Case Study on Corporate Governance: WorldCom Scandal

Established in 1988, WorldCom was formed so that the strongest, most capable public relations firms could serve national and international clients, while retaining flexibility and client- service focus inherent in independent agencies. Through WorldCom, clients have on demand access to in-depth communication expertise from professionals who understand the language, culture and customs in the geographic areas of operation. WorldCom has 105 offices in 90 cities and 40 countries on five continents, more than 2000 employees and recorded revenue of US $ 243.5 million in 2008.

In the 90’s WorldCom was involved in acquisitions and purchased over 60 firms. The complete financial integration of the acquired company must be accomplished, including an accounting of assets, debts, and a host of other financially important factors. WorldCom moved into Internet Traffic, controlling 50% of US Internet Traffic and 50% of the e-mails worldwide. In 1997, WorldCom and MCI completed a US $37 billion merger making it the largest merger in US History. In 1998 the new company MCI WorldCom opened for business. MCI WorldCom announced another merger agreement with Sprint that would have resulted in a $129 billion merger agreement. During this short period of time from 1995 to 1998, WorldCom’s growth was fueled by acquisitions and mergers. After the announcement of the merger with Sprint, the US Department of Justice and the European Unions’ had concerns of MCI WorldCom creating a monopoly. This merger would have put MCI WorldCom ahead of AT & T. MCI WorldCom and Sprint’s board of directors acted to terminate the merger after receiving pressure. This halt caused a set-back for WorldCom’s’ aggressive growth strategy, at a time when the telecommunications industry had entered a downturn.

Bernie Ebbers, Chief Executive Officer (CEO), had used his WorldCom stock to finance some of his other business ventures. As this stock began to decline banks were asking Ebbers for additional funds, to cover the margins on his securities accounts. Ebbers, then requested and obtained corporate loans from the WorldCom board of directors in excess of $400 million. The loan was so Ebbers could avoid from otherwise having to sell substantial amounts of his WorldCom stock causing a further downturn in stock prices. He had secured loans from WorldCom to fund personal investments which included a $100 million ranch in Canada, $658 million in Mississippi Timberlands, and a $14 million Georgia Shipyard. Bernie Ebbers netted around $140 million from stock sales. Scott Sullivan served as the Chief Finance Officer (CFO) and had directed the staff to make false entries. Personally he had made misleading public statements regarding finances of WorldCom to its customers netting around $45 million from stock sales. From 1998-2000, WorldCom reduced reserve accounts which were held to cover liabilities of the acquired companies by adding $2.8 billion to the revenue line from these reserves. Scott Sullivan, CFO had instructed the employees to record operating costs or “line costs”, such as fees paid to third party telecom providers for the right to access the third parties network, to its Capital Assets Account which were to the tune of $3.85 billion.

The computer expenses were recorded as assets to the extent of $500 million in the journal, but documents supporting the expenses were not found. These costs were not recorded in the income statement as supposed to; hence ignoring them, increased WorldCom’s net income as it was not reduced by the cost. The costs were added to the balance sheet, which is a totally different recording, as in the balance sheet they are recorded as assets and not as costs. Hence the balance sheet had shown an inflated increase in computer assets and leasing assets which were actually expenses. The liabilities were untouched which increased the retained earnings/shareholders equity to a large extent and from the perspective of the investor, portrayed a “Happy Investor” image. In 2001, the net income was $1.28 billion which in turn inflated the company’s value in its assets.

Details of the Fraud

There was an air of discomfort looming in and around WorldCom. Suspicions arose as to whether the financials are being maintained in the right manner. Obscure tips were sent to the internal audit team. By the end of the first quarter of 2002, a report prepared by WorldCom’s internal auditor and KPMG found that $2.86 billion of the EBITDA related charges occurred in 2000.In 2002, John Stupka, Senior VP complained to the internal audit about the $400 million he was asked to set aside by Scott Sullivan to boost WorldCom’s income. On March 7, 2002 the Securities Exchange Commission (SEC) questioned WorldCom as to how they could make so much money when AT&T was in a fix. The Securities and Exchange Commission (SEC) sought information from WorldCom about its accounting procedures and about loans it had extended to its officers. In April the company announced that it was cutting 3,700 jobs. Soon after, Standard & Poor’s, Moody’s and Fitch downgraded WorldCom’s credit ratings. The U.S. Justice Department has launched an independent probe into the WorldCom scandal.

In April 2002, Bernard J. Ebbers the CEO of WorldCom resigned after an SEC probe revealed that WorldCom had lent $339.7 million to him to cover loans that he took to buy his own shares. In May, Standard & Poor’s reduces WorldCom’s credit rating to junk status and WorldCom was removed from the prestigious S&P 500Index. On June 25, the company announced that improper accounting of $3.8 billion in expenses had covered up a net loss for 2001 and the first quarter of 2002. The company also announced that is planned to shed 17,000 jobs, more than 20 percent of its workforce. The Nasdaq halted trading in WorldCom’s stocks of WorldCom Group and MCI Group. In four months, ending of April, the share price fell by over 80 percent. On June 26, the SEC filed a suit alleging “securities fraud” against WorldCom is a district court in New York. It alleged that WorldCom’s top management “disguised its true operating performance” and “misled investors about its reported earnings”.

Even as the company was sliding, it announced on June 25 that it was “restating” its income for 2001 and the first quarter of 2002. It said that an internal audit had revealed that earlier financial statements of the company had deviated from accounting principles, resulting in an over-statement of its revenues and profits for 2001 and the first quarter of 2002 to the tune of $3.8 billion. The company had used a simple trick in its balance sheet to boost revenues and profits while hiding expenditures. By classifying ordinary day-to-day expenses as investments and long-term expenses associated with the acquisition of capital assets, on which companies enjoy certain tax advantages, WorldCom was able to hide expenses to the tune of nearly $4 billion and instead show this as profit. One of WorldCom’s major operating expenses relates to its “line costs”, the fees that it pays to third party telecom network providers for the right to access their networks. In effect, WorldCom capitalized these fees, terming them as investments, when in fact; they were one of the most important day-to-day expenses. The SEC, in its complaint in court, stated that WorldCom’s top executives did this in order to keep Wall Street happy. The shock turned anger as it became known that Arthur Anderson, who was WorldCom’s auditor.

Major Personnel Involved

The driving factor behind this fraud was the business strategy of WorldCom’s CEO, Bernie Ebbers. In the 1990s, Ebbers was clearly focued on achieving impressive growth through acquisitions. By using the stock of WorldCom to accomplish this buying spree, the stock had to continually increase in value.

WorldCom pursued scores of increasingly large acquisitions. The strategy reached its climax with WorldCom’s acquisition in 1990 of MCI Communications, a company with more than two-and-a-half times the revenue of WorldCom. Bernie Ebbers acquisition strategy largely came to an end by early 2000 when WorldCom was forced to abandon a proposed merger with Sprint because of antitrust objections.

Bernie Ebbers felt the need to show ever-increasing revenue and income. His only recourse to achieve this end was financial gimmickry. The problem is that the more one resorts to this sort of dishonesty, the more complicated it becomes to continue it. Dishonesty is jus not sustainable in the long run. Complicating Ebbers situation was an industry-wide downturn in telecommunications. During that time, Wall Street had continued expectation of double-digit growth for WorldCom. After all, they had achieved so much in such a relatively short period of time.

However, WorldCom needed time for its management to catch up to its newly acquired companies and learn how to run and manage them. Unfortunately, Ebbers did not have the courage to tell Wall Street that WorldCom needed time for the consolidation and digestion of its acquisitions. In order to satisfy Wall Street’s expectations, Ebbers had to examine his company’s books. If he had the courage to tell them what was really needed, WorldCom would be alive today and Ebbers would not be facing the prospect of spending the rest of his life in prison.

Moreover, another major factor driving to the fraud in WorldCom was Bernie Ebbers very apparent desire to build and protect his personal financial condition. For this reason, he had to show continually growing net worth in order to avoid margin calls on his own WorldCom stock that he had pledged to secure loans.

Other than him, there are few senior personnel involved in the manipulations at WorldCom included such as Scott D.Sullivan, the CFO, Buford Yates Jr, Director of General Accounting, David F. Myers, Controller; Betty L. Vinson, Director of Management Reporting, from January 2002 and Troy M. Normand, Director of Legal Entity Accounting, from January 2002.

Flaws in Corporate and Professional Accounting Governance Exposed

The flaws in terms of corporate governance in WorldCom are, where all the WorldCom’s board members approved nearly everything Bernie Ebbers suggested, mainly because Ebbers showered them with benefits. Half of WorldCom’s director were associates of Ebbers and had large personal stakes in the company. In addition, the board’s wealth was tied to the stock and therefore it was in the board’s interest to allow management to do whatever they wanted to keep the stock price up. WorldCom’s directors were so tied to management financially that they had little incentive to question management’s decisions, for fear of losing their wealth. The close relationship between management and the board made management believe that they would not get caught or fired because the board would not investigate decisions aggressively. Thus, management believes there was a low probability that they would get caught committing fraud.

Moreover, the flaws in professional accounting governance are where Arthur Anderson who was the external financial auditor or WorldCom took the incentive to keep his mouth shut about the problems. Management was able to exploit this problem and get its auditors to agree to the fraud it was committing. Because of the close relationship between auditor and company, management was under the impression that their auditors would not report their fraud. The complexity if financial accounting and disclosure rules allowed management to commit fraud with the thought that it was hidden from the eyes of other. Accounting is supposed to be based on the principle that it is looks like it, and then it should be recognized as such. However, this uncertainty has caused a need for further defined rules. The level of transparency within the financial statement is derived from lack if full disclosure. Management at WorldCom exploited the complexity and lack of disclosure by hiding their problems. In additions, because of the lack of disclosure, management felt they could hide their problem sufficiently to prevent them from getting caught committing fraud.

One of the improvements on the flaws that resulted such accounting scandals to happen is that Sarbanes-Oxley (SOX) Act was implemented. In the SOX Act, it states that the Public Accounting Oversight Board is responsible to monitor public accountants, make changes in the auditing rules and to authorized and increase in criminal penalties for more white-collar crimes. This is to further prevent similar cases from happening again.

Besides that, the New York Stock Exchange (NYSE) and the National Association of Securities Dealers also play a part in this improvement of the accounting scandal. Major additions and alterations in the rules for accounting, auditing and also corporate governance had been passed on. Those are all necessary conditions for listing of a corporation’s stock for trade on the exchange.

Standard and Poor’s which is one of the three major credit-rating agencies, has developed a new concept of “core earnings” with the assistance from the financial and investment communities. This “core earnings” is a measure of earnings from a company’s core business operations which includes the production and marketing line. The S&P measure excludes gains and losses from a variety of financial transactions such as gains and losses from the sale of a company’s assets and goodwill. This is different compared with the earnings as defined by the generally accepted accounting principles (GAAP). S&P has planned to report this measure of earnings for all publicly held U.S. companies to provide investors with a standardized and a more transparent way to compare companies’ earnings.

Not only that, the audit committee should meet with shareholders, portfolio managers and analysts at least once annually to solicit input and suggestions to improve the quality of the company’s disclosure. Meeting should be conducted at least once annually with the management and advisors together with the audit committee specifically to review revenues in order to improve transparency in public disclosures.

Besides that, the other corrective actions taken under SOX laws is that auditors are not allowed to offer both audit services and consulting services to the same company at the same time. This would results in self-evaluation and therefore the auditors would no longer be independent. The auditors of the company should be independent so that the auditors can make sure that the financial statements are of true and fair view and issue out an auditor’s report accordingly and not influenced by the cozy relationship the auditors had established with the company.

All the improvements are taken with the hope that no such scandals would reoccur. In addition, the number of corrective steps taken that will strengthen the governance practices at the companies in the future to safeguard and protect the interests of investors, and the larger public interest in the functioning of one of the country’s largest corporations.

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