WorldCon

By Daniel Kadlec

Soon after worldcom CEO John Sidgmore revealed the most sweeping bookkeeping deception in history, a marked-up copy of his internal memo on the scandal was e-mailed to folks around the telecom industry. Under his predecessor, Sidgmore announced, WorldCom had overstated a key measure of earnings by more than $3.8 billion over five quarters, dating back to January 2001. The company's reported profits, it turned out, were really losses. In his memo to employees explaining America's latest corporate disgrace, Sidgmore wrote last Wednesday, "Our customers can count on WorldCom to meet their communications needs today and tomorrow." The memo that circulated included one wag's cynical addition: "Friday is sort of doubtful." Sidgmore went on to write, "I know I can count on you to be with me." To which the wag had tacked on: "Don't bother with a resume; no other telecoms are hiring."

As WorldCom--once big and rich enough to swallow No. 2 long-distance carrier MCI--struggles to survive, it is laying off 17,000 workers. Its stock, which peaked at $64.50 three years ago, stopped trading last Tuesday at 83[cents], having all but wiped out employee retirement accounts. The plunge in WorldCom shares has cost investors upwards of $175 billion--nearly three times what was lost in the implosion of Enron. WorldCom is not yet financially bankrupt, but it's clear that it--like a fat slice of corporate America--has been ethically bankrupt for years. We're only now getting a look at the red ink on the moral balance sheets, and new revelations of malfeasance in one company after another are sending shocks around the globe.

The dollar is falling. Stocks are in a swoon. Foreigners are calling home capital. Corporate insiders are dumping shares by the bucketful. Individuals are redeeming mutual-fund shares. Pension funds are getting socked. Banks are taking loan-portfolio hits. This is all a direct result of the spreading collapse of confidence in U.S. companies and the executives and board members who run them--a crisis that threatens to untrack a fragile economic recovery. Speaking at an economic summit in Canada, President Bush said he was "concerned about the economic impact of the fact that there are some corporate leaders who have not upheld their responsibility." The Federal Reserve seems concerned as well. At a meeting last week, it left interest rates unchanged--signaling that the recovery isn't firmly rooted. Some economists speculate that the Fed will soon cut rates to guard against a "double-dip" recession.

In the context of recent developments, President Bush's musings on CEO responsibility are as understated as the expenses in WorldCom's financial statements, the flashpoint for new worries of widespread accounting abuse. WorldCom said that an internal review uncovered huge hidden expenses--mostly line charges that it pays to other telecom carriers--that were characterized as capital investments, a gimmick that boosted its profits.

The company fired its longtime chief financial officer, Scott Sullivan, 40, and is turning over its findings to the Securities and Exchange Commission. The SEC has filed fraud charges and is launching an investigation--as is the Justice Department, at least two congressional committees and the state of Mississippi, where WorldCom is based. All current and former employees, along with WorldCom's ex-accounting firm, Arthur Andersen, have been ordered to refrain from Enron-like paper shredding. Investigators are especially eager to hear from WorldCom founder Bernie Ebbers, who resigned as CEO in April, not long after it was revealed that he owed the company $366 million in low-interest loans. Ebbers had worked closely with Sullivan, whose office adjoined the CEO's. Ebbers could not be reached for comment.

In the same week that the veil was lifted from WorldCom's books:

--Xerox restated $6.4 billion in revenues dating to 1997. A restatement had been expected under an agreement Xerox reached with the SEC three months ago, over the company's practice of immediately booking revenue from long-term leases of copiers and other equipment. But the amount turned out to be more than triple what investors had expected and sparked a 13% sell-off of Xerox's stock.

--Tyco's former CEO, Dennis Kozlowski, already charged with evading $1 million of sales tax, was indicted anew, accused of tampering with evidence. He allegedly lifted a shipping document from a file before turning it over to prosecutors in New York City. He pleaded not guilty to the latest charges.

--Martha Stewart faced fresh doubts about her explanation of why, after buying stock in a drug company run by a close friend, she sold her shares just ahead of bad news about the company's cancer drug. Stewart, recently appointed a director of the New York Stock Exchange, denies wrongdoing, but shares in her Martha Stewart Omnimedia have declined 40% in the past month over fears of damage to her image.

--The Justice Department charged three former bankers in Britain with wire fraud in a $7.3 million scheme involving Enron-related partnerships.

--Minneapolis-based supermarket chain Supervalu revealed that, like WorldCom, it has been overstating profits--in its case, for four years.

--A federal grand jury in Harrisburg, Pa., indicted three former Rite Aid executives on fraud charges.

And then this: A survey by Starwood Hotels & Resorts showed that 82% of CEOS admit to cheating at golf. The same percentage hate others who do the same. "We're in a period of corporate Watergate, and Nixons are popping up all over," says John Challenger, CEO of outplacement firm Challenger Gray & Christmas. Qualified executives are turning down CEO offers out of fear they might be taking the helm of a firm about to crumble under some new accounting fraud, impeding the searches of even the cleanest firms. Among those looking for a new CEO are Gap and J. Crew.

The drumbeat of news about sleazy boardroom behavior has given investors someone to blame--fairly or not--for the money they have lost in stocks over the past two years. Seizing the moment, politicians are undertaking what could be the most sweeping structural reforms in the business world since the 1930s. The N.Y.S.E. has proposed stiff new rules for boards of directors, and the SEC has proposed changes in accounting and auditing procedures. The SEC has already imposed new rules to stamp out conflicts of interest among stock analysts.

Yet the accounting irregularities at WorldCom are much more than a continuation of a trend. This scandal sharply raises the stakes. When Enron filed for bankruptcy in December, it employed 28,000, of whom 12,600 have been let go. WorldCom employs 80,000 and will eliminate a fifth of those jobs almost immediately. The Enron-stock meltdown wiped out $67 billion of shareholder wealth, less than half what WorldCom investors have lost.

The losers include pension funds and mutual-fund investors across the country. And, as at Enron, WorldCom's 401(k) plan was full of company stock, socking employees with greatly diminished savings just when they are likely to need them the most. Says John Alexander, 31, a former WorldCom benefits manager: "Everything they ever told us was, 'We're making money hand over fist.'" Alexander lost $180,000, a large chunk of his life's savings.

Creditors and bondholders are also taking a hit as WorldCom struggles with its $32 billion of debt. Dozens of mutual funds, banks and financial-services firms are exposed, including Bank of America, Citigroup, Deutsche Bank and GE. Citigroup holds an estimated $335 million of WorldCom bonds and could face lawsuits as a result of its cozy ties to the telecom. In May 2001 Citigroup co-underwrote, along with J.P. Morgan Chase, an $11.9 billion WorldCom bond issue. Buyers of those bonds may move to sue the banks, claiming they failed to properly inspect WorldCom's books.

The developments at WorldCom suggest that accounting games may be more pervasive than we had thought. With Enron, the tricks involved complicated partnerships, off-the-books debt and exotic hedging techniques that made the firm's financial results difficult to assess even for pros. It seemed unlikely that anything so complex could be widespread. But with WorldCom, as House Financial Services Committee chairman Mike Oxley, an Ohio Republican, says, it looks like "good old-fashioned fraud." Oxley's committee subpoenaed Sidgmore, Sullivan, Ebbers and Jack Grubman, telecom analyst for the Salomon Smith Barney unit of Citigroup, to a July 8 hearing. Not to be outdone, House Energy and Commerce Committee chairman Billy Tauzin, a Louisiana Republican, announced his investigation and ordered that by July 11 WorldCom turn over all records relating to its internal audit and five years' worth of accounting-related documents.

Grubman gives the episode a surreal quality. A star telecom analyst, he was paid $20 million a year for covering the stocks of companies like WorldCom that send billions of dollars in investment-banking business to Salomon. He was so tied in at WorldCom that for a time he even advised Ebbers on takeover strategy. Grubman typically avoids the press. Last week a camera crew from financial channel CNBC tracked him down near his New York City residence and tried to interview him on the fly--evoking images of paparazzi stalking a movie star. "Nobody saw this coming," Grubman said, denying that his downgrade of WorldCom's stock to "underperform" the day before the firm restated earnings had anything to do with fraud rumors. Grubman, in fact, maintained a "buy" rating on the stock while it plummeted 90% from its peak in June 1999.

How, exactly, did WorldCom cook its books? By treating routine expenses as capital investments. Normal operating expenses must be subtracted from a company's revenues in the year they occur. But capital expenditures can be subtracted from revenues a little at a time over many years. In the short term, that lets money flow to the bottom line and boosts financial results. It's the oldest trick in the book, and mind-numbingly simple. Dennis Beresford teaches Accounting 101 at the University of Georgia and says what happened at WorldCom is "plain vanilla" trickery that he covers on the second day of class.

Yet WorldCom's auditor--Arthur Andersen, the firm convicted of obstructing justice in the Enron case--somehow missed it. Andersen, which was paid $4.4 million a year to certify that WorldCom's books were honest, says WorldCom CFO Sullivan never handed over the material Andersen requested. "That's like a police officer saying the criminal didn't turn himself in," scoffs analyst Patrick Comack of the brokerage Guzman & Co.

Even though WorldCom's new management, led by Sidgmore, has come forward with the bad news, stock analysts are skeptical about whether they have the full story. WorldCom's "line cost" category is a big bucket, says analyst Susan Kalla of Friedman, Billings, Ramsey. "People knowledgeable about WorldCom say they also capitalized expenses related to software development, maintenance and labor." She suspects that some other telecoms have been just as loosey-goosey with their numbers.

WorldCom's woes are hardly new. Indeed, part of the shock flows from investors' knowledge that though the company has been in decline for several years, it still managed to paper over its books. When the Internet bubble burst early in 2000, it took down many of WorldCom's biggest customers. The slide accelerated after regulators blocked the firm's $129 billion acquisition of Sprint in July 2000. In March the SEC launched a probe into how and why WorldCom had loaned Ebbers $366 million, most of which he ostensibly used to purchase WorldCom shares. The SEC also looked at the company's books just as scandals at other telecoms--Global Crossing and Qwest--were spooking investors. The loans led to Ebbers' ouster at the end of April (with a golden handshake worth $1.5 million a year for life). That's when Sidgmore took over and asked Cynthia Cooper, 37, vice president of internal audit, to take a close look at WorldCom's books. She found the bogus accounting and alerted WorldCom's board.

Some investigators and stock analysts say they find it difficult to believe that a hands-on CEO like Ebbers--who was tight with Sullivan--didn't know of the accounting tricks at WorldCom. Mississippi attorney general Mike Moore says his office investigated Ebbers when WorldCom was an upstart known as LDDS and found him playing loose with the rules. Ebbers' employees made a series of $200 campaign contributions to a local politician and were illegally reimbursed by the company. In 1995 WorldCom pleaded guilty to a felony charge and paid a $120,000 penalty. Moore says the evidence "showed that it was Bernie Ebbers who asked those employees to write those checks." (Ebbers could not be reached for comment.)

The upshot of the whole WorldCom debacle is that when even simple tricks go undetected, there is no saying where it all ends, and that's what investors are coming to understand. They're voting with their feet. Those losing faith include company insiders, who are in the best position to see how firms are managed. Since last September, insiders have sold $66 billion more of their employers' stock than they have bought (all of it legally and publicly disclosed). Insider purchases have all but dried up, according to research firm TrimTabs. A net $10 billion was withdrawn from U.S. stock funds in June, the largest monthly outflow since last September after the U.S. terror attacks. "Investors," says Robert Adler, president of AMG Data Services, "are reallocating into bonds and overseas equities."

In a new survey of wealthy Americans, U.S. Trust found that two-thirds do not trust the managements of publicly traded companies and three-quarters have little faith in the integrity of financial statements. "There have been enough serious breakdowns in corporate governance, accounting, auditing and investment banking to make everyone worry," says Morris Goldstein, a senior fellow with the Institute for International Economics.

With foreigners sending less money to the U.S. and Americans making more investments abroad, the dollar has slid 11% against major currencies since April 1. Famed hedge-fund manager and currency speculator George Soros says the buck could fall an additional 33%. "We're at a tipping point of whether foreigners take a massive stake out of the U.S.," says Joseph Quinlan, senior global economist at Morgan Stanley. "If you have another accounting issue along with weaker than expected growth and poor profitability, then you may see a vicious circle." The next in the series. --With reporting by Alice Jackson Baughn/Jackson, Daren Fonda/New York City and Collette Parker/Atlanta

With reporting by Alice Jackson Baughn/Jackson, Daren Fonda/New York City and Collette Parker/Atlanta