Friday Editorial: Thoughts about Joe Nacchio and SOX

It is ironic but Joe Nacchio sure could have benefited from SOX .  

Nacchio is alleged to have traded on material nonpublic information. The alleged information is really two different types. The first concerns the guidance issued to the public in a current report filed on an 8-K in September 2000. In that document, Qwest projected that it would earn between $21.3 and $21.7 billion for the year and compounded annual growth of 15-17% over a five year period.  The current report is here.  The projections were repeated publicly on a number of occasions by Nacchio, including in July.  The government alleges that Nacchio repeated the projections while aware that the numbers would not be met.   The second concerns the percentage of revenues that came from IRUs (sales of pieces of the Qwest fiber optics network) and other non-recurring sources.  So why wasn't the guidance "taken down" earlier and the make up of the revenue disclosed sooner? 

From the testimony, the government painted a picture of a disclosure process controlled by Nacchio.  He was, according to the closing argument of Colleen Conry, the one who had final say over press releases and who answered most questions from analysts.  Lee Wolfe, the head of Investor Relations, described what he labeled as Nacchio's golden rule, don't do anything that would make the stock price go down. 

The defense, during cross examination, often made the point that various people within Qwest could have spoken out if they believed the disclosure was not accurate.  Robin Szeliga, who served for a time as the CFO, never did, even though she expressed doubts.  The same was true of other officers, some of whom met on a regular basis with the audit committee of the board.  To the extent their story is believed (and the defense didn't), they did not second guess their boss.  And where was the audit committee of the board?  Deferring to management.  See the post here (quoting from the proxy statement filed in 2002:  "Therefore, the Audit Committee has 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 and on the representations of the independent accountants included in their report on the Company's financial statements.")

What if SOX had been in place in early 2001?  For a piece describing the governance provisions of SOX, go here. Had SOX been in place, the outcome would likely have been very different.  SOX among other things expanded the group of persons responsible for the disclosure process, both by increasing their legal obligations and by increasing the penalties for non-compliance.  They would, as Cliff Stricklin, counsel for the government would say, have "skin in the game."  In a post-SOX world, it would become much more difficult for one person to control the disclosure process. 

By requiring certification by the CFO (in addition to the CEO), and imposing stiff criminal penalties for willful violations, SOX gave the top financial officer the incentive to disagree with the top executive officer over disclosure.  Had Robin Szeliga faced a 20 year prison sentence, perhaps she would have insisted on a disclosure of the non-recurring revenues or a disclaimer of the guidance sooner. 

Had SOX been in place, the audit committee would have consisted of directors meeting a stricter definition of independent and the committee would have had greater authority over the independent auditors.  The committee would have the authority to hire and fire the auditors and have an obligation to discuss the financial statements with them.  The committee would also likely have a member with significant financial expertise (the Qwest committee in the first half of 2001 apparently did not).  The committee would have been in a better position to ask tough questions about the disclosure and, as likely targets in the event of any securities law suit, the economic incentives to pay closer attention.  They would not rely "without independent verification, on management's representation that the financial statements have been prepared with integrity and objectivity" 

Had SOX been in place, the independent auditors would have likely done a more thorough audit.  With consulting fees largely eliminated, they would have had less economic incentive to turn a blind eye to disclosure issues and problems confronted in the audit.  They would have had to "attest" to management's assessment of the internal controls.  All of this would likely have made the review more intense.    

A CEO like Joe Nacchio would probably not have appreciated the greater level of scrutiny given to his decisions.  It would have made the "golden rule" harder to enforce.  But if they had been present, they either would have ensured disclosure or given Nacchio a stronger hand in arguing that the information was not material or otherwise did not have to be disclosed.  If only that had at Qwest in early 2001.  The insider trading case against Joe Nacchio would not be taking place.