IBM deliberately misclassified mainframe sales to enrich execs, lawsuit claims

Lawsuit accuses Big Blue of cheating investors by shifting systems revenue to trendy cloud, mobile tech

Special report IBM has been sued by investors who claim the company under former CEO Ginni Rometty propped up its stock price and deceived shareholders by moving revenues from its non-strategic mainframe business to its strategic business segments, allegedly in violation of securities regulations.

The investors' securities fraud lawsuit [PDF] was filed on Tuesday, April 5 in a southern New York federal court. It names as defendants not only IBM but current and former executives including Rometty, former CFO Martin J. Schroeter (now CEO of IBM spin-off Kyndryl), current CFO James J. Kavanaugh, and current CEO Arvind Krishna.

IBM "improperly and in violation of Generally Accepted Accounting Principles ('GAAP') embarked on a fraudulent scheme to shift billions of dollars in revenues from its mainframe line of business to its Strategic Imperatives and CAMSS line of business," the complaint reads.

According to documents seen by The Register and interviews with former IBM employees, the case stems from years of allegedly unlawful and unethical business practices that served to inflate executive bonuses through revenue shifting, discriminatory layoffs, and the manipulation of sales commission, and other means.

This misbehavior, we're told, was rewarded by IBM's decision to tie executive compensation to sales of technologies deemed crucial to the US giant's future: Cloud, Analytics, Mobile, Social media, and Security, collectively referred to as CAMSS products. By transferring revenues from its systems division to trendy CAMSS initiatives, IBM's leaders would appear to be succeeding in important growth sectors and take home larger bonuses.

The complaint describes how IBM's leaders "were motivated to engage in this conduct by the bonus compensation structure they created – IBM’s AIP [Annual Incentive Program] (and other long-term incentive programs) – and their desire to drive up IBM’s stock price." And it claims they tried to ensure the bonus-boosting scheme's success by enlisting about 5,000 IBM account executives and other high-level employees into the same AIP bonus compensation plan.

'Appease Wall Street’s thirst'

"IBM Strategic Imperatives brand sellers (Cloud, Analytics, Mobile, Security and Systems) worked on a salary and commission basis that incentivized them to sell as much Strategic Imperatives branded software as possible and created an environment in which mainframe revenue was misclassified/reclassified as Strategic Imperatives Revenue in order to maximize the AIP and appease Wall Street’s thirst for an IBM revenue stream unrelated to its mainframe line of business," the complaint states.

IBM began focusing on boosting revenue from its CAMSS products in 2014, and in 2015 this became a Strategic Imperative (SI).

From 2015 through 2018, Big Blue tied executive bonuses and employee commissions in part to SI revenue – the sales of CAMSS products.

In March, 2018, an employee on behalf of several others emailed then SVP and Chief Human Resources Officer Diane Gherson seeking a meeting to discuss ethics concerns. The employee asked for confidentiality because the group believed their management might be involved and would retaliate. The correspondence, seen by The Register, indicates these concerns included allegations of efforts to mislead financial markets.

Then in 2019, IBM dropped SI from its executive compensation formula and replaced it with total IBM revenue.

According to the complaint, IBM ended its CAMSS-based compensation scheme after staff raised concerns. The IT giant subsequently began getting rid of those involved to conceal the alleged fraud, it is claimed.

Thousands of IBM account executives were terminated and other high-ranking executives moved to new departments or positions with the ultimate goal to cover up the fraudulent scheme

"Internally, the use of Strategic Imperatives had become troublesome with employees questioning the tactics used to shift revenues from non-strategic to strategic," the complaint states. "Thousands of IBM account executives were terminated and other high-ranking executives moved to new departments or positions with the ultimate goal to cover up the fraudulent scheme and get the market to no longer focus on Strategic Imperatives as a financial metric or use it to gauge the Company’s performance."

As The Register reported in 2018, IBM at the time did not consider revenue growth nor share price improvement in its formula for calculating performance-based compensation. Rometty and other top executives were instead assessed on the basis of operating profit growth, cash flow, and minimally on SI, which grew from $16bn when Rometty was put in charge to $40bn by the end of 2018, representing 50 percent of IBM revenue that year.

In a 2018 research report, "IBM: Are executives' incentives the right ones?", Bernstein research analyst Toni Sacconaghi wrote, "While SI growth drives just five percent total variable comp, it is the only revenue metric that IBM executives are incentivized to think about."

In other words, though SI was used to calculate a seemingly small percentage of executives' variable compensation, those managers could influence what counted as SI revenue, and thus boost their take-home pay. Sacconaghi also noted that SI growth was strong while total revenues had declined $28bn since 2011. According to the complaint, Rometty in 2017 earned $1.6m in salary and $5m in AIP compensation.

The court filing argues that IBM's incentive plan clearly had an effect on the executives' alleged bonus enhancement scheme, based on the apparent growth of IBM's Strategic Imperative revenues as a percentage of total revenues. Over the period from 2015 through 2018, SI revenue went from 35 percent of total revenues to, as we said, 50 percent.

Yet, we're told, despite this increase, there wasn't actually significant demand for IBM's CAMSS solutions, which perhaps explains IBM's sale of Watson Health.

In certain business divisions, like Global Business Service (GBS), we're told that executives made a concerted effort to shift revenue toward CAMSS products.

For example, it's claimed that a 2018 deal with Ocean Bank, the second largest retail bank in Florida, was closed by IBM GBS and AML Partners, a financial software provider. But IBM recorded the revenue for its Watson division while saddling its GBS division with the expenses.

These allegations surfaced in an intellectual property theft lawsuit filed against the IT goliath in March, 2021 and in its answer to that complaint, IBM denied that claim.

Similar concerns were also raised earlier in Rometty's tenure as CEO, which ran from 2012 to 2020. In its 10-Q financial filing for Q2 2013, IBM said, "In May 2013, IBM learned that the SEC is conducting an investigation into how IBM reports cloud revenue." The company said it was cooperating with the SEC in the matter.

And in 2015, a source at an IBM Business Partner told The Register that IBM was asking his company's collaboration software customers to purchase cloud service software in lieu of renewing previous software licenses, which would continue but be counted as a cloud product SKU.

They have been convincing customers to ditch their licensing renewals and buy 'new' cloud services, which the customer doesn’t have to use

"They have been convincing customers to ditch their licensing renewals/maintenance contract and buy 'new' cloud services, which the customer doesn’t have to use," our source told us at the time.

"IBM can book the ‘new’ services revenue as cloud revenue," the source claimed. "It is a quick and dirty scheme to inflate their cloud sales numbers. They are not new, they are simply gutting their software numbers."

We're told the reason these schemes were allegedly undertaken is to burnish bonuses. Co-opting and shifting revenue for strategic initiatives made IBM's stock look better to investors: it suggested the company, which had been underperforming for years, was rebounding under executive guidance; and it also increased executive stock and cash bonus compensation and boosted the commissions of IBM salespeople, whose awards are also tied to CAMSS sales or strategic initiatives.

IBM stock – and company officials receiving it – also benefited from the Rometty regime's $58bn in IBM stock buybacks between 2012 and 2019, some of which was paid for with borrowed funds.

Layoffs

Executive interest in supporting IBM's stock price to maximize payouts also provides a rationale, our sources argue, for the numerous lawsuits over the past several years alleging age discrimination and capped sales commissions.

That's because the compensation plan had performance targets, so where revenue shifting wasn't enough, results could be improved by cutting expenses. Getting rid of costly older workers and replacing them with lower-paid younger ones provides one way to do that. So too does paying salespeople less commissions than promised.

IBM has consistently denied wrongdoing for these sorts of allegations, even for cases it settles.

The Register is aware of several complaints filed by former IBM employees with America's Occupational Safety and Health Administration (OSHA) during this period that describe the alleged unlawful behavior. These individuals – those who raised their concerns about ethics violations and feared retaliation from management – contend that IBM punished them for reporting wrongdoing internally, firing them in some instances and surveilling them before and after leaving the company.

Their complaints – like the lawsuit filed in New York on Tuesday – describe a systematic effort in which IBM senior management allegedly coordinated with clients' legal and procurement departments to fraudulently shift revenues – occasionally with the knowledge of clients, we're told, but mostly in a way that deceived them.

One describes how IBM was improperly shifting revenue from GBS to Watson because senior leaders got paid better for sales categorized as Strategic initiatives. In so doing, an OSHA complaint argues, IBM was misleading the financial markets.

Another OSHA filing explains how a related scheme allows IBM salespeople to get their base pay plus a quarterly commission based on recently renewed contracts without closing a new sale. This means auditors see what they expect in terms of sales and commissions.

Our sources say that some of IBM's customers may face legal risks as a consequence of these alleged dubious deals.

Because CIOs and other IT executives often get compensated for reducing IT operational and capital expenditures, claiming refunds for unused products that had been part of the customer contracts would mean that corporate compensation for IT expenditure reduction would qualify as a kickback rather than a bonus under US tax rules.

What's more, IBM's large financial clients are subject to two financial reporting rules, Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act Stress Tests (DFAST), that were put in place after the 2008 US financial meltdown. IBM's actions, we're told, expose large financial clients to potential claims that they've failed their compliance obligations, underpaid their taxes, and misstated financial data to the SEC.

IBM did not respond to a request for comment. ®

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