By Scott B. MacDonald

June 26, 2002

Last week WorldCom's board of directors dropped a bomb in the form of financial fraud. The company stated that it capitalized $3.9 billion of expenses in 2001 and $797 million in Q1 2002 instead of listing them on the income statement as operating expenses. The result of this "transfer" is an overstatement of EBITDA by a parallel amount in each period. The CFO, Scott Sullivan, was fired, as was David Myers, the controller. The CEO, John Sidgemore, indicated that WCOM still hopes to remain an ongoing business. He also announced a new set of measures: a workforce reduction of 17,000; the selling of non-core assets; paying preferred dividends in stock; and continuing discussions with the banks for a badly needed new credit facility. Bankruptcy is a major concern for WorldCom's bond and equity holders. Although the stock market bounced back, the WorldCom bomb is also a blow to the confidence in the U.S. economy and has implications for other countries, especially those who rely upon exports and whose currencies are not tied to the dollar.

We see six major results from the WorldCom scandal. First and foremost, the negative perception of corporate America has only been reinforced. Investors already have developed a destructive sentiment vis-a-vis corporate management, accountanting firms, lawyers and investment banks. One of the jokes making the rounds after WorldCom is that CEO no longer stands for Chief Executive Officer, but Chief Embezzlement Officer and that EBITDA now means Earnings Before I Tricked Dumb Auditors. WorldCom clearly reinforces the lessons learned from Enron and Arthur Andersen and bolsters a negative perception about the U.S. corporate world during a period of time in which the economy is struggling to maintain momentum. Consequently, investors in Wall Street are fleeing anything that is remotely similar to WorldCom or other troubled sectors, such as energy and utilities (both of which were tagged by Enron). Banks, which lent money to all of these companies, are also under scrutiny by nervous investors.

The second result of the WorldCom scandal is that the government is moving to re-regulate the economy. Ironically it is a Republican administration that is moving to tighten controls over accounting, corporate governance and transparency and disclosure. While this is likely to reduce chances of corporate wrongdoing, it will also add layers of regulations on businesses that will be more costly in terms of time and money. The WorldCom scandal is likely to become an election issue in the upcoming fall 2002 congressional races, with the Democrats seeking to paint the Republicans as the friends of big sleazy business. This could prove difficult since the Clinton administration sat in the White House through the most exciting years of the bull market on Wall Street.

The third result is that WorldCom's customers are likely to leave it in large numbers. Who will benefit? AT&T is the most likely first choice for most enterprise customers seeking a relatively sophisticated network. After AT&T, the mostly likely candidates are Sprint and Qwest (which has its own set of problems).

A fourth result will be a reexamination of U.S. telecom policy. This is complicated as the Securities Exchange Commission sees WorldCom as one of the worst accounting scandals in history and will want to take enforcement action of considerable harshness. The Federal Communications Commission is likely to be more open to letting the company be sold to a rival, including one of the former Baby Bells. This would help remove WorldCom as an ongoing crisis.

The Department of Justice is also involved because of the anti-trust issue. It is no secret that several Bells have looked at buying WorldCom, largely for its position in the Internet backbone and enterprise markets. At some point in a bankruptcy proceeding, those assets might be attractively priced for a Bell. However, since the Justice Department not too long ago broke up Ma Bell, there are serious questions about allowing Bell's to buy WorldCom assets. Sadly, other long distance companies are in no condition to buy WorldCom, leaving the Bells as the only real possibility. All of this means U.S. telecom policy must be reconsidered and quickly. As Legg Mason's equity analysts Blair Levin and Michael J. Balhoff noted: "Over time, however, we think an additional and critical story will emerge: we believe that the fate of the company, and to a significant extent, the larger telecommunications sector, is in the hands of the government."

The fifth result is that WorldCom and the other scandals are weakening the dollar. As foreign investor confidence in the U.S. corporate sector declines, due to concerns about management sleaze, two things could happen. One, foreign investors, with an eye to the slumping value of the dollar, could demand a premium to hold U.S. securities. Two, they could also demand a premium for credit risk. Both trends would only accelerate the dollar's declining value in international markets. In addition, there is little confidence in U.S. Treasury Secretary O'Neill ability to manage the dollar. His off the cuffs remarks that Brazil was not worth throwing in more U.S. taxpayers dollars, while perhaps reflecting common sense, were disastrous to an already spooked market. The danger with the dollar is that O'Neill believes that market forces should be left to run and if so, the dollar plummets, he will seek to turn the situation too late in the day. Foreign funds flow into the United States is not to be casually dismissed considering that the U.S. needs to it help finance its current account balance of payments deficit, which is expected to be around 5% of GDP, a large number.

The sixth factor and closely related to number five is the impact of WorldCom beyond U.S. shores. Firstly, the sleaze element is already giving impetus to greater regulation and better corporate governance in countries such as Canada and the United Kingdom. Second, WorldCom as well as the earlier Enron scandal, are hurting the attractiveness of the so-called Anglo-American model of de-regulated capitalism and giving greater credence to a capitalism modified by a larger state role in the economy (Germany and France). Third, as WorldCom weakens foreign investor sentiment on U.S. securities, this feeds into a weaker dollar. This would be bad news for countries who rely upon exports, and whose currencies are not tied to the dollar.

The 1990s was a decade characterized by the bull market, the advance of new technologies and business management techniques, an erosion of corporate governance and accounting standards and easy big money in the stock market. In many respects, the rising tide of new IPOs and euphoria over the "new economy" raised all boats. The tide appears to have gone back out. The 2000s are shaping into a decade of bear market runs, a tightening of accounting and corporate governance standards, and difficult to achieve profits on Wall Street. No doubt other corporate scandals are lurking, which will reinforce the negative trends. Yet, it is important to remember that the vast majority of U.S. companies are not corrupt, many are beginning to return to profitability, and tighter standards will lead to better transparency and disclosure. The U.S. still remains one of the safest places to invest.