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Pipefitters Local No. 636 Defined Benefit Plan, Et Al. V. Zale

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Pipefitters Local No. 636 Defined Benefit Plan, Et Al. V. Zale Case 3:06-cv-01470 Document 25 Filed 01/29/2007 Page 1 of 61 UNITED STATES DISTRICT COURT NORTHERN DISTRICT OF TEXAS DALLAS DIVISION In re ZALE CORPORATION SECURITIES § Master File No. 3:06-cv-01470-K LITIGATION § ECF § CLASS ACTION CONSOLIDATED CLASS ACTION COMPLAINT FOR VIOLATION OF THE FEDERAL SECURITIES LAWS Case 3:06-cv-01470 Document 25 Filed 01/29/2007 Page 2 of 61 The Court-appointed Lead Plaintiffs, Pipefitters Local No. 636 Defined Benefit Plan, Iron Workers Local 16 Pension Fund and Mitchel Agoos, individually and on behalf of all other persons similarly situated (collectively, "Plaintiffs or "Lead Plaintiffs ), by and through their undersigned attorneys, for their complaint against Zale Corporation ("Zale or the "Company ), Sue E. Gove, Mary L. Fort , Mark R. Lenz, and Cynthia T. Gordon (collectively, the "Individual Defendants or, together with Zale, the "Defendants ), allege the following based upon personal knowledge as to themselves and their own acts, and as to all other matters, based upon, inter alia, an investigation conducted by and through their attorneys, which included, among other things: (i) interviews of persons with knowledge, including former employees and representatives of Zale; (ii) a review of Defendants' press releases and other public documents; (iii) conference calls and announcements made by Defendants; (iv) United States Securities and Exchange Commission ("SEC ) filings; (v) wire and press releases published by and regarding Zale; (vi) securities analysts' reports and advisories about the Company; and (vii) information readily obtainable from public sources. Plaintiffs believe that substantial additional evidentiary support will exist for the allegations set forth herein after a reasonable opportunity for discovery. NATURE OF THE ACTION 1. This is a federal securities class action brought on behalf of a class (the "Class ) consisting of all persons who purchased or otherwise acquired the publicly traded common stock of Zale between February 18, 2005 and May 5, 2006, inclusive (the "Class Period ), seeking to recover damages caused by Defendants' violations of § § 10(b) and 20(a) ofthe Securities and Exchange Act of 1934 (the "Exchange Act ), 15 U.S.C. §§78j(b) and 78t(a), respectively, and Rule lOb-5, 17 C.F.R. §240.1 Ob-5, promulgated thereunder. 2. Zale, through its wholly-owned subsidiaries, operates as a specialty retailer of fine jewelry in North America. It offers fine jewelry, watches and diamond products under the name -1- Case 3:06-cv-01470 Document 25 Filed 01/29/2007 Page 3 of 61 "Zales Jewelers in the United States. The Company also offers traditional jewelry under the brand name "Peoples Jewelers in Canada, gold and silver products through mall-based kiosks and carts under the brand names "Piercing Pagoda in the United States and "Peoples II in Canada, and operates "Zales, the Diamond Store outlets in North America and Puerto Rico. In total, as of July 31, 2005, the Company operated 1,464 specialty retail jewelry stores, 812 kiosks and 69 carts in North America and Puerto Rico. 3. Prior to the start ofthe Class Period, companies in the retail jewelry industry, such as Zale, enjoyed a healthy profitability - with net margins reaching as high as 50% in a given financial period, which, according to one ofPlaintiffs' confidential sources, had a 10%-12% impact on such a company's bottom line after costs and expenses. However, entering the Class Period, Defendants could no longer avoid recognizing that the Zales Jewelers division, which accounted for 45% of Zale's total sales , was continuing to lose market share. Defendant Fort had implemented a plan that steered the Company away from its historical platform aimed at average-income Americans. Fort attempted to push Zales Jewelers into a more up-scale market, de-emphasizing popular diamond fashion and solitaire categories in favor of more expensive gold and silver merchandise. These significant changes disrupted Zale's struggling flagship brand. Fort also tried to transition to the direct importation of diamond jewelry, while dramatically shifting the mix of products Zales Jewelers offered and canceling historically successful promotional events, which alone cost the Company $22 million. This unfocused merchandising strategy led to ordering delays and merchandise shortages during the critical 2005 holiday season. 4. While Zales Jewelers' market share rapidly eroded, Zale's competitors posted excellent sales results. Undeterred by the worsening business picture at Zale, the Individual Defendants provided unrealistic and unreasonable guidance to Wall Street that the Company just could not meet, so as to try to compare more favorably with the Company' s competitors. Indeed, the -2- Case 3:06-cv-01470 Document 25 Filed 01/29/2007 Page 4 of 61 Company's earnings guidance was so unrealistic that, during the fourth quarter of fiscal year 2005, Zale faced an earnings miss ofnearly $30 million. Further, payroll expenses - which were typically an area where the Company could cut expenses to meet forecasts - were already cut to "bare bones for the quarter, forcing the Company to look elsewhere to meet quarterly and year-end forecasts. 5. Faced with the threat of disappointing Wall Street, and in order to maintain the price ofZale common stock, Defendants engaged in a scheme and course offraudulent conduct during the Class Period to artificially inflate revenues by improperly accounting for extended service agreements ("ESAs ) with its customers . An ESA is a service warranty sold to customers to cover jewelry sizing and breakage issues over a period of two years. 6. Specifically, Zale engaged in "cookie jar accounting by improperly manipulating the amount and timing of revenue that it initially recognized upon the sale of ESAs in order to smooth its earnings . Whenever the Company was going to miss earnings targets, Defendants would increase the percentage of revenue the Company initially recognized upon the sale of ESAs, or change the timing over which it recognized revenues from ESAs. This practice violated not only Generally Accepted Accounting Principles ("GAAP ), but Zale's own publicly-stated revenue recognition policy with respect to ESAs. 7. In addition to manipulating the Company's financials through the improper accounting for ESAs, Defendants also manipulated the Company's free cash flow during the Class Period. Specifically, during 4Q04, at the direction of defendant Fort , defendants Gove and Gordon instructed the Zale "buyers to contact all of the Company' s vendors and change the terms of the buys to postpone receivables and payments. Thus, a letter was forwarded to these vendors explaining that vendors would not be paid until after July 31, 2005, because the Company's "inventory system and the "merchandising system did not match and, as a result, that Zale could not pay vendors. In reality, delaying vendor payments allowed Zale to reverse cost of goods sold -3- Case 3:06-cv-01470 Document 25 Filed 01/29/2007 Page 5 of 61 and accounts payable accounts, thus removing expenses that would otherwise impact the Company's free cash flow figures that were reported to Wall Street and investors. 8. As a result of these fraudulent practices which were unknown to investors, Defendants issued a series of materially false and misleading statements and omissions during the Class Period concerning: (i) Zale's quarterly and year-end financial results; (ii) Zale's policy for recognizing revenue from ESAs; and (iii) free cash flow figures. 9. Defendants were only able to carry on their scheme for so long, as they finally attracted the attention of the SEC. In particular, on April 10, 2006, the Company issued a press release announcing that the SEC had initiated a nonpublic investigation into various accounting and other matters related to the Company, including, among other things, the Company's accounting for ESAs and the timing of certain vendor payments.' This partial disclosure caused the price of Zale common stock to plummet $2.64, or 9.5%. Zale stock closed at $27.80 on April 7, 2006, and $25.16 on April 10, 2006, on unusually heavy trading volume of 1,599,700 shares. 10. Disclosure ofthe SEC investigation into Zale's accounting practices was just the tip of the iceberg. The true state of Zale's financial condition was further revealed on May 5, 2006, when the Company announced, after the close of market, that defendant Lenz had been placed on "administrative leave as a result of his failure to timely disclose to Zale's auditors that vendor payments scheduled to be made during the last two weeks of 4Q05 had been delayed into the first week of 1 Q06. This news also negatively impacted Zale's financial results, causing the price ofZale common stock to fall another $1 .73, or 7 .03%, the following week, from a closing price of $24.62 on May 5, 2006, to a close of $22.89 on May 12, 2006. 1 By letter dated September 21, 2006, the SEC notified Zale that its investigation had been terminated. The conclusions and recommendations of the SEC, if any, were not disclosed. -4- Case 3: 06-cv-01470 Document 25 Filed 01/29/2007 Page 6 of 61 11. As detailed herein, the Individual Defendants engaged in this scheme to defraud in order to sell $15.8 million of inflated Zale stock and to obtain significant bonuses which were tied to the false financial results the Company was reporting. JURISDICTION AND VENUE 12. The claims asserted herein arise under and pursuant to §§10(b) and 20(a) of the Exchange Act, 15 U.S.C. §§78j(b) and 78t(a), and Rule lOb-5 promulgated thereunder by the SEC, 17 C.F.R. §240. 1Ob-5. 13. This Court has jurisdiction over the subject matter of this action pursuant to 28 U.S.C.
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