Taking Down the Lion: The Rise and Fall of Tyco's Dennis Kozlowski (12 page)

Regulators, prosecutors, and legislators reacted quickly and zealously. Some tried to capitalize on the scandal. In the post-Enron environment, there were rewards for those who spotted the next evil corporate empire. Many corporations, boards of directors, and executives found themselves vulnerable to heightened scrutiny and unwarranted attacks as Enron’s long list of transgressions were projected onto them. The world forever changed on December 2, 2001. For Tyco and Dennis Kozlowski, the suspicions raised by David Tice two years earlier breathed new life, and scrutiny of the company ratcheted up as soon as Enron went down.

Of Enron’s effect on Tyco, Kozlowski said, “We did hundreds of acquisitions and they all went according to plan for the most part. CIT failed because Enron failed. Moody’s and S&P did what they said they would
not
do at the time of the acquisition. They dropped the credit rating and our cost of money went up. We knew that risk. We created a wall to keep CIT independent after we acquired it. Moody’s and S&P messed up bad with Enron. They became extra cautious and it was a big problem for our cost of money. We had to spin off CIT. That was the beginning of the end.”
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Ten

You Say You Want a Resolution

During a Tyco Board of Directors meeting on May 12, 1999, Dennis Kozlowski presented a proposal through which shareholders requested a change in the company’s governance policies. Shareholders wanted a majority of Tyco Directors to be independent—as “independence” was defined in the proposal.
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They wanted assurance that there would be no conflicts of interest, no personal stakes or relationships that might taint the judgment of Directors when they made decisions on Tyco’s behalf. The meeting minutes recorded that “it was the sense of the Board that it had in principle no objection to formally adopting a policy that a substantial majority of the Board should be independent directors and that indeed the Board had implemented such a policy. The Board noted, however, [the proposal] as submitted defined independence based on criteria that the Board felt were not appropriate for this purpose. Rather, the Board felt that the judgment regarding a director’s independence should be made by the Board based upon his particular circumstances rather than through the application of rigid criteria.”
2

In response to the proposal, the Board reported to shareholders that a substantial majority of Tyco Directors would be independent—so long as the Directors themselves could subjectively determine the meaning of independent on a case-by-case basis. The Directors passed a resolution in which they codified their
definition of “independence.”
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WHEREAS it is important for the Board of Directors of the Company to have a substantial degree of independence from management

NOW, THEREFORE, BE IT RESOLVED that the following Statement of Policy be, and it hereby is, adopted:

A substantial majority of the directors of the Company should be outside (non-management) directors. The degree of independence of an outside director
may be affected by many factors, including the personal stature of the director and any business relationship of the director with the Company or any business or personal relationship of the director with management. A director, or firm in which he has an interest, may sometimes be engaged to provide legal, consulting, accounting or other services to the Company, or a director may have an interest in a customer, supplier or business partner of the Company, or may at an earlier point in his career have been an employee or officer of the Company. Depending on their significance to the director and to the Company, such relationships may affect a director’s actual or perceived independence. Where such relationships exist, the Board of Directors should be mindful of them and make a judgment about a director’s independence based on his individual circumstances. This would involve consideration of whether the relationships are sufficiently significant as to interfere with the director’s exercise of independent judgment. If a particular director is not deemed sufficiently independent, the Board may nevertheless conclude that the individual’s membership on the Board remains highly desirable (as in the case of an inside director) in the context of the Board composed of a majority of directors with the requisite independence. The overall result should be a Board that, as a whole, represents the interests of shareholders with appropriate independence.
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In other words, the Board’s resolution allowed Directors to maintain a variety of financially lucrative relationships with Tyco and still label themselves independent. It allowed continuation of many conflicts of interest that existed for decades among the long-term members of the Tyco Board. Under the Board’s definition of “independence,” for example, Tyco’s legal work could continue to go to Director Josh Berman’s law firm and at the same time, Berman would be considered an independent Director. Berman, a former Tyco CEO, also maintained a full-time office in Tyco’s New York location, the company footed the costs of the office, and yet under the Board’s definition, Berman would still be considered independent.
5

Then Director John Fort, who like Berman was also a former CEO, continued to work out of his full-time office in Tyco’s Exeter, New Hampshire location for many years until he moved to Texas. Tyco paid the office expenses, and under the definition of “independence” he and his fellow Board members adopted in 1999, Fort could count himself an independent Director. When Fort was on the Board, there were also questions about a buyout firm in which Fort was an investor. The firm purchased $810 million worth of assets from Tyco in 1999, which raised concerns about conflicts of interest.
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However, under the newly adopted definition, Fort could still be considered independent.

Director Stephen Foss leased his aircraft, helicopters, and pilot services to Tyco, for which he received more than $750,000—on top of the Director’s fees he received from Tyco. In addition, Kozlowski said for years, Foss’s wife was the
real estate broker Tyco employees were directed to use for any relocation property purchases.

Longtime Tyco Director Richard Bodman took $5 million from CEO Dennis Kozlowski to invest in a private stock fund he managed and yet could call himself an independent Director. Kozlowski said he lost the vast majority of the $5 million he invested in Bodman’s fund. Director Frank Walsh held controlling interests in two firms that received more than $3.5 million for leasing aircraft and providing pilot services to Tyco between 1996 and 2000. There was a long list of Tyco Directors who benefited personally from selling services or leasing property to Tyco, and buying assets from or selling assets to the company. There were numerous real estate transactions in which Directors bought property from and sold property to Tyco. Directors solicited investments from officers and engaged in other business dealings between and among themselves—at the same time that they owed fiduciary duties to Tyco and its shareholders. Many financially beneficial relationships (beneficial to the Directors, not necessarily to Tyco) created clear and material conflicts of interest. There were too many blurred lines between personal matters and company business. But it was the way things had always been done at Tyco. The Tyco Directors’ definition of “independent” was patently self-serving and did nothing to protect Tyco shareholders.
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Other definitions of “independent” are in stark contrast to the one adopted by the Tyco Board in 1999. Other definitions recognize that directors who receive personal benefits from selling to or buying from the company to which they owe a duty of loyalty are
not
independent. For example, Section 301 of the Sarbanes-Oxley Act of 2002, which establishes the requirement that audit committees be composed of independent directors, states that in order to be considered “independent,” a director may
not
“(i) accept any consulting, advisory, or other compensatory fee from the [company]; or (ii) be an affiliated person of the [company] or any subsidiary thereof.”
8

Former Tyco director Stephen Foss testified as a witness for the prosecution during Kozlowski’s criminal trials. When he was cross-examined by defense attorneys, Foss was asked about payments Tyco Directors received from the company in addition to the fees they were paid for their duties as Directors. Foss was also questioned about a meeting on February 20, 2002 during which the Board approved a change in “its policy with respect to whether or not directors could get paid for services provided to the company other than in their role as directors.”
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The meeting minutes recorded that “[t]he Board expressed its policy regarding the compensation of independent directors by unanimously adopting a resolution that no independent director shall receive any payment for services rendered to, for or at the request of the company, other than the Directors’ fees received for his or her services as a director and the reimbursement of out of pocket expenses incurred in performing services as a director.”
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During his testimony, Foss confirmed that
the Board changed the policy and redefined independence in February of 2002 so that “directors knew
from that time forward
they could not accept money from Tyco other than the money they would get as remuneration for being directors and for their out of pocket expenses as directors.”
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The dramatic change to the long-protected policy was prompted by a payment made to Director Frank Walsh in 2001. That particular payment raised concerns among the Board members in January of 2002 and incited the rage of a handful of Directors. So why the change of policy? If it was wrong for a Director to accept a payment from the company in 2001, as some Directors insisted about the payment made to Walsh, if the payment to Walsh was a violation of company policy in 2001, why the need to change the policy in February of 2002? The actions and reactions of Directors related to an investment banking fee Walsh received were difficult to reconcile.

The root of the problem appeared to be perceived unfairness. A few members of the Tyco Board of Directors epitomized hypocrisy; they had for years received payments from Tyco in addition to their Directors’ fees. Was the payment to Frank Walsh any different than dozens, or perhaps hundreds of other payments the company made to Directors? There was only one significant difference. The Walsh payment was
big
—$20 million. Walsh received more than the others. One among them had pocketed more from the company’s coffers; one among them walked away with a greater personal financial benefit.

The reaction of the Tyco Board is perhaps best explained by the ultimatum game, an economic bargaining phenomenon first studied by economists Werner Güth, Rolf Schmittberger, and Bernd Schwarze in the early 1980s. Wharton Professor Adam Grant, in his 2013 book
Give and Take,
applied the ultimatum game to interpersonal relationships in a business organization. In the game, the “proposer” is given $100 and the authority to propose how to split the money between herself and a “responder.” After the proposer offers a split of the money, the responder decides whether to accept or reject the proposed split. If the responder accepts, the split is implemented and both keep the amounts proposed. If the responder rejects the proposed split, both players receive nothing.
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If our proposer decides to keep $80 for herself and offers $20 to the responder, studies show the responder will very likely reject the split. Rationally, it seems he would accept any amount offered. Wouldn’t it be better to have $20 than to walk away with nothing? But that’s not what happens most of the time. Responders will hurt themselves in order to hurt others they perceive as being financially unfair to them. Studies show the vast majority of responders will reject a split that favors the proposer by 80 percent or more.
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In our example, it costs the responder twenty bucks, but he is willing to forego the money to “punish” the proposer who tried to take more than she offered.

Some of the Directors on Tyco’s Board in January of 2002 were so angry about the unfairness they perceived in the Frank Walsh payment, they were willing to destroy their friends, their colleagues, the company, and even themselves in their quest to get even. To punish Frank Walsh for taking more than they took. To punish Dennis Kozlowski and Mark Swartz for paying Frank Walsh more than they were paid. Those Tyco Directors rejected the payment and made sure everyone walked away with nothing. In the spirit of revenge, they killed the goose that laid the golden eggs.

Eleven

When the CIT Hit the Fan

Frank Walsh, Jr., an investment banker by profession, joined the Tyco Board in 1992 after he was recommended to the Governance and Nominating Committee by Dennis Kozlowski. The two men knew each other through their connections to Seton Hall University, where each had a seat on the Board of Regents. As a member of the Tyco Board, Walsh served as Chairman of the Compensation Committee for several years and he was lead director from 2001 until 2002.
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When he became CEO in 1992, Dennis Kozlowski established the position of lead director, then a relatively new practice in corporate governance. According to a 2011 Harvard Business School (HBS) case study, “Kozlowski had become one of the first CEOs/chairman to have a lead director.” In the HBS case study, Kozlowski was quoted as saying, “I don’t want mushrooms [in the boardroom]. I want these guys to be in the foxhole with me.” The case study also shared Kozlowski’s rationale for adding a lead director to Tyco’s governance structure; he explained that the role would provide “a real good check and balance.”
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A federal judge who adjudicated the civil action Tyco filed against Frank Walsh years after Kozlowski appointed a lead director described the role more comprehensively when she opined that the lead director had “the responsibility for helping to coordinate the agenda of board meetings, the nomination of new directors, and the board’s review of the performance of the Chairman.”
3

In addition to creating the position of lead director, Kozlowski insisted on having a management liaison to the Board. “Our governance under Joe Gaziano and John Fort wasn’t as strong as it should have been,” Kozlowski explained, “so when I was named CEO and Chairman, I created the roles of lead director and management liaison to the Board. I thought it would improve the flow of information to the Board. It gave the Directors access to people they could contact directly and speak with regularly.”
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In recalling what he heard when former Tyco directors testified for the prosecution during both of his criminal trials, Kozlowski said, “For any of the Directors to say in court, under oath, that they didn’t have access to information is total and complete bullshit!” He insisted that “the Board had access to anyone or anything in the company.”
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But that’s not what the Directors said about the investment banking fee Frank Walsh received in 2001.

* * *

The Frank Walsh Investment Banking Fee

Dennis Kozlowski, the Tyco management team, and the Board of Directors had considered for quite some time the possibility of creating or acquiring a finance unit.
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When asked during Kozlowski’s second criminal trial why Tyco was interested in The CIT Group, Frank Walsh explained:

Tyco was being compared at the time favorably to General Electric Corporation. It was the configuration of the company, a group of industrial companies and so forth was viewed as very similar to G.E. and it was positive for the stock to have that view. A big part of General Electric’s business was their unit called G.E. Capital which was among other things in the finance business. So for several reasons, including that it was viewed as a logical business for Tyco to get into, also a number of Tyco companies did business with commercial finance companies financing their machinery or whatever it might be, and there were a number of potential so-called synergies or fits in that area so that was in the very general discussions the Board would have as to what new ideas might be worth pursuing. That type of business was identified and I think universally agreed as something logical for us to look at if the opportunity came along.”
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In mid-2000, Walsh told Tyco Directors during a brainstorming session in Bermuda that he had a connection to Al Gamper, then President and CEO of CIT. Walsh knew of the company and Gamper because “CIT was based in New Jersey not far from where I lived. Mr. Gamper lived nearby and over the years we had become friends from a variety of social church community activities, charitable things.”
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Once Walsh pointed Tyco in the direction of CIT, the Board expressed interest in the company, after which Tyco’s acquisition team spent a couple of months researching the commercial financing company. Kozlowski then called Walsh, told him CIT looked like an interesting target, and asked how best to proceed. In October of 2000, Walsh met with Gamper and pitched the idea of Tyco acquiring CIT. Immediately after the meeting, Walsh called Kozlowski to report what he learned. He recounted their conversation under oath during Kozlowski’s second trial. Walsh said:

I told him that the meeting had gone very well, that Al was potentially interested. He had several major threshold issues that would be potential problems that would have to be dealt with, but on balance he was open to the idea. I had gone to great length to show him the reasons why I thought it made sense from his point of view and his people’s, and he was—he indicated that—at that time their largest shareholder was a Japanese bank which owned about 20 percent of CIT and he indicated he wanted to run the thought by them. And he had a meeting coming up in Japan shortly thereafter, so that’s where we left it and I reported to Dennis [what] were initial concerns to Al so that Dennis and his people could look into them and develop responses.
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Walsh connected with Gamper again after his return from Japan. He arranged and attended a meeting with Kozlowski and Gamper at a restaurant in Florham Park, New Jersey in December of 2000. Kozlowski said after the men exchanged pleasantries, they discussed the possibility of joining CIT with Tyco. During his trial testimony, Kozlowski recalled that “Al Gamper raised some concerns and those concerns involved rating agencies . . . the agencies that rate his credit which becomes a function of how much money he has to pay or CIT has to pay for money, and just wondered if the rating agencies would look negatively towards CIT being owned by an industrial company.”
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Kozlowski explained for the jury the significance of a corporation’s credit ratings. “Rating agencies are companies like Standard and Poor’s and Moody’s. There are others. [They] assess the risks of a company’s credit and they rate from triple A to double A, a whole rating system. The higher your rating, the cheaper you borrow [money]. The lower your rating, the [more] you have to pay because you are considered to be riskier and CIT had a fairly good rating; I think double A or someplace around there.” Kozlowski continued by explaining that “[i]f you were to jeopardize that rating, your costs to run your business would go up substantially and could hurt your profits and hurt your ability to function as a business.”
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Gamper was right to raise concerns about the impact a combination with Tyco would have on CIT’s ratings.

Walsh said, “[After the meeting] I drove Dennis back to the airport, we had a discussion before he left to go where ever he was going, and we agreed in our discussion that the conversation had gone very well, and that, you know, we were—it was a very interesting prospect. And Dennis volunteered at the time that should the transaction—should a transaction ultimately be accomplished that I should be entitled to an investment banking fee for the work I had done teeing it up, so to speak, getting it to that point.”
12
Kozlowski’s testimony was consistent with Walsh’s recollection.

The acquisition team proceeded and a vote of the Tyco Board gave Kozlowski authority to move forward with the deal.
13
Walsh did not vote yea or nay—he was not present at the meeting when the Board approved the CIT acquisition. The
minutes from that meeting did not indicate whether other Directors knew, or did not know, of the fee that Kozlowski and Walsh had tentatively discussed.

CIT and Tyco reached and announced a merger agreement in March of 2001, after which Walsh said he revisited with Kozlowski the possibility of receiving an investment banking fee for the role he played in bringing CIT to Tyco. Walsh said he and Kozlowski “had a brief discussion where I said I’d like to keep that fee
discussion—keep that fee discussion we had had on the table and [Kozlowski] confirmed that it had never been off the table, I think were his words and that’s where things stood at that time.”
14

During Kozlowski’s criminal trial, Walsh confirmed that he reviewed the Form S-4 Registration Statement Tyco prepared in March of 2001. An S-4 is a form filed with the SEC—it is a public disclosure made as part of a plan of merger.
15
Walsh said the S-4 specifically disclosed investment banking fees that would be paid to Lehman Brothers and Goldman Sachs, but there was no indication that he would receive a fee. However, Walsh explained that when Tyco prepared the S-4, “there was no firm fee agreement. There had been that initial discussion and a subsequent discussion between Dennis and me that we had this fee discussion to deal with at some point, but there was no agreement.” After he reviewed the SEC disclosures, Walsh spoke to Mark Swartz, who assured him that his fee had been properly disclosed in Tyco’s financial statements. Swartz specifically referred to a
pro forma
balance sheet which reflected expenses Tyco would incur during the merger, including investment banking fees.
16
Years later in the civil action Tyco brought against Walsh, Swartz’s assertion was confirmed when Federal Judge Denise L. Cote stated in her findings of fact that “Tyco recorded the entire $20 million payment on its books as a cost related to the acquisition of CIT.”
17

Tyco completed the CIT acquisition in June of 2001. Later that summer, Walsh reminded Kozlowski of the fee he was owed for his work in facilitating the deal. Kozlowski said Walsh wanted his investment banking fee calculated using the same scale used to calculate the fees paid to Goldman Sachs and Lehman Brothers; Walsh expected a fee of around $40 million.
18
When he testified during Kozlowski’s trial, Walsh described the negotiation of his fee as “ . . . a cordial civil discussion and the objective was to come up with something that was fair and market, the kind of thing that was conventional for a 10 billion dollar transaction.”
19
Kozlowski researched the standard fee that would be paid for the services Walsh rendered to the company, after which he met with Walsh in July of 2001, at the same New Jersey restaurant where Walsh took him to meet Al Gamper several months earlier, and negotiated what both men believed to be a reasonable, arm’s-length fee—considering what Tyco would have paid an investment bank to perform the same services in a $10 billion acquisition. Kozlowski authorized a $10 million payment to Frank Walsh and a $10 million charitable contribution to a
charity of Walsh’s choosing.
20
The $10 million payment to Walsh was one tenth of one percent (0.1%) of the $10 billion transaction.

On its face, a $10 million fee seems outrageous for the work Walsh did for Tyco to facilitate the CIT acquisition. But relative to the market rate investment bankers receive for referrals, or finder’s fees, 0.1 percent is low. In 2012, an investment banker filed a civil action demanding a one percent finder’s fee for initiating contact between Apple and Anobit that resulted in a $390 million acquisition. The investment banker expected between $3.9 million and $4.5 million, depending on applicable currency exchange rates. In a 2005
Businessweek
article titled “The Facts on Finder’s Fees,” an investment banker said he would ask for one percent of the selling price but would be happy to settle for less.
21

After Kozlowski and Walsh agreed on the 0.1 percent fee (0.2 percent, taking into account the $10 million charitable contribution), there were a series of faxes and communications between Walsh and Tyco—faxes addressed to then CFO Mark Swartz and faxes sent from Tyco to Walsh requesting an invoice for his services. Walsh provided an invoice on July 18, 2001. It read, “For investment banking services rendered in connection with the acquisition of The CIT Group Inc. . . . $10,000,000.”
22
He also provided Tyco with information about the charity to which he designated the $10 million contribution.
23
After the charitable contribution was made, the organization provided Tyco a receipt reflecting the $10 million contribution and containing requisite tax information. The receipt was addressed and sent to Michael Robinson, then Treasurer of Tyco.
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Walsh testified that when he and Kozlowski met in July of 2001, Kozlowski “indicated he would prefer to keep the matter between the three of us; Mark, Dennis and myself.” When Kozlowski testified, his recollection was somewhat different than Walsh’s—but comparing the two men’s versions of the conversation, it’s easy to understand how there may have been some degree of miscommunication. When testifying in his own defense, Kozlowski was asked by his attorney Stephen Kaufman, “When you’re having these discussions with him about the deal, did you ever say to him, Frank, don’t tell anyone about the fee?” Kozlowski replied:

In July when I was having discussions with Frank and we were negotiating a fee, Frank suggested that he speak to other investment banks to get some guidance as to what an appropriate fee would be. I asked Frank that he keep our discussion on the fee during that time of the negotiations,
and the negotiations only,
I asked that he keep that between us. Now my concern there was if he were to go out and ask Goldman Sachs or Lehman Brothers or First Boston, their motivation is to drive up the fee. Because when an investment bank comes in to you to say we’re going to do a nine, ten billion dollar—when an investment bank comes in and negotiates
a fee, they show you what the last high fee was, what the high water mark was, so anybody Frank would be going to for advice would be very much motivated to get as much money as he possibly could.
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