Fast And Loose At WorldComAug 29, 2002 | The Washington Post
In the years before WorldCom Inc. announced the $3.9 billion in improper accounting that led to its bankruptcy this summer, the telecommunications giant was plagued by loose business practices, inadequate financial disclosure, and widespread internal chicanery and corruption.
Thousands of pages of previously undisclosed company documents reviewed by The Washington Post, along with interviews with former employees and people familiar with WorldCom's operations, reveal a grow-at-any-cost culture that made it possible for employees and managers to game the system internally and to deceive investors about the health of the business.
Salespeople and managers boosted their commissions by manipulating the company's billing systems. Orders for services or equipment were booked even if they were not provided, so that departments could meet revenue targets. Outside contractors billed for hours they could not have worked, and some equipment was purchased without anyone checking to see whether it was already in inventory.
The documents also show that a small group of WorldCom executives, knowing that their business was eroding rapidly, discussed various accounting maneuvers that would help prop up the company's bottom line. These discussions were separate from the fraud that two former WorldCom executives were accused of in indictments yesterday, and it is unclear how many of the activities under consideration were improper. On one occasion, these conversations included then-vice chairman John W. Sidgmore, who took over the company in April after chief executive Bernard J. Ebbers was forced to resign.
The company's finances were so tightly controlled that its internal auditors, who discovered the accounting improprieties almost inadvertently, did not normally review the company's books, leaving that duty to the company's former outside auditor, Arthur Andersen LLP. Instead, the internal group performed "operational" audits to assess how the company could tighten controls and save money.
Yet even those recommendations often languished, the documents show. And whistle-blowers were often intimidated or ignored.
"There seemed to be no inventory controls, no fraud controls, no nothing," said one investigator familiar with the documents.
So far, authorities have charged former chief financial officer Scott D. Sullivan and former controller David F. Myers with securities fraud for improperly reclassifying $3.9 billion in operating expenses for leasing other company's networks as capital costs, allowing the company to show profits instead of losses. Sullivan was indicted yesterday, but Myers was not, signaling that he is cooperating with authorities, according to sources familiar with the investigation.
Also indicted was another finance official, former director of general accounting Buford Yates Jr. Although he denied to internal auditors knowing anything about the nature of the accounting transfers, the documents show he was in discussions about the issue nine months before the practice began.
No accounting or audit employees responded to requests for comment for this story, nor did attorneys for Sullivan or Myers. An attorney for Yates, who recently resigned from the company, said he had not had a chance to review the indictment and could not comment.
WorldCom spokesman Brad Burns declined to make employees available for interviews, and he would not comment on specific allegations or issues contained in the documents that might be under investigation by the Justice Department, the Securities and Exchange Commission, Congress or an independent inquiry commissioned by the company.
He reiterated past statements that the company is cooperating fully with the investigations and that any evidence of wrongdoing will be acted upon quickly. Since the company announced June 25 that it had improperly booked billions in expenses, it has revealed that an additional $3.8 billion will have to be accounted for differently because of improper handling of reserve accounts.
Burns said that as employees raised allegations of improprieties, the concerns were forwarded to the legal, audit or human resources departments. If the allegations were proved, he said, corrective action was taken.
"It's no secret to anyone that WorldCom has had some issues, but what's important now is that we are restructuring the company, we're moving forward and we have 60,000 employees working hard," Burns said.
Some analysts believe that WorldCom, still a major U.S. long-distance carrier with significant revenue and Internet operations, can emerge from bankruptcy as a profitable business. But the documents bolster the analysts' view that many of its internal workings will need to change.
The Worsening Picture
In July 2000, a handful of senior financial executives at WorldCom were starting to confront the reality that their bubble-fueled telecommunications business was melting down. They were worried about how to characterize the health of the business in a way that didn't send investors heading for the exits, the way shareholders had bolted from so many other companies.
WorldCom's stock stood at a still lofty $45 a share, but the stock market had peaked three months earlier and was falling fast. Regulators had just blocked the company's proposed purchase of long-distance rival Sprint, dealing a blow to WorldCom's growth-by-acquisition strategy that had made it a company with $35 billion a year in revenue.
The executives discussed how a glut of network capacity was forcing down the prices that WorldCom and its rivals could charge for telephone and Internet service. Competition was cutthroat, and customers were growing scarce. Companies everywhere were slashing their spending. Dot-coms, once big clients, were folding.
As business slowed, WorldCom needed to dramatically cut costs and improve efficiency -- not something the company was built to do.
According to WorldCom documents, the sales division, for example, was not responsible for how much it cost to bring in new business. In simple, dot-com-era accounting terms, it was acceptable to sign a contract to provide a data network for $1 million even if it cost $2 million to fulfill the order. Company executives hoped the short-term loss would be offset by the long-term gain of having a bigger network that would accommodate ever-increasing business down the road.
Bringing costs and revenues into balance proved difficult when many of the most basic systems to control costs were absent or ineffective at WorldCom.
"Groups purchase new equipment without verifying whether the equipment is already in inventory," according to an internal audit report for 2001. "The purchasing system does not require that inventory be checked. . . . In December 2000, $10 million in new equipment purchases was processed without existing inventory review. A sample of these purchases indicated unnecessary spending of $2 million to $3 million . . . on fiber patch cords alone."
The problems were exacerbated by WorldCom having become, by 2000, the aggregation of more than 60 telecommunications companies it had acquired, including Arlington-based long-distance giant MCI and Ashburn Internet provider UUNet Technologies Inc. Internal documents, industry analysts and current and former employees describe how poorly WorldCom absorbed the companies, gaining their revenue but doing little to integrate them operationally to eliminate overlapping costs.
One finance official who was an early hawk on controlling costs was a telecommunications reporting manager named Tony Minert. Minert, who has since left WorldCom and could not be located for comment, began examining the company unit by unit and pressing for change.
"There seems to be no regard for cost," Minert wrote on July 20, 2000, in one of a series of e-mails to Myers and Yates. "This will continue in the future until we make people accountable for their actions."
About the same time, Minert began to eye ways of making the company's costs look better on paper. In the same e-mail exchange, he was the first to suggest the idea of shifting the operating costs of leasing network capacity to capital expenses. Operating costs typically cover the general expenses of running a business and must be booked at the time they are incurred. Capital costs generally include one-time purchases such as real estate and equipment, and the expense can be spread over longer periods.
Current and former employees said the company's various units often operated as fiefdoms, with little communication and overlapping billing systems. The acquisition of MCI in 1998 represented the greatest failure in this respect, according to financial analysts.
"There would be multiple sales teams, offering the same products, competing with each other," said Jim Andrew, a telecommunications consultant with the Adventis Group.
In addition, the pressure for revenue was intense all the way up the sales division, and there was little incentive for anyone to put a stop to other questionable practices. If anyone did, he or she would miss quotas and lose commissions.
Early this year, WorldCom fired or suspended several members of its sales team, including three in its Pentagon City offices, for improperly booking accounts to boost their commissions by $3 million. The company said at the time that the firings, initially reported by the Wall Street Journal, rooted out "a few bad apples" in a handful of offices around the country, and that the revenue from the accounts had not been counted twice in the company's earnings.
The scam was simple. Because the acquisition of MCI had given the company two major billing systems, some employees found they could switch existing customers to the other platform and get an extra commission, as if it were a new account. Other techniques that exploited the multiple systems were also employed.
In announcing the discovery, Senior Vice President for Sales Deborah Surrette admonished her staff in a Feb. 4 e-mail that commissions would not be paid "on the movement of existing services."
But the problem had been known to the company for some time. According to minutes of a June 6, 2001, meeting of the audit committee of the board of directors, Cynthia Cooper, head of the internal audit team, reported that "accounts that moved from one billing system to another resulted in commission overpayments." In all, "292 accounts had been moved over a year's period" and "overpayments of 28 of those accounts resulted in overpayments of commissions of $930,000," she reported. It's unclear whether the money was ever repaid.
Moreover, according to one former employee, Surrette told the staff that the scam involved many more employees, including a vice president, and significantly more money -- which the company disputes.
At one point in May 2001, another employee faxed an anonymous note to Surrette and Chief Operating Officer Ron Beaumont identifying several instances of improper billing by a manager in order to inflate commissions.
"There are lot more instances of things like this going on" at the company's Boca Raton, Fla., operations, the employee wrote. "Just ask around and you will find out." Nothing ever happened, the employee said.
According to an e-mail from an internal auditor on Feb. 20 of this year, an employee alleged that two network circuits from Los Angeles to Sydney were billed and recorded even though the customer never got access to the circuits and the order was later canceled.
The action was taken "because Ms. Surrette needed MonRev [monthly revenue] credit," said the e-mail, which was sent to Cooper, Sullivan and Ebbers.
"The company had done an internal review, and based on what we know now, any misbillings of this customer have been fully credited, and we found nothing to substantiate the claim that Ms. Surrette jiggered the account," Burns said.
Manipulating the Numbers
In October 2000, Sullivan and Ebbers began preparing for the company's toughest quarterly earnings announcement in years.
In the past, the complex financing of WorldCom's acquisitions had often helped obscure the company's actual performance, according to analysts. But with the Sprint merger blocked, the spotlight would fall squarely on the company's operations.
The company was scheduled to report its quarterly financial results on Oct. 26. In an e-mail exchange over two days that began on Oct. 21, Sullivan told then-Vice Chairman Sidgmore that the company was in a "really scary" situation of escalating costs and declining revenue growth in certain key areas. Just two months earlier, Sullivan had sold stock worth $18 million.
He told Sidgmore, for instance, that revenue from one of the company's biggest customers, America Online, was growing by only 1 percent, in part because its Internet traffic growth had slowed and much of the data was being carried on lines leased, not owned, by WorldCom.
"Wow! I had no idea that the revenue growth had deteriorated that much," Sidgmore wrote back, adding that "it's going to take some pretty fancy explaining."
Sullivan agreed, telling Sidgmore he would be making some accounting changes that would result in better margins for certain parts of the business. Sullivan said he would be taking two sources of revenue totaling about $225 million -- in one case certain fees and in another case some equipment sales -- and reclassifying them as cost reductions.
WorldCom spokesman Burns said Sidgmore's response to Sullivan dealt only with the difficult revenue picture, not with the accounting changes, which Burns said were legal.
But Edward Soule, a professor of corporate ethics at Georgetown University who also is a certified public accountant, reviewed the Sullivan-Sidgmore e-mail exchange and said that although the changes Sullivan discussed with Sidgmore might not technically violate accounting standards, they were "baldly manipulative." The adjustments did not alter the company's bottom line, Soule said, but they served to enhance the company's operating margin, a key statistic for Wall Street.
In fact, when it issued its quarterly financial report on Oct. 26, WorldCom touted "solid" results with a 12 percent increase in overall revenue, powered by especially strong growth in its international business. It faced some "challenges," but the company's operating margin improved, Sullivan told analysts.
The accounting changes, though, were fully disclosed, prompting one analyst to ask whether WorldCom's competitors were making similar accounting adjustments.
"We are going to be a leader in this area," Sullivan said.
To close a conference call, an upbeat Ebbers told analysts that given WorldCom's numbers and continued prospects for growth, he believed the company was "a very good bargain out there in the market today."
According to yesterday's indictment of Sullivan, October 2000 was also when he began directing finance officials to use company reserves to offset operating costs by $828 million, thereby increasing the company's earnings by the same amount.
Voice in the Wilderness
Probably few WorldCom employees worldwide ever heard of Kim Emigh, but he was notorious at the company's network systems engineering division in Richardson, Tex. Indirectly, he would turn out to be an unwitting central figure in the unraveling of the scandal that brought down the company.
Known as a demon for details, Emigh was a financial analyst who frequently challenged what he saw as a Wild West environment of profligate spending and suspect accounting at the former MCI division, which he had joined in 1996.
According to Emigh, for example, the division once hired a bartender who was friendly with some of the managers to do data entry as a contract worker on a project for a new budget system. The project was billed for the bartender's time at a rate equivalent to that of a senior financial analyst -- $120,000 a year.
On another occasion, Emigh said he found that 10 contract employees were being paid $25,000 each but several names were listed with the same Social Security numbers and others were already getting paid on monthly retainers as contractors.
Sometimes, hours for full-time employees would be improperly billed to capital projects. The company's systems encouraged the practice, Emigh said, because if capital costs were rising it meant there was more business, which meant it was assumed that operating budgets would need to rise. This allowed some managers to pad operating budgets with extra money to throw parties, use limousines and avail themselves of other perks, he said.
Though he was ostracized by several managers, his challenges often resulted in practices being reversed.
Then, on Dec. 12, 2000, the division's budget manager sent out a directive that Emigh thought was blatantly illegal. The manager ordered the division to stop charging certain work to capital projects and begin charging it to operating accounts.
In an odd twist, this was the opposite of the practice that ultimately took down the company, but to Emigh it was no less improper.
"This is a direct violation of the company policy to capitalize hours which are capitalizable and will result in a misstatement of the company's financial performance," Emigh wrote to superiors.
Getting no satisfaction, Emigh eventually took his complaint all the way up to Susan Dean, an assistant to Ron Beaumont, the company's chief operating officer. The next day the order was put on hold, and Emigh got a note from Dean praising him for bringing the matter to her attention.
But Emigh said his direct supervisors reprimanded him for going over their heads. In March 2001 he was laid off along with 375 others in the division. Emigh filed a $35 million lawsuit charging wrongful termination, which was dismissed, a decision he is appealing.
On May 16 of this year, 13 days before the audit team met and began questioning capital expense adjustments, an alternative newspaper, the Fort Worth Weekly, published a lengthy account of Emigh's story.
The article caught the attention of Mark Abide, the director of property accounting. On May 21, Abide forwarded the article to Glyn Smith on the internal audit staff, with a note saying the allegations were "worth looking into."
Indeed, a regularly scheduled capital expense audit for 2001 found that one outside contractor was paid for having worked 3,053 hours during the first three quarters of 2001, which is "nearly 50 percent more than a standard business year (2,080 hours)." The audit found 51 other employees and contractors who charged a year's worth of contracting time in the first three quarters of the year.
On May 29, the audit team, led by Cooper, met to discuss the audit report and the article on Emigh. It was during that meeting that they focused on one mysterious number: $1.4 billion that had been added to the company's capital expenses.
The team turned to Sanjeev Sethi, an accounting department employee also at the meeting, for an explanation. Sethi, according to an internal memo, said "he has no comfort level with the adjustments because his department does not generate them."
They were made, he said, by higher-ups in the organization.
Cooper and the team were at a crossroads. The company had just fired its longtime outside auditor, Arthur Andersen, after it was indicted in the Enron Corp. scandal. Ebbers had resigned over concerns about the huge loans he received from the company, which the SEC was investigating.
The internal audit team resolved to make tracking down the adjustments a top priority and pursued it despite pressure from Myers and Sullivan to drop the issue. Within a month, the auditors discovered that $3.9 billion in operating costs were improperly accounted for as capital expenses.
'Where Do I Sign My Confession?'
The transfers of operating expenses to capital expenses that would ultimately bring down WorldCom did not start until late in the first quarter of 2001. But the idea was discussed the previous summer.
As Tony Minert, the telecommunications reporting manager, was making the rounds of the company's divisions in a furious search for ways to cut costs, he began to focus on how much of the company's data network was not being used. In a series of e-mails that began July 19, 2000, Minert wrote to Myers, Yates and others noting that increasing amounts of line capacity went unused, although that capacity had already been paid for. In some cases, WorldCom had locked itself into long-term leases for line capacity from other companies, in anticipation of bringing in more and more business.
Why, he asked, couldn't the costs of that "prepaid capacity" be listed as a capital expense, meaning it would be treated as an asset whose costs could be spread out over time, instead of as an operating expense that is immediately reflected on the bottom line?
"The impact," Minert wrote, "could be huge."
But Minert's notion was firmly rejected several days later.
"David [Myers] and I have reviewed and discussed your logic of capitalizing excess capacity and can find no support . . . that would allow for this accounting treatment," Yates wrote to Minert on July 25.
But on Aug. 17, Minert sent an e-mail to Mark Willson who worked for Myers's deputy, with a copy to Yates, titled "Line Cost Capitalization."
Minert wrote that he was awaiting data, after which "we will be ready to dig into the numbers a little more to determine what should be capitalized and what should not be capitalized." It's unclear from the documents whether Minert knew of the transfers between the operating and capital budgets when they began in 2001.
According to the investigation by the internal audit team, the initial shift came in the first quarter of 2001, when $544.2 million of operating costs were recorded as capital transmission equipment costs. The next quarter, a total of $560 million was recorded in three capital accounts, including $150 million used to buy furniture and fixtures.
By the last quarter of 2001 the number grew to $941 million, and an additional $818 million was transferred in the first quarter of this year.
Although the transfers were enabling the company to continue to show a profit, business was still diving. Meanwhile, scandals had erupted at Enron, Global Crossing and other high-profile telecommunications companies, throwing a spotlight on corporate accounting everywhere. Executives were getting nervous.
When a staffer routinely e-mailed a March 2002 capital expense report to several finance managers on May 1, it set off alarms.
Upon seeing that the report was distributed, Buford Yates, the general accounting manager, sent Myers a private note that said, "Where do I sign my confession?"
Myers then sent a note back to two of the staffer's supervisors demanding: "Why did you distribute this report? I thought we were never again distributing this."
Probe That Didn't Stop
On June 4, several days after Cooper's probe began, Myers tried to derail it. He wrote Cooper a note asking why Sethi, the accounting official working with Cooper's team, was working on capital expense reports and could not collect data for some banks that Myers had requested.
"Not trying to get in your business so please don't take it that way," Myers wrote. "Sanjeev is too nice and I have our boss [Sullivan] breathing down my neck."
In a return e-mail, Cooper attempted to assure Myers that Sethi would put Myers's work first. The next day, however, Myers sent another note to Cooper and her deputy, Glyn Smith: "Sanjeev is prioritizing and you guys are giving him room."
Undaunted, Cooper met with Sullivan on June 11 to get an explanation of the transfers, according to an FBI affidavit filed in connection with Sullivan's arrest. Sullivan defended the scheme and allegedly said he intended for the company to take a one-time charge in the second quarter to offset them. He asked Cooper to delay the investigation until the third quarter. Cooper refused.
The audit team soon determined that the transfers were recorded in the company's books primarily by Betty L. Vinson, an accounting manager who reported to Yates. When internal auditors confronted Vinson about the transfers on June 17, she "stated that while she made the entries, she did not know what they were for and did not have support for them," according to an internal audit memo summarizing the exchange. Vinson, who was named yesterday by authorities as an unindicted co-conspirator in the alleged fraud, told them that Myers or Yates would provide her with the amounts.
That same day the auditors visited Yates, who claimed "he did not know what we were talking about" and did not know what "prepaid" capacity was, according to an audit memo. (Just two years earlier he had informed Minert that capitalizing such costs was improper.) Yates referred the team to Myers.
At 3:35 on the afternoon of June 17, Cooper and one of her deputies, Glyn Smith, confronted Myers. At first, Myers said ominously that if the company didn't reduce its costs, it "might as well shut its doors."
Then, however, Myers conceded that he had no accounting support for the expense changes, according to an auditor's report. Myers said he had never been comfortable with them but that once they started they were hard to stop.
"Glyn asked David how this would be explained to the SEC," an audit memo says, "and David stated he had hoped it would not have to be explained."
Soon thereafter, Cooper contacted Max Bobbitt, the chairman of the WorldCom board's audit committee, and pressed for disclosure of the problem at the committee's June 14 meeting. Shealso discussed the issue with Ferrell Malone, who was in charge of the WorldCom account for its new outside auditor, KPMG LLP.
Although Malone told Cooper he could not see how the transfers could be justified, he and Bobbitt decided against raising the issue at the June 14 meeting, preferring to wait until Sullivan was interviewed again.
On June 19, Sullivan said he had not asked, or informed, Arthur Andersen about the transfers, but he again defended them. At the request of the board of directors he then drafted a written explanation, which the board and its attorneys deemed inadequate. When Sullivan refused to resign, he was fired on June 24. Myers chose to quit.