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TROUBLE AT SAFECARD SERVICES!

How incompetence and greed undid the credit-card insurer

In 1969, Peter Halmos was a 25-year-old Hungarian emigre with an idea: People would be willing to pay a small annual fee for credit-card protection. If their cards were lost or stolen, they would be insured for any unauthorized charges, and the issuers would be notified to provide replacement cards.

Halmos launched SafeCard Services Inc. that year from the bedroom of his Fort Lauderdale condominium with his brother, Steven. It grew into a tidy little money machine. In 1977, SafeCard went public, and in 1989 it was listed on the New York Stock Exchange. By 1992, the company had 400 employees, 13 million customers, and was generating $158 million in revenues and $22 million in earnings. It had a hefty cash reserve of $170 million and no debt.

But in late 1992, SafeCard's fortunes began changing dramatically for the worse. Halmos, who had stepped down as chief executive in 1987 and as chairman in 1990, departed as a consultant in December, 1992. In the following 3 1/2 years, under new management and directors, the workforce ballooned to 1,200 and the company depleted most of its reserves, losing $47 million in the first half of 1995 alone. Its stock, by late May of that year, was selling at 7, down 65% from its 1994 high of 20. SafeCard was in such deep trouble by early 1996 that the anxious directors voted to sell the company, then based in Jacksonville, Fla., to CUC International Inc. for $375 million. CUC quickly shuttered the headquarters and absorbed the company.

Although SafeCard was a small company, its story holds a big lesson for Corporate America. The fall of SafeCard is a cautionary tale of incompetence and greed. It demonstrates how directors and managers with the best of credentials, and their high-powered advisers, can't always be counted on to guard the interests of shareholders. Indeed, some SafeCard directors were benefiting personally from their positions and failed to scrutinize management's ill-conceived projects.

HIGH-POWERED. The main participants were SafeCard Chief Executive Paul G. Kahn, the man behind the much-heralded launch of AT&T's Universal Card in 1990, and a supportive board, which for a time was dominated by Robert L. Dilenschneider, the former CEO of Hill & Knowlton Inc., the public relations concern. ''They took something that was built over 23 years and destroyed it in a few years,'' says Peter Halmos.

Halmos is far from objective. He has 14 lawsuits pending against SafeCard's former management, directors, accountants, and lawyers. In all, he has spent an astonishing $45 million in a legal vendetta to hold the entire SafeCard team accountable.

The latest charges were made on Dec. 5, 1996, when attorneys for shareholders, including Halmos, filed an amended sealed complaint to a 1995 suit in federal district court in Miami. A supporting filing that describes the sealed complaint was made in the Miami court--this time unsealed--on Mar. 31. According to the new filing, and a 400-page background document, the amended complaint contains serious allegations of stock fraud, including racketeering charges under the federal Racketeer-Influenced & Corrupt Organizations Act.

During a three-month investigation, BUSINESS WEEK has examined lawsuits and hundreds of other documents, including internal memos and notes, receipts, stock trading records, research reports, and Securities & Exchange Commission filings. BUSINESS WEEK also interviewed more than two dozen former employees, directors, and company consultants--most of whom spoke not for attribution. In addition, BUSINESS WEEK has reviewed two 60-odd-page signed statements by Douglas Spink, 25, who was SafeCard's director of financial controls in its information technology group from September, 1994, to March, 1996. Spink, an MBA from the University of Chicago Graduate School of Business, has also provided his statements to Halmos and is expected to be a key witness in the shareholder litigation.

At the very least, the evidence strongly suggests there was gross mismanagement of the company's financial affairs. Some $225 million was squandered between 1994 and 1996, much of it on new-business ventures and lavish corporate overhead.

The charges made in the shareholder lawsuits, one of which is scheduled for trial on Sept. 2, are more serious. The suits allege that certain officers and directors:

-- Leaked information to Wall Street analysts.
-- Wildly inflated profit predictions that misled investors.
-- Benefited personally from their dealings with the company.
-- Used accounting techniques to mask the company's deteriorating condition.

VENDETTA? No former SafeCard employees have been charged by the government with any civil or criminal securities violations. Kahn, interviewed at his Jacksonville (Fla.) office, denied each of the above allegations. He insists that at the time of his ouster in early 1996, SafeCard was back on course to be profitable. ''We could have got out of it,'' Kahn says. He also insists that ''I was not alone. The board knew about everything...they set me up for being the fall guy, not that I'm without sin. I was hung out to dry.''

Parker D. Thomson, attorney at Thomson Muraro Razook & Hart, represents SafeCard's seven former outside directors. ''You are dealing with completely unproven allegations made by one man [Halmos] who has publicly proclaimed litigation warfare against SafeCard Services and everyone connected to SafeCard,'' he says. Thomson says the charges ''have been made with reckless disregard for any truth.'' Thomson represents William T. Bacon Jr., a former Chicago investment banker, Dilenschneider, Eugene Miller, a former investor relations specialist, Marshall L. Burman, former chairman of the Illinois State Board of Investment, Thomas F. Petway, III, a Jacksonville real estate and insurance businessman, Adam W. Herbert Jr., president of the University of North Florida, and John Ellis ''Jeb'' Bush. The son of former President George Bush says: ''I believe I did my job with focus and intensity. Things the board did helped [SafeCard] return to profitability.'' Bush and Herbert joined the board in January, 1995.

Without question, the main figure in the SafeCard saga is Peter Halmos. Since the early '80s, Halmos himself has been the target of an extraordinary number of allegations, including insider trading, enriching himself with SafeCard monies, and using aggressive accounting to boost SafeCard's earnings. BUSINESS WEEK has examined Halmos' disputes with the IRS, the SEC, and shareholder charges of insider trading. Halmos was found to owe no money to the IRS. The SEC investigated SafeCard's accounting but didn't take action. And the shareholders dropped their lawsuit.

Halmos is known for relentlessly suing his adversaries. In 1981, he sued Barron's columnist Alan Abelson for libel. The suit was thrown out. In 1992, he filed a suit against the IRS, which he later dropped. Halmos plays hardball in other ways. He uses his private investigator to collect damaging evidence about his enemies.

The seeds of the battle between Halmos and SafeCard were planted in late 1991. Still influential, he decided to hire a top PR person to repair SafeCard's tarnished image. He chose Dilenschneider, put him on the board, and granted him 100,000 stock options. Steven Halmos, CEO since 1987, agreed.

Dilenschneider became more than just a PR man. As their friendship bloomed, Halmos even reviewed monthly budgets for Dilenschneider's fledgling public relations firm that Dilenschneider formed after resigning as head of Hill & Knowlton in September, 1991. SafeCard became one of the first and biggest clients for Dilenschneider's new PR shop, Dilenschneider Group Inc. (DGI). Dilenschneider declined to comment on the record.

On Oct. 23, 1992, at a SafeCard board meeting, Dilenschneider and Halmos abruptly parted company. It was a critical time, since the card protection business was mature, and SafeCard faced fierce competition. What happened at that meeting is the subject of considerable dispute. Peter Halmos' version is that an analysis done by the chief operating officer was discussed at the meeting and showed SafeCard heading downhill. Halmos wanted to make the analysis public. But he says the three-man board, comprising his brother, Steven, Bacon, and Dilenschneider, disagreed.

Halmos says the board forced him out in December, 1992, by withdrawing financial benefits they had promised him. At that time, Steven Halmos stepped down as CEO and director but kept a $2 million-a-year consulting job. The chairman and CEO jobs stayed vacant until December, 1993.

Thomson, the former board's attorney, paints a different picture. ''Although earnings projections were made on the basis of various assumptions...there is no single study of the kind you [BW] mention,'' says Thomson. Bacon and Dilenschneider don't recall a study, says Thomson, and Steven Halmos declined comment. As to whether a downbeat projection was discussed, Thomson declined to comment. He points out that Halmos doesn't have a copy of the projections, nor were they mentioned in the board minutes. And Thomson claims Halmos resigned over a failure to renegotiate his compensation.

Once Peter Halmos was gone, Dilenschneider moved to cement control of the board, whose only other member was Bacon. In February, 1993, Dilenschneider arranged for Miller, then at DGI, to join the board. Miller had been a senior vice-president of the New York Stock Exchange and was an editor at BUSINESS WEEK in the 1950s. He got 100,000 stock options.

Dilenschneider also took over Peter Halmos' job as SafeCard's investor relations honcho. In June, 1993, Dilenschneider signed a contract with SafeCard that, in addition to his $50,000 director's fee, renewed DGI's $180,000 retainer to handle public relations for that year. On top of that was a $150,000 retainer for an investor relations contract, according to SEC filings.

INSIDE TIPS? Looking to find a CEO, Dilenschneider and the board hired Paul Kahn, who joined SafeCard on Dec. 7, 1993. Kahn's success at AT&T gave him a dazzling reputation, and SafeCard's stock jumped 2 1/2 when he was hired. But Kahn also had a checkered history. At Wells Fargo & Co. from 1980 to 1985, where he ran the credit-card business, he developed a reputation as a big spender after management investigated a birthday party that was billed as a corporate expense. Kahn dismisses it as a secretarial error.

In 1986, Kahn landed at Mellon Bank Co., where he was laid off after two years. At AT&T, Kahn was so profligate that a former AT&T chairman warned a SafeCard director, recalls another SafeCard director. SafeCard hired him anyway on the recommendation of New York search firm Heidrick & Struggles Inc. Kahn doesn't deny he was a big spender but says the spending always yielded a boost to his employers' profitability. Heidrick & Struggles declined to comment. Kahn received a base salary of $750,000 and 1 million options that kicked in as the price of SafeCard's stock moved higher.

When Kahn came on board, he and Dilenschneider, Miller, and other top SafeCard executives launched a whirlwind of meetings with money managers and Wall Street analysts, according to internal SafeCard records. But according to the shareholder allegations, SafeCard went much further: It disclosed material inside information to analysts. According to one shareholder suit, the information was allegedly leaked in early December, 1993, when Oppenheimer & Co. was tipped by a SafeCard director that Kahn would be appointed CEO. In denying the charges, says Oppenheimer: ''We are vigorously defending the case.''

Whether or not Oppenheimer was tipped, it did buy SafeCard stock on Dec. 2 and the next two days, according to NYSE trading records, accounting for an average of 75% of SafeCard trading volume on the three trading days prior to the Dec. 7 announcement of Kahn's appointment. If information was leaked, says Alan R. Bromberg, professor of securities and corporate law at Southern Methodist University Law School, ''it looks to me like a violation on both sides.''

One analyst who allegedly received inside information was Clive Munro. Munro operated a tiny research boutique, Montecito Research, in the U.S. Virgin Islands with more than 100 institutional clients. SafeCard allegedly supplied him with pro forma profit estimates and information on Kahn's plans in 1994, and Munro used it in his research reports.

Munro faxed his research reports to SafeCard executives for review and editing suggestions, according to copies of faxes of Munro's draft research report obtained by BUSINESS WEEK. Those reports went to clients. Kahn adamantly denies ever having given anyone inside information. ''Did I look at Clive Munro's reports? I absolutely did. I offered directional guidance, not specific numbers,'' says Kahn. Munro denies receiving inside information. ''If I had inside information, I would have encouraged my clients to sell,'' he says.

CATHOLIC CARD. By mid-1994, Kahn had pushed out the handful of senior SafeCard employees and brought on three new directors: Petway in April, 1994, and Bush and Herbert in January, 1995. Kahn then went on a spending spree. Life at SafeCard now included travel by corporate jet and limousines, lavish receptions, and expensive art, according to internal company memos and interviews with former SafeCard employees. Says Kahn: ''I wanted to change the image of SafeCard. It was a calculated risk, and this time I lost.'' Kahn added layers of management and consultants, including many friends, relatives, and former associates and their wives.

Dilenschneider shared in the new era of easy spending. In 1994, SafeCard struck an $11 million, three-year deal with Museum Art Properties Inc., a company 10% owned by Dilenschneider, then located a floor above DGI's Manhattan offices. MAP developed a catalog for SafeCard to market reproductions from the Vatican Museum, such as crystal rosary beads and Sistine chapel ''fragments,'' which MAP supplied to SafeCard. The contract was disclosed in SafeCard's SEC filings. Kahn admits the deal was rich but says he thought it would help him secure the rights from the Vatican to his next big brainstorm: a Catholic credit card.

One software company, Image Consulting Group Inc. in Phoenix, was paid more than $1 million in a five-month period in 1995 to work on a new product, the Family Protection Network (FPN). ICG was co-owned by Dilenschneider's nephew, John Dilenschneider. Thomson says that Robert Dilenschneider didn't know about it and, because John was not immediate family, disclosure was unnecessary. Observers say ICG was a qualified contractor. John Dilenschneider says ICG got the job ''for business reasons, not relationship reasons.''

Petway was another director who benefited from his SafeCard ties. He was a one-third owner of Prudential Network Realty, a well-regarded local firm. PNR was recommended by SafeCard to handle the sale and purchase of homes for SafeCard employees, say two former SafeCard employees.

According to Thomson, Petway's attorney, PNR handled 51 transactions involving SafeCard employees as buyers or sellers from about 1993 to 1995. The commissions earned by PNR were approximately $154,000, plus $20,000 in referral fees, says Thomson. ''SafeCard reviewed these transactions at the time and determined disclosure in its public filings was neither necessary, required, nor appropriate,'' he says. But a former Safecard employee says PNR handled 100 SafeCard employees relocating to Jacksonville. If that is correct, PNR would have earned more than $300,000.

Kahn was spouting increasingly rosy forecasts for revenue growth from new products and acquisitions. In a June, 1994, Wall Street Journal article, Kahn raised his estimate of 20% compounded annual growth over the next several years to 30% growth for 1995. Then in September, 1994, Kahn told analysts in a private conference call to expect 45% growth in the next few years, according to a transcript of the teleconference.

In retrospect, Kahn's forecasts looked like pie in the sky. For one thing, SafeCard reported only a $20 million profit for the fiscal year ended Oct. 31, 1994, down 36% from 1993. SafeCard's overhead had expanded 72%, to $43 million. Even worse, despite spending $200 million on marketing in 1993 and 1994, the company could no longer add enough new members to fully offset the annual 25% loss in its 13 million membership base.

More disturbing, the $20 million profit was a fiction. SafeCard was amortizing the marketing costs of acquiring new subscribers over a 10-year period. But because it was losing customers and had begun to spend on marketing to retain them, SafeCard could no longer justify stretching the amortization out that long. This meant that the company needed to write down the deferred subscriber acquisition costs of $195 million over a much shorter period, according to an accounting expert. Indeed, a March, 1995, letter from the SEC shows that the agency had been corresponding with SafeCard about shortening the amortization period in April, 1994.

ACCOUNTING TRICKS? SafeCard in a press release issued on Dec. 14, 1994, said that it was considering changing the amortization period, which would result in an aftertax charge of about $45 million (about $65 million before taxes). On Dec. 22, it filed the same information in an 8-K with the SEC. If the company had taken the hit in its normal 1994 fiscal year, ended Oct. 31, it would have shown a $25 million loss--not a $20 million profit. But SafeCard would use a clever technique to record the write-off. It said that it was moving the end of its fiscal year from Oct. 31 to Dec. 31. This created a ''stub'' period, a two-month black hole that was not part of 1994 or 1995.

And indeed, on Jan. 25, 1995, the company announced that a $65 million pretax charge from the change would be recorded in this two-month transition period. But only six days before, on Jan. 19, SafeCard had filed a 10-K with the SEC detailing its results for the fiscal year ended Oct. 31, 1994--without taking the writeoff. Is it likely that the company knew on Jan. 19 that it would be making the change? If it did know, why didn't it include the $65 million charge in the 10-K? ''You have to ask yourself, who knew what when,'' says Abe Mastbaum, senior vice-president of American Securities LP and an accounting expert. The company's annual report sent to shareholders in February, 1995, dated Jan. 25, made no mention of either change. The company, in a Feb. 9 press release, reported a loss of $49.9 million for the two-month period and filed a 10-Q reporting the loss on Feb. 13.

SafeCard's accountants say that ''Price Waterhouse LLP conducted its work for SafeCard Services Inc. according to the highest professional standards and stands behind its work without reservation.'' Mahoney, Adams & Criser, the Jacksonville (Fla.) law firm that was SafeCard's principal counsel, says ''the allegations that Mahoney Adams engaged in wrongdoing are false and are categorically rejected.''

The stub technique only postponed public knowledge about the inevitable deterioration of the core business. SafeCard needed profits--and fast. In late 1994, Kahn began pushing two new products. The first was a credit card geared to golfers. Card members linked with the PGA Tour Partners, a golf organization, would get a variety of golf-related perks, such as access to PGA Tour events. Kahn's goal as of January, 1995, was to start in March, 1995, with 80,000 members, quickly expanding the number to 500,000 and to 1 million.

The second new product--the Family Protection Network--was, to be kind, bizarre. For $250 per year, parents could register information about their children with SafeCard. If a child was reported missing, a SafeCard SWAT team of ex-military and law enforcement experts would be dispatched forthwith to search for the child. No cost would be spared: An FPN press release promised ''search dogs...police artists...and even helicopters with thermographic capability.''

The company spent about $100 million and hired more than 300 employees to launch the ventures, according to financial filings and company records. But within a few months, it was clear both ventures would be spectacular failures. The first mailing for the golf card went out in mid-March, 1995. By Apr. 18, fewer than 5,000 people had enrolled, and they charged only $193,025. In March, 1995, the company had budgeted, through the end of April, 174,000 customers with credit-card charges of $19 million, according to internal company reports and Spink.

FPN was an even bigger dud. Starting on Apr. 10, 1995, and ending on Apr. 27, SafeCard mailed 1.2 million solicitations. On May 8, an additional 960,000 were mailed out, supported by print and TV advertising. The result: By May 16, only 3,525 enrollment kits were requested from the company, and only 14 people ponied up the $250. Total revenue: $3,500.

In contrast to these results, at an Apr. 11 conference call with investors and analysts, Kahn told analysts that FPN would exceed a 20% aftertax return and 1995 earnings would be 60 cents to 80 cents a share. Spink, who was responsible for compiling daily computer reports to senior management for the PGA Tour and FPN projects, says he talked to Kahn almost daily beginning on Apr. 20, 1995, and warned him FPN was bombing. By Apr. 25, only 286 people had sought enrollment information, and FPN didn't have a single paying customer, according to internal records. ''It was a known, irrevocable certainty within the company at the time of the Apr. 27, 1995, annual meeting that the company would report massive losses for 1995 due to the complete failure of the PGA Tour and FPN business launches,'' says Spink.

At an Apr. 27 annual meeting, however, Kahn glossed over the PGA Tour and FPN products. Even hinting at the probable debacle of its highly publicized new products at the meeting could have derailed SafeCard's plans. It was asking shareholders to approve an exchange offer that would allow it to vastly expand by issuing new stock for acquisitions and to change its name to Ideon Group Inc.

Kahn denies that he withheld bad news from shareholders or that he talked to Spink daily. He says it wasn't until much later that he knew of FPN and PGA Tour's woes. ''Why should I stand up at a public meeting saying it's great if it wasn't?'' says Kahn. As for the issue of what the directors knew, Thomson says: ''The directors did not have access to that information.''

The exchange offer was approved overwhelmingly. But on May 24, SafeCard's stock began to plunge. The company issued a press release on May 25, stating that its earnings projections ''will not be achieved.'' By May 26, SafeCard was down 44% for the week, its shares closing at 7 1/4.

With the company in a downward spiral, some board members became concerned about legal liability and wanted out, say two directors. The company's cash was dwindling fast, dropping to less than $50 million in the fall of 1995, says Kahn. FPN was shut down in June, 1995, and in September, PGA Tour was taken over by SunTrust Banks Inc. The Vatican project was ended in mid-1996. The two dismal failures, plus the Vatican project, racked up $95 million in operating losses for 1994 and 1995. On Feb. 6, 1996, Kahn was ousted with a severance package.

SafeCard had officially put itself on the block on Jan. 22, 1996, when it retained Lazard Frres & Co. In fact, the board had been looking for a buyer since the fall of 1995. Also trying to sell the company were Halmos and some SafeCard shareholders. In September, 1995, they approached SafeCard's chief competitor, CUC International, a Stamford (Conn.) direct-marketing giant with $1 billion in sales. SafeCard, after all, still boasted 12 million customers.

STOCK SWAP. At the same time, SafeCard reported $4.7 million in profits for the fourth quarter of 1995. But one charge in the Mar. 31 filing is that SafeCard used fraudulent accounting to do so. SafeCard wrote off $45 million for the first nine months of 1995 for restructuring costs associated with the new-products debacle. Some of the write-offs were legitimate, Spink says. But millions of dollars were for lease payments, equipment still in use, and salaries of people who still worked for the company--which should not be written off under generally accepted accounting rules, says Spink. Then, SafeCard allegedly reversed some of the write-offs and booked the excess as income.

Moreover, says Spink, ongoing operational costs in the fourth quarter, including salaries for current employees, were put into the restructuring reserves, thus reducing current expenses. Spink says he told his superiors and Price Waterhouse that the reserves were improper, but they ignored him. CUC says: ''We have no reason to believe that any questionable accounting occurred.'' Price Waterhouse stands by its work.

On Apr. 17, 1996, CUC announced a deal to buy SafeCard in a stock swap valued at $13.50 per share. SafeCard directors got what they wanted in order to put SafeCard behind them: indemnification against lawsuits. Dilenschneider alone made $450,000 by exercising his options.

The SafeCard story is not over. CUC CEO Walter A. Forbes and Halmos reached a handshake agreement in January, 1996, to settle Halmos' suits against SafeCard, says Halmos. Yet months of negotiations between Forbes and Halmos have been fruitless. CUC set aside $125 million in 1996 to cover SafeCard litigation. If the negotiations don't pan out, Halmos will get his day in court on Sept. 2. Then it will be up to a jury to decide if SafeCard's CEO, directors, and their advisers caused the downfall of what was once a cash cow.

By Michael Schroeder in Washington and Leah Nathans Spiro in New York



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