Taking Down the Lion: The Rise and Fall of Tyco's Dennis Kozlowski (8 page)

* * *

On the day Kozlowski was tapped to be CEO, he didn’t immediately pocket the key to the Chief Executive’s Office. Upon hearing that the proposed compensation package included a reduction in his salary, Kozlowski’s cool reaction to the Board was “I need to think about it.” As Kozlowski looked at the Directors after they proffered the Chief Executive’s position, he thought, “what are my options if I decline the offer? Can I stay with the company or will I have to leave?” Unbeknownst to the Board, Kozlowski had other job opportunities available to him at the time. He was prepared to leave Tyco—and a reduction in his salary was not an enticement for him to stay. The Board had to come up with a more attractive offer before Kozlowski would agree to serve as CEO.

About an hour after Kozlowski hedged in response to the initial offer, the Board agreed to increase his salary and to further sweeten the deal, offered additional performance-based compensation. Kozlowski explained, “I was okay with the offer. I felt confident I could achieve the performance goals.”
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Years later, Kozlowski pondered the discussions about compensation he had with the Directors on the day he became CEO. He said of the Board’s lowball offer, “I don’t know why they tried to cut my salary when making me CEO. The company was doing well, we were not struggling.” With the wisdom of twenty years’ hindsight, Kozlowski wondered if the initial offer he received in July of 1992 was an early indication of a dysfunctional Board.
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Robert A. G. Monks, one of the three Directors who interviewed Kozlowski for the CEO’s slot, served on Tyco’s Board from 1984 until 1993 and was connected to
Tyco from the company’s inception—Tyco’s incorporation documents were processed through the law firm where Monks practiced in 1962. Monks is a Harvard Law School alumnus and a respected expert and prolific author on a number of corporate governance issues. Long after both men’s relationships with Tyco had ended and years since the two had been in contact, Dennis Kozlowski described Monks as a man on the leading edge of corporate governance reform and as someone who can be “a very harsh and fearless critic.” When asked about his service as a Tyco Director, Monks said there came a time soon after Kozlowski was named CEO when he knew he had to leave the Board. More than twenty years after the fact, Monks used the exact same word that Kozlowski used to describe the Directors who sat on the Tyco Board in the 1990s. Like Kozlowski, Monks labeled the Board “dysfunctional.”
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Monks remembered sitting through a meeting in 1993 when actions of the Directors became red flags to him—indicators of serious problems. Bob Monks, a stickler for doing things right, didn’t want to be part of a Board that operated as the Tyco Board did at that time. As he considered his options, he spoke to a friend about his desire to disconnect from Tyco. Monks’s friend shared an anecdote about being asked to leave a board of directors almost immediately after he suggested that board members participate in a self-evaluation process. Monks decided to replicate the scenario so in 1993, he asked Tyco Directors to participate in a self-evaluation process. In response to his suggestions, Monks was promptly asked to leave the Tyco Board. Monks said it was somewhat embarrassing to be removed, but after 2002, after the scandal and legal actions for which the Tyco Board was responsible, at least in part, his 1993 dismissal from the Tyco Board of Directors was viewed favorably. “At speaking engagements and events, among the qualifications and accomplishments identified when I’m introduced to an audience,” Monks said, “is my timely departure from the Tyco Board.”
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* * *

Once the Board and Kozlowski reached an agreement on compensation, Kozlowski succeeded Fort as CEO. However, Fort remained Chairman of Tyco’s Board of Directors. That leadership structure was short-lived. Not long after Kozlowski was named CEO, the Board decided he should serve as Chairman as well.
23
Kozlowski explained during his trial that “[t]he Board noticed, for lack of a better word, some tension. . . . John Fort was a successful CEO for about ten years and he had a different style and different ideas than I did.”
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Kozlowski explained that after he became CEO, he and Fort addressed the same issues and opportunities in Board meetings and the two often expressed very different points of view.
25

In Kozlowski’s recollection, Phil Hampton broached the subject of Fort’s chairmanship with him about six months after Kozlowski was named CEO.
26
Kozlowski said Hampton experienced a similar governance dilemma when he sat on
the Board of Banker’s Trust. Hampton saw the same type of tension between a CEO and a Chairman, and as a result of the difficulties he observed, he thought the Tyco Board would function more effectively with one person assuming both roles. Hampton said he planned to speak to the rest of the Board about Kozlowski assuming both positions.
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His reasoning apparently persuaded the other Directors because shortly after Hampton’s conversation with Kozlowski, the Board in January 1993 rejoined the roles of CEO and Chairman and vested both in Dennis Kozlowski.
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At the time, Kozlowski was no doubt happy to assume the chairmanship. Being both the CEO and Chairman of the Board gave him more clout, more control, and freed him from the tension and obstructions created by a Chairman whose management style and vision for Tyco were different than his own. In the short term, serving in both roles made Kozlowski’s life easier. But in the long term, it may have been better both for Kozlowski and for Tyco if someone else had assumed the role of Chairman of the Board.

What’s the old saying? Penny wise, pound foolish.

* * *

Leadership structure, specifically the question of whether the roles of CEO and Chairman should be held by a single person or split between two individuals, has been a hot topic among publicly traded corporations, their shareholders, activists, and regulators for the past several years. While the majority of Standard & Poor’s (S&P) 500 companies continue to vest the roles of CEO and Chairman in a single individual, the past decade has seen an increasing number of companies splitting the roles.
29
According to the 2012
Spencer Stuart US Board Index
(
SSBI
), only 125 companies—twenty-five percent of the S&P 500—split the roles of CEO and Chairman in 2002. Reflecting the trend of the next decade,
SSBI
analysis of 2012 proxies revealed that 207 companies—forty-three percent of the S&P 500—split the roles of CEO and Chairman. The 2012
SSBI
analysis also revealed that eighteen S&P 500 companies had formal policies requiring a split between board leadership and management control.
30

Beginning in February of 2010, the SEC requires publicly traded corporations to disclose in annual proxy filings their board leadership structure including the rationale for either combining or splitting the roles of CEO and Chairman of the Board. Dodd-Frank also requires disclosure of leadership structure. There are many arguments advanced by proponents of splitting the roles and an equal number from advocates of combining board and management leadership. At the root of this dilemma is the inherent conflict of interest created by having the CEO, the individual responsible for management of the company, also serve as the leader of the board of directors, the body charged with overseeing, compensating, evaluating, and if necessary, terminating the CEO. The basic counterargument is that by
vesting the roles of CEO and Chairman in the same individual, the company can operate more effectively, with a single vision, clear objectives, and unity of purpose. Research of this issue has produced inconclusive results. There is no clear answer as to whether one leadership structure is more effective than the other.
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The Tyco scandal seems a case study in the risks of vesting in one person the roles of both CEO and Chairman. If another individual had assumed the role of Chairman during Kozlowski’s tenure as CEO, perhaps a second point of view would have counterbalanced Kozlowski’s aggressive growth style. Perhaps the Board would have benefited from the combined strengths of different leaders—from the “tension” Kozlowski described in his trial testimony. By giving Kozlowski control over both management of the company and leadership of the Board, Tyco Directors arguably gave him too much freedom, too much control, and not enough direction. For the decade the company flourished under Kozlowski’s leadership, the Board became increasingly hands off, investing ever less effort in oversight and paying minimal attention to corporate formalities—their primary duties as Directors of a publicly traded corporation. Had someone else been Chairman during the years Kozlowski was CEO, during the years his time and energy were consumed by travel, acquisitions, and concentrating on the “big picture,” splitting the roles would have almost guaranteed more effective corporate governance. Kozlowski would no doubt have received more guidance, feedback, and oversight. At the very least, had there been a different Chairman when the waters got rough in early 2002, it would have been more difficult for the Board to blame Dennis Kozlowski for anything and everything.

Of Tyco during the years Kozlowski was both CEO and Chairman, Bob Monks described an environment that gave Kozlowski “no protection from his own worst instincts.”
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Part Two

Timing Is Everything

The old adage “timing is everything” is true, which is probably why it has endured. Occasionally, an unlikely intersection of people, places, and circumstances conjures unexpected good fortune—the joy and magic of the human experience. It doesn’t happen often, but on rare occasions, timing is perfect. With equal force and numinosity, the same kind of arbitrary temporal collision can end in tragedy when the fates align with exact synchronicity and, against all odds, produce a perfect storm. This doesn’t happen often either, but on rare occasions, timing is perfect.

Seven

Big Time Scrutiny

Dennis Kozlowski excelled as the CEO of Tyco International. There was rough water from time to time, but for the most part, his decentralized, efficient, acquisitive organization sailed for many years with the wind at its back. In the three decades before Kozlowski was named CEO, Tyco was a little known New Hampshire conglomerate. But even as the company grew substantially larger, it wasn’t as widely recognized as companies of similar size and performance. Kozlowski and the Tyco Board thought the company’s price/earnings ratio suffered—its stock was undervalued in part because of Tyco’s relative anonymity. So, Dennis Kozlowski sought counsel from well-respected New York public relations guru Robert Dilenschneider with an eye to increasing Tyco’s and by necessity his own visibility.
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Of some of the first words of wisdom he received from Dilenschneider, Kozlowski recalled that “Bob said to me ‘You know, the only whales that are harpooned are the ones that come to the surface.’”
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* * *

Due to efforts to boost exposure, and more significantly, because of the company’s continued growth and strong performance, Tyco and its CEO gradually received more attention. The company appeared as one of “The Best Performers” on the list of the
Business Week
-50
in March of 1997. Over the next several years, interest in the company escalated. Eventually, burgeoning interest in Tyco led to hundreds of articles in the
New York Times,
the
Wall Street Journal,
USA Today,
Fortune
magazine,
Money
magazine, and a plethora of other outlets. Kozlowski was featured on the cover of
Businessweek
in May of 2001 when the publication tagged him “The Most Aggressive CEO.” Because of his seemingly fearless drive to grow the company through hundreds of mergers and acquisitions, Kozlowski was recognized as “perhaps the most aggressive dealmaker in Corporate America.” He appeared on a
Businessweek
cover again in January 2002 after being named one of “The Top 25 Managers of the Year.”

By the early 2000s, Kozlowski and Tyco were well known. The kid from Newark and the small New Hampshire company had made it to the big time.
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* * *

Once Tyco and Kozlowski were on the radar, every move the company and its CEO made seemed to be of interest to someone. Or to everyone. The larger the company grew, the more attention both Tyco and Kozlowski received—from journalists, analysts, investors, regulators, and others. Along with frequent public praise came occasional criticism and heightened scrutiny. Bob Dilenschneider’s observation foreshadowed Tyco’s newly found prominence; the whale became vulnerable to harpoons.

In October of 1999, Tyco had to address surprising allegations made by prominent short-seller David Tice. Short-sellers are traders who bet that the price of certain stock will fall. In order to short a stock, a short-seller borrows (for a fee) shares of a company’s stock in an agreement with the owner of the shares that they will be returned on a certain date. The short-seller immediately sells the borrowed shares on the market at the current, and what the short-seller believes to be inflated price, wagering that the stock price will fall before the date the borrowed shares must be returned to the owner. If the stock price falls, the short-seller buys replacement shares for less than the borrowed shares were sold—and the short-seller makes a profit. However, if the price of the stock increases, the short-seller is forced to buy replacement shares at a higher price than the price for which the borrowed shares were sold—and the short-seller suffers a loss.

For example, if a short-seller believes ABC Inc.’s stock is overvalued, he or she borrows 100 shares of ABC Inc. with an agreement to return replacement shares to the owner in
x
number of days. On the day the short-seller borrows the shares, ABC Inc. is trading at $15 a share. The short-seller sells the shares on the market for $15 ($15
×
100 shares = $1,500) The short-seller has $1,500 in his or her pocket and an obligation to buy replacement shares to return to the owner from whom they were borrowed within the predetermined time frame. This is when the short-seller hopes the value of the company’s stock will drop—he or she hopes the rest of the market will suddenly recognize the same overvaluation that the short-seller was smart enough to discern before everyone else. The short-seller hopes when ABC Inc. shareholders learn the stock has been shorted, they will believe they own overvalued stock and they’ll rush to sell their shares. During the window of time after the short-seller sells the borrowed shares and before he or she must return replacement shares, the price of ABC Inc. drops to $10 a share. The short-seller buys 100 replacement shares for $1,000 (100
×
$10 = $1,000), returns those shares to the owner from whom they were borrowed, and keeps the $500 profit. The short-seller wins because the stock of ABC Inc. dropped in value. If during the limited time frame the value of ABC Inc. doesn’t fall but instead increases to $20 a share, the
short-seller’s cost of replacement shares would be $2,000, and he or she would suffer a loss of $500 on the transaction. If a short-seller predicts that the price of ABC Inc. will drop, the short-seller needs the price of the stock to fall. The short-seller has a financial interest in seeing ABC Inc.’s stock price drop.

According to some experts, short-sellers played a role in almost every financial crisis of the last 400 years. After the U.S. stock market crash in 1929, President Hoover condemned short selling, and short-sellers were called on the carpet again after the market crashed in October of 1987. David Tice, the short-seller who created public suspicions about Tyco, acknowledged that short-sellers, as a group, are not held in high esteem. In a 2008
Reuters
article, Tice is quoted as saying “We’ve been the natural scapegoats for decades.”

Short-sellers defend their role, say they’re good for the market, and promote themselves as watchdogs who bring balance to the market by sniffing out stocks that are overvalued. For the
Reuters
article, written in the midst of the financial crisis of 2008, a self-reflective Tice said, “I feel like we are the good guys, but when the media attention is on us and the president and the treasury secretary are talking about it, it is kind of a lonely vocation.”
4

On Friday, October 8, 1999, David Tice publicly questioned Tyco’s accounting methods and alleged that Tyco overestimated restructuring charges when it closed deals to buy or merge with other companies. Tice said of his allegations against Tyco, “We told people that Tyco was stretching the truth on reported performance, which didn’t represent future growth prospects.”
5
The market reacted immediately to Tice’s claims. Within two trading days of his report, Tyco’s stock price dropped sharply. Over the next two months, the value dropped by nearly fifty percent.
6

Tice’s opinion that Tyco stock was overvalued and should be shorted proved correct—the stock price fell just after he discovered and announced Tyco’s questionable acquisition accounting. His timing was impeccable. But what was the
cause
and what the
effect?
Did the value of Tyco stock fall in October of 1999 because Tice was right about Tyco’s acquisition accounting methods? Or did the value of Tyco shares drop because of damaging rumors floated by a prominent short-seller who was advancing his own interests—did Tyco stock plummet because of the allegations of someone who ran a business that profited when the value of stocks dropped?

Tyco International was exactly the kind of company David Tice featured at the time in his newsletter “Behind the Numbers.” When asked in 2001 why he targeted Tyco, Tice told
MarketWatch
that “Tyco was a Wall Street darling with lots of buy recommendations and no sells from the analysts who followed the company.” So Tice took a close look at Tyco’s financial statements and concluded, contrary to the opinions of dozens of analysts, investors, investment bankers, and auditors, that the company should be shorted, that its organic performance was weak, and its growth was fueled primarily by an aggressive number of acquisitions. Tice made
the serious allegation that Tyco purposefully overestimated restructuring charges so the company could make adjustments in future periods to enhance its earnings.
7

Accounting rules at the time required that restructuring costs related to acquisitions be estimated and charged when deals closed. Of course, the
actual
costs of restructuring would not be known until after newly acquired companies were fully integrated—weeks or months later. Although estimates are by their very nature uncertain, acquirers were obligated to use professional judgment in forecasting costs, and restructuring charges had to be justifiable. Before taking charges, acquirers had to identify restructuring expenses that would be incurred by naming specifically any activities that would be discontinued, the method of disposition, the location of the named activities, and the expected dates of completion. The types of planned expenses included in restructuring charges (expenses for actions needed to implement strategic changes or to benefit from synergistic efficiencies) included consolidation or relocation of operations, the closing of plants and facilities, the termination of jobs, and impairment of the value of productive assets. For example, if integration included cutting 2,000 jobs, the acquirer had to identify and announce the 2,000 positions that would be eliminated. The costs of severance owed to the 2,000 identified employees could be included in restructuring charges.
8

When acquisitions closed, restructuring charges had an immediate negative impact on earnings; the restructuring charges were expenses. However, after newly acquired companies were successfully integrated, weeks or months later, if the expenses the acquirers anticipated were more than the actual costs of restructuring, the companies had to make adjustments and write down the charges, sometimes called reserves or “cookie jars,” which had a positive impact on pretax earnings in the quarters in which the adjustments were made.

For example, if an acquirer planned to close five facilities during the integration of an acquired company, the $10 million total cost of closing those facilities would have been included in the restructuring charge—and taken as an expense when the deal closed. But because of the efficient and orderly winding down of operations in three of the facilities, and effective revenue enhancements implemented during the first three quarters after the acquisition, two of the facilities slated to be closed remained in operation nine months later, and would continue to operate. As a result of the change of course, the actual costs of restructuring were only $8 million, less than the $10 million included in the restructuring charge. The acquirer had to make a $2 million adjustment—in essence reversing the expense booked earlier—which became a $2 million boost to pretax earnings in the quarter in which the adjustment was made. The adjustment directly affected operating income but was disclosed on a separate line—it was not buried in operating income.

This accounting method was vulnerable to abuse; an acquiring company could purposefully overstate restructuring charges and use the inflated amount in the
“cookie jar” to manipulate earnings when needed in future periods. Arguably, this was not illegal or in violation of the accounting standards in place in 1999, when Tice accused Tyco of manipulating earnings, however, this method could create serious problems if resultant financial reporting was misleading to shareholders.

The market’s reaction to David Tice’s accusations was understandable and predictable. If Tyco had in fact intentionally overestimated restructuring charges, considering the number and size of acquisitions Tyco made during the late 1990s, the amount of reserves in its “cookie jar” could have been substantial, thus giving the company the ability to pump up earnings anytime it wanted to mask a bad quarter. For example, when Tyco completed the acquisition of AMP in April of 1999, the company announced that it expected to take a restructuring charge of at least $200 million.
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If Tyco used an inflated number, if the company knew it wouldn’t really incur costs of $200 million, it could have written down any excess in the future, in a quarter when earnings weren’t as strong as expected. The fear was that investors would rely on numbers that reflected a quarter of strong performance when in reality, but for the adjustment of restructuring charges, performance for the quarter would have been lackluster. Kozlowski’s aggressive goals for growth and propensity to acquire large companies with correspondingly large restructuring charges added fuel to Tice’s fire.

In late 2007, the U.S. Financial Accounting Standards Board made changes to accounting standards for mergers and acquisitions, including the treatment of restructuring charges. For deals closed after December of 2008, material adjustments to restructuring charges had to be made to prior period financial statements—to the financial statements from the period in which the acquisition was completed—instead of reflecting adjustments in a later period.
10
The change in accounting standards prevented any further use of “cookie jars” or reserved charges that could be used to manipulate earnings.

During Kozlowski’s second criminal trial, former Tyco Executive Vice President Brad McGee was asked to describe the company’s reaction to Tice’s allegations. McGee was the company’s spokesperson in 1999 when Tice publicly questioned Tyco’s accounting methods. As the company’s spokesperson, McGee was unequivocally credible. He accepted a position at Tyco in 1991 and served in a number of high-level positions during the decade Dennis Kozlowski was CEO.
11
Kozlowski distinctly remembered how he came to hire McGee. He said, “During the years I was at Tyco, I received dozens of unsolicited resumes every day. My assistant put them into a folder and I would do a quick review before forwarding the folder to HR and they sent polite ding letters on my behalf. One day, I was flipping through the folder and I noticed Brad McGee’s resume. He was local—in Exeter, New Hampshire. He had an MBA from Harvard, but what I really noticed was his Navy service. He worked on nuclear subs. When he sent his resume, he was working as a consultant. I thought we could use some internal consulting, so I asked him to come in and
talk.”
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Kozlowski believed McGee was one of his best hires and said had things played out differently at Tyco, the leadership succession plan he envisioned would have seen Brad McGee as the company’s sixth CEO.
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