NEW YORK — The Securities and Exchange Commission’s intensified probes into corporate America’s accounting scandals are starting to burn a message into the minds of company executives: Play by the rules or else.

This story first appeared in the June 28, 2002 issue of WWD. Subscribe Today.

The fashion industry’s financial experts are predicting that last Friday’s indictments against former Rite Aid executives, and one current executive, could give a clearer picture of what kind of information the government is seeking as it begins to delve into the finances of bankrupt Kmart Corp.

Stanley B. Frieze, managing partner at the Carl Marks Consulting Group, a restructuring specialist, observed: “What I see for the future is the government taking a very high moral tone for years to come. You will see the government going after companies with a vengeance, looking at their financial reporting under a microscope, and the prosecution of some major executives.”

As reported, Kmart disclosed in its annual report that it is cooperating with the Securities and Exchange Commission and the U.S. attorney’s office in Detroit. Federal Bureau of Investigation Special Agent Dawn Clenney in the Detroit office said that the agency was looking at the Kmart situation to “determine if there are any criminal violations for potential prosecution.”

Kmart posted a staggering $2.42 billion loss in 2001 and acknowledged that it would restate certain quarters to correct the way it accounted for rebates and allowances. Kmart, for its part, on Wednesday asked the Chicago bankruptcy court overseeing the case permission to broaden its investigative inquisition of former executives, including the ability to demand documents and compel testimony.

In the case of Rite Aid, last week’s indictments charged three former executives — including former chairman and chief executive officer Martin Grass — with masterminding an accounting scheme that, at the time, overstated income by $1.6 billion, one of the largest scandals in corporate finance. A current Rite Aid executive vice president, Eric S. Sorkin, was charged with lying about when he received a letter from Grass over his compensation. Sorkin was placed on leave last Friday. The 37-count Rite Aid indictment contained a mixed bag of accounting tricks: recording of bogus credits from vendors for damaged goods; false accounts payable entries, and inaccurate reporting for stolen or otherwise unaccounted for inventory.

Richard Hastings, credit economist for CyberBusiness Credit, observed: “So many things about the Rite Aid fraud, the disclosed abuses in the retailer-vendor relationship, can occur very easily especially in the backend functions that have to do with receiving, distribution and unpacking of boxes. The indictment is sending a message that retailers need to be more careful about their vendor accounting methods.

“It also could lend a more serious tone to the Kmart investigations,” Hastings added. “It is logical to think that what is learned in Rite Aid will be useful knowledge in analyzing other retailer-vendor irregularities.”

“Everyone knows about Enron. But when you look at what Rite Aid did, it dwarfs Enron’s statements,” said Gerald Berkowitz, a lawyer who represents Anthony Verdini, president of Rite Aid Corp.’s former leading manufacturer broker, A. Verdini Associates. In 1999 Verdini sued the drugstore chain for alleged interference with contracts and potential contracts with manufacturers, as well as defamation. The lawsuit, which was settled with Rite Aid’s current executive team in January 2001, sought $10 million in damages, not including punitive damages.

Berkowitz said the indictments of Rite Aid’s former management were a long time in coming.

“When you know the types of things that went on there, it doesn’t surprise me,” Berkowitz said. “Verdini had to incur all these crazy charges because Rite Aid said they didn’t receive goods from their vendors or that goods were damaged. [Rite Aid] systematically stole from their vendors. That whole `no broker’ policy under Grass was a plot to grab broker commission and to try and hide the huge losses they were covering up. It cost [Verdini] God knows how much in company dollars.”

Jessica Butler, the partner in charge of the Chargeback Initiative at accounting firm Grant Thornton, observed: “The current rules are so hazy that they’ve given companies the opportunity to interpret them in the way that they want to interpret them. I expect that what will happen is that the Financial Accounting Standards Board will be asked by the SEC to come up with more stringent reporting requirements.”

Butler expects to see a benefit arising for vendors from the current flood of bad news. Fifteen years ago, she pointed out, chargebacks weren’t an issue. As transactions involving deductions, rebates and other charges are scrutinized more, retailers may finally have a uniform guideline on how and when certain charges and deductions ought to be accounted for, she said. “The beneficiaries will be suppliers, because a uniform standard means that retailers can’t be so cavalier about how they take the deductions,” Butler concluded.

To be sure, the scandals just keep popping up, from the Enron debacle to allegations of possible Martha Stewart insider trading transactions involving her shares of ImClone stock. The problems that befell Tyco Corp. and its former ceo Dennis Kozlowski are forcing the initial public offering of commercial financial services The CIT Group amidst an inhospitable IPO climate, both because CIT needs to be separated from the negative publicity of its parent and the fact that Tyco needs cash to pay down debt. On Wednesday, WorldCom shocked the financial markets with disclosures of accounting improprieties that resulted in an overstatement of losses to the tune of $3.8 billion, making the telecommunications giant possibly the largest case involving cooked books.

With investor confidence at an all-time low, what is the federal government to do?

In a presentation before the New York Economic Club Wednesday night, SEC chairman Harvey L. Pitt said that the current crises “reflect the irrational exuberance of the Nineties and the longest sustained bull market in history.” According to Pitt, the SEC has ordered WorldCom to file under oath before the opening of the market on Monday a detailed report of the specifics leading to the restatement, the third time in history — all within the last three months — that the Commission has invoked that specific authority.

He promised that “justice will not only be swift, it will be maximized. Serious jail time is called for by serious financial crime.” He added that as part of the SEC’s goal of reassuring “fraud-weary investors,” the Commission plans on requiring the 1000 largest public companies to file formal certification of the accuracy and completeness of their last annual reports, with the filings to occur by August 15 when most companies are expected to file their next quarterly report. That list would include not only Wal-Mart Stores, the world’s largest company, but presumably such retailers as Target, Sears, J.C. Penney, Federated and May Co.

Despite the challenges that lie ahead for the country’s third largest drugstore chain, many beauty manufacturers think Rite Aid, now led by ceo Robert Miller, can finally put the accounting scandal in its past.

“Rite Aid has it together and is getting its costs under control,” said Gary Schofield, president of Caboodles Cosmetics.

Another cosmetics executive added: “They are in such good moods and happy with the new management. We are getting items into the department that they never looked at before.”

Both retailers and manufacturers at the National Association of Chain Drug Stores’ Marketplace meeting in San Diego also praised Rite Aid’s private label efforts, in particular its new 411 hair care collection.”

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