WorldCom: rise and ruin of a giant

By ANDREW LAXON

What is WorldCom and where did it come from?

America's second-biggest long- distance phone-call company is the creation of cattle farmer Bernie Ebbers - also a former milkman, bouncer, barman and school basketball coach - who started the company in a Mississippi coffee shop.

From the beginning, Ebbers broke the chief executive mould. He wore cowboy boots, jeans and turquoise jewellery to work and let it be known that it wasn't beneath him "to occasionally castrate a bull".

Ebbers is a deeply religious man, who is said to begin board meetings with a prayer. Yet, incredibly for a businessman running a telecommunications company valued at $US115 billion ($236 billion) at its peak in 1999, he is also a technophobe. For years he refused to use a mobile phone or a pager and he started using email only last year.

Ebbers started WorldCom in 1983 as a long-distance telecommunications bucket shop based in Clinton, Mississippi. It made its money by buying network capacity at rock-bottom prices and reselling it.

By 1985 it had 5 per cent of the American long-distance market, including the White House-Kremlin hotline.

But the company did not take off until the mid-1990s, when it was taken under the wing of one of Wall Street's biggest investment banks, Salomon Smith Barney.

In the second half of the 1990s, WorldCom gobbled up 75 rival phone companies, including America's second-biggest long-distance carrier, MCI. Even Ebbers' yacht, sold this year, was called Aquasition.

The company played a leading role in the hype of the dotcom boom. Wall Street analysts nicknamed Ebbers and his sidekick, Scott Sullivan, WorldCom's chief financial officer, "The Scott and Bernie Show".

Were there warning signs?

Plenty. Shares had been dropping from their $62 high in 1999 as revenue growth dried up and cash reserves shrank.

Telecom Insider columnist Dave Burstein says WorldCom had problems almost everywhere, including "phony MCI bills [which] customers will never pay".

All telecommunications companies were having their profits squeezed in a similar way, he says, but for the first time, WorldCom found that continued expansion offered no solution.

The company's drastic efforts to cut costs, including sacking thousands of staff and merging business units, only cramped its potential to generate more income. It was saddled with US$28 billion ($57.5 billion) in loans it could not pay.

Then in April Ebbers resigned, after admitting he had borrowed US$366 million ($751 million) from the company to underwrite the inflated prices he had paid for WorldCom shares.

On Monday, investors got their first hint that much worse was to come. Salomon analyst Jack Grubman, dubbed "the ultimate insider" by some for his close links to the company, downgraded his WorldCom rating from "neutral" to "sell".

On Tuesday the company admitted inflating profits by US$3.8 billion between January last year and March this year - a deception six times bigger than the Enron scandal.

The US financial watchdog, the Securities and Exchange Commission, charged WorldCom with fraud and the Justice Department began a criminal investigation of the company's accounting practices.

WorldCom sacked Sullivan and announced 17,000 redundancies - one-fifth of its workforce but a cut expected even before the scandal.

The company is expected to file for bankruptcy soon, as its share price plummets, banks call in loans and customers leave.

How did the fraud work?

It was one of the oldest and simplest accounting scams in the book. WorldCom listed operating costs, such as routine network maintenance, as capital investments, which could be spread over a number of years.

This allowed the company to hide expenses, inflate its cashflow and report profits instead of losses in its last five quarterly reports.

The New York Times reported that the revelation that cashflow figures could be fiddled shocked even hardened short-sellers - investors who profit when stocks fall.

"I'm kind of shaken by that," said James Chanos, a short-seller who played a major role in unearthing Enron's overstated profits and hidden debt. "The one touchstone that investors had was that you couldn't fudge cashflow numbers, but apparently you can."

Who's to blame?

The obvious targets are Ebbers and Sullivan, who look likely to end up in prison as an angry American public looks for vengeance.

President George W. Bush called the fraud "outrageous" and vowed to pursue those responsible. Republican Senator John McCain summed up the mood when he declared: "Until somebody goes to jail, I'm not sure these people are going to get the message."

More condemnation lies in store for WorldCom's auditors, the disgraced former accountancy giant Arthur Andersen, already found guilty of obstructing justice for shredding documents related to its audit of Enron.

The firm tried to blame Sullivan for withholding vital information - an explanation rubbished by experts.

"The auditor is responsible for everything that goes on, whether it's discussed with the auditing firm or not," said Bob Bertucelli, director of the tax institute at Long Island University in New York. "It should have been found. It's a clear-cut violation of generally accepted accounting principles."

But whether Andersen has any reputation left to lose is debatable.

Who loses money?

Top banks across the world from New York to Frankfurt to Tokyo are owed about US$4.5 billion ($9.2 billion) by WorldCom. They include America's second-biggest bank, JP Morgan. However, the banks have parcelled out the loans among themselves, limiting possible losses, and are said to have cut off further credit.

Yesterday, stock markets across Europe and Asia fell sharply in response to the news, but New Zealand was unaffected.

The US Dow Jones index dropped only six points as bargain hunters moved in. However, many commentators expect this not to last because the scandal will cause American investors to lose faith in the market.

That could affect markets and investors round the world, including many New Zealanders whose pension funds have a high percentage of US shares.

"The stock market has become the equivalent of taking someone to go gambling at a crooked racetrack," warned Charles White, president of investment firm Avatar Associates.

"When people don't believe the game is fair, they don't play."

Is corruption widespread in United States business?

Many Americans, who would have shrugged off this idea a few years ago, are seriously wondering.

Bush conceded that "there is some concern about the balance sheet of corporate America and I can understand why".

Website MSNBC headlined its coverage of the ethical issues behind the growing number of corporate scandals "Are we a nation of greedy cheaters?"

It concluded that a big part of the problem was the enormous salary packages paid to top chief executives during the 1990s, which disconnected them from the lives of their workers and small investors.

Sissela Bok, author of Lying: Moral Choice in Public and Private Life, says many executives tend to be risk-takers who think they can get away with bending the rules. They may even get a thrill from cheating.

Some business ethicists argue that Wall Street and corporate America have concentrated on maximising profits with no concern for the broader context of ethical concerns and social responsibility.

Others say this kind of behaviour is typical of an overheated sharemarket, when certain stocks - in this case internet, telecommunications and media - are grossly overhyped and reach prices way beyond their realistic value.

Some welcome the shakeout and even a likely downturn in the international sharemarket as overdue. "Rather than the markets failing, they are working," argues Daily Telegraph economics editor George Trefgarne.

"Collapsing markets are about dismantling that elaborate superstructure of overinvestment, so unprofitable enterprises close, capital is reallocated and growth begins."

Herald business columnist Brian Gaynor sees merit in both explanations.

"I think greed took over," he says. He compares the run of corporate scandals hitting the US now to New Zealand's experience of the deregulated excesses of the 1980s, when household names such as Chase and Equiticorp ended up in disgrace.

The good news, says Gaynor, is that you can expect the Americans to ruthlessly prosecute everyone involved and tighten up their legislation. (Top of the list is a proposed law change preventing accountancy firms from acting as auditor and consultant to the same client - a conflict which emerged with Enron.)

Will the US scandals cause a worldwide downturn - and could that affect New Zealand?

Most commentators expect the scandals to hurt the US economy but disagree on the scope of the damage.

Independent columnist Hamish McRae expects some fallout but argues that the world's sharemarkets are unnecessarily nervous and looking for a systemic failure which does not exist.

But the same paper's business editor, Jeremy Warner, says the sheer scale of the fraud raises a huge question mark over US standards of corporate morality and disclosure.

He warns that with the end of the technology boom and a growing crisis of confidence, the US economy is already slowing.

"The WorldCom debacle may mark the bottom of the present cycle, but the climb back out is going to be long and hard."

Gaynor agrees, but predicts more scandals ahead. "We haven't seen the last of this. We will have a succession [of announcements] and it will affect confidence, undoubtedly."

However, he hopes New Zealand can escape the shockwaves this time, as it accidentally avoided the excesses of the 1990s.

"We had all that in the '80s. We didn't participate in the 1990s because we were hung over."

Asked about the prospect of similar scandals in New Zealand, he gives local firms 9.5 out of 10 for honesty, compared with 4.5 for US firms.

"I'm as cynical as anyone," Gaynor says. "But systemic fraud? I don't think we have that."


US corporate scandals at a glance

Enron: Politically well-connected energy giant which inflated profits for years. Likely to face criminal charges.

Arthur Andersen: Disgraced auditors of Enron.

Shredded vital documents before investigators could see them. Found guilty of obstructing justice.

Merrill Lynch: Top sharebroking firm whose analysts recommended shares to clients while privately describing them as "junk" or worse. Forced to pay US$100 million ($211 million) settlement.

ImClone: Cancer drug developer.

Founder Samuel Waksal and his friends and relatives, including home and garden guru Martha Stewart, dumped US$10 million ($20.5 million) of ImClone stock the day before the Food and Drug Administration refused an application for the company's drug Erbitux. Waksal has been charged with conspiracy, securities fraud and perjury.

Adelphia: Sixth-largest cable TV company in US.

Chief executive John Rigas and his three children took US$3.1 billion ($6.4 billion) in preferential loans from company funds. Filed for bankruptcy, facing criminal investigation.

Global Crossing: Digital communications company.

Chief executive Gary Winnick cashed in US$734 million ($1.5 billion) in shares before the company filed for bankruptcy.

WorldCom: Second-biggest long-distance phone company in US.

Inflated profits by US$3.8 billion between January 2001 and March 2002. The US financial watchdog, the Securities and Exchange Commission, has charged WorldCom with fraud and the Justice Department has begun a criminal investigation of its accounting practices.