taft v. ackermans 02-cv-07951-consolidated second amended...
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UNITED STATES DISTRICT COURTFOR THE SOUTHERN DISTRICT OF NEW YORK
PAULA TAFT, Individually and On Behalfof All Others Similarly Situated,
Plaintiff,v.
WILLEM ACKERMANS, JOHN A.MCMASTER, JEFFREY VON DEYLEN,RHETT WILLIAMS, BRENDANKEATING, JOSEPH P. NACCHIO,ROBERT WOODRUFF, DRAKETEMPEST, JOOP DRECHSEL, MARTINPIETERS, EELCO BLOK, QWESTCOMMUNICATIONS INTERNATIONAL,INC., and KONINKLIJKE KPN N.V. a/k/aROYAL KPN N.V.,
Defendants.
Civil Action No. 1:2002-CV-07951
CONSOLIDATED SECOND AMENDED CLASS ACTION COMPLAINT FOR VIOLATIONS OFFEDERAL SECURITIES LAW
JURY TRIAL DEMANDED
1. Lead Plaintiff Clyde Witham, by his attorneys, for his Class Action Complaint (the
"Complaint"), as well as the Class Representatives named herein (collectively referred to as
“Plaintiffs”), allege the following upon personal knowledge as to themselves and their own acts, and
upon information and belief, based upon the investigation of Plaintiffs’ attorneys as to all other
matters. The investigation includes the thorough review and analysis of public statements, publicly
filed documents of KPNQwest N.V. (“KPNQwest” or the “Company”), press releases, news articles
and the review and analysis of accounting rules and related literature. In particular, counsel’s
investigation includes a review of the testimony given before Congress by Qwest’s CFO and Global
Crossing’s CFO in hearings entitled “Capacity Swaps by Global Crossing and Qwest: Sham
Transactions Designed to Boost Revenues?” before the Subcommittee on Oversight and
Investigations of the Committee on Energy and Commerce, House of Representatives, 107th Cong.,
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2d Sess., Serial No. 107-129. Relevant documents referenced in the Complaint, which were
appended to the transcript of those hearings, are attached hereto as Exhibit “A”. Plaintiffs believe
that further substantial evidentiary support will exist for the allegations set forth below after a
reasonable opportunity for discovery.
2. Plaintiffs’ investigation is ongoing. In particular, Plaintiffs await release of a report
to be issued by officials in the Netherlands who have been investigating the reasons that KPNQwest
was suddenly forced to file for bankruptcy in May of 2002. The report originally was scheduled for
release in June 2003. Delays, to late 2003 and, now, to later in 2004, denote the seriousness and
comprehensiveness of the report. As reported by Dow Jones Newswires on November 25, 2003:
“A long-awaited report outlining the collapse of Dutch data-servicesprovider KPNQwest NV has been delayed until 2004 to giveaccountants time to verify the data, trustee Jan van Apeldoorn toldDow Jones Newswires Tuesday....” “We think it’s no longer realisticto assume we can put out the report in 2003, because we hiredaccountants who are checking some facts we included in the report,and that will take some more time,” van Aepeldoorn said....Thetrustees hired Dutch legal and accountancy firmSchaapBruinVanVliet B, which specializes in forensic accountingand investigations, to check certain financial elements and also todouble-check information provided by the named parties in thereport, such as former board members and house banks ofKPNQwest....Van Apeldoorn said the report won’t just outline thebankruptcy of KPNQwest, it will also give an idea of who shouldbe held responsible.” (Emphasis added).
3. On June 25, 2004 the KPNQwest bankruptcy trustees filed a RICO action in the U.S.
District Court for the District of New Jersey (Case No. 2:04-cv- 03026 JWB-GDH) against four of
the defendants named in this case: Qwest Communications International, John A. McMaster, Joseph
P. Nacchio and Robert S. Woodruff. The 125-page RICO complaint (hereinafter referred to as the
“trustees’ RICO complaint” or the “RICO complaint”) describes in detail how KPNQwest’s
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financial results were inflated by means of telecommunications capacity swaps and other IRU
transactions. Through this RICO complaint, KPNQwest’s swaps and other IRU transactions, and
the Company’s methodology of recording revenue from those transactions, are admitted to be
wrongful by the current custodians of the Company itself.
4. While the long-awaited trustees’ report on the wrongdoing at KPNQwest has not yet
been released, the RICO complaint is apparently based on the trustees’ investigation–including
forensic accounting analysis–which the trustees are using in preparation of that report. The RICO
complaint is thus highly credible.
5. On July 28, 2002, Qwest announced it was restating its financial results for 1999,
2000 and 2001 and during a conference call of that day, as reported in the Denver Post, various
Qwest executives told analysts that Qwest improperly accounted for $1.16 billion in IRU sales
during that period.
6. In addition, the SEC has begun an investigation of Qwest. The investigation is
pursuant to an order issued on April 3, 2002, SEC File No. D-2455A. Qwest’s press release of
March 11, 2002 admits that the SEC is investigating Qwest’s accounting treatment of IRU sales and
swaps. This investigation apparently led to the institution and settlement of a cease-and-desist
proceeding against Loren D. Pfau, a former Qwest employee, on September 29, 2003. As alleged
in more detail below, the SEC’s proceedings against Pfau are based on violations of many of the
same accounting principles violated by Defendants herein. Moreover, many of the capacity
transactions in question involved both Qwest and KPNQwest. Therefore, it is possible that
KPNQwest and/or Defendants may come under SEC scrutiny.
7. In the latest development in the SEC investigation of Qwest, Defendant Drake
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Tempest, former general counsel of Qwest, refused to appear for deposition (in response to an
investigatory subpoena), on the grounds that he will assert his Fifth Amendment right against self-
incrimination.
8. The SEC filed a motion to compel Tempest to appear. See Civil Action No. 04-B-
1547, filed in the U.S. District Court for the District of Colorado. The motion was granted.
9. Plaintiffs may seek leave of Court to further amend the complaint upon review of the
information contained in the official report from the Dutch bankruptcy proceeding for KPNQwest
and/or from the SEC’s investigation of Qwest, when that information is released.
SUMMARY OF ACTION
10. Lead Plaintiff brings this class action under sections 11 and 15 of the Securities Act
of 1933 (“Securities Act”), 15 U.S.C. §§ 77k and 77o, sections 10(b) and 20(a) of the Securities
Exchange Act of 1934 (“Exchange Act”), 15 U.S.C. §§ 78j(b) and 78t(a), and the rules and
regulations promulgated thereunder by the SEC, including Rule 10b-5, 17 C.F.R. § 240.10b-5, on
behalf of public investors who purchased the securities of KPNQwest (the “Company”) during the
period from November 9, 1999 through April 24, 2002 (the “Class Period”). Plaintiffs alleges a
fraudulent scheme and deceptive course of business that injured purchasers of KPNQwest stock
during the Class Period.
11. Beginning with the November 5, 1999, filing of KPNQwest’s Registration Statement
and Prospectus with the SEC, and continuing throughout the Class Period, Defendants caused the
Company to issue false and misleading statements and to conceal material facts concerning the
Company’s revenue and earnings growth and its improper recognition of revenue from non-cash
“swap” transactions. Specifically, defendants publicly portrayed KPNQwest as a rapidly growing
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company, providing telecommunications services to a growing base of customers throughout
Europe. To help defray the capital expense of building its network, from time to time the Company
would sell unused network capacity, known in the industry as “dark fiber” and “lit fiber” to other
providers. Thus, to enable investors to determine the success of KPNQwest’s business, i.e., the sale
of telecommunications services to customers on a recurring basis, KPNQwest should have reported
such telecommunications services revenues in one category and network capacity sales (of both dark
and lit fiber) in another. Instead, Defendants misled investors by creating a misimpression that
claimed revenues were not from unique transactions (the capacity sales) but instead could be viewed
as recurring revenues. In order to create this misimpression, Defendants improperly combined
revenues from non-recurring lit fiber capacity transactions – including non-cash swaps made for no
legitimate business purpose – with revenues generated by the provision of telecommunications
services to customers, into a single category called “Communications Services Revenues.” Sales
of dark fiber were separately recorded as “Infrastructure Revenues.” This false categorization was
materially misleading. Until late in the Class Period, KPNQwest did not reveal the percentage of
“Communications Services Revenues” attributed to capacity sales. In a KPNQwest Form 6-K filing
on February 12, 2002, defendants included the following chart which, for the first time, provided
this historical information from the outset of the Company’s operations in 1999. The chart
demonstrates that “capacity sales” – a side-line intended to help recoup capital costs – amounted to
54% of total revenues in 2001, more than the combined revenues from KPNQwest’s provision of
services to customers and sales of dark fiber.
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12. When KPNQwest’s scheme began to unravel, the price of its stock plummeted, losing
more than 46% of its value in a single day, causing material harm to Plaintiffs and the Class.
13. Unbeknownst to its shareholders, KPNQwest was able to post positive financial
results throughout the Class Period only as a result of its improper recognition of revenue from
“sales” of telecommunications capacity in the form of indefeasible rights of use (“IRUs”)--20-year
leases of telecommunications capacity–to other telecommunications carriers, including parent
companies KPN and Qwest. Even more wrongful and also not disclosed, was that many of these
“sales” were actually non-cash swaps.
14. Throughout the Class Period, KPNQwest improperly accounted for its IRU sales
(including swaps) by improperly booking the full value of a 20-year IRU contract as revenue in the
quarter the IRU sales contracts were executed, rather than ratably over the course of the IRU as
required by both Generally Accepted Accounting Principles (“GAAP”) and standard industry
practice. For example, KPNQwest swapped $54 million of dollars of fiber capacity with Global
Crossing in the third quarter of 2000 in exchange for similar capacity valued at approximately the
same amount. KPNQwest then booked the full $54 million as “sales” revenue in Q3 2000. Such
accounting violates GAAP in numerous respects, as explained below.
15. These swaps and other IRU transactions were entered into solely for the purpose of
artificially inflating KPNQwest’s revenues. Theoretically, capacity swaps could be used to provide
each telecommunications company involved with network capacity in a geographic region where
it did not already have network connectivity. KPNQwest, however, purchased capacity it did not
need and, in turn, sold capacity to its parents or to other companies that those companies similarly
did not need. These unnecessary transactions thus earned the moniker “hollow swaps.” By inflating
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Company revenues and thereby artificially meeting revenue targets, Defendants artificially boosted
the price of KPNQwest’s common stock. Similarly, KPN and Qwest purchased capacity they did
not need from KPNQwest to meet their revenue commitments to KPNQwest under the Company’s
business plan. These purchases were not bona fide business transactions and no revenue should
have been recognized therefrom.
16. In addition, the swaps were wrongful for another reason: they were just exchanges
of inventory, not the culmination of any earnings process. In the words of one witness, “you have
red apples, I have green apples, let’s swap.”
17. The IRU capacity transactions and swaps were highly material to KPNQwest’s
reported revenues. In FY 2001, KPNQwest’s swap “sales” with Global Crossing (a company whose
scandalous fall in January, 2002 resulted in the fourth-largest bankruptcy ever) alone amounted to
€100 million, more than 10% of the Company’s reported 2001 revenues. An additional $56 million
and $30 million in swap sales were derived that year from swap transactions with Teleglobe and
Flag Telecom, respectively.
18. Similarly, KPNQwest’s IRU “sales” to its two parent companies were highly
material. As reported to the SEC, “sales” to the Company’s parents and their affiliates represented
more than 40% of KPNQwest’s revenues in both FY 2000 and FY 2001. As explained below, it was
in the interests of both KPN and Qwest to purchase millions of dollars of unneeded capacity from
KPNQwest in order to maintain the market value of their shares of KPNQwest. For example, the
value of Qwest’s investment in KPNQwest was a factor in the valuation of Qwest’s merger with
U.S. West. Had Qwest timely devalued its equity position in KPNQwest – which would have been
required if KPNQwest’s true financial position had been revealed – U.S. West shareholders would
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have been entitled to receive greater consideration.
19. In early 2002, in response to the suspicions first arising in the wake of Global
Crossing’s collapse two weeks earlier, in a press release and Form 6-K filed on February 12, 2002,
Defendants flatly denied that the Company entered into shady hollow swap deals for the sole
purpose of boosting revenues. Another press release, issued the very next day, February 13, 2002,
expressly “reaffirm[ed]”: “All of KPNQwest’s transactions are in compliance with US GAAP.
KPNQwest continues to hold itself to the highest standards of financial disclosure and
communications to investors.”
20. To the contrary, internal e-mails and memoranda from KPNQwest, its parents and
major customers demonstrate that the Company repeatedly engaged in hollow swaps solely
motivated by a desire to engineer financial results to meet pre-determined revenue projections.
21. By filing the New Jersey RICO case, the current custodians of the Company have
admitted that KPNQwest’s swap and IRU transactions, and the accounting methods used to accrue
revenue from those transactions, were wrongful and were known by the participants therein to be
wrongful.
22. The trustees’ RICO complaint admits that the defendants in that case “caused
KPNQwest to enter into ‘capacity’ IRU transactions and ‘swaps’ and to record immediate (and
substantial) revenue from those transactions even though - unlike certain dark fiber IRUs - these
capacity deals did not satisfy the accounting criteria necessary for up-front revenue recognition.
These transactions and their related accounting treatment did not, in fact, produce the revenues or
cash flow necessary to sustain KPNQwest's build out, could not be justified under the governing
accounting rules, and did not have any other justifiable business purpose for KPNQwest. To the
1Paragraph references appearing in brackets in this complaint generally refer to paragraphsin the trustees’ RICO complaint.
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contrary, they often were nothing more than ‘paper transactions’ that simply made KPNQwest
appear to have revenues and financial capabilities that it did not truly have.” [¶131]
23. The trustees’ RICO complaint further admits that “[t]he IRU capacity transactions
were used to create the illusion of sales and revenue, even though the transactions lacked economic
substance and could not properly be treated as sales or revenue-generating events. Defendants
actively concealed the fact that many of the transactions lacked economic substance, and were mere
swaps, designed to create an illusion of revenue for each of the swapping parties....[¶15].
24. The filing of the New Jersey RICO case confirms many of Class Plaintiffs’
allegations in the instant case, contains multiple admissions of fact by the Company (which are
evidence in themselves), and adds detail about Defendants’ scheme. For example, the RICO
complaint discusses warnings from Arthur Anderson and the SEC (e.g., trustees’ complaint ¶78,
¶83), explains why KPNQwest’s IRU transactions failed to meet Arthur Anderson’s own (albeit
faulty) criteria for revenue recognition (e.g., trustees’ RICO complaint ¶107), and recounts efforts
to conceal the fraud by KPNQwest personnel (e.g. trustees’ RICO complaint ¶¶180-181).
25. The false IRU transactions are shown in the trustees’ RICO complaint to have had
a drastic impact on the Company’s financial results. The RICO complaint explains that although
KPNQwest in October 2001 internally projected €14.2 million of EBITDA in 2001, IRU EBITDA
alone was €297.1 million, so that without IRUs the true EBITDA was negative € 292.2 million.
KPNQwest reported EBITDA growth of 548% between the third and fourth quarters of 2001, but
excluding the IRU and infrastructure sales, EBITDA actually shrank by 8%. [¶163].
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26. Not surprisingly, considering that the preponderance of the Company’s revenues were
derived from the wrongful swap and IRU capacity transactions, Plaintiffs’ investigation has revealed
that general knowledge of the outline of the scheme (i.e., swapping of unneeded capacity with other
carriers) was widespread throughout the Company. For example:
M The swaps were discussed at monthly meetings between upper managementand the middle management from the technical side of the company (incharge of the data transmission (ATM/Frame Relay), IP and broadbandproduct platforms). According to CW 20, who was in attendance at thesemeetings, the participants often joked about how small their real sales to realcustomers were in comparison to the swap revenues.
M The Company’s ongoing sales funnel, reflecting the “real” sales (notincluding the swap and other capacity transactions), was, according to CW10, available to the entire sales force, and was the result of weekly reports onprospective sales and their closing from the sales people (including thosesupervised by CW 10), which were then input into an Excel spread sheet. Plaintiffs received a copy of the sales funnel from CW 8 for week 20 of theyear 2002 reflecting that only €73 million of sales was consummated by thattime. A true and correct copy of the first page of this document is attachedhereto as Exhibit “C.” CW 8 asks the question: how could the Companypossibly be recording hundreds of millions of Euros of revenues given thelow number of real sales? This differential was obvious to anyone who hadthe sales funnel document at the Company.
M KPNQwest’s upper management used a quarterly bonus system to focus theentire Company on the Company’s revenue targets. Upper managementmade the entire work force conscious of the connection between the targets,the financial community, and the Company’s stock price. For example, JackMcMaster made such a connection in a presentation to employees concerningthe bonuses for fourth quarter 2000. (Plaintiffs have a copy of thatpresentation from the Company’s intranet system.) Thus, it was widelyknown at the Company that, given the lack of “real” revenues from “real”customers, it was the swaps that enabled the work force to achieve therevenue targets for bonuses. For example, Peter Sminck advised an outsideconsultant of that fact when he started asking questions during aninvestigation of the Company’s financial profitability, as alleged herein.
M As alleged herein, there was a great last-minute rush of the engineering andcustomer network implementation (“CNI”) departments at the end of each
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quarter to implement the capacity necessary for each swap deal. Manypeople were involved in this effort, and they had to know what thesetransactions consisted of. In fact, the CNI department obtained thecontractual agreements f or the capacity that was being installed to “sell” tothe swap “customer” and also handled the other side of the transaction, i.e.,the reciprocal acceptance by KPNQwest of capacity from that same swappartner. There was also widespread knowledge that the capacity was notbeing used, as reflected, for example, in the signing of false test reportsbefore the end of the quarter, so the swaps could be invoiced and the revenuebooked.
27. Two judges in two federal courts have upheld claims concerning wrongful IRU and
swap transactions by two of KPNQwest’s biggest swap partners: Qwest and Global Crossing. See
In re Global Crossing, Ltd. Securities Litigation, 322 F.Supp.2d 319 (S.D.N.Y. 2004), upholding
claims that “the accounting for IRUs was misleading from the start...” and that the swaps “were
essentially unnecessary mirror-image transactions created with the specific intention of inflating the
Companies’ revenues and deceiving investors into thinking the company was financially sound
when it was, in fact, in increasingly perilous straits.” The Qwest ruling is contained in an unreported
Order Concerning Defendants’ Motions to Dismiss, filed on January 31, 2004 in In re Qwest
Communications International, Inc. Securities Litigation, U.S.D.C. for the District of Colorado Civil
Case No. 01-RB-1451 (CBS). KPNQwest had no more right to book these illegitimate revenues
than did its swap partners.
JURISDICTION AND VENUE
28. The claims asserted herein arise under sections 10(b) and 20(a) of the Exchange Act,
15 U.S.C. §§ 78j(b) and 78t(a), and SEC Rule 10b-5, 17 C.F.R. § 240.10b-5, as well as sections 11
and 15 of the Securities Act, 15 U.S.C. §§ 77k and 77o. This Court has jurisdiction over this action
pursuant to Section 27 of the Exchange Act, 15 U.S.C. § 78aa, and 28 U.S.C. §§ 1331 and 1337.
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29. Venue is proper in this District pursuant to Section 22 of the 1933 Act and Section
27 of the 1934 Act, 15 U.S.C. §78aa, and 28 U.S.C. §1391(b). Many of the acts giving rise to the
violations complained of herein, including the dissemination of false and misleading public
statements and financial information, occurred in this District.
30. In connection with the wrongs alleged herein, Defendants used the instrumentalities
of interstate commerce, including the United States mails, interstate wire and telephone facilities,
and the facilities of the national securities markets.
THE PARTIES AND OTHER RELEVANT ENTITIES
31. Plaintiff Clyde Witham purchased shares of KPNQwest common stock during the
Class Period and was damaged thereby. Paula Taft, who will also serve as a class representative,
purchased shares of KPNQwest common stock during the Company’s Initial Public Offering as set
forth in the Certification attached to her original complaint, and was damaged thereby. Edwin de
Jong, Daan van Os, and Hans Tazelaar, all residents of the Netherlands, who will also serve as class
representatives, purchased shares of KPNQwest common stock during the Class Period and were
damaged thereby, as reflected in their Certifications attached hereto as Exhibit “B”.
32. Headquartered in Hoofddorp, Netherlands, KPNQwest was a data communications
services company offering Internet connectivity, remote access, website hosting, Internet
broadcasting and other services in fifteen countries throughout Europe. The Company built and
operated the EuroRings, a fiber optic “backbone” network connecting more than 50 cities through
which KPNQwest provided its services. KPNQwest is not named as a defendant herein because the
Company filed for bankruptcy protection on May 31, 2002, in the district court in Haarlem,
Netherlands.
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33. Defendant John A. McMaster (“McMaster”) was, during the Class Period and at all
times relevant hereto, President and Chief Executive Officer of KPNQwest. McMaster signed
KPNQwest’s Form 20-F Annual Report for the year ending December 31, 2000. McMaster signed
KPNQwest’s Form F-1, the Registration Statement, on November 5, 1999.
34. Defendant Willem Ackermans (“Ackermans”) was, from the beginning of the class
period to June 11, 2001 and at all times relevant hereto, Executive Vice President and Chief
Financial Officer (“CFO”) of KPNQwest. Ackermans signed KPNQwest’s Form F-1 Registration
Statement, on November 5, 1999.
35. Defendant Jeffrey von Deylen (“von Deylen”) was, from June 11, 2001 to the end
of the class period and at all times relevant hereto, Chief Financial Officer of KPNQwest.
36. Defendant Rhett Williams (“Williams”) was, at all times during the class period, the
Chief Marketing Officer of KPNQwest, and had responsibility for locating, executing and
implementing the various swap deals with the design of creating the appearance that KPNQwest was
meeting its revenue targets as announced to the public, and in particular the analyst community.
Plaintiffs first learned that defendant Williams was involved in the scheme when speaking to
witnesses in Amsterdam in March, 2004 in the course of Plaintiffs’ investigation.
37. Brendan Keating (“Keating”) was, during the class period and at all times relevant
hereto, Controller of KPNQwest and later Senior Vice President of Finance. Keating signed
KPNQwest’s Form F-1 Registration Statement, on November 5, 1999.
38. Defendant Joseph P. Nacchio (“Nacchio”) was, during the Class Period and at all
times relevant hereto, Chairman of the supervisory board of KPNQwest (hereafter the “Supervisory
2 Supervisory Board members executed the Registration Statement and other SECfilings as agents of Qwest or KPN.
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Board”)2 and Chairman and Chief Executive Officer of Qwest. Nacchio signed KPNQwest’s Form
F-1 Registration Statement, on November 5, 1999. Nacchio served on the Supervisory Board of
KPNQwest in his capacity as an officer and director of Qwest and acted as an agent for Qwest.
From August 13, 1999 through the end of the Class Period, Nacchio received approximately
$186,000,000 in gains from his sale of Qwest stock.
39. Defendant Robert Woodruff (“Woodruff”) was, during the Class Period and at all
times relevant hereto, a member of the Supervisory Board of KPNQwest and Executive Vice
President of Finance and Chief Financial Officer of Qwest. Woodruff signed KPNQwest’s Form
F-1 Registration Statement on November 5, 1999. Woodruff served on the Supervisory Board of
KPNQwest in his capacity as an officer of Qwest and acted as an agent for Qwest. During the Class
Period, Woodruff sold 1,155,000 shares of his Qwest stock for proceeds of $52.79 million.
40. Defendant Drake Tempest (“Tempest”) was, during the Class Period and at all times
relevant hereto, a member of the Supervisory Board of KPNQwest. Tempest also served as
Executive Vice President, general counsel, and secretary of the board of directors of Qwest from
1998 through 2002. Tempest signed KPNQwest’s Form F-1 Registration Statement on November
5, 1999. Tempest served on the Supervisory Board of KPNQwest in his capacity as an officer of
Qwest and acted as an agent for Qwest. During the Class Period, Tempest sold 466,600 shares of
his Qwest stock for proceeds of $20.88 million.
41. According to a declaration filed by the SEC in connection with its motion to compel
Tempest to testify at deposition as part of the SEC’s investigation of Qwest, “Tempest has personal
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knowledge of matters that are the subject of the Commission’s investigation. For example, he:
created and enforced policies relevant to the Commission’s investigation; signed documents central
to the Commission’s inquiry, and was centrally involved in preparing, reviewing, and/or authorizing
the information contained in Qwest’s public filings with the SEC.” These were the same policies,
i.e., swaps and booking of up-front revenues from IRU transactions, which were developed jointly
by Qwest and KPNQwest. As such, Tempest was directly responsible for Qwest’s joint plan with
KPNQwest to carry out such policies.
42. Defendant Joop Drechsel (“Drechsel”) was, during the Class Period and at all times
relevant hereto, a member of the Supervisory Board of KPNQwest and a member of KPN’s Board
of Management. Drechsel signed KPNQwest’s Form F-1 Registration Statement on November 5,
1999. Drechsel served on the Supervisory Board of KPNQwest in his capacity as a director of KPN
and acted as an agent for KPN.
43. Dreschel had a long association with KPN and was a key player in the company’s
international expansion plans. From 1998 to 2000, Mr. Drechsel acted as Vice Chairman and
member of the Executive Board of KPN, with specific responsibility for KPN Mobile N.V., Internet,
Strategy, M&A and marketing. Before that, he was a member of the Board of KPN Telecom and
President of KPN International. CNN.com reported that Joop Drechsel “focused on KPN Telecom's
international strategy and struck several agreements with non-Dutch partners such as Japan's NTT
DoCoMo and Hong Kong's Hutchison Whampoa.” He is described in the Form 10-K for North
Coast Energy Inc., a company of which he is a director, as one of the “founders” of KPNQwest.
44. Defendant Marten Pieters (“Pieters”) was, during the Class Period and at all times
relevant hereto, a member of the Supervisory Board of KPNQwest and Executive Vice President of
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KPN International. Pieters signed KPNQwest’s Form F-1 Registration Statement on November 5,
1999. Pieters served on the Supervisory Board of KPNQwest in his capacity as an officer of KPN
International and acted as an agent for KPN.
45. According to his c.v. posted on the internet, Pieters worked for KPN since 1989 in
high-ranking positions, first as the secretary of KPN’s Board of Management, then as the
commercial director and executive director for Telecom regions. From his appointment as Vice
President of International Operations in 1995, Pieters was responsible for projects, joint ventures,
participations and international activities of KPN Telecom. As a member of KPN's Management
Board, he was responsible for the DATA/IP division and international participations.
46. Defendant Eelco Blok (“Blok”) was, during the Class Period and at all times relevant
hereto, a member of the Supervisory Board of KPNQwest and Senior Vice President of KPN’s fixed
network operator subsidiary. Blok signed KPNQwest’s Form F-1 Registration Statement on
November 5, 1999. Blok served on the Supervisory Board of KPNQwest in his capacity as an
officer of KPN’s fixed network subsidiary and acted as an agent for KPN.
47. Blok had a long association with KPN. From 2000 to 2003, he held the position of
Senior Vice President of KPN Fixed Network Operations. Before that, he was Senior Vice President
of KPN Corporate Networks and responsible for KPN's Benelux data communication activities.
From 1996 to 1998, he was Senior Vice President of KPN Carrier Services. From 1994 to 1996, he
was Vice President Marketing & Sales of KPN Carrier Services. Before that, he held several
positions in the KPN Finance organization.
48. Defendants McMaster, Ackermans, Keating, von Deylen, Williams, Nacchio,
Woodruff, Tempest, Drechsel, Pieters, and Blok are hereinafter collectively referred to as the
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Individual Defendants.
49. Defendant Qwest Communications International, Inc. (“Qwest”) is a corporation
organized and existing under the laws of the State of Delaware with its principal place of business
in Denver, Colorado. Qwest was a founder of KPNQwest and, at all times relevant hereto, a major
shareholder of KPNQwest.
50. Defendant Koninklijke KPN N.V., also known as Royal KPN N.V. (“KPN”), is a
corporation organized and existing under the laws of the Netherlands with its principal executive
offices in The Hague, the Netherlands. KPN was a founder of KPNQwest and, at all times relevant
hereto, a major shareholder of KPNQwest.
51. KPNQwest’s outside auditor during the Class Period was Arthur Andersen LLP
(“Arthur Andersen”). Arthur Andersen disbanded in 2002 and is not a party to this action.
52. As officers and/or controlling persons of a publicly-held company whose common
stock is registered with the SEC under the Exchange Act and traded on the NASDAQ National
Market, Defendants had a duty to promptly disseminate accurate and truthful information with
respect to the Company’s operations, finances, financial conditions, and present and future business
prospects, to correct any previously-issued statement from any source that had become untrue, and
to disclose any trends that would materially affect earnings and the present and future operating
results of KPNQwest, so that the market price of the Company’s publicly-traded securities would
be based upon truthful and accurate information.
53. During the Class Period, Defendants were privy to confidential and proprietary
information concerning KPNQwest, its operations, finances, financial condition, products, and
present and future business prospects. Because of their possession of such information, Defendants
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knew or, with deliberate recklessness, disregarded that the adverse facts specified herein had not
been disclosed to and were being concealed from the public. Because of their executive and
managerial positions with KPNQwest and/or control of KPNQwest, Defendants had access to
adverse material non-public information about KPNQwest’s operations, finances, financial
condition, products, inventories and present and future business prospects. Defendants had such
access via internal corporate documents, conversations and connections with other corporate officers
and employees, attendance at management meetings and committees thereof, and via reports and
other information provided to them in connection therewith. Because of their possession of such
information, Defendants knew or, with deliberate recklessness, disregarded that the adverse facts
specified herein had not been disclosed to and were being concealed from the public.
54. Defendants, because of their positions of control and authority with the Company,
were able to and did control the contents of the various quarterly reports, SEC filings, press releases
and presentations to securities analysts pertaining to the Company.
55. Defendants were responsible for the accuracy of the public reports and releases
detailed herein as “group published” information, and are therefore responsible and liable for the
representations contained therein.
56. During the Class Period, Defendants, individually and in concert, directly and
indirectly, engaged and participated in a continuous course of conduct to misrepresent the results
of KPNQwest’s operations, and to conceal adverse material information regarding the finances,
financial condition, and results of operations of KPNQwest as specified herein. Defendants
employed devices, schemes, and artifices to defraud, and engaged in acts, practices, and a course
of conduct, as herein alleged, in an effort to increase and maintain an artificially high market price
3KPN owned its KPNQwest shares through wholly-owned subsidiary KPN Telecom B.V.of the Netherlands. Likewise, Qwest owned its KPNQwest shares through wholly-owned subsidiaryQwest B.V.
20
for KPNQwest common stock. These activities included the formulation, making, and/or
participation in the making of untrue statements of material facts, and the omission to state material
facts necessary in order to make the statements made, in light of the circumstances under which they
were made, not misleading; such activities operated as a fraud or deceit upon Plaintiffs and the other
members of the Class.
THE ROLES OF PARENTS KPN AND QWEST IN THE FORMATION ANDOPERATION OF KPNQWEST
57. KPNQwest was formed on February 26, 1999 as a joint venture of two industry
powerhouses – Koninklijke KPN N.V., one of Europe’s well-established “Ma Bell”
telecommunications providers, and Qwest Communications International (“Qwest”), a fast-growing
newcomer that quickly became one of the United States’ largest telecom providers.3 KPNQwest
combined the pan-European fiber optic network that was being developed by KPN with the
European Internet-services business of Qwest, to provide European telecommunications and Internet
services. During its short existence, KPNQwest built a 25,000 kilometer network and became one
of Europe’s largest data communications services companies, offering Internet connectivity, remote
access, website hosting, Internet broadcasting and other telecommunications services in eighteen
countries and more than 50 cities.
58. Based upon its pedigree, shortly after its establishment, KPNQwest was able to raise
€800 million in high-yield debt.
4Approximately $1.04 billion U.S. dollars, based on the then-current exchange rate of €1 =$1.0405.
21
59. On or about November 5, 1999, KPNQwest’s Registration Statement and Prospectus
(the “Prospectus”) was filed with the Securities and Exchange Commission. The Prospectus covered
the Company’s Initial Public Offering (“IPO”), comprising 44,000,000 shares of Class C common
stock, and an additional 6,600,000 shares of common stock that the underwriters had the option to
purchase to cover over-allotments.
60. The IPO commenced on November 9, 1999, and the sale to the public, at €20 per
share including over-allotment shares, raised approximately €1 billion.4 The managing underwriters
were Morgan Stanley Dean Witter, Salomon Smith Barney International, Goldman Sachs
International, ABN AMRO Rothschild and Warburg Dillon Read.
61. After the IPO, KPN and Qwest each owned approximately 44.3% of the issued and
outstanding shares of KPNQwest. Thus, during the Class Period, KPN and Qwest held and
exercised control over KPNQwest. As described herein, KPN’s and Qwest’s control of KPNQwest
was critical to the fraudulent scheme alleged herein.
62. The structure of shareholder ownership of KPNQwest evidences KPN’s and Qwest’s
domination of the Company. Specifically, only Class C shares were issued to the public in the IPO.
KPN (through wholly-owned subsidiary KPN Telecom) owned all of the Company’s 200,000,000
Class A shares, and Qwest (through wholly-owned subsidiary Qwest B.V.) held all of the
Company’s 200,000,000 Class B shares. Holders of Class A and B shares held voting rights
superior to Class C shares, such that after the offering (including exercise of the underwriters’
overallotment option) KPN and Qwest each retained 44.3% of all outstanding common shares which
22
together controlled over 98% of the voting power of the Company.
63. Under the Company’s articles of association as they existed from the time of the IPO
until December 11, 2001, the holders of the Class A and B shares each had the right to make binding
nominations for three members of the KPNQwest Supervisory Board. The remaining two members
were appointed by the general meeting of shareholders.
64. In addition to their shared voting and operational control of the Company, KPN and
Qwest also agreed to act in concert concerning various transactional issues involving KPNQwest.
The KPN and Qwest joint venture agreement forming KPNQwest, and the articles of association,
specified various items which required approval of both KPN and Qwest. These included oversight
of material strategic transactions, and of acts material to the Company’s existence or governance
(bankruptcy, liquidation, amendment to constituent documents including articles of association).
65. KPN and Qwest each had veto power over the following transactional issues: any
changes in the scope of the Company’s network, services the Company provides or the territory in
which it operates, any material acquisitions or investments, any new business opportunities offered
by one of the shareholders to the Company, or material agreements with KPN, Qwest or their
subsidiaries or certain related parties. Under these provisions, either KPN or Qwest had veto power
over the various swap transactions alleged herein involving Qwest.
66. In addition, the joint venture agreement and the Company’s articles of association
set forth additional specific items requiring the affirmative vote of both (1) a simple majority of the
Supervisory Board members, and (2) at least two of the Supervisory Board members appointed by
KPN and at least two of the Supervisory Board members appointed by Qwest. These items included
the Company’s annual budget and three-year business plan, any material financing agreement, and
23
the terms and conditions of employment of the Company’s CEO and other members of management.
Thus, each of KPN and Qwest had control of the Company’s business plan including capital
expenditures related to the swap transactions.
67. Pursuant to these arrangements, KPN and Qwest each installed its own officers and/or
directors on the KPNQwest Supervisory Board. These individuals, while supervising and managing
the business of KPNQwest, acted in their capacities as officers and/or directors of the parent and
acted as agents for KPN and Qwest, respectively. As of the date of KPNQwest’s IPO in 1999, the
KPNQwest Supervisory Board consisted of: (1) Chairman Joseph P. Nacchio, also the Chairman and
CEO of Qwest; (2) Drake Tempest, Executive Vice President, General Counsel and Secretary of
Qwest; (3) Robert Woodruff, Executive Vice President of Finance and Chief Financial Officer of
Qwest; (4) Joop Dreschel, member of KPN’s Board of Management; (5) Eelco Blok, Senior Vice
President of KPN’s fixed network operator subsidiary; and (6) Marten Pieters, Executive Vice
President of KPN International. One year later, according to the KPNQwest Annual Report for the
year ended December 31, 2000, Qwest officers Nacchio, Tempest, and Woodruff all still served on
the Company’s Supervisory Board and were joined by Richard Liebhaber, Director of Qwest Digital
Media. KPN executives Dreschel, Blok, and Pieters (who, since March 2000, was a member of
KPN’s Board of Management responsible for KPN’s international data and IP activities in Europe
and the U.S.) still represented KPN’s interests on the Company’s Supervisory Board. At the
Company’s 2001 shareholders’ meeting, KPN replaced Blok with Maarten Henderson, a member
of KPN’s Board of Management and KPN’s CFO. On December 11, 2001, Qwest and its principal
shareholder, the Anschutz Company, purchased a substantial portion of KPN’s interest in the
Company, together taking majority control of KPNQwest. Specifically, Qwest purchased
5In the public version of the EEC’s Article 6(1)(b) decision in Case No.COMP/M-2648/KPNQwest/GTS/Ebone , Issued on January 16, 2002 (available on the internet and asdocument No. 302M2648 in the Celex database), “KPNQwest is a facilities-based, pan-Europeanprovider of data-centric communications services. KPNQwest was jointly created and controlled bythe Dutch telecommunications provider KPN Telecom B.V. and Qwest CommunicationsInternational Inc., a U.S. telecommunications company. In a letter dated 12 December 2001,KPNQwest informed the Commission that due to a separate transaction on 11 December 2001between Qwest Communications and KPN Telecom, KPN Telecom had lost its veto rights overKPNQwest‘s strategic commercial behaviour and Qwest had obtained sole control overKPNQwest....”
24
14,000,000 shares and the Anschutz Company purchased 6,000,000 shares. Following the shift in
ownership control, Nacchio (Chairman) and Tempest, were joined on the Supervisory Board by
Scott A. Berman, Qwest Senior Vice President and Treasurer. In addition to the two independent
members, only a single KPN nominee, Marten Pieters, remained.
68. In a submission to the EEC under EEC regulation 4064/89 (“merger procedure”) in
seeking approval for its merger with GTS/Ebone, KPNQwest admitted that until December 12, 2001,
KPNQwest was jointly controlled by KPN and Qwest, that each of its parents had a veto over the
Company’s “strategic commercial behavior,” and that subsequent to the December 11, 2001 stock
transaction between KPN and Qwest, Qwest “had obtained sole control over KPNQwest5.
THROUGHOUT THE CLASS PERIOD, DEFENDANTS FRAUDULENTLY INFLATEDKPNQWEST’S REVENUES THROUGH UNDISCLOSED SWAP TRANSACTIONS
A. Defendants’ Scheme to Artificially Inflate KPNQwest’s Revenues by Means ofSales of Wavelengths or other Lit Capacity, in Violation of GAAP, was Initiatedat or Before the Time of the Company’s IPO.
1. KPNQwest Announces its Adoption of the Qwest Model of Selling DarkFiber to Finance the Network
69. The foundation of Defendants’ scheme was KPNQwest’s adoption, by agreement
between KPN and Qwest, of the Qwest business model. Beginning in the mid-1990s, Qwest
25
transformed itself from a regional construction company to a major telecommunications company,
and commenced the construction of its own state-of-the-art national fiber optic telecommunications
network. A construction project of that scope presented significant costs, and required Qwest to
generate a significantly increased net cash inflow to finance the project. [¶ 33]
70. In order to finance its network infrastructure build-out, Qwest in effect sold part of
the network infrastructure it was building. The Qwest network consisted of fiber laid on ducts on
routes across the United States. Qwest sold unused optical fiber (so-called “dark” fiber) IRUs. The
dark fibers were readily available for sale since Qwest typically planned to install 96 fibers or more
in a cable along each route, it would keep 48 fibers for its own use and could sell the remainder to
third parties. [¶¶35-36]
71. In recording its dark fiber IRU transactions, Qwest would book the entire sales
revenue for the 20-year leases at the time of sale. The rationale for this revenue treatment was that
dark fiber IRUs could be treated as “sales type” leases under U.S. GAAP because the IRUs were
substantially equivalent to transfer of ownership of the fibers. [¶76]
72. In its IPO Prospectus, KPNQwest purported to adopt this same scheme. As stated
therein under the heading “Dark Fiber Sales,” “We expect to lower the building costs of our
network by selling dark fiber along portions of our network. ‘Dark fiber’ refers to fiber optic cable
that is not connected to transmission electronics. In a dark fiber sale, another communications
provider purchases right to one or more of our 96 fibers for its own use, and is responsible for
providing its own transmission electronics to enable the fiber to carry traffic. Sales of dark fiber
significantly reduce our net cost per fiber kilometer with respect to fiber retained for our own use
and enable us to share operating and maintenance costs....We intend to maintain at least 48 of our
26
96 fibers for our own use on all terrestrial routes.”
2. The Qwest Model Failed, as Dark Fiber Sales Dried Up
73. The business environment had considerably changed since the Qwest business model
was formulated. At or before the time of KPNQwest's initial public offering in November 1999,
Defendants realized that the model was beginning to collapse because network build-outs by
competing carriers would be complete. The IPO Prospectus claims that dark fiber sales “are likely
to exist only for the next two or three years,” but that was a misrepresentation of the Company
insiders’ true view of the bleak prospects for dark fiber sales. As CW 5, a member of the dark fiber
sales team working on swap transactions stated, by mid-1999 everyone at KPNQwest knew that after
a year there would be no more dark fiber sales. Indeed, as early as June 21, 1999, KPNQwest noted
that a "[d]ark fiber risk emerges from [a] market change." That "market change" was an evolution
of customer demand to purchase only "lit fiber" or "capacity," and there was little or no demand in
the marketplace for significant additional dark fiber IRU transactions. [¶62].
74. By the time of the IPO, the reality of collapsing demand for dark fiber market hit
hard. Dark fiber sales plummeted in 1999. KPNQwest had budgeted nearly $80 million in dark
fiber sales in 1999, but only was able to record revenue of less than $2 million for such sales during
that period. By the end of 1999, dark fiber IRU sales were largely a thing of the past. [¶62]
Moreover, the issue of how to account for lit fiber sales was ripe at the time of the IPO. CW 2 recalls
the first sale of KPNQwest lit fiber occurred even before the IPO. In July, 1999 KPNQwest engaged
in a transaction with Level 3. This involved the sale of 16 STM-1 transmission circuits, eight to the
east (Amsterdam-Dusseldorf-Frankfurt-Kaale-Paris-Brussels-Amsterdam), and eight on the west
(Amsterdam-London-Belgium-Brussels).
27
3. The Issue of How to Create a Revenue Base for KPNQwest Ripens,as the SEC Acts on Accounting for IRUs, and Arthur AndersenResponds Under Pressure from KPNQwest
75. By the time of the IPO, the issue of proper accounting for IRU transactions had come
become prominent. Other Big Five firms pressured the Financial Accounting Standards Board to
clarify that booking revenue up-front for IRU sales was improper. [GC ¶205].
76. In response, in May 1998, the FASB Emerging Issues Task Force asked the FASB
to review accounting rules relating to the transfer of real estate, seeking clarification of the
appropriate accounting treatment for transfers of real estate with property improvements or integral
equipment (such as fiber-optic cable). In October 1998, the FASB published an “exposure draft”
of its proposed conclusion that a transfer of an improvement or integral equipment would have to
be treated like real estate, requiring a transfer of title to be treated as a sale. FIN 43, an
interpretation of FASB Statement No. 66 which was widely interpreted as barring up-front revenue
recognition for IRU sales, (as discussed herein at *), was issued effective July 1, 1999.
77. In the second half of 1999, the SEC began to dispute the propriety of up-front
revenue recognition in connection with the dark fiber IRU sales. In a series of mail communications
in October 1999, Defendant McMaster was specifically questioned and admonished by the SEC's
Division of Corporate Finance as to KPNQwest's corresponding accounting for dark fiber operating
leases as sales-type leases. [¶78]. On, November 15-16, 1999 at the Global Capacity Providers CFO
Roundtable, Eric Casey of the SEC discussed the SEC staff’s concerns about claiming up-front
revenues from IRU sales. These concerns were made known to Qwest and KPNQwest, as attendees
at the roundtable, and/or because many of these concerns were explained in Arthur Andersen’s
update to its White Paper, as alleged below.
6The Perrone memo stated (having Perrone’s client Global Crossing in mind):“The following is tentative (If there is an integrated planned transaction, that includes the
following characteristics:• separate contracts,• separate cash settlements,• independent determination of fair market value,• would either party independently enter into the transaction and• the contracts are at least 60 days apart
Global Crossing might be able to recognize this transaction at fair value.”
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4. Arthur Andersen Formulated Its Position; KPNQwest Selected ArthurAndersen as Auditor and Pressured its Auditor Toward Ever MoreGenerous Revenue Recognition
78. Meanwhile, Arthur Andersen developed its position on the revenue recognition issues
involved in sales of IRUs. In a February 10, 1999 memo, Joseph Perrone, a leading Arthur
Andersen accountant in the field of telecommunications, explained how two telecom companies
could realize like amounts of revenue by exchanging like amounts of capacity. Perrone’s memo
concluded that the strictures of APB No. 29 for like kind exchanges could be avoided by obscuring
the reciprocal nature of the transaction6.
79. On September 30, 1999, Andersen published a report called “Accounting by
Providers of Telecommunications Network Capacity” (later simply called the “White Paper”), which
responded to FIN 43. The White Paper summarized FIN 43 but concluded that immediate
recognition of IRU sales was still possible if the deal documentation was crafted toward that end.
The White Paper also followed Perrone’s earlier endorsement of revenue-generating swaps. The
White Paper was distributed widely in the telecom community. [GC ¶¶ 223-225].
80. According to CW 26, who was part of the core group from KPN involved in forming
the Company and who became the company’s treasurer, the methodology for IRU accounting and
revenue recognition was an issue in the “beauty contest” between KPN’s accounting firm
7There was no need for a full-fledged outside auditor at the time of the IPO, since the IPOProspectus only presented a balance sheet dated as of the date of KPNQwest’s formation in April,1999. No income statement was included, and no audit of results of operations was thus requiredprior to the IPO. Thus there was no need to discuss the method to be used for IRU accounting inexpertised portions of the IPO Prospectus, i.e., in the financial statements section. PwC did notendorse or comment upon, either directly or indirectly, the discussion of IRU sales or of FIN 43 inthe body of the IPO Prospectus.
29
(PriceWaterhouseCoopers, or “PwC”) and Qwest’s accounting firm Arthur Andersen for the position
of KPNQwest outside auditor. Through its audit work for Qwest, Arthur Andersen endorsed the
approach taken by Qwest. PwC’s more conservative approach is reflected, for example, in the books
of Colt Telecom (another PwC client). A note on the Colt Telecom financial statements concerning
the reconciliation of U.K. GAAP to U.S. GAAP states that sales revenues from sale of 20 year IRUs
is taken upfront under U.K. GAAP, but “Under U.S. GAAP these leases are treated as a 20 year
operating lease.”
81. Thus, Defendants’ choice of Arthur Andersen as outside auditor for KPNQwest was
an essential part of Defendants’ scheme. The naming of PwC as KPNQwest’s auditor at the time
of the IPO does not undermine the existence of the scheme at that time, since it carries no
implication for whether or not Arthur Andersen had been selected as ongoing auditor by the time
of the IPO7.
82. KPNQwest received a Qwest memorandum, dated October 3, 1999, entitled
"Accounting for IRUs" that detailed the differences between Arthur Andersen's position paper on
IRU accounting and Qwest's accounting treatment for IRUs, and outlined how Qwest could
recognize up-front revenue on IRU transactions when, in fact, such treatment was inappropriate.
[¶110a]
83. Qwest personnel, acting on their own behalf and on behalf of KPNQwest, interacted
30
with Arthur Andersen in an effort to persuade Arthur Andersen to give its blessing to capacity IRUs.
This effort was an essential part of the scheme, because without it Qwest and KPNQwest’s financial
statements could not pass muster in the eyes of their outside auditor. The effort was successful, and
resulted in the publication, on or about February 29, 2000, of an update to the original White Paper
(hereinafter referred to as the “White Paper Update”), which set forth Arthur Andersen's opinion,
and at least some of the underlying rationale, for continuing to treat capacity IRUs deals as sales
type leases. By wire and/or mail, the White Paper Update was transmitted from Qwest and/or Arthur
Andersen in the United States to KPNQwest. [¶80]
5. Accounting Disclosures in the IPO Prospectus Reflect Formulation of theScheme to Recognize Up-Front Revenue for Sales of Lit Fiber IRUs
84. Thus KPNQwest formulated an approach to allay the SEC’s concerns by adopting
a more conservative approach concerning dark fiber sales, while at the same time failing to disclose
that it had adopted an accounting policy which provided for accrual of up-front revenues for sales
of 20-year lit fiber IRUs. The IPO Prospectus made the following disclosures regarding accounting
for dark fiber IRUs, under the heading “New Accounting Pronouncements”:
New Accounting Pronouncements....In June 1999, the FinancialAccounting Standards Board issued FASB Interpretation No. 43,‘Real Estate Sales, an interpretation of FASB Statement No. 66.’ Theinterpretation is effective for sales of real estate with propertyimprovements or integral equipment entered into after June 30, 1999.Under this interpretation, title must transfer on propertyimprovements and integral equipment for a lease transaction to beconsidered a sales-type lease. Under this interpretation, we haveconcluded that the conduit and possibly the fiber included in ourfuture dark fiber sales are integral equipment....Under the priorpolicy, we classified our sole dark fiber transaction as a sales-typelease and accordingly, the transfer price will be recognized asrevenue as the segments of our network specified by the contract aredelivered and accepted by the purchaser. Had this transaction been
31
entered into subsequent to the effective date of the interpretation, thetransfer price would be recognized as revenue ratably over the termof the contract....All future sales of dark fiber will be evaluated underthe new interpretation....If we do not pass title on the integralequipment pursuant to the agreements related to future transactionsinvolving dark fiber sales or if such transactions otherwise do notmeet the criteria in FASB Statement No. 66, we will recognize thetransfer prices as revenue ratably over the terms of the applicableagreements, rather than when the applicable segments of our networkare delivered to, and accepted by, the purchaser. Although theapplication of the new interpretation will affect the times ofrecognition of our revenue from dark fiber sales, we expect there willbe no effect on our financial position or cash flows from thisprospective change in accounting.
85. The IPO Prospectus further disclosed that “Prior to June 30, 1999, we entered into
one dark fiber transaction for a total transfer price of $22.0 million....Under the prior policy, we
classified our sole dark fiber transaction as a sales-type lease and accordingly, the transfer price will
be recognized as revenue as the segments of our network specified by the contract are delivered and
accepted by the purchaser. Had this transaction been entered into subsequent to the effective date
of the interpretation, the transfer price would be recognized as revenue ratably over the term of the
contract.”
86. Given this careful, elaborate disclosure of the accounting methodology for sales of
dark fiber IRUs, it was clearly reckless not to make corresponding disclosures for the accounting
for lit fiber IRU sales. The sale of lit fibers was disclosed in the IPO Prospectus, as follows:
“Products and Services Wholesale Services. Our managed broadband serviceprovides managed, city-to-city bandwidth capacities....We have also introduced anew class of wholesale services known as ‘colors’ or ‘wavelengths’ which provide2.5 Gbps or 10 Gpb wavelengths to customers. This service is designed forcustomers who require very large transport capacities between cities, but who do notwish to purchase dark fiber and invest in the transmission electronics necessary toenable the fiber to carry traffic.”
8 As demonstrated herein, and in various documents attached as Exhibit A hereto,many of the deals between Global Crossing and Qwest expressly indicate that they are forKPNQwest capacity and/or are being made to enable KPNQwest to meet its revenue projections.
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87. However, despite the existence prior to the IPO of at least one lit fiber IRU sale--the
sale to Level 3 alleged below--neither the existence of this sale, nor the accounting methodology
applied to this sale was disclosed in the IPO Prospectus.
B. The History of Hollow Swaps Among and Between KPNQwest, Qwest and Global Crossing Demonstrates That The Swaps Were Entered Into as Partof a Scheme to Generate Revenues to Meet Market Guidance and Expectations
88. Extensive documentation, in the form of correspondence within and among the
various companies involved, was released in conjunction with Congress’s investigation of Qwest’s
and Global Crossing’s abuse of capacity swaps. These documents, primarily authored by various
high-level employees of Qwest and Global Crossing, display various indicia of illegitimacy that
demonstrate that many of the swap deals entered into between and among KPNQwest, Qwest and
Global Crossing were not actual “sales.”8
89. First and foremost, the correspondence demonstrates that there was no bona fide
business purpose for many of these deals. If the companies involved actually needed to purchase
capacity in particular geographic locations where they did not have their own telecommunications
lines, they would have purchased such capacity regardless of whether their sellers purchased
anything in return. However, substantial evidence demonstrates that the KPNQwest-Qwest-Global
Crossing capacity swaps were two-sided, reciprocal deals, with each side’s purchases made solely
in exchange for the other side’s purchase. (Although each side of the swap was documented as a
separate transaction, both sides were an integral part of one deal between the companies involved.)
33
Based upon these emails and memos, it is apparent that KPNQwest’s sales to Qwest and Global
Crossing, which totaled nearly €325 million in 2001, were part of a fraudulent scheme to boost the
revenues of all three companies -- with reciprocity being a required element rather than an
unnecessary coincidence:
a. To: Patrick Joggerst. From: Brian Fitzpatrick: “We need the top line revenue bythe close of the quarter. In order to get it we have to spend a reciprocal amount withkey carriers. In this case Qwest.” (Global Crossing internal e-mail, from June 28,2001; emphasis supplied);
b. To: Steve Sherman. From:Vice President of Carrier Sales Robin Wright (“Wright”):“Subject: KPN/Qwest Big Deal #s and Qwest 3rd Qtr deal: Greg [Casey of Qwest]is ready to write a check for 75 million this quarter for capacity on SAC [SouthAmerican Crossing]. What the hell are we going to buy?” (Global Crossing internalmemo, August 24, 2001, referring to a swap with Qwest; emphasis supplied);
Sherman’s response queries: “Do we want to continue on a course of dollar for dollarreciprocal deals with Qwest ...” (Emphasis supplied.)
90. The unambiguous language of each of these communications leaves no doubt that
the purpose of these swaps was revenue recognition, not the operational business needs of the
parties. This explains the required reciprocity: one side would “buy” transmission capacity only if
that “buy” could generate revenue through a reciprocal capacity sale to the seller. The goal was to
generate sufficient revenue to meet the quarterly expectations of Wall Street analysts. The following
documents, drafted during the last month of various reporting quarters in 2001, underscore that
meeting revenue guidance figures (rather than making deals for needed capacity) was the sole
purpose for many of the capacity swaps made by Global Crossing, KPNQwest’s partner in €100
million worth of swap “sales” in 2001:
a. To: David Walsh. From: Brian Fitzpatrick. cc: Patrick Joggerst. bcc: JosephClayton. “Subject: GAP Closing - 3rd Q IRU Deals: As of today (Sept. 6th) the highend of the working IRU sales number for the 3rd quarter will be $100-$125M. Given
34
that we have a target of approximately $725M, we obviously have a huge gap. Aftermany discussions with the team we have identified the following deals that, ifconsummated could contribute to closing the $600M gap. No one on the team issuggesting that we enter into any of the following deals under normal operatingconditions.” (Global Crossing internal email, September 6, 2001; emphasissupplied);
b. To: David Carey. From: Patrick Joggerst. “Qwest is now in the MUST DO categoryto make this quarter’s numbers” (Global Crossing internal email, March 8, 2001;underline supplied);
c. To: Patrick Joggerst. From Robin Wright. “We are now 3 weeks away from the endof the quarter and it is clear that expediting some capital expenditures is going to bekey to meeting the Street’s expectations.” (Global Crossing internal email, March9, 2001; emphasis supplied);
d. To/cc: Various. From: Robin Wright. Subject: “1Q Reciprocal deals: Right nowit looks like we’ll need to make network purchases in the neighborhood of $250M-$350M in order to meet the revenue target.” (Global Crossing internal email, March13, 2001; emphasis supplied);
e. From: Robin Wright. To: David Walsh. “I think the IRU number ends up being theplug number in order to meet the street’s expectations.” (Global Crossing internalemail, August 30, 2000; emphasis supplied);
As accurately summarized by one participant, in an undated Global Crossing internal memo: “When
saddled with an unreasonable revenue expectations, we do the crazy deals at the end of the quarter.”
91. Moreover, there was no attempt to hide the fact that there was no bona fide business
justification for the deals, as demonstrated by the following internal Global Crossing documents:
a. To: S. Wallace Dawson. From: Michael Coghill. “In reviewing the latest Qwestdeal status I see that US domestic waves has been increased to 60m. We are nowbeing asked to provide business cases to support this transaction. This discussionbegan with US waves at 15M which we could not find justification for, let alone60m. We will be factual in our estimation of the value or usefulness of these assetsbut in good conscious cannot pretend to develop a business case that justifies thistransaction, but rather one that will show our economic risk.” (March 28, 2001,e-mail; emphasis supplied);
b. To: Jim Cali (“Cali”) (cc: David Walsh, Patrick Joggerst). From: Wright. Regarding
35
quarter-end deals: “As far as we know, the decision has been made to figure out howto make our quarterly commitment and that we are not backing away from any dealson the table.”
Cali responds to Wright: “Robin, [i]f we are moving ahead with these dealsregardless of the product management input that’s fine then I don’t see whywe are being asked what capacity we need in all these regions if the input isdisregarded anyway....It has been driven home we are going to be the groupresponsible for margin and revenues....” (September 26, 2001, e-mail).
92. Each party in these hollow swaps shaped its purchase to meet the other side’s goal,
to wit, revenue recognition. The following communications demonstrate that the companies actively
assisted one another to meet their respective revenue targets:
a. From: Robin Wright. To: Various. “Apparently Qwest is on track to meet theirquarterly numbers, but KPN/Qwest is struggling. They would like us to allocate$25M of the $100M for purchases in Europe.... Right now it looks like Europe needsto step up and commit to $25M to KPN/Qwest in order to move the deal along.”(Wright email, March 13, 2001; emphasis supplied);
b. From: Robin Wright. To: Various. Subject: “A bump in the Qwest road: In ourdeals with Qwest, any capacity/ducts/dark fiber that we by from them has to beactivated in order for them to get revenue recognition.” (Wright e-mail. June 25,2001);
c. Wright e-mail to Qwest’s Susan Chase: “As we’ve agreed, because we are bothbeing delivered what we probably don’t want in the long term, we have agreed, onboth sides, that the repurchase price is the actual amount paid, not the fair marketvalue.”
Chase responds: “I agree with your comments ... ” (E-mail exchange, June 25, 2001);
d. To: Richard Mondello, S. Wallace Dawson. From: Charles Morris. “Can we turnupMAC Waves for Qwest for their revenue recognition purposes instead of PEC? Iknow we don’t have SDH on it, but maybe we can structure the deal that we canborrow back the two waves to integrate them into our SDH until we turn up the SACstuff.” (Internal e-mail from Global Crossing’s Director of Business Development,September 24, 2001; emphasis supplied).
93. Because each side “purchased” assets in the swap which it did not need for business
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purposes, the deals allowed each side, to trade in its acquired assets at a date subsequent to the initial
swap, for other assets it may actually want or need. The following Global Crossing communications
detailed various “side deals,” including a Q1 2001 deal with KPNQwest which demonstrates that
KPNQwest did not complete the earning process for the capacity “sold” during Q1 2001:
a. To: Peter Alavanja. From: Peter Calis.“I understand that we commit for 45 M for‘wavelengths’ in Europe but to be converted into fiber and/or duct at a later stage .. . . April 10 I have a meeting scheduled with KPNQwest to discuss those details...soat this point of time I don’t know which fibers or ducts . . . ” (Global Crossing e-mail, March 29, 2001; emphasis supplied) and;
b. “Under the side letter...it was agreed that this dark fiber was portable for dark fiberanywhere in the US or Europe. So we have the right to exchange these routes forwhat we actually want.” (E-mail from Jackie Armstrong to Jamie Delorimier andPeter Avanja, forwarded to Wright from Delorimier, September 25, 2001).
C. Specific Swap Transactions During the Class Period
1. Transactions with Global Crossing
94. In the third quarter of 2000 and in the first and second quarters of 2001, KPNQwest,
Qwest and Global Crossing were involved in a number of hollow swaps. As the e-mails described
in the prior section demonstrate, Global Crossing purchased unneeded and/or unspecified capacity
from Qwest and KPNQwest to assist in inflating Qwest’s and KPNQwest’s revenues to meet the
revenue projections given to Wall Street analysts. Global Crossing was willing to so accommodate
Qwest and KPNQwest because these deals were conditioned on Qwest’s reciprocal “purchase” of
capacity from Global Crossing. Sometimes, KPNQwest’s involvement was with respect to the
European transmission capacity involved in deals between Qwest and Global Crossing. Specifically,
Confidential Witness No. 1, who was in charge of KPNQwest’s development department during the
Class Period and who handled submarine cables (including those which were swapped), explained
9The trustees’ RICO complaint alleges at ¶122.a: “In the third quarter of 2000, KPNQwestentered into a capacity swap with Global Crossing whereby KPNQwest purchased $54 million inunneeded capacity from Global Crossing, and sold $54 million in unneeded capacity to GlobalCrossing, and KPNQwest recorded as "sales" revenue the full $54 million in the third quarter(thereby boosting its apparent value as a Qwest asset).”
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that Qwest was dependent on KPNQwest for European transmissions. Thus, when Qwest’s partners
in swap deals, such as Global Crossing, sought European capacity, Qwest obtained it from
KPNQwest.
a. Third Quarter 2000 Swap
95. In the third quarter of 2000, KPNQwest entered into an undisclosed and improper
capacity swap with Global Crossing whereby KPNQwest purchased $54 million in capacity from
Global Crossing, and sold $54 million of capacity to Global Crossing. The trustees’ RICO
complaint confirms the existence of the third quarter 2000 swap with Global Crossing.9
96. Plaintiffs’ knowledge of this deal is derived from a complaint styled JP Morgan
Chase Bank v. Gary Winnick, et al., an action filed against Global Crossing officers and directors
by JPMorgan Chase Bank (“JPMC”) as administrative agent for a consortium of bank lenders that
lent money to Global Crossing or its subsidiaries or affiliates. The lawsuit, which was originally
filed in October 2003 in the Supreme Court of the State of New York, County of New York, and
assigned Index No. 603363/03, was immediately removed to the United States District Court,
Southern District of New York, and assigned Case No. 03 CV 8535 (the “JPMC Complaint”).
97. The JPMC Complaint alleges, at ¶108, that Global Crossing engaged in at least three
“Improper Swaps” in Q3 2000, including the $54 million swap with KPNQwest and swaps with
Cable & Wireless and Telecom Italia. The JPMC Complaint further alleges, at ¶113, that such
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swaps should not have been reported as revenue because “they were not true sales of IRUs but were
fraudulent transactions with no business purpose.”
98. The JPMC Complaint explicitly sets forth the basis for JPMC’s determination that
the Q3 2000 swap between Global Crossing and KPNQwest was not a legitimate sale:
a. JPMC alleged, at ¶¶86-91, the various elements which Global Crossing’s top
management indicated were essential to formulate a “business case,” i.e., an analysis
used by Global Crossing to justify a business decision, in this instance a capacity
swap;
b. JPMC averred, at ¶92, that it had undertaken a “detailed review of more than twenty
Global Crossing business cases for Improper Swaps concluded between the third
quarter 2000 and the third quarter 2001;”
c. JPMC averred, at ¶92, that the more than twenty business cases it reviewed failed to
contain any of the various analyses Global Crossing itself deemed essential to justify
going forward with a transaction. Specifically, the business cases -- including the
one pertaining to the $54 million swap with KPNQwest -- lacked discussions of the
“pros and cons” of the deal, the potential future costs of the deal, customer demand
forecasts, or estimates of customers’ technical requirements. Id. at ¶¶92-93.
b. First Quarter 2001 Swap
99. In the first quarter of 2001, KPNQwest’s revenue was inflated by $45 million,
representing the “purchase” of capacity by Global Crossing in exchange for Qwest’s “purchase” –
by swap – of an equal amount of capacity from Global Crossing (“First Quarter 2001 Swap”). The
10The trustees’ RICO complaint alleges at ¶122.a: “In the first quarter of 2001, KPNQwestrecorded $45 million in revenue from Global Crossing's "purchase" of capacity from KPNQwest,which Global Crossing agreed to in exchange for Qwest's swap purchase of an equal amount ofcapacity from Global Crossing. Because Global Crossing did not need the capacity it acquired fromKPNQwest, and in order to conceal the swap nature of the transaction, the parties entered into a sideagreement (dated March 27, 2001), which allowed Global Crossing to later exchange the unneededcapacity it was purchasing for other (as yet unspecified) Qwest or KPNQwest capacity ortelecommunications facilities.
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trustees’ RICO complaint confirms the existence of this deal.10 Documents reflecting this deal and
KPNQwest’s participation in this deal are as follows:
a. March 13, 2001 Global Crossing E-mail reflects that KPNQwest was included in the
deal with the specific intent of inflating its revenue:
“Subject: 1Q Reciprocal Deals....Apparently Qwest is on track to meet theirquarterly numbers, but KPN/Qwest is struggling. They would like us toallocate $25M of the $100M for purchases in Europe....Right now it lookslike Europe needs to step up and commit to $25M to KPN/Qwest inorder to move the deal.”
b. March 23, 2001 E-mail From Joe Dalton (“Dalton”) of KPNQwest to Greg Casey of
Qwest:
Here’s the latest idea. GC agreed to $110 M on EAC [East AsiaCrossing]...They up their purchase to $45M un-reg waves. $45M Europe*and they do a binding $30M MOU for metro IRUs....*The Euro capacity canbe $14M TAT14 backhaul and the balance in Euro rings (must be portableto Dark Fiber).
c. March 28, 2001, Qwest Internal E-mail:
From: Susan Chase. To: Roger Hoaglund, Joe Dalton, Britt Bischoff. Wehave all the agreements ready to sign. We will need to add some circuits tothe existing wave and European agreements to show the detail of the totalamounts. Legally we can sign and add in parallel. The acceptance letterswill be done in the am. I am trying to get Greg [Casey] to sign before heleaves for the airport. We will need to make sure we have the invoices doneand the wire transfer ready to go in the am ....
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In summary, Global Crossing is buying 60 million in US Wave service, withportability. With an additional 45 million for European services with theability to port to dark fiber. Grand total is 105 million in bookable revenueto Qwest. Global has also committed to a binding MOU for an additional$15 million in metro services. [Emphasis added].
Qwest is buying 110 million dollar North Asia ring with portability on all ofEAC. Additionally we are purchasing 30 million of PCI capacity...Totalpurchase is 140,000,000 million less the 20 million we paid in the 3rd quarterbrings the deal down to 120,000,000.
100. Global Crossing communicated to Qwest and KPNQwest that its purchases were
intended to allow the struggling KPNQwest to recognize revenue recognition, not for a bona fide
business purpose. Because Global Crossing was obtaining capacity it did not need, the parties
entered into a side agreement dated March 27, 2001, which allowed Global Crossing to exchange
its capacity for other Qwest or KPNQwest capacity at a later date. The side agreement states, in
pertinent part:
It is the intention of the parties to the Agreements that followingactivation of the capacity purchased thereunder (“Capacity”), thePurchaser will, subject to availability, upon mutual consent of theparties and upon thirty days written notice to the Provider, be allowedto sell back Capacity purchased pursuant to the Agreements inexchange for the relevant Purchaser’s purchase of an IRU, in any ofthe following: (the “New Assets”)
(i) bandwidth capacity between the same or alternative sites inEurope or the USA;
(ii) dark fiber between the same or alternative sites in Europe orthe USA;
(iii) conduits anywhere in Europe;
(iv) entrance facilities in North America which providesconnectivity to a mutually agreed upon point.
101. Thus, it was known to all parties from the outset that Global Crossing intended to
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convert the capacity it obtained (and did not want) for other fiber at a later date. A March 29, 2001
internal Global Crossing e-mail supports this conclusion:
This is a tricky one! I understand that we commit for 45M for“wavelengths” in Europe, but to be converted into fiber and/or ductat a later stage....April 10 I have a meeting scheduled with KPNQwest to discuss those details...so at this point of time I don’t knowwhich fibers or ducts...But since we should specify some detail here,I would suggest to detail our target for this 45M: 2 ducts on the routeFrankfort-Nuremberg-Prague-Vienna-Munich, for a total route lengthof some 1200 Km.” [Emphasis added].
102. Such side agreements confirm that Global Crossing accepted capacity it did not want
with the express intention of moving (sometimes expressed by the parties as “porting”) the capacity
to routes it actually desired at a later date -- a date beyond the close of the quarter in which the
revenue was booked by KPNQwest.
c. Second Quarter 2001 Swap
103. In second quarter 2001, an even larger swap deal occurred between Qwest,
KPNQwest and Global Crossing (the “Second Quarter 2001 Swap”). The European capacity for the
deal came from KPNQwest, part of which was purchased by Qwest from KPNQwest for the deal,
and part of which was contracted directly with KPNQwest. As stated in an Arthur Andersen memo
dated March 24, 2002 investigating Qwest’s swap transactions, in the Second Quarter 2001 Swap
“Global Crossing insisted on substantial European capacity in this transaction. Qwest needed to
acquire the capacity (for cash) from KPNQwest under its distribution agreement in order to complete
the transaction.” The side letter for the transaction, dated June 27, 2001, provided that Global
Crossing would acquire “Telecommunications Ducts with a purchase price of $38,000,000 (the
‘Ducts’) to be purchased pursuant to an Agreement for the sale of Telecommunications Ducts on
11In addition, in the second quarter of 2001, KPNQwest, Qwest, and Global Crossingengaged in a swap whereby KPNQwest provided unneeded telecommunications facilities to GlobalCrossing, part of which were purchased directly by Global Crossing and part of which werepurchased by Qwest and then conveyed to Global Crossing. As a result of this swap, KPNQwestrecorded approximately $55 million in revenues in the second quarter of 2001 (again pumping upits apparent asset value to Qwest). As with the first quarter 2001 swap transaction, the partiesreached a written side agreement and an additional oral agreement (confirmed through e-mail) toallow Global Crossing to later exchange what it purchased for something it wanted or needed andto make Global Crossing "whole."
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KPNQwest’s Eastern European Ring made between Qwest and GC Ireland” and “Dark fiber in
Europe with a purchase price of $17,000,000 (“Dark Fiber”) to be purchased pursuant to a Dark
Fiber IRU Agreement made between Qwest and GC Ireland.”
104. The Second Quarter 2001 Swap described above improperly inflated KPNQwest’s
revenues by at least $55,000,000 for the second quarter of 2001. The trustees’ RICO complaint
confirms the existence of this deal.11
105. KPNQwest’s direct involvement in this transaction is demonstrated by several e-
mails. For example, Jean Louis Colen of KPNQwest received a series of e-mails from Global
Crossing and/or Qwest dated June 20-21, 2001 that circulated the draft agreements and side letter
for the deal. A June 19, 2001 e-mail from Wright to personnel at Qwest and KPNQwest entitled
“Next Steps, Importance: High,” stated that “Jan and Jean Louis [Colen of KPNQwest] will work
on pricing first thing tomorrow then head to our [Global Crossing] offices at 88 Pine (at Water
Street) to finalize the commercial terms with Doug, Steve and Peter (via phone).”
106. Similarly, Casper Winkelman (“Winkelman”) of KPNQwest, Erin Wray (“Wray”),
corporate controller of KPNQwest and Graham King (“King”) of KPNQwest were included as
recipients of e-mails dated June 25, 2001, that circulated revised documentation of the deal. Their
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important roles are highlighted by the fact that they were included as recipients of direct e-mails
from Global Crossing’s counsel at the Perkins Coie law firm discussing terms of the deal
documentation. Another e-mail from Steve Sherman of Global Crossing dated June 22, 2001 stated
“[m]y understanding in speaking with Peter Calis and KPN/Qwest previously is that the Ducts
(Eschenfeld-Prague-Vienna-Munich) are only 85% complete. ...”
107. An issue arose concerning the side deal for “portability” which, like the side letter
in the First Quarter 2001 Swap, would enable Global Crossing to trade in, at a later date, capacity
it received in the swap which it did not need or want, for other capacity from Qwest or KPNQwest.
Qwest’s accounting department, as well as KPNQwest’s, wanted the traded-in capacity to be valued
at its fair market value at the time of the subsequent trade, rather than (as was the case in the First
Quarter 2001 Swap) the amount Global Crossing “paid” for that capacity, i.e., its value at the time
of the initial swap. Global Crossing objected to the revised pricing arrangement because the
ongoing steep declines in capacity price meant that Global Crossing would lose money if capacity
included on its books at its purchase price had to be subsequently marked down when traded.
108. In the e-mail discussions on how to price the trade-in, the parties openly discussed
that Global Crossing was obtaining capacity it did not want or need, with the intention of
exchanging it later. The parties also openly stated that such capacity was being activated or “lit”
to accommodate the revenue recognition needs of Qwest and KPNQwest.
109. A June 24, 2001 e-mail from Martin Rips to Jackie Armstrong (“Armstrong”) of
Global Crossing (which was copied to various people at Qwest and King, Wray and Winkelman of
KPNQwest) stated that “Qwest accounting people are focused on the issue of whether the repurchase
price should be based on fair market value (as Qwest prefers) versus what was paid for the item (as
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GC prefers).”
110. On June 24, 2001, Wray sent an e-mail to Armstrong, which was cc’d to various
people at Qwest, stating “Regarding the portability letter, KPNQwest also needs the repurchase price
to be at FMV and not what GC paid for it.”
111. A June 24, 2001 e-mail from Armstrong to various personnel at Qwest and
KPNQwest objected to the revised pricing arrangement:
We wont accept this. We have had this argument every quarter and it haspreviously been accepted that as we are only activating capacity we arebuying by 30 June because this is Qwests requirement it would beunreasonable that in say six months time when we activate what we actuallyneed we suffered because of a fall in the price. (Emphasis supplied.)
112. A June 25, 2001, e-mail from Robin Wright, “Subject: A bump in the Qwest road,”
stated as follows:
We’ve agreed to move forward but I wanted to alert you to an issue that cameup this evening. It has to do with portability. Here’s the deal:
In our deals with Qwest, any capacity/ducts/dark fiber that we buyfrom them has to be activated in order for them to get revenuerecognition. Since in many cases, we buy a bucket of services, theyjust activate what they can and we in turn have the right to port thatto what we want once we decide what we want. We have alwaysagreed that the value of that is what we paid for it, not fair marketvalue. Our argument has been that we do not want to be penalizedfor their rev recognition rules. Now, their accountants are insistingthat it has to be fair market value. So, we in turn are adding this toour agreement on the sell side. In truth, they have more at risk dueto the structure of the deal. In any case, we have no choice.
113. The outcome was to agree to do it “both ways,” by having the trade-in value specified
as the fair market value in the written side letter, with an unwritten understanding that Global
Crossing will be kept whole by recognizing the initial purchase price as the trade-in value of the
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capacity obtained in the swap. This understanding is stated in a June 25, 2001, exchange of e-mails
between Wright and Susan Chase (“Chase”) of Qwest:
This is an issue that we keeps raising it’s ugly head. As we’veagreed, because we are both being delivered what we probably don’twant in the long term, we have agreed, on both sides, that therepurchase price is the actual amount paid, not the fair market value.You both know the issue, we are taking capacity in order to help withrevenue recognition issues. Can you kindly tell Erin Wray (asap ifpossible) that we have already agreed on this and explain that we aredoing it both ways? Thanks much.
Chase’s response to Wright later on June 25, 2001:
I agree with your comments below. It is our intention to keep youwhole. This language is in our last agreements. Accounting needsto reflect this in the upgrade and portability language.. ...
114. When the issue of the terms of Global Crossing’s exchange of capacity obtained in
the third quarter was raised, Armstrong noted the “unusual” situation of the oral understanding
conflicting with the written side agreement. In an e-mail to Wright dated August 16, 2001,
Armstrong stated as follows:
This is a little unusual because what the agreement actually says andwhat we very clearly agreed with Qwest is not the same. This isbecause Qwest’s strict accounting requirements demand that the buyback language be couched in very specific language. What theagreement actually says is that we need their consent to the buy backof the circuits and that the circuits will be bought back at marketvalue at the time of the repurchase (which clearly could be less thanwhat we paid). So strictly under the terms of the agreement theycould just refuse to buy them back.
HOWEVER what was actually agreed (and we went through this amillion times so there is no misunderstanding) was that they wouldallow us to sell the circuits back to them at the price we paid and toswap them for capacity we actually want for the same price. ...
115. The parties’ verbal understanding that there would be free portability (exchange) of
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capacity was also reflected in a September 25, 2001, e-mail from Armstrong, forwarded to Wright,
which states: “As everyone involved knows the portability language is not great - we need their
consent to the swap - but we had their word that they would consent.”
116. CW2, vice president in charge of duct and infrastructure sales, and Ewoud
Mogendorff’s predecessor in charge of global trading before a separate department of that name was
established, recalls the second quarter 2001 Global Crossing deal, which is the only reason he made
his revenue targets for the year. He recalls it was a three-way deal with Qwest and Global Crossing,
wherein KPNQwest could off-load ducts and dark fibre. Although the deal was signed in May, 2001
and included in the second quarter 2001 results for the Company, KPNQwest did not have parts of
the East European ring routed through Munich-Vienna-Bratislava into Germany (Essenfelder, near
Nurenburg) in place. According to CW2, the deal really was not finalized until December, 2001.
d. The Q3 2000, Q1 2001, and Q2 2001 Swaps Improperly Inflated KPNQwest’s Financial Results
117. The three swap deals described above, among Global Crossing, Qwest and
KPNQwest, provided KPNQwest with $54, $45, and $55 million respectively, or €154 million in
total revenue. A February 22, 2002 list of assets compiled by Global Crossing confirms these
“sales,” indicating that Global Crossing owned $110 million in capacity originating from “Qwest
Eur,” i.e. KPNQwest. Plaintiffs are informed and believe, and based thereon allege, that the
difference between the capacity purchased between Q3 2000 and Q2 2001 and the capacity owned
by Global Crossing at the time of its bankruptcy, approximately €44 million, is either attributable
to a decline in the value of the assets and/or to the fact that Global Crossing swapped/sold the
European capacity it admittedly did not need to another telecommunications company.
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118. The trustees’ RICO complaint admits that the transactions between Global Crossing,
Qwest and KPNQwest were improper. As alleged therein: “The impropriety of these transactions
is admitted. For example, documents uncovered in recent Congressional inquiries into Global
Crossing's fraudulent accounting practices and resultant bankruptcy confirm that, with respect to the
Global Crossing, Qwest, and KPNQwest transactions described... (i) there was no bona fide business
purpose for many or all of these transactions; (ii) neither KPNQwest, Qwest, nor Global Crossing
needed the capacity they acquired from the others (underscored by the fact that the purchased
capacity in some instances was unspecified) or, if they did, they would have acquired it without a
reciprocal purchase from the other party; (iii) the transactions were two-sided, reciprocal swaps,
with each side's purchase made solely in exchange for the other side's purchase; (iv) the parties
would arrange side deals to allow for further exchanges or swaps and to make each side "whole";
and (v) the purpose of these transactions was to artificially boost the revenues of each side.”
2. Other Illegitimate Capacity Swap Transactions
a. Flag Telecom
119. On March 23, 2001 Flag Telecom (“Flag”) issued a press release announcing the sale
to KPNQwest of multiple wavelengths on Flag’s trans-oceanic cable system, Flag Atlantic-1, a new
cable between London, Paris and New York City. On March 29, 2001, just prior to the end of Q1
2001, Flag and KPNQwest jointly announced on Business Wire that Flag had selected KPNQwest
for its “European Network and Co-Location Expansion” which included the purchase of “dark fiber”
on KPNQwest’s pan-European fiber-optic network.
120. Communications between the parties in first quarter 2001 indicated that this was
another hollow swap deal, the “sale” part of which KPNQwest forced upon Flag. In particular, a
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series of e-mails circulated among Qwest and KPNQwest executives, including McMaster and
Afshin Mohebbi, Qwest’s COO, indicated that Flag was not in a position to enter into a “substantial
‘swap’ deal.” Thus, Qwest VP Frank Lukas initially concluded in a January 3, 2001 e-mail to Jack
McMaster, among others, that the initial plan -- for Qwest and KPNQwest to swap $70-80 million
worth of capacity in 2001 and 2002 – would have to be abandoned: “Based upon what we learned
from Flag, it looks like they cannot make a commitment for $80 M or anything approaching that.
In fact, they have indicated that they are not in the position to swap anything for Flag North Asia
Loop...” The reason given by Flag was that the North Asia Loop cable was still in the process of
being built and Flag need to obtain cash – not a swap of capacity – to pay its suppliers.
121. Prior to reaching this conclusion, Lukas listed potential transactions between
Qwest/KPNQwest and Flag, including the following: “Europe transaction $30 million. Flag and
KPNQwest have been working on a deal where Flag would buy dark fiber in Europe plus co-
location from KPNQwest and Flag would offer to return wavelength capacity on FA-1 Trans-
Atlantic cable and/or capacity on the older Flag Europe-Asia cable.” (These were the deal terms
ultimately announced.)
122. In a contemporaneous e-mail of January 3, 2001, discussing another potential deal
with Flag, McMaster set forth his intention that any deal be reciprocal, stating, “[at] the very least
we should make sure that if it turns out that Ross needs the Asia capacity that KQ [KPNQwest]
gets the benefit of a Euro order without having to take transatlantic capacity that we do not need.
...”
123. A January 4, 2001 email from Frank Lukas of Qwest to, inter alia, McMaster and
Rhett Williams of KPNQwest, stated that “Ross and Jack [McMaster] will call Ed McCormack, Flag
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COO, Monday a.m. to see what we can get from them in the way of a commitment (for US or
Europe purchases).”
124. The final email in the series, a curt reply from Qwest COO Afshin Mohebbi
(“Mohebbi”) to, inter alia, McMaster and Lukas, dated January 4, 2001, instructed the others to
ignore Flag’s hesitancy to enter into a swap deal with Qwest and KPNQwest:
We need to reduce our cash outlay on the asia [sic] deal andleverageour [sic] strenght [sic] here to get Flag and their freinds [sic]to buy things from us. I appreciate Flag’s position or wishes, but wehave the upper hand here.
They [Flag] either buy from us now or commit to buy from us within x-months certain capacity in US and Europe. They can also do thisas you said by putting together a buying group. Either way, we needthem and their friends to commit to buy certain amount of capacityfrom us. This is how the new world works. If the situation wasreversed they would have exactly done the same.
125. Less than three months later, in late March 2001, the reciprocal “purchases” were
announced.
126. Numerous witnesses recall the first quarter 2001 Flag deal. CW3, who was senior
dark fibre implementation manager, and who worked on the Flag swap said that Flag had an
agreement to buy 10,000 km of fiber in any location that Flag chose on the KPNQwest network.
He heard from a supervisor that Flag implemented roughly 50% or less of the dark fiber it purchased
127. CW 4 was project manager of colocation. He explained that a dark fibre deal needed
to include a purchase by the customer of colocation space, so the customer could put its own
equipment at the KPNQwest POPs to light the fibre. He recalls that the Flag deal was to buy $20
million in dark fibre and $10-15 million of colocation space, swapped for transatlantic capacity. He
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recalls that it was a “1 on 1" swap, i.e., the value of the transatlantic capacity equaled the value of
Flag’s “purchases.”
128. CW4 recalls that the deal was handled at the highest levels of KPNQwest, only SVPs
were allowed to make decisions or sign documents, that the CEOs of the two companies were
directly involved, and that JackMcMaster spoke directly to the CEO of Flag in putting the deal
together. CW4 recalls that there was panic concerning the deal because KPNQwest needed to get
million of dollars on the books to meet its target. Because the deal was below price, he could not
sign off, but his boss got a green light from the KQ managing board (Rhett Williams, McMaster and
the CFO) to get the deal done. He also sat in on conference calls related to the deal. CW 4 states
that before the Company personnel went into a conference call we discussed that Rhett and Jack
believed the deal was vital to meet the target. Participants in the conference call included Jan
Louwes, dark fiber vice president, and Jean-Louis Colen, who was one of the dark fiber sales team
working under Jan Louwes.
129. CW 4 states that he was copied on an e-mail from v.p. of dark fibre (Jan Louwes),
which was sent to Rhett William and JackMcMaster saying Flag/Verizon accepted the conditions
for the deal after a phone call from Rhett with Jack to the Flag CEO. After being copied on this e-
mail he went back to Rhett or Louwes and found out that KQ got the Flag deal by agreeing to buy
the transatlantic capacity. CW 4 went to the Hague office once a week to meet with network
capacity people and in one of those discussions it was made clear that KPNQwest did not need the
transatlantic capacity purchased from Flag, that KPNQwest had abundant unsold transatlantic
capacity already.
130. CW2 recalls the Flag/Verizon deal in the first quarter of 2001, worked on by Ewoud
12An article in the Dutch-language Quote magazine from fall, 2001 also reports on thistransaction: “ In the first quarter of 2001, KPNQwest announced that Flag Telecom had boughtglass fiber connections between several European cities and space in some KPNQwest junctions.The company didn’t mention any numbers, but the glass fiber cost 12.5 mln Euros and theacquisition of the switch centers cost 30 mln Euros. KPNQwest agreed to take over 42.5 mln Eurosworth of capacity from Flag Transatlantic Cable. Even though KPNQwest never received anymoney from this deal it booked the transaction as a profit of 12.5 million Euros.”
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Mogendorff and Pascal van Minderhout. CW 2 recalls that the deal consisted of KPNQwest
acquiring 10 gigs of lit wavelengths in Transatlantic capacity, and KPNQwest giving, in return,
10,000 kilometers of fibre priced at $10 million, plus 5.5 - 6 thousand square meters of colocation
space priced at $32.5 million. The transaction papers were prepared as if the wavelengths were
swapped only for the fibre, so that the wavelengths could be stated on KPNQwest’s book at a $10
million value, which would allow a profit if KPNQwest could subsequently re-sell them. CW2 also
recalls this deal included a side letter that specified its true nature and content.
131. The trustee’s RICO complaint describes another deal with Flag “designed to allow
KPNQwest and Qwest to recognize additional revenues for the quarter.” In that deal, KPNQwest
sold EuroRing capacity to Qwest in an IRU transaction on September 28, 2001, for $22 million. The
same day, Qwest sold the same capacity to Flag in an IRU transaction for USD $26 million (thereby
in effect taking a "commission" of $4 million from KPNQwest). Flag sold separate Europe Asia
capacity to KPNQwest on October 1, 2001, for $43.2 million. KPNQwest turned around and sold
this same capacity to Qwest and KPN in the third and fourth quarters for the identical $43.2
million12. [¶122.b].
132. CW 5, another member of the dark fiber sales team under Jan Louwes, states that he
worked on 2 or 3 deals involving Flag telecom, ranging from $10 to $25 million dollars, all in 2001,
the last one in November of 2001. These deals involved KPNQwest selling dark fibre and STM-16s
52
to Flag, and getting transatlantic capacity in return.
133. CW 5 acknowledged that KPNQwest had a lot more transatlantic capacity than
it needed for operating its own network. He understood that KPNQwest was doing these deals
just to increase its own stated revenue.
b. Teleglobe
134. On or about July 18, 2001, Teleglobe announced a swap transaction with KPNQwest,
whereby Teleglobe purchased $56 million of “lit fiber” from KPNQwest and KPNQwest purchased
$40 million of networking equipment. This deal is suspicious because Teleglobe had previously
announced a $100 million purchase of dark fiber from KPNQwest, but changed the deal to a
purchase of “lit fiber” – apparently to accommodate KPNQwest’s revenue recognition practices and
to procure KPNQwest’s reciprocal $40 million purchase. This deal was reported by the Washington
Business Journal on July 18, 2001 as follows:
Change order: Teleglobe alters $100M fiber-optic plan
Teleglobe said today it will buy $56 million worth of lit fiber fromNetherlands-based KPNQwest to expand its fiber-optic network inEurope.
The deal represents a change in strategy for the Canadian company,which previously had announced plans to spend $100 million forsome 9,000 miles of unlit fiber from KPNQwest. Lit fiber activelycarries data, while unlit fiber is not active yet.
Teleglobe, which makes its U.S. headquarters Reston, Va., also saidthe Dutch company agreed to buy $40 million worth of networkingequipment from it.
135. CW 2 recalls the Teleglobe transaction. He recalls that initially, there was a sale of
capacity, including 20 year IRUs, with a total value of $190 to $220 million. This was renegotiated
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to a $44 million swap. Initially a straight sale, it was renegotiated into a swap because Teleglobe
could not pay, but had a loophole to get out of the contract because of KPNQwest’s late delivery of
fiber in the Nordic region. KPNQwest took $44 million of second hand Norte equipment from
Teleglobe in Germany and the Nordics and gave Teleglobe 10 gig wavelengths in Europe. CW 2
confirmed that Teleglobe had originally purchased the “footprint” (i.e. network fibers), then bought
the same locations from KPNQwest as lit capacity in the revised deal.
c. 360networks
136. On March 13, 2000, 360networks and KPNQwest jointly announced a reciprocal
deal. Each side hailed the deal as a major milestone in its business development:
WORLDWIDE FIBER (360networks) SELLS $120 MILLION WORTH OFBROADBAND CAPACITY ON TRANS-ATLANTIC NETWORK
Also announces development of southern European fiber optic network.
VANCOUVER, B.C., March 13, 2000, Worldwide Fiber Inc., which is changing itsname to 360networks, today announced it will sell KPNQwest broadband networkcapacity between North America and the United Kingdom, valued at more than US$120 million.
KPNQwest will use multiple STM-16 channels to transmit data at up to 2.5 gigabitsper second per channel on 360networks’ transatlantic cable, a wholly owned,self-healing network ring currently under development and scheduled to enter serviceprior to March 2001.
"This is our first major sale of bandwidth capacity across the Atlantic," said GregMaffei, chief executive officer of 360networks. "It highlights our capability toprovide sophisticated customers like KPNQwest seamless, low-cost connectionsbetween Europe and North America."
360networks also announced an agreement with KPNQwest to purchase 7,300kilometers of fiber infrastructure on networks linking 19 cities in Europe, includingMilan, Zurich and Madrid. As a result, 360networks will have a strong networkpresence in Spain, Italy, France and Switzerland, and will offer network services insouthern Europe beginning in the third quarter of 2001.
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* * *
"This is a major milestone for us," said Jack McMaster, chief executive officer ofKPNQwest. "We are delighted that 360networks has become a major customer onour Iberian ring."
137. On April 25, 2000, KPNQwest announced its financial results for Q1 2000. With
respect to dark fiber (“infrastructure”) sales, KPNQwest reported:
Willem Ackermans, KPNQwest Executive Vice President and Chief FinancialOfficer said: "We had a strong quarter. We met or exceeded the analysts'consensus estimates. We are on target and on budget with our constructioncommitment and capital expenditures, including making excellent strides inrecovering our construction costs with infrastructure sales. [Emphasis added.]
Infrastructure revenues driven by the sale of dark fibre, were 3.1 million in firstquarter 2000, with no corresponding revenues in pro forma first quarter 1999. Therevenue recognized in the first quarter 2000 relates to contacts that were closed in1999.
The company closed an additional infrastructure contract in the first quarter 2000valued at 160.0 million, with cumulative closed infrastructure contracts to dateapproximating 210.0 million, of which more than 90% will be recognised as revenuein subsequent periods.
138. On July 7, 2000, after announcing a major deal between 360networks and Sycamore
Networks, Converge! Network Digest reported: “360networks has previously announced major fiber
swaps with KPNQwest [and others].” [Emphasis supplied.]
139. Evidence that KPNQwest had no legitimate business purpose for engaging in this
swap includes:
a. KPNQwest obtained its trans-Atlantic capacity from parent Qwest;
b. The swap was made within weeks of the end of the business quarter;
c. The value of the capacity “sold” was comparable in value to the value of the capacity
“purchased” by KPNQwest; and
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d. Defendants sought to demonstrate to investors that a critical part of KPNQwest’s
business plan – to defray the enormous capital expense of constructing KPNQwest’s
network by selling unused infrastructure fiber – was successfully progressing.
140. As reported in the Internet Bankruptcy Library: Troubled Company Reporter edition
of Monday, July 23, 2001, Volume 2, No. 142, it appears that KPNQwest collected very little of the
reported €160 million infrastructure-sales revenue it expected to record in subsequent quarters:
Fiber-optic network builder 360networks may not be able to pay thefull amount of a 160 million euro order for fiber from Dutchtelecommunications company KPNQwest as the company recentlyfiled for protection from creditors in Canada and for Chapter 11 inthe U.S. KPNQwest's head of investor relations Jerry Yohananov toldDow Jones Newswires on Wednesday that the company has notreceived any news from 360networks suggesting it will not take upthe full space. He added that KPNQwest has already received a downpayment of around 20 million euros from 360networks, but said theDutch company does not believe it is prudent to count on receivingany more with 360network's current situation.
141. CW5, a sales person on the dark fibre sales team of Company vice president Jan
Louwes, recalls that there were a number of deals with 360networks. He worked on the first one
in late 1999, consisting of a swap of dark fiber for 360networks’ transatlantic capacity. The deal
was valued at $78 million. He believes that the $120 million deal announced in March, 2000 was
an expansion of his original deal, because he would have heard if there was a separate deal in the
magnitude of $120 million.
d. Qwest
142. The trustees’ RICO complaint outlines a second quarter 2000 swap with Qwest.
“Qwest initially purchased capacity from Global Crossing and then "sold" that capacity to
KPNQwest, allowing Qwest to recognize the nominal purchase price ($25,230,960) just before the
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end of the second quarter in 2000. KPNQwest, for its part, "sold" to Qwest certain EuroRing
capacity. The very next day, KPNQwest turned around and "sold" the capacity it had acquired from
Qwest to FLAG. The parties to the transaction did not actually need the capacity they were acquiring
- as is evidenced by the fact that the parties did not retain the acquired capacity for any length of
time. The sole purpose of the transaction was to generate revenue recognition events for the involved
parties and, particularly, Qwest.” [¶122.c].
143. A telling e-mail quoted in the trustees’ RICO complaint shows that the legs of the
transaction were unified, by pointing out the need to avoid having Flag accept the capacity from
KPNQwest before KPNQwest accepts the capacity from Qwest. The e-mail states: “To: Graham
King (KPNQwest) and Jan Schreuder. From: Kimberly Stout (Qwest). "I need to speak with you
regarding the logistics of dating the signature blank on the Flag/KPNQwest acceptance letter, as we
cannot have that dated before the KPNQwest acceptance letter is finalized (and we're still
determining internally the date on which we need for you to accept that circuit)." (E-mail, June 28,
2000.)” [¶129]
144. In Q3 2000 Qwest sold KPNQwest 4 STM-1's from Seattle to Tokyo for $12 million.
Qwest received cash upon delivery and acceptance. The gross margin was $3 million. In a separate
legal transaction on October 15, 2000, Qwest purchased 13 STM-1's from New York to London for
$12 million. The timing of the transactions, as viewed in conjunction with facts uncovered through
Plaintiffs’ investigation, strongly indicates they comprised a hollow swap deal.
e. Sonera
145. On September 5, 2001, KPNQwest announced that the Company “has won a Euro
multi-million contract to provide international high capacity bandwidth services to Sonera Carrier
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Networks Ltd., the largest and most international network operator in Finland.” On September 19,
2001 Sonera Carrier Networks Ltd. announced that “Sonera Carrier Networks Ltd and European
operator KPNQwest have signed an agreement according to which Sonera Carrier Networks Ltd.
will offer KPNQwest...wavelengths in its DWDM network between Helsinki and Stockholm....The
value of the deal is several millions of euros.”
146. CW 6, who states that he worked on network design for the swap transactions and
thereby helped to determine what capacity was available to be swapped in any given transaction, he
states that he is in possession of an e-mail dated October 16, 2001 that indicates that this deal was
a swap transaction. He noted that the deal included KPNQwest trading some capacity on its
Helsinki-Stockholm circuit for the capacity of Sonera on that circuit. Although this deal was not
publicly announced as a swap, the rationale for this deal, as offered internally in KPNQwest’s
internal e-mail, was to provide redundancy in case of outages.
f. Fibernet
147. On September 5, 2000, KPNQwest and Fibernet Group PLC (“Fibernet”) announced
a purchase of dark fiber by Fibernet. The press release from Fibernet, as reported by PRNewswire,
stated as follows:
KPNQwest (Nasdaq:KQIP) (ASE: KQIP), the leading pan-European datacommunications company, today announced a multi-year contract with Fibernet, theUK-based next-generation telecommunications provider, in which KPNQwest willprovide up to 6,800 kilometres of fibre along with colocation facilities on their highspeed fibre-optic EuroRings(TM) network. The contract is expected to be worthover EUR 100 million, excluding additional network-related charges.
148. This was a dark fiber deal, which is why colocation facilities were necessary.
Colocation facilities allow the purchaser of dark fiber to put their own equipment in KPNQwest
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POPs to light the fiber.
149. KPNQwest failed to announce, however, that months later this deal was transformed
into an IRU swap allowing KPNQwest to take all the revenues up-front, instead of over 20 years as
for the original dark fiber purchase. This change was admitted by Ewould Mogendorff, who headed
up the KPNQwest “Global Trading Department” formed in mid-2000 for the purpose of carrying
out swaps. As reported in a 2002 Dutch-language article from business journalist Peter Verkooijen
on his website (modifiedcontent.com) entitled “KPNQwest - dubbele agenda's“ (KPNQwest -
Double agendas):
“At the end of the year 2000, [Ewoud] Mogendorff opened a department [inKPNQwest] called “Global Trading,” which was to focus on the sale of the fastdevaluing inventory. It was Global Trading that was involved in the notorious “swapdeals.” After the summer of 2000, a different department sold capacity in Germanyand France to Fibernet at 10 million Euros over a period of twenty years. Uponrequest of Fibernet, Global Trading transformed this deal half a year later into amutual deal of 24.5 million Euros at which Fibernet bought capacity fromKPNQwest between France and England.
The adjustment of the contract enabled KPNQwest to book the amount right away.“It was also in the interest of Fibernet,” said Mogendorff. It did have theconsequence though, that a contract of 110 million Euros of pure revenues waschanged in a swap deal, which didn’t influence KPNQwest’s balance at all. It onlylooked better on the books. “Fibernet didn’t have enough money to launch variousparts of the network by themselves,” Mogendorff found. “Therefore we added somecapacity under the same contract.”
150. Defendants never informed the public that the revenues of the Fibernet deal were
artificially accelerated, or that KPNQwest would not be obtaining the revenues projected in the
future from the original Fibernet deal.
g. MCI/Worldcom
151. CW 7, who was a project manager in the Customer Network Implementation (“CNI”)
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department and thereby worked on implementing the swap deals at the end of the financial quarters,
remembers in particular the swap deal with MCI Worldcom for the last quarter of 2000, valued at
approximately 40 million Euros. The instructions about the swap deal (both the buy and the sell
side) came to the CNI department from Berend-Jan van Maanen, vice president wholesale markets
and account manager for MCI-Worldcom.
152. In that deal KPNQwest provided transatlantic capacity via AC-1 (i.e. capacity on the
Global Crossing cable that KPNQwest had previously purchased from Global Crossing), and in
return obtained transatlantic capacity on MCI Worldcom’s Gemini cable from London to New York.
CW 7 remembers this deal because he had to go to New York to connect and test the connection,
which he managed to accomplish the day before Christmas, 2000. CW 7 also implemented the buy
side of this transaction, which merely involved accepting the capacity from MCI Worldcom.
h. Cable & Wireless-KPNQwest-Qwest Transaction.
153. The trustee’s RICO complaint describes a 3-way deal in the fourth quarter of 2000,
in which a swap negotiated between Qwest and Cable & Wireless became a 3-way transaction when
KPNQwest was inserted into the transaction as a middleman between Qwest and Cable & Wireless.
154. As to the KPNQwest-Qwest leg of the transaction, the trustees’ RICO complaint
admits that “In another end-of-quarter series of asset swaps, in the fourth quarter of 2000,
Defendants arranged the following: In December 2000, Qwest ‘sold’ KPNQwest $50 million worth
of U.S. capacity in exchange for $50 million worth of KPNQwest's EuroRing capacity (‘KPNQwest
footprint’). Even though no money changed hands, Qwest immediately booked $50 million as
revenue for the capacity it ‘sold’ to KPNQwest, while KPNQwest booked the value of the footprint
it ‘sold’ to Qwest. This allowed Qwest and KPNQwest both to inflate their end-of quarter revenues.
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KPNQwest's Erin Wray stated in an e-mail that the ‘cost on our books of the US capacity is not the
market value, but the cost basis that we give up [i.e., cost of EuroRing capacity]. Bottom line- helps
our margin!’” [¶122d].
155. As to the KPNQwest-Cable & Wireless portion of the transaction, the trustees’ RICO
complaint admits “KPNQwest then turned around and swapped the same U.S. capacity it had
acquired from Qwest [in the December, 2000 swap deal] to Cable & Wireless -("C&W") in
exchange for certain UK capacity. Specifically, on December 29, 2000, KPNQwest entered two
separate agreements with C&W whereby KPNQwest agreed to ‘purchase’ IRU capacity from C&W
for $15 million and $35 million, respectively, using the $50 million in U.S. capacity it had acquired
from Qwest as its consideration. The capacity KPNQwest ‘purchased’ from C&W in fact was
intended for Qwest and, per its arrangement with Qwest, KPNQwest expected that Qwest would buy
back (or swap for) this capacity.” [¶122.d]
156. With respect to the capacity KPNQwest purchased from C&W in the fourth quarter
of 2000 as well as other capacity purchased from Cable & Wireless in the first quarter of 2001,
Jeffrey von Deylen admitted to Qwest's Robin Szeliga that the capacity was "not required by
KPNQwest" and was not "part of its business plan." [¶126].
157. The trustees’ RICO complaint quotes two e-mails showing that the KPNQwest-C&W
buy-sell swap and the corresponding KPNQwest-Qwest swaps were part of a single deal, with the
KPNQwest-C&W swap having been negotiated by Qwest on behalf of KPNQwest. The e-mails
show that the real swap was for Cable & Wireless to obtain Qwest’s U.S. capacity in exchange for
Irish and U.K. capacity from Cable & Wireless. KPNQwest was merely inserted as a gratuitous
middleman between Qwest and Cable & Wireless. The e-mails state:
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To: Christel Rutten (KPNQwest). From: Jan Schreuder (Qwest). cc: EwoudMogendorff (KPNQwest). "We are supposed to play a major role in a large dealwhich should help us making the Quarter with over 50 mio in revenue. Your help isneeded as we are excited to buy: TAT14 Backhaul and London Dublin capacity ...I look forward to work with you in getting this done in the best possible way for usall." (Email, November 23, 2000.)
To: Various at KPNQwest. From: Jan Schreuder (Qwest). "[C]an you coordinate tohave the bulk done with regards to: 3 Legal contract prepared: 1] KPNQwest buyingIrish wavelength, based on Q-C&W's negotiations [2] KPNQwest buying UK DarkFibre, based on Q-C&W's negotiations [and 3] KPNQwest selling US-wavelength,based on QC&W's negotiations[.] For revenue recognition we need a lign [sic]like:'25% of the upfront to be paid on contract date' in all contracts ... And also: Weneed a Swap document for KPNQwest to deliver capacity to Qwest and for Qwestto deliver capacity to KPNQwest." (E-mail, December 18, 2000.) [¶127].
158. Still another e-mail from Brendan Keating to Erin Wray in the KPNQwest financial
department shows that the Cable & Wireless leg of the transaction was a swap. This e-mail states:
To: Erin Wray. From: Brendan Keating (a former Qwest executiveinstalled in KPNQwest Corporate Control). "Erin, I understand that the Q deal includes a swap of some of thecolours we acquired from C&W between London and Dublin forsome US Capacity. We will then turn around and sell the US capacityto Flag. I understand the deal value to be $17.5M. I believe the costbasis in the Irish colours to be around $7M. Please review the swapaccounting to ensure that we will be able to achieve the desired effectto the transaction." (KPNQwest internal e-mail, December 20, 2001.)
D. Additional Facts Concerning the Existence and Nature of the Swap andCapacity Transactions
1. Information About the Swap Sales
159. Multiple witnesses have informed Plaintiffs, in the course of Plaintiffs’ investigation
from March 2004 to the present, that the swaps were formulated and worked out by a number of
different actors. Rhett Williams was generally in charge of the swaps and of the big picture thinking
of what would be required to “close the gap” and meet the Company’s financial targets. Ewould
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Mogendorff, as head of Global Trading, was responsible for developing swap deals, with the
assistance of Kees Boer, MBBS wholesale product manager. Jan Louwes, formally titled senior vice
president of dark fiber sales, headed a team of sales people who worked on swap and capacity
transactions generally, not just for dark fiber, inasmuch as dark fiber sales had dried up soon after
the Company’s IPO. Jack McMaster and Rhett Williams were also responsible for the Company’s
deals with Qwest and also personally handled the large deals with Global Crossing. Ewould
Mogendorff handled the Company’s relationship with KPN.
160. CW 8 was aware of many swap deals as head of the technical sales engineers in the
sales support department. His department made sure the swap deals made sense technically, and
created a “business case” that served to confirm each deal’s purported profitability. CW 8 said, as
to the supposed cash down payment which was part of the swaps under the Arthur Andersen
paradigm, that the same cash was transferred back and forth in banks between the parties to the
swaps. CW 8 said there were “lots” of deals. CW 9 recalls capacity deals with 360networks and
Worldcom, with no benefit to either side. CW 8 observed that each quarter Ewoud Mogendorff
(head of Global Trading) and Kees Boer wholesale (MBBS product manager) “had to invent these
silly deals in the last 2 weeks of the quarter.” He recalls a $150 million swap between KQ and
360networks just before 360networks went into bankruptcy. In the swap deals each of the parties
bought capacity it did not need. CW 8 joined the company in January 2000, and explained that the
swaps had occurred before he started at KQ, and the volume kept increasing as revenue projections
became increasingly aggressive.
161. CW 9, who was vice president of global sales reporting to the head of Global
Accounts, noted that they had a management report of prospective sales that had to be filled in bi-
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weekly in Excel and reported on a bi-weekly basis to Jack McMaster and Rhett Williams. Jack
McMaster had two bi-weekly meetings, one with the sales people, and one with the operational
people. The bi-weekly sales meeting was attended by Rhett Williams, Jack McMaster, Jan Louwes,
Ewould Mogedorff, Margriet Koldyk, CW 9 and the corporate controller. Most of the meetings
were taken up by the swaps or other capacity transactions. Global Accounts [the department dealing
with multi-international or “global” customers] was the “closer of the meeting.” CW 9 stated that
“If we missed the quarterly targets, Jan Louwes or Ewould Mogendorf would close the gaps.” The
meetings were always a “shopping meeting” where the objective was to find money to close the gap
(i.e. make up the shortfall in meeting the revenue targets). Typically these were 2 hour meetings
where the participants went around the table and said “make” or “miss” referring to whether they
were going to make the revenue targets or not. If they were going to make the targets it was a short
meeting. If they were going to miss the targets it was a longer meeting.
162. CW 9 states that the heads of each department (Dark Fiber, Global Accounts,
National Sales, Global Trading) each came to the meeting with an Excel spread sheet reflecting the
target, realized sales to date, and the “sales funnel” consisting of the top 5 prospective sales deals.
Jack McMaster would go through the sales funnel list for each department. Jos van Schaik of the
finance department would sit next to Jack McMaster and read off the different results from each
department.
163. According to CW 9, there were two targets, “street expectations” and internal
expectations. “The internal targets were always higher because we were trying to beat the street.”
There were never deviations from the company’s overall target, but targets of each department could
be adjusted.
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164. Typically, continued CW 9, the gaps were in Global Accounts or National Accounts.
The capacity sales, by Jan Louwes and Ewould Mogendorf, usually had a surplus, not a gap. When
a gap was identified and the amount of the gap quantified, “we would find a GTS, Worldcom, or
Global Crossing which had the same problem each quarter as we did,” so 5-6 days before end of
quarter there would be conference calls between senior personnel in asset trading of each company
to close the gap. The capacity transactions made it easier to close the gap because you booked 100%
of the revenue up front, but the cost of the capacity was written off over all the years of the IRU.
165. The swap deals were ongoing, stated CW 9, but there was acceleration at the end of
the quarter as needed to close gaps. At the beginning of the quarter these meetings were fairly
harmonious. In the last two bi-weekly meetings per quarter the problems were manifested, and you
had the “closure” scenario of closing gaps via last-minute swap deals. Moreover, it became evident
that the Company was caught in a downward spiral, because initially the targets were missed in the
retail departments, but later in 2001 the targets were missed by wholesale as well, as wholesale
customers (i.e., other carriers) went out of business.
166. CW 10, the head of KPNQwest Global Accounts, states that Rhett Williams and Jan
Louwes and his team generally handled the swaps. CW 10 also confirmed that Rhett Williams was
in charge of all the swap deals, and further stated that it was “generally announced” and known that
the swaps involved useless capacity, i.e., capacity that was not being put to any use.
167. CW 11, head of engineering during 2001, attended two “quarter closing” meetings
for the second and third quarters of 2001. CW 11 relates that such all-day meetings were held a few
days before the end of each quarter, and were headed by Rhett Williams. In attendance were finance
people such as CFO Jeff von Deylen, David Monnat who worked on forecasts, and controller Matt
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Gough. These meetings included the product managers as well as sales people. Rhett Williams ran
through financial projections and actual sales numbers. Each product manager got up and made a
statement about the sales of his product for that quarter. Mr. Williams repeated the phrase “What’s
the gap?” referring to the shortfall of that product’s sales vs. the target. A report was produced for
Mr. Williams, and he left and apparently made some phone calls during a break in the meeting. “He
came back to the meeting and announced what kind of deals we were to implement to make forecast,
with large buyers of capacity such as KPN, Qwest, Global Crossing, GTS and AOL.”
168. CW 12, head of European sales for GTS/Ebone, sat in on executive meetings at
KPNQwest from October, 2001 onward, which was when KPNQwest had signed a deal to acquire
GTS/Ebone. CW 12 was absorbed into the KPNQwest organization as a direct subordinate of Rhett
Williams, and even though the GTS/Ebone merger with KPNQwest was not formally closed until
early 2002, Rhett Williams was CW 12's direct boss from October 2001 onward. CW 12 recalls an
executive session at the end of 2001 in which Rhett Williams remarked that “we’re still $175 million
short” and sent Ewoud Mogendorff to try to find partners for swap deals. CW 12 heard Mogendorff
say to Williams, “I don’t know what they [prospective swap or IRU purchasers] need right now”,
and Williams responded “I do not care what they need, just have them take something.” At a
meeting on November 11 and 12, 2002 Rhett Williams said to Ewould Mogendorf, “we have to go
to the well” by getting parent companies Qwest and KPN to provide revenues to KPNQwest
through IRU purchases. Williams said to Mogendorf that Williams would approach Qwest and that
Mogendorf was instructed to talk to KPN on this subject.
169. CW 12 stated that CFO Jeff von Deylen stated at meetings that he wanted the IRU
deals structured to allow up-front revenue recognition, regardless of the actual cash structure of the
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transactions. At von Deylen’s instructions, CW 12 restructured deals for capacity sales already
made by GTS/Ebone, which included restructuring deals with all of GTS/Ebone’s 44 major IRU
purchasers. The deals were restructured so that revenue could be taken up front, and none of the
customers ever gave him flak about the restructuring, because nothing about the deals actually
changed except on paper.
170. CW 12 stated that the IRU deals of Ebone were restructured by cancelling the IRUs.
Ebone, using its own accounting methods (which were different from the KPNQwest accounting
methods) had been including revenue pro-rata over time from the IRUs. But all the IRU revenues
had been paid up front, so if the IRUs were cancelled, the entire payment could be taken up front.
Thus, CW 12 went through the exercise of cancelling all the Ebone IRUs so when the merger with
KPNQwest became final, KPNQwest could obtain include the Ebone IRU revenues immediately.
This was done in three steps. First, the IRUs of bankrupt entities were cancelled. Second, CW 12
approached customers who were not making use of their IRUs, and who would thereby incur a
penalty fee. He said Ebone/KPNQwest would waive the penalty fees if the customer would simply
cancel the IRUs. Third, CW 12 approached the customers who were actively making use of the
IRUs. In these cases, he would work out a deal where the IRUs would be cancelled and then
reinstated as a lease, wherein the lease rental would be less than the maintenance fee the customer
was paying for the former IRU. The auditors would not allow recognition of revenue from the IRU
cancellation if the cancelled IRU and the newly leased circuits were exactly the same, so the deals
were worked out so that the customer would be transferred momentarily to a newly leased circuit
along the same route as the prior IRU, but not using the same circuit, and then switched back to
exactly the same circuit. The IRU cancellation methodology was constructed by Duncan Lewis,
13This includes the following meetings involving CW 12: 10/11/01 meeting with DuncanLewis, David Whitefoot (Qwest Euope) & Terry Lewis (Qwest Europe) at Qwest’s offices inLondon; 10/22/01 meting of executive team of Egone and Executive team of KPNQwest atKPNQwest headquarters in Hoofddorp, 10/24/01 major phone conference call; 10/31/01 discussionwith Rhett Williams, 11/12/01 10:30 a.m. phone call with Rhett Williams; 11/13/01 phoneconference, 11/16/01 conference with Rhett Williams and David Whitefoot; 11/16/01 meeting withDuncan Lewis and Steve Baus, with Rhett Williams participating by phone, 11/20-21/01 meetingsbetween major GTS/Ebone executives and KPNQwest counterparts at KPNQwest headquarters inHoofddorp, 11/22/01 meeting with Rhett Williams, 11/26/01 conference call with Duncan Lewis,11/29/01 meeting in London with Jan Louwes of KPNQwest, who reported directly to RhettWillaims, 11/30/01 meeting in Madrid with Duncan Lewis, Sean Ledgerwood (GTS/Ebone financialanalyst) and David Whitefoot (Qwest Europe) where relationship between GTS/Ebone and DeutscheTelecom was discussed, including how to transfer IRU revenues; 12/03/01 meeting with DuncanLewis, 12/04/01 meeting with Rhett Williams and his team at GTS/Ebone’s offices in London,12/10/01 meeting with Rhett Williams, Jan Louwes and Ewoud Mogendorff at KPNQwest officesin Hoofddorp with David Whitefoot on the phone, specifically discussing “reversals” of IRUs soldby GTS/Ebone to Equant, Sonera and UPC, 12/11-12/01 meetings with Duncan Lewis, 12/13/01conference calls with Rhett Williams, 12/18/01 meeting in London with an individual from theKPNQwest wholesale team in London, 12/19/01 meeting with Duncan Lewis, 1/3/01 meetingincluding Leo McClosky, meetings on 1/8/02, 1/15/02 and 1/20/02 with Bob Vickers, Jan Louwesand Keith Westcott (head of wholesale for KPNQwest), 1/20/02 meeting in Boston with GordonMartin, who was the main link between Rhett Williams and Qwest in arranging for the IRU dealsinvolving Qwest and KPNQwest, 2/26/02 and 2/28/02 meetings in London with Rhett Williams,Keith Westcott and Jan Louwes, 3/5/02 meeting with Rhett Williams in London, 3/8/02 meetingwith Jan Louwes in Franfurt, 3/12/01 meeting with Duncan Lewis and Steve Baus in London, mid-March Cebit computer and telecom fair in Hanover discussions with Keith Westcott and rest ofpeople from Jan Louwes’s team, with Jan Louwes participating by phone, 3/21/02 meeting inHoofddorp with Rhet Williams and a 12:00 noon to 3 p.m. meeting with Jeff von Deylen
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CEO of GTS/Ebone, Steve Baus, CFO of GTS/Ebone (reporting to Jeff von Deylen as the merger
with KPNQwest progressed), and Rhett Williams. CW 12 got the contracts signed with GTS/Ebone
customers for the cancellation program on the insturctions of Jeff von Deylen and Steve Baus. The
progress of the obtaining revenues for KPNQwest from the IRU cancellation program was discussed
in numerous meetings with Rhett Williams and others from Qwest, KPNQwest and GTS/Ebone13.
171. CW 13, a London-based sales person for KPNQwest, is reluctant to name the carriers
on the other side of his deals (because they are still his customers at his current employment), but
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describes the salesperson’s viewpoint concerning the swap deals. He noted that Rhett Williams
controlled and coordinated the deals all over Europe. Rhett Williams knew the Company’s revenue
target, knew how much money was needed from these deals to achieve the target, and tried to
increase the pending deals if any deals fell through.
172. CW 13 specifically remembers three deals: one for $65 million (3d quarter 2001) and
two at $20 million each (2d and 3d quarters of 2001). In the two $20 million deals, KPNQwest and
the swap partner agreed on the amount of the deal (i.e. “Let’s do a $20 million deal”) before the
particular circuits involved in the swaps were identified. CW 13 explains that “the senior VP at
KPNQwest told me that the Company needed this amount for our target, and he knew the other side
needed that amount as well.”
173. CW 13 explains that the genesis of the deals was that he had the sales relationship,
we knew each of us had targets, you’d say over a beer to the senior vice president, “what do you
need this quarter?” The other side would select from a list of wavelengths and circuits available
from KPNQwest at end of the quarter. CW 13 would take a list back from them and turn it over to
engineering and senior management, who would then say what they wanted.
174. According to CW 13, the $65 million swap deal was originally supposed to be $40
million, but had to be increased because a $25 million deal fell apart in the U.S. This deal consisted
of KPNQwest taking back dark fiber that it had sold a couple of quarters before. The other company
had purchased DWDM transmission equipment to light the dark fiber purchased from KPNQwest,
but now claimed that lighting the fiber would be too expensive. As a device to increase the swap
from $40 million to $65 million, KPNQwest took back the DWDM equipment as well as the dark
fiber, adding $25 million to the deal. KPNQwest swapped back lit wavelengths on the same route
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as the dark fiber that was swapped back. In other words, continued CW 13, while KPNQwest was
essentially rescinding the prior dark fiber deal, and replacing it with a sale of lit wavelengths to the
same customer on the same route, the rescission was cast as a “swap.”
175. Note that in this deal, what KPNQwest received in the swap was completely
unnecessary and useless to KPNQwest; KPNQwest would need neither the dark fiber nor the
DWDM equipment to light the wavelengths to be swapped back, since the Company had
wavelengths available all along its network on the one or two fibers already lit.
176. CW 13 relates that in the two $20 million deals he worked on (both with the same
company) KPNQwest gave up European capacity for transatlantic capacity, even though “we had
shitloads.” CW 13 asked why KPNQwest would do such a deal, and senior managers at KPNQwest
replied that “it helps our EBITDA, you’re being instructed to do it.” CW 13 states that at that time
trans-Atlantic capacity was dropping in price by 40% per year, falling even faster than pure
European capacity, so there was no way this transaction could make money by KPNQwest somehow
reselling the transatlantic capacity. The senior management told CW 13 not to worry about whether
KPNQwest needed the capacity, they generally said “we need the revenues, we’ll get rid of the
acquired capacity, swap it for something else.”
177. CW 13 further states that the contracts for these swap deals were “works of art,” there
was so much accounting and legal manipulation. You’d start working on the contracts from day
2 of the quarter and it takes the entire quarter to craft contracts. You would have legal counsel from
both sides arguing and working. Once they make changes the accounting people come in and find
you can’t have that or can’t book revenue up front and you’d have to start over. In the contract it
would specify the number of wavelengths on the particular route, and you had to be careful re:
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service credits. (According to the Arthur Andersen rules, the buyer of the IRU had to assume all risk
of ownership, which meant no service credits could be offered for outages). CW 13 explains that
“if some circuit went out of service the user got nothing, which caused a large amount of fights.”
He also explained that “To simplify the process of contract formulation, we would take phrases
acceptable from other contracts and drop them into other contracts, same jargon, same legal speak.”
178. For the $65 million swap deal, CW 13 continued, he was in the United States working
around the clock for about 4 weeks. CW 13 had an army of people working on it including the
senior legal person and the senior accounting person at KPNQwest. The deal was embodied in 15
different contracts, each in excess of 25-30 pages.
179. CW 13 states that “when the contracts were signed the parties also had to sign and
exchange a handover document to say we accepted their services and they accepted ours.” The
handover documents included the test results for the circuits. The contracts provided that without
the signed handover documents, the contracts couldn’t be invoiced. Management always wanted
us to believe testing was done, but CW 13 never believed testing could be done in such a short
amount of time. CW 13 explained that “sometimes the circuits did not work when we went to use
them. This happened on the two $20 million deals.”
2. Information About Implementation of the Swaps
a. Explanation of KPNQwest’s Excess Capacity
180. KPNQwest was able to use capacity transactions to artificially boost its revenues
because KPNQwest needed only a small fraction of its capacity to service its ongoing customers,
i.e. customers who were buying services and not just buying capacity. KPNQwest’s customers
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could be divided into three categories: (i) end user customers who purchased high-level services
from KPNQwest, such as a virtual private network or other data transmission services; (ii) customers
who were large and sophisticated enough to buy capacity from KPNQwest and who designed their
own transmission systems; and (iii) other carriers such as Cable and Wireless, Global Crossing, etc.
who purchased capacity to re-sell their services to their own customers. While all of KPNQwest’s
lit IRU sales were improperly recorded as up-front revenues, the capacity transactions which lacked
a proper business purpose were undertaken with other carriers, because both these carriers and
KPNQwest had abundant, useless capacity that could be used for swaps.
181. KPNQwest never used more than a minuscule portion of the Company’s tremendous
transmission capacity provided by the KPNQwest Eurorings extending across Europe. The
Company’s entire capacity utilization, even including the capacity which was given to other carriers
in the swap transactions, was less than 3% of available capacity on the Eurorings.
182. Capacity is generally conceptualized, according to witnesses, as being provided in
“layers,” beginning with raw capacity and progressively adding additional transmission features to
each new layer, until, at the highest layer, there is a fully-enabled end product which can be sold to
a retail (i.e. non-carrier) customer. The first layer is the dark fiber itself, which has its own physical
existence without reference to whether or not it is being used for transmission. According to CW
11, former head of engineering at KPNQwest, there were 96 fiber pairs in the rings, except that at
least some portions of the Nordic ring had 120 fiber pairs.
183. Next, as the second layer, is the optical layer, which involves transmitting light over
the fiber. The light can be divided by equipment known as “multiplexers” into 40 different
14WDM provided many virtual fibers on a single physical fiber. By transmitting each signalat a different frequency, network capacity providers can send many signals on one fiber just asthough each were traveling on its own fiber.” Source: Optical Networks, International EngineeringConsortium, quoted in
15See, e.g., Global Crossing 1998 10-K, filed on March 19, 1999, at 10: “[W]e are sellingcapacity in an increment of 155 megabits per second (Mbps), known as an STM-1, for the 25-yeardesign life of the system.”
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wavelengths. This is known as wave division multiplexing (“WDM”)14. A “wavelength” can also
be termed a “color” or a “lamda”). Each of the wavelengths had 2.5 gigabites per second of capacity
on KPNQwest’s basic Alcatel equipment, but each of the wavelengths could have 10 gigabites per
second of capacity if Nortel equipment was utilized, as it was in some portions of the KPNQwest
network.
184. Next, the third layer is the transmission layer, known as SDH. The transmission layer
is created by placing transmission equipment on a lit fiber. Each wavelength can be mutiplexed into
STM units. Generally, one wavelength is multiplexed into 16 STM units. Transmission can be sold
as multiples of the STM units.15 For example a customer can purchase an STM-1, an STM-4
(equaling 4 STM-1s) or an STM-16. An STM-16, for example, is an entire wavelength of capacity
with the transmission equipment running over the wavelength. For the most part, KPNQwest
multiplexed each wavelength into STM-16s, i.e., 16 STM-1 units.
185. Alternatively, using more advanced technology, if the Nortel equipment is used to
light a wavelength with 10 gigabites per second of capacity, that single wavelength can be broken
down into 64 STM units, and a full wavelength as multiplexed on that equipment would be referred
to as an STM-64.
186. The fourth layer represents the mode of transmission to the customer, such as the IP
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layer or ATM layer. This represents the transmission mode on the customer’s own equipment. SDH
is a voice transmission method, which was the predominant method used on the system.
Alternatively, there was IP (internet) or ATM (asynchronous transfer mode frame relay) service
available.
187. Finally there is a fifth layer, which the end user customer may or may not need. This
layer would entail selling a retail product that placed additional features on the transmission. An
example of the fifth layer would be the sale to a customer of a virtual private network (VPN) service
using ATM or IP transmission.
188. Conceptualizing the transmission layers lends itself to an understanding of how much
capacity KPNQwest had in relationship to what its customers demanded. The smallest unit for a
capacity sale to customers was the STM-1. There were 16 STM-1s per wavelength on the Alcatel
equipment, and 40 wavelengths per fiber. Each wavelength on the Alcatel equipment which was
the basic network backbone had 2.5 gigs, so each STM-1 had 1/16 of 2.5 gigs, or approximately 155
megabits per second. According to CW 6, no end-user customer needs that amount; 10, 20 or 30
megabits suffices.
189. Using the more advanced Nortel equipment expanded the capacity even further. On
the Nortel equipment, each of the 40 wavelengths per fiber had 10 gigs of capacity and could be
subdivided into 64 STM-1s So on the newer Nortel equipment, each fiber would have 40 X 64 =
2560 STM-1s.
190. Since there was so much capacity, the proportion of actual capacity usage to total
capacity at KPNQwest was minuscule. According to CW 11, in the Eastern & Western rings of
central Europe there were 2 fibers lit, and in Nordic, Italian and German rings only 1 fibre pair lit.
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“I never saw more than 20 wavelengths lit per fiber pair. In the Eastern and Western rings it was
only in late 2001 that we lit a second fibre pair, not because we needed the capacity, but to put on
newer type of equipment that had more capacity. There were always plenty of unused wavelengths
and no shortage of new fibers to light.”
191. CW 27 noted that at the time KPNQwest closed its doors, there were generally only
10-12 wavelengths in use out of the 40 available on the fibers. He noted that there were interface
cards installed (at the various KPNQwest POPs (points of presence) for only 24 of the 40
wavelengths at that time, and that the relevant equipment would increase the usage in steps of 8
wavelengths, plus a requirement of one interface card per wavelength.
192. Moreover, ongoing advances in technology made the overabundance of capacity even
more extreme. When KPNQwest started, according to CW 29, who had the job title of “structure
planner,” fibers can be lit to supply 16 wavelengths at 2.5 gigabites per second each. Subsequently,
with newer Nortel equipment, the fibers could be lit to supply 40 wavelengths at 10 gigabites per
second each. He noted that newer technology available within two years after KPNQwest was
founded permitted fibers to be lit to supply 80 wavelengths of 10 gigabites each, and he noted that
160 wavelengths per fiber was possible but never deployed.
b. Explanation of KPNQwest’s Methodology for Installing Capacityin Connection with the Large Sales of IRU Capacity
193. The term “capacity” is used in two senses, one relating to KPNQwest, one relating
to its customers. Thus KPNQwest, as alleged above, had enormous surplus reserves of capacity.
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However what the customers purchased from KPNQwest was also referred to as “capacity.” So
although KPNQwest had the capacity already, when that capacity was sold to a customer, it had to
be properly directed through the proper circuits according to the order of that customer. In other
words the customer capacity had to be “installed.”
194. This installation process involved directing the designated capacity through the
proper route. For example if another carrier purchased a wavelength between Paris and London
going through Amsterdam, a circuit would have to be set up between the customer’s equipment in
Paris and the customer’s equipment in London, with the two paths (London-Amsterdam and Paris-
Amsterdam) patched together in Amsterdam. The light is patched by making a connection between
two sides of an optical distribution frame. In that way, the light can be redirected (by re-patching)
without constantly working directly with the optical equipment itself. More specifically, if a
customer orders a particular “color” or wavelength for that route, after the light is passed through
the multiplexing equipment at the Amsterdam point of presence and the wavelengths are separated
out, the particular wavelength assigned to that customer is patched from where it comes in from
Paris, to where it goes out to London. The patching, along with testing and inputting the circuit into
billing and network operations system, is the “installation” of the capacity.
195. At the end point of the circuit, if a wavelength purchased by Cable & Wireless is to
terminate in London, it is patched through at KPNQwest’s London POP (point of presence) to a
Cable & Wireless optical distribution frame which is colocated at the KPNQwest POP (for which
Cable & Wireless would pay a “colocation fee”; there it is directed out of the POP to the Cable &
Wireless network. It is patched by connecting (1) the wavelength coming into the input or network
element (NE) side of the optical distribution frame to (2) the output or customer element (CE) side
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of the distribution frame. More precisely, the connection is made between the input side and a
connection on the output side which is connected to the customer’s equipment.
c. The Technical Side of the Company Knew About the SwapsBecause of the Need to Implement the IRU Capacity in Order toClaim Revenue from these Deals
196. KPNQwest had two main offices. Its administrative offices, which housed its CEO,
sales executives, finance personnel and product managers was located in Hoofddorp. However, its
technical personnel, such as engineers, were located in a separate office location in the Hague.
Officers such as Ray Walsh, head of operations, who had to coordinate executive decision making
with the technical side, had offices in both locations.
197. Plaintiffs’ investigation shows that the existence and nature of the swaps was known
to the technical personnel, including persons working in the Customer Network Implementation
(“CNI”) and engineering department, due to the need to implement the deals. In fact, the deals were
conspicuous, not hidden, since there was a rush to implement deals at the end of each quarter in
order to meet the financial targets.
198. CW 14 was a VP in the CNI department for “special projects” such as the swap
transactions, which means he implemented the swap transactions on the network of KPNQwest by
overseeing the installation of the relevant transmission capacity before the end of the quarter in
which revenues for the deals was recorded. CW 14 confirmed that each quarter the CNI department
selected people to work on the swaps that quarter, and set up a special target group with a couple
of network engineers, people from the network operations center, and a project manager from the
CNI department, to work on the so-called “non-standard orders” (swap deals), which were
implemented in day to day contact with the sales department. CW 14 understood the goal to be to
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provide a “clean book” by the end of the quarter, i.e. to implement all deals before the quarter’s end.
Most of the swaps deals (over 50%) involved KPN or Qwest CW 14 noted that what capacity was
sold to each customer in the swap deals involved an iterative process: the sales department
requested capacity and the response was “we can’t provide X capacity , but can sell that amount of
capacity in a different region,” then the sales department would come up with a revised list of what
it wanted to sell, etc. CW 14 said that this process reflects that the sales were driven by need for
revenue, not really business needs of the underlying customers. Normally, a customer has a need
for capacity in a particular region, for business purposes. If the customer is switching around the
location of the capacity to be purchased to accommodate what is available for sale, it’s because the
purpose of the transaction is just to generate revenue.
199. CW 7 was a project manager in the customer network implementation department
(“CNI”) working there since 1999. He explains that he was working under Martin Vlastra, later
replaced by Katie Drummy (of Qwest), CNI VPs. Similarly, the SVP for the CNI department,
Esther van Zeggeren, was later replaced by David Shorrosh of Qwest. CW 7 in the last year of
KPNQwest’s existence actually was responsible for managing implementation of all the wholesale
(MBBS and dark fiber) transactions, by assigning jobs to project managers or implementation
managers. The CNI department had to implement the orders for these swap and other capacity
transactions. CW 7 noted that suddenly the swap deals were given to the CNI department to
implement at the end of the quarter. The CNI department had a general understanding that all
projects, especially the swap deals, had to be implemented by the end of the quarter.
200. CW 7 said that occasionally the CNI department did not manage to deliver the
capacity by the end of the quarter but nevertheless the CNI project manager asked the customer to
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sign the protocol of delivery, and there were instances when the capacity was not well tested but the
customer accepted it anyway.
201. CW 15, manager of the Network Operations Center (“NOC”), said that when capacity
was installed he worked with the CNI department to verify that the connection was valid and had
been connected by the implementation team and that it had been properly mapped and was therefore
seen as a circuit in the NOC systems. CW 15 noted that the CNI people were informed about
whether the capacity they were installing was part of a swap. CW 15 said that there was always a
rush at the end of the quarterly financial periods to implement the capacity in connection with the
swap deals.
202. CW 16, who was manager of the field engineers on behalf of the CNI department,
worked on installation of the capacity associated with the swap deals in every quarter from the first
quarter of 2000 to the end of the Company’s existence. CW 16 states that each quarter, the amount
of revenues claimed from these transactions was more and more, and in 3-4 quarters there was over
$100 million per quarter of faked revenue. Most of the end of quarter transactions involved complete
wavelengths, which is a large amount of capacity. Every quarter the installation process was
handled by a different CNI project manger. This huge amount of capacity would have to be
installed in the last two weeks of the quarter by the project team, which met daily or bi-daily with
the sales department (typically Jan Louwes). CW 16 said that the Company’s engineers had to work
50% more hours during this end-of quarter period. The end-of-quarter capacity installation was a
different process than the conventional sales during the quarter.
203. CW 16 continued by explaining that Ray Walsh, head of operations, also attended
the project team meetings, as did Jan van Bepple, the CNI project manager for the quarter (e.g. Hans
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Snel, Henk van Veen, or Roland Heijmen of the CNI department) and himself. The meetings
focused on the available capacity and what was needed to achieve the Company’s financial targets.
The mentality was, no questions asked, just do it, even if, e.g. you have to fly to a distant location
to do it. According to CW 16, the CNI department was given Excel spread sheets with the available
capacity and the revenue figures and customers involved, and instructed, that “these are the revenue
we have to earn this quarter, just get capacity up and running and put it on paper.” He states that
he was instructed by the salse department (including Jan Louwes) that if it’s not possible to actually
install the capacity, “just put it on paper. Just make sure you have the test report.” This was a
reference to the test report required by the various sales contracts, for either a 24 hour or 48 hour
test of the capacity. The test reports were given to the customer as part of the handover documents,
which also contained the circuit identification numbers as reflected in the KPNQwest system.
204. It was easy to make up the test reports, CW 16 states, since they were just Excel
spread sheets. He says that “we were told by sales department personnel that customers, KPN,
Qwest and others, said don’t worry about it, we won’t use the circuits until later, we knew which
circuits not to worry about. In practice, due to the time limits we were not always able to connect
one site to another site. Sometimes the equipment, sometimes even the fibers, were not even there.
Yet we installed racks in the relevant POP locations, so it looked like it was there. Would look lit
it was running, we would power up the connections, see light burning. You would open the door,
see equipment, see red or green light on Cisco routers, or other equipment. If you are not that
technical and if you don’t put test equipment on it, you’d think its running (i.e. properly attached).”
205. The test reports were signed by one of the field engineers working for CW 16.
However, if it was a fake test report, then CW 16 signed it. 90% of the end of quarter capacity
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installation was faked. Capacity was shifted between customers: one day to KPN, another day to
Qwest, Flag, Global Crossing. Capacity was shifted; sometimes in quarter 1 it was installed for
customer A, next quarter it was for another customer. At least at that quarter it was put on paper,
in the Company’s internal systems it was corrected later as the capacity became technically
available. “Everything was a paper exercise,” CW 16 observes.
206. CW 16 further stated: “For Flag, Verizon, Worldcom, Level 3, Cable & Wireless, we
were told the capacity was just part of swap, not going to be used for a certain amount of time. For
example, in the deal with Worldcom we were told what capacity we had to install. On the Excel
spreadsheet was indicated the date the capacity had to be implemented whereas other capacity was
indicated to allow actual deliver at a later time. For the last four quarters of KPNQwest’s existence
“ we in the CNI department just took all the capacity that had been activated by the engineers in that
quarter and ‘put a name behind it’–either Qwest or KPN. I was told by Jan Louwes that KPN and
Qwest had a certain amount of revenue commitment to KPNQwest.” CW 16 noted the rush to get
the capacity installed at the end of the quarter, at least half the engineering staff (25 people) had to
put in 50% extra hours during the last two weeks of the quarter to perform installations for the large
capacity sales.
207. CW 16 asked Ray Walsh about what was going on and he was told that it was
absolutely legal, that this is the way it works these days in the financial markets. He was advised
by Jan Louwes, who headed the team of wholesale sales, that Jack McMaster approved the capacity
deals at least once each quarter.
208. CW 11, director of engineering from early 2001 to the end of the year, said when he
became head of engineering, “something quite weird happened,” business started to be artificially
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created by swap deals, “people started hiding things.” For example, “a list of swaps was provided
to me and I was told, please implement these for these customers and do not ask any questions.”
Information about the swaps came from the MBBS [wholesale] product manager (Kees Boer) or
sometimes directly from Rhett Williams, whereas regular sales information came from the sales and
finance departments.
209. CW 11 states that “The strange thing is, the customers were never to be contacted.”
“Normally,” CW 11 explained, “KPNQwest would assign a technical person, a CNI implementation
manager and someone to do acceptance testing. With the swap deals, no person was assigned and
next month we would use the circuit for another purpose-- clearly artificial. “ In normal deals,
usually the customer also assigned a technical person because the circuits are big investments of
$100,000 per month. CW 11 was told by Ray Walsh (head of operations) and Rhett Williams not
to worry about customers, because we just had a few days at the end of the quarter to install the
capacity, so CW 11 just labeled the circuits as assigned to the customers. “In forms we had a contact
sheet for customers, and these started to be empty.” CW 11 asked a couple of times, if we should
find out who the contact person is for the large capacity purchasers. CW 11 was told by Ray Walsh
and Rhett Williams that its their business, engineering should not worry about it. This contrasted
with major customers such as Dell, where there was a lot of interaction with the customer.
210. CW 11 was following KPNQwest’s revenue budget (i.e. projected revenue), getting
the financial report from Ackermans and his successors, which he needed to see amount of capacity
to be provisioned each quarter. “At the beginning of the quarter,” he explains, “we had projections
not including KPN and Qwest, at the end KPN and Qwest were added, always so late because
[purchases from the Company’s parents] were used to meet revenue budget [targets].” The sales
16When there were “real” purchasers, Each purchaser used one of the ITU-defined interfacesor a modified version of it, and this usually determined how the customer was connected.
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forecasts included a percentage representing a probability of success of the sale, and an estimated
time for the deal to close. The revenue forecasts were so high that CW 16 thought KPNQwest could
not sell so much, he states that “it forced me to obtain large amounts of hardware for customers I
did not believe to be there.”
211. For the end of quarter swaps or capacity transactions CW 11 received a short
document including just the customer name, number of circuits, location was vague (cities, not
points of presence identified), no interface defined16, no technical details. For these last minute
capacity deals “it didn’t matter what kinds of interface we used, so we used whatever interface cards
we had on hand.” CW 11 contrasts the situation for customers that truly intended to make use of
capacity, for which, according to CW 11, “we had to make sure that the local tail was compatible
with KPNQwest circuit.” These large capacity deals were provisioned POP to POP (i.e. from
KPNQwest point of presence to a second KPNQwest switching point) without worrying about any
local tail (i.e. any local connection outside the KPNQwest system to a customer.). CW 11 states that
“Sometimes we only had 48 hours to implement these deals. Sometimes we did not test the circuits
until after they were accepted by the customer, contrary to normal practice.”
212. CW 17, who acted as liaison between the engineering department and the CNI
department in implementing the capacity for the swap deals, said that sometimes if KPN or Qwest
took capacity, we would later implement the same capacity for “real customers” and delete it as
KPN or Qwest capacity. CW 17 said that at times he was asked to see where you can get capacity
of a certain sales value to make the revenue, particularly in instances where KPN or Qwest was
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going to be the buyer. In other cases CW 17 would suggest alternative capacity if the requested
capacity was not available. In situations involving such discussions, he remarked, he was “80%
sure” the capacity would not be used, because if there were a true need, the buyer wouldn’t switch
what it purchased.
213. CW 18, a field engineer who worked on capacity installation, noted that during the
last 1½ years at KPNQwest (5-6 quarters), on major orders from carriers, there were 5-10 instances
each quarter where the same capacity assigned to a customer was switched to another customer one
quarter later. For example, color [i.e. wavelength] 20, going from Amsterdam to London for
customer X, was reassigned through Amsterdam to Frankfurt for customer Y in the next quarter.
“It happened all over the rings”[KPNQwest’s Eurorings]. “At a certain point,” CW 18 explained,
“we knew it wasn’t legitimate because no one from the supposed customer complained about the
loss of the capacity.”
214. CW 17 stated that in the fourth quarter of 2001 there was a large customer “Seahorse”
representing up to 100% of capacity sales for that quarter. CW 17 tried to find the customer on
Google and it did not exist. CW 17 found out that this customer was actually a combination of the
KPN and Qwest capacity purchases for the quarter. The purchases were “ridiculous” in nature,
consisting of “fractional capacity” at scattered points in the KPNQwest network, he could “not
imagine any customer in the world needing that type of capacity, there was no use for it, and it was
silly to implement, so we just reserved it in the system” without actually implementing it.
BOGUS TRANSACTIONS WITH CORPORATE PARENTS KPN AND QWEST ARTIFICIALLY PROPPED UP THE COMPANY
215. During the Class Period, KPNQwest led investors to believe that revenues earned
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from transactions with its parent companies were derived from actual resales of
telecommunications services to customers of KPN and Qwest under KPNQwest’s distribution
agreements with its parents. For example, during a February 2001 visit with Peter J. Kennedy
(and other analysts) at Morgan Stanley, defendant McMaster indicated that “strong demand” in
the United States was driven by Qwest’s sales efforts. Because the Company thus gave investors
the impression that its parent companies’ customers provided, in essence, a “ready made” source
of demand for the Company’s services, KPNQwest was viewed favorably as compared to its
competitors once it became apparent that there was a glut of capacity on the market.
216. Class Period sales to the Company’s corporate parents and their affiliates
represented more than 40% of KPNQwest’s revenues in both FY 2000 and FY 2001. Following
the Class Period, it was revealed that the Company’s real, bona fide revenues from KPN and
Qwest were far less. According to a June 10, 2002, article by Peter Judge published in ZD/NET
UK, although Qwest paid the Company well in excess of $220 million in 2001 for “international
services,” Qwest stated in May 2002 that it “currently receives approximately $3 million in
monthly retail and wholesale revenues from its customers using the KPNQwest network.” Judge
concluded that, based upon its current needs, “[t]his implies that Qwest spent $187 [million in
2001] in exchange for bandwidth it did not need, to boost KPNQwest’s EBITDA.” [Emphasis
supplied.]
217. In fact, an e-mail by Qwest COO Mohebbi indicates that the amount of legitimate
service revenues from Qwest customers recognized by KPNQwest in 2001 was even less than
surmised by Judge: “In reviewing the business plan Jack McMaster presented to Joe [Nacchio,
Qwest’s CEO,] for KPNQwest’s plan in 2002, there is an assumption they will receive $35
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million in retail recurring revenue from us. That’s a very large number, compared to what we
are doing with them today.” (Emphasis supplied.)
218. A dispute arising after KPNQwest’s demise similarly revealed that the
Company’s sales to KPN of more than $113 million in 2001 did not represent services being
resold to KPN customers. In June 25, 2002, as indicated in a Bloomberg report, “KPN said its
records show it owes 8.8 million euros ($8.5 million) . . . . KPNQwest said that KPN owes [] 24
million euros for use of its network.” Even assuming the higher figure claimed by the Company,
KPN’s network use figures are a fraction of the sales revenues attributed to KPN in 2001, again
suggesting that unneeded capacity purchases to prop up KPNQwest’s value – rather than actual
customer service fees – represented the lion’s share of the revenues paid by KPN in 2001.
219. As alleged in the opportunity and motivation section of this complaint, parent
companies KPN and Qwest were each motivated to inflate KPNQwest revenues through bogus
capacity purchases in order to help inflate their own balance sheets.
220. Plaintiffs have learned through their investigation that the difference between the
bona fide revenues earned by the Company from parents KPN and Qwest, and the hundreds of
millions of dollars in reported revenues, was due to bogus purchases of network capacity from
KPNQwest by its parent companies. The capacity purchases were unneeded by KPN and Qwest
for bona fide business purposes, and thus were not truly bona fide revenues earned by
KPNQwest. Also, much of the capacity purchases were accomplished by means of swaps or
other similar transactions (e.g. nominally re-routing capacity purchases from a third party
through KPNQwest), and therefore did not generate cash flow or any other business benefit to
KPNQwest.
17Unisource was the means by which KPN provided intra-European services to its clientsprior to the formation of KPNQwest. Unisource, a joint venture of KPN, Swisscom and Telia (the
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221. An article in the Dutch publication FEM/De Week, appearing in mid-2001,
entitled “American Bluff Poker,” reported:
Each time KPNQwest didn’t realize its quarterly target it came knocking at thedoor of its parent companies. The parent companies had little choice. If theywouldn’t intervene, the stock price of KPNQwest, which had fallen to under the20 Euro IPO price at the beginning of 2001, would fall even more. And thatwould definitely affect the stock prices of KPN and Qwest. It was much easier tobuy new capacity each quarter from KPNQwest for millions of Euros. Even if theparent companies didn’t need this capacity, they bought it on stock anyway. Thisway, their subsidiary would have good numbers to show for themselves, and theirrespective market valuations would remain strong.
222. Still another article from Dutch-language Quote magazine’s fall 2001 issue
similarly reported:
“In the second quarter [of 2001], the parent company Qwest gave the jointventure a helping hand. It bought glass fiber worth 57 million Euros fromKPNQwest, and cables in Scandinavia and Eastern Europe. The contractrepresented 25% of the profit of KPNQwest for that quarter. At the moment thatthe transaction was closed, the cables in Eastern Europe were officially stillowned by the company Memorex. Only in December, when the American SECstarted to show some interest in the transaction, it was announced retroactivelythat KPNQwest received the proof of ownership of the cables.”
223. Qwest had no business purpose in making such a purchase, since it did not have
any operations in Scandinavia or Eastern Europe.
224. CW 9, who was vice president of global sales, noted that KPN and Qwest had
revenue commitments to KPNQwest: KPN’s commitment was 150 million Euros annually,
Qwest’s commitment was even more. These revenue commitments came out of the initial
business plan for KPNQwest put together by the parent companies. CW 9 worked at Unisource17
Ma Bell telephone providers of the Netherlands, Switzerland and Sweden), joined with AT&T toprovide intra-European telecommunications services under the name “AUCS.”
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corporate prior to working for KPNQwest, and in that capacity worked on the two alternative
business plans KPN was putting together in late 1998-early 1999: one planning for KPNQwest,
the other scenario of KPN supplying international customers through AUCS. CW 9 states that
Joop Dreschel and Win Dik (chairman of KPN) both approved the KPNQwest business plan in
February, 1999, and therefore were fully informed about KPN and Qwest’s revenue
commitments to KPNQwest.
225. According to CW 9, KPN and Qwest met these revenue commitments by taking
capacity into “stock” or inventory–idle capacity never to be sold because price erosion was so
high they could never re-sell this capacity at a profit, and there was no party in the market in a
global scale or anyone else who would be a potential buyer of the capacity from KPN. KPN had
no need for this capacity for its own use, since KPN did not use its own capacity for its
international customers, but merely marketed KPNQwest’s services to those customers. Qwest
similarly had an obligation to put its customers on KPNQwest’s European network and not to
compete with KPNQwest. So Qwest also did not need the European capacity it was acquiring
from KPNQwest. In dealing with KPN for its capacity purchases, Ewould Mogendorf dealt with
Hans Vogel, senior vice president of international distribution at KPN (Mogendorf’s counterpart
at KPN) and Fred de Goede, KPN executive vice president. Vogel reported to Marten Pieters
periodically and operationally reported to Fred de Groode, who was one level below the KPN
board. CW 9 goes “way back” with Vogel, and discussed with him over drinks, “why don’t we
tell the financial community that we don’t make the targets, take the pain, instead of creating the
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swap/capacity transactions.”
226. CW 19, who was KPNQwest’s vice president of indirect sales (reporting to
Ewould Mogendorf and his successor, was responsible for the Benelux region and therefore
focused on the relationship of KPNQwest with KPN. CW 19 was involved in negotiation of
capacity purchases by KPN each quarter, which KPN did in order to meet its annual 150 million
Euros revenue commitment to KPNQwest. CW 19 had two managers reporting to him one for
Benelux wholesale and one for Benelux retail. CW 19 states that “We three, together with John
Baron (Ewoud’s successor) concluded how much still needed to be covered by KPN,” i.e., how
much KPN still had to purchase at the end of the quarter to fulfill its revenue commitment. CW
19 states that the capacity “sold” to KPN by KPNQwest was mostly capacity that KPN already
owned by purchase from another carrier, i.e., Cable & Wireless, Global Crossing, Worldcom,
Colt or Level 3. In order to meet its revenue commitment to KPNQwest, KPN would revise its
already-existing purchases of capacity from third party carriers, so that instead of buying it
directly from these carriers, KPN bought the same capacity from KPNQwest, which in turn
bought if from whichever carrier had been supplying KPN.
227. CW 19 states that most of the time Ewould Mogendorff or later John Barton, did
these capacity deals at the end of each quarter working directly with the board of KPN, in
particular Marten Pieters, and the legal department of KPN. KPN’s target was to provide 150
million Euros per year and KPN reached 35 million in real revenues to KPNQwest in the full
2001 calendar year, so KPN had to provide 115 million Euros (or approximately 30 million
Euros per quarter) to KPNQwest through these phony capacity transactions (i.e. re-routing its
purchases). In each quarter CW 19 had discussions with Ewould Mogendorff about how much
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KPN fell short from its revenue commitment. Ewould said to CW 19 that KPN’s revenue
commitment to KPNQwest was a “gentleman’s agreement” between Jack McMaster and KPN
director Paul Smits.
228. CW 19 said that each quarter it was harder and harder to find solutions for KPN
to meet its revenue commitments through capacity purchases transferred from other carriers, so
eventually KPN had to directly buy capacity from KPNQwest that it had no need for at all.
229. CW 8, head of technical sales engineers across Europe in the KPNQwest sales
support department, said that KPN acquired a lot of STM-1s from KPNQwest just to create
artificial revenues, as way of subsidizing the Company. KPN bought lots of capacity they
wouldn’t fill [i.e., make use of] in 10 years. KPN acquired this capacity from KPNQwest at the
end of the quarter. CW 8 was sitting next to Kees Boer, MBBS (wholesale) product manager,
who was making up KPN’s shortfalls each quarter along with Ewould Mogendorf, to whom he
reported. CW 8 further explains that as SVP of “indirect distribution,” Mogendorf was in
charge of sales to KPN and Qwest, through the distribution agreements between KPNQwest and
those companies. These were so-called “indirect sales”, because they were theoretically sales to
KPN and Qwest customers through a direct sales relationship with KPN and Qwest. In fact,
KPN and Qwest bought capacity that they never used themselves or sold to customers.
230. CW 11, who was in charge of the engineering department in 2001, said everyone
knew that circuits provisioned with KPN and Qwest were not used. The KPNQwest
implementation manger working under CW 11 visited the POPS and every time he did not see
connections with the KPN and Qwest capacity, just empty sockets. KPN and Qwest both had at
least 16 STM-16s reserved for each company, maybe even more. KPN and Qwest were the
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major swap partners. KPN and Qwest purchases comprised 50% of KPNQwest’s revenue
towards the end of 2001 At the beginning of the quarter, CW 11 received revenue forecasts to
determine capacity to be installed, which did not include KPN or Qwest, and at the end of the
quarter KPN and Qwest capacity purchases were added in order to meet the targets. Sometimes,
according to CW 11, circuits were moved from KPN to Qwest, then moved back. In some
emergency cases, CW 11 used some of these circuits assigned to KPN or Qwest when others
broke down. For example, CW 11 used a few STM-16s assigned to KPN to restore service to
the IP backbone after a large cable breakdown in Amsterdam. KPN used some circuits
provisioned in 1999 and earlier, but CW 11 was not aware of KPN making use of any of the
circuits provisioned for KPN after 1999. Qwest used some of the circuits to transport IP traffic
from Washington, D.C. to New York to Europe. However, Qwest bought ten times the amount
that they were actually using.
231. Another individual working on network design, CW 6, said he knew KPN was not
using the capacity it reserved on the KPNQwest network for a number of reasons. First, there
was no interconnect from the KPNQwest network to the KPN network for much of this capacity,
Second, there was no call from the customer (KPN) when there was a disruption of the circuits
because they were not using them. Third, KPN had reserved multiple colors (wavelengths) but
KPN did not use wavelengths, only SDH transmission which would require putting transmission
equipment on those wavelengths. CW 6 noted specifically that in November of 2001, when he
was working on implementation of a network of international interconnections between various
universities (called the Dante network), he found that KPN was not using the transatlantic
wavelengths reserved for them on the KPNQwest system.
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232. Similarly, CW 14 of the CNI department said “we knew a lot of capacity sold to
Qwest or KPN was not used because those companies had no interest in the market being served
by the capacity. For example, KPN had no operations in France or the U.S. so what could they
be doing with the capacity.” In Germany, according to CW 14. KPNQwest sold a lot of capacity
to KPN, but that was not a big market for KPN customers based on the Netherlands.
233. CW 20, responsible for the data services retail platform from an engineering and
design point of view, said he believes that KPN and Qwest obtained capacity from KPNQwest
that was useless to them. CW 20 obtained this knowledge from written overviews of the
network capacity usage that he used in connection with his work, because he sometimes had to
work on expansion of the network. KPN obtained international bandwidth between Germany
and France, but KPN was supposed to sell intra-European transmission through KPNQwest.
THE COMPANY ABRUPTLY FAILED AS ITS DISMAL FINANCIAL STATE,LONG-DISGUISED BY ITS BOGUS CAPACITY TRANSACTIONS,
CAUSED THE BANKS TO PULL OUT
A. Defendants’ Favorable Portrayal of the Company’s Prospects Left Analystsand the Market Stunned by KPNQwest’s Abrupt Plunge into Bankruptcy
234. As specified below, throughout the Class Period, Defendants portrayed
KPNQwest as a thriving company which was experiencing and would continue to experience
rising revenue. This false front was maintained late in the Class Period, long after the
telecommunications market in Europe began to collapse under the weight of bandwidth capacity
that far outstripped demand. For example:
a. In response to public questions about its available cash, Defendants misrepresented
to the investing public that KPNQwest was “fully funded” until it achieved
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profitability. Specifically, CNN.com Europe/Business reported on July 23, 2001:
“Though KPNQwest has said its business plan is fully funded, some analysts expect
the company needs an extra 250 million euros by the end of next year.” In response,
when the Company announced its purchase of Ebone in October 2001, Defendants
stated that a bank loan obtained in conjunction with the purchase would render the
Company “fully funded” until profitability;
b. On October 29, 2001, KPNQwest adjusted its FY 2001 revenue guidance upward,
from 780 million to 800 million Euros;
c. On October 29, 2001, KPNQwest released revenue guidance for FY 2002,
forecasting that KPNQwest’s operations (including the operations of soon-to-be
acquired Ebone) would generate revenues in the range of $1.3-1.4 billion Euros;
d. On February 12, 2002, the Company announced its financial results for FY 2001,
reporting revenues of 810.1 million Euros, thereby exceeding the already increased
guidance by more than $10 million;
e. On March 14, 2002, defendant McMaster boasted at the CeBIT trade fair in Hanover,
Germany, that “only two to three international alternative network providers will be
around in three years time.”
f. On March 18, 2002, a KPNQwest press release touted the Company’s strength and
reiterated that it was “fully funded,” stating:
KPNQwest...announced that it has completed the acquisitionof the Ebone and Central European businesses of GlobalTelesystems, Inc. and Global TeleSystems Europe B.V....Theacquisition consolidates KPNQwest’s position as the leadingIP data communications provider in Europe. The new
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combined company will operate a 25,000-kilometre networkwith connections to 60 major European cities....The capitaland operating synergies estimated at over €600 million,uniquely derived from the combination of these twocompanies, are expected to exceed the purchase price in just4 years....To facilitate this transaction, KPNQwest hassecured a new senior credit facility of €525 million with aconsortium of financial institutions. With the new seniorcredit facility, the company believes that the newly combinedentity is fully funded for all of its capital and operating cashneeds.
235. In April 2002, two months after Defendants reported that FY 2001 revenues exceeded
already-raised guidance by $10 million, and only one month after Defendants had assured investors
that the Company was “fully funded” through profitability (in the following year), KPNQwest
drastically reduced its revenue guidance for FY 2002. Specifically, on April 24, 2002, the last day
of the Class Period, the Company stated:
KPNQwest Announces Revisions to Financial Guidance
Retains Bear Stearns & Co. Inc. to Advise on Strategic & Financial Alternatives
HOOFDDORP, Netherlands, April 24 /PRNewswire-FirstCall/ – KPNQwest N.V.today announced that it is reviewing its 2002 financial guidance in light of severelydeteriorating market conditions. KPNQwest believes that revenue for 2002 is likelyto be between euro 1,000 - euro 1,050 million against previous guidance of euro 1.3billion and EBITDA is expected to be in the region of euro 140 million compared toprevious guidance of euro 175 million for 2002.
The revision in the outlook is attributable to a number of factors, including a recentdramatic deterioration in the optical capacity and wholesale markets, the effectiveclosure of the IRU and infrastructure markets and a softening of demand in theenterprise market.
KPNQwest is currently reviewing its outstanding liabilities and has retained Bear,Stearns & Co. Inc., a leading investment banking and securities trading andbrokerage firm, to advise the company on exploring alternative means ofreorganising its balance sheet. Alternatives being explored include raising additionalcapital, selling certain non-strategic assets and a recapitalisation of the balance
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sheet, which may lead to the non-payment of interest on the company's high yieldindebtedness. KPNQwest plans to work closely with its banks, suppliers,bondholders and shareholders in reviewing these alternatives.
236. Although Defendants cited “severely deteriorating market conditions” for the vastly
lowered guidance, investors could not understand how so much had changed so quickly. An
immediate sell-off followed, and KPNQwest’s stock price dropped 46% in one day.
237. Shortly after revising its revenue guidance downward, KPNQwest announced in an
April 25, 2002 press release that it was “in talks with banks and major shareholders as [it] seeks to
reorganize debt of 1.8 billion euros ($1.6 billion) and weighs whether to stop payments on its
bonds.”
238. On May 15, 2002, KPNQwest announced that “it has experienced a continued
deterioration in its liquidity position as it reviews its options to stay in business.” The Company’s
stock fell 56% on that day, and another 23%, to 33 cents, on May 16, 2002. On May 22, 2002,
KPNQwest announced that “its first-quarter net loss widened to about 280 million euros ($258.7
million) because of slower demand.”
239. On May 23, 2002, the Company announced the resignation of its Supervisory Board,
and on that same day KPNQwest filed for bankruptcy protection under Netherlands law.
240. Industry analysts were stunned at the Company’s rapid demise. For example, an
article on Telecomweb, Volume 12, Issue 12, dated June 4, 2002, entitled “KPNQwest Suffers
Dramatic Fall from Grace,” stated:
Daan Muusers, a telecoms equity analyst at Friesland BankSecurities, told BNN: "KPNQwest going under is completelysurprising. We had the feeling until, say, April [2002] thatKPNQwest was the best funded of all of the alternative carriers thatwe were aware of. They also proved that ... in the downturn, they
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were able to acquire GTS/Ebone and ... they didn't run into trouble atthe same time as VersaTel and Global Crossing, for instance. Theremust have been something that went [terribly] wrong at the beginningof this year."
241. Indeed, when BNN interviewed KPNQwest CEO Jack McMaster in December 2001
– just after the GTS/Ebone acquisition – he made a point of assuring investors that the company was
fully-funded through to profitability and would not fall short of cash. The acquisition had been a way
for the operator to flex its muscles. McMaster said at the time that the Company would have the
largest pan-European data communications footprint and was in position to take advantage of the
fact that a number of its competitors had gone bankrupt. At that time, investors could not know that
a mere six months later KPNQwest would suffer the same fate.
B. The Company’s Stock Plummeted As the Reality of the Company’s Dependenceon IRU Sales and the Resulting Reduced Prospects for Future RevenuesEmerged Following the February 12, 2002 Earnings Release,
242. The Company’s descent into bankruptcy, and concurrent collapse of its stock price
was swift following the February 12, 2002 press release.
243. The impact of the February 12, 2002 press release (as specifically alleged below) was
substantial, even though the Company’s honesty was not called into question, because KPNQwest’s
dependence on IRU transactions reduced the prospects for future revenue. For example, the
Dominion Bond Rating Service (“DBRS”), in a February 15, 2002, while negating any inference of
fraud, commented on the fact that IRU transactions are not recurring sales. The DBRS release
stated:
KPNQwest N.V. ("the Company") disclosed in its year-end results that it hadEuro 438 million of capacity sales, representing 54% of its 2001 total revenues. DBRS believes that the dependence on this type of one-time revenue has
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potential negative credit implications going forward as: (1) capacity sales willdecline as emerging communication providers come under increasing financialduress, resulting in a substantial decrease for long-term IRU revenue; and (2)recurring revenues may not grow fast enough to replace the declining capacity sales,given the current market downturn. Core recurring revenues grew 24% and 21% in2001 and 2002, respectively.
While KPNQwest appears not to have violated U.S. GAAP on revenuerecognition of capacity sales, this method of revenue recognition is aggressive.Hence, this may not be truly indicative of the revenue generating capability ofKPNQwest on a go forward basis.
In addition, capacity sales included Euro 120 million of revenue relatedto capacity swaps, where KPNQwest simultaneously sold and bought capacityand assets with other carriers. This raises the issue of whether capacity swapsshould be recorded as deferred revenue and amortised over the life of theagreement, similar to the treatment of the purchased capacity which has beencapitalised. If so, EBITDA and operating cash flow would have been lower and theCompany would have reported a core EBITDA loss of approximately Euro 50million for 2001. (Emphasis added).
244. DBRS also expressed the concern that KPN and Qwest were having financial
problems of their own and might not be able to give the Company additional support.
245. As a result of the February 12th news and the market’s absorption of that information,
KPNQwest’s stock price dropped 5.76% on February 12th, 10.26% on February 13, 6.33% on
February 25, 7.27% on February 15, and 17.09% on February 19th a cumulative drop from a closing
price of $4.86 on February 11 to a price of $2.70, a combined drop of 44%.
246. McMaster’s reassuring interview on March 14th (as alleged above) kept the
Company’s stock price up. But in mid-April, reality struck again.
247. On April 15, 2002, Credit Suisse First Boston issued an analyst report downgrading
KPNQwest from a “Buy” to a “Sell.” The report stated, “we have reduced our EBITDA forecasts
by 29% for 2002 and 70% for 2003 following improved visibility of underlying revenues that
highlighted heavier-than-expected reliance on capacity sales. We believe management guidance that
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non-capacity sales will double in 2002 is optimistic in current market conditions.”
248. The report further stated that “KPNQwest will exhaust available liquidity by the end
of 2003" and that “KPNQwest’s major shareholders [KPN and Qwest] may prove to be reluctant
providers” of further cash. Thus, “[w]e believe a restructuring involving a dilutive debt for equity
swaps is now likely.”
249. Contemporaneous reports, such as an April 19, 2002 Bloomberg release, states that
KPNQwest expects 2002 sales to be “at the low end” of a previously stated range of 1.3 billion to
1.4 billion Euros. McMaster had reported guidance of 1.5 billion Euros in mid-March.
250. The KPNQwest stock price fell once again, dropping by 9.7% on April 17, 9.26%
on April 18th, and 16.33% on April 19th, falling cumulatively from $2.99 to $2.05, or almost 33%.
251. More dramatic bad news emerged on April 24, 2002, after the market’s close.
KPNQwest announced that it is “reviewing its 2002 financial guidance in light of severely
deteriorating market conditions” and now ‘believes that revenue for 2002 is likely to be between
euro 1,000 - euro 1,050 million....” The company blamed “a recent dramatic deterioration in the
optical capacity and wholesale markets, and effective closure of the IRU and infrastructure markets,
and a softening of demand in the enterprise market.” The Company also announced that Bear
Stearns was being retained to advise the Company on “exploring alternative means of reorganising
its balance sheet.”
252. On April 25, 2002, the Company announced that it was in talks with its banks to
reorganize its debt, and was weighing whether to top payments on its bonds. One analyst
commented that such a threat was “like putting a knife on the throats of shareholders and
bondholders.”
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253. The stock plummeted 48% on April 25th, 22.12% on April 26th and 13.58% on April
29th, falling from $2.00 at the market close on April 24th to 70 cents at the market close on April
29th.
254. On May 15, 2002 , the Company announced that “it will run out of cash this year
unless it can lower its debt, sell assets or find a buyer.” It also announced that its banks stopped the
Company from drawing on its 525 million euro credit line. The Company admitted that “there’s a
substantial risk its bonds and shares are worthless.”
255. On May 23, 2002, the Company’s supervisory board resigned, although the Company
said it was still in discussions with its banks for the purpose of reaching a standstill agreement. On
May 24, 2002 the Company filed for bankruptcy protection.
256. KPNQwest’s stock fell by 55%, 16.67% and 13.33% on May 15, 16 and 17
respectively, and by 42%, 17.24% and 41.67% on May 24, 28 and 29 respectively. Starting at a
market close of 80 cents on May 14, 2002, it fell to 26 cents by market close on May 17 and to 14
cents by market close on May 29, 2002.
C. By June 2002 Calls for An Investigation Were Heard From All Quarters
257. Analysts, the Company’s lenders and investors all demanded an immediate
investigation of KPNQwest’s collapse. How could this happen, they asked, given the Company’s
claimed revenue base?
a. “KPNQwest Could Face Enron-style Investigation”
“Analysts are calling for an investigation into the business dealings ofbankrupt network provider KPNQwest ... ‘Jack (McMaster, KPNQwest chiefexecutive) must have lied to the banks in March to get a credit facility,’ saidBert Siebrand, senior analyst of technology and telecoms at SNS Securities.
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The company should be investigated by the US Securities and ExchangeCommission, its Dutch equivalent, the AFM, or the Ondernemmingskamer,a court which investigates business malpractice in the Netherlands, saidSiebrand ... ‘It looks very much as if KPNQwest pumped up its EBITDA bybooking income as revenue that should not have been booked as revenue,’said Siebrand. KPNQwest appeared to be profitable in February, gave aprofit warning in April, and went bankrupt in May.’” [Emphasis supplied.][June 10, 2002, article by Peter Judge in ZDNet UK];
b. “KPNQwest’s Lenders Want Probe Into Company’s Accounts, FT [Financial Times]Says”
“Banks want transactions between KPNQwest and its two foundingcompanies, Royal KPN NV and Denver-based Qwest CommunicationsInternational, Inc., investigated to determine whether the company’s revenuewas exaggerated, the FT reported ... The lenders ... say they weren’t givensufficient information about KPNQwest’s finances before they agreed to a525 million euro ($509 million) credit facility, FT said.” [Bloomberg, June23, 2002];
c. “KPNQwest’s Lenders May Ask Court to Probe Company’s Accounts”
“Banks are concerned about KPNQwest’s reported revenue and the amountof cash it is owed by its founders . . . . ‘The banks provided 525 millionEuros in March,’ [lenders’ attorney Paul] Kuipers said. ‘Three months later,that money has disappeared like snow in the sun.’” [Bloomberg, June 24,2002].
d. “KPNQwest Bondholders Want Probe of Demise, Financial Times Says”
“‘Bondholders want to discover whether [KPN and Qwest] . . . knew offinancial concerns before they were made public,’ the FT said . . .‘Something like this does not happen that fast,’ the paper quoted Gary Klesch[chairman of investment company bondholder], as saying. ‘Someone musthave seen the train coming down the tracks for sometime.’” [Emphasissupplied.] [As Bloomberg, June 19, 2002].
258. In response, Defendants denied wrongdoing. A Forbes.com article entitled “Faces
In the News: June 21, 2002" reported:
Reasons--or excuses? In his first encounter with journalists sinceKPNQwest declared bankruptcy at the end of May, former Chief
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Executive Jack McMaster said KPNQwest's banks seized the lion'sshare of the company's assets and cash merely because of theSupervisory Board's resignation – not because the firm's financialshad been artificially inflated, as had been rumored. The CEOhastened to point out that KPNQwest did not violate any loancovenants. The firm was declared bankrupt when majorityshareholders KPN and Qwest – which together own 87% of its nearlyworthless equity – withdrew support as the company faced a loomingslagheap of debt and shrinking data-transfer revenue.
259. Amid reports of differences between the Company and KPN about amounts owed,
as alleged in ¶ 218, above, a dispute arose between KPNQwest and its former auditor, Arthur
Andersen. On June 25, 2002, Bloomberg reported:
KPNQwest Auditor Andersen Says It Didn't Approve 2001 Accounts
Amsterdam, June 25 (Bloomberg) -- KPNQwest NV's auditor said it didn't approvethe 2001 results of the insolvent operator of Europe's largest fiber-optic network, aspokesman for the Dutch business of Arthur Andersen LLP said.
``We never gave our approval'' to the numbers, said Paul Vermeij, a spokesman forthe Dutch business of Arthur Andersen.
260. Further specifics of this strange discrepancy between auditors and the audited
company came from other sources. As reported in The Sunday Business Post.IE on June 30, 2002,
a dispute arose after KPNQwest filed for bankruptcy protection as to whether the reported FY 2001
figures contained in the Company’s 2001 Annual Report had been audited. While defendant
McMaster maintained that Arthur Andersen had signed off on the reported numbers, new auditor
Deloitte & Touche (who took over Arthur Andersen’s Dutch unit after Andersen’s demise) flatly
denied that audit partner Paul Ogden ever gave his blessings to the figures reported by KPNQwest.
261. Additionally, as reported by Internet Bankruptcy Library on June 28, 2002, Deloitte
was shocked that 15,000 copies of the Annual Report had been printed, with some being shipped
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to Qwest in Denver, Colorado: “‘I have never experienced anything like this. We are surprised that
there is a printed report as there was no formal OK from the accountant,’ Mr. [Paul] Vermeij told
the Financial Times.”
D. Post-Bankruptcy Reports Tied the Company’s Demise to the Collapse of the Scheme to Pump Up the Company’s Revenues with Hollow Swapsand Sales of Unneeded Capacity to Qwest and KPN
262. KPNQwest’s rapid demise came quickly on the heels of Qwest’s April 2, 2002,
announcement that it may be forced to restate its results to eliminate swap revenues:
Qwest May Be Forced to Restate 3 Years of Results
Denver, April 2 (Bloomberg) -- Qwest Communications InternationalInc., the subject of a U.S. Securities and Exchange Commissionaccounting probe, said regulators may force the phone company torestate financial results for the past three years.
The investigation may “have a material effect on Qwest's reported netincome or earnings per share,”' from 1999 through 2001, Qwest saidin an SEC filing yesterday. The fourth-biggest U.S. local-phonecompany also disclosed it had revised last year's revenue lower,resulting in a wider loss.
Regulators are looking at transactions in which Qwest sold space onits fiber-optic network to other carriers, then agreed to buy a similaramount of capacity from them. Qwest was denied access to thecommercial paper market in February after investors questionedwhether the Denver-based company used the swaps to improperlyinflate sales. Qwest says its accounting is proper.
* * *
263. Qwest’s revelations concerning prior illegitimate swap deals had serious
consequences for KPNQwest in 2002. As reported in an article entitled “KPNQwest Books
Promises as Revenue” appearing in the Dutch publication NRC Handelsblad on June 3, 2002, KPN
and Qwest had given the Company revenue guarantees. According to KPNQwest spokesmen, for
18An analysis of the collapse by Paul Budde confirms that “The death-knell sounded whenthe company no longer received the financial support of its parents to conduct its business. Veryimportantly, the parents withdrew their contract for wholesale capacity. ...”
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FY 2002 KPN and Qwest committed to purchase network capacity and maintenance contracts
valued at €120 million. Customarily, such capacity deals were immediately booked as revenue.
264. However, in April and May the parent companies made clear, through write-offs
relating to the joint venture, that they no longer needed the capacity. Consequently, analyst Bert
Siebrand of SNS Securities suspected, because the parent companies had reported that they would
leave the capacity unused, that KPNQwest’s bookkeeper did not want to approve “ghost
transactions.” KPNQwest suddenly had a big accounting problem -- one made more severe because
the banks had extended credit in reliance on “a certain revenue level which included the
contributions from the parent companies. The banks stood firm and demanded the return of their
money immediately. The crisis was a fact.” (“KPNQwest Books Promises as Revenue,” June 3,
2002).
265. As widely reported, the banks demanded return of their money after KPN and Qwest
refused to support the Company any further.18 The bank’s commitment to the credit line used to
fund the GTS/Ebone transaction, which, as alleged below was induced by a warranty that
KPNQwest’s financial reports were true, was also induced by KPN and Qwest’s promises of
support for the Company. Specifically, it was reported that in early 2002, during a special meeting
of the audit committee in New York, KPN (led by KPN director Marten Pieters) and Qwest each
committed to contribute €100 million to the company.
266. Plaintiffs learned from talks with the Company’s bankruptcy trustees and others that
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after the GTS/Ebone acquisition deal closed in March, 2002, the banks were shocked when over
€300 of the credit line was drawn down almost immediately. The banks demanded reassurances
from KPN and Qwest, but Qwest refused to accelerate the revenues it had promised to KPNQwest.
267. Once KPNQwest’s parent companies enraged the Company’s lenders by withdrawing
support, the situation went from bad to grave within one month as evidenced by the April 25, 2002,
press release announcing the Company’s talks with banks and major shareholders, the May 15, 2002
announcement of deterioration in liquidity and the May 22, 2002 announcement of further
deteriorating performance – all of which came in rapid succession.
268. The matter finally came to a head during a tumultuous overnight meeting May 22-23.
While the banks thought that they could get their money back by foreclosing on all of the assets of
KPNQwest, the directors knew that the Company would be worth nothing once the cables were
turned off.
269. On May 23, 2002, the Company announced that its entire Supervisory Board had
collectively resigned. That same day, the Company filed for bankruptcy protection.
ACCOUNTING ALLEGATIONS: DEFENDANTS VIOLATED GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
WITH RESPECT TO KPNQWEST’S IRU SALES, INCLUDING SWAPS
A. Defendants Violated GAAP by Recognizing Revenues From the Swaps andother IRU Sales Up Front in the Period the Transactions Were Entered Into
270. GAAP are those principles recognized by the accounting profession as the
conventions, rules and procedures necessary to define accepted accounting practice at a particular
time. SEC Regulation S-X (17 C.F.R. section 210.4-01(a)(1)) states that financial statements filed
with the SEC which are not prepared in compliance with GAAP are presumed to be misleading and
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inaccurate, despite footnotes or other disclosures. Regulation S-X requires that interim financial
statements must also comply with GAAP, with the exception that interim financial statements need
not include disclosure which would be duplicative of disclosures accompanying annual financial
statements. 17 C.F.R. section 210.10-01(a).
271. KPNQwest’s practice was to recognize revenue from sales of transmission capacity
(so-called IRU sales), including IRU swaps, up front at the time of the transaction. This practice
was improper and violated four categories of GAAP principles:
a. NO ECONOMIC PURPOSE In recording revenue which lacked a businesspurpose, KPNQwest violated the basic GAAP concept of “substance over form.”FAS Concept 2, paragraph 160 states that “The quality of reliability, and, inparticular, of representational faithfulness leaves no room for accountingrepresentations that subordinate substance to form.” No revenue should have beenrecognized because the hollow swaps lacked economic purpose. Each side in theswap deals “bought” capacity it did not need for any business purpose. Such“purchases,” often made at quarter-end, were motivated not by a business need forthe purchased capacity, but by Defendants’ desire to meet Wall Street’s revenuepredictions. The same was true in other nominal IRU sales by KPNQwest, notablyin sales of capacity to parents KPN and Qwest. KPN and Qwest had no need for thecapacity. The transactions took place to meet the parents’ contractual obligations togenerate revenues for KPNQwest.
b. SWAP OF SERVICES, NOT SALES OF ASSETS The IRU swaps should beviewed as sales of services (i.e., the transmission of signals from location to location,regardless of circuit path taken between those two points), rather than as sales ofspecifically designated circuits which could be termed assets. Therefore, under thisanalysis, KPNQwest improperly recognized revenue up front which should havebeen recognized ratably over time.
c. SWAP OF INVENTORY Even if considered an exchange of assets, the swapswere non-monetary exchanges of assets which do not constitute the culmination ofthe earnings process, akin to exchange of inventory. Since the circuits were not litto be used, but only for revenue recognition purposes, they be should regarded asinventory to be used or sold at a later date. Under this analysis no revenue isrecognized. For exchanges that do not represent the culmination of an earningprocess, accounting for an exchange of a non-monetary asset between entities shouldbe based on the recorded amount of the non-monetary asset relinquished.
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d. THE IRUS WERE MERELY OPERATING LEASES, NOT SALES-TYPELEASES Sales-type leases require identification of specific assets to be sold. Theside agreements and/or informal understandings accompanying KPNQwest’s IRUsales (including the swaps), which permitted the exchange of IRUs by the purchasingparty after the transactions took place, demonstrate that the swapped interests were,at most, operating leases. Under this analysis, revenue is recognized ratably over thetime the capacity is “sold,” rather than all up front.
272. Many of these issues regarding IRU sales were discussed in the testimony of John
M. Morrissey, Deputy Chief Accountant, U.S. Securities and Exchange Commission, before the U.S.
House of Representatives Subcommittee on Oversight and Investigations of the Committee on
Financial Services on March 21, 2002 (the “Morrissey Testimony”).
273. The parties to the IRU transactions actually contracted for services, not assets, i.e.
for the transmission of electronic signals through circuits, not for the fibers or wavelengths
themselves. Although the documentation of swap deals called for sales of “fiber” and/or “ducts”
and/or “wavelengths” or other units of transmission capacity, KPNQwest never relinquished
dominion and control over the fiber or ducts of its Eurorings, and therefore retained control over the
wavelengths or other transmissions through these physical assets. The value of the deals was
derived from services supplied by KPNQwest. Without either the services of KPNQwest to
maintain the circuits or transmitting light (which was subdivided or “multiplexed” into individual
wavelengths only after being transmitted from KPNQwest switching point of presence (“POP”) to
KPNQwest POP, the physical circuits would not be useful for the production of business income for
Global Crossing or other carriers. Thus, although Arthur Andersen artificially formulated these
transactions so the customer was separately obligated to pay for maintenance, it was obvious to
Defendants, as part of their basic understanding of the business of KPNQwest, that the transmission
services (including maintenance) were at the heart of the transaction, not ownership of circuits,
19Quoting a document from Arthur Andersen entitled “Accounting by Providers ofTelecommunications Network Capacity An Update” (February 29, 2000) (hereinafter the “WhitePaper Update”).
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wavelengths or other transmission capacity. GAAP required that these transactions be recorded
based on their substance – service agreements – rather than their overt form as sales.
274. Another reason that the IRUs should be considered contracts for services is that the
IRUs with respect to lit fiber are merely the right to put a transmission through a wavelength, STM-1
or other unit of light capacity. A wavelength, STM-1 or other unit of transmission capacity is not
a depreciable asset. The SEC was thus concerned that a wavelength produced by wave division
multiplexing in a fiber did not qualify as a lease. “The staff’s concern is that an agreement that does
not give exclusive rights to all of the physical properties of a specific tangible asset for a continuous
period does not meet the accounting definition of a lease.19”
275. The SEC’s concern was wise. FAS 13 (entitled “Accounting for Leases”) states that
a lease is “an agreement conveying the right to use property, plant or equipment (land and/or
depreciable assets) usually for a stated period of time...” While a dark fiber itself might have been
depreciable, a wavelength, STM-1 or other capacity unit is not a “depreciable asset.”
276. The Morrissey Testimony stated that “[u]nder generally accepted accounting
principles (“GAAP”), revenues associated with long-term service contracts are generally recognized
over time as performance occurs.” This principle is embodied in SEC Staff Accounting Bulletin
101 (“SAB 101"), issued December 3, 1999, which states that “revenue should not be recognized
until it is realized or realizable and earned,” and Statement of Financial Accounting Concept No.
5, paragraph 83(b), which states that “revenues are considered to have been earned when the entity
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has substantially accomplished what it must do to be entitled to the benefits represented by the
revenues.’” Arthur Andersen’s White Paper recognized that “revenue from an IRU that is classified
as a service contract should be recognized on a straight-line basis over the life of the contract.”
However, because Arthur Andersen classified IRUs as leases of “identifiable assets” (a criterion that
Defendants themselves knew was violated–see scienter allegations), the services analysis was
disregarded.
277. Therefore, KPNQwest’s IRU “sales” (including the swaps) at best, should have been
recognized ratably over the term of the deals. For example, if KPNQwest “sold” a wavelength,
STM-1, or other unit of transmission capacity for 20 years (as an “IRU” (indefeasible right of use)),
any resulting revenue should have been recognized ratably over the 20 years, rather than recorded
as revenue up front, as KPNQwest improperly did repeatedly.
278. For those IRU sales which were swaps, if their character as service agreements is
disregarded and they are considered a swap of assets, the two sides of each swap together
represented a single, simultaneous, non-monetary transaction. Even though in form each side of the
swap was documented separately to create the illusion of two different IRU transactions (one a
purchase by KPNQwest, one a sale by KPNQwest), each swap was thus in substance a single asset
exchange.
279. Citing Accounting Principles Board (“APB”) Opinion No. 29, “Accounting for
Nonmonetary Transactions,” the Morrissey Testimony discussed the concept of non-monetary
transactions and explained that “an asset exchange that does not represent the culmination of the
earnings process” does not result in the accrual of revenue. Under APB Opinion No. 29, there can
be no gain in such a transaction since the asset received is “required to be accounted for based upon
20The directive was issued in a publicly disclosed communication to the [AICPA’s] SECRegulations Committee.
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the recorded amount, or book value, of the asset relinquished.”
280. Morrissey notes, as examples of asset exchanges which do not represent the
culmination of the earnings process, “an exchange of an asset held for sale in the ordinary course
of business (such as inventory) for an asset to be sold in the same line of business” or “the exchange
of a productive asset not held for sale for a similar productive asset” (paraphrasing paragraph 21 of
APB Opinion No. 29). The capacity swaps can be regarded as falling under either of those
categories. The transmission capacity can be viewed as a productive asset not held for sale. Also,
because KPNQwest used only one, or in some locations two, of its 96 fibers on each EuroRing for
actual transmission, the fibers were not needed for KPNQwest’s own business, and can be viewed
as primarily held for sale as inventory. Under either analysis, the exchange of transmission capacity
on fibers does not represent the culmination of the earnings process and should not result in the
recognition of income to KPNQwest, Qwest or the other party to the swap deals.
281. Confirming this analysis, in August 2002 the SEC issued a general directive that “all
IRU capacity swaps consisting of the exchange of leases should be evaluated within paragraph 21
of APB 29. That is, if a swap involves leases that transfer the right to use similar productive assets,
the exchange should be treated as the exchange of similar productive assets....This conclusion would
require that IRU capacity swaps involving the exchange of leases be recognized based on the
carrying value of the assets exchanged, rather than at fair value.20”
282. As reflected in the SEC’s retroactive enforcement of this directive, it did not reflect
a new principle, but merely served to reinforce well-established accounting principles. Thus, the
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SEC’s directive required a restatement of any financial statements which had improperly accounted
for swaps as sales. The directive stated: “The staff expects that registrants will apply this guidance
historically to IRU capacity swap transactions that occurred in prior years and, if appropriate, restate
their financial statements. The CEO and CFO should be advised to give consideration to this matter
prior to certifying the financial statements previously filed with the SEC.
283. Even disregarding the swaps’ characteristic as non-monetary exchanges, or that IRUs
are sales of services rather than assets, KPNQwest’s recording of up-front revenues from its swaps
and other IRU “sales” was improper because it entailed incorrectly treating the IRUs as sales-type
leases, rather than operating leases. The Morrissey Testimony explains the different treatments of
these two types of leases: “In a sales-type lease, which gives rise to manufacturer’s profit, the lessor
records the fair value of the leased assets as revenue upon inception of the lease.” “Alternatively,
in an operating lease...[t]he minimum lease payments are recorded as rental revenue by the lessor
over the lease term, typically on a straight-line basis. Operating lease accounting is similar to
service contract accounting.” FAS 13 requires income from an operating lease to be recognized
ratably over the period of the lease.
284. Under GAAP, sales of telecommunications capacity must be viewed as operating
leases (to be recognized ratably over time) rather than sales-type leases, which require the transfer
of title. FASB Interpretation (“FIN”) No. 43, “Real Estate Sales” issued in June, 1999 (which
interprets FASB Statement No. 66) confirms that pursuant to GAAP, the standards for real estate
sales must be applied to telecommunications capacity lease (IRU) transactions.
285. As explained in the Morrissey Testimony, FIN 43 requires title transfer for the IRU
transaction to be treated as a sales-type lease rather than an operating lease. KPNQwest knew of
21 Morrissey defined IRUs, stating: “The expansion of fiber optic communications increasedthe frequency of transactions involving the ‘sale’ of network capacity. The granting of anindefeasible right to use such network capacity is often referred to as an ‘IRU.’ Pursuant to an IRU,an entity purchasing network capacity has the exclusive right to use a specified amount of capacityfor a period of time.” An article on isp-planet.com entitled “When IRUs Become IOUs,” datedFebruary 15, 2002, notes that “Most IRUs seem to average between 20 and 25 years.”
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these rules at the time of the IPO Prospectus. As admitted in KPNQwest’s IPO Prospectus, the
application of FIN No. 43 meant that “title must transfer on property improvements and integral
equipment for a lease transaction to be considered a sales-type lease.” KPNQwest’s IPO Prospectus
not only admits that FIN No. 43 applies real estate criteria of FASB Statement No. 66 to capacity
transactions, but also discloses that “All future sales of dark fiber will be evaluated under the new
interpretation.” And while the Prospectus failed to disclose anything about accounting principles
applied to sales of lit fiber, KPNQwest later falsely claimed to be applying FASB Statement No. 66
to these transactions as well.
286. Although the IPO Prospectus mentioned FIN 43 only in the context of dark fiber, and
was silent on its application to lit fiber, the Morrissey Testimony reflects that there is no distinction
between dark fiber and lit fiber known as “IRU”s and that FIN No. 43 applies equally to both.
Morrissey specified that his testimony applied directly to accounting for IRU transactions, which
he defines as referred to the sale of “capacity” in the form of IRUs, not just the sale of a physical
fiber. So the testimony applies equally to lit capacity (wavelengths) and to dark fiber IRUs.21
287. The Arthur Andersen White Paper itself makes no distinction between dark fiber
IRUs and lit fiber IRUs, in reaching conclusions that FIN 43 applies to IRU sales, stating that “The
Firm believes that generally the greater part of the network assets provided under an IRU will meet
22The White Paper Update states: There appears also to be some uncertainty as to what thetransfer of title must relate. In the White Paper we refer to title being conveyed to an undividedinterest. We believe that there must be a provision providing for transfer [of] an undivided interestin the cable at the end of the IRU but also it must give the purchaser a right in perpetuity to theparticular wavelength/circuit it had under the IRU....”
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the FIN 43 test of being ‘attached to the land.’”
288. The only apparent reason that the accounting methods applied by KPNQwest
distinguished between dark fiber and lit fiber IRUs was because of the title transfer requirement.
FAS 66, together with FAS 13, requires transfer of title in order to obtain sales treatment for a real
estate lease. Paragraph 7(a) of FAS 13 requires that the transfer of title be accomplished at or before
the end of the lease term. When FIN 43 applied this real estate sales requirement of transfer of title
to sales of property improvements and integral equipment, providers such as KPNQwest could not
abide the notion of selling off their fiber itself, so dark fiber sales-type leases were not feasible.
289. The only alternative, as a means of inflating the Company’s revenue, would be to
obtain sales-type treatment for IRU lit fiber capacity sales. Applying FIN 43 to lit fiber, however,
doesn’t work for multiple reasons, and sales-type lease treatment to lit fiber capacity sales is
impermissible.
290. The first reason FIN 43 bars sale-type lease treatment for lit fiber IRUs is that there
is no transfer of title to a depreciable asset, and the transaction is really a service contract in any
event. Arthur Andersen tried to fit the template of FIN 43, and its concept of transfer of title, to the
transfer of a mere wavelength or other transmission capacity unit of lit fiber. In order to do so,
Arthur Andersen concocted a concept of giving the buyer of the lit fiber IRU an ownership interest
in the particular wavelength plus an undivided interest in the cable at the end of the IRU.22 But, as
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discussed above, SEC did not accept that as a transfer (see allegations above about service vs. lease).
291. The second reason that sales-type lease treatment is impermissible for lit fiber
capacity sales is application of the requirement that all the risks and reward of ownership have to
be transferred to qualify as a real estate sale under FAS 66. As a practical matter, the transfer of the
actual fiber would be required to transfer the entire risks and rewards of ownership ; the transfer of
merely an undivided interest, as in the Arthur Andersen paradigm, would be insufficient.
292. The third reason which remains an obstacle to sales-type lease treatment for lit fiber
IRUs concerns the fact that KPNQwest lacked title to the land underlying the lit fiber. FAS 66
generally requires transfer of the underlying land, for the transfer of title in the improvement alone
to be considered a sale. FAS 66 permits a “sale” of real estate improvements to be recorded, when
the underlying land is not sold, only if the right to use the underlying land is transferred for the entire
useful life of the improvement. This requires transfer of the full risks and rewards of ownership of
the underlying real estate to the IRU purchaser. This problem is stated in the White Paper: “FIN 43
only applies to sales of integral equipment where there is either an outright sale of the underlying
land or an explicit or implicit lease of the underlying land to the purchaser.”
293. However, a capacity provider such as KPNQwest is generally not the owner of the
underlying real estate. KPNQwest’s network was cobbled together from a combination of rights of
way and other usage rights all over Europe. For example, much of KPNQwest’s network in
Germany passed through ducts provided by a gas company. KPNQwest could not transfer title to
the real estate underlying its network to an IRU purchaser, because KPNQwest was not the title
holder. Similarly, KPNQwest could not transfer usage of the land, free and clear of obligation,
23The White Paper Update noted that at the November 15/16, 1999 CFO Roundtable, EricCasey of the SEC staff said: “Statement 66 precludes sale accounting where the seller has retainedsubstantial risks and rewards of ownership relative to the property being sold. It is not clear to mewhat the capacity provider’s contractual or other legal obligations are to the underlying landownersrelative to the fiber, conduit and landing or relay stations when the easements and right of wayagreements expire, if any....[T]he capacity provider may have retained substantial risks and rewardsof ownership and sales-type lease accounting for the fiber may not be appropriate.”
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because KPNQwest itself had its usage rights only subject to obligations to the title holder of the
underlying real estate. In other words, KPNQwest could not transfer the risks and rewards and
burdens of the underlying real estate to the purchaser of the IRU as required by GAAP for the
transaction to be treated as a sale (or a sales-type lease). This inability of the telecommunications
carrier (such as KPNQwest) to transfer the real estate underlying the IRU was raised by the SEC in
November, 1999, as noted in the White Paper Update.23
294. The White Paper itself raises a red flag on this issue, noting that “We have been told
that if the lessor does not have the ability under a right-of-way agreement to assign or transfer their
access right to the land to a third party then it may not be possible as a matter of law for the lessor
to transfer legal title to the integral equipment which is on the land.” So any transfer would be
subject to the limited rights and correlative duties of the IRU seller (KPNQwest) with respect to land
access. In other words, there would be no transfer of the risks and rewards of ownership of the IRU
wavelength and fiber, which would preclude sale-type lease treatment or up-front revenue
recognition.
295. To circumvent this issue, the White Paper discusses the need to transfer legal title
to the transferred wavelength and undivided interest at the end of the term of the IRU–at a time
when it posits that the there will be an “expiration of the land access right” of the IRU seller. This
begs the question of how the IRU provider (such as KPNQwest) could possibly transfer title to its
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wavelength and cable at a time when it lacks any land access right whatsoever. In other words, a
mere reading of the White Paper on this issue demonstrates that KPNQwest’s IRU transfers could
not pass muster as sales-type leases under FIN 43 and other applicable GAAP.
296. On July 19, 2001, Financial Accounting Standards Board (“FASB”) Emerging Issue
Task Force (“EITF”) 00-11 was issued. EITF 00-11 confirmed the principle which KPNQwest
already admitted in its IPO prospectus and subsequent SEC filings, i.e., that the real property criteria
of FASB Interpretation (“FIN”) 43 must be applied to leases of “integral equipment” such as IRUs.
297. The issuance of EITF 00-11 does not reflect the existence of a controversy
concerning the applicability of FIN 43 to IRU transactions. There was no controversy as far as
Defendants and Arthur Andersen were concerned. They admitted and acknowledged the
applicability of FIN 43 to IRU transactions in the IPO prospectus, so the EITF’s confirmation of that
fact does not excuse Arthur Andersen and KPNQwest (which publicly announced that it was
following that accounting principle) from applying it. Since Defendants and Arthur Andersen
always admitted the governing principle, their failure to apply this principle to lit fiber IRUs as well
as dark fiber IRUs was clearly reckless or knowing malfeasance.
298. Moreover, to the extent the issuance of the EITF made it seem as if any controversy
existed, the appearance of a controversy was manufactured by Arthur Andersen, since it was Arthur
Andersen itself who asked the EITF for clarification on IRU issues. Arthur Andersen’s White Paper
Update attaches Arthur Andersen’s submissions to the EITF. Since Defendants had a copy of the
White Paper Update, they knew that Arthur Andersen had manufactured any controversy by
applying for the EITF ruling. Surely, applying for an EITF ruling on a reckless and indefensible
revenue recognition position does not create a defense for that position, when the EITF’s substantive
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response is to reject the applicant’s viewpoint.
299. Also, FIN 43 itself was not a new principle, but merely clarified the applicability of
SAS 66 real estate sales standards to improvements. Thus, Judge Lynch recently held in the In re
Global Crossing, Ltd. Securities Litigation, 322 F.Supp.2d 319 (S.D.N.Y. 2004) that Global
Crossing and Arthur Andersen was obligated to apply the SAS 66 standard to IRU transactions even
before FIN 43 was issued. Judge Lynch credited the Global Crossing plaintiffs’ argument “that to
the extent that there was any uncertainty in the proper treatment of IRUs prior to the issuance of FIN
43, Andersen created that uncertainty through its overly aggressive accounting practices.” Given
that the Global Crossing court upheld a claim based on wrongfully taking up-front revenues from
IRU deals even before issuance of the FIN 43 clarification, it is untenable to cite the issuance of
EITF 00-11, which was merely a clarification of a clarification, as the basis for contending that a
true controversy existed.
300. While the title transfer requirement of FIN 43 cannot be met even if the IRU deals
(including swaps) did not include side agreements, the side agreements violate this and other
requirements. KPNQwest’s use of side letters and verbal understandings accompanying each swap,
which allowed for exchange of capacity acquired in the swap for capacity at a later date, meant that
the swap itself did not represent the culmination of the earnings process or the ultimate transfer of
title.
301. Even apart from FIN 43, a sales-type lease requires identification of the specific
property to be sold. GAAP requires that the sold assets must be properly identified and fixed,
because a sale takes place only if “[t]he seller has transferred to the buyer the usual risks and
rewards of ownership. ...” FAS 66, ¶5(d). The written and verbal side agreements and
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understandings violated this requirement.
302. Other parallel accounting rules were also abridged by the side agreements. First, FAS
66, ¶26, states that when “the seller has an obligation to repurchase the property, or the terms of the
transaction allow the buyer to compel the seller or give an option to the seller to repurchase the
property, [t]he transaction shall be accounted for as a financing, leasing or profit sharing
arrangement rather than as a sale.” Thus, no actual sale was consummated during the swap
transactions.
303. Moreover, SAB 101 notes that “[t]he staff is aware that sometimes a customer and
seller enter into ‘side’ agreements to a master contract that effectively amend the master contract.
... Side agreements could include cancellation, termination or other provisions that affect revenue
recognition. The existence of a subsequently executed side agreement may be an indicator that the
original agreement was not final and revenue recognition was not appropriate.” [Emphasis supplied.]
304. SAB 101 further states that “delivery generally is not considered to have occurred
unless the customer has taken title and assumed the risks and rewards of ownership. ...” The parties
acquiring KPNQwest’s capacity in swaps did not truly take delivery because they obtained capacity
which they did not need or use, they additionally reserved the right to exchange the capacity and did
not assume the risks and rewards of ownership. Thus, in violation of GAAP, KPNQwest improperly
recognized revenue on the hollow swap transactions.
305. Consistent with the foregoing, the Morrissey Testimony explained that flexibility in
capacity sales, as reflected in the KPNQwest swap side agreements, does not permit such swaps to
be treated as sales-type leases and does not permit up-front revenue recognition. The Morrissey
Testimony stated that “as the industry evolved, many capacity providers changed their service
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offerings to permit more flexibility than was previously available in fixed, point-to-point capacity
sales. Because these more recent service offerings typically do not grant the purchaser of such
services the right to use specific identifiable assets for a period of time, these arrangements fail to
meet the fundamental conditions for being treated as leases, and instead are considered executory
contracts (that is, contracts for the provision of services, which are specifically excluded from the
lease accounting literature). Therefore, the sales-type lease accounting model may not be
appropriate for more recent capacity contracts.” Thus, the swap transactions were in fact executory
contracts – not “sales.”
306. The accounting policies of KPNQwest and Qwest, by recording revenues from
capacity sales (including swaps) up-front, also did not comply with telecommunications industry
custom and practice. As explained in the Morrissey Testimony, when the FASB issued
Interpretation No. 43 in June 1999 (effective for transactions entered into after June 30, 1999), and
which rendered the capacity sales as real estate for accounting purposes, and when the related EITF
00-11 became effective, “many telecommunications capacity sellers concluded that they were unable
to meet the title transfer requirement for the assets subject to the IRU and, therefore, were required
to account for subsequent capacity sale transactions as operating leases” to be recognized ratably
over time.
307. This industry custom and practice is reflected in an article on isp-planet.com, entitled
“When IRUs Become IOUs,” dated February 15, 2002. In the article, James Q. Crowe, CEO of
Level 3 Communications (another Qwest and KPNQwest swap partner) explained that “Under
current [GAAP], if the IRU is for capacity in a land-based network, the revenue from the sale is
generally recognized, i.e., reported in GAAP financial statements, over the term of the IRU.”
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308. In fact, Global Crossing, unlike Qwest and KPNQwest, followed industry custom and
practice with respect to recognizing revenues ratably over time, even as to claimed revenues from
the bogus capacity swaps, as reflected in the Congressional testimony of Wright, Global Crossing’s
CFO. In contrast, Qwest CFO Szeliga admitted that Qwest (and KPNQwest) accounted for their
sides of the same swap deals as up-front revenue. See “Capacity Swaps by Global Crossing and
Qwest: Sham Transactions Designed to Boost Revenues?”; Hearings before the Subcommittee on
Oversight and Investigations of the Committee on Energy and Commerce, House of Representatives,
107th Cong., 2d Sess, Serial No. 107-129. While Global Crossing included such revenue up front in
its so-called “pro forma” revenue (hence the JPMorgan Chase lawsuit against Global Crossing, as
alleged herein), it did not include such revenue in its publicly reported audited financial statements.
B. Defendants Violated GAAP by Failing To Make Appropriate Disclosures about the Nature and Magnitude of the Swap Transactions
309. KPNQwest misled investors and the market by failing to disclose the existence,
amount, and meaningful specifics of its swap transactions. In order to provide useful information,
KPNQwest was required by GAAP to adequately disclose the relevant information about its swaps
in the notes to its financial statements. Throughout the Class Period, Defendants’ disclosures
regarding swaps were inadequate on numerous grounds, including:
a. FAS Concept 5, ¶7, which states in pertinent part that “some useful information . .
. is better provided, or can only be provided, by notes to financial statements or by
supplementary information or other means of financial reporting: a. Information
disclosed in notes . . . amplifies or explains information in the financial statements.
That sort of information is essential to understanding the information recognized in
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financial statements and has long been viewed as an integral part of financial
statements prepared in accordance with generally accepted accounting principles”;
b. FAS Concept 1, paragraph 34, which states that “Financial reporting should provide
information that is useful to present and potential investors and creditors and other
users in making rational investment, credit and similar decisions. The information
should be comprehensible to those who have a reasonable understanding of business
and economic activities and are willing to study the information with reasonable
diligence”;
c. FAS Concept 2, paragraph 59, which states that “The reliability of a measure rests
on the faithfulness with which it represents what it purports to represent, coupled
with an assurance for the user, which comes through verification, that it has that
representational quality.”
310. Moreover, pursuant to these general principles, GAAP requires specific disclosures:
a. First, GAAP requires separate disclosure of revenues obtained from nonrecurring
transactions. Each swap deal was a unique, carefully negotiated, intricate
arrangement. No swap deal could be considered a routine or recurring transaction.
These were not recurring revenues, but specialized, one-time deals, and had to be
separately disclosed as such. Defendants’ failure to make such disclosure violated
APB 22, ¶12, which states that “Disclosure of accounting policies should identify
and describe the accounting principles followed by the reporting entity and the
methods of applying those principles that materially affect the determination of
financial position, changes in financial position, or results of operations....that
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involve any of the following:...b. Principles and methods peculiar to the industry in
which the reporting entity operates....c. Unusual or innovative applications of
generally accepted accounting principles....”;
b. Second, as explained in the Morrissey Testimony, “Companies that engage in
material non-monetary transactions during a reporting period are required, under
GAAP, to disclose, in the footnotes to the financial statements, the nature of the
transactions, the basis of accounting for the assets transferred (that is, fair value or
book value), and gains or losses recognized. Moreover, Financial Accounting
Standards Concept 5 requires information about all investing and financing activities
of an enterprise that affect recognized assets or liabilities but that do not result in
cash receipts or payments, such as non-monetary asset exchanges, must be disclosed
in the footnotes to the financial statements.
c. Third, as also explained in the Morrissey Testimony, “the Commission’s rules
require registrants to include in their public filings a section entitled Management’s
Discussion and Analysis of Financial Condition and Results of Operations
(“MD&A”),” citing Regulation S-K, 17 CFR, Item 303. “In MD&A, registrants are
required to discuss the known trends, demands, events, commitments and
uncertainties that are reasonably likely to materially affect a registrant’s liquidity,
capital resources, and results of operations. To the extent that non-monetary
exchange transactions have a significant impact on a registrant’s liquidity, capital
resources or results of operations, disclosure would be required.”
d. Fourth, KPNQwest’s swap transactions with Qwest were considered related party
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transactions. SEC Regulation S-K, Item 404, 17 C.F.R. section 229.404, entitled
“Certain Relationships and Related Transactions,” requires the registrant of securities
sold pursuant to a registration statement to describe any transaction, or series of
similar transactions, since the beginning of the registrant’s last fiscal year or any
currently proposed transactions with a security holder who is known to the registrant
to own “five percent of any class of the registrant’s voting securities.” Similarly,
GAAP requires disclosures of the nature and amount of related party transactions in
the footnotes to the financial statements, under Financial Accounting Standard 57.
e. Additionally, to the extent that rather than directly swapping capacity with third
parties such as Qwest, KPNQwest “sold” capacity to Qwest so that Qwest could use
it for the purpose of such a swap, any claimed revenue from such a sale should have
been identified as a capital contribution. This is so because the “sale” did not result
in true arms’ length revenue derived from a business-motivated transaction, but
merely for the purpose of pumping up the revenues of KPNQwest and Qwest (when
Qwest “swapped” the capacity it had acquired from KPNQwest). Moreover, the
amount of revenues from any such “sale” of flipped assets should have been
separately disclosed and identified as derived from a swap transaction under the
foregoing principles, i.e., MD&A rules, related party disclosures, etc.
311. Moreover, the following additional GAAP standards were violated:
a. The concept that financial reporting should provide information about the economic
resources of an enterprise, the claims to those resources, and the effects of
transactions, events and circumstances that change resources and claims to those
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resources (Concepts Statement No. 1, ¶40);
b. The concept that financial reporting should provide information about how
management of an enterprise has discharged its stewardship responsibility to owners
(stockholders) for the use of enterprise resources entrusted to it. To the extent that
management offers securities of the enterprise to the public, it voluntarily accepts
wider responsibilities for accountability to prospective investors and to the public in
general (Concepts Statement No. 1, ¶50);
c. The concept that financial reporting should provide information about an enterprise’s
financial performance during a period. Investors and creditors often use information
about the past to help in assessing the prospects of an enterprise. Thus, although
investment and credit decisions reflect investors’ expectations about future enterprise
performance, those expectations are commonly based at least partly on evaluations
of past enterprise performance (Concepts Statement No. 1, ¶42);
d. The concept of completeness, which means that nothing is left out of the information
that may be necessary to ensure that it validly represents underlying events and
conditions (Concepts Statement No. 2, ¶79);
e. The concept that conservatism be used as a prudent reaction to uncertainty to try to
ensure that uncertainties and risks inherent in business situations are adequately
considered. The best way to avoid injury to investors is to try to ensure that what is
reported represents what it purports to represent (Concepts Statement No. 2, ¶¶95,
97).
C. Qwest’s Recent Accounting Restatement of its FY 2000 and 2001
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Financial Results Demonstrates That the KPNQwest Swap Transactions Involving Qwest Were False and Misleading When Reported
312. Qwest’s Form 10-K for the year ending December 31, 2002, filed with the SEC on
October 16, 2003, contained restated financial results for years 2000 and 2001, including
restatements based on swap transactions, which erased nearly $1 billion of previously-recorded
revenues.
313. Qwest admitted that numerous transactions were not properly reported because: (1)
revenues were recognized prematurely on IRU sales (rather than ratably over 20 years); and/or (2)
revenues were prematurely recorded because assets had not been transferred in the quarter in which
revenue was recorded (e.g., side agreements allowed the parties to specify the capacity to be
transferred at a later date); and/or (3) without prior segregation of assets/costs, non-monetary swaps
of capacity could not qualify as “sales” (i.e., capacity swaps amounted to an exchange of inventory
rather than an actual sale).
314. Note 3 to the financial statements contained in Qwest’s 2002 Form 10-K states, in
pertinent part, as follows:
Transfers of optical capacity for cash
In 2001 and 2000, we engaged in transactions where we transferredthe right to use our optical capacity assets, also referred to as IRUs,on our network primarily to other telecommunications servicesproviders. These IRU transactions involved specific channels in our“lit” network or specific strands of dark fiber. The terms of the IRUswere typically 20 years and reflected the estimated useful life of theoptical capacity.
In our previously issued consolidated financial statements werecognized a substantial portion of the total consideration receivedfor transfers of optical capacity for cash as revenue at the inceptionof the transaction. As part of our internal analysis of our accounting
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policies, practices and procedures in place in 2001 and 2000, wereviewed this previous accounting model for transfers of opticalcapacity for cash and concluded that we did not meet the criteria forup-front revenue recognition for sales-type leases under SFAS No. 13“Accounting for Leases” (“SFAS No. 13"). Revenues related to ourtransfers of optical capacity assets for cash should have beenrecognized ratably over the terms of the agreements. Accordingly,we have restated our previously issued consolidated financialstatements to defer the revenues on these transactions and recognizethem ratably over the terms of the respective IRU arrangements.
We also determined that in certain cases we had recognized revenuefrom optical capacity cash transfers in the wrong period based on ourprior accounting policies. These included instances in which theoptical capacity assets had not been transferred at the time of thepreviously reported recognition of revenue. The restatement nowreflects the recognition of the IRU fees beginning in the period of theIRU was delivered and when all other criteria for revenue recognitionhad been satisfied. Also, in certain of these transactions, once adetermination to restate was made for one reason, we did notcontinue to pursue whether there were other reasons for restatement.
In our restated consolidated financial statement we reduced ourpreviously reported revenue by $339 million and $150 million for theyears ended December 31, 2001 and 2000, respectively. Theseamounts reflect the reversal of sales-type lease revenue of $360million and $151 million, offset by the ratable recognition of revenueof $21 million and $1 million for the years ended December 31, 2001and 2000, respectively. We have also increased pre-tax loss by $163million and $106 million in the years 2001 and 2000, respectively,which reflects the adjustment to reduce revenue, partially offset byadjustments to decrease the related cost of sales.
Contemporaneous transfers of optical capacity
In 2001 and 2000, we also engaged in transactions with otherproviders of telecommunications services to exchange opticalcapacity assets. We refer to these transaction herein as“contemporaneous transactions.” In our previously issuedconsolidated financial statements, we recorded revenue of thesetransactions at the estimated fair value of the capacity transferred atthe inception of the transaction. Our previous accounting policy wasbased on the conclusion we were exchanging assets held for sale for
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assets to be held for use in the ordinary course of business, as allowedunder APB Opinion No. 29, “Accounting for NonmonetaryTransactions” (APB No. 29"), and related interpretive guidance.
We have since determined that the application of our prior policiesand practices did not support a position under APB No 29 because wedid not adequately identify the assets or segregate the costs ofcapacity held for sale in our records. As a result, we concluded thatwe could not establish that our contemporaneous transactions werethe culmination of an earning process and determined that theyshould be recorded as exchange of similar productive assets based onthe carrying value of the optical capacity assets that we provided inthe exchanges. Also, in certain of these transactions, once adetermination to restate was made for one reason, we did notcontinue to pursue whether there were other reasons for restatement.
In our restated consolidated financial statements we have decreasedour previously reported revenue by $649 million and $317 million forthe years ended December 31, 2001 and 2000, respectively, to reflectthe reversal of all revenue recognized on contemporaneous transfersof optical capacity assets. We have also increased our pre-tax lossesby $251 million and $169 million for the years ended December 31,2001 and 2000, respectively, which reflects the adjustment to reducerevenue, partially offset by adjustments to decrease the related costof sales.”
315. The restatement by Qwest of its swap transactions constitutes an admission that
Qwest’s financial reporting of those transactions, which applied the same principles as KPNQwest’s
reporting of those same transactions, was false and incorrect under GAAP at the time various
periodic filings containing such financial information were made with the SEC.
316. Pursuant to GAAP, as set forth in Accounting Principles Board Opinion ("APB") No.
20, the type of restatement announced by Qwest was to correct for material errors in its previously
issued financial statements. See APB No. 20, ¶¶7-13. The restatement of past financial statements
is a disfavored method of recognizing an accounting change as it dilutes confidence by investors in
the financial statements, it makes it difficult to compare financial statements, and it is often difficult,
24See Securities Act of 1933 Release No. 8295, Securities Exchange Act of 1934 Release No.48559, Accounting and Auditing Enforcement Release No. 1879, and Administrative ProceedingFile No. 3-11278, all dated September 29, 2003.
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if not impossible, to generate the numbers when restatement occurs. See APB No. 20, ¶14. GAAP
therefore provides that financial statements should only be restated in limited circumstances, i.e.,
when there is a change in the reporting entity, there is a change in accounting principles used, or to
correct an error in previously issued financial statements. Qwest’s restatement was not due to a
change in reporting entity or a change in accounting principle, but rather to errors in previously
issued financial statements. Thus, the restatement is an admission by Qwest that the principles used
to report its capacity swaps, and the application of those same principles with respect to the swaps
in which both Qwest and KPNQwest were involved (as alleged herein) were false when issued.
D. The SEC’s Recently-Instituted Proceedings Against A Former Qwest Employee Demonstrate That KPNQwest and Qwest Improperly Accounted For Their Swap Transactions
317. On September 29, 2003, the SEC instituted and settled a cease and desist proceeding
against a former Qwest employee, and a related action for civil penalties, based on Qwest’s improper
up-front recognition of revenues from capacity swaps – precisely the conduct alleged herein. These
proceedings are known as “In the Matter of Loren D. Pfau,” and the related civil case is known as
SEC v. Loren D. Pfau, Civil Action No. 03-D-1925 (MJW) (D.Colo.)24. The SEC’s announcement
of the Pfau case, Litigation Release No. 18374 (September 29, 2003), stated as follows:
In the [cease and desist] Order, In the Matter of Loren D. Pfau[33-8295], the Commission found that in the final days of eachquarter from December 2000 through June 2001, Qwest usedIndefeasible Right of Use ("IRU") agreements to sell fiber-optic cablefrom its telecommunications network as a means to meet aggressiverevenue targets. An IRU is an irrevocable right to use a specific
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amount of fiber for a specified time period. Qwest accounted forIRUs as sales-type leases and recognized nearly the entire amount ofthe IRU revenue "up-front" at the time of contract execution, ratherthan over the life of the IRU agreement. Qwest employees andmanagement commonly referred to IRU sales as "gap fillers," in otherwords, a means to make up the shortfall between the aggressiverevenue projections as publicly announced by Qwest and the actualrevenue earned.
Specifically, the Commission found that in three IRU transactionsexecuted between December 2000 and June 2001, Pfau, then a Qwestsales manager, along with Qwest senior management, provided secretside agreements allowing the purchasers of fiber-optic cable toexchange (or "port") the fiber purchased for different fiber at a laterdate. The explicit purpose of making the side agreements secret wasto conceal from Qwest's accountants and outside auditors thepurchasers' ability to port, since such exchange rights would havedefeated, under generally accepted accounting principles, the up-frontrevenue recognition sought by Qwest. According to the Commission'sfindings, Qwest improperly recognized from the three IRUtransactions $26.6 million of revenue in the first and second quartersof 2001. As a result, Qwest's quarterly reports for the first and secondquarters of 2001, and its annual report for 2001, contained materiallyfalse information.
318. The SEC’s Pfau case confirms the underlying accounting violations upon which this
case is based. KPNQwest, as a company related to Qwest, both of which employed Arthur Andersen
as auditor, followed the same accounting principles for capacity sales which the SEC found to be
improper.
DEFENDANTS’ FALSE AND MISLEADING STATEMENTS AND OMISSIONS DURING THE CLASS PERIOD
A. Material Misrepresentations/Omissions in the Offering Documents
319. The KPNQwest Prospectus was signed by KPNQwest’s CEO McMaster, Controller
Keating and CFO Ackermans. Additionally, Defendants Nacchio, Woodruff and Tempest executed
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the IPO Registration Statement and Prospectus both in their capacity as KPNQwest Supervisory
Board members and as senior executive officers of Qwest; Defendants Dreschel, Pieters and Blok
executed the Prospectus both in their capacity as KPNQwest Supervisory Board members and as
senior executive officers of KPN or its subsidiaries.
320. The KPNQwest IPO Registration Statement and Prospectus made representations
about dark fiber sales and revenue recognition for such sales, and also disclosed that the Company
would be selling a new service known as “wavelengths” or “colors:”
“Dark Fiber Sales. We expect to lower the building costs of ournetwork by selling dark fiber along portions of our network. ‘Darkfiber’ refers to fiber optic cable that is not connected to transmissionelectronics....To date, we have entered into one agreement for the saleof two fibers on EuroRings 1 and 2. We believe that additionalopportunities may exist to sell dark fiber on our network.”
“Products and Services Wholesale Services. Our managed broadbandservice provides managed, city-to-city bandwidth capacities....Wehave also introduced a new class of wholesale services known as‘colors’ or ‘wavelengths’ which provide 2.5 Gbps or 10 Gpbwavelengths to customers. This service is designed for customerswho require very large transport capacities between cities, but whodo not wish to purchase dark fiber and invest in the transmissionelectronics necessary to enable the fiber to carry traffic.”
“New Accounting Pronouncements....In June 1999, the FinancialAccounting Standards Board issued FASB Interpretation No. 43,‘Real Estate Sales, an interpretation of FASB Statement No. 66.’ Theinterpretation is effective for sales of real estate with propertyimprovements or integral equipment entered into after June 30, 1999.Under this interpretation, title must transfer on propertyimprovements and integral equipment for a lease transaction to beconsidered a sales-type lease. Under this interpretation, we haveconcluded that the conduit and possibly the fiber included in ourfuture dark fiber sales are integral equipment....Under the priorpolicy, we classified our sole dark fiber transaction as a sales-typelease and accordingly, the transfer price will be recognized asrevenue as the segments of our network specified by the contract are
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delivered and accepted by the purchaser. Had this transaction beenentered into subsequent to the effective date of the interpretation, thetransfer price would be recognized as revenue ratably over the termof the contract....All future sales of dark fiber will be evaluated underthe new interpretation....If we do not pass title on the integralequipment pursuant to the agreements related to future transactionsinvolving dark fiber sales or if such transactions otherwise do notmeet the criteria in FASB Statement No. 66, we will recognize thetransfer prices as revenue ratably over the terms of the applicableagreements, rather than when the applicable segments of our networkare delivered to, and accepted by, the purchaser. Although theapplication of the new interpretation will affect the times ofrecognition of our revenue from dark fiber sales, we expect there willbe no effect on our financial position or cash flows from thisprospective change in accounting.”
321. The Company’s IPO Prospectus failed to include the following information essential
to make the foregoing misrepresentations not misleading:
a. First, the investing public was misled by the Defendants’ failure to disclose that the
new “colors” and “wavelengths” products were created to circumvent FIN 43. Dark
fiber is interchangeable with lit fiber, in that any fiber must be “lit” in order to be
used. Categorizing the entire new wavelengths and colors product as “lit fiber”
rather than charging for the lighting of the pre-existing dark fiber product would,
however, give the Company a means of artificially and deceptively circumventing
the proper application of FIN 43, by disclosing its application to so-called “dark
fiber” while being silent in the IPO Prospectus about the fact that the Company was
not applying this accounting principle to lit fiber. The new “lit fiber” products
(“colors” and “wavelengths”) were created at the time of the IPO to accomplish this
accounting manipulation.
b. Second, the investing public was misled by the failure to disclose that the lit fiber
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products (managed bandwidth capacities, colors and wavelengths) were 20-year
IRUs, sales of which were going to be taken into revenues up front, not over the
terms of the IRUs. Contrary to this plan, GAAP required such revenues to be
recognized ratably either because these lit fiber products were really services, or
because they were at most operating leases rather than sales leases.
c. Third, rather than merely failing to disclose the true nature of the new products,
investors were affirmatively misled to believe the new “colors” and “wavelength”
products, as well as the production of so-called “managed bandwidth,” were services
which would generate recurring revenue, and that such revenue would be recognized
ratably over time.
d. The IPO Prospectus misleadingly called the new “colors” and “wavelengths”
products, as well as so-called “managed bandwidth,” “services” which appeared to
be ongoing. Instead of honestly calling these products “capacity” products, the IPO
Prospectus belied their nature as capacity products by distinguishing them from sale
of “city-to-city bandwidth capacities.” Also, falsely calling these new products
“services” meant that the investing public would believe the related revenues were
recognized ratably over time, pursuant to the GAAP rules applicable to services.
e. The IPO Prospectus, and future financial statements, created two categories of
revenues, “communications services and products” and “ infrastructure revenues.”
Whereas KPNQwest was in business to sell telecommunications services to end-user
customers, not to lease unused pieces of its network, the proper categorization of
revenues would have separated true communications services revenues, on the one
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hand, from all network capacity sales, be they of dark or lit fiber. By artificially and
deceptively combining recurring telecommunications services revenues with one-
time lit fiber capacity sales, Defendants could – and did – materially mislead
investors that its recurring business to end-user customers was growing, i.e., the
business was sustainable. This was not the case, despite having one of the largest
customer bases in all of Europe, KPNQwest was forced to shut down when its
parents refused to prop up its revenues with unneeded capacity purchases.
322. Scienter for these material misstatements and omissions is demonstrated by
Defendants’ explicit recognition in the IPO Prospectus that FASB Interpretation No. 43, which
required application of real estate principles to certain leases, did apply to telecommunications
capacity transactions. Defendants therefore knew that GAAP required that right, title and interest
of telecommunications capacity had to be transferred for the transaction to be considered a sales
lease rather than an operating lease. Scienter is further demonstrated by the fact that the new
“colors” and “wavelengths” lit capacity products were created at the very time that the Company
first applied FIN 43 to telecommunications capacity transactions, and that the disclosures in the IPO
Prospectus concerning FIN 43 mentioned its applicability to dark fiber transactions but was silent
on its applicability to lit fiber transactions. This pattern of disclosures created the false impression
that the Company was applying FIN 43 properly by accruing revenue ratably over time, whereas the
Company recognized revenues up-front for lit fiber sales. Scienter is further shown by the fact that
the KPNQwest capacity sales to related party Infonet, as alleged herein, occurred soon after the
KPNQwest IPO. Since Infonet was a related party because of KPN’s substantial stock ownership
thereof, it is reasonable to infer that Defendants knew of the upcoming sales to Infonet at the time
25Because KPNQwest was formed in April 1999, the press release covers the nine-monthperiod between April 1, 1999 and December 31, 1999.
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of the IPO and were concerned about how to book those capacity sales when they made the
misleading IPO disclosures. In view of the fact that the upcoming sales to Infonet were of lit fiber,
and there was at least one lit fiber sale preceding the IPO, it was at least reckless for Defendants to
fail to make appropriate disclosures in the IPO Prospectus about the revenue recognition policies
and applicability of FIN 43 with respect to lit fiber transactions. Scienter for these material
misstatements and omissions is demonstrated by Defendants’ explicit recognition of FASB
Interpretation No. 43, the new GAAP rule which expressly required that revenues from a sale of
dark fiber be accrued ratably over the term of the contract. Even though under either type of
transaction, right, title and interest to that portion of KPNQwest’s network covered by the agreement
did not pass to the buyer – the prerequisite for immediate accrual as an asset sale or a sales-type
lease – because the sales were, technically, not of “dark fiber,” KPNQwest recklessly excluded sales
of “color,” “wavelengths,” lit fiber and capacity from the application of FASB Interpretation No.
43.
B. Post-IPO Class Period Material Misrepresentations/Omissions
323. On February 1, 2000, Defendants disseminated a press release announcing
KPNQwest’s 1999 financial results.25 The press release quotes Defendant Ackermans and states in
pertinent part:
KPNQwest N.V. 1999 Revenues More Than Double; April-December 1999Revenues Reach 190.2 Million Euros
- Total Revenues Grow 120%* to 190.2 Million Euros***
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- Exceeded Consensus Financial Estimates***
REVENUESFor the nine-month period ended 31 December 1999, total revenue grew to 190.2Meuros, increasing by 120%, or 103.7 million euros, compared to the pro formanine-month period ended 31 December 1998.
Communication services revenues grew to 177.5 million euros in 1999, an increaseof 105% or 91.0 million euros, over pro forma 1998. The company experienceddramatic growth across its product lines, with Internet Protocol-based Value AddedServices (IP-VAS) and other new data services growing more than 90% and thedemand for IP connectivity and other bandwidth services growing more than 100%.
KPNQwest concluded many major contracts in 1999 for IP, bandwidth and otherdata services, including the announced contracts with Dante, Baan, Europe OnlineNetworks, Amsterdam Exchanges and CERN. It ended the year with over 75,000business Internet accounts, improving the company's mix of business accounts to75% and greatly increasing its average revenue per account.
Infrastructure revenues realised in 1999, driven by the sale of dark fibre and otherinfrastructure assets, were 12.7 million euros, with no corresponding revenues in proforma 1998. Three infrastructure contracts were closed in 1999 amounting toapproximately 50 million euros, with approximately 75% of the contract revenuesto be recognised after 1999.
***
EARNINGS1999 EBITDA earnings before interest, taxes, depreciation and amortisation(EBITDA) was negative 46.3 million euros.
***Net loss for 1999 was 59.9 million euros, which compares to 48.0 million euros netloss for pro forma 1998.
Loss per Share for 1999 was 0.15 euros as compared to 0.12 euros for 1998.
FINANCIAL ESTIMATESThe 1999 results exceeded all analysts' estimates for Revenue, EBITDA and EPS thatwere published in Europe by Morgan Stanley Dean Witter, Salomon SmithBarneyInternational, Goldman Sachs International, ABN AMRO Rothschild and WarburgDillon Read, who together formed the underwriting syndicate for KPNQwest's InitialPublic Offering on 9 November 1999.
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***
324. On February 2, 2000, Defendants filed a Form 6-K with the SEC attaching the press
release issued on February 1, 2000, as alleged above, and KPNQwest’s financial statements for
1999. The 6-K was signed by defendant McMaster.
325. Defendants knew or recklessly disregarded that the financial reporting in the February
1, 2000 press release and Form 6-K was materially false and misleading because it failed to disclose
that:
a. As described in ¶¶ 13-27 and ¶¶ 69-214, revenue from hollow swaps, for which
KPNQwest had no business purpose except to inflate revenues, were improperly
accorded revenue recognition;
b. As described in ¶¶ 321-322, by including capacity/“lit” fiber swap revenues in the
“communications services” revenues category rather than in “infrastructure”
revenues, investors were materially misled as to the overall percentage of revenues
that were attributable to actual sales of telecommunications services to customers.
The misleading nature of this presentation was exacerbated by the fact many of the
swaps were hollow swaps;
c. As described in ¶¶215-233, KPNQwest “sold” capacity to its main shareholders –
KPN and Qwest – to artificially boost KPNQwest’s revenue;
d. As described in ¶¶270-308, in violation of both GAAP and standard industry
practice, regardless of whether the transaction had a business purpose, Defendants
improperly accrued the full contract value of capacity/“lit” fiber deals, rather than
recognizing the revenues ratably over the term of the contract;
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e. No revenue should have been recorded for the swap transactions because they did
not represent the culmination of the earnings process, since they constituted mere
exchanges of inventory as explained in ¶279-281;
f. It was improper to record revenue from the KPNQwest swap transactions because
they included side agreements and verbal understandings which allowed subsequent
“puts” of the capacity obtained from KPNQwest in the swaps, so that the swaps did
not represent the culmination of the earnings process, as alleged in ¶¶100-102,
¶¶108-116, and ¶¶300-305.
As a result, KPNQwest’s loss and loss-per-share results were based on inflated and false revenue
figures.
326. Defendants’ statements in the February 1, 2000 press release and February 2, 2000
Form 6-K were made with scienter for the reasons set forth in ¶322, above, and ¶¶442-450 and
¶¶469-487 below.
327. On April 25, 2000, Defendants announced KPNQwest’s first quarter 2000 results in
a publicly disseminated press release. The press release states in pertinent part:
KPNQWEST 1ST-QUARTER NET LOSS WIDENS TO EU27.7 MILLIONKPNQwest N.V. Revenues More Than Double to 78.7 million in First Quarter2000- Total revenues Grow 114% to 78.7 million- Communications services revenue grows 105%* to 75.6 million- IP- value added services & new data service revenue Grows by more than 400%*- IP and Other Bandwidth Revenue Grows 90%*- Exceeded Consensus of Analysts' Estimates
***Willem Ackermans, KPNQwest Executive Vice President and Chief FinancialOfficer said: "We had a strong quarter. We met or exceeded the analysts'consensus estimates. We are on target and on budget with our construction
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commitment and capital expenditures, including making excellent strides inrecovering our construction costs with infrastructure sales. In addition, we aremaking progress on migrating our traffic to our own network and continue to investin our sales and marketing channels. "
REVENUESFor the first quarter ended 31 March 2000, total revenue grew to 78.7 million,increasing by 114%, or 41.9 million, compared to the pro forma three-monthperiod ended 31 March 1999.
Communication services revenues grew to 75.6 million in the first quarter of 2000,an increase of 105% or 38.8 million, over pro forma first quarter 1999. The companyexperienced dramatic growth across its product lines.
The Internet Protocol-based Value Added Services (IP-VAS) and other new dataservices grew more than 400% and the demand for IP connectivity and otherbandwidth services grew by 90%.
KPNQwest concluded many major contracts in the first quarter of 2000 for IP,bandwidth and other data services, including major contracts with CERN, Infonetand Telia. It ended the quarter with over 80,000 business Internet accounts, a 33%increase over pro forma first quarter 1999, and increased its average revenue peraccount.
Infrastructure revenues driven by the sale of dark fibre, were 3.1 million in firstquarter 2000, with no corresponding revenues in pro forma first quarter 1999. Therevenue recognised in the first quarter 2000 relates to contacts that were closed in1999.
***EARNINGS First quarter 2000 EBITDA was negative 31.9 million. It compares to a negative 2.1million in pro forma first quarter 1999, when the company was not engaged ininvesting in its SG&A for revenue growth.
Net loss for first quarter 2000 was 27.7 million, which compares to 9.1 millionnet loss for pro forma first quarter 1999.
Loss per share for first quarter 2000 was 0.06 as compared to 0.02 for pro formafirst quarter 1999.
328. Defendants knew or recklessly disregarded that the financial reporting contained in
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the April 25, 2000 press release was false and misleading for the reasons set forth in ¶325(a)-(f),
above. Additional false and/or misleading statements include:
a. Ackermans’ statement that KPNQwest “met or exceeded the analysts’ consensus
estimates.” The Company’s actual financial results – without the inclusion of
improperly accrued revenues – did not meet or exceed analysts’ expectations. As
KPNQwest’s CFO, Ackermans knew of or recklessly disregarded the falsity of this
statement;
b. Ackermans’ statement: “We are on target and on budget with our construction
commitment and capital expenditures, including making excellent strides in
recovering our construction costs with infrastructure sales.” As set forth in ¶¶136-
141, because the swap with 360networks had no business purpose and was a non-
cash exchange, KPNQwest would not receive €160 million towards the recovery of
network construction costs. As KPNQwest’s CFO, Ackermans knew of or recklessly
disregarded the falsity of this statement;
c. The financials improperly included up-front revenues from sales of lit capacity from
the related party, Infonet. On January 1, 2000, shortly after the Company’s IPO,
KPNQwest engineered an artificial boost in revenue of approximately €17 million
through a transaction involving AUCS and Infonet, parties related to KPNQwest
through KPN. On September 30, 1999, Infonet had entered into agreements to
purchase AUCS. On January 1, 2000, Infonet purchased circuits on the AUCS
network from KPNQwest which had previously been leased by AUCS. This revenue
should have been included in KPNQwest’s income statement only ratably over the
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course of the 20-year IRUs. Evidence of this transaction includes:
i. An Infonet memo dated June 15, 2001 entitled “June Circuit Report”
distributed to many persons at Infonet including Akbar Firdosy, the
company’s CFO, listed the following circuits purchased from KPNQwest as
of 1/1/00: (1) European Ring Amsterdam-Frankfurt-Massy (Paris)-Nanterre
(Paris) NP2000 99-0085, (2) Amsterdam-Frankfurt NP 7025 98-3168, (3)
Amsterdam-Frankfurt NP 7026 98-3073, (4) Amsterdam-London NP 7022
98-3072, (5) Amsterdam-New York NP 7001 98-3344, (6) Amsterdam-
Stockholm NP 7004 98-3104, (7) Frankfurt-Gothenburg NP 70000 98-3364,
(8) Frankfurt-New York NP 7001 99-0076, (9) European Ring London-
Zurich-Frankfurt NP 2001 99-0084, (10) Rotterdam, Stockholm 98-3359.
ii. According to the same aforementioned memo, these circuits were capitalized,
respectively, at the following cost, payable in the following monthly
amounts: 950,000 Euros (8,247e/mo), 450,000 Euros (4,108e/mo), 1,425,000
Euros (7,094e/mo), 522,500 Euros (3,677e/mo), 3,000,000 Euros
(18,518e/mo), 950,000 Euros (4,806e/mo), 2,090,000 Euros (10,425e/mo),
3,500,000 Euros (19,716e/mo), 2,565,000 Euros (14,416), and 1,850,000
Euros (9,266e/mo). This circuit “sale” right after the offering is part of
KPNQwest’s plan to sell lit circuits rather than dark circuits to artificially
generate revenues.
iii. Since these were purchased as lit fiber by Infonet (as explained by an Infonet
witness who was a former manager for circuits acquisition, and logically
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speaking since the circuits had previously been in use as lit leased circuits on
the AUCS network), the purchase price of these circuits represents revenue
improperly accrued to KPNQwest up front, rather than ratably over time.
329. Additional scienter for these misstatements is set forth in ¶322, above, and ¶¶499-504
below.
330. On July 18, 2000, Defendants continued to mislead investors, in a press release
announcing KPNQwest’s second quarter 2000 results:
KPNQwest N.V. Revenues Increase 137% to 105.7 Million Euros In Second Quarter2000
- Total revenues grows 137% to 105.7 million euros
***- Met or exceeded all components of analysts' consensus
***
KPNQwest, the leading pan-European Internet and data communications company,today reported strong revenue growth for the quarter ended June 30, 2000.Revenues for this quarter increased by more than 137% compared to second quarter1999 and by more than 34% compared to first quarter 2000. The company's resultsmet or exceeded the consensus of analysts' estimates for revenue, earnings beforeinterest, taxes, depreciation and amortization (EBITDA) and EPS for the thirdconsecutive period.
Willem Ackermans, KPNQwest Executive Vice President and Chief FinancialOfficer said: "We met or exceeded the analysts' consensus estimates for the thirdconsecutive period. This quarter is an important milestone for us, surpassing the100 million euros revenue mark for the first time.
***REVENUES For the second quarter ended June 30, 2000, total revenue grew to 105.7 millioneuros, increasing by 137%, or 61.2 million euros, compared to 44.5 million eurosrevenue in the second quarter ended June 30, 1999.
Communication services revenues grew to 95.0 million euros in the second quarterof 2000, an increase of 113% or 50.5 million euros compared to 44.5 million eurosrevenue in the second quarter 1999. The company continues to experience dramatic
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growth across its product lines.
Revenues driven by Internet Protocol-based Value Added Services (IP-VAS) andother new data services grew in excess of 400% compared to second quarter 1999and revenues from IP connectivity and other bandwidth services grew by more than90%.
KPNQwest concluded many major contracts in the second quarter of 2000 for IP,bandwidth and other data services, including major contracts with Microsoft Corp,Nokia, Lufthansa, BASF, BMW, Hoechst, Stonehenge, ETT, Teleglobe and RapidLink. It ended the quarter with over 90,000 business Internet accounts, a 50%increase over second quarter 1999, and increased its average revenue per account.
Infrastructure revenues driven by the sales of conduit and dark fibre were 10.7million euros in second quarter 2000, with no corresponding revenues in secondquarter 1999.
***
EARNINGS Second quarter 2000 EBITDA was negative 26.6 million euros. It compares to anegative 12.4 million euros in the second quarter 1999, when the company was notengaged in investing in its SG&A for revenue growth. EBITDA has improved by5.2 million euros from the first quarter 2000.
Net loss for second quarter 2000 was 30.2 million euros, which compares to 15.7million euros net loss for second quarter 1999.
Loss per share for second quarter 2000 was 0.07 euros as compared to 0.04 euros forsecond quarter 1999.
***331. Defendants knew or recklessly disregarded that the financial reporting contained in
the July 18, 2000 press release was false and misleading for the reasons set forth in ¶325(a)-(f).
Additional false and/or misleading statements include:
a. Ackermans’ statement that KPNQwest “met or exceeded the analysts’ consensus
estimates for the third consecutive period.” The Company’s actual financial results
– without the inclusion of improperly accrued revenues – did not meet or exceed
analysts’ expectations. As KPNQwest’s CFO, Ackermans knew of or recklessly
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disregarded the falsity of this statement;
b. Ackermans’ statement: “This quarter is an important milestone for us, surpassing the
100 million euros revenue mark for the first time.” This statement is false because
KPNQwest improperly booked hollow capacity swaps which lacked a business
purpose and/or improperly accrued full contract value on contracts which should
have been accrued ratably over the term of the agreement. As KPNQwest’s CFO,
Ackermans knew of or recklessly disregarded the falsity of this statement.
332. Additional scienter for these misstatements is set forth in ¶322, above, and ¶¶499-504
below.
333. On October 24, 2000 Defendants disseminated a press release announcing the
Company’s third quarter 2000 financial results. The press release states in pertinent part:
KPNQwest N.V. Reports Record Third Quarter Revenue Growth
Record Revenue Driven by Strong Growth in Hosting, IP-Value AddedServices and New Data Services
-- Total revenue grew 105% year-on-year to Euro 132.7 million -- Communication service revenue grew 83% year-on-year Euro 118.8 million
KPNQwest, the leading pan-European Internet and data communications company,today reported third quarter revenue of Euro 132.7 million, representing an increaseof 104.8% over third quarter 1999. ... For the fourth consecutive quarter, thecompany's results met or exceeded the consensus of analysts' estimates for revenue,earnings before interest, taxes, depreciation and amortisation ("EBITDA") andearnings per share ("EPS").
***As a result, KPNQwest is forecasting that the company will achieve EBITDAbreakeven in the fourth quarter of 2001, a milestone achieved a full year earlier thancurrent estimates.
***
REVENUES The company reported revenue for the quarter ended September 30, 2000 of Euro
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132.7 million, representing an increase of approximately 104.8%, compared to totalrevenue of Euro 64.8 million for the same period in 1999 and an increase ofapproximately 25.5% compared to total revenue of Euro 105.7 million for the secondquarter 2000.
Communication services revenue reached a new milestone in the third quarter byexceeding the Euro 100.0 million level, largely fueled by a doubling of IP ValueAdded Services ("IP-VAS") and new data services. Communication services revenueof Euro 118.8 million represents an increase of 83.3% from the Euro 64.8 million ofrevenue for the same period of 1999 and an increase of approximately 25.1%compared to communication services revenue of Euro 95 million for the secondquarter 2000.
***Infrastructure revenue, comprised of conduit and dark fibre sales, for the thirdquarter of 2000 was Euro 13.9 million for the quarter, with no correspondinginfrastructure revenue for the quarter ended September 30, 1999 and second quarterinfrastructure revenues of Euro 10.7 million.
***EARNINGS EBITDA for the three months ended September 30, 2000 was Euro (31.2) million.For the same period of 1999 and the second quarter of 2000 the company reportedEBITDA of Euro (5.4) million and Euro (26.6) million, respectively. EBITDAmargins improved from (25.2)% in the second quarter of 2000 to (23.5)% for thethree months ended September 30, 2000.
***The net loss for the third quarter was Euro (23.9) million, or Euro (0.05) per share,an improvement of Euro 6.3 million or Euro 0.02 per share from second quarter2000. The company incurred a net loss of Euro (14.8) million, or Euro (0.04) lossper share, for the third quarter of 1999.
***
334. On October 24, 2000, defendants McMaster and Ackermans held a conference call
with analysts and investors to discuss the Company’s results for Q3 2000. McMaster reported that
in the third quarter of 2000, KPNQwest had revenues of 118.8 million Euros, reflecting 25%
sequential growth over 2d quarter of this year.
335. Defendant Ackermans stated: “Since going public in November 1999, we have met
or exceeded the consensus of analysts for every quarter, this quarter included. For the third quarter
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our total revenue was 132.7 mil…a 26% sequential growth rate from the 2d quarter of 2000. The
third quarter of 2000 proved to be a new milestone for communications services revenue which
exceeded the hundred million mark for the first time. Specifically, communications services revenue
grew to 180.8 million…..sequential growth rate of 25%.”
336. Ackermans continued as follows: “In the course of the third quarter we also continued
our progress in the recovery of network buildout costs through infrastructure sales which include
the sale of dark fiber. For the third quarter of 2000 infrastructure sales totaled 30.9 million with no
corresponding revenues in 1999. To date the company has recovered approximately 55% of the
network construction costs through the sale of only 10% of our network, exceeding expectations set
out in the original business plan. These revenues are related primarily to two dark fiber sales and a
duct sale in the third quarter. Additionally, the company signed a contract for a dark fiber sale with
Fibernet. in the quarter with an estimated value of over 100 million Euros..To reiterate, we are ahead
of our strategy to recover 67% of our construction costs by selling up to 50% of our network. This
will place us in a very competitive low unit cost position as well as provide cash inflow for the next
couple of years.…”
337. Ackermans noted that “although we don’t give a detailed breakdown of our
communications services for competitive reasons, I would like to give you an idea of the services
that are fueling our strong rapid growth,” attributing growth to “IP connectivity and bandwidth
services” provided to “an increase in the number of business customers which constitute over 75%
of our total customer base as of 9-30-2000 and continued demand for high-speed data capacity in
Europe,” thereby masking the extent to which revenues were artificially boosted by swap and IRU
sales to KPN, Qwest and a handful of large international carriers.
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338. Defendants knew or recklessly disregarded that the financial reporting contained in
the October 24, 2000, press release and the conference call of the same day was false and misleading
for the reasons set forth in ¶325 (a)-(f). In particular, as explained in ¶¶95-98 above, a $54 million
capacity swap with Global Crossing was improperly accrued even though, inter alia, there was no
legitimate business purpose for the transaction. Additionally, there was a hollow swap deal, as
described in ¶144 above.
339. Scienter for these misstatements is set forth in ¶322, above, and ¶¶443-450 and
¶¶499-504 below.
340. In an interview with The Wall Street Transcript published on January 22, 2001, the
following colloquy occurred:
TWST: Of the EUR 132.7 million [in Q3 2000 revenues], about 66% of that is madeup of communications services revenue.
McMaster: No, it’s much more than that, EUR 118.8 of the EUR 132.7 iscommunications services. Only EUR 13.9 million is what we refer to asinfrastructure, either dark fibre or conduit sales.
341. For the reasons stated in ¶¶321-322 and ¶¶338-339, above, McMaster misled
investors to believe that the vast majority of KPNQwest’s revenues came from the sale of recurring
communications services to end-users rather than one-time dark or lit fiber sales.
342. On January 24, 2001, Defendants announced KPNQwest’s fourth quarter and full-
year 2000 financial results in the following press release:
KPNQwest N.V. 2000 Revenues More Than Double from 1999
-- Full year 2000 revenue of 461.6 million euro -- more than double 1999 results -- Fourth quarter 2000 revenue of 144.5 million euro -- up by 78.4% on Q4 1999
KPNQwest, the leading pan-European data communications company, todayreported record fourth quarter revenues of 144.5 million euro, representing an
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increase of 78.4% over the same period in 1999. For the sixth consecutive quarter,the company's results met or exceeded the consensus of analysts' estimates forrevenue, earnings before interest, taxes, depreciation and amortisation (EBITDA)and earnings per share (EPS).
For the twelve months ended December 31, 2000, the company reported revenuesof 461.6 million euro, which represents a growth rate of 103.3% over the proforma(1) total revenue of 227.1 million euro for 1999, its first year of operation. ....
*** REVENUES
For the quarter ended December 31, 2000 KPNQwest reported total revenue of 144.5million euro, representing an increase of approximately 78.4%, compared to totalrevenue of 81.0 million euro for the same period in 1999.
The company reported total revenue for the twelve-month period ended December31, 2000 of 461.6 million euro, or 103.3% growth compared to the 227.1 millioneuro for the pro forma twelve months ended December 31, 1999.
"KPNQwest continues its strong financial performance in all of Europe's datagrowth markets," said Willem Ackermans, Executive Vice President and ChiefFinancial Officer continued. "We have managed the balance of growing highermargin value added services, while continuing to roll out Europe's largest fibre-opticsource network. Furthermore, our recent successful high yield bond offering of 500million euro will give us the additional flexibility to continue the growth trajectorywe demonstrated in 2000 towards EDITDA breakeven by the end of 2001."
Communication services revenue of 134.6 million euro for the quarter representsgrowth of 97.4%, compared to the 68.2 million euro reported for the fourth quarterof 1999. This growth was driven by demand in hosting and new data servicesrevenue. Sequentially, communication services revenue increased 13.3% comparedto the 118.8 million euro reported for the third quarter of 2000.
For the full year ended December 31, 2000 the company reported communicationservices revenue of 423.9 million euro, a 97.8% improvement over the 214.3 millioneuro for the pro forma year ended December 31, 1999.
***
Infrastructure revenue for the quarter totaled 9.9 million euro and was comprised ofconduit sales, compared to 12.8 million euro of infrastructure sales for the sameperiod in 1999.
***EBITDA Reported EBITDA for the quarter was (32.9) million euro or (22.8)% of revenues
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compared to (28.5) million euro, or (35.2)% of revenues in the fourth quarter 1999,and (31.2) million euro, or (23.5)% for the third quarter of 2000. For the full yearthe company reported EBITDA of (122.5) million euro, or a (26.5) %margin,compared to (48.3) million euro, or a (21.3)% margin for the pro forma year endedDecember 31, 1999.
***EARNINGS The net loss for the fourth quarter was (56.8) million euro, or (0.13) euro per share,compared to a net loss of (29.5) million euro, or (0.07) euro loss per share, for thefourth quarter of 1999 and (23.9) million euro, or (0.05) euro loss per share for thethird quarter of 2000. The third quarter 2000 net loss included a non-recurringforeign currency gain of approximately 16.0 million euro. For the full year of 2000the company reported a net loss of (138.6) million euro, or (0.31) euro loss per share,compared to a (69.0) million euro, or (0.17) euro, loss per share for the pro formatwelve months ended December 31, 1999.
343. On January 24, 2001 defendants McMaster and Ackermans held a conference call
with analysts and investors to discuss the Company’s results for Q4 2000 and the entire year 2000.
McMaster stated:
“I’m delighted to share with you the fourth quarter and year 2000 results ofKPNQwest today. We’re very excited about the year that just passed. We believethat KPNQwest is delivering on its promises made in the marketplace. Our revenuesfor the quarter were 144.5, comfortably ahead of the consensus 16 analyst view ofabout 143 and our EBITDA was essentially 32.9, again well ahead of the consensus16 analyst view of about 35.7....We think that all told, it was a very strong quarter,it was our sixth consecutive quarter of double digit revenue growth at an exceptionalyear where we ended up at 461 million EU for the year. As you all know, this is wellin advance of the expectation that people had for KPNQwest at the start of our IPO,and we continue to deliver ahead of expectation. Our year over year revenuesdoubled again in the year 2000 versus 1999, and we had continued growth andimprovement in margin in both the gross margin and at our EBITDA margin.”
344. In that same January 24, 2001 conference call Ackermans stated:
“In addition to Jack’s overview of the quarter and the year, I would like to follow upwith some details regarding the strong quarter and the first full year of operationwe’ve just completed. Specifically, I would like to review the results for revenue,operating costs, gross margin, EBITDA margin for the quarter and year end. Andin addition, I will provide a quick update on capital expenditures over the last year.I’d like to being with revenue. For the fourth quarter, our total revenue was $144.5million EU, an increase of 78% over 1999. In addition, we experienced a 9%
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sequential growth rate. Communication services revenue for the quarter was $134.6million, nearly double the $68.2 million reported for the fourth quarter of 1999 anddouble digit sequential growth.”
345. Ackermans noted that “As you are aware that we don’t provide a break down of our
communication services revenue, I would like to provide some detail into the services that continue
to drive our strong revenue growth.” He then proceeded to emphasize growth in cyber-center and
hosting services, IP VPN (virtual private network) and the global accounts business “primarily
attributable” to the claimed growth in business customers constituting 80% of the claimed 100,000
customer base. Ackermans thereby masked that the dominant factor in communications services
revenues was hollow swaps and IRU sales transacted with only a handful of international carriers.
346. Defendants knew or recklessly disregarded that the financial reporting contained in
the January 24, 2001 press release and in the statements made in the conference call of that same day
were false and misleading for the reasons set forth in ¶¶325(a)-(f), above. In Q1 2000, the Company
engaged in a hollow swap transaction with 360networks, as described in ¶¶136-141, above.
Moreover, as set forth in ¶144, above, Defendants improperly recorded $12 million in revenue from
a capacity “sale” to parent Qwest. Additionally, as explained in ¶¶95-98, above, KPNQwest’s FY
2000 revenue figures included a $54 million capacity swap in the third quarter with Global Crossing,
which was improperly recognized even though, inter alia, there was no legitimate business purpose
for the transaction.
347. Scienter for these misstatements is set forth in ¶322, above, and ¶¶499-504 below.
348. On April 23, 2001, KPNQwest announced its first quarter 2001 results in the
following press release:
KPNQWEST N.V. DOUBLES REVENUES IN FIRST QUARTER 2001
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• Total revenue of €162.7 million, grows 106.7% over Q1 2000
KPNQwest, the leading pan-European data communications company, todayreported strong growth in first quarter 2001 revenues. For the first quarter of2001, the company reported total revenue of €162.7 million
***For the seventh consecutive quarter, the company’s results met or exceededthe consensus of analysts’ estimates for revenue, earnings before interest,taxes, depreciation and amortisation (“EBITDA”) and earnings per share(“EPS”).
***REVENUESDuring the first quarter of 2001, KPNQwest reported total revenue of €162.7million, an increase of approximately 106.7%, compared to total revenue of€78.7 million for the first quarter of 2000. In addition, total revenue grewsequentially by 12.6% from €144.5 million for the fourth quarter of 2000.
“Financial discipline and focused execution have allowed KPNQwest tocontinue strong revenue development in the high-growth European datacommunications market.” said Willem Ackermans, Executive Vice Presidentand Chief Financial Officer. “This discipline and focus have led us to a pointwhere for the first quarter in KPNQwest history we have achieved grossmargins of 40%. Our discipline also resulted in SG&A costs achieving realquarter-on-quarter reductions and improving by 130 basis points to 52.9% ofrevenue. These financial improvements were achieved without impactingrevenue growth and are sustainable. This financial performance led to asignificant improvement in EBITDA, both in margin and in absolute terms.
Communication Services RevenueCommunication services revenue increased 105.0% from €75.6 million for thequarter ended 31 March 2000, and 15.2% sequentially to €155.0 million. Thisgrowth was largely attributable to increased market penetration and first-mover advantage in the hosting and IP value added services (IP VAS)products. The largest growth for IP VAS was driven by strong demand andincreased provisioning of hosting services, which grew more than two-foldover the prior quarter.
As of the end of the quarter, the company had over 125,000 customeraccounts, which was comprised of approximately 100,000 business Internetaccounts – a growth of 25% over the previous year. Specifically, weexperienced double digit sequential growth in revenue from global accountsand from the National SME segment, demonstrating our ability to growrevenues across all market segments.
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Infrastructure RevenueFor the first quarter of 2001, KPNQwest reported a total of €7.7 million ininfrastructure sales, compared to €3.1 million of infrastructure sales for thesame period in 2000 and €9.9 million for the fourth quarter of 2000. TheCompany closed additional infrastructure contracts valued at €90 millionduring the first quarter. The cumulative closed infrastructure contracts to dateamount to approximately €765 million, of which over 90% will be recognisedas revenue in subsequent periods.
***EBITDAThe company reported an EBITDA loss for the first quarter €(20.9) million,representing (12.8)% of revenues compared to €(31.9) million, or (40.5)% ofrevenues in the same period of the prior year. Sequentially, the reportedEBITDA loss improved from €(32.9) million, or (22.8)% of revenues.
EARNINGSThe company’s first quarter net loss of €(46.4) million, or €(0.10) loss pershare, improved 18.3% over the net loss of €(56.8) million or loss per shareof €(0.13) per share for the fourth quarter of 2000. For the first quarter of2000, KPNQwest reported a net loss of €(27.7) million or €(0.06) loss pershare.
***
349. On April 24, 2001, Defendants filed a Form 6-K with the SEC attaching the press
release issued April 23, 2001, as alleged above, and KPNQwest’s financial statements for first
quarter 2001.
350. Defendants knew or recklessly disregarded that the financial reporting contained in
the April 23, 2001 press release and April 24, 2001 Form 6-K was false and misleading for the
reasons set forth in ¶325(a)-(f), above. In particular, as set forth in ¶¶99-102 above, the press release
and 6-K were false and misleading because $45 million in revenue from a hollow capacity swap with
Global Crossing was improperly accrued. Additionally, as set forth in ¶¶119-130, € 30 million of
the € 90 million of new infrastructure contracts was a hollow swap with Flag, rather than a
legitimate dark fiber sale.
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351. Defendants’ statements in the April 23, 2001 press release and April 24, 2001 Form
6-K were made with scienter for the reasons set forth in ¶322, above, and ¶¶406(a)-(c) and (g) and
¶¶407(d)-(f) below.
352. On or about May 14, 2001, KPNQwest filed a Form 6-K with the SEC attaching its
Annual Report for the year 2000. Even though revenues from such lit fiber capacity sales
constituted 42.2% of all “communications services” revenues (and 38.8% of KPNQwest’s total
revenues) for FY 2000, a description of capacity sales of lit fiber appeared for the first time in any
KPNQwest public filing since the November 1999 Prospectus. Whereas Defendants had originally
described as them as new colors/wavelengths “services” for those who did not wish to purchase fiber
and equipment, the new definition of these transactions was drastically revised. In order to claim
compliance with FASB No. 66 as a real estate sale, Defendants now falsely claimed that buyers did
purchase of “all right, title and interest” to the “sold” capacity:
Communications services revenue includes...network capacitysales...We have entered into capacity agreements whereby customersobtain capacity on our network. In a capacity transaction, a customeracquires the right to use certain capacity on our network, togetherwith all right, title and interest in that capacity, for substantially allof the economic life of the network. The revenue relating to theseagreements, which is a component of communication servicesrevenue, is recognized on the date of delivery and acceptance of thecapacity provide that we have passed title on the integral equipment,and have met the other criteria of FASB Statement No. 66.Communications services revenue includes approximately €179million relating to capacity transactions for the year ended December31, 1999.
353. Defendants knew or recklessly disregarded that the financial reporting contained in
the Annual Report and the revenue figures reported in the financial statements contained therein
were false and materially misleading for the reasons set forth in ¶¶321(a), (c) and (d), 328, 331, 338,
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and 346 above. Additionally, the above-quoted statement is materially false and/or misleading
because:
a. KPNQwest’s 20-year IRU leases covering lit fiber capacity sales did not meet the
GAAP criteria for recognizing revenue up front rather than ratably over time;
b. Defendants nevertheless recorded revenue on such sales in the quarter in which the
contract was executed, rather than ratably;
c. Defendants misled investors to believe that there were actual sales of capacity for
which revenues of €179 million were collected. To the contrary, many of
KPNQwest’s capacity sales were non-cash exchanges of capacity, in the form of
swaps. Even if the swaps had been made for a business purpose, they were, in
essence, an exchange of inventory. As such, the earnings process had not yet been
complete and revenues could not have been recognized;
d. Hollow capacity swaps which had no business purpose were included in the €179
million figure.
354. Footnote 5 of the financial statements for the year ended December 31, 2000,
entitled “Related Party Transactions,” stated:
In the ordinary course of its operations, the Company provides managed broadbandservices to an affiliate of KPN. In addition, the Company provides managedbroadband services to KPN. Total related party revenues for the year endedDecember 31, 1999 and the nine months ended December 31, 1999 and related partyaccounts receivable at December 31, 2000 and 1999 are summarized in the followingtable....The Company has entered into distribution agreements with KPN and Qwestwhereby KPN and Qwest are the exclusive distributors of KPNQwest’s services inthe Netherlands, Belgium, Luxembourg and North America. Under the distributionagreements, KPNQwest sells services to these exclusive distributors, and theseexclusive distributors sell the services to customers in their respective distributionterritory. For the year ended December 31, 2000, the Company directly sold €54.3
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million to KPN and €71.6 million to Qwest under the distribution agreements ofwhich €67.9 million was included in accounts receivable as of December 31, 2000.In addition, under the distribution agreement, KPNQwest invoices either KPN, KPNBelgium, or Qwest for services contracted and provided by KPNQwest to othercustomers, but invoiced by KPN, KPN Belgium or Qwest. For the year endedDecember 31, 2000, the total revenue reported under this arrangement from KPN,KPN Belgium and Qwest was €15.1 million, €29.9 million, and €4.7 million.
355. The foregoing statement misleadingly fails to disclose that much of the claimed
revenues derived from Qwest and KPN were from sales of unneeded capacity and/or hollow capacity
swaps, the purpose of which was to maintain an artificially inflated share price for KPNQwest, as
set forth in ¶¶215-233, above. The footnote also failed to describe the related party sales of capacity
to Infonet as alleged herein. KPNQwest admitted in its IPO Prospectus that Infonet and AUCS were
related parties. The IPO Prospectus states: “KPN Telecom also provides...services for international
business customers primarily through its indirect interest in AUCS Communication Services v.o.f.,
a wholly owned subsidiary of Unisource N.V. KPN Telecom owns a 33.33% interest in Unisource
N.V. Infonet Services Corporation, an entity in which KPN Telecom holds an 18.74% interest, has
recently announced its intention to acquire the business of AUCS Communications Services.” Yet
the aforementioned purchase of “lit” circuits (IRUs) by Infonet from KPNQwest was not disclosed
to the investing public.
356. Defendants’ scienter for the misstatements in and/or omissions from the 2000 Annual
Report is set forth in ¶322, above and ¶¶499-504 below.
357. On July 25, 2001, Defendants announced KPNQwest’s second quarter 2001 results
in a press release:
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KPNQWEST N.V. REPORTS STRONG SECOND QUARTER RESULTSWITH RECORD REVENUE AND POSITIVE EBITDA
Company Reports First-Ever Quarter of Positive EBITDA, Two QuartersAhead of Schedule
A Total revenue rises to EUR 229.9 million, up 117.5% year over year***
A Positive total EBITDA of EUR 15.1 million, a strategic milestone for thecompany
***A Strong gross margin improvement year over year and sequentially to 43.4%
***KPNQwest, the leading pan-European data communications and hosting company,today announced record second quarter revenue of EUR 229.9 million, an increaseof 117.5% over second quarter 2000, driven by strong growth in both communicationservices and infrastructure sales.
***KPNQwest continues to deliver on financial and operation milestones and recordedits eighth consecutive quarter of meeting or exceeding the consensus of analysts’estimates for revenue, earnings before interest, taxes, depreciation and amortisation(“EBITDA”) and earnings per share (“EPS”).
[McMaster]: “Doubling revenue yet again demonstrates our ability to take marketshare in the communication services and hosting markets and to continue to winsignificant deals in the European infrastructure market.”
“Strong one-time infrastructure revenues, coupled with our continued marginexpansion and disciplined management of SG&A costs, has enabled KPNQwest toachieve EBITDA positive two quarters in advance of expectations,” McMasteradded.
***REVENUESThe second quarter of 2001 represented a new milestone in KPNQwest's history -total revenue surpassed the EUR 200 million threshold. The EUR 229.9 million ofreported total revenue for the quarter is more than the company reported in the whole1999 reporting period. Specifically, total revenue increased 117.5% year-over-yearand 41.3% sequentially.
Year-to-date the Company reported a 113.0% growth in total revenue to EUR 392.5million from the EUR 184.3 million for the six months ended June 30, 2000.
Communication Services Revenue
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Second quarter communication services revenue grew 87.3% from EUR 95.0 millionin the second quarter of last year, and 14.8% sequentially to EUR 177.9 million. Thegrowth in communication services revenue is largely attributable to the strength ofKPNQwest's market position, with growth experienced in all product areas.
For the six months ended June 30, 2001 the Company reported communicationservices revenue of EUR 332.9 million – nearly doubling the EUR 170.5 million forthe same period in 2000.
Infrastructure RevenueFor the second quarter of 2001, KPNQwest reported a total of EUR 52.0 million ininfrastructure sales, compared to EUR 10.7 million of infrastructure sales for thesame period in 2000 and EUR 7.7 million for the first quarter of 2001. The growthin infrastructure sales resulted from a significant one-time infrastructure duct deal-demonstrating that we are well positioned in the European dark fibre and ductmarket.
***EBITDAFor the first time in the Company's history KPNQwest reported positive EBITDA.Specifically, the Company achieved EBITDA of EUR 15.1 million for the quarter,or 6.6% of total revenue. Communication services EBITDA (excluding infrastructuremargin impact) for the second quarter of 2001 was EUR (12.3) million, or (6.9)% ofcommunication services revenue, representing a 51.0% improvement over the EUR(25.1) million reported for the first quarter of 2001 and a 59% improvement over theEUR (30.0) million achieved in the second quarter of 2000.
EARNINGSThe company’s 2001 second quarter net loss of EUR (25.9) million, or EUR (0.06)loss per share, improved 44.2% over the net loss of EUR (46.4) million, or loss pershare of, EUR (0.10) per share, for the first quarter of 2001 and improved 14.2%over the net loss of EUR (30.2) million, or loss per share of, EUR (0.07) per sharefor the second quarter of 2000.
***
358. Also on July 25, 2001, Defendants filed a Form 6-K with the SEC attaching
the press release issued that same day, as alleged above, and KPNQwest’s financial
statements for second quarter 2001.
359. Defendants knew or recklessly disregarded that the financial reporting
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contained in the July 25, 2001 press release and Form 6-K was false and misleading for the
reasons set forth in ¶325(a), and (c)-(f) above. Additionally, as set forth in ¶¶103-116, the
April 23, 2001 press release is false and misleading because $55 million in revenue from a
hollow capacity swap with Global Crossing was improperly accrued. Additional material
misstatements and/or misrepresentations include:
a. When read together, McMaster’s statements: “Doubling revenue yet again
demonstrates our ability to take market share in the communication services
and hosting markets . . .” and “Strong one-time infrastructure revenues . . .
” give the false impression that KPNQwest’s “communications services”
revenue figure consisted primarily of recurring revenues from the purchase
of telecommunications services by end-users. In particular, the
characterization of dark fiber (infrastructure) sales as “one-time” in nature
implies that only infrastructure sales could be so-categorized. To the
contrary, the same held true for each unique capacity sale of lit fiber which
KPNQwest misleadingly reported in the “communications services” revenue
segment;
b. Because the Company’s revenue figures were based on improperly recorded
revenues, they did not “double” as defendant McMaster claimed, nor did
KPNQwest become EBITDA positive two months ahead of expectations, as
McMaster also claimed.
360. Defendants’ statements in the July 25, 2001 press release and Form 6-K were
made with scienter for the reasons set forth in ¶¶103-116 and 322 above, and ¶¶406(b) and
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(d)-(i), ¶¶407(a)-(b), (g)-(h) and (l), ¶¶408(a)-(b) and (d)-(e) and ¶¶499-504 below.
361. On October 29, 2001, Defendants in a press release announced the
Company’s third quarter 2001 results:
KPNQWEST N.V. REPORTS STRONG RESULTS FOR THE THIRDQUARTER 2001
KPNQwest Forecasts Positive EBITDA for 2001 on Improved RevenueGuidance of €800 Million for 2001
Reported Third Quarter 2001 Results Compared to the Previous Year:• Total revenues of €197.6 million, up 48.9% from Third Quarter 2000
***• Achieved Positive EBITDA of €2.7 Million compared to a loss of €(31.2)million.
***KPNQwest, the leading pan-European data communications and hostingcompany, today announced for the first time in company history that it hasreported positive communication services EBITDA – one quarter ahead ofexpectations. This achievement was driven by the combination of the growthof 64.6% over the prior year in communication services revenue andcontinued improvements in controlling the cost structure of the business andleveraging the completion of the network. Total revenue for the quarter grew48.9% to €197.6 million compared to third quarter 2000. The third quarterresults represent the ninth consecutive quarter that KPNQwest has met orexceeded the consensus of analysts’ estimates for communication servicesrevenue, earnings before interest, taxes, depreciation and amortisation(“EBITDA”) and earnings per share (“EPS”).
"In a quarter marked by significant market turbulence, KPNQwest’s resultscontinue to demonstrate a focus on delivering on its promises to the market,”said Jack McMaster, CEO and President of KPNQwest. “The third quartersees us report positive communication services EBITDA - one quarter aheadof schedule – and that we expect to be EBITDA positive for the full year2001. Based on the results achieved through the end of the third quarter,KPNQwest is raising its revenue guidance from €780 million to €800 millionin revenue for 2001.
***
REVENUESThe Company reported total revenue for the third quarter of €197.6 million,
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which represents 48.9% growth over the third quarter of 2000. In addition, forthe nine months ended September 30, 2001 the Company reported €590.1million in total revenue, resulting in an 86.2% increase over the €317.0million reported for the same period in 2000.
***EBITDAKPNQwest reported a breakthrough quarter in terms of EBITDA by achievingpositive communication services EBITDA one quarter ahead of expectations.The Company reported total EBITDA of €2.7 million for the quarter, or 1.4%of total revenue.
Year-to-date the company reported an EBITDA loss of €(3.2) million, or(0.5)% of total revenue, compared to an EBITDA loss of €(89.7) million, or(28.3)% of total revenue for the nine months ended September 30, 2000.
EARNINGSFor the third quarter of 2001 the company’s reported net loss was €(60.5)million, or €(0.13) loss per share, compared to the reported net loss of €(23.9)million, or loss per share of €(0.05) per share, for the third quarter of 2000.Year-to-date 2001 KPNQwest reported a net loss of €(132.8) million, or a€(0.29) loss per share, compared to a net loss of €(81.9) million, or a €(0.18)loss per share, for the nine months ended September 30, 2000.
***Looking forward to 2002, the company anticipates that KPNQwest, on astandalone basis, will achieve total revenue of approximately €1,000 millionto €1,075 million, and EBITDA in the range of €135 million to €155 million.Capital expenditures for 2002 are forecasted to be in the range of €325 millionto €375 million.
Assuming combined operations for KPNQwest and the acquired operationsof GTS’s Ebone and the Central European businesses for the full year of 2002,the company forecasts pro forma total revenue in the range of €1,300 millionto €1,400 million. In addition, for the full year of 2002 pro forma EBITDA isforecasted to be in the range of €175 million to €200 million. Capitalexpenditures for the pro forma combined entity are anticipated to be €330million to €360 million.
362. On October 29, 2001, defendants McMaster and von Deylen held a conference call
with analysts and investors in which they presented the Company’s third quarter 2001 financial.
Both defendants strongly emphasized the revenue derived from “communications services” without
disclosing that most of this consisted of revenues from undisclosed swap deals and was improperly
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accrued. Defendant von Deylen falsely implied that the Company’s losses were not operational, but
largely due to amortization of interest expense and depreciation, a non-cash item, and therefore did
not bear on the Company’s future wherewithal. In fact, without improperly taking the Company’s
swaps and other IRU sales into revenues, KPNQwest would be losing enormous amounts of revenue.
363. More specifically, in the October 29, 2001 conference call Defendant McMaster
stated:
“I feel very strong about our third quarter….I’d argue…we have the sector’s leadingrevenue growth whether on an annual basis or sequentially, Very important, weachieved positive comm. Services EBITDA, which is one quarter ahead of theexpectations we had for the year….The funding we executed to establish thattransaction resolves any uncertainty for the time being and once and for all regardingfunding for our business plan. Revenue growth is up 45%, communications servicesrevenue is up 65% per year over year and 10% sequentially. We still retain theindustry’s highest gross margin…We have positive communications services growthmargin of .9 million, one quarter ahead of expected.”
364. Defendant von Deylen stated in that same October 29, 2001 conference call as
follows:
“Total revenue for the quarter was 197.6 million which is up nearly 50% from 132.7 million in the third quarter of 2000. The sequential decline in revenue from 230million in Q2 to the 197 million I just spoke of is a result of 52 million Euros ofinfrastructure revenue that was recorded in the second quarter. That compares to 2million in this quarter.... As explained previously, this revenue stream is lumpy ona quarterly basis. However for our year we’ve exceeded our expectations and wecontinue to see opportunities on a go forward basis. Communications servicerevenue grew to 195.6 million Euros, an increase of 65% from 118.8 million in thethird quarter of 2000 and an increase of 10% sequentially….Our total gross marginfor the third quarter was 82.2 or 41.6% of revenue. Communications services grossmargin was 80.4 million or 41.1 % of revenue. Communications services grossmargin Euros nearly doubled from the third quarter of last year which was 34.1% andimproved sequentially from 40.6%. We still see opportunity in expanding ourmargins. Nearly 25% of our cost of good sold are on leased lines and as revenuegrows we will continue to optimize the fixed cost portion of our cost of goodssold…This resulted in total EBITDA for the quarter of 2.7 million compared to aloss of 31.2 million from the Q3 of 2000.…I think more comparable is thecommunications services EBITDA which was positive for the first quarter of .9
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million.. As you can see, we have consistently improved our communicationsservices EBITDA from the fourth quarter of 2000. Positive EBITDA forcommunications services was one quarter ahead of expectations and we expect thatin the fourth quarter will be between 3 and 8 million positive for communicationsservices EBITDA. In terms of our earnings and net earnings, operating loss for thequarter was 53.9 million which improved from a year ago of 56.3 but was downsequentially from 34.2 million. The primary increase was depreciation andamortization. It increased by approximately 30 million from Q3 of 2000 and about9 million from Q2 of 2001…Our net loss for the quarter, 65.5 million. This is upfrom 23.9 million a year ago and 25.9 million in the second quarter. The primaryreason for the increase in loss was the increase in interest expense. …This primarilywas a reduction in our capitalized interest….Our EPS for the quarter was a loss of13 cents per share compared to 6 cents per share in Q2 of 2001 and 5 cents per sharein Q3 of 2000. This is the ninth consecutive quarter we have either meet or exceededanalyst’s estimates for earnings per share.”
365. Defendants knew or recklessly disregarded that financial reporting contained in the
October 29, 2001 press release and Form 6-K, as well as the financial results set forth in the
conference call of that same day, were false and misleading for the reasons set forth in ¶¶325(a) and
(c)-(f) above. Additionally, as set forth in ¶134-135 above, a capacity “sale” of lit fiber to Teleglobe
was accrued for the full contract value of $56 million, even though it should have been accrued
ratably pursuant to GAAP and industry practice. Additional materially false and/or misleading
statements include:
a. Defendants’ increase of FY 2001 revenue guidance following a quarter “marked by
significant market turbulence” (particularly following the tragic events of September
11, 2001) misled investors to believe that KPNQwest’s business was strong and
unaffected by market weakness. Because a significant portion of KPNQwest’s
revenues came from hollow swaps entered into solely to meet revenue guidance and
analysts’ expectations – what Qwest employees commonly referred to as “gap
fillers” (see ¶317, above) – KPNQwest’s results did not constitute “delivering on its
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promises to the market,” as McMaster claimed. Rather, artificial revenue boosts
were achieved through bogus “sales” and/or prematurely recognized revenues in
violation of GAAP and industry practice.
b. Only hollow capacity swaps and prematurely recognized revenues allowed
KPNQwest to report “a breakthrough quarter in terms of EBITDA by achieving
positive communication services EBITDA one quarter ahead of expectations.”
Without such improper revenue accrual, KPNQwest would not have been EBITDA
positive in Q3 2001.
366. Defendants’ statements in the October 29, 2001 conference call, press release and
Form 6-K were made with scienter for the reasons set forth in ¶¶134 and322, above, and ¶¶406(i),
407(c) and (i)-(k), ¶¶408(b) and (c), and ¶¶499-504, below. Additional evidence of scienter includes:
a. KPNQwest announced its intention to purchase GTS/Ebone and needed to show
strong results in order to obtain a multi-million Euro line of credit to fund the
purchase;
b. Desperate to show increased revenues, KPNQwest changed its deal with Teleglobe
from a sale of $100 million of dark fiber – which had to be accrued ratably – to a sale
of $56 million of lit fiber (which KPNQwest improperly accrued in Q3 2001).
Whereas KPNQwest only agreed to purchase $40 million of equipment at the point
when Teleglobe agreed to change its purchase from dark to lit fiber, this is evidence
that the transaction was a tit-for-tat hollow swap.
367. On February 12, 2002, Defendants announced KPNQwest’s Q4 2001 financial results
in the following press release:
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KPNQwest N.V. Reports Results For the Fourth Quarter 2001And For Full Year 2001 KPNQwest Reports Full Year 2001 EBITDA of euro 13.7 Million Full Year 2001 Results Compared to Full Year 2000 * Total revenues of euro 810.1 million, up 75.5% from 2000
**** Full year 2001 EBITDA of euro 13.7 million compared to loss of euro (122.5) million in 2000 Fourth Quarter 2001 Results Compared to the Previous Year: * Total revenues of euro 220.0 million, up 52.2% from fourth quarter 2000
**** Achieved positive EBITDA of euro 16.8 million compared to a loss of euro (32.9) million
***The fourth quarter results represent the tenth consecutive quarter thatKPNQwest has met or exceeded the consensus of analysts' estimates forcommunication services revenue and EBITDA.
For the twelve months ended December 31, 2001, the company reportedrevenues of euro 810.1 million, which represents a growth rate of 75.5% fromthe year 2000.
Revenues The Company reported total revenue for the fourth quarter of euro 220.0million, which represents 52.2% growth over the fourth quarter of 2000. Totalrevenue grew sequentially by 11.3%, from total revenue of euro 197.6 millionfor the third quarter of 2001.
The Company reported euro 810.1 million in total revenue for the full year2001, resulting in a 75.5% increase over the euro 461.6 million reported forthe full year of 2000.
*** EBITDA The Company reported total EBITDA of euro 16.8 million for the fourthquarter, or 7.6% of total revenue, compared to euro 2.7 million in third quarter2001 and a loss of euro (32.9) million in fourth quarter 2000.
***
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"We are continuing to drive costs out of our business, both on the networkside and in overhead," commented Jeff von Deylen, EVP and Chief FinancialOfficer of KPNQwest. "By exercising strict controls on expenditure, whilecontinuing to increase our revenue stream, we have been able to improve ourEBITDA margins from 1.4% in the third quarter 2001 to 7.6% in the fourthquarter 2001."
For the full year 2001, the company reported total EBITDA of euro 13.7million, compared to an EBITDA loss of euro (122.5) million in 2000. For thefull year 2001, the company reported communication services EBITDA lossof euro (23.9) million, compared to a communication services EBITDA lossof euro (142.4) million in 2000. Earnings For the fourth quarter of 2001 the company's reported net loss was euro(133.2) million, or euro (0.30) loss per share, compared to the reported netloss of euro (56.8) million, or loss per share of euro (0.13) per share, for thefourth quarter of 2000.
***
368. Also on February 12, 2002, Defendants filed a Form 6-K with the SEC attaching the
press release issued that same day, as alleged above, and KPNQwest’s financial statements for
fourth quarter and full-year 2001.
369. Defendants knew or recklessly disregarded that the financial reporting contained in
the February 12, 2002 press release and Form 6-K was materially false and misleading for the
reasons set forth in ¶¶325(a) and (c)-(f), above, and for those set forth in ¶¶350, 359 and 365, below,
because it incorporated the false figures reported in each quarter of FY 2001.
370. Scienter for these statements is set forth in ¶322, 351, 360 and 366, above, and
¶¶408(f) and 499-504 below.
371. Defendants decided to present more information than ever before with respect to
capacity swaps. However, Defendants continued to misrepresent the true state of affairs with respect
26 In addition to the disclosure described in ¶352, a footnote to the Company’s June 30, 2001Form 6-K, indicated that of € 157.3 million in sales to parents KPN and Qwest in the first half ofFY 2001, a whopping € 128 million in contracts were capacity agreements. Rather than the twotelecom giants providing the Company with the recurring customer revenues touted, the reverse wastrue: More than 81% of KPN’s and Qwest’s purchases were bogus swap sales intended to boost therevenues of KPNQwest and to keep the Company’s share price artificially inflated.
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to their swap transactions.
372. In a chart attached to the Form 6-K filing, KPNQwest for the very first time,26 set
forth the dollar value of yearly capacity sales from 1999 through 2001 and the percentage of total
revenues such sales represent. Alarmingly, sales which were supposed to be a side-line to defray
the cost of network construction secretly became KPNQwest’s primary business: From €12.7
million in 1999, a mere 6.7% of total revenues, capacity sales ballooned to €437.8 million in 2001,
an astonishing 54% of total revenues.
373. According to the chart, “100% of capacity sales were cash sales.” However,
Defendants still denied that KPNQwest received €437.8 million in cash, rather than non-cash
swapped capacity -- elsewhere in the filing, indicating that revenue was recognized on the date of
delivery and acceptance as well as the receipt of “a cash payment for a portion of the total purchase.”
(Emphasis supplied.) In this section of the February 12, 2002, Form 6-K KPNQwest further
admitted that of the nearly €438 million in capacity sales, € 120 million were in fact reciprocal
transactions, i.e., “sales” made in conjunction with a KPNQwest’s reciprocal purchases from the
buyer:
During 2001, the company entered into long-term optical capacityagreements whereby customers obtain optical capacity assets. Thecustomers acquire the right to use specific capacity on the network,together with all right, title and interest in that capacity, for the lifeof the network. The revenue relating to these agreements, which isa component of communication services revenue, is recognized on
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the date of delivery, receipt of a cash payment for a portion of thetotal purchase and acceptance of the capacity. For the year endedDecember 31, 2001, the company recognized approximately € 438million relating to optical capacity asset sales compared toapproximately €179 million in 2000. Of the €438 million in opticalcapacity asset sales, approximately €120 million were sales inseparate transactions to customers from which the company alsopurchased assets for use in its own network....”
374. Nevertheless, the Company falsely denied that capacity swaps existed, instead
claiming that the purchases and sales of capacity from and to the same third party were “separate
transactions.” Thus, Defendants affirmatively represented that 27.4% of the Company’s “cash
sales” of capacity coincidentally happened to be to parties who had assets which KPNQwest sought
to purchase at or about the same time as the “separate” sale of capacity occurred.
375. The Form 6-K further stated:
KPN and Qwest were significant customers of KPNQwest for thetwelve months ended December 31, 2001 and 2000. KPN and Qwestpurchased network capacity and services from KPNQwest for theirown use and for their customers within the KPNQwest network.Purchases by KPN and Qwest for the year ended December 31, 2001were approximately 14% and 29% of total revenue, respectively.Purchases by KPN and Qwest for the year ended December 31, 2000were approximately 23% and 17% of total revenues, respectively.
376. This statement was materially false and/or misleading because of the clear
implication that KPN and Qwest either were reselling active telecommunications services to end-
user customers or purchasing capacity for their own use. Plaintiffs are informed and believes, and
based thereon allege, that Defendants failed to disclose: (1) that the bulk of their purchases – 81%
was reported for the first six months of the year – were of unneeded capacity to be swapped by KPN
and/or Qwest with another telecommunications industry provider; and (2) that the capacity was
purchased to artificially inflate the revenues of KPNQwest and Qwest, not for actual use by the
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“customer” to whom it was ultimately swapped.
377. All of the materially false and/or misleading statements in the Form 6-K were made
with scienter because, by the time the document was filed, Defendants were aware that many of the
Company’s large transactions were called into question in the wake of the Global Crossing
bankruptcy scandal and the revelations of hollow capacity swaps arising therefrom. Defendants had
previously stated in the Company’s public filings that immediate booking of capacity sales revenues
took place upon the transfer of all right, title and interest to the buyer and that the transactions
complied with GAAP. Defendants knowingly or recklessly reiterated this point in the February 12,
2002 Form 6-K, even where it was admitted that reciprocal transactions existed.
378. In a follow-up press release of February 13, 2002, the Company once again reiterated
its denial that improper hollow swap revenues were accrued, “reaffirm[ing]” the results reported for
FY 2001:
KPNQwest: Clarification on Press Reports
KPNQwest (Nasdaq: KQIP; ASE:) wishes to reiterate informationreported at its fourth quarter and full year 2001 results announcementmade on 12 February 2002 to correct any misconceptions that mayhave arisen from recent press reports. Several of these reports discussthe concept of “cashless transactions.” KPNQwest wishes to stressthat it does not engage, and has never engaged, in cashlesstransactions.
KPNQwest reaffirms that:
1. KPNQwest sold capacity to other carriers for approximately 438million euro in 2001. All of these sales were cash sales at fair marketvalue.
2. Of the 438 million euro in optical capacity asset sales,approximately 120 million euro were sales in separate cashtransactions in 2001 to customers from which the company alsopurchased assets for use in its own network for business purposes.
27 See June 25, 2001 E-mail from Wray to Qwest Personnel: “All, Regarding the portabilityletter, KPNQwest also need the repurchase price to be at FMV and not what GC paid for it.”
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These assets included optical equipment, capacity outside of theCompany's network footprint, metropolitan area networks andcapacity to enhance the resilience and reach of the EuroRings(TM)network. These too were cash sales at fair market value.
3. All of KPNQwest's transactions are in compliance with US GAAP.
379. The above misrepresentations were materially false and/or misleading for the many
reasons stated above. In particular, the series of e-mails circulated between the parties to the Q2
2001 swap with Global Crossing, at ¶¶103-116 above, concerning the parties’ side agreement
contradict Paragraphs 1 and 2 and demonstrate that Defendants made the statements contained
therein either knowing that the statements were false when made or with reckless disregard for the
truth. The upshot of the parties’ agreement was that capacity “sold” to Global Crossing would be
exchanged (“ported”) for other capacity at a later date at the price Global Crossing paid for it. In
fact, for the sole purpose of allowing Qwest (and KPNQwest) to accrue the revenue,27 a writing was
generated indicating that the exchange could only be made at fair market value. However, the
parties agreed that the writing was to be superceded by an oral agreement to the contrary.
380. Paragraph 3 is false because, for the reasons set forth in ¶¶270-311 above, sales of
lit fiber capacity never met the criteria for immediate revenue recognition in the quarter the contract
was executed and Defendants knew or recklessly disregarded the true facts when they repeatedly
represented otherwise. Additionally, hollow swaps can never comply with GAAP because they are
not made for a business purpose. Finally, Qwest and KPNQwest bucked industry practice in this
regard as well. In an exchange during the hearing before Congress underscores this point:
Rep. Stupak: In your testimony, in your review of testimony, it indicated on the
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swaps, Global Crossing reported the amount of the revenue itreceived as GAAP revenue, gradually over the life of the contract, adistinctly more conservative approach than one taken by Qwest.Why would Qwest take a different approach than Global Crossing onhow they did these swaps, how they reported them?
Robin SzeligaFormer Qwest CFO: I don’t know why there was a difference. I believed when we were
booking those and I believe now, that we were doing our best tofollow the technical literature that was out there and booking themthrough our books and records to reflect the transaction that we weredoing. So I can’t really speak to why there was a difference ofinterpretation or how it was different.
Rep. Stupak: Well, your auditor was Arthur Andersen, right?
Ms. Szeliga: That is correct.
Rep. Stupak: That’s the same for Global Crossing, correct?
Ms. Szeliga: That is correct, I believe they stated their auditors were Arthur Andersen...
Rep. Stupak: So this technical advice you got, you’re saying Arthur Andersen gave youtwo different interpretations for the same transactions between thesecompanies?
THE ROLES OF KPN AND QWEST IN THE SCHEME
381. When KPNQwest was formed, and for most of the Class Period, KPN and Qwest had
equal participation in KPNQwest. KPN, as the “Ma Bell” of the Netherlands, had deeper roots and
a more-well entrenched client base than Qwest. According to CW 10, when KPNQwest was formed,
60% of the Company’s personnel came from KPN, and these remained contractually employed by
KPN, not KPNQwest, until approximately April, 2000.
382. The preponderance of KPN executives–and the principal persons involved in the
swaps, came from KPN. KPN was represented on KPNQwest’s managing board by Henjo
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Groenewegen, Chief Operating Officer, Willem Ackermans Chief Financial Officer, and Rhett
Williams, Chief Marketing Officer. Both were closely connected to KPN. Groenewegen joined
KPNQwest following nine years in management roles within KPN, including the post of Vice
President in charge of the business unit International Network Services.
383. Ackermans joined the KPNQwest management team from KPN International, where
as Executive Vice President and Chief Financial Officer he has been responsible for all aspects of
their international financial strategy. Prior to joining KPN International, Ackermans was in charge
of corporate treasury for the KPN group, and Managing Director for KPN Finance and KPN
Ventures.
384. Williams, although an American, came from KPN. Immediately before joining
KPNQwest, Williams was Senior Vice President Corporate Accounts Group at KPN with
responsibility for the largest national and global customers of KPN Telecom.
385. Other top KPNQwest executives from KPN included Jan Louwes, in charge of dark
fiber sales, and Gerry Hubers, who also had responsibility for dark fiber and duct sales. After
Groenewegen left KPNQwest, according to one high ranking witness who was a long-time KPN
employee and one of the core founding group of KPNQwest serving in human resources, Ewoud
Mogendorff who headed Global Trading (specializing in swap deals), was responsible for the
relationship between KPN and KPNQwest. Williams was in charge of the swaps, Louwes headed
a department which sought large wholesale transactions including swaps, and Mogendorff
specialized in particular in exchanges of carrier capacity, i.e. “Global Trading,” taking over what
had previously been Hubers’ responsibilities.
386. The directors representing KPN on the KPNQwest supervisory board remained
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actively engaged with the Company’s overall strategy and available for input from the many
KPNQwest executives who had originally come from KPN. For example, in April 2001, Hans
Markowski, a top human resources executive at KPNQwest, sent Joop Dreschel and Marten Pieters
a letter expressing his concern about the problems at KPNQwest and the Company’s “culture based
on fear.” Markowski states that “The two of you have been pretty closely involved with KPNQwest
NV as members of the Board of Directors.” A true and correct copy of that Dutch language letter
and its English translation are attached hereto as Exhibit “D.” See also allegation herein concerning
the letter forwarded to Eelco Blok.
387. All the members of the KPNQwest supervisory board, including members from both
Qwest and KPN, received a bi-monthly report from the CFO (Ackermans or von Deylen, depending
on the time period), according to CW 28, a member of KPNQwest’s management board who came
from a predecessor entity which had been acquired by KPNQwest.
388. KPN abused its status as controlling parent of KPNQwest in connection with
its role as KPNQwest’s largest (or second largest vis a vis Qwest) customer and supplier. In a
lawsuit filed in the civil court located in the Hague, with case number 2002/2003, Citibank
International PLC, acting for a number of KPNQwest’s creditor banks, sued KPN and two KPN
subsidiaries for tortious interference with the banks’ security interests in KPNQwest’s receivables.
The banks allege that KPN exercised its control of KPNQwest at the highest levels of KPN in order
to wrongfully reduce the amounts that were payable by KPN to KPNQwest, thereby rendering
untruthful KPNQwest’s representations to the public regarding the amount of business revenues
generated by its business with KPN.
389. A document filed in the bank’s lawsuit, which is a summary of the arguments to be
28The Bank’s Case states that at an October 20, 2000 meeting of the KPNQwest auditcommittee with Arthur Andersen, the amounts owed by KPNQwest to KPN were discussed in ameeting attended by Martin Pieters (who was KPN’s appointee to the KPNQwest board of directorswho was also in KPNQWest’s audit committee) and Henderson. There was direct contacts betweenKPN CFO Hendersen and KPNQwest CFO Ackermans about this matter and it was alsocontinuously attended to on the level of the KPN board of directors. In April 2001 CFO Hendersonbecame a director of KPNQwest and a member of the KPNQwest audit committee. In May 2001Pieters and Henderson responded to a KPNQwest proposal to resolve the disputes and in June 2001there were direct contacts between KPNQwest board member Everaet and KPN board memberEustace (who chaired the KPN audit committee) about these matters. On December 28, 2001, KPNpaid KNQwest a settlement amount of 37.7 million Euros at the direction of KPN directors Pietersand P. Smits
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presented by the banks’ attorneys (entitled “Pleitaantekenningen van Mrs. G.H. Gispen en P.
Kuipers”) sets forth the banks’ overall arguments to be presented to the Dutch court at the end of
the case, citing to evidentiary documents presented to the court. This document, hereinafter referred
to as “Banks’ Case”, as part of the banks’ tort claims against KPN, sets forth a series of “settlement
meetings” dating from October 20, 2000, in which KPN at its highest levels attempted to prevent
KPN from making payments to KPNQwest by attempting to cut back amounts claimed by
KPNQwest from KPN and always offsetting such amounts against excessive amounts claimed by
KPN from KPNQwest.
390. In particular, the Banks’ Case states that defendant Martin Pieters and KPN’s CFO
J.M. Henderson were continuously involved with the ongoing disputes regarding payments between
KPN and KPNQwest. These disputes were always handled at the highest levels of both companies28.
All actions on the part of KPN with respect to payments to KPNQwest were undertaken at the
direction of KPN directors Pieters, Henderson and Smits. Overall, KPN failed to pay amounts owed
to KPNQwest and invoiced KPNQwest for inflated amounts, then engaging in undisclosed
settlements which were carried in a disguised matter, so that instead of one settled payment being
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made by KPN to KPNQwest (or vice versa), amounts were simultaneously paid back and forth
between KPN and KPNQwest. KPN exercised its control over KPNQwest to strong-arm the
Company into these inequitable settlements.
391. In an agreement of October 18, 2001 KPN purchased 133 million Euros of IRUs from
KPNQwest. On March 1, 2002 KPN purported to pay 35 million Euros to KPNQwest with respect
to this IRU agre ement. In reality KPN paid nothing, but merely gave KPNQwest an offset credit
with respect to the Comany’s claimed debts to KPN. In March, 2002, KPN informed KPNQwest
that KPN had no intention of making further payments with respect to its 133 million Euros IRU
obligation unless KPNQwest made payments to KPNQwest.
392. KPN and Qwest each had equal revenue commitments to KPNQwest, and both used
swaps and other non-cash means of satisfying their promises. Thus, the May, 2001 e-mail from a
KPNQwest employee to Ackermans, stated - with the preface that this was not new news - that
KPNQwest "is pushed more and more towards IRU's (with our parents) quarter by quarter."
Similarly, Ackermans mentioned in his May 11, 2001 e-mail to Jack McMaster that “KPN and
Qwest can only do swap,” and, on February 18, 2002, KPNQwest's Dean Mullane indicated that
KPNQwest would proceed with cash disbursements on the assumption that Qwest (and KPN) "will
deliver cash for IRU's." Jeff von Deylen, referring to a swap transaction, acknowledged in a
message to Qwest’s Matthew Scott that the deal was “structured as a three way transaction for both
KPN and Qwest to make revenue targets.” And controller Matt Gough’s e-mail of October 17, 2001
proposed that “[a]ll KPN and Qwest IRU’s should NOT be swaps, but rather cash deals....”
(Emphasis added). Those who knew about the swaps and IRU deals made no distinction between
the relative roles of KPN and Qwest.
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393. While Qwest may have had a deeper involvement in swaps because of its own swap
scheme, the swaps entered into by KPNQwest were engaged in for the benefit of, and at the direction
of, the Company. KPNQwest was not merely a tool of Qwest. For example, at the end of quarter
meetings chaired by Rhett Williams, once Williams quantified the “gap” between projections and
actual sales, he formulated transactions with Qwest and/or Global Crossing which closed
KPNQwest’s sales gap and thus were for KPNQwest’s particular benefit. Many of the swaps alleged
herein did not involve Qwest as a party. In order to facilitate this joint effort, KPNQwest had a team
of 4-5 people, headed by Jan Schreuder (a Dutch employee), sent to work at Qwest in Denver in
order to coordinate swaps and other IRU capacity deals with Qwest. So, when the trustees’ RICO
complaint cites Jan Schreuder of Qwest, these references reflect the cooperative relationship
between parent company and offspring, not (as the trustees’ RICO complaint implies) a subordinate
relationship of KPNQwest to parent Qwest. See, for example, the e-mails of November 23, 2000
and December 18 and 20th, 2000 concerning a Cable & Wireless deal quoted herein.
394. The situation changed around mid-2001, when Willem Ackermans left KPNQwest.
For example, a vice president of network development, originally from KPN, found his position
abruptly eliminated, and when he sued the Company for severance payments, he proved his case by
showing that numerous people from Qwest had been hired in positions for which he was qualified,
contemporaneously with his leaving the Company. David Sayre, of Qwest, lists a single employer
--“KPNQwest/Qwest Services Corp”--on his resume, states that he worked for Qwest in Dublin,
Ohio from July 1998 through May, 2001, and then was in the Hague as Senior Vice President,
Network Engineering and Operations, “Sent to Europe on Special Project as Qwest liaison for joint
venture. Responsible for Engineering, Planning, and Operations in KPNQwest. Responsible for
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building network to meet quarterly revenue goals....” Katie Drummey, also from Qwest, came into
the KPNQwest CNI department in mid-2001 with responsibility for implementing the swap deals
(replacing Martin Vlastra, a KPN-related individual), and David Shorrosh from Qwest replaced
Esther von Zeggeren as SVP of the CNI department.
395. Qwest, as part of its joint control with KPN of the Company, induced KPNQwest to
enter into two substantial transactions which KPNQwest would not otherwise have entered into for
the bona fide conduct of its own business.
396. Qwest exercised its control over KPNQwest by requiring KPNQwest to undertake
“Project Ferrari,” informally known as the “Golden Triangle” project, whereby KPNQwest was to
double its capacity in the sector of the network connecting London, Paris, Frankfurt and Amsterdam
(the “Golden Triangle”), by adding another lit fiber using Nortel equipment to the already-lit fiber
based on Alcatel equipment. CW 17, director of network implementation, states that some $100 to
$125 million was spent on the Golden Triangle project and states that he never knew why that
project was undertaken given that KPNQwest had abundant excess capacity. CW 27, who was vice
president of network development before being assigned to the metrorings project, had the same
concerns, and complained about Qwest’s imposition of this project onto KPNQwest, in an e-mail
that was ultimately forwarded to KPNQwest director Eelco Blok.
397. CW 11, former head of KPNQwest’s engineering department, learned of the Golden
Triangle project in late May or June, 2000. He was told about it by Ray Walsh, KPNQwest head
of operations. When CW 11 asked why the project was needed, Walsh said it was ordered by
Qwest. CW 11 indicated to Jack McMaster that this project was excessive for KPNQwest’s needs.
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398. Qwest sent its own implementation team to take care of the Golden Triangle project;
CW 11 and KPNQwest’s own engineering department were “just assisting.” CW 11 asked Jack
McMaster why Qwest’s own people were coming to KPNQwest to manage this project, but didn’t
receive an answer. CW 11 said it was difficult for him to allow a foreign company to come in and
impose their ways on KPNQwest.
399. Another instance of Qwest exercising its control over KPNQwest in its own interest
and contrary to the interest of other KPNQwest shareholders, was the selection of a vendor of
multiplexing (DWDM) equipment for the KPNQwest metrorings. CW 27, who was on the vendor
selection team for the metrorings, states that there was a lengthy vendor selection process in the
period November 2000 through April 2001, headed by John Giblin, vice president of the metro
network, and Louis de Wolff, the vendor selection manager. A group of 19 vendors tendering for
the contract was narrowed down. CW 27 was at the meeting when the vendor selection team
informed Ray Walsh, KPNQwest head of operations, of the selection of Sorrento Networks and
Walsh exclaimed “This is the most subjective vendor choice ever.”
400. John Mason, who was in charge of the tender process for the KPNQwest metrorings
project as head of European operations for Sorrento Networks, confirmed these events. He states that
the metrorings contract was worth about $250 million to the successful vendor. He believes
KPNQwest spend millions of dollars on the vendor selection process--it was the most extensive
tender process he had been involved with. His company had a dedicated team working 24/7 for the
period, in physical testing, due diligence on vendors, technical discussions and even participation
in KPNQwest’s business planning.
401. Mason explained that the list of prospective vendors was winnowed down to three.
29An August 15, 2000 article on Fortune entitled “Sand Hill Road’s Networking Guru PlugsUs In” explains that Khosla focuses his venture capital efforts on networking gear companies, andthat Khosla founded and funded Cerent and was on the boards of router maker Juniper Networks andRedback Networks. Khosla proceeds to explain to the reporter that Qwest had purchased equipmentfrom Cerent, Juniper and Redback, which is quite a coincidence.
30Logically that would be Ray Walsh, head of operations, who was the most senior memberof Company management located in the Hague office.
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Then after Mason’s company negotiated the contract, line by line with KPNQwest, Louis de Wolff
informed him that “we’re done” and the agreement was accepted. In a matter of hours he was told
that Jack McMasters had to talk to Qwest about the decision and he later learned that ONI Systems
(“ONI”), a company not in the final three, had nevertheless been selected. ONI was clearly an
inferior choice, according to Mason, because Sorrento Network’s price was 1/3 lower and ONI,
unlike Sorrento Networks, had no plan to install the equipment. In choosing ONI, the entire
business plan for the metrorings was changed to have Qwest to install the equipment for KPNQwest,
rather than have the vendor perform the installation.
402. Upon investigating, John Mason discovered that venture capital firm Kleiner Perkins
Caufield & Byers, whose partner Vinod Khosla was a Qwest director, was a major shareholder of
ONI. ONI’s proxy statement of April 20, 2001 confirms that Kleiner Perkins and affiliates owned
8.6% of ONI’s common stock. Interestingly, the two Kleiner Perkins affiliates had only acquired
their ONI shares recently, since the share acquisition was set forth in a Form 13B filed on February
14, 2001. Mason was told by a member of KPNQwest’s metrorings tender team that Mr.
Khosla–who was a venture capital “guru” specializing in telecom networking gear29--personally
phoned a senior KPNQwest operations person30 in the Hague to make sure the contract went to ONI.
Mason was so incensed that he wrote a letter to Elliot Spitzer, New York State Attorney General,
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a copy of which is attached as Exhibit “E.”
ADDITIONAL EVIDENCE OF SCIENTER AND AGENCY
403. In connection with transactions with third parties -- particularly Global Crossing --
Qwest and KPNQwest acted as one. This unity of interest is demonstrated, for example, in an email
exchange of January 3-4, 2001 between KPNQwest CEO McMaster, and Qwest COO Mohebbi,
in which McMaster sought to ensure that KPNQwest will benefit from a joint KPNQwest-Qwest
swap deal with Flag Telecom:
McMaster: “At the very least we should make sure that if it turns outthat Ross [Lau of Qwest] needs the Asia capacity that KQ gets thebenefit of a Euro order without having to take transatlantic capacitythat we do not need. Let’s stay very close together on this. Flagneeds this deal badly and the leverage is with us.”
Mohebbi responds: “Agreed. As we discussed we should always staytogether between Q and KQIP when it comes to certain customerssuch as Flag, 360, C&W, L3, Global Crossing, etc.
404. Therefore, Qwest would be the signing party in swap deals with Global Crossing, but
KPNQwest would be directly involved in the deals, have direct dealings with Global Crossing and
be a full participant in the negotiations. Qwest signed the deals on its own behalf and as
representative/agent of KPNQwest. Third parties such as Global Crossing understood KPNQwest
to be bound by the terms of the swap deals and relied on the provision of KPNQwest’s
telecommunications capacity as part of the deal packages. In fact, the fall 2002 issue of Quote
magazine, a Dutch publication, contained an article by Peter Verkooijen, stating that KPNQwest’s
COO said the Company was operated like a branch of Qwest:
KPN expected to learn a lot from Qwest, and that’s how theAmericans could fit in the driver’s seat from day one. JackMcMaster, ex-AT&T and international director of Qwest became theCEO of the joint venture. Henjo Groenewegen settled for the post of
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COO. McMaster turned out to be Nacchio’s puppet. After Nacchio’sarrival more former Qwest and AT&T employees landed inmanagement positions. They coordinated their strategic andcommercial management from the main office in Hoofddorp.Groenewegen operated out of The Hague and was responsible for theday to day operations. Nacchio and his men had all the “space.”Groenewegen: “KPNQwest was run as if it were a branch ofQwest.”
405. Because of the close relationship between Qwest and KPNQwest and their joint
activity and principal/agent relationship with respect to swap deals, there are four categories of
documents demonstrating scienter on the part of KPNQwest and Defendants: (1) documents
demonstrating KPNQwest’s direct involvement with the swap deals, (2) documents originating with
Qwest demonstrating scienter on its part, (3) documents originating with Global Crossing or other
third parties reflecting Qwest’s (and/or KPNQwest’s) expressed purpose and intent with respect to
the swap deals, and (4) documents demonstrating that auditor Andersen warned Qwest and
KPNQwest that their accounting treatment for the swap transactions was improper.
A. DOCUMENTS REFLECTING KPNQWEST’S DIRECT INVOLVEMENT IN THE SWAP DEALS
406. Documents reflecting KPNQwest’s direct involvement in the swap deals include:
a. March 13, 2001 Internal Global Crossing Email from Wright – Subject: “1Q
Reciprocal Deals.” “Apparently, Qwest is on track to meet their quarterly numbers,
but KPNQwest is struggling. They would like us to allocate $25M of the $100M for
purchases in Europe.”
b. March 27, 2001 Side Letter On Portability For First Quarter 2001 Swap – Refers
jointly to Qwest and KPNQwest as the “provider” of transmission capacity. The
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final side agreement refers to Qwest alone as the “provider,” reflecting a decision
that Qwest would act on KPNQwest’s behalf in the swaps. This allowed Qwest to
benefit from a double shot of increased revenue from the swap deal, first from the
“purchase” of capacity from KPNQwest (thus boosting KPNQwest’s revenue) and
then the swap of the same capacity. The same was true of the second quarter swap.
The original deal documentation provided for KPNQwest’s direct involvement, as
reflected in the draft side letter for the Second Quarter 2001 swap agreement which
refers to KPN European Capacity to be purchased directly from KPNQwest. The
final side letter had Global Crossing purchase the capacity on the KPNQwest
Eurorings from Qwest rather than KPNQwest.
c. March 29, 2001 Internal Global Crossing Email – “I understand that we commit for
45 M for ‘wavelengths’ in Europe, but to be converted into fiber and/or duct at a
later stage....April 10 I have a meeting scheduled with KPN Qwest to discuss those
details...so at this point I don’t know which fibers or ducts.” [Ellipses in original].
d. E-mails from June 19-21, 2001 – KPNQwest personnel copied on e-mails regarding
draft documentation for Second Quarter 2001 Swap (including side letter). One
email in particular denotes the central role of KPNQwest in the deals: “Jan and Jean
Louis [Colen, from KPNQwest] will work on pricing first thing tomorrow, then head
to our offices at 88 Pine (at Water Street) to finalize the commercial terms with
Doug, Steven and Peter (via phone).” The foregoing is an e-mail of 6/19/01 from
Robin Wright (Global Crossing CFO) to persons at Qwest and KPNQwest.
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e. June 22, 2001 Email from Steve Sherman of Global Crossing to various personnel
at Global Crossing, Qwest and KPNQwest – “My understanding in speaking with
Pete Calis and KPN/Qwest previously is that the Ducts (Eschenfeld-Prague-Vienna-
Munich) are only 85% complete, and the entire route will not be complete until July
sometime. ...”
f. KPNQwest personnel copied on June 21-22, 2001 E-mails About Maintenance Costs
for Global Crossing.
g. June 24, 2001 E-mails Between KPNQwest, Global Crossing and its Counsel – In
discussing whether the ability to subsequently exchange capacity that was
“purchased” in the swap should be at fair market value (“FMV”), Armstrong of
Global Crossing states: “[W]e wont accept this. We have had this argument every
quarter and it has previously been accepted that as we are only activating capacity
we are buying by 30 June because this is Qwest’s requirement, it would be
unreasonable that in say six months time when we activate what we actually need we
suffered because of a fall in the price. ....”
h. June 25, 2001 E-mail from Wray to Qwest Personnel – “All, Regarding the
portability letter, KPNQwest also needs the repurchase price to be at FMV and not
what GC paid for it.”
i. September 19, 2001 Global Crossing Memorandum – “Attached are the following
documents:... 2. Last quarter’s European dark fiber IRU Agreement pursuant to
which Qwest purchased fiber from KPNQ and flipped it to Global. KPNQ wants to
amend this document for the Qwest purchase from KPNQ of additional dark fiber
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this quarter (Qwest is purchasing Helsinki-Stockholm fiber from KPNQ and flipping
it to Global)...I’ll go through last quarter’s KPNQ-Q-Global dark fiber deal and add
the new required provisions.”
B. ORIGINAL QWEST DOCUMENTS DEMONSTRATING ITS SCIENTER
407. Original Qwest documents demonstrating scienter include:
a. May 10, 2001 E-mail from Matthew Scott, Director of Finance Strategic
Transactions at Qwest – Forwarded to Casey, Executive Vice President, and
Mohebbi, COO of Qwest: “Our CFO made a statement this morning that ‘there can
be no non-monetary transaction of any significance, ever again.’ This means any
deal, even when wires are exchanged, where Qwest purchases roughly similar
amounts from a vendor that we have sold an IRU to. Her concerns are that the
auditors have stated that we will need to disclose those in our financial releases, and
that disclosure will be expanded to show the total scope and volume of all IRU
transactions. She will not allow that to happen.”
b. May 13, 2001 E-mail from Casey to Mohebbi: “I think Robin said that we weren’t
[sic] going to do any more deals where we pick up facilities at the same time
somebody buys them from us.....[W]e’re going to have a hard time making the
quarter if we can’t do any more deals to expand our network as robin said....”
c. August 2, 2001 Memo from CFO Robin Szeliga to Casey – Subject: “IRU
Accounting- Some Rules of Engagement.” “The activity of ‘trading-in’ circuits for
circuits on different routes raises the question whether or not the earnings process
was in fact complete as of the date of the original transaction and therefore will not
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be considered. EFFECTIVE IMMEDIATELY, the following upgrade language will
be the only acceptable language to be included in an IRU’s agreement....note that
both parties are agreeing that any upgrade will be at fair market value at the date of
the upgrade. This does not mean what the customer originally paid, unless specific
evidence is provided that indicates that this represents the current fair market
value....In addition to the foregoing, there will be no side letters or verbal
commitments outside of the IRU agreement that conflict with the contractual upgrade
language or specifically indicate that no upgrade will be agreed to. Note that we are
required to provide representation to our auditors that no side letters or other verbal
or written agreements exist between the parties.” Non monetary transactions require
“[A] detailed business case showing how the products/services being purchased will
be monetized by Qwest. ...”
d. March 12, 2001 E-mail From Wright to Global Crossing: “The reason that the
$22.5M is not included [in GX revenue] is that they [Qwest] specifically asked that
they keep that amount open to portability anywhere on the GX network. The reason
for the language is that in order to prove that this is not a swap, we needed to give
them a BPO and portability one time....”
e. March 27, 2001 Email from Chase of Qwest: “I agree with Robin [Wright, Qwest
CFO] we are forcing them to take stuff they do not have a need for.”
f. March 28, 2001 Global Crossing Memo From Wright – Refers to a single “deal”
with a “sell side” and the “commitment” from Global Crossing (i.e. buy side).
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g. June 25, 2001 E-mail From Wright – Subject: “A bump in the Qwest road.” “In our
deals with Qwest, any capacity/ducts/dark fiber that we buy from them has to be
activated in order for them to get revenue recognition....”
h. June 25, 2001 Exchange Between Wright and Chase – “As we’ve agreed, because
we are both being delivered what we probably don’t want in the long term, we have
agreed, on both sides, that the repurchase price is the actual amount paid, not the fair
market value. You both know the issue, we are taking capacity in order to help with
revenue recognition issues. Can you kindly tell Erin Wray [of KPNQwest] (asap if
possible) that we have already agreed on this and explain that we are doing it both
ways?” Response from Chase to Wright: “I agree with your comments below. It
is our intention to keep you whole....”
i. September 19, 2001 Memo from Matthew Scott to Qwest Personnel – “Met with AA
[Arthur Andersen] yesterday. The proposed buy back of [certain circuits] was
discussed at a very high level....Bottom line, this cannot happen without seriously
jeopardizing all future IRU revenue recognition.....Issues are: 1) Different user
routes, not on same fiber; 2) Buy back of asset sold just last quarter; 3) replacement
circuits are at a effective lower rate per mile than original purchase (in other words
we are paying more for what we buying back than for what we are selling). All of
this implies this is a service and not an asset. This means we did not complete the
earning process with the original sale and should not have booked any revenues.
That taints all future IRU sales as they will never know if the earning process has
been completed....”
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j. September 25, 2001 Exchange of E-mails at Global Crossing – “I’ve attached the
Qwest business case & sign-off sheet from last quarter which clearly indicates we
purchased Helsinki-Stockholm DF [dark fiber] for $15M....However in reviewing the
contract I don’t see any mention of this dark fiber.” Response: “I’ll check the
contract when I get into the office - but from recollection it wasnt available for
activation by the end of the Q so we bought something else with the intention of
porting it into this dark fiber once it was ready....”
k. September 26, 2001 Email from Chase to Scott – “Global Crossing knows that they
can not port the waves they are buying from us. However some of their financial
guys are wanting me to provide a more formal response to the accounting issue we
have regarding the no port position. I need your help with providing this
response....” Response (of same date) from Matthew Scott: “The issue is the
‘ultimate culmination of the earnings process’, or lack thereof. If we offer portability
our Auditors view that as a service, not an asset sale. If we allow our customers who
buy assets to freely exchange those assets for other assets, then we really have not
sold a specific asset at all, we have a sold pre-paid ‘right to use’ of a service on
generic capacity.... Because the customer has a ‘defacto’ right to swap out capacity
that was not originally contemplated, the earnings process has not been completed
until such time as we have provide the ultimate capacity they need.....”
l. June 13, 2000 Exchange of Emails From Mohebbi Regarding Pacific West IRU Deal
– “We agreed at the time of the Touch America card allocation that we would not be
able to do both this IRU and Touch America.... From Mohebbi: “what if we mis-
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route the IRU and then route it as it is suppose to? To Mohebbi: “If we could do this
(which I’m not sure we can), then all we have to do is get audited, get caught and get
screwed. From Mohebbi: “i know it is risky. I will take the fall for it!” (Emphasis
supplied.)
C. THIRD-PARTY DOCUMENTS REFLECTING QWEST AND KPNQWEST’S SCIENTER
408. Certain third-party documents reflecting Qwest and KPNQwest’s scienter include:
a. May 10, 2001 Internal Global Crossing Email – “ The $60M payment to Qwest was
allocated against NA long haul waves. We allocated it to the waves for Qwest’s
revenue recognition purposes. What we want to purchase is local access IRU’s. We
have a side letter to the agreement that allows us to exchange the long haul waves for
ducts, dark fiber or local access IRU’s.”
b. August 24, 2001 E-mail from Wright to Steve Sherman – Subject: “KPN/Qwest Big
Deal #s and Qwest 2rd Qtr deal.” “Susan told me Greg is ready to write a check for
75 million this quarter for capacity on SAC. What the hell are we going to buy?”
From Sherman to Wright: “Do we want to continue on a course of dollar for dollar
reciprocal deals with Qwest?”
c. September 6, 2001 Internal Global Crossing E-mail – Subject: “GAP Closing - 3rd
Q IRU Deals.” “After many discussions with the team we have identified the
following deals that, if consummated could contribute to closing the $600M gap:”
Qwest deal is among those listed. “No one on the team is suggesting that we enter
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into any of the following deals under normal operating conditions. Each of the deals
require almost a 1:1 reciprocal purchase on our behalf.....” (Emphasis supplied.)
d. June 25, 2001 Email From Wright – Addressing whether the circuits obtained in the
swap would be portable at a later date at fair market value or at the original purchase
price: “Susan [Chase of Qwest] and I agreed that Greg Casey and David would talk
sometime tomorrow and just get a gentleman’s agreement that we’d work together
to establish pricing at the purchase price....” (Emphasis supplied.)
e. Undated E-mail Response From Armstrong of Global Crossing – Responding to an
internal e-mail which stated “I thought there was a portability clause that allowed us
to move [circuits] free of charge?” Armstrong responded: “[W]hat the agreement
actually says and what we very clearly agreed with Qwest is not the same. This is
because Qwest’s strict accounting requirements demand that the buy back language
be couched in very specific language. What the agreement actually says is that we
need their consent to the buy back of the circuits and that the circuits will be bought
back at market value at the time of the repurchase (which clearly could be less than
what we paid.). So strictly under the terms of the agreement they could just refuse
to buy them back. HOWEVER what was actually agreed (and we went through this
a million times so there is no misunderstanding) was that they would allow us to sell
the circuits back to them at the price we paid and to swap them for capacity we
actually want for the same price....” (Emphasis supplied.)
f. December 3, 2001 Email From Armstrong to Qwest – “As you know when we did
this deal - and the other similar deals with Qwest where portability was involved -
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the capacity which was activated was, for Qwest’s internal reasons, that which you
were able to activate by the end of the quarter, rather than that which we actually
required. Everyone involved was clear that the only reason that this was accepted
was in reliance on Qwest’s unequivocal representation that the capacity would be
ported to the required routes after the event....”
D. ADDITIONAL EVIDENCE OF SCIENTER FROM WITNESSES AND THETRUSTEES’ RICO COMPLAINT
409. The close association of the executives at the top of the Company, and their
interactions with respect to the swap and IRU capacity transactions shows their scienter. For
example, while serving as the CEO and sole Managing Director of KPNQwest, Defendant McMaster
was in the employ of Qwest and obligated to report to Defendant Nacchio, Qwest's Chairman and
CEO. McMaster was a close associate of Nacchio, having worked for Nacchio at AT&T for many
years prior to joining Qwest.
410. During McMaster's tenure at KPNQwest, there was considerable and consistent
contact between Nacchio and McMaster, often via use of the U.S. mail and wires, with Nacchio
providing direction and McMaster serving the policies and interests of Qwest and Nacchio.
Throughout most periods from 1999 through May 2002, McMaster was in contact with Nacchio at
least weekly and at times daily.
411. Similarly, Defendant Woodruff was Nacchio's principal advisor on accounting and
financial issues. Woodruff played a principal role in working with Arthur Andersen on developing
IRU accounting criteria for Qwest, and was knowledgeable of Qwest's own (fraudulent) accounting
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practices. He provided guidance to KPNQwest on its accounting and financial reporting through his
role on the Supervisory Board, the Audit Committee to the Supervisory Board, and otherwise. [¶55].
412. In addition, numerous facts obtained from witness interviews reflect that the swap
transactions were known at all levels of KPNQwest, at both the management headquarters in
Hoofddorp and the operational headquarters in Den Haag (the Hague).
413. CW 21 relates facts concerning an August 2001 project by outside consultant Cap
Gemini Ernst & Young, which reflect that there was widespread knowledge of the swap deals inside
the Company. CW 21 relates that the Pass to Profitability project was designed to improve
KPNQwest’s financial results. The project consisted of 15 people, divided into “streams” (i.e.
different subject matter). CW 21 was one of the persons from Cap Gemini assigned to the “business
case stream,” which was required to study the current state of the Company’s finances, once the
stream team begin to ask questions about the swaps. He states that those assigned to the business
case stream were deterred and CW 21 was eventually taken off the project. According to CW 21,
the team on the business case stream immediately detected a strange revenue pattern, huge swings
in KPNQwest’s revenue each third month–in the last month of the quarter, the first two months
getting the Company half way to the target, the third month of the quarter so good as to achieve the
target. CW 21 also noted that 80% of gross margin and ½ of revenues was IRU sales, whereas the
actual core business, recurring sales, was only 3% of gross margin, almost nothing, and that there
was a huge account called “assets for sale,” which was 600 million Euros.
414. Investigating these facts by speaking to the KPNQwest finance department, the Cap
Gemini team was told that under U.S. GAAP telecom companies can treat route capacity on cable
as revenue; as long as 10% of the value is paid in cash, the 20 year sales value can be taken upfront
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as revenues. In addition, according to CW 21, the Cap Gemini people were told that the assets held
for sale were not depreciated because that was the capacity received in the swaps, and KPNQwest
was buying it but not using it.
415. The Cap Gemini team examined lists of the swaps, since each swap transaction was
recorded separately, including the identification of the routes involved. The Cap Gemini team
noticed strange transactions such as trading capacity between London and Madrid for capacity
between San Francisco and /Tokyo, and other routes outside Europe. It seemed to the team, said
CW 21, that a European carrier would not have use for capacity between San Francisco and Tokyo.
The team learned that although 10% paid in cash was booked, it went back as 10% down payment
for the IRUs received by KPNQwest in the swap.
416. CW 21 further stated that the Cap Gemini business case stream also looked to the
technical side of the company for answers. They asked Peter Smink (in charge of the network
rollout) and Dennis de Vreede (who was in charge of financing network development) about the
swaps. Smink said, snickering, that “this is how people get their bonuses.” Obviously, CW 21
explained, the bonuses were linked to the financial targets. Smink explained to CW 21 that under
U.S. GAAP, with a 10% down payment, revenue for the swap of a 20 year IRU could be recognized
upfront.
417. Tom Jacquette, vice president of Cap Gemini and head of the Pass to Profitability
project, told CW 21 and the rest of the business case stream team not to look into swaps any more.
He said that he had spoken to Jack McMaster about the revenue irregularities detected by the team
and Jack said he would take care of that himself. Jacquette explained to CW 21 and the rest of the
business case stream that KPNQwest had a “Project Crystal” which was intended to address the asset
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for sale issue, with a plan to reduce assets for sale to zero within about a year. According to CW
21, Jacquette met with McMaster every Monday to discuss the project, and McMaster was the
“client,” i.e., McMaster oversaw the project for KPNQwest. Due to his discomfort with ignoring
the swaps, which he felt was unprofessional, CW 21 was assigned to another business stream and
finally taken off the KQ project. The people on the business case from Ernst & Young (which had
acquired Cap Gemini) resigned in protest from the project.
418. CW 8 discussed with Ewoud Mogendorf that the deals were intended to reach
revenue targets. Everything that was not sold by KQ a retail level had to be made up by the
wholesale dept. selling unneeded capacity, Ewould said to CW 8 that he was afraid that at some
point he might be sued for this. Kees Boer (MBBS wholesale product manager) said to CW 8 that
the other parties to these swap deals were doing them because they faced the same problem, to make
up for projections that otherwise were unachievable. Both Ewould Mogendorf and Kees Boer
expressed to CW 8 that they were not happy doing the swap and capacity sales, and knew it was
illegal. Both indicated they were aware it was not a normal business practice.
419. CW 16 said that he, Jan van de Pebble, and the CNI project manager all asked Ray
Walsh about the swap deals and he said it was perfectly legal, that is how the financial world works
these days. Jan Louwes (head of dark fiber sales) said he was meeting with McMasters about the
swap deals and Ray Walsh said that McMasters approved of these deals every quarter.
420. CW 5, who was part of Jan Louwes’ dark fiber sales team, explained that the sales
opportunities for the large swap transactions originated at the top of the Company. The 360networks
deal originated because 360networks did business with Qwest in the U.S. to give 360networks
(which was a Canadian company) a U.S. presence. Jan Louwes, KPNQwest Vice President, told
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CW 5 about this opportunity and directed him to go to a Phoenix, Arizona trade show to meet
360networks CEO Ashwin Chitamun. CW 5 recalls that Qwest called either Jack McMasters, Rhett
Williams or Louwes to alert KPNQwest to the opportunity.
421. CW 5 states that the Flag deals originated when Rhett Williams and Ed McCormack,
the Flag COO, met to see if there was business to be done. There were rough spots in the Flag deals
where CW 5 had to set up conference calls between Rhett Williams and McCormack. CW 5 states
that Jack McMaster personally approved the 360networks deal, and Rhett Williams gave final
approval to the much smaller Flag deals. CW 5 further noted that “nothing happens without Jack
[McMaster] having a say, and that the Global Crossing transactions were not handled in his sales
department, but were mostly handled by Jack McMaster and Rhett Williams personally, with the
help of Finance Department personnel.
422. The early genesis of the scheme is reflected in the statements from CW 22, director
of wholesale sales in Germany. He recalls a meeting in the Netherlands in early 2000 when Rhett
Williams described the swaps and encouraged the sales force to enter into such transactions, calling
them “whiskey & cigar” deals. CW 22 said that Rhett Williams was very proud of these deals and
advised the sales force that these sales opportunities turned on “who you knew,” i.e. personal
contacts with the sales targets. He also recalls a meeting in Hoofddorp in March, 2000 in which
Margriet Koldijk, senior vice president, global accounts, met with the sales force. She encouraged
the sales force to target global customers with transmission needs all over the world, explaining that
once KPNQwest had such customers, it could justify swap deals to obtain capacity in Asia or South
America. She cited KPNQwest’s friendship ties with Global Crossing and Cable & Wireless, and
presented these companies respectively, as reliable partners in South America and Asia.
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423. CW 20 said the knowledge of the swaps was widespread at KPNQwest. They were
discussed at monthly middle management meetings that included platform managers from retail, IP
and wholesale (bandwidth). At these meetings, chaired by John Giblin, who was in charge of overall
network design and worked under SVP-CIO Ray Walsh. The meeting participants laughed about
the small contribution regular customers were making to KPNQwest’s bottom line, in comparison
to the swap deals. CW 20 heard several times senior management bragging about swaps they had
just completed, including Jack McMaster’s bragging during a June, 2001 sailing trip. CW 20 found
out about other swap deals from Ray Walsh, head of KPNQwest operations. CW 20 said he was
told by the wholesale sales force doing the deals that they were zero cash deals.
424. CW 15, manager of the network operations center (NOC) in the Hague, notes the
NOC team would verify that the installed capacity was valid, that it had been tested by the
implementation team and that “we saw it as a circuit” (i.e. that it was mapped on the Company’s
records). CW 15 states that each quarter a number of swap deals came through. It was noted in
discussions with the implementation team (i.e. the CNI department) that the capacity being installed
was a swap.
425. Brendan Keating “played a key role in coordinating improper accounting of IRU
transactions in his capacity as Controller and, later, Senior Vice President of Finance.” [¶48] CW
23, who was in charge of MBBS product management (wholesale bandwidth sales), noted that
Brendan Keating was his main interface with finance when getting sign-offs for business deals that
required capital, i.e. the building of capacity. CW 23 also noted that toward the end of KPNQwest’s
existence, because of KPNQwest’s cash getting tight and the cash required to build the capacity,
CFO Jeffrey von Deylen had to sign off on large capacity transactions.
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426. CW 24, who was vice president of mergers and acquisitions, states that Keating was
in charge of creating the projections for the Company that gave rise to the Company’s “guidance”
(i.e. financial prognostications) to the analyst community and the investing public. Keating knew
or was reckless in creating projections based upon the improper swaps and sales of IRU capacity to
KPNQwest’s parents, and dependant upon the improper accounting methods alleged herein.
427. CW 25, who was working in KPNQwest product management, had a close friend who
joined the KPNQwest finance team in 2001. He saw “odd things,” such as that there were equal
amounts booked in accounts payable and accounts receivable for certain customers. In particular,
there was an account payable and account receivable balance of $18 million for Cable & Wireless.
He tried to get the payment by calling Cable & Wireless and asking for the money, but payment was
refused because of the offsetting account payable. CW 25 discussed the situation with Brendan
Keating, who he reported to, and was advised “not to touch sleeping dogs.” The trustees’ RICO
complaint admits that Brendan Keating and Jeffrey von Deylen had responsibility for “netting out
IRU sales and purchases [i.e. swaps], and understanding the resultant impact of those transactions
(i.e. lack of cash flow)....” [¶103].
428. The trustees’ RICO complaint also sheds light on the scienter of defendant Willem
Ackermans. Willem Ackermans is described in the trustees’ RICO complaint as a “key KPNQwest
decision maker.” In May, 2001, Ackermans was advised by a KPNQwest employee, in an e-mail -
with the preface that this was not new news - that KPNQwest "is pushed more and more towards
IRU's (with our parents) quarter by quarter," that without IRUs, "current order intake is way too low
to make recurring revenue target for the year," and that "this trend is not sustainable." [¶186].
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429. Ackermans admits that he knows in detail of the improper accounting methods used
by KPNQwest to inflate its revenues, stating in an internal KPNQwest e-mail that “[w]e know in
detail how Qwest accounts for all these revenues and costs. We are following the same model.”
[¶111].
430. On April 12, 2001, Ackermans raised a number of his concerns in an e-mail to
KPNQwest's Chief Marketing Officer, Rhett Williams, the individual at KPNQwest in charge of all
the swap deals. Ackermans objected to the pressure he had received from Rhett Williams with
respect to the Company’s accounting methods, stating: "the only thing you have been telling me up
to now is that we at Finance do not do our work properly. We should ... change our (cost) accounting
method and overall we should be more financially innovative." Ackermans candidly observed that
KPNQwest's sales and marketing approach would not be sustainable without real cash inflow,
regardless of how the accounting was handled. "This is all about `CASH,' not about accounting
and let me tell you this, your ideas about Finance will not solve the sales problem you have." On
May 11, 2001, Ackermans sent an e-mail to Jack McMaster, stating that although the current
KPNQwest projections assumed significant cash-generating IRUs from Qwest and KPN, "KPN and
Qwest can only do swaps and because of that KQ will be cash constrained." [¶186]. Within a few
weeks of Mr. Ackermans' memorandum, he was fired or forced to resign. He was replaced on June
11, 2001, by Jeff von Deylen, who previously had been employed as Vice President and Corporate
Controller of Qwest.
431. Qwest and McMaster clearly knew that each of the swap deals were non-cash trades
of IRU capacity, rather two separate buys and sells of capacity, although the separate buys and sells
were the illusory artifice created by the deals’ artificial documentation. As noted in the trustees’
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RICO complaint, “In private communications between Defendant McMaster and Qwest, McMaster
freely acknowledged that "I do not have sufficient cash on hand" due to significant capital
expenditures and the lack of legitimate cash-based IRU transactions. By e-mail of July 29, 2001,
Qwest President Afshin Mohebbi acknowledged that "KQ needs cash just like we do, but we both
are making a significant number of non-cash wholesale [i.e., capacity] transactions." Mohebbi
further conceded that "we have not been able to do [cash transactions] in 2 years" and plans for
additional such transactions would have to be considered unrealistic. This fact was known to
Defendant Nacchio as well. Defendants therefore knew that real revenues from IRU transactions
would not be available.” [¶165].
432. Defendant Woodruff’s scienter is shown by facts revealed in a book by Om Malik
entitled Broadbandits (John Wiley & Sons Inc. 2003). The book, at p. 60, notes that Qwest altered
its accounting rules to inflate revenues through the swap deals: “Normally Qwest would sell or lease
strands of fiber on its network to other companies and account the revenues for these 20-year deals
over two decades. In an apparent attempt to cook the books, artificially inflate the revenues, and
give an appearance of success and growth, Qwest decided to start booking the revenue and cash flow
from the sale of fiber strands in one lump sum....Some managers at Qwest tried to put an end to this
practice, but they were swept aside by the then chief financial officer Robert Woodruff. These
managers approached Qwest’s audit committee but were essentially ignored.” (Emphasis supplied.)
433. Defendants’ scienter and the wrongfulness of the transactions is further demonstrated
by the fact that these were not bona fide business deals done for any operational purpose.
434. According to CW 11, former head of the Company’s engineering department,
KPNQwest did not need the capacity received in the swap deals. When KPNQwest got capacity
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from other carriers it was just stored in inventory, not connected to our network. STM-16s were
swapped for connections to the Nordics before the Nordic ring was even built. KPNQwest ended
up with useless capacity such as a Tokyo-Los Angeles circuit, useless since KPNQwest was a
European carrier. In fact, CW 11 saw that there were several Pacific circuits in the KPNQwest
inventory. He was told by Kees Boer that they came from Global Crossing. One swap involved
obtaining transatlantic capacity in AC-3 (a Global Crossing circuit), even though KPNQwest had
plenty of capacity in its TAT-14 cable. According to CW 11, he was told to implement capacity on
Global Crossing’s networks although KPNQwest had the same capacity on its network.
435. CW 20, responsible for the data services retail platform engineering and design, said
that as a result of the swap deals, KPNQwest obtained sea capacity without a landing point to bring
the capacity to anyone, e.g. capacity leading to Brazil, but no landing point in Brazil. KPNQwest
owed capacity in South America and also Asia Pacific capacity through these deals, but KPNQwest
had no customers in those regions.
436. CW 10, in charge of Global Accounts, who was involved in biweekly meetings,
alleged herein, where sales and the swaps were discussed, states that it was “generally announced,”
and so everyone knew that the swaps involved capacity that was unneeded for either side of the
deals.
437. Additional facts concerning Defendants’ scienter are reflected in allegations in the
trustees’ RICO complaint concerning Defendants’ awareness of KPNQwest’s cash shortage, and the
corresponding manipulation of cash balances to deceptively reflect heightened cash balances on the
Company’s quarterly financial statements.
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438. Defendants knew that the Company’s financial results were misrepresented and that
the swap and IRU transactions were not generating the needed cash flows for the Company. Cash
deficiencies on the balance sheet might raise questions about whether the Company’s claimed sales
and revenues were genuine. The trustees’ RICO complaint admits that “KPNQwest was left with
serious cash flow issues by the third quarter of 2000 (and perhaps earlier) that only worsened over
time.” [¶164].
439. In private communications between Defendant McMaster and Qwest, McMaster
freely acknowledged that "I do not have sufficient cash on hand" due to significant capital
expenditures and the lack of legitimate cash-based IRU transactions. By e-mail of July 29, 2001,
Qwest President Afshin Mohebbi acknowledged that "KQ needs cash just like we do, but we both
are making a significant number of non-cash wholesale [i.e., capacity] transactions." Mohebbi
further conceded that "we have not been able to do [cash transactions] in 2 years" and plans for
additional such transactions would have to be considered unrealistic. The trustee’s RICO complaint
admits that “This fact was known to Defendant Nacchio as well. Defendants therefore knew that real
revenues from IRU transactions would not be available.” [¶165]. In fact, all the Defendants herein
knew of the lack of cash transactions and the prevalence of non-cash transactions (swaps and IRU
deals).
440. The widespread knowledge of the swaps and IRU deals at the Company and their
drastic impact on KPNQwest’s cash flows is reflected in the October 17, 2001 e-mail from
KPNQwest controller Matthew Gough to company treasurer Anno Kamphuis and Corporate Risk
Manager Jos Korsen, with a cc to David Monnat (who was in the Finance department in charge of
Network costing and therefore calculated the costs of good sold to be used in accounting for the
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swap and capacity deals), Casper Keizer (KPNQwest’s man in Denver at Qwest) and CFO Jeff von
Deylen). This e-mail, reported in the trustees’ RICO complaint, suggests the inclusion of a
provision in the KPNQwest cash flow forecast to the effect that ‘[a]ll KPN and Qwest IRU’s should
NOT be swaps, but rather cash deals.” [¶166].
441. Therefore Defendants manipulated the Company’s cash balances at the end of each
quarter so that KPNQwest could report more cash than it actually had as a result of its bona fide
business operations. The trustees’ RICO complaint admits that “[s]imultaneously, while knowing
that KPNQwest was suffering huge shortages in cash flow, Defendants nevertheless caused
KPNQwest's books to be manipulated in such a way that the appearance of available cash at the end
of each quarter suddenly ‘spiked.’” [¶167].
442. “In quarter after quarter, substantial cash reserves were suddenly made to materialize,
solely to beef up quarterly financial results.” [¶168]. “For example, on March 30, 2001, KPNQwest
received a ‘loan’ from Qwest. Ostensibly, the payment, in the amount of more than $56 million, was
to relieve KPNQwest's earlier IRU obligation to 360networks. In reality, however, it was merely a
device to prop up KPNQwest's reportable cash on hand in its first quarter financial report. On April
2, 2001, the loan was repaid to Qwest, thereby eliminating more than $56 million of the cash that
had supposedly been on hand two days earlier.” [¶169].
E. FACTS AND CIRCUMSTANCES DEMONSTRATING DEFENDANTS’SCIENTER CONCERNING THE IMPROPRIETY OF KPNQWEST’SACCOUNTING FOR THE SWAP AND CAPACITY TRANSACTIONS
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443. The facts alleged above in this complaint evidence scienter in various ways, including
the numerous facts showing that the swap and capacity transactions did not have a business purpose,
but were only intended to meet the financial expectations of the Wall Street analyst community
concerning KPNQwest, expectations that were created by the falsely inflated KPNQwest financial
results, and the Company’s own projections. The trustees’ RICO complaint admits that “At the heart
of this process was Defendants’ continuing insistence that KPNQwest meet its quarterly budget
projections at all costs. Defendant Nacchio, for example, repeatedly communicated to Defendant
McMaster that KPNQwest employees must do whatever it takes to meet their quarterly ‘numbers.’
McMaster regularly reiterated this instruction to his management team. Indeed, an internal
KPNQwest presentation entitled ‘Revenue Recognition’ expressly states that the first of three issues
of ‘Importance’ regarding revenue recognition on IRU transactions was ‘Revenue targets.’” [¶117].
444. In view of the overriding importance of meeting the targets, Defendants knowingly
or recklessly ignored and/or violated relevant GAAP principles and Arthur Anderson’s interpretation
(however faulty) of the revenue recognition rules with respect to IRU transactions. Defendants also
ignored the SEC’s and Arthur Anderson’s frequently-expressed concerns and warnings about
KPNQwest’s accounting methodology for the IRU transactions.
445. As to the SEC warnings, as alleged above, defendant McMaster was personally
contacted by the SEC concerning the agency’s criticism of dark fiber IRU accounting practices
utilized by the Company. By no later than November, 1999, Qwest became aware that the SEC
tentatively had reached a view that an IRU of “lit” fiber (i.e., a capacity IRU) was not a sales type
lease and, therefore, that up-front recognition of the ‘revenue from such transactions would not be
appropriate. [¶79] Also, in a November 15-16, 1999 Global Capacity Providers CFO Roundtable,
31This is described in the White Paper Update.
32For example, a Form 8-K filed by Asia Global Crossing in January, 2003, notes that withrespect to IRU transactions, “The Company had relied on guidance provided by [Arthur] Andersenand on [sic] industry white paper provided by Andersen that set forth principles for accounting forsales and exchanges of telecommunications capacity and services.”
33The update is not self-contained but instead is in the form of an addendum to the WhitePaper, following its outline and titles and adding to specific sections of the White Paper. In statesthat “This Paper is an update to the White Paper “Accounting by Providers of TelecommunicationsNetwork Capacity” prepared by Arthur Andersen and dated September 30 1999. It should be readin conjunction with the original paper.”
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Eric Casey of the SEC discussed the SEC staff’s issues regarding IRUs.31 Plaintiffs are informed
and believe, that Dan J. Cohrs, CFO of Global Crossing from 1998 to 2003, Robert Woodruff, the
CFO of Qwest and a member of the Supervisory Board of KPNQwest, as representatives of leading
global telecommunications providers listed on U.S. securities exchanges, were present at that
meeting.
446. The warnings from Arthur Andersen begin with the White Paper. Arthur Andersen
widely distributed its White Paper on telecommunications transactions. It was described in a
December 23, 2003 Wall Street Journal article as a “must-read in the telecom world.” Arthur
Andersen distributed the White Paper to its clients such as Qwest and KPNQwest32. Also, the
trustees’ RICO Complaint admits that KPNQwest obtained a copy of the White Paper Update, which
means they must have obtained the White Paper itself, since the update is not self-contained but is
intended to be read with its predecessor.33
447. The White Paper itself noted the accounting issues raised by applying FIN 43 to IRU
transactions, such as whether IRUs should be considered sale of services. The White Paper also
34Initially Global Crossing ceased up-front revenue accrual only on IRU sales of terrestrialfiber, but continued to accrue such revenues from sales of sea cable fiber, on the ground that therewas no title available to the seabed, so the title transfer requirement hadn’t been violated. Soonthereafter, however, Global Crossing began to treat all IRU sales as service revenue. See In reGlobal Crossing, Ltd. Securities Litigation, 322 F.Supp.2d 319 (S.D.N.Y. 2004) (”Following theissuance of FIN 43, GC changed its accounting to come into compliance with its requirements,although AGC [Asia Global Crossing] continued to book revenue for leases of subsea (as opposedo terrestrial cable as immediate revenue until mid-2000.”) (No point citation, since publication pagesnot available).
35Level 3's 2001 10-K disclosed, in footnote 1 to its financial statements, that “Revenue forcommunications services, including private line, wavelengths, colocation, Internet access, managedmodem and dark fiber revenue from contracts entered into after June 30, 1999 [the date of FIN 43],is recognized monthly as the services are provided.”
36See Global Crossing’s 1999 10-K/A at F-11.
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reflected that FASB disagreed with a crucial portion of its analysis, i.e. whether sales-lease type
treatment is permissible when the IRU provider is not the owner of the underlying land.
448. Moreover, not only was up-front revenue recognition from IRU sales a minority
position, but not all of Arthur Andersen’s clients even used that methodology. Specifically Global
Crossing, another major Arthur Andersen telecom provider, which specialized in sales of lit fiber,
ceased to take up-front revenue from its IRU sales after issuance of FIN 43.34 The same is true of
Level 3 Communications Inc., another Arthur Andersen client.35 Instead, Global Crossing
recognized IRU sales as sales of services, provided ratably over time.36 Since Defendants were well
aware of the issue of IRU accounting, and Arthur Andersen’s clients did not all accrue up-front
revenue, Plaintiffs believe Defendants did not blindly follow Arthur Andersen’s advice on the issue.
Rather, Defendants were presented by Arthur Andersen with a choice of how they wished to book
the IRU sales, and Defendants chose the misleading methodology.
37A Wall Street Journal article of October 3, 2002, entitled “Arthur Andersen Warned QwestOn Risks of Swap Transactions,” confirmed that Arthur Andersen warned Qwest at the October 4,2000 Qwest audit committee meeting.
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449. The February 29, 2000 White Paper Update was provided to KPNQwest according
to the trustees’ RICO complaint [¶80]. There was a general awareness at Qwest and KPNQwest
of the White Paper Update. The aforementioned December 23, 2002 Wall Street Journal article
notes an e-mail from a member of Qwest’s audit committee that jokingly refers to an update of the
Andersen White Paper as “a sedative.” The White Paper Update contains additional warnings.
450. The White Paper Update refers to SEC and FASB disagreements on critical issues.
For example, the Update states: “In January, 2000 Arthur Andersen became aware that the SEC
staff tentatively had reached the view that an IRU of lit fiber (lit fiber is the provision of fiber, plus
associated opto-electronics, between two points) is likely not a lease and that therefore up-front
revenue recognition is not appropriate.” The Update also notes that the FASB and SEC disagreed
with the Arthur Andersen position that revenue could be accrued up-front revenue for “sale” of lit
IRUs, where the IRU capacity provider does not own the underlying land itself.
451. Further warnings were conveyed by Andersen to Qwest at an October 4, 2000
presentation to the Qwest audit committee37. Documents produced by Qwest to Congress pursuant
to subpoena (as attached to the aforementioned Congressional hearings transcript) include an outline
of a presentation by Qwest’s auditors from Arthur Andersen at the October 4, 2000 Qwest Audit
committee meeting. This states as follows:
“Indefeasible Rights of Use (IRUs)
- Up-front revenuerecognition
SEC vigorously challenging salestreatment
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- Non-monetary exchanges Fair value accounting fromswapping IRUs for other assets orservices may be viewed as not theculmination of the earningsprocess.”
Referring to the aforementioned memo, PeterHellman, the Chairman of Qwest’s audit committeetestified before Congress as follows:
Q: “And in that [October 4, 2000] memo that Arthur Andersenpresented, they talked to you about these IRUs and about the SECinvestigating them, that you didn’t –SEC emphasis on no futurebenefit to the company and no future revenue generation from theactivity. SEC vigorously challenging sales treatment. So you wereaware of these problems clear back in 2000, right?
Hellman: “I was at the time. I don’t recall this meeting but clearly theIRUs were addressed at almost every meeting of the audit committee.And we met 35 times.
Q: And was Mr. Nacchio present at those meetings?
A: As a common practice, no.
Q: Okay. Do you know if Mr. Nacchio was aware of the concernsabout the IRUs?
A: He would have been, in that the audit committee reported back tothe full board, and he was a member of the full board. So, clearly,from the audit committee standpoint, he would have been aware ofthose concerns....
Q: And what specifically were the concerns of the auditcommittee...about the IRUs?
A: The concerns of the IRU is it is an extremely complextransaction, and it has to be appropriately applied to the specifictransaction the company is entering into....
Q: And it has to have a business purpose.
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452. The KPNQwest trustees’ RICO complaint admits that this meeting demonstrates
Defendants’ scienter. The RICO complaint alleges that by no later than October 2000, Defendants
knew that the "SEC continues to vigorously challenge sales treatment" for capacity IRUs and that
Arthur Andersen "expect[s] the SEC to ultimately disallow up front revenue recognition" for such
agreements. [¶82]
453. The RICO complaint further alleges that Arthur Anderson emphasized its concerns
to Qwest's Audit Committee at an October 4, 2000 meeting, expressly informing the committee that
Qwest's "aggressive" IRU accounting practices were problematic. Defendant Woodruff was aware
of Qwest's problematic accounting through his discussions with Arthur Andersen and/or in his
capacity as Qwest's Chief Financial Officer. Defendant Nacchio was made aware of Qwest's
problematic accounting practices through his position on Qwest's Board, to which the Audit
Committee directly reported. [¶83]
454. Arthur Anderson itself concluded that Defendants were being reckless with respect
to the IRU transactions. As stated in a 2001 Arthur Anderson memorandum: “During FY 2000 a
material part of [KPNQwest's] total revenues were generated with "Indefeasible Rights of Use" sales
(IRU sales). Given the increasing complexity of customer contracts and the evolving US GAAP
interpretations, KPNQwest runs the risk that, without full consideration of all aspects of the different
sales contracts, revenues are not recognizable on an up-front basis, but should be deferred and
released to revenues over the term of the lease contract. U.S. GAAP regulations and FASB
interpretations are not fully known throughout all of the relevant parts of the organization.” [¶108].
455. KPNQwest’s finance department staff, reporting to CFO von Deylen, knew that the
Company’s accounting for IRUs was improper and therefore potentially “sensitive.” As
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KPNQwest's Matthew Gough (controller) advised in a September 9, 2001 e-mail to KPNQwest's
David Monnat (of the finance department in charge of determining costs of goods sold in the swap
and other transactions), who had raised an issue regarding cost accounting for IRU transactions:
"[Y]ou should call me directly when you have a sensitive topic that involves my reporting. Do not
e-mail several people, do not call other people first, do not set meetings prior to discussing with me
... I see emails floating around which could impact OUR future careers." [¶187].
456. Defendants’ scienter is also demonstrated by the fact that they knew the capacity and
swap transactions violated Arthur Anderson’s rules for up-front revenue recognition. And knowing
these criteria were not met, they artificially constructed the transactions to falsely appear to meet
these criteria. The Arthur Anderson criteria permitted up-front revenue recognition for the IRU
transactions only under the following conditions:
a. the IRU contract must be the final understanding between the parties;
b. there must be a transfer of title to the underlying assets;
c. at the time of sale, there can be no contemplated "buy back" or reciprocal
arrangement, and no contemplated substitution of assets;
d. the capacity must be reserved to a specific fiber and a specific amount of capacity;
e. 25% of the cash has been received without any reciprocal cash payments made or
contemplated to the customer;
f. the customer is obligated to pay for "O-M" (operation and maintenance);
g. the selling party cannot have any continuing involvement in the capacity sold (i.e.,
the risks and rewards of ownership must pass); and
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h. the circuits in question must prior to the time of the transaction have been held for
sale (rather than "held for swap") and thus intended for cash sale, at least in most
cases. [¶84]
457. Defendants repeatedly and knowingly violated even these relaxed rules set forth in
the White Paper, treating IRU transactions as "sales-type" leases even though it did not define the
capacity it was granting with any specificity, purchased and sold capacity that was not needed (often
in contemplation of a "buy back" or substitution arrangement), engaged in an improper reciprocal
arrangement or "swap" that did not generate revenue. [¶85]
458. Moreover, Defendants, knowledgeable about the nature of IRUs and the market for
IRUs, knew that Arthur Anderson’s accounting criteria were not technically feasible and/or
acceptable in the market. The trustees’ RICO complaint admits that “Qwest knew” a number of the
conditions for revenue recognition set forth in the White Paper “were not technically feasible and/or
acceptable in the market.” For example, the Arthur Anderson White Paper provided that "not only
must there be a provision providing for transfer [of] an undivided interest in the cable at the end of
the IRU but also it must give the purchaser a right in perpetuity for the particular wave length/circuit
it had under the IRU ....[T]itle to that specific asset has to be transferred." Defendants knew,
however, that in any telecommunication network, the capacity being sold could not be associated
exclusively with a particular wave length circuit on a particular route, but inevitably would, from
time to time, be transmitted over various circuits and/or routes. Accordingly, for this and other
reasons, capacity IRUs could not be treated as sales type leases under the White Paper criteria or the
SEC's announced position. [¶81]
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459. Defendants knew and understood that IRUs could not be treated as "sales-type" leases
(for which revenue could be recognized up-front) unless title to the assets passed to the purchaser.
As Defendants also knew or should have known, however, the laws of European countries generally
did not recognize a right to pass "title" in capacity. [¶112]
460. In particular, with respect to the TAT-14 sea cable under the Atlantic, because it was
jointly owned by a consortium of companies including KPNQwest, Defendants knew that no legal
title could be conveyed by KPNQwest. In a series of e-mails and telephone conversations
transmitted over the wires between Qwest personnel in the United States and KPNQwest personnel
in Europe during July and August 2001, Qwest personnel (including William Heil, Russell
Nordstrom, and others) represented to various KPNQwest personnel (including Jan Louwes,
Bernard-Jan van Maanen, Graham King, and others) that both Qwest and KPNQwest could
recognize up-front revenue on IRU capacity sales in the so-called "TAT-14" cable, which was
jointly owned by a consortium of several companies that included KPNQwest. In response to a
proposed three-way IRU capacity transaction in which KPNQwest would sell capacity to Qwest,
who would then sell it to AOL, KPNQwest had raised a concern that (due to the consortium
ownership structure) KPNQwest could not transfer legal title to the capacity to Qwest and, therefore,
neither KPNQwest nor Qwest could recognize upfront revenues on their respective capacity IRU
sales. However, because Qwest wanted to recognize the revenue immediately, the above-referenced
Qwest personnel represented that up-front revenue recognition was appropriate (when it was not).
All the parties involved were well-aware of the issue, however, and since it was the nature of
KPNQwest’s own asset which was at issue, no one at KPNQwest had the right to rely on any
representation from Qwest. [110.e]
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461. Knowing that the IRU transactions did not meet Arthur Anderson’s criteria,
Defendants artificially shaped the deals to create the false impression that their auditor’s instructions
were being followed. The Trustees’ complaint alleges that Defendants McMaster, Nacchio,
Woodruff and Qwest explained to KPNQwest that in order to ensure proper IRU accounting
treatment, all purchases had to be separated from counter-purchases, not only in terms of separate
documents but also in terms of separate personnel and organizations that would negotiate the
arrangements. Accordingly, Defendants purposefully organized KPNQwest so that the organization
within KPNQwest that was responsible for IRU sales, headed up by Rhett Williams, was separated
in appearance from IRU purchases, which were directed to finance and network personnel, including
Brendan Keating. In practice, however, as alleged herein, the purchase and sale side of the swap
were treated as parts of a single transaction, as was known to those who initiated, negotiated, and
implemented these deals at KPNQwest. [¶102].
462. By e-mail of December 18, 2000, as part of a "battleplan" to "turn around things very
quickly" through a multi-party swap transaction between Qwest, KPNQwest, and Cable & Wireless,
Jan Schreuder directed various Qwest and KPNQwest employees to prepare a "swap document for
KPNQwest to deliver to Qwest and for Qwest to deliver capacity to KPNQwest," representing that
"for revenue recognition" it was appropriate (and necessary) to prepare "a line like '25% of the
upfront to be paid on contract date' in all contracts," when - even with the inclusion of such language
- revenue recognition was not proper in those circumstances.
463. In that same e-mail, Schreuder represented to KPNQwest's Rene Zaal that Qwest's
swap proposal could (and should) be broken down to appear as if each individual component were
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an isolated revenue event. In Schreuder's words, Zaal was to apportion the transaction "in nice
baskets ... to create any number on which people [can agree]."
464. Jan Schreuder was formally on the Qwest payroll [as alleged in the trustees’
complaint referring to “Qwest’s Jan Schreuder], and stationed in Denver. However, he was actually
a Dutch national who moved from KPN to KPNQwest, and was one of a group sent by KPNQwest
to work for the Company at Qwest in Denver.
465. In particular, Arthur Andersen’s rules for up-front revenue recognition for IRU sales
required that a specific wavelength or other unit of transmission capacity be identified on a specific
route as the subject matter of the sale, thereby connoting ownership, and thus potentially amenable
to sales-type lease treatment. But, as alleged above, Defendants knowingly flouted this and other
Andersen criteria by use of side letters which, inter alia, allowed buyers of the IRUs to trade them
in for other circuits. The use of side letters was to hide the deal terms embodied therein from Arthur
Andersen. For example, Erin Wray of the KPNQwest Finance Department noted in an April 3,
2001 e-mail to various KPNQwest personnel regarding a side letter for a particular proposed IRU
agreement, PricewaterhouseCoopers ("PwC") - KPN's auditor - had engaged in a review of Arthur
Andersen's KPNQwest files and "[i]f PwC is aware of the side letter, there is a good chance that they
will bring forward this information to Arthur Andersen. I wouldn't go there!" [¶182].
466. As reflected in the referenced and attached e-mails, the practice of KPNQwest’s use
of side letters was a product of Qwest’s identical practice with the identical purpose of hiding the
real structure of swap deals from Arthur Andersen, which also functioned as Qwest’s outside
auditor. As Congressman Deutsch observed at the Congressional Hearings of September 24, 2002,
Qwest's accountants were never shown the full picture of its accounting practices either and, if the
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accountants had known of Qwest's numerous IRU "side agreements," for example, it would have
"completely changed the accounting and reduced Qwest's revenue by hundreds of millions of
dollars." [¶183].
467. A book by Om Malik entitled Broadbandits (John Wiley & Sons Inc. 2003), at p. 60,
notes that Qwest altered its accounting rules to inflate revenues through the swap deals:
Normally Qwest would sell or lease strands of fiber on its network toother companies and account the revenues for these 20-year dealsover two decades. In an apparent attempt to cook the books,artificially inflate the revenues, and give an appearance of successand growth, Qwest decided to start booking the revenue and cashflow from the sale of fiber strands in one lump sum....Some managersat Qwest tried to put an end to this practice, but they were sweptaside by the then chief financial officer Robert Woodruff. Thesemanagers approached Qwest’s audit committee but were essentiallyignored. (Emphasis supplied.)
468. Because Qwest acted as KPNQwest’s agent in the swap transactions with Global
Crossing alleged herein and three of Qwest’s senior executives with knowledge of the likely
impropriety of IRU lease accrual in the initial quarter served as member of the Company’s
Supervisory Board-- including then-CFO Woodruff – Qwest’s knowledge of the dubious nature of
the swap accounting methodology is attributed to KPNQwest.
KPN, QWEST, AND KPNQWEST HAD MOTIVATION AND OPPORTUNITY TOCOMMIT FRAUD BECAUSE OF THEIR TRANSACTIONAL AND FINANCIAL
REQUIREMENTS, AND THE RESULTING IMPACT OF QWEST’S STOCK PRICE ON THEIR BUSINESSES
A. Motivation on KPN and Qwest and Defendants Related to Those Parties at theTime of the KPNQwest IPO
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469. From the time of the KPNQwest IPO, parent companies KPN, Qwest and their
progeny company KPNQwest had a unity of interest in cashing in on the Wall Street boom in
telecommunications stocks. The boom was near its peak at the time of the IPO.
470. Qwest was motivated to inflate the price of KPNQwest stock at the time of the
KPNQwest IPO and thereafter because KPNQwest stock’s valuation had a material impact on the
market value of Qwest stock. Qwest was using its own stock, at the time of the KPNQwest IPO to
effectuate Qwest’s merger with US West. Qwest was using its own stock to merge with US West.
471. On June 21, 1999, Qwest filed a Registration Statement with the SEC for the
registration of approximately 898 million Qwest shares to be used as consideration for the US West
merger. On July 18, 1999, Qwest entered into an Agreement and Plan of Merger (“Merger
Agreement”) for merger of Qwest and US West. The consideration for the merger was Qwest stock.
As disclosed in Qwest’s July 18, 1999 press release, under the Merger Agreement each share of US
West stock was to be exchanged for an amount of Qwest stock valued at $69 per share. If Qwest
stock fell below $38.70 in the trading days immediately prior to the merger closing, Qwest would
satisfy the difference with cash. The merger could be terminated by US West if the price of Qwest
stock fell below $22.
472. In addition, according to the trustees’ RICO complaint, the deal was contingent on
maintaining the average trading price of Qwest’s shares in a specified range from the time of the
Merger Agreement through closing of the transaction. If the average was not maintained, additional
cash consideration would have been required to close the deal. [¶67].
473. On July 19, 1999, the day after the Merger Agreement was signed, Qwest’s stock
closed at below $34 per share, and on August 12, 1999, the price had dipped to approximately $26
38Unisource corporation was jointly owned by the “Ma Bells” of Switzerland (Swisscom),Sweden (Telia) and Netherlands (KPN). Prior to 1999, KPN delivered international services to itsclients through AUCS (a consortium of AT&T and Unisource). According to CW 9, KPN studiedalternate business plans for placing its international clients with either Unisource or KPNQwest inlate 1998, early 1999. KPN decided to go with KPNQwest and abandon Unisource.
39Infonet was jointly owned in roughly equal shares by KPN, Swisscom, Telia, Telestra(Australia), Telefonica (Spain) and KDD (Japan). The Infonet IPO’s main value proposition wasInfonet’s acquisition of Unisource customers from KPN, Swisscom and Telia. Infonet’s telecomowners sold many shares in the Infonet IPO. KPN sold approximately 1.4 million Infonet sharesat the IPO price of $21 per share, and reported a profit of €23 million..
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per share. In order to raise its stock price, Qwest engaged in its scheme of falsely reporting IRU
sales, directly and through KPNQwest.
474. By June 27, 2000, Qwest’s stock was trading above $50 per share. On June 30, 2000,
Qwest announced the closing of its merger with US West. Because of the inflated market price of
the Qwest shares used as consideration for the merger, Qwest could minimize the dilution of its
stock and avoid the use of cash consideration in the merger transaction.
475. The vote on the Qwest-US West merger was apparently timed to take advantage of
the excitement about the KPNQwest IPO. On November 2, 1999, exactly one week before the
KPNQwest offering, the US West shareholders voted to approve the merger.
476. KPN was also well aware of the Wall Street telecom boom and eager to cash in. KPN
benefitted from two parallel offerings–KPNQwest and Infonet–taking place only one month apart.
By moving its international clients from AT&T Unisource (AUCS) to KPNQwest, selling its
interest in Unisource to Infonet (which KPN co-owned)38, and selling Infonet stock in that
Company’s IPO only one month after the KPNQwest IPO39, KPN cashed in on the boom, at its peak,
twice–once in November, 1999 and once in December, 1999.
40See Securities and Exchange Commission v. Citigroup Global Markets Inc., f/k/a SalomonSmith Barney Inc., filed on or about April 28, 2003 in the U.S. District Court, Southern District ofNew York.
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477. KPN, Qwest and KPNQwest’s joint interest in the stock market telecom boom
coalesced in their attempts to curry favor with the analysts community. For example the SEC has
alleged in a complaint filed against Salomon Smith Barney (“SSB”)40 that SSB managed the “family
and friends” program of the KPNQwest offering, which held back some of the IPO shares for
designated individuals. Several days after the offering, Willem Ackermans (who came from KPN
to KPNQwest) contacted SSB, advised them that 20,000 shares were left over from the “friends and
family” program, and asked if they would like to allocate the shares to their clients. SSB then
allocated the shares to a single favored customer at the IPO price.
478. Conversely according to the same SEC complaint, SSB allocated its friends and
family shares in numerous IPOs to the officers of its customers such as Qwest. For example, the
former Executive vice president of Qwest was allocated shares in more than one-third of the SSB
IPOs from May, 1998 through September 2000, and the president of Qwest, defendant Nacchio,
received shares in half of the SSB IPOs from June 1999 through September 2000. The SEC alleges
that Qwest executives personally garnered over $10 million in profits from IPO shares allocated to
them from SSB from 1/96 through 12/01.
479. During this KPNQwest IPO period, SBB issued analyst reports concerning Qwest,
KPN and KPNQwest which were conspicuous because of their generous use of superlatives, but also
because they were more positive than prior reports. SSB’s October 27, 1999 report on Qwest noted
“a breakout quarter in communications services;” SSB’s December 7, 1999 report on KPN was a
reinitiation of coverage which had a positive view, contrary to a report in September which had
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labeled KPN a “broadband loser.” SSB’s December 14, 1999 report on KPNQwest called the
Company “the pre-eminent internet network play in Europe.”
B. Motivation of KPN and Qwest and Defendants Related to Those Parties in thePeriod Subsequent to the KPNQwest IPO
480. Both Qwest and KPN were highly motivated in the period after the IPO to inflate the
value of KPNQwest stock. The trustees’ RICO complaint alleges, as to Qwest, that by acquiring US
West and otherwise, Qwest had taken on enormous debt, exceeding $25 billion. This staggering debt
imposed significant capital and financing burdens on Qwest, which required Qwest almost
continuously to seek or draw down funds from various loans or debt offerings. On information and
belief, these financing arrangements were subject to significant covenants and constraints that
required Qwest to achieve or maintain certain financial performance measures. [¶68].
481. In addition, Qwest needed to maintain its strong financial appearance in order to
obtain financing necessary to complete its own network and pay for other capital projects. In the
existing telecommunications climate, where many of Qwest's competitors were struggling
financially and, in some instances, declaring bankruptcy, Qwest needed to appear financially strong
in order to obtain access to funds. As Qwest's former CFO Robin Szeliga later admitted in
Congressional Hearings on September 24, 2002, the competitive landscape, along with the added
pressure of the U.S. West merger, "made it extremely difficult and there was certainly a heightened
sense of pressure for everyone in the company ... to keep" making the quarterly numbers that Wall
Street had come to expect. [¶69].
482. Moreover, Qwest’s stake in KPNQwest was valued at $7.4 billion as of the date of
the Qwest-US West merger, and stated at that value on the balance sheet of the merged company
41See In re Qwest Communications International, Inc. Securities Litigation, Case No. 01-$B-1541 (CBS), D. Colorado.
42See Order concerning Defendants’ Motions to Dismiss, filed in In re QwestCommunications International, Inc. Securities Litigation on January 13, 2004 at 18.
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as is required under the relevant merger accounting rules. Any impairment of that asset would
materially impact on the disclosed value of Qwest’s assets and the company’s market price. As
stated in a Morgan Stanley Dean Witter analyst’s report of June 20, 2001, which anticipated such
a write-down: “We believe it is likely that Qwest will need to take a substantial write down to the
value of its 44.5% investment in KPNQwest...The company currently has its stake valued at $7.4
billion on its balance sheet based on the market value when the deal closed at 6/30/00....The
expected write down of the KPNQwest stake would substantially reduce the disclosed tangible assets
of Qwest. We believe the market clearly understands the diminution in value of the KPNQwest
stake, but the scale of the write-down and the impact on balance sheet ratios could still be
significant.”
483. Qwest’s motivation to keep the stated value of its KPNQwest investment from being
impaired by lagging KPNQwest revenues is confirmed by Qwest’s misrepresentation of the value
of its KPNQwest investment. Even when Qwest finally did write down the asset, rather than write
down the investment by $5.4 billion, to adjust the book value to reflect market value, the valuation
change was a more modest $3 billion – resulting in Qwest’s continued overvaluation of
KPNQwest’s shares during the remainder of the Class Period. In the securities class action against
Qwest.41 the Denver court upheld a claim that Qwest falsely failed to write down the KPNQwest
investment when it knew the impairment was not temporary.42 Qwest also manipulated the initial
43Although the market value of Qwest’s investment in KPNQwest was $7.9 billion as of6/30/00, and its stated value was $7.4 billion at that time, Qwest later claimed in a 6/20/01 Form 8-K, that the value as of 6/30/00 was only $4.8 billion. As pointed out in the complaint in the Denvercase, the 6/20 announcement was merely a way to avoid taking a loss from a write down, since itis obvious that investments are not impaired down to $4.8 billion at a time when the market valuesthem at $7.9 billion. See Fifth Consolidated Amended Class Action Complaint in the QwestSecurities Litigation, at ¶136-¶144.
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value of the investment, to avoid the hit from a full-fledged write-down.43 If Qwest was sufficiently
motivated to commit multiple frauds in order to boost the stated value of the KPNQwest on Qwest’s
books and records, Qwest had at least as much motivation to artificially boost KPNQwest’s revenues
to support that same stated value.
484. KPN was equally motivated, because its expansionist business strategy had resulted
in ballooning indebtedness for the company. In February, 2000, KPN (through its subsidiary KPN
Mobile) acquired from Bell South a 77.49% interest in E-Plus, Germany’s third largest mobile
telecommunications operator. Although the consideration paid for E-Plus included cash (€9.1
billion) and assumption of a shareholder loan (€1.4 billion), it also included a significant equity
component. On December 9, 1999, KPN issued a warrant to BellSouth for approximately 95.7
million KPN shares to be newly issued on December 31, 2000. According to KPN’s 2000 annual
report, the value of the warrant was set at €2.3 billion, based on the price of KPN’s shares on
February 24, 2000. BellSouth was also given the right to exchange its 22.51% interest in E-Plus for
KPN or KPN Mobile shares. The exchange right was valued at €7.6 billion, according to KPN’s
2000 annual report. KPN therefore had an interest in increasing the price of its shares, through an
increased market price for KPNQwest stock, in order to indue BellSouth to accept the equity
component of the consideration for E-Plus, and to minimize interest rates on its debt.
44According to the Solomon Smith Barney report, “Approximately 38% of the estimatedequity value [of KPN] is due to KPN’s international investments, the largest of which are:KPNQwest (Eur. 7.2 bn or Eur 15/KPN share), EIRcom (Cur 1.9 bn), Infonet (Eur. 1.8 bn) SPT(Euro 0.93 m), KPN Orange (Eur. 0.73m) and Pannon (Eur 0.44m.” KPNQwest thus comprised 7.2billion of 13 billion (55%) of the total 38% equity for KPN’s international investments.
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485. In total, KPN’s indebtedness increased from €4.6 billion to €21.9 billion during 2000,
as a result of the E-Plus transaction plus the acquisition of European Universal Mobile
Telecommunications Systems (“UMTS”) licenses in the Netherlands, Germany, Belgium and the
U.K., plus investments of €3.8 billion in property, plant and equipment. On November 22, 2000,
KPN issued over 236.5 million shares to private investors in the Netherlands, Germany, Italy, Spain
and the United States and to institutional investors worldwide, raising over €4 billion to address
KPN’s indebtedness. In addition, on November 24, 2000, KPN issued a subordinated convertible
bond loan of €1.5 billion. In the September 2000 through February, 2001 period, Standard & Poor’s
and Moody’s downgraded KPN’s bond ratings and credit ratings. KPN had an interest in keeping
its share price high to maximize the returns of its offering and to prevent further deterioration in its
credit rating and thereby minimize interest expense from its debt.
486. KPN advised shareholders in its 2001 annual report that during 2001 its “primary
focus was the reduction of our net debt and the strengthening of our financial position.” Thus, KPN
secured a € 2.5 billion credit facility in Q3 2001, and raised € 4.8 billion in a December 12, 2001
public offering. This demonstrates KPN’s continuing incentive to inflate its stock price.
487. Inflation of KPNQwest shares was integral to KPN’s efforts to keep its stock price
as high as possible. According to the Solomon Smith Barney report on KPN dated December 7,
1999, KPNQwest alone accounted for 21% of KPN’s equity value44. KPNQwest’s reported income
went straight to KPN’s bottom line, since KPNQwest’s financial results were proportionately
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consolidated into KPN’s financial statements (as noted in the statement of Consolidation Principles
in KPN’s 2000 financial statements).
C. Motivation of KPNQwest to Continue and Expand the Scheme
488. As part of the overall scheme, with the intent of motivating KPNQwest employees
to carry out the scheme, Defendants instituted a systems of bonus pay and stock options which was
tied to revenue targets given by Defendants to the financial analyst community. Defendants made
sure that everyone working at KPNQwest knew that bonuses and the value of stock options were
tied to KPNQwest’s stock price and whether analysts looked favorably upon the Company. For
example, after KPNQwest’s first quarter 2001 results were announced, Jack McMaster gave a
lengthy speech to KPNQwest’s employees (as saved on the KPNQwest internal intranet web site)
which stated, in pertinent part, as follows:
I come to you today with good news because I can report today that the supervisoryboard of KPNQwest has approved the bonus pay out from the first quarter at 112%for the corporate portion of your bonuses. ...In the first quarter, the performance wehad on revenue but particularly on EBITDA was significant enough so that we morethan met the Street’s expectations. And if you actually looked at what the analystcommunity said, they were remarkably surprised at us delivering $20 million ofnegative EBITDA against their expectations of $30 million negative. And moreimportantly improving the margin on EBITDA from -$23% to -12%....And so I’mhere to tell you that the board is paying attention and that in addition to cash in yourpockets and in my pocket, at the 112% level, that if we continue to perform onrevenue, cost of goods sold and sales and general administrative expenses, we willcontinue to drive cash bonuses that are above the budgets that the board hasestablished. But just as importantly, the people in Wall Street and the City ofLondon analyst community are looking very hard right now at KPNQwest, and arepositively surprised by what it is we have been able to do. And of course, thatimpacts our share price, the share price to which we all have our options pegged. So,it’s actually a double opportunity for KPNQwest employees to help the company andhelp themselves by increasing their short term cash bonuses, by increasing ourEBITDA, and by increasing our EBITDA, to increase the value of KPNQwest sharesand increase the value of stock options that we all own. I hope that you take the time
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to reflect today as you think about this, about what you can continue to do to help upachieve greater levels of revenue growth and EBITDA....
489. Since the IRU transactions, in particular the swaps, were not generating any cash,
KPNQwest was in a much more severe cash flow crisis than investors were aware of. As admitted
in the trustees’ RICO complaint, “KPNQwest was directed to reflect on its own books "sales" of
capacity that in fact were without substance and, therefore, could not generate the net cash payments
that KPNQwest desperately needed to sustain its business.” [¶12] As a result of cash required for
the network build-out, “KPNQwest was left with serious cash flow issues by the third quarter of
2000 (and perhaps earlier) that only worsened over time.” [¶164]. The trustees’ RICO complaint
admits that by May 2001 “KPNQwest was in a desperate cash position” and had to delay payment
of certain fees owed to Qwest. [¶146].
490. The crisis resulted in significant layoffs. The head of engineering said his staff of
engineers was reduced from 100 to 50 during 2001. Jan Quellhorst, who was hired to set up the
DSL project and subsequently working on network design, said he left the Company in November
or December, 2001 with a layoff of 80 persons. He was told the Company was in financial trouble
and the layoffs were necessary to save the Company. CW 20 said that KPNQwest stopped paying
key vendors because of its cash shortage. He learned from the Nortel people at the weekly meetings
with them about installation, that the bills hadn’t been paid for six months (or one year before the
bankruptcy) He spoke to people in the Finance Department and Ray Walsh, who confirmed the non-
payment. He found out that electric companies were cutting power, and shipment companies refused
to do business with the Company.
45KPNQwest’s press release on the GTS acquisition stressed the benefits of incorporatingthe Ebone network into KPNQwest. The press release stated:
KPNQwest to Acquire GTS's Ebone & Central Europe Businesses2001-10-18 20:00 (New York) HOOFDDORP, The Netherlands, Oct. 18 /PRNewswire/ -- KPNQwest, the leading pan-European data communications and hosting company, today announced that it will acquire the Ebone and Central Europe businesses of Global TeleSystems, Inc (GTS)....T he acquisition consolidates KPNQwest's position as the leading IP data communications provider in Europe....The agreement would: * Complete KPNQwest's network and hosting construction programme * Add ten additional cities and three additional countries to bring KPNQwest' s EuroRings network to a total of sixty cities in eighteen countries(1) * Add over 48,000 European accounts to KPNQwest's existing customer base * Double the number of hosting centres on the KPNQwest EuroRings network footprint, bringing the total hosting capacity to 55,000 m2 in twenty-four cities(2) * Deepen KPNQwest's network penetration by adding fourteen metro area networks(3) * Significantly strengthen KPNQwest's operations in the fast growing Eastern & CentralEuropean Markets....” .... "The combination of KPNQwest and GTS's Ebone and Central European businesses marks theemergence of the first complete pan-European communications company, focused on delivering thepromise of next generation data and internet services to the businesses of Europe," said Jack McMaster, President and CEO of KPNQwest....”
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491. In a desperate attempt to obtain cash, KPNQwest entered into an agreement on
October 18, 2001 to acquire 100% of Global TeleSystems, Inc. (“GTS”). KPNQwest advised the
public that the purpose of this acquisition was to obtain the European IP backbone of GTS, known
as Ebone45. Representations to that effect were false. In fact, earlier in 2001, according to CW 27,
vice president of network development before he was assigned to the metrorings project, network
planners Frans Ekelshot and Louis de Wolff authored a study of Ebone which recommenced against
acquiring the company because its network would be useless to KPNQwest. CW 24, who
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formulated the business plan for the Ebone acquisition, admits that the business plan called for the
Ebone network to be shut down.
492. KPNQwest’s Ewoud Mogendorff commented that the Company’s acquisition of
GTS/Ebone could not be justified as financially rational. An article from the Dutch language Quote
magazine from Fall, 2002 noted: “according to Mogendorff, the Company [GTS] wasn’t worth more
than 40 mln Euros. ‘No competitor would pay so much money for that company.’ And besides, the
bank debts and the lease obligations of GTS were not 435 million but 590 million Euros.”
493. Contrary to what the public was told, the true end and aim of the transaction was to
obtain bank credit so KPNQwest could survive despite its severe cash flow deficiencies and allow
Defendants continue to cover up the Company’s cash flow crisis. For example, defendant McMaster
sent a letter to Qwest which was “particularly blunt about the need for cash in order to complete the
GTS transaction without going bankrupt. McMaster noted that there were four ‘scenario[s]’ for
KPNQwest’s future. Only two of them had KPNQwest avoiding bankruptcy.” Trustees’ RICO
complaint [¶215].
494. Accompanying the announcement of the GTS acquisition, KPNQwest announced that
it had reached agreement with banks to obtain a bank credit facility of €500 million as part of the
deal. The trustees’ RICO complaint states that the credit facility was obtained through “bank fraud,
in violation of 18 U.S.C. §1344, by...knowing misrepresentations and omissions....” [¶210].
495. The Commitment Letter from the banks providing the facility conditioned the facility
on the accuracy of the materials KPNQwest supplied to the lead arrangers, including KPNQwest
financial reports, and also required KPNQwest to meet financial covenants. These included a
minimum operating EBITDA of €45 million in Q1 2002 and total EBITDA of €150 million for
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2002, and minimum cash proceeds from dark fiber or duct sales of €45 million in 2002 and €50
million in 2003.
496. In fact, Defendants knew these covenants could not be met. For example, a
September 26, 2001 e-mail from McMaster to von Deylen stated that in order to comply with the
financial convenants in the Commitment Letter, KPNQwest would need €350 million in IRU
revenues in 2002. But Defendants knew it would be impossible to deliver legitimate IRU
transactions in that amount. [¶214]. Thus, although KPNQwest reported EBITDA to the bank
consortium financing the GTS deal on the assumption of real IRU revenues, KPNQwest internally
reported “pre-IRU” EBITDA as well, in recognition that such transactions did not generate real
revenue or cash flow. [¶213].
497. A member of Ebone management at the time saw the KPNQwest revenue projections
provided to the bank and was shocked because the growth figures were wildly overstated:
KPNQwest’s claims regarding its future revenue outlook and market share and what the combined
Ebone-KPNQwest entity would do were overly positive. In particular, the banks were advised that
the wholesale capacity sales to carriers was the main driver of revenue, but in fact that was a dying
business at the time.
498. The need for the GTS transaction to be completed to obtain the bank credit facility
and stave off KPNQwest’s bankruptcy, and the resulting need to meet the financial covenants given
to the bank as part of the bank’s Commitment Letter, compelled Defendants continue their scheme
of wrongfully recording revenues from IRU transactions and swaps.
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QWEST AND DEFENDANTS NACCHIO, WOODRUFF AND TEMPEST HADMOTIVATION AND OPPORTUNITY TO COMMIT FRAUD BECAUSE OF
QWEST EXECUTIVES’ TRANSACTIONS IN QWEST STOCK
499. Qwest executives profited handsomely from the inflation of revenues at Qwest and
KPNQwest due to the improper swap transactions and “sales” of capacity. As reported in a July 30,
2002, article in the Rocky Mountain News entitled “Pocketing millions: Qwest Execs Made a
BundleWhile Telco Misstated Numbers”:
“Qwest executives made hundreds of millions of dollars during thetime that improper accounting helped the Denver-based telco meet itsfinancial targets and maintain its high-flying stock price. FormerQwest Chief Executive Joseph Nacchio netted $232.5 million fromstock sales between 1999 and 2001, according to company proxystatements....During that period, a former Qwest vice president, LewWilks, netted $46.6 million. Another former vice president, SteveJacobsen, made $44 million. Wilks also sold stock in 2001, whichisn’t reflected in the proxy statement. Current senior legal counselDrake Tempest earned $13 million in stock profits during the period. Former Chief Financial Officer Robert Woodruff has sold $34million of stock since July 2000. His net gain wasn’t immediatelyavailable....Generally the insiders were able to sell their shares whenthe stock was trading at $40 or higher. Qwest closed Monday at$1.49; it traded as low as $1.11, an all-time low....Qwest directorsalso made money during the period, most notably Qwest founderPhilip Anschutz, who has sold about $2 billion in stock since 1999,including at least $179 million in May 2001.”
500. Plaintiffs’ calculations based on Form 4s filed with the SEC show that Defendant
Nacchio had $9,259,337.25 in gains from Qwest stock transactions in 1999; $81,054,997.50 in gains
from Qwest stock transactions in 2000; and $95,959,709.28 in gains from Qwest stock transactions
from January 1, 2001 to May 15, 2001. Plaintiffs believe that Nacchio enjoyed additional gains
from Qwest shares that Nacchio held in mutual funds or otherwise indirectly. Nacchio’s stock
transactions are illustrated by the following table:
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Transactions of Joseph Nacchio in Qwest
Date# of
Shares Acquired Sold
Price Total Cost Price Total Cost Gains/Losses
8/13/99 7,500 5.50 $ 41,250.00 $ (41,250.00)
8/13/99 7,500 $ 27.9333 $ 27.93 $ (41,222.07)
8/17/99 25,000 5.50 $ 137,500.00 $ 30,749.75
8/17/99 25,000 $ 31.5000 $ 787,500.00 $ 818,249.75
8/13/99 75,000 5.50 $ 412,500.00 $ 405,749.75
8/13/99 75,000 $ 27.9333 $ 2,094,997.50 $ 2,500,747.25
8/17/99 25,000 5.50 $ 137,500.00 $ 2,363,247.25
8/17/99 25,000 $ 31.5000 $ 787,500.00 $ 3,150,747.25
10/29/99 100,000 5.50 $ 550,000.00 $ 2,600,747.25
10/29/99 100,000 $ 36.5859 $ 3,658,590.00 $ 6,259,337.25
11/4/99 100,000 5.50 $ 550,000.00 $ 5,709,337.25
11/4/99 100,000 $ 35.5000 $ 3,550,000.00 $ 9,259,337.25
2/14/00 100,000 5.50 $ 550,000.00 $ 8,709,337.25
2/14/00 100,000 $ 48.7469 $ 4,874,690.00 $ 13,584,027.25
2/18/00 100,000 5.50 $ 550,000.00 $ 13,034,027.25
2/18/00 100,000 $ 50.0594 $ 5,005,940.00 $ 18,039,967.25
2/4/00 25,360 $ 0.00 $ 18,039,967.25
3/1/00 200,000 5.50 $ 1,100,000.00 $ 16,939,967.25
4/26/00 25,000 5.50 $ 137,500.00 $ 16,802,467.25
4/26/00 25,000 $ 44.5000 $ 1,112,500.00 $ 17,914,967.25
5/1/00 75,000 5.50 $ 412,500.00 $ 17,502,467.25
5/1/00 75,000 $ 43.9583 $ 3,296,872.50 $ 20,799,339.75
5/5/00 100,000 5.50 $ 550,000.00 $ 20,249,339.75
5/5/00 100,000 $ 44.2129 $ 4,421,290.00 $ 24,670,629.75
7/21/00 100,000 5.50 $ 550,000.00 $ 24,120,629.75
7/21/00 100,000 $ 55.0004 $ 5,500,040.00 $ 29,620,669.75
7/25/00 100,000 5.50 $ 550,000.00 $ 29,070,669.75
7/25/00 37,000 $ 50.0000 $ 1,850,000.00 $ 30,920,669.75
7/31/00 100,000 5.50 $ 550,000.00 $ 30,370,669.75
7/31/00 100,000 $ 48.9158 $ 0.00 $ 35,262,249.75
8/2/00 100,000 5.50 $ 550,000.00 $ 34,712,249.75
8/2/00 100,000 $ 49.0450 $ 4,904,500.00 $ 39,616,749.75
Transactions of Joseph Nacchio in Qwest
Date# of
Shares Acquired Sold
Price Total Cost Price Total Cost Gains/Losses
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8/4/00 100,000 5.50 $ 550,000.00 $ 39,066,749.75
8/4/00 100,000 $ 50.0000 $ 5,000,000.00 $ 44,066,749.75
8/7/00 200,000 5.50 $ 1,100,000.00 $ 42,966,749.75
8/7/00 200,000 $ 50.5512 $ 10,110,240.00 $ 53,076,989.75
8/8/00 150,000 5.50 $ 825,000.00 $ 52,251,989.75
8/8/00 150,000 $ 53.3375 $ 8,000,625.00 $ 60,252,614.75
10/30/00 300,000 5.50 $ 1,650,000.00 $ 8,000,625.00 $ 58,602,614.75
10/30/00 300,000 $ 49.4848 $ 14,845,440.00 $ 73,448,054.75
11/2/00 100,000 5.50 $ 550,000.00 $ 72,898,054.75
11/2/00 100,000 $ 46.0063 $ 4,600,630.00 $ 77,498,684.75
11/3/00 100,000 5.50 $ 550,000.00 $ 76,948,684.75
11/3/00 100,000 $ 46.7188 $ 4,671,880.00 $ 81,620,564.75
11/7/00 25,000 5.50 $ 137,500.00 $ 81,483,064.75
11/7/00 25,000 $ 45.7500 $ 1,143,750.00 $ 82,626,814.75
11/7/00 25,000 5.50 $ 137,500.00 $ 82,489,314.75
11/7/00 25,000 $ 45.5000 $ 1,137,500.00 $ 83,626,814.75
11/8/00 75,000 5.50 $ 412,500.00 $ 83,214,314.75
11/8/00 75,000 $ 45.5833 $ 3,418,747.50 $ 86,633,062.25
11/15/00 25,000 5.50 $ 137,500.00 $ 86,495,562.25
11/15/00 25,000 $ 42.0000 $ 1,050,000.00 $ 87,545,562.25
11/17/00 75,000 5.50 $ 412,500.00 $ 87,133,062.25
11/17/00 75,000 $ 42.4167 $ 3,181,252.50 $ 90,314,314.75
½/01 196,723 $ 39.8394 $ 7,837,326.29 $ 98,151,641.04
½/01 262,744 $ 39.3469 $ 10,338,161.89 $ 108,489,802.93
1/3/01 160,000 $ 40.2093 $ 6,433,488.00 $ 114,923,290.93
1/26/01 7,500 5.50 $ 41,250.00 $ 43.2800 $ 324,600.00 $ 115,206,640.93
1/26/01 7,500 $ 0.00 $ 115,206,640.93
1/29/01 92,500 5.50 $ 508,750.00 $ 114,697,890.93
1/29/01 92,500 $ 43.1356 $ 3,990,043.00 $ 118,687,933.93
1/30/01 70,000 5.50 $ 385,000.00 $ 118,302,933.93
1/30/01 70,000 $ 43.3571 $ 3,034,997.00 $ 121,337,930.93
2/1/01 10,000 5.50 $ 55,000.00 $ 121,282,930.93
Transactions of Joseph Nacchio in Qwest
Date# of
Shares Acquired Sold
Price Total Cost Price Total Cost Gains/Losses
225
2/1/01 10,000 $ 41.7500 $ 417,500.00 $ 121,700,430.93
2/5/01 70,000 5.50 $ 385,000.00 $ 121,315,430.93
2/5/01 70,000 $ 40.2261 $ 2,815,827.00 $ 124,131,257.93
2/6/01 30,000 5.50 $ 165,000.00 $ 123,966,257.93
2/6/01 30,000 $ 41.3967 $ 1,241,901.00 $ 125,208,158.93
2/7/01 20,000 5.50 $ 110,000.00 $ 125,098,158.93
2/7/01 20,000 $ 41.0000 $ 820,000.00 $ 125,918,158.93
2/8/01 90,000 5.50 $ 495,000.00 $ 125,423,158.93
2/8/01 90,000 $ 40.5000 $ 3,645,000.00 $ 129,068,158.93
2/9/01 10,000 5.50 $ 0.00 $ 129,013,158.93
2/9/01 10,000 $ 40.5000 $ 405,000.00 $ 129,418,158.93
2/12/01 70,000 5.50 $ 385,000.00 $ 129,033,158.93
2/12/01 70,000 $ 40.9857 $ 2,868,999.00 $ 131,902,157.93
2/13/01 180,000 5.50 $ 990,000.00 $ 130,912,157.93
2/13/01 180,000 $ 41.6898 $ 7,504,164.00 $ 138,416,321.93
2/13/01 30,000 5.50 $ 165,000.00 $ 138,251,321.93
2/13/01 30,000 $ 41.3433 $ 1,240,299.00 $ 139,491,620.93
2/15/01 70,000 5.50 $ 385,000.00 $ 139,106,620.93
2/15/01 70,000 $ 40.1857 $ 2,812,999.00 $ 141,919,619.93
2/20/01 11,500 5.50 $ 63,250.00 $ 141,856,369.93
2/20/01 11,500 $ 37.4763 $ 430,977.45 $ 142,287,347.38
2/21/01 11,500 5.50 $ 63,250.00 $ 142,224,097.38
2/21/01 11,500 $ 37.3670 $ 429,720.50 $ 142,653,817.88
2/22/01 11,500 5.50 $ 63,250.00 $ 142,590,567.88
2/22/01 11,500 $ 36.4497 $ 419,171.55 $ 143,009,739.43
2/23/01 11,500 5.50 $ 63,250.00 $ 142,946,489.43
2/23/01 11,500 $ 34.8355 $ 400,608.25 $ 143,347,097.68
2/26/01 11,500 5.50 $ 63,250.00 $ 143,283,847.68
2/26/01 11,500 $ 38.1230 $ 438,414.50 $ 143,722,262.18
2/27/01 11,500 5.50 $ 63,250.00 $ 143,659,012.18
2/27/01 11,500 $ 37.8861 $ 435,690.15 $ 144,094,702.33
2/28/01 11,500 5.50 $ 63,250.00 $ 144,031,452.33
Transactions of Joseph Nacchio in Qwest
Date# of
Shares Acquired Sold
Price Total Cost Price Total Cost Gains/Losses
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2/28/01 11,500 $ 37.2978 $ 428,924.70 $ 144,460,377.03
3/1/01 11,500 5.50 $ 63,250.00 $ 144,397,127.03
3/1/01 11,500 $ 35.1300 $ 403,995.00 $ 144,801,122.03
4/26/01 350,000 5.50 $ 1,925,000.00 $ 142,876,122.03
4/26/01 350,000 $ 38.8600 $ 13,601,000.00 $ 156,477,122.03
4/27/01 300,000 5.50 $ 1,650,000.00 $ 154,827,122.03
4/27/01 300,000 $ 39.6700 $ 0.00 $ 166,728,122.03
4/30/01 110,000 5.50 $ 605,000.00 $ 166,123,122.03
4/30/01 110,000 $ 41.1200 $ 4,523,200.00 $ 170,646,322.03
5/1/01 100,000 5.50 $ 550,000.00 $ 170,096,322.03
5/1/01 100,000 $ 40.8400 $ 4,084,000.00 $ 174,180,322.03
5/3/01 50,000 5.50 $ 275,000.00 $ 173,905,322.03
5/3/01 50,000 $ 39.0900 $ 1,954,500.00 $ 175,859,822.03
5/7/01 70,000 5.50 $ 385,000.00 $ 175,474,822.03
5/7/01 70,000 $ 38.3100 $ 2,681,700.00 $ 178,156,522.03
5/8/01 20,000 5.50 $ 110,000.00 $ 178,046,522.03
5/9/01 30,000 5.50 $ 165,000.00 $ 177,881,522.03
5/9/01 30,000 $ 38.0000 $ 1,140,000.00 $ 179,021,522.03
5/10/01 43,200 5.50 $ 237,600.00 $ 178,783,922.03
5/10/01 43,200 $ 38.0000 $ 1,641,600.00 $ 180,425,522.03
5/11/01 20,000 5.50 $ 110,000.00 $ 180,315,522.03
5/11/01 20,000 $ 37.2300 $ 744,600.00 $ 181,060,122.03
5/14/01 56,800 5.50 $ 312,400.00 $ 180,747,722.03
5/14/01 56,800 $ 37.6400 $ 2,137,952.00 $ 182,885,674.03
5/15/01 105,000 5.50 $ 577,500.00 $ 182,308,174.03
5/15/01 105,000 $ 37.7700 $ 3,965,850.00 $ 186,274,024.03
501. Defendant Woodruff engaged in the following transactions in Qwest stock from
November 1999 through February 2001:
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DATE SHARES PRICE PROCEEDS
11/05/99 45,000 $ 36.264 $ 1,631,876
11/10/99 25,000 $ 37.250 $ 931,250
11/18/99 25,000 $ 37.925 $ 948,125
02/15/00 50,000 $ 49.000 $ 2,450,000
02/17/00 50,000 $ 49.376 $ 2,468,800
05/05/00 40,000 $ 44.000 $ 1,760,000
05/08/00 40,000 $ 44.310 $ 1,772,400
07/28/00 100,000 $ 49.190 $ 4,919,000
08/04/00 100,000 $ 49.060 $ 4,906,000
08/07/00 280,000 $ 50.510 $ 14,142,800
10/30/00 35,400 $ 50.000 $ 1,770,000
11/17/00 114,600 $ 42.140 $ 4,829,244
02/08/01 150,000 $ 40.870 $ 6,130,500
02/12/01 50,000 $ 41.000 $ 2,050,000
02/13/01 50,000 $ 41.650 $ 2,082,500
Total 1,155,000 $ 52,792,495
502. Defendant Tempest engaged in the following transactions in Qwest stock from
November 1999 through April 2001:
DATE SHARES PRICE PROCEEDS
11/10/99 25,000 $ 37.250 $ 931,250
05/05/00 25,000 $ 44.050 $ 1,101,250
05/09/00 10,000 $ 44.820 $ 448,200
05/10/00 10,000 $ 43.380 $ 433,800
DATE SHARES PRICE PROCEEDS
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07/25/00 10,000 $ 51.640 $ 516,400
08/07/00 5,000 $ 51.500 $ 257,500
08/09/00 5,000 $ 50.380 $ 251,900
10/30/00 62,500 $ 49.340 $ 3,083,750
10/30/00 25,000 $ 49.800 $ 1,245,000
10/30/00 5,000 $ 49.000 $ 245,000
10/30/00 32,500 $ 49.250 $ 1,600,625
11/08/00 25,000 $ 45.250 $ 1,131,250
11/13/00 25,000 $ 41.000 $ 1,025,000
11/15/00 25,000 $ 42.260 $ 1,056,500
11/17/00 7,000 $ 42.390 $ 296,730
11/17/00 25,000 $ 42.390 $ 1,059,750
01/29/01 40,000 $ 43.180 $ 1,727,200
01/29/01 50,000 $ 43.180 $ 2,159,000
01/31/01 50,000 $ 42.570 $ 2,128,500
04/26/01 1,100 $ 39.000 $ 42,900
04/26/01 3,500 $ 38.650 $ 135,275
Total 466,600 $ 20,876,780
503. The inflation of KPNQwest’s stock price materially contributed to the foregoing
stock gains from transactions in Qwest stock. A Morgan Stanley Dean Witter report on Qwest
Communications, dated June 20,2001, explained:
“Qwest’s stake in KPNQwest was originally included as part of the purchase pricefor the merger [with US West], so any write-off to the investment could have animpact on goodwill charges going forward. The company currently has its stakevalued at $7.4 billion on its balance sheet based on the market value when the dealclosed at 6/30/00. Because new FASB rules concerning amortization andimpairment analysis of goodwill are anticipated to go into effect July 1, this may
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require an impairment charge....The expected write down of the KPNQwest stockwould substantially reduce the disclosed tangible value of Qwest. We believe themarket clearly understands the diminution in value of the KPN Qwest stake, but thescale of the write-down and the impact on balance sheet ratios could still besignificant.”
504. As similarly noted in Broadbandits, at p. 55, “In the summer of 2002, KPNQwest
declared bankruptcy. Still, KPNQwest had served its purpose: At its peak, Qwest’s stake in the
European venture was valued at around $8 billion, and that kept Qwest shares flying high on the
stock market–long enough for insiders to cash out.”
KPN HAD MOTIVE AND OPPORTUNITY TO COMMIT FRAUD, IN ORDER TO KEEP KPNQWEST ALIVE LONG
ENOUGH TO COMPLETE ITS EUROPEAN NETWORK
505. KPN was also motivated to keep KPNQwest afloat. KPNQwest’s construction of
a new, seamless European cross-border network was one of the Company’s key selling points. As
explained in KPNQwest’s 2000 annual report:
We are constructing a high capacity, advanced, fibre optic networkin Europe. We anticipate that our network, when completed, willconsist of a total of seven inter-connected fibre optic rings, known asEuroRings, which we expect to comprise 2.2 million fibre-kilometersand connect 50 European cities. Our network connects with Qwest’sfibre optic network in the United States and KPN’s fibre opticnetwork in Belgium, Luxembourg, and the Netherlands. We arecurrently operating three rings that span approximately 8,200Kilometers connecting 30 European cities....[W]e still anticipate thatour network will be completed by the second half of 2001.Completion of our network is an important element of our businessstrategy.
506. The Company later reported that completion of the network would be delayed until
early 2002. As stated in a Merrill Lynch analyst’s report dated July 2, 2001, “KPNQwest has
completed construction of the Southern and Eastern rings. The rings connect 13 cities over 3,900
230
kilometres. This construction closely follows the recent completion of the Nordic ring.
KPNQwest’s network now connects 40 of the planned 50 cities. The seventh (and last) ring has
been delayed until 1Q02.”
507. Before KPNQwest was formed, KPN had relied on a joint venture with AT&T, called
AUCS (“AT&T-Unisource Communications Services”) to service its Europe-based corporate
clientele with cross-border services. AUCS was jointly owned by AT&T and Unisource, a
consortium of KPN, Swisscom and Telia, the “Ma Bells” of the Netherlands, Switzerland and
Sweden respectively. AT&T had left AUCS, and the remaining owners sold AUCS to Infonet.
This left KPN dependent on KPNQwest to service its corporate clients.
508. KPN initially commenced construction of the EuroRings, its primary contribution to
KPNQwest. Following the formation of the joint venture, KPNQwest paid KPN €67 million, as the
contractor to complete construction of EuroRings 1 and 2. See KPNQwest, Form 20-F, filed May
23, 2001, at 64.
509. Once KPNQwest completed the EuroRing network in early 2002, its failure allowed
KPN to acquire the network on the cheap. In fact, when KPNQwest filed bankruptcy, almost all of
its network was acquired by KPN. KPN publicly bragged about the deal. As reported on November
29, 2002 by Bloomberg:
KPN's Groenewegen Comments on Data Traffic, EuroRings(Correct)Amsterdam, Nov. 19 (Bloomberg) -- Royal KPN NV's HenjoGroenewegen comments on the dominant Dutch phone company'sEuroRings international data-traffic unit. EuroRings consists of partsof bankrupt KPNQwest NV's network bought by KPN.
EuroRings will start offering fast Internet access to Dutch companieswith activities outside their home market in January using a
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fiber-optic network. Groenewegen, director of EuroRings, wouldn'tprovide specific earnings and sales goals for the unit.
He spoke at a press conference and in an interview.
On comparing EuroRings with KPNQwest:
“The network totals about 7,000 kilometers to 8,000 kilometers(4,938 miles) of glass fiber. With just one-third of the networkKPNQwest used we can still serve 70 percent to 80 percent of themarket at lower costs.''
“We paid a couple of cents to the dollar'' for the KPNQwest assets,Groenewegen said.”
510. While getting paid to construct a network it could later purchase for pennies on the
dollar, KPN was fully motivated to keep KPNQwest afloat during the Class Period, by inflating its
revenues based on the misrepresented capacity sales and swaps.
511. The Banks’ Case against KPNQwest states that from March 2002 onward KPN knew
that KPNQwest was going to file for bankruptcy. The bankruptcy was, in fact, a goal of KPN
because it allowed KPN to buy back for virtually nothing the network assets of KPNQwest (i.e.
Eurorings), including specifically those network assets which KPN had originally contributed to
KPNQwest. KPN also sought the to put KPNQwest into bankruptcy so that KPN could avoid its
obligations under the agreement of October 18, 2001 to purchase 133 million Euros of IRUs. As
of march 202 the market for IRUs had collapsed and the agreement by KPNQwest to buy IRUs was
a “millstone around the neck of KPN.” KPN had made it known to KPNQwest that KPN was not
going to pay a penny more on that contract.
CLASS ACTION ALLEGATIONS
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512. Lead Plaintiff brings this action as a class action pursuant to Rules 23(a) and 23(b)(3)
of the Federal Rules of Civil Procedure, individually and on behalf of all other persons or entities
who purchased or acquired KPNQwest during the Class Period and were damaged thereby,
excluding the Defendants herein, their affiliates and any officers or directors of KPNQwest or its
affiliates, and any members of their immediate families and their heirs, successors and assigns (the
"Class").
513. The Class is so numerous that joinder of all the members of the Class is
impracticable. Plaintiffs believe there are hundreds of record holders of the Company's common
stock located throughout the United States.
514. Lead Plaintiff’s claims are typical of the claims of absent Class members. Members
of the Class have sustained damages arising out of Defendants' wrongful conduct in violation of the
federal securities laws in the same way as Plaintiff sustained damages from the unlawful conduct.
515. Lead Plaintiff will fairly and adequately protect the interests of the Class. Lead
Plaintiff has retained counsel competent and experienced in class action and securities litigation.
516. A class action is superior to other available methods for the fair and efficient
adjudication of the controversy. The Class is numerous and geographically dispersed. It would be
impracticable for each member of the Class to bring a separate action. The individual damages of
any member of the Class may be relatively small when measured against the potential costs of
bringing this action, and thus make the expense and burden of this litigation unjustifiable for
individual actions. In this class action, the Court can determine the rights of all members of the
Class with judicial economy. Lead Plaintiff does not anticipate any difficulty in the management
of this suit as a class action.
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517. Common questions of law and fact exist as to all members of the Class and
predominate over any questions affecting solely individual members of the Class. These questions
include, but are not limited to, the following:
a. whether Defendants' conduct as alleged herein violated the federal securities laws;
b. whether the SEC filings, press releases and statements disseminated to the investing
public during the Class Period misrepresented KPNQwest‘s financial condition and
results;
c. whether Defendants acted knowingly or with recklessness in omitting and/or
misrepresenting material facts;
d. whether the market price of KPNQwest common stock during the Class Period was
artificially inflated; and,
e. whether the members of the Class have been damaged, and if so, what is the proper
measure of damages.
APPLICABILITY OF PRESUMPTION OF RELIANCE:FRAUD-ON-THE-MARKET DOCTRINE
518. In connection with the claims under Section 10(b) of the Exchange Act and Rule 10b-
5 thereunder, Plaintiffs will rely, in part, upon the presumption of reliance established by the fraud-
on-the-market doctrine. The market for KPNQwest common stock was at all times an efficient
market for the following reasons, among others:
a. As a regulated issuer, KPNQwest filed periodic public reports with the SEC;
b. The common shares of KPNQwest were traded throughout the Class Period on the
NASDAQ National Market, which is a well-developed and efficient market;
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c. KPNQwest disseminated information on a market-wide basis over various electronic
media services such as the Bloomberg newswires, and also issued press releases over
PRNewswire;
d. The market price of KPNQwest’s securities reacted efficiently to new information
entering the market; and
e. During the Class Period, KPNQwest was covered by a number of analysts.
INAPPLICABILITY OF STATUTORY SAFE HARBOR
519. The statutory safe harbor that applies to forward-looking statements under certain
circumstances does not apply to any of the allegedly false statements pleaded in this Complaint. The
statements alleged to be false and materially misleading herein relate to then-existing facts and
conditions. In addition, to the extent certain of the statements alleged to be false may be
characterized as forward-looking, they were not identified as "forward-looking statements" when
made, there was no statement made with respect to any of those representations forming the basis
of this Complaint that actual results "could differ materially from those projected," and there were
no meaningful cautionary statements identifying important factors that could cause actual results to
differ materially from those in the purportedly forward-looking statements. Alternatively, to the
extent that the statutory safe harbor does apply to any forward-looking statements pleaded herein,
Defendants are liable for those false forward-looking statements because at the time each of those
forward-looking statements was made, the particular speaker had actual knowledge that the
particular forward-looking statement was false, and/or the forward-looking statement was authorized
and/or approved by an executive officer of KPNQwest who knew that those statements were false
when made.
235
SECURITIES ACT CLAIMS
COUNT ONE
VIOLATIONS OF §11 OF THE SECURITIES ACT AGAINST DEFENDANTS MCMASTER, NACCHIO, ACKERMANS,
KEATING, WOODRUFF, TEMPEST, DRECHSEL, PIETERS, BLOK, KPN, AND QWEST (“SECTION 11 DEFENDANTS”)
520. Plaintiffs incorporate by reference and reallege the allegations as set forth above.
521. This claim is brought by Plaintiffs, including Lead Plaintiff and Class Representative
Paula Taft, who purchased shares of KPNQwest stock pursuant to the Registration Statement and
Prospectus on behalf of herself and other members of the Class who also purchased stock in the IPO.
Class members acquired their shares pursuant to or traceable to, and in reliance on, the Registration
Statement and Prospectus.
522. The Section 11 Defendants as officers or Supervisory Board members or principal
shareholders of KPNQwest and controlling persons of the issuer, owed to the purchasers of
KPNQwest stock in the IPO the duty to make a reasonable and diligent investigation of the
statements contained in the Registration Statement and Prospectus at the time it became effective
to ensure that such statements were true and correct and that there was no omission of material facts
required to be stated in order to make the statements contained therein not misleading. The Section
11 Defendants knew of, or were reckless, with respect to, the material misstatements and omissions
contained in or omitted from the Prospectus as set forth herein. As such, the Section 11 Defendants
are liable to the Class.
523. None of the Section 11 Defendants made a reasonable investigation or possessed
reasonable grounds for the belief that the statements contained in the Prospectus were true or that
236
there was no omission of material facts necessary to make the statements made therein not
misleading.
524. The Section 11 Defendants issued and disseminated, caused to be issued and
disseminated, and participated in the issuance and dissemination of, materially false and misleading
written statements to the investing public which were contained in the Registration Statement and
Prospectus, which misrepresented or failed to disclose, inter alia, the facts set forth above. By
reason of the conduct herein alleged, each defendant violated and/or controlled a person who
violated section 11 of the Securities Act of 1933.
525. As a direct and proximate result of the Section 11 Defendants' acts and omissions in
violation of the Securities Act, the market price of KPNQwest stock was artificially inflated in the
IPO and the Class suffered substantial damage in connection with their purchase of KPNQwest
common stock pursuant to the Registration Statement and Prospectus.
526. At the times they purchased their shares in the IPO, members of the Class who
purchased such shares were without knowledge of the facts concerning the false or misleading
statements or omissions alleged herein.
527. Less than one year has elapsed from the time that Class Representative discovered
or reasonably could have discovered the facts upon which this action is based, to the time that Class
Representative filed her complaint. Less than three years have elapsed from the time the securities
upon which this claim is brought were offered to the public to the time Class Representative filed
this action.
COUNT TWO
VIOLATION OF § 15 OF THE SECURITIES ACT AGAINST
237
DEFENDANTS NACCHIO, MCMASTER, ACKERMANS, WOODRUFF,TEMPEST, DRECHSEL, PIETERS, BLOK,
KPN, AND QWEST (“SECTION 15 DEFENDANTS”)
528. Plaintiffs repeat and reallege each and every allegation contained above as if alleged
in full herein, except for any allegations above that contain facts necessary to prove any elements
not required to state a Section 15 claim, including without limitation allegations relating to scienter.
This Count is brought pursuant to Section 15 of the Securities Act, 15 U.S.C. § 77o, on behalf of the
Plaintiffs and the Class, against The Section 15 Defendants.
529. As alleged above, the Section 15 Defendants violated Section 15 of the Securities
Act. At the time the Registration Statement and Prospectus was issued, the Section 15 Defendants
were each control persons of KPNQwest and each other, within the meaning of Section 15 of the
Securities Act, by virtue of their positions as senior officers, directors, and/or substantial
shareholders of KPNQwest.
530. KPN and Qwest, by virtue of their share ownership, rights under the KPNQwest
articles of association and joint venture agreement, and positions on KPNQwest’s Supervisory Board
and by their specific acts were, at the time of the wrongs alleged herein and as set forth in Count I,
controlling persons of KPNQwest within the meaning of Section 15(a) of the 1933 Act. The Section
15 Defendants had the power and influence and exercised the same to cause KPNQwest to engage
in the illegal conduct and practices complained of herein by causing the Company to disseminate
the false and misleading information referred to above.
531. By virtue of the conduct alleged in Count I, the Section 15 Defendants are liable for
the aforesaid wrongful conduct and are liable to Plaintiffs and the Class for damages suffered.
EXCHANGE ACT CLAIMS
238
COUNT THREE
VIOLATIONS OF SECTION 10(b) OF THE EXCHANGE ACTAND RULE 10b-5 PROMULGATED THEREUNDER AGAINST
NACCHIO, MCMASTER, ACKERMANS, WOODRUFF,TEMPEST, DRECHSEL, PIETERS, BLOK, KEATING, WILLIAMS, TEMPEST
KPN, AND QWEST(“SECTION 10(b) DEFENDANTS”)
532. Plaintiffs incorporate by reference and reallege each and every allegation contained
in the paragraphs above as if fully set forth herein.
533. At all relevant times, the Section 10(b) Defendants, individually and in concert,
directly and indirectly, by the use and means of instrumentalities of interstate commerce and/or of
the mails, engaged and participated in a continuous course of conduct whereby they knowingly
and/or with deliberate recklessness made and/or failed to correct public representations which were
or had become materially false and misleading regarding KPNQwest's financial results and
operations. This continuous course of conduct included public statements by the Section 10(b)
Defendants and KPNQwest which they knew, or were deliberately reckless in not knowing, were
materially false and misleading, in order to artificially inflate the market price of KPNQwest stock
and which operated as a fraud and deceit upon Plaintiffs and the members of the Class.
534. The Section 10(b) Defendants are liable for the wrongs complained of herein as direct
participants, and as persons who, directly or indirectly, controlled the preparation, issuance and/or
content of the aforesaid public statements relating to the Company.
535. The Section 10(b) Defendants had actual knowledge of the facts making the material
statements false and misleading, or deliberately acted with reckless disregard for the truth in that
they failed to ascertain and to disclose such facts, even though same were available to them.
239
536. In ignorance of the adverse facts concerning KPNQwest's business operations and
earnings, and in reliance on the integrity of the market, Plaintiffs and the members of the Class
acquired KPNQwest common stock at artificially inflated prices and were damaged thereby.
537. Had Plaintiffs and the members of the Class known of the materially adverse
information not disclosed by the Section 10(b) Defendants, they would not have purchased
KPNQwest common stock at all or not at the inflated prices paid.
538. By virtue of the foregoing, the Section 10(b) Defendants, and each of them, have
violated Section 10(b) of the 1934 Act and Rule 10b-5 promulgated thereunder.
COUNT FOUR
VIOLATION OF SECTION 20(a) OF THE EXCHANGE ACT AGAINSTNACCHIO, MCMASTER, ACKERMANS, WOODRUFF, TEMPEST,
DRECHSEL, PIETERS, BLOK, KPN, AND QWEST(“SECTION 20(a) DEFENDANTS”)
539. Plaintiffs repeat and reallege each and every allegation contained in the paragraphs
above as if fully set forth herein.
540. This count is asserted against the Section 20(a) Defendants and is based upon Section
20(a) of the 1934 Act.
541. The Section 20(a) Defendants, by virtue of their offices and specific acts were, at the
time of the wrongs alleged herein and as set forth in Count III, controlling persons of KPNQwest
within the meaning of Section 20(a) of the 1934 Act. The Section 20(a) Defendants had the power
and influence and exercised the same to cause the Section 10(b) Defendants and KPNQwest to
engage in the illegal conduct and practices complained of herein by causing the Section 10(b)
Defendants and the Company to disseminate the false and misleading statements referred to above.
240
542. The Section 20(a) Defendants’ positions made them privy to and provided them with
actual knowledge of the material facts concealed from Plaintiffs and the Class.
543. By virtue of their control over the conduct alleged in Count III, the Section 20(a)
Defendants are liable for the aforesaid wrongful conduct and are liable to Plaintiffs and the Class
for damages suffered.
544. KPN and Qwest, by virtue of their share ownership, rights under the KPNQwest
articles of association and joint venture agreement, and positions on KPNQwest’s Supervisory Board
and by their specific acts were, at the time of the wrongs alleged herein and as set forth in Count III,
controlling persons of KPNQwest within the meaning of Section 20(a) of the 1934 Act. KPN and
Qwest had the power and influence and exercised the same to cause KPNQwest to engage in the
illegal conduct and practices complained of herein by causing the Company to disseminate the false
and misleading information referred to above.
545. KPN and Qwest were provided with and had actual knowledge of the material facts
concealed from Plaintiffs and the Class.
546. By virtue of the conduct alleged in Count III, KPN and Qwest are liable for the
aforesaid wrongful conduct and are liable to Plaintiffs and the Class for damages suffered.
JURY DEMAND
Plaintiffs hereby demand a trial by jury.
PRAYER FOR RELIEF
WHEREFORE, Plaintiffs demand judgment:
241
1. Determining that the instant action is a proper class action maintainable under Rule
23 of the Federal Rules of Civil Procedure;
2. Awarding compensatory damages and/or rescission as appropriate against
Defendants, in favor of Plaintiffs and all members of the Class for damages sustained
as a result of Defendants' wrongdoing;
3. Awarding Plaintiffs and members of the Class the costs and disbursements of this
suit, including reasonable attorneys', accountants' and experts' fees; and
4. Awarding such other and further relief as the Court may deem just and proper.
Dated: October 15, 2004 KIRBY MCINERNEY & SQUIRE, LLP
__________________________________Ira M. Press (IP-5313)Pamela E. Kulsrud (PK-4310)830 Third Ave, 10th FloorNew York, NY 10022Telephone: (212) 317-2300Facsimile: (212) 751-2540
Liaison Counsel for Plaintiffs
GLANCY BINKOW & GOLDBERG LLPLionel Z. GlancyRobert M. Zabb (RZ-0625)1801 Avenue of the Stars, Suite 311Los Angeles, California 90067Telephone: (310) 201-9150Facsimile: (310) 201-9160
SCHIFFRIN & BARROWAY, LLPGregory M. Castaldo
242
Benjamin J. Sweet3 Bala Plaza East, Suite 400Bala Cynwyd, Pennsylvania 19004Telephone: (610) 667-7706Facsimile: (610) 667-7056
Co-Lead Counsel for Plaintiffs
LAW OFFICES OF BRIAN BARRYBrian Barry1801 Avenue of the Stars Suite 307Los Angeles, CA 90067Telephone: (310) 788-0831Facsimile: (310) 788-0841
LAW OFFICES OF KWASI ASIEDUKwasi Asiedu3858 Carson Street #204Torrance, California 90503Telephone: (310) 792-3948
Attorneys for Plaintiffs
i
TABLE OF CONTENTS
SUMMARY OF ACTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
JURISDICTION AND VENUE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
THE PARTIES AND OTHER RELEVANT ENTITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
THE ROLES OF PARENTS KPN AND QWEST IN THE FORMATIONAND OPERATION OF KPNQWEST . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
THROUGHOUT THE CLASS PERIOD, DEFENDANTS FRAUDULENTLY INFLATED KPNQWEST’S REVENUES THROUGH UNDISCLOSED SWAPTRANSACTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
A. Defendants’ Scheme to Artificially Inflate KPNQwest’s Revenues by Means ofSales of Wavelengths or other Lit Capacity, in Violation of GAAP, wasInitiated at or Before the Time of the Company’s IPO. . . . . . . . . . . . . . . . . . . . . 24
1. KPNQwest Announces its Adoption of the Qwest Model of SellingDark Fiber to Finance the Network . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2. The Qwest Model Failed, as Dark Fiber Sales Dried Up . . . . . . . . . . . . 26
3. The Issue of How to Create a Revenue Base for KPNQwest Ripens,as the SEC Acts on Accounting for IRUs, and Arthur AndersenResponds Under Pressure from KPNQwest . . . . . . . . . . . . . . . . . . . . . . 27
4. Arthur Andersen Formulated Its Position; KPNQwest SelectedArthur Andersen as Auditor and Pressured its Auditor TowardEver More Generous Revenue Recognition . . . . . . . . . . . . . . . . . . . . . . 28
5. Accounting Disclosures in the IPO Prospectus Reflect Formulationof the Scheme to Recognize Up-Front Revenue for Sales ofLit Fiber IRUs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
B. The History of Hollow Swaps Among and Between KPNQwest, Qwest and Global Crossing Demonstrates That The Swaps Were Entered Into asPart of a Scheme to Generate Revenues to Meet Market Guidanceand Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
C. Specific Swap Transactions During the Class Period . . . . . . . . . . . . . . . . . . . . . 36
ii
1. Transactions with Global Crossing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
a. Third Quarter 2000 Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37b. First Quarter 2001 Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39c. Second Quarter 2001 Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41d. The Q3 2000, Q1 2001, and Q2 2001 Swaps
Improperly Inflated KPNQwest’s Financial Results . . . . . . . . . . 46
2. Other Illegitimate Capacity Swap Transactions . . . . . . . . . . . . . . . . . . . 47
a. Flag Telecom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47b. Teleglobe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52c. 360networks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53d. Qwest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56e. Sonera . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57f. Fibernet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57g. MCI/Worldcom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59h. Cable & Wireless-KPNQwest-Qwest Transaction. . . . . . . . . . . . 59
D. Additional Facts Concerning the Existence and Nature of the Swap andCapacity Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
1. Information About the Swap Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
2. Information About Implementation of the Swaps . . . . . . . . . . . . . . . . . . 71
a. Explanation of KPNQwest’s Excess Capacity . . . . . . . . . . . . . . 71
b. Explanation of KPNQwest’s Methodology for InstallingCapacity in Connection with the Large Sales of IRU Capacity . 75
c. The Technical Side of the Company Knew About the SwapsBecause of the Need to Implement the IRU Capacity inOrder to Claim Revenue from these Deals . . . . . . . . . . . . . . . . . 76
BOGUS TRANSACTIONS WITH CORPORATE PARENTS KPN AND QWEST ARTIFICIALLY PROPPED UP THE COMPANY . . . . . . . . . . . 84
THE COMPANY ABRUPTLY FAILED AS ITS DISMAL FINANCIAL STATE,LONG-DISGUISED BY ITS BOGUS CAPACITY TRANSACTIONS,CAUSED THE BANKS TO PULL OUT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
iii
A. Defendants’ Favorable Portrayal of the Company’s Prospects LeftAnalysts and the Market Stunned by KPNQwest’s AbruptPlunge into Bankruptcy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
B. The Company’s Stock Plummeted As the Reality of the Company’s Dependenceon IRU Sales and the Resulting Reduced Prospects for Future RevenuesEmerged Following the February 12, 2002 Earnings Release . . . . . . . . . . . . . . . 95
C. By June 2002 Calls for An Investigation Were Heard From AllQuarters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
D. Post-Bankruptcy Reports Tied the Company’s Demise to the Collapse of the Scheme to Pump Up the Company’s Revenues with Hollow Swapsand Sales of Unneeded Capacity to Qwest and KPN . . . . . . . . . . . . . . . . . . . . 101
ACCOUNTING ALLEGATIONS: DEFENDANTS VIOLATED GENERALLY ACCEPTED ACCOUNTING PRINCIPLESWITH RESPECT TO KPNQWEST’S IRU SALES, INCLUDING SWAPS . . . . . . . 103
A. Defendants Violated GAAP by Recognizing Revenues From the Swapsand other IRU Sales Up Front in the Period the Transactions Were EnteredInto . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
B. Defendants Violated GAAP by Failing To Make Appropriate Disclosures about the Nature and Magnitude of the Swap Transactions . . . . . 118
C. Qwest’s Recent Accounting Restatement of its FY 2000 and 2001 Financial Results Demonstrates That the KPNQwest Swap Transactions Involving Qwest Were False and Misleading When Reported . . 123
D. The SEC’s Recently-Instituted Proceedings Against A Former Qwest Employee Demonstrate That KPNQwest and Qwest Improperly Accounted For Their Swap Transactions . . . . . . . . . . . . . . 126
DEFENDANTS’ FALSE AND MISLEADING STATEMENTS AND OMISSIONS DURING THE CLASS PERIOD . . . . . . . . . . . . 128
A. Material Misrepresentations/Omissions in the Offering Documents . . . . . . . . 128
B. Post-IPO Class Period Material Misrepresentations/Omissions . . . . . . . . . . . . 132
THE ROLES OF KPN AND QWEST IN THE SCHEME . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
iv
ADDITIONAL EVIDENCE OF SCIENTER AND AGENCY . . . . . . . . . . . . . . . . . . . . . . . . 177
A. DOCUMENTS REFLECTING KPNQWEST’S DIRECT INVOLVEMENT IN THE SWAP DEALS . . . . . . . . . . . . . . . . . . . . 179
B. ORIGINAL QWEST DOCUMENTS DEMONSTRATING ITSSCIENTER . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181
C. THIRD-PARTY DOCUMENTS REFLECTING QWEST AND KPNQWEST’S SCIENTER . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
D. ADDITIONAL EVIDENCE OF SCIENTER FROM WITNESSESAND THE TRUSTEES’ RICO COMPLAINT . . . . . . . . . . . . . . . . . . . . . . . . . 188
E. FACTS AND CIRCUMSTANCES DEMONSTRATINGDEFENDANTS’ SCIENTER CONCERNING THE IMPROPRIETYOF KPNQWEST’S ACCOUNTING FOR THE SWAP ANDCAPACITY TRANSACTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
KPN, QWEST, AND KPNQWEST HAD MOTIVATION AND OPPORTUNITY TOCOMMIT FRAUD BECAUSE OF THEIR TRANSACTIONAL ANDFINANCIAL REQUIREMENTS, AND THE RESULTING IMPACT OFQWEST’S STOCK PRICE ON THEIR BUSINESSES . . . . . . . . . . . . . . . . . . . . . . . . 211
A. Motivation on KPN and Qwest and Defendants Related to Those Parties atthe Time of the KPNQwest IPO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
B. Motivation of KPN and Qwest and Defendants Related to Those Parties in thePeriod Subsequent to the KPNQwest IPO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215
C. Motivation of KPNQwest to Continue and Expand the Scheme . . . . . . . . . . . . 219
QWEST AND DEFENDANTS NACCHIO, WOODRUFF AND TEMPEST HAD MOTIVATIONAND OPPORTUNITY TO COMMIT FRAUD BECAUSE OF QWEST EXECUTIVES’ TRANSACTIONS IN QWEST STOCK . . . . . . . . . . . . . . . 224
KPN HAD MOTIVE AND OPPORTUNITY TO COMMIT FRAUD, IN ORDER TO KEEP KPNQWEST ALIVE LONG ENOUGH TO COMPLETE ITS EUROPEAN NETWORK . . . . . . . . . . . . . . . . . . . . 231
CLASS ACTION ALLEGATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
v
APPLICABILITY OF PRESUMPTION OF RELIANCE:FRAUD-ON-THE-MARKET DOCTRINE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
INAPPLICABILITY OF STATUTORY SAFE HARBOR . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
SECURITIES ACT CLAIMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237
COUNT ONE
VIOLATIONS OF §11 OF THE SECURITIES ACT AGAINST DEFENDANTS MCMASTER, NACCHIO, ACKERMANS, KEATING, WOODRUFF, TEMPEST, DRECHSEL, PIETERS, BLOK, KPN, AND QWEST (“SECTION 11 DEFENDANTS”) . . . . . . . . . . . . . . . . . 237
COUNT TWO
VIOLATION OF § 15 OF THE SECURITIES ACT AGAINSTDEFENDANTS NACCHIO, MCMASTER, ACKERMANS, WOODRUFF,TEMPEST, DRECHSEL, PIETERS, BLOK, KPN, AND QWEST (“SECTION 15 DEFENDANTS”) . . . . . . . . . . . . . . . . . . . . . . . 239
EXCHANGE ACT CLAIMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
COUNT THREE
VIOLATIONS OF SECTION 10(b) OF THE EXCHANGE ACTAND RULE 10b-5 PROMULGATED THEREUNDER AGAINST NACCHIO, MCMASTER, ACKERMANS, WOODRUFF,TEMPEST, DRECHSEL, PIETERS, BLOK, KEATING, WILLIAMS, TEMPESTKPN, AND QWEST (“SECTION 10(b) DEFENDANTS”) . . . . . . . . . . . . . . . . . . . . 240
COUNT FOUR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241
VIOLATION OF SECTION 20(a) OF THE EXCHANGE ACT AGAINSTNACCHIO, MCMASTER, ACKERMANS, WOODRUFF, TEMPEST,DRECHSEL, PIETERS, BLOK, KPN, AND QWEST(“SECTION 20(a) DEFENDANTS”) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241
JURY DEMAND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
PRAYER FOR RELIEF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243