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The Rise and Fall of WorldCom

The World’s Largest

 Accounting FraudBy John P. Meyer, 2-23-07

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Agenda

Overview of WorldCom

Nature of accounting fraud Impact of the fraud

How it happened

Why ‘good’ managers make bad ethicalchoices

Key take aways

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Overview of WorldCom

WorldCom was the darling of Wall Street and theTelecom Industry of the 90‟s 

Grew rapidly through acquisitions and from increaseddemand for telecom services

High stock price was a powerful currency to makeacquisitions

WorldCom was a casualty of the Dotcom BubbleBurst of 2000 Resorted to accounting fraud to meet financial targets

Went bankrupt

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Overview of WorldCom

Key Events

 – 1996: Acquired MFS (including 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: Filed for Bankruptcy Protection – 2004: Emerged from Bankruptcy as MCI – 2005: Verizon agrees to acquire the company for $6.75B

(plus assumption of $6B of Debt)

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Overview of WorldCom

Financial Highlights 1994 1999 2001 2004

($ 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. $3.3 $150.5 $42.8 $ 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 Accounting Fraud

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

• Accounting Fraud occurred in two main forms:

Understatement of operating expenses of $7B through improper release

of accruals and through improper capitalization of operating expenses

Overstatement of revenues of $1B.

Summary of Improper Income statement amounts ($ in millions)

1999 2000 2001 2002 Total

Revenues $ 205 $ 328 $ 358 $ 67 $ 958

Line Costs $ 598 $ 2,870 $ 3,063 $ 798 $ 7,329

Other Expenses $ 135 $ 676 $ 177 $ (25) $ 428

Total $ 938 $ 3,874 $ 3,598 $ 840 $ 9,250

Source: Report of Investigation by the Special Investigative Committee of Board of Directors of WorldCom, Inc.

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Impact of the Fraud

Shareholders$180B of shareholder value lost (based on peak stock

price)Debt & Preferred Stock holders$37.5B of debt and preferred stock holder value lost

Company$750M settlement paid to SEC

Employees57,000 employees lost jobsAll current and former employees lost most of their 

retirement savings (invested in WorldCom stock)

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Impact of the Fraud

Executives and Accounting Staff 6 individuals convicted of fraud / conspiracy / false filings

Ebbers  – CEO 25 years in prisonSullivan – CFO 5 years in prisonMyers – Controller 1 year in prison

 Yates – Dir of Acctg 1 year in prisonVinson – Acctg Dept 5 months in prison

Manager 5 months house arrestNormand –Acctg Dept 3 years probation

Manager Above 6 individuals agreed to pay a total of $24-34M to

settle securities class action case 

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Impact of the Fraud

Board of Directors12 Directors agreed to pay (out of pocket) a total of $25M to

settle securities class action case

Investment BankersSettlement of securities class action case with banks:

Citi Group $2.6BJP Morgan 2.0BB of A .5B

Other .9B

SEC Action:Grubman an Soloman Brothers Securities Analyst fined $15M

and banned for life from practice.

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Impact of the Fraud

Independent Auditor 

Arthur Andersen agreed to pay $65M to settle securities class

action case

Insurance Companies

Agreed to pay $36M to settle claims against WorldCom directorsand officers

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How It Happened

WorldCom EnvironmentSubstantial Problems with the Company‟s Internal Controls 

WorldCom was dominated by Ebbers and Sullivan, withvirtually 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 themtheir 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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How It Happened

Macro Business EnvironmentThe 90‟s has been labeled by many as the “Perfect Storm” 

The whole system of checks and balances failedPublic Companies Accounting Profession- Management & Boards -Standard Setters

Investment Banks -Independent Auditors- Bankers and Analysts Legal Profession- Institutional Investors- Individual Investors

Resulted in a number of high profile business failures andwrongdoings

WorldCom Enron HealthSouthQwest Tyco AdelphiaGlobal Crossing Boeing ImClone

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Why „good‟ managers make bad

ethical choices (Source: HBS 1986 – Saul W. Gellerman)

Four Rationalizations To Justify QuestionableConduct

1) Believe that the activity is not “really” illegal 

2) Believe that it is in the individual‟s or 

corporation‟s best interest 

3) Believe that it will never be found out

4) Believe that the company will condone actionsthat are taken in its interest and will evenprotect the managers responsible

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Why „good‟ managers make bad

ethical choices (HBS 1986 – Saul W. Gellerman)

ConclusionA good way to avoid management oversights is to

subject the control mechanisms themselves toperiodic 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 goodethics 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 committingunethical acts for 

Your personal integrity is your most important asset – you own it and control it

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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