WorldCom and The Fraud That Was
Many cryptocurrency traders are too young to recall the infamous collapse of MCIWorldCom, so I thought I’d do a quick review of one of the largest frauds in American history. The reason that this is important and of interest for the cryptocurrency community is due to the fact that cryptocurrencies are largely unregulated markets and I personally often hear, “Why would any of these companies need to perpetrate fraud? They make tons of money!” Herein lies the lessons of MCIWorldCom.
In case you’re unfamiliar with WorldCom, it was a telecommunications company founded in Mississippi in 1983 under the moniker, “Long Distance Discount Services”. The CEO from the outset was a man by the name of Bernard Ebbers — a Canadian who earned a Bachelor’s Degree in Physical Education in ‘67.
WorldCom had the benefit of timing. The late 80s thru 90s were a great time to be a telecom company — with the emergence of cell phones, the internet, telecommunication deregulation, and scammy commercials for cheap long distance.
Most important, it was a time of innumerable mergers and acquisitions: “among the companies that were bought or merged with WorldCom were Advanced Communications Corp. (1992), Metromedia Communication Corp. (1993), Resurgens Communications Group (1993)… and MCI in 1998.”
This was actually the main growth model for WorldCom — even before it was WorldCom: rather than focus on internally growing their operations (laying down cables, installing new lines, hiring more adept employees), they had a simple mechanism for growing which entailed buying profitable businesses on an equal or lesser footing than themselves. This was an immensely successful business model for over a decade. Unfortunately, this also led to innumerable redundancies and cost inefficiencies.
As WorldCom continued its unwieldy growth, deregulation and greed started to rear their ugly heads within the telecom industry. An analyst by the name of Jack Grubman, an employee with PaineWebber and later Salomon Brothers, began informing investors that companies like WorldCom — newer co’s with high profit models and an easy ability to pivot — were the best buys on NASDAQ. As an industry insider, not only did Grubman have the trust of retail investors and the ears of bankers, but was actually able to help coordinate deals between possible M&As when he saw them. Grubman would sit in on board meetings, levy buy signals for his employer’s benefit, and give interviews to newspapers who were desperate to hear from the expert in telecom who was somehow always right. He’d end up making dozens of millions of dollars by helping WorldCom buy up much of its competition. By 1992, with WorldCom (still called LDDS at that point) raking in ~$950 million in profits, Grubman issued a “STRONG BUY” for the stock.
It’s 1993 and Bernie has just accomplished a major acquisition in Metromedia Communications by offering the executive leadership 30 million shares of LDDS. The heads of Metromedia immediately sell, profiting big. Meanwhile, Bernie is holding every share of LDDS he’s been awarded over a decade. At this point, Bernie says outright, “This company can go one of two directions. It can be built up through acquisitions. Or we can sell out.” LDDS has become an attractive buyout, but Bernie is unwilling to give up his baby, and also unwilling to start sinking in costs to actually grow the infrastructure.
So, instead of growing infrastructure, Bernie moves to purchase two other companies that will aid in providing satellite networking and internet/telephone landlines: IDB and WilTel, respectively. IDB is purchased for just under a billion dollars, and in a hostile takeover bid, WilTel eventually accepts a $2.5 billion all-cash offer (IDB in 1994, WilTel at the beginning of 1995). Now LDDS is becoming a major competitor in the Telecom game — not only for businesses (its main driving force and focus), but residential, too.
1995 proves to be a boon year for LDDS. With a switch to the moniker WorldCom, they become a household name, are competing with AT&T, Sprint, and MCI, have an international foothold, as well, and by ’96 land Michael Jordan — arguably the biggest name in sports ever — to do advertisements for them. Congress is reaching peak Telecom Deregulation. They are livin’ fat and happy. But trouble looms.
Four years after his initial recommendation, Jack Grubman is still keeping a STRONG BUY on WorldCom. This has played out nicely, thus far, due to the fact that with all the M&A’s WorldCom’s price has skyrocketed. The Wall Street Journal reports, “[WorldCom] now sits alone at the head of class of hundreds of long-distance concerns since the breakup of AT&T.” A $100 investment in WorldCom in 1989 would be worth $2,473 by ’96 and Bernie Ebbers is listed at Number 54 on Forbes list of 800 of “Corporate America’s Most Powerful People.” Along with his CFO, Scott Sullivan, Wall Street dubs the CEO/CFO duo “The Scott and Bernie Show.”
Jack Grubman helps negotiate a deal wherein WorldCom buys Metropolitan Fiber Systems for $14.4 billion in stock — the reasoning being that WorldCom has a very large and viable network, but needs, “the last mile” to get into businesses and homes without renting from AT&T or Sprint. Wall Street rejoices. With the purchase, WorldCom becomes the first company in America to offer long-distance, local, Internet, data, and international service. It is the largest internet service provider in the country, jumps from 498th to 341st on the Fortune 500, 19/24 analysts issue a BUY rating or better, and it’s is now nipping at the heels of it’s two largest competitors.
At the tail end of 1996 Alan Greenspan, the Federal Reserve Chair, issues a warning, wondering if markets are exhibiting, “irrational exuberance.” But the Fed doesn’t increase margin requirements and continues to lower interest rates. Telecoms begin a consolidation phase. It is now that The Bernie and Scott Show make a brash decision: They will bid to acquire MCI — a company four times the size of WorldCom.
“Every time there is… another merger, I ask myself, ‘How can you top this?’ And every time, there has been something new to come along to offer that challenge that makes this life so interesting.” - Scott Sullivan, WorldCom CFO
It takes about a year, but in March 1998, the deal is approved by shareholders. WorldCom acquires MCI for $36.5 billion (which would be a $56 billion merger in today’s dollars) and is the largest corporate merger in US history, making a spectacle out of Bernard Ebbers: he’s dubbed “The Telecom Cowboy”, as well as being elected to the Mississippi Businessman Hall of Fame and included in the, “Wired 25” via Wired Magazine.
“Mr. Ebbers will release many trillions of dollars in wealth in internet commerce and communications. He is a hero of the dimensions of Rockefeller and Milken.” -George Gilder, The Wall Street Journal
“WorldCom is here to stay.” - Time Magazine
Scott Sullivan receives a $19 million compensation package for his work on the merger that year, with Bernie and Jack Grubman receiving healthy packages from their respective employers, as well. By June of 1999, WorldCom’s stock price has peaked at $64.50/share, giving the company a marketcap of $115 billion and propping it up to the 14th most valuable company in world, according to BusinessWeek’s Global 1000 List. In 1990 corporate executives made an average of 85 times the compensation of regular employees — by 1999 this number is a staggering 531 times.
The bubble is getting ready to burst.
WorldCom becomes the second largest long-distance provider in the United States. This places it at the forefront of the internet bubble, and in a bold — and what would end up being final — attempt to keep WorldCom afloat, Ebbers and the board put in a bid to acquire Sprint for a whopping $129 billion (inflation adjusted, $195 billion, which would place it in the top five M&A’s of all time). This proposition is opposed by the DOJ and European Union, who are concerned about a monopoly forming. This singular moment sets into motion the eventual collapse of MCIWorldCom.
The WorldCom fiasco unravels very quickly, however the fraud itself is years in the making (markets [and frauds] take the stairs up and the elevator down). Arthur Anderson, the now infamous “Top 5 Auditing Firm” responsible for the collapse of Enron, is in charge of the books for WorldCom. Seeing as to how WorldCom is the crown jewel in the collection of corporations Arthur Anderson is taking care of, they are willing to bend over backwards to accommodate their number one client. This obfuscation of accounting numbers (termed “earnings management” in financial lingo) begins during the slowdown in 2000.
The idea behind earnings management is to hide losses via shady accounting practices that fall into a grey area. Often enough, and perhaps unsurprisingly, these methodologies end up working in concert with fraud. In the case of WorldCom, an Internal Auditing Committee was pressed to not follow GAAP (Generally Accepted Auditing Practices) and did so. This Internal Auditing Committee had two key members: Betty Vinson and Cynthia Cooper.
In June of 2000, as the internet bubble ground to a halt, the Scott and Bernie Show request that the Internal Auditing Committee be creative with the books. This amounts to a small change that non-accountants probably wouldn’t be able to decipher: instead of reporting leased lines as expenses that need to be paid back ASAP, they’re reported as capital expenses which have the luxury of being paid back over a number of quarters and years. Betty Vinson accomplishes this by transferring these expenditures under the title PREPAID CAPACITY, allowing the company to write-off spending as though it’s a deduction, offsetting increasing costs that aren’t being met with any revenue to match.
Prepaid Capacity: if you’ve never heard of it, you’re not alone. Neither had Cynthia Cooper, the lead of the Internal Auditing Committee. It’s a nonsense term for a nonsense concept. So Cynthia and her team begin to dig, and the more they dig, the harder it becomes to obfuscate. Not only this, but the stock market begins to dump in every sector and strikes telecom particularly hard. WorldCom stock is depreciating. This spells major financial issues for Mr. Bernie Ebbers.
By November of 2000 it comes to light that the Board of Directors of MCIWorldCom has approved hundreds of millions of dollars in personal loans to Bernie — without disclosing it to the rest of the company or the public at large. Why have they given him so many loans? Well, it turns out not only is Bernie one of the largest holders of WorldCom stock, but he’s actually bought more and more shares on margin (being the overconfident CEO that he was).
He has also purchased the following assets with his monster paycheck and available loans from banks that were certain the CEO of WorldCom would have the funds to pay them back:
A ~$14 million rice farm
A ~$14 million yacht-building company
A ~$65 million ranch (the largest working ranch in North America)
And 548,000 acres of timberland valued at an unconscionable $658 million
Worth $1.3 billion in 1999, as the WorldCom stock continues its slide into oblivion, Bernie finds himself being margin called. Not wanting millions of shares of their company to flood the market, the BoD — again, overconfident the price of the stock would soon rebound — agrees to loan after loan. Over 18 months, Bernie takes out $900 million in loans. But the stock continues its downward trajectory, and the margin calls continue, too.
By the start of 2002, WorldCom shares are valued at ~$15 a pop — a decline of over 75% from all-time highs. Nine million shares are released to cover Bernie’s margin calls and he submits his resignation to the BoD. It is immediately accepted, with the caveat that he’ll receive $1.5 million annually for the rest of his life, an office within WorldCom’s Jackson, MS branch (free of charge), and an administrative assistant, paid in full by WorldCom.
This actually isn’t the end of WorldCom. Scott Sullivan and others attempt to salvage the company. They fail, as Cynthia Cooper continues to uncover mounting multiples of fraud perpetrated over the previous years — all titled “PREPAID CAPACITY.” WorldCom’s stock slides to $0.83. The SEC opens an investigation. The Bernie and Scott Show are asked to testify before Congress. Bernie doesn’t disappoint, simultaneously invoking his Fifth Amendment right, and proclaiming his innocence — a faux pas for sure.
Eventually, MCI is spun back off of WorldCom, and the booming giant that once was dies in a large way: July 21st, 2002, WorldCom declares bankruptcy (the largest corporate bankruptcy in history at the time, listing $41 billion in debt and $107 billion in assets). A few months later Bernie, Scott Sullivan, and Betty Vinson are slammed with charges. Bernie ends up getting a 25 year sentence (which he is still serving to this day). Jack Grubman is fined $15 million for the role he played aiding and abetting WorldCom and is never allowed to work in the financial markets again. Many thank Cynthia Cooper for her relentless efforts to uncover the bullshit, non-GAAP auditing, but she insists the fraud would’ve destroyed itself eventually, all on its own. “Neither the fraud nor the discovery of the fraud caused the downfall of WorldCom. The fraud simply masked the true state of the business. WorldCom should’ve gone into bankruptcy long before it did.”
“So what?” I hear my cryptocurrency followers saying in unison.
There are a multitude of lessons to take away from MCIWorldCom.
First of all, just because a business seems to be making money hand-over-fist, doesn’t mean there aren’t shady dealings, fraud, scams, and other problems bubbling under the surface. What was the best stock to own between 1989–1999, became infamous as one of the worst examples of white-collar criminal ineptitude.
Secondly, crime pays — for awhile — but it always ends badly for investors, employees, and, occasionally, even executives.
Lastly, in the words of Cynthia Cooper, and this is actually very important, “People don’t wake up and say, ‘I think I’ll become a criminal today.’ Instead, it’s often a slippery slope and we lose our footing one step at a time.” The people and corporations I see at the heart of the issues with cryptocurrencies most likely didn’t intend to rip people off and rig a market — things just kind of worked out that way. At a certain point in time it becomes more difficult to tread back than to continue trudging forward, despite being aware of the problems you may be causing to a broader realm.
A 2002 report by The Association of Certified Fraud Examiners gives a chilling statistic to be left with: financial statement frauds continue, on average, for 25 months before being detected. Tips by employees tend to be the primary means of fraud detection and the second-highest percent of frauds are detected, “by accident.” Audits, what most of us believe to be a very important factor in the financial sector, account for but a small percentage of fraud detection.
Trade carefully out there, cause in the completely unregulated world of cryptocurrencies we undoubtedly have our fair share of Bernie Ebbers’ and WorldComs — they lie in plain sight and always appear successful.
This article heavily relied on the book Extraordinary Circumstances by Cynthia Cooper. As an insider and the main whistleblower at the heart of the WorldCom scandal, the book was not only great reading, but very important to getting the facts straight. I highly recommend it as an easy, exciting read that thoroughly explains what transpired — not only at her company, but industry-wide.