Joe Nacchio and SOX

I offer in this post some personal observations on the trial and conviction of Joe Nacchio, the former CEO of Qwest Communications, as well as some thoughts about the impact of SOX.  The Race to the Bottom has blogged the entire trial, with students or faculty attending all of the sessions. 

On Thursday, April 19, the jury found Nacchio guilty of 19 counts of insider trading (out of 42), all involving trades occurring in April and May of 2001, after the close of the first quarter.  During this time, Nacchio learned that Qwest’s “recurring revenues” (phone, internet, and data transfer) would be insufficient for the company to meet its publicly stated earnings guidance.  Despite these warnings, Nacchio reaffirmed earnings-per-share guidance and, during the same approximate time period, sold somewhere around 1.3 million shares.

A critical issue in the case concerned the failure of Qwest to disclose that its growth was dependent on non-recurring sources of revenue, a category labeled throughout the trial as “one-timers,” or Indefeasible Rights of Use (“IRUs”).  Had this information been disclosed, it is highly unlikely that the insider trading case against Nacchio would ever have  been brought.  The disclosure obligation, of course, rests with Qwest.  Why wasn’t this information disclosed?

While the trial only presented fragments of what was taking place inside Qwest, the evidence suggested that Nacchio controlled the decision not to disclose the amounts of these “one-time” revenues.  Lee Wolfe, former Vice President of Qwest’s Investor Relations Department, testified about the “Golden Rule“: Nacchio’s view that nothing should be done that harm share prices.  It was Nacchio, Wolfe indicated, who ultimately decided what would be told to investors.  And it was Nacchio who, in conversations with Wolfe about disclosing the one timers, would always ask:  “Can you guarantee me the stock price won’t go down?” 

This is not a case where the CEO manipulated internal controls or otherwise engaged in fraud on his or her own.  The non-disclosure of the “one-timers” was apparently widely known within Qwest.  The CFO and other officers inside Qwest did not stand up to Nacchio, and the audit committee was, apparently, quite deferential.  (As Qwest’s 2002 Proxy Statement indicates, the Audit Committee took the view that it did not have “responsibility to conduct auditing or accounting reviews or procedures,” and thus “relied, without independent verification, on management’s representation that the financial statements have been prepared with integrity and objectivity and in conformity with generally accepted accounting principles”).  

How about the outside auditors?  The 2002 proxy statement reveals that Arthur Andersen received about $3.5 million for audit related services and $8.3 million in tax and consulting services.  In other words, Andersen had considerable economic incentive to avoid alienating the CEO of Qwest.

SOX has changed these dynamics.  For one thing, a CFO who is too deferential confronts a 20 year prison sentence and fine of $5 million under Section 906.  The members of the audit committee have more clearly delineated responsibilities and the members must meet more stringent definitions of independence under Section 301.  The committee must include a financial expert or explain why one is not necessary under Section 407.  Accounting firms have a more arms’ length relationship with clients, a result both of provisions in SOX and an altered climate in the aftermath of Enron and WorldCom.

SOX essentially expanded the set of persons responsible for a public company’s financial disclosures.  Had these provisions been in place at Qwest during the first five months of 2001, the information about the magnitude of “one-timers,” and the effect of those transactions on financial results, may well have been disclosed.  Alternatively, the internal discussions on the matter would likely have sensitized Nacchio to the importance of the information, affecting his trading decisions and inclination publicly to restate the guidance. 

Either way, had Nacchio had the benefits of SOX, it is unlikely that he would have been convicted of insider trading.  Instead, he now faces as much as 15 years in prison for his offenses.