The Rise and Fall of WorldCom: Story of a Scandal

What Was WorldCom?

WorldCom was an American telecom company. At its height, WorldCom was one of the largest long-distance providers in the United States. The company is best known for being embroiled in one of the largest accounting scandals in the country, which came on the heels of the Enron and Tyco frauds. This came after it was revealed the company cooked its books. WorldCom was also involved in one of the largest bankruptcies of all time. The company came out of bankruptcy, rebranded itself, and its network assets were sold to Verizon.

Understanding WorldCom

WorldCom is now a byword for accounting fraud and a warning to investors that when things seem too good to be true, they just might be. The company was founded in 1983 as Long Distance Discount Service. It was established after the breakup of AT&T by Murray Waldron, William Rector, early investor Bernard Ebbers, and their business partners. The group secured a $650,000 loan, which allowed them to buy the technology to route long-distance calls.

Since courts ordered AT&T to lease its phone lines to new companies at cheap rates, Ebbers, who was the company's chief executive officer (CEO), could offer his customers very low rates. This allowed him to build the company into one of America’s leading long-distance phone companies by acquiring as many as 30 competing telecom companies. At the peak of the dotcom bubble, WorldCom's market capitalization grew to $186 billion.

When the tech boom turned to bust, and companies slashed spending on telecom services and equipment, WorldCom resorted to accounting tricks to maintain the appearance of ever-growing profitability. By then, many investors became suspicious of Ebbers’ story—especially after the Enron scandal broke in the summer of 2001.

In 2002, it was revealed that Ebbers borrowed $408 million from WorldCom's board of directors to cover margin calls on loans secured by company stock. At the same time the company's accounting fraud and real financial situation were coming to light as the SEC began to investigate. As a result Ebbers met his downfall and resigned as CEO on April 30, 2022. In 2005 he was convicted of securities fraud, conspiracy, and making false filings, and sentenced to 25 years in prison.

Cooking the Books

There were several factors that pushed WorldCom into a loss. The company pursued acquisitions aggressively, buying up rival companies in an attempt to gain market share. This, coupled with a major drop in revenue and rates, pushed the company into further into the red. Executives needed a way to prove WorldCom was still financially viable to its board and shareholders.

WorldCom used a series of questionable accounting techniques to hide its financial position, which inflated its profits. This amounted to billions in capital expenditures being improperly recorded on the books. But this was hardly a sophisticated fraud.

In order to hide its falling profitability, WorldCom inflated net income and cash flow by recording expenses as investments. By capitalizing expenses, it exaggerated income by $3.8 billion, including $3.055 billion in 2001 and $797 million in the first quarter of 2002, reporting a net profit of $1.38 billion instead of a net loss.

The WhistleBlowers

Several individuals played a key role in exposing the fraud at WorldCom. These people included Cynthia Cooper, who was vice president of WorldCom's internal audit department, and Gene Morse, another auditor. They became concerned about several inconsistencies in the company's financial records, including:

• The use of reserves to boost the company's income
• The company's capital expenditures, which another employee questioned and was fired over
• Complicated accounting terms (such as prepaid capacity), which were used to hide the movement of capital
• The lack of evidence to substantiate certain financial transactions, including a $500 million capital expenditure

Cooper and Morse conducted investigations on their own as well as an audit. They were challenged by the company's chief financial officer (CFO), Scott Sullivan, who requested that the process be delayed. They contacted KPMG, the external auditor that replaced Arthur Andersen, as well as WorldCom's audit committee.

As a result of her diligence, Cooper was named a Person of the Year by Time and was featured on the magazine's cover in 2002. She is now an author, consultant, and internationally-recognized speaker.

WorldCom Bankruptcy

The company could no longer keep up once things started to unravel. In fact, WorldCom had to adjust its earnings for the 10-year period from 1999 to 2002 by $11 billion dollars and the fraud was estimated to be in the neighborhood of $79.5 billion.

Bankruptcy was the only option. WorldCom filed for Chapter 11 bankruptcy on July 21, 2002, only a month after its now former auditor Arthur Andersen had been founded guilty in court and lost its license to practice accounting. By this time, the company was indebted to its creditors by as much as $7.7 billion. In its filing, the company noted $107 billion in assets and $41 billion worth of debt.

The filing allowed WorldCom to provide some restitution. Doing so allowed existing customers to continue receiving services. WorldCom was also able to pay its employees and keep its assets. It also provided some much-needed time to restructure even though it lost its luster within the corporate marketplace.

Fallout and Aftermath

Some of the key personnel involved in the firm's accounting scandal received harsh punishment for their roles, including:

• Bernard Ebbers was convicted on one count of securities fraud, one count of conspiracy, and seven counts fraud related to false SEC filings. He was sentenced to 25 years in prison in 2005. Ebbers was granted early release from prison on December 18, 2019, for health reasons after serving about 13 years of his sentence.
• Former CFO Scott Sullivan received a five-year jail sentence after pleading guilty and testifying against Ebbers.

Debtor-in-possession financing from Citigroup, J.P. Morgan, and G.E. Capital allowed the company to survive. It emerged from bankruptcy in 2004 and rebranded itself as MCI—a telecom company WorldCom acquired in 1997. Verizon purchased MCI and its assets in 2006. Worldcom's former banks settled lawsuits with creditors for $6 billion without admitting liability. Around $5 billion went to the bondholders, with the balance going to former shareholders.

In a settlement with the Securities and Exchange Commission (SEC), the newly formed MCI agreed to pay shareholders and bondholders $500 million in cash and 10 million shares of MCI.

This spate of corporate crime led to the Sarbanes-Oxley Act in July 2002, which strengthened disclosure requirements and the penalties for fraudulent accounting. In the aftermath, WorldCom left a stain on the reputation of accounting firms, investment banks, and credit rating agencies that had never quite been removed.

Who Was to Blame?

Although no one actually admitted their part in the scandal, there were several players who were at fault—some within the company and others who weren't even employed by WorldCom.

Arthur Andersen, an accounting firm that audited WorldCom's 2001 financial statements and reviewed WorldCom’s books for Q1-2002, was found to have ignored memos from WorldCom executives informing them that the company was inflating profits by improperly accounting for expenses.

Key management personnel, including WorldCom CEO Bernie Ebbers and CFO Scott Sullivan, the company's board of directors, and its internal audit team were also singled out for their lack of oversight, ignoring of accounting principles, and committing fraud. Ebbers and his lawyer initially denied any involvement or knowledge of the fraud. These claims were refuted by a Wall Street Journal report, which cited internal communications to the contrary.

Wall Street analyst Jack Grubman gave the company consistently high ratings even though the company (along with other telecoms) performed poorly. Grubman was fired from his job at Salomon Smith Barney and was fined $15 million by the SEC. He was also banned from any activity in securities exchanges.

The Bottom Line

WorldCom was a telecommunications company that prided itself on providing its customers with affordable long-distance services. But an aggressive acquisition strategy and falling revenues led the company to a downward spiral that would ultimately open the door to one of the largest accounting frauds and bankruptcies in the United States. The company used fraudulent accounting techniques to hide its losses while making itself look more profitable than it was, which helped it retain its place as a darling among investors. Although it managed to restructure and emerge from bankruptcy, WorldCom's example helped corporate management teams and investors learn a valuable lesson: If something looks too good to be true, it probably is.