L. Dennis Kozlowski, who stepped down this week as the CEO of Tyco International, loves art – not wisely but too well. Last fall he paid $13.1 million for paintings by Renoir, Monet and other artists, but instead of paying the $1 million in sales tax due on his purchases, he allegedly had empty crates shipped to Tyco’s offices in Exeter, N.H., while the paintings made their way to his Manhattan apartment. Kozlowski was indicted on June 4 for sales tax evasion by a grand jury in New York City. Should that be called the art of the steal?
This dramatic development comes at a time when Tyco – a global conglomerate with $36 billion in revenues – already faces a shaky future. The company has some $23 billion in debt, and it has lost more than $80 billion in market value this year. The stock price, which stood at $60 per share last December, now is less than $20. After Kozlowski’s departure, John F. Fort, a former Tyco chief, has taken charge while the search continues for a new CEO.
What can be learned from Tyco’s meltdown? Professors at Wharton say that in addition to obvious implications about the need for ethical corporate leadership, Tyco teaches important lessons about the importance of independent corporate governance as well as the ability – or inability – of conglomerates such as Tyco to deliver shareholder value.
Harbir Singh, a management professor at Wharton and co-director of the school’s Mack Center for Technological Innovation, points out that Kozlowski’s ethical – and possibly criminal – violations in personal financial dealings raise questions about “how he may have functioned in his professional life.” An investigation is already underway into Tyco’s accounting practices. As such, one of Fort’s top priorities should be to attempt to restore credibility. “The company must revamp corporate governance,” Singh says. “Fort should reorganize the board to include a large number of outsiders, including those who have a clear reputation for autonomy. It may be difficult to attract people during this crisis, but Tyco should try. Restoring credibility will require higher levels of disclosure and greater transparency.”
Michael Useem, director of Wharton’s Center for Leadership and Change, also believes that reforming corporate governance is crucial at Tyco and also at other companies. Commenting in the Wall Street Journal a day after Kozlowski’s indictment, (“What Tyco Tells Us,” Wall Street Journal, June 5), Useem points out that at Tyco “the future of a company with more than 200,000 employees and $32 billion in investors’ capital lies squarely in the boardroom. Let’s hope that the board is up to the task.”
Useem points out in his Journal article that the “best of reforms could go a long way in averting accounting disasters and ‘Enronitis,’ or to meeting the challenges of executive succession at companies like Tyco but too much of a good thing would not be wonderful. We must guard now against measures that, in trying to placate the public, become counter-productive for business.”
As an example of such a measure, Useem points to a proposal by the New York Stock Exchange, which is “announcing new regulations determining how listed companies must structure their boards.” While Useem agrees with many of the NYSE’s suggested changes, he explains that one that is well off the mark is “a new provision under which non-executive directors would have to meet regularly without management to assess executives.”
Why should this be a problem? “While it has long been common practice for outside directors to meet separately in succession planning and compensation reviews, formalizing such arrangements would create strains. Requiring routine meetings of outside directors will invariably drive a wedge between management and the board. Instead of a high-octane team at the top, we run the risk of dividing the board into a sub-squad and a police dog. Company governance should be a matter of building an enterprise to last, and for this the chief executive must be an integral part of any board, not isolated from the independent majority on it,” Useem writes.
In addition to these implications on the corporate governance front, Tyco also demonstrates the limitations of conglomerates, according to Robert E. Mittelstaedt, Jr., vice dean of Wharton’s Aresty Institute of Executive Education. In a recent article that he co-authored, (“Manager’s Journal: The Whole is Less Than the Sum of Its Parts,” Wall Street Journal, May 7), Mittelstaedt argues that Tyco’s predicament raises questions about whether conglomerates are really equipped to build shareholder value.
“In Tyco’s case, for much of the past decade, becoming a conglomerate and building shareholder value seemed to go together,” the article states. “The company launched an aggressive acquisition drive after Kozlowski became its boss in 1992, taking over more than 200 companies in less than 10 years. In the process, Tyco’s revenues went from $5 billion in 1995 to $36 billion in 2001, and shareholder wealth seemingly multiplied.” Now, of course, most of that wealth has vanished.
Why? The answer, according to Mittelstaedt, lies in what compels companies like Tyco to go on acquisition binges and turn themselves into conglomerates. “The economic rationale usually lies in the conglomerate’s ability to create value through scale. But they do this differently than companies that specialize in specific industries. When one widget maker acquires another, it can usually integrate operations to drive value creation. Conglomerates don’t have that sort of overlap,” he states in the Journal article.
“Advocates claim that conglomerates can slash their cost of money by creating internal capital markets and diversify risk by being active in several industries. But in practice, a conglomerate’s ability to realize these lofty goals depends on how well it does two things. The first is managing its financial resources – particularly its cost of capital – in a way that prevents overall shareholder value from evaporating as market conditions change. The second is managing human resources to keep top performers productively engaged.”
Mittelstaedt believes that although some conglomerates that manage money and manage people well do succeed, few actually conglomerates make it. Most of them tend to run into trouble – and that has also been the case with Tyco. “The market is reacting to the fact that Tyco didn’t add enough value when it acquired the many companies in its arsenal,” Mittelstaedt states. “Maybe the best way for investors to have seen such combinations would have been only in the context of their own portfolios.”
Singh, too, questions Tyco’s strategy of conglomeration. “Unrelated diversifiers generally under-perform,” he says. “The only exceptions are in parts of the world where capital markets are tight and where managerial talent is hard to find. Tyco seemed to be running against the grain for a while, but those gains seem to have been temporary.”
What should Fort do about Tyco’s conglomeration? Singh recommends that if possible, he should try not to sell off pieces of Tyco in an attempt to solve the company’s immediate financial problems. “The current value of the stock is below that of the company’s physical assets,” he says. “It makes sense for Tyco to hold on to its assets now and sell them later. If Fort tries to sell Tyco’s assets now, shareholders will lose their shirts. It will result in more value being lost.”