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THE EFFECTS OF THE GLOBAL CROSSING BANKRUPTCY ON INVESTORS, MARKETS, AND EMPLOYEES
THURSDAY, MARCH 21, 2002
U.S. House of Representatives,
Subcommittee on Oversight and Investigations,
Committee on Financial Services,
The subcommittee met, pursuant to call, at 10:05 a.m., in room 2128, Rayburn House Office Building, Hon. Sue W. Kelly, [chairwoman of the subcommittee], presiding.
Present: Chairwoman Kelly; Representatives LaFalce, Tiberi, Oxley, Jones, Capuano and Clay.
Also present: Representatives Slaughter and Baker.
Chairwoman KELLY. Good morning. This hearing of the Oversight and Investigations Subcommittee of the House Financial Services Committee will come to order.
I want to thank all Members of Congress who are present today, and without objection, all Members present will participate fully in the hearing. Their opening statements and their questions will be made part of the official hearing record. In the interest of ensuring proper subcommittee consideration of H.R. 3763, The Corporate and Auditor Accountability, Responsibility, and Transparency Act, known as CARTA, we are here today to examine the status of the telecommunications industry.
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We will hear from the executives of the companies, from the industry experts, and from an accounting expert at the Securities and Exchange Commission. Global Crossing's bankruptcy in January marked the fourth largest bankruptcy in the history of the United States.
It serves as an ominous warning to the financial and business community and has had far-reaching consequences. While the overall downturn in the telcom industry was a factor in the collapse, the fall of Global Crossing raises serious questions about current accounting practices, disclosure requirements, and corporate management.
Just yesterday we learned that Global Crossing did not disclose a complex communications deal, several months before the company filed for bankruptcy in January. Experts called the lack of disclosure a serious lapse by management.
An estimated 500,000 jobs have been lost in the telecom industry. Global Crossing's bankruptcy resulted in the loss of an estimated 9,000 jobs, and has caused real harm to investor confidence.
It has had an impact on my home State of New York. Statewide, Global Crossing has eliminated hundreds of local jobs, and the New York State Pension Fund lost $63 million as a result of the collapse.
How did a company that was perceived by all conventional measures as healthy, fall so far so fast? By all accounts, Global Crossing was a winner, but now we know that it was actually a financial time bomb.
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Did some top executives know that the clock was ticking and that time was running out? One thing is certain. We do know that the bomb was tossed right in the lap of employees and investors who didn't have a clue that the company was going under.
The collapse of Global Crossing calls into question, how much confidence employees, investors, and the public should have in financial information that's released by companies, particularly the pro forma financial projections. Since these pro forma statements are not required to use Generally Accepted Accounting Principles, known as GAAP Principals or GAAP Accounting, a company such as Global Crossing can massage the numbers on these pro forma financial statements, or, in other words, these pro forma statements can provide an easy opportunity to cook the books.
In the case of Global Crossing, the company's pro forma statements may have misinformed investors and employees as to the profitability and performance of the company. In an examination of Global Crossing's filings submitted last spring with the SEC, the company reported an additional $531 million in earnings in the pro forma statement, pumping up earnings by nearly 50 percent as the result of controversial swaps activities.
However, the $531 million was not included in the company's GAAP-compliant statement of earnings. Why not? Because under present required disclosure regulations, it didn't exist. It wasn't required to exist.
In addition, we need to examine the way in which companies report their swaps of indefeasible rights of use known as IRUs. It appears that swaps are being used as a quick and easy way to inflate earnings, and make a company look more profitable than it really is.
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Investors deserve accurate information and in some cases, they appear not to be getting it. We need to know how the SEC views these IRUs, since some have alleged that this accounting practice has misled investors and the companies' employees as to the true profitability of the corporations.
Other issues raised by the collapse of Global Crossing include corporate governance and responsibility, including blackout periods imposed on employee 401K plans. At the highest levels of Global Crossing, top executives were selling stock and pocketing millions before the company's collapse. Former CEO Gary Winnick, sold stock worth $734 million before the company collapsed, while this winter, employees of his company watched their savings, investments, and severance packages disappear.
The purpose of this hearing is to take an honest look at the issues surrounding this collapse. The ultimate goal is to protect workers and investors and prevent this from happening in the future through new legislation, if it's necessary.
Accounting methods, financial disclosure, and transparency and corporate governance are matters that the Full Committee is deliberating right now. I believe that CARTA provides a comprehensive solution to our concerns and will restore investor and employee confidence in company disclosures.
I would like to note for the record that we invited the President of the Communications Workers of America to testify, however, he was unable to join us due to scheduling problems. In addition, we also invited the American Institute of Certified Public Accountants to testify, but they were also unable to accept the invitation.
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Chairwoman KELLY. Unfortunately, my friend, the Ranking Member, Mr. Gutierrez, is unable to join us today, so I will now recognize the Ranking Member for the Full Committee, Congressman LaFalce, for his opening statement. Mr. LaFalce.
Mr. LAFALCE. Thank you very much. First of all, I am delighted that you are having this hearing today. I think it's very, very important, and I am pleased we have such distinguished witnesses.
Once again, investigation into the companies, most particularly Global Crossing's conduct, by the Securities and Exchange Commission and by the Justice Department have raised the specter of another major United States company that may have been engaged in very deceptive accounting practices.
While we do not yet know for certain if Global Crossing engaged in fraudulent accounting practices, there are certainly very serious questions as to whether it engaged in practices that had far more to do with meeting analysts' earnings estimates than with economic substance.
While its ultimate failure may have had to do primarily with its underlying business model, and alsoand very importantlyexcess industry capacity, Global Crossing may well have succeeded in keeping its share price inflated much longer than was justified, based upon its true value.
Global Crossing may not be alone within the world of companies or within the world of telecommunications companies. The Financial Services Committee is currently considering legislation aimed at correcting the systemic weaknesses that have become all to apparent in our financial reporting system.
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Mrs. Kelly has mentioned one of them, CARTA. That's been introduced by the Chairman and co-sponsored by many individuals in this subcommittee. There is another approach, too. While there's nothing wrong with the CARTA approach, in my judgment, as far as it goes, I just don't think it goes nearly far enough, and so I've introduced a bill, CIPA, The Comprehensive Investor Protection Act, and it, too, has been co-sponsored by a great many Members of our subcommittee and others within the House.
Some of the witnesses in our past hearings have warned that we should not overreact to the collapse of Enron and some other companies. Well, I don't think we should overreact to anything, but I don't think we should under-react, either.
The failure of Global Crossing, Enron, and so forth, is a powerful reminder that this is not just about the foibles of one or two companies, but it's about fundamental weaknesses that afflict our financial reporting system. The safegaurds intended to protect investors have been overwhelmed by the temptation for companies to sometimes cheat, but more often, overstate or obscure their financial disclosure to improve short-term results, to improve market capitalization, to meet analyst or investor expectations or analyst hype.
If we are to break out of this cycle of improprieties, I believe that we must fundamentally do a number of things. We must alter the relationship of the auditor to its client, making sure that everybody realizes that the auditor's responsibility is a fiduciary responsibility to the public.
We must strengthen corporate governance. I just think that the line between the boards of directors and the offices sometimes has been blurred, and boards of directors too often become passive puppets of officersnot always, to be sure, but too often. This is especially true with respect to audit committees, and we must provide meaningful oversight to both the accounting profession and the securities industry analysts.
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I've introduced a bill, as I've said, that seeks to do exactly that. I look forward to working with the Members of our subcommittee as we seek to learn the facts of the failure of Global Crossing and its management practices, its accounting practices, as I look forward to hearing today from other participants within the telecommunications industry to gain their perspective. And I hope that we can create a legislative response that will not simply follow the lead of either the Chairman or the Ranking Member, but a legislative response that will take each issue, issue-by-issue, and attempt to come up with a response that is the best way to deal with a particular issue, regardless of which side of the aisle it originated on. I thank the Chair.
Chairwoman KELLY. Thank you very much, Mr. LaFalce.
We turn now to the Chairman of the full Committee on Financial Services, Mr. Oxley.
Mr. OXLEY. Thank you, Madam Chairwoman, for this timely and, we hope, illuminating hearing today. It seems that each day brings us new allegations about the use or misuse of complex accounting practices that hide the information needed by the markets to assess a company's health.
When this happens to a healthy company during a period of growth, the company can work its way through it, but when the company is already experiencing a severe downturn in its business and then has its accounting question, as was the case with Global Crossing, it can be devastating.
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There are two sets of victims who get burned in this cycle: Investors suddenly receive new and damaging information about the company, and then lose confidence in it, and worse yet, the employees then lose their jobs and their pensions when the businesses turn bad and the capital markets freeze, because the good news they had about the company was not necessarily true.
While the Enron bankruptcy first brought these issues to our attention, it appears that Global Crossing, which has also declared bankruptcy, and other telecom companies accounted for key activities in a way that raises serious concerns. Employees and investors need to know whether they engage in swaps of capacity that had a legitimate business purpose or did not, and whether they were accounted for properly or in a way that just pumped up their projected cash flow and stock prices.
Global Crossing entered into these capacity swaps with a number of companies, including Qwest, Cable and Wireless, and WorldCom at a time when the entire telecom world was experiencing an excess of capacity. We need to understand how the industry's overall problems intersected with the use of those swaps.
I want to thank the CEO and CFO of Global Crossing and executives of Qwest, WorldCom and Cable and Wireless for agreeing to appear before us today to explain these issues to the subcommittee and to the American people. It is only by investigating these practices that we can help investors to base their decision upon a company's real financial condition, not just a projection released without an objective opinion by an independent party.
Page 9 PREV PAGE TOP OF DOC Just as important to my way of thinking is the desire to protect shareholders and employees from the kinds of activities that are often characterized as sweetheart deals that might have had an adverse impact on shareholder's value. Some of these practices include special treatments for loans, bonuses and pension payouts.
We need to discuss the propriety of 401K blackout periods wherein some employees are precluded from selling stock for specified periods of time. This hearing will be of enormous assistance in assuring that H.R. 3763, The Corporate and Auditing Accountability, Responsibility, and Transparency Act of 2002, or CARTA, is successful and effective.
In order for our Nation's economy to remain on sound footing and to continue its recovery and anticipated growth, it is vital for the American investor to have access to the most recent, meaningful, and accurate information possible. Good corporate governance is necessary for such an environment to exist, and that is one of the things we are seeking to accomplish by the introduction and implementation of the CARTA legislation.
Madam Chairwoman, we were pleased to have testimony yesterday from the Chairman of the SEC, who indicated very strongly, his support of our legislation and for a new way of looking at things in this modern world, particularly in the telecommunications sector. And for that, I think all of us can learn a great deal, not only from Mr. Pitt's testimony, but certainly from our witnesses today. And I thank you for the opportunity, and I yield back.
Chairwoman KELLY. Thank you very much, Mr. Chairman.
We turn now to Mrs. Jones.
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Mrs. JONES. Thank you. To Chairwoman Kelly; Vice Chairman Paul; Full Committee Chairman, Mr. Oxley; Ranking Member, Mr. LaFalce; and Members of the subcommittee, the witnesses who have come here this morning, thank you for coming.
In the wake of Global Crossing we have seen firsthand, the effects of poor corporate governance, perhaps, and financial irresponsibility, perhaps. The issues have been complicated, at best. The misdirection, finger-pointing, and complexity of personalities and accounting involved in the situation have made the root issues difficult to parse.
However, when the Gordian Knot has been tied by the Globals of the world, I think that it's best that we get back to basics and move forward to evaluate our position as a Nation with regard to corporate responsibility, governance, and ethics.
Let me first address those directly responsible for the well being of those least able to protect themselves. At a basic level, it is the role of the board of directors of any company to protect and act in the best interest of the shareholders. Protecting shareholders is a task simple enough to speak of, but seemingly infinite in its difficulty to perform.
Shareholders have no choice but to trust the board as fiduciary agents to act in their best interest, and it is because of this dependence that we must carefully evaluate what led to the down fall of Global Crossing. Second, we must examine the role that Global's corporate auditors had in effecting the company's downward spiral.
Page 11 PREV PAGE TOP OF DOC Is it more than a coincidence that Global Crossing and Enron were both audited by Andersen? Perhaps. But we are sure that both Enron and Global shared the same fate in Chapter 11 bankruptcy.
The notion of true auditor independence is at issue, and, specific to this hearing, how big of a factor it was in Global Crossing's demise, we hope to learn today.
Finally, I would like to acknowledge the employees of Global, who have often been overlooked in the media storm surrounding its once proud employer. I received several letters in my Congressional office from many of my constituents saying, why isn't Global getting the same attention as Enron? To each of my constituents who wrote to me, today we're going to address that issue.
Over 9,000 people lost their jobs as a result of the Global bankruptcy, most of which were unaware of the accounting improprieties that may have cost the company its life. The reach of the Global Crossing debacle into the telecommunications sector was deep: By some estimates over 500,000 jobs and $2 trillion in market capitalization in the sector was lost as a direct result of Global Crossing's bankruptcy.
This is reason enough why we must continue to scrutinize what happened to Global Crossing so that it will never happen again. Madam Chairwoman, I am pleased that you are hosting this hearing today. I thank everyone who has come out to testify, and I trust that we will get to the bottom of many of the issues that have been raised by both corporate leaders, by shareholders, by auditors, and by the general public. I yield the balance of my time; thank you very much.
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Chairwoman KELLY. Thank you very much, Mrs. Jones.
We turn to Mr. Tiberi. You have no opening statement at this time? Thank you, Mr. Tiberi.
We turn to Mr. Capuano.
Mr. CAPUANO. Thank you, Madam Chairwoman. I have no opening statement, because anything I said would probably be unprintable, based on this issue.
Chairwoman KELLY. Thank you, Mr. Capuano.
We turn to Mr. Baker.
Mr. BAKER. Thank you, Madam Chairwoman. I especially want to express your appreciation for your courtesy, not being a Member of the subcommittee, to allow my participation this morning.
I'll be very brief, but, I hope, to a specific point. I first want to express my appreciation for the gentlemen's appearance here today in helping the subcommittee to understand the mechanics of how this reporting difficulty occurred, and hopefully leading us to some resolution. It appears, preliminarily, that although there was compliance with the letter of the law, the letters weren't necessarily in an order that spelled anything.
Page 13 PREV PAGE TOP OF DOC In my review of the pro forma financials, even after the July 1999 1043 revisions, it appears that compliance, technically, with the warning statement, ''Read at Your Own Risk,'' sort of like a Surgeon General's warning, that if anyone wanted to get to the details of the content of corporate structure, you would go primarily to the pro forma, because there appeared to be more information than as to the GAAP standards.
It does indicate to me, at least, preliminarily, that the metrics included increasingly greater amounts of cash receipts for future sales and services that were not provided at the time of the revenue being reported, on the belief that those sales would eventually close.
In my simple calculation, that's called counting your chickens before they hatch, but there may be reasons for that conduct. Clearly, there is extraordinary pressure from Wall Street for corporations to meet quarterly expectations for cash revenues and the adjusted EBITDA, as it's called, and I can understand the pressure to generate a report that indicates that the cash is coming or is in the bank.
However, the definitions that were utilized, whether it's cash, cash receipts, adjusted EBITDA, are not apparently consistent from one telecom company to another in the methodology by which these quantities are measured or reported.
For example, a cash receipt in this instance would have been for, I believe, the sale of broad band capacity for portions of the network not yet complete. Madam Chairwoman, let me make that point. If I'm understanding the reports properly, they booked revenue in the current quarter for sale of broad band capacity for a portion of the network which was not yet constructed. I think that is something that needs to be thoroughly discussed.
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And, further, the company would incur substantial out-of-pocket expenses to fulfill these obligations at a later time, but that deduction was not taken in adjusted EBITDA. It appears that some of the transactions were actually swaps and not cash revenues, or, stated another way, money round tripped between parties that did not add value.
All of this apparently is within the context of the law, as I understand it, under the preliminary cover of legitimate business purpose, which is not a regulatory not statutory definition, but an accounting convention.
I think we need help in examining legitimate business purpose. It appears that the reporting, although consistent with rule and regulation, would lead a person to come to conclusions about cash adequacy that were entirely inappropriate in relation to the actual cash standing at the time of the report.
Madam Chairwoman, I don't have sufficient time to examine all of these questions this morning, and I would ask your further diligence, Madam Chairwoman, if I could perhaps provide more clarity with my questions in a written comment for the Chair to consider forwarding at the appropriate time, and I thank you for your courtesies.
Chairwoman KELLY. With unanimous consent.
Mr. Baker, you had mentioned that you were not a Member of the subcommittee, but you are a Member of the full Financial Services Committee, and, as such, you are welcome here at this panel.
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We turn now to Mr. Clay. Have you an opening statement, Mr. Clay?
Mr. CLAY. Madam Chairwoman, at this time, I will forego an opening statement, and wish to hear from the panel and have questions for them, thank you.
Chairwoman KELLY. Thank you very much.
Ms. SLAUGHTER. Madam Chairwoman, I thank you very much for allowing me to be here this morning. As you know, I'm not a Member of this subcommittee, and you are very gracious in allowing me to come. I appreciate the opportunity to submit my statement for the record.
And my interest in this hearing stems from the fact that thousands of people from my district have been affected by Global Crossing's bankruptcy filing. Actually, all the people in my district have been affected by it, because the economic displacement has the possibility of being quite profound.
Global Crossing's North American headquarters were located in Rochester, New York, and I hope they still are. They owned Frontier Communications which had an outgrowth from the Rochester Telephone Company, which had given wonderful service to the people of Rochester area for over 100 years. And then their 13,000 workers were taken over by Global Crossing with 220 workers.
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Now, as I said, the effect is devastating, and came as quite a surprise, as we had every indication in Rochester that Global was doing well, and, indeed, was planning to consolidate and move, and had gotten from the local IDA some $400,000 to help expedite that, on the grounds that they would immediately hire 72 new workers.
The bankruptcy came as a surprise to a lot of people because, indeed, the company still had adequate assets according to most people that I've spoken to, to continue. As a matter of fact, one of the first things that struck us as strange was that the offer for Global Crossing of $750 million was goingI think that was something like 69 percent ownership of that company, which claimed to have assets of $22 billion.
On March 9th, we hosted a public forum in Rochester, and over 250 people came to talk about their experiences, and it was heartbreaking. I'd like to quote from an article I received, written by a former employee, who summarizes the general sentiment at the forum:
''Many former employees have been economically devastated as the result of corporate greed and the mismanagement of Global Crossing. People spent their life savings, they've had to cash in their deflatedsince the stock market plummetedretirement 401K plans, just to survive the last few months, after Global Crossing abruptly ceased their promised severance payments.
''Some former employees are forced to file bankruptcy themselves, while others may lose their homes, have had to drastically change their lifestyles, and are barely surviving.'' Again, another impact on my community is that many of those extraordinarily talented and gifted people may have to leave our community altogether, because they are not able to find jobs that they can take care of their family.
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According to the press reports, there appears to be striking parallels between the cases of Enron and Global Crossing, including a lack of auditor independence, questionable executive mismanagement, misleading accounting methods, and questions on the accessibility of employees' 401K accounts before the bankruptcy filing.
And unlike the small shareholders and company workers, current and former top executives walked away the winners. This hearing begins the process of Congress asking the tough questions on how this occurred. Where did the system break down and allow this to happen?
Hearings like this will serve as a wakeup call to Congress, and, we hope, to corporate America, particularly those who are organized in Bermuda, that these types of business practices and bankruptcies can be neither sustained nor tolerated.
Additionally, current law must change to better protect the workers and investors, and, across the board, investors are now skiddish about relying on auditors' reports and analyst recommendations and that is a tragedy.
I certainly look forward to listening to the witnesses' views, their experience, and their suggestions on how Congress can take effective action, and I thank you again, Madam Chairwoman.
Chairwoman KELLY. We thank you.
If there are no further opening statements, I will introduce our distinguished panel of leaders of the telecommunications industry. We sincerely appreciate the effort that it took for you to prepare testimony on this difficult issue, and to travel here today. Mr. McGrath, you came from England, and I think you get our award for the longest traveled visitor to get here today, and for that, you get a free glass of water. I thank you all for making the effort.
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Our panel consists of Mr. John Legere, the Chief Executive Officer; and Mr. Dan Cohrs, the Executive Vice President and Chief Financial Officer of Global Crossing, Ltd. Next, we have Mr. Afshin Mohebbi. I'm pronouncing that wrong. Mr. Mohebbi, is that correct?
Mr. MOHEBBI. Yes.
Chairwoman KELLY. Thank you, Afshin Mohebbi, the President and Chief Operating Officer of Qwest Communications International; Mr. Michael Salsbury, Executive Vice President and General Counsel of WorldCom, Incorporated, and, Mr. Salsbury, we welcome you; and finally, Mr. Andrew McGrath, President of Service Providers Channel, Cable and Wireless Global.
We welcome you all here today, and we are looking forward to your testimony, and we thank you for appearing here. We begin with you, Mr. Legere.
Mr. LAFALCE. Madam Chairwoman, a parliamentary inquiry.
Chairwoman KELLY. Yes, sir?
Mr. LAFALCE. It is my understandingnot that it is necessary to tell the witnesses, but it won't hurtthe laws of perjury that obtain when you are asked to stand and be sworn in are the same, even though you're not asked to stand and be sworn in. The mere fact that you're testifying before Congress makes you fully subject to all the laws of perjury; is that correct, Madam Chairwoman?
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Chairwoman KELLY. That is correct.
Mr. LAFALCE. Thank you, Madam Chairwoman.
Chairwoman KELLY. You are still liable for your statements in front of this subcommittee, even though we are not swearing you in as witnesses. We all look forward to listening to your views on these important issues we touched on in our opening statements, and without objection, your written statements and any attachments will be made part of the record.
You will each now be recognized for 5 minutes for a summary of your testimony. There are lights in front of you and they indicate the amount of time you have. The green light signifies that you're in your first of the 4 minutes. The yellow light will turn on when you have 1 minute remaining; the red light will turn on when your time has expired. If possible, I would like to ask you to keep your summaries within the 5-minute sequence, so that people can ask questions.
And we'll begin with you, Mr. Legere.
STATEMENT OF JOHN J. LEGERE, CHIEF EXECUTIVE OFFICER, GLOBAL CROSSING, LIMITED
Mr. LEGERE. Good morning, Chairwoman Kelly and Members of the subcommittee. We prepared a longer statement, which I understand will be filed for the record. Now, this is my first appearance before a Congressional subcommittee, and I'm honored to contribute to your effort to take a serious look and a substantive look at the difficult financial issues facing the telecommunications industry.
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Our difficulties at Global Crossing and the measures we are taking as we continue our restructuring in bankruptcy, is a microcosm of an industry under tremendous economic pressure. I'm accompanied here today by Dan Cohrs, Global Crossing's Chief Financial Officer, and Ralph Ferrara, who is our outside counsel.
In response to the questions posed in your letter of invitation, we would like to respond to the three issues you raised. Dan Cohrs will respond to the first two of your questions, and I would like to provide a brief overview of Global Crossing and our efforts to rebuild our company.
My written statement amplifies on these remarks to respond to your final question, and to address steps that can be taken to enhance investor confidence in the accounting for and disclosure of financial information in the telecommunications industry.
Now, it's all too easy to dismiss Global Crossing's bankruptcy as the failure of yet another dot.com company or to attribute its collapse to fancy or misleading accounting. The media in this post-Enron environment, continue to focus on these issues.
The reality is that thousands of our employees continue to operate the real Global Crossing. Today, Global Crossing has over 85,000 customers, corporations, governments, associations, and organizations in over 200 cities in 27 countries who transmit voice and data over our global network.
Every day our employees keep coming to work, keep helping the customers keep the data moving, and keep their spirits high. I want to take this opportunity to thank them publicly and to thank our thousands of loyal customers who have supported us through this challenging time.
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A few facts about what Global Crossing really does: We transmit over $5 trillion U.S. dollars in financial transactions every business day. We connect over 7,000 financial institutions and hundreds of scientific research centers across the globe.
The Global Crossing network carries CNBC's video between Ft. Lee and London, over our high-capacity sub-sea fiber optic cables, something previously only satellites could do. NBC transported hundreds of hours of Winter Olympic news broadcasts to its affiliate stations across America over our network.
Because of our network, customers in KB Toy Stores can charge their purchases five times faster, and diplomats in over 240 British Embassies and Consulates can correspond with their colleagues, 24/7, reliably and securely. Many people who will see these hearings on television and reported on the nightly news shows, will be watching signals transmitted over our network.
Now, our pride in what we have accomplished is, of course, offset by tremendous disappointment. Although our network infrastructure is unique and unparalleled in the industry, building it came at a very high price, in excess of $15 billion U.S. dollars.
Global Crossing, like many other telecommunications companies, built aggressively as the forecasts of industry analysts, financial analysts, and technology experts predicted that our world would soon be one where classrooms would reside on computer desktops; movies would flow electronically on demand; and millions of people would be able to communicate through millions of personal channels.
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And though we continue to believe that people will one day be able to take advantage of this expansive infrastructure, the demand simply hasn't materialized as quickly as predicted. In what became a very volatile environment for the entire telecommunications industry, our company simply could not cut costs back fast enough to accommodate the sudden changes.
We need to take a more realistic approach. Part of what we're doing through the Chapter 11 bankruptcy process and through a continued series of painful cost reductions, is to restructure our balance sheet and realign our operations.
Since my arrival 6 months ago, my prime focus has been to realize the true potential of our company. With our restructuring now well underway, and despite the necessary and often painful actions we have had to take, my belief is that we will come back stronger than ever.
You asked for our views on H.R. 3763. We believe it provides a useful framework for discussions on auditing accountability, and we have offered several specific suggestions in our written testimony.
While our company and our industry continue the challenging, critical process of building the new business model in the more realistic context, we fully support the efforts of this subcommittee to develop, in parallel, ways of encouraging financial accountability that will enhance investor confidence in financial reporting in the telecommunications industry.
We have an opportunity, working together with you, with the SEC, with the accounting industry, and with our telecommunications industry colleagues here today, to improve the way we communicate. Whether this is through reformed accounting principles or clearer and more timely reporting practices, we support and intend to be the market leader, not only in how we run our business, but also in how we report on what we're doing. I'm confident, with our joint efforts, this industry, and Global Crossing, in particular, will once again be in a position to contribute strongly to this great Nation's prosperity. Thank you very much.
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Chairwoman KELLY. We turn to you, Mr. Cohrs. Do you have a statement?
STATEMENT OF DAN J. COHRS, Ph.D., EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER, GLOBAL CROSSING, LIMITED
Mr. COHRS. Yes, ma'am, if I may. Good morning, Chairwoman Kelly and Members of the subcommittee and also the Full Committee. John Legere has asked that I briefly address the accounting issues raised in your invitation to appear here.
Our industry and the accounting profession have struggled with how to adapt historic concepts of accounting for leases and real estate to purchases and sales of fiber optic capacity. Global Crossing settled upon an accounting model that our independent accountants advised was most appropriate to our business.
The accounting for the majority of our revenue, which is derived from providing voice and data services to our 85,000 customers, is not controversial. The accounting for the company's sales to other carriers of fiber optic capacity on its network raises the issue of the proper accounting for transactions known as sales of IRUs.
An IRU, which is an indefeasible right of use, is a contract like a lease, granting the right to use a fixed amount of capacity for a specified period. IRUs have been used in the telecom business for many years.
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Typically, the sale of an IRU involves an up-front cash payment of the full contract amount. However, revenue from the sale of an IRU is recorded only over the life of the lease. For example, for a 20-year lease for $20 million of capacity, only $1 million is recorded as GAAP revenue in the income statement for the first year and each year thereafter.
The other $19 million of cash paid up front on the contract is not recorded as revenue, but is recorded on Global Crossing's GAAP balance sheet as a liability called deferred revenue. Although Global Crossing has the cash in its bank account and the cash is non-refundable, it earns the revenue only over the 20-year life of the lease.
Not surprisingly, banks and investment analysts who need to assess the company's ability to service its debt were interested in our cash flow, including the amount of cash collected through IRU sales, which was shown as deferred revenue. The cash entering the deferred revenue account was not reflected in GAAP revenue or earnings.
To present a clearer picture of cash flow, two measurescash revenue and adjusted earnings before interest, taxes, depreciation and amortization, which we called adjusted EBITDAwere reported to the market to supplement our GAAP revenue and earnings. These measures included the cash from IRU sales; they were clearly defined, and we believe they were well understood by the marketplace.
Some questions have been raised about the quality of the company's disclosure respecting cash revenues and adjusted EBITDA. We are confident that Global Crossing fully and fairly disclosed the meaning of these terms in its press releases and SEC filings, and we believe that the additional information provided by these measures was useful to investors.
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The focus of virtually all the attention to Global Crossing's accounting model has been directed at how the company accounted for the relatively simultaneous purchase and sale of IRUs to the same counterparty. As the Global Crossing network grew, we and other carriers understood that it was sometimes cheaper and faster to buy capacity from another carrier than to build it ourselves.
In our case, we needed additional capacity on certain routes, redundant capacity to provide backup for potential network problems, and extensions of our network into new markets where building would not have been economic. Accordingly, we purchased IRUs for cash, as well as sold IRUs for cash, sometimes with the same counterparty.
These were two, independent transactions, each evaluated on its own merits. Nonetheless, due to the proximity in time of the two transactions, the question has been presented of whether revenue should be recognized on these sales with the purchases recorded as capital expenditures, rather than simply netting the sale and purchase amounts.
According to the accounting model that was developed and approved by our independent accountants, revenue and capital expenditures should be recognized on the two transactions, if, first, there was a valid business purpose for the asset we bought, and, second, the assets bought and sold embodied different risks and rewards of ownership.
In our case, the second test can be satisfied if the rights to the capacity sold had the risk profile of an operating lease and the rights to the capacity purchased had the risk profile of a capital lease. Today, some have raised questions as to whether the process we conducted adequately established the valid business purpose for our purchase of assets; that is, did we satisfy the first test? And that is the crux of the controversy.
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It's the subject of a detailed review by our Board of Directors and its independent counsel. The SEC and our independent accountants are also reviewing these transactions.
As we conduct these reviews, it's critically important to consider only the facts and circumstances that existed at the time the transactions were closed, not use hindsight. We now know that since the second quarter of 2001, the astounding deflation in the demand for fiber optic capacity has devastated our industry.
As demand waned in the industry, there was less need for both the capacity that we had built and for the capacity that we had purchased. These difficulties have also been experienced by others in our industry.
We hope to have fully considered conclusions on these matters in the very near future, and I'll be pleased to respond to any of your questions, thank you.
Chairwoman KELLY. Thank you very much, Mr. Cohrs.
We turn to you, Mr. Mohebbi.
STATEMENT OF AFSHIN MOHEBBI, PRESIDENT AND CHIEF OPERATING OFFICER, QWEST COMMUNICATIONS INTERNATIONAL
Page 27 PREV PAGE TOP OF DOC Mr. MOHEBBI. Thank you, Madam Chairwoman, and Members of the subcommittee. My name is Afshin Mohebbi, President and Chief Operating Officer of Qwest Communications International, Incorporated. I want to thank you for inviting me to appear today at your hearing.
Permit me to tell you a little bit about Qwest. Qwest is the fourth largest local telephone company in the United States with 25 million customers. We provide local services in a 14-state area that covers nearly 40 percent of the land mass of the United States. We have about 60,000 employees and annual revenue of more than $19 billion.
About 80 percent of our revenues, and more than 90 percent of our profits come from our local phone service. We also provide data and long distance services to businesses in 27 cities outside our 14-State local area, and we are the Nation's fourth largest long distance company.
In addition, we have about half a million high-speed internet service customers, more than a million wireless customers, and a large Yellow Pages business, and a product line that ranges from the most basic telephone service to the most sophisticated internet and data technologies available.
We're also very proud that we just completed one of the most technically trouble-free Olympics in history in Salt Lake City, where Qwest was one of the primary providers of communications services to the Olympics event.
Qwest has a state-of-the-art, worldwide fiber optic network in the United States, Asia, and Latin America and through its related company KPN Qwest in Europe. In addition to its fiber optics network, Qwest has 16 web-hosting centers that safeguard the critical data of banks, corporations, healthcare providers, and Government agencies, among others. Qwest does business with 60 percent of the Fortune 1000 companies around the world.
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Qwest's strategy in building its domestic network was to provide facilities for our own use, as well as constructing facilities for sale. Conduit, fiber, and capacity sales have paid for substantial portions of the cost of building our U.S. network.
As we completed our domestic network, we began to expand overseas. We made decisions whether to build or buy these international facilities. Based upon the analysis of time and cost, we purchased facilities to connect our network to Europe, Asia, and Latin America.
It was in this context that we entered into IRU transactions with a number of companies, including Global Crossing. The IRUs Qwest sold to Global Crossing were principally on domestic routes we built to sell. The IRUs that Qwest purchased from Global Crossing enabled us, quickly and cost-efficiently, to build our network internationally to locations that we could not otherwise serve.
An IRU is an indefeasible right of use, which is the exclusive right to use a specific amount of capacity or fiber for a specific period of time, usually 20 years or more. An indefeasible right is one that cannot be revoked or voided. IRUs are for specific point-to-point assets. IRUs are not services and are generally asset sales.
Once sold, they belong to the customer and cannot be moved without the consent of the customer. An IRU allows the purchaser to carry voice, data, video, or other traffic on that specific fiber or channel asset.
In some cases, Qwest enters into two transactions that occur at about the same time: One, to sell IRUs to companies; and, second, to acquire optical capacity from such companies. The agreements for the sale of such optical capacity are separate legal agreements that are enforceable, regardless of whether the other company performs under the separate purchase contract.
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In accounting for the purchase and sale of IRUs, Qwest complies with Generally Accepted Accounting Principles known as GAAP. Qwest's auditors review our IRU transactions in the context of reviewing our financial statements each quarter.
When Qwest sells IRUs, the customer receives the exclusive rights to a specific asset, and the risks and rewards of ownership passes to the buyer. Under the relevant accounting rules, Qwest recognizes revenue when Qwest delivers the asset, the buyer accepts it, and Qwest receives adequate consideration for those assets.
Where the purchase and sale transactions occur at about the same time, Qwest applies the more restrictive rule for revenue recognition on what the accountants called a non-monetary transaction. The revenues attributable to IRU sales that occurred at the same time as purchases of an IRU in 2000 and 2001, were approximately 2 percent in 2000 and 3.5 percent of total reported revenues of Qwest, respectively.
Qwest publicly disclosed the network expansion plans and the nature, size, and the accounting treatment of the IRU transactions undertaken to further that strategic objective. In various press releases and filings with the Securities and Exchange Commission, Qwest made appropriate disclosure of the existence of the IRU transactions and the way Qwest accounted for them.
In conclusion, as part of our business strategy to build a worldwide fiber optic network, we bought and we sold IRUs. When appropriate and in compliance with GAAP, we recognized revenue as well as costs from these transactions, when we entered into them, and although IRUs were not a material component of our revenues in the last 2 years, we publicly disclosed them and how we accounted for them.
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We're proud of the state-of-the-art network we have built and the services it enables us to provide, and I will be glad to answer any questions that you may wish to ask. Thank you for the opportunity.
Chairwoman KELLY. Thank you very much, Mr. Mohebbi.
And we now turn to Mr. Salsbury.
STATEMENT OF MICHAEL H. SALSBURY, EXECUTIVE VICE PRESIDENT AND GENERAL COUNSEL, WORLDCOM, INC.
Mr. SALSBURY. Thank you, and good morning. My name is Michael Salsbury, and I am the General Counsel of WorldCom, Incorporated. The questions and issues that the subcommittee seeks to address in this hearing, how accounting standards and Federal policies may have contributed to the problems experienced by Global Crossing and the industry are valid and important.
There has been a lot of press recently about swap transactions, whereby carriers record revenue from selling capacity that is not likely to be used, in return for a purchase of capacity that is not used and is capitalized rather than expensed. WorldCom does not participate in such transactions.
WorldCom sells IRUs and occasionally purchases them where needed, but in all cases, accounts for them appropriately. To put this into perspective, during 2001, WorldCom recorded recurring revenues of approximately $23 million out of total 2001 revenues for WorldCom of $35.2 billion from the sale of IRUs.
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During December 2001, WorldCom entered into two IRU transactions with Asia Global Crossingnot Global Crossing. WorldCom purchased needed capacity on AGC's East Asia Crossing Cable and AGC purchased capacity on WorldCom's Australia-Japan Cable.
Each transaction was for $20 million over a 10-year term. Because neither lease has yet become operational, WorldCom has not yet recognized either transaction on its P&L. As each IRU becomes operational, WorldCom will recognize approximately one-half million dollars per quarter in revenue and in operating expense over a 10-year period. Again, to place this into perspective, our 2001 revenues were $35.2 billion.
The subcommittee also asked to what extent certain factors served as a trigger for industry problems. WorldCom does not use unique accounting standards and does not issue pro forma revenue projections.
As many companies do, WorldCom issues pro forma profit and loss statements in conjunction with our regular financial statements to show the effect of acquisitions or of revenue from consolidated entities. WorldCom believes such statements assist investors in understanding the impact of certain transactions.
It has become fashionable recently to blame the large number of failures in competitive sectors of the telecommunications industry on bad planning. These claims, which generally emanate from the monopoly sectors of the industry and their pundits, but occasionally also from regulators, suggest that new entrants invested too much in new facilities and mis-forecast the demand for telecom services.
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There may well have been invalid assumptions by new entrants, but they related more to the expectation that Federal regulators would fairly and vigorously enforce the telecommunications and antitrust laws than to assumptions about consumer demand. By repeatedly favoring monopoly interests and undermining competition, these regulators increased the costs for new entrants, which led directly to higher prices and lower consumer demand for local telephone services and high-speed data services such as DSL.
The current problems in the competitive sectors of the telecommunications industry were not caused primarily or even significantly by accounting issues or assumptions about capacity utilization; rather, those problems resulted directly from the unrelenting efforts of the Bell Companies to retain their monopoly power, and the fundamental failure of the FCC and the DOJ to properly and effectively implement and enforce the law.
In WorldCom's view, those failures have destroyed far more market capitalization and robbed far more value from shareholders' investments than any accounting issues. Thank you.
Chairwoman KELLY. Thank you very much, Mr. Salsbury.
STATEMENT OF ANDREW McGRATH, PRESIDENT, SERVICE PROVIDERS CHANNEL, CABLE & WIRELESS GLOBAL
Page 33 PREV PAGE TOP OF DOC Mr. MCGRATH. Good morning, Chairwoman Kelly, Congressman LaFalce, and Members of the subcommittee. My name is Andrew McGrath, and I am the President of Cable & Wireless's Service Providers Division. Cable & Wireless is a global provider of telecommunications services, headquartered in the United Kingdom.
Cable & Wireless, with annual revenues of $11 billion, provides services ranging from local telephone services to internet backbone and web-hosting services in more than 70 countries. Cable & Wireless has been in business for over 100 years. It is well financed and has no net debt.
We are proud to have a substantial presence in the United States, where we provide IP and data services and solutions to business customers. I have been with Cable & Wireless since 1991, and currently head the Global group within Cable & Wireless that provides a broad range of services to carriers, ISPs and content owners.
I hold an engineering degree from Surrey University in the United Kingdom, and an MBA from London Business School. I have been invited to appear today to address the subcommittee's inquiry regarding telecommunications capacity transactions, typically called Indefeasible Rights of Use, or IRUs.
The nature of the telecommunications industry makes it essential for carriers to contract with each other to provide services to their respective customers. It is not always cost-effective for a carrier to build all aspects of its global network for its own exclusive use.
Page 34 PREV PAGE TOP OF DOC It has been a long-established industry practice for carriers to interconnect with other carriers and to purchase network capacity from other carriers, either through leases or IRUs. Cable & Wireless has undertaken IRU purchases for the purpose of obtaining the network capacity necessary to support its customer requirements.
Our internal governance policies are designed to ensure that, in each case, our acquisition of capacity serves a legitimate commercial need. Cable & Wireless has also sold network capacity to other carriers.
These IRU sales are a very small part of Cable & Wireless' business. At their peak, in the year ending March 31, 2001, such sales accounted for less than 5 percent of Cable & Wireless' revenues and have since declined as carriers have largely completed their network build-out programs.
In building its global network, Cable & Wireless has purchased capacity from several operators. A small proportion of these transactions has been with Global Crossing. As always, the network capacity we obtained through these transactions served specific commercial needs.
Cable & Wireless states its accounts in accordance with Generally Accepted Accounting PrinciplesGAAPas adopted in the United Kingdom, as it must do as a U.K. public limited company. As an additional disclosure, Cable & Wireless separately reports the amount of its IRU sales.
Our accounting policies with regard to the treatment of such transactions are disclosed as part of our financial statements and are readily available to the public. Because Cable & Wireless ADRsAmerican Depository Receiptstrade on the New York Stock Exchange, it also discloses its financial results in SEC Form 20-F.
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For these purposes, Cable & Wireless states its results, including IRU transactions in accordance with U.S. GAAP. A reconciliation of the net income under U.K. GAAP and that under U.S. GAAP is disclosed as part of our financial statements and is also readily available to the public.
Thank you for the opportunity to appear today. I welcome any questions from the Members of the subcommittee.
Chairwoman KELLY. We thank you, Mr. McGrath.
One of the issues that I'm most concerned about here is the issue of the pro forma financial statements by telecommunications companies. I'd like the entire panel to respond to my first question, and I'd appreciate it then, if you will, answer my followup questions.
I'd like to know how common pro forma financial statements are in your industry, and we will begin with anyone who wants to start the answer, but I'm going to ask each one of you to answer that. Mr. Cohrs, Mr. Legere?
Mr. COHRS. Yes, Ms. Chairman. My understanding is that in the industry, the use of pro forma statements is relatively common for the purposes of explaining the impacts of merger and acquisition activities, so that the presentation of pro forma statements can provide an apples-to-apples comparison from one period to the next when a significant number of companies have been either bought or sold by the company. And, in fact, I know that Global Crossing has used that to provide fair comparisons between one quarter and the next.
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I believe that your question probably refers to the use of measures like cash revenue and adjusted EBITDA, which are pro forma measures, and those measures became common as the industry of selling fiber optic capacity developed. It's a new industry.
I indicated in my opening remarks that there's a big divergence between the cash coming into the company and what's reflected in the GAAP statements, that is, in my example, $20 million IRU sale only is recorded as $1 million of revenue, even though the cash is in the bank and non-refundable. And so in our case, we adopted the practice of using pro forma measures to supplement our GAAP reporting so that we were showing investors the full picture of cash in addition to the GAAP picture.
Now, that practice was adopted by a number of other companies who went public after Global Crossing. Global Crossing was essentially the pioneer among publicly traded companies in the sub-sea business, and therefore, I believe we were the first to use those particular measures, and they were adopted by others in the industry after that.
Chairwoman KELLY. Mr. Mohebbi.
Mr. MOHEBBI. Madam Chairwoman, in terms of Qwest, the primary reporting vehicle that we have is GAAP revenues and GAAP accounting. However, Qwest is a company that was created as a result of six acquisitions, so sometimes as a supplement to our GAAP reporting, we provide, for the purposes of the investors who have specifically asked for it, pro forma numbers as a supplement, but our purpose, our main purpose of reporting and way or reporting our results are GAAP financials.
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Chairwoman KELLY. Mr. Salsbury.
Mr. SALSBURY. I think I would sort of reiterate what the others have said.
Chairwoman KELLY. Well, the others said two different things, sir, I'm sorry.
Mr. SALSBURY. Right. As I said in my testimony, our primary method of conveying our financial results is GAAP accounting and our regularly reported financial statements. Occasionally, as noted earlier, I think by Mr. Cohrs, we have obviously had acquisitions, and it's useful to supplement our financial statements with pro formas showing the effect of acquisitions over time, so that you have an apples-to-applies comparison.
Most companies, not just in telecommunications, do this. I certainly have been reading about occasions where companies have not done this. I was reading the paper this morning, and that's been criticized, because it gives a misleadinglooks like companies are growing faster, when you don't show the effect of acquisitions.
We also have an investment in Embratel in Brazil, and it's not a consolidated entity, but it's often useful to show, with a pro forma statement to our investors, the effects ofa pro forma statement, with Embratel and without. So those are the two examples I'm aware of. I'm not an accountant, and I don't pretend to know every single instance that the company may have used them, but we do not use pro forma revenue statements.
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Chairwoman KELLY. Thank you.
Mr. MCGRATH. Cable & Wireless provides a full disclosure of its accounts, consistent with U.K. GAAP. In addition, we provide separate disclosure of all IRU transactions. Our accounts are audited by KPMG, who have always provided an unqualified, clean audit report.
We find that with that level of disclosure, that we don't need to provide pro forma statements, and we haven't done so.
Chairwoman KELLY. Thank you. Mr. McGrath, you were saying that you do not file pro forma statements; is that correct?
Mr. MCGRATH. That is correct.
Chairwoman KELLY. Just for clarification, could you all just answer with a simple yes or no, did all of your companies file pro forma statements last year.
Mr. SALSBURY. I don't know the answer.
Page 39 PREV PAGE TOP OF DOC Chairwoman KELLY. Mr. Mohebbi.
Mr. MOHEBBI. I believe we did, but I'm not sure of it.
Chairwoman KELLY. Mr. Cohrs.
Mr. COHRS. Yes, we did.
Chairwoman KELLY. Do you all know if you all used the same methodology, if you filed pro forma statements?
Mr. COHRS. I just can't speak to any other companies' statements. I haven't studied them, so I just don't know the answer to your question.
Chairwoman KELLY. Do any of the rest of you know the answer?
Mr. MCGRATH. No, ma'am.
Chairwoman KELLY. So you don't know if there is a consistent methodology in preparing a pro forma; is that correct? I'd like an answer from the three of you, since Mr. McGrath doesn't have a background in the pro formas.
Mr. COHRS. Well, if I may respond?
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Chairwoman KELLY. Yes, Mr. Cohrs.
Mr. COHRS. The objective of a pro forma statement can serve various purposes. For example, if the pro forma statement is designed to normalize for the results of merger and acquisition activity, then the methodology, I believe, is relatively consistent across companies, because it's an attempt to show apples-to-apples comparison, as if that merger had not happened.
In the case of measures like cash revenue and adjusted EBITDA, as I said, I just don't know the details of other companies' disclosures, and so I'm just not aware if there are any differences. I believe that the measures are, you know, relatively similar, but I'm just not aware if there are differences in reports from other companies.
Chairwoman KELLY. Mr. Mohebbi, do you have any knowledge of that?
Mr. MOHEBBI. Madam Chairwoman, I certainly have no knowledge of how other companies, obviously, report on the pro forma basis, so I cannot say that there is a uniform or a non-uniform way. I do know that in some cases, again, as an appendix or a supplement to our GAAP reporting, which is our primary reporting of revenues, profits, and activities financially, we have provided pro forma to show the investors the differences between before and after acquisitions, but I can't give you an answer on an industrywide basis or multi-company look.
Chairwoman KELLY. Mr. Salsbury, is it safe to assume that your answer would be similar?
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Mr. SALSBURY. Yes.
Chairwoman KELLY. I guess the nature of my question is, the investing public will look at a pro forma and try to make some sense out of it. And if the pro formas are not based on the same types of procedures, the same type of methodology, it would be very difficult, if you wanted to invest in the industry itself, to determine between companies, which company had a better pro forma, if there is no structure that's a solid methodology underneath each one of the pro forma statements. Would that be a correct statement? And you can just answer quickly by saying yes or no.
Mr. LEGERE. I think inherent in your statement is that the answer would have to be yes. I mean, when we were reviewing H.R. 3763 and looking at some of the things that the industry could benefit from, one item is that at times when an industry is going through revolutionary change, as opposed to an evolutionary process, sometimes accounting or information disclosure could use some assistance from an otherwise staid set of rules.
And, you know, in the period we're talking about, this may have been an environment where some governing body could have enhanced the ability for the industry to have consistency in understanding so that this transparency that you speak to could be attained.
Certainly we look to our individual sets of auditors to provide us guidance from an industry expertise standpoint, but looking forward, I think we would all benefit from some knowledge about industry standards, things that we could apply to ensure that our information would be consistently viewed.
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Chairwoman KELLY. OK, thank you. I am out of time. I am turning now to Mr. LaFalce.
Mr. LAFALCE. Thank you very much, Madam Chairwoman. Mr. Legere, first of all, thank you for coming to my office before the meeting. I'm sorry we didn't have more of an opportunity to discuss the issues.
I have the honor of representing over 90,000 in Monroe County and all of the almost 45,000 people in Orleans County, most of whom are serviced by Global Crossing, formerly Frontier, formerly Rochester Telephone. In this morning's Rochester Democrat and Chronicle, Mr. Legere, there's an article on the business page, entitled ''Ex-Frontier Group to Bid on Global.''
It is written by Richard Mullins, and it says ''A Rochester group of former Frontier executives wants to buy a major part of the now-bankrupt Global Crossing. Leading the group is Anthony Casara, the former President of Frontier's Carrier Services Division. Also involved is Louis Massaro, the former Chief Financial Officer of Frontier. 'The group knows the business, the customer requirements, the infrastructure, and we understand how to realize its underlying potential with the right strategy,' said Casera. 'I believe there isn't a management team better suited for this opportunity than the team who originally built Frontier's North American business.' ''
Mr. Legere, as the ranking Democrat of the Financial Services Committee, I just want you to know that I strongly endorse, support, the effort by this local group of Rochester businessmen to repurchase that portion of Global Crossing. And I know that this is a business judgment that you, under the auspices of the Bankruptcy Court, will have to make, but I hope that our judgments will coincide. Fair enough?
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Mr. LEGERE. Congressman, we know these individuals. They're fine telecommunications people, and at this point in time, as part of the Chapter 11 restructuring process, we are engaged in period of time where any interested bidder can come forward through our advisors, the Blackstone Group, and make a proposal that they believe can maximize the return to all constituents who have a piece of the estate. And we look forward to seeing their proposal, along with, right now, over 40 interested parties that have gone to the point of non-disclosures to look further at the company. So, we certainly look forward to it.
Mr. LAFALCE. I appreciate that there are 40 bidders. I also appreciate the fact that these individuals are from Western New York; they're from Monroe County, in particular. They are the ones who originally built Frontier's North American business; they are the ones who are most likely best suited to enhance the future prospects for the company, its employees, the community in which it exists, and I think that that should be given great, great weight.
Now, Mr. Legere, I have about 20 questions, and I'm not going to be able to get through more than a few of them. And so I am going to submit them to you in writing, and ask you to respond for the record to each of them. Would you be willing to do that?
Mr. LEGERE. Anything that can be provided to our counsel, I'll be glad to do that.
Mr. LAFALCE. We will do that.
Page 44 PREV PAGE TOP OF DOC Chairwoman KELLY. If the gentleman will yield.
Mr. LAFALCE. Yes.
Chairwoman KELLY. Its my intention to hold the record open for 30 days. There are Members who are unable to be here today, and we will hold the record open for written questions and written answers to be inserted into the record, thank you.
Mr. LAFALCE. I thank the Chairlady for that.
Sir, it's my understanding that the auditor was hired by Global Crossing to become the Executive Vice President for Finance; is that correct?
Mr. LEGERE. Joseph Perone, who is currently our controller of the company is a former Andersen employee; that's correct.
Mr. LAFALCE. OK, well, did the Audit Committee ever think that this might compromise the independence of the audit to have the CFO, the former partner in charge of the audit from the auditing firm?
Mr. LEGERE. This hiring took place before I arrived, but it is my understanding that those were considered by the Audit Committee.
Mr. LAFALCE. OK, well, do we know if the Audit Committee ever spoke with the auditor out of the presence of the corporate officers? Do we know that?
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Mr. LEGERE. I'll defer to Mr. Cohrs, who was there.
Mr. COHRS. Yes, Congressman, our Audit Committee had the practice, at each Audit Committee meeting, which were held regularly, of asking the senior executives to leave the room and to speak privately with the auditors.
Mr. LAFALCE. For 5 minutes? Was this done regularly? Was it done in-depth? Did they spend a half a day going over the various books, or was this just a pro forma thing?
Mr. COHRS. Well, since I wasn't in the room, I actually don't know the content of the conversations, but that was the purpose of asking me to leave the room.
Mr. LAFALCE. About how long did these meetings usually last, when you weren't in the room?
Mr. COHRS. It was done regularly.
Mr. LAFALCE. But about how long did they last?
Mr. COHRS. I would say that they lasted anywhere from 10 minutes to an hour. And they were done regularly at every meeting of the Audit Committee.
Mr. LAFALCE. OK. My point is, very often the Audit Committeethat's a superficial meeting. Let me go on to two other areas, securities analysts and attorneys:
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When representatives of Global Crossing met with securities analysts, did they ever ask you or your colleagues about these swap transactions or your pro forma presentations? Did they have any questions about them?
And who were these security analysts, especially those that were hyping the Global Crossing stock?
Mr. COHRS. Yes, Congressman, we had regular contact with securities analysts, and since the beginning of the company, there were
Mr. LAFALCE. Did they ever question the swap transactions or your pro forma presentations?
Mr. COHRS. We had discussions about swap transactions, so-called swap transactions, which were
Mr. LAFALCE. Did they ever challenge the so-called swap transactions?
Mr. COHRS. They asked questions about the transactions, and we explained to them, actually, an explanation which is very much the same as was in my opening remarks, which was that these were independent transactions, separately negotiated, and that the proper accounting for the transactions was not to account for them as swaps. And we explained the economic reason for buying the assets and for selling the assets. We did have those discussions with securities analysts.
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Mr. LAFALCE. Well, I'm going to be going into the economic reasons for buying and selling at considerably greater length. I can't do it now; I don't have time. But I'm going to question the so-called economic rationale.
What was the role of your outside counsel in reviewing your public disclosure, outside a formal capital-raising scenario, and did they look at your 10K before it was filed? Did they look at your 10Qs?
Mr. COHRS. Our outside counsel reviewed all of our filings, and they reviewed our earnings releases, as well as all of our SEC filings, and all of the filings that we made in the process of the public securities offerings that we did. Those filings were reviewed by our outside counsel and by our outside auditors at some length.
Mr. LAFALCE. Let me just tell you what I'm getting at right now. I think it's imperative that we look at the propriety of the actions of corporate officers, who I have a lot of questions about, because so often their salary is based upon their stock optionsor their compensation is based upon their stock options, and, therefore, they have a tremendous interest in enhanced market capitalization.
The same thing is true with respect to the audit committees, and then the accounting firms have their own conflicts. And the primary focus has been placed upon the auditing profession, but I think we need to put much greater focus, too, on the securities industry and the quality of their analysis.
Page 48 PREV PAGE TOP OF DOC Most investors don't look to what's said by corporate presidentsthey expect pufferyor even the boards of directors or even the accountants. And most investors don't look at your statements, your 10Ks, your 10Qs, your financials, your pro formas; they look to the recommendations of the securities analysts.
And so I really think we need to focus in on them more, because I think that sometimes there's an awful lot to be seen that wasn't seen and conveyed by the securities industry. And also there's a fiduciary responsibility on the part of attorneys, too, and attorneys hired by a firm should not be in the business of giving firms advice and counsel that the firm wants to hear, but they should be in the business of giving companies the advice and counsel that they need to hear. And I don't know that that has been done.
My time has expired, Madam Chairwoman. I appreciate that. I will submit the balance of my questions in writing.
Chairwoman KELLY. Thank you very much, Mr. LaFalce.
We go to the Committee Chairman, Mr. Oxley.
Mr. OXLEY. Thank you, Madam Chairwoman.
Mr. Legere and Mr. Cohrs, in his letter to the Global General Counsel on August 6th, Mr. Roy Olafson asserted, among other things in his letter, that the terms that the company used do not really mean what you said that they mean; that there were amounts included in the cash flow definitions that shouldn't have been included, and that although Asia Global Crossing was a global subsidiary, it defined and calculated its cash flow differently.
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Can both of you address the points made in Mr. Olafson's letter?
Mr. COHRS. Yes, Congressman, the first question had to do with an allegation that the measures that we reported were somehow not what we claimed them to be. The pro forma measures, the cash flow and adjusted EBITDA, were very precisely defined in every one of our filings. Our press releases and our SEC filings defined exactly what these terms meant.
In fact, the origin of cash revenue and adjusted EBITDA was in our loan covenants. The bankers who were lending money to the company designed the loan covenants using adjusted EBITDA, and so these were very well understood by the banking community as representations of cash flow. The definitions were precise and they were well understood by the banking community and by the securities analyst community.
Mr. OXLEY. So, there was really full disclosurefrom your perspective, there was full disclosure and transparency going forward with that issue?
Mr. COHRS. We believe there was.
Mr. OXLEY. Let me ask you also, in this complaint, Mr. Olafson referred to swaps of about $100 million in capacity between Qwest and Global in each of the first two quarters of 2001, but that each company accounted for the transactions differently, despite having the same outside auditor.
It's not clear from your quarterly statements if that is true. Did the swaps actually happen?
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Mr. COHRS. We did transactions with Qwest and, you know, we had transactions, capacity transactions, with Qwest. We accounted for them in the manner I described in my remarks, and I just couldn't comment on any accounting practices at Qwest.
I would say that the accounting treatment for any transaction depends on the facts and circumstances of that transaction, and accounting treatments can differ, based on different facts and circumstances, but I certainly couldn't comment on how Qwest did any accounting.
Mr. OXLEY. Mr. Mohebbi, would you care to comment on that?
Mr. MOHEBBI. Congressman Oxley, again, we did transactions with Global Crossing in 2001. The specific amount is not exactly $100 million, as you indicated. However, the transaction involved Qwest buying capacity, international capacity that we needed to build our business strategy, which was to expand our international network.
And we had a number of bids from, if I'm not mistaken, three different providers, and Global Crossing's terms and conditions for those purchases were deemed to be the best, and we purchased those assets from Global Crossing.
Mr. OXLEY. Do you recall who the other bidders were?
Mr. MOHEBBI. I don't exactly recall, but I believe that there were a number of providers in this particular transaction who I believe were in Asia, and I believe that there are a number of providers in Asia that have the capacity where we wanted it, and we received bids from them. But I don't remember the specific names, Congressman.
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Mr. OXLEY. Was that a common practice, to bid that out and to have a competitive arrangement for that capacity?
Mr. MOHEBBI. As an internal process in Qwest, again, as we are buying capacity, part of the process is to look at the market-based pricing and see what other providers have as price. So that's one of the conditions in the process for reviewing what the winning proposal looks like, Congressman.
Mr. OXLEY. Are you able to supply for the subcommittee at a later date, the identification of the other bidders?
Mr. MOHEBBI. I will be certainly happy to go back to our files and look at the information that we had on those transactions.
Mr. OXLEY. I would appreciate that.
Let me ask actually all of you on the panel, in Mr. Legere's testimony, he said that the IRUs did not play a significant role in Global Crossing's problems, but have the revelations about the cash flow presentations of a number of telecom companies has that led to a loss of confidence by the investing public? Or what has happened with the overall perception of stock in the telecom sector, and has this led to a lack of support and confidence in that sector by the investing public? Anybody?
Mr. SALSBURY. Congressman, let me just take a crack at it. I do believe that theas I mentioned in my testimonythat some of the policies that have been followed by the FCC and the Department of Justice clearly have had a negative impact on the results of companies in the competitive sector. And I think that has led, with a combination of other events like the downturn in the economy last year, and so forth, to having poor results. And I think that has led to the sector somewhat being out of favor. I think accounting issues are a relatively small part of it.
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Mr. LEGERE. Congressman, if I could just add that I think there is a cause-and-effect situation. I'd just like to go back to some of my initial comments. The bankruptcy of Global Crossing is not the reason for the loss of 9,000 jobs. The 500,000 jobs that have been lost in the industry are indicative of an industry that has for a period of time, going across the board, pretty significant declines in market capitalization, because many companies in the sector found themselves over-capitalized, needing to reduce costs significantly, just to survive. So the restructuring that Global Crossing has gone through, which unfortunately led to a Chapter 11 restructuring, is similar to what the entire industry has gone through, and, I believe, you know, needs to go through in order to prepare itself for, hopefully, the return to normalcy of the industry.
But certainly that has been a period of shareholder concern, not only about the situations of reporting, but about the industry and the ability to make returns on the significant amount of capital that has been put into the industry over the last several years.
Mr. OXLEY. So it isat least the perception by the layman would beand I think you touched on itthat over-capacity in that sector really caused the downturn and the ultimate loss of confidence in the market; is that correct?
Mr. LEGERE. Well, it's important to note that the perception of over-capacity is just as damaging in customer purchases as real over-capacity, because, in effect, carriers who are larger purchasers of capacity, will delay purchases in anticipation of huge amounts of increase in capacity, which generally will lead to significant price declines.
Page 53 PREV PAGE TOP OF DOC So we have, at least as a minimum, a perception of an over-capacity of supply, globally. There are differing opinions, including this morning's USA Today, which are presenting information that suggests that the capacity and the supply of fiber optic capacity may not be as over-supplied as perceived.
But, I think we did have a time in the industry where demand was suppressed, because of a perception, at a minimum, of over-capacity, and, therefore, the value of the investments made by many players in capacity was, and still is, suppressed.
Mr. OXLEY. And do other witnesses share that same view, from the other companies?
Mr. MCGRATH. Yeah, I think, from my perspective in Cable & Wireless, I think that one of the visible signs that the industry is becoming extremely competitive is that companies start to fail and exit the market.
I think that's a very visible sign which is seen by shareholders, and it will affect confidence. It's a visible sign that there has been potentially over-supply, real or perceived; that the shareholders will see that and will demand increased scrutiny and be more conservative about investing in the sector. I think the simple answer to your question is yes.
Mr. OXLEY. And that's not necessarily a bad thing; is it?
Mr. MCGRATH. I think increased scrutiny, greater understanding in detail and the reality of business plans being understood is probably a good thing.
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Mr. OXLEY. I think that's been shared, Madam Chairwoman, by other witnesses that we've had in Mr. Baker's subcommittee as well as yours, that perhaps after all of this, we will have learned some valuable lessons in the marketplace, and that, indeed, markets can be very punishing, perhaps even more so than the Government as we work our way through some of these difficult problems. I thank the Chairlady for her indulgence, and I yield back.
Chairwoman KELLY. Thank you, Mr. Chairman.
Mrs. JONES. Thank you, Madam Chairwoman. There are so many questions I want to ask that 5 minutes won't allow me, but let me try and get started.
Mr. Legere, in an article around the time of the filing of the bankruptcy of Global Crossing, you're quoted as saying: ''Ours is a balance sheet issue, not an operational one. Today's actions are intended to directly address this issue. Even with financial uncertainty, we've recently experienced that customers have continued to choose our network over many others.'' And it goes on and on and on.
But, I want to go back to ''ours is a balance sheet issue, not an operational one.'' Would you be a little more specific and tell me what you meant?
Mr. LEGERE. I'd be glad to. When I became the chief executive on October 3rd, I immediately started a process of refocusing the company, lowering its cost structure, and significantly preparing it to do what every family in American needs to do, which is live on existing means.
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We have over $3 billion in service revenue, and I had prepared the company to start to generate enough cash to service its operating capital expenditures. The issue we have is, we were paying between $2 and $3 million a day on interest to service our debt. And that debt burden was just too large for us to be able to, as a young company, to be able to create the underpinnings of an organization and operations to support that debt.
Mrs. JONES. Thank you. Now, however, the debt was not so large as for them to pay you. How much did you receive to become the CEO of Global Crossing?
Mr. LEGERE. I think my salary is public information.
Mrs. JONES. I asked you, what did you receive, sir?
Mr. LEGERE. My salary is $1.1 million a year.
Mrs. JONES. And you received a signing bonus, also, sir?
Mr. LEGERE. I had a $3.5 million signing bonus.
Mrs. JONES. And in another article, there is a young lady by the name oflet me see if I can find her name real quickly. I just had it clearedah-hahoh, here she goesa Ms. Hinton said that: I was required to takeher severance pay in spread-out payments, rather than a lump sum. Note that all of her medical benefits were terminated, all of her 401K retirement plan was held for more than 30 days. Is that a correct statement, sir?
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Mr. LEGERE. I'm not familiar with the situation.
Mrs. JONES. Well, assume its a correct statement for purposes of this question. The employees of Global Crossing weren't able to receive a lump sum payment to pay their debts. They weren't able to receive any medical benefits, but what did you tell me your salary was, again, sir?
Mr. LEGERE. My salary is $1.1 million.
Mrs. JONES. And you got a signing bonus of how much?
Mr. LEGERE. $3.5 million.
Mrs. JONES. And if Ms. Hinton made $79,000 a year, how many Ms. Hintons could you have paid or could your company have helped with the $3.5 million bonus that you received, sir?
Mr. LEGERE. Well, first of all, you know
Mrs. JONES. My question is, how many Ms. Hintons could you have helped if you had paid
Mr. LEGERE.tremendousfor the issues
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Mrs. JONES. Hold on a second. I asked a question.
Mr. LEGERE. And I also
Mrs. JONES.and you give the answer.
Mr. LEGERE. I also believe that my pay
Mrs. JONES. Sir, Mr. Legere, stay with me, sir. My question is, how many Mrs. Hintons could you have helped or paid if they made $79,000 a year, with your $3.5 million bonus?
Mr. LEGERE. As a rule, I don't do math in public.
Mrs. JONES. Well, as a rule, would you pull out a calculator and do it for me, please?
Mr. LEGERE. Well, I don't
Mrs. JONES. I mean, I don't wantI'm trying to be real clear in my questions, and I'm not looking for smart answers, sir. You're here to help Congress come up with some decisions about how they handled this situation, Mr. Legere.
Mr. LEGERE. I understand.
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Mrs. JONES. And I do not appreciate the quirk.
Mr. LEGERE. I certainly understand as well
Mrs. JONES. And I hope you will apologize.
Mr. LEGERE.That there's a difficulty in trying to understand the complexities of a Chief Executive Officer in a turnaround situation of a major telecommunications company. To believe that anyone would have those skills is an understatement of the complexity of the task that we face.
Mrs. JONES. Mr. Legere, I don't believe that's what I said. I merely asked you, how many Ms. Hintons could you have helped with your $3.5 million, and seeing how you don't choose to do my math, let me proceed.
Is Arthur Andersen still your auditor, sir?
Mr. LEGERE. Yes, they are.
Mrs. JONES. And you've chosen to stick with them, even amidst all that's been going on; is that a fair statement?
Mr. LEGERE. Yes, we have.
Page 59 PREV PAGE TOP OF DOC Mrs. JONES. Can you give me a statement as to how much information is provided to your Audit Committee from Arthur Andersen, and are they serving also as consultants in addition to auditors?
Mr. LEGERE. I'll defer to Mr. Cohrs on that question.
Mr. COHRS. Well, on your first question, Congresswoman, we provide all of the information that we need to provide to the auditor and all the information that they request. And so they have full access to any information that they need to do their audit.
The second question is, have we used Arthur Andersen as consultants? Yes, we have.
Mrs. JONES. But are you using them currently as a consultant, sir?
Mr. COHRS. We have some consulting engagements. For example, Arthur Andersen has helped us collect the information required, which is a massive amount of information, to prepare our bankruptcy filings.
Mrs. JONES. Are they still your auditors, sir?
Mr. COHRS. Yes, they remain our auditors today.
Mrs. JONES. Are you aware, Mr. LegereI'm going to go back to himthat of the question in the industry with regard to the impropriety, ethically, of having auditors as both accountants and consultants? And I'm going to terminate in this area, Madam Chairwoman, if you'll allow me.
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Mr. LEGERE. I don't believe there is any impropriety associated with the roles that Andersen is playing in our company.
Mrs. JONES. That wasn't the questions. I said, are you aware, sir, in the industry, the concern about an auditor serving both as an auditor and as a consultant?
Mr. LEGERE. I'm aware of it from the standpoint that I reviewed H.R. 3763 and understand that it's one of the issues that is potentially going to be addressed, so, in that sense, I do understand.
Mrs. JONES. And you just did tell me, sir, that you have all these great qualifications to be a CEO, and so forth, in the industry, and that's why you were paid $3.5 million?
Mr. LEGERE. The pay was decided by the Compensation Committee with outside experts; the Committee offered me to take on the role.
Mrs. JONES. The point I'm trying to make to you, sir, is, right now, in these United States, there are investors and shareholders, and employees out here who are concerned about auditors serving both as auditors and consultants, but that doesn't appear to be an issue for your company; is that a fair statement, Mr. Legere?
Mr. LEGERE. In my understanding, I don't believe there's anything improper in the roles that our auditors are playing inside of our company.
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Mr. OXLEY. [Presiding] The time of the gentlelady has expired. The gentleman from Massachusetts, Mr. Capuano.
Mr. CAPUANO. Thank you, Mr. Chairman.
Mr. Legere or Mr. Cohrs, whoever is appropriate to answer, has your company ever received a qualified audit?
Mr. COHRS. I'm sorry, Congressman, are you referring to a qualified audit?
Mr. CAPUANO. Has your audit ever come back with a qualification?
Mr. COHRS. No, it has not.
Mr. CAPUANO. Has it ever had a disclaimer?
Mr. COHRS. No, it hasn't.
Mr. CAPUANO. Has it ever had an adverse opinion of any kind?
Mr. COHRS. No, our audit opinions have been unqualified.
Page 62 PREV PAGE TOP OF DOC Mr. CAPUANO. Thank you. Mr. Mohebbi, relative to Qwest, have you ever had a qualified report?
Mr. MOHEBBI. I'm not aware of one, Congressman.
Mr. CAPUANO. Have you ever had a disclaimer of any kind or an adverse opinion of any kind.
Mr. MOHEBBI. I'm not aware of one.
Mr. CAPUANO. OK, Mr. Salsbury, has your company ever had an adverse report, a disclaimer, or a qualification?
Mr. SALSBURY. Not to my knowledge.
Mr. CAPUANO. Mr. McGrath, you earlier said that you had not qualifications of any kind. I would take all of you and suggest to you that Enron also never had a qualification or a disclaimer or an adverse report, so, therefore, when you tell me you have clean audit reports, at this point in time with your auditors, it doesn't mean anything to me, and I would just suggest that it doesn't mean much to the general public as well.
Mr. McGrath, I would also suggest thatI don't know exactly the makeup of your company, but I know very well that the auditing rules and accounting rules in England are much more strict than we have in the United States, and for whatever businesses you do here, keep your eyes open; use your English requirements as opposed to your American requirements; you'll be safer and we won't have to call you back here at a future time.
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Mr. MCGRATH. Thank you.
Mr. CAPUANO. I guess it's not a real surprise that my understanding is that four of the five companies sitting in front of us have the same auditor and the same auditing company, and it is no surprise at all to me that Global Crossing has retained Arthur Andersen. When they were here, they did a very good job defending their relationship with you, so, therefore, I'm not surprised at all that the camaraderie is a two-way street.
But I'm going to tell you that I don't have a whole lot of questions, because, honestly, I don't like the answers I'm getting. I don't think we're going to get the answers, I don't think. I think this is the greatest forum. I think the SEC and the appropriate legal jurisdictions will be the ones who will ask tougher questions and will get the appropriate answers, and I will have to trust them at this point in time.
But I've got to tell you, from where I sit, the whole thing you're talking about is nothing more than a much more fancy and, you know, certainly larger Ponzi scheme, nothing new. You bought something you didn't need with money you didn't have, and sold it to somebody who didn't need it and didn't have any money, and you hid the bookings.
Gee, never heard that before. You're just doing it with a lot bigger money, nice, fancy technical terms, because you're in a new business. But the result is the same. The result is the same.
And that's why earlier I didn't have a whole lot of opening statements. I don't appreciate the way you do your business. I do appreciate the businesses you do. I find it unfortunate, to be perfectly honest, for the American public and for the entire business community, that we have to be sitting here having these hearings.
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I don't like doing them. I don't like overreacting to individuals in the business community that do these kinds of things. And I'm not going to sit here and blame any one of you individually. I'll leave that to the appropriate people as well, including your shareholders, who may or may not come after you.
But I will tell you that what you have done or what your companies have done or what your predecessors have done, no matter how you measure it, and no matter what you have said here today on the record, we all know in our hearts what you have done. I hopeI don't thinkI'm sure you're not embarrassed. I'm not sure you're not repentant, and it's not for me to make you so.
But I will tell that that's why I'm not asking questions today, because I don't expect to get answers that are going to be clear and concise. I don't expect to get answers that are going to do anything to help the employees that you have hurt, the shareholders that you have hurt, and I don't see any way that we can take steps to reconstitute the trust the American people once had in the American business community.
It will take time, and these kinds of auditing procedures, this kind of greed, absolute, unfettered greed, I don't think it's good for America. And I'm sorry that you or your predecessors did it, and I'm terribly sorry that your auditors allowed you to do it.
Mr. OXLEY. The gentleman's time has expired.
The gentlelady from New York, Ms. Slaughter.
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Ms. SLAUGHTER. I thank you, Mr. Oxley.
Mr. Legere, I can appreciate the difficulty that you face in trying to reconstitute a company, but I want to add on to what my colleague, John LaFalce, said, and to make a plea to let my people go in Rochester, and look favorably, if you can, to trying to reconstitute Frontier. The 13,000 jobs there mean the world to us.
Mostly I want to talk about some things that I've read in the papers that I'm really dying to talk to you about. First there's a piece from the New York Times on February 19th which says ''Mr. Perone authored a memo dated February 10, 1999, before his hiring by Global Crossing, in which he recommended how to best account for capacity swaps. The suggestions contained in the memo were to keep the contracts 60 days apart, apparently to avoid suspicion that the deals were reached merely to help each party meet its quarterly financial objectives, and to require each party to submit separate cash payments, apparently to create the look of a valid deal.''
To the untrained eye, gentlemen, that looks like you were trying to fool the public. Actually, I think that Global Crossing did decide that this was a pretty smart fellow over there at Andersen, and frankly, you decided to hire him for the company, perhaps to overlook this or look it over. I understand that he did have several relatives that he was also able to contribute.
What was the intent, other than fooling the investors and Wall Street, to have that kind of a system put together, which basically said that this will make it look all right?
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Mr. COHRS. Congresswoman, there are a number of memos, as I described in my testimony. The accounting for the transactions that we're talking about, any IRU transaction, whether they are relatively simultaneous or whether they are stand-alone IRU transactions, there are very difficult accounting questions.
We were struggling to adapt accounting rules that were originally applied in real estate and the leasing industry, because those were the only accounting standards available. And so our industrythe entire industry, as well as the entire accounting professionwas struggling to understand the right way to account for these transactions.
I described in my opening remarks that the GAAP treatment that's used now bears no relationship to the cash flow of the company. Now, for example, there was a meeting sponsored by Arthur Andersen, in which Global Crossing participated, in which all of the major accounting firms, the SEC, the FASB, at least one law firm, and participants from the industry met to try to develop the correct accounting for these transactions.
So that's the environment that we
Ms. SLAUGHTER. But, Mr. Cohrs, what I read here, what I understood from this, is that you were not looking for correct accounting procedures.
Mr. COHRS. Well, if I could
Ms. SLAUGHTER. But you were looking for a way that if you didn'tthat your revenue appears to have come from bookkeeping, right?
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Mr. COHRS. Well, if I could just finish.
Ms. SLAUGHTER. All right.
Mr. COHRS. In that context, the accounting memos that were developed by Arthur Andersen were extensive, going through a great deal of accounting theory on how these transactions should be developed, and a particular accounting model was developed that we applied.
And we were advised that that was proper GAAP accounting. But in addition
Ms. SLAUGHTER. But when it says that it is being done to avoid suspicion, wouldn't that make you feel a little peculiar about it?
Mr. COHRS. Congresswoman, we applied the accounting to the best of our ability. In addition to applying the accounting, in our press releases, when we did these transactions that were relatively simultaneous, we disclosed the transactions. We described the transactions that we were doing. We can provide you with the earnings releases that we issued in the first, second, and third quarter of 2001.
Ms. SLAUGHTER. In which you never made a profit; isn't that true?
Page 68 PREV PAGE TOP OF DOC Mr. COHRS. Well, as I said, we disclosed these transactions in those releases. In those releases
Ms. SLAUGHTER. Because that was the only transaction
Mr. COHRS.We also
Ms. SLAUGHTER.That you had, were the swaps. Let me go on.
Mr. COHRS. No, that's
Ms. SLAUGHTER. I don't want to use my time up here.
Mr. COHRS. They were a small number of the transactions that we had, to correct the facts.
Ms. SLAUGHTER. Let me just comment on this, because this is another statement. ''Instead of a stampede of customers to fill up the fiber optic highways, the industry found itself with too many vacant lanes, way too many. What had once seemed a brilliant idea, carriers buying and selling future access on the networks to meet expected demand, became a swap meet unto itself with its own peculiar bookkeeping,'' which reiterates, again, what you were saying.
Page 69 PREV PAGE TOP OF DOC But their own peculiar bookkeeping and the fact that Arthur Andersen was so close with what you were doing that you hired the man who authored it, I think is really a matter of some suspicion.
There are a couple of other things here that I want to comment on: One is that in an August, 2001, letter Mr. Olafson said that Global Crossing's Chief Financial Officer, Daniel J. Cohrs, had sent an e-mail message to Thomas Casey, who was chief executive, and to other high-ranking executives, expressing concern about a news release that Qwest had issued, giving the details of the IRU agreements, because Mr. Cohrs was worried that the Qwest statement would draw unwanted attention to Global Crossing's IRUs, Mr. Olafson said. Would you comment on that? You may not have had an opportunity to comment on that since it was printed.
Mr. LEGERE. I'll comment on it, Dan. I think the most important thing was
Ms. SLAUGHTER. I was asking Mr. Cohrs, since he was the author of the memo.
Mr. LEGERE. Well, I think that since it refers to Mr. Cohrs, if I could make one quick comment?
Ms. SLAUGHTER. Certainly, Mr. Legere.
Mr. LEGERE. And that is that, as was mentioned before, the SEC is doing a very detailed investigation of all the items that you spoke about. Our Board is doing the same, and we very much look forward to participating in those. I think the information that we can jointly share is the output, which will answer a lot of these questions, including most of what was written in Mr. Olafson's letter.
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Ms. SLAUGHTER. All right, well, let me just close with reiterating what Ms. Tubbs Jones said, and that is that it's very real, the pain in Rochester. I've talked to people who have had to put their homes up for sale, people who have no jobs, brilliant people who had very high positions in your company who are looking to see if they can run filling stations or something for a little while until they can tide themselves over; people who have lost their healthcare; people who are terrified of the future, young people, and scared that they're going to have to move and start all over again and look at something else.
Then there are the other people. The people who worked forever for Rochester Telephone, going out in the dreadful weather at night, going up those poles, making sure that the phone service worked. They are going; they have great concern about their pensions. And in that regard, I want to say that we are very much concerned that Global has not turned over the pensions to Citizens Communication. That, in itself, would moderate a great deal, I think, some of the fear of the workers up there.
But those who were let go who were promised severance and didn't get it, I don't think, unless you've had an opportunity to talk to them or look into their faces, that you could ever gauge the depth of the pain. These were people who liked your company, Mr. Legere. These were people who invested everything they had in it. Many of them left good jobs, enticed over because they thought that they saw the future.
Suddenly, 4 years later, it's all over, and they are left in an economy that's pretty bad, with very little hope, and it's devastating. So, let me say again to you, if there is an opportunity for us to back up and reconstitute Frontier, please give us every consideration to let us do it.
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Rochester's economy really needs it, and we ask you most sincerely to give that your utmost attention and to let that survive, so that these people can again have a job and a decent wage.
Mr. OXLEY. The Congresswoman's time has expired.
Mr. LEGERE. We feel the pain more than I think you understand. It's a very horrible thing that we've had to do to try to do something that I believe is in the best interests of Rochester, which is to save this company, save the jobs that exist, and hopefully get back to a time when we can grow jobs and bring new jobs back into Rochester.
Ms. SLAUGHTER. We do want you to save those jobs; they're very important to us. Thank you.
Mr. OXLEY. The gentleman from Washington State.
Mr. CLAY. Mr. Legere, one of the great outrages in the Enron collapse was the decision by management to black out their employees' ability to sell their stock while the executives retained their ability to sell their stock as the company was collapsing.
I've been toldand I'll just ask youthat there was a similar blackout for almost a month in your situation from December 14th to January 18th, while your employees were essentially blocked out, shackled, not allowed to sell their stock, and executives were allowed to sell theirs.
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Regardless of what was happening in the market at that time, was that the case, and if so, how would you justify blacking out, locking down, your employees during that situation, particularly in light of the fact that the world came to know what happened to the Enron employees, even before you ordered that lockdown?
Mr. LEGERE. I appreciate the opportunity to address this, and I'll start, and then ask Mr. Cohrs for some specifics.
What you're referring to is a lockdown period of our 401K plan, and it was locked down for everyone who participates, regular employees, as well as executives. It was announced first to the employees on October 2nd, and it was part of a move from Putnam to Fidelity as the manager of the plan.
Between October 2nd and the time from December to January when it was shut down, they were notified multiple times. And just for the record, one of the major differences here is on October 5th, our stock was trading at 83 cents. On October 9th, our stock was trading at 38 cents.
When the plan closed down on December 18th, approximately, the stock was trading at 67 cents. When it reopened in the middle of January with plenty of time to continue to sell, the stock was trading at 54 cents, so we're dealing with a very different scenario from the standpoint of what happened during the period of time. It was a planned, scheduled change between Putnam and Fidelity. It was announced many times in the time period going up to it, so it does have the similarities in that there was a blackout, but that's where the similarities cease to exist.
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Mr. COHRS. If I could just add, Congressman, the reason for the blackout period, as it's called, as Mr. Legere said, was the transition from one provider to the other. That was necessary because we had multiple 401K plans because of the acquisitions we had done.
So we had multiple plans with different levels of service, and we were in the process of consolidating those plans so that we could actually provide better service in the plans. And it's just necessary when you change providers to freeze the activity so that all the data can be transferred over. But as Mr. Legere said, this was announced 2 1/2 months before the blackout period began.
Mr. CLAY. And the executives who held stock themselves were free to sell their stock outside the 401K during that time; is that the situation?
Mr. LEGERE. All 401K participants were blacked out at the same time. All shareholders could sell under the rules, and executives who were not subject to a blackout period or a period of time that's normal for officers, could trade.
Mr. CLAY. Well, do you think it makes sense to allow executives, in that context, to be able to sell their stock while the company's falling apart, and lock down the employees who are in the 401K? Do you think that should be the rules of engagement, if you will?
Mr. LEGERE. I don't have the data, but maybe it would be important to look. During the blackout period of the 401K, I don't believe any people were trading shares outside of the program, either.
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Mr. CLAY. That's one thing we'll appreciate. I want to ask about swaps. And this has been a eye-opener for me, and, I think, for a lot of Americans. There is an old movie called ''The Flim-Flam Man,'' and it starred George C. Scott.
And why he didn't use swaps, I don't know, because to me, this has enormous potential for abuse, where you essentially buy an asset, spread out the cost over many years, with a counterparty and then sell it and take the revenue in 1 year, just has tremendous potential for abuse, it seems to me.
Now, I'm told that in your situation there was substantial swapping with other parties or counterparties, even though there was excess capacity pretty well known in the industry at that time. Tell us, to the extent you can, what economic rationale there was for those, and tell us, to the extent there was, if you will, simply a transfer by both parties, of a potential stream of revenue to something you book immediately as a stream of revenue?
Mr. LEGERE. If I could start, Congressman, I think the important difference between what you've described and what was taking place here is the notion almost sounds as if you're dealing with people sitting in empty rooms who are walking out, buying something, holding on to it, and then selling it to another.
We've constructed a 101,000 route-mile network that connects 27 countries and over 200 cities in the world. And it was through the process of building and acquiring the routes on this network, which is not just to sell capacity, but to serve enterprise customers advance data requirements. That's the requirement that drove us to looking to capacity that we would require to finish that network.
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And when you have 101,000 route-miles of network, you also are a logical place for people who need to buy things from someone, to come to, because you have the broadest reach. And, Dan, if you want to add
Mr. COHRS. If I could just address the accounting points that you mentioned, Congressman, it is quite often repeated improperly in the newspapers that these transactions generated revenue and spread the costs out over many years. That is simply not true.
As I explained in my opening remarks, an IRU transaction has the revenue recognized over the life of the lease, and the cost is amortized actually over a shorter period. So, in our GAAP accounting, the revenue on a 20-year IRU is only recognized, ratably, over 20 years. It is not recognized up front.
The cost of those assets is depreciated, just like any other asset that we would buy or build, generally over a shorter period, generally 12 to 15 years. And so the amortization of our cost on these transactions is actually much faster than the rate at which we booked the revenue.
The confusion comes because we also reported as a supplemental report, the number we called cash revenue. In addition to the GAAP revenue that I just described, we reported cash revenue because the cash was collected up front, and we felt it was important to our investors and our lenders and the markets as a whole to give both views, the GAAP view, of course, which we were required and which is the proper GAAP accounting, but also the view that more closely corresponded to the cash coming into the company.
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I'd just like to say and repeat that it is not true that these transactions generated up-front revenue with costs amortized over a long period of time. It's actually almost the opposite.
Mr. OXLEY. [Presiding.] The gentleman's time has expired.
Mr. CLAY. Thank you.
Mr. OXLEY. Let me thank this panel for your participation. As the subcommittee Chair indicated, the record will remain open for 30 days for written questions from the Members, and they will be forthcoming. Again, gentlemen, we thank you for your participation, and this panel is dismissed.
Chairwoman KELLY. [PRESIDING] I would like to thank the second panel for joining us today. And our second panel is going to discuss the accounting principles involved in the company's filings and disclosures, the state of the industry, and how some of the energy companies also tread into the telecom world and were caught in the vortex.
For our second panel, we welcome John Morrissey, Deputy Chief Accountant for the Securities and Exchange Commission; Scott Cleland, CEO of the Precursor Group; and a noted telecommunications industry analyst, Will McNamara, Director of Energy Industry Analysis for SCIENTECH, Incorporated.
I want to thank each of you for testifying here before us today, and I welcome you on behalf of the Full Committee. Without objection, your written statements and any attachments that you have, will be made part of the record.
Page 77 PREV PAGE TOP OF DOC You will each now be recognized for a 5-minute summary of your testimony. Your full written testimony, as I said, will be a part of the record. We begin with you, Mr. Morrissey.
STATEMENT OF JOHN M. MORRISSEY, DEPUTY CHIEF ACCOUNTANT, U.S. SECURITIES AND EXCHANGE COMMISSION
Mr. MORRISSEY. Congresswoman Kelly, Congressman LaFalce, and Members of the subcommittee. I'm John Morrissey, Deputy Chief Accountant at the United States Securities and Exchange Commission. Thank you for the opportunity to testify today on behalf of the Commission concerning several accounting issues affecting the telecommunications industry.
As the subcommittee has requested, my testimony will address the accounting by providers of indefeasible rights of use of telecommunications network capacity, the accounting for non-monetary transactions, including swaps, and the reporting of pro forma financial information. My written testimony addresses those matters in more detail, and I ask that it be included in the record.
As Global Crossing has disclosed, the SEC is investigating certain issues associated with the company's accounting and disclosure practices. The Commission appreciates the subcommittee's recognition of the non-public nature of its investigation. The Commission also asks that, in light of its ongoing investigation, the subcommittee understand our reluctance to address specific issues related to compliance with Federal securities laws at this time. You can be assured that the Commission staff is thoroughly investigating allegations of financial reporting improprieties.
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Confidence in our markets begins with the quality and transparency of financial information available to help investors decide whether and when to invest their hard-earned dollars. The goal of the Federal securities laws is to promote honest and efficient markets and informed investment decisions through full and fair disclosure of all material facts.
Transparency in financial reporting, that is, the extent to which financial information about a company is visible and understandable to investors and other market participants, plays a fundamental role in making our markets the most efficient, liquid, and resilient in the world.
The SEC's responsibility is to ensure that the financial markets are transparent and hospitable to all investors. Congress wisely ingrained in the Federal securities laws the philosophy that investors have the right to be fully informed of all material factors and to use markets that are free from fraudulent, deceptive, and manipulative conduct.
Telecommunications service providers often sell access to the networks on the basis of an Indefeasible Right of Use, or an IRU. Accounting for such capacity sales raises a number of issues that can become quite complex.
Perhaps the most important and basic accounting issue is when to recognize revenue from an IRU sale. My written testimony provides more detailed information on some of the considerations that go into this evaluation, and I will not repeat them here. However, I will note that the specific terms of the network capacity agreements between a provider and a purchaser can have a significant impact on how and when to recognize income from such sales under Generally Accepted Accounting Principles.
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For example, network capacity purchase agreements that qualify to be accounted for as leases could result in up-front revenue recognition, provided that certain criteria are met. Alternatively, network capacity purchase agreements that are not leases must be accounted for as service contracts, which typically requires that the related revenue be recognize into income over time as the access to the capacity is provided.
Several recent articles in the financial press have focused on the business practices of telecommunications companies swapping network capacity. These articles raise a number of legitimate questions about the accounting for network capacity swap transactions, which is discussed in my written statement.
While I cannot comment on specific companies or specific transactions, I assure you that if any financial reporting improprieties or violations of Federal securities laws have occurred, the Commission staff will not hesitate to seek appropriate remedies to protect investors.
Furthermore, recent press articles have focused on the use of pro forma financial information in Global Crossing's and others' earnings releases. While pro forma financial information can serve useful purposes, the Commission is concerned that pro forma financial information, under certain circumstances, can mislead investors if it obscures GAAP results.
On December 4, 2001, the Commission issued cautionary advice that companies and their advisors should consider when releasing pro forma financial information. The cautionary advice is part of our ongoing commitment to improve the quality, timeliness, and accessibility of publicly available financial information.
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At the same time, the Commission is focusing on ways in which our current periodic reporting and disclosure system can be updated to fill the void that pro forma statements may be attempting to fill.
Thank you for the opportunity to appear today. I am happy to try to respond to any questions that the Members of the subcommittee may have.
Chairwoman KELLY. I thank you very much, Mr. Morrissey.
STATEMENT OF SCOTT C. CLELAND, CHIEF EXECUTIVE OFFICER, THE PRECURSOR GROUP
Mr. CLELAND. Yes, thank you for the honor of testifying today, Chairwoman Kelly. I'm Scott Cleland, founder and CEO of the Precursor Group, an independent, research broker/dealer that provides telecom-tech investment research to institutional investors. I will try to provide the subcommittee with a broader, big-picture perspective today.
Global Crossing's bankruptcy is not unique; it's part of a broader telecom spiral, debt spiral in the sector. And we believe that the recession was not the cause of many of these telecom bankruptcies; it was only the trigger.
Nor is the cause what Federal Reserve Chairman Alan Greenspan called irrational exuberance. I surmise that the causes were the rational manipulation of the capital market system and the irrational economics of the telecom-internet sector, which created and burst the NASDAQ market bubble.
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I suspect there is some rational manipulation going on here. Global Crossing's bankruptcy is a wakeup call to us all.
First, we must improve our clearly inadequate investment research system that can't even expose a trillion-dollar fib. Investors depend on investment research for an objective assessment of the facts and due diligence on a company. However, they were not informed that the single most important trend buttressing Global Crossing's business model and that of most all the data traffic models, was hugely overstated and inflated for years.
The conventional wisdom, repeated by almost everyone for a few years, was, from 1997 to 2001, that the data traffic growth was exploding; that it was doubling every 3 to 4 months. But that is an 800 to 1600 percent annual growth rate through 1996 to 2001.
Unfortunately, it simply wasn't true. The actual growth rate was closer to 100 to 200 percent. Now, if you can see the chart that we brought with us, you can see then that roughly 14 companies, predicated on this exploding data thesis, that their market capitalization increased during that period by over a trillion dollars. That's the T-world, over a trillion dollars, and then it fell by over a trillion dollars as the bubble burst and the hype on data traffic was exposed.
But more troubling than that is that this is not an isolated incident. It appears that there may be a pattern of misrepresentation in the telecom-internet sector.
In addition to this trillion-dollar data traffic fib, U.S. investors lost almost another trillion dollars of shareholder wealth on the internet dot.com investment thesis, where everybody thought or everybody was told that the virtual economy was purported to obsolete the old economy.
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Now, second, I think it's pretty obvious from this that we do not have a well-functioning market. If these kinds of misrepresentations can go largely unchallenged in the system of investor protections, the system simply does not produce what investors needtrustworthy audits and investor research.
Effectively, the Big Five auditors function as a cartel where it's hard for investors to find a pure audit company that would best serve investor interest. Effectively, Wall Street functions as an investment banking cartel, where it is hard for investors to get objective investment research that's free of investment banking bias, that may be better at discovering the problems behind a Global Crossing.
In response, the Precursor Group, along with Argus Research and Egan-Jones, we're forming the Investor Side Research Association, and our mission is to increase the investor and pensioner trust in the U.S. capital market system through the promotion and use of investment research that is aligned with investor interests.
We're currently recruiting additional members, and recruiting organizations that support our mission, and our website will be www.investorsideresearch.org.
Now, third, we believe we must make our capital market system much less prone to manipulation. Growth or story stocks like Global Crossing have become very prone to manipulation, and, moreover, the options compensation culture that we have created for company management now, can perversely incent the management of publicly-traded companies to engage in very high risk behavior that this hearing is about today.
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It's the one-way nature of options that's the problem. It is that they only have something to gain on the way up, but in a down market or if there is a problem, they have nothing to lose on the way down, and, therefore, they can use the balance sheet as a piggy bank, as a way to goose the stock.
So, like a car, we believe that this system is badly out of alignment, which can allow it to dangerously veer off the road. And our capital market system is badly out of alignment, essentially leaving investors and pensioners potentially wounded in the ditch. It's skewed toward company interests over investor interest, and the system is skewed toward equity markets over credit markets.
In conclusion, I'm testifying today to try and bring the overall problem into better perspective. We believe there's no easy solution, however, the Government can improve the inadequate research investment system to prevent future trillion-dollar fibs. It can discourage the rational manipulation of the capital markets by better protecting investor interest, and it can also undo the irrational economics that led to the telecom and the internet debacle. Thank you very much again, Madam Chairwoman, for the opportunity to testify.
Chairwoman KELLY. Thank you, Mr. Cleland.
STATEMENT OF WILL McNAMARA, DIRECTOR, ENERGY INDUSTRY ANALYSIS, SCIENTECH, INC.
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Mr. MCNAMARA. Thank you, Chairwoman Kelly and Members of the subcommittee. I thank you for the opportunity to appear before you today. My name is Will McNamara, and I'm Director of Energy Industry Analysis for Scientech, an energy consulting firm focused on energy trends, both domestically and internationally.
The purpose of my testimony today is to discuss the recent trend of energy companies that may have expanded into the telecom sector through significant investments, and may have incurred financial or accounting problems as a result of the downturn in the telecom sector.
Deregulation of both the energy and the telecom sectors enabled the convergence between the two. An argument could be made and was often made that it was a strategic move for energy companies and electric utilities to expand into telecom, based on the following conditions:
Most of the companies already had the trenches in which to lay fiber optic cable. In addition, pushing voice and data files seemed similar to electricity distribution.
There were great expectations for the growth of dot.com companies, and energy companies traditionally have low-growth prospects, and many were looking for other revenue-drivers. Companies such as Enron Corporation and Williams Companies led the movement by buying or constructing many miles of fiber optic capacity. However, the prognosis for energy companies that expanded into telecom is virtually the same for the pure-plate telecom companies.
What we are witnessing is that demand was greatly overestimated; there was a glut of capacity or a perceived glut of capacity; there were heavy debt loads for telecom units and diminished opportunities for sales.
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To provide you with some specific examples of energy companies that moved into telecom and suffered the consequences, I provide the following data: Enron Corporation, former CEO of Enron, Jeffrey Skilling, had previously anticipated a $450 billion worldwide market for band-width trading by 2005, and specifically evaluated the valuation of Enron's own broad band unit at $35 billion.
However, in the second quarter of 2001, Enron reported a $102 million loss in its broad band unit, and by the third quarter of 2001, although the company had stopped separating telecom earnings, the company also reported that losses had continued. In addition, Enron acknowledged that its sales prospects for the telecom sector had dried up.
Williams Company, based on Tulsa, Oklahoma, had spun off its telecom unit, Williams Communications, but in March of 2002, said it could face a loss due to a stock-backing arrangement between the two companies. Williams Communications has about $5.16 billion in debt, currently.
Houston-based Dynergy, Inc., lost $31 million in telecom during the first 6 months of 2001. The company says it won't make any money from telecom for a year or more.
Butte, Montana, Montana Power, and Touch America, as it is now known, is the extreme example of an electric utility transforming into a pure-plate telecom company. The move has been met with financial losses, a lawsuit from shareholders, and community backlash due to rate increases that occurred as a result of the transformation.
Page 86 PREV PAGE TOP OF DOC Moreover, expansion into telecom has not been a successful strategy for energy companies thus far, although some companies maintain that their telecom investments will prove financially lucrative in the long term.
The degree of current financial impact on energy companies that moved into telecom depends on the extent of their investment. In terms of recommendations, energy companies will need to manage their own financial risk exposure to the telecom sector as most are currently doing.
To protect investors and enable analysts to have accurate financial data about energy companies, the SEC is widely working to revise financial disclosure and accounting rules, along with potential legislation supported by this subcommittee.
I thank you for the opportunity to appear before you. I have gone into much greater detail in my written testimony, and I welcome the opportunity to address any of your questions. Thank you.
Chairwoman KELLY. I thank you, Mr. McNamara.
I want to get back to the issue of the pro forma financial statements by the telecommunications companies. Mr. Morrissey, in your testimony you discuss that there is the new SEC guidance on pro forma financial statements. I wonder if you'd be willing to discuss what the SEC is planning to do in the future to address your concerns about those statements?
Mr. MORRISSEY. I'd be happy to. First of all, the Commission is very concerned about the misuse of pro forma financial information. This concern is translated into tangible, substantive action on a number of different fronts:
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On one front, we recently issued cautionary advice on the use of pro forma financial information. This cautionary advice acknowledges that pro forma information, when properly presented, can provide very useful and meaningful information to investors to help them understand what's going on.
But it also reminded individuals and preparers that the anti-fraud provisions of the Federal securities laws apply to a company issuing pro forma financial information. In addition, we offered some guidance in order to help avoid misleading investors in terms of preparation of this pro forma financial information.
For example, we said that they need to clearly disclose the basis of the presentation. They need to not omit material information that is meaningful to investors. They need to do it in plain English, so people can understand what the deviations are from GAAP, and, I think, very importantly, companies need to compare that information to GAAP-reported numbers, so that investors can be able to understand where the numbers come from, and have that basis of comparison.
And I think this has all been very well received within the community, the investment community and investors. Some information I received is that companies have welcomed this because if their desire is to present more meaningful information, to try to explain their results, they also want it to be perceived as being credible. And this is a way for them to comply with these guidelines and give it the type of credibility that, theoretically, they're looking for.
Page 88 PREV PAGE TOP OF DOC Second, on the other front, the Commission has been very active in also pursuing violations of the securities laws with respect to material misrepresentation. We recently brought a case against Trump Hotels, in which there is evidence to show that there was misleading financial information, pro forma financial information being disclosed, and we went after them and we prosecuted them and we brought that case.
So I think that one of the things that we've seen is that the new cautionary advice is now out there. It's being digested by preparers of financial information, and I think we're already seeing benefits from that now.
Where do we go from here? We need to, I think, wait and see a little bit to see how the improvement goes.
Chairwoman KELLY. Thank you.
Mr. CLELAND. Yes, could I add a point? The problem with pro forma is, it tends to beit can benot all timesit can be spin. And when it's put out, it is designed to then go to the investor relations department, to the public relations department as their press releases, where they may have had a GAAP accounting loss, however, on a pro forma basis, they're showing an improving financial situation.
And they know that by putting the pro forma first, in advance of the GAAP, that the headline will be, you know, ''Company Beats Expectations,'' or ''Company Showing Improving Results.'' And by baring the GAAP at the end, the perception of the public, through the media and through Wall Street, which loves the pro formaand they'll talk about the pro forma, pro forma, pro formathey don't get an accurate picture of what the real financial situation is that can be compared to other companies, because that's what GAAP is all about, is to know, should I invest in Company A, Company B, or in Bond A or Bond B?
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You need to have a common language, and that's what GAAP accounting is. And so the trouble is that pro forma contributes to a perception game that can mislead investors.
Chairwoman KELLY. Mr. Cleland, there are statements on the pro forma statements that are caveats. It seems to me that Mr. Morrisseyand, Mr. Morrissey, you may join in answering herethere may be a need for a stronger statement or for a pro forma to carry something that says very clearly, up frontMr. Baker talked about the Surgeon General's terse warning on every pack of cigarettes. Well, maybe there should bemy question to you really is, should there be a terse warning, large type, up front, on every one of these pro forma statements, so that everybody gets it, and the perception is, this iswhat the company is saying, this is not an audited statement.
I know that you do require some things, but perhaps we need to take a look at how that's working. Mr. Cleland, Mr. Morrissey, would you want to jump in there?
Mr. CLELAND. Where I jump in is that the problem isn't necessarily with one individual piece of the system; it's how the system behaves together, in the sense that the pro forma, by itself, might be innocuous, and the way investor relations may decide to put it out, it may be innocuous by itself. But it is the system that comes together, where everybody has an interest to say the good stuff about the stock and not the bad stuff about the stock.
And so what you get is the perception created. And we all know that the average investor reads the headlines and reads the first paragraph, or that's what we take away. We hear the radio announcement or the TV announcement, which is just the best stuff, and all of the other stuff just tends to fritter away. So, 99 percent of the perception is the good stuff, and you have to go digging for the bad stuff.
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Chairwoman KELLY. Mr. Cleland, let me just follow up on that for 1 minute, and then I'd like to have Mr. Morrissey kind of jump in on that original question. But, in recent years, the telecom industry has really just gone right straight up in terms of markets and so forth.
My interest in asking you this question is, whether or not there was any kind of a Government action, any kind of a Government policy that made this an arc rather than a continued curve up? I'm wondering if this was policy or if this was something that was driven by the companies themselves?
Mr. CLELAND. Well, it's a very good question, and when you look at the result on that chart, you see that the NASDAQ, which everybody thought was a bubble and went up, it went up 287 percent. And these data traffic stocks went up 1800 percent, so there is something extraordinary going on in that segment, and that segment helped drive that NASDAQ up 287 percent.
Now, the bubble that we all talk about was driven largely by telcom and tech. There was this culture of what I call rational manipulation of a system. It may not be any one individual, but they all said the same thing and they all knew they all benefited from hyping the traffic growth. That was the essence of it.
But there was also a Government problem in the sense that the Government created a set of irrational economics. Number one, you know, the Government commercialized essentially a not-for-profit peering system, so the entire industry structure of internet data traffic is not profitable.
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On top of that, the Government massively subsidized data at the expense of voice, billions of dollars every year. And what it did is, it added more cost to the telecom voice system and subsidized data, so it created this kind of free-lunch atmosphere.
Then you had the Telecom Act come in and said that everybody should build out these new data networks, and the problem was that this is a capital-intensive business where if you add risk, all the people that own the debt freak out and they don't want to necessarily be invested in it. So the Telecom Act essentially took an industry where capital was welcome and changed it into an industry where capital wasn't welcome.
And then the other thing that Government policymakers did is, they added the internet tax moratorium, which gave the perception that the internet was special. Essentially, if we transacted business over the internet, we didn't have to pay a tax, but if I did it over the phone or if we did it in person, the exact same purchase would be taxed, and so we created this unreal tax haven.
So all four of those things, the Government policy tended to inflate the bubble, and the market looked at the Government and the Government was the main cheerleader. So this is a dual problem.
Chairwoman KELLY. Would either Mr. Morrissey or Mr. McNamara like to get in here? Now, Mr. Morrissey, I said I'd come back to you, so let's start with you.
Mr. MORRISSEY. I guess I'd like to respond to your original suggestion and say I think that it has a lot of merit. It's a good idea to have a statement that may say something to the effect that these statements do not represent full financial information in accordance with Generally Accepted Accounting Principles and should be read in conjunction with financial statements prepared in accordance with Generally Accepted Accounting Principles. I think that idea has a lot of merit, and I appreciate the suggestion.
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One of the tensions you have, though, in reporting information, is that, we desire to have material information reach the market as quickly as possible. And one of the issues you have is that you may have some financial information that's of interest to investors, but not yet have prepared your financial information, financial statements in their entirety.
So the question is, do you withhold that information until the financial statements are ready, or do you go and do them at different times? And that's just one of the tension issues that needs to be addressed as we try to work through these different types of issues with respect to pro forma earnings releases.
Chairwoman KELLY. Mr. McNamara.
Mr. MCNAMARA. I would add that we spoke earlier about methodologies that companies use for pro forma accounting, and how often they vary from company to company and may not be disclosed to the public. So along with the disclaimer recommendation, which I think has a lot of merit, I think that the methodologies that companies use for their pro forma accounting projections should also be disclosed in the line of greater transparency. Certainly that is something that the SEC appears to be moving toward.
Chairwoman KELLY. Do you want to respond to that, Mr. Morrissey? Are you moving toward that?
Mr. MORRISSEY. As I said, with respect to pro forma, we had this recent initiative. It is something that we're watching very closely. We're hoping to see a significant shift in the market reaction to the issuance of pro forma information, in conjunction with the guidelines that we have established. And we have to watch and see the progress that's being made.
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Chairwoman KELLY. I would like now to just kind of go to swaps, the swaps issue. In July of 1999, the FASB mandated that the companies could not recognize all revenue earned from the new swaps in the current year. That was a change.
And they required then that the contract be amortized over its life. How did that affect the telecommunications companies' financial projections? And this is for all of you.
Mr. MORRISSEY. Do you want me to go first? Basically what was occurring within the industry and with an interpretation of the accounting literature was that it was progressing, evolving, and becoming more refined. And the statement that I believe you're referring to added clarification as to what type of lease these IRUs should be accounted under.
And what that statement said is that basically they have to be accounted for under the literature that applies to real estate transactions. Associated with real estate transactions are a whole series of criteria that you have to meet in order to recognize the revenue up front on one of these types of IRU transactions.
And my understanding is that when that statement came out, it effectively presented a significant hurdle that was very difficult to overcome for many of these types of transactions that had been recorded in the past with up-front revenue recognition. So my understanding is that, from an industry perspective, it had a significant impact, and that it reduced companies' ability to recognize the revenue up front.
Page 94 PREV PAGE TOP OF DOC Chairwoman KELLY. Thank you.
Mr. CLELAND. You know, the problem here is that you have a set of irrational economics in the industry. You have this extraordinary hype and expectations that were created. When you have, you know, 1800 percent increase in the market capitalization of 14 companies, you've created an unreal circumstance.
Then you have a culture which has a lot riding on keeping that stock up, because the options culture is one way; they want it to have momentum and to go up. And so what it does, it created enormous pressure, and investors wanted that money created. So, investors, the investment bankers, the auditors, the lawyers, everybody, had an interest in making sure that this bubble didn't get burst.
And so in that context of an unreal world and overextended expectations, I think people looked to the accountants and said, you know, how can we, within the rules, make this look the best possible? And what I think is important is, lots of times people can address the letter of the law, but not address the spirit of the law, and they'll say, well, I did this right; I did this right; and I did this right; there isn't anything wrong. When doing the three of those things together, you add them up, and it is a clear, obvious misrepresentation of the circumstance.
So we need to step back and look at these things in context to see whether or not there was rational manipulation or misrepresentation going on.
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Chairwoman KELLY. Mr. McNamara.
Mr. MCNAMARA. I would just add that I think Mr. Cleland's assessment is accurate. There is a parallel between the telecom's use of IRUs and the energy industry's use of the mark-to-market technique, although they're vastly different and involve different businesses and different commodities.
What essentially would be the same is that the pressure is to inflate current earnings on the basis of transactions that may not materialize until down the line. And so as changes regarding rules governing pro forma accounting emerge, it would be helpful to look at both industries.
Chairwoman KELLY. Mr. McNamara, you have delivered some really interesting testimony today. Any subsequent figures and facts that you can bring to flesh that out, the subcommittee would appreciate, because I think you've had some very interesting testimony.
I'm going to ask you just a couple of very straightforward questions, and basically I'm concerned that companies over-valued earnings. And I'm concerned that investors really didn't get a clear picture here. And it seems to me your testimony is saying that, and all I want to know is, if my perception is a correct one? And you can just answer that yes or no, and you can just start down the line and give me a quick answer.
Mr. MCNAMARA. I would say that the answer is yes, but I would say that both pro forma and real-time financial earnings are important, and why not offer both to investors and analysts, and they can choose which one they want to follow.
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Chairwoman KELLY. Mr. Cleland.
Mr. CLELAND. I think you can have as quick a disclosure and as complete a disclosure, and then you want to have a system that has people that are looking out for investors, either auditors that are pure audit companies or investor-side research, because we have a systemic problem here where the system is no longer working for investors. That's how Enron, Global Crossing, the bubble, happened. It is that the system got out of alignment and then it always wanted to go up.
And the thing is, markets don't always go up; they have ups and downs; they have corrections and whatever, but this system is out of alignment, and it will continue to veer off into the ditch until you figure out a way to let the free market and competitive use of ideas flourish. Because if somebody would have stood up and said there's a problem with Enron early on, and because they're paid by the system to find those things, or if, you know, if somebody was paid to find those things with Global Crossing and the telecom debacle, you would have identified those things. But the system didn't pay for capital preservation; it paid for stock promotion. It's a problem.
Chairwoman KELLY. Mr. Morrissey.
Mr. MORRISSEY. I guess the way I would answer the question is, at the Securities and Exchange Commission, we fully expect companies to comply with the Federal securities laws and comply with Generally Accepted Accounting Principles, and to reflect transactions based upon their substance.
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And that to the extent that mere compliance with the technicalities of the literature does not present a fair picture of what's happening, they have an obligation to disclose what really is going on in management's discussion and analysis, so that investors have a clear understanding of really what is happening.
If that is not occurring, they're going to have a serious problem with my fellow colleagues in the Division of Enforcement, and we expect that from all investors.
Chairwoman KELLY. All right, thank you. I have a few more questions, but I'm going to submit those in writing.
This has been a relatively long hearing. The Chair notes that some Members will have, in all probability, additional questions for this panel, and they will submit them in writing, so without objection, the hearing record is going to remain open for 30 days for the Members to submit written questions to these witnesses and to place their responses in the record.
We thank you very much for your patience in waiting through the first panel, and for your subsequent testimony here. This second panel is excused with our great appreciation for your time.
I want to briefly thank the Members who are here and other Members of this subcommittee who have shown a great deal of interest in this topic, and I also want to thank especially the staff that we have, my staff, and the staff on the Financial Services Committee. They have been terrific in making this hearing possible, and with that, this hearing is adjourned.
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[Whereupon, at 12:40 p.m., the hearing was adjourned.]