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Fraud, not incompetence, to blame for Nortel's accounting fiasco

SEC charges four execs

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The SEC today threw the book at four former Nortel execs for cooking the books. Frank Dunn, ex-CFO and CEO at the Canadian telecoms equipment maker, Douglas Beatty, ex-controller and CFO, Michael Gollogy, ex-controller, and MaryAnne Pahaphil, ex-assistant controller, are accused of manipulating secret cash reserves and recognizing revenues earlier than they should have done to meet Wall Street expectations and to line their own pockets.

The alleged frauds were simple enough. In late 2000, Beatty and Pahapill broke US accounting rules to bring forward revenue recognition for the sole purpose of meeting market expectations."However, because their efforts pulled in more revenue than needed to meet those targets, Dunn, Beatty and Pahapill selectively reversed certain revenue entries during the 2000 year-end closing process," the SEC said. Net result: "Nortel's Q4 revenues was inflated by $1bn, and the company met, but did not exceed Wall Street targets."

In 2002 and early 2003, the execs illegally set aside two pots of excess reserves, of $300m and $151m to smooth over gaps between company performance and Wall Street expectations. Under US company law, Nortel should have declared this money as income. In the first and second quarters of 2003, Dunn, Beatty and Gollogly released $490m from secret funds, "specifically to boost earnings, fabricate profits and pay bonuses," the SEC charges.

"These efforts turned Nortel's first quarter 2003 loss into a reported profit under US GAAP, which allowed Dunn to claim that he had brought Nortel to profitability a quarter ahead of schedule. In the second quarter of 2003, their efforts largely erased Nortel's quarterly loss and generated a pro forma profit. In both quarters, Nortel posted sufficient earnings to pay tens of millions of dollars in so-called "return to profitability" bonuses, largely to a select group of senior managers."

Nortel has been restating accounting statements since October 2003, sometimes on a fortnightly basis. But until today, incompetence, rather than accounting fraud, was the generally accepted explanation, Indeed this was the line of defense that Dunn and Beatty sought in November 2003, when they announced $980m in restated liabilites, following a "comprehensive review of assets and liabilities.

They blamed mistakes in internal control. But, says the SEC: "In reality Nortel's first restatement was necessitated by the intentional improper handling of reserves which occurred throughout Nortel for several years, and the first restatement effort was sharply limited to avoid uncovering Dunn, Beatty and Gollogly's earnings management activities."

Now for a punchy quote from Christopher Conte, an associate director of the SEC's division of enforcement: "The defendants charged today all disregarded accounting principles and disclosure requirements designed to provide investors with a clear and accurate picture of a company's performance. Investors were misled for extended periods of time about the health and stability of Nortel's operations. Further, these defendants all received significant compensation, in some cases in the millions of dollars, while they were manipulating Nortel's financial results. In some cases, these individuals received such compensation only because they manipulated Nortel's financial results."

Dunn, Beatty, Gollogly and Pahapill are charged with violating and/or aiding and abetting violations of the antifraud, reporting, books and records, internal controls and lying to auditors provisions of the federal securities laws. Dunn and Beatty are separately charged with violations of the officer certification provisions instituted by the Sarbanes-Oxley Act. The SEC seeks a permanent injunction, civil monetary penalties, officer and director bars, and disgorgement with prejudgment interest against all four defendants.

Nortel fired Dunn, Beatty and Gollogly in April 2004. MaryAnne Pahapill left the company in January 2005. ®

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