The Trial of Joe Nacchio and the Implications for Corporate Governance

In many ways, the trial of Joe Nacchio, former CEO of Qwest, involves a retrospective on corporate governance before the adoption of SOX.

In this case, there seems little doubt that the government would never have brought the case if Qwest had disclosed at a much earlier date the dependency of the company’s earnings forecasts (disclosed publicly) on what is being labeled “one timers,” mostly transactions involving the sale of a piece of the Qwest fiber optics line. The term of art is an IRU or “indefeasible right to use.”

The government has presented testimony that as recurring revenues within Qwest failed to meet targets, the company became more dependent upon the one timers. At the same time, witnesses have testified that the IRUs were “drying up.” To the extent true, this would suggest that Nacchio knew that the company would not meet it’s growth rate and earnings forecast for the year. Eventually Qwest did in fact “take down” its public guidance and issue lower forecasts (on Sept. 10, 2001 of all dates). The Government, of course, alleges that Nacchio knew this needed to be done much earlier, at a time when he was trading in the company’s shares.

We have so far received only limited information about the role of the board of directors and the audit committee in the disclosure process. We heard from one of the directors last week, but mostly about compensation decisions. We walked through minutes of a series of audit committee meetings used mostly to impeach a witness. We will learn more when the defense puts on its case and calls Philip Anschutz, another director.

We do know this. The Board back in 2002 was not considered to be a particularly good one. In an Oct 7, 2002 article, Business Week labeled Qwest as one of the worst boards, describing it this way:

• Founder Philip Anschutz has extensive dealings with the company and sits on compensation and nominating committees. The SEC is probing whether Qwest used ''swap'' transactions to boost revenue. The compensation committee -- described as ''comatose'' by one expert -- awarded ex-CEO Joseph Nacchio an $88 million pay package in 2001, one of the worst years in the company's history. No outside director has operating experience in company's core business.

Two of the 14 directors also had connections to Anschutz’ businesses. Given that Anschutz hired Nacchio, this suggests a board that would be deferential to the CEO.  At the same time, the audit committee indicated that it relied extensively on management.  As the 2002 proxy statement described:

• It is not the Audit Committee's duty or responsibility to conduct auditing or accounting reviews or procedures. 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.

SOX significantly changed the role of the auditing committee, toughened the definition of independent director for those sitting on the committee, and strongly encouraged the use of financial expertise. Moreover, the NYSE altered the definition of independent.  One wonders whether, had these provisions been in place, Joe Nacchio would be a defendant today.