Nortel board ‘sandbagged,’ says prosecutor

Howard Solomon

13 years ago

Staff at telecom equipment maker Nortel Networks were so desperate to make the company look profitable in 2003 that they were pulling the wool over the eyes of each other, the fraud trial of three ex-Nortel executives was told.

Prosecutor Robert Hubbard made the allegation Tuesday during his second day of opening remarks in the trial of ex-CEO Frank Dunn, CFO Douglas Beatty and Michael Gollogly in Toronto.

The trio are charged with defrauding the public and Nortel by deliberately misrepresenting Nortel’s financial results. In financial trouble since 2000, Nortel went into bankruptcy protection in 2009 with billions of dollars in debt.

Hubbard said the accused would tell the board of directors that losses were expected in a quarter, then, by lowering provisions set aside for expected liabilities (called accruals), boosted income and turned the losses into profits.

But at the same time, the prosecutor said, staff in Nortel’s divisions were holding back their financial numbers until near the end of a quarter, then used accruals they had access to boost their financials. At least once, he said, executives were caught off guard by an “embarrassment of riches” and had to reverse some of the accruals.

In short, Hubbard said, “everybody sandbags everybody.”

Using accruals to manipulate the books was a long-time practice at the Canadian-based company, Hubbard said. Each division in Nortel accumulated accruals in the normal course of business, which is why they had control of some of them. In this case, Hubbard said, the accused had access to what he called non-corporate accurals recorded at head office.

In the fall of 2002, Hubbard said he will show, executives were told $189 million in that category of accruals had to be lowered. But instead of restating previous financial statements, the accused used them over several quarters for to improve Nortel’s financial reports so they could qualify for bonuses, Hubbard said he will show. The bonuses were tied to For example, he said, only $80 million was reduced in the first quarter of 2003. Another $59 million was released the following quarter — which was then rolled back by $55 million. The reason, the prosecutor alleged, is that it was realized that only $4 million was needed to hit the bonus level.

Although only an opening statement, the claim that the board was fooled after it was shown dozens of forecasts in a quarter that gradually improved Nortel’s finances despite relatively flat revenue attracted a question from Judge Frank Marrocco.

Hubbard told him that in January, 2003 the board was told to expect an audited loss under generally accepted accounting principles (GAAP) of $240 million. Over the next few weeks the position gradually improved – despite the flat revenue – until April, when there was a prediction of a $54 million profit.

The shift was thanks to a total of $361 million in accruals that were released, Hubbard said. But of that, he added, $111 million was inappropriately reduced for that quarter.

Wouldn’t the board have asked executives how this could be, asked the judge.

The board was told there was a “normal change” in the estimates of loss provisions, Hubbard replied.

The situation was so odd that at when Nortel looked like it was going to have a profitable fourth quarter in 2002, the prosecutor said, executives decided to hold back accruals to manufacturer a loss because it was felt the investor community would be suspcious of a profit so soon.

The prosecutor also had careful words about the role of Nortel’s external auditor, Deloitte and Touche. At one point he said Deloitte’s staffers didn’t know everything the accused did. In fact, he said, on one accrual reduction there was “push-back” from the accounting firm. Ultimately, however, it yielded to the company. Deloitte may have been negligent, the prosecutor said, but that doesn’t let the accused off the hook.

The audited quarterly financial statements were signed by all three accused. But Hubbard also argues that all of them as accountants ought to have known the rules for properly treating accruals. Under GAAP rules, he said, if there’s a range of an estimated value in an accural a company has to pick the lowest number. But Nortel staff had a habit of being what he called “conservative,” meaning they picked the high end of the estimate.

This was not unknown, Hubbard said. Gollogly wrote a memo in 2003 — it isn’t clear who saw it — warning staff of this. A draft email to Beatty in 2003 also mentioned it.

He also noted that in 2003 Gollogly also sent a memo to staff reminding them of a 1999 rule from the U.S. Securities and Exchange Commission (SEC) that any misstatement of financials could be considered material if it masks a change in earnings or has an effect of increasing management compensation.

The accused, the prosecutor concluded, can’t say they knew there were mistakes in the financials but didn’t consider them important.

Hubbard is expected to finish his opening statement Wednesday, after which one of the defence lawyers will give a reply on behalf of all the accused. Then Hubbard will start calling witnesses.

The trial is expected to last months.