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Report alleges ex-CEO Frank Dunn and key executives improperly shifted loss provisions to achieve 2002-03 financial targets and trigger bonuses
TYLER HAMILTON
TECHNOLOGY REPORTER
Those who have worked with Frank Dunn know that the former chief executive of Nortel Networks Corp. was a finance man to the core, focused on numbers and driven to meet targets.
The damning report filed this week with the U.S. Securities and Exchange Commission and the Ontario Securities Commission reached the same conclusion, alleging in alarming detail that Dunn and key senior finance officers concocted a plan that led to the manipulation of 2003 profits, triggering a lucrative bonus payout for the executives involved.
The report, which contains the findings of a 15-month independent review, was prepared by Washington-based law firm Wilmer Cutler Pickering Hale and Dorr LLP. It was part of Nortel's 2003 audited financial report.
What follows is a summary of what the report concludes. The subjects of the report have not commented on the document.
"When Frank Dunn became CFO in 1999, and then CEO in 2001, he drove senior management in his finance organization to achieve (earnings before tax) targets that he set with his senior management team," according to the report.
Concern over accounting irregularities at Nortel first emerged in July 2003, when auditor Deloitte & Touche LLP alerted the company's audit committee to "deficiencies in documentary support" for certain provisions and accruals on Nortel's balance sheet.
An inquiry was launched that summer, but early on Dunn and his senior financial officers, all of whom have since been fired from Nortel, blamed the irregularities on a downturn in the telecommunications sector. Nortel was forced to axe 60,000 employees, or two-thirds of its workforce, in the aftermath. Remaining employees in Nortel's finance department were forced to take on extra work with no bonuses, and this had a dramatic impact on their morale. Dunn and members of his management team, according to the report, claimed that the downturn and resulting confusion led to a loss of documentation and a decline in financial discipline. Nortel's review came to a different conclusion: "While that downturn surely played a part in the circumstances ... the causes ran far deeper."
The report alleges that in early August 2002, Douglas Beatty, who was Nortel's CFO at the time and reported to Dunn, instructed finance employees across the global organization to dig deep into Nortel's books to analyze "accrued liabilities."
Accrued liabilities are provisions put on balance sheets in anticipation of future expenses related to anything from uncollectible or disputed contracts to the costs associated with job cuts. They're basically funds put in a reserve account to help reduce known risks.
Nortel finance staff called unnecessary or excess provisions "hardness," and their assignment over a number of financial quarters was routinely to find hardness in each of the company's business units.
When the troops reported back, Beatty and Nortel's controller, Michael Gollogly, discovered that the company had a whopping $303 million (U.S.) in hardness. According to U.S. Generally Accepted Accounting Principles, these excess provisions should have been reported as income at the time of discovery or disclosed by restating past financial results.
Beatty and Gollogly allegedly ignored these U.S. accounting standards, and exercised judgment far beyond what was acceptable under the rules. "Instead, they permitted finance employees in the business units and in the regions to release excess accruals into income over the following several quarters," the report alleges.
"Finance employees treated provisions ... as a pool from which releases could be made to `close the gap' between actual (earnings) and targets in subsequent quarters."
Perhaps more alarming, both executives also allegedly kept Nortel's audit committee and board in the dark.
"It was all centralized at the top," said Charles Smedmor, a forensics accountant with Toronto-based Smedmor & Associates. "This was not about a few bad apples. This was the chief bad apple making inappropriate decisions."
It's important to put what was happening in the fall 2002 into context. Morale at Nortel is sinking, putting Dunn in a pinch. He didn't want employees fleeing to competitors, but he also didn't want to give out so-called stay bonuses while the company was bleeding losses. It wouldn't sit well with investors.
The best compromise, Dunn figured, was to create two bonus plans that were tied to profitability. The first, called the "return to profitability" bonus, was a one-time payout to most employees. It would be triggered when the company reached its first profitable quarter.
The plan applied differently to Nortel's 43 top executives, including Dunn. They would get 20 per cent of their bonus during the first quarter of profitability, another 40 per cent of that bonus if the next quarter had even more pre-tax profits, and the rest of the bonus if the third consecutive quarter had even higher earnings.
Another bonus plan for these same 43 executives, called the "restrictive stock unit" plan, involved profit milestones. Bonuses were given under the discretion of Nortel's board, which approved both bonus plans.
Dunn told the board he didn't expected that the company, after three quarters of losses in 2002, would become profitable in the fourth quarter. To his surprise, the numbers coming in near the end of the fourth were, in fact, pointing to a profit.
Dunn believed it would look bad if Nortel issued bonuses in the fourth quarter after such a dismal first three quarters, the report alleges. He decided to create unnecessary provisions to turn a profit into a loss and, being so late in the quarter, set up what amounted to a command centre from the controller's office.
"Over a two-day period late in the closing process (for the quarter), the CFO and the controller worked with employees in the finance organizations in the business units, the regions, and in the global operations, to identify and record additional provisions totalling more than $175 million," the report alleges.
These actions were done behind the backs of the board. Employees, actually deserving a bonus in the fourth quarter of 2002, got nothing.
As Nortel enters the first quarter of 2003, Dunn has created two versions of reality regarding the company's financial situation. Publicly, he holds that Nortel will become profitable in the second quarter. But documents say he told a number of colleagues his real plan: to achieve profits in the first quarter.
"At Dunn's direction, `roadmaps' were developed to show how the targets could be achieved," the report says. "These roadmaps made clear that the internal (earnings before tax) 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."
The hunt for hardness that first began in August 2002 was launched again. This time, finance employees from business units around the world were able to round up $361 million in excess provisions, including the original $303 million.
To the delight of investors and analysts, Nortel announces its first profit since 1999. "What they wanted to do is they decided they would take the hit for the year 2002, because it was already a write-off, and do things better for the future," said Smedmor.
The process was repeated for a third time as Nortel neared the end of its second quarter in 2003. Dunn and his followers found more "hardness" and improperly shifted more provisions, this time amounting to $370 million, to the income side of the balance sheet.
It wasn't until the third and fourth quarters of 2003 that the shear volume of provisions rang alarm bells, and Nortel's audit committee took a magnifying glass to the provision releases.
Dunn, Beatty and Gollogly were eventually found out.
As part of its review, Wilmer Cutler ripped Nortel for having weak or ineffective accounting controls. William Owens, current CEO, has vowed to get cash from improper bonuses back.