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Up to 20 percent of Facebook’s pay-per-click advertising revenue could be affected by a pending ruling from a California federal appeals court on whether a group of Facebook’s advertisers were charged for “invalid,” clicks on their ads from 2009 onward.

Facebook has denied the claims, and successfully won a ruling denying class action status at the district court level. The appeal hinges on the technicality of what counts as a “class” under federal law, and whether the plaintiffs adequately represent advertisers on Facebook as a whole. The company told us:

“We have a team of professionals and use sophisticated technical measures to monitor click activity and guard against click fraud and other improper actions that affect the cost of running ads.  With respect to the lawsuit challenging our click filters, despite more than two years of discovery, the plaintiffs were unable to identify a single click that they believe was invalid. The allegations in the lawsuit are without merit and we were pleased with the district court’s decision.”

The papers within the case, however, could prove explosive for Facebook’s reputation. They include emails and internal memos written by Facebook’s engineers and advertising operations executives, and communications between employees of Facebook’s auditor, Ernst & Young.

• UPDATE: What Facebook's Biggest Advertisers Say About 'Invalid Clicks'

Several Facebook engineers and advertising staff have also been deposed in the litigation, and a handful of the company's biggest advertising clients have been served with subpoenas, the court docket shows. In one filing, a lawyer for Facebook notes that the discovery phase of the litigation has covered 200,000 documents and 16,000 emails from its engineers.

Some of the evidence allegedly shows that, internally, some Facebook staff regarded independent verification of its clicks as “toxic” because they knew they wouldn’t pass an audit. Internal Facebook emails in the case describe a proposed adjustment to a key algorithm to detect invalid, accidental or fraudulent clicks, which would cost the company sales. One email stated:

“I think this is pretty much a no-brainer, but it is a fair amount of revenue. So we got to go to the board on this one.”

The adjustment was never done because engineers did not receive approval, the suit alleges.

SECFacebook's ad revenues through Q3 2012.

Thousands of advertisers affected

If the appeal goes badly for Facebook, the class could cover as many as 100,000 of Facebook’s advertisers. Of those, 5,000 have made inquiries at Facebook about their clicks, the suit indicates. (It doesn't say whether they doubted the clicks' integrity.)

Sources tell Business Insider that between 40 and 80 percent of ads on Facebook are bought on a pay-per-click basis. Advertisers only pay for those ads if someone clicks on them. The plaintiffs have argued that up to 20 percent of those clicks are invalid, and that advertisers should get refunds for them. Assuming that Facebook recognizes roughly $1 billion per quarter in revenue, such a refund could amount to between $80 and $160 million per quarter.

Much of the paperwork filed in the case has been sealed or redacted to protect the confidentiality of Facebook’s business dealings. However, late last year MediaPost wrote a story about the case and published a pleading from it that was improperly redacted with black boxes to obscure the sealed text. Anyone with a PC could cut and paste the text underneath the black boxes into a word-processing document in order to read it.

Business Insider publishes those redactions here for the first time, on the following pages of this article. They include summaries of internal Facebook emails and what Facebook engineers told lawyers in depositions about the effect that adjusting their algorithms would have on Facebook’s revenue.

Nathan Fox / YouTube

“We take click quality very seriously”

The suit was brought by three small Facebook advertisers, RootZoo, Nathan Fox of Fox Test Prep and Steven Price from DriveDownPrices.com, who each bought a few hundred dollars worth of pay-per-click advertising on Facebook. RootZoo was a sports fan web site; Fox is a tutoring service and Price ran the now-defunct DriveDownPrices.com, a car sales site.

All the companies wanted the ads to drive traffic to their sites. But they noticed that when they used their own click measurement programs, such as Google Analytics, Facebook was allegedly charging them for more clicks than were actually landing on their web sites.

At the time, a number of advertisers complained that they were being overbilled for clicks. Facebook currently offers to investigate advertisers' complaints, and resolve disputes, if a client believes clicks were invalid. A Facebook spokesperson said in 2009 that the company had fixed the problem:

 “We take click quality very seriously and have a series of measures in place to detect it. We have large volumes of data to analyze click patterns and can identify suspicious activity quickly.”

“Over the past few days, we have seen an increase in suspicious clicks. We have identified a solution which we have already begun to implement and expect will be completely rolled out by the end of today. In addition, we are identifying impacted accounts and will ensure that advertisers are credited appropriately.”

Adam Gerston / FacebookAdam Gerston

Adam Gerston, a former manager at Facebook who worked on the company’s preferred marketing developers program, defended the company when he spoke to BI recently:

“I was working at Facebook when this issue arose. It’s an issue that Facebook has generally taken responsibility for, and it has taken lots and lots of steps to ensure clicks are real clicks.”

(Gerston is not involved in the suit; he now works at GraphEffect, a marketing company that does business with Facebook.)

Facebook offered the plaintiffs credit for more advertising on Facebook, but they decided to litigate instead. Facebook has since accused the companies – none of which is now actively doing business – of existing largely to pursue litigation against Facebook.

Fox, Facebook argues, failed to identify any damage he had suffered from missing clicks, and Facebook's analysis of his server showed that invalid clicks were actually "caused by Fox's own (mis)configuration of his servers and software."

No audits allowed

The companies were frustrated by Facebook’s “Statement of Rights and Responsibilities” for advertisers, which states that Facebook will not entertain inquiries about invalid clicks. Facebook specifically says it isn't responsible for invalid clicks:

We cannot control how clicks are generated on your ads. We have systems that attempt to detect and filter certain click activity, but we are not responsible for click fraud, technological issues, or other potentially invalid click activity that may affect the cost of running ads.

Facebook also declines to describe how it measures clicks. A Facebook glossary says:

Due to the proprietary nature of our technology, we’re not able to give you more specific information about these systems.

IABIAB's web site shows that Facebook vp/U.S. sales Tom Arrix is on the IAB board.

The suit also claims that Facebook declines to allow its clicks to be audited by a third party. That became an issue when the plaintiffs discovered that Facebook did not abide by the self-regulatory guidelines published by the Interactive Advertising Bureau.

The IAB represents 500 media companies in the online ad business. Its guidelines were crafted to give ad buyers confidence they weren’t being ripped off. They encourage the use of third-party ad verification services, like Adometry or RocketFuel, which identify invalid clicks caused by bots, fraud, or accidental clicks from users who clearly weren’t interested in an ad.

gulltaggenIAB boss Randall Rothenberg

Facebook is on the board of the IAB, but doesn’t adhere to its guidelines, the suit alleges. Facebook’s main competitors – Google, Yahoo! And Microsoft – have all put their names on the guidelines. BI asked IAB CEO Randall Rothenberg why Facebook was a holdout. He told us he didn’t know, and added:

"All standards we develop are voluntary by definition; as a 501(c)6, we are not and cannot be an enforcement body. Industry standards are a 'wisdom of the crowd' activity - they are developed by groups of volunteers from member companies [and] … they consequently represent the best collective judgment about how to take friction and cost out of a supply chain.  LOTS of companies adhere to standards but don't (and don't have to) sign their names to anything."

(Joe Laszlo, IAB’s senior director/mobile marketing center of excellence has also been subpoenaed in the case.)

“Toxic”

Facebook employees deposed in the case said they regarded the IAB as potentially “toxic,” according to a redacted motion from the plaintiffs. That pleading alleges:

… many Facebook witnesses in positions of authority with respect to click filtering either have either no idea what the IAB standards were or had little regard for them. Exh. 6 at 242:19-24 (characterizing the standards as “toxic”); Exh. 9 at 14:19-20 (“I personally didn’t read any IAB materials.”)

Facebook explicitly denies its advertisers the chance to audit their own clicks. On one of its FAQ pages, the company answers that question this way:

What can I do if I think I’m receiving invalid clicks?

Third-party aggregations or reports can’t be accepted for this purpose because they don’t contain the level of detail needed for investigation.

George Ivie / TwitterMRC CEO Ivie

Facebook isn’t accredited by the Media Ratings Council, either. MRC sets ad industry standards for audience measurement. MRC CEO George Ivie told us:

We don't do any auditing of Facebook's measurement systems. Facebook has not received accreditation from MRC, and they have never applied for accreditation of any kind.

Advertisers and engineers subpoenaed

We called a random sampling of Facebook’s advertisers for comment. None spoke for the record. Talking privately, however, they all noted that Facebook stood alone among the major web ad business by not allowing third-party verification, but they did not believe Facebook was ripping them off.

Among the Facebook ad buying clients subpoenaed for the case are Buddy Media (now the Marketing Cloud unit of Salesforce.com), Efficient Frontier, Marin Software, Digital Envoy, and AdParlor.

Facebook staffers who have been deposed or written affidavits in the case include Robert Kang-Xing Jin director of engineering at Facebook; John McKeenan, manager in advertising operations; Thomas Carriero, an engineer; and Jordan Blackthorne, a product marketing manager.

The company that audits Facebook’s financial accounts, Ernst & Young, also audits clicks for online businesses. But an email described in the case sent between two E&Y employees allegedly states that Facebook has resisted a click audit.

According to the plaintiffs' filings, Jackson Bazley, E&Y’s executive director for advisory services/media and entertainment, allegedly wrote to Illian Ilev, the E&Y partner in charge of tech audits:

“I talked to our contacts [at Facebook] and the sense is that they will not pass such an assessment...”

Facebook has argued that the IAB is not a legal body, and that its terms and conditions for advertisers are clear. No one is forced to advertise on Facebook, and there are plenty of competing services who will take their ad dollars.

Facebook has long regarded itself as different from the rest of the online ad industry, and its executives may feel that the usual standards should not apply. Users must login to see Facebook, unlike most media websites, for instance. And Facebook has its own proprietary ad units that work differently than the standard banners used elsewhere on the web.

What is an "invalid" click?

Lastly, the exact amount of allegedly “invalid” clicks is also in dispute. The idea that up to 20 percent of clicks shouldn’t be billed comes from a study the plaintiffs allege was commissioned by Facebook. In that study, ad verification service Adometry allegedly found that up to 33 percent of clicks coming off Facebook were invalid, but in the same period Facebook only discounted 12 percent of clicks as invalid.

The plaintiffs thus allege that the difference – 21 percentage points – is the total amount of invalid clicks that Facebook wrongly charges for. In oral arguments before the judge, the plaintiffs' lawyer said:

"One time they found — Adometry found — 33 percent of their clicks were bad. Facebook only found in the same period 12 percent. Facebook didn't say to Adometry, hey, guys, we've got a problem. You are finding a lot more bad clicks than us. No. They took it back — I don't know what they did with it, they didn't change the filters."

In response, Facebook's lawyer argued:

"Is there a law that says I have to make a second click within a minute free? 10 minutes, is that one free? 20 minutes? How do you determine that? How do you determine that?

The data can be interpreted in different ways, however. The same study — which allegedly analyzed about 464,000,000 clicks on Facebook in July and August, 2010, also showed that the margin of difference may be as little as 3 percentage points, depending on how you define “invalid” clicks, according to the suit.

Adometry — which is not part of the suit — denies the plaintiffs' interpretation of the data. "The percentage of clicks that Facebook's systems designate as invalid is in line with our independent analysis of data received from Facebook and with rates we typically see in the industry," Peter Norwood, COO at Adometry, told us.

The Ninth Circuit Court of Appeals has yet to set a date to hear the case. Even if the appeals court finds in Facebook's favor, the advertisers will still be able to continue litigating as individuals. A final decision is thus months, if not years, away.

• The following pages contain the unredacted text from a plaintiffs' motion for class certification. They should be read in context with Facebook's motion in opposition, and the lower court ruling that found in favor of Facebook. (These motions discuss the facts of the case more fully than the appeals briefs, which focus more on the technicalities of what counts as a class.)

Disclosure: The author owns Facebook stock.