The Sarbanes-Oxley Act of 2002 and How It Affected Tyco International Limited - Case Study Example

The Sarbanes-Oxley Act of 2002 and how it affected Tyco International Limited

Introduction

In 1934, the Securities and Exchange Commission was established with a view to helping monitor and regulate the financial markets in the United States. Presently, the agency continues to encourage more transparency by tightening reporting standards. However, such instances where reporting standards are regularly raised follow a failure of the system. One such instance of raising the standards was the passing of The Sarbanes-Oxley Act of 2002. The Act affected public companies through transforming the financial system. The Act, which was enacted in July 2002, was co-authored by U.S. Senators Paul Sarbanes of Maryland and U.S. Representative Michael Oxley of Ohio, following a series of prominent public company failures such as WorldCom and Enron. The Sarbanes-Oxley Act of 2002 covered investor confidence and fraud by reformation of the public company reporting standards. Nonetheless, significant damage in the market happened with the collapse of many big companies between 2002 and 2004. This paper analyzes the Sarbanes-Oxley Act of 2002 and how it affected Tyco International Limited (Tyco).

Mistakes made by Tyco’s leadership

Tyco International Limited is an American company founded in 1960 by Arthur Rosenberg. It has its headquarters Princeton, New Jersey. The company is made up of two major business sections: Security Solutions and Fire Protection. In 2011, the company reported revenues of $17.36 billion. It has over 67,000 employees (Tyco, 2016).

Following an internal investigation into Tyco’s financial dealings, it was discovered that there were accounting errors in the company. The investigation found that Tyco's then Chief Executive Officer (Dennis Koslowski), then Chief Financial Officer (Mark Swartz), and then General Counsel (Mark Belnick) were awarding themselves low-interest loans (which were sometimes veiled as bonuses) which were unapproved by the company board. The loans also went unpaid. Some of these so-called loans formed an integral component of the Key Employee Loan package offered by the company. Kozlowski and Swartz were also alleged to have sold their Tyco stock with no prior notification being given to the company’s investors. Notifying the investors prior to one selling his stock in a company is a mandatory obligation under SEC regulations. Kozlowski and Swartz were said to have obtained close to $430 simply by selling off their stock while manipulating the stock value to give the impression that its value was higher than it really was. The move led to the company stock value falling by more than 70% (Symonds, 2002).

Swartz, Belnick, and Koslowski stole over $600 million from Tyco International Limited through their unapproved loans, bonuses, and wasteful "company" spending. The media reported that the company had purchased a shower curtain for $6,000, a trash can for $2,000, as well as organizing a birthday celebration for Dennis Koslowski's wife that cost $2 million (Symonds, 2002). Over 40 Tyco International Limited executives borrowed loans which were subsequently written off as part of the company's loan-forgiveness drive, even though it was reported that several were not aware that they were illegally obtaining the loans. In some instances, the company also gave out money to those individuals it suspected would report Kozlowski to the authorities.

Steps that Could Have Prevented the Fraud

The company’s board of directors were best placed to uncover Swartz, Belnick, and Koslowski’s scheme to steal the company’ funds. The most serious failure of oversight happened on Tyco International Limited's board. Dennis Kozlowski went to great lengths to make sure that outside directors were not privy to what was really going on in the company. He controlled the flow of every information relating to the company, up to and including internal audits (which normally go to a company’s board). That the company’s board was unable to access this information should have been a red flag to the board. The board should have pressed the company’s leadership to provide the information, lest it was going to lodge a complaint to the SEC (Symonds, 2002).

The company’s board should have been alert and insist on hearing directly from the internal auditors, instead of Kozlowski. After approving the corporate loan program for the top executives, the board should have additionally closely monitored any subsequent transactions. Furthermore, the board should have also objected to the leadership’s decision to give the finance department, instead of the legal department, the responsibility for Tyco International Limited’s SEC filings. Had the company’s then board made any of these moves then it is possible that the massive company losses due to fraud would have been averted (Symonds, 2002).

The Role Played by the Market in the Fraud

For fraud to happen, three conditions have to exist: pressures to commit fraud, justification by the individual for committing the fraud, and also the opportunity to do so. These factors come together in what is known as the Fraud Triangle (Zhang, 2007). Pressure is what pushes an individual to commit fraud. The pressure is most regularly financial, and can include the inability to pay medical or school bills; an addiction to alcohol, gambling or drugs. It can even be motivated by the desire to have expensive, luxury items (University of Michigan). This was the motivation behind Dennis Kozlowski’s fraudulent activities at Tyco International Limited. Dennis Kozlowski was born to a family that was not wealthy; his mother was a school crossing guard while his father worked for the Public Service Transport (Sorkin, 2002).

Dennis Kozlowski’s modest upbringing was the catalyst behind the “get rich quickly” schemes he implemented at Tyco. His desire to be wealthy made him blinded to the way a company should be run. He did not appoint a president to the company, and he also handpicked the company’s top executives. He made sure that these executives were cut from the same cloth as him (that they were poor and wanted to be rich) to ensure that they were going to fall for his schemes.

The Impact of the Sarbanes-Oxley Act on Tyco

The Sarbanes-Oxley Act of 2002 breathed new life into the financial management of huge public corporations. The Act set up the Public Company Accounting Oversight Board, which is tasked with independent oversight of public accounting agencies that offer audit services to various companies. The Act also made the auditors independent (in that they could only offer auditing services to their clients); it made corporate executives individually responsible for the completeness and accuracy of their companies’ financial statements; it enhanced the reporting of financial transactions by including off-balance-sheet dealings together with the stock transactions of corporate executives (U.S. Securities and Exchange Commission, 2002). The Act also requires companies to put in place internal controls to avert, detect and deter any fraudulent activities, as well as to ensure the accuracy of their financial reports and makes it mandatory to audit these controls (U.S. Securities and Exchange Commission, 2002).

In Tyco’s point of view, the Act has closed the loopholes used by Swartz, Belnick, and Koslowski to defraud the company: it has made independent auditing mandatory, together with the monitoring of any stock transactions made by a company’s executives. The board members are also individually responsible for any erroneous financial results posted by the company.

Consequence of the Sarbanes-Oxley Act of 2002 on Ethical Behavior

After the enactment of the Sarbanes-Oxley Act of 2002, Tyco International Limited has become more ethical in its business operations and reporting of financial information. Section 302 of the Act made this possible by making financial reporting a corporate responsibility. Tyco’s CEO and CFO have to certify that they have studied the findings of quarterly or annual reports, and have found them to be correct and lacking any errors (U.S. Securities and Exchange Commission, 2002).

Section 402 of the Act illegalizes any company to give credit (as a personal loan) to the directors of the company. Furthermore, it is illegal for employees to solicit (directly or indirectly), these forms of loans. This will prevent the company’s leadership from awarding themselves loans unapproved loans as was the case with Swartz, Belnick, and Koslowski.

Section 409 of the Act makes it mandatory for the company to disclose any change in the financial operations in a quick and urgent manner that is also easy to understand. This will prevent any manipulations that can potentially place the investors and the public in danger (U.S. Securities and Exchange Commission, 2002).

How the Sarbanes-Oxley Act of 2002 Changed Financial Reporting

Most foreign companies do not follow Generally Accepted Accounting Principles (GAAP) that is in use in the United States. Instead, many of them adhere to the International Financial Reporting Standards (IFRS). However, for a company that does not follow IFRS procedures when preparing its statements, the SEC requires its financial statements to be in adherence to GAAP. Section 401(b) of the Sarbanes-Oxley Act explains the rules and regulations dealing with how a company can present numbers from their financial statements and still comply with the Act. For those companies that have been registered in the United States, with the SEC or the Public Company Accounting Oversight Board (PCAOB), section 401(b) of the Act necessitates two disclosures: (a) “a presentation of the most equivalent financial measure determined in accordance with GAAP”; and (b) “a reconciliation of the differences in that measure and the non-GAAP measure”. Such disclosures are as a consequence of the SEC implementing Regulation G in January 2003. Regulation G is a federal regulation that necessitates insured depository institutions (like banks) to report and disclose their written agreements with any nongovernmental entities (U.S. Securities and Exchange Commission, 2002).

How the Sarbanes-Oxley Act of 2002 has affected those in my Current Industry

The Act has positively affected those working in the financial sector in that there is more openness in the operations of various companies. Section 806 of the Act even provides protection to any person who might blow the whistle on any suspected fraudulent activities in a company (U.S. Securities and Exchange Commission, 2002). The section allows a whistleblower to file a complaint of discrimination with the Secretary of Labor, which if proven to have actually happened, can result in the whistleblower being compensated.