INSIDE AGENCY: THE RISE AND FALL OF NORTEL

Timothy Fogarty Professor and Associate Dean

Weatherhead School of Management Case Western Reserve University

10900 Euclid Avenue Cleveland, Ohio 44106-7235

Michel Magnan1

Professor and Associate Dean John Molson School of Business

Concordia University 1455, de Maisonneuve West

Montreal, Quebec CANADA H3G 1M8

Garen Markarian Assistant Professor Instituto Empresa

Serrano 105 Madrid 28006, Spain

Serge Bohdjalian

John Molson School of Business Concordia University

1455, de Maisonneuve West Montreal, Quebec, CANADA H3G 1M8

August 2007

1 Corresponding author, please address all communication to: Michel Magnan, Associate Dean, John Molson School of Business, Concordia University, 1455 de Maisonneuve West, Montreal, Quebec, CANADA H3G 1M8 (514-848-2424 x 4145; mmagnan@jmsb.concordia.ca).

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INSIDE AGENCY: THE RISE AND FALL OF NORTEL

ABSTRACT

By employing the theoretical template provided by agency theory, this paper

contributes a detailed clinical analysis of a large multinational Canada-headquartered

telecommunications company, Nortel. Our analysis reveals a 21st century norm of usual

suspects: a CEO whose compensation is well above those of his peers, a dysfunctional

board of directors, acts of income smoothing to preserve the confidence of volatile

investors, and revelations of financial irregularities followed by a downfall. In many

ways, the spectacular rise and - sudden - fall of Nortel illustrate excesses of actors within,

and contradictions of the system of corporate governance implied by the agency model.

Furthermore, this case illustrates limitations of the agency framework in complex

situations with short-term oriented investors.

Keywords: Agency theory, executive compensation, financial misstatement, income smoothing, stock options

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INSIDE AGENCY: THE RISE AND FALL OF NORTEL Agency theory offers management and accounting researchers a basic template

outlining fundamental incentives of the key actors involved with corporate governance.

The theory is defined generically as the contract wherein one party (the principal)

engages another (the agent) to accept the delegation of the principal’s authority to

accomplish some purpose (Jensen and Meckling, 1976). More practically, agency theory

provides a simple description of basic economic incentives that exist in business

relationships. Using this perspective, considerable progress has been made in that some

degree of organization exists over what would otherwise be a highly diffuse and

excessively pragmatic literature.

Since the rediscovery of the paradigm of the separation of ownership and control

by Jensen and Meckling (1976), and Grossman and Hart (1983), many researchers - in

pursuit of empirical generalizations - have focused on certain aspects of the theory, while

others have examined epistemological or political perspectives (for an excellent analysis,

see Kaen et al. 1988). This paper does not seek to comment on the specific successes and

failures of this body of work (see reviews by Namazi, 1985; Baiman, 1982). Instead, this

research suggests agency theory needs rich analysis of single companies, where the

shortcomings of the probabilistic predictions of agency theory are examined in the

context of a single entity. Abstracting particular measures and their statistical association

with other rarified operations allows for generalization, but only by sacrificing

appreciation for the rich confluence of forces that any company faces when governance is

enacted. For these purposes, the power of statistical analysis can be leveraged

longitudinally rather than cross-sectionally.

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This paper presents an in-depth examination of Nortel Networks Corporation

(Nortel); a major player in the telecommunication boom of the 1990s. The paper assesses

Nortel’s rise, as well as its sudden and precipitous decline early on in the twenty-first

century. More specifically, we investigate if and how four aspects of the firm’s

governance contributed to its downfall: 1) executive compensation, 2) governance

structure at the board level, 3) ownership structure and, 4) earnings management. For

these purposes, relying on a clinical study approach, different types of archival

information were studied in order to explore the rich context of agency theory thinking.

This paper contains eight subsequent sections. The first provides a thumbnail

sketch of agency theory as a means of extracting specific research questions. The second

outlines salient aspects of the Nortel story. This includes the facts that make the

company unique and those that make it a poster child of the era. This is followed by an

explanation of the data and methods. The next four sections pertain to evidence on the

four research questions. In each case, historical information is juxtaposed with original

empirical analyses. The paper ends with an analysis of irregularities and the downfall of

Nortel, followed by a conclusion that includes consideration of the role of clinical studies

in the future elaboration of agency theory.

AGENCY THEORY

Undeniably, one component of agency theory’s appeal is its elegant simplicity

and origins in early social interaction (Ross, 1973). How its representation in the modern

world of - unprecedented - corporate size, derivative ownership and governmental

regulation came about however, is quite intricate.

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Separating real control over profit-seeking affairs from owners represents

important degrees of risk and potential conflict (Jensen, 1986). Efforts to align incentives

of those in control with those at risk - for the consequences of action - become necessary.

Agents possess varying degrees of moral hazard for being less than completely forthright

stewards of principals. However, since principals are aware of these temptations,

contracting efforts will be made to impose costs upon agents that are unable to signal

their fiduciary adherence. Alternatively stated, agent contracts provide incentives to

ensure that agents expend the desired effort and truthfully reveal the private information

they may possess (Grenadier and Wang, 2005).

Grossman and Hart (1983) argue that agency problems are intensified, and the

principal’s welfare diminished, when information available to the principal decreases, or

the agent is in possession of special information. Similar consequences occur when the

agent becomes risk averse, or the monitoring capacity of the principal decreases.

Building upon ideas about shirking and monitoring explored earlier by Alchian and

Demsetz (1972), various studies have sought Pareto optimal means whereby agency costs

can be contractually mitigated (e.g., Kreps and Wilson, 1982; Conroy and Hughes, 1987;

Demski and Kreps, 1982). A theoretical solution depends heavily upon informed self-

interest in the absence of full information (Arrow, 1964) and may depend upon the trade-

offs existing between the need for precision and the costs of producing precision

(Verrechia, 1986). Due to various magnitudes of adverse selection and moral hazard

embedded in specific situations, there is no necessary equivalence between the costs

incurred by principals and the benefits realized by agents on these contracts (Denis and

Denis, 1997). Aghion and Bolton (1992), Hart (1995), and Hart and Moore (1998) are

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primary examples of studies that argue that complex situations are non-contractible. This

is a result of the costs, complexity, or verifiability of fully conditional contracts. Hart

(1995) and Hart and Moore (1998) argue that investment is not contractible, therefore the

need for monitoring. A large literature has developed examining the monitoring function

of the board of directors, audit committees, compensation structures, contracts, financial

analysts and institutional investors, and regulatory activity.

Though primarily economic in nature, agency theory offers a rich tableau of

behavioral ideas. As demonstrated by Hopwood (1974), personal motives and reactions

amplify and subvert rational plans in business. Humans tend to be resourceful

maximizers evaluating many dimensions of situations (Jensen, 1994) and realize that

scarce human capital, often in the form of reputations, are at stake as they make flawed

discretionary signals that reveal their positions. That this bears directly and

consequentially upon agent compensation fuels what could be seen as a solution

instrument into its own agency problem (Bebchuk and Fried, 2003).

Agency theory usually initiates its appeal with the single owner–single agent ideal

type. The extent to which that representation can also meaningfully describe situations

that depart substantially from this limiting model is debatable. Modern capitalism has

evolved into complex permutations of ownership rights and representational capacities

(e.g., Haugen and Senbet, 1981). The former includes institutional owners known to

behave differently than beneficial owners of single issues contemplated by the pristine

version of the theory, and also include financial analysts who act as sophisticated

information gatherers and disseminators, and as a disciplining mechanism on managerial

behavior.

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Regulation of accounting disclosures complicates the agency model. To the

extent that the information package required from publicly traded companies is set by

regulation, it cannot be considered a discretionary signal by agents to owners regarding

their faithfulness. Agency theory has grappled unsuccessfully with high level corporate

agents possessing powers to manipulate accounting used to “keep score” through their

compensation (Eaton and Rosen, 1983) and alter the nature and size of the very entity

they represent (Denis and Denis, 1997; Aggarwal and Samwick, 2003). In other words,

the theory does not adequately reflect that the central principal-agent relationship is

contextualized by external regulation and larger equilibrium markets. Large

organizations require the consideration of coalitions among hierarchically arrayed agents,

wherein intra-organizational rewards such as promotion can substitute for market

mediated ones (see also Arrow, 1964).

In sum, agency theory addresses the general contours of the issues for any specific

company. Its ability however, to reach the specific circumstances of any consequence

remains to be seen.

THE NORTEL STORY

At its peak, Nortel was a giant corporation. In July 2000, at the height of its

success with a market capitalization in excess of $350 billion Canadian dollars, it

accounted for more than 37 percent of the Toronto Stock Exchange Composite Index

value and ranked among the largest firms in the world (Hunter, 2003).

As a diversified company focused primarily on telecommunications, Nortel

seemed invincible. Commentators were pleased with its “strength across the board in its

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product markets” and its focus on the fastest growing wireless and broadband

communication segments (Simon, 1995). Its particular expertise – in wireless and

broadband communications - allowed it to post very impressive revenue gains in product

segments where it was a relative newcomer (Simon, 1996). Nortel seemed poised to

exploit new Internet technologies and an expected wave of international deregulation in

this sphere (Financial Times, 1995a). Using an aggressive acquisition strategy, Nortel

grew quickly and well beyond North America. As a result, analysts praised what they

perceived to be “solid, sustainable growth” from large R & D expenditures fueling the

‘perpetual surpassing ‘of earnings expectations (Financial Times, 1995b; Morrison,

1998). Nortel’s share price more than tripled in four years. By mid-2000, it reached a

peak of more than $200 Canadian dollars per share.

Starting from a strategy of being in every high-growth area in

telecommunications, and benefiting from tailwinds due to regulatory and market

conditions (MacDonald, 2000), Nortel tripled its sales and multiplied its pro forma

operating profits several fold within five years (1996-2000). Consequently, the media

proclaimed CEO John Roth a man of boldness and vision in possession of a Midas touch

(Network World, 1999). This mania also spread to the analyst community, as the market

grew increasingly reliant during the proliferation of the technology sector in the late

1990s. Nortel greatly increased its institutional investor ownership as more analysts

hailed its performance. Analysts grew lazy in their assessments during this time. They

justified high priced acquisitions such as the $US 3 billion purchase of Qtera, a firm with

no sales (Alden, 1999), failed to critically scrutinize accounting changes that had revenue

impacts (Morrison, 2000a) and cheerleaded questionable spin offs (Morrison, 2000b).

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Meanwhile, government regulators draped the company with the Canadian flag as a

symbol of national economic vitality (Kehoe, 1999). In short, everyone wanted to

believe in the Nortel supernova.

Nortel’s fall from grace came swiftly and on many fronts. Beneath the

unsustainable rate of growth and earnings lied massive accounting financial irregularities

where results had been seriously manipulated for some time. Not only could analyst

targets no longer be achieved, but good will had to be reinforced. For years, a cloud

would hang over accounting results reported by Nortel, including the perennial belief that

the company had “cookie jar reserves” useable to normalize results (Waters 2003).

Ultimately, Nortel announced several restatements, including the largest one in Canadian

history.

The accounting problems led commentators to retroactively question previously

unassailable acquisitions (Morrison, 1998). Trading in Nortel stock was suspended as the

trading price went into a free fall (Warn, 2001a). Before it was over, more than two

thirds of Nortel’s workforce would be discharged (Morrison, 2001). Several waves of

high-level corporate executives resigned, including John Roth, and Frank Dunn, the

former CFO, was appointed to the helm. Investors complained that even in its downward

spiral, these executives received bonuses and issued excessively optimistic projections

(Warn, 2001c). Soon there would not be much left other than the lawsuits alleging

issuance of misleading financial statements and blatant insider trading (Warn 2001).

Nortel’s fall had been as steep as its rise. From a share price of more than $200 CDN to

$0.67 CDN at its nadir, Nortel left more than 60,000 employees unemployed. Nortel

continues on, now with a legacy of continuing investigations, rapid executive turnover

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and empty optimism. Recently, it announced reorganizing of its basic product groups

(Taylor, 2005). In the latest development, the SEC brought civil fraud charges against

Frank Dunn, who has since departed, and three other former executives, for financial

improprieties relating to revenue recognition, and earnings manipulations, in the 2000-

2004 period (SEC, 2007). For a visual summary of Nortel performance, Figure 1 depicts

the market value of Nortel over the period 1996-2003.

(Insert Figure 1 about here)

The steep rise and the dramatic fall after the year 2000 can be understood in terms

of Jensen’s (2005) equity “overvaluation.” Overvaluation occurs when there is a large

deviation between share price and underlying value, where there is a near impossibility in

delivering to expectations. The conception is that once overvaluation occurs, it sets in

motion unmanageable organizational processes. The end result is that the market

exacerbates “agency” problems between managers and owners, rather than alleviating

them. Specifically, market delusion prompts value destroying managerial behaviour.

“Overvaluation” was a particularly severe problem at Nortel due to augmenting

factors: equity based compensation reliant on the realization of market expectations, a

non-functioning board, and price pressure exerted by short-term investors. As Jensen

(2005) argues, dishonesty in the earnings management game sets off irreversible forces in

motion, as borrowing from future revenues necessitates even further borrowing in

subsequent periods. The consequence being a total destruction of Nortel’s core value.

Evidently, the agency model did not operate very well in Nortel’s case.

Separating ownership and control did not account for counterbalances that might have

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checked abuses contributing to the sudden decline in fortunes of equity holders. Agency

costs were either dramatically miscalculated or greatly mis-specified. The balance of this

paper explores specific dimensions of this juxtaposition. Executive compensation, the

governance structure (mostly at the board level), the ownership structure and earnings

management comprise four typical agency theory domains.

RESEARCH DESIGN, DATA, AND METHODS

The paper examines a set of vignettes regarding Nortel, inspired by agency-

theory, to investigate the various incentives and motivations given to Nortel’s top

management, and their ensuing actions, that led to the biggest meltdown in Canadian

financial markets’ history. In addition to corporate documents such as the annual report,

financial statements and proxy statement, data is obtained from a variety of sources.

Compustat tapes for the various financial statement data, I/B/E/S for analyst forecasts,

CRSP for stock price information, Execucomp for executive compensation data, and

CDA spectrum for the institutional holdings data. To comparatively asses Nortel’s

various company characteristics, Nortel is compared to a control sample of firms.

Specifically, sell-side financial analyst reports are examined, from where control firms

are selected (the control sample is identical to A.G. Edwards’ analyst Greg Teets’ control

firms). Control firms are based on two dimensions. First, large-capitalization

communications equipment developers and manufacturers comprised of: Alcatel, Cisco,

Ericsson, Lucent Technologies, Motorola, and Nokia. Second, specialized

communications equipment manufacturers such as ADC Telecom, Adtran, Advanced

Fiber Communications, Ciena, Newbridge Networks, Pairgran, Qualcomm, and Tellabs.

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Wherever appropriate, comparative statistics with respect to other conglomerates are also

provided. In the first set of analysis, we examine the total compensation, and total

options held, held by the Nortel CEO. Next we examine the ownership structure of

Nortel in terms of institutional ownership, followed by income smoothing patterns. Next

we look at the propensity of Nortel to meet and beat analyst forecasts, followed by their

income reporting patterns. Finally, we look at share returns around option grant dates.

These above analyses are conducted in comparison to the peer group of control firms as

discussed above, and more details are given in each relevant subsection. Although Nortel

has a more than a 100 year history, due to space considerations, our analysis focuses on

the 1997-2000 sub-period with John Roth presiding at the helm, where we provide a

contextual analysis of the period leading to the financial meltdown.

EXECUTIVE COMPENSATION

Executive and owner incentive alignment is the most direct way to reduce the

agency problem. Agency theorists argue that firms can mitigate both the adverse

selection problem (Fama 1980; Gibbons and Murphy, 1992), and the moral hazard

problem (Lambert 1983; Rogerson 1985; Murphy 1986), by tying the agent’s

compensation to firm performance. Managerial incentives may not be in the best

interests of owners’ calls for intelligently designed compensation structures.

Remuneration aligned with unequivocal measures of corporate success is believed to

reduce agency costs such as the excessive consumption of prerequisites by higher-level

managers. While agency theory may clearly dictate that executive compensation is an

important lever for control of agent behavior, considerable disputes exist in the literature

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regarding an optimal structure for the components of total compensation (e.g., Oyer and

Schaefer, 2003; Yermack, 2003; Matsumara et al. 2005; Hall and Knox, 2006; Perel,

2003; Hall and Murphy, 2003). Early studies suggest that pay to performance sensitivity

tends to be excessively low (e.g., Garen, 1994; Jensen and Murphy, 1990), therefore

failing to curb agency costs. Higher levels of correspondence, to the point of recency

effects, have been exhibited more recently (see Matsunaga and Park, 2001).

Some researchers continue to question the basic agency proposition that

incentive-based compensation has desirable consequences. Fessler (2000) offers

experimental evidence suggesting pay incentives degrade certain elements of

performance. Managers with such contracts could become excessively risk-adverse

(Gupta and Bailey, 2001). Alternatively, incentives may also breed overconfident

reaction to the vicissitudes of cash flow (Malmendier and Tate, 2005). Non-financial

consequences of high compensation such as reputation (Fama, 1980) and follower

attributions (Martinko and Gardner, 1987) may also create divergent behaviors,

untraceable to the utility for personal wealth. Furthermore, potential goal congruence

induced fails to consider the interests of all constituents (Arora and Alam, 2002).

Perhaps a more fundamental challenge is the debate as to whether performance-

based compensation is actually dependent upon corporate results. Core et al. (2003)

argue that the inclusion of cash pay in empirical studies of performance relationship

merely serves to distort findings. Earlier, Antle and Smith (1986) observed critical non-

linearities in the pay-for-performance relationship, which they attributed to an

executive’s ability to hedge risk in these plans. More broadly, the substantial influence

wielded by top corporate officials over their pay arrangements can have consequences

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over its entire range and may be influenced in a large number of ways (Bebchuk and

Fried, 2003). The extent to which executive compensation is disclosed may also be

related to its magnitude (Coulton et al. 2001).

Hart (1995), and Hart and Moore (1998), argue that investment is not contractible,

and effort unobservable, therefore, the optimal compensation package links compensation

to various signals of executive effort. The most common signal being studied is firm

stock prices (Holmstrom, 1979; Barron and Wadell, 2003), because the prevailing view is

that capital markets are efficient, and that prices reflect firm fundamentals that are a

consequence of the agent’s effort.

As a result, equity based compensation, and specifically stock options have been

the dominant vehicle in incentive-based CEO compensation for the last quarter century.

Currently, options constitute more than half of the compensation package of top

corporate officials in publicly-traded corporations in the U.S. (Hall and Murphy, 2002).

Stock options have become a staple in the compensation of employees well below the

apex of the organizational chart by upwards of 40% of large U.S. companies (Hall and

Knox, 2006). That the individual is personally enriched by the very indicator (stock

price) that enriches all shareholders, and is the foremost indicator of company success

would seem the epitome of goal congruence. Issuing such options has also been

bolstered by very favorable accounting treatment in the U.S. where the issuance is not

considered an expense.

Many writers point out that using stock options may be dysfunctional on several

levels. “Accounting subsidy” for option-based compensation leads to excessive and

market distorting use (Bodie et al. 2003) and exposure of their use in great corporate

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collapses of the early 21st century (Enron, WorldCom, etc.) has led to speculation of its

role in the prolonged market expansion and serious contraction during this time

(Greenspan, 2002; Business Week, 2003). The essence of the problem is that stock

options create an excessive incentive to take steps causing a brief increase in the

company share price. Such a behavior by firms with higher levels of incentive options

can be observed through the timing of corporate insider trading behavior (McVay et al.

2004), the higher magnitude of discretionary accruals in accounting choice (Gao and

Shrieves, 2002) and the subsequent restatements of earnings (Johnson et al. 2003).

Nortel’s CEO’s compensation was higher than many firms. Figure 2 compares

Nortel to the control firms, where the comparison is relatively flat initially, but from the

beginning of 1999, Nortel’s CEO benefited from a threefold increase whose slope did not

abate in 2000.

[Figure 2 Here]

A more interesting comparison can be seen through the analysis of executive

stock option holdings. Based on the Black-Scholes valuation method, Nortel options

surpassed this benchmark in late 1997, departed from it during 1998, and exponentially

increased in 1999. With the fall in Nortel stock prices and following the massive exercise

of stock options, CEO option holdings decreased below to the control group at the end of

2000.

[Figure 3 Here]

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Nortel followed a compensation strategy heavily based on option compensation.

Fixed salary awarded every year amounted to a bit less than, or around, $1million a year,

while short term bonuses reached $1.3 million in 1998, $4.2 million in 1999, and $5.6

million in 2000. It must be pointed out that, according to Nortel’s 2000 and 2001 proxy

statements, the most heavily weighted driver for bonus compensation was revenue,

followed by operating earnings per share (i.e., non-GAAP earnings). Thus, on a straight

cash basis, there was strong inducement for Nortel’s CEO to engage in an unbridled

growth strategy, mostly through acquisitions.2 In contrast, in a year where the Nortel

CEO received a bonus of $5.6 million, the CEO of Lucent did not receive any bonus

payment, and the CEO of Motorola received a meager bonus of $1.25 million.

Although the CEO of Nortel received a fat cash payment in terms of salary and

bonus, these were eclipsed by the value of options awarded every year: $5m in 1998,

$18m in 1999, and $33m in 2000. The analysis above falls short on two respects: first

means are shown in the comparisons, masking the effect of variation in the control group.

Second, the control group is based on industrial membership, but since Nortel was the

industry leader, it is possibly better to compare compensation structures across a purely

size-based comparison group. Comparing Nortel to each individual firm in the control

group, it is found that the Nortel CEO not only had the highest total compensation for the

year, but also the largest amount of stock options. Finally, comparing Nortel to a peer

2 Such large bonuses in 1998-2000 have to be contrasted with the later findings of Wilmer Cutler and Huron Consulting, the investigators retained by the special committee of the Nortel Board of Directors. According to the investigators, manipulations to provisions in 2002-2003 were deliberately undertaken in an effort to maximize returns on a new bonus plan (“Return to Profitability”) implemented by the board of directors. Such findings and other events led to the firing of Nortel’s CEO, CFO and controller in 2004. The CEO at that time, Frank Dunn, used to be CFO under John Roth (CEO between 1996 and 2001).

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group based on size, defined as within 10% (larger or smaller) of Nortel’s market value

for each year, the $308.5 million of options held by John Roth in 1999 was second only

to the CEO of MCI.

Data suggests that the agency model did not work well when applied to Nortel’s

executive compensation arrangements during its examination period. As Jensen (2005)

argues, when equity is “overvalued,” option holding do not mitigate agency problems.

Equity-based incentives throw “gasoline on a fire” instead of being a solution (Jensen,

2005, p.14). In retrospect, agency theory provided simplistic predictions regarding

Nortel’s equity-based compensation, neither making managers part owners, and nor

ensuring the desired effects from contracting on “hard” signals such as stock prices.

GOVERNANCE STRUCTURE

One of the main challenges of corporate governance is solving the agency

problem (Grossman and Hart, 1983; Jensen and Meckling, 1976). From this perspective,

corporate governance is often examined from an agency point of view (Aguillera and

Jackson, 2003). It is predicted that agency costs can be reduced through a strong internal

mechanism of control, namely, an independent board of directors composed of non-

executive directors, that is nominated and elected by shareholders, and who act in

preserving the interests of owners who have the means to monitor management. This

section examines the internal governance structure of Nortel, and uses agency as a point

of departure in examining the role of the board of directors.

Prior empirical evidence shows that an independent board of directors is effective

in reducing agency costs. Although the board of directors of Nortel was independent, it

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is examined along three other dimensions: board size, the presence of a financial expert,

and the multiple directorships held by board members. With respect to board size, Jensen

(1993), and Lipton and Lorsch (1992), reason that as board size increases, boards become

less effective at monitoring management because of free-riding problems amongst

directors and increased decision-making time. Yermack (1996) finds that companies

with smaller boards have higher market valuations (arguing for a threshold of 9 directors

per firm). Upon examination of the size of the board just prior to the downfall, it could

be argued that the 12 member board was larger than that prescribed by academic studies,

a characteristic that could have contributed to board dysfunction.

From a financial expertise point of view, independent board members play an

important role in monitoring the financials of the firm. It has been shown that the

probability of restatement is significantly lower in companies whose boards or audit

committees include an independent director with financial expertise (Agrawal and

Chadha, 2006). Klein (2003) finds that financial expertise reduces earnings management,

and Defond et al. (2004) find that the market positively values the appointment of

financial experts to the board of directors. After the fall, advocates of the Nortel board

cited that it was not possible for the board to detect financial irregularities, as the board

relied on management in the communication and verification of financial results

(Tedesco, 2004). Nevertheless, the board was criticized where “the Board knew so little

about the company’s operations that it did not even know how it made money-how

revenues, expenses and profits were made, booked, adjusted and finagled” (Thain, 2004).

Additionally, the company was also criticized for delaying the appointment of financial

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experts to the board to handle the financial crisis. For instance, the former CEO of Royal

Bank of Canada, a Chartered Accountant, was appointed only in 2001.

A further reason for board dysfunction can be attributed to the multiple

obligations that non-executive board members had. The academic literature suggests that

busy directors increase agency costs because they are too busy to monitor, and do not

serve on important board committees (Ferris et al. 2003). Larcker et al. (2005) associate

busy directorship with bad governance, and serving on 2 or more boards is considered as

a “busy” directorship (Brink and Perkins, 2005). Upon examination of the Nortel board,

it is seen that with the exception of one director who had only 2 directorships, the rest had

on average 5.8 directorships, while four board members were already CEOs of other

companies (see Thain, 2004, for a related discussion on the multiple commitments held

by Nortel directors).

In sum, although agency theory predicts that appointing external board members

act in reducing agency costs, the board in itself adds another “layer” of agency since if

the monitors are not carrying out their duties, then who monitors the monitors. In Nortel,

a dysfunctional board was privy to a large financial crisis in part because it did not

possess the necessary expertise, and was too busy to monitor. Finally, it could be a

possibility that large shareholdings by the board exacerbated an already dire situation.

From this perspective, going beyond agency theory when addressing board issues, and

looking at the social-psychological processes of interaction, critical discussion and group

participation (Forbes and Milliken, 1999), and the dynamic processes of accountability

(Roberts et al. 2005), could be appropriate. The latter argue that understanding

governance processes necessitates going beyond agency theory, where board

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performance is determined by “managing” tensions regarding board engagement,

supportiveness to executives, and involved independence. The “challenge” and “support”

role provided by non-executive directors, and the management of boardroom tension,

ensures accountability, but more importantly, ensures “good” performance (Hendry,

2005). In the end, the agency theory predictions regarding the relationship between

board characteristics and firm performance, has not been empirically validated.

OWNERSHIP STRUCTURE

In the classic agency formulation, one principal exists to monitor the agent.

Although this principal is removed from the opportunity to directly observe the agent,

questions pertaining to the principal’s motivation and focus are largely extraneous.

Applied to modern corporate settings, unity of interests does not exist. Structure of

ownership therefore, presents an important supplementary dimension.

One of the most important changes in capitalism since World War II has been the

diversification of ownership interests. A large percentage of the U.S. population now

owns some degree of equity in publicly-traded companies, mostly through aggregation

vehicles such as pension funds, insurance companies and mutual funds. These entities,

collectively referred to as institutional investors, have gained popularity for a variety of

reasons including their forced savings and diversification attributes. Institutional

investors offer individuals professional management and, often a particular investment

strategy or restriction.

It has long been argued that institutional investors mitigate the agency problem

between investors and managers. This argument has been based on the notion that large

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investors, with their financial resources and political clout, have direct access to top

management, influencing a variety of organizational facets. Prior research has shown

that monitoring by institutional investors is both beneficial and also costly (see Shleifer

and Vishny (1986), Huddart (1993), Hartzell and Starks (2003), and Almazan et al.

(2006)). Some types of large institutional investors have active demands in the area of

corporate governance, environmental and social performance, and affect operational

decisions such as executive compensation (Hartzell and Starks 2003). Almazan et al.

(2006) show that institutional monitoring affects the structure of compensation packages

received by top managers, and affect the incidence of non-performing CEO replacement

(Brunello et al. 2003), hence institutional investors act toward the reduction of agency

costs.

However, not all classes of institutional investors mitigate agency problems.

Bushee (2001) provides a useful typology of institutional investors. Whereas “dedicated”

institutional investors provide market stability through a tendency to “buy and hold,”

“transient” institutional investors seek short term advantages through a trading strategy

featuring less commitment to fundamental value and higher turnover based on even brief

price turbulence. These organizations, by virtue of the large size of their ownership

blocks and their willingness to “vote with their feet,” are capable of increasing the price

volatility of the underlying issues.

Astute corporate managers should understand the composition of company

ownership. Since the “transient” owners arbitrage post-earnings announcement drifts (Ke

and Gowda, 2005), trade on expected news (Ali et al. 2004) and are more sensitive to

21

negative earnings surprises (Hotchkiss and Strickland, 2002), managers are provided with

no shortage of reasons to manage with a short run perspective.

Until the boom in the telecommunications industry fueled the growth of Nortel,

institutional investors did not follow the company in large numbers. The sudden influx

of transient investors - may have - laid the groundwork for an unusually fertile period of

“second stage growth” during which most firms stagnate (Anderson and Nyborg, 2001).

The extent to which institutional investors were led to Nortel by financial analysts

suggests a self-fulfilling logic wherein success built firm size and in turn attracted more

analyst attention (Hussain, 2000).

Studies that do not differentiate the type of institutional investors that take

ownership positions, find correlations with positive aspects of corporate governance. For

example, institutional investors may be more likely to demand that high quality audits be

purchased (Kane and Velury, 2004) and disclosure more robust (Bushee and Noe, 2000).

Furthermore, institutional ownership is inversely associated with the incidence of fraud

(Sharma, 2004). However, these tendencies are consistent with a longer run ownership

concern than one typically seen in the transient investor.

Agency theory provides predictions in the incentivization of the CEO in

increasing the long-term value of the firm. However, if a large number of shareholders

are “transient” shareholders who are focused on short- term performance, then it could be

argued that the CEO has also a duty of loyalty towards current short-term shareholders.

Thus, if a CEO acts to artificially drive up short-term stock price at the expense of long-

run value, it could be in the interests of his current Principals. Current shareholders may

prefer to incentivize the CEO for short-term stock performance, even if this results into

22

incentives for the CEO to manipulate earnings. The motive is simply that short-term

investors prefer that the CEO pursues short-term strategies at the expense of future

shareholders (Bolton et al. 2005). As suggested by Lewis (2004), short-term investors

care about short-term gains in stock prices more than long-term performance, preferring a

lucrative, managed performance, in lieu of an expensive truth. In the meantime, such

investors astutely let managers know of their intentions.

Figure 4 charts the rise of transient institutional ownership in Nortel. Again, this

is compared to the same ownership in the control group. Between 1997 and 2000,

transient ownership increased fivefold, peaking at 13%. At the same time, this metric fell

at comparable firms.

[Figure 4 Here]

The assumptions about the principal in agency theory became increasingly

unrealistic as applied to Nortel. Although no company of any size has the type of

ownership imagined in the ideal type of the theory, Nortel’s ownership did not even

approximate the concerns needed for a principal interested in devoting concern to the

monitoring of management. Ceteris parabus, changes in the structure of ownership

increased pressure on Nortel management to meet the expectations of new owners, in lieu

of the interests of long-term owners. The episodic ability to do so may have increased

the volatility of share price. As Botosan and Plumlee (2002) suggest, attracting short-term

investors can lead to volatility in stock prices, which also increases the expected return on

company shares. Gaspar et al. (2005) argue that firms with short term investors are more

23

likely to engage in value reducing acquisition activity. The preceding fits within the

Nortel story: the agency problem of “overvalued” equity problem was exacerbated by the

presence of short-term investors. Agency theory that predicts the disciplining mechanism

of institutional owners, also stipulates a long-horizon relationship between principal and

agent. In the case of Nortel, agency did not account for the short-term incentivization

provided by the “transient” institutional owners.

EARNINGS MANAGEMENT

Earnings manipulation in the context of agency theory has been considered as

early as Lacker et al. (1989). There would be no income manipulation in the absence of

agency problems (the owner cannot manipulate himself), hence earnings manipulation

lies in the heart of agency theory itself. Primarily, managers perform their stewardship

duties to owners by reporting results from operations and the current state of ownership.

Generally accepted accounting principles (GAAP) provide a set of guidelines for this to

be done without excessive ambiguity or moral hazard. In this way, agency theory

underlies a large part of the mainstream accounting research on disclosure and capital

market impacts (see Healy and Palepu, 2001 for a substantive review).

Contrasting the normative is a long history whereby purposeful income

manipulation through accounting has been documented (Matheson, 1893; Paton, 1932;

Buckmaster, 2001). That which is now known as earnings management may further an

organization’s interests in negotiations with external parties, but may also represent

opportunistic efforts by top management relative to corporate ownership (Christie and

24

Zimmerman, 1994). At its most blatant, managers can make accounting choices that

maximize manager compensation.

Earnings management by corporate agents appears to be an international

phenomenon varying only in its magnitude (Leuz et al. 2003, Kinnunen and Koskela,

2001). Although some of this fails to fool the market, attempts to manufacture a

systematic deviation from neutral ground persist. Manipulation in a positive direction

occurs with greater frequency at firms under economic duress, such as would be caused

by past losses (Callen et al. 2003). Triggering circumstances interact with the specific

types of accruals and manipulations that are deployed in this effort (Loh et al. 2001).

However accomplished, a large number of financial executives are willing to sacrifice

shareholder value to demonstrate short-run success (Graham et al. 2004).

Others argue that earnings management produces some benefits to owners. The

suppression of information embedded in the unmanaged pattern of earnings is not always

supportive of share prices (Arya et al. 2002). Along similar lines, special accounting

charges taken by managers do not necessarily undermine the agency relationship (Wu,

1999). Income smoothing may not be such a pernicious form of management if it more

accurately reflects recurring earnings potential (Zarowin, 2002). Likewise, dividend

smoothing may merely reflect national norms for relations with shareholders (Rahman,

2002).

Nortel certainly had both reason and opportunity to manage earnings, cull the

favor of financial analysts and “spin” the results of operations. As shown above, the

compensation of key managers was heavily dependent upon company results, and prior

research has argued that financial statement misstatements are related to “excessive”

25

options usage (Burns and Kedia, 2006; Bebchuk and Gill, 2003; Benabou and Laroque,

1992). The evidence appears to suggest that Nortel exploited the opportunity to fool the

market; at least temporarily. After all, the diminishment of the “overvaluation” would

induce significant costs to the managers.

Earnings Smoothing at Nortel

Again, comparisons between Nortel and the control group were made. For these

purposes, total accruals were calculated as the difference between net income before

extraordinary items and cash flow from operations. This allowed changes in accruals to

be computed and correlated with changes in cash flows from operations. Following

Myers and Skinner (1999), Leuz et al. (2003) and Zarowin (2002), earnings smoothing is

calculated as the correlation between the change in accruals and the change in cash flows

from operations (the correlation is calculated over a three year period).3 The underlying

intuition is that the variability of cash flow is smoothed through the usage of accruals.

Therefore, a more negative correlation would signify a smoother income stream with

respect to underlying fundamentals. Usage of this proxy is desirable in the case of Nortel

because of the high growth and the large number of investments, as this renders other

proxies of earnings management inaccurate4 (see Fields et al. 2001, for a related

discussion).

3 Using an alternate income smoothing measure, that of dividing the standard deviation of income by the standard deviation of cash flows, yields essentially similar results. 4 Earnings management is also calculated using the discretionary accruals methodology of the modified Jones (1995) model. Nortel’s discretionary accruals, depending on the year, had values ranging from 5%-15% of total assets. Since Nortel was a growth firm, discretionary accruals are also calculated using the “forward looking” Jones model (Philips and Pincus, 2003) where values for discretionary accruals, ranging from 2% to 30%, are obtained. Even though the numbers obtained fit very well with predictions, they are very large, and likely to be inaccurate. Therefore, total accruals are examined without distinguishing the

26

Figure 5 illustrates the smoothing that occurred, consistent with the other figures,

Nortel had higher degrees of income smoothing relative to the comparison group from

1997 to 2000 (a more negative correlation coefficient of between changes in accruals and

cash flows indicates higher income smoothing). It is apparent that Nortel was an

aggressive smoother of its earnings.

[Figure 5 Here]

Comparing Nortel’s results to the individual firms in the control group (results

unreported), we find that for the 11 control firms with sufficient data to calculate the

income smoothing measures for the year 1999 (the year before the downfall), Nortel,

alongside two other firms, had the highest value for the income smoothing measure. This

high income smoothing measure cannot be explained by industry-wide factors as the

sample of control firms is drawn from Nortel’s competitors. Even if Nortel is compared

to a sample of firms drawn on the basis of size (since Nortel arguably was a

conglomerate, transcending industrial characteristics), Nortel still exhibits extremely high

levels of income smoothing.

Financial Analysts and Earnings Surprises

A mapping of agency theory onto the modern publicly-traded corporation is also

complicated by the interposition of financial analysts. These individuals advise the

ownership community on the near-term trajectory of an equity position in the target

discretionary from the non-discretionary portion, hence the resulting calculation for “income smoothing” as discussed above.

27

company. The demand for financial disclosures is a consequence of agency conflicts

(Healy and Palepu, 2001). Imperfect information regarding the prospects of the firm

results into agency costs imposed on principal holders (Ashbaugh et al. 2004). Financial

analysts in their role as sophisticated information intermediaries serve in reducing friction

in capital markets, and ensure a more efficient allocation of capital. Their ability to

gather, analyze, and disseminate company level information serves as a monitoring

function over top management (Healy and Palepu, 2001). In addition, their expectations

of firms serve as a disciplining mechanism of managerial behaviour. A good part of

analysts’ influence is derived from their work on predicting future earnings. Analyst

reports may increase the efficiency of the market (Weigold et al. 2000) but at the cost of

increasing the stakes for all participants (Hussain, 2000). Attempts to reduce uncertainty

in the future tend to crystallize that which might or should happen into that which must

happen, as agents are judged.

The work of analysts, and their critical relationship with corporate managers is

deeply flawed. Their economic incentives systematically make them prone to optimism

regarding corporate results (Shipper, 1991; McNichols and O’Brien, 1997). Prior

evidence causes some to doubt whether analysts possess or can effectively use private

information or algorithms that would produce value added predictions (Byard and Shaw,

2003; Fogarty and Rodgers, 2005).

Managers facilitate the dysfunctional level of optimism surrounding corporate

results by withholding bad news from them (Moses, 1990) and issuing sanguine

forecasts. The latter appears strategic since they are likelier when less accountable

(Rogers and Stocken, 2005). This behavior may be predicated on preserving merger and

28

acquisition advantage (Wall Street Journal, 1995) or personal wealth (Matsunaga and

Park, 2001). Managers might be better off if they could encourage lower expectations so

that earnings management would not have to be so readily availed (see also Matsumoto,

2002).

Analyst targets may merely encourage agents to work diligently in the pursuit of

the best interests for their principals. To some extent, excesses in this effort might be

identified and corrected by the market (Raedy et al. 2006). At the same time, their

presence may distort the relationship as a truly exogenous element (Levitt, 1998).

The struggle to meet or beat analyst expectations forces a new interpretation upon

Akerlof’s (1970) “market for lemons” argument in this application. Whereas previous

attention focused upon disclosure quality and associated market reactions (e.g., Healy et

al. 1999) or information equilibrium and the cost of capital (e.g., Zhang, 2006), future

attention should be diverted into achieved reputation for attaining expectations set by the

market. Achieving EPS targets has become increasingly important, judging by the

increased sensitivity of share price to surprises (Brown, 2001). Avoiding negative

surprises seems to be the focal point for managers in several types of earnings trajectories

(Burgstahler and Dichev, 1997). Furthermore, firms with inevitable negative surprises

are advantaged by “talking down” expectations early on (Bernhardt and Campello, 2002).

Managers are now assessed not on their accounting choices or adequacy of their

disclosures, but upon the “bottom line” of achieving expectations set by analysts. Rather

than a contingent, context-specific disclosure credibility (Mercer, 2004), the market does

not tolerate failure and the only “lemons” are those firms that are unable to meet

expectations. To the extent that impression management has taken on greater salience,

29

agents’ rewards are now less coupled with a firm’s economic prospects. Thus, actual

earnings are less relevant (Hoitash et al. 2002) and it is difficult to say that accounting

rules have been helpful on balance (Penman, 2003).

Between 1997 and 2000, the number of analysts following Nortel tripled from 12

to 37 (I/B/E/S, 2005). This corresponds to the period most believe to be highly abusive,

preceding such reforms as Sarbanes-Oxley, Reg FD, and the creation of the Public

Company Accounting Oversight Board. During the sixteen quarters under study, Nortel

consistently outperformed the consensus analyst estimate of future earnings. Nortel

became the darling of Wall Street by just barely, but regularly, exceeding the analyst set

standard and delivering consistent positive surprises. Figure 6 below graphs Nortel’s

performance with respect to sell-side analyst consensus forecasts, in comparison to the

control firms. According to Brown and Caylor (2004), earnings surprise is calculated as

actual earnings with respect to the last I/B/E/S consensus forecast available before the

earnings announcement date, divided by the stock price of the firm on the closing day of

the quarter.

[Figure 6 Here]

While other Telecom firms experienced large fluctuations in their reported

earnings as compared to consensus forecasts, Nortel was relatively stable, exceeding

expectations consistently for all 16 quarters examined. Earnings surprises at the control

group of firms better matched their definition. For these firms, surprise was more

extreme and took on negative values in six quarters. Since one method by which firms

30

beat exceed forecasts is “managing” market expectations (Matsumoto, 2002), analyst

forecasts are examined in the three months preceding the quarterly earnings

announcement (results unreported). In the 16 quarters where Nortel earnings surprises

are examined, forecasts are “talked down” five times in the three months prior to the

earnings announcement date. In 11 of the quarters, there is no change in consensus

forecasts in the last three months (in none of the quarters examined do analyst forecasts

increase in the three months prior to the earnings announcement). This is evidence of

“overvaluation” a la Jensen (2005), where market expectations are high ex-ante, and if

the firm cannot achieve the required benchmark, forecasts are toned down (or income is

manipulated) rather than the firm experiencing a negative earnings surprise.

An alternative explanation of the data could be that Nortel had a more stable

earnings stream as compared to the control firms. In order to rule out this explanation,

Nortel’s earnings stream is compared to the control firms by calculating the standard

deviation of quarterly ROA (used as a measure of earnings variability). Unreported

results indicate that Nortel ranked sixth as compared to a control group of 13 firms. It

does not seem that a smoother earnings stream at Nortel contributed to its consistent

beating of analyst forecasts.5 Finally, examining the specific composition of the control

group (since it is possible that the negative earnings surprises of the control group could

be caused by a few firms), from the 11 firms that have analyst forecast data for the 16

quarters under study, only 2 other firms consistently beat analyst forecasts.

Sell-side analysts were themselves bullish about Nortel’s prospects. Even after

massive operational and financial problems, they kept on issuing positive (or non-

5 Similar inferences are arrived when examining the volatility of earnings normalized by market value (instead of assets).

31

negative) recommendations regarding its prospects. The buy recommendations for

Nortel shares proved “remarkably resilient” (Hunter, 2003). Although all financial

signals implied nothing more than a “sell” recommendation, the few downgrades were

either from a “strong buy” to a “buy” or from a “buy” to a “market outperform” (Hunter,

2003).

It is apparent that financial analysts did not reduce agency problems at Nortel.

Increases in analyst following, and the superior information gathering and disseminating

ability of financial analysts, are expected to reduce information asymmetries. This in

turn enhances the monitoring of managerial behavior, and allowing for an efficient

allocation of capital market resources. However, what is observed is evidence that

financial analysts increased rather than decreased such agency costs. The high market

expectations prompted managers to engage in an earnings management game, which then

resulted in unruly behavior. At Nortel, meeting and beating analyst forecasts for 16

consecutive quarters eventually resulted into a total destruction of core-value.

GAAP vs. Street Earnings

The late 1990s saw a highly nuanced earnings management process. Managers

were no longer passive while estimating future earnings. Practice emerged whereby key

executives would announce “pro forma” EPS (or more colloquially “street earnings”).

Here, announcers took liberties in the way earnings were measured, after departing from

GAAP. To the extent that such pronouncements excluded non-recurring items they may

have originally been useful. However, Bradshaw and Sloan (2000) demonstrate that

managers used them to manage earnings and - often – disguise poor performance.

32

Therefore, these pronouncements could be strategic in nature. “Pro forma” earnings are

measured in a methodology similar to that of Bradshaw and Sloan (2000), where

quarterly EPS measures are obtained from the IBES summary files which report earnings

figures on a continuing operations basis. In Figure 7, rather close harmony between

numbers before 1997 suggest the absence of a managing agenda. In later years, a distinct

departure occurred: “Street earnings” exceeded GAAP earnings suggesting the exclusion

of income reducing special items.

[Figure 7 Here]

Nortel put no emphasis on GAAP earnings, as evidenced by the fact that Nortel’s

2000 Letter to Shareholders did not contain a single reference to GAAP earnings (loss

was $3.47 billion) or Cash Flow from Operations (only $40 million, down from $1.5

billion two years earlier). The firm’s Management Discussion and Analysis (25 pages)

contains only one sentence on GAAP earnings. Finally, as further evidence that the

board was co-opted by management, the Letter to Shareholders was co-signed by the

chairman of the board.

Subsequent restatements of income taken by Nortel cast some light on the motives

of its key decision makers, and more specifically, for the excessive degree that it

managed its earnings. Apparently, the higher variability of operating cash flow posed the

prospect of higher risk associated with the firm’s earning potential. This allowed Nortel

executives to become more predictably enriched.

33

Nortel used a variety of techniques to accomplish its earnings manipulation. For

instance, it is now known that extremely aggressive revenue recognition techniques

enhanced the growth rate appearing to exist at Nortel between 1998 and 2001. Sales for

2000 include close to $3,000,000,000 for transactions that should have been recognized

in subsequent years (10% of that year’s sales and 40% of the sales growth between 1999

and 2000). The expensing of research and development costs from the companies that

were purchased over these years also needs to be compared to the less favorable

treatments available had the R & D been produced in-house: most of the acquisition

prices were booked as goodwill and amortized over 3 to 20 years.

The scale at which accounting is a distortive influence does not seem to be well

anticipated by agency theory and is exacerbated by equity markets attempting to value

future income power with such ferocity that intermediaries are commissioned for these

purposes. As shown by the Nortel case, there does not seem to be any effective

assessment of agency costs such that skepticism about agent communication is

impounded.

THE MISSING ELEMENTS

Agency theory, by legitimating the pursuit of self-interest by agents, offers a

deeply cynical perspective on human behavior. However, the lack of any serious

consideration of restatement in agency theory exists as an ironic juxtaposition. When is

the consumption of a principal’s rightful belongings no longer a game of greed? When

does it begin to take on subversive overtones? Should the failure to check agents be

34

blamed upon principals that do not anticipate agency costs and continuously monitor

actual results?

Agency theory does imply that managers who cannot be curbed will be dismissed.

This discharge seriously impairs the agent’s reputational capital, wherein the agent has an

undiversified exposure. By isolating individual actors, agency theory also cannot process

ideas such as an organization’s ethical climate. A large body of work points to the “tone

at the top” (Kalbers and Fogarty, 1993; Rezaee, 2003) as an important element of the

normative environment.

Agency theory does not possess a means to predict the irregular behaviors of key

corporate officials. The economic utility embedded in agency theory does not compare

favorably with a reasoned action theory that combines psychological and situational

variables (see Gillett and Uddin, 2005). In fact, agents of corporations that self-identify

with agency theory are less trustworthy than those that self-endorse a stewardship theory

(Albrecht et al. 2004). In other words, agency theory is limited by its unwillingness to

probe cognitive differences pertaining to financial irregularity proclivities.

Another issue unique to the application of agency theory to the corporate world is

that corporate results are expressly tied to trading markets. Corporate agents are not as

likely to commit the types of irregularities that directly affect the existing and continuing

owners. Through the use of stock options, the injury caused by information asymmetries

and moral hazard gets inflicted upon anonymous market participants. Motivated by

executive compensation arrangements and facilitated by earnings management abilities,

insider trading is a predictable outcome (Cheng and Warfield, 2005). Some evidence

suggests a certain degree of abuse of position is anticipated by these security markets

35

(Liu and Yao, 2003) or, at the autopsy, a pattern of insider trading enforcement (Erickson

et al. 2004). Even in a world not requiring absolute trust, markets need the assurance that

some insiders will be punished (Beny, 2004).

The timing linking personal trading by Nortel executives and other behaviors,

albeit circumstantial, is suggestive of intent. Here, the best evidence would be efforts to

depress the Nortel stock price before options were issued and to elevate it thereafter (see

Aboody and Kasnik, 2000; Yermack, 1997). Nortel agents controlled the flow of

information to the markets and this may have been the vehicle for stock price

manipulation. Hence observing stock price behavior around executive stock option

provides evidence on one of the many elements available to managers in maximizing

their payoffs.

In Figure 8, the share price performance around stock option grant dates is

compared to market wide returns during the same period. Using the small sample

randomization technique of Fortin et al. (2002), the period preceding the grant date is

marked by significant negative abnormal returns (-8% for the 60 days preceding the grant

date). However, these negative returns reverse themselves after option grant dates.

[Figure 8 Here]

Wilcoxon small sample tests indicate significantly lower (p < 0.05) returns 60

days before an option grant date, as compared to the 60 days after the grant date. This

statistical significance is replicated using -25/+25 and -7/+7 time periods around option

grant dates. It is interesting to see that the pattern in Figure 8 closely follows patterns that

36

are observed in the recent stock options backdating scandal (see Heron and Lie, 2006),

where patterns obtained for Nortel mimic those of firms accused of backdating options

Starting in 2003, under pressures from its board of directors, Nortel underwent an

extensive forensic accounting review. Findings from such review corroborated previous

allegations of irregularities. The company fired the CEO, CFO, and controller, and

alongside was the ouster of 10 top executives in 2004, and there were two major

restatements covering provisions, accrued expenses, revenue recognition and the

measurement of various expenses. Financial irregularities continued over prolonged

periods. For example, restatements in the year 2005 and 2006 related to improperly

booked revenues and pension accounting were filed. The independent review report

found that “…Management “tone at the top” that conveyed the strong leadership message

that earnings targets could be met through applications of accounting practices…not in

accordance with GAAP…(management) exercised their judgment strategically to achieve

EBT targets…” (Nortel Networks Corporation, 2003 Annual Report, Independent

Review, pp. 109-111). Additionally, Nortel auditors identified five material weaknesses

related to compliance, application of GAAP, lack of personnel, and a lack of awareness

and accountability. Although such internal control shortcomings were identified by

Deloitte in Nortel’s 2006 annual report, Deloitte provided a clean opinion on Nortel’s

financial statements (Nortel annual report, 2006). Nonetheless, perhaps as a way to part

with this past, Nortel ousted Deloitte as auditors in December 2006 and substituted

KPMG at the May 2007 shareholder meeting (Nortel Quarterly Report, 2nd quarter 2007).

CONCLUSION

37

The sudden and dramatic destruction of value that occurred in Nortel’s case

spread considerable pain to investors whose equity diminished, discharged employees

and many others. Top managers who purposefully create over-valuation encourage

expectations that cannot be sustained. Ultimately, the economics of the situation cannot

be gainsaid. Nonetheless, significant wealth transfers occur along the way with some

parties benefiting from the roller coaster ride of valuation.

Situations, such as Nortel, require a confluence of many circumstances to happen.

Aided by lax regulation and markets that demand superstar performers, the up cycle did

set internal forces in motion that could not be managed and lead inevitably to capitulation

(see also Jensen, 2005). This paper has documented some of these at Nortel.

Agency theory establishes a template for the balance of power between agents and

principals. The temptations created by moral hazard and information asymmetry are

made well-known through this perspective. However, an examination of how poorly

agency costs were understood, monitored or controlled in the Nortel case presents the

distinct prospect that agency theory has little explanatory power. Agency theory may

require very rigid assumptions and discrete action choices (e.g., Hofmann, 2003).

Perhaps some of these limiting assumptions pertain to the distribution of ownership (see

Piot, 2001). We may also need a better understanding about the relationship between

accounting choice and market valuation (Joos and Plesko, 2002). At best, what we have

now is highly simplistic and reductionistic.

This paper has separated four major elements of agency thinking: Executive

compensation designed to create goal congruence instead offers the irresistible promise

of great wealth for managers. Board governance, often put forward as a critical control

38

mechanism to reduce agency costs, loses effectiveness quickly when it lacks some key

attributes. Modern ownership structures dissolve the principal’s diligence in the name of

diversification and short-term yield chasing. Accounting, instead of providing discipline

for the reporting of results, offers ample opportunity whereby results are made to seem

what they are not. All of these operate within the agency Welterswang. However, since

they operate simultaneously, a more comprehensive picture may be needed. Whereas

others combine these elements in the hopes of designing more optimal contracts (e.g.,

Wu, 1999) or to create new constructs such as residual claims (Fama and Jensen, 1998),

this paper argues that a striking parallel exists to garden variety financial irregularities.

Reversing the tendency of agency theory to normalize the consequences of greed (even

on a massive scale), this paper discredits this behavior. Agency theory makes it more

difficult to see what is wrong with corporate governance and often stresses what does not

need to be remedied (e.g., Holmstrom and Kaplan, 2003). A perspective of financial

irregularities more fully brings actions, such as insider trading, into focus. Normative

dimensions, such as unfairness, rather than being applauded for their incentive effects

(see Lukas, 2004) need to be condemned. In this process, the reestablishment of

professional management methods might be useful. Agency theory has no doubt been

helpful in constructing a definition of managerialism as the antithesis of professionalism

(i.e., Brooks, 1999).

Agency theory sits uncomfortably together with any serious conception of top

managers as leaders of large and complex organizations. When CEOs and CFOs are little

other than those best positioned to extract the maximum personal wealth from

corporations, faith that needs to exist in the validity of organizations is lost (see Meindl,

39

et al. 1985). Intense scrutiny is necessary when excessive looting erodes the value

creation that organizations made possible (Sutton and Galunic, 1995). Norms that would

otherwise constrain the rationalization element of financial misstatements dissipate.

As a paper that focused upon a single corporation’s trajectory, obvious limitations

exist. Certainly, there are elements of the Nortel story that would be more or less salient

had a different corporation been in the spotlight. This paper does not attempt to measure

how typical Nortel may be. The most likely scenario is that the elements combine in

varying magnitudes. Every corporation has different strengths and weaknesses in its

corporate governance. The former may make even innocuous devices, such as budgeting,

powerful vehicles of agent control (see Hofmann, 2003). A large mis-specification may

have occurred by not directly addressing organizational culture. The idea of “tone at the

top” seems a tantalizing iceberg tip explaining why the large set of related behaviors that

made Nortel possible did not self-correct. Unfortunately, the focus upon the economic

aspects of contracting and the individual agent that is deeply embedded in agency theory

puts sociological constructs beyond the pale. This may be even truer for constructs that

necessitate a belief in a collective psychology, such as organizational trust (see Chen,

1997). Furthermore, though agency theorizing has begun to see boundaries established

by legal regimes (e.g., Palepu et al. 2006), these institutions may also matter for anti-

agency views.

The authors thank Salvador Carmona, Santosh Gowda, Nisreen Salti, Stephanie Moussalli, and Tom Robertson Lecture participants at the University of Edinburgh and workshop participants at the University of Central Florida for their comments and suggestions, as well as conference participants at the European Accounting Association annual meeting in Dublin, 2006, and the AAA annual meeting in Chicago, 2007. We would like to thank Brian Bushee of the Wharton Business School for his generous

40

sharing of the institutional trading classifications. We would also like to thank I/B/E/S international for their provision of the analyst forecast data. We acknowledge financial support from the Social Sciences and Humanities Research Council of Canada, Fonds quebecois de recherche sur la société et la culture and the Lawrence Bloomberg Chair in Accountancy (Concordia University).

41

Figure 1: Quarterly Market Value of Equity of Nortel, 1993-2002

0

25

50

75

100

125

150

175

200

225

1993

-1

1993

-3

1994

-1

1994

-3

1995

-1

1995

-3

1996

-1

1996

-3

1997

-1

1997

-3

1998

-1

1998

-3

1999

-1

1999

-3

2000

-1

2000

-3

2001

-1

2001

-3

2002

-1

2002

-3

Year and Quarter

Mar

ket V

alue

of E

quity

source: CRSP

Figure 2: CEO Total Compensation

$9,28$7,76

$23,39

$8,93

$6,44

$24,91

$4,16

$39,84

$0,00

$5,00

$10,00

$15,00

$20,00

$25,00

$30,00

$35,00

$40,00

$45,00

1997 1998 1999 2000

Year

$ (M

illio

ns)

Control group of firms Nortelsource: Execucomp

42

Figure 3: Value of Total Options Held by CEO

$308,50

$93,76

$113,27

$16,13

$19,85

$75,59

$25,54

$17,99$0,00

$50,00

$100,00

$150,00

$200,00

$250,00

$300,00

$350,00

1997 1998 1999 2000

Year

$ (M

illio

ns)

Control group of firms Nortelsource: Execucomp

Figure 4: "Transient" Institutional Ownership of Nortel Shares

0

5

10

15

20

25

1997-11997-2

1997-31997-4

1998-11998-2

1998-31998-4

1999-11999-2

1999-31999-4

2000-12000-2

2000-32000-4

Year and Quarter

% O

wne

rshi

p

Control group of firms Nortelsource: CDA SpectrumInstitutional classifications generously provided by Brian Bushee

43

Figure 5: Nortel Yearly Income Smoothing

-1

-0,95

-0,9

-0,85

-0,8

-0,75

-0,7

-0,65

-0,6

-0,55

-0,5

1997 1998 1999 2000

Year

ρ(∆

Acc

, ∆C

FO)

Control group of firms Nortelsource: Compustat

Figure 6: Nortel Earnings w.r.t. Consensus Analyst Forecasts

-0,002

-0,0015

-0,001

-0,0005

0

0,0005

0,001

1997-1 1997-2 1997-3 1997-4 1998-1 1998-2 1998-3 1998-4 1999-1 1999-2 1999-3 1999-4 2000-1 2000-2 2000-3

Year and Quarter

Earn

ings

Sur

pris

e Sc

aled

by

Stoc

k Pr

ice

Nortel Control group of firmssource: I/B/E/S and CRSP

44

Figure 7: Nortel GAAP vs. Street Earnings

-1,2

-1

-0,8

-0,6

-0,4

-0,2

0

0,2

0,4

1995-1 1995-3 1996-1 1996-3 1997-1 1997-3 1998-1 1998-3 1999-1 1999-3 2000-1 2000-3 2001-1 2001-4

Year and Quarter

$s P

er S

hare

EPSgaap special actualSource: Compustat and I/B/E/S

Figure 8: Cumulative abnormal returns around Option grant dates

-12%

-8%

-4%

0%-60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60

Trading days from grants

% A

bnor

mal

Ret

urn

source: Nortel 10-k and CRSP

45

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