Gateway Transcripts Show When The Direct Model Blew Up

Last week, a jury came back from deliberations and handed a federal judge its verdict: Two former top executives at Gateway had engaged in a massive scheme of fraud and deception designed to make the San Diego, Calif.-based PC maker, and its direct sales model, look strong when it was actually sliding into trouble.

The jury in the civil case found that John Todd, Gateway's former chief financial officer, and Robert Manza, the company's ex-controller, disguised accounting gimmicks as solid sales revenue at the same time company executives were telling Wall Street its direct model was, simply, superior to competitors. The schemes took place in 2000, as Gateway was hammering competition with low prices, market share gains and winning fawning praise from financial analysts and media. The SEC filed charges in 2003, alleging it was all a matter of fraud and deception. A civil trial in the case finally took place over the last month.

(Nota Bene: Today's Gateway is, essentially, a different company from top to bottom. It now embraces solution providers in the commercial and retail channel, its CEO is a former channel executive, the company is profitable and its management is entirely different.)

Testimony in the case showed that by 2000, Gateway's direct business model was beginning to jump off the tracks as internal sales numbers showed it was starting to fall significantly below Wall Street expectations. Behind the scenes, top Gateway executives worked feverishly to "close the gap" between the real sales numbers and investor expectations. And there, according to the U.S. Securities and Exchange Commission in its lawsuit, was where the trouble started.

In one quarter of 2000, Gateway was so desperate for revenue to meet the Wall Street consensus expectation that it sold $47 million worth of its own, in-house, in-use IT equipment to its integrator, Lockheed Martin Integrated Business Solutions, and then leased it back from Lockheed; it reported the $47 million as revenue, even though most of the IT equipment wasn't even Gateway equipment -- a lot of it were items like Sun Microsystems servers that Gateway bought previously to run its own business. That $47 million contributed to a top line that helped wow the market at the end of the quarter.

In another case, Gateway sold $54 million of high-risk consumer loans to a third-party, Venserv, and reported that money as revenue. It simultaneously made a $50 million loan to Venserv that Venserv was supposed to use to pay for PCs it would then resell, on credit, to more high-risk, low-credit customers. Gateway reported that, too, as quarterly revenue even though the PCs never left the warehouse while Venserv employees worked the phones trying to sell the units, on credit, to people that Gateway had already turned down for financing.

In one comic episode, Gateway had sectioned off Venserv PCs in its warehouse -- which it was reporting as having been sold -- from PCs it was selling to a company called Rentway. (Rentway bought Gateway PCs to, essentially, rent to low-income people with no credit.) In the frenzy to move PCs out of its warehouse toward the end of the quarter, Gateway employees mistakenly took skids of PCs from the Venserv pile and shipped them off to Rentway. It caused a paperwork nightmare for Todd.

"When I became aware of that, I became very agitated because I thought of it as Venserv's inventory and that, as I told the people, 'You're stealing from Venserv,'" Todd, on the witness stand, recalled, according to a transcript of his testimony in the case. "You know, I met with the HR group because I was at a point of almost firing these people and the weekend came and I calmed down."

Gateway reported all of the revenue -- from Venserv, Lockheed and the rest -- but it reported none of the maneuvering, lease-backs or high-risk financing to investors. Instead, the company pointed to its direct model as the core of its success.

"The combination of accelerating revenue and profit growth that leads the traditional PC industry further illustrates the differences in the Gateway business model," Todd said in a press release at the time.

Todd, in his testimony last month, said he still didn't think any of that was wrong.

"I don't think it masked the failure to meet analyst's (revenue) expectations," said Todd, who is now a finance executive in the food service industry. "It was revenue. I believe today it was revenue, and we met analysts' expectations, so I don't think it masked anything."

Lawyers for the SEC argued that it masked the true health of Gateway's direct PC business -- sparking investors to pump money into the company's stock, which eventually tanked. A jury last week agreed with the SEC, and Todd and Manza were both found liable on multiple counts of defrauding the public. A judge will order sanctions against them at a later date.