Sound governance is not some abstract ideal or utopian pipe dream. Nor does it occur by accident or through sudden outbreaks of altruism. It happens when leaders lead with integrity, when directors actually direct and when stakeholders demand the highest level of ethics and accountability. ~ J. Richard Finlay in testimony before the Standing Committee on Banking, Commerce and the Economy, Senate of Canada.
The SEC has apparently commenced an informal investigation into Countrywide Financial CEO’s sales of stock in recent months. Angelo Mozilo’s miraculous sense of timing captured our attention at Finlay ON Governance. We’re glad the SEC has been watching too.
Once again, the SEC has done the heavy lifting for Canadian investors by imposing, according to reports, a $100 million penalty on Nortel. Indeed, nothing could more graphically illustrate the contrast in approach toward the protection of the capital markets between the SEC and the OSC than this decision. For exactly the same kind of improprieties, the OSC thought just $1 million toward the costs of its investigation would be sufficient. Like us, the SEC was clearly not impressed with the OSC’s thinking and wanted to levy a penalty commensurate with the offense. We said at the time that the OSC hit Nortel with a wet noodle. The SEC’s action looks more like it threw the whole pot of pasta at them.
Nortel should move more aggressively to recoup these costs from the officers and directors on whose watch the wrongdoing occurred. But as long as the concept of limited liability exits, and companies have the right to sue and be sued as though they were legal persons, they will have to deal with fines and penalties. That’s why who is chosen to sit around the directors’ table and in the executive suite is important and needs to command more attention from shareholders than it often does —even when times seem so good, as they once did at Nortel.
Maybe Canadian investors should think about the added value they are getting with the SEC, which once again has acted true to its motto, “the investors’ advocate.” I’m open to suggestions as to what the OSC’s motto should be. They pay the OSC’s top level officials hundreds of thousands more than their SEC counterparts make. There are approximately 90 employees at the OSC who make as much or more than the head of the SEC. Yet time and again, it is the SEC who fills the void and makes the tough call when Canadian regulators fall short. Sort of makes you wonder what they have in mind for RIM next.
By the way, with this posting we have inaugurated a new category at Finlay ON Governance. Our Outrage of the Week has been published with regularity for a number of months each Friday and has become a popular feature. We think, however, that in the interests of encouraging a positive and balanced perspective, in those weeks where there has been a major breakthrough or step which we feel enhances the interests of transparency, accountability and sound governance, we will run that story. Outrage or Kudos? We don’t know which you will see more of on Fridays as time goes by, but it should be interesting.
The Melnyk/Biovail case is interesting from another perspective. While Mr. Melnyk was being investigated by Canada’s Ontario Securities Commission, he held on to his post. Just days after receiving the “Wells Notice” from the SEC, he threw in the towel. Members of the Hollinger International audit committee have also received Wells Notices, and judging by their recent testimony regarding the nature of their directorial “oversight, ” the SEC’s actions can’t come fast enough in my view.
As I said in the interview, when the SEC comes knocking at your door, it tends to get your attention. It’s another example of how differently the two regulators are viewed even in Canada by Canadian business figures and a further indication that the OSC has a problem being taken seriously and that Canadian investors have a problem being adequately protected by it.
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.
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.