Commission Wins Jury Verdict Against Former CEO Based On False MD&A
A jury returned a verdict in favor of the SEC on all counts on June 1, 2009, in a financial fraud case centered on false and misleading statements in the MD&A section of a Form 10-Q filing and related statements in an investor call. The case illustrates the Commission’s emphasis on full and complete disclosures in the MD&A and should be carefully reviewed by all issuers. SEC v. Conaway, Case No. 05 Civ. 40263 (E.D. Mich. Filed Aug. 23, 2005).
The case is based on the financial woes of Kmart which culminated with its filing for bankruptcy protection in January 2002. Prior to that time, Charles C. Conaway was the CEO of the company.
According to the SEC’s complaint, in the summer of 2001, the newly appointed company COO made a massive inventory overbuy which Mr. Conaway later called “reckless.” The purchase was for $850 million, paid for on a line of credit. While the company typically made a large inventory purchase prior to the holidays, it was later in the year and not nearly as large.
Once the senior management learned of the overbuy, they took steps to ease the resulting liquidity problems. When those steps did not resolve the crisis, Project SID was launched. Essentially this project slowed vendor payments. By October 31, 2001, the company was in a cash crunch with only about $267 million left on its line of credit and over $570 million in past due vendor invoices. A number of vendors had stopped shipping to Kmart. Employees were instructed to tell those outside the company that the slow payments were the result of glitches in implementing software changes associated with Project eLMO.
In its MD&A on Form 10 for the third quarter, Kmart noted that it had experienced an increase in its account payable. The company did not disclose that at least $570 million of that increase resulted from Project SID. The MD&A also noted that there was a change in the level of merchandise inventory. It described that change as seasonal, while failing to state that the COO had made a massive and unprecedented inventory purchase.
Later in the section, there was a discussion of liquidity. There, Kmart failed to note that in effect the $570 million constituted a borrowing from company vendors. According to the complaint, “the vendor borrowing constituted a material deficiency at quarter end that should have been identified in the MD&A, and Project SID was a source of liquidity that should have been identified and separately described.” The description of working capital in the MD&A was also deficient, since it failed to identify Project SID as a major source of such capital. Statements made on these topics during a subsequent earnings call were also false and misleading.
In its verdict, the jury concluded that Mr. Conaway had violated Section 10(b) and Rule 10b-5, and had aided and abetted violations of that section as well as the reporting provisions of the federal securities laws.
Shortly prior to trial, John T. McDonald, Jr., Kmart’s former CFO, settled with the Commission. He consented to the entry of a permanent injunction prohibiting future violations of the antifraud and reporting provisions, a five year officer and director bar and to the payment of a $120,000 civil penalty. In addition, the former CFO also consented to the entry of an administrative order barring him from practicing before the Commission as an accountant for three years.
The court will consider the question of remedies at a future hearing.