Fault Lines

Did Grant Thornton cause the downfall of tiny Carnegie International? Or is Carnegie seeking a scapegoat?
Joseph McCaffertyDecember 1, 2002

On April 29, 1999, E. David Gable’s improbable dream came true. Carnegie International Corp., a small Internet support and computer telephony holding company he took over three years earlier, graduated from the OTC Bulletin Board to a listing on the American Stock Exchange. Gable, a former car dealer, even rang the opening bell in honor of the listing for the company he had initially run out of his attic. “This was everything I’d ever worked for,” says the 54-year-old Baltimore native.

The very next day, Gable’s nightmare began. The Securities and Exchange Commission started asking questions about Carnegie’s accounting — specifically, about how the Hunt Valley, Maryland-based company had recognized revenue from a 1998 software-licensing deal — and Amex halted trading in the stock. As Gable tells it, he was confident it wouldn’t take long to allay the SEC’s concerns and get Carnegie back on the Amex board. But there was one problem: Carnegie’s auditors, Grant Thornton International, wouldn’t return Gable’s phone calls.

In fact, “it took three weeks and a letter from a New York law firm to get them on the phone,” recalls Gable. When he finally did, he didn’t like what he heard. Grant Thornton wanted to send in a new team to completely redo Carnegie’s 1998 audit, and Gable reluctantly agreed. “I didn’t want any more trouble,” he says. But the months passed while the auditors collected more and more information. In the meantime, business evaporated and investors filed a class-action lawsuit. Carnegie never did resume trading on Amex; the company was delisted in January 2000 and went back to penny-stock land, where it currently trades in the neighborhood of 1 cent.

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At first, hiring Grant Thornton had been a coup for Gable, since the accounting firm gave Carnegie, which lost more than $15 million in 1998 on revenues of $7.3 million, the credibility it needed to move to Amex. But today, Gable blames Grant Thornton for Carnegie’s demise. It was Grant’s botched audit, he charges, that led to the trading halt. As a result, Carnegie is now suing the firm, alleging fraud and negligence. It seeks a whopping $2.1 billion award, including punitive damages — steep recompense for a company whose annual revenue topped out at an unprofitable $20.3 million. “We had the business built, and Grant Thornton just burned down the house,” laments Gable, who remains chairman of Carnegie.

Grant Thornton sees it differently. The firm considers the case to be a frivolous one — a desperate act by a floundering company that went bust along with the Internet bubble. Grant admits that accounting errors were made, but it says Carnegie was responsible for them. Lawyers for Grant charge that Carnegie perpetrated a fraud by lying to them about the transactions in question and creating false documents to cover them up.

It’s not uncommon for clients to sue their auditors when problems with accounting arise. And the stakes for the auditor are high. “There is always a chance that a client will win a case against its auditor,” says Jay Nisberg, president of Jay Nisberg & Associates, an audit-firm consultancy. For this reason, says Nisberg, most auditors settle cases under pressure from their insurance companies, rather than take their chances in court. Last October, for example, PricewaterhouseCoopers agreed to pay $21.5 million to the shareholders and creditors of Anicom, a now-bankrupt wire and cable company, to settle a suit that claimed the accounting firm was reckless in its audits.

But Grant Thornton says it intends to fight the charges when the case resumes — likely in March — in a Baltimore circuit court. Will the facts of the case support the world’s fifth-largest accounting firm or an obscure telecom start-up with a checkered past? Says Nisberg, “You never know what a judge or jury will do.” Aside from the harm of a large financial award, a Grant Thornton defeat could wreak considerable damage to its reputation at a time when auditing firms are already scraping bottom in public opinion. (Grant Thornton CEO Ed Nussbaum has been vocal in recent months about what auditors need to do to clean up their act, and says Grant has added measures to detect fraud.

Roaring Mice

Unlike Grant Thornton, Carnegie doesn’t have much left to lose. The company’s history is brief but bizarre. One of the original partners, Scott Caruthers, is currently in jail, awaiting trial on charges that he conspired to murder Gable and two others. It was Caruthers who began one of Carnegie’s businesses in 1987, with a plan to develop a new kind of exercise weights.

Gable had other ideas for the company. After he took over in 1996, he took Carnegie public via a so-called reverse merger with Electronic Card Acceptance Corp. (ECAC) and DAR Products Corp., two bulletin-board companies in very different businesses: credit-card transactions and grip technology. Carnegie soon got rid of ECAC and DAR and acquired a series of businesses, mostly in the telecom industry. It even bought a Victoria Station restaurant to “provide cash flow,” according to the company’s 10-SB filing (an initial registration of securities for small businesses).

Gable’s ultimate ambition, however, was to create a one-stop telecom and networking shop for small and midsize companies — a strategy that would have eventually brought Carnegie in competition with companies like Lucent, Nortel, and the Baby Bells. Carnegie’s aim may have looked absurdly high, but it was a time when anything seemed possible. Other mice had roared by 1998, the year Bernie Ebbers completed WorldCom’s purchase of MCI Communications Corp. WorldCom had started out much the same way as Carnegie had, and Gable was looking to follow a similar path to stardom.

But even before Carnegie had its brief day in the Amex sun, there were signs that it may not have been all it was cracked up to be. In February 1999, G. Christopher Scoggin, a stock promoter who began touting Carnegie’s stock in October 1998, admitted that he was paid to do so by the company, to the tune of $900,000 in restricted stock, according to a complaint filed by the SEC this summer. The agency is seeking to recover illegal profits from Scoggin and bar him from participating in securities offerings.

Then, just two weeks before the Amex listing, the SEC raised concerns about Carnegie’s 10-SB filing. “The SEC took exception with the valuation of stock used in two acquisitions,” explains Gable. “We were disappointed that we had to restate, but it didn’t affect our ability to list on the Amex.” The chairman says that Carnegie was forced to take a $40 million hit to its market cap when the company restated the filing.

Still, on its only full day of Amex trading, Carnegie’s stock climbed to over $7, giving the company a market capitalization of nearly $600 million. Then, on April 30, trading was halted when the SEC again made inquiries about a transaction, this time a software-licensing agreement contained in Carnegie’s 10-K for 1998, which was filed just two days before the listing. The SEC disputed $3.1 million of revenue that Carnegie had claimed on the deal. Gable admits that he didn’t fully understand the transaction at the time. “I didn’t focus on the accounting back then,” he concedes.

Where Was the CFO?

This is where Grant Thornton comes in, says Gable; it was supposed to focus on the accounting, and it failed. Gable claims it was Grant Thornton, acting both as auditor and consultant, that mishandled both the stock valuation for the two acquisitions and the recognition of revenue from the software-licensing agreement. “They husbanded us through this stuff from the very first day,” says Gable. He claims that Carnegie relied completely on Grant’s expertise, and insists that the more than $650,000 it paid the firm in 1998 and 1999 included fees for consulting on Carnegie’s complex transactions.

Where was Carnegie’s CFO? It didn’t have one until 1998, when it hired Bennett Goldstein, the audit partner at Grant Thornton who led Carnegie’s 1997 audit. Goldstein’s dual role left him open to accusations from both sides. Gable says Goldstein is partly to blame for the accounting gaffes, both as auditor while at Grant Thornton and as CFO of Carnegie. Goldstein, though, says that he too was misled by Gable and Carnegie president Lowell Farkas. In his deposition, he bluntly declared that the “Gable and Farkas I know are boldfaced liars.” He says that believing in Gable’s argument for why one of the transactions would create operating income was like “believing in the Tooth Fairy,” but he went along. “Fraudulent financial statements were ultimately filed with the SEC,” he admits in the deposition.

Grant Thornton also claims the three transactions — the two acquisitions and the software-licensing agreement — were bogus. “They were all sham transactions,” asserts Larry Elliott, an attorney with the law firm of Cohen & Grigsby PC, which is representing Grant Thornton in the trial. “Grant Thornton was shown documents that led them to believe that software had been developed, but it never was,” says Elliott. “When Grant Thornton started to probe deeper, it found actions that it considered improper, so it went to the audit committee.” Although Goldstein declined comment for this article, his lawyer, Steven Fedder, says that when Goldstein couldn’t go along with what he now thought was fraud, he reported it to Carnegie’s general counsel and resigned.

Gable pressured Grant Thornton to fix the accounting problems quickly, and he says the accounting firm responded with a threat. “The chief of assurance [J.W. Mike Starr] said that if we fired them, they would file an 8-K so scathing it would be guaranteed to create an SEC investigation,” claims Gable. Finally, on September 24, 1999, Carnegie discharged Grant Thornton and hired New York-based Merdinger, Fruchter, Rosen & Corso. In May 2000, Carnegie filed the suit against Grant Thornton.

Twists and Shouts

The lawsuit is filled with serious allegations. Carnegie insists that Starr deleted E-mails and other evidence that would have helped to prove its case. “Starr destroyed every document associated with the case,” alleges Gable. “He was the only Grant Thornton liaison with our audit committee.” While Starr admitted under oath to deleting the files, he maintains that it was part of his normal file-management procedures. “It was prior to any litigation being filed, and he was no longer working for Carnegie, so he deleted them,” says Elliott. “He didn’t think he needed them any longer.” Elliott also says that all of Starr’s E-mails were recouped from others and provided to the court. Carnegie sought an entry of default judgment on the matter, which would have given them a victory, but the motion was denied by Judge Kaye Allison, who ruled that “the plaintiffs have not shown substantial preju-dice caused by Starr’s deletion of his computerized notes.”

While Grant Thornton has been largely silent, for its part Carnegie has been strikingly eager to spin its case. It hired Sitrick and Co., a top PR firm, to represent it in the court of public opinion. For legal representation it turned to attorney William “Billy” Murphy, a fiery defense lawyer whose clients have included fight promoter Don King. Murphy was also part of the team that sued Ernst & Young in Devan v. Ernst & Young in the Circuit Court for Baltimore City in 1998. In that case, E&Y was charged with fraud and malpractice for advisory services to Merry-Go-Round Enterprises Inc., a retailer that was forced into bankruptcy after accounting irregularities surfaced. Murphy helped win a settlement of $185 million, the largest single-defendant settlement in Maryland history.

In another twist, a set of Grant Thornton work papers for one of Carnegie’s audits mysteriously turned up well after the discovery period. Grant says the papers were misplaced. The judge appointed a “Special Master” to investigate how the papers were lost, which delayed the trial by more than a year. In the end, Grant was forced to cover the cost of the investigation (in excess of $1 million), but it wasn’t found to have harmed Carnegie’s case.

The case was finally set to resume in September, but again was delayed by the heavy volume of cases in the court. Now trial might not resume until March 2003. In the meantime, Carnegie is barely hanging on. The company hasn’t filed a financial statement since third-quarter 2001. “Grant has been screaming that we committed fraud,” says Gable. “That has made it difficult for us to maintain our customer base.” He says potential partners have shied away from deals because of the litigation. For example, Host Funding Inc., a Moraga, California-based hospitality company listed on the OTC (recently delisted from Amex), agreed to merge with Carnegie in January 2001, but has since walked away from the deal.

No Small Point

The outcome of the case may come down to what role Grant Thornton is judged to have played in constructing financial statements for Carnegie in 1997 and 1998, when the transactions at issue took place. While Grant Thornton acknowledges that the accounting was wrong, it claims it was acting only as auditor and was lied to by Carnegie. “Grant Thornton didn’t do anything wrong,” says Elliott. “A lot of information was withheld from the auditors. And when information is withheld, it makes it impossible to do an adequate audit.” He also maintains that the firm was hired only to be Carnegie’s auditor, not to make financial accounting decisions.

It is no small point. If Grant was making financial management decisions on a consulting basis, as Carnegie claims it was, then it would have been essentially auditing itself.

(New provisions of the Sarbanes-Oxley Act of 2002 now prohibit audit firms from conducting internal audits and engaging in consulting that is closely related to the audit work. In addition, the SEC’s new requirement that chief executives certify financial statements will preclude managers from shirking responsibility for accounting errors.)

As for Gable, he vows to keep fighting. “They screwed up. They chose to try to cover it up. And when they couldn’t, they blamed it on us,” he declares. “I fired them. And I sued them. And I am going to win.” He just might. But in the end, Grant Thornton may be guilty of nothing more than taking on a client it should have run from.

Joseph McCafferty is news editor at CFO.