Prosecution’s case takes shape at Enterasys trial

After the government finished presenting its case Dec. 4 in the securities fraud trial of five former Enterasys Networks executives, perhaps its most damaging piece of evidence did not come from a star witness or through skillful examination by prosecutors.

It was a short e-mail exchange shown to the jury without comment or rebuttal, entitled, “Deal Clean-Up.”

The e-mails were written four days after the crucial 2001 quarter when Enterasys was spun off from Rochester-based Cabletron Systems. Prosecutors contend that the executives conspired to conceal information from these deals from KPMG – its outside auditors — allowing it to inflate revenue to meet Wall Street expectations, enabling them to inflate their own stock options and ensure their jobs.

“Crack the whip” to get the deals “cleaned up,” urged Eric Jeager, Cabletron’s vice president of corporate affairs, in an e-mail to Robert Gagalis, Enterasys’ former chief financial officer. Jeager (who has not been charged in the case) also reminded Gagalis to remind Bruce Kay, vice president of finance, another defendant and two other executives “NOT to talk with KPMG until they have a clean set of paperwork and understand clearly each deal.”

Gagalis responded that his staff was putting together a package of information so he could review the deals before they would go to the auditors. Then he added, “no documentations of purchases through channel partners will be provided to kpmg.”

Shortly after the e-mails were shown, James Boyer, a KPMG partner and lead Enterasys auditor, took the stand. Boyer contended that KPMG allowed Enterasys to improperly report some $11 million in revenue from five deals “because we didn’t have all the facts.”

The auditors were not only among the last prosecution witnesses, they also, the government contends, were the first victims of a conspiracy that ranged from former CEO Enrique “Henry” Fiallo, who earlier pleaded guilty to one count of securities fraud, to defendant David Boey, who headed sales in the Asia Pacific region.

The other two defendants are Jerry Shanahan, the former chief operating officer, and Robert Barber, a former Cabletron executive who was a member of Enterasys’ investment team that allegedly put together some of these deals.

With the auditors fooled, prosecutors say, the executives were able to file false financial statements to the Securities and Exchange Commission and issue misleading press releases to the public, keeping the stock price high until February 2002, when the SEC launched its investigation and the company lost over $1 billion in value.

That’s the case that the prosecution is trying to prove. But a defense team consisting of at least nine attorneys hasn’t made it easy.

They pounced on the prosecution’s first witness, who contended that Shanahan pressured him to arbitrarily increase sales, using documents to prove that the allegation wasn’t true. U.S. attorney William Morse actually had to read a stipulation to the jury correcting the error.

Since then, the prosecution’s case has regained its footing. Thus far, the government’s strongest case appears to be focused on “three-corner deals,” essentially investments in shaky companies in order to generate revenue.

Enterasys would wire money to the company in exchange for stock. The company would then immediately wire the cash to a distributor, which would use it to buy product.

The auditors knew about the investments, testified Boyer, but despite specifically asking, they were not informed that there were related sales that were included as revenue. If auditors knew, they would have looked at it as a non-monetary transaction and would have had to figure out the actual value of the stock in order to determine how much revenue Enterasys actually received, he said.

The problem, Boyer said, was that these investments were in emerging high-tech companies that were strapped for cash.

“It is very difficult to value that stock,” Boyer said.

The government put on the stand executives from some of the companies involved, including John Scarfidi, the former CEO of WorldLink, which simply wanted to borrow money to purchase the company’s equipment, Scarfidi testified. The company only had $170,000 in the bank, and was seeking to buy some $6 million in equipment.

Barber instead wanted to structure the loan as an investment (contingent on the company’s financing coming through), Scarfidi said. On Barber’s instructions, Enterasys would wire some $6.8 million to WorldLink, which immediately used it to purchase $5.3 million in equipment from a distributor, two days before the quarter, Scarfidi said.

The following day Enterasys wired almost $500,000 and the company immediately wrote a check that matched the investment to the penny to purchase the software that went with it.

WordLink’s other financing never did come through, so the investment did not pan out. As for the equipment, Scarfidi said, much of it “was being packed up and being shipped back to” Enterasys when he left in 2003.

Prosecutors also questioned Joseph Regan, former CFO of Para Protect, a start-up security software firm with $1.5 million in the bank and burning some $500,000 in cash every month.

At first, the company sought a simple $1 million cash investment, but the “deal dramatically changed” as Enterasys instead said it wanted to give the company $700,000 in software and only invest $300,000 in cash, Regan said. The company then wanted Para Protect to take on another $150,000 of software in exchange for a $200,000 service contract.

Regan said he knew this was all being set up in order to recognize revenue, and he told Gagalis that the accounting rules wouldn’t allow it. He said Gagalis replied that all this was being reviewed through the auditors, KPMG.

It was Gagalis who had approved a policy change that would enable the company to “delink” various investments from the sales of products generated, testified the firm’s former controller, Anthony Hurley.

First, Gagalis, and later Kay, told Hurley that the new accounting rules allowed company auditors to recognize revenue just before the end of the quarter in question, said Hurley who pleaded guilty to one count of wire fraud in exchange for his testimony.

Both approved the policy, despite the former 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, Hurley said.

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

The deals were discussed weekly all through the crucial quarter (and more often by the end of the quarter) led by Gayle Spence, executive assistant of former CEO Fiallo. Spence also pleaded guilty to one count of securities fraud, 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 that she knew that “something was the wrong” with the deals, even while she was a “cheerleader” for Fiallo and Enterasys.

The idea for such deals was proposed by Barber in March 2001 while Enterasys was still part of Cabletron. Barber, according to Spence, said that deals that “would not stand up under the auditing rules would be purchased through a third party.”

The prosecution has had somewhat a tougher time establishing that revenue was improperly recognized in two other deals, involving Ariel International and Tech Data Canada.

It was the Ariel deal that led to an investigation into accounting fraud that eventually resulted in this criminal trial. Boyer said that he learned on Jan. 31, 2002, that there were two versions of the deal: One contract, signed on Aug. 31, 2001, hours before the quarter ended, had two terms that were problematic in recognizing the revenue. In another version, negotiated after the quarter ended but also dated Aug. 31, the language was removed — but that language was included on a side letter.

After a “quick read,” Boyer became concerned not only about the impact on revenue recognition, but that there was “something fundamentally wrong” that could include an attempt to keep information from auditors.

It was such a serious matter that he recommended an immediate meeting with the Enterasys board of directors’ audit committee, headed by Cabletron co-founder Craig Benson.

Boyer was not asked what Benson – who has not been implicated in the conspiracy in any way – said at the meeting the following day, but the result was an intensified audit.

Boyer focused on the “key” clause: “Enterasys will have the primary responsibilities for selling these products.” The clause originally came after Enterasys said it would sell $4 million of the products to Ariel.

“That doesn’t make sense,” said Boyer. “You sell something once and that’s it. How can you sell it a second time?”

The conclusion, said Boyer, is that if Enterasys was still responsible to sell it, as indicated in the side letter, it wasn’t a sale at all.

Despite this, several executives – including Gagalis – signed a management letter included in the quarterly filing with the Securities and Exchange Commission that said that there were “no side agreements with customers, or other terms in effect, which allow for the returns of merchandise”

In the Tech Data Canada deal, Shanahan ordered two other troublesome clauses removed from a contract with a distributor, but then slipped those terms back in an e-mail, enabling Enterasys to improperly recognize $3 million in revenue, testified James Benard, the firm’s former vice president of world wide sales operations

Benard said he was sent to Canada after an official from Enterasys stepped out to provide moral support. But while he was at the Manchester airport on the way to Canada days before the quarter closed, Shanahan reached him on his cell phone and allegedly asked him to remove two terms from the original deal.

The terms said Tech Data would not have to pay for goods that were sold in less than 90 days under one clause, and it would allow it to return goods that originally went through the old distributor.

Those terms “limited the ability to recognize revenue that quarter,” Shanahan allegedly told Benard.

Tech Data Canada officials balked at the new terms, so at Shanahan’s direction, Benard assured them that they would be put back in. Benard e-mailed Shanahan that he should reference the agreement and assure in writing the Tech Data that Enterasys plans to agree to those terms anyway. Shanahan, while not mentioning the original agreement, said that he would “confirm” both the 90 days option and the liberal rights of return.