Anatomy Of The Kurzweil Fraud
On September 11, Bernard F. Bradstreet will stand before a federal judge in Boston to receive a dubious distinction accorded only a handful of his fellow Harvard business school graduates: He will be sentenced to jail.
The 51-year-old former president and co-chief executive of Kurzweil Applied Intelligence Inc. was convicted in May of masterminding an astonishingly blatant accounting fraud at Kurzweil, a small but leading-edge player in computerized speech recognition based in Waltham, Mass. With Bradstreet at the helm, the company booked millions of dollars in phony sales in the two-year period straddling its August, 1993, initial public offering. Although supposedly sold to customers, the goods instead were shipped to a local warehouse, where they gathered dust.
BILKED INVESTORS. To hide the scheme from outside auditors, prosecutors contended, Bradstreet and other managers forged customer signatures, altered or concealed crucial documents, and surreptitiously shifted unsold goods between warehouses. The scheme allowed Kurzweil to show profits when it was really losing substantial amounts of money, in effect bilking the investors who plowed $24 million into the company's stock offering. When the fraud was finally exposed in mid-1994, the bottom dropped out of Kurzweil's stock. From a high of 21 in late 1993, the stock has sunk to about 2 1/2, and the company is still struggling to recover.
Despite the enormity of the chicanery and the large number of employees involved, it eluded not only auditors but also Kurzweil's outside directors and Robertson, Stephens & Co., which underwrote the IPO. In hindsight, these external watchdogs missed telltale signals, including soaring receivables. But it's often difficult to uncover fraud perpetrated by top management. And in the Kurzweil case, detection was made harder by the willingness of executives to brazenly lie and forge documents.
The involvement of Bradstreet in this sordid affair is especially bizarre. A former Marine fighter pilot who favored short hair and buttoned-down shirts, Bradstreet struck numerous associates over his 20-year career as the epitome of an honest and straightforward executive. "He was a highly ethical family man," recalls Richard B. Goldman, a former chief financial officer at Prime Computer Inc., where Bradstreet worked as treasurer from 1979 to 1985. "Certainly, the guy I knew wouldn't knowingly perpetrate the kinds of things he has been accused of."
Indeed, Bradstreet's apparent role in the fraud seems to defy logical explanation. With his background, he should have realized that such a crude scheme would inevitably be uncovered. And the usual explanation for such events--greed--doesn't seem convincing in this case. Even had the fraud succeeded, there was no big payday in store for Bradstreet: He owned just 3.4% of the company, worth barely $1 million at the time of the IPO.
"CLEAR-CUT CASE." On the witness stand, Bradstreet admitted the company had improperly accounted for some of its sales. But he contended the errors were the responsibility of underlings and said he didn't know about the apparent fraud until the very end. Prosecutors undermined that argument with a raft of evidence and the testimony of their star witness, former Kurzweil Treasurer Debra J. Murray. A quiet secretarial school graduate, Murray had worked closely with Bradstreet for nine years. She testified in mind-numbing detail that her former boss had directed or approved almost every step of the fraud.
Jeffrey B. Rudman, a senior attorney at Hale & Dorr in Boston who headed an investigation into the fraud for Kurzweil's outside directors, calls the scheme "the most clear-cut case with which I've ever been involved. The tragedy is that a very honorable and good man did something inexplicable in light of his history. That's what makes it so painful. What went wrong?"
Besides Bradstreet, at least 10 other employees were directly or tangentially involved. One junior accounting staffer even dummied up a phony logbook to help fool auditors, using three different inks to escape detection. Several salesmen testified they forged documents and otherwise aided in the scheme. But none of these low-level staffers were charged. Instead, prosecutors used their testimony to snare the big fish. Former Vice-President for Sales Thomas E. Campbell was found guilty of fraud and conspiracy charges alongside Bradstreet. Murray pleaded guilty and got probation.
The Kurzweil case raises the troubling question of why a group of otherwise law-abiding citizens veered into illegal behavior. One possible motivation may have been the unrelenting pressure on public companies to satisfy Wall Street's demands for steady quarterly growth. There's a huge temptation to push the accounting envelope, to enhance numbers by bending rules slightly. More than a few managers succumb to the lure and don't get caught. But how did the Kurzweil team go from bending to shattering the rules?
Unfortunately, the deepest motivations of the key players can only be surmised. Through their attorneys, Bradstreet and Campbell declined to be interviewed for this article, and Murray also demurred. But thousands of pages of trial transcript, plus interviews with numerous participants, provide an extraordinarily detailed picture of how a promising young company derailed.
"SQUEAKY-CLEAN." The Kurzweil saga starts with the company's founder, Raymond C. Kurzweil, now 48. A computer prodigy, at age 28 he invented a machine that could scan printed material and read it aloud to the blind, using synthesized speech. In 1982, he founded Kurzweil Applied Intelligence to commercialize his speech-recognition research, in this case using computers to transform spoken words into printed text. The idea was sexy enough to attract some big-name backers, including Harvard University's endowment fund and Xerox Corp.'s venture-capital arm.
Meanwhile, Bradstreet was compiling an impressive resume. After attending Harvard College on an ROTC scholarship, he spent five years as a Marine fighter pilot and air combat instructor during the Vietnam War, becoming a captain. Then came Harvard B-school, where former classmates remember "Brad" as hard-working and unusually devoted to his wife, Carol. "He was honorable, decent, steady, and straight as rain, not flashy at all," recalls Marguerite A. Piret, a fellow 1974 graduate.
After a stint as a loan officer at First National Bank of Chicago, Bradstreet in 1979 took the treasurer's job at Prime. There, he struck co-workers as hyperconservative. "Bernie was squeaky-clean," says John R. Colbert, who worked under Bradstreet as assistant treasurer. "He didn't even swear."
Looking for a more entrepreneurial career, Bradstreet jumped to Kurzweil in 1985 as chief financial officer. At the time, the company had only a few dozen employees and almost no revenues. Bradstreet soon realized that the company's technology, though promising, was too costly and underdeveloped for the broad electronic-dictation market. Bradstreet persuaded the company to focus on the medical field, using Kurzweil gear to help doctors dictate electronic medical records. Gradually, Bradstreet took on bigger roles, first as president, then as co-CEO with Ray Kurzweil, while also retaining his CFO job. By 1991, he was in charge of all day-to-day operations.
Progress in penetrating the medical market was far slower than anticipated, in part because the technology was tricky to perfect. But by early 1992, insiders had a feeling Kurzweil was on the verge of a breakthrough. The company had moved into the black, posting a slim profit of $111,000 in 1991 on revenues of $10.5 million.
Both Bradstreet and Ray Kurzweil, who remained co-CEO until 1994 but was concerned chiefly with technical matters, were itching to take the company public. But according to the testimony of several Kurzweil employees, Bradstreet was convinced the company needed to post six straight quarters of improving results to make the IPO happen. Trouble was, Kurzweil's systems were a difficult sell, requiring big financial commitments from hospitals to a completely new technology.
Kurzweil's slow slide into fraud started in a fairly innocuous manner during 1991, Murray testified. If a quarter was ending but a sales rep needed a few days to cement a sale, she said, Bradstreet began allowing the company to book the revenue a bit early. Instead of being shipped to the customer, the goods were "temporarily" stored at a Chelsea (Mass.) warehouse called FOB America until the order was signed. Under generally accepted accounting principles, a sale can only be counted when goods leave the company's premises en route to the customer. But the maneuver was impossible to detect as long as the sale was consummated quickly.
As sales proved harder to get during 1992, the company relaxed its policy to allow sales to be booked two weeks early. And by the following year, Murray testified, the rules were stretched until "the whole policy basically went out the window and [we did] whatever was necessary to book the revenue."
Aggressive accounting started to veer into chicanery. The turning point may have come in the final hours of Dec. 31, 1992. With the company still short of its quarterly targets, Campbell was pressuring Atlanta salesman James Hasbrouck to seal two orders from Georgia hospitals. Although Hasbrouck testified he told Campbell the customers weren't ready to sign, Campbell kept pushing, and the salesman eventually forged both customers' names on sales papers and faxed them to Campbell.
Soon after, Murray testified, Campbell came charging into her office with the $221,000 in ersatz orders. Campbell confided to her about the forgeries, saying Hasbrouck needed more time to "clean up the paperwork." Murray informed Bradstreet, she testified, and he told her not to worry--although Bradstreet countered in court that he didn't know about the forgeries. Murray posted the transactions.
Yet Hasbrouck never did secure the deals. Murray testified that she repeatedly asked Bradstreet what to do about the now bogus sales, but he told her to keep the sales on the books because Kurzweil "needed to meet [a] certain revenue number in order for the public offering to continue." The equipment sat in storage until the fraud was uncovered nearly 17 months later.
Ethics experts say the decision to keep the phony revenues may have arisen from a misguided sense of loyalty. "Executives in this type of situation often have an emotional investment in the company," says Barbara Ley Toffler, who heads an ethics consulting unit at Arthur Andersen & Co. "They have all this wonderful stuff to offer the world. So they rationalize. They say, `We'll do this temporarily, and that will give us time to make it all come out right.' But instead, they dig themselves in deeper."
Not long after, the fakery nearly caused the scheme to prematurely unravel. As part of the annual audit, Coopers & Lybrand accountants sent letters to both customers, asking for confirmation of the orders. After Murray put pressure on Hasbrouck to find a solution, the salesman testified, he retrieved the unsigned confirmation letter from one of the customers, again forged the signature, and faxed it to the auditors. Bradstreet and Campbell knew about this maneuver, Murray testified. The unwitting auditors gave Kurzweil a clean bill of health.
With the IPO planned for the summer of 1993, the first quarter of the new fiscal year would be the final one listed in the prospectus. But once again, sales were slow, and Murray testified that Bradstreet authorized her to book another series of questionable deals.
PAPER TRAIL. Late on the final afternoon of the quarter, with revenues still behind target, Bradstreet made a move that for the first time linked him directly to the fraud's paper trail. To reassure another customer, Bradstreet hurriedly signed and faxed a letter that a $450,000 order would be "contingent on our mutual agreement of the final document." This side letter meant that the customer hadn't actually agreed to buy anything. But Bradstreet told Murray to book the sale as a done deal. He never showed her the side letter, she testified, and the transaction didn't close until the following year. At the trial, Bradstreet defended his decision. But he conceded nailing down the details of the sale took longer than he expected.
On Aug. 24, the IPO finally closed. Investors paid $10 apiece for 2.4 million shares, 35% of the company's stock. Bradstreet sold $115,000 worth of his own shares. Although associates say Bradstreet didn't live an extravagant lifestyle, there were signs he might have needed the money. On his $200,000 annual salary, he was paying private-school tuition for his three children. And county records show that he had been borrowing money by increasing the mortgage on his house, a five-acre spread in the tony suburb of Sudbury. The mortgage started at $220,000 in 1983; by the early 1990s, it was up to $448,000.
How did Bradstreet hope to get out of this mess? The most likely explanation, say outside experts, is that he was counting on a surge in revenues so the company could continue to show growth over its prior (inflated) quarterly numbers. He presumably also hoped the sales force could find customers for the excess goods sitting at FOB America.
Neither one happened. Instead, prosecutors charged that about two dozen more improperly-recorded sales were used to pump up revenues in the next three quarters of the fiscal year ended Jan. 31, 1994. Trial evidence suggests that of the $18.4 million in sales recorded by Kurzweil that year, at least $6.3 million should not have been included. Through it all, Bradstreet continued to present a picture of confident leadership. He hosted informal weekly lunch meetings for the entire staff and never gave a clue, say employees, that anything was other than rosy.
PURGING FILES. With the next big audit looming in early 1994, Murray instructed her staffers to purge files of compromising material. She testified that she also was very concerned about a transaction booked the prior July involving Florida Health Care Inc., a health maintenance organization in Daytona Beach, Fla. A marketing rep then at the HMO, David W. Spearin, had expressed interest in buying Kurzweil gear, but the deal never went anywhere. Unbeknownst to him, Kurzweil had processed a $274,000 sale to his company--without a shred of paperwork to back it up.
Just before the audit, Murray said, she told Bradstreet they couldn't face the auditors without a signed order from Florida Health Care. She testified that he told her to give the papers to Campbell. The next morning, they appeared in her in-box, signed "Dave Spearin." The handwriting, Murray testified, appeared to be Campbell's. After the auditors picked Florida Health Care for a confirmation letter, Murray says, Campbell again stepped in, and the letter was signed in the same handwriting.
All this came as a shock to Spearin, who says the signatures are a far cry from his usual scrawl. The whole thing, he says, "is crazy. We never even came close to buying this equipment." He, too, testified for the prosecution.
But it was a seemingly innocuous slip of paper that finally brought the curtain crashing down. On April 14, a Coopers & Lybrand staffer was routinely checking shipping invoices from FOB America when he noticed a charge for nine months' storage on an order that was supposed to have been shipped the prior April. The auditors confronted Bradstreet and Murray, who told them it must be a mistake. Undeterred, the auditors demanded a list of everything stored at FOB America. A panicked Murray said she told Bradstreet that the auditors might suddenly show up at FOB America, and they needed to move the goods to a new hiding place. The next day, the goods were shifted to a warehouse on Cape Cod.
Bradstreet's explanation was quite different. He testified that, after the auditors found the invoice, he quizzed Murray, and she told him--for the first time--about the huge amount of merchandise at FOB America. He decided to secure the goods by moving them until they could be properly accounted for. But prosecutors poked holes in this account, pointing out he failed to alert auditors or the board about the hidden computer gear.
The outside directors, meanwhile, called in Hale & Dorr to investigate. But even with auditors and attorneys crawling all over Kurzweil headquarters, Bradstreet kept his fighter-pilot cool. According to Murray, he began planning to bring the still hidden goods back to Kurzweil, hoping to pretend they had been returned by customers. Murray, however, was getting cold feet. She testified that she told Bradstreet she wouldn't help. "Isn't it a little late for that?" she recalled him replying.
TEARS. The lawyers were making little headway until they got a huge break. On May 17, Murray confessed everything in an interview with Hale & Dorr. Merriann Panarella, the Hale & Dorr attorney, vividly recalls Murray calmly producing a chart detailing every questionable transaction. It was, she recalls, "one of the most poignant moments I've ever had practicing law. Both of us were on the verge of tears."
A few days later, Bradstreet, Murray, and Campbell were forced to resign by the board. Among the casualties in the ensuing purge were Murray's entire accounting staff and most of the sales force. The scandal nearly devastated the company. Unsure whether Kurzweil would survive, customers slowed orders to a crawl.
New CEO Thomas E. Brew Jr., a crisis specialist brought in the day Bradstreet resigned, is still struggling to turn the situation around. A few months ago, Kurzweil launched two new software products as advanced as anything on the market. Brew predicts the company will move into the black next year. "We're confident we've put the accounting irregularities behind us," he says.
Of the top managers, only Ray Kurzweil remains with the company, albeit as chief technical officer, not co-CEO. Murray told the FBI she thought Kurzweil was aware of questionable activity, but he vehemently denied it, and prosecutors apparently concluded he had no direct involvement. Today, he says he still can't fathom why colleagues with whom he had worked closely for years could have resorted to fraud.
As for Bradstreet and Campbell, they face almost certain jail time. Sentencing guidelines call for Bradstreet to receive up to 10 years, while Campbell could get nearly six. Most observers expect the judge to be somewhat lenient, given the pair's previously spotless records. But Bradstreet, in particular, should have plenty of time behind bars to ponder a question that only he can answer: What went wrong?
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