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July 27, 1992



The opinion of the court was delivered by: CONSTANCE BAKER MOTLEY


Plaintiffs brought this suit as a securities class action on behalf of all persons, other than defendants, who purchased the common stock of defendant AnnTaylor Stores Corporation ("AnnTaylor" or the "Company") in its May 16, 1991 Initial Public Offering ("IPO") and thereafter, through October 22, 1991 inclusive (the "Class Period"). (PP 1, 31). *fn1" Plaintiffs are several individuals and corporate entities who were allegedly damaged by their purchases during the Class Period. (PP 14-22). On April 14, 1992, plaintiffs filed a Second Consolidated and Amended Class Action Complaint (the "Complaint").

 On May 4, 1992, AnnTaylor and defendants Merrill Lynch & Co., Inc. ("ML & Co."), Joseph E. Brooks and Thomas H.K. Brooks filed a motion to dismiss the Complaint pursuant to Rules 12(b)(6) and 9(b) of the Federal Rules of Civil Procedure for failure to state a claim upon which relief can be granted and failure to plead fraud with the requisite particularity. Defendant Merrill Lynch, Pierce, Fenner & Smith Inc. ("MLPF&S"), which is named solely in Count I of the complaint, filed its own motion to dismiss which adopts, in pertinent part, the arguments of the other defendants.

 After briefing, the court held argument on June 12, 1992. On June 25, 1992, the court filed an Order denying defendants' motions. This Opinion sets forth the court's rationale for that Order.

 I. Background2

 A. The defendants.

 AnnTaylor is a Delaware corporation with its executive offices in New York City. (P 23). Through its wholly owned subsidiary, AnnTaylor, Inc., AnnTaylor is a leading specialty retailer of better-quality women's apparel, shoes and accessories. (P 23). As of November 2, 1991, AnnTaylor operated 200 stores in 36 states and the District of Columbia. (P 23).

 Joseph Brooks was the Chairman and Chief Executive Officer of AnnTaylor during the Class Period. (P 24). AnnTaylor announced in November 1991 that Joseph Brooks would retire. (PP 26, 85). He was succeeded on January 31, 1992 by Sally Frame Kasaks. (P 86).

 Thomas Brooks, the son of Joseph Brooks (together, the "individual defendants"), was president, Chief Operating Officer and a director of AnnTaylor during the Class Period. (P 27). His resignation from AnnTaylor was announced on October 15, 1991. (P 27).

 ML & Co., through its subsidiary Merrill Lynch Capital Partners, Inc. ("ML Capital Partners") and other affiliates, owns about 59.0% of AnnTaylor's common stock. (P 29). Three representatives of ML Capital partners are on AnnTaylor's board of directors. (P 29).

 MLPF&S is an underwriting and securities brokerage firm. (P 30). MLPF&S was one of the two lead underwriters in the IPO and is an affiliate of ML & Co. (PP 30, 56).

 B. The February 1989 buy-out.

 C. AnnTaylor's relationship with Joan & David

 Prior to 1990, all shoes sold in AnnTaylor stores were sold by non-party Joan & David Helpern, Inc. ("Joan & David"), whose shoes retail for $ 150-$ 300 a pair. (P 44). Joan & David's relationship with AnnTaylor went back roughly twenty five years. (P 44). Joan & David had a License Agreement with AnnTaylor whereby AnnTaylor received a fee equal to a fixed percentage of Joan & David's net sales. Prospectus at 26.

 After the buy-out, the business relationship between AnnTaylor and Joan & David soured. (PP 49-50). In December 1989, AnnTaylor announced the introduction in March 1990 of its new private label line of footwear into 50 of its then-139 stores. (P 51). The line of shoes would retail for $ 85-$ 100 a pair and be displayed separately from Joan & David shoes. (P 51). Three months later, Joan & David sued AnnTaylor to enjoin the Company from interfering with its business. (P 52). To settle the litigation, Joan & David agreed to close its leased shoe departments in AnnTaylor stores by February 1993. (P 53). Despite the settlement, tension between Joan & David and AnnTaylor continued throughout the "phase-out" period. (PP 53-54).

 D. AnnTaylor's May 16, 1991 IPO.

 In the IPO on May 16, 1991, AnnTaylor sold a total of 7,015,000 shares at $ 26 per share and defendants raised approximately $ 167 million for AnnTaylor. (PP 32(a), 56). Plaintiffs assert that the Brooks Group decided to commence the IPO in order to alleviate the heavy debt burden it incurred in taking AnnTaylor private two years earlier (P 55). In addition, ML & Co.'s aggregate investment in AnnTaylor increased from an original investment of $ 78 million to $ 298 million after the IPO and the value of the Brooks Groups' investment increased from an original investment of $ 1.9 to $ 7.5 million. (P 56). As an underwriter, MLPF&S received substantial fees, expenses and discounts from the IPO. (P 30).

 In connection with the IPO, AnnTaylor and ML & Co. filed a registration statement with the Securities and Exchange Commission. The registration statement included a Prospectus *fn3" dated May 16, 1991 and was signed by Joseph Brooks and Thomas Brooks (PP 24, 27). It was declared effective on May 16, 1991 and disseminated to the public. (PP 2, 56).

 E. Plaintiffs' claims.

 1. Count I of the Complaint: misstatements and omissions in the Prospectus.

 Count I of the Complaint alleges that the Prospectus is materially false and misleading in violation of Section 11 of the Securities Act of 1933 (the "1933 Act"), 15 U.S.C. § 77k. Plaintiffs allege four violations of Section 11. (P 89).

 First, plaintiffs claim that defendants failed to disclose that AnnTaylor had changed course, that the AnnTaylor described in the Prospectus was fundamentally different from the AnnTaylor which plaintiffs purchased during the Class Period. The Prospectus contains numerous positive statements concerning the better quality of AnnTaylor's exclusive private-label merchandise and its merchandising focus on upscale customers (PP 58-60). For instance, the Prospectus states that AnnTaylor

 Prospectus at 3.

 Plaintiffs allege that AnnTaylor changed in two ways: (a) by lowering the quality of its private label merchandise, substituting synthetic fabrics and blends for natural fibers, and becoming less fashion-forward and innovative with its merchandise, and (b) by changing its merchandising focus from an affluent, fashion conscious clientele to a less affluent, less fashion-forward client base. (PP 61, 89(a)). Plaintiffs assert that defendants not only failed to disclose these changes but also the risks attendant to such changes. (PP 61, 89(a)). Plaintiffs point out that after Thomas Brooks and Joseph Brooks resigned from AnnTaylor in October and November 1991, respectively (PP 26, 27), AnnTaylor's new chief executive, Sally Frame Kasaks, stated on February 3, 1992 that among her first priorities was "setting standards . . . to get the quality of merchandise back on track." (P 86).

 Plaintiffs' second Section 11 claim concerns the phase-out of Joan & David leased shoe departments. On this subject, the Prospectus states:

 Prior to 1990, all shoes sold in AnnTaylor stores were sold by Joan & David pursuant to the terms of the License Agreement. in 1990, the Company introduced a line of AnnTaylor shoes which can be coordinated with AnnTaylor clothing and accessories. The Company believes that, by providing its own shoe designs, it is better able to serve its customers' needs.

 To implement the transition from Joan & David leased shoe departments to AnnTaylor owned shoe departments, the Company and Joan & David entered into the Amended License Agreement which provides that Joan & David leased shoe departments will be gradually phased out of AnnTaylor stores and will be discontinued completely by February 1, 1993.

 * * *

 Sales through leased shoe departments totaled $ 42,591,000, or 12.0% of net sales, in 1989 (the last full year of Joan & David shoe sales prior to commencement of the transition to AnnTaylor shoes) and $ 35,517,000, or 8.6% of net sales, in 1990. . . . Because the Company expects to achieve higher operating margins through sales of its own shoes, the Company believes that the phasing out of its relationship with Joan & David will not have a material adverse effect on the Company's business or results of operations.

 Prospectus at 26. Previously, the Prospectus disclosed that AnnTaylor's decision to phase out Joan & David leased shoe departments had had a negative effect on comparable store sales *fn4" in 1990:

 The increase in comparable store sales in 1990 was negatively affected by adverse economic conditions, including the decline in consumer confidence due to the current economic downturn, the war in the Persian Gulf and the rise in unemployment, all of which contributed to the slowdown in consumer spending, particularly in the fourth quarter, and the phase-out of the Joan & David leased shoe departments. While total comparable store sales increased 2.3% in 1990, comparable store sales excluding Joan & David leased shoe departments net sales increased 5.1%.

 Prospectus at 16.

 Plaintiffs claim that the statement that "the phasing out of its relationship with Joan & David will not have a material adverse effect on the Company's business" was materially misleading because (1) Joan & David shoe departments attracted a significant number of customers to the floor, (2) Joan & David's high fashion shoes, which complemented AnnTaylor's traditionally fashion forward, high-quality private-label merchandise attracted higher-end recession proof customers to the stores, (3) AnnTaylor was taking a greater risk by designing and marketing its own brand of shoes, which were significantly different in price and quality from Joan & David shoes, and (4) the phaseout of the high fashion Joan & David shoe departments would result in the exodus of AnnTaylor's high-end, recession-proof customers, contribute to the decline in store traffic, and adversely affect comparable store sales. (PP 63, 89(b)).

 Plaintiffs' third Section 11 claim concerns AnnTaylor's rapid expansion program. In the Prospectus, AnnTaylor represents that it plans to expand to reach new customers in two ways: (1) by adding additional stores in major cities and their suburbs where it already has a presence and (2) by opening stores in additional cities which it believes has a sufficient concentration of its target customers. Prospectus at 24. The Prospectus indicates that AnnTaylor anticipates opening 30 or more new stores per year for the next three years. Prospectus at 24. The Prospectus goes on to state that:

 The Company's ability to continue to expand will be dependent upon general economic and business conditions affecting consumer spending, the availability of desireable locations and the negotiation of acceptable lease terms for new locations. The Company does not believe that the current economic downturn will adversely affect its ability to continue its store expansion program.

 Prospectus at 24.

 Plaintiffs allege that these statements are materially misleading because the Prospectus failed to disclose that (1) store expansion was cannibalizing the business of existing stores by opening new stores nearby, which cut into the sales of the existing older stores and adversely impacted comparable store sales, (2) a significant number of existing and newly-opened stores are located in the Northeast states, which were and would continue to be particularly affected by the economic downturn, and (3) AnnTaylor's rapid expansion program was not conducive to the purportedly focused merchandising strategy and blue-chip image touted in ...

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