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WorldCom’s Bankruptcy Crisis

INTRODUCTION

The story of WorldCom began in 1983 when businessmen Murray Waldron and William
Rector sketched out a plan to create a long-distance telephone service provider on a
napkin in a coffee shop in Hattiesburg, Miss. Their new company, Long Distance Discount
Service (LDDS), began operating as a long distance reseller in 1984. Early investor
Bernard Ebbers was named CEO the following year. Through acquisitions and mergers,
LDDS grew quickly over the next 15 years. The company changed its name to WorldCom,
achieved a worldwide presence, acquired telecommunications giant MCI, and eventually
expanded beyond long distance service to offer the whole range of telecommunications
services. WorldCom became the second-largest long-distance telephone company in
America, and the firm seemed poised to become one of the largest telecommunications
corporations in the world. Instead, it became the largest bankruptcy filing in U.S. history at
the time and another name on a long list of those disgraced by the accounting
scandals of the early 21st century.

ACCOUNTING FRAUD AND ITS CONSEQUENCES

Unfortunately for thousands of employees and shareholders, WorldCom used

questionable accounting practices and improperly recorded $3.8 billion in capital
expenditures, which boosted cash flows and profit over all four quarters in 2001 as well as
the first quarter of 2002. This disguised the firm’s actual net losses for the five quarters
because capital expenditures can be deducted over a longer period of time, whereas
expenses must be subtracted from revenue immediately. WorldCom also spread out
expenses by reducing the book value of assets from acquired companies and
simultaneously increasing the value of goodwill. The company also ignored or
undervalued accounts receivable owed to the acquired companies.

These accounting practices made it appear as if WorldCom’s financial situation was

improving every quarter. As long as WorldCom continued to acquire new companies,
accountants could adjust the values of assets and expenses. Internal investigations
uncovered questionable accounting practices stretching as far back as 1999. Investors,
unaware of the alleged fraud, continued to purchase the company’s stock, which pushed
the stock’s price to $64 per share.

Even before the improper accounting practices were disclosed, however, WorldCom was
already in financial turmoil. Declining rates and revenues and an ambitious acquisition
spree had pushed the company deeper in debt. The company also used the rising value of
their stock to finance the purchase of other companies. However, it was the acquisition of
these companies, especially MCI Communications, that made WorldCom stock so
desirable to investors.

In addition, WorldCom’s CEO Bernard Ebbers received a controversial $408 million loan
from the company’s board of directors to cover margin calls on loans that were secured by
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company stock. The board loaned Ebbers the money at rate below the national average
and below their rate of return. In July 2001, WorldCom signed a credit agreement with
multiple banks to borrow up to $2.65 billion and repay it within a year. According to the
banks, WorldCom tapped the entire amount six weeks before the accounting irregularities
were disclosed. The banks contend that if they had known WorldCom’s true financial
picture, they would not have extended the financing without demanding additional
collateral.

On June 28, 2002, the Securities and Exchange Commission (SEC) directed WorldCom to
disclose the facts underlying the events described in a June 25 press release regarding
the company’s intention to restate its 2001 and first quarter 2002 financial statements. The
resulting document explained that CFO Scott Sullivan had prepared the financial
statements for 2001 and the first quarter of 2002. WorldCom’s audit committee and Arthur
Andersen, the firm’s outside auditor, had held a meeting on February 6, 2002, to discuss
the audit for year ending in December 31, 2001. Arthur Andersen had assessed
WorldCom's accounting practices to determine whether there were adequate controls to
prevent material errors in the financial statements. Andersen attested that WorldCom's
processes for line cost accruals and for capitalization of assets in property and equipment
accounts were effective. In response to specific questions by the committee, Andersen
had also indicated that its auditors had no disagreements with management and that it
was comfortable with the accounting positions taken by WorldCom.
WorldCom admitted to violating generally accepted accounting practices (GAAP), and
adjusted their earnings by $11 billion dollars for 1999-2002. Looking at all of WorldCom’s
financial activities for the period, experts estimate the total value of the accounting fraud at
$79.5 billion.

WO RLDCO M FILES FO R B ANKRUP TCY

WorldCom did not have the cash needed to pay $7.7 billion in debt, and therefore, filed for
Chapter 11 bankruptcy protection on July 21, 2002. In its bankruptcy filing, the firm listed
$107 billion in assets and $41 billion in debt. WorldCom’s bankruptcy filing allowed it to
pay current employees, continue service to customers, retain possession of assets, and
gain a little breathing room to reorganize. However, the telecom giant lost credibility along
with the business of many large corporate and government clients, organizations that
typically do not do business with companies in Chapter 11 proceedings.
In 2001 WorldCom created a separate “tracking” stock for its declining MCI consumer
long-distance business in the hopes of isolating MCI from WorldCom’s Internet and
international operations, which were seemingly stronger. WorldCom announced the
elimination of the MCI tracking stock and suspended its dividend in May 2002 in the hopes
of saving $284 million a year. The actual savings were just $71 million. The S&P 500
reduced WorldCom’s long-term and short-term corporate credit rating to “junk” status on
May 10, 2002, and NASDAQ de-listed WorldCom’s stock on June 28, 2002, when the
price dropped to $0.09.
In March 2003, WorldCom announced that it would write down close to $80 billion in
goodwill, write off $45 billion of goodwill as impaired, and adjust $39.2 billion of plant,
property, and equipment accounts and $5.6 billion of other intangible assets to a value of
about $10 billion.
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These figures joined a growing list of similar write-offs and write-downs as companies in
the telecommunications, Internet, and high-tech industries admitted they overpaid for
acquisitions during the tech boom of the 1990s.

A detailed timeline of the events surrounding WorldCom’s bankruptcy is contained in the

appendix to this case.

WHO IS TO BLAME?

Naturally, no one stepped forward to shoulder the blame for WorldCom’s accounting
scandal, not its auditors, executives, board of directors, or analysts. As the primary
outside auditor, Arthur Andersen (also under fire for alleged mismanagement of many
other large scandal-plagued audits) was accused of failing to uncover the accounting
irregularities. In its defense, Andersen claimed it could not have known about the improper
accounting because former CFO Scott Sullivan never informed Andersen’s auditors about
the firm’s questionable accounting practices. However, in WorldCom’s statement to the
SEC, the company claimed that Andersen did know about the accounting practices, had
no disagreement with management, and that WorldCom had taken no accounting
positions with which Andersen was not comfortable.

Most people, including John Sidgmore, who replaced Bernard Ebbers as CEO for a time,
blamed WorldCom’s management for the company’s woes. An initial observation by the
independent investigator appointed by the bankruptcy court raised a “cause for substantial
concern” regarding the board of directors and the independent auditors of WorldCom. The
board has been accused of lax oversight. In particular, the board’s compensation
committee has been attacked for approving Bernard Ebber’s generous compensation
package.

Several former finance and accounting executives pleaded guilty to securities-fraud

charges, claiming they were directed by top managers to cover up WorldCom’s worsening
financial situation. In 2004, former WorldCom CEO Scott Sullivan, who worked above
many of these employees, pleaded guilty to criminal charges. Because of a plea bargain,
Sullivan was sentenced to only five years in prison in exchanged for testifying against
Bernard Ebbers.

Bernard Ebbers stated that he did nothing fraudulent and had nothing to hide. WorldCom’s
lawyers have indicated that Ebbers did not know of the money shifted into the capital
expenditure accounts. However, the Wall Street Journal reported that an internal
WorldCom report identified an email and a voice mail that suggested otherwise. In 2004,
Ebbers was charged with one count of conspiracy to commit securities fraud, one count of
securities fraud, and seven counts of fraud related to false filings with the SEC. Ebbers
was found guilty of all charges and sentenced to 25 years in prison. He is currently serving
his sentence in Louisiana and cannot be considered for parole until 2028 (when he will be
85 years old).

Additionally, Jack Grubman, a Wall Street analyst specializing in the telecommunications

industry and who rated WorldCom stock highly, admitted he did so for too long. Grubman
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knew WorldCom CEO Bernard Ebbers socially and even provided WorldCom executives
with special opportunities on investments. However, he insisted that he was unaware of
the company’s true financial condition. Grubman was later fired by Salomon Smith Barney
because of accusations that he hyped telecommunications stocks, including Global
Crossing and WorldCom, even after it became public that the stocks were poor
investments. He was also fined $15 million by the SEC and banned from participating in
securities exchanges in the future because of his conflicts of interest.

Investors also won several class action lawsuits against the financial industry for activities
related to the fall of WorldCom. These settlements included $1.64 billion from Citigroup for
purchasers of WorldCom securities and $2 billion from JPMorgan Chase to for selling $5
billion in WorldCom bonds. Arthur Andersen paid $65 million to investors to cover its
liability in the collapse of WorldCom. Several executives including Sullivan and Ebbers
also agreed to turn over substantial portions of their personal funds to employees and
investors.

REO RG ANI Z ATIO N AND ACQ UIST IO N

WorldCom took many steps toward reorganization, including securing $1.1 billion in loans
and appointing Michael Capellas as chairman and CEO. WorldCom also tried to restore
confidence in the company, including replacing the board members who failed to prevent
the accounting scandal, firing many managers, reorganizing its finance and accounting
functions, and making other changes designed to help correct past problems and prevent
them from reoccurring. Additionally, the audit department staff is was increased and
reported directly to the audit committee of the company’s new board. “We are working to
create a new WorldCom,” John Sidgmore said. “We have developed and implemented
new systems, policies, and procedures.” In 2003, the company renamed itself MCI and
emerged from bankruptcy proceedings in 2004. However, this reorganization was not
enough to restore consumer and investor confidence, and Verizon Communications
acquired MCI in December 2005.

The WorldCom accounting fraud changed the entire telecommunications industry. As part
of their overvaluing strategy, WorldCom had also overestimated the rate of growth in
Internet usage, and these estimates became the basis for many decisions made
throughout the industry. AT&T, WorldCom/MCI’s largest competitor, was also acquired.
Over 300,000 telecommunications workers lost their jobs as the telecommunications
struggled to stabilize. Many people have blamed the rising number of telecommunication
company failures and scandals on neophytes who had no experience in the
telecommunication industry. They tried to transform their startups into gigantic full-service
providers like AT&T, but in an increasingly competitive industry, it was difficult for so many
large companies could survive.
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APPE NDIX : WORL DCO M B ANKRUPT CY TI MELINE

Early 2001 WorldCom shows signs of financial troubles: rates and revenues decline and
debt rises.
July 2001 WorldCom receives $2.65 billion in loans from 26 banks to be repaid by the end
of 2001.

Feb. 6, 2002 Arthur Andersen, LLP, and WorldCom’s audit team meet to discuss the 2001
audit. Everything is deemed correct and Andersen gives its approval.

Mar. 11, 2002 The U.S. Securities Exchange Commission (SEC) requests more
information concerning accounting procedures and loans to officers.

Apr. 30, 2002 Bernard Ebbers resigns as CEO of WorldCom and is replaced by vice
chairman John Sidgmore.

Jun. 25, 2002 CFO Scott Sullivan is fired after improper accounting of $3.8 billion in
expenses covering up a net loss for 2001 and the first quarter of 2002 is discovered.

Jun. 28, 2002 WorldCom fires 17,000 employees to cut costs.

Jul. 8, 2002 John Sidgmore testifies before a Congressional Committee to explain how
internal investigations uncovered the accounting problems.

Jul. 21, 2002 WorldCom files for reorganization under Chapter 11 Bankruptcy, an action
that affects only the firm’s U.S. operations, not its overseas subsidiaries.

Aug. 9, 2002 Continued internal investigations uncover an additional $3.8 billion in

improperly reported earnings for 1999, 2000, 2001, and the first quarter of 2002, bringing
the total amount of accounting errors to more than $7.6 billion.

Aug. 13, 2002 WorldCom names Greg Rayburn as chief restructuring officer and John
Dubel as chief financial officer to lead the company through the reorganization process.
Sep. 10, 2002 WorldCom formally announces it is seeking a permanent chief executive
officer. Oct. 1, 2002 The U.S. Bankruptcy Court approves WorldCom’s request to pay full
severance and benefits to former employees, which had been limited under the company’s
Chapter 11 filing.

Oct. 15, 2002 The U.S. Bankruptcy Court approves up to $1.1 billion in debtor-in-
possession (DIP) financing for WorldCom while it undergoes reorganization.

Nov. 8, 2002 WorldCom files additional bankruptcy petitions for 43 of its subsidiaries.

Nov. 15, 2002 Michael D. Capellas, former president of Hewlett-Packard Company, is

named chairman and CEO.
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Mar. 14, 2003 WorldCom announces that it will take one-time $79.8 billion write-off.

Apr. 15, 2003 WorldCom unveils reorganization plan that would eliminate most of its debt,
rename the company MCI, and relocate its headquarters from Clinton, Miss., to Ashburn,
Va.
Apr. 22, 2003 Former CFO, Scott D. Sullivan, pleads not guilty today to securities and
bank fraud. May 19, 2003 WorldCom agrees to pay investors $500 million to settle civil
fraud charges.
Jul. 7, 2003 A federal judge approves a $750 million settlement between WorldCom and
federal regulators.

Jul. 31, 2003 The General Services Administration notifies WorldCom that it is ineligible to
win new federal contracts until it improves accounting controls.

Aug. 6, 2003 A bankruptcy judge approves a $750 million settlement of civil fraud charges
made by the Securities and Exchange Commission on WorldCom investors' behalf.

Aug. 12, 2003 WorldCom appoints former AT&T Corp. executive Richard R. Roscitt as its
new president and chief operating officer.

Aug. 27, 2003 Oklahoma Attorney General W.A. Drew Edmondson files criminal charges
against WorldCom Inc. and six former executives, including Ebbers. Sep. 3, 2003
Ebbers pleads not guilty.

Sep. 9, 2003 Two groups of creditors abandon their legal challenge to the WorldCom’s
reorganization plan in return for a combined payout of more than $400 million.

Sep. 15, 2003 WorldCom’s auditors testify in U.S. Bankruptcy Court that the company's
books remain a tangled mess.

Oct. 31, 2003 U.S. Bankruptcy Judge Arthur J. Gonzalez approves WorldCom’s
reorganization plan.

Dec. 22, 2003 Federal prosecutors say they intend to show that former CFO Scott
Sullivan was involved in 13 kinds of accounting fraud in addition to financial wrongdoing

Jan. 7, 2004 The government lifts the suspension that prevented WorldCom from
receiving new federal contracts.

Apr. 20, 2004 MCI officially emerges from bankruptcy, 21 months after filing the largest
Chapter 11 case in history.

May 10, 2004 MCI says it will eliminate 7,500 jobs (15 percent of its workforce).

Jan. 8, 2005 The lead plaintiff in the WorldCom class-action suit announces a $54 million
settlement covering 10 former WorldCom directors (part of the settlement is later rejected
by a federal judge).

Jan. 25, 2005 Bernard Ebbers’ trial begins.

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Feb. 14, 2005 Verizon Communications Inc. announces a $6.75 billion deal to buy MCI
Inc.

Mar. 15, 2005 Former WorldCom CEO Bernard J. Ebbers is found guilty of conspiracy,
securities fraud, and making false filings with regulators. He is sentenced to 25 years in
prison.

Aug. 11, 2005 Former CFO Scott Sullivan is sentenced to five years in prison.