Inside the Tough Call at Sprint:
Fire Auditor or Top Executives?

For months, Sprint Corp.'s directors had secretly debated a mounting conflict-of-interest crisis inside the telecommunications giant. Now, it was culminating in an extraordinary showdown as the board met on Dec. 9 to hear its top two executives explain why they shouldn't be fired.

The executives, Chief Executive William T. Esrey and President Ronald LeMay, came into the boardroom of Sprint's headquarters outside Kansas City with a slide presentation to argue their case. At stake for both men: not only their careers but also their vast personal fortunes.

In late 1999, Sprint's auditors Ernst & Young offered the two men and other Sprint executives a lucrative tax shelter. For Messrs. Esrey and LeMay, the maneuver could allow the executives to avoid paying taxes on more than $100 million each in stock-option gains.

SPRINT SHAKE-UP Messrs. Esrey and LeMay's use of the controversial tax shelters led to their ouster from Sprint and a management shake-up. Sprint is seeking to hire Gary Forsee, but BellSouth is blocking the move of its vice chairman. See a related article1, profiles of the key players2 in the management tussle and a note3 Mr. Esrey sent to Sprint employees about the shelter.

But in 2000, the Internal Revenue Service began probing a wide range of tax shelters, including this one. Suddenly it looked as though the two executives had been badly advised by Ernst & Young and would need to pay the taxes after all. The trouble is, the executives no longer have the money since Sprint's stock plunged amid the meltdown of the telecom industry.

The conflict for Sprint's board couldn't have been more acute: The company's two top executives were at war with the auditor the company relies upon to bless its financial results before the public.

How Sprint wound up in this mess is a cautionary tale of flawed executive decisions and corporate governance. Sprint's board helped create the trouble by requiring that its top executives use Ernst & Young to prepare their tax returns and, as a special perk, allowed the executives to consult the company's auditor for personal financial advice. While that practice is common, it has drawn criticism recently because the arrangement has the potential to create a conflict of interest. The boards of some that have used auditors as tax advisers for executives in the past, including Ryder System Inc. and Pfizer Inc., have long barred it.

Moreover, Sprint's board knew about the looming conflict for more than two years before it finally moved to address it. The conflict, and the broader question of who should run Sprint, were the subject of 20 board meetings over the last six months of 2002, say people close to the situation.

Sprint declined to comment on board issues. Messrs. Esrey and LeMay, who have worked as high-ranking executives at the company since the mid 1980s, have not commented beyond statements made last week to employees.

The blowup at Sprint has rocked the tight-knit business world of Kansas City. One of the board's most powerful outside directors, Irvine O. Hockaday, ran Hallmark Cards Inc., one of the city's other pre-eminent businesses, and is a close friend and neighbor of Mr. Esrey. (Mr. Hockaday also serves on the board of Dow Jones & Co., publisher of The Wall Street Journal.) Another director is Louis W. Smith, former chief of the Ewing Marion Kauffman Foundation in Kansas City, built on the fortune of the Marion Labs Drug company.

Mr. Esrey, 63 years old, has been battling lymphatic cancer since last fall. He has said that he could face financial ruin if the IRS rules against the shelters -- since he left the proceeds from exercising the options and most of his other personal assets in Sprint shares. "In the event of an extreme adverse outcome ... future taxes could take up most, if not all, of my assets since I have nearly all my assets in Sprint stock," Mr. Esrey said in a statement to employees last week.

Ernst & Young, which pocketed millions in fees paid by Sprint, initially recommended the shelters as a smart way to take advantage of Sprint's soaring stock price. In 1999, after WorldCom Inc. announced its blockbuster deal to buy Sprint, Sprint accelerated the vesting of options for its executives.

The Sprint executives found themselves with huge potential profits on their options as Mr. LeMay exercised options with a total taxable income of $150 million and Mr. Esrey exercised options with a taxable income of $138 million in 1999 and 2000. The two-part shelter involved several complicated trades that effectively eliminated the multimillion-dollar tax bill that the executives would have owed on the options exchanges.

The first part involved a series of swaps transactions intended to turn the income earned by the executives from the exercise of their options into capital gains, which are taxed at a much lower rate. In the second part the goal was to raise the cost of the asset, in this case the Sprint shares, so that any profit disappears. The planned end result: no tax bill.

Messrs. LeMay and Esrey have said that Ernst & Young assured them that the strategy was legal, and Mr. Esrey obtained an outside legal opinion saying the IRS would likely agree with it.

IRS Steps Up Campaign

Soon the IRS stepped up its campaign against aggressive tax shelters. In a notice released in August 2000, the tax agency singled out tax shelters that involved basis shifting, just the type used by the Sprint executives. Saying it had seen a slew of these tactics recently, the IRS warned that because the transaction had no purpose other than to cut taxes it was not valid. "Appropriate penalties may be imposed on participants in these transactions," the IRS warned.

In what would prove to be a fateful mistake, Ernst & Young advised them against putting shares aside to pay for the taxes, say people close to the situation. Ernst & Young has declined to comment.

Also, on the advice of Ernst & Young, to avoid having taxes withheld to cover money owed on their gain from the option exercise, they declared a huge number of exemptions. On one form prepared by Ernst & Young, Mr. LeMay, 57, claimed tens of thousands of exemptions, say people close to the situation. With that many exemptions, he would owe virtually no tax. Therefore, there would be no need for withholding.

The executives' bets soon went awry. The WorldCom deal ran aground on antitrust concerns in June 2000, tanking Sprint's shares.

By late 2000, Sprint's stock had sunk to $20, as investors worried about its ability to survive the increasingly brutal telecommunications downturn. The company had not been able to bump its share of the long-distance market past 10%. Its promising wireless business, now the nation's fourth largest, had racked up $14.5 billion in debt.

Late that year, Messrs. LeMay and Esrey, growing anxious about how their declining stock price affected their shelters, told the board about the problem, say people close to the situation. But they assured board members that Ernst & Young had told them the shelters were perfectly legal. Though increasingly concerned, Mr. LeMay decided not to sell shares to cover the taxes because he thought it would hurt the company, say people close to the situation. "As a matter of principle, while I have been a Sprint employee, I have never sold any of my shares and I continue to hold these shares today," Mr. LeMay said in a statement to employees last week.

The board left the matter alone.

Still the executives and the company were worried enough that in December 2000, Sprint and Ernst & Young together went to the Securities and Exchange Commission to discuss the possibility of undoing their option exercises. They ultimately decided not to because Sprint would have been subject to onerous accounting rules that could have hurt its earnings.

In late 2001, Messrs. Le May and Esrey, knowing the IRS was increasingly likely to rule against the shelter, alerted the IRS to the possible problem and were granted amnesty for any potential penalties.

In the spring of 2002, directors finally realized they needed to address the situation. Several factors came together: The company's performance was falling. It faced a raft of shareholder suits following its failed plan to merge with WorldCom. And the tax shelter problem, if it leaked, might only add fodder to those suits. In addition, Mr. Esrey approached the board with a request for more compensation to help cover his potential tax liability, which irked some directors, say people close to the situation. The board turned down the request.

Suddenly, board members realized that if they needed to replace Mr. Esrey, Mr. LeMay's tax issues could interfere with his leadership. "They knew the IRS problem wasn't going away," says one informed person.

The tipping point came in June 2002, when the board learned through Messrs. LeMay and Esrey that the IRS was reviewing the shelters they used. These concerns intensified as accounting scandals erupted at numerous companies, including WorldCom. Increasingly anxious about what action they should take, independent directors hired the law firm of Davis Polk & Wardwell that month.

Once they started conferring with Davis Polk over the summer, the directors discussed the looming collision between Sprint's auditors and their two top executives. Directors worried whether it was "a healthy thing to have that kind of tension" between the auditors and the company's leaders, one informed person says. Another tough issue was the embarrassing prospect of having executives at the top of Sprint who were facing possible personal bankruptcy.

By October, Davis Polk made a set of recommendations to the independent directors. Even though many of the directors, including Mr. Hockaday and Stewart Turley, a retired chairman of Eckerd Corp., remained reluctant to consider ousting the top executives, they were advised that might be the most expedient course. If Mr. LeMay was promoted to CEO, for example, the board would have to disclose his tax problems and potential conflict with Ernst & Young, the board was told.

"If it came out, some people might say, Mr. LeMay made a mistake, but others might say, 'How could the board pick someone who made such a colossal mistake?' " said one knowledgeable person.

Directors discussed the possibility of firing Ernst & Young, which had recommended the shelters, but worried that firing the auditors would be a public-relations disaster.

Seeking Assurances

While the board debated whether they should bypass Mr. LeMay, he sought his own assurances, especially as headhunters were seeking him out for other CEO searches, including WorldCom's. Early in October, Mr. LeMay was told by Sprint's board that he was still the top choice to succeed Mr. Esrey -- if they could work out his tax issues. The board told Mr. LeMay that it would hire a search firm to look at the pool of available talent but that they wouldn't interview any other candidates without first notifying him, according to people familiar with the discussions.

Later in October, Davis Polk, acting on behalf of the outside directors, hired executive recruiters Russell Reynolds Associates Inc. and instructed the firm "to be ready" to launch a CEO search and to draw up a list of possible candidates. The board formed a three-person search committee, whose members were Mr. Hockaday, Linda Koch Lorimer, vice president and secretary of Yale University, and Mr. Smith. "They were all agonizing," over having to look outside the company's ranks, according to one person close to the situation. "They were very uncomfortable."

Among directors, "there were a lot of debates because many of the directors liked and respected Mr. LeMay, and had a tough personal time saying he wasn't the right choice," says another informed person.

Ultimately, the sentiment shifted to ousting the veterans and seeking a new CEO. The directors worried that otherwise, Sprint would face constant bad publicity over the tax battle. If, however, they fired the auditors, they might be giving the IRS ammunition in saying Ernst & Young was wrong on its tax-shelter position and even invite an SEC probe of the company.

By the time of the Dec. 9 board meeting, most of the board members were leaning toward firing Messrs. Esrey and LeMay. But they decided to give the executives an opportunity to present their solution to the crisis. During the meeting at Sprint's sprawling headquarters outside Kansas City, Messrs. Esrey and LeMay methodically went through a slide presentation that recommended Sprint fire its auditors after the completion of its 2002 audit. "Sprint does not sacrifice loyal and dedicated employees," they told the board. "The potential for Ernst & Young conflict remains as long as Ernst & Young remains," the executives said, according to a review of their presentation.

A week later, the divided board finally came to a consensus and concluded that it would be preferable to jettison Messrs. Esrey and LeMay than Ernst & Young. Ernst & Young remains Sprint's auditor of 37 years. The company won't comment on whether Ernst & Young is still providing tax advice to executives.

According to an acquaintance, Mr. Hockaday finally concluded that "he couldn't tolerate having a new CEO who would be besmirched" by an IRS probe. People would say 'why did they put a guy in there with a stain on his shirt?' "

But directors were mistaken in thinking their ordeal was behind them.

After news leaked out that Gary Forsee, the No. 2 executive at BellSouth Corp., was Sprint's choice to succeed Mr. Esrey, BellSouth moved to block his exit. The dispute is now held up in court and could be decided as early as Monday.

While the court weighs Mr. Forsee's future, Sprint's directors are poised to begin considering other CEO candidates.

-- Joann S. Lublin, Shawn Young and Ken Brown contributed to this article.

Write to Rebecca Blumenstein at rebecca.blumenstein@wsj.com⁴ and Carol Hymowitz at carol.hymowitz@wsj.com⁵

Updated February 10, 2003