McDonnell Douglas to Pay $500,000 to Settle Charges on C-17 Program

McDonnell Douglas Corp. agreed Monday to pay a $500,000 civil fine to the Securities and Exchange Commission, settling federal charges that it had failed to disclose massive cost overruns on the C-17 cargo jet program in 1990.

The settlement sends a pointed message that financially significant cost overruns in the development of new products must be disclosed to the public, said Colleen Mahoney, the SEC’s deputy director for enforcement.

“It is unusual for the commission to get a civil penalty in a case that does not involve fraud,” Mahoney said. “But the commission believes the accounting violations were serious, and the penalty is intended to reflect that.”

Under a consent agreement, McDonnell neither admitted nor denied the SEC’s allegations that it used unreliable internal estimates in assuring shareholders that the C-17 program was in sound condition.

McDonnell Douglas spokesman Larry McCracken said the company “elected to enter into this settlement to avoid the diversion of resources that it would take to fight it.”

The SEC complaint is the second federal suit against the C-17 program this year. In February, the Justice Department joined a False Claims Act suit brought by a whistle-blower who alleged that the firm cheated the government on production tools used to build the C-17. That suit is still outstanding.

Nonetheless, the C-17, which is built in Long Beach, has staged a remarkable comeback in the last two years. McDonnell Douglas has ended cost overruns and silenced critics of the plane’s quality. After considering terminating the program, the Pentagon last year ordered 40 additional planes for roughly $17 billion.

In the early 1990s, controversies surrounding the C-17 program became the subject of acrimonious congressional hearings. Allegations that the Air Force attempted to secretly bail out the firm eventually triggered the downfall of three Air Force generals.

The SEC complaint charged the company with one count of failing to recognize a material loss, an accounting violation. As a result, the SEC said the firm “materially overstated its pretax income” in 1990.

The complaint alleged that throughout 1990, the company told its shareholders it would not go over budget on its $6.6-billion fixed-price Air Force contract--even while internal estimates were showing losses of $1 billion to $2 billion.

The complaint also alleged that costs on the C-17 program began to go out of control in the first two quarters of 1990, when development costs exceeded the budget by 31% in the first quarter and 38% in the second quarter.

In May 1990, senior executives ordered two new cost estimates for the C-17 program. The estimates showed that the firm would eventually bear a cost of $8.2 billion to complete the contract. Even so, the firm continued to tell shareholders that the program would cost just $6.5 billion.

By August 1990, the Air Force was dismissing the company’s estimates as unreliable, and its own estimates showed a sharp growth in costs. But the company insisted it would improve its efficiency and eliminate the cost overruns--a contention the SEC did not consider credible. The complaint said the company knew or should have known by the end of 1990 that its cost estimates could not be achieved.

The SEC probe began in 1993, when a former McDonnell consultant, William Jenne, disclosed the existence of the internal cost estimates in a hearing held by the House Government Affairs Committee.

Ironically, despite the company’s allegedly erroneous financial reporting, shareholders who have held on to their McDonnell stock since 1990 have done remarkably well.

In the second quarter of 1990, the stock traded as low as $34 per share. Today, after adjusting for splits, the stock is fetching the equivalent of about $300 per share, said McDonnell’s McCracken.

Mahoney, the SEC attorney, dismissed that calculation, saying: “That isn’t the way to look at it. This [information about the overrun] is something that would have been significant to shareholders at the time.”