Heightened Scrutiny in Silicon Valley
Known for decades as a hotbed of technological innovation, Silicon Valley in recent years has been nearly as inventive when it comes to keeping the books.
During the dot-com boom, pro forma earnings, entangling company alliances, revenue by barter, and stock options by the boatload were all part of the valley’s standard operating procedure before they spread to the likes of WorldCom Inc., Enron Corp. and Global Crossing Ltd.
Now, some of yesterday’s high-tech heroes are nervously awaiting a knock on the door from the Securities and Exchange Commission or the FBI, and they are cleaning up their practices even as they struggle to preserve the accounting for stock options that helped make them look good.
“We’re going to see more problems pop up,” said Lynn Turner, a former chief accountant at the SEC, who expects more tech companies to face the consequences of their past creativity. “I don’t know that they all will escape.”
The fall of one major valley firm, or a series of mid-size companies, could keep nervous investors from returning to a sector that’s already singed them in the market slide. That could seriously injure the technology economy as it struggles to emerge from recession and could even slow the pace of innovation, industry experts said.
Few executives at the better-known firms have been accused of major scams. But the pitter-patter of other shoes dropping is getting louder.
In the highest-profile case, the former president of e-mail provider Critical Path Inc. pleaded guilty this year to securities fraud.
The former CEOs of two small public companies, Unify Corp. and Quintus Corp., have been charged with criminal securities fraud for allegedly inflating sales figures, and the former CEO of a third company, David Lepejian of HPL Technologies Inc., has been accused by HPL of faking the majority of HPL’s fourth-quarter sales. The FBI is investigating, and Lepejian’s attorney declined to comment.
Also under SEC investigation is anti-virus software firm Network Associates Inc. of Santa Clara, Calif., which in May restated three years of results and said it had lost an additional $22.2 million over that time.
This month, Neoforma Inc., a small San Jose-based Internet firm, warned that it might be delisted from Nasdaq after announcing that it would reduce previously reported first-quarter sales by $13.9 million. And TiVo Inc., also of San Jose, said it would restate some expenses in the quarter ended in January.
The valley has escaped more serious scandals partly because many of the worst practices were perfected by Internet companies that have vanished, legal experts said.
Defunct companies are a less inviting target for investigators because there is little or no money to recover and less of a danger that others are being harmed, said FBI Special Agent Andrew Black.
“Prevention is critical. So if a company is still viable, that’s important,” said Black, a spokesman for the FBI in Northern California.
Still-viable companies of all sizes are going under the microscope, and prosecutors will first look at the biggest possible offenders.
To carry out their work, the authorities need three things: staffing power, wrongdoing and witnesses. All three are coming together.
The FBI has been adding to its white-collar crime team in the Bay Area, and the SEC’s national enforcement budget will jump 75% next year under a recently passed reform bill.
Wrongdoing remains a part of the ordinary landscape, according to a survey released this month by CFO Magazine. About 5% of the respondents volunteered that in their judgment, their own companies had violated generally accepted accounting principles, or GAAP. Nearly 10% said they had released pro forma earnings without connecting them to GAAP results, a practice the SEC has condemned.
And almost 7% said they excluded debt from their balance sheets by using special-purpose entities like those that tripped up Enron (that figure includes only those companies that were protecting outside investors in the special-purpose entities, which under accounting rules means the debt must be disclosed.)
“If they looked hard enough in the valley, they could find a lot of fraud,” said Stanford University accounting professor Karen Nelson.
Witnesses also are getting easier to find, law enforcement officials said.
With so many valley executives out of their jobs or stuck with worthless options, fewer have financial incentives to keep quiet about missteps by their employers.
One result: A first-of-its-kind securities fraud hotline to the FBI in San Francisco was established this month and netted 160 calls in its first 10 days. So many good tips poured in that the national headquarters is considering taking over the phone line, Black said.
About 60% of the calls are from investors unhappy that they lost money, while other tips probably will aid existing probes. But a surprising number are giving fresh leads on fraud in the valley.
“Several of them are very promising with regard to initiating new investigations,” Black said, adding that there is a likelihood of more charges in the future.
A major trouble area for technology companies is pro forma earnings--sometimes derided as “earnings before bad stuff.” In those figures, used by such valley stalwarts as Yahoo Inc., EBay Inc. and Cisco Systems Inc., companies tout financial performance based on the criteria they pick, excluding costs such as amortization, payroll taxes on stock options and merger expenses. All three companies have defended their reporting as providing a better picture of their operating results and have started to include more information.
If the SEC considers pro forma releases misleading, it can sue or force a settlement, as it did for the first time this year with Trump Hotels & Casino Resorts Inc. The SEC won a cease-and-desist order over a 1999 Trump news release that the SEC said “cited pro forma figures to tout the company’s purportedly positive results of operations but failed to disclose that those results were primarily attributable to an unusual one-time gain.”
A second danger spot is barter deals, which have been out of fashion since accounting rules on the issue were tightened. Dot-com companies were notorious for inflating revenue by trading advertising space on one another’s Web sites and counting the swaps as regular sales. Yahoo said it has kept barter revenue under 10% of its total, but the figure was more than 30% at smaller firms such as Fashionmall.com Inc.
From barter, it’s a small jump to so-called round-trip deals like those at energy firms and allegedly at Global Crossing, where capacity on telecommunications networks was traded between companies, boosting revenue figures.
But the type of deal that may be most emblematic of the valley’s methods are the sort of multi-part alliances that, until recently, were prevalent at AOL Time Warner Inc. AOL, which recently restated some results, said the accounting errors it found constituted a small percentage of its reported revenue.
In one of the AOL arrangements now under SEC scrutiny, the company struck a complex deal with PurchasePro Inc. of Las Vegas, agreeing to resell PurchasePro’s online marketplace software and taking warrants to buy PurchasePro stock, which AOL recorded as revenue.
Many of the largest companies in Silicon Valley had complicated alliances with other firms, some of which are now in trouble.
“With some of the technology companies, you looked at the customer list and the partner list, and they would be the same,” said Bob O’Connor, CEO of Softrax Corp., which sells software for tracking revenue.
That type of arrangement was the norm three years ago, said Suzanne Bell, a technology transactions lawyer with Silicon Valley law firm Wilson Sonsini Goodrich & Rosati.
“In some respects, maybe what AOL was doing was not all that different from what a lot of other companies in that position were doing,” Bell said.
For example, Sun Microsystems Inc. and AOL formed a now-defunct joint venture in 1998. AOL promised to buy $500 million of Sun goods and services as Sun committed to pay AOL $350 million in marketing, licensing and advertising fees. Sun declined to detail how it accounted for the deal or say whether the SEC had asked it for more information as part of its inquiry into AOL.
And Hewlett-Packard Co., like Sun a computer maker based in Palo Alto, had a deep relationship with Denver telecom firm Qwest Communications International Inc., which is under scrutiny by the SEC and federal prosecutors looking into how Qwest recorded revenue from capacity swaps with Global Crossing.
HP leased Qwest’s Web hosting facilities and bought broadband connections while selling Qwest hardware and management services. HP spokeswoman Rebeca Robboy said no barter was involved, and a former HP executive who worked on the deal said it and other HP ventures had conservative accounting, excluding any stock gains from revenue figures.
“Because the market was so hot, the name of the game was to get big quickly,” said the executive, who spoke on condition he not be named. “It was basically a land grab, so you found as many partnerships as possible.”
There’s nothing inherently wrong with such alliances, but they provide more opportunities for misclassifying revenue, experts said.
“A lot of the special kind of transactions we saw were definitely part of this big bubble of excess,” said Charles Mulford, an accounting professor at the Georgia Institute of Technology. “These methods of accounting for revenue entail judgment in application, and what might appear to be proper application of judgment at the time can often appear to be questionable in hindsight.”
All the regulatory and political changes have gotten the attention of tech executives.
Most are holding the line on one key issue, declining to record stock option grants as an expense. Critics say the practice obscures companies’ financial performance, but there’s no question that Intel Corp., Cisco and Sun are on solid legal ground in their defiance.
In other areas where the legal protections are slim, and seemingly getting slimmer every day, companies are changing their ways.
“A lot of companies are running scared. No one wants to be the next headline,” Nelson said.
Executives are spending more time evaluating how solid deals are and how they should be recorded, and outside directors are asserting themselves more, investors said.
The legal and regulatory shifts “give independent directors more clout to stand up to what may have been marginal practices,” said Dick Kramlich, co-founder of Menlo Park venture firm New Enterprise Associates.
Barter deals are nearly gone, fewer companies rely as much on pro forma income reports and big alliances are rarer. Some companies even seem to be competing over which can disclose the most. But in a twist to the trend, accounting experts fear some companies may be using the changing sentiment to gain an unfair advantage: Firms that have made massive restatements of past revenues or profits, including Qwest and Xerox Corp., may be setting the stage for numbers that look much better down the road.
“Some of the restatements have been overly conservative. They’re banking earnings for future periods,” Mulford said.
Although few major valley firms have restated earnings, Cisco already has made itself look better through an aggressively negative portrayal of its assets.
Cisco’s true performance already had been hard to track because of its rapid acquisitions, use of pro forma numbers and large option grants, analysts complained. Just over a year ago, Cisco took a $2.25-billion pretax charge for inventory that it said was worthless. That triggered a spate of still-pending class-action lawsuits accusing the company of accounting tricks and securities fraud. Cisco said the suits are without merit.
In the quarters since then, just as some had predicted, the company reversed more than $700 million from that charge, increasing its gross-profit margins.
