Tech’s Kickback Culture

It was showdown time in the Rockies. On the morn ing of Mar. 24, 2000, about

two dozen engineers at Qwest Communications International Inc crammed into a

conference room high above the Denver skyline for a meeting with the company’s

president at the time, Afshin Mohebbi.

In a three-hour presentation, neatly outlined in a 20-slide PowerPoint

presentation, the engineers complained that morale was sagging. They attributed

much of the unrest to one festering problem: a growing culture of palm-greasing

at Qwest. If top management didn’t remedy the problem, the engineers would

walk.

The engineers said Qwest executives were receiving lucrative stock offers

from companies angling for business. And this could entice them to steer big

contracts to companies in which they held investments. According to the slides

obtained by BusinessWeek and interviews with six of the engineers, Quest all too

often was buying inferior gear–while execs’ personal stock holdings shot

through the roof. "Decisions were not based on what equipment performed the

best or what would fit in best," says Kelly Marshall, a former manager of

the lab that tested Internet gear for Qwest. "They were based on who gave

stock options to people making the decisions."

Mohebbi heard the engineers out, and they left the meeting with hopes that

change was on the way. Little did they know they had stumbled onto a practice

that has raged throughout high tech. The booming stock market had minted a new

currency: a plethora of preferred and friends-and-family shares from hundreds of

high-tech initial public offerings. Much of the industry was lavishing this new

payola on the top brass of customers, partners, and suppliers alike–dividing

the loyalties of execs between their companies and their personal portfolios.

"It’s an ethical nightmare," says retired executive Richard

Liebhaber, who resigned from Qwest’s board in January, 2000.

High-profile cases of IPO payola already have rocked the investment-banking

world. During the boom, Wall Street firms allocated coveted IPO shares to the

private accounts of CEOs such as Ford Motor Co’s William Clay Ford and

WorldCom’s Bernard J. Ebbers, allegedly to win future banking business. On

December 20, regulators negotiated a $1.4 billion settlement with 10 investment

banks that, among other requirements, barred such practices.

But a more pervasive form of palm-greasing has plagued the high-tech

industry. A four-month BusinessWeek investigation has revealed hundreds of

managers who were granted exclusive stock in companies with which their

employers did business.

Interviews with 135 current and former executives from 87 companies,

including Cisco Systems and EMC, reveal an industrywide fever. The

influence-peddling spread beyond customers and suppliers–even reaching

so-called independent research houses that write industry reports and market

forecasts.

Rewarding A Customer Executives rarely take a pass on a chance to buy friends-and-family shares because they can be flipped on the first day of an initial public offer. Here’s how one manager made out: 1 Days before Commerce one went public on July 1, 1999, the e-biz software maker offered Colin Dalzell, a manager at systems integrator MCI System house, a chance to buy friends-and-family shares. MCI System-house used Commerce One’s software to put together systems for clients. 2 Dalzell bought 1000 shares for $ 21,000. He flipped the stock after Commerce One’s first day of trading and used his $40,000 profit to pay for a 1965 Cobra racking-car kit. 3 Dalzell says the money wasn’t enough to sway him. And his company would have worked with Commerce One regardless. But he concedes that if it had been more money, a conflict could have arisen.

Did the market crash put the kibosh on these excesses? Not entirely. Even

with fresh IPO currency in short supply, the culture of backroom back-scratching

hasn’t disappeared. "Companies are continuing to be approached for stock

by analysts and others who wield influence," says David Helfrich, a partner

at ComVentures, a venture-capital firm in Silicon Valley. Helfrich says two of

his portfolio companies, which he won’t identify, relented to pressure and

granted shares to market researchers in the latter half of 2002. Such deals

could pick up as the tech economy recovers and IPOs return.

Giving gifts to curry favor in business has long been standard operating

procedure–from a round of golf to theater tickets. Neither gifts nor stock

grants are against the law. But legal experts say stock allocations create

conflicts that put individuals in positions where they could place their own

interests ahead of their company’s. That’s why, long ago, much of the old

guard in Corporate America adopted rules to keep such perks from swaying its

executives. But at many young tech companies, traditional conflict-of-interest

rules are often a work-in-progress–and ignored.

In 1999, eight top EMC execs buy early shares in Storage Networks at 50 each. They funnel business to the startup- sometimes hurting EMC-before cashing out. Meanwhile, EMC complains to Storage Networks that the startup is interfering with its customer relationships. Response: Today, EMC says the impact on its business was immaterial.

It’s the New Economy turned Kickback Economy. Consider a typical deal:

After eight top sales executives at storage giant EMC Corp bought ultracheap,

pre-IPO shares in a customer and business partner, StorageNetworks Inc, they

started steering contracts to the upstart–including rich deals that some

former EMC execs think should have gone to their own company. These contracts

brightened the new company’s prospects and boosted its stock. While this may

have hurt EMC and its stockholders, it produced a windfall of $2 million for at

least one of the EMC executives who got those cheap shares.

Just as intoxicating as early-stage shares are offers for so-called

"friends-and-family" IPO stock. Such friends-and-family plans allow

companies going public to distribute about 5% of their offering to whomever they

choose. Those invited get to buy shares at the IPO price–a perk not available

to the average investor. At the height of the bubble, IPOs were jumping an

average of 65% in their first day of trading, virtually ensuring a large payday.

"The money to be made is so significant that it starts to look like

outright bribery," says Craig W. Johnson, chairman of Venture Law Group, a

law firm that specializes in advising high-tech startups.

In early 2000, CEO Greg Reyes buys pre-IPO stocks in Storage Networks for $8.57 a share. A month later, brocade signs a supply-and-marketing contract with Storage, which helps boost, its stock. Brocade invests later, at a higher price-and loses more than $ 2.5 million. But Reyes makes a profit of some $ 1.1 million. Response: Brocade says Reyes removed himself from dealings with Storage Networks.

These divided loyalties may have cost shareholders billions. Companies, along

with their bankers, wanted friends-and-family participants to make a tidy

profit. For that reason, among others, they may not have sought top dollar for

their offerings, according to research collected by Jay R. Ritter, a University

of Florida professor of finance. This contributed to a $62 billion disparity

between IPO prices and prices one day later for all public offerings in 1999 and

2000. That money could have gone into company coffers, increasing the value for

shareholders. "If it weren’t for friends and family," says Ritter,

"company executives would have pushed for a higher offering price."

Not all companies tolerate backroom dealing. A number of them, including IBM,

Dell Computer, and Nokia, long ago established tough rules governing employee

investments. Plenty of others, such as Microsoft, Sun Microsystems, and Computer

Associates, put policies in place in the heat of the dot-com boom. Still, many

corporate policies remain murky–leaving employees unclear about what’s

acceptable. "When you’re very vague about what the rules are, that’s

when people get into trouble," says Michael D Lambert, a former senior V-P

at Dell. These conflict-of-interest investments rarely lead to an explicit quid

pro quo. In some cases, the amounts of stock are minuscule. Then the question

becomes: At what point does a nice little thank-you become more like a bribe?

In 1999, Yahoo! Vice-President John Healy, a friend of Storage Networks’ founders, invests in the startup at 50% a share. He introduces Storage Networks execs to Yahoo engineers. By early 2000, Yahoo is a customer of Storage Networks–and an investor, at $22.75 a share. Healy starts selling his shares in Nov 2000 for a profit of $211,000. Yahoo sells in March, 2001, losing over $ 1 million. Response: Healy says he didn’t influence Yahoo’s decision to buy products from Storage Networks.

Tech-services upstart NetSolve Inc, for instance, says it doled out chunks of

its 1999 IPO to 42 executives at companies that were customers. But no one

received more than 100 shares. NetSolve’s stock closed up 46% in its first day

of trading, meaning 100 shares would have generated an immediate profit of just

$600. "It seemed unseemly to say: `Let us enrich you right before you make

a decision about buying NetSolve’s services,"’ says Kenneth C. Kieley,

NetSolve’s CFO. "But if someone asked, and everybody was doing this, we

didn’t want to be impolite."

For startup StorageNetworks, there was nothing small about its pre-IPO stock

allocations. In December, 1998, eight EMC sales executives accepted an

invitation to buy preferred stock in StorageNetworks for 50 cents a share,

according to Securities & Exchange Commission filings. StorageNetworks, a

business that operates storage systems for its corporate customers, had the

potential to become a customer, a partner, even a competitor to EMC.

In January, 2000, six Exodus execs buy friends-and-family shares of Storage Networks at $ 8.57. Six months later, Exodus signs a cross-marketing deal with Storage Networks. Sales Vice-President Sam Mohamed snares a $370,000 profit, selling his share throughout 2001. Exodus buys stock at the same time, but sells later, losing more than $ 1 million. Response: Exodus filed for bankruptcy in September, 2001, and was acquired two months later by Britain’s Cable & Wireless Mohamed didn’t return calls.

After the investments, the EMC sales staff began recommending StorageNetworks

to their customers. This business quickly grew to 40% of the startup’s $6.3

million revenue in 1999. Thanks in part to this relationship, StorageNetworks

was able to command a high share price when it launched its IPO on June 30,

2000. The young company raised $226 million that day.

And its shareholders at EMC saw their investments rocket from 50 cents a

share to $90.25. EMC sales exec Robin A. Monleon, for instance, turned $50,000

into more than $2 million in just two years, according to SEC filings and

insider-trading records.

But as StorageNetworks grew and EMC developed its services arm, the two

companies found themselves competing. It got so bad that in June, 2000, just

days before the IPO, EMC sent a letter to StorageNetworks complaining that it

was poaching its employees and interfering with EMC’s customer relationships.

"These guys were getting paid millions of dollars to push EMC equipment,

not to recommend Storage-Networks," gripes John F. Cunningham, a former EMC

board member who says he resigned in 1999 partly because his private complaint

to top management about the StorageNetworks investments yielded no action.

"No question, it had an impact on their day-to-day decisions. It was a

tremendous financial incentive."

An EMC spokesperson says Cunningham never voiced any complaints about the

EMC-Storage Networks investments, nor was he aware of anyone else protesting. He

adds that any business lost to StorageNetworks was a drop in the bucket of EMC’s

$6.7 billion in 1999 revenues. Through a spokesperson, Monleon declines to

comment. StorageNetworks didn’t return calls.

Tech executives and backers of startup companies admit they used their stock

to gain an edge over competitors–or at least to get their foot in the door.

Indeed, handing out shares often meant the difference between buyers taking a

phone call and banishing it to voice-mail purgatory. "It was a way to say

‘thank you’ and a way to reach people who we wanted to help us in the

future," says Dick Barcus, former president of optical-networking company

Tellium Inc, which gave stock to executives at potential customers.

And executives were eager to invest. Take Cisco Systems Inc’s Deborah

Traficante, a former regional sales director who oversaw a sales staff of 150.

In 1998, she was invited to buy 85,174 preferred shares in telecom startup

MegsINet at 56 cents a share, according to a list of shareholders prepared for

the Internal Revenue Service that was obtained by BusinessWeek. The stock

purchase came a few months before Cisco loaned MegsINet $12 million to purchase

Cisco equipment. When MegsINet was bought 10 months later by CoreComm Ltd,

Traficante’s stake was worth more than $200,000.

Cisco says Traficante’s investment had no impact on its relationship with

MegsINet or on its decision to extend financing to the firm. And Traficante’s

attorney says her behavior was appropriate and that she put all her gains back

into CoreComm stock. They are now worth less than $300. Cisco did adjust its

policy in 2000, however. Now, employees are required to get written permission

from their superiors before accepting equity in companies with which they might

be involved.

Few industry executives benefited as richly from suppliers’ largesse as the

brass at Qwest. According to public documents and BusinessWeek interviews, Qwest

execs held prime stock positions in at least a half-dozen suppliers, ranging

from Foundry Networks to Tellium–much to the chagrin of the company’s

engineers. Indeed, one slide of their presentation to Mohebbi asks the company

to bar vendors from "granting personal options to key decision-making

individuals." Mohebbi left Qwest at the end of last year. His home phone

has been disconnected, and he could not be reached. Qwest says it has no contact

information for Mohebbi.

Qwest’s biggest conflict may have involved CoSine Communications Inc and

Shasta Networks, which is owned by Nortel Networks. The two companies were vying

to sell hardware to Qwest. Engineers say Shasta’s gear cost less and could

handle more than 100 times the amount of traffic than could CoSine’s offering.

Shasta’s product also provided access to users connecting through everything

from cable modems to digital subscriber lines; CoSine’s gear could not.

"Shasta was so far beyond where CoSine was that there was no comparison at

all at the time," recalls former lab manager Marshall.

While Qwest bought gear from Shasta, it also bought from CoSine. In its

initial purchase, Qwest ordered 35 CoSine boxes, recalls one engineer. Many of

those boxes, say Qwest engineers, ended up sitting unopened in warehouses.

So why do the deal? Qwest engineers charge it was personal greed. At the

time, at least four top Qwest executives, as well as an investment firm

controlled by then-Chairman Philip F. Anschutz, held more than 1.6 million

preferred shares of CoSine stock, according to public documents. A Qwest

spokesperson will say only that the company has new management. Qwest changed

its conflict-of-interest policy in late 2002 to prohibit employees from

investing in companies that have a connection to Qwest. A spokesman for Anschutz

says he is not involved in decisions related to small investments and did not

influence the CoSine/Qwest relationship. CoSine declines to comment.

For some Qwest execs, investments in CoSine never paid off. Although the

stock popped 63% on its first day of trading, a lockup on preferred shares kept

Qwest managers from selling for 180 days. Public records show that only Anschutz

Investment Co, made a profit. Anschutz’ company bought in at an earlier date

(and a lower price), making a tidy $700,000.

Most friends-and-family stock, however, had no such lockup. That’s why

executives rarely passed on the opportunity. It took Colin Dalzell, an executive

at systems integrator MCI Systemhouse, just a few hours to decide to buy the

shares offered by e-business software maker Commerce One Inc in 1999.

It turned out to be a wise investment: Dalzell turned $21,000 into $61,000 in

a day. His $40,000 profit paid for a 1965 Cobra racing-car kit.

Dalzell says the payment wasn’t enough to influence his dealings with

Commerce One. He had worked with the software maker for years and says his

relationship with the company was established long before the IPO. Still, he

concedes that a conflict could have arisen. "If it had been for more money,

I would have thought more about how much bearing it had."

Execs say the best way to guard against conflicts and questionable behavior

is for the high-tech industry to adopt sharply chiseled rules that bar stock

ownership in companies where business ties exist. As recent events show, one

person’s conflict can be costly for many.

By Linda Himelstein and Ben Elgin With Ira Sager in New York

in BusinessWeek. Copyright 2003 by The McGraw-Hill Companies, Inc