Infectious Greed

by Frank Partnoy

  This swap, and others like it, were designed to help Global Crossing “manufacture” earnings, especially at the end of a financial quarter. Like the Wall Street banks, Enron disclaimed any responsibility for how Global Crossing accounted for the swap on its financial statements. One Enron executive reportedly said, “We were selling them bullets; they could use them any way they wanted.” Enron executives argued that there was nothing wrong with manufacturing earnings, and defended the swap with Global Crossing, because “[e]veryone was over-reporting their numbers back then.”21

  During the time of these trades with Enron, Global Crossing also began entering into swap transactions with other firms, to trade rights known in the telecommunications industry as Indefeasible Rights of Use. IRUs were created at AT&T, which had trained many of the executives running various telecommunications companies. Now, many of these executives’ companies were inflating their revenue and earnings with IRU swaps—telecommunications executives from AT&T included Joseph Nacchio, CEO of Qwest; and Robert Annunziata and Leo Hindery Jr., who had been CEOs of Global Crossing. Even Jack Grubman, the analyst from Salomon, had come from AT&T.

  In an IRU swap, two telecommunications companies agreed to exchange the rights to use bandwidth on different parts of their fiber-optic networks. One company might exchange the rights to use lines in New York for rights of roughly the same value in Kansas.

  The beauty of IRUs, from the perspective of a telecommunications company, was that accounting rules arguably permitted companies to treat the two legs of the swap differently, recording the revenue leg up front, while deferring the expense leg over time. In 1999, the SEC had published “Staff Accounting Bulletin No. 101” in an attempt to standardize the way companies recognized their revenues, and to ban revenue recognition practices that had deceived investors during the late 1990s (recall Al Dunlap’s “channel stuffing” of barbecue grills at Sunbeam). This bulletin set forth the requirements for when certain revenues should be recognized and for when certain costs should be spread over time. The bulletin was lengthy and complex; but, essentially, Global Crossing and other companies were using one portion of the bulletin to justify up-front recognition of revenues, while using another portion of the bulletin to justify spreading expenses over time. Global Crossing could argue that the incoming payments from the IRU were revenues, to be recognized right away, while the outgoing payments were a capital expense, to be spread over a period of several years.

  Not everyone in Global Crossing’s accounting department agreed with this interpretation. Roy Olofson, a vice president of finance at Global Crossing, believed the legs of the swap should be treated equivalently. But any support he had—within Global Crossing or among the firm’s auditors at Arthur Andersen—evaporated in May 2000, when Global Crossing hired Joseph P. Perrone as a senior vice president of finance. Perrone had been at Arthur Andersen for thirty-one years, where he audited Global Crossing, was involved in discussions about how to account for IRUs, and even suggested some restrictions on Global Crossing’s accounting practices.22 Winnick lured Perrone with a huge guaranteed bonus and 500,000 stock options, worth millions of dollars.23 (In addition, it was Perrone’s son who ran Withit.com, the Internet company that did its first major deal with Global Crossing.) With Perrone at Global Crossing in 2000, Arthur Andersen received $2.3 million in audit fees and $12 million for non-audit work. Not surprisingly, Global Crossing’s executives listened to Perrone more than Olofson.

  Olofson began reporting directly to Perrone during mid-2000, and the two men immediately clashed over accounting policies. However, the disputes lasted only a few months, because Olofson was diagnosed with lung cancer and took a leave from the firm beginning in January 2001.

  While the cat was away, the mice began to play. Global Crossing’s executives proposed to use IRU swaps in March 2001—the end of the firm’s first financial quarter—to generate revenues and earnings that the company needed to meet analysts’ expectations. Global Crossing’s accountants wanted employees entering into these swaps to be sure the swaps contained the correct language, so that they would receive appropriate accounting treatment. On March 8, 2001, they circulated a memorandum stressing, “It is important for GX [Global Crossing] to classify these purchases as a capital lease versus a pre-paid service, because the classification affects how the expense impacts our EBITDA [earnings] calculation. A capital lease expense is excluded from our EBITDA calculation, while a service expense is included as a deduction in our EBITDA.” In other words, the accountants wanted to ensure that the cost of deals was spread over time, not included as an immediate expense. (EBITDA is an acronym for one important measure of accounting earnings: Earnings Before Interest, Tax, Depreciation, and Amortization.)

  One $100 million IRU swap was with Qwest, a telecommunications company that had outbid Global Crossing for U.S. West, one of the regional Bell companies created by the breakup of AT&T. Qwest then used the IRU swap technique on its own. During the first three quarters of 2001, Qwest sold $870 million of capacity and bought $868 million of capacity—to and from the same parties.24 These swaps appeared to be round-trip transactions, which served no purpose other than to inflate Qwest’s revenues. A year later, on July 28, 2002, Qwest would file a billion-dollar-plus restatement, admitting that it had improperly recorded revenues from these trades.

  Meanwhile, Global Crossing did IRU swaps with other companies. When Olofson returned to work in May 2001, he expressed concern about the financial statements Global Crossing had filed for the first quarter of 2001. Olofson told Perrone he believed Global Crossing had done illegitimate end-of-quarter swaps to achieve revenue and earnings targets. Global Crossing conducted a study to assess the value of the firm’s swaps, and concluded that less than 20 percent of the swaps actually could be added to Global Crossing’s network.25 In other words, Global Crossing found it was doing swaps that had no real business use.

  Nevertheless, the firm continued doing IRU swaps, and continued booking revenue up front and spreading expenses over time. According to Olofson, $720 million of Global Crossing’s $3.2 billion in revenue during the first half of 2001 was from illegitimate swaps.26 Olofson also claimed that thirteen of eighteen of these swaps occurred during the last two days of the quarter,27 making it appear that Global Crossing was using the IRU swaps as a last-minute way to create fictional earnings it needed to meet quarterly expectations.

  On August 6, 2001—at almost exactly the same time an Enron employee, Sherron Watkins, was warning Ken Lay about the firm’s accounting practices—Olofson sent a five-page letter to James Gorton, Global Crossing’s 39-year-old general counsel and “Chief Ethics Officer,” warning him that the firm had engaged in misleading accounting practices.28 The letter closely resembled Sherron Watkins’s letter to Ken Lay, and even discussed similar issues.

  After consulting with Global Crossing outside counsel, Gorton responded that the company already knew of these accounting practices and then resigned a few days later, citing “personal reasons.”29 Apparently, Global Crossing’s top managers did not send the letter to its auditors or board of directors. Olofson was fired from Global Crossing in November 2001.

  According to a February 4, 2002, press release by Global Crossing, the firm did not inform Arthur Andersen or its audit committee about the contents of the letter until January 29, 2002, the day after it filed for bankruptcy, when the Los Angeles Times reported the existence of Olofson’s letter.

  Global Crossing later dismissed Olofson’s allegations as the rantings of a disgruntled former employee, notwithstanding the fact that Olofson was not fired until three months after he sent his pivotal letter. It was true that Olofson was embroiled in a legal battle with Global Crossing and Gary Winnick related to his dismissal. But you didn’t need to believe Olofson to spot Global Crossing’s accounting machinations. Congressional investigators and prosecutors were uncovering the same facts, and much of what Olofson alleged was plain from Global Crossing’s public disclosures. All you neede
d to do was read Global Crossing’s most recent annual report.

  Anyone looking carefully at Global Crossing’s annual financial filing for 2000 would find $350 million of revenue on page 29 listed under “Sales Type Lease Revenue,” the term Global Crossing used for swaps of fiber-optic capacity. There was no corresponding line item for the expenses associated with these revenues. Instead, on page 32, there was this statement: “In addition, depreciation and amortization includes non-cash cost of capacity sold resulting from capacity sales that meet the qualifications of sales-type lease accounting.” In other words, in 2000, Global Crossing was recognizing revenue up front from these transactions and spreading the associated expenses over time. This accounting treatment matched Roy Olofson’s allegations.

  Global Crossing apparently was concerned about continuing to follow these accounting practices, because it changed its reporting in 2001 in a way that made the firm’s quarterly filings look like financial reports from Wonderland. Suddenly, no “Sales Type Lease Revenue” was listed at all. Instead, Global Crossing downplayed the firm’s actual revenues and expenses—which were plummeting, along with those of the rest of the telecommunications industry—and encouraged investors and analysts to focus, instead, on something it called “Cash Revenue,” which was defined as the firm’s actual revenue plus “revenue” from IRU swaps. In other words, “Cash Revenue” was neither cash nor revenue. The additions were substantial: $551 million for the second quarter of 2001.30

  The firm then used the “Cash Revenue” number to calculate another accounting fiction, “Adjusted EBITDA,” a manufactured number that included EBITDA—the measure of accounting earnings—plus the “non-cash cost of capacity sold” and the “cash portion of the change in deferred revenue,” terms that referred to IRU swaps. In other words, Global Crossing’s “Adjusted EBITDA” was a measure of the firm’s income that included up-front revenue from the IRU swaps, but spread expenses over time. This also matched Olofson’s allegations.

  The securities analysts covering the telecommunications industry were aware of the bizarre accounting practices related to IRUs.31 They shouldn’t have cared whether Global Crossing recorded the costs up front or spread them over time, or whether the firm wanted to use make-believe terms such as “Adjusted EBITDA.” As long as they knew what the firm actually was doing, they should have been able to figure out what it was worth, and then either recommend the stock to investors, or not. In an efficient market, sophisticated investors would trade Global Crossing’s stock until its price was accurate, selling if uninformed investors had driven up the price. However, the market for Global Crossing stock did not seem to be an efficient one; it was dominated by investors who loved the idea of Global Crossing, but did not understand IRUs and did not even bother to read Global Crossing’s financial filings. They overestimated Global Crossing’s value, and their frenetic buying drove the price of the stock. An informed investor who tried betting against Global Crossing’s stock might be correct, but she was stepping in front of a speeding train.

  Meanwhile, Global Crossing’s executives were stumbling over each other to sell stock before reality struck, and the firm was awarding unprecedented pay packages to a rapid succession of short-lived CEOs.32 First, Gary Winnick paid Jack Scanlon 3.6 million stock options to take the top job in April 1998. Then, Robert Annunziata, a former AT&T executive, took over in February 1999, with a $10 million signing bonus and 4 million options.33 Then Leo Hindery was CEO for seven months, and received 2 million options. In October 2000, Winnick promised new CEO Thomas J. Casey, an investment banker from Merrill Lynch, an $8 million loan (which later was forgiven), in addition to a seven-figure salary and bonus, plus options on 2 million shares of Global Crossing stock. Casey lasted less than a year in the job, and so Winnick enticed John J. Legere with the same terms plus a $3.5 million signing bonus, an additional $7 million of loans, and an extra 3 million options. Interestingly, these executives were so eager to sign pay packages that they neglected to check the details of when their stock options would become available. Casey’s employment agreement omitted one of the option payment dates; as a result, he was not entitled to receive 440,000 options, with a value of millions of dollars at the time they were granted.34 It is unclear whether anyone at Global Crossing spotted this mistake. Whatever happened to Casey’s extra options, it was incredible that, throughout this period, with five CEOs, individual investors nevertheless remained interested in Global Crossing.

  The fictitious gains from IRU swaps could not continue indefinitely without real profits to replace them, and on October 4, 2001—less than three weeks before Ken Lay’s fateful conference call with Enron’s analysts and investors—Global Crossing announced that it would not meet analysts’ earnings estimates. As word spread about the way the firm had recorded revenues and expenses from IRU swaps, investors abandoned the stock. Enron’s collapse was a bad precedent, and investors watching Enron nervously sold their Global Crossing stock. The end was sudden, and Global Crossing filed for bankruptcy on January 28, 2002—less than two months after Enron. The firm had had a short life as a public company under Gary Winnick—just four years from IPO to bankruptcy. In the end, as in the beginning, the firm took care of its insiders. In addition to forgiving $18 million in loans to its last two CEOs,35 Global Crossing—like Enron—arranged for its top employees to be paid millions of dollars just before its bankruptcy filing.36

  Gary Winnick wasn’t suffering too much. In 1999, the Los Angeles Business Journal had named Winnick “Los Angeles’ richest man,” worth $6 billion. He was no longer worth that much, but he was still on the Forbes 400 list of the wealthiest U.S. citizens, behind Bill Gates but ahead of Donald Trump. And he still lived in a $40 million mansion in Beverly Hills, down the street from Barbra Streisand, where he was considering plans for a new 100-car parking garage. He was active with his favorite charities, although he no longer could use Global Crossing’s resources for contributions, as he had, repeatedly, as chairman, even offering use of Global Crossing’s marine-services division to assist in the rescue of the Russian submarine Kursk in 2000.37 It seemed likely that Winnick would avoid civil liability and criminal charges. The leaders of C. W. Post still cherished his support, and “Winnick House”—unlike Enron Field—kept its name.

  Since Bernard Ebbers was a child in Edmonton, Alberta, he had wanted to be a basketball player.38 He played for his high school team in Canada during the late 1950s, but didn’t receive any major scholarship offers. He enrolled at the University of Alberta, but after spending a year practicing his jump shot more than studying, he flunked out. Ebbers did odd jobs in Edmonton, including one summer at Edmonton Telephones39 and a stint driving a milk-delivery truck.40

  After a few years, he finally found a place where he could play basketball: Mississippi College, a small school affiliated with the Mississippi Baptist Convention, which was consistently listed in the top 100 “character-building” colleges in the United States. Mississippi College was just the kick in the pants Ebbers needed, and he graduated in 1967 with a degree in physical education.41

  Unfortunately, a Mississippi College degree didn’t do much more for Bernie Ebbers at first than a diploma from C. W. Post had done for Gary Winnick. Ebbers coached high school basketball in Mississippi for a year, and then ran a small garment factory.42 He eventually persuaded some friends to invest with him in a motel and restaurant in a small town in Mississippi. He kept costs low, and over time bought a few more motels.43 But sixteen years after graduation, he was a long way from becoming a multibillionaire.

  One day in 1983, as Ken Lay was ascending the corporate ladder in Houston, Ebbers was sitting in a coffee shop in Hattiesberg, Mississippi, discussing the recent breakup of AT&T with his friends Murray Waldron and William Rector. The men decided they might be able to make money by purchasing long-distance services from the major phone companies and then selling it to small, local companies. Their waitress was listening to their conversation, and suggested Long Distance
Discount Services as a name. The men started LDDS, and Ebbers abandoned his hotels to become CEO of the company in 1985.44

  Like Gary Winnick, Ebbers was an aggressive salesman. But unlike Winnick, Ebbers also was frugal, and his penny-pinching attitude appealed to companies interested in reducing their long-distance bills. During the next decade, LDDS acquired a portfolio of residential and business customers, and expanded by buying a handful of small long-distance companies, just as Ebbers previously had acquired hotels. By 1995, LDDS had become a substantial provider of discount long-distance services, and Bernie Ebbers decided that the waitress from Hattiesberg hadn’t been thinking big enough; he changed the company’s name to WorldCom.

  Like Gary Winnick, Ebbers built up WorldCom, piece by piece, by acquiring dozens of companies. And like Gary Winnick, Ebbers befriended Jack Grubman and Salomon Brothers, relied on Grubman for advice, and used Salomon as his firm’s primary investment bank. Grubman had an unusually close relationship with WorldCom’s top managers, and even attended three board meetings, where he discussed deals the company was considering (securities analysts typically were not permitted to attend board meetings).45 With Grubman’s help, WorldCom’s stock price soared, and Ebbers began considering acquiring larger companies. In all, WorldCom paid Salomon $80 million in fees for these deals and other investment-banking work.46

  In 1997, at Grubman’s urging, WorldCom offered to buy MCI in the highest-profile deal of Ebbers’s career, one of the biggest mergers in U.S. history. The media closely followed the deal, and sophisticated fund managers—including Long-Term Capital Management—bet on whether it would succeed. When MCI agreed to terms, WorldCom instantly became the second-largest provider of long-distance telephone services—and a household name.47 By the late 1990s, investors knew more about WorldCom than they did about AT&T, the dominant telecommunications firm from the prior decade. WorldCom was the fifth most widely held stock in the United States, and its shares were worth $115 billion, double the value of AT&T’s shares. Twenty million residential customers used WorldCom as their long-distance carrier.