Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 1 of 81 IN THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF COLORADO Judge Edward W. Nottingham Civil Action No. 05-cv-01563-EWN-BNB (Consolidated with Baird v. Red Robin Gourmet Burgers. Inc., 05-cv-01903; and consolidated for pretrial proceedings with Wilster v. Snyder, 05-cv-01707) ANDRE ANDROPOLIS, on behalf of himself and all others similarly situated, Plaintiff, v. RED ROBIN GOURMET BURGERS, INC., MICHAEL J. SNYDER, JAMES P . McCLOSKEY, LISA A. DAHL, KATHERINE L. SCHERPING, and DENNIS B . MULLEN, Defendants. CONSOLIDATED COMPLAINT 1. Lead Plaintiff, the City of Philadelphia Board of Pensions and Retirement, by its attorneys alleges the following facts, except as to allegations about itself or its counsel, based upon counsel's investigation, which included: analysis of publicly-available news articles and reports, press releases, transcripts of investor conference calls, analyst reports, and public filings with the Securities and Exchange Commission ("SEC"), review of other matters of public record, and interviews of certain former employees of Red Robin Gourmet Burgers, Inc. ("Red Robin" and the "Company"). The former Red Robin employees who provided information set forth in this complaint requested that their names not be revealed in the pleading but permitted counsel to identify Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 2 of 81 the general time period during which they were employed by Red Robin along with a general description of their positions and responsibilities: Confidential witness number 1("CW 1 ") is a former Red Robin staff accountant who worked at the Company ' s Greenwood Village, Colorado headquarters from 2001 until 2003. CW 1's responsibilities included, among other things , (i) processing travel and entertainment expenses for Red Robin ' s management and executive team, (ii) the accounts payable and accounts receivable functions for 22 company-owned restaurants, and (iii) the preparation of financial packets provided to the executive team and board of directors. Confidential witness number 2 ("CW2") is a former Red Robin staffaccountant who worked at the Company's headquarters from 2004 to 2005. CW2's responsibilities included, among other things, (i) processing travel and entertainment expenses for Red Robin's management and executive team, and (ii) the accounts payable function for 20 company-owned restaurants. CW2 explained that Red Robin's bookkeeping operations are on the first floor of the building that houses the Company's headquarters, and that the executives' offices are located on the second floor ofthe building. The former employee further explained that staff accountants work in cubicles as distinguished from enclosed offices. • Confidential witness number 3 ("CW3") is a former Red Robin senior officer who worked at the Company ' s headquarters prior to the Class Period. • Confidential witness number 4 ("CW4") is a former Red Robin senior executive who worked at the Company ' s headquarters prior to the Class Period. • Confidential witness number 5 ("CW5") is a former accounts payable specialist who worked at Red Robin ' s headquarters from 2004 until 2005. CW5 was responsible for accounts payables for 20 Red Robin restaurants. • Confidential witness number 6 ("CW6") is a former accounts receivable specialist who worked at Red Robin ' s headquarters prior to the Class Period. INTRODUCTION AND OVERVIEW 2. This is a securities class action on behalf of all persons who purchased the common stock of Red Robin between August 13, 2004 and January 9, 2006, inclusive (the "Class Period"), and asserts claims under Sections 10(b), 14 and 2 0(a) ofthe Securities Exchange Act (the "Exchange Act"), 15 U.S.C. §§78j, 78n and 78t(a), and the rules and regulations promulgated thereunder by the -2- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 3 of 81 SEC, including Rules IOb- 5, 14a-3 and 14a-9 (17 C.F.R. § 240.10b-5, .14a-3 and . 14a-9). 3. Mike Snyder -Red Robin's Chairman, Chief Executive Officer ("CEO") and President- transformed Red Robin from a small, stagnant restaurant chain into a fast-growing chain of gourmet burger restaurants with a wholesome image. 4. Red Robin's wholesome brand image and gourmet burgers became a hit with diners and eventually Wall Street as well. In fact, between the Company's July 2002 initial public offering and early August 2005, the value ofRed Robin's stock price increased five-fold -from $12 per share to more than $60 per share. 5. From 2003 through 2005, Red Robin added forty-eight (48) company-owned restaurants , increasing its total to 163, and supported the opening of thirty-three (33) franchised restaurants, increasing its total to 136. 6. However, Red Robin did not align its internal controls with the rapid growth of its operations. Section 13(b)(2)(B) of the Exchange Act requires registrants, like Red Robin, to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that: • transactions are executed in accordance with management's general or specific authorization; • transactions are recorded as necessary (i) to permit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements, and (ii) to maintain accountability for assets; • access to assets is permitted only in accordance with management's general or specific authorization; and • the recorded accountability for assets is compared with the existing assets at -3- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 4 of 81 reasonable intervals and appropriate action is taken with respect to any differences. Representations in Red Robin's quarterly and annual financial statements filed with the SEC throughout the Class Period, led investors to believe that the Company had adequate and effective internal controls in place. More specifically, Red Robin represented to investors that: (i) management conducted evaluations, under the supervision and with the participation ofthe CEO and chief financial officer ("CFO"), of the effectiveness of the Company's disclosure controls and procedures as of the end of each reporting period; (ii) based upon each evaluation, management concluded that disclosure controls and procedures were effective; and (iii) there were no changes during the reporting periods that materially affected internal controls over financial reporting. 7. Investors first became aware of cracks in internal controls in early 2005 when the Company acknowledged that deficient internal controls led to improper lease accounting that made earnings appear higher than they actually were. As a result, Red Robin was forced to restate its financial results for fiscal years 2002 and 2003. 8. As investors later learned through two major disclosures of fraudon August 11, 2005 and January 10, 2006, Red Robin's internal control deficiencies ran much deeper than just lease accounting. Red Robin's concealment of these deficiencies and the resulting diversion of corporate funds and issuance of materially false and misleading earnings and revenue forecasts caused Red Robin's common stock to trade at artificially inflated prices during the Class Period. 9. The first major disclosure of fraud came after the market closed on August 11, 2005 when investors learned that Chairman/CEO Mike Snyder had been treating the Company as his own personal fiefdom by diverting corporate and shareholder assets to pay for personal travel and non- -4- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 5 of 81 business related expenses . The Company explained that the improper transactions were uncovered during an internal investigation initiated by the Company' s Board of Directors at the conclusion of which Mr. Snyder retired and the Company' s longtime CFO, Jim McCloskey, resigned . Red Robin no longer appeared so wholesome, as shareholders and Wall Street questioned the Company's integrity and credibility. 10. In reaction to the August 11, 2005 disclosure, Red Robin's common stock plummeted 24% on August 12, 2005, closing at $45.55 per share, down significantly from the prior day closing price of $59.79. Red Robin subsequently acknowledged in its second quarter of 2005 Form 10-Q that inadequate controls enabled Mr. Snyder to disregard company policy and spend approximately $1.25 million of corporate and shareholder funds on personal expenses since 2001 . The SEC has launched a formal investigation of Red Robin. 11. Red Robin initiated its internal investigation of Mr. Snyder after members of the Board read an article published in the Wall Street Journal discussing how corporate executives may bill shareholders for their own pleasure trips and that many companies conceal the abuse. On the same day that the Wall Street Journal article was published, Messrs. Snyder andMcCloskey foresaw scrutiny and disclosure oftheir improper practices and, thus, made arrangements to lock in gains and unload a sizable amount oftheir personal holdings of Red Robin stock. Mr. McCloskey sold 10,000 shares at approximately $55.00 per share reaping proceeds in excess of $550,000. Mr. Snyder entered into two pre-paid variable share forward contracts through which he was paid a total of $14,086,341 in exchange for agreeing to deliver 150,000 shares on November 17, 2006 and another 150,000 shares on May 25, 2007. 12. Red Robin director, Denny Mullen, replaced Mike Snyder as Chairman of the Board -5- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 6 of 81 and CEO. Katie Scherping took over as CFO in June 2005 after Mr. McCloskey was quietly reassigned. Contributing to the sharp erosion in credibility was the replacement executives' vague explanation of the internal investigation and the sugar-coating oftheir former boss' and the former CFO's departures from the Company. Mr. Mullen and Ms. Scherping are collectively referred to herein as the "replacement executives". 13. Putting Snyder's $1.25 million of personal expenses into context, on average he obtained, without Board approval and in violation of Red Robin's policies and procedures, approximately an additional $278,000 of undisclosed annual compensation for each year between 2001 and 2004 and an additional $138,000 for the first-half of 2005. Under SEC rules, where an executive officer receives more than $50,000 of perquisites and other personal benefits during a fiscal year, the amount must be disclosed in the company's proxy. After adding the additional undisclosed compensation to Mr. Snyder's annual compensation disclosed inthe 2003 to 2005 proxy statements, Snyder's annual compensation for fiscal years 2001, 2002, 2003 and 2004 increases by 40%, 39%, 29% and 26%, respectively. 14. Based on information provided by former Red Robin executives and accounting department employees, use of shareholder and corporate funds to pay for non-business related expenses was not an abuse limited to Mr. Snyder. Indeed, based on information provided by the former employees, as a result of Snyder's open disregard of Red Robin's Code of Ethics and travel and entertainment expense policies, the policies became unenforceable and opened the door to employee abuse. One former Red Robin staff accountant stated that "the Company's travel and expense reimbursement system was a joke." Moreover, information from former employees as well as statements by Red Robin in SEC filings demonstrate that Mr. Snyder and Red Robin's key -6- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 7 of 81 accounting officers were fully-aware that Mr. Snyder and other employees were violating Red Robin's policies and Code of Ethics but did nothing to stop the abuse. 15. Had investors known that key officers and employees -including the person largely credited for Red Robin's rapid growth and success- were using shareholder funds for their own personal benefit and that internal controls were ineffective in preventing the improper conduct, they would not have purchased Red Robin common stock or, at a minimum, would not have purchased the shares at the prices paid. 16. In the Fall of 2005 Red Robin's understaffed financial and accounting department faced significant uncertainty. The Company had just completed its internal investigation into Mike Snyder's use of company funds to pay for personal travel and other non-business related items, which Red Robin acknowledged was caused by deficient internal controls. The Company was in the process ofimplementing remediation measures related to "design and operation ofcertain accounting procedures." There was a new CEO, a new President, a new CFO (who lacked experience in financial reporting for publicly- owned companies ), and a new Controller. Red Robin had no internal audit function in place. The Company's Audit Committee was like a revolving door. Earlier in the year, the Company was forced to restate two years of financial results due to lease accounting practices that violated fundamental accounting principles , which the Company and its outside auditor acknowledged were caused by ineffective internal controls. There were no internal controls concerning employee meal privileges and discounts, leading to abuse. Energy and petroleum prices had reached record levels in the United States. Red Robin was in the midst of opening a record number of restaurants, many ofwhich were located in new markets and in areas where the Company had no brand recognition. Finally, with the opening of a record number of restaurants, Red Robin -7- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 8 of 81 would need to purchase a higher volume of supplies and hire a large number of restaurant managers and employees which in turn would lead to increased labor costs, such as wages, benefits and workers' compensation. 17. Desperate to restore Red Robin's severely damaged credibility and ease investors' concerns about Red Robin's future, the replacement CEO and CFO in the face of significant uncertainty and known internal controls deficiencies knowingly provided investors false and misleading earnings and revenue forecasts. 18. On November 3, 2005, the replacement executives announced third quarter 2005 financial results -the first full reporting period during which Mr. Mullen and Ms. Scherping were in control ofRed Robin- and knowingly provided investors materially false and misleading earnings and revenue forecasts for the fourth quarter 2005. On the heels of the third quarter financial results and the bullish fourth quarter earnings forecast, several stock analysts issued positive investment reports, including a report by Piper Jaffrayentitled "Credibility Slowly Being Repaired." In reaction, Red Robin's common stock price increased 10% on November 4th, closing at $51.94. 19. The second major disclosure of fraud came before the market open on January 10, 2006 when the replacement executives once again stunned investors by warning that the fourth quarter earnings guidance that they had provided only two months earlier was off by at least 20% for inexplicable reasons. Hence, it became apparent that the replacement executives lacked credibility and Red Robin had additional undisclosed internal control deficiencies which affected the forecasts provided to investors. 20. Following the January 10th disclosure, Bear Stearns issued an investment report in which it stated: "Management credibility is an issue at Red Robin, given the recent CEO and CFO -8- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 9 of 81 changes, after irregularities involving inappropriate use ofchartered airplanes. A significant earnings down-guide and a lack of disclosure as to where the cost pressures are coming from has exacerbated this credibility issue." 21. As a result of the huge earnings miss caused by known deficient controls and the renewal of investor skepticism of Red Robin's and the replacement executives' credibility and integrity, Red Robin's common stock lost 29% of its value on January 10, 2006, falling to $37.12 from the prior day closing price of $51.98. 22. When Red Robin announced its actual fourth quarter 2005 results on February 16, 2006, Mr. Mullen and Ms. Scherping explained the reasons for the giant disparity between their fourth quarter forecast and the actual results. The explanation was effectively an admission that Mr. Mullen and Ms. Scherping knowingly issued false and misleading forecasts that forecasts in that the replacement executives: (i) were aware that deficient and ineffective internal controls made the forecasts inaccurate and unreliable and that, and (ii) knowingly used overly aggressive and inaccurate forecasting methods. In particular, the Company lacked adequate internal controls over its workers' compensation liability expenses, as Red Robin failed to monitor this expense and factor into its expense analysis the increase in employees due to labor demands stemming from adding new restaurants . In addition, the Company failed to consider the impact of new restaurant openings and increased petroleum prices when calculating its fourth quarter supplies expense. Moreover, the new executive team, after only two (2) to three (3) months on the job, deliberately changed the Company's sales forecasting method for new restaurants in new markets in a calculated move intended to reflect more aggressive sales growth, while also failing to take into account that new restaurants opened adjacent to unfinished shopping centers in new markets generate smaller sales -9- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 10 of 81 than restaurants that have been open more than five reporting periods in existing markets. JURISDICTION AND VENUE 23. This Court has jurisdiction over the subject matter of this action pursuant to Section 27 of the Exchange Act, 15 U.S.C. § 78aa. 24. Venue is proper in this Judicial District pursuant to Section 27 of the Exchange Act and 28 U. S.C. § 1391(b). Red Robin maintains its principal executive offices in this Judicial District and many of the acts giving rise to the violations of law complained of herein, including the preparation and dissemination to the investing public ofmaterially false and misleading information, occurred in this Judicial District. 25. In connection with the acts, conduct and other wrongs alleged in this complaint, the defendants, directly or indirectly, used the means and instrumentalities of interstate commerce, including the mails, telephone communications and the facilities of national securities exchanges. THE PARTIES 26. Lead Plaintiff, the City ofPhiladelphia Board ofPensions and Retirement, purchased shares of Red Robin common stock during the Class Period and held the stock at the time investors learned on August 11, 2005 that Chairman/CEO, Mike Snyder, had diverted shareholder funds to pay for unauthorized personal expenses and continued to hold stock when investors learned on January 10, 2006 that the replacement Chairman/CEO, Denny Mullen, and CFO, Katie Scherping, knowingly issued materially false and misleading fourth quarter 2005 earnings guidance. Lead Plaintiffhas thereby been damaged. The City ofPhiladelphia Board ofPensions and Retirement was appointed Lead Plaintiff in this action by Court Order dated December 19, 2005. 27. Red Robin is a Delaware corporation with its principal executive offices in -10- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 11 of 81 Greenwood Village, Colorado. Red Robin and its subsidiaries is a casual dining restaurant chain that operates company-owned restaurants and sells franchises and receives royalties from franchised restaurants . As of December 25, 2005, the Company operated 163 restaurants and franchisees operated 136 restaurants under franchise or license agreements in 33 states and two Canadian provinces. Red Robin's common stock is listed on the NASDAQ National Market under the symbol RRGB. 28. Michael "Mike" J. Snyder, age 55, was elected Red Robin's President, Chief Operating Officer and Director in April 1996. Mr. Snyder was then elected as CEO of Red Robin in March 1997 and Chairman of Red Robin's Board of Directors in May 2000. From 1979 to May 2000, Mr. Snyder also served as president of The Snyder Group Company. Mr. Snyder purportedly retired as Senior Chairman, CEO and President on August 10, 2005. He remains a consultant to the Company. 29. James "Jim" P. McCloskey, age 54, was elected as Red Robin 's CFO and Secretary in June 1996 . On June 20, 2005, Mr. McCloskey was replaced as CFO by Katie Scherping. Mr. McCloskey continued to serve as an Executive Vice President until he purportedly resigned on August 10, 2005. 30. Lisa A. Dahl, age 46, served as Red Robin's Controller from 1997 to 2005 when she was terminated. Ms. Dahl also served as a Vice President of Red Robin since 2003. Although Red Robin and Ms. Dahl represented that the Controller was a Certified Public Accountant in the 2004 Form 10-K, Ms. Dahl's certification lapsed in 1998 and was not renewed. 31. Dennis "Denny" B. Mullen, age 62, has been a member of Red Robin's Board of Directors since December 2002 , serving on the Audit Committee . -11- Mr. Mullen took over as Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 12 of 81 Chairman and CEO ofRed Robin around the time ofMr. Snyder ' s purported retirement. Mr. Mullen also serves as the chairman of the Janus Funds. 32. Katherine "Katie" L. Scherping, age 46, was hired as RedRobin's CFO in June 2005, replacing Mr. McCloskey. Ms. Scherping came to Red Robin from Policy Studies, Inc. where she was a controller. 33. Mike Snyder, Jim McCloskey, Lisa Dahl, Denny Mullen, and Katie Scherping are collectively referred to herein as the "Individual Defendants". SUBSTANTIVE ALLEGATIONS 1. FACTUAL BACKGROUND A. Franchisee Mike Snyder Takes Control and Reinvigorates Red Robin 34. The first Red Robin restaurant opened in 1969 in Seattle, Washington. In 1979, Mr. Snyder and his brother opened the first franchised Red Robin restaurant in Yakima, Washington. By 1995, Mike Snyder was Red Robin's largest franchisee, with 14 restaurants. It was at that time he approached Red Robin International's owner, privately-held Japanese food-service company Skylark, with a proposal to overhaul the slow-growing chain. In exchange for injecting some cash, Mr. Snyder was named President and Chief Operating Officer and obtained a minority stake in 1996. In 1997, Mr. Snyder was elected CEO. Mr. Snyder moved Red Robin International 's headquarters from California to Denver, Colorado, where his Red Robin franchisee company The Snyder Group was headquartered. According to an article published in Business Weekon October 10, 2005 entitled "Red-Faced at Red Robin; The resignation of two top execs cloud the fast-growing chain's future," Mr. Snyder "closed underperforming restaurants, added high-ticket items, and refinanced the chain's hefty debt." In 2000, Snyder re-capitalized Red Robin to position it for future growth. Mr. Snyder -12- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 13 of 81 acquired a large interest in the Company and merged it with The Snyder Group, his 14- restaurant franchise company, in exchange for equity, cash and notes. Skylark kept a minority interest in the restaurant chain. In addition, Quad-C, a private equity firm, made a $25 million equity investment in Red Robin through its affiliates, making Quad-C Red Robin's largest stockholder. In January 2001, the Company' s management formed Red Robin Gourmet Burgers , Inc., a Delaware corporation, to facilitate a reorganization. The reorganization was consummated in August 2001, and since that time, Red Robin Gourmet Burgers, Inc. has owned all of the outstanding capital stock ofRed Robin International and the Company's other operating subsidiaries through which companyowned restaurants are operated . In July 2002, Red Robin became a publicly-owned company after selling shares in a public stock offering. 35. According to Red Robin's 2004 Form 10-K andproxy, Mr. Snyder and Red Robin's Senior Vice President of Restaurant Operations, Robert "Bob" Merullo, own 31.0% and 7.0%, respectively, ofMach Robin, LLC ("Mach Robin"), which operates Red Robin restaurants in Illinois, New Mexico, Idaho, Nevada and Canada (through a subsidiary) under franchise agreements. B. Under Mike Snyder's Leadership, Red Robin Builds a Wholesome Brand Image by Touting an "Unbridled Philosophy" and the "Core Values" of "Honor, Integrity, Seeking Knowledge and Having Fun" 36. Mike Snyder created a brand image for Red Robin in the marketplace as a model publicly-held corporation dedicated to values in conducting its operations. Thus, in investor reports and various corporate marketing media, Red Robin emphasized that its mission was to be "the leading gourmet burger and casual dining destination," which it would accomplish through dedication to certain strategies . At the top of that list is "[f]ocus on key guiding principles, or `cornerstones,' that drive our success," which Red Robin summarizes as follows: -13- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 14 of 81 In managing our operations, we focus on four cornerstones that we believe are essential to our business. Our four cornerstones are: Values. To enhance the dining experience of our guests, we strive to maintain our core values : honor, integrity, seeldng knowledge and having fun. People. ... Burgers. ... Time. ... [Emphasis added.] 37. Similarly, the homepage for Red Robin 's website (www.redrobin.com) contains a link entitled "Values" that when selected leads to the following declaration: We live our values everyday. Overview HONOR - Unbridled caring for the Team, Guest and Company. INTEGRITY - Doing the right thing! SEEKING KNOWLEDGE - Seek first to understand, then to be understood. HAVING FUN - Make the ordinary extraordinary and the mundane fun. Our VALUES create an "Unbridled" culture where Team Members use honor, integrity, seeking knowledge and having fun to deliver unprecedented service to Guests. Sometimes extraordinary things happen as a result of our "Unbridled" philosophy, we call these "Unbridled Acts." 38. Keeping with its high-moral standards theme, Red Robin adopted a Code of Ethics that also is publicly accessible through the "Investor Relations" link on the Company's website. The Code of Ethics states, in relevant part, as follows: I. Doing Business in Keeping with Red Robin Gourmet Burgers' Core Values - Honor, Integrity, Seeking Knowledge and Having Fun Red Robin Gourmet Burgers, Inc. ("Red Robin" or the "Compan)?') has adopted this Code of Ethics ("Code of Ethics") to make clear to you, its directors, officers and Team Members (collectively and individually "you"), what the Company expects of you as you conduct business for the Company. Red Robin requires that you conduct business for the Company lawfully, ethically, fairly and impartially. This Code of Ethics states the standards and policies that you must follow as you conduct business for Red Robin. In addition to the requirements of this Code of Ethics, the Company -14- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 15 of 81 may impose separate requirements on you because ofthe types ofdecisions you make for the Company. Understanding this Code of Ethics will help you conduct business for the Company in keeping with our core values - Honor, Integrity, Seeking Knowledge and Having Fun. Red Robin intends to always conduct business in keeping with the law, fairly and ethically. You must conduct business in a manner that is lawful, fair to those involved, ethical, and you must do so with integrity. You must avoid conduct that may raise questions as to the Company's compliance with the law, that may raise questions as to whether you will be acting honestly, with integrity, or that could harm the reputation of the Company or embarrass the Company. *** IV. Red Robin's Books, Records an d Other Property. *** B. Improper Use of Company Assets and the Assets of Others. You may not use Red Robin ' s property for personal benefit or other improper uses . You may not use Red Robin ' s property for personal benefit or other improper uses. You may not sell, loan, use, give away, or discard any tangible or intangible Company property without written authorization from the Company officer who has responsibility for the asset in question.... *** D. Company Funds. Spend Company funds only on things that serve the Company's business . Make sure that the Company receives fair value in property or services in exchange for its funds. Obtain your supervisor ' s approval before spending Company funds . The Companyhas established specific authority limits for each officer and for each department.... *** ONLY THE BOARD OF DIRECTORS OR A BOARD COMMITTEE MAY WAIVE ANY REQUIREMENT OF THIS CODE OF ETHICS AS TO A DIRECTOR OR EXECUTIVE OFFICER OF THE COMPANY. ANY WAIVER GRANTED BY THE BOARD OR A BOARD COMMITTEE MUST BE PROMPTLY DISCLOSED TO THE SHAREHOLDERS . [Emphasis added.] 39. Red Robin's wholesome brand image and gourmet burgers became a hit with diners and eventually Wall Street as well. Between the Company's July 2002 initial public offering and the days prior to August 11, 2005, the value of Red Robin's stock price increased five-fold -from $12 per share to more than $60 per share. -15- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 16 of 81 C. Like a Wolf in Sheep's Clothing, Red Robin's Chairman/CEO Wrongfully Diverted Corporate Funds to Pay for Personal Expenses as Some Watched and Others Followed 40. Unfortunately for shareholders, under Mike Snyder's leadership, Red Robin's management did not practice what it preached and extended the "unbridled" philosophy to the use of shareholder funds to pay for personal expenses. Snyder's brazen use of shareholder and corporate funds as though they were his own created a culture of free-spending and excess at Red Robin. Certain officers effectively embezzled funds from Red Robin and its shareholders by having the Company pay for personal travel, entertainment, and other non-business related items as well as donations to favored charities. Officers used Red Robin's charteredjet for personal travel without reimbursing the Company or disclosing the unauthorized personal benefit to shareholders. According to CW2, " Snyder constantly preached that the backbone of Red Robin was integrity. However, that was all a big farce. Snyder's real motivation was to make money and have fun." 41. As set forth in paragraph 38 above, the Company's Code of Ethics expresslyprohibits all employees -senior officers and executives included- from using Red Robin's property for personal benefit or other improper uses. The Code of Ethics also expressly limits employees to spending Company funds "only on things that serve the Company business," and requires that "the Company receives fair value in property or services in exchange for its funds." 42. According to CW1 and CW2, Red Robin's travel and entertainment expense reimbursement policy generally required that: • Employees only be reimbursed for business-related expenses set forth on an expense report and supported with a receipt. -16- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 17 of 81 • For commercial reimbursement of business-related air travel expenses, employees were required to submit ticket stubs as well as receipts. • Managers' expense reports had to be approved by a senior manager, and officers' and expense reports had to be approved by another officer. • American Express card statements do not satisfy the receipt requirement. 43. CW2 witnessed "abuse oftravel and entertainment expenses byRed Robin's officers" and said that "the Company's travel andexpense reimbursement system was a joke,""a lot ofpeople took advantage of their title," and "Red Robin was paying for outrageous expense reports." Similarly, CW4 stated that "travel and entertainment expenses by some executives smacked of abuse." According to CW4, "the worst abuser was Mike Snyder who would charge virtually everything, including personal expenses , to his Red Robin Corporate American Express card and approve non-business related charges of other senior executives." According to both CW 1 and CW2, it was common knowledge in the accounting department that Mr. Snyder would only on rare occasions submit an expense report. Typically, he would merely submit the monthly bill from his Corporate American Express card for payment by Red Robin, without any supporting receipts or ticket stubs. Mr. Snyder's secretary, Nancy Cornell, would approve payment of Snyder's American Express bill, then deliver the bill to an accounts payable specialist, directing that it be paid in its entirety, according to CW2. 44. With respect to Mr. Snyder's use of Red Robin's chartered-Lear jet, CW 1 received for payment from Red Robin funds invoices from Mayo Aviation of Centennial, Colorado related to Snyder's travel. Mr. Snyder would never submit an expense report that corresponded to the invoiced trips , according to CW1. The Red Robin staff accountant described the Mayo Aviation invoices as being uninformative as to passengers and destinations, preventing anyone from -17- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 18 of 81 confirming whether the j et was used for business purposes. CW1 provided that it didn't really matter that no one could determine whether the invoice related to personal or business travel because CW 1 was instructed to pay the invoice by her superiors regardless. CW6 learned from colleagues in the accounting department that "Mike Snyder and his family used the Red Robin jet a lot for personal travel while charging the costs to Red Robin." According to CW4, on numerous occasions, Mike Snyder and Bob Merullo used Red Robin's charteredjet to conduct business related to their franchisee company Mach Robin, but, nevertheless, each trip was paid for by Red Robin. 45. According to CW3, Mr. Snyder ' s use of corporate funds topay for personal expenses extends back to the days of The Snyder Group. At the time of Red Robin's acquisition of The Snyder Group in or around 2000, Red Robin's accountants discovered that Mr. Snyder regularlypaid for his and family members' personal expenses, including travel on private jets, with The Snyder Group' s corporate funds, according to CW3. According to CW3, Mr. Snyder was confronted about the practice during the due diligence process prior to the acquisition. Similarly, according to CW4, Mr. McCloskey would repeatedly wam Snyder about his "travel and expense abuses," but Snyder ignored the warnings and McClosley took no further action. 46. Another example of Mr. Snyder's misuse of corporate funds described by CW3 related to a $15,000 Rolex watch that Mr. Snyder purchased on his Corporate American Express for Mach Robin business partner and fellow Red Robin officer, Bob Merullo. According to CW3, Snyder wanted the Rolex watch to be paid for by Red Robin and booked as a business-related expense. However, the Company' s assistant controller demanded that the $15,000 cost ofthe watch be booked as additional compensation for Mr. Merullo. Mr. Snyder eventually agreed, but onlyafter increasing Mr. Merullo's compensation to cover all income taxes that Merullo would incur as a -18- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 19 of 81 result of including the $15,000 cost of the watch in his compensation, according to CW3. 47. Red Robin, Messrs. Snyder and McCloskey, andMs. Dahl should have disclosed Mr. Snyder's (and perhaps other officers') perquisites as "travel and entertainment" costs, as required by the SEC's rules . See Regulation S-K, Item 402(b)(2)(iii)(C) and Instruction 1 thereto. 48. Due to ineffective internal controls, the perquisites described above were neither raised with nor authorized by Red Robin's Compensation Committee or its Board of Directors. 49. In addition, to violating Red Robin's Code of Ethics, and the Company's travel and entertainment expense policies , Mr. Snyder also violated the terms ofhis May 11, 2002 Employment Agreement, which stated the following with respect to "expenses": During the Employment Period, [Snyder] shall be entitled to receive prompt reimbursement for all reasonable travel and other expenses incurred by [Snyder] in carrying out [Snyder's] duties under this Agreement, provided that [Snyder] complies with the policies, practices and procedures of the Company for submission of expense reports, receipts, or similar documentation of the incurrence and purpose of such expenses . [Snyder] will be authorized to fly on charter or private aircraft for appropriate business use; personal use of charter or private aircraft will be for [Snyder's] personal account. Where a flight combines business and personal use, the cost of such flight will be appropriately allocated between the two uses.... [Emphasis added] 50. Mr. Snyder was not the only officer misappropriating Red Robin's funds. According to CW4, Mike Snyder and two of his former Synder Group officers , Bob Merullo (Red Robin's Senior Vice President of Restaurant Operations), and Michael Woods (Red Robin's Senior Vice President ofFranchise Development) "spent a lot of money playing golf and living the high-life with their families, all of which was paid for by Red Robin." For instance, the three executives and their families would all dine together at up-scale steakhouse Del Frisco's in Greenwood Village at least twice a week and would charge the bill to Red Robin, according to CW4. "When those three -19- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 20 of 81 [Messrs. Snyder, Merullo and Woods] traveled, sometimes on business, sometimes not, they would use the private jet, stay at the freest hotels, eat at the finest restaurants, and rent the most expensive cars, all of which was paid for by Red Robin," according to CW4. 51. According to CW2 , then Vice President of Restaurant Operations , Eric Houseman, also submitted expense reports with just his Red Robin Corporate American Express bill and never any receipts or airline ticket stubs. Despite having inadequate support for the expenses, Mr. Houseman's expense report was always approved for payment by another officer. CW2 recalled often seeing significant charges on Mr. Houseman's American Expressbill for Red Robin employee golf-outings. The travel and entertainment expense abuse occurred at the lower and middle management levels as well , according to CW 1 and CW2. According to both CW 1 and CW2, there were numerous charges for golf and country club memberships on expense reports and American Express bills. According to CW3, Red Robin and shareholders paid for Mr. Snyder's golf and country club memberships. 52. CW 1 also explained that some employees would often "double-dip" or submit expense reports seeking reimbursement for expenses that had already been paid directly by Red Robin, such as airline tickets, AT&T cell phone bills, gas and mileage (through monthly car allowances) and car rental bills, or for expenses that were paid for by another employee and submitted on that employee's expense report. CW2 explained that double-dipping could occur because the travel and entertainment expense policies were not enforced. For instance, CW2 said that employees could be reimbursed for a plane ticket that was purchased by another employee, because the practice became that so long as an expense report was approved and was accompanied by a ticket stub, then the fact there was no receipt was overlooked. It was not uncommon for CW2 -20- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 21 of 81 to receive American Express bills from executives, including Mr. Houseman, that contained charges for sales-staff members' plane tickets. CW 1 stated that officers submitted approved expense reports containing items that appeared to have been personal in nature but which were coded as being charitable donations, and the submitting and approving officers would insist that the expenses be classified as donations on the general ledger. 53. Another area of abuse, according to CW 1, was the purchase of computers , software and accessories by employees for personal use through Red Robin' s contract with Dell without reimbursing Red Robin for the cost. CW1 described receiving Dell invoices corresponding to products that were shipped to locations where no Red Robin restaurant or office existed. Upon asking then Vice President of Management Information Systems , Howard Jenkins , who was primarily responsible for the Dell contract about the suspicious invoices, Jenkins would tell CW 1 he would look into the matter. Red Robin, however, would never be reimbursed for the majority of the suspicious invoices, according to CW 1. 54. CW 1 and CW2 both voiced concerns about, among other things, paying for officers' personal expenses, insufficient expense report documentation, and double-dipping to Patty Leon (Accounts Payable Supervisor), Heather Slonka (Accounting Manager), andDoug Pierce (Assistant Controller), each ofwhom reported to Controller, Lisa Dahl, who in turn rep orted to Mr. McCloskey. Normally, the supervisors took no action to address CW 1's and CW2's concerns. CW2 said that when the supervisors would reject an expense reimbursement request, Lisa Dahl almost always would instruct that, so long as an officer or senior manager had approved it, the purported expenses should be paid. Thus, the standard became that if the expense reimbursement request -regardless ofthe form or inadequate support- was approved, it was to be paid, according to CW2. Occasionally -21- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 22 of 81 both CW 1 and CW2 went directly to Lisa Dahl about inadequate support for expense reimbursement requests . While the Red Robin Controller indicated she would look into the expense reimbursement request, most of the deficient reimbursement requests would be sent back to CW 1 and CW2 as approved for payment. 55. "Because so many people were not complying with Red Robin's policies regarding travel and entertainment expenses," in the Summer of 2003, a memo outlining Red Robin's travel and expense reimbursement policies was distributed to all employees, and each employee had to acknowledge with a signature having received and reviewed the guidelines, according to CW 1. Even after the new policy was put in place, employees, including officers, continued the same improper practices, according to CW 1. D. Red Robin's Board Launches an Investigation into the Company's Accounting for Travel and Entertainment Expenses 56. On May 25, 2005, The Wall Street Journal published an article entitled "Frequent Fliers: Amid Crackdown, the Jet Perk Suddenly Looks a Lot Pricier - For CEOs, Personal Flight Costs Can Reach Six Figures; Their Tax Bill Stays Low - Barry Diller's Plane in Africa." The article discussed how corporate executives may bill shareholders for their own pleasure trips and how many companies conceal the abuse. The article, in relevant part, specifically stated: Companies have long defended corporate jets as vital business tools, needed to efficiently convey top executives to far-flung operations or meetings. But new disclosures, prompted in large part by a crackdown by the Securities and Exchange Commission, show that executives are using the jets for vacation and leisure travel to a far greater extent than previously known. The SEC crackdown, which came after officials were convinced that many companies were hiding or undercounting the cost of this sensitive perk, has led to many more companies revealing six-figure spending on their executives' personal j et travel. At least 33 executives received more than $200,000 apiece in personal-plane -22- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 23 of 81 benefits in 2004, a Wall Street Journal analysis of recent proxy filings shows.... *** ... [P]ersonal-jet travel is by far the largest extra benefit given to many executives, raising new questions about whether it is being adequately regulated. Some critics contend even the beefed-up figures greatly undercount -by at least two to three times- the real costs of this perk. Recent scandals also have shown that executives can hide abuse of the corporate jet by claiming personal travel is for business purposes. *** [Alan Beller, Chief of the Corporation Finance division at the SEC] initiated the latest crackdown on personal-travel disclosures in a speech last October that excoriated companies for "opaque or unhelpful" disclosures of executive pay in general. The speech didn't announce a change in the rules, but it did signal the SEC would be taking a closer look at how companies followed the existing ones. Mr. Beller's speech was triggered, in part, by the furor over revelations that GE failed to disclose lushperks given to its former chief, Jack Welch, as part of an employment and consulting contract after he retired. Among the benefits Mr. Welch received after his 2001 retirement was unlimited access to GE jets, a benefit the SEC later valued at $1.2 million in Mr. Welch's first year of retirement. GE settled SEC charges over the matter in September. In his speech, Mr. Beller pointedly said some companies had been improperly calculating the value of perks like jet travel, reminding them that a decade-old SEC rule required disclosure ofthe so-called incremental cost to the company ofproviding such benefits -not a more favorable rate calculated by the IRS. Many companies, including J.P. Morgan, Kodak and Starwood Hotels & Resorts Worldwide Inc., had been valuing personal travel aboard corporate planes at the lower IRS rate. The IRS rate -a per-mile figure that is generally at or below the cost of first-class airfare- is typically the extra amount that's counted as income to the executive as a result of the free flight, on which he or she must pay tax. The "incremental cost" approach is fairly straightforward: Ifthe CEO takes the plane on a golf weekend, the company totes up the direct expenses of the flight, such as fuel, landing fees and crew hotel charges. The calculation doesn't typically include a percentage of other big-ticket expenses such as the capital cost of the plane, crew salaries and insurance, on the theory that the plane is mostly used for business and the company would have to pay those fixed costs anyway. For a 2,000-mile roundtrip from New York to Orlando, Fla., aboard a luxurious $43 million, 12-to-14-seat Gulfstream V flown by the likes of J.P. Morgan, a senior executive would get an extra $1,500 tacked onto his taxable income -under IRS -23- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 24 of 81 rules. But the incremental cost of that same flight would be more than $11,000, according to tables published by Conklin & de Decker Associates Inc., a company that tracks flight costs. *** Some companies require reimbursement from executives who take personal flights aboard the corporate j et -typically at the IRS rate or equivalent first-class fare. Critics contend that's still a bad deal for shareholders, arguing that any reimbursements should be at the open-market charter rate. After three executives of Dayton, Ohio, utility DPL Inc. resigned last year amid allegations of improper conduct, a probe by a company-hired law firm found among other things that the company had underreported the trio's taxable income associated with personal flights by a total of $225,000. The law firm's probe alleged that the executives had failed to count family members or guests who had traveled on the planes, or claimed they were flying on business when there was no evidence it was a legitimate business trip. They have disputed the charges.... Rampant abuse of corporate jets also underlies some ofthe criminal allegations faced by David Wittig, former CEO of Westar Energy Inc., Topeka, Kan. According to a company probe , Mr. Wittig , who resigned in 2002 , improperly claimed as business travel a number of journeys that were really personal. They included transporting his children ' s nanny to and from New York, ferrying his children to summer camp in Minnesota, a 10-day family vacation in Europe and Mr. Wittig's yearly trips to attend the NCAA Final Four basketball tournament. Mr. Wittig, who has denied wrongdoing, faces retrial next month in U. S. District Court in Kansas City, Kan., on fraud charges that include many of the same allegations, after a jury couldn't reach a verdict in a trial that ended in December. He also is appealing a conviction on separate money-laundering charges. 57. After members ofRed Robin's Board ofDirectors read the May 25, 2005 Wall Street Journal article, the Board decided to examine whether Red Robin was properly accounting for officers' use ofthe Company's chartered-plane, accordingto an article published in TheDenverPost on August 21, 2005 entitled "CEO takes a dive for nest feathering." The August 21, 2005 Denver Post article further reported that "[a]s the company examined its books in June, it found expenses that Snyder couldn't adequately document, including trips on company chartered jets." -24- Case 1:05-cv-01563-EWN-BNB 58. Document 87 Filed 02/28/2006 Page 25 of 81 On the same day the Wall Street Journal article was published, Messrs. Snyder and McCloskey foresaw scrutiny and disclosure of their improper practices and thus made arrangements to lock in gains and unload a sizable amount of their personal holdings of Red Robin stock. Mr. McCloskey sold 10, 000 shares at approximately $ 55.00 per share, reaping proceeds in excess of $550,000. Mr. Snyder entered into two pre-paid variable share forward contracts through which he was paid a total of $14,086,341 in exchange for agreeing to deliver 150,000 shares on November 17, 2006 and another 150,000 shares on May 25, 2007. Moreover, DennyMullen sold 2,500 shares for proceeds of more than $140,000 (May 31 - 1,000 shares at approximately $55.00 per, June 16 1,500 shares at approximately $58.20 per share) between the day the Wall Street Journal article was published and when the Company disclosed that its Board of Directors had conducted an internal investigation concerning travel and entertainment expenses on August 11, 2005. These insider sales are suspicious in timing given their contemporaneousness with the Wall Street Journal article and the Board's internal investigation. The sales are also suspicious in amount based on the size of the proceeds the executives/directors obtained while adverse information was being withheld from investors. 59. In July 2005, Red Robin hired law firm Hogan & Hartson to investigate Mr. Snyder's undocumented expenses, according to the August 21, 2005 Denver Post article. The Denver Post reported that Hogan & Hartson presented its conclusions to Red Robin's Board on August 8, 2005 and that "[t]he board met on Aug. 9 and 10 and decided it was time for Snyder to retire." 60. On August 10, 2005, Mr. Snyder and Red Robin entered into a Retirement and General Release Agreement that set forth the terms of Snyder's departure from the Company. The agreement provides that Mr. Snyder would immediately resign as Chairman, CEO and President of -25- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 26 of 81 Red Robin and retire as an employee of the Company effective August 31, 2005. The agreement also contains a provision regarding the "repayment of personal expenses," which states as follows: Prior to the date hereof, a special committee ofthe Board of Directors (the "Special Committee") has conducted an investigation into certain travel, lodging, entertainment and other expenses that have been incurred by Snyder and paid for or reimbursed by the Company. The Special Committee has presented Snyder with alist of such expenses for which the Special Committee has been unable to identify adequate documentary or other support as to the business purposes for such expenses (the "Disallowed Expenses"). Within twenty (20) days after the date of this Agreement (the "Petition Period"), Snyder may petition the Special Committee to reduce the Disallowed Expenses by submitting records or other proof demonstrating by clear and convincing evidence that any of the Disallowed Expenses were, in fact, incurred for appropriate business purposes.... Within ten (10) business days of the receipt of any submission by Snyder (or, if Snyder should fail to submit any petition within the Petition Period, then within three (3) business days after the expiration of the Petition Period), the Special Committee shall make a final determination as to the amount of Disallowed Expenses to be repaid by Snyder . . . . The Special Committee's final determination as to the amount ofDisallowed Expenses is binding and shall not be subject to challenge by Snyder. Within three (3) business days of his receipt of the Special Committee's final determination, Snyder shall repay to the Company the amount of the Disallowed Expenses as finally determined by the Special Committee, together with interest on all such amounts calculated from the date that each such expense was incurred until the date of Snyder's payment of the Disallowed Expenses at a rate equal to the interest rate currently in effect under the Company's existing credit facility. 61. Likewise, on August 10, 2005, Mr. McCloskey and Red Robin entered into a Resignation and General Release Agreement through which McCloskey resigned as Senior Vice President and as an Executive Officer of Red Robin effective immediately and resigned as an employee of Red Robin effective as of August 31, 2005. E. THE FIRST MAJOR DISCLOSURE OF FRAUD: Red Robin Informs Investors That Its Chairman/CEO Wrongfully Diverted Assets with the Aid of the CFO and Controller 62. After the market closed on August 11, 2005, Red Robin stunned investors when it announced that Mr. Snyder had retired as Chairman and CEO and long-time CFO, Jim McCloskey, -26- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 27 of 81 had resigned . The Company announced that Denny Mullen would take over as Chairman and CEO and that Eric Houseman was promoted to President and Chief Operating Officer. Ms. Scherping had taken over as CFO in June. The Company described the need for the abrupt management changes as follows: These management and governance changes follow an internal investigation conducted by a special committee ofthe Company's board of directors relating to use of chartered aircraft and travel and entertainment expenses. The special committee, which retained independent counsel to conduct the investigation, identified various expenses by Mr. Snyder that were inconsistent with Companypolicies or that lacked sufficient documentation. Mr. Snyder has agreed to reimburse the Company for such expenses following completion ofthe special committee's review. The Company has notified the Securities and Exchange Commission of the internal investigation.... In reaction to the August 11, 2005 announcement, Red Robin's common stock plummeted 24% on August 12, 2005, closing at $45.55 per share down significantly from the prior day closing price of $59.79. 63. In the August 11th press release and during the investor conference call held that same day, the replacement executives were vague in their description of the findings of the special investigation . During the conference call, Mr. Mullen asserted that, since the Company had informed the SEC of its internal control deficiencies and the improper conduct of its most senior officers, it was unable to provide shareholders full disclosure: Before we open this up to questions, I want to quickly speak to the events surrounding the management change. As we announced today, the management and governance changes follow an internal investigation conducted by a special committee of the board of directors. We have notified the [SEC] of this internal investigation. We do not know ... what action the SEC may or may not take in response to our notification. Because these matters are pending, we are not in a position to speculate or discuss or elaborate beyond the details provided in the Company's press release andpublic filings. When asked by an investment analyst whetherMr. McCloskey's resignation had anything to do with -27- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 28 of 81 the special committee investigation, Denny Mullen responded, "[t]he board discussed the findings and the resulting management changes with Jim, and he decided to resign. And we can't go into it any further." 64. It was only through an August 15, 2005 analyst report issued by Bear Stearns to its clients after meeting privately with Red Robin' s management that investors learned more details about Messrs. Snyder's and McCloskey's abrupt departures from Red Robin and the related investigation into the Company's accounting and disclosure practices with respect to travel and entertainment perquisites. The Bear Steams report provided in relevant part: Red Robin's management did a very poor j ob of explaining the situation surrounding the sudden departure of its 2 senior-most executives on its conference call, but we learned more about the situation Friday afternoon. The investigation was motivated by a late [May] article in the Wall Street Journal on accounting for air plane travel, which discussed that many high-profile companies were incorrectly accounting for it. The correct accounting procedure is the SEC method, but many companies were using the IRS method . Upon reading this article, Red Robin looked into its accounting, and realized it had been using the incorrect method as well. As they looked more deeply into its financial statements, Red Robin also discovered that the policy has been misused . Then they hired a law firm in early July to investigate, and received the results last Monday, August 8. They held a regularly scheduled board meeting Tuesday-Wednesday, which is when they determined that Snyder (chairman & CEO) would retire. Jim McCloskey (SVP and formerly CFO) resigned following this determination. [Emphasis added.] This timeline explains a bit more about the circumstances surrounding the executives' departures and, to some degree, the sudden nature of it. We are still confused as to why Snyder "retired", but McCloskey "resigned", since although the inappropriate expenses occurred under McCloskey's watch (as CFO), they were Snyder's expenses. The executives are approximately the same age (Snyder is 55; McCloskey is 54), and have been with the current company, Red Robin Gourmet Burgers, Inc., for the same duration.... 65. Based on information in theBear Stearnsreport, RedRobin's accounting department, led by Mr. McCloskey and Ms. Dahl, improperly calculated -using the IRS method rather than the SEC method- the dollar value of the unauthorized perquisite of employee usage of Red Robin's -28- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 29 of 81 charted-jet for personal travel. In other words, the Company calculated the value ofpersonal aircraft usage using the method required for imputation of income for tax purposes, known as Standard IndustryFare Level (SIFL) rather than the aggregate incremental cost method requiredby Instruction 2 to Item 402(b)(2)(iii )(C) ofRegulation S-K ofthe Exchange Act for disclosure of perquisites. 66. Additional details concerning the internal investigation were disseminated through an article published in The Denver Post on August 21, 2005 entitled "CEO takes a dive for nest feathering." The August 21, 2005 Denver Post article reported that "[a] s the company examined its books in June, it found expenses that Snyder couldn't adequately document, including trips on company chartered jets." 67. In its Form 10-Q for the second quarter of 2005, which was filed with the SEC on August 19, 2005, Red Robin admitted that internal control deficiencies enabled Mr. Snyder to divert corporate funds with the help of his CFO and Controller. More specifically, the Form 10-Q states that "deficiencies related to the design and operation ofcertain company-level controls" enabled the following improper conduct: Non-compliance by the former chief executive officer and former chief financial officer with existing policies and procedures for non-commercial aircraft usage and travel and entertainment expenses; Unauthorized usage ofnon-commercial aircraft by the former chief executive officer; and Unauthorized charitable donations of Company funds and services by the former chief executive officer of Company. The Form 10-Q proceeds to list the specific "deficiencies related to the design and operation of certain accounting procedures" Lack of clear procedures for ensuring appropriate dissemination of the noncommercial aircraft usage policy; -29- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 30 of 81 • Inadequate supervisory oversight of accounting personnel responsible for processing payment requests by our former chief executive officer related to travel and entertainment expenditures, including non-commercial aircraft usage and charitable donations; • Inadequate reporting and disclosure controls with regards to the identification of senior executive fringe benefit compensation; It related to all officers on this point ; and [Emphasis added] • Lack of a charitable donations policy, which resulted in unauthorized charitable donations by the former chief executive officer. 68. Red Robin disclosed in the second quarter of 2005 Form 10-Q that the Company had entered into a Restitution Agreement with Mr. Snyder on August 18, 2005 through which he agreed to reimburse Red Robin $1.25 million for "certain travel, lodging, entertainment and other expenses incurred since 2001" that were paid for by the Company even though there was inadequate documentary or other support as to the business purposes for such expenses. The Company stated that as a result of $1.25 million reimbursement , it would recognize a pre-tax gain of $1.25 million, or approximately $0.05 per share after tax, during third quarter of 2005. 69. Red Robin effectively admitted that since 2001 the Company has paid, at a minimum, on average an undisclosed $278,000 per year to Mike Snyder in the form of perquisites. 70. According to Red Robin's 2003, 2004 and 2005 proxy statements filed with the SEC, Mr. Snyder's compensation was as follows: Annual Compensation Long-Term Compensation All Other Compensation Year Salary Bonus Other Annual Compensation Securities Underlying Options /SARs Premiums paid for supplemental life ins. 2004 $492,308 $570,000 - 80,000 $2,819 2003 $446,717 $510,875 - 60,000 $2,160 2002 $364,652 $338,367 - - $4,851 2001 $340,609 $347,288 - - $4,620 -30- Case 1:05-cv-01563-EWN-BNB 71. Document 87 Filed 02/28/2006 Page 31 of 81 Red Robin failed to devise and maintain a system of internal accounting controls over personal use of assets sufficient to detect, prevent, or account properly for Mr. Snyder's and his family's and friends' use of company assets. Mike Snyder received at least $1.25 million in perquisites that went undisclosed because Red Robin's proxy reporting process failed to identify them. Moreover, the $1.25 million in personal benefits and perquisites provided to Mr. Snyder had not been raised with or authorized by the Compensation Committee or the Board of Directors. 72. In addition, the second quarter of 2005 Form 10-Q also stated that Red Robin had "implemented certain remediation measures," and was "in the process of creating and implementing additional remediation plans" for its internal control deficiencies. The Company specified that with regard to the "design and operation of certain company-level controls," it has completed the following remediation activities: The special committee conducted an internal investigation relating to use ofchartered aircraft and travel and entertainment expenses, including charitable donations. The special committee, which retained independent counsel to conduct the investigation , identified various expenses by the Company' s former chief executive officer since 2001 that were inconsistent with Company policies or that lacked sufficient documentation . On August 10, 2005, this individual retired from his positions with the Company. In addition, our former chief financial officer resigned as senior vice president and secretary on August 10, 2005 .... [Emphasis added.] Red Robin also instructed in its From 10-Q that another planned remediation activity for 2005 to help fix company-level controls was to implement an internal audit function that reports directly to the Audit Committee of the Board of Directors. 73. With regard to the "design and operation of certain accounting procedures," Red Robin further stated in the second quarter of 2005 Form 10-Q that it had "established new travel and entertainment expense authorization procedures for all members ofour executive committee," which is comprised of "the chief executive officer, president, chief financial officer, senior vice presidents, -31- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 32 of 81 and our vice president ofhuman resources." The Company also revealed other remediation activities that it was planning for 2005, but had not yet completed, regarding aircraft usage , travel and entertainment expenses, and charitable donations. 74. In addition, the second quarter of 2005 Form 10-Q stated that the Company "replaced" Mr. McCloskey with Katie Scherping in June, and admitted that his departure from the CFO position "will strengthen [the Company's] controls related to financial reporting." More specifically, the Company provided the following explanation regarding "changes in internal controls over financial reporting": During the twelve weeks ended July 10, 2005, we replaced our chief financial officer and controller.... We believe these personnel changes will strengthen our controls related to financial reporting.... Prior to the announcement of Ms. Scherping's hire on June 22, 2005, the Company never disclosed that it was searching for someone to replace Mr. McCloskey. Given the contemporaneousness between Ms . Scherping ' s hire and the Company' s investigation oftravel and entertainment expenses along with Red Robin 's statements regarding Mr. McCloskey 's improper conduct in the second quarter of 2005 Form 10-Q, the reasonable and logical inference is that the two events were related. 75. In the second quarter of 2005 Form 10-Q, Red Robin also informed investors for the first time that Vice President and Controller, Lisa Dahl, had been terminated. As it did with Mr. McCloskey, the Company stated in the Form 10-Q that Ms . Dahl's departure "will strengthen [the Company's] controls related to financial reporting." Once again, the contemporaneousness between Ms. Dahl' s termination and the Company' s internal investigation of travel and entertainment expenses along with Red Robin's statements regarding Ms. Dahl in the second quarter of 2005 Form 10-Q, give rise to the reasonable and logical inference that, like Mr. McCloskey, Ms. Dahl was terminated as a result of her involvement in Mr. Snyder's use of corporate funds to pay for $1.25 -32- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 33 of 81 million of personal travel and non-business related expenses. 76. On February 1, 2006, Red Robin was notified by the SEC that the agency had launched a formal investigation of the Company. According to Red Robin, the investigation relates to Mr. Snyder's use of chartered aircraft and travel and entertainment expenses. F. The Replacement Executives Faced Many Uncertainties in the Fall of 2005 77. Red Robin's new CFO had never served in a high level accounting position at a publicly-held company where she was responsible for ensuring transparent financial reporting to investors. Ms. Scherping's prior experience was limited to privately-held companies. 78. In addition to losing nearly 25% of its market value after the first disclosure of fraud on August 11'x, Red Robin's accounting and financial department was in a state of flux during the Fall of 2005. There was a new CEO, a new President, a new CFO, and a new Controller. Based on information from CW1, CW2 and CW5, prior to and throughout the Class Period, Red Robin's accounting department was severely under-staffed, resulting in staff accountants having workloads that prevented them from properly performing their jobs. Red Robin had no internal audit function in place. The Company's Audit Committee, which is responsible for reviewing the effectiveness of the Company's controls, was like a revolving door. The Company had just completed its internal investigation into the CEO/Chairman's use of company funds to pay for personal travel and other non-business related items, which Red Robin acknowledged was caused by deficient internal controls. The Company was in the process of implementing remediation measures related to "design and operation of certain accounting procedures." Earlier in the year, it was forced to restate two years of financial results due to lease accounting practices that violated fundamental accounting principles, which the Company and its outside auditor acknowledged were caused by ineffective -33- Case 1:05-cv-01563-EWN-BNB internal controls. Document 87 Filed 02/28/2006 Page 34 of 81 Internal controls concerning employee meal privileges and discounts were deficient, leading to abuse. Energy and petroleum prices reached record levels in the United States, impacting utilities and supplies expenses. Red Robin was in the midst of opening a record number of restaurants, many of which were located in new markets. Finally, with the opening of new restaurants, Red Robin had to purchase a higher volume of supplies and hire new restaurant managers and employees which naturally led to increased labor costs, such as wages, benefits and workers' compensation. 1. 79. No internal audit function In a Form 8-K which was filed with the SEC on November 17, 2005, Red Robin acknowledged that it was still in the process of remediating previously disclosed deficiencies and was in the process of retaining an audit service provider to implement the Company's internal audit function. An internal audit function was not implemented until late fourth quarter 2005 or earlyfirst quarter 2006. 2. 80. Revolving Door Audit Committee Red Robin's Audit Committee, according to its Charter, maintains responsibility for, among other things: Accounting Principles . Review with management and the independent auditors material accounting principles applied in financial reporting, including any material changes from principles followed in prior years and any items required to be communicated by the independent auditors in accordance with AICPA Statement of Auditing Standards ("SAS") 61. Internal and External Controls. In consultation with the independent auditors and the Company's financial and accounting personnel, review the integrity, adequacy and effectiveness of the Company's accounting and financial controls, both internal and external, and elicit any recommendations for the improvement of such internal control procedures or particular areas where new or more detailed controls or procedures are desirable. *** -34- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 35 of 81 Code of Ethics; Waivers. Monitor the Company's compliance with a code of conduct or ethics as required by applicable law or exchange listing standards and covering the conduct and ethical behavior of directors, executive officers and employees. Review and recommend to the Board action on any waivers of any portion of the code of ethics requested by any executive officer or director. 81. As of April 22, 2005 (the date Red Robin filed its 2005 proxy with the SEC), the Audit Committee ofits Board ofDirectors was comprised ofBenjamin Graebel, EdwardHarvey and Denny Mullen, with Mr. Graebel serving as the committee chairman. Indeed, Red Robin's Audit Committee had been comprised of Messrs. Graebel, Harvey and Mullen since 2003. 82. On May 11, 2005, the Company announced the Mr. Harvey "indicated his intent to resign from the Company' s Board of Directors" effective the August 2005 board meeting. 83. On August 11, 2005, Mr. Mullen left the Audit Committee, as he replaced Mike Snyder as Chairman and CEO. On that same day, Red Robin announced that Mr. Harvey was going to remain on Red Robin's Board as Lead Director. 84. Effective September 6, 2005, Red Robin appointed two new outside directors -Richard Howell and Taylor Simonton- who were named to the Audit Committee. 85. According to a Form 8-K filed on November 17, 2005, on November 11, 2005, Mr. Simonton replaced Edward Harvey as Chairman of the Audit Committee. Red Robin never previously disclosed to investors that Mr. Harvey had replaced Benjamin Graebel as committee chairman or that Mr. Graebel had been removed from the Audit Committee altogether. 3. 86. Improper lease accounting To accommodate lessees' cash flow situation, in commercial real estate, lessors commonly agree to defer collection of rent during months that the leased space is being converted into the lessees' place ofbusiness (the build-out period). The rent charges incurred during the buildout period are added to future rent obligations which are paid after the business is up and running. -35- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 36 of 81 Under Generally Accepted Accounting Principles ("GAAP"), and more specifically the American Institute of Certified Public Accountants' (AICPA) Statement of Position (SOP) 98-5, lessees must report the rent expenses for the build-out period. Red Robin violated the foregoing basic GAAP. 87. The Financial Accounting Standards Board (FASB) Technical Bulletin Nos. 85-3 and 88-1 direct that for financial reporting purposes lessees like Red Robin should recognize rent expense on leases with escalating rental obligations using the straight-line amortization method over the lease term. In violation of this fundamental accounting principle, Red Robin did not recognize rent expense on leases with escalating rental obligations using the required straight-line rent method. 88. In addition, Red Robin did not reflect lease incentives as reductions ofrental expense over the term of the lease , as required by GAAP (FASB Technical Bulletin No.88-1 ). Instead, Red Robin improperly recognized lease incentives provided by lessors as a reduction to leasehold improvement costs at the time the incentive was provided. 89. In the 2004 Form 10-K, Red Robin acknowledged that it "generally depreciated its buildings, leasehold improvements and other long-lived assets on those properties over a period that included both the initial non-cancelable lease term and all option periods provided for in the lease ... up to a maximum period of twenty years." This improper accounting practice violated GAAP and, more particularly, FASB Statement No.13 and AICPA Accounting Research Bulletin (ARB) No.43. 90. As part of its restatement of the fiscal 2002 and 2003 financial statements described in the 2004 Form 10-K, the Company revised previously reported financial results to be in accordance with GAAP and to reflect the proper rent expense in the appropriate time periods. In its 2004 10-K, Red Robin also admitted that internal controls over financial reporting as well as the Company's disclosure controls and procedures were not effective as of December 26, 2004: -36- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 37 of 81 Based on the Public Company Accounting Oversight Board's Auditing Standard No. 2, An Auditoflnternal Control Over Financial Reporting Performed in Conjunction With an Audit of Financial Statements, restatement of previously issued financial statements to reflect the correction of a misstatement should be regarded as at least a significant deficiency and as a strong indicator that a material weakness in internal control over financial reporting exists. Based on its evaluation as of December 26, 2004, management concluded that, because its consolidated financial statements required restatementas a result ofthe lease accounting misstatements described below, a material weakness existed in the Company 's internal control over financial reporting as of the date of this report and, to this extent, its internal control over financial reporting was not effective. *** Our management conducted an evaluation, under the supervision and with the participation of our chief executive officer and chief financial officer, as of the end ofthe period covered by this report, ofthe effectiveness of the Company's disclosure controls and procedures. In performing this evaluation, management reviewed the Company's lease accounting practices. As a result of this review, we concluded that our previously established lease accounting practices were not appropriate under GAAP. Accordingly, as described above, management has restated its audited consolidated financial statements for the fiscal years ended December 28, 2003 and December 29, 2002, to reflect the correction of these errors. These errors were attributed to deficiencies in the Company' s controls relative to the selection, monitoring, and review of assumptions and factors affecting lease accounting practices as of December 26, 2004, resulting from an error in the Company's interpretation of GAAP. Based on the aforementioned evaluation, management, under the supervision and with the participation of our chief executive officer and chief financial officer, concluded that the Company ' s disclosure controls and procedures were not effective as of December 26, 2004. [Emphasis added]. Outside auditor, Deloitte & Touche, also issued an opinion in the 2004 Form 10-K that Red Robin "has not maintained effective internal control over financial reporting as of December 26, 2004." 4. 91. Shareholder-paid employee meal privilege is abused due to deficient controls According to CW1 and CW2, all Red Robin employees ate for free at company- owned Red Robin restaurants. Family members or friends dining with employees also often ate for free, according to CW 1 and CW2. CW2 said all an employee had to do was show their Red Robin business card and the entire table's meal was usually free or at a minimum half-price. CW2 stated that managers and officers received monthly Red Robin meal cards worth $200 to $250. The -37- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 38 of 81 managers and officers would submit expense reports or American Express bills and be reimbursed for the tip given to the waiter/waitress that served the free meal, according to CW 1 and CW2. Red Robin had no system in place to monitor who used the employee meal cards or who was provided the complimentary meals , according to CW1 and CW2. 92. In its Form 10-Q for the second quarter of 2005, Red Robin acknowledged that it was improperly accounting for costs relating to complimentary employee meals . The Company had been reporting the complimentary portion ofteam member meals as restaurant revenues (thereby inflating reported revenues), with a corresponding expense reported in restaurant labor and general and administrative costs. The complimentary portion of team member meals should not have been recognized as revenues or costs and expenses. This accounting change resulted in a decrease in restaurant revenues and a corresponding decrease in restaurant labor and general and administrative costs. As a result of the change, restaurant revenues decreased by $1.6 million, or 1.4%, and restaurant labor costs and general and administrative costs decreased by $1.5 million and $67,600, respectively, for the twelve weeks ended July 10, 2005. For the twenty-eight weeks ended July 10, 2005, restaurant revenues decreasedby $3.5 million, or 1.4%, and restaurant labor costs and general and administrative costs decreased by $3.4 million and $ 141,100 , respectively. Based on these figures, Red Robin pays approximately $6 million per year for employees' meals. 5. 93. Oil Prices Reached Record Levels During August and September 2005 oil prices reached record levels, which correspondingly caused the price of energy and petroleum based products to rise. G. The Replacement CEO and CFO Knowingly Provide Investors False Guidance 94. The federal securities laws do not obligate companies to disclose their internal forecasts to investors. Before releasing forecasts to investors, the Company must ensure that the -38- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 39 of 81 information is reasonably certain. 95. Facing great uncertainty and aware that the Company' s internal controls were deficient, the replacement CFO and CEO, who had a limited history of working together, knowingly provided investors materially false and misleading earnings and sales forecasts for the fourth quarter 2005. More specifically, on November 3, 2005, Red Robin issued a press release in which it announced its financial results for the third quarter 2005. In the press release , Red Robin also represented to investors that the Company expected fourth quarter 2005 total revenues of approximately $118 to $119.5 million and earnings ofapproximately $0.40 to $0.41 per share, based upon an expected comparable restaurant sales increase of 3.0% to 4.0%, and the opening of eleven new company-owned restaurants during the quarter. Katie Scherping reiterated the same fourth quarter 2005 guidance during an investor conference call held that day. Denny Mullen was also on the call. 96. Following Red Robin's filing of the third quarter of 2005 Form 10-Q and issuance of false and misleading earnings and revenue guidance for the fourth quarter, several stock analysts issued positive investment reports on November 4, 2005: • Piper Jaffray issued a report entitled "Credibility Slowly Being Repaired," which stated, in relevant part, as follows: Twelve weeks ago [Red Robin] stunned the investment communitywith the surprise resignation of its CEO and CFO, side-saddling its 2Q [earnings per share] results. The stock reacted with an involuntary 4-for-3 split, meaning it was repriced but no extra shares were issued. The new CEO and his senior team wasted no time in rallying the troops and managed to keep the glue intact.... It always takes longer to rebuild credibility than it does to destroy it, but [Red Robin] is now clearly heading in the right direction.... We are raising our 2005 ... [earnings per share] estimates by $0.04 .... Our positive view of the stock remains based on the company's ability to regain -39- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 40 of 81 credibility with the investment community .... • Bear Stearns issued a report stating in relevant part: 3Q was the first quarter since new management took over, and we are encouraged with the results. We think it is critical that the new management team at least meet expectations for several quarters in order for the company to regain credibility with the Street, and they are off to a good start with this quarter. 97. In reaction to the third quarter of 2005 Form 10-Q, the fourth quarter 2005 earnings forecast, and positive stock analyst comments, shares of Red Robin common stock increased 10% on November 4th, closing at $51.94. H. THE SECOND MAJOR DISCLOSURE OF FRAUD: After Being Led to Believe That the Nest Was Back in Order, Investors Learn That Internal Control Deficiencies Are Much More Severe than Represented and That The Replacement Executives Knowingly Provided False and Misleading Fourth Quarter 2005 Financial Guidance 98. Before the market opened on January 10, 2006, Red Robin stunned investors after warning through a press release that the fourth quarter 2005 earnings guidance issued just two months earlier on November 3rd was too high and that the actual results were now expected to be at least 20% lower than the low end of its earlier guidance. More specifically, the Company lowered earnings guidance from $0.40-$0.41 to $0.29-$0.32. The Company also lowered its guidance for fourth quarter revenues to $116.5 million from the November 3rd guidance of $118 million to $119.5 million. The press release provided a vague explanation for the huge earnings miss: The lower than expected revenues in the fourth quarter will result in a de-leveraging of fixed costs and impact the Company's earnings in the fourth quarter. In addition, certain restaurant operating expenses were higher than expected during the fourth quarter of 2005.... The Company held an investor conference call on January 10' to discuss the huge reduction in earnings guidance. Denny Mullen and Katie Scherping each participated on the call. Much to the alarm ofthe stock analysts participating on the call, speaking on behalf ofthe management team, Mr. -40- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 41 of 81 Mullen expressed that he was unable to explain specific reasons for the poor results at that time: MATT DIFRISCO [ANALYST, THOMAS WEISEL PARTNERS]:... [C]an you describe like what you see or what you track, whether it is you, Dennis, or Eric, what you see on a month-to-month basis that sort of comes out a dime miss this midway through January? Was there something earlier on that we could have seen as far as an indication of these trends occurring or also controls over this on the cost side? Because I just you had a history of the third quarter you beat by what your forecast was by a couple ofpennies, and now we're missing by about a dime. It seems like the forecasting is getting a little bit more volatile. DENNIS MULLEN: The short answer is we're certainly looking into that in terms of our forecasting . But as soon as we knew the magnitude of the miss -- we knew the revenue missed earlier -- as soon as we knew the magnitude of the miss we wanted to go public with it. As we have said, we now have to do more analysis , detailed analysis , and we will certainly share all that with you on the February call. *** MIKE SMITH, ANALYST, OPPENHEIMER: What I'm interested in ... is you appear to have missed revenues by a couple of million bucks , and also missed the earnings by a couple of million bucks. And it seems like that is more deleveraging than I would expect from just a modest sales surprise. DENNIS MULLEN: Yes, it is , and that is why we said in addition to the deleveraging certain restaurant expenses were higher than we expected in the fourth quarter. Again, those expenses we will detail very specifically in the February call. MIKE SMITH: Are they labor or are they G&A? DENNIS MULLEN: They are restaurant operating expenses , not G&A. MIKE SMITH: [Y]ou can't be more specific? DENNIS MULLEN : Not at this time. The fact that the CEO could not specify what operating expenses lead to a huge disparity between the forecast and actual results sixteen (16) days after the quarter had ended demonstrated the degree to which internal controls were deficient and ineffective. Having reviewed the effectiveness of internal controls in the second and third quarters of 2005, as represented in the financial statements for those periods, Mr. Mullen and Ms. Scherping were aware of the extensive internal control deficiencies at the time they issued the voluntary guidance. In the case of Mr. Mullen, he would -41- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 42 of 81 have reviewed controls since as far back as 2003 as a member of Red Robin's Audit Committee. 99. After the January 10th conference call, several stock analysts issued reports questioning the credibility of Red Robin and its new management. For instance: Bear Stearns published a report on January 11th stating in relevant part: Red Robin lowered its 4Q [earnings per share] guidance range to $0.29-$0.32 from $0.40-$0.41 previously, a suprisingly large earnings revision after reporting revenue just slightly below expectations.... We underestimated the friction the management changes would have on short-term earnings .... Management credibility is an issue at Red Robin, given the recent CEO and CFO changes, after irregularities involving inappropriate use of chartered airplanes . A significant earnings down -guide and a lack of disclosure as to where the cost pressures are coming from has exacerbated this credibility issue. [Emphasis added.] CIBC issued a report on January 11th stating in relevant part: Two misses/sharp share price declines in three [quarters] have eroded investor credibility .... Before the open Tuesday, January 10, Red Robin announced a severe 4Q EPS miss - a 25% shortfall in EPS despite only a modest 1% sales miss. The company's management only exacerbated the issue (remember shareholders were already edgy given earlier events this year) by their inability to articulate the source of the miss.... What went wrong? A combination of industry and company specific cost pressures, combined with bad forecasting, in our view.... Two misses in three quarters , combined with a change in management, has strained investor credibility to the limit and does raise legitimate questions about management ' s ability to forecast its own business . [Emphasis added.] On January 10th, BB&T Capital Markets published a report that stated in relevant part: Conference call may have done more harm than good: Management hosted a conference call to discuss today's press release. However, management was unwilling and/or unable to provide much detail beyond the limited information in the press release. Management' s conduct on the conference call and lack of -42- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 43 of 81 specificity likely damaged their credibility with investors, in our view. [Emphasis added.] *** ... We like the Red Robin concept and its potential, but we had been concerned the company would miss its Q4'05 earnings targets. Now that our concerns have been realized, a host of other questions have been raised, including the likely success of the company's development plans, adequacyof internal controls, earnings visibility, management credibility, and how much the management change last August is impacting the company's performance, if any. On January 10th, Piper Jaffray issued a report in which the firm downgraded its investment rating for Red Robin stock, stating in relevant part As a reminder, [Red Robin] was put in the penalty box five months ago when the CEO and former CFO unexpectedly resigned. Today's news delays that credibility rebuilding process. Morgan Keegan & Co. issued a report on January 10' in which the firm downgraded its investment rating for Red Robin stock based on, among other factors: "[O]ur concern that management's credibility may be strained after two substantial earnings misses in the past six months." On February 16, 2006, CIBC World Markets issued a report in which it characterized the magnitude of the disparity between the November 3rd forecast and the pre-announcedresults on January 10th as "shocking". 100. In reaction to the January 10, 2006 disclosure, the value of Red Robin's common stock dropped dramatically. By the end of the day, the price of the Company's stock had sunk on extremely heavy trading volume to $38.29 from a closing price of $51.98 on the previous day. In the days that followed, the price of Red Robin's common stock continued to decline, trading as low as $35.29 on January 23, 2006. 1. The Replacement CEO and CFO Acknowledge Certain Internal Control Deficiencies That Caused the Giant Disparity Between Their Fourth Quarter Earnings Forecast and Actual Results 101. On February 16, 2006, Red Robin held an investor conference call to discuss its fourth quarter 2005 financial results. For the fourth quarter, the Company reported net income of $0.33 per diluted share and revenue of $116.5 million. -43- Case 1:05-cv-01563-EWN-BNB 1. 102. Document 87 Filed 02/28/2006 Page 44 of 81 Workers' Compensation Liability Was Not Closely Monitored Red Robin is self-insured for losses related to workers' compensation . According to its financial statements, the Company calculates its liability by estimating, based upon analysis of historical data and actuarial estimates, the ultimate cost of claims incurred and unpaid as of the balance sheet date. The Company does not discount its estimated liability. 103. In financial statements filed during the Class Period, Red Robin assured investors that it "closely monitored" workers' compensation liabilities and would adjust its reserve to cover such liabilities "when warranted by changing circumstances." 104. On the February 16, 2006 investor conference call, Ms. Scherping attributed $0.03 of the disparity between the fourth quarter earnings per share forecast and the actual results to a charge for workers' compensation insurance expense. Ms. Scherping explained that the $0.03 charge was a "true-up adjustment" that was necessitated by a staggering reserve shortage uncovered during a recent independent actuarial study. As Ms. Scherping stated on the February 16, 2006 conference call, for every $250,000 of pre-tax expenses, there is approximately a $0.01 decline in earnings per share. Hence, Red Robin was under-reserved forworkers' compensation liability by approximately $750,000. By not closely monitoring its workers' compensation liability as represented in SEC filings, Ms. Scherping and Mr. Mullen failed to ensure that they were providing accurate information to investors. 105. Given the amount by which Red Robin's workers ' compensation reserve was underfunded, the Company could not have been "closely monitoring" workers' compensation claims. The Company opened eleven (11) new company-owned restaurants and supported the opening of nine (9) new franchisee-owned restaurants in the fourth quarter of 2005, which required Red Robin to hire more employees and, correspondingly, led to an increase in workers' compensation expenses. -44- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 45 of 81 However, at the time they calculated the earnings forecasts that were disclosed to investors, Mr. Mullen, Ms. Scherping and their staff knew that the Company would be hiring new employees for its new restaurants which in would turn lead to higher workers' compensation costs. Each Red Robin restaurant employs approximately eighty-five (85) employees, including four (4) to five (5) managers. As stated by Mr. Mullen on the February 16, 2006 conference call, the twenty (20) new restaurants that opened in the fourth quarter "were under construction a long time, we knew they were coming, the teams had time to gear up for it." 106. Indeed, Mr. Mullen acknowledged that the Company could have taken additional steps or engaged in "initiatives" to ensure its workers compensation reserve was sufficient prior to providing investors the earnings forecasts. 2. 107. Treatment of Supplies Expenses Is Inconsistent With Financial Statements ; Supplies Expenses Are Affected By Deficient Controls According to Red Robin' s financial statements , the Company treats supplies as a component of inventory for financial reporting purposes . Under GAAP (AICPA Accounting Research Bulletin (ARB) No.43) the purchase of inventory does not constitute an expense. The cost of the supply is recorded as an expense only after the item is used, under GAAP (ARB No.43). For example, the cost of a container of plastic wrap should only be recognized after the plastic wrap is delivered from the warehouse to a restaurant for use, not when the plastic wrap is purchased and stored in the warehouse as inventory. 108. On the February 16, 2006 conference call, Ms. Scherping attributed $0.02 of the disparitybetween the November 2005 fourth quarter earnings forecast and the actual results to higher than expected supplies and utilities expense. With respect to supplies, Ms. Scherping explained that Red Robin had to purchase a higher volume of supplies than the amount that was factored into the -45- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 46 of 81 fourth quarter earnings forecast. This explanation indicates that Red Robin, contrary to its stated accounting policies, is recognizing supplies expense as the supplies are purchased and put into inventory rather than at the time at which the supplies are used by its restaurants. 109. Use of supplies (and correspondingly the recording ofexpense) parallels sales. For instance, if Red Robin sells 1,000 meals, it also uses approximately 1,000 napkins. Evidencing a lack of sufficient controls in the area of supplies, Red Robin had a higher than expected increase in expenses for supplies at the same time it reported lower than expected sales for its restaurants. 110. Red Robin maintained a warehouse in California that stored supplies for restaurants. According to CW6, "the amount of inventory in the California warehouse was always less than it should have been." There was never a physical inventory or an audit of the warehouse, according to CW6. 111. If Red Robin had adequate controls in place, it would have: (i) been able to monitor inventory levels and avoid having to incur higher expenses in the fourth quarter by making up for inadequate inventory levels; and (ii) easily been able to discern what its cash outlay was for supplies based on historical traffic at established restaurants. Correspondingly, if Red Robin did not have deficient controls regarding its inventory and supplies expenses, it would have been able to accurately forecast the increased expense that followed the opening of several new restaurants. 112. On the February 16, 2006 investor conference call, Ms. Scherping also blamed higher supplies and utilities expenses on the increase in oil and energy prices. However, the record oil and energy prices in August and September 2005 were widely-reported and any unexpected material impact would only have been a result of deficient internal controls and Ms. Scherping and Mr. Mullen's failure to ensure that rising oil and energy prices were factored into the earnings forecasts. 3. Modified Sales Forecasting Methodology To Use Unproven and Overly -46- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 47 of 81 Aggressive Model 113. Ms. Scherping attributed half ofthe disparity between forecasted fourth quarter 2005 revenue and actual revenue to restaurants that were open less than five (5) reporting periods (i.e., non-comp units). 114. As explained on the February 16, 2006 investor conference call, Red Robin's historical experience has been that, over the first year of operation, new restaurants in new markets average approximately 10% less in sales volume than restaurants that have been open more than five (5) reporting periods (i.e., comp units). New restaurants in existing markets average approximately 5% less in sales volume than the average volume for comp units. 115. In preparing the fourth quarter of 2005 revenue and earnings forecast, Red Robin's replacement executives disregarded historical trends and based it forecast for new restaurants in new markets on the restaurants averaging only 5% less in volume than comp units rather than the historically used 10% volume reduction. 116. On the February 16, 2006 conference call, Ms. Scherping admitted that the Company's fourth quarter sales forecast for new restaurants in new markets was overly aggressive as she explained that the Company decided to go with sales volume only 5% lower than the average volume for comp units because "[w]e were kind of using our optimistic view of what had happened [in the] previous three quarters of the year, which was pretty heavily weighted to the existing markets and ran closer to 95%." 117. Moreover, restaurants opened in what Red Robin refers to as "greenfield areas," or areas where the restaurant opens before development of an adjacent shopping center is complete as well as newly opened restaurants in markets where Red Robin lacks brand awareness typically generate even smaller sales than new restaurants opened in new markets. -47- Ms. Scherping Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 48 of 81 acknowledged that Red Robin failed to factor into its fourth quarter earnings forecast that restaurants in these "greenfield areas" would generate sales volumes even lower than new restaurants in more typical new markets would generate. 118. On February 17, 2006, the investment publication Motley Fool issued a report concerning Red Robin which stated in relevant part Last August, the casual dining chain saw the sudden departure of CEO Mike Snyder and CFO James McCloskey, after it was disclosed that Snyder had been using company funds for some of his personal expenses. The stock subsequently dropped 25% in one day. Snyder announced that he would reimburse the company for the expenses. However, any unexpected change in management is unsettling. Investors' fears of an SEC intervention were also warranted; a formal investigation was announced earlier this month. Another blow came just last month, when the company lowered guidance for Q4 and FY 2005 sales , same-store sales , and earnings. The reason given for the poor estimates was that the models used to calculate guidance did not take into account the higher percentage of company-owned restaurants opened in the fourth quarter in new markets and what the company calls " greenfield markets " -- areas where shopping centers are not fully developed . In general, these stores generate smaller sales than stores opened in established markets. While most restaurants' new stores enjoylarge "honeymoon" sales in their first few months of operation, Red Robin stores show the reverse; most actually take around three years to meet the company's performance expectations. II. DEFENDANTS' MATERIALLY FALSE AND MISLEADING STATEMENTS 119. Red Robin's Form 10-Q for the second quarter of 2004, which was signed by Mr. McCloskey and filed with the SEC on August 13, 2004, was a group-published document that involved the collective actions of Red Robin officers, including Mike Snyder and Lisa Dahl. The second quarter of 2004 Form 10-Q contained several materially false and misleading statements:' (A) The following representation concerning Red Robin's internal controls: 1 On May 19, 2005, Red Robin filed amended Forms 10-Q for the second and third quarters of 2004 restate its condensed consolidated financial statements and related disclosures. With the exception of the to restated financial results, the amended Forms 10-Q contain the same materially false and misleading statements set forth in the original Forms 10-Q. -48- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 49 of 81 As of the end of the period covered by this report, we performed an evaluation under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures. Based upon that evaluation, our management, including the Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report. No change in our internal control over financial reporting occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our intern al control over financial reporting. (B) The following certifications issued by Messrs. Snyder and McCloskey in accordance with Rule 13a-14 of the Exchange Act ("Rule 13a-14 certifications"): 1. I have reviewed this quarterly report on Form 10-Q of Red Robin Gourmet Burgers, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge , the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b. Evaluated the effectiveness of the registrant's disclosure control and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and -49- Case 1:05-cv-01563-EWN-BNB c. 5. Document 87 Filed 02/28/2006 Page 50 of 81 Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. (C) The following certifications issued by Messrs. Snyder and McCloskey in accordance with 18 U.S.C. § 1850, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, ("Section 906 certifications"): (i) [T]he quarterly report on Form 10-Q for the period ended July 11, 2004 ofthe Company (the "Periodic Report") fully complies with the requirements of section 13(a) and 15(d) of the Securities Exchange Act of 1934; and (ii) [T]he information contained in the Periodic Report fairly presents, in all material respects, the financial condition and results of operations of the Company. 120. The price of Red Robin's common stock increased approximately 9% on August 13, 2005 , closing at $33.71 up from the prior day closing price of $30.93. 121. The above representations by Red Robin, Messrs. Snyder and McCloskey, and Ms. Dahl in the second quarter of2004 Form 10-Q were materially false and misleading for the following reasons: -50- Case 1:05-cv-01563-EWN-BNB (A) Document 87 Filed 02/28/2006 Page 51 of 81 As Red Robin acknowledged in its second quarter of 2005 Form 10-Q, after evaluating the effectiveness of "the Company' s disclosure controls and procedures " -which were purportedly "designed to ensure that information required to be disclosed in [SEC] filings are recorded, processed, summarized and reported [to investors] .... and that such information is accumulated and communicated to management ... to allow timely decisions regarding required disclosure" in accordance with Rule 13a-15(e) and 15d-15(e) promulgated under the Exchange Actmanagement identified several deficiencies which together "resulted in a significant deficiency that existed during the twenty-eight weeks ended July 10, 2005, and in prior periods." Red Robin specifically acknowledged the following deficiencies and improper conduct in its second quarter of 2005 Form 10-Q: Deficiencies Related to the Design and Operation of Certain Company-Level Controls • Non-compliance by the former chief executive officer and former chief financial officer with existing policies and procedures for non-commercial aircraft usage and travel and entertainment expenses; • Unauthorized usage ofnon-commercial aircraft by the former chief executive officer; and • Unauthorized charitable donations of Company funds and services by the former chief executive officer of Company. Deficiencies Related to the Design and Operation ofCertainAccountingProcedures • Lack of clear procedures for ensuring appropriate dissemination of the noncommercial aircraft usage policy; • Inadequate supervisory oversight of accounting personnel responsible for processing payment requests by our former chief executive officer related to travel and entertainment expenditures, including non-commercial aircraft usage and charitable donations; • Inadequate reporting and disclosure controls with regards to the identification of senior executive fringe benefit compensation; It related to all officers on -51- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 52 of 81 this point; and • Lack of a charitable donations policy, which resulted in unauthorized charitable donations by the former chief executive officer. (B) Certain other officers and employees disregarded Red Robin's policies and procedures relating to travel and entertainment expenses and used Red Robin and shareholder funds to pay for unauthorized personal expenses. (C) The recordation of non-approved officer compensation as travel, lodging, entertainment and other expenses (this material misstatement has never been corrected through restatement). (D) As the Company acknowledged to a Bear Stearns analyst, Red Robin's accounting department, led by Mr. McCloskey and Ms. Dahl, improperly calculated the value of personal usage of Red Robin's charterjet using the method required for imputation of income for tax purposes, known as Standard IndustryFare Level, or SIFL, rather than the aggregate incremental cost method required by Instruction 2 to Item 402(b)(2Xiii)(C) of Regulation S-K of the Exchange Act for disclosure of perquisites. (E) Red Robin had no system in place to prevent non-employees from obtaining complimentary food and beverages through employee meal cards and the employee free meal and discount policy. 122. Red Robin's Form 10-Q for the third quarter of 2004, which was signed by Mr. McCloskey and filed with the SEC on November 5, 2004, was a group-published document that involved the collective actions of Red Robin officers, including Mike Snyder and Lisa Dahl. The third quarter of 2004 Form 10-Q contained several materially false and misleading statements: 2 See Footnote 1. -52- Case 1:05-cv-01563-EWN-BNB (A) Document 87 Filed 02/28/2006 A substantially similar representation concerning Red Robin' s internal controls that was set forth in the second quarter of 2004 Form 10-Q. (B) See ¶119(B)). Section 906 certifications by Messrs. Snyder and McCloskey substantially similar to those they issued in the second quarter of 2004 Form 10-Q. 123. See ¶119(A)). Rule 13a-14 certifications by Messrs . Snyder and McCloskey substantially similar to those they issued in the second quarter of 2004 Form 10-Q. (C) Page 53 of 81 See ¶119(C)). The above representations by Red Robin, Messrs. Snyder and McCloskey, and Ms. Dahl in the third quarter of 2004 Form 10-Q were materially false and misleading for the reasons set forth in paragraph 121(A) to (E) as to why representations in the second quarter of 2004 Form 10-Q were materially false and misleading. 124. Red Robin's 2004 Form 10-K, which was signed by, among others , Messrs. Snyder, McCloskey and Mullen and filed with the SEC on April 6, 2005, was a group-published document that involved the collective actions of Red Robin officers and directors, including Lisa Dahl. The 2004 Form 10-K contained several materially false and misleading statements, including: (A) The following representation concerning internal controls: Disclosure Controls and Procedures Our management conducted an evaluation, under the supervision and with the participation of our chief executive officer and chief financial officer, as of the end ofthe period covered by this report, ofthe effectiveness ofthe Company's disclosure controls and procedures.... *** No change in our internal controls over financial reporting occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our intern al controls over financial report ing. (B) Rule 13a-14 certifications by Messrs. Snyder and McCloskey substantially similar to those they issued in the second quarter of 2004 Form 10-Q. -53- See ¶119(B)). Case 1:05-cv-01563-EWN-BNB (C) Document 87 Filed 02/28/2006 Section 906 certifications by Messrs. Snyder and McCloskey substantially similar to those they issued in the second quarter of 2004 Form 10-Q. (D) Page 54 of 81 See ¶119(C)). The section of the 2004 Form 10-Kdedicated to the disclosure of "Executive Compensation" incorporates by reference the information on the subject set forth in the 2005 proxy. (E) The section of the 2004 Form 10-K concerning Directors and Executive Officers representing that the Board of Directors adopted a code of ethics that is publicly accessible through the Company 's internet website: Our board of directors has adopted a code of ethics that applies to our chief executive officer and other senior executives, including our chief financial officer and controller, as required by the [SEC]. The full text of our code of ethics can be found on our website at http://irpage.com/rrgb/.... (F) The representation that Controller, Lisa Dahl, was currently a CertifiedPublic Accountant. 125. The above representations by Red Robin, Messrs. Snyder, McCloskey and Mullen, and Ms. Dahl in the 2004 Form 10-K were materially false and misleading the reasons set forth in paragraph 121(A) to (E) as to why the representations in the second quarter of 2004 Form 10-Q were materially false and misleading as well as for these additional reasons: (F) The representation concerning "Executive Compensation" was false and misleading for the same reasons set forth in paragraph 128 as to why the representations concerning Mr. Snyder's compensation in Red Robin's Definitive Proxy Statement for the 2005 Annual Meeting of Stockholders were materially false and misleading. (G) Red Robin' s and Messrs . Snyder and McCloskey' s representation concerning Red Robin's Code of Ethics was materially false and misleading in that they omitted to state the material facts that Messrs. Snyder and McCloskey were actively violating several of the provisions -54- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 55 of 81 of the Code , including: • "You may not use Red Robin's property for personal benefit or other improper uses"; • "You may not ... use [or] give away ... any tangible or intangible Company property without written authorization from the Company officer who has responsibility for the asset in question...."; • "Spend Company funds only on things that serve the Company's business"; and • "Make sure that the Company receives fair value in property or services in exchange for its funds." (H) Ms. Dahl's Certified Public Accountant certification had lapsed in May 1998 and was not renewed. 126. Red Robin filed its Definitive Proxy Statement for the 2005 Annual Meeting of Stockholders with the SEC on April 22, 2005 . The 2005 proxy , which was signed by Mr. McCloskey on April 21, 2005, was a group-published document that involved the collective actions of Red Robin officers, including Mike Snyder, Dennis Mullen and Lisa Dahl. The 2005 proxy summarized Mr. Snyder's 2003 compensation as follows: Annual Compensation Long-Term Compensation All Other Compensation Year Salary Bonus Other Annual Compensation Securities Underlying Options /SARs Premiums paid for supplemental life ins. 2004 $492,308 $570,000 - 80,000 $2,819 2003 $446,717 $510,875 - 60,000 $2,160 2002 $364,652 $338,367 - - $4,851 A footnote to the "annual compensation" figures represented that, "[i]n accordance with the rules of the SEC, the compensation described in this table does not include ... perquisites and other personal benefits received by anynamed executive officer that in the aggregate do not exceed in any fiscal year ... $50,000...." -55- Case 1:05-cv-01563-EWN-BNB 127. Document 87 Filed 02/28/2006 Page 56 of 81 Matters up for shareholder vote in the 2005 proxy and at Red Robin' s annual shareholder meeting held on June 2, 2005 included the re-election of Messrs. Mullen and Graebel to another three year term on Red Robin's Board of Directors and Audit Committee. 128. Red Robin's, Messrs. Snyder, McCloskey and Mullen's, and Ms. Dahl's representations concerning Mr. Snyder's "Annual Compensation" for 2002 through 2004 in the 2005 proxy statement were materially false and misleading because the dollar value to Mr. Snyder ofthe perquisite of usage of Red Robin's charteredjet for personal travel under the aggregate incremental cost method required by Instruction 2 to Item 402(b)(2)(iii)(C) of Regulation S-K of the Exchange Act exceeded $50,000 for each year but was not disclosed. The defendants also failed to specifically identify by type and amount each of Mr. Snyder's perquisites that exceeded 25% of his total perquisites, and it incorrectly valued Mr. Snyder 's personal aircraft usage using the tax or SIFL method instead of using the aggregate incremental cost method required by Instruction 2 to Item 402(b)(2)(iii)(C). 129. Red Robin's Form 10-Q for the first quarter of 2005, which was signed by Mr. McCloskey and filed with the SEC on May 27, 2005, was a group-published document that involved the collective actions ofRed Robin officers, including Mike Snyder and Lisa Dahl. The first quarter of 2005 Form 10-Q contained several materially false and misleading statements, including: (A) The following representations concerning Red Robin' s internal controls: Our management conducted an evaluation, under the supervision and with the participation of our chief executive officer and chief financial officer, of the effectiveness of the Company's disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, management, under the supervision and with the participation of our chief executive officer and chief financial officer, concluded that the Company's disclosure controls and procedures were effective as of the date of such evaluation. *** During the sixteen weeks ended April 17, 2005, there were no other significant -56- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 57 of 81 changes in our internal controls over financial reporting that materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting. (B) Rule 13a-14 certifications by Messrs. Snyder and McCloskey substantially similar to those they issued in the second quarter of 2004 Form 10-Q. (C) Section 906 certifications by Messrs. Snyder and McCloskey substantially similar to those they issued in the second quarter of 2004 Form 10-Q. 130. See ¶119(B)). See ¶119(C)). The above representations by Red Robin, Messrs. Snyder and McCloskey, and Ms. Dahl in the first quarter of 2005 Form 10-Q were materially false and misleading for the reasons set forth in paragraph 121 (A) to (E) as to why the representations in the second quarter of 2004 Form 10-Q were materially false and misleading. 131. On June 20, 2005, Red Robin replaced CFO Jim McCloskey with Katie Scherping. The management change was announced on June 22, 2005. However, the June 22, 2005 announcement was materially false and misleading in that Red Robin omitted to state the material fact that Mr. McCloskey was replaced as a result of "[n]on-compliance by the ... former chief financial officer with existing policies and procedures for non-commercial aircraft usage and travel and entertainment expenses," as Red Robin stated in its Form 10-Q for the second quarter of 2005. 132. Similarly, sometime during the second quarter of 2005 (which ended on July 10th), Red Robin replaced Vice President and Controller Lisa Dahl. Item 5.02(b) ofForm 8-K concerning the disclosure of the departure of principal accounting officers, required Red Robin to disclose Ms. Dahl's termination to investors within four (4) days after the occurrence of the event. Ms. Dahl's termination was not disclosed to investors until August 19, 2005 in the Company's second quarter Form 10-Q. The Company admitted in the second quarter of 2005 Form 10-Q that Ms. Dahl's departure "will strengthen [the Company's] controls related to financial reporting." This statement -57- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 58 of 81 by the Company together with the contemporaneousness between Ms. Dahl's termination and the Company's internal investigation of travel and entertainment expenses, give rise to the reasonable and logical inference that the two events were related and timely disclosure would have been material to investors. 133. Sometime between April 22, 2005 (the date Red Robin filed its 2005 proxy) and November 11, 2005 (the date on which Taylor Simonton replaced Edward Harvey as Chairman of the Audit Committee, as disclosed in a Form 8-K filed on November 17, 2005), Edward Harvey replaced Benjamin Graebel as the Chairman of the Audit Committee. Sometime during that same period Mr. Graebel was removed from the Audit Committee altogether. Item 5.02(b) of Form 8-K concerning the disclosure ofthe departure ofdirectors, required Red Robin to disclose Mr. Graebel's removal from the Audit Committee to investors within four (4) days after the occurrence of the event. THE FIRST MAJOR DISCLOSURE OF FRAUD: Shareholders Learn That Their Chairman and CEO Wrongfully Diverted Red Robin ' s Funds With the Help of the CFO and Controller 134. After the market closed on August 11, 2005, Red Robin stunned investors when it disclosed that between 2001 and 2005 Red Robin paid for $1.25 million of personal expenses incurred by Mr. Snyder, that Mr. Snyder retired after he was confronted by the Board of Directors, and that the Company's CFO during the period in which Mr. Snyder's improper transactions occurred had resigned. In relevant part, the press release stated: Red Robin Gourmet Burgers, Inc. . . . has named restaurant industry veteran Dennis B. Mullen as the Company's Chairman and Chief Executive Officer, and elevated Eric C. Houseman to the position of President and Chief Operating Officer and Todd A. Brighton to the position of Senior Vice President and ChiefDevelopment Officer. The Company also announced the retirement of Michael J. Snyder as Chairman of the Board, Chief Executive Officer and President. Mr. Snyder will serve as a consultant to the Company and Mr. Mullen. -58- Case 1 : 05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 59 of 81 *** The company also announced the resignation of Senior Vice President, James P. McC los key. These management and governance changes follow an internal investigation conducted by a special committee ofthe Company's board of directors relating to use of chartered aircraft and travel and entertainment expenses. The special committee, which retained independent counsel to conduct the investigation, identified various expenses by Mr. Snyder that were inconsistent with Company policies or that lacked sufficient documentation. Mr. Snyder has agreedto reimburse the Company for such expenses following completion ofthe special committee's review. The Companyhas notified the Securities and Exchange Commission of the internal investigation. In reaction to the announcement, Red Robin's common stock plummeted on August 12, 2005, closing at $45.55 per share, approximately 24% below the prior day closing price of $59.79. Desperate To Re-Build Red Robin's Credibility & Ease Shaken Investors, The Replacement Executives Conceal Internal Control Deficiencies and Provide Investors False and Misleading Earnings Guidance 135. On August 11, 2005, Red Robin issued another press release in which it reported financial results for the second quarter of 2005. The Company reported total revenues of $114.1 million and net income of $0.45 per share. In the press release, Red Robin also guided investors that for the third quarter of 2005 the Company expects total revenues of approximately $113 to $115 million and net income of approximately $0.28 to $0.30 per share, based upon expected comparable restaurant sales increase of 2.0% to 3.0%. With respect to full-year 2005 results , the Company guided that it expected revenues of approximately $487 to $491 million and net income of $1.64 to $1.67 per share, based on an expected comparable restaurant sales increase of 4% to 5%.3 Denny Mullen reiterated the third quarter and full-year 2005 guidance on Red Robin's investor conference call held on August 11, 2005. Katie Scherping was also on the conference call. ' Red Robin explained that the projections for the third quarter of 2005 and for full-year 2005 included approximately $2.8 million ($1.8 million net of tax) or approximately $0.11 per share related to the recognition of a $1.8 million stock compensation cost, net of tax, for stock options granted to Messrs Snyder in McCloskey in 2000. -59- Case 1:05-cv-01563-EWN-BNB 136. Document 87 Filed 02/28/2006 Page 60 of 81 The voluntary guidance Red Robin, Ms. Scherping and Mr. Mullen provided investors on August 11, 2005 was materially false and misleading for the following reasons: (A) The Company' s internal controls regarding workers' compensation were deficient and Red Robin was not "closely monitoring" its workers' compensation liability as evidenced by the need to take a staggering $0.03 per share or $750,000 "true-up adjustment" in the fourth quarter of 2005. (B) On the February 16, 2006 conference call, Ms. Scherping attributed $0.02 of the disparity between the November 2005 fourth quarter earnings forecast and the actual results to higher than expected supplies and utilities expense. Ms. Scherping explained that Red Robin had to purchase a higher volume of supplies than the amount that was factored into the fourth quarter earnings forecast . This explanation indicates that Red Robin, contrary to its stated accounting policies, recognized supplies expense as the supplies were purchased and put into inventory rather than when the supplies were actually used by its restaurants. (C) Red Robin had no system in place to prevent non-employees from obtaining complimentary food and beverages through employee meal cards and the employee free meal and discount policy. (D) Red Robin's internal controls regarding supplies expenses were deficient as evidenced by information provided by a former member of Red Robin's accounting staff that the Company never audited or took a physical inventory of its California warehouse which stored supplies for restaurants and consequently "the amount of inventory in the California warehouse was always less than it should have been." The fact that Red Robin, as acknowledged by Ms. Scherping on the February 16, 2006 conference call, was forced to purchase an increased volume of supplies at the same time it reported lower than expected sales for its restaurants further evidences that -60- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 61 of 81 internal controls were deficient because: (i) use of supplies (and correspondingly the recording of expense) parallels or runs in tandem with sales ; and (ii) the Company would have been easily able to discern what its cash outlay was for supplies based on historical traffic at established restaurants (E) Red Robin's internal controls were deficient as evidenced by the fact that on the January 10, 2006 investor conference call, Denny Mullen admitted that the Company was unable to currently explain which specific restaurant operating expenses caused the giant disparitybetween actual and forecasted earnings. (F) On the February 16, 2006 conference call, Ms. Scherping attributed $0.02 of the disparity between the November 2005 fourth quarter earnings forecast and the actual results to higher than expected supplies and utilities expense. Mr. Mullen and Ms. Scherping failed to ensure that the forecast adequately took into account the impact record oil prices would have on its supplies expense and utilities expense. (G) Taking the allegations set forth herein in their totality, there is a strong inference that the replacement executives reached their earnings target for the third quarter of 2005 by not recording accrued workers' compensation liability expenses and supplies expenses and pushing the expenses into the fourth quarter of 2005. 137. Red Robin's Form 10-Q for the second quarter of 2005, which was signed by Ms. Scherping and filed with the SEC on August 19, 2005, was a group-published document that involved the collective actions of Red Robin officers, including Denny Mullen. The second quarter of 2005 Form 10-Q contained several materially false and misleading statements, including: (A) The following representation concerning internal controls: Our management conducted an evaluation, under the supervision and with the participation of our current chief executive officer and chief financial officer, of the effectiveness of the Company's disclosure controls and procedures as of the end of -61- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 62 of 81 the period covered by this report. Based upon the evaluation, management concluded that our disclosure controls and procedures were effective.... *** During the twelve weeks ended July 10, 2005, we replaced our chieffinancial officer and controller. In addition, we added a new director of corporate accounting. These individuals have extensive experience related to the application ofgenerally accepted accounting principles and Securities and Exchange Commission rules and regulations as they pertain to financial reporting. We believe these personnel changes will strengthen our controls related to financial reporting. Other than these changes and additions to personnel, there have been no other changes to our internal controls over financial reporting during the twelve weeks ended July 10, 2005 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting. (B) Rule 13a-14 certifications by Mr. Mullen and Ms. Scherping substantially similar to those issued by Messrs. Snyder and McCloskey in the second quarter of 2004 Form 10-Q see ¶119(B)) along with the following additional representation: 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15(a)-15(f)) for the registrant and have: *** b. Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. (C) Section 906 certifications by Mr. Mullen and Ms. Scherping substantially similar to those issued by Messrs. Snyder and McCloskey in the second quarter of 2004 Form 10-Q. See ¶119(C)). (D) The representation that the Company's self-insured workers' compensation liability is "closely monitored and adjusted when warranted by changing circumstances." (E) The incorporation by reference ofthe Significant Accounting Policies setforth in the 2004 Form 10-K which states that the Company treats supplies as a component of inventory -62- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 63 of 81 for financial reporting purposes. 138. The above representations by Red Robin, Mr. Mullen and Ms. Scherping in the second quarter of 2005 Form 10-Q were materially false and misleading for the same reasons set forth in paragraph 136 (A) to (G) as to why the earnings guidance provided to investors on August 11, 2005 was materially false and misleading. 139. On September 14, 2005, Red Robin issued a press release in which the company updated previous guidance for the third quarter of 2005 and full-year 2005 to include in net income projections the $0 . 05 per share increase attributable to the pre-tax gain of $1.25 million related to Mr. Snyder' s reimbursement to the Company. Thus, for the third quarter of 2005, Red Robin instructed investors that it continues to expect total revenues of approximately $113 to $115 million and net income of approximately $0.33 to $0.35 per share, based upon an expected comparable restaurant sales increase of approximately 2.0%. With respect to full-year 2005, the Company guided that it continued to expect revenues of approximately $487 to $491 million and net income of $1.69 to $1.72 per diluted share, based upon an expected comparable restaurant sales increase of 4.0% to 4.5%. 140. The voluntary guidance Red Robin, Ms. Scherping and Mr. Mullen provided investors on September 14, 2005 was materially false and misleading for the same reasons set forth in paragraph 136 (A) to (G) as to why the earnings guidance provided investors on August 11, 2005 was materially false and misleading. 141. On November 3, 2005, Red Robin issued a press release announcing financial results for the third quarter 2005. The Company reported total revenues of $114.2 million and net income of $0.39 per share. In addition, the Company announced that, as expected, it had opened four (4) new company-owned restaurants and that comparable restaurant sales for company-owned -63- Case 1:05-cv-01563-EWN-BNB restaurants increased 2.1%. Document 87 Filed 02/28/2006 Page 64 of 81 In the press release, Red Robin represented to investors that the Company expected fourth quarter of 2005 total revenues of approximately $118 to $119.5 million and earnings of approximately $0.40 to $0.41 per share, based upon an expected comparable restaurant sales increase of 3.0% to 4.0% and the opening of eleven (11) new company-owned restaurants during the quarter. With respect to full-year 2005 results , the Company guided that it expected revenues of approximately $487.5 to $489 million and net income of $1.71 to $1.73 per share per share, based on an expected comparable restaurant sales increase of 4.0% andthe addition of twenty-six (26) new corporate restaurants and seventeen (17) to nineteen (19) new franchise restaurants during fiscal 2005. Ms. Scherping reiterated the same fourth quarter and full-year 2005 guidance on Red Robin's investor conference call held on November 3, 2005. Mr. Mullen was also on the conference call. 142. Following the announcement of Red Robin's third quarter results and the issuance of materially false and misleading guidance for the fourth quarter of 2005, shares of Red Robin common stock increased 10%, closing at $51.94 on November 4th 143. The voluntary guidance Red Robin, Ms. Scherping and Mr. Mullen provided investors on November 3, 2005 was materially false and misleading for the same reasons set forth in paragraph 136 (A) to (G) as to why the earnings guidance provided investors on August 11, 2005 was materially false and misleading as well as for the following reasons: (H) On the February 16, 2006 conference call, Ms. Scherping admitted that the Company's fourth quarter 2005 sales forecast for new restaurants in new markets was overly aggressive as she explained that the Company decided to go with sales volume only 5% lower than the average volume for comp units rather than the historically used 10% reduction because "[w]e were kind of using our optimistic view of what had happened [in the] previous three quarters of the -64- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 65 of 81 year, which was pretty heavily weighted to the existing markets and ran closer to 95%." (I) Three (3) ofthe nine (9) restaurants opened in the fourth quarter were opened in what Red Robin refers to as "greenfield areas," or areas where the restaurant opens before development of an adjacent shopping center is complete. Although these restaurants generate even smaller sales than new restaurants opened in new markets, Red Robin failed to factor the decreased sales into its fourth quarter earnings forecast. 144. Red Robin's Form 10-Q for the third quarter of 2005, which was signed by Ms. Scherping and filed with the SEC on November 4, 2005, was a group-published document that involved the collective actions of Red Robin officers, including Denny Mullen. The third quarter of 2005 Form 10-Q contained several materially false and misleading statements, including: (A) The following representation concerning internal controls: Our management conducted an evaluation, under the supervision and with the participation of our current chief executive officer and chief financial officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based upon the evaluation, management concluded that our disclosure controls and procedures were effective.... *** There have been no changes to our internal controls over financial reporting during the twelve weeks ended October 2, 2005 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting, except as described above. (B) Rule 13a-14 certifications by Mr. Mullen and Ms. Scherping similar to those they issued in the second quarter of 2005 Form 10-Q. See ¶137(B)). (C) Section 906 certifications by Mr. Mullen and Ms. Scherping similar to those issued by Messrs. Snyder and McCloskey in the second quarter of 2004 Form 10-Q. (See ¶119(C)). (D) The representation that the Company's self-insured workers' compensation liability is "closely monitored and adjusted when warranted by changing circumstances." (E) The incorporation by reference ofthe Significant Accounting Policies set forth -65- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 66 of 81 in the 2004 Form 10-K, which states that the Company treats supplies as a component of inventory for financial reporting purposes. 145. The above representations by Red Robin, Ms. Scherping and Mr. Mullen in the third quarter of 2005 Form 10-Q were materially false and misleading for the same reasons set forth in paragraph 143 (A) to (I) as to why the earnings guidance provided to investors on November 3, 2005 was materially false and misleading. 146. In reaction to the third quarter of2005 Form 10-Q, the materially false and misleading earnings and revenue forecast for the fourth quarter 2005, and positive comments from stock analysts, shares of Red Robin common stock increased 10% on November 4'h, closing at $51.94. THE SECOND MAJOR DISCLOSURE OF FRAUD: The Replacement CEO and CFO Are Forced To Drastically Reduce Their Baseless Guidance 147. Before the market opened on January 10, 2006, Red Robin stunned investors after warning that fourth quarter 2005 earnings and revenue guidance issued just two months earlier on November 3rd was too high and that the actual results were now expected to be at least 20% lower than the low-end ofthe earlier guidance. More specifically, the Company lowered earnings guidance from $0.40-$0.41 to $0.29-$0.32. The Company also lowered its guidance for fourth quarter revenues to $116.5 million from management's November 3, 2005 guidance of $118 million to $119.5 million. The press release iss ued by management provided a vague explanation for the huge earnings miss: The lower than expected revenues in the fourth quarter will result in a de-leveraging of fixed costs and impact the Company's earnings in the fourth quarter. In addition, certain restaurant operating expenses were higher than expected during the fourth quarter of 2005.... The Company held an investor conference call on January 10th to discuss the earnings guidance shortfall. Denny Mullen and Katie Scherping hosted the call. Much to the alarm of the stock -66- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 67 of 81 analysts on the call, Mr. Mullen stated that the Company was unable to explain the reasons for the large discrepancy between preliminary fourth quarter results and the November 3rd forecast. In response to a question from an analyst for Oppenheimer & Co., Mr. Mullen attributed the miss to higher restaurant operating expenses in the quarter but said he couldn't get anymore specific as to what the higher expenses were. 148. After the stunning revelation, the Company's common stock plummeted to as low as $37.12 on January 10, 2006, approximately 29% lower than the closing price on January 9th of $51.98. III. ADDITIONAL SCIENTER ALLEGATIONS 149. As represented in Red Robin's SEC filings throughout the Class Period, Mike Snyder, Jim McCloskey, Denny Mullen and Katie Scherping supervised and participated in an evaluation of "the effectiveness of the Company's disclosure controls and procedures as of the end of [each reporting] period covered." 150. As the officers certified in Rule 13a-14 certifications filed with the SEC as part of Red Robin's financial statements throughout the Class Period, Messrs. Snyder, McCloskey and Mullen and Ms. Scherping were responsible fore establishing and maintaining disclosure controls and procedures. 151. Messrs. Snyder, McCloskey and Mullen and Ms. Dahl each would have been intimately familiar with the Company's Code of Ethics which prohibits the conduct in which they engaged. These long time Red Robin executives and directors would have been involved in the establishment, review and enforcement of the Code of Ethics. 152. Mr. Snyder's unauthorized personal useofRedRobin's chartered chartered-j et for personal use without reimbursing the Company violated his employment agreement with Red Robin which he -67- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 68 of 81 negotiated, reviewed and signed. 153. Snyder approved improper travel and entertainment expense reports for other executives. (See ¶43). 154. Snyder was confronted about use of company funds to pay for personal expenses on several occasions: (i) during the Snyder Group Acquisition; (ii) after purchasing a Rolex for Bob Merullo; (iii) numerous warnings by McCloskey, who did took no further action. 155. See ¶145-46). "Because so many people were not complying with Red Robin's policies regarding travel and entertainment expenses," in the Summer of 2003, a memo outlining Red Robin's travel and expense reimbursement policies was distributed to all employees, and each employee had to acknowledge with a signature having received and reviewed the guidelines. Even after the new policy was put in place, employees, including officers, continued the same improperpractices. See ¶55). 156. Accounts payable specialists directly took concerns about improper expense reports directly to Ms. Dahl. Most of the deficient reimbursement requests would be sent back to the staff accountants by Ms. Dahl as approved for payment. 157. See ¶54). For each year from 2003 to 2005, Mr. Snyder would have had to sign annual director and officer questionnaires used to prepare Red Robin's 2003, 2004 and 2005 proxy statements that failed to identify or quantify various perquisites. 158. Red Robin has acknowledged that Mr. Snyder diverted $1.25 million of company funds to pay for personal expenses and the improper practice had been going on since 2001. The magnitude and duration of the recurring improper transactions creates an inference that Messrs. Snyder and McCloskey and Ms. Dahl had knowledge of the abuse. 159. As a member of Red Robin's Audit Committee until August 2005, Denny Mullen, -68- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 69 of 81 as stated in the Audit Committee Charter, had the following responsibilities: • In consultation with the independent auditors and the Company' s financial and accounting personnel, review the integrity, adequacy and effectiveness of the Company's accounting and financial controls , both internal and external , and elicit any recommendations for the improvement of such internal control procedures or particular areas where new or more detailed controls or procedures are desirable. • Monitor the Company's compliance with a code of conduct or ethics as required by applicable law or exchange listing standards and covering the conduct and ethical behavior of directors, executive officers and employees. Review and recommend to the Board action on any waivers of any portion of the code of ethics requested by any executive officer or director. 160. Upon taking over as CEO/Chairman, Mr. Mullen received an option to purchase 100,000 shares of Red Robin common stock at $45.79. 161. According to Red Robin's 2005 proxy, Mike Snyder was the Company's second largest shareholder owning 9.5 % of the shares outstanding or 1,535, 802 shares . Mr. McCloskey and Mr. Mullen, according to the same report, owned 137,266 shares and 9,000 shares of Red Robin common stock, respectively. CLASS ACTION ALLEGATIONS 162. Lead Plaintiff brings this action as a class action pursuant to Federal Rules of Civil Procedure 23(a) and 23(b)(3) on behalf of a class of all persons who purchased Red Robin common stock during the period from August 13, 2004 to January 9, 2006 inclusive, and who were damaged thereby. Excluded from the Class are: Red Robin; the Individual Defendants named herein; members of the immediate families of the Individual Defendants; any parent, subsidiary, affiliate, officer, or director of defendant Red Robin; any entity in which any excluded person has a controlling interest ; and the legal representatives , heirs , successors and assigns of any excluded person. 163. The members of the Class are so numerous that joinder of all members is -69- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 70 of 81 impracticable. While the exact number of Class members is unknown to Lead Plaintiff at the present time and can only be ascertained from books and records maintained by Red Robin and/or its agent(s), Lead Plaintiff believes that there are, at a minimum, hundreds of members of the Class located throughout the United States. Throughout the Class Period, Red Robin had approximately 16.4 million shares of common stock outstanding, which were actively traded on the NASDAQ National Market in an efficient market. 164. Lead Plaintiff will fairly and adequately represent and protect the interests of the members of the Class. Lead Plaintiff has retained counsel who is competent to conduct and experienced in class action and securities litigation. Lead Plaintiff intends to prosecute this action vigorously. Lead Plaintiff is a member of the Class and does not have interests antagonistic to or in conflict with the other members ofthe Class. 165. Lead Plaintiff's claims are typical of the claims of the members of the Class. Lead Plaintiff and all members of the Class purchased Red Robin common stock during the Class Period at artificially inflated prices and have sustained damages arising out of the same wrongful course of conduct. 166. 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 and omissions as alleged herein; (B) Whether defendants participated in and pursued the common course of conduct and fraudulent scheme complained of herein; (C) Whether the documents, reports, filings , releases and statements disseminated -70- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 71 of 81 to the investing public during the Class Period misrepresented material facts about Red Robin, its key officers, and its operations; (D) Whether defendants acted knowingly orrecklesslyin misrepresenting material (E) Whether the market price ofRed Robin common stock during the Class Period facts; was artificially inflated due to the misrepresentations complained of herein; and (F) Whether Lead Plaintiff and the other members of the Class have sustained damages and, if so, the appropriate measure thereof. 167. A class action is superior to other available methods for the fair and efficient adjudication of this controversy since, among other things, joinder of all members of the Class is impracticable. Furthermore, as the damages suffered by individual Class members may be relatively small, the expense and burden of individual litigation make it virtually impossible for many Class members individually to seek redress for the wrongful conduct alleged. Lead Plaintiff does not foresee any difficulty in the management of this litigation that would preclude its conduct as a class action. APPLICABILITY OF THE FRAUD-ON-THE-MARKET DOCTRINE 168. Plaintiffs will rely, in part, upon the presumption ofreliance established by the fraud- on-the-market doctrine, in that, among other things: (A) Defendants made public misrepresentations and/or failed to disclose material facts during the Class Period; (B) The omissions and misrepresentations were material; (C) Red Robin common stock traded in an efficient market at all relevant times in that: (i) during the Class Period there was a cause and effect relationship between unexpected -71- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 72 of 81 corporate events or financial releases, including the two major disclosures of fraud on August 11, 2005 and January 10, 2006, and an immediate response in the stock price; (ii) the Company is eligible to file, and indeed files, S-3 Registration Statements in connection with public offerings of securities; (iii) Red Robin is coveredby several securities analysts, including, but not limited to, Bear Stearns & Co., Wachovia Securities, Oppenheimer & Co., Bank of America Securities, Standard & Poor's, Matrix Research, Morgan Keegan & Co., Friedman Billings Ramsey, Thomas Weisel Partners, McAdams Wright Ragen, BB&T Capital Markets, KeyBanc Capital Markets, CIBC World Markets, and Piper Jaffray; and (iv) the trading volume for the security is significant, as the average daily trading volume exceeds 550,000 shares. (D) The misrepresentations alleged would tend to induce a reasonable investor to misjudge the value of Red Robin common stock; and (E) Lead Plaintiff and the other members of the Class purchased Red Robin common stock between the time the defendants failed to disclose or misrepresented material facts and the time the true facts were disclosed, without knowledge ofthe omitted or misrepresented facts. 169. Based upon the foregoing, Lead Plaintiff and other members of the Class are entitled to a presumption of reliance upon the integrity of the market for, at least, the purpose of class certification, as well as for the ultimate proof of their claims on the merits. Lead Plaintiff will also rely, in part, upon the presumption of reliance related to a material omission. 170. The names and addresses of the record owners of the shares of Red Robin common stock purchased during the Class Period are available from Red Robin and/or its transfer agent(s). Notice can be provided to purchasers of Red Robin common stock by a combination of published notice and first class mail using techniques and forms of notice similar to those customarily used in class actions arising under the federal securities laws. -72- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 73 of 81 UNDISCLOSED ADVERSE INFORMATION 171. The market for Red Robin common stock was open, well-developed and efficient at all relevant times. As a result of the materially false and misleading statements and failures to disclose alleged herein, Red Robin common stock traded at artificially inflated prices during the Class Period. The artificial inflation continued until August 11, 2005 when Red Robin acknowledged having severe internal control deficiencies and disclosed that its Chairman/CEO, Mike Snyder, with the aid of CFO, Jim McCloskey , and Controller, Lisa Dahl, wrongfully diverted or appropriated corporate assets. Red Robin shares further deflated on January 10, 2006 when the announced that actual fourth quarter 2005 financial results would be significantly lower than what Denny Mullen and Katie Scherping had forecasted in November without being able to explain what caused the huge miss, revealing that the replacement executives provided forecasts despite knowing that internal control deficiencies made the forecasts unreliable and inaccurate. These disclosures were communicated to, and/or digested by, the securities markets. Lead Plaintiff and other members of the Class purchased or otherwise acquired Red Robin common stock relying upon the integrity of the market price of Red Robin common stock and market information relating to Red Robin, and have suffered damages. 172. During the Class Period, defendants materially misled the investing public, thereby inflating the price of Red Robin common stock, by publicly issuing false and misleading statements and omitting to disclose material facts necessary to make defendants' statements, as set forth herein, not false and misleading. These statements and omissions were materially false and misleading in that they failed to disclose material adverse information and misrepresented the truth about the Company, its key officers, and its operations. 173. At all relevant times , the material misrepresentations and omissions particularized -73- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 74 of 81 in this Complaint directly or proximately caused or were a substantial contributing cause of the damages sustained by Lead Plaintiff and other members of the Class. As described herein, during the Class Period, defendants made or caused to be made a series of materially false or misleading statements about the Company, its key officers, and its operations. These material misstatements and omissions had the effect of creating in the market an unrealistically positive assessment of Red Robin, its key officers, and its operations, thus causing the Company's common stock to be overvalued and artificiallyinflated at all relevant times. Defendants' materially false and misleading statements during the Class Period resulted in Lead Plaintiff and other members of the Class purchasing the Company's common stock at artificially inflated prices. After the market learned that the statements were false and misleading the value of Red Robin common stock dropped significantly, causing the damages complained ofherein. COUNT I Against the Individual Defendants and Red Robin for Violation of Section 10(b) of the Exchange Act and Rule 10b-5 174. Lead Plaintiff repeats and realleges each and every allegation contained in the preceding paragraphs as if set forth in full herein. 175. This Count is asserted against the Individual Defendants and Red Robin and is based upon Section 10(b) of the Securities Exchange Act, 15 U.S.C. § 78j (b), and Rule IOb-5 promulgated thereunder by the SEC. 176. During the Class Period, defendants, singly and in concert, directly or indirectly, engaged in a common plan, scheme, and unlawful course of conduct pursuant to which they knowingly or recklessly engaged in acts, transactions, practices, and courses of business which operated as a fraud and deceit upon Lead Plaintiff and the other members of the Class, and made various deceptive and untrue statements of material facts and omitted to state material facts -74- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 75 of 81 necessary in order to make the statements made, in light ofthe circumstances under which they were made, not misleading to Lead Plaintiff and the other members of the Class. The purpose and effect of the scheme, plan, and unlawful course of conduct was, among other things, to induce Lead Plaintiff and the other members of the Class to purchase Red Robin common stock during the Class Period at artificially inflated prices. 177. During the Class Period, defendants, pursuant to such scheme, plan, and unlawful course of conduct, knowingly and recklessly issued, caused to be issued and participated in the preparation and issuance ofdeceptive and materially false and misleading statements to the investing public which were contained in or omitted from various documents and other statements, as particularized above. 178. Defendants each knew the facts set forth herein and intended to deceive Lead Plaintiff and the other members of the Class, or in the alternative, acted with reckless disregard for the truth when they failed to ascertain and disclose or cause the disclosure of the true facts to Lead Plaintiff and the other members of the Class. 179. The facts alleged herein compel a strong inference that defendants made materially false and misleading statements to the investing public with scienter, in that the defendants knew that the public statements issued or disseminated in the name of the Company were materially false and misleading; knew or recklessly disregarded that such statements would be issued or disseminated to the investing public; and knowingly and substantially participated or acquiesced in the issuance or dissemination of such statements as primary violations of the federal securities laws. 180. As a result of the dissemination of the false and misleading statements set forth above, the market price ofRed Robin common stock was artificially inflated during the Class Period. In ignorance of the false and misleading nature of the representations described above and the -75- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 76 of 81 deceptive and manipulative devices and contrivances employed by defendants, Lead Plaintiff and the other members ofthe Class relied to their detriment on the integrity of the market price of the securities in purchasing Red Robin common stock. Had Lead Plaintiff and the other members of the Class known of the materially adverse information misrepresented or not disclosed by defendants, they would not have purchased Red Robin common stock at the artificially inflated prices they did. 181. As a result ofthe inflation of the prices of Red Robin common stock during the Class Period caused by defendants' material misrepresentations and omissions , Lead Plaintiff and the other members of the Class have suffered substantial damages as a result of the wrongs alleged. 182. By reason of the foregoing, defendants violated the Exchange Act and Rule I Ob-5 promulgated thereunder in that they: (A) employed devices , schemes, and artifices to defraud; (B) made untrue statements of material facts or omitted to state material facts necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; and/or (C) engaged in acts, practices, and a course ofbusiness which operated as a fraud and deceit and a scheme to defraud upon Lead Plaintiff and the other members of the Class in connection with their purchases of Red Robin common stock during the Class Period. 183. 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 such 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 provisions of the SEC as embodied in SEC Regulation S-X (17 C.F.R. § 210.01 et. seq.), Regulation S-K (17 C.F.R. §§ 229.10 et. seq.) and other SEC regulations, including accurate and truthful information with -76- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 77 of 81 respect to the Company's operations, financial condition and earnings so that the market price of the Company's common stock would be based on truthful, complete and accurate information. COUNT II Violations by Michael Snyder, James McCloskey, Dennis Mullen, Lisa Dahl and Red Robin of Section 14(a) of the Exchange Act and Rules 14a-3 and 14a-9 Thereunder 184. Section 14(a) of the Exchange Act requires registrants that solicit any proxy or consent or authorization in connection with any security registered pursuant to Section 12 of the Exchange Act (other than an exempted security), to comply with such rules as the SEC may promulgate. Rule 14a-3 provides that no solicitation of a proxy may occur unless each person solicited is concurrently furnished or has previously been furnished with a proxy statement containing the information specified in Schedule 14A. Rule 14a-9 prohibits, among other things, the use of proxy statements which omit to state any material fact necessary in order to make the statements therein not false or misleading. 185. Messrs. Snyder and McCloskey, Ms. Dahl and Red Robin were required to fully and accurately disclose Mr. Snyder's perquisites. Item 11 ofForm 10-K requires that registrants furnish the information required by Item 402 of Regulation S-K. Similarly, Item 8 of Schedule 14A, captioned "Compensation of Directors and Executive Officers," requires that registrants set forth in the proxy statement the information required by Item 402 of Regulation SK if action is to be taken with respect to, among other things , election of directors. Item 402 of Regulation S-K sets forth the required disclosures with respect to executive compensation. The underlying purpose of the Item 402 disclosures is "to improve shareholders' understanding of all forms of compensation paid to senior executives and directors." Securities Act Release No. 6962, Executive Compensation -77- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 78 of 81 Disclosure (Oct. 16, 1992). Proxy disclosures with respect to executive compensation "enhance shareholders' ability to assess how well directors are representing their interests." Id. 186. Item 402(b) of Regulation S-K requires disclosure of perquisites . Disclosure is required for named executive officers when the value of "perquisites and other personal benefits, securities or property" exceeds the lesser of $50,000 or 10% of the total annual salary and bonus reported for the executive. Two types of disclosures are required for each executive: (1) the total dollar amount of the perquisites must be included in the summary compensation table; and (2) an additional footnote disclosure is required to specifically identify "by type and amount" each perquisite that exceeds 25% of the total perquisites reported for the executive. 187. In proxy statements filed for fiscal years 2004 to 2005, Messrs. Snyder and McCloskey, Ms. Dahl and Red Robin omitted from disclosure information about personal benefits and perquisites provided to Mr. Snyder and otherwise failed to comply with Item 402(b). In addition, during this period, Red Robin and Messrs. Snyder and McCloskey failed to disclose more than $1.25 million in perquisites due to internal control failures. Red Robin also failed to specifically identify by type and amount each of Mr. Snyder's perquisites that exceeded 25% of his total perquisites, and it incorrectly valued Mr. Snyder' s personal aircraft usage using the tax or SIFL method instead of using the aggregate incremental cost method required by Instruction 2 to Item 402(b)(2)(iii)(C). COUNT III Against the Individual Defendants for Violation of Section 20(a) of the Exchange Act 188. Lead Plaintiff repeats and realleges each and every allegation contained in the preceding paragraphs as if set forth fully herein. 189. The Individual Defendants, by virtue of their offices and specific acts described -78- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 79 of 81 above, were, at the time of the wrongs alleged herein, controlling persons of Red Robin and all of its responsible employees within the meaning of Section 20(a) of the Exchange Act 190. The Individual Defendants had the power and influence and exercised the same to cause Red Robin's employees to engage in the improper conduct andpractices complainedof herein, and declined to exercise their authority to prevent Red Robin and its employees from engaging in the improper conduct and practices complained of herein. 191. By reason of the conduct alleged in Counts I and II, the Individual Defendants are liable for the aforesaid wrongful conduct, and are liable to Lead Plaintiff and to the other members of the Class for the substantial damages which they suffered in connection with their purchases of Red Robin common stock during the Class Period. JURY DEMAND Lead Plaintiff demands a trial by jury on all issues. WHEREFORE , Lead Plaintiff prays for relief and judgment as follows: (A) Determining that this action is aproper class action, certifying Lead Plaintiff as class representative under Rule 23 of the Federal Rules of Civil Procedure, and Lead Counsel as class counsel; (B) Awarding compensatory damages in favor of Lead Plaintiff and the other members of the Class against all defendants, jointly and severally, for all damages sustained as a result of defendants' wrongdoing, in an amount to be proven at trial, together with interest thereon; (C) Awarding Lead Plaintiff and the Class their costs and expenses incurred in this action including a reasonable allowance of fees for Lead Counsel and experts, and reimbursement of Lead Plaintiffs expenses; and (D) Granting such other and further relief as the Court may deemjust and proper. -79- Case 1:05-cv-01563-EWN-BNB Dated: February 28, 2006 Document 87 Filed 02/28/2006 Page 80 of 81 Respectfully submitted, BADER & ASSOCIATES, LLC s/ Renee B. Taylor Gerald L. Bader, Jr. Renee B. Taylor 14426 East Evans Avenue, Suite 200 Denver, CO 80014 Tel: (303) 534-1700 Local Counsel Sherrie R. Savett Casey M. Preston BERGER & MONTAGUE, P.C. 1622 Locust Street Philadelphia, PA 19103 Tel: (215) 875-3000 Lead Counselfor the City ofPhiladelphia Board of Pensions and Retirement and the Class ADDRESS OF LEAD PLAINTIFF: The City of Philadelphia Board of Pensions and Retirement Two Penn Center Plaza, 16' Floor Philadelphia, PA 19102-1721 CERTIFICATE OF SERVICE I hereby certify that on February 28, 2006, I electronically filed the foregoing with the Clerk of Court using the CM/ECF system which will send notification of such filing to the following email addresses: Karen Jean Cody-Hopkins kcody-hopkins(aD,lilleygarciacom rcosioc lilleygarcia.com Charles Walter Lilley clilleyc lilleygarcia.com -80- Case 1:05-cv-01563-EWN-BNB Document 87 Filed 02/28/2006 Page 81 of 81 F. James Donnelly f amesdonnellv(comcast.net Coates Lear Clear&hhlaw.com RJPacheco&hhlaw.com ecfnotices&hhlaw.com James E. Nesland neslandje &cooley.com foutsdlC cooley.com inghramjlc cooley.com Paul Howard Schwartz schwartzphC cooley.com inghramjlc cooley.com vrushC cooley.com coliti atg ions cooley.com Andrew Ryan Shoemaker arshoemaker&hhlaw.com tlfry&hhlaw.com ecfnotices&hhlaw.com Kip Brian Shuman KshumanC DyerShuman .com lcrisswell C dyershuman.com Jeffrey Allen Smith j smithlC cooley.com foutsdlC cooley.com inghramjlc cooley.com Pamela G. Smith t amela.smithC kattenlaw.com cvnthia.jukovichC kattenlaw.com Jeffrey Alan Springer jspringer@springer-and-steinberg.com law@springer-and-steinberg.com Thomas Lee Strickland tlstricklandC hhlaw.com kddarlingc hhlaw.com Marc M. Umeda umeda(,ruflaw.com zimmer(cr^,ruflaw.com Rachel M. Vorbeck rachel.vorbeckC kattenlaw.com christine.lymanC kattenlaw.com s/ Colette Poopel Colette Poeppel -81-