How Dunn's misplaced optimism snowballed

It was July 25, 2000, and the global telecommunications equipment market was heading into a tailspin. But Nortel Networks Corp.'s chief financial officer, Frank Dunn, was surprisingly upbeat on a conference call with analysts.

Mr. Dunn reported that the company's core optical business had reported a "very, very strong performance" and was poised to surpass an estimated target of $10-billion (U.S.) in revenue for the year.

But according to a detailed statement of allegations issued yesterday by the U.S. Securities and Exchange Commission, his optimism was terribly misplaced, and those promises would lead to financial manipulations that culminated yesterday in civil fraud charges against Mr. Dunn and three of his finance employees -- Douglas Beatty, Michael Gollogly and Mary Anne Pahapill.

By October, 2000, with many customers cancelling orders, the SEC said Nortel had determined its revenue estimates for 2000 were going to be $2-billion below expectations. And Nortel's culture did not tolerate missing earnings estimates, according to yesterday's filing by the SEC in a New York court.

"In that environment, accounting did not serve to measure Nortel's performance," the SEC alleged. "Instead, Nortel's executives and finance managers treated their books as tools to meet the company's financial objectives."

On Nov. 8, 2000, Mr. Beatty, then controller, held a conference call with senior staff and explained that Nortel was having difficulty meeting earnings estimates, the SEC said. He proposed using a form of accounting known as "bill and hold," in which inventory can be considered "sold" even when a customer hasn't taken possession of it.

That month, Nortel salesmen approached customers and offered an array of incentives -- price discounts, interest deferments and extended billing terms -- if they would agree to place further orders for delivery in 2001, the SEC alleged. The SEC said the strategy was "in complete disregard" of U.S. accounting rules and that the vast majority of transactions "had no substantial business purpose."

In the end, the scheme was too successful. The SEC alleged the company recorded an additional $1-billion of revenue through the improper bill-and-hold transactions in late 2000 -- $633-million more than it needed to meet its projected financial targets. In the end, finance staff had to reverse some of the gains before reporting year-end financial results.

Early in 2001, despite weakening market conditions, Mr. Dunn told investors Nortel would see revenue and profit grow a further 30 per cent in 2001, the SEC said.

But 2001 turned out to be a far worse year than 2000, and Nortel was forced to implement a company-wide restructuring program that included firing two-thirds of its global work force, or about 60,000 people. By November of that year, John Roth had stepped down as chief executive officer, and Mr. Dunn was promoted to the company's top job.

By the summer of 2002, Mr. Dunn told investors the worst was over and he expected Nortel to return to profitability by mid-2003. The company set up a controversial return-to-profitability bonus plan to encourage employees to meet that target.

Once again, overly optimistic earnings promises led to more earnings manipulation, according to the allegations by the SEC.

The SEC alleged that by the fourth quarter of 2002, it was clear Nortel could not meet the 2003 targets, and that Mr. Dunn and others began looking for way to fix that problem. They turned to the company's inflated accounting reserves -- liabilities that were overstated and available to be "reversed" in the future to bolster earnings.

By October, 2002, finance staff had determined Nortel was carrying at least $303-million in excess reserves on its books. Under normal accounting treatment, the SEC said Nortel should have restated its earlier financial results immediately to reverse the excess reserves.

"Dunn, Beatty and Gollogly instead decided to conceal the nature of these reserves and to keep the excess amounts for future earnings management purposes as needed," the SEC said.

By early 2003, Nortel found its profit forecasts falling more sharply for the year. Suddenly, instead of projected profit of $22-million for the year, the company was internally forecasting a $44-million loss. This threatened the June deadline for profitability and the ability to pay out the bonuses.

So Mr. Dunn publicly announced more "unrealistic and overly aggressive" profit targets for the year, and set in place plans to release more reserves to meet the targets, the SEC said. Nortel released another $372-million from reserves in the second quarter of the year and reported a pro forma profit for the quarter.

The results triggered the return-to-profitability bonuses, as well as a special issue of share units to executives. From both plans, Mr. Dunn received a total of $6.5-million, Mr. Beatty received $2.4-million and Mr. Gollogly was paid $1.4-million.

The SEC said the earnings management scheme "began to unravel" after mid-2003. In late July, auditor Deloitte & Touche went to Nortel's board to report it had found problems with the use of accounting reserves. The board ordered an internal review, leading to a $948-million restatement that fall.

The "fraud finally crumbled" in early 2004, the SEC said, after Nortel's board hired independent investigators to probe the company's accounting. Mr. Dunn and his colleagues were fired that spring.

SEC allegations

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Yesterday's close $33.01, up 9¢

Sept. 2000

Accounting games were allegedly started no later than this, involving schemes that included bill and hold transactions to count sales on unsold inventory.

Feb 2001

After using its inflated stock to conclude a $2.5-billion asset purchase from JDS, Nortel slashes forecasts and begins layoffs and restructuring, initially under John Roth, but then under Frank Dunn who took over the helm in late 2001.

Summer, 2002

Dunn vows return to profitability by the second quarter, 2003, and leads a plan to manipulate reserves to smooth earnings and make the company look like it's on the mend, with large bonuses promised to executives if successful.

Q4 2002

Fraud scheme has Nortel says it's on target to hit profit goal early, so reserves are used to make the numbers fall short. A "real" profit is hit in Q1 of 2003.

Q2 2003

Auditor suspicions make it harder to play with reserves but management squeaks out a pro forma profit, ensuring executives get their bonuses for returning to profitability.

Second half, 2003

Auditors get concerned. Dunn and Douglas Beatty respond by restating financials for several years, but do so in a way to cover up alleged fraud.

April 2004

Dunn, Beatty and Michael Gollogly are fired with cause.

Jan 2005

Second restatement issued, disclosing $3.4-billion in misstated revenues, blaming Dunn et al for reserve manipulation but no mention of revenue recognition fraud.

May 2006

Nortel acknowledges restated revenues were part of management fraud