A tsunami originating in the little town of Clinton, Mississippi, could soon whack the larger town of San Diego, California. Clinton was the home base of WorldCom, an $11 billion accounting fraud in the telecom industry. On Wednesday of last week, ten former outside directors of WorldCom agreed to pay $18 million out of their own pockets to settle a class-action lawsuit brought by victims. The total payment is to be $54 million. The difference between $18 million and $54 million will be paid by insurers. Ongoing criminal actions continue in the case of WorldCom, which emerged from bankruptcy in April of last year, shed $35 billion of debt, and moved from Mississippi to Virginia and changed its name to MCI, a carrier it had purchased in 1998.
On Friday of last week, former directors of Enron agreed to a similar settlement: they will pay $13 million of their own money to reimburse victims of that infamous scam.
The WorldCom directors' collective mea culpa was the lead story on the front page of the New York Times Thursday, January 6, because it is very seldom that outside directors have to pony up for frauds that take place on their watch. "The era in which huge accounting scandals occur, and the board can just rely on insurance, is over," says San Francisco attorney Sol Cera. "In situations of massive failure, the individuals on the board in this new environment will have to dig into their own pockets at the end of the day to satisfy investor claims." Around the country, legal scholars generally agree with Cera: from now on, boards of directors must take more responsibility for frauds at their companies.
Cera is lead attorney in a lawsuit in federal court here against former board members and officials of Peregrine Systems, a San Diego fraud in which revenues were overstated by $500 million from 1999 to 2001. During the same period, losses were understated by $2.5 billion. It is the board's job to supervise inside accountants and outside auditors. "When sales figures are inflated, the board holds ultimate responsibility," says Marianne Jennings, J.D., professor of legal and ethical studies in the college of business at Arizona State University.
Several civil suits are pending against former Peregrine directors, both in state and federal court, along with ongoing federal criminal and civil investigations. Critical differences make the Peregrine directors appear more vulnerable than the WorldCom directors. For one, the WorldCom directors, for the most part, appear to have been actual outside directors, who have already admitted their sins.
"Many of these WorldCom outside directors were not even located in the same state as WorldCom. Apparently, they were truly outside overseers who have acknowledged their own responsibility for the financial wrongdoing," says Pat Meyer, a San Diego attorney who represents a group of Texas investors who lost money in Peregrine. By contrast, "Many of the Peregrine directors were working side by side in the same office location and were involved in day-to-day activities of Peregrine."
Meyer continues, "Some of the outside directors in Peregrine were involved in forming the company and bringing it public and, until just prior to the financial disclosures of the problems, were major shareholders."
In fact, San Diego-based Peregrine was dominated by San Diego board members. When Peregrine went public in April of 1997, the prospectus acknowledged that the company subleased 13,310 square feet of office space to JMI Services, controlled by then-Peregrine chairman John Moores. Charles F. Noell III, a longtime associate of Moores, was president of JMI Services, a board member of Peregrine, and a member of both the audit and compensation committees. According to civil suits, Moores spent parts of his working days at Peregrine, dealing with executives and board members. Says Cera's federal suit, a combination of filings by several law firms, Moores "had control of Peregrine through his control and domination of the board." The lawsuit describes in detail how "almost every board member had ties to Moores."
There is another critical difference between the former WorldCom directors and the former Peregrine directors. The former WorldCom directors "lost about $250 million on their WorldCom shares," according to the Wall Street Journal. By contrast, the Peregrine directors -- particularly Moores -- raked in hundreds of millions before the company's problems were publicly aired.
According to a suit filed by the bankruptcy court-appointed Peregrine Litigation Trust, during the period of the fraud, board members dumped $540 million worth of stock. "Over $487 million of that amount is attributable to Mr. Moores alone," says the suit. After the company went public in 1997, he sold $650 million worth of stock, almost all he controlled. At the time of the stock sales, board members "were aware of material nonpublic information related to the financial condition and business prospects of the company," says the suit.
The former Enron directors had dumped stock during a period in which false information was sending it up. Significantly, those ex-directors agreed to cough up 10 percent of their pretax profits from this stock trading.
Both the Peregrine Litigation Trust suit and the Cera suit outline how the company's chief executive told the board members prior to board meetings that things were not going well, the outside accounting firm was nervous, regulators were cracking down on shabby accounting practices, and other software firms concocting the same tricks as Peregrine had been pounced on by government regulators. "The insiders knew of adverse developments not known to the investing public," says the Peregrine Litigation Trust suit, citing advance knowledge of distorted accounting, poor sales, and an acquisition that they knew would depress the price of the stock. (The insiders were prescient: Peregrine's stock plunged from $58 to $36.75 on the day of the acquisition announcement and within several weeks had hit $18. Moores had voted for the purchase, but only after he had jettisoned $177 million of stock, according to the suit.)
The former WorldCom outside directors were probably afraid that the lawsuit would have exposed more "wrongdoing that could have been disclosed in the course of legal proceedings," and they would be forced to pay more than $18 million, according to the New York Times.
The WorldCom settlement "sends a message to folks who are serving as members of boards that they really need to perform an oversight role in a careful and prudent way," says San Francisco-based attorney Richard Heimann, who is suing former Peregrine directors on behalf of shareholders of a company that Peregrine purchased. "The whole case in Peregrine revolves around egregious accounting and financial practices by the company -- some of the most outrageous that I have ever seen, and I have been practicing 25 years."
Like other civil suit attorneys, he does not view Moores as an outside director. "His ownership of stock, connection with senior management and other members of the board, and his physical location -- it's very difficult to understand how he could not be aware of the situation," says Heimann. "We have documents that tend to establish even more knowledge on his part; those documents were produced in discovery, and I can't talk about them in specific detail."
The civil lawsuits help to make the case. For example, Noell and other close Moores associates were on the audit committee. Although the company's by-laws required that minutes be kept of each meeting, investigators could find no minutes, "no resolutions reflecting its decisions, and no agendas," says the Peregrine Litigation Trust lawsuit. "Other than illegible scribblings" and a few special presentations by the outside auditor, "there is scant evidence the committee even existed."
The Cera suit agrees that the audit committee's failures "permitted the pervasive accounting fraud to go forward." However, at one of the special outside auditor meetings, the auditing firm (the now-defunct Arthur Andersen) stressed that Peregrine was improperly recognizing revenue and "not truthfully" disclosing this in filings to the Securities and Exchange Commission. But no change was made. In October of 2001, Andersen told the audit committee that "Peregrine was intentionally and repeatedly violating generally accepted accounting principles." The suit says Noell told Moores about the meeting right afterward.
This information is all available to government investigators. "The U.S. attorney's office brought criminal charges against a number of people," says Heimann. "As is typical, they first go after folks lower down and then move up the organization as far as the evidence takes them. I would not be surprised if others are indicted."
Moores has proclaimed all along that he did not know of the shenanigans. So have other board members. His attorney did not return calls asking about what the WorldCom settlement means to the Peregrine cases.