Board Members, Executives and Family Members Can Still Benefit

By David S. Hilzenrath
Washington Post Staff Writer
Monday, August 16, 2004; Page E01

Many of Corporate Washington's executives and board members have side deals with the companies they oversee.

In addition to their regular compensation, some are paid for legal work, consulting, or lobbying. Companies have leased real estate and chartered airplanes from insiders. Some have hired or awarded contracts to family members, according to regulatory filings.

These kinds of deals can sometimes enrich insiders at shareholders' expense and make directors less likely to stand up to management. Self-dealing by insiders was part of the backdrop for accounting manipulations at companies such as Enron and WorldCom.

In other cases, side deals may simply show that management has greater trust in family members or others they know well, including directors, corporate governance analysts said. The deals may reflect the companies' roots as family or entrepreneurial operations.

The accounting scandals of recent years focused new scrutiny on corporate boards, exposing some directors as little more than rubber stamps for management. Reforms were enacted, including a ban on new loans to officers and directors. The new rules were widely viewed as having transformed the culture of America's board rooms.

But disclosures in reports companies file with the Securities and Exchange Commission show that private dealings involving executives, directors and the largest companies in the Washington area continue. Companies defend those practices as legal and say they have taken steps to prevent abuse. Corporate governance experts say deals with insiders can be a warning to investors. And Beth Young, who analyzes corporate governance for the Corporate Library, said the disclosures about so-called "related party transactions" can be a window into the corporate culture.

The side deals reported by Washington area companies vary widely.

TeleCommunication Systems Inc., which provides wireless communications, has tentatively agreed to lease a major portion of an office park in Annapolis being developed by its chairman and chief executive, Maurice B. Tose.

NVR Inc., a homebuilder, last year spent $2 million buying lots from the company of a son-in-law of chief executive Dwight Schar, and it agreed to spend $6 million buying lots from the same company.

Fairchild Corp., a distributor of aircraft parts, disclosed a host of transactions, including various payments to Fairchild chief executive Jeffrey J. Steiner and his son Eric, Fairchild's chief operating officer. (See accompanying story.)

DigitalNet Holdings Inc., a government contractor, last year issued four subcontracts worth $694,000 to a company owned by a son of chairman and chief executive Ken S. Bajaj. The subcontracts were for systems engineering and economic analysis, DigitalNet reported.

Bajaj said he was surprised to learn that DigitalNet had done business with his son's company, and he added that it would not happen again. The deals are legal, Bajaj said, "but, hey, these days I don't even want the perception out there that we are doing business with related parties, period."

The Securities and Exchange Commission has required that related party transactions be disclosed since the stock market reforms of the 1930s. Before the crash of 1929, undisclosed stock transactions favoring insiders were frequent occurrences, a Senate investigation later found, said Joel Seligman, a legal scholar and financial historian. The disclosures can generally be found in "proxy" reports, which companies send to investors and submit to the SEC in advance of their annual shareholder meetings.

In a report analyzing the accounting fraud and self-dealing at WorldCom and recommending new ethical guidelines for its successor, MCI, court monitor and former SEC Chairman Richard C. Breeden wrote that related party transactions pose "the most serious risk to shareholders." For example, a former chairman of WorldCom's compensation committee accepted a sweetheart deal from the company's then-CEO to use a WorldCom jet, Breeden wrote.

Since then, MCI has taken steps to mitigate potential conflicts of interest. Last year, MCI reported paying $770,000 for legal services from the District law and lobbying firm Patton Boggs LLP. Laurence Harris, an MCI director since the company emerged from bankruptcy in April, was a Patton Boggs partner. "We believe that the fees paid to Mr. Harris's firm are normal and customary in amount and scope for the work performed and are similar to that paid by other clients," a company report said.

Harris, a former MCI executive, lobbied for the company through Patton Boggs before joining the board, MCI spokesmen said. To avoid potential conflicts of interest, Harris has ceased to be an equity partner at Patton Boggs, meaning that the fees MCI pays the firm do not influence his compensation there, MCI general counsel Anastasia D. Kelly said.

Though the term "related party transaction" has come to sound "like it's a dirty word," Kelly said, "to have a complete prohibition in my view . . . is a little bit like throwing out the bath water with the baby."

Cynthia Richson, corporate governance officer at the Ohio Public Employees Retirement System, a big institutional investor, however, has a harsher view of related party transactions. "In an ideal world, they would be banned," she said.

But the post-Enron reforms by Congress and the stock exhanges didn't bar all related party transactions. Instead the new rules assign more responsibility to independent directors, those considered free of potential conflicts of interest. Membership on committees that oversee auditing, for example, was restricted to directors considered independent of the company, and boards were required to have a majority of independent directors. In addition, the Nasdaq Stock Market required related party transactions to be approved by independent directors.

The distinction between independent directors and others, however, is sometimes not intuitive.

MicroStrategy, a software company that inflated earnings during the dotcom bubble, this February entered an agreement that allows Vestmark Inc. to use MicroStrategy software in Vestmark products, according to its SEC filings. Vestmark's chief executive and controlling stockholder, David Blundin, is a former MicroStrategy employee and a member of MicroStrategy's board. MicroStrategy, which declined to comment for this story, has reported that it considers Blundin an independent director.

Friedman, Billings, Ramsey Group Inc., an investment bank, last year paid $772,000 to the Dechert LLP law firm. Dechert partner Wallace L. Timmeny, who FBR classifies as independent by New York Stock Exchange standards, serves on the FBR board's nominating and governance committee and chairs the committee that oversees compliance with laws and regulations.

"The implication . . . is that the minute you accept a fee for something, you've sold your soul, and I don't buy that," said Timmeny, who has been a lawyer to Friedman Billings Ramsey since 1989 and a director since 1997.

"You want people who can add value, not who are some paper figures who are so remote they don't bring value," said William J. Ginivin, FBR's chief legal officer.

Fannie Mae, a government-sponsored housing finance company, reported that last year it paid $375,000 to the Duberstein Group, a lobbying and consulting firm led by Fannie Mae director and former White House chief of staff Kenneth M. Duberstein. In 2001, Fannie hired a son of board member H. Patrick Swygert, president of Howard University.

Fannie Mae said in a statement its hiring of Swygert's son after Swygert joined the board "does not impact Mr. Swygert's independence," but Fannie Mae does not consider Duberstein, the lobbying firm executive, to be independent.

TeleCommunication Systems reported a related-party transaction involving a company controlled by Tose, its chairman and chief executive. Tose owned a controlling interest, as of the company's last annual proxy report, in Annapolis Partners LLC, a real estate development firm that won an Anne Arundel County competition to develop a 46.5-acre former Navy waterfront site.

One of the assets Tose's development firm brought to the project was a potential prime tenant: TeleCommunication Systems. Under a contract the county signed with the development firm, Annapolis Partners had to execute a lease with Telecommunication Systems or another lead tenant before it could take ownership of the property. The transfer of the property took place in 2002.

In a report to the SEC, TeleCommunication Systems said it "entered a lease with Annapolis Partners LLC to explore the opportunity of relocating our Annapolis offices to a planned new real estate development." Under the lease, the TCS board reserved the right to cancel the deal and will consider alternatives, the company reported.

The chairman of TCS's audit committee, Richard A. Kozak, said there is no conflict of interest because it has not made a final commitment to Annapolis Partners. Any agreement would be reviewed by the board, would have to be at competitive rates or better, and would probably be negotiated by the chief financial officer and chief operating officer, Kozak said. Those executives report to Tose.

"I don't think they're negotiating with their boss," Kozak said. "They'll be negotiating a lease with the partnership or preferably whoever's going to be the property manager." Tose did not return calls seeking comment.

NVR, the big homebuilder, reported a deal involving the chief executive's son-in-law. But the wording, like many disclosures in corporate reports, is in obtuse, legalistic language, making it hard to understand. NVR reported that last year it "entered into a forward lot purchase agreement to purchase finished lots for a total purchase price of approximately $6,000,000 with Comstock Blooms Mill II LLC ('Blooms Mill'), an entity controlled 100 percent by an entity in which Mr. Schar's son-in-law is a principal." NVR said it purchased lots from Blooms Mill last year for about $2 million.

In addition, NVR bought $15 million of lots from Elm Street Development Inc., which is controlled by NVR board member William A. Moran, who is not considered an independent director. NVR also "entered into forward lot purchase agreements to purchase finished lots for a total purchase price of approximately $36,000,000 with Elm Street Development," the company said in its proxy report.

In each case, the purchases were at market prices and the agreements to buy were approved "by a majority of the disinterested members" of the board, NVR reported.

NVR's Schar and a company spokesman declined to comment. Moran referred questions to NVR, and Comstock personnel did not return calls.

Some complex transactions have the potential to benefit both sides. Sunrise Senior Living Inc. founders Paul J. Klaassen, the chief executive, and Teresa M. Klaassen, the chief cultural officer, in 1994 transferred ownership of their Fairfax County house to the company, which used it as collateral for a loan. At the time, they owned the company privately and received no payment for the real estate, Sunrise officials said, but they took back a 99-year lease on the house under which they pay the company $1 per month.

The Klaaseens moved out of the house, and for the last 10 years the house has primarily been used for Sunrise business purposes, including meetings and housing out of town employees, spokeswoman Sarah Evers said by e-mail. Sunrise currently pays average monthly expenses of $8,800 for real estate taxes, utilities, lawn service, housekeeping, maintenance, trash and supplies for the house, according to Evers.

Evers said the arrangement saves Sunrise money because it is less expensive than putting employees in hotels. The Klaassens "retain the economic value of the home," according to Evers. The property was assessed in 2004 at $363,070.

As of July, the Klaassens' son had lived in the house for about 18 months, Evers said.

Several companies, including Sensytech, MicroStrategy, NVR, and Friedman, Billings, Ramsey Group Inc., have paid to use their chief executives' airplanes, another transaction that companies say benefits both sides.

Sensytech chief executive S. Kent Rockwell said he charges Sensytech, a government contractor in defense and intelligence technologies, less than market rates under an arrangement approved by the government. Sensytech's payments help him defray the costs of owning his turboprops, and using the planes for business allows him to receive tax benefits in the form of depreciation, he said. Plus, Rockwell is more comfortable in his own planes, which are maintained and piloted by people he trusts, he said.

FBR said it saved more than $1 million last year using co-chief executive Eric Billings's plane, Ginivin said. MicroStrategy reported that it reimbursed chief executive Michael Saylor a total of $109,000 over 16 months, using the equivalent of first-class airline fares for each passenger, up to a limit of $10,000 per flight. NVR reported that it paid market rates, a total of $85,000, to sublease a plane from Schar.

Corporate governance experts scrutinize management deals with directors to see if those transactions could interfere with a board's responsibility to be an agressive watchdog for shareholders. Glass, Lewis & Co. LLC, which advises institutional investors on corporate governance, generally recommends that they withhold their votes from directors whose firms work for a company, chief executive Gregory P. Taxin said. "Their independence is tainted by virtue of the fact that they are the hired hand of management or seeking to be the hired hand of management," Taxin said.

Other specialists in corporate governance say side relationships between companies and their overseers should be evaluated on a case-by-case basis and, depending on the details, may be harmless or beneficial to shareholders.

When Martek Biosciences was preparing to build a production plant in South Carolina, it awarded Clark Construction Group a no-bid $2 million contract to manage the project. Robert J. Flanagan, a member of the Martek board's nominating and corporate governance committee, is executive vice president of Clark Enterprises Inc., the parent company of Clark Construction.

Flanagan proposed the arrangement to Martek management, said George P. Barker, Martek's general counsel. "He basically said, 'I think we can help you out if we can strike a deal,' " Barker said.

Flanagan recalled it differently. "It was management's idea," he said.

The nominating committee obtained opinions from independent consultants that it was a fair deal, and Flanagan did not participate in the committee's discussions, Martek reported. To avoid delay, the company did not seek competing bids, Barker said.

The contract "has absolutely no impact on his [Flanagan's] independence as a director," Barker said, adding that neither Martek nor Clark feels beholden to the other.

Xybernaut Corp., which sells wearable computers, paid board member James J. Ralabate $926,913 in legal fees from 2000 through 2002, the company said in a report filed last year. During most of that time, Xybernaut was Ralabate's "only significant client," the company reported.

"I don't think there's any conflict there," Xybernaut spokesman Michael Binko said. "I think it really comes down to Jim as a person. His integrity is impeccable."

At USEC Inc., a uranium enrichment company that was once owned by the federal government, board chairman James R. Mellor has a $350,000 per year consulting contract on top of the standard director's compensation -- a $65,000 retainer, which he takes in stock, plus fees for meetings attended, stock options, and $30,000 in restricted stock. When the board's outside directors held meetings with no members of management present, Mellor presided, and he serves on the committee that monitors USEC's compliance with regulations, the company reported.

USEC spokesman Charles Yulish said Mellor's role as consultant to the company "is quite different" from his role as chairman. As chairman, "he oversees the preparations for board meetings, conducts the board meetings and deals with all board related matters," Yulish said. As a consultant, "he's primarily focused on both strategic business, corporate governance and other matters and specifics," Yulish said.

Mellor is not considered independent , Yulish said.

Washington Post Co. director George J. Gillespie III is a partner at Cravath, Swaine & Moore LLP, one of several law firms used by The Post Co. Gillespie advises the family of Chairman and chief executive Donald E. Graham and serves as a trustee of Graham family trusts, said Diana M. Daniels, general counsel of The Post Co.

The company's proxy said that Elizabeth Weymouth, sister of Donald E. Graham, has a $25,000 annual contract to write for The Washington Post and is employed as a senior editor at the company's Newsweek magazine with "base compensation" of $170,000. The proxy did not mention that Weymouth's daughter, Katharine W. Scully, was the newspaper's director of recruitment in 2003. She is now director of advertising sales.

"We are confident that we've complied with all of the relevant regulations," said Ann L. McDaniel, a vice president and spokeswoman for The Post Co.

The Washington Post was among a number of publicly traded companies that employed relatives of top executives and major shareholders. Marriott International listed six members of the Marriott family, besides chairman and chief executive J.W. Marriott Jr., in its latest proxy report this spring.

"Our board of directors believes that the involvement of a significant number of Marriott family members in responsible positions of the Company makes a significant long-term contribution to the value of our corporate name and identity and to the maintenance of Marriott's reputation for providing quality lodging products," Marriott said in its latest proxy.

Some companies have purchased stock from insiders in private transactions so large that they could have depressed the stock price or required a protracted series of smaller trades if conducted on the open market.

For example, in October, directors of Varsity Group Inc. approved the company's purchase of 125,000 Varsity Group shares from chief executive Eric J. Kuhn. The transaction, carried out Nov. 4, exceeded the combined volume of shares that changed hands publicly over the preceeding six business days.

The company paid Kuhn $3.75 per share, a 5 percent discount from the average price over the preceding 30 days.

The board concluded it was in the best interest of shareholders for the company to purchase the shares "as opposed to me selling them on the open market," Kuhn said.

Similarly, on Aug. 26, Marriott International bought 750,000 Marriott shares from a company controlled by Richard E. Marriott, brother of Marriott International's chairman and chief executive and a former director of the company. But instead of a discount, Marriott paid the closing price that day, $40.71. The volume was more than the 609,700 shares that traded publicly the following day.

The private transaction was easier and cheaper than trading on the open market and paying brokerage commissions, said Laura E. Paugh, senior vice president for investor relations at Marriott International.

If the company had not bought the shares, Richard Marriott said, he would have sold on the open market and dribbled out the sales. "It would have had no effect on the stock price as far as I know," he said.

The government has taken the approach that the best way to protect investors is to require companies to disclose their related party transactions, allowing shareholders to decide whether specific deals are proper.

Some, like Richson of the Ohio Public Employees Retirement System, say such side deals should always set off alarm bells.

Others like FBR's Timmeny say that view is misguided. He said enforcing a standard of absolute independence would deprive boards of well-informed directors without addressing the core issue. "This is at base a situation that calls for a person to be a person of integrity and character, and if they are that, they will perform properly," he said.

Staff researcher Richard Drezen contributed to this report.