WorldCom’s stark warning for today’s bear market

Twenty years ago next week, a massive accounting scandal hit a leading US growth company, drove it into bankruptcy and spurred tighter accounting and securities laws that still shape America today.

No, not Enron. The Texas energy group, which collapsed six months earlier, has become shorthand for corporate fraud, even inspiring a musical. But it was the Mississippi-based telecoms company WorldCom, which admitted in June 2002 to booking billions of dollars in inflated profits, that finally spurred the passage of the Sarbanes-Oxley corporate accountability law.

The lesson for today’s investors is more than WorldCom’s fraud, however. A Wall Street darling, the company soared through the 1990s, gobbling up rivals and telling investors that the rise of the internet would drive huge increases in network demand. But it hit a wall amid the 2000s dotcom crash, when the actual data traffic failed to keep pace 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.

Back in May 2002, efforts to tighten US securities laws to prevent another Enron had bogged down completely, as Congress squabbled over just how tough to be. A less stringent bill pushed by House Republican Michael Oxley was gaining the upper hand when news broke of an even bigger fraud. WorldCom had been reclassifying billions of dollars in operating costs as capital expenditures to boost reported profit margins.

The manoeuvre disguised WorldCom’s slowing growth at a time when competitors such as AT&T were laying off workers. Folksy chief executive Bernie Ebbers was eventually sentenced to 25 years in prison.

The scandal gave Senator Paul Sarbanes and reformists the upper hand. They forced through the creation of an auditing regulator and required companies to demonstrate they had adequate internal financial controls. Critics say that “Sarbox” has deterred fast-growing companies from floating, leading to a drop in the ranks of US listed groups.

Fans of the law counter that US corporates have largely avoided massive accounting scandals since it passed, unlike the UK and Germany. But that record could be tested if another recession hits.

Now another bubble appears to be rapidly deflating, with the tech-heavy Nasdaq down more than 30 per cent for the year. Start-ups without a clear path to profits have taken the biggest hits so far. But the financial woes that started WorldCom down the road to fraud stand as a warning to investors that fledgling companies aren’t the only ones at risk.

In the 2001 crash, companies such as Cisco and Sun Microsystems that supplied start-ups with servers, routers and software got hammered along with their customers. But telecoms such as WorldCom also suffered because they built infrastructure for users and data demand that failed to materialise.

This time around, suppliers in the line of fire are likely to include purveyors of cloud computing and software as a service, as well as the online advertising and platform companies that start-ups pay to help them find new customers. The largest are diversified companies, but that hasn’t stopped Google shares from falling 25 per cent this year, and Facebook is down by twice that.

Investors looking for WorldCom-like strains may want to watch for companies that have boasted of 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 tumble.

Amazon has been caught out by slowing ecommerce 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 betting hard on the metaverse and Web3, either directly, or as a source of demand for their technology. The 1990s telecoms executives were not wrong about the long-term future of the internet. They just failed to realise how long primitive dial-up technology would hold down its appeal. Most companies took their lumps, WorldCom cooked its books instead.

If the next big online evolution takes as long to materialise, ethically challenged executives may be tempted to follow Ebbers’ example. WorldCom is an abject lesson in how that turns a painful short-term earnings squeeze into a full-on corporate disaster. Here’s hoping that Sarbox guides today’s companies on to a straighter path.

Follow Brooke Masters with myFT and on Twitter

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