BUSI-1410: Strategy and Transformation Course
Final Assignment: WorldCom case study
Richard Meredith 000690770
April 2012
Contents
Summary ................................................................................................................................................ 3
M&A case study: WorldCom Inc ............................................................................................................ 3
The key governance issues at WorldCom .............................................................................................. 4
Research questions ................................................................................................................................ 5
Academic theory .................................................................................................................................... 5
(a)
Corporate Governance theory ................................................................................................ 5
(b)
Corporate social, ethical and morality theory ........................................................................ 6
Application of theory at WorldCom....................................................................................................... 7
(a)
Risk oversight .......................................................................................................................... 7
(b)
Strategy ................................................................................................................................... 8
(c)
Executive Compensation ......................................................................................................... 8
(d)
Transparency ........................................................................................................................... 8
Conclusions ............................................................................................................................................ 9
Word Count .......................................................................................................................................... 10
Appendix: US Key Agreed Principles .................................................................................................... 11
Bibliography ......................................................................................................................................... 12
Summary
The craft and execution of a Merger & Acquisition (M&A) strategy is a recognised and sustainable
method to grow a firm (Drucker, 1981) (Trautwein, 1990). But is that also true if the two key
executives responsible for the corporate strategy and an external market analyst/ investment
banker have unprincipled business ethics and morals? What protections insure stakeholders? Is
the societal environment a defining factor?
This essay will examine these questions with a US case study of 1995-2002 WorldCom Executives
Bernie Ebbers (CEO), Scott Sullivan (CFO), and telecoms market analyst at Salomon Smith Barney,
Jack Grubman. Its purpose is to explore the mechanisms in the governance chain that should have
prevented what happened at WorldCom.
The underlying issue is whether the firm has broader
societal obligations as well as an economic one of creating wealth for its owners. This essay will
conclude that systemic checks and balances are no substitute for integrity in the senior agents of
the shareholders in a US society that didn’t challenge people who appeared to embody the
American Dream.
M&A case study: WorldCom Inc
Drawing on Malik (2003), Sidak (2003) , Gollakota & Gupta (2004), Zekany et al (2004), Boyd (2003),
Sadka (2006), Advameg (2007), and Clarke (2007), the salient facts about this case study were as
follows.
Long Distance Discount Services (LDDS) Inc. was established as a private company in 1983 in
Hattiesburg, Mississippi, when the breakup of regulated business of the national telephone Bell
system opened the market to alternative carriers to sell discount long-distance telephone call
routing to individual and business customers. After 2 years of losses, Bernard Ebbers (one of the
initial investors) became CEO of LDDS and turned around the company and made it profitable in 6
months. The acquisition of LDDS’ first competitor took place in 1987 and five further M&As by
1989 had achieved an annual profit of $4.5m and access to business customers in the states of
Alabama, Arkansas, Indiana, Kansas, Kentucky, Missouri, Tennessee , and Texas. One of these
acquisitions turned LDDS into a public company and, through that change, Ebbers began a
relationship with Wall Street financial analyst Jack Grubman, who endorsed and encouraged the
M&A strategy at LDDS.
Twenty five M&As later, in 1993, the firm’s network included all 48 mainland US states and was
renamed LDDS-Metro Communications Inc. One of those acquisitions brought with it Scott Sullivan
who became CFO of the company in 1994. In December 1994, IDB WorldCom was purchased and
the named changed from LDDS-MCI to WorldCom Inc. At the same time, Jack Grubman joined
Salomon Brothers.
At the end of 1995, WorldCom turnover was $3.9b and it had debt of $3.4b and with the advent of
internet and broadband, acquired MFS Communications in 1996 to be a pioneering Internet
provider, outbidding British Telecom PLC to merge with Microwave Communications Inc (MCI).
Thanks to recommendations by “independent” analyst Jack Grubman, shares in the company
peaked at $64.50 in 1999. By 2000, WorldCom turnover was $39.1b; it had debt of $24.8b and had
bought over 60 companies.
By late 2001, US telecoms firms had added significant capacity in networks, based on the
assumption of exponential world-wide demand for data traffic, and that their brand new networks
would be needed to carry that data. This left the industry facing chronic overcapacity and overinflated revenue forecasts – made worse by a world economic downturn. In February 2002, Arthur
Andersen LLP approved the 2001 WorldCom accounts. In March 2002, following a whistleblower
report from the WorldCom head of Internal Audit, the US Securities and Exchange Commission
(SEC) commenced an investigation into the accounting practices of WorldCom, including $400m
personal loan to Ebbers collaterised by WorldCom stock. In June 2002, WorldCom admitted that
its 2001 accounts needed to be restated because of accounting irregularities (eventually backdating
much further and amounting to nearly $11b of irregularities). Trading in WorldCom's stock was
suspended on 26th June 2002, SEC filed civil fraud charges against the company, Chapter 11
bankruptcy protection was filed, and as a result, 20,000 employees lost their jobs and shareholders
(including many pension schemes) lost about $180b.
In 2004, the company emerged from Chapter 11 bankruptcy protection in the name MCI and $5.7b
in debt and $6b in cash. Sullivan received a 5 year sentence for securities fraud in return for
testifying against Ebbers, who got 25 years. Jack Grubman was fined $15m and received a lifetime
ban from securities transactions by the SEC (although he reportedly still had net worth of $75-100m
after paying the fine). WorldCom’s auditors, Arthur Andersen paid $65 million in damages and
WorldCom’s investment bankers Citicorp (parent of Salomon Brothers) settled for $2.65b for
conflict of interest.
The key governance issues at WorldCom
The firm used (a) heroic and aggressive projections about consumer and business demand for
telephony and internet and (b) fraudulent accounting methods to paint a false picture of financial
growth and profitability to match Wall Street expectations, to which all top executive compensation
and bonuses were dependent and whole company culture was geared. This was achieved with the
explicit assistance of analyst Grubman, implicit poor auditing by Andersen, all overseen by a
complicit Board (worldcomlitigation, 2003). The fraud was accomplished by withholding
information and by underreporting costs and by inflating revenues with bogus accounting entries
(breaching generally accepted accounting practices (GAAP)). The Internal Audit Function at
WorldCom was kept away from finance audits by the CEO/CFO, who instructed them to focus on
operational audits, and avoid working on anything that might overlap with the role of the external
auditors, Arthur Andersen.
Research questions
What could have been done to prevent the fraud?. How could corporate ethics have played a part
in this failure? What difference would have been if guidelines and directions on business ethics for
corporate and accounting responsibility had existed at WorldCom in 1995-2002? Summing up what mechanisms in the governance chain that should have prevented what happened at
WorldCom?
Academic theory
(a) Corporate Governance theory
Economic theories focus on prices in a competitive market but treat the firm as a black box (Priem
& Butler, 2001). Manne (1965) argued that these market forces were a key element of corporate
governance, later echoed by Jensen (1986), and Walsh & Seward (1990). Shleifer & Vishny (1997)
defined the means established by investors to assure themselves about the return on their
investment as “corporate governance”.
Agency theory has been at the centre of research about ownership and control of the firm and
what owners should do to align the objectives of their various agents with wealth creation beyond
leaving the pressures of competitive markets (Jensen, 1983), (Perrow, 1986). Relevant to the case
study were that company directors do not always act in the shareholders’ best interest (Jense &
Meckling, 1976) and those managers pursue their self-interests (Fama & Jensen, 1983).
Eisenhardt (1989) reviewed academic work in the disciplines of accounting, economics, finance,
marking, political science, organisational behaviour and sociology and concluded that agent theory
should be considered as complimentary theory when examining the factors that influence the
relationship between the principal and the agent(s).
Hill & Jones (1992) extended agency theory to create a stakeholder-agency paradigm which
encompassed the implicit contractual relationships between managers and stakeholders in general
and not just shareholders. This is founded on the existence of a resource exchange relationship
(Freeman, 1984) (Pearce, 1982). Within this implicit contractual relationship, each of the
stakeholders supplies the firm with critical resources in exchange for their interests being met
(March & Simon, 1958) and thus managers of the firm are agents of the stakeholders (principals),
not just the shareholders (Hill & Jones, 1992). Pulled together into an overall a new stakeholder
view of the firm and a sustainability evaluation and reporting system by Perrini & Tencati (2006).
In that context, a stakeholder includes employees, regulators, suppliers, communities, clients, as
well as investors/shareholders (Maignan et al., 2011).
(b) Corporate social, ethical and morality theory
Ever since two seminal books – by Barnard (1938) and by Bowen (1953), the academic world has
been divided on the responsibilities of the firm to wider society. Garriga & Melé (2004) usefully
classified the theories into groups - see figure 1.
Instrumental theories
• meeting objectives that produce long-term profits, the firm is an
instrument for wealth creating and any social activities simply a means to
that end
• promoted by the likes of Friedman (1970) and Porter & Kramer (2002)
Political theories
• using business power in a responsible way, the firm is focused on
interactions and connections between business and society and on the
power and position of business and its inherent responsibility Corporate Constitutionalism and Corporate Citizenship
• promoted by Davis (1960) and Donaldson (1982);
Integrative theories
• integrating social demands, the firm is focused on satisfying social
demands
• promoted by Ackerman (1973), Jones (1980) and Caroll (1991);
Ethical theories
• contributing to a good society by doing what is ethically correct, the
normative core of ethical principles of the firm to society/stakeholders
• promoted from Kantian, Rawlsian and Libertarian theories by Freeman
(1984) and others
Plus
• human rights (Carroll, 1991)
• sustainable development (Wheeler et al., 2003);
• common good – global set of ethical principles (CRT, 2010)
Figure 1: Source derived from Garriga & Melé (2004)
Pae & Choi (2011) were among the first academics to examine corporate governance (CG) practices
and business ethics (BE) in relation to the value of the firm (specifically how it affects the cost of
capital). The financial crisis is Asia in 1997 stimulated significant financial economic and
governance reform in Korea and this was considered to be a useful precedent for the collapses in
arising just before and after the global financial crisis. Because investors considered that good
index ranking for CG and BE reduced their risk in a Korean firm, this affected the present value of
future expected cash flows. They concluded “The identification of the benefits of more
comprehensive CG and BE justifies managers’ time and effort to improve CG and protect ethical
values. Managers may allocate their scarce resources more efficiently to improve the long-run value
of their company” (p342).
Dyck (2001) considered that a formal governance chain has five links: (a) legal institutions to
separate powers among executive, legislative and judicial authorities; (b) independent boards to
monitor management, recruit executives, set compensation policy and handle dismissals (OECD
(2004) recommended more independent directors on the main board and key activities); (c) legal
institutions to require disclosure of information and accountability to investors; (d) financial
organisations to monitor firms and be information intermediaries; (e) regulatory organisations.
Nevertheless, there is no single or ideal model that has been created from the constantly evolving
corporate governance theories. But the general standard is that the structures, processes and
practices – or governance chain (Dyck, 2001) – should be designed specifically for the circumstances
of the firm, cognisant of sets of territory, country, global guiding principles, the relevant laws and
national and international standards. For example, United Kingdom opted for a principles-based
approach, while the United States a rules-based approach emanating from the Sarbanes-Oxley Act
2002.
Application of theory at WorldCom
The analysis will focus on the US jurisdiction relevant to WorldCom (evidence and testimonies
(FindLaw, 2004)), where corporate law provided for a fiduciary duty on directors to act honestly
and in good faith and to avoid conflicts of duty and self interest while acting in the best interests of
the corporation. But it will test retrospectively, applying the key agreed principles for US publicly
traded companies (NACD, 2011) – see appendix – and use the structure of four areas expanded
upon by NACD in a white paper (2009).
(a)
Risk oversight
The NACD Standard for this aspect of governance is that the Board assigned risk oversight
responsibilities, established risk identification procedures, evaluated risk models, and improved
overall information flow. The Interim Report of the Bankruptcy Examiner revealed a pattern of
failures to meet the fundamental stakeholder-agency paradigm (Hill & Jones, 1992), in that the
agent (CEO) completely dominated the principal (board of directors) to the extent that “critical
questioning was discouraged, and the Board did not appear to evaluate proposed transactions in
appropriate depth, even though several members of the Board had a significant percentage of their
personal wealth tied to the value of the Company’s stock.” (Thornburgh, 2002, p.7). The control
environment was not robust and therefore weaknesses and risks were not identified/ranked and
mitigated. For example (a) inadequate segregation of duties in the finance function in respect of
reconciliation and journal preparation and reviews; (b) lack of rigorous monitoring of the internal
control system by internal audit; (c) the procedures for external audit did not match the risk profile
that Andersen has assessed for the company (Thornburgh, 2002, p.7).
(b)
Strategy
The NACD Standard for this aspect of governance is that the Board has the right information to help
the firm successfully plan its way through the marketplace - to help management determine how
the company should react in response to the information, over short, medium, and long term
timeframes. There was no strategy (Mintzberg & Waters, 1985). “WorldCom grew in large part
because the value of its stock rose dramatically. Its stock was the fuel that kept WorldCom’s
acquisition engine running at a very high speed. WorldCom needed to keep its stock price at high
levels to continue its phenomenal growth. WorldCom did not achieve its growth by following a
predefined strategic plan, but rather by opportunistic and rapid acquisitions of other companies.
The unrelenting pace of these acquisitions caused the Company constantly to redefine itself and its
focus. The Company’s unceasing growth and metamorphosis made integration of its newly acquired
operations, systems and personnel much more difficult. This dramatic growth and related changes
also made it difficult for investors to compare the Company’s operations to historical benchmarks”
(Thornburgh, 2002, p.6).
There is no evidence of systematic consideration of all possible external forces (Political, Economic,
Social, Technological, Environmental, or Legal) before setting aggressive targets. Economic
conditions were not considered when implementing aggressive accounting measures. The industry
competition was in decline. The firm’s unit where acquisition due diligence was undertaken
(Corporate Development) was never subject to an Internal Audit.
(c)
Executive Compensation
The NACD Standard for this aspect of governance is of independence of the compensation
committee and its advisors, and more proactive shareholder communications. “The Compensation
and Stock Option Committee of the Board of Directors seemed largely to abdicate its responsibilities
to Mr. Ebbers. It approved compensation packages that appear overly generous and
disproportionate to either the performance of the Company or competitive pressures” (Thornburgh,
2002, p.7). The Directors authorised personal loans that totaled $400m to the CEO, secured
against plummeting stock value. The culture and incentives led to dishonest, illegal and unethical
activities - focus was put on employees to behave as a strong “team player”, with the CEO
reviewing the names of all stock sales and taking a dim view of any staff he found to have exercised
their right to sell. This was a tactic to reduce dissenting opinions, and to a patriarchal “groupthink”
organisation. Examples of this were absolute discretion to the CEO on a $240m bonus program in
2000. The CFO gave $10k to several employees and their spouses in the Finance and Accounting
Department.
(d)
Transparency
The NACD Standard for this aspect of governance is of corporate transparency through a
combination of increased communication and legal protections. “WorldCom's conferral of
practically unlimited discretion upon Messrs. Ebbers and Sullivan, combined with passive acceptance
of Management’s proposals by the Board of Directors, and a culture that diminished the importance
of internal checks, forward-looking planning and meaningful debate or analysis formed the basis for
the Company’s descent into bankruptcy” (Thornburgh, 2003, p.12). There was no evidence of
independent review of financial reporting controls and CEO and CFO knowingly reported
information to their stakeholders, including employees and shareholders that lacked GAAP
authority and integrity. They communicated false targets and outcomes to Wall Street to ensure
the stock price of WorldCom continued to escalate and consequently decided to use a wide range
of accounting measures to meet these targets. Internally, communication was poor “Mr. Ebbers
ran WorldCom as if it were a “7-11”” (Thornburgh, 2003, p.72).
Conclusions
The purpose of this essay was to explore the mechanisms in the governance chain that should have
prevented what happened at WorldCom.
The analysis shows the legal institutions to separate powers among executive, legislative and
judicial authorities in US were in place. The requirement for independent boards to monitor
management, recruit executives, set compensation policy and handle dismissals were in place but
failed because of too much deference to two executives with a significant imbalance in incentives.
The legal institutions requiring disclosure of information and accountability to investors were in
place, but the checks and balances failed to correct two unethical/fraudulent execs with unlimited
power. The financial and regulatory organisations to monitor firms and be information
intermediaries were in place, but again the checks and balances failed to correct two
unethical/fraudulent advisers/auditors with unlimited power .
So many aspects of the formal governance chain (Dyck, 2001) were in place, but human failing
caused many links to all fail at the same time and the systemic checks that the governance chain
provided were unable to detect that the senior agents of the shareholders had lost their integrity.
Suppliers will have suspected. Employees will have suspected. Community via ex-employees and
of acquired firms and family members will have suspected. But wider US society had for too long
celebrated the key offenders as people who embodied the spirit of the American Dream.
On balance, therefore, it is considered that no new mechanisms in the governance chain could have
prevented what happened at WorldCom. It is therefore fitting to find the former Chief Legal
Officer of GE (Heineman, 2008) argue that Boards must look for a new higher standard of CEOs –
those who demonstrate they have high personal integrity and a deep cultural commitment to
achieve high performance with high integrity.
To conclude, two quotes from the Bankruptcy Court Examiner provide the grounds for considering
that this case study was about circumstances rather than system.
“When Arthur Andersen was replaced by KPMG as the Company's external auditors, a former
Arthur Andersen engagement partner who had accepted a position as a partner at KPMG reassured
Mr. Sullivan that he would continue to "monitor" the engagement "from a distance to make sure
the engagement [was] conducted to [Mr. Sullivan's] satisfaction" even though he no longer
participated on the engagement based on SEC rules requiring rotation from the engagement after 7
years. He reminded Mr. Sullivan that, in the past he had been able to "work" his reviewing partners
"hard" in order to get "good" answers on accounting questions that needed to be reviewed by
partners in Arthur Andersen's National practice office in Chicago. He committed to doing the same
at KPMG once he got to know the KPMG team, and to eventually return to the engagement in two
years as the "lead partner." KPMG categorically rejected these reassurances to Mr. Sullivan once the
new KPMG engagement partner learned of them. The former Arthur Andersen partner is no longer
with KPMG” (Thornburgh, 2003, p.208).
“In many significant respects, WorldCom appears to have represented the polar opposite of model
corporate governance practices during the relevant period. Its culture was dominated by a strong
Chief Executive Officer, who was given virtually unfettered discretion to commit vast amounts of
shareholder resources and determine corporate direction without even the slightest scrutiny or
meaningful deliberation or analysis by senior Management or the Board of Directors. The Board of
Directors appears to have embraced suggestions by Mr. Ebbers without question or dissent, even
under circumstances where its members now readily acknowledge they had significant misgivings
regarding his recommended course of action. Moreover, the Directors unquestioningly complied
with Mr. Ebbers’ requests, even when it became apparent that his deteriorating personal financial
situation imperiled the Company and greatly undermined their confidence in him. Although the
absence of internal controls and the lack of transparency between senior Management and the
Board of Directors at WorldCom does not directly translate to the massive accounting fraud
committed by the Company, the Examiner believes these corporate governance failings fostered
an environment and culture that permitted the fraud to grow dramatically and ultimately
propelled the Company’s descent into bankruptcy. A culture and internal processes that discourage
or implicitly forbid scrutiny and detailed questioning can be a breeding ground for fraudulent
misdeeds. It also can beget ill-considered and wasteful acquisitions, improperly managed and
unchecked debt and poor credit management, a lack of due diligence regarding personal loans
made by the Company to its Chief Executive Officer, sales of Company stock by the Chief Executive
Officer that contravene WorldCom policy and possibly the federal securities laws, and an effective
neutering of other gatekeepers, such as the lawyers, Internal Audit Department and the Company’s
outside auditors. In tandem with the accounting irregularities, these developments fostered the
illusion that WorldCom was more healthy and successful than it actually was throughout most of
the relevant period. Ultimately, they also produced the largest bankruptcy in the history of the
United States”. (Thornburgh, 2003, p.217)
Word Count [3,608 words excluding bibliography]
Appendix: US Key Agreed Principles
Figure 2: Source: NACD (2011)
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