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The 2002 WorldCom scandal, one of a few historical collapses during the 2000 recession, cost an estimated $107 billion in lost assets. It has gone down as one of the biggest accounting scandals and bankruptcies ever.
Looking back at historic events such as the WorldCom scandal can help us prevent future catastrophes. You might think that you don’t have the power to protect yourself and others from financial crises, but you actually do. We’ll tell you how at the end of this article.
Key Questions of the WorldCom Scandal
The subprime mortgage crisis that followed the Lehman Brothers collapse reportedly cost $10 trillion in productivity, according to a Government Accountability Office report. Find out what role insurance giant AIG played in the crisis…
What was WorldCom?
Before the scandal, WorldCom was the second-largest long-distance telecom company in the United States, just behind AT&T.
Bernard Ebbers, the blue-jean and ten-gallon hat-wearing ‘Telecom Cowboy,’ started WorldCom from humble beginnings. PBS reports that a telecom giant got its start in a coffee shop in Hattiesburg, Miss., from a sketch drawn by local businessman Murray Waldron. While there’s no mention of the sketch being on a napkin, the classic Hollywood tale seemed destined.
Waldron’s idea was LDDS (Long Distance Discount Service): to use AT&T’s phone lines to offer cheap rates to small businesses. Due to the breakup of the Bell System in 1984, the government mandated AT&T to lease its phone lines to startups at cheap rates. Essentially, the doors to the telecom market had burst open.
Ebbers and a bunch of his church buddies recognized this opportunity and obtained a $650,000 bank loan. They bought a computer switch to route long distance calls. By 1994, the Telecom Cowboy had bought up 30 companies, and LDDS sales had nearly reached $1 billion. He changed LDDS to WorldCom in 1995.
Leading up to the WorldCom Scandal
A Chain of Successes
Before the WorldCom scandal erupted, the company had profited greatly due to the dot-com bubble. Its rise proved astounding, as WorldCom’s stock went from pennies per share to over $60 a share by 1997.
WorldCom’s expansion came from repeated use of its original growth strategy: acquisition with its own stock.
A New York Times article discusses how WorldCom had completed 65 acquisitions between 1991 and 1997. WorldCom reportedly spent nearly $60 billion to acquire many of these companies and took on $41 billion in debt in the process.
Two of those 65 acquisitions received significant public attention and made the company genuinely competitive with AT&T:
- The $12 billion MFS Communications acquisition, which included UUNet (a major supplier of Internet services to businesses)
- The $37 billion merger between MCI Communications and WorldCom turned the conglomerate into one of the largest providers of business and consumer telephone service
In the book Follow the Money: A Framework for Investors to Evaluate Management as Capital Allocators, authors Philip McCauley and Brett Neubert comment on the reputation of the company before the scandal. They write, “In the late 1990s, WorldCom became a veritable Wall Street darling, with many investment firms recommending shares as a “core” holding.”
By 2000 spring, WorldCom was not only competitive with AT&T, but it had everything in place to surpass the telecom colossus. 88,000 employees, 60,000 miles of telephone lines globally, and revenues projected to exceed $40 billion. As extra icing on the cake, the fast-expanding WorldCom was also in the midst of acquiring Sprint.
When the Tech Bubble Burst
The end of the dot-com era hurt many businesses that had doubled down on the tech boom. As you can tell from the graph below, the economy as a whole went into a recession.
From DailyFX
Companies cut spending budgets for telecom services and equipment, and technology stocks plummeted. Because the tech business had slowed considerably, the very acquisitions that had brought astronomic growth essentially doomed WorldCom.
‘The WorldCom Whistleblower’
Suspicions of foul play emerged when the Fort Worth Weekly published, in May 2002, the account of Kim Emigh, an ex-WorldCom employee reportedly fired for questioning the company’s accounting methods.
Word got around to WorldCom’s internal audit staff. The team claimed to have uncovered “$3.8 billion in fraudulent accounting entries that had the effect of inflating WorldCom’s earnings.” And turns out, the alleged fraud was quite a simple one. An unsustainable effort to conceal losses.
Wehe, a team of researchers at Northeastern University, University of Massachusetts — Amherst and Stony Brook University, conducted a study on traffic shaping showing evidence that “nearly every US cellular ISP (CISP) throttles (i.e., sets a limit on available bandwidth)…for at least one streaming video provider.” Is your internet service provider giving you the speeds you paid for? See what the ZT community has reported on the matter…
“What’s surprising about WorldCom is the very basic nature of what happened…what [the company] did wrong is something that’s taught in the first few weeks of a core financial reporting class. That’s why people are asking, given its basic nature and its magnitude, how could it have been missed.”
Karen Nelson, professor of accounting at Stanford Graduate School of Business
The failure itself did not result in the WorldCom scandal, it was the executive response that sullied the company’s reputation.
The alleged fraud was accomplished primarily in two ways:
1. Fraudulently Capitalizing Expenditures
Capitalizing refers to when a business or individual records a cost or expense on the balance sheet for the purposes of spreading payments over the lifespan of the purchased asset. This is especially useful when you have acquired an asset you plan to hold or use for a long time as you can amortize or depreciate the costs. Furthermore, it can help bolster investor confidence as
Say, for example, you want to start a coffee shop. The brewer will cost you thousands of dollars, but will likely last for a decade (hypothetically speaking). Instead of expensing the full cost of the brewer, Generally Accepted Accounting Principles (GAAP) allow you to write the cost off for the ‘useful life’ of the asset. In the example case, that would be 10 years.
According to the SEC investigation, “In 1999 and 2000, WorldCom reduced its reported line costs by approximately $3.3 billion. This was accomplished by improperly releasing “accruals,” or amounts set aside on WorldCom’s financial statements to pay anticipated bills. These accruals were supposed to reflect estimates of the costs associated with the use of lines and other facilities of outside vendors, for which WorldCom had not yet paid.”
In other words, the SEC investigation found evidence suggesting that those in charge of WorldCom’s books had reported ‘line cost transfers’ (interconnection expenses with WorldCom subsidiaries) as capital expenditures rather than as expenses. This would have allowed the company to spread these expenses to make profits appear greater than they actually were.
2. Inflating revenues with fake accounting entries
The SEC alleged another main method that WorldCom ‘cooked its books’: by inflating profits with fake accounting entries to ‘corporate unallocated revenue accounts.’ Again, this would have been done to keep up the appearance of a thriving business.
To return to the SEC investigation linked in the previous section, “Most of the questionable revenue entries we identified during our investigation were booked to “Corporate Unallocated” revenue accounts. These accounts were separate from those that recorded the operating activities of WorldCom’s sales channels. They were reported in an attachment to the MonRev known as the “Corporate Unallocated” schedule. Distribution of this schedule was limited and access to it was closely guarded. The questionable revenue entries included in Corporate Unallocated often involved large, round-dollar revenue items (in millions or tens of millions of dollars). They generally appeared only in the quarter-ending month, and they were not recorded during the quarter, but instead in the weeks after the quarter had ended.”
WorldCom reportedly added $2.8 billion to the revenue line from these reserves, causing profits to appear to increase for 1999 and 2000. However, CFO Scott Sullivan supposedly could not find a feasible way to use the accounting manipulation in 2001.
A 2017 Forbes article reports, “For most of the 20th century, stock buybacks were deemed illegal because they were thought to be a form of stock market manipulation. But since 1982, when they were essentially legalized by the SEC, buybacks have become perhaps the most popular financial engineering tool in the C-Suite tool shed…Buying back company stock can inflate a company’s share price and boost its earnings per share — metrics that often guide lucrative executive bonuses.” See what the ZT community has uncovered about stock buybacks…
Who was responsible for the WorldCom Scandal? Did they get charged?
In late June 2002, WorldCom admitted to inflating earnings by nearly $4 billion.
The SEC alleged a number of WorldCom executives conceived the scheme and knowingly carried it out. While all were charged, the two main figures were CFO Scott Sullivan and CEO, Bernard Ebbers.
Charges against Scott Sullivan
Per the SEC press release, “[The] Commission charged [him] with engaging in a fraudulent scheme to conceal WorldCom’s poor financial performance. The Commission alleged that Sullivan, with the consent and knowledge of WorldCom’s former Chief Executive Officer, caused numerous improper adjustments and entries in WorldCom’s books and records, often in the hundreds of millions of dollars, to make the company’s quarterly and yearly financial results appear to meet Wall Street’s expectations. In addition, the Commission alleged that Sullivan made numerous false and misleading public statements about WorldCom’s financial condition and performance, and signed a number of SEC filings that contained false and misleading material information.”
Sullivan pled guilty and served five years for committing financial fraud.
Charges against Bernard Ebbers
The SEC’s charges against Bernard Ebbers look very similar to those leveled against Sullivan. The agency’s press release states, “The complaint filed today alleges that Ebbers, along with other WorldCom senior officers, caused numerous fraudulent adjustments and entries in WorldCom’s books and records, often in the hundreds of millions of dollars, in furtherance of a scheme to make the Company’s publicly reported financial results appear to meet Wall Street’s expectations. The complaint further alleges that these market expectations were based, in some instances, on financial performance targets set by Ebbers that Ebbers knew could not be attained by legitimate means. In addition, the Commission alleged that Ebbers made numerous false and misleading public statements about WorldCom’s financial condition and performance, and signed multiple SEC filings that contained false and misleading material information.
Ebbers pled innocent to the charges leveled against him, but was convicted by a Manhattan jury in March 2005 for “orchestrating the fraud.” He’d served 14 of his 25-year sentence, before passing away in early 2020.
Did the WorldCom Scandal Lead to Regulatory Reform?
The WorldCom scandal, along with other massive cases of corporate crime, compelled the government to enact the Sarbanes-Oxley Act (SOX) in 2002. The aim was to close loopholes, boost investor confidence in financial markets as well as public companies, and prevent future cases of fraud.
Some of the main reforms are as follows:
- Make audit committees more prevalent
- Mandating public companies establish strong internal controls
- Limiting the number of Board members who are certified public accountants to a maximum of two
- Increasing criminal penalties for securities fraud
- Enforcing a change in a company’s audit partners every five years
The Undeserving Losers of the WorldCom Scandal
The SEC investigation linked above reports that “most of WorldCom’s people did not know it was occurring.” That makes the firing of nearly 30,000 innocent employees all the more terrible.
Think about the billions in retirement savings lost. And for that, WorldCom (after changing its name to MCI) paid nearly $51 million to settle the class action lawsuit brought by its employees.
How the Zero Theft Movement Helps You Protect Yourself
These major financial scandals and crises often involve moral hazards that ultimately end with the public shouldering the losses without any decision on the matter.
DID YOU KNOW?
According to a 2013 study by Vanderbilt University professor Mark A. Cohen, total victimization costs of white-collar crime exceed $1.6 trillion, excluding psychological costs and many other monetary damages. Compare that to street crime victimization costs, which were estimated to be $833.8 billion in 2012.
But how can you protect yourself and the public as a whole?
On the Zero Theft voting platform, citizens author theft proposals, and the community decides whether those investigations have convincingly proven (1) theft is or isn’t occurring in a specific area of the economy, and (2) how much is being stolen or possibly saved. Through direct democracy, we can collectively decide where crony capitalism is thriving and start working on addressing them systematically.
Standard Disclaimer
The Zero Theft Movement does not have any interest in partisan politics/competition or attacking/defending one side. We seek to eradicate theft from the U.S economy. In other words, how the wealthy and powerful rig the system to steal money from us, the everyday citizen. We need to collectively fight against crony capitalism in order for us to all profit from an ethical economy.
Terms like ‘steal,’ ‘theft,’ and ‘crime’ will frequently appear throughout the article. Zero Theft will NOT adhere strictly to the legal definitions of these terms (since congress sells out). We have broadly and openly defined terms like ‘steal’ and ‘theft’ to refer to the rigged economy and other debated unethical acts that can cause citizens to lose out on money they deserve to keep.