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Tyco International – Fraud Investigation

Tyco International Limited is a global diversified Company having operations in more than 100 countries. Its major businesses include electrical components, fire detection and suppression system and security systems.

In year 2002, a massive fraud by the executive officers of the Company was unveiled. The report discusses the various ways in which the fraud was executed. Parties which were held accountable for the fraud and penalties levied on them. It further discusses the non-compliance of various GAAPs and GAASs and the motive for committing the fraud. It also recommends certain ways to reduce the happening of such incidents in future. Such incidents impact the overall reputation of the accounting profession and hence it becomes important to learn lessons and to apply the same so that it can be avoided in the future.

Key events

The key events that took place in discovering the fraud were as follows: 

  1. An investor newsletter raised concerns on the Company’s acquisition accounting practices after which the Company requested Securities and Exchange Commission (SEC) to for an informal inquiry on the books of the Company (Dini, 2000). The inquiry started in 1999 and was closed in 2000. It was mentioned in the report that a large number of documents as requested by SEC were not submitted to them at the time of closing the inquiry. No enforcement action was recommended to the Commission (Hilzenrath, 2002).
  1. In January 2002, a tip was received regarding an illegal transaction taking place in the Company and the financial accounts came under review (Tyco Fraud InfoCenter, 2006). The transaction was payment of $20 million from the Company to its Director to help in broker an acquisition deal without disclosing the same to rest of the Board or the shareholders (Sorkin, 2002).
  2. In June 2002, the Chief Executive Officer (CEO) of the Company resigned just before he was investigated for tax evasion on some expensive art purchases which were purchased from the Company funds. (Tyco Fraud InfoCenter, 2006).
  1. In September 2002, the CEO, Chief Financial Officer (CFO) and Chief Corporate Counsel (CCC) of the Company were formally charged of civil fraud, by the SEC (Tyco Fraud InfoCenter, 2006).
  1. In January 2003, a Consolidated Securities Class Action Complaint was filed against the Company for the period 13th December, 1999 and 7th June, 2002 (Tyco International Ltd. Securities Class Action Settlement, 2011).

Facts of the case

The facts of the case are as follows:

  • Unlawful and undisclosed payment of $20 million made to the Company’s lead director as finder’s fees for the acquisition of CIT. The compensation was concealed from the other Board members and the shareholders.
  • Unlawful and undisclosed compensation paid to Officers: As per SEC regulations the Company is required to make periodic and detailed disclosures regarding the compensation paid, any loans given and any other related party transactions with their directors and officers. The various irregularities were observed in the same.
  • Large non-interest bearing relocation loans were unlawfully paid to some officers of the Company under the New York and Florida Relocation Schemes, which were not approved by the Company’s Board of Directors.
  • The CEO falsely represented that the Board pursuant to the successful IPO of one of the Company’s subsidiary TyCom have decided to forgive all the relocation loans under the Florida relocation scheme by grossing up the benefits. The expense was accounted in three different accounts i.e. TyCom offering expense, Accrued Federal Income Tax (Balance Sheet) and Accrued G&A expenses (Balance Sheet) to conceal the unlawful payments.
  • Sixteen executives of the Company were paid additional bonuses pursuant to the successful divestiture of ADT Automotive business. It was falsely represented by the CEO that the bonus amount is reviewed and approved by the Chairman of the Company’s Compensation Committee. The bonus amount was offset against the unrelated gains accrued on the disposition of ADT.
  • The Company reported false gain of the swap of TyCom shares with Flag Telecom Holdings Limited’s equity. Pursuant to the gain reported certain officers and directors of the Company received accelerated vesting of restricted shares.
  • The Company had a Key Employee Loan (KEL) Program which was intended to provide loans on favorable terms to its key personnel so that they can pay any taxes due on the vesting of restricted shares. This loan program was improperly used for other purposes than payment of taxes due and was borrowed in excess of the limit allowed under the scheme.
  • The compensation of Chief Corporate Counsel was unlawful and undisclosed and not approved by the Compensation Committee and the Board of Directors.
  • In 2002, a Retention Agreement for the Chief Corporate Counsel was agreed and executed. After few weeks the same was reported to the Compensation Committee in form of a term sheet from which many important terms were omitted.
  • The CEO and CFO of the Company misappropriated millions of dollars from the Company for their personal use. The officers compensation disclosed to the shareholders were materially misleading.
  • Misleading financial results: The Company has reported materially misleading financial results during the complaint period. The Company restated its financial results for the all financial years starting from 1998 to 2002.
  • The Company employed aggressive accounting approaches in acquisition accounting, classification of expenses as non-recurring, depreciation and amortization policy, revenue recognition and capitalization.
  • The Company made accounting errors in the ADT security business and was consistently reporting inflated financial results. The Company changed the way in which business was done i.e. instead of buying security contracts from dealers it started buying the customers and demanded payment from its dealers. The amount received from the dealers was reduced from the selling and general expense head and hence reduced the overall cost. The amount paid was treated as a capital expenditure and was written off over ten years.
  • The Company tried to manipulate the financial results of the acquired entities to inflate its own results. The same was done by asking the entity being acquired to delay its revenue generating activities so that the sales could be recorded post acquisition and similarly to accelerate its payment of expenses so that expenses will be on a lower side post acquisition.
  • Improper accounting and financial engineering used in the acquisition of Carlisle Plastics, Sigma Circuits, U.S. Surgical Corporation, Raychem, Mallinckrodt, Simplex, Sensormatic, CIT etc. led to inflated results of the Company.
  • Adequate procedures to eliminate intra-company and inter-company revenue were not maintained by the Company at its subsidiary EarthTech due to which there was double counting of some of the revenue.

False and misleading disclosures regarding the above transactions were made in various forms filed with SEC.

(United State District Court District of New Hampshire, 2005)

Accountability of parties and penalties imposed

  1. Tyco International Limited: The fraud happened in the Company hence it has been made accountable. Tyco agreed to pay $2.975 billion for the settlement of class action lawsuits filed against it (Klayman, 2007). The settlement seems small in comparison to the loss of $10 billion incurred by the investors who invested in the Company during the fraud period (Guerrera, 2007).
  1. Dennis Kozlowski: Kozlowski was the former CEO of the Company who was the main accused in the case. He was convicted of committing fraud, conspiracy, misleading the Company and the shareholders, securities fraud and fabricating business records. He got a prison sentence of 8 1/3 to 25 years. He was ordered to pay $70 million in fines and $97 million in restitution. He also settled a state tax case for $21.2 million for art and other purchases made by him. (Associated Press, 2006)

Tyco sued Kozlowski for an amount of $505.8 million which were the benefits provided to him by the Company for the period 1995 to 2002, however only a payment of $167 million was ordered (Stempel, 2010).

The former CEO and CFO of the Company were accused of paying themselves more than $150 million in illegal bonuses, manipulating the Company financials and forgiving the loans given to them (Associated Press, 2005). Swartz was ordered to pay $72.6 million.

  1. Mark A. Belnick: Belnick was the former Chief Corporate Counsel of Tyco and was convicted to have taken interest free loans of $14.5 million and unauthorized bonus of $17 million. The jury found Belnick not guilty of the charges. (Glater, 2004)
  1. PricewaterhouseCoopers (PWC): PWC was the auditors of the Company during the period of fraud. They were made responsible in the case they were not able to identify the frauds, irregularities in accounting and violated GAAP and GAAS while auditing the accounts. PWC agreed to settle the case by paying $225 million to the shareholders of the Company (Guerrera, 2007).  
  1. Frank E. Walsh: Walsh was the former ‘Lead Director’ of the Company’s Board. He was convicted of receiving an improper payment of $20 million as finder fees for one of the acquisition. He pleaded guilty and agreed to pay $20 million plus a $2.5 million fine as settlement to avoid the prison sentence. (Sorkin, 2002)
  1. Audit Committee: The Audit Committee of the Company was also made a defendant in the case as they were able to exercise control over the Company operation, however failed to discharge its responsibilities in an appropriate manner.

Accounting and auditing issues-GAAP

  1. Acquisition accounting: The Company used aggressive accounting approach in case of acquisitions. For example, the Company was utilizing inflated reserves created during acquisitions and were charging the expenses to these reserves to inflate its financial results. The Company violated opinion no. 22 of the Accounting Principles Board (APB) by not disclosing the aggressive interpretations applied to the GAAP provisions.
  1. Disclosures regarding compensation and related party transactions: The Company failed to adhere to various disclosure requirements regarding the compensation paid to key managerial personnel under ASC 850 & IAS 24 – Related party disclosures and SEC disclosure requirement under SAB Topic 4E.
  1. Inflated stockholders’ equity: The Company didn’t reduce the amounts owned by the Company’s officers from the stockholders’ equity as required as per SEC disclosure requirements under SAB Topic 4G. This led to reporting of inflated stockholders’ equity.

(United State District Court District of New Hampshire, 2005)

  1. Purchase Accounting Charges: At one of the Company’s subsidiary EarthTech an amount of $10.6 million of expenses were wrongly charged against purchase accounting accruals. The same was identified by the auditors and was asked to flow it through operating expenses. The Company accepted the same, however due to the unexpected charge it reversed $10.6 million of accruals in other accruals and reserves to eliminate the impact (Securities and Exchange Commission, 2003). The Company violated FASB concept statement No. 2 paragraph 78 which states that the financial statements must be free of bias. (Financial Accounting Standards Board, 1980)
  1. Use of unallocated reserves: The Company was using its unallocated reserves to offset unexpected expenses and compensation charges (Securities and Exchange Commission, 2003).

GAAS

  1. The audit opinion of PWC stated that the financial statements were prepared as per GAAP. However, basis the points discussed above the same was falsely represented and hence, PWC violated the GAAS Standard of Reporting No. 1.
  1. GAAS General Standard No. 2 requires the auditor to be independent in all matters relating to the audit. However, the audit firm ignored the various red flags over the period of many years that the financial statements were not prepared as per GAAP, as Tyco was one of its biggest clients.
  1. No adverse opinion was stated by the auditors of the Company regarding the preparation of financial statements not in accordance with GAAP and hence violated the GAAS Standard of Reporting No. 4.
  1. The audit firm failed to plan their audit adequately to find out the improprieties of the management. The procedures used were not reasonably designed to detect any existence of fraud and irregularities. There was a violation of SAS No. 1, SAS No. 53, AU 230 and GAAS General Standard No. 3.
  1. The auditors failed to review the internal controls including managerial and financial controls of the Company. If the internal controls are found deficient the scope of the audit is expanded. The auditors violated GAAS Standard of Field Work No. 2.
  1. As per AU 334 auditors need to examine the related party transactions and ensure that these transactions are adequately disclosed. There is a clear case of violation by the auditors.

(United State District Court District of New Hampshire, 2005)

Cause of the issue

  1. Unethical leadership: The former CEO of the Company Kozlowski was the main culprit behind the fraud. He used his position to illegally benefit from the Company’s funds. He involved various top level officers and directors and persuaded them to keep silent about his unethical activities.
  1. Unethical subordinates: The former CEO recruited people to support his illegal activities in the organization. He got many officers as well as directors involved in his unethical business practices. The subordinates could have raised the flag and reported the irregularities, however, they chose to remain silent in exchange of hefty bonuses, interest free loan etc. at the expense of the Company.
  1. Unethical auditors: PWC who was responsible for the auditing of the Company didn’t discharge its responsibilities in an ethical manner. The audit firm failed to identify the various irregularities even when there were many red flags. Due to the auditors negligence the management was able to perform the fraud for such a long time.

(Romero, 2017) 

Mistakes/ misrepresentations made by the defendants

This is a clear case of fraud by top executives of the Company who utilized Company’s funds for personal gain. The fraud took place over several financial years and was not uncovered during various Audit Committee meetings, Compensation Committee meetings, Board of Directors meeting etc. which shows that there was gross negligence in operating the Company. Further, even the audit was not able to uncover the irregularities and illegal acts of the officers.

The auditor, PWC was ready to defend the class action lawsuit; however the cost of defense made settlement a lucrative choice (Guerrera, 2007). 

Recommendations

Audit Strategy

  1. Regular risk assessment: It is the responsibility of the auditor to ensure reasonable assurance that the financial statements are not materially misstated. However, this should not be a one-time activity, basis the new information received, risk-assessment should be performed regularly and the audit strategy must be changed if there is any change in circumstances.
  1. Flexibility: Due to new information found during the field work it is possible that the audit procedures need to be modified. The audit strategy must be flexible enough to incorporate the changes required.
  1. Internal and managerial controls: While preparing the audit strategy due care must be given to the internal control and managerial controls in the organization and their impact on the financial statements. This helps in identifying major risk factors which may lead to fraud or misstatements.

Audit Program

  1. Detailed: The audit program must be detailed and should ensure all audit evidence is collected and documented in the process. The working papers including the audit program can be used as evidence in case there is a charge of negligence.
  1. Flexibility: A good audit strategy keeps on re-evaluating the risks and internal controls which may lead to change in the scope of the audit. The audit program must be flexible enough to incorporate the change in audit strategy effortlessly.

Other effective measures

  1. Rotation of auditors: In the current case the Company auditors were the same for many years. The auditors must be rotated by the Company periodically to ensure no such fraud or misrepresentations keep on happening in the Company.
  1. Rotation of the engagement partner: The audit firm must periodically rotate the engagement partner in an audit to ensure independence of the audit.

Conclusion

It is clear from the facts of the case that the fraud that was continuing from several years was unable to be identified due to negligence on part of the management committees of the Company and the Auditors. To ensure that such incidents don’t take place; the Company should address any red flags raised in a timely manner; there should be a code of ethics that should be binding on each and every employee, a vigilant eye must be kept on any insider stock sales, strict internal control measures should be adhered to and appointing auditors who are independent and are periodically changed.   

Such incidents put the Company’s operations at risk, gravely impact the Company’s stock price and its market capitalization and also impact the reputation and trust in the accounting profession. Hence it is important that adequate steps are taken in the first place to avoid such incidents.