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Guilty As Charged

The former CFO and CEO of California Micro Devices are going to jail. Others who commit accounting fraud may follow.

1Apr

The hearing last December in U.S. District Court in San Francisco had reached the moment of truth. Chan Desaigoudar and Steven Henke, former executives of California Micro Devices, had been convicted five months earlier of securities fraud and insider trading. And as the two stood for sentencing, Judge Vaughn Walker was weighing how tough he should be on the two white-collar criminals in his courtroom.


Four years earlier, in October 1994, shares in the Milpitas, California, maker of semiconductor components crashed amid allegations of accounting irregularities. Shareholders sued, and the Securities and Exchange Commission launched an investigation. Henke, the treasurer and most-senior financial officer, resigned that month. Desaigoudar, the CEO and largest shareholder, was fired five weeks later. In January 1995, forensic auditors reported that nearly half the $38 million in fiscal 1994 revenues were spurious.


A typical corporate fraud story would have ended soon after, with such civil remedies as SEC fines and penalties and a financial settlement with investors for the $139 million in lost market value.


But not this one. In September 1997, Henke and Desaigoudar were indicted on criminal charges, too. Accused of booking sales for unshipped products and unloading shares as the scam spiraled out of control, they were found guilty last July after a six-week trial. Under federal sentencing guidelines, Judge Walker could put each behind bars for as long as 15 years--or he could use his discretionary powers and impose no jail time at all.


Attorneys for the two defendants argued that their clients deserved probation because there was no proof that they ordered anyone to commit fraud. But federal prosecutors were adamant that Walker send both Henke and Desaigoudar to prison. "These defendants employed a sophisticated and elaborate scheme to artificially inflate the stock price, and they traded on information that was not publicly available," Pamela Merchant, senior trial attorney with the U.S. Department of Justice and co-prosecutor, told the judge.


As far as Merchant was concerned, this hearing wasn't just about punishing two rogue executives. It was about sending a message. The Cal Micro case is far from the first criminal trial for corporate fraud, but the vigor with which it was pursued signals a more strenuous effort by the federal government to go after senior executives who use accounting legerdemain to deceive investors. With SEC chairman Arthur Levitt threatening to crack down on companies pushing the envelope of accounting rules, Cal Micro represents the first of many cases that prosecutors say will show what's at stake for those who push too hard.


"People ought to expect more of this," says William McLucas, a partner in the Washington, D.C., law firm of Wilmer, Cutler & Pickering who headed the SEC's enforcement division from 1992 until last year. "There's the belief at the SEC and among U.S. attorneys that one of these cases prosecuted criminally has an equal deterrent value to 10 civil cases."



More of the Same

As the trial testimony made clear, the principals in the Cal Micro case were caught in a vicious cycle of arrogance, greed, and desperation. Like many companies with innovative technologies in the long-running bull market, the company was under continuous pressure to keep pumping up its stock price. Seeking to meet analyst expectations, attract strategic partners, and boost the value of a secondary offering, Cal Micro executives increasingly turned to ways of manufacturing sales--hoping no one outside the company would notice and that no one inside would care.


Criminal prosecutions of accounting fraud require evidence that shows intent to cook the books. In Cal Micro's case, there was plenty. At trial, in hundreds of exhibits of internal documents, the prosecution team outlined nearly a dozen revenue recognition tricks, including recording sales of orders that shipped in later quarters, early and unwanted shipments that were returned but whose sales were never reversed, and bogus sales to both legitimate and phony companies. The executives had faked reports to fool the auditors, investment bankers, and the board of directors, and had lied in SEC filings and to analysts to hide the chicanery.


The Feds went after the top four executives--those who signed off on the spurious annual reports. Chief accounting officer Ron Romito and president Surendra Gupta cut deals with the government in exchange for their testimony against Henke and Desaigoudar. But others played a role as well.


"It surprised me how many people were involved," says Russell Joy, the jury foreman, who happens to be CFO of privately held Sebastiani Vineyards Inc., in Sonoma, California. "We agreed that the fraud didn't take root at a predetermined meeting, but started from the pressures to pump up the revenue. And what I found interesting was how it got out of hand. The dynamics of the organization compelled people to report things that didn't happen, and no one could stop it, even though they knew it was wrong."


Desaigoudar and Henke testified that they knew nothing about the fraud, and blamed the subordinates who testified against them. Des-aigoudar repeatedly denied that he saw memos or attended meetings where the deceit and cover-up were discussed. Henke went so far as to tout his incompetence in accounting, and offered the novel argument that even though he signed the 10-Q and 10-K as the principal financial officer, he was not the chief financial officer.


But their arguments proved unconvincing. And based on trial transcripts, court documents, and interviews with key figures (neither Henke nor Desaigoudar could be reached for comment), the picture that emerges is of a public company run as the private domain of a spirited but corrupt leader, where beholden executives who were disinclined to rock the boat became ensnared in a scheme that ultimately proved to be their own undoing.



Unfulfilled Promise

The company was much different in 1979, when Desaigoudar answered a newspaper want ad from a Silicon Valley start-up called California Micro Devices. The company had a promising patent for semiconductor-chip technology, but had burned through its venture money and hadn't developed a product. That didn't faze Desaigoudar, a native of India with an engineering degree who had become a U.S citizen while working for a series of defense and electronic-component firms. Offered no salary and 20 percent of the company, Desaigoudar joined Cal Micro on one condition: that he be put in charge.


Within a year, he was able to use his military contacts to attract customers in need of specialty resistors and capacitors assembled on silicon chips. By mid-1980, Cal Micro was cash-positive, with nearly $2 million in sales. At that point, Desaigoudar offered to buy the balance of the company, and was told he'd have to come up with $2.2 million. To raise the money, he put up his retirement accounts and the equity in his home, arranged a $1 million bank loan, and attracted several private investors. That July, the company was his.


"I was impressed by Chan," recalls Stuart Schube, a Houston-based venture capitalist whose firm put about $340,000 into Cal Micro. "The guy seemed to truly understand the industry and the market."


Steve Henke landed at Cal Micro in 1984, after the Illinois native's journeyman career as a corporate controller hit a dead-end. He'd been laid off from an Oakland, California-based subsidiary of Midland-Ross Corp., and was unemployed for a year. He finally found work in Cal Micro's finance department after sending letters to some 300 small Bay Area companies. His first task was to clean up Cal Micro's general ledger, which hadn't been closed for nine months. In 1985, Henke was named CFO.


Almost immediately, the two were inseparable on the job, despite what employees say was a clash of personalities. While Desaigoudar could be charming and sociable, Henke was generally crude and caustic, and would never greet subordinates in the hallway. The two executives were frequently rude to each other, and Henke, according to one source, even mocked Desaigoudar's Indian origins. If they had anything in common, it was a taste for expensive homes and cars, and memberships at exclusive golf clubs.


By the mid-1980s, Cal Micro had begun to expand its customer base beyond the military, landing deals to supply components to such blue-chip firms as Motorola, IBM, and Kodak. Growth, however, was hampered by a lack of manufacturing capacity. Desaigoudar decided to take the company public in 1986 to finance expansion, and ultimately some of the proceeds were used to acquire from GTE a microchip manufacturing facility in Tempe, Arizona.


After the purchase of the plant in August 1987, Cal Micro had more than $30 million in revenues and some 215 employees at two locations. It could offer a broader line of products, and had a customer base that now included Apple, Fujitsu, and GTE. "That was a high point," says Schube, who had joined the board in 1986 and earned a handsome return when the company went public. "We thought we had gained a critical mass, which is important for a small, emerging company, and we were very optimistic."


Overly so, it turns out.



Warning Signs

Warning signs were evident as early as 1984. To begin with, there was Desaigoudar's leadership style. Employees found him inspiring, but also oppressive. He held so tight a rein on power that he insisted on authorizing $25 office-supply purchases. "He would stand at one end of the hallway and scream at you," recalls a former secretary. "He could be verbally abusive."


More troubling was the management turnover. The only senior people who didn't leave Cal Micro seemed to be the engineers Desaigoudar brought over from India to fill key sales and manufacturing slots. He paid them below-market wages, but they were thankful for the opportunity to work in the United States. "We really couldn't get top-flight people to stay and work under Chan," Schube says.


Then there was the apparent willingness at Cal Micro to bend accounting rules. By 1987, it was already common practice to ship orders for subsequent quarters to meet current revenue targets. Sometimes, the company would call customers and get permission to ship early. If the customer wouldn't accept the delivery, employees would prepare phony packing documents and find some place to store the goods until they were requested. At a summer barbecue at the home of the production control manager, A/R accountant Mary Bridges learned that about $100,000 in booked but unshipped product was in the garage. (For some of Bridge's other surprising discoveries, see the sidebar on page 60.)


During Cal Micro's annual audit in August 1989, Price Waterhouse approached Henke with a series of recommendations. The auditors cited "revenue and expense cut-off errors" at the end of several quarters and proposed some $2 million in adjustments. The company was forced to restate its earnings for fiscal 1989. Besides detailing internal-control weaknesses, the auditors advised the board to upgrade the finance team and replace Henke.


Rather than fire his trusty CFO, Desaigoudar merely forced Henke to give up the title and took away some of his accounting responsibilities. Named treasurer and vice president of new-business development in February 1990, Henke was left in charge of investor relations, treasury operations, and SEC filings. Longtime Cal Micro employees speculate that to buy Henke's silence, Desaigoudar had no choice but to keep him.


"They presented his demotion as a promotion," recalls Bridges. Henke was given a 35 percent raise, to $108,000 a year, and a generous cache of stock options. Eleven months later, his salary was upped to $120,000.


Cal Micro continued to dodge internal controls even after Ron Romito took over Henke's accounting duties. In 1992, as then-president Russell Krapf tried to coordinate end-of-quarter efforts to get products sold and shipped so that they could be recorded as revenue, he was told not to worry--the company had distributors that would take the unsold goods. Krapf complained that this was nothing more than a consignment sale. He quit after five months on the job.


Romito himself had quickly discovered that Cal Micro played fast and loose with accounting rules. Not long after he joined the company, he found in an unused office some boxes of product that had been recorded as sold. He immediately reported the situation to Desaigoudar, and was taken aback when his new boss told him, "I pay bonuses to people based on those numbers."


Romito had been unemployed for nearly a year before he was hired at Cal Micro, and had even allowed his CPA license to lapse. Like Henke, he needed the job. Unlike Krapf, he didn't resign.



From Bad to Worse

In October 1993, Desaigoudar told executives that he expected to see double-digit revenue growth every quarter. He wanted to attract new capital from a strategic partner, and could raise as much as $40 million in a secondary offering if the stock price went above $20 a share from its current level of $11. It didn't matter that California Micro Devices had just lost most of the business of its biggest customer, Apple Computer (a fact that was kept from the board for many months), after Desaigoudar haughtily refused to negotiate on price or make design modifications.


Nevertheless, things seemed to be working out precisely as Desaigoudar had hoped. On March 16, 1994, he announced that Hitachi Metals Ltd. had bought a 10 percent stake in Cal Micro and agreed to manufacture and sell its products overseas. Cal Micro would be getting an infusion of $24 million, news that prompted the stock to surge 52 percent that day, to $21.25 a share. De-saigoudar's net worth increased by $40 million.


With Cal Micro stock trading at an all-time high, Henke began selling off 29,920 shares on May 12, the day after the Hitachi deal closed. He netted $540,476 from the trade, and urged a secretary to do the same. "You would be stupid not to," he told her.


As accounts receivable ballooned with fake sales, Cal Micro executives had to work harder to keep the fraud under wraps. In February, Ron Romito prepared two different accounts-receivable reports, one for internal use and one for the board and the investment bankers. The one for outside use showed a balance that was 82.4 percent current. The real number was 51 percent.


At a board meeting that month, director Wade Meyercord was struck by the fact that the amount of current accounts receivable exceeded the company's quarterly revenues. "Something's not right here," he said to Romito, who explained that most product shipped at the end of the quarter. Meyercord kept pressing the issue, until Romito conceded that the company's Far East distributors were given up to 180 days to pay, so their receivables were included as current.


Aghast, Meyercord nevertheless saw nothing illegal about the practice. "It struck me as a bad choice," he recalls, "but fraud never entered my mind."


What Meyercord didn't know was that some of these Far East distributors were also given an unconditional right of return. That meant they would never have to pay their bills, unless they sold the product.


With these bogus sales swamping Cal Micro's balance sheet, cash collections were "dismal," as even Desaigoudar conceded in a March memo to senior management. That month, as the end of the third quarter neared, the company had collected only 25 percent of its cash target from the second quarter.


In late March, less than two weeks after the Hitachi deal was announced, Romito testified, he suggested to Henke that Cal Micro would have to put off a secondary offering until its books could be cleaned up. Despite the strong market reaction to the Hitachi investment, the bankers would require an audit for the first nine months of fiscal 1994, and Romito said the books would never pass.


On April 7, Romito met with Desaigoudar, Henke, and others about how to survive the annual audit. He stressed that all booked sales had to be shipped by June 30, the end of the fiscal year, and recommended a write-off of at least $3 million worth of uncollectable accounts receivable.


But as the end of the fourth quarter approached, the amount to be written off had mushroomed to $8.3 million, and the issue became how to make the charge palatable. In June, Romito ordered A/R accountant Mary Bridges to issue credit memos for some of these bogus sales and back-date them to May 31. He knew that besides testing a quarter's first-five and last-five invoices, its new accountants, Coopers & Lybrand (Price Waterhouse had resigned the account), randomly tested invoice register entries for the last month of the quarter. The chances were slimmer that the auditors would see the large credits dated from the middle month.


A tougher task for Romito was how to allocate the write-down of accounts receivable. Consulting with Henke, Romito testified, the two finance executives agreed to cover the fake revenue by claiming that the bulk of the write-offs were due to product returns and bad debt. Yet more creative was the decision to offset the write-off by recognizing $7 million in revenues from the Hitachi deal as nonproduct technology sales.


Even with the huge receivables charge, Cal Micro was able to post record sales and earnings for fiscal 1994.



The Reckoning

As California Micro Devices announced its results on August 4, it struggled mightily to postpone its day of reckoning. Analysts were immediately suspicious because the amount of the write-down and the Hitachi revenues were so similar, and pressed for an explanation for the accounts receivable problems.


Desaigoudar and Henke blamed the write-down on Asian distributors that were unable to pay for product and had since been terminated, and added that the Hitachi deal would allow them to find higher-quality partners. Desaigoudar took offense at the suggestion that the firm had become overly aggressive in its financial reporting and could not be trusted.


The spin didn't work. Cal Micro shares plummeted more than 40 percent that day, from $22 to just over $13. The following day, several shareholder lawsuits were filed. Five days later, Henke submitted his resignation. Desaigoudar would not accept it, and in September, Henke signed the fraudulent 10-K for fiscal 1994 as the principal financial officer. Then, on October 14, the board's audit committee--which included Desaigoudar--met with the law firm it had hired to represent the company against the shareholder suits.


The lawyers spent four hours laying out their preliminary findings, and then all eyes turned to Desaigoudar. "I can't believe what these people did," he said, shaking his head as if in disbelief. "This is really a shock."


For Schube, who had known Desaigoudar for 14 years, that statement itself was a shock. Desaigoudar had a hand in everything that went on in his company. "I was certain Chan was lying to me," Schube says.


The board issued a press release on the accounting irregularities, and Cal Micro's stock fell further, to $6 a share. By the end of the year, Desaigoudar, Henke, and Romito were gone. New auditors Ernst & Young (brought in by the board) restated a $7.7 million annual profit to a $16.6 million loss.


In December 1995, Romito cut a deal to avoid criminal prosecution, pleading guilty to insider-trading charges and agreeing to cooperate with federal investigators. Coopers & Lybrand quickly settled with shareholders for $2.3 million, while Cal Micro settled its class-action lawsuits for $13 million in March 1997. Six months later, on September 18, Desaigoudar and Henke were indicted on criminal charges of fraud and insider trading.



Unrepentant

At trial last summer, Henke and Desaigoudar both proclaimed their innocence, to no avail. During three days of deliberations, jurors reviewed multiple pieces of evidence and conflicting testimony to determine whether the defendants knew what was going on. "There was a lot of financial and accounting terminology to understand, but that wasn't the hardest part of the case," says Russell Joy, the jury foreman. "The hardest part was figuring out who was lying."


At their sentencing in December, the two defendants approached the bench disgraced but unrepentant. The 60-year-old Desaigoudar, his voice cracking, expressed his singular regret in this matter: "It's that I trusted key employees, and for this, I and my family have suffered." Henke, 52, was no more contrite, conceding that he was "very negligent" only for "blindly placing my trust in managers and employees who severely misused and betrayed me."


When the time came for Judge Walker to impose a sentence, the atmosphere in the courtroom thickened with anticipation. Prison terms are ultimately the most difficult issue in white-collar cases. Prosecutors want the maximum sentence possible to bolster the deterrence effect. "When you cause economic harm, whether with a gun at a convenience store or with a revenue ledger, the penalty should be substantial," says former SEC enforcement head McLucas.


In response, defense attorneys contend that their clients, while displaying aberrant behavior, did not prey on innocent victims as other criminals do.


Asking the defendants to stand, Judge Walker expressed his defense-friendly belief that, unlike telemarketing scams, for instance, the case against Desaigoudar and Henke "cannot be equated with frauds that take advantage of helpless, uninformed, and particularly gullible individuals."


He then gave both about one-third of the sentence they could have received--32 months for Henke and 36 months for Desaigoudar. Both must pay $100,000 in fines, and Walker ordered Desaigoudar to surrender his 1.5 million shares of Cal Micro stock, currently valued at roughly $2.25 million, in restitution to shareholders. He declined to impose any bail, and freed Henke and Desaigoudar pending appeal of their convictions.


Prosecutors were outraged. Such light sentences, they believed, amounted to little more than a slap on the wrist. Then again, Pamela Merchant wondered aloud, maybe seeing careers ruined, lives in turmoil, and executives behind bars even for a day is enough to scare anyone straight.


Stephen Barr is senior contributing editor of CFO.


------------------------------------------------------------------------ 8 WAYS TO COMMIT ACCOUNTING FRAUD
Improper Revenue Recognition Practices At California Micro Devices


1. RECOGNIZE REVENUE EARLY. Book revenue when an order comes in, not when the product ships. 2. SHIP EARLY. Ship product early to customers that do not want it yet. 3. SEND UNWANTED SHIPMENTS. Ship product to customers that did not order merchandise, and do not reverse the returns. 4. SHIP TO FREIGHT FORWARDERS. Ship product to freight forwarders to store until it is shipped to a legitimate customer or returned. 5. FAKE INVOICES. Create fake invoices and shipping documents to make it appear as if legitimate sales went out to real customers. 6. FAKE CUSTOMERS. Create invoices and orders to nonexistent companies. 7. PERMIT UNCONDITIONAL RIGHTS OF RETURN. Allow distributors to take product without taking title to the goods. 8. CREATE BOGUS TITLE TRANSFERS. Create records to make it look as if the title had been transferred on unshipped or fake goods.


------------------------------------------------------------------------ Witness for the Prosecution
In October 1993, Cal Micro A/R accountant Mary Bridges was on her way to the warehouse to meet a friend for lunch when she tripped over a box sitting on the loading dock. Checking the packing slip for the customer's name and contents, she immediately recognized the $250,000 order as one she had invoiced in the previous quarter.


She asked distribution manager Eric Parker if the shipment had been returned, and was told only that it was a "special shipment." Bridges had no clue what Parker was talking about, but pretended that she did in order to get more information from him. Noting that she spearheaded the company's collection efforts, Bridges asked for a list of everything that had been invoiced but not shipped. She told Parker she didn't want to look stupid and call the customer for payment on an order that was never sent.


To her amazement, Bridges learned that there were two sets of inventory books at Cal Micro's Arizona facility, where she worked, and that shipping people had deals with freight forwarders who would sign off on paperwork as if something had shipped. She eventually identified some $1.6 million in unshipped sales, while another accounting clerk, Neil Torres, amassed his own list of dubious orders out of the company's California headquarters. In November, the two combined their findings in a memo.


Almost weekly over the next six months, these widely circulated but internal reports tracked by customer the growing volume of booked sales that hadn't shipped. These so-called delayed-shipment memos were crucial evidence that helped convict Chan Desaigoudar and Steven Henke, Cal Micro's former CEO and CFO, respectively, of accounting fraud.


Bridges complained on numerous occasions to Ron Romito, Cal Micro's chief accounting officer, that the fake revenues should be reversed and that the wrongdoing would one day be exposed. "You don't sign the corporate papers," Romito would admonish. "It's not your business. Don't worry about it." And when Bridges questioned the legitimacy of a last-day-of-the-quarter order for parts she knew were not in inventory, Cal Micro's then-president, Surendra Gupta, barked angrily, "You're not a team player. If you don't do this, I have a stack of résumés, and I'll find somebody else to do it."


Some of the Indian managers brought to the United States by Desaigoudar felt pangs of guilt, but were reluctant to cross their benefactor. Bhasker Rao, the general manager in Arizona, wrote in a memo to Desaigoudar about his disgust over what he called "clean and unclean" revenue, but dropped the issue after he got no response. Similarly, Ramana Penumarty, Rao's counterpart in California, told Desaigoudar he was afraid of going to jail for faking sales, but calmed down when the CEO told him there was nothing to worry about.


"It was easier to do what Chan said and make his wishes happen," Bridges observes. Although she provided critical help in the case against Desaigoudar and Henke, she still berates herself for not doing more. "I feel really guilty that I wasn't able to stop this," she says.--S.B.

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