Case Study of The Nortel Company

Abstract

Nortel became a prominent telecommunications company during the 1990s, but saw a swift decline starting in August of 2000 due to unethical accounting procedures that dissociated the company with Generally Accepted Accounting Principles, instead using pro-forma accounting procedures that could be used to hide the company’s poor performance. The purpose of this paper is to explore and discuss the rise and downfall of Nortel from an ethical perspective and attribute the downfall to either a “people” problem or a “capital market process” problem and to discuss what measures could have been put in place to better align managements interests to those of the company’s shareholders. Additionally, this paper will discuss past cases and explore what these companies had in common that attributed to their downfalls and what remedies can be put in place to stop future occurrences from happening.

Keywords: Nortel, ethics, GAAP, fraud, John Roth

Nortel Networks Corporation was a Canadian telecommunication company who saw its popularity soar during the telecommunications boom that occurred during the 1990s and continued to rake in massive profits until its downfall starting in 2002. This paper will: explore the rise and fall of the Nortel Corporation, exploring the ethical ramifications of its actions during its rise and fall, explore the mechanisms that can be instilled in an organization to better align management’s interest with those of the shareholders, and discuss if people or the capital market process lead to the meltdown of the corporation; additionally, this paper will discuss why corporations and business professionals put themselves in similar situations and how regulation, education, incentives, and punishments can be used to detract from future unethical incidents occurring.

A Brief History and the Downfall of Nortel

Nortel’s prominence started when John Roth was named the Chief Executive Officer (CEO) in 1997 and was invigorated by buying up web-tech companies, the most prominent of which was Bay Networks, which sold for 9.1 billion dollars (USD – United States dollars); in Roth’s first 30 months as CEO, Nortel acquired 17 companies for the sum of more than 33 billion dollars (USD). In this same time frame the company’s sales tripled and the company’s market capitalization was over 350 billion dollars (CAD – Canadian dollars), ranking it as one of the world’s largest firms and accounting for over 37 percent of the Toronto Stock Exchange (TSX). (Collins, 2012 p. 535).

The downfall of the Nortel Corporation started in August of 2000, when the value of the company dropped from an all-time high of 398 billion dollars (USD) to five billion dollars (USD), or 200 dollars per share to 67 cents per share; in addition to the massive negative impact of the shareholders, the downfall of Nortel resulted in 60000 employees, or two thirds of the company’s employees, losing their jobs. (By, 2001 Oct 03). In November of 2001, Roth and several other high-level executives within the company resigned, leaving Frank Dunn, the former Chief Financial Officer (CFO), as the new CEO. It would not be long until the Securities and Exchange Commission (SEC) would bring civil charges of fraud against Dunn and other current and former executives. (Collins, 2012 p. 536).

SEC Charges and Ethical Decisions

The SEC charges filed against Dunn and other executives stemmed from what the SEC described as major accounting and financial irregularities and alleged that Nortel’s executives had been manipulating the results for quite some time. During the third quarter of 2000, Nortel’s stock lost over 22 percent of its worth, however, Nortel’s third quarter report to its shareholders painted an entirely different picture, instead insuring investors that the company’s outlook was looking strong and indicated significant growth in the near future. (Collins, 2012 p. 536). Roth stood further accused of passing along insider information concerning profits to certain analysts; additionally, Roth was tasked with defending his fellow executives, who sold massive amounts of company stock within weeks, and in some cases the day before, the announcement of reports that were devastating for the company.(Collins, 2012 p. 540). Nortel’s CEO and executive’s incentives were poorly aligned to what was best for the company, resulting in many lapses of corporate ethics. The four ethical factors that led to the downfall of Nortel were: the structure of the board of directors, the makeup of executive compensation, the structure of ownership, and earnings management. (Collins, 2012 p. 540).

Studies have shown that companies who use an independent board of directors elected by stakeholders of the company have better management of company finances and higher market valuations. (Collins, 2012 p. 540). Although Nortel used an independent board of directors, the company still failed in this regard due to the size of its board, dictatorships within the board, and the occupation of financial experts. Nortel’s unethical management of its board of directors was caused by the board relying on management to communicate and verify the company’s financial results, leaving the board unable to identify financial irregularities. Many have pointed to egoism, or the thought process that states a person is correct if a decision conforms to his or her personal interest, as a reason for executives to not relent power and as a basis for their decisions. (Collins, 2012 p. 149).

Executive compensation was another ethical factor leading to the downfall of Nortel; Nortel’s compensation package for its executives relied strongly on stock options, resulting in the executives to focus on the company’s stock price as a sole indicator to the health of the company. Compensation expenses were mainly judged on the basis of revenue and earnings per share, which do not adhere to Generally Accepted Accounting Practices (GAAP) and made the company’s acquisitions look much more promising without any recourse or concern to GAAP associated earnings. (Collins, 2012 p. 541). Nortel’s executives knew the implications of their actions and their ethical intentions were not to benefit their shareholders, but to benefit themselves instead.

The ownership structure of Nortel changed constantly during the company’s upward climb, with institutional investors buying up large portions of the company, many of which were short term investors whom did not hold the company stock for long, increasing the overall volatility of the price per share. The increase in institutional investors also gave more focus to the shares of Nortel and influenced the behavior of its managers, pressuring the managers to meet increasingly higher earning goals, which ultimately became unrealistic and set off an action-sequence of unethical decisions leading to fraud. (Collins, 2012 p. 542).

The rise of Nortel led many analysts to start predicting more optimistically towards future earnings for the company in order to drive the stock market valuations even higher, leading to even more pressure on the company’s managers to meet their earning goals. This led the company down the path of disassociating itself with GAAP procedures and instead turn to pro-forma procedures for financial reporting, which allowed management to hide poor performance from its shareholders because pro-forma reporting excludes extraordinary charges, depreciation, and charges occurred from mergers. (Collins, 2012 p. 544). These failures within the company could have been managed, reduced, or eliminated had certain mechanisms been instilled to better align the company’s manager’s interest with those of the company’s shareholders.

Aligning the Interest of Managers and Shareholders

Greed is enticing and a part of human naturethat will be present in any situation with such large amounts of money at stake, it is up to the company, and the senior management in particular, to help reduce situations where people may give into unethical actions; this can be accomplished with a combination of different types of power and pre-emptive measures. Company managers should be prevalent in using both reward power, which rewards employees for good behavior and work, and coercive power, which punishes employees for bad behavior and work; employees from the top to the bottom should be made aware that when they are hired, they are to abide by certain ethical actions outlined in the Code of Ethics and Code of Conduct, documents that outline the rules and values within a company. (Collins, 2012 p. 105). Ethical actions should be rewarded by promotions, bonuses, or written or verbal recognition, while unethical actions should be punished on the basis of the severity. A Code of Ethics and Code of Conduct, however, do not mean much unless they are followed by top management, otherwise an environment is fostered on the basis of ethical hypocrisy. (Collins, 2012 p. 124).

Removing temptation can also be accomplished by implementing measures that bring in independent oversight, such as hiring an Ethics and Compliance Officer (ECO), a high ranking employee who oversees ethical performances within a company. Having this position within the company is a pre-emptive move against unethical behavior and may make those thinking about unethical and fraudulent actions to think twice, as they are more likely to be caught and therefore punished. The ECO has many duties including: managing ethics training, developing ethics policies, providing guidance in regards to ethics, and managing a company’s internal reporting system. (Kavanagh, 2008). These actions and safe measures may have prevented the meltdown of Nortel, which was contributed to by both people and the capital market process.

People or the Process: What Lead to Nortel’s Meltdown?

There are many factors that lead to the meltdown of Nortel, some of which can be attributed to people and some of which that can be attributed to the capital market process, but seeing as the capital market process is influence by people, the majority of the blame can be attributed as a “people” problem, caused by unrealistic goals and a lack of moral imperative and ethical characteristics.

When analysts started predicting major future earnings for Nortel, managers became under greatly increased pressure to meet goals and expectations that were not realistic; Nortel should have instead set SMART goals for the company. SMART goals have five attributes: Specific (the goal is clearly defined), Measurable (the goal can be measured), Aligned (goals are aligned with the company strategy), Reachable (the goal is realistic), and Time-Bound (the goal is reached in a set time frame). (Collins, 2012 9. 283). These SMART goals would have been much more attainable then the unrealistic goals the company set, lessening the need to lie about the company’s health. Further “people” failures resulted from the character of those people making decisions, many of them simply lacked moral imperatives, such as do not lie and to “do unto others as you want done to you” and conscientiousness, which is a measurement of responsibility, work ethic, and dependability and is arguably the most important trait that indicates a person’s ethics. (Collins, 2012 p. 87). Even those that exhibited good ethical intuitionhad measures they could take to stop the unethical behavior, such as whistle-blowing, the act of contacting a person or organization about misconduct occurring inside one’s own organization. (Collins, 2012 p. 240). If those within Nortel did not want to take action against unethical behaviors, a whistle-blower could have informed an outside source, but again, the character of ethical behavior was not present with the people involved in this situation, which can be found in many similar situations.

Not Learning from Past Mistakes

The Nortel case is not a unique or isolated incident in the business world, many companies before them have found themselves in similar situations, such as Enron, WorldCom, Citibank, the Lehman Brothers, and many others in the wake of the 2008 banking crisis. However, many of these cases have various aspects in common that show trends in regards to ethical behavior and the failing of the company. During the timeframe of these cases, many of the high up executives accounting decisions were simply part of social group relativism, every executive in the industry were being awarded high bonuses consisting of stock bonuses and many companies were straying from GAAP practices in favor for pro-forma practices, these actions were the norm at the time. Another factor in these cases is the reliance on organization trust, where members of the board of directors trusted management to supply truthful financial statements, to the point where these financial statements were not even checked for accuracy, such in the case of Nortel, who even had an independent board of directors; these companies all shared in common with another, a lack of ethical leadership. (Collins, 2012 p. 540).

Cultural relativism, which concerns itself with how actions are regarded within the boundaries of the law, has also played a part in similar situations, in particular the inconsistent nature about how the executives of these companies have been treated in the aftermath of their scandals. In the wake of the Enron scandal, the CEO was sentenced to 24.5 years in prison, the CFO was sentenced to six years, the Chief Accounting Officer was sentenced to five and a half years, and the founder would have been looking at jail time had he not died before trial. (Sullivan, 2006). Similarly, the WorldCom CEO was sentenced to 25 years in prison for his part in the WorldCom accounting scandal. (Crawford, 2005 Sep. 23). On the other hand, the executives who played parts in the Citibank and Lehman Brothers scandals did not see any sort of judicial punishment, even though the SEC has accused them of criminal fraud. (White, 2013 Sep 13).Such future incidents can be reduced by prioritizing and enforcing the regulations of accounting and financial accounts, regulating incentives and rewards, and educating the leaders of tomorrow about better business practices.

Reducing Future Unethical Behavior

Creating a new business environment that does not tolerate unethical behavior is not an idea that can be created overnight, and must be instilled in the generations to come in order to become the norm. In order to reduce future occurrences of unethical behavior, companies should focus on the regulation of incentives and punishments, the regulation of accounting and financial markets, and business education. Regulating a program designed to reward good behavior and punish bad behavior could greatly reduce unethical behavior in the work place; goals that result in bonuses should not be based on arbitrary statistics such as sales, but instead be based on the overall health of the company, and should be reviewed by an independent over sight board and the Ethics and Compliance Officer. Punishments for not meeting goals related to the company’s health can include regulating the amount of the next bonus an employee can receive, giving employees further incentive to reach consecutive goals.

Regulation of accounting and financial markets can be accomplished, in part, by companies instilling a local version of the whistleblower reward program, offering employees a percentage of money saved by blowing the whistle on unethical employees who may be committing fraud. Additionally, ethical leadership is increasingly important in a corporation, as many employees see good ethical leadership as “leading by example” and poor unethical leadership as ethical hypocrisy, which may lead to a “you are not ethical, so why should I be” attitude. (Collins, 2012 p. 124). Lastly, employees are more likely to be loyal to a company who treats their employees well and provides their employees with meaningful work; employers should focus on fostering a positive work-life balance, paying attention to making sure their employees do not get burnt out. (Collins, 2012 p. 376).

Changing how ethics are viewed in the business setting must start from the get go; business education has increasingly focused on the teachings of ethical behavior and the consequences of unethical behavior. Business education, however, should not come to a standstill once outside of business school; employers can continue these lessons in a work environment, focusing on such subjects as the Caux-Principles for Responsible Business, a universal guide for conducting business. Employers can hire qualified instructors to hold ethics seminars, or may opt for web-based training that can be completed whenever individual employees have the time. (Collins, 2012 p. 113).

Conclusion

Nortel’s rise to prominence during the 1990’s would make it one of the biggest firms in the world, until its downfall starting in August of 2000, which resulted in 60,000 employees losing their jobs and the company’s share prices falling from over 200 dollars a share, to just 67 cents a share. Nortel’s downfall can be attributed to the people involved and was caused by unethical behavior, stemming from the company’s movement from GAAP procedures to pro-forma accounting, which helped executives hide the company’s poor performance from shareholders; these behaviors may have been reduced or eliminated had the company employed an Ethics and Compliance Officer to oversee ethical related decisions within the company. Similar situations arose in the past with other companies, Enron and Lehman Brothers among them; these companies share certain traits that lead to unethical behavior, such as lack of ethical leadership and the presence of social group relativism, or the fact that this behavior had become the norm. In order to combat future situations from occurring, businesses must prioritize the regulation of incentives and punishments, the regulation of accounting and financial markets, and business education; these measures can be accomplished my implementing an internal whistleblower reward program, focusing on meaning work and a positive work-life balance, and continued business education via web-based training.