UNITED STATES OF AMERICA
In the Matter of
|ORDER INSTITUTING CEASE-AND-DESIST PROCEEDINGS, MAKING FINDINGS, AND IMPOSING A CEASE-AND-DESIST ORDER PURSUANT TO SECTION 21C OF THE SECURITIES EXCHANGE ACT OF 1934|
The Securities and Exchange Commission ("Commission") deems it appropriate that cease-and-desist proceedings be, and hereby are, instituted pursuant to 21C of the Securities Exchange Act of 1934 ("Exchange Act") against McLeodUSA Incorporated ("McLeod" or "Respondent").
In anticipation of the institution of these proceedings, Respondent has submitted an Offer of Settlement (the "Offer") which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission's jurisdiction over it and the subject matter of these proceedings, which are admitted, Respondent consents to the entry of this Order Instituting Cease-and-Desist Proceedings, Making Findings, and Imposing a Cease-and-Desist Order Pursuant to Section 21C of the Securities Exchange Act of 1934 ("Order"), as set forth below.
On the basis of this Order and Respondent's Offer, the Commission finds that:
1. McLeod, organized in 1993, is a Delaware corporation with its principal office in Cedar Rapids, Iowa. McLeod's Class A Common Stock is registered under Section 12(g) of the Exchange Act. McLeod files periodic and other reports with the Commission pursuant to Section 13(a) of the Exchange Act. Until it was delisted in December 2001, McLeod's stock traded on the NASDAQ National Markets System under the symbol MCLD. On January 31, 2002, McLeod commenced Chapter 11 bankruptcy proceedings. Its Plan of Reorganization was confirmed on April 5, 2002 and became effective April 16, 2002. McLeod implemented "fresh-start" accounting on April 16, 2002. The reorganized McLeod's stock trades on the NASDAQ SmallCap Market under the symbol MCLD.
2. This case mainly involves McLeod's failure to disclose the likely non-recurring nature of revenue associated with sales of certain indefeasible rights of use ("IRUs") and, in particular, the importance of that revenue to earnings before interest, taxes, depreciation and amortization ("EBITDA"). During the relevant period, McLeod's primary business was providing integrated communications services to its customers, and McLeod also sold IRUs. An IRU is a long-term lease in which one company transfers rights of use to certain telecommunications network assets, typically fiber optic cable, to another company at a fixed price for an extended period of time. In 2001, IRU sales generated approximately 5.3% of McLeod's revenue and 30.8% of its EBITDA. McLeod provided EBITDA as an important non-GAAP performance measure in its publicly disseminated documents. McLeod did not generate a material amount of revenue or income from IRU sales before 2001 and, at the time it filed its third quarter 2001 Form 10-Q and 2001 Form 10-K, McLeod did not project significant IRU sales for 2002. However, in its third quarter and year ended December 31, 2001 periodic reports, McLeod failed to disclose the likely non-recurring nature of IRU sales and their proportionate contribution to the company's 2001 EBITDA. McLeod also erroneously recognized income on two IRU sales and made other minor accounting errors during 2001. The errors were not material to the financial statements individually or in the aggregate, but they did, however, impact EBITDA.
3. McLeod is a telecommunications company. McLeod provides integrated communications services to its customers in 25 states by packaging local, long distance, data and voice mail services on a single bill. McLeod provides its local and long distance services by using its own facilities and by leasing network capacity from other companies. Prior to 2002, McLeod planned to develop a nationwide network for its integrated communications services. As McLeod expanded its network, it obtained capacity by acquiring other companies and by installing extra fibers in routes it constructed for its own use.
4. McLeod sold some of its excess network capacity to other companies in the form of IRUs. McLeod's auditors told McLeod that income from the sale of IRUs may be recognized at the time of sale (a "sales-type" lease) or over the term of the lease (an "operating" lease). McLeod relied on this guidance and on an industry White Paper drafted by its auditor when classifying its IRUs as sales-type leases. Prior to 2001, McLeod did not generate a material amount of revenue or income from IRU sales.
5. In 2001, McLeod generated significant revenue from IRU sales, totaling 5.3% of McLeod's total revenue of $1.8 billion. McLeod's IRU sales, in turn, generated a significant amount of McLeod's 2001 earnings.1 McLeod has not generated a similar amount of its revenue or income from IRU sales since 2001.
6. McLeod's 2001 IRU sales revenue and income were likely non-recurring in nature. Consistent with the industry White Paper, McLeod categorized most of its IRUs as sales-type leases and recognized income on those IRUs at the time of sale rather than over the term of the lease. Income from individual sales-type leases is non-recurring. As part of its restructuring process in late 2001, McLeod developed a forecast that included lower levels of revenue or income from IRU sales (sales-type or operating) in future years. In October 2001, McLeod announced that it was abandoning its expansion plans, divesting non-core businesses and taking a significant restructuring charge. By that time, the telecommunications market had rapidly declined, resulting in a glut of excess capacity which made it difficult to predict future IRU sales activity. In its 2002 budget, prepared prior to the time McLeodUSA issued its 2001 Form 10-K, McLeodUSA projected that IRUs would only be 9.1% of total EBITDA in 2002 (compared to 30.8% in 2001 and 1.2% in 2000).
7. McLeod's IRU sales had a higher gross profit margin than the rest of the company's core integrated telecommunications services business. Although McLeod did not treat IRU sales as a separate business segment, McLeod's IRU sales accounted for a larger share of the company's earnings than their share of the company's revenue. Without a reduction for selling, general and administrative expenses, which the company did not allocate to IRU sales, McLeod's IRU sales generated 30.8% of the company's 2001 EBITDA.
8. McLeod did not disclose the likely non-recurring nature of its IRU revenue and income in its third quarter and year ended December 31, 2001 periodic reports. In its year ended December 31, 2001 10-K, filed on April 19, 2002, the company stated that its sales of network facilities through sales contracts and IRUs that qualified as sales-type leases represented less than 6% and 1% of total revenues for 2001 and 2000 respectively. McLeod made no disclosure regarding the significance of IRU revenues in the third quarter report. McLeod also briefly described its IRU revenue recognition policy as follows:
revenue from indefeasible rights to use fiber optic telecommunications network facilities is recognized over the term of the related lease unless the lease qualifies as a sales-type lease, on which revenue is recognized at the time the sale criteria in SFAS No. 66, "Accounting for Sales of Real Estate" are met. These criteria include requirements that (1) specific fiber be identified and accepted by the customer, (2) at least 25% of the sale proceeds have been received and (3) all additional services provided by us are separable and the related revenue is recognized as those services are performed.
McLeod, however, failed to mention that it classified most of its IRUs as sales-type leases and that it did not expect to generate a significant amount of IRU sales revenue or income in 2002.
9. McLeod also did not disclose the likely non-recurring nature of its IRU income in its 2001 earnings releases and conference calls. In its first quarter 2001 earnings release, McLeod stated that it had extended its "unbroken string of EBITDA positive quarters to 14" and exceeded its EBITDA forecast. In its second quarter 2001 earnings release, McLeod stated that its EBITDA, excluding one-time charges, had increased to $34.2 million, compared to $1.1 million for the second quarter of 2000 and that it had posted positive EBITDA for the 15th consecutive quarter. In its third quarter 2001 earnings release, McLeod stated that its EBITDA, excluding one-time non-cash charges, had increased 70% to $25.7 million from $15.1 million in the third quarter of 2000. In its fourth quarter and year 2001 earnings release, McLeod stated that its EBITDA, excluding restructuring and one-time charges, had increased 111% to $128.3 million from $60.8 million for the year 2000. McLeod did not indicate in its 2001 press releases and conference calls that IRU income contributed to its increasing EBITDA or that its IRU income was likely non-recurring. McLeod did mention other one-time gains, such as from sales of assets. McLeod also repeatedly disclosed that it had excluded certain one-time charges from its EBITDA calculations.
10. McLeod's 2001 Form 10-K, its third quarter report for 2001 and the accompanying earnings releases failed to disclose that its IRU sales revenue and income were likely non-recurring. McLeod did not disclose that it had recognized revenue (and income) at the time of sale on the majority of its IRUs and that the revenue (and income) on those sales were likely non-recurring in nature. McLeod also did not disclose that it was projecting lower IRU sales for 2002.
11. McLeod's 2001 Form 10-K, its third quarter report for 2001 and the accompanying earnings releases also failed to adequately communicate the effect of IRU sales on McLeod's 2001 operating results. McLeod recorded a higher gross profit margin on its IRU sales than on its core integrated telecommunications services. As a result, IRU sales constituted a higher percentage of McLeod's earnings than its revenues. Despite McLeod's reliance on EBITDA in its earnings releases and conference calls, McLeod did not break out its income from IRU sales in its 2001 earnings releases, conference calls or periodic reports. As a result, it was not possible to accurately measure the performance of the company's business.
12. During 2001, McLeod erroneously recognized income on two significant IRU sales. On the first sale, McLeod erroneously included certain costs in calculating its income and, therefore, recognized $3.4 million more income than permitted by GAAP. On the second sale, McLeod erroneously determined that an agreement met the sales-type lease requirements, and therefore recognized $1.8 million of accelerated income in 2001.
13. McLeod also made certain timing, contract interpretation and cost errors when it recognized income in 2001 for several less significant agreements. For example, in each quarter of 2001, McLeod erroneously recognized revenue and costs on several small IRU agreements, sales of fibers and sales of ducts, in some cases prematurely and in some cases belatedly. The aggregate effect of all errors on less significant agreements was an overstatement of 2001 EBITDA and an understatement of net loss of approximately $1.9 million.
14. As a result of the errors referred to above, in the aggregate, McLeod overstated its revenues by approximately $11.2 million and understated its net loss and overstated its EBITDA, which was adjusted by certain one-time charges, by approximately $7.1 million.
15. Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder require issuers with securities registered under Section 12 of the Exchange Act to file quarterly and annual reports with the Commission and to keep this information current. The obligation to file such reports embodies the requirement that they be true and correct. See, e.g., SEC v. Savoy Indus., Inc., 587 F.2d 1149, 1165 (D.C. Cir. 1978). 16. As a result of the conduct described above, McLeod committed violations of Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder by failing to disclose that its IRU sales revenue and income were likely non-recurring in nature and by failing to adequately communicate the significance of IRU sales to its third quarter and year-end 2001 EBITDA, a key measure it used during 2001 to describe its financial performance.
17. Section 13(b)(2)(A) of the Exchange Act requires Section 12 registrants to make and keep books, records, and accounts that accurately and fairly reflect the issuer's transactions and dispositions of their assets. 18. As a result of the conduct described above, McLeod committed violations of Section 13(b)(2)(A) of the Exchange Act because its books and records failed to accurately and fairly reflect its revenues and income. McLeod's books and records inaccurately reflected revenue, expenses and income on two significant IRU agreements and a number of the other small IRU agreements, sales of fibers and sales of ducts. Since McLeod classified the IRU transactions as sales-type leases, these errors affected the timing of income recognition.
In view of the foregoing, the Commission deems it appropriate to impose the sanctions specified in Respondent's Offer.
Accordingly, it is hereby ORDERED that:
Respondent McLeod cease and desist from committing or causing any violations and any future violations of Sections 13(a), and 13(b)(2)(A) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 promulgated thereunder.
By the Commission.
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