The Securities and Exchange Commission this week charged Joseph P. Nacchio, former co-chairman and chief executive officer of Qwest Communications International Inc., and eight other former Qwest officers and employees with fraud and other violations of the federal securities laws. In three separate but related civil actions, the Commission alleges that, between 1999 and 2002, the Qwest defendants engaged in a multi-faceted fraudulent scheme designed to mislead the investing public about the company's revenue and growth.
According to the SEC's complaints filed in the United States District Court for the District of Colorado, Nacchio and others made numerous false and misleading statements about Qwest's financial condition in annual, quarterly, and current reports, in registration statements that incorporated Qwest's financial statements, and in other public statements, including earnings releases and investor calls,. As a result of that scheme, Qwest fraudulently recognized over $3 billion of revenue and excluded $71.3 million in expenses. The Commission, in October 2004, sued Qwest in a settled injunctive action in which the company agreed to pay a $250 million penalty for its misconduct.
In addition to Nacchio, the Commission's complaints name former chief financial officers Robert S. Woodruff and Robin R. Szeliga, former chief operating officer Afshin Mohebbi, former executive vice president of wholesale markets Gregory M. Casey, former senior vice president of pricing and offer management Roger B. Hoaglund, former senior vice president of finance William L. Eveleth, former director of financial reporting James J. Kozlowski, and former senior manager of financial reporting Frank T. Noyes. The complaints seek injunctions, disgorgement of ill-gotten gains plus prejudgment interest, and civil penalties against all of the defendants, and officer/director bars against Nacchio, Woodruff, Szeliga, Mohebbi, Casey, and Eveleth.
"The disclosure fraud at Qwest was orchestrated at the highest level of the company to deceive investors," said Randall J. Fons, Regional Director of the Commission's Central Regional Office in Denver. "Qwest's CEO and other top executives projected revenue and earnings that they knew were overly aggressive, and then all of the defendants used smoke and mirrors to meet those unrealistic projections. These individuals must now answer for their conduct and the enormous decline in shareholder value that they caused."
Stephen M. Cutler, Director of the Commission's Division of Enforcement, added, "Joseph Nacchio and others at Qwest wanted the company's shareholders to believe that the company was doing better than it actually was. Today's enforcement action once again tells corporate executives that they will be held personally accountable when they keep the truth from the marketplace."
The Commission's complaints, which were filed in the United States District Court for the District of Colorado, allege as follows.
Nacchio and Others Fraudulently Misrepresented Qwest's Revenue Sources
In Commission filings and other public statements, Nacchio, Woodruff, and Szeliga fraudulently characterized nonrecurring revenue from the one-time sales of capacity in the form of indefeasible rights of use (IRUs) and equipment as recurring "data and Internet service revenues," thereby masking Qwest's declining financial condition and artificially inflating its stock price. Qwest used such nonrecurring revenue to fill the gap between actual and projected revenue. Over time, in fact, Qwest's dependence on such one-time transactions grew to the point that it was likened internally to an "addiction" and the nonrecurring IRU and equipment sale transactions were likened to "heroin." Among other things, the Qwest executives' misrepresentations about Qwest's revenue sources allowed Qwest to maintain a stock price sufficiently high to complete its pending merger with US West, Inc.
Fraudulent IRU Revenue Recognition and Other Fraudulent Conduct
- Nacchio, Woodruff, and Szeliga traded in Qwest stock on the basis of non-public material information. Specifically, they knew the extent to which Qwest relied on nonrecurring revenue sources to meet the unrealistic revenue and earnings projections and the true financial health of Qwest.
- Woodruff, Szeliga, Kozlowski, and Noyes ignored generally accepted accounting principles (GAAP) by recognizing revenue upfront on IRU transactions. Under GAAP, Qwest should not have recognized any revenue on those transactions.
- Kozlowski and Noyes participated in the top executives' scheme to mislead the public about Qwest's revenue sources.
- Mohebbi, Casey, and Hoaglund provided, or knew others provided, secret side agreements to IRU customers allowing those customers to exchange, or "port," the capacity purchased for different capacity. The purpose of the secret side agreements was to conceal from Qwest's accountants and auditors the purchasers' ability to port, as such exchange rights would have defeated, under GAAP, the immediate recognition of revenue.
- Mohebbi, Casey, Hoaglund, Eveleth, and Noyes participated in backdating IRU agreements to demonstrate falsely that the agreements were completed by the end of the quarter as required by GAAP to recognize revenue in that quarter.
- To close IRU sales, Mohebbi, Casey, Eveleth, and Noyes caused Qwest to purchase capacity Qwest did not need. Under GAAP, Qwest should not have recognized revenue where there was no legitimate business need for the IRU assets received.
- Nacchio, Woodruff, and Szeliga made misleading statements in Commission filings concerning revenue from its directory services unit, Qwest Dex, Inc. In particular, they stated that changes in period-over-period revenue were attributable to changes in the "number," "mix," or "length" of directories published. In fact, Qwest had advanced the publication dates of certain directories and extended the lives of others for the sole purpose of meeting revenue or earnings targets.
- Szeliga reduced expenses relating to compensated absences by $71.3 million to help Qwest meet earnings targets and fraudulently failed to disclose in Commission filings Qwest's change in accounting for compensated absences.
Without admitting or denying any allegations, Hoaglund consented to the entry of a judgment enjoining him from violating the antifraud, reporting, books and records, and internal control provisions of the federal securities laws, and directing him to pay a civil penalty of $100,000 and disgorgement of $200,000 plus prejudgment interest. Similarly, without admitting or denying any allegations, Eveleth consented to entry of a judgment enjoining him from violating the antifraud, reporting, books and records, and internal control provisions of the federal securities laws, directing him to pay a civil penalty of $75,000 and disgorgement of $35,575 plus prejudgment interest, and prohibiting him from acting as an officer or director of any public company for five years.
On March 15, 2005, the Commission instituted settled cease-and-desist proceedings and filed related civil actions for penalties against Mark A. Schumacher and Brian K. Treadway, former controllers at Qwest (Litigation Release Nos. 19134 and 19135; Sec. Exch. Act. Rel. Nos. 34-51373 and 34-51375).
On March 15, 2005, the Commission instituted settled cease-and-desist proceedings against Jennifer J. Black, a former director of finance at Qwest (Sec. Exch. Act. Rel. No. 34-51374).
In October 2004, the Commission filed a settled civil action against Qwest Communications International Inc. (Litigation Release No. 18936).
In July 2004, the Commission filed a civil injunctive action against Michael Felicissimo, the former CFO of Qwest's wireless division (Litigation Release No. 18800).
In June 2004, the Commission instituted settled cease-and-desist proceedings and filed related civil actions for penalties against Augustine M. Cruciotti, a former Qwest executive vice president, and Steven L. Haggerty, a former Qwest senior vice president (Litigation Release Nos. 18754 and 18755).
In September 2003, the Commission instituted a settled cease-and-desist proceeding and filed a related civil action for penalties against Loren D. Pfau, a former Qwest sales manager (Litigation Release No. 18374).
In February 2003, the Commission filed a civil injunctive action against former Qwest officers Joel M. Arnold, William L. Eveleth, Grant Graham, Thomas W. Hall, Douglas K. Hutchins, Bryan K. Treadway, John M. Walker, and Richard L. Weston (Litigation Release No. 17996).