An environment for fraud: with jail not yet a distant memory, Walter Pavlo recounts the decisions that led him to hide MCI's bad-debt expenses and embezzle millions

Internal Auditor, April, 2004 by J. Mike Jacka

In 1997--before MCI was acquired by WorldCom--Walter Pavlo, a former MCI billings manager, was sentenced to 41 months in federal prison for wire fraud and money laundering. Over a six-month period in 1996, Pavlo and two associates defrauded MCI customers out of approximately US $6 million. In addition, at the direction of his supervisors, Pavlo helped manipulate the telecom company's accounting records to hide bad-debt expenses totaling US $180 million. The road he traveled to get to this point should be a stark reminder to internal auditors about the benefits of controls and a lesson to anyone who doubts the necessity of those controls or the potential for committing fraud that's within everyone.

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THE START

Pavlo did not begin his business career with a plan to defraud MCI and its customers. "If someone asked me on my first day at MCI, how I was going to steal US $6 million after working here only a couple of weeks," says Pavlo, "I would have said that I would never do such a thing and I wouldn't even know how to do it." With an engineering degree from West Virginia University and a position in the aerospace division of Goodyear Tire & Rubber Co., Pavlo began his career. After a couple of years, he moved on to GEC Avionics and concurrently finished an MBA degree in finance. In 1992, he began working for MCI as a manager in the collections division.

Telecommunications companies and long-distance carriers as they are known today did not exist 25 years ago. But in 1983, the U.S. government gave final approval to break up telecom giant AT & T. From this decision, AT & T was forced to lease long-distance phone lines at a 40 percent to 70 percent discount to small, regional companies. These companies could then resell the bandwidth at a profit, while still undercutting AT & T's price. In the feeding frenzy that followed, innumerable small companies were created to take advantage of this lucrative situation. For all industries, the 1980s and 1990s spawned a new kind of growth that was often fueled more by acquisition than by internal development. Telecommunications was no different and, from this cannibalization, giants like MCI and WorldCom emerged.

The reselling of long-distance can be a complicated process. But, Pavlo explains, it's really just like the sale of widgets: A company sells its widgets wholesale and other companies buy them, putting their own brand name on them. MCI gave its customers access to the long-distance network--just like wholesaling--and the customers resold the access, putting their own brand on it.

At MCI, these customers--or carrier accounts--were separated into three tiers. Tier one comprised the premier companies such as AT & T and Sprint. Tier two consisted of the companies like WorldCom and almost everyone WorldCom bought. "Tier three," says Pavlo, "consisted of the bonanza of customers coming out of the woodwork to get into communications."

Although 80 percent to 90 percent of MCI's revenue was coming from the first two tiers, according to Pavlo, more than 80 percent of MCI's profit was coming from the tier three group. In addition, the company's dealings with the tier one and two groups were very relationship driven, he explains. All the companies had to buy long distance from each other, so the margins were 0 percent to 2 percent. But, Pavlo adds, "We didn't have an attachment or relationship with the tier three group. Our markups were 100 percent to 200 percent, so our profits were being driven by that rung of the carrier-account ladder."

And, there was a lot of profit coming in. When Pavlo was hired as a manager of collections in 1992, the billings for reseller accounts totaled US $250 million. By 1995, when he was promoted to senior manager, there was more than US $1 billion in accounts receivables per month. "The tier three group just kept growing," says Pavlo, "and the company got addicted to the profit."

But the third-tier customers were also making the company susceptible to problems. "Everyone knew the proven telecommunications model--everyone knew the formula," explains Pavlo. "These resellers in the third tier generated quick revenue, but they had very little in the way of assets." At that time, MCI didn't require a down payment or a security deposit; the company only conducted a background check to see if there was a criminal history. "They didn't look at financials," Pavlo continues, "because there weren't any. It didn't take long for these companies to figure out that MCI gave them an easy way into the business. Eventually, they learned that it was very easy to default on their payments." The problem grew because there were no consequences for nonpayment: the customers kept ignoring MCI's billing statements or delaying payment, but no one would cut off their service or do better credit checks in the beginning.

THE TONE AT THE TOP

In late 1995, when Pavlo was promoted to senior manager, MCI's budget for bad debt was about $15 million a year. "I sent a memo to senior staff telling them that we had about $180 million of bad debt for 1996 and asking how we were going to address it." he remembers. "The response I received was that the bad debt budget for 1996 was going to remain at $15 million and that we would just have to work through whatever issues we had."