Infectious Greed (65 page)

WorldCom's financial statements were much easier to understand, and appeared to be transparent. By 2001, given the downturn in the telecommunications industry, many investors expected that WorldCom's income would decline. There were no Special Purpose Entities or off-balance-sheet derivatives for the company to use to hide losses or inflate profits. WorldCom's top managers weren't sophisticated enough to use Enron's elaborate schemes or even Global Crossing's IRU swaps. It appeared that Ebbers and Sullivan would have to admit their business was struggling.

To save the day, Scott Sullivan wangled an accounting fix that was even simpler than Cendant's retyping of revenues and expenses. During 2001 and the first quarter of 2002, Sullivan simply transferred some expenses from the firm's operating account to its capital account.
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The operating account included the day-to-day costs of doing business, such as wages or advertising; the capital account included investments in long-term projects, such as the construction of a new building. Because operating expenses were incurred right away, whereas capital expenses were spread over time, the effect of the transfers was to reduce WorldCom's current expenses, pushing them off into the future. With lower
expenses, WorldCom showed higher earnings and, thereby, met expectations, even though, in truth, its business was declining.

The expenses involved the firm's payments to other telecommunications companies to access their networks, known as
line costs,
for the right to access a telecommunications line. From an economic perspective, line costs were indistinguishable from the costs of building a network; as Enron had shown, companies could either build their own network or purchase rights to someone else's. But from an accounting perspective, line costs were unambiguously operating expenses, which should have been deducted from WorldCom's revenues during the quarter the expenses were incurred. A student in Accounting 101 who classified line costs as capital expenditures to be spread out over several years would have failed the class, even if she had an argument about why line costs and new network construction costs were equivalent. Yet that was precisely what WorldCom did—for five straight quarters.

In May 2001—in the middle of Sullivan's scheme to defer WorldCom's expenses—WorldCom completed an $11.9 billion debt deal, the largest in U.S. history. The firms arranging the deal were J. P. Morgan Chase and, not surprisingly, Salomon (a division of Citigroup). These banks performed a supposedly thorough due-diligence investigation, as did WorldCom's accountants from Arthur Andersen; yet, apparently, no one spotted the fact that WorldCom
already
had transferred $771 million of line costs from operating to capital expenses during the first quarter of 2001.
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Even if Sullivan had been acting alone, it was incredible that top banks and accounting firms would understand their client so poorly that they would not notice a $771 million revision.

The credit-rating agencies also performed an extensive investigation of WorldCom before they decided to give the firm's bonds a rating of A minus, well above investment-grade, and they apparently did not spot the errors, either. In fact, the agencies did not downgrade WorldCom to a sub-investment-grade rating until May 9, 2002—two months after the Securities and Exchange Commission publicly announced an inquiry into WorldCom's accounting practices, and more than a week after Bernard Ebbers resigned.

No one spotted the fact that WorldCom used the same scheme to hide billions of dollars of expenses
after
its big debt deal, either: $610 million during the second quarter of 2001, $743 million in the third quarter, $931 million in the fourth quarter, and $797 million in the first quarter
of 2002.
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In fact, on February 6, 2002, Arthur Andersen, WorldCom's auditor, told the firm's audit committee that it had reviewed the processes management was using to account for line costs and found those processes to be “effective,” and had “no disagreements” with them.
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How could all of the watchdogs have missed such a basic multibillion-dollar accounting mistake? Perhaps they never imagined WorldCom's top executives would attempt such a simple scheme. Perhaps they were blinded by huge fees. Or perhaps they were no longer serving as watchdogs.

Several of WorldCom's banks—including J. P. Morgan Chase and Citigroup, Salomon's parent—also loaned billions of dollars to WorldCom, earning still more fees. These loans made it appear that the banks genuinely had not known about the accounting scheme; if they had, why would they have loaned WorldCom so much money? (The answer to that question involved credit swaps—more on them soon.)

After the collapse of Enron and Global Crossing, rumors spread that WorldCom was involved in similar dealings. The SEC began investigating WorldCom's finances and discovered that the company had made undisclosed loans to Bernie Ebbers of $366 million, twenty times the amount Global Crossing had loaned its last two CEOs. Ebbers had used the money to buy WorldCom stock, now below $3 per share, apparently oblivious to the fact that his company was unprofitable. In light of this, WorldCom's board asked Ebbers to resign.

Ebbers had lost much of his fortune, and now his job. Fortunately, he did not have Gary Winnick's profligate lifestyle. Even after advancing from a summer job at Edmonton Telephones to the top position at a leading global conglomerate, Ebbers had maintained frugal habits: a modest home in Brookhaven, Mississippi; an old red Ford pickup with a loose fender; and low-cost hobbies, such as playing pool, drinking beer, and listening to Willie Nelson.
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If he could avoid doing time in prison, Bernie Ebbers could handle the financial loss. A few days after he was fired, Ebbers told a local radio station, “I feel like crying. But I am a thousand percent convinced in my heart that this is a temporary thing.”

John W. Sidgmore, who had been WorldCom's vice chairman, replaced Ebbers on April 29, 2002. Sidgmore wisely had already sold almost $100 million of WorldCom stock. The rating agencies didn't like the fact that Bernie Ebbers had been forced out, and they immediately downgraded WorldCom to a rating of below investment grade, thereby ensuring that the end would come soon. To appease the rating agencies, and other investors and analysts, Sidgmore ordered a thorough internal review
of WorldCom's financial statements, to be done by the end of the third quarter of 2002. A few weeks later, he fired Arthur Andersen and hired KPMG as the company's new auditors.
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Still, no one outside WorldCom knew the details about WorldCom's fallacious financial statements.

At this point, Scott Sullivan was in serious trouble. Although it would take KPMG some time to unravel WorldCom's finances, Cynthia Cooper, an internal auditor at WorldCom, already had begun her own investigation of the company's capital expenditures for line costs. Cooper had discovered that someone had transferred line costs from the operating account to the capital account, so that those costs would be spread over time. Like Sherron Watkins of Enron and Roy Olofson of Global Crossing before her, she was about to blow the whistle on a billion-dollar-plus accounting error.

Cooper confronted Sullivan with her findings on June 11, 2002. According to Cooper, Sullivan said the problems would be corrected and asked her to delay her review, which did not need to be completed until the third quarter—she should be focusing on the second quarter, not the third. Sullivan had only three days to prepare for the next regularly scheduled audit-committee and board meetings, when he would need to present the company's preliminary financial statements for the second quarter, and he couldn't afford to have Cooper sniffing around. He still needed to decide what to tell board members about line costs.

Cooper ignored Sullivan's request for a delay, and immediately contacted Max Bobbitt, the chair of WorldCom's audit committee. Cooper told him she thought the audit committee should be apprised of the facts she had discovered, but Bobbitt said he believed it was premature.

At the meeting on June 14, Sullivan said WorldCom's second-quarter financial statement would be very “complex” and that he was continuing to examine line costs. The board members were not alerted to Cynthia Cooper's discovery that WorldCom had overstated its income by billions of dollars.

There was a flurry of meetings during the next week. On June 20, Sullivan explained to the audit committee that the accounting for line costs had required significant “judgments.” Sullivan's judgment had been that the line costs were long-term contracts and that, because WorldCom had not yet made any money from those contracts, it was appropriate to spread the costs over time, instead of incurring them all at once.
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WorldCom's directors asked Sullivan to take a few days to prepare a memorandum outlining his reasoning (just as a skeptical Ed Cerullo of Kidder Peabody
had asked Joseph Jett to explain his bond-trading strategy in writing). WorldCom's directors contacted representatives from Arthur Andersen, who said that Sullivan's reasoning was contrary to Generally Accepted Accounting Principles. Auditors from KPMG agreed. Andersen officials said they had not known about the line-cost transfers, and they said investors should not rely on the firm's written opinion that WorldCom's 2001 financial statements were accurate.
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In Sullivan's defense, his argument for spreading out the line-cost expenses made some sense. After all, there was no economic difference between paying money to build your own network—the costs of which
were
spread out over time—and paying money to access the lines on someone else's network, any more than there was an economic difference between leasing a car for a period of time and borrowing money for the same period of time to buy the car. If the “investment” in someone else's lines would yield returns only over a period of years, then it made sense to treat those costs as capital expenditures to be spread over several years. In fact, such a conclusion followed from one of the basic principles of accounting: matching the timing of revenues and expenses. If, as Sullivan claimed, revenues would occur over several years, then it made sense to record expenses over several years, too.

But economic reality didn't necessarily match accounting, as Enron's risk-management manual had instructed. Generally Accepted Accounting Principles were a somewhat arbitrary set of rules that all companies and their officials promised to live by, even if they diverged from economic reality. If the established accounting practice was to treat line costs as operating expenses, including them in the current period, then it was improper to spread those costs over time.

The effect of the reclassification of line costs was devastating. WorldCom had reported 2001 earnings of $10.5 billion. Now, it would need to reduce that number to $6.3 billion, to account for the additional expenses from line costs. The restatement of earnings was five times larger than Enron's. Sullivan was fired the day of the announcement.

Most of the events to follow were predictable: first, WorldCom's stock price plunged; second, once everyone understood the basics, the credit-rating agencies finally downgraded WorldCom; and third, the company filed for bankruptcy. Jack Grubman had hung on until the very end, finally issuing his first negative report about WorldCom on June 21, just days before WorldCom announced its accounting scheme.
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On August 2, 2002, there were photographs of Scott Sullivan and his assistant,
David Myers, on the front page of the
New York Times—
in hand-cuffs. A few days later, WorldCom announced that it had discovered another $3.3 billion of accounting mistakes—this time, it had artificially inflated the reserves it set aside for future expenses, just as Sunbeam had overstated its massive “one-time” charges so that it would appear to make more money in the future. In late 2002, the company announced billions more of accounting errors—the losses were a bottomless pit.

Previously, officials of many other companies—including Enron—had relied on the letter of the law to support their interpretations of accounting rules, even when they were contrary to economic reality or common sense. Now, they had a paradigmatic case to cite in their defense. How could any company official be expected to stray from the letter of rules in favor of economic reality, when a prominent CFO, Scott Sullivan, had been fired and prosecuted for following economic reality over accounting practice?

Of course, WorldCom's switch had occurred, not so coincidentally, when WorldCom's business was hurting and the company was falling short of analysts' earnings estimates. And although Sullivan had argued that WorldCom's expenses should be delayed along with its revenues, the reality was that WorldCom's revenues weren't merely delayed; instead, they weren't coming in at all, because of trouble in the telecommunications industry. Sullivan's legal defense would be a challenge.

Nevertheless, WorldCom's collapse presented a paradox for prosecutors. To prove a crime, they had to establish that corporate officials intended to commit fraud. But given the gap between economic reality and accounting rules, which people were guilty of criminal intent: those who followed accounting rules over economic reality, or those who followed economic reality over accounting?

 

 

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orldCom's bankruptcy filing listed J. P. Morgan Chase as being owed more than $3 billion. Other banks, including Citigroup, were owed nearly as much. These banks also were the major lenders to other failed companies, including Enron and Global Crossing. These sophisticated financial institutions had loaned billions of dollars to the same foolish firms. In 2000, there had been $42 billion of corporate defaults, a record. In 2001, that number tripled. More than 200 companies defaulted, including one of every nine telecommunications firms.
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And that was
before
Global Crossing and WorldCom.