Question: By the late 1990s, Nortel Networks Corporation,

By the late 1990s, Nortel Networks Corporation, headquartered in Brampton, Ontario, Canada, was one of the giants of the telecommunications industry. Seventy- five percent of North America’s Internet traffic was carried by Nortel equipment,1 which was manufactured by 73,000 employees around the world.2 The company’s shares were listed on both the New York Stock Exchange (NYSE) and the Toronto Stock Exchange (TSE). By July 2000, the company had issued over 3.8 billion shares worth C$473.1 billion in market capitalization at a peak price of C$124.50. So dominant was Nortel that it accounted for more than one-third the value of the S & P/TSE 300 Composite Index.3
Then the infamous dot-com bubble burst, and by September 2002, Nortel stock closed at C$0.63.4 John Roth, named Canada’s “business leader of the year” in 2000, indicated that he would step down as CEO in April 2001.5 This may have been partly because he had not foreseen a coming slump in sales and as a result appeared to have misled the investing public. Until Roth’s departure, Nortel was considered to have had an exemplary corporate culture and code of conduct.
Frank Dunn, a CMA who had been head of public affairs and then CFO, was named as replacement CEO in November 2001. He led Nortel through a radical restructuring that saw a reduction in its workforce by 50% to 45,000 in 2001 and a further 10,000 in 2002. Apparently as a result, Nortel’s financial picture showed a profit of U.S.$54 million in the first quarter of fiscal 2003, which ended on March 31, 2003. Profits were also reported in the second quarter.
However, on October 23, 2003, when Nortel reported profits in the third quarter, restatements affecting 2000, 2001, and 2002 financial statements were also announced. Concern over these restatements, delays in financial reports, and concerns over bonuses paid to executives triggered the Audit Committee of Nortel Networks Corporation to authorize an independent review (IR) of the company’s financial affairs by the Washington, D.C., law firm of Wilmer Cutler Pickering Hale and Dorr LLP.
The IR findings resulted in the need for a second restatement of Nortel’s financial statements and the termination for cause of ten senior employees, including the CEO, CFO, and controller. All were asked to repay bonuses received. A further twelve senior employees were required to repay bonuses received and did so. They were not terminated.
Summary of Findings and of Recommended Remedial Measures of the Independent Review6
The following excerpts provide an overview of the IR and its findings:
In l ate October 2003, Nortel Networks Corporation (“Nortel” or the “Company”) announced that it intended to restate approximately $900M of liabilities carried on its previously reported balance sheet as of June 30, 2003, following a comprehensive internal review of these liabilities (“First Restatement”). The Company stated that the principal effects of the restatement would be a reduction in previously reported net losses for 2000, 2001, and 2002 and an increase in shareholders’ equity and net assets previously reported on its balance sheet. Concurrent with this announcement, the Audit Committees of the Boards of Directors of Nortel Networks Corporation and Nortel Networks Limited (collectively, the “Audit Committee” and the “Board of Directors” or “Board,” respectively) initiated an independent review of the facts and circumstances leading to the First Restatement. The Audit Committee wanted to gain a full understanding of the events that caused significant excess liabilities to be maintained on the balance sheet that needed to be restated, and to recommend that the Board of Directors adopt, and direct management to implement, necessary remedial measures to address personnel, controls, compliance, and discipline. The Audit Committee engaged Wilmer Cutler Pickering Hale and Dorr LLP (“WCPHD”) to advise it in connection with its independent review. Because of the significant accounting issues involved in the inquiry, WCPHD retained Huron Consulting Services LLC (“Huron”) to provide expert accounting assistance. Huron has been involved in all phases of WCPHD’s work.
The investigation necessarily focused on the financial picture of the Company at the time that decisions were made and actions were taken regarding provisioning activity. Because of significant changes to financial results reflected in the Second Restatement, the restated financial results differ from the historical results that formed the backdrop for this inquiry.
In summary, former corporate management (now terminated for cause) and former finance management (now terminated for cause) in the Company’s finance organization endorsed, and employees carried out, accounting practices relating to the recording and release of provisions that were not in compliance with U.S. generally accepted accounting principles (“U.S. GAAP”) in at least four quarters, including the third and fourth quarters of 2002 and the first and second quarters of 2003. In three of those four quarters—when Nortel was at, or close to, break even—these practices were undertaken to meet internally imposed pro-forma earnings before taxes (“EBT”) targets. While the dollar value of most of the individual provisions was relatively small, the aggregate value of the pro- visions made the difference between a profit and a reported loss, on a pro forma basis, in the fourth quarter of 2002 and the difference between a loss and a reported profit, on a pro forma basis, in the first and second quarters of 2003. This conduct caused Nortel to report a loss in the fourth quarter of 2002 and to pay no employee bonuses, and to achieve and maintain profit- ability in the first and second quarters of 2003, which, in turn, caused it to pay bonuses to all Nortel employees and significant bonuses to senior management under bonus plans tied to a pro forma profitability metric.
The failure to follow U.S. GAAP with respect to provisioning can be understood in light of the management, organizational structure, and internal controls that characterized Nortel’s finance organization. These characteristics, discussed below, include:
• Management “tone at the top” that 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 with U.S. GAAP and that questioning these practices was not acceptable;
• Lack of technical accounting expertise which fostered accounting practices not in compliance with U.S. GAAP;
• Weak or ineffective internal controls which, in turn, provided little or no check on inaccurate financial reporting;
• Operation of a complicated “matrix” structure which contributed to a lack of clear responsibility and account- ability by business units and by regions; and
• Lack of integration between the business units and corporate management that led to a lack of transparency regarding provisioning activity to achieve internal EBT targets.
Nortel posted significant losses in 2001 and 2002 and downsized its work force by nearly two-thirds. The remaining employees were asked to undertake significant additional responsibilities with no increase in pay and no bonuses. The Company’s former senior corporate management asserted, at the start of the inquiry, that the Company’s downturn, and concomitant down- sizing of operations and workforce, led to a loss of documentation and a decline in financial discipline. Those factors, in their view, were primarily responsible for the significant excess provisions on the balance sheet as of June 30, 2003, which resulted in the First Restatement. While that downturn surely played a part in the circumstances leading to the First Restatement, the root causes ran far deeper.
When Frank Dunn became CFO in 1999, and then CEO in 2001, he drove senior management in his finance organization to achieve EBT targets that he set with his senior management team. The provisioning practices adopted by Dunn and other finance employees to achieve internal EBT targets were not in compliance with U.S. GAAP, particularly Statement of Financial Accounting Standards Number 5 (“SFAS 5”). SFAS 5, which governs accounting for contingencies, requires, among other things, a probability analysis for each risk before a provision can be recorded. It also requires that a triggering event—such as resolution of the exposure or a change in estimate— occur in the quarter to warrant the release of a provision. Dunn and other finance employees recognized that provisioning activity—how much to reserve for a particular expo- sure and when that reserve should be released—inherently involved application of significant judgment under U.S. GAAP. Dunn and others stretched the judgment inherent in the provisioning process to create a flexible tool to achieve EBT targets. They viewed provisioning as “a gray area.” They became comfortable with the concept that the value of a provision could be reasonably set at virtually any number within a wide range and that a provision release could be justified in a number of quarters after the quarter in which the exposure, which formed the basis for the provision, was resolved. Dunn and others exercised their judgment strategically to achieve EBT targets.
Third quarter, 2002. At the direction of then-CFO Doug Beatty, a company-wide analysis of accrued liabilities on the balance sheet was launched in early August 2002. The CFO and the Controller, Michael Gollogly, learned that this analysis showed approximately $303M in pro- visions that were no longer required and were available for release. The CFO and the Controller, each a corporate officer, knew, or ought to have known, that excess provisions, if retained on the balance sheet, would cause the Company’s financial statements to be inaccurate and that U.S. GAAP would have required either that such provisions be released in that period and properly disclosed, or that prior period financial statements be restated. Instead, they permitted finance employees in the business units and in the regions to release excess accruals into income over the following several quarters. They acted in contravention of U.S. GAAP by failing to correct the Company’s financial statements to account for the significant excess accrued liabilities. Neither the CFO nor the Controller advised the Audit Committee and/or the Board of Directors that significant excess provisions on the balance sheet had been identified and that the Company’s financial statements might be inaccurate, nor did either suggest such information should be disclosed in the Company’s financial statements.
As a result of this company-wide review, senior finance employees recognized that their respective business unit or region had excess provisions on Nortel’s balance sheet, and directed other finance employees to track these excess provisions. Nortel finance employees had their own distinct term for a provision on the balance sheet that was no longer needed—it was “hard.” Each business unit developed, in varying levels of detail and over varying periods of time, internal “hardness” schedules that identified provisions that were no longer required and were available for release. Finance employees treated provisions identified on these schedules as a pool from which releases could be made to “close the gap” between actual EBT and EBT targets in subsequent quarters.
Fourth quarter, 2002. By mid-2002, employees throughout the Company were being recruited by other companies and morale was low. Corporate management sought to retain these employees but recognized that other public companies had come under criticism for awarding “stay” bonuses in the face of enormous losses. At management’s recommendation, the Board determined to reward employees with bonuses under bonus plans tied to profitability. One plan, the Return to Profit- ability (“RTP”) bonus, contemplated a one-time bonus payment to every employee, save 43 top executives, in the first quarter in which the Company achieved pro forma profitability. The 43 executives were eligible to receive 20% of their share of the RTP bonus in the first quarter in which the Company attained profitability, 40% after the second consecutive quarter of cumulative profitability, and the remaining 40% upon four quarters of cumulative profitability. In order for the RTP bonuses to be paid, pro forma profits had to exceed, by at least one dollar, the total cost of the bonus for that quarter. Another plan, the Restricted Stock Unit (“RSU”) plan, made a significant number of share units available for award by the Board to the same 43 executives in four instalments tied to profitability mile- stones. Once a milestone was met, the Board had discretion whether to make the award.
Through the first three quarters of 2002, Nortel experienced significant losses, and management reported to the Board that it expected losses would continue in the fourth quarter. After the initial results for the business units and regions were consolidated, they showed that Nortel unexpectedly would achieve pro forma profitability in the fourth quarter. Frank Dunn, who had been promoted to CEO in 2001, understood that profitability had been attained from an operational standpoint but determined that it was unwise to report profitability and pay bonuses in the fourth quarter because performance for the rest of the year had been poor. He determined that pro- visions should be taken to cause a loss for the quarter. Over a two day period late in the closing process, the CFO and the Controller worked with employees in the finance organizations in the business units, the regions, and in global operations, to identify and record additional provisions totaling more than $175 million. All of these provisions were recorded “topside”—that is, by employees in the office of the Controller based on information provided by the business units, regions and global operations— because of the late date in the closing process on which they were made. Nortel’s results for the fourth quarter of 2002 turned from an unexpected profit into the loss previously fore- casted by management to the Board of Directors. Neither the CEO, the CFO, nor the Controller advised the Audit Committee and/or the Board of Directors of this concerted provisioning activity to improperly turn a profit into a loss. Nortel has since determined that many of these pro- visions were not recorded in compliance with U.S. GAAP, and has reversed those provisions in the Second Restatement. The loss then reported by Nortel in the fourth quarter meant that no employee bonuses were paid for that quarter.
First quarter, 2003. While Nortel had announced publicly that it expected to achieve pro forma profit- ability in the second quarter of 2003, Dunn told a number of employees that he intended to achieve profitability one quarter earlier, and he established internal EBT targets for each business unit and for corporate to reach that goal. At Dunn’s direction, “roadmaps” were developed to show how the targets could be achieved. These roadmaps made clear that the internal EBT targets for the quarter could only be met through release from the balance sheet of excess provisions that lacked an accounting trigger in the quarter. At the request of finance management in each business unit, finance employees identified excess, or “hard,” pro- visions from the balance sheet, and, together, they determined which pro- visions to release to close the gap and meet the internal EBT targets. That release activity was supplemented by releases, directed by the CFO and by the Controller, of excess corporate provisions that had been identified in the third quarter of 2002 as avail- able for release. Releases of provisions by corporate and by each business unit and region, including excess provisions, totaling $361M, enabled Nortel to show a consolidated pro forma profit in the first quarter, not- withstanding that its operations were running at a loss. The Finance Vice Presidents of the business units and two of the three regions, the Asia Controller, the CFO, the Controller, and the CEO knew, or ought to have known, that U.S. GAAP did not permit the release, without proper justification, of excess provisions into the income statement. Nortel has since determined that many of these releases in this quarter were not in accordance with U.S. GAAP, and has reversed those releases in the First and Second Restatements and restated the releases into proper quarters. When presenting the preliminary results for the quarter to the Audit Committee, the Controller inaccurately represented that the vast majority of these releases were “business as usual” and in compliance with U.S. GAAP, and that the remaining releases were one time, non-recurring events and in compliance with U.S. GAAP. Further, the CFO and the Controller failed to advise the Audit Committee and/or the Board of Directors that release of excess corporate provisions was required to achieve profitability and make up for the shortfall in operational results; that such releases were needed to cover the cost of the bonus compensation; that no event in the quarter triggered the releases (as required by U.S. GAAP); that the releases implicated Staff Accounting Bulletin 99 (relating to materiality) because they turned a loss for the quarter into a profit; and that they retained a significant amount of excess provisions on the balance sheet to be used, when needed, in a subsequent quarter. In separate executive sessions held by the Audit Committee with the CFO and the Controller, neither the CFO nor the Controller raised quality of earnings issues nor questioned the payment of the RTP bonus. Based on management’s representations, the Audit Committee approved the quarterly results, and the Board approved the award of the RTP bonus.
Second quarter, 2003. Seeking to continue to show profitability in the second quarter and meet the first RSU milestone and the second tranche of the RTP bonus, senior corporate management developed internal EBT targets to achieve pro forma profitability. As was the case in the first quarter, it became clear during the quarter that operational results would be a loss. At the request of finance management in each business unit, finance employees again identified “hard” provisions from the balance sheet, and, together, they determined which provisions to release to close the gap and achieve the internal EBT targets. Nortel has since determined that many of these releases were not in accordance with U.S. GAAP, and has reversed those releases in the First and Second Restatements and restated the releases into proper quarters. In both the first and second quarters of 2003, the dollar value of many individual releases was relatively small, but the aggregate value of the releases made the difference between a pro forma loss and profit in each quarter.
The CEO, the CFO and the Controller failed to advise the Audit Committee or the Board of Directors that operations of the business units were running at a loss during the second quarter and that the validity of many of the numerous provision releases, totaling more than $370 million, could be questionable. Based on management’s representations, the Audit Committee approved the quarterly results, and the Board approved payment of the second tranche of the RTP bonus and awarded restricted stock under the RSU plan.
Third and fourth quarters, 2003. In light of concerns raised by the inappropriate accounting judgments outlined above, the Audit Committee expanded its investigation to deter- mine whether excess provisions were released to meet internal EBT targets in each of these two quarters. No evi- dence emerged to suggest an intent to release provisions strategically in those quarters to meet EBT targets. Given the significant volume of pro- vision releases in these two quarters, the Audit Committee directed man- agement to review provision releases, down to a low threshold, using the same methods used to evaluate the releases made in the first half of the year. This review has resulted in additional adjustments for these quarters, which are reflected in the Second Restatement.
Governing Principles for Remedial Measures
The Audit Committee asked WCPHD to recommend governing principles, based on its independent inquiry, to prevent recurrence of the inappropriate accounting conduct, to rebuild a finance environment based on transparency and integrity, and to ensure sound financial reporting and comprehensive disclosure. The recommendations developed by WCPHD and provided to the Audit Committee were directed at the following:
• Establishing standards of conduct to be enforced through appropriate discipline
• Infusing strong technical skills and experience into the finance organization
• Requiring comprehensive, ongoing training on increasingly complex accounting standards
• Strengthening and improving internal controls and processes
• Establishing a compliance program throughout the company which is appropriately staffed and funded
• Requiring management to provide clear and concise information, in a timely manner, to the board to facilitate its decision making
• Implement in g a n information technology platform that improves the reliability of financial reporting and reduces the opportunities for manipulation of results
These recommendations were grouped into three categories— people, processes and technology which after thorough consideration, the Audit Committee has recommended and the Board of Directors has approved, adoption of each.
In summary form, these recommendations included the following:
People:
• Creation of an effective “tone at the top” through effective policies, procedures, and an awareness and commitment to fiduciary duty, accountability, and accuracy, particularly in financial reporting.
• Termination for cause of the CEO, CFO, controller, and seven additional senior officers.
• Return of RTP and RSU bonus payments.
• Clarification through training and other means (appropriate experience) that failure to adhere to U.S. GAAP will not be tolerated.
• External recruiting of individuals with strong accounting and reporting skills and expertise and proven records of integrity and ethical behavior, particularly in key finance positions.
• Enhancement and bolstering of often bypassed internal “technical accounting group.”
• Review and improve the training function. Clarify through training the accounting issues that lead to restatement, confirm knowledge and under- standing of the company code, and secure sign-offs testifying to reading and adherence. Introduce ongoing training requirements.
Processes:
• Remedial improvements to the control structure to permit sound corporate oversight—internal controls noted included financial policies, organizational structure, systems, processes, employees, leadership, and culture focused to foster accurate financial reporting and disclosure in a timely manner.
• Reexamination of the matrix structure and the specification of key responsibility for liability provisions that has been unclear.
• Confirmation of the role of the controller and the control structure—who should have the sole authority to release liability provisions—and the development of transparency of reporting standards.
• Reexamination and rewriting of Nortel’s accounting policies.
• Strengthen internal audit function and standards to provide a check on the integrity of financial reporting.
• Recruitment of a chief ethics and compliance officer; active, overt commitment to the new Nortel Code of Conduct; and the direction of management to reinforce and enhance the compliance program carrying this message to all employees.
• The Board and Audit Committee should regularly review the activities of the compliance officer and the related policies and performance involved.
• The board is to receive all necessary information for adequate review of policies and activities in a timely manner. Reports should be received from more than just the CFO, and meetings should be included with the chief operations and finance employees for each business unit.
Technology:
• The announced installation of a SAP information technology platform should be implemented such that the necessary and needed control elements are incorporated.
Board of Directors and Audit Committee
Guylaine Saucier, who sat on the board and its Audit Committee, has since stated that “directors were shocked to learn after an internal review in 2004”7 of the alleged manipulations that triggered the RTP bonus. She went on to say,
“What was the board’s reaction? First of all, it’s emotional. You feel betrayed,” Ms. Saucier said. “You trusted your management…”
Since then, Ms. Saucier said she has reflected on how a board can scrutinize a CEO to decide whether he or she has the right standards for the job, but said it is difficult because it comes down to many small elements that occur outside the boardroom.
“If the board had known that Frank Dunn was building a $12-million house for himself while we were let- ting go 60,000 people, would that be an element in our overall judgment? These are anecdotes. It’s very difficult to say somebody is ethical or unethical.”
Ms. Saucier also rejected the criticism that the company’s com- pensation plan created too much temptation for manipulation. She said most companies have bonuses based on performance.
“It depends on the people. If you have people with good ethical values, you won’t have any problems having a performance bonus.”
She said she has begun to question whether chief financial officers should be paid bonuses based on corporate performance, given that they are responsible for preparing finan- cial statements. 8
The directors did not bail out on Nortel. They hired a former U.S. admiral and member of the Joint Chiefs of Staff, Bill Owens, to be the new CEO and preside over the recovery of their company. This process was not without challenges since the directors were sued by aggrieved shareholders and by the company’s insurer, Chubb Insurance Co. Chubb wanted to rescind $40 million insurance coverage for the legal costs of defending Nortel and twenty of its officials because Nortel’s CEO (Frank Dunn), CFO (Douglas Beatty), and controller (Michael Gollogly) “made material misrepresentations with stock market regulators with the intent to deceive Chubb.”9
One of the new hires, as chief ethics and compliance officer, was Susan E. Shepard, a former commissioner for the New York State Ethics Commission and, earlier, assistant U.S. district attorney for the East- ern District of New York. Interestingly, the company announced on January 13, 2005, that “Ms. Shepard will receive a base salary of U.S.$375,000 (per annum) and will be eligible for a target annual bonus of 60% of base salary under the annual bonus plan of NNL (known as the SUCCESS Incentive Plan), based on the generally applicable performance criteria under such plan.”10
“Susan Shepard is not the first Nortel ethics guru. That distinction belongs to Megan Barry, who served as Nortel’s senior ethics advisor between 1994 and 1999.”11 As Megan noted, Nortel was once a world leader in ethics. “By the time she left, how- ever, Nortel wasn’t really a trailblazer in ethics anymore.” When John Roth took over as CEO in 1997, her department grew increasingly invisible within the organization. “When the senior leadership changed, you definitely saw a de-emphasis of ethics,” she says. “Roth’s legacy is what Nortel has to deal with today.”12
On February 8, 2006, Nortel announced that it had settled two shareholder lawsuits in relation to this accounting scandal for a maximum total of U.S.$2.47 billion.13
Questions
1. Why would Nortel Networks, a Canadian company, hire a U.S. law firm to undertake an independent review of factors that led to restatement of accounting reports?
2. Why did the independent review focus on the “establishment and release of contractual liability and other related provisions” (also called accruals, reserves, or accrued liabilities)? 14
3. How did the failure to follow U.S. GAAP permit the manipulation of Earnings Before Taxes (EBT) and lead to fraudulent behavior?
4. Describe the Nortel Return to Profitability (RTP) and Restricted Stock Units (RSU) bonus plans. What did the board of directors expect these plans to achieve?
5. Were the misstatements of EBT and bonuses paid material in an accounting sense?
6. Why did Nortel’s auditor not discover the misstatements?
7. Why did the Audit Committee (or board as a whole) not anticipate the manipulation?
8. What questions should the Audit Committee or board have asked?
9. What internal control flaws permitted the fraudulent manipulation to occur without detection?
10. Would the new requirements spawned by SOX and its SEC regulations have prevented the manipulation per se? Why or why not?
11. How have the expectations of the Audit Committee changed since SOX with regard to corporate culture, why is this so, and how can the Audit Committee ensure that these are met?
12. Should the Audit Committee or the whole board be held legally liable for the weaknesses noted in the review? Why and why not?
13. In February 2005, Nortel hired a new chief ethics and compliance officer using an incentive compensation scheme based on profits. Is this a sound arrangement?
14. Nortel has issued a new code of con- duct with striking similarity to their previous version. Why might this new code be more effective than the last?
15. In retrospect, what were the major failings of the Nortel Audit Committee? Were they the same as those for the board as a whole?