Tyco Took Profit on Bad Deal, Then Paid Bonuses to Executives
The New York Times
September 25, 2002
By FLOYD NORRIS
Tyco International claimed a profit on an investment even as the
company lost money on it, a review of the transaction shows. Tyco then used
that profit as an excuse to pay almost $24 million in bonuses to top managers.
Most of that went to L. Dennis Kozlowski, the former chief executive,
and Mark H. Swartz, the former chief financial officer.
Details of the transaction, which occurred 15 months ago, have emerged
only in recent days and are raising questions about the accuracy of the
company's profit reports, in the opinion of some accountants.
The transaction appears to have provided a clear economic loss for Tyco,
which was forced to pay an above-market price for an 11 percent stake in a
small company called Flag Telecom that has since gone bankrupt.
But Tyco disclosed last week that the company had managed to claim
a profit of $79.4 million on the transaction, and that this profit was used to
justify the bonuses.
Mr. Kozlowski and Mr. Swartz have been indicted for what the prosecutors
say was the looting of Tyco by paying multimillion-dollar bonuses to
themselves without the board's authorization.
The Securities and Exchange Commission has asserted that the tactics
involved the hiding of the bonus expenses in certain nonoperating accounts,
thus overstating the company's operating profits. But it has not said that net
income was exaggerated.
The Flag transaction, however, may indicate that the company reported
profits improperly, or at least in a way that bore no resemblance to economic
reality, and that the executives collected bonuses based on those so-called profits.
To justify the profits reported, Tyco apparently assumed that stock it obtained
was worth what it had paid - something that was clearly not the case
at the time - and then exaggerated that value by using outdated valuation figures.
A result was that Flag's value was overstated by 53 percent
when the transaction closed.
While the existence of the Flag transaction has been known since it occurred
in June 2001, some details necessary to evaluate it were not
disclosed until Tyco's report last week by David Boies, the lawyer whose
firm was hired to review what had happened at the company. Other details
were provided yesterday by Verizon Communications, which was on the other side
of the transaction and profited from it, and by a person close to
Tyco.
Flag was a company with audacious plans to build an international fiber
optic network. It hired Tycom, a Tyco subsidiary that was publicly traded, to
lay its cable under the Pacific Ocean.
Under the transaction, announced on June 20, 2001, Verizon sold 15
million shares in Flag, worth $74.4 million when the deal closed on June 22,
to Tyco.
Tyco paid $11.4 million in cash and 5.6 million shares of TyCom. At the June 22
price, those shares were worth $89.3 million, for a total
compensation of $100.7 million. A simple subtraction of the two values would
indicate that, economically, Tyco had a loss of $26.3 million - hardly a
reason to grant bonuses.
The sale was made under an agreement negotiated the preceding April,
providing for what was supposed to be an equal exchange of value, based on
trading prices over the five days before Verizon forced the sale to be made.
Because Verizon had the discretion to decide when the deal closed, it could
choose a date on which the movement of the shares gave it an
advantage, and it did so.
Under accounting rules, Tyco could claim a profit because its cost of the TyCom
shares was less than their market value at the time.
What Tyco did was to assume that the TyCom shares it gave up were worth
$16.38 each, according to a person close to Tyco, and to assume that the
Flag stock it bought was worth as much as it was giving up. That person said that
Tyco used a 10-day moving average price of TyCom shares, but said
he did not know what period was used. It appears that it was the period
ending June 14 - well before the actual transaction took place. By the time
the deal happened, values had fallen. The person close to Tyco said the profit was proper.
Accounting rules permit a company to base the value of a deal on the value of either
what was paid or what was received, depending on which is
ascertainable. In this case, both were, but Tyco chose to use the value of what it gave up,
even though the structure of the transaction - with
Verizon having the ability to choose a time opportune for it - had made it all but
certain that that figure was likely to be higher than the value Tyco
received. Some accountants say the value should have been set based on prices
when the deal closed, not weeks earlier.
In Tyco's financial statements for the quarter ended last June, the company
disclosed a profit of $64.1 million on the sale of stock in an unnamed
subsidiary, which Tyco officials confirmed yesterday was TyCom. The Boies
report said the company actually computed a profit of $79.4 million. It
appears the difference related to hiding the value of $15.4 million in compensation
expenses reflected in the bonuses the executives were paid. By
reducing the stated profit, the company could also avoid reporting the compensation
costs without affecting the reported income numbers.
In fact, a a person close to Tyco said, the bonuses paid were substantially more
than $15.4 million, although that fact is not reported in the Boies
report. That is because the bonuses to Mr. Kozlowski and Mr. Swartz were
"grossed up" to cover taxes on them - something not done for the other
five executives, who got smaller bonuses. It is not clear where the value of the
additional compensation was reported.
On paper, those bonuses were paid when the company gave stock to the executives
and then bought it back from them. The Boies report said most of
the sales were made on June 20, the day the Flag deal was announced and two days
before it closed, so eager were the executives to get their cash.
The remaining sales of stock by Mr. Kozlowski and Mr. Swartz were made two weeks later.
All told, their bonuses on the deal totaled $20.4 million.
A lawyer for Mr. Kozlowski dismissed as ridiculous the reported timing, which showed
that the stock sale was made before the profit justifying the
issuance of the stock was recorded. "It makes no sense for him to sell stock
before he received it," said Steve Kaufman, the lawyer. Scott Tagliarino,
a spokesman for Mr. Swartz, declined to discuss the timing. But the reports
the two executives filed with the S.E.C. many months later confirmed
the dates of the sales.
Tyco's board, according to the Boies report, was kept in the dark for many months
about those bonuses. On Oct. 1, the board's compensation
committee did approve them. But the report complained that
no one told the board that by Oct. 1, the Flag stock had declined sharply in value, "thus
undermining the basis" for the bonuses.
But if the board did not know of Flag's problems by then, it evidently was not
paying much attention. For those problems had had a significant and
well publicized effect on TyCom. On Aug. 6, Flag announced it was unable
to raise money to pay for the Pacific cable it had hired TyCom to install,
and TyCom said it would go ahead with the project on its own. Flag stock
was down to $2.63 and Jack B. Grubman, the Salomon Smith Barney
analyst who had been a strong supporter of Flag, removed his buy recommendation.
In the end, Flag went bankrupt and Tyco wrote off its entire investment, which it
valued at $114 million - a value of $7.60 per share of Flag stock.
But Flag shares were worth only $4.61 on June 20, when the deal was announced,
and $4.96 on the day it closed. Had either of those values been
used, Tyco's reported profits would have been far lower.
The deal was a fiasco for Tyco. Flag shares would never again trade for as
much as $6 a share, and yesterday, with the company in bankruptcy
proceedings that are expected to end with the shares worthless, they
closed at two-tenths of a penny.
Verizon did better on the deal. The TyCom shares it received were later
converted into Tyco shares, when Tyco reacquired the company. Verizon
sold some of the Tyco shares at relatively high prices, in January, and
the rest in July, at much lower prices. It received about $45 million for the
stock, plus the $11.4 million it got in the original transaction.
But if Tyco suffered from the transaction, it was just one more bonanza
for Mr. Kozlowski and Mr. Swartz, who were able to get millions in a way that
would not be reported as compensation.
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