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.

Two FCPA Settlements: The Need To Have And Comply With Procedures

The FCPA settlement announced on Friday by the Commission emphasized the necessity for adequate internal controls and compliance procedures and proper due diligence in retaining foreign agents and for adherence to procedures once they are instituted. SEC v. Wurzel, Civil Action No. 09-Civ-01005 (D.C.C. Filed May 29, 2009); In the Matter of United Industrial Corporation, Adm. Proc. File No. 3-13495 (Filed May 29, 2009). United Industrial Corporation is a Delaware corporation with headquarters in Hunt Valley, Maryland. ACL Technologies, Inc. is an indirect, wholly owned subsidiary of UIC. Thomas Wurzel served as president of ACL from 1992 through 2004.

Beginning in late 2001 and continuing through 2002, UIC, through ACL, made payments to a former Egyptian Air Force official retained as an agent, in connection with a military aircraft depot the subsidiary was building for the Egyptian Air Force in Cairo, Egypt. The agent had been retained earlier as a consultant.

According to the Commission’s papers, Mr. Wurzel authorized the payments to the agent, although he knew or disregarded the fact that the payments were going to Egyptian Air Force officials. There were three forms of payments: 1) payments to the agent claimed to be for labor subcontracting work; 2) a $100,000 advance payment to the agent in June 2002 ostensibly for equipment and materials; and 3) a $50,000 payment to the agent in November 2002 for so-called marketing services. As a result, ACL was awarded a Contract Engineering Technical Services contract. Gross revenue from that contract was $5.3 million, while net profits were $267,571.

The SEC claims that at the time the payments were authorized by Mr. Wurzel, UIC lacked meaningful controls to prevent or detect the illicit payments to the agent. Mr. Wurzel was able to approve payments to the agent as early as September 1997 in the absence of a written contract with that agent and while maintaining no written record of having conducted any due diligence. Although UIC instituted policies in late 1999 requiring any employee seeking to engage a foreign agent to submit due diligence forms for the agent to corporate counsel prior to the retention of the agent, ACL did not submit the appropriate forms until 2002. The forms submitted at that time were largely prepared by the agent.

The legal department of UIC approved the retention of the agent despite the fact that the person had been previously used by the company, without adequate due diligence and contrary to company policy. In fact, the agreement for the retention of the agent approved by the legal department did not contain the FCPA provisions required by corporate policy until 2003, and even then the representations were incomplete. The missing representations were that the consultant was aware of the FCPA, that UIC’s auditors and accountants would be granted access to the consultants’ books, and that the consultant would sign a statement of continuing FCPA compliance prior to each commission or other compensation payment. The payments to the agent were mischaracterized on the books of the company according to the SEC’s papers.

To resolve the administrative proceeding in which it was named as a respondent, UIC consented to the entry of a cease and desist order from committing or causing any violations of Sections 30A, 13(b)(2)(A) and 13(b)(2)(B) and to disgorge the profits from the contract along with prejudgment interest. No penalty was imposed. The Commission acknowledged the cooperation and remedial actions of the company.

Mr. Wurzel consented to the entry of a permanent injunction prohibiting future violations of Sections 30A and 13(b)(5) and from aiding and abetting violations of Sections 30A and 13(b)(2). He also agreed to pay a $35,000 civil penalty.