SEC’s Nortel Fraud Complaint

The SEC fraud complaint this morning against Nortel is fascinating forensic reading. While many of us had wondered at the repeated accounting restatements at Nortel, the SEC is saying that the root problem was that management refused to acknowledge the real source of the problem: Its own improperly-taken revenue reserves that it used to boost numbers in the 2003 period.

6. From the third quarter of 2000 through the first quarter of 2001, when Nortel reported its financial results for year-end 2000, Dunn (then CFO), Beatty (then Controller) and Pahapill (then Assistant Controller) altered Nortel’s revenue recognition policies to accelerate revenues (particularly revenues of Nortel’s optical internet business, which were closely watched by Wall Street) as needed to meet Nortel’s quarterly and annual revenue guidance, and to hide the worsening condition of Nortel’s business. Bill and hold transactions were at the center of the scheme. US GAAP permits a company to recognize revenues prior to delivery of a product if the bill and hold transaction has been structured properly. In the second quarter of 2000, Nortel banned the use of such transactions, but, when Nortel’s revenues fell significantly short of expectations in the third quarter of 2000, Dunn, Beatty and Pahapill reintroduced bill and hold transactions into the Company’s sales and accounting practices specifically to recognize revenues on idle, undelivered inventory sitting in Nortel’s warehouses and offsite storage locations. The transactions did not satisfy US GAAP requirements but Nortel nonetheless recognized revenues as if they did. In all, Nortel accelerated into 2000 more than $1 billion in revenues through its improper use of bill and hold transactions. Dunn, Beatty and Pahapill not only were able to steer Nortel’s results for the fourth quarter and fiscal year 2000 in line with Wall Street’s expectation, but also, they were able to show a sizable increase in optical revenues. Nowhere was the existence or effect of Dunn, Beatty and Pahapill’s accounting scheme disclosed to Nortel’s shareholders, the market or the Company’s independent auditors.

7. Beginning in February 2001, Nortel suffered serious losses when it finally lowered its guidance to account for the fact that its business was suffering from the same widespread economic downturn that impacted the entire telecommunications industry. As Nortel’s business plummeted throughout the remainder of 2001, the Company reacted by implementing a restructuring that, among other things, reduced its workforce by two-thirds and resulted in a significant write-downs of assets. Dunn became Nortel’s President and CEO in the midst of the restructuring. In the summer of 2002, as Nortel began to emerge from the downturn, Dunn publicly announced that he expected Nortel to return to profitability by the second quarter of 2003. Assisted by defendants Beatty (then CFO) and Gollogly (then Controller), Dunn then embarked on a second scheme – the manipulation of Nortel’s reserves – to manage Nortel’s publicly-reported earnings, create the false appearance that his leadership and business acumen was responsible for Nortel’s profitability and to pay bonuses to these three defendants and other Nortel executives.

8. From at least July 2002 through June 2003, Dunn, Beatty and Gollogly improperly established, maintained and released excess reserves to meet Dunn’s unrealistic and overly aggressive earnings targets. When Nortel internally (and unexpectedly) determined that it would return to profitability in the fourth quarter of 2002, sooner than Dunn had indicated in his guidance to the investment community, Dunn, Beatty and Gollogly established and maintained excess reserves in order to reduce earnings for the quarter, avoid reporting a profit earlier than Dunn had publicly predicted, and to create a stockpile of reserves that could be (and were) released in the future as necessary to meet Dunn’s prediction of profitability by the second quarter of 2003. When 2003 turned out to be rockier than expected, Dunn, Beatty and Gollogly orchestrated the release of excess reserves to cause Nortel to report a profit in the first quarter of 2003, a quarter earlier than the public expected, and to pay defendants and others substantial bonuses that were awarded for achieving profitability on a pro forma basis. Dunn publicly attributed Nortel’s first quarter 2003 return to profitability to the strength of his business model. Dunn, Beatty and Gollogly again planned to release excess reserves to achieve profitability in the second quarter of 2003, but, because their actions drew the attention of Nortel’s outside auditors, they made only a portion of the planned reserve releases. This allowed Nortel to report nearly break-even results (though not actual profit) and to show internally that the Company had again reached profitability on a pro forma basis necessary to pay bonuses.