Simpson v. Aol Time Warner Inc.

• Decision Date: 30 June 2006
• Docket Number: No. 04-55665.,04-55665.
• Citation: 452 F.3d 1040
• Parties: T. Jeffrey SIMPSON, on behalf of himself and all others similarly situated, Plaintiff, and California State Teachers Retirement System, Plaintiff-Appellant, v. AOL TIME WARNER INC.; Cendant Corporation; Richard A. Smith; L90, aka Max Worldwide; David Colburn; Eric Keller, Defendants-Appellees.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 1040

452 F.3d 1040

T. Jeffrey SIMPSON, on behalf of himself and all others similarly situated, Plaintiff, and California State Teachers Retirement System, Plaintiff-Appellant, v. AOL TIME WARNER INC.; Cendant Corporation; Richard A. Smith; L90, aka Max Worldwide; David Colburn; Eric Keller, Defendants-Appellees.

No. 04-55665.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted February 6, 2006.

Filed June 30, 2006.

Joseph W. Cotchett (argued), Bruce L. Simon and Nancy L. Fineman, Cotchett, Pitre, Simon & McCarthy, Burlingame, CA, for plaintiff-appellant California State Teachers' Retirement System.

Peter T. Barbur (argued), Cravath, Swaine & Moore LLP, New York, NY; John B. Quinn, Quinn Emanuel Urquhart Oliver & Hedges LLP, Los Angeles, CA, for defendant-appellee Time Warner Inc. Samuel Kadet, Skadden, Arps, Slate, Meagher & Flom LLP, New York, NY; Jeffrey Speiser, Stern & Kilcullen, Roseland, NJ, for defendants-appellees Cendant Corporation and Richard A. Smith. Carl S. Kravitz, Zuckerman Spaeder LLP, Washington, DC, for defendant-appellee David Colburn. J. Christian Word, Latham & Watkins LLP, Washington, DC, for defendant-appellee Eric Keller. Daniel J. Tyukody, Orrick, Herrington & Sutcliffe LLP, Los Angeles, CA, for defendant-appellee L90, Inc. d/b/a MaxWorldwide, Inc.

Michael L. Post, Senior Counsel, Washington, DC, on behalf of the Securities and Exchange Commission as amicus curiae in support of appellant. Peter H. Mixon, General Counsel, Sacramento, CA; Keith Johnson, Chief Legal Counsel, Madison, Wisconsin, on behalf of the California Public Employees' Retirement System and the State of Wisconsin Investment Board as amici curiae in support of appellant. Eric Alan Isaacson, Lerach Coughlin Stoia & Robbins LLP, San Diego, CA, on behalf of the Regents of the University of California as amicus curiae in support of appellant. Lawrence S. Robbins, Robbins, Russell, Englert, Orseck & Untereiner LLP, Washington, DC, on behalf of the American Institute of Certified Public Accountants as amicus curiae in support of appellees. David H. Braff, Sullivan & Cromwell LLP, New York, NY, on behalf of the Bond Market Association, et al., as amici curiae in support of appellees.

Appeal from the United States District Court for the Central District of California; Marsha J. Pechman, District Judge, Presiding. D.C. No. CV-01-11115-MJP.

Before BEEZER, T.G. NELSON, and GOULD, Circuit Judges.

GOULD, Circuit Judge.

This consolidated class action litigation alleges that multiple actors engaged in a scheme to commit securities fraud by overstating the reported revenues of an Internet company, Homestore.com ("Homestore"). Homestore eventually restated its revenues, resulting in a decrease in revenues of more than $170 million and corresponding declines in Homestore's stock value. The district court dismissed the securities claims against Defendants-Appellees, relying on the Supreme Court's decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 114 S.Ct. 1439, 128 L.Ed.2d 119 (1994).

In this appeal, the lead plaintiff, California State Teachers' Retirement System ("CalSTRS" or "Plaintiff"), seeks to reverse the district court's dismissal with prejudice of its claims under § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), against six outside defendants ("Defendants"): AOL Time Warner ("AOL") and two of its officers, Eric Keller and David Colburn; Cendant Corporation and one of its officers, Richard Smith; and L90, Inc. ("L90"). Plaintiff alleges Homestore entered into fraudulent transactions with these Defendants in which Homestore purchased revenue for itself and then recorded that revenue in violation of SEC accounting rules. In the alleged "triangular transactions," Homestore entered into sham transactions with "Third Party Vendors" who then returned the money to Homestore through contracts with AOL or L90. Plaintiff alleges Homestore overpaid for an asset owned by Cendant in return for Cendant's agreement that it would funnel some of the money back to Homestore through a related business entity. The complaint further alleged that the recording of gross revenue from these transactions contravened SEC rules regarding barter transactions or the buying of revenue, and that the triangular transactions were often done without the full knowledge of Homestore's auditor.

The Supreme Court held in Central Bank that § 10(b) does not allow recovery for aiding and abetting liability, Cent. Bank, 511 U.S. at 177-78, 114 S.Ct. 1439 but cautioned that secondary actors were not always free from liability under § 10(b) because they may still be liable as a primary violator. 511 U.S. at 191, 114 S.Ct. 1439. We address here the scope of primary violation liability that the Supreme Court did not fully define in Central Bank.

Plaintiff asserts that Defendants are primary violators under § 10(b) for engaging in a "scheme to defraud." In response, Defendants argue that the Supreme Court in Central Bank limited primary liability under § 10(b) to defendants who personally made a public misstatement, violated a duty to disclose or engaged in manipulative trading activity, and not to those engaged in a broader scheme to defraud. Although we hold that the scope of § 10(b) includes deceptive conduct in furtherance of a "scheme to defraud," when all elements of § 10(b) are otherwise satisfied, we conclude that Plaintiff's complaint insufficiently alleged that Defendants were primary violators of § 10(b) based on their conduct in the furtherance of the scheme.

I

CalSTRS alleges in its First Amended Consolidated Complaint ("FACC") that Homestore and its officers, along with its auditor PriceWaterhouseCoopers ("PWC"), AOL, Cendant, L90, and additional Third Party Vendors, committed securities fraud by engaging in round-trip or barter transactions whereby Homestore recorded net revenues from its receipt of monies that came from Homestore's own cash reserves.

Homestore created an online real estate website in 1996. In the late 1990s, there was an explosion of Internet start-up companies which consistently posted net losses and negative cash flows as those companies sought to develop leadership and market share in their industries. This development caused a corresponding shift in emphasis by financial analysts to the tracking and evaluation of revenues as an indicator of future earnings. Until 2001, Homestore was perceived as an Internet company that consistently matched or exceeded its estimated revenue goals. To meet its revenue expectations, Homestore relied increasingly on barter or round-trip transactions with other companies. In such transactions, Homestore paid a company, the company returned part of the money to Homestore by way of a different transaction, and Homestore recorded these returned funds as revenue.

Internet companies have historically engaged in barter transactions between themselves, often in order to place advertising on each other's websites. Beginning in fiscal year 2000, the SEC implemented a new accounting standard that required companies engaging in barter transactions to report only the net revenue that was earned from these related transactions, rather than the gross revenue received. Facing increasing scrutiny from its auditor PWC, Homestore's barter transactions grew more complex. Homestore engaged in triangular transactions, with the result that PWC did not recognize that the revenue that Homestore recorded was related to a prior transaction funded by Homestore. As the district court succinctly summarized, in these triangular transactions:

Homestore would find some third party corporation, one that was thinly capitalized and in search of revenues in order to "go public." Homestore then agreed to purchase shares in that company for inflated values or to purchase services or products that Homestore did not need. This transaction was contingent on the third party company "agreeing" to buy advertising from AOL for most or all of what Homestore was paying them. The money thus flowed through the third party to AOL, which then took a commission and shared "revenue" with Homestore.

In re Homestore.com, Inc. Securities Litigation, 252 F.Supp.2d 1018, 1023 (C.D.Cal. 2003). Against this background, we consider the allegations against the particular Defendants.

A. Allegations Involving AOL, and its officers Keller and Colburn

The history of Homestore and AOL for purposes of this appeal began with the creation of a legitimate partnership in April 1998, whereby Homestore purchased the "exclusive right to have the only online real estate listing product on AOL." In a second legitimate deal with AOL, Homestore entered into an advertising reseller agreement, under which AOL agreed in March 1999 to sell advertising on the Homestore website and retain a commission.

The triangular transactions at issue here occurred during the first two quarters of fiscal year 2001. Plaintiff alleges that Homestore entered into a series of sham transactions with various Third Party Vendors for some product or service that Homestore did not need. The Third Party Vendors would then contract with AOL for advertising on Homestore's website and AOL would give this money back to Homestore under their advertising reseller agreement. Both the Third Party Vendors and AOL would keep a portion of the money as a commission. Plaintiff only alleges that the first leg of the transaction was truly a sham because nothing of value was given in exchange for Homestore's payment. AOL continued to sell advertising on Homestore's website to Third Party Vendors, withholding commissions before passing the Vendors' payments on to Homestore.

Plaintiff alleges that Defendant Eric Keller, as an employee of AOL, jointly developed these transactions with Homestore. Keller was also alleged to have contacted some of the Third Party Vendors that took part in these triangular transactions. Plai...