The Sorry Side Of Sears

IT'S NOT EASY TO DIGEST A DISASTER at 8:30 a.m. on a Sunday. Sitting with his top executives at a conference table in Chicago on a spring morning in 1997, Arthur C. Martinez was in shock. His lawyers used overhead slides to explain how employees at Sears, Roebuck and Co.--the once moribund company he'd worked so hard to revive--had secretly violated federal law for a decade. Their actions, which had been exposed by a bankruptcy judge in Boston, were about to erupt in a nationwide scandal. Already the U.S. Justice Department was weighing not just civil penalties, but criminal prosecution. Worse, this wasn't a rogue operation, or an honest misinterpretation of the law: Sears appeared to have been violating the rights of some credit-card holders systematically and intentionally. The company, the lawyers were suggesting, may even have put the illegal practice in its procedures manual. How could such wrongdoing have gotten started, and how could it have gone unchecked for years? Martinez wanted to know. ""Not one phone call about this? Ever?'' he demanded. It was, says one participant in the meeting, ""a sickening moment.''

There would be many more sickening moments as Sears scrambled to contain the legal, financial and public-relations fallout from its lapse. Last week, after a 22-month FBI investigation, a Sears subsidiary agreed to plead guilty to a criminal charge of bankruptcy fraud--and to pay the government a stunning $60 million, the largest such fine in U.S. history. A federal judge still must approve the plea bargain. NEWSWEEK'S lengthy investigation of the scandal reveals the inside story of the turmoil at Sears during those intervening months. It shows how Sears struggled, first to assess the scope of its problem, and ultimately to understand what in its management structure, executive style or corporate culture had led it to commit the most serious ethical breach in its history.

It all began with what's known around federal bankruptcy court in Boston as the letter that cost Sears a half-billion dollars. Scrawling on a yellow legal pad in November 1996, a disabled security guard named Francis Latanowich begged to reopen his bankruptcy case. Although Judge Carol Kenner had wiped out his debts, Latanowich had agreed to repay Sears the $1,161 he owed for a TV, a car battery and other goods. But the monthly payment, he wrote, ""is keeping food off the table for my kids.''

Sears, it turned out, had mailed Latanowich an offer. In return for $28 a month on his account, it wouldn't repossess the goods he'd bought with a Sears charge card before he went bankrupt. Urging debtors to sign such deals, called reaffirmations, is legal, and roughly a third of bankrupts do so. But many judges view them as sucker deals that keep people from getting a fresh start. And every signed reaffirmation must be filed with the court so a judge can review whether the debtor can handle the new payment. Sears hadn't filed this one. Kenner wanted to know why.

At a Jan. 29, 1997, hearing, a Boston attorney working for Sears served up a convoluted technical excuse for not filing. Kenner's response: ""Baloney.'' There were hints from prior cases that Sears, both praised and feared nationwide as the most aggressive pursuer of reaffirmations, wasn't filing many of them with the court. If true, the company was using unenforceable agreements to collect debts that legally no longer existed. Kenner pushed for a list of such cases. Sears's response, delivered reluctantly in mid-March by a credit manager, was a shocker: since 1995 Sears apparently had ignored the law 2,733 times in Massachusetts alone.

It wasn't hard to conjure up a likely motive. With bankruptcies nationwide skyrocketing from 780,000 in 1994 to 1.3 million last year, many companies are awash in bad debts. Getting debtors to sign reaffs is a way to reclaim some of the losses. And not filing them keeps nosy judges from nixing many of those side deals. ""The worst thing about what Sears has done is that they're kicking the little guy when he's down--2,733 times,'' Kenner steamed. ""Frankly, I think their actions have been predatory. They've shown a wholesale disregard for the Bankruptcy Code, and sanctions will be stiff.''

The scandal couldn't have hit Sears at a more inopportune time. Martinez, an outgoing Brooklyn native who'd come to Sears from Saks Fifth Avenue in 1992, had rescued the huge retailer from years of drift. He'd killed off the old Sears catalog, cut 50,000 employees and promoted ""the softer side of Sears'' with a push into high-profit apparel lines. The ink was barely dry on a Barron's profile that approvingly discussed how Sears also cut losses by pursuing bad debts. Fortune was headed to press with a similar piece about the resurgence at Sears, where profits were rising 20 percent a year.

Word of a livid judge in Boston reached Michael Levin, then head of Sears's law department, on March 27. Like Martinez and other top execs at Prairie Stone, the company's glassy headquarters outside Chicago, Levin says he'd known nothing about Sears's misconduct; he had joined just 15 months earlier. But he quickly discovered that the company had been breaking the law in federal bankruptcy courts across the United States. Eventually Sears would determine it had improperly collected $110 million from 187,000 consumers. Early on Martinez asked Levin if Sears had ever pleaded guilty to a crime. The answer was no. ""I said to myself, "The company's 111 years old, and I'm the guy in the chair when we plead guilty to a criminal offense','' Martinez says. ""Wonderful.''

At 4:15 p.m. on April 9, a cryptic e-mail message flashed onto screens at Prairie Stone. It summoned Sears's top 200 executives--the so-called Phoenix Team--to an urgent meeting at 8 the next morning. As Martinez explained Sears's serious breach of law, says one attendee, ""Arthur was not angry, but very sad.'' The costs, he said, were incalculable. ""We've rebuilt our customers' trust and confidence in this company brick by brick,'' he said, ""and now all of that has been bulldozed.''

It was a devastating moment for the Phoenix Team. ""I was watching the veterans, the people who've been through so much,'' says one executive. ""There was no movement, no expression, no shuffling of feet. They were heartbroken.'' As the meeting ended, Martinez told every executive to spend the next half hour at his or her desk. Do nothing, he said, but think about your own operation. ""Not just to identify additional exposure,'' he says, ""but to fundamentally rethink--Is what I do, the direction I give, the body language I use, creating an environment where something like this could happen? Is my message, "Make the numbers at any cost'?''

Martinez has asked himself the same question. Sears had suffered a black eye before he arrived, when auto-repair employees in California were caught hiking their own commissions by selling customers products they didn't need. Martinez is proud of the ethics office and other integrity initiatives he launched after he joined Sears. ""We tried to set a tone at the top,'' he says. But in the early 1990s Martinez also oversaw the extension of credit cards to 17 million new customers. That's about 5 million more than Sears might routinely have added. Credit by itself is big business: last year the company earned 50 percent of its operating income from credit, including charge cards held by more than half of all U.S. households. The problem, Martinez admits, is that too many of those new cardholders barely qualified. So, in its zeal to attract new business, Sears became a lender to its riskiest customers. As the number of bankruptcies nationwide mushroomed, so did the number of unpaid accounts at Sears: by 1997 more than one third of all personal bankruptcies in the United States included Sears as a creditor.

Any company that dependent on income from its credit cards must aggressively pursue bad debts, and Sears isn't the only retailer to have crossed the line. Bankruptcy experts estimate that creditors historically haven't filed perhaps one third of all reaffirmations that bankrupt Americans sign. Since the Sears case broke, Federated Department Stores (which owns Macy's and Bloomingdale's), May (Filene's), G.E. Capital (Montgomery Ward) and Discover card have settled with debtors. But Martinez saw the scandal as more disturbing than a credit tactic run amok. Several weeks after the crisis erupted he probed for deeper cultural flaws during a Saturday retreat with his Phoenix Team. ""Maybe all the bullshit that's being written about how we've changed values and culture is just that,'' he told his executives. ""What allowed this thing to go unnoticed, untouched and unreported for so long?'' Talking in small groups, the managers agreed that Sears's transformation from an exhausted, defeatist bureaucracy into an aggressive, can-do company had an unanticipated consequence: they hated to send bad news back up to the top. That's a common pathology. Managers aren't trained to expose problems, says James Schrager, a business ethicist at the University of Chicago. ""They're trained to make their goals or heads will roll.'' CEOs can't control every employee's actions, Schrager says. They can, however, emphasize that workers may lose their jobs for failing to report violations--but never for telling management the truth.

Still, Sears's problem wasn't just culture. It was policy. To investigate the roots of its misconduct, Sears hired law firms in Chicago, New York, Detroit and Boston to interview 400 people inside and outside the company. Based on that probe, Martinez and Levin have given NEWSWEEK an explanation never aired in public or in court. They say the problem traces to a Sears lawyer working in a field office in 1985. Sears will not identify the lawyer. ""This fellow had gone to a seminar on bankruptcy,'' Levin says. ""Out of that, this idea was triggered. I don't believe the lawyer thought there was a criminal act involved.'' The practice of not filing all reaffs was later rolled out nationwide.

The next obvious question is why nobody at Sears ever stopped such a serious breach of law. Levin has told NEWSWEEK there were clues: at least one outside law firm had told someone at Sears that the company's policy was questionable. But word of that alert--which might have triggered a broader inquiry at Sears--never worked its way up through the company. ""There should have been a review,'' Levin says. ""Somebody in the law department should have stood up and said, "This is the wrong thing to do'.'' Martinez thinks he knows why nobody blew the whistle. ""I'm sure our people would say, "These goddamn deadbeats; they took the merchandise and they didn't pay for it, and they filed for bankruptcy. I'm going to find a way to protect my company.' That's wrongheaded, but it's an accurate reflection of the culture.'' Another discovery was even more disturbing: Sears's own procedures manual--actually, a database available to every computer user--was part of the problem. ""As a reader, you'd conclude that there are some circumstances--which you can't define with precision--when [reaffirmations] wouldn't be filed,'' Levin says.

The damaging discovery inside its own procedures manual helped cement Sears's resolve: get this over quickly, pay restitution in full, avoid years of litigation and bad press. Those who attended the first crisis meetings say Martinez insisted from the very beginning that Sears come clean. ""We had to admit to failure here and commit to repaying people the money we'd inappropriately collected,'' he says. ""We said to ourselves, "We can't go into court and defend any of our practices'.'' At Levin's suggestion, Sears made a startling admission: that its own ""flawed legal judgment'' was to blame for the misconduct.

With Kenner watching closely, Sears began a hunt for every case of wrongdoing back through 1992. (Before that records were fuzzy.) The raw numbers were daunting. In the prior five years 510,000 Americans had signed reaffirmations pledging to pay Sears debts that totaled $412 million. But figuring out which agreements hadn't been submitted to judges was a massive project. Reaff data retrievable by computer went back only eight months. Digging for clues, 60 computer and audit specialists searched records of 110 million Sears credit accounts. More workers scoured files in federal courts and Sears credit offices nationwide. So many documents flowed into a windowless workroom at Prairie Stone that one worried auditor performed weight calculations to see if the floor would collapse.

The search cost $14 million, but Sears's eagerness to find and repay the people it had wronged won high marks from Justice and other combatants in the case. ""Usually we have two years of knock-down, drag-out before we get down to business,'' says John Roddy, a Boston attorney for the debtors. ""This is the only case I've ever filed where I didn't get a pure stonewall response.'' A few of those affected stepped forward to identify themselves. Several dozen people wrote the company to say they didn't deserve refunds, and planned to keep paying off their debts. One man called to say that he'd declared bankruptcy twice, under the names Jeff and Geoff; he wanted to make sure he got both refunds. Another man called on his mobile phone while cruising past Prairie Stone on Interstate 90. Would it be possible, he asked, to drop by and pick up a refund?

When the last lawyer's bill arrives, the scandal will have cost Sears close to $475 million. Almost $300 million has gone to the wronged debtors, both as refunds (plus interest) of about $1.40 for every $1 Sears improperly collected, and as forgiveness of remaining debt for whatever items they'd purchased. The balance: the pending federal fine, a separate penalty paid to the 50 states and the cost of settling a lawsuit brought by a group of shareholders who claimed that the scandal had hurt the price of their stock. Sources outside Sears say six managers have been forced out of their jobs. (Levin also has departed for unrelated reasons.)

Last week's plea bargain--which Sears swallowed in order to avoid a criminal trial--should let the company dispose of the scandal for good. Martinez says he's pleased that ""the end is clearly in sight.'' He's got other things to worry about. His turnaround has lost some momentum, and Sears stock is languishing near its 52-week low. Martinez is now launching his ""Second Revolution,'' a plan to re-energize the company with, among other things, new merchandise and more store remodelings. Pressing as those challenges are, it's a relief for Martinez--and everyone else at Prairie Stone--to get back to business.

PROFIT--AND LOSS Sears makes much of its profits from credit cards. It pushed hard to expand that business, and ended up with less credit-worthy customers.

63 million households have Sears credit cards. In the last 12 months, 32 million of those accounts were active.

More than one third of all personal bankruptcies in 1997 included Sears as a creditor who hadn't been paid.