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Nortel: a Case Study of Human Fallibility

By Timothy Fogarty, Michel L. Magnan, and Garen Markarian

Timothy Fogarty, JD, PhD, CPA, is a Professor of Taxation and Business Law at the

Weatherhead School of Management, Case Western University; Michel L. Magnan, PhD,

CA, is a Professor of Accountancy at the John Molson School of Business, Concordia

University, Montreal, Canada; and Garen Markarian, PhD, is an Assistant Professor of

Accounting at IE Business School, IE University, Madrid, Spain.

1. Introduction and Overview

This case provides an in-depth anatomy of a company that failed because of greed

and excess. Guided by an ambitious CEO set to conquer the world, students go through the

step-by-step processes that drove the once stellar flagship of Canadian industry, Nortel, to

public humiliation and eventual liquidation. The actors examined, and the contextual

analysis that accompanies, can easily be applied to any company other than Nortel. The

main issues examined are that governance structures were none functioning, and that

incentivization and compensation of the CEO were based on stock options that heavily

depended on firm performance. The owners of Nortel were short-term oriented without any

patience for a stable and long-run growth. Throw into the mix the fact that the CEO, John

Roth, was a darling (and pride) of the Canadian media and a household name, with a lot of

stake to keep his star high, and rising. The consequence of these factors include poor

investments made, fraud undertaken, and stakeholders realized (or reacted) only when too

late.

This case study is wide in scope, hence an instructor can focus on any of its four

elements, choosing among corporate governance, executive compensation, ownership

structure, and earnings management/fraud. Moreover, it offers students an opportunity to

learn two further aspects of business life: a better understanding of the telecommunications

industry, and the anatomy of fraud. Depending on the interests of the students, or the

requirements of the degree program, one or more aspects can be the highlight of a session.

Consequently, this case can easily fit a two session class period. Below, a number of

detailed questions are provided that could be the topic of class discussions. The questions

are organized into multiple sub-topics, each with detailed questions, enough to easily fill a

full session.

2. Suggested Questions

2.1 Theory Questions: Corporate Governance

1. What was the role of governance structures in Nortel’s failure?

a. Is the success of the firm the responsibility of the board, or the CEO? What

about the monitoring of the firm: who monitors, the CEO, or the board?

b. Nortel mainly failed because it made poor business decisions, and such poor

business decisions led to eventual fraud. Who is responsible for these poor

decisions, the board or the CEO? Keep in mind that the board can replace

the CEO anytime it wants.

c. Some currents in modern corporate governance philosophy advocate that the

CEO should be fully empowered to lead the company, and the board should

be fully empowered, and ready, to monitor. Is this view contradictory?

Would things have been different in Nortel if this had been the case?

d. Is financial expertise on the board important? Given that we need to have

small boards for efficient decision making (10 or less), what are the pros and

cons of having financial monitors, versus general business experts?

e. What recommendations you have regarding corporate governance reform,

pertaining Nortel, or industry at large.

2.2 Theory Questions: Executive Compensation

2. What was the role of executive compensation in the failure of Nortel?

a. Discuss the culture of greed in modern corporations.

b. Discuss from a moral point of the view, the fact that CEOs now are paid

about 450 times more than the lowest paid employees within the same

organization.

c. Given that CEOs need to be compensated, what structure do you

recommend vis-à-vis shares, options, cash, bonus, and deferred

compensation?

d. If John Roth was paid in cash, would Nortel have crashed? Alternatively,

would Nortel have grown?

2.3 Theory Questions: Ownership Structure

3. What was the role of Nortel’s ownership structure in the meltdown?

a. Given that the owners of the firm are of different types: pension funds,

family owners, banks and insurance companies, mutual funds, hedge funds,

private equity funds, individual private investors. Some long term, some

very short term – often with very different interests: with whom does the

interest of the CEO lie? To which category should the CEO cater the most?

b. Discuss the pros vs. cons of short term oriented vs. long term oriented

investors.

c. What is the role of owners in the monitoring process?

d. What is the optimal “shareholder” composition of the firm?

2.4 Theory Questions: Earnings Management and Fraud

4. What was the role of earnings management in Nortel’s fall?

a. Accounting rules involve flexibilities and many grey areas, discuss the role

of morality in accepting what is “correct.”

b. Accounting transactions often involve “ranges.” Such acceptable ranges and

estimates can sometimes be quite disperse. What should managers do in

such cases?

c. If earnings management and fraud, in specific instances, are pareto optimal

from a social welfare perspective, should they be undertaken?

2.5 General Questions

5. What is the main reason, according to you, as to why Nortel failed?

a. Could the fall of Nortel been prevented? How?

b. Discuss the role of the media in Nortel’s rise and fall? Discuss the role

before the crash, and after the crash.

c. Nortel accompanied another well documented disaster, MCI. Discuss the

role of industrial characteristics in the anatomy of a failure. Focus particular

attention to the type of industry, the tremendous growth opportunities, the

competitive pressures, and the glamour attached by the media.

d. Was the Nortel failure due to luck? Discuss Nortel’s situation w.r.t. general

industrial conditions at the time (hard to predict outcomes, uncertain and

volatile environment, the necessity of quick and fast moving action and

growth).

3. Analysis

Given that this is a university level class, and we want to be free of dogma (if such a

thing is possible), and approach this with a broad horizon. Most importantly, students need

to see all sides of the argument. As such, the (more important) general questions come at

the end, discussed once all the technical issues are fully covered and understood

beforehand.

3.1 Governance

The most abject failure in Nortel was the failure in governance, hence, we start our

questions with this point, taking a bulk of the discussion. This is especially relevant given

that just 10 years after, we had another governance related crisis (the banking crisis), with

similar everywhere.

Certainly, Nortel’s failure started a broad ranging discussion about governance in

Canada, and in the US. The shock of Nortel was felt throughout the world, especially in the

Telecom sector. The issue with governance is that given dispersed ownership, the

representation,? Is the firm a young firm? What is the media interest? Who are the sell-side

analysts covering the firm? How opaque are firm operations? From a multitude of such

As such, at any point in time, who is in control is anyone’s guess.

Nevertheless, the identity of who is in control is not the primary point of interest,

but the capabilities are what matter. In other words, “fit” is very much what optimizes firm

resources to function. A CEO who informs the board of firm operations, seeks their advice,

and discusses challenges and opportunities. On the other hand, a board that provides

expertise, connections, know-how, and guidance.

What determines this fit is a matter of good judgment, but unfortunately, also of

luck. We do not want an overpowering board who constrains the decisions of the future

Jack Welchs, nor do we want a board who does not believe in the vision of the Bill Gates

Add to the mix that decisions are made under uncertainty. There is no perfect

information, and no clear expectations regarding future trends, costs, revenues, competitive

From this perspective, it certainly is the responsibility of the CEO to guide the

company in uncharted competitive waters. At the same time, it is the role of the board to

But we all recognize that this is no easy matter. Were the acquisitions of Nortel, at

the time, well justified? We are now sure, only with hindsight, and only with the

fixture in Canadian society, more conservative investment strategies should have been

followed.

Certainly, when it comes to board monitoring, financial expertise is important, and

understanding the numbers and providing a layer of control over the CEO is paramount.

This has to be in tandem with the external auditors, and the audit committee within the firm

3.2 Compensation

The issue of executive compensation is also a recurring issue when it comes to

booms, busts, fraud, and failures, the most recent banking crisis being the prime example.

At the heart of the matter is that humans prefer more money to less money, and prefer

epic proportions (more than $5 million a year, on average).

But, the other side of the argument clearly also exists. Some CEOs have stressful 18

hour days, 7 days a week. CEOs have an average tenure on the job between 12-36 months,

Current compensation structures have a number of facets: a standard cash pay that is

independent of performance (minimum retention fee); a bonus that is a reward for short

term performance (usually based on accounting profits); options that are incentive based,

There is a lot of conflict regarding what compensation to utilize. Options are the

most incentivized in the sense that CEOs do not get rich, unless stock price appreciates.

This, of course, is a great incentivization tool, except, that it also leads to hubris. A CEO

3.3 Ownership Structure

The structure of “optimal” ownership composition is a controversial matter. In the

late eighties and early nineties, the trend was strong close knit ownership by families,

Is there a superior system? It is too early to tell. Capital markets, and corporations,

have been in existence for such a short time that it is hard to make definitive conclusions.

At the heart of the matter lies a simple conflict: what is the time horizon of the

owner. Is it short term or long term? Mutual funds typically have a short term horizon,

sometimes in hours or days. On the other hand, families are in it for the long term. The rest

lie in-between. All perform benefits to society – mutual funds with short horizons often are

All investors “monitor” the CEO, irrespective of their time horizons. A long term

horizon investor could put pressure on a CEO who does not properly invest for long term

projects, or alternatively, supports a CEO when they undertake such investments at the

markets and other shareholders, of the repercussions of managerial actions.

Having discussed the pros and cons of each shareholder class, it is obvious that in

the case of Nortel, short term investors where dominant, and led the show. As such, long

3.4 Earnings Management and Fraud

The issues of earnings management and fraud have been in existence since the dawn

of modern times. Questionable auditing practices have been documented in the era of the

Once earnings management and fraud is uncovered, it is normally accompanied by

massive share price drops, as shareholders lose complete faith in a company. But earnings

management is not a cause in itself – it is often the result of a mixture of factors that

co-exist. In the case of Nortel, the high expectations by all stakeholders (especially the

Nevertheless, issues are not always black and white. Accounting rules involve

flexibilities and many grey areas. For example, when a company sells 100 TVs, it also

needs to make an “allowance” for returns. As such, if the company expects 3 of these to be

This represents a clear grey area that is subject to judgments and flexibilities. Some

people conclude that a CEO should report the 95 (although he would prefer to report 98,

possibly because he would receive a higher bonus), which is the more conservative number.

Earnings management and fraud are not easy matters to resolve or to think clearly

and objectively about detached from their contextual occurrence. Numbers reported in the

accounting system affect the welfare of society. They affect employee hiring and firing

decisions, the closure of plants, and the growth into markets and products, as such. They

3.5 Why did Nortel fail?

Nortel witnessed the most spectacular rise and fall of any public corporation. Apart

from its disastrous failure, Nortel’s rise from a small regional player to the global name in

telecommunications was like no other. Nortel failed because the perfect ingredients existed

simultaneously: the ambitious CEO who was the darling of Canadian society, a

cheerleading media, an overpowered board who did not monitor, impatient shareholders

The Fall of Nortel could have been prevented if the board had monitored and

approved less risky decisions – especially with so much at stake. The disaster could have

been prevented if compensation was not so incentivized for performance. The fall could

have been averted if the media and financial press had scrutinized Nortel’s decisions a bit

4. Teaching Suggestions and Conclusion

Ideally, students would read the case in advance and prepare answers to some

of the questions provided by the instructor (questions can be chosen based on the

plan of study for the students, and in conjunction with the other material provided).

The unfortunate outcomes of this case include the liquidation of Nortel in 2009

and 60,000 employees lost their jobs. Retirements and savings were totally lost.

In terms of the main power brokers:

John Roth: He personally cashed in on $135 million of stock options and retired in

2001. Several lawsuits are still pending against him – but with no resolution in

sight.

Frank Dunn: CEO who replaced John Roth and was previously the CFO. He was

5. References and Resources

Selected Newspaper and News Articles

Anonymous, “Canada’s Technology Star Becomes Financial Black Hole,” CBC News,

September 16, 2009, available at

http://www.cbc.ca/money/story/2009/01/14/f-nortel-backgrounder-january09.html,

and has many other links about Nortel

Anonymous, “Nortel sell-off brings TSE way down,” CBC News, October 25, 2000,

available at http://www.cbc.ca/news/story/2000/10/25/ott_nortel001025.html

James Bagnall, “Who Killed Nortel,” Canwest News Service, October 30, 2009,

available at http://www.nationalpost.com/rss/story.html?id=2164470

David Einstein, “Top Tech Execs: John Roth,” Forbes, December 13, 2000

Theresa Tedesco, “Nortel to Overhaul Board,” Financial Post, September 29, 2004.

Company Website Information

Nortel website, http://www.nortel.com/

Nortel historical timeline, beginning 1874,

http://www.nortel.com/corporate/corptime/1874.html

Nortel, “2000 Third Quarter Report to Shareholders,”

http://www.nortel.com/corporate/investor/reports/collateral/eng_q3_2000.pdf

Nortel Business and Financial Restructuring,

http://www.nortel.com/corporate/restructuring.html