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U.S. Securities and Exchange Commission

UNITED STATES DISTRICT COURT
SOUTHERN DISTRICT OF NEW YORK


 
SECURITIES AND EXCHANGE COMMISSION,
 
          Plaintiff,
 
      v.
 
WORLDCOM, INC.,
 
          Defendant.
 

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Civ No. 02-CV-4963 (JSR)  
FIRST AMENDED
COMPLAINT
   (SECURITIES
   FRAUD)
 

 

The Securities and Exchange Commission ("the Commission") alleges for its First Amended Complaint as follows:

  1. From at least as early as 1999 through the first quarter of 2002, defendant WorldCom Inc. ("WorldCom") misled investors. Defendant WorldCom has acknowledged that during this period, as a result of undisclosed and improper accounting, it materially overstated the income it reported in its financial statements by approximately $9 billion.
  2. In general, WorldCom manipulated its financial results in two ways. First, WorldCom reduced its operating expenses by improperly releasing certain reserves held against operating expenses. Second, WorldCom improperly reduced its operating expenses by recharacterizing certain expenses as capital assets. Neither practice was in conformity with generally accepted accounting principles ("GAAP"). Neither practice was disclosed to WorldCom's investors, despite the fact that both practices constituted changes from WorldCom's previous accounting practices. Both practices falsely reduced WorldCom's expenses and, accordingly, had the effect of artificially inflating the income WorldCom reported to the public on its financial statements from 1999 through the first quarter of 2002. As a result of, among other things, WorldCom's chronic and pervasive failures to follow GAAP standards, and to mandate and institute appropriate internal controls, the exact amount and extent of WorldCom's overstatement of its income has not yet been quantified.
     
  3. Certain of the improper accounting entries were made with respect to WorldCom's so-called "line costs," which were among WorldCom's major operating expenses. From at least the third quarter of 2000 through the first quarter of 2002, in a scheme directed and approved by members of senior management, WorldCom concealed the true extent of its "line costs." By improperly reducing reserves held against "line costs" and by transferring certain "line costs" to its capital asset accounts, WorldCom falsely portrayed itself as a profitable business when it was not, and concealed large losses WorldCom suffered. WorldCom's fraudulent accounting practices with respect to "line costs" were designed to and did falsely and fraudulently inflate its income to correspond with estimates by Wall Street analysts and to support the price of WorldCom's common stock in the market.
     
  4. While engaging in accounting manipulations with respect to line costs to fraudulently and falsely inflate its income, defendant WorldCom continued to offer and sell additional WorldCom securities, using fraudulent and materially false financial statements and financial information in the course of those offers and sales.
     
  5. By engaging in such improper conduct, WorldCom violated the anti-fraud, reporting, record-keeping, and internal controls provisions of the federal securities laws. The Commission requests, among other things, that this Court enjoin WorldCom from committing further violations of the federal securities laws as alleged herein, and order WorldCom to pay a monetary penalty based on its violations of the federal securities laws.

JURISDICTION

  1. The Commission brings this action pursuant to Section 20(b) and 20(d) of the Securities Act of 1933 ("Securities Act") [15 U.S.C. 77(b) and 77(d)], and Section 21(d) of the Securities Exchange Act of 1934 ("Exchange Act") [15 U.S.C. 78u(d)].
     
  2. This Court has jurisdiction over this action pursuant to Section 22(a) of the Securities Act [15 U.S.C. 77v(a)] and pursuant to Section 27 of the Exchange Act [15 U.S.C. 78aa].
     
  3. The defendant, directly and indirectly, has engaged in, and unless restrained and enjoined by this Court will continue to engage in, transactions, acts, practices, and courses of business that violate Section 17(a) of the Securities Act [15 U.S.C. 77q(a)], Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) of the Exchange Act [15 U.S.C. 78m(a) and 78m(b)(A)] of the Exchange Act [15 U.S.C. 78j(b), 78m(a), 78m(b)(A) and 78m(b)(B)] and Rules 10b-5, 12b-20, 13a-1, and 13a-13 thereunder [17 C.F.R. 240.10b-5, 240.12b-20, 240.13a-1, and 240.13a-13].

THE FRAUDULENT SCHEME REGARDING
WORLDCOM'S LINE COSTS

A. The Defendant

  1. WorldCom is a Clinton, Mississippi-based company incorporated in Georgia which provides a broad range of communications services to businesses and consumers in more than 65 countries. WorldCom provides data transmission and Internet services for businesses, and, through its MCI unit, provides telecommunications services for businesses and consumers. WorldCom is a public company whose securities are registered with the Commission pursuant to Section 12(b) of the Exchange Act and it is required to file periodic reports with the Commission pursuant to Section 13 of the Act. WorldCom's common stock was, at all times relevant hereto, listed and traded on the NASDAQ National Market System under the symbol "WCOM," and its stock was covered by Wall Street analysts who routinely issued quarterly and annual earnings estimates.

B. Relevant Accounting Principles

  1. Public companies, such as WorldCom, typically report the financial results of their operations in financial statements that include both an income statement and a balance sheet. A company's income statement reports, among other things, revenue recognized, expenses incurred, and income earned during a stated period of time -- usually for a fiscal quarter or a fiscal year. Within an income statement, expenses are generally subtracted from revenues to calculate income. A company's balance sheet reports, among other things, the assets and liabilities of a company at a point in time, usually as of the end of the company's fiscal quarter or fiscal year.
     
  2. When companies spend money or incur costs, those expenditures can be accounted for in a variety of ways depending on the nature of the transaction. Some types of expenditures, most commonly those incurred by a company in its normal operations, are treated as current period costs or "operating expenses." Examples of operating expenses include recurring costs such as salaries and wages, insurance, equipment rental, electricity, and maintenance contracts. Generally, almost all routine expenditures that a company makes are operating expenses. Other types of expenditures, most commonly those which result in the acquisition of, or improvement to, the company's assets, are treated as "capital expenditures." Examples of capital expenditures include purchases of real estate, manufacturing equipment, and computer equipment.
     
  3. Operating expenses and capital expenditures generally receive different accounting treatment. Operating expenses are generally reported on a company's income statement and subtracted from revenues in the period in which the expense is incurred or paid, resulting in the company's net income for that period. Generally, capital expenditures, by contrast, are not subtracted from revenues and are not reflected on the income statement. Instead, capital expenditures are reported as capital assets on a company's balance sheet.
     
  4. If a company makes entries in its accounts that effectively reclassify or transfer a given expenditure from an "operating expense" to a "capital asset," that action will have the following effects on the company's financial statements: (a) the reclassification or transfer will reduce the company's operating expenses, and the company's pre-tax net income consequently will increase by the amount reclassified or transferred; (b) the value of the company's capital assets and total assets will increase by the amount reclassified or transferred; and (c) the value of the company's net worth will increase.
     
  5. One of WorldCom's major operating expenses reported on its income statements which were periodically filed with the Commission was its so-called "line costs." "Line costs" represented the various fees WorldCom paid to third-party telecommunications carriers for WorldCom's right to access the third-party's network facilities in order to serve customers. Under GAAP, these fees must be reported as an expense on a company's income statement.
     
  6. From time to time, WorldCom established liabilities or "reserves" on its balance sheet for various future payments for goods or services it had previously received or incurred. Among the reserves WorldCom established were reserves for line costs and income taxes. Line cost reserves and income tax reserves were listed on WorldCom's balance sheet as liabilities.

C. WorldCom Changes its Accounting to Fraudulently Inflate Its Income

  1. Anticipating unabated growth in telecommunications services, WorldCom entered into a number of long-term lease agreements with various third-party telecommunication carriers to gain the right to access these networks in the late 1990s. Many of these leases required WorldCom to pay a fixed sum to the third-party carrier over the full term of the lease regardless of whether WorldCom actually made use of all or part of the capacity of the leased facilities. Before any improper entries to WorldCom's books and records were made at the corporate level, these fees were recorded by WorldCom employees on its books and records as "line costs," current expenses which would be reported as part of WorldCom's operating expenses on its income statements.
     
  2. Beginning in or around July 2000, WorldCom's expenses as a percentage of its total revenue began to increase, resulting in a decline in the rate of growth of WorldCom's income. This decline in income created a substantial risk that WorldCom's publicly reported income would fail to meet the expectations of Wall Street analysts and that the market price of WorldCom's securities would therefore decline.
     
  3. Starting at least as early as the third quarter of 2000, WorldCom, in a scheme directed and approved by members of senior management, engaged in a continuing series of improper and fraudulent accounting manipulations designed to inflate artificially WorldCom's publicly reported income by falsely reducing WorldCom's reported line cost expenses. As a result of this scheme, WorldCom materially understated its expenses, and materially overstated its income, thereby defrauding investors.
     
  4. In or around October 2000, WorldCom officers and employees fraudulently made and caused the making of certain entries in its general ledger intended to increase WorldCom's publicly reported income and conceal the true extent of its expenses; specifically, fraudulent and false entries were made in WorldCom's general ledger reducing its line cost expense accounts, and reducing -- in amounts corresponding to the fraudulent and false line cost expense amounts -- various reserve accounts. There was no documentation supporting, nor was there any proper business rationale for, the false and fraudulent entries. These entries had the effect of reducing the third quarter 2000 line costs by approximately $828 million, thereby increasing WorldCom's publically reported income for the third quarter of 2000.
     
  5. In or around February 2001, WorldCom officers and employees fraudulently made and caused the making of certain entries in its general ledgers intended to increase its publicly reported income and conceal the true extent of its expenses; specifically, fraudulent and false entries were made in WorldCom's general ledger reducing its line cost expense accounts, and reducing -- in amounts corresponding to the fraudulent and false line cost expense amounts -- various reserve accounts. There was no documentation supporting, nor was there any proper business rationale for, the fraudulent and false entries. These entries had the effect of reducing the fourth quarter 2000 line costs by approximately $407 million, thereby increasing WorldCom's publicly reported income in the year which ended December 31, 2000.
     
  6. In or around April 2001, because WorldCom could not continue to draw down its reserve accounts to hide the true extent of its line cost expenses, members of WorldCom's senior management effected a change in the method of making false accounting entries to fraudulently inflate WorldCom's income and to conceal the true extent of its expenses. Now, in addition to reducing WorldCom's line cost expenses with improper releases from reserve accounts, WorldCom officers and employees fraudulently made and caused the making of false and fictitious entries in WorldCom's general ledger which effectively "transferred" a significant portion of its line cost expenses to a variety of capital asset accounts, thereby effectively recharacterizing, without any supporting documentation, and in a manner inconsistent with GAAP, the operating expenses it had incurred for access to third party networks as "assets." In accordance with the directions and approval of members of WorldCom's senior management, WorldCom officers and employees made, and continued to make and cause the making of false and fraudulent entries in WorldCom's general ledger which were necessary to effect this scheme from the first quarter of 2001 through and including the first quarter of 2002. There was no documentation supporting, nor was there any proper business or accounting rationale for, the fraudulent and false entries.
     
  7. Specifically, in or around April 2001, WorldCom officers and employees fraudulently made and caused the making of false entries in WorldCom's general ledger reducing its line cost expenses and correspondingly increasing its capital asset accounts. These manipulations resulted in the fraudulent concealment of approximately $771 million in WorldCom's line cost expenses for that quarter. In or around July 2001, WorldCom officers and employees fraudulently made and caused the making of entries in WorldCom's general ledger which effectively erased approximately $560 million from its line cost expenses for the second quarter of 2001 and correspondingly increased capital asset accounts. In or around October 2001, WorldCom officers and employees fraudulently made and caused the making of entries in WorldCom's general ledger which effectively erased approximately $743 million from its line cost expenses for the third quarter of 2001 and correspondingly increased capital asset accounts. In or around February 2002, WorldCom officers and employees fraudulently made and caused the making of entries in WorldCom's general ledger which effectively erased approximately $941 million from its line cost expenses for the fourth quarter of 2001 and correspondingly increased capital asset accounts. And, in and around April 2002, WorldCom officers and employees fraudulently made and caused the making of entries in WorldCom's general ledger which effectively erased approximately $818 million from its line cost expenses for the first quarter of 2002 and correspondingly increased capital asset accounts.
     
  8. WorldCom's fraudulent, false and improper treatment of its line cost expenses, described above, was not disclosed to its investors, nor did WorldCom disclose to its investors, or elsewhere, that it had implemented such changes in its methods of accounting for line cost expenses.
     
  9. As a result of these fraudulent, false and improper accounting manipulations, WorldCom materially overstated its earnings as well as its assets and materially understated its expenses in its filings with the Commission, specifically, on its Forms 10-Q for each quarter from the third quarter of 2000 through and including the first quarter of 2002, and on its Forms 10-K for the fiscal years which ended on December 31, 2000 and December 31, 2001.
     
  10. The effects of WorldCom's fraudulent accounting scheme on WorldCom's filings with the Commission, which scheme resulted in material misstatements therein, are summarized on the following table:

WorldCom's False Statements in Filings With Commission

Form Filed
With the
Commission
Reported Line
Cost Expenses
Reported Income
(before Taxes
and Minority
Interests)
Actual Line
Cost Expenses
Actual Income
(before Taxes
and Minority
Interests)
10-Q, 3rd Q. 2000 $3.867 billion $1.736 billion $4.695 billion $908 million
10-K, 2000 $15.462 billion $7.568 billion $16.697 billion $6.333 billion
10-Q, 1st Q. 2001 $4.108 billion $988 million $4.879 billion $217 million
10-Q, 2nd Q. 2001 $3.73 billion $159 million $4.29 billion $401 million loss
10-Q, 3rd Q. 2001 $3.745 billion $845 million $4.488 billion $102 million
10-K, 2001 $14.739 billion $2.393 billion $17.754 billion $622 million loss
10-Q, 1st Q. 2002 $3.479 billion $240 million $4.297 billion $578 million loss
  1. WorldCom's disclosures in its Forms 10-K and in its Forms 10-Q failed to include material facts necessary to make the statements made in light of the circumstances in which they were made not misleading. Significantly, these filings failed to disclose the company's accounting treatment of its line cost expenses, that such treatment had changed from prior periods, and that the company's line cost expenses were actually increasing substantially as a percentage of its revenues.
     
  2. While WorldCom was engaged in the fraudulent accounting scheme described above, WorldCom filed numerous registration statements for the issuance of new stock, and related amendments thereto, which statements and amendments incorporated or contained WorldCom's fraudulent financial statements and financial information.

CLAIMS FOR RELIEF

FIRST CLAIM
Violation of Exchange Act Section 10(b) and Exchange Act Rule 10b-5

  1. Paragraphs 1 through 27 above are incorporated herein by this reference.
     
  2. Defendant WorldCom, directly or indirectly, by use of the means or instruments of interstate commerce, or of the mails, or of a facility of a national securities exchange, knowingly or recklessly (a) employed devices, schemes and artifices to defraud; (b) made untrue statements of material fact or omitted to state material facts necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; and (c) engaged in acts, transactions, practices, and courses of business which operated or would operate as a fraud or deceit upon the purchasers of securities and upon other persons, in connection with the purchase or sale of a security.
     
  3. In connection with the above described acts and omissions, defendant WorldCom, and members of WorldCom's senior management, acted knowingly or recklessly. They knew, or were reckless in not knowing, that WorldCom's Forms 10-Q for the periods commencing the third quarter of 2000 through the first quarter of 2002, inclusive, and that its Forms 10-K for 2000 and 2001, including the financial statements contained therein, as filed with the Commission, contained material misstatements and omissions.
     
  4. By reason of the foregoing, WorldCom violated Section 10(b) of the Exchange Act and Exchange Act Rule 10b-5.

SECOND CLAIM
Violation of Securities Act Section 17(a)

  1. Paragraphs 1 through 27 above are incorporated herein by this reference.
     
  2. On or about April 26, 2001, defendant WorldCom filed with the Commission a Form 425, a written communication deemed to be a prospectus under Rule 425. The Form 425, containing WorldCom's first quarter 2001 earnings, was filed in connection with a registration related to the offering of two types of tracking stock filed on a Form S-4 registration statement. Defendant stated in this Form 425 that its first quarter 2001 consolidated net income was $729 million. This reported consolidated net income figure was materially overstated as a result of WorldCom's manipulations of its accounts to fraudulently understate its line cost expenses by approximately $771 million for that quarter.
     
  3. On or about May 1, 2001, defendant WorldCom filed with the Commission a Rule 424(b)(5) prospectus for a previously filed registration statement on Form S-3, wherein defendant stated that its first quarter 2001 consolidated pre-tax net income was $594 million. This reported consolidated net income figure was materially overstated as a result of WorldCom's manipulations of its accounts to fraudulently understate its line cost expenses by approximately $771 million for that quarter. Defendant WorldCom subsequently filed the following documents on or about the dates listed below which incorporated and thereby repeated this materially false overstatement of its first quarter 2001 consolidated pre-tax net income:
Form

Description

Date Filed

Form S-4 Tracking Stock Registration Statement May 9, 2001
Form 424(b)(5) Amendment to Prospectus for Debt Offering May 11, 2001
Form S-4/A Amendment to Tracking Stock Registration Statement May 14, 2001
  1. On or about May 15, 2001, defendant WorldCom filed its Form 10-Q with the Commission for the first quarter of 2001, wherein it reported in its Consolidated Statement of Operations that its consolidated pre-tax net income was $610 million. This reported consolidated net income figure was materially overstated as a result of WorldCom's manipulations of its accounts to fraudulently understate its line cost expenses by approximately $771 million for that quarter. Defendant WorldCom subsequently filed the following documents on or about the dates listed below which incorporated and thereby repeated this materially false overstatement of its first quarter 2001 consolidated pre-tax net income:
Form

Description

Date Filed

S-8 WorldCom 1997 Stock Option Plan June 1, 2001
S-8 MCI Group 2001 Employee Stock Purchase
Plan
June 13, 2001
S-8 POS Post-Effective Amendment to Tracking
Stock S-4
July 2, 2001
S-8 POS Post-Effective Amendment to Tracking
Stock S-4
July 5, 2001
  1. As a consequence of the foregoing, defendant WorldCom, in the offer or sale of the securities described above, among others, by the use of means or instruments of transportation or communication in interstate commerce, or by the use of the mails, directly or indirectly: (a) employed devices, schemes or artifices to defraud; (b) obtained money or property by means of untrue statements of material facts or omissions to state material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; or (c) engaged in transactions, practices or courses of business which operated or would operate as a fraud or deceit upon purchasers of securities.
     
  2. In connection with the above described acts and omissions, defendant WorldCom, and members of WorldCom's senior management, acted knowingly, recklessly, or negligently. They knew, or were reckless in not knowing, or should have known, that the above mentioned filings with the Commission contained material misstatements and omissions. By reason of the foregoing, WorldCom violated Section 17(a) of the Securities Act.

THIRD CLAIM
Violation of Exchange Act Sections
13(a), 13(b)(2)(A) and 13(b)(2)(B) and
Exchange Act Rules 13a-1, 13a-13, and 12b-20

  1. Paragraphs 1 through 27 are incorporated herein by this reference.
     
  2. Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder require issuers of registered securities to file with the Commission factually accurate annual and quarterly reports. Exchange Act Rule 12b-20 provides that in addition to the information expressly required to be included in a statement or report, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made, not misleading.
     
  3. Section 13(b)(2)(A) of the Exchange Act requires issuers of registered securities to make and keep books, records, and accounts which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer. Section 13(b)(2)(B) of the Exchange Act requires such issuers to, among other things, devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that the Company's transactions were recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles.
     
  4. As a result of the conduct set forth above, WorldCom violated Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Exchange Act Rules 13a-1, 13a-13, and 12b-20.

PRAYER FOR RELIEF

WHEREFORE, the Commission respectfully requests that this Court:

Enter Orders:

  1. Permanently restraining and enjoining WorldCom from violating Section 10(b) of the Exchange Act and Rule 10b-5 thereunder;
     
  2. Permanently restraining and enjoining WorldCom from violating Section 17(a) of the Securities Act;
     
  3. Permanently restraining and enjoining WorldCom from violating Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder;
     
  4. Permanently restraining and enjoining WorldCom from violating Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act;
     
  5. Imposing civil monetary penalties on WorldCom pursuant to Section 20(d) of the Securities Act and Section 21(d) of the Exchange Act;
     
  6. Prohibiting WorldCom and its affiliates, officers, directors, employees, and agents, from destroying, altering, or removing from the court's jurisdiction any documents relevant to the matters alleged herein;
     
  7. Prohibiting WorldCom and its affiliates from making any extraordinary payments to any present or former affiliate, or officer, director, or employee of WorldCom, or its affiliates, including but not limited to any severance payments, bonus payments, or indemnification payments;
     
  8. Appointing a corporate monitor to ensure compliance with items F and G, above; and
     
  9. Granting such other and additional relief as this Court may deem just and proper.

Respectfully submitted,

 
           /S
Robert B. Blackburn (RB 1545)
Local Counsel for Plaintiff
Securities and Exchange Commission
Woolworth Building, 13th Floor
233 Broadway
New York, New York 10279
(646) 428-1610
(646) 428-1980 (fax)
     
           /S
Stephen M. Cutler
William R. Baker III
Charles D. Niemeier
Peter H. Bresnan (PB 9168)
Arthur S. Lowry (AL 9541)
Lawrence A. West
Gerald W. Hodgkins
Jose Rodriguez
Louis A. Randazzo
 
Counsel for the Plaintiff
Securities and Exchange Commission
Stop 9-11
450 Fifth St., N.W.
Washington, D.C. 20549
(202) 942-4868 (Lowry)
(202) 942-9581 (Fax)

Dated: November 5, 2002

 

http://www.sec.gov/litigation/complaints/comp17829.htm

Modified: 11/05/2002