Case Study: WorldCom’s Corporate Governance Failure

Subject:21874 Corporate Governance and SustainabilityProfessor: Thomas Clarke

Students: Charlie Chen (#00004301)

Table of Contents• Objective Summary• Brief history of the Company• The consequences of its failure• The Response of President and Parliament • Incompetence of the Company Board • Toxic culture of the Senior Management Team• Corrupted Senior Management Team• Unrealistic and unsustainable Business Model• Cooperate Governance Framework• Conclusion• References

Objective Summary•Analysis of corporate governance failure in WorldCom

case Using forensic skills to find out what went wrong

•Analysis of: • The history of the company and its Business model • the performance of the company, CEO and board, to the

business values, objectives, behaviour and their Relationship with corporate governance

• Introduces:• Recommended Corporate governance principles and

framework

The Rising Star• From 1995 until 2000, WorldCom purchased over sixty other telecom firms.

In 1997 it bought MCI for $37 billion. It was the largest corporate merger of US history.

• In the mid 90s WorldCom moved from long distance discount voice carrier into Internet and data communications carrier market, It was handling 50 percent of all United States Internet traffic and 50 percent of all e-mails worldwide.

• By 2001, WorldCom owned one-third of all data cables in the United States.

• Its Market Value 125 Billion and stock price @$63.50(WorldCom, Capital Edge, Kshitiji 2012)

• On Oct. 5, 1999 Sprint Corp and MCI WorldCom announced a $129 Billion merger agreement. It would be the largest corporate merger in the history. However, the deal was not finalized because of objections of US Department of Justice and European Union. (http://en.wikipedia.org/wiki/Worldcom)

The Falling Star• Beginning modestly during mid-year 1999 and

continuing at an accelerated pace through May 2002, the company (directed by Bernie Ebbers (CEO), Scott Sullivan(CFO), David Myers (Controller) and Buford Yates (Director of General Accounting)) used fraudulent accounting methods to disguise its decreasing earnings to maintain the price of WorldCom’s stock. The fraud was accomplished primarily in two ways:

• Booking ‘line costs’ (interconnection expenses with other telecommunication companies) as capital expenditure on the balance sheet instead of expenses.

• Inflating revenues with bogus accounting entries from "corporate unallocated revenue accounts".

Source: http://en.wikipedia.org/wiki/WorldCom

The stock price had fallen from around 60$ in 1999 to $1 in 2002

The Catastrophies of its Failure

1.On July 21, 2002, WorldCom Filed for Chapter 11 bankruptcy protection which was the largest such filing in the United States History at the time ($4.58 bn in liabilities)

• The company defaulted within two months of the decline to “junk” status

• The largest corporate accounting scandal in the United States, estimated at $11BN as of March 2004

• Almost 20,0000 employees lost their jobs• Investors lost more than 180bn

(Harmantzis, 2004)

The Response of President and Parliament

• President Bush called for tough new legislation to restore faith in American business. Mr Bush said those guilty of corporate fraud should be sent to jail for the sake of US capitalism. He argued that people guilty of such abuses should be prevented from holding high-level business positions again.

• SOX: Sarbanes-Oxley act 2002, was precipitated by Enron , Arthur Andersen , Tyco , Global Crossing and WorldCom. WorlCom was seen as the last straw in driving through legislation.

Lacking Corporate Governance was Root Cause of WorldCom’s Failure

• The WorldCom case has become a kind of poster child and a genuine case study in the failure of corporate governance, in this new century. (Dick Thornburgh, Former Attorney General of the United States and Court-Appointed Examiner in the WorldCom Bankruptcy

Proceedings)

Incompetence of the Board of WorldCom

(T. Clarke 2013)

• The company’s board of directors were not paying attention to how the company was running. Along the way, WorldCom amassed billions of dollars in debt, weighing down its sagging cash flow with massive debt-service obligations. WorldCom were having an incredibly devaluated asset next to $30bn debt.

• Starting in late 2000 and continuing throughout 2001, the board made a series of loans to Ebbers to prevent him selling his stock to meet margin calls. (Harmantzis, 2004)

• Board of directors had a “habit of rubber stamping senior management decisions without scrutinising” (Capital Edge, 2012)

Toxic Culture of Senior Management Team

• Believed that their actions were not “really” illegal• Unrealistic financial targets and inability to meet them• Recording of a/c entries without any evidence• Company was capitalizing its line costs. Line costs were operating

expenses but WorldCom classified as capital expenditure• In 2000 and 2001, WorldCom claimed pre tax revenue of 7.6 and 2.4

Bn $ respectively. Later discovered as loss of 49.9 and14.5 Bn $ for the respective years

• Reserve accounts were manipulated to increase figures• Two versions of accounts the actual version and the Final version for

investors

Corrupted Senior Management Team

• Chief Financial Officer Scott Sullivan and Controller David Myers arrested. Myer’s pleads guilty to three counts of conspiracy

• Chief Executive John W. Sidgmore steps aside from his post

• Buford Yates Jr. pleads guilty to two counts of securities fraud and conspiracy

• At his peak in early 1999, Ebbers was worth an estimated $1.4 billion and listed at number 174 on the Forbes 400.

• CNBC named Ebbers as the fifth-worst CEO in American history; Time Magazine named him the tenth most corrupt CEO of all time.

What will it profit a man if he gains the world but loses his own soul?

(Mark 8:36, Jesus Christ)

Insatiable Appetite for Acquisition• The 1996 Telecommunications Act opened up new markets for WorldCom by allowing long-

distance providers and local telephone companies to compete in other territories. The Act spurred WorldCom into a renewed frenzy of deal making. Among the biggest were MFS Communications (which had previously acquired UUNET, an Internet backbone company; the deal made WorldCom a major Internet player), and MCI, the second –largest telecommunications company in the U.S. after AT&T. at the time, the MCI merger was the largest in history (Harmantzis, 2004)

Date Target Company Price ($billions)

Dec-96 MFS, UUNET 12.5

Jan-98 Brooks, Fiber 2.4

Feb-98 CompuServe 1.3

ANS Communications 0.5

Aug-98 Embratel 2.3

Sep-98 MCI 40

Oct-99 SkyTel 1.7

Jul-11 Digex 5.8

WorldCom Acquisitions, Dec. 1996 to July 2011 Value 66.5

(Thomas Clarke, International Corporate Governance, 2007)

0

10

20

30

40

WorldCom Acquisitions

Unrealistic and Unsustainable Business Model• WorldCom raced to make more than 70 acquisitions in two decades

• acquisitions were never consolidated into a single, seamless enterprise. The company was incapable of functioning properly. Moreover, because of accounting manoeuvres, each new acquisition allowed the company to report higher per-share profits, even when its core business was barely growing, or losing ground (Eichenwald, 2002)

• The unrealistic growth target via massive acquisition introduced significant operational problem such as meagre customers, accounting systems, Telecommunication backbones infrastructures

(Thomas Clarke, 2013)

Proposed US Corporate Governance PrinciplesPosted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday August 17, 2012 at9:22 am

•select a chief executive officer and to oversee the CEO and senior management in the competent and ethical operation

•establishes a culture of legal compliance and integrity.

•develop and implement the corporation’s strategic plans, and to identify, evaluate and manage the risks inherent in the corporation’s strategy.

•oversight of the audit committee and the board, to produce financial statements that fairly present the financial condition and results of operations of the corporation

•engage an independent accounting firm to audit the financial statements prepared by management and issue an opinion that those statements are fairly stated in accordance with Generally Accepted Accounting Principles

•through its corporate governance committee, to play a leadership role in shaping the corporate governance of the corporation and the composition and leadership of the board.

•compensation committee, to adopt and oversee the implementation of compensation policies, establish goals for performance-based compensation, and determine the compensation of the CEO and senior management.

•deal with its employees, customers, suppliers and other constituencies in a fair and equitable manner

Cooperate Governance Framework

http://www.analytix.co.za/Consulting/CorporateGovernance.aspx

• COSO: Committee of Sponsoring Organizations of the Treadway Commission (http://en.wikipedia.org/wiki/Committee_of_Sponsoring_Organizations_of_the_Treadway_Commission)

• King III: Corporate Governance - King III report - Introduction and overview (http://www.pwc.co.za/en/king3/index.jhtml)

• SOX: Sarbanes–Oxley Act-Public Company Accounting Reform and Investor Protection Act' (in the Senate) and 'Corporate and Auditing Accountability and Responsibility Act' (in the House); http://en.wikipedia.org/wiki/Sarbanes%E2%80%93Oxley_Act

• Basel II: banking supervision Accords -recommendations on banking regulations (http://en.wikipedia.org/wiki/Basel_II)

Conclusion• Many contemporary cases in US and Australia told us that corporate governance is

extremely important in the developed world

• Without or lack of corporate governance, in many cases, equivalent to issue CEO a licence to failure

• Good corporate governance is the mechanism to ensure the sustainability of the company (balance shot term gain and long term prospect)

• Shleifer and Vishny(1997) assert that good corporate governance systems are rooted in a appropriate combination of legal protection of investors and some form of concentrated ownership(Denis, Diane & McConnell, John 2001)

• Key factors for effective Corporate governance(Kakabadse, 2009) should focus on:

http://www.youtube.com/watch?v=7g_d-hoUrU

Vision Transparency

Performance Monitoring Effectiveness

Values Accountability

References• BBC News on WorldCom:

• http://news.bbc.co.uk/2/hi/business/2182201.stm

• http://news.bbc.co.uk/2/hi/business/2073641.stm

• Clarke, T. (2007), ‘International Corporate Governance’, Routledge, London and New York

• Eichenwald, K. (2002), ‘For WorldCom, Acquisitions Were Behind Its Rise and Fall’, http://pythonkit.com/For-WorldCom,-Acquisitions-Were-Behind-Its-Rise-and-Fall-download-w18533.pdf

• Harmantzis, F.C. (2004). ‘Inside the Telecom Crash: Bankruptcies, Fallacies and Scandals – A Closer look at the WorldCom case’, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=575881

• Kakabadse, N.K. (2009), ‘Corporate Governance: Global Issues for the Future’, Northampton Business School, University College Northampton

• Khanna, Vikramaditya S. 2003. ‘Should the top behaviour of top management matter?’ Georgetown Law Journal. 91. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=339940

• Noked N. (2012), ‘Principles of Corporate Governance2012’, The Harvard Las School Forum on Corporate Governance and Financial Regulation, http://blogs.law.harvard.edu/corpgov/2012/08/17/principles-of-corporate-governance-2012/

• Sidak, J. Gregory. (2003). ‘The failure of good intentions: The WorldCom fraud and the collapse of the American telecommunications after deregulation’, Yale Journal on Regulation. 20. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=335180

• Thornburgh, D. (2004), ‘A Crisis in Corporate Governance? The WorldCom Experience’, California Institute of Technology

• Wikipedia on WorldCom: http://en.wikipedia.org/wiki/Worldcom