By  on August 24, 2005

NEW YORK — The Securities and Exchange Commission on Tuesday charged Charles C. Conaway, the former chairman and chief executive officer of Kmart Corp., with misleading investors about the retailer's finances before it filed for bankruptcy in 2002.

Kmart's ex-chief financial officer, John T. McDonald, was also accused in the case.

"Investors are entitled to both accurate financial data and an accurate description of the story behind the numbers," Peter Bresnan, associate director in the SEC's Division of Enforcement, said in a statement. "Kmart's senior management failed to honestly inform investors that Kmart faced a liquidity crisis in the third quarter of 2001, how the company's own ill-advised action had caused the problem and what steps management took to respond to it."

Kmart's liquidity issues pushed it into bankruptcy on Jan. 22, 2002, and questions leading up to the retailer's filing — ranging from charges of excessive compensation to accounting improprieties — triggered investigations by the SEC and by the U.S. Attorney in Detroit. The U.S. Attorney's office, along with the Federal Bureau of Investigation, worked with the SEC in connection with the charges against Conaway and McDonald.

It was uncertain whether the civil action might be a precursor to criminal charges. A government source on Tuesday said that criminal action by the U.S. Attorney's office is "typically filed on the same day that the SEC announces its action."

Both the SEC and the U.S. Attorney's office declined comment. The SEC is seeking civil penalties against Conaway and McDonald and wants to bar them from being officers or directors in any publicly traded company.

Conaway was recruited in June 2000 to succeed Floyd Hall as Kmart's chairman and ceo. Then 39 years old, he was to breathe new life into the discounter. He left the bankrupt firm in March 2002. The retailer emerged from Chapter 11 in May 2003 as Kmart Holding Corp. with the help of ESL Investments chairman Edward Lampert, who became chairman and engineered the merger in March with Sears, Roebuck & Co. to form the $55 billion Sears Holdings Corp. The Kmart nameplate operates under the Sears Holdings umbrella. A spokesman for Sears Holdings declined comment."Mr. Conaway is very disappointed in the action of the SEC," said Scott Lassar, an attorney representing the former ceo. "As a recent arbitration panel concluded, Mr. Conaway acted at all times in good faith and in the best interests of Kmart. Mr. Conaway expects to be exonerated again in this action."

The panel exonerated Conaway in a civil dispute filed by the retailer's former creditors, which was submitted to arbitration for resolution. It further determined that Kmart Creditors Trust, representing company creditors, was not entitled to any damages from Conaway.

In a separate statement, McDonald's lawyer, Jack Sylvia, said: "Although Mr. McDonald obviously is disappointed that the SEC elected to bring this action, he fully expects to be exonerated when the facts are tested in a court of law."

In a complaint filed on Tuesday by the SEC in a federal district court in Detroit, the two former executives were accused of being responsible for filing materially false and misleading statements about the retailer's liquidity in its quarterly report for the third quarter and nine months ended Oct. 31, 2001, and for statements made during an earnings conference call with analysts and investors on Nov. 27, 2001.

The complaint charged that Conaway and McDonald "failed to disclose that Kmart had made an extraordinary and reckless overpurchase of inventory. Instead of candidly admitting the fact of the ill-advised overbuy and the significant impact it had on the company's liquidity, Conaway and McDonald dealt with Kmart's liquidity problem by secretly slowing down payments owed to vendors. Defendants then lied about why vendors were not being paid on time and misrepresented the impact that Kmart's liquidity problems had on the company's relationship with its vendors, many of whom stopped shipping product to Kmart."

The complaint noted that while the "extraordinary purchase of inventory" before holiday in 2001 was actually $850 million, management initially thought it was in the range of $400 million, and didn't find out otherwise until after Labor Day. The purchase was made in the summer of 2001 by Kmart's new chief operating officer.

The individual was not named in the complaint. Mark Schwartz, Kmart's former president and chief operating officer, was appointed to those posts by Conaway in March 2001. The unnamed chief operating officer is not a party to the SEC action and has not been charged with any wrongdoing.The court document also alleged that Conaway and McDonald during the November conference call blamed the late payments to vendors on the company's conversion to a new inventory system called Project eLMO. The lawsuit alleged that the explanation was "false and misleading. Project eLMO did not cause invoices to be 'dropped.' Payments were deliberately withheld through Project SID." SID is the acronym for slow-it-down, referring to the plan that Kmart unilaterally implemented to extend the terms of payment to Kmart's suppliers.

Court papers also noted that on the eve of the bankruptcy filing, on Jan. 15, 2002, McDonald received a $1.75 million cash payment from Kmart, which "supplemented a similar $750,000 payment McDonald had received on Dec. 3, 2001." Conaway was "receiving $20 million in compensation from Kmart for 20 months service," the court papers said.

The discounter listed total liabilities of $10.3 billion and assets of $16.3 billion, according to the Chapter 11 petition filed in a bankruptcy court in Chicago.

Before joining Kmart, Conaway was president and chief operating officer at CVS Corp., overseeing the drugstore chain's merchandising, advertising, store operations, logistics and e-commerce. He previously had been the company's executive vice president and cfo, while also serving as executive vice president and cfo of Melville Corp., CVS' former parent company. In these roles, Conaway was credited as one of the architects of the restructuring of Melville from an overdiversified retailing company into one of the nation's largest drugstore chains.

Conaway runs a consulting business in Troy, Mich., and McDonald lives in Wheeling, W.Va., the Detroit Free Press reported.

In May 2000, at the time of Kmart's announcement that Conaway would take over, financial analysts applauded the choice, citing his experience at CVS. Several industry experts, however, warned that Conaway would face challenges at Kmart, given his dearth of apparel knowledge and lack of experience in orchestrating turnarounds.

Kmart Since 2000

  • August 2005: SEC files fraud charges against former Kmart Corp. chairman and chief executive officer Charles C. Conaway and ex-chief financial officer John McDonald.
  • March 2005: Shareholders approve merger of Kmart and Sears, Roebuck & Co., creating Sears Holdings Corp.
  • March 2005: Kmart Holding posts annual net earnings of $1.11 billion on sales of $19.7 billion.
  • November 2004: Kmart Holding and Sears, Roebuck agree to merge in an $11 billion deal.
  • March 2004: Kmart Holding returns to profitability with fourth-quarter income at $276 million, versus a loss of $1.1 billion in the previous year. Sales fall 25.8 percent to $6.33 billion.
  • November 2003: Federal prosecutors drop their case against two former Kmart vice presidents, Enio Montini Jr. and Joseph Hofmeister, who were indicted on securities fraud charges, conspiracy and making false statements to the SEC. Both left Kmart in May 2002 as part of a corporate restructuring.
  • May 2003: Kmart emerges from Chapter 11 as Kmart Holding Corp.
  • February 2003: Montini and Hofmeister are charged by federal prosecutors.
  • January 2003: Julian Day named ceo, succeeding James Adamson.
  • January 2003: Kmart's board of directors approves the company's plan for reorganization.
  • December 2002: Kmart says its fiscal 2002 third-quarter loss more than doubles to $383 million.
  • December 2002: Kmart says it will restate financial results for previous three and a half years.
  • March 2002: Adamson replaces Conaway as ceo. Day is named president and chief operating officer. Al Koch of turnaround firm AlixPartners is retained to serve as interim cfo, replacing McDonald.
  • January 2002: Kmart announces an internal probe into its stewardship under previous management, prompted by an anonymous letter from an employee.
  • January 2002: Kmart files Chapter 11 petition.
  • January 2002: Mark Schwartz, president and chief operating officer, exits Kmart.
  • May 2000: Conaway named chairman and ceo of Kmart to replace Floyd Hall, who retired.
— With contributions from Meredith Derby and Molly Prior

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