PIABA BAR JOURNAL (Vol 11 No. 2)

Another Serpent on Wall Street - The WorldCom Fraud

By Mark A. Tepper

Securtiies Fraud Lawyer
                               
Like the serpent in the Garden of Eden who beguiled Eve into eating the forbidden fruit, Salomon Smith Barney ("SSB"), now known as Citigroup Global Markets, Inc. stands accused by investors of being a Wall Street serpent.  SSB is alleged to have beguiled its brokers into recommending WorldCom to their customers by using misrepresentations and omitting material facts.  Investors argue that SSB placed its own self-interest ahead of the interests of its customers.     

Investors have some powerful arrows of evidence in their quivers, which were used during the class action to give SSB   the shivers.  However, unlike the serpent who was condemned to crawl on his belly for eternity because of its sins, SSB is still
negotiating its penalty.

This article summarizes some of the fraud allegations and arguments by investors against SSB related to its recommendation to purchase WorldCom.  The allegations have been collected from court filings, regulatory findings and newspaper articles. 

Investors argue that SSB fraudulently induced its customers to purchase and hold WorldCom stocks by providing them with recommendations and analyst reports from Jack Grubman, SSB's star telecommunications analyst, that were infected by
undisclosed conflicts of interest, contained misrepresentations and omitted material facts.  SSB misrepresented WorldCom's financial condition and failed to disclose the illegal quid pro quo relationship between SSB and WorldCom.  Had that self-serving arrangement been adequately disclosed, it would have been apparent that Grubman's positive reports about WorldCom and recommendations to buy WorldCom was not reliable advice from an independent analyst and trustworthy brokerage house.   

The illegal quid pro quo arrangement was that SSB and its agents would issue positive analyst reports about WorldCom, provide WorldCom senior executives with valuable IPO shares, and loan WorldCom's CEO, Bernard Ebbers, ("Ebbers") hundreds of millions of dollars in exchange for WorldCom's investment banking business and the substantial revenue and personal compensation that the business generated for SSB and its agents.

SSB and its parent, Citigroup, had a strong financial interest in propping up the price of WorldCom stock.  WorldCom was one of SSB's largest fee generating clients.  WorldCom was an extremely desirable client because it engaged in so many acquisitions, generating significant banking business.  Grubman's positive analyst reports played a significant role in assuring that SSB would retain WorldCom's lucrative investment banking business.  SSB even reconfigured Ebbers' WorldCom margin debt(fn. 1) which avoided selling Ebbers' WorldCom stock.  Had Ebbers been forced to sell, it would have negatively impacted the price of WorldCom stock.

SSB Failed to Disclose its Illegal Quid Pro Quo Relationship with WorldCom
                               
SSB and Grubman on the one hand and WorldCom and Ebbers on the other, had a close and self-serving relationship from which both sides derived substantial benefit.  WorldCom's securities prices were artificially inflated by Grubman's reports.
He was SSB's star telecommunications analyst and consistently encouraged investors to buy WorldCom securities.  An August 2002 Time magazine article reported that "Grubman was the 'ax', the one man who could make or break any stock in [the
telecommunications] industry."

SSB and Grubman were well remunerated for their support of WorldCom.  Between October 1997 and February 2002, SSB received a significant portion of WorldCom's investment banking business, for which WorldCom paid $107 million over the course of twenty-three deals.  Grubman's compensation was directly tied to SSB's investment banking business.  In 2001 alone, Grubman claimed compensation for his involvement in ninety-seven investment banking transactions which together generated $166 million in revenues.  When he attended Ebbers' wedding, he charged the trip to the investment banking department.  Grubman's importance to SSB is reflected in his compensation.  Between 1998 and 2002 Grubman made about $20 million per year and when he resigned from SSB in August 2002, he received a severance package of $32 million plus forgiveness of a $19 million loan.

In exchange for WorldCom's lucrative business, SSB provided Ebbers and other WorldCom senior executives with valuable IPO shares (fn. 2).  SSB's corporate sibling, the Traveler's Insurance Company ("Travelers"), secretly lent Ebbers hundreds
of millions of dollars, which were secured in part by Ebbers' WorldCom stockholdings (fn. 3).  And, SSB published Grubman's relentlessly positive, but materially false, reports about WorldCom.
    
    
SSB Misrepresented the Financial Condition of WorldCom

The accounting fraud at WorldCom involved, among other things, the improper classification of $3.8 billion in ordinary costs as capital expenditures in violation of generally accepted accounting procedures which led to WorldCom's overstatement of
earnings.  In 2000, Grubman adopted a new accounting model designed to omit the influence of capital expenditures a key element of WorldCom's accounting fraud.  This model was initially adopted for WorldCom alone among all of the telecom
companies Grubman followed.
    
SSB and Grubman knew, or by the exercise of proper due diligence should have known, that WorldCom's financial condition was deteriorating.  In early 2001, WorldCom badly needed to raise money and approached Citibank, and others about refinancing a $3.75 billion line of credit.  The Citibank loan approval memo, dated March 2001 discussed WorldCom's negative cash flows for fiscal 2001, 2002 and 2003.  According to the memo, WorldCom's negative free cash flow   essentially how much more it would spend than it took in   was expected to be $1.4 billion in 2002 and 2003.  The proceeds from a planned 2001 $11.8 billion note offering were going to be used to refinance $9 billion in debt, including $3 billion in short-term notes that were issued in 2000 but were coming due in 2001.  Despite internal views about the financial deterioration of WorldCom, Citibank approved the loan.  The March 2001 loan approval memo noted that Susan Mayer, former treasurer of WorldCom, had told Citigroup that if it committed $800 million to the $3.75 billion line of credit for WorldCom, Salomon Smith Barney would be awarded a coveted role as co-manager of the big note deal, earning $20 million in investment banking fees.  (New York Times, 3 Banks Had Early Concern About WorldCom Finances, March 17, 2004).

SSB had an Interest in Propping Up the Price of WorldCom
    
SSB had an interest in propping up the price of WorldCom because WorldCom was a leading fee generating client.  SSB's asset management group owned more than 45 million shares of WorldCom for its clients and when Grubman was at his most influential, SSB's brokerage unit controlled 13% of the trading in WorldCom.  If SSB was to continue to underwrite WorldCom stock and bond offerings and earn fees from trading WorldCom, it was necessary to fraudulently support its price.  SSB also lent Ebbers $560 million which was, in part, secured by WorldCom stock.  (See, New York Times, When Citigroup Met WorldCom, dated May 16, 2004).

When the price of WorldCom was declining in the summer of 2000, SSB reconfigured Ebbers' WorldCom debt to prevent the margin sell off of his shares which would have caused the price of the stock to drop.  Citibank agreed to take a $10 million unsecured exposure on the loan before any stock would be sold.

"SSB provided personal financial assistance to Mr. Ebbers as a means of enhancing the probability that SSB would keep a preferred position in receipt of WorldCom business, including investment banking and stock option business, and also
as a means of avoiding sales of Mr. Ebbers' stock, which would adversely affect WorldCom's stock price." Thornburgh Report." (fn. 4).

SSB's failure to disclose the illicit quid pro quo relationship between SSB, Grubman, WorldCom and its officers and the false and misleading description of WorldCom's financial condition in Grubman's analyst reports illegally propped up the
price of WorldCom stock.
    

SSB and Grubman Knew Grubman's WorldCom Analyst Reports were Fraudulent

Investors argue: SSB knew that Grubman's analyst reports were not the work of an objective researcher.  In addition to Grubman's ratings being driven by investment banking at SSB, he functioned as an insider at WorldCom.  Grubman attended at least two meetings of WorldCom's Board of Directors concerning the acquisition of MCI and Sprint, and advised WorldCom regarding a contemplated acquisition of Nextel. 

An allegation has surfaced that Grubman helped conceal WorldCom's financial problems by scripting Ebbers' statements for certain earnings conference calls.  In regard to a scheduled February 7, 2002 earnings conference call, during the beginning
of February 2002, Grubman sent Ebbers and/or Sullivan a series of e-mails instructing them to vouch for WorldCom's liquidity, accounting and business model, despite his understanding of the financial deterioration of WorldCom.  Grubman published a
corresponding research note that same day assuring investors that "WorldCom [had] addressed all issues surrounding liquidity, etc. of which there are none." 

In a June 2001 e-mail to Kevin McCaffrey, SSB's head of U.S. research management, Grubman confirmed his knowledge that his buy recommendations were unreliable when he admitted:

     Most of our banking clients are going to zero and you know I wanted
     to downgrade them months ago but got a huge pushback from
     banking.  I wonder of what use bankers are if all they can depend on
     to get business is analysts who recommend their banking clients.
    
At about the same time, Grubman e-mailed a research colleague about an upcoming dinner meeting at which he expected to hear two senior investment bankers complain about some of his recent commentary on telecom stocks.  Grubman again confirmed his knowledge of his allegedly fraudulent practices: "Screw [the investment bankers], We should have put a sell on everything a year ago."  (Emphasis added).

Investors argue that adequately disclosing the illicit relationships between WorldCom and SSB would have made it apparent to investors that SSB's and Grubman's analyst reports and recommendations were not reliable advice from an independent analyst and trustworthy brokerage house.

SSB senior management knew that Grubman had been corrupted and was not functioning as an independent analyst and knew that their analyst reports were improperly affected by pressure from SSB investment bankers.  NYSE Hearing Panel Decision, 03-72.  "In a February 22, 2001 memo, the [SSB] head of Global Equity Research told the managing directors in the U.S. equity research division that the global head of SSB's private client (i.e., retail division) said SSB's 'research was basically
worthless'. . . ."  Id. (Emphasis added).  SSB's continued recommendation to buy and/or hold WorldCom despite its knowledge of the falsity of the analyst reports was a reckless disregard for the truth. 

SSB and Grubman have also been the subject of government and regulatory investigations.  SSB was one of ten investment banks, and Grubman one of two individual analysts who entered into a global settlement arising from joint investigations conducted by the SEC, the New York State Attorney General's Office and others into the undue influence of investment banking on securities research.  Citigroup, SSB's parent, agreed to pay $400 million in settlement, including $150 million in penalties and $150 million in disgorgement.  Citigroup, which includes SSB, agreed to pay $2.65 billion to settle class action claims by investors that SSB misrepresented WorldCom's financial condition and omitted to disclose its quid pro quo relationship with WorldCom to investors.

Conclusion

The above allegations are disturbing because they reflect a breakdown of institutional controls that unfairly victimized thousands of investors.  The above described allegations raise questions about the wisdom of Congress having repealed the Glass-Steagall Act   one of the key stock market reforms to follow the 1929 market crash.  Without regulation, the temptation of huge investment banking fees was irresistible, focusing attention on the need for strict enforcement of investor protection statutes together with a strong regulatory presence. 

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1.  Typically a margin loan is 50% of the value of a stock.  When the stock drops, the margin debtor must cover the difference by selling stock or posting additional collateral.

2.  SSB  investment bankers controlled the research analysts empowering SSB to hand out wealth to others just by allowing them to buy the IPO stock they were selling.  This practice of allocating hot IPO shares to designated individuals is called “spinning” and is illegal.  SSB engaged in the illegal practice of spinning hot IPO shares to Bernard Ebbers, WorldCom CEO and director; Scott Sullivan, WorldCom CFO and director; and Stiles A. Kellett, WorldCom director.  “Ebbers alone received allocations of at least twenty-one “hot IPOs from which he derived profits of $11.5 million.  SSB, in a letter to the United States House of Representatives Committee on Financial Services has admitted that “some allocations to corporate officers and directors . . . were sufficiently large as to raise questions about the appearance of conflicts.  Spinning is a fraudulent practice which is prohibited by Federal Securities Law and NYSE Rules.  SSB has admitted that their spinning activities were fraudulent practices.  NYSE Hearing Panel Decision 03-72.

3.  Bernard Ebbers received hundreds of millions of dollars in loans from The Travelers Insurance Company (“Travelers”), a Citigroup subsidiary and a former parent of SSB.  Citigroup owns SSB.  These loans were not publicly disclosed.  They were effectively concealed because  they  were made to Joshua Timberland LLC, an entity  controlled  by  Ebbers, but held  by  another entity  whose connection with  Ebbers  was also obscured.  The loans were secured in part by WorldCom stock, a fact that gave Citigroup an additional incentive to prop up the price of WorldCom stock to protect its investment.

4.  Third and Final Report of Dick Thornburgh, Bankruptcy Court Examiner, In re WorldCom, United States Bankruptcy Court, Southern District of New York, Case No. 02-13533, (AJG).