Creditors Take on Kmart's "Frat Boys"

The former top managers are being sued for gross mismanagement and taking lavish perks even as the retailer's bankruptcy loomed

By Kathleen Kerwin

They were known inside Kmart (KMRT ) as "the frat boys." Former Chief Executive Charles C. "Chuck" Conaway and the cadre of young, ambitious senior managers he recruited after arriving at Kmart in May, 2000, were jokingly known for their brash ideas and fast living. Now, creditors are alleging that the retailer's former senior managers were indeed having one hell of a house party even as Kmart teetered on the brink of bankruptcy.

Kmart Creditor Trust filed a civil suit on Nov. 18 in Oakland County Circuit Court, near Kmart's Troy (Mich.) headquarters. It alleges that Conaway and five of his top executives squandered more than $1 billion during the less than two years they operated the ailing retailer, even as they ran up the corporate tab with lavish perks and pay. In addition to Conaway, the suit names ex-President Mark Schwartz and four other former managers: CFO John McDonald, Chief Administrative Officer David Rots, Chief Supply-Chain Officer Anthony D'Onofrio, and David Montoya, senior vice-president for store operations.


  The 116-page suit charges the officers with "gross mismanagement," including the alleged inventory bungling -- such as overordering that left Kmart holding nearly $500 million of goods it couldn't sell -- and allegedly damaging its critical access to short-term borrowing. The suit claims that the managers falsely inflated results in public filings and misled Kmart's board, creditors, and vendors about its health. Consequently, creditors claim, actions that might have minimized the eventual losses weren't taken until it was too late.

The creditors also charge that even as Kmart was bleeding red ink, Conaway and his team dipped into the corporate till to buy themselves Jaguars, luxury SUVs, and electronics; to cover trips to Las Vegas, home improvements, and dozens of personal trips on the corporate jet; and to pay nannies more than $100,000 to watch their children. D'Onofrio is accused of charging Kmart for $15,000 worth of dental work for his wife and letting a vendor pay for a trip to Asia for him and his girlfriend.

The suit says Conaway doubled Kmart's fleet of corporate jets to six and that he hired a dozen pilots, billed the discounter for more than $100,000 to increase security at his home, as well as for an $82,000 fence, snow removal, changing his blinds, and dismantling Christmas trees. Schwartz received more than $2 million in moving expenses, the suit alleges.


  Conaway disputes the charges against him. "Chuck Conaway poured his heart and soul into trying to turn around the giant retailer," said his lawyer, Scott Lassar, in a prepared statement. "At all times he acted honorably and in the best interests of Kmart's employees and shareholders." BusinessWeek Online was unable to reach the other accused former executives or their lawyers for comment. All of the managers named in the suit had left the company by May, 2002, and it's not known whether any of them found work after leaving Kmart.

The retailer is a textbook example, many would argue, of how not to run a business. Industry experts who have looked at its financials say Kmart was ultimately done in by years of mismanagement, along with poor inventory controls, lousy distribution, and crummy retail locations. The bankruptcy wiped out the equity of an outfit with a market capitalization of $4.5 billion less than a year before the Chapter 11 filing. Kmart was forced to close nearly 600 stores and lay off 57,000 people, before emerging from Chapter 11 in May.

The reorganization plan left $7.3 billion of unsatisfied claims, many belonging to the unsecured creditors represented by the trust that filed this lawsuit. Perhaps more important, it's still far from clear that Kmart will be able to survive in an increasingly cutthroat retail environment.


  The creditors' trust, consisting of all Kmart's unsecured creditors, was created when the retailer emerged from bankruptcy to pursue legal claims arising from the retailer's review of past "stewardship" and accounting. The trust recently sued six other former Kmart execs in U.S. bankruptcy court, seeking to reclaim their so-called retention loans. At least three other former managers, who aren't being sued, have returned their loans.

The six managers named in the latest suit were part of a group of 25 execs who creditors, laid-off Kmart employees, and the media have already excoriated for taking nearly $29 million in retention loans in November, 2001, just two months before the bankruptcy.

Shortly after receiving his $3 million retention loan, Schwartz quit in January, 2002, a week before Kmart's Chapter 11 filing, according to the suit. Conaway himself received a $5 million loan, plus $4 million in severance, when he left in March -- and an additional $3.9 million to cover taxes on the two payments, the suit alleges. The others named in the suit left in March. The creditors seek return of those loans and other "wrongfully obtained" money, plus interest and actual and compensatory damages.


  Conaway's attorney disputes that the former CEO obtained anything wrongfully. "Conaway did not engage in self-dealing. In fact, the board's compensation committee approved an $11 million cash payment for Mr. Conaway one week prior to the filing of bankruptcy. Mr Conaway turned down the money because of the impending bankruptcy. Mr. Conaway looks forward to rebutting the accusations in the complaint in court," Lassar said in a statement.

The suit also names Kmart's auditor during that period, PricewaterhouseCoopers, alleging accounting negligence. "Kmart's failure in the competitive marketplace resulted from adverse business developments and had nothing to do with accounting or auditing issues. All the services provided to Kmart complied with professional standards," says PwC spokesperson Steven Silber. "The complaint against us is without merit, and we're confident that ultimately it will be dismissed." Silber also points out that a shareholder suit against the auditors was dismissed a few months ago. PwC ceased working for Kmart on Oct. 9.

As for the retailer, Jack Ferry, spokesman for Kmart Holding Corp., the post-bankruptcy entity, says it's not responsible for recovering the retention loans and isn't "involved in the pursuit of these individuals or legal action initiated by the Creditors Trust against any other companies." He adds that Kmart won't receive any funds that many be recouped by the creditors trust.

Kerwin writes for BusinessWeek in the Detroit bureau

Edited by Beth Belton

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