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05/19/92

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Report finds no evidence of fraud at bookstore

STANFORD -- An independent study of Stanford Bookstore's unusual perquisites for some employees and serious investment losses in 1990 found no evidence of fraud, but was quick to criticize the bookstore board of directors and senior management for lax oversight and poor judgment.

The lack of "fraudulent or dishonest activity" is "all the more remarkable given the deficiencies in the bookstore's internal accounting controls," the committee wrote in a report and appendices almost two inches thick.

Bookstore directors commissioned the report after the Stanford Daily published allegations in February about a vacation home located in the Sierra foothills town of Twain Harte that the bookstore leased from its top two staff members, general manager Eldon Speed and assistant general manager Philip Chiaramonte. The newspaper also reported that, unknown to directors, the store had purchased or leased eight luxury or high- performance vehicles for top managers.

Additionally, a $1.8 million investment loss the bookstore suffered in 1990 became part of the investigation. The California Attorney General's Office is conducting separate investigations, as well as waiting for the results of the board's internal study.

Stanford Bookstore, incorporated in 1897 as a cooperative association, now is classified as a nonprofit public benefit corporation. It is independent of the university.

At the suggestion of the independent audit committee, the bookstore board on Thursday, May 14, directed bookstore managers to terminate the vacation home lease and the car program, and to sell a recreational vehicle owned by the bookstore but held in the name of a consulting company owned by Speed and Chiaramonte.

Members of the independent audit committee are Albert Hastorf, professor emeritus of psychology and former vice president and provost at Stanford; Leslie L. Luttgens, a Stanford alumna who has 45 years of extensive volunteer experience with nonprofit agencies; and Morton M. Winston, a lawyer and businessman who is a trustee of the Museum of Contemporary Art in Los Angeles.

Their findings were based on a report done by the Los Angeles investigative accounting firm of Neilson, Elggren, Durkin & Co., which specializes in detecting fraud, and a report on internal accounting controls by Deloitte & Touche of San Francisco. Two law firms also contributed to the study: Silk, Adler & Colvin of San Francisco and Tuttle & Taylor of Los Angeles.

The three-person committee said the bookstore outgrew its governance structure - a seven-member board of directors made up of faculty, staff and students - during rapid and successful bookstore expansion under the leadership of Speed and Chiaramonte.

Over the years, board members deferred too much to long-time board president Jack Friedenthal, a professor of law, and after his 1988 departure to head the law school at Georgetown University, bookstore proposals generally came from Speed and Chiaramonte, the audit committee said. None of the remaining board members took up Friedenthal's "activist role."

In a footnote, the committee criticized Friedenthal for his role in signing documents to open a margin account at a discount brokerage, which set the stage for the $1.8 million investment loss.

"His legal training should have alerted him to the necessity of care in such situations," they wrote.

Board members reserved their greatest interest, the report said, for assuring a large selection of books and considering the amount of annual bookstore rebate. They delegated a broad level of authority because of the "great and consistent success of Speed and Chiaramonte in managing the bookstore over a long period." However, if the board had been more proactive, the report said, "it is possible that the investment loss might have been avoided."

The directors view themselves as members of an academic committee rather than a legally responsible corporate board, the committee said in its report. To oversee a nearly $40- million enterprise requires an expanded board with greater expertise and knowledge to supervise operations, the committee suggested.

Third in total sales of all college bookstores, the independent firm is "perhaps the most respected college bookstore in the nation," according to the audit report. This is due, in large part, "to the exceptional skill and commitment of its senior managers, Speed and Chiaramonte," it said.

However, as the bookstore grew, "lines of trust were not supported by the checks, balances and controls that are essential in large enterprises," the report said. "Moreover, neither management nor the board has developed a sufficient awareness of the nonprofit sector's imperative legal and operational norms."

In response to the report, Speed and Chiaramonte issued a joint statement noting they had cooperated fully throughout the investigation.

"Our belief was that it was in the best interests of all segments of the community to have the perception of wrong-doing by management addressed and dispelled expeditiously," they wrote.

The two managers, who joined the bookstore in 1969 and 1971 respectively, quoted sections of the report that praised their accomplishments and said "action will be taken to correct" mistakes they made.

"The experience we have just completed has been an important moment for the bookstore," they said. "Out of it a more mature structure will emerge that will direct the store to even greater achievements."

In addition to orders that management disentangle itself from the vehicles and vacation home, the board last week initiated the process of structural change recommended by the audit committee by establishing three separate committees to:

  • Study the bookstore's entire compensation and benefits program, and recommend changes.
  • Develop new bylaws that will provide a more appropriate governance structure.
  • Develop a written policy on investment of bookstore funds.

Compensation and benefits

In the 1980s, the bookstore loaned money to both Speed and Chiaramonte to remodel their homes. Speed's loan of $58,000 was converted to a 10 percent equity interest in his home in 1984.

In October 1990, the bookstore began paying for expansion of Chiaramonte's San Jose home, but the board did not discuss and approve the loan until April 1991 and Chiaramonte did not sign loan documents until June 1.

More than $200,000 was disbursed before the board approved the loan. The committee said it considered that "a substantial breach" of Speed and Chiaramonte's management responsibilities. The panel recommended against future similar loans.

Chiaramonte recently refinanced his loan through a commercial lender and repaid the bookstore.

The matter may be complicated by state laws that prohibit nonprofit organizations from making loans to corporate officers, except to purchase a residence if necessary to attract or retain the person. Because the loans were for remodeling, "the loans may violate the letter, if not the spirit," of the law.

Speed and Chiaramonte are referred to on some legal documents as, respectively, chief executive officer and secretary/treasurer. The committee said, however, that the men are not corporate officers and therefore the law should not apply. No one considers either man to be a board member, and bookstore bylaws require the president and secretary to be board members, the panel said.

How the state will view the discrepancy is unclear, but the committee concluded that the "prohibition against loans to corporate officers does not apply to the loans to Speed and Chiaramonte."

The audit committee found that "bookstore salaries, as a percentage of sales and gross margin, are in the same range as those of comparable bookstores."

The board acted in good faith to provide "reasonable" compensation, although it collected data only in an informal and anecdotal manner, it said. The board did not, however, review the salary and benefits packages of Speed and Chiaramonte "as a whole," and the committee recommended that the board retain a compensation and benefits consultant to provide expertise.

In addition, all employees should have job descriptions, written annual evaluations and an opportunity to participate in performance-based incentive compensation, the audit committee suggested.

Some of the report's most harsh criticism is reserved for the issue of the Twain Harte vacation home, which the bookstore leased from Colleagues Management Services Inc., a consulting company owned by Speed and Chiaramonte. The bookstore has paid $283,900 in lease payments and costs of other items at the property, including utilities, cleaning, furnishings and improvements.

"We believe that the process of reaching this decision and its implementation were flawed," the committee said.

Former board president Friedenthal saw the house as a way to keep the top two managers from leaving for more lucrative employment, according to the report. The two-story, four- bedroom home was viewed as a fringe benefit for employees and a way of providing Speed and Chiaramonte a form of deferred compensation or retirement benefit resulting from the home's appreciated value, the report said.

In February 1986, the board approved a lease plan through June 1987, at which time the bookstore would have the option either to purchase the property for cost plus one year's interest or to continue the original lease agreement.

There is no evidence the board ever again reviewed the lease.

"Once the decision was approved by the board, appropriate follow-up did not occur," the committee said.

Curiously, the purchase option does not appear in the final lease, but the audit committee said a court might be willing to enforce it if the bookstore sought to purchase the property.

If the lease and other payments are treated as an equity investment, the bookstore may recoup a substantial portion of the money it has put out, or even make a profit, the report said.

"Therefore, until the option has been interpreted by the parties or by a court, we cannot determine whether the cost to the bookstore of providing this benefit was reasonable," it said.

The committee, however, found the house arrangement to be "speculative and uncertain as to its ultimate value," and therefore "an unreasonable form of retirement benefit."

Outside auditors "have advised us that the bookstore could have purchased a substantial retirement package for Speed and Chiaramonte for less than it spent on the house and its furnishings," the committee wrote. Calculations show that given the number of days the house was used, $200-a-day rooms could have been rented at a Sierra resort for about $101,600, far below the lease payments made.

The house lease "illustrates the lack of awareness, on the part of the board as well as management, of the constraints on behavior that arise from and are appropriate to a nonprofit institutional culture," the report said. A central theme of the modern nonprofit sector "is concern about self-dealing and avoidance of any appearance of waste or of improper economic benefit to insiders."

The committee suggested exploring alternatives to "unwind" - that is, close out - the transaction in a way that will preserve the bookstore's assets without working "unfair hardship on Speed and Chiaramonte." Furthermore, "concerns about their retirement should be addressed straightforwardly, as part of the compensation and benefits review," the panel said.

It said there are at least three possible options to get out of the house deal:

  • Exercise the option to purchase the house, hold it for appreciation and sell when appropriate.
  • Ask Colleagues Management Services to refund rental payments, less fair market value of use made by bookstore employees, and purchase from the bookstore the fixtures, furnishings and equipment.
  • List the house for sale, with Colleagues receiving the proportion of sale price attributable to the amount it actually paid for the land and construction, while the bookstore would receive sale price attributable to its lease payments and fair market value of the furnishings, less the value of the bookstore employees' use.

In the area of vehicles, the panel said the investment in luxury and sports vehicles to employees "cannot be reasonable - even where, as here, the cost of the vehicles is part of the employees' taxable compensation. The issue is the manifest impropriety of the appearance of the transaction. The practice offends the institutional ethics of nonprofit operations."

They suggest transferring the leases or selling the vehicles to employees who want them, and raising pay to avoid a reduction in total compensation.

This recommendation differs from that of the accountants Neilson, Elggren, Durkin & Co. In a preliminary report to the audit committee, Neilson said that "although much has been made of the employees' automobiles, the board should not alter the general policy." The accountants, however, note that "it might be more prudent to provide vehicles that are not considered luxury or sport vehicles."

The audit committee criticized management for not obtaining board approval for the vehicle program.

Management also "erred significantly in failing to obtain formal board review and approval" before purchasing a 27- foot recreational vehicle. The committee recommends that Colleagues Management Services transfer title to the bookstore, which should then sell the RV. It already has been on a sale lot for several months.

Investment loss

In 1990, the bookstore lost $1.8 million when its former controller, Patrick McDonald, invested on margin in speculative stocks.

The committee said that the board's delegation of responsibility was "sufficiently reasonable to satisfy the minimum legal standard." They said that "one employee exceeded his authority, to the detriment of the bookstore." Neither Speed nor Chiaramonte had much knowledge about investments and they trusted McDonald, who joined the bookstore in 1980, to handle that area, the panel said.

In 1986, the bookstore opened an account at the discount brokerage of Charles Schwab & Co. to invest funds it held in reserve for future expansion of the White Plaza store.

The bookstore supplied a certificate signed by Friedenthal as president and Chiaramonte as secretary saying the board had passed a resolution granting Speed, Chiaramonte and McDonald authority over the account. "These resolutions, however, do not appear in the bookstore's minutes," according to the audit committee.

Portions of the required application to open a margin account were not executed, but McDonald was allowed to incur margin debt beginning in 1989, the committee said; it is still investigating how this was possible.

The bookstore's original practice was to invest in cash equivalents or similar conservative funds. In late 1989, McDonald started to borrow heavily on margin and by April 1990, the account had almost $5 million in margin debt.

"This borrowing was not known to the board or Speed and Chiaramonte, and was in any event not authorized by any action or policy of the bookstore or the board," the report said.

In late May or early June 1990, Speed inquired about liquidity of the portfolio and discovered the leveraged and risk-equity nature of McDonald's investment strategy, the report said.

Speed and Chiaramonte met with McDonald and ordered him to eliminate the margin position by selling shares from the portfolio. He was then to shift investments to cash equivalents. McDonald started to reduce the margin debt, as ordered, but then increased it, even as the market started to turn down.

Absorbed in details of remodeling the White Plaza store, Speed and Chiaramonte reportedly did not check again with McDonald until early August, when the market dropped sharply in response to Iraq's invasion of Kuwait.

They discovered that McDonald had not followed instructions and a major loss had ensued. Speed discussed the matter with directors who were on campus, according to the report, and relieved McDonald of his duties.

Based on the directors' advice, the managers moved the account to Kidder Peabody Co., a full-service broker.

Enough stock was sold within two months to eliminate the margin debt by early November, and a board meeting that month was devoted to discussion of the loss. No further change in portfolio was recommended, the panel found.

In March 1991, a newly formed investment committee reviewed the portfolio and recommended selling the remaining stock. This was implemented by mid-summer, with a cumulative loss of $1.8 million.

McDonald separately managed an investment club, known as the ISBN account, in which various bookstore employees, including Speed, participated. In early 1990, $60,000 in bookstore funds being transferred to Schwab were "incorrectly credited to this account," according to the audit committee.

In a footnote, they said they have "not yet established definitively whether the misdirection was due to a misinterpretation by Schwab of McDonald's telephonic instructions, as McDonald has said, or to a deliberate action by McDonald. However, we note that, at a minimum, McDonald did not correct the error when he discovered it."

The transfer was discovered by Chiaramonte after McDonald had been terminated and the funds had been lost in the market. McDonald agreed to repay the lost amount, and signed a $60,000 unsecured promissory note.

The audit committee said the margin debt was "a principal cause of the disproportionate loss." The committee faulted the the lack of checks and balances, which left McDonald as the only person who got reports from the broker. Furthermore, "McDonald's management of the portfolio was inconsistent" with California law that directs nonprofit boards to "avoid speculation."

Speed and Chiaramonte put too much trust in McDonald and the board was not sufficiently involved, the report said.

In a footnote, the audit committee laid some blame on board president Friedenthal: "We cannot yet conclude, however, that Professor Friedenthal acted reasonably. He signed Schwab documents purporting to open margin accounts for the bookstore, although it remains unclear whether Schwab received all the appropriate authorizations.

"We think he should have inquired in more detail about the nature of the bookstore's investments," the report said. "Although he may be chargeable with setting the stage for the losses, he cannot be said to be responsible for losses which were incurred two years after he left the board," the committee concluded.

The committee suggested forming a new investment committee charged with establishing guidelines and monitoring actual investments, which should be in the hands of professional investment advisers.

Management also should obtain prompt repayment of McDonald's $60,000 interest-bearing note, they said.

Governance structure

The bookstore's problem was that it operated under a system of personal trust rather than accountability. While this may reduce bureaucracy, "it also creates a climate where errors in judgment may develop, undetected, into serious problems," the committee said.

The committee found no evidence that the board of directors "ever engaged in self-dealing or conflict of interest transactions." Directors are selected from among a group of approximately 30 association "members." None are compensated, except for a meal at the annual meeting and, usually, one gift book from the store inventory.

Board members have satisfied "the minimum acceptable standard of care required by law, largely because of board reliance on exceptionally able management," the committee said.

However, board members were disengaged, it said. They "did not know about many of the issues discussed in this report and could neither prevent nor remedy the problems that arose."

The "exceptional performance of Speed and Chiaramonte gave the board good reason to rely on their judgment. Similarly, Professor Friedenthal's legal background and his close involvement with the bookstore's day-to-day operations led the other directors to trust his recommendations.

"But the bookstore's very success, under their leadership, contributed to what is perhaps the bookstore's fundamental problems: the absence of conventional institutional checks and balances," the committee said.

"We are firmly of the opinion, however, that the fullest realization of the bookstore's educational purpose will come about only if the board adopts a higher and more committed standard of care and guidance, defining with more precision the mission of the corporation and determining the use to which profits should be put."

They suggested that it is "essential" for board members to participate in development of the bookstore's budget, not only on rebates, but on the larger question of how policy is translated into operations through the allocation of funds.

The panel recommended restructuring the board so that the bookstore would receive the attention "such a large and complex enterprise requires."

The first step in that process is "to identify and elect a board president with demonstrated experience and expertise in both management issues and nonprofit issues. The president's task will be to guide the board through this process in a manner which builds the board's skills and knowledge to the ultimate benefit of the bookstore," the panel said.

The board also should immediately elect a secretary and treasurer for the bookstore, as required by law.

Board members should determine whether the current "voting membership structure," adopted in 1897, is appropriate almost 100 years later.

"Whatever the function of members was originally envisioned to be, the voting membership today provides neither a check and balance function, nor a vehicle for bringing expertise onto the board," the report said.

The committee suggested replacing it with a director selection mechanism that serves the bookstore's needs more effectively and ensures the bookstore is accountable to the public.

Another option is to treat the entire Stanford community as though they are the "members" by publicly distributing an annual financial report via the Stanford Daily, and setting aside an evening for an annual meeting to which all students, faculty and staff are invited, the committee said.

"We believe that the bookstore can strengthen its governance structure without jeopardizing its success as an academic bookseller or abandoning those who have helped to make that success possible," the committee said in apparent reference to Speed and Chiaramonte.

"We are confident that the bookstore will emerge from this process of growth as a strong, effective, and vital part of the university community."

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