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IN RE: DISCOVERY ZONE SECS. LITIG.

September 27, 1996

In re: DISCOVERY ZONE SECURITIES LITIGATION


The opinion of the court was delivered by: CASTILLO

 Plaintiffs brought this class action securities fraud suit on behalf of all persons who purchased Discovery Zone, Inc. ("DZ") common stock between February 17, 1994 and September 15, 1995. *fn1" Under a fraud-on-the-market theory, the complaint charges five DZ senior officers *fn2" with misleading the investing public by repeatedly overstating DZ's earnings and engaging in a series of fraudulent acts designed to inflate stock prices. Plaintiffs claim that the defendants capitalized on these fraudulent acts by selling their own stock while the price remained artificially high. Shortly after these sales, DZ's share price allegedly began a steady descent, leaving plaintiffs with investments worth far less than they cost.

 Plaintiffs' Second Consolidated Amended Class Action Complaint ("Compl."), a product of multiple pleading efforts, unites these allegations in two counts. Count I claims that the defendants violated section 10(b) of the 1934 Securities Exchange Act ("the Act"), 15 U.S.C. § 78(j)b, and the SEC's corresponding Rule 10b-5, 17 C.F.R. § 240.10b-5. Count II asserts that the individual defendants are secondarily liable as "controlling persons" under section 20(a) of the Act, 15 U.S.C. § 78t(a).

 Pending before this Court is defendants' motion to dismiss the complaint under Federal Rules of Civil Procedure 12(b)(6) and 9(b). *fn3" The motion raises all manner of arguments in attempt to demonstrate that plaintiffs have failed to state a valid securities claim. For the reasons explained below, defendants' motion is granted in part and denied in part.

 RELEVANT FACTS *fn4"

 Discovery Zone is in the business of operating indoor child recreational facilities called "FunCenters." Compl. P 6. During its first few years of operation, DZ grew exponentially from owning just two FunCenters to managing over 100 by the end of 1993. Id. P 39. Despite this rapid expansion, the company remained unprofitable. Id. P 41. DZ's abiding outlook for FunCenter growth nonetheless enticed investors, who fully subscribed the company's initial public offering in June 1993. Id. After going public, DZ continued to expand FunCenter operations both at home and abroad. Id. PP 38-40.

 I. DZ's Accounting Methods

 Early in 1994, the company ostensibly began to enjoy some success. In a press release issued February 17, 1994, DZ reported a 205% increase in revenue for fiscal year 1993. Id. P 43. Likewise, the company informed the SEC in its 1993 10-K annual report that it had been a profitable year: DZ's stated earnings of over $ 3 million in 1993 compared favorably to the $ 4 million loss reported in 1992. Id. P 43. Donald F. Flynn, the company's CEO and a defendant in this case, said of these developments that "1993 was an outstanding year for Discovery Zone," rendering DZ "the clear industry leader." Id. Increased revenue was allegedly attributed to FunCenter expansion and a number of acquisitions. Id. But according to plaintiffs, the profits were a facade. Id. P 44.

 While the public was told that DZ had made money in 1993, defendants had allegedly manipulated the company's accounting to cover up a $ 2 million loss. Id. PP 9, 44. Plaintiffs state that to report a profit for the year, defendants improperly deferred and amortized the pre-opening costs associated with new FunCenters. *fn5" Id. P 44. Deferring these costs would have been acceptable only if defendants reasonably believed that their expenditure would produce a "probable future economic benefit." Id. ; see Financial Accounting Standards Board (FASB) Concepts Statement (CON) No. 6. Because DZ was such a new company, it allegedly did not have a sufficient operating history to use as a basis for predicting the gains from pre-opening costs. Compl. P 45; see FASB CON No. 6 app. B ("Certain expenditures for . . . preoperating activities . . . are examples of the kinds of items for which assessments of future economic benefits may be especially uncertain . . . ."). Under these circumstances, plaintiffs claim that this method of accounting was improper, and, in fact, violated Generally Accepted Accounting Principles (GAAP). Compl. PP 44-45.

 Defendants purportedly compounded the GAAP violation by amortizing DZ's pre-opening costs over impermissibly long periods of up to two years. Id. P 45. The two-year amortization term not only exceeded DZ's entire operating history at the time, but also allegedly departed from industry standards. Id. PP 7-8, 45. Together, the deferral and amortization practices artificially inflated company earnings, and, in turn, the stock price. Id. PP 9, 46. Instead of expensing pre-opening costs immediately, defendants minimized their impact on revenue by spreading them out over several periods. Id. P 46. Had the defendants properly expensed the FunCenter pre-opening costs, DZ would have lost money in 1993, and made far less in future quarters. Id. P 9; see Diagram A.

 DIAGRAM A

 Below are DZ's earnings, reported allegedly in violation of GAAP, for the calendar years 1992 and 1993, and for the first three quarters of 1994. Across from this are the earnings, according to plaintiffs, that DZ should have realized had the defendants complied with GAAP. This diagram appears at paragraph 9 of the complaint. Originally Reported Actual (In violation of GAAP) (In accordance with GAAP) 1992 ($ 4,969,095) ($ 5,128,393) 1993 $ 3,306,251 ($ 2,307,749) 1st Q 1994 $ 3,486,194 $ 2,478,706 2nd Q 1994 $ 3,899,953 $ 1,629,822 3rd Q 1994 ($ 16,904,945) ($ 21,845,335)

 Plaintiffs contend that the GAAP infractions paved the way for defendants to mislead DZ investors and the market. Id. PP 49, 52, 53. In a number of public announcements, the defendants allegedly created the false impression that DZ was indeed profitable and could legitimately increase both its earnings and size:

 
. On March 31, 1994, Reuters, a financial news service, interviewed DZ's Vice President and Chief Financial Officer, Robert Mitchum. Mitchum (a named defendant) detailed DZ's agenda for expansion, including a plan to open 200 additional FunCenters in 1994. Mitchum also stated that he was comfortable with analysts' 1994 per share earnings estimates, which were six times higher than per share earnings in 1993. He attributed the projected boost to DZ's expansion plans. Id. P 48.
 
. On or about April 7, 1994, DZ filed with the SEC its Annual Report to Shareholders for 1993, accompanied by a letter from Flynn. Flynn's letter stated that "acceptance and expansion of our concept was evidenced by our profitability," and contrasted the 1993 net profits with DZ's 1992 loss. Flynn also told shareholders that DZ had enough capital to fund its development schedule. Id. P 51.
 
. On April 20, 1994, DZ issued a press release over the PR Newswire. Reporting first quarter earnings of $ 3.5 million, Flynn allegedly claimed that the company earned as much in that quarter as it did in all of 1993. He pointed to the domestic and overseas jump in operating FunCenters as the reason for DZ's financial success. Id. P 53.
 
. On May 10, 1994, DZ filed its Form 10-Q for the first quarter of 1994 with the SEC. Signed by Mitchum, the 10-Q reported the same earnings figures as the April 20 press release. Id. P 54.

 Plaintiffs attack these statements as false and misleading. They claim that when Mitchum gave the March 31 interview to Reuters, he knew or was recklessly indifferent to the fact that 1993's earnings were artificially inflated by GAAP violations. Id. P 49. Consequently, these figures could not legitimately provide the basis for analysts' projected income increases, or fuel the kind of growth to which Mitchum had publicly committed DZ. Id. The Annual Report to Shareholders, along with Flynn's letter, allegedly misrepresented the source of DZ's income as expansion and public acceptance, not improper accounting. Id. P 52. The April 20 press release and Form 10-Q were allegedly misleading because they overstated DZ's first quarter earnings. Id. PP 53-54. The press release went even further by falsely attributing first quarter profits to DZ's expansion program. Id. P 53.

 II. The Acquisitions

 As of June 30, 1994, DZ was significantly behind schedule in meeting FunCenter projections. Id. P 56. Opening the number of FunCenters the projections called for by year's end would have caused DZ to post losses. Id. In addition, DZ had allegedly decided as of July 1, 1994 to change its accounting practice for pre-opening costs. Id. DZ would no longer defer and amortize them, but rather would expense the costs as each new FunCenter opened. Id. This accounting change, had it been announced, would have exacerbated DZ's losses. Id. So the defendants allegedly chose to conceal the new accounting method and its impact, and decided not to meet projections by opening more FunCenters. Id. Instead, DZ attempted to meet its FunCenter target with acquisitions. Id. PP 10, 57.

 On July 18, 1994, the company issued a press release revealing its plan to acquire McDonald's Leaps & Bounds, a competitor, as well as 57 of Blockbuster's Discovery Zone franchises. Id. P 57. Many of these facilities were located in the same metropolitan areas as existing FunCenters. Id. P 64. According to the release, the acquisitions would "produce a formidable company of enormous value to our customers and our stockholders." Id. P 57.

 But plaintiffs contend that this statement was false and misleading. Id. P 58. First, it concealed that defendants expected a material charge against earnings from operating competing, duplicative businesses. Id. Second, the press release omitted the "known trend" that Leaps & Bounds was historically unprofitable. Id. Plaintiffs claim that, under these conditions, it was inconceivable that the merger would create "a formidable company of enormous value." Id. Lacking the benefit of full information, the market reacted to the merger announcement by increasing DZ's stock price 20%, to $ 20.25 per share. Id. P 59.

 Two days later, on July 20, DZ issued another press release reporting increased earnings for the second quarter ending June 30, 1994. Id. P 60. The company's second quarter Form 10-Q, filed with the SEC on August 15, was to the same effect. Id. P 62. Flynn was quoted in the press release as being "pleased with our consistent gains in earnings and revenue." Id. He reiterated that the acquisition had "forged an extremely strong player in the children's and family entertainment markets." Id. Again, plaintiffs maintain that these statements and filings were false and misleading. Flynn mentioned nothing about the charges against income resulting from the acquisitions. Id. P 61. He omitted Leaps & Bounds' history of losses and their likely adverse impact on DZ's future performance. Id. The second quarter figures allegedly remained inflated, as they reflected the original improper method of accounting pre-opening costs. Id. And although the defendants had reached a decision to change their practices on July 1, Flynn said nothing about it. Id.

 The second quarter 10-Q allegedly deceived the public in one other respect: it stated that because DZ needed significant restructuring, "the Company's historical results of operations will not necessarily be indicative of the Company's future results of operations." Id. P 63. This announcement made it appear as though the acquisitions would alone be responsible for altering DZ's reported results. Id. P 66. But plaintiffs contend that the new accounting method of expensing pre-opening costs, which the defendants had silently implemented over a month earlier, would have a profound effect on stated earnings. Id. Earlier financial statements computed in violation of GAAP allegedly lost all utility for investors. Id. Absent disclosures on the accounting change and its significance, the 10-Q was misleading. Id.

 III. The Insider Sales

 On August 1st and 2nd, less than two weeks after DZ announced the acquisitions, defendants Mitchum and Victor Casini, DZ's Vice President, Secretary and General Counsel, sold over 95% of their holdings. Id. P 67. Their stock captured on average $ 19.24 per share, just under the $ 20.25 price set when the market learned about the acquisitions. Together, Mitchum and Casini realized proceeds of over $ 2.5 million on their sales. Id.

 Defendant Gerald Seegers, the President, Chief Operating Officer, and a director of DZ, along with defendant John McCarthy, also a DZ director, likewise allegedly profited from the price hike in the wake of the acquisitions. Id. P 68. From August 11-17, 1994, they collectively unloaded 111,116 shares at prices 27% to 43% higher than they were the day before DZ made the acquisitions public. Id. McCarthy received a total of $ 235,938; Seegers, over $ 2 million. Id. P 110.

 IV. DZ's Slow Decline

 By September of 1994, Mitchum and the other defendants had begun to reveal that DZ's once-rapid expansion was slowing. They told analysts on September 9 that the company would open only 60 more FunCenters in 1994, as opposed to the 80-100 originally projected. Id. P 71. Plaintiffs maintain that this was the first step in executing a so-called "soft landing" toward revealing the true state of the company. Id. Nevertheless, the defendants allegedly continued to hide the change in accounting practice and to obscure the acquisitions' adverse effects on the company. Id.

 On November 9, 1994, DZ issued a press release summarizing third quarter results. Id. P 74. The company reported losses of $ 16.9 million. Id. Included in a statement of operations was a provision for the change in accounting procedure. Id. The statement also disclosed a $ 15.1 million special charge against earnings for FunCenter closings resulting from the acquisitions. Id. On this subject, defendant Flynn commented that "as part of our long-term strategy, we wanted to put this charge behind us . . . ." Id. Plaintiffs claim this created the false impression that the closings charge was the only one DZ had to take in connection with the acquisitions; Flynn omitted the need to charge an additional $ 12.5 million for duplication in administration and management. Id. PP 75, 80. Furthermore, the statement of operations allegedly lead the public to believe, wrongly, that earlier financial reports remained useful despite the accounting change. Id.

 On November 21, 1994, DZ filed its third quarter Form 10-Q. Id. P 79. The document allegedly misled the public by continuing to herald the acquisitions' advantages and failing to fully disclose their associated charges. Id. PP 79, 80, 81. Plaintiffs state that defendants had "no reasonable basis" for assuring investors that the net result would be positive. Id. P 83.

 The defendants also publicly touted plans for growth, knowing that, to the contrary, the company needed to scale back expansion to address its negative cash flow and to digest the acquisitions. Id. P 82. Flynn, for example, talked of negotiations for a $ 175 million revolving credit line to facilitate domestic and international expansion. Id. P 77. The third quarter 10-Q assured investors that the company was "continuing to pursue its FunCenter development schedule." Id. P 82. According to plaintiffs, these statements were misleading. Id. P 77. Given the ongoing expenses associated with the acquisitions and the depressing effect that expensing pre-opening costs had on income, DZ could not simultaneously expand and stay profitable. Id. PP 77, 82.

 On February 13, 1995, DZ announced its expectations for a disastrous fourth quarter. Id. P 90. The company attributed its losses to acquisition-related expenses and fourth quarter pre-opening costs. Id. In response to the announcement, DZ common stock dropped the next day to a low of $ 7.25 per share, closing at $ 8.125 on extremely high volume. Id. The company's 1994 10-K annual report filed March 31 allegedly revealed more: the company needed to restate its figures for 1993 and the first three quarters of 1994 to adjust for the change in accounting procedures. Id. P 93.

 DZ experienced a tumultuous 1995. On April 18, the Wall Street Journal reported that Viacom would replace current DZ management. Id. P 98. Defendant Flynn immediately surrendered his daily responsibilities, and five board members were asked to resign by June. Id. P 98. On May 3, 1995, however, DZ appeared to reverse course, announcing first quarter earnings of $ 3.6 million. Id. P 100. Three weeks later, defendant Flynn sold over 1.2 million shares of his stock at $ 6.50 per share. Id. PP 101, 110. But DZ returned to unprofitability in the second quarter, posting a loss of $ 98 million. Id. P 102. On September 21, 1995, DZ allegedly announced that it expected a net loss for 1995 and did not foresee becoming profitable again until 1997. Id. P 106.

 V. The Defendants

 Plaintiffs allege the following additional facts in support of their claims that the individual defendants committed securities fraud and qualify as Discovery Zone's "controlling persons" ...


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