Tyco's betrayal of board governance.
By Pascal N. Levensohn

BOARD ACCOUNTABILITY Tyco's betrayal of board governance From this tangled web of related-party transactions, intra-board lawsuits, personal tax evasion indictments, and other value- and trust-destroying exploits, some recommendations for director accountability readily suggest themselves. BY PASCAL N. UEVENSOHN S ERIAL REVELATIONS of self-deaüng by Tyco International's former CEO, its for- mer general counsel, and individual mem- bers of the board of directors paint a shameful canvas of derelict corporate gov- ernance in the Tyco boardroom. Under scrutiny from investors and regulators alike, the Tyco board has adopted a finger-pointing and blame-shifting approach in response to the charges leveled against management and the company. This may help some board members save face, but there is no denying that something was seriously awry in the Tyco boardroom for many years. With powerful rights come equally powerful re- sponsibilities. If public company directors have the right to attractive cash and stock option compen- sation packages, to the prestige associated with their positions, and to exercise the power corporate strat- egy, they also have the responsibility to be proac- tive in their oversight and to ask the hard questions of the CEO before trouble is irreversible. In my opinion, the Tyco board of directors has failed to acknowledge that it abdicated its responsibilities to the owners of the company — the shareholders — thereby compromising the board's rights to the benefits of directing the future of this company. In examining the Tyco governance record, we draw three conclusions that may be helpful to other companies so that they may avoid breeding governance cultures that allow confiicts of interest to flourish: first, that boards must be proactive in their oversight of company management; second, that a board with a majority of independent di- rectors should also include a diversity of skills, favoring directors with operating experience; and third, that aligning director interests with share- holder interests through stock ownership should be balanced by establishing a reserve system for re- alizing gains that is long-term in its construction. Even in the context of the acquisitive 1990s, Tyco was one of the most acquisitive, having amassed a collection of companies for a total of over $60 bil- lion in cash and stock over the past decade. Until January of this year, Tyco had brought the con- glomerate concept to levels of investor acceptance not seen since the glory days of Gulf & Western, and its management made a science of creating ac- counting and tax loophole exploitation. Along the way, the company's growth under CEO Dennis Ko- zlowski generated both controversy and, for some, great success. From January 1996 to December 2001, Tyco's common stock appreciated at a com- pound rate of 37%, compared to 11% for the S&P 500. Tyco's market capitalization as of December 31, 2001,was$116.3billion, making it one of the top 20-valued public companies listed on the New York Stock Exchange. But the Tyco edifice crumbled in 2002. In the six montlis since December 31, the actions, inactions, and reversals of actions by the Tyco board have cost common eq- uity owners approximately $88 billion in lost shareholder value (through June 24), which is roughly three-times the $33 bil- lion in equity losses triggered by the Enron implosion and almost twice the equity losses in WorldCom year to date. Pascal N. Levensohn is the president and CEO of Levensohn Capital Management LLC, a San Francisco-based firm that since 1996 has specialized in public and private technology investing and risk management of concentrated equity positions. He is currently a director of LiDCO Group PLC, a publicly traded medical device company listed in the United Kingdom, and of three venture-backed emerging technology companies based in California's Silicon Valley — TeraLogic Inc, Covigo, and NexVerse Networks. SUMMER 2002 35 BOARD ACCOUNTABILITY Accident avoidance „„t be held responsible for improper acts by a How can a company avoid this type of accident- member of the management team. But the fact is waiting-to-happen in the boardroom? Three years that the board should have been aware of signifi- ago I wrote an article for DIRECTORS & BOARDS cantpayments to one oftheir own, and they should ["The Problem of Fmotion in the Boardroom," not have been so complacent as to simply rubber- Spring 1999] that analyzed, in the context of the stamp the CEO's actions. takeover battle for AMP Inc., the disproportionate influence of former AMP CEOs on the AMP board. An action step I expressed the view that former CEOs of compa- What can be done? It would be healthy, for example, nies do not make very good independent-minded to establish a cap on the maximum realizable cash directors because "It is naturally very difficult to value of stock options to directors in any one year, move a CEO aside, have him remain a voting board with future paytnents of the value to be held in re-' member, and proceed to undo major projects that serve based on some kind of multiyear performance this person has previously done with the board's standard or high water mark, similar to that imposed blessing. When more than one former CEO remains on many investment fund managers. Specifically, on the board, this problem is many investment managers, hedge funds, and ven r* 1^ U U J u magnified. Retired senior ex- ture capitalists in particular, who receive an alloca- lt WOUia úe Healthy to ecutives have a natural ten- tion of the profits of their portfolio appreciation, ,,. , , deticy to glorify their exploits must measure that profitability over a multiyear pe- estamtsn a cap on the and to treasure past contribu- riod. For instance, suppose a portfolio gains 50Û/O ,. , , , tions as well as to protect one in one year and they are entitled to an allocation of maximum realizable cash another and their reputations. 20% of those profits. In the following year, if the , r * 7 • It is therefore extremely risky portfolio loses 20%, the manager may not receive an- Value of stock options to to keep them at the table " other profit sharing allocation until the portfolio has t. ^ . Again, the pattern is re- recouped the 20% in depreciation and exceeds the directors in any Oneyean peatedatTyco.Thell-mem- original 50% high water mark. , , ber Tyco board of 2000 con- Directors commonly receive annual options sisted of three insiders, one awards, and, at Tyco, they have a history of con- former Tyco CEO, one CEO of a manufacturing verting their cash cotiipensation into stock. Cur- I company, and six investment company profession- rently directors can sell during open market win- I als (one of whom passed away in 2001 ). Eive of these dows for insiders, and they can reload the next year SIX mvestment professionals were either chairman and start all over again. Companies should revisit or president of their respective firms and three had this policy and create a longer-term, multiyear pro- mvestment banking backgrounds. Tyco's board tlius gram that requires directors to become long-term included four CEOs, three of them with direct Tyco shareholders who cannot lower the bar when the or predecessor compatiy backgrounds, and a con- company fails to deliver value to shareholders over centration of finance professionals rather than man- a multiyear compounding period. agers/operators. Such a board composition raises questions about the ability of tliese independent di- Where does Tyco go from here? rectors to be proactive and to adequately oversee the The $10 billion CIT acquisition and its public di- vast and complex operating companies that com- vestiture within a 12-month period culminate prise Tyco. Xyco's failure to create a GE done. While we believe I beheve that board members must be account- that IPO proceeds of S4.6 billion, added to over $4 able for the actions oftheir CEO. This means that billion in existing cash and forecasted operating the board must be proactive in discharging the re- cash fiow of $3 billion for 2002, legitimately meet sponsibthtyof CEO oversight and fully understand the $7.7 billion in refinancing obligations that Tyco what tools management utilizes to achieve business faces between now and February 2003, investors' plan objectives. At a minimum, it would appear concerns continue to linger and Tyco's stock has not that the loyalty of the board to Dennis Kozlo^vski materially appreciated since the closing of this crit- led to an absence of oversight. Perhaps, while every- ical transaction. Investors aren't the only ones who otie was maktng plenty of money, the board wasn't remain wary. Despite stabilizing its balance sheet, asking Kozlowskt a lot of questions. Clearly, if we Tyco has not yel convinced the ratings agencies that are to accept the board s statements that they had all is well. Prior to the IPO, S&P, MoSdy's, and Fitch no knowledge of questionable payments until ail downgraded Tyco's short-term atui lono-term months after they had been made, the board can- debt due to concerns regarding retlnancin^^ risk. 36 DIRECTORS ft BOARDS BOARD ACCOUNTABfLITY asset securitization, and the specter of having $5.9 billion in zero coupon bonds "put" back to Tyco in the event of balance sheet deterioration. Al- though it would appear that many of these issues have been suppressed, the lack of upgrades of Tyco's debt status is surprising. In sharp contrast, subse- quent to the IPO, GIT debt has been upgraded by both Fitch and Moody's and all indications are that S8iP will do the same. Like the ratings agencies, we remain concerned about the lack of visibility into the minutia of com- pany operations, which contain complicated, inter- related finaticing structures (debt, bank lines, swaps, forward contracts). Most of these instruments re- quire the maintenance of certain balance sheet and income statement ratios that are precarious under the current environment. Although we recognize that many of the above financial concerns assume the "worst case" scenario for Tyco financially, the fact that this scenario exists begs the question. Timeline of iniquity January 22,2002— Tyco announces a com- plete about-face in its historic core growth strategy with a plan to break the company into four pieces in orderto "maximize shareholder value." Says Kozlowski: "We believe each will be valued substantially higher than the implied valuations it has received in recent years as part of Tyco." However, in conjunction with this new strategy, the company announces that it posted negative free cash flow in the prior quarter. Tyco tfien projects a gloomy outlook for 2002. The market reacts negatively to this announcement, taking the stock price down 59% over the following five weeks. Over the same period, the S&P 5ÍX) declines by 1 %. January W— With the public filing of ttie ccm- pany's 2001 proxy statement, a bombshell explodes:Tycodisclosesthat, in July2001,$20 million in cash payments had been made to board member Frank Walsh and his designat- ed charity as a "finder's fee" related to the CIT acquisition. These payments were made, and accepted by Walsh, despite the factthat Walsh was the Tyco "lead director," a member of the board's corporate governance and nominating committee, and personally a substantial share- holder in CIT. Subsequently the company affirmed thatthese were "improper" payments. According to the company, the board did not learn of the S20 million in improper pay- ments made to their lead director Walsh until approximately two weeks prior to the filing of the 2001 proxy statement in January 2002. Apparently these payments were authorized by Dennis Kozlowski and made with no knowl- edge from any other director Recognizing that this prospective disclosure would cause sig- nificant harm to shareholders, according to the company's press release, the board demanded a return of the cash on January 16, 2002, which Walsh allegedly refused to do. Walsh and Kozlowski were not fired at that time. Instead, the proxy was filed on January 28. As a result of this disclosure, which omit- ted the fact that the payments were made without board knowledge or approval, the stock value declined by approximately $17 bil- lion in one day. The board had 12 days to fire Walsh over this issue and immediately initiate a plan to remove Kozlowski, but it did not. Instead, the board continued to support Kozlowski and endorse what would become a series of cata- strophic choices for the Tyco shareholders. This culture of blame shifting and feigned igno- rance is emblematic of the disease that brings a crisis of confidence in U.S. equity investing to the front pages of virtually every publication in this country. —Tyco confines that ithad acquired 700 companies for$8 billion in aggregate with- out disclosing the acquisitions in SEC filings. April—Tyco announces that it would aban- don the value-maximizing breakup plan it had just announced in January, and posts a $1.9 bil- lion loss. May— Tyco announces the possible impair- ment of goodwill on its balance sheet from the CiT acquisition, subsequently confirmed when the company takes a $4.5 billion charge and restates previously issued financial statements for the quarter ending March 31, 2002. While these reversals of course are enough to make one's head spin, they adopt a more sinister tone when considered in the context of sub- sequent alarming disclosures by the company and the media regarding conflicts of interest in the boardroom. June— Kozlowski, under criminal investigation for suspected tax evasion, resigns. The Wail Street Journal and New York 77/nes variously report ongoing investigations into irregularities concerning the alleged use of Tyco funds relat- ing to property transfers in Florida; unreported plane leasestoaTyco director; the exploitation of insider sales reporting loopholes that facili- tated undisclosed liquidations of more than S500 million in stock by Kozlowski and CFO Mark Swartz since July 1999; and as much as S2 million annually in unreported legal fees to a board member's law firm that compensated him on a fonnula that was directly tied to how much Tyco business was referred to his firm. A law- suit filed by the company against former gen- eral counsel Mark Belnick alleges that Belnick accepted $35 million in undisclosed compen- sation between 1998 and 2001 without approval or knowledge of the board and improperly used $14 million in Tyco funds to acquire personal residences in New York and Sait Lake and that he covered up records in order to keep this information unknown to the board. Ignoring the personal tax evasion allega- tions facing former CEO Kozlowski, the remain- ing directors are clearly pointing the finger of blame away from themselves. The Kozlowski, Belnick, and Walsh troika may, indeed, be proven guilty in a court of law of the multiple accusations levied against them. But there should be no doubt that the entire board must both acknowledge and bear responsibility for allowing a culture of duplicity and deception to flourish in the office of the Tyco chief execu- tive for years as a precondition for the trans- gressions of the others. — Pascal Levensohn SUMMER 2002 37 BOARD ACCOUNTABILITY While the Tyco board has publicly stated that they are conducting a search for a new CEO as well as considering expanding the board, I believe that this approach avoids taking proper responsibility for their breach of pubhc trust and fiduciary duty. It may be possible that a talented, charismatic CEO will assume the reins at Tyco and restore credibili- ty, growth, and stability to tbe company. It is also possible that an infusion of new talent to the Tyco board will quiet matters down at the company and keep it off the front pages. Tyco's operating busi- nesses appear to remain strong, and the talented managers who must exist within the company should have a chance to show their talents with the Kozlowski cloud removed. But this may take years, while Tyco shareholders have lost 77% of their eq- uity investment value in just six months. Ultimate redemption By all outward appearances, the entire Tyco culture was based on legal subterfuge and duplicity, from its Bermuda offshore tax status to its oblique, though apparently generally accepted, application of accounting principles. In rny opinion, the only way the Tyco board can redeem itself is to cotiduct a full auction of all of its operating entities and dismantle Tyco. If there is any fundamental value in the underlying as- sets, it should be unlocked through this process and the net cash proceeds should be distributed to the company's shareholders. Anything less is an avoidance of responsibility for one of the great- est corporate disgraces in the history of America and strikes a blow at our public company gover- nance system. • A revealing perspective on CEO character During the period beginning with the hostile takeover of AMP Inc. initiated by AlliedSignai Inc. in August 1998 and culminating in AMP's "friendly" acquisition by Tyco for SI 1 billion in Tyco common stock in April 1999, 1 had the opportunity to develop some valuable insight into the very different personalities of two CEOs — Larry Bossidy of AlliedSignai and Dennis Kozlowski of Tyco — as I represented a large block of stock held by the extended family of one of the co-founders of AMP, the Hixons. It was reported in the press atthe time thatthe shares under my representation had a market value of approximately $320 million, representing the second-largest AMP institu- tional shareholding. AlliedSignai made its unsolicited all cash bid for AMP on August 4,1998. On August 5, Alexander P Hixon, a former director of AMP who served for seven years from the late 1980s to the early 1990s, sent a letter to the AMP board advocating thatthe company maximize shareholder value by negotiating with all cred- ible and interested acquirers, including but not limited to AlliedSignai. The AMP board vigor- ously resisted our suggestion to negotiate, and we received emphatic, if not threatening, exhortations from Bob Ripp, at that time the AMP CEO, and certain longtime AMP direc- tors, to abandon our position and supporttheir attempt to fight the takeover. Keeping the AMP board's vievws in mind, we chose to assert our shareholder rights independently and met with representatives of both AliiedSignal and AMP Finally, as AMP pursued an ill-conceived Pennsylvania leg- islative initiative to disenfranchise its share- holders in the name of preserving its inde- pendence, we expressed our views to The Wall Street Journal m an article that appeared on October 5, 1998. On November 23, 1998, AMP announced that it had agreed to be acquired by Tyco. Between August 1998 and April 1999 I had the occasion to meet privately with both Larry Bossidy and Dennis Kozlowski, and one anec- dote from both meetings now bears retelling. We met with Bossidy in New York in September 1998. Bossidy sought support from the Hixons, and we sought to facilitate a nego- tiation between Bob Ripp, who was outspo- kenly anti-AlliedSignal, and Bossidy. Among other topics, we raised the question as to whether a post-merger operating role for Mr. Ripp could exist at AlliedSignai. While Bossidy listened politely, he responded emphatically, "There is no job for Bob Ripp at AliiedSignal, and I can't manufacture one or make him believe there will be one justto get his support for a merger." The Tyco press release of November announcing the agreed acquisition included the following statement: "Bob Ripp will serve on the Tyco Board of Directors and will con- tinue as President of AMP'We are extreme- ly pleased to have Bob and his team join Tyco's management team,' said Dennis Kozlowski." Four months later, on April 1,1999, we met with Dennis Kozlowski and Mark Swartz on the afternoon before the AMP acquisition was scheduled to go effective to introduce the Hixon family, AMP's longest-term sharehold- ers, to Tyco management and get a sense of the team's vision for the future of Tyco and AMP. During the course of our 90 minutes together, Kozlowski outlined his overall busi- ness plan, described the business philosophy of the conglomerate — "we are friendly oli- gopolists" — and mentioned, almost as an aside, that Bob Ripp would be terminated the next morning, just prior to the moment when the acquisition went effective, as he had no operating role atthe company going forward and didn't belong on the Tyco board. It is possible that Ripp's performance dur- ing the pre-closing period caused Tyco man- agement to reevaluate their commitment to him. It is also possible that Tyco never intend- ed to honor this commitment. When consid- ered in the context of the tangled weh of relat- ed-party transactions, intra-board lawsuits, personal tax evasion indictments, and now criminal indictments for tampering with evi- dence, this example may seem largely irrele- vant But it is relevant because it implies that good faith in business dealings was in short supply at Tyco. — PascalLevensohn 38 DIRECTORS & BOARDS

2002 Summer

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