Dell faces fresh threat from old PC failures

NEW YORK (CNNMoney.com) -- A six-year-old hardware meltdown that plagued millions of computers is coming back to haunt Dell.

From 2003 to 2005, Dell sold computers with faulty capacitors that allegedly caused most motherboards on two Dell Optiplex models to break, rendering the computers useless. Dell was aware of the issue, according to recently unsealed court documents from a pending lawsuit, yet continued to sell the computers anyway.

Though the juiciest details are still sealed by the court, several internal company e-mails show that Dell instructed its sales staff to downplay the malfunctions to customers.

"We need to avoid all language indicating the [mother]boards were bad or had 'issues,'" Jeff DilLullo, a Dell sales manager, wrote in a March 2004 e-mail.

One December 2004 e-mail shows that the company was hiding the reason for and severity of the crashes from its customers.

"Need to know why we informed this customer of the GX270 motherboard issue while they have only had 2 failures," wrote Duane Aparo, a Dell project manager.

A filing says one of the still-sealed documents includes a company e-mail instructing sales personnel to "emphasize uncertainty" in responding to customer concerns about capacitor problems, while another tells sales representatives, "Don't bring this to customer's attention proactively."

"Dell was engaged in a cover-up," said Peter Cohan, a venture capitalist and management consultant at Peter S. Cohan & Associates. "This could have a long-term effect on the company."

The revealing internal communications were unsealed as part of a three-year court battle between Dell and Web hosting business Advanced Internet Technologies -- a case that has not yet gone to trial.

AIT, based in Fayetteville, N.C., sued Dell in a local federal court for damages stemming from the breakdown of nearly 2,000 Dell Optiplex systems that AIT had leased to its clients. The company says it lost nearly $16 million from cancelled contracts and $22 million on discounts it offered to retain affected customers. AIT also says it hired dozens of additional customer service and repair workers to deal with the crisis.

In total, AIT lists damages of $40 million -- and because Dell could be liable for treble damages, it could end up on the hook for as much as $120 million if it loses the lawsuit. Filed in 2007, the case is schedule for trial later this year.

Dell says it shipped at least 11.8 million of the affected computers, 8 million of which were at "high risk" for default. A company study found that 97% of those Optiplex computers were likely to fail over a three-year period.

Because thousands of other customers also bought the affected computers, an AIT win could bring on an ensuing flood of lawsuits, analysts say.

"If AIT wins the $120 million lawsuit, it would be worth it for any other company affected to sue Dell as well to get a large share of the loot," Cohan said.

Dell has already made some amends for the capacitor issue. Its fiscal year 2006 financial results include charges of more than $300 million for servicing or replacing the affected Optiplex computers. Many customers who suffered failures had their faulty machines fixed, and Dell extended the warranties on the affected computers through January 2008.

But the company has also drawn fire for trying to bury the problem.

Dell recently set aside $100 million for a settlement it is negotiating with the Securities and Exchange Commission on a bundle of fraud charges stemming from years of accounting violations. An internal Dell investigation, completed in 2007, found that company officials improperly manipulated Dell's reserve accounts -- such as those set aside to cover product warranty claims -- to hide earnings shortfalls. In the wake of that investigation, Dell overhauled its management team and accounting department, and restated its financial results from 2003 to 2006.

But even if AIT wins and inspires others to go after Dell for damages stemming from the capacitor debacle, it wouldn't likely break the company: experts note that most cases of this kind end up getting settled out of court for far less than the "jugular" amount that plaintiffs say they're after. What's more, Dell is currently sitting on a $9.5 billion of cash, so it can likely afford any potential pile-on.

"Dell has the balance sheet strength to deal with an impending flow of legal battles," said Ashok Kumar, analyst at Rodman & Renshaw. "Dell will set aside money and say it is the cost of doing business."

Investors don't seem too concerned yet: Shares of Dell (DELL, Fortune 500) have fallen nearly 8% since The New York Times first broke the story of AIT's lawsuit on Tuesday. But the overall stock market has dropped, too: The S&P 500 index is down more than 5% since Tuesday.

What could hurt more than the legal bills is the blow to the company's reputation. Documents excavated for the lawsuit show that Dell was slow to react to customers' complaints about the Optiplex computers, even after the company finally acknowledged the issues in 2005.

Even the law firm now defending Dell against AIT's charges got hit by the motherboard meltdowns.

"Cory -- I'm really dying here," Jeff Allaman, IT director at law firm Alston & Bird, wrote to Dell sales rep Cory Dial in March 2005 in the wake of a rash of system failures at his firm.

Like many customers, Allaman was frustrated by Dell's tight-lipped, "completely unacceptable" response to the problem.

"A description of how wide spread this issue would have been helpful. Is this a problem Dell is encountering across the entire model production or have you narrowed it down to specific product runs?" he asked by e-mail. "I need definitive information on why we are experiencing such high failure rates on our servers and laptops and if I need to start planning for the same level of failures on our desktops."

Meanwhile, some key customers got favorable treatment. After Puerto Rico Telephone Co. requested that Dell replace its affected computers, Dell quickly approved the claim, despite a Dell accountant's worry that "we open ourselves up to a flood of customers wanting whole system replacements -- which would be disastrous."

But a regional sales manager slapped down the objection: "The risk of rejecting includes losing a multi million dollar customer which I am not prepeared [sic] to do," Alvaro Echeverria wrote in a December 2005 e-mail. "We need to do what is right for our customer."

The paper trail documenting Dell's reluctance to face up to the scope of the problem -- and its occasional deceit in answering customer queries about it -- could make future sales tougher to corporate and government customers, which make up 78% of Dell's business.

"The overhang from this is the taint on company's brand name," analyst Kumar said. "Dell cut corners to deliver profit margins, so the question becomes, 'How forgiving will business customers be?'"

Dell spokesman David Frink brushed off the capacitor issue as "old news." He stressed that the computers that the company currently sells no longer use the faulty capacitors, which were made by a third-party vendor named Nichicon and not by Dell itself.

Faulty Nichicon capacitors affected other manufacturers, causing problems in some Apple (AAPL, Fortune 500) iMac G5 computers and Hewlett-Packard (HPQ, Fortune 500) PCs, but Dell appears to have had many more computers affected by the malfunction. Unlike Dell, which took a big one-time charge, Apple and HP did not disclose any major financial fallout from the Nichicon debacle.