Nortel’s rise and fall were affected by four key factors: board composition, earnings management, ownership structure, and executive compensation. Board structure was a problem in the company because board size was greater than the prescribed role. Furthermore, members had too many external interests to focus on their role as directors. Additionally, they lacked the financial expertise needed to analyze the manager’s decisions. When Nortel’s stock prices soared, the board of directors was too delineated from the goings-on of the firm to question it, and this led to its collapse.
Executive compensation explains the firm’s performance between the late 90s and early 2000s. The CEO’s pay structure was strongly tied to stock options. In fact, this accounted for half of the executive’s earnings. John Roth, who was the acting company CEO at its realm and fall, had an incentive to pursue continual growth. His stock options held no value if stock prices did not supersede the exercise price. However, if he pursued a continual growth strategy, then the value of his options would rise, and so would his overall compensation. The way Nortel had structured its executive pay system made it relatively appealing to manipulate earnings. Earnings manipulation, information manipulations, and restatements were just some of the platforms that management used to increase the value of stock prices, and hence executive stock options. These fraudulent tactics eventually set the company up for failure.
The problem also emanated from Nortel’s ownership structure. Prior to the late 1990s, the company’s primary shareholders were long term investors whose goal was to purchase the firm’s shares and grow with the firm. However, its continual acquisitions and relentless growth attracted the attention of short-term traders in the US and elsewhere in the world. These were financial institutions that were only concerned about short term interests. Such firms are the first to exist a company’s shareholder base if its performance starts declining. At the beginning of the Nortel performance bubble, their presence gave the company an incentive to keep meeting shareholder expectations. However, when this was not possible, Nortel started to manipulate its earnings in order to please them. When the manipulations reached unsustainable levels, Nortel’s stocks were exposed for what they really were, and its value went tumbling down.
Earnings management also explains why the company rose and fell so drastically. The company adopted an earnings manipulation tactic that became popular in the 90s. Instead of reporting all the organizations’ earnings, as required in GAAP, it chose to delineate nonrecurring costs from continuing costs under the label of pro forma earnings. This approach had the effect of masking costs that emanated from mergers or acquisitions, depreciation, and unusual charges. The organization strategically chose to disclose its pro forma earnings (street earnings) during occasions in which it expected losses. As a result, the organization appeared to beat its benchmarks.
This tactic had the effect of turning losses into profits, on paper, while the real value of the company remained hidden from the public. Nortel appeared relatively stable when its competitors performed poorly because it had perfected the game of benchmark beating. However, the masking could not continue for long because it was not founded on the company’s financial fundamentals. Additionally, the company could not keep manipulating these earnings. The accounting committee caught the company and thus highlighted its fall.
Mechanisms that can align managers and shareholders’ interests
A board of directors is a party whose primary responsibility is to align managers and shareholders’ interests. An organization ought to have a committed and competent board of directors. They need to be committed to their respective positions as intermediaries between managers and shareholders. This implies that they should not have any conflict of interest. Here, directors ought not to serve on each other’s boards or be committed to too many business ventures. Nortel’s board of directors was too preoccupied with its own commitments to safeguard shareholder interests. Additionally, companies need to make sure that board members own no stock in the organization.
Therefore, the independence of the directors is a key issue. Furthermore, their sizes should comply with international or national governance standards. No board should exceed prescribed values. Since financial performance is a prime indicator of company performance, then a board of directors needs to have financial expertise. No compromise should be allowed in this regard. Finally, the board of directors needs to conduct managerial reviews of performance. They should evaluate how managers are performing by understanding how the company makes money and tying these sources with managerial explanations. The directors ought to do their work as required, and failure to meet all the above requirements should lead to their elimination. The company’s owners should replace the underperforming board of directors with performing ones.
The problem of executive compensation must also have structural solutions. As mentioned in the case study, Nortel’s primary problem emanated from its overreliance on stock options as a standard-bearer for CEO pay. Stock options are a form of pay-for-performance reward that incentivizes the manager to align his interests with that of the shareholders. However, this method does not always work because some individuals may adopt a self-serving attitude during periods of financial collapse. Stock options differ from shareholder stocks because shareholders risk their money while executives are not under any obligation to do so.
In order to protect firms from the tendency to swap stocks in financial downturns, companies ought to forbid CEOs from re-pricing or swapping stocks whenever the price of stocks falls below the exercise price. Alternatively, organizations can change the percentage of CEO remuneration that they allow a CEO to make. This will minimize the incentive always to maintain rising stock prices even when the long-term wellbeing of the organization is at stake. As a principle, CEO compensation should reflect company assets, sales, and industry standards.
The problem of earnings manipulations stems from having a short-sighted approach to the management of organizations. Many corporations align managers’ performance with short term indicators of growth, like stock prices. This implies that managers will sacrifice shareholders’ interests for an opportunity to increase share prices. Sometimes an investment opportunity may come along that could potentially increase a company’s long term prospects, but this could hurt its financials in the short term. Current performance structures make managers susceptible to safeguard their short term interests. Organizations can change this propensity by aligning pay to long term measures of performance, such as growth or annual returns on capital.
Whether the failure at Nortel stemmed from people or capital market processes
Capital market processes led to the failures at Nortel. The value model in the company strongly relied on the share price. The major problem with this approach was that it was only weakly-related to company performance. At a glance, a firm’s share price can be declining in one year and increase in the next. Furthermore, quarterly results may change within the same year. Low share prices do not necessarily mean that a company is in decline. It is a combination of investor psychology, stock market inclinations, and other external circumstances. Share prices are an inadequate way of assessing a firm’s growth, especially if it is large. This was the case for Nortel; stock prices seemed to be the make or break point for executives, managers, and employees in the organization. It was this overemphasis that moved stakeholders away from market fundamentals to short term behavior. The choice to use such an approach was beyond the people in the organization; it was process-related.
When one analyses the behavior of the accountants, managers, and executives at fraudulent companies, one must look beyond the symptoms of the problem and establish its causes. Nortel’s managers or employees might have been corrupt, but it was the loopholes and incentives in the system that allowed them to exercise fraud. Well-run firms seal these loopholes by eliminating incentives that perpetuate it. Share-based incentives pressured the people of Nortel to hide poor performance in order to safeguard their interests. Clearly, these were structural issues.
The nature of company investors also had a role to play in the Nortel crisis. This was a situation that was also structural or based on capital market processes. In theory, shareholders are supposed to use superior market information to sell or buy stocks up to a point when their expectations match stock prices. For this to happen, average holding periods ought to belong. Furthermore, shareholders need to intervene actively in firms where they have invested. However, institutional investors have become a common category of shareholders.
Many of them manage thousands of portfolios, thus making it difficult to intervene. Furthermore, their holding periods are relatively short. Institutional stakeholders will hold stocks for no more than one year. As a result, passivity has become a common trait. In Nortel’s case, institutional shareholders, who had a short term, passive interests, did not exercise voice when their interests were at stake. The capital market has made it quite difficult for long term goals to take precedence over profits because institutional investors are evaluated annually.
Problems in the company also emanated from limited gatekeeper capacity. Human beings are susceptible to unethical behavior; therefore, gatekeepers must keep them in check. In Nortel’s case, it appears that the gatekeepers had insufficient expertise and the ability to enforce rules. The board of directors was overwhelmed by its tasks. Furthermore, rating companies and accounting bodies did not catch up with Nortel’s lying game. If they had better resources and expertise to audit organizations, then they would have caught the information and earnings manipulations in the company. If Canada strictly enforced GAAP compliance, then it would have prevented Nortel from engaging in unethical behavior for such a long time.
Certain unsustainable financial practices have gained favor among capital markets in the developed world. These ideas were not invented by Nortel or its employees but were used by them to manage their earnings. One such idea is issuing guidance on earnings. Analysts rely on managers to give guidance on profits. However, because analysts will get more contracts from investment bankers if they generate more sales, then most of them give optimistic forecasts. In return, this move pressures managers to meet those forecasts or benchmarks. Eventually, some of them will manipulate financial reports in order to reach those targets. Providing guidance on profits was a new form of analysis that led to the company’s decline. Another accounting practice that also gained popularity in the same period was the use of pro forma or street earnings. This practice gives managers the flexibility to choose how they report their earnings even when this involves masking. If institutional structures existed to prevent companies from changing earnings measurements, then the crisis at Nortel would not have occurred.
Why business people still keep making the same mistake as Lehman, Enron, and Citigroup
Some business people still engage in unethical behavior because they believe that they can get away with it. These individuals do not have confidence in enforcement measures or external regulators. One reason could be that no systems exist to regulate such behavior or regulations enforcement is not strict enough. Therefore, business people will engage in risky investment choices, fraudulent activity, or conflict of interest merely because they know they can. A company that is left to regulate itself is unlikely to choose the ethical route if a profitable path is available.
In Enron’s case, a lot of things did not make sense to outsiders, yet no one objected to this. For instance, a gap existed between the company’s profits and its cash flows. Additionally, the company’s revenue generation source was mysterious. It was simply not possible to pin down how the company made so much money. It did not make sense that the organization had discovered a new way of generating wealth that no else could use. Nortel’s stock prices rose continually while its competitors’ stocks did not. While these gaping irregularities existed, no one asked questions about them, so the fraudulent behavior continued.
Lack of power and courage to speak out against corrupt behavior also perpetuates the problem. When senior managers instruct employees to facilitate fraudulent behavior, few individuals have the power to act. They often fear for their jobs and worry that they will not find employment elsewhere. Furthermore, if practices of manipulating earnings have become so widespread, then employees will think that they have minimal control over it. They might fear to get the whistle-blower label, and thus do nothing.
Other individuals are too risk-inclined to learn from the mistakes that other companies, like Enron and Lehman, made. For instance, if two investment decisions exist, and one of them may undermine the long term viability of the company, some managers may choose the riskier alternative owing to its return. They downplay the danger of their actions and only focus on the returns. This is especially common among individuals who have minimal disclosure rules on risk-taking. Managers with a lot to gain from additional risk (such as through stock-based pay) will continue to push the accounting envelope for personal gain.
Some individuals may not understand the danger of financial manipulation. A company can choose to borrow from future earnings in order to cushion its current cash flows. When done in relatively small quantities, it may seem like a harmless act. However, with time, this could spiral out of control and cause a company’s downfall. Some individuals may understand the dangers of such practices and will continue to manipulate finances. However, others may not be aware of this process and may only realize its repercussions after a relatively long period of time.
Greed also explains why individuals keep doing the same thing over again. Financial companies that are well aware of the risks behind certain investments will continue to pursue them. For instance, they will engage in risky commodities trading or other methods of investment as a result of their need to protect themselves. Individuals, such as Madoff, deliberately create sham schemes in order to make millions of dollars for themselves. They liaise with lower-level employees to cookbooks and cover their activities. Many employees will play along in order to benefit from the scheme. Self-seekers who do insider trading are also driven by greed.
How to prioritize the remedies
In order to tackle the problem accordingly, organizations and governments need to start with proactive approaches before they instate reactive ones. The first and most important issue is the regulation of accounting or financial markets. Companies have been left to regulate themselves, and this has perpetuated an unfettered and profit-centered mentality. Countries within the US passed hasty regulations after the Enron scandal as a knee-jerk response. It is more effective to think through the laws and make them as simple as possible. Regulation should entail the eradication of harmful practices like profit guidance and street earnings measures. It should give regulators greater capacity to intervene in questionable dealings as potential financial disasters usually have many red flags. Additionally, regulation must empower gatekeepers to act. These activities would ensure that repercussions for fraudulent behavior exist. They would instate sanity in capital markets by dealing with the free-for-all environment.
The second priority ought to be the regulation of incentives. As mentioned above, the most significant driver of unethical behavior at Nortel and several other institutions is short-termism. This emanates from share-based models of valuation. Governments or accounting bodies ought to pass laws that cup stock incentives or govern the way managers can use them. Insider trading before a massive financial collapse stems from poor regulation of incentives. Inflation of earnings, selective reporting, and borrowing from future income all stem from too much focus on stock prices in company incentives. Therefore, laws should exist to prevent self-seekers from doing the same.
Regulation of punishment should be the next priority because it would cause fraudsters to pay for their actions. This may be a reactive approach to those who committed the wrong, but it would send the message to potential wrongdoers that certain financial practices are unacceptable. However, care should be taken to avoid overreach.
Business education is the last form of action. Some of the problems at Nortel occurred because of a lack of awareness among stakeholders. However, this cause was not as significant as the other structural factors. Education should involve institutional investors, accountants, managers, and other people involved in making business or financial decisions. They need to learn about market fundamentals. For instance, instead of focusing on pleasing institutional investors, company analysts should learn the importance of long term value creation. Education ought to focus on reversing short-termism by telling stakeholders about the dangers of such a practice.