Five Lessons of the WorldCom Debacle

Five Lessons of the WorldCom Debacle By Steve Rosenbush

The rise and fall of WorldCom founder Bernard Ebbers likely will be studied for years to come. Certainly, Ebbers' Mar. 15 conviction on nine counts of fraud, conspiracy, and filing false documents marked a major victory in the government's war on white-collar corruption (see BW Online 3/16/05, "Ebbers: Giant Fraud, Simple Conclusion"). Ebbers' "I-knew-nothing-about-the-books" defense failed to persuade the jury. "This is absolutely going to raise the level of expectation that CEOs should know everything that's going on inside their companies, because they will be held responsible for it," says Dan Reingold, a former telecom analyst with Credit Suisse First Boston. WorldCom's collapse already has had a profound impact on the business climate in the U.S. It was one of the major reasons lawmakers passed the Sarbanes-Oxley Act, which requires companies to share more information with investors, says Reingold, who witnessed the trial and plans to publish a book on it later this year. But WorldCom was more than just a tale of lax accounting principles or substandard reporting requirements. Some important lessons can be gleaned from the testimony in the trial for investors, B-school students, and aspiring execs alike. Here are five: Beware of companies with cult-like corporate cultures. From the start, telecom upstart WorldCom functioned more like a tribe than a business. Its operations centered around a charismatic leader, the imposing former basketball coach Ebbers. If Ebbers was the oracle, Chief Financial Officer Scott Sullivan was his high priest. Together, they exercised unquestioned authority and demanded unquestioned loyalty from employees. Both men imbued WorldCom shares with enormous symbolism. Each employee received a grant of stock, a form of initiation into the tribe. But the culture created by Ebbers and Sullivan prevented them from selling the stock, lest the employees be ostracized from the group, according to testimony at the trial. This closed culture turned out to be dangerous. The jury found that Ebbers and Sullivan compelled their subordinates to cook the financial books to protect their sacrosanct stock. Subordinates said they simply concluded that the accounting manipulations must be legitimate, because their infallible leadership had approved them. And the penalty for challenging their authority was excommunication. That allowed the blatant fraud to go on for seven quarters, with the participation of at least a half-dozen key executives. In truth, WorldCom wasn't solely to blame for this situation. Investors, analysts, and the media also bought into its corporate mindset. Some viewed it as heroic. Everyone lost sight of a simple, mundane reality: It was a publicly traded company, just like any other. Beware of too much corporate reliance on Washington. WorldCom, like many telecom companies, spent an enormous amount of time and energy lobbying regulators and elected officials. The telecom boom led by WorldCom was driven mostly by the government-ordered breakup of AT&T (T) in 1984 and the Telecom Act of 1996. As an upstart, WorldCom benefited from rules that helped it compete. But when the rules unexpectedly changed, it found itself in trouble, ultimately pulling out of the consumer market.

Investors should be very wary of industries that have high exposure to government policy, which can shift as quickly as the political winds. The climate becomes even more treacherous when the government tries to pick winners and losers. As an industry, telecom has long favored big companies that can distribute fixed costs over a huge base of customers. But with telecom reform, federal policymakers tried to nurture a vision of open competition that ultimately didn't make economic sense. Too many poorly funded rivals were encouraged to enter the market. That led to overcapacity -- and financial disaster for some. Beware of companies that rely too heavily on mergers and acquisitions. There's no question that M&A is a legitimate means of growth for many companies. But when a corporation like WorldCom, which did nearly 70 deals in less than five years, bases its business plan on acquiring even more companies, that's a flashing yellow light. It's a strong signal that the other engines of growth, such as product development, sales, and marketing, aren't very strong. If the M&A machine stallS, as WorldCom's did, the company could wind up in real trouble. And the accounting surrounding M&A activity raises other risks, because it's very hard to compare the performance of ongoing operations from one quarter to the next -- the surest metric of corporate health. Plus, the constant write-offs of good will, which reflects the premium that an acquiring company pays on a purchase, distorts quarterly earnings and can lead to confusion. The hares need as much watching as the tortoises. Everyone loves an amazing success story. But just as investors are usually wary of the worst-performing company in a group, they ought to approach the biggest winners with caution, too. Certainly, examples are plentiful of companies that dramatically raced ahead of their rivals thanks to legitimate means, such as introducing new products or exercising more astute management. But investors must remember that companies in a specific sector -- in this case, telecom -- are generally subject to the same rules and market conditions. When a company like WorldCom, which promised inordinate revenue growth and enjoyed some of the best stock returns of any company, comes along, investors, analysts, and journalists must demand a rigorous explanation of the exceptional results. Sometimes they turn out to rest on a shaky foundation. Enron boasted of outperforming its rivals in dramatic ways, too. Beware of close personal ties between management and the board. Most of WorldCom's directors had been with the company for years. Many of them invested in the company at the founding, or led companies that WorldCom acquired. All of them received significant amounts of stock and in some cases enjoyed perks like the use of corporate jets. Yes, their share values dropped, too, like everyone else's, when WorldCom hit the skids, and there's no suggestion that any were aware of fraud. Still, close ties didn't help the board when it came to asking tough questions about the company's accounting, or probing the wisdom of Ebbers' strategy, or offering hundreds of millions of dollars in loans to Ebbers, their benefactor and CEO. The biggest lesson. The most haunting of them all, it's the image of Ebbers sitting in that old Manhattan courtroom, stoically contemplating his fate before the jury returned its verdict. It's no place

any CEO would ever want to be. Rosenbush is a senior writer for BusinessWeek Online in New York