How Nortel executives were found not guilty of fraud

In basketball terms, it was a slam dunk.

After looking at thousands of pages of documents and listening to two dozen witnesses, Ontario Justice Frank Marrocco said the Crown hadn’t proved former Nortel Networks executives Frank Dunn, Douglas Beatty and Michael Gollogly deliberately misrepresented financial results of the ailing telecom company.

The year-long trial dealt with the release of accrued liabilities into income on financial statements, which the prosecution said was done so the accused and other managers could qualify for profitability bonuses.

But aside from one release of $80 million in the first quarter 2003 results, liabilities released in the next two quarters weren’t outside the normal course of business.

As for the $80 million, the judge said it didn’t make a difference – Nortel would have been in the black with or without it.

As for alleged hokey-pokey in the fourth quarter 2004 financial statement that turned a profit into a loss, Marrocco said no matter what was done Nortel wasn’t profitable that quarter.
In short, he rejected Crown prosecutor Robert Hubbard’s entire case. Still, Marrocco said, “it was entirely appropriate that we go through this process to find out what happened.”

His 141-page written decision goes into greater detail than these transactions, but Marrocco’s shorter oral decision read Monday in court had an interesting preface before he got into the nitty-gritty.

For many former Nortel employees, pensionners and shareholders this was no ordinary trial.

For them the collapse of Nortel after so many years of being a telecommunications giant had to be explained beyond mere poor sales or more agile competitors — and Marrocco obviously had a sense of how many eyes were on the courtroom.

In fact, coincidentally in a nearby Toronto hotel Ontario’s chief judge this week is trying to broker a deal to slice up some $9 billion (all figures U.S.) of remaining Nortel assets to creditors, including former staff.

“I know that there are other proceedings going on which deal with Nortel Networks Corporation,” Marrocco said starting his oral decision. “Those matters are not before me.”

Marrocco emphasized that his decision is based on evidence heard and documents presented in his courtroom only and that the criminal charges had to be proven beyond a reasonable doubt.

As background, Marrocco then briefly recounted Nortel’s background, which showed how great the company had been and how low it fell: Between 1998 and 2001 the company spent $29 billion on 22 acquisitions, the judge noted, during a period of strong economic growth in the telecom industry. But by 2001 the industry “began to experience a slowdown attributed to excess capacity.”

Others called it the dot-com implosion, when tech stocks plunged in part because manufacturers had advanced too much money to dot-com companies with sketchy business plans and sketchier assets. Those were not the judge’s words. But the outcome, he acknowledged, “was a dramatic and significant reduction in the demand for Nortel’s products and services.”

As a result Nortel cut its workforce from 94,000 to 37,000 by the end of 2002, Marrocco said. He also noted it wrote down $12.4 billion in goodwill and other intangible assets in 2001.

Then the judge read a sickening recitation of the red ink:

In 1999 Nortel lost $197 million, $2.9 billion in 2000, $27.4 billion in 2001, and $3.6 billion in 2002.

Then he turned towards the particulars of the fraud case.

1. The re-statement of financial results
During 2002-2004 cash was critical to Nortel’s survival, Marrocco noted. But, he said Nortel maintained an accounting policy of conservatism, or understating assets and income. It was suggested by the prosecution that was contrary to U.S. generally accepted accounting principles (GAAP), which Nortel adhered to. But, said the judge, that wasn’t backed up by the evidence.

That was a significant conclusion in light of his interpretation of how the three accused dealt with the heart of the prosecution’s case, the addition of accrued liabilities to quarterly financial statements to seemingly change losses to profits, or in one case, a profit to a loss. Accrued liabilities are estimates of money that might have to be paid out – for example, if a lawsuit is lost. Eventually these liabilities have to be recorded in a financial statement, usually as income.

Marrocco concluded that during the period the trial was concerned, Nortel’s accrued liabilities were estimated at the high end of valuations – in other words, the judge said, Nortel executives, staff and auditors “wanted to account for every possible risk.”

One of the risks of Nortel’s condition was that excess accrued liability balances would find their way onto the company’s balance sheet, Marrocco said, that that’s what happened.

Ultimately Nortel had to re-state $900 million in excess liabilities in 2003 and 2004 from previous financial results, he said.

That re-statement meant $900 million in expenses didn’t have to be paid, and therefore shareholders’ equity was increased by that amount.

However he found no criminal fault. The threshold of measuring the value of the accrued liabilities was lowered when the restatements were made, he said, and also factored in errors in revenue recognition – or, as he wrote in his full decision, a difference of opinion.

2. The Q4 2002 ‘profit-into-a-loss’

Although the prosecution focused on seven transactions between 2002 and 2004, Marrocco said the heart of the case was whether the accused deliberately turned a pro forma, or interim, profit in the fourth quarter 2004 financial statement into a loss through the use of accrued liabilities.

When Nortel went into the red, the board of directors decided to give management a performance incentive to turn the company around that would be paid if it turned quarterly profits.

The prosecution alleged the three accused used the accrued liabilities to in effect cook the books in 2003. But what about the Q4 2002 results? The prosecution said the accused had promised Nortel would be profitable in 2003, so when the Q4 2002 results were positive the trio felt it wouldn’t look good — the company had gone into the black too fast. Hence, it was alleged, a profit was turned into a $248 million loss.

But, Marrocco asked, was it true that there really was a pro forma $73 million profit in that quarter? That was the amount claimed in testimony by Brian Harrison, Nortel’s director of financial planning an analysis. However, the judge said Harrison wrongly included $59 million from the sale of bonds in Q4 2002. Plus Nortel recorded $50 million liability expense on a lawsuit that was expected to demand $100 million.

Add those two and it would have added another $109 million to the Q4 2002 statement, the judge said. That was enough to turn the $73 million profit into a loss.

“Therefore I am not satisfied that Nortel was pro forma profitable in Q4 2002,” Marrocco said.

The Q4 2002 results, originally a $248 million loss were re-stated twice and finally set a $294 million.

One more thing, the judge added: Nortel always said it was net cash positive. No restatement changed that, he said, nor was there evidence that it was a misrepresentation. So he said he wasn’t satisfied the Q4 2002 results were misstated, even with the addition of accrued liabilities.

3. Using $303 million in liabilities

A 2002 Nortel staff accountant’s report suggested $303 million in accrued liabilities (of a total $5 billion) weren’t required and had to be released into financial statements as income, the judge said, although timing was a question. Of that, $222 million was released in Q3 and Q4 2002 financial statements. During that period, the judge said, Nortel lost about $2 billion. “No witness suggested the difference (of adding $222 million) made a difference” in the loss, Marrocco concluded.

Even after two re-statements of financials the loss during the two quarters was $1.8 billion., he pointed out,

Therefore, he said, “I’m not satisfied that the manner in which the three accused dealt with the $303 million in accrued liability balances … resulted in a misrepresentation of Nortel’s fiscal fourth quarter results.”

4. The $80 million used in Q1 2003

As for the allegation the accused improperly released $80 million in liabilities to income in Q1 2003 to earn their bonuses, the judge zeroed in on a memo from Deloitte & Touche, Nortel’s outside auditors, which analyzed the release’s effect on the company’s income. In the auditors’ opinion the release of those funds wasn’t material to Nortel’s financial statements, the judge said.

The bonus threshold was met whether the $80 million was released or not, the judge noted, because Nortel had positive earnings either way.

“I thought the analysis in the memo was thoughtful and detailed,” said the judge. “I found it persuasive. I accepted it.”

So, he said, the $80 million was properly released at the time by the accused and their bonuses were deserved.

“The accused are presumed innocent,” the judge finished. “The burden (of proof) is on the prosecution … The burden, in my view, is not met. The charges are dismissed.”



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