The Circuit City-SEC Mystery

Did Circuit City have to contend with an undisclosed probe from the Securities & Exchange Commission?

Disclosure Insight, run by John Gavin, is an independent research firm that prepares in-depth risk reports on public companies. This research includes information it acquires under the Freedom of Information Act [FOIA] filings it sends to the Securities and Exchange Commission.

Disclosure Insight, formerly known as SEC Insight, routinely files about 2,500 FOIA requests per year for investigative records from the SEC. It makes its findings available to anyone who registers for its complimentary alerts at http://www.disclosureinsight.com/.

Disclosure Insight sent a FOIA request to the SEC for information on Circuit City. The SEC then sent a letter back to Disclosure Insight noting that it was "withholding certain nonpublic records that may be responsive to your request" citing an exemption under securities law. Its letter adds: "This exemption protects from disclosure records compiled for law enforcement purposes, the release of which could reasonably be expected to interfere with enforcement activities."

When Disclosure appealed that decision with the agency, it got a letter back from the SEC which reads that SEC "staff responsible for the commission's investigation have confirmed that releasing the withheld information could reasonably be expected to interfere with an on-going commission investigation."

The questions come at a time when Circuit City is at a crossroads. It now faces a buyout by video-store chain Blockbuster (BBI), which wants to purchase the beleaguered electronics retailer for $1.35 billion. Billionaire corporate raider Carl Icahn, a big Circuit City shareholder, recently said that he would buy Circuit City (CC) if Blockbuster (BBI) can't get financing.

Both companies are unprofitable, but many investors believe a combination of the two--with Circuit City selling electronic devices and Blockbuster media content--would produce a viable company.

Circuit City initially resisted Blockbuster's offer, saying it feared Blockbuster didn't have the financial clout to carry out the deal. With Icahn on board, the situation may change.

Circuit City has been caught in the same downdraft that has dragged down other big-box retailers like CompUSA and Best Buy. Meanwhile Blockbuster has been socked hard by tough competition from Netflix and video streaming from Apple's iTunes service. Last year, Circuit City's decision to fire 3,400 of its highest-paid sales staff and replace them with lower-paid workers was met with negative headlines, as dumping high performers was seen as a risky strategy to cut costs.

In a conference call with William Cimino, Circuit City's spokesman, and Jay Oakey, its assistant general counsel, I asked whether Circuit City had an undisclosed SEC probe on its hands. Prior to the call I e-mailed a list of questions, including the following:

"Can you please confirm that Circuit City is now dealing with an SEC probe?" and "What is the probe about, what are the issues?"

In response to these questions, Cimino said emphatically, "No there is no probe."

But I worded the questions incorrectly. I then sent a follow-up email to Circuit City in which I stated: "You say there is no probe. At any time in the past year has CC had contact of any kind with the SEC's Division of Enforcement?" and "If so, what did it entail, when did that contact first start, when was your last contact, and where does it stand today?"

Here's what I got back in an e-mail from Cimino: "Our practice is to not comment on past or present regulatory actions of any nature involving the company, except as required by law."

As Gavin points out, "companies are not required to disclose SEC probes. Investors think they are, that's just a myth. They are, however, required to disclose matters deemed material." Gavin adds that "The problem is that management is the judge of whether an SEC probe is material. That this company is in play changes the materiality threshold quite dramatically; that is, perhaps more than ever the company should be striving to make sure all parties involved know exactly what's going on."

Again, to be clear, Circuit City says there is no SEC probe. Gavin's company thinks there was an undisclosed one. Investors won't know what's going on at Circuit City with regards to the SEC until the company chooses to tell us in its filings.

Circuit City has been under the gun lately, as was highlighted in a recent research report published by Disclosure Insight. In its recent annual report, it disclosed that it had identified "errors" in its internal controls overseeing its deferred tax assets, including the calculation of the company's valuation allowance on deferred tax assets, during its fiscal third quarter of 2007.

Though the company says these errors "did not have a material impact on the financial statements related to the third quarter," they "had the potential to do so," and in turn concluded that this "deficiency constituted a material weakness in internal control over financial reporting" that could have resulted in "a material misstatement" of its financials.

It added: "The material weakness did not result in the restatement of the company's financial statements for any period." The IRS audited Circuit City's fiscal 2001 through 2003 tax returns, an audit that is now complete.

Circuit City has a new chief financial officer as of July 30, 2007; the previous CFO left to join Petco. Its CEO was appointed on March 1, 2006, but the stock has declined 79% since then, having risen during that time as well.

What is the reason for the stock decline? Earnings performance, which has been dismal. Circuit City is vastly dependent on the domestic market, and the company's earnings have been hurt due to its exposure to the weakening US economy. Circuit City has revenue concentration of 40.9% of domestic sales in the video category, which includes TVs, for the last 12 months for its most recent fiscal year.

For now, Circuit City plans to ask shareholders to expand its board of directors from 12 to 15, diluting the gains made by a dissident stakeholder last week.

The consumer electronics retailer would keep three directors thought to have lost their seats stemming from a potential proxy fight with Mark J. Wattles, president of Wattles Capital Management. Wattles now owns a 6.5% stake in Circuit City.