1. Background
On September 26, 2006, Bernard J. Ebbers ("Ebbers"), the former Chief Executive Officer of WorldCom, Inc. ("WorldCom"), reported to a federal prison in Oakdale, Louisiana, to begin serving his 25-year jail sentence from his conviction by a jury on nine counts of conspiracy, securities fraud and related crimes related to the bankruptcy of WorldCom in July 2002. Ebbers’ appeals from his conviction and 25-year jail sentence were dismissed by the United States Court of Appeals for the Second Circuit on July 28, 2006.1
In its decision upholding the jury conviction and the 25-year jail sentence imposed by the trial judge, the Court of Appeals for the Second Circuit commented that Ebbers’ actions that were specifically intended to create a false picture of profitability for WorldCom were "motivated by his personal financial circumstances".2 Ebbers personal finances imposed significant pressures on him to ensure that the WorldCom stock price did not fall and that WorldCom’s guidance of its future financial performance and investors’ expectations were met. Ebbers was a wealthy man with a significant personal business empire outside WorldCom. He had also accumulated millions of shares of WorldCom stock. However, he had borrowed over US$400 million from banks, using his stock in WorldCom as collateral. As WorldCom stock price began to drop in 2000, Ebbers received margin calls from the banks requiring him to either put up more stock as collateral or to pay back a portion of the money he owed. Because he had used much of the borrowed money to buy relatively illiquid assets, such as a ranch, timberlands and a yacht-building company, Ebbers could not use those assets to meet the margin calls. Every share of WorldCom stock that Ebbers owned was pledged as collateral for the loans. WorldCom commenced to provide financial assistance to Ebbers in September 2000 with an initial loan of US$50 million. From October 18, 2000 until April 1, 2002, the WorldCom Compensation Committee met and discussed the Company’s financial arrangements with Ebbers 26 times, and for 13 of these meetings, Ebbers financial situation was the only topic specifically identified in the minutes. By April 2002, the Compensation Committee had approved numerous additional loans and guaranties for Ebbers, eventually totalling
US$165 million of direct loans to Ebbers plus payments to banks under guarantees of US$235 million. All the loans and guaranties from WorldCom were consolidated into a single promissory note of US$408 million (including interest) when Ebbers’ employment with WorldCom terminated at the end of April 2002.3 The Special Investigative Report of the Board of Directors of WorldCom concluded that the extension of these loans and guarantees "was a 19-month sequence of terrible decisions - badly conceived, antithetical to shareholder interests - and a major failure of corporate governance."4
In his report to the United States District Court for the Southern District of New York, Richard C. Breeden, the Court-appointed Corporate Monitor of WorldCom and a former Chairman of the Securities and Exchange Commission,5 commented on Ebbers’ personal debt issues and WorldCom’s financial assistance to Ebbers as follows:
"During the late 1990s the telecom bubble burst, as all bubbles do. The telecom industry began to suffer serious decline, and stock values began to fall at all telecom companies including WorldCom. This put Ebbers under enormous pressure to stave off margin calls, since they could have lead to a forced liquidation of his holdings and potentially to a personal bankruptcy filing. Literally, anything that would increase the price of WorldCom stock or slow its rate of decline, such as strong reported earnings, would help relieve the intense financial pressure on Ebbers. At the same time, if WorldCom were perceived as having earnings too low to carry the massive volume of debt Ebbers had incurred in conducting scores of acquisitions, Ebbers would most likely have been financially destroyed.
As has been extensively reported, Ebbers turned to his longtime associates on the WorldCom Board for help in handling his debt. Two members of the Board, Mr. Stiles Kellett (chairman of the Compensation Committee) and Mr. Max Bobbitt (chairman of the Audit Committee) appear to have made the initial decision to use Company funds to extend Ebbers’ massive personal loans to help support his personal debt. Ultimately the program of loans and guarantees grew to more than $400 million, representing a substantial portion of WorldCom’s cash reserves and its net worth, had its balance sheet been accurately reported. Amazingly, at least $50 million of these loans was apparently wired to Ebbers before the Board of Directors as a whole was even notified. Unfortunately when the full Board discovered what Kellett and Bobbitt had done, it ratified the loans and allowed the program to continue and grow."6
The telecommunications industry as a whole and WorldCom in particular experienced sharp and continuous declines in share prices from early 2000 and thereafter. WorldCom common stock fell from a high on June 30, 1999 of US$96.766 per share to a low of US$46 per share by June 30, 2000. As of December 29, 2000, the stock’s high was US$18.656. For the next year it generally fluctuated between US$24 and US$12 per share. It fell precipitously in 2002, being at US$0.83 per share on June 25, 2002, when the Company announced its improper accounting and intention to restate its financials, and at US$0.06 per share on July 1, 2002. WorldCom filed voluntary petitions seeking relief under Chapter 11 of the United States Bankruptcy Code on July 21, 2002, and was delisted from NASDAQ stock exchange as of July 30, 2002.7
The finding of the Court of Appeals for the Second Circuit that the false financial picture at WorldCom was motivated by Ebbers personal financial circumstances is supported by the report of the investigation of the Special Investigative Committee of the Board of Directors of WorldCom. The Special Investigative Committee Report noted:
"Ebbers directed significant energy to building and protecting his own personal financial empire, with little attention to the risks these distractions and financial obligations placed on the Company that was making him one of the highest paid executives in the country. It was when his personal financial empire was under the greatest pressure - when he had the greatest need to keep WorldCom’s stock price up in order to avoid margin calls that he could not meet - that the largest part of the fraud occurred. And it was shortly after he left that it was discovered and disclosed."8
2. Releasing Accruals and Capitalizing Operating Expenses
As noted in the Special Investigative Report of the Board of Directors of WorldCom, WorldCom’s improper accounting took two principal forms: the reduction of reported line costs by capitalizing such expenses and the exaggeration of reported revenues. The overall objective was to hold reported line costs to approximately 42% of revenues and to continue reporting double-digit revenue growth, while actual growth rates were generally substantially lower. As part of its international telecommunications business, WorldCom built a global network of fibre-optic cables and telephone wires to transmit data and telephone calls. It also leased capacity on other companies’ network facilities to transmit its customers’ data and calls. The cost of the leasing was WorldCom’s single largest expense - categorized as "line costs" - accounting for approximately half of the Company’s total expenses. One key measurement of performance both within WorldCom and with the investing public was the ratio of line costs to revenue (the "line cost E/R ratio").
The Special Investigative Report of the Board of Directors of WorldCom summarized the accounting fraud at WorldCom in its report as follows:
"In 1999 and 2000, WorldCom reduced its reported line costs by approximately $3.3 billion. This was accomplished by improperly releasing "accruals", or amounts set aside on WorldCom’s financial statements to pay anticipated bills. These accruals were supposed to reflect estimates of the costs associated with the use of lines and other facilities of outside vendors, for which WorldCom had not yet paid. "Releasing" an accrual is proper when it turns out that less is needed to pay the bills than had been anticipated. It has the effect of providing an offset against reported line costs in the period when the accrual is released. Thus, it reduces reported expenses and increases reported pre-tax income.
WorldCom manipulated the process of adjusting accruals in three ways. First, in some cases accruals were released without any apparent analysis of whether the Company actually had an excess accrual in the account. Thus, reported line costs were reduced (and pre-tax income increased) without any proper basis. Second, even when WorldCom had excess accruals, the Company often did not release them in the period in which they were identified. Instead, certain line cost accruals were kept as rainy day funds and released to improve reported results when managers felt this was needed. Third, WorldCom reduced reported line costs by releasing accruals that had been established for other purposes. This reduction of line costs was inappropriate because such accruals, to the extent determined to be in excess of requirements, should have been released against the relevant expense when such excess arose, not recharacterized as a reduction of line costs.
The improper releases of accruals had several features in common. They were directed by senior members of the corporate finance organization, including Chief Financial Officer Scott Sullivan, Controller David Myers, and Buddy Yates, Director of General Accounting. They did not occur in the normal course of day-to-day operations, but instead in the weeks following the end of the quarter in question. The timing and amounts of the releases were not supported by contemporaneous analysis or documentation. Most significantly, WorldCom employees involved in the releases generally understood at the time that they were improper. Some even raised concerns at the times of the releases.
By the end of 2000, WorldCom had essentially exhausted available accruals, at least on the scale needed to continue this manipulation of reported line costs. Thereafter, from the first quarter of 2001 through the first quarter of 2002, WorldCom improperly reduced its reported line costs by $3.8 billion, principally by capitalizing $3.5 billion of line costs - at Sullivan’s direction - in violation of WorldCom’s capitalization policy and well-established accounting standards. The line costs that WorldCom capitalized were ongoing, operating expenses that accounting rules required WorldCom to recognize immediately. Sullivan made comments indicating that he intended ultimately to reduce these inflated asset accounts by including them in a large restructuring charge later in 2002.
By capitalizing operating expenses, WorldCom shifted these costs from its income statement to its balance sheet and increased its reported pre-tax income and earnings per share. Had WorldCom not capitalized these expenses, it would have reported a pre-tax loss in three of the five quarters in which the improper capitalization entries occurred. By reducing reported line costs, the capitalization entries also significantly improved WorldCom’s line cost E/R ratio. In its public filings, WorldCom consistently emphasized through 2001 that its line cost E/R ratio stayed the same - about 42% - quarter after quarter. That representation was false. Had it not capitalized line costs, WorldCom’s reported line cost E/R ratio would have been much higher, typically exceeding 50%. This device also made it appear that softening markets were not reducing the Company’s profitability, when the opposite was the case."9
3. Exaggerating Revenues
In addition to the improper release of reserves and the capitalization of operating expenses, WorldCom improperly exaggerated its reported revenues. Beginning in 1999, WorldCom personnel made large revenue accounting entries after the close of many quarters in order to report that it had achieved the high revenue growth targets that Ebbers and Scott Sullivan, the WorldCom CFO, had established. Most of the questionable revenue entries that were identified by the Special Investigative Committee of the Board of Directors of WorldCom were booked to "Corporate Unallocated" revenue accounts. These accounts were separate from those that recorded the operating activities of WorldCom’s sales channels. Distribution of the separate schedules for "Corporate Unallocated" revenue was limited and access to it was closely guarded. They generally appeared only in the quarter-ending month, and they were not reported during the quarter, but instead in the weeks after the quarter ended. Ebbers, along with Sullivan, was aware of the use of non-recurring items to increase reported revenues. The amounts booked in the "Corporate Unallocated" revenue accounts were critical to WorldCom’s perceived successes. Without the revenue booked in those accounts, WorldCom would have failed, in six out of the twelve quarters between the beginning of 1999 and the end of 2001, to achieve the double-digit growth it reported. As stated by the Special Investigative Report of the Board of Directors of WorldCom:
"Our investigation has identified over $958 million in revenue that was improperly recorded by WorldCom between the first quarter 1999 and the first quarter of 2002. Our accounting advisors have identified $1.107 billion of additional revenue items recorded during this period that they considered questionable, based on the circumstances in which they were recorded and the lack of available or adequate support."10
The First Interim Report of Dick Thornborough, Bankruptcy Court Examiner, succinctly summarized the principal areas of improper financial reporting of additional revenues and the capitalization of expenses as follows:
"It appears if WorldCom’s revenue figures did not meet or exceed the budgeted amounts, the Company would increase improperly revenues. Between the first quarter of 1999 and the first quarter of 2002, adjustments were made to approximately 400 items totalling over $4.6 billion….
WorldCom manipulated its reported financial performance by drawing down excess or other reserves into earnings. At around the time that the reserves were being drawn down, WorldCom agreed to combine with Sprint Communications, Inc. ("Sprint") in October 1999. This combination would have allowed the Company not only to replenish its reserves, but also to increase them dramatically. When the government ultimately refused to approve the Sprint merger in July 2000, and signalled that it would not be sanctioning other larger mergers, WorldCom did not have adequate excess reserves to draw down as a vehicle to increase earnings going forward. Shortly after this time, the Company took the brazen and radical step of converting substantial portions of its line cost expenses into capital items. These conversions ultimately added approximately $3.8 billion improperly to income. The disclosure of improprieties was the subject of the June 25, 2002 restatement announcement."11
4. Ebber’s Resignation and Internal Audit Review of Transfers to Capital accounts
Ebbers resigned as President, CEO and a director of WorldCom at the end of April 2002 following the announcement of an investigation into the accounting practices of telecommunications and other companies, including WorldCom, by the Securities and Exchange Commission in March 2002. On March 11, 2002, WorldCom announced that it had received a confidential request from the SEC for voluntary production of documents and information. In a press release, WorldCom listed the areas of inquiries by the SEC, which included, among others, accounting treatment for goodwill, loans to WorldCom’s officers and directors, the Company’s policies and procedures concerning revenue recognition, accounts receivable-related reserves and certain write-offs.12 By late April 2002, the combination of the Company’s sagging performance and share price, Ebbers personal financial difficulties and complications with respect to the Company’s loan and guarantee covering a margin loan against Ebbers’ WorldCom stock holdings, and other issues, convinced the independent directors to call for Mr. Ebbers’ resignation. The non-officer WorldCom directors and their counsel met on April 26, 2002 in person at a meeting called by the Chairs of the Compensation Committee and the Audit Committee. This was the first time this group had ever met on its own in person. By a unanimous vote, Ebbers’ resignation was demanded.13 Ebbers’ resignation was announced on April 30, 2002.14
The Internal Audit group of WorldCom commenced a review of WorldCom’s capital expenditures and capital accounts in May 2002, after Ebbers’ resignation.
The Internal Audit group determined that a number of questionable transfers had been made into the Company’s capital accounts in 2001 and the first quarter of 2002. Internal Audit had discussions with Scott Sullivan, the CFO of WorldCom, and others in the financial and accounting departments who reported to Scott Sullivan. In discovering the capitalization of line costs (which were labelled under the asset description of "Prepaid Capacity"), Internal Audit was advised by some of the principal financial and accounting officers that they were unable to provide justification for these capital expenditure additions. Scott Sullivan asked Internal Audit to delay the current review until the third quarter of 2002. He also advised that these line costs had been expensed prior to the third quarter of 2001 and that going forward they would be expensed or recognized as a restructuring change.15 Internal Audit advised the chairman of the WorldCom’s Audit Committee of these issues and the newly appointed external auditors, KPMG (the prior auditors, Arthur Andersen, having resigned in May 2002), were contacted for their review of the capitalization of the line costs and related accounting issues. The persistence of Internal Audit in pursuing its continuation of its review and the practices and policies of capitalizing these line costs lead to a full meeting of the Audit Committee in mid-June 2002. The Audit Committee informed the new CEO and the General Counsel of the situation who attended an Audit Committee meeting on June 20, 2002 which reviewed the propriety of transferring line costs to capital accounts. The external auditors, KPMG, were also present at the June 20 Audit Committee meeting. KPMG advised the Audit Committee that the transfer of line costs to the Company’s capital accounts, in its view, did not comply with general accepted accounting principles and noted in particular the absence of documentation supporting the transfers. On June 24, 2002, the Audit Committee conducted an expanded meeting with senior management, a number of additional directors, outside legal counsel for the Audit Committee and outside counsel for WorldCom, to make a final determination of the issues. The former external auditors, Arthur Andersen, attended by telephone and informed the Company that in light of the transfer of line costs during 2001 and the first quarter of 2002, Arthur Andersen’s opinion regarding the Company’s 2001 financial statements no longer could be relied upon. They stated that Arthur Andersen had no knowledge of the transfers but declined to respond to questions regarding how Arthur Andersen’s audit activities could have failed to discover the transfers. KPMG agreed with Arthur Andersen’s conclusion that the transfers in question could not be supported by GAAP. The Audit Committee concluded that it should report to the Board that a restatement of the Company’s financial statements for 2001 and the first quarter of 2002 would be necessary.16 Following the June 24, 2002 meeting of the Audit Committee, the Board of Directors of WorldCom met on June 25, 2002, and, following a report by the Audit Committee, determined to restate the Company’s financial statements for 2001 and the first quarter of 2002, to inform the SEC of the Board’s decision and events leading up to it, to terminate Scott Sullivan, the CEO, without severance and to accept the resignation of the Company’s Controller, David Myers, without severance, and to publicly announce the Board’s actions.
On June 25, 2002, WorldCom publicly announced that it had misstated its earnings for 2001 and the first quarter of 2002 and that it intended to restate its financial statements for those periods.
On July 21, 2002, WorldCom filed voluntary petitions for bankruptcy under Chapter 11 of the United States Bankruptcy Code.
5. WorldCom Culture
The Special Investigative Committee Report of the Board of Directors commented on the culture of WorldCom in connection with WorldCom’s financial misfeasance. It noted as follows:
"Numerous individuals - most of them in financial and accounting departments at many levels of the Company and in different locations around the world - became aware in varying degrees of senior management’s misconduct. Had one or more of these individuals come forward earlier and raised their complaints with Human Resources, Internal Audit, the Law and Public Policy Department, Andersen, the Audit Committee, individual Directors and/or federal or state government regulators, perhaps the fraud would not have gone on for so long. Why didn’t they? The answer seems to lie partly in a culture emanating from corporate headquarters that emphasized making the numbers above all else; keep financial information hidden from those who needed to know; blindly trusted senior officers even in the face of evidence that they were acting improperly; discouraged dissent; and left few, if any, outlets through which employees believed they could safely raise their objections.
This culture began at the top. Ebbers created the pressure that lead to the fraud. He demanded the results he had promised, and he appeared to scorn the procedures (and people) that could have been a check on this reporting. When efforts were made to establish a corporate Code of Conduct, Ebbers reportedly described it as a "colossal waste of time". He showed little respect for the role lawyers played with respect to corporate governance matters within the Company. While we have heard numerous accounts of Ebbers’ demand for results - on occasion emotional, insulting, and with express reference to the personal financial harm he faced if the stock price declined - we have heard none in which he demanded or rewarded ethical business practices."17
The Special Investigative Report of the Board of Directors, in addition to noting that the fraud occurred as a result of knowing misconduct that was directed by a few senior executives and implemented by personnel in the Company’s financial and accounting departments, also concluded that the financial fraud at WorldCom was the consequence of the way Ebbers ran the Company. In this regard, it commented:
"…he [Ebbers] was the source of the culture, as well as much of the pressure, that gave birth to this fraud. That the fraud continued as long as it did was due to a lack of courage to blow the whistle on the part of others in WorldCom’s financial and accounting departments; inadequate audits by Arthur Andersen; and a financial system whose controls were sorely deficient. The setting in which it occurred was marked by a serious corporate governance failure."18
6. Internal Controls at WorldCom
The Corporate Monitor was also critical of the Company’s financial and internal controls over financial reporting. The Corporate Monitor noted that a contributing factor that allowed the books to be deliberately falsified without attracting much notice was the Company’s weak internal controls over the preparation and publication of its financial results and that such internal controls were "dysfunctional at best, and in some areas controls were missing entirely".19 The Corporate Monitor also noted that another element in the disaster was an exceptionally weak accounting and finance department overall. The Company’s accounting and finance functions were fragmented across numerous geographic locations. Financial results posted by operating units were altered after accounts were submitted to senior accounting personnel as part of the final consolidation of accounts. The Corporate Monitor also noted that the overall quality of the senior accounting staff during the period the fraud was operating was "abysmal", as suggested by a number of indictments of these personnel and the widespread control issues documented by the Special Investigative Report of the Board of Directors of WorldCom and by the new Company’s auditors who replaced Arthur Andersen. The Corporate Monitor stated that this weakness in accounting personnel extended to the internal audit department, whose personnel appeared to have been substantially inadequate in number, training and experience to conduct the types of thorough testing and review of the Company’s financial results that should have occurred in a company of this size.20
The lack of internal controls over financial reporting was also noted by the Bankruptcy Court Examiner. In his Second Interim Report, the Bankruptcy Court Examiner noted:
"A fraud of such magnitude did not occur in a vacuum. Key systems and layers of the Company’s oversight and internal controls failed to detect some of the problems until June 2002. Even then, a portion of the fraud was detected due to a confluence of events, rather than as a result of any systemized audit procedures."21
7. Corporate Governance at WorldCom
With respect to the failures of corporate governance at WorldCom that underlay the accounting failures of the Company, the Corporate Monitor made the following comments:
"One cannot say that the checks and the balances against excessive power within the old WorldCom didn’t work adequately. Rather, the sad fact is that there were no checks and balances. The failures of governance allowed the reckless pursuit of wealth by the CEO, and his domination of compensation decisions throughout the Company. Indeed, Ebbers as CEO was allowed nearly imperial reign over the affairs of the Company, without the Board of Directors exercising any apparent restraint on his actions, even though he did not appear to possess the experience or training to be remotely qualified for his position. Within the Company, senior executives knew that wealth primarily through stock options and "retention" grants flowed solely from the dictates of Ebbers, who was allowed to run the Company as if he were running a private family business. Ebbers became an unrestrained force capable of decreeing virtually everything that had happened within WorldCom. The Compensation Committee of the Board seemed to spend most of its efforts finding ways to enrich Ebbers, and it certainly did not act as a serious outside watchdog against excessive payments or dangerous incentives.22
An observation from Richard Breeden, the Corporate Monitor, reflects some of these points in commenting on the WorldCom Board.
"Lack of time commitment was not the board’s worst failing. Despite having a separate Chairman of the Board and independent members, the board did not act like it was in control of the Company’s overall direction. Rather than making clear that Ebbers served at the pleasure of the board, and establishing reasonable standards of oversight and accountability, the board deferred at every turn to Ebbers."
"Ebbers controlled the board’s agenda, the timing and the scope of board review of transactions, awards of compensation, and the structure of management. He ran the Company with iron control, and the board did not establish itself as an independent force within the Company. The Chairman of the Board did not have a defined role of substance, did not control the board’s agenda, did not run the meetings and did not act as a meaningful restraint on Ebbers."23
Worthy of note, Richard Breeden also commented in connection with the characteristics of the WorldCom directors:
"While not found in most descriptions of director qualifications, ‘backbone’ and ‘fortitude’ may be the most important qualities needed by a director of a public company."24
8. Convictions and Legal Settlements
In March 2005, Bernie Ebbers, the former CEO of WorldCom, was convicted, in a jury trial, of securities fraud and seven counts of filing false reports with regulators and sentenced to 25 years in prison.25 His appeals from these convictions were dismissed by the Court of Appeals for the Second Circuit on July 28, 2006. Former WorldCom CFO, Scott Sullivan, pleaded guilty to charges and testified against Ebbers. Scott Sullivan was sentenced to five years in prison, but was not ordered to pay restitution or a fine.26 WorldCom controller David Myers was sentenced to one year and a day; accounting director Buford Yates a year and a day; Betty Vinson, director of management reporting, five months; and Troy Norman, director of legal entity accounting, three months probation.
In March 2005, the 12 former outside directors of WorldCom settled securities class action lawsuits by agreeing to pay personally out of their own assets US$24.75 million, with the D&O insurer agreeing to pay an additional US$36 million on their behalf. The payments by the former directors represented approximately 20% of the directors’ collective net worth, excluding primary residences, retirement funds and certain joint marital assets.27
In July 2006, Scott Sullivan consented to a final judgment holding him liable for US$10 million in disgorgement, representing a retention bonus he received in 2000, and US$3.6 million in prejudgment interest. The final judgment, however, waived payment of the US$13.6 million and did not impose a civil penalty based on Sullivan’s demonstrated inability to pay. In 2005, Sullivan settled securities class action litigation by, among other things, surrendering the proceeds from the sale of his home and his WorldCom 401(k) account. The Court had also previously permanently enjoined and prohibited Sullivan from acting as an officer or director of any public company. In separate earlier administrative proceedings, Sullivan agreed to suspension from practicing before the SEC as an accountant.
David Myers consented to a similar final judgment with the SEC in July 2005 in which he was found liable for approximately US$1 million in disgorgement, representing bonuses he received during the pendency of the fraud. The Court waived payment of the disgorgement due to Myers’ demonstrated inability to pay and did not impose a civil penalty. Myers was also permanently enjoined and prohibited from acting as an officer or director of any public company and suspended from practicing before the SEC as an accountant. A similar liability judgment and waiver of payment of disgorgement due to demonstrated inability to pay was entered against Buford Yates. Betty Vinson and Troy Norman were not found liable for disgorgement as they were not determined to have received ill-gotten gains from their participation in the fraud. All of the latter three also were enjoined and prohibited from acting as an officer or director of any public company and, in the case of Yates and Vinson, suspended from practicing before the SEC as accountants.28
9. No Need to Prove Violations
In his appeal to the Court of Appeals for the Second Circuit, Ebbers argued that his conviction by the jury in the trial was flawed and should be overturned because the indictment did not allege that the underlying accounting in WorldCom’s financial statements in the years in question was improper under GAAP and that the trial court should have required that the government prove violations of GAAP at the trial. Ebbers argued that where a fraud charge is based on improper accounting, the impropriety must involve a violation of GAAP, because financial statements that comply with GAAP necessarily meet SEC disclosure requirements. The Court of Appeals for the Second Circuit dismissed this argument, noting that it had addressed a similar issue in United States v. Simon29 where three accountants asked for a jury instruction that they could not be found guilty of securities fraud if the financial statements in question were in compliance with GAAP. The Second Circuit noted that it ruled that the District Court properly refused to give that instruction and stated in the Ebbers’ appeal that the Second Circuit could see not reason to depart from Simon. The Second Circuit went on to state:
"To be sure, GAAP may have relevance in that a defendant’s good faith attempt to comply with GAAP or reliance upon an accountant’s advice regarding GAAP may negate the government’s claim of an intent to deceive….Good faith compliance with GAAP will permit professionals who study the firm and understand GAAP to accurately assess the financial condition of the company. This can be the case even when the question of whether a particular accounting practice complies with GAAP may be subject to reasonable differences of opinion.
However, even where improper accounting is alleged, the statute requires proof only of intentionally misleading statements that are material, i.e., designed to affect the price of a security.…If the government proves that a defendant was responsible for financial reports that intentionally and materially mislead investors, the statute is satisfied. The government is not required in addition to prevail in a battle of expert witnesses over the application of individual GAAP rules.
For example, an addition to revenue used in the "Close Gap" program may or may not have been improper under particularized GAAP rules. However, where an addition intentionally involved funds that had not previously been used to calculate revenue and were a one-time addition to revenue, investors would not have been alerted to the fact that revenue as previously calculated was actually down. Such an intentionally misleading financial statement violates the statute. For similar reasons, the addition of under usage penalties to revenue may or may not have been proper under some GAAP rule, but was intentionally misleading because the penalties were not expected to be realized. Finally, appellant [Ebbers] claims that capitalization of some leases may have been proper under GAAP, but the capitalization of line costs - again an unannounced change in bookkeeping - was based not on an examination of particular leases but on the financial targets needed to keep share price high.
In a real sense, by alleging and proving that the financial statements were misleading, the government did, in fact, allege and prove violations of GAAP according to the AICPA’s Codification of Statements on Accounting Standards, AU §312.04, "[f]inancial statements are materially misstated when they contain misstatements whose effect, individually or in the aggregate, is important enough to cause them not to be presented fairly, in all material respects, in compliance with GAAP." Thus, GAAP itself recognizes that technical compliance with particular GAAP rules may lead to misleading financial statements and imposes an overall requirement that the statements as a whole accurately reflect the financial status of the company.
To be sure - and to repeat - differences of opinion as to GAAP’s requirements may be relevant to a defendant’s intent where financial statements are prepared in a good faith attempt to comply with GAAP. The rules are no shield, however, in a case such as the present, where the evidence has showed that accounting methods known to be misleading - although perhaps at times fortuitously in compliance with particular GAAP rules - were used for the express purpose of intentionally misstating WorldCom’s financial condition in artificially inflating its stock price."30
The decision of the Court of Appeals for the Second Circuit on this point underscores the principle that a public company’s filed financial statements should fairly present in all material respects the financial condition and results of operations and cash flows of the company for the periods covered by the filings, irrespective of compliance with GAAP.
Footnotes
1United States of America v. Bernard J. Ebbers, United States Court of Appeals for the Second Circuit, Docket No. 05-4059-cr, July 28, 2006 (the "Ebbers Court of Appeals Decision").
2 Ebbers Court of Appeals Decision, at page 45.
3 Report of Investigation by the Special Investigative Committee of the Board of Directors of WorldCom, Inc., Dennis R. Beresford, Nicholas deB. Katzenbach and C. B. Rogers, Jr.; Counsel: Wilmer, Cutler & Pickering; Accounting Advisors: PricewaterhouseCoopers LLP, (March 31, 2003) ("Special Investigative Report of the Board of Directors of WorldCom"), at pages 294-306.
4 Ibid., at page 311.
5 Richard C. Breeden was appointed Corporate Monitor, with the consent of WorldCom, on July 3, 2002, by the United States District Court for the Southern District of New York.
6 Richard C. Breeden, Corporate Monitor, Restoring Trust, Report to The Hon. Jed S. Rakoff, United States District Court for the Southern District of New York, on corporate governance for the Future of MCI, Inc. (August 2003) ("Restoring Trust"), at pages 27-28.
7 First Interim Report of Dick Thornborough, Bankruptcy Court Examiner, United States Bankruptcy Court, Southern District of New York, (November 4, 2002) ("First Interim Report") and Ebbers Court of Appeals Decision, at page 41.
8 Special Investigative Report of the Board of Directors of WorldCom, at page 6.
9 Special Investigative Report of the Board of Directors of WorldCom, at pages 10-12.
10 Ibid., at pages 15-16.
11 First Interim Report, at page 8.
12 Ibid., at pages 22-23.
13 Special Investigative Report of the Board of Directors of WorldCom, at page 309.
14 First Interim Report, at page 23. See Special Investigative Report of the Board of Directors of WorldCom, at pages 309-311 regarding the Board’s decision to seek Ebbers’ resignation.
15 WorldCom Internal Audit correspondence dated June 12, 2002.
16 Statement of Michael H. Salsbury, WorldCom General Counsel, dated July 8, 2002 pursuant to Section 21(a)(1) of the Securities Exchange Act of 1934.
17 Special Investigative Report of the Board of Directors of WorldCom, pages 18-19.
18 Ibid., at page 1.
19 Restoring Trust, at page 22.
20 Restoring Trust, at pages 23-24.
21 Second Interim of Dick Thornborough, Bankruptcy Court Examiner (June 9, 2003), at page 172.
22 Restoring Trust, at page 25.
23 Restoring Trust, at page 33.
24 Restoring Trust, at page 30.
25 Wall Street Journal, March 16, 2005, page A1.
26 Wall Street Journal, August 12, 2005, page C1. United States v. Scott D. Sullivan, 02 Cr 1144 (BSJ)(SDNY).
27 See, http://www.worldcomlitigation.com/html/citisettlementm.html; Ira Millstein and E. Norman Veasey, Weil, Gotshal & Manges, The Corporate Advisor (April/May 2005).
28 SEC Litigation Release No. 19776 (July 27, 2006).
29 425 F.2d 796, 805-06 (2nd Circuit 1969) (Friendly, J.).
30. Ebbers Court of Appeals Decision, at pages 33-37.
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