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SEC Nears WorldCom Settlement

Court Examiner’s Report Speeds Talks In Fraud Action

Nov 5, 2002 | Wall Street Journal

WorldCom Inc. and the Securities and Exchange Commission are in talks to settle SEC fraud charges against the company amid rapid developments in the case, according to people familiar with the talks.

THE BROAD OUTLINES of an agreement in the massive accounting-fraud case, hammered out a week ago, would include a court injunction barring WorldCom from violating securities law. WorldCom would also agree to a consent decree of those terms, under terms of the settlement. The SEC is also expected to settle charges against several individuals. The individuals’ names aren’t known, but people close to the situation say they are low- to mid-level executives who wouldn’t be subject to charges by federal prosecutors who are also conducting an investigation. Some of those people have already worked out or are working out plea agreements.

The amount of the fines against WorldCom — and potentially against individuals as well — under the settlement terms is unclear. One of the considerations the SEC is said to be looking at is how potential fines would affect shareholders and creditors of WorldCom.

A deal could be announced within the next week or so. A WorldCom spokesman declined to comment.

On a separate front Monday, a special bankruptcy-court examiner accused WorldCom of a “smorgasbord” of fraudulent accounting adjustments and disclosed that ousted Chief Executive Bernard Ebbers personally guaranteed or pledged WorldCom stock in order to receive $1 billion in loans — an amount considerably higher than previously believed.

In a highly critical report that is the most sweeping to date of WorldCom’s massive accounting problems, former U.S. Attorney General Richard Thornburgh describes a company culture rife with conflicts of interest and lacking proper controls. Mr. Thornburgh, appointed in August by the bankruptcy court to examine wrongdoing, mismanagement and incompetence at WorldCom, found some of each.

The “report indicates a trifecta,” he said in an interview after releasing his 118-page preliminary document. Many details were excised from the report so that it doesn’t compromise continuing inquiries by the Justice Department and Securities and Exchange Commission, Mr. Thornburgh said.

The report, which also criticized the company’s outside auditors and Salomon Smith Barney’s former telecommunications analyst Jack Grubman, hints that the extent of the improper accounting at WorldCom, this time relating to revenue, could be more extensive than the $7.2 billion restatement the company already has said it will make. Now, the report indicates, WorldCom also is under fire for accounting methods used in recording revenue, an entirely new avenue for investigators. Those investigators also are looking at what the report refers to as “fraudulent journal entries and adjustments” made by WorldCom executives.

Details from the report also imply that Mr. Ebbers’s financial condition is greatly weakened. At the end of 2001, Mr. Ebbers’s net worth was $295 million while his stock holdings were valued at $286.6 million. Now that stock is worthless, leaving him with a net worth of $8.4 million, if all his other assets remained the same. Mr. Ebbers couldn’t be reached for comment.

The report also provides new details about Mr. Ebbers’s $1 billion in borrowings and makes the argument that the leverage Mr. Ebbers placed on his huge WorldCom holdings put the interests of WorldCom shareholders at risk since the company’s shares could plummet if he tried to sell the stock. “Furthermore by using his WorldCom shares to collateralize massive debt obligations, Mr. Ebbers placed himself under intense pressure to support WorldCom’s share price,” the report says.

In all, the report said, Mr. Ebbers personally guaranteed or pledged WorldCom stock as security for more than $1 billion in personal and business loans. The company itself lent Mr. Ebbers $415 million, which contributed to his ouster. Though the money was intended to help him cover margin calls on bank loans that he had collateralized with WorldCom stock, Mr. Ebbers, according to the report, used $27 million of the proceeds for other personal reasons.

According to the report, those personal uses included “payments of $1.8 million for the construction of his new house, $2 million to a family member for personal expenses, approximately $1 million in loans to his family, his friends, and a WorldCom officer, and payments of $22.8 million to his own business interests.” At the same time, the report notes, the company gave him loans before they were “reduced to writing” and some loan documentation may have been backdated.

In a statement, John Sidgmore, the current CEO, said: “We are working to create a new WorldCom. We have developed and implemented new systems, policies and procedures,” including doubling the internal-audit staff, to correct the company’s past problems and to ensure that they don’t recur.

Mr. Thornburgh portrays WorldCom, a telephone and data-services concern bloated by its speedy acquisition of more than 70 companies, as a company where management and internal controls couldn’t keep pace. He says the company’s board of directors and audit committee were ineffective while the compensation committee “seemed to abdicate its responsibilities to Mr. Ebbers.” Arthur Andersen LLP, the company’s external auditor, was too lackadaisical given WorldCom’s risk category, the report says, and one of its bankers, Salmon Smith Barney had a relationship so close that it is “potentially problematic.”

DECLINING REVENUE

By the second quarter of 2001, WorldCom’s revenue was declining, hurting its ability to meet quarterly revenue-growth targets, the report says. “Accordingly, the company undertook an analysis of ways to boost the company’s quarterly revenues. Ultimately, it appears that improper additions to revenue were later booked in connection with this process,” the report says.

The report also describes a series of false internal reports that were generated at WorldCom to support the doctored financial reports that would later be given to Wall Street. The report said Mr. Thornburgh who conducted interviews with employees and reviewed internal company documents would present his findings on the false entries later, “in deference to governmental investigations.”

Separately, other lawyers in the case have described the preparation of what amounted to a second set of books that were prepared for David Myers, controller, and Scott Sullivan, chief financial officer. At the end of each quarter, Buford Yates, director of general accounting, would prepare two charts, with one showing accurate results from operations. Next to those numbers would be a series of accounting adjustments necessary to hit Wall Street estimates. Mr. Yates would then prepare a second chart with doctored results after the adjustments had been made, these lawyers say. Those doctored results would then be presented to the public each quarter, they say.

The report also provides insight into the company’s “manipulation of reserve accounts” to meet Wall Street earnings estimates. Reserves are typically set up to meet certain expected, but not yet realized, costs. If reserves are determined to be in excess of what is needed, companies are allowed, under accounting guidelines, to “release” those reserves into earnings.

SEVEN ITEMS

Mr. Thornburgh is continuing to investigate the company’s accounting practices regarding the establishment of reserves for seven financial items, including reserves for taxes, depreciation, legal costs and bad debts, among others, the report says. The release of reserves added particularly heavily to the company’s earnings before interest, taxes, depreciation and amortization, or Ebitda, during 2000. In that year, the release of reserves added between $374 million and $661 million each quarter to the company’s reported Ebitda.

The Thornburgh report also chastises the company for limiting the role of its internal auditors to audits of the company’s operations. At the same time the report applauds three internal auditors who first investigated the company’s fraudulent accounting and brought the matter to light with the board and outside auditors.

The report also raises questions about whether Arthur Andersen, WorldCom’s auditors before its collapse, “should have done more to determine whether the risks of abuses were adequately taken into account” by the company. Arthur Andersen, according to the report, had identified WorldCom as a “maximum risk client.” It doesn’t appear, the report says, that Andersen took measures that were appropriate for the risk profile it ascribed to the company.

The report also points to Mr. Ebbers’s role in determining bonuses and other compensation for WorldCom executives. Though WorldCom’s disclosure documents suggest that bonuses were paid to top executives based on performance, the report says that Mr. Ebbers could adjust performance bonuses received by individual employees. “Some individuals, even at lower ranks, were paid massive performance bonuses equal to many times their base salaries, while others received bonuses equal to only a small percentage of their salaries.” Mr. Thornburgh intends “to inquire whether these bonuses were indeed based on quantitative performance factors or were used instead for some improper or other purpose.”

In his report, Mr. Thornburgh also discusses the relationship between WorldCom and former Salomon Smith Barney analyst Jack Grubman. The report reiterates much of the allegations previously leveled against Mr. Grubman and his former company: That Salomon granted Mr. Ebbers and WorldCom directors lucrative shares in initial public offerings in exchange for investment-banking business, which generated fees of $107 million for 23 deals between October 1997 and February 2002.

Vowing to investigate further, Mr. Thornburgh noted that Mr. Grubman routinely rated WorldCom stock as a buy and urged investors at one point to “load up the truck” with the company’s stock. He didn’t change his “risk factor” rating until a week after the SEC initiated an inquiry, the report said.

A spokeswoman for Citigroup, parent of Salomon, said that “in light of ongoing discussions with the various regulators, we are declining to comment.” A lawyer for Mr. Grubman couldn’t be reached.


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