Editor’s note: The series has been corrected and amended in response to requested corrections, clarifying statements and additional information brought forward by lawyers for Realogy and Richard A. Smith.
This is the second of a two-part series on a legal settlement resolving the alleged involvement of Realogy Corp.’s predecessor, Cendant, in inflating the revenue of Realtor.com operator Homestore (now Move Inc.). Part 1, "Realogy puts Homestore behind it," detailed the terms of the settlement, and the reasons each side gave for agreeing to end their long court battle. This report examines details of deals between Cendant and Homestore that Homestore investors would later claim were concealed from them.
When circular deals that artificially pumped up the revenue of Realtor.com operator Homestore during the dot-com boom unraveled, the crash of the company’s stock and subsequent criminal trial of founder and former Chief Executive Officer Stuart Wolff grabbed headlines.
Nearly a decade later, Cendant Corp. has quietly become the last company accused of helping Homestore inflate its revenue to settle with Homestore investors, who filed a class-action lawsuit in December 2001.
The settlement allows Cendant to collect nearly $12 million from other defendants in the case, in return for giving up at least $4 million it might otherwise be entitled to (see Part 1).
When granted final court approval in March, the settlement went largely unnoticed. In an Aug. 11 second-quarter earnings report, Realogy Corp. disclosed that as a successor company to Cendant, it had received $11 million in settlement proceeds in April and was entitled to receive another $800,000.
The lawsuit against Cendant accused the company of funneling millions in revenue to Homestore through a "sham company" in exchange for Homestore’s purchase of Move.com and Welcome Wagon businesses from Cendant at an inflated price.
The deal left Cendant owning one-fifth of Homestore and holding a seat on the company’s board of directors, creating an "incestuous" relationship between the companies, the lawsuit alleged. Lawyers for Smith and Realogy note that Smith "was on the board of directors of Homestore for a very brief time, beginning … in April 2001."
As a former Homestore shareholder, Cendant was not only a defendant in the lawsuit filed on behalf of Homestore investors, but a potentially injured party eligible to collect a share of the settlements paid by the other defendants to date.
Over the years, Homestore and other defendants in the case have paid out $120 million to settle claims that they violated securities law by misleading investors about how the company had generated its revenue.
Settlement proceeds that Cendant might be entitled to as an injured party were placed in escrow, to be released only when claims against Cendant were resolved.
Homestore — which has since rebranded as Move Inc. — paid $13 million in cash and turned over 20 million shares of company stock to settle investors’ claims against it.
Homestore’s accounting firm, PriceWaterhouse Coopers LLC, was accused of coaching the company in some of the techniques it allegedly used to inflate revenue and settled for $17.5 million.
America Online, accused of entering into circular advertising deals with Homestore and third-party vendors, paid $6.5 million to settle its liability in the case. Several Homestore executives paid out $5.9 million in cash.
Those settlements represent only a fraction of the estimated $853 million in losses allegedly suffered by Homestore investors when the company’s share price collapsed. The lead plaintiff in case, the California State Teachers’ Retirement System, claimed losses of more than $9 million on its $13.4 million investment in Homestore.
After Homestore’s share price collapsed, in December 2001 the company issued a formal announcement that it would restate seven quarters of earnings — an action that would ultimately erase $192.6 million in revenue generated by circular deals from the company’s books.
In deals involving America Online, Homestore would allegedly pay third-party vendors for services the company had no use for. The vendors would then buy advertising from America Online. Finally, America Online would take the money it received from the vendors — which had originated with Homestore — and buy advertising from Homestore.
According to lawyers for Homestore investors, America Online’s incentive to participate in the deals was that its advertising agreements with Homestore allowed it to keep up to 68 percent of the money Homestore paid to the vendors as sales commissions.
In the criminal and civil lawsuits that ensued, 13 former Homestore employees were convicted of violating securities law or settled charges with the U.S. Securities and Exchange Commission, and investors sought to recover damages from 28 companies and individuals.
The deals between Homestore, America Online and third-party vendors took center stage at Wolff’s criminal trial (Wolff’s 2006 conviction of 18 counts of securities fraud was vacated by the Ninth Circuit Court of Appeals, on the grounds that the trial judge in the case should have recused himself from the case because he owned AOL stock).
Cendant and Smith were named as defendants in the class-action lawsuit in November 2002, but two complaints against them had been dismissed before a settlement was reached, and Cendant and Smith have denied any wrongdoing.
‘Incestuous’ relationship
In their third and final attempt to file a complaint that would stick, attorneys for Homestore investors put a new spin on previous claims that side deals with Cendant — allegedly tied to Homestore’s purchase of Cendant’s Move.com and Welcome Wagon businesses at an inflated price — had helped Homestore boost revenue.
The Move.com deal, announced in the fall of 2000, made Cendant a 20 percent owner of Homestore. It also landed Smith — the head of Cendant’s real estate division, later to be spun off as Realogy — on Homestore’s board of directors. …CONTINUED
Lawyers for Smith and Realogy note that Smith "was on the board of directors of Homestore for a very brief time, beginning … in April 2001."
Cendant’s ownership of one-fifth of Homestore, along with Smith’s seat on the company’s board of directors, created an "incestuous" relationship between the two companies, attorneys for Homestore investors said, citing the testimony of former Homestore Chief Financial Officer Joseph Shew in Wolff’s criminal trial.
Not only did Cendant hold a "huge financial stake" in Homestore, but Smith "wore two hats and operated under an irreconcilable conflict of interest throughout his tenure as a Homestore director," the July 2008 third amended complaint against Smith and Cendant alleged.
The alliance between Cendant and Homestore actually dated to 1998, lawyers for Homestore investors said, when Homestore allegedly paid Cendant $13 million to $15 million for a noncompete agreement.
Cendant granted Homestore.com exclusive license to publish 400,000 listings on Realtor.com, and also endorsed Homestore.com’s Web page design, hosting and maintenance services to brokers and agents in Cendant’s Century 21, Coldwell Banker and ERA franchise systems, the complaint said.
A legal dispute over the agreement led to a settlement that gave Cendant a small stake in Homestore — 250,000 shares of common stock, the complaint said.
Homestore, which changed its name to Move Inc. in 2006, operates Realtor.com on behalf of the National Association of Realtors under a series of agreements dating to 1996. The agreements gave NAR a 15 percent ownership stake in RealSelect Inc., a subsidiary Homestore created to build and operate Realtor.com and other Web sites, which NAR converted into Homestore.com stock in 1999.
NAR continues to hold one of 10 seats on Move’s board of directors, and two of eight seats on RealSelect’s board of directors. RealSelect’s "perpetual agreement" to operate Realtor.com requires Move to make annual royalty payments to NAR (which totaled $1.9 million in 2008). The agreement can be revoked if Move or RealSelect are taken over by another company, if traffic on Realtor.com falls below 500,000 unique visitors a month, or if there is a substantial decrease in the number of property listings on the site.
The next phase of the relationship between Cendant and Homestore allegedly began in January 2000, when Cendant and the National Association of Realtors launched a new Web site offering relocation and real estate services to consumers: Move.com.
Cendant, realizing that the site was not going to be profitable, began separating Move.com’s results from its own profit and loss statements, attorneys for Homestore investors said. Cendant also made plans to spin Move.com off in an initial public offering, but abandoned the idea, the complaint said.
Instead, in October 2000, Homestore and Cendant announced that Homestore would purchase Move.com and another business, Welcome Wagon, for 26.3 million shares of Homestore common stock, valued at $761 million at the time.
In a press release, the companies said the deal guaranteed Homestore’s Realtor.com Web site "exclusive 40-year access" to listings from Century 21, Coldwell Banker and ERA real estate franchises. The deal also included an agreement by Cendant to purchase technology, services, and Web-based marketing products from Homestore.
‘Sham company’ alleged
What Cendant and Homestore did not reveal, attorneys for Homestore investors said in their complaint, was that Cendant planned to make those purchases through a third channel — an "independent technology trust."
The complaint alleged that this third channel — later identified as the Real Estate Technology Trust, or RETT — was "a sham company" used to conceal how dependent Homestore was on Cendant for revenue.
But Samuel Kadet, a lawyer representing Realogy and Smith, pointed out to Inman News that the RETT was identified by name as a Cendant affiliate in a November 2000 regulatory filing. The Nov. 29 proxy statement, filed by Homestore, “specifically disclosed that the Move.com deal was contingent on the execution of various agreements” including several that Kadet said obligated Cendant to purchase $80 million of goods through the RETT.
Two agreements described in the proxy statement — a "Software License Agreement" and "iLead Agent Services Agreement" — accounted for $40 million of RETT’s $80 million purchase commitment, Kadet told Inman News. A third "purchase agreement" mentioned in the proxy statement accounted for the other $40 million, Kadet said.
The proxy statement, filed one month after the Move.com deal was announced, did not reveal the dollar amounts enumerated by Kadet in a letter to Inman News.
Lawyers for Homestore investors claimed the first public disclosure of the magnitude of Cendant’s funding of the RETT was made several months later. In an April 2001 regulatory filing, Cendant revealed a $95 million charge to an "independent technology trust" responsible for providing technology for its Century 21, Coldwell Banker and ERA franchisees.
Citing confidential sources, attorneys for Homestore investors said the Move.com deal would never have happened without guarantees from Cendant that it would channel $80 million in revenue to Homestore through the RETT.
"Homestore knowingly greatly overpaid for Move.com and Welcome Wagon," the complaint alleged. But the Move.com deal generated revenue for Homestore because Cendant, through the RETT, had "agreed to buy products (from Homestore)."
In the April 2001 regulatory filing, Cendant revealed a $95 million charge to an "independent technology trust" responsible for providing technology for its Century 21, Coldwell Banker and ERA franchisees.
That filing was misleading, attorneys for Homestore investors would later claim, because it did not mention that the "independent technology trust" was actually RETT, a related party to Cendant. The statement should have made clear to investors that $80 million of the $95 million was earmarked for Homestore, and that the contribution was contingent on the completion of the Move.com acquisition, the complaint said.
Homestore’s auditor, PriceWaterhouse Cooper, wanted the deals between Homestore and RETT to be disclosed as "related party transactions," but Cendant’s auditor, Deloitte & Touche, disagreed, attorneys for Homestore investors said, citing confidential sources.
Not until March 2002 would Homestore reveal in another regulatory filing that the Move.com deal was contingent on the RETT’s purchase of $75 million in technology and subscription-based products from Homestore over three years, the lawsuit claimed. The filing, which amended Homestore’s first-quarter earnings report in 2001, disclosed the company had received $11.1 million in revenue from RETT and Cendant in the first half of 2001.
Citing confidential sources, attorneys for Homestore investors said Cendant’s initial obligation to provide $80 million in revenue to Homestore through the RETT had been pared down to $75 million in fourth-quarter 2000, when Cendant agreed to purchase $5 million of a software product called Top Presenter from Homestore’s newly acquired subsidiary, Top Producer.
Shew would later testify at Wolff’s criminal trial that the Top Presenter deal was made solely to help Homestore meet its quarterly revenue target, lawyers for Homestore investors said, and Cendant should have disclosed that the purchase reduced its $80 million obligation to Homestore contingent on the pending Move.com deal.
Kadet maintains that in April 2001, Cendant’s CEO publicly stated that all $95 million in funding Cendant set aside for the RETT "was intended for the purchase of products from Homestore." Attorneys for Homestore investors noted this public statement in their first amended complaint, Kadet said. But they made no reference to the statement in the third amended complaint against Cendant and Smith, “because it destroyed (their) new theory that the RETT’s funding was ‘hidden’ by Cendant,” Kadet said.
In a December 2006 order denying lawyers for Homestore leave to file a second amended complaint, U.S. District Judge Ronald Lew noted that Cendant’s press release announcing the Move.com acquisition had mentioned the agreement by Cendant to purchase technology, services, and Web-based marketing products from Homestore. The press release “suggests that there was no potential for the investing public to be deceived as to the nature of Cendant’s relationship with the RETT,” Lew wrote.
In establishing the RETT in 1996, Cendant had stated in a regulatory filing that its purpose was to “acquire technology on behalf of Cendant.” This “suggests that no false appearance was created as to either Cendant’s funding of the RETT or its use of the RETT to buy technology products," Lew said.
The dot-com bust
The circular deals that Homestore later acknowledged had inflated the company’s revenue sent Homestore’s share price skyrocketing, before nearly bringing the company to its knees. But Homestore’s stock was taking a beating long before the deals were exposed.
Homestore, like many companies that caught the fancy of investors during the dot-com boom, lost some of its luster in the March 2000 NASDAQ stock market crash. After peaking at $122.25 on Jan. 25, the price of a share of Homestore common stock closed at $35.62 on March 23 — a 71 percent decline in less than two months. …CONTINUED
From that point until the Move.com deal was announced on Oct. 27, the stock traded in a wide range — from a low of $15.13 to a high of $54.12.
When the Move.com deal was announced, it helped bump the company’s share price by nearly $9, to$37.94. The following summer, when Homestore’s share price reached a peak for the year of $36.48 on July 2, it looked as if the company had managed to put the dot-com crash behind it.
But Homestore’s share price then began a steady slide as doubts grew about whether Homestore’s revenue growth was sustainable. On Oct. 3, when Homestore announced that it would miss its third-quarter 2001 revenue projections, the stock closed at $6.20.
The company blamed its failure to hit its third-quarter targets on the Sept. 11 attacks — a claim later contradicted by the testimony of three Homestore executives.
In fact, lawyers for Homestore investors would later claim, Homestore could no longer hit its revenue targets because the circular deals it had depended on were unraveling.
To obtain the remainder of $95 million in funding Cendant had provided to the RETT, in June and September of 2001 Homestore sold Cendant $15 million in virtual tours from a newly acquired subsidiary, iPix.
In return, the complaint said, Homestore entered into four "preferred alliance agreements" in which Homestore agreed that it would purchase an identical amount of products and services from Cendant the following year.
Virtual tours — online videos of homes often created from still photos — are used to market homes for sale. The virtual-tour deals should have raised red flags with accountants, attorneys for Homestore investors said, because Cendant overpaid for the tours and would need 20 years to use all the services it had purchased.
But almost as soon as the agreements were signed, Homestore allegedly asked Cendant to tear them up. Homestore CFO Shew feared the timing of the "give backs" from Cendant would make them contingent transactions, the complaint said, and that Homestore’s accountants would not allow the company to claim the revenue from Cendant in the company’s third-quarter 2001 results.
After a Nov. 13, 2001, phone call, Smith agreed to tear up the contracts obligating Homestore’s "give back" purchases from Cendant, lawyers for Homestore investors said, while lawyers for Smith and Realogy dispute this claim and say that Smith "never ‘agreed to tear up the contracts.’ "
Homestore went on to claim the revenue it had received from Cendant for virtual tours in the quarterly report it filed with regulators the next day.
Homestore would later erase from its books $14.64 million it received from RETT for the virtual tours when it restated $192.6 million in revenue it received during seven quarters of 2000 and 2001, confidential sources told attorneys for Homestore investors.
Once again citing confidential sources, lawyers for Homestore investors alleged that Smith, the head of Cendant’s real estate division at the time, was a "close friend" of Homestore CEO Wolff, and "personally involved" in the creation the preferred alliance agreements. Lawyers for Realogy and Smith, though, state that Smith "was not a ‘close friend’ " of Wolff and "only knew Mr. Wolff through their very limited business dealings."
Smith, the complaint said, was also present at a meeting where Homestore executives allegedly decided to blame the company’s failure to hit revenue targets on the Sept. 11 attacks.
‘Aiders and abettors’ defense
Cendant and Smith have denied any wrongdoing, and two complaints against them by Homestore investors have been dismissed.
The original complaint against Smith and Cendant was dismissed in 2003 by the U.S. District Court for the Central District of California. The Ninth Circuit Court of Appeals upheld that decision three years later, and rejected a second amended complaint against Cendant and Smith by Homestore investors.
A January 2008 U.S. Supreme Court ruling in another case sent the Homestore lawsuit back to the original trial court for reconsideration, and attorneys for Homestore investors prepared a third amended complaint against Cendant and Smith.
"The allegations in the third amended complaint were the same baseless allegations that the District Court had determined had no legal merit and dismissed in 2003," said Realogy spokesman Mark Panus. Realogy, the successor company to Cendant’s real estate division, agreed to settle the lawsuit "to get the funds that belonged to the company on a quicker basis," Panus said.
But Cendant and Smith have never had to respond directly to the allegations in the complaints. Instead, they have successfully argued that under securities laws governing publicly traded companies they cannot be held liable for the actions of Homestore and its officers.
"It is well-settled that Smith’s mere status as an outside director is insufficient, as a matter of law, to establish that he owed any duty to Homestore shareholders," attorneys for Smith and Cendant said in opposing the third amended complaint against their clients.
Lawyers for Smith also argued that as a former Homestore board member, Smith was immune from further claims by the company’s investors. Homestore’s Aug. 12, 2003, settlement with investors released the company’s present and former officers and directors from any further liability, they said.
In a March 2003 order, Cendant, Smith and other defendants were dismissed from the class-action lawsuit.
At the time, four former Homestore executives had already pleaded guilty to criminal charges involving securities fraud and insider trading. The question, Pechman said, was not "whether the fraud actually happened, but rather who knew about it, who participated in it, and who can be held liable for it."
In the aftermath of the great stock market crash of 1929, Pechman explained, Congress attempted to restrict some of the practices and abuses that contributed to it by passing the Securities Exchange Act of 1934. Among other things, the Act gave injured shareholders the ability to sue for damages when companies issued misleading statements or withheld "material facts" — information of importance to investors.
In 1995, with shareholder lawsuits against publicy traded companies and their business partners becoming increasingly commonplace, Congress passed the Private Securities Litigation Reform Act (PSLRA), a law that raised new barriers against such lawsuits. …CONTINUED
Passed over a veto by President Bill Clinton, PSLRA was intended to "put an end to the practice of pleading ‘fraud by hindsight,’ by which investors allege fraud by questioning past corporate decisions once a company’s stock price has dropped," Pechman said.
To successfully allege that a company made an untrue statement — or neglected to state a material fact vital to understanding its business — the PSLRA requires that investors provide details "giving rise to a strong inference that the defendant acted with the required state of mind."
Unfortunately for judges and juries charged with interpreting the law, Congress failed to spell out what was meant by "the required state of mind," which courts have interpreted to mean intentional misconduct or deliberate recklessness, Pechman said.
Further complicating the issue, a 1994 Supreme Court decision limited the ability of investors to sue "aiders and abettors" of companies found to have violated securities law, largely reserving that power for the Securities and Exchange Commission.
All 17 of Homestore’s business partners and third-party vendors claimed that even if all the allegations against them were true, "they cannot be held liable because their actions constitute mere ‘aiding and abetting,’ " Pechman said. Looking at the letter of the law and past rulings, Pechman said she had to agree with such arguments.
"While this court feels compelled to arrive at this result, it does so with reservation," Pechman said in dismissing Cendant, America Online, and Homestore’s other third-party vendors from the case. "The acts alleged … describe a massive conspiracy driven by pure avarice. In particular, the detailed factual allegations describing the role of AOL and its agents in helping Homestore please Wall Street and in boosting its own revenues through bogus commissions give this court great pause.
"Nevertheless, the role of AOL and the other business partner and third-party vendor defendants appears to be exactly the role of aiders and abettors" exempted from liability under a U.S. Supreme Court ruling (Central Bank of Denver v. First Interstate Bank of Denver), Pecham stated.
Supreme Court ruling
Pechman’s ruling dismissing the complaint against Cendant and Smith was upheld by the Ninth Circuit Court of Appeals in June 2006.
But last year, the Supreme Court issued an opinion in another case addressing whether "secondary actors" can be held liable for another company’s violations of securities laws. The ruling allowed some leeway for suits against secondary actors, if it was clear they had provided information that was misleading to investors.
The decision led the Ninth Circuit Court of Appeals to vacate its ruling in the Homestore case, creating an opportunity for Homestore investors to seek approval from the trial court to file a third amended complaint against Cendant and Smith.
In their third amended complaint, attorneys for Homestore investors alleged Cendant had committed "primary violations," such as concealing the true source of revenue Homestore received through the RETT and leaving investors in the dark.
With no guarantee that the trial court would see the legal arguments against Cendant and Smith in a new light — and the possibility of another long legal battle if the complaint against them was allowed — the parties agreed to mediation and reached a settlement agreement three months later.
Although the agreement allowed Cendant, as a former Homestore shareholder, to claim nearly $12 million in settlement proceeds paid by other defendants, the lead attorney representing Homestore investors said she was satisfied with the outcome.
"The Supreme Court has made it very difficult to hold companies like Cendant responsible when they haven’t made a public statement that can be shown to have misled investors," plaintiff’s attorney Nancy Fineman told Inman News. Fineman represented the lead plaintiff in case, the California State Teachers’ Retirement System.
As part of the settlement, Cendant agreed to relinquish claims to an additional $4 million in settlement proceeds it would have been entitled to if it had prevailed in court, and to relinquish any claim to proceeds from a potential settlement with the final defendant in the civil case, former Homestore chairman, CEO and founder Stuart Wolff (the civil case against Wolff is on hold until at least this fall, until his retrial on criminal charges is completed).
The negotiations "were hard fought and definitely conducted at arms’ length," Fineman said in a motion urging the court to approve the settlement with Cendant and Smith. Notices of the proposed settlement were mailed out to nearly 13,000 Homestore investors, including brokerages and banks, and none objected, Fineman said.
Some lawmakers have since had second thoughts about the protections so-called secondary actors enjoy against shareholder lawsuits.
On July 30, Sen. Arlen Specter, D-Pa., introduced a bill, S 1551, which would amend the Securities Exchange Act of 1934 to explicitly permit lawsuits against secondary actors.
The "Liability for Aiding and Abetting Securities Violations Act of 2009" would allow investors to sue "any person that knowingly or recklessly provides substantial assistance to another person (violating the Securities Exchange Act of 1934) … to the same extent as the person to whom such assistance is provided."
The bill, which has three cosponsors, has been referred to the Senate Judiciary Committee.
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