Infectious Greed

by Frank Partnoy

  Beginning in 1994, Andersen auditors identified numerous adjustments they thought were necessary to correct misstatements in Waste Management’s books. The firm had been pushing expenses into the future, much as CUC had done. Waste Management refused to correct the misstatements and, after some debate, Andersen’s partners apparently decided that the problem was temporary. They signed off on Waste Management’s 1994 annual report, but wrote a memorandum specifying the minimum steps Waste Management “must do” to correct the problems. Andersen also identified Waste Management as a “high risk client.”

  Notwithstanding this warning, nothing changed. As Andersen’s auditors reviewed Waste Management’s financial statements in 1995, they worried that Waste Management had not “taken the pill” yet. Waste Management had continued to roll forward its expenses. Moreover, in December 1995, it recorded a gain of $160 million by exchanging shares it owned in a limited partnership called ServiceMaster for shares of ServiceMaster’s parent. It was merely a paper transaction—Waste Management retained the same economic interest in ServiceMaster after the deal—but company officials wanted to use this “gain” to offset accumulating expenses.

  Accounting rules clearly prohibited the offset. One-time gains from deals such as the ServiceMaster transaction had to be separated from operating expenses, so that investors could get an accurate picture of the company and understand that it was losing money, generally, but had booked a substantial gain on one financial transaction.

  However, Andersen concluded that even though the offset was improper, it was not “material” and, therefore, did not need to be disclosed. This interpretation was dubious at best. The legal test for whether information was material was whether an investor would consider it important in the total mix of information about the company. The $160 million offset was obviously important; its disclosure would have caused Waste Management’s stock to plummet. Andersen officials wrote another memorandum, this time noting that they had “communicated strongly to WMX [Waste Management] management that this is an area of SEC exposure.” But Andersen nevertheless signed off on the firm’s 1995 financial statements.

  In 1996, Waste Management was even more aggressive. It continued to push expenses into the future and it netted other one-time gains against various expenses. It even conducted a “sweep” of its field offices, in which it asked controllers to try to find some extra reserves the company could claim as income. At the last minute, one day before releasing its earnings, Waste Management came up with an additional $29 million of such income—an extra four cents a share, which greatly pleased investors and analysts. Again, Andersen signed a statement that Waste Management’s annual report presented an accurate financial view of the company.

  As with Cendant, this sort of accounting at Waste Management didn’t remain hidden forever. Rumors spread about the aggressive practices, and Dean Buntrock stepped down in 1996. The next year, former SEC chairman Roderick Hills joined Waste Management’s board and audit committee, and ordered a thorough audit, which revealed that the company had overstated its earnings by $1.43 billion, twice as much as Cendant had.23 In February 1998, Waste Management announced this finding to the public—the company had lost almost as much money as Orange County had lost a few years earlier. At the time, it was the largest corporate financial restatement in history.

  Andersen again issued its unqualified approval of the firm’s financial statements, which—this time, at least—were accurate. The SEC wasn’t impressed, and fined Andersen $7 million for approving Waste Management’s earlier, inaccurate financial statements.24

  Like Cendant, Waste Management was sued for securities fraud, but Dean Buntrock wasn’t indicted or found personally liable. His reputation suffered, but he did just fine financially. He had earned a salary of about a million dollars for several years, and had received huge grants of stock options (one grant in 1995 was for options on 205,505 shares). As one sign of Buntrock’s wealth, he was able to donate $26 million to his alma mater, St. Olaf College, where the student center was now called Buntrock Commons. A St. Olaf philosophy professor said he planned to use the fraud at Waste Management as an example in class: “I’m not saying Buntrock did anything. But this issue would be a good one.”25

  The Waste Management saga ended like a bad horror film, with the perpetrator rising from the dead to commit another wicked act. The plotline was similar: after a smaller garbage company, USA Waste Services, bought Waste Management in July 1998,26 the new executives failed to tell investors about yet another round of accounting problems. The company—still called Waste Management after the merger—failed to meet its earnings estimates, and the stock plunged from $54 to $34 in one day. The board of directors immediately ousted the new management and began yet another investigation, which revealed an additional $1.2 billion of charges. Was anyone really that surprised? The various cases and appeals were still winding through the courts in 2009, when shareholders were awaiting Waste Management III.

  When Sunbeam Corporation announced it had hired Al Dunlap in July 1996, the company’s shareholders, directors, and securities analysts were thrilled. Sunbeam’s shares went up 50 percent on the day of the announcement. As far as investors knew, Dunlap was a master cost-cutter, with the credentials and credibility to turn the failing company around.

  For Sunbeam, the key fact about Al Dunlap was that he had become CEO of Scott Paper, where he had earned the nickname “Chainsaw Al” by firing 11,200 people—one in three of the firm’s employees. Scott Paper’s stock was up, and shareholders loved Dunlap, even if employees didn’t.

  In 1996, Sunbeam was in the same predicament Scott Paper had been in a few years earlier. It was bloated and inefficient, and needed similarly radical reforms. To Sunbeam’s board, Dunlap seemed like the perfect person to come in and start cutting.

  They couldn’t have been more wrong. Within two years, the board would fire Dunlap, the SEC would begin an investigation into massive accounting fraud at Sunbeam, and the company would be headed for bankruptcy. There would be numerous parallels to Cendant and Waste Management.

  In fact, if Sunbeam’s board had asked more questions about Dunlap’s past, they might not have hired him at all. Dunlap’s résumé had not listed the fact that Max Phillips & Son had fired him in 1974, or that Nitec Paper Corporation had fired him in 1978, allegedly for overstating profits.27 (In 1982, Nitec Paper filed for bankruptcy after some executives accused Dunlap of a massive accounting fraud.)28 Nor did Sunbeam’s directors hear from executives who had worked with Dunlap when he ran an Australian firm called Consolidated Press Holdings; they alleged similar improprieties.29 If the board members had known how many times Al Dunlap had been fired, they might have found his eagerness to fire others suspicious.

  In any event, Dunlap didn’t disappoint the shareholders’ expectations: he fired half of Sunbeam’s 12,000 employees right away, and shut down numerous plants. These actions had substantial one-time costs, but the hope was that, with lower future expenses, Sunbeam finally would look attractive to investors and analysts.

  At the end of 1996, Sunbeam took a huge one-time restructuring charge of $338 million. Executives padded this charge by $35 million, in the same way Cendant and Waste Management had padded their reserves. In accounting parlance, Sunbeam created a “cookie-jar” reserve. By overstating one-time expenses, it created a $35 million stash from which it could take a cookie when necessary.

  In addition, executives front-loaded as many expenses as they could into 1996, in an effort to guarantee that 1997 would be a good year. For example, at the end of 1996, Sunbeam understated the value of inventory it was planning to sell in 1997, thereby guaranteeing that it would make more money when the inventory was later sold. It also recognized expenditures made for 1997 advertising as a 1996 expense.

  In 1997, Sunbeam engaged in a variety of accounting games to inflate its income, including channel stuffing—stuffing its distribution channels with so many advance sales that there would be little revenue lef
t in future periods. For example, just before the end of the first quarter, Sunbeam booked $1.5 million from sales of barbecue grills, even though it had promised the purchaser it could return any grills it did not sell (in fact, six months later, all of the grills were returned unsold).30 Sunbeam also began rewarding customers for agreeing to buy products before they needed them, so that Sunbeam could book the revenue earlier (again, purchasers had the right to return unsold products). Throughout 1997, even with these adjustments, Sunbeam just barely beat analysts’ earnings estimates, by a penny or two per share. By the end of 1997, it appeared that even with all of the accounting games, Sunbeam’s earnings nevertheless would “miss” analysts’ estimates. Like Cendant, it was running out of schemes.

  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.”31

  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.”32

  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.33

  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.

  On 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.34 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.35 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.36 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).37

  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.”38

  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.39

  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.40