Category Archives: Sarbanes–Oxley Act

Introduction

WorldCom, an American telecom company, experienced a significant rise followed by a dramatic fall due to its involvement in one of the largest accounting scandals in the country’s history. This scandal occurred in the aftermath of the Enron and Tyco frauds. WorldCom resorted to fraudulent practices, leading to its eventual bankruptcy and the subsequent sale of its network assets to Verizon. This article provides a comprehensive overview of WorldCom’s background, the scandal, and its aftermath.

What Was WorldCom?

• WorldCom was established in 1983 as Long Distance Discount Service, following the breakup of AT&T.
• Founders: Murray Waldron, William Rector, Bernard Ebbers, and their business partners.
• Initially, the company secured a $650,000 loan to purchase the technology necessary for routing long-distance calls.
• WorldCom offered discount long-distance services to customers and pursued an aggressive acquisition strategy, becoming the largest company of its kind in the United States.

The Scandal and Bankruptcy

• Facing financial difficulties, WorldCom resorted to questionable accounting techniques to conceal its losses from investors and other stakeholders.
• The company manipulated its financial statements, falsely inflating revenues and concealing expenses.
• These fraudulent practices came to light after the Enron scandal in the summer of 2001, causing suspicion among investors.
• In April 2002, WorldCom’s CEO, Bernard Ebbers, was forced to step down, and it was later revealed that he had borrowed $408 million from Bank of America, using his WorldCom shares as collateral.
• The company filed for bankruptcy in 2002, making it one of the largest bankruptcies in history.

Consequences and Punishments

• Following the scandal, several key figures at WorldCom faced legal consequences.
• Bernard Ebbers, the CEO, was convicted of securities fraud in 2005 and received a 25-year prison sentence.
• The Chief Financial Officer (CFO) Scott Sullivan pleaded guilty to conspiracy and securities fraud charges.
• The scandal led to the dissolution of Arthur Andersen, WorldCom’s external auditing firm.

Recovery and Acquisition

• WorldCom emerged from bankruptcy, underwent restructuring, and rebranded itself.
• The company’s network assets were eventually sold to Verizon, another prominent telecommunications company.
• The sale of assets allowed WorldCom to repay its creditors to some extent.

Lessons Learned and Sarbanes-Oxley Act

• WorldCom’s scandal served as a warning to investors about the dangers of accounting fraud and the need for thorough due diligence.
• The scandal contributed to increased regulatory scrutiny and led to the passage of the Sarbanes-Oxley Act of 2002 (SOX).
• SOX aimed to enhance corporate governance, financial transparency, and accountability to prevent similar frauds in the future.
• The act introduced stricter regulations for financial reporting, internal controls, and the independence of auditors.

Conclusion

The rise and fall of WorldCom exemplify the devastating consequences of accounting fraud. The company’s aggressive acquisition strategy, coupled with its fraudulent accounting practices, ultimately led to bankruptcy and legal repercussions for its top executives. WorldCom’s scandal had far-reaching implications, prompting regulatory changes and emphasizing the importance of ethical conduct and financial transparency in corporate governance.

Cooking the Books

WorldCom’s Accounting Fraud

WorldCom, driven by aggressive acquisitions and a decline in revenue and rates, faced financial difficulties. To maintain the appearance of financial viability, the company resorted to questionable accounting techniques, inflating its profits and hiding its falling profitability.

1. Capitalizing Expenses to Inflate Profits
   • WorldCom recorded expenses as investments, capitalizing them instead of properly reporting them as expenditures.
   • By inflating net income and cash flow through this method, the company exaggerated profits by $3.8 billion in 2001 and $797 million in Q1 2002.
   • This allowed WorldCom to report a profit of $1.4 billion instead of a net loss.
2. Whistleblowers Exposing the Fraud
   • Cynthia Cooper, WorldCom’s vice president of internal audit, and Gene Morse, another auditor, played a crucial role in uncovering the fraud.
   • They identified inconsistencies in the company’s financial records, including the use of reserves to boost income, disputed capital expenditures, complicated accounting terms used to hide capital movement, and lack of evidence for certain financial transactions.
   • Cooper and Morse conducted independent investigations and contacted KPMG, the external auditor, and WorldCom’s audit committee.
3. WorldCom’s Bankruptcy
   • As the fraud unraveled, WorldCom’s true financial position became unsustainable.
   • The company had to adjust earnings for the 10-year period from 1992 to 2002 by $11 billion, with an estimated fraud amount of $79.5 billion.
   • WorldCom filed for Chapter 11 bankruptcy on July 21, 2002, shortly after its auditor, Arthur Andersen.
   • With debts totaling as much as $7.7 billion, the company had $107 billion in assets and $41 billion of debt at the time of filing.
   • Bankruptcy provided an opportunity for restitution, enabling WorldCom to continue providing services to existing customers, pay employees, and retain assets.
   • The company used the time during bankruptcy to restructure, although its reputation suffered within the corporate marketplace.

Sarbanes-Oxley Act of 2002 and Lessons Learned

The WorldCom scandal and similar accounting frauds led to the enactment of the Sarbanes-Oxley Act of 2002 (SOX). Here’s how SOX applies:

1. Enhanced Corporate Governance and Transparency
   • SOX aimed to improve corporate governance, financial transparency, and accountability.
   • It established stricter regulations for financial reporting, internal controls, and the independence of auditors.
   • Companies were required to establish effective internal control systems and ensure accurate and reliable financial statements.
2. Prevention of Similar Fraudulent Practices
   • SOX introduced provisions to deter accounting fraud and promote ethical conduct in corporate governance.
   • It emphasized the responsibility of executives and auditors in ensuring the accuracy and integrity of financial information.
3. Strengthened Oversight and Accountability
   • SOX established the Public Company Accounting Oversight Board (PCAOB) to oversee auditors of public companies.
   • The PCAOB sets auditing standards and conducts inspections to ensure compliance with regulations.
4. Investor Protection and Restoring Trust
   • The act aimed to restore investor confidence by enhancing the integrity and reliability of financial information.
   • It introduced criminal penalties for securities fraud and improved mechanisms for reporting corporate misconduct.

Conclusion

WorldCom’s accounting fraud, involving the manipulation of financial records, inflated profits, and subsequent bankruptcy, serves as a cautionary tale. The company’s unethical practices led to significant financial losses, legal consequences for executives, and a loss of trust among stakeholders. The enactment of the Sarbanes-Oxley Act aimed to prevent similar frauds and restore.

Fallout and Aftermath

Punishment for Key Personnel Several individuals involved in the WorldCom accounting scandal faced severe consequences for their actions:

1. Bernard Ebbers:
   • Convicted on nine counts of securities fraud.
   • Sentenced to 25 years in prison in 2005.
   • Granted early release in 2019 for health reasons after serving 14 years.
2. Scott Sullivan (Former CFO):
   • Received a five-year jail sentence after pleading guilty and testifying against Ebbers.

Debtor-in-Possession Financing and Settlements WorldCom’s survival and post-bankruptcy resolution involved the following:

1. Debtor-in-Possession Financing:
   • Provided by Citigroup, J.P. Morgan, and G.E. Capital to help the company continue operations.
2. Settlements with Creditors:
   • Former banks of WorldCom settled lawsuits with creditors for $6 billion without admitting liability.
   • Approximately $5 billion went to bondholders, with the remaining balance going to former shareholders.
3. Settlement with the Securities and Exchange Commission (SEC):
   • The newly formed MCI (rebranded WorldCom) agreed to pay shareholders and bondholders $500 million in cash and $250 million in MCI shares.
   • MCI’s network assets were acquired by Verizon Communications in January 2006.

Sarbanes-Oxley Act and Reputation Impact The WorldCom scandal played a significant role in shaping financial regulations and industry perceptions:

1. Sarbanes-Oxley Act (SOX):
   • Enacted in July 2002 to strengthen disclosure requirements and penalties for fraudulent accounting.
   • A response to the corporate crime wave, including WorldCom’s accounting scandal.
2. Blame for the Scandal:
   • Arthur Andersen, the accounting firm auditing WorldCom, disregarded warnings from company executives about inflated profits.
   • Key management personnel, including CEO Bernie Ebbers, CFO Scott Sullivan, the board of directors, and the internal audit team, were criticized for inadequate oversight and failure to adhere to accounting principles.
   • Wall Street analyst Jack Grubman gave consistently high ratings to WorldCom despite its poor performance. He faced significant penalties and was banned from securities exchanges.

What Happened to WorldCom?

1. WorldCom’s Business and Scandal:
   • WorldCom was a telecom company providing discount long-distance services.
   • Involved in one of the largest accounting scandals in the United States due to fraudulent accounting practices.
2. Exposure of Fraud and Restructuring:
   • Concerned individuals reported fraudulent financial transactions and inconsistencies.
   • WorldCom filed for bankruptcy, leading to a restructuring process.
   • The company rebranded as MCI, a telecom company it had previously acquired.
3. Acquisition by Verizon:
   • Verizon Communications acquired MCI and its network assets in 2006.

Lessons Learned and Impact of Sarbanes-Oxley Act The WorldCom scandal and subsequent regulatory actions resulted in significant outcomes:

1. Lessons Learned:
   • The scandal highlighted the importance of corporate governance, ethical conduct, and adherence to accounting principles.
   • It emphasized the need for independent audits and effective internal control systems.
2. Sarbanes-Oxley Act (SOX):
   • SOX introduced stricter regulations, enhanced financial transparency, and increased penalties for fraudulent accounting.
   • It aimed to restore investor confidence and improve corporate governance practices.
3. Reputation Impact:
   • WorldCom’s scandal left a lasting stain on the reputation of accounting firms, investment banks, and credit rating agencies involved.
   • The incident reinforced the need for ethical practices and accountability within the financial industry.

Key Players in the WorldCom Scandal

WorldCom scandal involved several individuals and entities, each playing a significant role in the events:

1. Bernie Ebbers (CEO):
   • The CEO of WorldCom at the time of the scandal.
   • Convicted on nine counts of securities fraud and sentenced to 25 years in prison.
   • Granted early release in 2019 after serving 14 years.
2. Scott Sullivan (CFO):
   • WorldCom’s CFO during the scandal.
   • Pleaded guilty and received a five-year jail sentence.
   • Testified against Ebbers in the trial.
3. Arthur Andersen (Auditing Firm):
   • The accounting firm responsible for auditing WorldCom’s financial statements.
   • Found to have ignored warnings and failed to address improper accounting practices.
4. Jack Grubman (Wall Street Analyst):
   • Provided WorldCom with consistently positive ratings despite its poor performance.
   • Fined $15 million by the SEC, fired from Salomon Smith Barney, and banned from securities exchanges.
5. Cynthia Cooper (Whistleblower):
   • Vice President of WorldCom’s internal audit department.
   • Discovered financial inconsistencies and reported them to auditors and the company’s board.
   • Instrumental in exposing the fraud and named a Person of the Year by Time in 2002.

Cynthia Cooper’s Impact and Current Endeavors

Cynthia Cooper played a crucial role in exposing WorldCom’s fraudulent accounting practices:

• Cooper discovered inconsistencies in WorldCom’s financial statements and reported them to auditors and the company’s board.
• She faced challenges and difficulties during this period of her career.
• Recognized for her efforts, she was named a Person of the Year by Time in 2002.
• Cooper currently works as a speaker and consultant, sharing her experiences and knowledge.

WorldCom’s Downfall and Lessons Learned

WorldCom was a telecommunications company focused on affordable long-distance services. However, its aggressive acquisition strategy and declining revenues contributed to its downfall:

• WorldCom engaged in questionable accounting practices to hide losses and present inflated profits.
• These practices deceived investors and maintained the company’s favorable image.
• The scandal eventually led to WorldCom’s bankruptcy, one of the largest in U.S. history.

Lessons learned from the WorldCom scandal:

• Corporate management teams and investors realized the importance of skepticism and due diligence.
• The scandal played a role in the enactment of the Sarbanes-Oxley Act in 2002, which aimed to improve financial transparency and corporate governance.
• It served as a reminder that if something appears too good to be true, it probably is, emphasizing the importance of ethical practices and financial integrity.

Additional Resources for Further Reading

Websites and Online Resources:

1. Verizon: About WorldCom
2. Auburn University: WorldCom’s Bankruptcy Crisis

Books:

1. Cynthia Cooper: Extraordinary Circumstances: The Journey of a Corporate Whistleblower
2. Eugene Soltes: Why They Do It: Inside the Mind of the White-Collar Criminal

Academic Journals and Research Papers:

1. Auburn University: WorldCom’s Bankruptcy Crisis
2. University of Virginia: Cynthia Cooper and WorldCom

Reports and Studies:

1. U.S. Securities and Exchange Commission: Report of Investigation by the Special Investigative Committee of the Board of Directors of WorldCom, Inc.
2. U.S. Securities and Exchange Commission: SEC Charges WorldCom With a $3.8 Billion Fraud

Professional Organizations and Associations:

1. The Wall Street Journal: MCI to State Fraud was $11 Billion
2. Congress.gov: H.R.3763—Sarbanes-Oxley Act of 2002

These resources offer authoritative information and valuable insights into the WorldCom scandal, its aftermath, the role of key players, and the impact on corporate governance and regulation. They provide a comprehensive understanding of the events and factors that led to one of the largest accounting frauds in history, as well as the lessons learned from this significant case.