• by Tig Tillinghast , January 31, 2003

Customers in some industries require that business go overboard in giving the public a sense of security. Banks – especially those built closer to the 1930s – have always had lots of marble and big pillars, suggesting longevity, solidity and perhaps even having lasted through ages. They needed to do this after the Great Depression in order to attract customers back to the capital markets. The customers had been burned, and burned badly. And the banks succeeded only slowly when it came to the retail customer.

We saw a similar situation developing last year when all the accounting scandals were falling about our ears. Everyone seemed worried that a “crisis of confidence” in the numbers by which we judge success in public companies would send investors out of the market like rats jumping off a flaming scow.

This was a double-whammy for people in the Internet industry. As the industry bubble burst, and people lost great portions of their wealth in Internet stocks, the industry itself became suspect. Pile on top of that a general suspicion of “audited” numbers, and we had the makings of a true market crisis.

Which was, for a time, staved off by three factors: prompt prosecution of known cases that involved criminal wrong-doing; new legislation that made it harder to pull shenanigans; and the fact that after a three-month confessional period, it appeared that most of the financial illusions had already been revealed.

Until this week, that is. First, the Bush Administration’s SEC poked several large holes in the legislation Congress passed to try to make financial fraud more difficult. Then, just a few days ago, AOL dropped the other shoe on its write-downs, claiming another few tens of billions of dollars in losses.

Part of this write-off process was inevitable, as the traditional media geniuses of Time Warner chose to join with AOL at the very height of its business model. AOL had spent years idly collecting money as the Internet service provider to the Internet-ignorant, wishing away the fact that those newbie AOL members would eventually discover that they had been corralled off into a mere play-version of the Internet.

But part of it was also a more insidious use of accounting. Barter deals were apparently made to look like ad deals. Long-term ad deals are alleged to have been booked as revenue earlier than appropriate. AOL and Homestore.com are in hot water for just such alleged deception. The result was that after reporting a stunning rate of online ad growth (making the sillier of the pundits predict that online media would aggregate to a few lead players) that was unsustainable. In fact, much of the ad “decline” in the past year has been not so much a real reduction of advertiser spending, but a reflection of new accounting methods used.

This hurts the online sector particularly, not just because it reveals the seamy underside of the industry, but also because the Internet sector relies on public capital more than most because it’s still very much an immature industry. There’s still a lot of building to do, and that’s going to require capital, and that capital isn’t going to be readily available if we’re seen as a bunch of small AOLs.

That capital, and much advertising billings attending it, will flow toward new Internet opportunities only if investors can have some confidence that earnings and revenues, losses and liabilities will be shown clearly and honestly. The Internet industry, buyers and sellers alike, should be adamant that the SEC not water down the Sarbanes-Oxley Act. Hopefully, the people responsible for deliberate misrepresentations will be held criminally responsible. Hopefully, investors will come to understand that this is not an accepted norm in our industry.