The Nuttiest Thing I Have Heard

— The so-called outside board members of Peregrine Systems insist they didn't know of the corruption inside the company, but they have a credibility problem: beginning in 1999, former chief executive Stephen Gardner warned the board of dubious accounting and briefed the board about other software companies that had run afoul of regulators for doing the same things Peregrine was doing. Many board members -- particularly former chairman John Moores -- had a deep understanding of the software industry, and recently a Delaware Chancery Court judge ruled that directors with "specialized expertise or knowledge" can be held to a high standard in litigation. Attorneys heading civil suits against Moores and fellow board members say the new ruling should be persuasive in state court. On October 6, the Justice Department released a criminal grand jury indictment of 11 Peregrine-connected officials, including Gardner, for conspiracy to cook the books. The Securities and Exchange Commission made similar civil charges on October 5. However, the purported "outside" board members have not been charged, though they were dumping the stock more rapidly than anyone else, armed with adverse information that ordinary investors didn't have. In this month's filings, the U.S. attorney and the securities commission took notice of Gardner's revealing messages to the board.

From 1999 to late 2001, the company inflated its revenue by more than $500 million, almost 40 percent of its sales. Over the same period, the directors unloaded $540 million of stock. More than $487 million of that total was jettisoned by Moores, who during the company's history sold well over $600 million of stock, according to the civil suit against former directors filed by the bankruptcy court-appointed litigation trustee. That suit is based on information that Peregrine supplied to the government.

As the Justice Department and Securities and Exchange Commission point out, Peregrine was using phony techniques to make Wall Street believe that sales were zooming each quarter. It would record sales that occurred long after the quarter closed. It would ring up sales that were product swaps with other companies that also wanted to meet Wall Street's expectations. It would grant covert kickbacks to customers to get them to agree to a sale. It engaged in channel stuffing, or deliberately sending its distributors more products than they could sell to end-users. It sent "side letters" to distributors, secretly loosening payment terms.

In April of 1999, the Peregrine board officially approved a form of accounting by which it would say it had completed a sale though its distributors had no commitment from end-users -- or even any end-users in sight. The then-chief financial officer told the board that this was not the "preferred method." But the public was not told, according to a civil suit in federal court here.

The U.S. attorney's indictment notes that on October 15, 1999, "Gardner expressed concerns about Peregrine's channel sales activities in a presentation to Peregrine's board of directors," although, again, the news was not passed on to the public.

Gardner said then that only a "strong channel performance" overcame weak direct sales. "In other words, loading up the channel with inventory that could not ultimately be sold was allowing the company to maintain the illusion of prosperity and success," says the federal court suit, describing channel stuffing.

In its complaint this month, the Securities and Exchange Commission cited another critical meeting: the one of October 16, 2000. Gardner told the board that Peregrine "had to borrow from the future to make the present happen. In other words, we had to grant some extraordinary terms on a few deals in the closing hours of the quarter to move business into the September time period."

Could Gardner have spelled out the deceitfulness any more clearly? But Moores's Los Angeles-based lawyer, John Quinn, says, "Without question, Moores didn't know of the backdating of documents and the rest of it." But wait a minute. Ten months before the October 16, 2000, meeting, there was a message from Gardner to the board. On January 18, 2000, Gardner told the members, "Our bread-and-butter business went to hell. Sales-force productivity is at a ridiculously low level." And the company wasn't doing well with sales in the channel either.

Then came the punch line. "Due to several highly publicized incidents at other companies (Informix, Network Associates, HBOC), the rules are tightening and practices are being reexamined," said Gardner. Peregrine faced "a changing accounting and regulatory landscape." (Italics mine.) Continued Gardner, "The net of this is that we are now at a level of channel inventory that makes our auditors uncomfortable." (The auditor was the infamous Arthur Andersen firm, which has been effectively wiped out by the federal government because of its roles in corporate scams. The Andersen partner who oversaw the Peregrine account was among the 11 criminally indicted.)

The companies Gardner cited got into trouble with the Securities and Exchange Commission. Among many things, Informix was using side agreements with software distributors; Network Associates made secret payments to distributors to get them to hold excess inventory and buy more products; HBOC used backdating of contracts and side letters to distributors.

So how in the world can Peregrine directors claim they were not informed of the accounting violations? "That is a superb question," says San Francisco attorney Robert Friese, the litigation trustee. If a person has knowledge of a material fact that other investors don't have, "you're not supposed to sell," says Friese. The board knew of the accounting chicanery, knew the company was doing poorly, and concealed the information from the public. The suit charges Moores with violating the California corporations code against insider trading. Quinn says that the board was entitled to rely on Andersen, which gave clean accounting opinions, despite its growing apprehension. (Lawyers for other defendants, including Gardner, did not return calls.)

But don't talk about purported innocent outside directors to Marianne Jennings, J.D., professor of legal and ethical studies at the Arizona State University business school and author of The Board of Directors: 25 Keys to Corporate Governance, published by the New York Times. The idea that the board wasn't required to ride herd on the company is "rubbish -- the nuttiest thing I have heard," she says. Ignorance is no excuse for a board. "Your duty is enhanced if you're an outside board member. Your duty is to the shareholder."

In this case, the board had been warned of the operational and accounting problems. Board members "had information that the rest of the market didn't have. It was classic insider trading -- no ifs, ands, or buts about it," she says.

Daniel Rubenstein is a deputy assistant director of enforcement for the Securities and Exchange Commission in Washington, D.C. Asked how the Peregrine board could claim ignorance when Gardner repeatedly briefed it on the company's questionable accounting and bad results, he responds, "I understand your question. All I feel comfortable in saying is that the investigation is ongoing."

"It looks like more is to come," says Solomon B. Cera, a San Francisco attorney who is overseeing the consolidated suit against directors in federal court. He has access to records Peregrine gave the government. "The board members were complicit, with knowledge of the accounting shenanigans. It's very clear they were trading on material, nonpublic information. If you know the revenue numbers are being artificially goosed, you cannot benefit by selling at a higher stock price that is caused by the fraud. And the defense of 'I was just an outside director' is extremely feeble." Peregrine's lawyer was telling board members they shouldn't be selling.

Besides, Moores was hardly an outside director, says Cera. He had his office at Peregrine headquarters and participated in day-to-day activities. The company identified him as a member of the "Senior Management Team." He was a de facto officer. He controlled the company, says Cera.

Both Cera and Friese say the Delaware ruling should help the plaintiffs in superior court.

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