WorldCom’s Failure: Why Did It Happen?

When WorldCom, the telecommunications giant, failed and was put into bankruptcy, the U.S. witnessed one of the largest accounting frauds in history. Former CEO, Bernie Ebbers, 63, was convicted of orchestrating this US$11 billion accounting fraud and was sentenced to 25 years in prison on July 13, 2005.

How could a loss of this magnitude have occurred? Where were the checks and balances? The watchdogs? Specifically, whatever happened to WorldCom’s board of directors, the custodians of this once mighty corporation? Were they “asleep at the switch?”

While examining this colossal failure in corporate governance and what could have been done to avoid it, I came across a fascinating document entitled “Report of Investigation” dated March 31, 2003. This Report was prepared for, among others, the Federal Bankruptcy Court overseeing WorldCom. A great deal of my research was obtained from the Report and all of the quotes below can be directly attributed to the Report.

Accounting Misstatements

WorldCom made major accounting misstatements that hid the increasingly perilous financial condition of the company. The Report described the accounting shenanigans as follows: “… As enormous as the fraud was, it was accomplished in a relatively mundane way: more than $9 billion in false or unsupported accounting entries were made in WorldCom’s financial systems in order to achieve desired reported financial results …”

What Drove the Fraud?

The driving factor behind this fraud was the business strategy of WorldCom’s CEO, Bernie Ebbers. In the 1990s, Ebbers was clearly focused on achieving impressive growth through acquisitions.

How was he going to pay for this acquisition binge? By using the stock of WorldCom. To accomplish this buying spree, the stock had to continually increase in value.

Here’s a bit of how the Report describes this scenario:

“… WorldCom pursued scores of increasingly large acquisitions. The strategy reached its apex with WorldCom’s acquisition in 1998 of MCI Communications, a company with more than two-and-a-half times the revenue of WorldCom. Ebbers’ acquisition strategy largely came to an end by early 2000 when WorldCom was forced to abandon a proposed merger with Sprint because of antitrust objections …”

Ebbers felt the need to show ever-increasing revenue and income. His only recourse to achieve this end was financial gimmickry. The problem is that the more one resorts to this sort of deception, the more complicated it becomes to continue it. Deception is just not sustainable in the long run.

Complicating Ebbers’ situation was an industry-wide downturn in telecommunications. During this time, Wall Street had continuing expectations of double-digit growth for WorldCom. After all, they had achieved so much in such a relatively short period of time.

However, WorldCom needed time for its management to catch up to its newly acquired companies and learn how to run and manage them. Unfortunately, Ebbers did not have the courage to tell Wall Street that WorldCom needed time for the consolidation and digestion of its acquisitions. In order to satisfy Wall Street’s expectations, Ebbers had to doctor his company’s books.

If he had had the courage to tell them what was really needed, WorldCom would be alive today and Ebbers wouldn’t be facing the prospect of spending the rest of his life in prison.

Another major factor driving this fraud was Ebbers’ very apparent desire to build and protect his personal financial condition. For this reason, he had to show continually growing net worth in order to avoid margin calls on his own WorldCom stock that he had pledged to secure loans.

This Debacle Could Have Been Stopped

It is obvious that the Board of Directors that was in place when WorldCom was planting the seeds of its destruction could have stepped in and stopped this financial death spiral.

Although the Report clearly puts a great deal of the blame on Ebbers saying, “… The fraud was the consequence of the way WorldCom’s Chief Executive Officer, Bernard J. Ebbers, ran the Company … he was the source of the culture, as well as much of the pressure, that gave birth to this fraud,” the Board of Directors certainly shares this blame. As the Report states, “… The setting in which it occurred was marked by a serious corporate governance failure …”

The Court-Ordered Fix

The Bankruptcy Court directed the newly constituted Board of Directors and the newly appointed Corporate Monitor to fix this horrible example of corporate malfeasance.

The Report of Investigation includes recommendations meant to “… cure the principal failing that gave rise to the fraud: a lack of effective checks and balances on the power of senior management …”.

Here are a few:

• An active and independent Board of Directors and Committees;
• A corporate culture of candor, in which ethical conduct is encouraged and expected, as exemplified by the ethics pledge that the Company and the Corporate Monitor have developed and that senior management has signed;
• A corporate culture in which the advice of lawyers is sought and respected; and
• Formalized and well-documented policies and procedures, including a clear and effective channel through which employees can raise concerns or report acts of misconduct.

Make Your Company Transparent

You can avoid the pitfalls that plagued WorldCom by choosing a corporate culture which would insure that a similar situation doesn’t happen to your company. Two sources of information on how to do this include the articles entitled “Your Corporate Culture: A Boon or a Bane?” and “Choosing Your Board of Directors.”

You should never have to fear what regulators or other government officials would uncover if they were to take a good look at the workings of your company. Transparency can bring you safety. It’s a great way to get a good night’s sleep!

Good luck!

Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which deals in bringing small-cap companies public. He also is a frequent speaker on the subject of financial advice for small businesses as well as the IPO process. He can be contacted at [email protected].