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December 15, 2004.


The opinion of the court was delivered by: DENISE COTE, District Judge


This Opinion addresses issues related to an underwriter's due diligence obligations. Following the conclusion of fact discovery, several of the parties in this consolidated securities class action arising from the collapse of WorldCom, Inc. ("WorldCom") have filed for summary judgment. This Opinion resolves the motions for summary judgment filed by Lead Plaintiff for the class, who seeks a declaration that certain of the WorldCom financials incorporated in the registration statements for two WorldCom bond offerings contained material misstatements; and by the underwriters for those same bond offerings, who seek a declaration that they have no liability for any false statements in the WorldCom financials that accompanied the registration statements or for the alleged omissions from those registration statements.

  It is undisputed that at least as of early 2001 WorldCom executives engaged in a secretive scheme to manipulate WorldCom's public filings concerning WorldCom's financial condition. Because those public filings were incorporated into the registration statements for the two bond offerings, the underwriters are liable for those false statements unless they can show that they were sufficiently diligent in their investigation of WorldCom in connection with the bond offerings. Through these motions, the Lead Plaintiff emphasizes that the underwriters did almost no investigation of WorldCom in connection with their underwriting of the bond offerings for the company, and because they did essentially no investigation, will be unable to succeed with their defense that they were diligent. The Lead Plaintiff contends moreover that there were "red flags" that should have led the underwriters to question even the audited financials filed by WorldCom.

  For their part, the underwriters emphasize that WorldCom management concealed the fraud from almost everyone within WorldCom, from WorldCom's outside auditor, and from the underwriters themselves. They assert that they were entitled to rely on WorldCom's audited financial statements as accurately describing the company's financial condition, and also on the comfort letters that WorldCom's outside auditor provided for the unaudited financial statements. While they have not moved for summary judgment on the adequacy of their due diligence efforts per se, they do argue that those efforts should not be measured solely by the work that they undertook in connection with the bond offerings themselves, but should be assessed against a background of their long term familiarity and work with the company. They also argue that much of the information that was allegedly omitted from the bond registration statements was already known to the public. For the following reasons, the Lead Plaintiff's motion is granted in part. The underwriters' motion is also granted in part.


  These summary judgment motions require, in varying amounts of detail, an understanding of the industry in which WorldCom operated, some of the accounting issues that affected the reliability of the WorldCom financial statements, and the due diligence work performed by the underwriters in connection with the two bond offerings. The facts recited here are either undisputed or as shown by the party resisting summary judgment, unless otherwise identified. A brief description of the history of this litigation and the context for the summary judgment motions precedes the factual recitation.

  Procedural History

  WorldCom announced a massive restatement of its financials on June 25, 2002. It reported its intention to restate its financial statements for 2001 and the first quarter of 2002. According to that announcement, "[a]s a result of an internal audit of the company's capital expenditure accounting, it was determined that certain transfers from line cost expenses*fn1 to capital accounts during this period were not made in accordance with generally accepted accounting principles (GAAP)." The amount of transfers was then estimated to be over $3.8 billion. Without the improper transfers, the company estimated that it would have reported a net loss for 2001 and the first quarter of 2002. On July 21, it filed for bankruptcy. A restatement of WorldCom's financials was issued in 2004 in connection with WorldCom's emergence from bankruptcy. WorldCom restated its financial information for the years ending 2000 and 2001. The restatement included approximately $76 billion in adjustments, which reduced WorldCom's net equity from approximately $50 billion to approximately minus $20 billion.

  Securities litigation addressing the accuracy of WorldCom's financial statements commenced in the Spring of 2002. Those class actions filed in this district were consolidated on August 15, 2002. The Judicial Panel on Multi-District Litigation ("MDL Panel") transferred the securities litigation pending in federal courts to this district and all of the actions, both individual ("Individual Actions") and class actions, were consolidated for pre-trial purposes on December 23, 2002. In re WorldCom, Inc. Sec. Litig., No. 02 Civ. 3288 (DLC), 2002 WL 31867720 (S.D.N.Y. Dec. 23, 2002). This litigation is referred to as the Securities Litigation.*fn2 The consolidated class action complaint in the Securities Litigation was filed on October 11, 2003, and the first wave of motions to dismiss that pleading were resolved in an Opinion of May 19, 2003. In re WorldCom, Inc. Sec. Litig., 294 F. Supp. 2d 392 (S.D.N.Y. 2003). Fact discovery in the Securities Litigation concluded on July 9, 2004.*fn3 Before its conclusion, Citigroup, Inc., Citigroup Global Markets Inc. f/k/a/ Salomon Smith Barney Inc. ("SSB"), Citigroup Global Markets Limited f/k/a/ Salomon Brothers International Limited, and Jack B. Grubman ("Grubman") (collectively "Citigroup Defendants") settled the class action lawsuit. A fairness hearing on the $2.575 billion settlement was held on November 5, 2004, and the settlement was approved. In re WorldCom Sec. Litig., No. 02 Civ. 3288 (DLC), 2004 WL 2591402 (S.D.N.Y. Nov. 12, 2004).

  SSB had functioned was the co-lead underwriter for the two bond offerings issued by WorldCom that are at issue in the class action: one in May 2000 ("2000 Offering") and one in May 2001 ("2001 Offering"). Grubman, an SSB employee, was the leading telecommunications analyst covering WorldCom and it is alleged that he had issued reports urging investors to purchase WorldCom securities when he knew that WorldCom's financial statements did not accurately disclose information that was material to investors. The plaintiffs asserted that SSB's desire to obtain WorldCom's investment banking business caused it to issue misleading analyst reports that urged investors to purchase WorldCom securities. The class action complaint alleged that the Citigroup Defendants violated not just the strict liability statutes governing securities offerings, but also the securities statutes that forbid fraud, including Section 10(b) of the Securities Exchange Act of 1934 ("Section 10(b)" and "Exchange Act").

  The defendants in the class action, as named in a Corrected First Amended Class Action Complaint of December 1, 2003, include former WorldCom executives Bernard J. Ebbers ("Ebbers"), WorldCom's CEO, and Scott Sullivan ("Sullivan"), WorldCom's CFO; members of WorldCom's Board of Directors ("Director Defendants"), investment banks that underwrote the 2000 and 2001 Offerings,*fn4 and Arthur Andersen LLP ("Andersen"), WorldCom's former auditor. The plaintiffs allege that the Underwriter Defendants violated Sections 11 and 12(a)(2) of the Securities Act of 1933 ("Section 11", "Section 12(a)(2)", and "Securities Act"), 15 U.S.C. § 77k and § 77l, and that Andersen violated Section 11 of the Securities Act and Section 10b of the Exchange Act.

  On August 20, 2004, summary judgment motions were filed by parties to the class action. The trial is scheduled to begin on February 28, 2005.

  The Lead Plaintiff has moved for partial summary judgment, and the Underwriter Defendants have moved for complete summary judgment.*fn5 The Lead Plaintiff moves for summary judgment on its Sections 11 and 12(a)(2) claims with respect to certain statements in WorldCom's financial filings that the Lead Plaintiff contends are indisputably false and material. WorldCom's financial filings were incorporated into the registration statements for the 2000 and 2001 Offerings. The allegedly false statements on which the Lead Plaintiff's motion is based relate to the reporting of WorldCom's line costs, capital expenditures, depreciation and amortization, assets, and goodwill. The Underwriter Defendants move for summary judgment on the Sections 11 and 12(a)(2) claims against them with the argument that it is undisputed that they conducted reasonable due diligence with respect to the WorldCom financial statements that were incorporated into the registration statements for the 2000 and 2001 Offerings. They argue in particular that they were entitled to rely on WorldCom's audited financial statements and had no duty to investigate their reliability unless they had reasonable grounds to believe that they were not accurate, and that they were also entitled to rely on the "comfort letters" from WorldCom's auditor for the interim unaudited WorldCom financial statements. With respect to the alleged material omissions that are also a basis for those same Securities Act claims, the Underwriter Defendants contend that none of the omissions are actionable, for instance, because the information was already publicly disclosed or was not material.

  The parties have made extensive submissions in connection with these competing motions. Because of the analysis which follows, it is only essential to set forth a small portion of the factual material presented through these motions. The essential facts as shown through the evidence presented with these motions include the following. WorldCom and its Role in the Telecommunications Industry

  Ebbers founded a long-distance telephone service provider in 1983 in Mississippi. His company grew by purchasing other small long-distance companies throughout the late 1980s and early 1990s. The company went public in 1989, and by 1993 it was the fourth largest long-distance carrier in the United States. It took the name WorldCom in 1995.

  Congress enacted the Telecommunications Act in 1996, 47 U.S.C. § 251 et seq., which encouraged competition in local and long-distance telephone services. At this same time, the Internet was expanding rapidly and there was a demand for increased bandwidth.*fn6 To meet that demand and in response to the intense competition, telecommunications companies made substantial capital investments in fiber optic networks and telecommunications infrastructure.

  Between 1996 and 1999, WorldCom completed several major acquisitions that helped diversify or enlarge its business. Through a merger with MFS Communications, Inc., WorldCom acquired UUNET Technologies Inc., which was the world's largest Internet service provider and which had a substantial fiber optic cable network. It acquired CompuServe Corporation and ANS Communications Inc., which gave WorldCom a large Internet dial-up communications network. The acquisition of SkyTel Communications, Inc. gave WorldCom an expertise in the wireless business. In 1998, WorldCom acquired MCI Communications ("MCI"), a company whose revenues were more than two and half times greater than WorldCom's. With that acquisition WorldCom became the second largest telecommunications company in the world. Its share price, which had been approximately $8 per share in 1994, increased to $48 per share by September 1999.

  As noted, by the late 1990s, the telecommunications industry was growing increasingly competitive. Regional companies were entering the long-distance market, long-distance carriers were entering the local call market, and many companies were seeking to provide Internet services. Some analysts expressed concerns about WorldCom's weakness in wireless technologies and the increased competition it faced in the long-distance telephone service market, where competition was driving prices down.

  On October 5, 1999, WorldCom announced that it had agreed to merge with Sprint in a transaction valued at $129 billion. With this acquisition, WorldCom would get Sprint's wireless business and address some of the concerns expressed about its competitive posture in the telecommunications market. The market initially reacted enthusiastically to the announcement, but as time passed WorldCom's share price fell dramatically. On May 18, 2000, attorneys in the Antitrust Division of the United States Department of Justice formally recommended to their division chief that the merger be blocked. On July 13, WorldCom announced that it was terminating its merger agreement with Sprint. By the end of August 2000, WorldCom's stock was trading in the low $30s.

  On September 5, 2000, WorldCom announced that it had entered into a $6 billion merger agreement with Intermedia. Intermedia had a local exchange carrier business and owned a web hosting business, Digex. WorldCom hoped to sell the local carrier business and to take advantage of the Digex Internet business. With the acquisition of Intermedia, WorldCom assumed massive debt obligations. WorldCom paid approximately $250 million a quarter to fund Intermedia's business and approximately $300 million a year to support Digex's capital expenditure needs. WorldCom was unable to find a buyer for the Intermedia local carrier business.

  On November 1, 2000, WorldCom announced that its revenues for 2001 would not be as high as previously estimated. WorldCom indicated it was issuing "new financial guidance due to continuing competitive pressures in the telecommunications industry, increased spending to support the Company's growth initiatives and other economic factors."

  Ebbers' Dependence on WorldCom Stock

  Ebbers' personal finances were dependent on the rise and fall of WorldCom's stock price. The majority of his wealth was concentrated in his holdings of WorldCom stock. He pledged essentially all of his WorldCom stock to secure loans that he used to acquire other businesses and to fund their operations. Most of his personal debt was held by affiliates of Citibank and Bank of America.

  As described above, WorldCom's stock price fell during 2000. By the Fall of 2000, Ebbers began receiving substantial margin calls from Bank of America's private bank. Because Ebbers had already pledged all of his holdings to secure his personal debt, he was unable to pledge any additional stock. On September 6, WorldCom agreed to extend Ebbers a $50 million loan to cover the margin calls. Within a few weeks, Ebbers faced additional margin calls. When WorldCom refused a request for an additional loan, Ebbers entered into a forward sale of three million WorldCom shares to raise $70 million. The sale was reported by the media on October 4, and WorldCom's stock price dropped nearly 8%, to $24.93.

  In early October 2000, Citibank issued margin calls to Ebbers. Its affiliate SSB had a significant investment banking relationship with WorldCom, and SSB agreed to guarantee payment of Ebbers' personal debt to Citibank.*fn7 On October 27, WorldCom agreed to loan Ebbers an additional $25 million and to guarantee an additional $75 million of Ebbers' debt to Bank of America, staving off additional margin calls. In mid-November, the guarantee was increased to $100 million. By the end of 2000, WorldCom had extended a total of $200 million in loans and guarantees to Ebbers. The loans increased to over $250 million by May 2001.

  On April 11, 2001, Ebbers met with the private banking arm of J.P. Morgan and requested a loan of $40 million to refinance $20 million of his debt to Bank of America relating to his investment in a yacht building business, and to invest another $20 million in building additional yachts. The investment bankers encouraged their bank to accommodate Ebbers, and in June, J.P. Morgan gave Ebbers a personal line of credit of $20 million. An April 26 memorandum analyzing Ebbers' personal financial situation noted that "Ebbers has used his wealth in WCOM to fund his investments," principally in a yacht building business, timber, motels, a trucking company and the largest working ranch in North America. The memorandum continued,
Unusual for a CEO of this type, he has virtually no other marketable securities. . . . To finance these private investments, Ebbers has accumulated substantial margin loans against his WCOM shares. Last fall, when the share price of WCOM declined substantially, his largest lender, Bank of America, issued some well-publicized margin calls. In order to forestall a sale of the Chairman's shares and risk further downward pressure on the share price[,] WCOM stepped in and replaced Bank of America as lender on $75 million and provided an additional guaranty on the remaining $186 million loans outstanding. . . . While Bank of America seems comfortable for the moment, the current margin structure of his debt and the illiquid nature of his other assets provides little room for movement in the WCOM share price.
(Emphasis supplied.) The memorandum added that Ebbers had a "highly leveraged balance sheet with $315 million in debt structured as margin loans against his [WorldCom] shares. 80% leverage against WCOM shares."

  WorldCom's Accounting Strategies

  WorldCom's single largest operating expense was its line costs. This item accounted for roughly half of its expenses and was so material that it was reported as a separate line item on its financial statements. WorldCom's ratio of line cost expense to its revenue was called the E/R ratio, was used as a measurement of its performance, and was also publicly reported in its SEC filings. The lower the ratio, the better the performance.

  The parties dispute the extent to which WorldCom's financial statements were intentionally and materially false before the first quarter of 2001. They do not dispute, however, that senior management in WorldCom manipulated the public reports of WorldCom's line costs beginning in the first quarter of 2001 through shifting a portion of them to capital expenditures accounts, and that this manipulation was criminal.*fn8 The manipulation reduced the reported line costs and resulted in a lower E/R ratio.

  Before capitalizing the line costs in 2001, WorldCom had engaged in other strategies to reduce the apparent magnitude of its line costs. One example will suffice. During 2000, WorldCom released reserves or accruals that had been set aside to cover anticipated costs, and used them to offset line costs. These reserves had been maintained to cover additional bills that WorldCom had estimated it might receive from outside service providers.*fn9 By releasing these reserves, line costs appeared smaller. Prior to 2000, WorldCom had a 24-month billing reserve for invoices it had not yet received. This reserve covered its estimated exposure for a rolling 24-month period. In the first quarter of 2000, WorldCom management decided to reduce the period of time covered by the reserve from 24 to twelve months. WorldCom divided the impact from this change in policy between the first and second quarters of 2000: $59 million was released in the first quarter; $77 million was released in the second quarter. In the last quarter of 2000, WorldCom reduced the period from twelve months to 90 days and released $70 million in reserves in that quarter.

  Unable to reduce reserves further, and still wishing to conceal the magnitude of WorldCom's expenses and artificially inflate WorldCom's reported income, senior management of WorldCom started in 2001 to capitalize WorldCom's line costs. They would review WorldCom's financial results toward the end of each quarter in order to decide how much of the line cost expenses to capitalize. The capitalization of line costs was unsupported by any contemporaneous analysis or records, and was a violation of GAAP. It is undisputed that it constituted fraud.

  The capitalization fraud began on Friday, April 20, 2001, when Troy Normand, WorldCom's Director of Legal Entity Reporting in General Accounting, directed that line costs be reduced by $771 million by booking that amount of line costs in an entry labeled "prepaid capacity." Between that day and Tuesday, April 24, WorldCom personnel allocated the line costs expenses to WorldCom's two tracker stocks*fn10 and other business units. This manipulation was necessary to make the E/R ratio for the first quarter of 2001 "fairly consistent" with the E/R ratio for the prior quarter.

  Andersen was unaware of the manipulation of line costs through this capitalization scheme. On April 26, WorldCom issued a Form 8-K.*fn11 That Form 8-K falsely represented WorldCom's financial condition.

  The Lead Plaintiff contends that two WorldCom documents from March and April 2001, if reviewed, would have revealed the discrepancy between WorldCom's actual financial condition and its public reports.*fn12 A March 20, 2001 document, which is labeled "2001 Line Cost Budget/Final Pass/Corporate Financial Planning," reveals that WorldCom internally projected line costs to be materially higher than what it was reporting for line costs in 2001. The document projects line costs for the first quarter at $4.65 billion. On April 26, 2001, it publicly reported in its Form 8-K first quarter line costs of only $4.1 billion, or half a billion dollars less.

  The 2001 Line Cost Budget document also showed that WorldCom expected an E/R ratio of 47.6% for 2001, based on $19.2 billion of line costs on $40.3 billion of revenue. WorldCom had reported an E/R ratio of 39.6% in 2000. The document attributes the difference to several factors, including the fact that WorldCom could no longer release line cost reserves.*fn13 The document cryptically lists dollar values as "tasks" and computes the effect of the "task" on WorldCom's E/R ratio. For instance, a "Task of $100M improves E/R to 40.7%." Overall, the document reflects a "proposed 2001 task" in the amount of $471 million.

  WorldCom's Capital Expenditure Report, prepared on a monthly and quarterly basis by its Financial Planning Department, described its capital expenditures. The March 2001 Capital Expenditure Report was distributed on April 20, 2001. It reported that WorldCom's capital expenditures (excluding software) were $1.691 billion for the first quarter. On April 26, however, WorldCom's Form 8-K publicly reported that the first quarter capital expenditures were $544 million more or $2.235 billion.*fn14

  The significance of the Capital Expenditure Report was self-evident. On May 1, 2002, after the March 2002 report was distributed, one co-conspirator e-mailed a colleague: "Where do I sign my confession?" Another complained, "Why did you distribute this report? I thought we were never again distributing this. . . . No need to reply but do not distribute again."

  The improper capitalization of line costs continued through the first quarter of 2002. WorldCom's internal audit department had completed its last audit of WorldCom's capital expenditures in approximately January of 2002, and had not uncovered any evidence of fraud. In May of 2002, it began another audit of the company's capital expenditures. The fraudulent capitalization of line cases was uncovered as a result of a May 21 meeting between the company's internal auditors and the WorldCom director in charge of tracking capital expenditures. During that meeting the director used the term "prepaid capacity" to explain the difference between two sets of schedules that he was being shown. The auditors were unfamiliar with the term. After asking questions of several people about "prepaid capacity," Eugene Morse, a member of WorldCom's internal audit group, used a new software tool to investigate WorldCom's books and was able to uncover the transfer of line costs to capital accounts in a matter of hours.*fn15

  On June 17, David Myers, WorldCom's former controller, admitted to the internal audit team that there was "no support" for the prepaid capacity entries and that there was "no standard" supporting the entries. He explained that the "entries had been booked based on what they thought the margins should be." Myers told the team, "if we couldn't get the costs down that we might as well shut the doors of the business, that we can't continue." On June 20, during a meeting in which Sullivan was confronted with the fraud, Myers told internal audit that the capitalization of line costs had started in the first quarter of 2001. As of that time, the internal audit team thought that the capitalization of line costs had begun in the second quarter of 2001, and was no longer trying to find out how far back the entries went.

  Andersen and the 1999 Form 10-K*fn16

  Andersen had been the auditor for WorldCom or its predecessors for almost twenty years. It issued an unqualified or "clean" opinion for the WorldCom annual financial statements for 1997 through 2000*fn17 After the public disclosure of the accounting fraud, Andersen withdrew its support for the WorldCom 2001 Form 10-K, but it never withdrew its audit opinions for the 1999 or 2000 Form 10-Ks.

  The WorldCom 1999 Form 10-K, for the year ending December 31, 1999, was dated March 30, 2000. It included detailed discussions of a number of the items that are central to the parties' motions for summary judgment. Its description of the business of WorldCom included the following: "MCI WorldCom leverages its facilities-based networks to focus on data and the Internet. MCI WorldCom provides the building blocks or foundation for the new e-economy. . . . MCI WorldCom provides the broadest range of Internet and traditional, private networking services available from any provider." The 10-K described nine mergers since 1995. In describing the merger agreement with Sprint, it defined its strategy as an effort

to further develop as a fully integrated telecommunications company positioned to take advantage of growth opportunities in global telecommunications. Consistent with this strategy, the Company believes that transactions such as the MCI Merger, the CompuServe Merger, the AOL Transaction, the SkyTel Merger and, if consummated, the Sprint Merger, enhance the combined entity's opportunities for future growth, create a stronger competitor in the changing telecommunications industry and allow provision of end-to-end bundled services over global networks, which will provide new or enhanced capabilities for the Company's residential and business customers. In particular, the Company believes that if consummated, the Sprint Merger will enable the combined company to: (i) offer a unique broadband access alternative to both cable and traditional telephony providers in the United States through a combination of digital subscriber line ("DSL") facilities and fixed wireless access using the combined company's "wireless cable" spectrum; (ii) continue to lead the industry with innovative service offerings for consumer and business customers; and (iii) continue as an effective competitor in the wireless market in the United States.
  In a section labeled "transmission facilities," the 1999 Form 10-K explains that it owns long-distance, international and multi-city local service fiber optic networks with access to additional fiber optic networks through lease agreements with other carriers. It also owns and leases trans-oceanic cable capacity. WorldCom uses what it calls "ring topology." The network backbones for this system are installed in conduits owned by WorldCom or leased from third parties. The lease arrangements "are generally executed under multi-year terms with renewal options and are non-exclusive." To serve its customers in buildings that are not located directly on the fiber network described in the Form 10-K, WorldCom leases lines from local exchange carriers and others.

  The 1999 Form 10-K described WorldCom's ability to generate profits as depending in part "upon its ability to optimize the different types of transmission facilities used to provide communications services." While the Company's own networks were "typically" the most effective transmission routes, "a variety of lease agreements for fixed and variable cost (usage sensitive) services" ensured "diversity and quality of service." The "rapid and significant" changes in technology were also discussed.

  In describing rates and charges, the Form 10-K explained that its rates "are generally designed to be competitive." It reported that to date, "continued improvement in the domestic and international cost structures" had allowed the Company to maintain "acceptable margins."

  The topics of competition and regulation were discussed at length. WorldCom represented that it expected that competition, which was already extreme, would "intensify in the future." After discussing different business competitors, the 1999 Form 10-K reported that "WorldCom may also be subject to additional competition due to the development of new technologies and increased availability of domestic and international transmission capacity." It noted that the desirability of its fiber optic network could be adversely affected by changing technology, and that it could not predict which of many future product options would be important. It noted that the Telecommunications Act of 1996 had removed barriers to competition. Once the Bell operating companies were allowed to offer long-distance services, they would be in a position "to offer single source local and long-distance service similar to that being offered" by WorldCom. It predicted that the increased competition would result in increased pricing and margin pressures. As for its data communications services, including Internet access, that was also extremely competitive. "The success of MCI WorldCom will depend heavily upon its ability to provide high quality data communications services, including Internet connectivity and value-added Internet services at competitive prices."

  In its lengthy description of the regulatory environment, the 1999 Form 10-K noted that access charges are a principal WorldCom expense. WorldCom was attempting to bring access charges down to cost-based levels.

  Voice revenues for 1999 were described as having increased by 6% over the prior year because of a 10% gain in traffic. "These volume and revenue gains were offset partially by anticipated year-over-year declines in carrier wholesale traffic as well as federally mandated access charge reductions that were passed through to the consumer."

  Line costs "as a percentage of revenues" for 1999 were reported to be 43% as compared to 47% for 1998. "Overall decreases are attributable to changes in the product mix and synergies and economies of scale resulting from network efficiencies achieved from the continued assimilation of MCI," and other companies into the Company's operations.

Additionally, access charge reductions that occurred in January 1999 and July 1999 reduced total line cost expense by approximately $363 million for 1999. While access charge reductions were primarily passed through to customers, line costs as a percentage of revenues were positively affected by over half a percentage point for 1999.
  The report explained that the "principal components of line costs are access charges and transport charges." It added that WorldCom's "goal is to manage transport costs through effective utilization of its network, favorable contracts with carriers and network efficiencies made possible as a result of expansion of the Company's customer base by acquisitions and internal growth."

  WorldCom's total debt was reported to be $18.1 billion. It had available liquidity of $8.7 billion under its credit facilities and commercial paper program and from cash. Its aggregate credit facilities were $10.75 billion.

  WorldCom represented that the development of its business "will continue to require significant capital expenditures." Failure to have access to sufficient funds for capital expenditures on acceptable terms or other difficulties in managing capital expenditures "could have a material adverse effect on the success" of WorldCom.

  Andersen consented to the inclusion of its March 24, 2000 audit report in the Form 10-K. In that report, Andersen represented that it had audited WorldCom's balance sheets, and statements of operations, shareholders' investment and cash flows. It reported that
[w]e conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit . . . provide[s] a reasonable basis for our opinion.
In our opinion, based on our audit . . ., the financial statements referred to above present fairly, in all material respects, the financial position of MCI WorldCom, Inc. and subsidiaries as of December 31, 1999 . . ., in conformity with accounting principles generally accepted in the United States.
2000 Offering
  On May 24, 2000, WorldCom conducted a public offering of debt securities by issuing approximately $5 billion worth of bonds ("2000 Offering"). It filed a registration statement dated April 12, 2000, and prospectus supplement dated May 19, 2000 (collectively "2000 Registration Statement") that incorporated by reference among other things the WorldCom Form 10-K for the year ending December 31, 1999, and its Form 10-Q*fn18 for the quarter ended March 31, 2000. SSB was the book runner and, with J.P. Morgan, was the co-lead manager.*fn19 The April 12, 2000 Registration Statement*fn20 began with a warning that
[w]e have not authorized anyone to give any information or to make any representations concerning the offering of the debt securities except that which is in this prospectus or in the prospectus supplement. . . . You should rely only on the information contained in or incorporated by reference into this prospectus.
The document then explained that it was part of a registration statement that was filed with the SEC using a "`shelf' registration process."
Under this process, we may sell any combination of the debt securities described in this prospectus in one or more offerings up to a total dollar amount of $15,000,000,000. This prospectus provides you with a general description of the securities we may offer. Each time we sell securities, we will provide a prospectus supplement that will contain specific information about the terms of that offering. The prospectus supplement may also add, update or change information contained in this prospectus.
  In describing recent developments, the 2000 Registration Statement focused exclusively on the merger agreement with Sprint. It warned that consummation of the merger was subject to various conditions, including regulatory approval.

  In describing how the proceeds would be used from the sale of debt securities, it represented that the proceeds would be used "for general corporate purposes. These may include, but are not limited to, the repayment of indebtedness, acquisitions, additions to working capital, and capital expenditures."

  The 2000 Registration Statement included a section labeled "experts." It explained that the year-end WorldCom consolidated financial statements

have been audited by Arthur Andersen LLP, independent public accountants, as indicated in their report with respect thereto, and are included in the MCI WorldCom's Annual Report on Form 10-K for the year ended December 31, 1999, and are incorporated herein by reference, in reliance upon the authority of such firm as experts in accounting and auditing in giving such reports.
  Among the "undertakings" contained in the 2000 Registration Statement was the obligation to file during the period in which sales were being made, a post-effective amendment to "reflect in the prospectus any facts or event arising after the effective date of this registration statement (or the most recent post-effective amendment hereof) which, individually or in the aggregate, represent a fundamental change in the information set forth in this registration statement."

  The May 19, 2000 Prospectus Supplement explained that the net proceeds from the $5 billion offering would be used to "repay commercial paper, which was issued for general corporate purposes." It announced that following that repayment, WorldCom expected "to incur additional indebtedness. . . ." The document briefly explained WorldCom's business. The bulk of the document addressed the proposed Sprint merger, described Sprint, and presented an unaudited pro forma condensed combined financial statement for the merged entity. It warned that "the merger is subject to the receipt of consents and approvals from various government entities, which may jeopardize or delay completion of the merger or reduce the anticipated benefits of the merger."

  The document also included the following explanation of the relationship between the Underwriter Defendants and WorldCom:
The underwriters and their affiliates have performed certain investment banking and advisory and general financing and banking services for us from time to time for which they have received customary fees and expenses. The underwriters and their affiliates may, from time to time, be customers of, engage in transactions with and perform services for us in the ordinary course of their business. Salomon Smith Barney Inc. has acted as financial advisor to WorldCom in connection with the Sprint merger, for which it has received certain fees and for which it expects to receive additional fees upon the closing of the Sprint merger. In addition, Salomon Smith Barney will receive a financial advisory fee in connection with this offering.
  Each of the Underwriter Defendants involved in the 2000 Offering has stated that it relied on the due diligence performed by SSB. Many of the Underwriter Defendants had underwritten prior WorldCom offerings or had other dealings with WorldCom prior to the 2000 Offering. For example, J.P. Morgan was involved in an offering of WorldCom securities in 1998 and participated in syndicating credit extended to WorldCom that same year. Bank of America had a web of relationships with WorldCom and considered itself the "leading capital provider" to WorldCom since 1990. Among other things, it participated in the securitization of WorldCom's accounts receivable and a private placement for WorldCom in the 1990s, participated in an April 1998 bond offering by WorldCom, and was a lead manager of the WorldCom acquisition of MCI in 1998.

  The prospectus supplement for the 2000 Offering did not include a section labeled "risk factors." Several weeks earlier, on April 30, an investment banker at SSB sent a draft prospectus supplement to a more senior SSB banker with a detailed list of risk factors included in it. Under the heading "Risk Factors," the draft itemized risk factors relating to the Sprint merger, WorldCom's business, and competition in the telecommunications industry, among other things.*fn21 At the request of WorldCom, the risk factors section was removed.*fn22

  The only written record of due diligence performed by the Underwriter Defendants for the 2000 Offering is a May 26 memorandum prepared by Cravath, Swaine & Moore ("Cravath"), counsel to the Underwriter Defendants. The memorandum reflects due diligence conducted from May 15 to 23.*fn23 It describes a May 17 telephone conversation in which Sullivan was asked questions about the Sprint merger, whether WorldCom had experienced problems integrating either SkyTel or MCI, and whether there were any other material issues.*fn24 In that conversation, Sullivan predicted overall growth for the year 2000 would be about 14%, represented that the proceeds for the 2000 Offering would be used to repay "commercial debt," reported that WorldCom was experiencing a very competitive environment but that there were no changes in that environment since 1999, and stated that there were no other material issues than the ones he described in the call. The memorandum then outlines the board minutes for WorldCom, lists its public filings, refers to its press releases, and discusses Sprint documents.

  J.P. Morgan's 1998 Overview of the Debt Underwriting Process was still in effect in 2000 and contained the following descriptions of an underwriter's responsibility.

In our role as an underwriter or distributor of securities, performance by J.P. Morgan entities of an appropriate due diligence investigation of the issuer serves a variety of important purposes. The most obvious key advantage of proper due diligence is protection against unexpected news regarding the issuer or its business having an adverse effect of the pricing and/or placement of the offered securities during the primary distribution and in the immediate aftermarket.
From a legal perspective, under the securities laws of the U.S. and several other jurisdictions, due diligence creates an affirmative defense to underwriter/distributor liability for misstatements or omissions of material facts in offering documents. In practical terms, this means that if the market value of the offered securities declines weeks, months or years after closing and unhappy investors sue the issuer and the underwriters, on the theory that the underlying reason for such market decline should have been disclosed in the offering document, then J.P. Morgan should be able to avoid an expensive adverse judgment, so long as we can demonstrate that we conducted an appropriate due diligence investigation of the issuer and its business in connection with the offering. . . .
At least as importantly, due diligence reduces the possibility of commercial and reputational losses arising out of such misstatements and provides us with an opportunity to demonstrate to the issuer client our professionalism, our understanding of its business and our commitment to the transaction.
In order to successfully establish a due diligence defense, underwriters and securities distributors may not take at face value representations made to them by the issuer and its representatives, but rather must demonstrate they made a reasonable investigation of the facts to ensure there is no misstatement or omission of a material fact in the offering documents. . . .
Generally such investigation will focus on discussions with and information provided by the issuer and its counsel and accountants, although it may be appropriate, in the case of some issuers and industries, to include meetings with outsiders, such as consultants with industry expertise, major suppliers or dominant customers.
(Emphasis supplied.)

  Andersen created an undated worksheet in connection with WorldCom's first quarter 2000 unaudited financial statement. The worksheet was an eleven-page Andersen form entitled "U.S. GAAS Review of Interim Financial Statements of a Public Company," and was a vital step in preparing a "comfort letter" for a company and underwriters. The form reflects tasks to be performed, with boxes to indicate whether the task had been "done" or was "N/A." Most of the tasks had one of those two boxes checked, some had both boxes checked, and one task — reading the financial statements and disclosures in the client's draft Form 10-Q — was left blank. Brief comments were handwritten next to some of the tasks. The form paragraph that appears directly above the engagement partner's signature, states: "Based on the results of the review procedures, we are not aware of any material modifications that should be made to the interim financial statements for them to be in conformity with generally accepted accounting principles consistently applied."

  A "comfort letter" for the first quarter 2000 unaudited financial statement is dated May 19, is eight pages long, and indicates that it is written at the request of WorldCom. In it, Andersen reaffirms its audits, including those incorporated in the 2000 Registration Statement. It warns that having not audited any financial statements for any period subsequent to December 31, 1999, it is unable to express any opinion on the unaudited consolidated balance sheet of WorldCom as of March 31, 2000, or the results of operations or cash flows as of any date subsequent to December 31, 1999. The letter indicates, however, that Andersen had performed the procedures specified by the American Institute of Certified Public Accountants for a review of interim financial information as described in SAS No. 71 on the unaudited condensed consolidated balance sheet as of March 31, 2000, and related statements, and had made certain inquiries of WorldCom officials who have responsibility for financial and accounting matters. Andersen represented that nothing had come to its attention as a result of that work that caused Andersen to believe that "[a]ny material modifications should be made to the unaudited condensed consolidated financial statements [for the first quarter of 2000], incorporated by reference in the Registration Statement, for them to be in conformity with generally accepted accounting principles" or that "[t]he unaudited condensed consolidated financial statements . . . do not comply as to form in all material respects with the applicable accounting requirements of the Act and the related published rules and regulations." The letter concludes that it is offered to "assist the underwriters in conducting and documenting their investigation" of the affairs of WorldCom in connection with the offering of securities covered by the 2000 Registration Statement. A two page May 23 Andersen letter reaffirmed the May 19 letter. Late 2000 Investment' Banking Transactions

  As already described, in November 2000, WorldCom announced that it would be creating two tracking stocks. J.P. Morgan and SSB were involved in this project.

  On December 14, 2000, WorldCom conducted a $2 billion private placement of debt. J.P. Morgan was the lead manager and sole book runner for that private placement.

  The Underwriter Defendants' Credit Assessment of WorldCom as of Early 2001

  In February 2001, several of the Underwriter Defendants downgraded WorldCom's credit rating due to their assessment of WorldCom's deteriorating financial condition. Then, during the weeks that followed, several of the Underwriter Defendants made a commitment to WorldCom to help it restructure its massive credit facility. In doing so, there is evidence that at least some of the Underwriter Defendants internally expressed concern again about WorldCom's financial health. WorldCom had required the banks to participate in the restructuring of the credit facility if a bank wished to play a significant role in its next bond offering, the 2001 Offering. That offering turned out to be the largest public debt offering in American history. The Lead Plaintiff contends that the evidence of the Underwriter Defendants' concerns about WorldCom's financial condition in the months immediately preceding the 2001 Offering undercuts their contention that the due diligence that they performed in connection with the 2001 Offering was reasonable.

  As noted, several of the Underwriter Defendants downgraded WorldCom as a credit risk in February 2001. At the same time, one of the major credit rating agencies publicly announced that it was downgrading long-term WorldCom debt.

  On February 22, Bank of America downgraded WorldCom's credit rating from 3 to 4, citing its lack of revenue growth, margin deterioration, the likelihood that WorldCom revenue from its long-distance business would continue to decline, the increasing competitive landscape, WorldCom's increasing debt load, and concerns regarding its strategic direction following the failure of the merger with Sprint.

  On February 27, a J.P. Morgan document reflects that the bank reduced its internal "senior unsecured" risk rating for WorldCom from A2 to BBB1 because of WorldCom's "weakened credit profile and continued pressure on its MCI long-distance business segment."*fn25 The internal report noted that WorldCom's cash flow had moved from a positive to a "Cash Burn" of negative $137 million. It also emphasized WorldCom's high ratio of debt. The report observed that "[i]t remains to be seen if WCOM can stabilize cash flows and increase profitability in its MCI segment while supporting the capital requirements for the high growth data business in an increasingly competitive environment."*fn26

  On February 27, Standard & Poor's ("S&P") also downgraded WorldCom's credit rating, albeit just its ratings on WorldCom's long-term debt instruments. Those were downgraded from a rating of A- to BBB. S&P simultaneously removed WorldCom from its previously imposed "creditwatch." S&P did not revise its ratings for WorldCom's short-term debt. S&P explained that the downgrade reflected WorldCom's "heightened business risk profile" because of competitive challenges and pricing pressures in the voice and data markets. It observed that the risk was "somewhat offset by the company's financial flexibility and experienced management." It described the outlook for WorldCom as "stable."

  In late February, Deutsche Bank downgraded WorldCom as part of a global credit review because of price declines in the long-distance market and WorldCom's need to generate cash. The credit review listed WorldCom's credit status as "[p]erformance concerns" and the bank's credit strategy and risk appetite as "[r]isk appetite reduced."

  Within weeks of these decisions to downgrade WorldCom's credit rating, the Underwriter Defendants had to consider whether to participate in WorldCom's restructuring of its credit facility, which was a line of credit extended to WorldCom by several of the banks, and whether to compete for investment banking positions in the bond offering that WorldCom hoped to undertake that Spring. WorldCom had a $10.25 billion credit facility with affiliates of some of the banks and it wanted to restructure that facility in a $8 to 10 billion transaction. WorldCom informed banks that they could only participate as an underwriter on the 2001 Offering if they agreed to participate in the restructuring. WorldCom also let banks know that the greater a bank's commitment to the credit facility, the greater the role it could have in the offering. With a commitment of at least $800 million to the new credit facility, a bank was promised a role as "joint book running manager" in the offering.*fn27 Bank of America calculated that if it were successful in becoming a joint book running manager, it could earn 20 to 25% of an expected investment banking fee of $10 to 12.5 million.

  There is evidence that several of the Underwriter Defendants*fn28 decided to make a commitment to the restructuring of the credit facility and to attempt to win the right to underwrite the 2001 Offering, while at the same time reducing their own exposure to risk from holding WorldCom debt by engaging in hedging strategies, such as credit default swaps.*fn29 For example, as early as March 23, J.P. Morgan identified one of its three key objectives in connection with the restructuring of the credit facility and its participation in the 2001 Offering as: "to minimize exposure after $800MM initial commitment. . . ." The memorandum recommended developing a strategy that would give up some participation in the 2001 Offering in return for reducing the bank's exposure under the credit facility down to $600 million. It concluded, "Lets [sic] make this a true team effort: first class execution for the client, attractive economics for JPM and the minimum credit exposure." (Emphasis supplied.) Within less than a month, J.P. Morgan wanted to reduce its exposure to $500 million. By May 22, through a carefully managed entry into the market, J.P. Morgan had entered a $150 million credit default swap, out of a goal of $200 million, to reduce its exposure in the event of a default by WorldCom. J.P. Morgan personnel structured its activities so that neither WorldCom nor any of J.P. Morgan's investment banking rivals would learn what it was doing. A May 16 e-mail captured the problem with these words: "if WCOM gets any sense that we're laying off exposure DURING the syndication process (and wouldn't SSB love to pass that along), it would not be good news. Understandably" this point is "Jennifer's greatest and principal concern." (Emphasis in original.) Jennifer Nason was the bank's due diligence team leader for the 2001 Offering.

  Bank of America was in a particularly precarious position. It had been the sole lead arranger and sole book manager for a $10.75 billion senior credit facility for WorldCom in August 2000. It was one of five arrangers for a $2 billion WorldCom trade receivable securitization program. As of March 2001, it had an exposure of approximately $1.5 billion to WorldCom. This exposure was concentrated in a syndicated credit facility of about $600 million, an accounts receivable securitization of $306 million, and a commitment of $175 million to Intermedia. Bank of America sought to make a commitment of $800 million to the restructured credit facility and yet reduce its overall exposure to WorldCom to no more than $500 million through credit default swaps and other devices, again, without telling WorldCom.*fn30 Those within Bank of America, who were recommending that the bank participate in the restructuring of the credit facility in order to be eligible to play a lead investment banking role in the 2001 Offering, argued in a March 28 memorandum that it was likely that WorldCom would never need to draw on its credit facility — in their words: "No funding anticipated."

  2000 Form 10-K

  The April 26, 2001 WorldCom Form 10-K for the year ending 2000 explained that, if approved by WorldCom's shareholders, the company would create two separately traded tracking stocks to correspond to "the distinct customer bases" served by its businesses. It advised shareholders that if they did not approve the creation of the two stocks, the company would still realign its businesses into the two distinct service entities.

  With respect to long-distance services, the document reported that revenue fell in 2000 in absolute terms and as a percentage of total WorldCom revenues. In its description of operations, line costs were shown as a decreasing percentage of revenues for each year from 1998 to 2000, beginning with 45.3% in 1998, and ending at 39.6% in 2000. The Form 10-K explained that the improvement was a result of increased data and dedicated Internet traffic.

  2001 Offering

  Through the 2001 Offering WorldCom issued $11.9 billion worth of notes. The May 9, 2001 registration statement and May 14, 2001 prospectus supplement (collectively, "2001 Registration Statement") for the 2001 Offering incorporated WorldCom's 2000 10-K and first quarter 2001 Form 8-K dated April 26, 2001.

  J.P. Morgan and SSB served as co-book runners. Each of the Underwriter Defendants for the 2001 Offering have stated that they relied on the due diligence performed by SSB and J.P. Morgan. Cravath again represented the Underwriter Defendants. A May 16, 2001 memorandum prepared by Cravath describes the due diligence conducted from April 19*fn31 through May 16, 2001 in connection with the 2001 Offering.*fn32 On April 23, the Underwriter Defendants forwarded due diligence questions to WorldCom. The due diligence for the 2001 Offering included telephone calls with WorldCom on April 30 and May 9, and a May 9 telephone call with Andersen and WorldCom. The due diligence inquiry also included a review of WorldCom's board minutes, 1998 revolving credit agreement, SEC filings, and press releases from April 19 to May 16, 2001.

  During the April 30 telephone call, two bankers from J.P. Morgan and SSB, and two attorneys from Cravath spoke with Sullivan. Sullivan explained that WorldCom intended to use half of the proceeds from the 2001 Offering "to repay the balance of its outstanding commercial paper, to retire debt and to fund a portion of the Company's negative free cash flow." When asked whether WorldCom had significant reserves for bad receivables, Sullivan responded that WorldCom had a general $1.1 billion reserve. Sullivan indicated that WorldCom was comfortable with the current earnings per share, that there were no issues that could affect the company's credit rating, and that the company had nothing material to disclose that had not been discussed with the investment bankers. When asked about the competitive environment, Sullivan answered that
the general economic slowdown has not had a material impact on the Company's business, however the telecommunication environment has affected the Company. In particular, he was surprised that receivables declined in the first quarter. Despite this, the Company is selling through the rough parts of the telecommunications slowdown and the number of new installations is still strong.
On May 9, Sullivan confirmed that there were no material changes since the April 30 telephone call.

  On May 9, a banker from J.P. Morgan and two Cravath attorneys spoke by telephone with Sullivan and Stephanie Scott of WorldCom and with representatives of Andersen. Andersen indicated that it had not issued any management letters to WorldCom and that there were no accounting concerns. WorldCom and Andersen assured J.P. Morgan that there was nothing else material to discuss. In neither the April 30 due diligence telephone call nor the May 9 call did Sullivan disclose the $771 million capitalization of line costs.

  On May 9 and 16, Andersen issued comfort letters for the WorldCom first quarter 2001 financial statement. The 2001 comfort letters stand in contrast to the 2000 comfort letter, which expressed that nothing had come to Andersen's attention to cause it to believe that "[a]ny material modifications should be made to the unaudited condensed consolidated financial statements described in 4(a)(1), incorporated by reference in the Registration Statement, for them to be in conformity with generally accepted accounting principles" or that "[t]he unaudited condensed consolidated financial statements . . . do not comply as to form in all material respects with the applicable accounting requirements of the Act and the related published rules and regulations." In 2001, by comparison, the letters indicated that nothing had come to Andersen's attention that caused it to believe that the financial statements "were not determined on a basis substantially consistent with that of the corresponding amounts in the audited consolidated balance sheets of WorldCom as of December 31, 2000 and 1999, and the consolidated statements of operations, shareholders' investment and cash flows for each of the three years in the period ended December 31, 2000. . . ." A J.P. Morgan banker and a Cravath attorney noticed the absence of the "negative GAAP assurance" in the 2001 comfort letter. An SSB banker noted that the issue was important to understand but advised against getting "too vocal" about it since "WorldCom's a bear to deal with on that subject."

   Some of the investment bankers responsible for performing due diligence in connection with the 2001 Offering were aware of their own bank's credit concerns regarding WorldCom, and some were not. For instance, the lead investment banker for J.P. Morgan testified that she was unaware of her bank's memorandum downgrading WorldCom's risk rating. Two investment bankers at Deustche Bank testified that they were aware that their bank had downgraded WorldCom's credit rating. One testified that he believed that the downgrading ...

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