Ex-controller details Enterasys ‘delinking’

Robert Gagalis — Enterasys Networks’ former chief financial officer — approved a policy change that would enable the company to “delink” various investments from the sales of products generated, thereby enabling the company to improperly record millions of dollars of revenue, according to the testimony of the company’s former controller.

The former controller, Anthony Hurley, testifying on Monday in the securities fraud conspiracy trial against Gagalis and four other former Enterasys executive, said that first Gagalis, and later defendant Bruce Kay – former vice president of finance — told Hurley that new accounting rules allowed the company’s auditors to recognize revenue just in time for the crucial quarter after Enterasys was spun off from Cabletron Systems in 2001.

Hurley, who pleaded guilty to one count of wire fraud in exchange for his testimony, said the two approved the policy, despite the advice of auditors that such deals gave the “appearance of recycling cash” if the companies were so financially weak that they couldn’t purchase the product without the Enterasys investment.

In such three-cornered deals – as Hurley explained in a chart displayed for the jury – the shaky company would use the investment cash to immediately buy product from an Enterasys distributor. The distributor would then immediately wire the cash back to Enterasys, which would then be recorded as sales.

But, Hurley testified, Enterasys stopped telling auditors that the deals were linked.

Gagalis said that as long as a purchase order was not actually written into the agreement, there was no need to link the deals and the company could record the revenue, Hurley testified.

Kay also had reservations about this, but later agreed to delink them, Hurley said.

“Bruce was on board with the decoupling theory,” Hurley said.

Hurley, however, told the court he continued to believe that recognizing such revenue was “inappropriate,” even though he went along with it.

The deals were discussed weekly all through the crucial quarter (and more frequently by the end of the quarter) by the investment team, which looked for and tracked investments primarily because of the revenue they generated, Hurley said.

The meetings were led by Gayle Spence, executive assistant to former Enterasys Chief Financial Officer Enrique “Henry” Fiallo. Both Fiallo and Spence have pleaded guilty to one count of securities fraud and both testified last week.

But while Fiallo said he tried to stay as far away from such deals as possible, Spence was right in the thick of it.

Spence testified she knew that “something was wrong” with three-cornered deals.

Spence said that the pressure was particularly “hellacious” during the end of the quarter. Not only was Cabletron Systems spinning off Enterasys on Aug. 6, but Enterasys also was trying reach Wall Street’s expectations of meeting a $240 million revenue target, despite a depressed high-tech market.

Spence, who joined Enterasys from Cabletron, drew a distinction between investments made by the company’s business development team, which were done primarily for technology, and those made by the “investment team,” which were solely for a “product buy.”

The idea for such deals was proposed by defendant Robert Barber in March 2001, when Enterasys was still a Cabletron subsidiary. Barber, according to Spence, said that deals that “would not stand up under the auditing rules because they would be purchasing through a third party.”

But Barber’s attorney, Richard McCarthy, pointed out that Barber and Spence didn’t get along. Spence, who said she had nothing against Barker, agreed that their personalities did not “mesh,” and “I felt like he left things in a mess.”

Defense attorneys tried to discredit Spence, implying that Spence only questioned these deals because she was earlier asked about them by prosecutors, who could put her in jail for – in Spence’s words – “a big chunk of my life.” But Spence said she wasn’t just cooperating to avoid a long prison term.

Hurley also testified about another method of inflating revenue: hiding the true terms of a deal in a secret side agreement, particularly in a $3.9 million sale to Ariel International, a distributor in the Asia Pacific region.

Hurley said that it was he who first called attention to the problematic terms in the original deal closed hours before the quarter ended: the fact that Enterasys retained responsibility for the sale and Ariel had 150 days to pay for the deal, as opposed to 90 days.

Both terms would prevent Enterasys from recognizing the revenue in that quarter, he said. After bringing this to the attention of Kay and then Gagalis, Kay eventually approved a revised version of the deal. (Others testified that a side agreement still preserved the problematic terms of the deal.)

When Hurley saw this new version on an electronic photocopy of the contract – still dated Aug. 31 – he also changed a Microsoft Word document so it would match the photocopy to make the auditors “believed that it was created on Aug. 31,” even though he thought that “people can’t make changes on a backdated” document.

He asked Kay whether the new version should be sent to auditors, and Kay allegedly told him that this is the agreement “we are going to live with.”

Hurley is scheduled to continue his testimony today. – BOB SANDERS

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