SEC Charges Qwest with Multi-Faceted Accounting & Financial Reporting Fraud

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Qwest Agrees to Anti-Fraud Injunction, $250 Million Penalty, and Will Permanently Maintain Chief Compliance Officer Reporting to the Outside Directors of the Board.

On Thursday, The Securities and Exchange Commission charged Qwest Communications International Inc., one of the largest

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telecommunications companies in the United States, with securities fraud and other violations of the federal securities laws. The Commission's complaint alleges that, between 1999 and 2002, Qwest fraudulently recognized over $3.8 billion in revenue and excluded $231 million in expenses as part of a multi-faceted fraudulent scheme to meet optimistic and unsupportable revenue and earnings projections. Without admitting or denying the allegations in the complaint, Qwest consented to entry of a judgment enjoining it from violating the antifraud, reporting, books and records, internal control, proxy, and securities registration provisions of the federal securities laws.

The judgment also directs Qwest to pay a civil penalty of $250 million and $1 disgorgement. The entire penalty amount will be distributed to defrauded investors pursuant to the Fair Funds provision of Sarbanes-Oxley. In assessing the penalty amount, the Commission considered Qwest's current financial condition.

In addition, Qwest is required to maintain permanently a chief compliance officer (“CCO”) reporting to a committee of outside directors and responsible for ensuring the company conducts its business in compliance with the federal securities laws. The CCO shall aid the board in maintaining, implementing and enforcing standards of conduct for the corporation. The CCO shall also respond to employee concerns that may implicate matters of ethics or questionable business practices.

Randall J. Fons, Regional Director in the Commission's Central Regional Office in Denver, added: “Qwest senior management created a corrupt corporate culture in which meeting Wall Street expectations was paramount. Senior management projected unrealistic revenue growth and would not tolerate missing the numbers. As a consequence, accounting rules, policies, and controls that interfered with meeting financial targets were ignored. The Commission will continue its investigation in an effort to hold personally accountable those individuals responsible for the fraud.”

“Today's action once again sends the message that the Commission will hold accountable not only the individuals who commit securities fraud, but the companies that serve as vehicles for their misconduct,” said Stephen M. Cutler, Director of the Commission's Division of Enforcement. “While our investigation of individuals is active and ongoing, the $250 million penalty levied against Qwest should signal to executives at other companies that they need to worry about more than their own personal compliance with the law; they also need to ensure that their companies have established a culture of compliance and integrity.”

The Commission's complaint, which was filed in United States District Court for the District of Colorado, alleges as follows:

Fraudulent Use of Non-Recurring Revenue

After its initial public offering in 1997, Qwest touted itself as a progressive, new-generation technology company with enormous growth potential. Beginning in 1999, in fact, Qwest's CEO consistently predicted publicly that Qwest would achieve double-digit revenue and earnings growth. By mid-1999, it became clear to Qwest senior management that the market for telecommunications services was declining and that revenue from those services would not sustain Qwest's projected revenue and earnings growth.

To “fill the gap” between its actual and projected revenue, Qwest, at the direction of its senior management, began selling indefeasible rights of use (“IRUs”). An IRU is an irrevocable right to use a specific fiber strand or specific amount of fiber capacity for a specified time period. Thus, to meet revenue expectations that it created, Qwest sold what the company had previously identified in Commission filings and press releases as its “principal asset.” When the demand for IRUs declined, Qwest engaged in IRU “swaps” whereby Qwest bought IRUs from other companies in exchange for agreements from those companies to buy IRUs from Qwest. As another “gap filler,” Qwest sold capital equipment.

Both IRU and equipment sales were referred to internally as “one hit wonders.” Indeed, the investment community generally discounted such non-recurring revenue sources when valuing telecommunications companies because non-recurring revenue sources were not sustainable. Qwest's use of one-time transactions to fill the gap between actual and projected revenue became so common that many Qwest employees likened the practice to an “addiction” and the non-recurring IRU and equipment sale transactions as Qwest's “heroin.”

In Commission filings and other public statements, Qwest fraudulently characterized non-recurring revenue from IRU and equipment transactions as recurring "data and Internet service revenues," thereby masking its declining financial condition and artificially inflating its stock price.

Fraudulent Accounting for IRU and Equipment Sale Transactions

In addition to fraudulently characterizing non-recurring revenue as recurring revenue, Qwest ignored generally accepted accounting principles (“GAAP”) by recognizing upfront revenue from IRU transactions and equipment sales. Qwest, in fact, employed fraudulent devices such as backdated contracts and secret side agreements to conceal the fact that its IRU and equipment transactions did not meet GAAP's requirements for upfront revenue recognition. Under GAAP, Qwest should either have not recognized any revenue on these transactions or recognized revenue ratably over the lives of the contracts.

Other Fraudulent Conduct

Qwest engaged in a variety of other fraudulent conduct. In particular:

  • Qwest fraudulently failed to disclose in periodic filings with the Commission that Qwest committed to buy millions of dollars of equipment that it never intended to deploy in its network and entered into strategic relationships with, and invested in, many equipment and service vendors in part for the personal benefit of certain members of its senior management. Qwest also failed to disclose that Qwest executives received, as compensation, investment opportunities in some of Qwest's vendors.

  • Qwest made misleading statements in Commission filings concerning revenue from its directory services unit, Qwest Dex, Inc. In particular, Qwest 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.
  • Qwest fraudulently concealed the fact that, based on a series of accounting errors, it improperly recognized $112 million of revenue between 2000 and 2002 from its Wireless division.
  • Qwest fraudulently understated expenses relating to sales commission plans and compensated absences.

Other Securities Law Violations

Qwest's lack of internal controls and inadequate books and records resulted in numerous other accounting errors during the same period, including a $56 million overstatement in operator services revenue, $200 million in improper capitalized costs associated with its design service centers, and a total of $850 million understatement of expenses in accounting for its merger with US West, Inc. and in certain restructuring charges. Further, Qwest failed to disclose a related party transaction with Anschutz Company and sold unregistered securities.

Source: SEC

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