SEC: Enterasys fraud goes back 10 quarters

The conspiracy to fraudulently inflate revenue at the former Rochester-based Cabletron Systems — and its spinoff, Enterasys Networks — lasted more than 10 quarters, and attempts by former executives to poke holes in charges related to particular deals are an attempt to “mistake the forest from the trees,” according to Securities and Exchange Commission attorneys in U.S. District Court filings.

The SEC is objecting to motions by former Cabletron CEO Piyush Patel, former CFO James Kirkpatrick and executive vice president-counsel Eric Jaeger to dismiss civil securities fraud charges filed against them. Seven other executives also allegedly participated in the fraudulent scheme, four of whom were found guilty last December of similar criminal charges related specifically to the Enterasys spinoff in 2001. Those four received sentences ranging from 3 to 11-1/2 years.

The alleged fraud in the SEC civil suit, however, covers a much broader time frame and many more transactions, starting with the preparation and filing of the firm’s June 2000 SEC filing and continuing into the middle of 2002.

“This scheme was extensive and of long duration,” claimed the SEC. “It ultimately allowed the company falsely to report, for 10 consecutive quarters, that it had met or exceeded Wall Street analyst’s expectation.”

As a result of this fraud, Cabletron – once the state’s largest employer – “launched two of its subsidiaries [Enterasys and Riverstone Networks] and the Defendants reaped millions of dollars in bonuses and stock sales to the detriment of the Company’s shareholders,” according to the SEC.

Both spinoffs faced similar accounting fraud charges, never recovered after that, left the state and were eventually sold off at a fraction of their former value.

The defendants argue that charges that their actions were taken in conjunction with the scheme were either not particular or detailed enough or that each act did not result in a large enough misstatement of revenue as to be material.

But the SEC argues that the “attempt to divide a continuing fraudulent scheme into a series of discreet acts that … should be viewed separately is unsupported and invites the court to mistake the forest for the trees.”

There were four specific accounting tricks employed by the defendants, according to the SEC:

• Contingencies in sales of products that were neither disclosed or recognized.

• Sales involving the undisclosed ability to return product, which precluded revenue recognition.

• Sales that a distributor would not have to pay until it had sold the product through its own customer base or that the company would sell on behalf of distributor, thereby retaining the risk of the sale.

• Recycling of the company’s cash to create the appearance of a sale to a third party where none exists. In such “three-corner deals,” Cabletron would invest the cash in shaky companies, who would then use the cash to buy Cabletron’s product through a third-party distributor. The set-up enabled Cabletron to conceal the true nature of the revenue from its auditors and the public.

Other deals

The accounting tricks varied, but the “common element to these frauds was the misstatement of or failure to disclose material aspects of sales transactions in order to facilitate improper revenue recognition,” said the SEC. And they all involved to some degree “uncertainty of acceptance or collectability” or contingencies that were put in various “side agreements” that were not disclosed in the company’s books.

The SEC alleges that Patel and Kirkpatrick devised and presented the three-corner deals and both signed the various SEC filings knowing they were false, and Jaeger allegedly helped them both in concealing such deals from auditors and in preparing the false SEC filings. (Patel later went on to chair the Riverstone board, but he has not been charged in an ongoing civil securities fraud suit relating to that company.)

In addition, the filing reiterated the defendants’ participation in specific deals:

• Kirkpatrick allegedly structured a deal with SG Cowen, with contingencies hidden in a side agreement. He also is charged with participating in a three-corner deal with

• Patel and Jaeger structured another three-corner deal with TrustWave, and executed another with Cellit.

• Jaeger executed a three-corner deal with Digital Mojo, as well as negotiated deals with Centricity and iPolicy, which were subject to contingencies that would have precluded revenue recognition.

In a separate filing, the SEC countered a motion from former Enterasys COO Jerry Shanahan that it must restate its complaint because it wasn’t specific enough.

Shanahan also was tried on criminal securities fraud charges in December. In his case, the jury was unable to reach a verdict.

In addition to restating charges that Shanahan was involved in specific transactions, the SEC also urges the court to reject that his actions be considered “in a vacuum, untethered from the overall scheme.”

Patel’s predecessor, Cabletron co-founder Craig Benson, has not been charged civilly or criminally. Benson stepped down as CEO in June 1999 – a year before the alleged conspiracy — though he remained as a board member and largest individual stockholder during the split-up and became a member of the audit committee at Enterasys. He later went on to serve a term as the state’s governor.