The WorldCom settlement

Ten ex-WorldCom directors have reportedly agreed to pay 54 million to settle a suit brought by the NY Common Retirement Fund arising out of the WorldCom accounting scandal.  Most importantly, this includes $18 million of their own money, or more than 20% of their combined net worth. 

There are many interesting facets to this settlement. To begin with, what are the implications for director liability generally? The above linked WaPo article says “courts may be becoming more open to holding outside directors to a tougher standard,” pointing to the Disney case. 

I have previously discussed  the potential and possibly conflicting implications of Disney, e.g., here, suggesting that the result in the case may end up reflecting the fact that we are in a calmer post-post Enron phase. 

But I'm not sure this calm applies to WorldCom. The failings at WorldCom are in a class by themselves  – with profit overstatements for 2000 and 2001 now at $74 billion, it was WorldCom’s spectacular fall in the summer of 2002, and not Enron, that led directly to Sarbanes-Oxley. 

Moreover, WorldCom is not merely a corporate mismanagement case, but a federal securities case. Directors are not here subject to the lax business judgment rule.  They signed off on securities filings, including 1933 Act filings that exposed the defendants to strict liability, without proof of scienter. But I should note that WorldCom stands as a warning of the potential bite of Sarbanes-Oxley Section 302 requiring executive certification of SEC reports.

Another interesting aspect of the case concerns one particular defendant. I find it somewhat notable that, with all the pontificating we have heard from legal academics about the failings of corporate management in the Enron era, a law professor who actually got involved in such management ends up taking one of the biggest legal hits.  Specifically, Judith Areen, former Georgetown dean and ethics expert is one of the ten settling defendants who must pay over a substantial chunk of her personal wealth. She was on the WorldCom audit committee and signed its 10K’s in 1999-2001, and registration statements for WorldCom acquisitions and securities WorldCom offerings.

Although Areen and her co-defendants didn’t steal and they were not the main perpetrators of the fraud, they were not innocent bystanders.   They settled because they faced potentially awesome liability for the collapse of the company in a trial to begin February 28.  The Financial Times quotes Nell Minow as saying “If there ever was a case where directors should reach into their own pockets, this is it.”  Gary Lutin, an investment banker, is quoted as saying “management would not have been able to hide billions of dollars if even one member of the board had done his job in reviewing the expenditures he had approved.”

Indeed, the settling defendants make a tempting target here. The amended complaint characterizes the WorldCom board (at pp. 11) as “utterly derelict in fulfilling the most basic functions of a true board.” The audit committee’s failings are layed out on pages 151-72.  Here’s some of the allegations

402. In order to function effectively, it was vital for the Audit Committee to have a detailed understanding of the Company, particularly its financial systems and internal controls. However, the Audit Committee was reckless by failing to become sufficiently familiar and involved with the Company’s internal financial workings, to see the weaknesses in the Company’s internal control structure, and to appreciate or detect the true corporate culture at WorldCom. WorldCom was a complicated company in a fast-evolving industry. It had expanded quickly, through a series of large acquisitions, each of which raised concern about WorldCom’s accounting and internal controls. As the Audit Committee members should have recognized, these acquisitions were not integrated, posing serious challenges for the Company and the Audit Committee. WorldCom had accounting-related operations scattered in a variety of locations around the country. To gain the knowledge necessary to function effectively required the Audit Committee to spend a substantial amount of time learning about the Company’s accounting practices. However, the Audit Committee only met for three to five hours a year, which was wholly inadequate.

403. As discussed in more detail below, the Audit Committee abdicated its responsibilities in at least two critical ways. First, it allowed a “serious failure of communication” between itself and Andersen. As stated in  436 - 454, Andersen – which described WorldCom as one of its “crown jewels” and the client that would make Andersen’s reputation in the telecom industry – utilized a “non-traditional” approach for its auditing of WorldCom. However, the Audit Committee did not understand the non-traditional audit approach Andersen employed, which should have been a matter for great scrutiny by the Audit Committee and discussion with Andersen.

404. Second, the Audit Committee failed to establish a strong reporting mechanism between itself and the Internal Aud it Department. As a result, the Internal Audit Department fell under the control of Company management and spent much of its time performing operational, not audit-related, functions. Moreover, as the Audit Committee should have known, Andersen and the Internal Audit Department rarely, if ever, coordinated efforts to audit the Company’s financial statements. As a result, “Internal Audit and Arthur Andersen were two ships passing in the night,” according to the Examiner’s Second Interim Report.
*  *  * *  *  *
408: As the Examiner determined, structural weaknesses in WorldCom’s internal accounting controls fostered an environment that allowed the fraud to go undetected.

But holding the audit committee responsible does not even begin to address the fundamental problems this case illustrates.  After all, the WorldCom audit committee was the very model of the independent board Sarbanes-Oxley and other laws so heavily bank on. According to paragraph 406 of the amended complaint:

Under the terms of the [WorldCom] Charter, the Audit Committee was to be made up of three or more independent directors who would be “free from any relationship that, in the opinion of the Board, would interfere with the exercise of his or her independent judgment as a member of the Committee.” The Charter charged all members with being familiar with basic finance and accounting practices, including the ability to read and understand fundamental financial statements, and required at least one of the members to have accounting or related financial management expertise.

Well, the audit committee was independent, and at least one member did have the requisite expertise, but according to the complaint that didn’t prevent them from completely falling down on the job.  Moreover, the complaint details disturbing governance failings at all levels – executives, underwriters, accountants.

I believe an important lesson from all this is that our current model of corporate governance just isn’t working, and that we delude ourselves if we think that Sarbanes-Oxley is going to fix it.  I have previously laid out the inadequacies of Sarbox.

Among other problems, Sarbox banks on an absence of conflicts, not the presence of expertise and incentives to actually do a good job.  (Indeed, the defendant directors were unusually incentivized compared to the usual outside directors, as they were substantial shareholders who personally lost about $250 million according to the Financial Times.)

As for expertise, corporate boards will continue to be the playgrounds of do-gooder social responsibility activists who have other things on their minds than actually understanding and doing the nitty gritty of business and finance.  In what alternative reality is it that a busy law dean and expert on ethics can be expected to spot accounting fraud?  And as the complaint makes clear, all the other layers of responsibility our laws impose just increase the opportunities for shirking and finger pointing.

So what’s the answer?  First, we need high-powered market-based incentives that would be provided by the return of an active market for corporate control.  Second, as I’ve been saying (e.g., here) we need to encourage alternative business structures that take near-absolute power over corporate earnings away from corporate executives and give it to the firm’s owners. 

In other words, cases like WorldCom tell us that the answer to the corporate governance problems lies in getting rid of the corporation as the exclusive structure for business enterprise.

PS:  Here's more on the settlement from the W$J (here and here) and of course Houston's Clear Thinkers, the standard source on the litigation fallout from the Enron era.

Comments

[Robert Schwartz]

I said before, the management has to buy it. The public needs rights like those the VC gets.