Bernard Ebbers — an expense relabeled as an asset, eleven billion times

Summary

In a federal courtroom in Manhattan, on March 15, 2005, a jury convicted Bernard Ebbers, the founder and former chief executive of the telecommunications giant WorldCom, of orchestrating what was then the largest accounting fraud in United States history. The company he had built through a frenzy of acquisitions had concealed roughly eleven billion dollars in losses by the simple expedient of treating ordinary operating expenses as if they were long-term investments, a reclassification that turned mounting deficits into reported profits and kept the stock aloft until the arithmetic gave way.

The verdict was complete. After a six-week trial and eight days of deliberation, the jury found Ebbers guilty on all nine counts: one of conspiracy, one of securities fraud, and seven of making false filings with regulators. On July 13, 2005, U.S. District Judge Barbara Jones sentenced him to twenty-five years in federal prison, a term that, given his age, amounted to a likely life sentence and signaled a new judicial severity toward executives who presided over large corporate frauds in the wake of Enron.

The fraud's scale was measured in the eventual collapse it produced. When WorldCom filed for bankruptcy protection on July 21, 2002, it listed roughly $107 billion in assets, making it the largest corporate bankruptcy the country had yet seen. The accounting deception that precipitated the fall, initially uncovered as about $3.8 billion in misclassified costs, was ultimately found to have inflated the company's reported assets by approximately $11 billion before it was exposed.

What distinguished the WorldCom fraud was its crude simplicity. There was no exotic instrument and no offshore labyrinth of the kind that characterized Enron; there was an accounting entry, repeated quarter after quarter, that moved everyday costs off the income statement and onto the balance sheet. The largest such cost was the fee WorldCom paid other carriers to route its calls, and by capitalizing those line costs rather than expensing them, the company manufactured profits that did not exist until an internal auditor, working quietly at night, found the entries and refused to look away.

Timeline

The Acquisition Machine

WorldCom was, in its essence, a creature of acquisition. Ebbers had assembled it not by building infrastructure organically but by buying company after company, dozens in all, culminating in the roughly $40 billion purchase of MCI in 1998. The strategy worked only so long as the share price kept climbing, because the stock was the currency with which the deals were financed and the metric by which the market judged the enterprise. Growth was not merely desirable; it was structurally necessary.

When the telecommunications boom turned to bust around 2000, that machine lost its fuel. Revenue growth slowed and a planned merger with Sprint was blocked by regulators. WorldCom now faced the predicament its strategy had made dangerous: a company built to grow, whose valuation presumed growth, confronting an industry-wide contraction. The gap between what Wall Street expected and what the business could deliver became the pressure under which the fraud took form.

Ebbers's own finances tightened the vise. He had borrowed heavily against WorldCom shares to fund outside ventures ranging from timberland to a yacht-building business, and the board had extended him hundreds of millions of dollars in loans to forestall margin calls as the stock wavered. A falling share price thus threatened not only the company's strategy but its chief executive's personal solvency, aligning his incentives with the imperative to make the numbers appear better than they were.

The Entry That Made Losses Vanish

The mechanism of the fraud was almost banal in its mechanics, which is what made it so large. WorldCom's single biggest cost was the set of fees it paid other telecommunications companies to carry its traffic over their lines, an ordinary operating expense known as line costs. Under standard accounting, such costs are subtracted from revenue in the period they are incurred, reducing reported profit. Beginning around late 2000, WorldCom instead recorded large portions of these costs as capital expenditures, the kind of long-term investment that is spread out over many years rather than charged against current earnings.

The effect was to make current losses disappear. By the logic of the maneuver, money spent renting other carriers' networks was treated not as the cost of doing business but as the purchase of an enduring asset, which let WorldCom report healthy operating margins while its actual results deteriorated. The reclassification was supplemented by a second technique, the inflation of revenue through entries drawn from vague "corporate unallocated" reserve accounts. Together the methods could manufacture close to a billion dollars of phantom profit in a single quarter, and they were repeated across successive reporting periods.

The fraud's crudeness was, paradoxically, its strength and its weakness. It required only the willingness of senior finance officials to make and conceal improper entries, which made it easy to execute and easy to scale. But it also left a clear trail in the company's own books, a set of large, anomalous capitalizations that any determined examiner could find. The deception's survival depended not on its complexity but on no one with access and authority choosing to investigate, an assumption that held until it did not.

The Five Factors

Aftermath

The collapse inflicted broad and lasting damage. WorldCom's shareholders, including pension funds and ordinary investors who had held what was considered a blue-chip telecommunications stock, lost tens of billions of dollars in market value, and thousands of employees lost their jobs as the company restructured. The bankruptcy, the largest in the nation's history when it was filed, became a symbol, alongside Enron, of an era of corporate financial deception, and it hardened public demand for accountability at the top of large companies.

The institutional response reshaped corporate governance. WorldCom emerged from bankruptcy reorganized under its old MCI name, relocated, and was acquired by Verizon Communications in 2006, ending its independent existence. More durably, the back-to-back scandals of Enron and WorldCom drove the passage of the Sarbanes-Oxley Act of 2002, which imposed new requirements for the certification of financial statements by chief executives and chief financial officers, strengthened the independence of audit committees, and created the Public Company Accounting Oversight Board to police the auditors themselves.

For the individuals, the reckonings varied with their cooperation. Scott Sullivan, who pleaded guilty and testified against his former chief, received five years, a fraction of Ebbers's term, reflecting the value the government placed on his testimony. Ebbers surrendered to federal prison in 2006 after his appeal to the Second Circuit failed. He served thirteen years before being granted compassionate release in December 2019 owing to severe deterioration in his health, including dementia and near-blindness, and he died weeks later, on February 2, 2020, at the age of seventy-eight.

Lessons

References

• Bernard Ebbers WIKIPEDIA
• WorldCom WIKIPEDIA
• Scott D. Sullivan WIKIPEDIA
• Bernard Ebbers, ex-CEO convicted in WorldCom scandal, dies CNBC