SEC Charges Two Former Kmart Executives

by Glen Shapiro, LawAndTax-News.com, New York

25 August 2005

On Monday the US Securities and Exchange Commission filed charges against two former top Kmart executives for misleading investors about Kmart's financial condition in the months preceding the company's bankruptcy in 2002.

According to the Commission's complaint, former Chief Executive Officer Charles C. Conaway and former Chief Financial Officer 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 (MD&A) section of Kmart's Form 10-Q for the third quarter and nine months ended October 31, 2001, and in an earnings conference call with analysts and investors.

Recently, a Michigan arbitration panel cleared Mr. Conaway of allegations of fraud, mismanagement and corporate looting, deciding that Kmart Creditors Trust, which aims to recover money owed to creditors when Kmart sought Chapter 11 protection, wasn't entitled to damages. Mr. Conaway was appointed CEO of Kmart in May 2000 and resigned in March 2002, after the retailer entered bankruptcy-court proceedings.

Mr. Conway's attorney, Scott Lassar, said in a statement: "Mr. Conaway is very disappointed in the action of the SEC. As a recent arbitration panel concluded, Mr. Conaway acted at all times in good faith and in the best interests of Kmart. Mr. Conaway expects to be exonerated again in this action."

Linda Chatman Thomsen, Director of the Division of Enforcement, said, "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."

Peter H. Bresnan, an Associate Director in the Division of Enforcement, stated, "Investors are entitled to both accurate financial data and an accurate description of the story behind the numbers. 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 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 withholding $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 Jan. 22, 2002.

The Commission's complaint, which was filed in the United States District Court for the Eastern District of Michigan, charges Conaway and McDonald with violating Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and aiding and abetting violations of Sections 10(b) and 13(a) of the Exchange Act and Rules 10b-5, 13a-13, and 12b-20 thereunder by Kmart, and seeks as relief permanent injunctions, disgorgement with prejudgment interest, civil penalties and officer and director bars.

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