Former Nortel CEO Frank Dunn leaves the Toronto court house where he and two other former executives are on trial for fraud, Jan. 12, 2012.
Nortel Networks Corp. executives knew as early as the fall of 2002 that they were facing losses in the first half of 2003, but manipulated accounting reserves to ensure a profit in the period so they could trigger their "return to profitability" bonus payments, a Toronto court heard Tuesday.
In his opening statement in the fraud trial of three former Nortel executives, Crown attorney Robert Hubbard said the executives even turned an unexpected profit into a loss in the final quarter of 2002 because it came too early to trigger their bonuses.
"Contrary to Nortel's own policy for closing its books, senior executives solicited further [accounting]accruals from across the company to turn a profit into a loss," Mr. Hubbard told Mr. Justice Frank Marrocco of the Ontario Superior Court.
Former Nortel chief executive officer Frank Dunn, former chief financial officer Douglas Beatty and former controller Michael Gollogly are accused of fraud for manipulating Nortel's financial statements in 2002 and 2003 to trigger $5-million in bonus payments and ensure their restricted share units would pay out.
The men have denied the charges and the allegations have not been proven.
On the second day of his opening remarks, Mr. Hubbard led Judge Marrocco through details of the accounting reserves that were shifted between periods to help achieve desired results.
Mr. Hubbard said former accounting employee Brian Harrison is expected to testify at the trial that he was told Mr. Dunn wanted to report a profit in the first quarter based on generally accepted accounting principles – and not just a pro forma profit using Nortel's internal calculations.
As a result, Mr. Harrison was told to figure out how reserves could be shifted to make it happen, including enough reserves to cover the costs of paying $73-million in bonuses that would be triggered if a profit were achieved. A handwritten document Mr. Harrison created at that time includes a note on the margin saying "rock vs. hard place," Mr. Hubbard said.
"It is expected Harrison will liken this process to playing Sudoku," Mr. Hubbard said, referring to the popular number puzzle.
Another internal document, prepared by another accounting employee in February, 2003, lists $189-million of head office "non-operating" reserves – such as provisions set aside to account for possible settlements in lawsuits – that were no longer needed. They should have been restated back to their proper periods, Mr. Hubbard said.
Instead, he said evidence will show that only $80-million was recorded in the first quarter because that was the amount needed to ensure a profit in that period. "Without that $80-million in Q1 of 2003, they would not have been able to pay a $73-million return-to-profitability bonus," he said.
A further $59-million of the head office reserves were going to be released in the second quarter of 2003 to guarantee a profit in that period, Mr. Hubbard said. But when operating divisions found more of their own accruals to release than had been expected, executives shelved the plan to release most of the head office reserves, using only $4-million instead.
Mr. Hubbard alleged that the reason $4-million was used was because that amount was needed to reach a threshold to trigger a payout under the executives' restricted share unit plan. He said the amount proves that the accounting used in the quarter was intentionally manipulative and not simply an error as the defence has suggested.
"When considering was it intentional or was it an error, bear that [amount]in mind," Mr. Hubbard told the judge.
He said employees will also testify about the unprecedented push at the end of the fourth quarter of 2002 to find new accruals to turn an unexpected profit into a loss for the period. He said internal memos showed executives wanted to adhere to Mr. Dunn's goal of achieving profitability by the second quarter of 2003, although ultimately Nortel reported a profit starting in the first quarter.
Nortel employees from operating divisions will testify that they were happy with the state of their reported results at the end of 2002, and only found extra provisions to book because they were told to do so by head office in a rush in early 2003, Mr. Hubbard said.
He said the trial will hear that Mr. Beatty expressed concerns that Nortel would not get credit in the markets for reporting a "blip" of one quarter of profits after years of large losses.
Mr. Hubbard also explained that an internal report from September, 2002, estimated that the company would earn $2.4-billion to $2.5-billion in revenue in the first quarter of 2003 and report a loss of about $95-million. In early 2003, the board was told revenue would be about $2.35-billion for the quarter and the company could have a loss of $240-million in the period.
But by April, the board was told the company expected to report revenue of $2.39-million for the first quarter and earn a profit in the period. The change was achieved by using the company's "cookie jar" of accounting reserves, Mr. Hubbard suggested.
Judge Marrocco asked Mr. Hubbard why the board of directors didn't question such a substantial reversal of fortune.
"No one puts together the fact they're told we need $2.3-billion to experience a loss of $240-million, and we have $2.3-billion [of revenue]and we actually have a profit of $54-million," he asked. "Why didn't someone ask the question, 'What happened?' "
Mr. Hubbard said the judge was right in his understanding of the issue, but did not offer a further response. He later noted that the board was being told that the accounting provisions reflected in the financial statements were the result of normal changes in estimates, rather than improper releases of the amounts.
Judge Marrocco also asked if Nortel's auditors at Deloitte & Touche knew of the misuse of accruals. Mr. Hubbard said some of the amounts were contentious at the time, but were ultimately permitted by the auditors.
He said the approvals do not lessen the legal responsibility of the accused executives to state their financial results properly, however.
"Whether or not other parties were acquiescing or were negligent, Your Honour may have to draw conclusions, but it doesn't exculpate the accused."
Janet McFarland