08.31.08

Charles Pancerzewski and Microsoft Fraud Revisited (Updated)

Posted in Law, Microsoft, Finance, SCO, Steve Ballmer, Deception, Bill Gates, Courtroom, Fraud at 1:43 pm by Roy Schestowitz

The man who snitched on Microsoft and became a millionaire

Background

According to many reports such as this recent one (or this and this older one, with a photo of the man here), Microsoft’s Charles Pancerzewski retired and became a collector some time after Microsoft had paid him millions of dollars not to sue Microsoft over systematic fraud, for which there was enough evidence according to the judge. Charlie later testified before the SEC and was he employed by in least one other industry before retiring.

This post, however, is now about Charlie, who is also listed here. His personal life is quite irrelevant compared to the Pandora’s box which he opened. It has potentially huge implications.

We have taken a good look around and studied events which span about 6 years (1996-2002). Here are some of the articles that we found. You can read further and explore more deeply, but we only highlight snippets. We also show that Bill Gates and Steve Ballmer are allegedly involved in a direct way.

The First Settlement

The following old article explains how Microsoft escapes tax. It’s an issue which was explored here several times before, e.g. in [1, 2]. Pay special attention to this:

We know that the SEC became interested after Microsoft settled with a whistleblower former employee, who funnily enough then shut up, and because Microsoft admitted that the SEC has started a “non-public investigation into the company’s accounting reserve practices”. This investigation was spurred following disclosures related to a wrongful dismissal claim brought by Microsoft’s former (internal) general auditor, Charles Pancerzewski, who had been offered a “resign or be fired” choice in 1996 after he claimed accounting practice irregularities. Pancerzewski complained that Microsoft used its reserves to pad its earnings in lean quarters, with the result that Microsoft misreported its earnings.

Microsoft’s “unearned revenue from prior periods” in its cash flow statement shows that Microsoft recognised $5.6 billion in fiscal 2000, up from $4.526 billion in fiscal 1999 and $1.798 billion in fiscal 1998. Pancerzewski filed suit under the Whistleblowers Protection Act, resulting in Microsoft’s records being subpoenaed. The judge decided there was enough evidence to go to trial on the whistleblower charges, but Microsoft quietly settled out of court, with Pancerzewski apparently accepting $4 million in compensation, a gagging agreement, and the sealing of the court record.

It is interesting to recall that pundit Robert Cringely noted a conversation he had with former Microsoft CFO Frank Gaudette. When asked what signs there would be as to when Microsoft stock should be sold, Gaudette said: “Watch for any changes in our accounting. If I need, I can start depreciating the software and maintain earnings growth for years on flat revenue.” Although Microsoft hasn’t yet reached the point of doing this, it is highly significant that a major change in the accounting system was introduced recently, especially as lacklustre results are expected for the current Q1.

Steve Ballmer is claimed to have been personally involved, but evidence may not be sufficient.

A lengthy anecdote about accounting irregularities exposed by whistleblower Charles Pancerzewski concludes weakly, “Microsoft paid over $4 million to make Pancerzewski go away, an amount that presumably wouldn’t be paid out without the Office of the President, the trio to which Ballmer belonged, signing off on it.”

Sadly, part of the settlement involved sealing (maybe destruction) of evidence. We saw this in the past, just before SCO attacked. What was Microsoft so afraid of if it claims to be innocent?

One strategy that Microsoft has employed in the past is paying for the silence of people and companies. Charles Pancerzewski, formerly Microsoft’s chief auditor, became aware of Microsoft’s practice of carrying earnings from one accounting period into another, known as “managing earnings”. This practice smoothes reported revenue streams, increases share value, and misleads employees and shareholders. In addition to being unethical, it’s also illegal under U.S. Securities Law and violates Generally Accepted Accounting Practices (Fink). Mr. Pancerzewski claims he was forced to retire, for raising the issue of deferred earnings with Microsoft executives, thereby making plausible deniability more difficult for said executives. He has since sued Microsoft, who responded by settling out of court, but also sealing the records to prevent public disclosure (Fink).

Here are some more details.

In his lawsuit, Pancerzewski cited Microsoft’s use of deferred revenue as a potential means of creating such a reserve, and brought in William Simpson, a former SEC accountant in its Los Angeles office and now a consultant, to testify that Microsoft did indeed manage its earnings through such means, according to court documents. Microsoft convinced the court to seal Simpson’s testimony from public view, and both he and Pancerzewski declined to be interviewed for this article.

Remember that Microsoft is claimed to have lost $18 billion in 1998. There is a lot that the company refuses to tell the public.

More unique information can be here:

When a Microsoft auditor alerted chief operating officer Bob Herbold and then-chief financial officer Mike Brown to the practice, he was urged to destroy copies of his report and ultimately was fired, court papers on file in Seattle federal court alleged.

[…]

But a surviving transcript of a June 1998 hearing quotes Pancerzewski’s attorney as saying that Microsoft “systematically and deliberately excluded hundreds of millions of dollars from their publicly reported financial statements in order to smooth income and conceal volatility.” The practice violated the Securities Exchange Act, the Federal Foreign Corrupt Practices Act, and European tax laws, argued Pete Vial, Pancerzewski’s lawyer.

Vial went on to allege that Brown, then Microsoft’s CFO, wrote in an email to chief executive Bill Gates that “we should do all we can to smooth our earnings and keep a steady state earnings model.” After Pancerzewski reported the alleged reserves to Herbold and Brown, “what they did was isolate him, demote, him,” Vial argued.

It therefore seems as though ‘charitable’ Chairman Gates endorsed these practices.

Nicholas Petreley once alluded to this incident too.

My suspicions regarding Microsoft stock are partly due to year-2000 issues and problems delivering Windows 2000. But I’m also concerned about the recent allegations of securities fraud in a wrongful termination suit by former Microsoft Chief of Internal Audits Charles Pancerzewski. Pancerzewski claims to have discovered that Microsoft violated Securities and Exchange Commission regulations in order to show steady net revenue growth every quarter.

And lastly:

He claimed to have been forced to resign in 1995 after reporting his suspicions about Microsoft bookkeeping to CFO Mike Brown and COO Bob Herbold.

[…]

But court records of the case show Pancerzewski had claimed he’d been ordered to destroy a consultant’s report about potential tax liabilities in Europe, and that he’d found that Microsoft was controlling the level of reported income by switching money back and forth from reserves. Much simplified, this procedure involves putting money into reserves in good times, and transferring it back into reported income when times are hard. It’s used to keep earnings apparently growing smoothly, and it is illegal, under SEC rules.

Destroying reports, switching money back and forth, escaping tax…. is this the ‘honuorable’ company we are asked to respect [1, 2, 3]?

The SEC’s Response (Second Settlement)

There are actually a lot more articles about those later events (unlike the former), which mostly revolve around the toothless SEC.

Here is one report.

Microsoft’s earnings may become less predictable if the world’s largest software maker is forced to change accounting practices because of a review by the U.S. Securities and Exchange Commission, analysts said.

From CNN:

The Wall Street Journal article, dated Jan. 14, 1999, concerned a wrongful-discharge lawsuit filed by Charles Pancerzewski, a former Microsoft internal auditor. Pancerzewski charged the company with manipulating hundreds of millions of dollars in revenue reserves to make its profits appear more stable.

Also from CNN:

The paper cites an e-mail, disclosed during Pancerzewski’s suit, that former Microsoft Chief Financial Officer Michael Brown sent to company Chairman Bill Gates in which he said, “I believe we should do all we can to smooth our earnings and keep a steady state earnings model.”

Information control is showing.

“It is really inappropriate for us to comment further,” he added, noting that the review would have “no material impact on our business or financial condition.”

Maffei said he learned of the SEC investigation “several months ago.” The company chose to disclose the existence of the investigation now due to the fact that it had heard of rumors circulating about such a probe and wanted to be sure the information was disseminated to the financial community and investors in an accurate fashion, according to a Microsoft spokeswoman.

Let’s fly a couple of years into the future.

Interestingly, Microsoft claims not to have broken the rules. If so, what’s the meaning of the article “Microsoft Agrees To Refrain From Accounting Violations in SEC Settlement”? This headline suggests that Microsoft acknowledges violation. If any of its past promises are something to rely on, it’s likely that nothing has changed since.

Microsoft has agreed to refrain from accounting violations to settle federal regulators’ allegations that it misrepresented its financial performance, the government announced Monday.

Under a settlement with the Securities and Exchange Commission, the software giant neither admitted to nor denied wrongdoing. No fine was imposed.

The SEC alleged that Microsoft’s accounting practices from July 1994 through June 1998 caused its income to be substantially misstated.

This article also available from here (Associated Press, thus distributed widely). The statements above say it all. Microsoft did not deny fraud and it escaped without harm.

Given that Microsoft now employs a young man from the paper industry as its CFO (more here), the last sentence below rings a bell of sounds an alarm.

The lawsuit, filed last year by Mukilteo City Councilman Charles Pancerzewski, alleges that he was forced to resign as Microsoft’s general auditor in January 1996 after working for the company’s internal auditing department for more than four years. The suit claims that a “significantly younger man” with little auditing experience was picked to replace Pancerzewski, who was finally forced out because he discovered Microsoft might have been violating government regulations. Once Pancerzewski left the company he was replaced by the younger man, who his attorneys believe was “less prone to raise issues of possible legal improprieties which could threaten or embarrass Microsoft or its management.

From the Microsoft-influenced New York Times:

Industry experts said the S.E.C. investigation could be part of its effort to restrain ‘’cookie jar'’ accounting, which can smooth over differences between strong and weak quarters.

[…]

The S.E.C. and its chairman, Arthur Levitt, have begun cracking down on what they consider earnings manipulation by companies. The issue ‘’certainly has Mr. Levitt’s attention,'’ said Peter H. Knutson, an associate professor emeritus of accounting at the Wharton School at the University of Pennsylvania.

[…]

Microsoft has set aside about $4 billion in what it calls ‘’unearned revenues'’ as a result of the way it sells both its Windows operating system products and its Office suite of software applications. The company often sets revenue aside to account for upgrades and components that may be delivered later during the product life. It also sells some products on a license or subscription basis, and sets revenue aside there as well.

But Microsoft also sets aside non-public reserves for bad debts, returned products and other related business contingencies, and it is possible that the S.E.C. investigation is related to those practices.

[…]

The company has still not made enough information public to provide analysts with detailed information on the profitability of its MSN Internet business, Mr. Galvin said, adding, ‘’There’s still room for them to obfuscate.'’

Watch this one, which alleges the CFO was personally involved

“I can confirm that the SEC has contacted Charlie Pancerzewski and that Charlie has cooperated with the SEC,” McNaul said.

That cooperation has included being interviewed by investigators and handing over a substantial volume of records about Microsoft’s practices, McNaul said.

[…]

“The CFO to whom Charlie was reporting his concerns about illegality was the biggest advocate for the very illegality that was going on,” Vial argued in court a year ago.

So, at the end, another unknown settlement was reached and Microsoft was not punished. Could Microsoft’s relationship with the SEC be similar to that which it enjoys with the Department of ‘Justice’? █

Update: Rex Ballard has added some valuable information and it’s quoted below verbatim.

Message-ID: <a12b7776-c665-4db3-a4a9-9d7e263d4925@y21g2000hsf.googlegroups.com>
From: Rex Ballard <rex.ballard@gmail.com>
Newsgroups: comp.os.linux.advocacy
Subject: Re: Ballmer Maybe Peronally Involved in Microsoft’s Fraud, Evidence Destroyed
Date: Sun, 31 Aug 2008 14:41:45 -0700 (PDT)

On Aug 31, 8:15 am, Roy Schestowitz <newsgro…@schestowitz.com>
wrote:

> Sadly, part of the settlement was destruction of evidence. What was Microsoft
> so afraid of if it claims to be innocent? it later settled with the SEC, too.

This is by no means a NEW settlement tactic for Microsoft. Most
settlements involve a number of agreements including
1- court seal of all evidence presented - so that it can’t be used
against them in other civil or criminal cases.
2- immunity from future prosecution, including a declaration that no
guilt is admitted
and that any wrongs ruled by the judge to be violations of law be
dropped, in effect
declaring microsoft and it’s people to be innocent of any
criminal acts.
3. Agreement not to disclose any information related to the case.
Even in the event
of a federal court subpoena, if the plaintiff talks, they lose
the money.
4 Agreement to destroy all exhibits as soon as applicable statutes
permit.
5 Purge of all public records, wherever possible, for example
removal from web sites.
6 On-line publications can be asked to purge the records (but are
not required to do so)
7 Court seals that prevent republication of the exhibits by the
court or the plaintiffs.

One of the clever strategies of Combs versus Microsoft was that all
exhibits, and transcripts of key witnesses and judicial decisions were
published while they were still in public domain. This allowed
interested parties to capture and circulate all of the evidence BEFORE
court seals “Locked up” the official transcripts and exhibits.

We have seen similar terms in cases where public disclosure of the
settlement is required by state or federal law.

> Whistleblower settles after Microsoft SEC fraud claim

> ,—-[ Quote ]
> | He claimed to have been forced to resign in 1995 after reporting his
> | suspicions about Microsoft bookkeeping to CFO Mike Brown and COO Bob Herbold.
> | […]

The interesting part of this case is that even though the central
issue of the case was whether or not Microsoft terminated the
plaintiff BECAUSE he was a whistle blower or not, a bunch of secondary
evidence describing what the plaintiff had found, why he thought it
might be illegal, and how he found it, were also presented (even
though those were not critical elements of the case).

During the settlement process, not only were the reasons for
terminations put under seal, but ALL documents related to the the SEC
violations were also presented. In the settlement all of those
records were put under seal, the court gave immunity, and the
settlement allowed both Microsoft and the plaintiff to distroy the
records.

It almost looks to me like the plaintiff was actually working for
Microsoft and EARNED is $4 million by taking a bunch of very
incriminating evidence out of play. Whether the plaintiff KNEW that
was what was happening or not is probably up for speculation, but it
is clear that Microsoft played him perfectly. He pointed out the
obvious, and became the perfect pawn to get the very evidence he
threatened to disclosed taken out of play.

The problem for prosecutors is that none of the evidence in the case
can even be used to establish probable cause, since it would be poison
fruits, which means that Microsoft executives effectively gave
themselves immunity by firing this guy in such a way that he was sure
to fight back. I wouldn’t be surprised if Microsoft even had some of
their people put the idea of suing Microsoft into his head, and maybe
even gave him the name of a good lawyer who would be sure to put
everything into the court record.

> | But court records of the case show Pancerzewski had claimed he’d been ordered
> | to destroy a consultant’s report about potential tax liabilities in Europe,
> | and that he’d found that Microsoft was controlling the level of reported
> | income by switching money back and forth from reserves. Much simplified, this
> | procedure involves putting money into reserves in good times, and
> | transferring it back into reported income when times are hard. It’s used to
> | keep earnings apparently growing smoothly, and it is illegal, under SEC
> rules.

Yes, and we’ve seen clear evidence of Microsoft doing that since the
release of Vista. Microsoft has been financing huge quantities of
Vista sales and flooring, then writing it down in subsequent quarters
as bad debt. It lets them keep revenues up while profits go down from
their typical 80% to as low as 30% due to bad receivables.

> http://www.theregister.co.uk/1999/01/09/whistleblower_settles_after_m…

[snip other fine references]

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