FLEMING FIVE'S ACCOUNTING FRAUD BARED IN SEC COMPLAINT

David Merrefield

On the front page of SN last week was a news article about charges contained in a civil complaint by the Securities and Exchange Commission against five highly placed former executives of the now-defunct Fleming Cos.

The 41-page complaint lays out an astonishing litany of dodges the Fleming five allegedly concocted to wring payments from vendors that were made to appear to be up-front and non-revocable monies, sometimes by means of bogus vendor-issued "side letters." In reality, funds often were provisional and to be paid over time. The side letters were presented to Fleming's internal and external auditors, powering through immediate recognition of funds. It was known by all parties, except for auditors, that the side letters wouldn't be enforced, but that the undisclosed real contract would be. Truly, Fleming practiced the ugly art of making money by buying product, not selling product.

Let's look at just a couple of the methods Fleming concocted to separate vendors from their funds, according to the complaint.

Perhaps one of the more pernicious practices had to do with forward buying -- not the usual type designed to ensure a longer pipeline of deal-discounted product, but buying intended solely to win incentives, which were booked as an instant cost-of-goods reduction. At one point, Fleming made forward buys that "added more than $50 million of merchandise to Fleming's already bloated inventory balance and generated rebates or discounts of $5.6 million. This inventory exceeded capacity at Fleming's warehouses, forcing the company to spend additional capital to secure temporary storage space." It's further alleged that the inventory likely would "have to be sharply discounted to sell, thus driving down future margins."

That situation brings diverting to mind. Another part of the complaint details how Fleming was able to generate funds from both inbound and outbound diverting. It also suggests why vendors agreed to issue side letters. Among many others, the complaint cites the experience of Dexsi, described as a small diverter. The company had made "substantial investments" to deliver against a new supply deal with Fleming, and "recognizing its precarious position, Dexsi acquiesced to Fleming's demands." The demands? Dexsi agreed to pay Fleming $2 million and signed a letter stipulating that the payment was to award "past performance." In fact, the real agreement was that Dexsi would recover its payment by means of inflated prices on future deliveries. Later, another $4 million was exacted from Dexsi. Conversely, Fleming also was an outbound diverter, which opened another angle. Fleming mined $7.5 million and later $5.6 million from Kraft by pledging not to sell its products to diverters, and to forgo certain fees. Side letters allowed the sums to be recognized as immediate income.

The upshot of these practices, and many more? The complaint lays out what's well known: "Fleming ultimately could not maintain the illusion." Fleming filed for Chapter 11 bankruptcy in April 2003 and exited wholesaling shortly thereafter.

Finally, the biggest question of all: Is it likely the SEC will charge executives to whom the Fleming five reported, those who were at the very top of Fleming? The complaint is silent about that, but an SEC lawyer told SN that "the investigation is continuing."