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Goldman's 1% Solution


In more ways than one, the news from the European Union was bad. It was October, 2000, and the EU's executive arm, the European Commission, had just jolted America Online Inc. with a ruling that its pending acquisition of Time Warner Inc. (TWX) could harm competition in Europe's media markets, especially the emerging online music business. The EC was concerned that AOL was a 50-50 partner with German media giant Bertelsmann in one of Europe's biggest Internet service providers, AOL Europe. Now the EC was ordering Bertelsmann to give up control over AOL Europe.

With the AOL-Time Warner deal due to close in just three months, Bertelsmann needed to reduce its AOL Europe holding -- pronto. But the obvious buyer, AOL, didn't want to own more than 50% or more of the venture, either. Going above half might trigger a U.S. accounting rule that would force AOL to consolidate all the struggling unit's losses on its books when AOL was already grappling with deteriorating ad revenues and a declining stock price.

Enter Goldman Sachs Group Inc. (GS) BusinessWeek has learned that the premier Wall Street bank agreed to buy 1% of AOL Europe -- half a percent from each parent -- for $215 million. AOL Europe, in return, agreed to a "put" contract promising Goldman that it could sell back the 1% by a specific date and at a set price. That simple transaction solved Bertelsmann's EU problem without trapping AOL in an accounting conundrum -- a perfect solution.

LEGAL HEADACHES

Or so it seemed at the time. But the deal also may have violated U.S. securities laws. The Securities

A: Exchange Commission and the Justice Dept. have construed some deals involving promises to buy back assets at a specific time and price as share-parking arrangements designed to mislead investors. The former chief executive of AOL Europe says the Goldman deal may have kept up to $200 million in 2000 losses off of the combined AOL-Time Warner financials -- enough, he says, that Time Warner might have tried to change the terms of the $120 billion merger, since AOL wouldn't have looked as healthy. But as the deal moved toward consummation, the Goldman arrangement was never disclosed in public documents to AOL or Time Warner shareholders.

The AOL Europe transaction threatens to create problems for Goldman Sachs. But it could also prolong the legal headaches of Time Warner Inc., as the AOL-Time Warner combine is now called. For the past two years, Time Warner has been in heated negotiations with the SEC over AOL's accounting for advertising revenues (BW -- June 7). Just as the SEC is wrapping up that case -- it could warn Time Warner as early as this summer that it intends to bring civil fraud charges -- the Goldman transaction raises troubling new questions about AOL's financial dealings prior to the merger.

The SEC has not brought charges over the 1% solution, and an SEC spokesman would not comment on whether the agency is probing the deal. Time Warner spokeswoman Tricia Primrose Wallace says the company will not comment on any part of the Goldman arrangement. A lawyer for Stephen M. Case, AOL's chairman and CEO at the time of the deal, referred questions to Time Warner. Thomas Middelhoff, who was Bertelsmann's chairman at the time of the deal and negotiated the AOL Europe joint venture with Case in 1995, says through a spokesman that the sale of a 0.5% stake was "purely a financial technique" handled by others. And Lucas van Praag, a Goldman Sachs spokesman, says: "We handled this entirely appropriately. We don't believe there is anything untoward here."

TROUBLESOME PRECEDENT

That, of course, depends on how law enforcers view the deal. A lawsuit that the SEC brought in March, 2003, against Merrill Lynch

A: Co. (MER) raises a troublesome precedent for Time Warner and Goldman. That case grew out of Merrill Lynch's acquisition from Enron Corp. of an interest in generators mounted on barges floating off the coast of Nigeria late in 1999. Merrill paid $7 million into a special-purpose entity that let Enron book income on the deal and get the barges off its balance sheet. But in a side deal, Enron promised to buy the barges back from Merrill in six months -- at a 22.5% return -- according to SEC documents.

The SEC called this a case of asset-parking designed to help Enron meet analysts' earnings expectations. "This was, at best, a bridge loan because the risks and rewards of ownership...did not pass to Merrill Lynch," the agency said. Without admitting or denying guilt, Merrill last September paid $80 million to settle charges that it aided and abetted Enron's financial-statement fraud.

The penalties may not stop at fines. Four former Merrill officials, including the former head of investment banking, and two ex-Enron employees face the prospect of jail time if found guilty of criminal charges alleging that they arranged the barge transaction knowing that it violated securities laws. The six have pleaded not guilty.

Could AOL and Goldman face similar civil and criminal charges? If the 1% of AOL Europe that Goldman acquired didn't really change hands, then the SEC could conclude that AOL, and later Time Warner, had clear control and should have consolidated the European unit on its financial statements in 2001. Time Warner did not merge AOL Europe's figures until 2002, when it bought Bertelsmann's remaining 49.5%.

But Goldman insists that the AOL Europe deal was nothing like the furtive Enron barge transaction. One big difference, says Goldman's van Praag, is that the transaction was not secret. While AOL never disclosed the deal formally, he says, it did broach the subject with several investment banks. It was widely reported that Bertelsmann was planning to get out of the AOL Europe joint venture, awaiting a 2002 change in German tax law. And, van Praag adds, the arrangement was reviewed by Goldman's in-house and outside lawyers. Also in Goldman's defense: The EC published its order that Bertelsmann had to give up control.

Van Praag concedes that, if the transaction had been with parent AOL rather than with its AOL Europe subsidiary, then "you could categorize it as a loan. The risk would have been close to zero." But since the arrangement was with the AOL Europe subsidiary, the deal should be seen as a straight equity investment, he asserts. "If the [AOL Europe] joint venture had failed, Goldman Sachs would have lost all its money," says van Praag.

Others see it differently. A source familiar with the AOL-Goldman deal says that Goldman had a guaranteed profit in the high teens. Neither AOL nor Goldman will say what Goldman's return was. But in a 2001 annual report filed with the SEC, Time Warner says that "in February, 2002, certain redeemable preferred securities issued by AOL Europe were redeemed for $255 million." If the filing was referring to Goldman's 1% holding, then the bank's $215 million, 15-month investment in AOL Europe returned $40 million, a 19% profit.

The Goldman stake "doesn't sound like the same equity as that held by other investors," says Jack T. Ciesielski, an accountant who publishes a newsletter. Ciesielski based his comment on BusinessWeek's description of the deal. A former SEC accounting official says: "If this transaction had been brought in for my review, there's no way in hell it would have been accepted." He says he would have told AOL to consolidate AOL Europe.

"TOTALLY ADAMANT"

Goldman concedes that the deal was deliberately structured so that AOL would not have to add AOL Europe to its financials until it owned all the equity in the venture. But former Bertelsmann executive Andreas Schmidt, who was AOL Europe's CEO at the time of the Goldman deal, says the motive was different. Schmidt told BusinessWeek that the unit lost $350 million to $400 million in 2000, in part because of a $900 million marketing initiative that helped boost AOL Europe's subscribers from 1.5 million in 1999 to 5.5 million in 2000. Under joint-venture accounting, AOL and Bertelsmann each absorbed half the losses, but "AOL did not want to show [all AOL Europe's] losses" on its books, says Schmidt. "They were totally adamant about this."

Then there is the question of disclosure. Goldman maintains that the deal was not material because it did not involve at least 3% of AOL Europe's assets. But 1999 SEC guidelines state that materiality cannot be reduced to a numerical formula. Instead, companies are supposed to consider other factors that could be important to investors, such as whether a subsidiary played a significant role in a company's profitability. Goldman says that was considered.

Schmidt also says he does not believe Time Warner officials at the time were aware of the Goldman deal, which took place between the merger's announcement and its consummation, when AOL's share price fell more than 20%. "It could have influenced the merger price" if Time Warner execs knew, Schmidt says.

If the SEC concludes that AOL parked assets to avoid complying with accounting rules, then Time Warner shareholders just might wish they had been forced to swallow their medicine way back in 2000.

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


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