Company LoansA Potential Abuse

Company Loans”A Potential Abuse

One area of recent abuse by executives is borrowing money from the company they work for. Not all borrowing is bad. When recruiting a new executive who needs to relocate, a company may offer that person a loan to purchase a new house. The company may offer to lend several hundred thousand or even a million dollars as a mortgage. After all, a relocating executive must sell one house and buy another. The loan makes this process easier and quicker. This is a perk that most new employees don't get, but it is a relatively harmless one.

The problem occurs when executives start borrowing much larger sums of money for other purchases. Consider the predicament Bernard Ebbers, former CEO of WorldCom, found himself in. In the late 1990s, Ebbers borrowed $61.5 million from WorldCom to buy WorldCom stock for himself. He also borrowed another $100 million that WorldCom guaranteed in order to buy more stock. ^[13] WorldCom stock sold in the $40 and $50 range in the late 1990s, so, to illustrate the problem, let's say that Ebbers bought $160 million of stock at $40 per share. By late 2000, the stock was trading at only $20 per share. Ebbers owned stock worth $80 million, but owed $160 million in loans. He was down $80 million. That kind of personal trouble can cause someone to do things he or she would not ordinarily do. In total, Ebbers borrowed more than $400 million from WorldCom, and much of this was to purchase WorldCom stock.

As the economy started slowing in 2000 and 2001, WorldCom's business also slowed. The stock price also slowly declined to $15 per share. As the stock price fell further, Ebbers' personal financial problems deepened. He became desperate. The following events appear suspicious. On April 29, 2002, Ebbers resigned from WorldCom, and the stock price was just $2.50. Two months later, WorldCom announced that it had inflated earnings over the past five quarters by nearly $4 billion. The Justice Department and SEC are investigating.

As another example, consider how Enron CEO Kenneth Lay abused a loan arrangement with Enron. The Enron board approved a credit line of $7.5 million for Lay. In the twelve months before the Enron scandal broke, Lay repeatedly drew out $7.5 million in cash from the credit line and immediately paid off the loans using some of his Enron stock. In this way, he was able to sell $77 million in stock back to Enron without having to report the stock sales for more than a year. ^[14] By then, the stock price had plummeted and the firm was in bankruptcy court . All the while he was secretly selling stock, he was publicly encouraging Enron employees to buy stock. This particular scheme could not have succeeded without the company line of credit and an agreement that the loans could be repaid with stock.

But even the home loan can be abused. Tyco's former CEO, Dennis Kozlowski, received a zero-interest loan of $19 million from Tyco to purchase a new home in Boca Raton, Florida, in 1998. Two years later, the firm forgave the loan as a "special bonus." Tyco also kicked in another $13 million to help Kozlowski pay the taxes on the bonus. Neither the loan forgiveness nor the cash were disclosed to shareholders as executive compensation.

Allowing executives to borrow substantial amounts from the company they run creates an environment in which the executives are tempted to break the trust between themselves and shareholders. Not all executives would break this trust. But high levels of debt and personal financial problems can cause desperation.