Free «WorldCom Fraud Report» Essay Paper
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The WorldCom Company was one of the most significant examples of American capitalism in modern business in the telecommunications market. For ten years, small regional operator of Mississippi has become the second largest operator of long-distance communication in the United States. The client base of the company amounted to 20 million people, and the share price on the stock exchanges reached $ 60 per share (Ashraf, 2011). The company WorldCom Inc. was one of the world's market leaders in the field of telecommunications and distant data communications. The company provided local, long distance and international telephone services in more than 65 countries around the world. It served individuals, corporate clients and public institutions with wired telephone lines, a wide network of high-speed fiber-optic backbones, mobile and satellite communications. WorldCom was present in almost all segments of the telecommunications services market, such as the traditional telephone business, data transmission and Internet. The company also has leading positions in the dynamic and very promising market of wireless, dial-up Internet access and provides combined voice and video services. Gross revenue for 1999 amounted to more than 37 billion dollars (Ashraf, 2011).
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Description of the Fraud
WorldCom 4 billion dollar scandal occurred after its chief, Bernard Ebbers, asked the company to lend almost $ 400 million to cover margin positions on the companies' shares pledged loans. Despite the threat of Bernard to sell the shares, the Board of Directors of WorldCom could not grant corporate loans and guarantees. Moreover, Ebbers further lowered to the value of shares. The ensuing replacement of Bernard and other executives allowed the company's office to identify the fraud with the following indicators:
- Capitalization of operating costs. Operating expenses for the maintenance of telecommunication networks with other companies were capitalized; thereby costs and overestimate profits were underestimated;
- Falsification of the implementation transactions.
In general, a large number of financial transactions and reporting indicators, such as the capitalization of costs, amortization, stock assessment, the creation of reserves, and future-based valuation of cash flows, required a manual value assessment from the board. By deciding on estimates, leadership tempted to provide information and results in the most favorable way.
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Investigation of the Fraud and Its Management
There has been a decline after the continuous and rapid growth of the telecommunication service in the US market. Exchange rate of the WorldCom shares went down, and its largest shareholder, Bernie Ebbers, began selling his own stocks. In order to resolve the crisis, the WorldCom board provided Ebbers a credit for 341 million dollars under two per cent per annum (Ashraf, 2011). Consequently, a terrible scandal erupted and ordinary shareholders resented the low interest rate. On April 29, 2002, the company's general manager Bernard Ebbers was forced to retire with a lifetime pension of $ 1.5 million per year. Ebbers said in an interview: “People ask me how I feel. You know what I say? I am the son of the King, and the King's name remains unchanged - our Lord Jesus Christ, so I'm absolutely happy” (Cooper, 2009).
Incident with Ebbers was only the beginning of the high-profile revelations related to the telecommunication giant. Cynthia Cooper, internal auditor of WorldCom, initiated the investigation of the fraud (Pulliam & Solomon, 2002). Moreover, in order not to arouse suspicion in others, she often had to study the documents at night. Cooper found that the company's executives increased revenue and reduced costs to improve the financial statements. Cynthia shared this information with colleagues. Soon, the chief financial officer, Scott Sullivan, summoned her, threating to dismiss her and requiring Cynthia to stop playing a detective (Cooper, 2009) Cooper refused and ended Sullivan’s investigation. On June 25, 2002, the management of WorldCom announced a review of the financial statements for 2001 and the first quarter of 2002. Scott Sullivan was dismissed for violations. David Myers, a comptroller, retired (Romero, 2002).
According to the chairperson of the Finance Committee US House of Representatives, Mike Oxley, there has been a ‘good old fraud’ concerning the case of WorldCom (Cooper, 2009). Operating costs, which mainly were the costs of the services of other companies, magically appeared under the capital investment category. According to the rules of financial accounting, operating costs must be deducted from the income of the company for the same year they were received. Indeed, capital costs can be spread over time for several years, and in this case, the current profit is artificially overestimated.
As mentioned above, WorldCom Company spent $ 3.8 billion on operating costs to maintain its business. However, instead of reporting these costs as expenses, WorldCom management stated that the money was spent on the purchase of fixed assets, equipment and real estate. Within fifteen months, WorldCom regularly pointed these amounts under the capital costs, which allowed the possibility to spread the mentioned amount for many years. This made the WorldCom Company's revenues before taxes and fees by $ 3.8 billion higher than they actually were (Ashraf, 2011). Dimensions of the revealed fraud had an enormous scale.
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At that time, many experts were wondering why Arthur Andersen, one of the most well-known audit companies, did not reveal the obvious violations. In fact, WorldCom paid to Arthur Andersen auditors 4.4 million dollars annually. Representative of Arthur Andersen Company was justified by the fact that the verification of WorldCom accounting documents was carried out in accordance with the rules established by the US Securities and Exchange Commission. However, the Arthur Andersen concealed the information about the enrollment of current expenditure under capital investments. When violations were found, Arthur Andersen warned the WorldCom that the financial statements of the company for the 2001 year did not inspire confidence and could lead to a scandal. However, such an explanation did not satisfy the court (Romar & Calkins, 2006).
One of the memorable characters of the erupted scandal was a leading analyst in telecommunications, Jack Grubman, who worked in the Citigroup Company. During the boom of the telecommunication industry, Grubman gained a reputation as one of the most successful players on the market. As a leading analyst in the telecommunications industry, he was paid 20 million dollars a year for insuring other companies like WorldCom, which were transferring billions of dollars in investment banking business (Cooper, 2009). Grubman continuously assigned the highest rating to the shares of the telecommunications giant, and only on 18 March 2002, when the company's stock price has fallen by 90 per cent, he placed these shares under the category of risk (Cooper, 2009).
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On July 21, 2002, WorldCom management filed for bankruptcy protection in connection with the reorganization under the 11th chapter, which ensured protection from creditors' claims for the restructuring period (Ashraf, 2011). The official representative of the Securities and Exchange Commission, David Fiske, said that ‘the US government uses all the means at its disposal leverage to protect consumers and the integrity of telecommunication networks of the country’ (Lavey, 2006).
Consequences in Details
The WorldCom announced bankruptcy, as it similarly happened to the Global Crossing and Enron. The second-largest network operator, among others US telephone networks, fell victim to rampant megalomania of its managers and accounting innovation of financiers, having assets of $ 104 billion. By the volume of the declared assets, it is the third largest bankruptcy in history. The two previous records included Global Crossing and Enron, which happened the same year. Enron at the time of bankruptcy has estimated its assets at $ 63.4 billion, and WorldCom at $ 104 billion (Martin, 2005). However, after the revaluation of WorldCom Company, assets became cheaper by $ 15 billion. Corporate debt was $ 41 billion (Martin, 2005). The board of directors of WorldCom admitted that the company has no more money, and voted unanimously to announce bankruptcy under the Chapter 11 of the Bankruptcy Act, which protects bankrupt company from creditors and allows restructuring. At that time, WorldCom executives assured customers that the company would continue to operate normally. However, many understood that bankruptcy could lead to unpredictable consequences in the telecommunications market. About 20 million individuals and thousands of corporations used voice and data services provided by WorldCom. The company's network held up to 50% of all Internet traffic in the United States. Meanwhile, John Sidgmore, who led WorldCom after the dismissal of its discredited founder, Bernard Ebbers, introduced a plan that would complete the restructuring in 9 - 12 months without the need to sell the core assets (Ashraf, 2011). Analysts believed that the company would be very attractive to potential buyers, especially for operators of local telephone services, if it straightened its balance sheet. Then, according to Sidgmore, some companies were interested in buying WorldCom, and hired experts in investment banking to assess the feasibility of the transaction. In 2004, WorldCom Company paid a fine of $ 750 million and went out of bankruptcy proceedings, changing its name to MCI. In 2005, Verizon Company, the largest US telecommunications company, acquired the company for 7.6 billion dollars (Cooper, 2009).
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As for WorldCom management, the court sentenced Bernard Ebbers to twenty-five years in prison. It was the most severe sentence for corporate fraud in modern America. Of course, lawyers then filed an appeal. Scott Sullivan was sentenced for five years in prison, and the comptroller, David Myers, and chief accountant, Buford Yates, were sentenced for one year in prison (Romero & Atlas, 2002). The analyst, Jack Grubman, paid a fine in the amount of $ 15 million, in addition, he was forbidden to work with any kind of businesses, which had any connections to stock activities. Cynthia Cooper was declared a women of the year by the Time magazine. In addition, she received several awards for bravery and professionalism in exposing fraud. Cooper gave lectures to students and financiers. However, her position at the WorldCom Company significantly declined, her wages were frozen, the amount of audit working drastically reduced, and the budget for her division was cut (Cooper, 2009).
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As for employees, the WorldCom Company’s management announced the upcoming dismissal of 17 thousand employees (28 per cent of the total staff). Former employees of the company appealed to the Court of Bankruptcy to approve the compensation. Four thousand hired employees of WorldCom have raised the question of obtaining $ 36 million. The company also announced that it intends to lay off another 2,000 of its employees in the units, which were operating in Europe, Africa and the Middle East. For example, in the UK WorldCom planned to reduce headcount by 750 people. Another 1,250 employees were cut in Germany and France (Cooper, 2009).
As for company’s auditors, in May, during a standard audit of financial statements, Cynthia Cooper became noticed a number of suspicious transactions. Then Sullivan asked the auditor not to bring the information to the attention of the shareholders. The delay was caused by the need of Sullivan to deal with their own problems. Sullivan demanded Cooper to postpone the publication of data until the end of the third quarter of 2002 (Cooper, 2009). The independent auditor of WorldCom Company, the Arthur Andersen Company, hence, found no problems in the financial statements of telecommunication giant during the test in February 2002. At that time, Arthur Andersen noted that WorldCom Company did not make any suspicious financial transactions. In addition, the auditors noted the absence of any complaints from the company's management. After the fraud was revealed, WorldCom accounting books were actually rewritten with the cooperation of the KPMG auditing company. More than 500 auditors and accountants had to rewrite almost 3 million accounting records in WorldCom Company reports. This process cost the company nearly $ 250 million. Meanwhile, the first auditor of the company, Arthur Andersen Company, which in 2002 was found guilty of obstruction of justice and ceased operations, continued to pay the charges for investors in the court. The company agreed to pay $ 65 million to investors for the bankruptcy of telecommunications giant WorldCom in 2002 (Cooper, 2009). Under the agreement, the plaintiffs also received 20% of the funds that Arthur Andersen Company was obliged to return to the partners upon completion of all trials and implementation of all payments. As the auditor of the company, Arthur Andersen was the only remaining defendant in the case of WorldCom. Investment banks agreed to pay $ 6 billion to settle charges for the inadequate assessment of the financial condition of the company, when it issues shares. Twelve independent members of the board of directors of WorldCom agreed to pay $ 60.8 million in this case, the $ 24.8 million of which they had to pay out of own pocket (Ashraf, 2011). Arthur Andersen Company managed to convince the judge and the plaintiffs in the absence of the considerable financial resources, which explains the fact that the company paid only $ 65 million to investors who were mostly affected by the incident.
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Additionally, the bankruptcy of the WorldCom Corporation had a negative impact on global market, since the fall of the US indices had a domino effect. At that time, in the first hour of trading Dow Jones plunged below 8000 points. The largest telephone operator of the southeastern USA, Bellsouth Company, announced sharp threefold fall in net profit in the second quarter. As a result, its shares fell by almost 17% (Sidak, 2003). At the same time other telecommunication companies drastically dropped in price, including Verizon Communications (-7.5%) and SBC Communications (-6.9%). The securities of finance companies, which actively promoted and provided lending to the ruined giant, collapsed. Shares of the world's largest financial group, Citigroup, fell nearly by 7%, the capitalization of JP Morgan Chase investment bank declined by 3%. As a result, the Dow Jones index stood at around 7784 points, which recorded a four-year minimum. Following the results of the last 11 trading sessions, Dow Jones rose only once. Over the last two weeks of its decline, Dow Jones reached 15% and was the highest since the stock market crisis in 1987. The S&P 500 and the NASDAQ fell to a 5-year low (Lavey, 2006).
Analysis of the fraud revealed two important factors in the formation of the market value of shares. They include subjective factor in assessing the current state and prospects of the company and reliability of the information underlying the assessment. Understanding the WorldCom events requires the identification of the senior management’s motivation for the analyzed behavior. Explanation of their actions as personal greed would be too superficial. It is obvious that the managers understood that their actions were detrimental to the company. They did realize that eventually their abuse of power would be revealed. Consequently, they had a reason to believe that the collapse of the company would not entail the collapse of their own careers and welfare. Study of the circumstances of WorldCom bankruptcy showed that fundamental economy processes and the system of management of large companies took an active part in the incident.
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The essence of the WorldCom scandal lies in the development of financial affairs. Thus, complicating the management of large corporations led to the isolation of financial professionals and senior managers in the caste. Their actions were not clear for shareholders and society. The latter were forced to rely on the finance professionals’ competence, integrity and responsibility that the information that management considered necessary to publicize is true. The emphasis on the improvement of methods of corporate governance confirms the interest in top managers, making it an object of attention and proving that the incident remained in the shadow.