On November 4th, 1997, MCI and Worldcom merged in a deal worth $37 billion. This was an attempt by two large telecommunications companies to to combine and rival AT&T, but instead it turned into one of the biggest scandals and bankruptcies of its era. On July 21, 2002, the combined company went bankrupt, setting a record at the time as the largest bankruptcy in history.
In many ways, MCI represented the past while Worldcom represented the future. MCI specialized in selling long distance service to consumers. Worldcom sold long distance service too, but also sold high-speed data connections. Worldcom had purchased Compuserve’s network services business, among other acquisitions.
The long distance business model
MCI, along with AT&T and Sprint, was one of the largest providers of long distance telephone service. This is a business model that barely exists today, and there were signs even in the ’90s that it was running on borrowed time. But the merger made MCI Worldcom the second largest long distance provider at the time. Nearly two years later, Worldcom tried to acquire #3 Sprint to become larger than AT&T, but the US Department of Justice and European Union scuttled the deal due to antitrust concerns.
A landline type telephone could make unlimited local phone calls for free. What constituted a local phone call varied and was somewhat arbitrary. In Chicago, a local phone call might actually span multiple area codes because of the population density. Where I lived in St. Louis, the 314 area code covered more than just the St. Louis area. I could call exchanges within the same county for free, but I couldn’t call very far into neighboring counties for free. I had two friends who lived about 30 minutes away from me in essentially opposite directions. One of them was a long distance call and the other wasn’t, simply because one of the calls crossed a county border and the other didn’t.
It turns out I was an MCI/Worldcom customer. Not a super happy one. Here’s a very old blog post where I talked about that experience.
Profit margins
At one time, there was a lot of manual labor involved in making a phone call, with human beings having to physically plug and unplug wires from a switchboard to make the phone call happen. But by the ’90s, virtually all of it was automated, so companies like MCI could charge you around $0.10 per minute to make long distance phone calls and enjoy huge profit margins.
It was a business model ripe for disruption. Cellular providers would run advertisements telling college students and young professionals how they could save a lot of money by getting a cell phone and using it to make long-distance calls. I remember seeing those ads as early as 1993.
Against that backdrop in 1997, the MCI-Worldcom merger made sense. MCI still had some years of good profitability left before the general population switched from primarily using landlines to cellular. So it made sense to ride that out, plow the profits into other business models with better long-term growth, and build for the future.
But it became a problem when the growth didn’t happen fast enough.
The MCI Worldcom scandal
There were several accounting scandals that happened around the same time: Enron, Worldcom, and the accounting firm Arthur Andersen. Arthur Andersen was the common link between the two, as it was the accounting firm for both companies.
On July 13, 2000, the boards of directors of both MCI Worldcom and Sprint terminated their planned merger due to antitrust concerns. But that simply concealed a bigger problem, a problem of Worldcom’s own making. As early as mid-1999, CEO Bernard Ebbers, CFO Scott Sullivan, controller David Myers and general accounting director Buddy Yates started hiding WorldCom’s decreasing earnings to prop up the company’s stock price.
Loans to Worldcom CEO Bernard Ebbers
Between September 2000 and April 2002, Worldcom’s board of directors authorized several loans and loan guarantees to CEO Bernard Ebbers. The dotcom collapse was hurting Worldcom’s share price. These loans protected Ebbers from having to sell his shares to meet margin calls. By April 2002, the board had lost patience with these loans. Directors also believed that Ebbers lacked a coherent strategy after the Sprint merger collapsed.
On April 26, 2002, the board asked for Ebbers’ resignation. Ebbers formally resigned on April 30, 2002. As part of his departure, Worldcom consolidated Ebbers’s loans into a single $408.2 million promissory note. In 2003, Ebbers defaulted on the note and WorldCom foreclosed on many of his assets.
Suspicious balance sheet entries
In June 2002, a small team of internal auditors at WorldCom led by division vice president Cynthia Cooper and senior associate Eugene Morse started investigating suspicious balance sheet entries discovered during a routine capital expenditure audit. Ultimately they found $3.8 billion worth of fraudulent entries in WorldCom’s books. Cooper notified the company’s audit committee and board of directors in June 2002. The board forced Myers to resign and fired Sullivan when he refused to resign. Arthur Andersen withdrew its audit opinion for 2001. Worldcom admitted it overstated its assets by more than $11 billion.
It was the largest instance of accounting fraud in American history, exceeding the fraud uncovered at Enron less than a year earlier. It would remain the largest accounting fraud ever uncovered until the exposure of Bernard Madoff’s giant Ponzi scheme in 2008.
Just two years earlier, Worldcom was attempting the largest corporate merger in history. In 2002, it set two different records, both of which were more dubious.
Worldcom’s Bankruptcy
On July 21, 2002, WorldCom filed for Chapter 11 bankruptcy protection after laying off 17,000 employees. With $107 billion in assets and $30 billion in debt, it was the largest bankruptcy filing in United States history at the time, a record that stood for about six years. The bankruptcies of Lehman Brothers and Washington Mutual in September 2008 as a result of the mortgage crisis broke Worldcom’s dubious record. As part of the bankruptcy reorganization agreement, the company paid $750 million to the Securities and Exchange Commission in cash and stock in the new company, now called MCI, which was intended to be paid to wronged investors.
WorldCom agreed to pay a civil penalty of $2.25 billion to the U.S. Securities and Exchange Commission. The SEC and federal judge Jed Rakoff essentially took control of the scandal-ridden company. Rakoff appointed former SEC chairman Richard C. Breeden to oversee WorldCom’s compliance with the SEC agreement. Breeden took an active role in MCI’s management, proposing extensive corporate governance reforms, hoping to create a new model of how shareholders should be protected and how companies should be run.
MCI emerged from bankruptcy in 2004 with about $5.7 billion in debt and $6 billion in cash. About half of the cash was intended to pay various claims and settlements. Previous bondholders ended up being paid 35.7 cents on the dollar in bonds and stock in the new MCI company. The previous shareholders’ stock was cancelled.
In January 2006, Verizon Communications acquired MCI and later integrated it into Verizon Business. Instead of being bigger than Verizon, Worldcom ended up being part of Verizon.
Criminal fallout from the Worldcom accounting scandal
Six former Worldcom executives were found guilty of criminal charges related to the accounting scandal.
On March 15, 2005, Bernard Ebbers was found guilty of all charges and convicted of fraud, conspiracy and filing false documents with regulators. Former CFO Scott Sullivan pleaded guilty on March 2, 2004, to one count each of securities fraud, conspiracy to commit securities fraud, and filing false statements. Former controller David Myers pleaded guilty to securities fraud, conspiracy to commit securities fraud, and filing false statements on September 27, 2002. Ex-accounting director Buford Yates pleaded guilty to conspiracy and fraud charges on October 7, 2002. Finally, former accounting managers Betty Vinson and Troy Normand both pleaded guilty to conspiracy and securities fraud on October 10, 2002.
On July 13, 2005, a federal judge sentenced Bernard Ebbers to 25 years in a federal prison in Louisiana. Ebbers was 63 years old. He appealed, allowing him to remain free another year. On September 26, 2006, Ebbers drove himself to prison. He was released in late 2019 for health reasons and died February 2, 2020, having served 13 years of his sentence.
David Farquhar is a computer security professional, entrepreneur, and author. He has written professionally about computers since 1991, so he was writing about retro computers when they were still new. He has been working in IT professionally since 1994 and has specialized in vulnerability management since 2013. He holds Security+ and CISSP certifications. Today he blogs five times a week, mostly about retro computers and retro gaming covering the time period from 1975 to 2000.
Great reading Dave!!