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Worldcom Debacle - A Case Study in Risk Management.

BY: Vivek SHARMA | Category: Finance | Submitted: 2011-10-15 04:54:33
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Article Summary: "The article explains the risk management in context of Worldcom Debacle. Worldcom was America's second largest telecom company in 2000. But, the company filed for bankruptcy protection on July 21st, 2002. Could it have been avoided?.."


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Introduction

Worldcom was America's second largest telecom company in 2000. Making a modest beginning in the hinterland of Mississippi in 1983 with a meager capital of less than 100,000 USD it reached the pinnacle of corporate success reporting more than USD 39 billion in revenue and USD 150 billion in MCAP. In the process it became 42nd in the Fortune 500 list. Under the leadership of flamboyant promoter and CEO Bernie Ebbers it grew rapidly by means of acquisitions and increased demand for telecom services farther fuelled the growth of Worldcom during the whole of 90s. However on June 25, 2002, WorldCom, announced that it had overstated earnings in 2001 and the first quarter of 2002 by more than $3.8 billion.

WorldCom filed for bankruptcy protection on July 21st, 2002. Farther on August 8th, 2002, the company admitted that it had also manipulated its reserve accounts in recent years, affecting an additional $3.8 billion., making the total extent of fraud to more than USD 7.5 billion. US legal system and SEC charged CEO Bernie Ebbers, CFO Scott D. Sullivan and David F. Myers (the former controller) with securities fraud, conspiracy, and filing false statements with the SEC and subsequently found them guilty of those charges. As a result of this fraud common investors and pension funds including the pension fund of employees of Worldcom lost billions of dollars as the stock price fell from $64 in 2001 Dec to less than $1 by August 2002.

Here, as we deconstruct the Worldcom fraud in the following steps, it becomes clear that it is a glaring case of operational risk that has not been managed well because except investors no stake holder performed its duty.


1. The first to come to light, because of persistent probing by an internal audit staff named Cynthia Cooper, was that the line cost, which is the fees paid by one telecom company to other companies for using their infrastructure and which is essentially a current expenditure, was accounted as Capex in the pretext that the fees have been paid in advance and therefore should be treated as an asset, to the tune of $3.8 Billion. This helped them to reduce expenditure, thereby increase profit and increase asset. Using this illegal accounting practice Worldcom intended to defer and spread the expenditure for the next 5-10 years.

2. Inconsistent release of accruals was the second major accounting irregularity that inflicted Worldcom. Line cost to total expense ratio became very fashionable parameter among telecom analysts in different investment banks. Worldcom became obsessed to keep that ratio below 0.42. It is a standard accounting practice to keep aside the near future expenditures under the heading accruals. After real expenditures happen, the accrual account is verified and if any amount remains unspent, the same is released to the general pool. Worldcom manipulated the accrual account by a) at times releasing accruals without verifying the actual costs in detail to reduce the line cost b) and at certain other times, when actual expenditure was low, accruals were not released in the anticipation of higher expenditure in future, thereby using accruals as camouflaged working "reserve and surplus". This was solely done to avoid any volatility in the line cost to expense ratio and show to the world that the company has a very stable revenue and expenditure. When this fraud was unearthed, the monetary value of the fraud was pegged at $3.8 billion.

3. Mr. Ebbers pledged some of his promoter holdings with a bank to secure loans for certain other business ventures and to acquire personal assets. In the wake of dotcom bubble when all the telecom stocks were falling, bank made a margin call. Mr. Ebbers convinced the board of directors that if bank starts selling his pledged shares the company stocks will fall very sharply and therefore the company should provide cheap loan to Mr. Ebbers to avoid such a scenario. The board obliged. In our opinion this was the perfect example of a rubberstamp board of directors.


What was the risk involved?

As has been mentioned previously that this is primarily a manifestation of operational risk as evident from the fact that CEO Mr. Ebbers and CFO Mr Sullivan completely dominated the affairs of Worldcom virtually without any checks and balances on their activities. Both of them had larger than life egos. As evident from the points above, they always felt that what they were doing was for the ultimate good of the company. Some "temporary" and "minor" adjustments should be ignored. However what they themselves possibly did not anticipate was the fact that they were riding a tiger without knowing when and how to get down. Their problem went out of control because of dot com bubble, which worsened the revenue flow of all telecom companies, including Worldcom, making those "temporary" and "minor" adjustments difficult to reverse. On the contrary, they indulged in more of those "temporary" and "minor" adjustments to dress up the balance sheet to remain respectable in the corporate world in the face of dot com bubble till a time came when the castle fell down like a pack of cards.

This showed a financial system completely deficient in internal as well as external control. Although Ms Cynthia Coopers was highly praised for her persistent efforts to unearth what was seemingly an innocuous aberration, questions were subsequently asked as to why it was not brought to the notice of the regulatory authority. However, one should take into consideration of the fact that very rarely the lower level employees feel the urgency to go to the regulatory authority in the first instance. General work ethics demand that any suspicious corporate action will be brought to the notice of the higher authority which Ms Coopers did. What was completely unthinkable to her at that point was the fact that her own boss was involved in it. In light of these facts and considerations we are of the opinion that in the Worldcom accounting fraud case, if any agency proved its utility, it was the small internal auditor team headed by Ms Coopers. On the contrary, we feel that the board of the company is to be blamed, particularly the independent directors, for allowing an atmosphere to develop within the company where Ebbers and Sullivan felt completely immunized against any action they deem fit. This is highly evident from the dubious decision of the board to allow a loan to Ebbers to meet his margin requirement for a mortgaged loan to save the company's scrip from plummeting. This is unheard of in corporate world. This shows that the board was a puppet board and more to be blamed than the internal auditors. Finally, the board members indirectly acknowledged their deficiency by agreeing to pay $12 million from their own pockets to settle part of a class action law suit.

It has been recognized well by everybody that the external auditors failed miserably. The external auditor, Arther Anderson was also involved in another high profile corporate fraud case around the same time i.e. Enron. They completely lacked professional ethics, commitment and efficiency. Ultimately Arther Anderson, although nominally exists today, went out of accounting and auditing business.

How it could have been avoided? (Risk Management - I).

We conclude that the debacle in Worldcom could have been avoided by a more independent and watchful board of directors, which should have sent a signal to the company management that somebody is watching them closely and they better mend their ways and means. The concept of board of directors is age old and when it functions properly it is effective. In this case the independent directors failed in their responsibilities. In almost all corporate fraud it has been seen that the board has been ineffective over a long period of time and aggressive managers use this opportunity (of toothless board) to take the rein completely in their own hand. We also conclude that Arther Anderson miserably failed in its duty as external auditor. We hold a puppet board and a malleable auditor as responsible in allowing Ebbers and his associates to perpetrate the accounting fraud. Both the board of directors and external auditors have roles in averting operational risk and they have failed in their responsibilities.

Regulatory Measures (Risk Management - II).

Finally as a result of Worldcom accounting fraud and other accounting fraud like that of Enron's, SEC and US government took a serious note of the accounting loop holes. It culminated in Sarbanes Oxley legislation being passed in US senate and congress. It is beyond the scope of the present discussion to examine the Sarbanes-Oxley legislation here. However, in short this law made many disclosures and certifications on the part of the firm mandatory. It also made the commitment of the external auditor binding. This is significant in view of the fact that when Worldcom fraud came to light, Arther Anderson simply issued a statement saying the last two years' accounting statement are no longer reliable without owning much responsibility. What is noteworthy is the fact that US authority introduced the risk management step in the form of Sarbanes Oxley legislation, making the BOD, the company management and the external auditor responsible and bound by law.

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