Summer of scandal: accounting tricks, software scams, price fixing make 2002 a tech summer to forget - Business of Technology - Industry Overview

Computer Technology Review, August, 2002 by Joshua Piven

April is the cruelest month, the poet T.S. Eliot once wrote. It appears that for our industry, cruelty is making a late arrival. The month of July took the prize as the most scandal-filled four-week period in high-tech history. Accounting fraud, Department of Justice probes, anti-trust investigations, and just more general malfeasance seem to have replaced the wide-eyed optimism that once grabbed headlines in the computer business.

While July and August are typically the slowest news months of the year, would that it were so in 2002--no news would certainly be good news, it seems. The unprecedented implosion of WorldCom clearly gets the blue ribbon for potential scale of lawbreaking, but other, smaller investigations of industry companies are sapping investor confidence and shifting investment dollars away from the high-tech darlings of old. In this story, we examine some of the technology companies under investigation for misdeeds, and then try to assess the impact on the rest of us. Call it our roundup of rogues.

Crisis at WorldCom

By now, the details of the newest, and presumably largest, corporate accounting scandal are well known. The company, under the leadership of CEO Bernard Ebbers, hid billions in losses by apparently faking not only earnings reports but actual earnings statements.

What the company did, according to investigators, is deceptively simple. It characterized basic expenses as capital investments, thereby limiting the company's apparent losses while at the same time raising its apparent gains. For example, when WorldCom needed to spend capital to, say, fix a segment of cut fiber line, this was booked as "capital spending" rather than as an expense. In this way, it could limit losses, which of course gives the appearance of more revenue. It appears that all earnings reports from 2001 an(l 2002 are in doubt-covering $3.8 billion--and investigators are expecting to find as much as a billion more dollars in hidden losses when balance sheets from 1999 and 2000 are examined.

At press time, Ebbers and former chief financial officer Scott Sullivan had invoked their constitutional right against self-incrimination and refused to testify before a congressional panel investigating the scandal. Other aspects of the case have chilling similarities to the Enron and Global Crossing debacles. Auditors from the Andersen company are being questioned about how earnings statements were audited, and investment analysts from Salomon Smith Barney are under investigation for promoting the stock even as the company was tanking. New WorldCom chief executive officer John Sidgmore testified that the company is fighting for its survival, and that plan includes its bankruptcy filed in late July--purported to be the largest bankruptcy in history. Some members of Congress are calling for jail time for executives if their complicity is established.

What is the likely impact on the industry of this unprecedented collapse? First, a few facts. WorldCom is the nation's second largest long distance carrier. It or its subsidiaries UUnet and Digex carry about half of the world's Internet traffic. Sidgmore has said that the company is a "key component of our nation's economy and communications infrastructure." (Michael Powell, chairman of the FCC, has sought to reassure a jittery market that WorldCom's network will stay operational.) The company also has enormous hosting, co-location, and Internet access businesses serving hundreds of Fortune 1000 companies (Ford Motor Company, NASDAQ) and government agencies, including the Federal Aviation Administration. These companies probably have no choice but to hang on, as most of them have long-term contracts and would have to pay significant early termination penalties.

Further, the impact on personnel alone is staggering: about 17,000 employees are scheduled for layoffs, or 20 percent of WorldCom's work force. The bankruptcy filing is also expected to affect tens of thousands more. In further shades of Enron, much of the company's 401(k) plan was in WorldCom stock--soon to be de-listed--affecting thousands of retirement plans, as well as individual investors.

Eric Paulak of Gartner Research (who terms the news "disastrous") says the huge staff cuts will inevitably hurt WorldCom's service quality, and enterprises must make contingency plans. Paulak says that enterprises should:

* Consider not signing up for any new WorldCom services until its financial situation is clearer and it is guaranteed some bank credit.

* Sign six-month extensions for expiring contracts.

* Start duplicating data and considering alternative hosts for Web sites hosted by WorldCom or Digex.

* Evaluate how a second Internet service provider (ISP) might be used for Internet access as well as for WAN needs by deploying a virtual private network (VPN).

* Order back-up dial-up ISDN services for key locations where there is no alternative ISP.

Obviously, prudence comes with a price, and such contingency plans may have significant costs for affected companies. But there may be no other choice. Switching carriers on short notice is virtually impossible (and prohibitively expensive), and anyway would probably not be technically feasible with the drops in service likely to result from such massive layoffs.