WHO KILLED NORTEL?
In his new book, JAMES BAGNALL tells the tale of how a seemingly straightforward quest to double-check Nortel’s accounts turned into a witch hunt that eventually brought down the company. In the first of two excerpts, the award-winning Citizen writer char
In an excerpt from his new book, associate business editor James Bagnall investigates how what began as a simple check of the company’s accounts led to its destruction.
There was a peculiar mood that day, everyone noticed it. Early in February 2001, a dozen or so executives gathered in a boardroom at Nortel Networks’ regional headquarters on the outskirts of Raleigh-Durham, N.C. Led by chief operating officer Clarence Chandran, the sales executive slated to take over as CEO later that spring, they were to review company operations and prospects.
Just three weeks earlier Nortel had announced a record $30 billion in sales for 2000 and CEO John Roth predicted this would jump another $10 billion in 2001. (All figures U.S. except where indicated.) The forecast surprised industry skeptics and some of Nortel’s less senior managers — the ones closest to the customers. But it hadn’t been conjured up from thin air. It was based on intelligence supplied by the people in the room, most notably Greg Mumford, the head of Nortel’s optical products group.
Mumford’s business unit, with $10 billion in revenues the previous year, had been struggling to keep up with orders from customers such as Qwest Communications of Denver and MCI Communications of Washington, D.C. These and dozens of smaller carriers were building fibre-optic networks at breakneck pace to win over a new generation of subscribers with high-speed Internet services.
They had assured Mumford throughout the fourth quarter and into January that they would continue buying optical gear at prodigious rates. Indeed, one customer demanded that Mumford sell it transmission gear that had already been allocated to one of the customer’s rivals. Mumford refused.
There were a few worrying signs. Some customers had warehouses stuffed full of Nortel technology still waiting to be deployed. But when queried about their ability to absorb more, the customers responded: “Let us worry about that, just keep our place in your production line.”
Other hints something was amiss could be discerned by the public. Three-anda-half months before the meeting in Raleigh-Durham, Nortel published thirdquarter results showing sales of fibre-optic gear had, for the first time in many quarters, failed to double year-over-year. Some investors sold shares, particularly those who based their holdings on momentum.
Nortel’s stock price began to weaken. Roth held to his view that Nortel’s revenue and operating profits in 2001 would grow between 30 per cent and 35 per cent — and he made it clear he expected the heads of his firm’s business units to meet the targets. When investors continued driving down Nortel’s share price, Roth responded by repeating his projection in press releases on Nov. 1, Nov. 20, Dec. 14 and Jan. 18. Roth could not accept that the tide had turned.
Shortly before the meeting in North Carolina, the heads of the business units learned, separately, that Qwest and other carriers were suddenly having trouble raising money. Nortel’s top customers were now saying they would have to scale back orders.
The extent of the reversal was about to become clear to Nortel’s top managers as a group. When the executives finally settled in position around the conference table, Frank Dunn — the company’s chief financial officer — began seeking updates. He gestured to Mumford.
For the first time in as long as anyone there could remember, the head of the optical products unit predicted a decline in sales prospects. Dunn paused, absorbing the bad news. Then he canvassed the other unit leaders — of wireless products, Internet telephony and enterprise technology. The outlook in every case was worse than expected.
For a moment, there was dead silence. Everyone realized an important line had been crossed. What they knew, what Dunn realized more than anyone, was that investors had to be told quickly about the dramatic change in Nortel’s outlook.
Dunn reached Roth at the company’s offices in France, where the CEO had been reviewing the firm’s plans for wireless technologies.
“To say I was shocked is an understatement,” Roth later acknowledged, comparing the level of his astonishment to the one he experienced later that year when terrorists crashed aircraft into New York’s twin towers. The CEO contacted board chairman Red Wilson and told him a press release was being developed.
At Nortel’s suddenly sombre facility in Raleigh-Durham, Dunn turned to Tom Manley. “You’re coming with me to Brampton,” he told Chandran’s top finance executive. Both men were rattled. They prided themselves on their ability to closely track business trends and felt they had been blindsided by the suddenness of the change in their customers’ order books.
Some colleagues were less charitable — they said Nortel’s most senior executives had seen what they wanted to see and had been unwilling to challenge Roth’s sales targets for being unrealistic. At Brampton headquarters, Manley and Dunn worked into the night recalibrating Nortel’s financial forecasts.
Roth delivered the unwelcome news to investors on Feb. 15, noting that Nortel’s sales would grow just 15 per cent in 2001. This was half the growth he had projected just four weeks earlier.
Yet even this downgrade would prove hopelessly optimistic. In coming months, Roth would have to make several more major changes to company guidance. By yearend, Nortel would eke out sales of little more than $17 billion, a moonshot short of the promised $40 billion.
“Our customers continued to search for new sources of funding to complete their networks and while they did so, reassured us that they would buy our equipment,” Roth recalls, “but month by month they conceded that they could not secure financing and cancelled their orders.”
Nortel was horribly exposed. The company had spent billions to build manufacturing facilities and open offices around the globe. It had also paid a fortune in signing bonuses to new employees and rewarded its executives with princely sums — more than $200 million in total compensation in 2000 for its top five executives alone — which was now seriously at odds with the coming era of austerity.
The company was also unexpectedly in the midst of a leadership crisis. For months Roth had stepped back from dayto-day management to give Chandran more freedom to put his stamp on Nortel.
Chandran had been heir apparent since his appointment as chief operating officer the previous year, but the reality was he had faced no serious competition for the top job for much longer than that.
Chandran earned his privileged status in 1996 when Newbridge Networks Corp. — the telecommunications equipment firm founded by Kanata billionaire Terence Matthews — lured him to become CEO. Nortel’s board of directors learned of Chandran’s imminent defection just as Newbridge was set to announce it. In fact, the press release had already been prepared. In order to convince Chandran to stay, Nortel’s directors took the unusual step of promising him the inside track for the top job upon Roth’s retirement, scheduled for the fall of 2001.
Roth was eager to retire. Visitors to his office in 2000 noticed he had already begun a countdown of the days to his exit. Then, early in 2001, he began to make plans to leave even earlier, perhaps in the spring.
Two developments put an end to this. First was the phone call he received from Dunn after the Raleigh-Durham session. Second was the fact that Chandran — the executive who had done more than anyone to expand Nortel’s physical presence, who had enthusiastically embraced the excesses of the telecom bubble economy — was nowhere to be seen.
Citing complications from a knife wound sustained when he had tried to defend himself from a robber on a late 1990s business trip to Singapore, Chandran bowed out. The wound was real but his closest colleagues knew that Chandran — an engaging salesman — was temperamentally unsuited to the job at hand.
That brutal task was left to Roth and Dunn, who became CEO in November 2001. Nortel started that year with 95,000 workers on the payroll. By yearend 2002, the company employed just 37,000.
Between them, Roth and Dunn closed 20 million square feet of real estate and cancelled thousands of contracts with suppliers. Nortel’s accountants and lawyers prepared quick estimates for how long the offices would remain empty and how much the company would have to pay to settle lawsuits threatened by suppliers. Projections were made for severance pay and the value of medical and other fringe benefits that would be used by employees put on layoff notice.
Nortel’s finance group tabulated these and other future liabilities and forklifted them onto the company’s ledger. By mid2002, Nortel’s balance sheet was groaning with more than $5 billion in accrued liabilities, also known as accruals or reserves.
These were costs that had been incurred but not yet paid. They were up sharply from the more usual average of $3.7 billion recorded during the last half of 2000. (It was normal for Nortel to maintain a fairly large balance of accruals to recognize obligations — such as software upgrades and next-generation technology — related to customer contracts.)
The danger with placing so many new reserves so quickly on the balance sheet became obvious later when Nortel realized it had overestimated what it required to cover contingencies. Lawsuits were settled for less than expected, the company found firms to sublet empty buildings, suppliers with a claim disappeared, customers declined promised upgrades of technology – the world did not end.
In the years to come, outside investigators and prosecutors would focus intensely on how Nortel’s accountants added to and subtracted from its tower of reserves. They would also read much — far too much — into why Nortel set up the liabilities and how the company justified removing them from the books.
Frank Dunn waited impatiently in his office for his last appointment of the day. Chief executive of Nortel Networks for the past two years, he had been instructed by his board of directors to take this meeting on his own — no lawyers, no advisers. Two Washington lawyers and a forensic accountant would ask him a few questions. That was all.
It was approaching 5 p.m., near dusk on this February day in 2004, and his visitors were almost two hours late. Dunn was feeling squeezed. He was to make sales calls the next day in Europe and the company plane, a Bombardier business jet, was leaving Toronto at dawn.
The CEO took in the view outside his second-floor office at the company’s sprawling headquarters in Brampton. It had been a warm day, a few degrees above zero, and parts of the nearby ice-encrusted pond were obscured by haze. Dunn had turned 50 the previous month and his thinning hair was mostly white. The window reflected a gaze hardened by an ultracompetitive streak. A former jock, Dunn played tight end for McGill University’s football squad in the early-1970s while earning his business degree. When he got really excited about something — which happened often — his colleagues involuntarily stepped back to avoid the spray of his words.
A few years earlier, the idea that Dunn would now be serving as the top gun at Nortel Networks would have struck many in the organization as improbable. Nortel’s finance group, where Dunn devoted his career, was a distinctive minority within the firm, representing fewer than two of every hundred employees. The unit was made up of chartered accountants — the detailed numbers professionals who were qualified to make entries on Nortel’s general ledger — and business experts such as Dunn, who viewed the world from a higher plane. Among other things, he calculated the value of companies Nortel purchased, arranged corporate financing, and briefed the burgeoning group of independent analysts who wrote reports about the firm for investors.
The knock against Dunn was that he had never mastered telecommunications technology or detailed accounting. He made up for it with an approach to business that was utterly relentless.
When company chairman Red Wilson sought a new CEO to replace Roth in 2001, he picked Dunn, the one senior executive familiar with all of Nortel’s dozens of product lines. “The time for visionaries is over,” Wilson said. The collapse of the telecommunications equipment industry that year demanded a different set of skills — someone with a thorough understanding of how Nortel was put together, an executive capable of restoring the company to profitability.
Dunn hadn’t really wanted the job. He had been Roth’s right-hand man for a tumultuous decade and had seen what the job entailed. Dunn had also absorbed some of the opprobrium that had been heaped upon Roth after the telecom crash and he wasn’t comfortable with the limelight. But he eventually determined it was time to step up.
Dunn was as surprised as everyone else at how quickly the tide turned. He signed a $1-billion deal in the first week of 2004 to sell Internet gear to Verizon, one of America’s largest phone companies. Later the same month, Dunn closed the books on Nortel’s first annual profit since 1997. There were other bits of good news that preceded his meeting with the Washington lawyers. The Dominion Bond Rating Service had upgraded its view of Nortel’s debt to stable from negative. And independent financial analysts were forecasting a second consecutive year of profits, one in which Nortel would grow revenues faster than its rivals.
Even more remarkable, given the utter misery of the past three years — the period that became known as the industry’s nuclear winter — Nortel had recently reclaimed the title of Canada’s most valuable corporation with a market capitalization of nearly $50 billion Cdn. It was a far, far cry from the $366-billion Cdn. market value reached during the telecom bubble of 2000, but the idea that Nortel might die on his watch no longer tormented Dunn. It’s why he had no qualms about taking his next meeting.
Laura Wertheimer entered Dunn’s office just as winter daylight was fading into dusk. She was accompanied by William McLucas — her fellow law partner at Wilmer Cutler — and Stephen Burlone, a principal at Huron Consulting and a forensic accountant.
They had been hired by Nortel’s audit committee to provide a second opinion on the company’s accounting. Nortel the previous autumn realized it had over-stated the liabilities carried on its June 30 balance sheet — a consequence of the wrenching restructuring. Accordingly, the company had revised its accounting for the quarters prior to June 30.
McLucas was the only one of the three professionals known even vaguely to the general public — he was a former director of investigations for the U.S. Securities and Exchange Commission, a role that for a time made him one of America’s top white-collar crime fighters.
Surprisingly though, it was Wertheimer leading the investigation of Nortel’s accounts. She had joined Wilmer Cutler just a few months earlier and this was her first assignment with her new firm. An experienced litigation lawyer in her late 40s, Wertheimer had spent most of her career with little-known Gardner & Shea where she quietly advised accountants and lawyers on rules of professional conduct.
She got right to the point, noting her team had been examining Dunn’s computer files and was puzzled by the relatively small number of emails. Was Dunn using some kind of software program to eliminate them? If the intent was to shock, it worked: This would not be an ordinary interview. It was odd in another way — no one took detailed notes. There was no tape recorder, no video. Nor did the lawyers show Dunn documents.
An hour into the session, Dunn appeared increasingly puzzled about its purpose. He’d been told by Nortel’s in-house counsel that Wertheimer’s job was to assess the quality of the company’s revised financial results.
Dunn believed the accounting for the $952-million restatement had been above board, and saw the Wilmer Cutler review as little more than fact-checking. But as the interview progressed, it seemed that Wertheimer had another agenda. She was focusing on transactions involving Nortel’s liabilities and how these had influenced quarterly profits. And she really wasn’t asking questions — she was making assertions.
Wertheimer brought up his accountants’ use of balance sheet reserves in the fourth quarter of 2002. She said Nortel had improperly added a sufficient number of new liabilities to turn an unexpected quarterly profit into the loss that Dunn had earlier forecast. The reserves were booked properly, Dunn replied. “What you get each quarter is what you get,” he said, adding that any accountant would know “you don’t book to (meet) a forecast.”
Wertheimer added there were groups of liabilities that Dunn’s staff had left on the company’s balance sheet improperly, the ‘cookie jars’ as these came to be called. For instance, there was a $25-million reserve for an executive bonus to be awarded at the discretion of the CEO. Nortel used these cookie jars to manipulate earnings, she asserted.
Wertheimer and her colleagues left shortly before 11 p.m. Dunn remained in his office for a few minutes trying to piece together where this stuff was coming from. As CEO he had certified, in writing, that the accounting was correct. But he had relied on representations from Deloitte and Michael Gollogly — Nortel’s top accountant. Something, suddenly, was very wrong.
What Dunn didn’t know, indeed would have been shocked to realize, was that he was already powerless to alter Nortel’s tragic trajectory.