Case 7-1
Nortel Networks
Canada-based Nortel Networks was one of the largest telecommunications equipment companies in the
world prior to its filing for bankruptcy protection on January 14, 2009, in the United States, Canada, and
Europe. The company had been subjected to several financial reporting investigations by U.S. and
Canadian securities agencies in 2004. The accounting irregularities centered on premature revenue
recognition and hidden cash reserves used to manipulate financial statements. The goal was to present the
company in a positive light so that investors would buy (hold) Nortel stock thereby inflating the stock
price. Although Nortel was an international company, the listing of its securities on American stock
exchanges subjected it to all SEC regulations, along with the requirement to register its financial statements
in accordance to U.S. GAAP.
The company had gambled by investing heavily on Code Division Multiple Access (CDMA) wireless
cellular technology during the 1990s in an attempt to gain access to the growing European and Asian
markets. However, many wireless carriers in the aforementioned markets opted for rival Global System
Mobile (GSM) wireless technology instead. Coupled with a worldwide economic slowdown in the
technology sector, Nortel’s losses mounted to $27.3 billion by 2001, resulting in the termination of two-
thirds of its workforce.
The Nortel fraud primarily involved four members of Nortel’s senior management as follows: CEO
Frank Dunn, CFO Douglas Beatty, controller Michael Gollogly, and assistant controller, Maryanne
Pahapill. Dunn was a certified management accountant, while Beatty, Gollogly, and Pahapill were chartered
accountants in Canada.
Accounting Irregularities
On March 12, 2007, the SEC alleged the following in a complaint against Nortel:
• In late 2000, Beatty and Pahapill implemented changes to Nortel’s revenue recognition policies that
violated U.S. GAAP, specifically to pull forward revenue to meet publicly announced revenue targets.
These actions improperly boosted Nortel’s fourth quarter and fiscal 2000 revenue by over $1 billion,
while at the same time allowing the company to meet, but not exceed, market expectations. However,
because their efforts pulled in more revenue than needed to meet those targets, Dunn, Beatty, and
Pahapill selectively reversed certain revenue entries during the 2000 year-end closing process.
• In November 2002, Dunn, Beatty, and Gollogly learned that Nortel was carrying over $300 million in
excess reserves. The three did not release these excess reserves into income as required under U.S.
GAAP. Instead, they concealed their existence and maintained them for later use. Further, Beatty, Dunn,
and Gollogly directed the establishment of yet another $151 million in unnecessary reserves during the
2002 year-end closing process to avoid posting a profit and paying bonuses earlier than Dunn had
predicted publicly. These reserve manipulations erased Nortel’s pro forma profit for the fourth quarter of
2002 and caused it to report a loss instead.1
• In the first and second quarters of 2003, Dunn, Beatty, and Gollogly directed the release of at least $490
1 Pro forma means literally as a matter of form. Companies sometimes report income to the public and financial analysts that
may not be calculated in accordance with GAAP. For example, a company might report pro forma earnings that exclude
depreciation expense, amortization expense, and nonrecurring expenses such as restructuring costs. In general, pro forma earnings
are reported in an effort to put a more positive spin on a company’s operations. Unfortunately, there are no accounting rules on
just how pro forma should be calculated so that comparability is difficult at best, and investors may be misled as a result.
million of excess reserves specifically to boost earnings, fabricate profits, and pay bonuses. These efforts
turned Nortel’s first quarter 2003 loss into a reported profit under U.S. GAAP, which allowed Dunn to
claim that he had brought Nortel to profitability a quarter ahead of schedule. In the second quarter of
2003, their efforts largely erased Nortel’s quarterly loss and generated a pro forma profit. In both
quarters, Nortel posted sufficient earnings to pay tens of millions of dollars in so-called return to
profitability bonuses, largely to a select group of senior managers.
• During the second half of 2003, Dunn and Beatty repeatedly misled investors as to why Nortel was
conducting a purportedly “comprehensive review” of its assets and liabilities, which resulted in Nortel’s
restatement of approximately $948 million in liabilities in November 2003. Dunn and Beatty falsely
represented to the public that the restatement was caused solely by internal control mistakes. In reality,
Nortel’s first restatement was necessitated by the intentional improper handling of reserves, which
occurred throughout Nortel for several years, and the first restatement effort was sharply limited to avoid
uncovering Dunn, Beatty, and Gollogly’s earnings management activities.
The complaint charged Dunn, Beatty, Gollogly, and Pahapill with violating and/or aiding and abetting
violations of the antifraud, reporting, books and records requirements. In addition, they were charged with
violating the Securities Exchange Act Section 13(b)(2)(B) that requires issuers to devise and maintain a
system of internal accounting controls sufficient to provide reasonable assurances that, among other things,
transactions are recorded as necessary to permit the preparation of financial statements in conformity with
U.S. GAAP and to maintain accountability for the issuer’s assets.
Dunn and Beatty were separately charged with violations of the officer certification provisions instituted
by SOX under Section 302. The commission sought a permanent injunction, civil monetary penalties,
officer and director bars, and disgorgement with prejudgment interest against all four defendants.
Specifics of Earnings Management Techniques
From the third quarter of 2000 through the first quarter of 2001, when Nortel reported its financial results
for year-end 2000, Dunn, Beatty, and Pahapill altered Nortel’s revenue recognition policies to accelerate
revenues as needed to meet Nortel’s quarterly and annual revenue guidance, and to hide the worsening
condition of Nortel’s business. Techniques used to accomplish this goal include:
1. Reinstituting bill and hold transactions. The company tried to find a solution for the hundreds of
millions of dollars in inventory that was sitting in Nortel’s warehouses and offsite storage locations.
Revenues could not be recognized for this inventory because U.S. GAAP revenue recognition rules
generally require goods to be delivered to the buyer before revenue can be recognized. This inventory
grew, in part, because orders were slowing and, in June 2000, Nortel had banned bill and hold
transactions from its sales and accounting practices. A bill and hold transaction is one where the
customer agrees to purchase a product but the seller (Nortel in this case) retains physical possession until
the customer can accept delivery. The company reinstituted bill and hold sales when it became clear it
fell short of earnings guidance. In all, Nortel accelerated into 2000 more than $1 billion in revenues
through its improper use of bill and hold transactions.
2. Restructuring business-asset write-downs. Beginning in February 2001, Nortel suffered serious losses
when it finally lowered its earnings 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.
3. Creating reserves. In relation to writing down the assets, Nortel established reserves that were used to
manage earnings. Assisted by defendants Beatty and Gollogly, Dunn manipulated the company’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 pay bonuses to these three
defendants and other Nortel executives.
4. Releasing reserves into income. From at least July 2002 through June 2003, Dunn, Beatty, and Gollogly
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, the reserves were used to reduce earnings for the quarter, avoid reporting a profit earlier than
Dunn had publicly predicted, and 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. 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.
Role of Auditors and Audit Committee
In the second half of 2003, Nortel’s outside auditors raised concerns about Nortel’s handling of reserves
and, from that point forward, defendants’ scheme began to unravel. To appease the auditors, Nortel’s
management—led by Dunn and Beatty—conducted a purportedly comprehensive review of Nortel’s assets
and liabilities. This resulted in an announcement, on October 23, 2003, that Nortel would restate its
financials for FY 2000, FY 2001, and FY 2002.
Shortly after Nortel’s announced restatement, the audit committee commenced an independent
investigation and hired outside counsel to help it “gain a full understanding of the events that caused
significant excess liabilities to be maintained on the balance sheet that needed to be restated,” as well as to
recommend any necessary remedial measures. The investigation uncovered evidence that Dunn, Beatty, and
Gollogly and certain other financial managers were responsible for Nortel’s improper use of reserves in the
second half of 2002 and first half of 2003.
In March 2004, Nortel suspended Beatty and Gollogly and announced that it would “likely” need to
further revise and restate previously filed financial results. Dunn, Beatty, and Gollogly were terminated for
cause in April 2004.
On January 11, 2005, Nortel issued a second restatement that restated approximately $3.4 billion in
misstated revenues and at least another $746 million in liabilities. All of the financial statement effects of
defendants’ two accounting fraud schemes were corrected as of this date, albeit, there remained lingering
effects from defendants’ internal control and other nonfraud violations.
Nortel also disclosed the findings to date of the audit committee’s independent review, which concluded,
among other things, that Dunn, Beatty, and Gollogly were responsible for Nortel’s improper use of reserves
in the second half of 2002 and first half of 2003. The second restatement, however, did not reveal that
Nortel’s top executives had also engaged in revenue recognition fraud in 2000.
In May 2006, in its Form 10-K for the period ending December 31, 2005, Nortel admitted for the first
time that its restated revenues in part had resulted from management fraud, stating that “in an effort to meet
internal and external targets, the senior corporate finance management team . . . changed the accounting
policies of the company several times during 2000,” and that those changes were “driven by the need to
close revenue and earnings gaps.”
Throughout their scheme, defendants lied to Nortel’s independent auditor by making materially false and
misleading statements and omissions in connection with the quarterly reviews and annual audits of the
financial statements that were materially misstated. Among other things, each of the defendants submitted
management representation letters to the auditors that concealed the fraud and made false statements, which
included that the affected quarterly and annual financial statements were presented in conformity with U.S.
GAAP and that they had no knowledge of any fraud that could have a material effect on the financial
statements. Dunn, Beatty, and Gollogly also submitted a false management representation letter in
connection with Nortel’s first restatement, and Pahapill likewise made false management representations in
connection with Nortel’s second restatement.
The defendants’ scheme resulted in Nortel issuing materially false and misleading quarterly and annual
financial statements and related disclosures for at least the financial reporting periods ending December 31,
2000, through December 31, 2003, and in all subsequent filings made with the commission that
incorporated those financial statements and related disclosures by reference.
Settlement
On October 15, 2007, Nortel, without admitting or denying the commission’s charges, agreed to settle the
commission’s action by consenting to be permanently enjoined from violating the antifraud, reporting,
books and records, and internal control provisions of the federal securities laws and by paying a $35
million civil penalty, which the commission placed in a Fair Fund2 for distribution to affected shareholders.
Nortel also agreed to report periodically to the commission’s staff on its progress in implementing remedial
measures and resolving an outstanding material weakness over its revenue recognition procedures.
In settling the matter, the SEC acknowledged Nortel’s substantial remedial efforts and cooperation. After
Nortel announced its first restatement, the audit committee launched an independent investigation that later
uncovered the improper accounting. Nortel’s board took extensive remedial action that included promptly
terminating employees responsible for the wrongdoing, restating its financial statements four times over
four years, replacing its senior management, and instituting a comprehensive remediation program
designed to ensure proper accounting and reporting practices. Nortel also shared the results of its
independent investigation with the SEC. As part of the settlement, Nortel agreed to report to the
commission staff every quarter until it fully implements its remediation program, and the company and its
outside auditor agreed that the existing material weakness has been resolved. The commission
acknowledged the assistance of the Ontario Securities Commission, which conducted its own separate,
parallel investigation.
Nortel in Canada
After a four-year investigation, on June 20, 2008, Canadian authorities arrested three high-level ex-Nortel
Networks executives on fraud charges for their alleged part in what has been described as the worst stock
scandal in Canadian history. The Royal Canadian Mounted Police in Toronto arrested ex-CEO Dunn, ex-
CFO Beatty, and former corporate controller Gollogly, who were each charged with seven counts of fraud.
The charges include “fraud affecting public market; falsification of books and documents; and false
prospectus, pertaining to allegations of criminal activity within Nortel Networks during 2002 and 2003.”
The three pleaded innocent and were released on bail.
On January 14, 2009, Nortel filed for protection from creditors in the United States, Canada, and the
United Kingdom in order to restructure its debt and financial obligations. In June, the company announced
it no longer planned to continue operations and that it would sell off all of its business units. Nortel’s
CDMA wireless business and LTE access technology were sold to Ericsson, and Avaya purchased its
Enterprise business unit.
2 A Fair Fund is a fund established by the SEC to distribute “disgorgements” (returns of wrongful profits) and penalties (fines) to
defraud investors. Fair Funds hold money recovered from a specific SEC case. The commission chooses how to distribute the money
to defraud investors, and when completed, the fund terminates.
The final indignity for Nortel came on June 25, 2009, when Nortel’s stock price dropped to 18.5¢ a
share down from a high of $124.50 in 2000. Nortel’s battered and bruised stock was finally delisted from
the S&P/TSX composite index, ending a colossal collapse on an exchange on which the Canadian
telecommunications giant’s stock valuation once accounted for a third of its value.
Postscript
The three former top executives of Nortel Networks Corp. were found not guilty of fraud on January 14,
2013. In the court ruling, Justice Frank Marrocco of the Ontario Superior Court found that the accounting
manipulations that caused the company to restate its earnings for 2002 and 2003 did not cross the line into
criminal behavior.
Accounting experts said the case is sure to be closely watched by others in the business
community for the message it sends about where the line lies between fraud or acceptable use of discretion
in accounting.
The decision underlines that there is still the duty of management to prepare financial statements
that “present fairly the financial position and results of the company” according to a forensic accountant,
Charles. Smedmor, who followed the case. “Nothing in the judge’s decision diminished that duty.”
During the trial, lawyers for the accused said the men believed that the accounting decisions they
made were appropriate at the time, and that the accounting treatment was approved by Nortel’s auditors
from Deloitte & Touche. Judge Marrocco accepted the arguments, noting many times in his ruling that
bookkeeping decisions were reviewed and approved by auditors and were adequately disclosed to investors
in press releases or notes to the financial statements.
Nonetheless, the judge also said he believed the accused were attempting to “manage” Nortel’s
financial results in both the fourth quarter of 2002 and in 2003, but added that he was not satisfied the
changes resulted in material misrepresentations. He said that except for $80-million of reserves released in
the first quarter of 2003, the rest of use of reserves was within “the normal course of business.” And Judge
Marrocco also said the $80-million release, while clearly “unsupportable” and later reversed during a
restatement of Nortel’s books, was properly disclosed in Nortel’s financial statements at the time and was
not a material amount. He concluded Beatty and Dunn “were prepared to go to considerable lengths” to use
reserves to improve the bottom line in the second quarter of 2003, but said the decision was reversed before
the financial statements were completed because Gollogly challenged it.
In a surprising twist, Judge Marrocco also suggested the two devastating restatements of Nortel’s
books in 2003 and 2005 were probably unnecessary in hindsight, although he said he understood why they
were done in the context of the time. He said the original statements were arguably correct within a
threshold of what was material for a company of that size.
Darren Henderson, an accounting professor at the Richard Ivey School of Business at the
University of Western Ontario, said a guilty verdict would have raised the bar for management to justify
their accounting judgments. But the acquittal makes it clear that “management manipulation of financial
statements is very difficult to prove beyond a reasonable doubt in a court of law,” he said.
It is clear that setting up reserves or provisions is still subject to management discretion,
Henderson said. “The message … is that it is okay to use accounting judgments to achieve desired
outcomes, [such as] a certain earnings target.”
Questions
1. Auditors are required to assess fraud risks as part of their ethical and professional
responsibilities. What characteristics of Nortel might have caused it to be identified
as a high-risk audit? Use the fraud triangle in answering this question.
Nortel had invested heavily in the Code Division Multiple Access (CDMA) wireless
cellular technologies in the 1990s. However, by the later1990s and early 2000s, it was
clear the industry standard would be the rival Global System Mobile (GSM). There was
a worldwide economic slowdown in the technology sector. Those two indicators should
The auditors should have assessed the likelihood of fraud at Nortel. Using the fraud
triangle, the officers were under pressure to meet market expectations and the managers
accelerated the recording of revenue into earlier periods to meet revenue targets. The
managers were motivated by meeting these targets and receiving bonuses. The company
restated its financial statements due to earnings management and the selective release of
2. In the Ontario Superior Court ruling, Justice Marrocco “found that the accounting
manipulations that caused the company to restate its earnings for 2002 and 2003
did not cross the line into criminal behavior.” Marrocco added he was “not satisfied
beyond a reasonable doubt” that the trio [i.e., Dunn, Beatty, and Gollogly} had
‘deliberately misrepresented’ financial results.
Review the accounting manipulations in the case and answer the following
questions:
a. What types of “financial shenanigans” were used by the trio to manipulate
earnings?
Nortel used the financial shenanigans of recording revenue too soon, used cookie jar
b. Do you agree with the decision of Judge Marrocco in not holding the trio legally
liable? Why or why not?
The trio lied and committed fraud. They manipulated the accounting records to meet
market expectations. The manipulations seemed to have been to achieve bonuses but not
to drive the stock price up and trade on insider trading. Under ethical theories of virtues,
justice, deontology and the six pillars of character, the Judge would have realized that
regardless of the perceived culpability of the auditors, it was management that initiated
the fraud through deceitful actions. The trio ignored shareholder interests and their rights
to accurate and reliable financial information without smoothing the net income or
3. Trust is an essential element in the relationship between the external auditor and top
management. Evaluate the actions taken by the defendants with respect to its
relationship and responsibilities to the Deloitte & Touche auditors, their fiduciary
responsibilities as the head of Nortel and corporate governance in general.
The defendants lied to Deloitte and deceived them through bill and hold transactions,
business – asset write downs, creating reserves, and releasing reserves into income. As
officers of Nortel, they had a fiduciary duty to shareholders to act with due care and
loyalty to shareholder interests, act in the company’s best interests, and to safeguard the
company’s assets. They had a duty to set an ethical tone at the top for the company to
strengthen corporate governance systems. Additionally, as the CEO and CFO, the