SEC Accounting Probe Expands in Silicon Valley
In a show of force by the federal government against Silicon Valley, top executives from three Bay Area software companies were charged with accounting fraud Monday. Managers at two of the firms were charged criminally as well.
The charges allege that five executives at Quintus Corp., Unify Corp. and Legato Systems Inc. separately engaged in a laundry list of illegal practices that wildly inflated revenue during the technology boom.
According to the Securities and Exchange Commission, a Quintus executive created false contracts, e-mails and purchase orders, as well as forged signatures and faked the proof of a sale needed by an auditor; Unify managers paid other firms to buy its software; and Legato booked sales on deals that were never consummated.
Also Monday, accounting firm Ernst & Young was charged with civil violations for getting involved in an allegedly improper business relationship with PeopleSoft, a software firm that was its client.
Federal officials are expanding their probes into the technology sector, amid mounting evidence of widespread fraud in the late 1990s. The SEC also is targeting what it believes were inflated revenue figures across a broad expanse of U.S. industry, as managers sought to pump up their stock prices.
“With some tech companies, the key to their fame was thinking outside the box,” said Charles Niemeier, head of accounting for the SEC’s enforcement division. “That does not work well when it comes to the accounting rules.”
At their peak, the three software companies charged Monday had a combined stock market value of about $8 billion. Legato has fallen to $650 million, while Unify trades for pocket change. Quintus went bankrupt and no longer exists.
“We all knew that the bubble was being fueled by massive amounts of hype,” said Silicon Valley hedge fund manager Eric Von der Porten. “But even the skeptics didn’t imagine just how many maneuvers companies were using to puff up their revenues and make it look like they might justify their market values. It’s only now in the post-bubble, post-Enron environment that all the dirty little secrets are starting to be revealed.”
Monday’s charges were announced simultaneously because “we wanted to send a message to the firms in Northern California that if they play these games, we’re going to go after them aggressively,” said Helane Morrison, SEC district administrator for the Bay Area. Federal prosecutors simultaneously announced criminal charges against the Quintus and Unify officers.
According to the complaints filed in U.S. District Court in San Francisco, the three companies seemed to expend more energy on faking sales than they did in generating legitimate business.
“The nature of most financial fraud is that it begins subtly and then it grows,” Niemeier of the SEC said. “Once a company starts manipulating the numbers, it’s almost impossible to stop without revealing the fraud. Once started, the company is pushed to add more fraudulent revenue or earnings in order to maintain the scheme.”
Unify, which makes database management software, was founded in San Jose in 1980. It went public in 1996 and saw its stock soar in the Internet boom as it started marketing e-commerce applications. But sales during fiscal 2000 were in danger of falling short of expectations.
As a result, the government charges, Chief Executive Reza Mikailli and Chief Financial Officer Gary Pado resorted to fictitious sales.
In one case, a Panamanian company called Open owed Unify $400,000 on a software contract. Despite this obligation, the SEC says, the Unify executives negotiated a new $1.15-million contract. Open’s chief executive warned Unify that he couldn’t pay, but the executives told him not to worry, according to the SEC’s civil suit.
Unify’s auditors refused to record the new sale until Open paid its existing debt, according to the suit. Mikailli wired Open $400,000 of his own money, which Open then sent back to Unify. Open never paid the $1.15 million, but Unify recorded the revenue anyway, the SEC says.
In another episode, according to the SEC, Mikailli was in discussion with the chief executive of Internet company Ichatterbox Inc. about joining the Unify board of directors. There was a catch, however: Ichatterbox had to buy $100,000 worth of Unify software, even though the Internet company had no need for it and very little cash, the SEC says.
Mikailli paid Ichatterbox $300,000, instructing its chief executive that a third of it was for the software and the rest was an investment, the SEC says. Unify then reimbursed Mikailli his $300,000.
Such fraudulent deals, the SEC charges, allowed Unify to report revenue of $39.5 million and net income of $15.3 million for the 12 months ended April 30, 2000. More than half the revenue, or $21.1 million, was fake, the SEC says; as for the profit, it actually was a loss of $7.7 million.
Mikailli sold all his Unify stock--more than $8 million worth--during this time. The sales went unnoticed, the SEC says, because he failed to report them.
Mikailli was arrested Monday morning at his home in Saratoga, Calif. He was indicted on 10 counts of securities fraud and conspiracy and faces SEC civil fraud charges. His lawyer did not return a call for comment Monday night.
Pado, the CFO, pleaded guilty last week to conspiracy to commit securities fraud, the government said.
After its accounting problems were first revealed in July 2000, Unify’s stock fell as low as 3 cents a share.
Quintus was founded in 1984 as an artificial intelligence firm. By the time it went public in late 1999, it was touting itself as a maker of software that allowed companies to manage their customer relationships. The stock rose from $18 to $55 the first day. Chief Executive Alan Anderson’s stake was immediately worth $62million.
“To create and maintain interest in the stock,” the SEC charges in its complaint, “Anderson embarked on a campaign to falsely bolster the company’s reported revenue.”
In one deal, the SEC says, Quintus negotiated to make AT&T; Corp. a reseller of its software. Quintus asked AT&T; to guarantee that it would purchase $8 million worth. AT&T; declined, saying it would pay for the software as it was resold to third parties.
According to the court documents, Anderson forged an AT&T; executive’s signature on a contract that guaranteed a $7-million payment. Quintus then added the $7million to its quarterly revenue.
As part of its standard policy to test the accuracy of Quintus’ books, the software company’s auditor asked AT&T; to confirm the deal. “When AT&T; did not respond to the request for confirmation,” the SEC charges, “Anderson offered to locate [the executive] and deliver the confirmation request.” Instead, the complaint says, Anderson forged a response confirming the deal.
When the accounting discrepancies were first revealed in late 2000, Quintus collapsed. Within three months, it entered bankruptcy proceedings.
Anderson’s lawyer, Michael Tubach, said, “Mr. Anderson has fully cooperated with the government.”
The third company, Legato Systems of Mountain View, Calif., was founded in 1988 and went public in 1995. A maker of software for managing large computer networks, it was once a hot stock, reaching a high of $82 a share in late 1999.
Civil fraud charges were filed against David Malmstedt, Legato’s former executive vice president of worldwide sales, and Mark Huetteman, its former vice president of North American sales.
The complaint charges the pair with causing Legato to fraudulently record millions of dollars of sales. In one case the company recognized $7 million of revenue on a deal that was never implemented, the SEC says.
Malmstedt’s lawyer, Kyle Kirwan, said “the SEC allegations are completely false.” Huetteman’s attorney did not return a call for comment Monday night.
