Got Three Hours to Kill?

I ran across two documentary videos last night on YouTube that SOME here might find a bit enlightening / nostalgic (if you worked through the 1997-2001 Internet bubble) and ALL might find enlightening (if you are interested in how rapid changes in macro factors can accelerate existing bubbles and frauds).

I saw the first video, didn’t realize it was 90 minutes long, started watching and stayed hooked. Then as it got to the end, I suddenly realized there was part 2. I wasn’t sure about watching another 90 minutes but started to watch, remained hooked and watched to the end. – The Company That Broke Canada – Part I – What Killed Canada’s Biggest Company? – Part II

The videos focus on how Nortel became Canada’s largest company amid the Internet bubble and how its rapid collapse not only wiped out retail investors but retirees across Canada and Nortel’s own pensioners. For those working within the telecom field at the time (whether on the dull voice side or sexy new IP and fiber optics side), the documentary sheds light on how multiple factors (technology shifts, strategy shifts, national financial policies, tax policies and accounting processes) all magically clicked in all the wrong ways to trigger the firm’s rocket trajectory skyward and return to terra firma.

The nutshell version? The forces behind Nortel’s rise and failure were far more systemic than we could see at the time from “normal” bubble dynamics. Nortel’s spike to $124/share and collapse and eventual bankruptcy were triggered by:

  • at the beginning of the mid-1990s bubble, Nortel and Lucent first focused on voice switching and ATM technologies while Cisco focused on packet switching

  • after it became apparent IP was the future, Nortel, Lucent and Cisco went through three years of competition to buy up new tech firms to catch up to Cisco

  • quirks in Canadian finance laws aimed at “protecting” Canadian businesses imposed caps on Canadian mutual fund purchases of non-Canadian stocks, creating artificial demand for Canadian stocks

  • a quirk in the management of the Toronto Stock Exchange 300 index (TSE300) failed to account for differences between TOTAL available shares and ACTUAL available shares artificially inflated demand for Nortel, which had many shares tied up as retention incentives to employees of the firms it was gobbling up

  • a matching rush in Canada for firms to switch from defined-benefit pension plans to defined-contribution plans caused millions of individuals to begin investing in the Toronto Stock Exchange 300 (TSE300) index fund which already held a large number of Nortel shares and had to buy more to maintain that share

  • changes in the capital gains tax rate within Canada, lowering it from 75% to 66% to 50% in only about two years, triggered MORE demand of individual investors to shift money into stocks, including the TSE300, driving MORE demand for Nortel stock

  • use of Nortel shares to purchase many of its acquisitions at inflated prices rather than cash further limited the availability of Nortel shares for those 401k index fund purchases, further driving up the stock price via artificial constraints on supply of shares

Nortel managed to hang around until after the 2008 financial crisis, then its board made a bad bet by filing for Chapter 7 bankruptcy for re-organization, thinking they would get bids on some underlying assets to produce some cash and they would be able to use that to re-orient what was left. In reality, they got virtually no bids for ANY of the assets except the patent pool which was bought up by a consortium of Google, Microsoft and a few other big players.

By the time they filed for BK, it then became apparent the company had been underfunding its pension fund for over a decade by probably 30%. In bankruptcy, the firm put the pension obligations at the end of the line in priority. So after screwing millions of shareholders across Canada who had poured money into Nortel stock at the peak via Canadian equivalents of 401ks, the company further screwed its actual pension holders and only paid out about 70% of amounts owed. In contrast, the firm paid $170 million in bonuses to about 980 employees after filing for bankruptcy. The actual bankruptcy case wound up being the longest BK in US court history as issues required litigation in Canada, the US and UK. Over one billion dollars were spent on legal fees for the BK.

Again, those who worked in this sector during that time will appreciate all of the little details scattered throughout the presentation. Company sponsored softball teams… After-hours beer bashes… Sports tickets. Luxury boxes. Morning donuts! You’ll also understand the parade of company names that came and went in only two or three years. Ascend. Bay Networks.

Those who didn’t work through that financial fever dream would still benefit from watching this entire three hour extravaganza. It serves as another explicit reminder that NOTHING in a properly functioning economy grows 15-20 percent yearly without end without other unaccounted forces at work that have nothing to do with the performance of the company involved or your genius as a stock picker.

The final chapter in the documentary is perhaps the best lesson. When you operate for years in a way that destroys the public’s trust in your ethics, you lose any margin of error you might have had to survive small surprises. It turns out that Nortel’s final demise might have been avoided had its own board trusted its internal accountants more than outside consultants hired by the board to investigate a suspected case of revenue manipulation.