Capital Markets

Boeing’s Finance Unit: Fuel for Scandal?

Lost in the hubbub over ex-CFO Michael Sears's dealings with a former top Air Force purchasing official has been the role he and other officials pl...
Kris Frieswick and Roy HarrisDecember 16, 2003

The turbulence surrounding Boeing’s recently fired CFO, Michael Sears, is about to intensify. As it does, expect Sears’s former post as chairman of the Boeing Capital Corp. (BCC) finance arm to get a much closer look.

Government reviews of a proposed $21.5-billion Air Force contract to lease 100 Boeing-built refueling planes suggest that representatives of BCC had a pivotal role in convincing the Air Force to accept a controversial structure built around a special-purpose entity (SPE) that both Boeing and the Air Force would help create.

The plan has been amended to become a deal involving a partial lease and a partial purchase. But the original 100-plane lease arrangement put BCC — a Boeing unit that’s been overshadowed in media reports so far — in the middle of a scandal involving suggestions of improper sharing by the Air Force of proprietary information about a rival tanker bid and charges that Boeing wielded unethical influence in the shaping of the huge contract.

By using an SPE, Boeing could record immediate sales revenues for the planes it sold to the entity, which would then lease them to the Air Force. A Boeing spokeswoman confirms that BCC was involved in helping structure the lease proposal.

Dubbed “the KC-767A Tanker Trust” after the name of the aircraft, the nonprofit SPE would issue bonds to pay for the planes. The bonds would be linked to the Air Force’s credit rating, rather than Boeing’s.

Under the arrangement, the Air Force’s lease payments to the trust would be used to pay the bondholders’ principal and interest. The Air Force’s payments would be recorded as operating-lease payments, spread out over six years for each plane. At the end of the lease term, the Air Force could either buy the planes for an added $31 million each or let the trust keep them. If the trust sold the planes for more than the amount owed on the bonds, any profits would be returned to the U.S. Treasury.

Buttressed by a Congressional Budget Office analysis in August, Sen. John McCain (R-Ariz.), chairman of the Commerce Committee, determined that the Air Force would eventually pay up to $5.6 billion more for the leased planes than it would have for an outright purchase. The CBO also found that because the government (through the Air Force) would both direct the trust’s financing activities and benefit from them, those activities should be recorded in the federal budget as federal outlays as they occur — not as operating lease payments.

Because the trust is essentially an extension of the government, the CBO stated, the deal meant the government would be leasing the planes from itself. The lease deal further failed to meet government criteria that any leased military items must be general purpose in nature and not built to military specifications — a position in the case of the KC-767A that the Air Force has disputed.

Indeed, Air Force officials have approved the lease deal, and a modified version calling for an initial 20-plane lease, followed by a purchase of 80 aircraft, was submitted to President Bush — who signed it, coincidentally, the day Sears was fired. The deal has since been put on hold until the Pentagon conducts a full investigation of the circumstances surrounding the dealings between Boeing and Air Force officials leading up to the lease deal’s approval.

A Late Recusal

That investigation was sparked by Boeing’s allegation that Sears had discussed a Boeing job with senior Air Force acquisition official Darleen Druyun in 2002, before she had recused herself from matters concerning the tanker deal. After she began working for Boeing in January 2003, the two compounded matters by attempting to cover up the earlier discussions, the company said at the time their firing was announced. Questions have also surfaced about whether Druyun might have provided Boeing with proprietary information about competing tanker-plane bids from Airbus. (For the full story on the intense competition between the two giant aircraft makers, read “Air Wars.”)

Attorneys for Sears and Druyun didn’t return phone calls from CFO.com. However, in a statement his lawyers issued shortly after his firing, Sears said that he had not engaged in any conduct that violated company policy. “At all times, I have faithfully carried out my duties on behalf of Boeing to the best of my ability,” Sears said. “I am deeply disappointed by the action the company took.”(Ironically, advance copies of a new book by Sears containing his views on corporate ethics and disclosure were in circulation just days before his firing.)

The Pentagon had already been investigating the link between Druyun and Sears even before the two were fired. Whether that investigation led to the revelations about the unethical job discussions is not known. A Boeing spokeswoman says new information in the company’s own inquiry surfaced two weeks before the two were dismissed. She says that in the internal investigation, “documents were collected and potential witnesses were interviewed, some on multiple occasions.” The Wall Street Journal reported Friday that the U.S. Attorney’s Office in Northern Virginia, aided by the Defense Department’s Criminal Investigative Service, has launched a new probe into dealings between Sears and Druyun.

The Pentagon’s Inspector General and the Senate Commerce Committee are also investigating the case, and the Pentagon recently expanded its probe to other major Boeing defense contracts, going back to 2000, in which Druyun was involved. At Commerce hearings Senator McCain led in September, the Arizona Republican, an early critic of the leasing deal, said that documents Boeing provided to the committee investigation “provide a troubling view of the extent to which the company, and not the military, controlled the acquisition.” He said the committee’s review showed “an extremely aggressive sales pitch not only by a company whose mission is to protect its shareholders and to make profitable deals, but by the United States Air Force whose mission is very different.”

A Senate staffer familiar with the case says that questions about BCC “reflect a degree of granularity that the senator hasn’t focused on.” But, the staffer notes, Boeing Capital emerges as a player over and over in the various Boeing investigations.

Beyond Finance

When Boeing chief executive Phil Condit resigned on December 1, a week after Sears’s ouster, media attention quickly moved beyond the “unethical conduct” that Boeing alleged Sears had engaged in. Recently, the quality of Condit’s leadership through a range of Boeing ethical lapses and the lost airliner competitions to Airbus, has taken center stage. Even before news of the Sears-Druyun case broke, the company had become embroiled in a scandal involving a competition with Lockheed Martin Corp.

Condit was replaced as CEO by Boeing director Harry Stonecipher, a former company president who came out of retirement to take the job. Stonecipher, as it turns out, had much to do with the creation of Boeing Capital after he joined Boeing in the 1997 merger with McDonnell Douglas Corp., which he had headed. A General Electric Corp. executive before going to McDonnell, he was familiar with the success GE had had with GE Capital Corp.

While Boeing had been shy about aggressively providing customer finance, McDonnell Douglas had its own MD Financial Services unit. Boeing’s newly hired CFO, General Motors veteran Deborah Hopkins, was placed in charge of Boeing Capital in 1998. BCC then went about making financial arrangements to help customers, especially airlines in need of fleet replacements or expansions.

When Hopkins left for Lucent Technologies and Michael Sears replaced her in 2000, he was given the chairmanship of Boeing Capital, and the aggressive lending continued. Little is known about how Boeing developed its specific plan to offer the Air Force an attractive deal to replace old airborne tankers with brand new KC-767s. But Boeing Capital pops up in many of the early E-mails that the Commerce Committee has collected from Boeing. They reveal the pitch being made to the Air Force.

“Boeing knew that the Air Force wasn’t going to be able to get anybody to spend $2 billion – $3 billion for tankers right away,” says aerospace industry analyst Paul Nisbet of JSA Research in Newport, Rhode Island. There was no money for tankers in the defense budget, so a leasing arrangement “was the only way to get the deal done,” Nisbet says.

From Boeing’s standpoint, with commercial sales sharply off and production rates for 767s in particular trouble, an immediate tanker deal was a lifesaver to pump up the assembly line. Such a transaction would obviously mean a huge amount for the embattled company “It’s one of the biggest deals ever for them,” according to Nisbet. The 100 tankers, he says, represent only a start toward multiyear Air Force replacement of a large fleet of hundreds of aging airborne tankers. The Air Force says that eventually it must replace its 544 KC-135s, which share Boeing’s four-engine 707 design. They have an average age now of 44 years.

From McCain’s perspective, expressed in his September hearings into the matter of the tanker lease, the Air Force proposal did not go through normal processes. Rather, the request for a 100-plane Boeing deal popped up as a rider on the 2002 Defense Appropriations Bill — which the senator notes was written a few months after global airliner demand was devastated by the events of 9/11. The deal also emerged after Boeing had lost its bid for the Joint Strike Fighter program, which Lockheed Martin Corp. won, McCain noted.

The E-mails eventually provided to McCain’s committee by Boeing throw some light on the process that was going on between Boeing and the Air Force, Senate staffers suggest. In one E-mail to Michael Sears, written October 21, 2001, Gerald Daniels, president of the Boeing Military Aircraft and Missile Systems unit, describes a Boeing meeting with Darleen Druyun: “USAF wants us [Boeing] to support their language for an operating lease. Darleen will make the actual contract favorable and is willing to go to the financial market with us to stress the low risk in such a lease with the USAF. I think we should support her plan.”

Two months later, an internal BCC E-mail from Robert W. Gordon, vice president, space and defense financial services for Boeing Capital, said: “The USAF clearly does not understand financing and has asked for our help to educate them [in layman’s terms.]” He added, “Bottom line: We need to prepare a plainly worded explanation of pricing.”

Limiting the Partnership

The added cost that the leasing conditions created for taxpayers clearly irked McCain, who at one point described the SPE as “Enron-esque.” While Enron used SPE’s to obscure the amount of debt being incurred, in the Air Force’s case it would be the taxpayers, not shareholders, for whom the financial realities are obscured, however. “Boeing has been very clear and careful about limiting the amount of its participation in the SPE,” says a senate staffer. “They’re acutely aware of the accounting rules.” He adds: “Boeing did a good job of maximizing the interests of its shareholders. It crafted a transaction around an SPE” so the entity would have to consolidate the debt issued for the acquisition and construction of the tankers. “Clearly, Boeing had no interest in having this deal come up in its own financials,” the staffer says.

In what may be a peculiarity of timing, Boeing announced the restructuring of its Boeing Capital unit on November 12, two weeks before Michael Sears was fired as CFO and from his BCC chairman’s post.

At the time Boeing described BCC as having a $12 billion portfolio, with about 80 percent of that in BCC’s aircraft financial services group and the balance in commercial financial services. It described the separate space and defense financial services group of BCC as helping Boeing customers arrange for satellites, launch vehicles, military transports and tankers, and other products.

During the November restructuring of BCC — which aimed to take the finance unit away from aggressive customer lending and focus it more on supporting the operations of the company’s business units — Sears was left as chairman. BCC president Jim Palmer took early retirement and was replaced by Walter Skowronski, who is also Boeing’s senior vice president and treasurer. James A. Bell, senior vice president, finance, and corporate controller for Boeing Co., was named Boeing’s acting CFO after Sears’s firing. Boeing says the BCC chairmanship “is currently vacant.”

Asked about whether Sears’s alleged unethical conduct was found by the company to be in his role of corporate CFO or of BCC chairman, a Boeing spokesman called it “a moot question.” Sears’s unethical actions, the spokesman said, reflected his position “as a senior Boeing executive.”