In re WorldCom, Inc. Securities Litigation, United States District Court for the Southern District of New York (Cote, D.J.), the defendants included outside accounting firm Arthur Andersen LLP; the two engagement partners for the Andersen audits of WorldCom's financial statements during the relevant years; Arthur Andersen UK, which audited the WorldCom financial statements for Europe and Asia; and Andersen Worldwide SC, the Swiss umbrella organization for all of the Andersen entities.
The complaint
The complaint alleged that WorldCom manipulated its books in two main areas: (i) its charges to income and classification of assets in connection with acquisitions, and (ii) its accounting for line costs. After the closing of its acquisitions, WorldCom improperly recorded expenses at the time of the acquisition, effectively inflating earnings in later periods when the expenses were actually incurred and should have been recorded. At the same time, WorldCom took overly large and unjustified charges to income, creating inflated merger reserves that it would later tap into to boost reported earnings, based on the theory that Wall Street would not be concerned about the size of these charges.
Line costs, which were fixed monthly payments for the use of networks or lines, regardless of whether WorldCom or its customers used the leased lines, were WorldCom's biggest expense. However, network demand did not grow as anticipated, and WorldCom found itself with substantial line costs for networks that were not generating sufficient revenues. Under GAAP, line costs must be reported as an expense. To camouflage this, WorldCom's accounting department made journal entries crediting WorldCom's line cost expenses accounts and made corresponding reductions in various reserve accounts so that the general ledger would balance. In 2001, WorldCom changed its method of disguising the impact of line costs on its revenues by simply reclassifying them as capital expenditures that could be depreciated over time. In 2002, an internal audit discovered the accounting fraud. WorldCom's stock price plunged dramatically.
Those held responsible
Evidence produced during discovery indicated that Andersen did not verify WorldCom's treatment of merger reserves or line costs. Rather, it relied on management's representations. The court noted that if Andersen had sought supporting documentation for various adjustments and journal entries, or reviewed WorldCom's general ledgers, it would have discovered that WorldCom had no documentation to support many of the significant adjustments or the results reported in its financial statements.
In filing its motion for summary judgment, Andersen asserted that WorldCom's senior management had admitted it lied to WorldCom's auditors and concealed the falsification of the WorldCom books from the auditors. The court held that the complaint alleged with sufficient particularity that Andersen would have uncovered the fraud if it had conducted the required review before issuing its audit opinions in connection with WorldCom's annual financial statements. The court held that the Andersen audit opinions included in WorldCom's year-end financial statements materially misrepresented the company’s financial condition.
Those not held responsible
On the other hand, the court dismissed the complaint against the individual engagement partners because there was no statement attributed to the engagement partners at the time of the engagement. All of the statements were issued in the name of Andersen. Further, the court held that the complaint did not sufficiently allege scienter against either of the engagement partners. The court also dismissed the claims against Andersen UK since there were no specific allegations concerning their alleged wrongdoing. There was one internal email showing that there were questions raised about the international operations of WorldCom, but the court noted that this email was after the European and Asian entities had closed their books and reported their quarterly figures to the United States. There were no other red flags that Andersen UK should have or would have encountered in its audits of WorldCom's Asian and European entities alleged.
The court also dismissed all claims against the Andersen umbrella organization because the complaint did not allege that Andersen was an agent of Andersen Worldwide or that Andersen Worldwide and Anderson were partners. Alleging the status as a mere umbrella organization was deemed insufficient.
In contrast
In another recent case -- also decided by Judge Cote -- Cromer Finance Ltd., et al. v. Berger, the court used a different analytical approach in analyzing participation for purposes of subject matter jurisdiction. It ruled that Deloitte & Touche Bermuda remained a defendant because it had subject matter jurisdiction over this Bermuda-based accounting firm. This was the accounting entity that directly participated in auditing the net asset value of a hedge fund, which later turned out to be grossly inflated.
In Cromer the principal who was responsible for the fraud was a U.S. resident. The audit proposal to obtain the account was submitted to New York. There were numerous telephone calls and facsimile transmissions made to U.S. entities or persons, and the fund was designed for both foreign investors and tax-exempt U.S. investors.(2)
In its decision, the court applied a relatively new test concerning whether U.S. courts have subject matter jurisdiction over a particular transnational securities fraud claim -- the conduct test and the effect test -- in order to determine whether there is a sufficient U.S. involvement to justify the exercise of jurisdiction by an American court. In applying this test, Judge Cote stated that the issue is whether the court has jurisdiction over the transaction and not whether it separately has jurisdiction over the particular acts committed by each defendant in connection with the transaction.
Conclusion
The underlying moral of a differentiation between who is held responsible and who is not, is that the plaintiff must allege and prove how that a particular organization or individual directly participated in the alleged fraudulent conduct or was directly responsible.
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CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Mr. Hecht would appreciate any input on subject matters within the SEC accounting area which you believe would be appropriate for a future article.
