NORTEL CASE NEARS ITS END

The case against three former executives at Nortel is coming to an end.  Their actions have been characterized as a “fraud on the public” by the Canadian prosecutors during their closing statements.  These managers at Nortel Networks Corporation allegedly used accounting tricks to buoy quarterly profits and activate various bonuses for themselves.  Linda Nguen quotes prosecutors as saying, “You cannot just monkey with the accounting.”

The SEC previously examined the accounting and reporting issues at Nortel, and we re-examine the relevant Litigation Releases and Complaint to review the case against these managers.  We also note the slow justice in this case.  The fraud occurred over 10 years ago, and only now have these executives faced a criminal trial for their deeds.

Nortel’s shenanigans fall into two groups.  The first set of activities dealt with revenue recognition issues beginning in 2000.  Specifically, the firm employed bill and hold transactions to increase revenues and earnings.  For the most part, generally accepted accounting principles require inventory to be delivered to the customer before the corporation can recognize the revenues.  There are some exceptions, and bill and hold transactions may be an exception.

Bill and hold transactions are governed by Staff Accounting Bulletin No. 101, and they must meet several guidelines in order for the revenues to be considered realized.  They are:

• The risks of ownership must have passed to the buyer;
• The customer must have made a fixed commitment to purchase the goods, preferably in written documentation;
• The buyer, not the seller, must request that the transaction be on a bill and hold basis. The buyer must have a substantial business purpose for ordering the goods on a bill and hold basis;
• There must be a fixed schedule for delivery of the goods. The date for delivery must be reasonable and must be consistent with the buyer’s business purpose (e.g., storage periods are customary in the industry);
• The seller must not have retained any specific performance obligations such that the earning process is not complete;
• The ordered goods must have been segregated from the seller’s inventory and not be subject to being used to fill other orders; and
• The equipment [product] must be complete and ready for shipment.

The SEC (Litigation Release No. 20036 and Litigation Release No. 20275 and the related complaint SEC v. Dunn, Beatty, Gullogly, and Pahapill) pointed out two major deficiencies in Nortel’s accounting for these transactions, both violations of the third criterion.  The bill and hold transactions under questions were requested by Nortel, and not by its customers.  Additionally, the customers of Nortel did not have any particular reason for having bill and hold transactions; there was no business purpose for these activities.

The second accounting scheme involved manipulation of reserves (liabilities).  When more reported income was not necessary to achieve manager bonuses, no later than 2002, Nortel started accruing a number of items, thereby recognizing the expenses, and the related current liabilities.  Later, when they desired greater income, the managers released the reserves by reducing current debts when incurring various costs, instead of recognizing them as expenses.  These transactions make a mockery out of expense and liability recognition criteria.

The SEC linked these accounting shenanigans with the compensation schemes of Nortel Networks.  In particular, not only did Nortel managers manipulate revenues and expenses to obtain the bonuses, but they were careful not to exceed the thresholds by very much.  In this way, managers were able to save revenues and incomes for the proverbial rainy day, and collect bonuses whether the business climate rained or shined.

In October 2007 Nortel Networks paid $35 million in fines for these behaviors (Litigation Release No. 20333).  We still find this amazing inasmuch as the shareholders are paying these fines.  Thus, shareholders get whacked twice: first by the scoundrels masquerading as managers, and then by the SEC who is supposed to be giving them justice!  We just don’t understand fines against a company.

Three top managers of Nortel settled with the SEC (Litigation Release No. 20546).  These three individuals were vice presidents of the business units involved in the accounting schemes.  They paid fines, disgorgement, and interest to the tune of $143,481 to $163,031 each.  Given their salaries and given how much they earned via unwarranted bonuses, we wonder whether these fines were sufficiently high to serve as a disincentive to other managers.

Recently we discussed “Restoring Criminal Liability for Financial Fraud.”  The Nortel case is an attempt to restore such legal exposure, but it is only one case.  We still do not understand why so little has been done to hold bank managers responsible for what they did in the financial crisis of 2008 that continues to reverberate through our society.

This essay reflects the opinion of the authors and not necessarily the opinions of The Pennsylvania State University, The American College, or Villanova University.