Prosecution stumbles as Enterasys trial opens

Prosecutors are struggling to prove that five former Enterasys Networks executive conspired five years ago to defraud investors while the firm was being spun off from Cabletron Systems, in a trial that has been quietly unfolding in U.S. District Court in Concord.

The case, in the words of U.S. Assistant Attorney William Morse, involves “cheating and lying” by executives who were greedy for stock options, fearful for their jobs, caught up in a company culture that would not allow failure, and willing to break accounting rules in order to inflate revenue while concealing the company’s bleak financial condition from its auditors, regulators and the public.

The resulting scandal ended up decimating the successor company to what was once the state’s largest employer. Enterasys, which ended up abandoning its Rochester headquarters to move to Massachusetts, was sold last spring to a handful of private investors at a small fraction of its stock price, causing shareholders to lose billions of dollars in value.

The five defendants, who had various roles in the alleged scheme are:

• Robert Gagalis, former chief financial officer

• Jerry Shanahan, former chief operating officer

• Bruce Kay, vice president of finance

• Robert Barber, a consultant for the investment team

• David Boey, who directed the sales and operations department in the company’s Asia and Pacific region.

Similar to a “basketball team” they all had “the common goal of the game – to deliver the numbers,” Morse told the jury. “At crunch time, the defendants didn’t play by the rules.”

So far, prosecutors have attempted to tell the story through witnesses who have admitted their own participation in the scheme, especially CEO Enrique “Henry” Fiallo, who now faces a possible five-year prison sentence after pleading guilty to conspiracy.

Yet the trial threatens to stretch out beyond the expected four-to-six-week time frame, bogged down by so many sidebars and jury breaks.

U.S. District Court Judge Paul Barbadoro has turned to calling in the 14 attorneys involved early each morning, has had them stay long after the jury goes home, and even meet on Saturdays, in order to work out evidentiary issues.

Prosecution on defensive

Barbadoro, who had at one point threatened to cite all attorneys with contempt for not following his instructions to work things out more among themselves, called the case “almost unmanageable.”

In his 14 years on the bench, he said, “I have never had a trial that was more difficult,” he said.

While Barbadoro, not known as an easy judge, has admonished both sides during the trial, he has reserved his most scathing comments for the prosecution, mostly when the jury is out of the room, but sometimes even during questioning.

The prosecution was put on the defensive from the very beginning. The trial had already been delayed for nearly half a year because prosecutors questioned Enterasys’ payments of defendants’ legal fees.

Prosecutors eventually lost the battle, and now this fully funded high-powered defense team is making their life miserable. While most of the defense’s objections are overruled, enough are sustained to prevent whole areas of questioning from being undertaken. Defense attorneys also have been able to seize on any prosecution gaffes and exploit them for days.

The defense team’s tenacity was on exhibit during the jury selection process.

While questioning and qualifying the jury was left to the judge, defense attorneys got him to ask their questions – whether potential jurors were ever victims of fraud, lost any money in the stock market, followed any corporate scandal in the media, had strong feelings about corporate executives, or even if they had any problem with Cabletron co-founder Craig Benson.

Benson, who later went on to serve a term as the state’s governor, is neither a defendant nor a witness in the trial. So far his name has only been mentioned once, as a member of the auditing committee that recommended an internal investigation after the scandal broke in February 2002.

While Barbadoro only disqualified jurors with strong feelings that might cloud their judgment in this case, the defense team had 20 challenges without cause, compared to the prosecution’s six. By the time the selection process was done, almost anybody with any familiarity with corporate malfeasance was gone from the jury pool.

‘Three-corner deals’

When the trial finally began, Morse’s opening statement was given in the broadest terms. The conspirators, he said, were in a “huge jam” because Enterasys made a “promise that it just couldn’t deliver” to hit its revenue target for the quarter ending Sept. 31, 2001 – its first quarter as a stand-alone company.

When it couldn’t do so, Morse said, rather than “take their lumps,” the conspirators “falsified documents” and “altered the books.” And “once they fooled the auditors” they “lied to the public.”

The prosecution concentrated on five transactions. Two – involving the companies Tech Data (Canada) and Ariel – were cases in which Enterasys allegedly agreed to a secret side letter that would lead auditors to conclude that deal would not count as revenue given the accounting practices in force.

The three other transactions – involving GEMMS, Paraprotect and Worldlink – were investment deals in which the company would invest in a firm if that firm used the money to purchase Enterasys products, using a particular distributor. If auditors knew the nature of such “three-corner” transactions, they never would have counted them as revenue, prosecutors maintain.

The defense however was ready to try to pick this story down piece by piece, starting with the whole idea of a conspiracy.

If this is a conspiracy, argued Bruce Singal, representing Kay, “it was the oddest group of conspirators that you could ever imagine.”

Kay was on his way out, Singal said, demoted from CFO to be replaced by Gagalis.

Gagalis landed from Fisher Scientific on July 19, argued attorney James Rehnquist, and was immediately whisked away on a “road show,” only to be back in the office on Aug. 2, less than a month before the quarter in question ended.

Similarly, defendant Robert G. Barber wasn’t even with the company. Although he worked for Cabletron for more than a decade, by the time of the alleged conspiracy he was a private contractor, “outside looking in” and “essentially kind of hanging there” as a member of an investment team, according to his attorney, Richard McCarthy.

Gagalis wanted him off the team, and defendant Shanahan became chief operating officer – the job Barber wanted to keep.

Shanahan, for his part, argued his attorney, Andrew Good, was only at the company on a two-year contract, temporarily in New Hampshire from his native Ireland. He was primarily concerned with production schedules, and had nothing to do with accounting.

And several of the defendants hadn’t even met David Boey before the trial, since he was working in Singapore – “on the other side of the planet,” said Singal.

Kay, for his part, didn’t even know about the side agreement, said Singal. He had tried to “put the brakes on the deal” by having it corrected before the quarter, and when he found out what happened later, “he was angry because it creates unnecessary red flags.”

Then there were the “three-corner deals.”

When Morse described such deals, he urged the jurors to “keep your eyes on the cash.” Enterasys was “buying its own revenue. The return of so-called investments was sometimes a matter of hours after the cash went out the door.” Then the company hid that fact from auditors, Morse said.

But it was not unusual, maintained Rehnquist, for investing companies to insist that the company receiving the investment buy its products. Such “strategic alliances” often use distributors, or “channel partners.”

Trial missteps

As the trial started, the prosecution’s first witness, Gary Workman – former president of Enterasys’ Asia Pacific division – delivered what Barbadoro called “devastating” testimony, not to the defense, but to the prosecution’s credibility.

In testimony that the judge later called a defense “lawyer’s dream,” Workman eventually admitted living “a life of falsehood.”

Workman’s credibility was under question to begin with, because he had already admitted lying under oath to Securities and Exchange Commission investigators. The government dropped the charge after he pleaded guilty to wire fraud in exchange for his testimony.

Workman described one of the secret side agreements involving a $3.9 million deal with Ariel International Technologies Ltd., a company that would resell Enterasys products to end-users. It was the discovery of this Singapore deal that launched the SEC investigation that eventually led to the current trial.

That deal mainly involved Boey, who with Workman’s approval, allegedly changed the document terms after the deal was recorded as revenue.

Shanahan had little, if anything, to do with this particular deal, but he supposedly provided the “pressure” to do “whatever it takes” to meet the target, that pushed people under him to break the rules, Workman testified.

Under Morse’s questioning, Workman – despite projections that he could not increase his division’s sales beyond the previous quarter’s $25 million – arbitrarily insisted on a $31 million target, a 25 percent increase, even though the high-tech market was collapsing.

But Good – Shanahan’s attorney – confronted Workman with a document sent to Shanahan that stated that the previous quarter’s goal had already been $31 million, not $25 million. “That’s what the document says,” agreed Workman.

When pressed, Workman said he had inflated that previous quarter in order to meet his bonus goal of $30 million, because of his own “greed.” So the figure was $25 million “in my mind,” he said, and he believed that Shanahan also knew that the $31 million figure would be adjusted downward eventually.

Defense attorneys spent hours tearing apart Workman in front of the jury, and Barbadoro, calling a problem of the government’s making, gave the defense free reign, even allowing attorneys to call Workman a liar in front of the jury.

“Yes, I lived a life of falsehood,” Workman agreed.

Similarly, defense attorney Cathy Green – who also represents Gagalis – tore into Fiallo, who testified that he was “extremely nervous” before Gagalis “reiterated” Enterasys’ revenue goal in a July conference call, because of a recent revenue update provided by Shanahan.

“You didn’t share that with Bob,” Green said

Fiallo said he didn’t.

“You were deceiving him, right?”

“I didn’t tell him a lot of things,” Fiallo replied.

“He was putting his credibility on the line and you let him do it, right?”

“I wouldn’t characterize it that way,” Fiallo said.