UNITED STATES DISTRICT COURT EASTERN DISTRICT OF MICHIGA N D .E . & J LIMITED PARTNERSHIP, Individually And On Behalf of All Others Similarly Situated, Plaintiff , vs . CHARLES CONAWAY, JEFFREY CIVIL ACTION NO . 02-7068 4 GERALD E . R S E BOYER, MARK S . SCHWARTZ, ) MATTHEW F . HILZINGER, MARTIN E . ) JURY TRIAL DEMQ1E1 WELCH and PRICEWATERHOUSECOOPERS ) LLP, )'s Defendants . ) ,77 CORRECTED CONSOLIDATED AMENDED COMPLAINT "3 7 Plaintiffs, by their undersigned attorneys, on behalf of themselves and the Class they see k to represent, for their Consolidated Amended Complaint, make the following allegations agains t defendants based upon the investigation conducted by and under the supervision of plaintiffs ' counsel, which included reviewing and analyzing information relating to the relevant time perio d obtained from numerous public and proprietary sources including United States Securities an d Exchange Commission ("SEC") filings by Kmart Corporation ("Kmart" or the "Company"), as wel l as regulatory filings and reports, securities analysts' reports and advisories about the Company, pres s releases and other public statements issued by the Company, and media reports about the Company . The investigation of plaintiffs' counsel also included interviewing or consulting with numerou s individuals with relevant information, including : (a) Former employees of Kmart, who worked at the Company during the relevant tim e and who are knowledgeable with respect to the matters referred to herein ; and
Transcript
UNITED STATES DISTRICT COURTEASTERN DISTRICT OF MICHIGAN
D.E. & J LIMITED PARTNERSHIP, IndividuallyAnd On Behalf of All Others Similarly Situated,
Plaintiff,
vs .
CHARLES CONAWAY, JEFFREY
CIVIL ACTION NO. 02-70684
GERALD E. R SE
BOYER, MARK S . SCHWARTZ, )MATTHEW F . HILZINGER, MARTIN E. ) JURY TRIAL DEMQ1E1
WELCH and PRICEWATERHOUSECOOPERS )LLP, )'s
Defendants. )
,77
CORRECTED CONSOLIDATED AMENDED COMPLAINT
"37
Plaintiffs, by their undersigned attorneys, on behalf of themselves and the Class they see k
to represent, for their Consolidated Amended Complaint, make the following allegations agains t
defendants based upon the investigation conducted by and under the supervision of plaintiffs '
counsel, which included reviewing and analyzing information relating to the relevant time perio d
obtained from numerous public and proprietary sources including United States Securities and
Exchange Commission ("SEC") filings by Kmart Corporation ("Kmart" or the "Company"), as wel l
as regulatory filings and reports, securities analysts' reports and advisories about the Company, pres s
releases and other public statements issued by the Company, and media reports about the Company .
The investigation of plaintiffs' counsel also included interviewing or consulting with numerou s
individuals with relevant information, including :
(a) Former employees of Kmart, who worked at the Company during the relevant tim e
and who are knowledgeable with respect to the matters referred to herein ; and
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(b) Former employees of certain vendors of Kmart who are knowledgeable with respec t
to matters referred to herein .
2 . Except as alleged herein, the underlying information relating to defendants '
misconduct and the particulars thereof is not available to plaintiffs and the public and lies within th e
possession and control of defendants and other Kmart insiders, thus preventing plaintiffs from
further detailing defendants' misconduct at this time . Plaintiffs believe that substantial additiona l
evidentiary support will exist for the allegations set forth herein after a reasonable opportunity fo r
discovery.
SUMMARY AND OVERVIEW
3 . This is a federal securities class action on behalf of purchasers of the securities o f
Kmart between March 13, 2001 and May 15, 2002, inclusive (the "Class Period "), seeking to pursue
remedies under the Securities Exchange Act of 1934 (the "Exchange Act")
4. Kmart is one of the world's largest discount retailers . The Company operates in th e
general merchandise retailing industry through approximately 1,900 Kmart discount stores, wit h
locations in each of the 50 United States, Puerto Rico, the United States Virgin Islands and Guam.
Kmart recently filed for bankruptcy (making it the largest retail bankruptcy in U .S . history) and i s
now operating under the supervision of the bankruptcy court as it undergoes a reorganization .
5. Prior to the start of the Class Period, Kmart was in the midst of a major effort to
revitalize its business . The giant retailer was succumbing to competition as its stores started to sho w
their age and its competitors began to lower prices and provide better service than Kmart . In an
effort to help in the transformation of Kmart, in May 2000, the Company hired Charles Conawa y
("Conaway") from CVS Corporation and provided him with a mandate to turn Kmart around an d
make it competitive with Wal-Mart Stores, Inc . ("Wal-Mart") and Target Corporation ("Target") --
its two primary competitors . Conaway quickly started to replace Kmart management an d
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purportedly implemented certain initiatives to strengthen Kmart's inventory controls, improve
customer service and make Kmart competitive on price .
6. By the start of the Class Period, Conaway's actions appeared to be working . Kmart
reported improving sales and gross margins and the Company's inventory situation was reportedly
improving . As a result, the price of Kmart stock began to increase, rising from $9 .19 per share on
March 13, 2001 to $13.16 per share on August 7, 2001, an increase of 43% while the general stock
market was stagnant or declining .
7. Unbeknownst to investors, however, Kmart's business was failing miserably. The
reported improvement in Kmart 's business was not the result of Conaway 's turnaround efforts but
instead a massive accounting fraud whereby more than $500,000 ,000 of vendor rebates -- which
have been described by Kmart as periodic payments from vendors in the form of volume or other
periodic discounts -- were improperly and fraudulently recognized on Kmart's financial statements
thereby vastly overstating Kmart's gross margins during the Class Pe riod and vastly understating
Kmart 's reported losses during the Class Period . Kmart has now admitted that it reported hundreds
of millions of dollars of vendor rebates during 2001 prior to even procuring a written agreement(s)
from vendors entitling it to such rebates . Moreover, Kmart 's inventory situation was no better than
it had been - the Company lacked the internal controls necessary to monitor and account for its
inventory and, as a result, was overstating the value of its inventory on its financial statements by
more than $750,000,000. As a result of the foregoing accounting manipulations , among others
detailed herein , Kmart 's financial statements issued during the Class Period were materially false
and misleading and not prepared in accordance with Generally Accepted Accounting Principles
("GAAP"), and the true condition of Kmart' s business was concealed from investors .
8. The truth about Kmart ' s business and operational performance began to be revealed
on January 22, 2002 when Kmart filed for bankruptcy . Shortly after that filing, Kmart announced
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that it had received an anonymous letter which purported to be from Kmart employees to the SE C
and which raised issues with the Company's accounting as well as the integrity of Kmar t
management . Kmart further announced that it would be conducting an "independent investigation "
into the allegations raised in the letter .
9 . A copy of the letter and three other letters apparently sent by those same employee s
are attached hereto as Exhibit A (although Kmart has not publicly provided the letter(s) to investors) .
The first letter states , among other things, that :
We have kept copies of transactions we consider to be inaccurate and achronology of direction given by officers of the corporation . We have also recordedconversations during which distortions and misstatement of records were discussed .In May 2001, Mr. Mark Schwartz, President and Chief Operating Officer, told oursuperior to not be surprised if Kmart shares were trading at four or five dollars pershare by the end of the year . He did not explain why shares would drop to that levelbut suggested management employees could benefit significantly from stock optionswhich would be priced at that depressed level .
Because of the current climate at our company and the ongoing restructuringwithin our financial area, we know we must be careful in calling out theseimproprieties to avoid almost certain retribution. Resident auditors fromPricewaterhouseCoopers are hesitant to pursue these issues or even question obviouschanges in revenue and expense patterns . We are sending this letter toPricewaterhouseCoopers regional and national offices hoping they will direct a morethorough review of practices . If questions are asked, we will provide copies of fileswe have kept . We are seeking help and advice through professional organizationswe belong to. They have suggested we contact you .
10. Then, on May 15, 2002, after the "independent investigation" was purportedl y
complete (for which Kmart's lawyers reportedly billed the Company $2 .4 million in fees), Kmart
issued a press release announcing its fiscal 2001 financial results and restated its financial results for
2001 interim periods . The Company reported a staggering $2 .4 billion loss for fiscal 2001, or $(4 .89)
per share . With respect to the restatement, the press release stated in pertinent part as follows :
Based on the results of the Company's previously announced investigation ofaccounting matters conducted under the supervision of the Audit Committee ofthe Board of Directors, as well as the new management team's review of Kmart'saccounting policies and methods, Kmart concluded that (1) an adjustment should b e
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made with respect to an up-front payment in a single vendor transaction that moreappropriately should have been deferred and recognized over the life of the contract,and (2) the recording of additional general liability reserves in the fourth quarter wasmore appropriately designated as a second quarter event . Accordingly, adjustmentswere made for such transactions, including restatements of previously reportedunaudited quarterly financial statements for fiscal 2001 as follows :
The first adjustment increased Cost of sales, buying and occupancy,resulting in a net reduction to operating results in the second quarterof $42 million ($2 8 million, after tax) or $0 .06 per share, and anincrease in third quarter operating results of $15 million ($10 million,after tax) or $0.02 per share .
The second adjustment increased general liability reserves in thesecond quarter, rather than the fourth quarter, by approximately $167million ($112 million, after tax), or $0 .23 per share through a chargeto SG&A.
The Company also reported that "given the Company's bankruptcy filing and the increase d
uncertainty and corresponding difficulty in reliably estimating future vendor allowances, Kmart' s
new management team reviewed the accounting for allowances and concluded that it would b e
preferable to change the Company's accounting method for interim recognition of cost recoverie s
from allowances. While this change in method was made in the fourth quarter of fiscal 2001 ,
generally accepted accounting principles require the restatement of the first three quarters of fiscal
2001 to reflect this change." The Company further reported that under the :
new methodology, Kmart will recognize a cost recovery from an allowance onlywhen a formal agreement for such an amount is obtained and only to the extentKmart has fulfilled its performance obligations under the agreement . Previously.Kmart had recorded vendor allowances and rebates during each of the first threequarters based on an estimated annual level of rebates and allowances it expected toreceive during the year. These estimates were based on Kmart's historical experienceand current understandings with our vendors, and were supplemented by vendor.allowances and rebates obtained that were not contemplated in the Companyoriginal estimates . [Emphasis added . ]
Kmart also provided a table setting forth the impact of the restatement for both the change in
accounting methodology for vendor rebates and the other items described above and noted that
"[e]mbedded in the accounting change that gives effect to the change in interim financial reporting
itrle . .a-r eMr x x ... e .~~ . . . ~ . . .i r :l!'x '. .s'e . .~. . y a ..~e_~._ w~ - _. .: _.. . . .. _. ...... . . . .-: ... .. .. . . .
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for allowances is an adjustment for an indeterminate amount of supplemental or incremental vendo r
allowances that were initially recorded in the first three quarters prior to having been documented,
or otherwise deemed appropriate, pursuant to Kmart's historical policy . Kmart has determined that
it is not practical to determine the impact on prior quarters ." The table revealed, among other things,
that: (i) for the first quarter of 2001, Kmart recorded $311,000,000 of vendor rebates which it was
restating; (ii) for the second quarter of 2001, Kmart recorded $211,000,000 of vendor rebates which
it was restating ; and (iii) for the third quarter of 2001, Kmart recorded $32 million of vendor rebates
which it was restating . Finally, the Company reported that it was cooperating with the SEC and the
U.S. Attorney's Office for the Eastern District of Michigan with respect to their investigations of
Kmart and its accounting practices .
11 . Even in announcing the restatement, Kmart misrepresented and misled investor s
about the Company and its accounting . The Company attributed the restatement of its interim
reporting periods for vendor rebates to a change in an accounting p rinciple -- from one appropriate
method to a more preferable one . However, Kmart's historical accounting policy for vendor rebates
did not comply with GAAP . Thus, its representation concerning the purported "change to a more
preferable method" is materially false and misleading in and of itself , as its prior method was
improper and overstated Kmart's interim fin ancial results .
12 . Unlike plaintiffs and the members of the Class , who paid art ificially inflated prices
for their Kmart securities and will likely have their ownership in Kxnart extinguished in th e
bankruptcy, defendants Conaway and Schwartz, in addition to other Kmart executives, renegotiated
their employment agreements during the Class Period and received, in aggregate, $30 million of
retention bonuses . Defendant Conaway himself received a $5 million retention bonus in May 2001
and, during his two year rein at Krnart, while the Company deteriorated and eventually collapsed into
bankruptcy, received over $23 million in compensation .
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13 . Plaintiffs now bring this action on behalf of themselves and the other members of th e
Class seeking damages for defendants' violations of the federal securities laws .
JURISDICTION AND VENU E
14. The claims asserted herein arise under and pursuant to Sections 10(b) and 20(a) o f
the Exchange Act [15 U .S.C. §§ 78j(b) and 78t(a)] and Rule 10b-5 promulgated thereunder by th e
Securities and Exchange Commission ("SEC") [17 C .F.R. § 240.10b-5] .
15. This Court has j urisdiction over the subject matter of this action pursuant to 28 U .S .C .
§§ 1331 and 1337 and Section .27 of the Exchange Act [15 U .S .C. § 78aa] .
16 . Venue is proper in this District pursuant to Section 27 of the Exchange Act, and 2 8
U.S .C. § 1391(b). Kmart maintains its principal place of business in this District and many of the
acts and practices complained of herein occurred in substantial part in this District .
17 . In connection with the acts alleged in this complaint, defendants, directly o r
indirectly, used the means and instrumentalities of interstate commerce, including, but not limite d
to, the mails, interstate telephone communications and the facilities of the national securities
markets .
PARTIES
18. Proposed Lead Plaintiffs Ascend Capital, LLC, Ronald E. & Kathleen A. Bergh
JTWROS and Frederick Dominikus purchased the common stock of Kmart, as set forth in thei r
certifications, which have been previously filed with this Court and are incorporated herein b y
reference, during the Class Period and were damaged thereby .
19. Kmart is a Delaware corporation with its principal place ofbusiness at 3100 West Big
Beaver Road Troy, MI 48084 . Kmart is a discount retailer and general merchandise retailer . The
Company operates in the general merchandise retailing industry through approximately 1,900 Kmart
discount stores, with locations in each of the 50 United States, Puerto Rico, the United States Virgi n
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Islands and Guam. On January 22, 2002, Kmart announced that it had filed for bankruptc y
protection and is therefore not named as a defendant in this action.
20. Defendant Charles Conaway ("Conaway"), served as the Company's Chairman and
Chief Executive Officer from May 2000 until his resignation in March 2002. According to the
Company's public filings, Conaway received $23 million in compensation during his tenure a t
Kmart .
21 . Defendant Jeffrey Boyer ("Boyer") served as the Company's Chief Financial Officer
from May 4, 2001 until November 9, 2001, when he resigned from the position .
22. Defendant Mark S . Schwartz ("Schwartz") served as the Company's President an d
Chief Operating Officer from March 14, 2001 until November 9, 2001 . From September 2000 unti l
March 2001, he served as Executive Vice President, Store Operations . According to the Company' s
public filings, Schwartz received $10.8 million in compensation during his tenure at Kmart .
23. Defendant Matthew F . Hilzinger ("Hilzinger") served as the Company's Vic e
President and Controller at all times relevant to this action until his resignation in July 2001 .
24. Defendant Martin E. Welch ("Welch") served as the Company's Executive Vice
President and Chief Financial Officer until his resignation in May 2001 .
25 . Defendant Conaway, Boyer, Schwartz, Hilzinger and Welch are sometimes referre d
to herein as the "Individual Defendants ."
26 . Because of the Individual Defendants' positions with the Company, they had acces s
to the adverse undisclosed information about Kmart's business, operations, products, operationa l
trends, financial statements, markets and present and future business prospects via access to interna l
corporate documents (including the Company's operating plans, budgets and forecasts and repo rts
of actual operations compared thereto), conversations and connections with other corporate officers
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and employees, attendance at management and Board of Directors meetings and committees thereo f
and via reports and other information provided to them in connection therewith .
27. As officers and controlling persons of a publicly-held company whose common stock
was, and is , registered with the SEC pursuant to the Exchange Act, and was traded on the New York
Stock Exchange (the "NYSE"), and governed by the provisions of the federal securities laws, the
Individual Defendants had a duty to disseminate promptly, accurate and truthful information with
respect to the Company' s financial condition and performance, growth, operations, financial
statements, business, markets, management, earnings and present and future business prospects, an d
to correct any previously-issued statements that had become materially misleading or untrue, so that
the market price of the Company's publicly-traded securities would be based upon truthful an d
accurate information . The Individual Defendants' misrepresentations and omissions during the Clas s
Period violated these specific requirements and obligations .
28 . The Individual Defendants participated in the drafting, preparation, and/or approva l
of the various public and shareholder and investor reports and other communications complaine d
of herein and were aware of, or recklessly disregarded, the misstatements contained therein an d
omissions therefrom, and were aware of their materially false and misleading nature . Because of
their Board membership and/or executive and managerial positions with Kmart, the Individual
Defendants had access to the adverse undisclosed information about Kmart's business prospects an d
financial condition and performance as particularized herein and knew (or recklessly disregarded )
that these adverse facts rendered the positive representations made by or about Kmart and its
business issued or adopted by the Company were materially false and misleading .
29. The Individual Defendants because of their positions of control and authority as
officers and/or directors of the Company, were able to and did control the content of the various SE C
filings, press releases and other public statements pertaining to the Company during the Class Period .
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The Individual Defendants were provided with copies of the documents alleged herein to be
misleading prior to or shortly after their issuance and/or had the ability and/or opportunity to preven t
their issuance or cause them to be corrected . Accordingly, the Individual Defendants are responsibl e
for the accuracy of the public reports and releases detailed herein and is therefore primarily liabl e
for the representations contained therein .
30. Defendant P ricewaterhouseCoopers LLP ("PwC") is a worldwide firm of certified
public accountants, auditors and consultants that provides a variety of accounting, auditing an d
consulting services . PwC, through its Detroit office, served as Kmart 's auditor and principal
accounting firm commencing prior to the Class Period herein and continuing at all relevant times.
Kmart acted in these capacities pursuant to the terms of contracts it had with Kmart that, among
other things, required PwC to audit Kmart's financial statements in accordance with Generally
Accepted Auditing Standards ("GAAS"), to report the results of those audits and qua rterly review s
to Kmart, its board of directors, its audit committee and the members of the investing public ,
including plaintiffs and the members of the Class . With knowledge of Kmart's true financia l
condition and grossly inadequate financial controls, as alleged below, or in reckless disregar d
thereof, PwC certified the false and misleading financial statements of Kmart described below an d
provided an unqualified Independent Auditors' Report (dated March 13, 2001) on those financia l
statements, which were included in various of the Company's SEC filings and public disseminations .
31 . Defendants are liable as participants in a fraudulent scheme and course of busines s
that operated as a fraud or deceit on purchasers of Kmart securities by disseminating materially fals e
and misleading statements and/or concealing material adverse facts . The scheme : (i) deceived the
investing public regarding Kmart's business, operations, management and the intrinsic value of
Kmart common stock ; (ii) enabled Kmart to acquire Bluelight .com using its artificially inflate d
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common stock as currency; (iii) permitted Kmart to sell more than $430 million of notes in a privat e
transaction to institutional investors ; (iv) enabled defendants Conaway and Schwartz and other
Kmart executives to receive $30 million in retention bonuses in addition to the excessiv e
compensation they already received ; and (v) caused plaintiffs and other members of the Class to
purchase Kmart securities at artificially inflated prices .
UNDISCLOSED ADVERSE FACTORS IMPACTINGKMART DURING THE CLASS PERIOD
32. Throughout the Class Period, Kmart and the Individual Defendants represented tha t
Kmart was experiencing a turnaround as it was improving its operations, maintaining and/or
improving its gross margins and positioning the Company to better compete with Walmart and
Target -- its two primary competitors . However, by at least the start of the Class Period, Kmart was
experiencing severe adverse problems that were negatively impacting its operations, or threatened
to do so, and which jeopardized the Company's ability to continue as a going concern . These
adverse factors, which were not disclosed to investors, are detailed below.
33 . Vendor Rebates : Prior to and throughout the Class Period, Kmart was reporting
vendor rebates as a reduction of expenses in its interim financial statements prior to the rebates bein g
earned. In some cases, Kmart recorded a rebate without having a written commitment from th e
vendor entitling it to the rebate . Kmart has now admitted that, prior to and during the Class Period ,
it was reporting rebates on an "estimated" amount of sales that it expected to achieve by the end o f
the year. This practice violated GAAP and exposed Kmart to the risk that it would be unable t o
obtain the rebate either because it could not reach an agreement with the vendor or because it was
unable to perform its obligations .
34. According to a former employee of the Company, who was employed in the finance
department of the Company, vendors would make up-front payments for the next quarter or the next
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year and Kmart would report these vendor allowances in the current quarter - before they wer e
actually earned.
35. Aside from the fact that Kmart was recognizing vendor rebates without a writte n
commitment from the vendor and prior to actually earning the rebate, the Company was settin g
aggressive unattainable sales forecasts, which it then utilized in "estimating" its vendor rebate s
thereby causing the Company to recognize increasing levels of rebates which it was not assured o f
receiving. According to another former employee of Kmart, who was a vice president at th e
Company, Kmart was forecasting increased sales during 2001 and recorded vendor rebates based
on unattainable sales projections . According to a former operations manager of Kmart, the
Company was setting unrealistic sales expectations for 2001 :
All I can tell you is that at the store level, it seemed to me they were puttingunreasonable, unattainable sales projections for certain stores . For instance, they willgive you a plan of fourteen million and they will give you a projection of twelve'tothirteen percent increase in sales . You know deep inside that there is no way, no howyou can attain that sales goal .
36. Supply Chain Management : Kmart was unable to effectively track and monitor it s
inventory because it lacked the systems and internal controls to do so . Prior to and throughout the
Class Period, the Company could not accurately gauge how much inventory it had, what had bee n
shipped to particular stores or how much inventory it needed to order for future sales . According
to a former employee of Kmart, who was an operations manager that covered all of the Company' s
distribution centers :
we knew the inventory was off, but we wouldn't do anything to fix it . Every day,
every time the orders came down and there were shorts - we wouldn't have the stuffthat they were ordering which meant the system thought we had it, but we didn't .
What we would do - we would go ahead and change the order instead of showing
it as short so we could adjust the inventory .
Furthermore, according to this same former employee :
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the things got so out of whack that they kinda hoped that they (inventory) were thereand would show back up, but they wouldn't, so then we would do it again the nextmonth and the same thing would just keep happening over and over, so instead ofhaving eight missing, you might end up with sixteen . So instead of taking that losslittle by little, you just built up - in my eyes it built up to the point where they didn'twant to take the loss . It was too big of a deal .
Finally, this former employee recounted that :
there were inventory errors that weren't being addressed and huge inventory write-offs that were coming back from a year or two before that still weren't beingcorrected. There was such a push to get production and to keep the operation movingthat we wouldn't take an opportunity to stop to correct the books, in order to get aclearer picture -- it just kept digging a deeper hole . It was old school thinking -- we'llpush it through and worry about the numbers later, it's like I don't have time tobalance my checkbook, I'll figure it out at the end of the month .
37. According to a former employee of Kmart who was employed as a customer care
manager [act as a liaison between the distribution centers and the stores], "the dcs [distributio n
centers] have absolutely no control over what gets shipped to the stores, the orders came down fro m
corporate ." Furthermore, Kmart "had absolutely no way to verify what we shipped to them," an d
"after three to four days, the system wasn't big enough to hold all the information, so it would purge,
so you couldn't go back, if you wanted to investigate something, you couldn't go back -- anythin g
over a week old, forget . "
38 . This same employee recounted that the Company would report an item as "in-stock "
if the Company only had one piece of inventory . Accordingly, when Kmart reported "that they were
95% in stock, meaning that 95% of all items they were supposed to be selling, were on the shelf, tha t
included items where they only had one piece . "
39. Adding to and exacerbating the problems Kmart had keeping track of its inventory ,
the Company employed a "push" ordering system for stores -- that is it shipped goods to stores base d
on what the Company's Allocation Department determined should be shipped . This "push" ordering
system, which was referred to at the Company as automatic replenishment, led to an inventor y
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buildup at the stores as goods started to pile up and many stores did not have adequate space to stor e
all of the inventory that they had been shipped and had to line up trailers outside stores to hold th e
goods . In addition , stores were sent goods that they simply could not sell , e .g . picnic tables without
chairs . According to a former employee ofKmart, the automatic replenishment system caused stores
to accumulate obsolete merchandise or merchandise that would never be sold given the location an d
the demographics of the store :
what we call automatic replenishment . They went across the board and treated everystore as an "A" store . They disregarded the location of that store . What sells goodat my store may not sell good at another store . They did not take that intoconsideration, that geographic demand of certain items and merchandise . TheColumbia area is really a residential area . It's away from the water . Fishing was nota big deal, sports was, like basketball, football and so forth . Those kind of sportswere good, but as far as fishing and hunting and automotive stuff, it was not reallythat great .
40. During the Class Period, Kmart took short-term actions designed to conceal th e
problems it was experiencing managing its inventory . According to a former employee of Kmart
who worked in supply chain management on the international side, the Company pressure d
employees to understate inventory :
there was an awful lot of pressure to understate inventory, and it certainly wentacross the Company, and it was acute in the international department as well . . . therewere some changes in shipping terms, and stuff like that -- they were just trying tominimize the inventory number as much as they could .
This employee further recounted that in July 2001, Kmart changed its inventory recognition policy
from "F.O.B. foreign ports to D.E .Q . U.S. ports, they basically took a couple of weeks of inventory
off the books ." According to this former employee the change in policy materially affected th e
Company's reported inventory as :
you reduced the inventory balance, because if you're picking up inventory at foreignport, you're going to hold it through the entire carriage process, if you pick it up at
the U.S . port you don't recognize it as quickly -- basically dump inventory - you
dump your transit inventory for 15-17 days .
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The Company's change in accounting for inventory received from foreign ports was confirmed by
another Kmart employee, who was employed as a buyer at the Company, who recounted that the
change had a negative effect on the Company as "we didn't know exactly how much inventory w e
had."
41 . As a result of the Company's problems monitoring and tracking its inventory, Kmar t
amassed hundreds of millions of dollars of impaired inventory which was of diminishing value an d
should have been written-off. Furthermore, the Company's inventory ledgers did not accurately
reflect the true value of the Company's inventory .
42 . Relationships With Vendors : Prior to and throughout the Class Period, Kmart wa s
regularly charging its vendors (which amounted to a deduction on an invoice of monies owed b y
Kmart) for their purported failure to comply with Kmart's delivery policies, as detailed in a vendor
guide that the Company created and disseminated in 1998 -- known in the Company as "vendo r
compliance". The vendor guide contained numerous requirements that vendors had to follow whe n
making deliveries to Kmart or risk having Kmart take a deduction from the bill . By the start of th e
Class Period, Kmart's aggressive actions on vendor compliance was damaging its relationships wit h
its vendors and exposing the Company to the heightened risk that its vendors would curtail their
business with the Company .
43 . For example, according to a former employee ofWaterpik Technologies, a househol d
and consumer goods company that was a vendor of Kmart, "Kmart had a list of 30 different things
they would come up with to take deductions, from a shipment arriving one day late to a damage d
pallet ." Similarly, according to a former employee of Meadow Industries (which is now a subsidiary
of Pennzoil), which was a vendor of Kmart, who dealt with Kmart and the issue of vendor charge-
backs, the charge-backs that Kmart charged her company were "astronomical." According to this
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person, Kmart created a vendor guide in 1998 that outlined how Kmart wanted vendors to act an d
then would charge vendors for failing to comply with one of Kmart's policies .
44 . Bluelight Always Marketing Campaign : In the summer of 2001, Kmart expanded
its "Bluelight Special" marketing program to "Bluelight Always ." In theory, through "Bluelight
Always" Kmart would reduce its prices on more than 30,000 items, thereby enabling it to compet e
with Wal-Mart and Target . In practice, "Bluelight Always" was a disaster from the beginning. Wal-
Mart and Target responded by cutting their prices and Kmart was unable to respond accordingly .
Customer traffic did not increase and inventory began to buildup . Furthermore, the price cuts that
the Company implemented in connection with Bluelight Always significantly decreased the
Company's gross margins .
45. According to a former employee of Kmart, who was employed by the Company fo r
twenty-seven years and was recently a store manager, the "Bluelight Always" marketing program
was "nothing short of suicide ." In addition, this former employee recounted that the reason for
lowering prices was to sell more products, drive-up traffic and sell more merchandise . In order to
make the program work, Kmart needed a 10-12% increase in sales but sales only increased 2-3% .
46. According to another former employee who was employed at Kmart as a Logistic s
Analyst and a Merchandise Coordinator , the Bluelight Always program did not work because o f
problems in the warehouse and poor customer service .
47 . On March 13, 2001, Kmart issued a press release announcing its financial results for
the fourth quarter of 2000 and fiscal year 2000, the periods ending January 31, 2001 . For the fourth
quarter, the Company reported net income of $249 million, or $0 .48 per share, exceeding analysts '
16
earnings expectations for the quarter . Defendant Conaway commented on the results stating i n
pertinent part as follows :
We finished the fiscal year with solid evidence that we are building momentum andmaking progress in the implementation of our three key strategic imperatives . . . .With our same store sales increasing over the past four months, it is clear that thenew Kmart is closing the gap with our competition, and in some cases moving ahead .With a heightened sense of urgency, we are properly focused on the massivestructural and cultural transformation necessary to convert these gains into a strongand sustainable improvement in our financial performance . After only 215 days ofoperating under aggressive new metrics and management, we have generatedsignificant strides in sales growth, merchandise in-stock position, customersatisfaction and other key measures .
48. On March 21, 2001, Kmart filed its Form 10-K with SEC for fiscal year 2000 (the
"2000 Form 10-K"), which was signed by defendants Conaway and Hilzinger, among others . The
2000 Form 10-K confirmed the previously-announced financial results and contained financia l
statements for fiscal 2000 . The 2000 Form 10-K contained a statement entitled "Management' s
Responsibility For Financial Statements" . The statement represented the following :
Management is responsible for the preparation of our consolidated financialstatements and related information appearing in this annual report . These financialstatements have been prepared in conformity with generally accepted accountingprinciples on a consistent basis applying certain estimates and j udgments based uponcurrently available information and management's view of current conditions andcircumstances . On this basis, we believe that these financial statements reasonablypresent our financial position and results of operations .
To fulfill our responsibility, we maintain comprehensive systems of internalcontrols designed to provide reasonable assurance that assets are safeguarded andtransactions are executed in accordance with established procedures . The conceptof reasonable assurance is based upon a recognition that the cost of the controlsshould not exceed the benefit derived. We believe our systems of internal controlsprovide this reasonable assurance .
We have adopted a code of conduct to guide our management in thecontinued observance of high ethical standards of honesty, integrity, and fairness in
the conduct of the business and in accordance with the law . Compliance with the
guidelines and standards is periodically reviewed and is acknowledged in writing by
all management associates .
17
Our Board of Directors have an Audit Committee, consisting solely of outsidedirectors. The duties of the Committee include keeping informed of the financialcondition of Kmart and reviewing our financial policies and procedures, our internalaccounting controls, and the objectivity of our financial reporting . Both our inde-pendent accountants and the internal auditors have free access to the AuditCommittee and meet with the Committee periodically, with and without managementpresent .
49. The statements referenced above in ¶¶ 46 and 47 were each materially false an d
misleading because they failed to disclose and misrepresented the following material facts which
were known to defendants or recklessly disregarded by them :
(a) that Kmart was unable to account for or value its inventory because it lacke d
the systems and internal controls to do so . The Company could not accurately gauge how much
inventory it had, what had been shipped to particular stores or how much inventory it needed to order
for future sales ;
(b) that the Company was experiencing significant difficulties in allocating
products to stores such that massive amounts of unsaleable inventory was overwhelming storag e
facilities at individual stores ;
(c) that the Company was artificially inflating its repo rted financial results for, the
fourth quarter of 2000 and fiscal year 2000 by failing to properly account for its inventory and
carrying hundreds of millions of dollars of inventory on its books that either should have bee n
written-off or did not exist ;
(d) that the Company's policy of accounting for vendor rebates violated GAAP ,
caused the Company to report interim financial results that were inaccurate, inflated and no t
representative of the Company's true financial performance and exposed the Company to th e
heightened risk that it would have to reverse rebates that it had previously recognized should Kmar t
not attain ce rtain sales goals or be unable to reach an agreement with its vendors ;
18
(e) based on (a)-(d) above, it was not true that Kmart's "financial statement s
reasonably present our financial position and results of operations" or that "we maintain
comprehensive systems of internal controls designed to provide reasonable assurance that assets ar e
safeguarded and transactions are executed in accordance with established procedures . "
50. On April 2, 2001, Kmart issued a press release announcing the return of the
"BlueLight Special," which the press release described as a "Major new marketing initiative
designed to create an in-store excitement, reward loyal customers and attract new shoppers ."
Defendant Conaway commented on the announcement stating in pertinent part as follows :
The return of the BlueLight Special signals a critical milestone in the currentrevitalization of Kniart and reinforces our drive to meet consumers' needs and wantsin all aspects of their shopping experience . . . We are focused on building excitementin the stores by bringing back a retail phenomenon that provides consumers withtremendous value and an opportunity to reconnect with Kmart .
' 51 . On April 12, 2001 , Kmart issued a press release announcing its same store sales fo r
the four week period ended April 4, 2001 . The Company reported that net sales increased I% on a
same-store basis. Defendant Conaway stated in pertinent part as follows:
For the fifth consecutive month, we have met or exceeded our sales expectations .This was accomplished while reducing advertising for the month in comparison toour historical trend and also facing adverse weather conditions throughout thecountry that affected our seasonally-sensitive businesses . . . We continue to growsame-store sales as we make consistent progress in our three strategic imperatives .Our in-stock position and customer satisfaction metric, which measures customerswho rate their overall shopping experience as excellent, have both reached an all-timehigh, indicating significant improvement in our execution . We are now growing inan intelligent, consistent and healthy manner .
52. On May 10, 2001, Kmart issued a press release announcing its same store sales for
the four week period ended May 2, 2001 . The Company reported that net sales increased 1 .1%.
Defendant Conaway stated in pertinent part as follows :
We are pleased that for the sixth consecutive month, Kmart's same-store sales metor exceeded expectations . This was accomplished as we continue to reduce ourreliance on advertising and improve our store execution . . . Focusing on our operating
19
metrics, our in-stock levels have reached an all-time high, providing a qualityshopping experience for our customers . We continue to strive to exceed theirexpectations as we are focused in world-class execution and a customer-centricculture .
53 . On May 17, 2001, Kmart issued a press release reporting its financial results for th e
first quarter of 2001, the period ending May 2, 2001 . The Company reported that net sales wer e
$8.337 billion, an increase of 1 .7% from the first fiscal quarter the prior year . Defendant Conaway
commented on the financial results, highlighting Kmart's purported turnaround stating in pertinen t
part as follows :
These results are in-line with our plan to fix our business b y taking decisive,aggressive, and focused steps to transform our company. . . . We continue to striveto provide world-class execution, deliver superior customer service and differentiateourselves from our competitors .
We are making strong progress on several key operating metrics . The company's in-stock levels have improved from 79% in October 2000 to 88% at the end of the firstquarter of 2001 . Likewise, Kmart's Super Service Index (SSI), our measure ofservice excellence, has increased from 40% last fall to 57% today. [Emphasis added . ]
The Company reported that gross margins were 20 .7%.
54. Also, on May 17, 2001, Kmart filed its Form 10-Q for the first quarter of 2001, th e
period ending May 2, 2001 (the "First Quarter 10-Q"), with the SEC which was signed by
defendants Boyer and Hilzinger . The financial statements contained in the First Quarter 10- Q
reported that for the first quarter the "Cost of sales, buying and occupancy" was $6,608,000,000 ,
gross margins were $1,729,000,000 and net income was a loss of $(0.05) per share. With respect
to the financial statements contained therein, the First Quarter 10-Q represented that :
These interim consolidated unaudited financial statements have been prepared inaccordance with the rules and regulations of the Securities and Exchange
Commission ("SEC"), and, in the opinion of management, reflect all adjustments
(which include normal recurring adjustments) necessary for a fair statement of theresults for the interim periods .
20
misleading for the reasons set forth above in j 48 . In addition, the statements referenced above in
¶¶ 49-53 were each materially false and misleading because they failed to disclose and
misrepresented the following material facts which were known to defendants or recklessly
disregarded by them :
(a) that the Company was recording vendor rebates without even having a written
commitment from its vendors entitling it to such rebates . During the first quarter of 2001, th e
Company reported $311,000,000 of vendor rebates before they were actually earned and for whic h
the Company did not have a firm commitment from the vendor. As a result, Kmart was subject t o
a significant risk that it would be unable to obtain the rebate either because it did not perform it s
obligations or because it could not reach an agreement with the vendor ;
(b) that the Company had understated the "Cost of sales, buying and occupancy"
by $226,000,000 as the true amount was $6,834,000,000 ;
(c) that the Company had overstated the amount of gross margin by $226,000,000
as the true amount was $1,503,000,000 . Accordingly, the Company's gross margin for the first
fiscal quarter of 2001 was understated by 15% ;
(d) that the Company had understated its losses for the quarter by $208,000,000 ;
(e) based on (a) - (d) above, it was not true that Kmart's interim financia l
statements "reflect all adjustments (which include normal recurring adjustments) necessary for a fai r
statement of the results for the interim periods" as the Company was fraudulently accounting fo r
vendor rebates, among other accounting improprieties as detailed below in ¶¶ 95-139 ;
(f) that it was misleading to represent that Kmart's in-stock levels were
increasing when, contrary to the industry norm, Kmart considered an item to be "in-stock" if ther e
was only a single item in stock ;
21
beginning to experience liquidity problems . As a result, the Company began to extend its payment s
to vendors and started to seek additional capital to alleviate its liquidity problems ; and
(h) based on the foregoing, defendants' positive statements about Kmart, its sales ,
earnings and the revitalization of the Company was lacking in a reasonable basis at all times and
were materially false and misleading .
56 . On June 7, 2001, Kmart issued a press release announcing its same store sales for th e
four week period ended May 30, 2001 . The Company repo rted that net sales decreased 1% .
Defendant Conaway, however, continued to represent that Kmart was successfully turning aroun d
its business, stating in pertinent part as follows :
We reported sales slightly less than plan despite major disruptions in our operationscaused by resetting 20% of our entire store base, reducing our reliance on advertising,and experiencing significantly unfavorable weather conditions across the countrywhich adversely affected our apparel and seasonal sales . We continue to see stronggains in our frequency businesses, the Drug and Food categories . . . .Over the nexttwo quarters, we are aggressively pursuing resetting every store to drive higherfrequency and initiating new food distribution and assortments, which is necessaryto make Kmart more competitive . We are working to complete these storedisruptions by the end of the third quarter, as committed .
57. On June 19, 2001, Kmart completed a private placement of $430 million aggregat e
principal amount of 9 7/8% bonds due June 15, 2008. According to the Company, the fund s
generated from this sale were used to pre -pay the Company' s obligations on other notes and for
general corporate purposes .
58 . On July 12, 2001, Kmart issued a press release announcing its same store sales for
the five-week period ended July 4, 2001 . The Company reported that net sales increased 1 .1% on
a same-store basis . Defendant Conaway commented on the seemingly positive results stating i n
pertinent part as follows :
22
We are pleased with our sales for the month of June particularly in light of ourongoing transformation . The extensive disruption in our stores continued during themonth as we completed the conversion of our entire store base to the Flemingdistribution system, reset another 726 stores and reduced our advertising by over30% from last year . . . .We've achieved an increase in customer traffic and theaverage number of items in a market basket driven by our BlueLight Alwaysprogram and improved store execution . This has resulted in significant increases inour high frequency categories compared to last year . We are providing ourcustomers with excellent savings by lowering prices on thousands of items as part ofour long-term strategy to build loyalty with our customer and drive repeat traffic .
59. On July 23, 2001, Kmart issued a press release announcing that it had entered into
a merger agreement with BlueLight.com, LLC pursuant to which Kmart would purchase all of th e
shares and interests of BlueLight .com LLC not currently owned by Kmart .
60. On August 1, 2001, Krnart issued a press release announcing that it had completed
the acquisition of Bluelight .com, the Company's e-commerce subsidiary . According to the press
release, Kmart paid $15 million in cash and 6 million shares of its common stock for Bluelight .com.
Defendant Conaway commented on the acquisition, stating in pertinent part as follows :
With the future ofretail evolving into an integrated "bricks and clicks" model, Kmartis very pleased that the BlueLight.com stockholders voted in favor of the merger . .. . Strategically, this acquisition of BlueLight .com continues our focus on buildinga holistic approach in serving our customer in every aspect of their shoppingexperience. We will fully integrate and restructure BlueLight .com leveragingKmart's resources while still providing our customers with a variety of servicesonline, including product extensions, store promotions and pharmacy refills .
61 . On August 9, 2001, Kmart issued a press release announcing its same store sales for
the four-week period ended August 1, 2001 . The Company reported that net sales increased 3 .4%
on a same-store basis. Defendant Conaway commented on the seemingly positive results stating in
pertinent part as follows :
We are extremely pleased with our results for the month of July, particularly given
the disruption in 40% of our stores due to resets and the price deflation related to our
BlueLight Always program . During the month, we continued the implementation of
our strategic alliance with Fleming, who is now serving our entire store base for food
and consumables . . . . We are driving customer traffic and conversion through the
success of our BlueLight Always program. We have permanently lowered prices on
23
nearly 20,000 high-frequency items, meeting our customers' needs by providingstronger values , improved store execution and better customer service .
62. Then, on August 14, 2001, Kmart filed a registration statement and prospectus (th e
"Registration Statement") with the SEC which related to the shares of Kmart that the Company had
exchanged for the shares of Bluelight .com. The Registration Statement indicated that the shares
were being sold by certain venture funds that had owned Bluelight .com prior to the acquisition. The
Registration Statement was never declared effective by the SEC and the shares whose sale was to
be registered appear to have not been sold into the market.
63 . On August 23, 2001, Kmart issued a press release announcing its financial results
for the second quarter of 2001, the period ending August 1, 2001 . The Company reported that net
sales were $8.998 billion. Defendant Conaway commented on the financial results stating i n
pertinent part as follows :
We are pleased with our results as we continue our strategies to transform Kmart . .. . As planned, we completed our conversion of our entire store base to the Flemingdistribution network and reset over 90% of our store base during the quarter. Wecontinue to reduce our reliance on advertising and, with the lowering of prices on20,000 items as part of our BlueLight Always program, face deflationary pricingconditions .
The Company further reported that gross margin for the second quarter of 2001 was 20 .8%,
compared to 20 .5% last year and that the increase in gross margin was "due to a solid performanc e
in reducing merchandise shrinkage , which offsets the price reductions attributable to the Bluelight
Always program . "
64. On August 23, 2001, Kmart fi led its Form 10-Q for the second quarter of 2001, th e
period ending August 1, 2001 (the "Second Quarter 10-Q"), with the SEC which was signed by
defendants Conaway, Boyer and Schwartz. The financial statements contained in the Second
Quarter 10-Q reported that for the second quarter the "Cost of sales, buying and occupancy" was
24
$7,058,000,000, gross margins were $1,859,000,000 and net income was a loss of $(0 .19) per share .
With respect to the financial statements contained therein, the Second Quarter 10-Q represented that :
These interim consolidated unaudited financial statements have been prepared inaccordance with the rules and regulations of the Securities and ExchangeCommission ("SEC"), and, in the opinion of management, reflect all adjustments(which include normal recurring adjustments) necessary for a fair statement of theresults for the interim periods .
65 . The statements referenced above in ¶¶ 55, 57, 59, 60, 62 and 63 were each materiall y
false and misleading for the reasons set forth above in ¶ 48 . In addition , the statements referenced
above in ¶¶ 55, 57, 59, 60, 62 and 63 were each materially false and misleading because they failed
to disclose and misrepresented the following material facts which were known to defendants o r
recklessly disregarded by them :
(a) that the Company was recording vendor rebates without even having a written
commitment from its vendors entitling it to such rebates . During the second quarter of 2001, the
Company reported $211,000,000 of vendor rebates before they were actually earned and for whic h
the Company did not have a firm comr itment from the vendor . As a result, Kmart was subject to
a significant risk that it would be unable to obtain the rebate either because it did not perform it s
obligations or because it could not reach an agreement with the vendor ;
(b) that the Company had understated the "Cost of sales, buying and occupancy"
by $195,000,000 as the true amount was $7,253,000,000;
(c) that the Company had overstated the amount of gross margin by $195,000,00 0
as the true amount was $1 ,664,000,000 . Accordingly, the Company 's gross margin for the second
fiscal quarter of 2001 was overstated by 11 .7% . It was materially misleading to represent that th e
increase in gross margin was "due to a solid performance in reducing merchandise shrinkage" when ,
in fact, the increase was the result of the accounting improprieties described herein ;
25
(d) that the Company had improperly recognized $42 million vendor rebate in th e
second quarter when such payment should have been deferred over the life of the contract ;
(e) that the Company failed to record accrue $167 million of expenses during th e
quarter ;
(f) that the Company had understated its losses for the quarter by $282,000,000;
(g) that the Bluelight Always program was not meeting with success as customer
traffic was not increasing while the price reductions caused by the marketing initiative were erodin g
the Company's gross margins, which fact was being concealed by the Company's fraudulent
accounting for vendor rebates ;
(h) that Bluelight.com was not performing well and was losing substantial money ;
and
(i) based on (a) - (h) above, it was not true that Kmart's interim financia l
statements "re flect all adjustments (which include normal recurring adjustments ) necessary for a fair
statement of the results for the interim periods" as the Company was fraudulently accounting fo r
vendor rebates, among other accounting improprieties as detailed below in ¶¶ 95-139 .
66. On September 6, 2001, Kmart issued a press release announcing its same store sales
for the four-week period ended August 29, 2001 . The Company reported that net sales increase d
0.2% on a same-store basis . Defendant Conaway commented on the seemingly positive results
stating in pertinent part as follows :
During this past month, we experienced growth as increase in back to school supplies
and high frequency categories were offset by our new lower prices under the
BlueLight Always program . We continue our transformation through significantlyreducing our reliance on advertising and striving to improve our in stock levels . . .
. To further support our high-frequency strategy, on August 29, we unveiled our
national BlueLight brand strategy, which rewards our customers through value-base dprograms .
26
67. That same day, Kmart issued a press release announcing that the Company wil l
restructure certain aspects of its overall operations . The Company reported that it would b e
restructuring its supply chain infrastructure including its distribution centers and implementation of
new operating software across its supply chain . Kmart further reported that in connection with thi s
"restructuring" the Company would be taking a charge of $195 million -- approximately $13 0
million relates to the impairment of supply chain hardware and software that will no longer be used.
68. On October 11, 2001, Kmart issued a press release announcing its same-store sale s
for the five-week period ended October 3, 2001 . The Company reported that net sales were flat on
a same-store basis . Defendant Conaway commented on the financial results stating in pertinent part
as follows :
In light of the exte rnal events and internal changes during the month of September,we are pleased with our results . . . . The horrific tragedy of September 11 saddenedall of us at Kmart . We were affected signi ficantly that day, as we had to closenumerous high volume stores in New York City and Washington D .C. areas andshorten store hours for the remaining stores in those areas . However, with basicitems accounting for approximately 40% of our business , we have been able tomaintain our sales base even in times of unce rtainty .
. . . The majority of our stores have now completed their resets, adding to the strengthof our high frequency categories, which continue to drive our business . In addition,we launched our BlueLight Always program on September 1 . This had allowed usto reduce our reliance on advertising by nearly 20% . Unfortunately, our launchincluded a heavy television campaign, which was interrupted by the September 11tragedy. We continue to execute our plan and we are taking the necessary actions,on both the structural and cultural side of the business, to transform Kmart into aretailer of choice .
69. On October 25, 2001, Kmart issued a press release announcing that it was adding 1 5
Kmart Supercenters to its portfolio by mid-November of 2001, bringing the number of Supercenter s
to 124 by year-end. Defendant Conaway commented on the announcement stating in pe rtinent part
as follows :
We're excited about the possibilities of our "in-the-box"conversions to SuperCenters .. . . Right now our plans are to go slow and treat these openings as test cases that w e
27
can study before we move forward . But we believe that we have anywhere from1,000 to 1,300 stores that could be converted to SuperCenters . And with our realestate portfolio, that gives us leverage to better serve our customers and shareholders .
70. On November 8, 2001, Kmart issued a press release announcing its same-store sale s
for the four-week period ended October 31, 2001 . The Company reported that net sales decrease d
from the same period the prior year . However, Kmart further reported that in October 2000 th e
Company had liquidated $52 million of discontinued inventory which "accounted for 2% of it s
same-store sales for that month . Excluding the effect of these liquidation sales, Kmart's same-store
sales for October 2001 would have improved by 200 basis points [2%] over the reported results . "
Defendant Conaway commented on the financial results stating in pertinent part as follows :
Our sales mix was healthier this year with an increase of more than 10% in regularpriced merchandise compared to last year, reflecting our launch of B1ueLight Alwaysand a significant reduction ofprint media . In addition to the weaker Halloween salesas some communities scaled back trick or treating, we moved our very important toycatalog promotion into November, for a higher return on capital . . . . As part of ourlong-term strategy to drive customer frequency through routine shopping trips, wecontinue to build customer loyalty by delivering on merchandise in-stock, superiorstore experience and competitive pricing .
71 . The next day, on November 9, 2001, Kmart issued a press release announcing tha t
Boyer was resigning his position of Chief Financial Officer, six months after having been appointe d
to the post and that John McDonald was assuming the position .
72. On November 27, 2001, Kmart issued apress release announcing its financial result s
for the third quarter of 2001, the period ending October 31, 2001 . The Company reported that ne t
sales were $8 .199 billion . Defendant Conaway commented on the financial results stating in
pertinent part as follows :
We continue to work at fixing our core business by being in-stock, pricingcompetitively and providing an excellent shopping experience for Kmart customers .
We have made considerable progress in all of these areas but have a lot more workto do. During this past quarter, we completed all of our store resets, launchedBlueLight Always everyday low pricing for our frequency categories and installed
self-checkout registers in more than 1,000 stores . . . . We are committed to our long-
28
term strategy to be the authority for Mom focusing on her two most emotionalpurchases by providing her value pricing on her everyday needs and a qualityselection for her home and children's needs . We are focused on eliminating Kmart'sliabilities and building a bridge of trust with Mom so that she can rely on us day inand day out .
The press release also noted that gross margin for the third quarter of 2001 was 20 .6% of sales a s
compared to 20.5% last year. The Company attributed the increase in gross margin to "lower foo d
and consumable distribution costs under the Company's arrangement with Fleming and the reductio n
of shrink, which offset the increase in sales of high frequency categories which carry a lower margi n
rate."
73. On November 27, 2001, Kmart filed its Form 10-Q for the third quarter of 2001, the
period ending October 31, 2001 (the "Third Quarter 10-Q"), with the SEC which was signed by Joh n
T. McDonald, Jr ., Kmart's newly-appointed Executive Vice President and Chief Financial Office r
and Richard J . Noechel, Kmart's Vice President and Controller . The financial statements containe d
in the Third Quarter 10-Q reported that for the third quarter the "Cost of sales, buying an d
occupancy" was $6,425,000,000, gross margins were $1,594,000,000 and net income was a loss o f
$(0.45) per share . With respect to the financial statements contained therein , the Third Quarter 10- Q
represented that :
These interim consolidated unaudited financial statements have been prepared inaccordance with the rules and regulations of the Securities and ExchangeCommission ("SEC"), and, in the opinion of management, reflect all adjustments(which include normal recurring adjustments) necessary for a fair statement of theresults for the interim periods .
74. On December 6, 2001, Kmart issued a press release announcing its same -store sale s
for the four-week period ended November 28, 2001 . The Company reported that net sales decrease d
2 .6% on a same-store basis . Defendant Conaway commented on the financial results, stating in
pertinent part as follows :
29
Our sales performance for the month of November fell short of our expectations as
our planned reductions in advertising and promotional activity decreased customertraffic more significantly than we anticipated . . . . Recognizing the impact, we haveadjusted our advertising and marketing strategy appropriately for the holiday season
and over the Thanksgiving weekend we recognized significant sales increasescompared to last year . We continue to transform Kmart to provide an in-stock,
75. On January 17, 2002, Kmart issued a press release announcing that James B .
Adamson has been elected non -executive Chairman of the Board ofDirectors effective immediately ,
and will serve as the principal liaison between the Board and the Company's senior management an d
that Charles C. Conaway will continue as Chief Executive Officer of the Company . Kmart also
reported that Mark S . Schwartz, the Company's President and Chief Operating Officer, is no longer
with the Company.
76. The statements referenced above in ¶J 65-69 and 71-73 were each materially fals e
and misleading for the reasons set forth above in ¶ 48 . In addition, the statements referenced above
in IT 65-69 and 71-73 were each materially false and misleading because they failed to disclose an d
misrepresented the following material facts which were known to defendants or recklessly
disregarded by them :
(a) that the Company was recording vendor rebates without even having a written
commitment from its vendors entitling it to such rebates. During the third quarter of 2001, the
Company reported $32,000,000 of vendor rebates before they were actually earned and for which
the Company did not have a firm commitment from the vendor . As a result, Kmart was subject to
a significant risk that it would be unable to obtain the rebate either because it did not perform it s
obligations or because it could not reach an agreement with the vendor ;
(b) that the Company had understated the "Cost of sales, buying and occupancy"
by $9,000,000 as the true amount was $6,434,000,000 ;
30
~ ir, .em ,:rv .. ., r avz .. a •r,.. . rRee. ~ .a....~ ,::y-:t..,.,,-..,r r .. ~ ,,-.-- ...-..,.-~. . . : x n.~ ~-_~r'-•~r --~'~•~-..-. Wr.~.- . ..,. ...,.s.,- ..-,..a.~.r:~s . . ._u~~.--. w....-p.-~~~,-:.- ..-..~-. ~,e~ ..,, .,w.,a .. . ~ . . . .
(c) that the Company had overstated the amount of gross margin by $9,000,00 0
as the true amount was $1,585,000,000 . Accordingly, the Company' s gross margin for the third
fiscal quarter of 2001 was overstated by 1% ;
(d) that the Company had understated its losses for the quarter by $11,000,000 ;
(e) based on (a) - (d) above, it was not true that Kmart's interim financia l
statements "reflect all adjustments (which include normal recurring adjustments) necessary fora fai r
statement of the results for the interim periods" as the Company was fraudulently accounting fo r
vendor rebates, among other accounting improprieties as detailed below in ¶¶ 95-139 ;
(f) that the Bluelight Always program was not meeting with success as customer
traffic was not increasing while the price reductions caused by the marketing initiative were erodin g
the Company' s gross margins , which fact was being concealed by the Company's fraudulent
accounting for vendor rebates ; and
(g) that the Company was nearing insolvency, would soon have to seek protectio n
under the Bankruptcy laws and would have to completely reorganize its operations .
77. On January 22, 2002, Kmart issued a press release announcing that the Company an d
37 of its U . S . subsidiaries have filed voluntary petitions for reorganization under Chapter 11 of the
U.S. Bankruptcy code . According to the press release, the Company' s decision to seek "judicial
reorganization" was based on a "combination of factors, including a rapid decline in its liquidity
resulting from Kmart's below-plan sales and earnings performance in the fourth quarter . "
78 . Following this announcement, the price of Kmart common stock dropped from $1 .74
per share to $0.70 per share, a one day decline of 59%, on extremely heavy trading volume .
79. On January 25, 2002, Kanart issued a press release announcing that the Company had
received an "anonymous letter expressing concern regarding unspecified accounting matters ." The
press release stated in pertinent part as follows:
31
The letter which was addressed to the Securities & Exchange Commission (SEC), theCompany's auditors and Board of Directors purports to come from employees of theCompany. The letter has been referred to the Audit Committee of the Board ofDirectors, which promptly engaged outside counsel and accounting consultants toconduct an independent investigation.
80. On March 11, 2002, Kmart issued a press release announcing the appointment and
promotion of a number of senior officers . The Company reported, among other things, that Jame s
B. Adamson would be Chairman of the Board and Chief Executive Officer immediately and tha t
Charles Conaway would be leaving the Company and that Albert Koch would be appointed Chie f
Financial Officer succeeding John T . McDonald .
81 . On May 1, 2002, Kmart issued a press release announcing that it would be filing a
form with the SEC to extend the filing date of its Form 10-K . The Company reported that it was
delaying the filing of its Form 10-K in order to complete its review of its accounting methods an d
to provide "additional time to complete the assessment of a possible restatement of the Company's
quarterly financial statements for 2001 . . . "
82. On May 20, 2002, Albert Koch ("Koch"), the Company's newly-appointed chie f
financial officer gave an interview to Bloomberg Business News concerning the Company' s
operations and the investigations into Kmart's accounting practices . During the interview, Koch
admitted that the Bluelight Always program was an unmitigated disaster :
[Interviewer] : Kmart last week announced that it lost more than $2 .4 billion last year,including $1 .5 billion in the fourth quarter . What went wrong? And is the worstbehind Kmart?
KOCH: Well, we certainly hope the worst is behind Kmart . We had last year about
a billion-dollar loss from what I consider to be continuing operations . I think theprimary thing that went wrong was the company's move into the Bluelight Alwa
which turned out to be -- it was designed to bring in more customers. It wasdesigned to lower prices and with more traffic generate, more margin . What actually
happened was we had fewer customers, lots of inventory, horrible margins . It was
83. On May 15, 2002, Kmart issued a press release announcing its financial results for
its 2001 fiscal year, which ended on January 30, 2002 . The Company also reported that it wa s
restating its unaudited fiscal 2001 quarterly financial data . For 2001, Krnart reported a staggering
loss of $2.42 billion, or $(4 .89) per share as compared to a loss of $244 million, or $(0 .48) per share
for 2000. With respect to the restatement, the press release stated in pertinent part as follows :
Based on the results of the Company's previously announced investigation ofaccounting matters conducted under the supervision of the Audit Committee ofthe Board of Directors, as well as the new management team's review of Kmart'saccounting policies and methods, Kmart concluded that (1) an adjustment should bemade with respect to an up-front payment in a single vendor transaction that moreappropriately should have been deferred and recognized over the life of the contract,and (2) the recording of additional general liability reserves in the fourth quarter wasmore appropriately designated as a second quarter event . Accordingly, adjustmentswere made for such transactions, including restatements of previously reportedunaudited quarterly financial statements for fiscal 2001 as follows-
0 The first adjustment increased Cost of sales, buying and occupancy,resulting in a net reduction to operating results in the second quarter of $42 million($28 million, after tax) or $0 .06 per share, and an increase in third quarter operatingresults of $15 million ($10 million, after tax) or $0 .02 per share .
• The second adjustment increased general liability reserves in thesecond quarter, rather than the fourth quarter, by approximately $167 million ($112million, after tax), or $0 .23 per share through a charge to SG&A .
The Company also reported that "given the Company's bankruptcy filing and the increase d
uncertainty and corresponding difficulty in reliably estimating future vendor allowances, Kmart' s
new management team reviewed the accounting for allowances and concluded that it would b e
preferable to change the Company's accounting method for interim recognition of cost recoverie s
from allowances . While this change in method was made in the fourth quarter of fiscal 2001 ,
generally accepted accounting principles require the restatement of the first three quarters of fisca l
2001 to reflect this change ." The Company further reported that under the :
new methodology, Kmart will recognize a cost recovery from an allowance onlywhen a formal agreement for such an amount is obtained and only to the extentKmart has fulfilled its performance obligations under the agreement . Previously ,
33
Kmart had recorded vendor allowances and rebates during each of the first threequarters based on an estimated annual level of rebates and allowances it expected toreceive during the year. These estimates were based on Kmart's historical e ep rienceand current understandings with our vendors, and were supplemented by vendorallowances and rebates obtained that were not contemplated in the Companyoriginal estimates . [Emphasis added.]
Krnart also provided a table setting forth the impact of the restatement for both the change i n
accounting methodology for vendor rebates and the other items described above and noted tha t
"[e]mbedded in the accounting change that gives effect to the change in interim financial reportin g
for allowances is an adjustment for an indeterminate amount of supplemental or incremental vendo r
allowances that were initially recorded in the first three quarters prior to having been documented ,
or otherwise deemed appropriate, pursuant to Kmart's historical policy . Kmart has determined that
it is not practical to determine the impact on prior quarters ." The table revealed that : (i) for the firs t
quarter of 2001, Kmart recorded $311,000,000 of vendor rebates which it was reversing ; (ii) for the
second quarter of 2001, Kmart recorded $211,000,000 of vendor rebates which it was reversing ; and
(iii) for the third quarter of 2001, Kmart recorded $32 million of vendor rebates which it wa s
reversing . Finally, the Company reported that it was cooperating with the SEC and the U .S .
Attorney's Office for the Eastern District of Michigan with respect to their investigation of Kmart .
84. At the end of the Class Period, Kmart common stock closed at $1 .17 per share .
85. On June 14, 2002, Kmart issued a press release announcing its financial results for
the first quarter of 2002, the period covering the first three months following the Company' s
voluntary bankruptcy filing . For that thirteen-week period, the Company reported a net loss of $1 .45
billion, or $(2 .88) per share . Notably, the Company also revealed that in the first quarter it had
recorded a charge of $758 million to "write-down inventory in 283 stores that were closed in May
and June, and inventory transferred from the remaining stores to the closing stores ." As set forth in
the press release, $384 million of the inventory charge relates to the write-down of inventory at the
accurate and reliable information concerning an entity's financial performance during the perio d
being presented . Concepts Statement No. 1, paragraph 42, states :
Financial reporting should provide information about an enterprise's financialperformance during a period. Investors and creditors often use information about thepast to help in assessing the prospects of an enterprise. Thus, although investmentand credit decisions reflect investors' and creditors' expectations about futureenterprise performance, those expectations are commonly based at least partly onevaluations of past enterprise performance .
97 . At all relevant times during the Class Period , defendants represented that Kmart' s
financial statements were prepared in conformity with GAAP, which are recognized by th e
accounting profession and the SEC as the uniform rules, conventions and procedures necessary t o
define accepted accounting practice at a particular time .' The representations that the Company's
financial statements were prepared in accordance with GAAP were materially false and misleadin g
because the defendants knew, or recklessly ignored that Kmart employed improper accountin g
practices , in violation of GAAP and the SEC 's financial reporting requirements , to falsely overstate
and misrepresent its financial performance during fiscal 2000 and 2001 .2
98 . Kmart's fiscal 2000 and 2001 financial statements were materially false and
misleading and were presented in violation of GAAP and SEC rules and regulations because th e
Company: (i) improperly accounted for vendor rebates and allowances ; (ii) failed to disclose its
policy of accounting for vendor rebates and allowances; (iii) failed to disclose material related
party transac-tions ; (iv) failed to timely record an impairment in the value of its obsolete inventory ;
and (v) improperly accounted for loss contingencies . Each of these misrepresentations , standing
alone, was a material breach of GAAP . In the aggregate, these practices , which occurred over an
1 SEC Regulation S-X states that financial statements filed with the SEC that are notprepared in compliance with GAAP are presumed to be misleading and inaccurate . 17 C.F.R. §
210.4-01 (a)(1) .
2 Kmart's fiscal 2000 and 2001 years ended on January 3 1 , 2001 January 30, 2002,respectively .
38
extended period of time, materially misled investors and distorted Kmart's actual financial
performance during the Class Period, as the Company has now admitted .
Kmart's Improper Accounting for Vendor Rebates and Allowances
99. On May 15, 2002, Kmart announced among other things that :
Additionally, given the Company's bankruptcy filing, and the increased uncertaintyand corresponding difficulty in reliably estimating future vendor allowances, Kmart Isnew management team reviewed the accountingfor allowances and concluded thatit would be preferable to change the Company's accounting method for interimrecognition of cost recoveriesfrom allowances . While this change in method wasadopted in the fourth quarter of fiscal 2001, generally accepted accounting principlesrequire the restatement of the first three quarters of fiscal 2001 to reflect this change .[Emphasis Added]
Under the new methodology, Kmart will recognize a cost recovery from anallowance only when a format agreementfor such amount is obtained and only tothe extent Kmart has fulfilled its performance obligations under the agreement.Previously, Kmart had recorded vendor allowances and rebates during each of thefirst three quarters based on an estimated annual level of rebates and allowances itexpected to receive during the year . [Emphasis Added ]
Embedded in the accounting change that gives effect to the change in interimfinancial reportingfor allowances is an adjustment for an indeterminate amountof supplemental or "incremental" vendor allowances that were initially recordedin the first three quarters prior to having documented, or otherwise deemedappropriate, pursuant to KmartIs historical policy. [Emphasis Added]
100. The above disclosure, which was repeated in Kmart's 2001 Form 10-K filed with the
SEC on or about May 15, 2002 and in its amended 2001 Forms 10-Q was materially false and
misleading . First, Kmart's previous "policy" of accounting for vendor allowances and rebates durin g
interim periods did not comply with GAAP . Second , as Kmart's previous policy of accounting fo r
vendor rebates and allowances during interim periods did not comply with GAAP , Kmart' s
representation that the restatements of its interim 2001 financial statements were due to a change i n
its accounting "policy" was false and misleading . In fact, despite attempts to characterize it s
39
restatement as being due to a benign change to a more "preferable" accounting policy, in truth, th e
restatement was made to correct previously issued false and misleading financial statements . '
Kmart's Previous Policy of Accounting for VendorRebates and Allowances Did Not Comply with GAAP
101 . Although Kmart reports vendor rebates as a reduction of the cost of revenue (i .e . ,
"cost recovery"), the accounting of vendor rebates by retailers, such as Kmart, is governed, in part ,
by GAAP's criteria of revenue recognition .4 GAAP, in FASB's Concepts Statement No . 5, ¶ 83,
provides that revenue should not be recognized until they are earned . Further, revenue which arise s
from circumstances involving uncertainty as to possible gains should not be recognized since to d o
so might result in gains being recognized on revenue prior to its realization . FASB Statement of
Financial Accounting Standards ("SFAS") No . 5, ¶ 12 .
102. Accordingly, GAAP required that Kmart defer recognizing vendor rebates (whic h
it reported as a reduction in its cost of revenue) until such time that the rebates were earned (i .e . ,
when Kmart sold the specified amount of its suppliers product in order to be entitled to such rebate) .
Moreover, in furtherance of its attempt to inflate its operating results, in certain instances, Kmar t
recorded vendor rebates and allowances prior to even entering into a rebate agreement with its
vendors .'
GAAP, in Accounting Principles Board ("APB") Opinion No . 20, requires thatpreviously issued financial statements be restated when they are materially misstated due to amisapplication of accounting principles or when they are misstated due to an oversight or misuse offacts existing when such financial statements were prepared.
4 GAAP defines revenues as "inflows or other enhancements of assets of an entity
or settlements of its liabilities (or combination of both) from delivering or producing goods,rende ring services , or other activities that constitute the entity' s ongoing major or central operations ."FASB's Concepts Statement No. 6, ¶ 78 .
See Cmplt filed by the SEC, at ¶ 41, in SEC v . Ber onzi No . 1 :CV 02-1084 (June20, 2002) for the SEC's view that : (1) the recognition of vendor rebates by a retailer which arecontingent upon future sales are unearned and violates GAAP and (2) the recognition of vendorrebates by a retailer prior to the consummation of a legally binding obligation by the vendor is i n
40
103 . Kmart has now disclosed that it will no longer recognize vendor rebates prior to th e
existence of a formal agreement with the vendor or prior to having fulfilled its obligations under a
vendor rebate agreement . This disclosure is an admission that Kmart's prior "policy" of accountin g
for vendor rebates and allowances violated GAAP .
104. Indeed, numerous former Kmart employees confirmed the Company's improper
accounting for vendor related credits including vendor rebates . For example, a former Kmart Vice
President stated :
The biggest problem was that Km art took credits (rebates) from vendors andallocated them on the books on the basis of expected sales . Then at the end of theyear, made adjustments. This was being done to make profits look better by takingcredits early and was improper since they were not guaranteed credits.
The former vice president added that the practice was employed to allow Kmart officers to receive
their bonuses. In addition, this former Vice President stated that the credits were taken when
Km art knew " in all probability " that the level of sales for vendor credit entitlement would not b e
reached.
105. This representation was confirmed by other former Kmart employees . For example,
a former Kmart operation manager who attended the 2000 annual Kmart meeting for executives ,
regional managers, district managers, store managers and vendors nationwide stated that a number
of regional, district and sales managers at the meeting indicated that the sales projections were
unattainable . Nonetheless, these sales projections were used as the basis for recording vendor
rebates and allowances in Kmart's interim financial statements . Another Krnart manager stated that :
I have been in the buying offices for almost 10 years, and this very last year Icouldn 't tell you what my sales plan was . . . . The numbers did not make sense andthey were changing daily.
106. Yet another Assistant Store manager lamented :
violation of GAAP .
41
[Sales projections] would always be high . No matter what, the projections werealways through the roof even though nothing was moving . . . Everyone's gutfeeling was that projections were set high to satisfy Wall Street.
107 . Kmart's policy of accounting for vendor rebates : (1) prior to such rebates being
earned; (2) when signi ficant contingencies existed as to the realization of rebates ; and (3) when th e
rebates were calculated based on wholly unreliable sales estimates violated the most fundamenta l
tenets of revenue recognition prescribed by GAAP .
108 . In addition, in the May 15, 2002 press release, the Company stated that :
Embedded in the accounting change that gives effect to the change in interim
financial reporting for allowances is an adjustment for an indeterminate amountof supplemental or "incremental" vendor allowances that were initially recordedin the first three quarters prior to having documented, or otherwise deemedappropriate, pursuant to Km art's historicalpolicy.
109. Accordingly, Kmart has admitted that its accounting for vendor rebates and
allowances during 2001 was otherwise false and misleading because the Company did not eve n
comply with its improper "policy" of accounting for such matters . Indeed, GAAP in Concepts
Statements No . 5, ¶ 63 provides that in order for an item to be recognized in an entity's financia l
statement, it must be verifiable and measurable with sufficient reliability . Kmart has now admitte d
that its previously issued financial statements failed to comply with GAAP as it reported vendor
rebates which were not documented or verifiable .
110. In fact, numerous Kmart vendors and former employees have stated that Kmart
improperly recorded credits purportedly due from vendors . For example, a former financial/credi t
analysis of a Kmart vendor stated :
Kmart had a list of 30 different things they would come with in order to take
deductions, from shipments arriving one day late to a damaged pallet. Kmart tookso many deductions, we could not keep track of them . Every month Kmart wouldsend back deduction sheets for absurd reasons. I
42
These representations were confirmed by former Kmart employees . For example, a former buying
manager in Kmart's soft lines division stated :
[Kmart] came up with all these rules . . . . The vendors were getting charged for thingsthey had no knowledge of. The vendors were really taken advantage of. I can tellyou for a fact that they (Kmart) were doing that to make money.
This former manager also stated that :
The big, big problem was that -- when [Kmart wanted a vendor to] deliver somethingto the distribution center, you make an appointment date - let's say tomorrow, butwhen the truck driver comes in to deliver , the warehouse will say, you know what,we're reallyfull today, bring it back tomorrow. . . . Now it 's going to be one day lateand it's not the vendor 's fault and we [would] charge them a heck of a lot of moneyfor [being one day late].
The former manager indicated that these practices were deliberately employed to record vendo r
credits that Kmart was not entitled to :
When we were in trouble , that's one way that the Company got money - we got alot ofmoneyfrom that. For me, and I was a teeny weeny little department - mydepartment volume was $50 million - and [vendors were charged] $377,000 for onelittle mistake .
111 . A former employee of another Kmart vendor stated it was common practice for Kmar t
to charge her five percent for a purchase order for day late shipments . This individual stated her
company was "ready and able"to deliver the product but could not because Kmart's distributio n
center wouldnot give them permission to deliver. This individual described this practice ofKmart
as "the biggest profit center I ever saw" and described the amounts that Kmartt charged he r
company as "astronomical. "
112 . In addition to the foregoing improper vendor-related accounting practices, Kmart ha s
also admitted that it overstated its 2001 earnings because a vendor payment that was recognized an d
reported as income immediately when GAAP required that it be deferred and recognized into income
over the life of the contract . As a result of its improper accounting of vendor related payments ,
43
rebates, allowances and credits, at least, Kmart's interim 2001 gross margins and earnings were
materially inflated, as the Company has now admitted.
113. Moreover, Kmart's disclosure concerning the restatement of its interim 2001 financia l
statements otherwise admits that the Company' s accounting for vendor rebates and allowances did
not comply with GAAP and were false and misleading . In explaining the restatement of the 200 1
interim financial statements, Kmart disclosed :
This change in methodology does not affect the results that otherwise would havebeen reported for the full fiscal year, but rather affects the interim recognition ofallowances during the year .
114. This disclosure indicates that Kmart's previous method of accounting for vendor
rebates and allowances during interim periods was different than the policy it employed at year end .
However GAAP, in APB Opinion No . 28, ¶ 11, provides that revenue should be recognized during
an interim period on the same basis followed at year end. Here again, Kmart has admitted that, at
least, its interim 2001 financial statements filed on Forms 10-Q during the Class Period did not
comply with GAAP and were materially false and misleading .
115. In addition, APB Opinion No . 28, ¶ 31 provides :
When interim financial data and disclosures are separately reported for the fourth
quarter, [financial statement users] often make inferences about that quarter by
subtracting data based on the third quarter interim report from annual results . In the
absence of a separate fourth quarter report or disclosure of the results . . . for thatquarter in the annual report, . . . unusual or infrequently occurring items recognized
in the fourth quarter, was well as the aggregate effect of the year-end adjustments
which are material to the results of that quarter . . . should be disclosed in the annual
report in a note to the annual financial statements .
116. Kmart's 2000 and 2001 year end financial statements were otherwise false and
misleading as they failed to disclose the effect associated with the adjustments made to account fo r
vendors rebates and allowances in the fourth quarter of those years . The adjustments recorded by
Kmart associated with its "preferable" accounting change increase its gross margins and operatin g
44
income during the fourth quarter of 2001 by approximately 30% and 50%, respectively. Indeed the
positive impact on Kmart's fourth quarter 2001 resulting from its purported change in accountin g
policy was not disclosed to investors, thereby misleading investors about the Company's earning s
absent such adjustments .
Kmart's Representation that its Interim 2001 Restatement was due toa "Change in Accounting Policy" is Materially False and Misleading-
117 . In furtherance ofits attempt to deceive investors and shield itself from liability, Kmart
has compounded its false and misleading accounting for its vendor rebates and allowances by
characterizing the restatement of such improper accounting as being due to a "preferable" accountin g
policy change.
118 . GAAP, in APB Opinion No . 20, provides guidance in reporting changes in an
accounting principle . 6
119 . In an attempt to shield itself from liability associated with its knowingly false an d
misleading accounting, Kmart has now characterized hundreds ofmillions of dollars in 2001 charge s
associated with its improper accounting for vendors rebates and allowances as being due to a
"preferable" change in an accounting principle adopted in the fourth quarter of 2001, for whic h
"generally accepted accounting principles require the restatement of the first three quarters of fisca l
2001 to reflect this change ." In truth and fact, Krnart's previous "policy" of accounting for its
vendor rebates did not comply with GAAP in numerous respects and its characterization of the
restatement of its interim 2001 financial as being due to a change to a more preferable accountin g
method is nothing more than an attempt to whitewash the fraudulent accounting practices note d
herein .
6 APB Opinion No. 20 provides that the term "accounting principle" includes "not onlyaccounting principles and practices but also the methods of applying them . "
45
Kmart's Failure to Disclose its Policy of Accountingfor Vendor Rebates and Allowance s
120. The objectives of financial reporting begin with providing information that is usefu l
in helping to make informed investment and credit decisions . Concepts Statement No . 1, ¶32 .
GA AP, in Accounting P rinciples Board ("APB") Opinion No. 22, provides that "a desc ription of al l
significant accounting policies of the reporting entity should be included as an integral part of th e
financial statements ." It further states :
Disclosure of accounting policies should identify and describe the accountingprinciples followed by the reporting entity and the methods of applying thoseprinciples that materially affect the determination of the financial position or resultsof operations . In general, the disclosure should encompass important judgments asto appropriateness of principles relating to recognition of revenue and allocation ofasset costs to current and future periods . In particular, it should encompass thoseaccounting principles and methods that involve any of the following :
a. A selection from existing acceptable alternatives;
b. Principles and methods peculiar to the industry in which the reporting entityoperates, even if such principles and methods are predominantly followed in thatindustry;
c. Unusual or innovative applications of generally accepted accountingprinciples (and, as applicable, of principles and methods peculiar to the industry inwhich the reporting entity operates) .
121 . Concerning the Company's vendor rebates , the only disclosure in Kmart's financia l
statements for the year ended January 31, 2000 that is even arguably associated with vendor rebate s
is "advertising costs, net of co-op recoveries from vendors, are expensed the first time advertising
occurs and amounted to $508 million, $453 million, and $443 million in 2000, 1999 and 1998 ,
respectively . "
122. Kmart's 2000 year-end financial statements failed to disclose its policy of accounting
for vendor rebates and allowances . Consequently, Kmart's policy of estimating vendor rebates and
allowances in its 2001 quarterly financial statements deceived the investing public as its improper
46
policy was adopted and applied , without disclosing such practice . Accordingly, Kmart's fiscal year-
end 2000 financial statements were materially false and misleading and otherwise failed to compl y
with GAAP as a result of its improper failure to identify and describe the Company 's practice of
accounting for vendor rebates and allowances . As a result, investors were uninformed about an d
unable to make important judgments concerning the appropriateness of principles Kmart employe d
relating to its accounting for vendor rebates and allowances. Ultimately, in its January 31, 2002 year
end financial statements, filed with the SEC on or about May 15, 2002, Kmart disclosed its polic y
of accounting for vendor rebates and allowances .
Kniart's Failure to Disclose Related Party Transaction s
123. GAAP, in FASB 's Statement of Financial Accounting Standards ("SFAS")
No. 57, requires that financial statements disclose related party transactions because, among other
things, "[t]ransactions involving related parties cannot be presumed to be carried out on an arm's-
length basis ." Accordingly, SFAS No. 57 requires that financial statements include disclosure s
about material related party transactions which include : (a) the nature of the relationship(s), (b) a
description of the transaction, (c) the dollar amount of transactions for each period for which an
income statement is presented, and (d) the amounts due from or to the related parties as of the dat e
of each balance sheet . SFAS No. 57 indicates that transactions between an enterp rise and its
principal owners, directors, management, or members of their immediate families are examples o f
related party transactions . In addition , Article 4-08(k)( 1) of Regulation S-X [17 C .F.R. § 210.4-
08(k)(1)] provides that "[r]elated party transactions should be identified and the amounts stated on
the face of the balance, income statement , or statement of cash flows . "
124. Moreover, the SEC's Staff Accounting Bulletin ("SAB") Topic 4E, provides that :
. . .in some cases the significance of an amount may be independent of the amountinvolved. For example, amounts due to and from officers and directors, because of
47
their special nature and o rigin, ought generally to be set forth separately [ in financialstatements] even though the dollar amounts involved are relatively small .
125. On May 16, 2002, Kmart disclosed that it had made "more than $30 million in loan s
to sixty-three executives in the year prior to filing for Chapter 11 in January [2002] . "
Nonetheless, Kmart's Class Period financial statements failed to disclose such related party
transactions in violation of GAAP and the SEC accounting rules and regulations , as defendants knew
or recklessly ignored.
Kmart's Failure to Record an Impairment in the Value of its Invent o
126. Kmart's audited 2000 financial statements disclosed its policy of accounting fo r
inventory as follows :
Merchandise inventories are stated at the lower of cost or market, primarily using theretail method. The last-in, first-out (LIFO) method, utilizing internal inflationindices, was used to determine the cost . . . of inventory .
127. Kmart's periodic reports filed with the SEC, and the press releases issued by the
Company during the Class Period which included financial statements, materially overstated th e
Company's inventories as a result of Kmart's improper failure to timely record an impairment in the
value of its outmoded inventory . In so doing, Kmart also materially overstated its gross margins ,
and earnings during the Class Period .
128. GAAP, as stated in Accounting Research Bulletin No . 43, Chapter 4,117-8, provides
that :
A departure from the cost basis of pricing the inventory is required when the utility
of the goods is no longer as great as its cost . Where there is evidence that the utility
of goods, in their disposal in the ordinary course of business, will be less than cost,whether due to physical deterioration, obsolescence, changes in price levels, or other
causes, the difference should be recognized as a loss of the current period . This is
generally accomplished by stating such goods at a lower level commonly designatedas market .
The term market means the current replacement cost except that :
48
a) Market should not exceed the . . . estimated selling price in the ordinary course ofbusiness less reasonably predictable costs of . . . disposal; and
b) Market should not be less than the . . . estimated selling price in the ordinary courseof business less reasonably predictable costs of . . . disposal reduced by a . . . normalprofit margin .
129. Accordingly, for financial reporting purposes , the issue is not whether a product i s
not usable or obsolete, but, rather, whether obsolescence, physical deterioration, changes in pric e
levels, or other factors cause inventory to be worth less than its stated cost.
130. During the Class Period, defendants knew, or recklessly ignored that Kmart failed t o
timely record an impairment in the value of its inventory. For example, a former senior accountant ,
who left the Company in 2000, stated that Kmart's distribution centers maintained "large amount s
of old inventory that should have been written off." This former employee stated that, in November
2000, Kmart's distribution center in Fort Wayne had "$4 - $6 BILLON" in inventory that should
have been written off.
131 . This representation was confirmed by other former Kmart employees . A former
Krnart operations manager stated :
Within a month of my arrival l knew that there were inventory errors that weren'tbeing addressed and huge inventory write-offs that were coming back from a yearbefore that still weren't being corrected . There was such a push to get production andto keep the operation moving that we wouldn't take the opportunity to stop to correctthe books, in order to get a clearer picture -- it just kept digging a deeper hole .
132. Numerous former employees stated that stores were also loaded with inventory the y
could not sell . A former assistant store manager stated that his store had "an unbelievable
amount" of inventory the store did not order and could not return, and that his store had so much
inventory that the inventory loft was packed full and product had to be stored in storag e
containers and trailers . This fact is confirmed by a farmer operations director who stated :
We still had a ton of issues with a lot ofproduct being forced out to stores that theydid not need. Igot those comments all the time. There was so much product at my
49
stores - trailers and trailers and trailers of stuff that had been therefor two years. .. the stuffjust sat there.
133. In fact, a former analyst and merchandise coordinator stated :
I know for a fact that during the end of a fiscal [accounting period], they wouldhide inventory when it was time to close the books. They would ship product to anundisclosed location until after the inventory was done, then ship theproduct bac k
134. These factors required the defendants to timely evaluate whether the value of Kmart' s
inventory was impaired pursuant to GAAP. Nonetheless, Kmart failed to timely record an
impairment in the value of its inventory, as the defendants knew, or recklessly disregarded .
Ultimately, during the first quarter of fiscal 2002, Kmart recorded a charge of $758 million to writ e
down its inventory to net realizable value .
Kmart's Improper Failure to Account For Loss Contingencie s
135. GAAP requires that financial statements account for existing uncertainties as to
probable losses . Such loss contingencies should be recognized and reported as a charge to incom e
when: information existing at the date of the financial statements indicates that it is probable (g„
a likely chance) that an asset has been impaired or a liability has been incurred ; and the amount o f
such loss can be reasonably estimated . FASB's Statement of Financial Accounting Standards
("SFAS") No . 5, ¶ 8 .
136. GAAP also requires that financial statements disclose contingencies when it is at least
reasonably possible (e,, a greater than slight chance) that a loss may have been incurred . SFAS
No. 5, ¶ 10 . The disclosure shall indicate the nature of the contingency and shall give an estimate
of the possible loss, a range of loss or state that such an estimate cannot be made . Id .
137. The SEC considers the disclosure of loss contingencies to be so important to an
informed investment decision that it promulgated Regulation S-X [17 C .F .R. § 2 10 .10-011, which
provides that disclosures in interim period financial statements may be abbreviated and need no t
50
duplicate the disclosure contained in the most recent audited financial statements, except that,
"where material contingencies exist, disclosure of such matters shall be provided even though a
significant change since year end may not have occurred ."
138. In violation of GAAP , Kmart has now admitted that its second quarter 2001 financial
statements improperly failed to account for $167 million in probable losses . This failure, which
Kmart has now admitted was due to an oversight or misuse of facts that existed when such financia l
statements were prepared , materially overstated the Company's operating results during the quarter
ended August 1, 2001 . Indeed, not only did Kmart fail to account for such loss contingency, but i t
did not even disclose the existence of the contingency in its second quarter 2001 financia l
statements .
139. In the above ways, Kmart issued financial statements that did not conform wit h
GAAP or the accounting and regulations of the SEC . In so doing, Kmart materially overstated and
misrepresented its operating results during the Class Period and failed to provide investors with th e
information necessary for an informed investment decision . Defendants overstated the Company' s
interim 2001 operating results in the approximate amounts reflected in the chart below :
(Data in $ Millions) Quarter Ended Quarter Ended Quarter Ende dMay 2 , 2001 August 1, 2001 October 31, 200 1
Net Loss Previously Reported $ (25) $ (95) $ (224)
Restatement Associated Withthe Failure to Defer VendorPa ent of Life of Contract 0 (42) 1 5
Overstatement Associated (311) (211) (32)Improper Accounting Polic y
Restatement Associated With 0 (167) 0the Unrecorded Reserve
Income Tax Benefit 103 138 6
Restated Loss $(233) $(377) $(235)
51
89.2% o 0.0 1
Percent Over (Understated) Quarter Ende dMay 2, 2001
Quarter Ende dAugust 1, 2001
Quarter Ende dOctober 31, 200 1
Gross Pro fit 15.0 % 11 .7 % . 6
Operating Loss * (95.5) % 6.9 %
Net Loss (89.3) % (74.8) % (4.7) %
Other Current Assets 6.1 % 34.3 % 19.5 %
Accounts Payable (1 .2)% (11 .4)% (11 .2) %
% 8.8 % 9.4 %
* Not meaningful as Kmart restated its first quarter operating profit of $63 million to an operatingloss of $248 million .
140. As a result of the foregoing accounting improprieties , Kmart presented its financia l
results during the Class Period in a manner which violated numerous provisions of GAAP. In
addition to the accounting improprieties stated above, Kmart presented its financial statement s
during the Class Period in a manner which also violated at least the following provisions of GAAP :
(a) the principle that interim financial reporting should be based upon the same
accounting principles and practices used to prepare annual financial statements (APB No . 28, ¶ 12) ;
(b) the concept that financial reporting should provide information that is usefu l
to present and potential investors and creditors and other users in making rational investment, credi t
and similar decisions (FASB Statement of Concepts No. 1, ¶ 34) ;
(c) the concept that financial reporting should provide information about the
economic resources of an enterprise, the claims to those resources, and effects of transactions, events
and circumstances that change resources and claims to those resources (FASB Statement of Concept s
No. 1, ¶ 40) ;
(d) the concept that financial reporting should provide information about ho w
management of an enterprise has discharged its stewardship responsibility to owners (stockholders )
52
for the use of enterprise resources entrusted to it . To the extent that management offers securitie s
of the enterprise to the public, it voluntarily accepts wider responsibilities for accountability t o
prospective investors and the public in general . (FASB Statement of Concepts No . 1, ¶ 50) ;
(e) the concept that financial reporting should provide information about an
enterprise's financial performance during a period . Investors and creditors often use information
about the past to help assess the prospects of an enterprise . Thus, although investment and credit
decisions reflect investors' expectations about future enterprise performance, those expectations are
commonly based at least partly on evaluations of past enterprise performance. (FASB Statement of
Concepts No. 1, ¶ 42) ;
(f) the concept that financial reporting should be reliable in that it represents what
it purports to represent . That information should be reliable as well as relevant is a notion that i s
central to accounting . (FASB Statement of Concepts No . 2, ¶¶ 58-59) ;
(g) the concept of completeness, which means that nothing is left out of th e
information that may be necessary to insure that it validly represents underlying events an d
conditions (FASB Statement of Concepts No . 2, ¶ 79) ; and
(h) the concept that conservatism should be used as a prudent reaction t o
uncertainty to try to ensure that uncertainties and ri sks inherent in business situations are adequately
considered. The best way to avoid injury to investors is to try to ensure that what is reporte d
represents what it purports to represent . (FASB Statement of Concepts No . 2, ¶¶ 95, 97) .
PwC'S PARTICIPATION IN THE FRAUD
141 . Plaintiffs incorporate by reference all allegations above insofar as they relate to PwC' s
materially false. and misleading audit opinion on Kmart's 2000 and 2001 fiscal year end financial
statements .
53
142 . Kmart was a long time and signi ficant client of PwC and a major source of incom e
for PwC's Detroit office . In fact, during fiscal 2000 alone, the fees paid by Kmart to PwC's
approximated $13 million . Only 10% of this amount were auditfees while consulting and other
fees accounted for the balance.
143 . As a result of its longstanding relationship with Kmart and the nature of the auditing
and consulting services rendered to the Company, PwC's personnel were regularly present at Kmart' s
corporate headquarters throughout the year and had continual access to, and knowledge of, Kmart' s
confidential corporate financial and business information through conversations with employees o f
Kmart and through review of Kmart's non-public documents .
144. Moreover, PwC had access to Kmart's internal accounting records . PwC therefore
knew of or recklessly disregarded the following adverse facts concerning Kmart that rendered the
Company's reported financial results during the Class Period, including the Company's 2000 an d
2001 year end financial statements and PwC's unqualified audit opinion thereon, materially false an d
misleading :
(a) Kmart's policy of accounting for vendor rebates and allowances during it s
2001 and 2000 interim periods in a manner which was different than it did at year end was a
violation of GAAP ;
(b) Kmart's 2000 financial statements failed to disclose its policy of accounting
for vendor rebates and allowances in violation of GAAP;
(c) Kmart's 2000 and 2001 financial statements did not disclose adjustments t o
vendor rebates made in the fourth quarter of the year ;
(d) Kmart's 2001 financial statements misleadingly disclosed that the restatemen t
of its 2001 interim financial statements was due to a change in accounting policy ;
(e) Kmart's 2001 financial statements to fail to disclose related party transactions ;
54
(f) Kmart's 2001 and 2000 financial statements failed to timely account for a n
impairment in the value of its inventory ; and,
(g) Kmart's 2000 financial statements prematurely recorded vendor rebates an d
allowances . Nonetheless, PwC knowingly, or recklessly, issued false unqualified audit opinion s
during the Class Period.
145. PwC issued its audit opinion, dated March 13, 2001 on Kmart's 2000 and 199 9
financial statements . PwC's opinion stated that such Kmart financial statements were presented i n
conformity with GAAP and that PwC's audit was performed in accordance with GRAS :
In our opinion, the accompanying consolidated balance sheets and the relatedconsolidated statements of operations, shareholders' equity and cash flows presentfairly, in all material respects, the financial position of Kmart Corporation and itssubsidiaries at January 31, 2001 and 2000, and the results of their operations andtheir cash flows for each of the three years in the period ended January 31, 2001, inconformity with accounting principles generally accepted in the United States ofAmerica . These financial statements are the responsibility of the Company'smanagement ; our responsibility is to express an opinion on these financial statementsbased on our audits . We conducted our audits of these statements in accordance withauditing standards generally accepted in the United States o fAmerica, which requirethat we plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement . An audit includes examining,on a test basis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimates madeby management, and evaluating the overall financial statement presentation . Webelieve that our audits and the report of other auditors provide a reasonable basis forour opinion.
146 . PwC issued its audit opinion, dated May 15, 2002, on Kmart's 2001 and 200 0
financial statements which it stated that such Kmart financial statements were presented i n
conformity with GAAP and that PwC's audit was performed in accordance with GAAS :
In our opinion, the consolidated financial statements listed in the accompanyingindex present fairly, in all material respects, the financial position of Kmart
Corporation and its subsidiaries at January 30, 2002 and January 31, 2001, and the
results of their operations and their cash flows for each of the three years in theperiod ended January 30, 2002, in conformity with accounting principles generally
accepted in the United States of America . In addition, in our opinion, the financialstatement schedule listed in the accompanying index presents fairly, in all material
55
respects, the information set forth therein when read in conjunction with the relatedconsolidated financial statements . These financial statements and financial statementschedule are the responsibility of Kmart's management ; our responsibility is toexpress an opinion on these financial statements and financial statement schedulebased on our audits . We conducted our audits of these statements in accordance withauditing standards generally accepted in the United States of America, which requirethat we plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free ofmaterial misstatement . An audit includes examining,on a test basis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimates madeby management, and evaluating the overall financial statement presentation . Webelieve that our audits provide a reasonable basis for our opinion .
The accompanying consolidated financial statements have been prepared assumingthat Kmart Corporation will continue as a going concern, which contemplatescontinuity of Kmart's operations and realization of its assets and payments of itsliabilities in the ordinary course of business . As more fully described in the notes tothe consolidated financial statements, on January 22, 2002, Kmart Corporation fileda voluntary petition for reorganization under Chapter I1 of the United StatesBankruptcy Code . The uncertainties inherent in the bank-ruptcy process and Kmart'srecurring losses from operations raise substantial doubt about Kmart Corporation'sability to continue as a going concern . Kmart Corporation is currently operating itsbusiness as a Debtor-in-Possession under the jurisdiction of the Bankruptcy Court,and continuation of Kmart as a going concern is contingent upon, among otherthings, the confirmation of a Plan of Reorganization, Kmart's ability to comply withall debt covenants under the existing debtor-in-possession financing agreement, andKmart corporation's ability to generate sufficient cash from operations and obtainfinancing sources to meet its future obligations . If no reorganization plan isapproved, it is possible that Kmart's assets may be liquidated . The consolidatedfinancial statements do not include any adjust-ments to reflect the possible futureeffects on the recoverability and classification of assets or the amount andclassification of liabilities that may result from the outcome of these uncertainties .
147. PwC turned a blind eye to Kmart's improper accounting and disclosure as describe d
above and issued an unqualified audit opinion on Kmart's 2001 and 2000 financial statements, eve n
though PwC knew or recklessly disregarded that : (a) Kmart's financial statements had not been
prepared in conformity with GAAP and did not present fairly, in all material respects, the financial
position of Kmart and its subsidiaries as of January 30, 2002 and January 31, 2001, and the results
of their operations and cash flow for the period ended January 30, 2002 and January 31, 2001 ; and
(b) PwC had not audited Kmart's 2001 and 2000 financial statements in accordance with GAAS .
56
148. Among other things, PwC knew or recklessly disregarded that Kmart's 2001 and 2000
financial statements violated numerous provisions of GAAP and were materially false and
misleading and inherently unreliable as set forth above. In certifying Kmart's 2001 and 2000
financial statements , PwC also falselyrepresented that its examination was made in accordance with
GAAS. This statement was materially false and misleading in that the audit conducted by PwC wa s
knowingly or recklessly not performed in accordance with GARS in the following respects :I
(a) PwC violated GAAS Standard of Repo rt ing No. I that requires the audi t
report to state whether the financial statements are presented in accordance with GAAP . PwC's
opinion falsely represented that Kmart's 2001 and 2000 financial statements were presented in
conformity with GAAP when they were not for the reasons herein alleged .
(b) PwC violated GRAS Standard of Reporting No. 4 which requires that, when
an opinion on the financial statements as a whole cannot be expressed, the reasons therefore must
be stated. PwC was required to have stated that no opinion could be issued by it on Kmart's 200 1
and 2000 financial statements or issued an adverse opinion stating that the 2001 and 2000 financia l
statements were not fairly presented.
(c) PwC violated GARS General Standard No. 2 that requires that an
independence in mental attitude is to be maintained by the auditor in all matters related to the
assignment .
(d) PwC violated SAS No . 54 by failing to perform the audit procedures require d
in response to possible improper acts by Kmart in connection with its audit of Kniart's 2001 and
2000 financial statements . PwC knew or recklessly disregarded that Kmart improperly recorde d
vendor rebates and allowances that did not comply with the Company's historical "policy" or were
recorded prior to being "supported" by formal agreements as noted above .
57
(e) PwC violated GAAS and the standards set forth in SAS No . 1 and SAS No.
53 by, among other things, failing to adequately plan its audit and properly supervise the work o f
assistants and to establish and carry out procedures reasonably designed to search for and detect th e
existence of errors and irregularities which would have a material effect upon the financia l
statements . PwC knew, or recklessly ignored, that Kmart accounted for vendor rebates durin g
interim periods in a manner that was different than at year end and that it failed to report materia l
fourth quarter adjustments ensuing from this practice .
(f) PwC violated GAAS General Standard No . 3 that requires that due
professional care must be exercised by the auditor in the performance of the audit and the preparatio n
of the report .
(g) GAAS Standard of Field Work No . 2 which requires the auditor to make a
proper study of existing internal controls , including accounting , financial and managerial controls ,
to determine whether reliance thereon was justified, and if such controls are not reliable, to expand
the nature and scope of the auditing procedures to be applied . The standard provides that a sufficient
understanding of an entity' s internal control structure be obtained to adequately plan the audit and
to determine the nature , timing and extent of tests to be performed . AU § 150 . 02. In all audits, the
auditor should perform procedures to obtain a sufficient understanding of three elements of an
entity's internal control structure : the control environment, the accounting system, and contro l
procedures . AU § 319 .02 . The control environment , which includes m anagement 's integrity and
ethical values, is the foundation of internal control and provides discipline, structure and sets th e
tone of an organization . After obtaining an understanding of an entity's internal control structure,
the auditor assesses the entity's control risk. AU § 319 .02 . Control risk is the risk that a material
misstatement in an assertion by management contained in a company' s financial statements will not
be prevented or detected on a timely basis by an entity's internal control structure policies o r
58
procedures . AU § 319 .29 . The ultimate purpose of assessing control risk is to aid the auditor i n
evaluating the risk that material misstatements exist in the financial statements . AU § 319 .61 .
(h) In the course of auditing Kmart's 2001 and 2000 financial statements, Pw C
either knew or recklessly disregarded facts which evidenced that it either failed to sufficientl y
understand Kmart's internal control structure and/or it disregarded weaknesses and deficiencies i n
Kmart's internal control structure, and failed to adequately plan its audit or expand its auditing
procedures . Numerous former Kmart employees related widespread problems associated with
Kmart's inventory control, practices and procedures . In fact, one Assistant Store Manager stated that
the computer system for tracking inventory was usually in error . "It might show that hundreds of
an item was in stock when in fact there were none, or it might show none in inventory when there
might be 30, 40, or 50 [items] on the shelves. The stuff they were ordering meant the system thought
we had it, but we didn't ." PwC was required by GAAS to sufficiently understand Kmart's interna l
control structure to adequately plan its audit and to determine the nature, timing and extent of test s
to be performed.
(i) PwC violated Standard of Field Work No . 3, which requires sufficient
competent evidential matter to be obtained through inspection, observation, inquiries an d
confirmations to afford a reasonable basis for an opinion regarding the financial statements under
audit . As described above, PwC knew or recklessly disregarded that it could not obtain sufficien t
competent evidential matter as to Kmart's vendor rebates and allowances, inventories, los s
contingencies and related party transactions .
(j) PwC violated the requirements of Section 1 OA ofthe Securities Exchange Act
which requires auditors of public companies to design procedures to identify related part y
transactions . PwC also violated AU §334, which requires auditors to identify, examine an d
determine that financial statements disclose related party transactions . As stated above, Kmart' s
59
financial statements failed to provide the disclosure required by GAAP concerning the transactions
between it and its executive officers .
(k) PwC violated auditing standard AU § 508 .48 which requires auditors to issu e
a qualified or adverse opinion when an inappropriate accounting principle causes financia l
statements to be materially misstated. As noted above, Kmart's historical policy of accounting fo r
vendor rebates and allowances did not comply with GAAP . Nonetheless , PwC issued an unquali fied
opinion on Kmart's 2001 and 2000 financial statements .
(1) PwC violated auditing standard AU § 508.41 which requires auditors to issu e
a qualified or adverse opinion when the financial statements (including related footnotes) contai n
inadequate disclosure . As noted above , Kmart's 2000 financial statements improperly failed t o
comply with GAAP concerning the Company's vendor rebates and allowances, contingencies an d
related parties . In addition, Kmart's 2001 financial statements misleadingly disclosed the Company' s
restatement of its interim 2001 financial statements as being to change in accounting policy rathe r
than being due to a correction of previously issued erroneous financial statements .
(m) PwC violated auditing standard AU § 9331 .01 which requires auditors to
observe inventory. Indeed, a former Kmart distribution center operations manager described the
variances between the Company's inventory records and physical inventories at the Manteno, Illinoi s
and Groveport, Ohio distribution centers as "huge."
149. In addition, GAAS, as set forth in the AICPA's auditing standard AU § 508, provides
that the auditor should update his report on the financial statements of the prior periods (Le ., Kmart's
2000 financial statements) presented on a comparative basis with those of the current period (i .e . ,
Kmart's 2001 financial statements ) . Paragraph 68 of AU § 508, provides :
During the course of the audit of the current-period financial statements, the auditorshould be alert for circumstances or events that affect the prior-period financialstatements presented . . . or the adequacy of informative disclosures concerning thos e
60
statements . . . . In updating his report on the prior period financial statements, the
auditor should consider the effects of any such circumstances or events coming to hisattention.
150. PwC's unqualified opinion on Kmart's 2001 also updated and reaffirmed PwC's
unqualified opinion on Kmart's 2000 financial statements , despite the fact that, by this time, PwC
knew or recklessly disregarded that its opinion was materially false and misleading . Among other
things, when PwC reaffirmed its opinion on Kmart's 2000, it knew, or recklessly disregarded tha t
Kmart improperly accounted for its vendor rebates and allowances in 2000 and that it failed to timely
record an impairment in the value of its inventory .
151 . PwC's opinion, which represented that Kmart's 2001 and 2000 financial statement s
were presented in conformity with GAAP, was materially false and misleading because PwC kne w
or was reckless in not knowing that Kmart's 2001 and 2000 financial statements violated th e
principles of fair reporting and GAAP . In the course of rendering its unqualified audit cert ification
on Kmart's 2001 and 2000 financial statements, PwC knew it was required to adhere to each of the
herein described standards and principles of GAAS , including the requirement that the financial
statements comply in all material respects with GAAP . PwC, in issuing its unqualified opinion,
knew or recklessly disregarded that by doing so it was engaging in gross departures from GAAS ,
thus making its opinions false, and issued such certification knowing or recklessly disregarding tha t
GAAS had been violated.
152. PwC knew or recklessly disregarded facts which indicated that it should have: (a)
disclaimed or issued an adverse opinions on Kmart's 2001 and 2000 financial statements ; (b)
withdrawn, corrected or modified its opinion for the year ended January 30, 2002 and January 31 ,
2001 to recognize Kmart's improper accounting stated above .
153 . As a result of its failure to accurately report on Kmart's 2001 and 2000 financia l
statements, PwC utterly failed in its role as an auditor as de fined by the SEC. SEC Accountin g
Series Release No . 296, Relationships Between Registrants and Independent Accountants, Securities
Act Release No. 6341, Exchange Act Release No . 18044, states in part :
Moreover, the capital formation process depends in large part on the confidence ofinvestors in financial reporting. An investor's willingness to commit his capital toan impersonal market is dependent on the availability of accurate, material andtimely information regarding the corporations in which he has invested or proposesto invest . The quality of information disseminated in the securities markets and thecontinuing conviction of individual investors that such information is reliable arethus key to the formation and effective allocation of capital . Accordingly, the auditfunction must be meaningfully performed and the accountants' independence notcompromised. The auditor must be free to decide questions against his client'sinterests if his independent professional judgment compels that result . [Emphasisadded.]
APPLICABILITY OF PRESUMPTION OF RELIANCE :FRAUD-ON-THE-MARKET DOCTRINE
154. At all relevant times , the market for Kmart's securities was an efficient market for
the following reasons, among others :
(a) Kmart's stock met the requirements for listing, and was listed and actively trade d
on the NYSE, a highly efficient and automated market ;
(b) As a regulated issuer, Kmart filed periodic public reports with the SEC and th e
NYSE ;
(c) Kmart regularly communicated with public investors via established marke t
connmunica-tion mechanisms, including through regular disseminations of press releases on the
national circuits ofmaj or newswire services and through other wide-ranging public disclosures, suc h
as communications with the financial press and other similar reporting services ; and
(d) Kmart was followed by several securities analysts employed by major brokerage
firms who wrote reports which were distributed to the sales force and certain customers of thei r
respective brokerage firms. Each of these reports was publicly available and entered the public
marketplace .
62
155. As a result of the foregoing, the market for Kmart's securities promptly digeste d
current information regarding Kmart from all publicly available sources and reflected suc h
information in Kmart's stock price . Under these circumstances, all purchasers of Kmart's securitie s
during the Class Period suffered similar injury through their purchase of Kmart's securities at
artificially inflated prices and a presumption of reliance applies .
NO SAFE HARBO R
156. The statutory safe harbor provided for forward-looking statements under certai n
circumstances does not apply to any of the allegedly false statements pleaded in this complaint .
Many of the specific statements pleaded herein were not identified as "forward-looking statements"
when made . To the extent there were any forward-looking statements, there were no meaningfu l
cautionary statements identifying important factors that could cause actual results to differ materially
from those in the purportedly forward-looking statements . Alternatively, to the extent that th e
statutory safe harbor does apply to any forward-looking statements pleaded herein, defendant i s
liable for those false forward-looking statements because at the time each of those forward-lookin g
statements was made, the particular speaker knew that the particular forward-looking statement wa s
false, and/or the forward-looking statement was authorized and/or approved by an executive officer
of Kmart who knew that those statements were false when made .
CLASS ACTION ALLEGATION S
157 . Plaintiffs bring this action as a class action pursuant to Federal Rule of Civi l
Procedure 23(a) and (b)(3) on behalf of a Class, consisting of all those who purchased or otherwis e
acquired the securities of Kmart between March 13, 2001 and May 15, 2002, inclusive (the "Clas s
Period") and who were damaged thereby . Excluded from the Class are the defendant, the officer s
and directors of the Company, at all relevant times , members of their immediate families and their
63
legal representatives, heirs, successors or assigns and any entity in which defendant has or had a
controlling interest .
158. The members of the Class are so numerous that joinder of all members is imprac-
ticable. Throughout the Class Period, Kmart common shares were actively traded on the NYSE .
While the exact number of Class members is unknown to plaintiffs at this time and can only b e
ascertained through appropriate discovery, plaintiffs believe that there are hundreds or thousands o f
members in the proposed Class . Record owners and other members of the Class may be identifie d
from records maintained by Kmart or its transfer agent and may be notified of the pendency of thi s
action by mail, using the form of notice similar to that customarily used in securities class actions .
159. Plaintiffs' claims are typical ofthe claims of the members of the Class as all members
of the Class are similarly affected by defendant's wrongful conduct in violation of federal law tha t
is complained of herein .
160. Plaintiffs will fairly and adequately protect the interests of the members of the Class
and has retained counsel competent and experienced in class and securities litigation .
161 . Common questions of law and fact exist as to all members of the Class and
predominate over any questions solely affecting individual members of the Class . Among the
questions of law and fact common to the Class are :
(a) whether the federal securities laws were violated by defendant's acts as allege d
herein ;
(b) whether statements made by defendant to the investing public during the Clas s
Period misrepresented material facts about the business, operations and management of Kmart ; and
(c) to what extent the members of the Class have sustained damages and the
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