Spurred in part by a Washington Post investigation into "unconventional deals" at the pre-merger AOL, the Securities and Exchange Commission is rummaging through the attic of the hobbling post-merger AOL. At the center of the investigation, according to the Wall Street Journal,are so-called round-trip transactions, which the Journal defined as a company selling "an unused asset to another company while at the same time agreeing to buy back the same or similar assets at about the same price."
Round trips—also known as "Lazy Susans"—were a commonplace not just of AOL but at many other New Economy companies, from dot-coms to energy traders, from fiber-optic networkers to computer hardware manufacturers. Investigators are also looking into the round-trip practices of Qwest, Global Crossing, Enron, Dynegy, and other companies.
While the theory behind round trips was sound and perfectly in keeping with the spirit of the times, the practice ultimately proved damaging. Much like Marxism, round trips were elegant in theory but corrupted by the ambitions and shortcomings of flawed individuals.
Unlike Marxism, round trips rested soundly on one of the oldest pillars of trade and capitalism: barter. Indeed, for a variety of reasons, the oldest way of doing business made a great deal of sense in the new networked economy. While they differ in their mechanics and execution, round trips and barter have the same net effect: Goods or services of roughly equivalent value change hands, without either side suffering a meaningful reduction in its cash position.
In the mature, old economy, businesses generally paid for goods and services with cash. Components suppliers sold parts to manufacturers, who in turn sold finished products into the distribution channel. Advertisers paid cash for time on television. The parties involved may have worked together on marketing or promotional efforts, but essentially the business relationship ended with a trade of cash for goods or services.
But as the Internet altered traditional modes of doing business, it also disrupted the traditional relationships between suppliers and business customers. The networked economy was all about taking what you had in abundance—eyeballs, software, content, routers—and leveraging it into that which you needed—consulting services, Web traffic, advertising.
Very few New Economy companies—save the software and hardware firms—were in the business of selling products you could throw in the back of your Jeep. They were selling content, services, placement, and access to networks and customer bases. What's more, the Internet facilitated entirely new means of promotion and marketing: click-throughs, pop-up ads, etc. And so it was natural for companies to strike deals to harmonize their interests.
Companies that provided online software, for example, were natural suppliers to big Web sites and Internet service providers. But they were also natural advertisers on those same sites. And so they began to swap equipment and their goods and services for placement and ad space. The same held for consultants of all varieties. Ultimately, the items available for trading came to include placement on Web sites, fulfillment functions, computer supplies, and equity.
Even the dot-coms flush with cash recognized the advantages of trading stuff for goods and services. Among the unconventional deals cited by the Washington Post was an instance in which AOL traded advertisements for computer equipment with Sun Microsystems. Of course, AOL could have afforded the equipment, and Sun could have afforded the advertising, but it was cheaper, cooler, and (that ultimate New Economy attribute) frictionless to do it this way.
The biggest firms were in a prime position to cut deals. Frequently, the big firms took stock, stock options, or warrants as their consideration. By swapping placement on its online store for equity stakes, Amazon amassed a substantial portfolio of investments in other dot-coms.
Another class of New Economy companies was also active in swapping assets: fiber-optic network companies like Global Crossing and Qwest Communications. Here the swaps made even more sense. To provide customers with seamless connections, companies had to either construct a network spanning the globe or rent access in places where they had yet to build. Let's say your network connects New York and Los Angeles, and my network connects New York and London. Instead of paying tolls to one another for use of the information highways, why not simply swap equal amounts of network access?
So how did the barter economy lead to the round-trip disasters? Bartering goods for other goods is a highly efficient means of exchange. But that wasn't enough for companies that wanted to make their books look better. To help their accounting, they graduated from barter to full-on, and much more dubious, round trips. Companies realized having two parties pay each other for roughly the same amount of products or services could yield bottom-line benefits.
For example, it is alleged that when some telecommunications companies swapped capacity, they booked the value of the incoming capacity as revenue and the value of the outgoing capacity as an investment. Doing so had the effect of inflating profits. Earlier this week, the SEC, in a classic case of ex post facto prevention, ruled that booking revenues from swaps in telecommunications capacity was improper.
Some companies—particularly those in the energy-trading field—used a variation of round-tripping to distort the market by establishing false bench marks. In the wake of the Enron scandal, a host of energy companies have confessed to engaging in round-trip contracts with other energy companies. Here the intent wasn't to increase profits—in this instance, the two equivalent trades canceled each other out—but rather to increase revenues or to make it seem as if the energy-trading markets were far more robust than they actually were. Simply swapping the actual kilowatts wouldn't do the trick. Such fictitious trades could also have the effect of establishing an artificially high bench mark for prices for other customers. It's as if two eBay vendors selling the same Alex Rodriguez bobblehead doll agreed to bid up each other's offerings to the exact same price. In the same way, when AOL booked revenue from a round-trip deal as advertising, it could effectively choose the rate at which it would bill advertising, regardless of what the market would bear at the time.
Companies also began to rely on round trips to meet or beat the numbers put out by Wall Street analysts. With time running out, companies that sensed they might not make the numbers would concoct a series of swaps or trades that could make numbers look better. Among Enron's many alleged misdeeds is a series of complicated round-trip trades conducted by offshore units very close to the end of certain quarters, which resulted in no oil or gas actually changing hands.
As a result of the perversions of round trips, barter between publicly held companies is now frowned upon. And that's too bad. For much of the late 1990s, the companies that engaged in round trips could have afforded to pay cash for the goods and services they obtained through barter. The cost of capital was very low. Venture capital firms, institutions, and individual investors stood ready to throw bucket-loads of cash at untested investors. Now, at a time when cash is difficult to come by—especially for startups—engaging in primitive trading may be the only way some companies can do business.