June 4, 2009
For the past several months, we have advised you of various plans announced by the Securities and Exchange Commission ("SEC") to revitalize its enforcement activities (see Gibson Dunn’s May 11, 2009 Update on newly appointed Direct of Enforcement Robert Khuzami’s plans). Demonstrating the adage that actions speak louder than words, the SEC on June 1, 2009 obtained a jury verdict against the former CEO of Kmart Corp for misleading investors about inventory levels and liquidity levels as the company was approaching a January 2002 bankruptcy filing. The SEC proceeded with the trial even though it dealt with conduct that took place over seven years ago, an arbitration panel had absolved the CEO of similar charges in 2005, and after the CFO had consented to a permanent injunction, a five year officer and director bar, and a $120,000 civil penalty shortly before trial.
Charles Conaway joined Kmart in 2000 after a successful career in the drugstore industry. The SEC challenged statements and omissions in the Management’s Discussion and Analysis ("MD&A") section of Kmart’s Form 10-Q for the third quarter of 2001 and during a November 2001 conference call with analysts, which failed to disclose an improvident purchase of $850 million of excess inventory and attributed increases in inventory to "seasonal inventory fluctuations and actions taken to improve" the in-stock position. The jury was not swayed by Conaway’s testimony that he did not write or even read the MD&A, and instead relied on his CFO.
The SEC presented testimony about a "Project Slow it Down" scheme planned by the CEO and the CFO to delay payments to vendors, and the jury found that delaying payments to vendors was a "material liquidity deficiency" affecting Kmart’s finances and should have been publicly disclosed. The CFO testified that the head of the board’s finance committee told him to slow-pay vendors to conserve cash. According to the SEC’s Litigation Release, "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."
After a ten day jury trial in Ann Arbor, Michigan, the jury found that Conaway acted with "intent to defraud or with reckless disregard for the truth." The SEC trial attorney called the verdict a "clean sweep." The magistrate judge who presided over the trial will handle the penalty phase, which could result in a similar officer and director bar and a civil penalty.
As we reported in May, the new Director of the Division of Enforcement outlined plans to revitalize enforcement, and proposed to increase the number of trial unit attorneys to present a "credible threat" to defendants. This case was filed in August 2005 during the tenure of the previous Director of Enforcement, Linda Chatman Thomsen, but the jury trial took place under new Director of Enforcement Robert Khuzami and the new Chairman, Mary Schapiro. While Mr. Conaway’s attorney has promised to appeal, the SEC will take this victory as a measure of validation that it presents a credible threat and that the "new" SEC won’t shy away from pursuing jury trials against senior executives in order to hold them accountable, even for actions taken years ago.
Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you work or any of the following:
Mark K. Schonfeld (212-351-2433, firstname.lastname@example.org
Lee G. Dunst (212-351-3824, email@example.com)
Jim Walden (212-351-2300, firstname.lastname@example.org)
Lawrence J. Zweifach (212-351-2625, email@example.com)
Alexander H. Southwell (212-351-3981, firstname.lastname@example.org)
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