Enterasys trial filings say auditors claimed interference

Cabletron Systems co-founder Craig Benson, along with officials of Enterasys Networks, repeatedly complained about — and threatened to replace — accountants who were looking into the company’s accounting practices, according to documents filed in the upcoming trial of former Enterasys executives accused of securities fraud relating to some of those very same practices.

But the former governor’s attorney said there was no attempt to interfere with the accountants’ investigation.

“At no time did Craig Benson ever request that the accountants do anything other than their best job, and there has never been any allegation to the contrary,” said Harvey Wolkoff, an attorney with the Boston law firm of Ropes and Gray, who represents both Benson and Enterasys.

Benson never worked for Enterasys, which was spun off from Cabletron – once the state’s largest employer — in August of 2001, but he was a member of the board’s audit committee and was the company’s largest individual stockholder at the time in question.

Benson has never been implicated in the case, for which jury selection had been scheduled to begin on March 7 in U.S. District Court in Concord. At press time, however, the trial appeared headed for another postponement after the U.S. District Court scheduled a hearing on an emergency motion filed by defense attorneys. The defense is charging that government lawyers government interfered with their trial preparations.

A hearing on the motion will be held March 7 – the day the long-anticipated trial had been expected to begin.

When it is rescheduled, the trial will involve five former Enterasys executives:

• Robert Gagalis, the company’s former chief financial officer

• Jerry Shanahan, the former chief operating officer

• Robert G. Barber, senior vice president of business development at Cabletron and an Enterasys consultant

• Bruce D Kay, senior vice president of finance

• Hor Chong “David” Boey, director of Enterasys’s Asia Pacific division.

Former CEO Enrique “Henry” Fiallo has already pleaded guilty, along with three other executives to reduce charges.

The charges mainly center on an alleged conspiracy to fraudulently inflate revenue through a variety of methods: using “investments” in other companies to purchase Enterasys products; selling products with secret side agreements that raise doubts about the legitimacy of the revenue; shipping products with such generous rights of return that they really were never sold; and incorrectly dating receivables to increase the previous quarter’s profits.

The executives allegedly did this to maintain Enterasys’s stock price during and immediately after the spinoff, hurting investors who believed earlier revenue estimates and then took a huge loss on the stock when the firm’s true financial picture came to light.

Both Enterasys and Riverstone, a smaller Cabletron spinoff, are in the midst of being sold privately at only a fraction of their former price. Stockholders voted to sell Enterasys to private investors on Feb. 15 in a deal expected to close in March. Riverstone – whose trading license was revoked for not filing accurate financial documents – is attempting to sell its assets to Lucent Technologies through Chapter 11 bankruptcy.

Auditor complaints

Benson’s name came up in pretrial documents filed in mid-February. They were filed in an attempt to exclude the testimony of James Boyer and David Wilson, the KPMG accountants in charge of auditing the books of Cabletron and Enterasys before and after the spinoff.

The prosecution wants the two to provide expert testimony on accounting fraud as well as well as their personal participation in how the alleged fraud came to light. The defense argues that the accountants were too caught up in the chain of events – and too self-serving — to be objective experts, and produced a series of summary interviews by federal investigations to back up their point.

The defense later argued that the government blocked its access to these accountants, which – along with other government tactics – they said warrants a further delay in the trial.

According to a summary of a January 2004 interview conducted by the FBI, the U.S. Postal Inspection Service and the Department of Justice, Boyer, a KPMG partner, said that Benson requested a meeting in May 2001 with KPMG Chairman Steve Butler. This was during the transition stage, after Enterasys became a Cabletron subsidiary but before Aug. 6, 2001, when Enterasys succeeded Cabletron as an independent publicly traded company. It also was before KPMG began looking for evidence of fraud.

At the meeting, according to the summary, Benson complained that KPMG was “too detailed,” took an “excessive time to complete” their work and too expensive.”

In addition, “Benson questioned whether KPMG wanted to be Enterasys’ auditor,” the summary says. “He wanted the team changed,” specifically mentioning David Wilson, who was in charge of the audit, Boyer told the interviewers. Wilson had been working on the Cabletron accounts since 1998.

Benson also complained that KPMG was not buying Enterasys products.

Boyer kept the team in place. In July 2001 – a month before the official spinoff — Boyer had another meeting with Benson, who again criticized the accountants – this time for being “unfair to Enterasys” with respect to accounting issues involving Riverstone (which Cabletron had spun off in February 2001.) Boyer contended that certain Cabletron liabilities should have been pushed down onto Riverstone’s books.

“Benson believed Boyer was going overboard,” the summary states.

When Boyer met with the audit committee concerning a critical report dated July 17, 2001, concerning Cabletron/Enterasys control practices – including disclosure of all information regarding revenue recognition – Benson didn’t say much, according to the summary.

But Benson’s concerns were later echoed by other company officials, including Gagalis, who said he was putting KPMG’s contract out to bid. Gagalis, according to the summary, said that the audit was “too detail-oriented”

The auditors were looking at large sales at the end of a quarter to companies that Cabletron or Enterasys invested through various resellers. The “three-cornered deals” concerned prosecutors, who suspected a company’s “investments” were really a way to purchase its own product, fraudulently boosting sales.

Long-standing complaints

As KPMG kept digging into these deals, Gagalis and other officials allegedly complained that the auditors were “being too strict, with too many rules.”

According to former CEO Fiallo – in a FBI summary of his 2004 interview – it was COO Jerry Shanahan who was at the heart of these deals. It was Benson, along with Benson’s hand-picked successor, Piyush Patel, who recommended Shanahan, Fiallo is reported to have said.

“Shanahan knew that a number of investment deals were being done simply for Enterasys to hit the numbers (revenue) for the quarter,” according to the summary. Shanahan allegedly formed an investment group by which such revenue-enhancing deals were discussed.

But Gagalis and another officials said that such deals were “like cocaine” and that the company was “addicted to them.”

Still, Gagalis said, the investments and the sales were not related and did not have to be disclosed, Fiallo reportedly alleges in the summary.

Auditors also were looking at Enterasys’ return policy for resellers, which Cabletron had started employing a year earlier. The auditors contended that sales made under an overly generous sales policy should not be counted as sales.

In late January 2002, Wilson examined a separate secret side agreement involving one of the resellers, which led to an expanded audit, as well as Enterasys’ disclosure of accounting irregularities.

Harvey Wolkoff, Benson’s attorney, disputes the summaries of the accountants’ interviews. It was company officials, and a forensic auditor – not KPMG – who discovered the accounting issues that led to Enterasys’ subsequent regulatory issues, he said.

He also said that Benson’s complaints merely echoed the dissatisfaction with KPMG that ran throughout the company, and they referred to normal accounting issues, not any investigation into fraudulent practices.

Benson, he said, never would have said the accountants were too detailed. “It was just that they were taking too much time and were slow in reaching conclusions,” said Wolkoff.

And once there was an indication of irregularities, he said, “Benson was in the forefront for calling the company to open its books. He was the first person to call for a thorough investigation.”