Containing more pages than the Lord of the Rings trilogy, the judgment in the civil damages case brought by Hewlett-Packard Enterprise (HPE) against chief executive officer (CEO) Michael Lynch and chief financial officer (CFO) Sushovan Hussain unpicked a string of bogus deals that helped sustain the company’s market value.
Autonomy was a UK-based pioneer of business data analysis using machine learning and what the PhD-holding CEO called “adaptive pattern recognition”. The innovative technology came to the attention of US-based tech services giant Hewlett-Packard (as was), which acquired the company for £7.1bn in 2011.
A year later, HP cited accounting irregularities at Autonomy as the main reason for $8.8bn in asset impairments it reported in 2012. All manner of lawsuits followed, starting with shareholders suing HP and accountants KPMG and Deloitte for carrying out “cursory due diligence on a polluted and vastly overvalued asset”, HP suing Lynch and Hussein for fraud and Lynch counter-suing HP for unfounded claims that demonstrated “a fundamental misunderstanding of [international] accounting practices”.
Deloitte’s discomfort deepened after the Financial Reporting Council (FRC) investigated its work on the Autonomy audit, leading to a £15m fine with £5.6m costs in 2020. This sum still holds the record for the largest-ever audit regulation sanction in the UK.
The HPE vs Lynch & Hussain case started with 93 days of hearings in 2019. The epic final judgment delivered last week may explain why Mr Justice Hildyard has gained a reputation for taking his time in compiling his decisions. Working in a manner that might be familiar to trained auditors, the judge’s team extracted a bundle of 28,000 documents focusing on a series of grouped transactions from an evidence database containing “many millions” of similar documents.
The Autonomy artificial revenue-boosting campaign wasn’t based on a single spectacular scam, the claimants alleged, but a dishonest ethic that spawned a sequence of side deals and accounting feints designed to hoodwink the company’s auditor, Deloitte, and audit committee. The transactions at the heart of the judgment included:
- Hardware-only sales recognised as recurring software sales
- “Impugned” software sales through resellers acting as commercial fronts to inflate reported revenues, often arriving right at quarter ends
- The use of “improper” acquisition accounting in the $55m purchase of US subsidiary MicroLink
- Four “other transactions” for one-off services delivered by Autonomy and its Spanish subsidiary during 2010-11 that the defendants alleged were falsely accounted for as licence sales to falsely reflect an element of recurring revenue.
Reseller deals
The bulk of the judgment is taken up with the “impugned” software sales through value-added resellers (VARs). The judge explained that the approach helped establish a pattern of transactions where revenue was improperly recognised from sales that “lacked any real substance in order to make good… shortfalls in properly recognised revenue from software sales”.
One £4m deal (VT10) was concluded with the UK’s own Financial Services Authority at 11:39pm on 29 March 2010, the night before the end of Autonomy’s first quarter. Capax was brought into the deal partly because it was based on the US East Coast, five hours behind European time. In several example cases like this, the transactions were later converted into direct deals between Autonomy and the end customer.
Resellers typically only paid Autonomy when they received funds from the customer and did not appear to have any liability should the sums not be paid According to the judge, they effectively acted as placeholders for the real transactions, and were expected to do nothing and pay nothing out of their funds.
IAS18 revenue recognition lapses
Most of the VAR transactions examined were impugned by reference to some form of side agreement or understanding as seen at Capax. In some of the other cases examined, the claimants merely maintained that the transactions did not satisfy the IAS 18 Revenue Recognition requirements set out section 18.14:
- IAS 18.14(a) there was no transfer of risk of ownership
- IAS 18.14(b) Autonomy in substance retained managerial control of the goods; and
- IAS 18.14(d) there were grounds for doubting collectability.
These lapses were central to the FRC’s 2020 misconduct findings against Deloitte, which ruled that the auditor should not have issued an unmodified audit opinion in the 2009 financial year. The tribunal castigated Deloitte and its engagement partners for failing to exercise adequate professional scepticism about the sales and for not obtaining the appropriate audit evidence to substantiate them.
Hardware sales
The hardware element of HPE’s case was based on the purchase and resale by Autonomy, usually at a loss, of computers totalling more than $100m. Since Autonomy presented itself as a pure software company these transactions gave a false impression of how Autonomy was performing.
The hardware case also raised the issue why the hardware sales were accounted for as marketing expenses so as artificially to increase gross margins, and whether Deloitte was misled about their true purpose.
Mr Justice Hildyard had no doubts: “The purpose of the hardware selling strategy was to meet market expectations of revenue maintenance and growth, by misleading the market as to the true market position of Autonomy.
“These loss-making transactions were not commercially justified on any basis. The justifications advanced by the defendants were no more than pretexts to increase stated revenue in the accounts. The strategy was not for the purpose of raising software revenue sales. That justification was a pretence, fashioned principally for the audit committee and Deloitte, who would not have approved the accounting treatment without the pretence.”
OEM sales
Autonomy’s code was often installed on systems sold and delivered by original equipment manufacturers (OEMs), for which Autonomy earned recurring royalty payments. The case against Autonomy alleged that the company included one-off software sales within a measure it compiled known as the “OEM Metric”.
Once again, the judge found in HPE’s favour: “The accounts and the representations they made in this regard gave a misleading picture of Autonomy’s OEM business. They did so because they knew revenues were included from transactions lacking the characteristics associated with OEM business. They knew that such revenues were considered in the market to generate a particularly dependable and valuable revenue stream.”
Improper acquisition accounting
Autonomy acquired US reseller MicroLink for $55m at the end of 2009. The rationale for the acquisition was that MicroLink was an accredited US government supplier when Autonomy was not. At the time of the acquisition, MicroLink owed Autonomy $22.7m.
The company was founded by David Truitt, who according to hearsay evidence cited in the judgment was the brother of Dan, Autonomy’s federal district sales manager. Just before the acquisition, another company, DiscoverTech, was spun out of MicroLink. This entity was formed by yet another Truitt brother and acted as a reseller for Autonomy in another eight of the impugned VAR transactions.
Deloitte was aware of MicroLink’s indebtedness but focused its analysis of the deal on whether MicroLink would have to be treated as a separate segment for accounting purposes but dealing also with the structure and rationale of the acquisition including the prior spin-off. The claim against Autonomy included the allegation that $10m was added to the MicroLink purchase price so that DiscoverTech could buy a software licence for the same amount that Autonomy could recognise as $10m of revenue from yet another impugned VAR transactions.
Reviewing these circumstances, the judge concluded that, “Autonomy did what was necessary to ensure that its friendly VARs were not left ‘on the hook’.”
Other transactions
HPE did not have everything its own way in the case against Lynch and Hussain. The services-as-software sales were not adequately explored during the hearings. In his conclusions, the judge said that whether the accounting was wrong was “a matter of accountancy judgment on which views might properly differ”. If Autonomy’s CFO had “guilty knowledge” of these accounting treatments, it would make no contribution to any loss calculation.
The judge still has the little matter of the quantum to resolve in this case – how large the damages awarded to the claimants will be.
While the claimants substantially succeeded in making their case, the final award will be considerably less than they sought. “The calculation of loss remains an exercise of assessing proper compensation, not meting out punishment or conferring windfalls,” the judge wrote in Part A (para 537) of his judgment.
Deloitte: Guided by process, not scepticism
Autonomy’s VAR strategy was directed by CFO Hussain, encouraged and presided over by Lynch, the judge concluded: “Both knew that the VAR transactions were not being accounted for according to their true substance. Both knew that the recognition of revenue on the sale to the VAR was improper, and that the accounts were thus false.”
Viewed up close, the evidence presents a surprisingly mundane picture of false accounting, characterised less by financial sorcery than shady side dealings and cosy relationships between Autonomy and its business partners. Yet the sheer scale of the fraud was impressive, and is exposed in unedifying detail across the judgment’s four sections.
Yet Deloitte adopted a worryingly passive role as the double-dealings unfurled, studiously avoiding any concerns about some of the transactions arriving at the last minute and ducking any checks on the substance of these deals.
The judge noted that Deloitte was not on trial in this case, having paid its dues for these shortcomings elsewhere. Whether or not the auditor was misled (it was), mistaken (it was) or beholden and leant on by its client (that too) had no impact on HPE’s claim, Mr Justice Hildyard ruled.
He nevertheless devoted several paragraphs in Part 1 of his judgment to highlight the limited nature of audit’s approach: “Provided that the VAR sale fulfiled the criteria in IAS 18.14, the VAR’s arrangements with the specified or any other end-user were not of concern.” Deloitte made no effort to interrogate either Autonomy or third parties on subsequent negotiations between resellers and end-users.
“Deloitte’s working papers for the VT1 transactions,” he noted, “demonstrate a careful and methodical, but essentially process-driven, approach based on the apparent contractual arrangements. The criteria stipulated by IAS 18.14 were ticked off against the contractual provisions and buttressed by the audit confirmation letters: but the economic reality was not sceptically examined.”
