Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 1 of 202

IN THE UNITED STATES DISTRICT COURT FOR THE NORTHERN DISTRICT OF ILLINOIS EASTERN DIVISION

In re SPIEGEL, INC. SECURITIES ) LITIGATION ) ) No. 02 C 8946 ) This Document Relates To: ) ) ALL ACTIONS. ) )

THIRD CONSOLIDATED AMENDED COMPLAINT

Lead Plaintiffs, as defined herein, have alleged the following based upon the investigation of their counsel, which included a review of United States Securities and Exchange Commission

(“SEC”) filings by Spiegel, Inc. (“Spiegel,” “Spiegel Group” or the “Company”), as well as regulatory filings, and reports, securities analysts’ reports and advisories about the Company, press releases and other public statements issued by the Company, interviews with former employees of

Spiegel, review of the allegations contained in concurrent actions pending against the Company, the

Independent Examiner’s Report Concerning Spiegel, Inc. (“Independent Examiner’s Report”), review of the Consent Order styled In the Matter of First Consumers National Bank (“OCC Consent

Order”), and media reports about the Company, and Lead Plaintiffs believe that substantial additional evidentiary support will exist for the allegations set forth herein after a reasonable opportunity for discovery. Because Lead Plaintiffs have not had a full opportunity to review documents provided to the Independent Examiner, allegations concerning the Independent

Examiner’s findings are asserted upon information and belief based upon the Independent

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NATURE OF THE ACTION

1. This is a federal securities class action on behalf of purchasers of Spiegel Class A

Non-Voting common stock (“common stock”) between February 16, 1999 to June 4, 2002, inclusive

(the “Class Period”), seeking to pursue remedies under the Securities Exchange Act of 1934 (the

“Exchange Act”).

2. Spiegel is a retail marketer of apparel and home furnishings. The Company was

founded in 1875 and, since that time, was well-known throughout the country for its catalog sales

and more recently its Eddie Bauer chain of retail stores. This case concerns a massive financial

fraud at Spiegel whereby hundreds of millions of dollars of earnings were manufactured and billions

of dollars of debt was artificially removed from the Company’s balance sheet through accounting

manipulations. These accounting manipulations, as well as other fraudulent conduct at the

Company, were employed by Defendants to mask Spiegel’s deteriorating financial condition.

Unable to sustain its financial ruse, Spiegel was forced to file for bankruptcy. As a result of the bankruptcy, Spiegel shareholders are likely to see their interests in the Company extinguished.

3. Prior to the start of the Class Period, Spiegel’s business was performing poorly as the

Company’s catalog business was facing increased competition among Internet retailers, among others, and Eddie Bauer was experiencing difficulties and declining same-store sales. By at least the start of the Class Period, in an effort to reverse these negative trends, Spiegel, through First

Consumers National Bank (“FCNB”), its wholly-owned banking subsidiary, aggressively increased its marketing and issuance of millions of “private-label” credit cards to its customers. Spiegel’s massive credit extension strategy provided high risk, sub prime borrowers an expanded ability to purchase products from Spiegel’s catalogs, thereby increasing Spiegel’s reported sales. Indeed, from

1998 to 2000, at the very time that the Company significantly relaxed its credit extension practices,

Spiegel reported an increase of sales from $2.6 billion to over $3.0 billion. During this same time,

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Spiegel repeatedly issued statements highlighting the seemingly positive performance of the

Company and its increase in sales and earnings. From all appearances, Spiegel was experiencing a

revitalization and it was reflected in the price of its stock, as the price of Spiegel common stock rose

from $8.00 per share on the first day of the Class Period to $14.75 per share, on November 8, 1999, a

Class Period high.

4. At this time, and as a result of its increased issuance of credit cards, Spiegel’s

reported credit card receivables rose precipitously. As it had done in the past, Spiegel securitized

many of its credit card receivables.1 That is, the Company purportedly sold certain of its credit card

receivables to a trust. The trust then sold notes to the public, collateralized by the credit card receivables.

5. During the Class Period, Spiegel securitized more than $2.0 billion of credit card receivables. As noted below, Spiegel fraudulently recognized and reported hundreds of millions of dollars in “gains” in connection with these securitizations.

6. Thus, during the Class Period, Spiegel created the illusion that it was performing well. Unbeknownst to investors, however, Spiegel was a house of cards waiting to collapse. In

truth, Spiegel orchestrated a ponzi-scheme type financing arrangement that allowed Spiegel to

monetize its high risk, sub-prime credit card financing without recording debt, and falsely recorded hundreds of millions of dollars in “gains” on the very same transactions.

1 Securitization is also called “structured finance” because the legal and accounting relationships are structured in such a way as to remove assets from the balance sheet of the originator by selling them to special purpose entities (“SPEs”) in a “true sale” transaction. Removing the receivables from the issuer’s financial statements, particularly in the case of a federally insured financial institution like FCNB, allows the issuer to maintain lower levels of capital against its assets and still comply with federally imposed capital requirements. The consumer who has a credit card does not experience any change in his perceived relationship with the Bank. Only the legal relationships and the resulting accounting treatment are changed.

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7. Moreover, as was revealed at the end of the Class Period, FCNB lacked even the most

basic internal controls over its credit card receivables. In short, FCNB had extended credit to the

riskiest of borrowers and did not have the ability to remotely track and monitor such financings.

8. As detailed herein, Spiegel reported hundreds of millions of dollars in phony gains

and concealed billions of dollars of debt through the use of clandestinely controlled special

purpose entities (“SPEs”). In so doing, the Spiegel materially inflated its profits and hid billions of

dollars of debt that was required to have been reported on its balance sheet. In this way, Spiegel

inflated its operating results, financial strength and credit rating and allowed its wholly-owned bank

subsidiary, FCNB, to maintain less regulatory capital than would have been required had it

accounted for its transactions in accordance with Generally Accepted Accounting Principals

(“GAAP”).

9. Ultimately, however, the Defendants’ financial charade came to an end and Spiegel

filed for bankruptcy in March 2003.

10. In fact, even if the transfer of Spiegel’s credit card receivables was a true sale, which

it was not, Spiegel was otherwise precluded from recording any gains on the transfer of the

receivables to the trusts. Indeed, Spiegel, through FCNB, had an inadequate basis upon which to

base the assumptions it utilized in calculating a gain on the sale of the credit card receivables. As

detailed herein, and as set forth in the OCC Consent Order with the Office of the Comptroller of

Currency (the “OCC”), FCNB lacked the most rudimentary of banking records necessary to track and manage its credit card portfolio. Thus, the assumptions used by Spiegel were not based on any

reliable data. This fact alone precluded Spiegel from recording hundreds of millions of dollars in gains during the Class Period upon the transfer of credit card receivables to SPEs.

11. Moreover, throughout the Class Period, Spiegel falsely and misleadingly characterized its receivable securitizations as being “non recourse” in nature. In truth, however,

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Spiegel was contingently liable to repay SPE noteholders approximately $20 million monthly.

Only after the Class Period, when Spiegel belatedly filed its 2001 Form 10-K, did the Company’s financial statements disclose such contingent liability.

12. In addition, during the Class Period, Spiegel misrepresented the finances and operating condition of FCNB. Throughout the Class Period, Spiegel issued statements concerning

FCNB and its positive performance. Unbeknownst to investors, however, and contrary to Spiegel’s positive portrayal, FCNB was in complete shambles and in gross violation of federal banking regulations.

13. By the beginning of 2002, the fraud at Spiegel was starting to unravel. On February

21, 2002, Spiegel shocked the market by announcing that it would be selling FCNB and that in connection with that sale it had accrued a loss of $310 million. In response to this announcement the price of Spiegel stock declined 11%.

14. In furtherance of their scheme to defraud investors about Spiegel’s true financial condition, Spiegel, as detailed herein, knowingly and fraudulently withheld the filing of its 2001

Form 10-K with the SEC. In fact, Spiegel delayed issuing the Form 10-K and all other periodic filings for the following fifteen months in order to prevent having investors learn that its auditor,

KPMG, would be issuing a “going concern” opinion on the Company’s financial statements, which would damage the price of Spiegel stock.

15. On June 4, 2002, it was revealed that Spiegel would have “going concern” qualification placed on its independent auditors’ report when the Company filed its Form 10-K for the year ended December 29, 2001.

16. Finally, on March 7, 2003, Spiegel issued a press release announcing that the SEC had commenced a civil proceeding in federal court in Chicago against the Company. According to the press release, the SEC alleged, among other things, that the Company’s public disclosures

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violated Sections 10(b) and 13(a) of the Exchange Act of 1934. Simultaneous with the filing of the

SEC’s complaint, the Company announced that it had entered into a Consent and Stipulation with

the SEC resolving, in part, the claims asserted in the SEC action. The press release further reported

that the Company had consented to the appointment of an independent examiner by the court to

review its financial records since January 1, 2000, and to provide a report to the court and other

parties regarding its financial condition and financial accounting.

17. In the Consent and Stipulation, the SEC alleges, in part, that the Company and its

Board of Directors were advised in February 2002 prior to the release of the Company’s earnings

announcement on February 22, 2002, by their auditor that the auditor had “substantial doubts” about

Spiegel’s ability to continue as a “going concern.” Furthermore, the SEC alleges that the Company

delayed the filing of its Form 10-K in order to avoid disclosing the going concern qualification.

18. On March 17, 2003, the Company filed for protection under Chapter 11 in the

Bankruptcy Court in the Southern District of New York and it is likely that Spiegel shareholders will

have their interests in the Company extinguished in the bankruptcy.

19. It was only the prospect of an SEC Enforcement Division investigation that made

Spiegel begin to belatedly file reports in February 2003 – after not having filed a single periodic report since November 2001 (its third-quarter 2001 Form 10-Q). This 15-month hiatus in periodic reporting left investors without the disclosures and other protections mandated by the federal securities laws. All investors could do during this period was to attempt to piece together several incomplete pieces of information from a few press releases and news stories.

20. This matter involves not simply a failure to make required SEC filings. Rather, it involves a failure to make disclosure of material information about Spiegel’s financial condition that investors needed to make their investment decisions about Spiegel. The SEC has already charged

Spiegel with fraud for failing to disclose its auditors’ going concern position. But as discussed

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below, investors likewise failed to get a variety of other material information about Spiegel’s financial condition, including:

(a) The material adverse change in Spiegel’s balance sheet: In just the few months leading up to Spiegel’s failure to file its 2001 Form 10-K in March 2002, its shareholders’ equity dropped from $792 million to $215 million, its total assets shrank from $2.7 billion to $1.9 billion, and its cash and equivalents dropped from $73 million to $29 million;

(b) The full story of the material adverse change in Spiegel’s performance during

2001: Spiegel went from net earnings of $121 million in 2000 to a loss of $587 million in 2001, from operating income of $172 million in 2000 to a loss of $226 million in 2001, and from earnings from continuing operations of $112 million in 2000 to a loss of $285 million in 2001. In addition,

Spiegel’s only public statement in this regard – contained in a February 2002 earnings release – materially understated the magnitude of its poor performance in 2001;

(c) Spiegel was in a liquidity crisis and would soon be illiquid: Its liquidity shortfall was $317.6 million in Spring 2002 and could be significantly greater. Its survival depended on continuing capital infusions from Otto affiliates, which were under no obligation to make these capital infusions;

(d) Spiegel faced the possibility of involuntary bankruptcy from at least two directions: It was in default on all of its bank loan covenants, and its lenders could force it into bankruptcy. Additionally, Spiegel was deferring payments to certain of its vendors, who likewise could have pushed it into bankruptcy; and

(e) Spiegel’s efforts to restructure its debt were running into serious obstacles:

Negotiations with lenders were increasingly difficult for Spiegel due to: (i) significantly worse sales forecasts; (ii) severe credit restrictions being imposed by federal regulators on Spiegel’s credit card bank, with resulting further negative impact on sales; (iii) advice that Spiegel’s credit card

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receivables portfolio was overvalued; and (iv) the fact that its credit card bank could not be sold in its present condition.

21. Nor were investors told that Spiegel had engaged in a number of undisclosed material accounting irregularities, as detailed herein, including:

(a) Deliberate manipulation of Spiegel’s “interchange rate” (a fee purportedly charged Spiegel’s retail companies by its credit card bank) in order to enhance reported performance of Spiegel’s credit card receivables: Spiegel did this to avoid hitting a “trigger” that would plunge

Spiegel’s asset-backed securitization transactions into a “rapid amortization” that would have doomed Spiegel over a year earlier to the bankruptcy it eventually filed in 2003;

(b) Failure to disclose, at various times throughout 2000 and 2001, additional violations and waivers of triggers in Spiegel’s securitization transactions, as required by GAAP and the SEC: Had Spiegel failed to obtain waivers, the consequences for Spiegel’s viability would have been similar to that described above;

(c) Material overvaluation of Spiegel’s “retained interest” in its securitization transactions: This resulted in an overstatement of Spiegel’s assets on its December 30, 2000 consolidated balance sheet;

(d) A serious failure in Spiegel’s internal controls over its credit underwriting process that allowed its retail (“merchant”) subsidiaries to pump up their sales by granting easy credit to high risk borrowers;

(e) Spiegel’s failure to timely disclose its violations of multiple covenants in its financing agreements as of December 29, 2001: These debt covenant breaches meant that Spiegel’s sizable long-term debt became immediately due and payable; and

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(f) Improper revenue recognition based on purchases by credit card customers who were more likely than not, as Defendants knew or recklessly disregarded, unable to ultimately pay for the merchandise they bought on credit.

JURISDICTION AND VENUE

22. 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 thereunder by the SEC

[17 C.F.R. §240.10b-5].

23. 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 [15 U.S.C. §78aa].

24. Venue is proper in this District pursuant to Section 27 of the Exchange Act and 28

U.S.C. §1391(b). Many of the acts charged herein, including the preparation and dissemination of materially false and misleading information, occurred in substantial part in this District and Spiegel conducts business in this District.

25. In connection with the acts alleged in this complaint, Defendants, directly or indirectly, used the means and instrumentalities of interstate commerce, including, but not limited to, the mails, interstate telephone communications and the facilities of the national securities markets.

PARTIES

26. Lead Plaintiffs Johann Oliver, Lisa Oliver, Andrews Dennore, Ronald Peters, Steven

Simmons, and Dionne Tonetti (collectively, the “Lead Plaintiffs” or “Plaintiffs”) each purchased the common stock of Spiegel at artificially inflated prices during the Class Period and have been damaged thereby. Lead Plaintiffs’ certifications have been previously filed in this litigation and are hereby incorporated by reference.

27. Spiegel is a corporation organized under the laws of Delaware with principal executive offices located at 3500 Lacey Road, Downers Grove, Illinois. Spiegel is a retail marketer

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of apparel and home furnishings. Spiegel has not been named as a herein because it has filed for bankruptcy.

28. Defendant Michael Otto (“Otto”) was, at all times relevant to the allegations raised herein, Spiegel’s Chairman of the Board of Directors. At all relevant times, Otto also served as the

Chairman of Spiegel’s Board Committee (or Executive Committee) and as Chairman of Spiegel’s

Audit Committee. At all relevant times, the Otto Family, sometimes referred to herein as the “sole voting shareholder,” maintained effective control over Spiegel Holding, Inc. (“SHI”). SHI is a corporation organized under the laws of Delaware, and owns 99.9% of the Class B Voting Common

Stock of Spiegel, thereby affording SHI control of the Company. Since gaining control of the

Company in 1982, the Otto Family has caused a majority of the Company’s Board of Directors to be comprised of interlocking directorships tied to other entities controlled by the Otto Family, including

Otto Versand (GmbH & Co.) (“Otto Versand”) and Otto Versand Group, among others.

29. Defendant Michael R. Moran (“Moran”) was at certain times relevant to the allegations raised herein, Spiegel’s Chairman of the Office of the President, Chief Legal Officer,

Principal Operating Executive Officer and a Director. Moran also served as Chairman of the Board of FCNB at certain times relevant to this action.

30. Defendant James W. Sievers (“Sievers”) was at certain times relevant to the allegations raised herein Spiegel’s Office of the President, Chief Financial Officer, Principal

Operating Executive Officer and Principal Financial and Accounting Officer.

31. Defendant Martin Zaepfel (“Zaepfel”) was at certain times relevant to the allegations raised herein, Spiegel’s Vice Chairman, President, Chief Executive Officer, a Company Director and member of Spiegel’s Board Committee.

32. Defendant Michael E. Crusemann (“Crusemann”) is, and at all times relevant to the allegations raised herein was, a Director of the Company, a member of Spiegel’s Board Committee

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and a member of Spiegel’s Finance Committee. Crusemann was, at all relevant times, a member of

Otto Versand’s Executive Board, the Director of Finance of Otto Versand and the Chief Financial

Officer of Otto Versand Group.

33. Defendant Horst R.A. Hansen (“Hansen”) is, and at all times relevant to the allegations raised herein was, a Director of the Company and a member of Spiegel’s Audit

Committee. Hansen was, prior to March 1994, a member of Otto Versand’s Executive Board, the

Director of Finance of Otto Versand and the Chief Financial Officer of Otto Versand Group.

34. Defendant Peter Muller (“Muller”) is, and at all times relevant to the allegations raised herein was, a Director of the Company and a member of Spiegel’s Audit Committee. Muller was, prior to January 1998, a member of Otto Versand’s Executive Board and the Director of

Advertising and Marketing of Otto Versand.

35. Defendant James R. Cannataro (“Cannataro”) was at certain times relevant to the allegations raised herein, Spiegel’s Executive Vice President and Chief Financial Officer.

36. Otto, Moran, Zaepfel, Crusemann, Hansen, Muller, Sievers and Cannataro are referred to herein as the “Individual Defendants.”

37. During the Class Period, the Individual Defendants, as the senior executive officers and/or directors of Spiegel were privy to confidential and proprietary information concerning

Spiegel, its operations, finances, financial condition, and present and future business prospects. The

Individual Defendants also had access to material adverse non-public information concerning

Spiegel, as discussed in detail below. Because of their positions with Spiegel, the Individual

Defendants had access to non-public information about its business, finances, products, markets and present and future business prospects via access to internal corporate documents, conversations and connections with other corporate officers and employees, attendance at management and board of directors meetings and committees thereof and via reports and other information provided to them in

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connection therewith. Because of their possession of such information, the Individual Defendants knew or recklessly disregarded the fact that adverse facts specified herein had not been disclosed to, and were being concealed from, the investing public.

38. Dismissed-party KPMG is a firm of certified public accountants that audited

Spiegel’s financial statements during the Class Period and issued materially false and misleading opinions on these financial statements. KPMG also consented to the use of its opinion on Spiegel’s financial statements filed with the SEC and otherwise disseminated to the investing public during the

Class Period. KPMG’s participation in the materially false and misleading statements and omissions alleged herein is described in ¶¶357-415.

PLAINTIFFS’ CLASS ACTION ALLEGATIONS

39. Plaintiffs bring this action as a class action pursuant to Federal Rule of Civil

Procedure 23(a) and (b)(3) on behalf of a Class, consisting of all those who purchased the Class A

Non-Voting Common Stock of Spiegel during the Class Period and who were damaged thereby.

Excluded from the Class are Defendants, the officers and directors of the Company, at all relevant times, members of their immediate families and their legal representatives, heirs, successors or assigns and any entity in which Defendants have or had a controlling interest.

40. The members of the Class are so numerous that joinder of all members is impracticable. The company’s Class A Non-Voting Common Stock was traded on the NASDAQ

National Market System under the ticker symbol: SPGLA. Effective June 4, 2002, Spiegel’s Class

A Non-Voting Common stock was traded on the over-the counter market under the symbol SPGLA.

While the exact number of Class members is unknown to Plaintiffs at this time and can only be ascertained through appropriate discovery, Plaintiffs believe that there are hundreds or thousands of members in the proposed Class. Record owners and other members of the Class may be identified

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from records maintained by Spiegel or its transfer agent and may be notified of the pendency of this action by mail, using the form of notice similar to that customarily used in securities class actions.

41. Plaintiffs’ claims are typical of the claims of the members of the Class as all members of the Class are similarly affected by Defendants’ wrongful conduct in violation of federal law that is complained of herein.

42. 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.

43. 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 Defendants’ acts as alleged herein;

(b) whether statements made by Defendants to the investing public during the

Class Period misrepresented material facts about the business and operations of Spiegel; and

(c) to what extent the members of the Class have sustained damages and the proper measure of damages.

44. A class action is superior to all other available methods for the fair and efficient adjudication of this controversy since joinder of all members is impracticable. Furthermore, as the damages suffered by individual Class members may be relatively small, the expense and burden of individual litigation make it impossible for members of the Class to individually redress the wrongs done to them. There will be no difficulty in the management of this action as a class action.

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SUBSTANTIVE ALLEGATIONS

Background Facts

45. The Spiegel Group describes itself as a leading international specialty retailer

marketing apparel and home furnishings to customers through catalogs, more than 550 specialty

retail and outlet stores, and e-commerce sites. Historically, the operating results for the Company

were reported for two segments: merchandising and bankcard. The merchandising segment included

an aggregation of the Company’s three merchant divisions and the private-label preferred credit

operation. The bankcard segment included primarily the credit card operations of FCNB, the

Company’s credit card bank.

46. The merchandising segment is comprised of the Company’s Eddie Bauer, Newport

News and Spiegel subsidiaries which distribute apparel, home furnishings and other merchandise

through catalogs, e-commerce sites and retail stores. The primary source of the Company’s catalog

sales revenues were derived from the Spiegel-Catalog and Newport News subsidiaries. Eddie Bauer

through its more than 500 retail stores provided a majority of the Company’s retail store sales.

47. FCNB was founded in 1988 and acquired by the Company in 1990. The Company

represented that FCNB possessed the requisite expertise to manage the higher risk and increased

servicing requirements associated with its sub-prime lending activities. As a credit card bank,

FCNB’s activities were limited primarily to the issuance of credit cards, including MasterCard and

VISA credit cards (“FCNB Bankcard(s)”), as well as the bank’s private label credit card, the FCNB

Preferred Charge card (“Preferred Card(s)”).

48. Beginning in 1997, FCNB also issued co-branded FCNB Bankcards imprinted with the logo of one of the Company’s merchant divisions. The Preferred Card and the FCNB Bankcard could be used for purchases at any of the Company’s three merchant divisions. Generally, Preferred

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Cards usage for catalog and e-commerce merchandise and services accounted for the vast majority of sales in those distribution channels.

Spiegel’s Credit Approval Process

49. According to Spiegel’s SEC filings, as detailed herein, FCNB was responsible for developing and managing the Company’s credit granting procedures for both Preferred Card and

FCNB Bankcard accounts. With regard to Preferred Card application approvals, Defendants, except for Defendant Cannataro, represented that FCNB evaluated prospects using proprietary credit scoring systems developed by the Company based on historical data from FCNB’s account base.

According to Defendants, except for Cannataro, the Company periodically revises its scoring models in order to “capture diversified trends within each merchant portfolio.”

50. During the Class Period, a vast majority of the Company’s Preferred Card account originations were generated from “preapproved” applications. According to Spiegel’s SEC filings, from time to time, FCNB obtained lists of prospects from credit bureaus and screened these prospects using the Company’s proprietary scoring models. After this screening process, certain prospects were sent pre-approved Preferred Card applications along with a merchandise catalog.

Generally, these pre-approved applications included an initial credit line ranging from $250 up to

$3,300 depending upon the applicant’s credit score. At October 31, 2000, more than 72% of the total Preferred Cards issued by the Company fell into this credit limit range. FCNB has never publicly disclosed the minimum score needed for credit application approval.

51. In truth and in fact, however, the Company’s credit approval process differed markedly from Defendants’, except for Cannataro’s, public disclosures. According to the

Independent Examiner’s Report, Spiegel lured credit customers to its merchandise by offering

Preferred Card promotional programs like delayed billing (not charging purchases until the end of a specified period) and deferred billing (no monthly payment required for a specified period and no

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finance charge if paid in full at the end of the deferral period). Spiegel used pre-approved, direct mail solicitations for over 90% of its new preferred credit accounts. Spiegel Catalog offered credit to customers placing phone orders, approved their credit with FCNB on the spot, and gave the phone customers a 10% discount on their first day purchases.

52. Moreover, based on Company documents reviewed by the Independent Examiner, in implementing credit promotions during the Class Period, Defendants, except for Cannataro, used a technique called the “net down” process to skew Spiegel’s credit portfolio toward high risk customers – often the best “responders” – to boost Spiegel Catalog’s sales numbers. Using this approach, Spiegel would provide a pool of prospective customers containing persons over a range of risk from “A” (low risk) to “F” (high risk) for pre-approval by FCNB using a credit bureau. But after getting FCNB to pre-approve a pool reflecting a full range of credit risk levels, Defendants, except for Cannataro, and Spiegel’s merchant subsidiaries – not FCNB – would next proceed to drop many of the prospective customers at the “A” through “C” levels (the more credit-worthy customers) before mailing out catalogs and notices of pre-approval of credit. The effect was to deprive FCNB of the ability to control risk, and instead give it to the merchants, whose primary concern was boosting their sales numbers.

53. In particular, based on documents reviewed by the Independent Examiner, in four solicitations during the Fall 2001 season, Defendants, except for Moran, Sievers and Cannataro, caused Spiegel Catalog to drop high percentages of the pre-approved customers who were good credit risks (risk levels A-C), but dropped low percentages (or none) of the pre-approved customers who were poor credit risks (risk levels D-F), as follows:

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Percentages of FCNB-Approved Prospects Before Mailings

Risk Level 1st 2nd 3rd 4th

A 40% dropped 82% dropped 13% dropped 55% dropped B 41% dropped 72% dropped 40% dropped 55% dropped C 34% dropped 53% dropped 30% dropped 54% dropped D 19% dropped 26% dropped 0% dropped 42% dropped E 0% dropped 0% dropped 0% dropped 34% dropped F 0% dropped 0% dropped 0% dropped 19% dropped

54. With Spiegel Catalog’s pre-approved solicitation going to primarily customers at the

“D” through “F” levels (those with the highest credit risk), the actual population getting the solicitation was at a substantially higher risk level than the population that had been pre-screened for

FCNB by the credit bureau. This meant that FCNB lost control over the risk profile of the mailed universe (the pre-approved customers that ultimately got the mailing offering them credit). Thus

Defendants’, except for Cannataro, public statements and numerous filings with the SEC, regarding

FCNB’s credit granting procedures were materially false and misleading.

55. The effect of the net down process was that at the end of 2000 and continuing at the end of 2001, the credit files of the Company’s merchandise segments, including Spiegel Catalog and

Newport News, showed the following customer mix tilted decidedly toward higher risk customers:

Spiegel Catalog Newport News Risk Level YE 2000 YE 2001 YE 2000 YE 2001 A 3.7% 3.6% 3.8% 3.2% B 8.3% 8.2% 9.8% 8.6% C 15.8% 15.7% 21.7% 22.5% D 32.6% 29.1% 21.4% 23.5% E 28.5% 29.1% 34.0% 31.5% F 11.2% 14.2% 9.3% 10.6%

56. Defendants’, except for Moran, Sievers and Cannataro, knowledge of or reckless disregard for the damage the net down process had done to Spiegel’s credit profile is further evidenced by the fact that, according to documents reviewed by the Independent Examiner, in April

2002 Spiegel and FCNB agreed that FCNB should expect a mailed distribution that mirrors the pool

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of customers preapproved for the granting of credit. Based on documents reviewed by the

Independent Examiner, FCNB did not draft a new risk management policy incorporating these changes to control credit risk until May 2002.

57. Spiegel’s credit problems were further exacerbated by Defendants’, except for

Cannataro, elimination of a critical monitoring process known as “back-end screening.” Back-end screening is a technique that puts a preapproved credit prospect through a second credit check at the point credit is actually to be extended – sometimes months after the pre-approval process – to determine whether they still qualify for credit. According to the Independent Examiner’s Report,

Defendants, except for Cannataro, stopped back-end screening of Spiegel’s Preferred Card accounts

– during portions of 1999 and 2000 – just as Spiegel was engaged in its major acquisition of subprime customers. The effect was that a high percentage of the Spiegel customers getting credit from FCNB did not satisfy FCNB’s credit requirements at the time FCNB actually extended the credit to them. Based on documents reviewed by the Independent Examiner, while FCNB later resumed back-end screening, the damage was already done and manifested itself when the customers who slipped in without back-end screening accounted for a significant portion of the charge-offs as late as 2002 and 2003.

58. According to the Independent Examiner’s Report, Defendants, except for Cannataro, likewise damaged Spiegel’s credit portfolio through liberal “open to buy” policies, dealing with the amount of credit it gave to new customers and the increases in credit it gave to existing customers.

Additionally, based on documents reviewed by the Independent Examiner, Defendants, except for

Cannataro, engaged in other practices evidencing a lack of control over its credit portfolio such as authorizing purchases when customers were delinquent in their payments, and when the customers were over their credit limits. Finally, according to the Company’s SEC filings, Spiegel followed a

“recency” policy for delinquent accounts that treated delinquent accounts as if they were current

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provided the delinquent customer made only a minimum payment following two months of

nonpayment. All told, Defendants’, except for Cannataro, knowing or reckless behavior facilitated the easy credit the Spiegel merchant divisions pressed for to boost Spiegel’s sales. As described below, this phenomenon of “easy credit to pump sales” was several years in the making.

59. As found by the Independent Examiner, Defendants, except for Cannataro, knowing or reckless actions caused FCNB to operate in violation of federal regulations in at least two ways:

(a) Defendants, except for Defendant Cannataro, violated standards applicable to

national bank directors by allowing the merchants to control credit decisions through the “net-down”

process described above. “Directors of a national bank have a responsibility to diligently administer

all of the bank’s affairs. 12 U.S.C. §§71, 73. Since the responsibility of making credit decisions is

an essential one to the bank, bank directors may not delegate this decision-making power to

outsiders.” 1983 OCC Ltr. LEXIS 12 (July 28, 1983). This OCC letter states that if a parent

corporation makes credit decisions for a bank subsidiary, then the bank’s directors will have failed to

perform their duties. The letter strongly emphasizes that the bank cannot yield any of its

management responsibilities to the parent corporation, and that the bank officers must

“conscientiously review the facts and opinions offered by” the parent corporation.

(b) The “net down” process violated the Fair Credit Reporting Act (“FCRA”) and

its “prescreening” rules. Under those rules, a financial institution such as FCNB is required to make

a firm offer of credit to all of those consumers who meet the criteria provided to a credit bureau by

the financial institution. Under the “net-down” process, Defendants, except for Cannataro, caused

Spiegel to take the prescreened list of consumers selected by FCNB and manipulate the list to

minimize the number of “good” credits and maximize the number of subprime credits, a violation of

the prescreening rules of the FCRA. See Federal Reserve Research Service (“FRRS”) at

6-1649-1652 (Q 62-65), and Section 604(a)(3)(A) of the FCRA, 15 U.S.C. §1681b(a)(3)(A).

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Spiegel’s ‘Return to Profitability’ Was Based on Artificially Inflated Merchandise Sales

60. In the mid-1990’s Spiegel sustained a significant decline in its traditional direct sales

channel of catalog merchandising, posting losses totaling $55.6 million for 1995, 1996 and 1997. In

the face of increasing competition from a number of sources, Spiegel undertook a major

reorganization of the Company’s marketing programs at each of its merchant divisions, especially at

its namesake – the Spiegel Catalog division. Announced during 1997, a major thrust of the

reorganization was directed at implementing “specialty” merchandise catalogs that could be

“targeted” specifically to customer tastes and preferences.

61. According to the Independent Examiner’s Report, in conjunction with Spiegel’s

reorganization efforts, Otto assigned Zaepfel, an Otto Versand director, as his special liaison to

oversee the efforts. On assuming these liaison duties, unofficially on September 1, 1997 and

officially on January 1, 1998, Zaepfel focused his energies on Spiegel Catalog, which he viewed as

an “urgent” problem. Zaepfel’s background was in merchandising and marketing. Zaepfel’s analysis of the problem was that Spiegel Catalog was simply one of many retailers carrying the same brands. Spiegel Catalog was losing volume and was unable to compensate with adequate profit margins. According to the Company’s SEC filings, even after Zapfael arrived the Company’s catalog, merchandise sales continued to decline by more than 11% during the first-half of 1998.

Additionally, the Company was facing major liquidity issues having incurred cash operating deficits of over $129 million over the past eighteen months.

62. By mid-1998, however, unknown to the investing public, Defendants, except for

Cannataro, shifted the focus the Company’s reorganization efforts away from Spiegel’s

merchandising programs and increasingly emphasized the aggressive expansion of the Company’s

bankcard segment. During the ensuing three years, Spiegel seemingly turned its sales around.

According to Company documents reviewed by the Independent Examiner, in November 2000, - 20 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 21 of 202

Defendants, except for Cannataro, forecasted Spiegel Catalog net sales for 2000 at $770.2 million, a

22% improvement over the previous year, with forecasted EBT (earnings before taxes) of $24 million. This gave the catalog division its first reported profit in over three years. Defendants, except for Cannataro, prepared and approved forecasts of Spiegel Catalog 2001 net sales of $835 million, an 8.4% increase, with EBT of $28.3 million for a 17.9% increase. Similarly, Defendants, except for Cannataro, forecasted Newport News net sales of $473 million, a 15% increase over the previous year, and EBT of $19.8 million (an increase over the prior year’s $14 million). While the

Spiegel Catalog and Newport News credit portfolios showed increased charge-offs driven by new account growth, according to Spiegel’s SEC filings, FCNB was supposedly taking certain risk management steps to deal with this.

63. Defendants, except for Cannataro, knew that by lowering Spiegel’s credit criteria for the Company’s Preferred cards and co-branded Bankcards, they could artificially boost Spiegel’s merchandise sales by offering credit cards to individuals who were unable to obtain credit from any other sources. Coupling these lower credit standards with the Company’s existing account origination programs, Defendants, except for Cannataro, exponentially increased the Company’s

“preapproved” Preferred Card solicitations.

64. As a result, the Company issued several million Preferred Cards and co-branded

FCNB Bankcards to low- income/high risk borrowers with credit limits as low as $250, sending merchandise catalogs with the mailing of the “preapproved” account applications. In the Company’s public statements, during this time, Defendants, except for Cannataro, misleadingly attributed

Spiegel’s double-digit growth trend in catalog merchandise sales to “refined marketing” strategies and credit card “repricing” programs.

65. In the short-run, Defendants’, except for Cannataro, scheme had its intended effect, as the Company’s merchandise revenue purportedly rose by over $419 million during 1999 and 2000

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and its earnings increased from $3.3 million in 1998 to over $120 million in 2000. The vast majority of these incremental sales were made using the Company’s Preferred Cards causing Spiegel’s credit card receivables to balloon from $1.7 billion in 1997 to over $3.5 billion in 2001. Market analysts estimated that the Company’s “new customer acquisition” rate increased by 77% over the prior year, during the 3rd quarter of 1999 alone, and statistics released by the Company in April 2001 indicated that FCNB was issuing over 1.7 million Preferred Cards annually. By lowering the credit standards for account originations, Defendants, except for Cannataro, knew or recklessly disregarded that the

Company’s “top-line” revenues, especially its catalog merchandise sales, would receive an extraordinary boost that could only be sustained through the continuous issuance of additional credit cards to marginal and sub-standard credit risks, enticed to purchase goods and services on credit that they could not otherwise obtain. The primary beneficiary of these artificially inflated sales was Otto himself, as more than half of the apparel Spiegel sold originated with Otto Versand, and Spiegel purchased almost all of its private label merchandise through Otto’s family-owned businesses.

Defendants, except for Cannataro, also knew, or recklessly disregarded, that this build-up of high credit risks was deteriorating the overall quality of the receivables portfolio.

66. In addition, Moran and Sievers personally profited from this boost in sales. During the Class Period, executives in each business unit had the potential to receive an annual performance bonus. According to the Independent Examiner’s Report, Spiegel based these performance bonuses on earnings before taxes of the executives’ unit, as well as a long-term incentive bonus based on earnings before taxes of the Spiegel Group as a whole for the preceding two years. The increased sales revenue recognized by Spiegel in 2000 (artificially inflated by “easy credit”) translated into hundreds of thousands – and for some executives, millions – of dollars in performance bonuses on top of their 2001 salaries.

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67. According to Company documents reviewed by the Independent Examiner, based on

Spiegel’s 2000 earnings, Moran obtained a bonus of $1,711,599. Upon his departure from Spiegel in

mid-2001, Moran’s severance package provided for a $4,000,000 severance payment, again

calculated based on Spiegel’s 2000 earnings. Moran also received a $709,000 bonus payment for the

first six months of 2001, and salary for the first six months of 2001 at an annual rate of $445,000.

68. Likewise, based on Spiegel’s 2000 earnings, Sievers obtained a bonus of $1,616,574.

Upon his departure in mid-2001, Sievers’ severance package likewise provided for a $4,000,000

severance payment based on 2000 earnings, a $671,000 bonus payment for the first six months of

2001, and salary for the first six months of 2001 at an annual rate of $420,000.

69. Throughout this period Defendants, except for Cannataro, issued and/or contributed to dozens of press releases and news articles discussing the Company’s “targeted” and “refined” marketing strategies and programs but never disclosed the artificial boost to revenue and profits resulting from Defendants’, except for Cannataro, virtually extending credit to customers whom

Defendants, except for Cannataro, knew or recklessly disregarded were unable to pay for the goods they purchased. Nor did Defendants disclose the deleterious impact these polices were having on the collectability of the Company’s credit card assets. According to Spiegel’s SEC filings, during fiscal year 2000 alone, over 108% of the Company’s increase in merchandise sales revenue compared to the previous year – or $157 million – which based upon Plaintiffs’ investigation, was primarily attributable to purchases through un-seasoned accounts opened with low-income high risk borrowers, issued credit cards under Spiegel’s relaxed credit standards. According to the

Independent Examiner’s Report, by September of 2001 more than 62% of Spiegel’s Preferred Card accounts were comprised of substandard credit risks (rated D, E and F) as a result of Defendants, except for Cannataro, knowing, or reckless actions in pursuit of compensation bonuses based on

Spiegel’s artificially inflated sales and profits.

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70. Subsequently, in an interview with D. Koopman, Spiegel’s public relations

spokesperson, who then reported to Cannataro, Koopman admitted to this aspect of Defendants’,

except for Cannataro, numerous deceptive practices and schemes. The interview appeared in an

April 2002 article by Paul Miller and Mark Franco published in Catalog Age. The article stated in

relevant part as follows:

Of all Spiegel purchases paid for by credit card, 78% were charged to the company’s private-label cards. In fact, a key benefit of the card program for Spiegel was its ability to drive merchandise sales. Merely by loosening its credit criteria and offering more consumers its branded cards, Spiegel could spur top-line growth. “All in all,” Koopman says, “it had a positive effect on our sales.”

Those additional merchandise sales came at a price of course. “When you ease up your credit scoring to entice more lower-income buyers,” says Kevin Silverman, an analyst with capital growth fund ABM AMRO/Chicago, “you allow less credit worthy people to borrow and fewer loans get paid. Then you have to rein in the credit side, and the merchant side suffers.” [Emphasis added.]

Asset Securitizations

71. The credit card securitization market is a multi-trillion dollar market that allows

banks and other issuers of credit cards to convert their receivables into cash. In essence,

securitization is a complex way to obtain money. Investors in a securitization receive certificates or

notes that give them the right to receive a certain return on their investment usually priced at an

attractive rate for both the issuer and the investor. In return, the issuer receives cash upon the sale of

the receivables to the trust and also retains an interest in the receivables (the “retained interests”).2

In addition to the protection afforded by the retained interest, investors have the benefit of certain credit enhancements that may include cash collateral accounts and insurance policies that assure

2 The retained interest includes all of the interests in the trust that remain after all investors are paid and all other obligations of the trust are satisfied. By not selling all of the interests of the trusts to investors, the issuer provides an additional layer of protection for investors since the retained interest is subordinated in favor of the payment to the investors.

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payment of an investor’s principal and interest in the event the cash flow from the securitized

receivables is insufficient.3 Each of the trust documents also contains trust performance requirements (sometimes referred to as “triggers” and conceptually akin to events of default) that, if violated, results in the immediate payout of all collected cash receipts to the trust investors until the obligation to them is satisfied.4 This circumstance, called “rapid amortization,” results in the trust no

longer having the use of the principal proceeds to purchase newly-generated receivables, nor the

issuer having the benefit of the excess cash flows available after the payments to investors. Instead,

all excess cash flows immediately go to the repayment of principal to investors.

72. Generally, there are two types of retained interests both of which were held by

Spiegel during the Class Period. One is a retained interest in the excess principal receivables in the

trusts often represented by a retained interest certificate. The other is the interest-only strips (“I/O

strips”). I/O strips represent the right to receive the interest portion of the receivables after all

investors in the trust have been paid their interest. During the Class Period, Spiegel reported

carrying values for each of these retained interests.

3 The various cash collateral reserve accounts are established from time to time based upon the financial performance of the receivable portfolio. In the Spiegel securitizations, MBIA Insurance Corporation (“MBIA”) provided credit enhancement in the form of financial guaranty insurance to protect investors in the publicly offered SCCMNT 2000-A and SCCMNT 2001-A Series. In exchange for insurance premiums paid by the trust, such insurance policies guarantee that the investors would receive timely monthly interest payments and repayment of principal.

4 Pay out events or “triggers” applicable to the Spiegel trusts included: (i) failure to make certain payments or transfers of funds; (ii) failure to convey certain receivables to the trusts; (iii) occurrence of certain insolvency or bankruptcy events; (iv) defaults by the servicer, FCNB; (v) material breaches of representations, warranties and covenants; (vi) failure to maintain minimum ownership requirements; (vii) inability by FCNB to meet financial and capitalization requirements; and (viii) failure of the receivables to meet certain minimum performance standards including maintenance of an adequate “profit ratio” or difference between portfolio yield and base rate (the so-called “excess spread trigger”), an adequate level of delinquent accounts (the “delinquency ratio trigger”), and an appropriate limit on defaults in the portfolio (the “default rate trigger”).

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73. The retained interest can be held by the issuer or an affiliate (although if certificated, it can be sold to a third party investor). For financial accounting purposes, under FAS 125 and its successor FAS 140, the estimated cash flows of the retained interest must be discounted to its net present value. The I/O strip is periodically recorded on the balance sheet as an asset of the issuer having a certain value. The estimated cash flows of the retained interests change with any changes in the variables used (such as delinquency rates) in determining its fair value.

74. Financial statement risks to the issuer in connection with securitizations include inappropriate calculation of the gain on the sale of the receivables to the trusts and the possibility that the retained interests becomes overvalued. To guard against misstatements of value related to the retained interests, issuers need to be make sure that the assumptions used to determine the value of the retained interest continue to be reasonable. For example, if default rates exceed those originally anticipated and used in the valuation model, the holder of the retained interest must consider how this change affects the value reflected on the balance sheet for the retained interest.

Spiegel’s Securitizations

75. Spiegel began securitizing its credit card receivables through its bank subsidiary

FCNB in the early 1990s. FCNB financed its credit card business – both Preferred Card and FCNB

Bankcard – through the sale of substantially all of its credit card receivables to special purpose entities structured as common law trusts, that in turn sold certificates or notes to investors. During the Class Period, the securitization transactions at FCNB were generally structured as follows:

• A Spiegel customer using a Preferred Card or an FCNB Bankcard at a Spiegel merchant purchases an item and creates a receivable in favor of FCNB. The merchant looks to FCNB to pay the amount of the charge, less an interchange fee. And FCNB then looks to the customer to pay principal, interest (at typical credit card rates), late fees and other charges.

• Rather than holding the receivable on its financial statements, FCNB sells it to an intermediary special purpose entity (“SPE”). By selling the receivable, FCNB is relieved of the obligation to maintain capital against it, as well as the obligation to fund the receivable. However, with Spiegel’s - 26 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 27 of 202

securitizations, Spiegel remained in control over the cardholder’s account and adjust payment terms or fees.

• The SPE then resells the receivable to a so-called qualified special purpose entity (“QSPE”) (as defined in FAS 140), structured as a common law master trust. Each QSPE sells multiple series of certificates or notes to investors at different times.

• Each series also assigns the retained interest to Spiegel Acceptance Corp. (“SAC”) (a wholly owned subsidiary of Spiegel) or to FCNB. FCNB then transfers part of its retained interest to Financial Services Acceptance Corporation (“FSAC”) (also a Spiegel affiliate). These retained interests generate “finance revenue” for Spiegel that essentially comes from excess cash flows after required payments to the investors in the trusts and deductions are made.

Omissions and Misstatements in Asset Securitization Public Offerings

76. As detailed herein, Spiegel financed the substantial funding requirements of its credit

card portfolio by securitizing substantially all of the Company’s credit card receivables, a technique

Spiegel had employed since the early 1990s. During the Class Period, the Company’s assets

securitizations included a series of five transactions in late 2000 and in 2001 resulting in financings or commitments of approximately $3.4 billion. Two of these five securitization transactions completed by Defendants, except for Cannataro, during the Class Period were public debt offerings –

(i) the Spiegel Credit Card Master NoteTrust (“SCCMNT”) Series 2000-A issued on December 19,

2000 and (ii) the SCCMNT Series 2001-A issued on July 19, 2001. The remaining three securitizations were private placements.

77. Ultimately, following the deterioration in the credit card portfolios sold to the trusts, all of the trusts went into rapid amortization in early March, 2003. The privately placed

securitizations have either been paid in full or will be in the near future. However, the publicly

offered securitizations – the SCCMNT Series 2000-A and SCCMNT Series 2001-A – each have

approximately $300 million owing to investors and are currently being paid down in rapid

amortization at the rate of approximately $30 million a month.

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78. In a number of respects, the offering documents that had been used to sell these

securitization investments to the public did not disclose the substantial risks, discussed in detail

above, to the collectability of the credit card receivables being securitized. Among other things, the

prospectuses failed to describe the focus on attracting a subprime customer base,5 failed to describe

the so-called “net down” process, described in ¶52, failed to describe the fact that the merchant

retailers (and not FCNB) were in charge of the final credit granting process to assure sufficient credit

to pump sales, described in ¶¶60-70, regardless of purchasers’ ability to repay FCNB.

79. Moreover, the offering documents failed to warn that FCNB had ceased doing back

end screening on customers solicited – a technique that would have materially decreased fraud losses

and enhanced the integrity of the credit granting process. Most importantly, the disclosures do not

describe how close the various series were to violating the excess spread trigger and that the

interchange fees and other charges would have to be increased to avoid a payout event in the asset

backed notes being offered for sale to the public.

80. In addition to such material omissions during the public offering of these investments,

the prospectuses contained a number of affirmative misstatements, described in ¶¶135-137 and

¶¶151-153 below.

5 The risk of lending to high risk borrowers was of great concern to FCNB’s regulator, the OCC, as early as Spring 1999 (before the SCCMNT transactions in 2000 and 2001). On April 5, 1999, the OCC issued guidance to national banks on subprime lending to assist national banks engaging in this “new activity” to insure that they understood the risks involved and had the appropriate controls in place. See OCC Release 99-32 at www.treas.gov./ftp/release/99-32.txt. The disclosure of the substance of this release, and the steps that FCNB was taking to comply with it, would have been a material factor to investors in appropriately evaluating risks and making a decision whether to invest in the securitizations of FCNB in 2000 and 2001.

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Defendants Failed to Consolidate Spiegel’s Securitization SPEs

81. Throughout the Class Period, Defendants, except for Cannataro, misleadingly

represented: (i) that Spiegel’s securitization transactions were bonafide sales, which allowed the

Company to remove its credit card receivables and the face value of any notes sold to investors from

its balance sheet; (ii) that cash flows from the transferred credit card receivables were sufficient to

support repayment of the certificates or notes and any credit losses that might be sustained; and

(iii) that in any event, the “sales” were made without recourse, and therefore the Company was not

required to record any reserves for losses that might arise.

82. In form, the transfers were structured by Defendants, except for Cannataro, such that

it would appear that Spiegel sold the receivables to the SPEs in exchange for cash. In substance,

however, the “purchasers” of the transferred assets (i.e., the SPEs) did not control or possess the

risks and rewards of ownership of the receivables necessitated by GAAP to allow Spiegel to treat

such transfers as sales. (See ¶¶213-245)

83. In fact, events have already transpired, which clearly show that Defendants’, except

for Cannataro, representations of Spiegel’s securitizations in its public statements were materially

false and misleading, at all relevant times. For example, in May of 2002, a “pay-out” event occurred when the receivables in the trusts failed to perform within specific parameters as defined in the

Company’s agreements with its noteholders. This required the Company to pay $20 million per month to satisfy accelerated principal repayments under the trust’s obligations to its noteholders.

84. These events clearly illustrate that Spiegel controlled and retained the risks associated

with ownership of financial assets, in spite of Defendants’ machinations and deceptions to the

contrary. Accordingly, GAAP requires that the financial statements of the trusts (i.e., SPEs) be

consolidated with those of Spiegel. Had it done so, during the Class Period, Spiegel could not have

recorded millions of dollars in fictitious gains and would have recorded billions of dollars in

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additional debt. Subsequent events have also shown that over $3.5 billion in noteholder obligations became payable by the Company in 2003, necessitating a reduction in Spiegel’s credit rating and, ultimately, its filing of bankruptcy.

Defendants Materially Overstated Spiegel’s Carrying Value of Retained Interests

85. Moreover, even if Defendants, except for Cannataro, were in conformity with GAAP when they caused Spiegel to record gains upon the transfer of assets to the trusts, which they were not, GAAP requires that such gains be recorded using appropriate valuation and modeling methodologies. As belatedly disclosed by Defendants, and confirmed by the OCC, the Company employed inappropriate valuation and modeling methodologies and thus was unable to reliably calculate the “gain” on the sale of recoverable transferred to SPEs. In fact, the valuation methodology employed by Defendants, except for Cannataro, deviated significantly from standard industry practice and was in direct violation of GAAP and federal banking regulations. Nonetheless, during the Class Period Defendants, except for Cannataro, caused the Company to report over $240 million in “gains on receivable sales.”

86. As determined by the Independent Examiner, had Defendants, except for Cannataro, based Spiegel’s retained interest on contemporaneously available information discussed below, the finance charge rate used by Spiegel in the valuation model should have been lower. Similarly, the charge-off rate and the discount rates used in the valuation model should have been higher.

Recalculating the valuation model at December 2000 with these adjusted rates would have required a $113 million write down of Spiegel’s retained interests. The restated value of the retained interests using valuation model assumptions that accurately reflected the actual risk inherent in Spiegel’s rapidly deteriorating portfolio of credit card assets as of December 2000 should have included the following assumptions:

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(a) Finance charge rate – 25.6%. This rate was calculated by taking the average of the actual year-to-date 2000 finance rate from the Performance Reports (25%) and a year-to-date average rate derived from the 2000 Monthly Noteholder Statements (26.15%). Defendants, except for Cannataro, knowingly or recklessly used a fraudulent rate of 27.13% causing Spiegel’s assets and earnings to be overstated by at least $37 million.

(b) Charge-off rate – 13%. This was the rate experienced in December of 2000.

The rate continued to trend up from 13% in January and February 2001. Defendants, except for

Cannataro, knowingly or recklessly used a fraudulent charge-off rate of 12.18% causing Spiegel’s assets and earnings to be overstated by $21.2 million.

(c) Discount rate – 20% – as discussed above, this was in all likelihood, based on the Trust performance and the risk an investor would be assuming, too low. Defendants, except for

Cannataro, knowingly or recklessly used fraudulent discount rates varying from 9% to 15% causing

Spiegel’s assets and earnings to be overstated by $57.3 million.

87. Had Defendants, except for Cannataro, given appropriate consideration to the deterioration of Spiegel’s receivables portfolio in determining the fair values of the retained interests, it would have been necessary for the Company to record material write-offs through the income statement throughout the Class Period. However, since Defendants, except for Cannataro, used assumptions for which there was no supported basis, the financial statements filed with the SEC and otherwise disseminated to the investing public during the Class Period were materially misstated.

Defendants Manipulated and Failed to Disclose Trust Trigger Violations

The Interchange Rate

88. In exchange for providing credit to Spiegel’s merchant divisions, FCNB charged the merchants (Spiegel, Eddie Bauer and Newport News) an interchange fee based on a percentage of - 31 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 32 of 202

the dollar value of the credit transactions processed by FCNB. By way of example, using a 1%

interchange rate, a $100 credit purchase processed by the Bank would generate a $1.00 interchange

fee. The fee is intended to compensate the bank for time value of money, handling charges, and the like. Based on Company documents reviewed by the Independent Examiner, in 2001, the operating agreements between FCNB and each of Spiegel’s merchants set forth a 1% interchange rate. In

2002, the operating agreements were amended to raise the rate to 2%.

89. On each credit transaction processed by FCNB, the interchange fee was to be paid by the merchants to FCNB, and subsequently transferred from FCNB to SAC (an entity wholly owned by Spiegel that held the seller’s interest on the related credit card receivables). The interchange fee was used by Spiegel to calculate both the finance charge collections amount and the overall

“portfolio yield,” a key metric used to measure the performance of the Trusts. The portfolio yield is reported to note investors in Monthly Noteholder Statements.

90. By February 2001, the declining performance of Spiegel’s Preferred Card portfolio was threatening to violate one of the securitization pay out triggers, with the result that the notes would go into rapid amortization. The pay out trigger implicated was the excess spread trigger.

91. In April 2001, to protect this ratio, Moran and Sievers (collectively Spiegel’s Office of the President) decided that the trusts would report that the merchant companies paid a higher interchange rate to FCNB. By increasing the reported interchange fee, Moran and Sievers were able to report that portfolio yield was increased and subsequently the excess spread percentage was higher.

92. Specifically, to protect Spiegel from violating the trigger, Moran and Sievers unilaterally increased the interchange rate from 1% to 5%, retroactively to January 1, 2001.

Defendants Moran and Sievers did this by simply reflecting the accumulated amount of interchange

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fees calculated at 5% on the trustee servicer report filed with the SEC for April 2001, for the period

January 2001 through April 2001. Defendants did not amend Spiegel’s prior servicer reports.

93. Based on documents reviewed by the Independent Examiner, Moran and Sievers had no basis for the increase in Spiegel’s interchange rate and should have consistently used a 1% interchange rate for trust reporting purposes in 2001, for the following reasons:

(a) Defendants did not perform a benchmarking study to validate the higher rate when Spiegel’s interchange rate was increased in 2001. Nearly a year after Defendants, except for

Cannataro, had increased Spiegel’s interchange rate for trust reporting purposes, in March 2002 both

KPMG and Rooks Pitts advised Spiegel that, in the absence of a benchmarking study to support a higher interchange rate, Spiegel would have to restate its interchange rate and excess spread calculations for 2001. Such recalculation of excess spread would cause Spiegel’s publicly held –

SCCMNT Series 2000-A and SCCMNT Series 2001-A securitizations to breach their triggers, causing both to go into early amortization. The result would be a diversion of approximately $40 million in excess monthly cash flow from Spiegel to pay down these series.

(b) Defendants did not amend any of Spiegel’s operating agreements with its merchant units to reflect the higher interchange rates. In fact, Defendants did not inform Spiegel’s merchants that the interchange rate was being increased.

(c) Spiegel and the merchants continued to record the interchange rate at 1% on their general ledger.

(d) Contemporaneous documents reviewed by the Independent Examiner shows that Defendants, except for Cannataro, were concerned with decreasing excess spreads in April and again in October 2001. Defendants, except for Cannataro, knew or recklessly disregarded that the consequences of reaching excess spread funding triggers would require significant cash deposits to

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restricted cash accounts. To avoid breaching the triggers, Defendants, except for Cannataro,

misleadingly increased the interchange rate retroactively.

(e) Based on Company documents reviewed by the Independent Examiner, the

only place these increased spreads were recorded was in the Monthly Noteholders Statements. All

other financial documents continued to reflect the 1% rate.

94. Defendants, except for Cannataro, knowingly or recklessly misreported the financial

performance of Spiegel’s trust portfolio assets for its publicly-held asset securitizations completed

during the Class Period – SCCMNT Series 2000-A and SCCMNT Series 2001-A – and for at least

one of the privately placed assets securitizations outstanding, during a period from at least April

2001 through December 2001 by using the inflated interchange rate in the calculation of portfolio

yield and excess spread. Such misrepresentations were included on the monthly noteholder

statements filed by FCNB’s former Chief Financial Officer. Additionally, certain 2001 Monthly

Noteholder Statements which reflected the higher interchange rates were filed by Spiegel Credit

Corporation III Spiegel Master Trust on Form 8-K. The Forms 8-K were signed by John Steele as

Treasurer and Director of Spiegel.

95. By knowingly or recklessly utilizing the inflated interchange rate in Spiegel’s public

filings, Defendants, except Cannataro, clearly misled Spiegel investors. If the Excess Spread

Percentage had been calculated for 2001 using the appropriate rate of 1%, the Excess Spread

Percentage would have been lower than reported on the Monthly Noteholder Statements filed with

the SEC. As a result, Spiegel would have been required to significantly increase cash funding under

the Excess Spread Funding Requirements and in all likelihood would have reported a Pay Out Event

under its trust agreements as early as October or November 2001. Instead Defendants’ Otto, Moran,

Zaepfel, Crusemann, Hansen, Muller, and Sievers improper manipulation of the interchange rate

forestalled the reporting of a Pay Out Event for nearly two years.

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Trust Trigger Violations

96. Each of Spiegel’s securitization SPEs were subject to specific trust triggers which dictate when payout events or excess funding events occur. The triggers in Spiegel’s securitization agreements created significant ongoing risks for Spiegel. In the event of a violation or potential violation of a trigger, Spiegel would see its cash flows negatively impacted; Spiegel’s balance sheet assets (including residual interests and receivables) would decline in value; and Spiegel would in some cases have to increase restricted cash deposits - thereby materially and adversely impacting

Spiegel’s cash flows and financial condition.

97. Beginning in the second quarter of fiscal 2000 and continuing through the third quarter of fiscal 2001 (the last public filing of the Company’s financial statements during the Class

Period) Defendants, except for Cannataro, failed to disclose material and adverse risks and contingencies stemming from the deterioration in the credit quality of its securitized assets and the resulting violation or potential violation of certain trust triggers associated with the portfolios payment rates, delinquency ratio, default ratio, and excess spread ratio. As result each of the

Company’s periodic filings with the SEC on Form 10-Q and Form 10-K, from the first fiscal quarter of 2000 through the third fiscal quarter of 2001 were materially false and misleading.

FCNB Lacked Adequate Internal Controls and Was in Violation of Regulatory Requirements

98. At all relevant times, the Company represented that FCNB possessed the requisite expertise to manage the higher risk and increased servicing requirements associated with its sub-prime lending activities. In fact, however, Defendants, except for Cannataro, knew Spiegel’s system of internal control failed to possess even the most basic mechanisms.6 Nonetheless,

6 The OCC Consent Order issued on May 15, 2002 cited among other things FCNB’s lack of a current chart of accounts, supervisory failures to approve entries to the Company’s books and

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Defendants, except for Cannataro, knowingly or recklessly relied on such flawed data and falsely

represented that its credit card receivables were performing better than they actually were.

99. Defendants, except for Cannataro, knew of these systemic weaknesses when they

formulated and executed a suite of credit marketing programs designed to exponentially increase the

number of accounts originated and serviced by FCNB during the Class Period. The Company’s

2000 Form 10-K described FCNB’s credit marketing programs as follows:

In 2001, the bankcard segment intends to continue to grow its portfolio through initiatives aimed at customer acquisition and retention and increasing average account balances. This will entail the continued development and marketing of customized bankcard credit programs, including programs specific to the Company’s merchant divisions.

During 2000, FCNB employed an average of approximately 1,075 employees. At February 24, 2001, FCNB employed approximately 1,208 full-time equivalent employees, a reflection of the growth of the bankcard business. [Emphasis added.]

100. During the Class Period, Defendants, except for Cannataro, caused Spiegel’s merchandise divisions to influence FCNB’s decisions on risk management and credit underwriting decisions that determined the ultimate composition of the credit card portfolio. Decisions related to

FCNB’s credit underwriting should have been segregated from Spiegel’s management, as Spiegel’s management was motivated to facilitate sales rather than control credit risk. FCNB should have independently made underwriting decisions free from interference by Spiegel management. In practice, however, Defendants’, except for Cannataro, scheme, allowed such decisions to be influenced by Spiegel’s need to generate retail sales. As a result of Defendants’, except for

Cannataro, fraudulent scheme, FCNB lowered its credit underwriting standards in 1999 and 2000

and increasingly became dependent on high-risk credit card customers.

records, failures to require documentary support for entries, as well as failures to reconcile account balances on a periodic and comprehensive basis, among other things.

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101. Moreover, as subsequently found by the OCC, FCNB lacked the appropriate

management information systems (“MIS”) to effectively monitor the performance of it credit card receivables. For example, FCNB was unable to determine the total credit risk associated with any single customer. As a result, FCNB was unable to generate reports that appropriately analyzed asset quality in terms of portfolio dimensions, composition and performance. Most importantly, the

Company’s MIS and reports failed to include adequate information relating to product profitability, account volumes, delinquencies, charge-offs, recoveries, bankruptcies, fraud, over limits, credit line increases, debt management programs, aggregation, and other key elements and assumptions that

Defendants, except for Cannataro, used to calculate or review revenues and earnings from Spiegel’s securitization activities.

102. An example of the disarray and unreliability of the information generated by FCNB’s credit and financial MIS is illustrated by the Company’s reporting of its delinquent and past due aging of credit card receivables during 2000. In the Company’s financial statements for the year ended December 30, 2000, Spiegel reported that the amount of its Preferred and Bankcard credit card receivables more than 60 days past due totaled $270.2 million. When Spiegel filed its financial statements for the year ended December 29, 2001, it reported the amount of its Preferred and

Bankcard credit card receivables more than 60 days past due on December 30, 2000 actually totaled

$470.9 million, or approximately 74% more than it reported in its prior year financial statements. As a result Spiegel’s charge off rates and loss rates, which were based in large part on FCNB’s past due aging of outstanding receivables, were massively understated, but nevertheless used by Defendants, except for Cannataro, to calculate or review the gain on “sale” of Spiegel’s receivables.

103. Additionally, findings by the OCC directed the Company to implement revised accounting policies and procedures related to each of the “key assumptions” disclosed by the

Company in its annual financial statements and employed by Defendants, except for Cannataro, in

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making or reviewing Spiegel’s calculations of its “gains” on receivable sales and periodic valuations

of the Company’s retained interests during the Class Period. These included developing actual payment rates, loss rates, market discount and interest rate comparisons and actual portfolio gross yields. Defendants, except for Cannataro, knew or recklessly disregarded, that these “key assumptions” were wholly inconsistent with the actual performance of the Company’s receivable

portfolio, but used them, or allowed them to be used, nonetheless to overstate the Company’s

revenues and earnings by hundreds of millions of dollars during the Class Period.

104. Defendants’, except for Cannataro, scheme to issue millions of credit cards to sub-standard credit risks, caused FCNB’s credit card receivable outstandings to grow from $1.7 billion at the end of 1997 to over $3.5 billion at the end of 2001. This necessitated Defendants’, except for Cannataro, use of Spiegel’s asset “sales” transactions in order to make it appear that the

Company and FCNB were in compliance with all federal banking regulations regarding statutory and risk capital requirements. If Defendants, except for Cannataro, had reported these “sales” correctly,

as financing arrangements, the Company would have violated its regulatory capital requirements. In

fact, Defendants’, except for Cannataro, use of FCNB to fund these transactions, caused the OCC to direct the Company to curtail its unrestricted growth of the Company’s credit receivables and to maintain certain risk-adjusted capital levels. The OCC’s directives stated:

– The Bank shall immediately, and until further notice from the OCC, not permit its average total assets at any calendar quarter end (commencing with the quarter ending June 30, 2002) to increase more than three percent (3%) over its average total assets at the end of the preceding calendar quarter.

– The Bank [FCNB] shall achieve by June 30, 2002, and thereafter maintain the following capital levels (as defined in 12 C.F.R. Part 3):

(a) Tier 1 capital at least equal to twenty-eight percent (28%) of adjusted total assets as determined by line 32 of Schedule RC-R of the Call Report (or the corresponding line item should this line item change as a result of an amendment to the Call Report); and

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(b) Total risk based capital at least equal to twelve percent (12%) of total risk weighted assets after the subprime assets are risk-adjusted by three hundred percent (300%) consistent with the Interagency Guidance on Subprime Lending.

– The Bank shall immediately, and until further notice by the OCC, make no capital distributions without the prior approval of the OCC.

105. The Consent Order entered into on May 15, 2002 by FCNB in order to avert the commencement of a “cease and desist proceeding” against FCNB, contained, among others, these additional “orders” and prohibitions of the OCC with respect to the conduct of FCNB’s business:

--“The Bank shall immediately, and until further notice by the OCC, cease and desist any and all transactions with its affiliates” except those authorized by OCC or permitted by banking regulations for national banking associations.”

--“The Bank shall immediately review all existing contracts and agreements with all of its affiliated companies, written or otherwise, to determine whether such contract or agreement represents an arm’s length transactions whose terms and conditions are fair and reasonable to the Bank. [. . .] shall terminate within forty-five days . . . all contracts and agreements with affiliates not on an arm’s length basis and shall similarly terminate all such contracts or agreements whose terms and conditions are not demonstrably fair and reasonable to the Bank.”

--“At a minimum, the Bank shall immediately develop, document and implement policies, procedures, systems and controls to ensure that, on an on-going basis, the books and records of the Bank: [. . .] reflect all of the assets, liabilities, capital, income and expenses of the Bank in accordance with [GAAP].”

--“The Bank shall engage subject to the supervisory non-objection of the Director of Supervision/Fraud (the “Director”), an independent accounting firm to review all material 2001 income and expense accounts, all material asset and liability accounts as of December 31, 2001, and all affiliate party transactions since January 1, 1999. For purposes of this Order, “material” shall have the same meaning accorded in Securities and Exchange Commission Staff Accounting Bulletin No. 99 on Materiality, or as the OCC may, in its discretion, otherwise determine.”

--“With the assistance of the independent accounting firm, the Board shall cause to be developed and implemented revised written accounting policies and procedures for all significant Bank activities including sale of assets, and other securitization activities.”

--“The Bank shall obtain and begin using on an ongoing basis, a residual asset valuation model (“model”) that comports with industry practice and OCC Bulletin 2000-16 [...] The Bank’s valuation estimate and the applicable valuation assumption shall comply with GAAP and OCC Bulletin 99-46.”

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--“On an on-going basis, the Bank shall ensure that it is accurately reporting on allowance for loan and lease losses (‘ALLL’) for all credit card receivables.”

--“The Board shall ensure that the Bank has appropriate management information systems in place so that the Bank’s management can effectively monitor the performance of the Preferred and Bankcard receivables by product marketing initiative, and vintage. The Bank shall generate reports to analyze assets quality in terms of portfolio dimensions, composition, and performance.”

--“The Bank shall develop, document and implement policies, procedures, systems and controls designed to identify, monitor and control on an on-going basis, the total credit risk associated with any single customer. Until such policies, procedures, systems and controls are in place and operational, the Bank shall not issue any additional card(s) to any existing Bankcard or Preferred card customer.”

--“The Board shall cause to be developed and implemented and thereafter ensure Bank adherence to written risk management program [. . .] The Board shall ensure that the Bank has processes, personnel, and control systems to ensure implementation of and adherence to the [risk management] program [. . .] The Board shall identify and appoint an individual with demonstrated experience and skills in providing overall risk management to implement the Bank’s risk management program.”

--“Effective immediately, the Bank shall develop and implement policies and procedures governing the retention of documents in the ordinary course of business.” Emphasis added.]

Materially False and Misleading Statements Issued During the Class Period

106. The Class Period begins on February 16, 1999. On that date, Spiegel issued a press release announcing its financial results for the fiscal year ended January 3, 1999. The Company reported net earnings $3.3 million and earnings before the redemption of preferred stock of $11.8 million, or $0.09 per share, compared to a net loss of $33.0 million, or $0.28 per share, for the 1997 fiscal year. The Company’s fourth quarter earnings of $41.5 million, or $0.32 per share purportedly exceeded Wall Street analysts’ consensus earnings by $0.04 per share. Defendants Sievers and

Moran commented on the Company’s seemingly improving financial results, stating, in pertinent part as follows:

“The Spiegel Group realized progress in both its merchandising and bankcard segments in 1998. The key factors that contributed to the progress in our merchandising segment included the improving performance of Spiegel Catalog,

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solid sales and earnings gains by Newport News, and the significant earnings contribution realized from our Preferred Charge programs.

* * *

Looking ahead, Michael R. Moran, Office of the President of Spiegel, Inc., said, “Now that we have returned The Spiegel Group to profitability, we are committed to keeping it there and generating consistent profit growth in 1999 and the years ahead. We remain excited about our company’s outlook. We have a strong presence in established and growing marketing channels, including catalogs, specialty retail stores and the Internet. We have made important strides in sharpening the focus of our merchandise and assortments, enhancing customer services, including our Preferred Charge programs, and in building the brand equity of Eddie Bauer, Newport News and Spiegel Catalog. We also have reduced costs across our merchandising business and provided a solid platform for continued progress. In addition, we have diversified and strengthened our FCNB bankcard business, positioning it for further growth.” [Emphasis added.]

107. On or about March 25, 1999, Spiegel filed its Form 10-K for the fiscal year ended

January 2, 1999, (the “1998 10-K”) which confirmed the previously announced financial results and was signed by Moran, Zaepfel and Sievers, among others. The 1998 10-K contained financial statements for the years ended 1998 and 1997. The Company reported outstanding debt of $609 million and $817 million at the end of 1998 and 1997, respectively, and stockholder’s equity of $637 million and $565 million at the end of each year.

108. The 1998 10-K described the Company’s asset securitization transactions and represented that the receivables had been sold “without recourse.” The 1998 10-K stated in pertinent part as follows:

The Company routinely transfers portions of its customer receivables to trusts that, in turn, sell certificates representing undivided interests in the trusts to investors. The receivables are sold without recourse, and accordingly, no bad debt reserve related to the receivables sold is maintained. In addition to the certificates sold, an additional class of investor certificates, currently retained by the Company, was issued by the trust in certain transactions.

The Company accounts for these asset-backed securitizations in accordance with SFAS No. 125, which requires that the Company recognize gains on its securitization of customer receivables. Incremental gains of $45,328 and $75,141 were recorded as finance revenue in fiscal year 1998 and 1997, respectively, representing the present value of estimated future cash flows the Company will receive over the estimated - 41 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 42 of 202

outstanding period of the asset securitization. These future cash flows consist of an estimate of the excess of finance charges and fees over the sum of the return paid to certificate holders, contractual servicing fees, and credit losses along with the future finance charges and principal collections related to interests in the customer receivables retained by the Company. These estimates are calculated utilizing the current performance trends of the receivable portfolios. Certain estimates inherent in determining the present value of these estimated future cash flows are influenced by factors outside the Company’s control, and, as a result, could materially change in the near term. [Emphasis added.]

109. The statements referenced above in ¶¶106-108 were each materially false and misleading because they failed to disclose and misrepresented the following adverse material facts, among others:

(a) that the Company had materially understated its debt by at least $1.4 billion at

January 2, 1999;

(b) that the Company’s revenues, earnings and stockholders’ equity were materially overstated by tens of millions of dollars as a result of the Company’s improper recognition of “receivable gains” and “servicing fees” from the Company’s securitizations of credit card receivables. Thus, it was not true that the Company had returned to “profitability”;

(c) that the assumptions, estimations and forecasts utilized by Defendants, except for Cannataro, in calculating the Company’s “receivable gains” were grossly inconsistent with the credit characteristics of the underlying assets, thereby resulting in the material overstatement of the

Company’s revenues and earnings. Such assumptions included, among others: expected charge-offs, expected delinquencies and expected payment streams;

(d) that it was not true that Spiegel’s securitized receivables were sold without

recourse, as set forth in further detail herein at ¶¶213-245;

(e) the Company’s financial statements were not prepared in accordance with

GAAP in numerous respects and were materially false and misleading as detailed herein at ¶¶208-

356;

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(f) that Defendants, except for Cannataro, had materially lowered the Company’s

credit criteria for account originations thus exposing the Company to increased risk of loss from

account charge-offs, delinquencies and defalcations;

(g) that Defendants’, except for Cannataro, lax credit policies and high risk

lending activities to sub-standard borrowers were fueling the Company’s credit card account

origination programs and resulting catalog merchandise sales revenues, especially at the Company’s

Spiegel and Newport News divisions;

(h) that demand for the Company’s merchandise products and services had

materially declined but for Defendants’, except for Cannataro, aggressive and high-risk marketing of

Spiegel’s credit card services to sub-standard borrowers;

(i) that the Company’s “proprietary” credit scoring methods and practices, both in design and utility, were wholly inadequate for identifying adverse credit risk and varied significantly from standard industry practice and federal banking regulatory guidelines;

(j) that the Company’s credit authorization procedures and determination of

“credit limits” regarding “secured lines of credit,” among others, varied significantly from standard industry practice, resulting in the extension of credit to certain individuals that exceeded security deposits levels by as much as 500% in some instances, and routinely exceeded such deposits by at least 200%;

(k) that the Company was currently experiencing certain adverse trends in the repayment of its credit card account receivables assets, both in receivables “retained” by the

Company and in “securitized” receivables “off-balance sheet receivables” serviced by the Company;

(l) that FCNB was actually operating in violation of federal banking regulations as it failed to maintain statutory and risked-based capital requirements;

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(m) that the Company violated GAAP and its own policies by failing to adequately compensate FCNB for the increased cost of collections due to increasing account delinquencies and defalcations, such “servicing fee liabilities” amounted to at least $50 million on an annual basis; and

(n) based on the foregoing, the Company’s revenues, earnings and financial position were materially misstated at all relevant times and Defendants’, except for Cannataro, opinions, projections and forecasts concerning the Company and its operations were lacking in a reasonable basis at all times and therefore materially false and misleading.

110. On April 22, 1999, Spiegel issued a press release announcing its financial results for the first quarter ended April 3, 1999. The Company reported a loss of $10.0 million or $0.08 per share. Defendant Sievers commented on the financial results stating in pertinent part as follows:

This marks our sixth consecutive quarter of improved earnings performance versus the prior year’s quarter. Each of our merchant companies reported better operating results for the quarter, driven primarily by strong response to merchandise offerings and gross margin growth. The progress realized in the first quarter moves us closer to our primary objective for 1999: achieve significant earnings improvement for The Spiegel Group . . .

111. On May 18, 1999, Spiegel filed its Form 10-Q for the quarter ended April 3, 1999, with the SEC which confirmed the previously announced financial results and was signed by

Sievers. The Form 10-Q represented the following concerning the financial statements contained therein:

The consolidated financial statements included herein are unaudited and have been prepared from the books and records of the Company in accordance with generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission. All adjustments (consisting only of normal recurring accruals) which are, in the opinion of management, necessary for a fair presentation of financial position and operating results for the interim periods are reflected.

112. On July 22, 1999, Spiegel issued a press release announcing its financial results for the second quarter ended July 3, 1999. The Company reported net income of $16.5 million, or $0.13 per share. Defendant Sievers commented on the results stating in pertinent part as follows:

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We achieved strong operating results for the quarter due to sales growth and significant margin improvement in our merchandising segment along with the continuing positive contribution from our bankcard segment. Our merchant businesses attained significantly higher productivity in all marketing channels – retail stores, catalog and Internet – while exceeding earnings expectations for the quarter. We are very encouraged by the progress noted in each of our businesses and look to continue to build on this positive momentum as we move forward.

113. On August 17, 1999, Spiegel filed its Form 10-Q for the quarter ended July 3, 1999,

with the SEC which confirmed the previously announced financial results and was signed by

Sievers, among others. The Form 10-Q represented the following concerning the financial

statements contained therein:

The consolidated financial statements included herein are unaudited and have been prepared from the books and records of the Company in accordance with generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission. All adjustments (consisting only of normal recurring accruals) which are, in the opinion of management, necessary for a fair presentation of financial position and operating results for the interim periods are reflected.

In addition, the Form 10-Q represented that the Company’s improved earnings reflect “an increase in

customer utilization of Preferred charge programs [. . .]” The Form 10-Q stated in pertinent part as

follows:

Additionally, the Preferred charge programs realized improved yields and lower charge-offs from reduced delinquencies, resulting in an increase in the net excess recognized in finance revenue from off-balance sheet receivables. There have been no material changes in the assumptions utilized in the calculation of receivable gains in accordance with SFAS No. 125 since January 2, 1999. [Emphasis added.]

114. On October 21, 1999, Spiegel issued a press release entitled, “Spiegel Reports

Significant Earnings Improvement and 15 Percent Sales Increase for the Third Quarter 1999”

announcing its financial results for the quarter ended October 2, 1999. The Company reported net income of $4.2 million or $0.03 per share. Defendant Sievers commented on the announcement stating in pertinent part as follows:

“We are very pleased with the overall results we have achieved to date. Operating income increased $39.1 million in our merchandising segment for the quarter driven by significant gains in sales and gross profit margin. This positive momentum - 45 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 46 of 202

reflects the solid execution of refined merchandising strategies by our lifestyle retailers, particularly Eddie Bauer and Spiegel Catalog, combined with a higher contribution from our FCNB Preferred credit programs.” [Emphasis added.]

115. On November 16, 1999, Spiegel filed its Form 10-Q for the quarter ended October 2,

1999, with the SEC which confirmed the previously announced financial results and was signed by

Sievers, among others. The Form 10-Q represented the following concerning the financial

statements contained therein:

The consolidated financial statements included herein are unaudited and have been prepared from the books and records of the Company in accordance with generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission. All adjustments (consisting only of normal recurring accruals) which are, in the opinion of management, necessary for a fair presentation of financial position and operating results for the interim periods are reflected.

116. On December 2, 1999, Spiegel issued a press release announcing its sales for

November and providing “comments” on the fourth quarter. Defendant Sievers stated in pertinent part as follows:

While we experienced weakness during the month in the outerwear sales at Eddie Bauer, we saw good performance in other areas of our business, with particular strength at Spiegel Catalog in our credit operations. Based on our performance through November, we expect to achieve significant earnings improvement in the fourth quarter compared to last year.

The press release also represented that the “First Call consensus estimates for the fourth quarter of

1999 are reasonable based on performance through the first two months of the quarter . . . .”

117. On February 15, 2000, Spiegel issued a press release announcing its earnings for the fourth quarter and year ended January 1, 2000. For 1999, the Company reported that net earnings grew by $73.5 million to $85.3 million, or $0.65 per share, compared to earnings before the redemption of preferred stock of $11.8 million, or $0.09 per share, a year ago. Additionally the

Company reported that net sales revenues increased by $274 million or over 10%. The press release stated in relevant part as follows:

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James W. Sievers, office of the president and chief financial officer of The Spiegel Group, said, “The solid performance we achieved throughout the year continued in the fourth quarter, propelling The Spiegel Group to record operating income in 1999. Initiatives aimed at strengthening our merchandise performance by generating higher gross margins on a growing sales base produced dramatic improvement by each of our brands: Eddie Bauer, Newport News and Spiegel. The progress complemented by profitable growth in our FCNB Preferred credit operations combined to deliver a $168 million operating income improvement in our merchandising segment for the year.”

* * *

Sales growth in the fourth quarter was heavily influenced by a stronger contribution from Spiegel Catalog, delivering a 38 percent sales gain. In addition, all three marketing channels contributed to the Group’s progress, with total catalog sales rising 14 percent, total e-commerce sales jumping 358 percent and Eddie Bauer comparable-store sales growing 3 percent.

Finance revenue rose 19 percent in the quarter due to higher receivables resulting from increased utilization of the company’s FCNB Preferred and bankcard programs. Higher credit usage was driven by stronger sales growth, particularly from Spiegel and Newport News.

* * *

The company also noted that it will continue to utilize asset-backed securitization of receivables as a financing resource to manage debt and help fund the growth of its credit businesses. [Emphasis added.]

Defendant Moran also commented on the results stating in pertinent part as follows:

“[. . .] Our top priority is to continue to drive sales and gross profit margins higher by keeping our merchandising strategies focused on our customers’ lifestyle needs and in sync with customers’ expectations of the Eddie Bauer, Newport News and Spiegel brands. Another top priority is maximizing the e-commerce potential of each of our brands. As a multi-channel retailer, our company is uniquely positioned to capitalize on consumers’ growing interest in electronic shopping without the costs of building brand equity or a service infrastructure from scratch. We have capitalized on our core competencies to build a strong platform for future growth. Working from this stronger base, we are well positioned to achieve our financial objective for 2000 of at least 15 percent earnings per share improvement driven by continued expansion of gross profit margins on moderate sales growth.” [Emphasis added.]

118. On February 20, 2000, an article by Scott Silvestri was published in the Daily Herald based, in part, on information provided by the Company. The article discussed the Company’s

“astonishing” one-year turnaround, stating, in relevant part, as follows:

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Between 1996 and 1998, Spiegel Inc. scaled back Spiegel Catalog circulation, cut jobs and repackaged and sharpened its focus. And Eddie Bauer, which has seen flat or declining same-store sales for four years, adjusted its product lines in stores and the catalog. The moves were part of Spiegel’s plan to win back customers in a hurry.

Spiegel’s repositioning plan for its ailing units worked, with the payoff coming in the last fiscal year, which ended Jan. 31.

“It’s astonishing,” retail consultant Leo J. Shapiro, of Leo J. Shapiro & Associates in Chicago, said of the company’s one-year turnaround. “It’s a good sign that their improvement came across the board in every division of the company.” [Emphasis added.]

Spiegel’s Moran said the company won’t rest on its laurels. “While last year was a very successful year, we’re not satisfied with that and we’ll continue to work hard, refine our strategies and stay close to our customers,” he said. He expects sales from the three retail businesses to grow 8 to 10 percent in 2000.

119. On or about March 24, 2000, Spiegel filed its Form 10-K for the fiscal year ended

January 1, 2000, (the “1999 10-K”) with the SEC which confirmed the previously announced financial results and was signed by Moran, Zaepfel and Sievers, among others. The 1999 10-K represented that the Company had outstanding debt of only $781 million and stockholder’s equity of

$725 million at the end 1999.

120. The 1999 10-K described the Company’s asset securitization transactions and represented that the receivables had been sold “without recourse.” The 1999 10-K stated in pertinent part as follows:

The Company routinely transfers portions of its customer receivables to trusts that, in turn, sell certificates representing undivided interests in the trusts to investors. The receivables are sold without recourse, and accordingly, no bad debt reserve related to the receivables sold is maintained. In addition to the certificates sold, an additional class of investor certificates, currently retained by the Company, was issued by the trust in certain transactions.

The Company recognizes gains on its securitization of customer receivables. Net gains of $15,760 and $45,328 were recorded as finance revenue in 1999 and 1998, respectively, representing the present value of estimated future cash flows the Company will receive over the estimated outstanding period of the asset securitization. These future cash flows consist of an estimate of the excess of finance charges and fees over the sum of the return paid to certificate holders, contractual servicing fees, and credit losses along with the future finance charges and principal - 48 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 49 of 202

collections related to interests in the customer receivables retained by the Company. These estimates are calculated utilizing the current performance trends of the receivable portfolios. Certain estimates inherent in determining the present value of these estimated future cash flows are influenced by factors outside the Company’s control, and, as a result, could materially change in the near term. [Emphasis added.]

121. The statements described in ¶¶110-120 were each materially false and misleading when made because they failed to disclose and misrepresented the following adverse facts, among others:

(a) that the Company had materially understated its debt by at least $1.6 billion at

January 1, 2000;

(b) that the Company’s revenues, earnings and stockholders’ equity were materially overstated by tens of millions of dollars as a result of the Company’s improper recognition of “receivable gains” and “servicing fees” from the Company’s securitizations of credit card receivables. Thus, it was not true that the Company had returned to “profitability”;

(c) that the assumptions, estimations and forecasts utilized by Defendants, except for Cannataro, in calculating the Company’s “receivable gains” were grossly inconsistent with the credit characteristics of the underlying assets, thereby resulting in the material overstatement of the

Company’s revenues and earnings. Such assumptions included, among others, expected charge-offs, expected delinquencies and expected payment streams;

(d) that it was not true that Spiegel’s securitized receivables were sold without recourse, as set forth in further detail herein at ¶¶213-245;

(e) that the Company’s financial statements were not prepared in accordance with

GAAP in numerous respects and were materially false and misleading as detailed herein at ¶¶208-

356;

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(f) that Defendants, except for Cannataro, had materially lowered the Company’s

credit criteria for account originations thus exposing the Company to increased risk of loss from

account charge-offs, delinquencies and defalcations;

(g) that Defendants’, except for Cannataro, lax credit policies and high risk

lending activities to sub-standard borrowers were fueling the Company’s credit card account

origination programs and resulting catalog merchandise sales revenues, especially at the Company’s

Spiegel and Newport News divisions;

(h) that demand for the company’s merchandise products and services had

materially declined but for Defendants’, except for Cannataro, aggressive and high-risk marketing of

Spiegel’s credit card services to sub-standard borrowers;

(i) that the Company’s “proprietary” credit scoring methods and practices, both in design and utility, were wholly inadequate for identifying adverse credit risk and varied significantly from standard industry practice and federal banking regulatory guidelines;

(j) that the Company’s credit authorization procedures and determination of

“credit limits” regarding “secured lines of credit”, among others, varied significantly from standard industry practice, resulting in the extension of credit to certain individuals that exceeded security deposits levels by as much as 500% in some instances, and routinely exceeded such deposits by at least 200%;

(k) that the Company was currently experiencing certain adverse trends in the repayment of its credit card account receivables assets, both in receivables “retained” by the

Company and in “securitized” receivables “off- balance sheet receivables” serviced by the

Company;

(l) that FCNB was actually operating in violation of federal banking regulations as it failed to maintain statutory and risked-based capital requirements;

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(m) that the Company violated GAAP and its own policies by failing to adequately compensate FCNB for the increased cost of collections due to increasing account delinquencies and defalcations, such “servicing fee liabilities” amounted to at least $50 million on an annual basis; and

(n) based on the foregoing, the Company’s revenues, earnings and financial position were materially misstated at all relevant times and Defendants’, except for Cannataro, opinions, projections and forecasts concerning the Company and its operations were lacking in a reasonable basis at all times and therefore materially false and misleading.

122. On April 25, 2000, Spiegel issued a press release announcing its financial results for the first quarter ended April 1, 2000. The Company reported purported “Record First Quarter

Earnings” of $20.2 million or $0.15 per share as compared to a loss of $0.08 per share for the same period the prior year. Defendant Sievers commented on the results stating in pertinent part as follows:

The significant earnings turnaround reported this quarter reflects the combined strength of our merchant companies and our credit operations. We realized improved operating income from each of our businesses – Eddie Bauer, Spiegel, Newport News and FCNB, driving operating income up by more than $49 million for the quarter . . . .

123. On May 16, 2000, Spiegel filed its Form 10-Q for the quarter ended April 1, 2000, with the SEC which confirmed the previously announced financial results and was signed by

Sievers, among others. The Form 10-Q represented the following concerning the financial statements contained therein:

The consolidated financial statements included herein are unaudited and have been prepared from the books and records of the Company in accordance with generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission. All adjustments (consisting only of normal recurring accruals) which are, in the opinion of management, necessary for a fair presentation of financial position and operating results for the interim periods are reflected.

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124. On July 6, 2000, Spiegel issued a press release announcing its sales for June and providing “comments” on its second quarter earnings estimates. Defendant Siever provided the following statement concerning the Company’s expected second quarter earnings:

“Continued growth in our direct [catalog and e-commerce] business accompanied by higher gross profit margins will offset weakness experienced in our retail business, resulting in improved earnings in the second quarter of 2000 compared to 1999. We expect to meet our second quarter earnings estimates which are in line with consensus analysts’ estimates published by First Call.” [Emphasis added.]

125. Then, on July 25, 2000, Spiegel issued a press release announcing its financial results for the quarter ended July 1, 2000. The Company reported net earnings of $25.8 million or $0.20 per share. Defendant Sievers commented on the results stating in pertinent part as follows:

We are pleased with the continued earnings growth achieved in the second quarter, which represents our 11th consecutive quarterly improvement . . . . The earnings improvement was driven by higher performance levels in both our merchandising and bankcard segments . . . .

Defendant Moran commented on the announcement stating in pertinent part as follows:

Overall, The Spiegel Group continues to make solid strides in boosting its profit performance. Moving forward, we will continue to carefully exploit our unique positioning as a multi-channel, multi-brand lifestyle retailer . . . .

126. On August 15, 2000, Spiegel filed its Form 10-Q for the quarter ended July 1, 2000, with the SEC which confirmed the previously announced financial results and was signed by

Sievers, among others. The Form 10-Q represented the following concerning the financial statements contained therein:

The consolidated financial statements included herein are unaudited and have been prepared from the books and records of the Company in accordance with generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission. All adjustments (consisting only of normal recurring accruals) which are, in the opinion of management, necessary for a fair presentation of financial position and operating results for the interim periods are reflected.

127. On August 31, 2000, Spiegel issued a press release announcing a 6% sales increase for the thirty-four weeks ended August 26, 2000, the Company noted “continued sales strength in

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its Newport News and Spiegel divisions, reporting 26 percent and 14 percent sales increases,”

which offset declines in Eddie Bauer’s comp-store sales. [Emphasis added.]

128. On September 11, 2000, Spiegel issued a press release announcing that Moran and

Sievers had conducted presentations at First Security Van Kasper’s Class of 2000 Growth Stock

Conference in San Francisco. The press release contained the following comment from Defendant

Sievers which was made during his presentation:

“Our current plans call for 10 percent top-line growth and about 55 percent bottom-line growth this year. Over the next three years, we have planned continued sales growth of about 10 percent accompanied by higher earnings growth of 15 percent or more. We are off to a strong start this year towards achieving our objectives, with earnings well ahead of last year.” [Emphasis added.]

129. On October 5, 2000, Spiegel issued a press release announcing that it “would meet or exceed consensus analysts estimates” for the third quarter based in large part on increased securitization activity to fund growth in its credit business. [Emphasis added.]

130. On October 12, 2000, Spiegel issued a press release announcing that it had made

presentations at Robertson Stephens Conference in New York. During the presentation, Moran

outlined the Company’s “core competencies” currently driving its “improved financial

performance” stating in pertinent part as follows:

“[T]he company’s core competencies that have been fundamental in driving its improved financial performance, including: the brand power of Spiegel, Eddie Bauer and Newport News, multi-channel marketing capabilities, long-standing direct marketing expertise and a well-established infrastructure of systems and services.”

“These core competencies will give us powerful advantages as we strive to grow our businesses in the years ahead.” [Emphasis added.]

131. On October 24, 2000, Spiegel issued a press release announcing its financial results

for the quarter ended September 30, 2000. The Company reported net earnings of $13.5 million or

$0.10 per share. Defendant Sievers commented on the results stating in pertinent part as follows:

We are pleased to report our 12th consecutive quarter of year-over-year earnings improvement. Each of our merchant companies achieved higher earnings in the - 53 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 54 of 202

quarter with the exception of Eddie Bauer . . . . Meanwhile, our bankcard segment continued to post strong earnings growth, significantly exceeding last year’s third quarter . . . .

Defendant Moran noted that Spiegel’s full year forecasts and profits relied heavily on “securitization income.” The press release stated in relevant part as follows:

“[. . .] we expect to achieve 40 to 45 percent earnings per share growth for the year compared to last year’s earnings of $0.65 per share, which puts us at the lower end of the range of estimates, $0.92 to $1.05, previously published by First Call. Earnings growth from our credit business, including higher securitization income will be an important factor in the fourth quarter. [Emphasis added.]

132. On November 14, 2000, Spiegel filed its Form 10-Q for the quarter ended September

30, 2000, with the SEC which confirmed the previously announced financial results and was signed by Sievers, among others. The Form 10-Q represented the following concerning the financial statements contained therein:

The consolidated financial statements included herein are unaudited and have been prepared from the books and records of the Company in accordance with generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission. All adjustments (consisting only of normal recurring accruals) which are, in the opinion of management, necessary for a fair presentation of financial position and operating results for the interim periods are reflected.

133. At the November 2000 board meeting, Michael Moran (head of Spiegel’s Office of the President and chairman of FCNB) assured the directors that FCNB was under control. Yet the minutes of this meeting show that the directors knew or recklessly disregarded that credit problems were brewing:

This . . . significant increase in charge-offs not fully offset by finance revenue . . . is primarily driven by the new account growth at Spiegel and Newport News, as well as less favorable composition of seasoned versus unseasoned accounts. Also, there has been a degrading in the quality of new customer groups, and finally there is a higher composition of Newport News receivables within the proprietary portfolios which is the highest risk logo . . . . To improve Preferred credit portfolio for 2001, certain actions have been taken that include risk management, such as reestablished back-end screening, slower credit limit development on new accounts, enhanced fraud screens and enhanced customer scoring models.

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134. The statements described in ¶¶122-133 were each materially false and misleading when made because they failed to disclose and misrepresented the following adverse facts, among others:

(a) that the Company had materially understated its debt by failing to properly account for its securitization SPEs as consolidated entities;

(b) that the Company’s revenues, earnings and stockholders’ equity were materially overstated by tens of millions of dollars as a result of the Company’s improper recognition of “receivable gains” and “servicing fees” from the Company’s securitizations of credit card receivables. Thus, it was not true that the Company had returned to “profitability”;

(c) that the assumptions, estimations and forecasts utilized by Defendants, except for Cannataro, in calculating the Company’s “receivable gains” were grossly inconsistent with the credit characteristics of the underlying assets, thereby resulting in the material overstatement of the

Company’s revenues and earnings. Such assumptions included, among others, expected charge-offs, expected delinquencies and expected payment streams;

(d) that it was not true that Spiegel’s securitized receivables were sold without recourse, as set forth in further detail herein at ¶¶213-245;

(e) that the Company’s financial statements were not prepared in accordance with

GAAP in numerous respects and were materially false and misleading as detailed herein at ¶¶208-

356;

(f) that Defendants, except for Cannataro, had materially lowered the Company’s credit criteria for account originations thus exposing the Company to increased risk of loss from account charge-offs, delinquencies and defalcations;

(g) that Defendants’, except for Cannataro, lax credit policies and high risk lending activities to sub-standard borrowers were fueling the Company’s credit card account

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origination programs and resulting catalog merchandise sales revenues, especially at the Company’s

Spiegel and Newport News divisions;

(h) that demand for the company’s merchandise products and services had

materially declined but for Defendants’, except for Cannataro, aggressive and high-risk marketing of

Spiegel’s credit card services to sub-standard borrowers;

(i) that the Company’s “proprietary” credit scoring methods and practices, both in design and utility, were wholly inadequate for identifying adverse credit risk and varied significantly from standard industry practice and federal banking regulatory guidelines;

(j) that the Company’s credit authorization procedures and determination of

“credit limits” regarding “secured lines of credit”, among others, varied significantly from standard industry practice, resulting in the extension of credit to certain individuals that exceeded security deposits levels by as much as 500% in some instances, and routinely exceeded such deposits by at least 200%;

(k) that the Company was currently experiencing certain adverse trends in the repayment of its credit card account receivables assets, both in receivables “retained” by the

Company and in “securitized” receivables “off- balance sheet receivables” serviced by the

Company;

(l) that FCNB was actually operating in violation of federal banking regulations as it failed to maintain statutory and risked-based capital requirements; and

(m) that the Company violated GAAP and its own policies by failing to adequately compensate FCNB for the increased cost of collections due to increasing account delinquencies and defalcations, such “servicing fee liabilities” amounted to at least $50 million on an annual basis; and

(n) based on the foregoing, the Company’s revenues, earnings and financial position were materially misstated at all relevant times and Defendants’, except for Cannataro,

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opinions, projections and forecasts concerning the Company and its operations were lacking in a

reasonable basis at all times and therefore materially false and misleading.

135. On December 14, 2000, the Company filed with the SEC a prospectus supplement

and to a prospectus dated December 8, 2000, as part of previously filed registration statement on

Form S-3 in connection with the public offering of $600 million SCCMNT Series 2000-A asset

backed notes (collectively, the prospectus, prospectus supplement and registration statement are

referred to herein as the “SCCMNT Series 2000-A Registration Statement”). The series 2000-A

notes were collaterlized by approximately $670 million of Preferred Card receivables. On December

19, 2000, issuance of the notes was completed. The registration statement,7 signed by Sievers and

Moran, among others, included the following representations concerning the Company’s credit- granting procedures:

The bank solicits new accounts with both preapproved and non-preapproved applications. Preapproved accounts constitute the majority of new account originations. Prospect lists are prescreened by the major credit reporting services to develop a list of preapproved prospects. The bank obtains a report from the credit bureau providing a list of prospects who are preapproved based on the bank’s proprietary scoring models. The bank compares the preapproved prospects against its own database, and excludes customers based on specified criteria. For example, the bank excludes customers who have an existing account with the bank, who are in bankruptcy, who are deceased or whose credit report history contains an a/k/a name or history of fraud. Prescreened offers range from $250 to $3,300. The initial credit lines are based on the information contained in the credit bureau report obtained when the applicant responds to the offer.

All non-preapproved applications are processed through an empirically derived, statistically validated scoring model that was developed based on historical data from the bank’s account base. The model is periodically re- validated for predictability every six to twelve months and evaluates a variety of factors including:

• performance with other creditors,

7 The first amended registration statement was filed by Spiegel on August 8, 2000, a second amended registration statement was filed on October 10, 2000.

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• number of references on credit file,

• length of time on credit file, and

• utilization of credit lines with other creditors.

A credit report is obtained for each non-preapproved application. Credit lines are assigned based on credit score. Credit limits granted range from $250 to $3,300.

FCNB revised their internal scoring models in 1996 to capture diversified trends within each merchant portfolio. The new model is more predictive of risk in each targeted portfolio.

A small portion of total applications processed through the internal scoring model are routed by the system for manual verification handling. These applications are so routed due to credit bureau alert messages, name or address variations between applications and credit reports or an existing credit line from the bank listed on the report. Only applications meeting the final credit score requirement are referred for verification procedures. Once applications are referred, they are approved only upon successful verification of the information in question. Besides this manual verification process, no manual overrides are possible on the system. Generally, all approvals are automated, except for credit limits in excess of $7,590. The Senior Vice President/Credit Operations Manager is authorized to approve limits ranging from $7,591 to $25,000. Limits in excess of $25,000 and up to $50,000 must be approved by the Executive Vice President/Director of Operations. Limits in excess of $50,000 must be approved by the bank’s board of directors. [Emphasis added.]

136. The SCCMNT 2000-A Registration Statement included the following representation related to the Company’s delinquency reporting and credit collection practices:

The bank classifies an account as delinquent for collections purposes when the minimum payment due on the account is not received by the payment due date specified in the cardholder’s billing statement. The bank collections staff is segregated into five separate collection departments, each of which is made up of six queues based on severity of delinquency. The collections staff initiates collection efforts as early as the third day of delinquency if no contact has been made through the autodialer as discussed below. Accounts are placed in the collection office at various levels of delinquency, with all accounts being placed no later than 60 days after the first payment is missed. The majority of accounts are placed within the first 30 days of a missed payment. The bank uses behavioral scoring of all accounts to adjust its collection efforts based on the potential risk of an account and the dollars at risk. Collection efforts escalate in intensity as an account cycles into a more advanced delinquency category.

The bank’s collection strategy begins with an early delinquency calling program using state of the art technology that includes predictive dialing for accounts that are up to two payments past due. Statement messaging and automatic letter dunning are

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also used on delinquent accounts up to two payments past due. Accounts which are placed in the collections office are assigned to specific members of the bank collections staff for accelerated collection efforts, including demands for balance in full, correspondence from one or more of the national credit bureaus describing the impact that the delinquent credit obligation has on the cardholder’s credit history and preparatory actions to place accounts with attorneys for legal action. Additionally, in 1999 the bank began outsourcing a portion of pre- charge-off accounts to external collection agencies for resolution.

Additional purchases are not permitted to be charged to accounts which are two or more payments past due. [Emphasis added.]

137. The statements referenced above in ¶¶135-136 were each materially false and

misleading for the reasons set forth in ¶135 because they failed to disclose and misrepresented the

following adverse material facts, among others:

(a) that final credit approval for Preferred Card account applications was in fact

being determined by Spiegel’s merchant divisions and not FCNB. The descriptions of credit

underwriting procedures under the control of FCNB was false. In fact, Spiegel’s top management

has now admitted that FCNB’s credit underwriting was for some time controlled by Spiegel’s

merchant subsidiaries. According to documents reviewed by the Independent Examiner, FCNB

president James Huston stated, “. . . initial [credit] criteria [were] set by FCNB, but . . . the actual

distribution of credit offers [was] manipulated by the merchants,” meaning Spiegel Catalog and

Newport News. In particular, the representation in the prospectuses that the bank’s scoring models could, to some degree, accurately predict losses was false when made. The inherent lack of FCNB to accurately forecast delinquencies and losses caused material misstatements of Spiegel’s financial results throughout the Class Period;

(b) that FCNB made all of the credit decisions regarding whom to solicit for accounts. This was not true since the Spiegel merchants used the “net down” process to eliminate many of the better accounts that FCNB wished to solicit and increased the number of subprime

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borrowers that were offered a credit card. This important risk factor was never disclosed to investors;

(c) that customer purchases authorizations were routinely approved regardless of pre-established credit limits and “strategies” employed by the bank to provide approval buffers above those limits. As determined by the Independent Examiner, customers could make purchases above the stated credit limit. This practice put more accounts at risk and put pressure on already inaccurate forecasts and should have been disclosed to investors;

(d) that instead of dealing aggressively with delinquencies, FCNB employed so-called “recency accounting” to manage the credit portfolio. Under this practice, a customer could cure a delinquency extending over several months simply by making one minimum monthly payment, and thereby have the delinquency clock set back to zero, despite a continuing outstanding balance. Customers could thus be current for FCNB’s accounting purposes, while at the same time delinquent on a contractual basis. Recency accounting stretched out delinquencies, and kept an account out of charge-off status for a longer period of time. FCNB employed recency accounting for its Preferred Cards only, not for its issued bank cards. Based on documents reviewed by the

Independent Examiner, FCNB had disclosed its use of recency accounting over five years earlier in offering the SMT 1995-A series to the public. But by the time it was offering the SCCMNT Series

2000-A, Spiegel had dropped this disclosure practice. Indeed, notes by legal counsel during the preparation of the offering documents used to sell the SCCMNT Series 2000-A securities show an effort of “not going into too much detail re: contract.” Furthermore, no mention is made at all that recency accounting was used in determining the numbers given in the delinquency experience tables.

Therefore, because the delinquency experience numbers were presented using recency accounting, investors had no way to determining how many accounts were really “delinquent” since an account

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could be considered current even if a substantial number of payments had been missed. Given the

rapidly rising delinquencies at FCNB, these disclosures were a material omission; and

(e) that the cause of FCNB’s increasing credit card delinquencies was not

primarily due to the increase in new and unseasoned accounts. The offering documents failed to

disclose that these delinquencies resulted in large measure from the lowering of credit standards,

approval of riskier accounts for credit, and the “net down” process that gave the Spiegel merchant

retailers the power to pump sales by soliciting the least creditworthy customers.

138. On January 4, 2001, Spiegel issued a press release announcing the Company’s sales

results for the month of December 2000 and providing “comments” on its earnings for the fourth

quarter. Defendant Moran commented in the press release, stating in pertinent part as follows:

For the full-year 2000, we expect to report our second consecutive year of record earnings, as the Group continues to benefit from its unique positioning as a multi- channel retailer with strong brands and outstanding service, meeting the needs of customers at different market levels. Looking at 2001, we see opportunity for continued sales and earnings growth, despite our expectation that the retail environment will be challenging. Our plans call for revenue growth of 8 to 10 percent accompanied by a slightly higher range of earnings growth, with stronger performance in the second half of the year.

139. In January 2001, Sievers commented on the percentage of defaults among Spiegel’s preferred credit card customers. He received a report from FCNB showing that the default rate was significantly higher than projected. He reacted in a memo that stated:

The above forecast differences raise serious doubts about our ability to manage our credit business and forecast its direction. This causes serious credibility problems both internally and externally and jeopardizes our ability to finance this business.

140. On January 19, 2001, Spiegel issued a press release announcing that Defendants

Moran and Sievers had “decided to retire,” effective June 30, 2001. It was also announced that

Zaepfel, a current Spiegel director and former executive of Otto Versand, would become Spiegel’s

President and CEO, and that Cannataro would become the Company’s CFO, effective July 1, 2001.

Subsequently, it was revealed that Sievers and Moran had each received cash payments of - 61 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 62 of 202

$4,000,000, which exceeded their annual salary and bonus compensation by more than 400%, as part

of their “retirement agreements.”

141. On February 15, 2001, Spiegel issued a press release announcing its earnings for the

fourth quarter and year ended December 30, 2000. Under the banner headline, “The Spiegel Group

Reports 46 Percent Increase in Earnings For 2000 Fourth Quarter Results Meet Expectations,”

(emphasis added) the Company reported that earnings grew by 46 percent for the year to $124.9 million or $0.95 per share with a 9 percent increase in revenue. Defendant Sievers attributed the earnings increase to a “substantial improvement” in the earnings reported by Spiegel’s credit card operations which more than offset declines in the Company’s Eddie Bauer merchandise division.

Commenting on the Company’s 2001 earnings outlook, Moran stated, “[. . .] we expect our credit business to generate a significant earnings contribution for the year.”

142. On or about March 30, 2001, Spiegel filed its Form 10-K for the fiscal year ended

December 30, 2000, (the “2000 10-K”) with the SEC which confirmed the previously announced financial results and was signed by Moran, Zaepfel and Sievers, among others. The Company reported that it had outstanding debt of only $795 million and stockholder’s equity of $827 million at the end of 2000.

143. The 2000 10-K described the Company’s asset securitization transactions

representing that the receivables had been sold “without recourse” and also representing that the

trusts compensated the Company at fair market for the servicing rights retained by the Company.

The 2000 10-K stated in pertinent part as follows:

The majority of the Company’s credit card receivables are transferred to trusts that, in turn, sell certificates and notes representing undivided interests in the trusts to investors. The receivables are sold without recourse. Accordingly, no allowance for doubtful accounts related to the sold receivables is maintained by the Company. When the Company sells receivables in these securitizations, it retains interest-only strips, subordinated certificates, receivables and cash reserve accounts, all of which are included in retained interests in securitized receivables. Recognition of gain or loss on the sale of receivables depends in part on the previous carrying amount of - 62 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 63 of 202

the financial assets involved in the transfer, allocated between the assets sold and the retained interests based on their relative fair value at the date of transfer.

* * *

The Company also maintains responsibility for servicing the securitized receivables and receives annual servicing fees of 2 percent of all receivables transferred to the trusts. This servicing fee reflects the fair market value for these servicing rights; accordingly, the Company does not record servicing assets or liabilities. [Emphasis added.]

144. The statements described in ¶¶138 and 140-143 were each materially false and

misleading when made because they failed to disclose and misrepresented the following adverse facts, among others:

(a) that the Company had materially understated its debt by at least $3.1 billion at

December 30, 2000;

(b) that the Company’s revenues, earnings and stockholders’ equity were materially overstated by tens of millions of dollars as a result of the Company’s improper recognition of “receivable gains” and “servicing fees” from the Company’s securitizations of credit card receivables. Thus, it was not true that the Company had returned to “profitability”;

(c) that the assumptions, estimations and forecasts utilized by Defendants, except for Cannataro, in calculating the Company’s “receivable gains” were grossly inconsistent with the credit characteristics of the underlying assets, thereby resulting in the material overstatement of the

Company’s revenues and earnings. Such assumptions included, among others: expected charge-offs, expected delinquencies and expected payment streams;

(d) that it was not true that Spiegel’s securitized receivables were sold without

recourse, as set forth in further detail herein at ¶¶213-245;

(e) that the Company’s financial statements were not prepared in accordance with

GAAP in numerous respects and were materially false and misleading as detailed herein at ¶¶208-

356; - 63 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 64 of 202

(f) that Defendants, except for Cannataro, had materially lowered the Company’s

credit criteria for account originations thus exposing the Company to increased risk of loss from

account charge-offs, delinquencies and defalcations;

(g) that Defendants’, except for Cannataro, lax credit policies and high risk

lending activities to sub-standard borrowers were fueling the Company’s credit card account

origination programs and resulting catalog merchandise sales revenues, especially at the Company’s

Spiegel and Newport News divisions;

(h) that demand for the company’s merchandise products and services had

materially declined but for Defendants’, except for Cannataro, aggressive and high-risk marketing of

Spiegel’s credit card services to sub-standard borrowers;

(i) that the Company’s “proprietary” credit scoring methods and practices, both in design and utility, were wholly inadequate for identifying adverse credit risk and varied significantly from standard industry practice and federal banking regulatory guidelines;

(j) that the Company’s credit authorization procedures and determination of

“credit limits” regarding “secured lines of credit”, among others, varied significantly from standard industry practice, resulting in the extension of credit to certain individuals that exceeded security deposits levels by as much as 500% in some instances, and routinely exceeded such deposits by at least 200%;

(k) that the Company was currently experiencing certain adverse trends in the repayment of its credit card account receivables assets, both in receivables “retained” by the

Company and in “securitized” receivables “off-balance sheet receivables” serviced by the Company;

(l) that FCNB was operating in violation of federal banking regulations as it failed to maintain statutory and risked-based capital requirements. Accordingly, it was not true that

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FCNB was being positioned for “further growth” as FCNB was being run in an extremely reckless manner;

(m) that the Company violated GAAP and its own policies by failing to adequately compensate FCNB for the increased cost of collections due to increasing account delinquencies and defalcations, such “servicing fee liabilities” amounted to at least $50 million on an annual basis; and

(n) based on the foregoing, the Company’s revenues, earnings and financial position were materially misstated at all relevant times and Defendants’, except for Cannataro, opinions, projections and forecasts concerning the Company and its operations were lacking in a reasonable basis at all times and therefore materially false and misleading.

145. On April 24, 2001, Spiegel issued a press release announcing its financial results for the first quarter ended March 31, 2001. The Company reported a net loss of $12.2 million, including a 3% decline in merchandise sales and a 10% decline in finance revenue. Defendant Moran commented on the announcement stating in pertinent part as follows:

“Given the challenging economic environment, we have intensified our efforts to reduce expenses and conservatively manage our inventory commitments going forward. Although the economic outlook for the second half of the year is uncertain, we have taken important actions in our credit business and in our Eddie Bauer division that are expected to positively impact earnings.” [Emphasis added.]

146. On May 15, 2001, Spiegel filed its Form 10-Q for the quarter ended March 31, 2001, with the SEC which confirmed the previously announced financial results and was signed by

Sievers, among others. The Form 10-Q represented the following concerning the financial statements contained therein:

The consolidated financial statements included herein are unaudited and have been prepared from the books and records of the Company in accordance with generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission. All adjustments (consisting only of normal recurring accruals) which are, in the opinion of management, necessary for a fair presentation of financial position and operating results for the interim periods are reflected.

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147. On June 7, 2001, Spiegel issued a press release announcing that Moran had made a presentation to investors at the U.S. Bancorp Piper Jaffray Consumer Conference in New York.

During the presentation, as repeated in the press release, Moran represented that the Company would have a “45% to 50%” increase in earnings during the second half of 2001 and forecasting “higher securitization income for the second quarter of 2001 compared to 2000.” [Emphasis added.]

148. The statements described in ¶¶145-147 were each materially false and misleading when made because they failed to disclose and misrepresented the following adverse facts, among others:

(a) that the Company had materially understated its debt by failing to properly account for its securitization SPEs as consolidated entities;

(b) that the Company’s revenues, earnings and stockholders’ equity were materially overstated by tens of millions of dollars as a result of the Company’s improper recognition of “receivable gains” and “servicing fees” from the Company’s securitizations of credit card receivables. Thus, it was not true that the Company had returned to “profitability”;

(c) that the assumptions, estimations and forecasts utilized by Defendants, except for Cannataro, in calculating the Company’s “receivable gains” were grossly inconsistent with the credit characteristics of the underlying assets, thereby resulting in the material overstatement of the

Company’s revenues and earnings. Such assumptions included, among others: expected charge-offs, expected delinquencies and expected payment streams;

(d) that it was not true that Spiegel’s securitized receivables were sold without recourse, as set forth in further detail herein at ¶¶213-245;

(e) that the Company’s financial statements were not prepared in accordance with

GAAP in numerous respects and were materially false and misleading as detailed herein at ¶¶208-

356;

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(f) that Defendants, except for Cannataro, had materially lowered the Company’s

credit criteria for account originations thus exposing the Company to increased risk of loss from

account charge-offs, delinquencies and defalcations;

(g) that Defendants’, except for Cannataro, lax credit policies and high risk

lending activities to sub-standard borrowers were fueling the Company’s credit card account

origination programs and resulting catalog merchandise sales revenues, especially at the Company’s

Spiegel and Newport News divisions;

(h) that demand for the company’s merchandise products and services had

materially declined but for Defendants’, except for Cannataro, aggressive and high-risk marketing of

Spiegel’s credit card services to sub-standard borrowers;

(i) that the Company’s “proprietary” credit scoring methods and practices, both in design and utility, were wholly inadequate for identifying adverse credit risk and varied significantly from standard industry practice and federal banking regulatory guidelines;

(j) that the Company’s credit authorization procedures and determination of

“credit limits” regarding “secured lines of credit”, among others, varied significantly from standard industry practice, resulting in the extension of credit to certain individuals that exceeded security deposits levels by as much as 500% in some instances, and routinely exceeded such deposits by at least 200%;

(k) that the Company was currently experiencing certain adverse trends in the repayment of its credit card account receivables assets, both in receivables “retained” by the

Company and in “securitized” receivables “off- balance sheet receivables” serviced by the

Company;

(l) that FCNB was actually operating in violation of federal banking regulations as it failed to maintain statutory and risked-based capital requirements;

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(m) that the Company violated GAAP and its own policies by failing to adequately compensate FCNB for the increased cost of collections due to increasing account delinquencies and defalcations, such “servicing fee liabilities” amounted to at least $50 million on an annual basis; and

(n) based on the foregoing, the Company’s revenues, earnings and financial position were materially misstated at all relevant times and Defendants’, except for Cannataro, opinions, projections and forecasts concerning the Company and its operations were lacking in a reasonable basis at all times and therefore materially false and misleading.

149. On June 29, 2001, Spiegel issued a press release announcing that Spiegel Credit Card

Master Note Trust’s $600 million series 2001-A floating rate asset backed notes were expected to be rated ‘AAA’ by Fitch, a credit rating agency. The press release reported that the expected ratings were based on the financial guaranty insurance policy provided by MBIA Insurance Co. and by:

the quality of the underlying receivables pool, available credit enhancement in the form of subordination and a spread account, First Consumers National Bank’s underwriting and servicing capabilities, adequate cash flows, and a sound legal structure, which employs the use of early amortization triggers.

150. On July 1, 2001, Martin Zaepfel – formerly the Otto “liaison” with Spiegel – took over as Spiegel’s new president and CEO. According to interviews conducted by the Independent

Examiner, at that time, he knew that Spiegel Catalog was using credit to pump sales, and he was aware that it was a credit-driven marketing company. Spiegel Catalog was the Spiegel unit most pushing for easy credit, with a “credit penetration” (percentage of customers served by Preferred

Card credit) that exceeded 70%.

151. On July 16, 2001, the Company filed with the SEC a prospectus supplement and to a prospectus dated June 27, 2001, as part of previously filed registration statement on Form S-3 in connection with the public offering of $600 million SCCMNT Series 2001-A asset backed notes

(collectively, the prospectus, prospectus supplement and registration statement are referred to herein as the “SCCMNT Series 2001-A Registration Statement”). The series 2001-A notes were - 68 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 69 of 202

collaterlized by approximately $685 million of Preferred Card receivables. On July 19, 2000,

issuance of the notes was completed. The registration statement,8 signed by Sievers and Moran,

among others, included the following representations concerning the Company’s credit-granting

procedures:

Pre-approved accounts constitute the majority of new account originations.

FCNB obtains lists of prospective candidates for pre-approved offers from one of several list brokers and major credit bureaus. These lists are prescreened based on the bank’s proprietary scoring models to develop a refined list of pre-approved prospects. The bank then compares this refined list of pre-approved prospects against its own database, and excludes customers who, among other things:

• have an existing account with the bank,

• are in bankruptcy,

• have a history of fraud,

• have judgments or liens against them, or

• are deceased

Credit limits on pre-approved offers range from $250 to $3,300. The initial credit lines are based on the information contained in the credit bureau report obtained when the applicant responds to the offer.

All non-pre-approved applications are processed through an empirically derived, statistically validated scoring model. A credit report is obtained for each non-pre-approved application. Credit limits are assigned based on the credit score obtained from one of the major credit bureaus and range from $250 to $3,300.

The bank’s internal scoring models for both pre-approved and non-pre- approved accounts were developed based on historical data from the bank’s account base and by identifying distinguishing characteristics on customer payment behavior. The models were revised in 2001 to capture diversified trends within each merchant portfolio. For example, customers of Eddie Bauer traditionally have a higher average income than customers of Spiegel Catalog and Newport News. The new models should more accurately predict losses for a given credit score and will be periodically re-validated for predictability every six to twelve

8 The first amended registration statement was filed by Spiegel on August 8, 2000, a second amended registration statement was filed on October 10, 2000.

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months. The predictive nature of the models will be evaluated based on the actual performance of accounts versus the predicted performance at origination. Each of the models evaluates a variety of factors. Although the relative importance of these factors varies among models, the following factors currently contribute the most to the credit score:

• performance with other creditors,

• number of references on credit file,

• length of time on credit file,

• utilization of credit lines with other creditors,

• types of trade lines,

• total amount of available credit,

• recent inquiries into credit file, and

• payment performance on other trade lines.

A small portion of total applications processed through the internal scoring model are routed by the system for manual verification handling. These applications are so routed due to credit bureau alert messages, name or address variations between applications and credit reports or an existing credit line from the bank listed on the report. Only applications meeting the final credit score requirement are referred for verification procedures. Once applications are referred, they are approved only upon successful verification of the information in question.

Generally, all approvals are automated, except for requested credit limits on non-pre-approved applications in excess of $3,300. Limits in excess of $3,300 and up to $7,591 must be approved by a credit supervisor. The Senior Vice President/Credit Operations Manager is authorized to approve limits ranging from $7,591 to $25,000. Limits in excess of $25,000 and up to $50,000 must be approved by the Executive Vice President/Director of Operations. Limits in excess of $50,000 must be approved by the bank’s board of directors.

New purchases for existing accounts must fall within the authorized credit limit plus an approval buffer determined by behavior scores and a set of strategies, collectively referred to as “adaptive control software.” All existing account authorizations are approved if the account is in good credit standing and the resulting balance is within the credit limit and the approval buffer. The vast majority of existing account authorizations are handled by the bank’s system logic without manual interruption. [Emphasis added.]

152. The SCCMNT 2001-A Registration Statement included the following representation related to the Company’s delinquency reporting and credit collection practices: - 70 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 71 of 202

The bank classifies an account as delinquent for collections purposes when the minimum payment due on the account is not received by the payment due date specified in the cardholder’s billing statement. The bank collections staff is segregated into five separate collection departments, each of which is made up of six queues based on severity of delinquency. The collections staff initiates collection efforts as early as the third day of delinquency if no contact has been made through the autodialer as discussed below. Accounts are placed in the collection office at various levels of delinquency, with all accounts being placed no later than 60 days after the first payment is missed. The majority of accounts are placed within the first 30 days of a missed payment. The bank uses behavioral scoring of all accounts to adjust its collection efforts based on the potential risk of an account and the dollars at risk. Collection efforts escalate in intensity as an account cycles into a more advanced delinquency category.

The bank’s collection strategy begins with an early delinquency calling program using state of the art technology that includes predictive dialing for accounts that are up to two payments past due. Statement messaging and automatic letter dunning are also used on delinquent accounts up to two payments past due. Accounts which are placed in the collections office are assigned to specific members of the bank collections staff for accelerated collection efforts, including demands for balance in full, correspondence from one or more of the national credit bureaus describing the impact that the delinquent credit obligation has on the cardholder’s credit history and preparatory actions to place accounts with attorneys for legal action. Additionally, in 1999 the bank began outsourcing a portion of pre-charge-off accounts to external collection agencies for resolution.

Additional purchases are not permitted to be charged to accounts which are two or more payments past due.

* * *

. . . delinquency and loss experience primarily reflects the overall credit quality of the cardholders, the seasoning of the accounts, servicing procedures utilized and general economic conditions. The service’s experience indicates that new customers demonstrate higher delinquency rates than more seasoned customers. Recent increases in Spiegel Catalog and Newport News account originations have decreased the ratio of seasoned accounts in the portfolio. As a result of this change in composition, together with economic and competitive circumstances and account management practices that have been designed to promote account balance growth for existing accounts, delinquency rates have increased through December 31, 2000 and loss rates have increased through April 30, 2001. We have taken steps to reverse the trend including implementing improved modeling, restrictions to credit limit increases and authorization procedures and increased collection activities. [Emphasis added.]

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153. The statements referenced above in ¶¶151-152 were each materially false and

misleading for the reasons set forth in ¶148 and because they failed to disclose and misrepresented

the following adverse material facts, among others:

(a) that final credit approval for Preferred Cards account applications was in fact

being determined by Spiegel’s merchant divisions and not FCNB. The descriptions of credit

underwriting procedures under the control of FCNB was false. In fact, Spiegel’s top management

has now admitted that FCNB’s credit underwriting was for some time controlled by Spiegel’s

merchant subsidiaries. According to documents reviewed by the Independent Examiner, FNCB

president James Huston stated, “. . . initial [credit] criteria [were] set by FCNB, but . . . the actual

distribution of credit offers [was] manipulated by the merchants,” meaning Spiegel Catalog and

Newport News. In particular, the representation in the prospectuses that the bank’s scoring models could, to some degree, accurately predict losses was false when made. The inherent lack of FCNB to accurately forecast delinquencies and losses caused material misstatements of Spiegel’s financial results throughout the Class Period;

(b) that FCNB made all of the credit decisions regarding whom to solicit for accounts. This was not true since the Spiegel merchants used the “net down” process to eliminate many of the better accounts that FCNB wished to solicit and increased the number of subprime

borrowers that were offered a credit card. This important risk factor was never disclosed to

investors;

(c) that customer purchases authorizations were routinely approved regardless of

pre-established credit limits and “strategies” employed by the bank to provide approval buffers

above those limits. As determined by the Independent Examiner, customers could make purchases

above the stated credit limit. This practice put more accounts at risk and put pressure on already

inaccurate forecasts and should have been disclosed to investors;

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(d) that instead of dealing aggressively with delinquencies, FCNB employed so-called “recency accounting” to manage the credit portfolio. Under this practice, a customer could cure a delinquency extending over several months simply by making one minimum monthly payment, and thereby have the delinquency clock set back to zero, despite a continuing outstanding balance. Customers could thus be current for FCNB’s accounting purposes, while at the same time delinquent on a contractual basis. Recency accounting stretched out delinquencies, and kept an account out of charge-off status for a longer period of time. FCNB employed recency accounting for its Preferred Cards only, not for its issued bank cards. Based on documents reviewed by the

Independent Examiner, FNCB had disclosed its use of recency accounting over five years earlier in offering the SMT 1995-A series to the public. But by the time it was offering the SCCMNT Series

2000-A and Series 2001-A, Spiegel had dropped this disclosure practice. Indeed, notes by legal counsel during the preparation of the offering documents used to sell the SCCMNT Series 2000-A securities show an effort of “not going into too much detail re: contract.” Furthermore, no mention is made at all that recency accounting was used in determining the numbers given in the delinquency experience tables. Therefore, because the delinquency experience numbers were presented using recency accounting, investors had no way to determining how many accounts were really

“delinquent” since an account could be considered current even if a substantial number of payments had been missed. Given the rapidly rising delinquencies at FCNB, these disclosures were a material omission; and

(e) that the cause of FCNB’s increasing credit card delinquencies was not primarily due to the increase in new and unseasoned accounts. The offering documents failed to disclose that these delinquencies resulted in large measure from the lowering of credit standards, approval of riskier accounts for credit, and the “net down” process that gave the Spiegel merchant retailers the power to pump sales by soliciting the least creditworthy customers.

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154. On July 24, 2001, Spiegel issued a press release announcing its financial results for

the second quarter ended June 30, 2001. The Company reported earnings of $5 million, or $0.04 per

share. Defendant Cannataro commented on the results stating in pertinent part as follows:

While under last year’s record performance, earnings were in line with our expectations. We anticipate substantial year-over-year earnings improvement in the fall season as we compare against last year’s weaker sales period, particularly at Eddie Bauer . . . .

155. On August 13, 2001, Spiegel filed its Form 10-Q for the quarter ended June 30, 2001, with the SEC which confirmed the previously announced financial results and was signed by

Cannataro. The Form 10-Q represented the following concerning the financial statements contained therein:

The consolidated financial statements included herein are unaudited and have been prepared from the books and records of the Company in accordance with generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission. All adjustments (consisting only of normal recurring accruals) which are, in the opinion of management, necessary for a fair presentation of financial position and operating results for the interim periods are reflected.

156. On September 6, 2001, Spiegel issued a press release announcing its sales for August and providing “comments” on earnings expectations for the third and fourth quarter of 2001. The

Company reported that “as a result of continued sales weakness in its merchandising companies and higher than anticipated charge-offs in its private-label credit business, third quarter earnings are now expected to be between a loss of $0.05 and $0.10 per share.” Defendant Cannataro provided the following explanation concerning the Company’s credit card receivables:

After seeing positive delinquency trends in prior months, an improvement in customer charge-offs was anticipated in the second half of the year, however, subsequently delinquency rates have increased in our private-label credit business. In reaction, we are implementing more restrictive credit measures aimed at lowering our charge-off exposure and improving the quality of our portfolio, although it will take time for these actions to make an impact. Therefore, we now expect higher charge-offs to negatively affect our earnings in the third and fourth quarters . . . .

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157. According to Company documents reviewed by the Independent Examiner, in late

October 2001, Spiegel’s internal audit director Michael McKillip circulated two documents that

alerted senior management to the seriousness of the credit problems then facing FCNB. On October

18, 2001, McKillip sent his “preferred collection process review” to Horst Hansen (audit committee

chair), Martin Zaepfel (CEO) and others in senior management. This review identified “several

policy driven factors contributing to the increase in delinquency ‘roll rates’ and, in turn,

charge-offs.” According to the internal audit director, these factors included:

• increased solicitation of credit customers with low credit scores;

• managing credit delinquencies on a “recency” basis – thus allowing a delinquent customer to become current with only a minimum qualifying payment;

• allowing delinquent customers to continue purchasing for three months;

• giving delinquent customers credit limit increases; and

• allowing credit customers to continue purchasing while over their credit limit.

158. McKillip attached a memo from FCNB’s own internal audit director noting that

“[o]ver the last three years, charge-off rates on our preferred credit card accounts have increased

substantially.”

159. According to the Independent Examiner’s Report, just two weeks later, on October

31, 2001, McKillip circulated his “key credit indicators report,” again to Hansen (audit committee

chair), Zaepfel (CEO) and others in senior management. This report forecast that Preferred Card

charge-offs (including charge-offs due to fraud) would jump from $206.2 million (11.2%) in 2000,

to $388.4 million (17.7%) in 2001. McKillip blamed this jump on “[h]eavy reliance on subprime credit accounts – for example, 62% of Spiegel Catalog’s new credit customers booked in Spring

2001 were D and F accounts compared to only 31% in 1998,” as well as on “[e]xcessive credit limit increases granted to sub-prime accounts beginning in 1998.” - 75 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 76 of 202

160. On October 23, 2001, Spiegel issued a press release announcing its financial results for the third quarter ended September 29, 2001. The Company reported a loss of $12.3 million or

$0.09 per share. Defendant Zaepfel commented on the Company’s outlook stating:

Each of our merchant companies and our bank are focused on actions that will improve earnings performance in the fourth quarter. At the same time, we are developing merchandise strategies aimed at improving sales productivity and reducing the reliance on credit marketing programs to drive sales.

161. On November 13, 2001, Spiegel filed its Form 10-Q for the quarter ended September

29, 2001, with the SEC which confirmed the previously announced financial results and was signed by Cannataro. The Form 10-Q represented the following concerning the financial statements contained therein:

The consolidated financial statements included herein are unaudited and have been prepared from the books and records of the Company in accordance with generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission. All adjustments (consisting only of normal recurring accruals) which are, in the opinion of management, necessary for a fair presentation of financial position and operating results for the interim periods are reflected.

162. The importance of internal audit director McKillip’s conclusions was not lost on

Spiegel’s audit committee. According to the Independent Examiner’s Report, at its November 27,

2001 meeting in Hamburg – just a month before its fiscal year-end – Spiegel audit committee chair

Hansen reviewed “significant issues” from McKillip’s “key credit indicators report,” and commented that “issuance of high risk credit had increased dramatically.” Audit committee member

Michael Crusemann (also Otto Versand CFO) responded that “the Audit Committee and the Board had been previously told by management that these things were under control – obviously they were not” and that it appeared that “easy credit was used to pump up sales,” with “too much concentration on sales and not enough on profitability, including credit.” Spiegel’s new CFO James Cannataro commented “that it is clear the Risk Management function at FCNB did not monitor what was happening closely enough, and did not exercise independent judgment when they should have been

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resisting pressure from the merchants to loosen up credit.” Crusemann agreed and stated his belief

that “Risk Management was forced to give into the merchants’ demands.”

163. According to the Independent Examiner’s Report, at the full board meeting the next

day Zapfael reported to the board that Spiegel Catalog’s 2001 EBT was expected to plummet to

$10.9 million, a drop of $22.5 million from the year before, and that Spiegel Catalog would work during 2002 “to reduce the company’s dependence upon high risk credit customers.” Newport News likewise projected a drop to a loss of $7 million, a drop of $31.5 million from the previous year’s

$24.5 million EBT.

164. On December 6, 2001, Spiegel issued a press release announcing that it now expected

lower fourth quarter earnings due to “sales weakness” but did not disclose that the true reason for the

sales declines – Spiegel Catalog’s curtailment of high risk credit programs. The press release stated

in pertinent part as follows:

Commenting on earnings for the fourth quarter ending December 29, 2001, the company stated that given the continued sales weakness experienced across its merchant companies, fourth quarter results are expected to be below its previous earnings guidance of $0.25 to $0.30 per share. December represents a significant month to the Group’s fourth quarter earnings and given the uncertainty surrounding its outcome, the company is not providing further guidance at this time. [Emphasis added.]

165. At the end of January 2002, internal audit director McKillip sent audit committee members Hansen and Crusemann, as well as a number of Spiegel senior executives, his key credit

indicators report for all of 2001. The report showed that charge-offs for Spiegel’s Preferred Card

“continued to increase, coming in at $392.2 million (18.0%) for 2001, . . . nearly double last year’s

$206.2 (11.2%).” McKillip’s report blamed this increase on:

• “Heavy reliance on sub prime accounts – for example, 62% of Spiegel Catalog’s new credit customers booked in Spring 2001 were E and F accounts compared with 31% in 1998”;

• “Excessive credit limit increases granted to sub prime accounts beginning in 1998”; and - 77 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 78 of 202

• “Rapid growth of unseasoned accounts.”

166. The statements referenced above in ¶¶154-156, 160-161 and 164 were each materially false and misleading because they failed to disclose the following material adverse facts, among others:

(a) that the Company had materially understated its debt by at least $3.5 billion at

December 29, 2001;

(b) that the Company’s revenues, earnings and stockholders’ equity were materially overstated by tens of millions of dollars as a result of the Company’s improper recognition of “receivable gains” and “servicing fees” from the Company’s securitizations of credit card receivables. Thus, it was not true that the Company had returned to “profitability”;

(c) that the assumptions, estimations and forecasts utilized by Defendants, except for Cannataro, Moran and Sievers, in calculating the Company’s “receivable gains” were grossly inconsistent with the credit characteristics of the underlying assets, thereby resulting in the material overstatement of the Company’s revenues and earnings. Such assumptions included, among others: expected charge-offs, expected delinquencies and expected payment streams;

(d) that it was not true that Spiegel’s securitized receivables were sold without recourse, as set forth in further detail herein at ¶¶213-245;

(e) that the Company’s financial statements were not prepared in accordance with

GAAP in numerous respects and were materially false and misleading as detailed herein at ¶¶208-

356;

(f) that Defendants, except for Cannataro, had materially lowered the Company’s credit criteria for account originations thus exposing the Company to increased risk of loss from account charge-offs, delinquencies and defalcations;

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(g) that Defendants’, except for Cannataro, Moran and Sievers, lax credit policies

and high risk lending activities to sub-standard borrowers were fueling the Company’s credit card

account origination programs and resulting catalog merchandise sales revenues, especially at the

Company’s Spiegel and Newport News divisions;

(h) that demand for the company’s merchandise products and services had

materially declined but for Defendants’, except for Cannataro, aggressive and high-risk marketing of

Spiegel’s credit card services to sub-standard borrowers;

(i) that the Company’s “proprietary” credit scoring methods and practices, both

in design and utility, were wholly inadequate for identifying adverse credit risk and varied

significantly from standard industry practice and federal banking regulatory guidelines;

(j) that the Company’s credit authorization procedures and determination of

“credit limits” regarding “secured lines of credit”, among others, varied significantly from standard

industry practice, resulting in the extension of credit to certain individuals that exceeded security

deposits levels by as much as 500% in some instances, and routinely exceeded such deposits by at least 200%;

(k) that the Company was currently experiencing certain adverse trends in the repayment of its credit card account receivables assets, both in receivables “retained” by the

Company and in “securitized” receivables “off- balance sheet receivables” serviced by the

Company;

(l) that FCNB was operating in violation of federal banking regulations as it failed to maintain statutory and risked-based capital requirements. Accordingly, it was not true that

FCNB was being positioned for “further growth” as FCNB was being run in an extremely reckless manner;

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(m) that the Company violated GAAP and its own policies by failing to adequately compensate FCNB for the increased cost of collections due to increasing account delinquencies and defalcations, such “servicing fee liabilities” amounted to at least $50 million on an annual basis; and

(n) based on the foregoing, the Company’s revenues, earnings and financial position were materially misstated at all relevant times and Defendants’, except for Cannataro,

Moran and Sievers, opinions, projections and forecasts concerning the Company and its operations were lacking in a reasonable basis at all times and therefore materially false and misleading.

THE TRUTH BEGINS TO EMERGE

Defendants Awareness of Spiegel’s Financial Crisis

167. Around the middle of January 2002, Cannataro led several other senior members of

Spiegel’s management in forming what they called the “Condor Group,” which was to be a “crisis management” team to deal with Spiegel’s problems. The group recognized that they were in a

“desperation high stakes ball game,” where “the very survival of the enterprise” was at stake. The group included Cannataro (CFO), John Steele (Treasurer), James Pekarek (Controller), Michael

McKillip (Internal Audit Director), Robert Sorensen (General Counsel) and Deborah Koopman

(Investor Relations).

168. On February 7, 2002, KPMG wrote to Spiegel CFO Cannataro and raised the prospect that KPMG would have to issue a going concern opinion on Spiegel’s financials. A going concern opinion – universally dreaded by corporate management – is an auditor’s statement that there is “substantial doubt about the Company’s ability to continue as a going concern.” KPMG told

Spiegel’s CFO that to avoid a going concern opinion, Spiegel would have to obtain the following:

• a written funding commitment from a viable source to cover Spiegel’s projected cash shortfall beginning in March 2002;

• a closing or binding sale agreement for Spiegel’s sale of its credit business, already reclassified as a discontinued operation in Spiegel’s 2001 financial statements; and - 80 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 81 of 202

• extension beyond June 15, 2002 of the bank lenders’ waiver of Spiegel’s existing loan covenant breaches (coverage ratio and debt to EBITDAR ratio), as well as Spiegel’s possible breach of yet unwaived covenants (leverage and net worth).

169. On February 21, 2002, Spiegel issued a press release announcing its earnings for the

fourth quarter and year ended December 29, 2001. Spiegel shocked the market by announcing that it had “implemented a plan to sell its credit card business,” in anticipation of the sale the Company had accrued a loss of over $310 million. Additionally, the Company reduced the amount of “gains” it previously reported on the sale of its credit card receivables by approximately $78 million dollars due to deterioration in the credit quality of the portfolio. Defendant Zaepfel commented on the

Company’s credit policies during 1999 and 2000, stating, in part:

“In 1999 and 2000, during a stronger economic period, the company aggressively grew its credit card accounts, which included extending credit to higher-risk market segments. At the same time, we adopted a ‘risk-based’ pricing policy to match credit pricing with the level of risk. In the fourth quarter of 2000, in response to rising delinquencies and charge-offs in our private-label credit card programs, we began implementing actions to strengthen our credit portfolio and reduce charge-offs. These actions included implementing more restrictive underwriting policies, more aggressive collection efforts and selectively re-pricing certain segments of the portfolio. However, the economic downturn, which began in mid-2000 and accelerated in 2001, combined with the high account growth that was heavily weighted toward higher-risk accounts, resulted in a rapid deterioration in our credit portfolio and a significant earnings shortfall.” [Emphasis added.]

The Company’s press release also noted Spiegel’s ongoing negotiations with its lenders:

As a result of its 2001 financial performance, including the estimated loss recorded in the fourth quarter for the disposition of its credit card business, the company is not in compliance with certain of its 2001 loan covenants. The company stated that it is currently working closely with its bank group and its majority shareholder to restructure its credit facilities.

Zaepfel stated, “We have strong support from our majority shareholder and are confident that we will be able to secure the necessary financial support. Our goal is to have new financing arrangements in place by mid-April. In the interim, with the support of our majority shareholder, we have adequate liquidity and cash flows to fund our day-to-day operations. Additionally, the anticipated sale of the credit card business will reduce our debt and capital requirements.” [Emphasis added.]

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170. In response to this announcement, the price of Spiegel common stock declined from

$2.80 per share to $2.50 per share.

171. The statements referenced above in ¶169 were, however, materially false and

misleading for the reasons stated above in ¶166. In addition, the statements were materially false and misleading because they failed to disclose:

(a) that KPMG had informed Spiegel in writing two weeks earlier that it would receive an audit report calling into question its ability to continue as a going concern unless it could satisfactorily resolve a number of issues. Ultimately KPMG did issue such a report when these issues were not resolved;

(b) that Spiegel’s 2001 net loss was $398 million, but its actual 2001 net loss was

$587 million (a difference of $190 million, or 48%), as revealed in an SEC filing a year later;

(c) that Spiegel’s operating results for fiscal 2001 was a loss of $226 million and not a $15 million profit as reported in the press release;

(d) that Spiegel had actually defaulted on all four of its covenants in its $750 million revolving credit facility and had obtained temporary waivers to only two of its four breaches;

(e) that Spiegel had violated multiple violations of the trust triggers on its securitized credit card portfolios, which could plunge the securitizations into a rapid amortization that would be catastrophic for Spiegel;

(f) that Spiegel was currently in the midst of a $300 million liquidity crisis;

(g) that Spiegel’s “significantly worse” sales forecast could make the liquidity crisis worse, the possible rapid amortization of the securitizations resulting in additional cuts cut $40 to $60 million monthly from Spiegel’s operating funds and further worsen liquidity;

(h) that the interchange rate Spiegel reported to its securitization trustee was not the rate actually used by the Spiegel merchants;

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(i) that purported waivers obtained by Spiegel to cure actual or potential trust

trigger violations were obtained using falsified trust reports, including manipulations of the

interchange rate, among other things, and therefore were ineffective;

(j) that the negative impact expected from the OCC consent order, the fact that

Spiegel would likely receive no cash on selling FCNB; and

(k) that Defendants, except for Moran and Sievers, had been advised by Spiegel’s

bankers that would be unable to sell its bankcard business.

172. Then, on February 22, 2002, an article appearing in Cardline, stated that Spiegel’s

actual credit card charge-offs during 2001 exceeded the assumptions the Company had used to

calculate its “gains on securitized receivables” by more than 49%, the article stated:

Credit card chargeoffs far surpassed The Spiegel Group’s predictions for 2001, according to data for one of its card-bond trusts. In its 2000 annual report, the Downers Grove, IL-based retailer and card issuer projected that chargeoffs in its private-label card portfolio would be 12.2% of receivables, up from 9.3% in 2000. But December 2001 performances data for a $2.21 billion trust of Spiegel securities backed by private-label card receivables show a chargeoff rate of 18.17%, according to securities rating agency Moody’s Investors Service. Yesterday, Spiegel said it would sell its card program, including card-issuing subsidiary First Consumers National Bank, whose private-label portfolio added many subprime cardholders in 1999 and 2000. New CEO Martin Zaepfel blamed the worsening economy and the deteriorating credit quality of many cardholders for FCNB’s woes (CardLine special Bulletin, 2/21). In 2001, Spiegel’s portfolio of private-label and bank cards had $3.5 billion in managed receivables and 4.2 million active accounts. About two-thirds of the portfolio consisted of private-label receivables in 2000; figures for 2001 were not immediately unavailable. [Emphasis added.]

173. According to Company documents reviewed by the Independent Examiner, on March

15, 2002, Ludwig Richter, the Director of Corporate Accounting at Otto Versand reported to

Spiegel’s Hamburg-based audit committee, its chairman Otto, and its president Martin Zaepfel on a review he had performed of Spiegel’s financial statements and his meeting with KPMG in February

2002. He reported that Spiegel Catalog and Newport News had employed a business strategy of

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economic downturn, “combined with the high account growth that was weighted toward higher-risk accounts, resulted in a rapid deterioration of the credit portfolio and a significant earnings deterioration.” Richter further reported that KPMG’s audit opinion for Spiegel would likely contain a going concern qualification, unless Spiegel obtained: (i) a written funding commitment to cover a projected cash shortfall; (ii) an executed agreement to sell Spiegel’s credit card business; and (iii) a waiver of Spiegel’s loan covenants (already in default) or a renegotiated credit agreement.

174. According to the Independent Examiner’s Report, on March 25, 2002, Spiegel management met to discuss a number of “life threatening” issues facing Spiegel. Among other things, treasurer John Steele reported on a recent meeting with Spiegel’s investment bankers at J.P.

Morgan, who advised that Spiegel’s credit portfolio was worth only 25 percent of what they originally thought, and that Spiegel probably could not sell it. McKillip advised that Spiegel would have to restate the interchange rate used to calculate excess spread, and that this would blow a trigger in the Preferred Card 2000-A and 2001-A securitization trusts. The group agreed that

Zaepfel and Cannataro, among others should immediately travel to Germany to brief Otto personally on the situation.

Awareness of “Board Committee” and Sole Voting Shareholder

175. According to the Independent Examiner’s Report, Zaepfel and Cannataro left for

Germany the next day and on March 27, 2002 met with Spiegel chairman Otto and Spiegel’s audit committee member Crusemann in the Otto Versand board room in Hamburg. Also present was

Alexander Birken, Otto Versand’s Vice President of Group Controlling. Five months later, on

August 15, 2002, Birken moved to the U.S. at Otto’s request and became Spiegel’s Chief

Administrative Officer.

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176. Based upon Spiegel’s SEC filings, Otto, Crusemann and Zaepfel also constituted all

of the members of Spiegel’s “board committee” – the committee empowered to act for Spiegel’s full

board. According to the Independent Examiner’s report, the meeting lasted about seven hours.

177. At the meeting, Spiegel management gave Otto and Crusemann copies of a written

analysis of the difficulties then facing Spiegel, and covered every part of the written presentation during the meeting. This written presentation, reviewed by the Independent Examiner, included the following review of Spiegel’s problems:

• OCC Determinations: The OCC determined a month earlier to substantially lower FCNB’s rating. The OCC’s “greatest” concern was “the low quality of the bank’s receivables and the danger that one or more securitization trusts would go into early amortization.” The concern was “liquidity and capitalization,” as well as “a great many deficiencies in the bank’s operations.”

• OCC Restrictions: In addition to requiring liquidation of FCNB by December 2002, the “final draft” of the OCC’s consent order for FCNB required “significant restrictions” on credit for both new and existing FCNB customers. The OCC was also requiring a standby letter of credit of approximately $198 million.

• Resulting Decrease in Sales: Spiegel determined that these OCC restrictions on FCNB’s ability to grant credit would result in a reduction in annual net sales by the Spiegel merchant companies of between $192 million and $442 million. This reduction in sales would mean that the merchants could expect their profitability to decline between $45.3 million and $108.4 million.

• Inability to Sell Bankcard Business: Spiegel’s investment bankers (J.P. Morgan) advised that Spiegel could not expect to get any cash from the planned sale of its bankcard business. Indeed, J.P. Morgan concluded that it would be “very difficult” to sell the bankcard business at all. As the OCC was requiring Spiegel to sell or liquidate FCNB in 2002, Spiegel believed it would have to simply “walk away” from its bankcard business. Walking away from the bankcard business could have a $310 million equity impact for Spiegel, and a $170 debt impact ($120 million to pay off depositors’ interest, and $50 million for exit costs).

• Inability to Sell Preferred Card Portfolio: J.P. Morgan also advised Spiegel that it could probably not sell its Preferred Card portfolio. Potential purchasers had indicated a lack of interest based on concern over the sub-prime credit card industry, Spiegel’s issues with the OCC, and Spiegel’s financial performance. - 85 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 86 of 202

• End to Off-Balance Sheet Financing of Credit Receivables: Going forward, Spiegel would have to find a new way to finance credit receivables for sales by its merchant companies. J.P. Morgan advised Spiegel that it would be difficult to finance new receivables off-balance sheet through a securitization transaction, as investors would be wary of Spiegel’s financial condition. If Spiegel used its credit facility to finance these receivables, debt would then increase on Spiegel’s balance sheet for all new receivables from preferred credit sales by the Spiegel merchant companies.

• Increased Fees Using Outside Servicer: Without FCNB to service its credit card receivables, Spiegel’s merchant companies would have to use an unrelated third-party servicer. But then, instead of the 2% servicing fee then being paid to FCNB, the merchant companies would have to pay a 6% to 12% servicing fee to a third-party servicer, according to J.P. Morgan. For each 1% increase in the fee above the existing 2%, Spiegel would suffer a $13 to $15 million reduction in EBT.

• Liquidity Shortfall: “The Spiegel Group is in a liquidity crisis” and “will soon be illiquid.” Spiegel expected that Otto Versand would have to infuse $317.6 million in capital into Spiegel to deal with its liquidity shortfall, which Spiegel expected to peak in October 2002. This was $260 million higher than the $60 million in capital Otto Versand had already infused in Spiegel during 2002. Spiegel noted, however, that if it could not fulfill “certain favorable assumptions,” Otto Versand would have to infuse a “significantly greater” amount into Spiegel.

• Default on Loan Covenants: Spiegel was in default on its loan covenants, and its plan to restructure its finances by mid-April “is no longer possible.” It concluded that the longer it remained in default, the more problems it faced in getting products from vendors. “There is also a growing threat of an involuntary bankruptcy proceeding being filed against us by our creditors.”

• Refinancing Efforts: Spiegel was negotiating to restructure its loan agreements to put in place a $750 million revolving credit facility, $441 million in term loans, and a $150 million letter of credit facility. While Spiegel had reached an agreement in principle with the three agent banks involved, this was based on 2002 business plan presented to the banks. But Spiegel concluded that, “[d]ue to the impact of OCC restrictions on our merchant businesses and significantly lower expectations for the disposition of our credit business, we cannot proceed with a credit restructuring based on the 2002 plan presented to the banks.” Most of the banks were unaware of these negative developments. Spiegel still had to develop a revised 2002 business plan for the banks.

• Contents of New Business Plan: A new 2002 plan to provide to the banks for further negotiation would include factors that “will cause profitability to be substantially lower in 2002.” These factors included: (i) the impact of “severe credit restrictions” on sales; (ii) a change in valuation of the bankcard and - 86 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 87 of 202

Preferred portfolios following J.P. Morgan’s assessment that FCNB could not be sold in its present condition, with resulting further writedown of assets with an offsetting reduction to equity; and (iii) an increase in servicing fees payable to a third-party service provider.

• Outstanding Securitizations: Spiegel had financed its preferred credit card receivables through asset-backed securitizations. However, Spiegel was then facing “a probable rapid amortization in our ABS financings, which will divert cash flow ($60 million/month) from Spiegel to ABS investors.”

• Need for a Restatement: Both KPMG and Rooks Pitts recently (March 2002) advised Spiegel that, in the absence of a benchmarking study to support a higher interchange rate, Spiegel would have to restate its interchange rate and excess spread calculations for 2001. Such recalculation of excess spread would cause Spiegel’s 2000-A and 2001-A series securitizations to breach their triggers, “causing both to go into early amortization.” The result would be diversion of approximately $40 million excess monthly cash flow from Spiegel to pay down these series.

178. According to the Independent Examiner’s Report, this March 27, 2002 written presentation, prepared by Spiegel’s management (including its general counsel Robert Sorensen),

also advised Otto and Crusemann on their disclosure obligations under the U.S. securities laws. The

presentation noted that “SEC and Nasdaq regulations require companies that are publicly traded to disclose all material news,” meaning information that would “affect the value of a company’s securities or influence investors’ decisions.” The presentation identified the following as items that

“may be considered material and require public disclosure”: (i) the OCC’s enforcement action against FCNB; (ii) the “[n]egative sales and earnings impact due to OCC credit granting restrictions”; (iii) the “[c]hange in the valuation of the bank from what was previously disclosed”; and (iv) the “delay in securing new credit facilities.” Spiegel’s management concluded that “once any of these potential subject matters break, there will be a blitz of negative news articles.”

179. In addition to presentation and discussion of the written report described above, the draft minutes of the March 27th meeting, reviewed by the Independent Examiner, confirms discussion of the following particular points:

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• Spiegel was in a liquidity crisis and would soon be short of cash. It projected a $318 million shortfall, but acknowledged this could be worse “if the Company’s performance was lower than forecast and/or if the performance of the Securitizations did not improve.” Spiegel decided to “take aggressive action to defer vendor payments,” but to pay important vendors “to ensure that an involuntary bankruptcy is not proposed by third-party vendors.”

• Spiegel’s current sales forecast was “significantly worse” that the forecast it had given its bank lenders as part of its efforts to renegotiate its credit agreements. And this forecast did not yet reflect “the negative sales impacts which would occur from the OCC Consent Order.” The 2002 plan Spiegel had given its bank lenders could be “severely impaired by the OCC restrictions and the current forecast from the merchants.”

• Absent a waiver, the proposed OCC consent order would trigger early amortization of Spiegel’s securitizations, as would performance triggers below required minimums. This would make Spiegel’s liquidity problem “significantly worse” than the then-anticipated $318 million shortfall. Rapid amortization would result in $40 million to $60 million less cash each month for Spiegel’s operations.

• There was a “disconnect” between the interchange rate used in Spiegel’s securitization trust reporting and Spiegel’s agreements with its merchants. Spiegel “needed to discuss the issue with KPMG,” but Spiegel decided to defer this discussion to a later date.

180. According to documents reviewed by the Independent Examiner, J.P. Morgan had reduced its valuation of FCNB and concluded that Spiegel could not expect to receive any cash on the sale of FCNB. There was also the possibility that the OCC might simply “take over” FCNB, which meant that Spiegel had to act immediately to find a third-party servicer for its preferred credit card receivables. However, J.P. Morgan had concluded it was “not likely” that Spiegel would be able to get a third-party agreement for its existing accounts given “the risk in the portfolio” and “the on-going viability of the Spiegel Group,” among other factors.

Spiegel Misses the Filing Date for Its Form 10-K

181. Just days after this March 27, 2002 meeting in Hamburg, Spiegel was required to file its 2001 annual report on Form 10-K. According to the Independent Examiner’s Report, at the time, the Form 10-K had been prepared, and was virtually ready for filing. But instead of filing its Form

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10-K as required, Spiegel filed a “notification of late filing” on Form 12b-25 on April 1, 2002.

Zaepfel and Cannataro made the decision to delay filing the Form 10-K at this time after

consultation with Otto.

182. In response to the requirement in Form 12b-25 that Spiegel state “in reasonable detail

the reasons why [its Form 10-K] could not be filed within the prescribed time period,” Spiegel stated

only the following:

“As has been publicly disclosed, the Registrant is not currently in compliance with its 2001 loan covenants and has reached a strategic decision to sell its credit card subsidiary, and as a result the Registrant is not in a position to issue financial statements for its 2001 fiscal year pending resolution of these issues.”

183. Spiegel further responded that it could not make a reasonable estimate of its results

because, “[a]s disclosed in the Company’s press release on February 21, 2002, a significant loss will

be reported in the 2001 earnings statement due to the Company’s decision to sell the bank.”

184. This statements in ¶¶182-183 were materially false and misleading for the reasons

stated in ¶171 and because they misrepresented the reasons for the delay in filing the Form 10-K.

The true reason, which Defendants Otto, Zaepfel, Crusemann, Hansen, Muller, and Cannataro failed

to disclose, was that these Defendants did not want to reveal Spiegel’s auditors’ “going-concern”

audit opinion qualification on Spiegel’s 2001 financial statements.9 Defendants Otto, Zaepfel,

9 Pursuant to Securities Exchange Act Section 10A, if, during the course of conducting an audit, the independent accountant detects or otherwise becomes aware of information indicating that it is likely that an illegal act has occurred, the independent accountant must inform management and assure that the audit committee is adequately informed of the illegal act. If the independent accountant concludes that senior management has not taken appropriate remedial action which respect to the illegal act that materially effects the issuer’s financial statements, the auditor must directly report its conclusions to the Board of Directors. If the Board of Directors fails to file a copy of such report with the SEC within one business day, the independent auditor must directly furnish a copy of such report to the SEC. KPMG knew, or was reckless in not knowing, that Spiegel’s Form 12b-25 was materially false and misleading because it failed to disclose that the opinion KPMG was to issue on Spiegel’s 2001 year-end financial statements was to be qualified as to the Company’s ability to continue as a going concern. KPMG also knew, or was reckless in not knowing, that the SEC’s

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Crusemann, Hansen, Muller, and Cannataro knew that a going concern opinion would create

“negative publicity” that would: (i) cause many suppliers to refuse to sell goods to Spiegel on credit, or at least to restrict such credit; (ii) have a “substantial negative impact on the Spiegel stock price”; and (iii) adversely impact customer sales and employee morale and turnover. In addition, Spiegel’s

Form 12b-25 did not disclose the material information discussed at the March 27th meeting – as outlined above.

185. An April 2, 2002 memo from Spiegel’s controller Pekarek to its audit committee chairman Hansen, reviewed by the Independent Examiner, confirmed that, consistent with the collection of bad news contained in the March 27, 2002 presentation in Hamburg, Defendants, except for Moran and Sievers, reasons for not filing the Form 10-K had additional dimensions:

. . . In February/March 2002, the Company had prepared a draft of the Form 10-K and was prepared to file . . . . The only open item at that time was the completion of a new credit agreement . . . . [T]he Company wanted to ensure that an ‘unqualified audit opinion’ was received from KPMG . . . . This was contingent upon the completion of a new credit agreement.

Since that time, the Company has been informed of two significant events that were not contemplated at the time the financial statements were initially completed. First, on March 21, 2002, JP Morgan informed the Company that it could no longer expect to receive any cash for the sale of the Bank . . . . With this new information, the Company is required to reassess the estimated loss derived at the end of 2001 . . . .

[Second] . . . [c]ertain provisions in [the OCC] Consent Order mandate that FCNB be sold or liquidated by a certain date in 2002. As of April 1, 2002, the Company has not signed the Consent Order due to the growth limitations placed upon the Company . . . . [I]f a Consent Order is not signed, FCNB could be involuntarily sent into receivership by the regulators as early as this week. The ramifications of this, from a financial statement perspective are unclear at this time.

Financial Reporting Release No. 16 required such financial statement to provide appropriate and prominent disclosures about the Company’s financial difficulties and viable plans to overcome such difficulties. Accordingly, KPMG had an affirmative obligation under the Securities Exchange Act to notify the SEC that the Company’s Form 12b-25 was materially false and misleading as a result of the omissions detailed herein, which it did not.

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The April 19, 2002 Press Release

186. After failing to file its Form 10-K as required by the extended filing date of April 15,

2002, Spiegel issued a press release on April 19, 2002 that told a far more limited story and gave investors far less material information that they would have gotten from a Form 10-K. On April 19,

2002, two days after NASDAQ’s delisting notice and with its Form 10-K still not filed and now delinquent, Spiegel issued a press release “regarding the status of several business initiatives.”

Spiegel had to say something to the public that day, as that morning NASDAQ had changed

Spiegel’s trading symbol from SPGLA to SPGLE, denoting for investors Spiegel’s continuing failure to file its Form 10-K or otherwise comply with NASDAQ’s listing requirements.

187. Spiegel’s press release made the following points, without detailed discussion:

• Spiegel’s efforts to sell its credit card operations were “ongoing,” with discussions with interested parties “at various stages.” Spiegel added that, based on “current market” conditions, its loss on this sale would be “higher than previously estimated,” resulting in lower 2001 earnings than previously reported. The release did not quantify these amounts.

• FCNB was in discussions with the OCC over “the timing for the previously announced disposition of the bank, and the terms and conditions under which the Bank will operate during this period, including with respect to capital, liquidity, product offering, transactions with affiliates, and growth.”

• On April 10, 2002, MBIA declared a payout event under two series of Spiegel’s credit card receivables securitizations. Spiegel and FCNB disagreed with MBIA and obtained a temporary restraining order against enforcement of the payout event by MBIA. A payout event would divert excess cash flow of about $20 million monthly to repay noteholders. Spiegel was in discussions with MBIA over this matter.

• Due to these developments, Spiegel’s negotiations with lenders to restructure its credit facilities were delayed. Also due to these developments, Spiegel did not file its Form 10-K for 2001. Due to its failure to file its Form 10-K, Spiegel received a delisting notice from Nasdaq on April 17, 2002, but Spiegel requested a hearing that would stay the delisting. Spiegel expected to file its Form 10-K before Nasdaq had to take further action to delist its stock.

188. This press release was materially false and misleading for the reason stated in ¶184 and because it failed to disclose and/or misrepresented the following adverse facts: - 91 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 92 of 202

(a) that current topics of discussion with the OCC included establishing additional

liquidity and capital requirements, as well as restrictions on credit granting measures at the bank;

(b) that a Pay Out Event would prevent the company from receiving up to $40

million per month, twice the $20 million per month in the press release, from the trust and divert the

funds to the repayment of note principal, thereby denying FCNB the liquidity afforded by the trust,

and that a Pay Out Event would seriously threaten the company’s Spiegel’s business viability; and

(c) that as part of its ongoing discussions with its bank group, the company would

provide a revised business plan, which would include financial projections that are significantly

lower than those previously submitted to the bank group.

The April 22, 2002 Audit Committee and Board Meetings

189. Immediately after Spiegel missed the April 15, 2002 extended deadline for filing its

Form 10-K and instead issued its April 19, 2002 press release, Spiegel’s directors met for their

regularly-scheduled semi-annual audit committee and board meetings.

190. According to the Independent Examiner’s Report, on April 22, 2002, Spiegel’s audit

committee conducted a “special discussion on the credit situation currently facing” Spiegel.

McKillip reported on credit risk control and described Spiegel Catalog’s “net down” process, which

skewed sales to high risk buyers and overrode FCNB’s risk model. He also reported on MBIA’s position that blanks should have been calculated as charge-offs, which should have violated the excess spread trigger in January 2002, with resulting rapid amortization. He further reported on the discrepancy in interchange rates, with 2% used for accounting purposes and 6% used for securitization trust reporting. Shortly after this meeting, McKillip sent Hansen a memo describing the “net down” process at Spiegel Catalog, described above, that skewed the credit portfolio to customers in the highest risk levels.

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191. On April 22, 2002, in order to avoid immediate delisting, Spiegel requested a hearing before NASDAQ to explain why it had not filed its Form 10-K. NASDAQ scheduled a delisting hearing in Washington D.C. for May 17, 2002. In attendance at the May 17, 2002 hearing were two of Spiegel’s officers, a member of Spiegel’s Audit Committee and an attorney who attended the meeting at the invitation of Spiegel’s majority shareholder. It was reported that NASDAQ received assurances at the meeting that the Company would file its 10-K by May 28, 2003, regardless of the status of its negotiations with its lenders.

192. According to Company documents reviewed by the Independent Examiner, the following day’s full board meeting was told to “focus on the crisis issues facing the Company.” The

“update on critical issues” included the following:

• Spiegel’s February 2002 earnings release (covering 2001) showed a $310 million after-tax loss, reflecting sale of the credit business.

• Spiegel had still not filed its Form 10-K “because the Company’s auditors indicate they will give the Company a ‘going concern’ opinion,” absent disposition of FCNB, settlement with the OCC, resolution of the securitization trigger default declared by MBIA, and restructuring of Spiegel’s credit.

• Additionally, Nasdaq was threatening to delist Spiegel’s stock.

193. Based on uncertainty over whether Spiegel would be able to enter into a new credit facility with its lending institutions, Defendants, except for Moran and Sievers, realized that

Spiegel’s financial statements would have to reflect all of its debt obligations as current obligations.

194. According to the Independent Examiner’s Report, by the middle of May 2002,

Spiegel’s lead banks J.P. Morgan Chase and Deutsche Bank were advising that there were problems getting a number of banks to agree to the term sheet for refinancing Spiegel. Among the banks still having problems with the terms were CSFB, Credit Lyonnaise, BCI, West LB, Bankgesellschaft

Berlin, Nord LB, Danske, HypoVereins and DZ Bank. One of these banks, BCI, had confirmed that

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it had no intention of agreeing to the revised loan facility, and instead wanted another lender to take over its $21 million participation in the Spiegel credit facility.

195. Based on Company documents reviewed by the Independent Examiner, on May 13,

2002, KPMG repeated its advice to Spiegel’s audit committee that KPMG would have to issue a going concern opinion. To avoid a going concern opinion, Spiegel would have to: (i) obtain agreement from its lenders to waive existing loan covenant defaults; (ii) obtain new loan agreements

(or “binding and enforceable unconditional Commitment Letter signed by all Lenders”); (iii) achieve

“final resolution” of Spiegel’s challenge from MBIA, which was then claiming that Spiegel’s credit card securitizations should go into rapid amortization; (iv) achieve “final resolution” of outstanding issues with the OCC, which was then insisting on a consent decree with restrictions on Spiegel’s future business; and (v) resolve Spiegel’s projected cash shortfall.

196. According to the Independent Examiner’s Report, on May 15, 2002, the OCC’s ongoing discussions with FCNB culminated in a consent order. The OCC’s consent order:

(i) contained restrictions on transactions between FCNB and its affiliates and required FCNB to complete a review of all existing agreements with affiliated companies; (ii) required FCNB to obtain an aggregate of $198,000,000 in guarantees through Spiegel’s majority shareholder; (iii) restricted

FCNB’s ability to accept, renew or rollover deposits; (iv) placed restrictions on FCNB’s ability to issue new credit cards and make line increases; (v) required FCNB within 30 days to file with the

OCC a disposition plan to sell, merge or liquidate FCNB; (vi) required FCNB to maintain sufficient assets to meet daily liquidity requirements; (viii) required FCNB to complete a comprehensive risk management assessment; (viii) established minimum capital levels for FCNB; and (ix) provided for increased oversight by and reporting to the OCC.

197. In mid-May, Defendants failed to file Spiegel’s Form 10-Q reporting on its performance during the first quarter of 2002. In Spiegel’s notification of late filing, on Form 12b-25,

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Defendants, except for Moran and Sievers, simply repeated the statement used in Spiegel’s prior

Form 12b-25 notice, when it failed to file its Form 10-K, in spite of the changes that had occurred in

the period from its last Form 12b-25 until this new Form 12b-25 filing.

198. On May 29, 2002, Spiegel announced that it had entered “an agreement” with the

OCC with respect to FCNB. The press release stated, in pertinent part, as follows:

FCNB’s agreement with the OCC calls for FCNB to comply with certain requirements with respect to capital, liquidity, growth, product offering, and transactions with affiliates. The agreement, among other things, includes restrictions on extending credit to certain customers and requires the bank to obtain a $198 million guarantee, which has been provided through the company’s majority shareholder. In addition, the bank must provide to the OCC the details of a plan to sell, merge or dispose the bank. [. . .]

199. On June 3, 2002, when the Company still had not filed its 2001 Form 10-K,

NASDAQ delisted “the company’s Class A common stock on the NASDAQ National Market

System effective with the open of business on June 3, 2002, “based on the [C]ompany’s filing delinquencies and other public interest concerns.”

200. The Class Period ends on June 4, 2002. On that date, Spiegel revealed that its 2001 financial statements would reflect a qualified audit opinion. The disclosure appeared in an article

published in the Chicago Tribune, which stated in relevant part:

The Downers Grove–based parent of Eddie Bauer and the Spiegel Catalog hasn’t been able to file the 10-K because it does not have a new lending agreement in place. And without that, Spiegel’s auditors would have to express doubt about the company’s ability to continue as a going concern, the company said. “We felt it would be detrimental to file it now without a clean opinion from the auditors,” said Spiegel spokeswoman Debbie Koopman. “The board is doing what they think is right to preserve the value of the company.” [Emphasis added.]

201. Following Defendants’, except for Moran and Sievers, belated disclosure the price of

Spiegel’s publicly traded common shares fell by 51% to close at $0.49 on June 5, 2002, a decrease of

over 99% from the Class Period high of $14.75 reached on November 8, 1999.

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202. On or about February 4, 2003, Spiegel filed its Form 10-K for the year ended

December 29, 2001 (the “2001 10-K”) with the SEC which was signed by Zaepfel and Cannataro,

among others. The 2001 10-K included restated financial results for the Company’s fourth quarter and full year earnings, increasing the loss previously reported by over $189 million. The Company attributed the increase in reported losses to the OCC’s mandate that it adopt accounting policies and valuation methodologies for its securitized receivables which comport with GAAP and standard industry practices. These changes resulted in the Company reducing its previously reported “gains on off-balance receivables” by more than $206 million.

203. The Company’s 2001 10-K, as detailed herein, also included Defendants’, except for

Moran and Sievers, admission that the receivables the Company claims to have sold during and prior to the Class Period reverted back to the Company when a “pay out event” occurred under the

Company’s noteholder agreements. Despite these admissions the Company has never restated its

financial statements to reflect over $3.5 billion in debt which the Company incurred in connection

with its securitized receivable transactions.

204. On or about March 6, 2003, FCNB filed with the SEC on Form 8-K, notice that it was

forecasting that a ‘pay-out event’ would occur in early March 2003 because the payments then being

received by FCNB from Spiegel’s credit cardholders would fall below certain minimum

performance requirements and would cause a cross default on all of the Company’s securitized

transactions. FCNB also disclosed that its auditor had informed Spiegel’s audit committee of certain

internal control deficiencies related to FCNB, which constituted reportable conditions. These

deficiencies were in stark contrast to Defendants Otto, Moran, Zaepfel, Crusemann, Hansen, Muller, and Sievers representations during the Class Period concerning FCNB’s proficiency and expertise in

managing the Company’s credit card operations, the report stated, in relevant part as follows:

FCNB’s independent auditors have informed the audit committee of Spiegel, Inc., FCNB’s parent company, of certain internal control deficiencies related to FCNB, - 96 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 97 of 202

which constitute reportable conditions. Specifically, the deficiencies relate to routine transactions and accounting estimates, policies and procedures, and account balance classifications in the financial statements. FCNB and its parent company, Spiegel, Inc., have assigned the highest priority to the correction of these deficiencies and are committed to addressing them as soon as possible. FCNB believes that other controls are in place to mitigate the risk that these deficiencies could lead to material misstatements in FCNB’s financial statements. In addition, as disclosed herein, Spiegel, Inc. has formalized a plan to sell their bankcard segment and FCNB will be sold or liquidated as part of the disposition of the bankcard segment.

205. Then, on March 7, 2003, Spiegel issued a press release announcing that the SEC had commenced a civil proceeding in federal court in Chicago against the Company. According to the press release, the SEC alleged, among other things, that the Company’s public disclosures violated

Sections 10(b) and 13(a) of the Exchange Act of 1934. Simultaneous with the filing of the SEC’s

complaint, the Company announced that it had entered into a Consent and Stipulation with the SEC

resolving, in part, the claims asserted in the SEC action. The press release further reported that the

Company had consented to the appointment of an independent examiner by the court to review its

financial records since January 1, 2000, and to provide a report to the court and other parties

regarding its financial condition and financial accounting.

206. On March 11, 2003, the ‘payout event’ forecasted by FCNB occurred. Spiegel issued

a press release announcing the event which reported:

First Consumers National Bank (FCNB), its special-purpose bank subsidiary, has notified the trustees for all six of its asset backed securitization transactions that a Pay Out Event, or an early amortization event, had occurred on each series. As a result of these Pay Out Events, substantially all monthly excess cash flow remaining after the payment of debt service and other expenses is diverted to repay principal to investors on an accelerated basis, rather than to pay the cash to Spiegel, Inc. or its affiliates upon deposit of new receivables. [Emphasis added.]

207. As a result of the ‘pay out event’ which diverted million of dollars per month in

operating cash flows, Spiegel was unable to fund its ongoing operations and filed for bankruptcy on

March 17, 2003.

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SPIEGEL’S FALSE AND MISLEADING FINANCIAL STATEMENTS AND FINANCIAL DISCLOSURES

208. Prior to and during the Class Period, retailers that traditionally offered their products for sale through “bricks and mortar” store fronts, increasingly began to utilize the internet to sell

consumer products. As a result, mail-order and catalog companies, like Spiegel, began to experience

unprecedented competition from the ever increasing number of retailers that began selling products

on-line.

209. In an attempt to portray itself as being able to effectively compete in an e-commerce

environment, Spiegel relaxed its credit standards and aggressively extended credit to sub-prime

borrowers to spur revenue growth. To mitigate the significantly increased financial and credit risks

ensuing from this strategy, Defendants, except for Cannataro, knowingly or recklessly caused

Spiegel to employ deceptive accounting practices which violated GAAP.10

210. Nonetheless, throughout the Class Period Spiegel represented that each of the financial statements it issued to investors were prepared in accordance with GAAP and the rules and regulations of the SEC. These representations were materially false and misleading when made as

Defendants, except for Cannataro, knowingly or recklessly employed numerous deceptive accounting practices over an extended period of time. In so doing, Spiegel reported hundreds of millions of dollars in phony gains and concealed billions of dollars of debt through the use of clandestinely controlled SPEs. As a result, the Defendants, except for Cannataro, materially inflated

Spiegel’s profits and hid billions of dollars of debt that Spiegel was required to report on its balance sheet. In this way, Spiegel inflated its operating results, financial strength and credit rating and

10 GAAP are those principles recognized by the accounting profession as the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time.

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allowed its wholly-owned bank subsidiary, FCNB, to maintain less regulatory capital than would

have been required had it accounted for its transactions in accordance with GAAP.

211. As set forth in Financial Accounting Standards Board’s (“FASB”) Statements of

Concepts (“Concepts Statement”) No. 1, a fundamental objective of financial reporting is to provide

accurate and reliable information concerning an entity’s financial performance during the period

being presented. Concepts Statement No. 1, paragraph 42, states:

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 in assessing the prospects of an enterprise. Thus, although investment and credit decisions reflect investors’ and creditors’ expectations about future enterprise performance, those expectations are commonly based at least partly on evaluations of past enterprise performance.

212. By failing to file financial statements with the SEC that conformed to GAAP,

Defendants, except for Cannataro, repeatedly disseminated financial statements of Spiegel that were

“presumed to be misleading or inaccurate.”11 As a result, Spiegel’s actual financial condition,

financial performance and financial ratios were materially distorted and its Class Period financial

statements were materially false and misleading and not issued in conformity with GAAP and the

rules and regulations of the SEC, as Defendants, except for Cannataro, knew or recklessly ignored.

Spiegel’s Improper Accounting for SPEs

213. In an attempt to maintain favorable credit ratings in the face of issuing ever increasing

amounts of credit to sub-prime borrowers, Spiegel created a ponzi-scheme type financing arrangement that allowed it monetize its high risk, sub-prime credit card financing without recording

debt, and falsely recorded hundreds of millions of dollars in “gains” on the very same transactions.

11 Regulation S-X (17 C.F.R. §210.4-01(a)(1)) states that financial statements filed with the SEC that is not prepared in conformity with GAAP are presumed to be misleading and inaccurate.

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214. Prior to and during the Class Period, Spiegel transferred certain of its volatile, troubled and/or nonperforming credit card receivables to SPEs. In form, the transfers were structured by Defendants, except for Cannataro, such that it would appear that Spiegel sold the troubled and/or non-performing receivables to the SPEs in exchange for cash. In substance, however, the “purchasers” of the transferred assets (i.e., the SPEs) did not control or possess the risks and rewards of ownership of the receivables necessitated by GAAP to allow Spiegel to treat such transfers as sales.

215. In fact, the hundreds of millions of dollars in gains that Spiegel reported on such

“sales” during the Class Period were fiction.

216. Since Spiegel controlled and retained the risks and rewards of ownership over the credit card receivables it transferred to various SPEs, GAAP required that the financial statements of the SPEs be consolidated with those of Spiegel. Had it done so, Spiegel could not have recorded millions of dollars in gains and would have recorded billions of dollars in additional debt.

217. GAAP as set forth in Accounting Research Bulletin (“ARB”) No. 51, ¶¶1-2, provides:

The purpose of consolidated statements is to present, primarily for the benefit of the shareholders and creditors of the parent company, the results of operations and the financial position of a parent company and its subsidiaries essentially as if the group were a single company with one or more branches or divisions. There is a presumption that consolidated statements are more meaningful than separate statements and that they are usually necessary for a fair presentation when one of the companies in the group directly or indirectly has a controlling financial interest in the other companies. [Emphasis added.]

218. FASB’s Emerging Issues Task Force (“EITF”) issued Topic D-14, which provides accounting guidance concerning the transfer of assets to, and the consolidation of SPEs, states:

Generally, the SEC staff believes that for nonconsolidation and sales recognition by the sponsor or a transferor [i.e., Spiegel] to be appropriate, the majority owner (or owners) of the SPE must be an independent third party who has made a substantive capital investment in the SPE, has control of the SPE and has substantive risks and rewards of ownership of the assets of the SPE (including residuals). Conversely, the SEC staff believes that nonconsolidation and sales recognition are not appropriate by the sponsor or transferor [i.e., Spiegel] when the majority owner of - 100 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 101 of 202

the SPE make only a nominal investment, the activities of the SPE are virtually all on the sponsor’s or transferor’s behalf, and the substantive risks and rewards of ownership of the assets or debt of the SPE rest directly or indirectly with sponsor and transferor. [Emphasis added.]

219. In 1996, the FASB issued Statement of Financial Accounting Standards (“SFAS”)

No. 125 which provided that, to account for a transfer of financial assets (such as credit card receivables and other revolving charge accounts) as a sale and to not consolidate such assets as its own, the transferred assets must be isolated from the transferor (that is, put presumptively beyond the reach of the transferor or its creditors) and the transferor must relinquish effective control over

the of the assets upon transfer. SFAS No. 125, ¶¶9c, 23, 24, 26.12

220. Accordingly, GAAP makes clear that a fundamental predicate associated with the

non-consolidation and sale of transferred financial assets is that the transferor has effectively

surrendered control over such assets. Thus, the SPEs must control and possess the risks and rewards

of ownership of the credit card receivables transferred to them by Spiegel in order for Spiegel to treat

such receivables as a sale and not consolidate the financial statements of the SPEs with its own.

221. Defendants, except for Cannataro, knew or recklessly ignored, however, that Spiegel

did not effectively relinquish exclusive control over its credit card receivables or the risks and

rewards of ownership associated with the receivables when they were transferred to various SPEs.

As a result, millions of dollars of phony gains were improperly reported by Spiegel and its billions of

dollars of debt were improperly excluded from Spiegel’s financial statements.

12 SFAS No. 125 was replaced by SFAS No. 140 for transfers of financial assets occurring after March 31, 2001. Consistent with SFAS No. 125, SFAS No. 140 provides, among other things, that a transferor can account for a transfer of financial assets only if it surrenders control over the assets transferred. SFAS No. 140, ¶5, 9.

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Spiegel’s False Financial Statement Disclosures

222. In its financial statements for the year ended January 2, 1999, filed with the SEC on

Form 10-K, Spiegel disclosed:

The Company recognizes gains on the sale of customer receivables in accordance with Statement of Financial Accounting Standards (SFAS) No. 125, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” These gains are recorded as finance revenue in the Consolidated Statements of Earnings.

* * *

The Company accounts for these asset-backed securitizations in accordance with SFAS No. 125, which requires that the Company recognize gains on its securitization of customer receivables. Incremental gains of $45,328 and $75,141 were recorded as finance revenue in fiscal year 1998 and 1997, respectively, representing the present value of estimated future cash flows the Company will receive over the estimated outstanding period of the asset securitization. These future cash flows consist of an estimate of the excess of finance charges and fees over the sum of the return paid to certificate holders, contractual servicing fees, and credit losses along with the future finance charges and principal collections related to interests in the customer receivables retained by the Company. These estimates are calculated utilizing the current performance trends of the receivable portfolios. Certain estimates inherent in determining the present value of these estimated future cash flows are influenced by factors outside the Company’s control, and, as a result, could materially change in the near term. [Emphasis added.]

223. In its financial statements for the year ended January 1, 2000, filed with the SEC on

Form 10-K, Spiegel disclosed:

The Company recognizes gains on the sale of customer receivables. These gains are recorded as finance revenue in the Consolidated Statements of Earnings.

* * *

The Company routinely transfers portions of its customer receivables to trusts that, in turn, sell certificates representing undivided interests in the trusts to investors. The receivables are sold without recourse, and accordingly, no bad debt reserve related to the receivables sold is maintained. In addition to the certificates sold, an additional class of investor certificates, currently retained by the Company, was issued by the trust in certain transactions. The Company recognizes gains on its securitization of customer receivables. Net gains of $15,760 and $45,328 were recorded as finance revenue in 1999 and 1998, respectively, representing the present value of estimated future cash flows the Company will receive over the estimated outstanding period of the asset securitization. These future cash flows consist of an estimate of the

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excess of finance charges and fees over the sum of the return paid to certificate holders, contractual servicing fees, and credit losses along with the future finance charges and principal collections related to interests in the customer receivables retained by the Company. These estimates are calculated utilizing the current performance trends of the receivable portfolios. Certain estimates inherent in determining the present value of these estimated future cash flows are influenced by factors outside the Company’s control, and, as a result, could materially change in the near term. [Emphasis added.]

224. Similarly, Spiegel’s financial statements for the year ended December 30, 2000, filed with the SEC on Form 10-K disclosed:

Excess cash flows resulting from the Company’s securitization activity are recorded as finance revenue when earned. Annual credit card fees are recognized as finance revenue over a 12-month period. Gains recognized on the sale of credit card receivables are recorded as finance revenue.

* * *

The majority of the Company’s credit card receivables are transferred to trusts that, in turn, sell certificates and notes representing undivided interests in the trusts to investors. The receivables are sold without recourse. Accordingly, no allowance for doubtful accounts related to the sold receivables is maintained by the Company. When the Company sells receivables in these securitizations, it retains interest-only strips, subordinated certificates, receivables and cash reserve accounts, all of which are included in retained interests in securitized receivables. Recognition of gain or loss on the sale of receivables depends in part on the previous carrying amount of the financial assets involved in the transfer, allocated between the assets sold and the retained interests based on their relative fair value at the date of transfer.

* * *

The Company has established trusts for the purpose of routinely securitizing credit card receivables. The Company retains interest-only strips, subordinated investor certificates, receivables and cash reserve accounts resulting from these securitizations. The Company also maintains responsibility for servicing the securitized receivables and receives annual servicing fees of 2 percent of all receivables transferred to the trusts. This servicing fee reflects the fair market value for these servicing rights; accordingly, the Company does not record servicing assets or liabilities. The investors and the securitization trusts have no recourse to the Company’s other assets for failure of credit card debtors to meet payment obligations. Certain of the Company’s retained interests are subordinate to investors’ interests. The value of the retained interests is subject to credit, payment- and interest-rate risk on the transferred financial assets.

Net pretax gains, including gains on the sale of credit card receivables and adjustments to fair value of the Company’s retained interests in securitized

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receivables, were $70,974, $15,760 and $45,328 in 2000, 1999 and 1998, respectively. [Emphasis added.]

225. In its Form 10-Q for the nine months ended September 29, 2001, filed with the SEC in November 2001, Spiegel disclosed:13

The Company routinely securitizes FCNB preferred credit card and FCNB bankcard receivables to fund the growth of its receivables. When the Company securitizes credit card receivables, it retains interest-only strips, subordinated investor certificates, receivables, servicing rights, and cash reserve accounts, all of which are retained interests in the securitized receivables. Gains or losses on the sale of receivables depends in part on the previous carrying amount of the financial assets involved in the transfer, allocated between the assets sold and the retained interests based on their relative fair value at the date of transfer. Quoted market prices are not available for retained interests; therefore, the Company estimates the fair value based on the present value of future expected cash flows using management’s best estimates of the key assumptions including portfolio yield, charge-offs, liquidation rates, interest rates, and discount rates commensurate with the risks involved. Gains and losses recognized upon securitization of credit card receivables and subsequent fair value adjustments to retained interests are recorded as net pretax gains on the sale of receivables and are included in finance revenue.

* * *

FCNB preferred credit finance revenue decreased 67% to $14,259 in the third quarter from $43,489 in the comparable prior year period. For the 39-week period, finance revenue decreased 47% to $69,181 from $129,954 in the prior year period. The decline in finance revenue is due primarily to lower retained-interest income from securitized receivables. While average receivables serviced increased and the finance charge and credit fee yields remained relatively constant, retained-interest income decreased significantly reflecting an increase in charge-offs on securitized receivables compared to last year. The Company sold additional FCNB preferred credit card receivables of $76,000 in the third quarter compared to $67,578 in the same period last year. The Company recorded a $4,000 reduction to net pretax gains on the sale of receivables in the 13-week period compared to a reduction of $59 in the same period last year. The reduction to net pretax gains in the third quarter reflects the expectation of higher charge-offs. In addition, the cash reserve accounts related to securitization activities have been discounted to net present value resulting in lower net pretax gains on the sale of receivables. For the 39-week period,

13 As noted in detail below, Defendants fraudulently caused Spiegel to withhold the filing of its Form 10-K and its financial statements for the year ended December 29, 2001 contained therein until February 2003 even though such Form 10-K and financial statements were required to be filed with the SEC on or about March 29, 2002.

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receivables sold increased $21,998 compared to a net increase of $222,579 in the prior year period. Net pretax gains on the sale of receivables totaled $13,834 for the 39-week period compared to $13,588 for the same period last year.

* * *

For the 39-week period, bankcard revenue increased 11% to $137,510, compared to $123,549 for the prior year period. The growth in revenue was attributable to a 67% increase in average receivables serviced, offset somewhat by lower retained-interest income. Retained-interest income was negatively impacted by an increase in charge- offs, which reduced the excess cash flows from securitized receivables that are recorded as finance revenue. The Company sold additional bankcard receivables of $165,000 in the 39-week period, compared to $224,000 in the comparable prior year period. Net pretax gains on the sale of receivables totaled $29,894 compared to $25,575 for the same period last year. Incremental gains in the 39-week period were driven by the sale of additional receivables and reflected anticipated improvements in portfolio performance, primarily related to finance charge yields. Impacted by the increase in charge-offs, operating income for the bankcard segment declined to $32,925 for the third quarter from $40,557 for the comparable period last year. For the 39-week period, operating income increased to $72,892 from $66,726 in the comparable prior year period driven by growth in the portfolio. [Emphasis added.]

Spiegel’s Class Period Securitizations

226. During the Class Period, Spiegel’s wholly-owned bank, FCNB, transferred its FCNB

Bankcard receivables to First Consumers Master Trust (“FCMT”). FCMT then issued a collateral certificate representing a beneficial interest in the receivables of FCMT to First Consumers Credit

Card Note Trust (“FCCCNT”). FCCCNT then sold a series of notes to investors in public offerings, collateralized by the certificates issued by FCMT to FCCCNT, and used the proceeds from the offering to retire the collateral certificates. In this way, Spiegel’s BankCard receivables were securitized.

227. Similarly during the Class Period, Spiegel, via a series of transactions with affiliated entities, transferred its Preferred Card receivables originated by its wholly-owned bank, FCNB, to

Spiegel Master Trust (“SMT”). SMT then issued a collateral certificate representing an interest in the receivables and the other assets of SMT to Spiegel Credit Card Master Trust (“SCCMT”).

SCCMT then sold a series of notes to investors in public offerings, collateralized by the certificates - 105 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 106 of 202

issued by SMT to SCCMT, and used the proceeds from the offering to retire the collateral certificates. In this way, Spiegel’s Preferred credit card receivables were securitized.

Spiegel’s Retained Risks and Rewards of Ownership Over Sold Receivables

228. As noted above, GAAP provides that it is improper to treat a receivable transfer as a sale when the transferor retains the risks and rewards of ownership over the transferred receivables.

During the Class Period, as Defendants, except for Cannataro, knew or recklessly ignored, Spiegel did not comply with GAAP in accounting for its transfers of credit receivables when it accounted for credit card receivables as “sales,” thereby recognizing hundreds of millions of dollars in phony gains, while it retained the risk of ownership over the transferred receivables. Accordingly, such transfers were nothing more than a secured borrowing arrangement, and Spiegel was required by

GAAP to consolidate the assets (credit card receivables) and liabilities (the note offerings) of the

SPEs with its own.

229. As noted in the prospectuses used to publicly sell SCCMT’s notes to investors,

SCCMT “will begin to repay the principal of the notes before the expected principal payment date if a ‘pay out event’ occurs.” The SCCMT prospectuses then define a series of adverse financial circumstances that are deemed to be “pay out events.”14

230. On April 19, 2002, Spiegel, for the first time, disclosed “[A] ‘Pay Out Event’ would divert excess cash flow of approximately $20 million monthly to repay [SCCMT] noteholders.”

Accordingly, Spiegel, and not SCCMT, possessed substantive risks of ownership associated with the

14 The SCCMT prospectuses state that it will begin to repay the principal of the notes before the expected principal payment date if a pay out event occurs. Examples of pay out events include: (1) SCCMT’s failure to make required payments or deposits or material failure to perform other obligations; (2) material inaccuracies in SCCMT’s representations and warranties; (3) notes not being paid in full on the expected principal payment date; and (4) an event of default occurs for the notes.

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Preferred Card receivables transferred to SCCMT because Spiegel was contingently liable to

SCCMT’s note holders upon the occurrence of a pay out event by SCCMT. As a result, Spiegel was

precluded from treating such transfers as sales and was required under GAAP to consolidate the

financial statements of the SCCMT its own during the Class Period, as Defendants, except for

Cannataro, knew or recklessly ignored.

Spiegel’s Retained Control Over “Sold” Receivables

231. As noted above, GAAP also provides that it is improper to treat a receivable transfer as a sale when the transferor retains control over the transferred receivables. During the Class

Period, as Defendants, except for Cannataro, knew or recklessly ignored, Spiegel did not comply with GAAP in accounting for its transfers of credit receivables when it accounted for credit card

receivables as “sales”, while it retained control over the transferred receivables. Here again, such transfers were required to be accounted for as a secured borrowing arrangement rather than a sale.

232. In at least the following ways, Spiegel retained control over transferred FCNB

Bankcard receivables:

(1) The terms of trust agreement between FCNB and FCMT’s trustee, Bankers Trust Company (“BTC”), provides that in the event BTC resigned as trustee, FCNB was required to appoint a successor trustee. In addition, the trust agreement provides that FCNB was required to approve the appointment of any co-trustee or separate trustee of FCMT, and, under certain conditions, FCNB had the ability to discharge BTC.

(2) The trust agreement between FCNB and BTC also provides that in the event BTC is unable to decide between alternative courses of action permitted or required by the terms of any transactional document (as defined), then BTC is required to request instruction from FCNB as to the course of action to be adopted.

(3) Although FCNB transferred a portion of its BankCard receivables to FCMT, FCNB continued to own the accounts underlying the transferred receivables. As the owner of the accounts, FCNB retained the right to change account terms, including finance charges, fees and monthly minimum payments.

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(4) FCNB had the right to designate a percentage of the receivables that would otherwise be treated as principal receivables to be treated as financing receivables in order to compensate for a decline in the portfolio yield.

(5) FCNB charged receivables off as uncollectible in accordance with it credit card guidelines and customary policies and procedures.

(6) FCNB had the right to direct BTC to issue one or more series of investor certificates and define the terms of such series certificates.

233. As the Defendants, except for Cannataro, knew or recklessly ignored, the foregoing

provided Spiegel’s wholly-owned subsidiary, FCNB with effective control over FCMT and the

receivables transferred to it, thereby precluding its accounting for such transfers as sales.15 In fact,

FCNB collected the cash on the receivables it “sold” and had the right to commingle the cash it collected on such receivables with its own cash deposits, collect interest on the commingled cash, utilize the commingled funds for its own benefit, and, in the event of FCNB’s insolvency, FCMT

“may not have a first-priority perfected security in those collections.”

234. Accordingly, Spiegel’s recognition of a sale of the FCNB Bankcard receivables transferred to FCMT violated GAAP, because the activities of FCMT were virtually all on FCNB’s

behalf; the receivables transferred to FCMT were not isolated from FCNB and not put presumptively

beyond the reach of the FCNB or its creditors; and FCNB never relinquished effective control over

the of the BankCard receivables it transferred.

Spiegel’s Accounting for Receivable Transfers as Sales Otherwise Violated GAAP

235. As noted in the OCC Consent Order issued on May 14, 2002, during the Class Period, numerous, material internal control deficiencies existed at FCNB. As a result, Spiegel, in violation of the mandate of §13 of the Securities Exchange Act of 1934, was unable to make and keep books,

15 Upon information and belief, the same terms existed with respect to other SPEs with which FCNB transacted to securitize its BankCard receivables.

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records and accounts which accurately and fairly reflected its transactions. Accordingly, Spiegel was unable to accurately calculate the purported hundreds of millions of dollars in gains it reported on the receivables it “sold” during the Class Period. This fact otherwise precluded Spiegel from accounting for its credit card receivable transfers as sales, as Defendants, except for Cannataro, knew or recklessly disregarded.

236. GAAP, in FASB’s Concepts Statement No. 5, ¶¶58-65 provides that before a gain can be recorded in financial statements, it must be quantifiable with sufficient reliability. GAAP also provides that gains should not be recognized until they are realized or realizable. FASB Concepts

Statement No. 5, ¶83. Gains are realizable when related assets are convertible to known amounts of cash or claims to cash. Id. Further, circumstances involving uncertainty as to possible gains should not be recognized since to do so might result in gains being recognized revenue prior to its realization. SFAS No. 5.

237. As noted above, Spiegel calculated the gain on the sale of its receivables based on the present value of future expected cash flows using management’s “best estimates” of the key assumptions, including portfolio yield, charge-offs, liquidation rates, interest rates, and discount rates.

238. Spiegel’s recognition of hundreds of millions of dollars of gains on the sale of receivables during the Class Period otherwise violated GAAP because the “estimates” utilized by

Defendants, except for Cannataro, to calculate such gains were wholly unreliable. Accordingly, the gains were not realized or realizable, nor were they quantifiable with sufficient reliability, when they were recognized and reported by Spiegel to investors.

239. For example, the Consent Order issued by the OCC states, among other things, that:

(1) The Bank [FCNB] shall maintain its books, records and management information systems (“MIS”) in a complete and accurate condition, and the Bank’s files shall contain all records and information necessary to allow the Comptroller to determine the details or purposes of each of the Bank’s transactions. At a minimum, - 109 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 110 of 202

the Bank shall immediately develop, document and implement policies, procedures, systems and controls to ensure that, on an on-going basis, the books and records of the Bank:

(a) utilize a chart of accounts that contains account descriptions consistent with the activity in the account;

(b) reflect all of the assets, liabilities, capital, income and expenses of the Bank in accordance with Generally Accepted Accounting Principles (“GAAP”);

(c) provide references from the general ledger to the journal entries and, in turn, reference to the supporting source documents;

(d) reflect readily available documentation to adequately support all general ledger entries;

(e) reflect approval of all general ledger entries by an appropriate supervisor before being recorded in the books and records;

(f) include account analyses and/or reconciliations where appropriate or useful to evaluate or understand amounts recorded in the account; and

(g) readily reflect that the Bank has complied with all affiliate transaction laws.

* * *

(5) Within one hundred and twenty (120) days, with the assistance of the independent accounting firm, the Board shall cause to be developed and implemented revised written accounting policies and procedures for all significant Bank activities including sales of assets, and other securitization activities.

(6) Within sixty (60) days of the effective date of this Order, the Bank shall obtain and begin using on an ongoing basis, a residual asset valuation model (“model”) that comports with industry practice and OCC Bulletin 2000-16 and shall, at a minimum, base its estimation process on the following factors or assumptions:

(a) an actual cash payment rate - which the Bank shall calculate based on the history of actual payments made;

(b) a loss rate - which the Bank shall calculate on the basis of a three month rolling average loss rate (including roll rate analysis) from the relevant portfolio and trends in delinquency rates;

(c) a discount rate - which the Bank shall calculate based on appropriate comparisons with at least three comparable portfolios and supported by such other market information as is available to determine the appropriate required yields for residual assets; and

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(d) gross yield - which the Bank shall calculate based upon historical cash yields and the use of a three-month rolling average.

* * *

(8) The Bank’s valuation estimate and the applicable valuation assumptions shall comply with GAAP and OCC Bulletin 99-46 and be acceptable to the OCC.

(9) . . . The Bank shall not record in its books and records any estimate of the value of a residual where the estimate was not generated according to its written policies without the prior approval of the OCC.

(10) On an on-going basis, the Bank shall ensure that it is accurately reporting its allowance for loan and lease losses (“ALLL”) for all credit card receivables. Within sixty (60) days, the Bank shall submit to the OCC for review and prior supervisory non-objection, a description of its methodology for determining the ALLL. The methodology shall be consistent with the Interagency Guidance on Subprime Lending, OCC Bulletin 99-10 and the Interagency Expanded Guidance for Subprime Lending Programs, OCC Bulletin 01-6 (collectively “Interagency Guidance on Subprime Lending”) and also with the Allowance for Loan and Lease Losses booklet, A-ALLL, of the Comptroller’s Handbook. [Emphasis added.]

240. The mandates of the OCC evidences Spiegel’s improper recognition of hundreds of millions of dollars of gains on the sale of receivables during the Class Period because such gains were not realized, realizable or reliable, as contemplated by GAAP. Indeed, even if the sales of the receivables were true sales, which they were not, Spiegel did not have the internal controls necessary to compute amounts gained on the sale of those receivables.

241. In its financial statements for the year ended December 30, 2000, Spiegel disclosed that the amount of its Preferred credit card receivables that were more than 60 days past due on

December 30, 2000 totaled $191.6 million. When Spiegel filed its financial statements for the year ended December 29, 2001, it inexplicably reported that the amount of its Preferred Card receivables that were more than 60 days past due on December 30, 2000 totaled $334.6 million, or approximately 75% more than it reported in its prior year financial statements. As noted above,

Spiegel’s charge off rates, which were based on the past due age of outstanding receivables, was a factor used by Spiegel to calculate the gain on the “sale” of its receivables.

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242. For the foregoing reasons, Spiegel’s accounting for its transfers of credit card

receivables to SPEs were materially false and misleading and violated GAAP during the Class

Period.16 Defendants, except for Cannataro, inflated Spiegel’s profits, as noted in the chart below,

thereby inflating its credit rating and its financial strength during the Class Period:17

Year Ended Year Ended Year Ended Nine Months Ended (Data in $1,000s) January 2, 1999 January 1, 2000 December 30, 2000 September 29, 2001

Pre-Tax Profit (Loss) $ 18,110 $ 137,127 $ 196,024 $ (30,938) Improperly Recognized Gains On The Transfer Of Receivables To SPEs 45,328 15,760 70,974 43,728 Pro-forma Pre-Tax Profit (Loss) $ (27,218) $ 121,367 $ 125,050 $ (74,666) Percent Over (Under) Stated N/A 13.0% 56.8% (58.6)%

243. Moreover, by improperly accounting for its credit card receivables transfers to SPEs

as sales rather that as secured borrowings, Spiegel understated its reported debts by billions of

dollars.

244. In addition, Spiegel falsely reported that its operations generated $168.7 million in

cash during fiscal 1998, when, it truth and in fact, the Company’s operations actually consumed

more than $4.6 million in cash. Plaintiffs cannot reasonably calculate Spiegel’s improper reporting

of operating cash flow, during fiscal 1999 and 2000, because in its fiscal 1999 Form 10-K, Spiegel

reported that it securitized $1.639 billion of receivables while its fiscal 2000 Form 10-K discloses

that, during fiscal 1999, Spiegel securitized $1.963 billion in receivables, or approximately 20%

more than the Company originally reported. Accordingly, Plaintiffs are uncertain as the true

16 The “fees” Spiegel recognized and reported during the Class Period on the servicing of credit card receivables held by the SPE were likewise false and misleading and in violation of GAAP.

17 Spiegel’s reported profits during the Class Period were also artificially inflated due to the material understatement of interest expense resulting from the improper understatement of billions of dollars of debt.

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amount of receivables securities in fiscal 1999, further evidencing its material internal control

weaknesses noted above.18

245. Defendants, except for Cannataro, deceitfully clever financial manipulations created

the appearance that Spiegel was effectively competing in the new e-commerce environment and that

its financial health was strong. In truth, however, Spiegel was on the brink of bankruptcy.

Spiegel’s Improper Failure to Disclose Contingent Liabilities and Significant Risks and Uncertainties

246. Defendants’, except for Cannataro, attempt to deceive investors during the Class

Period is otherwise evidenced by the failure of Spiegel’s financial statement to disclose its

contingent liabilities in conformity with GAAP.

247. GAAP requires that financial statements disclose contingencies when it is at least

reasonably possible (i.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.

248. The SEC considers the disclosure of loss contingencies to be so important to an informed investment decision that it issued Article 10-01 of Regulation S-X [17 C.F.R. §210.10-01], which provides that disclosures in interim period financial statements may be abbreviated and need not 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.”

18 The true and accurate amount of receivables securitized in fiscal 1999 is needed to calculate Spiegel’s true operating cash flows for both fiscal 1999 and 2000.

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249. In addition, GAAP requires that financial statements disclose significant risks and

uncertainties associated with an entity’s business. American Institute of Certified Public

Accountant’s (“AICPA”) Statement of Position No. 94-6.

250. In its financial statements for the year ended December 30, 2000, Spiegel deceptively

disclosed:

Cash reserve accounts are maintained as necessary, representing reserve funds used as credit enhancement for specific classes of investor certificates issued in certain securitization transactions. The discounted value of these funds was included in other assets and totaled $5,391 and $10,192 at December 30, 2000 and January 1, 2000, respectively.

* * *

Certain restrictions exist related to securitization transactions that protect certificate holders against declining performance of the credit card receivables. In the event performance declines outside stated parameters and waivers are not granted by certificate holders, note holders and/or credit enhancement providers, a rapid amortization of the certificates could potentially occur. At December 30, 2000, the credit card receivables were performing within established guidelines.

251. In violation of GAAP, Spiegel’s Class Period financial statements improperly failed

to disclose that it was contingently liable to pay BILLIONS of dollars to SPEs’ investors upon the

occurrence of a “pay out event.” In fact, to the contrary, Spiegel’s financial statements for the

year ended December 30, 2000 falsely and misleadingly disclosed:

The investors and the securitization trusts have no recourse to the Company’s other assets for failure of credit card debtors to meet payment obligations. [Emphasis added.]

252. Indeed, throughout the Class Period, Defendants, except for Cannataro , misled and

falsely characterized Spiegel’s receivable securitizations as being “non recourse” in nature.19 In

19 Moreover, SCCMT’s prospectuses disclosed “The timely monthly payment of interest on the notes and the full and timely payment of principal of the notes on the final maturity date, will be guaranteed under a financial guaranty insurance policy issued by MBIA Insurance Corporation.”

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truth, however, Spiegel was contingently liable to repay SPE noteholders approximately $20 million monthly if triggered by a “pay out event.”

253. Only after the Class Period, when Defendants, except for Moran and Sievers belatedly filed Spiegel’s 2001 Form 10-K, did the Company’s financial statements disclose:

A “Pay Out Event” would divert monthly excess cash flows remaining after the payment of debt service and other expenses to repay principal to noteholders on an accelerated basis. [Emphasis added.]

254. Indeed, Spiegel failed to make such disclosure because Defendants, except for Moran and Sievers, knew that such disclosure would unveil the Company’s false and misleading accounting for its receivables transferred to SPEs, as noted above, thereby revealing its ponzi-scheme type financing arrangement that allowed it to boost product sales via the ever increasing extension of credit to sub-prime borrowers that it “sold” for amounts that it could not reasonably estimate and reported hundreds of millions of dollars in “gains” on such “sales.”

Spiegel’s Failure to Disclose Trust Trigger Violations

255. According to the Independent Examiner’s Report, as set forth below, there were several specific instances of SPE trigger violations or potential violations, which Defendants, except for Cannataro, knowingly or recklessly failed to disclose during the Class Period:

Second Quarter of Fiscal 2000

256. The Spiegel Master Trust (“SMT”) 1999-AS(57) agreement provides that the average rolling payment rate for any two months must remain above 4.5% in order to avoid a payout event.

[Section 8 (i)] In June 2000, Spiegel violated this payment rate trigger when the two month average

“principal payment rate” for SMT 1999-A fell to 4.31% as reported on the monthly noteholder statement. Weakness in the payment rate means that cardholders are paying back principal at a slower rate than anticipated, which may foreshadow future collectibility problems with respect to the accounts receivable.

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257. On August 15, 2000, Spiegel filed its Form 10-Q for the second quarter ended July 1,

2000 which included its unaudited consolidated financial statements and Management’s Discussion

and Analysis (“MD&A”). In its public filing, Defendants, except for Cannataro, did not disclose the

fact that Spiegel had violated the 4.5% payment rate trigger for SMT 1999-A, which resulted in an

automatic payout event but for a waiver that was obtained from 100% of the certificate holders.

Third Quarter of Fiscal 2000

258. The trusts were also required to maintain performance criteria measured by a default

ratio (pertains to the percentage of charge-offs in the receivable pool held in the Spiegel Master

Trust) and a delinquency ratio (measures the aggregate amount of receivables in the Preferred Card

portfolio that were greater than 91 days past due). During the third quarter of fiscal 2000, Spiegel

violated the “default ratio” payout trigger for SMT 1999-A. Spiegel also projected a violation of the

“delinquency ratio” payout trigger for SMT 1999-B in November 2000.

259. For SMT 1999-A, the two-month rolling average default ratio trigger was set at 12%.

The October 2000 SMT 1999-A trust financing commentary prepared by FCNB indicated that:

“[t]he current forecast two-month average default ratio for October is 12.43%, above the trigger

level. In his third-quarter 2000 key credit indicator report, McKillip advised the board that a payout

trigger on the SMT 1999-A had been activated in October 2000, when the two-month average

default ratio exceeded 12%.

260. In November 2000, Spiegel purportedly obtained the necessary waivers and the

Pooling and Servicing Agreements were amended to reset various trust triggers for both the SMT

1999-A(58) and SMT 1999-B(59) series. An amendment, dated November 14, 2000 for the SMT

1999-A, changed the default ratio trigger from 12% to 13.5%. Defendants, except for Cannataro, were alerted to the fact that Spiegel’s receivable charge-off rates were climbing.

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261. The applicable agreement for SMT 1999-B(61) required that the three-month rolling average ratio of delinquencies to total receivables be no greater than 4.75%. Steele noted in a

September 19, 2000, email that the forecasted range for the annual delinquency rate for September through December 2000 was 4.70% to 5.75%. In an October 31, 2000 letter from McKillip to

Hansen, Spiegel projected violations of the three-month average delinquency ratio payout trigger on the SMT 1999-B, above the 4.75% threshold, in November 2000.

262. In November 2000, the Amended and Restated Pooling and Servicing Agreement for

SMT 1999-B was amended to reset various trust triggers. The Amendment No. 2, dated November

10, 2000, for the SMT 1999-B, changed the delinquency ratio trigger from 4.75% to 13.5% and revised the definition of delinquency from 91 days past due to 31 days past due. The same Second

Amendment also softened the liquidation rate requirement so that it could not be less than 4.75% instead of the former 6% threshold.

263. Before the Form 10-Q for the third quarter of 2000 was filed, Spiegel either violated or projected violations of two trust payout triggers which it purportedly resolved by obtaining a waiver and two amendments. Defendants, except for Cannataro, failed to make appropriate financial reporting disclosures in Spiegel’s financial statements, as required by GAAP (in violation of SAB 99 and SFAS 78) and the SEC (in violation of SEC Regulation S-K 229.303, MD&A of Financial

Condition and Results of Operations and Financial Reporting Codification 500, Exchange Act Rule

240.12b-20 and Regulation S-X Section 210.10-01 (a) (5)) in Spiegel’s Form 10-Q for the Third

Quarter of 2000.

Fourth Quarter of Fiscal 2000

264. In its audit workpapers for fiscal 2000, KPMG noted that Spiegel expected to exceed the Amended Default Ratio covenant on the SMT 1999-A in February 2001. By year-end 2000,

Spiegel had not obtained an amendment or a waiver to cure its projected violation of the new default

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ratio threshold on the SMT 1999-A. After year end but before the Form 10-K was filed, an amendment dated February 13, 2001 changed the default ratio from 13.5% to 17% through the trust’s June 2001 distribution date.

265. To avoid activating the delinquency ratio payout trigger on SMT 1999-B in October

2000, Defendants, except for Cannataro, charged-off accounts in order to reduce delinquencies and thereby reduce the delinquency ratio below the payout threshold. As noted in FCNB’s October 2000

Trust Financing Commentary regarding the SMT 1999-B:

“The 3-month average Delinquency Ratio trigger is set at 4.75%. In September 2000, the 3-month average was 4.73%. The current forecast indicates the delinquency ratio will exceed the trigger level by the end of November if no action is taken. FCNB will attempt to secure relief from this trigger by mid-November. In order to remain below this trigger level in October, FCNB will accelerate approximately $10 million additional charge-offs during October. This will not impact full year 2000 results.”

Through its acceleration of charge-offs in the fourth quarter of 2000, Defendants, except for

Cannataro, used an artificial means to avoid violating the delinquency trust trigger on its preferred portfolio. By charging off these receivables, Defendants, except for Cannataro, improperly reduced delinquencies in Spiegel’s Monthly Noteholder Statements and gave the false appearance that they avoided violating the delinquency trigger.

266. On March 30, 2001, Spiegel filed its audited consolidated financial statements on

Form 10-K for the fiscal year ended December 30, 2000. In that filing, Spiegel represented that “[a]t

December 30, 2000, the credit card receivables were performing within established guidelines.”

Spiegel’s Form 10-K for the fiscal year ended December 30, 2000 also noted “the FCNB Preferred credit programs realized improved yields and lower charge-offs from reduced delinquencies

(emphasis added).” This representation is not consistent with the trends noted in KPMG’s workpapers. KPMG’s significant issues memo for the fiscal year ended December 30, 2000, noted a reverse trend:

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Based on discussions with the client, the Trusts have exceeded the trigger points due to changes in the composition of receivables in the Trusts. Delinquencies and charge-offs have increased, as a result of marketing efforts to grow the portfolio with more aggressive underwriting standards.

267. The performance trends of the securitized receivables clearly could have had a

material impact on Spiegel, and investors should have been provided with information about the

potential impact of this trend in order to fully understand the risks of investing in Spiegel.

First Quarter of Fiscal 2001

268. On December 19, 2000, Spiegel issued its first offering pursuant to the SCCMNT, the

publicly offered SCCMNT 2000-A series. By April 2001, it was apparent to Spiegel’s management

that Spiegel was in danger of violating the excess spread funding trigger on the SCCMNT 2000-A,

which was 3.5%. Specifically, in April 2001, Spiegel projected that the excess spread percentage on

the SCCMNT 2000-A Series would decline from 4.41 % in March 2001 to 1.09% in April 2001, and

then down to 0.48% in May 2001. This would have resulted in a three-month average excess spread

percentage of 1.99%. The three-month average excess spread funding threshold was 3.5%. FCNB

management, including Moran, knew, or recklessly disregarded, that Spiegel’s projected decline in

excess spread would require a significant increase to the Excess Spread Restricted Cash Account

from $12 million to $60 million in May 2001. In an April 26, 2001 memorandum to Moran, titled

“Preferred Portfolio Deterioration,” Aube wrote:

The ‘excess spread’ ratio for the [SCCMNT] 2000-A series is forecasted to be near zero for May . . . we are in the preliminary stages of replacing 1999-A with a public term transaction and negative excess spread trends will create difficulties in arranging new financing. Also, if the spread falls below 3.5%, we will have to increase a restricted cash account from $12 million to $60 million, thereby increasing debt by $48 million.

269. Defendants, except for Cannataro, avoided disclosing this excess funding requirement by fraudulently increasing the interchange rate from 1% to 5% for trust reporting purposes in April

2001, retroactive to January 1, 2001. Spiegel’s April 2001 Monthly Noteholder Statement, dated

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May 7, 2001, included the effect of the increased interchange rate. In April, Spiegel increased its

excess funding deposit from approximately $12,000,000 to approximately $23,000,000, and in May

2001 to approximately $27,000,000, and then reduced the balance to $12,000,000 in July.

270. If Defendants, except for Cannataro, had not improperly raised Spiegel’s interchange

rate from 1% to 5%, the excess spread percentage on the SCMNT 2000-A Series would have

declined below the 3.5% funding threshold to 2.63% in May 2001.

271. Spiegel continued to forecast increasing default rates on the SMT 1999-A series. In

February 2001, Defendants, except for Cannataro, purportedly obtained an amendment, which raised

Spiegel’s default rate trigger from 13.5% to 17% through the June 2001 trust distribution date.

272. On May 15, 2001, Spiegel filed its Form 10-Q for the first quarter of 2001 (ended

March 31, 2001), which included its unaudited consolidated financial statements and MD&A.

KPMG had performed a review of the unaudited financial statements as required by the SEC. In its

public filing, Defendants Otto, Moran, Zaepfel, Crusemann, Hansen, Muller, and Sievers did not

disclose the projected or actual trigger events, as they were required to do under the relevant SEC

and accounting guidance.

Second Quarter of Fiscal 2001

273. Based upon an actual interchange rate of 1%, the excess spread percentage on the

SCMT 2000-A Series would have declined below the 3.5% funding threshold to 2.63% in May

2001. At that time, Spiegel would have been obligated to fully fund its excess spread restricted cash account, to the maximum amount of $60 million.

274. Default ratios also failed to improve on the SMT 1999-A. Although the series was not scheduled to retire for several years, when Spiegel violated the default ratio payout trigger, it agreed to pay down the series and refinance the private placement through the issuance of a public offering. KPMG’s second quarter 2001 workpapers noted that the “SMT 1999-A default ratio has

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exceeded the default payout measure, and Bank of America signed a waiver through June 2001.

SMT 1999-A will be fully refinanced with the issuance [sic] of SCCMNT 2001-A on July 19, 2001.”

On June 11, 2001, Spiegel purportedly obtained an Amendment and Consent, which postponed the

Commitment Termination Date on its May 2001 default payout waiver from June 26, 2001 to July

30, 2001.

275. Spiegel informed J.P. Morgan that the average of the delinquency ratios for FCMT

1999-B and SMT 1999-B for the three consecutive monthly periods ending July 31, 2001 exceeded the trigger levels. Under the relevant Pooling and Servicing Agreements, violation of these triggers would not become payout events until either the Trustee or the Administrative Agent for the conduit banks declared a payout event. To avoid a payout event, Defendants, except for Cannataro,

requested a waiver from J.P. Morgan, the Administrative Agent for the conduits. In a memorandum

dated August 14, 2001, J.P. Morgan recommended a waiver to the conduit banks, noting that

“Morgan [was] willing to provide th[e] waiver, particularly in light of the fact that both series

continue to generate significant positive excess spread.” The Conduit Managing Agents waived

their right to declare a Series Payout Event (under Section 8(h) for FCMT 1999-B) and 8(i) for SMT

1999 B with respect to the three consecutive monthly periods ending July 31, 2001.

276. Spiegel was having similar difficulties with its bankcard series. In June 2001, just four months after closing the First Consumers Credit Card Master Note Trust (“FCCCMNT”)

2001-A, Spiegel exceeded the three-month rolling average delinquency ratio on the new bankcard series, triggering an increase in the excess spread account to the $36 million maximum.

277. On August 13, 2001, Spiegel filed its Form 10-Q for the quarter ended June 30, 2001 which included its unaudited financial statements and MD&A. KPMG performed a review of these financial statements pursuant to the regulations of the SEC. Defendants Otto, Zaepfel, Crusemann,

Hansen, and Muller did not disclose the projected and actual violations of trust triggers on Spiegel’s

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securitizations during the second quarter of fiscal 2001. Prior to filing its Form 10-Q for the Second

Quarter 2001, Spiegel had violated its delinquency trust triggers for SMT 1999-B and FCMT

1999-B and had not obtained either waivers or amendments by its filing date.

278. In addition to the violations stated above, Defendants Otto, Zaepfel, Crusemann,

Hansen, and Muller also violated: EITF 86-30 – “Classification of Obligations When Violation is

Waived by the Creditor.”

Third Quarter of Fiscal 2001

279. In September 2001, Spiegel violated the rolling three month average delinquency

triggers for the SMT 1999-B and FCMT 1999-B Series. According to an October 31, 2001 Key

Credit Indicator letter from McKillip to Hansen, the delinquency rate for the SMT 1999-B was

15.5% versus a trigger of 13.5%, and the delinquency rate for the FCMT 1999-B was 12.95% versus

a trigger of 1.75%.

280. In September 2001, Spiegel also projected violations of the excess spread percentage

funding triggers for SCCMNT 2000-A and SCCMNT 2001-A.

281. Spiegel increased the excess spread percentage, through an artificial interchange rate

increase for the SCCMNT from 5% to 6% in October 2001. This enabled Spiegel to temporarily

avoid its full cash funding obligations under the SCCMNT 2000-A and SCCMNT 2001-A.

However, in November, Spiegel was again forecasting a deterioration in its excess spread. An

October 2001 Trust Commentary Report from Mary Hankins to Cannataro and Zaepfel, among

others, noted that “November forecasted excess spread of 2.17% for SCCMNT 00-A and 3.21% for

SCCMNT 01-A reflects continued deterioration in portfolio performance, despite 1% increase in merchant interchange.” McKillip reported this same information to Horst Hansen in the Key Credit

Indicators Report for the fiscal year 2001:

Despite taking steps to improve excess spread in October 2001 (i.e. increasing the interchange rate by 1.0%) the three-month rolling average excess spread for the - 122 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 123 of 202

2000-A Series dropped to 1.79% in January, triggering an increase in spread account funding from $42.0 million to the maximum (capped) level of $60.0 million.

282. On November 13, 2001, Spiegel filed its Form 10-Q for the quarter ended September

29, 2001 which included its unaudited financial statements and MD&A. KPMG performed a review of these financial statements pursuant to SEC regulations.

283. Ultimately, however, the Defendants’ financial charade came to an end and Spiegel filed for bankruptcy in March 2003.

Spiegel’s Improper Failure to Disclose Debt Covenant Violations

284. Spiegel’s Second Amended and Restated Revolving Credit Agreement (“Credit

Agreement”) set forth four financial covenants with which Spiegel had to comply to avoid default:

1) Total Leverage Ratio; 2) Tangible Net Worth; 3) Fixed Charge Coverage Ratio; and 4) Debt to

Earnings Before Interest, Taxes, Depreciation, Amortization and Rental Expense (“EBITDAR”)

Ratio.

285. Throughout 2001, Spiegel came increasingly closer to violating all of these triggers, and by the fourth quarter of fiscal 2001, the Company violated each of the loan covenants in the

Credit Agreement. The violations precluded Spiegel from drawing on letters of credit to purchase merchandise for sale, and resulted in a liquidity crisis. Certain violations were waived, but others were not. Ultimately, as discussed above, Spiegel failed in its attempts during 2002 and 2003 to negotiate new financing agreements with a consortium of lender banks.

Spiegel’s Failure to Disclose Probable Default in Third Quarter 2001 Form 10-Q

286. On November 13, 2001, Spiegel filed its unaudited consolidated financial statements on Form 10-Q for the quarter ended September 29, 2001. As of October 28, 2001, which was prior to Spiegel’s filing of its unaudited consolidated financial statements, Spiegel had projected the year-end EBITDAR financial covenant default. Notwithstanding its projection of the year end

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EBITDAR financial default, Defendants Otto, Zaepfel, Crusemann, Hansen, and Muller made no

disclosure of the projected default in its September 29, 2001 unaudited consolidated financial statements on Form 10-Q for the Third Quarter of fiscal 2001. If this disclosure had been made, it would have alerted investors to the impending debt covenant violations referred to above.

287. EITF 86-30 and applicable SEC rules and regulations require that a borrower disclose

the adverse consequences of its probable failure to satisfy future covenants and or existing covenants

at future compliance dates.

Financial Reporting Requirements for Defaults at 2001 Year-End

288. SFAS No. 78 (“Classification of Obligations That Are Callable by the Creditor”) and

EITF 86-30 provide guidance as to how a borrower must classify debt on its balance sheet in circumstances where a covenant has been violated, including situations where a lender has waived the violation. SFAS No. 78 and EITF 86-30 provide that a borrower must classify long-term debt as a “current liability” on its balance sheet in circumstances where debt covenant violations have occurred and such violations, by the terms of the loan, cause the debt to be callable by the creditor.

The only exceptions that would allow a borrower to retain the long term designation are: (1) The creditor has waived or subsequently lost the right to demand repayment for more than one year (or operating cycle, if longer) from the balance sheet date; or (2) for a long-term obligation containing a grace period within which the debtor may cure the violation, it is probable that the violation will be cured within that period, thus preventing the obligation from becoming callable. Neither exception applied to Spiegel at the time the covenants were violated.

289. On November 9, 2001, Spiegel obtained waivers for its expected violations of the

Fixed Charge Coverage Ratio and the Debt to EBITDAR Ratio. The waivers, however, extended only through June 15, 2002 – a period less than 12 months, and, thus, too short to allow Spiegel to fall within any exception that would allow Spiegel to maintain the classification of the revolving

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loans as “long-term debt.” Spiegel never obtained waivers for non-compliance with the Leverage

and Tangible Net Worth ratios. Therefore at December 29, 2001, in accordance with the guidance

set forth in EITF 86-30, as well as SFAS No. 78, the violations of the debt covenants precluded

Spiegel from classifying the debt as a non-current liability. Thus, approximately $933 million in long term debt was classified as a current liability at December 29, 2001. However, Defendants, except for Moran and Sievers, did not issue Spiegel’s December 29, 2001 audited consolidated financial statements on a timely basis. Instead, Spiegel’s statements were not filed until February

2003.

290. In addition to reclassifying Spiegel’s long-term debt, under the guidance set forth in

Regulation S-X Section 210.4-08, Defendants Otto, Zaepfel, Crusemann, Hansen, Muller, and

Cannataro were required to make certain disclosures concerning these debt covenant violations. S-X

Section 210.4.08 requires that “the facts and amounts concerning any . . . breach of covenant of a

related indenture or agreement, which default or breach existed at the date of the most recent balance

sheet being filed and which has not been subsequently cured, shall be stated in the notes to the

financial statements. If a default or breach exists but acceleration of the obligation has been waived

for a stated period of time beyond the date of the most recent balance sheet being filed, state the

amount of the obligation and the period of the waiver.”

291. Therefore, Defendants, except for Moran and Sievers, did not timely disclose this

adverse change caused by the violation of Spiegel’s debt covenants in its financial condition, as the

Defendants, except for Moran and Sievers, were required to do under United States securities laws.

292. Defendants’, except for Moran and Sievers, failure to timely disclose the

reclassification of Spiegel’s long-term debt as current misled and investors about Spiegel’s true

financial condition. In its February 21, 2002 press release, Spiegel disclosed, “As a result of our

2001 financial results, including the loss recorded for the disposition of our credit card business, we

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are not in compliance with certain of our 2001 loan covenants.” However, no balance sheet was

included in the release. Accordingly, Defendants, except for Moran and Sievers, failed to disclose critical information such as: (1) the outstanding debt amount at December 29, 2001; (2) the severity of the impact of Spiegel’s non-compliance with its loan covenants; and (3) the fact that the Company had not obtained waivers on all of its loan covenant defaults. This information, while known to

Defendants, except for Moran and Sievers, was not disclosed until nearly 14 months later, when the

December 29, 2001 Form 10-K was filed in February 2003.

293. At December 29, 2001, under the governing accounting guidance, Spiegel should have: (1) reclassified this long-term debt as a current obligation immediately due and payable; and

(2) disclosed the violation of the debt covenants in its consolidated financial statements for the year ended December 29, 2001. Moreover, Defendants Otto, Zaepfel, Crusemann, Hansen, Muller, and

Cannataro were required to disclose the projected violation of its EBITDAR covenant in its unaudited consolidated financial statements for the quarter ended September 29, 2001 filed with the

SEC on Form 10-Q.

Spiegel’s Improper Failure to Disclose KPMG’s Audit Opinion and Disclosure About Its Ability to Continue as a Going Concern

294. In furtherance of their scheme to defraud investors about Spiegel’s true financial condition, Defendants Otto, Zaepfel, Crusemann, Hansen, Muller, and Cannataro knowingly and fraudulently withheld the filing of Spiegel’s 2001 Form 10-K with the SEC.

295. On or about March 7, 2002, the SEC filed a complaint against Spiegel seeking a permanent injunction and other ancillary relief.20 Days later, on March 10, 2003, Spiegel consented,

20 See United States Securities and Exchange Commission v. Spiegel Inc., 1:03cv1685 (JBZ) (N.D. Ill. March 7, 2003).

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without admitting to or denying the allegations in the SEC’s complaint, to the relief sought by the

SEC. The SEC’s complaint alleged:

In or about the beginning of 2002, the engagement partner on the Spiegel audit, informed Spiegel that the audit firm had doubts that Spiegel could continue as going concern. These concerns were later included in a proposed auditor report dated February 14, 2002 which stated in a separate paragraph that the firm had “substantial doubts” about the company’s ability to continue as a going concern.

Because Spiegel had not resolved its financial problems by the due date of its Form 10-K, its outside auditor insisted on issuing an audit report containing a separate paragraph stating that it had substantial doubts about Spiegel’s ability to continue as a going concern. However, instead of filing the Form 10-K with the audit report - Spiegel simply choose not to file at all. It likewise withheld the going concern notice from its press releases and public statements regarding its financial condition.

Despite receiving its outside auditor’s “going concern” notice, Spiegel issued a number of press releases and public statements regarding its financial condition without disclosing this important and negative piece of information. These press releases discussed in great detail its Fourth Quarter and Fiscal Year 2001 results. These press releases also provided Spiegel’s “financial outlook” for 2002 stating that it expected “modest improvement” in revenue by the second half of the year and provided “updates on business developments.” Spiegel executives made similar statements in its conference calls with analysts. Yet the company failed to disclose that its auditor had actually questioned the company’s ability to exist as a going concern absent the company addressing certain financial issues.

Spiegel was required to file its Form 10-K for 2001 on April 1, 2002. Had it done so, it would have been required to include its outside auditor’s going concern report with the filing. However, Spiegel did not file the Form 10-K. Instead, on April 1, 2002, Spiegel, with the assistance of its then outside counsel, filed with the Commission a Form NT inaccurately stating that it was not in a position to file its Form 10-K because it had violated certain of its loan covenants and because it had decided to sell its bank subsidiary. No mention was made of the going concern report.

Spiegel withheld information from the public to avoid a negative impact on its stock price and to its business operations.

On April 22, 2002, in order to avoid immediate delisting, Spiegel requested a hearing before Nasdaq to explain why it had not filed its Form 10-K. Nasdaq scheduled a delisting hearing in Washington D.C. for May 17, 2002. In attendance at the May 17, 2002 hearing two of Spiegel’s officers, a member of Spiegel’s Audit Committee and an attorney who attended the meeting at the invitation of Spiegel’s majority shareholder.

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In the hearing, Spiegel’s representatives did not dispute that the company had the ability to file timely its Form 10-K. Instead they stated that the reason Spiegel did not file its Form 10-K was because it did not want to reveal the going concern report to the public.

Spiegel’s officials told the Nasdaq panel that it felt that certain loan covenant problems with its lenders would be resolved within five business days of the hearing and asked for an extension until May 28th, by which time, it would have worked out a new deal with its lenders, a consortium of three American banks and fifteen European banks with close ties to the majority shareholder, which the company indicated would enable it to file its Form 10-K without any going concern report.

In discussing the real reasons why Spiegel had not filed its Form 10-K, one of Spiegel’s officers at the hearing stated:

“Well, because, again it comes back to we could file today. If we did, all we would do is create a going concern, some upset in the market, some turmoil in the market.”

A member of Spiegel’s Audit Committee in attendance at the hearing stated:

“It was very important to get this company really in the shape where you could say they have a clean opinion, an unqualified opinion, also to safeguard all this money we have, so to say, put in the company . . .”

* * *

“. . . we want of course, to have an unqualified opinion because the vendor side is important, the image of the company is important . . .”

When May 28th arrived, the Nasdaq had not yet ruled upon the delisting petition and Spiegel still did not file its Form 10-K, but instead asked for an additional 48 hours to file. Eventually, on Monday June 3rd, when Spiegel had still not filed its Form 10- K, Nasdaq finally sent notice to Spiegel that it was being delisted. Spiegel had not filed its Form 10-K despite specific assurances given to Nasdaq that it would file on May 28th regardless of the status of the negotiations with its lenders.

The board committee of Spiegel’s board of directors and its audit committee participated in the decision to withhold the Form 10-K reflecting the going concern report. In fact, some Spiegel officers sought, but failed to gain, authority from Spiegel’s board committee to file the Form 10-K. For instance, on May 30th 2002, at least one of Spiegel’s officers sent the board’s audit committee a letter requesting that the company be authorized to file its Form 10-K. Instead, the audit committee passed a resolution recommending to the board committee of the board of directors that the company delay filing its Form 10-K.

An article in the Chicago Tribune on June 4, 2002, the day after Spiegel was delisted and nearly six months after learning of the audit firm’s concerns, stated that the Form 10-K was not filed because a new lending agreement was not in place and that - 128 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 129 of 202

without that Spiegel’s outside auditor would have had to express doubts about the company’s ability to continue as a going concern. A company spokeswoman was quoted in the article: “We felt it would be detrimental to file it now without a clean opinion from the auditors . . . The board is doing what they think is right to preserve the value of the company.”

After this article appeared, there were no press releases or interviews discussing the going concern issue.

Since being delisted, Spiegel has filed three separate Forms NT claiming that it was not in a position to file its Forms 10-Q because, among other things, it was still negotiating new lending agreements. None of these filings mentioned the going concern issue. Spiegel also continued to issue press releases discussing portions of the company’s financial condition including sales figures and revenues. Once again, none of these press releases mentioned the going concern issue.

After being contacted by the Enforcement Division of the SEC, Spiegel finally filed its Form 10-K for 2001 on February 4, 2003. The Form 10-K contained the outside auditor’s going concern report and also revealed that Spiegel had a net loss of $587.5 million in 2001.

The belated Form 10-K also revealed that Spiegel had $1 billion in debt on the books as well as an additional $3.55 billion in debt off the books. At least $700 million of the balance sheet debt and all $3.55 billion of the off balance sheet debt may become due in 2003 due to the company’s violation of its loan covenants. [Emphasis added.]

296. The failure to disclose KPMG’s going concern opinion further evidences the

Defendants, except for Moran and Sievers, intent to deceive the investors about Spiegel’s true financial condition. Indeed, §607.02 of the SEC’s Codification of Financial Reporting Policies require that:21

. . . filings containing accountant’s reports that are qualified as a result of questions about the entity’s continued existence must contain appropriate and prominent disclosure of the registrant’s financial difficulties and viable plan to overcome these difficulties. Such disclosure is required by existing rules and by the antifraud provisions of the federal securities laws.

21 The Codification of Financial Reporting Policies are the SEC’s current published views and interpretations relating to financial reporting.

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297. Nonetheless, Defendants, except for Moran and Sievers, knowingly and willfully failed to timely provide such disclosure to investors in Spiegel’s Class Period financial statements.

Spiegel’s Improper Failure to Correct Its Previously Issued Financial Statements

298. GAAP provides that previously issued financial statements which are misstated as a result of an oversight or a misuse of facts that existed at the time that the financial statements were prepared are to be retroactively restated. See e.g., Accounting Principles Board (“APB”) Opinion

No. 20, APB Opinion No. 9 and the AICPA’s Statement on Auditing Standard (“SAS”) No. 53.

299. Spiegel’s Class Period financial statements and disclosures in its press releases were materially false and misleading when made.

Spiegel Failed to Record Retained Interests at Fair Value

300. By fiscal year 2000 the quality of the accounts receivable that Defendants, except for

Cannataro, used in Spiegel’s securitization transactions had deteriorated. Despite Defendants’, except for Cannataro, awareness of this fact, Defendants, except for Cannataro, failed to properly reflect the effect this had on the assumptions used in determining the fair value of the retained interests and the corresponding impact to the Company’s financial statements.

Background

301. When Spiegel sold receivables through its securitization transactions, it typically retained the following assets, known as “retained interests” in the securitized receivables:

• Sellers Interest in Receivables (receivables placed in the trust by Spiegel for which it has received no cash).

• Subordinated or Retained Investor Certificates (held as enhancement for the benefit of certificate holders and considered a subordinate interest in the trusts).

• Interest Only Strips (“I/O Strips”)

• Cash Reserve Accounts (an enhancement to the certificates and “cushion” to any defaults in the trusts). [KPMG 12367] - 130 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 131 of 202

302. The receivables held in trust represent receivables that have been placed in the trust by Spiegel but for which no cash has been received. As such, the receivables were not considered to have been sold, and Spiegel continued to record them on the balance sheet as accounts receivable, valued at the gross amount less a reserve established for the estimated uncollectible portion. The subordinated investor certificates and I/O strips were treated as trading securities and, as such, had to be carried at fair value with fluctuations in value recorded in the income statement. Spiegel estimated “fair value” by using an Excel spreadsheet known as the residual asset value (“RAV”) model.

303. Simply stated, the RAV model calculated the net present value (“NPV”) of the retained certificate principal payments and the future excess cash flows generated from the receivables. Variables such as finance yield, charge-offs, discount rates22 and interest rates were used by Spiegel in the NPV calculations. Minor changes in any one of these variables has a significant impact on the value of the retained interest.23 In light of: (1) the significance of these assets to

22 SFAS No. 140 states that I/O strips and retained interests are to be accounted for in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. As Spiegel chose to account for these under SFAS No. 115 as a trading security, these financial interests are required to be reported in the balance sheet at their then fair value with any changes in fair value being reported in the income statement. SFAS 140 and FASB Concepts Statement (SFAC) No. 7, Using Cash Flow Information and Present Value in Accounting Measurements define fair value as “The amount at which that asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.” SFAC No. 7 further states that “a. . . . estimated cash flows and interest rates should reflect assumptions about the future events and uncertainties that would be considered in deciding whether to acquire an asset or group of assets in an arm’s-length transaction for cash . . . b. Interest rates used to discount cash flows should reflect assumptions that are consistent with those inherent in the estimated cash flows . . . c. Estimated cash flows and interest rates should be free from both bias and factors unrelated to the asset . . . . For example, deliberately understating estimated net cash flows to enhance the apparent future profitability of an asset introduces a bias into the measurement.”

23 For example, increasing the charge-off rate by 1% in the December 2000 RAV model decreases the value of the net I/O Strip from $142 million to $116 million.

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Spiegel’s financial statements; (2) the volatility of the asset values with slight changes in valuation

assumptions; and (3) the GAAP requirement that the assets be carried at fair value, the assets represented a high risk to the fair representation of Spiegel’s financial condition as set forth in their consolidated financial statements filed periodically with the SEC.24 Accordingly, it was critical that

the assumptions used to estimate fair value of the assets (or any changes in such assumptions)

needed to be based on competent, relevant, sufficient and reliable data. Information related to the

receivables, as included in Spiegel’s consolidated balance sheet for the year 2001, reflects that these

assets comprised a significant portion of Spiegel’s balance sheet.

304. The RAV model used by Spiegel was intended to accomplish two goals: (1)

estimation of the fair value of the retained investor certificates; and (2) estimation of the fair value of

the I/O strips. The RAV model estimated the fair value of the Retained Investor Certificates by

projecting the cash flow from the certificates using an assumed liquidation rate and default rate.

Since Spiegel was required to over collateralize the Trust, the cash collected on the excess

receivables passed through to Spiegel. This cash flow annuity constituted the Retained Investor

Certificates and was discounted at a rate of 9%, at year-end 2000, to arrive at the value recorded on the balance sheet. In addition to the excess collateral, the collateralized accounts receivables earn interest at a higher rate than is passed on to the certificate holders. Spiegel had the right to receive the excess interest, provided that certain payout triggers were not activated. Spiegel estimated this cash flow stream by deducting: (1) assumed principal charge-offs; (2) interest paid to Investors; and

24 Documents obtained by the Independent Examiner showed that KPMG’s planning documents for the year 2000 note that the preliminary risk assessments related to the accuracy, valuation and presentation and disclosures for residual interests in securitized receivables is high. The workpaper states “Inherent risk is assessed at high for all objectives, as there is significant management judgment; control risk is assessed at high for all objectives . . . and risk of significant misstatement as high for all objectives.”

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(3) servicing fees from the estimated net portfolio yield.25 The excess interest or cash flow is determined as: “Net Finance Charges” less “Principal Charge-Offs” less “Interest Paid to Investors” less “Service Fees” equals “Excess Interest/Cash Flow.” In order to estimate the fair value of the cash stream, it is discounted at a rate to arrive at NPV. For the I/O strips, Spiegel used a 15% discount rate, at year-end 2000.

305. As time progresses, evidence necessitating changes in the model assumptions, including charge-off rates, provides indication that the fair value of the retained certificates and I/O strips recorded on the balance sheet has been affected. For example, if charge-offs are lower than anticipated (reflecting better performance), an investor would be willing to pay more for the retained interest in an arms- length transaction. Conversely, if actual charge-offs are higher than anticipated

(reflecting worse performance), an investor would pay less for the retained interest.

306. GAAP requires that retained interests in securitizations (other than the seller’s interest in receivables held in trust) be recorded like debt securities. Paragraphs 14 of both SFAS 125 and

SFAS 140 require that interest-only strips, retained interests in securitizations, loans, other receivables, or other financial assets that can contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment should be subsequently measured like investments in debt securities classified as available-for sale or trading under SFAS 115. Unrealized holding gains and losses for trading securities are required to be included in earnings. Pursuant to GAAP, unrealized holding gains and losses for available-for-sale

25 This calculation also involves an assumption regarding liquidation rates. Liquidation rates are the assumed rates at which credit card holders will pay back the principal that they owe. Assuming all other assumptions were appropriately estimated, if the Trust liquidates more slowly than originally estimated, the value of the I/O strips is increased and the value of the Retained Interest Certificates is decreased. The opposite is true if the Trust liquidates at a more rapid rate than was originally assumed.

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securities (including those classified as current assets) shall be excluded from earnings and reported as a net amount in a separate component of shareholders’ equity until realized. In its consolidated financial statements included in the Form 10-K filed with the SEC for fiscal year ended December

30, 2000, Spiegel disclosed the following:

Marketable securities consist of the retained certificates issued by the trusts in conjunction with the securitization of the Company’s credit card receivables. These debt securities, classified as trading and stated at fair market value, are included in net receivables. [Emphasis added.]

Paragraph 12 a. of SFAS 115 defines trading securities as:

Securities that are bought and held principally for the purpose of selling them in the near term (thus held for only a short period of time) shall be classified as trading securities. Trading generally reflects active and frequent buying and selling, and trading securities are generally used with the objective of generating profits on short-term differences in price.

307. According to the Independent Examiner’s Report, no evidence was found that Spiegel was actively trading in the retained interest certificate market. However, as a result of Defendants, except for Cannataro, classifying Spiegel’s retained certificates as trading securities, it reported market value gains or losses immediately in the determination of income. Defendants’, except for

Cannataro, baseless decision to classify the retained certificates as trading securities, when coupled with the fraudulent assumptions used in the Company’s valuation model, allowed

Defendants, except for Cannataro, to overstate the Company’s earnings by hundreds of millions of dollars during the Class Period.

308. As evidenced by Defendants’ Otto, Moran, Zaepfel, Crusemann, Hansen, Muller, and

Sievers continuous struggles to avoid trigger violations as discussed above, it is clear they were aware that the securitization asset portfolios were not performing at levels expected when the retained interests were initially valued and recorded. Specific communications made available to the

Independent Examiner revealed that members of Spiegel’s management confirmed Spiegel’s awareness of problems with the portfolio at least as early as the fall of 2000. - 134 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 135 of 202

309. For example, on November 9, 2000, Spiegel’s internal auditor, McKillip wrote the following comments to Hansen concerning credit issues in the third quarter of 2000:

• Referring to SMT Series 1999 B: “Current projections indicate that this delinquency ratio [payout trigger] will trip the trigger in November 2000 if no action is taken.”

• Preferred charge offs and fraud losses continue to grow. Increasing delinquencies, driven by a newer customer file, deterioration of new customer credit quality, less restrictive new account credit standards and a more liberal credit limit strategy along with increased fraud expense driven by an influx of new accounts and the absence of backend screening in Fall 1999 and Spring 2000 have combined to put upward pressure on Preferred charge offs. The November Board estimate calls for this expense to reach $206.4 million (11.2%) in 2000, up from April Board of $182.9 million (10.1%). It appears that this trend will continue into 2001, where net charge offs and fraud losses are currently projected at $283.9 (12.5%).

310. Furthermore, not only had the portfolio already shown signs of deterioration over fiscal year 2000, but Spiegel was also aware that there was little hope for improvement. A

November 24, 2000 memorandum from Mark Lowe (Spiegel risk manager) to Moran, and other

Spiegel executives drafted in response to questions raised about the portfolio reflected that Spiegel had strategically pursued high- risk cardholders:

• Although their expected charge off rates were high, FCNB and Spiegel deliberately selected these customers because they had several desirable characteristics – excellent response, activation, and credit utilization.

• The consumers FCNB and Spiegel target trend to high deterioration in their credit files. These individuals are highly utilized with their existing lines of credit. They also have more irregular payment histories. The ones that respond to the credit and merchandise offers have even higher rates of decline within a four to six month period. Forty to fifty two percent of these customers have expected charge off rates that are higher than they were a few months earlier.

• A table in the document indicates that 22% of the accounts receivable balances relate to customers with FICO scores between 351 and 550 [ “High Risk”]. It further states that the charge-off rate for this group is 53.38% and ‘This group as [a] whole not able to make minimum $15.00 monthly payments.’

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311. Additionally, according to the Independent Examiner, Spiegel was advised by a third party, Fair Isaac, which developed the FICO scoring system, that the strategy it undertook was going to result in a portfolio with high delinquency rates and charge-offs. FCNB retained Fair Isaac to study the impact on the receivables portfolio related to FCNB’s credit line policy of granting credit line increases every two months. The December 2000 Report titled “Strategy Review: Private Label

Portfolios Credit Line Management” included various comments about delinquencies and credit strategies:

• Delinquency rates for the Preferred portfolio are significantly higher than industry averages. The national average 2+ cycle delinquency rate is 4.33% as of the second quarter 2000 according to the Federal Reserve. “In contrast, Spiegel’s 2+ cycle delinquency rate [is] 18.7%, Newport News’ delinquency rate is 19.8% and Eddie Bauer’s is 9.3% as of October 2000.

• [E]conomic conditions also suggest the need to consider reducing loss exposure. For example, leading industry groups are predicting bankruptcy rate increases in the next few years…Credit quality and account management issues will become increasingly important during any economic tightening.

• Aggressive credit line strategies often produce positive results very quickly in the form of increased revenue and charge volume. However, it takes substantially longer to measure the corresponding increase in charge-off losses that often result from aggressive strategies.” The conclusion states “. . . the frequency of line increases and the broad–based nature of these increases is creating greater loss exposure without providing clear increases in revenue for the bank or for the merchants.

312. Other evidence obtained by the Independent Examiner clearly confirms that

Defendants, except for Cannataro, were aware of problems with the Preferred series:

• November 21, 2000 Board of Directors (“BOD”) Packet – FCNB acknowledges problems with the preferred portfolio and sets forth steps to improve credit quality; however, “No significant impact will be recognized until Fall season 2001. In the interim, FCNB will take steps to improve yield in order to off-set increased losses. These steps will include further pricing changes.

• November 21, 2000 BOD Packet – Credit quality of the new customer group has deteriorated due to lower activation rates across all risk levels, adverse selection, competitive pressures and aggressive new account management to support sales. - 136 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 137 of 202

• December 2000 Trust Financing Commentary – Referring to the SMT Series 1999-A and 1999-B – “Spiegel Treasury advised to seek reset of delinquency trigger in Q12001.

• December 2000 Trust Financing Commentary SMT Series 1999-A – Spiegel Treasury in process of renegotiating default trigger with Bank of America; documentation to follow.

• Loree Vandenberg – former head of internal audit at FCNB stated in an interview with representatives of the court-appointed examiner on July 24, 2003 that for the Preferred Card, it was known that certain late fees would not be collected and should have been written down sooner.

• November 17, 2000 facsimile memo from Bob Gill to Skip Behm (VP of Finance Planning and Control for Spiegel) referring to changes in the credit limit strategies – “The attached will outline for you changes to be made to the credit limit strategies effective in January 2001. This change is exactly what was recommended, but blocked last month. You will see that the vintage we are tracking has further deteriorated during the last 30 days. Anticipate that March 2001 will bring further recommendations to rein in high risk transactions with continued emphasis upon higher risk FICO ranges (under FICO 650) and we will begin to address the size and frequency of increases then.

313. Despite this evidence of a clear awareness by Spiegel management of the sub-performance of the receivables portfolio, the Defendants, except for Cannataro, continued to value the retained interests as if this deterioration had no adverse impact on their value. To the contrary, during the Class Period, Defendants, except for Cannataro, knowingly or recklessly, used assumptions in the RAV model that resulted in increases in the fair value of the assets thereby permitting them to recognize gains during this period instead of write downs ($8.6 million as of

3/31/00, $13.6 million as of 6/30/00, $13.6 million as of 9/30/00 and $28.3 million as of 12/31/00 – all amounts are cumulative).

Lack of Adequate Support for Retained Interest Valuation Assumptions

314. Some of the variables used to value retained interests, such as finance yield and charge-off rates, were obtained from board forecasts and five-year plans. The assumptions used by

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Defendants, except for Cannataro, in the RAV model during various quarters are shown in the following Table:

RAV Model Assumptions Mar-00 Jun-00 Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Finance yield 23.69% 22.88% 24.86% 27.13% 27.93% 26.94% 28.70% Charge-Offs 9.43% 9.19% 9.92% 12.18% 12.92% 12.22% 15.31% Servicing Fee 2.00% 2.00% 2.00% 2.00% 2.00% 2.00% 2.00% Avg. Interest Rate Paid 5.47% 5.00% 5.29% 5.19% 4.69% 3.96% 4.33% Discount Rate 12.00% 12.00% 13.00% 15.00% 15.00% 15.00% 15.00% Retained Cert. Discount Rate 7.47% 7.00% 8.00% 9.00% 9.00% 9.00% 9.00%

Portfolio Finance Yield

315. The retained assets were very sensitive to slight changes in assumptions used to value

them. For example, a 1% decrease in the finance yield used in the RAV model decreases the value of the retained interests of $142.6 million by $25 million or 18%. That reality, coupled with the fact

that Spiegel was concerned about the quality of the portfolio and possible trigger violations in 2000,

created a situation in which the Company either had to recognize a significant writedown of retained

interests or use variables from unrealistic Company-prepared forecasts that justified no diminution in value. Spiegel chose to do the latter.

316. The increase in portfolio yield used in the RAV model from 24.86% to 27.13% in

December 2000 was a significant increase. The only explanation regarding the jump in yield found in the documents obtained by the Independent Examiner was in the year-end 2000 audit workpapers of KPMG. According to those workpapers:

The increase in the finance charge rate is partially due to a higher prime rate used to forecast December’s estimate than the September estimate, as the cardholder APR is based on prime rate. The prime rate has increased during the current year, and is remains higher at December 31, 2000 than it was during the early part of 2000. The increase in the finance charge rate is also consistent with the increase in charge-offs and delinquencies for both bankcard and preferred. Higher risk portfolios have a higher finance charge rate and higher charge-offs.

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317. No support could be found that quantified or explained the basis for this increase.

First, the assertion that the prime rate increased during 2000 is correct in that the rate increased from

8.5% at January 1, 2000 to 9.5% in mid-May 2000. However it remained at 9.5% for the balance of the year. In addition, the prime rate decreased on January 4, 2001, and continued to decrease every month in the first half of 2001 to 6.75% at the end of June 2001. Secondly, a higher risk portfolio should yield higher gross rates, but the rate discussed above is net of finance charge and late fee charge-offs, which would also increase with a high-risk portfolio.

318. In fact, the assumed finance charge and late fee charge off rate was assumed to be

5.11% for purposes of doing the calculation of fair value at year end 2000. This is a 3.7% increase over the annualized year-to-date experience at the end of the 2000 third quarter of 4.93%. Yet, for principal chargeoffs, the assumptions in the model increased from 9.92% to 12.18%, an increase of

22.8%. It is likely that the charge-offs related to finance charges and late fees would be greater than principal charge-offs; however at the very least, the increase in finance charge and late fee charge-offs should be assumed to be proportionate to the principal charge-offs based on the logical assumption that a non-paying credit customer would not differentiate between principal and finance charge payments. Had Spiegel employed such an assumption, this change alone would have decreased the finance yield used in the model by approximately 1% [4.93 * 1.228 = 6.05 instead of

5.11].

319. Also, as indicated in the table above, it was assumed that the rates paid to certificate holders, who theoretically share in the portfolio risk, would decrease from the 5.29% used at the end of the third quarter 2000 to the 5.19% used at the year end 2000.

320. Obviously, the certificate holders would not experience a proportionate increase in their yield as they have protections, but no explanation is provided that justifies a decrease in yield to investors in the same assets, while another investor, i.e., Spiegel, experiences an increase in yields.

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Although the portfolio yield of 27.13% is reflected in a Company prepared forecast, according to the

Independent Examiner no support could be located to explain how this forecast was derived. To

the contrary, the 2000 forecast prepared in September 2000 projected yields for 2000 at 24.50% and for 2001 at 25.22%.

Charge-Off Rate

321. As noted above, the charge-off rate was increased in the RAV model for the year ended December 30, 2000 from 9.92% to 12.18%. Given the experience of the trust portfolio, an increase was clearly in order. The need for an increase was explained as being due to a combination of the seasoning of new accounts and a rise in portfolio charge-offs and total delinquencies. Also, receivables significantly increased during the current year and typically, the new accounts that charge-off will do so around six months. The December 2000 forecast indicated that the charge-off rate should be 10.88% and to that was added an extra 1.3% to arrive at a total charge-off assumption of 12.18%. No documentation could be found that explained the basis for the additional 1.3%, or how the Company determined whether it was adequate. Unquestionably, the charge-off rate needed to be increased but the increase applied was inadequate. Delinquencies were increasing, and they were increasing at a rate greater than the charge-off assumption was being increased in the model.

322. Additional evidence made available to the Independent Examiner revealed that the difference between the actual delinquency rate and the model charge-off rate at the first quarter was approximately 5.5 percentage points. By the end of the year, the differential between the model charge-off rate and the delinquency rate was over 10 percentage points. Thus, the assumed charge-off rate was not keeping pace with the delinquency rate.

323. In addition to considering this pattern, had the Company taken into account the actual rates they experienced in late 2000 and January 2001, information that was available prior to filing

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their 2000 Form 10-K, it would have recognized that 12.18% was inadequate. The actual charge-off

rates experienced in December 2000 and throughout the first quarter were in excess of the rate

assumed in the RAV model. The Monthly Noteholder Statements show that charge-off rates were

13% in December 2000 and 13.7% for January 2001.

324. The Company increased the charge-off rate to 12.18% in December 2000 for

purposes of valuing the retained interests at year-end. Raising the charge-off rate from 9.92% to

12.18%, without a corresponding change in the finance yield, would result in an approximate $56

million write-down of the retained interests. As discussed in the section above, however,

management changed the finance yield from 24.86% in September 2000 to 27.13% in December

2000 – an increase of 2.27%. Coincidentally, this precise increase corresponds almost exactly with

the 2.26% increase in the charge-off rate of 9.92% used in September to the 12.18% rate used in

December. By raising the finance yield rate and the charge-off rate in tandem, and by virtually

the same amount, Spiegel created the appearance that a write-down in the value of the retained interests was unnecessary.

325. Except for a brief period in early 2001, delinquencies remained in the 22% to 24% range throughout 2001. At June 2001, with delinquencies at about the same level as year-end 2000, there was still an approximate 10 percentage point differential between the model rate and delinquencies. Ultimately, Spiegel raised the model rates in September and December 2001 to

15.3% and 18.2%, respectively.

326. Delinquencies at year-end 2000 were approximately 23% of outstanding accounts

receivable balances. At the end of 2001, delinquencies were approximately 24% of outstanding accounts receivable balances, and at year-end 2002, delinquencies were 23.5% of outstanding accounts receivable balances. The information available in 2002 that led to the write-down of the

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retained interests in the 2001 financial statements had not changed drastically from the

information that existed at year-end 2000.

Resulting Overvaluation of Retained Interests

327. As stated above, Spiegel had no basis to assume that the portfolio yield for these trust

receivables would ever achieve 27.13%. Also contemporaneous evidence shows that the increase in

the charge off rate from 9.92% in the third quarter of 2000 to 12.18% in December 2000 was

inadequate. Since Spiegel classified its retained interests as trading securities, the discount rates

used should have reflected market rates for investments with similar risks. As discussed more fully

above, at least by the fall of 2000, some trigger violations occurred and others threatened to occur

that could have resulted in a payout event in the SMT Series.

328. For example, a memorandum, made available to the Independent Examiner, dated

October 11, 2000 from Alan D. Coogan (FCNB General Counsel) to Mike McKillip attached the

October 2000 Trust Financing Commentary. This memo discussed the potential trigger violations of

series 1999-A and 1999-B of the SMT. The memorandum indicates that the liquidation rate will be

tracked carefully as the two- month average trigger is set at 6% and the current two- month average

is 6.27%. More importantly, it reflects that the 1999-A series was in violation of the default trigger

and that management was going to work to gain relief from this trigger.

329. The same memorandum expresses concern regarding a possible violation of the

delinquency ratio trigger in the 1999-B series, which did not contain a default trigger. In fact, on

November 14, 2000 an amendment and consent was given to Series 1999-A for its violation of the default rate. This amendment facilitated Spiegel’s ability to accelerate $10 million of charge-offs in

October 2000 thereby avoiding a delinquency ratio trigger being violated by series 1999-B.

330. The manipulative appearance of these actions aside, the fact that Spiegel was struggling to avoid violation of the established triggers was a harbinger of the direction that the value

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of these assets were headed. Had these series gone into rapid amortization, the value of the retained

interests would be severely diminished. In other words, as the likelihood of a trigger violation

increases, the risk of an investment in the retained assets increases as well, thereby decreasing the

amount that a third party would be willing to pay for the investment in an arms- length transaction.

That risk should have been reflected in the discount rate. Despite Spiegel’s assertion that the retained interests were trading securities, the Company did little, if anything, to determine whether the

discount rate used reflected a market rate for similar investments.

331. In fact, KPMG instructed its Structured Finance Group to evaluate the RAV model in

connection with the year-end 2000 audit. KPMG provided a recommendation that Spiegel obtain

supporting information for its discount rate assumption. Examples of supporting information would

include a letter from an investment banker or market information based on comparable assets with

similar ratings, risk and duration profiles. The Structured Finance Group stated that other issuers

had been typically using discount rates ranging from 12% to 20% per annum. Spiegel management

responded that they were willing to incorporate the recommendation in their fiscal year 2001 policy.

This implies that no such procedures were performed in fiscal 2000 and raises further questions as to

the basis for the rates used by Spiegel. Based on the fact Spiegel had already violated triggers and

remained in danger of violating others, an investor would view a purchase of Spiegel’s retained

interests as a high-risk investment. The value of the I/O strips is dependent on the accuracy of the

assumed liquidation rates. A payout event leading to rapid amortization would have a devastating

effect on the value of an I/O strip. Accordingly, since an investor would be putting their principal at

very high risk, they would expect a very high return and the discount rate should have reflected that

risk.

332. The Independent Examiner found that there was little or no real market for this type

of portfolio. Nevertheless, if a transaction were to occur, any potential buyer would likely conduct a

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very thorough due diligence prior to making a purchase to identify the relevant risk issues associated

with the portfolio and determine an appropriate discount rate. Ultimately, in 2002, when Spiegel

solicited bids for its portfolios, one offer through JP Morgan related to the preferred portfolio

included a 45-50% discount. Given the sensitivity of these assets to slight fluctuations in the

discount rate, it was imperative that they obtained a market opinion from a third party.

333. For all the reasons discussed previously, Spiegel’s retained interests were high risk

and, at the very least, the rate used to value the portfolio should have been at the high end of the

range, which was 20%. Even this is aggressive, as had any investor performed due diligence on these assets in anticipation of purchasing them and realized how closely and routinely they

approached a payout event, a higher rate would have been demanded. Instead, Spiegel used 15% for

the I/O strips and 9% for the retained certificate discount and did nothing to evaluate whether these

rates were justified.

Defendants’ Failure to Restate Retained Interest Carrying Values

334. Had Spiegel given appropriate consideration to the deterioration of the receivables

portfolio in determining the fair values of the retained interests, it would have been necessary for the

Company to record material write-offs through the income statement at year-end 2000. However,

since Defendants, except for Cannataro, used assumptions for which there was no supported basis,

the December 30, 2000 financial statements included in Form 10-K filed with the SEC were

materially misstated.

335. Based on contemporaneously available information discussed below, the finance

charge rate used by Spiegel in the RAV model should have been lower. Similarly, the charge-off

rate and the discount rates used in the RAV model should have been higher. Recalculating the RAV

model at December 2000 with adjusted rates would have required a $113 million write down of

Spiegel’s retained interests. The Independent Examiner recalculated the value of the retained

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interests with the RAV model using rates that reflect the risk and reality of the portfolio. The rates and the bases follow:

• Finance charge rate – 25.6%. This rate was calculated by taking the average of the actual year-to-date 2000 finance rate from the Performance Reports (25%) and a year-to-date average rate derived from the 2000 Monthly Noteholder Statements (26.15%).

• Charge-off rate – 13%. This was the rate experienced in December of 2000. The rate continued to trend up from 13% in January and February 2001.

• Discount rate – 20% - as discussed above, this was in all likelihood, based on the Trust performance and the risk an investor would be assuming, too low.

Application of these rates yields the following results:

• The retained interest write-down required due to decreasing the finance charge rate from 27.13% to 25.6% is $37.7 million.

• The retained interest write-down required due to increasing the charge-off rate from 12.18% to 13% is $21.2 million.

• The retained interest write-down required due to increasing the discount rates from 15% (for the excess cash flow calculation) and 9% (for the retained certificate discount calculation) to 20% overall is $57.3 million.

• As of December 31, 2000, the aggregate retained interest write-down required based on adjusting the finance charge rate, charge-off rate and discount rate is $113 million. This amount exceeds pre-tax income of $112 million.

336. Other documents produced by Spiegel indicate that the charge-off rates were higher than the amounts used in the RAV model and the Board forecasts. These spreadsheets produced by

Spiegel show a comparison of actual charge-off rates to rates used in the RAV model, and were prepared based on information obtained from the Monthly Noteholder Statements (“MNS”). These documents and data contained in the FCNB Performance Reports show that Spiegel Management knew that the Company was consistently overestimating the portfolio yield of the receivables and underestimating charge-offs.

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337. When Spiegel finally filed its Form 10-K for fiscal 2001, the report showed that the

value of Spiegel’s I/O Strip decreased from $191.2 million at year-end 2000 to $59.8 million at

December 31, 2001. This represented a $131.4 million or 69% decrease in value during this

12-month period. The primary write-down ($117.8 million) was made based on changes to the

finance yield rates (decrease) and charge-off rates (increase). Other adjustments were made related to implementation of a new RAV model and the availability of actual finance yield and charge-off data through August 2002 due to Spiegel’s late filing of its 2001 financial statements.

Revenue Recognition

338. Spiegel’s credit card portfolio shifted from lower risk customers to higher risk customers in 1999 and early 2000. Spiegel’s reliance on high-risk customers continued into 2001.

By the Spring of 2001, 62% of new credit card customers booked were rated “E” and “F” compared to only 31% in 1998. The growth in high-risk Preferred customers is illustrated in the table below, which shows the percentages by risk level for the total Preferred portfolio:

Preferred Credit Balances by Risk Level Levels Dec-98 Sep-01 Change A 4% 2% (50%) B 12% 5% (58%) C 31% 16% (48%) D 27% 34% 26% E 24% 33% 38% F 2% 10% 400%

339. The rapid growth in higher risk segments and the related charge-off rates are also

demonstrated in the following table created by Spiegel:

The “Top 6” Fastest Growing Risk Segments ($ in millions) Balances Charge-off Rate Growth Portfolio, Risk Level Mar-00 Sep-01 % Annualized Spiegel, F $ 20.7 $ 91.3 341% 29.40% Newport News, D $ 77.2 $ 119.8 55% 32.90% Spiegel, E $ 247.8 $ 360.1 45% 30.20% Newport News, E $ 103.0 $ 143.9 40% 47.90% Newport News, F $ 42.8 $ 58.3 36% 37.10% Spiegel, D $ 303.2 $ 392.0 29% 24.90%

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340. Spiegel attributed its 2001 credit performance to several factors, including:

• Underwriting criteria supported an increase in risk beginning in the Fall of 1999;

• Aggressive credit line management strategies contributed to excessive bad balance growth beginning in the Fall of 1998;

• Rapid growth in higher risk segments;

• Unseasoned balance growth;

• Economic slowdown in Fall 2001; and

• Delays in implementing recommended credit policy changes.

With this growth in high-risk accounts, Defendants, except for Cannataro, knew or recklessly disregarded that higher chargeoff rates and potential losses would have an adverse effect on the collectibility of Spiegel’s credit card receivables. For example, in an April 2000 FCNB report,

FCNB forecasted higher charge-off rates in 2000 driven in part by Defendants’, except for

Cannataro, efforts to stimulate Spiegel’s sales with higher risk/higher response programs.

341. A November 24, 2000 memorandum, obtained by the Independent Examiner, noted that the annualized charge-off rates for customers with FICO Credit Bureau Scores of 351 to 550 was 53.38%. Lowe added that “This group [FICO 351 to 550] as [a] whole [are] not able to make minimum $15.00 monthly payments.”

342. Defendants’, except for Cannataro, knew or recklessly disregarded that Spiegel’s growing reliance on sales to high credit risk customers raised an issue regarding what implications such reliance might have on Spiegel’s revenue recognition policy with respect to such sales. More specifically, the actual and expected charge-off (credit loss) data compiled by Spiegel during this period raised a serious question as to whether collectibility was reasonably assured with respect to these sales transactions.

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343. Accounting Research Bulletin No. 43, Chapter 1A states that “[p]rofit is deemed to be

realized when a sale in the ordinary course of business is effected, unless the circumstances are such

that the collection of the sales price is not reasonably assured.” As summarized in SAB 101,88 revenue is generally realized or realizable and earned when all of the following criteria are met:

• Persuasive evidence of an arrangement exists;

• Delivery has occurred or services have been rendered;

• The seller’s price to the buyer is fixed or determinable; and

• Collectibility is reasonably assured.

344. The assessment of whether revenue is collectible must be based on circumstances that

exist when the revenue is recognized. The SEC has indicated that the term “reasonably assured”

represents a higher threshold than the term “probable” as that term is used in SFAS No. 5

(“Accounting for Contingencies”). The term “probable,” in turn, is defined in SFAS No. 5 as “likely

to occur.” Defendants, except for Cannataro, failed to draw the obvious logical conclusion from the

common meaning of these terms: if there is less than 50% likelihood of an event occurring, such

event would not be considered to be probable, likely or reasonably assured of occurring.

345. Applying this rationale, Defendants, except for Cannataro, knew or recklessly

disregarded that it was improper for Spiegel to recognize revenue associated with sales transactions

where historical and forecasted charge-off rates associated with certain credit risk categories of

Spiegel’s preferred credit card customers would exceed 50% until such time as the cash was actually

collected. Additionally, the Independent Examiner found no indication in KPMG’s workpapers that

they addressed revenue recognition issues related to customers with potential charge-off rates in excess of 50%.

346. As of October 2000, an analysis of Preferred Card account balances by credit risk category indicated that Spiegel had recognized over $235 million dollars in revenues on sales

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transactions where the forecasted charge-off rates exceeded 50% and were in fact, greater than 75% in most instances. Defendants, except for Cannataro, violated GAAP by recognizing 100% of the revenues associated with these sales prior to their being collected thus improperly overstating the

Company’s revenues and earnings by hundreds of millions of dollars throughout the Class Period.

Servicing Liabilities

347. SFAS 125 and 140 requires an entity that undertakes a contract to service financial assets shall recognize either a servicing asset or a servicing liability. Each securitization transaction undertaken by the Company during the Class Period retained Spiegel’s servicing rights over the accounts transferred. A servicer of financial assets commonly receives the benefits of servicing – revenues from contractually specified servicing fees, late charges and other fees, all of which it is entitled to receive only if it performs the servicing and incurs the costs of servicing the assets.

Typically, the benefits of servicing are expected to be more than adequate compensation to the servicer for performing the servicing, and the contract results in a servicing asset. However, if the benefits of servicing are not expected to adequately compensate the servicer for performing the servicing, the contract results in a servicing liability.

348. Spiegel used a 2% servicing fee in the calculations and assumed that it adequately compensated them. Consistent with Spiegel’s approach with other assumptions, as set forth in the

Independent Examiner’s Report, Defendants, except for Cannataro, had no support to determine that there was any reasonable basis for this assumption.

349. As a result, Spiegel did not record a servicing asset or liability in any fiscal year prior to 2000. The only reference that addresses whether the Company considered this requirement is a

KPMG workpaper that includes responses from the audit team to KPMG’s Structured Finance Group

(“SFG”). The SFG did not note any calculations for an asset or liability in their review and recommended that the audit team follow up with Spiegel. The audit team responded that “A

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servicing asset and liability represents the difference between the market servicing rate and the rate

of the deal. KPMG notes that FSAC and SAC do not have a servicing asset and liability, as the

servicing rate is consistent with market and the sub-prime industry standard servicing rate.”

350. FCNB’s CFO at the time stated in his interview conducted by the Independent

Examiner on June 4, 2003, that FCNB maintained a file that supported the 2% servicing rate used by

FCNB. However, FCNB was not able to produce this document. In late 2002, FCNB undertook a review of the servicing contracts between FCNB and the Trusts to service the receivable portfolios to evaluate whether the servicing contracts were at market rates. Based on proposals received from two vendors, FCNB concluded that a 4.41% servicing fee rate was an appropriate approximation of adequate compensation for servicing fees. Using the 4.41% proposal, FCNB recorded a servicing liability of $49.7 million in Spiegel’s December 30, 2000 financial statements based on the difference between the 4.41% market rate and the contractual rate of 2%.

351. It is highly unlikely during the Class Period that the rates for servicing receivable

portfolios increased by 120% (2.41% divided by 2.00%). Had Spiegel undertaken a similar review of its servicing contracts and market rates prior to fiscal 2000, a servicing liability would likely have been required.

352. Nonetheless, in an apparent attempt to shield itself from liability, Spiegel has continued its deceptive financial reporting by improperly failing to restate its grossly misstated Class

Period financial statements in accordance with GAAP.

Spiegel’s Other Violations

353. The foregoing accounting machinations resulted in Spiegel’s issuance of financial statements during the Class Period that violated numerous provisions of GAAP and the SEC’s

accounting rules and regulations. In failing to file financial statements with the SEC which

conformed to the requirements of GAAP, Spiegel disseminated financial statements that were

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presumptively misleading and inaccurate. Indeed, the numerous accounting machinations detailed herein evidence Defendants’ intent to deceive investors during the Class Period and misrepresent the truth about the Company and its business, operations and financial performance to the detriment of those who relied on them. As a result of the accounting improprieties noted above, Defendants presented Spiegel’s financial statements in a manner which also violated at least the following provisions of GAAP:

(a) The principal that financial statements record a liability when they are probable and reasonably estimable. In violation of GAAP and its publicly stated accounting policies, Spiegel failed to timely record liabilities associated with its servicing of the SPEs credit card receivables (SFAS No. 5);

(b) the concept that financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions (Concepts Statement 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 the effects of transactions, events and circumstances that change resources and claims to those resources (Concepts Statement

No. 1, ¶40);

(d) the concept that financial reporting should provide information about how management of an enterprise has discharged its stewardship responsibility to owners (stockholders) for the use of enterprise resources entrusted to it. To the extent that management offers securities of the enterprise to the public, it voluntarily accepts wider responsibilities for accountability to prospective investors and to the public in general (Concepts Statement 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

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about the past to help in assessing 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

(Concepts Statement 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 is central to accounting (Concepts Statement No. 2, ¶¶58-59);

(g) the concept of completeness, which means that nothing is left out of the information that may be necessary to ensure that it validly represents underlying events and conditions (Concepts Statement No. 2, ¶79);

(h) the concept that conservatism be used as a prudent reaction to uncertainty to try to ensure that uncertainties and risks inherent in business situations are adequately considered.

The best way to avoid injury to investors is to try to ensure that what is reported represents what it purports to represent (Concepts Statement No. 2, ¶¶95, 97); and

(i) the Concept that financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions (FASB Statement of Concepts No. 1, ¶34).

354. Further, the undisclosed adverse information concealed by Defendants during the

Class Period is the type of information that, because of SEC regulations, regulations of the national stock exchanges and customary business practice, is expected by investors and securities analysts to be disclosed and is known by corporate officials and their legal and financial advisors to be the type of information that is expected to be and must be disclosed.

355. In addition, disclosure obligations under the SEC’s rules and regulations concerning

Management’s Discussion and Analysis of Financial Condition and Results of Operations and

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Quantitative and Qualitative Disclosures About Market Risk, are required to be considered in

financial disclosures. See Exchange Act Rule 12b-20; see also 17 C.F.R. §229.303. Registrants

must consider the economic and business realities and risks of their corporate structures and

affiliations, their financial structures and financing methods, their lines of business and operational

activities, and ensure that the way they publicly portray themselves discloses, as required, the

material elements of those economic and business realities and risks.

356. In this regard, Defendants, except Cannataro, were required to disclose but did not,

that during the Class Period, Spiegel used special purpose entities, the true structure of these

transactions, the true risks that these transactions presented, and the uncertainties that were

reasonably likely to materially effect Spiegel’s results of operations or liquidity and capital

resources. These disclosures should have been made regardless of whether Defendants, except for

Cannataro, believed that the SPE transactions complied with GAAP.

KPMG’S ROLE IN THE FRAUD

357. Spiegel was a long time and significant client of KPMG and a major source of income

for KPMG’s Chicago office. KPMG has served Spiegel in various consulting capacities for many

years and had earned significant fees for performing these services. Based on information and

belief, such fees related, in part, to KPMG’s promotion of SPEs and its involvement in rendering important judgments in the preparation of Spiegel’s Class Period financial statements.

358. As detailed above, KPMG had a primary role in creating the SPEs and accounting for

Spiegel’s asset transfers to the SPEs during the Class Period.

359. KPMG provided numerous services to Spiegel and knew or recklessly ignored that, in violation of GAAP, Spiegel employed an improper accounting scheme to allow the Company to report hundreds of millions of dollars in phony gains during the Class Period and under report billions of dollars of debt. KPMG also knew, or recklessly ignored that GAAP, in numerous

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respects, precluded Spiegel from accounting for receivable transfers to SPEs as sales. Indeed, by accounting for Spiegel’s receivable transfers to the SPEs as sales, KPMG knew or recklessly ignored that such accounting was nothing more than a deliberate attempt to circumvent a fundamental tenet of GAAP which holds that the substance of a transaction, rather than its form, should determine its accounting treatment.

360. KPMG also knew, or recklessly ignored, that Spiegel’s Class Period financial statements failed to disclose the information required by GAAP. KPMG violated Generally

Accepted Auditing Standards (“GAAS”), specifically AU §431, which provides that financial statements disclosures are to be regarded as being reasonably adequate unless otherwise stated in the auditor’s report.

361. In particular, in connection with the financial statement disclosures related to the carrying value of Spiegel’s retain interests in securitized assets for fiscal 2000 quarterly and year-end audit procedures, KPMG performed various analyses on the assumptions used in the RAV model.

During the quarterly work they compared the RAV model assumptions to the prior year and agreed or compared charge-off and finance yield rates to the BOD forecast. Additionally, they reviewed the actual rates from FCNB’s Performance Reports. During the quarterly review work in 2000, the rates used in the RAV model were deemed adequate by KPMG because the RAV model yield rate was lower than actual and the RAV model charge-off rate was higher than actual. Using the lower yield rate and higher charge-off rate in the RAV model resulted in a lower retained interest value and was therefore considered by KPMG to be a “conservative” approach.

362. However, in connection with the preparation of the year-end 2000 financial statements, this approach was not followed as it had been in the previous quarters. For example, the

27.13% finance yield rate used in the year-end 2000 RAV model was higher by 1.13% to 2.13% than the actual year-to-date average, which ranged between 25% and 26%, depending on whether the

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Performance Reports or Monthly Certificateholder Statements were used to calculate the average.

While the differences between these percentages seem minor, because RAV model is extremely

sensitive to changes in assumptions, a 1% decrease in the finance yield would have resulted in a $25

million write-down of the retained interests.

363. The quantitative work performed by KPMG to test the year-end finance yield rate

included an analysis of the adequacy of the September 2000 rate using a comparison of actual rates calculated from the Monthly Noteholder Statements for the period January through October 2000.

KPMG noted on this schedule that they recalculated the rates based on the Monthly Certificateholder

Statements. There is no evidence of further audit testing of these documents. KPMG’s planning documents stated that at year-end they will analyze the changes in assumptions between 9/30/00 and

12/31/00 and perform additional test work on large and/or unusual fluctuations. Based on the sensitivity of the model’s assumptions, a change from 24.86% to 27.13% was significant and should have been considered unusual. The workpapers show that November and December 2000 and

January 2001 rates were not considered in any detailed analysis. Instead, the analysis appears to consist of KPMG comments noting that the increased rate used in the year-end model were partially due to an increase in the prime rate and it was consistent with the increase in charge-offs and delinquencies. The workpapers reflect no other substantive work or evaluation of the rate change.

364. Instead of calculating a year-to-date average, as was the practice during the quarterly review work, KPMG simply stated that the actual net rates ranged between 23% and 29%

(September and October) and thus “The FAS 125 model finance yield of 24.86% appears to be within the range of the actual finance charge yield earned during the current year.” The workpapers do not contain a detailed quantification or analysis that explains the increase from September to

December. Aside from the general comments regarding the prime rate and increases in charge-offs and delinquencies, and the acknowledgment that the most recent forecast of finance yield was

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27.13%, there was no detailed analysis in the workpapers that showed how or why the 27.13% was

determined to be accurate and reasonable. As previously noted, the year-to-date average calculation

of the finance yield rate in 2000, using the Performance Reports and Monthly Noteholder

Statements, was 25% and 26.15%, respectively.

365. Similar to the work performed on finance yield, KPMG analyzed the September 2000

charge-off rate at year-end. KPMG recalculated the charge-off rates using information contained in

the Monthly Noteholder Statements through October 2000. The analysis indicated the charge-off

rates ranged between 6.76% and 11.55%. Based on this analysis, KPMG deemed that the 9.92% rate

used in the September 2000 model appeared to be within the range of actual charge-offs during the

current year.

366. The workpapers state that the year-end increase to 12.18% was due to a combination

of the seasoning of new accounts and a rise in portfolio charge-offs and delinquencies. KPMG

compared the model rate to the forecast and noted that FCNB added 1.3% to the 2000 forecast of

10.88%. Based on the increased delinquencies and charge-offs, KPMG deemed the 1.3% reasonable.

367. Similar to the finance rate analysis, the 2000 audit workpapers indicate that KPMG did not consider what was actually occurring with the rates subsequent to October 2000. The

Monthly Noteholder Statements show charge-off rates of 13%, 13.7% and 13.68% in December

2000, January 2001 and February 2001, respectively.

368. KPMG failed to perform any detailed analysis or calculations that show whether the

1.3% was an adequate increase. AU Section 326.01 requires the auditor to obtain sufficient competent evidential matter to afford a reasonable basis for an opinion. Also, as discussed above,

SAS No. 57 states that the auditor’s objective when evaluating accounting estimates is to obtain sufficient competent evidential matter to provide reasonable assurance that all accounting estimates that could be material to the financial statements have been developed and the estimates are

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reasonable in the circumstances. In addition, the auditor should obtain an understanding of how management developed the estimate. Based on this understanding, the auditor should review management’s process to develop the estimate, develop an independent estimate or review subsequent information. The work performed on the charge-off rates, particularly related to the

1.3%, does not meet these standards.

369. In addition, KPMG noted in the third quarter 2000 workpapers that the default covenants for SMT 1999-B and the delinquency ratio covenants for SMT 1999-A were expected to be triggered in the near future. The workpapers state that “[p]er discussions with [FCNB’s CFO], the composition of the portfolio is more risky since the inception of the Trust.” They also noted that

FCNB had obtained covenant waivers in the past, however, if a waiver is not granted, the Trust would default into rapid amortization. At year-end 2000, KPMG addressed these triggers again.

KPMG noted that the SMT 1999-B default covenants and the SMT 1999-A delinquency ratio covenants were triggered during the year and the SMT 1999-A was expected to exceed the default ratio trigger in February 2001. KPMG noted that FCNB obtained waivers from the investment banks related to the triggers. In a section of the FCNB audit program related to going concern issues, KPMG indicated “No significant doubt about the entity’s ability to continue exists – see trigger point analysis . . . .”

370. KPMG tracked the Trust performance and triggers because they were aware that the violation of certain triggers could cause a rapid amortization and have a devastating impact on the financial condition and cash flows of FCNB and Spiegel. The above quote from the audit program addressed this very issue. In addition, in KPMG’s 12/31/00 Significant Issues and Decisions

Document, KPMG describes the following significant issue, including potential financial statement effect:

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estimates. Furthermore, the requirements of SFAS 125 (and SFAS 140 in future periods) are extensive and must be fully analyzed. Also, during fiscal 2000 the Spiegel Group obtained a waiver to avoid certain trust covenant violations that could, if not waived, result in rapid amortization of the trust which could ultimately impact the valuation of the Company’s retained interests in securitized receivables. Management’s projections may indicate future violations may occur if additional waivers / term modifications are not obtained.

371. Thus, while there is acknowledgment that FCNB was able to obtain waivers for the trigger violations and the impact if not waived, there is no specific documentation in the KPMG workpapers that addressed the potential impact on the value of the retained interests related to the risk of rapid amortization.

372. At year-end 2000, KPMG’s Structured Finance Group reviewed the RAV model and noted that other issuers had been typically using discount rates ranging from 12% to 20%. They suggested that FCNB provide documentation to support the model discount rate assumption. If provided by FCNB and properly analyzed, this would have addressed KPMG’s requirement to obtain sufficient competent evidential matter pursuant to AU Section 326.01 and the SAS No. 57 requirements discussed above. However, based on discussions with FCNB’s controller, FCNB responded they were willing to incorporate the recommendation in their policy in their next fiscal year 2001. This implies that no such evidence was obtained in fiscal year 2000.

373. Ultimately, in the 2001 financial statements issued in 2003, Spiegel had to write-down the value of the retained interests by over $100 million. As detailed herein, KPMG’s lack of detailed work performed at year-end 2000 resulted in the failure to address the reality of the portfolio’s declining performance and the risk associated with the possible rapid amortization.

Specifically, KPMG failed to conduct independent estimates, tests of management’s estimates and analyses of the most recent available data that show how the finance yield, charge-off and discount rates were established. Yet, this detailed analysis was critical considering the significant impact a small rate change can have on the value of the retained interests.

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374. Furthermore, Spiegel’s Form 10-K for the fiscal year ended December 30, 2000 noted that “the FCNB Preferred credit programs realized improved yields and lower charge-offs from reduced delinquencies.” This information is not consistent with the actual finance yield and charge-off rates experienced by the preferred portfolio in 2000. While the finance yield rate in

January 2000 (net of finance charge-offs of 4.95%) was 23.72%, the rate remained constant at approximately 25% for the remaining 11 months of 2000. The charge-off rate in January 2000 was

10.32% and decreased to a low of 6.76% in April 2000. However, it began to increase after the

April low to 13.01% in December 2000.

375. There is no evidence that this inconsistency between the Form 10-K and actual rates was addressed by KPMG. Because of the significant impact a small finance yield or charge-off rate change can have on the value of retained interests, this was an important disclosure.

376. Auditor’s have an obligation with respect to other information in documents containing audited financial statements, such as annual reports or other documents to which the auditor devotes attention at the request of the company they audit. Pursuant to AU 550.04-06, the auditor “should read the other information and consider whether such information, or the manner of its presentation, is materially inconsistent with the information, or the manner of its presentation, appearing in the financial statements. If the auditor concludes that there is a material inconsistency, he should determine whether the financial statements, his report, or both require revision. If he concludes they do not require revision, he should request the client to revise the other information.

If the other information is not revised to eliminate the material inconsistency, he should consider other actions such as revising his report. If the auditor concludes that material misstatement of fact remains, the action he takes will depend on his judgment in the particular circumstances. He should consider steps such as notifying his client in writing of his views concerning the information and consulting his legal counsel as to further appropriate action in the circumstances.”

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KPMG’s Failure to Identify Material Deficiencies in Spiegel’s System of Internal Controls

377. Statement on Auditing Standards No. 55, AU 319, Consideration of Internal Control

in a Financial Statement Audit, provides guidance on the independent auditor’s consideration of an

entity’s internal control in an audit of financial statements in accordance with generally accepted

auditing standards. AU 319.06 defines internal control as a process effected by an entity’s board of

directors, management and other personnel, designed to provide reasonable assurance regarding the

achievement of objectives in the following categories (a) reliability of financial reporting,

(b) effectiveness and efficiency of operations, and (c) compliance with applicable laws and

regulations. AU 319.25 requires an auditor to “obtain an understanding of each of the five

components of internal control sufficient to plan the audit.” Statement on Auditing Standard No. 60,

AU 325, Communication of Internal Control defines different types of weaknesses in internal

controls. A “reportable condition” is a “matter coming to the auditor’s attention that, in his

judgment, should be communicated to the audit committee because they represent significant

deficiencies in the design or operation of internal control, which could adversely affect the

organizations ability to initiate, record, process and report financial data consistent with the

assertions of management in the financial statements.” Examples provided by the standard include

an absence of appropriate segregation of duties, an absence of appropriate reviews and approvals of

transactions, accounting entries or systems output, evidence of failure of identified controls in

preventing or detecting misstatements of accounting information, evidence of intentional override of

internal control by those in authority to the detriment of the overall objectives of the system, and

evidence of intentional misapplication of accounting principles. AU Section 325.15 also defines a material weakness in internal controls as a reportable condition in which the design or operation of one or more of the internal control components does not reduce to a relatively low level the risk that misstatements caused by error or fraud in amounts that would be material in relation to the financial - 160 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 161 of 202

statements being audited may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions.”

378. Statement on Auditing Standard No. 82, AU 316a, Fraud in a Financial Statement

Audit, notes that AU 319 requires the auditor to gain an understanding of internal control in a financial statement audit. It notes “The understanding often will affect the auditor’s consideration of the significance of fraud risk factors.” This standard, which was effective for the audits of the

Spiegel’s financial statements through the end of fiscal year end 2001, cites fraud risk factors that existed at Spiegel including a lack of appropriate segregation of duties and a lack of appropriate system of authorization and approval of transactions.

379. AU 325.01 requires that matters of internal control should be reported directly to the audit committee. AU 325.09 states “Conditions noted by the auditor that are considered reportable under this section . . . should be reported, preferably in writing. If information is communicated orally, the auditor should document the communication by appropriate memoranda or notations in the working papers.”

380. KPMG’s 2000 year-end workpapers address the SAS 55 requirements and notes that the audit team will make inquiries of management, supervisory and staff personnel. KPMG’s

“Control Overview Document” states that “KPMG notes that overall, the bank appears to have adequate controls to help mitigate the risks of material misstatement in the financial statements . . .

The only potential deficiencies in internal control noted during this overview are those noted by IRM

[Information Risk Management Group] during their review of the information technology systems.”

KPMG also wrote to the Audit Committee of the Board of Directors at Spiegel on February 26, 2001 in connection with their audit of the December 2000 financial statements and indicated “. . . we noted no matters involving internal control and its operation that we consider to be material weaknesses . . . .”

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381. KPMG’s 2001 year-end workpapers include documentation on procedures to analyze the “process-level business/financial statement risks and understand the business controls and residual business risks.” In order to assess the risks associated with credit strategies, credit policies and procedures, decline in credit worthiness of borrowers and related credit issues, KPMG assessed

Spiegel’s controls related to the internal compilation and reporting of charge-offs, delinquencies, trust trigger forecasts, loss reserve rates, historical roll rates and related data. They also reviewed

Spiegel’s procedures in connection with its (Spiegel) allowance for loan loss calculations. No letter to the Audit Committee related to internal control could be found in connection with the KPMG audit performed on the December 29, 2001 financial statements.

382. As discussed herein, the Spiegel merchants exerted control over the credit underwriting process. In any organization, those motivated to sell goods should not also make decisions about granting credit to customers. As a consequence of this structure, easy credit was afforded to customers allowing Spiegel to increase its sales. Allowing credit decisions to be made at the merchant level was a material weakness in internal controls and was a major contributing factor to the deterioration of Spiegel’s portfolio. There is no indication in KPMG’s workpapers that they identified or addressed this material weakness.

Retailers’ Control Over FCNB’s Credit Underwriting

383. Spiegel’s reliance on high-risk customers to artificially inflate retail sales was clearly known to the Audit Committee, as evidenced in the minutes of the November 27, 2001 Audit

Committee meeting reviewed by the Independent Examiner: “Dr. Crusemann stated that the Audit

Committee and the Board had been previously told by management that these things were under control - obviously they were not. He said that it appears that easy credit was used to pump up sales, and there was too much concentration on sales and not enough on profitability, including credit.”

Defendant Cannataro commented in the same Audit Committee meeting “that it is clear the Risk

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Management function at FCNB did not monitor what was happening closely enough, and did not exercise independent judgment when they should have been resisting pressure from the merchants to loosen up credit.”

384. The FCNB November 2001 Board Presentation packet noted that the performance of sub-prime credit accounts deteriorated rapidly during 2001 and attributed the credit performance in part to the following:

• Underwriting criteria supported an increase in risk beginning in Fall 1999

• Aggressive credit line management strategies contribution to excessive bad balance growth beginning Fall 1998 . . . [and]

• “Delays in implementing recommended credit policy changes.”

385. Other FCNB and Spiegel officers/directors, as well as Spiegel Audit Committee members agreed that Spiegel wielded influence over FCNB’s credit underwriting:

• Greg Aube, former FCNB President, stated that implementation of more conservative underwriting practices was delayed and attributed this delay to Spiegel. Specifically, he believed that limiting credit limit extensions was important to improving the portfolio’s performance. Aube stated that when FCNB sought to initiate plans to address weaknesses the merchants were resistant because they wanted the weaknesses to continue.

• In March 2002, Robert Gill (former Executive Vice President of FCNB) stated in his resignation letter from FCNB that, “[a]fter tremendous deliberation I have concluded that the level of influence I have within the organization to control risk and align business practices at FCNB with regulatory direction to be lacking.”

• Jim Huston, President of FCNB also acknowledged that Spiegel controlled the underwriting process for the Preferred portfolio when he wrote a memo to McKillip in April 2002 stating “I am writing this letter in response to your question, ‘does FCNB control the credit risk associated with new credit customer acquisition?’ It is my opinion that FCNB currently does not have adequate control over the credit prescreen process, and therefore FCNB does not solely manage credit risk.” Huston further states in the same memo that “FCNB exhibits no control over the final composition of credit customers that are mailed by each merchant.”

• In an April 2002 board meeting, Mr. Hansen asked “who is responsible in the end for granting credit and credit distribution?” Mr. Huston commented that - 163 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 164 of 202

“currently initial criteria are set by FCNB, but that the actual distribution of credit offers is manipulated by the merchants.” Mr. Hansen also commented, “that the bank has a real issue with quality of accounting systems and personnel, and training.”

• An apparent draft for a Spiegel presentation in May 2002 stated, “The current process between FCNB and the merchants does not allow for sufficient risk control and is not optimized concerning overall profitability - risk composition of pre-approved credit customers is being altered by customer selection (net-down process).”

• James Brewster (Spiegel CFO) sent an email in May 2002 stating, “It is clear that the bank had a fundamental breakdown in internal controls. In fact given where we are today, I guess we could now conclude that it was a material weakness in internal control that resulted in the bank’s inability to determine which accounts would be profitable and which accounts would generate a loss.”

• Mike McKillip (Spiegel Chief Auditor) sent an email in May 2002 referring to prior years and indicating that “in years past it looked like we were really making money on credit, when in fact all we were doing was accruing interest and late fees that were eventually written off on these high risk customers.”

Exploitation of “Net-Down” Technique to Control Credit Underwriting

386. One of the reason Huston stated that FCNB exhibits no control over the final composition was due in part to the “net-down” process. Spiegel was a primary user of the net-down process. This process allowed Spiegel Catalog to make the ultimate decision regarding which pre-approved customers actually received mailings of catalogs and pre-approved customers account for approximately 85% of new credit customers. In a direct marketing campaign, Spiegel would provide a portfolio of these pre-approved accounts, with varying risk levels, to the bank for authorization.

387. However, after this authorization was received, Spiegel Catalog used a second credit bureau, for which it provided instruction, to do the solicitation mailing. Through this process,

Spiegel avoided the obligation to send mailings to 100% of the customers included in the portfolio and decided what portion of the potential customers actually received mailings of the catalog.

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Consequently, Spiegel ended up managing the final risk composition of their customers rather than

FCNB. For example, while an authorized portfolio may have consisted of an even allocation

between A and F rated customers, Spiegel may have elected to have the second credit bureau only

send mailings to all of the E and F rated customers. This disproportionately weighted their customer

balance towards the higher risk sector, without notification to FCNB.

388. Spiegel’s control of the net down process was a significant contributing factor to

Spiegel’s acquisition of 62% of new pre-approved credit customers at the E and F levels during

Spring 2001 versus 31% in 1998. Spiegel Catalog continued to exhibit substantial reliance on E and

F level customers in 2001. As a result of targeting lower rated customers, the overall

creditworthiness of the portfolio declined and charge-off rates increased. According to Bob Gill, in

1998 Spiegel “booked only 600,000 new accounts with only 188 thousand being E level” (31%) and

booked no “F” level customers. In 2000, Spiegel booked 1,770,000 new customers and 35% were

“E” level and 21% were “F” level. In 2001, Spiegel budgeted 73% to be booked at “E” and “F”

levels. Thus, the combined “E” and “F” segments of the total new accounts grow from 31% in 1998,

to 56% in 2000, and 73% budgeted in 2001. KPMG noted in their December 31, 2001 audit, that for

both FCNB and SAC, the trends indicated that accounts greater than 60 days delinquent had been

increasing. KPMG noted that “[f]or FCNB, the delinquency rate increase [was] primarily due to aggressive marketing activities and the quality of new accounts. FCNB’s primary source of new accounts [was] ABS [American Bankruptcy Service] customers, which represent[ed] unsecured credit cards provided to individuals recently out of bankruptcy. SAC’s delinquency rate increased primarily due to a decline in the underwriting standards and increased credit limits for existing cardholders.” FCNB management told KPMG that they had a niche in the sub-prime market and historically had done well marketing to ABS customers. “Management also indicted that the decline in SAC’s underwriting standards was a strategic decision to help boost retail sales.”

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389. The poor level of FICO and custom score distribution of customers in the portfolio is evidence of the high- risk nature of the resulting portfolio. Although FCNB was aware of the rise in delinquencies and charge-off rates during 2001, the high risk FICO stratification of its Preferred portfolio continued to grow. In March 2001, 68.9% of balances related to accounts with FICO scores under 641. This percentage increased to 71.2% by December 2001.

390. FCNB also extended credit to Bankcard customers with low FICO scores. The percentage of customers with FICO scores below 601 remained fairly consistent during 2001, from

42.8% at March 2001 to 42.4% at December 31, 2001.

Use of Recency Delinquency to Expand Credit Offering

391. Spiegel’s Preferred card portfolio was managed based on recency delinquency.

According to John Collins, FCNB Collection Manager, recency treatment allowed a customer to make one minimum payment and be considered current. A minimum payment for recency purposes is defined as the greater of $15 or 50% of the required minimum monthly payment. If for example, an account was 150 days past due, one minimum payment would make the account current and the account would begin the aging process all over again. Conversely, contractual delinquency as used by the bank in the bankcard portfolios requires a payment of 90% of the monthly required payment every month and charge-off after 180 days of nonpayment.

392. According to FCNB’s Internal Audit Department, recency had allowed customers to increase their balances while in delinquency. Michael McKillip cited his view that recency accounting is an accepted industry practice but a company going into high charge-offs would not want to manage on a recency basis. Michael Manaton, former Credit Risk Department Manager, noted that there were discussions at FCNB that recency was not showing the level of risk in the portfolio. According to Manaton, FCNB did not change to contractual delinquency because significant losses would have to be recognized if the change was made. Greg Aube said that bank

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management informally discussed the possibility of changing to a contractual delinquency basis but determined that it was not feasible as the related losses would be significant. From January 2001 through December 2002, an average of 6.4% of accounts were made current each month, although still contractually delinquent.

FCNB Internal Audit Findings Confirming Critical Lack of Internal Controls

393. FCNB’s Internal Audit Department conducted several important internal audits of the accounting and underwriting systems employed by FCNB. The results of these audits are summarized below:

• An FCNB Bankcard Credit Audit Report, dated July 18, 2000, noted that override reports are not monitored consistently. When an associate chose to override the system’s credit granting decision, an exception report is generated and supervisory personnel were not monitoring this report in a consistent manner.

• The Bank did not require credit impact to be assessed prior to making marketing strategy changes, a circumstance which could also cause collectibility to become an issue. In an August 31, 2001 email to John Steele, Buda noted that “Aggressive credit limit promotions have increased the average balances in some groups to an uncomfortable level, and driven higher charge-offs rates than historical.”

394. FCNB’s internal audit team identified several significant issues in the second quarter of 2002. “The most significant [was] the lack or [sic] control surrounding accounting processes, as well as financial reporting and data integrity of the information contained within the Performance

Book Schedules.” Internal audit also noted a number of other issues and brought them to the attention of the Audit Committee in October 2001. These included:

• Solicitation of D through F customers increased significantly;

• Late fees increased from $10 to $35 which negatively impacted delinquency roll rates and inflated charge-offs;

• Delinquencies were managed on a recency basis;

• Delinquent customers were allowed to continue purchasing as long as they were no more than three months delinquent and had available open-to-buy; - 167 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 168 of 202

• Credit limit increases continued to be given to delinquent customers; and

• Credit customers were allowed to continue purchasing over their credit limit.

395. In a July 2003 interview, Ms. Vandenberg, former head on FCNB’s Internal Audit

Department, noted that because of the high risk nature of the portfolio the Bank needed to be even more careful. Vandenberg added that, although Spiegel granted automatic credit line increases every two months, there was no system for bank management to receive reports on credit limit increases.

Ms. Vandenberg also noted that there were no reports that tracked aggregations (multiple accounts for one customer). These multiple accounts to one customer increased credit risk especially if they were not identified and underwritten based on the total accounts outstanding.

396. According to Vandenberg, there was no coordination between FCNB and the merchants in developing marketing strategies. Rather, Spiegel would mandate marketing strategies for the Preferred card.

397. Even if misstatements are immaterial, registrants must comply with Sections

13(b)(2)-(7) of the Exchange Act. Under these provisions, each registrant with securities registered pursuant to Section 12 of the Exchange Act or required to file reports pursuant to Section 15(d), must make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and disposition of assets of the registrant and must maintain internal accounting controls that are sufficient to provide reasonable assurances that, among other things, transactions are recorded as necessary to permit the preparation of financial statements in conformity with GAAP. Staff Accounting Bulletin Topic 1M, Materiality. Spiegel and its management, under the oversight of its audit committee, failed to comply with this provision of the Exchange Act as management manipulated its key assumptions underlying the valuation of its residual interests recorded as assets on the balance sheet, thereby overstating both its financial condition, and its income.

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398. Statement on Auditing Standards No. 55, AU 319, Consideration of Internal Control

in a Financial Statement Audit, provides guidance on the independent auditor’s consideration of an

entity’s internal control in an audit of financial statements in accordance with generally accepted

auditing standards. AU 319.06 defines internal control as a process affected by an entity’s board of

directors, management and other personnel, designed to provide reasonable assurance regarding the

achievement of objectives in the following categories: (a) reliability of financial reporting;

(b) effectiveness and efficiency of operations; and (c) compliance with applicable laws and regulations. AU 319.25 requires an auditor to “obtain an understanding of each of the five components of internal control sufficient to plan the audit.”

399. Nonetheless, KPMG improperly issued unqualified opinions on each of Spiegel’s

1998, 1999 and 2000 financial statements.

400. In addition, KPMG violated the requirements of Section 10A of the Securities

Exchange Act (15 U.S.C. §78j) which requires auditors, among other things, to notify the SEC when the management and the Board of Directors of an SEC registrant has not taken timely and appropriate remedial action with respect to an illegal act26. As noted above, in early 2002, a KPMG partner informed Spiegel that KPMG had substantial doubts about the ability of Spiegel to continue as going concern. These concerns were later stated in a separate paragraph of a proposed KPMG report, dated February 14, 2002, on Spiegel’s fiscal 2001 financial statements.

401. KPMG knew or recklessly ignored that Spiegel did not file its 2001 Form 10-K with the SEC on its required due date, and that Spiegel issued a number of press releases and public statements regarding its financial condition without disclosing KPMG’s going concern opinion or its

26 GAAS, in AU §317.02 , defines an illegal act as violations of laws or governmental regulations.

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required viable plan information required pursuant to §607.02 of the SEC’s Codification of Financial

Reporting Policies, noted above.

402. KPMG also knew or recklessly ignored that it violated the mandate Section 10A of the Securities Exchange Act which provides that when illegal acts that have a material effect on the financial statements of the issuer come to the auditors attention and senior management and/or the

Board of Directors have not taken timely and appropriate remedial action with respect to the illegal act, the auditor is required to notify the SEC about the illegal act.

403. As Spiegel’s auditor, KPMG had a duty to correct any public statements issued by or on behalf of the Company which were false or misleading. Therefore, KPMG was a direct participant in the scheme to falsify Spiegel’s financial statements during the Class Period.

404. As a result of its longstanding relationship with Spiegel and the nature of the accounting and auditing services rendered to the Company, KPMG’s personnel were regularly present at Spiegel’s corporate headquarters throughout the year and had continual access to, and knowledge of, Spiegel’s confidential corporate financial and business information through conversations with employees of Spiegel and through review of Spiegel’s non-public documents.

405. Therefore, KPMG knew or recklessly disregarded the following adverse facts that rendered Spiegel’s reported financial results during the Class Period, including the Company’s fiscal

1998, 1999 and 2000 financial statements and KPMG’s unqualified audit opinions thereon, materially false and misleading:

(a) Spiegel’s material internal controls weaknesses and deficiencies did not accurately provide even the most basic data needed for financial reporting purposes including, but not limited to, an accounting system that: (1) recorded transactions in accounts whose descriptions were consistent with the activity in the account; (2) referenced journal entries in the general ledger;

(3) adequately supported all general ledger entries with documentation; (4) contained appropriate

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approval of entries reflected in the general ledger; and (5) contained account analyses and/or

reconciliations to evaluate, support or understand amounts recorded in accounts;

(b) Spiegel maintained inappropriate written accounting policies and procedures

for significant FCNB activities including sales of assets, and other securitization activities;

(c) Spiegel did not utilize a valuation model to calculate its “gains” on the

transfers of credit card receivables which comported with industry practice and OCC Bulletin 00-16

and, in direct contradiction to its public disclosure, Spiegel’s estimation process was not based on the following factors or assumptions: (1) a history of actual payments made; (2) a three month rolling average loss rate; (3) an appropriately calculated discount rate; and (4) a gross yield rate based upon historical cash yields;

(d) Spiegel’s valuation estimates and assumptions did not comply with GAAP and OCC Bulletin 99-46; and

(e) Spiegel inaccurately reported its allowance for loan and lease losses on credit card receivables.

406. Nonetheless, KPMG issued the following unqualified audit opinions, respectively dated February 10, 1999, February 9, 2000, February 14, 2001 on Spiegel’s 1998, 1999 and 2000 financial statements, each of which stated that Spiegel’s financial statements were presented in conformity with GAAP and that KPMG’s audit was performed in accordance with GAAS:

1998

We have audited the accompanying consolidated balance sheets of Spiegel, Inc. and subsidiaries as of January 2, 1999 and January 3, 1998, and the related consolidated statements of earnings, stockholders’ equity and cash flows for each of the years in the three-year period ended January 2, 1999. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. - 171 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 172 of 202

An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Spiegel, Inc. and subsidiaries as of January 2, 1999 and January 3, 1998, and the results of their operations and their cash flows for each of the years in the three-year period ended January 2, 1999 in conformity with generally accepted accounting principles.

1999

We have audited the accompanying consolidated balance sheets of Spiegel, Inc. and subsidiaries as of January 1, 2000 and January 2, 1999, and the related consolidated statements of earnings, stockholders’ equity and cash flows for each of the years in the three-year period ended January 1, 2000. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Spiegel, Inc. and subsidiaries as of January 1, 2000 and January 2, 1999, and the results of their operations and their cash flows for each of the years in the three-year period ended January 1, 2000 in conformity with generally accepted accounting principles.

2000

We have audited the accompanying consolidated balance sheets of Spiegel, Inc. and subsidiaries as of December 30, 2000 and January 1, 2000, and the related consolidated statements of earnings, stockholders’ equity and cash flows for each of the years in the three-year period ended December 30, 2000. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the

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audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Spiegel, Inc. and subsidiaries as of December 30, 20000 and January 1, 2000, and the results of their operations and their cash flows for each of the years in the three-year period ended December 30, 2000 in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 2 to the consolidated financial statements, the Company changed its method of recording revenue for discount club memberships.

407. KPMG turned a blind eye to Spiegel’s improper financial reporting and systemic and pervasive internal controls deficiencies noted above and issued an unqualified audit opinion on each of Spiegel’s 1998, 1999 and 2000 financial statements, even though KPMG knew or recklessly disregarded that: (a) such financial statements had not been prepared in conformity with GAAP and did not fairly present Spiegel’s financial position, results of their operations and cash flows; and (b)

KPMG had not audited Spiegel’s 1998, 1999 and 2000 financial statements in accordance with

GAAS.

408. Among other things, KPMG knew or recklessly disregarded that Spiegel’s 1998,

1999 and 2000 financial statements violated GAAP and were materially false and misleading because: (a) Spiegel fraudulently recognized and reported servicing fees and gains on the “sales” of credit card receivables; (b) Spiegel failed to adequately disclose contingent liabilities and significant risks and uncertainties required by GAAP and SEC regulations; and (c) Spiegel failed to disclose

KPMG’s 2001 audit opinion and its viable plan to overcome it financial difficulties.

409. In certifying each of Spiegel’s 1998, 1999 and 2000 financial statements, KPMG also falsely represented that its examination was made in accordance with GAAS. This statement was

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materially false and misleading in that the audit conducted by KPMG was knowingly or recklessly not performed in accordance with GAAS in the following respects:

(a) KPMG violated GAAS Standard of Reporting No. 1 that requires the audit report to state whether the financial statements are presented in accordance with GAAP. KPMG’s opinion falsely represented that Spiegel’s 1998, 1999 and 2000 financial statements were presented in conformity with GAAP when they were not for the reasons herein alleged;

(b) KPMG violated GAAS 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. KPMG was required by GAAS to disclaim or issue adverse opinions stating that

Spiegel’s 1998, 1999 and 2000 financial statements were not fairly presented. KPMG also failed to require Spiegel to restate its previously issued materially false and misleading Class Period financial statements and allowed Spiegel to make material misrepresentations regarding the Company to its shareholders and to the investing public during the Class Period. The failure to make such a qualification, correction, modification and/or withdrawal was a violation of GAAS, including the

Fourth Standard of Reporting;

(c) KPMG violated the standards set forth in AU §561, which sets forth the auditor’s responsibility to investigate and perform necessary audit procedures when, subsequent to the date of the audit report, the auditor becomes aware of facts that may have existed at the date of the audit which might have affected the audit report if the auditor had then been aware of such facts.

Generally, AU §561 provides that when the auditor becomes aware of information which relates to financial statements previously reported on by him and it is reasonable to believe that there are persons who would attach importance to the information and the client refuses to disclose such information, the auditor should notify the SEC. In addition to violating Section 10A of the

Securities Exchange Act noted above, KPMG also violated AUI §561 when it failed to notify the

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SEC that Spiegel did not disclose that KPMG issued an opinion on Spiegel’s 2001 financial

statements which stated that KPMG had substantial doubts about Spiegel’s ability to continue as a going concern and its viable plan to overcome its financial difficulties;

(d) KPMG violated GAAS 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;

(e) KPMG 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 preparation of the report;

(f) KPMG violated GAAS Standard of Field Work No. 2 which requires the auditor to make a proper study of existing internal 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 obtain an understanding of the internal control process, which includes an assessment of: (1) management’s integrity and ethical values; (2) the risk relevant to the preparation of financial statements in accordance with GAAP; and (3) the ability of the entity’s procedures, records and accounting system to prepare reliable financial reports. §AU 319.07. A sufficient understanding of internal control is obtained by performing procedures necessary to aid the auditor in identifying potential misstatements and to design audit tests. §AU 319.25. In the course of auditing Spiegel’s 1998, 1999 and 2000 financial statements, KPMG either knew or recklessly disregarded facts which evidenced that it either failed to sufficiently understand Spiegel’s internal control structure and/or it disregarded weaknesses and deficiencies in Spiegel’s internal control structure, and failed to adequately plan its

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audit or expand its auditing procedures. As noted above, Spiegel’s internal control policies and

procedures were grossly inadequate. KPMG was required by GAAS to sufficiently understand

Spiegel’s internal control structure to adequately plan its audit and to determine the nature, timing

and extent of tests to be performed. As noted above, the OCC cited numerous material internal

control deficiencies as a result of its examinations, which KPMG knew of or recklessly disregarded;

(g) KPMG violated AU §342 in that it failed to perform the audit procedures

required to determine that the estimates Spiegel used in the preparation of its financial statements

were adequate. AU §342 provides that in evaluating the reasonableness of an estimate, the auditor

normally concentrates on key factors and assumptions that are: a) significant to the accounting

estimate; b) sensitive to variations; c) deviations from historical patterns; and d) subjective and

susceptible to misstatement and bias. As noted above, and as KPMG knew or recklessly

disregarded, Spiegel’s internal controls and information systems were in such disarray that neither its

historical or current data on which Spiegel based its calculation of gains on the “sale” of credit card receivables during the Class Period were reliable. In fact, the model inputs assumed and disclosed

by Spiegel to calculate such gains were not based on a history of actual cash collections, relevant

delinquency rates, or verifiable discount rates, as KPMG knew or recklessly disregarded. As KPMG was well aware, Spiegel’s accounting records were such that KPMG could not have identified

whether Spiegel was developing sufficiently reliable accounting estimates, including its reported gain on the sale of its receivables; and

(h) KPMG violated Standard of Field Work No. 3, which requires sufficient competent evidential matter to be obtained through inspection, observation, inquiries and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit. Had KPMG obtained sufficient competent evidential matter during the course of its audits of

Spiegel’s Class Period financial statements, it would have realized, if it did not already know, that

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the terms of the Company’s agreements with SPEs required that Spiegel account for its transfers of

credit card receivables as secured borrowing arrangements and precluded Spiegel from accounting

for its credit card receivable transfers as sales and that Spiegel’s financial statements were required to disclose its contingent liability upon the occurrence of a “pay out” event.

410. KPMG’s opinions, which represented that each of Spiegel’s 1998, 1999 and 2000 financial statements were presented in conformity with GAAP, were materially false and misleading because KPMG knew or was reckless in not knowing that such financial statements violated the principles of fair reporting and GAAP. In the course of rendering its unqualified audit certification on each of Spiegel’s financial statements during the Class Period, KPMG 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. KPMG, 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 that GAAS had been violated.

411. KPMG also audited the financial statements of Spiegel’s FCNB subsidiary during the

Class Period. As noted above, the OCC stated in its May 2002 Consent Order, that FCNB “shall immediately develop” policies, procedures, systems and controls to ensure the bank’s financial statements are prepared in accordance with GAAP. Nonetheless, KPMG rendered an unqualified opinion on Spiegel’s financial statements during the Class Period.

412. GAAS, as set forth in AU §508, provides that the auditor should update his audit report on the financial statements of the prior periods (i.e., Spiegel’s 2000 financial statements) presented on a comparative basis with those of the current period (i.e., Spiegel’s 2001 financial statements). Paragraph 68 of AU §508, provides:

During the course of the audit of the current-period financial statements, the auditor should be alert for circumstances or events that affect the prior-period financial - 177 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 178 of 202

statements presented . . . or the adequacy of informative disclosures concerning those 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 his attention.

413. Spiegel’s 2000 Form 10-K included disclosure about the financial consequences to

Spiegel upon the occurrence of a “pay out event” by SCCMT. KPMG’s unqualified opinion on

Spiegel’s 2000 financial statements also updated and reaffirmed KPMG’s unqualified opinion on

Spiegel’s 1999 financial statements, despite the fact that, by this time, KPMG knew or recklessly disregarded that its opinion was materially false and misleading. Nonetheless, KPMG failed to take any steps, as required by GAAS, in connection with Spiegel’s failure to restate its 1999 financial statements in order to, inter alia, avoid liability for its participation in the fraud alleged herein.

KPMG has never withdrawn its unqualified opinions on Spiegel’s 1998, 1999 and 2000 financial statements.

414. KPMG knew or recklessly disregarded facts which indicated that it should have: (a) disclaimed or issued an adverse opinion on Spiegel’s 1998, 1999 and 2000 financial statements; (b) withdrawn, corrected or modified such opinions to recognize Spiegel’s improper accounting noted above.

415. As a result of its failure to accurately report on Spiegel’s Class Period financial statements, KPMG utterly failed in its role as an auditor as defined by the SEC. SEC Accounting

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 of investors in financial reporting. An investor’s willingness to commit his capital to an impersonal market is dependent on the availability of accurate, material and timely information regarding the corporations in which he has invested or proposes to invest. The quality of information disseminated in the securities markets and the continuing conviction of individual investors that such information is reliable are thus key to the formation and effective allocation of capital. Accordingly, the audit function must be meaningfully performed and the accountants’ independence not compromised. The auditor must be free to decide questions against his client’s - 178 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 179 of 202

interests if his independent professional judgment compels that result. [Emphasis added.]

CONTROL PERSON LIABILITY

Spiegel’s Governance Structure

416. At all times relevant to this action, Spiegel had two classes of shares outstanding.

Spiegel Class A shares, which are non-voting, are the Company’s only publicly-held equity

securities. All of the voting stock – Class B shares – is owned by a single shareholder, SHI, which is

not publicly held. SHI’s Class B voting stock represents about 90% of the ownership of Spiegel.

Almost all of the stock of SHI is owned by Spiegel’s chairman, Otto and his family. Spiegel’s

ownership structure effectively placed 100% of the voting control over Spiegel (and 90% of its total

equity) in the hands of Otto, and Spiegel’s management referred to him as the “sole voting

shareholder.” Otto’s involvement in Spiegel represented his only direct experience with a United

States publicly- held company.27 As discussed herein, Otto and associates of Otto Versand actively

exercised control over key aspects of Spiegel’s corporate governance and control structure, to the

detriment of Spiegel’s public shareholders. Otto’s personal financial interests and those of his

‘family-run’ businesses relegated the rigors of independent, objective and fair financial reporting

principles to a ‘second-class’ status within Spiegel’s governance structure.

417. In furtherance of his personal financial interests, Otto placed Otto Versand associates

in leadership positions at Spiegel. During the Class Period, all of Spiegel’s audit committee

members – Hansen, Crusemann and Mueller – were present or retired Otto Versand executives. In

27 Otto is also chairman, CEO and majority owner of the privately-held Otto Versand GmbH (recently renamed Otto GmbH), a catalog merchandiser based in Hamburg, Germany, with annual sales in excess of $25 billion. Otto Versand controls 89 companies in 21 countries, all of which are private-held, with the exception of a grocery business in Germany that has public investors.

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addition, many of Spiegel’s board members were present or retired Otto Versand executives. While board members could vote independently, the ultimate decision maker was plainly Otto.

418. Under Otto’s direction, Otto Versand always assigned one of its own directors with responsibilities for active involvement in Spiegel’s affairs. In 2001, Otto Versand dispatched

Zaepfel, Otto Versand’s deputy chairman who had the authority to act for Otto in his absence, to the

U.S. to formally take over Spiegel as its new president and CEO. In August 2002, after Spiegel ran into trouble under Zaepfel’s leadership, Otto dispatched Alexander Birken, Otto Versand’s Vice

President for Group Control, to assume the newly-created position of Chief Administrative Officer of Spiegel.

419. Spiegel’s executive committee – called its “board committee” – had the power to act for the full board, and routinely operated on behalf of the board. Spiegel’s board committee consisted of Otto, Michael Crusemann and Martin Zaepfel. Spiegel’s full board held only two meetings each year. These alternated between Spiegel headquarters in Downers Grove, Illinois and

Otto Versand headquarters in Hamburg. Spiegel’s audit committee routinely met the day before the full board meeting.

420. At all relevant times, Otto tightly controlled Spiegel’s access to credit markets and played a significant role in Spiegel’s asset backed securitizations. According to documents obtained by the Independent Examiner, Spiegel’s executives, including Sievers, were required to obtain prior approval from Otto Versand’s Chief Financial Officer for all of Spiegel’s financing arrangements.

During the Class Period, Spiegel’s substantial revolving credit facility came from a consortium composed largely of German banks with Otto relationships.

421. Otto Versand executives, participated in the oversight and preparation of Spiegel’s financial statements. According to documents obtained by the Independent Examiner, on February

22, 2002, the three Otto Versand executives comprising Spiegel’s non-independent audit committee

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appointed Ludwig Richter, Otto Versand’s Director of Group Accounting, as their agent to “review

and scrutinize” Spiegel’s 2001 financial statements to report to the audit committee “all pertinent

facts and significant issues concerning these statements.” Richter’s report was to be of “sufficient

detail” to allow the audit committee to decide whether to recommend to the board that the financial

statements be included in Spiegel’s Form 10-K for 2001. By this action, the Spiegel audit committee

effectively delegated to the Otto Versand Accounting Director a substantial portion of its

responsibility to review Spiegel’s 2001 financial statements. The audit committee had made the

same delegation to the Otto Versand Accounting Director the year before concerning Spiegel’s 2000

financial statements included in its Form 10-K for 2000.

422. Spiegel and its auditor specifically focused on Otto Versand’s control over Spiegel,

although they did nothing to change the relationship. According to the Independent Examiner’s

Report, in April 1999, Spiegel management worked with its outside auditor, KPMG, to prepare a

report considering recent recommendations on audit committee independence. The report noted that

the three current members of Spiegel’s audit committee “have varying relationships with an affiliate

(Otto) of the Spiegel Group (one has been retired from Otto for five years, one is just recently

retired, and one is currently employed by Otto).”28 Although Spiegel’s existing audit committee

charter provided that audit committee members must be “independent, non-Management directors

who do not have a significant financial or business relationship with the corporation,” the KPMG

partner then in charge of the Spiegel audit advised that he was “comfortable with . . . the current role

of the Audit Committee.”

28 The Spiegel/KPMG report noted the recommendations by the Blue Ribbon Panel on Improving the Effectiveness of Corporate Audit Committees (formed at the suggestion of SEC Chairman Arthur Levitt) that all audit committee members should be independent, meaning they should not have been employed during the last five years by, or have accepted compensation from, the corporation or any affiliate.

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423. In the years leading up to its realization that “easy credit was used to pump up sales,”

Spiegel’s audit committee claims not to have perceived Spiegel’s growing credit risk. Throughout this period, according to the Independent Examiner’s Report, the audit committee claims to have relied on the fact that KPMG appeared to be happy with everything, according to audit committee chairman Hansen and audit committee member Crusemann.

Defendants Knew of the Problems at Spiegel

424. According to the Independent Examiner’s Report, by October 2001, at the latest,

Spiegel’s Board Committee and Otto were aware that Spiegel was manufacturing sales through the extension of credit to high-risk individuals. Spiegel’s internal audit director Michael McKillip circulated two documents that alerted senior management to the seriousness of the credit problems then facing FCNB. On October 18, 2001, McKillip sent his “preferred collection process review” to

Hansen and Zaepfel and others in senior management. This review identified “several policy driven factors contributing to the increase in delinquency ‘roll rates’ and, in turn, charge-offs.” According

to the internal audit director, these factors included:

• increased solicitation of credit customers with low credit scores;

• managing credit delinquencies on a “recency” basis – thus allowing a delinquent customer to become current with only a minimum qualifying payment;

• allowing delinquent customers to continue purchasing for three months;

• giving delinquent customers credit limit increases; and

• allowing credit customers to continue purchasing while over their credit limit.

425. McKillip attached a memo from FCNB’s own internal audit director noting that

“[o]ver the last three years, charge-off rates on our preferred credit card accounts have increased substantially.”

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426. Based on documents reviewed by the Independent Examiner, just two weeks later, on

October 31, 2001, McKillip circulated his “key credit indicators report,” again to Hansen and

Zaepfel and others in senior management. This report forecast that Preferred Card charge-offs

(including charge-offs due to fraud) would jump from $206.2 million (11.2%) in 2000, to $388.4

million (17.7%) in 2001. McKillip blamed this jump on “[h]eavy reliance on subprime credit

accounts – for example, 62% of Spiegel Catalog’s new credit customers booked in Spring 2001 were

D and F accounts [the lowest score a customer could receive based on objective factors] compared to

only 31% in 1998,” as well as on “[e]xcessive credit limit increases granted to sub-prime accounts

beginning in 1998.”

427. According to the Independent Examiner’s Report, at its November 27, 2001 meeting

in Hamburg – just a month before its fiscal year-end – Spiegel audit committee chair Hansen

reviewed “significant issues” from McKillip’s “key credit indicators report,” and commented that

“issuance of high risk credit had increased dramatically.” Audit committee member Crusemann

(also Otto Versand CFO) responded that “the Audit Committee and the Board had been previously told by management that these things were under control – obviously they were not” and that it appeared that “easy credit was used to pump up sales,” with “too much concentration on sales and not enough on profitability, including credit.” Spiegel’s new CFO Cannataro commented “that it is clear the Risk Management function at FCNB did not monitor what was happening closely enough, and did not exercise independent judgment when they should have been resisting pressure from the merchants to loosen up credit.” Crusemann agreed and stated his belief that “Risk Management was forced to give into the merchants’ demands.”

428. At the full board meeting the next day – the first time Moran was no longer on hand to make the FCNB presentation to the board – the directors heard Spiegel CEO Martin Zaepfel describe FCNB as Spiegel’s “greatest single disappointment for 2001,” attributing its poor

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performance to “a far too aggressive and high risk credit granting policy during the last two or three

years.” Defendant Otto therefore, at this time, knew that merchandise sales had been artificially

inflated though lax credit procedures. It was also reported to the directors that Spiegel Catalog’s

2001 EBT was expected to plummet to $10.9 million, a drop of $22.5 million from the year before, and they heard Spiegel Catalog promise to work during 2002 “to reduce the company’s dependence

upon high risk credit customers.” Newport News likewise projected a drop to a loss of $7 million, a

drop of $31.5 million from the previous year’s $24.5 million EBT.

429. At the end of January 2002, internal audit director McKillip sent audit committee

members Hansen and Crusemann, as well as a number of Spiegel senior executives, his key credit

indicators report for all of 2001. Based on documents reviewed by the Independent Examiner, the

report showed that charge-offs for Spiegel’s Preferred Card “continued to increase, coming in at

$392.2 million (18.0%) for 2001, . . . nearly double last year’s $206.2 (11.2%).” McKillip’s report

blamed this increase on:

• “Heavy reliance on sub-prime accounts – for example, 62% of Spiegel Catalog’s new credit customers booked in Spring 2001 were E and F accounts compared with 31% in 1998”;

• “Excessive credit limit increases granted to sub-prime accounts beginning in 1998”; and

• “Rapid growth of unseasoned accounts.”

430. According to the Independent Examiner’s Report, by February 19, 2002, Spiegel told

its bankers that Spiegel was now paying the price for FCNB’s aggressive credit growth:

During the strong economic growth of 1999 and 2000 FCNB aggressively grew its credit business, including extending credit to higher risk segments. At the same time, a risk-based pricing model was implemented to match pricing with credit risk. In 2000, delinquency rates and charge-off losses increased. In the fourth quarter 2000, management began taking action to tighten credit standards. However, the economic downturn, which began in mid-2000 and accelerated in 2001, combined with the high account growth that was weighted toward higher-risk accounts, resulted in a rapid deterioration in our credit portfolio and a significant earnings deterioration.

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431. On March 15, 2002, Ludwig Richter, the Director of Corporate Accounting at Otto

Versand reported to Spiegel’s Hamburg-based audit committee, its chairman Otto, and its president

Zaepfel on a review he had performed of Spiegel’s financial statements and a meeting he had with

KPMG in February 2002. According to the Independent Examiner’s Report, Richter reported that

Spiegel Catalog and Newport News had employed a business strategy of “highly relying on increasing credit sales, including extending credit to higher-risk segments.” The economic downturn, “combined with the high account growth that was weighted toward higher-risk accounts, resulted in a rapid deterioration of the credit portfolio and a significant earnings deterioration.”

Richter further reported that KPMG’s audit opinion for Spiegel would likely contain a going concern qualification, unless Spiegel obtained: (i) a written funding commitment to cover a projected cash shortfall; (ii) an executed agreement to sell Spiegel’s credit card business; and (iii) a waiver of

Spiegel’s loan covenants (already in default) or a renegotiated credit agreement.

432. According to the Independent Examiner’s Report, on March 25, 2002, Spiegel’s management met to discuss a number of “life threatening” issues facing Spiegel. Among other things, treasurer John Steele reported on a recent meeting with Spiegel’s investment bankers at J.P.

Morgan, who advised that Spiegel’s credit portfolio was worth only a quarter of what they originally thought, and that Spiegel probably could not sell it. McKillip advised that Spiegel would have to restate the interchange rate used to calculate excess spread, and that this would blow a trigger in the

Preferred Card 2000-A and 2001-A securitization trusts. The group agreed that Zaepfel and

Cannataro, among others, should immediately travel to Germany to brief Otto personally on the situation.

433. Zaepfel and Cannataro left for Germany the next day and on March 27, 2002 met with Spiegel chairman Otto and Spiegel’s audit committee member Crusemann in the Otto Versand board room in Hamburg. Also present was Alexander Birken, Otto Versand’s Vice President of

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Group Controlling. Five months later, on August 15, 2002, Birken moved to the U.S. at Otto’s request and became Spiegel’s Chief Administrative Officer. Otto, Crusemann and Zaepfel also constituted all of the members of Spiegel’s “board committee” – the committee empowered to act for

Spiegel’s full board.

434. At the meeting, Spiegel management gave Otto and Crusemann copies of a written analysis of the difficulties then facing Spiegel, and covered every part of the written presentation during the meeting. According to the Independent Examiner’s Report, this written presentation included the following review of Spiegel’s problems:

• OCC Determinations: The OCC determined a month earlier to substantially lower FCNB’s rating. The OCC’s “greatest” concern was “the low quality of the bank’s receivables and the danger that one or more securitization trusts would go into early amortization.” The concern was “liquidity and capitalization,” as well as “a great many deficiencies in the bank’s operations.”

• OCC Restrictions: In addition to requiring liquidation of FCNB by December 2002, the “final draft” of the OCC’s consent order for FCNB required “significant restrictions” on credit for both new and existing FCNB customers. The OCC was also requiring a standby letter of credit of approximately $198 million.

• Resulting Decrease in Sales: Spiegel determined that these OCC restrictions on FCNB’s ability to grant credit would result in a reduction in annual net sales by the Spiegel merchant companies of between $192 million and $442 million. This reduction in sales would mean that the merchants could expect their profitability to decline between $45.3 million and $108.4 million.

• Inability to Sell Bankcard Business: Spiegel’s investment bankers (J.P. Morgan) advised that Spiegel could not expect to get any cash from the planned sale of its bankcard business. Indeed, J.P. Morgan concluded that it would be “very difficult” to sell the bankcard business at all. As the OCC was requiring Spiegel to sell or liquidate FCNB in 2002, Spiegel believed it would have to simply “walk away” from its bankcard business. Walking away from the bankcard business could have a $310 million equity impact for Spiegel, and a $170 debt impact ($120 million to pay off depositors’ interest, and $50 million for exit costs).

• Inability to Sell Preferred Card Portfolio: J.P. Morgan also advised Spiegel that it could probably not sell its Preferred Card portfolio. Potential purchasers had indicated a lack of interest based on concern over the - 186 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 187 of 202

sub-prime credit card industry, Spiegel’s issues with the OCC, and Spiegel’s financial performance.

• End to Off-Balance Sheet Financing of Credit Receivables: Going forward, Spiegel would have to find a new way to finance credit receivables for sales by its merchant companies. J.P. Morgan advised Spiegel that it would be difficult to finance new receivables off-balance sheet through a securitization transaction, as investors would be wary of Spiegel’s financial condition. If Spiegel used its credit facility to finance these receivables, debt would then increase on Spiegel’s balance sheet for all new receivables from preferred credit sales by the Spiegel merchant companies.

• Increased Fees Using Outside Servicer: Without FCNB to service its credit card receivables, Spiegel’s merchant companies would have to use an unrelated third-party servicer.

• Liquidity Shortfall: “The Spiegel Group is in a liquidity crisis” and “will soon be illiquid.” Spiegel expected that Otto Versand would have to infuse $317.6 million in capital into Spiegel to deal with its liquidity shortfall, which Spiegel expected to peak in October 2002. This was $260 million higher than the $60 million in capital Otto Versand had already infused in Spiegel during 2002. Spiegel noted, however, that if it could not fulfill “certain favorable assumptions,” Otto Versand would have to infuse a “significantly greater” amount into Spiegel.

• Default on Loan Covenants: Spiegel was in default on its loan covenants, and its plan to restructure its finances by mid-April was “no longer possible.” It concluded that the longer it remained in default, the more problems it faced in getting products from vendors. “There is also a growing threat of an involuntary bankruptcy proceeding being filed against us by our creditors.”

• Refinancing Efforts: Spiegel was negotiating to restructure its loan agreements to put in place a $750 million revolving credit facility, $441 million in term loans, and a $150 million letter of credit facility. While Spiegel had reached an agreement in principle with the three agent banks involved, this was based on 2002 business plan presented to the banks. But Spiegel concluded that, “[d]ue to the impact of OCC restrictions on our merchant businesses and significantly lower expectations for the disposition of our credit business, we cannot proceed with a credit restructuring based on the 2002 plan presented to the banks.” Most of the banks were unaware of these negative developments. Spiegel still had to develop a revised 2002 business plan for the banks.

• Contents of New Business Plan: A new 2002 plan to provide to the banks for further negotiation would include factors that “will cause profitability to be substantially lower in 2002.” These factors included: (i) the impact of “severe credit restrictions” on sales; (ii) a change in valuation of the bankcard and Preferred portfolios following J.P. Morgan’s assessment that FCNB - 187 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 188 of 202

could not be sold in its present condition, with resulting further writedown of assets with an offsetting reduction to equity; and (iii) an increase in servicing fees payable to a third-party service provider.

• Outstanding Securitizations: Spiegel had financed its preferred credit card receivables through asset-backed securitizations. However, Spiegel was then facing “a probable rapid amortization in our ABS financings, which will divert cash flow ($60 million/month) from Spiegel to ABS investors.”

• Need for a Restatement: Both KPMG and Rooks Pitts advised Spiegel that, in the absence of a benchmarking study to support a higher interchange rate, Spiegel would have to restate its interchange rate and excess spread calculations for 2001. Such recalculation of excess spread would cause Spiegel’s 2000-A and 2001-A series securitizations to breach their triggers, “causing both to go into early amortization.” The result would be diversion of approximately $40 million excess monthly cash flow from Spiegel to pay down these series.

Defendants Consciously Chose to Hide Spiegel’s Problems from Investors

435. According to the Independent Examiner’s Report, this March 27, 2002 written presentation, prepared by Spiegel’s management (including its general counsel Robert Sorensen), also advised Otto and Crusemann on their disclosure obligations under the U.S. securities laws.

The presentation noted that “SEC and Nasdaq regulations require companies that are publicly traded to disclose all material news,” meaning information that would “affect the value of a company’s securities or influence investors’ decisions.” The presentation identified the following as items that

“may be considered material and require public disclosure”: (i) the OCC’s enforcement action against FCNB; (ii) “[n]egative sales and earnings impact due to OCC credit granting restrictions”;

(iii) “[c]hange in the valuation of the bank from what was previously disclosed”; and (iv) “delay in securing new credit facilities.” Spiegel concluded that “once any of these potential subject matters break, there will be a blitz of negative news articles.”

436. In addition to presentation and discussion of the written report described above, the draft minutes of the March 27th meeting confirm discussion of the following particular points:

• Spiegel was in a liquidity crisis and would soon be short of cash. It projected a $318 million shortfall, but acknowledged this could be worse “if the - 188 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 189 of 202

Company’s performance was lower than forecast and/or if the performance of the Securitizations did not improve.” Spiegel decided to “take aggressive action to defer vendor payments,” but to pay important vendors “to ensure that an involuntary bankruptcy is not proposed by third-party vendors.”

• Spiegel’s current sales forecast was “significantly worse” than the forecast it had given its bank lenders as part of its efforts to renegotiate its credit agreements. And this forecast did not yet reflect “the negative sales impacts which would occur from the OCC Consent Order.” The 2002 plan Spiegel had given its bank lenders could be “severely impaired by the OCC restrictions and the current forecast from the merchants.”

• Absent a waiver, the proposed OCC consent order would trigger early amortization of Spiegel’s securitizations, as would performance triggers below required minimums. This would make Spiegel’s liquidity problem “significantly worse” than the then-anticipated $318 million shortfall. Rapid amortization would result in $40 million to $60 million less cash each month for Spiegel’s operations.

• There was a “disconnect” between the interchange rate used in Spiegel’s securitization trust reporting and Spiegel’s agreements with its merchants. Spiegel “needed to discuss the issue with KPMG,” but Spiegel decided to defer this discussion to a later date.

437. Just days after this March 27, 2002 meeting in Hamburg, Spiegel was required to file its 2001 annual report on Form 10-K. At the time, the Form 10-K had been prepared, and was virtually ready for filing. But instead of filing its Form 10-K as required, Spiegel filed a

“notification of late filing” on Form 12b-25 on April 1, 2002. Defendants Zaepfel and Cannataro made the decision to delay filing the Form 10-K at this time after consultation with Otto.

438. After failing to file its Form 10-K as required by the extended filing date of April 15,

2002, Spiegel received a delisting notice from NASDAQ. Spiegel issued a press release on April 19,

2002 that told a far more limited story and gave investors far less material information that they would have gotten from a Form 10-K. On April 19, 2002, two days after NASDAQ’s delisting notice and with its Form 10-K still not filed and now delinquent, Spiegel issued a press release

“regarding the status of several business initiatives.” Spiegel had to say something to the public that

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day, as that morning NASDAQ had changed Spiegel’s trading symbol from SPGLA to SPGLE,

based on Spiegel’s failure to file its Form 10-K.

439. According to the Independent Examiner’s Report, on April 22, 2002, after Spiegel’s

audit committee conducted a “special discussion on the credit situation currently facing” Spiegel,

Defendants, requested a hearing before NASDAQ to explain why it had not filed its Form 10-K.

NASDAQ scheduled a delisting hearing in Washington D.C. for May 17, 2002. In attendance at the

May 17, 2002 hearing were two of Spiegel’s officers, a member of Spiegel’s Audit Committee and

an attorney who attended the meeting at the invitation of Spiegel’s majority shareholder. It was

reported that NASDAQ received assurances at the meeting that the Company would file its 10-K by

May 28, 2003, regardless of the status of its negotiations with its lenders.

440. According to the Independent Examiner’s Report, on May 15, 2002, Spiegel’s outside

counsel Kirkland & Ellis gave Spiegel’s management its opinion that Spiegel’s failure to file its

Form 10-K could result in an SEC enforcement action against Spiegel, its officers and directors, and

its controlling shareholder. Kirkland & Ellis noted that the SEC could take the position that, in

addition to failing to file its Form 10-K, Spiegel had engaged in fraudulent or deceptive conduct, and

that the sanctions could include civil penalties, officer and director bars, and criminal prosecution.

441. Based on documents reviewed by the Independent Examiner, on May 29, 2002, one day after Spiegel had again failed to file Form 10-K, CEO Martin Zaepfel sent Horst Hansen a handwritten letter (in German) stating that, over the last two days, Zaepfel and Otto had come to the

“opinion” that a delisting would be preferable to filing the Form 10-K with a going concern

statement, “even though we know that we are not complying with the law by not filing a 10-K.”

Otto recalls agreeing on this with Zaepfel in their telephone discussions.

442. Thereafter, on May 31, 2002, during an audit committee meeting attended by Hansen

and Crusemann, among others, attorneys from Kirkland & Ellis gave unequivocal advice that

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Spiegel had to file its Form 10-K, that there was a concern over individual officers’ liability, that

Spiegel had no defense if it did not file, and that it was illegal and would be breaking the law for

Spiegel not to file.

443. Rather than file Spiegel’s overdue Form 10-K as required by law, Spiegel’s audit committee in Hamburg (including Hansen, Crusemann and Mueller) and Spiegel’s senior management reviewed an analysis of the pros and cons of not filing Spiegel’s now overdue Form

10-K.

444. According to the Independent Examiner’s Report, the analysis noted that the disadvantages of not filing included an increased likelihood of a shareholder lawsuit and an increased likelihood of an SEC enforcement action. The analysis further noted that officers are personally liable and have a fiduciary responsibility to file the financial statements based upon the securities laws. The analysis attached a copy of Section 20A of the Securities Exchange Act of 1934

(the “Exchange Act”), highlighting that it is “unlawful” for a director or officer to “hinder, delay, or obstruct” the filing of a report with the SEC.

445. Thereafter, Spiegel management was advised by the NASDAQ’s staff counsel that the Spiegel’s press releases and 8-Ks on certain financial information was not acceptable and violated the federal securities law.

446. Nonetheless, Defendants Otto and Crusemann advised Spiegel management that they were not to file its Form 10-K.

447. Spiegel management was advised by the Company’s general counsel that the consequences of non-filing included possible criminal prosecution.

448. Defendants Otto and Crusemann were advised that, as a result of their failure to file the Form 10K, the NASDAQ would delist Spiegel and issue an opinion that stated Spiegel was being delisted for “public interest concerns (thus creating problems for future relisting), that Spiegel is

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operating unlawfully in willfully withholding financial information that it is clearly legally required

to file, and that the investing public has the legal right to interpret Spiegel’s financial position.”

449. Defendant Otto was personally advised of the consequences of not filing the Form

10-K, including personal liability, SEC action, class actions, and adverse impact on careers. Otto

simply said that the decision not to file was now made.

450. The Individual Defendants are liable as direct participants in, and co-conspirators

with respect to the wrongs complained of herein. In addition, the Individual Defendants, by reason

of their status as senior executive officers and/or directors, were “controlling persons” within the

meaning of Section 20 of the Exchange Act and had the power and influence to cause the Company

to engage in the unlawful conduct complained of herein. Because of their positions of control, the

Individual Defendants were able to and did, directly or indirectly, control the conduct of Spiegel’s

business.

451. The Individual Defendants, because of their ownership of and positions with the

Company, controlled and/or possessed the authority to control the contents of its reports, press

releases and presentations to securities analysts and through them, to the investing public. The

Individual Defendants were provided with copies of the Company’s reports and press releases

alleged herein to be misleading, prior to or shortly after their issuance and had the ability and

opportunity to prevent their issuance or cause them to be corrected. Thus, the Individual Defendants

had the opportunity to commit the fraudulent acts alleged herein.

452. As a controlling person of a publicly-traded company and senior executive officers

and/or directors whose Class A Non-Voting Common Stock was, and is, registered with the SEC

pursuant to the Exchange Act, and was traded on the NASDAQ National Market (“NASDAQ”) and

governed by the federal securities laws, the Individual Defendants had a duty to disseminate promptly accurate and truthful information with respect to Spiegel’s financial condition and

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performance, growth, operations, financial statements, business, products, markets, management,

earnings and present and future business prospects, to correct any previously issued statements that

had become materially misleading or untrue, so that the market price of Spiegel’s common stock would be based upon truthful and accurate information. The Individual Defendants’ misrepresentations and omissions during the Class Period violated these specific requirements and obligations.

453. The Individual Defendants are liable as participants in a fraudulent scheme and course of conduct that operated as a fraud or deceit on purchasers of Spiegel common stock by disseminating materially false and misleading statements and/or concealing material adverse facts.

The scheme deceived the investing public regarding Spiegel’s business, operations and management

and the intrinsic value of Spiegel Class A Non-Voting Common Stock and caused Plaintiffs and

members of the Class to purchase Spiegel Class A Non-Voting Common Stock at artificially inflated

prices.

Additional Scienter Allegations

454. As alleged herein, Defendants acted with scienter in that Defendants knew that the

public documents and statements issued or disseminated in the name of the Company were

materially false and misleading; knew that such statements or documents would be issued or

acquiesced in the issuance or dissemination of such statements or documents as primary violations of the federal securities laws. As set forth elsewhere herein in detail, Defendants, by virtue of their receipt of information reflecting the true facts regarding Spiegel, their control over, and/or receipt and/or receipt of information of Spiegel’s allegedly materially misleading misstatements and/or their associations with the Company which made them privy to confidential proprietary information concerning Spiegel, participated in the fraudulent scheme alleged herein.

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455. Defendants’ scienter is also evidenced by the performance based compensation which

certain of the Individuals Defendants benefitted from during the Period, as detailed herein.

456. Defendants’ Otto, Moran, Zaepfel, Crusemann, Hansen, Muller, Sievers, and

Cannataro scienter is further evidenced by the asset securitizations that Spiegel completed during the

Class Period. Through these securitizations, Spiegel was able to generate hundreds of millions of

dollars of much needed cash and book hundreds of millions of dollars of profits. Had the truth been

known about the Company and the quality of its credit card receivables, Defendants would not have been able to complete the credit card securitizations on the favorable terms they received, if at all.

457. Finally, Defendants’ scienter is demonstrated by their actions at the end of the Class

Period. As alleged by the SEC, Defendants concealed the “going-concern” qualification of its auditors in order to prevent an adverse impact on the price of Spiegel common stock.

Applicability of Presumption of Reliance: Fraud-on-the-Market Doctrine

458. At all relevant times, the market for Spiegel’s Class A Non-Voting Common Stock was an efficient market for the following reasons, among others:

(a) Spiegel’s stock met the requirements for listing, and was listed and actively traded on the NASDAQ, a highly efficient and automated market;

(b) as a regulated issuer, Spiegel filed periodic public reports with the SEC and the NASDAQ;

(c) Spiegel regularly communicated with public investors via established market communication mechanisms, including through regular disseminations of press releases on the national circuits of major newswire services and through other wide-ranging public disclosures, such as communications with the financial press and other similar reporting services; and

(d) Spiegel was followed by several securities analysts employed by major brokerage firms who wrote reports, which were distributed to the sales force and certain customers - 194 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 195 of 202

of their respective brokerage firms. Each of these reports was publicly available and entered the

public marketplace.

459. As a result of the foregoing, the market for Spiegel’s Class A Non-Voting Common

Stock promptly digested current information regarding Spiegel from all publicly available sources

and reflected such information in Spiegel’s stock price. Under these circumstances, all purchasers of

Spiegel’s Class A Non-Voting Common Stock during the Class Period suffered similar injury

through their purchase of Spiegel’s Class A Non-Voting Common Stock at artificially inflated prices

and a presumption of reliance applies.

No Safe Harbor

460. The statutory safe harbor provided for forward-looking statements under certain

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 meaningful

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 the statutory safe harbor does apply to any forward-looking statements pleaded herein, Defendants are liable for those false forward-looking statements because at the time each of those forward-looking statements was made, the particular speaker knew that the particular forward-looking statement was false, and/or the forward-looking statement was authorized and/or approved by an executive officer of Spiegel who knew that those statements were false when made.

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COUNT I

Violation of Section 10(b) of the Exchange Act and Rule 10b-5 Promulgated Thereunder Against All Defendants

461. Plaintiffs repeat and reallege each and every allegation contained above as if fully set forth herein.

462. During the Class Period, Spiegel and the Individual Defendants, and each of them, carried out a plan, scheme and course of conduct which was intended to and, throughout the Class

Period, did: (a) deceive the investing public, including Plaintiffs and other Class members, as alleged herein; (b) artificially inflate and maintain the market price of Spiegel’s Class A Non-Voting

Common Stock; and (c) cause Plaintiffs and other members of the Class to purchase Spiegel’s Class

A Non-Voting Common Stock at artificially inflated prices. In furtherance of this unlawful scheme, plan and course of conduct, Defendants, and each of them, took the actions set forth herein.

463. Defendants: (a) employed devices, schemes, and artifices to defraud; (b) made untrue statements of material fact and/or omitted to state material facts necessary to make the statements not misleading; and (c) engaged in acts, practices, and a course of business which operated as a fraud and deceit upon the purchasers of the Company’s Class A Non-Voting Common Stock in an effort to maintain artificially high market prices for Spiegel’s Class A Non-Voting Common Stock in violation of Section 10(b) of the Exchange Act and Rule 10b-5. All Defendants are sued either as primary participants in the wrongful and illegal conduct charged herein or as controlling persons as alleged below.

464. In addition to the duties of full disclosure imposed on Defendants as a result of their making of affirmative statements and reports, or participation in the making of affirmative statements and reports to the investing public, Defendants had a duty to promptly disseminate truthful information that would be material to investors in compliance with the integrated disclosure

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provisions of the SEC as embodied in SEC Regulation S-X (17 C.F.R. Sections 210.01 et seq.) and

Regulation S-K (17 C.F.R. Sections 229.10, et seq.) and other SEC regulations, including accurate and truthful information with respect to the Company’s operations, financial condition and earnings so that the market price of the Company’s Class A Non-Voting Common Stock would be based on truthful, complete and accurate information.

465. Spiegel and the Individual Defendants, individually and in concert, directly and indirectly, by the use, means or instrumentalities of interstate commerce and/or of the mails, engaged and participated in a continuous course of conduct to conceal adverse material information about the business, operations and future prospects of Spiegel as specified herein.

466. These Defendants employed devices, schemes and artifices to defraud, while in possession of material adverse non-public information and engaged in acts, practices, and a course of conduct as alleged herein in an effort to assure investors of Spiegel’s value and performance and continued substantial growth, which included the making of, or the participation in the making of, untrue statements of material facts and omitting to state material facts necessary in order to make the statements made about Spiegel and its business operations and future prospects in the light of the circumstances under which they were made, not misleading, as set forth more particularly herein, and engaged in transactions, practices and a course of business which operated as a fraud and deceit upon the purchasers of Spiegel’s Class A Non-Voting Common Stock during the Class Period.

467. The Individual Defendants’ primary liability, and controlling person liability, arises from the following facts: (a) the Individual Defendants were high-level executives and/or directors at the Company during the Class Period; (b) the Individual Defendants were privy to and participated in the creation, development and reporting of the Company’s internal budgets, plans, projections and/or reports; and (c) the Individual Defendants were aware of the Company’s dissemination of

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information to the investing public which they knew or recklessly disregarded was materially false and misleading.

468. The Defendants had actual knowledge of the misrepresentations and omissions of material facts set forth herein, or acted with reckless disregard for the truth in that they failed to ascertain and to disclose such facts, even though such facts were available to them. Such

Defendants’ material misrepresentations and/or omissions were done knowingly or recklessly and for the purpose and effect of concealing Spiegel’s operating condition and future business prospects from the investing public and supporting the artificially inflated price of its Class A Non-Voting

Common Stock. As demonstrated by Defendants’ overstatements and misstatements of the

Company’s business, operations and earnings throughout the Class Period, Defendants, if they did not have actual knowledge of the misrepresentations and omissions alleged, were reckless in failing to obtain such knowledge by deliberately refraining from taking those steps necessary to discover whether those statements were false or misleading.

469. As a result of the dissemination of the materially false and misleading information and failure to disclose material facts, as set forth above, the market price of Spiegel’s Class A

Non-Voting Common Stock was artificially inflated during the Class Period. In ignorance of the fact that market prices of Spiegel’s publicly-traded Class A Non-Voting Common Stock were artificially inflated, and relying directly or indirectly on the false and misleading statements made by

Defendants, or upon the integrity of the market in which the Class A Non-Voting Common Stock trade, and/or on the absence of material adverse information that was known to or recklessly disregarded by Defendants but not disclosed in public statements by Defendants during the Class

Period, Plaintiffs and the other members of the Class acquired Spiegel Class A Non-Voting

Common Stock during the Class Period at artificially high prices and were damaged thereby.

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470. At the time of said misrepresentations and omissions, Plaintiffs and other members of

the Class were ignorant of their falsity, and believed them to be true. Had Plaintiffs and the other

members of the Class and the marketplace known of the true financial condition and business

prospects of Spiegel, which were not disclosed by Defendants, Plaintiffs and other members of the

Class would not have purchased or otherwise acquired their Spiegel Class A Non-Voting Common

Stock, or, if they had acquired such Class A Non-Voting Common Stock during the Class Period, they would not have done so at the artificially inflated prices which they paid.

471. By virtue of the foregoing, Defendants have violated Section 10(b) of the Exchange

Act, and Rule 10b-5 promulgated thereunder.

472. As a direct and proximate result of Defendants’ wrongful conduct, Plaintiffs and the

other members of the Class suffered damages in connection with their respective purchases and sales

of the Company’s Class A Non-Voting Common Stock during the Class Period.

COUNT II

Violation of Section 20(a) of the Exchange Act Against the Individual Defendants

473. Plaintiffs repeat and reallege each and every allegation contained above as if fully set forth herein.

474. The Individual Defendants acted as a controlling person of Spiegel within the meaning of Section 20(a) of the Exchange Act as alleged herein. By virtue of their high-level positions, and their ownership and contractual rights, participation in and/or awareness of the

Company’s operations and/or intimate knowledge of the statements filed by the Company with the

SEC and disseminated to the investing public, the Individual Defendants had the power to influence and control and did influence and control, directly or indirectly, the decision-making of the

Company, including the content and dissemination of the various statements which Plaintiffs contends are false and misleading. The Individual Defendants were provided with or had unlimited - 199 - Case 1:02-cv-08946 Document 146 Filed 05/23/2006 Page 200 of 202

access to copies of the Company’s reports, press releases, public filings and other statements alleged by Plaintiffs to be misleading prior to and/or shortly after these statements were issued and had the ability to prevent the issuance of the statements or cause the statements to be corrected.

475. In particular, the Individual Defendants had direct and supervisory involvement in the day-to-day operations of the Company and, therefore, are presumed to have had the power to control or influence the particular transactions giving rise to the securities violations as alleged herein, and exercised the same.

476. As set forth above, the Individual Defendants each violated Section 10(b) and Rule

10b-5 by their acts and omissions as alleged in this Complaint. By virtue of their positions each as a controlling person, the Individual Defendants are liable pursuant to Section 20(a) of the Exchange

Act. As a direct and proximate result of the Individual Defendants’ wrongful conduct, Plaintiffs and other members of the Class suffered damages in connection with their purchases of the Company’s

Class A Non-Voting Common Stock during the Class Period.

WHEREFORE, Plaintiffs pray for relief and judgment, as follows:

(a) Determining that this action is a proper class action, designating Plaintiffs as a class representative under Rule 23 of the Federal Rules of Civil Procedure and Plaintiffs’ counsel as

Lead Counsel;

(b) Awarding compensatory damages in favor of Plaintiffs and the other Class members against all Defendants, jointly and severally, for all damages sustained as a result of

Defendants’ wrongdoing, in an amount to be proven at trial, including interest thereon;

(c) Awarding Plaintiffs and the Class their reasonable costs and expenses incurred in this action, including counsel fees and expert fees; and

(d) Such other and further relief as the Court may deem just and proper.

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JURY TRIAL DEMANDED

Plaintiffs hereby demand a trial by jury on all issues so triable.

Dated: May 23, 2006 By: ______Marvin A. Miller MILLER FAUCHER and CAFFERTY LLP 30 North LaSalle Street, Suite 3200 Chicago, Illinois 60602 (312) 782-4880

Liaison Counsel for the Class

Samuel H. Rudman Robert M. Rothman Russell J. Gunyan LERACH COUGHLIN STOIA GELLER RUDMAN & ROBBINS LLP 58 South Service Road Suite 200 Melville, NY 11747 (631) 367-7100

Guri Ademi ADEMI & O’REILLY, LLP 3620 East Layton Avenue Cudahy, WI 53110 (414) 482-8000

Co-Lead Counsel for the Class

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CERTIFICATE OF SERVICE BY ELECTRONIC MEANS

I, Marvin A. Miller, one of the attorneys for plaintiffs, hereby certify that on May 23, 2006, service of the Third Consolidated Amended Complaint was accomplished pursuant to ECF as to Filing Users and I shall comply with LR 5.5 as to any party who is not a Filing User or represented by a Filing User .

s/ Marvin A. Miller ______Marvin A. Miller

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