Paperwork Crime

Why the SEC is going after Tyco’s executives.

The Securities and Exchange Commission and Manhattan District Attorney Robert Morgenthau today unveiled civil and criminal fraud charges, respectively, against three former Tyco executives: ex-CEO Dennis Kozlowski, ex-chief financial officer Mark Swartz, and ex-general counsel Mark Belnick. The three men, the charges allege, received unauthorized compensation worth several hundred million dollars—largely in the form of loans—that was kept secret from the board, shareholders, and the SEC. 

New York’s criminal indictment paints Kozlowski and Swartz as nefarious masterminds. The two were members of a “Top Executives Criminal Enterprise” aimed at looting Tyco by “falsifying records, concealing material information and providing false information to Tyco’s Board of Directors and stockholders.”

But the main offense of the Tyco executives, according to the SEC, was something altogether milder. Even though the compensation of Kozlowski and his co-conspirators was obscene, it wasn’t illegal for them to take hundreds of millions in low-interest loans. Nor was it illegal for them not to pay back those loans. (It would be a crime, however, not to declare such forgiven loans as income.) As far as the SEC is concerned, the violation is how they reported the compensation. The crime, in other words, is the cover-up.

Tyco, like all publicly held companies, is required to file annual and quarterly reports, as well as annual proxy statements. The highly detailed filings are supposed to give investors comprehensive information so they can judge a company’s prospects and rate the performance of the executive team and board of directors.

The proxy statement—the DEF 14A, for short—is the only document that is delivered to all shareholders every year. It includes a ballot for investors, information about the people standing for election as directors, shareholder-sponsored resolutions being put to a vote, and details of the stock-option plan, which investors also must approve.

Since 1992,when SEC Regulation S-K was promulgated, companies have also been compelled to file detailed data on executive compensation in the proxy—even though shareholders don’t get to vote on the pay packages.

Item 402 of the regulation requires that companies present the compensation for “named executive officers,” which include the CEO and the four highest-paid officers of the company, in a standardized form. A table must show salaries, bonuses, and other compensation going back three years. Companies must also append these officers’ employment agreements and contracts.

The “named executives” aren’t necessarily the five best-paid employees of a company. On Wall Street and in Hollywood, there are plenty of people whose titles place them squarely in the middle of an organizational chart but who earn far more than the CEO. Companies have leeway in determining who is an “officer” and who isn’t. But the top four after the CEO generally include the CFO, COO, and division heads. In the case of Tyco, the named executives included Kozlowski and Swartz but not lawyer Belnick.

The same regulation compels companies to disclose financial transactions between the company and named officers or company directors. These “related-party transactions” might include loans to executives, leases on property owned by a director, or purchases of goods or services from a company in which a director has an ownership stake.

The board compensation committee—at Tyco, it was composed of three independent board members—is responsible for fixing and approving executive compensation for the top five officers and for approving compensation programs that may spread throughout management ranks. If a company forgives a loan to a named officer—or to any senior employee—the compensation committee must approve the transaction, and it must be reported.

If a company establishes loan programs for executives—to help defray the costs of relocation, or to pay taxes triggered by exercising options—the compensation committee must approve them, and the amounts of the loans made must be reported in the proxy. The compensation committee is also supposed to ensure that the loans made are actually used for the purposes intended. Names of borrowing executives who are not directors or among the top five are frequently not reported.

And here’s where Kozlowski, Swartz, and Belnick got into trouble.

In 1983, Tyco established a Key Employee Corporate Loan Program, under which executives could borrow to pay taxes they incurred when restricted shares became vested. Between 1997 and 2002, Kozlowski and Swartz allegedly borrowed a combined $322 million under this program and used the funds for purposes other than paying taxes. These loans weren’t disclosed by the executives and hence were not revealed to investors. Kozlowski and Swartz have also been charged with corruptly engineering the forgiveness of various portions of these loans.

Belnick’s case is slightly different. He wasn’t one of the named executive officers, and Tyco was never required to disclose his compensation. But he was required to disclose to the board loans made to him under established programs and to use those loans for the purpose for which they were intended. Belnick allegedly took $14 million in undisclosed loans under a Tyco program that made interest-free loans to employees who had to move from New Hampshire to New York when the company moved its executive offices to Manhattan and, later, to Boca Raton, Fla. Belnick, who joined Tyco in 1998, had never worked in New Hampshire and already owned a house in Westchester County. He used some of these loans to buy a house in Utah. Again, the SEC’s beef is that neither loan was properly disclosed.

(Their activities sound an awful lot like common embezzlement, like taking cash out of the register at a convenience store, only on a grand scale. As Nell Minow, the corporate governance activist, puts it, “The only difference between unauthorized compensation and embezzlement is how much money is in your bank account. If you’re a junior associate, it’s embezzlement.”)

Time and again throughout the SEC’s litigation release, the agency harps upon the fact that the loans “were not disclosed to shareholders, contrary to the requirements of the federal securities laws.” The SEC makes no moral judgment about the validity of using shareholder cash for sweetheart loans to wealthy executives, but it is very agitated about the failure of corporate officials to file the appropriate paperwork. It’s tempting to ascribe this rage to a bureaucracy’s innate obsession with process. (Indeed, had the loans been properly disclosed, the SEC may very well not have raised any objection.)

But the SEC is doing exactly what it’s supposed to. It isn’t primarily an enforcement agency. It’s a disclosure agency. Markets depend on information: The whole premise of our system is that investors will use that information to punish executives who abuse their trust and resources. Without honest and complete disclosure, the system breaks down. At Tyco, because of a lazy, dysfunctional board and mendacious top executives, investors were unable to enforce their brand of justice. That’s why the SEC brought charges today.