CronyismPosted on Monday, June 21st, 2004 by Elizabeth Macdonald
Cronyism is Alive and Well in American Business
Are these people in the corner office tone-deaf? The public is clamoring for clean corporate governance, and here they are cutting themselves cute little side deals with shareholders’ money.
Lawmakers applauded when President George W. Bush signed the Sarbanes-Oxley bill into law on July 30, 2002, ushering in a postscandal crackdown aimed at curbing the kind of self-dealing and conflicts of interest that brought down Enron, WorldCom and other giants. One day earlier executives at Crescent Real Estate Equities of Fort Worth, Tex. were busy trying to blunt the impact of one part of the new law.
Sarbanes-Oxley, among other things, bans company loans to executives and extending the terms of existing loans. Crescent previously had lent $26 million to its chief executive, John Goff, and $9 million more to half a dozen insiders, to buy shares in Crescent. So Crescent, a real estate investment trust, extended the payback deadline by ten years. Myriad companies made similar moves in the weeks before the signing ceremony. Electronic Arts gave a $4 million loan to Warren Jenson, its chief financial officer, admitting in a filing it was doing so a month prior to “the prohibition on loans to executive officers.” Reebok International gave a $300,000 relocation loan to then-executive Martin Coles. Wyeth, the drugmaker, handed a $250,000 relocation loan to a division president, Ulf Wiinberg.
As a form of fringe benefit, most corporate loans like these are petty change, really. After all, you expect the boss to be paid a few million dollars. So what’s wrong with them? Just that they are in bad taste. Despite all the furor about bad governance, despite the bad name that miscreants at Tyco and Enron gave to capitalism, some executives are still practicing old-fashioned corporate cronyism. Some 75% of companies still engage in related-party deals, says the Corporate Library, a research group in Portland, Me. that studied 2,000 publicly held firms. That means the companies have to make embarrassing disclosures in their proxy statements about nepotism, property leased from the boss, corporate-owned apartments and other forms of insiderism that ought to be passé. What’s the matter with these guys?
With help from the Corporate Library and a review of 520 company reports, we went trolling for mischief in the executive suite. What follows is a summary of the more outlandish moves. Please note that none of them is illegal (although new corporate loans would be) and a lot are a continuation of arrangements in place before the congressional crackdown on self-dealing. But self-dealing is bad for the corporate image. Directors should give serious thought to just giving the boss a pay raise, if he’s really hard up, and knocking off the monkeyshines.
Nice Deals if You Can Get Them
As corporate executives line their pockets via insider deals, investors are often left clueless as to just how they’re making these moves. Here are the most common actions, ranked by frequency. Find them in the related-party-transaction section of a company’s proxies and annual filings with the Securities & Exchange Commission. The numbers don’t add up to 100%, as companies typically engage in more than one type of insider deal. -E.M
47% Purchases or sales of insiders’ products or services.
39% Loans to executives.
35% Directors who sell legal or banking services to company.
21% Buying, selling, lending to or investing in companies insiders own.
14% Hiring relatives.
11% Director consulting arrangements.
10% Leasing, selling or buying airplanes to or from insiders.
6% Company borrowing from insider or insider’s company.
Source: The Corporate Library.
Crescent, a publicly held REIT that owns 75 commercial properties primarily in the Southwest, has been involved in at least 70 related-party deals totaling $1.6 billion since 1997, according to its own related-party disclosures. The deals entail investments in or loans to companies in which Crescent insiders own a stake. Crescent has booked at least $279 million in related writedowns for these deals since 1999.
“Crescent engages in way more related-party deals than the majority of other REITs; it has a lot of conflicts of interest,” says Jon A. Fosheim, cofounder of Green Street Advisers, a research boutique that studies REITs. Crescent officials counter that the filings create a misleading picture. They argue the $1.6 billion figure is overstated by as much as $200 million by dint of double counting. They say deals with insiders the company can trust are sometimes better for shareholders than deals with strangers. And numerous deals, Crescent argues in an e-mail, are due to arcane tax rules that “place very strict limits on the amount of operating and inventory revenue a company can earn without losing its REIT status.” To get around this Crescent created separate units, typically owning 90% or more, and gave 1% stakes–and all voting control–to a Crescent insider. Once the old rules were reformed in 2001, the REIT retook control of the units, Crescent says. A spokeswoman says the REIT “takes very seriously its responsibility of full and complete disclosure” of these deals and that its independent directors approved them.
One insider deal was particularly ugly for Crescent, which was formed in 1994 by Goff and billionaire Richard Rainwater, now chairman. In 1997 Rainwater got Crescent to pay Magellan Health Services $387 million for a chain of psychiatric hospitals. Crescent and Magellan then each took a 50% stake in the chain’s holding company, Charter Behavioral Health Systems. Rainwater held a 19% stake in Magellan, and his wife, Darla Moore, was a director. Goff, for his part, had 28,500 warrants to buy Magellan stock, along with 57,000 shares; disclosures are unclear as to whether Goff cashed out his stake.
In 2000 Charter filed for bankruptcy protection, months after 60 Minutes II reported on allegations of mistreatment at the Charter chain. Crescent eventually booked $170 million in writedowns to cut the value of its stake. Crescent insists the price it paid for the hospitals was fair; it says a committee of independent directors, along with advisers at Merrill Lynch, concurred.
Crescent also used shareholder capital to buy a house in 2002 from its chief investment officer, Kenneth Moczulski, paying him $2.7 million. And though its specialty is real estate, a year later it effectively admitted it overpaid and took a charge of $900,000 on the deal. Since Sarbanes-Oxley became law, Crescent’s related-party disclosures indicate that it has had related-party deals totaling $72 million.
FRIENDS AND FAMILY
American Financial Group’s 84-year-old chief executive, Carl H. Lindner, has controlled the big Cincinnati insurer and its predecessors for 26 years. And though it went public in 1995, he still runs it as if it were his own personal fief; he owns a 14% stake and his family owns another 27%. Since 1997 American Financial has done at least $60 million in business with companies owned by his brothers or by Lindner himself.
An American unit in 1997 paid $4.9 million for a 49% stake in a private ethanol company, New Energy Corp. of South Bend, Ind., in which Lindner had invested $5.1 million for a 51% share. American Financial units then gave the ethanol company a $10 million credit line and a $4 million loan. When Lindner decided to buy out the American-held stake in 2000, instead of putting up his own money he had the American unit accept a $19 million IOU, a subordinated debenture, from New Energy in exchange for the 49% interest. The ethanol company also paid the American unit $7.5 million in cash. The $19 million subordinated debt and the $4 million loan were repaid in 2003; New Energy still has access to the $10 million credit line.
Lindner family members also own 24% of Provident Financial Group (American owns 15%), a publicly traded state bank that paid American $3.3 million in 2003 to rent its main banking and corporate offices, situated in the same buildings as American’s headquarters. American says the rent is at market rates. During 2003 American Financial’s units invested $20 million in a separate, undisclosed “unrelated party,” which then used those funds to repay $3.4 million in loans and fees it owed to Provident.
American also owned 49% of American Heritage Homes, a home builder in Orlando, Fla. 51%-owned by Lindner’s brothers. American paid $3.6 million for its stake in 1995. In 1998 American loaned $8 million to the home builder, which repaid the loan when American sold its stake in 2002. American says it netted $9.3 million on the sale; it’s unclear what the brothers earned. Investing in home builders “is not something we generally do, I can tell you that,” concedes spokeswoman Anne Watson. Then why do it at all? “We didn’t do it in a large way here.”
UICI, a North Richland Hills, Tex. insurer, has done tens of millions of dollars in business with its executives, as well as with companies that are partly owned by UICI’s founder and chairman, Ronald Jensen, 73, and his family. Jensen and his adult children owned 59% of a long-distance company that billed UICI $5 million for calls from 2001 through the first half of 2003. The phone company typically charged 7 cents a minute for long distance, higher than IDT’s 5 cents and AT&T’s 6 cents. UICI says it put this contract out for a competitive bid.
And Jensen’s children, through their company, also got a put option to sell 369,200 of their UICI shares back to UICI for $11.9 million, or $32.25 a share, in 2002–even though the stock at the time had never traded higher than $20. UICI’s general counsel, Glenn Reed, says that, in hindsight, “the facts proved our deal was not a good one.” UICI says all of these deals were fair and were approved by a majority of its board, and that Jensen didn’t vote on them. But it refuses to identify how many directors voted against the deals. UICI also gave $3.7 million in loans to Gregory Mutz, who stepped down as chief executive on June 30, 2003. UICI forgave $1.5 million of the loans, and by 2003 Mutz paid off the rest in cash by selling back to UICI shares that the company had given him.
UICI’s conflicts have spilled over into suits alleging UICI is concealing its “incestuous relationship” with a nonprofit that it uses to sell insurance. The suits say that though the National Association for the Self-Employed purports to be an independent nonprofit, it really is run by Jensen’s children and his former business partner in order to sell UICI’s insurance. UICI settled the suits in May; it has set up a $25 million reserve to handle any payouts. “We disagree with the allegations in the complaints,” says Reed. “The lawsuits did not have merit.”
Anam Semiconductor and Amkor Technology operate a world apart, but they enjoy a rather cozy relationship. Anam, in Seoul, South Korea, makes microchips. Amkor, of West Chester, Pa., packaged and sold them, hawking $874 million worth of Anam chips in three years, from 2000 to 2002, or 17% of Amkor’s total sales in the period. Amkor, in the same time, paid $58 million to Anam for financial services, construction services, materials and equipment, which included assistance in building factories in the Philippines. Amkor’s chief executive: James Kim, 68. Anam’s founder: Kim’s father, H.S. Kim.
Amkor held a 42% stake in Anam, which it acquired for $501 million in 1999 and 2000. But it took a $172.5 million charge on its Anam holdings in 2002 when Anam got hit by the downturn that swept the semiconductor industry. It has since pared its holdings to 4%, losing $275 million in the process. In February 2003 the son’s Amkor sold its chip-packaging business to the father’s Anam for $62 million. The company admits in filings that investors “could have had different conclusions as to fair value” of such deals when viewed on a “stand-alone basis.”
Elsewhere in the chip business Alliance Semiconductor Chief N. Damodar Reddy, 65, has committed $20 million of his company’s cash to Solar Ventures, a venture capital company run by his brother C.N. Reddy. Other unnamed insiders bought undisclosed stakes in Solar, but Alliance won’t disclose who they are, and it won’t say whether its chief executive is one of them. To date it has invested $12.5 million. “The question is, is Reddy using shareholder capital just to keep afloat his brother’s fund and the insiders’ investment?” says Beth M. Young, senior research associate at the Corporate Library.
On the board of FedEx Corp. is sports fan J.R. Hyde III, who with his wife owns 13% of the NBA Memphis Grizzlies basketball team. FedEx paid the team $90 million for a multiyear deal to name the new arena in Memphis, Tenn. the FedExForum. FedEx also bought $2 million in municipal bonds to help finance it.
FedEx boss Frederick W. Smith owns a 10% stake in the Washington Redskins, which sold a 27-year, arena-naming license to FedEx for $205 million. He presumably isn’t getting rich off the arrangement since he bought the Redskins stake long after the license deal was signed.
Micky M. Arison, 54, is chief executive of Carnival, the big cruise line. He’s also chief executive and an owner of the Miami Heat basketball team. Carnival paid the Heat $675,000 in fiscal 2002 and 2003 for sponsorship and advertising as well as season tickets. That’s a small sum given Carnival’s $2.2 billion in earnings for the period. “But would Carnival be spending that shareholder money on something else if it wasn’t for Arison’s stake?” asks Young. Both companies say these are just good marketing moves.
COME FLY WITH ME
Young says 200 companies have leased or bought airplanes from insiders. Among them is Pilgrim’s Pride of Pittsburg, Tex., a chicken processor with $2.6 billion in annual sales. It has leased an airplane from its chief executive and founder, Lonnie Pilgrim, since 1985. The chief made $656,000 in fiscal 2003 from this deal, on top of his $1.7 million compensation. The company defends the pact as cost-efficient since it’s in a small town. Pilgrim also provides some bookkeeping services for his personal businesses but won’t give details.
That any company would shield any information in this pious, postscandal era surprises even veteran regulators. Says Lynn Turner, former chief accountant for the Securities & Exchange Commission: “I’m surprised at the amount of insider dealmaking still going on–and the number of executives who are in on it.”