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Sec Investigation of Worldcom

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Imagine working for a company that provides everything you need financially from an employer, good benefits, decent salary and stock options that make other companies within the industry jealous. How many other middle managers in the industry can claim a net worth of over one million dollars? During WorldCom’s highest point, some of the middle managers could honestly make such a claim because they had so much stock and the price seemed to just keep going up and up. The stock splits, and because of the stock option, instead of a dividend the employees get more stock. Then all of a sudden one March morning all these millionaire managers wake up to discover they are not only now worth just a few hundred bucks, but that their jobs were disappearing. This situation was a reality for many WorldCom workers, because on that March morning America’s largest fraud at the time had been reported.

WorldCom was a publicly traded corporation established in 1983 to provide Long Distance Discount Services (LDDS) (Internet Services, 2011). Through the acquisition of other businesses Worldcom became the world’s second largest telecommunication company. LDDS began by leasing a wide-area telecommunications service (WATS) line and resold time to other businesses (Internet Services, 2011). WATS is a form of fixed-rate long distance telecommunication service in which certain area codes, such 800, 888, or 877, are reserved for businesses and when customers call these numbers they are not charged for long-distance but rather the business is charged as a subscriber of the WATS service (Rouse, 2006).

Beginning in 1988, LDDS began growing through the acquisition of other companies such as Telephone Management Corp., National Telecommunications, IDB WorldCom, and WilTel Network Services (Internet Services, 2011). In 1989, LDDS went public through the acquisition of Advantage Companies Inc. In 1995, LDDS changed their name to WorldCom WORLDCOM 3

(Internet Services, 2011). In 1996, WorldCom became an Internet service provider (ISP) after the acquisition of three additional businesses. In 1998, WorldCom formed its first international partnership, teaming with MCI and Spain’s Telefonica to expand the company’s reach in Europe and Latin America (Internet Services, 2011).

WorldCom became a telecommunications giant following its 1998 acquisition of MCI Communications Corp. which provided local and international telecommunications services, such as voice, data, paging services, and Internet access (Internet Services, 2011). WorldCom was now able to provide services over its own network of fiberoptic cables located in major cities, as well as some between the United States and the United Kingdom. In 2000, WorldCom organized into two divisions: MCI Group, which concentrated on the consumer market including dial-up Internet services, and WorldCom Group, which managed networking, data, and Internet operations (Internet Services, 2011).

WorldCom’s success acquiring other companies and creating some of the largest telecommunications mergers in history had investors taking notice and purchasing stock in the company. Rising stock prices gave the company financial leverage and allowed it to purchase more companies. The stocks highest trade was near $65 in 1999. The pressure on WorldCom to keep the stock high and maintain its success was the beginning of its fraudulent accounting practices. The company had over 20 million consumer customers, thousands of corporate clients and 80,000 employees (Sandberg, Blumenstein, & Young, 2002). This was the case until it was discovered that the company had done some improper accounting procedures.

WorldCom Inc.’s audit committee uncovered, at the time, the largest accounting fraud in U.S. history, with the discovery of $3.8 billion in expenses improperly booked as capital WORLDCOM 4

expenditures--a gimmick that boosted cash flow and profit over the past 5 quarters (Sandberg et al., 2002). In early 2001, regular costs for the company started being treated as capital expenses, which of course resulted in significant boosting of the company’s earnings before interest, taxes, depreciation and amortization. These are otherwise known as EBITDA, which WorldCom used as a critical gauge of its growth. (Sandberg et al., 2002).

These actions affected the company’s cash flow and helped them report a grossly overstated profit for all of 2001 and the first quarter of 2002. They reported $1.4 billion profit for 2001 and $130 million for the 1st quarter for 2002; in reality, these periods should have reported a net loss. A number of things occurred within two days of the discovery of these misstatements. After the company’s board was told of the problem, WorldCom’s internal investigation went into high gear, additionally a powerful outside legal team was brought in. The next day as the Securities and Exchange Commission (SEC) was told of the issue the technical workers were engaged in cutting access that Scott Sullivan, the company’s CFO, had to the internal company network. That same night Mr. Sullivan was fired and fraud was laid bare (Chaffin, Kirchgaessner, & Waters, 2002, p.22).

The company investigated whether Mr. Sullivan was behind these entries and who else could be involved. In order to save some cash, they laid off 17,000 employees and cut capital spending to $2.1 billion annually (Sandberg et al., 2002). In the end, WorldCom settled its fraud case with US regulators in a move that would help the bankrupt telecommunication company’s new management proceed with its salvage operation (Michael & Thal Larsen, 2002). One of the settlement issues that they agreed to was not be involved with fraud activities again. WorldCom also consented to continuing scrutiny by an independent monitor of its corporate governance, WORLDCOM 5

policies, plans, and internal controls (Michael & Thal Larsen, 2002). Even though WorldCom settled the case, they never did admit or deny any wrongdoings. This settlement gave the company hope that they could emerge from bankruptcy. This settlement, however, had no bearing on the civil and criminal cases.

As part of the settlement requirements the SEC wanted an approved outside consultant to review the accounting in addition to a hefty a fine (Michaels & Thal Larsen, 2002). The SEC said the settlement also ordered WorldCom to “provide reasonable training and education to certain officers and employees to minimize the possibility of future violations of the federal securities laws” (Michaels & Thal Larsen, 2002). The SEC complaint was amended from the original one filed that indicated overstatements went back as far as 1999. The SEC slapped WorldCom with a fine in the hundreds of millions after concluding its’ investigation into the carrier’s $11 billion fraud case (“SEC, Worldcom,” 2003). Some people felt that this fine was not stiff enough-- it was only roughly one week of revenue for the company-- and that the settlement would not provide solace to the tens of thousands of stock investors, mutual fund shareholders, employees and pensioners who were taken to cleaners by WorldCom’s actions (“SEC, WorldCom,” 2003).

The SEC’s investigation led WorldCom into bankruptcy. In an attempt to resurrect WorldCom’s downfall, the company filed for bankruptcy, Chapter 11, on July 21, 2002. Chapter 11 of the Federal Bankruptcy Code allows businesses the opportunity to reorganize their finances and momentarily hold off creditors. “Under this protection, the company was allowed to operate under court supervision and implement financial and organizational restructuring for improving its internal systems and processes” (Pandey & Verma, 2005). WorldCom’s petition for Chapter WORLDCOM 6

11 was accepted; in bankruptcy court, their fine was reduced to $750 million. WorldCom distributed this amount by paying “$500 million in cash and transferring $250 million worth of common stock in the reorganized company” when it emerged from bankruptcy, payable to a “fund for later distribution to victims of the company’s fraud” (“SEC charges,” 2004).

The SEC filed charges against the CEO, Bernart Ebbers, and CFO, Scott Sullivan. On March 15, 2005, Bernard Ebbers was found guilty of all charges. The first charge was “conspiracy to commit fraud and falsifying WorldCom’s books, records, and SEC filings, which resulted in 1 count maximum of 5 years. The second charge was securities fraud, which resulted in 1 count maximum of 10 years. The third charge was false filings with the SEC, which resulted in 7 counts maximum of 10 years” (Masters, 2005). Mr. Ebbers received the maximum sentence on all charges. He was sentenced to federal prison for 25 years. On August 5, 2005, Scott Sullivan, the CFO of WorldCom, plead guilty to all charges. Mr. Sullivan was indicted with the same charges as Mr. Ebbers, but sentenced to federal prison for 5 years. Mr. Sullivan’s sentence was less than Mr. Ebbers’ because he cooperated with the officials. Other executives implicated were David Myers, Comptroller, and Buford Yates, Accounting Director, who was sentenced to a little over a year. Betty Vinson, Accounting Manager, was sentenced to less than a year. Troy Normand, Accountant, was given several years of probation.

The executives who were imprisoned were all found to hold some level of guilt for the WorldCom scandal. The scandal came to light because the first actions taken against the perpetrators of fraud were internal. After the Vice President of Internal Audit, Cynthia Cooper, bravely warned the WorldCom board about suspicious accounting practices, the board asked Scott Sullivan, the CFO, and David Myers, the Controller, to resign; Myers resigned and WORLDCOM 7

Sullivan was fired (Pandey & Verma, 2005, p. 55). Note that Cynthia Cooper was named one of Time Magazine’s persons-of-the-year for her role in exposing the fraud (“Time names,” 2002).

Just before the fraudulent accounting was discovered, the CEO, Bernard Ebbers, who had led the company into fraudulent activity had been let go by the board because of the March 2002 SEC investigations into WorldCom’s loans to Ebbers (Pandey & Verma, 2004, p. 117). On June 25, 2002, WorldCom made a public announcement that it would be adjusting financial results for the years 2001 and 2002; on June 27, WorldCom sent a letter to President Bush indicating that actions were being taken internally to address the fraudulent accounting (Pandey & Verma, 2004, pp. 112-117). These internal actions were much too late. The day after the WorldCom press release announced the internal actions of adjustments for 2001 and 2002, the SEC filed a civil fraud suit against WorldCom; the next day, “US district court Judge, Jed S. Rakoff, issued an order to WorldCom to preserve documents and assets and to appoint a corporate monitor to keep an eye on WorldCom’s activities” (Pandey & Verma, 2004, p. 114). Vasilescu and Rusello (2006) point out that “federal securities laws are the main avenue for relief to address financial misconduct by public companies;” under these laws, criminal and civil charges can be brought by the SEC and by private plaintiffs (p. 5).

The legal framework for holding WorldCom accountable included the SEC civil fraud suit, SEC fines against WorldCom, felony charges against Ebbers and other WorldCom executives; additional suits were filed against Arthur Anderson, LLP, CitiGroup, JP Morgan Chase, Bank of America Corp, WorldCom directors, and a class action suit against WorldCom by investors. Settlements and payouts were made as a result of the suits; Ebbers is incarcerated and according to the Federal Bureau of Prisons website, bop.gov, his projected release date is 2028. WORLDCOM 8

As a result of the fraud, WorldCom was allowed to enter into Chapter 11 bankruptcy to restructure and deal with the massive debt. As evidenced by the passage of new laws, the legal framework for addressing the WorldCom scandal was lacking. Some of the new laws due in part to the WorldCom scandal include the Sarbanes Oxley Act--which allows the SEC to “set up what is called a ‘Fair Fund’ into which it could deposit any disgorgement and penalties for the compensation of investors” (Vasilescu, 2006, p. 7), provides more specifics about independent directors, and provides more powerful tools to the DOJ and SEC to go after perpetrators of corporate misconduct (Vaslilescu, 2006, p. 7); FCC “changes in regulatory accounting and intercarrier compensation rules” (Lavey, 2005, p.j 622); the Dodd Frank Law which further addresses corporate governance; and new SEC governance standards set in 2003 (Pozen, 2010, p. 54).

Many would argue that the massive fines and settlements paid out after the WorldCom scandal were not enough. As some law professors note, shareholders received a “pittance compared to the losses suffered by the owners of the company's stock who were wiped out in the bankruptcy” (“WorldCom securities,” 2005). As Congress worked to pass new laws and government entities such as the SEC and FCC worked to change regulations, many in the corporate world have worked to change corporate culture and apply a renewed attention to ethics. The new CEO Michael Capellas brought WorldCom out of bankruptcy a better company aided by his ethical leadership. More universities are now requiring ethics courses for business and accounting majors, and are also increasing the ethics curricula. Though the legal framework might always be working to catch up with new avenues for fraud, ethical leadership can be always a beacon. WORLDCOM 9

The most landscape changing regulation which emerged during the aftermath of WorldCom, is the Sarbanes-Oxley Act (SOX). In a nutshell SOX is designed to prevent repeats of massive fraud and misstatement by not only requiring certain controls for publicly traded companies, but also reporting on those controls. SOX reports require companies to report on and attest to the effectiveness of internal controls (Kieso, Weygandt, & Warfield, 2007). The Act also established the Public Company Accounting Oversight Board (PCAOB). The PCAOB essentially governs accounting firms to establish auditing standards, provide quality control in addition the PCAOB conducts inspections, investigations and disciplinary proceedings of registered accounting firms (“Public company,” 2006).

While the country made changes by leaps and bounds to learn from the mistakes at WorldCom, the fact that other scandals have occurred since that time simply means that laws and regulations are a work in progress. Hopefully through the diligence of watchdog groups like the SEC and the determination of educators to ensure executives receive ethics education, these scandals will continue to decline. During times when business is strong workers should feel safe with their company and not fear that the growth is due to fraud, or that the rug will be pulled out from under them. WORLDCOM 10

References

Chaffin, J., Kirchgaessner, S. & Waters, R. (2002, June 27). Routine audit exposed $3.8 bn fraud WorldCom scandal revelations ad to strain on corporate credibility: *Manipulation was one of the “simplest tricks in the book” but not necessarily easy to spot. Financial Times. [London Edition], pp. 1-22.

International Journal Of Disclosure & Governance, 3(1), 3-15. WorldCom securities class action settlement approved; Ebbers prepares his appeal. (2005, September, 22). White Collar Crime Prof Blog. Retrieved from http://lawprofessors.typepad.com/whitecollarcrime_blog/2005/09/worldcom_securi.html

Internet Services. (2011). In Encyclopedia of Global Industries (5th ed., pp. 624-636). Detroit: Gale. Retrieved from http://go.galegroup.com.ezp.waldenulibrary.org/ps/i.do?id=GALE %7CCX1930300087&v=2.1&u=minn4020&it=r&p=GVRL&sw=w

Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2007). Intermediate accounting (12th ed.). Hoboken, NJ: John Wiley & Sons.

Lavey, W.G. (2006). Responses by the Federal Communications Commission to WorldCom’s accounting fraud. Federal Communications Law Journal 58(3), 613-681.

Masters, B. A. (2005). WorldCom’s Ebbers convicted. Washington Post. Retrieved from http://www.washingtonpost.com/wp-dyn/articles/A36896-2005Mar15.html

Michaels, A., & Thal Larsen, P. (2002, November 27) Settlement in WorldCom $9 bn fraud case bankrupt telecom group agrees to independent monitor: *Deal will help new management run salvage operation RUN SALVAGE OPERATION. Financial Times [London (UK)], pp. A1.

Pandey, S. C., & Verma, P. (2004). WorldCom Inc. Vikalpa: The Journal For Decision Makers, 29(4), 113-126. WORLDCOM 11

Pandey, S. C., & Verma, P. (2005). Organizational decline and turnaround: Insights from the WorldCom case. Vision (09722629), 9(2), 51-65.

Pozen, R. C. (2010). The Case for professional boards. Harvard Business Review, 88(12), 50-58.

Public company accounting oversight board (PCAOB). (2006). Retrieved from http://www.sec.gov/answers/pcaob.htm

Rouse, M. (2006, November). WATS (wide-area telephone service). Retrieved from http://searchnetworking.techtarget.com/definition/WATS

Sandberg, J., Blumenstein, R., & Young, S. (2002, June 26) WorldCom admits $3.8 billion error, in its accounting---firm ousts financial chief & struggles for survival; SEC probe likely to widen. Wall Street Journal, pp. A.1.

SEC Charges Scott D. Sullivan, WorldCom’s Former Chief Financial Officer, with engaging in multi-billion dollar financial fraud. (2004). SEC Press Releases. Retrieved from http://www.sec.gov/news/press/2004-25.htm.

SEC, WorldCom settle their fraud differences as Ebbers defaults. (May 20, 2003).

Communications Today. 9.90 :1.

Time names whistleblowers as Persons of Year. (2002, December 23). CNN. Retrieved from http://archives.cnn.com/2002/US/12/23/time.persons.of.year/index.html

Vasilescu, A. M., & Russello, G. J. (2006). As gatekeepers, independent directors of public companies face additional scrutiny and liability in the post-Enron/WorldCom world.
International Journal Of Disclosure & Governance, 3(1), 3-15.

WorldCom securities class action settlement approved; Ebbers prepares his appeal. (2005, September, 22). White Collar Crime Prof Blog. Retrieved from http://lawprofessors.typepad.com/whitecollarcrime_blog/2005/09/worldcom_securi.html

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...Order Code RS21253 Updated August 29, 2002 CRS Report for Congress Received through the CRS Web WorldCom: The Accounting Scandal Bob Lyke Specialist in Social Legislation Domestic Social Policy Division Mark Jickling Specialist in Public Finance Government and Finance Division Summary On June 25, 2002, WorldCom, the Nation’s second largest long distance telecommunications company, announced that it had overstated earnings in 2001 and the first quarter of 2002 by more than $3.8 billion. The announcement stunned financial analysts and, coming on top of accounting problems at other corporations, had a noticeable effect on the financial markets. The accounting maneuver responsible for the overstatement – classifying payments for using other companies’ communications networks as capital expenditures – was characterized by the press as scandalous, and it was immediately asked why Arthur Andersen, the company’s outside auditor at the time, had not detected it. WorldCom filed for bankruptcy protection on July 21st. On August 8th, the company announced that it had also manipulated its reserve accounts in recent years, affecting an additional $3.8 billion. Response in Washington was swift. On June 26th, the U.S. Securities and Exchange Commission (SEC) charged the company with massive accounting fraud and quickly obtained court order barring the company from destroying financial records, limiting its payments to past and current executives, and requiring an independent monitor...

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