A peek at what SEC says Qwest did wrong
By Rob Reutman
Rocky Mountain News
Saturday, March 19, 2005

It's not a smoking gun or even the straw that broke the camel's back, but one illuminating scenario in the 50-page civil complaint filed Tuesday against seven ex-Qwest execs speaks volumes about the inside workings of a corporation gone wrong.

In fact, it is the reason why the Securities and Exchange Commission filed the complaint this week - to beat the five-year statute of limitations on misdeeds associated with the March 17, 2000, filing of Qwest's 1999 annual report.
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In early 2000, Qwest was in the midst of putting together its annual report, the detailed financial statement required of every company that sells stock.  The comprehensive balance sheet is scrutinized by investors, creditors, analysts, reporters - and the SEC.  The accuracy of all annual reports is imperative and inaccuracy can be criminal, but for Qwest the 2000 report was especially crucial.  The company had announced a merger agreement with U S West the previous July and the deal had not closed.  A lot of people were suspicious of a deal in which the relatively tiny newcomer could swallow up a Baby Bell.  The currency in the deal was Qwest stock, which the SEC now says "was significantly inflated by the fraudulent scheme."

Without getting too technical, much of the alleged fraud revolved around Qwest making a lot of shady one-time transactions but representing them in its accounting as "recurring revenue."  As the complaint reads, "To meet the aggressive targets, Qwest fraudulently and repeatedly relied on immediate revenue recognition from one-time sales of assets known as 'IRUs' (indefeasible rights of use) and certain equipment while falsely claiming to the investing public that the revenue was recurring."  In other words, they were telling the investment community, these aren't one-time fluke deals, this is how much we make all the time and our stock price should reflect that.

James J. Kozlowski was Qwest's senior director of financial reporting at the time.  According to the complaint, in early 2000 Kozlowski determined that these one-time transactions were a significant-enough part of Qwest's overall revenue picture that they needed to be disclosed as such in the company's upcoming annual report, also known as a 10-K.  He told Qwest's chief financial officer, Robert Woodruff, "that the scope and extent of reliance" on the one-time deals "should be disclosed" in the annual report.  "In response, Woodruff asked Kozlowski to draft proposed language," the complaint reads.

Kozlowski also discussed all this with Qwest's auditing firm, Arthur Andersen, which "told him Qwest should provide disclosure in the footnotes to the financial statements, detailing not only Qwest's IRU accounting policy but also the amount of revenue and gross margins from IRU transactions."  The complaint says Arthur Andersen closed the loop by telling Woodruff that Qwest should make the disclosures.

Kozlowski and Frank T. Noyes, another Qwest director of financial reporting, then drafted the disclosures for inclusion in the annual report.  "At Kozlowski's direction, Noyes inserted this draft IRU disclosure" in a draft version of the annual report, which he circulated to Woodruff and then-senior vice president of financial planning, Robin Szeliga, for review.

Before filing the report with the SEC, Woodruff told Kozlowski he had to discuss the IRU disclosure with Chief Executive Officer Joe Nacchio.  Then, before the report was filed with the SEC, Woodruff told Kozlowski "to remove the IRU disclosure language," the complaint alleges.  "As a result Kozlowski told Noyes to 'take it out' and the IRU disclosure language was removed from Qwest's 1999 10-K filed with the SEC."

The complaint alleges that Szeliga, who later replaced Woodruff as CFO, knew the disclosures had been removed and that she, Nacchio and Woodruff "each signed false management representation letters to Qwest's outside auditors falsely stating, among other things, that the financial statements in the 1999 10-K were not materially misleading."  The complaint also says that auditor Arthur Andersen approved a version of the annual report that had included the requested disclosure language and "was never consulted about the removal of that language from the filed annual report and had no knowledge that the 10-K was filed without the IRU disclosure language."

For their roles in the above scenario, everyone mentioned is being sued by the SEC for a fraudulent scheme to report $3 billion in revenue that "facilitated the company's June 2000 merger with U S West."  It was later determined that these hidden one-time sales accounted for 26 percent of Qwest's 1999 revenue.  What a tangled web the defendants wove and what a difficult time they will have trying to weasel out of it.

reutemanr@RockyMountainNews.com or 303-892-5177