During the trial, lawyers for the accused said that the men believed that the accounting decisions they made were appropriate at the time, and that the accounting treatment was approved by NortelâÂÂs auditors from Deloitte & Touche. Judge Marrocco accepted these arguments. Marrocco added he was âÂÂnot satisfied beyond a reasonable doubtâ that the trio (i.e., Dunn, Beatty, and Gollogly) had âÂÂdeliberately misrepresentedâ financial results. Given the facts of the case, do you believe Judge MarroccoâÂÂs decision was justified? Explain.
Canada-based Nortel Networks was one of the largest telecommunications equipment companies in the world prior to its filing for bankruptcy protection on January 14, 2009, in the United States, Canada, and Europe. The company had been subjected to several financial reporting investigations by U.S. and Canadian securities agencies in 2004. The accounting irregularities centered on premature revenue recognition and hidden cash reserves used to manipulate financial statements. The goal was to present the company in a positive light so that investors would buy (hold) Nortel stock, thereby inflating the stock price. Although Nortel was an international company, the listing of its securities on U.S. stock exchanges subjected it to all SEC regulations, along with the requirement to register its financial statements with the SEC and prepare them in accordance with U.S. GAAP.
The company had gambled by investing heavily in Code Division Multiple Access (CDMA) wireless cellular technology during the 1990s in an attempt to gain access to the growing European and Asian markets. However, many wireless carriers in the aforementioned markets opted for rival Global System Mobile (GSM) wireless technology instead. Coupled with a worldwide economic slowdown in the technology sector, NortelâÂÂs losses mounted to $27.3 billion by 2001, resulting in the termination of two-thirds of its workforce.
The Nortel fraud primarily involved four members of NortelâÂÂs senior management as follows: CEO Frank Dunn, CFO Douglas Beatty, controller Michael Gollogly, and assistant controller Maryanne Pahapill. At the time of the audit, Dunn was a certified management accountant, while Beatty, Gollogly, and Pahapill were chartered accountants in Canada.
Accounting Irregularities
On March 12, 2007, the SEC alleged the following in a complaint against Nortel:1
In late 2000, Beatty and Pahapill implemented changes to NortelâÂÂs revenue recognition policies that violated U.S. GAAP, specifically to pull forward revenue to meet publicly announced revenue targets. These actions improperly boosted NortelâÂÂs fourth quarter and fiscal 2000 revenue by over $1 billion, while at the same time allowing the company to meet, but not exceed, market expectations. However, because their efforts pulled in more revenue than needed to meet those targets, Dunn, Beatty, and Pahapill selectively reversed certain revenue entries during the 2000 year-end closing process.
In November 2002, Dunn, Beatty, and Gollogly learned that Nortel was carrying over $300 million in excess reserves. The three did not release these excess reserves into income as required under U.S. GAAP. Instead, they concealed their existence and maintained them for later use. Further, Beatty, Dunn, and Gollogly directed the establishment of yet another $151 million in unnecessary reserves during the 2002 year-end closing process to avoid posting a profit and paying bonuses earlier than Dunn had predicted publicly. These reserve manipulations erased NortelâÂÂs pro forma profit for the fourth quarter of 2002 and caused it to report a loss instead.2
In the first and second quarters of 2003, Dunn, Beatty, and Gollogly directed the release of at least $490 million of excess reserves specifically to boost earnings, fabricate profits, and pay bonuses. These efforts turned NortelâÂÂs first-quarter 2003 loss into a reported profit under U.S. GAAP, which allowed Dunn to claim that he had brought Nortel to profitability a quarter ahead of schedule. In the second quarter of 2003, their efforts largely erased NortelâÂÂs quarterly loss and generated a pro forma profit. In both quarters, Nortel posted sufficient earnings to pay tens of millions of dollars in so-called return to profitability bonuses, largely to a select group of senior managers.
During the second half of 2003, Dunn and Beatty repeatedly misled investors as to why Nortel was conducting a purportedly âÂÂcomprehensive reviewâ of its assets and liabilities, which resulted in NortelâÂÂs restatement of approximately $948 million in liabilities in November 2003. Dunn and Beatty falsely represented to the public that the restatement was caused solely by internal control mistakes. In reality, NortelâÂÂs first restatement was necessitated by the intentional improper handling of reserves, which occurred throughout Nortel for several years, and the first restatement effort was sharply limited to avoid uncovering Dunn, Beatty, and GolloglyâÂÂs earnings management activities.
The complaint charged Dunn, Beatty, Gollogly, and Pahapill with violating and/or aiding and abetting violations of the antifraud, reporting, and books and records requirements. In addition, they were charged with violating the Securities Exchange Act Section 13(b)(2)(B) that requires issuers to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that, among other things, transactions are recorded as necessary to permit the preparation of financial statements in conformity with U.S. GAAP and to maintain accountability for the issuerâÂÂs assets.
Dunn and Beatty were separately charged with violations of the officer certification provisions instituted by SOX under Section 302. The commission sought a permanent injunction, civil monetary penalties, officer and director bars, and disgorgement with prejudgment interest against all four defendants.
Specifics of Earnings Management Techniques
From the third quarter of 2000 through the first quarter of 2001, when Nortel reported its financial results for year-end 2000, Dunn, Beatty, and Pahapill altered NortelâÂÂs revenue recognition policies to accelerate revenues as needed to meet NortelâÂÂs quarterly and annual revenue guidance, and to hide the worsening condition of NortelâÂÂs business. Techniques used to accomplish this goal include:
Reinstituting bill-and-hold transactions. The company tried to find a solution for the hundreds of millions of dollars in inventory that was sitting in NortelâÂÂs warehouses and offsite storage locations. Revenues could not be recognized for this inventory because U.S. GAAP revenue recognition rules generally require goods to be delivered to the buyer before revenue can be recognized. This inventory grew, in part, because orders were slowing and, in June 2000, Nortel had banned bill-and-hold transactions from its sales and accounting practices. The company reinstituted bill-and-hold sales when it became clear that it fell short of earnings guidance. In all, Nortel accelerated into 2000 more than $1 billion in revenues through its improper use of bill-and-hold transactions.
Restructuring business-asset write-downs. Beginning in February 2001, Nortel suffered serious losses when it finally lowered its earnings guidance to account for the fact that its business was suffering from the same widespread economic downturn that affected the entire telecommunications industry. As NortelâÂÂs business plummeted throughout the remainder of 2001, the company reacted by implementing a restructuring that, among other things, reduced its workforce by two-thirds and resulted in a significant write-down of assets.
Creating reserves. In relation to writing down the assets, Nortel established reserves that were used to manage earnings. Assisted by defendants Beatty and Gollogly, Dunn manipulated the companyâÂÂs reserves to manage NortelâÂÂs publicly reported earnings, create the false appearance that his leadership and business acumen was responsible for NortelâÂÂs profitability, and pay bonuses to these three defendants and other Nortel executives.
Releasing reserves into income. From at least July 2002 through June 2003, Dunn, Beatty, and Gollogly released excess reserves to meet DunnâÂÂs unrealistic and overly aggressive earnings targets. When Nortel internally (and unexpectedly) determined that it would return to profitability in the fourth quarter of 2002, the reserves were used to reduce earnings for the quarter, avoid reporting a profit earlier than Dunn had publicly predicted, and create a stockpile of reserves that could be (and were) released in the future as necessary to meet DunnâÂÂs prediction of profitability by the second quarter of 2003. When 2003 turned out to be rockier than expected, Dunn, Beatty, and Gollogly orchestrated the release of excess reserves to cause Nortel to report a profit in the first quarter of 2003, a quarter earlier than the public expected, and to pay defendants and others substantial bonuses that were awarded for achieving profitability on a pro forma basis. Because their actions drew the attention of NortelâÂÂs outside auditors, they made only a portion of the planned reserve releases. This allowed Nortel to report nearly break-even results (though not actual profit) and to show internally that the company had again reached profitability on a pro forma basis necessary to pay bonuses.
Siemens Reserve
During the fraud trial, former Nortel accountant Susan Shaw testified about one of the most controversial accounting provisions on the companyâÂÂs books, relating to a 2001 lawsuit filed against Nortel by Siemens AG. It was long-standing practice across Nortel to establish reserves on a âÂÂworst caseâ basis, which meant at an amount equal to the maximum possible exposure.
Nortel had created an accounting reserve on its books at the time the Siemens lawsuit was filed to provide for a settlement in the case, but it was alleged that a portion of the provision was arbitrarily left on NortelâÂÂs books long after the lawsuit was resolved in the fourth quarter of 2001. It became part of a group of extra head office, non-operating reserves that allegedly was reversed arbitrarilyâÂÂand with no appropriate business triggerâÂÂto push the company into a profit in 2003 and earn âÂÂreturn to profitabilityâ bonuses for executives.
The $4-million remaining Siemens provision was initially booked to be reversed into income in the first quarter of 2003, but then withdrawn, allegedly because it was not needed to push the company into a profitable position in the quarter. It was then booked to be used in the second quarter, and became the only head office non-operating reserve used in the quarter.
The contention was that the Siemens reserve was used in that quarter because Nortel needed almost exactly $4 million more income to reach the payout trigger for the companyâÂÂs restricted share unit plan at that time. However, lawyer David Porter argued the Siemens amount was triggered in the second quarter because that is when the company believed it was no longer needed and should appropriately be reversed.
In cross-examination, Porter showed Shaw a working document recovered from the files of NortelâÂÂs external auditors at Deloitte & Touche, showing the auditor reviewed NortelâÂÂs justifications for keeping the Siemens reserve on the books until that time and for reversing it in the second quarter of 2003. DeloitteâÂÂs notes showed the auditor reviewed NortelâÂÂs detailed rationale for the reserve and concluded its release in the second quarter was âÂÂreasonable.âÂÂ3
The company said it was holding on to the reserve because the settlement with Siemens had been âÂÂrancorousâ and Nortel wanted to be sure there would be no further claims made after the lawsuit was settled and $32 million was paid to Siemens in two installments in late 2001 and late 2002.
In its working notes, Deloitte recorded that Nortel felt it was âÂÂprudentâ to keep the $4 million on the books until mid-2002. Shaw testified she felt the reserve was being reversed on schedule with the plan to keep it in place for the first two quarters of the year. Porter asked Shaw whether the auditors were satisfied at the time there was an appropriate triggering event to use the reserve in the second quarter of 2002, and she replied there was one.
However, the amount became part of a broad restatement of reserves announced at Nortel at the end of 2003. The company noted in the restatement that the Siemens reserve should have been reversed in the fourth quarter of 2001 when the lawsuit was settled.
Role of Auditors and Audit Committee
In late October 2000, as a first step toward reintroducing bill-and-hold transactions into NortelâÂÂs sales and accounting practices, NortelâÂÂs then controller and assistant controller asked Deloitte to explain, among other things, (1) âÂÂ[u]nder what circumstances can revenue be recognized on product (merchandise) that has not been shipped to the end customer?â and (2) whether merchandise accounting can be used to recognized revenues âÂÂwhen installation is imminentâ or âÂÂwhen installation is considered to be a minor portion of the contractâÂÂ?4
On November 2, 2000, Deloitte presented Nortel with a set of charts that, among other things, explained the US GAAP criteria for revenues to be recognized prior to delivery (including additional factors to consider for a bill-and-hold transaction) and also provided an example of a customer request for a bill-and-hold sale âÂÂthat would support the assertion that Nortel should recognize revenueâ prior to delivery.
NortelâÂÂs earnings management scheme began to unravel at the end of the second quarter of 2003. On the morning of July 24, 2003, the same day on which Nortel issued its second Quarter 2003 earnings release, Deloitte informed NortelâÂÂs audit committee that it had found a âÂÂreportable conditionâ with respect to weaknesses in NortelâÂÂs accounting for the establishment and disposition of reserves. Deloitte went on to explain that, in response to its concerns, NortelâÂÂs management had undertaken a project to gather support and determine proper resolution of certain provision balances. Management, in fact, had undertaken this project because the auditor required adequate audit evidence for the upcoming year-end 2003 audit. Nortel concealed its auditorâÂÂs concerns from the public, instead disclosing the comprehensive review.
Shortly after NortelâÂÂs announced restatement, the audit committee commenced an independent investigation and hired outside counsel to help it âÂÂgain a full understanding of the events that caused significant excess liabilities to be maintained on the balance sheet that needed to be restated,â as well as to recommend any necessary remedial measures. The investigation uncovered evidence that Dunn, Beatty, and Gollogly and certain other financial managers were responsible for NortelâÂÂs improper use of reserves in the second half of 2002 and first half of 2003.
In March 2004, Nortel suspended Beatty and Gollogly and announced that it would âÂÂlikelyâ need to revise and restate previously filed financial results further. Dunn, Beatty, and Gollogly were terminated for cause in April 2004.
On January 11, 2005, Nortel issued a second restatement that restated approximately $3.4 billion in misstated revenues and at least another $746 million in liabilities. All of the financial statement effects of the defendantsâ two accounting fraud schemes were corrected as of this date, but there remained lingering effects from the defendantsâ internal control and other nonfraud violations.
Nortel also disclosed the findings to date of the audit committeeâÂÂs independent review, which concluded, among other things, that Dunn, Beatty, and Gollogly were responsible for NortelâÂÂs improper use of reserves in the second half of 2002 and first half of 2003. The second restatement, however, did not reveal that NortelâÂÂs top executives had also engaged in revenue recognition fraud in 2000.
In May 2006, in its Form 10-K for the period ending December 31, 2005, Nortel admitted for the first time that its restated revenues in part had resulted from management fraud, stating that âÂÂin an effort to meet internal and external targets, the senior corporate finance management team . . . changed the accounting policies of the company several times during 2000,â and that those changes were âÂÂdriven by the need to close revenue and earnings gaps.âÂÂ
Throughout their scheme, the defendants lied to NortelâÂÂs independent auditor by making materially false and misleading statements and omissions in connection with the quarterly reviews and annual audits of the financial statements that were materially misstated. Among other things, each of the defendants submitted management representation letters to the auditors that concealed the fraud and made false statements, which included that the affected quarterly and annual financial statements were presented in conformity with U.S. GAAP and that they had no knowledge of any fraud that could have a material effect on the financial statements. Dunn, Beatty, and Gollogly also submitted a false management representation letter in connection with NortelâÂÂs first restatement, and Pahapill likewise made false management representations in connection with NortelâÂÂs second restatement.
The defendantsâ scheme resulted in Nortel issuing materially false and misleading quarterly and annual financial statements and related disclosures for at least the financial reporting periods ending December 31, 2000, through December 31, 2003, and in all subsequent filings made with the SEC that incorporated those financial statements and related disclosures by reference.
On October 15, 2007, Nortel, without admitting or denying the SECâÂÂs charges, agreed to settle the commissionâÂÂs action by consenting to be enjoined permanently from violating the antifraud, reporting, books and records, and internal control provisions of the federal securities laws and by paying a $35 million civil penalty, which the commission placed in a Fair Fund5 for distribution to affected shareholders.6 Nortel also agreed to report periodically to the commissionâÂÂs staff on its progress in implementing remedial measures and resolving an outstanding material weakness over its revenue recognition procedures.
On January 14, 2009, Nortel filed for protection from creditors in the United States, Canada, and the United Kingdom in order to restructure its debt and financial obligations. In June, the company announced that it no longer planned to continue operations and that it would sell off all of its business units. NortelâÂÂs CDMA wireless business and long-term evolutionary access technology (LTE) were sold to Ericsson, and Avaya purchased its Enterprise business unit.
The final indignity for Nortel came on June 25, 2009, when NortelâÂÂs stock price dropped to 18.5Ă¢ a share, down from a high of $124.50 in 2000. NortelâÂÂs battered and bruised stock was finally delisted from the S&P/TSX composite index, a stock index for the Canadian equity market, ending a colossal collapse on an exchange on which the Canadian telecommunications giantâÂÂs stock valuation once accounted for a third of its value.
Postscript
The three former top executives of Nortel Networks Corp. were found not guilty of fraud on January 14, 2013. In the court ruling, Justice Frank Marrocco of the Ontario Superior Court found that the accounting manipulations that caused the company to restate its earnings for 2002 and 2003 did not cross the line into criminal behavior.
Accounting experts said the case is sure to be closely watched by others in the business community for the message it sends about where the line lies between fraud and the acceptable use of discretion in accounting.
The decision underlines that management still has a duty to prepare financial statements that âÂÂpresent fairly the financial position and results of the companyâ according to a forensic accountant, Charles Smedmor, who followed the case. âÂÂNothing in the judgeâÂÂs decision diminished that duty.âÂÂ
During the trial, lawyers for the accused said that the men believed that the accounting decisions they made were appropriate at the time, and that the accounting treatment was approved by NortelâÂÂs auditors from Deloitte & Touche. Judge Marrocco accepted these arguments, noting many times in his ruling that bookkeeping decisions were reviewed and approved by auditors and were disclosed adequately to investors in press releases or notes added to the financial statements.
Nonetheless, the judge also said that he believed that the accused were attempting to âÂÂmanageâ NortelâÂÂs financial results in both the fourth quarter of 2002 and in 2003, but he added he was not satisfied that the changes resulted in material misrepresentations. He said that except for $80 million of reserves released in the first quarter of 2003, the rest of the use of reserves was within âÂÂthe normal course of business.â Judge Marrocco said the $80 million release, while clearly âÂÂunsupportableâ and later reversed during a restatement of NortelâÂÂs books, was disclosed properly in NortelâÂÂs financial statements at the time and was not a material amount. He concluded that Beatty and Dunn âÂÂwere prepared to go to considerable lengthsâ to use reserves to improve the bottom line in the second quarter of 2003, but he said the decision was reversed before the financial statements were completed because Gollogly challenged it.
In a surprising twist, Judge Marrocco also suggested the two devastating restatements of NortelâÂÂs books in 2003 and 2005 were probably unnecessary in hindsight, although he said he understood why they were done in the context of the time. He said the original statements were arguably correct within a threshold of what was material for a company of that size.
Darren Henderson, an accounting professor at the Richard Ivey School of Business at the University of Western Ontario, said that a guilty verdict would have raised the bar for management to justify their accounting judgments. But the acquittal makes it clear that âÂÂmanagement manipulation of financial statements is very difficult to prove beyond a reasonable doubt in a court of law,â he said.
It is clear that setting up reserves or provisions is still subject to management discretion, Henderson said. âÂÂThe message . . . is that it is okay to use accounting judgments to achieve desired outcomes, [such as] a certain earnings target.âÂÂ
