Summer of scandal: accounting tricks, software scams, price fixing make 2002 a tech summer to forget. (Business of Technology).

April is the cruelest month, the poet T.S. Eliot once wrote. It appears that for our industry, cruelty is making a late arrival. The month of July took the prize as the most scandal-filled four-week period in high-tech history. Accounting fraud, Department of Justice probes, anti-trust investigations, and just more general malfeasance seem to have replaced the wide-eyed optimism that once grabbed headlines in the computer business.

While July and August are typically the slowest news months of the year, would that it were so in 2002--no news would certainly be good news, it seems. The unprecedented implosion of WorldCom clearly gets the blue ribbon for potential scale of lawbreaking, but other, smaller investigations of industry companies are sapping investor confidence and shifting investment dollars away from the high-tech darlings of old. In this story, we examine some of the technology companies under investigation for misdeeds, and then try to assess the impact on the rest of us. Call it our roundup of rogues.

Crisis at WorldCom

By now, the details of the newest, and presumably largest, corporate accounting scandal are well known. The company, under the leadership of CEO Bernard Ebbers, hid billions in losses by apparently faking not only earnings reports but actual earnings statements.

What the company did, according to investigators, is deceptively simple. It characterized basic expenses as capital investments, thereby limiting the company's apparent losses while at the same time raising its apparent gains. For example, when WorldCom needed to spend capital to, say, fix a segment of cut fiber line, this was booked as "capital spending" rather than as an expense. In this way, it could limit losses, which of course gives the appearance of more revenue. It appears that all earnings reports from 2001 an(l 2002 are in doubt-covering $3.8 billion--and investigators are expecting to find as much as a billion more dollars in hidden losses when balance sheets from 1999 and 2000 are examined.

At press time, Ebbers and former chief financial officer Scott Sullivan had invoked their constitutional right against self-incrimination and refused to testify before a congressional panel investigating the scandal. Other aspects of the case have chilling similarities to the Enron and Global Crossing debacles. Auditors from the Andersen company are being questioned about how earnings statements were audited, and investment analysts from Salomon Smith Barney are under investigation for promoting the stock even as the company was tanking. New WorldCom chief executive officer John Sidgmore testified that the company is fighting for its survival, and that plan includes its bankruptcy filed in late July--purported to be the largest bankruptcy in history. Some members of Congress are calling for jail time for executives if their complicity is established.

What is the likely impact on the industry of this unprecedented collapse? First, a few facts. WorldCom is the nation's second largest long distance carrier. It or its subsidiaries UUnet and Digex carry about half of the world's Internet traffic. Sidgmore has said that the company is a "key component of our nation's economy and communications infrastructure." (Michael Powell, chairman of the FCC, has sought to reassure a jittery market that WorldCom's network will stay operational.) The company also has enormous hosting, co-location, and Internet access businesses serving hundreds of Fortune 1000 companies (Ford Motor Company, NASDAQ) and government agencies, including the Federal Aviation Administration. These companies probably have no choice but to hang on, as most of them have long-term contracts and would have to pay significant early termination penalties.

Further, the impact on personnel alone is staggering: about 17,000 employees are scheduled for layoffs, or 20 percent of WorldCom's work force. The bankruptcy filing is also expected to affect tens of thousands more. In further shades of Enron, much of the company's 401(k) plan was in WorldCom stock--soon to be de-listed--affecting thousands of retirement plans, as well as individual investors.

Eric Paulak of Gartner Research (who terms the news "disastrous") says the huge staff cuts will inevitably hurt WorldCom's service quality, and enterprises must make contingency plans. Paulak says that enterprises should:

* Consider not signing up for any new WorldCom services until its financial situation is clearer and it is guaranteed some bank credit.

* Sign six-month extensions for expiring contracts.

* Start duplicating data and considering alternative hosts for Web sites hosted by WorldCom or Digex.

* Evaluate how a second Internet service provider (ISP) might be used for Internet access as well as for WAN needs by deploying a virtual private network (VPN).

* Order back-up dial-up ISDN services for key locations where there is no alternative ISP.

Obviously, prudence comes with a price, and such contingency plans may have significant costs for affected companies. But there may be no other choice. Switching carriers on short notice is virtually impossible (and prohibitively expensive), and anyway would probably not be technically feasible with the drops in service likely to result from such massive layoffs.

WorldCom's customers should keep in mind, however, that the company is likely to delay indefinitely the rollout of any new data services. In addition, the telecom sector overall is in the midst of an unprecedented slump, and a schedule for recovery is still unknown. According to a report from Challenger, Gray & Christmas Inc., an executive placement firm, one-third of all job cuts in the nation announced since January came from technology companies, led by the telecommunications sector: fully one-quarter of jobs eliminated were in the telecom market. This year is looking just as bad or even worse than 2001, the report indicates.

Incredibly, WorldCom is not the only major telecom carrier facing serious legal scrutiny. Qwest Communications' accounting practices are being examined by the Securities and Exchange Commission, and published reports indicate that the Department of Justice and FBI are also investigating the company. As this issue went to press, Qwest confirmed that it has been notified that the U.S. Attorney's office in Denver has begun a criminal investigation of the company.

Qwest is the No. 4 long distance carrier in the nation and the dominant local carrier in more than a dozen states, from Minnesota to Arizona. In April, the SEC recommended action against Qwest for inaccurately reporting revenue in 2001, including directory publication revenue and sales of equipment. It also indicated irregularities relating to the company's purchase of U.S. West and the company's involvement with the purchase of assets from the bankrupt Global Crossing. Qwest's credit rating has been lowered to junk status by ratings firms and its stock hovers in the single digits, down from about $30 a year ago. On news of the Denver investigation, Qwest's shares lost about 35% of their remaining value, falling to $1.70. Qwest recently ousted its CEO Joseph Nacchio and replaced him with former Tellabs head Dick Notebaert.

While the nation watches the Qwest and WorldCom woes, regulators in California are now targeting other telecom companies. The California Public Utilities Commission has undertaken an investigation of Pac Bell Wireless (Cingular) in response to numerous customer complaints.

California, Scandal Central

According to the CPUC, the commission is seeking to determine whether Cingular has violated the state's rules in its collection of termination fees from customers, and whether its network is oversubscribed, preventing customers from using the service. While the use of early termination fees is fairly standard for wireless carriers that require annual commitments, this is the first time that California has indicated that such fees may not be legal if the carrier's network does not meet the customer's reasonable service expectations. According to the regulatory filing:

"Cingular makes the implied promise that adequate system coverage and capacity will exist in the subscriber's area of use. This promise is then taken back--in some of Cingular's marketing materials-by a fine-print [disclaimer of warranty."

The filing adds that the limitations of Cingular's system "often defeat the customer's reasonable expectations of coverage and capacity." The customer,' however, may be prevented from canceling Cingular's service and returning the phones by virtue of a $150 (or higher) early termination fee (ETF) and other fees which make cancellation more costly than continuing to use the inadequate service.

The commission has received thousands of complaints from Cingular users, many stating that they 'do not have, coverage where they live, work, or commute, or that their calls are routinely dropped. Many are also angry at Cingular's unwillingness to provide a refund or cancellation without charging the ETF and, in some instances, unwillingness to refund the full sale price of its phones--even when a customer is willing to return it. The company is also charged with falsely advertising its coverage area on marketing materials. Cingular has denied the charges.

The wireless phone market now appears to be set for stagnation through 2002, although things may get better next year, if only slightly. In a recent research report by Cahner's InStat/MDR, the company found that total worldwide handset semiconductor revenue is forecast to be flat this year compared to last, at approximately $14.35 billion each year. While the total number of handsets 'produced is expected to increase slightly this year, a drop in prices will counteract any revenue increases, according to the report. From 2001 to 2006, the compound average revenue growth from handset semiconductor components will average only a little over 7% per year, with' the greatest growth occurring in the area of' handset add-on semiconductor components.

California has also been enmeshed in a complex software scandal that has finally managed to bring down the entire Department of Information Technology for the state; its duties are now being spread across multiple agencies. In July California Governor Gray Davis issued the executive order disbanding the department. after months of hearings over a complex software licensing scheme involving numerous state agencies, an Oracle software reseller, and Oracle itself.

California's multi-billion dollar Web portal runs on Oracle, and the recent scandal has brought state lawmakers to the decision that the portal needs to be controlled inhouse. "The portal is too vital a state service, and it is tied: too intimately to basic state 'operations, for it to be run 'by outside vendors," said J. Clark Kelso, the interim director of the Department of IT who recommended the changes instituted by Govemor Davis. "We need to develop these skills in 'our own employees and get control over the portal and its development."

California has now canceled the contract entirely, although it is likely to pay some hefty penalties for 'doing so. It is unclear how the portal will operate independently of Oracle software, although the firm of Deloitte Consulting will assist in re-training state employees; seeking R.FPs and competitive bids 'for new database contractors; and presumably moving the My California portal to a different platform.

The controversy arose several months ago when an independent state audit found that California was likely to spend $41 million on unnecessary software licenses over a multi-year period--rather than save the nearly $100 million that Oracle had claimed when the contract was signed.. Because the deal was made at the 11th hour and without competitive bidding, and because Oracle:made significant campaign contributions'to' Gov. Davis the month after 'the contract was signed, the debacle :created.the appearance of impropriety, and several Department of IT officials have either resigned or been suspended. Further, many of the state's agencies found themselves out of compliance with Oracle's licensing' agreement, and still owe tens of thousands of dollars to the software maker. (Oracle's share price has been hammered of late, down to $7 from a high of $20 a year ago.)

DRAM Dramatics 

As if the memory market doesn't have enough problems, now comes news of a new Department of. Justice investigation into possible price fixing. The DOJ's antitrust division has been investigating. several companies independently for some time, but recent indications are that virtually all major DRAM manufacturers have received or expect to receive subpoenas, including Micron, Infineon, Hynix, and Samsung, according to published reports. (The DOJ refuses to identify the companies under investigation.)

The DOJ is likely examining why prices rose about twoand-a-half times over a recent six-month 'period, according' to Steve Cullen, director and principal analyst for the firm Semiconductor Research at InStat/MDR. "Every significant DRAM firm that sells in the U.S. seems to have been served with a subpoena from a grand jury investigating charges of uncompetitive practices in the industry," Cullen notes in a report on the investigation. "An investigation does not necessarily result in an indictment, but something must have caught the attention of the DOJ."

Cullen points out that the average price per megabit increased from $0.014 in October 2001 to $0.035 in March 2002.But during: the same period, monthly megabit shipments declined by 30%. "Since we did not hear of any factories blowing up, it is unlikely that the price rise was in response to any sudden imbalance between supply and demand."

There has been speculation for months that the DRAM industry has been manipulating prices in some fashion, although such behavior is only illegal if companies agree among themselves to raise prices (collusion), as opposed to reacting to[R]Tghepricing 'structures of their competitors. (The airlines have been engaged in the latter form of pricing, for years, notes InStat's Cullen, and it is perfectly legal.)

In April, Dell CEO Michael Dell said that, "There was some cartel-like behavior by a number of DRAM suppliers. These companies assumed that they could increase the price of DRAM and see an' increase in supply," Dell said, "But the world doesn't work that way." Indeed, as a response, Dell indicated that the company was turning' to Nanya, a Taiwanese DRAM maker offering the computer giant more attractive pricing.

Bring On The Pain

What may be the result of so many scandals at once? In one sense, we are already seeing the fallout. The industry, while still fundamentally sound, has lost its luster for venture capitalists. One empirical piece of evidence: According to VentureOne Corp., an industry research firm, venture capital funds invested a scant $5.1 billion in high tech in Q2 2002, a 53% drop from a year ago. In the first quarter, they raised just $2.25 billion, the lowest amount since the Internet boom began 1995.

And there is more bad news. According to a recent report in the Washington Post, in 2001, the value of early-stage venture capital funds fell 33.9%. This means that $100 invested in an early-stage fund on Jan. 1, 2001, would have been worth $66.10 on Dec. 31. Later-stage venture investments (those made after a company has received its initial round of financing) fell 20% in 'the same period. Even more worrisome, the value of all venture funds fell an average :of 27.8%, which marks the first annual loss recognized in any year since the industry began tracking returns in 1980.

Stock prices are another telling indicator of the strength of the sector, and the 'news is abysmal. While virtually all stocks are down across all industries, the numbers in the tech sector are eye-opening. The Nasdaq-100 Index Tracking Stock (QQQ) is a good general indicator of 'the strength of tech stocks. In the year period from July 2001June 2002, the 'stock has lost nearly half its value, falling from :about $43 to about $23. But a better number might be the two-year share price: from July 2000-June 2002, the price has plummeted from almost $100 to $23, a staggering 77% loss in share value (there were no splits during the period).

The numbers are only half' the story, of course, and the entire economy has contracted, not just high tech. But perceptions can make a difference, and until and unless the accounting scandals fade and capital investments rise, the scandalous "summer wind" may send technology companies scurrying for cover through the winter.