April 23, 2001
A week after Cisco Systems Inc. (Nasdaq: CSCO) announced a $2.5 billion inventory write-off (see Cisco's Inventory Woes Mount), investors and their lawyers are taking aim at the company and its officers (see Cisco Faces Another Suit).
It's common for shareholder lawsuits to emerge after a precipitous drop in stock price, regardless of cause. Cisco's case is interesting, however, because it is being hit by several suits targeting its accounting practices at a time when those very practices are coming under increased scrutiny.
“This is one of the most egregious abuses of insider trading that we have ever encountered,” says William Lerach, a partner at the law firm Milberg Weiss Bershad Hynes and Lerach LLP, which filed suit against Cisco on Friday.
Milberg Weiss is one of at least two firms that have already filed federal lawsuits in California and in Maryland on behalf of shareholders, alleging that Cisco and its officers violated federal securities laws by disseminating false and misleading information about its products, financial results, and prospects for fiscal 2001 and 2002 and beyond.
Investors typically file shareholder lawsuits after a company pre-announces negative earnings news, says Daniel Sommers a partner at Cohen Milstein Hausfeld & Toll, a firm that also handles shareholder lawsuits. Foundry Networks Inc. (Nasdaq: FDRY) and Lucent Technologies Inc. (NYSE: LU) have also been targets of similar lawsuits since the market took a nose-dive back in December (see Foundry Slapped With Shareholder Suit).
Many of these suits never make it to trial, because they are either dismissed or settled out of court. But analysts who follow Cisco think that shareholders could have a good case against the company.
“This was the biggest inventory write-off in the technology sector ever,” says Gina Sockolow, an analyst with Buckingham Research Associates (BRA). "I think the inventory write down and the implications on future earnings are so great that the suit might actually have legs. But what it comes down to is what they knew and when they knew it."
The lawsuits center around Cisco’s accounting practices, which the suits claim are in violation of Financial Accounting Standards Board (FASB) and Securities and Exchange Commission (SEC) rules.
According to the suit filed in California, Cisco provided excessive financing to fledgling CLECs (competitive local exchange carriers) like American Metricom, Digital Broadband Communications, Harvardnet, PSINet, and Vectris Communications even when its officers knew the service providers could not meet very minimal convenants with Cisco Systems Captial, the financing arm of the company. The suit alleges that Cisco offered these liberal terms to generate more business for the company. But many of these providers defaulted on their loans and never paid for the products that were shipped.
“In order to inflate prices of Cisco stock defendants caused the company to falsely report results for at least the 4th Q 99, 1st Q 2000, 2nd Q 2000, 3rdQ 2000, 4th Q 2000, 1st Q 2001 and 2nd Q 2001 through improper revenue recognition including recognizing as sales shipments of shell units of products not yet developed, manipulating revenue on financing arrangements with certain of its indirect customers including CLECs and failing to adequately accrue for bad debts, thereby materially overstating its revenue and net income during the class period,” reads the lawsuit filed in California.
But more than taking on risky business, the suit also contends that Cisco tried to hide this bad debt by not accounting for it properly. The suit says that the company violated the FASB Statement of Financial Standard No. 5 that requires the estimated portion of uncollectable receivable accounts be accrued in the period in which it becomes evident that it won’t be collected.
So when did company officers know there was a problem?
Sockolow says signs that Cisco was in trouble were surfacing this summer and the CLEC situation had become clear by October.
“You have to wonder if they were really caught by surprise,” she says. “The balance sheet had been falling apart since last summer. The payables and receivables had been growing, and the company was struggling to get its inventory under control. I’m not privy to all the details in the balance sheet, but it makes you wonder.”
The suit also alleges that Cisco was shipping incomplete boxes to customers and booking them as revenue, shipping the fully operational pieces in later quarters. In the summer of 1999 it allegedly shipped 14 switches to software maker Worldwide Web in Miami, Fla., recognizing $400,000 for each device. When the technicians turned on the box, nothing happened, says the complaint, and Cisco agreed to send the appropriate blades to the customer in a subsequent quarter.
The practice of shipping boxes without the appropriate blades continued into 2000. Back in November Light Reading reported that Cisco had problems shipping blades for its ONS 15454 optical transport due to a component shortage (see Cisco's Optical Customers Face Delays).
But this point may actually not mean anything in court. Why? The accounting standards do not specifically state that companies cannot recognize revenue on boxes that are incomplete or not functioning, says Doug Reynolds with FASB.
“The standard assumes that these are finished products,” says Reynolds a practice fellow at FASB. “But we don’t specifically state that anywhere. Application of the rules varies. The rules are straightforward, but it’s not as easy as it sounds to apply them.”
Cisco hasn’t issued a comment on the lawsuits and was unavailable for comment. Its stock ended at $17.33 today, down 9.5 percent from yesterday’s close.
-- Marguerite Reardon, senior editor, Light Reading http://www.lightreading.com
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