Peregrine Trial – Week 20

Comments by Bob Grimes and Dana Grimes

February 5, 2008 – 10:00 a.m. to 3:30 p.m.

Testimony resumed this morning after motions were ruled upon outside of the jury’s presence. As it turns out, the next government witness, Bob Austrian, is an economist. He was a securities analyst who researched Peregrine stock for his clients. The court ruled that he will be allowed to testify as a fact witness. The court also ruled that the government’s notice of a witness named Mr. Orstman was not timely if they intended to call him as an expert, so he will testify, if at all, as a fact witness. Attorneys Attanasio and Thickstun also argued that it is inappropriate to illicit expert testimony from lay witnesses who participated in the fraud, as allowing them to put on “expert hats” would add greater credibility in an unfair way to their testimony regarding their perceptions of events. Judge Whelan ruled that to the extent that those lay witnesses do have expertise in accounting, they will, for example, be allowed to say whether or not their own actions were consistent with GAAP; however, Judge Whelan will not allow them to testify as experts regarding the actions of others.

As soon as the jury was seated, the court read them an instruction essentially stating that during Mr. Weinstein’s testimony, they had heard about various accounting standards, principles and regulations which were not sufficient to establish an offense. The jurors were instructed that Mr. Weinstein’s testimony was about accounting principles, and that it would be up to them to determine what weight, if any, to give to his testimony.

Attorney Thickstun moved, on behalf of her client Mr. Towle, to sever his trial from Mr. Stulac’s, as the government witness Lynne Morimoto will likely testify that the purpose of whiting-out a fax is to confuse auditors, and this testimony will put Towle and Stulac “head-to-head.” The court denied her motion, noting that the state of the law allows for inconsistent defenses, just not mutually exclusive defenses.

AUSA Beste then continued his direct examination of Mr. Weinstein, asking how auditors recognize revenue from software sales, and how auditors correct the intentional and unintentional errors of their clients. Mr. Weinstein responded that how an auditor deals with an error depends on the situation, because “Sometimes systems malfunction; sometimes people malfunction.” “Quantitative materiality” was explained in terms of an auditor’s role in determining what amount of an error they find tolerable based on a given company’s earnings per share ratio and other criteria. AUSA Beste elicited from Mr. Weinstein that an “unsupported journal entry” (recorded revenue for which no transactional record can be found) in the books of a company is a “fraud indicator.” In a similar vein to his testimony last Friday, Mr. Weinstein discussed various SEC rules. He also stated that, until recently, the process of withdrawing a company’s financial statement and entering a restatement was horribly damaging to companies and auditors alike. The Court then took its first morning recess.

Attorney Attanasio began his cross-examination of Mr. Weinstein by reading him a quote stating that auditors must be diligent and thorough, but cannot be made into scapegoats: “we and our public must recognize that every instance of management fraud cannot be detected. Failure to detect such frauds may result in onerous civil penalty, but should not result in the public assessing criminal charges . . . .” Attanasio asked Mr. Weinstein, “Do you agree with this?” Mr. Weinstein did in fact agree with the quote; it turns out he wrote it. Additionally, in a separate article, written in 1986, Mr. Weinstein indicated that he might not recommend to a young person that he enter the field of accountancy in the United States, where the risk of practice is too high – and that the young person might be better off in Germany, South Africa, or Switzerland.

Much of Attorney Attanasio’s cross-examination was focused upon the theme of “collusive fraud,” and a problem which auditors face called the “expectation gap.” Mr. Weinstein conceded on cross-examination that accounting is an art, and that the general public perception of what an audit is, versus the reality of it, creates an expectation gap that is “widening,” dragging auditors into unfair litigation. Attorney Attanasio gave Mr. Weinstein copies of various speeches and articles written by Mr. Weinstein himself, along with other experts such as the former CEO of Deloitte & Touche. The articles emphasized that the public misperceives an auditor’s role, and expects him to find fraud immediately as if he is an “omniscient watch dog.”

Attorney Attanasio asked questions designed to show that the example of shoe sales used on direct examination to illustrate revenue recognition was inapplicable to the complicated world of software revenue recognition. However, Mr. Weinstein disagreed, maintaining that the principles used in both shoe and software companies are essentially the same. Attorney Attanasio, after some tense moments with Mr. Weinstein (and a few objections by AUSA Beste that he was being argumentative), elicited the expert’s opinion that auditing does require judgment calls on which different auditors may legitimately reach different opinions. To make his point with respect to how complicated software revenue recognition is, Mr. Attanasio handed Mr. Weinstein a thick book written by his former firm, Deloitte & Touche, designed as a roadmap for software revenue recognition. He read a quote from the book, which stated “such accounting is complex.” Mr. Weinstein responded that he did not necessarily agree with that statement by his former firm.

Many of these questions were designed to highlight Attorney Attanasio’s points. First, that software revenue recognition is not a science, and that disagreements exist amongst auditors regarding proper revenue recognition practices and “rules of thumb.” Second, that even a properly performed audit may not catch collusive management fraud, which according to Mr. Weinstein’s testimony, is an “insidious problem” that is harder to catch when many people are involved in the collusion.

Concluding his cross-examination, Attorney Attanasio asked Mr. Weinstein to read again from an article Mr. Weinstein had written, which advised auditors to consider what they had been taught in their profession: (1) with collusion, internal controls fail; and (2) verification by third parties constitutes adequate evidential support of financial statements.

In the last thirty minutes of court today, Attorney Kate Thickstun began her cross-examination of Mr. Weinstein. She asked him to describe the various educational requirements of accountants. She also asked him to describe the roles typically performed by CFOs and controllers within a company. Mr. Weinstein explained the “dominant CEO problem” that arises within a company when a particularly strong personality leads the company and demands conformity to his expectations. She also elicited from him that outside auditors have different perspectives than the accountants within a company. It is likely that when testimony resumes tomorrow, Attorney Thickstun will explore avenues of questioning designed to distinguish the skill level of her client – a relatively young and inexperienced CPA – from that of this expert witness – a 40-year veteran and former Senior Partner of Deloitte & Touche.

February 6, 2008 – 9:30 a.m. to 4:00 p.m.

The testimony today began with continued cross-examination of witness Weinstein by Kate Thickstun. She asked questions regarding the segregation of duties within a company. She established that, since different people in a company do different things, a system of checks and controls exists.

On re-direct of witness Weinstein, AUSA Beste asked questions about how difficult it is for an auditor to detect fraud within a company that he is auditing. Mr. Weinstein indicated that if an auditor does his job competently, he should be able to detect fraud. Mr. Weinstein testified that it is an auditor’s duty to be ever alert to the possibility of fraud when he is conducting an audit. Mr. Weinstein likened the assurance that auditors give to outside investors to the assurance that home inspectors give to prospective home buyers.

On re-cross by Attorney Attanasio, Mr. Weinstein admitted that this assurance aspect of auditors can be frustrated by collusive fraud. He testified that collusive fraud can defeat the most perfect audit; however, the witness noted that if an audit is not done correctly there is no hope of detecting collusive fraud.

The Government called Bob Austrian to the stand. Mr. Austrian is currently a software executive for a company in the Bay area. From 1996 – 2004, Mr. Austrian worked for Bank of America Securities as a financial analyst of the software industry. Bob Austrian testified that his work as a financial analyst required him to evaluate each software company according to its recent financial history and to project how that software company would do in the future.

AUSA Beste put several Peregrine press releases and earnings statements on the overhead projector screen. These documents all indicated that Peregrine had lived up to or exceeded Wall Street expectations. Attorney Beste also displayed several Bank of America analyst reports generated by Mr. Austrian that indicated his recommendation that investors buy Peregrine stock. Starting on October 24, 2000, all the reports from Peregrine or from Mr. Austrian about Peregrine were positive. The first negative report occurred after Peregrine issued a press release on April 5, 2002 that stated that Peregrine had retained KPMG as its new Independent Auditor. Mr. Austrian testified that he believed at the time that the replacement of Peregrine’s auditor suggested the possibility of friction between Peregrine and its previous auditor, Arthur Andersen. On May 6, 2002, Peregrine announced its internal accounting investigation and the resignation of CEO Gardner and CFO Gless, which led to the total plummeting of Peregrine stock.

Under cross-examination by Attorney Attanasio, witness Austrian testified that he needed to speak directly to the top management of the software companies that he analyzed. Attanasio introduced two separate e-mail streams between Mr. Austrian and Peregrine CFO Gless and Peregrine employee Kate Patterson. These e-mails demonstrated that Bob Austrian had direct access to Peregrine’s management if he needed information from them in order to produce his financial reports on Peregrine. Mr. Austrian testified that he needed to be able to evaluate Peregrine’s top management team personally and that this was a normal part of his job.

Mr. Austrian testified that he never suspected the ongoing fraud that was occurring at Peregrine. During the time period that Peregrine was run by CEO Gardner, he testified, the management team seemed proven and experienced.
Attorney Attanasio read a quote from a paper that Mr. Austrian wrote in January 2003. Bob Austrian wrote that “Accounting is widely misunderstood to be a science; it is an art.” Mr. Austrian testified that today he believes that accounting is more science and less art.

The jury of nine women and three men (as well as the alternates), were paying close attention to this witness as he described the process by which analysts evaluate a public company and the specific Peregrine public filings that he had relied upon in making his recommendations to investors.

February 7, 2008 – 9:00 a.m. to 3:20 p.m.

With a faint accent and perfect English, Phillipp Turowski, a former member of Arthur Andersen in Germany, testified today. Mr. Turowski was the German Peregrine Engagement Partner during the time period in which Mr. Stulac was the Peregrine Worldwide Engagement Partner. Through the testimony of this witness, AUSA Bill Narus entered into evidence numerous e-mails regarding the 2001 Peregrine audit. The first e-mail chain, with a subject line reading “Early Warning Peregrine Systems Germany,” included one e-mail written by Daniel Mair (who worked under Turowski in Germany), sent to Leslie Sadoff, Nevanna Sacks, and Dan Stulac. This e-mail stated, with reference to three specific 2001 contracts, that fees were not fixed and determinable, the customers were all resellers, there was no delivery, and there were extended payment terms, and that therefore it would not be appropriate to recognize revenue. Mr. Turowski testified that with the information available to him in Germany on those three contracts, he would have reversed the revenue recorded (an amount totaling approximately $11 to $12 million).

Next, with the help of Special Agent Cook, who displayed the e-mails and other exhibits organized on her computer screen on a projector, AUSA Narus asked Mr. Turowski to go over Stulac’s response to the e-mail sent from Germany bringing up revenue recognition problems. Mr. Stulac wrote in his e-mail, that the contracts at issue were “ASP contracts” and that there was “a history of collection on them.” At this point in the e-mail chain, Mr. Turowski himself responded to Mr. Stulac, disagreeing with the assessment that the contracts were ASP contracts, and stating that even if they were, no revenue should be recognized because the customers were channel partners (resellers), there were extended payment terms, and no delivery had been effectuated. This particular e-mail from Mr. Turowski concluded in language that he described as “very strong wording” for an e-mail to a worldwide engagement partner: “So how in the world can revenue be recognized on these contracts?” Mr. Turowski further indicated that, in his opinion, revenue recognition on these contracts did not fall within a shade of grey or require a judgment call on behalf of the auditor. He also stated that management representations in and of themselves would not be enough to cure the revenue recognition problems of those contracts.

Shortly after he had written this e-mail, according to the witness, Stulac called Mr. Turowski at his request, and told him that Arthur Andersen would handle the revenue recognition issue in consolidation (i.e., at the San Diego headquarters). Mr. Turowski took this call as he drove down the Autobahn, recalls it lasting five minutes, and indicated that he found it unsurprising. The witness testified that he interpreted this action to be a “scope limitation,” ending the Arthur Andersen Germany responsibilities with respect to revenue recognition. He then stated that it is “quite normal” to come to a decision at a group level, and assumed further inquiries regarding the problems the Germany office had identified would be addressed in San Diego.

In other exhibits, the Government demonstrated that Nevanna Sacks had requested an opinion from Mr. Turowski’s office regarding financial statements, and that the German office felt incapable of forming an opinion because they lacked sufficient information. Mr. Turowski told Ms. Sacks that Arthur Andersen Germany could not give any kind of opinion of revenue recognition at all.

The Arthur Andersen Germany office wrote in a memo dated April 25, 2001, that their preliminary judgment on revenue recognition was that there was a risk of materially misstated revenue. Nevertheless, due to the scope limitation, they did not propose any adjusted journal entries.

On cross-examination, Attorney Attanasio revisited the e-mails discussed during direct. He elicited from the witness that, although he was not personally aware of any documentary support for recognizing the $11 or so million worth of revenue at issue, such support could have been accessible in consolidation at the San Diego office to Stulac and his staff. Mr. Turowski told Attorney Attanasio that for one major contract signed in December 2000 the German audit team at Arthur Andersen had “no support at all.” However, he testified that such support could have been available to Arthur Andersen in San Diego from the sales records of Peregrine’s headquarters. Mr. Turowski never asked anyone in the San Diego office if they had found such support. Attorney Attanasio pointed out that some of the e-mails discussed on direct examination were not sent to Mr. Stulac, and as to others he was one of several people copied on the e-mail.

On direct, AUSA Narus presented one e-mail dated May 1, 2001, in which Mr. Turowski referred to the Peregrine bookkeeping situation in Germany as being in a “state of total disorder” and also referred to a problem of “questionable system integrity.” Attorney Attanasio asked many questions about this, and elicited answers from the witness indicating that the books and recordkeeping of Peregrine in Germany was “very bad,” largely due to the implementation of a new and unfamiliar software system called “PeopleSoft.” Due to the poorly functioning PeopleSoft program, it was impossible for the German office to issue an opinion on the balance of their work for Peregrine, irrespective of the revenue recognition problem, because the head financial officer at Peregrine Germany, Ms. Goetz, could not provide enough financial information to them. According to an e-mail written by Mr. Mair, the information flow was “horrible,” and a “major problem.” Often, when Mr. Mair would ask Ms. Goetz for information, she would not be able to provide an answer, and would tell him that the information might exist in San Diego.

With respect to the Autobahn phone call, Attorney Attanasio established that Mr. Turowski did not feel pressured into changing his position, and that nothing Dan Stulac said struck Mr. Turowski as improper. According to Mr. Turowski, there is generally nothing wrong with handling something in consolidation. Mr. Attanasio also presented an e-mail written by Mr. Mair in April 2000 (at which time Dick Bigelow was the Arthur Andersen engagement partner, not Stulac), in which the same problems with channel sales, extended payment terms, and the collectability of accounts receivable were presented.

The Government’s next witness, Richard Corgel, worked at Arthur Andersen for 30 years. In the fall of 2000 he was a practice director who consulted with audit partners regarding the judgment calls they made in the course of their audits. During the time in question, he was essentially in charge of the Arthur Andersen risk management team for North America. (Interestingly, although a few days ago expert witness Mr. Weinstein quarreled with Attorney Attanasio regarding the complexity of software revenue recognition, this witness volunteered on direct that revenue recognition issues in the software industry are indeed particularly risky and complex.) Mr. Corgel went over many of the things that the audit teams are supposed to discuss in mandatory risk management meetings, such as: 1) fraud; 2) proposed adjusted journal entries; and 3) “aggressive GAAP.” Mr. Corgel stated that he did not remember discussing these things with Mr. Stulac at a June 27, 2001 meeting.

(It appeared that by this point in the afternoon, at about an hour past lunch, the jurors had understandably abandoned their efforts to take notes. The terms of art in the accounting industry are numerous, the concepts are complicated, and with all due respect to our accountant readers – the topic is not exactly riveting.)

Mr. Corgel was asked about a business performance review of Peregrine in 2001, in which no write-off of accounts receivable was discussed in the “risk assessment” portion of the document. He also went over a memo from Nevanna Sacks to the file, indicating that on the advice of Arthur Andersen, Peregrine had adopted a policy during quarter four of fiscal 2000 of not recognizing revenue to channel partners with extended payment terms. The government further elicited from this witness that he never had any indication that there were concerns in Germany regarding the three contracts discussed earlier in the morning, nor that there were internal control problems in Peregrine Germany. Mr. Corgel stated that he would have expected serious internal control issues to have been brought to his attention, and that he does not remember any scope limitation of German partners being discussed at a risk assessment meeting he attended on June 27, 2001.

In perhaps the most effective cross-examination so far in this retrial, Attorney Attanasio elicited from Mr. Corgel that the risk review process may consist of two mandated meetings, but that it usually is a fluid process consisting of more meetings at various levels throughout any given year. Attanasio put the exhibits used by the Government back in front of the jury, and went back through the items that are meant to be discussed in risk management, such as fraud and proposed adjusted journal entries, etc. He then asked the witness if he was aware that a risk review meeting had occurred on June 14, 2001, and showed him a slide from June 14 on the projector which indicated that the concerns gone over by the prosecutor (including fraud, proposed adjusted journal entries, and aggressive GAAP), and had the word “DONE” written next to them. The witness indicated that it is consistent with his experience that the slides being shown to him reflected that these concerns had indeed been addressed.

Mr. Corgel explained on cross-examination that he did not recall if he was at the June 14 meeting, and that he does not recollect much at all of what occurred at the June 27 meeting. Attorney Attanasio asked Mr. Corgel “June 14 of 2001 was a long time ago, wasn’t it?” To which Mr. Corgel responded “I had brown hair back then.” Mr. Corgel agreed with Attorney Attanasio that in hindsight, seven years later, he cannot second-guess any audit judgments made at the time. Moreover, in the context of AICPA Statement of Position (SOP) 97-2, he agreed that two auditors could reach two different judgments regarding revenue recognition in good faith.

Mr. Corgel did not respond with certainty to very many questions posed to him by the Government or the defense, because he clearly did not recall much about the substance of his involvement in the risk assessment of Peregrine in 2001. However, he did respond quickly and without hesitation to one question. Attorney Attanasio asked “Is it true that a properly performed audit can be undermined and defeated by collusive fraud?” When Mr. Corgel responded “Absolutely,” Attanasio thanked him and had no further questions.

February 8, 2008 – 9:00 a.m. to 12:30 p.m.

The Government called Attorney Scott Vick to the stand. Attorney Vick represented Arthur Andersen in 2002. The scope of Mr. Vick’s testimony was limited to five meetings that he had with Daniel Stulac. The first meeting was on June 15, 2002 and the fifth meeting was on July 23, 2002. These five meetings occurred after the May 2002 announcement that Peregrine was undergoing an internal investigation and that Peregrine’s CEO Gardner and CFO Gless had resigned.

Attorney Vick listened carefully to each question while he was under oath today. He appeared to think before answering and he measured his words carefully. At the first meeting with Daniel Stulac on June 15, 2002, Mr. Vick testified that he was alone with Mr. Stulac. Scott Vick explained that Mr. Stulac did not know that the meeting had actually been cancelled and that was why there was no one else at the meeting. At the remaining four meetings there were a variety of people present, such as other attorneys and accountants.

Mr. Vick testified that Daniel Stulac told him that BJ Rassam had been the first person to suggest to Stulac that Peregrine could write off accounts receivable as acquisition costs. It was Scott Vick’s recollection that Mr. Stulac said he was unconvinced at first. Scott Vick said that Daniel Stulac told him that BJ Rassam explained that there was channel conflict due to Peregrine’s acquisition of other companies and that the accounts receivable occurred because the channel was not paying. Mr. Vick testified that Stulac told him that he (Stulac) told Rassam that the accounts receivable could be written off as acquisition costs if the reason they were uncollectible had to do with Peregrine’s acquisition of other companies. Mr. Vick testified that shortly after talking about this write-off with BJ Rassam, Stulac said he spoke to Matt Gless alone. Mr. Vick recalls that Stulac said that CFO Gless told Stulac that he “would go to his grave arguing that the accounts receivable in question were collectible,” but that if he had to write them off, Gless would only agree to write them off as acquisition costs.

Under direct examination, AUSA Narus further established that Daniel Stulac told Vick that he had not performed any substantive audit testing on these accounts receivable in order to test if they were related to acquisition costs. AUSA Narus also established that Mr. Vick asked Daniel Stulac if he had talked to anyone else at Arthur Andersen to explore the issue of whether this was a proper write-off and Stulac told him he had not done so.

Scott Vick testified that Daniel Stulac was a frustrating person to interview because he tended to jump from one topic to another. During the fifth and final interview, Vick said, Daniel Stulac arrived looking disheveled, with a wrinkled suit, blood-shot eyes, and reeking of alcohol. It was during this final interview that Stulac broke down and said that the write-off of accounts receivable had been wrong. Attorney Vick testified that during the interview he had characterized Stulac’s argument that the accounts receivable could be written off as acquisition costs due to channel conflict as “ridiculous.” Vick testified that Stulac indicated that he also thought it was a ridiculous argument and said that he had felt sick to his stomach after agreeing to write-off the accounts receivable as acquisition costs.

On cross-examination by Attorney Attanasio, Scott Vick admitted that, by the time of the fifth and final meeting on June 23, 2002, Vick knew that Daniel Stulac had a lot of problems. Mr. Vick knew that Daniel Stulac had suffered from a bad ending of a personal relationship, had a problem with alcoholism, and took anti-anxiety and anti-depressive medication. Mr. Vick admitted that Mr. Stulac may have been under the influence of alcohol and /or some mixture of those prescribed medications at the time of the fifth meeting.

Scott Vick also acknowledged that the concept of channel conflict was new to him at the time Daniel Stulac first told Mr. Vick that this was Peregrine’s rationale for writing off the accounts receivable. Mr. Vick testified today that he now realizes that it was not a ridiculous argument. Attorney Attanasio suggested that perhaps Daniel Stulac was just worn down at the time of the fifth meeting and that is the explanation for Stulac’s characterization of the write-off as being “wrong” and ridiculous.

Attanasio suggested that Stulac may have felt sick to his stomach due to the overwhelming nature of the Peregrine audit. Vick testified that Daniel Stulac had the heaviest workload of any auditor at Arthur Andersen San Diego. Mr. Vick testified that Daniel Stulac never said that he was involved in collusive fraud while working as an independent auditor at Peregrine.

The nine women and three men on the Peregrine jury already appear to be a close-knit group, sitting together at lunch, and socializing during recesses. So far, and in contrast to the first trial, the testimony presented to this jury has centered on accounting and financial principles. AUSAs Eric Beste and Bill Narus are using a different game plan this time around, painting a broader picture than the Government did in the first trial with respect to the complicated legal and ethical framework of accounting and auditing.

The trial will resume on Tuesday, February 11 at 9:15 a.m.