Twenty years ago next week, a massive accounting scandal hit a leading US growth company, bankrupting it and sparking stricter accounting and securities laws that still shape America today. .
Nope, not Enron. The Texas energy group, which collapsed six months earlier, has become shorthand for corporate fraud, and even inspired a musical. But it was Mississippi-based telecommunications company WorldCom, which admitted in June 2002 to posting billions of dollars in inflated profits, that finally pushed through the Sarbanes-Oxley corporate responsibility law.
However, the lesson for today’s investors goes beyond the WorldCom fraud. A Wall Street darling, the company soared during the 1990s, gobbling up rivals and telling investors that the rise of the Internet would fuel huge increases in network demand. But it hit a wall in the midst of the dot-com crash of the 2000s, when actual data traffic couldn’t keep up with investment.
With the US currently tipping into another tech-driven bear market, WorldCom’s $104bn bankruptcy (still the third largest in US history) contains important warnings.
In May 2002, efforts to tighten US securities laws to prevent another Enron bogged down completely, as Congress argued over how tough to be. A less stringent bill pushed by House Republican Michael Oxley was gaining traction when news broke of even bigger fraud. WorldCom had been reclassifying billions of dollars of operating costs as capital expenditures to boost reported profit margins.
The move covered up WorldCom’s slowing growth at a time when competitors like AT&T were laying off workers. Folksy CEO Bernie Ebbers was eventually sentenced to 25 years in prison.
The scandal gave Senator Paul Sarbanes and the reformists an advantage. They forced the creation of an auditing regulator and required companies to demonstrate that they had adequate internal financial controls. Critics say “Sarbox” has deterred fast-growing companies from floating, causing a drop in the ranks of US-listed groups.
Fans of the law counter that US corporations have largely avoided massive accounting scandals since it was passed, unlike the UK and Germany. But that record could be tested if another recession hits.
Now it looks like another bubble is rapidly deflating, with the tech-heavy Nasdaq down more than 30 percent for the year. Startups without a clear path to profit have taken the biggest hits so far. But the financial problems that have sent WorldCom down the path of fraud are a warning to investors that start-ups are not the only ones at risk.
In the 2001 crash, companies like Cisco and Sun Microsystems that supplied servers, routers, and software to startups were hit along with their customers. But telcos like WorldCom also suffered because they built an infrastructure for users and demand for data that didn’t materialize.
This time, vendors in the line of fire are likely to include cloud computing and software-as-a-service providers, as well as online advertising and platform companies that startups pay to help them find new customers. The largest are diversified companies, but that hasn’t stopped Google shares down 25 percent this year, and Facebook is down twice as much.
Investors looking for strains similar to WorldCom may want to look for companies that have boasted rapid revenue growth and an “if you build it, they will come” approach. Those investing in blockchain-related infrastructure come to mind as the prices of bitcoin and other cryptocurrencies fall.
Amazon has been caught up in slowing e-commerce growth. The company admitted in April that aggressive investment in warehouses and infrastructure had left it with excess capacity. They are unlikely to be alone.
Vulnerable companies also include those that bet heavily on the metaverse and Web3, either directly or as a source of demand for their technology. Telecommunications executives of the 1990s were not wrong about the long-term future of the Internet. They just didn’t realize how long primitive dial-up technology would retain its appeal. Most companies picked up their bundles, WorldCom cooked their books instead.
If the next big evolution online takes so long to materialize, ethically challenged executives may be tempted to follow Ebbers’ lead. WorldCom is an abject lesson in how that turns a painful short-term profit squeeze into an outright corporate disaster. We hope that Sarbox will guide today’s businesses down a straighter path.
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