LERNOUT & HAUSPIE SPEECH PRODUCTS (L&H)

BACKGROUND
Lernout & Hauspie Speech Products (L&H) was founded in 1987 when Jo Lernout, then a
sales executive with the Belgian arm of Wang Laboratories, Inc., grew intrigued by an early
Wang voice-mail system. The system was not selling well because many Europeans still had
rotary phones and could not use them to select amongst the voice-mail choices. Mr. Lernouts
idea was to create software that allowed users to make voice-mail selections by speaking into
the phone. He set up a company to commercialize speech technology. Pol Hauspie, who
owned a small firm that made accounting software, joined him. Belgium seemed a good
location from which to operate the company because the country was home to many software
engineers fluent in multiple languages. The two partners based their company in Ieper,
Belgium.

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-blonde hair,
recalled in an interview that convincing his wife was the hardest road show Ive ever had.1
The company barely survived several early financial crises. At one point it couldnt 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 other edge of the
precipice.2

Starting any new company is difficult, but two factors helped L&H survive in its early years.
The first was Belgiums national pride. Like much of Europe, Belgium envied the United
States 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. In L&Hs early years
Flanders, Belgiums Dutch-speaking region, formed a tax-exempt zone in Ieper which
gradually became 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&Hs cash crunches it guaranteed 75% of a bank loan to

M. Maremont, J. Eisinger and J. Carreyrou, Muffled Voice: How High-Tech Dream at Lernout & Hauspie
Crumbled in Scandal, The Wall Street Journal (December 7, 2000), p. A1.
2
Ibid.

the company. Without that, Mr. Lernout says, we would have gone broke.3 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.4

The second factor 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
Pols forte, Mr. Lernout says. He is very creative. Legally its all right, and it helps you
survive.5

In late 1995, the company went public with a listing on the NASDAQ Stock Exchange, even
though it had never been profitable and had just a few million dollars in annual revenue. As
with many high technology firms, the hope lay in a glittering future. Natural speech interface
is the next technology wave, one analyst wrote, a potential multimillion dollar market.6 L&Hs
managers dreamed of creating software that would let computers effortlessly understand
human speech, speak back, and translate among the worlds tongues.

The company seemed to face many challenges. Technical development was painstakingly
slow, as the systems had to cope with many different accents and patterns, not to mention the
need to sort out homonyms such as wait and weight. And industry demand was sluggish.
Many rivals struggled. One, Kurzweil Applied Intelligence, Inc., in Massachusetts, imploded
after auditor found that its managers had faked a large proportion of the companys sales.
Another Massachusetts rival, Dragon Systems, Inc., eked out only slow growth in mid-1990s.
At L&H, however, sales quadrupled in 1996 to $31 million. Though some small acquisitions
produced part of the growth, L&H seemed to be relying on sales to customers with which it
had financial ties.

Over the years, many of L&H customers received investments from Flanders Language Valley
Fund (FLV Fund), a venture capital pool that Mr. Lernout and Mr. Hauspie helped create the
year L&H went public. Mr. Lernout and Mr. Hauspie were directors of the funds management
arm until 1997, and even afterward they maintained considerable sway over its affairs.
3

Ibid.
Ibid.
5
Ibid.
4

Ibid.

Michael Faherty, a former L&H salesman in the United States, says he and others were
encouraged to refer potential customers who were cash poor to the FLV Fund. If FLV invests
$1 million in the customer. He says, it was understood that wed get about $300,000 [in the
form of license fee paid by that customer to L&H].7 Though the FLV Fund denied financial
links between L&H and FLV, the close dealings between the two were evident to some
informed parties from the start. In 1995, for example, FLV took 49% stake in the Belgian unit
of Quarterdeck Corp., a high-flying California software company. This Belgian unit became
L&Hs largest customer, accounting for 30% of revenue that year, and Quarterdeck in
California accounted for another 6.5% of L&Hs sales.
The CEO
In late 1996, Gaston Bastiaens was hired as L&Hs president and CEO. Mr. Bastiaens was an
engineer who led the failed Newton project at Apple Computer, Inc. But he flourished at L&H.
Around the same time, Mr. Bastiaens joined L&H the company discovered a new and unusual
source of revenue: its own research and development needs. This required an intricate
accounting maneuver, one that L&H continued to lean on throughout its tenure as a public
company. L&H knew it was trailing competitors in developing software to recognize words
spoken at an ordinary speed. If we didnt catch up, we were cooked, Mr. Lernout recalled in
an interview. But we couldnt catch up, because we didnt have enough R&D dollars.8

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 startup, called Dictation Consortium, NV.
But L&H employees wrote its business plan and did the software work under contract. When
the software was finished L&H had an option to buy the 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 in 1996 and 1997, about
one-quarter of its 1996 sales and 19% of its 1997 sales. Since Dictation Consortium bore the
R&D costs they didnt burden L&H 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 the entire price represented goodwill, it could be amortized over seven
years, further shielding L&Hs bottom line.
7
8

Ibid.
Ibid.

Bouyed by such deals and spate of fresh acquisitions, L&Hs revenue mushroomed to
$211.16 million in 1998, more than double 1997s. The stock soared. Mr. Lernout and Mr.
Hauspie became entrepreneurial celebrities, Belgiums answer to Microsofts Bill Gates and
Paul Allen.

With the stock price up, Mr. Bastiaens bought technology leaders Kurzweil Technologies, Inc.,
a speech-recognition company in Wellesley Hills, Massachusetts, and Mendez Translation
Group of Brussels, Belgium. In 1997, a year after he came on board, Mr. Bastiaens landed an
important investor: Bill gates. Microsoft invested $45 million in L&H, ending up with an 8%
stake. The early Microsoft investment gave L&H much needed credibility and revenues. In
1999, Intel invested $30 million in L&H and formed a venture with it to develop e-commerce
and telecommunications products.
Though all seemed well from the outside, internally there were continuing glitches with L&Hs
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 recalled. The
bottom line was that the technology wasnt ready and the market wasnt ready, this person
says, but management had to deliver every quarter.9 Under Mr. Bastiaens, it did. L&H kept
reporting growth. Its sales rose 63% in 1999 to $344 million. Its Asian sales exploded to more
than $150 million from less than $10 million in 1998. In March 1998, its stock hit $72.50, up
2,500% from its initial offering price four and a half years earlier.10
However, financial analysts had been suspicious of L&Hs financial results as far back as
1997. In February 1997, Lehman Brothers Brian Skiba issued a report, claiming that L&Hs
growth in the United States and Europe much lower than investors had assumed, and that the
company was not coming clean. Mr. Bastiaens denied it, but in the conference call he refused
to give a geographic breakdown of sales.11
Still investors ignored financial analysts warnings and applauded the 1998 acquisitions of
Dictaphone, based in Stratford, Connecticut, and Dragon Systems, of Newton,

Ibid.

10

11

Ibid.

Ibid.

Massachusetts. The future did, indeed, look bright. L&H seemed to have a lock on some of
the best speech-recognition software, and the company was powerfully positioned as the Web
migrated into phones and cars, where people would talk to machines and machines would talk
back. At the time, Mr. Bastiaens assured anybody who would listen, This market is going to
explode.12 With the purchase of the companys two main US rivals L&H was suddenly a
software company with $1 billion in annual sales, and it was poised to follow SAP and Nokia
Corp. into Europes technology elite.
The Dictaphone purchase, however, meant more than half of L&Hs business was in the
United States. This obliged the company to file detailed account with the Securities and
Exchange Commission (SEC). Analysts learned that sales in Korea had soared from a mere
$97,000 in 1998 to $58.9 million in the first quarter of 2000, some 52% of the total sales of the
company. Suspecting an attempt to pump up results, investors began to dump the stock in
2000.13

The Wall Street Journal report

In August 2000, The Wall Street Journal reported that some Korean companies L&H
described as customers denied doing business with it, while others said they had bought less
than L&H said they had:
In all, the Journal contacted 18 of about 30 companies claimed by L&H as customers.
Three of the companies said they werent, in fact, L&H customers. Three more
companies said their purchases from L&H over the past three quarters were smaller
than figures provided by Mr. Bastiaens or Sam Cho, vice president of L&H Korea. One
additional company said it is in a joint business with L&H that produces considerably
less revenue than L&H claims. Officials from an eighth company initially said it had
formed a joint venture with L&H and that the joint venture, not the company itself, had
purchased products from L&H.
Of the other 10 companies, three confirmed they were customers but wouldnt give the
size or timing of their purchases. Officials at another six confirmed total purchases

12
13

W. Echikson and I. Moon, How to Spook Investors, Business Week (September 18, 2000), pp. 69-72.
Ibid.

totaling $450,000 to $5.5 million in the period since [September 1999]. One company
says it signed a $10 million contract with L&H and paid in May 2000.

All told, of the 12 companies that responded to inquiries about their purchases from
L&H in the period since [September 1999], the revenue tallied roughly $32 million.
From all its customers in Korea, in 1999 and the first quarter of 2000, L&H posted
$121.8 million of Korea sales, and it had said that it expected second-quarter revenue
from that country to exceed the first quarters $58.9 million.

14

L&H responded with a statement saying that comments attributed to L&H customers were
misquoted or factually incorrect and that other information in the article was distorted.15 To
buttress its case, L&H commissioned a midyear audit by KPMG.

After the Korea scandal broke, Mr. Bastiaens rushed to restore confidence. He contacted
several of the Korean customers interviewed for the Journal story, and they publicly said they
were misquoted. A trip to Korea was arranged for two financial analysts, both of whom were
impressed with the companys business there. I met customers and saw L&H products really
being used, says Kurt Janssens of KBC Securities in Brussels.16 Most important, Mr.
Bastiaens asked for the KPMG special audit. He wouldnt be so stupid as to ask for an audit if
he had something to hide, says Pierre-Paul Verelst, an analyst at Brussels brokers
Vermeulen Raedonck.17

By this time, founders Mr. Lernout and Mr. Hauspie thought Mr. Bastiaens had become a
liability. On August 25, 2000 he was replaced by John Duerden, a Biritish-born US citizen who
had wored at Xerox Corp. and Reebok International, Ltd., before running Dictaphone.18

DISCOVERY OF A MASSIVE FRAUD

L&Hs new management team called for an investigation by PricewaterhouseCoopers (PwC).
The PwC report was released on April 6, 2001. It revealed that 70% of the nearly $160 million
14

M. Maremont, J. Eisinger and M. Song, Tech Firms Korean Growth raises Eyebrows, The Wall Street Journal
(August 8, 2000), p. C1.
15
M. Maremont, Lernout & Hauspie Fall 19% As It Attacks Article, The Wall Street Journal (August 9, 2000), p.
A16.
16
W. Echikson and I. Moon, How to Spook Investors, Business Week (September 18, 2000), pp. 69-72.
17
Ibid.
18
Ibid.

in sales booked by L&Hs Korean unit between September 1999 and June 2000 were
fictitious. In an effort to earn rich bonuses tied to sales targets, the Korean units managers
developed highly sophisticated schemes to fool L&Hs regular auditor, KPMG International.
One especially egregious method involved funneling bank loans through third parties to make
it look as though customers had paid when in fact they had not.
L&Hs new chief executive, Philippe Bodson, who replaced Duerden in January 2001, said
that upon learning of PwCs findings he was very impressed by the level of sophistication of
the fraud and the amount of imagination that went into it.19 Mr. Bodson said the fraud at L&H
Korea should become a case study in business schools.

To fool auditors, L&H-Korea used two types of schemes. The first involved factoring unpaid
receivables to banks to obtain cash up front. Side letters that were concealed from KPMG
gave the banks the right to take the money back if they couldnt collect from L&H Koreas
customers. Hence, the factoring agreements amounted to little more than loans.

The second, more creative scheme was set in motion after auditors questioned why L&H
Korea wasnt collecting more of its overdue bills from customers. L&H Korea told many
customers to transfer their contracts to third parties. The third parties then took out bank
loans, for which L&H Korea provided collateral, and then paid the overdue bills to L&H Korea
using the borrowed money. The upshot is that L&H Korea was paying itself. When the
contracts were later cancelled, L&H Korea paid penalties to the customers and the third
parties to compensate them for the inconvenience of dealing with the auditors.20
The probe also found that the bulk of L&H Koreas sales came from contracts signed at the
end of quarters, so managers could meet ambitious quarterly sales targets and receive
multimillion dollar bonuses. For instance, 90% of the revenue recorded by L&H Korea in the
second quarter of 2000 was booked in 30 deals signed in the final nine days of the quarter.
But L&H Korea was forced to subsequently cancel 21 of those contracts because the
customers most of them tiny start-ups didnt have the means to pay.

19
20

J. Carreyrou, Lernout Unit Book Fictitious Sales, Says Probe, The Wall Street Journal (April9, 2001), P. B2.
Ibid.

The fraud appears to have begun in earnest when L&H bought a small Korean firm called
Bumil Information & Communication Co. in September 1999 and put Bumils headed by Joo
Chul Seo, in charge of L&H Korea. L&H Korea, which had been reporting negligible sales until
then, recorded nearly $160 million in license revenue the time Bumil was acquired and June
30, 2000, Mr. Seo made $25 million from the sale of Bumil to L&H and earned another $25
million in bonuses for meeting sales targets while at the head of L&H Korea. 21
WHERE WERE THE AUDITORS?

In the aftermath of the accounting scandals at L&H, angry investors turned their gaze on
KPMG International, the giant accounting firm that audited L&H books and gave the company
clean opinions in 1998 and 1999. KPMG also gave a clean 1999 opinion regarding the
accounting for L&Hs South Korean operations, where sales had grown improbably to $62.8
million from just $245,000 in the previous year. Michael G. Lange, a partner at a Boston law
firm that was leading one of the shareholder lawsuits seeking class-action status against L&H,
said that the accounting irregularities at L&H were so pervasive and included so many
aspects of the business that there had to be red flags that KPMG auditors missed.22

KPMG, in its defense, accused the former top management of L&H of signing off on revenue
over-inflation tactics, of lying about key business structures within the company, of influencing
others to give false information to KPMG auditors, and of orchestrating a campaign to
minimize their involvement in the events that had led to the calamitous downfall of the
company. In April 2001, a few hours before the release of an abridged version of PwCs
report, KPMG filed a lawsuit against L&Hs former management in a Belgian court. The
complaint alleged that former senior L&H executives deliberately provided false or
incomplete information to KPMG and conspired to obstruct the firms audits.23
In its complaint, KPMG said that L&Hs former top management was fully aware and actively
involved in the irregularities and that these people have wittingly given false information to

21

Ibid. According to the PwC report investigators have been unable to track down Mr. Seo since L&H fired him in
November 2000. Mr. Bodson said Mr. Seo was last spotted in China
22
M. Maremont, KPMG, Former Auditor of L&H, May Draw Investors Ire, The Wall Street Journal (January 18,
2001), P. C1.
23
R. Conlin, KPMG: Lernout and Hauspie Top Management Lied, www.CRDDaily.com (May 11, 2011).

KPMG.24 KPMG alleged that Mr. Hauspie was implicated in a scheme to illegally raise money
for a fund he participated in. The scheme involved a complex web of Korean banks, L&H
subsidiaries and Joo Chul Seo, the companys former head of Korean operations. KPMG also
alleged that the company co-founder Jo Lernout, at the very least, participated in the
campaign to conceal information from its auditors.

In addition, KPMG commented that the practice of inflating revenues was a common one at
L&H. Afterwards [referring to a period in 1999] it appeared that the antedating of contracts to
increase the turnover of the relevant quarter was common practice, said the KPMG report.25
The company, on a regular basis, increased its turnover of a particular year or quarter by
means of various kinds of irregularities.26
THE AFTERMATH

In April 2001, Jo Lernout and Pol Hauspie were arrested in Belgium on charges of forgery and
stock price manipulation. The arrests came after a new round of audit uncovered an additional
$96 million in fictitious sales, which brought the tally of fake sales from early 1998 to mid-2000
to $373 million, or 45% of reported revenue.27

L&H was declared bankrupt in October 2001 after the commercial court in Belgium rejected
the companys request for bankruptcy protection.
Questions
1. Is there anything unique about L&H that made the company prone to engage in fraudulent
accounting practices?
2. Which were the questionable business (accounting) practices that L&H engaged in?
Classify each practice as acceptable, unethical, or fraudulent. Are such practices smart? Are
they legal?
3. Do you believe KPMGs claim that its auditors have been misled by L&H? If yes, how
could the auditors have been fooled so easily? If you dont believe they were fooled, why did
they go along with the aggressive financial reporting?
24

Ibid.
Ibid.
26
Ibid.
27
J. Carreyrou, Lernout & Hauspie Figures Are Arrested, The Wall Street Journal (April 30, 2001), p. A15.
25

4. What could have been done to prevent the fraudulent behaviors from taking place at L&H
(or to prevent similar scandals from taking place at other companies in the future)?
Exhibit 1:

Appendix to the August 8, 2000 The Wall Street Journal report

A Kick from Korea

Lernout & Hauspie sales by region or country for the three months ended March 31, 2000 ($000).
The companys South Korean business soared after an acquisition in September 1999.
1999

2000

Europe (excluding Belgium)

22,435

19,748

US

20,154

19,939

Belgium

14,739

9,178

Singapore

10,430

501

Other Far
East
2,853
Source:
The
Wall Street Journal (August 8, 2000) p.
C1.

2,396

South Korea
97C1.
Source:
The Wall Street Journal (August 8, 2000) p.

58,932

Exhibit 2:

10 steps to Chapter 11

A Lernout & Hauspie Chronology

June 30, 2000

L&H reveals that nearly all of its overall growth in recent quarters came from South
Korea and Singaporean business.

Aug. 8, 2000

The Wall Street Journal reports that some Korean customers claimed by L&H do
no business with the company. Others said their purchases were smaller than L&H
reported.

Aug. 25, 2000

CEO Gaston Bastiaens steps down; former Dictaphone CEO John Duerden steps
in. The companys stock fall 9% to $31.

Sept. 20, 2000

The SEC launches a formal investigation of L&Hs accounting practices.

Sept. 22, 2000

The Wall Street Journal reveals that 25% of L&H revenue came from start-up
companies that it helped create.

Sept. 25, 2000

Europes Easdaq launches a formal investigation into L&H.

Sept. 27, 2000

L&H issues a profit warning for the third quarter.

Nov. 9, 2000

L&H says it will revise financial statements for 1998, 1999 and the first half of 2000
to make up for past accounting errors and irregularities, co-chairman Jo Lernout
and Pol Hauspie resign their executive posts; trading of L&H stock is suspended.

Nov. 16, 2000

The companys accounting firm KPMG International withdraws its audits of 1998
and 1999 results.

Nov. 29, 2000

L&H files Chapter 11 bankruptcy protection along with its Dictaphone unit, after
$100 million is discovered missing in the firms South Korea unit.

Source: The Wall Street Journal (November 30, 2000), p. A3.

Exhibit 3:

Accounting for auditing problems: recent large settlements paid by auditors

Auditor

Company

Year

Allegations

Settlement

audited
Ernst & Young

Cendent

amount
1999

Inflated revenue, understated

$335m

expenses
Ernst & Young

Informix

1999

Inflated revenue

$34m

Arthur

Waste

1998

Overstated assets and other

$75m

Anderson

Management

Coopers
Lybrand

&

Centennial

accounting problems
1998

Bogus sales

Technologies

Now part of PwC.

Source: The Wall Street Journal (January 18, 2001), p. C1.

420