The civil suit is the latest sign that the SEC intends to turn the "management's discussion and analysis" (MD&A) section of quarterly and annual reports into a no-spin zone. Already, hundreds of companies have received letters exhorting them to tell the unvarnished truth. The reports are supposed to discuss the story behind the numbers, highlighting factors that could have a significant impact on company financials. But the SEC believes too many managers may be giving investors a skimpy or distorted picture of their business.
In Kmart's case, executives blamed a big spike in inventories on "seasonal fluctuations." In fact, the SEC alleges, they were hiding massive unauthorized purchases by one top official. The SEC also alleged that the executives lied about why Kmart was slowing payments to vendors and the impact the company's liquidity crisis had on its relations with vendors. Kmart filed for bankruptcy in 2002. After reorganizing, it acquired Sears, Roebuck & Co., now Sears Holdings Corp. (), in March.BUSY PIPELINE
Misleading MD&A reports also were at the heart of cases the SEC brought in April against Coca-Cola Co. () and Global Crossing Ltd. () Without admitting or denying wrongdoing, Coke settled charges that it failed to disclose shipments of excess beverage concentrate to bottlers in Japan from 1997 through 1999 to meet earnings expectations. Such "gallon-pushing" isn't illegal, but the SEC says Coke left investors in the dark about the impact on company finances. The SEC faulted Global Crossing and three former executives for inadequate disclosure of fiber-optic capacity swaps with other telecom carriers in 2001. Global Crossing and the executives -- who each paid penalties of $100,000 -- settled the charges without admitting or denying guilt.
Defense lawyers and compliance experts suspect more such cases are in the pipeline. Now that most companies have adjusted to the major reporting requirements in the Sarbanes-Oxley Act, there's a renewed focus on risk assessment and disclosure, says Scott S. Cohen, editor and publisher of newsletter Compliance Week. "Everyone, from regulators to institutional investors, has been calling on companies to provide more clear, forward-looking, transparent, 'plain English' MD&A," Cohen says.
CEOs, who must sign the reports, can't blame shoddy MD&A discussions on auditors or other gatekeepers. The MD&A "is specifically designed to let investors view the company's financial condition through the eyes of management," says Peter H. Bresnan, an associate director at the SEC's Enforcement Div.
Managers had ample warning about what the SEC expects. Agency staffers have issued repeated guidance on what MD&A should cover. "What we are looking for in MD&A is the fresh story," says SEC chief accountant Donald T. Nicolaisen. "Often management repeats the same old boilerplate again and again. There is high resistance to change."BEEFED-UP REPORTS
Databases of SEC documents compiled by Global Securities Information Inc., a publisher of the SEC's electronic document filing service, reveal a constant stream of staff requests to companies to amend and expand their MD&A filings. On Aug. 9, Johnson Controls Inc. () added 14 pages of information to its 2004 annual report in response to SEC requests. "We've gotten mixed messages from investors about it, though some say 'the more information, the better,"' says R. Bruce McDonald, Johnson Controls' CFO. In March, Dress Barn Inc. () beefed up its management discussion for its 2004 annual report after the SEC asked for an overview that would "identify the most important matters on which you focus in evaluating financial condition and operating performance."
Still, corporate arrogance remains an obstacle to candid, easy-to-read reports. "Many executives think they can get away with spoon-feeding investors whatever information they want them to have, not what they're entitled to," says former SEC chief accountant Lynn E. Turner, a managing director at investment researcher Glass, Lewis & Co.
Corporate lawyers argue that managers have valid reasons to parse their words. Saying too much could give rivals an edge; saying too little could invite shareholder suits. And there are tough calls. If a company's biggest customer is threatening to walk, must management disclose that? Lawyers say it depends on whether management believes it will lose the customer. "There are a lot of gray areas," says Brian Lane, a partner at Gibson, Dunn & Crutcher and a former director of the SEC's Corporation Finance Div.
So far, the agency has been vigilant about flushing out executives who try to hide bad news in those gray areas. If the Kmart case goes to trial, it will show just how much power the SEC has to deal harshly with those it thinks have given investors a whitewashed version of company finances. By Amy Borrus in Washington