Analyzing the Corporate Governance Failures Behind WorldCom’s Scandal

1. What role did the Board of Directors play in the WorldCom scandal? Were they effective
in their oversight responsibilities?

Although there was no evidence that the board of directors was aware of the accounting fraud at
the company, they failed tremendously in fulfilling their responsibility to monitor management.
One of the key factors that caused the scandal was that the information presented to the board did
not necessarily indicate a need for further examination of the accounting practices. However,
with that being said, many would still argue that the Board played too small of a role in the
company's direction and culture.

One of the common problems that many companies face is that the executives usually dominate
the non-executive directors since they are more aware of the details of the company’s operations.
Similar to WorldCom’s case, Ebbers controlled the board's agenda, discussions, and decisions,
fostering an environment where meeting financial numbers was highly emphasized, control
departments were weak, and senior management's word was final. For instance, the board made a
problematic decision by allowing Ebbers to receive more than $400 million in loans and
guarantees, which was done to stop him from selling his WorldCom shares. Additionally, the
rules about when board members could trade stock were fragile. Together, these actions show
that the board simply followed Ebbers' lead without thoroughly checking his decisions. In
addition, the Audit Committee also lacked sufficient understanding of the company's internal
financial operations and devoted a very little amount of time to their role, meeting as little as
three to five hours per year.

2. Should the Board have been more proactive in questioning the financial decisions and
reporting practices of senior management? Why or why not?

Yes, the Board should have been more proactive in questioning the financial decisions and
reporting practices of senior management. For example, the stability of the line cost E/R ratio
and the disparity between reported and actual capital expenditures should have prompted
questions, and the board should have recognized these obvious anomalies to be questioned.
Therefore, we can conclude that the Board's reliance on Ebbers and Sullivan limited their ability
to detect red flags. However, it is important to note that outside directors had minimal interaction
with employees outside of board meetings, resulting in little sense of the company culture or The
board should be aware of issues beyond those presented by senior managers. This indicates that
the problems do not solely revolve around their lack of proactiveness in questioning the
decisions and practices conducted by senior management; it also shows the importance of how
the board should have kept a closer relationship with the other stakeholders (e.g., employees) of
the company because, without a comprehensive understanding of the company, the board would
not be able to ask the right questions in the first place.

3. What were the responsibilities of WorldCom’s audit committee, and how did they fail to
detect the fraudulent activities?

A. Overview
WorldCom’s audit committee, like any other audit committee, had the main responsibility to
ensure that the company’s financial statements were being presented fairly and in accordance
with accounting standards. Nevertheless, the board overlooked a scandal that inflated earnings by
more than $1 billion, which caused the company to file for bankruptcy in 2002.

B. Responsibilities
The WorldCom audit committee undertook the following tasks:
1.​ The role involves ensuring the implementation of internal controls and monitoring the
company's accounting practices to ensure they align with best practices, such as the
Generally Accepted Accounting Principles (GAAP).
2.​ Ensuring the company’s external auditors, Arthur Andersen, remained independent and
accountable throughout the auditing process.
3.​ I am examining the financial statements to ensure that they are in accordance with the
accounting standards.

C. How They Failed

There are several theories on why the audit committee didn’t catch the fraud:
Failure Factor Details

Not Enough Time The audit committee spent only three to six hours annually on its
task, which is way insufficient for a company as big as
WorldCom.

Lack of Independence Max Bobbitt, the chairman, had a close relationship with Bernard
Ebbers, the CEO, and even extended numerous personal loans.
These factors could potentially lead to biases in the audit
committee's evaluation.

Poor Oversight They neglected their duty in making sure that the external
auditors were making a thorough assessment, and the auditor also
didn’t tell them about the problems that they faced—the
management was blocking them access to information. They also
overlooked major internal control issues, allowing the fraud to
continue on for years.
4. What role did the external auditors (Arthur Andersen) play in the scandal? Were there
any conflicts of interest that compromised their independence?

A. Overview
Arthur Andersen was one of the “Big Five” accounting firms at the time, which served as
WorldCom's external auditors during the period. Their role, like any other auditors, is to issue an
independent opinion regarding the fairness and accuracy of WorldCom’s financial statements and
whether or not they’re in line with the GAAP. Arthur Andersen collapsed after the scandal, with
one of the consequences being a $65 million settlement with WorldCom investors in 2025.

B. Role of Arthur Andersen in the Scandal

The SEC report highlights several aspects of Arthur Andersen’s role and failure:
Failure Details

Audit Approach and Arthur Andersen rated WorldCom with the maximum risk of
Failure to Detect Fraud conducting fraud. However, they assessed their fraud risk as
moderate, which limits their auditing procedures. They did a very
limited form of control assessment audit where they relied solely
on management representations without further adequate testing.
As a result, they failed to detect $7.329 billion in improper line
cost reduction and $958 million in improper recorded revenue.

WorldCom Interference WorldCom personnel controlled information and also denied

access to critical documents, which made it difficult for Arthur
Andersen to do their audit process. Furthermore, the report
indicates a potentially too-friendly relationship, which could
further suggest a lack of independence for Arthur Andersen.
C. Conflicts of Interest
1.​ Dual Role as Auditor and Consultant: Arthur Andersen provides both auditing and
consulting services for WorldCom. Arthur Andersen also considered WorldCom as their
‘Crown Jewel’ client, so they were eager to secure millions of dollars in deals from
consulting services, which was way more profitable than auditing, which might lead them
to avoid asking critical questions of WorldCom.
2.​ Failure to Inform Audit Committee: The report also indicated that Arthur Andersen failed
to inform the audit committee regarding issues such as WorldCom interference with
access to documents.

5. How could the audit committee and external auditors have worked more effectively to
prevent the fraud?
To prevent the fraud committed by WorldCom, there are several ways where the audit committee
and external auditors can work more effectively.

The audit committee has the potential to enhance its oversight capabilities. The audit committee
should conduct more meetings to review the financial statements, accounting policies, and
internal controls. The audit committee should also spend a lot of time on the task. Give more
protection to whistleblowers to encourage employees to report any unethical behavior.

The external auditors should do more rigorous audits by performing detailed transaction testing
and reviewing the adjustments made to the financial statements. Another strategy could be to use
a rotation for the audit teams, as new teams may detect the fraud earlier.

6. What internal control weaknesses allowed the fraud to occur and go undetected for so
long?

Internal control Details

Weakness

Weak Governance & Bernard Ebbers, the CEO, has created a “cult” relationship with
lack of oversight the employees, causing them to be intimidated, which ends up
with the CEO’s decision to not be questioned or challenged by
anyone in the company. Furthermore, there’s only a little external
oversight.

Poor Auditing -​ Lack of meetings and lack of expertise to detect frauds

-​ Restricted access to financial records
-​ Inadequate external auditing by Arthur Andersen, missing
the fraud

Too much power in the The CFO Scott Sullivan and his team had full control over the
hands of executives accounting adjustments, enabling them to hide the frauds

Weak whistleblower With the employees being intimidated, the employees have no
system safe way to report unethical behaviour

7. How did WorldCom’s executive compensation structure (e.g., stock options, bonuses)
contribute to the fraudulent behavior?

WorldCom's executive compensation structure, according to Fahy and Chanos (2002), is a NYU
Stern case study. The Compensation and Stock Option Committee was the one with power; the
structure is made to line up with shareholder goals and attract, motivate, and retain executives.
The plan consisted of three key components: base salary, annual incentive compensation , and
long-term incentive compensation, primarily stock options.

Base salaries were set competitively, in the median to high end of industry ranges based on role
and responsibility, with input from Ebbers as CEO. Bonuses are used to reward short-term
financial goals like revenue increases. Stock options, the cornerstone of long-term incentives,
were granted at market price with delayed vesting, tying executive wealth to stock value. With
massive loans, they once gave over $300 million to Ebbers at low rates (Fahy & Chanos, 2002).

Factor How It Contributed to Fraudulent Example

Behavior

Stock Options and Executives’ wealth relied on stock value, Sullivan misclassified
Stock Price leading to fraud to keep prices high. $3.8B in expenses to
Dependence inflate earnings.

Bonuses and Bonuses tied to financial targets encouraged In 2001, a $500M loss was
Earnings executives to fake profits, turning losses into manipulated into a $150M
Manipulation gains to meet bonus criteria. profit to ensure bonus
eligibility.

Short-Term Focus Stock options and annual bonuses WorldCom ignored its
Over Long-Term prioritized quick gains, driving executives to debt and used accounting
Stability conceal financial troubles. tricks to delay collapse.

8. How can companies prevent similar governance failures in the future? What best
practices should be adopted?

WorldCom’s collapse is mainly brewed from a compensation structure over $300 million in
loans to CEO Bernard Ebbers, incentivized short-term manipulation, coupled with a compliant
board and weak audits. Companies can prevent such events by incorporating governance
standards in their Articles of Incorporation (Fried, Frank, Harris, Shriver & Jacobson, 2003).

The article should be filled with agreement, where changes should be approved by shareholders.
Unlike WorldCom's underqualified committee, the directors should be independent and
competent, and the CFO should possess expertise in finance or industry specifics. Having term
limits and annual evaluations can refresh boards while separating the CEO and chairman roles,
allowing checks on power. Shareholder participation via proxy access and nominations from
major investors, absent at WorldCom, enhances accountability. Compensation reforms with no
equity plans for independents, capped executive severance, and long-term equity holding rules
would curb the short-term thinking that drove Ebbers’ $140 million and CFO Scott Sullivan’s
$19.2 million windfalls (Fried, Frank, Harris, Shriver & Jacobson, 2003).

Key committee assurances must have domain experts combined with audit independence while
rotating firms every year or so, and transparent cash flow reports via online forums can expose
risks WorldCom hid. These measures, rooted in ethical commitment and continuous
improvement, removed the issue of oversights that let WorldCom’s diminish, ensuring
sustainable governance over fraudulent drama (Fried, Frank, Harris, Shriver & Jacobson, 2003).
 Sources

Fahy, J., & Chanos, J. (2002). Compensation and governance at WorldCom.

Fried, Frank, Harris, Shriver & Jacobson. (2003). A new voice in the corporate governance

debate - the recommendations of WorldCom’s Corporate Monitor.