(FORTUNE Magazine) – If you didn't know any better, you'd almost feel sorry for James Adamson, CEO of beleaguered, bankrupt Kmart. Despite laying off 22,000 employees and closing hundreds of stores so far this year, the retailer continues to hemorrhage cash as sales keep plunging. Three separate government probes are looking into millions in loans and bonuses handed out by Adamson's predecessor. The investigations were spurred by an explosive series of anonymous letters from inside headquarters that tell of bogus accounting and other shenanigans just before Kmart filed for Chapter 11 in early 2002. And with the crucial holiday season fast approaching, creditors are growing frustrated, raising doubts about Adamson's future at the company, not to mention the fate of Kmart's 220,000 remaining employees.

Shuttling between meetings with employees at headquarters in Troy, Mich., and sit-downs with lawyers and creditors in New York City, Adamson has publicly struck a Trumanesque stance, taking full responsibility for the chain's fate and vowing to do whatever it takes to turn Kmart around. "If this company doesn't succeed, it's on my watch," he told a Detroit newspaper this summer. "I'll take the hit."

Actually he won't. Because despite the pitch-perfect PR, the reality is that even if Kmart goes down, Adamson will still walk away with a shopping cart full of cash. He has already received $2.5 million--the company calls it an "inducement payment"--just for coming aboard as CEO, and his annual salary totals $1.5 million. Then there are the perks guaranteed in his contract--weekly private plane service between his residences in Detroit, New York, and Florida; a car and driver in Michigan and New York; and temporary accommodations at the swanky Townsend Hotel near Kmart headquarters. A standard room there costs $320 a night.

Even if Adamson were the right person to fix the company, such perquisites might seem over the top, especially since most of Kmart's laid-off employees didn't get a dime in severance. But what's especially galling to critics is that Adamson has been a member of Kmart's board of directors since 1996--yup, the same board that okayed those tens of millions in bonuses and loans to other top executives even as Kmart slid toward the precipice. And that's not all: Adamson also headed up the board's audit committee in 2000 and 2001, which happens to be the period now being examined by the SEC and the local U.S. Attorney's office for accounting irregularities.

Meanwhile, the company has set up its own internal "stewardship review" to probe the payouts to ex-execs and alleged accounting hanky-panky. That puts Adamson in the incredibly awkward, deeply conflicted position of heading up Kmart even as his own role in its collapse is being scrutinized by underlings. The retailer had hoped to wrap up the internal investigation by Labor Day but now says its goal is to finish by year-end. Already Kmart has restated 2001's results because of an accounting error that masked $500 million in additional losses.

What's extraordinary about Kmart is not merely that its top brass rewarded themselves so lavishly while their company foundered. As anyone with even fleeting familiarity with WorldCom, Enron, and Tyco can tell you, executives at other companies have been known to do that too. Instead, the story here is that Kmart execs are still living large and getting paid handsomely, even though Kmart is deep in bankruptcy and could face liquidation. By contrast, the CEO of bankrupt US Air, David Siegel, recently took a 20% pay cut, reducing his salary to $600,000, and refused a $750,000 bonus guaranteed under his contract. "Kmart boggles the mind," says Patrick McGurn, special counsel for Institutional Shareholder Services, which advises big investors on issues like corporate governance and CEO pay. "At least Tyco still has some value for shareholders. You can't say that for Kmart. It's really a pay-for-failure situation. Since the company's in bankruptcy, the shares are likely to end up being worthless." A better way to compensate executives trying to lead their firm out of Chapter 11, experts say, is to tie their pay to how much lenders, bondholders, vendors, and other creditors actually receive when their company emerges from bankruptcy.

Adamson, for his part, plays down the perks. He insists that he hasn't taken full advantage of what his contract entitles him to. "I had a good, aggressive lawyer," he said in an interview. "But there's a lot I don't take." For example, Adamson says he has never flown back and forth to Florida on the company's dime, and that he is no longer commuting weekly to New York or using a car and driver there. He points out that he isn't staying at the Townsend Hotel anymore; he's renting a place in Michigan instead. So who, we asked, is picking up the tab for the place? You guessed it: Kmart. "Forget the perks," insists Adamson. "That's the small stuff.... There's always critics. My contract was signed off by creditors and approved by the judge."

But hasn't Kmart's board been overly accommodating in recent years? Not at all, says Adamson. "This board never rubber-stamped anything," he says. "When you're on a board, you rely on managers and auditors to provide information." As for the bonuses and loans, Adamson notes that although he was a board member, he wasn't on the committee that oversaw compensation.

Even in its current sad state, Kmart remains a behemoth. Although down 12% from last year, sales are still expected to total more than $30 billion in 2002. That means the company probably will once again rank in the top 50 of the Fortune 500. Kmart has also managed to hold on to its exclusive deal with Martha Stewart, which helped generate more than $1 billion in revenues last year (and continues to do well despite the decorating diva's own much-buzzed-about scandal). Even after the recent cutbacks, Kmart still employs more people than Nordstrom, Saks, and Kohl's--combined. With the Christmas season approaching, Adamson is trying to improve service and store appearance, while giving managers more autonomy. One bright spot: a new deal with apparel maker Joe Boxer has scored $100 million in sales since Aug. 1.

But if the company ultimately does follow other doomed retailers like Montgomery Ward into liquidation, it will be the final blow for Kmart's long-suffering employees and retirees. Over the years they've witnessed a succession of highly paid executives come and go, each with bold turnaround plans, only to watch as one new strategy after another failed to reverse Kmart's decline. That has hit workers where it hurts. When Nathan Menoian took early retirement in 1998 and left his job in the advertising department at Kmart headquarters, the stock in his retirement plan was worth nearly $10,000. Today his shares are worth less than $250. It's not just the loss of his nest egg that angers Menoian--it's also the excess at the top. "When I was there, they made a valid point that you had to pay good salaries to attract and keep talented people," says Menoian. "But somewhere along the line, it just became outrageous. They just wanted to take as much as they could get."

It's true that Blue Light specials for executives didn't start with Adamson--they go back years at Kmart. In the late 1990s, despite slow top-line growth and fierce competition from Wal-Mart and Target, then chairman and CEO Floyd Hall was richly compensated, taking home $3.3 million in total compensation in 1999 even as Kmart's stock fell 34%. Although Hall stepped down at the end of May 2000, he collected another $3.5 million that year, according to Kmart's SEC filings.

By the time Hall left, the red ink was beginning to flow, and Kmart was desperate to bring in a turnaround artist. The board tapped Chuck Conaway, the 39-year-old president of CVS, the drugstore chain. CVS was one of retailing's big success stories in the 1990s--its stock rose 227% between 1995 and 2000--and Conaway had a reputation as an energetic, detail-oriented leader who could fix long-standing Kmart problems like rundown stores and poor inventory control. He didn't come cheap--to lure him, Kmart handed Conaway a first-year bonus of more than $8 million, plus another $943,056 in salary.

To remake Kmart, Conaway brought in a raft of young execs from companies like Sears, Wal-Mart, and Coke. Although some of the hires ended up staying for just a few months, they, too, received lavish signing bonuses and salaries. Sears veteran Jeffrey Boyer, who joined as CFO in May 2001 but was gone by November, got more than $1 million in cash, bonus, and severance payments. But it was Conaway's handpicked No. 2, Wal-Mart veteran Mark Schwartz, who would make the biggest impression, with his domineering style and determination to take on Wal-Mart, mano a mano. Although Conaway and Kmart's board were taken with Schwartz's 17 years of experience at Wal-Mart, they probably should have paid a wee bit more attention to what happened to the two companies he headed up after leaving Wal-Mart, home-products seller Hechinger's and the Big V Supermarkets chain. Both ended in bankruptcy.

Nevertheless, Schwartz was hired at Kmart in September 2000, and he earned more than $2 million just in fiscal 2000, according to Kmart's SEC filings. Together, he and Conaway pushed Kmart to challenge Wal-Mart on price, and their "Blue Light Always" program eventually cut prices on thousands of items. At the same time the duo spent millions to improve Kmart's inventory and back-office systems. To get employees revved up, Conaway borrowed a trick from Wal-Mart's playbook and instituted pep rallies on Friday mornings in the 1970s-style auditorium at Kmart headquarters, complete with "give me a K, give me an M" chants.

It didn't work. Competing head-to-head with Wal-Mart on price was simply impossible, given the Arkansas giant's huge advantages of scale and far better technology and logistics. Back at headquarters, the losses continued to pile up. Kmart recorded a $244 million loss in fiscal 2000, and by mid-2001 the red ink was at flood tide. Investors didn't know the half of it. In August 2001, Kmart reported publicly that it had lost $120 million for the first half of the year. Four months ago it restated its earnings for 2001, revealing that it had actually lost more than $600 million in the first two quarters of 2001. This discrepancy--and what Adamson knew about it--is one of the issues being probed by the SEC, Congress, and the U.S. Attorney's office for eastern Michigan. Whatever emerges from those inquiries, it's now clear that Conaway and Schwartz's strategy was a bust--Kmart lost a whopping $2.4 billion in fiscal 2001.

So with Kmart's financial condition worsening dramatically in 2000 and 2001, did Conaway and other top brass cut back on their perks? Nope. Kmart shelled out over $500,000 for housing and other personal expenses for Conaway in 2000 and 2001, along with another $122,000 for "nonbusiness use" of the company plane, according to Kmart's most recent 10-K filing. Incredibly, Schwartz collected even more in freebies--$1.2 million for housing just in 2001.

But time was running out for the two. Results for the crucial 2001 Christmas season were lousy, and by January, Kmart's stock was plunging on bankruptcy speculation. On Jan. 17, Adamson was appointed chairman of the board, although Conaway continued as CEO. Schwartz was fired. And five days later Kmart filed for Chapter 11, the biggest retail bankruptcy in U.S. history.

Conaway is now gone--he finally departed in March. But like Banquo's ghost, he has haunted Adamson because of what Conaway did in his final months at the company. First, news leaked that in the months leading up to bankruptcy, Kmart had handed out roughly $30 million in retention loans to 25 top execs, including $5 million for Conaway and $3 million for Schwartz. The ostensible reason for the loans was to keep top talent from jumping ship. But most of the recipients left anyway. More outrageous was the $4 million severance package for Conaway, approved by Adamson even as Kmart shuttered stores and laid off thousands.

With all the investigations underway, Kmart's creditors--bondholders, vendors, and the banks that have provided billions in loans since the Chapter 11 filing--are considering suing to recover the payments to Conaway and Schwartz, according to sources close to the creditors. Although Adamson initially treated the golden parachutes as a done deal (he even praised Conaway's "high integrity'' and "high professionalism'' in negotiating his severance package), he now says that Conaway and Schwartz could have to return their loot--including the $8 million in loans they received--depending on the outcome of Kmart's internal investigation. Conaway and his attorneys declined to comment for this story. Even if Conaway is sued by the creditors, however, any settlement is likely to be covered by his director's and officer's liability insurance policy, which was paid for by Kmart. As for the criminal probe, neither the U.S. Attorney's office for eastern Michgian nor the FBI has contacted Conaway or his attorneys.

Adamson's relations with creditors are also worsening because Kmart continues to post horrendous operating results. In the second quarter of 2002 it lost $377 million, which followed a $1.45 billion loss in the first quarter. And the face value of Kmart bonds--a key yardstick for a company in bankruptcy--has dropped from 40 cents on the dollar at the end of June to less than 20 cents now, infuriating bondholders who have watched their investments in Kmart vaporize. "They need to come out with a plan for reorganization and get out of bankruptcy quickly," says one major bond investor. "And if they're the right guys for the job, they should be flying coach."

There's little in Adamson's record to suggest he's up to the task. From 1995 through 2001, he was CEO of the Advantica Restaurant Group, owner of Denny's. Although Adamson did a great job at transforming Denny's from a chain infamous for discriminating against black customers into a company that actually welcomed diversity (Advantica was No. 1 in FORTUNE's annual ranking of the Best Companies for Minorities in 2000 and 2001), its financial performance was much less impressive. Despite the fact that Adamson received more than $2 million annually in 2000 and 2001, Advantica lost $98 million and $89 million in those years, respectively. And as at Kmart, Adamson got generous bonuses and perks--a $3 million retention bonus in 1998, as well as an agreement that called for Advantica to buy his Greenville, S.C., home for $1.5 million after he left in 2001. At the moment, shares of Advantica, now known as Denny's, are trading at 75 cents a share, about 25 cents more than Kmart's own stock.

The latest worry for Adamson: the anonymous letters on Kmart letterhead that continue to trickle out to government investigators and local media. The FBI and the U.S. Attorney's office are treating the letters very seriously, especially since they show a detailed knowledge of activities at Kmart headquarters. A Sept. 9 letter to Representative Billy Tauzin, whose House Energy and Commerce Committee is probing corporate wrongdoing, charges that Adamson and other top officials are impeding the investigation into the loans and accounting problems. The letter--a copy of which was obtained by FORTUNE--notes that while Kmart general counsel Janet Kelley has played a key role in Kmart's stewardship review, she herself received a $500,000 retention loan. Adamson insists that the company's internal investigation is being headed by Kmart's outside counsel, and that Kelley's current role in the probe is minimal. As for the money itself, Adamson maintains that "Janet has been willing to give her money back." Before that happens, though, "we have to evaluate all the loans and get all the facts on the table," he says.

It would be unfair, of course, to pin the blame on Adamson for everything that's gone wrong at Kmart. The company's nine- member board of directors also played a big part. Incredibly, the only board member who has resigned since Kmart filed for bankruptcy is Conaway himself. Nor have any new board members been appointed. So the same board that signed off on all the question-able accounting and the millions in loans and bonuses to all the executives passing through Kmart's revolving door is still in place. No wonder the anonymous letter from Sept. 9 was signed "Concerned and Very Worried Employees of Kmart."

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