01/18/2012 10:54 EST | Updated 03/19/2012 05:12 EDT

Crown says letters show Nortel execs knew they were getting bonuses fraudulently

TORONTO - The three former Nortel Networks Corp. executives on trial for fraud knowingly manipulated the now insolvent company's books to reap nearly $13 million in cash and stock bonuses, the Crown alleged Wednesday.

Lead prosecutor Robert Hubbard has said that former Nortel chief executive Frank Dunn, finance chief Douglas Beatty and controller Michael Gollogly falsified Nortel's financial statements to show a return to profitability in 2003, even though the company was still in the red.

The three men have pleaded not guilty to the charges and none of the Crown's allegations has been proved in court. The defence opening arguments begin on Thursday, the fourth day of what's expected to be a six-month trial.

The crux of the Crown argument is that under Dunn's direction, Nortel had a culture of "cookie-jar accounting" in which hundreds of millions of dollars worth of reserves weren't released when they should have been and later used fraudulently to shore up quarterly results.

Hubbard said he plans to prove that those in control of the company knew what they were doing was wrong. He plans to show that many misleading transactions were not simply a result of bad accounting or improper record keeping, but part of a plan to give the illusion the company had returned to profit, when it had not.

He said the senior executives should have known that the company shouldn't bolster results in a lacklustre period by releasing excessive amounts of cash from reserves, which Hubbard repeatedly referred to as the "cookie jar."

"It's accounting 101," Hubbard said. "That's a pretty good indication that the results drive the accounting, rather than the accounting driving results."

Dunn's defence lawyer is set to deliver opening arguments for all three defendants Thursday morning in what is expected to be a lengthy trial that could be one of the biggest cases of corporate fraud in Canadian history.

Hubbard showed the court Wednesday a draft letter allegedly written by Gollogly to the company's board of directors in which he voices concerns about how Nortel reported a profit in the second quarter of 2003.

Dunn had originally said he was "embarrassed and ashamed" that the company would not be able to turn a profit in that quarter, but then had employees look for any possible reserves they could find, and the company reported a profit, triggering the bonuses, Hubbard said.

Concerned about "spotty" documentation, Gollogly offered to resign and give up alleged fraudulently earned bonuses in a letter penned to the fallen telecom equipment maker's board, the Crown argued.

But it appears that letter was never sent, and Gollogly accepted his $571,000 bonus, Hubbard said.

"In my opinion, the company has not returned to profitability, at least not in the spirit the (return to profitability) program was intended," Gollogly allegedly said in the letter.

Gollogly's letter also allegedly drew attention to how a forecasted loss for the company's third quarter, when it planned to clean up its books again, could call into question how the second quarter profit was achieved, Hubbard argued.

"The obvious question is how the company can lose $75 million in Q3 off revenue of $2.3 billion but essentially broke even in Q2 with the same revenue base," Hubbard said.

A note, allegedly in Gollogly's handwriting, was also shown to the court, in which he calls the effort to clean up the balance sheets in the third quarter "a joke," because, as his assistant controller allegedly put it, the company's finances were already "polluted," Hubbard said.

His assistant controller, Karen Sledge, is also expected to testify.

Hubbard argued that the alleged scheme delivered each of the senior executives millions of dollars in cash and stock bonuses, as the return to profitability also had the effect of raising Nortel's stock price.

However, the results were later restarted several times to reflect the misleading accounting, which sent Nortel shares into a tailspin and wiped out the value of its stock.

"It's only when the truth leaks out ... that the shares dip, and that's the effect of telling the truth," Hubbard said.

Under the return to profitability plan, Dunn received $4.8 million, Beatty received $1.75 million and Gollogly received $471,000. They also received millions more through a stock option program tied to a return to profitability, Hubbard argued.

When the three executives were fired over the allegations in 2004, the board demanded the repayment of bonuses totalling about $12.9 million, including payments from a restricted share scheme in 2001.

The company demanded $7.8 million from Dunn, $3 million from Beatty and $2 million from Gollogly.

The Crown has a list of 28 witnesses it plans to call, including former employees expected to testify about how they helped move money, and has warned the judge that some of them may have been accomplices.

The first three witnesses will be Brian Harrison, Karen Sledge and Sue Shaw — three mid-level employees Nortel's once 1,500 member finance group.