On January 14, 2013, three former Nortel executives were acquitted on two counts of fraud. The Crown alleged that the accused, Nortel’s former directing minds, had manipulated Nortel’s financial statements during a time that management was trying to return the company to profitability. In a judgment spanning 140 pages, Mr. Justice Marrocco held that the Crown had failed to prove the charges beyond a reasonable doubt. The implications of this decision are of interest to criminal and civil lawyers alike.
Frank Dunn, Douglas Beatty, and Michael Gollogly were charged with two counts of fraud over $5,000. The Crown alleged that the defendants had defrauded the investing public (count 1) and Nortel itself (count 2) by deliberately misrepresenting Nortel’s financial results between 2000 and 2003. The three accused were Nortel’s CEO (Dunn), CFO (Beatty), and Corporate Controller (Gollogly) during the time-frame of the indictment. All three men were experienced accountants who understood accounting principles had spent substantial portions of their careers within ascending financial and accounting votes at Nortel.2
The Crown alleged that the accused had managed Nortel’s earnings by arbitrarily manipulating accrued liability balances. By doing so, the allegation was that they misrepresented Nortel’s financial results to the investing public, to Nortel’s Audit Committee, and to Nortel’s Board of Directors.3 In particular, the Crown alleged that the accused manipulated accrued liability balances to engineer profits in the fourth quarter of 2002 and the first, second, and third quarter of 2003.4 In other words, the Crown said that the accused maintained a “cookie jar”5 of accrued liabilities in order to achieve profitability targets. Meeting these targets permitted Nortel to pay bonuses to management, including the three accused.
In 2003 and 2005, Nortel restated financial statements that it had previously published. The two restatements related to financial results from 2000 to 2003. Many of the restated items were corrections and adjustments to accrued liability balances. The Crown argued that the two restatements, per se, proved that Nortel’s original accounting was misrepresented, false, and non-compliant with U.S. GAAP.6 In addition, the Crown alleged that the accused misled the public when they asserted that the first restatement was “comprehensive.” In the Crown’s view, this first restatement was narrow in scope, rushed, and under-funded; for this reason, a second restatement was required.7
The Evidence at Trial
The Crown called numerous witnesses, several of whom were former Nortel employees involved in the preparation of Nortel’s financial results. The Crown described these witnesses as potential “accomplices” whose evidence ought to be received with caution.8 The Crown also called employees of Deloitte & Touche, Nortel’s longstanding auditors. Like the Nortel employees, the Deloitte witnesses were implicated in the alleged fraud. The Court commented that Deloitte was “embedded in one form or another in all aspects of Nortel’s operations.”9
The Crown also called several lawyers from McCarthy Tétrault LLP and Borden Ladner Gervais LLP who represented Mr. Dunn and Mr. Beatty during the independent review of Nortel’s restatements. These lawyers advised and assisted Mr. Dunn and Mr. Beatty while they were interviewed by Wilmer Cutler Pickering, the US law firm retained by Nortel to conduct the independent review.10 The Crown wished to tender notes taken by counsel during the interviews of Mr. Dunn and Mr. Beatty. The accused objected, arguing that the notes were protected by litigation privilege.11 In an interesting mid-trial ruling, Justice Marrocco held that the counsel-witnesses could use the notes to “refresh their memories” while testifying.12 However, the Crown could not read the notes or attempt to admit them into evidence.13 The mid-trial ruling emphasizes the importance of a lawyer’s notes to the performance of his or her duties.14 Thus, while the defendants’ former lawyers could be called to testify, their pre-litigation work product was protected.
In addition to the Nortel, Deloitte, and lawyer witnesses, the Crown tendered an expert witness to comment on basic accounting principles, including U.S. GAAP.15
The three accused called no defence. As a result, the question for Justice Marrocco was whether, on the basis of the Crown evidence that he accepted, he was convinced of guilt beyond a reasonable doubt. 16
Justice Marrocco held that, based on the evidence, Nortel’s financial results did contain excess and unsupported accrued liabilities.17 However, the court found that the accused did not know the extent to which Nortel’s accrued liabilities were excessive and unsupported.18 Justice Marrocco attributed the excess accrued liabilities to Nortel’s “culture of conservatism” (a tendency to understate rather than overstate net income and assets).19 The unsupported liabilities, on the other hand, could be explained by Nortel’s financial troubles and downsizing; documentation, employees, and institutional memory were lost during this period. 20
Crucially, Justice Marrocco rejected the Crown’s characterization of Nortel’s two restatements. His Honour emphasized that a restatement, per se, does not necessarily mean that the original treatment of a restated item was false or fraudulent.21 Justice Marrocco criticized the Crown for failing to recognize that auditors could “change their minds” about the accounting treatment of an item.22 While Justice Marrocco agreed that a restatement of accrued liabilities could ground an inference that the liabilities were originally misrepresented, he was not persuaded that an inculpatory inference was warranted on the evidence.23 In His Honour’s view, “[the] specifics of each restated item are a story, the details of which cannot be inferred from the ending.”24
Comments and Analysis
The Line Between Discretion and Criminality
A key theme in R. v. Dunn is the fine line between “managing earnings” and manipulating financial results. In his reasons, Justice Marrocco endeavours to distinguish criminality from the acceptable exercise of judgment in accounting.25 At multiple points in the judgment, His Honour explains that there is nothing criminal about managing the affairs of a corporation to achieve a financial target.26 Further, he emphasizes that the process of estimating, adjusting, and releasing accrued liabilities involves considerable judgment and discretion.27 For this reason, there may be differences of opinion with respect to the treatment of certain amounts.28 Ultimately, Justice Marrocco refused to second-guess the decisions made by Nortel’s accountants; given the amount of discretion involved, the Crown could not prove that Nortel’s results were deliberately misrepresented.
“Materiality” is an Essential Ingredient of Fraud
R. v. Dunn also highlights the importance of the “materiality” requirement in a fraud analysis. In order to prove fraud, the alleged deceit or misrepresentation must be “material” – i.e. the judgment of a reasonable person would be influenced by the correction of the misrepresented item29. The Crown did not call any expert to comment on the issue of “materiality.”30 As a result, Justice Marrocco was tasked with making his own determinations on the materiality of the impugned entries in Nortel’s books. For example, despite finding an $80 million entry that was clearly unsupportable, His Honour held that the amount was not “material” given Nortel’s net worth of $2.33 Billion in the relevant quarter.31 In other words, an error of $80 million was not material to an enterprise of Nortel’s financial size.
The Difficulty in Proving Mens Rea
Justice Marrocco’s reasons also illustrate the difficulty in proving fraud where hundreds of people are involved in the auditing process.32 As the three accused did not testify, there was no direct evidence of their subjective knowledge or intentions with respect to the impugned financial statements. As a result, the Crown faced an uphill battle in proving that the accused – three high level executives – had knowledge of and were primarily responsible for alleged material misrepresentations in Nortel’s financial results.
The Focus on Nortel’s Financial Crisis
Throughout the decision, Justice Marrocco analyzes the accused’s conduct through the lens of Nortel’s precarious financial position. To an extent, His Honour excuses certain oversights because Nortel was struggling to meet the cash reserves it needed to survive.33 Ultimately, Justice Marrocco was convinced that the accused made a conscientious effort to preserve the integrity of Nortel’s accounting.34 In particular, he found that the Mr. Gollogly was committed to “cleaning up” the balance sheets.35 His Honour also cited Nortel’s culture of conservatism to explain away its excess accrued liabilities; he emphasized that there was no evidence that conservatism is in and of itself contrary to the U.S. GAAP.36 Thus, Justice Marrocco accorded deference to Nortel’s internal culture and to the accounting decisions made during its financial crisis. In effect Justice Marrocco was prepared to defer to the expertise and judgment of management, respecting what in civil cases is referred to as the “business judgment rule”.
Lawyers with sophisticated corporate clients can for the most take some comfort in the outcome of R. v. Dunn. The decision confirms that allegations of large-scale fraud are indeed defensible. In particular, Justice Marrocco confirmed that bona fide accounting decisions will be accorded deference by the courts. Where the impugned amounts are not “material” and there is no evidence of a deliberate intent to mislead, the Crown will be hard-pressed to prove a case alleging fraud beyond a reasonable doubt. The sheer magnitude of defending large scale criminal and civil fraud actions like R. v. Dunn is tremendous.
Because of its judicial review of the principles of materiality and fraud in a complex accounting case, R. v. Dunn should prove a useful and interesting study for corporate governance experts, securities regulatory lawyers, accountants, auditors and directors and officers liability insurers.
1R. v. Dunn, 2013 ONSC 137 [Dunn].
2Ibid, at paras. 156, 162, 147.
3Ibid, at para. 913.
4Ibid, at para. 73.
5Ibid, at para. 115.
6Dunn, at para. 490.
7Ibid, at para. 303.
8Ibid, at para. 71.
9Ibid, at para. 130.
10R. v. Dunn, 2012 ONSC 2748 [Ruling re: Litigation Privilege], at paras. 4-5, and 22.
11Ibid, at paras. 17-18, 37-40.
12Ibid, at para. 62.
13Ibid,at paras. 63 and 91.
14Ibid, at paras. 54, 59, 84, and 91.
15Dunn, at para. 180.
16Dunn, at para.
17Ibid, at para. 1132.
18Ibid, at paras. 1132, 1134.
19Ibid, at paras. 210-211, 232-233, and 1130.
20Ibid, at para. 1133.
21Ibid, at para. 492.
22Ibid, at paras. 1179, 1181.
23Ibid, at paras. 663, 1180.
24Ibid, at para. 1184.
25Ibid, at para. 810.
26Ibid, at paras. 400, 810, 825.
27Dunn, at paras. 120, 217.
28Ibid, at para. 662.
29Ibid, at paras. 43-59.
30Ibid, at para. 695.
31Ibid, at paras. 732, 756 and 1156.
32Ibid, at para. 171.
33Ibid, at para. 1137.
34Ibid, at para. 1169.
35Dunn, at para. 1136.
36Ibid, at para. 1098.