Worldcom Case Study Update 2006 Honda

The five biggest corporate bankruptcies – and nine of the top 10 – in the U.S. all occurred in the first decade of the 21st century. This should come as no surprise, given that there were two distinct recessions and bear markets that savaged the U.S. economy over this period. The technology sector was the worst hit in the 2000-2002 downturn – the Nasdaq Composite tumbled as much as 78% over this period – and was marked by an outbreak of accounting scandals that led to the bankruptcy of a number of companies including WorldCom and Enron. The 2007-2009 global recession was unprecedented in the scale of destruction it wrought worldwide. It erased $37 trillion, or 60%, of global market capitalization within a span of 17 months, raising fears of a global depression. Corporate icons that were forced into bankruptcy during this tumultuous period included Lehman Brothers and General Motors. (If you're unclear how this recession began, see The 2007-08 Financial Crisis In Review.)

There are obvious differences in size and complexity between corporate financial statements (such as the balance sheet, income statement and cash flow statement) and your own personal financial statements. But these differences apart, there are a number of important lessons to be learned from some of the biggest bankruptcies in U.S. history that are applicable to our own personal finances.

Lesson 1
Excessive leverage is usually a high-risk strategy.
Financial leverage refers to the practice of utilizing borrowed money to invest in an asset. Leverage is often referred to as a double-edged sword, since it can amplify gains when asset prices are rising, but can also magnify losses when asset prices are tumbling.

Excessive leverage was a major contributing factor to the 2001-2006 U.S. housing bubble and the subsequent bust from 2007. The housing bubble was fueled by a huge increase in subprime lending, as borrowers with poor credit histories were lured into the housing market by low introductory interest rates and minimal down payments. Excessive leverage was also apparent on the banking side, as the five largest U.S. investment banks significantly increased their leverage between 2003 and 2007, borrowing vast sums to invest in mortgage-backed securities.

Lehman's demise is a case study in the dangers of excessive leverage. Lehman's big push into the subprime mortgage market initially provided stellar returns, as it reported record profits every year from 2005 to 2007. But by 2007, its leverage was reaching dangerously high levels. In that year, Lehman was the leading underwriter of mortgage-backed securities on Wall Street, accumulating an $85 billion portfolio. The ratio of total assets to shareholders equity was 31 in 2007, which meant that each dollar of assets on its balance sheet was backed by only three cents in equity.

Legions of real estate speculators and "condo-flippers" in the U.S. also resorted to excessive leverage during the housing bubble, with equity withdrawals from residences used to fund speculation in additional real estate. Similar to Lehman, their initial success encouraged progressively greater risk-taking, but eventually, they had little choice but to resort to distress sales as the crumbling housing market rapidly erased their minimal equity cushion.

It is safe to surmise that none of these parties – subprime borrowers, real estate speculators or the investment banks – saw the crash coming. Their entire speculative strategy may have been predicated on being able to exit their investments while the going was good – in other words, cash out while still ahead. But market corrections can occur faster and run deeper than speculators generally expect, and excessive leverage gives borrowers very little flexibility at such times.

The lesson here is that, while a reasonable degree of leverage is not necessarily a bad thing, excessive leverage is generally too risky for most individuals. It is prudent to have an adequate amount of equity backing an asset purchase or investment, whether the asset in question is one's residence, a vacation property or a stock portfolio.

Lesson 2 – Adequate liquidity is always a good thing.
Washington Mutual was forced into bankruptcy because a "run on the bank" – amounting to 9% of its deposits – occurring over a 10-day period in September, 2008. The credit markets were virtually frozen at that time following the bankruptcy of Lehman Brothers, and the near-collapse of AIG, Fannie Mae and Freddie Mac. The mass and speed of deposit outflows from Washington Mutual Bank shortened the time available for them to find new capital, improve liquidity or find an equity partner.

The lesson from the WaMu debacle is that often cash is a drag in a bull market, but cash is king when times are tough. Therefore, it makes sense to have adequate liquidity at all times, in order to meet contingencies and unexpected expenses – for example, an unexpected job loss or a medical emergency.

According to a September, 2009 survey by the American Payroll Association, 71% of Americans were living from paycheck to paycheck. Just over 28,000 of the nearly 40,000 respondents in the online survey said that they would find it somewhat difficult or very difficult to pay their bills if their paycheck was delayed by a week. A similar survey of 3,000 Canadians revealed that 59% would have trouble making ends meet if their paycheck was delayed by a week.

Given this reality, it would seem like a difficult task for most households to stash away enough cash to meet expenses for three months, as most financial planners recommend. But this does not preclude exploring other alternatives to build up a liquidity cushion, such as opening up a standby line of credit at your local financial institution or drawing up a plan to sell assets if required. (One way to start on the road to better finances is to examine your current budget; check out How Do Your Finances Stack Up? to learn more.)

Lesson 3 – Fraud never pays.
With former WorldCom CEO Bernard Ebbers serving a 25-year jail sentence for fraud and conspiracy as a result of the company's fraudulent accounting and financial reporting, the lesson here is that fraud never pays.

WorldCom was by no means the only company to indulge in accounting fraud – other perpetrators to be caught in 2002 alone included Tyco, Enron and Adelphia Communications. There have also been numerous other forms of corporate fraud in recent years, from multi-billion Ponzi schemes run by Bernie Madoff and Allen Stanford to insider trading and options-backdating scandals. Many of the executives who were involved in these frauds ended up serving time in jail and/or paying very stiff fines. In a few instances, top executives have been fired for providing false information about their educational qualifications on their resumes.

As far as an individual is concerned, fraudulent activities can range from perceived trivial ones such as resume falsification or embellishment to more serious offenses such as tax evasion. But if one is found guilty of fraud, the damage to that person's reputation, career and employability can be much greater than any monetary gain from such activities. (Sometimes reporting someone evading taxes can be beneficial to you, learn more in our article Reporting A Tax Cheat.)

Lesson 4 – Update your product/service/skills to remain competitive (before your financial situation deteriorates).
General Motors was the world's largest automaker for 77 years. In 1979, it was also the largest private sector employer in the U.S., with over 618,000 employees. But it ultimately became a victim of its own success, as a bloated cost structure and poor management saw it rapidly lose market share to aggressive Japanese automakers such as Toyota and Honda, from the 1980s onward. As a result, GM's share of the U.S. market declined from 46% in 1980 to 20.3% by the first quarter of 2009. This very substantial erosion of market share, coupled with the company's huge overheads, resulted in GM's financial position deteriorating at an accelerated pace during the recession, with total losses of close to $70 billion in 2007 and 2008.

The moral of the GM story is that a company needs to update its product or service in order to counter competition, well before its financial situation deteriorates. GM was literally in the driver's seat for decades, but squandered its lead by virtue of being unresponsive to its customers' requirements. As a result, its gas-guzzlers steadily lost mindshare and market share to the more fuel-efficient Accords and Camrys.

Likewise, an individual also needs to keep skills current in order to remain competitive in the workforce. This assumes greater urgency at times when the unemployment rate is high and household balance sheets are under a great deal of pressure, such as in the second half of 2009, when the jobless rate approached 10%.

Lesson 5 – If you can't understand it, don't invest in it.
One of Warren Buffett's maxims is, "Never invest in a business you cannot understand." This is the key lesson that the Enron bankruptcy holds for the investor. (To learn more about how investors were led astray in the Enron scandal, check out Enron's Collapse: The Fall Of A Wall Street Darling.)

Enron succeeded in deceiving the "smart money," such as pension funds and other institutional investors for years, before the company's lack of transparency and policy of obfuscation, which was in turn prompted by its accounting gimmickry, caught up with it.

Enron was founded in 1985 through the merger of two natural gas pipeline companies. But by 2001, it had become a conglomerate that owned and operated gas pipelines, electricity plants, water plants and broadband assets, and also traded in financial markets for similar products. As a result, Enron's business model was very complex, and its financial statements were difficult to understand because of the complexity of its financing structures involving hundreds of special purpose entities and off-balance-sheet vehicles. (Read about some typical off balance sheet items in Off-Balance-Sheet Entities: The Good, The Bad And The Ugly.)

The lesson here is that a company that is not being fully transparent or that is using creative accounting might be masking its true performance and financial position. So why bother investing in a business that is hard to understand, when there are numerous investment alternatives in the marketplace?

Conclusion
A unique set of factors in each case eventually led to these five massive corporate bankruptcies in the U.S. These bankruptcies can provide valuable lessons to individuals and investors, despite the obvious differences in size and complexity between corporate financial statements and personal financial statements. From the perspective of financial planning and personal investments, these lessons are applicable to most individuals, from young investors to seasoned market professionals.

For related reading, take a look at 7 Lessons To Learn From A Market Downturn.

This article is about the company. For its founder, see Arthur E. Andersen. For the U.S. Supreme Court case, see Arthur Andersen LLP v. United States. For the songwriter and composer, see Arthur Olaf Andersen.

Arthur Andersen LLP, based in Chicago, is an American holding company. Formerly one of the "Big Five" accounting firms (along with PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young, and KPMG), the firm had provided auditing, tax, and consulting services to large corporations. By 2001 it had become one of the world's largest multinational companies.

In 2002, the firm voluntarily surrendered its licenses to practice as Certified Public Accountants in the United States after being found guilty of criminal charges relating to the firm's auditing of Enron, an energy corporation based in Texas, which filed for bankruptcy in 2001.[1] In 2005, the Supreme Court of the United States unanimously reversed Arthur Andersen's conviction due to serious errors in the trial judge's instructions to the jury that convicted the firm.[2]

The former consultancy and outsourcing practice of the firm separated from the firm's accountancy practice in 1987, split from Andersen Worldwide in 2000, and renamed itself Accenture. It continues to operate.

History[edit]

Founding[edit]

Main article: Arthur E. Andersen

Born 30 May 1885 in Plano, Illinois, and orphaned at the age of 16, Arthur E. Andersen began working as a mail boy by day and attended school at night, eventually being hired as the assistant to the comptroller of Allis-Chalmers in Chicago. In 1908, after attending courses at night while working full-time, he graduated from the Kellogg School at Northwestern University with a bachelor's degree in business.[3] That same year, at age 23, he became the youngest CPA in Illinois.

The firm of Arthur Andersen was founded in 1913 by Arthur Andersen and Clarence DeLany as Andersen, DeLany & Co.[4] The firm changed its name to Arthur Andersen & Co. in 1918. Arthur Andersen's first client was the Joseph Schlitz Brewing Company of Milwaukee.[5] In 1915, due to his many contacts there, the Milwaukee office was opened as the firm's second office.

Andersen had an unwavering faith in education as the basis upon which the new profession of accounting should be developed. He created the profession's first centralized training program and believed in training during normal working hours. He was generous in his commitment to aiding educational, civic and charitable organizations. In 1927, he was elected to the Board of Trustees of Northwestern University and served as its president from 1930 to 1932. He was also chairman of the board of certified public accountant examiners of Illinois.

Reputation[edit]

Andersen, who headed the firm until his death in 1947, was a zealous supporter of high standards in the accounting industry. A stickler for honesty, he argued that accountants' responsibility was to investors, not their clients' management. During the early years, it is reputed that Andersen was approached by an executive from a local rail utility to sign off on accounts containing flawed accounting, or else face the loss of a major client. Andersen refused in no uncertain terms, replying that there was "not enough money in the city of Chicago" to make him do it. For many years, Andersen's motto was "Think straight, talk straight."

Arthur Andersen also led the way in a number of areas of accounting standards. Being among the first to identify a possible sub-prime bust, Arthur Andersen dissociated itself from a number of clients in the 1970s. Later, with the emergence of stock options as a form of compensation, Arthur Andersen was the first of the major accountancy firms to propose to the FASB that stock options should be included on expense reports, thus impacting on net profit just as cash compensation would.

By the 1980s, standards throughout the industry fell as accountancy firms struggled to balance their commitment to audit independence against the desire to grow their burgeoning consultancy practices. Having established a reputation for IT consultancy in the 1980s, Arthur Andersen was no exception. The firm rapidly expanded its consultancy practice to the point where the bulk of its revenues were derived from such engagements, while audit partners were continually encouraged to seek out opportunities for consulting fees from existing audit clients. By the late-1990s, Arthur Andersen had succeeded in tripling the per-share revenues of its partners.

Predictably, Arthur Andersen struggled to balance the need to maintain its faithfulness to accounting standards with its clients' desire to maximize profits, particularly in the era of quarterly earnings reports. Arthur Andersen has been alleged to have been involved in the fraudulent accounting and auditing of Sunbeam Products, Waste Management, Inc, Asia Pulp & Paper,[6] the Baptist Foundation of Arizona, WorldCom, as well as the infamous Enron case, among others.[7][8]

Two of the last three Comptrollers General of the US General Accounting Office (now the Government Accountability Office) were top executives of Arthur Andersen.[9]

Andersen Consulting and Accenture[edit]

The consulting wing of the firm became increasingly important during the 1970s and 1980s, growing at a much faster rate than the more established accounting, auditing, and tax practice. This disproportionate growth, and the consulting division partners' belief that they were not garnering their fair share of firm profits, created increasing friction between the two divisions.

In 1989, Arthur Andersen and Andersen Consulting became separate units of Andersen Worldwide Société Coopérative. Arthur Andersen increased its use of accounting services as a springboard to sign up clients for Andersen Consulting's more lucrative business.

The two businesses spent most of the 1990s in a bitter dispute. Andersen Consulting saw a huge surge in profits during the decade. The consultants, however, continued to resent transfer payments they were required to make to Arthur Andersen. In August 2000, at the conclusion of International Chamber of Commerce arbitration of the dispute, the arbitrators granted Andersen Consulting its independence from Arthur Andersen, but awarded US$1.2 billion in past payments (held in escrow pending the ruling) to Arthur Andersen, and declared that Andersen Consulting could no longer use the Andersen name. As a result, Andersen Consulting changed its name to Accenture on New Year's Day 2001 and Arthur Andersen meanwhile now having the right to the Andersen Consulting name rebranded itself as "Andersen".

Four hours after the arbitrator made his ruling, Arthur Andersen CEO Jim Wadia suddenly resigned. Industry analysts and business school professors alike viewed the event as a complete victory for Andersen Consulting.[10] Jim Wadia would provide insight on his resignation years later at a Harvard Business school case activity about the split. It turned out that the Arthur Andersen board passed a resolution saying he had to resign if he didn't get at least an incremental US$4 billion (either through negotiation or via the arbitrator decision) for the consulting practice to split off, hence his quick resignation once the decision was announced.[11]

Accounts vary on why the split occurred — executives on both sides of the split cite greed and arrogance on the part of the other side. The executives on the Andersen Consulting side maintained breach of contract when Arthur Andersen created a second consulting group, AABC (Arthur Andersen Business Consulting) which competed directly with Andersen Consulting in the marketplace. AABC grew quickly, most notably its healthcare and technology practices. Many of the AABC firms were bought out by other consulting companies in 2002, most notably, Deloitte (especially in Europe), Hitachi Consulting, PwC Consulting, which was later acquired by IBM, and KPMG Consulting, which later changed its name to BearingPoint.

Enron scandal[edit]

Main article: Enron scandal

Following the 2001 scandal in which energy giantEnron was found to have reported $100bn in revenue through institutional and systematic accounting fraud, Andersen's performance and alleged complicity as an auditor came under intense scrutiny. The Powers Committee (appointed by Enron's board to look into the firm's accounting in October 2001) came to the following assessment: "The evidence available to us suggests that Andersen did not fulfill its professional responsibilities in connection with its audits of Enron's financial statements, or its obligation to bring to the attention of Enron's Board (or the Audit and Compliance Committee) concerns about Enron's internal contracts over the related-party transactions".[12]

On June 15, 2002, Andersen was convicted of obstruction of justice for shredding documents related to its audit of Enron, resulting in the Enron scandal. Although the Supreme Courtreversed the firm's conviction, the impact of the scandal combined with the findings of criminal complicity ultimately destroyed the firm. Nancy Temple (in the firm's legal department) and David Duncan (lead partner for the Enron account) were cited as the responsible managers in this scandal because they ordered subordinates to shred relevant documents.

Because the U.S. Securities and Exchange Commission will not accept audits from convicted felons, the firm agreed to surrender its CPA licenses and its right to practice before the SEC on August 31, 2002—effectively putting the firm out of business. It had already started winding down its American operations after the indictment, and many of its accountants joined other firms. The firm sold most of its American operations to KPMG, Deloitte & Touche, Ernst & Young and Grant Thornton LLP. The damage to Andersen's reputation also destroyed the firm's international practices. Most of them were taken over by the local firms of the other major international accounting firms.

The indictment also put a spotlight on the firm's faulty audits of other companies, most notably Waste Management, Sunbeam, the Baptist Foundation of Arizona and WorldCom. The subsequent bankruptcy of WorldCom, which quickly surpassed Enron as the biggest bankruptcy in history (and has since been passed by the bankruptcies of Lehman Brothers and WaMu in the 2008 financial crisis) led to a domino effect of accounting and corporate scandals.

On May 31, 2005, in Arthur Andersen LLP v. United States, the Supreme Court of the United States unanimously reversed Andersen's conviction because of serious errors in the trial judge's jury instructions.[2] The Supreme Court held that the instructions were too vague to allow a jury to find that obstruction of justice had occurred. The court found that the instructions were worded in such a way that Andersen could have been convicted without any proof that the firm knew it had broken the law or that there had been a link to any official proceeding that prohibited the destruction of documents. The opinion, written by Chief Justice William Rehnquist, also expressed skepticism of the government's concept of "corrupt persuasion"—persuading someone to engage in an act with an improper purpose without knowing that the act is unlawful.

Demise[edit]

Since the ruling vacated Andersen's felony conviction, it theoretically left Andersen free to resume operations. The damage to the Andersen name was so severe, however, that it has not returned as a viable business even on a limited scale. There are over 100 civil suits pending against the firm related to its audits of Enron and other companies.[when?] Even before voluntarily surrendering its right to practice before the SEC, it had many of its state licences revoked. A new verb, "Enron-ed", was coined by John M. Cunningham, the former Arthur Andersen Director in the Seattle Office, to describe the demise of Arthur Andersen.

From a high of 28,000 employees in the US and 85,000 worldwide, the firm is now down to around 200, based primarily in Chicago. Most of their attention is on handling the lawsuits and presiding over the orderly dissolution of the company.[citation needed]

As of 2011[update], Arthur Andersen LLP has not been formally dissolved nor has it declared bankruptcy. Ownership of the partnership has been ceded to four limited liability corporations named Omega Management I through IV. Arthur Andersen LLP operated the Q Center conference center in St. Charles, Illinois until it was sold to Dolce Hotels and Resorts in 2014.[13] The Q center is currently used for training, primarily for internal Accenture personnel, and other large scale companies.[14]

Migration of partners and local offices to new firms[edit]

Many partners formed new companies or were acquired by other consulting firms. Examples include:

  • Accuracy which was founded in 2004 by a team of seven former partners and is headquartered in Paris.
  • Andersen Tax LLC which acquired the rights and changed their name from WTAS in 2014.[15]
  • BearingPoint, formerly the US consulting unit spun off by KPMG, which purchased Andersen business consulting practices in France and Spain
  • Huron Consulting Group
  • West Monroe Partners which was founded in 2002 by four former consultants, and is based in Chicago.
  • KPMG which absorbed the Computer Forensics division based in Cypress, CA and the Boise, Kansas City, Philadelphia, Portland, Salt Lake City and Seattle offices, among others
  • Navigant Consulting which absorbed eleven partners in Chicago and Washington D.C.
  • Perot Systems which absorbed six partners in the East
  • Protiviti hired approximately 800 former workers
  • SMART Business Advisory and Consulting which absorbed some of the Philadelphia office
  • jcba Limited which was founded by a partner from the aviation practice[16][17]
  • Grant Thornton International which absorbed the North Carolina, South Carolina, and Tulsa offices.
  • True Partners Consulting
  • Portions of Andersen Audit practice merged with Deloitte and Ernst & Young.

See also[edit]

References[edit]

External links[edit]

Revenue per year in million U.S. dollars.
Source: corporate press releases
  1. ^Brown, Ken; Dugan, Ianthe Jeanne (June 7, 2002). "Arthur Andersen's Fall from Grace Is a Sad Tale of Greed and Miscues". Wall Street Journal. 
  2. ^ abArthur Andersen LLP v. United States, 544 U.S. 696 (2005).
  3. ^Arthur Anderson: Challenging the Status Quo (Moore, Mary Virginia and John Crampton)
  4. ^Moore, Mary Virginia; Crampton, John (2000). "Arthur Andersen: Challenging the Status Quo"(PDF). The Journal of Business Leadership. American National Business Hall of Fame. 11 (3): 71–89. Retrieved 2008-05-05. 
  5. ^Squires, Susan (2003). Inside Arthur Andersen: Shifting Values, Unexpected Consequences. FT Press. p. 28. ISBN 9780131408968. Retrieved July 8, 2014. 
  6. ^Sara Webb (August 20, 2001). "APP and Arthur Andersen Face Class-Action Lawsuits". Wall Street Journal. 
  7. ^Terry Greene Sterling (October 1, 2006). "Executives Sentenced in Church Fraud". The Washington Post. 
  8. ^Dan Ackman (June 27, 2002). "WorldCom: Too Easy, Too Late". Forbes. 
  9. ^"U.S. GAO – Video Gallery". Retrieved July 2, 2015. 
  10. ^Mitchell Martin (August 8, 2000). "Arbitrator's Ruling Goes Against Accounting Arm: Consultants Win Battle Of Andersen". International Herald Tribune. Archived from the original on March 8, 2008. Retrieved 2008-05-05. 
  11. ^Philip Aldrick (August 8, 2000). "Andersen chief quits as $14bn claim fails". The Daily Telegraph. 
  12. ^Cornford, Andrew (June 2004). "Internationally Agreed Principles for Corporate Governance and the Enron Case"(PDF). G-24 Discussion Paper Series No. 30. New York: United Nations Conference on Trade and Development. p. 30. Archived from the original(PDF) on October 18, 2010. 
  13. ^Menchaca, Charles (3 September 2014). "Dolce Hotels named manager of the Q Center in St. Charles". Kane County Chronicle. Retrieved 24 April 2017. 
  14. ^"Our History – Q Center – The Dolce Conference Collection". Q Center. Retrieved 24 April 2017. 
  15. ^Rapoport, Michael. "Revive Arthur Andersen Name". Wall Street Journal. ISSN 0099-9660. Retrieved 2015-12-15. 
  16. ^"ADA Millennium " About". Retrieved July 2, 2015. 
  17. ^"The jcba team " jcba – jcba". Archived from the original on July 3, 2015. Retrieved July 2, 2015. 

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