Duane Read, Inc. Securities Litigation 02-CV-6478-Consolidated

UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF NEW YORK

IN RE DUANE READE, INC. ) CIVIL ACTION NO.: SECURITIES LITIGATION ) 1:02cv6478(NRB)

) CONSOLIDATED AMENDED ) COMPLAINT

Lead Plaintiff, individually and on behalf of all other persons similarly situated, alleges upon personal knowledge as to itself and its own acts, and upon information and belief as to all other matters, based upon, inter alia, the investigation made by and through its attorneys, which investigation included, without limitation, communications with persons with first hand knowledge of the allegations herein, including former employees of Duane Reade ("Duane" or the "Company"), who are knowledgeable about Duane's business, operations, accounting and business practices and/or about the industry and markets in which Duane operated, and review and analysis of various accounting literature and public statements, including documents filed by or on behalf of Duane with the Securities and Exchange Commission ("SEC"), news and media reports, press releases, and reports by securities analysts. Plaintiff believes that, after a reasonable opportunity for discovery, further substantial evidentiary support for the allegations set forth herein will be shown to exist.

NATURE OF THE ACTION

1. This is a federal class action on behalf of purchasers of the common stock of

Duane between April 1, 2002 and July 24, 2002 inclusive (the "Class Period"), seeking to pursue remedies under the Securities Exchange Act of 1934 (the "Exchange Act"). Defendants are the

Company, Tony Cuti, Duane's President, Chief Executive Officer and Chairman of the Board of

Directors, Gary Charboneau, Duane's Senior Vice President of Sales and Marketing, and John K. Henry, Senior Vice President and Chief Financial Officer who were responsible for the public dissemination of materially false and misleading statements made during the Class Period. Cuti,

Charboneau, and Henry will be collectively referred to herein as the "Individual Defendants."

2. As alleged in detail below, during the Class Period, Defendants knowingly issued to the investing public materially false and misleading financial statements, press releases, and other information concerning Duane's overall financial condition. Moreover, Defendants' failed to correct their false and misleading statements throughout the Class Period. Defendants were motivated to issue materially false and misleading statements and omissions to conceal the true financial condition of the Company. Having inflated the price of Duane common stock artificially, Defendants were able to retire certain of the Company's high cost debt and to acquire assets using far fewer shares of the Company's stock.

3. By 2000, the Company was involved in a campaign to open a Duane Reade drugstore on virtually every corner in Manhattan. By the end of 2001, the Company was operating more than 200 stores in the New York City area and the Company was setting its sights even higher — Duane announced its intention to open 35 new stores in 2002.

4. To effectuate its 2002 expansion plan, Defendants had to rid the Company of its 9

114 % senior convertible notes coming due in 2008 and obtain an infusion of capital. As a result, between April 10, 2002 and June 21, 2002 the Company commenced and completed a $381 million convertible note offering due in 2022 and corresponding retirement of its 9 1/4 % senior convertible notes due in 2008. The convertible note offering depended on the issuance of 5.389 . million shares of Company stock. Additionally, the Company continued its practice of acquiring

2 pharmacy assets using common stock as currency and orchestrated at least one such acquisition during the Class Period.

5. As the 2001 fiscal year came to a close, the Company's business seemed to be thriving. Despite the "temporary dampening" of revenues caused by the terrorist attacks on

September 11, 2001, the Company on February 19, 2002 announced record sales and earnings for fiscal year ending December 29, 2001. The Company attributed its ability to meet expectations in the post-September 11 environment to its self-proclaimed "expertise" as an urban-retailer. On various occasions throughout the first quarter 2002, The Company's purported expertise led

Company officials to announce that the New York sales trends were improving.

6. The Company's claimed ability to predict sales trends after the September 11th attacks appeared to be substantiated as the Company, on April 25, 2002, announced that Duane had achieved "record sales and earnings" for the first quarter 2002. Additionally, the Company reiterated that sales, both pharmacy and non-pharmacy sales (referred to as "front-end sales") were continuing to improve post-9/11. Taking advantage of this purported trend to push ahead with its expansion plan, Company officials again touted their self-proclaimed "urban retailing knowledge" and assured investors that the Company officials would achieve sales and earnings estimates of $335 million and $.40 - $.44 for the second quarter 2002, respectively.

7. The improvement in front-end sales was vitally important to Defendants because the Company carried 33 percent more front-end merchandise than the national average and the gross margins on the front-end merchandise are two times higher than those on prescription drugs.

8. Unbeknownst to investors, however, with a month of the second quarter already

behind the Company, Defendants knew on April 25, 2002, but failed to disclose, that the

Company's front-end sales business was trending downwards and that they would not achieve

the previously announced sales and earnings estimates.

9. In fact, Defendants knew that their April 25, 2002 statements were materially false

and misleading when made as they misrepresented the financial condition of the Company and

failed to disclose the following information, which they monitored on a daily basis:

a. The Company's front-end sales were declining; and

b. Costs associated with already planned new store openings would

contribute to lower earnings.

10. Moreover, despite repeated statements by analysts and members of the press

recommending that investors purchase stock in the Company based on the April 25, 2002 false

and misleading statements, Defendants made no statements during the Class Period to update

and/or correct them.

11. Additionally, within the Class Period, Defendants learned that theft and vendor

errors (referred to as "shrink") were cutting into earnings, but failed to timely disclose such to

investors.

12. As mentioned above, Defendants were motivated to make and conceal the

aforementioned false and misleading statements throughout the second quarter 2002 to

consummate the convertible note offering and corresponding stock issuance and to finalize the

pharmacy asset acquisition using artificially inflated Company stock as currency.

13. Had the Company's true financial condition been disclosed at the outset of the

4 second quarter, Duane would not have been able to consummate the aforementioned transactions on the same favorable terms.

14. On July, 25, 2002, Defendants revealed that they missed earnings by more than 50 percent. The news of Duane's disappointing results caused the price of its common shares to fall

38 percent from a closing price on July 24, 2002 of $23.55 to a closing price on July 25, 2002 of

$14.60 per share on abnormally heavy trading volume of 5.463 million shares compared to a 52 week volume average of nearly 282,000 shares per day. Defendants blamed the earnings shortfall on slow front-end sales, increased shrink and costs associated with new store openings — issues Defendants had been monitoring on a daily basis since the inception of the Class Period.

JURISDICTION AND VENUE

15. The claims asserted herein arise under and pursuant to Sections 10(b) and 20(a) of the Exchange Act [15 U.S.C. §§ 78j(b) and 78t(a)] and Rule 10b-5 promulgated under Section

10(b) by the SEC [17 C.F.R. § 240.10b-5].

16. This Court has jurisdiction over the subject matter of this action pursuant to 28

U.S.C. §§ 1331 and 1337, and Section 27 of the Exchange Act [IS U.S.C. § 78aa].

17. Venue is proper in this District pursuant to Section 27 of the Exchange Act, and

28 U.S.C. § 1391(b). In addition, Duane maintains its principle executive offices at 440 Ninth

Avenue, New York, New York in this District. Many of the acts and practices complained of herein occurred in this District.

18. In connection with the acts alleged in this complaint, Defendants, directly or indirectly, used the means and instrumentalities of interstate commerce, including, but not

5 limited to, the mails, interstate telephone communications and the facilities of the national securities markets.

PARTIES

19. Lead Plaintiff Capstone Asset Management Company purchased the common stock of Duane at artificially inflated prices during the Class Period and has been damaged thereby.

20. The Court appointed Capstone Asset Management Company to serve as Lead

Plaintiff on November 26, 2002.

21. Defendant Duane, incorporated in Delaware, is the largest drug store chain in the metropolitan New York City area which, as of December 28, 2002, operated 228 stores, offering a wide variety of prescription and over-the-counter drugs, health and beauty care items, cosmetics, hosiery, greeting cards, photo supplies and photo finishing. Duane maintains its headquarters and executive offices at 440 Ninth Avenue, New York, NY 10001.

22. Defendant Anthony J. Cuti is and was, at all relevant times, Chairman of the

Board of Directors and Chief Executive Officer of Duane.

23. Defendant Gary Charboneau is and was, at all relevant times, Senior Vice

President of Sales and Marketing of Duane.

24. Defendant John K. Henry is and was, at all relevant times, Senior Vice President and Chief Financial Officer of Duane. Together, Defendants Cuti, Henry and Charboneau are referred to as the "Individual Defendants."

25. Because of the Individual Defendants' positions with the Company, their status as signatories to certain of Duane's filings with the SEC, and as principal spokespersons for the

6 Company in its news releases, they had access to adverse undisclosed information about Duane's business, operations and its financial condition, including its debt obligations and plans to repay those obligations, as well as its markets and present and future business prospects, via access to internal corporate documents including the Company's operating plans, budgets and forecasts, daily reports of actual operations, including sales and profit figures, formal weekly sales and profit reports, as well as conversations with corporate employees. The Individual Defendants have control over Duane's operations and its public disclosures and has access to all of the internal material facts concerning Duane and documents generated at Duane.

26. As the most senior officers 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 ("NYSE"), and governed by the provisions of the federal securities laws, the

Individual Defendants had a duty promptly to disseminate accurate and truthful information with respect to the Company's financial condition and performance, growth, operations, financial statements, business, products, markets, management, earnings and present and future business prospects, and to correct any previously-issued statements that had become materially misleading or untrue, so that the market price of the Company's publicly-traded common stock would be based upon truthful and accurate information. The Individual Defendants' alleged misrepresentations and omissions during the Class Period violated these specific requirements and obligations.

27. The Individual Defendants participated in the drafting, preparation, and/or approval of the various public, shareholder and investor reports, and other communications complained of herein, signed certain of the Company's filings with the SEC and were quoted in

7 the Company's earnings news releases and were aware of, or recklessly disregarded, the

misstatements contained therein and omissions therefrom, and were aware of their materially

misleading nature. Because of their positions with the Company, as signatory to SEC filings, and

spokespersons in news releases, The Individual Defendants had access to the adverse undisclosed

material information about Duane's business prospects, fmancial condition, including dampening

front-end sales, increased "shrink" liabilities, increased generic pharmaceutical sales and the use

of improper accounting techniques to boost Company profit margins, and performance as

particularized herein, and knew or recklessly disregarded, that these adverse facts rendered the

positive representations made by or about Duane and its business materially misleading.

28. Each of the Defendants is liable as a participant in a fraudulent scheme and course

of business that operated as a fraud or deceit on purchasers of Duane common stock by

disseminating materially misleading statements and/or concealing material adverse facts and

failing to correct the misleading statements throughout the Class Period. The scheme: (i)

deceived the investing public regarding Duane's business and operations and the intrinsic value

of its common stock; (ii) enabled Defendants to use the inflated price of Duane common stock as

currency to acquire other businesses and assets and to fulfill its obligations to certain debt holders

to resell the debt to the general public; and (iii) caused Plaintiff and other members of the Class

to purchase Duane common stock at artificially inflated prices.

BACKGROUND

A. Importance of Front-End Sales

29. The Company's financial success is dependent in large part on its front-end, non- pharmacy sales. On January 21, 2002, the Drug Store News published an article confirming the

8 Company's focus on selling front-end merchandise to reap its higher profit margins. The article quoted Defendant Cuti as stating, "for an urban chain like Duane Reade, the opportunity is to continue to line extend in convenience items because there's so few competitive alternatives for those items in our marketplace. So, obviously we are focusing on carrying many items that are often found in large food/drug combo or mass merchant stores in our market."

30. According to the Company's Annual Report on Form 10-K for the year ending

December 29, 2001 ("2001 10-K"), the Drug Store News ranked Duane as the leading U.S.

Drugstore chain in 2000 in terms of sales per square foot. The March 28, 2002, Form 10-K stressed the importance of the Company's profitable front-end sales:

In 2001, we believe that we led the New York City market in sales of both pharmacy and front-end product categories. Sales of higher-margin front-end items accounted for 60.8% of our total sales in fiscal 2001, the highest of any major conventional drugstore chain in the United States.

(Emphasis added).

31. On a February 20, 2002 Fox News interview, Defendants' again confirmed their focus and reliance on front-end sales to drive higher margins. In response to a question concerning the purported disappearance of "mom and pop" drug stores in favor of Duane stores and whether that would lead to higher prices, Cuti answered that Duane does not believe consumers miss mom and pop drug stores. He continued that:

I think many of the mom-and-pops got overwhelmed with the needs to provide commodities. You know, most mom-and-pop drug stores get 90 percent of their sales from the pharmacy. And you look at New York City, there is [sic] no 7-11s, no Wawas, no convenience stores, no super drug combination stores at all. So we are New York's convenience store. And mom-and-pops were not doing a good job at that.

9 32. Thus, front-end sales were the key to Duane's maintainability or increasing its gross margins. Statements from former Duane employees, detailed below, demonstrate that because front-end sales were the life-blood of the Company, Company management, including the Individual Defendants, were acutely aware of and reviewed the Company's detailed sales and earnings figures on a daily basis.

B. Defendants' Knowledge of the Company's Financial Position

33. According to several former employees, Cuti and other management officials received daily reports of, and attended weekly meetings concerning, the financial condition of the

Company. Additionally, the former employees confirmed that the problems on which

Defendants blamed the Company's second quarter earnings shortfall would have been known by management, including the Individual Defendants, when the earnings forecast was made on April

25, 2002.

1. Defendants' Daily Monitoring of the Company's Finances

a. Former Employee Statements

34. A former Vice President of Distribution (W-1) who worked in the Company's

Long Island distribution center from late-1997 through mid-2000, made frequent visits to headquarters, reported to Senior Vice President of Sales and Marketing, Gary Charboneau, and had a great deal of direct contact with Defendant Cuti, stated that the Company's management team, including W-1, met every Tuesday for an executive staff meeting wherein weekly sales reports were gone over in "great detail." The reports included "very specific information" that was broken down by detailed categories within pharmacy and front-end sales. For example, the sales categories contained in the reports included, but were not limited to: sales by specific store;

10 sales by product group (e.g., cosmetics, snacks and jewelry); sales of generic drugs; and sales of brand name drugs.

35. According to W-1, the Individual Defendants blew how the Company was performing, in all areas, on a daily basis. "Tony Cuti had receipts everyday, and he is an intelligent guy so he knew exactly what was up in each store and product area. He was always on top of the numbers."

36. A former Inventory Analyst (W-2), who worked for the Company at its headquarters from early 1998 through early 2002 and who tracked all sales of the Company on

Excel spread sheet reports, confirmed that Defendants closely monitored the Company's operations and finances. According to W-2, formal sales reports were distributed, on a weekly basis to, inter alia, Gary Charboneau, who delivered the reports to upper management, including

Defendant Cuti. The formal reports disclosed, inter alia, gross margin data, which management would review against the backdrop of what promotions and markdowns were active and working.

37. Also according to W-2, the formal weekly reports were detailed and categorized.

The reports detailed weekly sales information on merchandise categories such as aspirin, depilatory, cosmetics, fragrances, general merchandising (such as holiday merchandise), and various drug categories. The Company buyers then used this information to determine which promotions were working, and whether they would go forward within the future planning period.

(The Company scheduled various concurrent "planning periods" ranging in length from a week to a year.)

38. W-2 also stated that forecasts were constantly being made and adjusted, based on the weekly formal reports. W-2 said that, "we would redo our numbers ... after we saw what was

11 selling," and that sales planning was done on a store-by-store basis, as reports were generated for each store. In general, "reports were closely analyzed to see where sales and margins were dropping."

39. A former Executive Administrative Assistant (W-3) for Defendant Cuti from early

2002 through middle 2002, who characterized Cuti as "very hands-on" and very demanding of executives, stated that Cuti received daily sales reports that were "of the utmost importance to

[him]." W-3 confirmed that sales figures were generated daily, and that "the second I got them,

I had to walk them in to him and they had to be shredded after he looked at them." According to

W-3, Saturday's sales reports were the most important to Cuti, and he looked at them "first thing every Monday morning." W-3 recalls that sales reports were compiled by district and were broken down (in dollar amounts) by pharmacy and other categories.

40. A former Senior Accountant and Inventory Analyst (W-4), who worked at

Company headquarters from late 1997 through late 1998 said that the Company operated a realtime computer system, the POS (Point of Sale) system. According to W-4, the POS system connected all Company stores to headquarters so that headquarters would have real time access to, inter alia, store sales, inventory, and margins. According to W-4, the POS system was part of a more extensive RS 6000 system.

41. A Former Executive Assistant to a Senior Vice President of Merchandising and

Gary Charboneau, Senior Vice President of Sales and Marketing (W-7), who worked for the

Company from mid-1998 through mid-2001, said that she generated sales reports for

Charboneau. According to W-7, the reports were in spreadsheet form and contained considerable detail on every conceivable aspect of sales. The spreadsheet figures were broken down by, inter

12 alia, store, zone (grouping of stores), sales category, specific product, and promotion.

42. W-7 provided further that the sales amounts contained in the spreadsheets were downloaded from scanned sales at each store through the RS 6000 system. The system thus contained a download, every day, of information on every product sold in every store. The information was sorted by category, e.g., "cosmetics, diapers, cigarettes, back to school items, and candy," or by specific item, e.g., "Luvs, and Scott Toilet Tissue."

43. According to W-7, the RS 6000 spreadsheet reports, were reviewed at weekly executive meetings to track DR's financial status relating to promotions and targets that had been previously set. Accordingly, at every meeting sales were analyzed in many different ways, such as by "store zone" and "price point" (i.e., different zones would have different prices for the same items, and sales volume vis-à-vis price points within zones and across different zones were compared). Commenting on the Company's capability, W-7 stated, laThsolutely the main goal of management was to track sales by category, price and promotions, and we had the supporting hardware and software to give us this information on a day to day basis."

b. Public statements concerning the Company's realtime analysis of front-end sales

44. The 2001 10-K discussed, in part, the Company's computer system operations.

In 2000, DRD completed development and chain-wide implementation of new computer assisted ordering system, designed to help minimize out-of-stock situations, but also to allow us to set the required inventory levels for every item at every store according to historic sales patterns. We believe this permits lower overall investment in inventory while further improving our in- stock conditions.

We use scanning point of sale, or POS, systems in each of our stores. These systems allow better control of pricing, inventory

13 and shrink, while maximizing the benefits derived from the other parts of our systems application development program. POS also provides sales analysis that allows for improved labor scheduling and helps optimize product shelf space allocation and design by allowing detailed analysis of stock-keeping unit sales.

In 1999, DRD implemented computerized merchandise replenishment system for the 86% of front-end merchandise distributed to stores from its warehouse. Fully automated system uses item-specific and store-specific sales history to produce suggested orders for each store, which can be accepted or modified by the store before being released to the distribution center, improving in-stock conditions at reduced inventory levels.

(Emphasis added).

45. Several weeks later, in an April 9, 2002 press release, JDA Software Group, Inc.

("JDA") announced that Duane, a customer since 1994, will significantly enhance its ability to view sales trends in realtime and assess its capabilities through its use of JDA's host

Merchandise Management System ("MMS") at Duane's corporate headquarters. Duane had already been using JDA's "Retail IDEAS and "E3TRIM" software, and according to Duane's

Vice President of Management Information Systems Joe Lacko, "The analytic information we receive from Retail IDEAS enables us to better recognize trends, analyze inventory and target customers for our loyalty program...." (Emphasis added).

46. According to JDA's website, http://e3corp.com/RetaillDEAS.asp,

[r]etail IDEAS features powerful applications for retailers to analyze their business, monitor strategic plans and enable tactical actions. By fully integrating with JDA's merchandising and other primary business systems, Retail IDEAS ensures rapid access to current and consistent information for secure decision making. Retail IDEAS' "out-of-the-box" functionality includes over 100 pre-configured views that reflect retailers' most critical needs for quickly identifying problems, uncovering trends and understanding the impact of decisions before they're even

14 made. Users can also quickly build their own custom views tailored to their unique requirements."

(Emphasis added).

47. The aforementioned statements from the Company's former employees confirmed that the Company's computer system provided Defendants with, and the Defendants did in fact review, daily front-end sales records from the POS/RS 6000 computer system.

2. Costs Associated with Store Openings

a. Former Employee Statements

48. Statements from former employees of the Company confirm that Defendants knew that the Company was going to open 10 new stores at the outset of the Class Period and, as such, Defendants also knew any increased costs Duane would have associated with the new store openings. Additionally, the former employee in charge of opening the new stores during the first half of 2002 stated that the Company knew that it was behind in new store openings going into the second quarter and thus, knew it would be incurring higher opening expenses in the quarter.

49. A former pharmacy technician (W-5) who worked for the Company from

February 2001 to October 2002 at Company locations in Staten Island and Brooklyn stated that the Company takes "far longer" to open a store than it initially forecasts. The former employee, who assisted in all areas of the pharmacy, e.g. , handling inventory and stock, counting medications and filling prescriptions, accessing insurance information, and serving customers, stated that the Company typically needs 6 months to open a store.

50. Similarly, W-4 confirmed that there was usually a large lead time between the decision to open a new store and its opening. The former employee stated further that

15 merchandisers and senior management always knew about the new stores months in advance of its entry into the Company's computer system, which was at least 60 days before the store was set to open.

51. A former Director of Advertising (W-6) who worked in the Company's headquarters from October 2000 through October 2001 and was responsible for signage at each of the Company's new stores stated that once the Company knew a store was "coming open" they had a timetable that they followed which was "nearly always on track."

52. A former Merchandising Manager (W-8), who worked for the Company in 2001 through Mid-2002, was in charge of merchandising and "setting up all the new stores, resets, remodels, and so on." With respect to new store openings, W-8 and his team of approximately

70 people were involved in everything from the construction of new stores to opening the doors to the public. W-8 went to headquarters approximately two days a week, but was primarily in the field "trying to get stores up and running."

53. W-8 claims that the Company was "behind" on its new store opening plan at the outset of second quarter 2002. Accordingly, the Company "pushed" a number of openings from the first quarter into the second quarter. This alteration caused extra costs to be incurred in the second quarter. Indeed, W-8 opined that $1.5 million in expenses that the Company claimed to have incurred in the second quarter seemed like a "very low number."

54. In fact, W-8 claims that the Company's opening expenses should have been higher because the Company employed a scheme to amortize a portion of its payroll over the life of the store rather than recognize the payment as an expense against revenue in the second quarter. W-8 stated that due to the increase in costs associated with the greater number of store

16 openings, the Company came up with a scheme to decrease its payroll and thus, its expenses.

The Company created another payroll, "which we amortized into the building of the stores," W-8 said. When W-8 questioned the practice, management told W-8 that it was "legal." The

Company's practice of capitalizing certain pre-opening costs was in violation of generally accepted accounting principles ("GAAP"). GAAP are those principles recognized by the accounting profession as being the conventions rules and procedures necessary to define accepted accounting practices at a particular time. During the Class Period, Statement of Position

("S.O.P") 98-5, "Reporting on Costs of Start-up Activities," was in effect, providing guidance on financial reporting of start-up costs. This S.O.P. requires Duane to expense the costs of start-up activities as incurred. Start-up expenses include one time activities related to opening a new facility including all pre-opening costs. Thus, had defendants caused the Company accurately to report pre-opening costs, the total pre-opening costs would have exceeded the shockingly high reported pre-opening costs.

55. Based on the above statements from former employees, which independently confirmed that new store opening expenses were regimented and predictable and that the

Company knew it was going to incur greater store opening costs at the outset of the second quarter, any increased costs associated with the second quarter store openings were not a surprise to Defendants at the outset of the quarter and should have been disclosed as of April 25, 2002, at latest.

b. Historical New Store Pre-Opening Expenses

56. On November 15, 2001, the Company filed its Form 10-Q for the quarter ended

September 29, 2001 with the SEC. The 10-Q provided, in relevant part:

17 [wie incurred store pre-opening expenses of $1.4 million during the first nine months of 2001 related to the opening of 24 stores. Pre-opening costs of $1.1 million were incurred during the first nine months of 2000 for the opening of eighteen stores.

We incurred store pre-opening expenses of $0.5 million during the third quarter of 2001 related to the opening of nine stores. During the comparable period last year, we incurred pre-opening expenses of $0.3 million related to the opening of seven stores.

57. On March 29, 2002, the Company filed its annual report on Form 10-K for year ended December 29, 2001 with the SEC. The 10-K provided, in relevant part:

Store pre-opening expenses of $1.7 million related to the opening of 31 stores in 2001 as compared to $1.4 million reflecting 24 store openings in 2000.

58. The Note 1, "Organization and Significant Accounting Policies," to Consolidated

Financial Statements contained in the March 29, 2002 10-K provided that "pre-opening expenses" are "store pre-opening costs, other than capital expenditures, are expensed when incurred."

59. Notwithstanding their close monitoring of store openings and the exorbitant costs incurred in the second quarter, at no time prior to or during the Class Period did Defendants advise the public that it would incur "pre-opening expenses" of $1.5 million to open just 10 stores in the second quarter 2002.

3. Defendants' Close Monitoring of "Shrink"

60. Former Company employees consistently reported that the Company guarded against and monitored for "shrink," losses caused by theft and vendor errors very closely.

61. W-3 stated that Cuti's corporate policy was to be extremely tough on shoplifters.

According to W-3, "[Cuti] wants to know that people are arrested."

18 62. W-5 stated that management took theft very seriously and prosecuted to the fullest extent of the law. According to W-5, all shoplifters were turned over to police. Indeed, W-5 recalls that a number of employees were fired for infractions as minor as eating out of date candy bars that were being returned to the manufacturers. W-5 stated that the Company's internal reputation of dealing very harshly with theft kept such activity to a minimum as compared to similar stores.

63. W-4, who was involved in monitoring inventory, stated that the Company took shrink very seriously and tracked it closely. Moreover, W-4 said that the "[Company] wouldn't

stand for errors [and] managers would get fired if their stores had greater than 5% shrink." As

such, shrink rarely had an effect on the Company's earnings. Moreover, W-4 stated that vendor

errors, such as shipping errors, which contributed to shrink figures were disclosed to Defendants

as they occurred. W-4 explained that the Company would check the manifest against the items

actually shipped to the Company, so that if only 7 of 10 items were in the shipment, only 7 would

get booked into inventory.

64. Because Defendant monitored for shrink very closely and remedied any instances

of shrink as they occurred, Defendants knew or were reckless in not knowing that it was

occurring far more than Defendants had led the market to believe throughout the Class Period.

Defendants had a duty to disclose any such material increase in shrink to investors.

DEFENDANTS' MOTIVE AND OPPORTUNITY

65. Defendants were motivated to inflate earnings improperly, in turn to inflate the

Company's stock price artificially. Given the necessity for Defendants to grow Duane Reade's

business through expansion and acquisition, a high stock price was essential. With regard to

19 expansion, Duane sought to open stores at a fast pace, requiring that the Company have access to capital at low rates of interest, lest it be saddled with debt expenses that rendered any accretive effect of its expansion illusory. With regard to expansion through acquisition, Defendants caused

Duane to use its own common stock as currency to acquire pharmacies. The artificially inflated stock price enabled Defendants to acquire pharmacies for fewer shares.

66. In the 2001 10-K, the Company described the progress of its expansion. During fiscal 1999, Duane closed one store and opened 21 stores, an approximately 15.5% expansion in the number of stores. During fiscal 2000, Duane closed one store and opened 24 stores, an approximately 16% expansion in the number of stores. During fiscal 2001, Duane closed 1 store, lost 2 stores in the September 11 terrorist attack, and opened 31 stores, an approximately 14% expansion in the number of stores. Had it not lost two stores, Duane would have posted a 16.8% expansion rate for 2001, in line with the previous two years.

67. The Company tied its capital requirements directly to its expansion, stating, in the

2001 10-K:

Our capital requirements primarily result from opening and stocking new stores, remodeling and renovating existing retail locations and from the continuing development of management information systems. We believe that there are significant opportunities to open additional stores, and currently plan to open approximately 60 to 70 stores during the next two years. . . .

68. The September 11 terrorist attacks on New York City did nothing to halt Duane

Reade's aggressive expansion plans. A January 7, 2002 article in Grain 's New York Business, for example stated:

Rather than halting its aggressive growth trajectory, New York's No. 1 drug chain, Duane Reade, has quickly adapted to the post-

20 September 11 business environment. CEO Anthony Cuti shifted his focus, speeding up construction of stores in areas that are more densely populated since the attack, such as Times Square. Mr. Cuti believes so strongly in the city that the Company opened 30 stores last year, topping its original budget by five units. . . .

69. Indeed, in a February 20, 2002 press release announcing the Company's results for the fourth quarter and full fiscal year, 2001, Defendant Cuti stated, "[w]ith respect to our performance for the upcoming year, in view of our ability to maintain our originally scheduled store opening plan, we believe that our expectations for fiscal 2002 are achievable. . .."

70. In addition to discussing the Company's planned expansion, the 2001 10-K detailed the effects of the Company's debt obligations:

We believe that, based on current levels of operations and anticipated growth, cash flow from operations, together with other available sources of funds, including additional borrowings under our credit agreement, will be adequate for at least the next two years to make required payments of principal and interest on our indebtedness, to fund anticipated capital expenditures and working capital requirements and to comply with the terms of our debt agreements. .. . Our ability to meet our debt service obligations and reduce our total debt will depend upon our future performance which, in turn, will be subject to general economic, financial, business, competitive, legislative, regulatory and other conditions, many of which are beyond our control. In addition, we cannot assure you that our operating results, cash flow and capital resources will be sufficient for repayment of our indebtedness in the future. Substantially all of our borrowings under the Restated Credit Agreement bear interest at floating rates. Therefore, our financial condition will be affected by changes in prevailing interest rates.

71. In the Notes to the Consolidated Financial Statements in the 2001 10-K, the

Company disclosed its debt structure, including a term loan facility and a revolving credit facility received pursuant to a 1998 Credit Agreement and 9 1/4 Senior Subordinated notes ("2008

21 Senior Notes"). With respect to the Credit Agreement, due in large part to a June, 2001, follow- on equity offering, which raised $130.4 million, the company was able to negotiate improved financing terms, manifest in a Fourth Restated Credit Agreement. The Company stated:

As the financing requirements of the Company increased, reflecting the growth in the Company's acquisition activity and new store development, the Credit Agreement was amended and restated commensurately. Each subsequent change provided the Company with increased availability of revolving and/or term loan borrowing, which were used for capital expenditures, working capital needs and general corporate purposes.

72. Importantly, the Restated Credit Agreement permitted the Company to increase its annual capital expenditures from $30 million to $50 million "and certain restrictive covenants were modified to provide the Company with additional flexibility." The Company disclosed that

"[a]t December 29, 2001, the weighted average combined interest rate on all borrowings under the Restated Credit Agreement, including the impact of the interest rate swap transaction which had an effective date of January 12, 2001, was 7.83%."

73. But the Company had still further high cost debt. In 1998, it issued the 2008

Senior Notes. The aggregate principle amount was $80 million and the interest rate was 9 1/4 % per annum, payable semi-annually in arrears. The 2008 Senior Notes were to expire on February

15, 2002. Sometime prior to April 10, 2002, the Company determined to eliminate the high cost of the 2008 Senior Notes. This too would increase the Company's ability to expand, using lower cost debt.

74. Toward that end, in a press release on April 10, 2002, when the Company announced its intention to raise approximately $110 million in gross proceeds through an offering of 20-year convertible notes. According to the announcement, the Company intended to

22 use the net proceeds of the offering to repay amounts outstanding under its senior credit facility

and for general corporate purposes, which may have included the purchase of a portion of the 9

1/4% Senior Subordinated Notes due 2008. The release indicated that the 20-year notes would be convertible into shares of Duane Reade common stock.

75. On April 11, 2002, the Company announced that it had priced its previously announced offering of 20-year Senior Convertible Notes due 2022 ("2022 Senior Notes").

The Company anticipates that the transaction will close on April 16, 2002. The securities will be senior unsecured notes convertible into shares of Duane Reade Inc. common stock under certain conditions. The underwriter also has an option to exercise an over allotment option for up to 15% of the amount of this offering. Each Senior Convertible Note has a yield to maturity of 3.75% and is convertible into 14.1265 shares of Duane Reade's common stock. The Company intends to use the net proceeds of the offering to repay amounts outstanding under its senior credit facility and for general corporate purposes, which may include the purchase of a portion of the 9-1/4% Senior Subordinated Notes due 2008."

76. In a Current Report on Form 8-K, filed with the SEC on April 16, 2002, the

Company reported the completion of the note offering announced on April 10, 2002. The offering was for $381.5 million in convertible notes that netted the Company $210 million in proceeds. The Company intended to, and did in fact, use the proceeds throughout the second quarter to pay off certain outstanding debt, including to repay indebtedness under the term A and term B loans under the Credit Agreement and to purchase a portion of the 2008 Senior Notes.

77. Indeed, in its Earnings Conference Call for the first quarter of fiscal 2002, held on

April 25, 2002, in response to a question regarding Duane's progress in repurchasing the 2008

Senior Notes, CFO John Henry stated:

23 we are actively engaged in that effort. We have not provided for any benefits in the guidance associated with interest savings, that we would expect to get on completion of the retirement of some of the higher interest forms of debt. We expect to have a clear picture by the end of 2002. We are moving quickly and may even get benefit before that. There is going to be a slight negative carry for the period until we get some more debt back, but that is being worked on.

78. Similarly, in an interview on CNBC on April 25, 2002, defendant Cuti touted the recent offering of the 2022 Senior Notes, stating:

We were really pleasantly surprised that most of [the] Street advised us that at our capital structure and size, we probably could only float $100 million or $125 million. The offering was extremely well received, another endorsement of the strength of the relationship between the company and the Street. And we have every intention to apply the proceeds to reduce debt. It will reduce our debt interest load to as much as half of the rate we were paying for prior years.

79. Duane Reade's interest expenses during fiscal 2000 and fiscal 2001 were $35.9 million and $27.6 million respectively. Thus, reducing the Company's interest expense by one half as anticipated by the 2022 Senior Notes offering would add materially to Duane's bottom line and also make the cost of capital lower, enabling it to fuel its program of growing through new store openings.

80. In a May 3, 2002 press release, the Company announced that it had commenced a tender offer for all of the 2008 Senior Notes. The Company also sought "consents to certain proposed amendments to the Indenture under which the notes were issued. In a May 21, 2002 press release, the Company announced that it had received consent to eliminate "substantially all of the restrictive covenants of the indenture governing the [2008 Senior] Notes and to make

24 certain other amendments. . .." Finally, in a June 3, 2002 press release, the Company announced the successful completion of the tender offer for the 2008 Senior Notes.

81. On June 21, 2002, the Company filed a Registration Statement on Form S-3 with respect to the 2022 Senior Notes ("S-3"). According to the S-3, the purpose of registering the

2022 Senior Notes was to enable holders to sell the notes to the public and to register the 5.389 million shares of common stock into which the 2022 Senior Notes could be converted. The 2022

Senior Notes were issued with a $1,000 principal amount at maturity, but were sold at a discounted price of $572.76. The conversion rate at which the notes could be converted to

Duane common stock was tied directly to the stock price on or around the time Duane offered the

2022 Senior Notes for sale and subsequently registered them to the public. Accordingly, critical to the 2022 Senior Notes was the conversion rate. Upon the occurrence of specified triggering events, holders of the 2022 Senior Notes were entitled to convert those notes into 14.1265 shares of Duane common stock.

82. The S-3 discussed the note to stock conversion procedure as follows:

Holders may surrender notes for conversion into our shares of common stock in any fiscal quarter commencing after June 29, 2002 if, as of the last day of the preceding fiscal quarter, the sale price of our common stock for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading day of such preceding fiscal quarter is more than 110% of the accreted conversion price per share of common stock on the last day of such preceding fiscal quarter.

*****

The conversion trigger price per share of our common stock in respect of each of the first 20 fiscal quarters following issuance of the notes is $44.60. This conversion trigger price reflects the accreted conversion price per share of common stock, multiplied

25 by 110%. Thereafter, the accreted conversion price per share of - common stock increases each fiscal quarter by the accreted original issue discount for the quarter.

83. Thus, for the first five years after issue, if the trading price of Duane was $44.60 during the required period, holders of the 2022 Senior Notes were entitled to convert those notes to Duane common stock. As the Company noted, "[o]n June 20, 2002, the last reported sale price of the common stock on the NYSE was $32.50 per share," nearly 73% of the threshold for conversion.

84. Convertible securities can be considered to include embedded options.

Convertible securities give the holder a right to convert a given security to an alternative security.

Convertible securities can be a way for investors to hedge. They allow them to acquire a debt instrument, for example, with its rights to interest and principal payments, without sacrificing the chance to participate in the company's stock price appreciation. When a company does well, the investor can convert his debenture into stock that is more valuable. When a company is less successful, the investor can retain his debenture and receive his interest and principal payments.

85. If the price of Duane's common stock at or around the time it offered the 2022

Senior Notes for sale and registered those Notes for public sale had been far lower than the $30 range, Duane would have been forced to increase the conversion ratio to borrow the same amount. It follows that the greater the risk that an investor will be unable to convert, that is the greater the conversion ratio, the higher the interest rate would have had to be.

86. Thus, if Duane's stock price in April or June, when it sold 2022 Senior Notes and registered both those notes and the underlying common stock respectively, had been approximately $15 per share (the price to which it fell after the July 25, 2002 announcement

26 ending the Class Period) instead of approximately $32 per share, the Company would have been forced either to increase the conversion ratio or to increase the amount of interest it was to pay or both if it wanted to borrow the same amount as it ultimately did. This would have rendered the

2022 Notes far more expensive to sell in the first place, disabling Duane from redeeming its high cost debt or substantially raising the cost of that redemption. Moreover, it also would have had a deleterious dilutive effect, requiring Duane to register far more shares to cover the conversion.

Thus, Duane was motivated to maintain the price of its common stock at artificially inflated prices to enable it to complete the sale and registration of its 2022 Senior Notes on its terms.

87. The Company also was motivated to inflate the price of its stock artificially to reduce the costs of its acquisitions. In 1999, 2000, and 2001, the Company paid $2.1 million,

$24.6 million and $25.3 million respectively to purchase chain and individual drug stores. By contrast, in 2002, "[d]uring the first six months of fiscal 2002, the Company acquired the customer files of six pharmacies and the operations.. . of seven pharmacy establishments," for a total cost, "principally paid for by the issuance of common stock," of $17.3 million.

88. Thus, Defendants were motivated to maintain the price of the Company's common stock at artificially inflated prices to lower its interest expense and in turn promote both greater expansion through both new store openings and acquisitions using common stock as currency.

BACKGROUND STATEMENTS

Fourth Quarter 2001 Results and First Quarter 2002 Projections

89. In a February 19, 2002 press release, Defendants caused the Company to announce publically its results for the fourth quarter and fiscal year ended December 29, 2001.

27 Despite the tragic events of September 11, 2001, the Company reported "record" sales and earnings for the year and fourth quarter. According to the Company, net income for 2001 grew

8.8 percent to $24.7 million from $22.7 million in 2000. Additionally, sales during fiscal 2001 (a

52-week period) purportedly increased 14 percent to $1.14 billion from $1 billion in fiscal 2000

(a 53-week period). On a comparable 52-week basis, the Company claimed that sales improved

16.3 percent, with pharmacy sales rising 28.7 percent and front-end sales rising 9.5 percent.

90. As to the fourth quarter 2001, the Company claimed that the September 11, 2001 attacks and their aftermath reduced net profits for the year by an estimated $6.5 million and sales by $27 million. Notwithstanding the profit reduction, the Company posted a 4.7 percent increase in net income for the fourth quarter 2001 as compared to the same quarter in 2000 ($10 million v.

$9.55 million).

91. About those results, Defendant Cuti stated:

It is important to note that fourth quarter earnings were adversely impacted by the aftermath of the September 11 th disaster and subsequent anthrax incidents which had the combined effect of depressing front-end sales and gross margins. ...

Clearly, our fourth quarter performance was materially impacted by the business and consumer disruptions that occurred in New York City following the tragic events of September 11 th. Therefore, reported results should not be considered as representative of the Company's normal performance, nor indicative of the inherent potential of the business. It is more important to recognize that our in-depth knowledge of the metro New York market not only enabled us to accurately project revenues for the quarter, despite the magnitude of the disruptions and the market relocations that occurred, but also to operate our business by appropriately controlling costs.

(Emphasis added).

28 92. Cuti stated further:

Despite the difficult conditions of fiscal 2001 and the challenges stemming from the events of September 11th, the Company's financial outlook remains positive. For the first quarter 120021, the Company anticipates sales of $310 million and diluted earnings per share between $0.21 and $0.23.... For the full 2002 fiscal year, the Company anticipates that sales will total approximately $1.3 billion and expects to achieve diluted earnings per share between $1.62 and $1.67. ...

As we enter fiscal 2002, we remain confident in the strength of Duane Reade and are optimistic about the long-term prospects for both our business and market. Although front-end sales have not yet returned to pre-disaster sales growth levels, we are witnessing a consistent improvement in general market conditions as the city and surrounding areas adapt to the many changes induced by the disaster. In fact, it is likely that the metro New York area will benefit significantly in the mid-to long-term due to the expected infusion of rebuilding capital. Based on this, our market could actually become a uniquely positive one relative to the balance of the U.S. With respect to our performance for the upcoming year, in view of our ability to maintain our originally scheduled store opening plan, we believe that our expectations for fiscal 2002 are achievable. Additionally, we are also looking forward to a fair and timely resolution of our business interruption insurance claim which, if resolved expeditiously, will contribute additional capital and income not currently reflected in our 2002 guidance.

(Emphasis added).

93. The release qualified the above statements with boilerplate language found in virtually every Company publication -- "It is important to note that the above expectations are the

Company's current targets and not predictions of actual performance. Actual results may differ materially from these projections."

29 94. By touting their ability to accurately project revenues and earnings in the face of an unpredictable disaster, Defendants lent credibility to their representations that would mislead investors during the Class Period. Defendants' positive assurances continued the very next day.

95. On February 20, 2002, Cuti appeared on CNN's "The Money Gang." Cuti reaffirmed Defendants' confidence in the Company's ability to project results in the aftermath of

September 11th. He stated,

we took a look at '02 and we released at the end of September that we thought the '02 impact was going to be about $65 million in lost volume. We're holding firm on that estimate. Our guidance, that we just released, is still projecting about that level of lost volume versus where we would have been. That — the fourth quarter we estimated would come in at $300 million at the end of September and it did. So that sort of fortified the fact that our look is, in fact, the way we're trending in this market.

(Emphasis added).

96. Cuti also gave an interview to CNBC on February 20, 2002, wherein Cuti engaged in the following question and answer session:

CUTI: I think our results are rebounding, but certainly showing that effect.

Q: What's your overall take on the earnings? And then, if you would, quantify to what extent because of the heavy New York emphasis you ended up losing, I guess, what, $0.15? You're quantifying that $0.15?

COTT: Correct.

Q: Tell us about that.

Well, the fourth quarter clearly had the impact of 9-11. The guidance we gave for the quarter was released at about September 28. And with the shadow of 9-11 right behind us I think we took our best stab of where we were going for the quarter. In

30 retrospect, we were virtually spot on our volume estimates. Our mix was a little bit more toward the pharmacy, a little bit lighter in the front end, but overall we were satisfied with the performance. I think in our conference call this morning we also released the fact that every subsequent month in the fourth quarter, October, November, December, has shown an improving trend in sales and most notably our year to date results through '02 current day are even improved since December. So we're very positive about where the market's going.

Q: Let's take a look, if we can get a two year chart, let's talk share price for a minute. You've got a range of $26 to $39 and we're sort of about $2 away from the lows here. Your guidance for next year is a tad under estimates. So what do shareholders need to know here, and potential shareholders, about your stock and why they should either hold it or buy it if they don't?

CUT!: Well, I think the shadow of September 11 raised a specter, an aura of whether Duane Reade could survive this blow, and I think the fourth quarter and our guidance is saying definitively yes. I think the concern was reflected in the stock. Just prior to 9-11, we were in the mid to high $30s and then I think the concern of the disaster dampened the price. Hopefully the fourth quarter and our guidance for '02 now with the fourth quarter behind us will take that doubt away.

(Emphasis added).

97. In a March 10, 2002, Cosmetics International article, Defendants again touted their ability to succeed in the post-9/11 New York market and again relayed their positive outlook for 2002:

US drug store chain Duane Reade has said that its last quarter results were seriously affected by the September 11 events, though it reported earnings per diluted share for the quarter and fiscal 2001, ended 29 December 2001, at $ 0.42 and $ 1.20 respectively. The company also saw net sales for the quarter reach $ 300.1mn up 12.2% and fiscal 2001 results reach $ 1.144bn, up 16.3%. The company said that its fourth quarter results were adversely impacted by the terrorist events and anthrax incidents which had the combined effect of depressing front end sales and gross

31 margins. However, despite these events, during the year, Duane Reade opened or acquired 31 stores, closed three, and remodeled or relocated seven stores. As of 29 December 2001, it operated 200 stores in the US.

The company is optimistic about its future as well. Anthony J. Cuti, Chairman of the Board and CEO of Duane Reade said, "As we enter fiscal 2002, we remain confident in the strength of Duane Reade and are optimistic about the long term prospects for both our business and market." He went on to say that although front end sales have not returned to pre-September 11 levels, there is "a consistent improvement in general market conditions as the city [New York, US] and surrounding areas adapt to the many changes induced by the disaster."

He added that the company believes its expectations for fiscal 2002 are achievable. Duane Reade is expecting sales of $ 31Ornn in the first quarter of 2002 with sales to be around $ 1.3bn for the year as a whole.

98. Thus, by the beginning of the Class Period, Defendants had convinced the market that they understood the impact of New York's economic downturn, that they had included provisions for that downturn in the Company's second quarter forecast and that the underlying economic condition in New York City was improving. Unbeknownst to investors, however,

Duane's second quarter 2002 results revealed that the Company's front-end sales were declining at the beginning of the Class Period and did not improve until the end of June 2002.

FALSE AND MISLEADING STATEMENTS

99. On April 1, 2002, the start of the Class Period, the Chain Drug Review published an article entitled "Duane Reade Posts Record Sales, Profits in Fiscal '01." The article provided that, despite the tragic events of September 11, 2001, "Duane Reade reported record sales and fully taxed earnings for the year and quarter ended December 29." The article went on to discuss

32 the Company's fourth quarter and fiscal year 2001 results detailed above, and excerpted the following from Defendant Cuti's February 19, 2002 commentary.

[c]learly our performance was materially impacted by the business and consumer disruptions that occurred in New York City following the tragic events of September 11. Therefore, reported results should not be considered as representative of the company's normal performance, nor indicative of the inherent potential of the business.

It is more important to recognize that our in-depth knowledge of the metro New York market not only enabled us to accurately project revenues for the quarter, despite the magnitude of the disruptions and the market relocations that occurred, but also to operate our business by appropriately controlling costs.

(Emphasis added).

100. The April 1, 2002, Chain Drug Review article also provided the following from

Cuti concerning the Company's outlook:

As we enter fiscal 2002 we remain confident in the strength of Duane Reade and are optimistic about the long-term prospects for both our business and market. Although front-end sales have not yet returned to predisaster growth levels, we are witnessing a consistent improvement in general market conditions as the city and surrounding areas adapt to the many changes induced by the disaster.

In fact, it is likely that the metro New York area will benefit significantly in the mid- to long-term due to the expected infusion of rebuilding capital. Based on this, our market could actually become a uniquely positive one relative to the balance of the United States.

(Emphasis added).

101. Defendants statements contained in the April 1, 2002, Chain Drug Review concerning the Company's front-end sales were false and misleading as of April 1, 2002 because

33 Defendants failed to include the following adverse factors, which were necessary to make the statements not misleading:

a. the Company's front-end sales were decreasing; and

b. the Company had incurred or was already incurring $1.5 million in

unexpected expenses to open 10 new stores during the quarter.

102. Defendants knew that the statements concerning the trend of the Company's second quarter 2002 front-end sales were false and misleading because:

a. Defendants second quarter records demonstrate that the Company's front-

end sales were decreasing as of April 1 and did not improve until the end

of the second quarter. Additionally, various former employees

independently confirmed that management, including Defendant Cuti

reviewed one-third of the Company's second quarter sales and earnings

results on a daily and weekly basis, which demonstrated that front-end

sales and earnings were declining by April 1, 2002. Specifically,

management, including the Individual Defendants, (1) received and

reviewed real time daily reports of the Company's sales figures compiled

from the Company's POS computer system and broken down (in dollar

amounts) by district and by pharmacy and front-end sales categories; (2)

received formal weekly reports that were detailed and categorized by

merchandise categories such as aspirin, depilatory, cosmetics, fragrances,

general merchandising (such as holiday merchandise), and various drug

categories, which the Company used to determine what promotions were

34 working and how to revise earnings estimates; and (3) met every Tuesday

for an executive staff meeting wherein weekly sales reports were gone

over in "great detail". W-1 further confirmed that the reports included

"very specific information" that was broken down by detailed categories

within pharmacy and front-end sales all of which advised Defendants that

front-end sales were decreasing in the second quarter. b. management knew by April 1, 2002 that they were going to incur certain

costs upon opening 10 stores during the Class Period as it typically took

more than 6 months to bring a store on line, and management knew about

the new store openings more than three months in advance of the actual

opening. Moreover, once management knew a store was "coming open"

they had a timetable that they followed which was "nearly always on

track." Additionally, W-8 confirmed that the Company was "behind" on

its new store opening plan at the outset of second quarter 2002 and

"pushed" a number of openings from the first quarter into the second

quarter. This schedule change caused extra costs to be incurred in the

second quarter. Indeed, W-8 opined that the $1.5 million in expenses that

the Company claimed to have incurred in the second quarter seemed like a

"very low number." Additionally, W-8 stated that the number in fact was

higher, but not disclosed to the public, as the Company improperly

characterized certain employee salaries as "capital expenses" and

35 amortized them over the life of certain stores rather than expensing them

in the second quarter.

103. Defendants intentionally and/or recklessly made and failed to update and correct the April 1, 2002 statements so that:

a. Defendants could effectuate the last in a series of drugstore asset purchases

from Masta Pharmacy using the Company's artificially inflated common

stock as currency during the Class Period. Indeed, on May 24, 2002,

Duane issued Company common stock to Masta Pharmacy as

consideration for drugstore assets. The purchase followed similar stock-

based transactions on January 30, February 6, and February 8, March 4,

and April 8, 2002; and

b. Defendants could consummate the aforementioned April 10, 2002, $381.5

million convertible note offering and 5.389 million share issuance. Had

the truth been disclosed to the market concerning the Company's true

financial condition and Defendants' revenue manipulation schemes, the

stock price would have fallen and Defendants would not have been able to

consummate the offering on the stated terms. Indeed, Defendants would

have had to issue a great deal more shares of stock to effectuate the

transaction and net the Company $210 million in proceeds — money

needed to retire the Company's high-priced debt in furtherance of the

Company's expansion efforts.

36 104. Furthermore, Defendants' statements in the April 1, 2002 article touting their "in- depth knowledge of the metro New York market" and how that knowledge "enabled [them] to accurately project revenues" in 2001 added credibility to the Defendants' upcoming earnings guidance for the second quarter 2002. Accordingly, Defendants' statements assessing the condition of the New York market, including the impact of September 11, 2001 terrorist attacks, and how it would affect the Company's financial position, mislead and conditioned investors to believe that Defendants' future statements properly accounted for the post-9/11 economic environment.

First Quarter Results and Second Quarter Projections

105. On April 25, 2002, the Company released a statement touting "record sales and earnings" for the first quarter 2002 ending March 30, 2002. According to the release, the

Company's net sales increased 12.5 percent to $305.8 million and net income increased 100 percent from $2.6 million to $5.3 million, which was in-line with Company estimates. In breaking down the first quarter earnings, the Company reported that pharmacy same store sales increased 15.8 percent whereas same store front-end sales declined 1.3 percent. The Company attributed the decline to "the temporary dampening of front-end sales in the post-September 11 period and also ... to a $0.4 million LIFO provision in the period." However, the Company later that day claimed that while down from pre-9/11 levels, front-end sales showed an increasing trend throughout the first quarter that was expected to remain consistent, j, was better than January, March was better than February, and April through June would remain consistent with March levels.

37 106. Having witnessed this purported front-end sales trend through his daily review of the Company's first quarter finances and one-third of the Company's second quarter sales and earnings information, as detailed above, Defendant Cuti gave a positive outlook for the second quarter 2002. In fact, as part of the April 25, 2002 press release, Cuti stated that the Company expected to realize $335 million in net sales and earnings per share in the $.40 - $.44 range.

Commenting on the Company's future, Cuti stated the following in the press release:

We are particularly pleased with the record-breaking improvement in the rate of generic prescriptions filled during the first quarter and we expect that this will go a long way toward improving pharmacy gross margins going forward. Also noteworthy is the fact that we recently completed a $218 million convertible notes offering, which will enable us to significantly improve our capital structure and will allow us to more readily achieve — and potentially surpass — our earnings growth objectives. ...

Looking to the balance of the year, we have a positive outlook and remain confident in our ability to achieve our sales and earnings targets. With respect to the second quarter we anticipate achieving sales of approximately $335 million and expect diluted earnings per share will range from $0.40 to $0.44. For the full fiscal year, we expect revenue growth in the range of 15% to 18% over fiscal 2001 and net earnings between $1.64 and $1.68 per diluted share, exclusive of the one-time charge for the accounting change as well as any extraordinary costs related to the retirement of debt with the proceeds of the convertible note offering.

(Emphasis added).

107. Unbeknownst to investors, Defendants' statements in the April 25 th press release assuring investors that the Company would recognize income of $.40 - $.44 per share in less than two months were false and misleading when made as Defendants failed to include the following adverse factors, which were necessary to make the statements not misleading:

38 a. By April 25, 2002, with one month of the second quarter already complete,

Defendants knew the Company's front-end sales were decreasing; and

b. the Company had incurred or was incurring $1.5 million in unexpected

expenses to open 10 new stores during the quarter.

108. Defendants' statements were false and misleading because:

a. Defendants second quarter records demonstrate that the Company's front-

end sales were decreasing as of April 25 and did not improve until the end

of the second quarter. Additionally, various former employees

independently confirmed that management, including Defendant Cuti

reviewed one-third of the Company's second quarter sales and earnings

results on a daily and weekly basis, which demonstrated that front-end

sales and earnings were declining by April 25, 2002. Specifically,

management, including Cuti, (1) received and reviewed real time daily

reports of the Company's sales figures compiled from the Company's POS

computer system and broken down (in dollar amounts) by district and by

pharmacy and front-end sales categories; (2) received formal weekly

reports that were detailed and categorized by merchandise categories such

as aspirin, depilatory, cosmetics, fragrances, general merchandising (such

as holiday merchandise), and various drug categories, which the Company

used to determine what promotions were working and how to revise

earnings estimates; and (3) met every Tuesday for an executive staff

meeting wherein weekly sales reports were gone over in "great detail". W-

39 1 further confirmed that the reports included "very specific information"

that was broken down by detailed categories within pharmacy and front-

end sales all of which advised Defendants that front-end sales were

decreasing in the second quarter. b. management knew on April 25 that they were going to incur certain costs

upon opening 10 stores during the Class Period as it typically took more

than 6 months to bring a store on line, and management knew about the

new store openings more than three months in advance of the actual