Case Study on WorldCom

WorldCom Accounting Fraud

Siva Sivani Institute of Management

Submitted by

Satyajit Banik

(B3-40)
Abstract:

The case discusses the accounting frauds committed by the leading US telecommunications giant,
WorldCom during the 1990s that led to its eventual bankruptcy. The case provides a detailed description
of the growth of WorldCom over the years through its policy of mergers and acquisitions. The case
explains the nature of the US telecommunications market, highlighting the circumstances that put
immense pressure on companies to project a healthy financial position at all times. The case provides an
insight into the ways by which WorldCom manipulated its financial statements. The case also describes
the events that led the company to file for reorganization under Chapter 11 of the U.S. Bankruptcy Court
in 2002.

The role of the company's top management in the scandal has also been discussed. Finally, the case
explores the initiatives being taken by the company to change its management structure, improve its
performance and restore investor confidence.

WorldCom 2002: Yet another Corporate Scam

On June 26, 2002, the US-based telecommunications major WorldCom received unprecedented media coverage all
over the world. Not for good reasons though. The company had earned the dubious distinction of being involved in
the largest accounting scandal ever to hit the US corporate history. WorldCom had reportedly misrepresented its
financial statements to an extent of around $ 4 billion.

The company admitted that it had resorted to fraudulent accounting practices for five quarters (four quarters of 2001
and the first quarter of 2002). Soon after, WorldCom terminated the services of some of its top executives including
Scott Sullivan (Sullivan), the Chief Financial Officer and David Myers, the Senior Vice President and Controller.

The company's auditors held Sullivan responsible for the accounting mess and Sullivan was soon arrested on
charges of fraud and misrepresentation. Adding fuel to the fire was the fact that Arthur Anderson was WorldCom's
auditor while the inappropriate accounting was taking place.

However, Arthur Andersen tried to wash its hands off the crisis stating that it was not aware of the accounting
discrepancies. They accused Sullivan for withholding crucial information about book-keeping practices followed at
WorldCom.

With the sudden appearance of a $ 4 billion hole in its balance sheet, WorldCom was in an acute financial crisis. A
severe cash crunch forced the company to layoff 17000 workers, which constituted 20% of its global workforce.
Eventually, the financial crisis forced WorldCom to file for reorganization under chapter 113 of the Bankruptcy
Code in July 2002., In August 2002, WorldCom shocked company observers and stakeholders yet again by reporting
an additional improper reporting in its financial statements. This time around, the amount involved was $ 3.3 billion,
carried out by manipulating the EBITDA4 during 1999-2001, and the first quarter of 2002. By late 2002, the extent
of misappropriation by WorldCom was estimated to be well over $ 9 billion...

From being one of the world's most valuable companies (valued over $ 100 billion at its peak), WorldCom came to
be known as one of the biggest instances of the 'fraud wave' sweeping the global corporate world since the late
1990s. The company's downfall from WorldCom to 'WorldCon' is a story of a corporate feeding its greed through
financial and accounting manipulations.

WorldCom: The Company

WorldCom was started by Bill Fields in Hattiesburg, Mississippi, in 1983 under the name 'Long Distance Discount
Services' (LDDS), providing long distance telecommunication (telecom) services. The venture was profitable right
from the start. In 1985, Bernie Ebbers (Ebbers) became the company's CEO.

Ebbers reportedly played a major role in the success of LDDS in the following years. The company went public in
1989 when it acquired Advantage Companies Inc., a publicly traded long distance telecom services company.
Throughout the 1990s, the company continued to grow by acquiring various companies and expanding its operations
across the world

In 1992, LDDS acquired Advanced Telecommunications Corp. In 1995, LLDS changed its name to WorldCom, as
the management found the new name to be consistent with the company's future growth strategy of building a global
presence through acquiring telecom-related companies across the world.

In 1998, WorldCom bought the network units of America Online and CompuServe. However, WorldCom's biggest
deal was that of acquiring Microwave Communication Inc (MCI) for an estimated $ 40 billion in the same year. The
company now operated under the name 'MCI WorldCom.'

To complete the merger that year, MCI sold its Internet access business to Cable & Wireless plc (a leading
communication company), and British Telecommunications (BT) ended its partnership with the company and
bought MCI's Concert Communication6 stake. Bert Roberts (Roberts), CEO-MCI was made the Chairman of MCI
WorldCom, and Ebbers, the CEO...

WorldCom: Genesis of the Frauds

In the early 1990s, the US economy went through a phase of consolidation, in which many major companies
acquired or merged with weaker companies to strengthen their own position in the market (as seen earlier,
WorldCom happened to be one of the key acquirers in this phase).

The share prices of companies play a vital role during mergers and acquisitions. Therefore companies try to
'maintain' the prices of their shares (that is, keep them sufficiently high). If they fail to do so, they can easily become
targets for takeover/acquisition.

Moreover, if a company wishes to raise capital from the market, its performance on the stock exchange is considered
to be very important. The companies are generally valued on the basis of cash flows they could generate in future.
As the financial performance of a company is one of the most important (and direct) factors affecting its share price,
companies were under constant pressure to show positive revenue streams...

WorldCom: The Ebbers Angle

During the 1990s, Ebbers borrowed more than $ 1 billion for personal purposes from various banks. He pledged his
WorldCom stock as collateral.

When the prices of the WorldCom stock began declining in the early 21st century, Ebbers' lenders began
pressurizing him to sell the stock and raise cash to support his loans. Reportedly, Ebbers decided to sell some of his
shares in the company to meet these personal liabilities.

However, fearing that the sale would result in a further drop in WorldCom's share prices, the company board
decided to authorize loans to Ebbers so that he could pay off his debts. The company gave him loans to the extent of
$ 408 million between 2000 and 2002. The company justified this by stating that it had to stop Ebbers from selling
his stock in order to prevent a fall in the share prices of WorldCom...

WorldCom: The Final Countdown

As media, legal and investor unrest intensified against WorldCom, there was little hope left for the company. The
company was required to pay $ 172 million in interest and debt in 2002, which was to increase further to $ 1.7
billion and $ 2.6 billion as a part of the repayment schedule in 2003 and 2004.

Analysts remarked that the company, which had a negative cash flow of $ 871 million in 2001, would be able to
generate only $ 564 million in free cash flow in 2002 and $ 1 billion in 2003. Considering the situation, many
company observers predicted that the company would soon declare itself bankrupt. On April 19, 2002, the company
revised its financial predictions for the year 2002, citing a downturn in the long
distance consumer business. WorldCom announced that its revenues would range
between $ 21 billion to $ 21.5 billion, as against the earlier projection of $ 22
billion. The overall revenues were supposed to drop by 5%. Similarly, the net
income was expected to fall by 40% (to $ 1.6 billion approximately)...

WorldCom: Lessons from the Saga

WorldCom had an audit committee consisting of 11 directors (refer Exhibit V for the board's composition), eight of
whom were independent.

The objective of the audit committee was to review the company's financial statements, monitor internal accounting
control activities, communicate with the company's external auditors and review internal accounting control
activities.

However, media reports claimed that WorldCom's board of directors failed to fulfill their basic responsibilities.
Analysts also felt that apart from inefficient corporate governance practices followed by the company, the naivety of
the investors was also equally responsible for the crisis. They felt that the investors should have demanded for more
transparency in the accounting systems...

Worldcom: The Aftermath

In November 2002, Michael D. Capellas (Capellas, Former President,
Hewlett-Packard) was appointed as the Chairman and CEO of WorldCom.
Despite the bankruptcy proceedings and the legal troubles, WorldCom
officials seemed rather positive about the company's future. John
Sidgmore (Retiring CEO) said that the company's focus would be on
reorganizing, regaining financial strength, and operating with the highest
integrity. He also said that the company would emerge from chapter 11 as quickly as possible and with their
competitive spirit intact...

Case Study on ENRON

The
ENRON
saga

"This case has highlighted to the people how even after 50 years of independence, political
considerations outweigh the public interest and the interest of the state and to what extent the government can go
to justify its actions and not only before the public but even before the courts of law."

- Bombay High Court's passing remark after dismissing a bunch of petitions that had challenged the
legality of the Enron power project.
Abstract:

The case 'The Enron Saga' outlines the problems faced by Enron in starting its operations in India-the legal, political
and economic forces at play during the early 1990s. The case is an example of how Enron surmounted the different
hurdles and made the project viable under the then prevailing business environment in India. The case outlines the
various events from the time the MoU was signed till the final clearance. The case is a good example of the strategy
adopted by Enron to make the project a success. It also draws a comparison with Cogentrix, which failed to take off
under similar conditions as faced by Enron. The case also touches the various options available to Enron and the
MSEB to sustain the project under the prevailing circumstance of MSEB defaulting on payments.

The case helps them to understand how an effective strategy can overcome the various political, legal and economic
hurdles. The case also shows how the political and legal environment influenced the approval of the project thus
proving advantageous to Enron. From the case, the students are expected to understand the various factors (mainly
the external environment) that should be taken care of before entering an international market.

The case is a good example of the role of ethics in business. One of the teaching objectives is that a foreign (not
local) company can drain away large amounts of profits if the contract that is signed is not fair. To avoid this, it is
important to regulate the entry of companies to negotiate a fair deal.

The rate of return is not important in the power sector; the single most important factor is the price at which one gets
the power. This can be lowered if there is competitive and transparent bidding. It is also important that the state
boards are run on a competitive basis.

Introduction

In 1996, Rebecca Mark, CEO, Enron Corporation, managed to wrest the controversial Dabhol Power Company
(DPC) from the jaws of death. Five years later (2001), the survival of DPC was at stake. Both DPC and the
Government of Maharashtra (GoM) have been accused of corruption and economic insanity. With the controversy
regarding the price of power still raging and the latest payments crisis that the Maharashtra State Electricity Board
(MSEB) faced, both Enron and GoM were desperately looking for a solution.

The MSEB was not able to lift even the first phase supply fully. It was caught in a vicious circle with high fuel
prices leading to low off take of Dabhol power into the grid. This in turn caused the unit capacity cost to rise. In
October 2000, the price of Dabhol power touched Rs. 7.09 per kWh, due to the high price of fuel and the worsening
exchange rate. In January 2001, responding to Business World's query on the state government's stand, Padmasinh
Patil, energy minister, GoM, said, "We will set up a review committee shortly. There are complex issues to work
out".

Analysts felt that the possibility of Enron selling out or invoking penal clauses in its contractual agreement with
MSEB, to exit could not be ruled out.

In Quest of Power
In June 1992, a team of officials of the Government of India (GoI) toured the USA with the aim of inviting power
producers in the USA to invest in India.1 Prior to this, the government drew up a list of projects in which the private
sector could participate.
In addition to the coal based projects, (Refer Exhibit II) there were two or three gas-based projects in the list. The
Enron Corporation showed interest in setting up a power station in India based on the import of Liquefied Natural
Gas (LNG).

Enron was one of the world's leading power companies and figured in the list of the 500 largest corporations in the
USA. In 1993, Enron's total sales stood at US$ 7.1 billion (Rs. 22,000 crore).

At the time of coming to India,2 Enron's experience in building and running power stations was limited to a few
stations in the US and the Philippines. (capacities ranging from 28, 105 and 110 MW stations in the Philippines and
a 110 MW station in Puerto Rico, to 149 to 450 MW plants in the USA).

In India, the size of the proposed station would be 2500 MW.

On 15 June 1992, a team of officials from Enron Corporation arrived in New Delhi. On 18 and 19 June, the team
visited over half a dozen potential sites in Maharashtra and on 20 June 1992, the MSEB signed a Memorandum of
Understanding (MoU) with Enron. The MoU specified that the MSEB would buy electricity and/or capacity from
Enron which would build, own and operate (but not transfer) a plant of about 2000-2400 MW capacity.

The power station would be built near Dabhol in the Ratnagiri district, about 300 km south of Mumbai. The MoU
also specified that the MSEB agreed that there was a need to set up a 2000 MW plant to be run on LNG. The
"electrical power purchase contract” would be a contract for 20 years and would be structured to achieve a price of
US $ 0.073/kWh (Rs. 2.34 per unit at the then prevailing exchange rates)."

At the price quoted by Enron for a unit, MSEB would be paying a sum of US $ 1300 million (Rs. 400 crores) every
year for the total capacity of 2000 MW. The total payments for 20 years would be around 35 billion US dollars.

The Power Sector

In India the power sector was dominated by Central and State government owned organizations. In most of the
cases, any State Electricity Board (SEB) was the sole generator, transmittor and distributor of power. Power was
generated by Central Utilities such as NTPC, NHPC, Nuclear Power Corporation, Damodar Valley Corporation and
NEEPCO; State Electricity Boards which were state-owned utilities; licensees such as BSES and CESC and
Independent Power Projects (IPPs).

Transmission and distribution was mostly in the hand of SEBs with the sole exception of Orissa where power
distribution was in the hands of the private sector. In 2000, India's power generation capacity stood at around
96600MW (Approx. 478 billion units).3 The major portion of the capacity was set up by SEBs (58%). This was
followed by centrally controlled plants which contributed 34%. IPPs started contributing to installed capacity only
as recently as 1996.

Central Utilities dominated the Indian power generation sector. Even after the new power policy of 1991came into
effect, their share in power generated, as well as new capacity added, did not diminish significantly.

This was largely due to the failure of IPPs to take off. Central Utilities included Powergrid Corporation of India,
Power Finance Corporation of India, Rural Electrification Corporation and Power Trading Corporation of India.

To meet the growing shortage of power, the government encouraged private (including foreign) participation in the
power sector. The new power policy permitted 100 per cent foreign owned companies to set up power projects of
any capacity and type (coal, gas, hydel, wind or solar). An Independent Power Producer (IPP), after getting
government approvals for its specified plant size, could generate power and sell it to the respective SEBs under a
Power Purchase Agreement (PPA).
Licensees were predominantly private companies that generated and distributed electricity to urban areas...

The Power Factor

The MoU between Enron and MSEB was signed prior to the examination of the terms and conditions and
implication of the project. Among the parameters that should have been examined were the capital cost of the plant
(on which the price of electricity depends), the type of fuel to be used, the location of the plant etc.

An autonomous organization, the Central Electricity Authority (CEA) was supposed to examine these aspects. In
July 1992, the CEA examined the MoU and pointed out that the price agreed on was a "departure from the existing
norms and parameters notified by the Government." It also pointed out that “denominating the price in US dollars
was also a departure from the existing norms." According to the CEA, the price that had been agreed upon was
"considered high."

In July 1992, the Government of India asked Enron to submit a break-up of the project costs and the return on equity
that was assumed. Enron wrote back stating, “…We advice you against auditing project costs and predetermining
return on equity.”...

The Peak Load

The project generated much controversy in Maharashtra. Of the two main opposition parties (the BJP and Shiv
Sena) , the BJP was in the forefront of the opposition to the project on a number of grounds. Their primary
contention was that the deal indicated corruption at the highest level. In January 1995, elections to the Maharashtra
state assembly were announced. Enron was made a key issue in the elections. Gopinath Munde, leader of the BJP,
visited the Enron site and promised to throw "the project in the Arabian Sea". Business Line and Frontline carried
long and detailed articles on the PPA, which had been kept secret up till then...

A Tripp
The MSEB's inability to pay DPC was rapidly emerging as a threat to the viability of phase II of the project which
involved a generating capacity of 1, 400 MW and an LNG terminal of 5 million tons.

There was an increasing possibility that the dispute over phase I might end up in international arbitration, if MSEB
failed to pay up and the state government refused to bail out the ailing MSEB. The PPA had provisions for
arbitration in case a dispute could not be resolved through negotiations.

The DPC and the MSEB would have to work out alternative options as the project was unviable in its present form.
Said Kirith Parikh, former director, Indira Gandhi Institute of Development Research (IGIDR), "Yes, the power
from Enron is currently expensive, but a solution needs to be worked. Throwing the Enron project into the sea is not
an option."...