The Autumn Leaves - 1999

TRUE SAVE

For True Save Corp the fall came fast. The company entered 1999 as a “Fortune 200” company operating 3,500 drugstores in 28 states, with over $12.5 bn in sales and a share price ranging between $40-50, In mid-March, the company reported that quarterly earnings would come in at 30 cents per share, compared with analysts' consensus estimates of 52 cents. Taken by surprise, Wall Street pummeled the share price from $37.00 to $22.56 in a single day.

Investors were upset. Within weeks 11 class action lawsuits were filed against the chain.

In September 1999 the company began negotiations for an $800 million bank line of credit.

By October, the company was the subject of intense media coverage. Reports about its aggressive marketing of pharmaceutical products and other consumer-unfriendly practices, including selling date-sensitive products well past the due dates circulated in the press. It was being investigated by government regulators in California, Washington and Oregon. On the financial pages, news emerged that the company would once again restate income (it had already done so in June) for the previous three years. True Save shares were now trading at $10. Within weeks, the CEO and several top executives would be forced to leave by the Board of Directors.

A Brief History of True Save (1962- 1998)

Alex Sands opened his first drugstore in September of 1962 as Thrifty Discount Center in Scranton, Pennsylvania. From the start, the company grew rapidly through acquisitions and the opening of new stores, expanding to five northeastern states by 1965. In 1968 the company changed its name to True Save, made its first public offering and started trading on the American Stock Exchange. In1970, True Save moved to the New York Stock Exchange.

By 1972, after ten years in business, True Save operated 267 stores in 10 states. By 1981, True Save had become the third largest retail drugstore chain in the country and in 1983, passed the $1 billion sales mark for the first time.

The year True Save celebrated its 25th Anniversary, 1987, the company acquired 420 stores in Florida, Maryland, Washington D.C., Delaware, Indiana, New York, Ohio, Virginia, West Virginia, North Carolina and Pennsylvania greatly expanding the company's market penetration and passing the 2,000-store mark to become the nation's largest drugstore chain by number of stores.

The 90’s saw the emergence of two powerful national drugstore chains Allgreens and CTS that surpassed True Save in sales and profits. With the increased scale and buying power of the large players and the emergence of managed care programs from health insurers, margins thinned at smaller chains and independent drugstores, making them more vulnerable to takeover.

This case study has been developed based on a true situation and drawn from publicly available information by Genesis Corporation. For permission to use this case study for instructional purposes and for additional reference material and instructor notes, contact Genesis Corporation at www.consultgenesis.com. In 1995, Alex Sands passed over control of True Save to his 41 year old son, Martin who became CEO. That year the company acquired Penny Drugs, the largest drugstore chain in Michigan and the largest acquisition to date for True Save. By of March 1995, True Save operated nearly 3,000 stores. Late in the year Martin agreed to purchase Saveco, a major drug chain then similar in size to True Save. The acquisition bid was withdrawn when the FTC filed a suit to block it alleging it would limit competition in too many markets in the East.

1996 saw True Save expand its services to the West Coast through the acquisition of the 1,000- store chain, Thrifty Holdings, Inc., the largest drugstore chain in the western United States. Soon after that, True Save entered the Gulf Coast region with the acquisitions of Tuscaloosa, AL based Gulfco, Inc. and New Orleans, LA based A & B Incorporated, adding 332 stores to True Save.

In 1998, True Save acquired XYZ Health Systems Inc., one of the leading pharmacy benefits management companies in the country and the following January formed a strategic partnership with ABC, the largest specialty retailer of vitamins, mineral supplements, sports nutrition and herbal products. This partnership created ABC "stores within stores" in True Save drugstores across the country.

The Boss and the Top Brass

For the years 1995-99 senior management of True Save was in the hands of CEO Martin Sands, President and COO Timothy J. Norton, CFO Frank Bordeaux and Chief Counsel and Vice Chairman Franklin White.

Martin Sands, a graduate of the University of Pennsylvania and holder of a master's degree in business administration from Cornell University started working at True Save in 1978 at age 23.

From his youth, Sands, the family's eldest son, was the anointed successor to the drugstore empire created by his father. The move was resented by one of his siblings, who once described Martin as incompetent.

During his years working at True Save he lived near Baltimore, was an avid Orioles fan and a benefactor of the arts, donating $1 million to the city's opera house and several thousand dollars to the Baltimore Symphony Orchestra. He was described by those who knew him as family- oriented; married with two school-age children.

He was also known in Baltimore County for legally battling his neighbors over the noisy helicopter that shattered the serenity of Happy Valley every time he left his home to commute to his Sandy Hill, Pennsylvania headquarters.

In 1989, as president of True Save, Martin Sands dodged a major criminal charge. On that occasion he took the company jet from Sandy Hill to Cleveland, where he met with a member of the state pharmacy board at an airport hotel. As he handed the man a check for $33,000, Cuyahoga County sheriff's deputies and prosecutors entered the room and arrested Sands on bribery charges. The meeting had been videotaped from adjacent rooms. But Sands was acquitted 15 months later.

2 The Unraveling

When True Save missed its earnings estimates for 1999, Sands addressed the matter in a conference call with media and analysts, and pinned most of the chain's profitability problems on "our Achilles' heel ... the tremendous real estate effort. Earlier in the year, we announced we'd increase our new store construction schedule from 400 to 500, primarily because of the success that we were seeing in the relocated and new True Save No. 1 stores that we'd been opening over the past three years."

On June 1, 1999, when True Save announced that it had restated 3 previous years of earnings, BIG4 LLP was its external auditor. On June 30, 1999, BIG4 delivered a letter to the audit committee that described a number of material weaknesses in True Save’s internal controls. The letter stated that True Save’s internal controls were insufficient to allow the company’s management “to accumulate and reconcile information necessary to properly record and analyze transactions on a timely basis.” The letter also suggested a number of actions to improve the quality of True Save’s financial accounting and reporting functions. BIG4 informed the company and the audit committee at the June 30, 1999, meeting that, as a result, BIG4 LLP would not be in a position to issue quarterly review reports until the matters it raised were addressed and resolved. BIG4 also asserted that it was no longer willing to rely on representations made by CFO Bordeux. The members of True Save’s audit committee and another member of the company’s board of directors who attended the June 30 meeting would later deny that any such statements had been made, while BIG4 would strenuously insist that they had.

In October True Save announced that it would not be able to file its Form 10-Q on time.

On November 11, 1999, BIG4 LLP resigned as auditor of True Save because it was unable to rely on management’s representations. BIG4 also withdrew its auditor’s report dated May 28, 1999, on True Save’s financial statements. Neither that report nor BIG4’s report on True Save’s financial statements for the fiscal year ended February 28, 1998, contained an adverse opinion or a disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope, or accounting principles.

2002: Pick Your Suit

On June 21, 2002 — The Securities and Exchange Commission filed accounting fraud charges against several former senior executives of True Save Corp. The U. S. Attorney for the Middle District of Pennsylvania simultaneously announced related criminal charges.

The Commission's complaint charged former CEO Martin Sands, former CFO Frank Bordeaux and former Vice Chairman Franklin White with conducting a wide-ranging accounting fraud scheme. The complaint alleged that True Save overstated its income by massive amounts in every quarter from May 1997 to May 1999. When the wrongdoing was ultimately discovered, True Save 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 charged that Sands caused True Save to fail to disclose several related-party transactions, in which Sands sought to enrich himself at the expense of True Save's shareholders. Finally, the Commission alleged that Sands fabricated Finance Committee minutes for a meeting that never occurred, in connection with a corporate loan transaction.

3 The Commission sought disgorgement of annual bonuses and imposition of civil penalties against Sands, Bordeaux and White, as well as 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 settled administrative cease-and-desist proceedings against True Save and against Timothy Norton, the company's former Chief Operating Officer, who collaborated with the investigators.

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

"The charges … reveal a disturbing picture of dishonesty and misconduct at the highest level of a major corporation. True Save'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 Sands concealed his use of company assets to line his own pockets. When the house of cards teetered on the edge of collapse, Sands fabricated corporate records in a vain effort to forestall the inevitable. The Commission's enforcement action, and the related criminal prosecutions … 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, alleged

Accounting Fraud Charges

As a result of the fraudulent accounting practices described below, True Save inflated its reported pre-tax income:

 Upcharges — True Save 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, True Save 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 True Save did not disclose to the vendors, resulted in overstatements of True Save's reported pre-tax income of $8 million in FY 1998 and $28 million in FY 1999.

 Stock Appreciation Rights (SARs) — True Save 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 True Save stock. True Save should have accrued an expense of $22 million in FY 1998 and $33 million in FY 1999 for these obligations. When questioned by True Save's independent auditors about the existence of any SARs, Bordeaux falsely denied that any had been issued.

 Reversals of Actual Expenses — In certain quarters, Bordeaux directed that True Save'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 True Save's income during the period in which the expenses were actually incurred. For example, Bordeaux directed entries of this nature which caused True Save's pre-tax income for the second quarter of FY 1998 to be overstated by $9

4 million.

 "Gross Profit" Entries — Bordeaux directed True Save'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 True Save's reported earnings. For example, as a result of these entries alone, True Save overstated pre-tax income by $100 million in the second quarter of FY 1999.

 Undisclosed Markdowns — True Save 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 True Save misled the vendors into believing that these deductions — taken in February 1999 — were for damaged and outdated products. As a result, True Save overstated its FY 1999 pre-tax income by $30 million.

 Vendor Rebates — On the last day of FY 1999, Bordeaux directed that True Save 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 — Bordeaux directed that the books be reopened to record an additional $33 million in credits. All of these entries were improper, as True Save had not earned the credits at the time they were recorded and had no legal right to receive them. Moreover, due to True Save's pass-through obligations in agreements with its own customers, True Save 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 True Save's reported pre-tax income for FY 1999.

 Litigation Settlement — In the fourth quarter of FY 1999, Sands, Bordeaux and White caused True Save 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 — True Save routinely incurred expenses for legal services, title searches, architectural drawings and other items relating to sites considered but later rejected for new stores. True Save capitalized these costs at the time they were incurred. True Save subsequently determined not to construct new stores at certain of these sites. Under Generally Accepted Accounting Principles, True Save 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, True Save 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 — True Save often received payment from insurance carriers for prescription orders that were phoned in by customers but never picked up from the store. True Save recorded a "will-call" payable that represented the total amount of these payments received from insurance carriers that True Save would be obligated to return to the carriers. In the fourth quarter of FY 1999, True Save improperly reversed this $6.6 million payable. When True Save's general counsel learned of this reversal, he

5 directed that the payable be reinstated. Bordeaux 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 True Save's books, True Save wrote down its book inventory to reflect this "shrink" (i.e., reduction presumed due to physical loss or theft). In FY 1999, True Save failed to record $8.8 million in shrink. In addition, also in FY 1999, True Save 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 Sands

 Sands caused True Save to fail to disclose his personal interest in three properties that True Save leased as store locations. True Save was obligated to disclose these interests as related party transactions. Even after press reports in early 1999 prompted True Save to issue corrective disclosure regarding these matters, Sands continued to conceal and misrepresent the facts, which caused True Save's corrective disclosures to be false.

 Sands never disclosed an additional series of transactions, in which he funneled $2.6 million from True Save to a partnership controlled by Sands and a relative. The partnership used $1.8 million of these funds to purchase an 83-acre site intended for a new headquarters for True Save. True Save subsequently paid over $1 million in costs related to this site even though it was owned by the partnership, and not by True Save. After press reports raised questions about this site, Sands transferred $2.9 million back to True Save from a personal bank account, but continued to conceal the series of transactions from True Save's Board.

Fabrication of Minutes by Sands

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

The Shifty Sands

In May 1999, the indictment said, Sands telephoned the BIG4 partner in charge of auditing True Save and told him "skeletons would come out of BIG4's closet" if True Save suffered as a result of a BIG4 audit.

The following month, Sands traveled to BIG4's offices in New York and sought removal of the partner in charge of the audit, the indictment says. At the same meeting, Sands allegedly offered to sign a consulting contract with BIG4 -- a deal that was later consummated.

6 The indictment also alleged that Sands had True Save pay a $3 million settlement to a former senior vice president to "silence" him after learning he was threatening to expose a scheme the company was using to defraud vendors and inflate income.

Even after Sands resigned as CEO, he prepared backdated letters to two of his co- defendants and a third employee granting them millions of dollars in enhanced severance and deferred compensation.

In May 2001, while True Save officials were being interviewed by federal investigators over suspicious severance letters, Sands is heard on a recorded conversation reassuring colleagues that investigators "do not have and will never have" the computer that generated the back-dated severance letters "unless they use a Trident submarine."

Final Sentences

Three of the top executives at True Save sentenced to jail time. Bordeaux and Sands pleaded guilty to various charges and did not go to trial. Bordeaux was sent to prison for 28 months while 8 years was the sentence in the case of Martin Sands. Chief Counsel and Vice Chairman Franklin White went to trial, was convicted and was sentenced to 10 years in prison.

"As it turns out, I tried to do too much, too fast," Sands told the judge. When the company's finances took a turn for the worse in early 1999, he said, "I did some things to try and hide that fact."

"Those things were wrong. They were illegal," he said. "I did not do them to line my own pockets."

Assignment

From your reading of the information presented, how would you characterize the fraud by True Save’s management? What do you think motivated Grass and the top executives?

Avoiding losses perpetrated by bank clients should begin with sensitivity to fraud and a methodology for picking up potential warning signals. What should you be looking for? What factors might have alerted you to be more cautious in your dealings with True Save? What actions might you have taken to enhance your due diligence, better identify the fraud and minimize your vulnerability?

Bankers maintain relationships with companies like True Save offering various products. Imagine that your bank had been a lender, a loan or bond syndicator, an underwriter for equity issues, or an advisor on M&A activity; what might some of the consequences of the fraud be for your bank, the bank’s image and the bank’s relationship with other customers?