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2 Ex-Officials At Kmart Face Fraud Charges

Two former Kmart executives were indicted yesterday by a Detroit grand jury on federal charges of fraud, conspiracy and making false statements over their recording of a $42 million payment that resulted in an overstatement of Kmart's results.

The executives, who ran Kmart's drugstore division until they were dismissed from the company nine months ago, had been trying to spruce up their division's performance in a particular quarter, according to investigators.

The two men, Enio A. Montini Jr. and Joseph A. Hofmeister, were also charged with fraud by the Securities and Exchange Commission in a related complaint. They are the first people to be indicted as a result of investigations into Kmart's former management that began after an anonymous letter detailing internal problems was sent to the Kmart board and government officials last January, around the time Kmart sought Chapter 11 bankruptcy protection. The investigations are continuing.

The complaints filed yesterday offer a glimpse into the byzantine world of retail accounting, describing how one eight-figure payment, intended to cover a five-year period, was used to improve the quarterly results at Kmart's drugstore division.

The payment was made as a kind of advance by American Greetings to Kmart on the anticipated sale of greeting cards. At American Greetings, the payment would be offset by actual sales of cards over the term of the contract, a spokesman, David Poplar, said.

''It's a classic case of matching expenses with revenue,'' Mr. Poplar said.

But at Kmart, the entire $42 million was recorded in a single quarter, which improved the company's results per share for that period by 6 cents. Under generally accepted accounting principles, as well as S.E.C. rules, the payment, known as a vendor allowance, should have been recorded over the entire term of the contract, the S.E.C. complaint states. The quarter ended in August 2001, five months before Kmart filed for bankruptcy.

''The pressure is always there to meet the needs of today and let tomorrow take care of itself,'' said Tom Newkirk, an associate director of enforcement for the S.E.C. ''That's not the way the capital markets run. Investors need accurate information.''

Lori McTavish, a spokeswoman for Kmart, said the company would not comment on the charges.

''These two individuals are no longer employed by Kmart and have not been for some time,'' she said, adding, ''Kmart has and will continue to cooperate fully with all government investigations.''

The payment came about as a result of a decision by Mr. Montini, 51, and Mr. Hofmeister, 52, to turn over all of the discounter's greeting card business to a single supplier. The winning bidder, American Greetings, agreed to pay Kmart $50,000 for each of the 827 stores where Hallmark had been selling cards. The total came to $42 million.

The five-year deal was completed on Jan. 21, 2002 -- one day before Kmart filed for bankruptcy. American Greetings executives, aware of the retailer's shaky finances, had insisted on a repayment provision in the agreement in case Kmart canceled the contract without cause. Mr. Montini concealed that from his division's accountant on three occasions, according to the S.E.C. complaint, characterizing the contract as ''no strings attached.''

In the second quarter of 2001, which ended Aug. 1, the drugstore division was having trouble meeting its gross-margin numbers. So the $42 million was recorded as a $27 million ''offset'' to a payment of the same size that Kmart had made to Hallmark, with the remaining $15 million booked as an ''incremental vendor allowance.''

When the accountant, after seeing a copy of the American Greetings contract, questioned Mr. Montini about whether it included a repayment provision, he and Mr. Hofmeister ''engaged in a charade wherein Montini called Hofmeister into his office and chastised him for preparing the draft incorrectly,'' according to the indictment. He then told the accountant that he would have American Greetings sign a new letter reflecting the ''correct understanding'' about the money, and asked her to draft it.

Later, Kmart's internal auditors sought to have the language in the letter clarified and asked Mr. Montini to send it to American Greetings. ''The grand jury does not believe that this letter was ever forwarded to American Greetings,'' the indictment states.

American Greetings faxed a letter of its own, specifying that Kmart must pay liquidated damages if it ended the contract without cause before the term was up. That letter was concealed from auditors and the division accountant, according to the indictment.

At the end of 2001, Mr. Montini received a $750,000 forgivable retention loan from Kmart, the S.E.C. complaint states, approved by Kmart's board. ''Had the board of directors known these facts, it is highly unlikely that Montini would have received the $750,000,'' the complaint adds.

One retail expert said he expected the S.E.C. to call for an overhaul of retail accounting rules before long.

''It's the last of the wild, wild West on Wall Street,'' said the expert, Burt Flickinger III, managing partner of the Strategic Resource Group, a consulting firm. Gary M. Giblen, a retail analyst for C. L. King, said accounting rules for vendor allowances were among the easiest to bend. ''The temptation is too great to abuse the accounting so you can deliver what the Street wants you to deliver,'' he said.

Mr. Hofmeister began working at Kmart in 1972, and Mr. Montini joined the company in 1982, a Kmart spokeswoman said. Yesterday Mr. Montini resigned from his current job, as head of merchandising for the Rite-Aid drugstore chain.

A version of this article appears in print on  , Section C, Page 1 of the National edition with the headline: 2 Ex-Officials At Kmart Face Fraud Charges. Order Reprints | Today’s Paper | Subscribe

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