Four former top executives of Nortel Networks Corp have been charged with accounting fraud by the Securities and Exchange Commission, which alleges that they fiddled the figures to meet earnings targets, fabricate profits and pay performance-related bonuses.
It alleges that former CFO and CEO Frank Dunn and finance executives Douglas Beatty, Michael Gollogly and MaryAnne Pahapill engaged in a wide-ranging financial fraud to bridge gaps between its true performance, internal targets and Wall Street expectations.
Dunn, Beatty and Gollogly were all terminated for cause in April 2004, leaving the Toronto, Canada-based telecoms equipment with a huge restatement of its accounts, and a crisis from which it has only recently begun to emerge.
In a suit filed in the US District Court for the Southern District of New York, the SEC claims that the motive behind the fraud was to meet unrealistic revenue and earnings guidance that they had provided to Wall Street.
They also wanted to create the false appearance that, because of their leadership and planning, Nortel was weathering the economic downturn better than its competitors, the SEC claims. Later, they created a false appearance that, because of their leadership and planning, Nortel had stabilized and returned to profitability for the first time in over three years.
The four also wanted to pay bonuses to themselves and other Nortel executives, according to the SEC.
In its background to the case, the SEC says that in the late 1990s, the US economy experienced substantial and rapid growth in the telecommunications and internet sectors. In 2000, however, those sectors contracted significantly and demand for products used by the sector waned.
By September 2000, it says that Nortel’s revenues began to slip from internally budgeted amounts by hundreds of millions of dollars. Orders began to soften and anticipated revenues from many customers failed to materialize.
By mid-October 2000, Nortel’s finance managers and executives estimated that the Company’s results were falling short of its 2000 revenue goals by almost $2bn, and anticipated a similar shortfall in the first half of 2001.
Although both Nortel’s competitors and its customers were similarly affected by this dramatic slowdown, Nortel did not share its bad news with Wall Street. Instead, the SEC says that Nortel continued to claim that it would experience substantial growth for the remainder of 2000 and into 2001, despite its reduced expectations internally.
It says that in late 2000, Beatty and Pahapill implemented changes to Nortel’s revenue recognition policies that violated US GAAP, specifically to pull forward revenue to meet publicly announced revenue targets. Their actions improperly boosted Nortel’s fourth quarter and fiscal 2000 revenue by over $1bn.
The SEC claims that in November 2002, Dunn, Beatty and Gollogly learned that Nortel was carrying over $300m in excess reserves. They did not release these excess reserves into income as required under US GAAP. Instead, they concealed their existence and maintained them for later use.
In early January 2003, Beatty, Dunn and Gollogly directed the establishment of yet another $151m 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 Nortel’s pro forma profit for the fourth quarter of 2002 and caused it to report a loss instead.
In the first and second quarters of 2003, it says Dunn, Beatty and Gollogly directed the release of at least $490m of excess reserves specifically to boost earnings, fabricate profits and pay bonuses. These efforts turned Nortel’s first quarter 2003 loss into a reported profit under US GAAP, which allowed Dunn to claim that he had brought Nortel to profitability a quarter ahead of schedule.
In the second quarter of 2003, the SEC says their efforts largely erased Nortel’s 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, the SEC says Dunn and Beatty repeatedly misled investors as to why Nortel was conducting a purportedly comprehensive review of its assets and liabilities, which resulted in Nortel’s restatement of approximately $948m in liabilities in November 2003.
It says Dunn and Beatty falsely represented to the public that the restatement was caused solely by internal control mistakes. In reality, the SEC argues that Nortel’s 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 Gollogly’s earnings management activities.
The complaint charges Dunn, Beatty, Gollogly and Pahapill with violating and/or aiding and abetting violations of the antifraud, reporting, books and records, internal controls and lying to auditors provisions of the federal securities laws. Dunn and Beatty are separately charged with violations of the officer certification provisions instituted by the Sarbanes-Oxley Act.
The SEC is seeking a permanent injunction, civil monetary penalties, officer and director bars, and disgorgement with prejudgment interest against all four defendants.
This is only the first court action to be taken against the four. In August 2004, the Integrated Market Enforcement Team of the Royal Canadian Mounted Police said it was mounting a full-scale investigation into allegations that the figures at Nortel were massaged to exaggerate losses during the recession and then overstate a recovery to enhance executive bonuses.