Ex-Enterasys exec grilled on business deals
Was changing the language on a business deal a clarification or was it altering a document to fool auditors and the public?
What accounting rules apply when recognizing revenue from a company you are investing in?
Should a purchase order count as a sale when it is signed, when the product is shipped or when it is paid for?
These are the questions that a jury with little financial experience must sort through as the securities fraud trial of five former Enterasys Networks officials finishes up its third week. The officials are accused of breaking accounting rules in order to inflate revenue in the quarter when Enterasys was spun off from the Rochester-based Cabletron Systems, once the state’s largest employer.
On the witness stand for the second day was Anthony Hurley, a former Enterasys controller, who pleaded guilty to one count of wire fraud in exchange for his testimony.
On Monday, Hurley testified that he altered an attachment to an e-mail to make it appear that a revised contact had been completed at the end of that crucial quarter, so that Enterasys could recognize $3.9 million of revenue in that quarter. In reality, the contract – with a deal with Ariel International, a distributor from the Asia Pacific region – was revised several weeks later.
On Tuesday, William Cintolo, attorney for defendant William Boey — former director of sales and operations in the company’s Singapore office — cross-examined Hurley. Boey is accused of revising and backdating the document, but Cintolo asked Hurley: “It was you that manipulated it?”
Hurley said that he did.
It was Hurley who first raised questions about the original contract, signed hours before the quarter closed, because of problematic language in two clauses: one that left the “primary responsibility” with Enterasys to sell the product, and the other that gave Ariel as much as 150 days to repay it. (That problematic terms, however, were put back in a secret side letter that was not initially shown to auditors.)
But Cintolo said that there was nothing wrong with “clarifying” an agreement after the fact, especially an agreement that was negotiated in another language that was being translated into English. The question was “when, not if, you are going to pay,” he said.
So if it “did not change the meaning, it would be OK to correct it?” he asked.
Hurley agreed that it would be.
Also on Tuesday, Hurley went into detail concerning so-called three-corner deals. In such deals, investment cash in a third party is “recycled” back through a distributor and recorded as a sale. Hurley focused on three questionable deals – involving three firms, GEMMS, Paraprotect and Worldlink — that resulted in almost $7 million in revenue. But auditors were told that only a tenth of the deals were revenue related, he said.
The deals, Hurley said, violated accounting rules that went back at least three years. Under those rules – which Hurley had drafted himself – such revenue should be not be counted when the deal was made if the company was relatively new and didn’t have enough cash to pay for them independent of the investment.
But Hurley said he had questions about these transactions, either when they were discussed in conference calls, or when documents were prepared for auditors to be filed with the Securities and Exchange Commission.
Reading from handwritten notes, Hurley noted that GEMMS was a “young company” with limited financial ability, and that Paraprotect’s Dun & Bradstreet report “makes them look poor,” and that in the deal with Worldlink — another “young service provider” — $6 million would be wired through a distributor the same day in order to purchase the product. Worldlink, he testified earlier, only had $100,000 in cash and more than that in current liabilities.
Hurley was concerned that Worldlink “couldn’t keep its doors open. That it could go out of business,” he said.
However, despite being the usual liaison with auditors, it was defendant Robert Gagalis – the former chief financial officer – who was going to provide the auditors from KPMG with financial information about those deals, Hurley said.
“This was a change,” said Hurley.
The auditors asked Hurley specific questions about whether these transactions were related to sales, even sales through distributors. Enterasys didn’t tell them the truth, Hurley said.
Cintolo questioned whether Hurley’s revenue recognition policy was ever official adopted by Enterasys. He even noted that auditors had criticized the company for not having one.
Hurley agreed that it as “not formally enacted,” but that the policy had been reviewed by his superiors — “no one contracted it,” he said. – BOB SANDERS