Tech's Kickback Culture

Inside the sweet deals that grease the industry

It was showdown time in the Rockies. On the morning of Mar. 24, 2000, about two dozen engineers at Qwest Communications International Inc. (Q ) 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, Qwest 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 (F ) William Clay Ford and WorldCom Inc.'s Bernard J. Ebbers, allegedly to win future banking business. On Dec. 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 (CSCO ) and EMC (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.

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.

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. (STOR ), 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.

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 (IBM ), Dell Computer (DELL ), and Nokia (NOK ), long ago established tough rules governing employee investments. Plenty of others, such as Microsoft (MSFT ), Sun Microsystems (SUNW ), and Computer Associates (CA ), 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 vice-president 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?

Tech-services upstart NetSolve Inc. (NTSL ), 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.

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 StorageNetworks," 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-StorageNetworks 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. (TELM ), which gave stock to executives at potential customers.

And executives were eager to invest. Take Cisco Systems Inc.'s (CSCO ) 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 company. 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. (COSN ) and Shasta Networks, which is owned by Nortel Networks (NT ). 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 (DSLs); 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. (CMRC ) 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," he says.

Friends-and-family stock also cements relationships with market researchers. Juniper Networks (JNPR ), for example, gave IPO shares to analysts at a smattering of research houses, including Yankee Group and RHK, according to Juniper's former director of communications, David Abramson. The idea was to garner favorable attention among influential analysts, he says. Abramson was fired by Juniper in January, 2000, and recently had a lawsuit against the company dismissed. While Juniper declines to comment on the stock allocations, the company says it did not need to buy influence. RHK says its will no longer take stock in companies it covers. Calls to Yankee Group were not returned.

Others dispute that there's anything to clean up. Frank Dzubeck, a networking analyst with his own firm, Communications Network Architects in Washington, D.C., admits he held stock in several startups, including Foundry Networks (FDRY ), Alteon (ALT ), and Convergent Networks. He says it was payment for consulting services. Dzubeck says that hasn't influenced his opinions and he always discloses his ownership stakes to clients. "I'm always going to give my honest opinion," he says.

Taking Dzubeck at his word may be fine for some. But 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

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