Commentary: Tyco: How Did They Miss A Scam So Big?Sep 30, 2002 | BusinessWeek.com While CEO of Tyco International Ltd. (TYC ), L. Dennis Kozlowski often invited journalists, analysts, and others to the company's unassuming corporate offices in Exeter, N.H. Visitors were impressed by Kozlowski's assertion that frugality inspired him to run one of the world's largest companies out of a modest, two-story wooden structure. "We don't believe in perks," Kozlowski once told BusinessWeek. "Not even executive parking spots."
Today, with Kozlowski accused by the Securities & Exchange Commission of running his company like a "private bank" and lavishing hundreds of millions in unauthorized loans and exorbitant gifts on himself and his lieutenants, his frugal image has been shattered. Tyco's former CEO will be remembered as one of the great corporate hoodwinkers. In his wake, he has left a host of questions, the most important being how he managed to preside for seven years over what prosecutors call "a criminal enterprise." Why did no one see through the scam--not the Tyco board; not PricewaterhouseCoopers, Tyco's outside auditor; and not even the SEC, which probed Tyco's accounts in 2000?
It is becoming increasingly clear that Tyco was not run or structured like any other company. Even as it ballooned to a $36 billion giant with over 200,000 employees, Kozlowski allowed only a relative handful of trusted lieutenants to work with him at Tyco's headquarters operations, TME Management Inc. Tyco's once-heralded lean, mean management structure now looks more like a setup designed to keep out prying eyes. Within his inner sanctum, Kozlowski reigned supreme: He never appointed a president and handpicked his top managers, insuring that they were cut from his own mold: "smart, poor, and wants-to-be-rich," as he once said.
But that cunning structure is no excuse for the seemingly willful blindness exercised by other key Tyco players. Indeed, there's plenty of blame to go around in the sorry saga. The most egregious failure of oversight occurred on Tyco's board. True, Kozlowski apparently went to enormous lengths to keep outside directors in the dark: He took control of all information including internal audits that usually go to a board. But that, in and of itself, should have been a red flag. An alert board would have insisted on hearing directly from internal auditors, not from Kozlowski. Having approved a corporate loan program for top executives, a vigilant board would also have required close monitoring of any transactions. And it could have objected to the decision to give the finance department, rather than the general counsel, responsibility for Tyco's SEC filings. "That's highly unusual," says John Coffee, a law professor at Columbia University.
Given that many of Tyco's supposedly independent directors had direct financial dealings with the company, it's little surprise that the board lacked vigilance. One director, for instance, Joshua M. Berman, was receiving $360,000 annually for "legal services," according to SEC filings. But that pales compared with the $20 million fee Koz-lowski paid to "lead director" Frank E. Walsh Jr. for his services in helping to arrange Tyco's disastrous 2001 acquisition of commercial-finance company CIT Group.
Board members are hardly the only ones who blew it. Why didn't PwC catch wind of the massive loans and self-dealing that Kozlowski and others allegedly engaged in? "You would think that if the auditors could spot anything, it would be the loans" to corporate execs, says Columbia's Coffee.
Moreover, given the potential for abuse, the outside auditors "should have reviewed all transactions between the company and its officers," argues Philip Livingston, CEO of Financial Executives International, a professional association of chief financial officers. Such a standard review could have uncovered how these loans had mushroomed far beyond anything the board authorized. PwC says "ethical obligations" to Tyco prohibit it from discussing the case.
Early on, the SEC also missed a key chance to unearth Tyco's seamy underside and to prevent itself from being used to deflect critics of Tyco's accounting. The agency spent months investigating Tyco after questions arose about its books in late 1999, but it never got wise to Kozlowski's alleged manipulations.
True, the SEC was focused on entirely different issues--namely, whether the company was using its merger-related accounting to inflate its results. An SEC spokeswoman says that if it tried "to reconstruct every item in a company's books, we'd do only three cases a year." But critics argue that the agency should have looked more broadly at Tyco. Taking a hard look at Tyco's internal auditing procedures as part of its investigation, for example, would likely have have raised questions about its unusual practices. "They had too narrowly defined the problem," says Jeffrey A. Sonnenfeld, associate dean of executive programs at the Yale School of Management. Instead, the SEC effectively signed off on Tyco's books--a fact that company executives trumpeted loudly whenever further doubts arose about its numbers.
The din of questions is louder than ever. Edward D. Breen, Tyco's new CEO and chairman, will have trouble convincing investors that the previous management didn't fiddle with the company's operating results as well. Breen has brought in forensic accountants to help PwC scour the numbers back to 1999. Although the review isn't expected until late fall, Breen has told investors there is "no reason to believe that there are any material adjustments necessary."
Skeptics abound. "If Kozlowski was doing what he is accused of, the odds are pretty good" that there's something wrong with Tyco's numbers, says Charles L. "Chuck" Hill, director of research at Thomson Financial/First Call. And Nicholas P. Heymann, an analyst at Prudential Securities Inc. (PRU ), expects a big restatement of earnings in the not-too-distant future. So much for the virtues of frugality--or at least the frugality practiced at Tyco's now notorious wooden headquarters.