We predicted last year there would be more surprises in connection with RIM’s backdating scandal. We have been following those developments regularly at Finlay ON Governance, with an admitted degree of skepticism. Most of the time it seemed we were the only ones to be doing so, as so many reporters, analysts and investors appeared to have fallen under the RIM spell that deprives certain people of the ability to think clearly.
Now, apparently some investors and analysts, like the legendary Captain Renault, are “shocked, shocked” to find that backdating has been going on here and that the U.S. attorney for the Southern District of New York and the SEC are taking it seriously. Both have opened formal investigations.
The history of this thing is tailor-made to raise the suspicions of investigators. We identified a number of them, starting with the feeble way the so-called internal probe began, RIM’s appalling state of corporate governance and antiquated board structure, the sudden bailing by some RIM directors after the investigation commenced —directors, as it turns out, who also received backdated stock options— and the flimsy, self-serving report that the company eventually produced which raised more questions than it answered. Remember how RIM’s estimated accounting restatement of between $25 million and $45 million suddenly shot up to more than $250 million? That’s some accounting.
Journalists and analysts in Canada, where RIM is headquartered, are sometimes surprised to find that the U.S. system of securities law enforcement and regulation doesn’t operate like the Ontario Securities Commission. In the U.S., they actually believe in enforcement. We have noted here before that the OSC is little more than a delayed echo of what the SEC does —and sometimes not even that— despite its top officials and staff being paid hundreds of thousands more than their counterparts at the SEC. The OSC has been meeting with, and regularly receiving updates from, RIM for nearly eight months. There is still no indication that they see anything amiss at the high tech icon. They have scheduled their next get together for June.
Here’s just one of the big problems facing RIM: The SEC gave Apple’s Steve Jobs a pass on his role in options backdating because he claimed he had no knowledge of the accounting implications of what he had done. Jim Balsillie, RIM’s co-CEO, has tried that line too. And the board committee investigating his actions —which, by the way, was also investigating its own members’ receipt of stock options and had nothing to say about how they were backdated— agreed with Balsillie. Except, as we have noted before —and Mr. Balsillie boasts about this on his company’s website— he is a chartered accountant holding the highest designation in that profession. RIM’s then CFO, Dennis Kavelman, also involved in backdating options, is an accounting professional, too. So it’s hard to see how the Jobs defense will work at RIM. They also tried the “we’re still young” defense, the “we grew too fast” defense and the “we only had metal desks when we started” defense, which we discussed here. Maybe the SEC and the U.S. attorney will be more impressed with those lines. Maybe Donald Trump will suddenly follow the teachings of Mother Teresa.
Shaken over the sudden loss of BlackBerry service last week, and now hit with formal investigations by tough regulators and prosecutors, RIM’s shareholders, customers and cheerleading chorus of journalists and stock analysts may now be poised to take a second look at what they seemed to think was a perfect company. We said there would be more surprises. Stay tuned.
There are too many unanswered questions and inconsistent statements for anything less than a formal investigation by the U.S. regulator. It is another example of how Canada’s OSC has dropped the ball.
There is a lesson for companies conducting internal investigations that are to be reviewed by securities regulators. When writing the report, don’t do it on Swiss cheese. We set out our misgivings about Research In Motion’s board probe some time ago. Now it seems the SEC is having a problem with some of the rather flimsy and self-serving findings of RIM’s directors, who discovered backdating had occurred at the company. Quite a lot of it, actually. The U.S. securities regulator has launced a formal investigation into RIM’s practices. The fact that directors overseeing RIM also received stock options that were backdated, with no explanation as to who approved the move, and RIM co-CEO Jim Balsillie’s assertion that, even though he is a chartered accountant who holds that profession’s highest designation and is both founder and chair of an institute specializing in financial governance, he had no idea that backdating was wrong, may leave too many holes to ignore. The inconsistencies between what RIM’s directors and top officers were saying in their securities filings about the company’s stock options practices —including important certifications by RIM’s CEO and CFO made under U.S. Sarbanes-Oxley legislation, which we talked about here— are matters that need to be taken seriously. Apparently, Canadian regulators have not seen it that way. They need to get another pair of glasses.
Fortunately, the SEC may not entirely be buying what it has been handed by RIM, and as a result, investors seem to be selling. The stock was down substantially overnight. As for the OSC, which we noted here has often been little more than a delayed echo of the SEC, it seems once again to have been outpaced by its American counterpart. The OSC appears quite happy to dine on Swiss cheese, even though, in news The Centre for Corporate & Public Governance broke earlier this week, it has 90 employees who earn more than SEC chairman Christopher Cox. I have a suspicion, based on the volume of emails received at Finlay ON Governance, that a large number of Canadian investors and policy makers are beginning to ask if they are really getting value for their money.
With 90 OSC employees making more than the chairman of the SEC, it’s time to look at the Ontario securities regulator’s performance and accountability
Its chair and just one of its vice-chairs together make more than all five members of the U.S. Securities and Exchange Commission combined, including SEC chairman Christopher Cox. Yet the Ontario Securities Commission has become the object of ridicule among investors for acting like something of a dummy to the SEC’s ventriloquist when it comes to prosecuting high profile cases such as Hollinger and Nortel. And the OSC still lags in adopting corporate governance and disclosure standards similar to those in the U.S. and continues to bungle and drag its feet on one major case after another. Just look at how it handled the RIM stock options backdating scandal, for instance.
But, in a move that can only be seen as an attempt to compete with Nigeria in a race to the bottom in investor protection, the OSC is apparently considering ending criminal prosecutions in Ontario courts altogether. It claims the standard of proof may be too high to obtain a conviction. The boo hoo prize is hereby awarded. If the OSC is allowed to carry through with this policy, there would be no jail time for insider trading or other violations of Ontario Securities laws. Talk about a move backwards. If the idea is to attract capital markets miscreants from the U.S. and other jurisdictions and encourage them to set up shop under a more lax regulatory regime, it’s headed in the right direction. But if the OSC’s mandate is still to protect investors, it seems akin to going the wrong way on a very busy superhighway.
One of the big problems with the OSC is that it was made “self-funding” in the 1990s. The change allowed the OSC to become accountable essentially to itself. It even gets to nominate its own members, which it has in plenitude. The OSC has 13 commissioners as compared with the SEC’s total of five (who are nominated by the President and confirmed by the Senate). The SEC regulates a capital market of 300 million citizens. The OSC regulates just for Ontario. Its board sets policy, makes rules, adjudicates hearings and oversees the commission’s finances. That’s already a lot of power for one body. The OSC —not the government— even sets the salary for its own chair, commission members and staff. And it shows. As revealed for the first time by The Centre for Corporate & Public Governance, in 2006 the OSC had a staggering 90 employees who made more than the SEC chairman himself. Even a senior manager at the OSC pulls down $194,000. The previous OSC chair, by the way, roamed the world as part of his official duties and spent thousands on a foray to Kenya alone. How did that protect Ontario investors? Has any elected official ever questioned the OSC’s salary and expense levels? Unlike the sharp Congressional supervision that occurs with the SEC, there is no meaningful oversight of the OSC, which explains why it can indulge in a lavish style of self-governance more resembling Conrad Black than a securities regulator.
I think most investors will agree that this is not the time for the OSC to engage in introspective musings. A more volatile capital market that is capable of turning south overnight needs rigorous and competent enforcement of the rules. And I am on record as far back as 1994 in advocating a single national securities commission for Canada —long before it became the current popular topic that it is. But, since the OSC has opened the door to this discussion by thinking out loud about abandoning criminal prosecutions and seems to be a delayed echo of the U.S. regulator anyway, you might wonder why the OSC doesn’t just find another line of work entirely and leave regulation of the North American capital markets to the SEC, which, when it comes to cases like Hollinger and Nortel, seems to be doing the heavy lifting in protecting Ontario investors.
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Not to be lost in the recent accusations of accounting fraud involving former top management of Nortel is the fog that company’s financial statements continue to produce.
With its fourth restatement announced two weeks ago —the fourth in four years— Nortel landed firmly in the record books. No publicly traded company has ever had as many restatements in this period of time. Nortel changes its financial statements more often than some people change their hair styles. News of the latest re-do may well prompt investors to ask if the company is really in the telecom business or whether it has gone into the accounting restatement business. After all, the newest restatement will restate financial results that have themselves been the subject of previous restatements. Which begs the larger question: Has Nortel reached the point where it is reasonable to conclude that this once world class manufacturer of technology equipment is metaphysically incapable of producing accurate and reliable numbers to guide investors and company stakeholders? Evidence leans in that direction.
In January 2005, William Owens, Nortel’s then CEO, pronounced that with the release of the company’s restated financials for 2001, 2002 and 2003, a task which he claimed had been “monumental,” “we have a solid foundation on which to move forward with our business.” Then, under its new CEO, Mike Zafirovski, there was a further restatement in March of 2006. One would have thought that no stone would have been left unturned during the three previous reviews, and certainly the one conducted last March —the first to be carried out under Mr. Zafirovski’s tenure— to ensure that every possible contingency was fully considered in order to avoid just this kind of embarrassment.
By the way, the same Form 52 certifications under which the SEC is charging Nortel’s former CEO and CFO were signed by the current CEO and CFO on a regular basis. The period to be restated includes quarterly statements for 2006 and the annual results for 2005 to which both Mr. Zafirovski, as Nortel’s CEO, and CFO Peter Currie, attested as to their accuracy under the provisions of Sarbanes-Oxley. I would not want to be the CEO or the CFO who had to explain that one, since the whole purpose of this part of the legislation is to ensure the precision of financial statements and to avoid Enron-type cases where a CEO could claim to be taken by surprise by their inaccuracy.
One of the most underreported facts about Nortel was the astonishing revelation contained in its most recent annual report that the company’s auditors discovered five material deficiencies in its accounting control system. It boasts in its latest statements that it now has only one such deficiency. Nortel’s own auditors define a material deficiency as:
…a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.
The auditors go on to note:
In our opinion, management’s assessment that Nortel did not maintain effective internal control over financial reporting as of December 31, 2005, is fairly stated….
Yikes! It’s hard to know whether fraud or just plain incompetency was the biggest threat to Nortel’s investors.
All of this brings us to corporate governance —not the ivory tower theory of corporate governance or a society columnist’s celebrity view of corporate governance, but the idea that directors will actually direct and protect investors. That kind of corporate governance.
During the time of Nortel’s major losses and irregularities, it had one of the top paid boards in Canada. The company boasted big name trophy directors. Several had financial and accounting backgrounds. Some sat on the boards of major banks. The fact that three Nortel directors sat on a committee reviewing board standards for Canada’s publicly traded companies, including Nortel’s then CEO John Roth and Guylaine Saucier, who chaired the panel, is something to file under the corporate governance category of Ripley’s Believe It or Not. (I raised a number of criticisms about this committee and its membership in my op-ed columns in The Globe and Mail at the time, which was prior to Nortel’s disaster coming to light.) Yet these directors not only presided over a series of embarrassing scandals and financial mishaps, but as Nortel’s auditors have stated, they failed to ensure adequate internal controls were in place. Several continue to serve on the boards of prominent Canadian companies today.
It might seem odd that failure is so well rewarded in the boardroom. But in the culture that too often prevails in the world of the corporate director, underperformance is rarely seen as an unaccommodating vice, and adherence to the rules of the club, of which thou shall not rock the boat heads the list, is typically viewed as a most admired virtue.
Fast forward to the current board. Under its governance, two restatements have already taken place in as many years. Hundreds of other large and complex companies routinely provide accurate financial statements to the investing public. They do not require repeated do-overs. Yet Nortel has become a serial re-stater of financial results. And the board appears to have hit the mute button regarding this latest fiasco, just as its predecessors did for too long. There are no statements of explanation from Nortel’s audit committee. Its well paid non-executive chairman is silent. And the board itself seems unable to issue a reassuring word. It gives the impression that Nortel’s directors see nothing out of the ordinary in this latest announcement –which is, perhaps more than anything, symbolic of the problem.
Instead, Nortel’s current board seems bent on following in the steps of its predecessors, who are remembered for a governance legacy that produced financial scandal and investor mistrust, huge sums being doled out to a former CEO who left the company in tatters, and a compromised system of financial controls whose effects continue to reverberate among investors.
Nortel was once filled with innovators and highly motivated employees. But with its inability to get out from under the cloud that has long followed its missteps and blunders, the time has come for investors to seriously consider whether the assets of the company would be better off in new hands. Here, the emphasis is on a board that is visible, engaged and capable of instilling confidence on the part of all the stakeholders needed for success –not clamping shut when crisis strikes.
Nortel needs a lot more than another accounting restatement. With its history so steeped in scandal and its present still darkened by constant financial backpedaling, it needs to think through whether Nortel can go on being Nortel.
Scandals are real time drainers. Last week, it was the stock options backdating mess at RIM. This week, and it’s only Monday, I’ve spent a lot of time answering press inquiries about the SEC’s charges against Nortel announced this morning. And I’m actually on vacation.
The Centre for Corporate & Public Governance has a statement on its website about the charges —late in coming for thousands of aggrieved shareholders and employees who have lost their jobs, to be sure. But the prospect of a process that will get to the truth about this unfortunate saga and perhaps bring its perpetrators to justice is no less welcome.
I find the OSC’s piggybacking on the SEC’s allegations of accounting fraud to be rather amusing. Canada’s regulators routinely show themselves to be bit players in the North American capital markets. They had a chance to change that with Nortel —a Canadian headquartered and founded company. They left the heavy lifting to their American cousins instead.
I’ll have more to say about this developing story later in the week.
