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Friday, January 14, 2005

Nortel heads into Sarbanes-Oxley headwind

What were they thinking?

Former Nortel Networks chief executive Frank Dunn and his financial executives are alleged to have manipulated their company's accounts -- only a few months after the passage in mid-2002 of the Sarbanes-Oxley bill in the U.S. This is the landmark legislation that compels chief executives to certify their company's accounts are accurate or risk substantial penalties.

Nortel was obviously aware of the bill's significance -- in the summer of 2002 it established a management "disclosure" committee of eight or so top executives. The group met on a near-weekly basis for a time to establish appropriate responses to a multitude of new governance rules that have recently come into effect.

Among the legislation's goals was to improve the "tone at the top" of publicly-traded companies. Since Dunn was a key member of the disclosure committee, his alleged behaviour is all the more puzzling.

Nortel reported on Tuesday that Dunn and members of his finance team had used inappropriate accounting manoeuvres to transform money-losing quarters into profitable ones early in 2003. Why would Dunn and his colleagues have left themselves so open to charges of breaching accounting rules at the dawn of the Sarbanes-Oxley era?

So far, all we have to go on are this week's extensive filings by Nortel and the report of the independent review it commissioned from the Washington law firm Wilmer Cutler. It's a detailed account, but it's still only one side of the story. Nevertheless, the report of the review does contain tantalizing clues about how the finance group got snared in such a multi-faceted probe.

Start with the fact, buried deep within Nortel's 10-K filing to the U.S. Securities & Exchange Commission, that the company's accounting reviews were triggered in May 2003 "at the direction of certain members of former management." A quick check with Nortel about who these might have been elicits the response "The document speaks for itself."

Well, no, it doesn't. But the filing does imply that a few ex-managers were concerned enough about certain accounting practices to push formally for a review of Nortel's balance sheet. What we don't know is their motivation for acting.

A possible sequence would have seen the concerned ex-managers take their case directly to the board's audit committee, chaired by John Cleghorn, the former top executive of the Royal Bank.

The subsequent analysis of the balance sheet -- it's not clear who did it, although it appears to have been an internal effort -- uncovered enough question marks to trigger a full-blown review of Nortel's numbers. At this point, Nortel's outside auditors,

Deloitte & Touche got more deeply involved. D&T told Cleghorn late in July 2003 that it had discovered certain "reportable conditions" in Nortel's numbers. In plain English, the auditor had found weaknesses in Nortel's internal reporting controls -- but it seems these were not judged serious enough to be material.

By October 2003 enough information was in to indicate that Nortel's balance sheet indeed required repair. Dunn revealed that the company's liabilities had been over-stated by nearly $1 billion and blamed the "volatile environment" for the errors. He assured investors that he would provide re-statements for the 42-month period ended June 30, 2003, as soon as possible.

From there, it appeared to be business as usual. Dunn was giving press interviews and seemed in very good humour. But the comprehensive review was still under way. And, for good measure, Nortel's board invited Wilmer Cutler to conduct its own, more independent review into the circumstances that led to the need for a re-statement. Dunn's mood suggests he did not expect anything untoward.

Meantime, Nortel's compensation committee of the board would likely have reviewed the multi-stage management bonus scheme that was rescinded, in part, this week. This, too, suggests that no one had yet uncovered anything terribly damaging.

This seems to have included D&T. According to the SEC filing, D&T did not report material deficiencies in Nortel's accounting until Nov. 18, 2003, as part of its interim audit for calendar year 2003. A material weakness, in accounting terms, involves internal controls that allow significant errors that are difficult to detect.

At this point, the red flags should have been flying high. Yet, late in January 2004, Dunn triumphantly told investors that Nortel had scored big profits for the quarter just ended. A few days later, Nortel's top executives received $27.3 million U.S. worth of restricted stock units, part of a bonus program tied to company earnings. (The cash portion, about $8.5 million U.S., is now being returned.) It would take a few more weeks before the board received evidence that led it to fire Dunn and his finance executives.

Should D&T have been quicker to unearth evidence of accounting misdeeds, if these did occur? Not necessarily. Paul Labarge, the founding partner of LaBarge Weinstein in Ottawa, points out that outside auditors are constrained by a couple of realities. First, they do audits by sampling accounting transactions, he says. There's never enough horsepower to cover all transactions. Second, he adds, a common practice at very large corporations is to consolidate numbers (for example, by combining sales across several countries or product lines) before they present them to auditors for analysis. It's designed to make things manageable, but it also makes it more difficult to spot inconsistencies.

Nortel's financial managers would have presented the information in a similar manner to their company's audit committee.

This is why a key reform will see Nortel board members receive financial information in much greater detail -- no consolidation, in other words. Not only that, but Cleghorn's audit committee will from now on conduct separate sessions with the top finance and operations employees of each of Nortel's many business units.

This way, the audit committee should immediately be able to spot any effort aimed at manipulating company-wide results. Under the rich bonus program approved by Nortel's board, there was certainly every incentive for top management to manipulate numbers to produce the desired earnings. Whether that was the intent -- provable in court -- of Dunn and his nine fired finance colleagues is another matter. Certainly it was the result. And, coming as it did at the launch of the Sarbanes-Oxley era, the timing could hardly have been worse.

posted by Brian Moran @ 9:12 AM   1 comments

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