On Monday, Dec. 30, mega-lawyer David Boies issued his second report on the financial misdeeds of Tyco International Ltd. during the reign of former CEO Dennis Kozlowski. Boies' first report, filed last September, introduced the $15,000 umbrella stand into the lexicon of greed. This report, conveniently timed to vanish into the holiday merriment, is less sensational, a dissection of Tyco's accounting practices. Yet the sequel is in some ways more troubling, not so much for what it reveals about Tyco's slimy bookkeeping in the past, as for what it hints about Tyco's present and future—that the conglomerate's new management team is still hoping to confuse investors and investigators.
The accounting report is designed to give the impression of independence and thoroughness. The company would have the public believe that Boies functioned more like an independent prosecutor than an in-house counsel. His team, Tyco noted, had unfettered access to Tyco records and personnel, "had no fixed or limited budget," and could review whatever it wanted to.
And like Kenneth Starr, Boies spared no expense. Twenty-five of his lawyers and 100 Ernst & Young accountants trotted the globe, interviewing Tyco employees at 45 operating units in 13 countries. "In total, more than 15,000 lawyer hours and about 50,000 accountant hours were devoted to the Boies Firm's Phase 2 review and analysis." A crude estimate—$300 per lawyer hour and $200 per accountant hour—adds up to $15 million in costs, before expenses like 20-cent-per-page copies and airline tickets.
It's important to remember that Boies' clients were not shareholders but Tyco's current executives, and the report, which you can read here, very much serves their interests. The 33-page document is calibrated carefully to make Kozlowski and his team look maximally bad—but not so bad that they turned the company into a criminal enterprise.
The report begins with a tone of Clintonian self-pity. "Few, if any, major companies have ever been subjected to the corporate governance and accounting scrutiny entailed in Phase 2 of the Boies Firm's work." (Of course, few, if any, have so richly deserved it.) But in fact the investigation was less than entirely thorough. Despite Boies' long leash, "the Company has not sought to go back and identify every accounting decision and every corporate act over a multi-year period that was wrong or questionable." Tyco's operations are simply too sprawling for that Herculean task.
Boies and his gang did turn up of plenty of no-nos. Tyco routinely used aggressive, and frequently inappropriate, accounting techniques to make its profits look better. The company encouraged acquisition targets to tamp down results before deals closed so that they could show quick profit hikes once in the Tyco fold. Loan and bonus programs were abused, charitable donations were given to non-charities, and one unit spent $113,000 on 10 days of hotel accommodations for Kozlowski in London. To correct all the errors that Boies and company ferreted out, Tyco will reduce fiscal 2002 earnings by $382 million. (For 2002, the company reported a net loss of $9.4 billion.)
In constructing the report, Boies and Tyco had to walk a fine line. They had to acknowledge the obvious misdeeds and lay bare some of what the Securities and Exchange Commission, the Justice Department, the Manhattan district attorney, the Internal Revenue Service, and other lawyers suing Tyco may discover anyway. At the same time, they attempted to quarantine the misdeeds to the past and subtly to make the case that while this stuff was bad, it is not necessarily worthy of indictment.
And so, Boies concludes, "There was no significant or systemic fraud affecting the Company's prior financial statements." What's more, "the incorrect accounting entries and treatments are not individually or in the aggregate material to the overall financial statements of the Company."
This begs several questions. Since when is a $382 million earnings restatement "not material"? Omitting "material information" is a violation of accounting standards and SEC rules and hence exposes a company to greater potential liability. Frequently, material information is in the eye of the beholder. But the paper trail makes it difficult to believe that the $382 million—a sum equal to one-tenth the company's 2001 profits—is merely a series of coincidental rounding errors and honest goofs.
Whether there was "significant or systemic fraud" is similarly a matter for legal authorities to determine. But the evidence that Boies amasses in this report—admittedly less than comprehensive—seems a bit at odds with the exculpatory conclusion. Of course, the existence of such fraud would place the company at the greater risk of a civil or criminal indictment and transform Tyco from victim into a corrupt enterprise. That fate, which befell Arthur Andersen, is what Tyco's current management wishes to avoid above all.
Tyco's stock rallied about 10 percent on the release of the report. Investors apparently were relieved that Boies hadn't found anything really bad. And, as we are always told, the stock market is a futures market, not a past market. But Tyco's future may not look so bright. On Tuesday, the New York Times questioned the way new CEO Ed Breen chose to report earnings. And TheStreet.com's Peter Eavis makes a compelling case for why Tyco's stock was overvalued, even before its recent rally.
Breen has tried to set a new tone at Tyco. But the company's attempt to spin the results of Boies' admittedly incomplete investigation into a clean slate signals that Tyco may still be trying to put one over on shareholders.