Nortel case study

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NORTEL NETWORKS CORPORATION*

ETHICAL MISSTEPS

Linda A. Robinson

Centre for Accounting Ethics School of Accountancy University of Waterloo Waterloo ON N2L 3G1

June 2005

* This case has been developed from publicly available information solely for discussion purposes and does not purport to be a complete and accurate recounting of all relevant

facts, events and conditions.

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Acknowledgment:

I would like to thank Efrim Boritz, Allan Foerster and Alister Mason for their helpful comments on this case

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NORTEL NETWORKS CORPORATION

Learning Objectives

This case is designed for use in an ethics, auditing or corporate governance course. Through the case, students are encouraged to consider how a corporation once considered a Canadian jewel could lose its way ethically.

Background

It has been a long road that brought Nortel Networks Corporation (“Nortel”) to its present state. Northern Telecom, known as Northern Electric until 1976, was at one time a wholly owned subsidiary of Bell Canada. By the mid 1980’s Northern Telecom was the second largest supplier of telecommunications equipment, largely electronic telephone switches, in North America. Northern Telecom expanded worldwide firstly into Asia then Europe, followed by Latin America. In 1995 Northern Telecom shortens its name to Nortel. Bell Canada, later known as BCE, divested its interest in Northern Telecom throughout the 1970’s owning just over 50 percent by 1980. Finally in 2000, BCE distributed its remaining ownership interest in Nortel to the shareholders of BCE.

Not only was Nortel a telecommunications company, it was a major research powerhouse, receiving substantial support from provincial and national governments. The bulk of Nortel’s R&D was done in Canada to take advantage of generous R & D tax incentives.

Nortel, despite its large size, international shareholders and global reach, was still a “Canadian” company, with the majority of its management and board of directors’ Canadian citizens.

It was John Roth (“Roth”) CEO who took Nortel from traditional telephone technology to the Internet.1 Nortel equipment carried 75 percent of the North American Internet traffic in the late 1990’s. The company’s growth was due to both the explosion in the Internet market and through acquisitions. In 2000 alone, Nortel acquired 11 companies at a cost of US$19.7 billion. By 1998, Nortel was Canada’s largest telecommunication company with 73,000 employees and revenues of US$22 billion.2

The bubble burst when Nortel’s customers stopped buying telecom equipment in the great high-tech bust in 2001. As the industry imploded, Nortel seemed the most secure, until it announced huge declines in prospective sales.

1 CBC.CA News Nortel: Canada’s Tech Giant, May 2, 2005 2 CBC.CA News Northern Telecom buys American firm Nov 13, 1998

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During 2000, Nortel, with over 3.8 billion shares outstanding, accounted for greater than one third of the value of the entire S&P/TSX 300 composite index. Nortel shares peaked at the end of July 2000 at Cdn$124.50, giving Nortel a total market capitalization of $473.1 billion. As a secure, growing Canadian company, the company’s shares were held in a large number of institutional and private investor portfolios. In addition, due to Canada’s restrictive rules with respect to pension plans’ investing in foreign securities, Nortel was the most widely held security in Canada. The shares took a two-year slide bottoming out in September 2002 at under Cdn$1. The once mighty Nortel risked being de-listed from the NYSE, which, under exchange rules, can happen if a stock closes below US$1 for 30 consecutive trading days.3 By 2002, Nortel’s long-term debt was downgraded to “junk” status.

The desperate times from mid 2000 through 2002 called for desperate measures. Roth, who had been named Canada’s ‘business leader of the year’ in 2000, announced in April 2001 his intention to step down as CEO . Roth was replaced as CEO in October 2001 by Frank Dunn (“Dunn”), CMA, Nortel’s CFO since 1999. In 2001, Nortel reduced its workforce by 50% to 45,000 with a further 10,000 job cuts in 2002.

In the third quarter of 2002, CFO Doug Beatty directed a company-wide analysis of provisions. Upon completion, Controller Michael Gollogly reported an excess of $303 million of accruals much of which had been left over from charges taken in prior years. Upon determination of the excess, GAAP required that the accruals be immediately released to income. Both Beatty and Gollgoly, officers of the Company withheld disclosure of their discovery from the Audit Committee and the Board. From this point forward, senior divisional finance managers were instructed to report the “hardness” of any excess provisions they were carrying in their divisional records.

During the close of Q4 2002, it was determined that Nortel would report profitability on an “internal” pro forma basis. Under the direction of Frank Dunn, Beatty and Gollogly undertook another review that resulted in a “top-side” increase of $175 million to the reserve account producing a loss and increasing the “hardness” of consolidated provisions. Unlike the reserves that were identified in the second quarter that mainly related to previously estimated cost for restructuring these new reserves were related to valuations estimates on accounts receivable and inventory.

Morale at Nortel was quite low by mid 2002, after the employee base of the company had shrunk to one third of pre-2001 level. Bonus plans involving stock options were substantially “out-of-the-money.” To motivate the remaining employees and convince them to stay at Nortel, the board of directors established a bonus plan tied to profitability. One plan, called the Return to Profitability (“RTP”) bonus, was to pay a one-time bonus to every employee, except the 43 most senior executives, in the first quarter the company achieved a pro forma profit. The senior 43 executives were eligible to receive 20 percent of their share of the RTP bonus in the first quarter in which Nortel attained profitability, 40 percent after the second consecutive quarter and the remaining 40 percent upon the 3 CBC.CA News Nortel: The wild ride of Canada’s most watched stock, May 2, 2005

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fourth quarter of cumulative profitability. In order for the RTP bonuses to be paid, the pro forma quarterly profit had to exceed the bonuses paid by at least one dollar. Further, the 43 executives were eligible to receive Restricted Stock Units (“RSU’s”) tied to internal profit targets. The RTP and RSU allocations were based on internal, non-GAAP metrics. Deloitte & Touche LLP who audited Nortel’s annual financial statements did not audit the quarterly statements upon which the bonuses were calculated. Nortel paid out approximately US$50 million in bonuses to the select group of officers based on the pro forma financial statements after profits were reported during the second quarter of 2003. Dunn’s share was US$2.15 million.

At a Board meeting in January of 2003, management indicated that Q1 was going to be a loss of approximately $110 million despite the drastic restructuring that had taken place in previous years. By the close of the quarter, the loss had in fact turned into a US$54 million profit in the first quarter of 2003, its first profit in three years. This resulted in the payment of the RTP cash bonus to virtually all employees and the first tranche to 43 executives. Behind the scenes, Dunn and the finance team had established “roadmaps” that would achieve internal EBT targets by the timely, but non-GAAP release of provisions to income. The Q1 2002 results were inflated by the release of $361 million of accruals to income. Dunn, Beatty and Gollogly continued to represent these adjustments to the Audit Committee and Board as “business as usual”.

In August 2003, Nortel posted a second quarterly profit. The profit was the direct result of $370 million in excess provisions released to income. The 43 executives now received the second tranche of RTP and the RSU’s. On October 23, 2003, in the same press release that Nortel announced third quarter earnings of US$179 million, it advised that a restatement of previous financial statements was required. The restatement would affect the financial statements back to 2000, reducing previously reported net losses and increasing net assets.

As is often the case, the board of directors established a Special Committee to review the reasons for the restatement. The US law firm of Wilmer Cutler was engaged to assist the Special Committee in their review of the restatement. As a result of the review, it was determined that a second restatement of Nortel’s financial statements would be required. The second restatement was completed with the issuance of the December 31, 2003 financial statements on January 10, 2005.

As a result of the review, ten employees were terminated for cause including the CEO, Frank Dunn, the CFO Douglas Beatty and the Controller Michael Gollogly. The remaining seven employees all held senior finance positions throughout the global operating units of Nortel. They were all requested to repay bonuses received. A further twelve senior executives who were not terminated, voluntarily agreed to repay their bonuses. William Owen, a former Admiral in the US Navy, and deputy chief of the US Joint Chiefs of Staff, replaced Dunn as CEO.