Risk & Compliance

SEC Sues Former Kmart CEO, CFO

Charles C. Conaway and John T. McDonald are responsible for ''materially false and misleading disclosure about the company's liquidity and related ...
Stephen TaubAugust 23, 2005

The Securities and Exchange Commission has filed civil charges against the former chief executive officer and former chief financial officer of Kmart for allegedly misleading investors about the discounter’s financial condition in the months leading up to the company’s bankruptcy.

According to the SEC, former chief executive Charles C. Conaway and former finance chief John T. McDonald are responsible for “materially false and misleading disclosure about the company’s liquidity and related matters” in the management’s discussion and analysis section of Kmart’s quarterly report for the third quarter and nine months ended October 31, 2001, and in an earnings conference call with analysts and investors. (At first glance, notes senior editor Tim Reason, that’s a remarkable charge, given that McDonald was CFO for only four months.)

In the MD&A section, the commission alleged, Conaway and McDonald failed to disclose the reasons for a massive inventory overbuy in the summer of 2001 and its impact on Kmart’s liquidity. The SEC noted, for example, that the disclosure attributed increases in inventory to “seasonal inventory fluctuations and actions taken to improve our overall in-stock position.” This disclosure was materially misleading, in the words of the commission, 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 SEC complaint, the two former executives dealt with Kmart’s liquidity problems by slowing down payments to vendors, withholding a total of $570 million by the end of the third quarter. The commission also accused Conaway and McDonald of lying about the reasons for the late payments and misrepresenting the impact of Kmart’s liquidity problems on the company’s relationship with its vendors — many of whom stopped shipping products to the company during the fall of 2001.

Kmart filed for bankruptcy on January 22, 2002.

“The SEC has repeatedly emphasized the important role MD&A disclosure is intended to play in giving shareholders the ability to examine a corporation ‘through the eyes of management.’ Kmart senior management deprived its shareholders of that opportunity,” said Linda Chatman Thomsen, director of the SEC’s Division of Enforcement, in a statement.

“Investors are entitled to both accurate financial data and an accurate description of the story behind the numbers,” added associate director Peter H. Bresnan, in a statement. “Kmart’s senior management failed to honestly inform investors that Kmart faced a liquidity crisis in the third quarter of 2001, how the company’s own ill-advised action had caused the problem, and what steps management took to respond to it.”

The SEC is seeking permanent injunctions, disgorgement with prejudgment interest, civil penalties, and officer and director bars.

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