Worldcom Scam: The fall of the biggest US Telecommunication company

This article focuses on the biggest stock scam that has taken place in the corporate world i.e. the WorldCom scam. The author majorly talked about the fraud and specific acts done by people to perpetrate the fraud and aims to highlight need of stringent laws and guidelines to prevent such scams in future.
Estimated Reading Time: 9 minutes

Introduction

This article focuses on the biggest stock scam that has taken place in the corporate world i.e. the WorldCom scam (hereinafter referred to as “the scam”). The article also discusses the incorporation of a company, the modus operandi of the scam that was conducted, and also the impact on the company after the unveiling the WorldCom scam. It further discusses the legal proceedings in the scam, the role of the accountants, the revelation of the scam, and effects on the investors and competitors of the company.

About Worldcom

WorldCom (hereinafter referred as “the company”) was incorporated in the year 1983, and it specialised in providing telecommunication services to residents and businesses. The company when incorporated was a small company with Long Distance Discount Services (hereinafter referred as “LDDS”). Over the years, the company became the third largest company of telecommunications in the United States under the guidance of Chief Executive Officer (hereinafter referred as “CEO”), Bernard Ebbers. The company had 85,000 employees and was at its peak in 65 countries around the globe. The company incurring more profits and soon the company became public. In less than a decade, the company acquired more than sixty telecommunication companies and generated revenue of 30 billion dollars. The company seemed to be a huge company, incurring huge profits with the hope for growth of economy but the actual scenario was in complete contradiction and all this turned out to be a perception. On June 25, 2002 the company revealed that it had been conducting fraudulent activities. The books of accounts of the company depicted profit of 3 billion dollars but in fact it was incurring a loss of half a billion.

Reasons for fraud in WorldCom

The company only focussed on growth and kept acquiring more and more companies to attain their sole purpose. While serving this purpose, the company became negligent towards corporate governance protocols. They also lacked in formulating proper strategies for the growth and sustainability of the company in the market. The company had an impressive growth from the year 1191 to 1997 and was a leading internet providing company in the United States but halt came to this when the company’s strategy of acquisition was failed. The failure came when the merger with Sprint was cancelled. The CEO, Bernard Ebbers wanted to display company in strong financial position in order to attract more investors. Further, non-compliance to the general code of conduct and ethics by the Worldcom had also came to limelight. It is majorly believed that the fall of WorldCom initiated with their endeavour to merge with the second largest telecommunication of that time i.e. Sprint. It was terminated by the U.S. government on the grounds of lacking anti-competitiveness in the telecommunication sector. Since, there was no company which could be acquired by or merged with WorldCom so the whole strategy of company’s growth through acquisition and merger came to halt. 

Another major reason for downfall of the company was the desire of Bernard Ebbers to strengthen his own financial position and status. He provided his own share of company’s stock on pledge in order to secure his investment in his personal business. He wanted to avoid margin calls from bank on his own stock and to do that he needed to ensure that WorldCom was in great and strong financial position. To attain this objective, the CEO of the company resorted to manipulation of books of accounts and depicted  a strong financial position of the company.

Pressure increased on Bernard Ebbers when the company could not manage its own acquisition and the Wall Street was expecting huge profits from the company. In such a situation, Ebbers could not inform the Wall Street that the company needed time to consolidate the acquisitions as he had the pressure to maintain the company in great financial position. 

Also Read, Freddie Mac – The Accounting Scandal

Accounting fraud and its consequences

WorldCom with the intention to make illegal and illicit profits in the business used strategies of accounting system. The company recorded 3.8 billion dollars of capital expenditure. This disguised the actual profits earned and net losses incurred by the company for five quarters. The books of accounts depicted that the company was growing each quarter and was in a strong financial position. The investors being unaware of such activities and manipulation of the books of accounts kept investing their funds in the shares of the company, which subsequently increased the share price to 64 dollars. But these manipulations can only be continued till the time acquisition and mergers are carried on by the company as the amounts are adjusted in the transactions relating to such acquisitions.

It is also asserted that even before the accounting fraud came to light the company was in a state of financial distress. Reducing revenues and vehemently increasing acquisitions had pushed the company in deeper debts. On June 25, 2002 the Securities and Exchange Commission (hereinafter referred as “SEC”) ordered the company to disclose more details about the accounting irregularities that were discovered through inspection of MIC’s books of accounts. Subsequent to this, the company declared insolvency under Chapter 11 of bankruptcy protection on July 21, 2002.[1] Further, WorldCom had to terminate services of around 17,000 workers to sustain in the industry. In the legal proceedings, the CEO of the company was found guilty of fraud and sentenced to 25 years of imprisonment. Bernard Ebbers was also found guilty for conspiracy and for filing false and inaccurate documents with the regulators.[2]

Modus Operandi of the Fraud

The accounting fraud came to light when MIC’s books of accounts displayed irregularities and subsequent to this, a further investigation was conducted through which the internal auditor discovered the accounting manoeuvre. The company undertook this fraud by treating revenue expenditure as capital expenditure which resulted in depicting an overstatement of profits in the books of accounts. Thereafter, Arthur Anderson, the auditor of the company assured in a public statement that he had acted in pursuance of accounting standards and the internal audit shall not be relied upon.[3] Notwithstanding this, the Auditor’s committee and board of directors replaced Anderson with KPMG, an outside auditor to investigate the scam. The scam took place in two main steps, the steps are hereinafter mentioned in detail:

  1. Reducing the Reserve Accounts: The operating margin of the company indicated that the profits were decreasing since year 1998 and therefore there arose a need for accounting manipulations to improve the margins and display such impressive and attractive margin so as to depict company in a stable position in the market. The revenues were inflated with illegal counting entries from “corporate unallocated revenue accounts.”[4] By doing this, the company reduced the reserve accounts which were held to cover the liabilities of the company. As a result of these transactions, the profits seemed to be increasing in the year 1999 and 2000 but the company was unable to continue the same in the year 2001 and the operating margin kept on decreasing which resulted in the company being bankrupted.
  2. Expenses being underreported: With the intention to increase the stock price of the company, the auditors and the accounting department underreported the ‘line cost’ which is a link to interconnect expenses with other telecommunication companies. It has also been observed that in the year 2000, the profits of the company depicted were 2608 million dollars but the actual profits were 649 million dollars.[5] WorldCom kept increasing their net profits and assets which led to incurring huge losses.

Breach of Accounting Rules

The basic principle of accounting  is treatment of capital expenditure by accrual method which was continuously breached by the CEO of the company i.e. Mr. Scott Sullivan.[6] The Generally Accepted Accounting Principles (hereinafter referred as “GAAP”) articulates that the expenses incurred by the company shall be allocated during the entire period which shall benefit the company. This rule was also broken by the company in its fraudulent transactions. Mr. Sullivan had taken billion dollars of operating expenses and recorded them under capital expenses account, specifically in property accounts.

Further GAAP also directs that the company needs to estimate the expected payments and maintain expenses with its revenue. Mr. Scott Sullivan instructed his employees to release such accruals which were too high to meet the future payments. In this way the company understated its liabilities and overstated its profits.

Legal Proceedings

The proceedings started as soon as the fraud was discovered. A District Court in New York City appointed a former SEC Chairman on 3rd July, 2002 to review the payments and made sure that the documents are not destroyed by the company.  In the initial proceedings Mr. Arthur Anderson, the accountant of the company and Mr. Bernard Ebbers, the CEO of the company denied to testify. After the company declared itself insolvent, the U.S. bankruptcy judge directed an independent prosecutor to be appointed to investigate the books of accounts and the financial statements of WorldCom and further scrutinize the existence of fraud and mismanagement.   Meanwhile, NASDAQ declared that it will delist the company. After some time, the company admitted the commission of fraud and inflating its profits for the years 1999, 2000 and 2001.

Steps Taken After the Scam

The first step taken was to remove the top management officials of the company. Following this, entire body of the board of directors was also terminated from their services. A new set of the board of directors was appointed so as to ensure that the company’s acts are transparent and in compliance with the accounting standards and legal ethics. Even the finance and auditing department of the places where the fraud was conducted was shunned from performing its functions. The company also appointed four hundred new auditors and accountants and terminated seventeen thousand from its employment. The company also hired a new auditor to re-audit the accounts of the company. The major change that company implemented was, conducting an ethics training program for making them realise their duties towards the company and to comply with legal ethics while carrying on their duties as employees of the company. All these steps were taken to ensure and rebuild the trust of investors and to stabilise the position of company. The name of the company was also altered and was renamed as MCI which was also its biggest acquisition. Ultimately, the company was brought by Verizon in 2006 for 8 million dollars.

This scam also had repercussions on the investors. There were many investors who lost huge amounts of money due to the scam. The largest pension fund in U.S. also lost 300 million dollars due to the company. It was also considered as the world’s largest bankruptcy. Contrary to the speculations, even the competitors of the company like Sprint and AT&T also suffered as they had to restructure their management significantly to attain apposition akin to WorldCom.

Conclusion

This scam was unveiled just after the Enron scam and investors and authorities were shocked by such scams. It is quint-essential to learn from such scams the necessary compliance of legal ethics and accounting standards. The scams clearly show that there is a need for more vigilant officials and auditors and also for stringent laws in order to prevent such scams in future. The people should also be able to foresee the repercussions of such scams. If we look into this scam, the person committing it, was completely unaware of the consequences the scam would have on the investors in the company. The offender must not have thought that he is shunning retirement benefits for a lot of people. The government and international organisations like WHO should make endeavours to spread awareness about business codes and ethics and also about the application of GAAP. When such a fraud occurs, there are a lot of people employed under such companies are also affected. In such a case, if the employees were made aware about the consequences of such fraudulent activities then they would have thought before aiding the top management.

Also Read, Freddie Mac – The Accounting Scandal


[1]WorldCom: The Accounting Scandal, EveryCSRReport.com,https://www.everycrsreport.com/reports/RS21253.html

[2]The 10 worst corporate Accounting scandals of all time, Accounting Degree Review, https://www.accounting-degree.org/scandals/

[3]WorldCom scam was conducted in two main ways, https://www.ukessays.com/essays/management/worldcom-fraud-was-committed-in-two-main-ways-management-essay.php

[4]Id

[5] Id

[6]https://www.sec.gov/Archives/edgar/data/723527/000093176303001862/dex991.htm#ex991902_6

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