U.S. SECURITIES AND EXCHANGE COMMISSION
Litigation Release No. 18936 / October 21, 2004
Accounting and Auditing Enforcement Release No. 2127 / October 21, 2004
SEC v. Qwest Communications International Inc., Civil Action No. 04-Z-2179 (OES) (D. Co.)
SEC Charges Qwest Communications International Inc. with Multi-Faceted Accounting and Financial Reporting Fraud
Qwest Agrees to Anti-Fraud Injunction, $250 Million Penalty, and Maintain Permanently Chief Compliance Officer Reporting to the Outside Directors of the Board
The Securities and Exchange Commission today charged Qwest Communications International Inc., one of the largest 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 Sections 5(a), 5(c), and 17(a) of the Securities Act of 1933 and Sections 10(b), 13(a), 13(b)(2), and 14(a) of the Securities Exchange Act of 1934 and Rules 10b-5, 12b-20, 13a-1, 13a-11, 13a-13, 13b2-1, 14a-3, and 14a-9 thereunder.
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 the Sarbanes-Oxley Act of 2002. 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.
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 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.
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). 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 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 July 2004, the Commission filed a civil injunctive action against Michael Felicissimo, the former CFO of Qwest’s Wireless division (Litigation Release No. 18800). Also in July 2004, the Commission filed a subpoena enforcement action against Drake Tempest, Qwest’s former general counsel (Litigation Release No. 18804).
The Commission's investigation into matters related to Qwest's financial fraud is continuing.
SEC Complaint in this matter