SEC Announces Fraud Charges Against Former Rite Aid Senior Management

FOR IMMEDIATE RELEASE
2002-92

Washington, D.C., June 21, 2002 -- The Securities and Exchange Commission today filed accounting fraud charges against several former senior executives of Rite Aid Corp. The U. S. Attorney for the Middle District of Pennsylvania simultaneously announced related criminal charges.

The Commission's complaint charges former CEO Martin Grass, former CFO Frank Bergonzi and former Vice Chairman Franklin Brown with conducting a wide-ranging accounting fraud scheme. The complaint alleges that Rite Aid overstated its income in every quarter from May 1997 to May 1999, by massive amounts. When the wrongdoing was ultimately discovered, Rite Aid was forced to restate its pre-tax income by $2.3 billion and net income by $1.6 billion, the largest restatement ever recorded. The complaint also charges that Grass caused Rite Aid to fail to disclose several related-party transactions, in which Grass sought to enrich himself at the expense of Rite Aid's shareholders. Finally, the Commission alleges that Grass fabricated Finance Committee minutes for a meeting that never occurred, in connection with a corporate loan transaction.

The Commission is seeking disgorgement of annual bonuses and imposition of civil penalties against Grass, Bergonzi and Brown. The Commission also seeks an order permanently enjoining each defendant from violating the securities laws and barring each of them from serving as an officer or director of a public company. The Commission also announced settled administrative cease-and-desist proceedings against Rite Aid and against Timothy Noonan, the company's former Chief Operating Officer.

Wayne M. Carlin, Regional Director of the Commission's Northeast Regional Office, stated:

"The charges announced today reveal a disturbing picture of dishonesty and misconduct at the highest level of a major corporation. Rite Aid's former senior management employed an extensive bag of tricks to manipulate the company's reported earnings and defraud its investors. At the same time, former CEO Martin Grass concealed his use of company assets to line his own pockets. When the house of cards teetered on the edge of collapse, Grass fabricated corporate records in a vain effort to forestall the inevitable. The Commission's enforcement action, and the related criminal prosecutions announced today, demonstrate that there will be no refuge for corporate executives who commit this kind of wrongdoing."

The Commission's complaint, filed in federal court in Harrisburg, Pennsylvania, alleges as follows:

Accounting Fraud Charges

• As a result of the fraudulent accounting practices described below, Rite Aid inflated its reported pre-tax income by the following amounts:
   
  

  1Q98	38%
  2Q98	66%
  3Q98	16%
  FY98	9%
  1Q99	71%
  2Q99	5,533%
  3Q99	94%
  FY99	Percentage not mathematically calculable -- reported pre-tax income of $199.6 million, when actual results were loss of $14.7 million
  1Q00	54%

  
   
• Upcharges -- Rite Aid systematically inflated the deductions it took against amounts owed to vendors for damaged and outdated products. For vendors who did not require the unusable products to be returned to them, Rite Aid applied an arbitrary multiplier to the proper deduction amount, which resulted in overcharging its vendors by amounts that ranged from 35% to 50%. These practices, which Rite Aid did not disclose to the vendors, resulted in overstatements of Rite Aid's reported pre-tax income of $8 million in FY 1998 and $28 million in FY 1999.
   
• Stock Appreciation Rights (SARs) -- Rite Aid failed to record an accrued expense for stock appreciation rights it had granted to employees, in a program that gave the recipients the right to receive cash or stock in amounts tied to increases in the market price of Rite Aid stock. Rite Aid should have accrued an expense of $22 million in FY 1998 and $33 million in FY 1999 for these obligations. When questioned by Rite Aid's independent auditors about the existence of any SARs, Bergonzi falsely denied that any had been issued.
   
• Reversals of Actual Expenses -- In certain quarters, Bergonzi directed that Rite Aid's accounting staff reverse amounts that had been recorded for various expenses incurred and already paid. These reversals were completely unjustified and, in each instance, were put back on the books in the subsequent quarter, thus moving the expenses to a period other than that in which they had actually been paid. The effect was to overstate Rite Aid's income during the period in which the expenses were actually incurred. For example, Bergonzi directed entries of this nature which caused Rite Aid's pre-tax income for the second quarter of FY 1998 to be overstated by $9 million.
   
• "Gross Profit" Entries -- Bergonzi directed Rite Aid's accounting staff to make improper adjusting entries to reduce cost of goods sold and accounts payable in every quarter from the first quarter of FY 1997 through the first quarter of FY 2000 (but not at year end, when the financial statements would be audited). These entries had no substantiation, and were intended purely to manipulate Rite Aid's reported earnings. For example, as a result of these entries alone, Rite Aid overstated pre-tax income by $100 million in the second quarter of FY 1999.
   
• Undisclosed Markdowns -- Rite Aid overstated its FY 1999 net income by overcharging vendors for undisclosed markdowns on those vendors' products. The vendors did not agree to share in the cost of markdowns at the retail level, and Rite Aid misled the vendors into believing that these deductions -- taken in February 1999 -- were for damaged and outdated products. As a result, Rite Aid overstated its FY 1999 pre-tax income by $30 million.
   
• Vendor Rebates -- On the last day of FY 1999, Bergonzi directed that Rite Aid record entries to reduce accounts payable and cost of goods sold by $42 million, to reflect rebates purportedly due from two vendors. On March 11, 1999 -- nearly two weeks after the close of the fiscal year -- Bergonzi directed that the books be reopened to record an additional $33 million in credits. All of these entries were improper, as Rite Aid had not earned the credits at the time they were recorded and had no legal right to receive them. Moreover, due to Rite Aid's pass-through obligations in agreements with its own customers, Rite Aid would have been obligated to pass $42 million out of the $75 million through to third parties. The $75 million in inflated income resulting from these false entries represented 37% of Rite Aid's reported pre-tax income for FY 1999.
   
• Litigation Settlement -- In the fourth quarter of FY 1999, Grass, Bergonzi and Brown caused Rite Aid to recognize $17 million from a litigation settlement. Recognition was improper, as the settlement was not in fact consummated in legally binding form during the relevant period.
   
• "Dead Deal" Expense -- Rite Aid routinely incurred expenses for legal services, title searches, architectural drawings and other items relating to sites considered but later rejected for new stores. Rite Aid capitalized these costs at the time they were incurred. Rite Aid subsequently determined not to construct new stores at certain of these sites. Under Generally Accepted Accounting Principles, Rite Aid should have written off the pertinent "dead deal" expenses at the time that it decided not to build on each specific site. Such writeoffs would have reduced reported income in the relevant periods. Instead, Rite Aid continued to carry these items on its balance sheet as assets. By the end of FY 1999, the accumulated dead deal expenses totaled $10.6 million.
   
• "Will-Call" Payables -- Rite Aid often received payment from insurance carriers for prescription orders that were phoned in by customers but never picked up from the store. Rite Aid recorded a "will-call" payable that represented the total amount of these payments received from insurance carriers, that Rite Aid would be obligated to return to the carriers. In the fourth quarter of FY 1999, Rite Aid improperly reversed this $6.6 million payable. When Rite Aid's general counsel learned of this reversal, he directed that the payable be reinstated. Bergonzi acquiesced in the reinstatement, but then secretly directed that other improper offsetting entries be made which had the same effect as reversing the payable.
   
• Inventory Shrink -- When the physical inventory count was less than the inventory carried on Rite Aid's books, Rite Aid wrote down its book inventory to reflect this "shrink" (i.e., reduction presumed due to physical loss or theft). In FY 1999, Rite Aid failed to record $8.8 million in shrink. In addition, also in FY 1999, Rite Aid improperly reduced its accrued shrink expense (for stores where a physical inventory was not conducted), producing an improper increase to income of $5 million.

Related-Party Transactions with Grass

• Grass caused Rite Aid to fail to disclose his personal interest in three properties that Rite Aid leased as store locations. Rite Aid was obligated to disclose these interests as related party transactions. Even after press reports in early 1999 prompted Rite Aid to issue corrective disclosure regarding these matters, Grass continued to conceal and misrepresent the facts, which caused Rite Aid's corrective disclosures to be false.
   
• Grass never disclosed an additional series of transactions, in which he funneled $2.6 million from Rite Aid to a partnership controlled by Grass and a relative. The partnership used $1.8 million of these funds to purchase an 83-acre site intended for a new headquarters for Rite Aid. Rite Aid subsequently paid over $1 million in costs related to this site even though it was owned by the partnership, and not by Rite Aid. After press reports raised questions about this site, Grass transferred $2.9 million back to Rite Aid from a personal bank account, but continued to conceal the series of transactions from Rite Aid's Board.

Fabrication of Minutes by Grass

• In September 1999, when Rite Aid was in perilous financial condition, and in order to obtain a bank line of credit to keep the company afloat, Grass caused minutes to be prepared for a meeting of Rite Aid's Finance Committee, stating that the Committee had authorized the pledge of Rite Aid's stock in PCS Health Systems Inc. as collateral. Grass signed these minutes even though he knew that no such meeting occurred and the pledge was not authorized.

In the injunctive action, the Commission charges Grass, Bergonzi and Brown with violations of Section 17(a) of the Securities Act of 1933; Sections 10(b) and 13(b)(5) of the Securities Exchange Act of 1934 and Rules 10b-5, 13b2-1 and 13b2-2 thereunder; and, as controlling persons of Rite Aid, Sections 13(a) and 13(b)(2) of the Exchange Act and Rules 12b-20 and 13a-1 thereunder. The complaint also charges Bergonzi, as a controlling person, with violations of Rule 13a-13 under the Exchange Act; and charges Grass and Brown, as controlling persons, with violations of Section 14(a) of the Exchange Act and Rules 13a-11 and 14a-9(a) thereunder.

The settled cease-and-desist proceeding against Rite Aid, in which the company neither admits nor denies the Commission's findings, makes findings that Rite Aid violated Sections 13(a) and 13(b)(2) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder. In the settled cease-and-desist proceeding against Noonan, in which Noonan neither admits nor denies the Commission's findings, the Commission finds that Noonan violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder and caused violations of Sections 13(a) and 13(b)(2) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder. Both respondents are ordered to cease and desist from future violations. In determining the appropriate resolution of these proceedings, the Commission considered the substantial cooperation provided by Rite Aid and Noonan in the investigation of this matter.

The Commission acknowledges the invaluable assistance it received in this investigation from the Office of Thomas A. Marino, the U. S. Attorney for the Middle District of Pennsylvania, and the Federal Bureau of Investigation.

Contact:
Wayne M. Carlin   (646) 428-1510
Caren Nelson Pennington   (646) 428-1845