-0 • I LERACH COUGHLIN STOIA GELLER RUDMAN & ROBBINS LL P 2 . DANIEL S . DROSMAN (200643) DAVID A. THORPE (216498) 3 TED MINAHAN (227969 ) y`t 655 West Broadway, Suite 1900 4 San Diego, CA 92101 Telephone : 619/231-1058 5 619/231-7423 (fax ) - and - 6 PATRICK J . COUGHLIN (111070) 9601 Wilshire Blvd., Suite 51 0 ~u ! Z r' 2d1~5 7 Los Angeles, CA 90210 Telephone : 310/859-3100 -01 .j T 8 310/278-2148 (fax ) ANIA DEPUTY 9 Lead Counsel for Plaintiff 10 UNITED STATES DISTRICT COURT 11 SOUTHERN DISTRICT OF CALIFORNIA 12 In re PETCO CORPORATION SECURITIES Master File No . 05-CV- 23-H( BB) 13 LITIGATION ) CLASS ACTION 14 This Document Relates To: ) CONSOLIDATED COMPLAINT FOR 15 VIOLATIONS OF THE FEDERAL ALL ACTIONS. ) SECURITIES LAWS 16 17 18 19 20 2 1 ~5 6 7 28 ~`Q 6 0 1 TABLE OF CONTENTS 2 Page 3 INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 4 JURISDICTION AND VENUE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 5 THE PARTIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 6 BACKGROUND TO THE CLASS PERIOD AND SUMMARY OF THE ACTION . . . . . . . . . . . . . . . . 2 3 7 DEFENDANTS' FALSE AND MISLEADING STATEMENTS AND OMISSION S DURING THE CLASS PERIOD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 1 8 August 2004 - October 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 1 9 November 2004 - January 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 1 10 February 2005 - April 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 7 lI May 2005 - August 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 4 12 CONFIDENTIAL SOURCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 3 13 PETCO'S FALSE FINANCIAL REPORTING DURING THE CLASS PERIOD . . . . . . . . . . . . . . . . . . . . . 7 6 14 GAAP and SEC Vio lations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 8 15 ACCOUNTING SCHEME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 0 16 Dist ri bution Centers ' Expense Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 1 17 PETCO'S GAAP VIOLATIONS WERE MATERIAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 4 18 DEFENDANTS CERTIFIED FALSE AND MISLEADING FINANCIAL RESULTS . . . . . . . . . . . . . 8 5 19 PETCO FAILED TO MAKE REQUIRED DISCLOSURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 6 20 PETCO LACKED ADEQUATE INTERNAL CONTROLS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 8 2 1 PETCO SHOULD HAVE RESTATED ITS FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 9 22 ADDITIONAL GAAP AND SEC VIOLATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 23 CONFIDENTIAL SOURCES CONFIRM DEFENDANTS' SCI ENTER . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92 24 DEFENDANTS' PARTICIPATION IN A SCHEME TO DEFRAUD SHAREHOLDERS . . . . . . . 9 6 25 DEFENDANTS INSIST THAT PETCO'S DISTRIBUTION CENTERS OPERAT E 26 UNDER UNREASONABLE COST CONSTRAINTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 7 27 DEFENDANTS ORDER DISTRIBUTION CENTER DIRECTORS AND MANGER S TO WITHHOLD INVOICES IN ORDER TO STAY WITHIN THE BUDGET . . . . . . . . . . . . 9 9 28 05-CV-0823 -H(RBB) 6 . 1 2 Page 3 Distribution Department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 4 Traffic and Transportation Department . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 5 PETCO'S OCTOBER 2004 EMPLOYEE SURVEY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 6 PETCO'S DECLINING SAME-STORE SALES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110 7 DEFENDANTS' INSIDER SALES DURING THE CLASS PERIOD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 8 LOSS CAUSATION/ECONOMIC LOSS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118 9 CLASS ACTION ALLEGATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 10 NO SAFE HARBOR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122 11 FIRST CLAIM FOR RELIEF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 12 SECOND CLAIM FOR RELIEF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 13 THIRD CLAIM FOR RELIEF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125 14 PRAYER . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 15 JURY DEMAND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127 16 17 18 19 20 21 22 23 24 25 26 27 28 1 ii 05-CV-0823- H(RBB) . • INTRODUCTION 2 1 . This is an action on behalf of purchasers of PETCO Animal Supplies , Inc . ("PETCO" 3 or the "Company") common stock during the period from August 18, 2004 to August 25, 2005 (the 4 "Class Pe riod") for violations of §§10(b), 20(a) and 20A of the Securities Exchange Act of 1934 (the 5 "1934 Act" or "Exchange Act") and Rule IOb-5 promulgated by the Secu ri ties and Exchange 6 Commission ("SEC") . Defendants are PETCO and its top officers , directors, and controlling 7 shareholders during the Class Period , who made or are otherwise responsible for false and 8 misleading statements and omissions regarding PETCO' s financial forecasts and results with respect 9 1 to earnings per share (" EPS"), net earnings and same-store sales , which had the effect of artificiall y t o inflating PETCO's stock price during the Class Period and allowed defendants to sell approximately 11 $270 million worth of inflated PETCO common stock in less than one year . 12 2. For the two years before the Class Period, PETCO, which was under the control of 13 shareholders Texas Pacific Group ("TPG") and Leonard Green & Partners ("LGP"), told the market 1 4 how its aggressive growth strategy, i .e., more PETCO stores nationwide, would translate into greater 1 5 shareholder returns . While defendants told investors that PETCO effectively executed its nationwide 1 6 store expansion strategy, they failed to inform investors during the Class Period that defendants were 1 7 unwilling to expend extra money on distribution infrastructure to support this expansion . According 18 to a former manager at PETCO, at the beginning of the Class Period the Company was internally 19 discussing the need to open additional distribution centers in the West and South to address the 20 increasing distribution costs . Defendants, however, failed to open additional distribution centers 21 where they were greatly needed, especially in Georgia and Florida, where PETCO had expanded 2 2 exponentially . In addition, defendants only approved distribution center budgets that wer e 23 unrealistically low and had no reasonable chance at being achieved . 24 3 . Over the course of the Class Period, defendants consistently forced operational 25 divisions of the Company to accept unrealistic budgets far below actual operating costs . This under- 26 budgeting resulted in the under-accrual of expenses from operations through the failure to recor d 27 I expenses, which defendants were forced to admit took place during the Class Period . See 11218- 28 1279 . 05-CV-0823- H(RBB) 0 0 1 4. According to former employees of PETCO, beginning in 2004, defendants rejected an 2 already bare -bones operational budget and required additional cuts of up to $1 .5 million . Under 3 these extreme budgeting pressures imposed by defendants , costs naturally exceeded budgeted 4 amounts . See 11226-234 . Former Company employees specifically relayed this information to 5 senior management as early as October 7, 2004, as part of PETCO's Employee Survey . See 1111275- 6 7 279. 8 5. In order to meet quarterly expectations given these unrealistic budgets, defendants 9 instructed PETCO employees to hold back the recording of incurred expenses and liabilities . See 10 ~~235-279 . For example , in the beginning of October 2004, defendant Razia Richter ("Richter"), 11 Senior Vice President, Supply Chain for PETCO, began part icipating in weekly forecasting calls 12 with logistics and operations employees , including the directors of the three central dist ribution 1 3 centers . During one of these calls, in October 2004, defendant Richter told the distribution directors 14 15 to "hold onto any invoices because we gotta make the quarter ."' At the same time, defendant 16 Richter instructed the dist ribution directors to "do whatever it takes to be o n budget ." This under- 17 accrual resulted in millions of dollars worth of unrecorded expenses and liabilities in order to 18 "make " the quarterly results . 19 6. Furthermore , in the second week of January 2005, defendant Richter sent an email 20 to distribution center directors stating that she wanted to schedule a conference call with the 2 1 22 directors in reference to accruals and invoices being held back to make budget . Attached to 23 defendant Richter 's email was a selected compilation of responses fron~ the early October 2004 24 Employee Survey which showed that m anagem ent was forcing unrealistic budgets on the 25 distribution centers and invoices and expenses were being improperly unrecorded in an effort to 26 27 I Unless otherwise noted , all emphasis is added . 28 -2- 05-CV-0823-H(RBB) 0 1 reduce expenses and increase net earnings . See Exhibit 1 . One day later, however, defendan t 2 Richter cancelled the conference call with no explanation and never rescheduled for a new date . I f 3 defendants recorded these expenses and liabilities as required by GAAP, PETCO's reported financial 4 results would have been materially different . 5 7 . Defendants falsely reported PETCO's financial results, which materially overstated 6 1 PETCO's net earnings before taxes by $3 .2 million, $5.6 million, and $5 .6 million for Q3 2004, Q4 7 2004, and fiscal year 2004, respectively . Furthermore, EPS was overstated by $0 .03, $0.06 and 8 $0.06 for Q3 2004, Q4 2004, and fiscal year 2004, respectively . See ¶168-192 . 9 8. Former PETCO employees have provided plaintiff with a detailed list of over $3 .1 1 0 million worth of unrecorded freight and fuel invoices incurred at the distribution centers . A copy of PETCO's general ledger detailing these unrecorded distribution costs is attached hereto as Exhibit 2 . 12 In addition, PETCO erroneously accounted for tenant improvement allowances associated with its 13 leases . PETCO understated its cost of sales by improperly amortizing its tenant improvement 14 allowances as a reduction to depreciation and amortization in violation of Generally Accepted 15 Accounting Principles ("GAAP") in the amount of $1 .2 million through Q3 2004 . See 11168-192 . 16 PETCO's fraud is shown graphically in the following stock chart : 17 18 19 20 21 22 23 24 III 25 26 27 28 -3- 05-CV-0823- H(RBB) PET!O Animal Sup ' Daily Share Pricing : August 2, 7 ' $45 1011104 .11 /1 )04: Insiders 1r 8 21010641 0f4in:a PnEcTiaCl Ore rseupltosr twsith wi1Pn0Aivt1he 1is n2ft i1ovn0rAa4snb :i cnPhi aEPtlh hTaienClyaaOdlrye esmaltfpsfe hiareimnats,ded s$• e2Gfa5or 2r7e ,$e.611n2011:6 9,3,90,,4231015005 .s,,09h05a04re ssh faorres sf1o2er1l l1 $61270,4,46:9 0I2n0,s3 si0dh4earrse' comparable store sales of third quarter guidance and • TPG: 3, 305,955 shares 6.7%. EPS of $0.33 . and net full-fiscal year guidance . for $117,600,000 . ea rnings of $19.3M . PETCO states its ■ Insiders: 444,101 shares $40 PETCO provides 3004 excep ti onal financial for $15,621,921 . financial guidance with performance will continue. comparable store sales of --I _- 1 GA G) -0 Q) n $5%0,.363%4 0an.3d4 E. PES ToCf O CFO, L 6) 0) B ~v ' aRsnotdro n'nseguy co Ccpeaesrstaefturin,lagen xmneoacrugntiocnenss' 9a1n9n/o04un: cPeEsT tCheO Ua) O O 0nI-fi .OC'Lo N Q 0 of [Isl long-term growth opening of its CDN a strategies . . . wil enhance 700th store . O a N $35 sthearfeuhtuorled.e*r value wel into 00 a Oa N0 Q) 606 Al h Enr p a t ~+ J V W tDra - y ~DO ~p ~o 3cl' 0) ON a O (h 0 UL, CU $30 9/1!N 0 Ali 0 for I 1 q E a rel UP $25 ine P E u n 0 e n G G on a v,"1 G a G 0 0 0 0 $20 08102/2004 O81~ • • 1 9. Ultimately, after a whistleblower notified the defendants of the accounting fraud, 2 PETCO was forced to reveal that it had failed to accrue $5 . 6 million in expenses during 2004, and 3 KPMG, PETCO' s independent auditors, concluded that PETCO had mate rial weaknesses relating to 4 accruals for vendor invoices . 5 10 . Defendants also issued false forecasts concerning PETCO' s same-store sales , 6 consistently projecting growth in the 5% to 6% range , despite knowing that stores around the 7 country were repo rt ing decreased customer traffic , that PETCO did not have a cost -effectiv e 8 distribution chain to service new stores in parts of the Southeast and that the new store format that 9 defendants represented as the model for future growth and distinction from its competitors actually 10 afforded less shelf space and sales potential than previous models . See ¶280-287. Additionally, in 11 announcing PETCO's net sales figures to the market, defendants concealed that net sales growth 12 throughout the Class Period was primarily due to increased pricing, rather than increased customer 13 traffic as reported . See J280-287 . 14 11 . By issuing false and misleading statements and omitting the true facts regarding the 15 costs of operations at PETCO, the Company' s same-store sales , and customer traffic and sales based 16 on a new store format , PETCO stock was artificially inflated throughout the Class Period . Through 17 their false and misleading statements , defendants artificially inflated PETCO' s stock price to over 18 $39 per share . At the end of the Class Period , PETCO's stock collapsed to approximately $21 per 19 share . Thus, PETCO stock fell dramatically in price as the state of the Company' s financial an d 20 I operational condition came to light . 2 1 12 . This inflation, caused by defendants' false and misleading statements, allowed 22 PETCO's insiders to reap over $4.7 million in proceeds from the sale of PETCO common stock 23 between August 18, 2004 and October 1, 2004 . But defendants sought to profit even more . Faced 24 with the serious obstacle to selling off additional holdings of their PETCO stock because of negative 25 market reaction to large blocks of insider stock sales, and the resulting price instability, defendants 26 decided to undertake a public offering of millions of shares of PETCO stock . 27 13. On October 22, 2004 - weeks after defendants learned through an employee tha t 28 11 PETCO was violating accounting rules by systematically withholding payment for invoices - -4- 05-CV- 0823-H( RBB) • S 1 PETCO filed a prospectus for a public offe ri ng of approximately 6 .9 million shares of common stock 2 (the "Public Offering ") with a proposed maximum aggregate value of over $247,nillion to b e 3 received by the selling shareholders . The Public Offering not only allowed PETCO insiders the 4 opportunity to sell vast stuns of conunon stock, but it also afforded PETCO's nvo largest and 5 controlling shareholders, Texas Pacific Group and Leonard Green & Partners, the opportunity to 6 sell-off 100% of their remaining shares of PETCO common stock . PETCO received no financial 7 benefit from the Public Offering, and indeed, paid the expenses of the Public Offering . 8 1 14 . Defendants ' sales in the October 2004 Public Offering occurred after PETCO's 9 senior management, including defendant Razia Richter, PETCO's Senior Vice President of Supply 10 1 Chain, instructed distribution center managers to withhold invoices and falsify distribution center 11 budgets, which caused PETCO to report false financial results . See ¶288 . 12 15 . From the Public Offering through April I, 2005, defendants sold over $15.5 million 13 worth of PETCO common stock at inflated prices . Then, in April 2005, defendants were forced to 14 publicly disclose that PETCO failed to record or accrue known distribution expenses and would 15 delay filing its annual report . On April 15, 2005, before the market opened, the Company issued a 1 6 press release entitled "PETCO to Delay Filing of Form 10-K." The release stated that PETCO 1 7 would delay the filing of its Form 10-K with the Securities and Exchange Commission, for the year l 8 ended January 29, 2005, and that it had requested a 15-day extension after it discovered accounting l9 errors related to certain under-accrued expenses in its distribution operations . The Company 20 anticipated its Q4 2004 earnings would be reduced by $3.0-$4.5 million and that fiscal year 2005 21 earnings would be reduced by a similar amount, as it took into consideration the nature of the under- 22 accrual of distribution expenses . Despite admitting that they were aware of this accounting fraud 23 an April 1, 2005, defendants sold over $2.5 million worth of inflated common stock on that very 24 day . 25 16 . In fact, defendants were told of this systematic under-accrual of distribution expense s 26 as early as October 2004, and again on March 25, 2005, in an email to defendants James Myers 27 ("Myers"), Chief Executive Officer of PETCO, and Rodney Carter ("Carter"), Chief Financia l 28 Officer of PETCO . See 11235-274 . As part of this email , a former PETCO employee also attache d -5- 05-CV-0823- H(RBB) • 0 1 portions of the Company's general ledger stating : "lalttached is information concerning 2004 2 expenses carried over into 2005 which were not accrued for in 2004. This information is not 3 meant to be 100% accurate but I feel firrdier erammination is in order. I think you will find this is 4 a substantial amount worthy ofyour concern and attention." The total amount of invoices just for 5 2004 freight and fuel ("freight out") costs that had neither been recorded as an accrued expense nor 6 paid by the end of fiscal 2004 (January 29, 2005) totaled over $ 3 million . See Exhibit 2 . 7 17 . Defendants continued, however, to publicly represent to investors that same-store 8 sales were on track to meet guidance and that the new store format and customer traffic were drivin g 9 improvement , which further inflated the price of PETCO's common stock to an all-time high of over 10 $39 per share in December 2004 . ll 18 . As investors and the market became aware that PETCO's prior statements and 12 financial results had been false and that PETCO's actual business prospects were far worse than it 13 had led investors to believe, the stock began to free-fall . But before they released their final 14 bombshell, defendants quickly sold appro_riniately $3 .8 million worth of additional inflated 15 PETCO common stock between July 1, 2005 and August 1, 2005 . 16 19. Finally, on August 25, 2005, PETCO announced that its Q2 2005 same-store sales 17 li increase was only 2 .5%, missing its prior estimates . PETCO also lowered guidance for same-store 1 8 sales in Q3 2005 to 0% to 2% . The price of PETCO's stock plummeted to $21 .99 per share on this 19 news, a one-day drop in price at 13%. 20 JURISDICTION AND VENU E 2 1 20. The claims asserted herein arise under §§10(b), 20(a) and 20A of the 1934 Act, 15 22 U.S.C. §§78j(b), 78t(a) and 78t-1, and Rule lob-5 promulgated thereunder by the SEC, 17 C .F.R . 23 §240. lob-5 . 24 21 . This Court has ju ri sdiction over the subject matter of this action pursuant to 28 U.S .C . 25 §§ 1331 and 1337 and §27 of the 1934 Act, 15 U .S.C . §78aa . 26 22. Venue is proper pursuant to §27 of the 1934 Act as defendant PETCO, TPG, LGP 27 and/or the Individual Defendants conduct business in and the wrongful conduct alleged herein too k 28 -6- 05-CV-0823- H(RBB)