January 12, 2012
In a case that spans well over 4 years now, 3 ex Nortel executives are finally set to appear in Ontario courts for allegedly violating securities law. The accused currently stand charged with two counts of fraud and one count of making a false accounting entry. The accused had originally been charged with 4 other charges as well, but a charge related to omitting “a material fact” from financial documents and three counts related to “circulating or publishing a false statement or account” were dropped. These were similar to the remaining counts, but leave the core fraud allegations intact. To note, fraud charges carry a maximum penalty of 14 years under the Criminal Code. It is also important to mention the Conservative government’s newer tough on crime policies are on the books, and if the parties involved are convicted of a fraud over $1 million, then the new law requires a minimum jail sentence of 2 years.
During the time the incidents occurred, Dunn served as the CEO, Beatty as the CFO and controller, and Gollogly as assistant controller. Each of them have elected a trial by judge only and the Chief Justice to preside over the case is Mr. Justice Frank Marrocco, an experienced judge in financial securities matters.
According to the court documents, the 3 defendants – Frank Dunn, Douglas Beatty, and Michael Gollogly, are charged, “between January 1, 2000 and April 28, 2004, in the Province of Ontario, and elsewhere in Canada and elsewhere in the United States of America did by deceit, falsehood or other fraudulent means, defraud the public of property, money, or valuable security…and Nortel Networks Corporation (NNC) of property, money, or valuable security having a value exceeding $5000.00 to wit: by deliberately misrepresenting the financial results of Nortel Networks Corporation (NNC), contrary to section 380(1)(a) of the Criminal Code of Canada.” They have also been charged contrary to section 397 (1) of the Criminal Code as well. During Thursdays pre-trial court hearing, it was found that 4 of the 7 charges were dropped. The lead prosecution Crown attorney Robert Hubbard said the four dropped charges were “duplicative“.
The RCMP charges allege that the defendants, including ex-Nortel chief executive Frank Dunn, engineered an elaborate accounting fraud to mask falling Nortel sales after the dot.com stock bubble burst in the spring of 2000.
According to prosecutors, the fraud cost Nortel’s shareholders billions with Nortel now sunk into creditor protection.These criminal charges are set to begin almost four years after the RCMP originally charged ex CEO Dunn, ex CFO Beatty, and assistant controller Gollogly with the charges. If the trio are found convicted by the judge, the maximum sentences under law are 14 years for fraud affecting markets, 5 years for falsifying accounts, and 10 years for filing a false prospectus. The three executives were fired by Nortel’s board under “due cause” in 2004 following an audit investigation into the company’s finances.
In 2007, the Securities and Exchange Commission (financial regulator) filed civil charges against former Nortel executives including Dunn, Beatty, Gollogly. The SEC alleges the former Nortel executives concocted a scheme to improperly book sales and manipulate cash reserves in an effort to bump up Nortel financial results to meet Wall Street expectations and trigger bonus payouts. The documents filed by US regulators back in 2007 showed that outside auditor Deloitte & Touche LLP helped uncover the accounting fraud committed by Nortel. The accounting scandal at Nortel, initially discovered in 2004, led to a plunge in the company’s shares. Nortel appeared to return to profitability under Dunn until March 2004, when the company said it would delay filing audited financial statements for the preceding year.
There was eventually an Ontario Securities Commission settlement with the company that saw Nortel pay $1 million and prompted a criminal investigation by the RCMP. According to the OSC settlement filings, under point 4: “..Nortel expressly denies that this Settlement Agreement is intended to be an admission of civil or criminal liability by Nortel and Nortel expressly denies any such admission of civil or criminal liability.” According to the filing, Nortel’s conduct at issue related to Nortel’s financial results for the fiscal year ended Dec 31, 2000, the Q3, Q4 of 2002 and Q1, Q2 of 2003. All of these time periods are collectively referred to as “Material Time”. As found under point 11: “During the Material Time, the emphasis by former members of Nortel’s senior corporate finance management on meeting revenue and/or earnings targets led to a culture within the finance organization of Nortel that condoned two types of inappropriate accounting practices which did not comply with applicable GAAP and were contrary to the public interest.” The court documents also include the summary of findings and of recommended remedial measures of the independent review that was submitted to the audit committee of the boards of directors of Nortel Networks. Found on page 30 of 64.
—-The case before the story—-
Three former executives from the former Nortel Networks Corp. settled charges brought from the Securities and Exchange Commission (SEC). The members involved; Craig Johnson, James Kinney, and Kenneth Taylor were vice presidents for Wireline, Wireless, and Enterprise business units of Nortel respectively and each admitted to the commission’s allegations, without admitting to them or being forced to admit guilt. The final judgement unraveled a penalty of $75,000 dollars and each of them were not allowed to act as an officer or director for any public company for five years. Meanwhile, the Royal Canadian Mounted Police (RCMP) also pursued the case north of the border, targetting several other executives. The SEC’s compliant alleged that Johnson, Kinney, and Taylor acted on the orders of former Nortel executives Frank Dunn, Douglas Beatty, and Michael Gollogly, and engaged in manipulating Nortel’s earnings by establishing about $37 million in unncessary reserves during the Q4 of 2002 in order to suppress an unexpected profit and pat Nortel’s consolidated financial results. They were accused of releasing about $213 million in excess reserves into income in order to establish profits deemed fictitious for the first and second quarters of 2003. This in turn triggered the payment of “return to profitability” bonuses to Nortel’s employees and officers.
Nortel’s story runs back 11 years ago in 2000, when originally, demand for telecommunications equipment fell due to the dotcom bust. Despite the dynamics in the changing market – Nortel did not revise its full-year revenue forecast, and began to look at ways to achieve the current goals it set. The SEC alleged, that Beatty and assistant controller Pahapill, considered bringing back “bill and hold” transactions, and they had asked Deloitte for information on “bill and hold” rules in October of 2000. These “bill and hold” transactions allowed for revennue to be booked, even though it hadn’t been delivered yet. The outcome of this was that Nortel was able to pull forward more than $1 billion in revenue in 2000 to meet its targets and Dunn provided Deloitte with a letter that the SEC alleged included false statements about 2,000 results including statements that they complied with generally accepted accounting principles (GAAP). A few years later another accounting scheme emerged, and in Q1 of 2003, Dunn, Beatty, and Gollogly issued the release of “Reserves” or liabilities in order to post a profit, thus triggering bonus payments. In March 2003 Deloitte was alerted to the release of some reserves, and inquired for more supporting documentation from Nortel. In July of 2003, Deloitte asked Nortel to hold some of the reserves until it was able to produce backup documents for verification. Nortel’s plan could not proceed and Nortel reported a US GAAP loss for the quarter although it showed a “pro forma” profit necessary to pay [return to profitability] bonuses that quarter. Even Nortel’s climate seemed not to tolerate missing earnings estimates, as would have been the case in 2000, where it had $2 billion below expectations. According to SEC filings, “In that [Nortel] environment, accounting did not serve to measure Nortel’s performance. Instead, Nortel’s executives and finance managers treated their books as tools to meet the company’s financial objectives.”
In November of 2000, Beatty placed a conference call with senior staff on talks that Nortel was experiencing difficulty in meeting earnings estimates and so he proposed using “bill and hold” accounting. In which inventory can be considered “sold” even when a customer hasn’t taken possession of it. In that very month, Nortel salesmen approached customers and offered many incentives such as price discounts, interest deferments, and extended billing terms if they agreed to place further orders for delivery in 2001. The SEC alleged that the strategy was “in complete disregard” of U.S. accounting rules and that the vast majority of transactions “had no substantial business purpose.” Nortel recorded 1 billion additional revenue through the improper bill and hold transactions in late 2000, 633$ million more than it needed to meet its projected financial targets.
In 2001 the previous CEO stepped down and Dunn took the top position, and in mid 2002 – Dunn advised investors that the worst was over, promising expectations that Nortel would return to profitability by mid 2003. The company set up a controversial return-to-profitability bonus plan to encourage employees to meet that target. And the same situation unfolded, as over optimistic promises of earnings potential led to more manipulation of those earnings. By Q4 of 2002, it was known that Nortel could not meet the 2003 earnings targets, so Dunn and others took steps to turn the company’s inflated accounting reserves (liabilities that were overstated and available to be reversed in the future to bolster earnings).” Dunn,Beatty, and Gollogly decided to hide the nature of the reserves (which should have been restated to earlier financial results in order to reverse the excess reserves ~ for normal accounting treatment).
By Q1 2003, Nortel saw its forecasts for profit fall even more sharply for the year and instead of projected profits of 22 million for the year, the company forecasted a 44$ million loss. This threatened their June deadline they had promised investors for a return to profitability, and it also threatened their ability to pay out bonuses. So Dunn then called for more unrealistic and over aggressive profit targets for the year and set plans to release more reserves to meet targets. Nortel released 372$ million more from reserves during Q2,and reported a “pro forma profit” for the quarter. The results of this triggered the return to profitability bonuses as well as special issue of share units to executives.
From both, Dunn reaped $6.5 million, Beatty with $2.4million, and Gollogly with $1.4 million.
The whole story unwrapped in early 2004 when Nortel’s board of directors hired independent investigators to probe into the company’s accounting (Auditor report can be found in Schedule B of the SEC settlement document above). In the spring, Dunn and colleagues were fired with cause. In 2006, Nortel acknowledged their restate revenues were part of management fraud.
The trial into this court case will be begin on Monday January 16th, 2012 and expected to continue for the next six months as all of the evidence is examined.