Long WSJ article on report on Krispy Kreme ...........................................
August 11, 2005
Report Shows How Krispy Kreme Sweetened Results
Panel Says Doughnut Maker Used 'Egregious' Practices, Blames Ex-CEO, Directors
By MARK MAREMONT and RICK BROOKS
Staff Reporters of THE WALL STREET JOURNAL
Former executives at Krispy Kreme Doughnuts Inc. who oversaw its rise from a regional chain to a highflying sensation used improper, even "egregious," accounting to satisfy Wall Street's hunger for growth, according to a sweeping internal report from the company.
The report, which followed a 10-month investigation of the doughnut maker by a special board committee, provided fresh details of how a team led by former Chief Executive Scott A. Livengood fudged financial results during the company's meteoric rise starting in the late 1990s. The report marked the company's clearest account yet of its financial and governance shortcomings, which first surfaced last year and led to the ouster of Mr. Livengood and other senior executives.
After going public in 2000, Krispy Kreme sought to capitalize on Wall Street's appetite for growth stocks at the end of the stock-market boom. But the doughnut maker wasn't ready for prime time. The report, a 24-page summary of which was made public in a regulatory filing yesterday, says it lacked internal controls, didn't employ a general counsel for a two-year period and hired three chief financial officers in four years -- including one who told the panel he wasn't comfortable in the job.
"The Krispy Kreme story is one of a newly public company, experiencing rapid growth, that failed to meet its accounting and financial reporting obligations to its shareholders and the public," the report said.
Though the report stopped short of accusing former executives of outright fraud, it included a strong condemnation of the former management team led by Mr. Livengood, as well as the company's outside directors, noting that senior managers "were profiting greatly" from questionable accounting.
Indeed, the panel said Krispy Kreme's woes stemmed in part from a common 1990s-era practice: Setting earnings-per-share targets for Wall Street analysts and then pushing to beat them by a penny. The panel noted that executive bonuses were tied to exceeding those growth targets.
"While some may see the accounting errors...as relatively small in magnitude, they were critical in a corporate culture driven by a narrowly focused goal of exceeding projected earnings by a penny each quarter," the report said.
Among other things, the panel slapped Mr. Livengood for what it said was his abuse of corporate aircraft, reporting that in two years he racked up at least $320,000 more in personal-flight costs than was permitted by the board, while company filings hid the true costs from shareholders.
It highlighted the company's decision to spend $500,000 to sponsor a "storytelling festival" in the hometown of Mr. Livengood's wife. Part of the money came from a "brand fund" paid for by franchisees, some of whom have criticized the spending as a waste of money for Mr. Livengood's personal benefit.
The panel also described several methods that it said were used to boost results. For instance, it said Krispy Kreme improperly boosted profits by shipping high-margin doughnut-making equipment to franchisees -- long before they wanted or needed it.
Though the company would book revenue, some of that equipment would then sit unused for months in trailers controlled by Krispy Kreme, and franchisees didn't have to pay until it was actually installed, said one person familiar with the probe's findings.
In another deal cited in the report, Krispy Kreme sold costly equipment to a franchisee and booked it as revenue -- immediately before it bought the same company for a price that was inflated by the cost of the equipment.
The committee said it has turned over its full report, for which it said it interviewed more than 100 people, to federal officials, who are conducting criminal and civil investigations of Krispy Kreme's accounting.
It also ordered a board shake-up, saying that a "substantial majority" of new directors are needed. The board, it said, approved big acquisitions based on little more than what it called "back-of-the-envelope" calculations by executives, failed to oversee management with "an appropriately skeptical eye," and was "distracted" by the company's apparent success and Mr. Livengood's charisma.
The panel didn't directly tie Mr. Livengood to any particular accounting maneuver, but criticized him for setting aggressive growth targets and being "too focused on meeting and exceeding" Wall Street expectations, while disregarding "essential requirements of public company stewardship." Mr. Livengood remained a consultant after being forced out in January, but yesterday the panel said it cut off the former CEO's monthly pay and medical benefits in May after he stopped cooperating with its probe.
Mr. Livengood declined to comment yesterday. An attorney who is representing him, F. Joseph Warin, said he and his client were "pleased" that the committee had finished its work and that "the report specifically stated that no employee said that they participated in or were directed to manage earnings."
He added, "We strongly disagree with the subjective speculation of the report. Mr. Livengood devoted his heart and soul to Krispy Kreme."
Besides blaming Mr. Livengood, the panel singled out John W. Tate, the company's former chief operating officer. The panel said Mr. Tate "appears to have been directly involved in inappropriate efforts to increase or accelerate the recognition of revenue."
Mr. Tate resigned in August 2004 and is now executive vice president and chief operating officer at Restoration Hardware Inc., a retailer in Corte Madera, Calif. David Siegel, a Los Angeles attorney who represents Mr. Tate, said the former chief operating officer "denies any wrongdoing."
The report marks an ugly postscript to the career of Mr. Livengood, who started at Krispy Kreme as a personnel trainee and became its CEO in 1998. As CEO, he recounted that while growing up not far from the company's Winston-Salem, N.C., headquarters, he was such a fan that he ordered a plate of chocolate-covered, cream-filled Krispy Kremes for his 16th birthday. At his 2002 wedding, he served a cake made of 720 doughnuts.
It is also a blow for Krispy Kreme itself. Founded in 1937, the chain had fewer than 100 stores in 1996 when it opened its first Manhattan store, which helped catapult its glazed doughnuts to cult status and fuel rapid growth. Today it has 420 stores in 45 U.S. states and five other countries and sells doughnuts in thousands of supermarkets, convenience stores, truck stops and other locations.
The panel's findings show that recent reforms intended to clean up business practices haven't penetrated all executive suites and boardrooms. The bulk of the accounting problems at Krispy Kreme occurred after passage of the 2002 Sarbanes-Oxley Act, which was intended to strengthen corporate governance.
But Charles Mulford, an accounting professor at Georgia Institute of Technology in Atlanta, said the special committee's sharp criticism of Messrs. Livengood and Tate and its move to reshape the board reflected a new push by companies "to build a wall between themselves and former officers" who allegedly use aggressive accounting.
"They're doing it to preserve as much shareholder value as possible, but also to try to mitigate possible penalties from regulators," Mr. Mulford said.
New management led by turnaround specialist Stephen F. Cooper has been struggling to fix Krispy Kreme amid tumbling sales and signs of franchisee financial distress. The company hasn't filed any financial reports in nearly a year, and is unlikely to file its restated financials for at least several more months.
As a result of the probe, Krispy Kreme said yesterday it would have to restate its results downward back to before it first went public in 2000, slicing an estimated $25.6 million from pretax profits over the years. Of that, $22.2 million would be backed out of pretax profits from fiscal year 2001 through fiscal 2005's third quarter, which ended last October, about 9% of the $241.9 million in pretax profits originally reported over that period.
Krispy Kreme shares, which hit a high of $49.37 in August 2003, rose 15 cents, or 2.1%, to close at $7.30 in 4 p.m. New York Stock Exchange trading.
The company faces numerous lawsuits, including a shareholder lawsuit claiming that it overpaid for franchises and misrepresented its sales slowdown. In an unusual move, the board's special committee said it "will not seek the dismissal of claims asserted" in shareholder suits against Messrs. Livengood, Tate and another former executive, citing "serious concerns about their discharge of their management duties."
Some shareholders burned by the problems at Krispy Kreme said they hope the boardroom changes pushed by the special committee will help the company turn itself around. "I think this will have a sobering effect on those who are left," said Don Hodges, co-manager of Hodges Fund, a mutual fund in Dallas, which took a loss on its stake in the doughnut maker but started buying shares again in March. "They've got a great name that's known all across the country. It's a shame they drug it through the mud."
The special committee probe was led by two outside directors who joined the board late last year, Michael Sutton and Lizanne Thomas. Mr. Sutton is a former chief accountant of the Securities and Exchange Commission. Ms. Thomas is a partner in the Atlanta office of law firm Jones Day. Attorneys from the law firm of Weil Gotshal & Manges LLP served as outside counsel to the committee.
Write to Mark Maremont at mark.maremont@wsj.com and Rick Brooks at rick.brooks@wsj.com
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