What's up guys and welcome back to wall street millennial on this channel, we cover everything related to stockton. Investing today we're talking about one of the biggest financial scandals in american corporate history, the 11 billion dollar worldcom scandal. Worldcom was one of the biggest telecommunications companies in the country back in the 90s, but because of the severity of the scandal, the company crumbled and the name was destroyed two decades later, many people have never even heard of the company. The shocking part of the scandal was how big it was bad enough to take down a company bigger than morgan stanley, intel, johnson, johnson or target.

It was also shockingly flagrant. The ceo and cfo essentially just lied about the company's revenues and profits and faked billions of dollars of fraudulent revenues in this video, we'll explain the backstory of worldcom and go over the details of how exactly a scandal is perpetrated, but before we dive in i'm so Excited to tell you about our new website at wallstreetmillennial.com, we've redesigned it and added new features. You can use the site to look up the historical financial numbers of any us-based stock and easily graph metrics, such as revenue, total operating costs, gross profit and net earnings. The full data is available for viewing at the quarterly level, also use the form on the bottom of the page to discuss the stock with other users of the site.

You can also use a site to look up holdings of any us-based hedge fund, both current and historical holdings. Finally, the insider trades tracker page shows you all the recent reported insider trading activity for any stock. Of course it's all completely free to use, and if you make a post on the discussions forum, there's a good chance, i will personally respond so go check it out. The multi-billion dollar worldcom scandal should be viewed with both background on the company and the state of its operations in the years leading up to the scandal.

Although the brand name worldcom no longer exists just 20 years ago, it was the largest telecom company in the country. They provided high-tech services like internet and telephone lines to both consumers and commercial customers. Today, internet service providers and landlines don't seem like a big deal. Even wireless service seems like just a utility, but back in the 90s.

It was huge with the internet revolution just coming onto the world stage. It seemed like everything was built on worldcom services and those of its smaller competitors. Worldcom was started as the long distance telephone provider, long distance, discount services or ldds inc. It immediately started growing rapidly at that time, telephone technology adoption was booming and becoming an integral part of everyday life, and business ldds was part of that revolution and made money by purchasing wholesale blocks of bandwidth from long distance carriers and then reselling it to local telephone Providers, essentially, they were just a middleman, buying and reselling telephone bandwidth that they didn't produce themselves that made it a capital light operation that fetched high margins, rapid growth and, importantly, high stock market valuations.

Throughout the early 1990s, the newly renamed worldcom stock price went up eightfold in pretty much a straight line. In 1996, the stock price had doubled again to 16 dollars. A share wall street eventually adopted worldcom as one of its darlings in an economy of advancing technology. Growth forecasts were extrapolated, every quarter and price targets were constantly being raised by 1999.

Worldcom was one of the world's most valuable companies. It had a market capitalization of 180 billion dollars and did 37 billion dollars of revenue that put it at number 25. On the fortune, 500 list of america's largest corporations above companies like target morgan stanley, intel and johnson johnson and investors couldn't get enough. So what was the secret to their unicorn-like business growth? Surely, if it was as easy as just being in a favorable industry, their competitors could have squashed them at d, sprint and other companies all had huge interest in taking market share from what was then ldds the secret lane.

Their fundamental strategy of growth by merger and acquisition, particularly in the 1990s ldds, acquired numerous smaller telecom companies they acquired or merged with mid-american communications, corporation america and first phone advanced telecommunication, corporation world communications, inc, dial net and others by 1995. They've done so many mergers and acquisitions that they were already the fourth largest long distance carrier in the entire country. Keep in mind that 1995 was only 12 years after the company was founded and its growth was still showing no signs of slowing down after acquiring several high-profile competitors with valuable brand names and realizing the need to adopt a catchy recognizable name. Shareholders of the company voted to officially rename the company to worldcom in may of 1995.

in the second part of the 1990s worldcom, only accelerated its acquisitions and started going after bigger and bigger targets. For example, they acquired mfs communications company in 1996 for a staggering 12.4 billion dollars. That's a bigger price tag than many recognizable companies that you consider, mid-cap or even large cap today, when you adjust for inflation. For example, twitter had a market cap of about 26 billion dollars at the time of recording this video, which is approximately equal to the inflation-adjusted value of the 12.4 billion dollars that worldcom paid for mfs communications in the 90s.

All of these acquisitions should make you think where the target company is really worth the price to worldcom. The reality is that they really had no choice. Their entire growth story was built on purchasing their competitors and integrating them under one big roof. In the early and middle stages.

This worked flawlessly. They benefited from a positive feedback loop enabled by their use of stock, to pay for their acquisitions. How it works is as follows: they use their stock to pay for an acquisition of another company when the acquisition closes their revenue gets consolidated, resulting in visible revenue growth that wall street rewards with a higher stock price. The higher stock price then enables worldcom to pursue other stock-based acquisitions in the cycle repeats each time the acquisition cycle repeats, worldcom's revenue increases and then its share price increases.

But at a certain point, when you become one of the top four companies in your industry, the pool of available acquisition targets starts to dry up potential targets, demand richer valuations and, at the same time, wall street analysts, growth expectations become greater and greater any deceleration in The exponential growth rate would cause a severe re-rating of the stock's valuation, but in the real world, exponential growth cannot continue forever. Something has to give for worldcom. The turning point came in 1999 when they attempted to merge with the telecommunications giant sprint with the rise of the internet and wireless technologies. Putting pressure on the traditional landline business worldcom hoped that merging with sprint would allow them to continue to grow.

The deal would have been a 115 billion dollar value and combined two of the country's most powerful telecom companies. Perhaps, unsurprisingly, the deal was quickly shut down by the justice department's anti-trust division by the year 2000. Worldcom's hopes of merging and acquiring their way into the wireless industry were dashed. The failed merger attempt with sprint was a pivotal moment for worldcom.

It was a rude awakening to them that the days of huge mergers and acquisitions were over. For them they could no longer just buy revenue growth with their own stock, especially because their stock price started tanking around that time. Their traditional landline business was dying because the industry's secular decline and wall street was finally realizing that double-digit growth every year was no longer possible throughout the course of 2000 worldcom stocks, slowly bled out from over fifty dollars a share to less than fifteen dollars. A share.

Worldcom's business results were more than anything else. Dependent online costs line costs are the cost of carrying a call or other data transmission from a starting point to an end point: for example, the electrical and infrastructure cost of transmitting a long distance voice call from massachusetts to california would be recorded as line costs. It also includes paying third-party carriers for use of their networks to fulfill customer calls, because worldcom used a strategy of relying heavily on purchased bandwidth from other providers. This contributed to a significant portion of their line costs.

Worldcom's, total expenses were dominated by line costs. In fact, about half of the company's total expenses were line costs and thus they were immensely important to worldcom's profitability. As a result, reducing line expenses was the first target of worldcom's upper level leadership when the company's financial performance started to deteriorate. In the late 90s.

Later investigations found that bernard evers and scott sullivan worldcom, ceo and cfo respectively, were frequently visibly agitated at company meetings and exerted significant pressure to find ways to cut line costs. As the landline business became, less profitable, worldcom's margins shrunk fast. They had to do something fast and it had to be on a massive scale: around 1999 and 2000 worldcom's business deterioration pushed ebers and sullivan to accounting fraud. They began directing their accountants to reduce the recorded estimated expenses of line costs associated with purchasing third-party bandwidth.

It might seem strange to hear that they just told their accountants to record less expenses, but that's essentially what happened, because a significant portion of worldcom's line costs were payments of third-party bandwidth providers. Those costs are billed at a later date than when the purchases were made. That means that those portions of the cost must be estimated in the immediate term evers and sullivan artificially reduced those reported estimated costs with no justification in the beginning. It wasn't that much and was isolated in their domestic us business accounting, but after a couple quarters with no one catching on, they expanded the unjustified expense reductions to nearly a billion dollars per quarter in total by the end of the year 2000, they had improperly faked 3.3 billion dollars of line cost reductions over the course of seven quarters.

They ended up reducing their actual line costs by 16 by basically just lying in their financial reports. The farce was successful in taking billions of dollars of expenses off of worldcom's income statement, but despite ebbers and sullivan's desires, those billions of dollars were in fact real expenses that would eventually have to be paid from somewhere. The solution that sullivan came up with was to label them as capital expenditures. How it worked was that the money that worldcom had to pay for its long-distance telecommunications infrastructure, in particular its line costs, were deemed capital investments that would lead to future revenues.

In that sense, they'd be considered investments on the company's balance sheet rather than expenses on the income statement. As a result, those expenses would not immediately impact net earnings. In total, billions of dollars of expenses were improperly capitalized or recorded as capital expenditures. In this way, these capitalizations were directed by sullivan the cfo, but were not unnoticed by others in the company.

Several people in the company's accounting function left the company in protests at various points, as they felt uncomfortable being a part of what was clearly a fraud, but the world calm fraud extended far beyond just fake expense reductions. They also inflated revenue to the tune of billions of dollars. They did this through a combination of many factors, so we'll only go into a couple of them. One way that they improperly inflated revenue was through something called minimum deficiency charges when a large, usually commercial customer entered into a contract to purchase bandwidth from worldcom.

The contracts usually specified a minimum amount of usage that the customer would purchase by the year 2000. The landline business was dying and customers frequently did not reach that minimum usage. However, worldcom usually excused the charges or renegotiated new contracts with those customers instead of collecting on the minimum usage charges. This way they were able to incentivize the customers to continue purchasing new contracts with worldcom.

These minimum deficiency charges were thus usually not collectible, and worldcom historically, was only able to collect on less than 10 of them. Despite this sullivan released. Hundreds of millions of dollars of these charges to be recognized as actual revenue for the company, even though they were not actually collected and most likely never would be similarly to the minimum deficiency charges. Worldcom also unfairly recognized revenue from early termination charges.

These charges also had very low actual collection rates for the same reason as the minimum deficiency charges, but since they are technically in the contracts with the customers and some customers terminated contracts, early sullivan, recognized them as revenue. One more revenue gimmick that worldcom made was a contract with another data provider called electronic data systems corporation or eds worldcom entered into an exchange of service agreement with eds, in which eds committed to a minimum amount of usage of worldcom services in the first quarter of The year 2000 worldcom claimed that eds was unlikely to meet their minimum amount and recorded tens of millions of dollars in revenue from minimum usage penalties from eds. This revenue was questionable at best, because eds still had a significant amount of time to meet the minimum commitment. Eventually, eds sued worldcom over the fees, a judge ruled that eds would in fact have to pay worldcom, but only a significantly lower amount than what worldcom recognized as revenue worldcom, technically failed to adjust that revenue down.

In response, these are only a few of the dozens of accounting irregularities that were uncovered at worldcom. The magnitude and breadth of the irregularities perpetrated at the highest levels of the company, soon caught the suspicion of cynthia cooper, an internal audit officer. She conducted interviews with various accountants around the company who had made the quote prepaid capacity entries in the capital expenditures part of the fraud, as it turns out. Almost no one in the company knew what prepaid capacity even meant.

After all, it's not a standard accounting item cooper, informed the head of worldcom's internal audit committee max bobbitt of her findings. The audit committee then launched its own investigation. They uncovered three billion dollars of improper line, expense entries that were allocated as capital expenditures. They also brought in kpmg one of the so-called big four accounting firms to conduct an independent audit kpmg uncovered even more improper accounting, including costs of the cfo, had moved around among various accounts in small amounts to hide their traces.

They concluded in their audit report that the accounting irregularities were made for the sole purpose of meeting wall street expectations. The only solution to the mess was to restate worldcom's earnings for most of 2001 and 2002. after the official audit was completed. Worldcom's board demanded the resignation of cfo scott sullivan when he refused the board fired him.

By this point, there was no way to save the company. They had tens of billions of dollars worth of debt, deteriorating revenue and margins and were speculated to be close to bankruptcy. With the restatement of their earnings adjusting down their reported cash flows by a staggering 3.8 billion dollars, investors started fleeing the stock like rats off a sinking ship, the sec pressed civil charges against worldcom, and the ceo bernard ebbers was convicted of fraud. He was sentenced to 25 years in prison within the span of just a couple years.

Worldcom's telecommunications empire had crumbled into dust. What remained of the company was eventually sold to verizon and the name worldcom was abandoned forever. The whole history of worldcom lasted only two decades. It went from being a small, innovative tech company to a corporate behemoth behold into wall street when they couldn't meet.

Analysts expectations of unreasonably high growth, their highest level executives, couldn't resist trying to fraud to keep the growth story going for just another couple quarters we've seen similar accounting frauds before perpetrated for the same purpose of kicking the can down the road when it came to reporting. Subpar financial results, the company waste management similarly experienced stratosphere growth in the 80s and 90s and improperly extended the reported service life of their garbage trucks to inflate their earnings that multi-billion dollar scandal was discovered around the same time as worldcom. Then there was toshiba who reported revenues before they were actually earned, and sometimes just didn't report losses that they incurred until many months later. Another fatal flaw on worldcom was their unsustainable strategy of growth through acquisition.

This strategy was dependent on the company being rewarded for their acquisitions with a higher stock price, which they could then use to acquire more companies, but they didn't incorporate their acquisitions well and eventually became a bloated amalgamation of redundant business units. General electric made the same mistake under ceo jack welch and starting with the 2008 financial crisis, they paid dearly for it. In all cases, these companies seemed unstoppable in their heydays. Their ultimate fates show that when upper level management becomes overzealous and satisfying wall street expectations, the higher the companies fly the harder they fall.

Alright, guys that wraps it up for today's video, if you enjoyed this content, make sure to smash the like button and subscribe. So you don't miss future videos in the meantime. Thank you. So much for watching and we'll see in the next one wall, street millennial signing out.