Infectious Greed (36 page)

How could Sunbeam conceal more of its expenses, to meet the estimates? As Cendant had shown, mergers were the only answer. Sunbeam began negotiating to buy Coleman (camping gear), First Alert (fire alarms), and Signature Brands (Mr. Coffee), each of which might enable Sunbeam to overbook merger reserves and, thereby, artificially reduce future expenses. Dunlap hurriedly met with financier Ronald Perelman, who owned 82 percent of Coleman, but Perelman wanted $30 per share, and Dunlap was only willing to pay $20. Dunlap again showed he was a tough guy, stomping out of Perelman's house in Palm Beach, Florida, reportedly screaming, “Fuck you! And fuck your company.”
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Meanwhile, Arthur Andersen—Sunbeam's auditor—began questioning the firm's aggressive accounting policies and proposing some changes to the financial statements, just as it had done with Waste Management. But Sunbeam rejected the changes, and Andersen nevertheless issued an opinion that Sunbeam's 1997 financial statements were fair, even though 16 percent of Sunbeam's 1997 income was from sources Andersen deemed improper.

On January 28, 1998, Sunbeam announced its annual results, calling
its earnings a “record” compared to previous years. But on Wall Street, the only relevant benchmark was what analysts were expecting, and this time Sunbeam fell short by three cents per share. Investors were no longer thrilled with Al Dunlap; the stock fell almost 10 percent.

The first quarter of 1998 was desperate. Sunbeam had borrowed too much from future earnings by channel stuffing, and now senior managers were receiving reports that customers held up to eighty weeks of Sunbeam's inventory—that meant those customers wouldn't need to buy anything else from the company for well over a year.

Dunlap returned to Perelman and agreed to exchange $30 worth of Sunbeam's shares for each of Perelman's Coleman shares. It also borrowed money to buy First Alert and Signature Brands. But by the time the merger negotiations had ended, there was not enough time for Sunbeam to conjure false profits from its merger reserves before it had to disclose results for the first quarter of 1998. This time, the news was awful: Sunbeam had actually lost money. The stock dropped by 24 percent that day.

Al Dunlap tried to persuade investors that it was just a one-time problem. He was just as surprised as they were. But his story that he had believed “until the very end of the quarter” that Sunbeam would exceed its results from the first quarter of 1997 seemed implausible. It had taken several years, but investors finally had learned they could not trust Al Dunlap.

In April 1998, an analyst at PaineWebber, Andrew Shore, downgraded Sunbeam's stock from “buy.” When other analysts followed, and began questioning the company's accounting practices, Sunbeam's board hired a headhunter to find a replacement for Dunlap.

Dunlap was furious, and refused to leave. When
Fortune
magazine reporter Patricia Sellers asked Dunlap if he was afraid of losing his job, he told her to “get goddamn serious!” and said he would be staying as CEO for another three years. At a meeting before 200 analysts and investors, Dunlap tried to explain why Sunbeam's stock had lost half of its value since March. He blamed Sunbeam's troubles on a recently departed junior executive and on the recent El Niño-related weather (“People don't think about buying grills in a storm”). When Andrew Shore, the PaineWebber analyst, questioned Dunlap at the meeting, Dunlap confronted him afterward, called Shore a “son of a bitch,” and threatened, “If you want to come after me, I'll come back at you twice as hard.”
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Dunlap never got the chance to come back. The board of directors fired him on June 13, 1998. Ironically, Waste Management had considered hiring Dunlap several months earlier, when the height of that firm's troubles coincided with the height of Dunlap's glory. Now, of course, Dunlap was an untouchable. But he had used the possibility of a job at Waste Management to persuade Sunbeam's board to double his salary and pay him even more stock options.
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Stock options had given Dunlap an incredible incentive to pump up Sunbeam's stock price. When Dunlap joined Sunbeam in July 1996, he had received 2.5 million 10-year options to buy Sunbeam shares—a meatier signing bonus than most professional athletes received. Dunlap received another 3.75 million options in February 1998. At Sunbeam's peak stock price of $52, Dunlap's options were worth well over $100 million dollars, based on the Black-Scholes option-pricing model. In November 1998, when Sunbeam finally issued accurate financial statements for the previous year—reducing its 1997 income by half—the stock fell, and at a stock price of just $7, Dunlap's options were worth close to zero.

Ultimately, Sunbeam would file for bankruptcy. The lawsuits against Al Dunlap for Sunbeam's fraud were covered by insurance. Arthur Andersen paid $110 million to settle securities-fraud suits in 2001 (Andersen also had insurance, through a complicated self-insurance program established by the major accounting firms.) The SEC brought civil cases against several Sunbeam executives, as well as the former lead partner at Andersen for the Sunbeam audits, but the settlements did not include jail time or large fines. Dunlap settled civil charges with the SEC in September 2002, and his $500,000 fine didn't hurt much. He remains in retirement—a wealthy, if disgraced, man.

 

 

O
n May 5, 1989, Martin L. Grass—the 35-year-old heir apparent to Rite Aid, his father's retail drugstore chain—boarded the firm's nine-seat corporate jet and flew to Cleveland, Ohio.
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He had worked for Rite Aid since he was 13, and had just been named president of the firm.

Grass was planning to meet with Melvin Wilczynski, a member of the Ohio Pharmacy Board, which represented local drugstores. Two months earlier, Rite Aid had purchased Lane Drug, a local pharmacy that previously had hired Wilczynski as a consultant. The Ohio Pharmacy Board
was unhappy about Rite Aid's intrusion into the state, and had penalized Rite Aid for security violations related to the Lane Drug deal.

When Martin Grass arrived in Cleveland, he went directly to a room at the Sheraton Hotel near the airport and met with Wilczynski. Wilczynski had asked for a meeting, and knew that Rite Aid's managers wanted him to resign from the Pharmacy Board. Grass gave Wilczynski a check for $33,249.93, and a form guaranteeing him four years of health-care coverage, along with six letters of resignation from the Ohio Pharmacy Board. Wilczynski could sign the letter he liked best, and keep the check and the health insurance.

Grass didn't know they were being videotaped—Wilczynski had contacted the police to complain that Grass was trying to bribe him—and, moments after Wilczynski signed one of the letters, Grass was arrested. The case went to trial in Cuyahoga County—which, coincidentally, was about to lose millions of dollars on leveraged derivatives—and a judge ultimately dismissed the charges. Grass's lawyers had argued that the Ohio bribery law covered only a person's actions as a public official, not that person's decision whether to remain a public official.
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In other words, Grass did not commit bribery simply by paying Wilczynski to resign. After the charges were dismissed, Grass sued Wilczynski for defamation, and agreed to dismiss the suit in exchange for the return of the $33,249.93 check and a letter of apology.
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Grass kept the apology letter framed on his wall, as a message to anyone who questioned his authority and willingness to retaliate against opponents.

By 1995, Martin Grass and Rite Aid were managing 2,717 stores, and preparing to buy Revco, which operated another 2,000 stores. Rite Aid was such a sprawling enterprise that, in order to keep in touch with store managers, Martin Grass hosted a talk show on Rite Aid's internal television network (he discussed issues ranging from where to put perfume racks to current profit reports).
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Rite Aid's accounting scheme began in 1996, when it sold 189 stores for a $90 million gain. Instead of recognizing the one-time gain from the sale, it used the $90 million to absorb operating expenses. It was the same game Cendant, Waste Management, and Sunbeam had played; the one-time gain and the operating expenses should have been listed separately. Ninety million dollars was a substantial sum for Rite Aid; it represented more than one-third of the company's 1996 income. Yet Rite Aid's annual report stated that “gains from drugstore closings and dispositions were not significant.”
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When this 1996 accounting scheme seemed to work, Rite Aid began a systematic effort to inflate its profits and reduce expenses. Rite Aid's overstatement was almost as large as those at Cendant, Waste Management, and Sunbeam—combined. In all, Rite Aid overstated its income by $2.3 billion.
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The Rite Aid accounting adjustments were too widespread to describe in detail, even for the SEC, which provided only a summary in its 2002 description of the charges. The charges read like a condensed version of the charges against Cendant, Waste Management, and Sunbeam—as if the SEC lawyers understood that the reader had heard all of this before and needed only a summary. The fraud included inflated revenues, reductions of previously recorded expenses, inflated deductions for damaged and outdated products, and unwarranted credits to various stores at the end of particular quarters.

The Rite Aid charges included one new element that would haunt the financial markets after Enron's collapse:
related-party transactions.
Martin Grass was a “related party” to Rite Aid, and he had been dealing with Rite Aid accounts as if they were his own, borrowing from and lending to the company using other “related parties.” For example, Rite Aid did not disclose the fact that Grass had financial interests in properties that Rite Aid leased as store locations. In January 1988, Rite Aid transferred $2.6 million to a real-estate partnership controlled by Grass and a relative; the partnership then purchased an 83-acre parcel of land to be used for Rite Aid's new headquarters, and paid off some of Grass's debts. When the deal unraveled, Grass allegedly tried to conceal it, and repaid the money from his personal account. In another instance, in September 1999, Grass reportedly signed false minutes from a Rite Aid finance-committee meeting purporting to approve a stock pledge that was a prerequisite for a loan Rite Aid needed. In fact, the meeting Grass swore to had never occurred. Like Walter Forbes, Martin Grass reportedly sought reimbursement for various expenses, but whereas Forbes (and Buntrock and Dunlap) had merely used a private jet, Grass commuted daily from Baltimore County to Harrisburg, Pennsylvania, by helicopter, with the majority of the costs paid by the firm.
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Rite Aid's accounting firm was KPMG, one of the so-called Big Five. In auditing Rite Aid, KPMG behaved no differently than Ernst & Young in auditing Cendant or Arthur Andersen in auditing Waste Management and Sunbeam. Grass treated KPMG's auditors like low-level employees. When KPMG auditors raised questions about Rite Aid's accounting
practices, Grass reportedly began threatening them. He told the KPMG partner with primary responsibility for Rite Aid's audit that “skeletons would come out of KPMG's closet” if Rite Aid suffered from an audit. At the same time, Grass also offered KPMG a lucrative consulting contract, in addition to the fees associated with the Rite Aid audit. KPMG graciously accepted.

Throughout this time, Rite Aid granted millions of options to Martin Grass. For example, in 1999 he received one million options with a value of about $12 million. At their peak, Grass's options were worth in the range of $100 million.

Charges against Rite Aid and Martin Grass were brought in June 2002. Prosecutors intended to make an example of Grass, just as they were trying to do with Walter Forbes of Cendant.

Fortunately for the prosecutors, Grass hadn't learned his lesson about recording in sting operations from the Ohio Pharmacy Board incident. Rite Aid's former president, Timothy Noonan, secretly recorded conversations with Grass and a Rite Aid lawyer in which they allegedly discussed submitting false information to the FBI, fabricating contrived explanations for certain events, back-dating documents, and destroying the computer that generated them.
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Grass argued that the tapes should be suppressed, but in early 2003 the judge overseeing his case decided to permit prosecutors to use the tapes at trial. In June 2003, Grass pleaded guilty to conspiracy to defraud and obstruction of justice, and agreed to pay $3.5 million in fines and forfeitures. The 1990s stock bubble had ended.

 

 

T
he list of companies manipulating their earnings during the mid-to-late 1990s goes on (W. R. Grace, Livent, Oxford Health Plans, and Xerox, for example), but you get the point. Over a hundred companies filed financial restatements in 1997. In a 1998 survey of chief financial officers of major corporations at a
BusinessWeek
conference, 12 percent admitted they had “misrepresented corporate financial results,” and 55 percent said they had been asked to misrepresent results but had “fought off” the demand.
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In other words, two-thirds of CEOs were asking their assistants to misrepresent financial statements. And even these numbers were probably too low; not everyone was willing to admit to fraud in a survey, even a confidential one.

In sum, the system of financial controls had broken down, and it stayed broken for several years. Corporate executives created fictitious
earnings, and no one caught them or even asked serious questions. There were numerous parties to blame. Accounting firms had become conflicted by high audit fees and revenues from their consulting businesses. (To his credit, Arthur Levitt finally began complaining about these conflicts.) Securities analysts covering these companies had become conflicted by the investment-banking revenues the companies paid their firms. Boards of directors and members of audit committees failed to ask hard questions. Corporate lawyers not only created the deals that generated false profits or hid losses, but also set up programs to deter the hostile takeovers that had dominated the 1980s. Because of legal defenses against takeovers, the threat of a corporate raider buying a company's stock and ousting a selfish CEO was virtually nil.