WorldCom: Bernie Ebbers and the $11 Billion Fraud, 1999–2002

At 4:42 p.m. on Tuesday, 25 June 2002, with the NYSE closed but the after-hours wires still live, WorldCom Inc. filed an 8-K with the Securities and Exchange Commission disclosing that the company had improperly capitalised $3.055 billion of line-cost expenses in 2001 and a further $797 million in the first quarter of 2002. The release named no individuals. It noted that Scott D. Sullivan, the chief financial officer who had won CFO Magazine's Excellence Award in 1998, had been "terminated" earlier that day; David Myers, the senior vice president and controller, had "resigned." The next morning, before the bell, WorldCom shares — which had traded as high as $96 three years earlier — opened at 9 cents. Trading was halted at 6 cents and the stock never reopened.

The SEC filed a civil action against the company that evening in the Southern District of New York. Judge Jed Rakoff signed an emergency injunction by close of business. Twenty-six days later, on 21 July 2002, WorldCom filed Chapter 11 in the Bankruptcy Court for the Southern District of New York — at $107 billion in book assets, the largest US corporate bankruptcy filing in history, eclipsing Enron's December 2001 record by a factor of nearly two. The filing came less than seven months after Enron's, and on the same day that the Senate-House conference committee chairing the corporate-reform bill named for Senator Paul Sarbanes and Representative Michael Oxley reported a final version to both chambers.

From Mississippi motel to second-largest long-distance carrier

Bernard J. Ebbers ran the Master Hosts motel in Columbia, Mississippi in the early 1980s. He had played basketball at Mississippi College on a partial scholarship, coached high-school physical education in Hattiesburg, sold milk in Brookhaven, and bought into the motel after a brief detour as a bouncer at a Holiday Inn. He was not a telecoms man. In September 1983 he attended a meeting at the Days Inn in Hattiesburg with three other Mississippi investors — Murray Waldron, William Rector, and David Singleton — who had pulled together $650,000 to start a long-distance reseller. The four of them, sitting around a coffee-shop table, sketched on a paper napkin a model in which their new company would buy bulk long-distance minutes from AT&T at wholesale and sell them to small Southern businesses at a discount. They named the company Long Distance Discount Services. Ebbers, then 42, agreed to serve as chief executive on the understanding that he could keep running his motels.

The first year produced revenues of about $1.5 million and a loss. The second produced a profit. By 1989, LDDS was acquiring small regional resellers; by 1992, after merging with the Atlanta-based Advanced Telecommunications, it was listed on Nasdaq. In 1995 Ebbers renamed the holding company WorldCom. Between 1995 and 1999 WorldCom completed more than sixty acquisitions, the largest of which was the November 1998 purchase of MCI Communications for approximately $40 billion in stock and assumed debt — the largest corporate merger in US history to that date, and one that vaulted WorldCom into second place behind AT&T in long-distance share, with the customer base, fibre rings, and undersea cables to match.

The merger was financed almost entirely in WorldCom paper. MCI shareholders received 1.2439 WorldCom shares per MCI share, an exchange ratio set on 10 November 1997 when WorldCom traded at $42. By the close on 30 June 1999 — the first reporting quarter after the deal closed — WorldCom touched $96.75, a peak the stock would never see again. Salomon Smith Barney's lead telecoms analyst, Jack Grubman, who had advised on the MCI deal and on the failed 1999–2000 Sprint bid that followed, kept his "buy" rating with a 12-month target of $130 through May 2001 (Beresford et al., 2003). His compensation that year was $20 million.

The line-cost problem

WorldCom's business model rested on a deceptively simple fact. A long-distance carrier owns its own backbone — fibre, undersea cable, switches — but the call originates and terminates on a local network it does not own. Every minute a WorldCom customer in Atlanta spent talking to a customer in Sacramento generated two access-charge bills: one from BellSouth on the originating end, one from Pacific Bell on the terminating end. These payments, known industry-wide as "line costs," were the single largest expense item on WorldCom's income statement. Through the late 1990s they ran at about 42 per cent of revenue. They were a current-period operating expense — the FCC's tariff structure required them to be paid in cash within thirty to sixty days — and they were under contract for years forward at fixed minute rates, regardless of whether traffic materialised.

Through 1999 and most of 2000 this did not matter. WorldCom's revenue grew at roughly 17 per cent year-on-year, and the line-cost-to-revenue ratio held. Then, in the autumn of 2000, the telecoms construction boom that had defined the dot-com bubble — the same overbuild that left Global Crossing, 360networks, and Williams Communications drowning in dark fibre — broke. Enterprise demand for circuits flat-lined. The competitive local exchange carriers (CLECs) that had been WorldCom's growth tail filed for bankruptcy in waves, defaulting on the access lines they had contracted from WorldCom while WorldCom itself remained on the hook to BellSouth and Pacific Bell and Verizon for the underlying capacity. WorldCom's revenue growth slowed to 6 per cent in the fourth quarter of 2000. Its line-cost ratio began to climb toward 50 per cent.

Ebbers, who had built his career on hitting Wall Street consensus and had personally borrowed roughly $400 million from Bank of America and other lenders to buy WorldCom shares on margin — collateralised by those same shares — could not afford a downgrade. The Special Investigative Committee's later report quoted him telling Sullivan in October 2000, "We have to hit our numbers" (Beresford et al., 2003). Sullivan, the report concluded, did not believe at that point that the gap could be closed legitimately. He directed his staff to close it anyway.

The mechanics: $9 billion of line costs reclassified as capital

The first step was the simpler one. In the closing days of the fourth-quarter 2000 books, Sullivan instructed the company's reserve accountants to release approximately $828 million of previously-accrued tax and other balance-sheet provisions directly into earnings — provisions that had been established for specific contingent liabilities and could be reversed only when the underlying obligations no longer existed. The releases were not documented as the contingencies resolving; they were simply made. Across the next five quarters, similar reversals added a further $1.6 billion. The auditors, Arthur Andersen, did not test the underlying liabilities and accepted the company's representations that the reserves were no longer needed (Cooper, 2008).

The second step, beginning in the first quarter of 2001, was larger and more brazen. Buford Yates, the director of general accounting in Clinton, was instructed by Sullivan and Myers to capitalise — that is, to record as a long-lived fixed asset rather than as a current operating expense — a portion of the line-cost payments due to local carriers. The journal entry debited "prepaid capacity" or "construction in progress" and credited line-cost expense. There was no operational basis for the entry. WorldCom did not own the local lines and was not building them; it was simply paying for the right to terminate calls on them, period by period, under existing tariff. Yates's deputies Betty Vinson and Troy Normand later testified that they signed the entries despite their own conviction that the treatment violated US GAAP, because Sullivan and Myers told them the entries were temporary "and would only need to be made for one quarter" (United States v. Ebbers, trial transcript, 2005). The quarters continued.

Source: WorldCom Special Investigative Committee Report to the Board (Beresford et al., 2003), Tables 1–2, with totals reconciled to the SEC's Second Amended Complaint of 6 November 2002. The "later phases" line aggregates further line-cost reclassifications uncovered in the restated 2000 figures; for the full quarter-by-quarter breakdown, see the Committee Report Annex C.

The mechanism worked because of where line-cost payments sat on a properly-prepared income statement and where capital expenditures sat on a balance sheet. By moving the entry, Sullivan converted a roughly $9 billion negative impact on operating margin into a $9 billion increase in the gross book value of property, plant, and equipment, depreciable over an average of twenty to forty years. The income-statement effect of each quarter's reclassification was therefore $9 billion in expense removed, less perhaps $100 million of depreciation added back — a near-permanent uplift in reported earnings. Operating margin for full-year 2001 was reported as approximately 18 per cent; the restated figure, post-disclosure, was negative.

Cynthia Cooper, the night audit

Cynthia Cooper was vice president of internal audit at WorldCom from her office in the Clinton, Mississippi headquarters. She was 38 in the spring of 2002, an accountant with a master's from the University of Alabama and a steady career through Price Waterhouse and then WorldCom itself. Her department reported to Sullivan administratively but to the board's audit committee functionally. In late March 2002, Gene Morse, a senior auditor on her staff, was looking at a routine capital-expenditure review when he flagged an unsupported $500 million entry to a fixed-asset account. Morse asked Sullivan's office for the underlying documentation. He was told there was none — the figure was a "top-side" adjustment booked at corporate.

Cooper, suspicious, redirected her team to an unannounced full audit of the capital-expenditure cycle. Sullivan ordered her, through her nominal reporting line, to defer the work until the third quarter. She did not defer it. Instead, Morse, Glyn Smith, and Tonya Roundy ran the queries at night from a server room on the third floor of the headquarters building, after Sullivan's staff had gone home, to avoid the audit trail attaching their user IDs to the data extracts. By 11 June 2002 the team had isolated $3.055 billion of line-cost reclassifications in the 2001 books and an additional $797 million in the first quarter of 2002. Cooper drafted a memo to the audit committee chairman, Max Bobbitt, and on 20 June 2002 — in a conference call from a hotel room in Washington where Bobbitt was attending an industry meeting — she presented the findings (Cooper, 2008). The committee retained KPMG as forensic auditor that night. Sullivan was terminated on 25 June. The disclosure followed two hours later.

"It was not a moment of bravery," Cooper later told the Mississippi Public Broadcasting interview in 2008. "It was a moment of not knowing what else to do. The numbers were wrong. Someone had to say so."

Bankruptcy, prosecution, and Sarbanes-Oxley

The 21 July 2002 Chapter 11 filing was the largest in US history at the time. WorldCom's pre-petition assets of $107 billion would not be surpassed in a bankruptcy filing until Lehman Brothers in September 2008, at $639 billion. The plan of reorganisation, confirmed by Judge Arthur Gonzalez on 31 October 2003, wiped out the common equity, converted roughly $35 billion of bond claims into $5.6 billion of new debt and new equity at recoveries of about 36 cents on the dollar, and renamed the surviving company MCI Inc. Verizon Communications acquired MCI in January 2006 for $7.6 billion. The new entity's customer base, fibre, and undersea cables — the underlying operating business that had been profitable until the bubble broke — survived. The capital structure did not.

Sullivan, facing a 165-year maximum sentence, pleaded guilty on 4 March 2004 to securities fraud, conspiracy, and false-statement charges. He testified for the government at Ebbers's trial and received five years. David Myers and Buford Yates each pleaded guilty in 2002 and 2003 and received one year and one day. Betty Vinson and Troy Normand received five months and a probationary sentence respectively. Ebbers, who had refused all plea discussions and maintained at trial that he had been a "big-picture guy" who knew nothing of the accounting, was convicted by Judge Jones's jury on 15 March 2005 of all nine counts after thirty-three hours of deliberation. He was sentenced to twenty-five years on 13 July 2005 — the longest sentence ever imposed in a US securities-fraud case at the time. The Second Circuit affirmed in 2006. Ebbers reported to the Federal Medical Center in Fort Worth, Texas on 26 September 2006. He was released to home detention on compassionate grounds in December 2019 and died at his home in Brookhaven on 2 February 2020.

The Sarbanes-Oxley Act passed the Senate 99–0 and the House 423–3 on 25 July 2002, four days after WorldCom's Chapter 11 filing. President Bush signed it on 30 July. Section 302 required the CEO and CFO of every issuer to personally certify, under criminal penalty, the accuracy of each quarterly and annual filing. Section 404 required management to assess and report on internal controls over financial reporting, and required the external auditor to attest separately. Section 906 made the act of knowingly certifying a false filing a felony punishable by up to twenty years. The statute drew on Enron, on Tyco, on Adelphia, but the line-cost reclassifications at WorldCom — booked in plain English, signed by a CFO with a magazine award on his wall, approved by a Big Five auditor — were the case the legislators kept returning to in floor speeches that week (Jeter, 2003).

The story of the broader dot-com bubble's irrational exuberance and the internet gold rush from 1995 to 2000 explains the demand collapse that left WorldCom's line-cost ratio rising in late 2000; the parallel collapse of Enron, America's most innovative company turned biggest fraud in 2001 provided the political fuel for Sarbanes-Oxley. The pattern of accounting-driven corporate failures had earlier antecedents — see the Drexel Burnham collapse and the fall of Michael Milken's junk-bond empire, 1986–1990 for an earlier case in which an entire firm built on questionable financing failed within a single regulator's tenure. Compared to Bernie Madoff's Ponzi scheme, the largest financial fraud in history, exposed in 2008, WorldCom's fraud was smaller in absolute dollars but larger in counterparty surface — the company's bonds were held in nearly every US pension fund.

In December 2002, Time magazine named its Persons of the Year as Cynthia Cooper of WorldCom, Sherron Watkins of Enron, and Coleen Rowley of the FBI — three women who, in the magazine's framing, had each "done what they were supposed to do" inside institutions that had stopped doing so. Cooper left WorldCom in 2004, founded a consulting firm, and now teaches forensic accounting at the University of Alabama. Her hand-written ledger of the line-cost queries, the one she carried home with her in the spring of 2002 because she did not want Sullivan's staff to find it on her office desk, sits in the Smithsonian's National Museum of American History in a glass case, two floors below the Star-Spangled Banner.