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.