How the telecom boom pushed Nortel into questionable behaviour
James Bagnall
The Ottawa Citizen
Saturday, March 17, 2007
http://www.canada.com/ottawacitizen/news/story.html?id=8735348a-0256-4872-a53e-8dfaefc160a0&k=86840
It may have been the most reckless conference call Nortel Networks ever made.
On Jan. 18, 2001, with his industry already under deep stress, CEO John Roth told dozens of financial analysts his company had closed the books on a brilliant year with the prospect of more to come.
Roth said Nortel's sales in 2000 had reached $30 billion (all figures in U.S. currency) -- up an astonishing 42 per cent from the previous year. He also projected "continuing strong market demand" for his company's telecommunications products. Nortel's chief financial officer, Frank Dunn, echoed his boss's optimism by noting he expected sales and earnings would jump 30 per cent in 2001.
The projections would prove to be pure fantasy. But investors had no firm basis for suspecting they might have been deliberately misled. That is, until early this week.
On Monday, the U.S. Securities & Exchange Commission charged Dunn and three of his former financial colleagues -- Douglas Beatty, Michael Gollogly and MaryAnne Poland (formerly Pahapill) -- with a "wide-ranging financial fraud" that began as early as Sept. 15, 2000.
None of the charges has been proved in court and the four former Nortel managers have declined to be interviewed. Dunn issued a statement in which he expressed hope that a parallel hearing by the Ontario Securities Commission will allow "the truth to finally come out."
The SEC's civil complaint, which draws upon interviews with former members of Nortel's financial staff, offers some intriguing insight into 2000 -- a critical year that has so far received scant attention from a series of probes into Nortel's financial history. Most investigators to date have focused on the period surrounding the award of "return to profitability" bonuses to executives early in 2003. Nortel the following year sacked 10 of its financial managers -- including Dunn, Beatty and Gollogly (though not Poland) -- for their role in manipulating the accounts to produce early profits.
This week's complaint by the SEC covers wider territory. Especially noteworthy is the commission's description of Nortel's financial managers as they confronted the company's weakening sales prospects on the eve of the telecom industry's collapse.
On Sept. 15, 2000, for example, Dunn purportedly received a set of forecasts from one of Nortel's finance vice-presidents showing that the company would miss its third quarter revenue targets by at least $405 million and earnings by an even larger margin. Four weeks later, according to the SEC, Nortel's finance personnel warned Dunn that the company had lost $1.9 billion worth of potential revenues because customers from mid-September to mid-October were scaling back orders.
Rather than address the central problem -- shrinking demand for fibre optics and other telecom gear -- Dunn and his colleagues created incentives for customers to keep placing orders. The SEC alleges the resulting transactions broke accounting rules.
For instance, as sales slowed during the fall, Nortel accumulated hundreds of millions of dollars worth of optical transmission gear in warehouses. Dunn's financial team, the SEC asserts, converted this inventory into significant revenues through "bill and hold" transactions.
Here's how the deals are supposed to work under generally accepted accounting practices: if a customer is eager to place an order for gear but lacks warehouse space of its own, it can ask Nortel to store the product temporarily. Nortel is entitled to record a sale provided the customer initiated the bill and hold transaction and, among other things, has made a firm commitment to buy the product.
The SEC alleges that Nortel's sales people contravened accounting rules by soliciting bill and hold customers, including ones who had no obvious need for the gear in the particular quarter. These deals generated $1 billion worth of revenue that, under normal accounting rules, should have been recorded after 2000 -- as Nortel itself acknowledged in early 2005 when it corrected the record by reversing a number of revenue entries.
Seen in isolation, Nortel's tactics at the tail end of the telecom boom appear egregious. Yet the desperate hunt for revenues was part of the context of the times.
During much of 2000, Nortel's market value was in excess of $200 billion. The company's managers knew that any failure to deliver stellar growth in sales would be punished severely in the stock markets, thus potentially affecting the value of their stock options and bonuses.
They had seen this occur at Lucent Technologies. Their New Jersey-based archrival had suffered a 50-per-cent drop in its share price from February to August in 2000 as investors realized Nortel was winning more optical networking business.
Nortel's managers, in turn, were shocked when their own firm's share price fell 40 per cent in the final week of October following the publication of third-quarter results. Nortel's sin? It had only just met analysts' expectations.
At Lucent, the pressure to show sales growth poisoned the company's culture. In her book Optical Illusions, author Lisa Endlich describes a late-2001 scene in which Lucent CEO Henry Schacht plays the role of priest.
Standing before nearly 60 of his executives at a corporate retreat, Schacht cited a long list of practices that had corrupted the Lucent name -- bill and hold transactions, buying sales at a large discount, stretching the rules for when to recognize revenues, delaying writeoffs, creating revenues by manipulating the balance sheet.
After mulling Schacht's words, Lucent managers re-
assembled into smaller groups and confessed their sins. "One by one they stood up and told of transactions that they should have walked away from (and deals) they had not had the backbone to refuse," Endlich wrote.
The SEC charged nine Lucent managers in 2004 with fraudulently booking more than $1 billion in revenues and $470 million in pre-tax earnings during the fiscal year ended Sept. 30, 2000.
The SEC alleged two of the executives improperly recognized revenues from products that had merely been shipped to distributors, and not to the ultimate customers. The executives had promised the distributors they would receive full payment even if the customers did not accept delivery -- then failed to tell Lucent's chief financial officer of these verbal agreements.
There was evidence of subterfuge as well at Nortel, according to the SEC. In its complaint made public Monday, the commission alleged that Beatty and Poland misled Deloitte -- Nortel's auditor at the time -- about transactions relating to fourth-quarter revenues in 2000.
The gist of the SEC allegation is that Nortel's campaign to generate extra revenues through bill and hold deals had been too successful -- the finance team realized early in 2001 that they had more than $600 million worth of sales in excess of what was needed to meet stock market expectations.
The SEC asserts the finance group took measures to reverse some of what they had done. This involved shifting revenue entries from the fourth quarter of 2000 (where the extra revenue was not needed) to the first quarter of 2001.
Since these steps contravened normal accounting practices, the SEC alleged, Dunn's team hid this element of their accounting from Deloitte. The SEC complaint quotes from an e-mail sent by an associate of Poland to other Nortel employees: "We need to ensure that we have a crisp story," the employee wrote in early January, "on why we reversed these entries for the auditors that will be in today."
This suggests tensions were rising between Deloitte and Nortel's finance group. Several weeks earlier, according to the SEC, Deloitte had warned Dunn's team about the rules relating to bill and hold deals.
The SEC is not the first to describe Nortel's accounting team in terms of a rogue element. The Ontario Securities Commission, class action lawsuits and independent reports commissioned by Nortel's own audit committee have all alleged that Nortel's financial managers relied on questionable accounting to get results they wanted.
An obvious omission from these reports is what role, if any, was played by John Roth, the company's CEO until late 2001.
Mr. Roth yesterday confirmed he has not been approached by either the SEC or OSC, implying the two regulatory agencies found nothing in their investigations that would suggest Roth had a hand in the accounting transgressions.
It was well known within Nortel that Roth had stepped back from day-to-day activity during the summer of 2000 -- and had encouraged his No. 2. executive, Clarence Chandran to take over.
Chandran, a consummate salesman, had little interest in number crunching and, anyway, was based in the U.S., away from Dunn's bean counters in Brampton, Ont.
Not only that, Chandran was suffering the aftermath of a knife attack suffered years earlier. Complications would become so severe by March 2001 that Chandran resigned from the company. Roth reluctantly took over the helm again, at least until his retirement six months later.
Roth may be guilty of abrogating some of his responsibility for oversight as CEO, but the SEC and OSC appear to have concluded he did not contribute to his firm's financial fraud.
When contacted yesterday about his tenure, Mr. Roth expressed surprise. "I do not see the point in discussing my term as CEO," he noted, "It is now ancient history."
Perhaps for him. Certainly not for the financial team that now finds itself in the crosshairs of investigators from both sides of the border.
© The Ottawa Citizen 2007
James Bagnall
The Ottawa Citizen
Saturday, March 17, 2007
http://www.canada.com/ottawacitizen/news/story.html?id=8735348a-0256-4872-a53e-8dfaefc160a0&k=86840
It may have been the most reckless conference call Nortel Networks ever made.
On Jan. 18, 2001, with his industry already under deep stress, CEO John Roth told dozens of financial analysts his company had closed the books on a brilliant year with the prospect of more to come.
Roth said Nortel's sales in 2000 had reached $30 billion (all figures in U.S. currency) -- up an astonishing 42 per cent from the previous year. He also projected "continuing strong market demand" for his company's telecommunications products. Nortel's chief financial officer, Frank Dunn, echoed his boss's optimism by noting he expected sales and earnings would jump 30 per cent in 2001.
The projections would prove to be pure fantasy. But investors had no firm basis for suspecting they might have been deliberately misled. That is, until early this week.
On Monday, the U.S. Securities & Exchange Commission charged Dunn and three of his former financial colleagues -- Douglas Beatty, Michael Gollogly and MaryAnne Poland (formerly Pahapill) -- with a "wide-ranging financial fraud" that began as early as Sept. 15, 2000.
None of the charges has been proved in court and the four former Nortel managers have declined to be interviewed. Dunn issued a statement in which he expressed hope that a parallel hearing by the Ontario Securities Commission will allow "the truth to finally come out."
The SEC's civil complaint, which draws upon interviews with former members of Nortel's financial staff, offers some intriguing insight into 2000 -- a critical year that has so far received scant attention from a series of probes into Nortel's financial history. Most investigators to date have focused on the period surrounding the award of "return to profitability" bonuses to executives early in 2003. Nortel the following year sacked 10 of its financial managers -- including Dunn, Beatty and Gollogly (though not Poland) -- for their role in manipulating the accounts to produce early profits.
This week's complaint by the SEC covers wider territory. Especially noteworthy is the commission's description of Nortel's financial managers as they confronted the company's weakening sales prospects on the eve of the telecom industry's collapse.
On Sept. 15, 2000, for example, Dunn purportedly received a set of forecasts from one of Nortel's finance vice-presidents showing that the company would miss its third quarter revenue targets by at least $405 million and earnings by an even larger margin. Four weeks later, according to the SEC, Nortel's finance personnel warned Dunn that the company had lost $1.9 billion worth of potential revenues because customers from mid-September to mid-October were scaling back orders.
Rather than address the central problem -- shrinking demand for fibre optics and other telecom gear -- Dunn and his colleagues created incentives for customers to keep placing orders. The SEC alleges the resulting transactions broke accounting rules.
For instance, as sales slowed during the fall, Nortel accumulated hundreds of millions of dollars worth of optical transmission gear in warehouses. Dunn's financial team, the SEC asserts, converted this inventory into significant revenues through "bill and hold" transactions.
Here's how the deals are supposed to work under generally accepted accounting practices: if a customer is eager to place an order for gear but lacks warehouse space of its own, it can ask Nortel to store the product temporarily. Nortel is entitled to record a sale provided the customer initiated the bill and hold transaction and, among other things, has made a firm commitment to buy the product.
The SEC alleges that Nortel's sales people contravened accounting rules by soliciting bill and hold customers, including ones who had no obvious need for the gear in the particular quarter. These deals generated $1 billion worth of revenue that, under normal accounting rules, should have been recorded after 2000 -- as Nortel itself acknowledged in early 2005 when it corrected the record by reversing a number of revenue entries.
Seen in isolation, Nortel's tactics at the tail end of the telecom boom appear egregious. Yet the desperate hunt for revenues was part of the context of the times.
During much of 2000, Nortel's market value was in excess of $200 billion. The company's managers knew that any failure to deliver stellar growth in sales would be punished severely in the stock markets, thus potentially affecting the value of their stock options and bonuses.
They had seen this occur at Lucent Technologies. Their New Jersey-based archrival had suffered a 50-per-cent drop in its share price from February to August in 2000 as investors realized Nortel was winning more optical networking business.
Nortel's managers, in turn, were shocked when their own firm's share price fell 40 per cent in the final week of October following the publication of third-quarter results. Nortel's sin? It had only just met analysts' expectations.
At Lucent, the pressure to show sales growth poisoned the company's culture. In her book Optical Illusions, author Lisa Endlich describes a late-2001 scene in which Lucent CEO Henry Schacht plays the role of priest.
Standing before nearly 60 of his executives at a corporate retreat, Schacht cited a long list of practices that had corrupted the Lucent name -- bill and hold transactions, buying sales at a large discount, stretching the rules for when to recognize revenues, delaying writeoffs, creating revenues by manipulating the balance sheet.
After mulling Schacht's words, Lucent managers re-
assembled into smaller groups and confessed their sins. "One by one they stood up and told of transactions that they should have walked away from (and deals) they had not had the backbone to refuse," Endlich wrote.
The SEC charged nine Lucent managers in 2004 with fraudulently booking more than $1 billion in revenues and $470 million in pre-tax earnings during the fiscal year ended Sept. 30, 2000.
The SEC alleged two of the executives improperly recognized revenues from products that had merely been shipped to distributors, and not to the ultimate customers. The executives had promised the distributors they would receive full payment even if the customers did not accept delivery -- then failed to tell Lucent's chief financial officer of these verbal agreements.
There was evidence of subterfuge as well at Nortel, according to the SEC. In its complaint made public Monday, the commission alleged that Beatty and Poland misled Deloitte -- Nortel's auditor at the time -- about transactions relating to fourth-quarter revenues in 2000.
The gist of the SEC allegation is that Nortel's campaign to generate extra revenues through bill and hold deals had been too successful -- the finance team realized early in 2001 that they had more than $600 million worth of sales in excess of what was needed to meet stock market expectations.
The SEC asserts the finance group took measures to reverse some of what they had done. This involved shifting revenue entries from the fourth quarter of 2000 (where the extra revenue was not needed) to the first quarter of 2001.
Since these steps contravened normal accounting practices, the SEC alleged, Dunn's team hid this element of their accounting from Deloitte. The SEC complaint quotes from an e-mail sent by an associate of Poland to other Nortel employees: "We need to ensure that we have a crisp story," the employee wrote in early January, "on why we reversed these entries for the auditors that will be in today."
This suggests tensions were rising between Deloitte and Nortel's finance group. Several weeks earlier, according to the SEC, Deloitte had warned Dunn's team about the rules relating to bill and hold deals.
The SEC is not the first to describe Nortel's accounting team in terms of a rogue element. The Ontario Securities Commission, class action lawsuits and independent reports commissioned by Nortel's own audit committee have all alleged that Nortel's financial managers relied on questionable accounting to get results they wanted.
An obvious omission from these reports is what role, if any, was played by John Roth, the company's CEO until late 2001.
Mr. Roth yesterday confirmed he has not been approached by either the SEC or OSC, implying the two regulatory agencies found nothing in their investigations that would suggest Roth had a hand in the accounting transgressions.
It was well known within Nortel that Roth had stepped back from day-to-day activity during the summer of 2000 -- and had encouraged his No. 2. executive, Clarence Chandran to take over.
Chandran, a consummate salesman, had little interest in number crunching and, anyway, was based in the U.S., away from Dunn's bean counters in Brampton, Ont.
Not only that, Chandran was suffering the aftermath of a knife attack suffered years earlier. Complications would become so severe by March 2001 that Chandran resigned from the company. Roth reluctantly took over the helm again, at least until his retirement six months later.
Roth may be guilty of abrogating some of his responsibility for oversight as CEO, but the SEC and OSC appear to have concluded he did not contribute to his firm's financial fraud.
When contacted yesterday about his tenure, Mr. Roth expressed surprise. "I do not see the point in discussing my term as CEO," he noted, "It is now ancient history."
Perhaps for him. Certainly not for the financial team that now finds itself in the crosshairs of investigators from both sides of the border.
© The Ottawa Citizen 2007
