Cisco Socked with Shareholder Suits

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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voyeur 12/4/2012 | 8:28:12 PM
re: Cisco Socked with Shareholder Suits Has anyone seen this?


Cisco may have sold as much as US$500 million of the $2.5 billion of inventory it wrote off two weeks ago, according to an analyst at Dresdner Kleinwort Benson. "We have heard from two sources in Japan that Cisco was able to sell up to $500 million of the $2.5 billion of the inventory write-off it announced on April 16," said Dresdner's Ariane Mahler. If the rumours prove to be true, said Mahler, it raises questions about the credibility of Cisco's management, and could attract the attention of the Securities and Exchange Commission. Any sale of goods written off just two weeks ago would be a "contradiction" of statements made by chief executive John Chambers regarding the level of demand for the components, explained Mahler. AFX (AP), May 1, 2001

I just thought it might be pertinent to the subject of lawsuits.

restonrangers 12/4/2012 | 8:30:04 PM
re: Cisco Socked with Shareholder Suits Can anyone give me an update?
pstafford 12/4/2012 | 8:30:21 PM
re: Cisco Socked with Shareholder Suits I raed the article and then turned to the board and I must say I don't understand much of this discussion. The aricle was clearly factually based, referencing the text of the lawsuit, with no judgement passed. Sure these suits go down all the time; I thought the angle that this one might have some actual merit was well-supported.

So what if lots of companies pull these sorts of vendor-financing and revenue-recognition shenanigans? It's still at the very least unfair to shareholders, and when a bellweather like CSCO does it, they should be called on it. There is little question they were doing it -- I've been hearing these rumours, sometimes from CSCO employees, for months. Everyone knew the CLECs were a house of cards; this amounted to a big gamble that they'd hurt competitors badly enough that it would mask the damage to their own balance sheet.

Not that I think shareholder suits are such a great idea. If you were dumb enough to be long CSCO, it's probably best to simply take your medecine. A little snooping at trade shows easily uncovered their malpractice... The real criminals here are the wall street analysts who knew, or should have known better, and still routinely cranked out "strong buys" on this turkey.

DCITDave 12/4/2012 | 8:30:24 PM
re: Cisco Socked with Shareholder Suits Um, I don't hate our readers. Where do you get off saying something like that?

I disagree with our readers sometimes. Like now, for instance.

But there's no hatred here.

P.S. A.D.'s parody of MTV's Fear was brilliant. Great fun.
Hanover_Fist 12/4/2012 | 8:30:24 PM
re: Cisco Socked with Shareholder Suits no...no...

I referred to LR's removal of offensive information on this message board...
cfaller 12/4/2012 | 8:30:25 PM
re: Cisco Socked with Shareholder Suits "Way to go, Steve. Once again you clearly demonstrate your true intentions...never bog down news analysis with meaningful facts..."

What meaningful facts are being excluded? Just because the analysis isn't kind to Cisco doesn't mean it's not factual.

What's wrong with you people?
Hanover_Fist 12/4/2012 | 8:30:32 PM
re: Cisco Socked with Shareholder Suits Reading the posts on this article is awe-inspiring.

LightReading - the National Enquirer of the Technology Industry.

Steve Saunders: "Boo...hoo...hoo...If people pick on MY website, then I'll just pull all those posts off MY message board - there. That'll teach those nasty reader a lesson. I only want people to agree with me to be allowed to post - snif...whimper"

Way to go, Steve. Once again you clearly demonstrate your true intentions...never bog down news analysis with meaningful facts...
Tight Underwear Kills! 12/4/2012 | 8:30:34 PM
re: Cisco Socked with Shareholder Suits I hope you're not another masquarading type. There are enough of those on these boards.

Face it - LR is the only stop in town for certain things, like industry overviews.

The owner makes no bones about the companies that bother him. Don't know why he chooses the companies he does - most say because of advertising. But I admire him for his honesty - he writes to these boards in fact.

Welcome to the Real World.
The Andy Dick Show 12/4/2012 | 8:30:35 PM
re: Cisco Socked with Shareholder Suits ...but you guys gotta admit, the Andy Dick Show is the funniest show on earth.

The Andy Dick Show 12/4/2012 | 8:30:35 PM
re: Cisco Socked with Shareholder Suits Whoah man...alot of hatred going on here. I don't remember this stuff way back mid-last year when I last read.

The readers hate LR, LR hates the readers. What's going on, man?

LR writes some wicked-good stuff. What's with the vendettas goin back and forth? Is it because it drives traffic here? I can't make out these LR guys at all.
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