Wednesday, April 8, 2015

Roll-Ups and Fraud - WorldCom


In Seven Ways to Fail Big, it is mentioned that many roll-ups are afflicted by fraud including MCI, WorldCom, Philip Services, and Tyco.  I am a Certified Fraud Examiner (ACFE designation), although fraud investigation is only loosely related to what I do now.  This was of particular interest to me.

According to Patrick Gaughan in Mergers, Acquisitions, and Corporate Restructurings, WorldCom was formed through a series of more than 40 acquisitions in the 1990s.  Most of the companies WorldCom acquired were regional resellers of long-distance telecomm.  Gaughan remarks that WorldCom CEO Bernie Ebbers was a successful dealmaker, but a lousy manager.  The Board of Directors was ineffective.  Eventually WorldCom became so big that antitrust regulators halted the proposed acquisition of Sprint.  Ultimately, management resorted to fraud to try to demonstrate profits it couldn’t actually achieve.  WorldCom eventually became the largest bankruptcy of all time.

The WorldCom fraud was not particularly complex in nature.  WorldCom simply made false accounting entries totaling 9 billion dollars over the course of about four years in order to report favorable financial results.  The report states in part,

The fraud was implemented by and under the direction of WorldCom’s Chief Financial Officer, Scott Sullivan. As business operations fell further and further short of financial targets announced by Ebbers, Sullivan directed the making of accounting entries that had no basis in generally accepted accounting principles in order to create the false appearance that WorldCom had achieved those targets. In doing so he was assisted by WorldCom’s Controller, David Myers, who in turn directed the making of entries he knew were not supported. This was easily accomplished, because it was apparently considered acceptable for the General Accounting group to make entries of hundreds of millions of dollars with little or no documentation beyond a verbal or an e-mail directive from senior personnel.

Since the fraud was occurring at the very top of the organization, almost nobody knew it was occurring.  The official SEC investigative report states that, while the fraud was implemented by others, it was Bernie Ebbers that instigated the fraud.  It further states that a lack of courage by other employees to blow the whistle led to its continuance over so many years.  Even professional audits by Arthur Anderson did not uncover the fraud (interestingly, AA also audited Enron).

This is a type of securities fraud.  As opposed to embezzlement fraud in which an employee misappropriates company resources for his own personal benefit, securities fraud is generally not conducted by individuals that receive immediate, direct financial gain as a result of their misdeeds.  However (as in most similar situations) the executives at WorldCom would ultimately benefit from the positive earnings reports in the form of a higher stock price and performance-based bonuses and raises.  

Generally, this type of fraud starts when a company finds it is underperforming in the short term.  For instance, WorldCom may have been missing earnings by a relatively small margin in a single financial quarter.  Several individuals may believe they can fudge the numbers by a relatively small amount and make up the difference in the next quarter.  Unfortunately, the company is then often unable to over perform to the extent required to ‘right’ the books.  Since there is no way to correct the books without revealing the fraud, it is nearly impossible for them to exit the scheme once it has started.  In addition, once the decision is made to falsify numbers to meet earnings, it seems to become easier to make the decision again.  Companies tend to continue the behavior over time, thereby widening the gap between actual earnings and reported earnings.

What is it about roll-ups that pave the way to fraud for some companies?  Given that companies attempting roll-ups are doing so in spite of the fact that the strategy is usually unsuccessful, it would seem that executives attempting rollups are, in general, likely to have a rosy perspective of their organization.  These individuals may be more likely to believe they can make up for false entries in the future.  It would also seem that forecasting earnings while executing a roll-up strategy would be especially challenging, and the company would therefore be more likely to miss earnings. 

 

Investigative Report

http://www.sec.gov/Archives/edgar/data/723527/000093176303001862/dex991.htm#ex991902_1

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