The content of this report will discuss the destruction and collapse of the WorldCom corporation as of June 2002 and the fraud that was perpetrated by, among others, senior officers of WorldCom, its directors, its outside auditor ArthurAndersen LLP, and the investment banking firm of Salomon Smith Barney, Inc.
We have researched the accounting frauds committed by WorldCom. We discovered that they were the leading US telecommunication giant during the 1990's, and that they committed several fraudulent acts that lead to their eventually bankruptcy.
On June 22, 2002, announcements of a scandal at Worldcom, hit the news. Media coverage was unlike any other in history, being that this was the largest accounting scandal to hit the United States corporate history. At this time it was reported that WorldCom had misrepresented their financial statements in excess of $4 billion dollars.
What factors led to the fraud?
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. [i] 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. [ii] This halt caused a set-back for WorldCom's' aggressive growth strategy, at a time when the telecommunications industry had entered a downturn.
Ebbers 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. [iii]
What specific fraud occurred?
From 1998-2000, WorldCom reduced reserve accounts held to cover liabilities of acquired companies, WorldCom added $2.8 billion to the revenue line from these reserves. CFO told key staff members to make false accounting entries, turning operating expenses into assets, and other financial misstatements on the income statement and balance sheets to a total of $3.85 billion. For example, operating expense to assets, CFO directed to remove computer expenses and fees paid to lease other companies to phone networks (huge decrease of expenses which leads to huge increase of net income).
What was the effect on?
Investors and Creditors
The WorldCom scandal had a range of effects on Investors, Creditors, Company employees, the investment and regulatory markets and the people who perpetrated the fraud. Depending on the amount of accessibility to investment accounts, knowledge of the stock market, and amounts invested varied the effects of financial impact upon each investor.
Some investors experienced small losses while others may have lost everything. In whole WorldCom investors lost nearly $150 billion on WorldCom common stock alone, and tens of billions of dollars more on debt and other securities. Other effects on investors, was mistrust in WorldCom executives due to their deceit and betrayal.
A group of 67 institutional investors opted out of the class action lawsuit. Later this group pursued its own filing to recover their losses due purchases of WorldCom Stock. These investors received $651 million from a certain banks and other defendants, it compensated the investors for losses from purchases made during the period of 1998 through 2001, As stated by Lerach Coughlin Stoia Geller Rudman & Robbins LLP, the law firm that represented the group [iv] (Stephen Taub - CFO.com | US, October 27, 2005)
WorldCom listed an estimated 1,000 creditors according to bankruptcy filings, some of these same creditors were named in litigation to compensate investors for their losses on purchases of WorldCom bonds and stocks. After the bankruptcy the previous bondholders were less the 36 cents on the dollars.
Company Employees
On June 28, 2002 Fifty one hundred employees were laid off, severance and benefits were withheld when WorldCom filed bankruptcy. On August 07, 2002 the ex-WorldCom "5100" group was launched. The group was composed of the WorldCom employees with a common goal of seeking full payment of severance and benefits based on the WorldCom Severance Plan. [v] The number "5100" represents the number of employees laid off before WorldCom's bankruptcy.
Individuals who perpetrated the fraud
Betty Vinson received sentences of both prison and home for a five month period, due to her role in WorldCom's accounting scandal. vi (Washington Business Journal - by Jeff Clabaugh ) Buford Yates Jr., and David Myers, could have received up to five years of prison for however, they each received a year and a day. Troy Normand only received probation. [vi] The three former WorldCom employees cooperated with the prosecution in the government's case against Bernie Ebbers.
Scott D. Sullivan, who acknowledged his leading role in the accounting fraud, and was sentenced to five years in prison and three years' probation. As a plea bargain for working with the government, Sullivan sentence was a fifth of what sentencing guidelines suggested. Mr. Sullivan was not fined and would not pay penalties beyond certain assets that he agreed to turn over. He was sent to a minimum-security prison in Pensacola, Fla., near his home, and received treatment for alcohol abuse. Mr. Sullivan agreed to liquidate a selected amount of his non cash assets to settle with investor lawsuits. Sullivan also surrenders a portion of his personal cash assets.
CEO Bernard Ebbers was sentenced to 25 years for committing conspiracy, securities fraud, and seven counts of making false statements to the Securities and Exchange Commission (By Krysten Crawford, CNN/Money staff writer/ September 23, 2005). He then agreed to pay almost 45 million to settle claims by the government, ex-employees and defrauded investors. Also he had to make cash payment to settle cash action lawsuits as well as liquidate all of his remaining non cash assets.
Ebbers, is now serving his sentence as inmate #56022-054 in the Federal Correctional Institution (FCI) in Oakdale. He is scheduled to be released on July 04, 2028. [vii]
Investment and Regulatory Markets
WorldCom's disclosures have wreaked havoc on the financial markets. WorldCom common stock dropped from a Class Period high of approximately $65 per share to pennies, leading to its delisting from the NASDAQ exchange. The impact on WorldCom bonds was also catastrophic. For example, on June 27, 2002, WorldCom 8% Notes, which had a value of $62.25 a few days prior to the announcement, traded at $11, a loss of over 80%. These Notes once traded as high as $106. Some Published estimates place the losses of WorldCom bondholders alone at more than $9 billion. [viii]
A number of regulations were created due to the WorldCom scandal. The most commonly known regulation is the Sarbanes Oxley Act. this act was formed so that the CEO, or any other high ranking official in a company cannot say "I did not know what was going on in the company" Also external auditors should not serve as internal auditors of the same company that the do the external audits for. With the proposal of tougher IPO's (initial public offerings) rules by the National Association of Securities Dealers (NASD), the SEC Voted on Rules to stop IPO trading manipulations.
Some of these abuses such o as "spinning" which is defined as giving hot IPO's to favorable executives, such as that deals between Solomon Smith Barney and top WorldCom executives. Though these alleged abuses are already banned by the NASD, the proposals would apply stronger and more specific procedures, such as disclosing information on who receives the stock. [ix]
What was the role of the auditors in the fraud?
There were two very distinctive roles for the auditors in the WorldCom scandal. One role being that of the Whistle-blower played by Cynthia Cooper, a former chief audit executive at WorldCom. She discovered an $11 billion accounting fraud scheme. Since uncovering the scandal, Cooper has been spoke publicly about her role at WorldCom.
Beginning in 1999 and continuing through May 2002, the company used fraudulent accounting methods to mask its declining earnings. She was able to implement the whistle blower steps that were outlined by Trevino & Nelson in their book Managing Business Ethics. When Ms. Cooper confronted Scott Sullivan, he claimed that the financial transfers were appropriate. The companies lease payments were for the purchase of capacity the company intended to use them in the future, making them appear as a capital expense.
Despite all of Mr. Sullivan's efforts to delay her, Ms. Cooper continued her review of the company's books. She demanded him to produce documentation on the purchasing of these capital expenditures, when he failed to produce the needed evidence she report her findings to the board of directors for WorldCom.
"Courage" she said;" isn't doing something without fear, but doing something in spite of fear. She also said; as long as there are human beings on Earth, we will continue to see frauds and scandals. Students may have to face similar dilemmas sooner than they might think."Cooper warned.
She continues to say" you just need to stick with your morals and stick to your values." She also point that out by referring to the two key accountants who first altered the books they wrote their resignation letters but never resigned. Afraid to lose their incomes, one of them said, "It just goes to show how easy it can be to cave under pressure."
In my opinion Cooper helped reestablish some faith in the profession showing that people will take the steps they need to keep the profession honest even when it might affect their own lives. On the other hand, we can see the role played by Arthur Anderson, and was one of the so-called "Big Five" accounting firms in the United States. Represented by Dick Marvin Former CPA and used to be an audit partner for the Firm, he was the lead engagement partner for WorldCom Audit.
In 2008 The SEC denied him the privilege of appearing or practicing before the Commission as an accountant. This is a as a result of failing to conduct or supervise the audit of world com's financial statement in accordance with GAAS. Dick Marvin failed to take engagement risk into consideration even after Arthur Anderson audit team had rated WorldCom as a "Maximum" risk client, He was aware of CEO Bernard Ebbers substantial personal debt owned and secured by WorldCom Stock price. He also should have been aware of the deteriorating market conditions and the significant downturn in the telecommunications industry all which created a pressure to increase the risk of fraud. He did not exercise due professional care in the planning and performance of the audit. Which resulting a violation of the professional standards.
In the WorldCom case Arthur Anderson became so involved with their client that it would turn a blind eye to any fraud, Melvin Dick denies wrong doing and he testified that Andersen carefully reviewed the company's statements and conducted stress tests, computer analysis and other sophisticated reviews that failed to detect the transfers, which occurred during their audit of the financial reports.
John J. Fahy, a New Jersey was embarrassed as an accountant and former prosecutor that this kind of fraudulent activity was missed. Andersen has to confess to incompetence or complicity". In the end I think any set of rules alone. Disconnected from the values, which those rules are ultimately meant to reflect is like a body without a soul.
How was the audit firm affected by the fraud?
Generally the Public Companies have two types of auditors: internal auditors and external auditors. Each of the members of the internal audit team for WorldCom was able to find good jobs after the 2002 scandal. Jon Marbry works as a contractor. Ten former WorldCom internal auditors work with Jon Marbry. Glyn Smith, who was senior manager in Internal Audit, works as an Internal Auditor Director position with Blockbuster in Texas. Gene Morse and Tonia Buchanan who were senior auditors were able to find jobs in the Jackson area.
Dean Taggart is the Vice President of Internal Controls in charge of the Sarbanes Oxley compliance at HealthSouth. Lisa Smith is a Director of Internal Controls with HealthSouth as well. Cynthia Cooper was chief audit executive and she is the person who blew the whistle on what became one of the biggest accounting scandals in the corporate history. Since she left WorldCom she speaks for corporation, professional groups and students about her experience. She also wrote a book called "Extraordinary Circumstances" about her journey with WorldCom. In 2002 the Time magazine named her "Person of the Year "because she " took a huge professional and personal risks to blow the whistle on what went wrong at WorldCom, and in so doing helped remind us what American courage and American values are all about". Also she was nominated in 2004 for the AICPA Hall of Fame and she is the first woman to receive this distinction.
The external auditing firms before and after the fraud was Arthur Andersen and KPMG. Prior to May 16, 2002 Andersen LLP was the WorldCom's external auditing firm. Andersen audited the Company's 2001 financial statements and reviewed the Company's first quarter 2002 financial statements. During this period, Andersen's engagement partner on the company's audits was Melvin Dick. Andersen gave an unqualified opinion on the company 2001 financial statements following its audit.
The Securities and Exchange Commission barred two of the Arthur Andersen auditors from practicing before the agency. Melvin Dick and Kenneth Avery didn't admit or deny any wrongdoing on their settlements.
One of the external auditors from Arthur Anderson, Kenneth Avery currently serves as Vice President for Monsanto Vegetables covering Japan to Australia and over to India. Arthur Anderson, once the fifth largest US accounting firm, collapsed in 2002.
On May 16th 2002, KPMG LLP was appointed as the Company's external auditing KPMG would later be accused in a report by WorldCom's bankruptcy examiner, Richard Thornburgh, a former U.S. attorney general who is now a lawyer at Kirkpatrick& Lockhart LLP of its flawed tax advice to WorldCom. The report said the company had avoided state taxes by charging subsidiaries more than 12 million dollars in royalties in over 4 years. KPMG assigned Farrell Malone as the engagement partner on this audit. In 2004 the Accountingweb.com says "The Commonwealth of Massachusetts is claiming that it was denied $89.9 million in tax revenue because of an aggressive KPMG-promoted tax strategy that helped WorldCom cut its state tax obligations by hundreds of millions". KPMG is still in business and Farrell Malone is still with KPMG.
What could have been done to prevent the fraud?
In my opinion to reduce the fraud in the future and what we should have done to prevent the fraud in the past we definitely first need to spend more time teaching the young generation especially in schools about ethics, moral values and leadership.
Secondly to prevent the fraud, the Security and Exchange Commission needed to come up with new rules and regulations. The Sarbanes-Oxley Act of 2002 also known as the 'Public Company Accounting Reform and commonly called Sarbanes-Oxley or SOX enacted on July 30, 2002. It is named after sponsors U.S. Senator Sarbanes, Paul and U.S. Representative Oxley, Michael. Sarbanes-Oxley contains 11 titles that describe specific mandates and requirements for financial reporting including and some the titles are: Auditor Independence, Corporate Responsibility, Corporate and Criminal Fraud Accountability, White Collar Crime Penalty, Corporate Tax Return, and Corporate Fraud Accountability. PCAOB is working on establishing a financial-reporting fraud center for collecting information on preventing and detecting fraud. The regulator published a job posting for a director last month.
Thirdly, the Congress and IRS should have come up that time with changes in Internal Revenue Code which was in discordance with the Exchange Commission (SEC) rules. Under IRS rules, a company is not allowed to expense an item until the item has been put in service.
Finally, the Federal Bureau of Investigation (FBI), Department of Justice, U.S. attorney general, and other federal agencies should have extensive investigative and prosecuting powers to bring white-collar criminals to justice to protect people from these kinds of financial frauds.
Opinion:
In our opinion, WorldCom's destruction was not only the result of its executive officers, and directors. Shown through a number of court cases, litigations, and congressional hearings companies that rated WorldCom's worth such as investment banks, along with the external Auditors made it possible for WorldCom to commit and conceal the fraud for a period of time. It had been stated the WorldCom was the largest client for both Arthur Anderson and Solomon Smith Barney. The greed of some U.S. investment and commercial banks helped to take down the world's economy. The said companies benefitted greatly from doing business with WorldCom, this benefit may have contributed to the company's reluctance or incapability of detecting, reporting, or rating the target company honestly. Auditors should only be allowed to Audit a company. No other business with the client company should be allowed, brokerage companies, (Smith Barney) should not be allowed to recommend companies with which they do substantial business with. Conflict of interest and coercion were common factors for all involved.
"Mrs. Vinson was among the least culpable members of the conspiracy at WorldCom. Still, had Ms. Vinson refused to do what she was asked, it's possible this conspiracy might have been nipped in the bud", as stated by Judge Barbara S. Jones of United States District Court in Manhattan during the hearing of Betty Vinson. Sometimes it is a simple act of courage the makes all the difference. Just voicing your concerns, to senior executives, as Mrs. Vinson had stated, was not enough to detour the fraud. Cynthia Cooper has said it best as she believes "where ethics are concerned, you have to obey your conscience and accept the consequences".
Maybe if just one of the six perpetrator, had a similar belief, they would have had the courage to prevent the destructions that were passed on to thousands of investors, employees, and creditors of WorldCom, due to the greed of a handful of individuals.
