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, UNITED STATES DISTRICT COURTSOUTHERNDISTRICT OF NEW YORK

SECURITTES AND EXCHANGE COMMISSION,- - - - - 1 - - - - - - - - - ~ - - - ~ - ~ ~ - ~ - - - - - ~ - - ~ -

Plaint i ff ,

- v -

WORLDCOM, INC ,

xI

I

I

I

X

0 2 C i v , 4963 (JSR)

OPINION AND ORDER

JED S . R A K O F F, U.S.D.J.

This case raises fundamental questions about how market

regulators , and the courts, should respond when criminals use t h e

vehicle of a public company t o commit a massive f r a u d . While the

p e r s o n s who perpetra ted the fraud can be criminally prosecuted,

the exposure of the fraud of ten c r e a t e s liquidity pressures that

c a n drive t h e company i n t o bankruptcy, leaving unsecured

creditors w i t h l i t t l e and shareholders w i t h nothing, Innocent

employees m a y find their j o b s in jeopardy, and, if the company is

very l a r g e , ent i re segments of t h e market may be disrupted. In a

s i tua t ion where immense financial suffering is t h e r e f a r e l i k e l y ,

is t h e r e nothing government regulators can do to res tore

equil ibrium?

I n t h e case of Wo r l d C o m , h e . , w e have perhaps the

largeat account ing fraud in history, w i t h t h e companys income

overstated by an ee t ima ted $11 billion, i t a ba lance sheet

overstated by more than $ 7 5 billion, and t h e l o ~ s o shareholders

estimated at as much as $200 billion, Those individuals who

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allegedly p e r p e t r a t e d the fraud are either under indictment or

being criminally investigated by the Depar tment of Just ice;

c r e d i t o r s are seeking recompense in t h e Bankruptcy C o u r t (in h e

matters before J u d g e Gonzalez); and shareholders and employees

are seeking t h r o u g h private d a a s a c t i o n s (in the matters before

Judge Cote) to recover what they can, if n o t rsm the company

(which s in bankruptcy) , t h e n from o t h e r alleged par t i c ipan t s in

the effectuat ion of t he fraud. These ar e the traditional

responses.

In t h e i n s t a n t lawsuit, however, th e Securities and

Exchange Commission ( t h e \Tornmiss ion") , w i t h t h e full cooperation

o f t h e company's new management and significant encouragement

from t h e Court-appointed Corporate Monitor (Richard C. Breeden,

E s q . ) , ha s sought something d i fe ren t :

- - not j u s t to clean house b u t to p u t th e company on a

new and p o s i t i T 7 e footing;

- - n o t j u s t to e n j o i n f u t u r e violations but to createmodels of corporate governance and internal compliance for this

and o t h e r companies t o follow;

- - not j u s t to impose penalties but to h e l p etabil izs and

reorganize the company an d thereby help preserve more t h a n 5 0 , O O S

j o b s and obta in some modest, if inadequate , recompense for thoae

shareholder v i c t i m s who would otherwise recuver nothing whatever.

from t h e company i t s e l f ,

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T h e f i r a t s tep in chis j o u r n e y, taken a t the v e r y outaet

of t h e litigation, w a s the j o i n t decision of th e parties to have

the Court appoint a C o r p o r a t e Monitor to oversee t h e proposed

transformation. While t h e C o r p o r a t e Monitors effor ts were

initially directed at preventing c o r p o r a t e looting and document

destruction, his role and duties have steadily expanded, w i t h the

parties! full consent, to the point where he now a c t B n o t o n l y as

financial watchdog (in which capacity he has saved t h e company

tens of millions of dollars) b u t also a s an overseer who h a s

initiated vas t improvements in t h e companys internal controls

s u b j e c t to such wide-ranging internal oversight imposed from

without; but to t h e companys c r e d i t it has fully supported th e

Corporate M o n i t c x g e f f o r t s and i A e s t r i c t discipline thereby

imposed

under t h e Corporate Moni tor s w a t c h f u l , e y e , t h e company

has replaced i t s entire b o a r d of directors, h i r e d a new and

dynamic chief executive off icer and begun recruiting o t h e r s e n i o r

managers from without, fired or accepted the resignation of e v e r y

employee accused b y either t h e boardl8 ow n Special Invest igat ive

Commit tee or the Bankruptcy Examiner of having part ic ipated i n

the f r a u d , an d terminated even t h o s e employees who, while n o t

accueed o f personal misconduct, are alleged to have been

insuff ic ient ly at tent ive in preventing t h e Eraud, In this

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connection, t h e company has already Speht mare t h a n $50 million

of i t s Qwn money to f u n d unreEtricted inves t iga t ions by both t h e

S p e c i a l Inveatigative Commit tee and t h e Bankruptcy Examiner, and

their detailed reports have been given wide publici ty.

I The company ha B also c o n s e n t e d to a permanent injunction

authorizing t h e Corporate; Monitor to undertake a complete

overhau l of t h e companys c o r p o r a t e governance and authorizing a

group o f highly-q ualified independent consultants ta a s c e r t a i n

that the company has fully eliminated t h e many defecte in t h e

companys internal controls detected a f t e r a comprehensive review

by t h e companys new outside auditors.

governance strictures will, among much else, mandate an active,

informed, and highly independent board, prohibit related-party

transactions and confl ic ts of interest, r e q u i r e a unique

shareholder role in t h e nomination of d i r e c t o r s , and impoae

The new corporate

significant restrictions on executive compensation packages.

Moreover, even though not al l of t h e s p e c i f i c changes in

corporate governance and internal c o n t r o l s have yet been

formulated, t h e company has committed in advance to a d o p t and

adhere t o a l l c o r p o r a t e governance and internal c o n t r o l

recommendationB made by t h e Corpora te Monitor and t h e i n d e p e n d e n t

consultants, subject only to appeal to chis C o u r t . Final ly, the

company has agreed to impoee al l internal controls required by

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section 404 of the Sasbanes-Oxley A c t by no l a t e r than June 3 0 ,

2004, a full y e a r earlier t h a n the A c t requires ,

The permanent injunction a lso requires t h e company to

provide a large segment of i ts employees w i t h specialized

t r a i n i n g in accounting p r i n c i p l e s , publie reporting obligations,

and business ethics, in accordance w i t h programs being specially

developed for the company by N e w York University a n d t h e

University of Virginia. At the behest of the Corporate Monitor,

t h e C o u r t also obtained f rom t h e new Chief Executive O f f i c e r a

sworn "Ethica Pledge," requir ing, on p a i n o f dismissal , a degree

of transparency we11 beyond S . E . C . requirements. The company has

since r e q u i r e d it s s e n i o r management to sign a similar pledge,

and has planB to obtain similar p l e d g e s from virtually al l

employees.

T h e Court is aware of no large company accused of fraud

t h a t has so r a p i d l y and so completely d i v o r c e d i t s e l f from t h e

misdeeds of t h e immediate p a s t and undertaken such extraordinary

s t e p t o p r e v e n t such misdeeds in t h e future. While t h e Courtl

at the parties' express request, will continue t o retain

jurisdiction fo r however long i t t a k e s to make c e r t a i n t h a t t h e w

new controls an d p r o c e d u r e s a r e f u l l y implemented and secured,

t h e C o u r t is sat isf ied that t h e a t e p a already t a k e n have gone a

very long way toward making t h e company a good c o r p o r a t e ci t izen-

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P. O 7 / 1 5

This is not to say t h a t the sins of the past can be

forgotten or wholly Eorgiven.

transformed i t s e l f , no matter how diferent a company i t is now

from t h e company that was u s e d as a vehicle to commit t h e

aforementioned fxauds, those frauds were still c o l o s s a l and must

No m a t t e r how much t h e company has

be p u n i ~ h e d ,

The bes t punishment, unquestionably, is t h e c r i m i n a l

prosecution of those persons found to have p e r p e t r a t e d the

f rauds , Such punishment, however, is not w i t h i n t h e prerogatives

of t h e Commission ( l e t alone the C o u r t hearing this lawsuit) but

r a t h e r is the r e e p o n a i b i ~ i t y, n t h e firat instance, of the

D e p a r t m e n t of Justice,

In this lawsuit, t h e Commission c o u l d theoretically seek

t h e effect ive l iquidation of the company. Several of the

companys c o r n p e t i t o r e , n Q t a b l y Verizon and AT&,T, have urged such

an outcome, arguing that i t i s unfair tha t , a$ a r e s u l t o f the

bankruptcy laws, Worldcorn, t he wrongdoer, m a y emerge from

bankruptcy with l e s s of a debt load t h a n t h a t assumed by its

competi tors . This argument, however, has n o t commended i t s e l f to

the Commission, and does not persuade this Court. Corporate

reorganization under Chapter 11 of t h e b a n k r u p t c y laws always

confers a compet i t ive advanrage to t h e d e b t o r in t e r m s of

el iminat i on of debt ; ye t companies rarely seek b a n k r u p t c y except

as a l a s t resort, f o r it involves numerous competitive

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P. 88/15

disadvantages a E well, not o n l y in public relations and cuatorner

dissat isfact ion but in f u t u r e capacity to borrow and to raise

capital . Moreover, whatever advantages in debt reduct ion

Worldcorn will realize from bankruptcy reorganization, any

Etuggeat ion that companies as large and well-positioned as Verizon

and AT&T will not be able to compete effectively with the new

WosldCom/MCI lacks c r e d e n c e - Verizon, indeed, already enjoys a

apecia l competi t ive advantage of its own by v i r t u e of i t s sta tus

under FCC rules as a de f a c t 0 local monopoly.

To kill the company, by contrast, would unfairly penalize

i t s 50,000 innocent employees, remove a major compet i to r f r o m a

market t h a t involves significant barriers to e n t r y , and se t at

naugh t th e company's extraordinary efforts to become a model

c o r p o r a t e citizen. It would also unfairly impact creditors, o v e r

8 0 percent of whom have stated their support for the company'a

plan of reorganization in recognition that i t affords them far

more value t h a n l iquidat ion, Finally, it would u n d e r c u t the

b a a i e teneta of bankruptcy reorganizat ion, a unique innovation of

United S t a t e s bankruptcy l aw t h a t haa contr ibuted mater ia l ly to

t h e conservation of economic resources and t h e stability o f t h e

U.S. economy- Accordingly, t h e Commission has sought n e i t h e r

outright liquidation n o r a monetary penal ty so large as t o make

liquidation inevitable, an d t h e Cour t sees no reason not to defe r

to t h a t j u d g m e n t .

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I . .-.- I I I , I , _I- . IS * I I L L- 1 \I I , , - , I

What, then, is the g r o p e r monetary penalty? From t h e

P. 09/15

Commissions standpoint, it must be one large enough t o r e f l e c t

the magnitude of t h e fraud and ye t not so l a rg e as to force t h e

company into l iquidation and t h e r e b y u n d e r c u t : the Commissions

own intensive efforts to reform the company t h r o u g h injunctive

r e l i e f , The matter is Eu r the r complicated by the bankruptcy lawsI

and by sect ion 3 0 8 ( a > of t h e Sarbanes-Oxley Act . Under t h e

bankruptcy laws, the Cornmisaions penal ty c la im i s t r e a t e d a s

simply another c l a i m by one a many unsecured creditors, a group

t h a t , under the plan of reorganization presently pending before

Judge Gonzalez, will generally recover about one-third of every

dollar claimed. Under any analysis, moreover, secured creditors

have a bet ter legal c l a i m t h a n t h e Commission to Worldcorns

l imi ted asseta (estimated, on a l iquidation basis, at between

f o u r and six billion d o l l a r s ) , so t h a t t h e kind a mul t i -b i l l ion

dollar penalty t h a t might otherwise be worth considering is not

even an option except f o r the purpose (already r e j e c t e d ) of

forcing liquidation.

As fo r a e c t b n 3 0 8 ( a ) , while it gives t h e Commhaion the

opportuni ty to pay any penalty it recovers to the shareholder

v i c ~ i m s a t h e r t h a n to t h e U S - Treasury, a penal ty t h a t was

premised primarily on t h a t baais might arguably run afoul of t h e

proviaions o f t h e Bankruptcy Code that subordinate shareho lder

claims be low a l l othere . A B a general rule, defrauded

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shareholders can not expect to recover one penny in bankruptcy;

and n o t h i n g in sect ion 308(a) auggests that Congress intended to

give shareholders a

previously en j oyed

g ive

This is not

greater

t o

i t s penalty recovery

priority

however,

in bankruptcy

t h a t the

to t h e shareholders,

than they

Commission cannot

as Election 308 ( a >

so laudably p r e s c r i b e s , or t h a t it cannot take some account of

shareholder l o s s in formulating t h e s i z e and nature of i ts

penalty: for while t h e securities laws limit t h e s i z e of t h e

penal ty to the amount t h a t the company h as gained from i t a fraud1

(an amount here estimated at between ten and seventeen billion

dollars) that doe3 not mean that t h e Commission cannot

rationally t a k e account of shareholder loas a a a relevant factor

in determining t h e s i z e of the penal ty up to that l imit . What

t h e Commission not at Least in a case which the

company is in bankruptcy, is determine t h e s i z e of the penalty

primari ly on t h e b a s i s of how much shareholder loas will thereby

be recompensed, for : this would not only be adverse to the

p r i o r i t i e s eatablished u n d e r t h e bankruptcy laws b u t a l s o would

run contrary to t he p r i m a r y purposes of S . E . C . f raud penalties

themselves. See S.E.C. v. Fischbach C O m . , , 13 3 F . 3 d 170, 175 (2d

C i r . 1997)(compensation of vict ims is "a distinctly secondary

g o a l " of S,E.C. actions).

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P. 11/15

G iv en a l l these compfications, difficulties, and

uncertainties, the Commiaaion has wisely chosen, in formulating a

penalty proposal in t h i s c a s e , to look to t h e penal t ies it ha s

imposed in p r i o r cases and th e factors t h e r e considered, see,

e . g b , , $ . E X . v, Kane, 2 0 0 3 WL 1741293 at: * 4 ( S , D . N . Y- p r ? 1,

2 0 0 3 ) (describing f a c t o r s commonly conaidered in making S . E . C .

penalty determinations). On that basis, t h e Commission h a s

negot ia ted a sett lement t h a t results in a penal ty dozens of t imes

l a r g e r t h a n any it previously imposed against a publ ic company,

thereby ref lect ing t h e huge s i z e of the i n s t a n t fraud and t h e

need to deter o t h e r s similarly situated.

Specifically, in their initially proposed settlement of

the monetary penal ty, dated M a y 19 , 2003, the p a r t i e s proposed a

pena l ty of approximately $ 1 . 5 billion, which, a f t e r t h e discount

in bankruptcy, would result in an actual payment of $500 million,

orSO t i m e s t h e l a r g e s t such penalty previously

irnpoaed. In

response, t h e C o u r t gave all interested parties the opportunity

to submit papers in oppoaition to t h e proposed set t leme nt , and

then conducted a lengthy public hearing on June 11, 2 0 6 3 , so as

t o air the concerns t h u s raised.

In particular, the Court took note of t h e concern that

t h e pena l ty, despi te i t s substantial s i z e relative t o thecompanys l iquidat ion value, might not adequately t a k e account of

t h e l a r g e r value t h e company va a p r o j e c t e d to have upon

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P. 12/15

reorganizat ion ( s o m e w h e r e between twelve an d fifteen billion

dollars) This concern might be mitigated, it was suggested, by

modifying the settlement lo a s t o inc rease somewhat the s i z e of

t h e penalty and make t h e increase payable i n common s t o c k . Such

a modification, while avoiding additional caah outlays at a t ime

when the companys cash was limited, woald make the t o t a l penalty

more commensura te with t h e companys estimated reorganization

value. By v i r t u e of section 3 0 8 ( a ) , a f u r t h e r consequence would

be to give t h e victim shareholders t h e opportunity to

par t ic ipate , a lbe i t modestly, i n any i n c r e a s e in t h e c o m p a n y c s

value following i t s emergence from bankruptcy-

Re8pOnSiVe to these concerns, the part ies filed on July

2 , 2003 a revised proposed sett lement of t h e monetary penal ty

a s p e c t of this lawsui t . The revised settlement proposes, f i r s t ,

an overall penalty of $2.25 billion (or more than 40 p e r c e n t

o f t h e meanest imated

l iquidationvalue

of t h e company and

more than 1 5 p e r c e n t of the mean estimated reorganization value

of t h e company) . Taking account of the bankruptcy discount, it

proposes , second, t h a t i f the Bankruptcy Court approves both t h e

set t lement and t h e plan of reorganization, the actual penalty

payment will be $ 7 5 0 million - - or 7 5 t imes g r e a t e r t h a n any

p r i o r such penalty - Third, it proposes t h a t , of t h e $ 7 5 0million, $500 million will be p a i d in cash and t h e o t h e r $250,000

in t h e form of the companys new common stock, aa valued in

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- - Y c - . L l \ l I I \ U I I

accordance w i t h th e p l a n of reorganization. ( I f , instead, th e

company is forced i n t o liquidation, t h e penalty payment will be

l imited to th e $500 miJ.l . ion in cash, aince t h e enhanced

reorganization value will n o t have been realized.) F o u r t h , it

proposes t h a t these payment8 w i l l be made initially to a

Distribution Agent appointed by this C o u r t , who will t h e n

undertake to distribute t h e cash and, at a s u i t a b l e t ime , t h e

proceeds of t h e stock, to t h e victim ahareholders, as determined

by t h e Distribution Agent and the Court in accordance w i t h

guideline8 set forth in th e Commission's prior submissions and a

more detailed p l a n to be h e r e a f t e r submitted.

The parties strongly urge approval of t h e revfaed

settlement as being in t h e public i n t e r e s t . Before signing the

proposed settlement, moreover, the C o m m i s s b n , cognizant that any

s e t t l e m e n t to be approved by t h e Bankruptcy Court must also be

conaiatent with the best interests of the creditors, requested

an d received the aigned endorsement of the Officia l Committee of

Unsecured Creditors of Wo r l d C o m , I n c . (representing t h e c r e d i t o r s

affected by t h e settlement), who approved the settlement and

promised to upp port it before the Bankruptcy Court, Se e Congent

and Undertaking of Defendant Wo r l d C o m , Inc., d a t e d July 3 , 2003,

at 10.

A C o u r t reviews s u c h a settlement p r o p o s a l not on t h e

basis of what i t might i tself determine is t h e appropriate

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penal ty but on the bas16 of whether the settlement is f a i r#

reasonable, and adequa te . See S.E.C, y J Wanq, 9 4 4 F 2 d 8 0 , 8 5

(2d Cir. 1991) Uni ted , t a t e s v - Cannons E n s h e e r i n s C ~ r p., 0 9 9

F - 2 d 7 9 , 84 ( l g t i r - 1990). Moreover, where ode of t h e settling

parties is a public agency, its determinations as to why and to

what degree t h e settlement advances t h e public i n t e r e s t are

entit led t o substantial d e f e r e n c e - See F, T , C , v . Skandard

Financial Manaqement Carp., 8 3 0 F, 2 d 404, 408 ( I s t C i r . 1987);

S .E .C . v. Randolph, 73 6 F.2d 525, 530 ( s thCir. 1984) ("The

initial determinat ion whether the consent decree is in the public

i n t e r e s t is bee t l e f t to t h e S , E . C _ and i t s decision deserves our

deference I ) .

Here , t h e C o u r t is sat isf ied t h a t t h e Commission haa

carefully reviewed all relevant considerations and has arrived at

a penal ty t h a t , while t a k i n g adequate account of the magnitude of

the f r a u d and the n e e d o r punishment and deterrence, f a i r l y and

reasonably reflects t h e realitiee of this complex situation.

Undoubtedly the settlement will be criticized by, among others,

those s h a r e h d d e r s unfamiliar with t h e severe limit s imposed on

their recovery by the bankruptcy l a w s , thoae competitors whose

own self- interest blinds them to t h e b r o a d e r r a n g e of publ ic

policies that such a settlement implicates, and those professed

pundits an d ideologue& f o r whom anything l e s ~ h a n a corporate

d e a t h penalty c o n s t i m t e s an "outrage.N But t h e C o u r t is

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convinced, or t h e reasons a l r e a d y o u t 1 n e d above khat the

proposed set t lement is not o n l y fair and reasonable but as good

an, outcome a 8 anyone could reasonably expect in theae difficult

circumstances.

Accordingly, the settlement of the monetary penalty phawi?

of this l i t igation i e hereby approved , and the Court will e n t e r

today t h e F i n a l J u d g m e n t a s t o Monetary Relief in the form '

submitted by the p a r t i e s .

SO ORDERED.

D a t e d ; New Ybrk, New YorkJuly 7, 2003

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