December 9, 2010
In our June 4, 2009 Client Update, we reported on the jury verdict the Securities and Exchange Commission (“SEC”) obtained against Charles Conaway, the former CEO of Kmart Corp for misleading investors about inventory and liquidity levels as the company was approaching its January 2002 Chapter 11 bankruptcy filing. The CEO subsequently appealed the judgment, and recently agreed to dismiss the appeal in exchange for the SEC’s agreement to a reduction in penalties from $10.35 to $5.5 million.
During the ten-day jury trial in Ann Arbor, Michigan, 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 June 1, 2009 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.”
The jury found that Conaway acted with “intent to defraud or with reckless disregard for the truth.” The district court ordered Conaway to pay a total of $10.35 million, composed of $5 million in disgorgement, $2.85 million in prejudgment interest, and a $2.5 million civil penalty. Conaway appealed to the Sixth Circuit Court of Appeals, and later agreed to dismiss his appeal in return for an Amended Final Judgment calling for a total payment of $5. 5 million. The Sixth Circuit returned the case to federal court in Detroit, and on November 15, 2010, the district court entered the Amended Final Judgment.
In the last couple of years, the SEC has been actively increasing its enforcement activities (see Gibson Dunn’s July 27, 2010 Client Update on SEC Awards $1 Million Bounty for Information Leading to an Insider Trading Action, and the July 21, 2010 Client Update on The Dodd-Frank Act Reinforces and Expands SEC Enforcement Powers). The Director of the SEC’s Division of Enforcement has been following through on his plans to increase the number of trial unit attorneys to present a “credible threat” to those who may run afoul of the SEC’s rules and regulations. On December 6, 2010, The Attorney General of the United States announced with some fanfare the results of a new enforcement program, Operation Broken Trust, in which a fraud enforcement task force that includes, among others, the Department of Justice, the SEC, the FBI, and the IRS, brought enforcement actions against 343 criminal defendants and 189 civil defendants for fraud schemes. This case illustrates that litigation involves constant analysis of the risks and benefits, and the SEC is often willing to compromise, even after a rare jury trial win over a former CEO of a public company.
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, the author, Timothy K. Roake (650-849-5382, firstname.lastname@example.org), or any of the following lawyers:
Securities Enforcement Group:
Gibson Dunn is one of the nation’s leading law firms in representing companies and individuals who face enforcement investigations by the Securities and Exchange Commission, the Department of Justice, the Commodities Futures Trading Commission, the New York and other state attorneys general and regulators, the Public Company Accounting Oversight Board (PCAOB), the Financial Industry Regulatory Authority (FINRA), the New York Stock Exchange, and federal and state banking regulators.
Our Securities Enforcement Group offers broad and deep experience. Our partners include the former Director of the SEC’s prestigious New York Regional Office, a former Associate Director of the SEC’s Division of Enforcement, the former Director of the FINRA Department of Enforcement, the former general counsel of the PCAOB, the former United States Attorney for the Central District of California, and former Assistant United States Attorneys from federal prosecutor’s offices in New York, Los Angeles, and Washington, D.C.
Securities enforcement investigations are often one aspect of a problem facing our clients. Our securities enforcement lawyers work closely with lawyers from our Securities Regulation and Corporate Governance Group to provide expertise regarding parallel corporate governance, securities regulation, and securities trading issues, our Securities Litigation Group, and our White Collar Defense Group.
Mark K. Schonfeld – Practice Co-Chair (212-351-2433, email@example.com)
Lee G. Dunst (212-351-3824, firstname.lastname@example.org)
George A. Schieren (212-351-4050, email@example.com)
Alexander H. Southwell (212-351-3981, firstname.lastname@example.org)
Jim Walden (212-351-2300, email@example.com)
Lawrence J. Zweifach (212-351-2625, firstname.lastname@example.org)
John H. Sturc – Practice Co-Chair (202-955-8243, email@example.com)
Barry R. Goldsmith – Practice Co-Chair (202-955-8580, firstname.lastname@example.org)
David P. Burns (202-887-3786, email@example.com)
K. Susan Grafton (202-887-3554, firstname.lastname@example.org)
Michael M. Farhang (213-229-7005, email@example.com)
Douglas M. Fuchs (213-229-7605, firstname.lastname@example.org)
Timothy K. Roake (650-849-5382, email@example.com)
Paul J. Collins (650-849-5309, firstname.lastname@example.org)
Charles R. Jaeger (415-393-8331, email@example.com)
George B. Curtis (303-298-5743, firstname.lastname@example.org)
Robert C. Blume (303-298-5758, email@example.com)
Richard M. Russo (303-298-5715, firstname.lastname@example.org)
M. Byron Wilder (214-698-3231, email@example.com)
Kelly Austin (+852 2214 3788, firstname.lastname@example.org)
Charles Falconer (+44 20 7071 4270, email@example.com)
Philip Rocher (+44 20 7071 4202, firstname.lastname@example.org)
Benno Schwarz (+49 89 189 33-110, email@example.com)
Michael Walther (+49 89 189 33-180, firstname.lastname@example.org)
Mark Zimmer (+49 89 189 33-130, email@example.com)
2010 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.