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Line Charges: Ex-WorldCom CFO Indicted

Sullivan accused of masterminding accounting scheme; key members of finance department also named as co-conspirators. Plus: PNC's new CFO, and hugs and kisses at XO.
Joseph Radigan, | US
August 29, 2002

Scott Sullivan, the disgraced former CFO of WorldCom Inc., was indicted by a federal grand jury in New York on Wednesday on two counts of securities fraud and five counts of filing false reports with the SEC. Also indicted: Buford Yates, who has served as the bankrupt telecom company's director of general accounting since 1997.

The grand jury also named David Myers, the company's onetime controller, as an unindicted co-conspirator in the case. Along with Yates, two other current WorldCom finance department employees were named as unindicted co-conspirators: Betty Vinson, director of management reporting, and Troy Normand, director of legal entity accounting Troy Normand.

Sullivan and Myers were arrested in a high-profile bust in New York on Aug. 1. The two finance department executives had left the company in June, following Worldcom's initial disclosure of a $3.9 billion accounting error.

No members of WorldCom's internal audit team were named in the case. Cynthia Cooper and Glyn Smith, the two top officials on the telco's internal audit staff, have been generally credited with uncovering the alleged accounting scheme.

The 23-page indictment handed out on Wednesday spells out an elaborate bookkeeping ploy allegedly hatched by Sullivan and the other four co-conspirators in July 2000. At the time, WorldCom's fixed costs for access to outside telecom networks were rising more quickly than revenues. The alleged plot was intended to hide from Wall Street investors the true scale of the company's operating costs.

According to the indictment, WorldCom had locked itself into long-term contracts for access to external telecom networks. Those contracts were intended to help the company coin it off the surging new economy. But after the stock market bubble burst in early 2000, growth in Internet traffic tailed off -- and so did WorldCom's top line revenue.

By April 2001, the line costs to outside networks continued to mount, and WorldCom apparently could no longer mask those costs by offsetting debits to reserve and capital accounts and credits to line costs. At that point, CFO Sullivan allegedly made the crucial decision to start recording the line costs as capital costs, rather than operating expenses.

The ploy enabled WorldCom to file financial statements showing that line costs were holding steady at roughly 40 percent to 42 percent of total sales from 1999 through 2001. In reality, the costs had grown close to 50 percent -- out of whack with what other telcos were reporting at the time.

According to the indictment, the alleged co-conspirators were aware they were committing an unlawful act by treating operating costs as capital expenses. "Neither Sullivan nor Myers provided Yates, Vinson, or Normand with any supporting documentation or business rationale for the entries," the indictment states. "As Sullivan, Myers, Yates, Vinson, and Normand well knew, there was no justification in fact or under GAAP."

The two counts of securities fraud against Sullivan and Yates stem from false accounting entries. The five additional accounts of false filings with the SEC result from using the improper accounting in the company's 10-K and 10-Q filings for 2001 and the first quarter of 2002. WorldCom management has already admitted the company's accounting for those periods was in error.

In addition to indicting Sullivan and Yates, the U.S. Attorney for the Southern District of New York announced its plan to file "informations" against Myers, Vinson and Normand. According to observers, the filing of criminal informations is often a sign that prosecutors are about to announce plea agreements in a case.

But lawyers note that prosecutors in the WorldCom case are taking an unusual tack in the filing of the criminal informations. Christopher Bebel, an attorney in Houston, told Bloomberg News that prosecutors typically wait until the day a plea agreement is announced before disclosing the filing of a criminal information. By announcing the WorldCom information filings early, government lawyers may be attempting to add to the psychological pressure felt by other targets of the investigation.

"The government is becoming quite accomplished at rattling sabers," Bebel told Bloomberg.

In a scant two months, the scope of the WorldCom fraud has come to rival that of Enron Corp. as the most notorious business scandal in recent memory. The misappropriation of $3.9 billion in operating costs was disclosed on June 25. On Aug. 8 -- just a week after Sullivan and Myers were anarrested -- WorldCom disclosed the discovery of another $3.3 billion in improper accounting. That raised the total accounting error to $7.2 billion.

Within the past week, investigators from the House Financial Services Committee have also released details about the extent of the relationship between WorldCom executives and investment bankers at Citigroup Inc.'s Salomon Smith Barney unit. According to documents Salomon has submitted in response to a Committee subpoena paint, the business dealings between the New York bank and the Clinton, Miss. telco were tainted by conflicts of interest.

In particular, Salomon and its star telecom analyst, Jack Grubman, apparently made WorldCom's former CEO Bernie Ebbers a favored client, setting aside one million shares in hot IPOs during the Internet stock bubble of the late Nineties. In return, WorldCom used Salomon's investment banking services -- earning Salomon tens of millions of dollars in fees for advising WorldCom on the telco's string of mergers.

WorldCom's questionable dealings with Salomon are not related to the company's accounting problems. But critics note that the two on-going scandals blend into a single image of a company that is, at best, unflattering, at worst, downright shameful. Indeed, despite carrying half of the Internet traffic in the U.S. -- and despite growing into a major force in the in the long-distance market -- it appears that WorldCom's meteoric success may have been little more than a Ponzi scheme.

PNC's CFO Takes a Hike
Robert L. Haunschild has resigned as CFO at PNC Financial Services Inc., the Pittsburgh-based banking company that has been surrounded by controversy since January (see "Working Both Sides of the Street.").

Replacing the 52-year-old Haunschild is William Demchak, who most recently served as the global head of structured finance and credit portfolio for JP Morgan Chase. Demchak is expected to take over the CFO's job in September. Haunschild will stay on for an interim period to assist with the transition.

It may be no coincidence that Demchak's background is in structured finance. PNC's use of special purpose entities (SPEs) to offload $762 million in bad loans has generated keen interest at both the Federal Reserve Bank and the Securities and Exchange Commission. The SPEs were run by insurance giant American International Group Inc., which formed the off-balance sheet entities by relying on consulting services from Ernst & Young.

Ernst is also PNC's auditor and was also providing consulting services to the bank. The close relationship between PNC and its auditor and insurer created a conflict of interest in the eyes of the SEC and federal banking regulators.

PNC was forced to restate its 2001 earnings, lowering profits by $155 million in January. In February, the company once again restated its 2001 earnings, slashing another $55 million from the bottom line. The reason? Reportedly, PNC improperly accounted for the sale of its mortgage banking business.

Last month, the bank settled fraud charges with government regulators related to the SPEs. According to the charges, PNC used the off-balance sheet vehicles to inflate 2001 earnings by 52 percent. As part of the settlement, the company must clear all changes to senior management and its board of directors with the Fed or the Office of the Comptroller of the Currency.

In the meantime, the SEC is still investigating the roles that Ernst and Young and AIG played in helping the bank set up the special purpose entities.

In Europe, Signs of Unrest
The campaign by U.S.-listed European companies to avoid certifying their financial statements with the SEC is heating up.

Some 1,300 foreign companies have shares traded on U.S. markets, and are therefore subject to the provisions of July's Sarbanes-Oxley Act that call for CEOs and CFOs to certify their financial statements with regulators.

But in several overseas markets, particularly Germany and the U.K., opposition to the certification rule is mounting. The opposition is by no means unanimous: executives at several German and British companies have already said they won't fight the requirements.

But it appears that government officials from both nations are lending an official stamp to the protests. For example, German Justice Minister Herta Daeubler-Gmelin told Bloomberg News: "What disturbs us in Europe is that we're supposed to act as if the U.S. way is sacred."

Meanwhile, Britain's Ambassador to Washington has reportedly lobbied the SEC, noting that the rules place an unfair burden on U.K. companies.

One of the objections the Europeans raise, Bloomberg reports, is that the U.S. accounting methods still fall under GAAP, while the European Union has already ruled that European companies will, by 2005, have to adhere to the standards now under development by the International Accounting Standards Board. In all likelihood, the IASB rules will be a significant departure from GAAP.

While the U.S.-based FASB is working with the IASB to align bookkeeping standards, a global code for corporate accounting is still a long ways off.

Short Takes: XO row, Enron deal, Aldephia nixers

Reuters reported that Forstmann had tried to back out of the deal after already investing $1.5 billion in the company. The reason for the apparent reversal? Weakening market conditions. But XO's management has apparently fought to have the court compel Forstmann and Telefonos to live up to their pledge.

The company says Rigas plans to sell real estate in New York, Colorado, and Hilton Head, South Carolina, and that the sales could violate the laws governing the company's Chapter 11 reorganization. Bankruptcy law protect a company's assets during a reorganization.

Rigas and his sons have been accused of plundering Adelphia's finances by using company funds to purchase billions of dollars of personal property, including the Buffalo Sabres franchise in the National Hockey League. The league assumed control of the team after the company's $20 billion bankruptcy filing in June.