LITIGATION RELEASE NO. 17577 / June 21, 2002

ACCOUNTING AND AUDITING ENFORCEMENT
RELEASE NO. 1581 / June 21, 2002

SECURITIES AND EXCHANGE COMMISSION V. FRANK M. BERGONZI, MARTIN L. GRASS, AND FRANKLIN C. BROWN, 1:CV02-1084 (M.D.Pa.)

RITE AID'S FORMER MANAGEMENT TEAM
CHARGED WITH SECURITIES FRAUD BY SEC

The Securities and Exchange Commission announced today that it filed accounting fraud charges in federal district court in the Middle District of Pennsylvania against three former senior executives of Rite Aid Corporation, the nationwide drug store chain based in Harrisburg, Pennsylvania. The United States Attorney for the Middle District of Pennsylvania simultaneously announced related criminal charges.

The Commission also announced today that it instituted separate settled cease-and-desist proceedings against Rite Aid and its former president and COO Timothy J. Noonan.

In the civil action, the Commission charged that Martin L. Grass, Rite Aid's former long-time CEO, Frank M. Bergonzi, the drug chain's former CFO, and Franklin C. Brown, the former vice chairman and chief legal officer, were responsible for one of the most egregious accounting frauds in recent history. The Commission also charged Grass and Brown with concealing certain related party transactions that enriched Grass at shareholder expense, and charged Grass with fabricating Board committee minutes in order to support a lie he told in connection with obtaining a loan critical to keeping Rite Aid in business.

The Commission alleges that Grass, Bergonzi, and Brown conducted a wide-ranging accounting fraud scheme that resulted in the significant inflation of Rite Aid's net income in every quarter from May 1997 to May 1999. After the discovery of improper and unsubstantiated accounting transactions, in July and October 2000 Rite Aid restated cumulative pretax income by a massive $2.3 billion dollars and cumulative net income by $1.6 billion dollars. Rite Aid's restatement was, and to this day is, by far the largest financial restatement ever by a public company. The Commission's subsequent investigation of the reasons for this massive restatement resulted in the current charges against the company and its former top managers.

The Commission is seeking permanent injunctions prohibiting violations of the antifraud, reporting, books and records, internal controls, and other provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934; civil money penalties; bars against acting as officers and directors of public companies; and disgorgement of ill-gotten gains, including performance-based bonuses.

The Commission's Complaint alleges as follows:

Summary

  • From at least March 1997 through at least September 1999, the Defendants engaged in a fraudulent scheme to misrepresent Rite Aid's financial condition and result of operations, and to hide from public view the existence of certain transactions designed to enrich Grass at shareholder expense. They did this with the intent to enrich themselves through performance-based bonuses of stock and cash, and to keep the price of Rite Aid stock from falling as it would have if the public knew the truth about Rite Aid's actual financial condition and results of operations.

  • At the Defendants' direction and/or with their knowledge, for over two years Rite Aid's accounting staff entered into Rite Aid's books and records various kinds of false and misleading accounting entries based on unsubstantiated or otherwise inadequate information, frequently in violation of Generally Accepted Accounting Principles ("GAAP"). The information was generally supplied by Bergonzi but on occasion was also supplied by and/or originated with Grass or Brown.

  • As a result of the misleading accounting entries, all of Rite Aid's publicly reported financial statements from 1997 through May 2000 were materially false or misleading, as were its registration statements and other documents relating to Rite Aid's offerings of securities.

  • The misleading accounting entries enabled Rite Aid to report positive net income when in fact the Rite Aid should have reported materially lower income or losses for the affected periods. For example, Rite Aid's reported pre-tax income was inflated by at least $214.3 million dollars for the fiscal year ended February 27, 1999 ("FY 1999"), turning Rite Aid's actual loss of $14.7 million into a large reported profit.

  • Rite Aid's pre-tax income was overstated by 54% for the first quarter of the period ended May 29, 1999 (the first quarter of fiscal 2000); by 71%, 5533%, and 94% for the first three quarters of FY 1999; by a huge (but indeterminable) percentage for FY 1999 as a whole; by 38%, 66%, and 16% for the first three quarters of the fiscal year ended February 28, 1998 ("FY 1998"), and by 9% for FY 1998 as a whole.

  • In addition, the Defendants were responsible for public reports that failed accurately to disclose several related party transactions by Grass, including one in which Grass arranged for Rite Aid to transfer $2.6 million to a partnership between Grass and a relative purportedly for the purpose of purchasing a new 83-acre site for Rite Aid's headquarters. When this undisclosed transaction unraveled, Grass and Brown attempted to conceal the fact that it had ever occurred.

  • Finally, Grass made material misrepresentations to Rite Aid's lenders in order to obtained a critical loan from them based on a pledge of stock owned by Rite Aid. In support of his false statement, he arranged for the creation of, and personally signed, minutes approving the stock pledge from a meeting of the Board's finance committee that in fact never occurred.

The Accounting Fraud

  • Bergonzi caused Rite Aid to make improper accounting entries in the following subject areas:

    Vendor-Related Accounting Irregularities

    • Improper Vendor Deductions/"Upcharges": With the knowledge of Grass, Brown, and Bergonzi, Rite Aid systematically inflated deductions it took against future amounts owed to vendors for purportedly damaged and outdated products ("D&Os"). The vendors did not agree to or know about this practice. In FY 1999 and FY 1998, Rite Aid overstated reported pre-tax income by approximately $28 million and $8 million, respectively.

    • Undisclosed Markdowns: With the knowledge of Grass and Bergonzi, Rite Aid also overstated FY 1999 pre-tax income by $30 million by charging vendors for undisclosed markdowns relating to vendor products. Like the upcharges, the vendors did not agree to or know about these markdowns. Rite Aid misled them into believing that the deductions taken by Rite Aid were for D&Os.

    • Vendor Rebates: With the knowledge of Grass and Bergonzi, Rite Aid improperly recognized $75 million from vendor rebates, which represented 37% of Rite Aid's reported pre-tax income for FY 1999. At Bergonzi's direction, Rite Aid recognized $42 million of these rebates on the last day of FY 1999 and reopened its books after the close of the fiscal year to recognize the other $33 million. Because the entries were based on expected credits from two vendors which in fact were expressly contingent upon Rite Aid's future sales of these vendors products, they should not have been recognized during FY 1999.

    • Litigation Settlement: In the fourth quarter of FY 1999, in order to help fill a $100 million shortfall perceived by Bergonzi, Grass, Brown and Bergonzi arranged for Rite Aid to prematurely recognize $17 million relating to a litigation settlement with one of the vendors referenced above. It was improper to recognize the $17 million during this quarter because the settlement was contingent on the execution of a purchasing agreement and the finalization of a settlement agreement.

      Other Major Areas of Accounting Irregularities

    • Stock Appreciation Rights ("SARs"): With the knowledge of Grass and Bergonzi, Rite Aid failed to account for SARs which gave certain field managers the right to receive in cash or Rite Aid stock an amount equal to the change in price in Rite Aid's stock between the date of grant and the vesting date. Rite Aid should have recorded, but failed to record, an accrued expense of approximately $33 million for FY 1999 and $22 million for FY 1998.

    • Reductions of Previously-Recorded Expenses: Bergonzi caused Rite Aid to improperly reduce previously-recorded expenses from at least the first quarter of FY 1998 through the first quarter of FY 2000. Rite Aid routinely reduced amounts already booked for expenses in its retail stores and at the corporate level, typically in the quarter subsequent to the one on which it had entered the reductions. For example, in the second quarter of FY 1998, Rite Aid in August credited expenses by a total of $9 million, and then reversed the entries in September. The effect of the expense reduction was to overstate pre-tax income for the second quarter by $9 million, and to understate pre-tax income in the third quarter. There was no support for these reductions.

    • Gross Profit Entries: Bergonzi caused Rite Aid to record unsubstantiated "gross profit" entries that had the effect of lowering cost of goods sold and accounts payable, and therefore caused overstatements of net income in every quarter in which they were made. For example, in the second quarter of FY 1999, as a result of these entries alone Rite Aid overstated pre-tax income by $100 million.

    • "Dead Deal" Expense: Bergonzi caused Rite Aid to improperly account for costs related to the development of store sites which Rite Aid later determined not to use. Although the costs associated with these transactions (known within the company as "dead deals") should have been written off when Rite Aid decided not to develop the sites, Rite Aid instead carried the expenses on its books as assets and wrote them off over time (based on a budget) in violation of GAAP. By February 27, 1999, the dead deal expense totaled $10.6 million.

    • "Will-Call Payables": Bergonzi caused Rite Aid to improperly recorded payments received from insurance carriers for medication ordered by customers over the telephone but that the customers never picked up. Rite Aid reversed the $6.6 million "will-call" accounts payable in the fourth quarter of FY 1999 without basis and in violation of GAAP. When the accounting department employee responsible for this area told the general counsel about this reversal, he directed that the payables be reinstated. Bergonzi then directed that improper off-setting entries be recorded in the general ledger in a different account. This achieved the same improper effect as had the original reversal.

    • Inventory Shrink: Bergonzi allowed Rite Aid to under-accrue for inventory "shrink" or the reduction of inventory presumed due to physical loss or theft. In FY 1999, Rite Aid failed to record $8.8 million in shrink, and improperly reduced the shrink account for 2000 stores resulting in an aggregate increase to income of $5 million. As a result, Rite Aid's pre-tax income for FY 1999 was overstated by $13.8 million attributable to shrink.

    • Depreciation Charges: Bergonzi caused Rite Aid to retroactively increase the estimated lives (periods of time) over which some groups of assets were depreciated, in violation of GAAP. The effect of these changes resulted in an approximately $14.6 million overstatement of FY 1998 pre-tax income.

Fraud Relating to Concealed Related Party Transactions Benefiting Grass

  • Based on false questionnaires provided by Grass, Rite Aid made material misrepresentations concerning three properties that Rite Aid leased as store locations. Rite Aid was required to disclose these transactions as related party transactions. After press reports in early 1999 prompted Rite Aid to correct previous disclosures, Grass not only did not provide correct information about the three properties, he and Brown actively concealed the existence of a transaction where Rite Aid had transferred $2.6 million to a real estate partnership between Grass and a relative. The partnership used $1.8 million to purchase an 83-acre site in its own name, and used most of the balance to pay off debts of other partnerships involving Grass. Rite Aid subsequently paid over $1 million in costs connected to this site, which purportedly would be used as Rite Aid's future headquarters, even though the site was entirely owned by the partnership.

  • Instead of disclosing the transaction as he was obligated to do, Grass, with the knowledge of and help from Brown, took several actions to conceal it. After press reports raised questions about the purpose of the site, Grass paid Rite Aid $2.9 million from his own personal account. He also provide a false affidavit to the Board attesting that other than interests previously disclosed, neither he nor any entity associated with him "has or had" any business dealings with Rite Aid. Grass and Brown also attempted to cover up the transactions by means of a false email and a back-dated letter.

Fraud Relating to Stock Pledge and Grass's Fabrication of Minutes

  • In September 1999, when Rite Aid was in perilous financial condition and needed a significant loan, Grass falsely told the lead bank on Rite Aid's line of credit that the Board's finance committee had approved a stock pledge that was a condition of getting the needed loan. He then arranged for the creation of minutes documenting the purported finance committee meeting and its purported results, even though no such meeting had ever occurred and the pledge had never been authorized. Grass then signed these false minutes.

Specifically, the Commission has charged all Defendants with violations of Section 17(a) of the Securities Act, Sections 10(b) and 13(b)(5) of the Exchange Act, and Rules 10b-5, 13b2-1, and 13b2-2 thereunder, and as controlling persons of Rite Aid pursuant to Section 20(a) of the Exchange Act, Sections 13(a) and 13(b)(2) of the Exchange Act and Rules 12b-20 and 13a-1 thereunder; Bergonzi, as a controlling person, with violations of Rule 13a-13 under the Exchange Act; and Grass and Brown, as controlling persons, with violations of Section 14(a) of the Exchange Act and Rules 14a-9(a) and Rule 13a-11 thereunder.

The Commission also instituted separate settled cease-and-desist proceedings against Rite Aid and its former president and COO Timothy J. Noonan. The Commission considered Rite Aid's and Noonan's cooperation during the investigation in determining the appropriate resolution of the proceedings against them

Rite Aid agreed to settle the action against it by consenting to a cease-and-desist order prohibiting it from committing or causing violations of Sections 13(a) and 13(b)(2) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder, the reporting, books and records, and internal controls provisions. Rite Aid also agreed to cooperate with the Commission during any future judicial proceedings.

Noonan agreed to settle the action against him by consenting to a cease-and-desist order prohibiting him from committing or causing violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, the antifraud provisions of the Exchange Act, and from causing violations of Sections 13(a) and 13(b)(2) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder, the reporting, books and records, and internal controls provisions.

* * *

The Commission acknowledges the assistance of the United States Attorney's Office for the Middle District of Pennsylvania in the investigation of this matter.

*  SEC Complaint in this matter.