Losing a Virtual Fortune

SAN FRANCISCO — As the last days of 2000 ticked by, Critical Path Inc. President David Thatcher saw disaster rushing to swallow him.

Thatcher knew the software company was going to fall short of the $54 million in fourth-quarter sales it had promised Wall Street. The bad news would surprise analysts, disappoint investors and hammer the company’s stock.

Desperate to avoid such a fate, Thatcher encouraged Critical Path’s sales personnel to commit fraud. They persuaded an ex-colleague working at a small concert and sports ticket brokerage to sign a bogus contract for $2 million worth of Critical Path software.

The ticket broker was assured he would never actually receive the software, though Critical Path immediately booked it as a sale. A couple of days later, the software showed up on his desk. A Critical Path sales executive told him to throw it away.

While Enron Corp. and Global Crossing Ltd. have been grabbing headlines for financial chicanery, the tech community is quietly awash in its own accounting scandals. The number of high-tech companies issuing restatements--essentially admissions that previous revenue reports were more vapor than reality--has at least quadrupled since the early 1990s, according to New York University doctoral candidate Min Wu. Tech companies now constitute nearly 40% of all corporate restatements.

Restatements almost always damage or destroy investor confidence and spawn multiple lawsuits. In some cases, a restatement launches a company on its death spiral.

Clarent Corp., a Silicon Valley manufacturer of Internet telephone software, said in September that it had significantly overstated its revenue. Shares of Clarent, which traded at $178 two years ago, now are about 30 cents each.

Homestore.com, the Westlake Village real estate Web site, has restated its results for much of the last two years, shrinking them dramatically. The stock, which hit $120 during the dot-com boom, is trading at less than $3.

Quintus Corp., a business software maker based in the East Bay that had a market value of $1 billion, filed for bankruptcy protection after acknowledging that much of its 2000 revenue was based on “falsified documentation.”

“Over the past several years, we have sued many tech companies, sought tougher sanctions, referred more cases to the criminal authorities, and yet people are still committing accounting fraud,” said Helane Morrison, the SEC’s chief in the Bay Area. “They just haven’t stopped.”

Few companies tried to get away with more than Critical Path. During its brief heyday, it was in the vanguard of high-tech upstarts that were supposed to destroy the dinosaurs of the “old economy.” This was a pleasant fantasy that masked an ugly truth: Critical Path was a multibillion-dollar con game.

Thatcher, who pleaded guilty in February to securities fraud in U.S. District Court in San Francisco, told the judge that other members of the company’s management were in on it. “The object of this conspiracy,” he said, “was to report false revenues to meet Critical Path’s predicted financial results.”

In other words, the executives found themselves in the position of having to commit fraud merely to reach the revenue targets they had set themselves. Those targets offered the illusion that Critical Path was everything the media and analyst hype said it was.

“They used accounting to try to manufacture a reality that wasn’t there,” said Bill McGlashan Jr., who was brought in to run Critical Path last year after the fraud was exposed. “That’s insanity. It’s like, what were you thinking?”

Internet mania peaked only two years ago, but already it feels like another lifetime--an era when young entrepreneurs, often equipped with no more than a good story and a sincere desire to be rich, received tens of millions in funding from venture capitalists.

The resulting companies often were taken public before they had reaped enough revenue to buy a house in a middle-class San Francisco neighborhood, but that didn’t matter. For a while, everyone made a fortune and looked like a genius.

Company Was Hyped

as a Digital Visionary

Critical Path was founded in early 1997 by David Hayden, the former chief executive of Magellan, an Internet directory that tried and failed to compete with Yahoo. Realizing that e-mail was the oxygen of the Internet, Hayden formed Critical Path to provide corporations with one-stop communications packages.

By the time the company went public two years later, it was servicing 1.4 million mailboxes. With an estimated 245 million mailboxes on the Internet and the number rising rapidly, the company seemed poised for tremendous growth.

The analysts and the media certainly thought so. Gartner Group, a much-quoted consulting firm, estimated that two-thirds of all companies soon would be outsourcing their e-mail to firms such as Critical Path. Forbes magazine put Hayden on its cover as one of a dozen “digital visionaries.” Hambrecht & Quist analyst Dan Rimer said the only way Critical Path could be in trouble was “if people suddenly decide to go back to using fountain pens.”

In a sense, however, Critical Path’s growth from the beginning was artificial. It acquired rights to service many of those 1.4 million mailboxes by giving equity stakes to their owners; for example, online broker E-Trade Group Inc. and phone company US West Inc. received 21% of the company.

This was a perfectly legal gambit used by many Silicon Valley start-ups, but there was only so much of the company that could be traded away. Critical Path had to find new ways to grow quickly, one reason it went public as soon as it could. It needed to raise money to buy other companies that immediately would boost its revenue.

Critical Path’s initial public offering took place March 29, 1999, at a moment when Internet stocks were at their most glamorous. Investors ignored the fact that the company had revenue of only $897,000 in the previous year. Barbra Streisand asked for--and got--so-called friends and family shares, which enabled her to buy in at the offering price of $24.

It was a good deal: The stock rose 174% the first day, giving the company a valuation of $2.5 billion. At the IPO party, three employees were so giddy that they streaked. Maybe it was the four bottles of Dom Perignon sent by Streisand.

Within a few weeks, the stock jumped to $135. The gap between reality and expectations had become a chasm. At $135, the stock was factoring in expectations that Critical Path would service, and make at least a small profit from, every e-mail box on the Internet.

Employees, whose number would swell from 182 at the time of the public offering to 1,042 at the end of 2000, naturally were thrilled to be working at a hot company. Many programmed their computers to constantly display the stock price.

Employees knew they suddenly were rich--Hayden’s stake alone was worth more than $300million--but there were constant reminders about how fragile it all was. In May 1999, when a computer failure temporarily shut down many Critical Path mailboxes, the stock immediately dropped 7%.

Even before the stock was offered to the public, the board of directors had kicked Hayden upstairs. This followed another venerable tradition in Silicon Valley, where it’s the founder’s job to launch the company, not run it. Hayden used a little of his Critical Path wealth to buy, with television producer Norman Lear, one of the four surviving privately owned copies of the Declaration of Independence. The price: $8.1 million.

The task of turning Critical Path from a raw start-up into a truly successful company that would match its valuation fell to CEO Doug Hickey and to Thatcher, chief financial officer and, as of January 2000, president. Both were in their mid-40s, with sober backgrounds--Thatcher a former auditor for accounting firms Touche Ross and Price Waterhouse, Hickey a veteran tech executive--that would be reassuring to Wall Street.

It certainly started to seem like a real company, one former employee recalled. “Critical Path was started by a bunch of raver-hippie-engineer types, and they tended to hire their friends,” said Mike Wertheim, a programmer. “Hickey was slick. He turned the company corporate. But people figured that was just what had to be done.”

Hickey and Thatcher went on a spending binge, acquiring 10 companies from May 1999 to September 2000. Most of these companies had few real assets; in fact, four had liabilities that exceeded their assets. At best, they were developing exciting technology that might work out well. That was enough to make them hot properties: Critical Path paid a total of $1.8 billion for them, nearly all in stock.

The acquisitions, along with other efforts, boosted the number of mailboxes the company serviced to 6.7 million in fall 1999 and then to 55 million early in 2000.

“I don’t know if we are naive or what it is, but I’ve got to tell you, we really think we can touch virtually every Internet user in the world,” Hickey told one Internet news site.

Forbes ASAP magazine voted Critical Path its No. 1 “ramp champ,” saying that out of 100 fast-growing tech companies, it had the highest score in management, market opportunity, finances and competitive position. This was not, the magazine said, one of those companies “that are growing so fast that they spin out of control and crash.”

Still, the pace was frantic. Thatcher told Forbes ASAP he had worked all night half a dozen times in the previous six months and logged 30,000 frequent-flier miles in one 15-day span. Employees were on call 24 hours a day.

The goal, one former employee recalled, was to do whatever was necessary to make the company look good. That would keep the stock price up.

“Financial statements usually tell you how successful a company’s product is, but we wanted ours to look like advertising for the stock,” said former Director of Engineering Steve Simitzis. “You would multiply your stock options by the day’s stock price and just want the company to make its numbers to satisfy the market. You just wanted your net worth to continue to exist.”

Those net worths could be considerable, as outlined in the company’s 2001 proxy. Thatcher, who was paid $500,000 in 2000, made $5 million off his options. That was only a small part of his holdings: He had half a million additional shares in vested and unvested options. Sales chief William Rinehart was paid $210,000 and cashed in 200,000 options--every one that he could--for stock that was worth $10 million. An additional 200,000 options were scheduled to vest over the next several years. Chief Executive Hickey, who was paid $600,000 in 2000, had vested and unvested options for 1.2 million shares.

Of course, the size of any prospective windfall would depend on the stock price. And Wall Street by this point was beginning to want more than just growth. It wanted Internet companies to be profitable too. At a March 2000 investors’ conference, Hickey promised both. “We’ll achieve fourth-quarter profitability and at the same time achieve explosive revenue growth,” he said.

But as 2000 wore on and the tech sector peaked, the canyon between the hype and the reality finally became unbridgeable. Those 10 acquisitions initially may have added to the bottom line--1999 revenue was up 1,700%, to $16.2million, and 2000 was expected to easily clear the $100-million mark--but the new units proved hard to integrate. The mergers swelled the number of products the company offered, many of which had little to do with the one thing it really understood: e-mail management. The company eventually would have 77 facilities on several continents, becoming much too far-flung for its size.

It’s not clear, and won’t be until federal prosecutors have finished their investigations, exactly who might face prosecution at Critical Path besides Thatcher. Twenty-two people were dismissed by the company after it made its own internal investigation, but prosecutors aren’t likely to pursue anyone below the executive level, a source said.

Timothy Ganley, former vice president of strategic sales, pleaded guilty last month to selling $31,885 worth of stock based on inside information about the fraud. Thatcher, meanwhile, is pledging cooperation and alleging conspiracy.

An attorney for CEO Hickey, who resigned early last year in the wake of the fraud revelations, said his client “did absolutely nothing wrong.” Hickey relied on Thatcher to give him honest information, said Richard Marmaro of law firm Proskauer Rose, adding, “It’s not the chief executive’s job to go to the customer to confirm that revenue is real.”

An attorney for Rinehart, the former sales vice president, didn’t return calls. Rinehart was fired when the fraud was discovered.

Hayden, the founder, “has not been the subject of any criminal or SEC investigation,” the company said.

If the “who” beyond Thatcher awaits the filing of new charges, the “how” and the “why” are more obvious. Software accounting is complex and vague, which makes it highly susceptible to abuse.

“A grocery store either sells $1,000 worth of groceries or it doesn’t. At technology companies, it’s not so simple,” said Dennis Beresford, former chairman of the Financial Accounting Standards Board.

For one thing, software is small, lightweight and virtually cost-free to reproduce. It’s often bundled with service contracts that last for several years, which brings up questions about whether the revenue should be recognized now or later. All those things make it easy to distort or fake sales in a way that would be impossible with bread or automobiles.

Several experts said high-tech accounting fraud almost always begins the same way: slowly.

“No one comes in to work and says, ‘We’re going to do a big fraud starting right now.’ It’s a continuum,” said Charles Mulford, professor of accounting at Georgia Tech and author of “The Financial Numbers Game: Detecting Creative Accounting Practices.”

“What they think is, ‘We’ll do this right now, but I just know there’s that big order down the road, and we’ll make good on it.’”

During the second half of 2000, as detailed in court filings, Critical Path used just about every trick it could to improperly and illegally boost its revenue.

The first gimmick was a software swap, sometimes called a Barney deal in tribute to the purple dinosaur who proclaims, “I love you, you love me.” Under accounting rules, the goods on both sides of the swap must be valued at fair-market prices.

Critical Path’s swap was with Peregrine Systems Inc., a San Diego company at which Thatcher had once worked.

“To avoid the appearance that the transaction was a software swap, Critical Path and Peregrine prepared separate contracts for each purchase, each paid the full amounts owed, and made payments to each other on different days,” Thatcher admitted in his plea agreement.

Thatcher admits that Critical Path didn’t actually want what it was buying from Peregrine. The deal, he told the judge, “was driven by the need to report revenue”--$3million worth.

Peregrine, based in San Diego, maintains that there were two separate transactions and that its accounting was appropriate. (The company said Wednesday that it was delaying reporting fiscal-year results “pending continued audit activities.” Its shares dropped 50% to $3.45.)

A second deal was done with International Computers Ltd. ICL said it was owed $8.7 million by PeerLogic, one of Critical Path’s many acquisitions, but was willing to settle the claim for $6 million.

Instead, Critical Path paid the full $8.7 million, and ICL paid back $2.7 million to Critical Path for software, according to Thatcher’s plea agreement. Essentially, Critical Path paid ICL to buy its software--not only a gross violation of accounting rules but a crazy way of doing business.

ICL, a London division of Fujitsu Ltd., didn’t respond to e-mails about the deal.

These and other improper deals added $9.7 million in revenue to Critical Path’s third-quarter total, bringing it to $45 million. Wall Street, which had been expecting only $39 million, immediately sent the stock up $5 a share. Hickey used the occasion to raise fourth-quarter revenue estimates from about $50 million to $54 million to $56 million.

Two weeks later, on Nov. 2, Critical Path held a meeting for 100 investors and analysts. The company, Hickey said, was about to join “an elite group of profitable ‘new-economy’ companies.”

The Wholesale

Deception Begins

But if it was all smiles and sunlight outside, in the management suite there was gloom and recklessness. As the dot-coms began to fade, Critical Path lost about three-quarters of its value in the first 11 months of 2000. The easiest accounting tricks had been used in the third quarter. Now the wholesale deception began.

Critical Path sent $2.1 million in software to Storerunner Network, a struggling San Diego shopping site, despite the fact that Thatcher knew the chances of getting paid were essentially nonexistent. But he booked the shipment as revenue anyway. Storerunner filed for bankruptcy protection two months later.

Another customer was Education Networks of America, a Web resource for teachers that was interested in Critical Path’s software and services but wasn’t sure it could afford them. So Critical Path issued a side letter that gave ENA the ability to back out of the $2.2-million deal, according to Thatcher’s plea agreement. Critical Path booked the revenue, even though ENA exercised its option to cancel.

Finally came the $2-million deal with Bestseats.com, the ticket broker. When the Critical Path finance department, unaware of the fraud, asked the broker for proof he could pay for his $2-million purchase, he responded with an e-mail saying his firm had only $250,000 in capital. Before the finance department could see it, Thatcher changed the number to $12.5 million. Bestseats, which is based in the East Bay, declined to comment.

Even with nearly $10 million in sham revenue, Critical Path couldn’t make its fourth-quarter sales goals, much less a profit. Total sales for the quarter were $52million, $2million shy of its low estimate. Instead of the promised profit, there was a net loss of $11.5million. Analysts were upset, and the stock immediately lost half its value.

Two weeks later, on Feb. 2, 2001, the company said it had “discovered a number of transactions” that were improper.

Analysts were livid. Bert Hochfeld of Josephthal & Co. said he felt as if he had been raped. The stock fell 70% more, to $3. Lawsuits were filed. The company restated its revenue. The stock slid all year, bottoming out at 24 cents in September.

The SEC’s chief accountant, Charles Niemeier, warned in February that even if a company strictly followed accounting rules, it still could face fraud charges if its filings distorted the company’s true condition.

By that standard, a great number of tech companies might have reason to be worried.

“There was so much greed and so many get-rich-quick schemes,” said Ram Shriram, a Silicon Valley financier and an early investor in Critical Path. “People did not take a long-term view of building businesses. Some not only cut corners but ran afoul of ethics and the law.”

Painfully Becoming

a Real Company

Critical Path says it finally has that long-term view. Hayden reassumed control after the fraud came to light; he and McGlashan, the new CEO, closed two-thirds of those 77 offices, cut the number of products and employees in half, settled the shareholder lawsuits and convinced most of the board that it was time to move on. Of the $1.8 billion paid for acquisitions, $1.3 billion was written off.

The Critical Path of two years ago wasn’t a real company, McGlashan said in an interview in the company’s new and cheaper offices next to the San Francisco-Oakland Bay Bridge. “There was no cash management, no budget. Nothing was ever integrated. Basic 101 stuff seemed to be missing.”

Instead, according to the company’s 2001 proxy, there were a lot of sweetheart deals for executives. A plane was leased from an aviation company that Thatcher and Hickey had invested in. Bonuses could approach or even exceed salaries, despite the fact that the company lost $79million in 2000. The company lent CFO Larry Reinhold $1.7million after he was hired in December 2000. One clause in the loan said he wouldn’t have to pay either interest or principal if he quit. Saying he had accomplished “a great deal,” Reinhold quit last August.

Critical Path would be a much harder place to commit fraud now. To take just one example, salespeople no longer approve contracts. The legal and finance departments do.

All the old management except for Hayden, who remains as executive chairman, and the chief technical officer are gone.

McGlashan doesn’t miss them.

“It was a corporate culture based on people thinking they’re going to be rich,” he said. “The temptation, when billions and billions are involved, becomes extraordinary.”

Critical Path isn’t very tempting anymore. Though the stock has recovered to about $2, only one analyst, Larry Berlin of First Analysis, still is tracking it.

“It’s a viable company with a good product that has potential,” Berlin said. “But it’s not going to be a get-rich-quick scheme for anyone.”