The Curious Case of WorldCom

Arghya Sarkar, 10012311

Introduction

July 21, 2002. WorldCom, then world’s leading telecom company filed for chapter 11

bankruptcy. In spite of a slow market, WorldCom showed, at least on paper, good

potential for growth and sustainable expansion. So, what really happened to the

telecom giant is a burning question. Through this discussion we try to find and

answer some of the questions and doubts raised by the incident.

Industry Overview

The telecom boom of 1990s coincided with the discovery of internet and the so-called

dot-com bubble. The telecom companies seemed to be developing tangible assets that

were valuable in the information age: fibre-optic networks, routers and other telecom

equipment, satellites, wireless systems, and upgraded telephone and cable TV

networks capable of providing high-speed Internet connections. Secondly, the

telecom industry was not only well-established but had long been the very

embodiment of stability and guaranteed returns. Even after the breakup of the Bell

system in 1984, AT&T and the regional Bell operating companies (the "Baby Bells")

had remained bulwarks of the economy. Third and most importantly, governments

all over the world, led by the United States, were opening up their telecom markets

to competition. Public policy was inviting new entrants to jump in. Competition

meant that returns were no longer guaranteed, but the simultaneous rise of the

Internet and advent of deregulation created an unprecedented opportunity to make

money -- and, as many discovered, to lose it.

After congress passed the telecommunications Act of 1996, capital flooded into

telecom, as existing firms and new ones began building networks over land, undersea

and in the air. "Business plans all looked alike," one industry insider recalls.

"Massively parallel systems were being built up."

By 2000, however, companies began to realize that there simply wasn't enough

business to go around, and they raced "to gain market share" in a burst of "hyper-

competition" and "vicious price wars" that drove down revenues.

So, despite the bankruptcy and subsequent failure of WorldCom being largely

accredited to the internal fraud and accounting scandal, the effect of the market

cannot be ignored altogether. After a supersonic boom in the telecom industry during

the 1990’s the market experienced sudden shocks, and responded badly. Suddenly,

stock analysts were devaluing telecom stocks, people were not willing to invest in

such companies, and the expansion stopped. Companies had to take notice and

devise alternate methods to counter this trough. WorldCom being an exclusive

telecom company had to depend on their previous policies and could not diversify or

diverge in the tight market situation.

Company Profile

The story of WorldCom began in 1983 when businessmen Murray Waldron and

William Rector sketched out a plan to create a long distance telephone service

provider on a napkin in a coffee shop in Hattiesburg, Miss. Their new company, Long

Distance Discount Service (LDDS), began operating as a long distance reseller in

1984. Early investor Bernard Ebbers was named CEO the following year.

Through acquisitions and mergers, LDDS grew quickly over the next 15 years. The

company changed its name to WorldCom, achieved a worldwide presence, acquired

telecommunications giant MCI, and eventually expanded beyond long distance

service to offer the whole range of telecommunications services. WorldCom became

the second-largest long-distance telephone company in America, and the firm

seemed poised to become one of the largest telecommunications corporations in the

world. Instead, it became the largest bankruptcy filing in U.S. history at the time and

another name on a long list of those disgraced by the accounting scandals of the

early 21st century. @ danielsethics.mgt.unm.edu/pdf/WorldCom%20Case.pdf

Rapid Growth

WorldCom reached the pinnacle of the telecom industry using aggressive expansion

strategy. The aggression is most evident in the 65 acquisitions & mergers in 6 years.

Between 1991 and 1997, WorldCom spent almost $60 billion in the acquisition of

many of these companies and accumulated $41 billion in debt. Two of these

acquisitions were particularly significant. The MFS Communications acquisition

enabled WorldCom to obtain UUNet, a major supplier of Internet services to business,

and MCI Communications gave WorldCom one of the largest providers of business

and consumer telephone service. By 1997, WorldCom's stock had risen from pennies

per share to over $60 a share.

Through what appeared to be a successful business strategy at the height of the

boom, WorldCom became a darling of Wall Street. This was a company "on the move,"

and investment banks, analysts and brokers began to make "strong buy

recommendations" to investors. This rapid and vicious expansion strategy actually

stems the problem for WorldCom. Once the acquisitions were prohibited to maintain

market structure, the debt hit back severely. Plus, the company policy was strictly

to gobble up competitors but management did not take enough measure to efficiently

integrate newly acquired firms. This resulted in operational shortcomings and cross-

departmental discrepancies.

Only Acquisition, No Merger, Poor Integration

Mergers and acquisitions present significant managerial challenges in at least two

areas. First, management must deal with the challenge of integrating new and old

organizations into a single smoothly functioning business. This is a time-consuming

process that involves thoughtful planning and considerable senior managerial

attention if the acquisition process is to increase the value of the firm to both

shareholders and stakeholders. With 65 acquisitions in six years and several of them

large ones, WorldCom management had a great deal on their plate. The second

challenge is the requirement to account for the financial aspects of the acquisition.

The complete financial integration of the acquired company must be accomplished,

including an accounting of assets, debts, good will and a host of other financially

important factors. This must be accomplished through the application of generally

accepted accounting practices (GAAP).

WorldCom's efforts to integrate MCI illustrate several areas senior management did

not address well. In the first place, Ebbers appeared to be an indifferent executive

who paid scant attention to the details of operations. For example, customer service

deteriorated. For all its talent in buying competitors, the company was not up to the

task of merging them. Dozens of conflicting computer systems remained, local

systems were repetitive and failed to work together properly, and billing systems were

not coordinated.

Regarding financial reporting, WorldCom used a liberal interpretation of accounting

rules when preparing financial statements. In an effort to make it appear that profits

were increasing, WorldCom would write down in one quarter millions of dollars in

assets it acquired while, at the same time, it "included in this charge against earnings

the cost of company expenses expected in the future. The result was bigger losses in

the current quarter but smaller ones in future quarters, so that its profit picture

would seem to be improving."

The acquisition of MCI gave WorldCom another accounting opportunity. While

reducing the book value of some MCI assets by several billion dollars, the company

increased the value of "good will," that is, intangible assets-a brand name, for

example by the same amount. This enabled WorldCom each year to charge a smaller

amount against earnings by spreading these large expenses over decades rather than

years. The net result was WorldCom's ability to cut annual expenses, acknowledge

all MCI revenue and boost profits from the acquisition.

WorldCom managers also tweaked their assumptions about accounts receivables,

the amount of money customers owe the company. For a considerable time period,

management chose to ignore credit department lists of customers who had not paid

their bills and were unlikely to do so. In this area, managerial assumptions play two

important roles in receivables accounting. In the first place, they contribute to the

amount of funds reserved to cover bad debts. The lower the assumption of non-

collectable bills, the smaller the reserve fund required. The result is higher earnings.

Secondly, if a company sells receivables to a third party, which WorldCom did, then

the assumptions contribute to the amount or receivables available for sale.

This merry-go-round continued only until the acquisitions were going on smoothly.

After strict legal bindings were put into place, WorldCom started to feel the pressure.

On October 5, 1999, Sprint Corporation and MCI WorldCom announced a $129

billion merger agreement between the two companies. Had the deal been completed,

it would have been the largest corporate merger in history, causing MCI WorldCom

to be even larger than AT&T and therefore the largest communications company in

the United States. However, the deal did not finalize because of opposition from the

U.S. Department of Justice and the European Union on concerns of it creating a

monopoly. On July 13, 2000, the boards of directors of both companies terminated

the merger process. This halted the WorldCom expansion juggernaut.

Bernie Ebbers’ Loan

One other ethical and operational issue people want WorldCom to answer is the

Board decision to allow Bernie Ebbers a mammoth loan to cover up margin calls.

Through generous stock options and purchases, Ebbers' WorldCom holdings grew

and grew, and he typically financed these purchases with his existing holdings as

collateral. This was not a problem until the value of WorldCom stock declined, and

Bernie faced margin calls (a demand to put up more collateral for outstanding loans)

on some of his purchases. At that point he faced a difficult dilemma. Because his

personal assets were insufficient to meet the call, he could either sell some of his

common shares to finance the margin calls or request a loan from the company to

cover the calls. Yet, when the board learned of his problem, it refused to let him sell

his shares on the grounds that it would depress the stock price and signal a lack of

confidence about WorldCom's future.

Had he pressed the matter and sold his stock, he would have escaped the bankruptcy

financially whole, but Ebbers honestly thought WorldCom would recover. Thus, it

was enthusiasm and not greed that trapped Mr. Ebbers. The executives associated

with other corporate scandals sold at the top. In fact, other WorldCom executives did

much, much better than Ebbers did.

The policy of boards of directors authorizing loans for senior executives raises

eyebrows. The sheer magnitude of the loans to Ebbers was breath-taking. The $341

million loan the board granted Mr. Ebbers is the largest amount any publicly traded

company has lent to one of its officers in recent memory. Beyond that, some question

whether such loans are ethical. "A large loan to a senior executive epitomizes

concerns about conflict of interest and breach of fiduciary duty," said former SEC

enforcement official Seth Taube. Nevertheless, 27 percent of major publicly traded

companies had loans outstanding for executive officers in 2000 up from 17 percent

in 1998 (most commonly for stock purchase but also home buying and relocation).

Moreover, there is the claim that executive loans are commonly sweetheart deals

involving interest rates that constitute a poor return on company assets. WorldCom

charged Ebbers slightly more than 2percent interest, a rate considerably below that

available to "average" borrowers and also below the company's marginal rate of

return. Considering such factors, one compensation analyst claims that such lending

"should not be part of the general pay scheme of perks for executives…I just think

it's the wrong thing to do."

Jack Grubman Effect

Philip F. Anschutz, founder of ailing local and long-distance upstart Qwest

Communications International Inc. reaped $1.9 billion from company stock sales

since 1998. Former Qwest CEO Joseph P. Nacchio sold $248 million worth of stock

before he was pushed out of the scandal-plagued company in June. Global Crossing

founder Gary Winnick sold $734 million of his shares before his company filed for

bankruptcy in January. And former WorldCom CEO Bernard J. Ebbers borrowed

$341 million from his company before he was ousted in April--and that loan remains

to be repaid.

What do these execs have in common? They were all central players in a tight-knit

telecom clique that dominated the communications industry in the second half of

the last decade. Individually, some of these men were well known, but the ties among

them are much tacit. The group was linked through Salomon Smith Barney's telecom

analyst Jack B. Grubman.

Grubman's influence stretched far beyond the three companies mentioned above.

According to Thomson Financial Securities Data, Salomon helped 81 telecom

companies raise $190 billion in debt and equity since 1996, the year the

Telecommunications Act was passed to deregulate the telephone industry. In return,

Salomon, part of Citigroup, received hundreds of millions in underwriting fees and

tens of millions more for advising its stable of telecom players on mergers and

acquisitions. Grubman himself was paid about $20 million a year.

Grubman first met Bernie Ebbers in the early 1990s when he was heading up the

precursor to WorldCom, LDDS Communications. The two hit it off socially, and

Grubman started hyping the company. Investors were handsomely rewarded for

following Grubman's buy recommendations until stock reached its high, and

Grubman rose financially and by reputation. In fact, Institutional Investing magazine

gave Jack a Number 1 ranking in 1999, and Business Week labelled him "one of the

most powerful players on Wall Street.

So powerful was Grubman in his heyday that he could direct development of the

telecom industry. He could raise millions for start-up players, win investor support

for a proposed acquisition, or boost a company's stock price. But Grubman's

interests were deeply conflicted, and he came to personify the blurred lines between

research and investment banking in the boom. More than any other telecom analyst,

he was actively involved with the companies he covered. Many critics felt that made

it impossible for him to be objective about those companies' prospects. For example,

he helped Anschutz recruit Nacchio as Qwest's chief executive in 1997, and he aided

Global Crossing's Winnick in his $11 billion acquisition of Frontier Communications.

Certainly Grubman did everything he could to tout his personal relationship with

Bernie Ebbers. He bragged about attending Bernie's wedding in 1999. He attended

board meeting at WorldCom's headquarters. While the other analysts strained to

glimpse any titbit of information from the company's conference call, Grubman would

monopolize the conversation.

As the telecom bubble began deflating in 2000 and 2001 and other analysts began

to warn that the industry was straining under the weight of excess capacity and

enormous debt, he continued urging investors to load up on shares of Qwest, Global

Crossing, WorldCom, and others. In March, 2001, Grubman issued a "State of the

Union" report in which he wrote:

"We believe that the underlying demand for network based services remains strong.

In fact, we believe that telecom services, as a percent of [gross domestic product], will

double within the next seven or eight years."

Just for the readers’ information, Grubman had a personal history of distorting truth

for personal gain. He lied on his official Salomon biography for years--claiming he

had graduated from the prestigious Massachusetts Institute of Technology when his

alma mater was really Boston University. He also claimed to have grown up in South

Philadelphia when he really was from Oxford Circle in the northeast part of

Philadelphia.

Other Wall Street analysts, including Daniel P. Reingold of CS First Boston, stopped

recommending the stock last year because of its deteriorating long-distance business

and slowing growth rate. Yet Grubman reiterated his "strong buy" regularly in 2001

because, he said, it had the "best assets in the telecom industry." Grubman didn't

downgrade WorldCom to a "neutral" until Apr. 22, when the company slashed its

revenue targets for 2002. By that time, WorldCom's shares had dropped about 90%

from their peak, to $4.

Both Ebbers and WorldCom CFO Scott Sullivan were granted privileged allocations

in IPO auctions. While the Securities and Exchange Commission allows underwriters

like Salomon Smith Barney to distribute their allotment of new securities as they see

fit among their customers, this sort of favouritism has angered many small investors.

Banks defend this practice by contending that providing high-net-worth individuals

with favoured access to hot IPOs is just good business. Alternatively, they allege that

greasing the palms of distinguished investors creates a marketing "buzz" around an

IPO, helping deserving small companies trying to go public get the market attention

they deserve. For the record, Mr. Ebbers personally made $11 million in trading

profits over a four-year period on shares from initial public offerings he received from

Salomon Smith Barney.

No question, the damage caused by Grubman and his circle of insiders is threatening

to undermine the health of the telecom industry. While Grubman and his allies

encouraged investors to cough up the billions of dollars needed to make huge new

capital investments in fibre-optic networks and broadband connections, it's now

clear that that vision of the future was wildly hyped. Billions in investments are going

to waste, as little as 3% of new long-distance networks are being used, and investors

are fleeing the sector. Even once-stable players are suffering. On July 23, local-phone

giant BellSouth said WorldCom owes the company $75 million to $160 million,

contributing to a 15% drop in BellSouth's stock price that day.

Fraud and Accounting Scandal

Unfortunately for thousands of employees and shareholders, WorldCom used

questionable accounting practices and improperly recorded $3.8 billion in capital

expenditures, which boosted cash flows and profit over all four quarters in 2001 as

well as the first quarter of 2002. This disguised the firm’s actual net losses for the

five quarters because capital expenditures can be deducted over a longer period of

time, whereas expenses must be subtracted from revenue immediately.

WorldCom also spread out expenses by reducing the book value of assets from

acquired companies and simultaneously increasing the value of goodwill. The

company also ignored or undervalued accounts receivable owed to the acquired

companies. These accounting practices made it appear as if WorldCom’s financial

situation was improving every quarter. As long as WorldCom continued to acquire

new companies, accountants could adjust the values of assets and expenses.

Internal investigations uncovered questionable accounting practices stretching as far

back as 1999. Investors, unaware of the alleged fraud, continued to purchase the

company’s stock, which pushed the stock’s price to $64 per share. Even before the

improper accounting practices were disclosed, however, WorldCom was already in

financial turmoil. Declining rates and revenues and an ambitious acquisition spree

had pushed the company deeper in debt. The company also used the rising value of

their stock to finance the purchase of other companies. However, it was the

acquisition of these companies, especially MCI Communications, that made

WorldCom stock so desirable to investors.

In July 2001, WorldCom signed a credit agreement with multiple banks to borrow

up to $2.65 billion and repay it within a year. According to the banks, WorldCom

tapped the entire amount six weeks before the accounting irregularities were

disclosed. The banks contend that if they had known WorldCom’s true financial

picture, they would not have extended the financing without demanding additional

collateral.

On June 28, 2002, the Securities and Exchange Commission (SEC) directed

WorldCom to disclose the facts underlying the events described in a June 25 press

release regarding the company’s intention to restate its 2001 and first quarter 2002

financial statements. The resulting document explained that CFO Scott Sullivan had

prepared the financial statements for 2001 and the first quarter of 2002. WorldCom’s

audit committee and Arthur Andersen, the firm’s outside auditor, had held a meeting

on February 6, 2002, to discuss the audit for year ending in December 31, 2001.

Arthur Andersen had assessed WorldCom's accounting practices to determine

whether there were adequate controls to prevent material errors in the financial

statements. Andersen attested that WorldCom's processes for line cost accruals and

for capitalization of assets in property and equipment accounts were effective. In

response to specific questions by the committee, Andersen had also indicated that

its auditors had no disagreements with management and that it was comfortable

with the accounting positions taken by WorldCom.

WorldCom admitted to violating generally accepted accounting practices (GAAP), and

adjusted their earnings by $11 billion dollars for 1999-2002. Looking at all of

WorldCom’s financial activities for the period, experts estimate the total value of the

accounting fraud at $79.5 billion.

Caught Red-handed

So long as there were acquisition targets available, the merry-go-round kept turning,

and WorldCom could continue these practices. The stock price was high, and

accounting practices allowed the company to maximize the financial advantages of

the acquisitions while minimizing the negative aspects. WorldCom and Wall Street

could ignore the consolidation issues because the new acquisitions allowed

management to focus on the behaviour so welcome by everyone, the continued rise

in the share price. All this was put in jeopardy when, in 2000, the government refused

to allow WorldCom's acquisition of Sprint. The denial stopped the carousel, put an

end to WorldCom's acquisition-without-consolidation strategy and left management

a stark choice between focusing on creating value from the previous acquisitions

with the possible loss of share value or trying to find other creative ways to sustain

and increase the share price.

In July 2002, WorldCom filed for bankruptcy protection after several disclosures

regarding accounting irregularities. Among them was the admission of improperly

accounting for operating expenses as capital expenses in violation of generally

accepted accounting practices (GAAP). WorldCom has admitted to a $9 billion

adjustment for the period from 1999 through the first quarter of 2002.

The chunk of the credit goes to Cynthia Cooper whose careful detective work as an

internal auditor at WorldCom exposed some of the accounting irregularities

apparently intended to deceive investors. Originally assigned responsibilities in

operational auditing, Cynthia and her colleagues grew suspicious of a number of

peculiar financial transactions and went outside their assigned responsibilities to

investigate. What they found was a series of clever manipulations intended to bury

almost $4 billion in misallocated expenses and phony accounting entries.

Aftermath

WorldCom did not have the cash needed to pay $7.7 billion in debt, and therefore,

filed for Chapter 11 bankruptcy protection on July 21, 2002. In its bankruptcy filing,

the firm listed $107 billion in assets and $41 billion in debt. WorldCom’s bankruptcy

filing allowed it to pay current employees, continue service to customers, retain

possession of assets, and gain a little breathing room to reorganize. However, the

telecom giant lost credibility along with the business of many large corporate and

government clients, organizations that typically do not do business with companies

in Chapter 11 proceedings.

In 2001 WorldCom created a separate “tracking” stock for its declining MCI consumer

long-distance business in the hopes of isolating MCI from WorldCom’s Internet and

international operations, which were seemingly stronger. WorldCom announced the

elimination of the MCI tracking stock and suspended its dividend in May 2002 in the

hopes of saving $284 million a year. The actual savings were just $71 million. The

S&P 500 reduced WorldCom’s long-term and short-term corporate credit rating to

“junk” status on May 10, 2002, and NASDAQ de-listed WorldCom’s stock on June

28, 2002, when the price dropped to $0.09.

In March 2003, WorldCom announced that it would write down close to $80 billion

in goodwill, write off $45 billion of goodwill as impaired, and adjust $39.2 billion of

plant, property, and equipment accounts and $5.6 billion of other intangible assets

to a value of about $10 billion. These 3 figures joined a growing list of similar write-

offs and write-downs as companies in the telecommunications, Internet, and high-

tech industries admitted they overpaid for acquisitions during the tech boom of the

1990s.

Biggest Losers

One person who was largely affected by the fall of WorldCom is definitely Bernie

Ebbers. He sincerely believed in the company. Even during the recessionary phase

he did not behave like other senior execs and sell his shares. He held onto them in

hope that WorldCom will bounce back. In his entire career as the head of WorldCom

and its predecessors, Mr. Ebbers sold company shares only half a dozen times. Under

the terms of the settlement, Ebbers agreed to relinquish a significant portion of his

assets, including a lavish home in Mississippi, and his interests in a lumber

company, a marina, a golf course, a hotel, and thousands of acres of forested real

estate. On paper, Ebbers was supposedly left with around $50,000 in known assets

after settlement. Furthermore, on July 13, 2005, Bernard Ebbers received a sentence

that would keep him imprisoned for 25 years. On September 26, 2006, Ebbers

surrendered himself to the Federal Bureau of Prisons prison at Oakdale, Louisiana,

the Oakdale Federal Corrections Institution to begin serving his sentence.

Those hardest hit, though, are not in boardrooms, but the thousands of former

WorldCom employees, who lost both their jobs and their insurance and pensions.

Many of their savings were wiped out by the collapse in the price of the company's

stock, and some are still struggling to find work. On August 7, 2002, the exWorldCom

5100 group was formed. It was composed of former WorldCom employees with a

common goal of seeking full payment of severance pay and benefits based on the

WorldCom Severance Plan. The "5100" stands for the number of WorldCom

employees dismissed on June 28, 2002 before WorldCom filed for bankruptcy.

Reorganisation & Acquisition

WorldCom took many steps toward reorganization, including securing $1.1 billion in

loans and appointing Michael Capellas as chairman and CEO. WorldCom also tried

to restore confidence in the company, including replacing the board members who

failed to prevent the accounting scandal, firing many managers, reorganizing its

finance and accounting functions, and making other changes designed to help

correct past problems and prevent them from reoccurring. Additionally, the audit

department staff is was increased and reported directly to the audit committee of the

company’s new board. “We are working to create a new WorldCom,” John Sidgmore

said. “We have developed and implemented new systems, policies, and procedures.”

In 2003, the company renamed itself MCI and emerged from bankruptcy proceedings

in 2004.

However, this reorganization was not enough to restore consumer and investor

confidence, and Verizon Communications acquired MCI in December 2005. The

WorldCom accounting fraud changed the entire telecommunications industry. As

part of their overvaluing strategy, WorldCom had also overestimated the rate of

growth in Internet usage, and these estimates became the basis for many decisions

made throughout the industry. AT&T, WorldCom/MCI’s largest competitor, was also

acquired. Over 300,000 telecommunications workers lost their jobs as the

telecommunications struggled to stabilize. Many people have blamed the rising

number of telecommunication company failures and scandals on neophytes who had

no experience in the telecommunication industry. They tried to transform their start-

ups into gigantic full-service providers like AT&T, but in an increasingly competitive

industry, it was difficult for so many large companies could survive.

Acknowledgements

[1] Romero, Simon, & Atlas, Rava D. (2002). WorldCom's Collapse: The Overview.

New York Times (July 22)

[2] Rosenbush, S. (2002). Inside the Telecom Game. Business Week (August 5)

[3] WorldCom, a case study update

http://www.scu.edu/ethics/dialogue/candc/cases/worldcom-update.html

[4] WorldCom, a case study

http://www.scu.edu/ethics/dialogue/candc/cases/worldcom.html

[5] The big lie: Inside the Rise & Fraud of WorldCom, Documentary

http://www.liveleak.com/view?i=fe0_1194129196

[6] WorldCom's Bankruptcy Crisis

danielsethics.mgt.unm.edu/pdf/WorldCom%20Case.pdf

[7] Sandberg, J. (2002). Bernie Ebbers Bet the Ranch-Really-on WorldCom stock.

Wall Street Journal (April 14)

[8] Belson, Ken. "WorldCom's Audacious Failure and Its Toll on an Industry." The

New York Times, 18 January 2005.

[9] MCI Inc. (WorldCom) Wikipedia http://en.wikipedia.org/wiki/MCI_Inc.

[10] Bernard Ebbers Wikipedia http://en.wikipedia.org/wiki/Bernard_Ebbers

[11] Google Images for the images used, and Wikipedia in general.