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The WorldCom collapse

Print edition : Jul 20, 2002 T+T-

The meltdown of WorldCom, one of the biggest telecom companies in the United States, has rekindled the debate on corporate accountability and raised fears that the corporate system in the U.S is rotting at its core.

IN 2001, when Enron Corporation filed for bankruptcy, the biggest in the corporate history of the United States, amid charges of dubious accounting practices and a scandal over favours shown to the company by the political establishment, shocked investors were assured by President George W. Bush that Enron was just a case of one "rotten apple" in an otherwise healthy corporate system. Since then, however, a string of sleaze-hit collapses of high-profile companies in the U.S. has raised the fear that the corporate system is rotting at its very core. Recent revelations that WorldCom, one of the biggest telecom companies in the U.S., fudged accounts to show inflated profits in the two preceding years, have rekindled the debate on corporate accountability. There is also growing anger about the culture of greed in the boardrooms.

WorldCom was the quintessential New Economy company. It was the second biggest long-distance telecom company in the U.S and was also the biggest carrier of Internet traffic and electronic commerce in the world. During the 15 years of its existence, the company grew at a scorching pace, fuelled by the almost insatiable appetite of its former chief executive officer (CEO) Bernard J. Ebbers for acquiring companies. As long as the stock market boomed and the dot com business expanded recklessly, not a thought was given to the fundamentals of the company. Wall Street analysts and investment bankers looked the other way even as auditors failed to exercise due diligence.

WorldCom has business interests in more than 65 countries, and a network that stretches over almost 150,000 kilometres. It gobbled up several pioneering Internet firms such as UUNET, MCI and CompuServe, which created the first e-mail services in the late 1970s. But, the company is now on the verge of collapse. The fate of its more than 80,000 employees across the world hangs in the balance.

In March 2002, the U.S. Securities and Exchange Commission (SEC) sought information from WorldCom about its accounting procedures and about loans it had extended to its officers. In April the company announced that it was cutting 3,700 jobs. Soon after, Standard & Poor's, Moody's and Fitch downgraded WorldCom's credit ratings. The U.S. Justice Department has launched an independent probe into the WorldCom scandal.

In April 2002, Ebbers resigned as CEO after an SEC probe revealed that WorldCom had lent $339.7 million to him to cover loans that he took to buy his own shares. In May, Standard & Poor's reduced WorldCom's credit rating to junk status and WorldCom was removed from the prestigious S&P 500 Index. On June 25, the company announced that improper accounting of $3.8 billion in expenses had covered up a net loss for 2001 and the first quarter of 2002. The company also announced that it planned to shed 17,000 jobs, more than 20 percent of its workforce. The Nasdaq halted trading in WorldCom's stocks of WorldCom Group and MCI Group. In four months, ending April, the share price fell by over 80 per cent. On June 26, the SEC filed a suit alleging "securities fraud" against WorldCom in a district court in New York. It alleged that WorldCom's top management "disguised its true operating performance" and "misled investors about its reported earnings".

Even as the company was sliding, it announced on June 25 that it was "restating" its income for 2001 and the first quarter of 2002. It said that an internal audit had revealed that earlier financial statements of the company had deviated from accounting principles, resulting in an over-statement of its revenues and profits for 2001 and the first quarter of 2002 - to the tune of $3.8 billion. The company had used a simple trick in its balance sheet to boost revenues and profits while hiding expenditures. By classifying ordinary day-to-day expenses as investments and long-term expenses associated with the acquisition of capital assets, on which companies enjoy certain tax advantages, WorldCom was able to hide expenses to the tune of nearly $4 billion and instead show this as profits. One of WorldCom's major operating expenses relates to its "line costs", the fees that it pays to third party telecom network providers for the right to access their networks. In effect, WorldCom capitalised these fees, terming them as investments, when, in fact, they were one of the most important day-to-day expenses. The SEC, in its complaint in court, stated that WorldCom's top executives did this in order to keep Wall Street happy. The shock turned to anger as it became known that Arthur Andersen, the now-disgraced auditing and consulting major and a player in the Enron saga, was WorldCom's auditor too.

Bernard Ebbers was an icon of the dot com era, a darling of Wall Street during the height of the longest stock market boom in U.S. history, which came crashing down in 2000. Ebbers started off by investing in Long-Distance Discount Service (LDDS), a small telecom company, in 1983. Two years later he took over LDDS as CEO, having been in the right place at a time when the demand for Internet and telecom services was starting to expand. LDDS basically bought bandwidth capacity from AT&T and resold it at lower prices to customers. Just as Enron took full advantage of the deregulatory framework in the power sector, Ebbers was quick to spot fresh opportunities in the wake of the deregulation of the telecom industry in the U.S. A series of acquisitions later, by 1993, LDDS had become the fourth-largest long-distance telecom network in the U.S. The booming stockmarkets enabled the company to leverage its own shares to raise debt to make these expensive acquisitions.

In 1995, LDDS acquired its now-disgraced name, WorldCom. After the renaming, the company started to acquire even bigger companies. Among them was UUNET, one of the oldest carriers of Internet traffic and the inheritor to the publicly funded Internet backbone, which was privatised by the National Science Foundation in the U.S. In 1998, WorldCom merged with MCI, in a deal valued at $40 billion, the highest-priced acquisition in history at that time. The company, which already enjoyed a stranglehold on the Internet backbone, met its first roadblock when its attempt to take over Sprint was halted by regulators in Europe and the U.S. in 2000.

Financial experts have pointed out that WorldCom's accounting practices, particularly those relating to the acquired businesses, made it impossible for investors to gauge the performance of the company. Revisions in financial statements were thus the norm in WorldCom. While profitability was overstated, investors were misled by the opaque nature of its regular operating performance. Even in 2001, as the dot com bubble burst, WorldCom continued to maintain that all was fine. And analysts played ball. In October 2001, one analyst at a large investment bank even predicted that WorldCom would be the "fastest growing megacorp" in 2002.

What is the likely impact of the WorldCom meltdown? As is the case with any corporate failure, there are going to be a few gainers but the losers will be many. The company's share- and bond-holders are left holding practically worthless assets. With assets well below the company's debt of over $30 billion, creditors are unlikely to get their money back. WorldCom's 80,000 employees are likely to pay with their jobs. According to a mutual fund advisory group, 539 mutual funds own 400 million of the three billion in outstanding shares of WorldCom. Ordinary investors in these funds are likely to suffer severe losses. Moreover, there are also the 401(k) plans of ordinary workers in these mutual funds. In contrast to the losses that are immediate for ordinary people hooked to shares and investments in mutual and pension funds, corporate laws provide a far better cushion to top executives. On July 8, Ebbers and former Chief Financial Officer Scott Sullivan refused to testify before the congressional Financial Services Committee inquiring into the WorldCom scandal. The Committee is particularly keen to investigate links between the company and an investment analyst who is believed to have had prior knowledge about the dubious accounting methods employed by WorldCom. The telecom major AT&T is seen as a potential gainer in the aftermath of WorldCom's inevitable collapse.