>>The Fiber Optic Fantasy Slips Away
By SIMON ROMERO and SETH SCHIESEL
O nly a few years ago, the dream of striking it rich by transmitting Internet data and telephone calls
across continents and under oceans, through endless ribbons of fiber optic cable, captivated
one company after another. But rarely in economic history have so many people with so much money
got it so wrong.
Instead of a stampede of customers to fill up these fiber optic highways, the industry found itself with
too many vacant lanes — way too many. What had once seemed like a brilliant idea — carriers'
buying and selling future access on those fiber networks to meet expected customer demand —
became a swap meet unto itself, with its own peculiar bookkeeping.
As an element of the telecommunications meltdown that has come to light only recently, the market for
fiber network access seems to have been an important common ingredient in the epidemic of
accounting fiascos bursting out all over. Certainly, it played a major role in the unraveling of Global
Crossing, which filed for bankruptcy protection last month. Fiber swaps hurt other big
communications companies, like Qwest Communications International (news/quote) and Cable and
Wireless (news/quote). And they played roles in the cascading problems of Enron (news/quote) and
Tyco International (news/quote).
Significantly, the Securities and Exchange Commission took a close look at the practices involved in
fiber deals a few years ago and apparently did little to contain transactions that later became the basis
for a vibrant swapping market. Now, though, the S.E.C. and the Federal Bureau of Investigation are
taking a new look, searching for signs of accounting fraud. Investors and former employees of the
companies laid low by fiber swaps probably wish the government had stepped in sooner.
The S.E.C. has declined to comment on its previous or current look at Global Crossing. But its
silence, together with copies of correspondence between the company and the commission obtained
through the Freedom of Information Act by SEC Insight, a private research company in Plymouth,
Minn., prompt a flurry of questions.
Among them are these: Did liberal use of such long- term capacity sales encourage the creation of an
active swapping market? Did the S.E.C. accept Global Crossing's assertion of its accountants'
independence without a fuss? More troubling, and perhaps hardest to answer: How can the
telecommunications industry, now plagued by suspicions of sham transactions and accounting, right
itself?
"There is no sector that illustrates creative destruction so effectively," said Howard Holme, president
of Bandwidth Exchange, a capacity broker in Denver, referring to the theory of the economist Joseph
A. Schumpeter that entrepreneurs generate innovation by rendering their predecessors' ideas
obsolete.
There are few other industries aside from telecommunications that changed so quickly and produced
so much confusion, Mr. Holme said.
Certainly, telecommunications is no stranger to turmoil after a meltdown at upstart carriers and
established equipment makers resulted in the loss of more than 500,000 jobs worldwide in the last
two years. Communications companies large and small are now in for an unexpected extension of this
instability.
Among the most obvious candidates for closer scrutiny is Qwest, which said last week that it had
received an S.E.C. subpoena demanding details of its dealings with Global Crossing.
Qwest has been forced out of the short-term debt markets amid growing doubts about the legitimacy
of off-balance-sheet transactions involving Global Crossing and other companies. Fortunately for
Qwest, which is based in Denver, it can count on a stream of revenue from local phone operations in
14 states.
The stress from the Global Crossing inquiry also extended to Europe, where Cable and Wireless of
Britain and KPNQwest (news/quote) of the Netherlands came under pressure last week as investors
questioned their use of swap transactions to show healthy revenue gains when little or no money was
actually generated.
Roy L. Olofson, a former vice president for finance at Global Crossing, contends that the company
misled investors by engaging in these swaps, in which the outgoing transfer of capacity was counted as
revenue while the incoming capacity was considered a capital expense, making it seem as if the
company's cash flow kept climbing from such deals.
In some of the deals, Global Crossing and its counterparts issued checks to each other in equal
amounts, potentially allowing each to use the proceeds as an increase in revenue, according to Mr.
Olofson's lawyer, Brian C. Lysaght. In other transactions, no money may have changed hands.
Qwest and Cable and Wireless are just two companies known to have done swaps of this type with
Global Crossing. Other companies include Flag Telecom of Britain, China Netcom and Telecom New
Zealand, according to people close to Global Crossing. Many other companies, including Tyco and
WorldCom (news/quote), used the same type of transaction to show growing revenue before the
market for such transactions abruptly collapsed about the middle of last year.
The collapse was caused, in effect, by market forces. With the spot price of bandwidth down 90
percent and bound to fall further, it made no economic sense for carriers to make long-term leasing
arrangements.
Such complexity was much less common in the telecommunications world just five years ago, when
big companies like AT&T (news/quote), British Telecommunications (news/quote) and Deutsche
Telekom (news/quote) dominated the business.
Long-distance phone calls were of decent quality but expensive. The Internet was not the big deal it is
today. When the industry's titans ran short of capacity on their own systems or on crowded
transoceanic cables, they hammered out deals with one another by swapping space on their networks.
This system worked fairly well, partly because it helped the companies avoid the need to raise
additional money for the installation of cables across the Atlantic or the Pacific. That changed in 1997
with the creation of Global Crossing. It dreamed of profitably transmitting phone calls and Internet
data across a 100,000-mile fiber optic network spanning more than two dozen countries. Companies
like Level 3 Communications (news/quote) and 360networks (news/quote) quickly sprang up as
rivals.
There was no way the average investor could have known that Global Crossing's business model had
come under scrutiny in June 2000, when the company's potential appeared almost as unlimited as that
of the Internet itself. But on June 5 of that year, the S.E.C. began to take a close look at Global
Crossing's books.
Among the S.E.C.'s concerns were how Global Crossing accounted for capacity swaps and the
independence of its auditor, Arthur Andersen. Global Crossing had recently hired as its executive vice
president for finance Joseph Perrone, the Arthur Andersen executive in charge of auditing Global
Crossing.
In fact, according to people close to Global Crossing, Mr. Perrone was already known at the
company as co- author of a two-page memo dated Feb. 10, 1999, before his hiring, in which he
recommended how to best account for capacity swaps.
Among Mr. Perrone's suggestions in the memo, these people said, were to keep the contracts 60
days apart, apparently to avoid suspicion that the deals were reached merely to help each party meet
its quarterly financial objectives, and to require each party to submit separate cash payments,
apparently to create the look of a valid deal.
In its July 20, 2000, response to the S.E.C. query, Global Crossing made it clear that its accounting
had been accepted by Arthur Andersen. Global Crossing also said it had based its long-term leases
on an arcane interpretation of Statement 66, a rule for recognizing profit or loss from sales of real
estate developed by the Financial Accounting Standards Board, the group that sets accounting
standards for business.
The S.E.C. apparently gave Global Crossing its blessing to proceed with the long-term leases of
capacity on its network that eventually were the basis for the swaps the company made with Qwest
and several other companies in 2000 and 2001.
Global Crossing continues to deny that it has done anything wrong. And transactions by Global
Crossing and others that have been called into question are based on a legitimate, longstanding
practice in the telecom industry known as an I.R.U. sale.
I.R.U. stands for the indefeasible right to use a certain amount of bandwidth on a communications
company's network. For instance, Company A might own a network that links Seattle and Chicago.
Company B has customers in those two cities who want to communicate.
Company A might sell Company B the right to use 622 megabits of capacity on the Seattle-Chicago
route for 25 years, meaning that Company B would have the right to transmit 622 million bits of digital
information each second on that route. In exchange, Company B might write a check to Company A
for $100 million.
Company A must now choose between two methods of accounting for the $100 million, both
potentially legal. The more conservative path would be to record the $100 million as income
gradually, over the life of the I.R.U. contract. If the contract were for 25 years, the company would
record $4 million in revenue each year, or $1 million each quarter. Most well-established
telecommunications companies, like AT&T, use the more conservative method.
The more aggressive method would be to record the $100 million as revenue all at once. Under
certain circumstances, this method can fall within generally accepted accounting principles.
Nonetheless, it is generally shunned. In fact, Qwest appears to be one of the only major companies to
use it.
GLOBAL CROSSING essentially tried to have it both ways at once, and even then did not follow its
own rules and may have misled investors, according to statements by Mr. Olofson.
In some cases, Global Crossing appeared to use the more conservative method in its formal revenue
statements. Global Crossing, however, encouraged investors to focus not on its formal revenue
statements but rather on an unofficial measure that it called "cash revenue." Many analysts and
investors did just that.
It was in its cash revenue statements that Global Crossing often recorded all of its I.R.U. sales at
once, helping the company meet its quarterly financial targets. In the first quarter of 2001, for instance,
about one-third of Global Crossing's roughly $1.6 billion in cash revenue appeared to come from the
upfront recognition of I.R.U. sales.
A result, according to Mr. Olofson, is that Global Crossing did not even follow its own rules for
reporting cash revenue, rules that investors relied upon. Last year, Global Crossing recorded $150
million in cash revenue from a transaction in which it did not actually receive any cash, according to
Mr. Olofson.
Among the company's partners in various reciprocal deals, EPIK and Qwest have publicly
acknowledged working with Global Crossing. A Cable and Wireless spokesman said, "Certainly we
have purchased capacity from Global Crossing, mainly capacity within Europe." He declined to
specify the size of the deals. A spokesman for Flag declined to say whether his company had any
dealings with Global Crossing. Calls to China Netcom and Telecom New Zealand were not returned.
As far as the other companies' accounting practices are concerned, EPIK has said that it uses the
more conservative method, as has Flag. Cable and Wireless reports its results under the accounting
standards of both Britain and the United States. Under British standards, the company often records
I.R.U. sales all at once. Under American standards, the company says it spreads out those sales over
the life of the various contracts. It is unclear how China Netcom and Telecom New Zealand report
results.
There will it all end? One clue may lie in the history of the nation's railroads, which are often compared
to relatively young fiber optic systems. Some fiber optic operators, like Qwest, even got their start by
laying fiber along existing rail lines.
By now it is almost forgotten that railroad companies expanded with ferocity in a post-Civil War
boom that resulted in a spectacular financial collapse called the Panic of 1873. Many small investors
were burned by the scandalous activities of concerns like Union Pacific Railroad, which, like Global
Crossing, stretched the boundaries of corporate behavior in its day.
But eventually, as true believers of the fiber optic age are quick to point out, the glut of unused railway
capacity was absorbed.<<
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