The Securities and Exchange Commission filed civil fraud charges yesterday against two former top Kmart Corp. executives, alleging they failed to disclose a cash crunch shortly before the retailer filed for bankruptcy protection three years ago and lied about why vendors weren't being paid on time.
The suit is somewhat unusual for the agency, which is alleging not that the executives approved misleading figures in financial statements but that their verbal explanation of the numbers was false.
In the suit, filed in federal court in Detroit, the SEC alleges that former Kmart chief executive Charles C. Conaway and former chief financial officer John T. McDonald Jr. filed false statements in the section known as Management's Discussion and Analysis of Kmart's financial report for the third quarter of 2001. Among other things, the SEC says the former executives failed to disclose that the company was in the throes of a liquidity crisis, caused by an executive's "reckless" purchase of $850 million in excess inventory. The SEC alleges Kmart fraudulently attributed inventory increases to "seasonal inventory fluctuations."
The SEC also asserts that the two failed to disclose that the company had embarked on a secret in-house program to delay payments to vendors, known as Project SID, for "slow it down," and, in a November conference call with investors, falsely attributed vendor complaints to computer problems.
Kmart filed for protection under the federal bankruptcy code in January 2002, two months after the call. Conaway and McDonald were both fired by the company's board in March of that year.
Scott R. Lassar, a lawyer for Conaway, said in a statement that Conaway was "very disappointed" in the SEC's action and that he "acted at all times in good faith and in the best interests of Kmart." Lassar pointed to an arbitration panel's decision in July that found that Conaway did not breach his obligations as the company's top executive. The case, brought by Kmart creditors, had alleged Conaway had damaged the company through "negligence and gross mismanagement."
A lawyer for McDonald, John F. Sylvia, also said that he was "disappointed" and that McDonald "fully expects to be exonerated when the facts are tested in a court of law."
The retailer, which had been based in Troy, Mich., emerged from bankruptcy protection in 2003 under the control of hedge fund manager Edward S. Lampert. Last year, Lampert engineered Kmart's takeover of Sears, Roebuck and Co., now known as Sears Holdings Corp., based in Hoffman Estates, Ill.
The lawsuit is the agency's second in two days alleging that former public-company officials made fraudulent financial disclosures. On Monday, the SEC accused two former Bristol-Myers Squibb Co. executives of organizing a scheme to "stuff" wholesale pharmaceutical channels with phony sales to inflate the company's earnings and stock price. That case hinges on an allegation that the drugmaker's sales and earnings figures as reported in its financial statements were materially false.
In the case against the former Kmart executives, however, the SEC concedes that the company's third-quarter disclosure accurately reported that Kmart's third-quarter accounts payable, the amount owed vendors and others, had jumped 56 percent from the start of 2001, while inventories had risen 30 percent.
The SEC alleges that by Labor Day, the slowdown program implemented by Conaway and McDonald had created "serious business relationship issues" between Kmart and several vendors, including Black & Decker Corp., Gillette Co., and Lego Group, which by early November had stopped shipments to Kmart.
The SEC says the management's discussion section of the quarterly report failed to disclose "the inventory overbuy," the cash crunch, the SID program and Kmart's effective withholding of $570 million from vendors without their consent.
Therese D. Pritchard, a former SEC assistant director and a securities lawyer with Bryan Cave LLP, said the SEC's stance is "pretty aggressive" given that the allegations focus on the executives' failure to explain in the text what was "perfectly obvious" in the numbers -- that the company was late paying vendors.
"Isn't that pretty obvious if your accounts payable goes up 56 percent?" she said. "Even mom and pop know that if they're not paying their bills the explanation is probably that they're paying them more slowly."
Peter H. Bresnan, the SEC's associate enforcement director, said the agency has a long history of enforcing the law to prevent executives' use of the management's discussion section to mislead investors. He cited a recent case alleging that Coca-Cola Co. had issued false and misleading commentary about inventory levels of its beverage concentrate. The company agreed in April to cease the practice without admitting or denying wrongdoing.
"This is something we've been attentive to for decades," Bresnan said.