Espionage, exploding capacitors and fraud

Delayed responses to impending financial disasters can send shockwaves through investor and shareholder communities, and can create cracks in the pillars of corporate ethics and fiduciary responsibility. Here we explore how one high-profile company waited too long to respond to faulty vendor parts on computer motherboards, which led to compounded market share loss, accounting irregularities, customer lawsuits and an SEC investigation.

In the high-tech world, claims of intellectual property theft, corporate espionage and patent infringement are costly but aren’t uncommon. In 2015, the courts ordered Apple to pay $523 million in a patent dispute with SmartFlash over iTunes software.

In 2013, Nintendo paid a $30 million fine for allegedly stealing crucial pieces of its 3D technology from Tomita Technologies.

In 2016, a federal appeals court awarded Carnegie Mellon University a $750 million settlement with Marvell Semiconductor in a patent infringement case that was the second-highest monetary award ever handed down by the courts. This decision — along with some questionable accounting and internal control practices discovered by Deloitte & Touche in 2015 — forced the board of directors to remove Marvell’s husband and wife co-founding team from executive positions in 2016.

And then there are the “patent trolls” — companies that file frivolous lawsuits against large technology companies in the hopes that the companies will opt for quick, hefty settlements rather than pursue lengthy and more expensive trials. Fortunately, the U.S. Supreme Court has consistently ruled against these scourges of the high-tech industry.

The domino effect of upstream supply-chain issues

The quest for market share in the high-tech world sometimes steps into a shadowy ethical — and even illegal — environment that can have expensive, disastrous results. In what’s become known as the “race to the bottom,” computer manufacturers and component companies look for overseas suppliers who can meet nearly impossible delivery schedules to support a zero-inventory business model (called “just-in-time” manufacturing), all aimed at driving down the price of PC computers for consumers.

Such a tightly tuned business model can’t tolerate supply chain surprises. It’s already difficult to find the right balance between providing the lowest-possible price to consumers and maintaining quality control in the supply chain. When tremors begin propagating, any disruption can encourage shortcuts, rounded corners and other shady methods to maintain the “most-favored vendor status” in the supply chain.

But sometimes a disruption in the supply chain has a domino effect, which is exactly what happened with the “Capacitor Plague” between around 2000 and 2007.

Espionage and intellectual property theft

In the late 1990s, a materials scientist for Rubycon Corporation Japan left the company to take a position with Luminous Town Electric (LTE) Company in China. Both companies manufacture electrolytic capacitors (known in the industry as “e-caps”) that are used in computer motherboards to regulate power to various microprocessors. Unbeknownst to Rubycon, the secret scientist also took a copy of the company’s formula for its water-based electrolyte, which is a water-based chemical solution found inside capacitors that enhance the capacitor characteristics. (See Stolen formula for capacitors causing computers to burn out, by Charles Arthur, The Independent.)

The faulty formula for e-caps

Following the intellectual property theft, members of the scientist’s staff defected to Taiwan to create their own company. Taiwan provides nearly one-third of the world’s electrolytic capacitors (more than 22.5 billion pieces, according to Low-ESR Aluminum Electrolytic Failures Linked to Taiwanese Raw Material Problems in the September/October 2012 issue of Passive Component Independent Magazine) and assembles most of the big PC-makers’ machines.

The team that defected to Taiwan took a copy of the scientist’s electrolyte formula; however, the stolen formula was incomplete because it lacked the specific proprietary proportions of ingredients essential to long-term e-cap stability. (See Stolen formula for capacitors … The Independent.) This meant that the Taiwan company would be using a faulty formula for its electrolyte, which it was selling at rock-bottom prices to other capacitor companies. As many as 11 other companies might have been using the faulty electrolyte formula in motherboards for major computer manufacturers.

After 2,000 hours of operation, the e-caps made in Taiwan began to fail when they’d been rated to work for at least 4,000 hours. Intel claimed to have measured capacitor failure after only 250 hours of operation, according to the Passive Component Industry Magazine article.

Only a few heard the alarms at first

Initially, only industry specialist publications carried the story of problems seen in Taiwanese e-caps. These journals notified well-known electrical engineer gurus with special knowledge of such devices and of the issues, but the problems received no further attention, and the public was none the wiser.

But then Carey Holzman, an IT professional and freelance journalist, began publicizing his findings on the leaking capacitors on the internet and in newspapers. His articles were accompanied by impressive images of exploded capacitors on computer motherboards that revealed bulging or bursting aluminum capacitor housings, expelled rubber sealant and leaking electrolyte fluid.

Technology bloggers picked up the story, and even though various PC manufacturers were telling them the problem was something else, tens of thousands of computer users knew the capacitors were the actual cause of the failures. And Holzman added, “Failures can occur after the warranty has expired.” (See Leaking Capacitors Muck up Motherboards, by Samuel K. Moore and Yu-Tzu Chiu, IEEE Spectrum, Feb. 1, 2003.)

… how Dell handled the fallout was just one step that led to its tumble from grace for several years, losing market share and customers.

The start of the fall from grace

Dell Computer is headquartered in Round Rock, Texas, and sits just 15 miles north of The University of Texas at Austin along Interstate 35. The Dell computers in the UT math department were failing at an unusual rate, and after performing post-mortems on the machines, Dell concluded that the department had simply overtaxed the machines by forcing them to perform math operations that were “too difficult.” Tech support response was beyond belief. (See Suit Over Faulty Computers Highlights Dell’s Decline, by Ashlee Vance, The New York Times, June 28, 2010.)

The City of New York reported problems on 1,100 of 5,000 Dell computers between 2003 and 2005. Microsoft stated that 300 computers in a recent batch purchase of 2,800 computers had issues. General Electric, William W. Backus Hospital, Denison University and the Montana Justice Department all experienced similar problems with their Dell computers. (See An Unsealed Lawsuit Indicates Dell Hid Faults of Computers, by Ashlee Vance, The New York Times, Nov. 18, 2010.)

Dell Computer hid knowledge of bad e-caps from customers

In 2007, Advanced Internet Technologies (AIT) filed a lawsuit against Dell for refusing to take responsibility for 2,000 of its computer failures. Documents from the lawsuit made public in 2010 showed that Dell field representatives looked at the AIT computers in question and determined that AIT had “driven many of the computers too hard in a hot, confined space.” Dell’s sales team discussed selling more expensive computers to AIT as a resolution.

Wal-Mart, Wells Fargo, the Mayo Clinic and thousands of other large and small businesses used Dell computers. One customer, PointSolve, reported every one of their dozens of computers failed nearly simultaneously. Greg Barry, PointSolve’s president, stated that, “… Dell didn’t seem to recognize this as a problem at the time.”

These customers and others weren’t victims of computers that couldn’t take the heat of complex math. Dell had shipped them PCs with faulty e-caps — and Dell knew it.

A bad situation snowballs

Customer complaints quickly began flooding Dell headquarters. And the bad news kept coming: A contractor discovered that the number of OptiPlex computers at risk of catastrophic failure was 10 times higher than what Dell had estimated. The failed motherboards were replaced with other motherboards containing the faulty e-caps.

Then things went from bad to worse. In filed lawsuit documents, Dell employees attempted to conceal the real issue from customers, going so far as to state in an email: “We need to avoid all language indicating the boards were bad or had ‘issues’ per our discussion this morning. …” And in internal presentations, Dell salespeople were advised to not “bring this to customer’s [sic] attention proactively” and to “emphasize uncertainty.”

Ira Winkler, a technology analyst and former computer analyst for the National Security Agency, said, “They [Dell] knew millions of computers would be out there causing inevitable damage and were not giving people an opportunity to fix that damage.”

In fact, Dell was performing customer “triage” by responding first to those customers most likely to move their accounts to another PC manufacturer. Dell refused to recall the affected PC models (as did IBM, which handled the issue under product warranty) and responded only to customers who met predetermined sales and failure rate numbers.

Most other PC companies addressed the motherboard issues through product warranty or replacement. In 2005, Dell announced that it was taking a $300 million charge because it had to replace damaged computers. (See Unsealed lawsuit reveals Dell lied about millions of faulty computers, by Devindra Hardawar, Venture Beat, Nov. 19, 2010.)

After a 2007 audit showed that Dell employees had manipulated financial results to meet forecast targets, Dell restated its earnings from 2003 to 2006 and the first quarter of 2007. It also adjusted sales and net income totals downward for that same period.

While the massive PC failures weren’t the fault of Dell or any other PC manufacturers, how Dell handled the fallout was just one step that led to its tumble from grace for several years, losing market share and customers.

Questions in search of answers

Questions from customers, analysts and others were mounting:

• How much did the problems with the motherboard e-caps contribute to the eventual reasoning for adjusting Dell’s financial results?
• Was there some other reason to justify cooking the books?
• Was the pursuit of Wall Street’s unsustainable quarter-over-quarter growth model at fault?
• What additional processes should’ve been part of standard operating procedure to prevent senior executives from overriding accounting safeguards?
• How did Dell’s internal audit committee or its external accounting firm not detect the accounting improprieties?
• Why didn’t anyone in either of these groups report potential irregularities?

Securities and Exchange Commission steps in

Between 2003 and 2007, many problems had beleaguered Dell, including wrongly anticipating what customers wanted, poor customer service, suspect product quality (primarily the e-caps) and improper accounting.

On July 22, 2010, Dell set aside $100 million to handle a potential settlement that had been brewing for five years with the Securities and Exchange Commission (SEC). (The SEC had been looking into Dell’s books.) The SEC alleged that Dell failed to disclose to investors large exclusivity payments it had received from Intel Corporation to not use microprocessors manufactured by Advanced Micro Devices (AMD), Intel’s main rival. These undisclosed exclusivity payments totaled $4.3 billion for 20 straight quarters between 2003 and 2007 and were the thread that let Dell meet its earnings targets. In 2007, Dell announced it would be using AMD microprocessors. As a result, Intel stopped making exclusivity payments — as high as 76 percent of Dell’s operating income in Q1 2007. (See the SEC release, SEC Charges Dell and Senior Executives With Disclosure and Accounting Fraud.)

The SEC charged Dell Chairman and CEO Michael Dell, former CEO Kevin Rollins, and former CFO James Schneider for their participation in the disclosure violations. The SEC charged Schneider, former regional Vice President of Finance Nicholas Dunning, and former Assistant Controller Leslie Jackson, for their participation in the accounting impropriety.

Dell Inc. agreed to pay a $100 million penalty to settle the SEC’s charges (without admission of guilt). Michael Dell and Rollins each agreed to pay a $4 million penalty (the $4 million represented one percent of Michael Dell’s stock option gains during the period), and Schneider agreed to pay $3 million, to settle the SEC’s charges against them. Dunning and Jackson also agreed to settle the SEC’s charges. (See the SEC release.)

Dell’s actions at the time were the result of a toxic amalgamation of failed strategy, unethical shortcuts, poor board leadership, insufficient public accounting and the absence of meaningful punitive penalties from regulating agencies. Edward D. Hess, professor of business administration at the University of Virginia, raised several questions regarding the SEC outcome of the Dell case:

“Since the SEC found that Dell committed multi-year multiple frauds, why was Dell’s case not referred to the Department of Justice for criminal prosecution? And why was Dell treated differently than Enron or WorldCom?… The board could have informed Michael Dell that if he wanted to stay on as CEO he needed to claw-back his stock option gains attributable to the allegedly fraudulent accounting, but it did not. Nor did Dell’s Board elect an independent chairman to oversee management. The board didn’t even announce steps to reform how executive compensation was to be calculated to shift rewards to long-term, real value creation rather than quarterly earnings gamesmanship.” (See Stark Lessons from the Dell Case, by Hess, Fortune magazine, Oct. 13, 2010.)

Christopher Conte, associate director of the SEC’s Division of Enforcement at the time, stated:

“Dell manipulated its accounting over an extended period to project financial results that the company wished it had achieved, but could not. Dell was only able to meet Wall Street targets consistently during this period by breaking the rules. The financial results that public companies communicate to the investing public must reflect reality.” (See the SEC release.)

Dell Computer underwent significant operational changes after the SEC ruling. Shareholders filed lawsuits; the courts dismissed some. Other shareholders settled prior to appeals court rulings. After going private in 2013, Dell’s financial information became confidential, which prevented Fortune magazine from ranking the company.

In 2015, Dell Computer climbed to the No. 3 largest PC vendor in the world behind Lenovo and HP. (See the Newsroom press release, Gartner Says Worldwide PC Shipments Declined 8.3 Percent in Fourth Quarter of 2015.) In the period after the SEC ruling, most PC manufacturers, including Dell, were faced with changing markets as the demand for laptops, and then mobile devices, overtook customer preferences. However, Dell’s latest financial results (F17 Q2) showed worldwide growth in commercial PCs by 6.2 percent and a 14th consecutive quarter of year-over-year share gains in PCs.

Turning the ship around

Many households in the U.S. have at least one Dell computer or laptop, and many businesses use Dell products. But after the SEC ruling, it would take a lot more than fixing exploding e-caps for Dell to turn the business around. Corporate and retail customers have long memories of being kept in the dark by Dell salespeople and technicians about resolving their motherboard issues.

Donn LeVie Jr. is a frequent contributor to the “Career Connection” column in Fraud Magazine and a speaker and career strategist at ACFE annual conferences. He’s a former employee of two companies mentioned in this story (Intel Corporation and Marvell Semiconductor). Follow him on Twitter: @donnlevie. His website is donnleviejrstrategies.com. His email address is donnlevie@austin.rr.com.

Why electrolyte capacitors failed on PC motherboards

Capacitors aren’t supposed to burst the metal housing or leak the water-based fluid (the electrolyte). The faulty electrolyte capacitors were known as “equivalent serial resistance” (ESR) types. Other capacitor types weren’t affected. The faulty electrolyte formula was unstable when it was placed inside the aluminum capacitor housing. (See Leaking Capacitors Muck up Motherboards, by Samuel K. Moore and Yu-Tzu Chiu, IEEE Spectrum, Feb. 1, 2003.)

If the proper amount and proportion of additives isn’t present in the electrolyte solution, which is 70 percent water, electrolysis occurs when the system is charged. Electrolysis is an electro-chemical process that separates hydrogen from oxygen in a water-based solution. With the faulty electrolyte, the result was the formation of a small amount of hydrogen gas and hydroxide within the small low-ESR aluminum capacitor, which caused capacitor rupture and spilled the brown liquid over the motherboard. The overall result was catastrophic: The computer or high-speed modem was ruined.

Visibility into downstream computer component supply chains can be difficult because so many vendors subcontract out some of the component manufacturing. The combination of sourcing contract electrical component manufacturers to Asia and the drive to source low-cost components at the local level can create the potential for low-quality issues arising downstream.