America Online Inc. should be subject to lawsuits by Homestore.com shareholders who are seeking to prove that AOL engaged in sham deals that helped Homestore improperly report higher revenue, lawyers at the Securities and Exchange Commission argued.
The SEC's top lawyer urged an appeals court to reinstate a lawsuit against AOL, Cendant Corp. and L90 Inc., all of which allegedly helped Homestore meet Wall Street targets in 2000 and 2001 through agreements in which it appeared the Internet companies were paying for advertising when, instead, they were trading services for ads. Homestore later restated earnings by $190 million for that period.
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A district court judge last year threw out the shareholder case against the three companies, arguing that they were not "primary" participants in the alleged fraud and thus could not be held liable for Homestore's misstatements to investors. Lawyers for the California State Teachers' Retirement System, which lost $9 million when Homestore's stock plunged, appealed that ruling to the U.S. Court of Appeals for the 9th Circuit.
The SEC is not directly involved in the case. Instead, general counsel Giovanni P. Prezioso took the unusual step of filing a court brief supporting the shareholders, saying in court papers that exempting AOL, Cendant and L90 could set a damaging precedent in a large number of cases where Internet companies, insurers and investment banks are accused of helping business partners disguise severe financial problems.
In the court papers, filed late Thursday, regulators did not make judgments about the underlying conduct by AOL, which is still under investigation by the SEC's enforcement division and federal prosecutors in Virginia. Instead, the lawyers argued the broader issue of whether shareholders in a fraud-ridden company could sue other businesses and executives that play a role in the fraud.
SEC lawyers argued that U.S. District Judge Marsha J. Pechman applied the wrong legal standard when she tossed out the case last year. They asserted that companies or individuals who commit a "manipulative or deceptive act" as part of a larger fraud could be subject to plaintiff lawsuits.
"If . . . the third party engages with the corporation in a transaction whose principal purpose and effect is to create a false appearance of revenues, intending to deceive investors in the corporation's stock, it may be a primary violator," the lawyers wrote.
Tricia Primrose, a spokeswoman for Time Warner Inc., which controls AOL, declined comment yesterday on the SEC court papers.
Duke University law professor James D. Cox said the SEC was proposing a broader standard than many courts presently allow. "It is a much wider test and it would sweep in a much bigger group of people," Cox said. "I think you'd have much dancing in the hallways of [plaintiff law firms] Milberg Weiss and Lerach Coughlin" if it were adopted.
Westlake Village, Calif.-based Homestore agreed to pay $93 million in cash and stock to settle the shareholder lawsuit earlier this year. Several former Homestore officials have pleaded guilty to criminal charges stemming from the accounting manipulations.
It is rare, but not unprecedented, for SEC lawyers to weigh in on important legal issues in a case filed by private litigants. Earlier this year, for instance, the agency told a New York court that Citigroup Inc. should be liable for an alleged "fraud on the market" based on optimistic public statements by former analyst Jack Grubman. Citigroup later settled the case.