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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

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).

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

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 principals 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.

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
Nortels 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 firms
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 theorys 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.

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
principals 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 selfinterest in the absence of full information (Arrow, 1964) and may depend upon the tradeoffs 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

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 ownersingle 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.

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

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). Nortels 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).

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.
Nortels 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 Nortels 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).
Nortels 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

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 20002004 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 Jensens (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 Nortels core value.
Evidently, the agency model did not operate very well in Nortels 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 agencytheory, to investigate the various incentives and motivations given to Nortels 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 Nortels
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 agents
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 performancebased 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 nonlinearities in the pay-for-performance relationship, which they attributed to an
executives 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 agents 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).
Nortels CEOs 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, Nortels 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 Nortels 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 Nortels 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

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 Nortels 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 Nortels 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 Nortels
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
Nortels 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 nonexecutive 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 companys 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 principals 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

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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 longrun 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, Nortels 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
organizations 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).

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. Nortels 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 Nortels 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 Nortels 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 OBrien, 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
Akerlofs (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 firms 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 Nortels
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,
Nortels 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 Nortels prospects. Even after
massive operational and financial problems, they kept on issuing positive (or non-

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 Nortels
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 firms 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 firms 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 years 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 principals 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 agents reputational capital, wherein the agent has an
undiversified exposure. By isolating individual actors, agency theory also cannot process
ideas such as an organizations 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 practicesnot 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 Nortels 2006 annual report, Deloitte provided a clean opinion on Nortels
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 Nortels 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 principals 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 corporations 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 antiagency 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 socit et la culture and the Lawrence Bloomberg Chair in
Accountancy (Concordia University).

41

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


225

200

Market Value of Equity

175

150

125

100

75

50

25

-1

-3
20
02

-1

-3

-3

20
02

20
01

20
01

-1

20
00

-1

-3

-3

20
00

19
99

19
99

-1

19
98

-1

-3

19
98

19
97

-1

-3

-1

-3

19
97

19
96

19
96

19
95

-1

-3

19
95

19
94

19
94

19
93

19
93

-3

-1

Year and Quarter

source: CRSP

Figure 2: CEO Total Compensation


$45,00
$39,84
$40,00

$35,00

$ (Millions)

$30,00
$24,91
$25,00
$23,39
$20,00

$15,00
$8,93

$10,00
$6,44

$9,28

$7,76

$5,00
$4,16
$0,00
1997

1998
source: Execucomp

1999

Year

42

2000
Control group of firms

Nortel

Figure 3: Value of Total Options Held by CEO

$350,00

$308,50

$300,00

$ (Millions)

$250,00

$200,00

$150,00
$113,27
$100,00
$93,76
$75,59
$50,00
$25,54

$19,85
$17,99
$0,00
1997

$16,13
1998

1999

source: Execucomp

2000

Year

Control group of firms

Nortel

Figure 4: "Transient" Institutional Ownership of Nortel Shares


25

% Ownership

20

15

10

0
97
19

97
19

97
19

97
19

98
19

-2
98
19

98
19

98
19

99
19

99
19

-3
99
19

99
19

-1
00
20

00
20

00
20

Year and Quarter


source: CDA Spectrum
Institutional classifications generously provided by Brian Bushee

43

Control group of firms

Nortel

00
20

Figure 5: Nortel Yearly Income Smoothing


-0,5
-0,55
-0,6

(Acc, CFO)

-0,65
-0,7
-0,75
-0,8
-0,85
-0,9
-0,95
-1
1997

1998

1999

source: Compustat

Year

2000
Control group of firms

Nortel

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

Earnings Surprise Scaled by Stock Price

0,001

0,0005

-0,0005

-0,001

-0,0015

-0,002
-1
1997

-2
1997

-3
1997

-4
1997

source: I/B/E/S and CRSP

-1
1998

-2
1998

-3
1998

1998

-1
1999

1999

Year and Quarter

44

-3
1999

1999

Nortel

-1
2000

2000

-3
2000

Control group of firms

Figure 7: Nortel GAAP vs. Street Earnings

0,4

0,2

$s Per Share

-0,2

-0,4

-0,6

-0,8

-1

1995-1

1995-3

1996-1

1996-3

1997-1

1997-3

Source: Compustat and


I/B/E/S

1998-1

1998-3

1999-1

1999-3

Year and Quarter

2000-1
EPSgaap

2000-3

-1,2
2001-4

2001-1

special

actual

Figure 8: Cumulative abnormal returns around Option grant dates

0%

% Abnormal Return

-60

-50

-40

-30

-20

-10

10

-4%

-8%

-12%
source: Nortel 10-k and CRSP

Trading days from grants

45

20

30

40

50

60

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