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NEW YORK (CNN/Money) - The Securities and Exchange Commission filed civil charges Tuesday against former Kmart CEO Charles Conaway and ex-financial chief John McDonald for allegedly misleading investors about the retailer's financial strength before it declared bankruptcy, the SEC said in a statement.
The SEC said Conaway and McDonald didn't properly disclose the reasons behind the company's massive inventory problems in the summer of 2001 and their effect on Kmart's liquidity in its filing for the third quarter ended Oct. 31, 2001, and in its earnings conference call with analysts.
"We won't allege that the numbers that were disclosed in the financial statements were wrong," Cheryl Scarboro, assistant director at the SEC's Division of Enforcement, told CNN/Money. "It's the story behind the numbers."
The SEC charged that both Conaway and McDonald incorrectly reported in company filings that the large inventory buildup in 2001 was the result of "seasonal inventory fluctuations and actions taken to improve our overall in-stock position."
The SEC said that the former officers withheld from analysts and investors the fact that the buildup was because the chief operating officer had unnecessarily and recklessly purchased $850 million in excess inventory.
According to the civil complaint filed with the U.S. District Court Eastern District of Michigan, Conaway originally thought that the company's inventory overbuy was in the range of $400 million. Once it became clear the enormity of the excess inventory, the complaint alleges, the defendants approved and authorized a plan called "Project SID" -- an acronym for slow-it-down -- in which the company withheld $570 million in payments to vendors to hide its cash flow problems.
The complaint contended that then-CFO Jeffrey Boyer -- who had joined the company six months earlier from retailer Sears, Roebuck -- warned Conaway in a series of e-mails that the company's "crash crunch" was serious and advised him that Kmart would have to consider filing for bankruptcy. He also recommended discussing the liquidity problems and "Project SID" at an upcoming board of directors meeting.
The complaint said Boyer was fired the next day and replaced with McDonald, who had been the company's former treasurer.
Scott Lassar, an attorney for the former chief executive, said in a statement that Conaway "is very disappointed in the action of the SEC." He added that a recent arbitration panel concluded that Conaway had acted "in good faith and in the best interests of Kmart."
Jack Sylvia, an attorney for McDonald, said the former financial chief was also disappointed at the SEC action and "fully expects to be exonerated when the facts are tested in a court of law."
The SEC's complaint seeks civil penalties against the two former executives and other penalties. Scarboro said the company will look to retrieve the $2.5 million McDonald received from Kmart in the form of a retention loan, along with any interest.
She added that the SEC will seek civil penalties but a dollar amount won't be determined until the end of the litigation.
As for any other investigations into Kmart or its executives, Scarboro said the SEC wouldn't comment.
Kmart emerged from bankruptcy in 2003 and has since acquired Sears, Roebuck and Co. The combined company is called Sears Holding Corp. A spokesman from Sears Holding declined to comment.
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