Cut from Whole Cloth
The expression “cut from whole cloth” was originally used to describe clothing the material for which was cut from a run of fabric taken straight from the loom—it was whole and had never been used for another purpose. Clothing that was cut from whole cloth was special. It was not seamed or structurally weak, but was well made and with integrity that set it apart from less valuable garments that were pieced together from remnants or from the repurposing of tattered cloth.
During the 1800s, tailors began advertising clothing as cut from whole cloth even though the claims were untrue—the clothing in fact was made from old fabric that was cut and creatively pieced together so it appeared to be of high quality when in fact it was weak and lacked structural integrity. The tailors’ deceptive claims were fictitious and misleading, and their goods lacked integrity. Thus the phrase “cut from whole cloth” came to mean a fiction, a falsehood—a deceptive story represented as true, but when examined closely, was found to have no integrity.
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In an interview she provided for a 2011 Harvard Business School case study, former Tyco Director Wendy Lane, who was a member of the Board’s Audit Committee in 2001 and 2002, spoke of the Board’s and her own reliance on independent audits. Kozlowski said that he, like Lane and the Board, relied greatly on the PricewaterhouseCoopers (PwC) audits each year. “We employed highly-paid professionals—accountants and attorneys. The services cost us tens of millions of dollars every year. Of course I relied greatly on the results of the audits. I met with the PwC people every quarter. I believed they would inform us if anything was being done wrong. They didn’t find anything—they never found anything wrong,” Kozlowski recalled.1
During his testimony during the second criminal trial, former Tyco SVP Mark Foley confirmed that Tyco paid PwC more than $56 million in 2000 and more than $51 million in 2001—two of the years during which the questioned bonuses were paid.2 In July of 2007, PwC settled a class action lawsuit brought by Tyco shareholders as a result of the scandal. PwC agreed to pay $225 million but admitted no wrongdoing or failures in performing Tyco audits. When the firm settled with shareholders, PwC spokesman David Nestor said that the firm had been “prepared to continue to defend all aspects of its work” but that the cost of doing so “made settlement the sensible choice.”3 PwC had to settle. The firm had little solid ground to stand on after Kozlowski and Swartz were convicted of a long list of felonies. Wendy Lane stated that “there was no indication that anything was wrong. We had 80% of what would later be required with Sarbanes-Oxley. The accountants and internal controllers said everything was in order.” She also said, “There were not the red flags you would have expected.”4
Perhaps there was nothing to see, nothing to catch. Maybe there were no red flags. It’s possible, maybe even likely that there was nothing wrong. It seems the entire case was cut from whole cloth.
The Foolish Use of KELP
Very few facts in the case were in dispute, so why did the trials require a combined eleven months to present evidence? Throughout both trials, the juries were subjected to voluminous testimony and a mass of other evidence, much of which seemed unnecessary because it was either unrelated to the charged offenses or it was not in dispute. For example, there was lengthy and detailed testimony about how, when, and why Kozlowski authorized the purchase of the Tyco apartment at 950 Fifth Avenue. Why bring in witnesses to go through the accounting process? The journal entries? Why bring in the broker who sold the apartment? Why bring in the housekeeper who cleaned it? Why was there testimony about how often Kozlowski and his wife slept there? Kozlowski never once disputed that Tyco purchased the apartment. Not a single witness disputed it. He never claimed that he owned the apartment. More relevantly, he wasn’t charged with stealing the money that paid for the apartment. None of the charges had anything to do with the purchase or use of the Tyco apartment. Yet the jury heard volumes of evidence about the place. Tyco, the DA, and hundreds of media outlets used the fixtures the decorator chose for the apartment to ridicule, chastise, and judge Kozlowski’s lifestyle. But there were no criminal charges related to the apartment, the doggy umbrella stand, or the $6,000 shower curtain.
The same is true of the birthday party. The jury saw video and photos of the Roman orgy–themed event. They heard that Tyco paid for about half of the expenses related to Sardinia events. Yet Kozlowski wasn’t charged with stealing that money.
The prosecution did a masterful job of muddying the waters with irrelevant and explosive evidence of the spending habits of a newly wealthy business executive. The sensational details definitely helped them paint an unflattering picture for the jury.
Unfortunately for Kozlowski, he had made it quite easy for prosecutors.
Kozlowski was not charged with any crimes related to his use of Tyco’s Key Employee Loan Program (KELP) or the relocation loan program—other than paying down or paying off his loans with unapproved bonuses. But his KELP loans and other loans he received from the company probably caused him more harm than anything else presented during the criminal trials.
Kozlowski used KELP and relocation loans long before he was Tyco’s CEO. The loan programs were in place under his predecessor. The primary purpose of KELP was to allow employees to borrow funds from the company to satisfy the tax liability related to the vesting of restricted shares of Tyco stock. The vesting of Tyco restricted shares was a taxable event—it was income. The program was established to encourage executives like Kozlowski to retain their ownership of Tyco stock instead of selling it to satisfy the tax liability that arose as a result of vesting. KELP allowed employees to borrow up to 50 percent of the amount of shares that vested. For example, if an employee’s restricted shares were worth $10 million on the day they vested, that employee could borrow $5 million from KELP. The employee had to immediately give enough of those funds to Tyco to cover the related payroll withholding required, but the remainder went to the employee. The wisdom of such a policy is subject to the business judgment of the board that adopts the policy, and subsequent boards that allow it to continue.
Kozlowski made a serious misjudgment about how his KELP loans were handled. When he was CEO, all of his personal finances were managed in a department of Tyco corporate called Executive Treasury. The duties of the individuals who worked in Executive Treasury were to manage the personal finances of the CEO and CFO.
All of Kozlowski’s personal bills and expenses were paid through Executive Treasury. He sent all purchases, payments, and investments through the department, and all of his personal financial information was housed in Tyco corporate offices—in the Executive Treasury department. Kozlowski’s personal financial matters circulated throughout Tyco corporate offices as wire transfers and other transactions were processed by a number of corporate employees.
When Kozlowski had vesting events—dates on which his restricted shares vested, dates on which he was responsible for payroll withholding, and when he was eligible to take loans through KELP, he did not transfer the loan proceeds out of the company into a personal account and he didn’t pay his tax liability with those funds. Instead, Kathy McRae of Tyco Executive Treasury added the amount Kozlowski was allowed to borrow to “his KELP account,” which was used as a quasi revolving line of credit. If Kozlowski was permitted to borrow $50 million on a day his restricted shares vested, McRae simply added $50 million to the amount Kozlowski had available, and then used the money to pay his bills as needed. She kept a running balance and increased the amount available in his “KELP account” every time his shares vested. Money went out of his account when bills needed to be paid. If he bought a boat for $15 million, she processed it through his “KELP account.” Kozlowski’s payment for the boat was then sent from Tyco to the seller. If a bill arrived from the lawn service at his house in Florida, McRae used KELP to pay it. There were hundreds of entries, anything from $350 in petty cash for Kozlowski’s housekeeper to the $3.95 million payment to the art gallery for the Monet. There were volumes of invoices and payments—every one of Kozlowski’s personal expenditures was processed through the company, through his “KELP account.”5
McRae also made decisions about what were personal expenses and what were business expenses on Kozlowski’s credit card bills. She managed the expenses for his yacht. Kathy McRae even helped with Kozlowski’s first divorce. She testified during the trial that “[t]hey were growing the company. They didn’t have time to take care of this much work and they gave me more work and more responsibility.” McRae testified that she never believed she, Kozlowski, or Swartz was doing anything wrong. She also told jurors that PwC knew about and saw the KELP records and that she was never asked to hide anything. Kathy McRae said after Kozlowski was fired, he called her because he didn’t know where his bank accounts were. He didn’t even know his Social Security Number.6 The record keeping used by Executive Treasury created blurred lines between the personal finances of the CEO, the CFO, and the company. Although it was possible to sort out what was personal from what was not, the web of intermingled records and access to all of Kozlowski’s personal spending habits gave David Boies and the Manhattan DA a treasure trove of damaging evidence that was sold to jurors throughout two criminal trials.
Kozlowski paid back all of the loans, except the balance outstanding when he was indicted in June of 2002 and ousted from the company.
Logic and Reasoning . . . and Relevant Evidence
In addition to the charges related to their bonuses, the former executives were charged with grand larceny in the first degree for authorizing and paying the $20 million investment banking fee to Frank Walsh during the CIT acquisition ($10 million to Walsh, $10 million to a charity). There seemed to be no genuine dispute of the facts. All of the evidence came from Tyco’s books and records, and the testimony of witnesses was consistent. Removing the mass of evidence about Kozlowski’s lifestyle and personal expenditures that served only to muddy the waters, and looking only at the relevant evidence, the elements of grand larceny are impossible to prove.
The facts do not indicate or even imply criminal intent or acts. The facts show that the Board granted Dennis Kozlowski the authority to spend up to $200 million without Board approval, then when the Directors were sued after the payment made to Frank Walsh was disclosed, they were displeased with how Kozlowski exercised the authority they granted him, so they allowed and participated in the process that transformed his business judgment into a charge of grand larceny.
Other than the four bonuses and the payment to Walsh, the three additional grand larceny charges were related to Dennis Kozlowski’s art purchases. Kozlowski and Swartz were charged with taking $1.975 million for the paintings Kozlowski purchased with his Board-granted spending authority for the Tyco apartment at 950 Fifth Avenue. The paintings were purchased with Tyco funds and were reflected as Tyco assets on the audited books and records of the company.
Kozlowski and Swartz were charged with grand larceny in the first degree for the $8.8 million paintings Kozlowski purchased in Florida when art dealer Christina Berry had the London gallery ship pieces to Kozlowski’s home for his review. Kozlowski borrowed money through the KELP to pay for the paintings. He signed a promissory note for $8.8 million and repaid the loan. The paintings were insured in Kozlowski’s name.
The two former executives were also charged with grand larceny in the first degree related to Kozlowski’s purchase of a Monet painting for $3.95 million. Kozlowski borrowed money through KELP to pay for the painting. He signed a promissory note for $3.95 million and he repaid the loan. This painting was also insured in Kozlowski’s name.
All of the artwork in question hung in the Tyco corporate apartment. Dennis Kozlowski did not move or take any of the paintings—not the ones the company purchased and not the ones he purchased personally. When Kozlowski was indicted on sales tax charges in June of 2002—charges that were ultimately dropped—Tyco seized possession of all of the artwork in question and took possession of other art Kozlowski owned as well as all of his other personal property that was in any Tyco office, apartment, or facility on the day before he was indicted.
Who should be charged with grand larceny for taking Kozlowski’s personal property, including multi-million dollar paintings? Or is Dennis Kozlowski not entitled to protections of the law because he made and spent a lot of money?
If the painting purchases were grand larceny, why were there no charges for the literally hundreds of other purchases that were processed exactly the same way through Kozlowski’s “KELP account”? If the payment to Frank Walsh was grand larceny, why weren’t the years of payments to Josh Berman’s law firm? Or the unapproved payments for pilot and chartering services paid to other Directors? If the four bonuses were grand larceny, why not the other bonuses paid as a result of nonrecurring gains? Why just those four? The logic is very difficult to follow.
Summations
Good faith = no criminal intent. No criminal intent = no crime.
The most critical element the prosecution had to prove was criminal intent. When Justice Obus instructed the jury, he told them that “in order to establish that a defendant acted with the requisite larcenous state of mind, the People must prove that the defendant did not act under a claim of right made in good faith. That is that he did not believe that he had authority to take the property. The defendant does not have the burden of proof in taking the property he acted under a claim of right made in good faith. Rather, the prosecution must prove beyond a reasonable doubt that the defendant knew he did not have authority to take the property.”9
In his summation, Mark Swartz’s attorney Charles Stillman told the jury that when they looked at all that had been presented over the prior months, “[t]hat evidence will be—perhaps better said, the lack of evidence demonstrates that the District Attorney has failed entirely to meet its burden of proving beyond a reasonable doubt that [the defendants are] guilty of any crime.”
Stillman said, “My shorthand way of saying that to you now is good faith equals no criminal intent. In other words, as I said when we first spoke back in January, no criminal intent means no crime.”10
The jury was charged and deliberations began on Thursday, June 2, 2005. On Friday, June 17, 2005, the jurors sent a note to the judge stating that they had reached a verdict.