The feds have turned to Qwest ( Q) in their quest to figure out what's going on at Global Crossing.

Qwest shares fell 4% Monday after the Denver telco said it received a Securities and Exchange Commission subpoena related to dealings with undersea network builder Global Crossing, which filed for Chapter 11 last month. Most analysts and investors don't expect the probe to unearth anything untoward about broadband builder Qwest, whose shares are already more than 75% off their 52-week high.

What the investigation could do is show just how widespread the age-old industry practice of swapping long-distance capacity became in the late-1990s Internet construction spree, and how some players used the concept to their advantage. With Wall Street unnerved by the accounting scandal at Enron as well as earnings restatements elsewhere, the probe could easily damage already flagging investor confidence in the entire telecom sector.

"In the beginning stage of network construction, swaps were a cheaper way to provide capacity," says Friedman Billings Ramsey analyst Susan Kalla. "But by 2000 and 2001 when most of these networks were built out, swapping became more of a revenue enhancement deal."

Where It Starts

Qwest for Fire
Stock slides during 2002

Global Crossing became the telecom industry's biggest-ever bankruptcy case when the company sought protection from creditors on Jan. 28. The onetime highflier's accounting immediately came under scrutiny from both the SEC and the FBI; a spate of class-action securities fraud lawsuits followed. The company has said that both its accounting and its disclosure were proper.

Industry observers say SEC investigators are looking to find out three things: Did Global Crossing need to buy network capacity from other carriers to satisfy customer demand? Did Global Crossing artificially inflate the value of the contracts? And did Global Crossing buy and sell the same network routes to pad sales?

Global Crossing, like nearly all phone companies, bought capacity from other carriers, including Qwest, to satisfy traffic demands and fill in missing pieces of network maps. These transactions, known as indefeasible rights of use, or IRUs, are typically multiyear leases of communications routes in or between cities.

The practice has been commonplace in the telecom industry ever since there have been competitors in long-distance phone service. And it has been customary for phone companies to list rivals among their top customers. But since the Net building boom of the late 1990s, the industry has faced an excess of capacity and a troubling erosion of revenues, which some observers say pressured managers to come up with new sources of investor-pleasing growth.

Rising From the Dead

Now, industry watchdogs and investigators are questioning whether arrangements such as IRUs have been abused to enhance sales. Among the more questionable practices is a swap setup called "round-tripping," in which a carrier buys a route from another carrier, say between Chicago and Atlanta. At the same time, the other carrier buys the identical route. Both companies record the deal as a sale -- possibly at inflated prices, analysts and investors say -- and both companies record the purchase as a capital expense, which keeps the deal from hurting earnings. As TheStreet.com's own Peter Eavis outlined last summer, deals of this nature can enhance sales numbers without boosting costs.

"There's a fundamental tenet of accounting that says you must match sales with expenses," Kalla says. "What I couldn't understand, after following the long-distance business for 20 years, is how it suddenly rose from the dead."

Qwest has since separated capacity sales in its accounting, in part so investors can better gauge the recurring nature of its revenue.

"Qwest did the right thing to segregate out the one-time IRU revenues and show recurring revenue from this point on," says Thomas Weisel Partners analyst Peter DeCaprio, who has an attractive rating on Qwest. Weisel has no underwriting ties to Qwest. "You can get all hot and bothered about what happened in the past and how this is a quality of revenue issue, but they seem to have gotten it behind them."

Even in the unseen event that Qwest doesn't emerge squeaky clean from this inquiry, DeCaprio sees little to worry about for the company's shareholders. "Then people would have another reason to beat up Qwest and CEO Joe Nacchio," he shrugs.

As DeCaprio points out, Qwest trades at $9 and change -- which is roughly the value of its local phone service business and puts the value of its broadband network at zero. To DeCaprio, at least, most of the bad news is priced in.