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Who killed Nortel: Scandal tainted telco

Updated:2009/11/9 10:33

On a brisk November day in 2003, two of Nortel's most senior directors entered the business-aviation terminal at Toronto's international airport for a meeting that would change everything.

Red Wilson and John Cleghorn were recognizable to readers of the business pages. Mr. Wilson, a former CEO of Redpath Industries and Bell Canada Enterprises, had joined Nortel's board in 1991 and was now its chairman. Mr. Cleghorn became a director in 2001 after a long and distinguished career at Royal Bank of Canada, where he had served as CEO from 1994 until joining Nortel. He was head of the board's audit committee.

During the previous two years, they had overseen a dramatic restructuring. Nortel had sacked two-thirds of its workforce and wrote down nearly US$16-billion in 2001 alone. Early in 2003, the company had started to report profits. The worst seemed over. There was just one piece of leftover business.

The loose end was the subject of that airport meeting. It had surfaced on April 24 when CEO Frank Dunn announced first-quarter net earnings of US1¢ per share. After massive losses in 2001 and 2002, even the small profit was a welcome relief--especially to the firm's most senior executives.

The sudden shift triggered millions in "return-to-profitability" bonuses. In 2003, the company's top 43 managers received a total of US$19-million in such payments. More than US$5-million of this would go to just three individuals-- Mr. Dunn, chief financial officer Douglas Beatty and controller Michael Gollogly.

But there was something about the first-quarter numbers that Nortel's independent auditors, Deloitte&Touche, didn't like. Deloitte advised Mr. Cleghorn that the board should take a closer look at how the profits were created.

Deloitte's concern had to do with how Nortel was accounting for billions of dollars in special charges related to its frenetic downsizing. These were estimates of how much Nortel would pay in future for severance, lawsuit settlements, breaking office leases and other contracts.

The company recorded these in the form of special charges that were deducted from revenues. The result was to produce exceptionally large losses in 2001 and 2002.

It's what happened next that showed up on Deloitte's radar.

Under normal accounting rules, when a company discovers it has overestimated its potential exposure to a lawsuit, it's supposed to go back and adjust its earnings in the quarter in which the mistake was discovered. In this case, the removal of the reserve for legal exposure would cause earnings to rise. If the adjustment is significant, the company must disclose the full influence on earnings in the current and former accounting periods, and, perhaps, issue a restatement of results.

In the first quarter of 2003, Nortel improperly reversed at least $274-million in previously recorded special charges, according to a civil complaint in March 2007 by the U.S. Securities and Exchange Commission. (Most of the executives named in the complaint have either denied wrongdoing or agreed to pay a civil fine and other penalties without admitting to the allegations.)

In March 2003, Deloitte was concerned Nortel could not justify through documentation a significant portion of the US$274-million in special charges. The result was material. Instead of showing a first-quarter loss of US$220-million, Nortel reported a US$54-million profit.

In May 2003, Nortel's board ordered its executives to conduct a thorough review of the firm's balance sheet, which contained the estimates for future liabilities.

An internal review concluded Nortel would have to revise its financial statements from 2001 to mid-2003. Some US$900-million in liabilities -- about 7% of the firm 's total-- would be shifted. However, these changes did not affect earnings sufficiently to kill the executive bonuses.

Mr. Wilson and Mr. Cleghorn, acting on the advice of Nortel's in-house lawyers, wanted to be sure the assessment was legitimate and accurate. That's why they were at the airport to meet William McLucas, a partner with WilmerHale, one of the best-connected law firms in Washington, D.C.

Mr. McLucas listened carefully to the Nortel directors.

The sought-after advisor had helped the boards of Worldcom and Enron clean up after epic accounting scandals and was previously a director of enforcement at the U.S. Securities and Exchange Commission. He thought the likelihood of deliberate wrongdoing was low. Every year, hundreds of U.S. firms filed restatements; fewer than one in 10 involved fraud.

"Well," he concluded when they were done detailing the situation, "this looks pretty straightforward."

In fact, it would prove anything but.

After months of combing through detailed balance sheets and hundreds of thousands of emails from Nortel's financial employees, WilmerHale's investigators concluded in 2005 that the company's finance team "conveyed the strong leadership message that earnings targets could be met through application of accounting practices that finance managers knew or ought to have known were not in compliance."

The repercussions were swift. Most of the executives who received return-to-profitability bonuses returned them to Nortel. On April 28, 2004, the board sacked Mr. Dunn, Mr. Beatty and Mr. Gollogly. In August, more financial managers were let go.

Along with the WilmerHale report, Nortel announced a second restatement of its numbers going back to 2001 and launched a review of previously published revenues.

Finally, in 2007, it seemed over, at least for the company, if not for the executives it fired, who face a litany of legal and regulatory actions in Canada and the United States.

The various legal cases have cost Nortel dearly, both in reputation and money. The company has invested heavily to find and fix mistakes and retrain staff. Mike Zafirovski, company CEO from 2005 until August 2009, estimated Nortel spent more than US$400-million on outside auditors, management consultants and other accounting specialists.

To settle a class-action lawsuit, Nortel shelled out US$575-million cash and 629 million common shares early in 2006. The suit, which claimed Nortel had misled investors about the health of the company, was difficult to defend -- not least because Nortel had fired its financial team for cause.

The loss of nearly US$1-billion in professional fees and class-action awards proved crucial during the final months of 2008 when Nortel began to mull creditor protection.

Had it not been for the accounting scandal, Nortel would likely still be solvent. It was a costly distraction, and it led observers to conclude that Nortel had itself to blame. Indeed, the numbers debacle had made it easier for Stephen Harper's government to say "no" to a bailout.

Despite all this, it would not be fair to blame accounting alone for Nortel's demise. Its rivals -- including Lucent Technologies and Siemens AG -- survived serious accounting scandals. Why not Nortel? It turns out it wasn't just the alleged accounting fraud that hurt Nortel. When the scandal broke, the company was already in an advanced state of decline.


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