Nortel Settles Fraud Suit with $35M

Trying to put years of accounting and regulatory turmoil behind it, the company also will update the SEC every quarter on how it's addressing a material weakness in its internal controls.

Nortel Networks announced Monday that it will pay the Securities and Exchange Commission $35 million to settle accounting fraud charges.

The Canadian telecommunications equipment maker has not admitted or denied the SEC’s accusations but agreed to periodically update the commission on progress made in a remediation plan and ways it will address an outstanding material weakness in its internal controls over financial reporting.

The SEC had charged that Nortel’s “extremely target driven” culture led to fraudulently reported revenue and earnings management in the early years of this decade. The company had previously settled similar charges lobbed against it by the Ontario Securities Commission and shareholders. Nortel also has made several internal changes including making new executive hires, improving its financial processes and controls, redoing its ethics policy, and establishing a new code of conduct.

The fallout from Nortel’s accounting troubles included the dismissals of several executives, including CFO Douglas Beatty. The SEC’s case against Beatty, former CEO Frank Dunn, and six other executives is ongoing.

The regulator alleges that the executives knew millions in excess reserves should have been released in accordance with GAAP, but instead allowed them to be held to manage earnings. The suit says the individuals violated or aided and abetted violations of the antifraud, reporting, books and records, internal controls, and lying to auditors provisions of the federal securities laws for more than three years.

According to the SEC, this behavior stemmed from a downturn in the telecom industry in late 2000. At that time, “Nortel responded to market pressures by engaging in a fraudulent accounting scheme in which it primed Wall Street’s expectations by issuing unrealistic financial guidance, and then used accounting adjustments that did not comport with generally accepted accounting principles, to move its revenues and earnings upward or downward as necessary,” the regulator said.

The company was able to inject this flexibility into its financial reporting by altering its revenue recognition policies, according to the SEC. Essentially, the company went against GAAP by recording transactions involving its optical business that had not yet been delivered. In the meantime, it was releasing unrealistic earnings guidance to investors.

The result: the company’s alleged fraud led to inflated revenues of approximately $1.4 billion for the company’s 2000 fourth quarter and fiscal year, the SEC’s complaint says. When it announced its FY00 results, Nortel was keeping more than $400 million in excess reserves, the SEC claims, allowing the company to report a loss so that it could report a higher-than-predicted profit at another time (indeed, Nortel allegedly did so in the first two quarters of 2003 by releasing about $500 million from its reserves to “boost its earnings and fabricate a return to profitability,” according to the SEC).

Nortel’s inflated earnings helped justify so-called “return to profitability” bonuses worth tens of millions of dollars to some of its senior executives, including Dunn and Beatty.

In the settlement announcement on Monday, the SEC acknowledged Nortel’s efforts in righting itself. In addition to terminating the executives for wrongdoing, the company has made several restatements and shared the results of its internal investigation with the commission. The company will report to the SEC’s staff every quarter until it has fully implemented its remediation plan and it external auditor agrees that its outstanding material weakness has been resolved. Nortel says it has fixed four of five material weaknesses found in its internal controls during this process.

Former CFO Peter Currie, who spent nearly three years helping the company turn itself around, left earlier this year. Nortel recently hired former Marconi PLC CFO Pavi Binning as its new finance chief.

“Under new leadership, Nortel has undertaken significant efforts to address the wrongdoing, remedy the harm, and implement a remediation pan to prevent recurrence of the misconduct,” said Linda Thomsen, director of the SEC’s Division of Enforcement.

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