How High-Tech Dream Shattered in Scandal at Lernout & Hauspie
By Mark Maremont, Jesse Eisinger and John Carreyrou
Staff Reporters of THE WALL STREET JOURNAL
December 7, 2000
John Duerden wanted his $100 million, and he wanted it now.
The chief executive officer of Lernout & Hauspie Speech Products NV had come to South Korea to solve a mystery: why his Korean lieutenants refused to release $100 million in cash they had on their books. Amid a deepening accounting scandal, Lernout & Hauspie, a leading maker of speech-recognition software, desperately needed the funds to stave off bankruptcy.
Arriving at the Seoul office of L&H Korea on Nov. 17, he was kept waiting for an hour before being ushered into a room with a visibly nervous Joo Chul Seo, head of the subsidiary. Mr. Duerden began grilling him about the cash. "Suddenly," Mr. Duerden recalls, "the door was kicked open with a terrific crash and three guys ran into the room, shouting and gesticulating."
The CEO watched in shock as the men dragged Mr. Seo out of the room and into an adjoining office, from where loud shouts and bangs were heard. "I thought the guy was getting beaten up," Mr. Duerden says. After urging employees to call the police, he left the building and high-tailed it out of the country.
The whereabouts of Mr. Seo, whom L&H has suspended, are unknown. But Mr. Duerden soon learned the worst about the $100 million: It was gone. And with it went the company's last hope to remain solvent. Last week Lernout & Hauspie, once one of Europe's leading technology companies, filed for bankruptcy protection.
The scene in Korea was just the latest strange twist in the growing financial scandal at L&H. New management named in August believes it has strong evidence of a pattern of deceptive and questionable accounting practices stretching across many of L&H's operations, according to people close to the Belgian company.
The company, these people say, appears to have improperly reported revenue from barter deals with other software firms in which no cash changed hands; immediately recognized revenue for sales that were contingent on L&H later performing development work for the customer; and sometimes reported sales before contracts were signed, when it was unclear the customer had the ability to pay or when the customer's ability to pay depended on investment from L&H.
In all, tens of millions of dollars in revenue over the past several years may have been improperly recorded, in addition to the problems in Korea, these people say. More details could emerge when and if L&H releases results of a special audit by its regular accounting firm, KPMG International, and of an investigation by its board audit committee.
Thousands of individual shareholders have lost a collective fortune in the fall of a company whose market value was nearly $10 billion nine months ago. Others who stand to lose include some of the savviest technology investors around, including Microsoft Corp., the owner of about 5% of L&H, and Intel Corp., plus Michael Dell, an investor in bonds of an L&H unit. Stonington Partners Inc., a New York buyout firm, sold L&H a company earlier this year for half a billion dollars in stock that now is close to worthless.
The bankruptcy filing follows L&H's announcement last month that the past 2½ years of its financial statements need to be revised because of errors and "irregularities," a term that in official accounting literature often signifies fraud. Sales are tumbling, and four longtime senior executives have abruptly resigned their posts. L&H, which has headquarters in Burlington, Mass., as well as in Ieper, Belgium, is the focus of a Securities and Exchange Commission investigation and a Belgian judicial probe. Co-founder Pol Hauspie, 49 years old, quit the company's board and has hardly left his home in Belgium in weeks, say people who know him.
L&H got its start 13 years ago when Jo Lernout, then a sales executive with the Belgian arm of Wang Laboratories Inc., grew intrigued by an early Wang voice-mail system. It wasn't selling well because many Europeans still had rotary telephones and couldn't use the dial to make choices. Mr. Lernout's idea: create software that allowed users to make voice-mail selections by speaking into the phone.
He set up a company to commercialize speech technology, and Mr. Hauspie, who owned a small firm that made accounting software, joined him. Belgium seemed a good spot for it, with many software engineers fluent in multiple languages. The duo based their company in Mr. Lernout's Flemish hometown of Ieper, a picturesque place, called Ypres in French, that was the scene of bitter World War I fighting.
To finance the business, Mr. Hauspie sold his software firm and Mr. Lernout sold his house. Mr. Lernout, an ebullient chain-smoker with ruddy cheeks and a mop of sandy-blond hair, now 52 years old, recalled in an October interview that convincing his wife "was the hardest road show I've had."
The company barely survived several early financial crises. At one point, it couldn't make the payroll and "bailiffs came" to seize property, Mr. Lernout recalled. But he seemed to thrive on crisis. One of his favorite sayings is, "The grass is always greener on the edge of the precipice."
Two things saved the company. The first was national pride. Like much of Europe, Belgium envied America's great high-tech engine of wealth. And now here were two guys with ambitions to turn a rural corner of Flanders into a Silicon Valley of language technology. Soon Flanders, Belgium's Dutch-speaking region, formed a tax-exempt zone in Ieper -- grandly known as the Flanders Language Valley -- and showered L&H with research grants.
The Flanders regional government became a major L&H investor through a venture-capital arm. During one of L&H's cash crunches, it guaranteed 75% of a bank loan to the company. Without that, Mr. Lernout says, "we would have gone broke."
Stefaan Top, a Belgian venture capitalist, says the combination of ambitious entrepreneurs and a government that sorely wanted "a local tech champion was a combustible mix -- it was dangerous."
The other reason the company survived was a series of complex financing plans dreamed up by Mr. Hauspie. The taciturn former tax accountant set up an intricate holding-company structure that let the founders retain control while selling various minority interests. Devising such structures "is Pol's forte," Mr. Lernout says. "He's very creative. Legally it's all right, and it helps you survive."
In hindsight, Mr. Lernout says, the complexity fed suspicion about the company. To outsiders "it looks like a scam," he says. "But it isn't."
In those difficult years, the entrepreneurs found support among the well-to-do farmers and factory owners near Ieper. According to a 1997 history of the company written by Piet Depuydt, the pair once called on a local pig farmer seeking an investment. After a short presentation, the farmer produced a half-eaten bank savings certificate for about $60,000 that he had salvaged after it was accidentally fed to his pigs. If the bank would accept the certificate, the farmer told Messrs. Lernout and Hauspie, he would let them invest the funds on his behalf in L&H bonds. After much convincing, the bank took the certificate.
In late 1995, L&H went public on the Nasdaq Stock Market, although it had never been profitable and had just a few million dollars in annual revenue. As with many tech firms, the hope lay in a glittering future. "Natural speech interface is the next technology wave," one securities analyst wrote, a potential multibillion-dollar market.
L&H dreamed of creating software that would let computers effortlessly understand human speech, speak back, and translate among the world's tongues. But development was painstakingly slow, what with many different accents and speech patterns, not to mention the need to sort out homonyms such as "wait" and "weight." Early dictation software required the user to train for hours and then pause between words.
Demand was sluggish, and many rivals struggled. One, Kurzweil Applied Intelligence Inc. in Massachusetts, imploded after auditors found it had faked a big chunk of its sales, and a top executive went to prison. Another Massachusetts rival, Dragon Systems Inc., eked out only slow growth in the mid-1990s.
But at L&H, sales quadrupled in 1996, to $31 million. Though small acquisitions helped, L&H also relied on sales to a web of customers with which it had financial ties. Investors are always wary of such "related-party revenue," because it is hard to be certain the transactions involve bona fide products worth the price paid.
A Fund in Flanders
Over the years, many of L&H's customers received investments from Flanders Language Valley Fund NV, a venture-capital pool Messrs. Lernout and Hauspie helped create the year L&H went public. They were directors of the fund's management arm until 1997, and afterward maintained considerable sway over its affairs. Some backers of L&H, including Microsoft and the Flanders government's venture-capital arm, also put money into FLV Fund.
Michael Faherty, a former L&H salesman in the U.S., says he and others were encouraged to refer potential but cash-poor customers to FLV Fund. "If FLV invests $1 million" in the customer, he says, "it was understood that we'd get about $300,000" in the form of license fees paid by that customer to L&H.
In internal L&H sales forecasts provided by Mr. Faherty, an entire category was devoted to prospects that had been referred to FLV Fund. A description of one potential $250,000 L&H customer noted that its business plan was "in to FLV." Mr. Faherty, who was fired by L&H early this year, has been subpoenaed by the SEC.
An FLV Fund spokesman says that "there are no legal or financial links between L&H and FLV Fund. But we have never made a secret of the fact that we've received a lot of referrals out of our network, which includes technology companies such as L&H." About Mr. Faherty's specific allegations, the spokesman, Johnny Kegels, says, "Those are arrangements I'm unaware about." Philip Vermeulen, managing director of FLV's management arm, has said the fund's investment decisions "absolutely" weren't influenced by L&H.
But close dealings between L&H and FLV Fund were evident from the start. In 1995, for example, FLV took a 49% stake in the Belgian unit of Quarterdeck Corp., a highflying California software company headed by another Belgian, Gaston Bastiaens. This Belgian unit became L&H's largest customer, accounting for 30% of revenue that year, and Quarterdeck itself chipped in 6.5% of L&H's sales.
The next year Mr. Bastiaens was out as CEO of Quarterdeck, having presided over a series of disastrous acquisitions at the company, which was taken over after its stock plunged. He quickly found a new job. He became president of L&H.
Around the time Mr. Bastiaens arrived in late 1996, L&H hit on a new and unusual source of revenue: its own research-and-development needs. This required an intricate accounting maneuver, one that L&H has continued to lean on throughout its tenure as a public company.
L&H knew it was trailing competitors such as Dragon in developing software to recognize words spoken at an ordinary clip. "If we didn't catch up, we were cooked," Mr. Lernout recalled in the October interview. "But we couldn't catch up, because we didn't have enough R&D dollars."
The solution was to start a company and have it contract with L&H to develop the software. L&H said it gathered outside investors to fund the start-up, called Dictation Consortium NV. But L&H employees wrote its business plan and did the software work under contract, Mr. Lernout says. When the software was finished, L&H had an option to buy this "legal structure," as he calls Dictation Consortium, at a profit to the investors.
The arrangement ensured that L&H could claim to be growing at a rapid pace. Dictation Consortium provided L&H with $26.6 million in revenue over the next two years, about one-quarter of its 1996 sales and 19% of its 1997 sales. Since Dictation Consortium bore the R&D costs, they didn't burden L&H's bottom line. In 1998, L&H bought Dictation Consortium for $40 million, gaining control of the software it so badly wanted.
Since Dictation Consortium had few assets and almost all of the price represented "goodwill," it could be amortized over seven years, further shielding L&H's bottom line.
Mr. Lernout describes the arrangement as perfectly proper, because the outside investors risked losing their money if L&H couldn't develop the product or later decided not to buy the "legal structure" company. "It's your money and your risk," Mr. Lernout says he told the investors. "It's certainly not our money, because that would be illegal."
But whose money was it? The year it was founded, Dictation Consortium was 61% owned by a familiar name -- FLV Fund. The following year, the fund's stake dropped to 43%. The rest was owned by what L&H described in a news release as "private investors." Mr. Lernout says these were "five or six people," but declines to name them. The listed owners were companies incorporated in the secrecy and tax havens of Luxembourg and the British Virgin Islands, their owners undisclosed.
Once again, the Flanders government played a key role, guaranteeing 75% of a $15 million bank loan to Dictation Consortium. Government officials didn't seem inclined to ask many questions. Only months earlier, L&H had requested a similar loan guarantee for the same R&D project, then abruptly withdrew its application in favor of the Dictation Consortium request.
Wivina Demeester, then the Flanders minister of finance in charge of the loan guarantees, said in an interview in October that officials never asked the identities of the investors behind Dictation Consortium because that was a task for the banks. She said the loan guarantee was handled properly and the loans repaid on time.
L&H in 1997 made a similar arrangement with another venture it helped start, Brussels Translation Group NV, this time to develop software for automatic translation from one language to another. In public filings, Brussels Translation Group's ownership can be traced through a Luxembourg company to two entities based in the Channel Islands, but no further.
Buoyed by such deals and a spate of fresh acquisitions, L&H's revenue mushroomed to $211.6 million in 1998, more than double 1997's. The stock soared.
Messrs. Lernout and Hauspie became entrepreneurial celebrities, Belgium's answer to Bill Gates and Paul Allen of Microsoft. They started a nonprofit foundation and hired a former Belgian prime minister as its chairman. Mr. Lernout also won plaudits for supporting a local basketball team, FLV Athlon, which used the money to recruit top talent and become a Belgian league powerhouse. Mr. Hauspie splurged on a powerful BMW motorcycle to ride across the flat Flanders countryside.
The founders also spawned the Flanders Language Valley office park, housing L&H and some of its customers and suppliers. Built partly with government funds, it is arranged in the spiral shape of a cochlea, or inner ear, a symbol of speech. The two men could hardly walk around Ieper without being greeted by someone who had a friend working at the fast-growing company.
In information technology, a company often is judged by its partners, and L&H had some top ones. Intel invested $30 million in L&H and formed a venture with it to develop e-commerce and telecommunications products. Microsoft licensed L&H's text-to-speech software in 1996 and later invested $60 million for a 10% stake in the company, since reduced to 5%.
At Microsoft, where Mr. Gates has long been enthusiastic about speech-recognition technology, a spokeswoman says the company "values L&H as a partner" and appreciates the quality of its technology. An Intel spokesman says his company "went in and did our financial due diligence" -- relying on public documents -- "and we were satisfied."
Though all seemed well from the outside, internally there were continuing glitches with L&H's technology. A 1998 presentation Mr. Lernout gave to French executives in Paris turned into a debacle when the software failed to recognize many words, an L&H insider recalls. "The bottom line was that the technology wasn't ready and the market wasn't ready," this person says, "but management had to deliver every quarter."
In addition, the company's related-party dealings and serial acquisitions attracted critics in the investment world. These included short-sellers, who profit from a decline in a company's stock price, and many market commentators, especially TheStreet.com's Herb Greenberg, who has mentioned L&H at least 96 times in his daily column during the past two years.
Short-seller Marc Cohodes of the New York hedge fund Rocker Partners L.P. railed for years about L&H, suspecting that some of its revenue came from a circle of L&H-friendly companies, not real demand. He weathered bitter attacks from the company and loyalists who posted on Internet message boards. Mr. Cohodes once said on his Internet radio show that he hoped L&H's supporters would wind up "eating cat food under some bridge in Belgium."
Yet L&H withstood the salvos. And under Mr. Bastiaens, by then chief executive, it kept reporting ferocious growth. Its sales rose 63% in 1999 to $344 million.
L&H seemed to have cracked the Asian market. That year, its Asian sales exploded to more than $150 million from less than $10 million in 1998. Mr. Bastiaens said L&H had spotted opportunities in the area ahead of rivals. In March, the stock hit $72.50, up 2,500% from its initial offering price 4½ years earlier.
Using this powerful currency, L&H early this year made two notable acquisitions: rival Dragon Systems (for $460 million in stock) and Dictaphone Inc., which was founded by Alexander Graham Bell. Dictaphone's owner, Stonington Partners, also took its payment in stock, $504 million worth, part of which it had to hold for two years. It recently sued L&H in Delaware Chancery Court, claiming it had been defrauded.
The acquisitions proved fateful. Dictaphone came with $430 million of debt, putting financial pressure on L&H. Moreover, with a large part of its business now in the U.S., L&H was required to file detailed financial reports with American regulators, including a geographic breakdown of sales.
Its 1999 annual report, filed this past June, contained one striking fact: Nearly all of the Asian revenue was from two countries, Singapore and Korea. While European sales had fallen and U.S. sales had stagnated, those in Singapore, for instance, soared to $80.3 million from a mere $29,000 in 1998.
Thirty More Companies
Slowly, the explanation began to emerge. In late 1998, L&H's top brass again had turned to a Dictation Consortium-type structure -- but on steroids. L&H helped create 30 start-up companies, based in Belgium and Singapore. Most of them, the company has explained, were formed to develop variants of its software for nonmainstream languages such as Urdu, Armenian and Farsi.
Initial license fees paid by these companies accounted for 10% of L&H's revenue in 1998 and 25% in 1999. L&H has said the start-ups planned to pay its employees to develop the software under contract, which could have brought L&H as much as $300 million more over succeeding years. With few exceptions, L&H has made little progress in developing the software, in some cases two years after receiving its upfront fees.
- Click on the date to see a related Wall Street Journal article.
1. June 30: Lernout reports 1999 revenue of $143.2 million from South Korea and Singapore, up from less than $300,000 in the prior year.
2. Aug. 8: The Wall Street Journal reports some Korean customers claimed by L&H do no business with the company. Others said their purchases were smaller than L&H reported.
3. Aug. 24: CEO Gaston Bastiaens steps down; former Dictaphone CEO John Duerden steps in.
5. Nov. 9: L&H says it will revise financial statements for two and a half years because of "errors and irregularities"; Jo Lernout and Pol Hauspie resign as co-chairmen; trading of L&H stock is suspended.
6. Nov. 29: L&H files for Chapter 11 bankruptcy-law protection
As with Dictation Consortium, L&H has said the start-ups were owned by independent investors, with L&H having an option, but no obligation, to acquire them someday. Although L&H has so far refused to publicly disclose the 30 start-ups' investors, it turns out that FLV Fund, once again, had come in. The fund backed at least eight of the Singaporean firms, a tie that wasn't disclosed to L&H investors in regulatory filings.
Then there was the explosion of sales in Korea. In regulatory filings, L&H said sales there hit $127 million in this year's first two quarters -- up 100-fold from a year before. L&H executives credited the September 1999 acquisition of a local firm, Bumil Information & Communications Ltd. It enabled L&H to tap a rich vein of speech-recognition demand from Korean businesses, for everything from phone-in stock-quotation services to toys, the executives said.
But in August, The Wall Street Journal reported that some Korean companies L&H described as customers denied doing business with it, while some others said they had bought less than L&H said they had. L&H vehemently disputed these claims and, to buttress its case, commissioned a special midyear audit by KPMG.
Yet within the top ranks, there were shock waves. Mr. Hauspie flew off to Korea to see if he could contain the situation, says an L&H insider. When he returned to Ieper three weeks later, he looked dispirited and holed up in his house, this person says.
In late August, the board forced Mr. Bastiaens, who is 53, to step down and gave the CEO post to Mr. Duerden, a 59-year-old British-born American who had been Dictaphone's chief. A former Xerox and Reebok executive, Mr. Duerden was better-equipped to integrate L&H, Dictaphone and Dragon, Mr. Lernout said. Insiders say the co-founders also realized that U.S. investors were losing patience with the company's opaque financial dealings, and thought that maybe a U.S. executive could revive investors' trust.
Mr. Duerden says he initially wasn't much concerned about Korea, believing the story of booming growth there was "plausible" and confident that the KPMG audit would clear the company. He had other matters to deal with. In late September, the SEC launched a formal investigation. Customers slowed orders, forcing Mr. Duerden to warn that third-quarter sales wouldn't meet expectations and L&H would post a quarterly loss.
But the new CEO soon had to focus on Korea, particularly on $106 million supposedly sitting in the Korean unit's bank accounts. Mr. Duerden says he was told most of it came from factoring L&H Korea's receivables, that is, selling them at a discount to third parties.
Mr. Duerden says he repeatedly asked how and when the cash could be sent to headquarters but got evasive answers from Mr. Seo, the Korean unit's chief. Despite being CEO, Mr. Duerden says, "I never felt like I had control over the Korean operation," which he adds was "managed close to the chest" by Mr. Hauspie, Mr. Bastiaens and then-Vice Chairman Nico Willaert.
He tells of having "heated conversations" with Mr. Seo to "remind him that I was CEO." Once, Mr. Duerden says, he was supposed to meet with the Korean at L&H's Ieper headquarters, but "he avoided me." In early November, Mr. Duerden succeeded in getting $5.7 million transferred, but there was no sign of the rest.
Not long after, Mr. Duerden and his allies won a tense boardroom face-off with the Lernout & Hauspie camp. The co-founders resigned as co-chairmen, Mr. Lernout becoming vice chairman but Mr. Hauspie soon leaving the board altogether. In announcing the resignations, the company also said it had discovered "accounting errors and irregularities" and the need to restate results going back through 1998.
Having firmed up his control, Mr. Duerden says, he was determined to "follow the money." He booked a flight to South Korea. Just before going, though, he received two unsettling signals. He says that in a sketchy report, KPMG told him it had found that some of the Korean revenues "were not supported financially." (The accounting firm won't comment.) In addition, Mr. Duerden says, an executive with the Korean unit asked to speak to him privately.
Off to Korea
At a meeting at the Westin Chosun Hotel in Seoul, Mr. Duerden says, the executive said he believed some L&H Korea officials "had been misrepresenting the revenue and financial statements of the subsidiary." The confidant, not part of the subsidiary's inner core, suspected that some of L&H Korea's purported customers "either didn't exist or weren't able to pay," Mr. Duerden says.
Then came the meeting with Mr. Seo, with the three men bursting into the room and dragging him away. Moments earlier, Mr. Duerden says, Mr. Seo had complained that he was being pressed by angry customers and creditors and feared for his safety. After Mr. Duerden got over the shock of seeing his host manhandled, he began to wonder whether the beating might have been staged. Buttressing this suspicion, Mr. Duerden says, he later received a letter from Mr. Seo in which the Korean said the cash had been used to repay customers.
Meanwhile, FLV Fund also reports missing cash in Korea. The fund says $30 million of its cash was improperly pledged as collateral for Mr. Seo. The disclosure last month prompted Europe's Easdaq market to suspend trading in FLV Fund's shares.
Mr. Duerden says he still isn't sure of the real story. But after getting fresh information from new management installed at L&H Korea, he believes that some of L&H's $100 million may never have been fully within its control. One theory at L&H is that banks that bought its receivables had been secretly assured they would be repaid if they couldn't collect from L&H Korea's customers -- and they couldn't.
If this is correct, L&H at minimum had improperly included that cash on its balance sheet. In any case, it now appears that much of the $100 million shouldn't have been counted as revenue, throwing into doubt a majority of the Korean unit's sales since late 1999.
"The only thing I know for certain," Mr. Duerden says, "is that the money is not in the bank accounts."
Write to Mark Maremont at firstname.lastname@example.org, Jesse Eisinger at email@example.com and John Carreyrou at firstname.lastname@example.org