Inside the Telecom Game

How a small group of insiders made billions as the industry collapsed

Telecom has been a disaster for just about everyone. Investors have lost some $2 trillion as stock prices have tumbled 95% or more from their highs. Half a million workers have lost their jobs during the past two years. Dozens of debt-laden companies, from Winstar Communications to Global Crossing, have collapsed into bankruptcy. And on July 21, the sector sank to a once-unimaginable low when WorldCom Inc., the company that embodied the industry's power and promise, filed the largest bankruptcy claim in U.S. history.

Yet a small group of CEOs and financiers managed to save the family silver before the house burned to the ground. Philip F. Anschutz, founder of ailing local and long-distance upstart Qwest Communications International Inc. (Q ), reaped $1.9 billion from company stock sales since 1998. Former Qwest CEO Joseph P. Nacchio sold $248 million worth of stock before he was pushed out of the scandal-plagued company in June. Global Crossing founder Gary Winnick sold $734 million of his shares before his company filed for bankruptcy in January. And former WorldCom CEO Bernard J. Ebbers borrowed some $400 million from his company before he was ousted in April--and that loan remains to be repaid.

What do these execs have in common? They were all central players in a tight-knit telecom clique that dominated the communications industry in the second half of the last decade. Individually, some of these men were well known, but the ties among them are little understood even today. The group was linked through Salomon Smith Barney's telecom analyst Jack B. Grubman, the son of a Philadelphia municipal worker who rose from his blue-collar roots to become one of the most powerful players on Wall Street. He helped raise money for Qwest, Global Crossing, and WorldCom, recommended their stocks to investors, attended board meetings, and was elbows-deep in working with them to plot strategy.

Grubman's influence stretched far beyond the three companies that have collapsed in scandal in recent months. According to Thomson Financial Securities Data, Salomon helped 81 telecom companies raise $190 billion in debt and equity since 1996, the year the Telecommunications Act was passed to deregulate the telephone industry. In return, Salomon, part of Citigroup (C ), received hundreds of millions in underwriting fees and tens of millions more for advising its stable of telecom players on mergers and acquisitions. Grubman himself was paid about $20 million a year.

So powerful was Grubman in his heyday that he could direct development of the telecom industry. Like junk-bond king Michael Milken at the height of his power in the 1980s, Grubman's word was good as gold. He could raise millions for startup players, win investor support for a proposed acquisition, or boost a company's stock price. On Mar. 14, 2000, for example, he raised his price target for Metromedia Fiber Network, which Salomon had taken public, and its shares surged 16%, to about $46. MFN filed for bankruptcy in May. "Jack orchestrated the industry," says analyst Susan Kalla of investment company Friedman, Billings, Ramsey Group Inc.

Individual investors may have jumped at Grubman's picks because they thought he was doling out impartial advice on his favorite stocks--the traditional job of Wall Street analysts. But Grubman's interests were deeply conflicted, and he came to personify the blurred lines between research and investment banking in the boom. More than any other telecom analyst, he was actively involved with the companies he covered. Many critics felt that made it impossible for him to be objective about those companies' prospects. For example, he helped Anschutz recruit Nacchio as Qwest's chief executive in 1997, and he aided Global Crossing's Winnick in his $11 billion acquisition of Frontier Communications in 1999. Could Grubman then step back and make critical assessments about Qwest and Global Crossing for investors?

In the wake of the telecom meltdown, Grubman is facing more intense scrutiny than ever before. As the telecom bubble began deflating in 2000 and 2001 and other analysts began to warn that the industry was straining under the weight of excess capacity and enormous debt, he continued urging investors to load up on shares of Qwest, Global Crossing, WorldCom, and others. In March, 2001, Grubman issued a "State of the Union" report in which he wrote: "We believe that the underlying demand for network-based services remains strong. In fact, we believe that telecom services, as a percentage of [gross domestic product], will double within the next seven or eight years." Now, investors are questioning whether Grubman was motivated by his true opinions--or by the millions of dollars he received from supporting his telecom clique.

Grubman, 48, knew he was crossing a line few analysts dared traverse. But he forcefully defended his dual roles. In a 2000 profile in BusinessWeek, he said he was the model of the modern Wall Street analyst. "What used to be a conflict is now a synergy," he said at the time. "Someone like me, who is banking-intensive, would have been looked at disdainfully by the buy side 15 years ago. Now, they know that I'm in the flow of what's going on." At the time, Sanford Weill, Citigroup's chairman, voiced support for Grubman's activities, though he said analysts have to maintain their objectivity as stockpickers or "they will lose their credibility." Both men declined to comment for this story.

Grubman's credibility was strained even at the time. In the 2000 article, BusinessWeek reported for the first time that Grubman had lied on his official Salomon biography for years--claiming he had graduated from the prestigious Massachusetts Institute of Technology when his alma mater was really Boston University. He admitted the discrepancy at the time. "At some point, I probably felt insecure, and it perpetuated itself," he said. He also claimed to have grown up in South Philadelphia when he really was from Oxford Circle in the northeast part of Philadelphia. Both are blue-collar neighborhoods. But South Philly is a more historic neighborhood, the stomping grounds of singer Frankie Avalon and movie boxer Rocky Balboa, and would hold more appeal for a one-time amateur boxer like Grubman.

Despite such issues, Grubman was able to wield his influence in the telecom industry, which benefited his inner circle. When analyst Vik Grover of Kaufman Bros. LP questioned Winstar's prospects in January, 2001, Grubman blasted him in a research note issued later that day. "We believe this is highly irresponsible of the analyst since they do not have coverage of [Winstar], nor did they speak with senior management," he wrote. He also chastised Grover during Winstar's quarterly conference call on Feb. 1. That helped buoy Winstar's stock--but only for several weeks. Short of cash, the company, under CEO William Rouhana, filed for bankruptcy two months later, in April. The National Association of Securities Dealers is investigating whether Grubman's recommendations on the stock violated its standards for stock analysts.

Nowhere was Grubman's loyalty more evident than with WorldCom. Other Wall Street analysts, including Daniel P. Reingold of CS First Boston, stopped recommending the stock last year because of its deteriorating long-distance business and slowing growth rate. Yet Grubman reiterated his "strong buy" regularly in 2001 because, he said, it had the "best assets in the telecom industry." Grubman didn't downgrade WorldCom to a "neutral" until Apr. 22, when the company slashed its revenue targets for 2002. By that time, WorldCom's shares had dropped about 90% from their peak, to $4.

Grubman's allies may have benefited from his actions in other ways. According to a lawsuit filed by David Chacon, a Salomon broker who was fired in 2000, Grubman doled out shares in hot initial public offerings to Ebbers, Nacchio, and several other telecom executives to win investment banking business. Ebbers allegedly received stock in broadband provider Rhythms NetConnections Inc. at the time of its initial public offering in 1999. When the upstart's stock soared 229% in the first day of trading, Ebbers cashed out for a $16 million profit, according to the suit. If Chacon's allegations are true, Salomon may have violated securities regulations that bar investment banks from paying individuals for banking business. Salomon denies the assertion.

Now, Grubman's entire network is unraveling. The Securities & Exchange Commission is investigating Qwest for alleged accounting improprieties in what has become a criminal probe. Global Crossing is under investigation by the Securities & Exchange Commission, the FBI, and two congressional committees. WorldCom faces scrutiny from the SEC, the Justice Dept., and the House Energy & Commerce Committee. WorldCom has admitted to a $3.8 billion accounting error in its financial statements. A spokesman says the company "supports the investigators and wants them to get to the bottom of things so we can all move forward." Qwest and Global Crossing have denied any wrongdoing. Global Crossing execs were not available for comment. A spokesman for Qwest says, "We worked with [Grubman] as we would any analyst."

Grubman is under the microscope, too. Besides the NASD, he is being investigated by New York Attorney General Eliot Spitzer and U.S. Attorney James B. Comey in Manhattan. He was called before the House Committee on Financial Services on July 8 to explain his role in the WorldCom accounting scandal--and was hammered by legislators. "We have an independent analyst who is neither independent and apparently can't analyze," said Michael E. Capuano (D-Mass.). "My major fear is that you'll get away with it." Salomon has supported Grubman, although Citigroup said in July that it would support a ban on analysts participating in many investment banking activities.

Grubman has defended his actions before Congress and elsewhere. He said that he helped Qwest, Global Crossing, WorldCom, and others raise billions of dollars because he saw a brilliant future for the telecom industry. He thought a rapid deployment of broadband connections to businesses and consumers around the country would lead to a surge in Internet traffic that would require the creation of new networks with vast amounts of capacity. He admits he was wrong in his analysis. But he says he was not motivated by conflicted interests. "I am saddened by the events that have brought us here," he told congressional probers on July 8. "I am sorry to see investors suffer losses. I am sorry to see employees laid off."

No question, the damage caused by Grubman and his circle of insiders is threatening to undermine the health of the telecom industry. While Grubman and his allies encouraged investors to cough up the billions of dollars needed to make huge new capital investments in fiber-optic networks and broadband connections, it's now clear that that vision of the future was wildly hyped. Billions in investments are going to waste, as little as 3% of new long-distance networks are being used, and investors are fleeing the sector. Even once-stable players are suffering. On July 23, local-phone giant BellSouth said WorldCom owes the company $75 million to $160 million, contributing to a 15% drop in BellSouth's stock price that day.

The crisis could relegate the U.S. to second-class status in the communications industry. In the 20th century, U.S. phone services were the envy of the world, reaching 95% of the population and operating with 99.999% reliability. They played a crucial role in the U.S.'s economic development and even served as a strategic asset in World War II, thanks to innovations such as early wireless communications. But in recent years, the rollout of high-speed Net access and other services has been led by other nations, such as South Korea and Japan. As telecom companies cut back on capital spending, it will be harder to catch up. "The U.S. is already behind, and will likely fall further behind as telecom companies find it extremely difficult to raise funds in the near term," says James Glen of

Already, the fallout is brutal. The $2 trillion in losses that telecom investors have suffered is twice the damage caused by the bursting of the Internet bubble and on a par with the savings- and-loan crisis of the late 1980s. Bank exposure to the telecom mess is tens of billions of dollars. Worse, the investigations into WorldCom, Global Crossing, and Qwest, layered on top of the Enron scandal, are dealing a huge blow to investor confidence. They've led the entire stock market down as the Standard & Poor's 500-stock index has tumbled 29% drop so far this year.

It wasn't supposed to turn out this way. The incestuous telecom players had a legitimate business idea: making the U.S. industry the most competitive in the world. Deregulation in 1996 allowed any company, including long-distance players such as AT&T (T ) and WorldCom, to move into the local telephone business and compete against the Bells. One of the first success stories was MFS Communications Co., which was started in the early 1990s by execs from construction giant Peter Kiewit & Sons in Omaha. MFS built local phone networks around the country. After WorldCom decided to move into the local business in 1996, it bought MFS for the then-unheard-of price of $10 billion.

It was a windfall for everyone involved. Top MFS execs, such as James Q. Crowe and Royce J. Holland, made tens of millions apiece. WorldCom's banker, Salomon Smith Barney, reaped tens of millions in fees. Even WorldCom shares rose, which is unusual for a company that plays the acquiring role in a deal. But the company had a key supporter: Grubman, who endorsed the deal.

The temptation to keep using the formula was irresistible. MFS execs left WorldCom to set up new telecom companies. Crowe created long-distance data upstart Level 3 Communications Inc. (LVLT ), and Holland created local-service competitor Allegiance Telecom Inc. (ALGX ), both of which received funding from Salomon and glowing recommendations from Grubman. "These guys decided they should all jump on the Net bandwagon. They were all trying to tap markets as quickly as possible before others jumped in first," says telecom analyst Glenn Waldorf of UBS Warburg.

Grubman and the telecom execs argued that the market could easily absorb all the new capacity. At one road show after another, from the meeting halls of San Jose, Calif., to the dining rooms of plush Manhattan hotels, Crowe stood before audiences, charming them with the bearing and voice of a senior military official. He argued that the telecom sector was going through the same sort of changes that had spawned successful startups in the software and computer industries. He said that "Silicon economics" would allow upstarts such as Level 3 to offer more capacity at lower prices than mature rivals such as AT&T. And the demand for these networks would soar as voice communications gave way to e-mail, pictures, video--even holograms, Crowe said. Investors ate it up, and the shares of these companies soared.

Before long, the line of entrepreneurs waiting for funding stretched out the door. Salomon funded upstarts Qwest, Global Crossing, Teligent, Winstar, Rhythm, Williams Communications, Focal, and dozens more. "WorldCom delivered such success that Grubman had [other telecom executives] mimic [WorldCom's approach]," Kalla says. "He would put them up on the pulpit at his conferences, where they were the keynotes. It was just very well orchestrated."

Meantime, Grubman was becoming a star. He rose from humble roots--his father was a construction manager for the city of Philadelphia, and his mother worked in a dress shop. A math whiz, he worked at AT&T from 1977 to 1985, doing quantitative research, among other things, and then jumped to Wall Street. But it was moving to Salomon in 1994 that gave him the chance to become the most powerful analyst in his field.

His formula for his success was to grow increasingly close to the managers at the telecom companies he was covering. He recruited execs, helped plot strategy, and advised on mergers. For example, he helped Ebbers launch WorldCom's hostile bid for MCI in 1998, which resulted in the $43 billion acquisition. In his congressional testimony on WorldCom, Grubman revealed that he had attended "two or three" board meetings at WorldCom at the company's headquarters in Mississippi. Rival analysts chafed at Grubman's chumminess with the execs he was covering. "He'd get on a company's conference call and just start talking about what he thought about the company," says one analyst. "We all had questions for the company, and he was asking them `so, how about that dinner last night, huh?"'

The relationships in Grubman's network go back years. Clark McLeod sold his long-distance upstart to MCI in 1990 for $1.25 billion, pocketing $50 million. Then, in the mid-1990s, Grubman and the bankers at Salomon helped him launch a new company called McLeod Communications, raising $3.4 billion for construction of a 31,000-mile telephone network. McLeod, a Midwesterner who handed employees copies of his book This Way Up, boldly promised that revenues would hit $11 billion by 2007. Grubman maintained a buy rating on the company--right until it declared bankruptcy in January of this year with $1.8 billion in revenue.

At first, no one ever worried about whether these telecom upstarts were making money. Even older telecom players, such as MCI and Sprint (FON ), needed years to invest in their network. MCI didn't turn profitable for more than a decade. When Grubman helped them raise money in the late 1990s, the Internet bubble was in full swing, and claims that rising data traffic would allow them to become profitable someday sounded believable. The unspoken assumption was that they would be acquired anyway by the likes of WorldCom, AT&T, or one of the Bells.

These assumptions were shaken when the Internet bubble burst in March, 2000. As one dot-com after another went bust, the growth of data traffic slowed. Network utilization on all the new optical telecom networks fell to just 3%, and prices started plunging 50% a year. The capital windows quickly slammed shut.

Telecom executives realized that they could never deliver on their promises of revenue growth of 20% or more. But rather than come clean to investors, an alarming number of them resorted to misleading accounting practices to preserve the illusion of stability. In the first six months of 2001, Qwest sold $857 million worth of network capacity to Global Crossing and other carriers. It also bought $450 million worth from Global Crossing and other carriers. That helped Qwest's revenue rise 12% for the first half of the year. Without those deals, Qwest revenue would have increased only 7%.

Such deals may have allowed senior management to cash out before the bubble finally burst. In May of last year, Winnick sold $123 million worth of Global Crossing stock. That same month, Anschutz sold $230 million worth of Qwest stock. The SEC is investigating both companies.

With investors losing trillions of dollars and dozens of telecom players in bankruptcy, there are growing calls for tough action against those responsible. Grubman, certainly, will face more scrutiny. New York Attorney General Spitzer has subpoenaed his research records, e-mail, and other documents. If Spitzer finds wrongdoing, Salomon may have to pay a fine or even discipline Grubman. The U.S. Attorney's investigation could even result in criminal charges.

Two years ago, Grubman claimed he was creating a new model for Wall Street analysts. Today, it's a model that Grubman--and most telecom investors--may wish they had never heard of.

By Steven Rosenbush in New York, with Heather Timmons in New York, Roger O. Crockett in Chicago, Christopher Palmeri in Los Angeles, and Charles Haddad in Atlanta

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