Rite Aid Corporation

Securities Exchange Act of 1934
Release No. 46099 / June 21, 2002

Accounting and Auditing Enforcement
Release No. 1579 / June 21, 2002

Administrative Proceeding
File No. 3-10808

I.

The Securities and Exchange Commission ("Commission") deems it appropriate that public cease-and-desist proceedings be, and hereby are, instituted against Rite Aid Corporation ("Rite Aid" or "the Company") pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act").

II.

In anticipation of the institution of these proceedings, Rite Aid has submitted an Offer of Settlement ("Offer"), which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceeding brought by or on behalf of the Commission or in which the Commission is a party, and without admitting or denying the findings contained herein, except as to the Commission's finding of jurisdiction over Rite Aid and the subject matter of these proceedings, which Rite Aid admits, Rite Aid consents to the issuance of this Order Instituting Public Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease-and-Desist Order ("Order") and to the entry of the findings and imposition of the cease and desist order set forth below.

III.

FINDINGS

On the basis of this Order and the Offer submitted by Rite Aid, the Commission finds¹ that:

A. The Respondent

Rite Aid is a Delaware corporation with principal offices located in Camp Hill, Pennsylvania. Rite Aid is one of the nation's largest drugstore chains, operating more than 3500 stores located in twenty-eight states and the District of Columbia. Rite Aid's stock is registered with the Commission pursuant to Section 12(b) of the Securities Exchange Act and is listed on the New York Stock Exchange.

B. Summary

Rite Aid's former senior management team engaged in a financial fraud that materially overstated the Company's net income for the fiscal years ("FY") 1998, 1999, the intervening quarters and the first quarter of FY 2000.² In addition, the former senior management failed to disclose material information, including related party transactions, in Proxy and Registration Statements, as well as a Form 8-K filed in February 1999. Initially in July 2000 and later in October 2000, Rite Aid restated reported cumulative pre-tax income by a total of $2.3 billion and cumulative net income by $1.6 billion. Rite Aid's massive restatement was, and to this day is, the largest financial restatement of income by a public company.

As a result of the improper acts and accounting practices described below, Rite Aid violated the reporting, books and records, and internal controls provisions of the Exchange Act.³

The Commission notes that Rite Aid cooperated in the Commission's investigation of this matter, including declining to assert its attorney-client privilege with regard to various matters relevant to the investigation and voluntarily providing the Commission staff with full access to an internal investigation conducted by Rite Aid's counsel. The Commission has considered the value of this cooperation in determining the appropriate resolution of this matter.

C. Rite Aid's Reported Financial Statements Were False and Misleading and Its Books and Records Were Inaccurate

1. Accounting Entries Affecting All Quarterly and Annual Financial Statements

From at least the first quarter of FY 1998 through the first quarter of FY 2000, Rite Aid inflated net income by reducing its Vendor Accounts Payable and Cost of Goods Sold for unearned vendor credits. For these periods, Rite Aid also failed to record as an expense the cost of the Company's stock appreciation rights program.

a. Improper Vendor Deductions/"Up-charges"

Rite Aid systematically inflated deductions it took against amounts owed to vendors for damaged and outdated products ("D&Os"). For those vendors that did not require Rite Aid to return D&Os to them ("deduct vendors"), Rite Aid had the product destroyed and reported to the deduct vendors the quantity and dollar value of the destroyed product. Rite Aid then deducted the dollar value of destroyed product from a future remittance to the vendor. Rite Aid improperly inflated the quantities and dollar value of D&Os reported to the deduct vendors through a practice known within Rite Aid as the vendor "up-charge." The vendors did not agree to or know about the up-charge. The effect of this practice was to overstate Rite Aid's reported net income. In FY 1998 and FY 1999, Rite Aid overstated reported pre-tax income by approximately $8 million and $28 million, respectively, as a result of the undisclosed vendor up-charges.

b. Stock Appreciation Rights ("SARS")

In May 1995, Rite Aid granted SARS to certain field managers. These SARS gave the holders the right to receive in cash or Rite Aid stock an amount equal to the change in the price of Rite Aid's stock between the date of grant and the vesting date. Under Generally Accepted Accounting Principles ("GAAP"), Rite Aid should have recorded an accrued expense each quarter based on the then-current market price of Rite Aid stock. Rite Aid never recorded any such accruals. In FY 1998 and FY 1999, Rite Aid should have recorded an accrued expense of approximately $22 million and $33 million, respectively.

2. Accounting Entries Affecting Quarterly Financial Statements Only

Rite Aid had a practice of making unsubstantiated quarterly adjustments to cost of goods sold and expense accounts, and then reversing the adjustments in later periods. The initial adjustments and subsequent reversals were not based on GAAP. The practice had the effect of inflating earnings in the quarters that the adjustments were made, while deflating earnings in the quarters that the reversing entries were made.

a. Reduction of Previously-Recorded Expenses

In certain quarters from at least the first quarter of FY 1997 through the first quarter of FY 2000, Rite Aid reduced amounts already booked for various expenses incurred in its retail stores and at the corporate level. Rite Aid typically reversed these expense reductions in the quarter subsequent to the one in which it had entered the reductions, thus returning the expenses to its books but reflecting them in an incorrect period. For example, in connection with the closing of Rite Aid's books for the second quarter of FY 1998 (August 1997), Rite Aid credited its retail stores general ledger expense accounts for the month of August by a total of $9 million across eleven separate accounts. The amounts credited in August were reversed in the following month, September. The effect of the expense reductions was to overstate Rite Aid's pre-tax income for the second quarter of FY 1998 by $9 million. The reversal in the following month had the effect of understating pre-tax income in the third quarter of FY 1998.

b. Gross Profit Entries

From at least the first quarter of FY 1997 through the first quarter of FY 2000, Rite Aid made adjusting entries known as "gross profit" entries. This practice had the effect of lowering the Cost of Goods Sold and Accounts Payable accounts. The gross profit entries were determined by one person without input or review by anyone and were completely unsubstantiated. These entries caused material overstatements of Rite Aid's net income in each quarterly period in which they were made. In the second quarter of FY 1999, for example, Rite Aid improperly reduced Cost of Goods Sold and Accounts Payable accounts by approximately $100 million. As a result of these "gross profit" entries alone, Rite Aid overstated pre-tax income by $100 million in the second quarter of FY 1999. In each of the relevant years, the gross profit entries made during the first three quarters of each fiscal year were reversed in the fourth quarter of that fiscal year.

3. Accounting Entries Recorded in the Fourth Quarter That Affected the FY 1999 Financial Statements

The reversal of the gross profit entries described above created an understatement of fourth quarter income that necessitated the recording of new entries in the fourth quarter that would overstate income in the fourth quarter by at least a like amount. Some of these entries were recorded just as the fiscal year was ending or just after the year ended. Rite Aid's reported net income of $143 million for fiscal year 1999 was materially overstated as a result of these entries. In fact, without such entries Rite Aid would have suffered a net loss for FY 1999.⁴

a. Undisclosed markdowns

In addition to the improper vendor deductions discussed in Section C.1.a above, Rite Aid overstated its FY 1999 Net Income by falsely reporting to vendors as D&Os the cost of marking down the price of certain products in its stores. The vendors did not agree to share in the cost of the price markdowns and were misled by Rite Aid into believing that the deductions taken by Rite Aid in February 1999 were for D&Os. These purported D&Os resulted in an overstatement of FY 1999 pre-tax income of approximately $30 million.

b. Vendor Rebates

On the last day of FY 1999, Rite Aid recorded reductions to accounts payable and cost of goods sold totaling $42 million. The reductions were based upon purported credits from two vendors. These credits, however, were expressly contingent upon Rite Aid's future sales of these vendors' products. Rite Aid even went so far as to reopen its books to record an additional $33 million of these credits on March 11, 1999, subsequent to the close of the fiscal year, when it was readily apparent that the Company's results would fall short of Wall Street analysts' projections. These entries violated GAAP because the credits were unearned as of FY 1999. Moreover, the purchasing agreements pursuant to which Rite Aid might have earned these credits in the future were not consummated in legally binding form on or before February 27, 1999.

c. Litigation Settlement

In the fourth quarter of FY 1999, Rite Aid prematurely recognized a $17 million litigation settlement with one of the two vendors referenced in the paragraph above. Rite Aid should not have recognized this sum because the settlement offer was expressly contingent upon the execution of a formal settlement agreement which did not take place until May 1999. Moreover, the litigation settlement was also contingent upon the execution of the purchasing agreement referenced in the prior paragraph, which was not finalized until May 1999.

d. "Dead Deal" Expense

Rite Aid incurred costs for matters such as legal services, title searches, and architectural drawings relating to sites being considered for possible construction of new stores. Rite Aid capitalized these costs at the time they were incurred. Subsequently, during FY 1999 (and during prior periods), Rite Aid determined not to construct new stores at certain of these sites. Under GAAP, Rite Aid should have written off the capitalized costs relating to each site at the time that Rite Aid decided not to develop that site. Such write-offs would have adversely affected Rite Aid's reported net income in the relevant periods. Rather than write off these expenses (which Rite Aid called "dead deal" expenses), Rite Aid continued to carry them on its books as assets. Despite knowing that writing such amounts off based on a budget was contrary to GAAP, Rite Aid's accounting department wrote off portions of these expenses at the fixed rate of $125,000 per month (later increased to $250,000 per month), rather than write off the full amount of dead deal expenses. By February 27, 1999, the accumulated dead deal expense totaled approximately $10.6 million.

e. Will-Call Payables

. Rite Aid often received payment from customer insurance carriers whether or not the customers actually picked up medication ordered by telephone. Beginning in 1997, a member of Rite Aid's accounting staff recorded a "will-call" account payable that represented the total amount of payments received from private insurance carriers for prescription orders never picked up by customers. Rite Aid reversed the will-call account payable without sufficient justification or basis in violation of GAAP. Ultimately, the accrual was re-established and the $6.6 million attributable to the will-call payable was repaid to the insurance carriers.

f. Inventory Shrink

Rite Aid periodically conducted physical inventories of retail stores. If the physical inventory count was less than the inventory carried on Rite Aid's books, Rite Aid wrote down its book inventory accordingly to reflect this "shrink" (i.e., reduction of inventory presumed due to physical loss or theft). In FY 1999, Rite Aid failed to record $8.8 million in shrink. For retail stores in which a physical inventory was not conducted, Rite Aid recorded a shrink accrual, reflecting Rite Aid's estimate of the shrink during the period. In FY 1999, Rite Aid improperly reduced the accrued shrink expense for 2,000 stores, resulting in an aggregate increase to income of $5 million. As a result of this improper accounting for shrink, Rite Aid's pre-tax income for FY 1999 was overstated by $13.8 million.

4. Summary of Rite Aid's FY 1998, FY 1999 and 1^st Quarter FY 2000 Overstatements of Pre-tax Income

The quantifiable effect of Rite Aid's practices in the above-described areas on Rite Aid's reported pre-tax income are summarized below:

5. Additional Misrepresentations and Omissions In Rite Aid's Public Filings

a. Misleading Disclosures of Related Party Transactions

(i) Prompted by a series of newspaper articles in January 1999, Rite Aid filed a Form 8-K on February 9, 1999 purporting to disclose its CEO's interest in three properties that Rite Aid leased as store locations. While the Form 8-K acknowledged that the CEO owned one of the three properties in a partnership with his relatives (in contrast with the CEO's prior public comments), the Form 8-K inaccurately stated that (1) the second property was owned by the CEO's brother-in-law but the CEO had no interest in the second property; (2) the third store was now on a new property controlled by an "unrelated entity;" and (3) the CEO had no participation in approval of any real estate deals in which "a related party or any person with whom he has business relationships is involved." In fact, on February 9, 1999, (1) the CEO was still a partner in the second property; (2) the third store was now on property controlled solely by a man with whom the CEO had multiple real estate partnerships, including joint ownership of its previous location; and (3) the CEO approved the terms of the lease for the third location with the new "unrelated entity." Prior to the February 9, 1999 Form 8-K, Rite Aid had not disclosed any of these related party transactions and relationships.

(ii) The February 9, 1999 Form 8-K also did not disclose dealings the CEO had involving an 83 acre parcel of land (the "Site") which was considered as a relocation site for Rite Aid's headquarters. In January 1998, with the knowledge of other senior officers, the CEO caused $2.6 million to be transferred from Rite Aid to a partnership controlled by the CEO and a family member (the "Partnership"). The Partnership used $1.6 million to purchase the Site in its own name, and most of the balance to pay off debts of other partnerships involving the same partners. Rite Aid subsequently paid over $1 million in costs connected to the Site even though it was owned by the Partnership and not by Rite Aid. These costs were capitalized in Rite Aid's Land Holding account.

(iii) Shortly before the Form 8-K was filed in February 1999, the CEO transferred $2.9 million to Rite Aid from a personal bank account. Soon after the Form 8-K was filed (with no mention of the Site), a published report questioned whether Rite Aid intended to relocate its headquarters to the Site. Grass then provided an affidavit to Rite Aid's Board falsely stating that neither he nor any entity in which he had an interest had any business dealings with Rite Aid Corporation other than as described in the Form 8-K. None of these facts, including the money transfers, were disclosed by Rite Aid in the Form 8-K or in proxy statements that Rite Aid distributed to shareholders for FY 1998 and FY 1999.

b. Non-Disclosure of Debt Financing Issues

(i) In January 1999, Rite Aid acquired PCS Health Systems Inc. ("PCS"), a pharmacy benefits manager, for $1.5 billion. In order to finance the PCS deal, Rite Aid issued short-term commercial paper ("CP") backed by a $1.3 billion line of credit ("Credit Line"). By the end of September 1999 Rite Aid could not roll over its' CP for a variety of reasons. Rite Aid approached its lenders in late September 1999 and asked to draw down on the Credit Line in order to repay maturing CP, but the request was denied because the creditors discovered that the company was not in compliance with the Credit Line's covenants. Instead, the CEO of Rite Aid pledged Rite Aid's ownership of PCS as collateral and paid $5 million in fees to obtain an interim facility from five banks that was used to pay off immediately maturing CP. Four days later, the lending syndicate waived the covenant violations on the Credit Line, allowing Rite Aid to pay off the interim loan as well as additional maturing CP. Rite Aid's interest in PCS was again used as collateral for the newly amended Credit Line.

(ii) Rite Aid did not timely disclose its violation of the original loan covenants, the interim loan, or the pledge of PCS. In fact, during a conference call with analysts on September 29, 1999, the CEO affirmatively denied that Rite Aid had used any sources other than the Credit Line to pay off CP, and failed to mention any of the other financing problems.

6. Accounting Entry That Affected FY 1997 Pre-tax Income

Rite Aid sometimes improperly recorded gains from the sale of stores as additions to reserve accounts rather than as income, and Rite Aid also improperly charged current or future period expenses against the same reserve accounts. The most extreme example of this occurred in FY 97 in connection with Rite Aid's sale of 189 stores to another company for a gain that Rite Aid inaccurately calculated to be $90 million. Rite Aid recorded this gain in a reserve account and improperly used the reserve to absorb an equivalent amount of operating expenses that should have been charged to the income statement. As a result of these accounting practices, Rite Aid appeared to have achieved its reported net income for FY 1997 by controlling recurring operating expenses, when in fact it was by means of an undisclosed one-time nonrecurring gain of $90 million. The $90 million represented 34% of Rite Aid's $261 million Pre-tax Income for FY 1997. Moreover, Rite Aid's FY 97 Form 10-K stated that "[g]ains from drugstore closings and dispositions were not significant." This statement was misleading for the reasons discussed above. The inaccurate FY 1997 financial statements were republished in Rite Aid's Forms 10-K for FY 1998 and FY 1999.

D. The Restatements

Rite Aid restated its reported financial statements on July 11, 2000 and October 11, 2000 in a Form 10-K and an amended Form 10-K for FY 2000. The Forms 10-K and 10-K/A restated reported cumulative pre-tax income by $2.3 billion and cumulative net income by $1.6 billion.

E. Legal Analysis

Rite Aid Violated the Reporting, Record-keeping and
Internal Controls Provisions of the Exchange Act

1. Sections 13(a) and 13(b)(2)(A) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 require issuers to make and keep accurate books, records, and accounts, to file annual and quarterly reports with the Commission, and to keep reported information current and not misleading. Section 13(b)(2)(B) of the Exchange Act requires issuers to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles and to maintain the accountability of assets. No showing of scienter is necessary to find a violation of these provisions. See SEC v. Wills, 472 F. Supp. 1250, 1268 (D.D.C. 1978).

2. As described in detail above, Rite Aid's internal books, records, and accounts reflected numerous transactions that were invalid or without substantiation, had no legitimate business purpose, and were recorded in violation of GAAP. Moreover, from at least 1997 to July 11, 2000, all of the annual and quarterly reports that Rite Aid filed with the Commission contained misleading financial statements. As a result, Rite Aid violated Sections 13(a) and 13(b)(2)(A) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder.

3. Rite Aid's system of internal accounting controls was not designed to provide reasonable assurances that transactions were recorded as necessary to permit preparation of financial statements in conformity with GAAP or to maintain the accountability of assets. Rite Aid's system of internal accounting controls failed to prevent, and indeed facilitated, the improper accounting practices described in detail above. As a result, Rite Aid violated Section 13(b) of the Exchange Act and Rule 13(b)(2)(B) thereunder.

IV.

Rite Aid has submitted an Offer in which, without admitting or denying the findings herein, it consents to the Commission's entry of this Order, which (1) makes findings as set forth above; and (2) orders Rite Aid to cease and desist from committing or causing any violation, or any future violation, of certain provisions of the federal securities laws. As set forth in its Offer, Rite Aid undertakes to cooperate with the Commission staff in connection with this action and any related judicial or administrative proceedings or investigation commenced by the Commission or to which the Commission is a party.

V.

Based on the foregoing, the Commission deems it appropriate to accept the Offer submitted by Rite Aid and to impose the relief specified herein.

Accordingly, IT IS HEREBY ORDERED, effective immediately, that Rite Aid shall cease and desist from committing or causing any violation, and from committing or causing any future violation, of Sections 13(a) and 13(b)(2) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder; and

IT IS FURTHER ORDERED that Rite Aid comply with its undertaking described in Section IV. above.

By the Commission.

Jonathan G. Katz
Secretary

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