What is WorldCom?
WorldCom was not just the biggest accounting scandal in the history of the United States, but it was also one of the biggest bankruptcies. Considered a telecommunications giant, the revelation that it had cooked its books came on the heels of the Enron and Tyco frauds, which had rocked the financial markets. However, the scale of the WorldCom fraud put even them in the shade. This spate of corporate crime led to the Sarbanes-Oxley Act in July 2002, which strengthened disclosure requirements and the penalties for fraudulent accounting. However, WorldCom left a stain on the reputation of accounting firms, investment banks and credit rating agencies that has never quite been removed.
Breaking Down WorldCom
WorldCom has become a byword for accounting fraud, and a warning to investors that when things seem too good to be true, they just might be. Its CEO, Bernie Ebbers — a larger than life figure whose trademark was cowboy boots and ten-gallon hat — had built the company into one of America’s leading long-distance phone companies by acquiring other telecom companies. At the peak of the dotcom bubble, its market capitalization had grown to $175 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 had become suspicious of Ebbers’ story — especially after the Enron scandal broke in the summer of 2001. Shortly after Ebbers was forced to step down as CEO in April 2002, it was revealed that he had, in 2000, borrowed $400 million from Bank of America to cover margin calls, using his WorldCom shares as collateral. As a result, Ebbers lost his fortune.
Cooking the Books
This was not a sophisticated fraud. To hide its falling profitability, WorldCom had simply inflated net income and cash flow by recording expenses as investments. By capitalizing expenses, it exaggerated profits by around $3 billion in 2001 and $797 million in Q1 2002, reporting a profit of $1.4 billion instead of a net loss.
WorldCom filed for bankruptcy on July 21, 2002, only a month after its auditor, Arthur Andersen, was convicted of obstruction of justice for shredding documents related to its audit of Enron. Arthur Andersen, which had audited WorldCom's 2001 financial statements and reviewed WorldCom’s books for Q1 2002, was found later to have ignored memos from WorldCom executives informing them that the company was inflating profits by improperly accounting for expenses.
Bernard Ebbers was sentenced to 25 years in prison, and former CFO Scott Sullivan received a five-year jail sentence after pleading guilty and testifying against Ebbers.
Thanks to debtor-in-possession financing from Citigroup, J.P. Morgan and G.E. Capital, the company would survive as a going concern when it emerged from bankruptcy in 2003 as MCI – a telecom company WorldCom had acquired in 1997. However, tens of thousands of workers lost their jobs.
Without admitting liability, Worldcom's former banks, including Citigroup, Bank of America and J.P. Morgan, would settle lawsuits with creditors for $6 billion. Of that amount, around $5 billion went to the firm's bondholders, with the balance going to former shareholders. In a settlement with the Securities and Exchange Commission, the newly-formed MCI agreed to pay shareholders and bondholders $500 million in cash and $250 million in MCI shares.