Home History of Financial Crises The WorldCom Scandal (2002)

History of Financial Crises

THE WORLDCOM SCANDAL (2002)

September 29, 2021

Coming hot on the heels of accounting scandals involving Enron and Tyco, both of which sent financial
markets into tailspins, the fraud committed by WorldCom, one of the world’s biggest
telecommunications companies, ended up dwarfing even those infamous crimes in terms of sheer
numbers.

By June 2002, the United States’ second-largest long-distance telecommunications company confirmed
it had overstated its earnings, mainly by classifying as capital expenditures those payments it was
making for using the communications networks of other companies. WorldCom had “cooked the books”
repeatedly—including its income statement, balance sheet, Form 10-K filing and annual report—in its
attempts to inflate its profit-and-loss position by a whopping $3.8 billion, with senior management well
aware of the skulduggery being committed. It became the biggest accounting scandal on record in the
US and was one of the biggest ever bankruptcies ever filed. And as a result of the company’s actions,
Chief Executive Officer Bernard Ebbers was sentenced to 25 years in prison, while the company’s chief
financial officer, Scott Sullivan, received five years behind bars. But things had been so markedly
different just a few years before….

WorldCom had experienced stellar growth throughout much of the 1990s, mainly by achieving a number
of highly profitable strategic acquisitions of other telecommunications companies, including MCI
Communications—a company with 2.5 times larger revenue than WorldCom—for $37 billion in 1998. It
then moved aggressively into internet communications, and by 2001, it was handling half of all internet
and e-mail traffic in the US. For this acquisition strategy to be successful, much depended on the
company’s stock price staying on a consistently upward trajectory. Until early 1999, the strategy seemed
to be working for the company—especially for Ebbers, who was worth an estimated $1.4 billion and had
been named the 174th richest American on the Forbes 400.
But that year saw WorldCom’s revenue growth begin to slow, which in turn dragged down its stock
price. This could partly be attributed to the vast oversupply of US telecommunications networks at the
time, which overshot demand in the face of excessively bullish expectations surrounding the growth of
the internet. And to compound matters, its proposed merger with Sprint Corporation was shut down
that year based on antitrust concerns.

As such, there was much concern from Ebbers and senior management that WorldCom’s earnings would
not meet the expectations set by Wall Street analysts. In response, WorldCom began tampering with its
financial statements to conceal its lacklustre performance and give the impression that it had met those
analysts’ projections. It reduced the amount it held in reserve by $2.8 billion and reclassified those funds
as revenues; it then did the same with operating expenses that represented the amount WorldCom paid
to other telecommunications companies to access their networks, “hiding” those expenses as long-term
capital investments. The reclassifications gave WorldCom an additional $3.85 billion—the changes
making it appear as though the company had generated $1.38 billion in profits, along with heavily
inflated assets.

Ebbers continued to manage Wall Street expectations of double-digit growth by reporting the
manipulated numbers and presenting the false impression of a thriving company to the market as well
as internally to both the WorldCom employees and board of directors. But he was receiving information
internally that was wholly inconsistent with such an impression, particularly from CFO Sullivan and
WorldCom’s controller, David Myers. Indeed, much of the fraudulent activity was conducted under the
direction of Sullivan. As the company continued failing to meet financial targets announced by Ebbers,
Sullivan continued making false accounting entries to give the appearance that those targets were being
achieved. And he was ably assisted by Myers, who similarly directed the making of unsupported entries.

Evidence also made clear that Ebbers was aware of the manipulations being undertaken by Sullivan and
Myers, and Sullivan later confirmed that Ebbers knew of the capitalisation of line costs. And yet, the
chief executive continued to make unrealistic projections to the market and failed to disclose any of the
internal dishonesty taking place. Some believe this was the case because Ebbers was more concerned
about protecting his vast personal wealth and his huge salary, which made him one of the country’s
highest-paid executives.

By February 2002, WorldCom’s results for the fourth quarter of 2001 were well below Wall Street
expectations, and the company reduced its guidance for 2002. But Ebbers still provided a very upbeat
outlook for the company, saying, “We have solid investment grade debt ratings; and we are free cash
flow positive” and “Let me be clear, we stand by our accounting”. Nevertheless, Ebbers resigned in April
after being told he would be dismissed by the board.

Ratings agencies subsequently downgraded WorldCom, with Moody’s downgrade in May putting
WorldCom debt at junk status. WorldCom’s Internal Audit Committee also undertook a review of the
company’s capital expenditures, despite opposition from Sullivan and Myers. More personnel began
questioning Sullivan and Myers about the dubious accounting entries before Myers finally admitted to
internal auditors that he could not support the capitalization of line costs. Once the Audit Committee
was made aware of the irregularities, they duly terminated Sullivan and received Myers’ resignation.

On June 25, 2002, WorldCom disclosed to the U.S. Securities and Exchange Commission (SEC) and the
public that for 2001 and the first quarter of 2002, it had determined that certain transfers amounting to
$3.852 billion from “line cost” expenses to asset accounts were not made in accordance with generally
accepted accounting principles (GAAP). A few weeks later, the company filed for bankruptcy, shortly
before revealing an additional $3.831 billion in improperly reported earnings for 1999, 2000, 2001 and
the first quarter of 2002.

The next day, the SEC filed a lawsuit against WorldCom shortly before the board of directors accepted a
full, independent investigation of the accounting practices that occurred. Hearings were also held by the
House Committee on Financial Services and the Senate Committee on Commerce, Science, and
Transportation. In total, WorldCom made more than $9 billion in erroneous accounting entries to
achieve the impression it was making profits. It was orchestrated by a few key members of senior
management based in the company headquarters in Mississippi and executed by employees in the
financial and accounting departments across various locations.

Former WorldCom Chief Executive Officer Bernard Ebbers, second from left, on Capitol Hill (Washington-
DC) Monday, July 8, 2002 during a hearing on accounting irregularities.

“The fraud was implemented by and under the direction of WorldCom’s Chief Financial Officer, Scott
Sullivan. As business operations fell further and further short of financial targets announced by Ebbers,
Sullivan directed the making of accounting entries that had no basis in generally accepted accounting
principles to create the false appearance that WorldCom had achieved those targets,” according to the
SEC’s report of the investigation. “In doing so he was assisted by WorldCom’s Controller, David Myers,
who in turn directed the making of entries he knew were not supported.”
The SEC concluded that the scandal was very much the result of the way CEO Ebbers ran WorldCom. He
was at the heart of the company’s culture and exerted much of the pressure that led to the fraud lasting
as long as it did. A lack of controls within the financial system at the time also played a major
contributory role in the fraud. As the SEC reported, the improper accounting entries were easily
accomplished because “it was apparently considered acceptable for the General Accounting group to
make entries of hundreds of millions of dollars with little or no documentation beyond a verbal or an e-
mail directive from senior personnel”.

The SEC also highlighted the part played by Arthur Andersen’s grossly inadequate auditing, and while
there was insufficient evidence that WorldCom’s auditing firm during the fraud period was aware of the
capitalization of line costs or that WorldCom’s revenues were being improperly reported, there were
clear flaws in Andersen’s audit approach, which limited the likelihood it would detect the accounting
irregularities. “Andersen appears to have missed several opportunities that might have led to the
discovery of management’s misuse of accruals, the capitalization of line costs, and the improper
recognition of revenue items,” the SEC report stated. “For their part, certain WorldCom personnel
maintained inappropriately tight control over information that Andersen needed, altered documents
with the apparent purpose of concealing from Andersen items that might have raised questions, and
were not forthcoming in other respects. Andersen, knowing in some instances that it was receiving less
than full cooperation on critical aspects of its work, failed to bring this to the attention of WorldCom’s
Audit Committee.”

The regulator also cited “a lack of courage” by others in WorldCom’s financial and accounting
departments to blow the whistle. “Employees in the financial and accounting groups believed that
forcefully objecting to conduct that they knew was being directed by Sullivan would cost them their
jobs; few of them were prepared to take that risk.” That said, the SEC did acknowledge that some did
make complaints to their supervisors as well as refused to take certain actions they considered
inappropriate. Nonetheless, no one took the necessary action to halt or expose the ongoing practices
until the spring of 2002.