R. v. Dunn, Beatty and Gollogly 2013 ONSC 137
The collapse of Nortel Networks Corporation (Nortel) after the bursting of the technology bubble in 2001, and the ultimate bankruptcy of Nortel, is a dramatic and sad chapter in the history of a Canadian corporate icon. Nortel, which was listed on the Toronto Stock Exchange and New York Stock Exchange, was one of the most valuable companies on the Toronto Stock Exchange in 1999. It had a share price that often exceeded $100 U.S. It was widely held by many Canadians in their retirement plans, and by pension funds. The collapse of Nortel’s share price in 2000 and 2001 affected virtually every Canadian who owned shares in public companies, and Nortel’s ultimate filing for bankruptcy protection in 2009 represented an unfortunate end to the Nortel story in Canada.
In June 2008, three former executives of Nortel: Frank Dunn, the former CEO; Douglas Beatty, the former CFO; and Michael Gollogly, the former controller, were charged with two counts of fraud in relation to the preparation of the financial statements of Nortel between 2000 and 2004. Each was alleged to have committed fraud by "deliberately misrepresenting the financial results" of Nortel between 2000 and 2004, thereby defrauding the public in count 1, and Nortel, in count 2 of the indictment. The case was highly publicized, principally because of the wide public interest in the collapse of Nortel and the public assumption that someone must be to blame in this unhappy story.
In fact, the allegations of criminal fraud had little connection to the circumstances which caused Nortel to apply for bankruptcy protection in 2009. Nevertheless, the case attracted widespread attention in the legal and business communities, and in the general public.
The Acquittal of the Three Former Executives
On January 14, 2013, Marrocco J. of the Ontario Superior Court of Justice acquitted the three former executives of Nortel*. The acquittals involved a fundamental rejection by the trial judge of the Crown theory that, in Q4 2002 and Q1 and Q2, 2003, the three former executives of Nortel had fraudulently manipulated the booking, and release, of accrued liabilities in an effort to create false financial statements, triggering bonuses to which they were not entitled.
The Crown alleged that Nortel’s first restated financial statements for 2000 to Q2 2003 (first restatement), issued December 23, 2003, were themselves fraudulent in their representation that they were a comprehensive restatement of Nortel’s original accounting. In making this allegation, the Crown relied upon the fact that, in January 2005, Nortel issued a second set of restated financial statements for 2000 to 2003 (second restatement), approved by Nortel’s original auditors (who had also approved the first restatement). The Crown alleged that there were fundamental differences between the first and second restatements and that these differences were demonstrative of fraud in relation to both the original accounting at Nortel, and the first restatement for which the three senior executives were responsible.
The Crown also alleged that in Q4 2002 accruals were booked to deliberately move Nortel from a pro forma profit to a pro forma loss. The allegation was that this was done to "store up" excess accruals to be later released to fraudulently meet earnings targets and to trigger the payment of bonuses.
After a six-month trial, and reviewing thousands of pages of documentary exhibits, Marrocco J. acquitted the accused, concluding that the original financial statements of Nortel were not materially misrepresented, and that the first restatement was comprehensively and honestly completed. Marrocco J. concluded that the second restatement involved Nortel’s auditors, Deloitte and Touche LLP (D&T), disagreeing with its previous opinions with respect to accounting, and acting upon new information. Marrocco J. also concluded that additional items concerning revenue recognition were considered in the second restatement, which also contributed to the differences between the first and second restatements. Marrocco J. concluded that the second restatement was no evidence that either the first restatement (completed by the three accused) or the original accounting, were in any way fraudulent.
The Wilmer Cutler Pickering Investigation
The criminal allegations stemmed from a review performed by Wilmer Cutler Pickering (WCP), an American law firm.1 Nortel’s Audit Committee retained WCP as its legal counsel and asked WCP to perform the review to determine the circumstances leading to the decision by Nortel to restate its financial statements in the fall of 2003 in an attempt to satisfy regulators concerned about the need for Nortel to restate its financial statements.2
Nortel initially restated its financial results when, through a comprehensive balance sheet review conducted in the fall of 2003, $900 million in excess accrued liabilities were discovered.3 Nortel’s Audit Committee decided to restate its financial results a second time when WCP advised that "aspects of the prior accounting were not correct and raised the potential of earnings management".4 The second restatement produced different results than the first, leading the Crown in this case to allege that the initial balance sheet review was not comprehensive and the results of the first restatement, as well as the initial accounting statements, were materially misrepresented.5
The Crown’s allegations against the accused in this case were similar to those in the WCP review: ongoing earnings management by the defendants for the purpose of receiving bonuses to which they were not entitled.6 The evidence at trial established that the analysis by WCP, which led to the criminal charges, had drawn conclusions about the cause of the first restatement, but in the WCP review: "the work of Nortel’s external auditor, Deloitte & Touche LLP, was not examined".7
At the six-month long criminal fraud trial of the three executives starting January 16, 2012, the defence relied on voluminous documentary evidence from D&T, Nortel’s auditors, filed as business records, to show that Nortel’s original accounting was reasonable and comprehensively reviewed by D&T.
Once the D&T documents were examined, along with all of the other evidence, it was clear to Marrocco J. that
the second restatement produced different results than the first restatement because the thresholds of the second restatement were different, because the second restatement concentrated on revenue recognition, as well as excessive accrued liability balances, and because Deloitte changed its mind about the accounting for specific transactions. Sometimes,...Deloitte disagreed with itself.8
Marrocco J. also found that Nortel’s original financial statements were materially accurate — contrary to the Crown’s theory, they were not materially misrepresented.9
In relation to Q4 2002, Marrocco, J. concluded that accruals entered late in the Q4 2002 close process did not move Nortel from a pro forma profit to a pro forma loss. Furthermore, Marrocco J. concluded:
I am not satisfied beyond a reasonable doubt that the accruals solicited by [the Director of Global Planning] and recorded in Q4 ’02 resulted in a misrepresentation of Nortel’s U.S. GAAP financial results for Q4 ’02 or fiscal 2002.
As a result, the three former executives of Nortel were acquitted.10
The Importance of Context – the Bursting of the Dot-Com Bubble
Marrocco J. recognized that it is impossible to understand the nature of the alleged criminal conduct without an appreciation for the context in which the three men were charged.11 Nortel was an international company that provided data, wireless and optical networking products and services to telecommunications carriers and enterprise customers worldwide.12 The company rapidly expanded in 1999 and 2000, undertaking 22 acquisitions for a total of $29 billion — a move that mirrored the growth of the industry at the time.13 However, in 2001, the industry experienced a significant slowdown that caused a dramatic decline in demand for Nortel’s products and services.14 In an attempt to streamline its operations, Nortel reduced its workforce from approximately 94,002 employees in 2001 to 37,000 at the end of 2002, incurring billions of termination and severance charges on top of goodwill write downs and other necessary measures for survival.15 The company experienced losses of $197M in 1999, $2.9B in 2000, $27.4B in 2001 and $3.6B in 2002.16 As the Vice-Chair and Deputy Chief Executive of D&T (Canada), Mr. Bruce Richmond, testified:
Nortel was descending down a very slippery path at a very fast rate... The notion of where the bottom was going to be was not understood at that point in time by anybody... One day a client existed the next day it was out of business... The team was clearly on red alert in terms of what they were facing... ....endeavoring to the best of our collective ability, and I’m talking Nortel folk and I’m talking Deloitte folk, to put your arms around a situation ... that we had never seen before...
…in the years 2001, 2002, the company was fighting for its very survival...17
Marrocco J. concluded that Nortel’s Audit Committee and Board of Directors were extremely concerned with Nortel providing for every risk it might face and ensured that message was communicated throughout the company.18 As a result, excess liabilities accrued.19
Conservatism was Acceptable
Marrocco J. found that Nortel had a long-standing culture of conservatism in accounting that had "existed for in excess of twenty years"20 — long before the three accused earned their executive positions.21 The Crown argued that Conservatism was contrary to US GAAP; however, Marrocco J. was not satisfied that was the case.22 When a company provides for liabilities in a manner consistent with the policy of Conservatism, "uncertainties that surround the preparation of financial statements are reflected in a general tendency toward early recognition of unfavorable events and minimization of the amount of net assets and net income".23 In its Statement of Financial Accounting Standards No. 5 (FAS 5) released in March 1975, The Financial Accounting Standards Board specifically noted that FAS 5 is not inconsistent with the accounting concept of Conservatism.24
Marrocco J. was "satisfied beyond a reasonable doubt that all three accused, by virtue of their long experience with Nortel and their positions of responsibility, well-understood how the men and women in the field were implementing Nortel’s policy of Conservatism".25 He found that the accused understood that liabilities were often estimated on a "worst-case scenario basis" and that "in order to avoid exposing Nortel to risks that were not provided for, there was a reluctance to reduce accrued liability balances in the appropriate quarter in response to a triggering event".26
However, Marrocco J. did not agree with the Crown’s allegations that the excess liabilities on Nortel’s balance sheet were false — they were, in fact, genuine.27 He stated that he was "not satisfied that any or all of the accused understood the extent of the unsupported liabilities" and he accepted that this was in part because
the downsizing of Nortel, which involved the closing of offices, the selling of real estate and, undoubtedly, the storage of documents, created a situation in which supporting documentation for some of existing accrued liability balances could not be located. Further, the loss of employees (two out of every three worldwide) created a situation in which the institutional memory concerning the unsupported accruals no longer existed within the company.28
Marrocco J. was satisfied that "the enormous losses suffered by Nortel in fiscal 2000 and 2001 created a situation in which senior management, Nortel’s Board of Directors and Nortel’s auditors were concentrating their efforts and energy on doing what was necessary to make sure that Nortel had sufficient cash reserves to survive."29
In the Summer of 2003, Nortel began an enhanced review of its balance sheet (Balance Sheet Review).30 It was through the Balance Sheet Review that the extent of the issue was discovered.31 Marrocco J. concluded that the "comprehensive balance sheet review" which resulted in the first restatement was, indeed comprehensive and that its scope was reasonable.32 He accepted evidence heard at the trial that the first restatement reflected a concerted effort by senior management at Nortel, including the three defendants, to correctly re-state the $900 million in excessive accrued liabilities on the balance sheet identified in the comprehensive balance sheet review.33
The Restatements were not Evidence of Fraud
The evidence at trial showed that Nortel restated its financial statements for the year 2000 through Q2 2003 on two occasions.34 Marrocco J. conceded that "[i]n the abstract, it is true that the fact that accrued liability balances in Nortel’s balance sheet were restated is capable of supporting an inference that, in their original form, the financial statements misrepresented Nortel’s financial results"; however, he concluded that "[b]ased on the evidence that [he] heard, [he] should not draw such an inference in this case."35 Marrocco J. then warned of the dangers of giving credence to that inference,36 stating:
It would be imprecise and dangerous to conclude, without knowing the specifics of the transactions, that Nortel’s prior published financial results were false because transactions...were restated. The more accurate statement is that Deloitte changed its mind about the accounting treatment for these transactions and, as a result, previously-published financial statements had to be changed.37
After looking at the evidence of specific transactions in the periods, he concluded:
I am not satisfied by the evidence in this case, including the fact that the second restatement resulted in financial statements which were different than Nortel’s previously-published and restated financial statements, proves that the previously-published and restated financial statements misrepresented Nortel’s financial results.38
In short, as summarized by Marrocco J.:
I am satisfied that Nortel’s original financial statements for the years 2000, 2001, 2002 and Q1 ’03 and Q2 ’03 properly reflected Nortel’s financial reality.39
Materiality is Key
Materiality played an important role in Marrocco J.’s decision, for he framed the constituent elements of the Crown’s allegations as follows:
Count 1: "the Crown has to prove that the accused knew that Nortel‘s financial statements contained misrepresentations that were material to the decision of a member of the investing public to buy, hold or sell Nortel publicly-traded securities."
Count 2: "the misrepresentation of Nortel‘s financial results created the economic risk that Nortel Networks Corporation would pay money to the defendants that ought not to be paid to them."40
Marrocco J. accepted the definition of materiality provided by the report prepared by the Crown’s expert, Mr. Robert Chambers:
The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.41
After reviewing the transactions at issue, Marrocco J. was satisfied that they were not material.42 In particular, Marrocco J. accepted the evidence of Bruce Richmond, one of Deloittes’ Senior partners on the Nortel file, that the $900 million in excess accrued liabilities on the balance sheet that were re-stated in the first restatement, were not material to Nortel’s financial results in 2001 and 2002, primarily because of the $33 billion of losses Nortel experienced in those years.43
Marrocco J. also rejected the Crown’s theory that if it were not for the release of $80 million in accrued liabilities in Q1 03, profit targets necessary for the payment of bonuses would not have been met.44 A draft memorandum by Deloitte & Touche, prepared within the time frame of the allegations, analyzes the release of the $80 million in detail and concludes that "the thresholds for these two bonuses would have been met whether or not the $80 million in accrued liability balances is released to the profit and loss statement."45 Marrocco J. accepted that conclusion: the bonuses would have been payable with or without the release of the $80 million.46
The Importance of Nortel’s Open and Candid Relationship with its Auditors
Nortel’s relationship with Deloitte & Touche figures prominently in Marrocco J.’s judgment — he understood that it could not be underestimated.47 He asserted the importance of this relationship for context and found:
I am satisfied that Nortel was a significant Deloitte & Touche client. I am satisfied that Deloitte & Touche were embedded in one form or another in all aspects of Nortel’s operations. The evidence is replete with communications between Nortel staff and Deloitte staff. Many of the witnesses testified that, when Deloitte asked for information, it was provided. This assertion is amply borne out by the documentary record.48
Marrocco J. understood that the inferences the Crown had asked him to draw were not justified given the complexities of the whole situation — the tech crash, the forced downsizing of Nortel, and Nortel’s longstanding, candid relationship with D&T. He declined to give those inferences effect49, stating
The restated releases referred to in the evidence lead me to the conclusion that the decision to restate on account of an error can be the same thing as saying that there was a decision to restate on account of a difference of opinion. The difference of opinion can occur with the benefit of hindsight. The difference of opinion can be influenced by new information. As indicated earlier, when deciding to restate an accrued liability balance, sometimes Deloitte disagreed with itself. The specifics of each restated item are a story, the details of which cannot be inferred from the ending....50
The decision of Marrocco J. in Regina v. Dunn, Beatty and Gollogly is the first time a Canadian criminal court has considered an allegation of accounting fraud against corporate executives, based on a prosecution claim that the existence of fraud can be inferred from the restatements themselves.
This claim was firmly rejected by Marrocco J., having regard to his factual findings that the differences between the first restatement, the second restatement, and the original accounting was not attributable to fraud but rather to different thresholds between the first and second restatement and, more fundamentally, to D&T changing their minds concerning the proper accounting for the transactions at issue. In the end, Justice Marrocco’s decision was a resounding victory for the accused, and a fundamental rejection of the Crown’s case reflected in his central finding that:
Nortel’s original financial statements for the years 2000, 2001, 2002, Q1 ‘03 and Q2 /03 properly reflected Nortel’s financial reality.
*The decision is reported at R v. Dunn 2013 ONSC 137 (Ontario Superior Court of Justice)