117. On Aug. 9, 1996, Lehman Brothers issued a report on AOL
written by Oakes which was based on and repeated information given
him in the conference call and follow-up conversations with Case
and Leader. The report forecast F97 and F98 EPS of $1.00 and
$1.75, respectively, for AOL, and stated:
The conference call was upbeat, with growth picking
up, churn and support calls down and the new pricing plan
working in the company's favor.
* * *
American OnLine (AOL) reported a blowout fourth
quarter earnings of $0.19 from operations.
* * *
The company also mentioned that in July, churn was the
lowest it had been in over three months. In addition,
- 94 -
the new version 3.0 of AOL software is producing about a
10% increase in usage and 50% fewer support calls - both
very bullish signs for the quarters ahead.
* * *
Gross margins jumped to 47% from 42% and operating
margins improved to almost 10% from 7% in the prior year.
Thus earnings per share jumped to $0.19 from $0.06. We
are encouraged that the company began to demonstrate the
true profit potential of this business . . . .
We are comfortable with our $1.00 estimate for
fiscal 1997 . . . .
* * *
Subscriber acquisition costs were the LOWEST all
year, and the amount expensed was the HIGHEST all year,
thus the balance sheet and earnings were much improved.
The model is changing to an expensed versus capitalized
one, thus clearing up the accounting issues.
* * *
The cost per registration has fallen and will level
out next year. . . . More importantly, an increasingly
higher percentage of these costs will be expensed versus
capitalized. This should serve to clean up the balance
sheet and remove the negative stories regarding the 24
month amortization of those expenses.
* * *
Finally, AOL has taken many steps to create a very
successful earnings and cash flow business, which
positions them well for the future. We think investors
have to begin to look beyond the top line story that was
so easy to understand, and drill down into the earnings
growth and free cash flow growth potential of these
businesses.
118. On August 9, 1996, Alex. Brown issued a report on AOL
written by Eskenazi which was based on and repeated information
given him in the August 8, 1996 conference call and follow-up
conversations with Case and Leader. The report forecast F97 EPS of
$1.00 for AOL, a 40% 3-5 year growth rate, and stated:
America Online (AOL) reported F4Q (June) 1996
operating EPS results of $0.19 that were essentially in
line with our $0.18 EPS estimate . . . .
- 95 -
. . . [M]ember forecasts maintained at 10 million
for FY 1997 along with our FY 1997 EPS estimate of $1.00.
We have raised our CY 1997 EPS estimate to $1.33 (up from
$1.25).
* * *
On balance, AOL enters FY 1997 in a much stronger
position than it entered FY 1996 . . . .
119. On Aug. 13, 1996, Merrill Lynch issued a report on AOL
written by Fine which was based on and repeated information given
Fine in the August 8, 1996 conference call and follow-up
conversations with Case and Leader. The report forecast F97 and
F98 EPS of $1.00 and $2.25 for AOL, and a 5-year EPS growth rate of
50%. The report stated:
FOURTH QUARTER RESULTS & OUTLOOK:
AMER report 4Q EPS of $0.19/sh (before a $0.05/sh
charge for settling billing practices) compared to
$0.06/sh a year ago. While the June quarter was above
expectations, it wasn't all good news. For the year,
AMER reported $0.51/sh which is line with the estimate we
have been carrying for the year. We think it is worth
noting that while earnings growth should not be the
metric upon which AOL is measured (subscriber gains and
growth in other revenues should be), the company has
provided terrific guidance and there have had to be few
changes in estimates. We continue to estimate $1.00/sh
for the current fiscal year and have a preliminary and
likely somewhat aggressive estimate of $2.25/sh for FY98.
* * *
While no specific churn numbers were provided,
management provided an indication that churn had declined
from the peak experienced in the Spring. . . . Last week
was the lowest churn experienced in 13 weeks. . . .
Management addressed several issues on the quarterly
conference call in addition to the quarter. . . .
Management also addressed the issue of future
subscriber growth and their strong view that it will
continue and continues to be a priority due to the
ability to generate other types of higher margin revenues
such as advertising, transactions, etc. Management
continued to emphasis [sic] their belief, with which we
agree, that on-line services ease of use, intuitive
- 96 -
navigation, editorial selectivity coupled with full web
access will attract a disproportionate amount of usage.
We continue to believe that 10MM subscribers is an
achievable figure by June 1997 (including overseas and
GNN) . . . .
120. On Sept. 30, 1996, AOL held a conference call for
reporters and analysts, during which Case stated, as was reported
by, inter alia, Reuters:
Case also said that AOL is on target to reach 10
million members next summer . . . .
"We do think we can get to the 10 million by next
summer," Case said.
121. On Oct. 7, 1996, AOL issued its F96 Annual Report to
Shareholders, which included a letter from Case that stated:
What an incredible year. . . .
Despite the investments we made to grow rapidly, we also
grew profitably; in the most recent quarter, for example,
we set new records for gross profit margins and earnings-
per share from operations.
Year Ended June 30,
1996
(in thousands, except per share data)
Statement of Operations Data:
Online service revenues $991,656
Other revenues 102,198
Total revenues 1,093,854
Income (loss) from
operations 65,243
Income (loss) before
extraordinary 29,816
Net income (loss)* 29,816
Income (loss) per common
share:
Income (loss) before
extraordinary item $ 0.28
Net income (loss) $ 0.28
Balance Sheet Data:
Total assets 958,754
Stockholders' equity 512,502
* Net income in the fiscal year ended June 30, 1996, includes charges of
approximately $17.0 million for acquired research and development, $8.0 million
for the settlement of a class action lawsuit, and $3 million for merger expenses.
122. AOL's F96 Annual Report also stated:
- 97 -
Effective July 1, 1995, the Company modified the
components of subscriber acquisition costs deferred, and
changed the period over which it amortizes subscriber
acquisition costs. The period over which the Company
amortizes subscriber acquisition costs was changed from
twelve and eighteen months to the period described above
[24 months] in order to more appropriately match
subscriber acquisition costs with associated online
service revenues.
123. AOL's F96 financial statements included in AOL's F96
Annual Report to Shareholders, were audited by Eamp;Y, which issued an
unqualified "clean" opinion certifying those financial statements.
In Oct. 1996, AOL filed its Annual Report on Form 10-K for F96.
This report was signed by Case, Kimsey, Leader, Caufield, Haig and
Andress. The Form 10-K contained the same financial information
and statements as AOL's F96 Annual Report to Shareholders,
including Eamp;Y's clean, unqualified opinion.
124. The positive statements made by AOL both directly and
indirectly through securities analysts set forth in ¶¶104-111, 113-
122 during June-October 1996 were each false and misleading when
made and failed to disclose the following material adverse facts,
disclosure of which was necessary to make the statements made not
false and misleading:
(a) AOL's profits, EPS, assets and shareholders' equity
for the period ended June 30, 1996 were each improperly and
artificially inflated due to AOL's failure to write off its
previously deferred and capitalized subscriber acquisition costs
and failure to expense such costs in the current period, as
required by GAAP and necessary for a fair presentation of AOL's
actual results from operations;
(b) AOL's lengthening of the amortization period for
deferred subscriber acquisition costs was not undertaken in an
- 98 -
effort to more accurately match the expenses of obtaining
subscribers with revenues from obtained subscribers, as most
subscribers to the AOL service remained subscribers only a short
period of time and, in fact, this change was made for the purpose
of permitting AOL to conceal the deterioration of its competitive
position in actual earning power and to help it avoid reporting
sharply declining profits or even losses during F96;
(c) AOL's actual "churn" rate was much higher than AOL
had disclosed or confirmed and AOL was concealing the true high and
escalating rate of "churn" of its subscribers by secretly allowing
trial subscribers to extend their trial subscription period or
offering other inducements to existing subscribers who wanted to
cancel their AOL service in order to keep them on AOL's subscriber
roles;
(d) AOL's "churn" rate was in fact escalating which
escalation was being concealed only through the artifice of
offering trial and regular subscribers secret inducements such as
extended trial membership periods or additional free usage time in
order to induce people not to terminate the AOL service;
(e) AOL's retention rate was not improving, but rather,
was deteriorating due to increasingly effective competition from
Internet access providers which was siphoning off AOL's heaviest
users and because AOL's massive marketing campaign was increasingly
attracting far less sophisticated, i.e., marginal users, who were
much more likely to terminate the AOL service after the free trial
membership period, and thus, AOL's "churn" rates were not normal or
customary for the on-line service business and were much higher
than AOL had disclosed or confirmed;
- 99 -
(f) AOL's GNN (direct Internet access system) and its
Booklink WebBrowser was a failure, and AOL would have to write off
its entire investment in GNN in the near term;
(g) Defendants had no reasonable basis in fact when they
represented that AOL was on target to obtain 10 million subscribers
by mid-1997, as, in fact, due to AOL's declining retention rate,
escalating true "churn" rate and increasing inability to compete
effectively with the Internet access providers, and thus those
forecasts were inconsistent with and contradicted by the above
adverse facts and thus were known by defendants to be false when
made; and
(h) As a result of the foregoing, there was no
reasonable basis in fact for defendants' forecasts that AOL would
be profitable during F97 or achieve EPS of approximately $1.00 in
F97 and $2.25 in F98 as, in fact, those forecasts were inconsistent
with the adverse facts set forth above and thus were known by
defendants to have been false when made.
125. AOL's F96 financial statements included in AOL's F96
Annual Report to Shareholders, were audited by Eamp;Y, which issued an
unqualified "clean" opinion certifying those financial statements.
In Oct. 1996, AOL filed its Annual Report on Form 10-K for F96.
This report was signed by Case, Kimsey, Leader, Caufield, Haig and
Andress. The Form 10-K contained the same financial information
and statements as AOL's F96 Annual Report to Shareholders,
including Eamp;Y's clean, unqualified opinion.
126. On Oct. 29, 1996, just a few weeks after AOL issued its
F96 Annual Report and Form 10-K, AOL admitted that its practice of
deferring subscriber acquisition marketing costs was not justified
- 100 -
and that it would write off an astonishing $385 million in
previously capitalized costs and immediately expense them in the
future, resulting in a huge loss of $353 million/$3.80 per share
for the first quarter of F97 and a loss for all of F97 as well.
This write-off was so huge it literally blew a hole in AOL's
balance sheet -- wiping out the single largest asset on AOL's
balance sheet and reducing its shareholders' equity to $100 million
-- 80% less than the $512 million certified by Eamp;Y as fair,
accurate and in accordance with GAAP just a few weeks earlier! It
also more than wiped out all the reported profits AOL had reported
in its history as a public company, as the charge was five times
the reported pre-tax earnings actually reported by AOL over the
past five fiscal years! As a result, it is now clear that AOL had,
in fact, never made a profit (and it is likely it never will), and
the only shareholders' equity now remaining on AOL's balance sheet
results not from any profits AOL ever earned, but rather, only from
its prior sales of stock to the public for high, artificially
inflated prices in excess of the stock's par value.
127. After AOL's revelations and admissions of Oct. 29, 1996,
one analyst close to the Company stated "the stock has been a
nightmare," that AOL had had to "bite the bullet on its smoking
bomb of subscriber acquisition costs" and "will finally clean up
its balance sheet." Other analysts wrote that this "makes the
earnings numbers more indicative of what is really happening at
AOL" and "provides . . . a true earnings story for the stock," and
"reflects the realities of the market and . . . the true cost of
acquiring subscribers." Allan Sloan wrote an article in Newsweek
entitled "Profits? What Profits? AOL Reboots Its Books, And Its
- 101 -
Earnings Disappear." The article included a picture of Case,
captioned "What, me worry? Chairman Case's quest for profits has
so far proved illusory." The article stated that AOL had "wiped
out most of AOL's net worth, plus all the profits it claimed to
have made in its entire 11-year history" and "offers a classic
example of how investors can be burned by taking a company's
utterances at face value," concluding:
In case you missed it, here's what the fuss is
about. Until last week, AOL insisted on accounting for
its promotion expenses in an unrealistic way. Instead of
considering the costs a regular expense, as normal
companies do. AOL spread them over two years. This let
AOL report profits while spending much more money than it
took in.
Let's be specific. In its fiscal year ended June
30. AOL spent $363 million on promotion. That's a third
of its total revenues. However, AOL charged only $126
million of promotion costs against its profits. The
difference, $237 million, was lots more than the $65
million pretax profit AOL claimed. Thus, AOL was burning
cash even as it reported profits.
Now AOL has gotten accounting religion. The company
says it will henceforth charge its promotion expenses to
earnings as it spends the money, the way a normal company
does. In addition, AOL will take a special charge of
$385 million for "deferred" promotion costs. That's
money AOL had spent but hadn't charge against profits,
and is counted as an asset.
You have to love this. By deferring those costs,
AOL over the years reported profits $385 million greater
than they would otherwise have been -- which would have
been far enough below zero as to make the Arctic seem
tropical. AOL then used these nonexistent "profits" to
bill itself as a money-making company. That boosted its
stock price. Now AOL is taking a special charge,
suggesting that "it's just bookkeeping" and doesn't
really matter.
Nonsensical numbers: Forgive my gloating. But AOL
in essence is conceding that skeptics like me, who said
that AOL's accounting verged on fantasy, were right.
Please note that I'm not accusing AOL of illegality; its
outside accountants blessed everything. But the numbers
were nevertheless nonsensical.
- 102 -
AOL'S FALSE FINANCIAL STATEMENTS
128. In F96, in order to cover up AOL's slowing growth and the
increasingly adverse impact of its growing amortization expense due
to its prior capitalization of deferred subscriber costs, and to
mask the true escalating cost of obtaining new subscribers, its
increasing churn and declining subscriber retention rate, effective
July 1, 1995, AOL changed its already extremely aggressive practice
for accounting for subscriber acquisition costs to fraudulently
increase the period over which AOL amortized such costs against
earnings to 24 months, twice the period AOL had used to amortize
such costs when it went public in 1992. By this subterfuge AOL was
able to avoid writing off millions in previously deferred or
capitalized subscriber acquisition costs at year-end F95 and report
profitable operating income (before charges for acquisitions) in
each of the quarters ended Sept. 30, 1995, Dec. 31, 1995, Mar. 31,
1996 and the quarter and year ended June 30, 1996, instead of the
large operating losses it actually incurred in each of those
periods.
129. Ultimately, in late 1996, AOL realized it could no longer
continue the facade it had used to justify the capitalization of
those expenses -- i.e., an average subscriber life of 40+ months
and an average lifetime subscriber value of $700+ as its severe
subscriber "churn" and retention problems were having such an
increasingly adverse effect on its operating results that AOL had
to admit it could not forecast subscriber retention rates and
therefore, average subscriber life or lifetime revenue per
subscriber. Thus, AOL changed its accounting practice to expense
"subscriber acquisition costs" as incurred. As a result, AOL wrote
- 103 -
off $385 million to eliminate all subscriber acquisition costs it
had previously incurred but not expensed. This huge charge was
more than five times all the operating income AOL had ever
reported. AOL's improper accounting for subscriber acquisition
costs caused its financial statements for each quarter of F96 as
well as for the year-end F96 (which Eamp;Y had represented to conform
to GAAP) to be false and to be in violation of GAAP.
130. In each of its quarterly reports filed on Form 10-Q,
signed by defendants' Case and Leader, for the first, second and
third quarters of F96, AOL represented the following with regard to
its financial results for those quarters:
The accompanying unaudited condensed consolidated
financial statements . . . have been prepared in
accordance with generally accepted accounting principles
for interim financial information and with the Instruc-
tions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all of the information
and footnotes required by generally accepted accounting
principles for complete financial statements. In the
opinion of management, all adjustments, consisting only
of normal recurring accruals, considered necessary for a
fair presentation, have been included in the accompanying
unaudited financial statements.
With regard to AOL's F95 and F96 results, Eamp;Y represented in its
Report of Independent Auditors, in Aug. 1995 and Aug. 1996, that:
We have audited the accompanying consolidated
balance sheets of America Online, Inc. . . . and the
related consolidated statements of operations, changes in
stockholders' equity and cash flows . . . .
We conducted our audits in accordance with generally
accepted auditing standards. Those standards require
that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free
of material misstatement. An audit includes examining,
on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also
includes assessing the accounting principles used and
significant estimates made by management, as well as
evaluating the overall financial statement presentation.
- 104 -
We believe that our audits provide a reasonable basis for
our opinion.
In our opinion, the financial statements referred to
above present fairly, in all material respects, the
consolidated financial position of America Online, Inc.
. . . and the consolidated results of their operations
and . . . in conformity with generally accepted
accounting principles.
These statements were false and misleading as Eamp;Y had not performed
its audits in accordance GAAS and AOL's balance sheet and results
of operations were not fairly reported during F96 due to AOL's
improper capitalization and inadequate amortization of subscriber
acquisition costs, causing such financial statements to not be
presented in conformity with GAAP.
131. GAAP are those principles recognized by the accounting
profession as the conventions, rules and procedures necessary to
define accepted accounting practice at the particular time.
Regulation S-X (17 C.F.R. §210.4-01(a)(1)) states that financial
statements filed with the SEC which are not prepared in compliance
with GAAP are presumed to be misleading and inaccurate, despite
footnote or other disclosure.
132. During F96, AOL incurred more than $363 million in
advertising costs but recognized as an expense only $126 million
of this amount, some of which represented costs incurred in prior
years which were finally expensed in F96. GAAP, as set forth in
AICPA Statement of Position ("SOP") 93-7 (Reporting on Advertising
Costs), requires that advertising costs be expensed as incurred
unless such costs provide a discernible future benefit. If
advertising costs do clearly provide such a future economic
benefit, the costs may be deferred but must be amortized or
- 105 -
expensed over the period of time reasonably expected to be
benefitted by the cost.
133. Thus, SOP 93-7 states that costs of advertising should be
expensed as incurred with certain exceptions. SOP 93-7, ¶26. One
exception is direct-response advertising, which is limited to
advertising "(a) whose primary purpose is to elicit sales to
customers who could be shown to have responded specifically to the
advertising, and (b) that results in probable future [economic]
benefits . . . ." Id., ¶¶28 and 33. For interim periods, GAAP
reiterates this rule: "Advertising costs may be deferred within a
fiscal year if the benefits of an expenditure made clearly extend
beyond the interim period in which the expenditure is made."
Accounting Principles Board Opinion No. 28, ¶16(d).
134. GAAP, as set forth in SOP 93-7, also requires that an
entity set a reasonable period over which to amortize its
capitalized advertising costs. SOP 93-7 envisions a relatively
short period of time over which advertising costs should be
amortized. SOP 93-7.72: "The response to advertising usually
occurs shortly after the advertising takes place, but in mail-order
catalogue advertising, for example, it can take place over a longer
period." SOP 93-7, ¶74 states:
AcSEC [an authoritative Accounting Committee] concluded
that it should not arbitrarily limit the period over
which the direct-response advertising should be
amortized. However, AcSEC believes that the reliability
of accounting estimates decreases as the length of the
period for which such estimates are made increases.
Therefore, the period over which the benefits of direct-
response advertising are amortized often is no longer
than the greater of one year or one operating cycle.
However, under certain circumstances, such as those
discussed in paragraph .72, an entity may be able to
demonstrate that the duration of the probable future
- 106 -
benefits is greater than the longer of one year or one
operating cycle.
135. AOL's accounting practice of capitalizing its subscriber
acquisition costs (which AOL described as direct response
advertising) and writing them off over a 24-month amortization
period was a fraudulent contrivance and trick to allow AOL to
report profits rather than losses while its marketing/advertising
expenses were ballooning out of control, and the benefits of those
expenditures and their probable future economic benefits were
sharply diminished and highly doubtful and AOL's competitive
position and business position was weakening:
• AOL had no historical basis to believe that its
aggregate deferred subscriber acquisition cost would be
recovered in any reasonable period of time from aggregate
subscriber revenues, given AOL's true "churn" rate, its
low subscriber fees, increasing competition, the ability
of any AOL subscriber to cancel at will and without
penalty, and AOL's inability to generate significant non-
subscriber fee revenues from users. A "churn rate" of
20% was considered very serious at AOL and the "churn
rate" in 1995 and 1996 was as high as 60%.
• AOL's usage fees -- and thus the value to it of a
subscriber -- were falling sharply from $3.50 per hour to
$2.95 per hour in 1995 and to $1.00 per hour in May 1996.
• AOL's claimed average 40+ month subscriber life and
lifetime subscription/usage revenue of $700+ were bogus
figures, contrived by AOL to provide a justification for
its accounting artifices. Only a tiny fraction of AOL's
subscribers stayed for 40 months or longer and the
purported average was based not on historical experience,
but future expectations, which were unrealistic and
inconsistent with AOL's actual experience, especially
since AOL kept as counted subscribers persons who wanted
to cancel (by providing free trial periods or free usage
time) and persons who were not paying for that service.
AOL admittedly could not predict retention rate.
• AOL's management was aware of increasing competition
from other internet service providers and this
competition was a matter of serious and frequent
discussion among AOL's upper-management, such that AOL
internally recognized that changing market forces put the
reliability of AOL's projections in serious question.
- 107 -
Due to the increased competition and the changing
conditions of AOL's market, AOL's upper-management knew
that public projections of future revenues from
subscribers were extremely uncertain.
• AOL had come to the conclusion during 1995 that it
could not rely on user fees from subscribers to generate
sufficient revenue and that it desperately needed other
sources of revenue to survive. Mayer Berlo was hired as
Vice President to run the National Accounts' Department
in the fall of 1995. Shortly thereafter, the focus of
the National Accounts' Department changed to generating
revenues from advertising, as opposed to its prior focus
on obtaining interested content providers to attract as
many subscribers as possible.
• AOL's insiders were well aware that the existing
data about subscriber usage did not support their
capitalization of subscriber acquisition costs. In an
effort to conceal this, in June of 1995, AOL began
restricting the access of lower level AOL personnel to
the subscriber usage information and changed the reports
which showed such information to delete references to
"churn rates," usage hours, and sessions per user.
• AOL was aware that the subscriber numbers which was
reported to the public and which was purportedly a basis
for the capitalization of amortization of deferred
subscriber acquisition costs, were unreliable at best.
AOL knew that it had many fake accounts started by
individuals using multiple free disks. AOL's management
instructed employees to not remove fake accounts from the
subscriber counts. AOL also knew that it had been paying
bounties as high as $25 per subscriber for subscriptions
by employees of major advertising accounts such as:
Century 21 Realty, TWR, and ERA Realty which had paid up
front payments for companies to use AOL's service. AOL
knew that subscribers who were employees of these
accounts were being counted in the subscriber numbers,
but were not paying customers.
• AOL's reported average subscriber life of 41 months
was based on a premise that AOL knew was false, i.e.,
that the relatively tiny portion of its subscriber base
which had been with AOL for more than 18 months was
representative of the new subscribers AOL was acquiring
during F95 and F96. AOL knew that its newer subscribers
were not the heavy on-line service users who had earlier
signed up with AOL (and who generated significant monthly
fees) nor were the new subscribers as likely to spend the
same number of money hours of their lives on-line. AOL
also knew that many of these newer subscribers were most
interested in e-mail services which, after the initial
free trial period, these subscribers could obtain
elsewhere for much lower fees.
- 108 -
• Because AOL's service was a month-to-month arrange-
ment with no long-term subscriber commitment (unlike a
magazine subscriber where a subscriber pays $x for a 36-
month subscription period and no penalty for
cancellation), AOL had no reasonable basis to believe,
given increasing competition and greater free Internet
access, that AOL subscribers would on average remain as
subscribers long enough and spend enough to ever recover
AOL's average new net subscriber expenditures.
• AOL was concealing its true increasingly high
"churn" rate and falsifying its average subscriber life
and lifetime revenue through various illicit, secret
practices. AOL allowed thousands of subscribers to
remain subscribers even though they were delinquent in
paying their accounts. Also, when trial subscribers
notified AOL they wanted to cancel the service at the end
of their free "trial period," AOL permitted them to take
additional free trial periods, and AOL was permitting
persons to repeatedly sign up as trial subscribers
without becoming paying subscribers and was giving
persons who signed up extra hours of free usage time not
to quit as subscribers -- practices which were inconsis-
tent with the studies AOL had used to justify AOL's
deferral of hundreds of million of dollars in subscriber
acquisition costs.
• AOL however did not want to pay taxes on the phony
profits it was generating on its publicly distributed
financial statements by its accounting tricks. Thus, on
AOL's tax returns, AOL expensed 100% of its subscriber
acquisition advertising and marketing expenditures as
incurred -- an accounting treatment that was completely
inconsistent with its accounting practice in its public
financial statements. As a result, AOL reported large
losses on tax returns and avoided paying taxes on the
phantom profits its accounting artifices were creating
for its publicly disseminated financial statements.
136. AOL's capitalization, as opposed to expensing, of certain
of its advertising costs, as well as the two-year amortization
period it used during fiscal 1996, was also improper considering
the nature and trends in AOL's business:
(a) AOL's "subscribers" did not make any commitment to
use AOL's service over any extended length of time. In fact, once
many of AOL's customers used their free trial time of 10 to 15
hours on AOL and then used the service for a month or two, they
- 109 -
would then change over to a less expensive service. AOL was losing
a third to a half of its customers every quarter.
(b) AOL was spending more and more money to get
subscribers who were spending less and less. In February 1996, AOL
had to extend the free trial time from 10 hours to 15 hours to
compete with Prodigy which offered 20 hours and CompuServe which
offered a free month. At the same time, AOL's newest subscribers
were more marginal customers (i.e., not heavy users) who were less
likely to generate significant monthly revenues to AOL.
(c) AOL had no reasonable historic basis to estimate the
amount of time its customers would remain subscribers of AOL or the
amount of money its customers would pay to AOL in the future. As
of June 30, 1995, less than a quarter of AOL's customers had been
with AOL for even one year.
(d) AOL was suffering from free-trial-time churning in
which recipients of free-trial-time disks would use multiple free
trials without ever paying AOL anything.
(e) AOL was experiencing dramatic decreases in prices,
thereby decreasing the revenues AOL would receive from each
subscriber and making the recovery of subscriber acquisition costs
more uncertain. Whereas AOL had been charging $3.95 per hour in
1994, this decreased to $2.95 per hour in 1995 and to $1.00 per
hour in May 1996.
137. Despite these factors, AOL continued to capitalize the
advertising costs and even lengthened the time over which it
amortized the costs against earnings in F96. Had AOL not used its
practice of capitalizing "subscriber acquisition costs" its income
- 110 -
from operations (excluding charges for acquisitions) would have
been much different than those reported, particularly during F96:
America Online, Inc.
Operating Income Comparison
Excluding Special Charges
138. The chart below shows what AOL's net income and EPS would
have been in F96 had AOL properly accounted for its subscriber
costs:
America Online, Inc.
Amounts in thousands except EPS
EPS adjusted for 10/95 split
RESULTS AS REPORTED - EXCLUDING CHARGES FOR PURCHASED R&D
9/30/95 12/31/95 3/31/96 6/30/96 F96
Revenues $197,865 $249,145 $312,340 $334,467 $1,093,875
Operating Income 10,875 16,089 24,720 32,332 68,839
Net Income 6,719 10,590 15,127 16,066 47,805
Earnings Per Share 0.08 0.10 0.14 0.15 0.47
- 111 -
RESULTS IF SUBSCRIBER ACQUISITION COSTS NET DEFERRED/AMORTIZED
9/30/95 12/31/95 3/31/96 6/30/96 F96
Revenues $197,865 $249,146 $312,340 $334,487 $1,093,875
Operating Income -44,651 -40,558 -63,493 -4,234 -153,633
Net Income -24,209 -24,335 -38,096 -2,540 -89,180
Earnings Per Share -0.36 -0.23 -0.34 -0.02 -0.95
139. AOL also reported false balance sheet financial
information during F96 in which both assets and shareholders'
equity were overstated by hundreds of millions of dollars. FASB
Statement of Concepts ("CONCEPTS") No. 6, ¶¶25-26 state:
Assets are probable future economic benefits obtained or
controlled by a particular entity as a result of past
transactions or events.
An asset has three essential characteristics: (a) it
embodies a probable future benefit that involves a
capacity, singly or in combination with other assets, to
contribute directly or indirectly to future net cash
inflows, (b) a particular entity can obtain the benefit
and control others' access to it, and (c) the transaction
or other event giving rise to the entity's right to or
control of the benefit has already occurred.
140. Moreover, CONCEPTS No. 5, ¶87 states in part:
An expense or loss is recognized if it becomes evident
that previously recognized future economic benefits of an
asset have been reduced or eliminated . . . .
141. AOL and its insiders knew that the hundreds of millions
of dollars of deferred subscriber acquisition costs reported on its
balance sheets as of Sept. 30, 1995, Dec. 31, 1995, Mar. 31, 1996
and June 30, 1996, did not represent the economic future benefit
AOL would realize due to: (1) the high "churn" rate AOL was
experiencing with its subscribers; (2) the limited commitment AOL's
subscribers made to continue using AOL; and (3) the dispropor-
tionately high cost AOL was paying (and capitalizing as an asset)
for each new subscriber. Nevertheless, in order to overstate
assets and earnings, AOL reported the costs as an asset, rather
- 112 -
than as an expense, in each quarter during F96, thereby overstating
total assets in each quarter by more than 33%.
142. AOL also overstated its shareholders' equity due to the
accumulated earnings credited to AOL's retained earnings account
through AOL's improper capitalization and inadequate amortization
of subscriber acquisition costs.
143. AOL's falsification of its balance sheet was a violation
of the basic GAAP precept that financial information be presented
in a manner that is useful to readers. CONCEPTS No. 1, ¶34:
Financial reporting should provide information that is
useful to present and potential investors and creditors
and other users in making rational investment, credit,
and similar decisions.
CONCEPTS No. 1, ¶¶40-41:
Financial reporting should provide information about the
economic resources of an enterprise, the claims to those
resources (obligation of the enterprise to transfer
resources to other entities and owners' equity), and the
effects of transactions, events, and circumstances that
change resources and claims to those resources.
Financial reporting should provide information about an
enterprise's economic resources, obligations, and owners'
equity. That information helps investors, creditors, and
others identify the enterprise's financial strengths and
weaknesses and assess its liquidity and solvency.
As a result, AOL's F96 financial statements did not accurately or
fairly report its results of operations in accordance with GAAP,
due to this deferring of expenses of acquiring subscribers, and
then expensing these costs over two years. Such costs should have
been charged against earnings as incurred as AOL was unable to
project a future economic benefit from these costs with any degree
of certainty. By this practice, AOL and Eamp;Y turned its actual
losses into reported profits.
- 113 -
144. AOL's insiders and Eamp;Y realized that their distortion of
AOL's financial results could not continue forever, particularly
since the actual rate of churn and subscriber loss was continuing
to increase and AOL's ability to maintain the subterfuge of long
subscriber life and substantial economic value was impossible and
having an increasingly adverse affect on AOL's operating results.
Thus, AOL was forced to change its accounting practice for
subscriber acquisition costs in Oct. 1996 to expense them as
incurred, and to write off the more than $385 million in
advertising costs AOL had incurred in the past but had not
recognized as an expense and had treated instead as an asset. AOL
admitted that it could not forecast subscriber retention rates and
that "the Company believes it no longer has an adequate accounting
basis to support recognizing deferred subscriber acquisition costs
as an asset."
145. When AOL announced the large charge of $385 million, it
stated that it was "as a result of a change in accounting
estimate." In essence, AOL was asserting that facts and
circumstances had changed so significantly within two months from
the time AOL and Eamp;Y asserted that AOL's June 30, 1996 financial
statements complied with GAAP, that AOL could no longer justify
deferring subscriber acquisition costs. AOL effectively asserts
that it wrote-off a full one-third of its assets due to a change in
estimate. Considering that AOL operates in an industry that has
been under constant change, AOL's position that the facts,
circumstances, and/or uncertainties changed so significantly in
October of 1996, to justify the elimination of one-third of its
- 114 -
reported assets from two months earlier, flies in the face of
reason.
146. Accounting Principles Board Opinion ("APB") No. 20,
Accounting Changes, defines the term "accounting change" as a
change in either accounting principle, accounting estimate, or
reporting entity. AOL asserted that the write-off was the result
of a change in "estimate" as opposed to change in principle.
According to APB No. 20, a change in estimate is the result of new
events, more experience, or when additional information is
obtained. Had AOL acknowledged that the charge was the result of
a change in accounting principle, it would have had to also
acknowledge that the new accounting principle it was using was
"preferable" to the accounting principle it used before i.e.,
capitalizing, amortizing, subscriber acquisition costs. Rather
than acknowledge this, AOL chose to categorize the change as a
change in estimate, which misrepresents AOL's business and
practices and the extremely uncertain environment AOL has operated
in since inception. Effective July 1, 1995, AOL had increased the
period for amortizing subscriber acquisition costs from 12 and 18
months to 24 months. Then less than fourteen months later, AOL
changed its method to expense all subscriber acquisition costs
representing a 180-degree reversal from the previous year. Such
erratic actions cannot be justified by categorizing such changes as
changes in estimates. GAAP states that consistency in the
application of accounting principles is important. APB No. 20,
states in part:
"The board concludes that in preparation of financial
statements, there is a presumption that an accounting
principle once adopted should not be changed in
- 115 -
accounting for events and transactions of similar type.
Consistent use of accounting principles from one
accounting period to another enhances the utility of
financial statements to users by facilitating analysis
and understanding of comparative accounting data."
147. AOL's penchant for distorting its reported operating
results is further illustrated by its actions in the quarter ended
Sept. 30, 1996, when it finally changed its accounting practice for
subscriber acquisition costs. In that quarter, AOL continued to
capitalize subscriber acquisition costs in order to misrepresent
its operating margins, excluding the charge. In this way, AOL was
able to mitigate the impact of the large charge to earnings which
had effectively eliminated all the earnings AOL had ever reported,
by reporting an operating profit and EPS for that quarter.
148. AOL had concluded, prior to reporting its 1Q F97 results,
that it "did not have an adequate basis to support recognizing"
such subscriber acquisition costs as an asset, and that such costs
should be charged against earnings as an operating expense when
incurred. Nevertheless, In the very same quarter, AOL capitalized
as an asset more than $130 million in subscriber acquisition costs,
the most AOL had ever capitalized in any one quarter. AOL then
included these additional costs in the $385 million write-off of
unamortized subscriber acquisition costs.
149. In this way, AOL was able to report earnings, for 1Q F97,
before the charge, which were in line with estimates. AOL falsely
reported earnings from operations of $19 million or $.17 per share
for 1Q F97. Had AOL accounted for subscriber acquisition costs in
the method which it had acknowledged was appropriate (to charge
such costs against earnings as the costs were incurred), it would
- 116 -
have reported a loss from operations exceeding $50 million, or $.45
per share for 1Q F97.
AOL'S AND ITS INSIDERS' STOCK SALES
150. While AOL's insiders were issuing false and misleading
statements about AOL's business, the AOL insiders named as
defendants sold 2,130,500 shares of the AOL stock they owned for
proceeds of about $96 million to profit from the artificial
inflation in AOL's stock price their fraud had created, in most
instances selling large portions of the shares they owned or had
acquired via the exercise of options during the Class Period.
Notwithstanding their access to non-public information as a result
of their positions with the Company, the Individual Defendants sold
the following amounts of AOL shares at artificially inflated prices
throughout the Class Period while in possession of material non-
public information:
SHARES
NAME DATE SHARES PRICE PROCEEDS PURCHASED PRICE HOLDINGS
Andress, J. 02/09/96 8,000 $50.41 $ 403,280 8,000 $ 1.98
02/09/96 25,000 $50.50 1,262,500 25,000 $ 1.98
04/08/96 16,000 $53.44 855,040 16,000 $ 7.23
04/08/96 11,000 $53.44 587,840 11,000 $ 1.98
04/08/96 40,000 $53.44 $2,137,600 40,000 $ 8.07 800
Subtotals: 100,000 $5,246,260 100,000
Percentage of Shares Sold: 99%
Brandt, J. 11/30/95 637 $15.30
12/01/95 10,000 $39.50 $ 395,000 10,000 $ 6.95
12/01/95 10,000 $39.50 395,000 10,000 $ 2.92
02/13/96 6,000 $49.38 296,280 6,000 $ 6.95
02/22/96 6,000 $54.50 $ 327,000 6,000 $ 6.95 4,113
Subtotals: 32,000 $1,413,280 32,637
Percentage of Shares Sold: 89%
Case, S. 11/15/95 40,000 $38.45 $ 1,538,000 40,000 $ 2.92
11/16/95 20,000 $39.69 793,800 20,000 $ 2.92
11/17/95 30,000 $39.26 1,177,800 30,000 $ 2.92
11/29/95 5,000 $40.13 200,650 5,000 $ 2.92
12/01/95 5,000 $39.50 197,500 5,000 $ 2.92
02/09/96 65,000 $50.50 3,282,500 65,000 $ 2.92
02/09/96 35,000 $50.77 1,776,950 35,000 $ 2.92
03/15/96 100,000 $54.23 5,423,000 100,000 $ 2.92
- 117 -
05/21/96 200,000 $53.01 10,602,000 200,000 $ 2.92
06/03/96 75,000 $55.00 $ 4,125,000 75,000 $ 2.92 186,556
Subtotals: 575,000 $29,117,200 575,000
Percentage of Shares Sold: 76%
Caufield 11/17/95 6,000 $39.19 $ 235,140 6,000 $ 1.12
11/17/95 12,000 $39.00 468,000 12,000 $ 1.12
11/17/95 2,000 $39.38 78,760 2,000 $ 1.12
06/12/96 28,200 $46.88 $1,322,016 28,200 $ 1.12 0
Subtotals: 48,200 $2,103,916 48,200
Percentage of Shares Sold: 100%
Cole, D. 11/16/95 40,000 $39.72 $1,588,800 40,000 $ 6.95
02/09/96 17,100 $51.00 $ 872,100 17,100 $ 6.95 16,976
Subtotals: 57,100 $2,460,900 57,100
Percentage of Shares Sold: 77%
Connors, M. 11/16/95 10,000 $39.25 $ 392,500 10,000 $ 1.62
11/17/95 10,000 $39.56 395,600 10,000 $ 1.62
11/28/95 10,000 $36.19 361,900
11/29/95 5,000 $38.75 193,750
11/29/95 5,000 $39.96 199,800
11/30/95 638 $15.30
11/30/95 10,000 $40.38 403,800
12/01/95 10,000 $39.50 395,000 10,000 $ 1.62
02/09/96 20,000 $50.75 1,015,000 20,000 $ 1.62
02/15/96 8,300 $53.55 444,465 8,300 $ 1.62
04/17/96 61,408 $ 3.25
05/21/96 5,000 $53.38 266,900 5,000 $ 1.62
05/31/96 309 $31.55
06/03/96 5,000 $54.94 $ 274,700 5,000 $ 1.62 65,619
Subtotals: 98,300 $4,343,415 130,655
Percentage of Shares Sold: 60%
Davies, J. 11/30/95 637 $15.30
02/15/96 23,300 $53.54 $1,247,482 23,300 $ 4.43 3,175
Subtotals: 23,300 $1,247,482 23,937
Percentage of Shares Sold: 88%
Gilburne 02/14/96 5,000 $50.88 $ 254,400 5,000 $ 0.06
02/14/96 11,000 $51.00 561,000 11,000 $ 0.06
05/22/96 23,056 $49.88 1,150,033 23,056 $13.62
05/22/96 900 $49.88 44,892 900 $13.62
05/22/96 1,044 $49.88 $ 52,075 1,044 $ 0.06 0
Subtotals: 41,000 $2,062,400 41,000
Percentage of Shares Sold: 100%
Haig, A. 11/30/95 12,500 $41.13 $ 514,125 12,500 $ 1.12
12/01/95 7,500 $41.00 307,500 7,500 $ 1.12
03/15/96 7,200 $54.63 393,336 7,200 $ 1.12
03/15/96 19,000 $54.25 1,030,750 19,000 $ 1.12
03/15/96 1,000 $54.50 $ 54,500 1,000 $ 1.12 0
Subtotals: 47,200 $2,300,211 47,200
Percentage of Shares Sold: 100%
Hanlon, R. 02/13/96 5,000 $50.88 $ 254,400 5,000 $13.62
02/15/96 1,000 $54.38 $ 54,380 1,000 $13.62 0
Subtotals: 6,000 $ 308,780 6,000
Percentage of Shares Sold: 100%
Kimsey, J. 10/13/95 400,000 $29.19 $11,676,000 400,000 $ 0.25
02/09/96 1,000 $51.25 51,250
02/09/96 30,000 $51.00 1,530,000 30,000 $ 0.25
02/09/96 10,000 $50.50 505,000 20,000 $ 0.25
02/09/96 5,000 $50.00 250,000 5,000 $ 0.25
02/09/96 15,000 $50.77 761,550 15,000 $ 0.25
- 118 -
02/15/96 5,000 $52.25 261,250 5,000 $ 0.25
02/15/96 5,000 $53.25 266,250 5,000 $ 0.25
02/22/96 5,000 $54.00 270,000 5,000 $ 0.25
02/23/96 5,000 $55.38 276,900 5,000 $ 0.25
03/15/96 15,000 $54.00 810,000 15,000 $ 0.25
03/15/96 5,000 $54.13 270,650 5,000 $ 0.25
05/21/96 25,000 $53.00 1,325,000 25,000 $ 0.25
05/21/96 25,000 $53.50 1,337,500 25,000 $ 0.25
05/21/96 5,000 $53.38 266,900 5,000 $ 0.25
05/22/96 5,000 $50.00 250,000 5,000 $ 0.25
05/23/96 2,500 $51.50 128,750 2,500 $ 0.25
05/24/96 5,000 $51.75 258,750 5,000 $ 0.25
05/24/96 7,500 $51.50 386,250 7,500 $ 0.25
05/24/96 5,000 $51.00 255,000 5,000 $ 0.25
05/28/96 2,500 $54.00 135,000 2,500 $ 0.25
05/28/96 12,500 $52.25 653,125 12,500 $ 0.25
05/29/96 5,000 $54.50 272,500 5,000 $ 0.25
06/13/96 30,000 $46.93 1,407,900 30,000 $ 0.25
06/14/96 20,000 $45.00 $ 900,000 20,000 $ 0.25 143,808
Subtotals: 651,000 $24,505,525 660,000
Percentage of Shares Sold: 82%
Kirsh, E. 11/29/95 10,000 $39.00 $ 390,000 10,000 $ 5.78
11/30/95 539 $15.30
11/30/95 2,500 $41.00 102,500 2,500 $ 5.78
11/30/95 7,500 $41.13 308,475 7,500 $ 5.78
02/15/96 7,250 $53.56 $ 388,310 7,250 $ 5.78 2,653
Subtotals: 27,250 $1,189,285 27,789
Percentage of Shares Sold: 91%
Korn, M. 11/30/95 424 $15.30
11/30/95 10,000 $40.88 $ 408,800 10,000 $ 2.92
02/22/96 7,150 $54.50 $ 389,675 7,150 $13.62 2,742
Subtotals: 17,150 $ 798,475 17,574
Percentage of Shares Sold: 86%
Leader, L. 11/15/95 2,000 $40.00 $ 80,000 2,000 $ 0.12
11/16/95 6,000 $39.81 238,860 6,000 $ 0.25
11/16/95 6,000 $38.50 231,000 6,000 $ 0.12
11/16/95 10,000 $39.88 398,800 10,000 $ 0.25
11/29/95 8,000 $39.63 317,040 8,000 $ 0.12
11/29/95 5,000 $40.00 200,000 5,000 $ 0.25
11/29/95 5,000 $39.00 195,000 5,000 $ 0.25
11/29/95 5,000 $40.13 200,650 5,000 $ 0.25
11/30/95 2,000 $41.13 82,260 2,000 $ 0.12
11/30/95 638 $15.30
11/30/95 2,000 $41.00 82,000 2,000 $ 0.12
11/30/95 2,500 $41.00 102,500 2,500 $ 0.25
11/30/95 4,000 $41.13 164,520 4,000 $ 0.25
12/01/95 2,500 $40.00 100,000 2,500 $ 0.25
02/09/96 5,000 $50.77 253,850 5,000 $ 0.25
02/09/96 5,000 $51.00 255,000 5,000 $ 0.25
02/09/96 5,000 $50.00 250,000 5,000 $ 0.25
02/09/96 5,000 $51.25 256,250 5,000 $ 0.25
02/09/96 15,000 $50.75 761,250 15,000 $ 0.25
02/09/96 8,000 $50.69 405,520 8,000 $ 0.25
02/09/96 10,000 $50.50 505,000 10,000 $ 0.25
02/15/96 4,800 $52.94 254,112 4,800 $ 0.25
03/01/96 22,416 $ 3.25
03/01/96 24,000 $ 1.12
05/14/96 22,416 $ 3.25
05/21/96 10,000 $53.38 533,800 10,000 $ 0.25
05/22/96 20,000 $49.25 985,000
05/22/96 6,800 $49.13 334,084 6,800 $ 2.92
05/22/96 5,000 $49.50 247,500
05/22/96 5,000 $50.13 250,650
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05/22/96 8,200 $49.13 402,866 8,200 $ 0.25
05/22/96 5,000 $50.25 251,250
05/23/96 5,000 $50.13 250,650
05/24/96 18,000 $51.50 927,000
05/24/96 5,000 $51.50 257,500
05/28/96 2,500 $54.00 135,000 2,500 $ 2.92
05/28/96 2,500 $52.25 130,625 2,500 $ 2.92
05/31/96 $ 309 $31.55 106,799
Subtotals: 210,800 $10,039,537 217,579
Percentage of Shares Sold: 66%
Leonsis, T. 11/28/95 20,000 $35.50 $ 710,000 20,000 $ 7.62
11/29/95 20,000 $38.88 777,600 20,000 $ 7.62
11/30/95 637 $15.30
02/12/96 25,200 $50.31 1,267,812 25,200 $ 7.62
02/13/96 10,000 $50.04 500,400 10,000 $ 7.62
05/31/96 372 $31.55
05/31/96 4,800 $54.97 263,856 4,800 $ 7.62
05/31/96 19,200 $54.97 $1,055,424 19,200 $13.62 161,707
Subtotals: 99,200 $4,575,092 100,209
Percentage of Shares Sold: 38%
Seriff, M 11/16/95 20,000 $39.75 $ 795,000 20,000 $ 6.95
11/16/95 3,120 $39.75 124,020 3,120 $ 0.06
11/16/95 16,880 $39.75 670,980 16,880 $ 2.92
12/18/95 500 $ 0.06
12/18/95 $ 14,000 $ 0.06 70,500
Subtotals: 40,000 $1,590,000 54,500
Percentage of Shares Sold: 36%
Villanueva 11/30/95 196 $15.30
11/29/95 6,000 $38.75 $ 232,500 6,000 $ 0.43
11/30/95 3,400 $41.00 139,400 3,400 $ 6.95
11/30/95 600 $41.00 24,600 600 $ 0.43
02/22/96 7,000 $52.88 $ 370,160 7,000 $ 6.95 1,436
Subtotals: 17,000 $ 766,660 17,196
Percentage of Shares Sold: 92%
Weil, A. 11/15/95 16,000 $38.74 $ 619,840
11/28/95 2,000 $35.63 71,260
11/30/95 510 $15.30
11/30/95 2,000 $41.13 82,260
02/14/96 15,000 $50.46 756,900
02/15/96 5,000 $52.75 $ 263,750 67,018
Subtotals: 40,000 $1,794,010 510
Percentage of Shares Sold: 37%
TOTALS: 2,130,500 $95,862,428 N/A N/A 72%
151. Defendants' sales of AOL stock during the Class Period
were unusual in timing and amount and inconsistent with their prior
transactions in AOL stock:
(a) During the entire Class Period, none of the
Individual Defendants purchased a single share of AOL stock on the
open market.
- 120 -
(b) In the 14-month period prior to the Class Period
from June 1994, i.e., Aug. 1995, the Individual Defendants sold
approximately 33,000 shares of AOL stock on an average per month,
compared to the 138,000 shares they sold per month during the Class
Period, 318% more than the monthly average over the prior 14
months.4 In terms of dollar volume, the difference in the insider
sales by the Individual Defendants is also dramatic. The average
aggregate monthly proceeds for the Individual Defendants' stock
sales in the 14-month period prior to Aug. 1995 were $1.87 million,
compared to the average $6.85 million they pocketed monthly from
their stock sales during the Class Period -- a 266% increase during
the Class Period.
(c) After the collapse of AOL's stock during July 1996
and in the succeeding 3 months ending Oct. 31, 1996, during which
time AOL has traded at prices far below the prices it traded at
during most of the Class Period when the Individual Defendants sold
2,130,500 shares for $95+ million, these same defendants have sold
not a single share of AOL stock.
(d) The stock sales by the Individual Defendants during
the Class Period were unusual in amount of shares sold and the
amount of sales proceeds in the aggregate as shown by the charts
below:
//
//
//
//
____________________
4 Not adjusted for the 2-1 split declared on October 31, 1995.
- 121 -
America Online, Inc.
Defendants' Stock Sales-Dollar Volume
Quarterly Stock Sales - March 1992 to December 1996
America Online, Inc.
Defendants' Stock Sales-Share Volume
Quarterly Stock Sales - March 1992 to December 1996
Includes stock sales by: Miles Gilburne, Alexander Haig,
Janice Brandt, Ellen Kirsch, Matthew Korn, Richard Hanlon,
James Andress, Lennert Leader, Theodore Leonsis, Stephen Case,
Michael Connors, Frank Caufield, James Kimsey, David Cole,
John Davies, Marc Seriff, Audrey Weil and Jean Villanueva.
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152. Also, during the Class Period, AOL completed the largest
stock offering in its history, selling more shares (4.9 million)
and raising more capital ($139 million) than ever before in its
existence as a public company.
Eamp;Y'S PARTICIPATION IN THE FRAUD
153. Eamp;Y, a firm of certified public accountants, was engaged
by AOL to provide independent auditing, accounting and consulting
services throughout the Class Period. Eamp;Y examined and certified
the financial statements of AOL for F95 and F96 ended June 30, 1995
and June 30, 1996. In addition, Eamp;Y reviewed AOL's interim
financial statements, in particular its financial statements for
the quarters ended Sept. 30, Dec. 31, and March 31 in each of those
years and its quarterly Form 10-Q filings. Eamp;Y represented in
AOL's F95 and F96 Forms 10-K that the financial statements of AOL
for those years fairly presented its financial condition and
results of operation in conformity with GAAP and had been audited
in accordance with GAAS.
154. As AOL grew rapidly it became a major client of Eamp;Y's
Virginia/Washington, D.C. offices -- and one of the firm's major
audit clients. The incomes of the Eamp;Y partners responsible for
this account benefited from this and they were determined to keep
AOL as a client for the firm, so that they would continue to
benefit economically. Eamp;Y participated in the wrongdoing alleged
herein in order to maintain its competitive position as to other
large accounting firms by retaining AOL as a client, protect and
enhance the substantial fees which it received from AOL, maintain
and increase its market share for auditing, accounting and
consulting services to be performed by its Washington, D.C. and
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Virginia offices, and increase the income received by the Eamp;Y
partners responsible for the AOL engagement, since their income was
directly tied to retaining accounting and auditing clients in the
Washington, D.C. and Virginia market.
155. In addition, during AOL's F95 and F96 years, the "Big
Six" accounting firms (led by Eamp;Y's Washington, D.C. office) and a
collection of high-tech public companies was engaged in a massive
publicity and lobbying campaign to get Congress to amend the
securities laws to make it more difficult for allegedly defrauded
investors to bring suit. AOL, as a high profile high-tech growth
company, was playing a prominent role in these efforts and, in part
at the request of Eamp;Y, Kimsey testified at a Congressional hearing
on the proposed legislation on Jan. 19, 1995 -- and supposedly
symbolized the unfair treatment which important high-tech
entrepreneurs were threatened with from class action suits for
violation of the federal securities laws. The campaign of the Big
Six accounting firms and the high-tech companies to secure passage
of this legislation continued until Dec. 22, 1995 when the
legislation was finally enacted. Thus, it would have been a major
embarrassment to both Eamp;Y and AOL and would have impaired their
legislative efforts, if at year-end F95 or during F96, AOL and Eamp;Y
had admitted AOL's accounting practices were bogus and AOL and Eamp;Y
had been inflating AOL's financial results while AOL and its
insiders were selling hundreds of millions of dollars in AOL stock
to the public at inflated prices.
156. In addition, Eamp;Y was not independent of AOL with respect
to its audit of AOL's deferred subscriber acquisition costs. This
was because Eamp;Y actually helped develop AOL's accounting practices
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of deferring these costs and helped AOL to develop the rationale of
a 40+-month average subscriber life and $700+ average subscriber
lifetime value used by AOL to justify their fraudulent accounting
artifice. Since Eamp;Y was in effect so intimately involved in
developing this accounting practice and its purported rationale,
Eamp;Y was then auditing or revising its own work and thus was not
independent.5
157. As a result of the services rendered to AOL, Eamp;Y's
personnel were present at AOL's corporate headquarters frequently
throughout the year and had continual access to, and knowledge of,
AOL's private and confidential corporate financial and business
information and thus knew of the true facts as alleged herein
concerning AOL's actual financial condition and business problems
which were concealed from the investing public.
158. (a) Defendant Eamp;Y conducted audit examinations and
participated in investigations into the business operations,
financial, accounting and management control systems of AOL. Eamp;Y
reviewed the Company's quarterly financial reports and
unqualifiedly certified that AOL's financial statements for the
years ended June 30, 1995 and 1996 fairly presented the Company's
financial position and results from operations in conformity with
GAAP and that said statements had been examined in accordance with
____________________
5 The SEC has stated that GAAS requires an auditor to "maintain
an unimpeachable independence from their client (General Standard
No. 2)." In re David J. Checkosky and Norman A. Aldrich, Exchange
Act Release No. 31094, [1991-1995 Transfer Binder] Fed. Sec. L.
Rep. (CCH) ¶73,871, at 63,128-29 (Aug. 26, 1992) ("During this
period, and continuing through 1984, Savin was reporting net
operating losses even as the balance of deferred start-up costs
grew. In these circumstances, an auditor clearly must bring the
highest degree of skepticism to management's representations
supporting deferral of costs.").
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GAAS. At the time Eamp;Y issued its unqualified opinion as to AOL's
F96 financial statements and consented to the use of its opinion on
AOL's F95 financial statements in the Oct. 95 Prospectus, it knew
or recklessly disregarded the facts set forth in ¶¶79, 96, 103,
123. Among other things, Eamp;Y knew that AOL's reported operating
income and net income were grossly overstated, because, inter alia:
(i) the Company was recording as an asset advertising costs for
which a future economic benefit was uncertain; and (ii) AOL's two-
year amortization period was unjustified and a contrivance to
artificially inflate AOL's reported results.
(b) Eamp;Y helped further the fraud complained of herein by
permitting AOL to continue to circulate copies of AOL's financial
statements, which Eamp;Y had certified, even though Eamp;Y knew or
recklessly disregarded the fact that they had not been prepared in
conformity with GAAP or audited in accordance with GAAS.
(c) Eamp;Y consented to the inclusion of its F95 audit
opinion in AOL's Registration and Prospectus filed pursuant to
AOL's Oct. 95 secondary offering knowing that AOL had changed,
effective July 1, 1995, the amortization period for deferred
subscriber acquisition costs to 24 months, which period Eamp;Y knew,
or recklessly disregarded, was not justified by AOL's internal
customer retention data.
(d) Eamp;Y reviewed AOL's interim financial statements for
the quarters ended Sept. 30, 1995, Dec. 31, 1995 and March 31, 1996
and knew of the material falsity of the quarterly reports filed
with the SEC reporting those results and containing those financial
statements.
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159. Eamp;Y knew that pursuant to GAAP, as set forth in SOP 93-7,
AOL was not permitted to defer advertising costs unless it could
demonstrate probable future revenues arising from that advertising
in excess of future costs to be incurred in realizing those
revenues. SOP 93-7, ¶37 states:
Demonstrating that direct-response advertising will
result in future benefits requires persuasive evidence
that its effects will be similar to the effects of
responses to past direct-response advertising activities
of the entity that resulted in future benefits. Such
evidence should include verifiable historical patterns of
results for that entity. Attributes to consider in
determining whether the responses will be similar include
(a) the demographics of the audience, (b) the method of
advertising, (c) the product, and (d) economic
conditions.
160. Despite Eamp;Y's knowledge of the appropriate accounting
pronouncements and its knowledge that AOL's records and experience
did not support capitalization of advertising costs, Eamp;Y not only
helped AOL develop a rationale to support capitalization of such
costs, it permitted AOL to continue to capitalize these costs and,
beginning July 1, 1995, to lengthen the amortization period to 24
months. Thus, Eamp;Y knew that AOL's financial statements for F96 did
not comply with GAAP and that Eamp;Y's audit was not undertaken in
accordance with GAAS, causing Eamp;Y's opinion letter for F96 to be
false and misleading.
161. Eamp;Y knew that AOL's audited financial statements for F96
and the quarterly reports issued during F96, which Eamp;Y reviewed,
were presented in a manner which violated the following GAAP, among
others:
(a) The principle that financial reporting should
provide information that is useful to present and potential
investors and creditors and other users in making rational
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investments, credit, and similar decisions (see CONCEPTS No. 1,
¶34);
(b) The principle of conservatism. Conservatism is a
prudent reaction to uncertainty to try to ensure that uncertainties
and risks inherent in business situations are adequately considered
(see CONCEPTS No. 2, ¶95);
(c) The principle of reliability. The quality of
information that assures that information is reasonably free from
error and bias and faithfully represents what it purports to
represent (see CONCEPTS No. 2);
(d) The principle that financial reporting should
provide information about how management of an enterprise has
discharged its stewardship responsibility to owners (stockholders)
for the use of enterprise resources entrusted to it. To the extent
that management offers securities of the enterprise to the public,
it voluntarily accepts wider responsibilities for accountability to
prospective investors and to the public in general (see CONCEPTS
No. 1, ¶50); and
(e) 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
accessing the prospects of an enterprise (see CONCEPTS No. 1, ¶42).
162. In connection with the work it performed for AOL, Eamp;Y:
(a) Examined, reviewed and/or participated in reviews,
investigations and audit procedures regarding AOL's financial
condition and operations. In the course of performing such
services, Eamp;Y either obtained, or recklessly disregarded,
evidential matter revealing the adverse facts about AOL's business
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and finances described at ¶¶79, 96, 103 and 123, and improperly
failed to require, or make disclosure of such facts. As a result
of its reviews and audit work, Eamp;Y knew that the AOL reports and
financial statements described in this Complaint were materially
misleading or recklessly disregarded facts which showed that such
statements were materially misleading;
(b) Knew or recklessly disregarded facts which indicated
that it should have (i) qualified its opinion on AOL's financial
statements for the year ended June 30, 1996, or (ii) withdrawn,
corrected or modified its opinion to recognize AOL's improper
accounting practices for subscriber acquisition costs on AOL F95
financial statements, or (iii) not have given an opinion in light
of the potentially materially adverse effects of the undisclosed
facts concerning AOL's operating income, net income, EPS and
shareholders' equity. The failure to make such a qualification,
correction, modification and/or withdrawal was a violation of GAAS,
including the Fourth Standard of Reporting; and
(c) Failed to require AOL to disclose material facts and
allowed AOL to make material misrepresentations regarding the
Company to its shareholders and to the investing public during the
Class Period.
163. In certifying AOL's F95 and F96 financial statements, Eamp;Y
represented that its examinations were made "in accordance with
Generally Accepted Auditing Standards." This statement was false
and misleading in that the audit conducted by Eamp;Y was deliberately
or recklessly not performed in accordance with GAAS in the
following respects:
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(a) Eamp;Y violated GAAS General Standard No. 3 that
requires that due professional care must be exercised by the
auditor in the performance of the audit and the preparation of the
report.
(b) Eamp;Y violated GAAS Standard of Field Work No. 2, that
requires the auditor to make a proper study of existing internal
controls, including accounting, financial and managerial controls,
to determine whether reliance thereon was justified, and if such
controls are not reliable, to expand the nature and scope of the
auditing procedures to be applied. Eamp;Y, knowing that the internal
controls were insufficient, failed to expand its auditing
procedures.
(c) Eamp;Y violated Standard of Field Work No. 3 that
requires sufficient, competent evidential matter to be obtained
through inspection, observation, inquiries and confirmations to
afford a reasonable basis for an opinion regarding the financial
statements under audit. As described above, Eamp;Y failed to obtain
sufficient, competent evidential materials as to the amounts of
AOL's advertising costs which were capitalized and as to the
correct valuation of AOL's assets.
(d) Eamp;Y violated GAAS Standard of Reporting No. 1 that
requires the audit report to state whether the financial statements
are presented in accordance with GAAP. Eamp;Y's opinion
inappropriately represented that AOL's financial statements
complied with GAAP, when they did not for the reasons herein
alleged.
(e) Eamp;Y also violated GAAS Standard of Reporting No. 3
that requires informative disclosures in the financial statements
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to be regarded as reasonably adequate unless otherwise stated in
the audit report. Here, the disclosures were not adequate. The
Notes to the financial statements failed to set forth appropriate
principles of accounting relating to the deferral of advertising
costs. The disclosures were further inadequate with respect to the
overstatement of AOL's earnings, assets and net worth. The audit
report of Eamp;Y failed to disclose that such disclosures or omissions
of material information, as heretofore alleged, rendered the
respective financial statements false and misleading.
(f) Eamp;Y violated GAAS Standard of Reporting No. 4 that
requires, when an opinion on the financial statements as a whole
cannot be expressed, that the reasons therefore be stated. Eamp;Y
should have stated that no opinion could be issued by it on AOL's
financial statements or issued an adverse opinion stating that the
financial statements were not fairly presented.
(g) Eamp;Y violated GAAS Standard of Field Work No. 1 and
the standards set forth in AICPA Auditing Standard ("AU") §§310,
320 and 327 by, among other things, failing to adequately plan its
audit and properly supervise the work of assistants so as to
establish and carry out procedures reasonably designed to search
for and detect the existence of errors and irregularities which
would have a material effect upon the financial statements.
(h) Eamp;Y violated Auditing Standard AU §316.16, in that
Eamp;Y failed to plan and perform its examination with an attitude of
professional skepticism in connection with the year-end F95 and F96
audits.
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(i) Eamp;Y violated Auditing Standard AU §316.25 which sets
forth the steps an auditor should take upon suspecting accounting
irregularities. AU §316.25 states:
If the auditor has determined that an audit adjustment
is, or may be, an irregularity and has either determined
that the effect could be material or has been unable to
evaluate potential materiality, the auditor should-
a. Consider the implications for other aspects of
the audit.
b. Discuss the matter and the approach to further
investigation with an appropriate level of management
that is at least one level above those involved.
c. Attempt to obtain sufficient competent eviden-
tial matter to determine whether, in fact, material
irregularities exist and, if so, their effect.
(j) Eamp;Y violated Auditing Standard AU §316.28 which
requires auditors communicate reportable irregularities
(intentional misstatement) to the audit committee of companies when
Eamp;Y became aware of irregularities and failed to communicate these
to the audit committee:
(i) AU §316.28 states that irregularities involving
senior management should be reported directly to the audit
committee; and
(ii) Eamp;Y knew, or should have known, that AOL had
recorded as assets advertising costs for which any future economic
benefit was uncertain and that AOL was improperly amortizing these
costs over two years. Eamp;Y knew that this type of deferral of
expenses was inappropriate and forbidden under SEC rules. Eamp;Y,
however, failed to fully communicate these matters to the audit
committee in violation of GAAS.
(k) Moreover, Eamp;Y violated Auditing Standard AU §722
which requires that auditors assure that the audit committee be
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made aware of, and respond appropriately to, any irregularities
(intentional misstatements) the auditor discovers as part of a
review of interim financial information to be filed with a
regulatory agency, such as the SEC:
(i) AU §722.21-22 states:
If, in the accountant's judgment, management does not
respond appropriately to the accountant's communication
within a reasonable period of time, the accountant should
inform the audit committee, or others with equivalent
authority and responsibility (hereafter referred to as
the audit committee), of the matters as soon as
practicable. This communication may be oral or written.
If information is communicated orally, the accountant
should document the communication in appropriate
memoranda or notations in the working papers.
If, in the accountant's judgment, the audit committee
does not respond appropriately to the accountant's
communication within a reasonable period of time, the
accountant should evaluate (a) whether to resign from the
engagement related to the interim financial information,
and (b) whether to remain as the entity's auditor or
stand for reelection to audit the entity's financial
statements. The accountant may wish to consult with his
or her attorney when making these evaluations.
(ii) Eamp;Y knew at the time it reviewed AOL's Sept.
30, Dec. 31 and Mar. 31, F96 financial statements, that the
deferral of advertising costs and 24-month amortization period did
not reflect AOL's true financial condition but failed to assure
itself that the audit committee responded appropriately.
(l) Eamp;Y violated the Second General Auditing Standard
which requires the auditor maintain independence in mental attitude
in all matters related to an assignment. AU §220.01. Eamp;Y actually
helped to develop AOL's accounting practice of deferring direct
subscriber acquisition costs, including helping AOL to develop the
rationales and projections it used to justify that accounting
practice. As a result, Eamp;Y was not independent with respect to
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auditing or reviewing AOL's financial statements or opining
thereon, as Eamp;Y was, in effect, auditing its own work and had a
stake in justifying the correctness of an accounting practice, and
its underlying justifications, it had helped create. Eamp;Y rendered
a materially false opinion on AOL's F95 and F96 financial
statements for the F95 and F96 years ended June 30, 1995 and 1996,
respectively. Eamp;Y also participated in making false statements
about AOL's financial results for each of the interim quarters of
F96, ended Sept. 30, 1995, Dec. 31, 1995 and March 31, 1996, by
reviewing the interim financial statements contained therein,
knowing of or recklessly disregarding their falsity, including the
false statement that the amortization period for such costs had
been lengthened to 24 months in F96 "based on the Company's
historical average customer life expectancy" and "to more
appropriately match subscriber acquisitions costs." Alternatively
Eamp;Y over-relied on management representations and failed to obtain
sufficient competent evidence to test management assertions
regarding subscriber life and value.
164. Eamp;Y's opinion which represented that AOL's financial
statements were presented in conformity with GAAP was false and
misleading because Eamp;Y knew or was reckless in not knowing that
AOL's financial statements violated the principles for fair
reporting and GAAP.
165. In violation of these principles, Eamp;Y certified AOL's
financial statements even though Eamp;Y was aware that during all of
F96, AOL was employing a method of accounting for its advertising
costs (subscriber acquisition costs) that violated GAAP and caused
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AOL's financial statements not to accurately reflect its results of
operations nor its assets and liabilities and owner's equity.
166. In the course of rendering its unqualified audit
certification on the F96 financial statements of AOL, Eamp;Y knew it
was required to adhere to each of the herein described standards
and principles of GAAS, including the requirement that the
financial statements comply in all material respects with GAAP.
Eamp;Y, in issuing its unqualified opinion, knew that by doing so it
was engaging in gross departures from GAAS, thus making its
opinions false, and issued such certification with reckless
disregard of whether or not GAAS was being complied with.
167. As a result of its failure to accurately report on AOL's
financial statements, Eamp;Y failed in its role as an auditor as
defined by the SEC. SEC Accounting Series Release No. 296 states
in part:
Moreover, the capital formation process depends in
large part on the confidence of investors in financial
reporting. An investor's willingness to commit his
capital to an impersonal market is dependent on the
availability of accurate, material and timely information
regarding the corporations in which he has invested or
proposes to invest. The quality of information
disseminated in the securities markets and the continuing
conviction of individual investors that such information
is reliable are thus key to the formation and effective
allocation of capital. Accordingly, the audit function
must be meaningfully performed and the accountants'
independence not compromised. The auditor must be free
to decide questions against his client's interests if his
independent professional judgment compels that result.
CLAIM FOR RELIEF I
Section 10(b) Of The Exchange Act
And Rule 10b-5 Against All Defendants
168. Plaintiffs incorporate by reference ¶¶1-166.
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169. Each of the defendants: (a) knew or had access to the
material adverse non-public information about AOL's financial
results and then existing business conditions, which was not
disclosed; and (b) participated in drafting, reviewing and/or
approving the misleading statements, releases, reports and other
public representations of and about AOL.
170. During the Class Period, defendants, with knowledge of or
reckless disregard for the truth, disseminated or approved the
false statements specified above, which were misleading in that
they contained misrepresentations and failed to disclose material
facts necessary in order to make the statements made, in light of
the circumstances under which they were made, not misleading.
171. Defendants have violated §10(b) of the Exchange Act and
Rule 10b-5 promulgated thereunder in that they: (a) employed
devices, schemes and artifices to defraud; (b) made untrue
statements of material facts or omitted to state material facts
necessary in order to make statements made, in light of the
circumstances under which they were made, not misleading; or
(c) engaged in acts, practices and a course of business that
operated as a fraud or deceit upon the purchasers of AOL stock
during the Class Period.
172. Plaintiffs and the Class have suffered damage in that, in
reliance on the integrity of the market, they paid artificially
inflated prices for AOL stock. Plaintiffs and the Class would not
have purchased AOL stock at the prices they paid, or at all, if
they had been aware that the market prices had been artificially
and falsely inflated by defendants' false and misleading
statements.
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CLAIM FOR RELIEF II
Section 20(a) Of The Exchange Act
Against Defendants AOL, Case, Kimsey And Leader
173. Plaintiffs incorporate by reference ¶¶1-171.
174. Case, Kimsey and Leader acted as controlling persons of
AOL within the meaning of §20 of the Exchange Act. By reason of
Case and Kimsey's positions as co-founders of AOL and as Chairman
Emeritus, Chairman of the Board and/or CEO of AOL, and Leader's
position as CFO and Treasurer, they had the power and authority to
cause AOL to engage in the wrongful conduct complained of herein.
AOL controlled each of the Individual Defendants and all of its
employees.
175. By reason of such wrongful conduct, AOL, Case, Kimsey and
Leader are liable pursuant to §20(a) of the Exchange Act. As a
direct and proximate result of these defendants' wrongful conduct,
plaintiffs and the other members of the Class suffered damages in
connection with their purchases of AOL stock during the Class
Period.
CLASS ALLEGATIONS
176. Plaintiffs bring this action as a class action pursuant
to Federal Rules of Civil Procedure 23(a) and 23(b)(3) on behalf of
all persons who purchased the stock of AOL during the Class Period
(the "Class"), except defendants, members of their immediate
families and any entity in which a defendant has a controlling
interest.
177. The members of the Class are so numerous that joinder of
all members is impracticable. AOL has more than 93 million shares
of stock outstanding. During the Class Period, millions of shares
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of AOL stock were purchased by thousands of persons who were
damaged thereby.
178. Plaintiffs' claims are typical of the claims of the Class
because plaintiffs and the Class members sustained damages from
defendants' wrongful conduct.
179. Plaintiffs will adequately protect the interests of the
Class. Plaintiffs have retained counsel who are experienced and
competent in class action securities litigation. Plaintiffs have
no interests which conflict with those of the Class.
180. A class action is superior to other available methods for
the fair and efficient adjudication of this controversy.
181. Common questions of law and fact predominate over
questions which affect only individual members. Among the
questions of law and fact common to the Class are:
(a) Whether the federal securities laws were violated by
defendants' acts;
(b) Whether AOL's statements during the Class Period
misrepresented and/or omitted material facts;
(c) Whether defendants pursued the fraudulent scheme and
course of business complained of;
(d) Whether defendants acted intentionally or reck-
lessly;
(e) Whether the market price of AOL's stock was
artificially inflated due to the activities complained of; and
(f) The extent and measure of damage sustained by the
Class.
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BASIS OF ALLEGATIONS
182. Plaintiffs have alleged the foregoing based upon the
investigation of their counsel, which included a review of AOL's
SEC filings, securities analysts reports and advisories about the
Company, press releases issued by the Company, media reports about
the Company and discussions with consultants, and believe that
substantial evidentiary support will exist for the allegations set
forth in ¶¶7-10, 12-23, 25-26, 40, 45, 47, 48, 50-52, 54, 65, 72,
79, 85, 96, 100, 103, 115, 123, 127, 129, 134-137, 140-148 and 153-
165 after a reasonable opportunity for discovery.
PRAYER FOR RELIEF
WHEREFORE, plaintiffs pray for judgment as follows:
1. Declaring this action to be a proper class action
pursuant to Rules 23(a) and 23(b)(3) of the Federal Rules of Civil
Procedure on behalf of the Class defined herein;
2. Awarding plaintiffs and the members of the Class
compensatory damages;
3. Awarding plaintiffs and the members of the Class
pre-judgment and post-judgment interest, as well as reasonable
attorneys' fees, expert witness fees and other costs;
4. Awarding extraordinary, equitable and/or injunctive
relief as permitted by law, equity and the federal statutory
provisions sued hereunder, pursuant to Rules 64, 65 and any
appropriate state law remedies; and
5. Awarding such other relief as this Court may deem just
and proper.
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JURY DEMAND
Plaintiffs demand a trial by jury.
DATED: February 21, 1997 RICHARDS McGETTIGAN REILLY
& WEST, P.C.
MICHAEL McGETTIGAN (VSB#13426)
CRAIG C. REILLY (VSB#20942)
______________________________
MICHAEL McGETTIGAN
Suite 700, King Street Station
225 Reinekers Lane
Alexandria, VA 22314
Telephone: 703/549-5353
MILBERG WEISS BERSHAD
HYNES & LERACH
WILLIAM S. LERACH
/s/
______________________________
WILLIAM S. LERACH
600 West Broadway, Suite 1800
San Diego, CA 92101
Telephone: 619/231-1058
MILBERG WEISS BERSHAD
HYNES & LERACH
KEITH M. FLEISCHMAN
SAMUEL H. RUDMAN
One Pennsylvania Plaza
New York, NY 10119-0165
Telephone: 212/594-5300
MORRIS AND MORRIS
KAREN MORRIS
ABRAHAM RAPPAPORT
______________________________
KAREN MORRIS
1105 N. Market Street
Suite 1600
P. O. Box 2166
Wilmington, DE 19801
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SCHIFFRIN & CRAIG, LTD.
RICHARD S. SCHIFFRIN
Three Bala Plaza East
Suite 400
Bala Cynwyd, PA 19004
Telephone: 610/667-7706
SPECTOR & ROSEMAN, P.C.
ROBERT M. ROSEMAN
2000 Market Street
12th Floor
Philadelphia, PA 19103
Telephone: 215/864-2400
LAW OFFICES OF ALFRED G.
YATES, JR.
ALFRED G. YATES, JR.
519 Allegheny Building
429 Forbes Avenue
Pittsburgh, PA 15219
Telephone: 412/391-5164
BERNSTEIN LIEBHARD & LIFSHITZ
MEL E. LIFSHITZ
274 Madison Avenue
New York, NY 10016
Telephone: 212/779-1414
KAPLAN, KILSHEIMER & FOX, LLP
ROBERT N. KAPLAN
685 Third Avenue, 26th Floor
New York, NY 10017
Telephone: 212/687-1980
THE CUNEO LAW GROUP
JONATHAN W. CUNEO
MIKE LENETT
317 Massachusetts Avenue, N.E.
Suite 300
Washington, D.C. 20002
Telephone: 202/789-3960
FRUCHTER & TWERSKY
JACK FRUCHTER
275 Madison Avenue
Suite 1000
New York, New York 10016
Telephone: 212/889-9351
STULL STULL & BRODY
JULES BRODY
MELISSA EMERT
6 East 45th Street
New York, New York 10017
Telephone: 212/687-7230
- 141 -
WEINSTEIN, KITCHENOFF,
SCARLATO & GOLDMAN
MARK GOLDMAN
1608 Walnut Street, #1400
Philadelphia, PA 19103
Telephone: 215/545-7200
Attorneys for Plaintiffs
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