Michael Dell took a two-fisted punch from the Securities and Exchange Commission Thursday: One popped him with charges for failure to disclose material information to investors and the other tagged him with a $4 million settlement fine (the good news for Dell is that the SEC's actions didn't result in a prison sentence). His company, Dell (DELL) got hit even harder, agreeing to pay $100 million to settle both failure to disclose charges, as well as charges of accounting fraud in a case involving its relationship with chip giant Intel.
Dell and the company he founded appeared to be prepared to make the deal, announcing last month that the company had set aside $100 million for a potential SEC settlement and that Dell, as far as the company could tell, would not be barred from serving as an officer and director at the company.
If the SEC's allegations are true, then investors may be feeling duped that they bought Dell's highly-touted direct sales model hook, line and sinker. According to the SEC's charges, the model wasn't the efficiency engine that everyone thought. For many years, Dell and his lieutenants -- namely former CEO Kevin Rollins, former CFO James Schneider, former regional Finance Vice President Nicholas Dunning and former Assistant Controller Leslie Jackson -- basked in admiration from investors who praised their savvy management style while other industry behemoths stumbled. But, according to the SEC's allegations, all of that chest-thumping may not have been justified. Here's what the SEC claims:
Dell Inc., Michael Dell, Rollins, and Schneider misrepresented the basis for the company's ability to consistently meet or exceed consensus analyst EPS estimates from fiscal year 2002 through fiscal year 2006. Without the Intel (INTC) payments, Dell would have missed the EPS consensus in every quarter during this period. The SEC's complaint further alleges that Dell's most senior former accounting personnel including Schneider, Dunning, and Jackson engaged in improper accounting by maintaining a series of "cookie jar" reserves that it used to cover shortfalls in operating results from FY 2002 to FY 2005. Dell's fraudulent accounting made it appear that it was consistently meeting Wall Street earnings targets and reducing its operating expenses through the company's management and operations.
According to the SEC's complaint, Intel made exclusivity payments to Dell. In return, Dell agreed not to use processors manufactured by Intel's rival - Advance Micro Devices (AMD). These exclusivity payments grew from 10% of Dell's operating income in fiscal 2003 to 38% in fiscal 2006, and peaked at 76% in the first quarter of fiscal 2007.
The SEC alleges that the company and its top executives failed to disclose the basis for the company's sharp drop in its operating results in its second quarter of fiscal 2007 -- when Dell announced its intention to begin using AMD processors and Intel cut off payments to the company. In dollar terms, the reduction in Intel exclusivity payments was equivalent to 75% of the decline in Dell's operating income. Instead of explaining the decline to investors, the SEC says the executives told them that the sharp drop in the company's operating results was attributable to pricing that was too aggressive in the face of slowing demand and to component costs that declined less than expected.
The SEC's complaint further alleges that the reserve manipulations allowed Dell to materially misstate its earnings and its operating expenses as a percentage of revenue - an important financial metric that the company itself highlighted - for more than three years. It also enabled the company to falsely state the amount of operating income it derived from its EMEA segment, an important business unit that Dell also highlighted, from the third quarter of FY 2003 through the first quarter of FY 2005.
"Dell manipulated its accounting over an extended period to project financial results that the company wished it had achieved, but could not. Dell was only able to meet Wall Street targets consistently during this period by breaking the rules. The financial results that public companies communicate to the investing public must reflect reality," Christopher Conte, associate director of the SEC's Division of Enforcement, said in a statement.
Reality distortion in the tech industry, where have we heard this before?
"We are pleased to have resolved this matter. We are committed to maintaining clear and accurate reporting of our periodic results, supporting our customers, and executing our growth strategy," said Michael Dell in a statement. As part of the settlement, Dell's CEO did not admit or deny the SEC's allegations.
As for the company, Dell director Sam Nunn, said in a statement: "The Board believes that this settlement is in the best interest of the company, its customers and its shareholders, as it brings a five-year SEC investigation to closure. Dell's Board reaffirms its unanimous support for Michael Dell's continued leadership, and the management team in its ongoing commitment to transparent accounting, integrity in financial reporting and strong corporate governance."
Without admitting or denying the SEC's allegations, here are the parties involved in the SEC's dragnet and the agreements they reached with regulators:
Dell Inc.: Charged with failure to disclose material information to investors and fraudulent accounting to meet earnings estimates. Agrees to enhance its Disclosure Review Committee and disclosure processes, including the retention of an independent consultant to recommend improvements to those processes and enhance training regarding the disclosure requirements of the federal securities laws. Settlement fine - $100 million.
Former CEO Kevin Rollins: Charged with failure to disclose material information. Agrees to abide by securities laws and is not prohibited from serving as a director or officer of a publicly traded company. Settlement fine - $4 million.
Former CFO James Schneider: Charged with failure to disclose material information and fraudulent accounting to meet estimates. Agrees to suspend appearing or practicing before the SEC as an accountant for five years. Settlement fine - $3 million, disgorgement of $83,096, and prejudgment interest of $38,640.
Former regional Finance Vice President Nicholas Dunning: Charged with improper accounting. Agrees to suspend appearing or practicing before the SEC as an accountant for three years. Settlement fine - $50,000.
Former Assistant Controller Leslie Jackson: Charged with improper accounting. Agrees to suspend appearing or practicing before the SEC as an accountant for three years.
For Dell and company, the penalties -- while steep -- were not as bad as the $400 million levied on Fannie Mae in 2006, after the SEC cited the company for similar improper accounting disclosures.
Intel, meanwhile, cooperated with the SEC's Dell investigation, but noted that none of the allegations in the SEC's Dell complaint have been tested and adjudicated in court, says a spokesman for the chip giant. But what's particularly interesting to note about the SEC's settlement agreement is that apparently more folks may be on the hook. The agency says: "The SEC's investigation is continuing as to other individuals." Ouch.