WorldCom Report Finds Ebbers
Played Role in Inflating Revenue

A long-awaited report on the accounting fraud at WorldCom Inc. -- the largest in U.S. history -- will conclude for the first time that former Chief Executive Bernard J. Ebbers played a role in the company's effort to improperly boost revenue to meet Wall Street expectations, according to people familiar with the matter.

The expansive report, due to be released Monday, is the product of an independent investigation commissioned by the company and led by William McLucas of the law firm of Wilmer Cutler & Pickering. It details how, starting in 1999, the company used accounting fraud to cover up more than $10 billion in losses. WorldCom was one of the biggest stars of Wall Street, and its bankruptcy has cost shareholders $180 billion as the result of the drop in the stock's value.

The report highlights questions about the role of WorldCom's auditors, both internal and external, as well as the board of directors and scores of employees who knew about the fraud or helped carry it out. The company, now called MCI, plans to emerge from bankruptcy-court protection this fall and is hoping that the report will answer many of the questions that continue to create a cloud of distrust.

There hasn't been any decision thus far whether to bring a civil or criminal case against Mr. Ebbers.

Reid Weingarten, Mr. Ebbers's lawyer, said prosecutors determined to pin something on the former chief executive are only looking at revenue issues after making no progress in tying him to anything else. "It sounds to me that they are looking at every business decision that was ever made at WorldCom to find something wrong," said Mr. Weingarten. "I am hopeful and confident that the prosecutors will not proceed with some razor-thin case based on an allegation that does not directly implicate Mr. Ebbers." Mr. Weingarten said Mr. Ebbers wouldn't comment.

While much attention has been paid so far to WorldCom's $3.8 billion in fraudulent expense entries, the McLucas report addresses the remaining $7 billion in fraud and other accounting irregularities. For the first time, it asserts that Mr. Ebbers carefully followed monthly revenue reports and that he knew that revenue for the third quarter of 2001 was short of what he had told Wall Street to expect. At one October 2001 meeting, former Chief Financial Officer Scott Sullivan and former Chief Operating Officer Ron Beaumont talked with Mr. Ebbers about one-time revenue items they could use to close the gap for that quarter, according to people familiar with the report. The gap was closed by the time earnings were released to investors two weeks later.

The report describes WorldCom's repeated efforts to boost revenue by including one-time items in an exercise known internally as "Close the Gap." In several quarters, the company didn't disclose the items to investors and in the third quarter of 2001 specifically said there were no nonrecurring items.

A separate report by the law firm of Kirkpatrick & Lockhart LLP, led by former U.S. Attorney General Richard Thornburgh, who was appointed as bankruptcy examiner after WorldCom filed for Chapter 11, also is scheduled to be released Monday. Among other things, that report, commissioned by the U.S. Bankruptcy Court in New York, examines how WorldCom's mountain of debt, along with failures in the company's corporate governance, contributed to its collapse. In one example, the report cites WorldCom's lawyers and executives announcing the acquisition of Intermedia Communications Inc. in February 2001 before the board had approved the deal. The report says the lawyers created false minutes to make it look as though the board had already approved the transaction.

Messrs. McLucas and Thornburgh declined to comment.

Federal prosecutors in New York asked in March that the release of the McLucas report be delayed while they interviewed witnesses on some of its findings, including the revenue-recognition fraud and Mr. Ebbers's possible role. In particular, prosecutors in recent weeks have been asking witnesses how WorldCom doubled its revenue growth in the final days of the third quarter of 2001. According to the report, officials pumped up revenue growth to 12% from 6% with a series of nonrecurring revenue items. In its earnings report, WorldCom told investors there were no such items.

Any case against Mr. Ebbers has turned into a far more difficult prospect than investigators had expected. They have pored through hundreds of thousands of documents and for the most part have come up dry. Mr. Ebbers didn't use e-mail and made a point of not being involved in the paper trail of one the world's largest telecommunications companies. Moreover, Mr. Sullivan, the former CFO, has pleaded innocent to charges that he orchestrated the fraud, making him a difficult witness to use against Mr. Ebbers. WorldCom's head of internal audit, Cynthia Cooper, who unearthed the initial $3.8 billion of fraud, told authorities that she doesn't believe Mr. Ebbers knew about it, according to people familiar with the matter. To charge Mr. Ebbers with accounting fraud, prosecutors need to prove not only that Mr. Ebbers played a role, but also understood why the accounting moves were wrong.

If no evidence directly implicating him in the fraud emerges, investigators could build a circumstantial case against Mr. Ebbers, driven by the size of the fraud and the fact that Mr. Ebbers was in charge of the company, say people familiar with the investigation and the company. For example, if prosecutors can prove that Mr. Ebbers knew there was a revenue gap and that it disappeared by the time earnings were released, as well as that the earnings contained one-time items and he knew it was wrong not to disclose them, that could support a criminal charge of failure to disclose material information.

According to people familiar with the matter, investigators working for Mr. McLucas recently determined that WorldCom prepared two sets of financial results each quarter. One set reflected WorldCom's actual results from operations; the other included a laundry list of questionable revenue items as well as the fraudulent reductions in expenses that Mr. Sullivan allegedly masterminded.

Investigators began chasing down reports from witnesses that WorldCom produced documents each quarter detailing how the company inflated the company's actual results to meet Wall Street's estimates. One report, known internally as the "mon rev," or monthly revenue, tallied revenue each quarter from all of WorldCom's units and analyzed the data in a variety of ways. The investigators were told by witnesses that tracking the "mon rev" report was one of Mr. Ebbers's consuming passions as CEO.

The new thread in the investigation became even more intriguing when the gumshoes began to hear about a quarterly scramble in 2001 by Mr. Beaumont and his staff to "close the gap" between what the company had actually produced in revenue and what Wall Street had expected.

The effort to boost revenue peaked in the third quarter of 2001 when the company included items such as $50 million recognized by WorldCom in the third quarter of 2001 from a legal settlement. Even more damaging to WorldCom was the fact that the company hadn't disclosed that it had met Wall Street's estimates by including such nonrecurring types of revenue in its results.

The Wilmer Cutler lawyers also found two pieces of evidence that suggested Mr. Ebbers knew there was "fluff" in the company's second-quarter numbers. In one e-mail, accounting employee Ronald Lomenzo wrote to Mr. Sullivan that Mr. Ebbers wanted to make sure commissions for salespeople were based on the "operational," or lower revenue, figures, rather than those reported publicly. Then, in a voicemail left for Mr. Ebbers, Mr. Sullivan warned that the quarter included too much "fluff." Mr. Sullivan added: "We are going to dig ourselves into a huge hole."

Last October, investigators began to drill into the issue for the first time. Meeting in New York, more than a dozen lawyers led by Wilmer's Charles Davidow, grilled Mr. Beaumont about his knowledge of the "mon rev" reports and the close-the-gap process. Flipping through several three-ring binders filled with evidence on the subject, they asked him about two presentations he made at WorldCom in 2001.

One of the presentations was made to Messrs. Sullivan and Ebbers. During the meeting, the three executives talked about slow revenue growth for the quarter, which, at that point, totaled only 6% -- half what Wall Street had been promised. Beginning Oct. 17, 2001, the executives began adding revenue items such as the legal settlement.

When WorldCom reported its third-quarter results on Oct. 25, 2001, the company posted revenue of $5.5 billion, a 12% increase from the year-earlier period despite a deepening downturn in the telecommunications industry. "WorldCom delivered excellent growth this quarter, while substantially improving the free cash flow of our businesses," Mr. Ebbers boasted to investors in the earnings release. Regarding nonrecurring items, the release stated simply: "There were no nonrecurring items this quarter."

Write to Rebecca Blumenstein at rebecca.blumenstein@wsj.com³ and Susan Pulliam at susan.pulliam@wsj.com⁴

Updated June 6, 2003 11:07 a.m.