U.S. SEC Agrees to Fifty Percent Reduction in Jury Award Against Former CEO of Kmart

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, [email protected]), or any of the following lawyers:

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