Probe looks at Enterasys’ earliest days

A new series of federal indictments not only widens the net in the probe of Enterasys Networks Inc. but seems to narrow the focus of the investigation, to the point in time when the company was being spun off from Cabletron Systems, its predecessor.

According to the March 23 indictment, Enterasys – like Cabletron, formerly located in Rochester — began some of its allegedly fraudulent behavior two days before it was born – on Aug. 6, 2001 — with at least one Cabletron executive knowing about the behavior.

Investigators said that the probe into investor fraud is continuing.

The indictment says Enterasys repeatedly invested in third-party companies in exchange for those companies agreeing to buy Enterasys products. It then allegedly hid those transactions from auditors and shareholders in an attempt to boost sales for its first quarter, according to the indictment. The company also allegedly hid side letters from auditors that — if known — would cast doubt on the reported sales.

Enterasys, which has since moved to Andover, Mass., admits that it had overstated its first-quarter revenue by $83 million. The indictment focuses on roughly $10 million in alleged inflated revenue.

Thus far, nine Enterasys’s executives have been indicted. Four – including former CEO Enrique Fiallo — have pleaded guilty. Two were named for the first time on March 23.

All indicted conspirators also worked for Cabletron, including the latest two: Jerry A. Shanahan, an Enterasys chief operating officer who was previously in charge of Cabletron’s manufacturing plant in Ireland; and Robert G. Barber, an accountant who once was the senior vice president of business development at Cabletron. He worked for Cabletron for more than a decade.

The indictment also says that Shanahan reviewed the improper deals with an unnamed “senior Cabletron executive” two weeks after the Aug. 6, 2001, spin-off. Two weeks later, on Sept. 4, 2001 Robert Gagalis, a former Enterasys chief financial officer – who was indicted last year — assured a “senior Cabletron executive” that Enterasys’s outside auditors would not be given documents showing the link between the company’s investments and its sales. It’s not clear if the same senior executive is involved.

In the indictment, Shanahan is portrayed as kind of a cheerleader in the drive to inflate revenue. In July 2001, a month before the Enterasys spin-off, Shanahan allegedly said there was a $20 million “serious disconnect” between the anticipated actual revenue and “where we absolutely have to be,” and that company officials should “take absolute ownership for meeting the target no matter what.”

One way to meet those goals in Enterasys’s first quarterly report was “three corner transactions” through which the company invested in small third-party companies in exchange for buying Enterasys’s products, while hiding the true nature of the transactions from the company’s auditors, the indictment says.

‘Routine business operation’

The indictment named three such companies — Gateway Electronic Medical Management Systems LLC (GEMMS), of Indianapolis, Ind., Para-Protect Services, a Virginia company that appears to have gone out of business, and Worldlink Technologies Inc., an Internet service company.

None of the companies themselves were indicted because the charges are not related to the deal itself, but how it was reported, said Assistant U.S. Attorney William Morse.

For instance, on Aug. 8, 2001, two days after the spin-off, Barber told an executive at GEMMS that Enterasys would “wire funds ‘through’ GEMMS’s account to the distributor as payment for GEMMS’ order,” according to the indictment.

At the end of the month, the $1 million transaction was completed “whereby Enterasys used $1 million of its own money to enable GEMMS to purchase $1 million of Enterasys product.”

GEMMS CEO Rodger Pinto confirmed the deal.

“We gave them some equity of the company and they gave us inventory,” Pinto told New Hampshire Business Review in a telephone interview. “This is a routine business operation. It’s not new, nor is it illegal.”

GEMMS, however, recorded the deal as equity, whereas Enterasys allegedly put it down as sales.

“It is all about how you book it,” Pinto said.

Enterasys asked last year that the deal be reversed, which it was, Pinto said. Enterasys no longer has any equity in the company.

Enterasys also invested $1.2 million in Para-Protect – with the promise of another $1 million more — in exchange for the purchase of $697,000 of Enterasys products. It also invested $6.3 million in Worldlink, with the promise of $6.8 million more, to allow Enterasys to improperly record $4.6 of revenue for its products, according to the indictment.

The other two examples in the indictment had to do with side agreements allegedly used to conceal the dubious nature of some of the sales.

The first charge expands on an earlier indictment involving arrangements with Ariel International Technology in order to falsely report $3.9 million in sales in China.

The second details for the first time another secret side letter on another $3 million deal with Tech Data Canada Inc., allegedly involving Shanahan.

Riverstone settlement

Federal prosecutors say they expect Shanahan, currently back in Ireland, to surrender to federal authorities. Shanahan’s attorney reportedly told the Associated Press that he would contest the charges.

Barber pleaded not guilty at his arraignment in Concord federal Court on March 25.

After leaving Enterasys, Barber went on to become a founder and president of Pannaway Technologies, a firm with $5 million in sales and 120 employees that specializes in helping small phone companies expand to data services.

Barber left Pannaway in October for “personal reasons” and has not been involved in the company since, said Pannaway spokesperson Dale Allair. The indictment came as a surprise to the company, Allair said.

A number of other executives at Pannaway have Cabletron ties. The firm was financed by both of Cabletron’s co-founders, former Gov. Craig Benson and Robert Levine.

Gary Davis, another former Cabletron official, replaced Barber as president. Michael Skubisz, Pannaway’s chief technical officer, also formerly worked at Cabletron and once headed Aprisma, another Cabletron spin-off, which was eventually bought by a private company. Skubisz also served on Benson’s transition team.

Pannaway is totally separate from Cabletron and Enterasys and neither company directly invested in it, said Allair.

Meanwhile, the day following the indictments, Riverstone Networks – Cabletron’s other public spin-off – announced that it had settled with bondholders, agreeing to pay them half of the $131 million owed to them now, with the rest of the payment coming by 2006.

The bondholders filed the suit after the company was delisted from the Nasdaq because Riverstone failed to file updated accurate reports with the Securities and Exchange Commission. That delay was due to an SEC investigation into charges that Riverstone too improperly inflated revenues shortly after it spun off from Cabletron.

Piyush Patel, who as successor CEO to Benson, engineered the split at Cabletron and relocated Riverstone to California, headed Riverstone’s board of directors. Patel has since resigned from the company.