The civil fraud charges levied by the Securities and Exchange Commission against former Kmart chief executive officer Charles Conaway and former chief financial officer John McDonald are the latest sign that the SEC is keeping its promise to carefully scrutinize the disclosures made by companies in the Management's Discussion and Analysis section of their periodic filings.
As a reminder of what the Commission expects—and what it won’t tolerate—in terms of MD&A disclosure, the SEC filed charges last week against Conaway and McDonald for misleading investors about Kmart's financial condition in the months preceding the company's January 2002 bankruptcy.
“Investors are entitled to both accurate financial data and an accurate description of the story behind the financial data, which is clearly called for by MD&A,” Alan Lieberman, SEC assistant chief litigation counsel, told Compliance Week. “Companies can’t simply get the numbers right and then in a narrative either obscure the message or misrepresent the meaning of the numbers,” he adds. “That’s what occurred here.”
The Commission's complaint, filed Aug. 23 in a Michigan District Court, alleges that the two executives are responsible for making materially false and misleading disclosure about the company's liquidity and related matters in the MD&A section of Kmart's 10-Q for the third quarter of 2001, and in a November 2001 earnings conference call with analysts and investors.
A call for comment to Kmart was not returned. The SEC alleges that Conaway and McDonald failed to disclose in the MD&A section of the company’s filing the reasons for a massive inventory overbuy in the summer of 2001 and the impact it had on the company's liquidity.
While the company’s MD&A disclosure attributed increases in inventory to "seasonal inventory fluctuations” and actions taken to improve its overall in-stock position, the SEC says the disclosure was misleading because it says most of the inventory buildup was caused by what it deemed “a Kmart officer's reckless and unilateral purchase of $850 million of excess inventory.” The company then slowed payments owed to its vendors, withholding $570 million from them by the end of the third quarter. The SEC claims Conaway and McDonald lied about why vendors weren’t being paid on time, and misrepresented the impact that Kmart's liquidity problems had on its relationship with its vendors, many of whom stopped shipping product to Kmart during the fall of 2001.
“We didn’t bring this lawsuit because Mr. Conaway and Mr. McDonald and others made a business decision to slow pay their vendors,” Lieberman said. “We didn’t bring this lawsuit because Kmart may have made an imprudent inventory buy. This lawsuit was brought because of the impact of those acts and the course of conduct followed was misrepresented in the MD&A and in the Nov. 27 conference call.”
Behind The Numbers
Over the past several years, the SEC has been calling on companies to present more useful information to investors outside the GAAP framework. In the aftermath of the high-profile corporate failures at Enron, Global Crossing and other companies, the Commission expanded the rules governing public company disclosure in hopes of eliciting more meaningful MD&A. In 2003, the SEC issued interpretive guidance and warned that it would continue to bring enforcement actions on alleged MD&A violations.
RECENT ACTIONS
According to SEC's December 2003 guidance on MD&A, the Commission has brought numerous enforcement actions based on alleged violations of MD&A requirements "and will continue to bring such actions under appropriate circumstances." Among the actions referenced in the guidance were:
In The Matter Of Edison Schools (May 14, 2002)
In The Matter Of Sony And Sumio Sano (Aug. 5, 1998)
In The Matter Of Bank Of Boston (Dec. 22, 1995)
In The Matter Of Gibson Greetings (Oct. 11, 1995)
Recent enforcement actions show that the SEC has been vigilant in its efforts to prevent executives' use of MD&A section to mislead investors. In April, the Coca-Cola Co. agreed to make changes to its compliance procedures to settle charges by the SEC that the soft drink giant engaged in “channel stuffing” by asking some of its bottlers in Japan to purchase extra inventory to inflate its sales numbers in the late ‘90s. In that case, the SEC focused on how Coca-Cola explained its position in its MD&A—the Commission alleged that Coke misled investors by failing to disclose the channel stuffing practices in its periodic reports.
Other recent enforcement actions also alleged violations of MD&A requirements. In 2002, the Commission charged that Edison Schools failed to disclose the amount or existence of certain expenses in their MD&A reports. In 1998, a proceeding against Sony alleged that the company did not adequately describe in its MD&A negative results and trends at Sony Pictures—the company provided positive data, like information on box office share and Academy Award nominations, but not downward trends that the Commission considered material.
Other charges in the mid-1990s—against Bank of Boston, Gibson Greetings, America West Airlines, Caterpillar, and others—also alleged MD&A failures (see box at right).
The clear message to companies from the SEC is that boilerplate MD&A is not going to cut it. “MD&A is the place to tell the public what they need to know about your liquidity, among other things, so shareholders can make investment decisions and can determine whether the performance within the quarter is indicative of future performance,” said Lieberman.
"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,'” Linda Chatman Thomsen, director of the SEC’s Division of Enforcement, said in announcing the charges. “Kmart senior management deprived its shareholders of that opportunity."
Allen
“This [case] is interesting because the SEC is not alleging that the financial statements were wrong, just that the MD&A describing the financial statements was wrong,” says P. Blake Allen, a partner in the San Diego office of Duane Morris. “Sometimes companies have a tendency to think that if the financial statements show the information accurately, that's good disclosure and that's enough.”
With the action against Kmart, Allen says, the SEC is saying “the story behind the numbers is of equal importance as the numbers themselves.”
Grover
“This is a concrete illustration to companies of why it’s critical to get disclosure right,” says Gavin Grover, a partner in the San Francisco office of Morrison & Foerster and head of the firm’s Corporate Finance Group. “MD&A is some of the most important disclosure a company can make in any given filing. There’s been some significant enforcement in this area to show the community what does and doesn’t work.”
Personal vs. Corporate Accountability
While many earlier enforcement cases in this area have targeted companies, Grover points out that the Kmart action focuses on individuals. “The message to the community in the recent wave of enforcement has been a heavy focus on individuals in key roles, the gatekeepers,” says Grover. “The clear takeaway here is that the SEC is watching, and if they think you got it wrong on disclosure, the responsibility goes beyond the company to the individuals. That’s been the theme of the SOX era.”
“Management needs to ensure their MD&A tells investors what keeps them up at night,” adds Duane Morris’ Allen. “The SEC complaint alleges management had very specific concerns internally and took great pains to prevent investors from knowing about these concerns. The bottom line is, if you're losing sleep over something, your investors should get to lose sleep over it also.”
In light of the SEC’s stance in the Kmart case, Allen also advises that companies “really need to drill down on their material sources and uses of liquidity, both external and internal.”
Says Allen, “Liquidity disclosure has to be on companies’ radar screens in a big way today. The investor has to have the information to see what's on the horizon for the company's liquidity. Accurate disclosure about whether a company can pay its bills is about as important as it gets.”
While liquidity was an issue for Kmart, Grover says, “For most companies I wouldn’t think liquidity is a major risk area.” He says a “crux issue” in MD&A is the “known trend or uncertainty.”
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