Was the WorldCom Scandal an Effect of its Quality of Board and Committee Structure?

Was the WorldCom Scandal an Effect of its Quality of Board and Committee Structure?

Manuëla Dagmar Belder

University of Maastricht

Abstract

WorldCom, one of the world’s largest telecommunication companies, filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code on July 21, 2002. The company manipulated its financial data between 1999 and 2002 totaling 3.8 billion dollars of fraudulent balance sheet entries. Bernard Ebbers, the CEO of WorldCom, was sentenced to twenty-five years in prison for fraud. The purpose of this paper is to understand if the quality of the board of WorldCom might help to explain its fraudulent activities. Therefore, this paper compares the board of directors and its committees to how an ideal board should look like, as described in various literature works.

Keywords: board of directors, board committees, board size, board composition, board leadership structure, board meetings, director and executive’s compensation

Introduction

WorldCom used to be one of the world’s largest telecommunication companies, however, it is now known as one of America’s largest accounting scandals. Between 1999 and 2002, the company manipulated its financial data by inflating its earnings in order to increase WorldCom’s stock price.  In June 2002, Vice President Cynthia Cooper discovered over 3.8 billion dollars of fraudulent balance sheet entries. This paper discusses whether the quality of the board of directors made this scandal possible.

When studying American boards, Lorsch and MacIver (1990) have discovered that directors acted more like puppets of their CEO instead of monitoring the company unrestrained. So, what makes a good board? According to Berghe and Levrau (2004), the quality of a board of directors is most effected by its; board size, board composition, board leadership structure, director and executive compensation, board committees, and its board meetings.

1. Board size

According to Coles, Daniel and Naveen (2008) either very small or very large boards are optimal due to the relation between Tobin’s Q and board size. Tobin’s Q increases in board size for complex firms because these firms have greater advisory needs and, thus, are supported by outside directors. However, if firm-specific knowledge is important, Q is positively related to the fraction of insiders on the board.

In 2001, the board of WorldCom consisted of thirteen directors (Exhibit 1). Graph 1 depicts that for a complex firm – such as WorldCom – a board size of twelve directors is optimal, inconsequential of whether deviations are random or not. Therefore, the board of directors of WorldCom is not fully optimal, as it is slightly too large (Coles, Daniel & Naveen, 2008).

2. Board composition

The monitoring effect theory claims that outside directors are superior in monitoring a company – their careers do not depend on the firm’s CEO (Dionne & Triki, 2005). They also feel freer to express opinions that contradict the CEO, as they have incentives to build a credible reputation as an expert monitor (Dionne & Triki, 2005).

In 2001, the board of WorldCom consisted of more non-executive directors than executive directors, also known as ‘professional boards’ (Tricker, 2019). However, these non-executive directors cannot be seen as fully independent. Namely, Gerson & Alhassan (2004) state that the board of directors of WorldCom consisted out of friends of the CEO, Bernard Ebbers, and executives from companies previously acquired by WorldCom. In addition, board members seemed to be very loyal to Ebbers and “in turn received multiple perks, including millions of dollars in WorldCom stock, use of the company’s private jet and financial support to pursue a variety of individual projects” (Gerson & Alhassan, 2004). A decline of board or audit committee independence results in large increases of abnormal accruals (Klein, 2002), which is proven to be no different for WorldCom.

Board diversity, meaning the percentage of women and other minorities on the board of directors, is positively correlated to firm value as measured by Tobin’s Q (Carter et al., 2003). In addition, Kamalnath (2018) recognized that gender diversity in particular can overcome groupthink if those female directors are independent outside directors. Groupthink severely limits the probability of a successful outcome to decision making (Scharff, 2005).

At WorldCom, there was a “variety of group madness…. which created a kind of psychic prison for many employees” (Scharff, 2005). WorldCom’s culture ensures that employees were afraid of losing their jobs if they were to disagree with top executives, which leads to groupthink (Scharff, 2005). The major symptoms of groupthink are invulnerability, rationalizations, morality, pressure, stereotypes, self-censorship, and unanimity (Janis 1971, 1982). According to Scharff (2005), all of these stereotypes hold true for WorldCom.

3. Board committees

According to Cadbury’s Report, the first corporate governance code, a board should have three subcommittees; an audit committee, a remuneration committee, and a nomination committee (Tricker, 2019).

The audit committee should work closely with the external auditor, senior management, and the internal audit (Tricker, 2019). At WorldCom, the report of completed projects and the plans for future projects are presented only once a year by the internal audit to the audit committee. The rest of the year, the internal audit would report directly to Scott Sullivan, CFO (Zekany, Braun & Warder, 2004).

The audit committee members lacked knowledge of WorldCom’s internal financial workings and, thus, were not able to understand and exercise judgement on financial issues (Kaplan & Kiron, 2007). In addition, the members were not involved with the company – the committee held one meeting of only three to five hours each year (Kaplan & Kiron, 2007).

Audit committees need to be fully independent in order to monitor the management of the company properly (Tricker, 2019). Unfortunately, audit members are often appointed from the CEOs social networks. “These social ties have a negative effect on variables that proxy for oversight and quality, especially when audit committees have ‘friendship’ ties.” (Bryenseels & Cardinaels, 2013) The chairman of the audit committee and member of the remuneration committee of WorldCom, Max Bobbit, was known to be a loyalist of CEO Ebbers – also referred to as one of Ebbers’ four ‘Bernie’s boys’ (Jeter, 2003).

The remuneration committee is responsible for overseeing the remuneration packages of board members and derives its authority from terms of reference, relevant law, and corporate governance codes (Tricker, 2019). Stiles Kellett, the chairman of the remuneration committee at WorldCom, another one of the ‘Bernie’s boys’ (Jeter, 2003), received multiple perks. One being able to rent the company jet for a substantial low amount, which saved Kellett $1 million per year (Gershon & Alhassan, 2004). In return, the remuneration committee approved loans and guarantees from WorldCom so that CEO Ebbers could finance the acquisition of multiple unrelated businesses (Kaplan & Kiron, 2007). The committee did not receive any form of collateral from Ebbers to secure these loans nor did they oversee Ebbers’ use of these funds, which eventually exceeded over $400 million (Kaplan & Kiron, 2007).

A nomination committee exists in order to independently give recommendations on replacement of members on the board of directors (Tricker, 2019). WorldCom did not have a nomination committee. As previously stated, members of the board of directors were personal friends of CEO Ebbers and former CEOs of the companies that were acquisitioned by WorldCom.

As the external accountant of WorldCom, Arthur Andersen’s auditors had serious concerns regarding WorldCom’s financial statements and recognized WorldCom was a “maximum risk” (Zekany, Braun & Warder, 2004). However, in Andersen’s signed audit opinion in 2001, none of these concerns were expressed and WorldCom’s financials got a clean opinion. Even when Cynthia Cooper, the whistleblower, went to Arthur Andersen to express her concerns, the audit company told Cooper there was nothing to worry about (Gershon & Alhassan, 2004).

4. Board leadership structure

In Anglophile countries, unitary boards are most common whilst they are inferior to compound boards, also known as two-tier boards (Turnbull, 2000). Namely, access to information is limited for unitary boards and external directors often have “little knowledge, authority, or experience with the detailed operation of the firm” (Turnbull, 2000). As

the role chairman of the board is not also exercised by CEO Bernard Ebbers, WorldCom seems to have a two-tier board. However, Chairman Bert Robbers’ role was honorary and Ebbers “presided over board meetings and determined their agendas” (Kaplan & Kiron, 2007). So, in fact, we can state that WorldCom had an unitary board and the downsides of unitary boards addressed by Turnbull (2000) seem to be true for WorldCom (Kaplan & Kiron, 2007).

5. Director and executive’s compensation

Weak governance structures with agency problems allow CEOs to be heavily compensated, such as the $408 loan Ebbers received on top of his regular compensation (Core, Holthausen & Larcker, 1999). “The use of discretionary accruals to manipulate reported earnings is more pronounced at firms where the CEO’s potential total compensation is more closely tied to the value of stock and option holdings” (Bergstresser & Philippon, 2006). This statement is heavily supported by what happened at WorldCom. Namely, WorldCom’s board granted stock options to Ebbers and other top executives that were worth hundreds of millions of dollars, and they allowed the manipulation of financial statements in order to maintain a stable stock price during a time of economic instability in the U.S. (Chan, 2008). In addition, the CEO provides perks for himself and WorldCom’s directors such as the use of the corporate jet for personal reasons, which reduces firm value directly if the directors consume more than what is desired by its shareholders (Yermack, 2006).

6. Board meetings

For a board meeting to be effective, directors must have the correct information available before the meeting starts (Berghe & Levrau, 2004). In addition, there must be a high quality of discussions for board meetings to be productive and each director must have the opportunity to speak freely. Moreover, the chairman must not be dominant, but must also be a strong leader. Lastly, directors must be mentally present and actively involved in the decision-making process (Berghe & Levrau, 2004). WorldCom fails on all three aspects; directors received false and plausible information (Kaplan & Kiron, 2007), the CEO is dominant, employees do not dare to contradict him (Scharff, 2005), and directors are not as involved as required (Kaplan & Kiron, 2005).

Epilogue

The poor functioning of the board of directors and its committees of WorldCom have indeed contributed to the possibility, and the duration, of an accounting scandal. In this paper, the difference between an ideal board, as expressed in various literature works, and the board of WorldCom are brought to light. The choice of board size and board leadership structure at WorldCom was adequate; the board size of WorldCom lies very close to the optimal board size and the majority of Anglophile companies have a unitary board, which manage without fraudulent behavior. However, the composition of the board, the board committees, the director and executive’s compensation, and the board meetings of WorldCom show some serious problems. Namely, the board and its committees were not independent nor diverse, the compensation of executives and directors was abnormally high, and board meetings seem to be a facade instead of members intending to professionally monitor the company. For these reasons, it is no surprise that WorldCom’s board failed and became one of the reasons for the enaction of the Sarbanes-Oxley Act (Brickley, 2003).

Word count: 1713

Word count of in-text references: 154

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Appendix

Graph 1: Optimal Board Size

A – deviations from board size are random. For both types of firms, simple and complex, the figures represent the objective functions that firms would maximize in the absence of substantial costs.

B – deviations form board size is not random; simple firms have larger board than optimal and complex firms have smaller boards than optimal. Therefore, we observe only the part of the hump-shaped relation that is to one side of the optimum. So, Q then should be negatively related to board size for simple firms and positively related to board size for complex firms.

Source:

Coles, J. L., Daniel, N. D., & Naveen, L. (2005). Boards: Does One Size Fit All? SSRN Electronic Journal, 329–356. https://doi.org/10.2139/ssrn.665746

Exhibit 1: WorldCom’s Board of Directors (2001)

James C. Allen (55), a nominee, director of WorldCom since March 1998. Former Vice-Chairman and Chief Executive Officer of Brooks Fiber Properties until its merger with WorldCom.

Judith Areen (57), a nominee, director of WorldCom since September 1998. Executive Vice-President for Law Center Affairs and Dean of the Law Center of Georgetown University since 1989.

Carl J. Aycock (53), a nominee, director of WorldCom since 1983. Self-employed as a financial administrator since 1992. Former employee of WorldCom.

Ronald R. Beaumont (53), not a nominee, Chief Operating Officer of WorldCom since December 2000. Served as the President and Chief Executive Officer of WorldCom’s Operations and Technology unit form 1998 until 2000. President of WorldCom Network Services from 1996 until 1998.

Max E. Bobbitt (57), a nominee, director of WorldCom since 1992. Director of Verso Technologies, inc., and Metromedia China Corporation as a former President and Chief Executive Officer of Metromedia China Corporation. Former President and Chief Executive Officer of Asian American Telecommunications Corporation, which was acquired by Metromedia China Corporation.

Bernard J. Ebbers (60), a nominee, President and Chief Executive Officer of WorldCom since 1985. Served as a director of WorldCom since 1983. Current director of Digex.

Francesco Galesi (71), a nominee, director of Worldcom since 1992. Chairman and Executive Officer of the Gelesi Group. Current director of Keystone Property Trust.

Stiles A. Kellett, Jr. (58), a nominee, director of WorldCom since 1981. Chairman of Kellett Investment Corp. Since 1995. Current director of Netzee, Inc., Air2web, and Virtual Bank.

Gordon S. Macklin (73), a nominee, director of WorldCom since Sepember 1998. Corporate financial advisor since 1992. Former Chairman of the Hambrecht and Quist Group. Former President of the National Association of Securities Dealers, Inc. Current director, trustee, or managing general partner of forty-eight investment companies in the Franklin Templeton Group of Funds.

Bert C. Roberts, Jr. (59), a nominee, Chairman of the Board and a director of WorldCom since 1998. Former Chairman, Chief Executive Officer, President, and Chief Operating Officer of MCI, which merged with WorldCom. Current director of the News Corporation Limited, Valence Technology, Inc., CAPCure, and Digex.

John W. Sidgmore (51), a nominee, Vice-Chairman of the Board and a director of WorldCom since December 1996. Former Chief Operations Officer of Worldcom. Former President and Chief Operating Officer of MFS Communications Company, a company acquired by WorldCom. Current director of MicroStrategy Inc.

Scott D. Sullivan (40), a nominee, director of WorldCom since 1996. Served as Chief Financial Officer, Treasurer, and Secretary of WorldCom since 1994. Current director of Digex.

Lawrence C. Tucker (59), director of WorldCom since 1992. Former general partner of Brown Brothers Harriman & Co. Current director of Riverwood Hilding, Inc., National Healthcare Corporation, VAALCO Energy Inc., US Unwired, Inc., Network Telephone, Xspedius, Inc., Z-Tel Technologies, Inc. and Digex.

Remuneration Committee: Stiles A. Kellet, Jr. (Chairman), Max E. Bobbitt, Gordon S. Macklin, and Lawrence C. Tucker.

Audit Committee: Max E. Bobbitt (Chairman), James C. Allen, Judith Areen, and Francesco Gelesi

Independent External Auditor: Arthur Andersen LLP

Sources:

Kaplan, R. S., & Kiron, D. (2007). Accounting Fraud at WorldCom. Harvard Business School, 113–126. Retrieved from https://www.academia.edu/34728990/Accounting_Fraud_at_WorldCom

Pandey, S. C., & Verma, P. (2004). WorldCom Inc. Vikalpa: The Journal for Decision Makers29(4), 113–126. https://doi.org/10.1177/0256090920040409