This week marks the anniversary of, at the time, the largest bankruptcy in American history and the conclusion of the largest case of accounting fraud in history. *
WorldCom declared bankruptcy July 21st, 2002 with $107 billion in assets.
How did this fraud develop? How was the WorldCom scandal discovered? How did WorldCom investors fare?
The Start of WorldCom’s Fraud
In 1999, WorldCom’s (and every other telecommunication company) was seeing declining revenues due to intense competition within the telecommunications industry.
Meanwhile, Bernard Ebbers, the CEO of WorldCom at the time and now known as one of the most corrupt CEOs of all time, had used his shares of WorldCom as collateral for loans for his many other ventures and hobbies. Ebbers would accumulate over $1 billion in loans in which he offered his WorldCom holdings as collateral. As the stock began to fall in late 1999 and into 2000, Ebber’s lenders were demanding that he sell some of his shares in order to pay back his loans.
Ebbers would have to find a way to keep the price of WorldCom shares higher…
How WorldCom Fraud was Discovered
As business continued to slow down through 2001, WorldCom’s accounting got more aggressive and internal auditors started to become suspicious.
In early 2002, a group of internal auditors discovered a $500 million charge for computer equipment that had no invoices or documentation to back up the charge. Their suspicion led to a deeper dive into the company’s books where they would uncover the $3.8 billion fraud.
The group would have numerous meetings with upper management, only to find their efforts to research further halted.
The story of the 3 main auditors who had to work during the nights to avoid getting detected and face threats from the CEO to stop their investigation is told in a great article by The Wall Street Journal.
Meanwhile, Ebbers would continue to ask WorldCom’s compensation committee to lend him money to cover his margin calls as the value of his WorldCom shares declined. In total, Ebbers would take over $400 million in loans from WorldCom, including $65 million just 7 months before the company would declare bankruptcy.
By March 2002, the SEC was getting suspicious of WorldCom’s financial reports. As many large telecommunication companies were reporting losses, WorldCom continued to report profits. On March 7th 2002, the same day that an internal auditor would receive a threat from Ebbers to halt her investigation into WorldCom’s books, the SEC would surprise the company with a request for more information on their business.
By the end of June 2002, internal auditors would brief WorldCom’s board on their findings. When CEO Ebbers had no evidence to dispute the charges, the board fired Ebbers and announced the next day that the company had overstated its profits by $3.8 billion over the previous 5 quarters.
A month later the company would declare bankruptcy:
Ebbers would eventually be sentenced to 25 years in prison for fraud, conspiracy and filing false documents with regulators.
What Did WorldCom Actually Do?
The primary way that WorldCom overstated its profits was by counting certain costs as Capital Expenditures (CAPEX) instead of normal expenses. By considering expenses as CAPEX, the company was able to depreciate its costs over numerous years, instead of having to take the full charge in a single year. This allowed WorldCom to report higher profits.
What did WorldCom’s financial statements look like prior to the fraud being uncovered?
WorldCom had originally reported a profit of a little over $4 billion for 2000. In reality:
After all the books were restated, WorldCom would book a $48 billion LOSS for the year instead.
Chart of WorldCom Stock – How Would WorldCom Investors Fare?
WorldCom’s troubles started well before the company announced its accounting fraud. By early 2001 the company’s stock had fallen more than 60%:
Common stock holders would be wiped out. WorldCom bond holders would get 35.7 cents for every dollar in debt they held.
More on WorldCom
The book “Disconnected: Deceit and Betrayal at WorldCom” documents the fraud at WorldCom in more detail for those interested.
*- Since WorldCom there have been 2 larger bankruptcies; Lehman Brothers and Washington Mutual in 2008 and one larger case of accounting fraud – Bernie Madoff’s $64 billion ponzi scheme.