1 The Rise and Fall of WorldCom (Now owned by Verizon) One (of many) Accounting Frauds Leading to the Sarbanes-Oxley Act By John P. Meyer (JFZ edited)

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The Rise and Fall of WorldCom (Now owned by Verizon)

One (of many) Accounting Frauds Leading to the Sarbanes-Oxley ActBy John P. Meyer (JFZ edited)

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Overview of WorldCom

WorldCom was the darling of Wall Street and the Telecom Industry of the 1990’s Grew rapidly through acquisitions and from increased

demand for telecom services High stock price was a powerful currency to make

acquisitions

WorldCom was a casualty of the Dotcom Bubble Burst of 2000 Mgmt resorted to acct fraud to meet financial targets

Mgmt Motive to Manipulate Earnings (see text – pg 19)

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Overview of WorldCom

Key Events– 1996: Acquired MFS Communications (internet backbone)– 1998: Acquired MCI (more than twice it’s size)– 2000: Failed merger with Sprint (would have been the

largest merger in history)– 2000: Dotcom Bubble Burst (rapid decline in telecom

stock values)– 2000-02: WorldCom loans $400M to CEO (Ebbers)– 2002: Accounting Fraud uncovered 2002: Accounting Fraud uncovered – 2002: Filed for Bankruptcy Protection– 2004: Emerged from Bankruptcy as MCI (changed name)– 2005: Verizon agrees to acquire the company for $6.75B

(plus assumption of $6B of Debt)

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Financial Overview of WorldCom

Financial Highlights 19941994 19991999 20012001 20042004

($ in billions)

Revenues $2.2 $37.1 $35.2 $20.7

Total Assets $3.4 $91.1 $103.9 $17.1

Employees (in 000's) 7.5 97.6 87.8 40.4

Market Cap (total shs Market Cap (total shs * market price)* market price) $3.3 $3.3 $150.5 $150.5 $42.8 $42.8 $ 6.4 $ 6.4

Debt $0.8 $ 13.1 $30.0 $ 5.9

Total Capitalization $4.1 $163.6 $72.8 $12.3

Source: Original SEC Filings, before restatements for accounting fraud.

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Nature of the Accounting Fraud

• $11 Billion Accounting Fraud over 3 year period (1999 - 2002)

• Accounting Fraud occurred in two main forms:

1) Understatement of operating expenses through improper

accruals and through improper capitalization of operating expenses.

2) Overstatement of revenues of $1B.

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Impact of the Fraud

Shareholders$180 Billion of shareholder value lost (based on peak

stock price)

Debt & Preferred Stock holders$37.5 Billion of debt and preferred stockholder value lost

Company$750 Million settlement paid to SEC

Employees57,000 employees lost jobs* * Also, current and former employees lost most of their Also, current and former employees lost most of their

retirement savings (invested in WorldCom stock)retirement savings (invested in WorldCom stock)

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Impact of the Fraud

Executives and Accounting Staff6 individuals convicted of fraud / conspiracy / false filings

Ebbers – CEO 25 years in prisonSullivan – CFO 5 years in prisonMyers – Controller 1 year in prisonYates – Dir of Acctg 1 year in prison Vinson – Acctg Dept 5 months in prison Manager 5 months house arrestNormand –Acctg Dept 3 years probation

ManagerAbove 6 individuals agreed to pay a total of $34M to

settle securities class action case.

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Impact of the Fraud

Independent AuditorArthur Andersen agreed to pay $65M to settle securities class

action case.

Insurance CompaniesAgreed to pay $36M to settle claims against WorldCom directors

and officers.

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How It Happened

WorldCom Environment:Substantial Problems with the Company’s Internal Controls

WorldCom was dominated by Ebbers and Sullivan, with WorldCom was dominated by Ebbers and Sullivan, with virtually no checks and constraints placed on their actions.virtually no checks and constraints placed on their actions.

Significant pressure to “meet the numbers”. Lack of courage of employees to communicate the

fraudulent activates – believed it would have cost them their jobs.

A financial system in which controls were extremely deficient.

The BOD and Audit Committee did not appear to have had an adequate understanding of the company and culture.

Inadequate audits by independent auditors.___________Source: Report of Investigation by the Special Investigative Committee of the Board of Directors of

WorldCom, Inc.

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Why ‘good’ managers make bad ethical choices (Source: Saul W. Gellerman)

Rationalizations To Justify Questionable Conduct (One part of the “Fraud Triangle”)

1) Belief that the activity is not “really” illegal.

2) Belief that it is in the individual’s or corporation’s best interest.

3) Belief that it will never be found out or it will correct itself in the future.

4) Belief that the company will condone actions that are taken in its interest and will even protect the managers responsible.

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Why ‘good’ managers make bad ethical choices (Saul W. Gellerman)

ConclusionA good way to avoid management oversights is to

subject the control mechanisms themselves to periodic surprise audits… The point is to make sure that internal audits and controls

are functioning as planned. It is a case of “inspecting the inspectors” and taking the

necessary steps to keep the controls working efficiently.

It is up to Top Management to send a clear & pragmatic message to all employees that good ethics is still the foundation of good business

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Key Take Aways

History repeats itself. Be aware of your environment. If it seems too good to be true, it probably is. No job is worth breaking the law or committing

unethical acts for. Your personal integrity is your most important Your personal integrity is your most important

asset – you own it and control it.asset – you own it and control it. ““Trust, but Verify”.Trust, but Verify”.

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References

First Interim Report of Dick Thornburgh, Bankruptcy Court Examiner – United States Bankruptcy Court Southern District of New York – re. WorldCom, Inc. (November 4, 2002)

Report of Investigation by the Special Investigative Committee of the Board of Directors of WorldCom, Inc. (March 31, 2003)

Second Interim Report of Dick Thornburg, Bankruptcy Court Examiner (June 9, 2003 Why ‘good’ managers make bad ethical choices by Saul W. Gellerman– Harvard Business

Review (July – August 1986) Order to Commit Fraud, A Staffer Balked, Then Caved by Susan Pulliam – Wall Street

Journal (June 23, 2003) Ebbers Is Convicted in Massive Fraud by Almar Latour, Shawn Young and Li Yuan – WSJ

(March 16, 2005) At Center of Fraud, WorldCom Official Sees Life Unravel by Susan Pulliam – WSJ (March

24, 2005) WorldCom’s Myers Gets One-Year Prison Term by Shawn Young – WSJ (August 10,

2005) WorldCom’s Sullivan Gets Five Years in Jail by Dionne Searcey and Shawn Young – WSJ

(August 11,2005) Settlements – WorldCom Securities Litigation – www.worldcomlitigation.com