Cooking the Books: A Convicted Fraudster Tells his Tale
Walt Pavlo doesn’t look like a major criminal. With floppy blond hair and boyish good looks, he could pass for a mild-mannered suburban accountant. Except that in the 1990s, this former collections manager for MCI Telecommunications helped hide millions of dollars in bad debt for his employer. He siphoned off $6m in the process for his troubles, and has since served time in gaol for his crimes.
Speaking to an enthralled audience at the International Financial Reporting Standards conference in Dubai last month, Pavlo was very matter-of-fact when he detailed his experience at MCI and his subsequent undoing. This is a man who is now well rehearsed as a public speaker on matters of fraud. What makes Pavlo’s presentations particularly engaging is that audiences know his offences were only the tip of the iceberg in a sequence of events that later saw the merger of MCI with WorldCom, and the corporate accounting scandal that saw the dramatic fall of the telecommunications giant in 2002.
The seeds of Pavlo’s own downfall began when he joined the four-person carrier finance department of MCI in 1992. By 1995 he was a senior manager and the finance unit had grown to 120 people, the growth in his department reflecting MCI’s tremendous rise in fortunes.
Deregulation of the US telecommunications industry in the mid-1990s broke down monopolies and saw a large number of telecom resellers spring to life. MCI, as a large carrier, would sell spare capacity to these resellers, who then repackaged the capacity into pre-paid phone cards and other services at rock bottom prices. At MCI, these resellers were categorised into three tiers. Tier one and two accounts were low risk and high volume, but brought in only 20 per cent of profits. Tier three accounts were high risk and low volume, but were very lucrative – raking in 80 per cent of MCI’s carrier finance profits.
As a result, a business decision was made by executives at MCI to lower the credit requirements for tier three accounts. The company extended its contracts to new businesses with no credit history, and that in many cases owned no equipment or buildings. “Many of them were like virtual companies,” Pavlo recalls. But these tier three resellers were growing rapidly, and were launching numerous products such as debit and pre-paid cards, international calling plans, and highly profitable adult, gambling, and fortune-telling telephone services.
While the sales team at MCI signed up as many of these resellers as it could, Pavlo, now assigned to handle high-risk accounts and collect due receivables, spotted a growing problem with these accounts – their high default rate. These tier three carriers were paying MCI very slowly, or simply weren’t paying up at all. Debt mounted quickly, and as Pavlo explains: “In January, a carrier’s usage might be $250,000, and we would send an invoice for that amount in February. But by then their usage would be $500,000 for that month, so the overall debt would be $750,000. By March, when the invoice was due, they would have used another $750,000. In three months, our exposure would have amounted to $1.5 million.”
With MCI’s stock on the rise, Pavlo says that senior executives allowed him to indulge these resellers as their business made MCI’s books look good. He came up with payment plans, made them sign promissory notes, and allowed them to make deposits or place collateral with MCI well before making any demands for payments in full. Only as a last resort would he threaten disconnection of service. On paper at least the plan worked. MCI’s revenue was growing, profit goals were met, and importantly for senior executives who were partially rewarded in stock options, MCI’s share price continued to increase.
So the pressure on Pavlo to keep up the good work increased. He began writing huge numbers of promissory notes, hiding bad debts of smaller companies, applying current payments to old balances, accelerating unsigned contract credits into the balance sheet, and holding disconnected accounts in the accounts receivable for long periods of time to avoid writing them off as bad debt. He even created a new accounting code called ‘cheque is in the mail’. This allowed him to enter credits into the balance sheet to boost the month’s revenues.
In 1996, Pavlo began to worry though. Following the departure of his mentor, the director of his department, he started looking for help and someone to confide in. Eventually, he wrote a memo to the executive management of MCI, stating that bad debt levels had risen as high as $180m. The response was not what he expected. He claims MCI executives categorically stated that bad debt for that year, as in previous years, would be only $15m. Pavlo was promptly promoted.
With his mentor gone, and executive management turning a blind eye to the mounting debt, an increasingly isolated Pavlo again sought someone to confide in. He turned to a good friend and wealthy businessman who asked him a simple question: “When are you going to get yours?” Pavlo admits that at the time he did feel like he was doing all the dirty work for MCI but without the benefits. What was the harm in getting some payback if a scheme could be developed that would solve MCI’s problems?
Together with his friend, Pavlo came up with a plan. He was to approach indebted tier three carrier customers and threaten them with disconnection, then his friend would approach the same companies as a seemingly unconnected third party investor. The ‘angel investor’ would offer to invest in the company in return for paying the debt to MCI – in effect a factoring deal. In return, the investor would receive a fee, 25 per cent ownership in the company, and the debt repaid in weekly instalments to bank accounts in the Cayman Islands. The carrier companies that accepted the ‘investment’ deal would then receive a letter from Pavlo saying that their debt had been cleared, while in reality Pavlo continued to fudge the books and cover the debt as he had previously done. Within six months the scheme netted seven customers, $35 million had been hidden in MCI’s accounts receivable, and $6 million had been sent to private accounts in the Cayman Islands.
“I knew what I was doing was wrong,” Pavlo admitted to the audience in Dubai when questioned as to his state of mind at the time. “But I felt I could justify it.” He said that with his friend on the board of the companies as an investor, he could influence their accounts and make the companies pay their MCI invoices on time. Besides, Pavlo felt he was left with little choice, as MCI was not going to write off the debts anyway.
Then, while on a business trip in early 1997, Pavlo received a phone call from MCI. Could he come back to the office as an accounting anomaly had been found? Nothing too serious, but he was needed back in the office. Pavlo panicked, and never returned to MCI.
What followed was a miasma of legal wrangling as Pavlo’s fraud gradually unfolded through an internal investigation. In addition to his redirection of funds for personal gain, Pavlo had orchestrated another scam involving a genuine factoring company. This company acted as a factor, paying MCI for its receivables, but to get bank financing the factor company wanted MCI to cover any collections shortfalls. Pavlo had agreed and authorised MCI as a guarantor, and a $45m revolving credit line had been established involving the National Bank of Canada, NationsBank and the CIT Group. According to court documents, due diligence took the form of one phone call by a loan officer at the National Bank of Canada to make sure that Pavlo was an MCI employee.
When MCI was forced to admit Pavlo’s scam to the banks, some seven months after his departure, the suits began. The banks sued MCI for overstating assets on its books, avoiding write-offs and concealing misconduct. The factor company sued MCI for breach of contract, and MCI counter-sued for negligent misrepresentation, fraud and conspiracy. The complicated nature of the suits meant that it took two years to get to court, and by then MCI had merged with telecommunications giant WorldCom.
Meanwhile, Pavlo himself hit an all-time low. He became the target of a federal investigation and began to grow paranoid about being arrested, followed, and having his phone tapped. Feeling that he had no one left to turn to, he retreated from the world, and three years later he cracked. Turning himself in to investigators in October 2000 he cut a deal that included admissions to charges of wire fraud, money laundering and obstruction of justice. In the same month the merged entity of MCI and WorldCom wrote-off $685 million in bad debt that sparked off an SEC inquiry. The rest, as they say, is history. Or is it?
The ramifications of the WorldCom corporate scandal are still reverberating throughout the financial services industry. Recently, Citigroup was stung with a $2.6bn settlement payout on claims that it was partly to blame for losses suffered by WorldCom shareholders. The banking giant had lent money to WorldCom, and analysts at its Smith Barney subsidiary had keenly backed WorldCom shares. The US bank announced at the same time that it had set aside a further $6.7bn for potential legal bills arising from the other spectacular corporate scandal – Enron. Other banks, including JPMorgan Chase, Bank of America and others facing assorted lawsuits from angry WorldCom investors may also need to brace themselves for similar large settlements. If they want to avoid problems of this type, bankers would do well to ask themselves whether they really can be confident in their clients’ reporting processes. If the answer is no, they had better hope there isn’t a Walt Pavlo at work in the company.