WorldCom: A Bunch of Dirty Rotten Fraudsters

1. WorldCom: A Bunch of Dirty Rotten Fraudsters MGT 506: Financial Fraud Randy Kim Marina Malyshkina Dominic Ong

2. WorldCom: Overview • Global communications company offering Internet, voice, and data services for business • MCI: WorldCom’s business and residential communication service division. MCI is the nation's second-largest long-distance provider and serves 20 million consumers and thousands of corporate customers. • Market Capitalization of $120 billion in Summer 1999 • Current examples of $120 billion companies: Coca-Cola, Altria, Merck, and Bank of America • Key Executives (Crooks): • CEO Bernie Ebbers • CFO Scott Sullivan • Controller David Myers

3. Quick Review of Accounting 101 (aka MGT870) • Operating Expenses: salaries, insurance, equipment rental, electricity, maintenance contracts. • subtracted from revenue on income statement. • Capital Expenditures result in the acquisition of, or improvement to, the company’s assets. Examples are purchases of real estate, manufacturing equipment, and computer equipment. • Are NOT counted against revenues on income statement. Instead, they are booked as capital assets on the balance sheet. • Reserves: set up to cover adverse developments such as bad debts, anticipated restructuring costs, or warranty claims • Balance sheet item (approx $10 billion at WorldCom) • Companies have discretion on how large to make them. • “Releasing” an accrual is proper when it turns out that less is needed to pay the bills than had been anticipated. It has the effect of providing an offset against reported expenses in the period when the accrual is released. Thus, it reduces reported expenses and increases reported pre-tax income.

4. Accounting Fraud #1: Improperly Releasing Reserves Held Against Operating Expenses (1999 - 2000) • WorldCom has set reserves to pay anticipated bills, reflecting estimates of (unpaid) costs associated with the used of lines and other facilities of outside vendors • In the third quarter of 2000, WorldCom starts to manipulate true line cost expenses by releasing reserves (reduced 3Q line costs by $828 million, and 4Q line costs by $407 million). • How WorldCom manipulated the process of adjusting reserves • First , in some cases accruals were released without any apparent analysis of whether the Company actually had an excess accrual in the account. Thus, reported line costs were reduced (and pre-tax income increased) without any proper basis. • Second , even when WorldCom had excess accruals, the Company often did not release them in the period in which they were identified. Instead, certain line cost accruals were kept as rainy day funds and released to improve reported results when managers felt this was needed. • Third , WorldCom reduced reported line costs by releasing accruals that had been established for other purposes. This reduction of line costs was inappropriate because such accruals, to the extent determined to be in excess of requirements, should have been released against the relevant expense when such excess arose, not recharacterized as a reduction of line costs. • In 1999 and 2000, WorldCom reduced its reported line costs by approximately $3.3 billion through this fraud. Sources: WorldCom’s 6/9/03 8K report to the SEC and Report of Investigation by the Special Investigative Committee of the Board of Directors of WorldCom, Inc., March 31, 2003

5. Accounting Fraud #2: Recharacterizing Certain Expenses as Capital Assets (2001 – 2002) • Line Costs: Fees WorldCom paid, under long-term contracts, to third-party telecommunication carriers for the right to access their network in order to service their customers. • WorldCom’s largest operating expense and typically reached 50% of revenue. • By booking line costs as capital assets instead of as an operating expense, WorldCom. 1. reduced their operating expenses (and increased pre-tax income) 2. increased the value of their capital assets (and total assets) 3. increased the value of the company’s net worth • In April 2001, WorldCom starts making false general ledger entries which transfer a significant portion of line cost expenses to a variety of capital asset accounts. Violates GAAP. • In 2001 and 2002, WorldCom improperly capitalized $3.5 billion of line costs. Sources: WorldCom’s 6/9/03 8K report to the SEC and Report of Investigation by the Special Investigative Committee of the Board of Directors of WorldCom, Inc., March 31, 2003

6. A Bunch of Dirty Liars

7. A Bunch of Dirty Liars (cont.)

8.  How Was Fraud Uncovered? • On May 21, 2002, a WorldCom employee sent a featured article to an internal auditor, indicating that the issues raised in the article might warrant investigation • Article was from the May 16 edition of Fort Worth Weekly Online and was based upon interviews with a former WorldCom employee who was allegedly fired for whistle blowing. • WorldCom’s Internal Audit Department began an investigation concerning the capitalization of line costs. • On June 12, 2002, the Internal Audit team contacted Max Bobbitt, the Chairman of the Audit Committee of the Board of Directors. • $2.5 billion in line costs that had been capitalized. • Mr. Bobbitt requested that these issues be discussed with KPMG prior to a meeting of the Audit Committee on June 14, 2002. • On June 25, 2002, the Board determined that WorldCom would restate its financial statements for 2001 and the first quarter of 2002. • KPMG would reaudit the Company’s financial statements for 2001 • It decided to terminate Mr. Sullivan without severance and to accept the resignation of Mr. Myers without severance.

9. Effect of Fraud • WorldCom/MCI has acknowledged that it committed more fraud than it original reported, raising the estimate from $3.8 billion (June 25, 2002) to $7.2 billion (August 9, 2002) to $9 billion (September 19, 2002). • WorldCom/MCI overpaid taxes and sought to recover $300 million in federal tax payments that it made to cover up its fraudulent activity. • Misrepresented cash position to analysts as “solid” while facing cash crunch. Made loan to Ebbers constituting 30% of WorldCom’s cash. • WorldCom continued to issue securities using fraudulent and materially false financial statements and information. • American investors in WorldCom/MCI lost an estimated $176B in value in WorldCom stock, laid off 25,000 employees and caused another 73,000 job losses in the industry. Source: Gray Panthers, June 25, 2003

10. WorldCom Files for Bankruptcy on July 21, 2002 Image borrowed from www.clarionleger.com

11. WorldCom: The Poster Child For Corporate Governance Failures • WorldCom was dominated by Messrs. Ebbers (CEO) and Sullivan (CFO) with virtually no checks or restraints placed on their actions by the Board of Directors or other Management. • WorldCom Management provided the Company’s Directors with extremely limited information regarding many acquisition transactions. Several multi-billion dollar acquisitions were approved by the Board of Directors following discussions that lasted for 30 minutes or less and without the Directors receiving a single piece of paper regarding the terms or implications of the transactions (e.g. Intermedia -$6B acquisition, 60 –90 min due diligence, 35 min telephone Board meeting) • No evidence of meaningful debt planning. The ability to borrow was facilitated by massive accounting fraud. In 4 years issued more than $25 billion in debt securities at complete discretion of Ebbers and Sullivan. Board rubber-stamped Pricing Committee decisions. • The Compensation and Stock Option Committee approved Company loans of more than $400million to Mr. Ebbers without initially informing the full Board or taking appropriate steps to protect the Company (no due diligence of collateral, use of proceeds). • The Board never questioned non-WorldCom business activities of CEO and effectively funded those with the company money.

12. WorldCom: The Poster Child For Corporate Governance Failures (cont.) • Audit committee had little power, was under funded and understaffed; concentrated only on operational audit. Also improper oversight by external audit – Arthur Andersen. • Screwed up compensation structure. Decisions single-handedly taken by CEO. Most Board members also had stock-based compensation. • Board members had poor oversight on corporate strategy. Very little meaningful or coherent strategic planning at WorldCom. Absence of proper corporate governance protocols.The Company’s approach to acquisitions and significant outsourcing transactions was ad hoc and opportunistic. • Loyalty of Board was ensured by members whose companies had been acquired by WorldCom (6 out of 10) and whose personal fortunes through ownership of the Company’s stock had, for a long period of time, been greatly enhanced during Ebbers’ leadership of WorldCom. • WorldCom was a company that grew tremendously in both size and complexity in a relatively short period of time. Its management, systems, internal controls and other personnel did not keep pace with that growth. WorldCom grew in large part because the value of its stock rose dramatically. Source: FIRST AND SECOND INTERIM REPORTS OF DICK THORNBURGH, BANKRUPTCY COURT EXAMINER, Kirkpatrick & Lockhart LLP, 2002 – 2003.

13. Potential Solutions - Actual Steps Taken Following SEC Investigation: • On April 30, 2002, the Company announced that Mr. Ebbers had resigned as President, CEO and Director. • KPMG became the Company’s independent auditor and accountants effective May 14, 2002, replacing Arthur Andersen. • In May 2002, the Company’s Internal Audit Department began an investigation concerning the capitalization of line costs. • The Board has terminated jobs of CFO Sullivan and Chief Controller Myers. • Appointed 3 independent directors – professionals in financial fraud investigations.

14. Corporate Governance • Improve Boards • Greater independence • Rotate auditors Culture • Improve Management • Integrity and ethics • Correct incentive scheme Potential Solutions – Same Recommendations As For Qwest?