Wednesday, August 24, 2005

SEC Files Securities Fraud Suit Against Former Kmart CEO and CFO

Just last week, former Kmart CEO Joseph Conaway was exonerated on the bankruptcy trustee's claim that he breached his fiduciary duty to the company in taking actions that caused its bankruptcy while receiving approximately $23 million in compensation for 20 months work (earlier post here).  The SEC has now joined the fray by filing a securities fraud action alleging that Conaway and former CFO John McDonald made misleading statements in the Management's Discussion and Analysis (MD&A) section of quarterly and annual reports filed by Kmart.  According to the SEC's Litigation Release (here):

The Commission alleges that, in the MD&A section, Conaway and McDonald failed to disclose the reasons for a massive inventory overbuy in the summer of 2001 and the impact it had on the company's liquidity. For example, the MD&A disclosure attributed increases in inventory to "seasonal inventory fluctuations and actions taken to improve our overall in-stock position." The Commission alleges that this disclosure was materially misleading because, in reality, a significant portion of the inventory buildup was caused by a Kmart officer's reckless and unilateral purchase of $850 million of excess inventory. According to the complaint, the defendants dealt with Kmart's liquidity problems by slowing down payments owed vendors, thereby effectively borrowing $570 million from them by the end of the third quarter. According to the complaint, Conaway and McDonald lied about why vendors were not being paid on time and misrepresented the impact that Kmart's liquidity problems had on the company's relationship with its vendors, many of whom stopped shipping product to Kmart during the fall of 2001. Kmart filed for bankruptcy on January 22, 2002.

After a 3+ year investigation by both the SEC and the Department of Justice, the Commission's case is really quite narrow, alleging only that the MD&A did not disclose the true extent of Kmart's inventory and liquidity problems, but not that Conaway or McDonald failed to properly account for the inventory or engaged in other types of accounting fraud. 

Making a securities fraud case under Section 10(b) and Rule 10b-5 out of misleading MD&A disclosure -- assuming that it is indeed misleading -- may be difficult for the Commission.  A fraud claim requires proof of intent or recklessness, and that by withholding information from the MD&A Conaway and McDonald knew or recklessly disregarded the effect that would have on investors.  Can the Commission establish intent, and not just that bad business decisions were made by Conaway and McDonald?

While the MD&A section in the periodic reports is designed to provide management's perspective on a company's prospects, it is just that: an estimation from a particular point of view.  The market takes a somewhat jaundiced view of MD&A, and there is no allegation that the underlying financials were misstated by Conaway or McDonald.  While disclosure should be be a "connect the dots" exercise, whether the MD&A was material to investors at the time is another issue.  The SEC complaint (here) does not include any allegations of a specific market effect from the inadequate disclosures, and market participants surely were aware of Kmart's precarious financial situation.  Indeed, Conaway was hired (and paid such outlandish compensation) because he was a turnaround specialist, and many understood the weaknesses in K-Mart.  Is the failure to disclose everything about the company's delayed payment program for vendors of sufficient importance to investors that it influenced their investment decision?  That question is inherently fact-bound, but the Commission will have to make its case that the failure to disclose had an impact on the market.

Finally, among the relief sought by the Commission is disgorgement of ill-gotten gains, and mention is made of Conaway and McDonald's compensation in this period.  Is there a claim that the MD&A somehow affected the compensation?  It will be interesting to see if the Commission will be able to show a link between what appears to be excessive management compensation and the rather narrow claim that the executives did not make adequate disclosure, particularly when their compensation was approved by the board of directors. (ph)

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