Qwest Financial Fraud Essay
Financial Fraud- Qwest Communications
Introduction
In the late 90’s, early 2000’s, Qwest Communications International Inc. (Qwest) was a rapidly growing telecommunications company that provided global internet and telephone services. At their pinnacle, Qwest was one of their industry’s top leaders, reporting revenues of $16.7 billion in 2001 (Anonymous, 2013). Through continued expansion and acquisitions of other large telecommunications companies, it seemed things were only headed in a positive direction for Qwest. Their technology and advancement were consistently outpacing the competition, and they were dominating the marketplace. Then things took a turn for the worse in 2002, with the discovery that the President and CEO, in conjunction with several other top executives, were committing several types of financial fraud, including insider trading. Unraveling the web of lies and deceit uncovered billions of dollars of falsely reported revenue, and ultimately led to the tarnished brand image of Qwest, millions of dollars lost by investors and hundreds of employee out of work.
According to sources, Qwest began in 1988 as SP Telecom, a subsidiary of Southern Pacific Transportation Co. located in San Francisco, California. Southern Pacific Transportation was purchased and owned by billionaire oil …show more content…
tycoon, Philip Anschutz. In 1995, SP Telecom assumed the name Qwest Communications Corp. and moved company headquarters to Denver, Colorado. The company was growing quickly, and Qwest soon launched an Initial Public Offering (IPO) and became publicly traded as Qwest Communications International Inc. in 1997. The organization sold 13.5 million shares for $297 million, though Anschutz remained primary shareholder, retaining 86 percent of the company. At this time Joseph Nacchio, former head of Consumer Services at AT&T, became Qwest 's new President and CEO. Qwest soon became a powerhouse, acquiring smaller companies at a rapid pace. In 1997, the company acquired SuperNet Inc. for $20 million and soon after, in 1998, acquired LCI International for $4.4 billion, EUNet for $154 million, Icon CMT of Weehawken for $185 million, and finally, US West in 2000 for an amount ranging from $35 to $80 billion. The acquisition of US West was a defining moment for the company, and showcased the continued growth and success of Qwest (Funding Universe, 2014).
Continued information from sources explained that in 1999, Qwest employed about 8,700 employees and brought on an additional 55,000 from the US West acquisition. They had a national fiber-optic network with 18,500 route miles and 4,300 route miles in Mexico and Canada. They were also entering into new agreements and partnerships, including a deal with Microsoft in which they offered a wide range of internet services using Windows 2000. Qwest quickly became one of the telecommunication industry leaders. They specialized in services including long-distance telephone service and high-speed internet. They were paired against the three largest competitors in the industry: AT&T, MCI Worldcom, and Sprint Corp. Qwest aimed to develop a competitive advantage by providing faster, more affordable services, while expanding their network coverage and presence (Funding Universe, 2014).
Qwest’s growth continued and was aided by acquiring the rights to bury fiber optic cables from land owners. They would construct and lay the cables, and then ultimately sell these cables and/or the right to use them with other providers. These are referred to as indefeasible rights of use (IRU). By 1999, Qwest reportedly recouped 90 percent of its total cost to obtain and construct the entire network through the sale of IRU’s to their competitors (SEC, 2014)
In 2002, at the peak of Qwest’s fraudulent activity, the acting Chairman and Chief Executive Officer (CEO) was Joseph Nacchio. Other top executive officials declared on the company’s annual 10-K statement were Afshin Mohebbi, the company’s President and Chief Operating Officer (COO), Drake S. Tempest the Vice President, General Counsel and Corporate Secretary, and Robin Szeliga the Vice Chairman and Chief Financial Officer (CFO) (Qwest, 2002). Although their levels of involvement vary, as top executives of the company, they all hold some responsibility for information reported in the financial statements, especially the CEO and CFO.
Explanation of Fraud
The U.S. Securities and Exchange Commission (SEC) is a federal government agency that is charged with regulating, monitoring and enforcing securities laws, including the Sarbanes-Oxley Act of 2002 (SOX). SOX is a piece of legislation meant to strengthen regulations put on a company’s financial reporting practices. It was created and needed in response to an overwhelming impact on shareholders from the fraud committed by companies like Enron, Worldcom and even Qwest. The Generally Accepted Accounting Principles (GAAP) are a standard of rules and methods to which companies are required by the SEC to follow when preparing financial information. It is set in GAAP and required by the SEC that publically traded companies release quarterly and annual financial statements to the public that are considered to be “transparent”. Meaning they are inclusive, truthful, correct, accurate, comprehensive and in no way deceptive to the public. Therefore, it is in violation of SOX and the SEC to hold back or misconstrue important information in order to improve a company’s financial standing.
To better understand the Qwest case study, we must first understand the basics of financial fraud and insider trading. There are three types of fraud that are present in fraudulent financial reporting situations, referred to as the three M’s of financial reporting fraud. The three M’s are manipulation, misrepresentation, and misapplication (Crumbley, 2011). Manipulation involves the purposeful falsification or alteration of accounting records. Misrepresentation refers to the omission of information such as events or transactions. Misapplication occurs when accounting principles are purposely abused; such as amounts, classification, manner of presentation or disclosure. The purpose for each of these forms of fraud is to alter the financial statements.
When it pertains to a company’s financial status and overall success, a publically traded company has not only a fiduciary responsibility to its investors, stockholders and every other shareholder, but a legal responsibility as well. The investors and stockholders are the owners of a publically traded company, and therefore, have every right to know what is going on within it. Although certain key information would put a company at a competitive disadvantage if released to the public, the financial standings of the company are a necessary disclosure. In the end, stock prices are the ultimate measure of a publically traded company’s financial standing, at least in the eyes of the owners or stockholders. If stock prices are the ultimate measure of a public company’s success, it is no surprise that it is also the primary motivating factor that entices most individuals to commit fraud. There can often be other motivations for an executive to commit fraud, such as reaching unrealistic growth objectives, pressure from the board of directors, compensation tied to the company performance or even just to steal directly from the company. However, most often the financial fraud committed by executives is ultimately committed to achieve higher stock prices because this will translate into better success for them. Greed and selfishness are the building blocks of fraud. Stock prices are driven by financial calculations, public perception and future growth expectations; the backbone of all of these components are the company’s earnings.
Generally, the most common methods for a company to deceive the public of the true nature of their earnings are through the inflation of sales, under statement or delay of expenses or over reporting of assets; all of which lead to a higher reported net income. Inflating sales may be done by creating fictitious sales, recognizing revenue early or misclassifying sources of revenue. In accrual based accounting, revenue is recognized when it is earned and realizable. There is also a significant difference between operating revenue and non-operating revenue. Operating revenue is revenue earned from what is considered the normal course of business operations. For example, a car manufacturer recognizes revenue when they sell a car, not when they sell a car dealership. This is important for investors because increased operating revenue is usually an indication of growth, while non-operating revenue is not expected to be a reoccurring event and is therefore not included in growth calculations.
Linked to revenue are expenses. Expenses should be reported in the period in which the associated revenue was recognized. This often requires the use of accruals, since many times the period in which an expense should be reported is different than that in which it was paid. For instance, wages should be reported in the period in which employees earned them, not when paychecks were actually issued. Since the nature of these transactions may involve complicated accounting methods and estimations, it can be easy for a company to find ways to “fudge” or alter these accruals.
Finally, a company may falsely state assets by over reporting inventory, capital assets or even accounts receivable (A/R). Each component has several commonly used deceptive practices to overstate. For example, capital assets can be over reported by switching or misapplying depreciation methods. Inventory can be overstated by reporting fictitious inventory, the misapplication of goods in transit or several other accounting tricks. A component of A/R is the calculation of bad debt, or receivables that will likely not be collected. Since this is an internal calculation under management discretion, bad debt can be easily under accrued, which in turn overstates A/R. These are a few of the common ways for a company to inflate their income or earning on their financial statements.
Insider trading is a common method for an executive to acquire money from inflated earnings and stock prices. Insider trading can be legal or illegal. The legal version occurs when an employee of a company buys, sells, or trades stocks within their own company. This type of transaction should be reported to the SEC and is a common legal occurrence. If, however, the employee or even an outside party uses material, nonpublic information when trading securities, they have committed illegal insider trading (SEC, 2013). If an executive within the company knew of an important event that was going to take place, that the public was not informed about or aware of, it would be considered illegal insider trading if that executive used this information to beneficially trade stock. If a CEO sells his company stock prior to a press release announcing the discovery of a major defect in their product, for example, the CEO could be charged with illegal insider trading; especially if it was proven that he had knowledge of the announcement prior to selling.
Examining Qwest’s Fraudulent Activity
One method commonly used to discover fraud or look for red flags is to test if the three components of the fraud triangle pyramid apply. The three factors are motive, rationalization and opportunity (Crumbley, 2011). Motive acts as the intrinsic driver, rationalization is making excuses for behavior, and opportunity is the ability to commit fraud due to lack of internal controls. Nacchio, like most others, naturally had motive. Motive can be the need to pay off gambling debt, pay the mortgage or even put food on the table; however, in high profile cases such as Qwest, it is often simply about greed, which is somewhat of a natural human characteristic for many people. In general, especially through time, many people can justify anything to themselves if they truly want to. This is often the case with fraud or other types of theft. People may tell themselves they have “earned it”, they need or deserve it more than someone else, or even that the money will never be missed. It is safe to assume that Nacchio had both motive and rationalization. Then the perfect opportunities presented themselves thanks to Qwest’s lack of internal controls.
Beyond Nacchio’s motivational greed, Qwest as a whole had several other incentives for committing fraud. For one, a provision included in the agreement for the acquisition of US West was that Qwest stock had to be trading between $28.26 and $39.90. US West had the option to terminate the agreement if Qwest stock fell below an average of $22 per share. In August 1999, Qwest stock fell from $34 to $26 per share (SEC, 2014). This was when Qwest began an ugly cycle of reporting its one time IRU sales as operating revenue. As explained above, Qwest’s primary business is not the construction and trade of optic fiber networks, therefore this should be broken out on their financial statements as non-operating income. It is important for investors to know that this is a onetime source of revenue and that if everything else remains the same, this will not become a repetitive or sustainable source of revenue. By June 2000, Qwest stock was trading above $50 per share, and the acquisition of US West was completed (SEC, 2014).
Following the acquisition of US West, Qwest senior management consistently projected double-digit earnings growth from quarter to quarter. When a company projects tremendous growth like this, and investors are confident in the company’s ability to deliver, stock prices will soar. In the beginning, Qwest was motivated to report higher revenue to ensure the acquisition of US West was successful, but if they failed, the deal fell through and Qwest was back where they started. However, after senior management officially released projections to the public, they became obligated to those numbers. For example, if a company projects revenue of $10 million dollars, and then either fails to deliver or later decides this goal was too high and $1 is more accurate, shareholders and investors will be very upset. Usually an investor that just lost a significant amount of their investment is not likely to stand idly by; after all, the point of investing is simple, to increase that investment. They are likely going to take action and look for retribution. Often this is accomplished in the form of terminating or replacing board members and top executives. With that said, the incentive for Qwest senior management to meet goals is to keep their jobs. This attitude will carry a waterfall effect throughout the company. If a CEO is at risk of losing his or her job, they will likely hold their CFO and COO to the same standard. The CFO will then increase pressure on the Controller and the Controller on their accounting staff, and so on. In this circumstance, everyone in the company is either fearful of losing their job or at least under incredible pressure to meet their projections.
At one point in an interview conducted with former Qwest employee, R. Neuberger, he confirmed that the pressure he as his fellow sales associates felt was “brutal”. The expectations to consistently meet high sales goals were overwhelming, and he feared losing his job if he was unable to meet quotas. He and colleagues were well aware of Nacchio’s “drive-by-downsizing” techniques, where Nacchio would not hesitate to let people go if he found any conduct or performance he did not agree with (R, Neuberger, personal communication, February 23, 2014).
Finally Qwest executive and other employees have incentive to meet projections because their bonuses were based directly on their ability to perform and meet these goals. “Qwest senior management ensured that company and business unit projections were met by paying bonuses to management and employees only for the periods when they achieved the target revenue” (SEC, 2014). Extra money can often cloud the judgment and ethical choices of people whether they are a top executive or a front line technician.
It 1999, it became clear to Qwest senior management that their projected growth was not realistic and that instead, it would only be moderate. Senior management then decided to sell an increasing amount of their IRUs and capital equipment to meet objectives, thus selling what was previously identified as a “principle asset” (SEC. 2012). Once again, they were reporting this as regular operating revenue and misleading investors. In the telecommunications industry this type of transaction was routine, however, it is classified as non-recurring income and is recognized over the period in which it was earned.
Once this pattern was started it couldn’t be stopped. If Qwest needed to use the sales of IRUs to achieve their goals this quarter, and projected a minimum of 10 percent growth next quarter, they needed to sell even more IRUs to stay above water. It quickly became a downward spiral effect for Qwest. Some employees even referred to it as an “addiction” and called IRUs Qwest’s “heroin” (SEC, 2014). Qwest knew this would not be sustainable, and always planned to stop this behavior, but like many addictions the problems only grew worse. On October 27, 1999, Qwest bragged that they achieved their first billion dollar quarter, and that their Internet and data services grew by more than 200 percent. Unbeknownst to the investing public, 140 percent of this and 32 percent of their total revenue was from non-recurring sales. By the end of 1999, non-recurring revenue comprised 33 percent of Qwest’s fourth quarter total revenue and 26 percent for the entire year (SEC, 2014).
It is common practice in the telecommunications industry to “swap” fiber cables or capacity. This occurs when two companies trade fiber cables that are close to the same value and are more beneficial to each other. This may occur, for example, if one company is expanding or requiring more capacity in one region, and the other is focusing on a different one. As Qwest continually sold IRUs, they found it increasingly difficult to find customers without performing some type of swap. According to GAAP, in a transaction such as this, it is a swap of capital assets with a possible non-recurring loss or gain, which is the difference between values of the assets. Capital assets are also depreciated over a life; the associated expenses are spread out over a period of time instead of recognized all at once. The issue for Qwest in this circumstance, beyond fraudulently reporting these gains as operating revenue, was that in a swap transaction where the exchange was equal, there was no gain or revenue to report at all. Against the principles of GAAP, Qwest reported the outgoing fiber cables as operating revenue and the incoming as an increase in capital asset to be depreciated over a life of 20-25 years (SEC, 2014). Fundamentally, this does not make sense. Qwest, well aware of the improper reporting, required their sales force to conduct these transactions with secret agreements and verbal assurances meant to conceal this information from the accountants. One email from a manager at Qwest referring to this stated, “By the way, we should NOT have an email chain that indicates that verbal commitments such as these were made” (SEC, 2014).
Simultaneously, Qwest was misclassifying data by ignoring GAAP principles and recognizing revenue in incorrect periods, thus perpetuating timing errors. One way they did this was by backdating contracts to recognize revenue sooner. Qwest failed to deliver fiber cables to customers in a timely manner, however against revenue recognition; they would record it as sales anyways. Qwest’s wireless subsidiary, also improperly recognized revenue of approximately $112 million by failing to adjust revenue for returned phones and phone repairs, accessories given to customer for free, and other miscellaneous billing adjustments (SEC, 2014). When this error was discovered, the CFO of Qwest’s wireless division actively hid the errors and instructed others to do the same. The lies and deceit continued as Qwest orchestrated a series of fictitious transactions and improperly recognized millions of dollars. In one such case, Qwest reported a sale of routes to Enron, who actually cancelled their order and never paid for services (SEC, 2014).
When these fraudulent activities were no longer enough to ensure that Qwest would meet their financial growth targets, senior management went even further. They began to misstate expenses in several ways. One of these techniques was to capitalize expenses. Similar to the swapping scheme, expenses were depreciated over a life, instead of reported in the period of occurrence. Alternatively, these expenses should have been reported in the period in which the associated revenue was recognized. From doing so, Qwest was able to increase their 2001 earnings by $231 million (SEC, 2014). Another way Qwest muddied expenses was by improperly deferring commission expenses, even though they did not meet deferral qualifications. They also failed to disclose their change in this policy (SEC, 2014). Finally, they altered their employee vacation expense by ignoring the standard, 100 percent accrual policy to instead only accrue for 19 percent. This decreased the accrual from $118 million to only $24 million (SEC, 2014).
Cleary, the fraudulent activity over the three years between 1999 and 2002 was extensive and engrossed many facets of the organization. Along with the examples above, Qwest continued their fraudulent behavior with the following actions: (1) improperly recognizing funds from operator services that were meant to be remitted to a third-party, (2) failure to maintain adequate reserve for billing credits, (3) including unfavorable contract costs as merger-related liabilities and (4) exerting leverage of size and power by requiring smaller vendors going public to allow Qwest executives to invest before their IPO (SEC, 2014).
Finally, the investment community and analysts began to see holes in Qwest’s financial data and questioned them on the matter. Reluctantly and under extreme pressure from the public, Qwest senior management disclosed the true revenue earned from the sale of IRU on their 2001 second quarter form 10-Q (SEC, 2014) The cat was out of the bag. Fortunately for Nacchio, he had already sold all of his own shares in Qwest. He performed all the fraudulent activities previously described in order to deceive the public and allow him to sell his stock for more than it was worth before anyone knew better. Through intensive forensic accounting investigation and discovery, it was determined that between 1999 and 2002, Qwest fraudulently recognized approximately $3.8 billion of misclassified revenue and excluded about $231 million in expenses (SEC, 2014).
The key players in the execution of the fraudulent activity committed by Qwest were CEO, Joseph Nacchio, CFO, Robin Szeliga, and COO, Afshin Mohebbi. As the leaders of the company, other employees look to them to make the “tough” decisions and to act in best interest of the company as a whole. With that being said, every employee still has an ethical responsibility to ask themselves what is right and wrong, and not blindly follow management. Therefore, some level of responsibly falls on the shoulders of any persons aware or involved in the misstatement or misleading nature of the numbers. Generally this is especially true of the accountants, since they should not only be educated in the matter, but have more accessibility and clarity to the direct effects on the financial statements. To further reiterate, all three, the CEO, CFO, and COO, had all the pieces to the puzzle, knew the exact consequences and materiality of what was being done, and not only did not stop it, but encouraged it.
The Aftermath
Due to Qwest’s negligence in regards to the discovery and prevention of the fraud committed by its top executives, Qwest was charged with securities fraud and other violations of the federal securities laws by the SEC on October 21, 2004. Charges claiming that between 1999 and 2002, Qwest fraudulently recognized over $3.8 billion in revenue and excluded $231 million in expenses (SEC, 2014). More specifically, this included fraudulent use of non-recurring revenue, fraudulent accounting for IRU and equipment sale transactions, failing to disclose in periodic filings strategic relationships vendors, misleading statements connected to directory service units, improper revenue recognition in its wireless division and understating expenses related to sales commission plans. The judgment directed Qwest to pay a civil penalty of $250 million to be distributed back to defrauded investors (SEC, 2014). Qwest agreed to pay the fine without admitting or denying guilt in their actions. The SEC also required Qwest to employee a Chief Compliance Officer (CCO), who reported to an outside committee of directors. The COO would be responsible for ensuring the company’s future compliance with federal securities laws. Several charges, and cease and desist orders were also brought against Qwest executive officers.
On March 15, 2005, after the prosecution had time to put their case together, charges were brought specifically against Nacchio for fraud and other securities violations. Later that summer, CFO, Robin Szeliga was charged with insider trading and pled guilty, admitting to having access to information not available to the public when she sold 10,000 shares of Qwest stock for a profit of $125,000. In December 2005, Nacchio was indicted on 42 criminal counts of insider trading, allegedly selling over $100 million in stock (Stanwick, 2009).
On March 19, 2007, the criminal trial of Joseph Nacchio commenced in Denver, Colorado. Former Investor Relations Chief, Lee Wolfe, testified against Nacchio, stating that Nacchio improperly projected high revenue growth levels of 15 and 17 percent, when in fact; a major source of the growth was a one-time sale of network capacity (Stanwick, 2009). Nacchio refused to testify, for fear of self-incrimination. Exactly one month after trial began, on April 19, 2007, Nacchio was found guilty on 19 of the 42 counts of insider trading. He was sentenced to six years in prison, and ordered to pay a $19 million fine and forfeit his profits on the sale of illegally sold stock in the amount of $52 million (Stanwick, 2009). After being released temporarily on bail, on April 14, 2009, Nacchio was placed in a Pennsylvania federal prison to begin his six year sentence (Vuong, 2009).
Quickly after the verdict, Nacchio appealed the court’s judgment and would later get a small victory. The federal appeals court ruled that his sentence was too harsh because the ruling judge had miscalculated Nacchio 's net gains from his sale of stock. In 2010, a judge reduced two months from his prison term and $7.4 million from the amount he was required to forfeit. In 2011, for unclear reasons Nacchio voluntarily withdrew his final appeal. This allowed the fines and forfeiture which Nacchio was mandated to pay to be released from hold in an escrow account to finally be paid to the victims. (The Huffington Post, 2011)
Due to his reduced sentence and good behavior, Nacchio was released on September 20, 2013, after spending approximately four and a half years in prison (Harden, 2013). Nacchio spent most of his sentence in two Pennsylvania facilities. These facilities were low-level security camps that did not make use of walls or bars (Searcy, 2013). Nacchio was even allowed access to emails. Although Nacchio did not succumb to what is typically considered “hard time”, he emerged fit, muscular, and with a shaved head and goatee. Some might argue that prison strengthened him up or even improved him as a person. He even compares himself to actor Edward Norton (Searcy, 2013). Although it is not clear how or why he compared himself, some may speculate that Norton had a similar appearance, bald with a goatee, in the film American History X. Interestingly enough he played an angry, racist, Neo-Nazis who was imprisoned after murdering two men, or a criminal.
Like many corporate, publically traded companies, Qwest employees were often rewarded with stock or stock options. In general, this is a great perk for both a company and its employees. The company was able to substitute some cash payments or bonuses to employees with stock, and employees received incentive to work harder. The more successful the company, the more the stock becomes worth. Not only do the employees see direct compensation for their hard work and efforts, but the company increases their vested interest in its success. It is a win-win situation; unless however, the stock prices drop drastically or become worthless altogether. In this case the company which is already losing ground takes its employees with it, creating a lose-lose situation. Many experts say this may have been a cause or at the very least a negative side effect of the dot.com bubble bursting, since many start-up companies would pay their employees almost entirely in stock options.
Qwest was no different. Employees were rewarded and incentivized with the use of stock or stock options. It was routine for Qwest to give employees shares as part of their employee savings plan (Vuong, 2012). Due to Nacchio’s security fraud and insider trading, Qwest stock prices plummeted from a $60 high to approximately $1 per share (Waters 2012). Many people lost a great deal of money during this time. Imagine if an employee and his family had saved $600,000 for their future and/or retirement in Qwest stock. After it the plummeted, they would have been left with only $10,000.
Stockholders did receive a portion of the penalties from Nacchio’s conviction, but it was nothing compared to the losses felt by so many. In the end, after his reduced sentence and forfeiture, Nacchio was forced to payback $44 million to the victims of his security fraud scheme. Reportedly there were 112,210 victims (Waters 2012). Doing the math shows that this equates to an average of $392 per victim, if there were no legal fees, taxes, or other associated costs. In one case, an 83 year old Westminster resident who owned 852 shares in Qwest, received a payment of $44.23 from the forfeiture by Nacchio (Vuong, 2012). Some victims found this to be insulting and even claimed they would simply return the check. Prosecutors, however, were quite pleased with the outcome. U.S. Attorney John F. Walsh said “I am pleased that we were able to recover more than $44 million in criminal proceeds and return it to innocent Qwest investors” (U.S. Justice Department, 2012).
According to an explanation in an interview conducted with former Qwest employee, R. Neuberger, tensions and corporate culture were uneasy under the leadership of Nacchio. Neuberger was a US West employee when the acquisition by Qwest occurred. He remained with Qwest for several years and personally experienced the backlash of the fraudulent activities by Nacchio and his team. Neuberger explained that company morale was in steady decline right when the two companies joined. He did speculate if this was because the two cultures were inheritably different, if Qwest, under the thumb of Nacchio, was not welcoming to the US West employees, or both. Regardless, Neuberger described the merger as a “cultural explosion” (R, Neuberger, personal communication, February 23, 2014).
On top of the environmental instabilities, Neuberger saw issues with leadership right away. Nacchio considered his leadership role with Qwest as a calling to be the “white knight”, here to take the reins and lead the company into a bright future. Others saw through the façade. Neuberger quickly felt something amiss with Nacchio. He blatantly describes Nacchio as “arrogant”, “cocky” and as someone who likens himself to a famous leader such as Caesar. From the first meeting Neuberger heard him speak at, and from details like the way he walked in the room, he knew Nacchio was not a man he wanted to work for. Neuberger compares scenarios in which a ship is sinking or an airplane is crashing, and the captain chooses to “go down with the ship”. Nacchio, as the top leader of Qwest, was literally the first to “jump ship” and abandon everyone. He sold his stock, while knowing his fraud would soon be discovered, and left everyone else behind. In the end, Neuberger made clear that he found Nacchio to be a “corporate sociopath” (R, Neuberger, personal communication, February 23, 2014).
After all the commotion, for all the good he preaches to do, the Denver community, as a whole, took a large blow from the fraud committed by Nacchio. Many employees were left jobless and without savings. Stockholders and investors were out billions of dollars and lucky to be able to scavenge for remnants. It has been determined that the recognized losses are likely somewhere around $12 billion (Vuong, 2012). The Denver, Colorado, and even national communities were rocked by the fact that one person could directly impact so many people and the outcome of their futures. The public’s confidence was shaken in the stability and reliability of publically traded companies, and the SEC that governed them. U.S. Attorney Walsh also said about securities fraud, “Securities fraud is a particularly insidious crime because it undermines public confidence in the financial markets” (U.S. Justice Department, 2012)
Lessons Learned
It is the responsibility of the leadership of a company to set the example for others to follow. Work ethic often trickles from the top down. If the leaders are not ethical, responsible, accountable or professional, their employees will see this and may often mimic the behavior. According to the Prosecuting attorney, Nacchio stated that “the most important thing we do is meet our numbers. It’s more important than any individual product and it’s more important than any individual philosophy. It’s more important than any individual cultural change that we’re making. We stop everything else when we don’t make the numbers” (Stanwick, 2009). While it is true that if a company consistently recognizes poor performance and numbers, it will often dissolve and fail to continue producing numbers at all; however, numbers should not be the main and only focus of the company. A company will often produce a mission statement that tells customers and other stakeholders what their main focus for success is. For example Hilton’s mission statement is “To be the preeminent global hospitality company - the first choice of guests, team members, and owners alike” (Hilton Worldwide, 2014). A mission statement may even be to achieve financial success and create the highest profit for stockholders, but it should never be achieved through lying, cheating or stealing. In this case, it is very clear how Nacchio felt about running his business; the company’s financial success trumped all other factors and should be achieved by any means necessary. This mantra spread from Nacchio to others and likely set Qwest up for failure very quickly.
Studying the case, there are several clear actions that may have prevented the fraud committed by Joe Nacchio and other Qwest executives. The most significant practice lacking was Qwest’s internal controls and policy regulation. Like many companies, most Qwest employees and stockholders likely believed that their internal controls and accounting methods were sufficient. We now know this to be inaccurate, based on the perpetrators ability to completely overstep these controls and conceal a vast number of fraudulent activities. Qwest should have implemented better practices concerning: segregation of duties, checks and balances, fraud risk assessments, internal testing of controls and policies, and more efficient use of independent auditors.
So where were the auditors? Qwest employed independent audit firm, Arthur Anderson LLP, throughout the course of their misconduct (Berman, 2002). Despite Arthur Andersons’ continued warnings to Qwest about their risky behavior towards the use of IPUs and swap transactions, Qwest ignored these warnings and continued anyways. It is the duty of an auditor to search for material misstatements of financial reports and discover misleading information for the public. If they saw warnings signs and the client refused to adhere, they should have refused to issue an unqualified opinion. Arthur Anderson failed to accomplish this with Qwest, as well as Enron, Worldcom, Waste Management, and several other large corporate accounting fraud cases. They have since closed their doors. In 2002, Qwest switched their independent audit firm to KPMG (Berman, 2002).
A major lesson learned through the Qwest case and seeing all the damage that was done, is that stealing from a corporation is not always a victimless crime like many may believe. It is common for petty fraudsters to say things like “It’s such a big company, they won’t miss it!” Sometimes this may even be true. However, after reviewing the Qwest case and learning how many people this affected, how many life savings it wiped out, and how many lives it negatively affected; there is no doubt this is not a victimless crime. It raises eyebrows to speculate what Nacchio himself believes about this.
For every negative there is usually some positive and some good did come out of the Qwest fraud case. In combination with several other high profile corporate fraud cases, the U.S. government and SEC tightened and restricted their hold on corporate responsibly and accountability. This is directly reflected in the creation of SOX legislation. SOX may inspire criminals to find other ways to commit fraud, but at least it is a giant step in the right direction and a message to those considering committing fraud.
Conclusion
On April 1, 2011 Qwest was purchased by Century Link for $24 billion.
(Vuong, 2011) The once iconic symbol that helped perpetuate the image of Denver’s growth and success is now just a piece of CenturyLink, a company based out of Monroe, Louisiana. The ex -“Qwest Tower”, is located at 1801 California Street, and remains Denver’s second tallest skyscraper, standing at 709 feet or 52 floors (The Denver Post, 2014). Many Denver locals and visitors knew this prominent building as the “Qwest Tower” thanks to its size and the massive Qwest logo displayed across the top. Today, it instead reads Century Link and is emblazoned with their large, glowing green
logo.
It would be difficult to claim that the fraud committed by Nacchio was the lone reason for Qwest’s eventual acquisition by Century Link. However, it is not farfetched to see that the scandal, at the very least, played a role. Interestingly enough, this case study began by examining the many acquisitions executed by Qwest, how they were seen as a measurement of the company’s success, and now the story ends with the acquisitions of Qwest itself. Hopefully lessons have been learned, governing bodies have honed their skills, laws have become more stringent and actions have been taken to prevent another Enron, Worldcom, and Qwest debacle.
References
Anonymous. (2003, February). Qwest Reports $35 Billion Loss In 2002. Retrieved from CRN website: http://www.crn.com/news/channel-programs/18829785/qwest-reports-35-billion-loss-in-2002.htmBerman, D. K. (2002, October). Arthur Andersen Warned Qwest About Risk of Swaps. Retrieved from The Wall Street Journal website: http://online.wsj.com/news/articles/SB1033610506150854313Crumbley, D. L., Heitger, L. E., & Smith, G. S. (2011). Forensic and investigative accounting (5th ed.). Chicago, IL: CCH.
Funding Universe. (2014, February). Qwest Communications International, Inc. History. Retrieved from Funding Universe website: http://www.fundinguniverse.com/company-histories/qwest-communications-international-inc-history/Harden, M. (2013, September). Wall Street Journal interviews 'unrecognizable ' Joe Nacchio. Retrieved from Denver Business Journal website: http://www.bizjournals.com/denver/news/2013/09/27/wall-street-journal-interviews.htmlHilton Worldwide (2014, February). Discover our vision, mission, and values. Retrieved from Hilton Worldwide website: http://www.hiltonworldwide.com/about/mission/Qwest. (2002). 2002 Annual Report. Retrieved from Beatrice Companies website: http://www.beatriceco.com/bti/porticus/bell/pdf/Qwest_AR2002.pdfSearcy, D. (2013, September). Former Qwest CEO Joseph Nacchio: Tales From a White-Collar Prison Sentence. Retrieved from The Wall Street Journal Web website: http://online.wsj.com/news/articles/SB10001424052702303983904579093173797712780Stanwick, P A., Stanwick, S D. (2009). Qwest Communications: A Case Study of Fraud and Greed. Retrieved from The Clute Institute- Journal of Business Case Studies website: http://journals.cluteonline.com/index.php/JBCS/article/view/4695The Denver Post (2014, February). Qwest Tower. Retrieved from Denver Post website: http://calendar.denverpost.com/denver_co/venues/show/6688825-qwest-towerThe Huffington Post. (2011, February). Joseph Nacchio Drops Appeal Of Sentence. Retrieved from Huff Post Denver website: http://www.huffingtonpost.com/2011/02/12/joseph-nacchio-drops-appe_n_822382.html
The United States Department of Justice. (2012, May). Justice Department Returns $44 Million to Victims of Qwest Communications Fraud. Retrieved from Department of Justice website: http://www.justice.gov/opa/pr/2012/May/12-crm-577.htmlU.S. Securities and Exchange Commissions. (2004, October). SEC Charges Qwest Communications International Inc. with Multi-Faceted Accounting and Financial Reporting Fraud. Retrieved from SEC website: http://www.sec.gov/news/press/2004-148.htmU.S. Securities and Exchange Commissions. (2013, January). Securities and Exchange Commission, Insider Trading. Retrieved from SEC website: https://www.sec.gov/answers/insider.htmU.S. Securities and Exchange Commissions. (2014, January). Securities and Exchange Commission, Plaintiff, v. Qwest Communications International Inc., Defendant. Retrieved from SEC website: http://www.sec.gov/litigation/complaints/comp18936.pdfVuong, A. (2009, April). Ex-Qwest chief Nacchio reports to prison in Pennsylvania. The Denver Post. Retrieved from Denver Post website: http://www.denverpost.com/ci_12139713Vuong, A. (2011, April). CenturyLink completes purchase of Qwest. Retrieved from Denver Post website: http://www.denverpost.com/ci_17750883Vuong, A. (2012, May). Victims of Qwest securities fraud get little back. Retrieved from The Denver Post website: http://www.denverpost.com/ci_20548197/victims-qwest-securities-fraud-get-little-backWaters Kraus-Attorneys and Counselors. (2013, January). $44 Million Returned to Victims of Qwest Securities Fraud Scheme. Retrieved from Waters Kraus website: http://www.secfraudlawyer.com/index.aspx?id=news_qwest_securities_fraud_scheme
Introduction
In the late 90’s, early 2000’s, Qwest Communications International Inc. (Qwest) was a rapidly growing telecommunications company that provided global internet and telephone services. At their pinnacle, Qwest was one of their industry’s top leaders, reporting revenues of $16.7 billion in 2001 (Anonymous, 2013). Through continued expansion and acquisitions of other large telecommunications companies, it seemed things were only headed in a positive direction for Qwest. Their technology and advancement were consistently outpacing the competition, and they were dominating the marketplace. Then things took a turn for the worse in 2002, with the discovery that the President and CEO, in conjunction with several other top executives, were committing several types of financial fraud, including insider trading. Unraveling the web of lies and deceit uncovered billions of dollars of falsely reported revenue, and ultimately led to the tarnished brand image of Qwest, millions of dollars lost by investors and hundreds of employee out of work.
According to sources, Qwest began in 1988 as SP Telecom, a subsidiary of Southern Pacific Transportation Co. located in San Francisco, California. Southern Pacific Transportation was purchased and owned by billionaire oil …show more content…
tycoon, Philip Anschutz. In 1995, SP Telecom assumed the name Qwest Communications Corp. and moved company headquarters to Denver, Colorado. The company was growing quickly, and Qwest soon launched an Initial Public Offering (IPO) and became publicly traded as Qwest Communications International Inc. in 1997. The organization sold 13.5 million shares for $297 million, though Anschutz remained primary shareholder, retaining 86 percent of the company. At this time Joseph Nacchio, former head of Consumer Services at AT&T, became Qwest 's new President and CEO. Qwest soon became a powerhouse, acquiring smaller companies at a rapid pace. In 1997, the company acquired SuperNet Inc. for $20 million and soon after, in 1998, acquired LCI International for $4.4 billion, EUNet for $154 million, Icon CMT of Weehawken for $185 million, and finally, US West in 2000 for an amount ranging from $35 to $80 billion. The acquisition of US West was a defining moment for the company, and showcased the continued growth and success of Qwest (Funding Universe, 2014).
Continued information from sources explained that in 1999, Qwest employed about 8,700 employees and brought on an additional 55,000 from the US West acquisition. They had a national fiber-optic network with 18,500 route miles and 4,300 route miles in Mexico and Canada. They were also entering into new agreements and partnerships, including a deal with Microsoft in which they offered a wide range of internet services using Windows 2000. Qwest quickly became one of the telecommunication industry leaders. They specialized in services including long-distance telephone service and high-speed internet. They were paired against the three largest competitors in the industry: AT&T, MCI Worldcom, and Sprint Corp. Qwest aimed to develop a competitive advantage by providing faster, more affordable services, while expanding their network coverage and presence (Funding Universe, 2014).
Qwest’s growth continued and was aided by acquiring the rights to bury fiber optic cables from land owners. They would construct and lay the cables, and then ultimately sell these cables and/or the right to use them with other providers. These are referred to as indefeasible rights of use (IRU). By 1999, Qwest reportedly recouped 90 percent of its total cost to obtain and construct the entire network through the sale of IRU’s to their competitors (SEC, 2014)
In 2002, at the peak of Qwest’s fraudulent activity, the acting Chairman and Chief Executive Officer (CEO) was Joseph Nacchio. Other top executive officials declared on the company’s annual 10-K statement were Afshin Mohebbi, the company’s President and Chief Operating Officer (COO), Drake S. Tempest the Vice President, General Counsel and Corporate Secretary, and Robin Szeliga the Vice Chairman and Chief Financial Officer (CFO) (Qwest, 2002). Although their levels of involvement vary, as top executives of the company, they all hold some responsibility for information reported in the financial statements, especially the CEO and CFO.
Explanation of Fraud
The U.S. Securities and Exchange Commission (SEC) is a federal government agency that is charged with regulating, monitoring and enforcing securities laws, including the Sarbanes-Oxley Act of 2002 (SOX). SOX is a piece of legislation meant to strengthen regulations put on a company’s financial reporting practices. It was created and needed in response to an overwhelming impact on shareholders from the fraud committed by companies like Enron, Worldcom and even Qwest. The Generally Accepted Accounting Principles (GAAP) are a standard of rules and methods to which companies are required by the SEC to follow when preparing financial information. It is set in GAAP and required by the SEC that publically traded companies release quarterly and annual financial statements to the public that are considered to be “transparent”. Meaning they are inclusive, truthful, correct, accurate, comprehensive and in no way deceptive to the public. Therefore, it is in violation of SOX and the SEC to hold back or misconstrue important information in order to improve a company’s financial standing.
To better understand the Qwest case study, we must first understand the basics of financial fraud and insider trading. There are three types of fraud that are present in fraudulent financial reporting situations, referred to as the three M’s of financial reporting fraud. The three M’s are manipulation, misrepresentation, and misapplication (Crumbley, 2011). Manipulation involves the purposeful falsification or alteration of accounting records. Misrepresentation refers to the omission of information such as events or transactions. Misapplication occurs when accounting principles are purposely abused; such as amounts, classification, manner of presentation or disclosure. The purpose for each of these forms of fraud is to alter the financial statements.
When it pertains to a company’s financial status and overall success, a publically traded company has not only a fiduciary responsibility to its investors, stockholders and every other shareholder, but a legal responsibility as well. The investors and stockholders are the owners of a publically traded company, and therefore, have every right to know what is going on within it. Although certain key information would put a company at a competitive disadvantage if released to the public, the financial standings of the company are a necessary disclosure. In the end, stock prices are the ultimate measure of a publically traded company’s financial standing, at least in the eyes of the owners or stockholders. If stock prices are the ultimate measure of a public company’s success, it is no surprise that it is also the primary motivating factor that entices most individuals to commit fraud. There can often be other motivations for an executive to commit fraud, such as reaching unrealistic growth objectives, pressure from the board of directors, compensation tied to the company performance or even just to steal directly from the company. However, most often the financial fraud committed by executives is ultimately committed to achieve higher stock prices because this will translate into better success for them. Greed and selfishness are the building blocks of fraud. Stock prices are driven by financial calculations, public perception and future growth expectations; the backbone of all of these components are the company’s earnings.
Generally, the most common methods for a company to deceive the public of the true nature of their earnings are through the inflation of sales, under statement or delay of expenses or over reporting of assets; all of which lead to a higher reported net income. Inflating sales may be done by creating fictitious sales, recognizing revenue early or misclassifying sources of revenue. In accrual based accounting, revenue is recognized when it is earned and realizable. There is also a significant difference between operating revenue and non-operating revenue. Operating revenue is revenue earned from what is considered the normal course of business operations. For example, a car manufacturer recognizes revenue when they sell a car, not when they sell a car dealership. This is important for investors because increased operating revenue is usually an indication of growth, while non-operating revenue is not expected to be a reoccurring event and is therefore not included in growth calculations.
Linked to revenue are expenses. Expenses should be reported in the period in which the associated revenue was recognized. This often requires the use of accruals, since many times the period in which an expense should be reported is different than that in which it was paid. For instance, wages should be reported in the period in which employees earned them, not when paychecks were actually issued. Since the nature of these transactions may involve complicated accounting methods and estimations, it can be easy for a company to find ways to “fudge” or alter these accruals.
Finally, a company may falsely state assets by over reporting inventory, capital assets or even accounts receivable (A/R). Each component has several commonly used deceptive practices to overstate. For example, capital assets can be over reported by switching or misapplying depreciation methods. Inventory can be overstated by reporting fictitious inventory, the misapplication of goods in transit or several other accounting tricks. A component of A/R is the calculation of bad debt, or receivables that will likely not be collected. Since this is an internal calculation under management discretion, bad debt can be easily under accrued, which in turn overstates A/R. These are a few of the common ways for a company to inflate their income or earning on their financial statements.
Insider trading is a common method for an executive to acquire money from inflated earnings and stock prices. Insider trading can be legal or illegal. The legal version occurs when an employee of a company buys, sells, or trades stocks within their own company. This type of transaction should be reported to the SEC and is a common legal occurrence. If, however, the employee or even an outside party uses material, nonpublic information when trading securities, they have committed illegal insider trading (SEC, 2013). If an executive within the company knew of an important event that was going to take place, that the public was not informed about or aware of, it would be considered illegal insider trading if that executive used this information to beneficially trade stock. If a CEO sells his company stock prior to a press release announcing the discovery of a major defect in their product, for example, the CEO could be charged with illegal insider trading; especially if it was proven that he had knowledge of the announcement prior to selling.
Examining Qwest’s Fraudulent Activity
One method commonly used to discover fraud or look for red flags is to test if the three components of the fraud triangle pyramid apply. The three factors are motive, rationalization and opportunity (Crumbley, 2011). Motive acts as the intrinsic driver, rationalization is making excuses for behavior, and opportunity is the ability to commit fraud due to lack of internal controls. Nacchio, like most others, naturally had motive. Motive can be the need to pay off gambling debt, pay the mortgage or even put food on the table; however, in high profile cases such as Qwest, it is often simply about greed, which is somewhat of a natural human characteristic for many people. In general, especially through time, many people can justify anything to themselves if they truly want to. This is often the case with fraud or other types of theft. People may tell themselves they have “earned it”, they need or deserve it more than someone else, or even that the money will never be missed. It is safe to assume that Nacchio had both motive and rationalization. Then the perfect opportunities presented themselves thanks to Qwest’s lack of internal controls.
Beyond Nacchio’s motivational greed, Qwest as a whole had several other incentives for committing fraud. For one, a provision included in the agreement for the acquisition of US West was that Qwest stock had to be trading between $28.26 and $39.90. US West had the option to terminate the agreement if Qwest stock fell below an average of $22 per share. In August 1999, Qwest stock fell from $34 to $26 per share (SEC, 2014). This was when Qwest began an ugly cycle of reporting its one time IRU sales as operating revenue. As explained above, Qwest’s primary business is not the construction and trade of optic fiber networks, therefore this should be broken out on their financial statements as non-operating income. It is important for investors to know that this is a onetime source of revenue and that if everything else remains the same, this will not become a repetitive or sustainable source of revenue. By June 2000, Qwest stock was trading above $50 per share, and the acquisition of US West was completed (SEC, 2014).
Following the acquisition of US West, Qwest senior management consistently projected double-digit earnings growth from quarter to quarter. When a company projects tremendous growth like this, and investors are confident in the company’s ability to deliver, stock prices will soar. In the beginning, Qwest was motivated to report higher revenue to ensure the acquisition of US West was successful, but if they failed, the deal fell through and Qwest was back where they started. However, after senior management officially released projections to the public, they became obligated to those numbers. For example, if a company projects revenue of $10 million dollars, and then either fails to deliver or later decides this goal was too high and $1 is more accurate, shareholders and investors will be very upset. Usually an investor that just lost a significant amount of their investment is not likely to stand idly by; after all, the point of investing is simple, to increase that investment. They are likely going to take action and look for retribution. Often this is accomplished in the form of terminating or replacing board members and top executives. With that said, the incentive for Qwest senior management to meet goals is to keep their jobs. This attitude will carry a waterfall effect throughout the company. If a CEO is at risk of losing his or her job, they will likely hold their CFO and COO to the same standard. The CFO will then increase pressure on the Controller and the Controller on their accounting staff, and so on. In this circumstance, everyone in the company is either fearful of losing their job or at least under incredible pressure to meet their projections.
At one point in an interview conducted with former Qwest employee, R. Neuberger, he confirmed that the pressure he as his fellow sales associates felt was “brutal”. The expectations to consistently meet high sales goals were overwhelming, and he feared losing his job if he was unable to meet quotas. He and colleagues were well aware of Nacchio’s “drive-by-downsizing” techniques, where Nacchio would not hesitate to let people go if he found any conduct or performance he did not agree with (R, Neuberger, personal communication, February 23, 2014).
Finally Qwest executive and other employees have incentive to meet projections because their bonuses were based directly on their ability to perform and meet these goals. “Qwest senior management ensured that company and business unit projections were met by paying bonuses to management and employees only for the periods when they achieved the target revenue” (SEC, 2014). Extra money can often cloud the judgment and ethical choices of people whether they are a top executive or a front line technician.
It 1999, it became clear to Qwest senior management that their projected growth was not realistic and that instead, it would only be moderate. Senior management then decided to sell an increasing amount of their IRUs and capital equipment to meet objectives, thus selling what was previously identified as a “principle asset” (SEC. 2012). Once again, they were reporting this as regular operating revenue and misleading investors. In the telecommunications industry this type of transaction was routine, however, it is classified as non-recurring income and is recognized over the period in which it was earned.
Once this pattern was started it couldn’t be stopped. If Qwest needed to use the sales of IRUs to achieve their goals this quarter, and projected a minimum of 10 percent growth next quarter, they needed to sell even more IRUs to stay above water. It quickly became a downward spiral effect for Qwest. Some employees even referred to it as an “addiction” and called IRUs Qwest’s “heroin” (SEC, 2014). Qwest knew this would not be sustainable, and always planned to stop this behavior, but like many addictions the problems only grew worse. On October 27, 1999, Qwest bragged that they achieved their first billion dollar quarter, and that their Internet and data services grew by more than 200 percent. Unbeknownst to the investing public, 140 percent of this and 32 percent of their total revenue was from non-recurring sales. By the end of 1999, non-recurring revenue comprised 33 percent of Qwest’s fourth quarter total revenue and 26 percent for the entire year (SEC, 2014).
It is common practice in the telecommunications industry to “swap” fiber cables or capacity. This occurs when two companies trade fiber cables that are close to the same value and are more beneficial to each other. This may occur, for example, if one company is expanding or requiring more capacity in one region, and the other is focusing on a different one. As Qwest continually sold IRUs, they found it increasingly difficult to find customers without performing some type of swap. According to GAAP, in a transaction such as this, it is a swap of capital assets with a possible non-recurring loss or gain, which is the difference between values of the assets. Capital assets are also depreciated over a life; the associated expenses are spread out over a period of time instead of recognized all at once. The issue for Qwest in this circumstance, beyond fraudulently reporting these gains as operating revenue, was that in a swap transaction where the exchange was equal, there was no gain or revenue to report at all. Against the principles of GAAP, Qwest reported the outgoing fiber cables as operating revenue and the incoming as an increase in capital asset to be depreciated over a life of 20-25 years (SEC, 2014). Fundamentally, this does not make sense. Qwest, well aware of the improper reporting, required their sales force to conduct these transactions with secret agreements and verbal assurances meant to conceal this information from the accountants. One email from a manager at Qwest referring to this stated, “By the way, we should NOT have an email chain that indicates that verbal commitments such as these were made” (SEC, 2014).
Simultaneously, Qwest was misclassifying data by ignoring GAAP principles and recognizing revenue in incorrect periods, thus perpetuating timing errors. One way they did this was by backdating contracts to recognize revenue sooner. Qwest failed to deliver fiber cables to customers in a timely manner, however against revenue recognition; they would record it as sales anyways. Qwest’s wireless subsidiary, also improperly recognized revenue of approximately $112 million by failing to adjust revenue for returned phones and phone repairs, accessories given to customer for free, and other miscellaneous billing adjustments (SEC, 2014). When this error was discovered, the CFO of Qwest’s wireless division actively hid the errors and instructed others to do the same. The lies and deceit continued as Qwest orchestrated a series of fictitious transactions and improperly recognized millions of dollars. In one such case, Qwest reported a sale of routes to Enron, who actually cancelled their order and never paid for services (SEC, 2014).
When these fraudulent activities were no longer enough to ensure that Qwest would meet their financial growth targets, senior management went even further. They began to misstate expenses in several ways. One of these techniques was to capitalize expenses. Similar to the swapping scheme, expenses were depreciated over a life, instead of reported in the period of occurrence. Alternatively, these expenses should have been reported in the period in which the associated revenue was recognized. From doing so, Qwest was able to increase their 2001 earnings by $231 million (SEC, 2014). Another way Qwest muddied expenses was by improperly deferring commission expenses, even though they did not meet deferral qualifications. They also failed to disclose their change in this policy (SEC, 2014). Finally, they altered their employee vacation expense by ignoring the standard, 100 percent accrual policy to instead only accrue for 19 percent. This decreased the accrual from $118 million to only $24 million (SEC, 2014).
Cleary, the fraudulent activity over the three years between 1999 and 2002 was extensive and engrossed many facets of the organization. Along with the examples above, Qwest continued their fraudulent behavior with the following actions: (1) improperly recognizing funds from operator services that were meant to be remitted to a third-party, (2) failure to maintain adequate reserve for billing credits, (3) including unfavorable contract costs as merger-related liabilities and (4) exerting leverage of size and power by requiring smaller vendors going public to allow Qwest executives to invest before their IPO (SEC, 2014).
Finally, the investment community and analysts began to see holes in Qwest’s financial data and questioned them on the matter. Reluctantly and under extreme pressure from the public, Qwest senior management disclosed the true revenue earned from the sale of IRU on their 2001 second quarter form 10-Q (SEC, 2014) The cat was out of the bag. Fortunately for Nacchio, he had already sold all of his own shares in Qwest. He performed all the fraudulent activities previously described in order to deceive the public and allow him to sell his stock for more than it was worth before anyone knew better. Through intensive forensic accounting investigation and discovery, it was determined that between 1999 and 2002, Qwest fraudulently recognized approximately $3.8 billion of misclassified revenue and excluded about $231 million in expenses (SEC, 2014).
The key players in the execution of the fraudulent activity committed by Qwest were CEO, Joseph Nacchio, CFO, Robin Szeliga, and COO, Afshin Mohebbi. As the leaders of the company, other employees look to them to make the “tough” decisions and to act in best interest of the company as a whole. With that being said, every employee still has an ethical responsibility to ask themselves what is right and wrong, and not blindly follow management. Therefore, some level of responsibly falls on the shoulders of any persons aware or involved in the misstatement or misleading nature of the numbers. Generally this is especially true of the accountants, since they should not only be educated in the matter, but have more accessibility and clarity to the direct effects on the financial statements. To further reiterate, all three, the CEO, CFO, and COO, had all the pieces to the puzzle, knew the exact consequences and materiality of what was being done, and not only did not stop it, but encouraged it.
The Aftermath
Due to Qwest’s negligence in regards to the discovery and prevention of the fraud committed by its top executives, Qwest was charged with securities fraud and other violations of the federal securities laws by the SEC on October 21, 2004. Charges claiming that between 1999 and 2002, Qwest fraudulently recognized over $3.8 billion in revenue and excluded $231 million in expenses (SEC, 2014). More specifically, this included fraudulent use of non-recurring revenue, fraudulent accounting for IRU and equipment sale transactions, failing to disclose in periodic filings strategic relationships vendors, misleading statements connected to directory service units, improper revenue recognition in its wireless division and understating expenses related to sales commission plans. The judgment directed Qwest to pay a civil penalty of $250 million to be distributed back to defrauded investors (SEC, 2014). Qwest agreed to pay the fine without admitting or denying guilt in their actions. The SEC also required Qwest to employee a Chief Compliance Officer (CCO), who reported to an outside committee of directors. The COO would be responsible for ensuring the company’s future compliance with federal securities laws. Several charges, and cease and desist orders were also brought against Qwest executive officers.
On March 15, 2005, after the prosecution had time to put their case together, charges were brought specifically against Nacchio for fraud and other securities violations. Later that summer, CFO, Robin Szeliga was charged with insider trading and pled guilty, admitting to having access to information not available to the public when she sold 10,000 shares of Qwest stock for a profit of $125,000. In December 2005, Nacchio was indicted on 42 criminal counts of insider trading, allegedly selling over $100 million in stock (Stanwick, 2009).
On March 19, 2007, the criminal trial of Joseph Nacchio commenced in Denver, Colorado. Former Investor Relations Chief, Lee Wolfe, testified against Nacchio, stating that Nacchio improperly projected high revenue growth levels of 15 and 17 percent, when in fact; a major source of the growth was a one-time sale of network capacity (Stanwick, 2009). Nacchio refused to testify, for fear of self-incrimination. Exactly one month after trial began, on April 19, 2007, Nacchio was found guilty on 19 of the 42 counts of insider trading. He was sentenced to six years in prison, and ordered to pay a $19 million fine and forfeit his profits on the sale of illegally sold stock in the amount of $52 million (Stanwick, 2009). After being released temporarily on bail, on April 14, 2009, Nacchio was placed in a Pennsylvania federal prison to begin his six year sentence (Vuong, 2009).
Quickly after the verdict, Nacchio appealed the court’s judgment and would later get a small victory. The federal appeals court ruled that his sentence was too harsh because the ruling judge had miscalculated Nacchio 's net gains from his sale of stock. In 2010, a judge reduced two months from his prison term and $7.4 million from the amount he was required to forfeit. In 2011, for unclear reasons Nacchio voluntarily withdrew his final appeal. This allowed the fines and forfeiture which Nacchio was mandated to pay to be released from hold in an escrow account to finally be paid to the victims. (The Huffington Post, 2011)
Due to his reduced sentence and good behavior, Nacchio was released on September 20, 2013, after spending approximately four and a half years in prison (Harden, 2013). Nacchio spent most of his sentence in two Pennsylvania facilities. These facilities were low-level security camps that did not make use of walls or bars (Searcy, 2013). Nacchio was even allowed access to emails. Although Nacchio did not succumb to what is typically considered “hard time”, he emerged fit, muscular, and with a shaved head and goatee. Some might argue that prison strengthened him up or even improved him as a person. He even compares himself to actor Edward Norton (Searcy, 2013). Although it is not clear how or why he compared himself, some may speculate that Norton had a similar appearance, bald with a goatee, in the film American History X. Interestingly enough he played an angry, racist, Neo-Nazis who was imprisoned after murdering two men, or a criminal.
Like many corporate, publically traded companies, Qwest employees were often rewarded with stock or stock options. In general, this is a great perk for both a company and its employees. The company was able to substitute some cash payments or bonuses to employees with stock, and employees received incentive to work harder. The more successful the company, the more the stock becomes worth. Not only do the employees see direct compensation for their hard work and efforts, but the company increases their vested interest in its success. It is a win-win situation; unless however, the stock prices drop drastically or become worthless altogether. In this case the company which is already losing ground takes its employees with it, creating a lose-lose situation. Many experts say this may have been a cause or at the very least a negative side effect of the dot.com bubble bursting, since many start-up companies would pay their employees almost entirely in stock options.
Qwest was no different. Employees were rewarded and incentivized with the use of stock or stock options. It was routine for Qwest to give employees shares as part of their employee savings plan (Vuong, 2012). Due to Nacchio’s security fraud and insider trading, Qwest stock prices plummeted from a $60 high to approximately $1 per share (Waters 2012). Many people lost a great deal of money during this time. Imagine if an employee and his family had saved $600,000 for their future and/or retirement in Qwest stock. After it the plummeted, they would have been left with only $10,000.
Stockholders did receive a portion of the penalties from Nacchio’s conviction, but it was nothing compared to the losses felt by so many. In the end, after his reduced sentence and forfeiture, Nacchio was forced to payback $44 million to the victims of his security fraud scheme. Reportedly there were 112,210 victims (Waters 2012). Doing the math shows that this equates to an average of $392 per victim, if there were no legal fees, taxes, or other associated costs. In one case, an 83 year old Westminster resident who owned 852 shares in Qwest, received a payment of $44.23 from the forfeiture by Nacchio (Vuong, 2012). Some victims found this to be insulting and even claimed they would simply return the check. Prosecutors, however, were quite pleased with the outcome. U.S. Attorney John F. Walsh said “I am pleased that we were able to recover more than $44 million in criminal proceeds and return it to innocent Qwest investors” (U.S. Justice Department, 2012).
According to an explanation in an interview conducted with former Qwest employee, R. Neuberger, tensions and corporate culture were uneasy under the leadership of Nacchio. Neuberger was a US West employee when the acquisition by Qwest occurred. He remained with Qwest for several years and personally experienced the backlash of the fraudulent activities by Nacchio and his team. Neuberger explained that company morale was in steady decline right when the two companies joined. He did speculate if this was because the two cultures were inheritably different, if Qwest, under the thumb of Nacchio, was not welcoming to the US West employees, or both. Regardless, Neuberger described the merger as a “cultural explosion” (R, Neuberger, personal communication, February 23, 2014).
On top of the environmental instabilities, Neuberger saw issues with leadership right away. Nacchio considered his leadership role with Qwest as a calling to be the “white knight”, here to take the reins and lead the company into a bright future. Others saw through the façade. Neuberger quickly felt something amiss with Nacchio. He blatantly describes Nacchio as “arrogant”, “cocky” and as someone who likens himself to a famous leader such as Caesar. From the first meeting Neuberger heard him speak at, and from details like the way he walked in the room, he knew Nacchio was not a man he wanted to work for. Neuberger compares scenarios in which a ship is sinking or an airplane is crashing, and the captain chooses to “go down with the ship”. Nacchio, as the top leader of Qwest, was literally the first to “jump ship” and abandon everyone. He sold his stock, while knowing his fraud would soon be discovered, and left everyone else behind. In the end, Neuberger made clear that he found Nacchio to be a “corporate sociopath” (R, Neuberger, personal communication, February 23, 2014).
After all the commotion, for all the good he preaches to do, the Denver community, as a whole, took a large blow from the fraud committed by Nacchio. Many employees were left jobless and without savings. Stockholders and investors were out billions of dollars and lucky to be able to scavenge for remnants. It has been determined that the recognized losses are likely somewhere around $12 billion (Vuong, 2012). The Denver, Colorado, and even national communities were rocked by the fact that one person could directly impact so many people and the outcome of their futures. The public’s confidence was shaken in the stability and reliability of publically traded companies, and the SEC that governed them. U.S. Attorney Walsh also said about securities fraud, “Securities fraud is a particularly insidious crime because it undermines public confidence in the financial markets” (U.S. Justice Department, 2012)
Lessons Learned
It is the responsibility of the leadership of a company to set the example for others to follow. Work ethic often trickles from the top down. If the leaders are not ethical, responsible, accountable or professional, their employees will see this and may often mimic the behavior. According to the Prosecuting attorney, Nacchio stated that “the most important thing we do is meet our numbers. It’s more important than any individual product and it’s more important than any individual philosophy. It’s more important than any individual cultural change that we’re making. We stop everything else when we don’t make the numbers” (Stanwick, 2009). While it is true that if a company consistently recognizes poor performance and numbers, it will often dissolve and fail to continue producing numbers at all; however, numbers should not be the main and only focus of the company. A company will often produce a mission statement that tells customers and other stakeholders what their main focus for success is. For example Hilton’s mission statement is “To be the preeminent global hospitality company - the first choice of guests, team members, and owners alike” (Hilton Worldwide, 2014). A mission statement may even be to achieve financial success and create the highest profit for stockholders, but it should never be achieved through lying, cheating or stealing. In this case, it is very clear how Nacchio felt about running his business; the company’s financial success trumped all other factors and should be achieved by any means necessary. This mantra spread from Nacchio to others and likely set Qwest up for failure very quickly.
Studying the case, there are several clear actions that may have prevented the fraud committed by Joe Nacchio and other Qwest executives. The most significant practice lacking was Qwest’s internal controls and policy regulation. Like many companies, most Qwest employees and stockholders likely believed that their internal controls and accounting methods were sufficient. We now know this to be inaccurate, based on the perpetrators ability to completely overstep these controls and conceal a vast number of fraudulent activities. Qwest should have implemented better practices concerning: segregation of duties, checks and balances, fraud risk assessments, internal testing of controls and policies, and more efficient use of independent auditors.
So where were the auditors? Qwest employed independent audit firm, Arthur Anderson LLP, throughout the course of their misconduct (Berman, 2002). Despite Arthur Andersons’ continued warnings to Qwest about their risky behavior towards the use of IPUs and swap transactions, Qwest ignored these warnings and continued anyways. It is the duty of an auditor to search for material misstatements of financial reports and discover misleading information for the public. If they saw warnings signs and the client refused to adhere, they should have refused to issue an unqualified opinion. Arthur Anderson failed to accomplish this with Qwest, as well as Enron, Worldcom, Waste Management, and several other large corporate accounting fraud cases. They have since closed their doors. In 2002, Qwest switched their independent audit firm to KPMG (Berman, 2002).
A major lesson learned through the Qwest case and seeing all the damage that was done, is that stealing from a corporation is not always a victimless crime like many may believe. It is common for petty fraudsters to say things like “It’s such a big company, they won’t miss it!” Sometimes this may even be true. However, after reviewing the Qwest case and learning how many people this affected, how many life savings it wiped out, and how many lives it negatively affected; there is no doubt this is not a victimless crime. It raises eyebrows to speculate what Nacchio himself believes about this.
For every negative there is usually some positive and some good did come out of the Qwest fraud case. In combination with several other high profile corporate fraud cases, the U.S. government and SEC tightened and restricted their hold on corporate responsibly and accountability. This is directly reflected in the creation of SOX legislation. SOX may inspire criminals to find other ways to commit fraud, but at least it is a giant step in the right direction and a message to those considering committing fraud.
Conclusion
On April 1, 2011 Qwest was purchased by Century Link for $24 billion.
(Vuong, 2011) The once iconic symbol that helped perpetuate the image of Denver’s growth and success is now just a piece of CenturyLink, a company based out of Monroe, Louisiana. The ex -“Qwest Tower”, is located at 1801 California Street, and remains Denver’s second tallest skyscraper, standing at 709 feet or 52 floors (The Denver Post, 2014). Many Denver locals and visitors knew this prominent building as the “Qwest Tower” thanks to its size and the massive Qwest logo displayed across the top. Today, it instead reads Century Link and is emblazoned with their large, glowing green
logo.
It would be difficult to claim that the fraud committed by Nacchio was the lone reason for Qwest’s eventual acquisition by Century Link. However, it is not farfetched to see that the scandal, at the very least, played a role. Interestingly enough, this case study began by examining the many acquisitions executed by Qwest, how they were seen as a measurement of the company’s success, and now the story ends with the acquisitions of Qwest itself. Hopefully lessons have been learned, governing bodies have honed their skills, laws have become more stringent and actions have been taken to prevent another Enron, Worldcom, and Qwest debacle.
References
Anonymous. (2003, February). Qwest Reports $35 Billion Loss In 2002. Retrieved from CRN website: http://www.crn.com/news/channel-programs/18829785/qwest-reports-35-billion-loss-in-2002.htmBerman, D. K. (2002, October). Arthur Andersen Warned Qwest About Risk of Swaps. Retrieved from The Wall Street Journal website: http://online.wsj.com/news/articles/SB1033610506150854313Crumbley, D. L., Heitger, L. E., & Smith, G. S. (2011). Forensic and investigative accounting (5th ed.). Chicago, IL: CCH.
Funding Universe. (2014, February). Qwest Communications International, Inc. History. Retrieved from Funding Universe website: http://www.fundinguniverse.com/company-histories/qwest-communications-international-inc-history/Harden, M. (2013, September). Wall Street Journal interviews 'unrecognizable ' Joe Nacchio. Retrieved from Denver Business Journal website: http://www.bizjournals.com/denver/news/2013/09/27/wall-street-journal-interviews.htmlHilton Worldwide (2014, February). Discover our vision, mission, and values. Retrieved from Hilton Worldwide website: http://www.hiltonworldwide.com/about/mission/Qwest. (2002). 2002 Annual Report. Retrieved from Beatrice Companies website: http://www.beatriceco.com/bti/porticus/bell/pdf/Qwest_AR2002.pdfSearcy, D. (2013, September). Former Qwest CEO Joseph Nacchio: Tales From a White-Collar Prison Sentence. Retrieved from The Wall Street Journal Web website: http://online.wsj.com/news/articles/SB10001424052702303983904579093173797712780Stanwick, P A., Stanwick, S D. (2009). Qwest Communications: A Case Study of Fraud and Greed. Retrieved from The Clute Institute- Journal of Business Case Studies website: http://journals.cluteonline.com/index.php/JBCS/article/view/4695The Denver Post (2014, February). Qwest Tower. Retrieved from Denver Post website: http://calendar.denverpost.com/denver_co/venues/show/6688825-qwest-towerThe Huffington Post. (2011, February). Joseph Nacchio Drops Appeal Of Sentence. Retrieved from Huff Post Denver website: http://www.huffingtonpost.com/2011/02/12/joseph-nacchio-drops-appe_n_822382.html
The United States Department of Justice. (2012, May). Justice Department Returns $44 Million to Victims of Qwest Communications Fraud. Retrieved from Department of Justice website: http://www.justice.gov/opa/pr/2012/May/12-crm-577.htmlU.S. Securities and Exchange Commissions. (2004, October). SEC Charges Qwest Communications International Inc. with Multi-Faceted Accounting and Financial Reporting Fraud. Retrieved from SEC website: http://www.sec.gov/news/press/2004-148.htmU.S. Securities and Exchange Commissions. (2013, January). Securities and Exchange Commission, Insider Trading. Retrieved from SEC website: https://www.sec.gov/answers/insider.htmU.S. Securities and Exchange Commissions. (2014, January). Securities and Exchange Commission, Plaintiff, v. Qwest Communications International Inc., Defendant. Retrieved from SEC website: http://www.sec.gov/litigation/complaints/comp18936.pdfVuong, A. (2009, April). Ex-Qwest chief Nacchio reports to prison in Pennsylvania. The Denver Post. Retrieved from Denver Post website: http://www.denverpost.com/ci_12139713Vuong, A. (2011, April). CenturyLink completes purchase of Qwest. Retrieved from Denver Post website: http://www.denverpost.com/ci_17750883Vuong, A. (2012, May). Victims of Qwest securities fraud get little back. Retrieved from The Denver Post website: http://www.denverpost.com/ci_20548197/victims-qwest-securities-fraud-get-little-backWaters Kraus-Attorneys and Counselors. (2013, January). $44 Million Returned to Victims of Qwest Securities Fraud Scheme. Retrieved from Waters Kraus website: http://www.secfraudlawyer.com/index.aspx?id=news_qwest_securities_fraud_scheme