Spider in the Middle

— Almost a decade ago, David Thatcher, chief financial officer of Peregrine Systems, was effervescing superlatives about his boss, John Moores, then considering purchase of the Padres.

"He's interested in doing things top-notch," enthused Thatcher, pointing to Moores's financial background. The date was December 37, 1994.

You won't find that date on your calendar. But you will find that, in the 1990s, managements of software companies made cynical references to their own fraudulent behavior, such as boasting about transactions on December 37 -- swaps, Barney deals, round trips, and double-dips.

Thatcher left Peregrine in 1995 to become CFO and then president of the Bay Area software firm Critical Path. With great fanfare, Critical Path and Peregrine announced a strategic relationship to help each other's customers.

Early last year, while residing in Rancho Santa Fe, Thatcher admitted guilt to criminal securities fraud. He confessed that, greatly under his direction, Critical Path had entered into a number of phony deals to boost sales artificially. (With profits nonexistent, Wall Street was fixated on sales. To match or beat Wall Street's sales projection each quarter, software companies found it more expedient to fabricate sales fraudulently than to manufacture products legitimately.)

In his confession, Thatcher admitted he helped arrange a swap deal with Peregrine. A swap arrangement is floutingly called a "Barney" deal, after the children's TV character who sings, "I love you, you love me." Two companies desperate to meet Wall Street's expectations simply agree to swap assets -- each, for example, "selling" the other $10 million worth of product. It should be a wash. But each chalks it up as a sale, then writes the expense off over a long period. Voila! Both companies report a juicy sale with no major hit to yearly costs.

Thatcher admitted that his company had no need whatsoever for Peregrine's product.

Importantly, Peregrine and Critical Path were hardly the only software firms playing swappies or other rigged games. Around the same time, the U.S. attorney's office in San Francisco was bringing criminal charges against executives of such software firms as Quintus, Unify, Informix, and Indus for similar sales-bloating fraud. The Securities and Exchange Commission was contemporaneously filing charges against those same firms and investigating large software companies such as Computer Associates.

Now, Peregrine is software's reigning bad boy. The SEC says Peregrine concocted "a massive financial fraud." It smacked of a hoax.

Last month, the former CFO of now-bankrupt Peregrine, Matthew C. Gless, pleaded guilty to criminal conspiracy and securities-fraud charges filed by the Department of Justice. The SEC had brought parallel charges. Gless and other still-unnamed co-conspirators cooked up numerous tricks to keep sales zooming as the stock soared heavenward. Insiders bailed out massively, and the company used the inflated stock for acquisitions.

Oh, the cynicism. There were several "Barney" deals. And Peregrine made numerous side deals with customers that inflated sales by hundreds of millions of dollars, according to the government. Peregrine was recording sales when it knew customers wouldn't pay. In some cases, Peregrine simply paid for its customers' purchases -- the infamous "round trip." (It sounds crazy for a company to pay for its customers' purchases, but if your objective is to run up your stock, bail out, and get rich, and use the bloated stock for acquisitions, it makes sense.)

Peregrine would permit contracts to remain open long after a quarter ended, then shove them back into the prior quarter to bamboozle Wall Street. Executives chuckled that such sales had been recorded on December 37, but actually, some transactions didn't close for months after the quarter's end.

Gless and his coterie would huddle just before the end of each quarter and decide how much sales the company had to ring up that period to satisfy Wall Street. One time, with Gless's blessing, an underling simply created a phony $19.58 million invoice.

Then there was the double-dip. Peregrine would sell its accounts receivable -- knowing some were uncollectable -- to banks. Peregrine would reduce its accounts receivable as soon as it sold a receivable to a bank. Then, if it actually collected money from a customer, it would reduce accounts receivable a second time -- erasing a previously erased receivable.

Wall Street analysts regularly watch to see if a company's accounts receivable are growing too fast. By sleight of hand, Peregrine was keeping the receivables off the books. In the last quarter of 2001, Gless took $30 million of uncollectable receivables and chucked them into a completely inappropriate category called "acquisition costs and other expense."

This was important, because Peregrine was losing money by the bushel and then blaming the losses on acquisitions. Wall Street, which gets fat on acquisitions fees, winks at such expenses.

Through 2001, Peregrine had a cumulative loss of a staggering $917.1 million. But that was according to generally accepted accounting principles (GAAP). The company used so-called "pro forma" accounting, called by one SEC official "earnings without the bad stuff." For its third quarter of 2002, Peregrine reported a pro forma loss of $16.1 million. But its loss by GAAP accounting was a whopping $88.3 million. It blamed most of the difference, of course, on acquisition costs and amorphous "other charges."

Who profited the most? Moores, chairman of the board from 1990 to 2000. For a brief period after the fraud was initially uncovered in May of 2002, he jettisoned more than $600 million of stock at fancy prices. But his board buddies rolled up big bucks, too -- including Charles E. Noell III, Moores's longtime investment-banking lieutenant, head of Moores's JMI Services and general partner of JMI Equity Partners. One civil suit charges that Noell was the conduit through which Moores controlled Peregrine.

In contravention of accepted management principles, Peregrine was an insiders' web, and Moores was the spider at the center, despite his claim that he was an outsider. For instance, in 2000, most boardmembers and officers had been connected with other non-Peregrine, Moores-related enterprises. Two had been with XVT Software, controlled by Moores's JMI Equity. According to a civil suit by San Diego attorney Michael Aguirre, Peregrine bought XVT for $4.7 million when its liabilities exceeded its assets by $915,000. Through the years, there were also boardmembers connected with several other Moores investments, such as Texas-based Neon Systems and Bindview.

After the Peregrine scandal first broke and Moores returned as chairman, he quickly recruited Padres-related associates, including a law firm and an accounting firm, and, according to the unsecured creditors committee, dissipated the ailing company's assets to whitewash himself and board cronies in a report to the SEC.

In stepping back in, Moores said he would run the company with two colleagues, Rod Dammeyer and Noell. Dammeyer headed and Noell was a member of the critical-audit committee, which should have monitored the bookkeeping. The accounting firm that discovered the fraud, KPMG, said Peregrine wasn't cooperative in the effort to uncover the past deceit, the audit committee had no formal minutes, and management wouldn't even show KPMG the handwritten notes of audit committee meetings.

After KPMG made this revelation, Dammeyer quickly resigned, but management wanted to reward him for fees and expenses, noted the unsecured creditors committee. In March of this year, Moores, Noell, and two others left the board. The new board has indicated it will sue the old board. Moores, Noell, and the others claim they had no idea what was going on.

But as New York's Conference Board points out, it is the board's responsibility to set the ethical tone at a corporation -- and to mind the store. "Many of the good things that happen to companies and almost all of the bad things really emanate from the boardroom," says corporate-governance expert Henry Wendt of the American Enterprise Institute.

"When sales figures are inflated, the board holds ultimate responsibility," says The Board of Directors, published by the New York Times.

As the government's criminal and civil investigations continue, there are also more than 40 civil suits, several naming Moores as the deep pocket.

The government charged Gless with fraud for dumping $4 million of stock during the inflated-sales period. Moores sold about 100 times that during the fraud period. Aguirre intends to tell the jury that the amount of stock an individual sold was roughly proportionate to knowledge of what was going on.

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