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WORLDCOM, INC., Et Al. Debtors UNITED STATES BANKRUPTCY COURT SOUTHERN DISTRICT OF NEW YORK § Chapter 11 In re: § § Case No. 02-15533 (AJG) WORLDCOM, INC., et al. § § Jointly Administered Debtors. § _____________________________________ § FIRST INTERIM REPORT OF DICK THORNBURGH, BANKRUPTCY COURT EXAMINER November 4, 2002 Kirkpatrick & Lockhart LLP 1800 Massachusetts Avenue, N.W. Washington, D.C. 20036 (202) 778-9000 (202) 778-9100 (fax) Counsel to Dick Thornburgh, Bankruptcy Court Examiner Table of Contents I. INTRODUCTION ...............................................................................................................1 II. PROCESS OF EXAMINATION AND NATURE OF FIRST INTERIM REPORT..........2 III. SUMMARY OF INITIAL OBSERVATIONS....................................................................6 IV. FACTUAL BACKGROUND..............................................................................................9 A. Overview of the Telecommunications Industry: The Breakup of AT&T and the Advent of a Highly-Competitive Marketplace. ..........................................................................9 B. The Evolution of WorldCom: Growth that Presented Significant Challenges. .........11 C. Five Phases of Growth and Transformation ................................................................12 1. The Emergence of LDDS (1983 – 1989): Expansion of a Reseller Network and Becoming a Public Company......................................................................................12 2. From LDDS to WorldCom (1990 – 1995): Expansion to a National and International Long Distance Provider and Acquisition of Significant Transmission Facilities. ...........................................................................................................................14 3. WorldCom (1996): Expansion into Local Markets and Internet Service.............16 4. WorldCom (1997 – 1998): Consolidation of Its Leadership Position in Local and Long Distance Telecommunications Services. .................................................17 5. WorldCom (1999 – 2001): Expansion of Wireless and Web Services. ................19 D. WorldCom 2001: The Downturn for Telecom: Falling Share Prices, Failure of a Tracking Stock Initiative and Signs of Trouble. ...................................................................20 E. Recent Developments ..................................................................................................22 1. March 2002 – SEC Investigation...........................................................................22 2. April 2002..............................................................................................................23 3. May 2002...............................................................................................................24 4. June 2002...............................................................................................................24 5. July 2002 – Chapter 11 Filings..............................................................................30 6. Further Restatement of EBITDA...........................................................................31 7. Criminal and SEC Actions Against Former Officers and Employees...................31 F. The Company’s Response to Developments in 2002 ..................................................32 1. New Members of Senior Management ..................................................................32 2. New Directors........................................................................................................33 3. Enhancements to the Company’s Accounting, Audit and Internal Control Functions............................................................................................................................33 G. WorldCom’s Current Business. ...................................................................................35 H. The Management Structure at WorldCom...................................................................36 I. The Board of Directors ................................................................................................37 1. Composition...........................................................................................................37 2. Board Meetings......................................................................................................38 3. Director Compensation and Stock Ownership.......................................................39 4. Board Committees .................................................................................................40 i V. The Finance and Accounting Process................................................................................43 A. Introduction..................................................................................................................43 B. The WorldCom Finance Group ...................................................................................44 C. Overview of Revenue Budgeting and Planning...........................................................46 1. Annualized Budget Plans.......................................................................................46 2. Monthly Revenue Forecasts, Analyses and Outlooks ...........................................47 3. Process to Meet Projected Revenues .....................................................................48 D. The WorldCom Financial Reporting Process ..............................................................48 E. The Role of the Independent Auditors.........................................................................49 1. Independent Auditor’s Responsibilities vs. Management’s Responsibilities........49 2. WorldCom’s Relationship with Arthur Andersen .................................................50 3. The Company’s Internal Audit Function...............................................................52 1. The Absence of a Comprehensive Audit Plan.......................................................55 2. Audit Committee Oversight...................................................................................55 3. Reports to Company Management ........................................................................56 4. Staffing and Compensation....................................................................................57 5. Dealings with Arthur Andersen .............................................................................57 VI. ACQUISITIONS AND OTHER TRANSACTIONS........................................................58 A. Volume of Transactions...............................................................................................59 B. Apparent Absence of Defined Strategic Plan ..............................................................60 VII. PERSONAL ENRICHMENT AND RELATED CONTROLS.........................................63 A. Introduction..................................................................................................................63 B. The Compensation Packages Awarded to Mr. Ebbers ................................................64 C. A Compensation System That May Have Been Vulnerable to Abuse by Mr. Ebbers and Others....................................................................................................................65 1. The Role Played by Mr. Ebbers in Many Compensation Decisions .....................66 2. The May 2000 Retention Bonus Program .............................................................68 3. The Compensation Committee's Role: Theory and Practice ................................69 D. The Compensation Committee's Role In Authorizing Over $400 Million in Loans and Guaranty Payments To Mr. Ebbers or His Banks ..................................................71 2. The Compensation Committee's Approval of the WorldCom Loans and Guaranty That Benefited Mr. Ebbers.................................................................................73 3. Matters Relating to the Loans and Guaranty Requiring Further Investigation......78 VIII. WorldCom’s Relationships With SSB and Jack Grubman................................................81 A. Introduction..................................................................................................................81 B. SSB Was WorldCom's Primary Investment Bank.......................................................83 C. SSB Allocated Lucrative IPOs to Mr. Ebbers and Other WorldCom Directors..........84 ii D. The Enthusiastic Ratings and Reports of SSB Securities Analyst Jack Grubman ......87 1. The Role of Securities Analysts.............................................................................87 2. WorldCom's General Interactions with Securities Analysts..................................88 3. Mr. Grubman's Extremely Favorable Analyst Reports..........................................89 4. Mr. Grubman's Departures From The Role of An Independent Securities Analyst...............................................................................................................................97 E. WorldCom's Record In Meeting Analyst Expectations...............................................99 IX. ACCOUNTING AND FINANCIAL REPORTING ISSUES.........................................104 A. Reserves and their Role in a Company’s Financial Statements.................................106 B. Line Cost Capitalization ............................................................................................109 C. The Preparation of Misleading Reports.....................................................................109
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