An unbalanced sheet
SEC lays out how Nacchio may have cooked Qwest books
By Jeff Smith and David Milstead, Rocky Mountain News
Saturday, March 19, 2005

Joe Nacchio faces civil charges while Bernie Ebbers faces prison time, but that's where the differences between the two former telecom titans and their companies end.

Set aside the irony that Qwest is turning up the heat to buy MCI, formerly WorldCom, in what would be a marriage of scandal-plagued companies.
Right-click here to download pictures. To help protect your privacy, Outlook prevented automatic download of this picture from the Internet.
Right-click here to download pictures. To help protect your privacy, Outlook prevented automatic download of this picture from the Internet. Right-click here to download pictures. To help protect your privacy, Outlook prevented automatic download of this picture from the Internet.
Right-click here to download pictures. To help protect your privacy, Outlook prevented automatic download of this picture from the Internet.
Look instead to the actions of former CEOs Ebbers and Nacchio that helped propel the two telcos to their current depths.

Jurors in the Ebbers trial said they based their decision to convict the WorldCom boss on the documents, rather than testimony by the prosecution's star witness, former Chief Financial Officer Scott Sullivan.  They concluded Ebbers must have known about the company's accounting fraud.

In the suit filed against Nacchio and six other former Qwest executives Tuesday, the Securities and Exchange Commission also presented plenty of documents.  They contrasted those with public statements at the time and potential witness recollections to make this essential allegation:  Nacchio knowingly misled investors about Qwest's true financial condition.

"It's a little parallel to WorldCom and Ebbers," said Carr Conway, a former SEC investigator who now is a forensic accountant at the Dickerson Financial Investigation Group in Lakewood.

Patrick Comack, a telecommunications analyst for Zachary Investment Research in Miami, said Nacchio is in hot water.

Federal prosecutors, Comack said, have learned from their failures, such as the first trial of four former Qwest midlevel executives last year, and likely are emboldened by the Ebbers conviction.

"They're not finished," Comack said.  "Nacchio should be more concerned about the (Department of Justice) than the SEC.  That's the next shoe to drop.  Especially with the Ebbers thing, the DOJ has momentum.  I think Nacchio is at risk."

Besides a paper trail, regulators painted a "culture of fear," marked by Nacchio's allegedly explosive temper and his focus at an all-hands meeting in January 2001 for employees to make their revenue targets.

The squeeze also is being put on former executives who were close to Nacchio, including former Chief Legal Officer Drake Tempest and his two former chief financial officers, Robin Szeliga and Robert Woodruff.   Tempest wasn't charged by the SEC but remains under criminal suspicion.

The flurry of legal motions will start in the civil case and, judging by past cases such as one involving Xerox, a conclusion to the Qwest saga could still be years away.  A civil case generally leads to settlements, sometimes just prior to a trial's start.

A criminal case, if it is filed, would require a much higher burden of proof.

Nacchio's attorney, Charles Stillman, defended his client this week.

"The case against Joe Nacchio comes down to the simple proposition:  Should he have known that a particular kind of revenue needed to be disclosed in Qwest's public statements?  The answer is no.  Qwest made its disclosures only after experienced, expert employees, auditors and lawyers determined what was appropriate."

The Rocky Mountain News went through the SEC's 50 pages of allegations this week and picked 10 of the most surprising, revealing or important pieces of evidence in the case.

1. Paper trail

CEO Joe Nacchio and CFOs Robert Woodruff and Robin Szeliga met with executives at the end of every quarter to review the financial performance of each business unit.

As a result, the SEC charges, the three were fully aware that Qwest was making much of its revenue from one-time sales of capacity on its fiber-optic network and telecommunications equipment.

The three also were in control of which information would be released to investors during conference calls with analysts after each quarter.

In a late January 2001 earnings call, for example, Nacchio evaded a specific question about how Qwest's revenues were derived.

A senior Qwest executive characterized Nacchio's skills in not answering questions as dodging "the elephant in the room."

In July 2001, Nacchio and Szeliga allegedly were provided with documents showing more than one-third of Qwest's total growth resulted from one-time sales.

Yet in the conference call with analysts on July 24, 2001, neither Nacchio nor Szeliga disclosed that information, instead focusing on growth in data and Internet services.

Analysts later "barraged" Qwest with e-mails asking for the revenue breakdown and questioned the credibility of Nacchio and Szeliga.

2. Growth above all

Most arguments between management and its auditors about what to disclose to investors center on materiality - whether the number is large enough to matter in the company's overall results.  Historically, that argument centered on a company's total revenue, and if a transaction or type of revenue was a small part of the big pie, the decision might have been that it wasn't "material."

But the SEC had been warning companies that small transactions can be material if they're important to what investors care about.  And the SEC's complaint shows in detail that when Nacchio told the Qwest story to investors, the message was revenue growth.  "We have 12 percent revenue growth our first quarter (2001) over first quarter (2000) - it is two to three times the rate of everyone in the industry," Nacchio told analysts in an earnings call, the SEC said.

That focus on growth makes smaller deals subject to disclosure, which Nacchio and his executives consciously failed to do, the SEC says.

3. Disclosure deleted

Accountant Jim Kozlowski and outside auditor Arthur Andersen told Woodruff in March 2000 that Qwest should disclose the amount it made by booking revenue up front from capacity sales.  The disclosure was included in drafts of Qwest's 1999 annual report to be filed with federal regulators in March 2000.

Woodruff allegedly told Kozlowski that he needed to discuss the disclosure with Nacchio.  Just before the report was filed with the SEC, Woodruff ordered Kozlowski to remove the disclosure.

Carr Conway, a former SEC investigator, called the anecdote a "pretty powerful" piece of evidence.  "They can't say it was a mistake or an oversight; someone did something here."

If the case goes to trial, the SEC is likely to argue that analysts would have lowered their value of Qwest if they had known how much the company relied on one-time deals and aggressive accounting.

4. Robin Szeliga: whistle-blower or co-conspirator

Szeliga was little-known to investors before she was elevated to chief financial officer in April 2001, succeeding Robert Woodruff.  But the complaint alleges she played a key role in financial reporting before she became a public face of the company to investors.  "Although this is my first opportunity to speak with you . . . it is in fact my 15th consecutive quarter of participation with this management team in achieving our quarterly objectives," she said in the first-quarter 2001 conference call.

When Qwest executives testified before Congress in 2002, Szeliga seemed to have repeatedly questioned portions of Qwest's accounting.  But the SEC complaint says she personally manipulated other areas of Qwest's financial reporting to help the company hit earnings targets.  According to the SEC, Qwest had a liability on its balance sheet for unused employee vacation.  Szeliga made three "improper and arbitrary" downward adjustments in the liability, which added $71.3 million to 2001 earnings.

5. Wasted cable

For Qwest to recognize revenue and profits when it exchanged network capacity with other telcos, it had to pass a test that included this requirement:  There must be a legitimate business purpose for the transaction.

Instead, the SEC said, capacity was swapped purely to make a quarter's revenue numbers, with little or no thought or consultation as to whether Qwest actually needed what it was getting.

In the first two quarters of 2001, Qwest acquired $289 million of East Asia capacity.  "Qwest did not need at least two-thirds of the East Asia cable it bought," the SEC alleges, but was able to book $288 million in revenue from the swaps.

The SEC said that a November 2001 internal analysis showed that of $1 billion of international ready-to-use network capacity, Qwest could use only one-third of it.  "It just blew my mind when I found how much (international capacity) we had," the SEC quotes a Qwest senior vice president of network planning, engineering and technology as saying.

6. Ignorance is bliss

Qwest didn't want to know what the SEC - the final arbiter - thought about its aggressive accounting of fiber-optic capacity sales and swaps.

In August or September 2001, Qwest's outside auditor, Arthur Andersen, told Szeliga she should ask the SEC about the propriety of the accounting.

Szeliga refused, allegedly saying:  "F--- no.  Last time I went to the SEC, I ended up writing off $3 billion" of assets.

7. Changing dates

It can be tough for the SEC to win arcane arguments about the accounting theory for exchanges of network capacity.  It's easier to prove fraud if documents are faked - such as when a contract is signed in the second quarter, but the paperwork is changed to make it look like the deal was closed in the first quarter instead.  This practice of "backdating" paperwork has been a key part of dozens, if not hundreds, of frauds by public companies.

The SEC says President Afshin Mohebbi and Executive Vice President Greg Casey both knew that a 2001 deal with British telco Cable & Wireless that brought in $69.8 million in revenue did not close by March 31 - a requirement for Qwest to count the numbers in their first-quarter report.  When the contract was finally executed on April 12, "Casey executed the backdated contract with a false date of March 31, 2001," the SEC alleges.

8. Merger magic

The SEC charges that Nacchio directed a fraudulent scheme to prop up the company's stock price so a planned $40 billion merger with U S West could be completed in mid-2000.

U S West had the option to end the merger if Qwest stock had fallen below $22 a share for 20 consecutive days, and the stock slipped from $34 to $26 by August 1999.

Even within Qwest, some apparently believed the merger wouldn't have happened had it not been for the one-time capacity sales and swaps.

In a June 2001 e-mail, Mohebbi referred to Casey as the "guy who made (the merger with U S West) happen" because of the one-time deals.

Management and employees referred to the heavy reliance on such deals to make revenue targets as an "addiction," "heroin," or "cocaine on steroids."

9. Skeletons in the closet

Qwest announced in September 2002, under new CEO Dick Notebaert, that it would erase almost $1.5 billion in swap and capacity-sale revenue because of a lack of supporting documentation for the deals.

But today's Qwest is the old-U S West from an accounting standpoint.  When the merger of the two companies closed on June 30, 2000, the historic numbers of the new Qwest belonged to U S West, not the pre-merger Nacchio outfit.  That meant that when Qwest chose to re-audit its results, it only went back to the final two quarters of 2000 to examine the swaps and sales of capacity.  Any questionable deals before July 1, 2000, weren't part of the examination.

The SEC's exhumation of the "classic" Qwest numbers showed more than $1.7 billion in revenue from sales of capacity and network equipment in 1999 and the first two quarters of 2000.  That was more than one-quarter of total Qwest revenue in that period.

In all, the SEC estimates, there was about $3 billion of capacity sales and swaps from 1999 to 2001 that never should have made Qwest's top line.

10. Dex-terity

The SEC alleges that Nacchio, Woodruff and Szeliga manipulated the schedules of the Dex telephone directories in order to make up a revenue shortfall in 2000.

A Dex executive came up with the idea of publishing the Colorado Springs directory twice in 2000 to book more revenue, accelerating the January 2001 directory by a month.  Another Dex executive expressed concern that that would reduce 2001 revenue and should be disclosed to investors.

Nacchio, in the presence of Woodruff and Szeliga, allegedly directed Dex to go forward with the schedule change.  The change and its implications weren't disclosed, the SEC charges.