lerach coughlin stoia geller rudman & robbins...

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

LERACH COUGHLIN STOIA GELLER RUDMAN & ROBBINS LLP PATRICK J. COUGHLIN (111070) CHRISTOPHER P. SEEFER (201197) 100 Pine Street, Suite 2600 San Francisco, CA 94111 Telephone: 415/288-4545 415/288-4534 (fax)

– and – WILLIAM S. LERACH (68581) DARREN J. ROBBINS (168593) 401 B Street, Suite 1600 San Diego, CA 92101 Telephone: 619/231-1058 619/231-7423 (fax)

Lead Counsel for Plaintiffs

UNITED STATES DISTRICT COURT

NORTHERN DISTRICT OF CALIFORNIA

In re LEAPFROG ENTERPRISES, INC. SECURITIES LITIGATION

This Document Relates To:

ALL ACTIONS.

) ) ) ) ) ) ) )

No. C-03-05421-RMW

CLASS ACTION

CONSOLIDATED CLASS ACTION COMPLAINT FOR VIOLATIONS OF THE FEDERAL SECURITIES LAWS

DEMAND FOR JURY TRIAL

Case 5:03-cv-05421-RMW Document 121-1 Filed 06/17/2005 of 135

TABLE OF CONTENTS

Page

CONSOLIDATED CLASS ACTION COMPLAINT FOR VIOLATIONS OF THE FEDERAL SECURITIES LAWS – C-03-5421-RMW

- i -

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

INTRODUCTION ...........................................................................................................................1

JURISDICTION AND VENUE ......................................................................................................4

THE PARTIES.................................................................................................................................4

CONFIDENTIAL WITNESSES ...................................................................................................10

FACTS SHOWING DEFENDANTS’ KNOWLEDGE OF..........................................................13

MATERIAL ADVERSE INFORMATION ..................................................................................13

A. Defendants Knew There Were Several Material Risks that Could Adversely Effect LeapFrog’s Business and Operating Results .............................13

B. Defendants Knew There Were Numerous Problems with LeapFrog’s Distribution and Supply-chain Operations.............................................................16

1. Defendants Knew DSS Repeatedly Failed to Fulfill Customer Orders Which Caused the Sales Shortfall in 3Q03 and Other Problems ....................................................................................................18

2. Defendants Knew LeapFrog Cancelled the Implementation of Supply-Chain Software Before 3Q03 that Was Needed to Accurately Forecast Customer Demand and to Assure Sufficient Levels of Inventory to Meet Customer Demand........................................20

3. Defendants’ Failed Scheme to Fabricate Sales to Avoid the 3Q03 Shortfall......................................................................................................21

4. Defendants Knew that Delays in Consolidating Warehouse Operations, Changing Warehouse Providers and Implementing Supply-Chain Software Caused the Distribution and Supply-Chain Problems to Continue in 4Q03 and 2004...................................................22

5. Defendants Knew the Distribution and Supply-Chain Problems Caused LeapFrog to Report Materially False and Misleading Financial Results that Were Not Prepared in Accordance with GAAP or the Company’s Publicly Reported Accounting Policies............31

a. Improper Revenue Recognition .....................................................31

b. Failure to Accurately Report Inventories.......................................33

c. Understatement of Expenses and Liabilities..................................36

6. After the Class Period, Defendants Admitted There Were Numerous Material Weaknesses in LeapFrog’s Distribution and Supply-Chain Operations that Prevented the Company from Accurately Forecasting Results and from Reporting the Company’s Financial Results in Accordance with GAAP............................................37


Page

CONSOLIDATED CLASS ACTION COMPLAINT FOR VIOLATIONS OF THE FEDERAL SECURITIES LAWS - CLASS ACTION

- ii -

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

C. Defendants Knew that Mattel’s Competing PowerTouch Product Had Caused LeapFrog to Lose Sales and Lower Prices while they Falsely Told Investors that Mattel’s PowerTouch Product Was Only a Potential Risk to LeapFrog’s Sales....................................................................................................39

D. Defendants Knew that LeapFrog’s Results Were Dependant on a Few Customers that Were Deferring Orders to Reduce Their Levels of LeapFrog Inventory and Reducing Their Purchases Due to the Problems with LeapFrog’s Distribution and Supply-Chain Operations ................................48

E. Defendants Received Millions of Dollars in Proceeds from Their Sales of LeapFrog Stock While Making Material Misrepresentations and Concealing Material Adverse Information from Investors....................................51

DEFENDANTS’ FALSE AND MISLEADING STATEMENTS ................................................53

ISSUED DURING THE CLASS PERIOD ...................................................................................53

A. False and Misleading Statements Between 7/24/03 and 10/20/03: Defendants Falsely Assure Investors There Are No Impediments to LeapFrog Meeting 3Q03 Guidance, Include Materially False and Misleading Risk Factors in the Company’s 2Q03 10-Q and Downplay the Impact of the PowerTouch.....................................................................................53

B. False and Misleading Statements Between 10/21/03 and 2/9/04: Defendants Cause LeapFrog to Report False and Misleading Financial Results in 3Q03, Falsely Assure Investors that the Distribution and Supply-Chain Problems that Caused the 3Q03 Revenue Shortfall Were Fixed, and Include False and Misleading Risk Factors in the Company’s 3Q03 10-Q .............................................................................................................67

C. False and Misleading Statements Between 2/10/04 and 3/9/04: Defendants Falsely Portray Management Changes, Cause LeapFrog to Report False and Misleading Financial Results for 4Q03 and FY03 and Provide Investors with Guidance for 2004 that They Knew LeapFrog Could Not Meet .......................................................................................................................78

D. False and Misleading Statements Between 3/10/04 and 4/20/04: Defendants Lose All Credibility by Preannouncing 1Q04 Results Just One Month After Providing Initial Guidance but Assure Investors the Supply-Chain Operations Are Being Strengthened and Include Materially False and Misleading Financial Results and Risk Factors in the Company’s FY03 10-K .............................................................................................................86

E. False and Misleading Statements Between 4/21/04 and 7/20/04: Defendants Cause LeapFrog to Report False and Misleading Financial Results for 1Q04 and Include Materially False and Misleading Risk Factors in the Company’s 1Q04 10-Q ...................................................................93

F. False and Misleading Statements Between 7/21/04 and 10/18/04: Defendants Cause LeapFrog to Report False and Misleading Financial


Page

CONSOLIDATED CLASS ACTION COMPLAINT FOR VIOLATIONS OF THE FEDERAL SECURITIES LAWS - CLASS ACTION

- iii -

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Results for 2Q04 and Include Materially False and Misleading Risk Factors in the Company’s 2Q04 10-Q .................................................................101

THE END OF THE CLASS PERIOD AND POST CLASS PERIOD .......................................112

EVENTS FURTHER DEMONSTRATING DEFENDANTS’ FRAUD ....................................112

LEAPFROG’S FALSE FINANCIAL REPORTING ..................................................................117

DURING THE CLASS PERIOD ................................................................................................117

A. LeapFrog’s Improper Revenue Recognition and Failure to Adequately Reserve for Accounts Receivable with Doubtful Collectibility ..........................118

B. LeapFrog’s Improper Accounting for Inventory .................................................119

C. LeapFrog’s Failure to Report Expenses Related to Goods and Services Purchased from Its Vendors.................................................................................120

D. Defendants’ False Representations and Certifications that LeapFrog’s Financial Reporting Was Reliable, LeapFrog’s Financial Statements Were Prepared in Accordance with GAAP and that LeapFrog’s Disclosure Controls and Internal Controls over Financial Reporting Were Effective ..........120

E. Additional Violations of GAAP and SEC Regulations .......................................121

PROXIMATE LOSS CAUSATION ...........................................................................................123

CLASS ACTION ALLEGATIONS ............................................................................................124

FIRST CLAIM FOR RELIEF .....................................................................................................125

For Violation of §10(b) of the 1934 Act and Rule 10b-5 Against All Defendants .....................125

SECOND CLAIM FOR RELIEF ................................................................................................126

For Violation of §20(a) of the 1934 Act Against All Defendants ...............................................126

PRAYER FOR RELIEF ..............................................................................................................126

JURY DEMAND.........................................................................................................................127


CONSOLIDATED CLASS ACTION COMPLAINT FOR VIOLATIONS OF THE FEDERAL SECURITIES LAWS – C-03-5421-RMW - 1 -

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

INTRODUCTION

1. This is a securities class action on behalf of all persons who purchased the class A

common stock and options of LeapFrog Enterprises, Inc. (“LeapFrog” or the “Company”) between

7/24/03 and 10/18/04 (the “Class Period”), against LeapFrog and certain of its officers and directors

for violations of the Securities Exchange Act of 1934 (the “1934 Act”).

2. LeapFrog is a designer, developer and marketer of technology-based educational

products and related proprietary content, which are marketed both through retail outlets as

educational “toys” and to schools as learning devices. LeapFrog’s biggest retail product is its family

of LeapPad products which are hand-held or lap-held electronic platform devices marketed with a

variety of content books that use a game and entertainment technology to teach reading, writing and

math skills to children. The Company went public on 7/24/02, selling 9.96 million shares (including

1.35 million shares to cover over-allotments) of class A common stock at $13 per share. Before the

Class Period, LeapFrog grew rapidly, consistently reported quarterly revenues and earnings that

exceeded consensus analyst estimates and defendants told investors that sales and earnings growth

would continue in 2003 and 2004. Thus, defendants knew the market expected LeapFrog to report

increasing future sales and earnings at the beginning of the Class Period.

3. Defendants also knew that there were several impediments to the Company reporting

increasing sales and earnings. They knew the Company’s sales were increasingly dependant on

three U.S. retail customers – Wal-Mart Corporation (“Wal-Mart”), Toys R Us Inc. (“Toys R Us”)

and Target Corporation (“Target”) – who accounted for more than two-thirds of total sales. In

addition, they knew LeapFrog did not have long term agreements with the retailers who were

delaying orders to reduce inventory levels. As a result, the Company had to fill orders and supply

product to these retailers within shorter time periods. This was a particular challenge to LeapFrog

because the second half of the year was the peak back-to-school and holiday selling season for

LeapFrog (and other toy makers) when the Company generated 80% of its sales. Further, defendants

knew LeapFrog’s distribution warehouses were managed by third parties – DSS until it was replaced

by Commodity Logistics West, Inc. (“CLI”) in 7/04 – who were responsible for delivering product to

the Company’s retail customers within the shorter time periods.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

4. Defendants also knew that LeapFrog had suspended implementation of new supply-

chain software designed to, among other things, ensure LeapFrog had sufficient levels of inventory

to meet actual and forecasted orders from the Company’s retail customers. In addition to the

distribution and supply-chain challenges, defendants knew that LeapFrog, which had no meaningful

competition prior to 7/03, now faced competition from Mattel, Inc.’s (“Mattel”) PowerTouch

product which was Mattel’s largest product launch in the company’s 73-year history.

5. As detailed herein, defendants misled investors by making numerous false and

misleading statements about LeapFrog’s current and future business results, concealing numerous

problems with the Company’s distribution and supply-chain operations that prevented the Company

from shipping product to its retail customers, concealing the fact that LeapFrog was losing millions

of dollars in sales and profits to Mattel’s competing PowerTouch product, and selling 4.3 million

shares of their class A stock at artificially inflated prices for more than $103 million.

6. As explained below, defendants knew that DSS and CLI were unable to ship product

within the required shorter time periods and that DSS and CLI shipped product to LeapFrog’s

customers that they had not ordered and would not pay for. Due to the shipping problems,

defendants also knew LeapFrog reported inflated revenues, earnings, receivables and inventories in

violation of Generally Accepted Accounting Principles (“GAAP”) and the Company’s publicly

reported revenue recognition policy which only permitted revenue to be recognized upon shipment if

collection was reasonably assured.

7. In addition, defendants knew that the distribution and supply-chain problems were

damaging LeapFrog’s relationship with the retail customers who comprised a majority of the

Company’s sales. They knew the retail customers continually complained about the repeated failure

to accurately fulfill orders or deliver products on time, and that the retail customers reduced their

purchases of the Company’s products and imposed millions of dollars in “vendor violation” penalties

when the problems were not solved.

8. Compounding the distribution and supply-chain problems was the fact that LeapFrog

was losing millions of dollars in sales and profits to Mattel and other competitors. Defendants

downplayed Mattel’s competing PowerTouch product (and other competition) and represented that



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

the Company’s sales and market share would actually increase. In the Company’s Securities and

Exchange Commission (“SEC”) filings, defendants represented that sales and market share could

decline if LeapFrog was unable to compete effectively with existing or new competitors, including

Mattel’s PowerTouch. LeapFrog’s patent infringement suit against Mattel, however, shows that

defendants misled investors by representing that a decline in sales and market share was only a

possibility. Defendants knew, as shown by their sworn testimony and pleadings filed in LeapFrog’s

patent infringement suit against Mattel, that sales of the PowerTouch caused LeapFrog’s market

share to decline 25%. Specifically, LeapFrog “drastically reduced” prices of LeapPad platforms and

to lose more than one million sales of LeapPad platforms and more than 2.9 million sales of content

books used with the platforms. Indeed, defendants have admitted that LeapFrog lost approximately

$85 million in profits – substantially more than the $66.2 million of profits LeapFrog reported in

2003 and 2004 combined.

9. The following chart illustrates LeapFrog’s inflated stock price caused by defendants’

false and misleading statements and omissions, defendants’ insider selling and the declines in the

Company’s stock price which caused class members to suffer actual economic loss as the adverse

information was revealed to the market:



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

JURISDICTION AND VENUE

10. Jurisdiction is conferred by §27 of the 1934 Act. The claims asserted herein arise

under §§10(b) and 20(a) of the 1934 Act and Rule 10b-5.

11. (a) Venue is proper in this District pursuant to §27 of the 1934 Act. Many of the

false and misleading statements were made in or issued from this District.

(b) The Company’s principal executive offices are in Emeryville, California,

where the day-to-day operations of the Company are directed and managed.

THE PARTIES

12. Lead plaintiffs are William Sullivan and Alice Cupples. Each of these class members

purchased LeapFrog’s class A common stock at artificially inflated prices during the Class Period.

13. Defendant LeapFrog is a designer, developer and marketer of technology-based

educational products and related proprietary content, which are marketed both in retail stores and to

schools. During the Class Period, LeapFrog reported between 26.3 million and 33.2 million shares

of outstanding class A common stock which were traded on the New York Stock Exchange and

between 27.6 million and 31.6 million shares of class B common stock which were privately held.

According to the Company’s 2003 10-K, LeapFrog had 869 full time employees, including 11

executive officers. All of the Individual Defendants were executive officers.

14. According to the Company’s Reports on Form 10-K and Proxy Statements, defendant

Michael C. Wood (“Wood”) founded LeapFrog in 1995, served as President and Vice Chairman

since 9/97 and as Chief Executive Officer (“CEO”) from 3/02 until 2/04 when he was demoted to

Chief Vision and Creative Officer. Wood was forced out of the Company in 9/04. According to the

Company’s Amended and Restated Bylaws, as President and CEO, Wood was the senior most

officer of the Company and responsible for the general supervision, direction and control of the

business and its officers. According to the Amended and Restated Employment Agreement between

Wood and LeapFrog, Wood was responsible for managing the day-to-day operations of the

Company, supervising staff, and developing programs. The Amended Employment Agreement also

stated Wood was a “key executive” of the Company whose services were material and significant to



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

LeapFrog’s success and placed Wood in a position of confidence and trust which allowed him access

to confidential information.

(a) The false and misleading statements alleged herein were made by or are

attributable to Wood. Wood participated in the preparation of the Company’s press releases, many

of which included quotes by Wood. Before his demotion to Chief Vision and Creative Officer, he

participated in the Company’s quarterly earnings conference calls on 7/24/03, 10/22/03 and 2/11/04.

Wood signed the Company’s 2Q03 10-Q filed on 8/11/03, the 3Q03 10-Q filed on 11/10/03 and the

FY03 10-K filed on 3/10/04.

(b) According to the Company’s Proxy Statements and the Amended and

Restated Employment Agreement between Wood and LeapFrog, Wood received a salary of

$277,100 in 2003 and a salary of $239,321 in 2004 prior to his forced resignation in 9/04.

(c) During the Class Period, Wood sold substantial amounts of his LeapFrog class

A common stock that were suspicious in timing and amount. Wood sold 3,475,588 shares, or 100%

of his class A common stock and vested options during the Class Period at inflated prices for

$76,701,710. His sales during the Class Period were dramatically out of line with prior trading

practices. Prior to the Class Period, Wood sold 1,026,084 shares for proceeds of $25,157,492.

Wood’s sales during the Class Period were at prices ranging from $25.32 to $45.16 – two to four

times higher than the $11.99 price the stock traded at on 10/19/04.


Thomas J. Kalinske (“Kalinske”) was the Chairman of the LeapFrog Board of Directors since 9/97

and was CEO from 9/97 to 3/02, when Wood became CEO. Kalinske reassumed the position of

CEO in 2/04 when Wood was demoted to Chief Vision and Creative Officer. Since 1996, Kalinske

has also served as President of Knowledge Universe, Inc., LeapFrog’s parent corporation.

According to the Company’s Amended and Restated Bylaws, as CEO, Kalinske was the senior most

officer of the Company and responsible for the general supervision, direction and control of the

business and its officers. According to the Employment Agreement between Kalinske and

LeapFrog, Kalinske’s services were deemed by the Company to be material and significant to



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

LeapFrog’s success and placed Kalinske in a position of confidence and trust which allowed him

access to confidential information.


attributable to Kalinske. Kalinske participated in the preparation of the Company’s press releases,

many of which included quotes by Kalinske. He participated in the Company’s quarterly earnings

conference calls on 2/11/04, 4/21/04, 7/21/04 and 10/18/04. He made presentations at the Bank of

America Securities 33rd Annual Investment Conference and the ThinkEquity Partners Conference

on 9/17/03. Kalinske signed the Company’s FY03 10-K filed on 3/10/04, the 1Q04 10-Q filed on

5/7/04 and the 2Q04 10-Q filed on 8/6/04.

(b) According to the Company’s Proxy Statements and the original Employment

Agreement between Kalinske and LeapFrog, Kalinske received a salary of $269,000 in 2003. He

received a salary of $469,812 in 2004 after reassuming the job of CEO from Wood and entering into

a new Employment Agreement in 4/04.

(c) During the Class Period, Kalinske sold substantial amounts of his LeapFrog

class A common stock that were suspicious in timing and amount. Kalinske sold 122,777 shares, or

20% of his class A stock and vested options during the Class Period at inflated prices for $4,286,831.

His sales during the Class Period were dramatically out of line with prior trading practices. Prior to

the Class Period, Kalinske sold just 30,000 shares of his LeapFrog class A common stock.

Kalinske’s sales during the Class Period were at prices ranging from $28.00 to $42.90 – two to four



James P. Curley (“Curley”) was LeapFrog’s Chief Financial Officer (“CFO”) from 12/91 until

11/11/04, when he reportedly resigned. According to the Company’s Amended and Restated

Bylaws, as CFO, Curley was responsible for the financial reporting by LeapFrog.


attributable to Curley. Curley participated in the preparation of the Company’s press releases. He

participated in the Company’s quarterly earnings conference calls on 7/24/03, 10/22/03, 2/11/04,

4/21/04, 7/21/04 and 10/18/04. He made presentations at the Bank of America Securities 33rd



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Annual Investment Conference and the Think Equity Partners conference on 9/17/03. He signed the

Company’s 2Q03 10-Q filed on 8/11/03, the 3Q03 10-Q filed on 11/10/03, the FY03 10-K filed on

3/10/04, the 1Q04 10-Q filed on 5/7/04 and the 2Q04 10-Q filed on 8/6/04.

(b) According to the Company’s Proxy Statements Curley received a salary of

$258,125 in 2003. LeapFrog did not report his 2004 salary.

(c) During the Class Period, Curley sold substantial amounts of his LeapFrog

class A common stock that were suspicious in timing and amount. Curley sold 30,000 shares of his

LeapFrog class A common stock – 96.5% of his stock and 24% of his stock and vested options – at

inflated prices for $988,900. The sales were at prices ranging from $27.06 to $38.00 – two to three



Timothy M. Bender (“Bender”) was President, Worldwide Consumer Group of LeapFrog.

According to Bender’s 11/1/03 Employment Agreement, Bender reported to the President and CEO,

and was a key executive of LeapFrog whose services were deemed by the Company to be material

and significant to LeapFrog’s success, placing Bender in a position of confidence and trust which

allowed him access to confidential information.


attributable to Bender. Bender participated in the preparation of the Company’s press releases. He

participated in the Company’s quarterly earnings conference call on 7/24/03.

(b) According to the Company’s Proxy Statements, Bender received a salary of

$263,900 in 2003 and a salary of $283,900 in 2004.

(c) During the Class Period, Bender sold substantial amounts of his class A

common stock that were suspicious in timing and amount. Bender sold 170,000 shares of his class

A common stock, 98.7% of his stock and 77.1% of his stock and vested options, for $4,415,300.

The sales were at prices ranging from $20.02 to $41.12, two to four times the $11.99 price the stock

traded at on 10/19/04.

18. Defendant Paul A. Rioux (“Rioux”) was Co-Vice Chairman of the Board and a

director of LeapFrog since 1/01, LeapFrog’s acting Chief Operating Officer (“COO”) from 10/02 to



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

8/03, an advisor to the CEO, and Vice Chairman of the Board of Directors since 9/04. According to

the Employment Agreement between Rioux and LeapFrog, Rioux reported to the President of

LeapFrog and was a “key executive” of the Company whose services were material and significant

to LeapFrog’s success and placed Rioux in a position of confidence and trust which allowed him

access to confidential information. According to the Company’s Proxy Statements, Rioux

implemented LeapFrog’s planning, manufacturing and operating strategy in 2001 and 2002.


attributable to Rioux. He participated in the preparation of the Company’s press releases and signed

the 2003 10-K files on 3/10/04.

(b) According to the Company’s Proxy Statements, Rioux received a salary of

$374,000 in 2003, a salary of $307,300 in 2004 and a $47,250 bonus in 2004.

(c) During the Class Period, Rioux sold substantial amounts of his LeapFrog class

A common stock that were suspicious in timing and amount. Rioux sold 180,000 shares of his class

A common stock, 93.2% of his stock holdings and 52.2% of his stock holdings and vested options, at

inflated prices for $5,928,450. The sales were at prices ranging from $26.78 to $40.15, two to four


19. According to the Company’s Form 10-K, defendant James L. Marggraff

(“Marggraff”) was the Executive Vice President Worldwide Content of LeapFrog. During the Class

Period, Marggraff sold substantial amounts of his class A common stock that were suspicious in

timing and amount. Marggraff sold 69,432 shares of his LeapFrog class A common stock – 29.7%

of his stock and 15.2% of his stock and vested options – for $2,238,548.

20. According to the Company’s Form 10-K, defendant Mark B. Flowers (“Flowers”)

was the Executive Vice President, Chief Technology Officer of LeapFrog. During the Class Period,

Flowers sold substantial amounts of his class A common stock that were suspicious in timing and

amount. Flowers sold 145,000 shares of his LeapFrog class A common stock – 60.7% of his stock

and 34.2% of his stock and vested options – for $4,197,550.

21. According to the Company’s Form 10-K, defendant Robert W. Lally (“Lally”) was

the Executive Vice President, Education and Training Group and President, SchoolHouse Division



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

of LeapFrog until his forced resignation on 12/14/04. He participated in the Company’s 7/21/04

conference call. During the Class Period, Lally sold substantial amounts of his class A common

stock that were suspicious in timing and amount. Lally sold 153,750 shares of his LeapFrog class A

common stock – 70.1% of his stock and 54.2% of his stock and vested options – for $4,354,188.

22. The individuals named as defendants in ¶¶14-21 are referred to herein as the

“Individual Defendants.” The Individual Defendants, because of their positions with the Company,

possessed the power and authority to control the contents of LeapFrog’s quarterly reports, press

releases and presentations to securities analysts, money and portfolio managers and institutional

investors, i.e., the market. Each defendant was provided with copies of the Company’s reports and

press releases alleged herein to be misleading prior to or shortly after their issuance and had the

ability and opportunity to prevent their issuance or cause them to be corrected. Defendants regularly

received information on the status of LeapFrog’s sales, sales of Mattel’s PowerTouch and the

Company’s distribution and supply-chain operations. Bender testified in LeapFrog’s patent

infringement trial against Mattel that the Company (1) tracked sales of platforms, (2) tracked sales of

content books by platform and by year (the “tie ratio”), (3) tracked sales of Mattel’s competing

PowerTouch product, (4) conducted market research on the impact of Mattel’s competing

PowerTouch product on the market for educational toys, (5) tracked retail pricing of LeapFrog’s

products, (6) had 20-30 executive team meetings to discuss reducing the price of the LeapPad family

of platforms in response to the PowerTouch, and (7) had online access to look at retail inventory

levels for any item by store and by chain from which the Company prepared reports. Ex. A at 714-

15, 720-23, 730, 736-37. In addition, he testified that the Company tracked orders it was unable to

ship due to the distribution and supply-chain problems. Ex. A at 790-792.

23. Because of their executive positions and access to material non-public information

available to them but not to the public, each of these defendants knew that the adverse facts specified

herein had not been disclosed to and were being concealed from the public and that the positive

representations which were being made were then materially false and misleading. The Individual

Defendants are liable for the false statements pleaded herein at ¶¶143, 153, 160, 164, 166, 171, 177,

179, 183, 185 and 190, as those statements were each “group-published” information, the result of



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

the collective actions of the Individual Defendants. Moreover, when defendants sold their LeapFrog

stock, they had a duty to disclose adverse information that was not publicly available.

24. Each defendant is liable for (i) making false statements or (ii) failing to disclose

adverse facts known to him about LeapFrog in connection with his stock sales. Defendants’

fraudulent scheme and course of business that operated as a fraud or deceit on purchasers of

LeapFrog common stock was a success, as it (i) deceived the investing public regarding LeapFrog’s

prospects and business; (ii) artificially inflated the prices of LeapFrog’s common stock; (iii) allowed

defendants to arrange to sell and actually sell over $103 million worth of LeapFrog shares at

artificially inflated prices while in possession of material non-public information; and (iv) caused

plaintiffs and other members of the class to purchase LeapFrog common stock at inflated prices and

suffer economic loss when the inflation was removed from the stock price as defendants’ fraud was

revealed.

CONFIDENTIAL WITNESSES

25. Several of the allegations included herein are based on information provided by

several former LeapFrog employees referred to as confidential witnesses (“CW”). The information

provided by the former employees is reliable and credible because (1) each of the witnesses stated

they had personal knowledge of the information provided, (2) the witnesses worked at LeapFrog

during the Class Period, (3) the witnesses’ job titles and responsibilities show they had personal

knowledge of the information provided, (4) many of the witness accounts corroborate one another

and (5) the witness accounts are corroborated by other information alleged herein.

26. CW1 was an allocations analyst at LeapFrog from 6/03 through approximately 10/04,

when CW1 resigned. As an allocations analyst, CW1 was supposed to utilize the Company’s

supply-chain software to compare actual and projected levels of inventory against current and

forecasted customer orders to determine what products LeapFrog’s various customers were to

receive. As explained herein, however, CW1 was never able to perform the allocations analyst job

function because LeapFrog did not implement the necessary supply-chain software before CW1

resigned.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

27. CW2 was a director of information technology at LeapFrog from 12/99 through

approximately 6/04, when CW2 resigned. During the Class Period, CW2 reported to John Casella,

LeapFrog’s Chief Information Officer, who reported to Curley and Director of Credit John Forsyth

(“Forsyth”). CW2 was involved in all aspects of LeapFrog’s IT infrastructure. As detailed below,

CW2 has personal knowledge about the delayed implementation of supply-chain software from

Manugistics, the problems with DSS, and the delay in transitioning from DSS to CLI.

28. CW3 was a manager of credit and collections at LeapFrog from 7/04 through 2/05,

when CW3 was laid-off as part of the Company’s 180-person reduction in force. CW3 reported to

Director of Credit Forsythe who reported to defendant Curley until Curley’s forced resignation in

11/04. CW3 was responsible for the day-to-day operations of the credit and collection department

including (1) the release of customer orders after performing credit checks, (2) collecting past due

accounts, and (3) resolving disputes with customers about amounts owed to LeapFrog. As detailed

below, CW3 has personal knowledge about LeapFrog improperly recognizing revenues and

overstating receivables due to problems with the Company’s distribution and supply-chain

operations that resulted in customers not receiving products they ordered and receiving products they

had not ordered.

29. CW4 was an accounts receivable specialist at LeapFrog from 11/00 through 11/04

when CW4 resigned. Like CW3, CW4 reported to Director of Credit Forsythe who reported to

defendant Curley until Curley’s forced resignation in 11/04. CW4 was responsible for invoicing

customers, tracking cash receipts from customers and analyzing chargebacks claimed by customers

against LeapFrog invoices. As detailed below, CW4 has personal knowledge that problems with the

Company’s distribution and supply-chain operations caused the sales shortfall in 3Q03. In addition,

CW4 stated that LeapFrog tried unsuccessfully to make up the 3Q03 sales shortfall by having DSS

prematurely ship product (due to be shipped to Toys R Us in 4Q03) from one of the Company’s

warehouses to an empty warehouse around the corner. However, the Company’s auditors discovered

the impropriety and required LeapFrog to reverse the revenue.

30. CW5 was a director of supply-chain finance and accounting, a contract position with

LeapFrog, from 7/04 through 2/05 when CW5 was laid-off as part of the Company’s 180-person



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

reduction in force. CW5 reported to Peter David (“David”), LeapFrog’s senior director of supply-

chain finance and accounting, who reported to Curley until Curley’s forced resignation in 11/04.

CW5 was very involved in the Company’s supply-chain operations. CW5 was responsible for

determining whether LeapFrog’s inventory was properly reported, including whether there was

excess and obsolete inventory. CW5 was also responsible for reviewing the bills from CLI to ensure

the charges were valid and determining the amount to accrue and report on LeapFrog’s financial

statements. As detailed below, CW5 has personal knowledge about the delay in transitioning from

DSS to CLI until the peak selling season in 2004, why it was known that delay would cause

problems, CLI’s inability to deliver product to LeapFrog’s retail customers in accordance with the

customers’ purchase orders, and how those problems caused strained relations between LeapFrog

and its retail customers and between LeapFrog and CLI.

31. CW6 was an operations analyst at LeapFrog from 10/00 through 2/05 when CW6 was

laid-off as part of the Company’s 180-person reduction in force. CW6 worked on site at the

warehouse managed by DSS and provided support and assistance to John Gleason, LeapFrog’s

former Director of National Distribution. As detailed below, CW6 has personal knowledge of the

problems with DSS and problems caused by the delay in replacing DSS with CLI.

32. CW7 was an engineering procurement analyst at LeapFrog’s Los Gatos research and

development facility from 6/01 through 2/05 when CW7 was laid-off as part of LeapFrog’s 180-

person reduction in force. CW7 supported ten different engineering divisions (mechanical,

hardware, quality assurance, general R&D, software, manufacturing, concept, toy, documentation

and facilities) and was responsible for handling engineering purchases, coding budgets so they

would reconcile with general ledger accounts, data entry of purchase orders and fixing miscellaneous

problems that occurred in the procurement process. As explained herein, CW7 has personal

knowledge about LeapFrog incurring expenses related to the purchase of materials and components

used to manufacture and assemble products that were not reflected in the Company’s financial

statements because purchase orders were not created, approved or entered into the general ledger.

33. CW8 was a director of international distribution at LeapFrog from 1/02 until 11/04

when CW8 was laid off. Although CW8 was the director if international distribution, during the



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Class Period, CW8 was responsible for overseeing domestic and international distribution, including

distribution of products by DSS and CLI. CW8’s duties were expanded to oversee domestic

distribution because of the severe operational problems with DSS in 3Q03. CW8 reported to Andrew

Murrer (“Murrer”) who reported to G. Frederick Forsyth, LeapFrog’s COO. As detailed below,

CW8 has personal knowledge about the problems with DSS in 2003 and 2004, the problems caused

by the delay in replacing DSS with CLI until the peak selling season in 2004 and the problems

caused by the failure to implement supply-chain software before the peak selling season in 2004.

FACTS SHOWING DEFENDANTS’ KNOWLEDGE OF MATERIAL ADVERSE INFORMATION

A. Defendants Knew There Were Several Material Risks that Could Adversely Effect LeapFrog’s Business and Operating Results

34. LeapFrog is a designer, developer and marketer of technology-based educational

products and related proprietary content, which are marketed both in retail stores and to schools.

LeapFrog’s biggest retail product is its family of LeapPad products which are hand-held or lap-held

electronic platform devices which are marketed with a variety of content books that use a game and

entertainment technology to teach reading, writing and math skills. Prior to the Class Period,

LeapFrog reported substantial sales growth and enjoyed a near monopoly on the educational retail

electronic toy market until the beginning of the Class Period when Mattel introduced its competing

PowerTouch product. The financial press reported that LeapFrog had been “virtually unchallenged”

until Mattel introduced its competing PowerTouch product and the Company has admitted (in its

lawsuit against Mattel) that it had stable pricing and no meaningful competition before the

introduction of the PowerTouch. As a result, by 2003 LeapFrog was the third largest toy

manufacturer, only behind Hasbro, Inc. (“Hasbro”) and Mattel.

35. The Company operated in three business segments – U.S. Consumer, Education and

Training, and International. The majority of LeapFrog’s significant sales growth from 2001 through

2003, was in the U.S. Consumer business segment (in millions):



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

2001 2002 2003 2004

U.S. Consumer $289 (92%) $458 (86%) $546 (80%) $432 (67%) International $16.3 (5%) $53.6 (10%) $97 (14%) $153 (24%) Educational & Training

$8.8 (3%) $20.1 (4%) $38 (6%) $55 (9%)

Total $314.2 $532 $680 $640

36. Defendants knew as was reported in LeapFrog’s SEC filings that there were several

material risks that could adversely affect the Company’s financial results. Defendants knew that the

Company’s business and operating results were increasingly dependent on sales to Wal-Mart, Toys

R Us and Target as sales to those three retailers accounted for 80% of the Company’s U.S.

Consumer sales in 2002, 85% in 2003 and 95% in 2004. In every 10-Q and 10-K issued during the

Class Period, the Company warned that its business and operating results could be harmed if Wal-

Mart, Target or Toys R Us reduced their purchases of LeapFrog’s products.

37. Defendants also knew, as was disclosed in the Company’s SEC filings, that

LeapFrog’s results were dependant on its ability to ship product to Wal-Mart, Target and Toys R Us

in 3Q03 and 4Q03, the peak back-to-school and holiday selling seasons, when approximately 79% of

the Company’s sales and all of the Company’s earnings were realized. Further, the Company did not

have long term agreements with its retail customers who were reducing inventory levels by timing

their orders so that LeapFrog had to fill the orders closer to the time of purchase by consumers. As a

result, and as admitted by the Company in its SEC reports, the Company’s sales could decline,

shipping costs could increase and relationships with the retailers could be damaged if LeapFrog was

unable to ship product to its retail customers within the required shorter time periods.

38. The increased pressure to fill orders and supply product to retailers within shorter

time periods was particularly challenging to LeapFrog given the Company’s distribution and supply-

chain operations. LeapFrog outsourced substantially all of its finished goods manufacturing to

multiple companies in China and relied on four contract ocean carriers to ship the finished goods to

its primary distribution centers in California, which were managed by DSS until 7/04 when CLI took

over the management of the Company’s warehouse operations. DSS (and later CLI) was responsible



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

for ensuring the purchase orders from LeapFrog’s retail customers were fulfilled on time and

accurately.

39. Defendants also knew, as was disclosed in the Company’s SEC filings, that

LeapFrog’s operating results could suffer if it failed to develop and maintain management systems

that were sufficient to keep pace with the Company’s rapid growth. Specifically, defendants knew

that LeapFrog needed to implement supply-chain software that would allow the Company to

accurately forecast and fulfill retailer orders during the peak selling season by providing information

on actual and projected orders, inventory levels and manufacturing.

40. Defendants knew, as was reported in the Company’s SEC filings that LeapFrog’s

sales and market share could decline if the Company was unable to effectively compete with other

toy companies, particularly Mattel which launched the PowerTouch in 7/03.

41. In the four quarters that followed the 7/02 IPO, LeapFrog reported quarterly financial

results that exceeded consensus estimates and the Company’s stock price increased from $13 on the

date of the IPO to $34 on 7/8/03. For example, on 7/23/03, Merrill Lynch analyst Lauren Rich Fine

issued a Research Bulletin following LeapFrog’s release of its 2Q03 financial results entitled “LF

Bounds Past Estimates Again” which reported the Company’s earnings per share (“EPS”) was $0.08

better than consensus estimates and the “fourth consecutive quarter of large positive surprises.”

42. Ms. Fine and other analysts noted, however, that the price of the Company’s stock

had declined 17% over the past two weeks due to the shipping of Mattel’s competing PowerTouch

product, general industry retail softness and recent insider selling following the expiration of the

180-day lock-up period following LeapFrog’s 7/02 IPO. As a result, the analysts cautioned investors

to wait for the Company to provide details on product sales trends at retail and 2003 market share

gains. In addition, the analysts wanted to see if the Company would be changing its previous

guidance of 3Q03 revenues of $225-$235 million, 3Q03 EPS of $0.55-$0.58, 4Q03 revenues of

$277-$297 million, and 4Q03 EPS of $0.68-$0.74.

43. Thus, prior to the Class Period, defendants knew that (1) a substantial majority (80%)

of the Company’s sales and all of the Company’s net income would occur in the third and fourth

quarters, (2) the sales were dependant on three retail customers, Wal-Mart, Toys R Us and Target,



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

who were reducing inventory levels and requiring LeapFrog to fill orders within shorter time

periods, (3) the Company relied on DSS to fill the retailers’ orders within the required shorter time

periods, (4) LeapFrog had suspended the implementation of supply-chain software designed to

enable LeapFrog to assure it had sufficient inventory to meet actual and projected demand, and (5)

LeapFrog had to compete with Mattel’s PowerTouch product after going “virtually unchallenged”

prior to its release. In addition, they knew that the Company’s stock price had declined from almost

$34 on 7/8/03 to $27.65 on 7/22/03 and that they had told investors that LeapFrog would continue to

report growth in sales and earnings.

B. Defendants Knew There Were Numerous Problems with LeapFrog’s Distribution and Supply-chain Operations

44. On 7/24/03, during the Company’s 2Q03 earnings conference call, defendants

reported that LeapFrog’s 2Q03 financial results exceeded consensus estimates for the fourth

consecutive quarter since the 7/02 IPO and reiterated guidance for 3Q03 and 4Q03. In addition,

defendants assured investors that they felt “very positive” and that there were “no impediments” to

reporting sales and earnings in line with the reiterated guidance. Defendants knew these positive

statements were false and misleading. They knew problems with LeapFrog’s distribution and

supply-chain operations were very real impediments to reporting financial results in line with

guidance; indeed, defendants knew the distribution and supply-chain operations were in total

disarray.

45. Witness accounts, other documents and information and defendants’ admissions

during and after the Class Period show that defendants knew there were material weaknesses with

LeapFrog’s distribution and supply-chain operations throughout the Class Period that prevented

LeapFrog from (1) shipping retailers’ product within the shorter time periods they required, (2)

shipping the retailers’ products they actually ordered, (3) reporting LeapFrog’s financial results in

accordance with GAAP and the Company’s publicly reported accounting policies, and (4)

forecasting the Company’s future financial results.

46. According to several former LeapFrog employees, DSS and CLI repeatedly failed to

ship product ordered by LeapFrog’s U.S retail customers within the required shorter time periods (or



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

at all) and also shipped the wrong product to them. The shipping problems damaged the Company’s

relationship with the retail customers who repeatedly complained about LeapFrog’s inability to

fulfill their orders, returned and refused to pay for product they had not ordered, threatened to, and

did, reduce and cancel their orders when the problems were not fixed and imposed tens of millions

of dollars of vendor violation penalties.

47. The shipping problems also caused LeapFrog to improperly recognize revenues in

violation of GAAP and the Company’s publicly reported revenue recognition policy which only

permitted revenue to be recognized upon shipment if collection was reasonably assured. Defendants

knew collection was not reasonably assured because DSS and CLI were shipping product to the

retailers that they did not order and would not pay for. After the Class Period, LeapFrog admitted in

its 2004 10-K that it could not reasonably assure the reliability of its financial reporting or that its

financial statements were prepared in accordance with GAAP because there were numerous material

weaknesses with the Company’s internal controls related to, inter alia, revenues and accounts

receivable and the distribution and supply-chain operations.

48. Defendants also knew the failure to implement supply-chain software during the

Class Period caused LeapFrog to overstate inventory in violation of GAAP and LeapFrog’s publicly

reported inventory policy. The witness accounts describe how the lack of supply-chain software

prevented LeapFrog from accurately reporting inventory levels and from establishing sufficient

reserves for excess and obsolete inventory. After the Class Period, the Company increased the

reserve for excess and obsolete inventory by 400%, or $14 million. During the 10/18/04 conference

call, Curley admitted that the lack of supply-chain software during the Class Period prevented

LeapFrog from identifying obsolete and excess inventory: “as we started getting into our supply-

chain system, we also identified, you know, inventory – excess component inventory that we never

had visibility clearly on before, but now that we’ve, you know, have a system that’s not manual,

it’s giving us long-term visibility.” In addition, the Company admitted in its 2004 10-K that it could

not reasonably assure the reliability of its financial reporting or that LeapFrog’s financial statements

were prepared in accordance with GAAP because of numerous material weaknesses in the areas of

costs of goods sold and inventory and distribution and supply-chain operations.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

49. The witness accounts show that defendants also knew LeapFrog was underreporting

expenses and liabilities because the Company’s engineering department was purchasing materials

and components from vendors that were used to manufacture and assemble products without a

written purchase order. As a result, the purchases were not reflected in the Company’s financial

statements. After the Class Period, the Company admitted in its 2004 10-K that it could not

reasonably assure the reliability of its financial reporting or that its financial statements were

prepared in accordance with GAAP due to material internal control weaknesses related to the

creation of purchase orders, inventory purchasing, the purchase of materials and components used to

manufacture and assemble products and payments to vendors.

50. Defendants also knew the shipping problems and the impact of Mattel’s PowerTouch

on the Company’s sales and lack of supply-chain software precluded LeapFrog from accurately

forecasting and fulfilling customer orders which in turn prevented the Company from accurately

forecasting LeapFrog’s future financial results. As detailed herein, the Company repeatedly missed

or revised guidance during the Class Period due to the shipping problems and lost sales. After the

Class Period, defendants stopped providing guidance, effectively admitting they never had a

reasonable basis for the guidance provided during the Class Period. Indeed, as Kalinske admitted

during the Company’s 12/16/04 conference call, “we’ve been so horrible at providing guidance I

just don’t think there’s any benefit in continuing the practice for the rest of this year.”

1. Defendants Knew DSS Repeatedly Failed to Fulfill Customer Orders Which Caused the Sales Shortfall in 3Q03 and Other Problems

51. Several witnesses, including CW1, CW2, CW4, CW6 and CW8 stated that DSS was

the company that managed and oversaw the receipt, warehousing and shipping of goods from 2000

until 7/04 when LeapFrog replaced DSS with CLI. The witnesses also stated that DSS repeatedly

failed to ship product ordered by LeapFrog’s retail customers and also shipped them the wrong

product.

52. CW6, the former operations analyst who worked at the DSS warehouse, stated that

LeapFrog had to closely monitor DSS throughout the time DSS managed the Company’s warehouse

operations to ensure DSS fulfilled its obligations. Because DSS did not provide reports showing



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

what products had been shipped to the Company’s retail customers, LeapFrog maintained staff,

including CW6, on-site at the warehouse to make sure products were shipped in accordance with the

retail customers’ purchase orders. CW6 stated that LeapFrog management was unhappy with the

degree of oversight required and wanted a warehouse provider that did not require the same level of

oversight. As a result, LeapFrog decided to change warehouse providers sometime before 3Q03.

53. CW6 stated that after DSS found out LeapFrog intended to change warehouse

providers their performance deteriorated and became unacceptable during 3Q03 and 4Q03, the

critical peak selling season for LeapFrog’s products. CW8 also stated DSS management knew

LeapFrog had decided to replace DSS with CLI by 11/03 because the decision was discussed with

the DSS senior managers. CW6 stated that DSS failed to fulfill many customer orders during the

peak selling season including $12-$13 million of orders from Toys R Us in 3Q03. CW6 stated that

Toys R Us sent its trucks to the DSS warehouse on multiple occasions to pick-up orders but DSS

was unable to deliver the product. During LeapFrog’s patent infringement trial against Mattel,

Bender testified that LeapFrog lost 1.2 million in LeapPad orders from Target and 2.8 million

LeapPad orders from Toys R Us in 3Q03 because of the inability to ship the product. Ex. A at 790-

92.

54. Other witnesses confirmed DSS was unable to ship product to the Company’s retail

customers. CW2, the former information technology director, said that the primary reason for the

3Q03 sales shortfall was the deteriorating relationship between LeapFrog and DSS. CW4, the

former accounts receivable specialist, also stated that LeapFrog began experiencing a lot of

warehouse problems in 3Q03 and that DSS’s inability to fulfill customer orders caused the 3Q03

sales shortfall. CW4 stated that DSS “quit on LeapFrog” because DSS knew LeapFrog was going to

switch warehouse providers. CW4 stated that the 3Q03 sales shortfall was also caused by LeapFrog

not having sufficient amounts of product available to fill customer orders. CW8, the former director

of international distribution, stated the inability of DSS to ship product to fulfill customer orders in

3Q03 was the reason CW8’s duties were expanded to include the oversight of domestic distribution.

CW8 also said the problems continued in 4Q03. CW8, who worked at the DSS warehouse in 4Q03,



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

stated that most of the orders that were not shipped in 3Q03 and additional orders that DSS was

unable to ship in 10/03 were lost and not shipped at a later date.

55. After LeapFrog reported 3Q03 sales of $203.9 million that were substantially less

than the $225-$235 million they previously represented there were no impediments to reporting,

defendants admitted shipping problems caused the shortfall. During the Company’s 10/22/03

conference call, Wood stated that the inability to ship product to the Company’s retailers caused the

sales miss and that defendants knew about the problems much earlier in the quarter. In fact, Wood

admitted LeapFrog “thought about pre-announcing and made the decision not to.”

2. Defendants Knew LeapFrog Cancelled the Implementation of Supply-Chain Software Before 3Q03 that Was Needed to Accurately Forecast Customer Demand and to Assure Sufficient Levels of Inventory to Meet Customer Demand

56. In addition to the shipping problems, defendants knew that LeapFrog had not

developed, implemented or maintained adequate supply-chain software needed to ensure LeapFrog

had sufficient inventory to meet actual and projected demand. According to CW1, LeapFrog

intended to implement supply-chain logistics software applications from Manugistics and Valdero in

2003 that were designed to link up and synchronize orders and projected orders from the Company’s

retailers to the inventory on hand and projected inventory. The software applications were intended

to extract information from LeapFrog’s Oracle database and to generate tailored reports that the

Oracle system could not generate. The software and the reports generated by the software would

allow CW1 to compare inventory on hand and inventory expected to arrive against current and

forecasted orders so that CW1 could allocate available inventory to the Company’s customers. CW1

stated that Wal-Mart, Toys R Us and Target were “Tier One” customers that received priority over

LeapFrog’s other customers to ensure they received their orders in full. Other customers would only

receive product that was not needed to fulfill orders received from Wal-Mart, Toys R Us and Target.

57. CW1 and CW2 stated that LeapFrog cancelled the implementation of the Manugistics

software prior to 3Q03 and that the software was supposed to perform supply-chain functions that

the Oracle system was unable to perform satisfactorily. As a result, CW1 was unable to perform a

forward looking allocation analysis. Instead, CW1 extracted data from the Oracle database and



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

prepared spreadsheet reports that compared how many products were shipped in a particular period

to what had been forecasted. CW2 stated that the Oracle supply-chain module was very lacking and

very rudimentary. Thus, as CW2 stated, LeapFrog’s software applications did not keep pace with

the increasingly complex requirements that accompanied the Company’s rapid growth. CW2 stated

that the Company’s business systems required ever-increasing amounts of manual processes because

the software applications did not perform the functions and because there was concern whether the

information generated by the software was accurate. As a result, the Company relied on manually

prepared spreadsheets to support their operations.

58. Other sources corroborate the witnesses. In a 10/30/03 article in Baseline magazine,

LeapFrog spokesperson Cherie Stewart (“Stewart”), stated that LeapFrog suspended deployment of

new supply-chain logistics software (version 6.15) before the beginning of 3Q03. On 11/13/03, Bear

Stearns analyst Jennifer Childe (“Childe”) reported that LeapFrog began deploying Manugistics

supply-chain software in the first half of 2003 but could not complete the implementation and

ultimately abandoned it prior to 3Q03.

3. Defendants’ Failed Scheme to Fabricate Sales to Avoid the 3Q03 Shortfall

59. Defendants’ knowledge of the 3Q03 sales miss is also shown by their unsuccessful

attempt to fabricate sales. CW4 stated that LeapFrog tried unsuccessfully to fabricate sales in 3Q03

to make-up the shortfall caused by the problems with DSS and the cancelled implementation of the

supply-chain software. CW4 stated that DSS shipped product in 3Q03 that was schedule to be

shipped to Toys R Us in 4Q03 to an empty warehouse around the corner from the warehouse

managed by DSS. Curley then caused LeapFrog to improperly recognize the revenue on the

fabricated sales. But according to CW4, LeapFrog’s auditors discovered the scheme and required

the Company to reverse the improperly recognized revenue. In addition, CW4 stated that the scheme

was also discovered when LeapFrog attempted to collect on the sales and were informed by Toys R

Us that it never received the product for which collection was being sought. CW4 also stated that

DSS and the freight company confirmed that the product had simply been shipped around the corner

to an empty warehouse.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

60. CW4 first learned of the scheme from Forsythe in 9/03 when Forsythe informed CW4

and others in the accounting department that they were going to have to work long hours to reverse

the improperly recognized revenue. In 9/03, CW4 and other accounting personnel began reviewing

the numerous invoices that had been generated to book the Toys R Us orders prematurely to ensure

the revenue was reversed and not included in LeapFrog’s reported results. CW4 stated this project

was a “mad scramble” and was not completed until 10/03, just two days before the Company

announced 3Q03 results on 10/21/03. Curley cautioned the accounting personnel that worked on

reversing the improperly recognized revenue, including CW4, that they must never speak about what

happened. After the project was completed, Curley treated the accounting personnel to lunch at

Trader Vics restaurant in Emeryville which, according to CW4, was understood to be a reward for

having to work such long hours and a reminder not to speak about what had transpired.

4. Defendants Knew that Delays in Consolidating Warehouse Operations, Changing Warehouse Providers and Implementing Supply-Chain Software Caused the Distribution and Supply-Chain Problems to Continue in 4Q03 and 2004

61. Several witnesses, CLI’s suit against LeapFrog (Ex. B) and statements by defendants

after the Class Period show that defendants knew delays in (1) replacing DSS with CLI, (2)

consolidating warehouse operations, and (3) implementing supply-chain software until the peak

selling season in 2004 would cause the distribution and supply-chain problems to continue. Delays

in consummating the relationship with CLI resulted in DSS managing the Company’s warehouses

through 7/04. CW2 stated that CLI was supposed to take over warehouse operations from DSS in

3Q03 but the change was delayed. CW6 and CW8 also stated that LeapFrog decided to replace DSS

with CLI in late 10/03 or 11/03, but postponed executing a contract with CLI until 5/04.

62. CLI’s lawsuit against LeapFrog (which was filed on 1/12/05 in the U.S. District

Court, Southern District of Ohio) corroborates the witness accounts and confirms the delay. Ex. B.

In its complaint, CLI stated that LeapFrog and CLI began discussions about CLI overseeing and

managing the receipt, warehousing and shipping of goods from LeapFrog’s Fontana warehouse in or

around 11/03 but did not execute the warehouse management agreement (which is attached to the



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

complaint) until 7/1/04. Curley, former COO Forsyth and Murrer, LeapFrog’s Senior Vice President

of Operations and Logistics, signed the warehouse agreement on behalf of LeapFrog.

63. Delays in consolidating LeapFrog’s warehouse operations from several warehouses to

one warehouse located in Fontana, California contributed to the supply-chain problems and the delay

in replacing DSS with CLI. According to CLI’s suit against LeapFrog, when LeapFrog began

discussions with CLI in 2003 about CLI taking over management and operation of the Company’s

warehouses, the plan was to have CLI manage one warehouse located in Fontana. Ex. B. But

LeapFrog did not execute the lease for the Fontana warehouse until 3/31/04 and the term of the lease

did not commence until the later of 6/15/04 or substantial completion of required tenant

improvements. Like the warehouse agreement with CLI, Curley, Forsyth and Murrer signed the

Fontana warehouse lease on behalf of LeapFrog.

64. Due to the delays, DSS continued to manage LeapFrog’s warehouse operations

through 7/04. CW4, CW6 and CW8 stated that problems with DSS continued in 4Q03 and that

LeapFrog was scrambling in an attempt to repair customer relationships after the shipping problems

in 3Q03. For example, CW4 stated that in 11/03, Target threatened to stop doing business with

LeapFrog because Target was not receiving the products it had ordered.

65. CW6 stated that LeapFrog management was furious at DSS for the problems in 3Q03

and sent down additional reinforcements during 4Q03 in an attempt to salvage the remainder of

4Q03. Those reinforcements included CW8, John Gleason (“Gleason”), Wood, Forsyth and Murrer.

CW6 stated that the problems became a crisis in 11/03 when large numbers of LeapFrog personnel

were sent to the DSS warehouse to resolve various issues impeding the fulfillment of orders.

66. In 11/03, Murrer told CW8 to go to the DSS warehouse to help fix the shipping

problems that occurred in 3Q03 and 10/03. CW8 said that a number of additional LeapFrog

personnel, including Murrer and Forsyth, were on-site at the DSS warehouse on a regular basis in

4Q03. CW8 initiated daily conference calls between the sales and operations personnel in

LeapFrog’s Emeryville headquarters building and personnel at the DSS facility in an attempt to

make sure there were clear communications regarding what product needed to be shipped to each

customer and when the shipments needed to be made. CW8 said that LeapFrog had to ship products



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

by air from the manufacturing plants in China to be able to fulfill orders received late in 4Q03 which

increased shipping costs.

67. Several witnesses stated there were numerous reasons defendants should have known

problems would continue with CLI. CW5, the former director of supply-chain finance and

accounting, said LeapFrog chose CLI based on a recommendation from Wal-Mart which used CLI

for some of its operations. But CW5 said that CLI only managed a couple of Wal-Mart’s warehouses

and was not a national warehouse management company that could handle the national distribution

requirements of a company like LeapFrog. CW5 also stated that CLI had never started up a

warehouse operation like it was doing for LeapFrog with the new 600,000 square foot Fontana

warehouse. CW5 said that CLI continued to assign its most skilled personnel to the warehouses it

managed for Wal-Mart, CLI’s primary customer, and assigned less skilled and competent personnel

to the LeapFrog account.

68. Several witnesses stated the biggest problem was the delay in transitioning to CLI

until LeapFrog’s peak selling season in 2004. According to CW5 and CW8 the delay in

transitioning to CLI occurred because a senior executive at LeapFrog put the entire deal on hold for

3-4 months because the senior executive was concerned the deal was too expensive for LeapFrog.

Murrer told CW8 that LeapFrog decided to delay consummating the relationship with CLI. CW5

and CW8 stated that the delay meant there was no way CLI and LeapFrog could get the supply-chain

operations up and running smoothly by the time the peak selling season began. CW8 said delaying

the transition until 7/04 meant that CLI did not have time to thoroughly master its responsibilities

and would not begin shipping product until the peak selling season.

69. CW2 stated that it takes three to four months to accomplish a major transition from

one logistics provider to another and that the delay meant CLI did not begin to implement and handle

logistics functions for LeapFrog until after the Company’s peak selling season began. Similarly,

CW6 said the delay meant CLI would not begin managing LeapFrog’s warehouse until the peak

selling season in 2004 and that the transition was a major undertaking that should have begun 6-9

months before to allow sufficient time to identify and address operational problems. CW5 stated

that the transition to CLI had to occur prior to the peak selling season so any bugs and problems



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

could be eliminated before the peak selling season began. CW8 stated that the delay in transitioning

to CLI had severe consequences and that the transition needed to be completed several months

before 7/04 to ensure CLI could handle LeapFrog’s shipping requirements during the peak selling

and shipping season.

70. CW8 also said the problems CLI had with handling the shipping operations due to the

delay in transitioning to CLI were compounded by problems the delayed transition caused with DSS.

Specifically, CW8 said the delay prevented LeapFrog from removing inventory from the DSS

managed warehouses to the Fontana warehouse that CLI would be managing. In 2004, defendants

assured investors that the shipping problems that caused the sales shortfall in 3Q03 would not

reoccur in 3Q04 because LeapFrog was keeping inventory with DSS as a back-up. But as was

reported by Merrill Lynch on 11/4/04 and confirmed by CW8, DSS “shut [LeapFrog] down given

the decision to go with CLI and their [DSS] ability to find replacement customers, which meant that

LF had to quickly move all of its inventory into the new warehouse.”

71. After the Class Period, defendants admitted they knew the delay in changing

warehouse providers, consolidating warehouses and implementing supply-chain software would

harm the Company’s financial results. During the 10/18/04 conference call, Kalinske stated the

following:

[W]e have experienced several challenges getting our new distribution center up and running smoothly. As you will recall, we consolidated our distribution centers into one, newer, larger facility this past July. At the same time, we also launched a number of new information management systems to build out our supply-chain. In addition, we hired a new third-party logistics venture, Commodity Logistics, Inc., to implement these operations. However, getting all this up and running during this peak time has been challenging and we have experienced negative financial ramifications through this transition, ultimately impacting margin.

During LeapFrog’s 10/27/04 conference call, Jerome Perez (“Perez”) stated,

“[I]n our commitment to improving the supply-chain, we attempted too many improvements at one time and too close to our key selling season.”

72. The problems with LeapFrog’s warehouse operations continued after CLI replaced

DSS in 7/04. According to CW3, the former credit and collections manager, CLI also was unable to

fill sales orders received from the Company’s retail customers. CW2, CW5, CW6 and CW8 stated

that the delay in finalizing the relationship with CLI until 7/1/04, just as LeapFrog was entering the



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

busy back-to-school and holiday seasons when 80% of the Company’s sales occurred, contributed to

the problems.

73. CW5 stated that the delay in transitioning to CLI and the other problems with CLI

caused many problems. CW5 said CLI “screwed up so many times” by failing to fulfill orders for

Wal-Mart, Target and K-Mart in 3Q04 and 4Q04. CW5 stated that a common problem was that CLI

shipped orders to the wrong customers, i.e., CLI would ship Wal-Mart’s orders to K-Mart and K-

Mart’s orders to Wal-Mart. CW5 also stated that CLI failed to ship all of the product ordered by

LeapFrog’s retail customers and shipped more product than had been ordered.

74. CW5 stated there were so many problems with CLI that LeapFrog sent many of its

own employees to the Fontana warehouse in an attempt to solve them, including Peter David

(“David”), Murrer, and Mara Still (“Still”), a LeapFrog accountant. In fact, CW5 said that Murrer

fired a bunch of people he felt were not sufficiently helping rectify the problems.

75. CW8 knew that the delays in transitioning to CLI and the failure to implement

supply-chain software until 8/04 led to a variety of operational problems which resulted in CLI being

unable to fulfill customer orders in 3Q04. CW8 knew by mid 8/04 that there was no way LeapFrog

would meet 3Q04 projections because CW8 knew there were huge variances between how much

product was shipped on a daily basis compared to projections and personally questioned the veracity

of public statements made by LeapFrog executives in 3Q04 regarding the Company’s earnings

projections. CW8 had daily conversations with Murrer and Forsyth regarding CLI’s inability to

fulfill customer orders. After the Class Period defendants admitted they knew about CLI’s inability

to correctly ship product to LeapFrog’s retail customers no later than 8/04. Kalinske admitted during

the Company’s 2/15/05 conference call that defendants knew CLI was unable to ship orders

correctly by 8/04: “[t]he shortages occurred – the inability to ship correctly occurred in the August,

September, October period.”

76. Peter David, LeapFrog’s senior director of finance, global supply-chain, who CW5

reported to, told CW5 that Wal-Mart told LeapFrog in 9/04 that if their next scheduled shipment was

wrong in any way that Wal-Mart would refuse the order and stop ordering products from the

Company. But the next shipment to Wal-Mart was incorrect. CW5 stated that Wal-Mart did not



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

completely stop purchasing product from LeapFrog as threatened but the relationship between Wal-

Mart and LeapFrog became even more strained and compromised and Wal-Mart did substantially

reduce its purchases. The Company’s SEC reports show that Wal-Mart reduced its purchases by

more than $30 million from 2003 to 2004.

77. In addition, CW5 stated that the incorrect shipment to Wal-Mart led to meetings

between LeapFrog representatives (including Perez, Murrer, Forsyth and David) and CLI in 11/04

which deteriorated into shouting matches between the two companies. CW5 stated that LeapFrog, at

David’s direction, began withholding payments to CLI due to the problems and because the bills

provided by CLI lacked sufficient details and were completely inadequate for CW5 to determine if

the charges were valid. According to CW5, LeapFrog demanded detailed bills from CLI so it could

determine whether or not the bills made sense and received boxes of supporting documentation for

the bills after CLI hired a new CFO. CW5 said the documentation showed CLI’s bills were valid but

that LeapFrog continued to withhold payment. Although the bills were valid, CW5 said that the

“cost-plus” contract between LeapFrog and CLI allowed CLI to pass all of their costs onto

LeapFrog. CW5 stated that many of the costs were for airfare and luxury hotels because CLI flew

personnel to Los Angeles from Minnesota to manage the Fontana warehouse.

78. These witness accounts about the problems with CLI are corroborated by CLI’s suit

against LeapFrog and by admissions made by LeapFrog after the Class Period. In its complaint, CLI

stated that it was not retained until 7/04 and had to hire temporary help in the summer of 2004 to

accommodate the busy holiday season. Ex. B. Further, CLI alleged that LeapFrog failed to pay CLI

$4.3 million for work performed under the warehouse agreement in 9/04,10/04 and 11/04. Id.

According to the complaint and a 1/12/05 letter to Kalinske from CLI’s CEO (James D. Thomas),

Peter David, LeapFrog’s senior director of finance, global supply-chain, told Norm Murphy

(“Murphy”), CLI’s CFO, that LeapFrog would not make any payments to CLI on any invoices until

after Thomas traveled to California for a meeting with Kalinske, Perez and others. David also told

Murphy that LeapFrog would not pay CLI until senior management from LeapFrog and CLI reached

some agreement as to allocating losses that LeapFrog contended it suffered in connection with the

Fontana warehouse.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

79. Several witnesses stated that the failure to complete implementation of supply-chain

software before the peak selling season in 2004 also contributed to LeapFrog’s inability to accurately

forecast and fill customer orders. CW1 stated that the Company worked literally day and night in

2004 to get the supply-chain software implemented but that LeapFrog never completed the

implementation of the Manugistics or Valdero software during the time CW1 was employed by the

Company (6/03 through 10/04). As a result, as was the case in 2003, CW1 was unable to perform a

forward looking allocation analysis. Instead, CW1 continued to prepare spreadsheet reports that

compared how many products were shipped in a particular period compared to what had been

forecasted to determine if LeapFrog was under or over its forecasts.

80. In addition to the delays in implementing the Manugistics supply-chain software,

CW5 and CW8 stated that LeapFrog delayed and abandoned implementation of Highjump software

at the end of 2004 because it was too complicated. CW5 and CW8 stated that LeapFrog

management tried to implement new supply-chain software during the peak selling season in 2004

which did not allow sufficient time to test and de-bug the software. CW5 said that some elements of

the Manugistics software were in place and operational in 2004 but that very few people at LeapFrog

used the software because the various information systems did not tie into each other. As a result,

employees continued to do everything by hand and relied on LeapFrog’s contract manufacturers for

the amount of inventory on hand.

81. CW8 was directly involved with the efforts to implement the Highjump warehouse

management software that was supposed to allow CLI and LeapFrog to receive orders and track

inventory and shipments, in addition to other functions. CW8 said there was intense pressure from

senior management to get the Highjump software implemented by the end of 2Q04 but that the

software was definitely not up and running until 8/04. CW8 repeatedly told Murrer and Forsyth that

the Highjump software would not be completed by the end of 2Q04 which CW8 said upset a lot of

people. CW8 said the shipping function of the Highjump software did not go live until the second

week of 8/04 and that before that time all shipping functions were handled by the DSS system which

was very different. As a result, CW8 said that the Highjump software went live in 8/04 during the

peak shipping season and was a very painful experience which directly resulted in CLI being unable



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

to fulfill customer orders in 3Q04. CW8 said there were additional problems operating the

Highjump software because there was a lot of turnover at CLI. As a result, CLI personnel were

inexperienced and had to be trained how to use the software during the peak shipping season.

82. The Company recently admitted that it still has not completed the implementation of

the supply-chain software. In LeapFrog’s 2004 10-K, filed on 3/28/05, the Company reported that it

was still “upgrading existing and implementing new operational information systems, including

supply-chain management systems.” As detailed herein, throughout the Class Period defendants

assured investors that the Manugistics supply-chain software would be implemented by the end of

2Q04.

83. After the Class Period, defendants admitted the delay in transitioning to CLI and

consolidating warehouses caused substantial problems. During the Company’s 10/18/04 conference

call, Kalinske stated that LeapFrog had “experienced several challenges getting our new distribution

center up and running smoothly” which caused “negative financial ramifications” and that LeapFrog

had brought in “outside consultants, such as Accenture” to help LeapFrog “significantly improve and

strengthen our supply-chain management.” In addition, Kalinske admitted that LeapFrog would now

“focus[] on building the infrastructure necessary for future success” whereas during the Class Period

“the emphasis was on feeding [LeapFrog’s] rapid growth with new products delivered to market as

quickly as possible.”

84. Similarly, Curley stated that LeapFrog “experienced a significant amount of

disruption in the third quarter. Just – we had the demand from the retailers, we had the inventory,

and our supply-chain, you know, problems did cause us not to be able [to] ship the full demand that

was out there. And it was significant.”

85. During the Company’s 10/27/04 conference call, Kalinske stated that LeapFrog “had

several challenges getting our new distribution center and supply-chain systems up and running

smoothly during this peak season.” Curley stated that “logistics issues hampered third quarter sales,

and caused us to undership the third quarter sales demand.” Perez also confirmed that LeapFrog

“couldn’t execute in the shipping windows.” On 11/4/04, Merrill Lynch analyst Fine issued a report

after meeting with Kalinske and other LeapFrog management. During the meeting Kalinske



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

admitted that he and the other defendants knew since at least 7/04 that there were numerous

problems with the transition from multiple warehouses managed by DSS to one warehouse managed

by CLI:

LF outsources its distribution. In 2003, LF used a company DSS; it was determined that their facility was too small, so after careful consideration and input from LF’s largest customer, the company switched to CLI. However, almost anything that could have gone wrong in the process did. The building wasn’t ready on time, the electricity didn’t get turned on, the inspections were late and equipment was delivered late. The result was a late July move in date and instead of a month of training, shipments and training were being done simultaneously. Furthermore, LF had kept inventory with DSS as backup, expecting to duplicate its efforts in case of any issues with the new warehouse, but DSS shut them down given the decision to go with CLI and their ability to find replacement customers, which meant that LF had to quickly move all of its inventory into the new warehouse. Not only did this cost a lot, but more consultants have also had to be involved. The system is still not perfect but it is improving daily. Compounding these issues are the problems with the ports at Long Beach, CA, which do not have enough dock workers, and shortages in truckers. Management indicated that they may need to look into another distribution facility outside of Long Beach since it seems like they will continue to have issues there.

Management estimates that they lost about $20MM plus in sales due to LF’s inability to ship; at this juncture, given the need to improve relationships combined with the abrupt change in sell-through at retail, these sales are viewed as permanently lost. LF must now build back credibility with retailers, who had placed orders that LF couldn’t fill; this is particularly unfortunate as this was exactly the area LF was seeking to improve upon this year as it had increased inventory levels to focus on improving order fill rates. The good news is that LF continues to expect shelf space gains this year and the retailers were excited about LF’s ’05 line-up, according to the company. Management changes have taken place both at LF and at the warehouse.

86. During LeapFrog’s 2/15/05 conference call, Kalinske admitted that CLI was unable to

ship product to its retailers correctly beginning in 8/04, just one month after CLI began managing

the Company’s Fontana warehouse: “[T]he inability to ship correctly occurred in the August,

September, October period.” Kalinske also acknowledged that the shipping problems “negatively

impacted [LeapFrog’s] business,” and that the Company’s supply-chain processes had “not been

very effective.” In LeapFrog’s 2004 10-K, the Company also admitted that delays in transitioning to

CLI caused significant difficulties and adversely impacted 2004 results:

[I]n the second half of 2004, we had operational difficulties related to our new U.S. distribution center, which had an adverse impact on our 2004 financial results.

* * *



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

During the second half of 2004, we had significant difficulties operating our management systems and the new consolidated distribution center during our peak shipping season. This expansion has presented, and continues to present, significant challenges for our management systems and resources and has resulted in a significant adverse impact on our operating and financial results.

5. Defendants Knew the Distribution and Supply-Chain Problems Caused LeapFrog to Report Materially False and Misleading Financial Results that Were Not Prepared in Accordance with GAAP or the Company’s Publicly Reported Accounting Policies

87. In every 10-Q and 10-K issued during the Class Period, it was represented that

LeapFrog’s financial results were prepared in accordance with GAAP and that the Company’s

internal controls over financial reporting – a process designed to provide reasonable assurance that

the Company’s financial reporting was reliable and that the Company’s financial statements were

prepared in accordance with GAAP – were effective.

88. In addition, as required by §302 of the Sarbanes-Oxley Act (“Sarbanes-Oxley”),

Curley, and Wood or Kalinske certified that: (1) every 10-Q and 10-K filed during the Class Period

did 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, (2) the financial statements included in the 10-Qs and 10-K fairly presented in all

material respects the financial condition, results of operations and cash flows of LeapFrog, (3) they

were responsible for designing and evaluating the Company’s disclosure controls and (4) they had

disclosed all significant deficiencies and material weaknesses in the design or operation of the

Company’s internal controls over financial reporting which were reasonably likely to adversely

affect LeapFrog’s ability to record, process, summarize and report financial information.

89. Defendants knew these representations and certifications were false and misleading

because there were numerous material weaknesses in the Company’s internal controls over financial

reporting that prevented LeapFrog from reporting its financial results in accordance with GAAP.

a. Improper Revenue Recognition

90. Defendants represented that LeapFrog recognized revenue in accordance with GAAP

and LeapFrog’s publicly reported revenue recognition policy which allowed revenue recognition

upon shipment provided there were no significant post-delivery obligations to the customer and



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

collection was reasonably assured. Defendants knew, however, that LeapFrog’s revenues, earnings

and receivables were overstated and not prepared in accordance with GAAP or LeapFrog’s publicly

reported revenue recognition policy because defendants knew DSS and CLI were not fulfilling

customer orders at all or shipping product the customers had not ordered and would not pay for.

Therefore, they knew collection on these sales was not reasonably assured when the revenue was

recorded upon shipment.

91. According to CW3, LeapFrog’s credit and collections manager, there were a host of

operational and personnel problems at LeapFrog that prevented the Company from ensuring revenue

was appropriately recognized. For example, CW3 stated that LeapFrog recognized revenue when it

generated an invoice upon shipment of the product to the customer. CW3 stated that LeapFrog often

generated invoices and recorded revenue in a quarter even though the product was not supposed to

ship until the following quarter. CW3 stated the improper revenue recognition was primarily due to

the operational problems at LeapFrog’s distribution center managed by CLI. Like the other

witnesses, CW3 stated that CLI was unable to ship product properly or on time to meet customer

requirements. CW3 learned of the ongoing and serious problems with CLI in meetings with David

and Murrer.

92. CW3 also found out about the premature shipments when attempting to collect a

receivable that appeared to be past due. According to CW3, customers often informed CW3 and

CW3’s subordinate collectors that they would pay LeapFrog based on the terms of the purchase

order, not the incorrect terms included in LeapFrog’s invoice. In addition, CW3 stated that

customers often said they had not even received the product for which they had been invoiced.

Customers also told CW3 that their accounts were overstated because LeapFrog had not credited

(reduced) the accounts for product returns.

93. CW3 said that the increase in LeapFrog’s days sales outstanding (“DSO”) was caused

by the Company having to extend payment terms for premature shipments and by customers refusing

to pay for (1) product they received but had not ordered, (2) incomplete shipments that did not

include all of the product the customer ordered and (3) substitution products, i.e., product LeapFrog



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

shipped that the customer had not ordered to replace product ordered that LeapFrog did not have in

stock.

94. According to CW3, LeapFrog’s inability to ship all of the product the customers

ordered, shipping the wrong product and missing delivery dates constituted “vendor violations”

which resulted in purchase price reductions. CW4, the former accounts receivable specialist, also

stated that retailers assessed charge-backs for vendor violations such as shipping the incorrect

product. CW3 explained that LeapFrog’s customers had vendor guides that included rules that

LeapFrog had to follow on numerous issues including how products were packaged and tagged, and

delivery standards and expectations. CW3 said there were so many problems fulfilling customer

orders that LeapFrog faced upwards of $10 million in vendor violation price reductions in 2004.

CW3 had serious concerns by 8/04 that 3Q04 was in jeopardy and stated that it was well known

throughout the Company that the quarter was in jeopardy and that LeapFrog’s customers would be

assessing substantial vendor violation price reductions.

b. Failure to Accurately Report Inventories

95. Defendants also knew the Company’s inventories were materially misstated and not

reported in accordance with GAAP or LeapFrog’s publicly reported inventory policy. GAAP

Accounting Research Bulletin (“ARB”) No. 43 required and the Company represented that

LeapFrog’s inventories were stated at the lower of cost , on a first-in, first-out basis, or market value

and that the carrying value of inventories was reduced by an allowance for slow-moving, excess and

obsolete inventories. LeapFrog further represented that the estimate for slow-moving, excess and

obsolete inventories was based on management’s review of on-hand inventories compared to their

estimated future usage and demand for the Company’s products. Defendants knew LeapFrog’s

inventories were misstated during the Class Period for several reasons.

96. Defendants knew inventories were understated because LeapFrog was reducing the

carrying value of inventories when DSS and CLI shipped product to the Company’s retail customers

that they had not ordered, would not pay for and subsequently returned.

97. Defendants also knew inventories were overstated because LeapFrog did not establish

sufficient allowances for slow-moving, excess and obsolete inventories. In 2003, LeapFrog actually



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

reduced inventory allowances from $5.3 million as of 12/31/02, to $3.3 million as of 12/31/03.

LeapFrog did not establish any allowances for excess and obsolete inventory in 1Q04 and

established approximately $2.0 million of allowances in 2Q04. After the Class Period, LeapFrog

increased inventory allowances by more than 300%, or $14.1 million, to $18.9 million. The

Company increased the allowance by $3.5 million in 3Q04, an additional $9 million in 4Q04, and an

additional $1.6 million in 1Q05.

98. CW5, who was responsible for determining the allowances for excess and obsolete

inventory, stated that there were significant variances between the amount of inventory LeapFrog

reported and the results of physical inventory counts at year end 2004 which required multiple

counts and recounts by CLI and the Company’s auditors. CW5 stated that the need for the multiple

recounts meant the inventory levels reported by LeapFrog before 12/31/04 were not reliable or

accurate. In the 2004 10-K, LeapFrog admitted it could not reasonably assure the reliability of its

inventory reporting or that inventories were reported in accordance with GAAP due to numerous

material internal control weaknesses in the area of costs of good sold and inventory.

99. CW5 also stated that LeapFrog accumulated inventory of older products that were no

longer sellable and needed to be written-off as excess and obsolete. CW5 said that some of the

excess and obsolete inventory in the warehouse was three years old and covered with an inch of dust.

In addition, CW5 said that marketing materials such as product displays set up at retail stores were

improperly capitalized as inventory rather than expensed and had to be reserved. In 7/04, David

instructed CW5 to “look into” the obsolete inventory because it had become an issue of mounting

importance. CW5 stated that one reason for the mounting importance was an email prepared by one

of the Company’s sales senior vice presidents at the end of 1Q04 in which the sales senior vice

president said he could sell three types of potentially obsolete inventory items, including the

Company’s MindStation product, by the end of 2Q04. CW5 was forwarded this email in 7/04. CW5

stated, however, that the excess and obsolete inventory was not sold by the end of 2Q04. As a result,

the Company and its auditors reevaluated the allowances.

100. CW5 estimated the allowance for excess and obsolete inventory by inputting the

amounts of excess and obsolete inventory and a demand forecast for the Company’s various



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

products into the manufacturing resource planning (“MRP”) system. The estimate of excess and

obsolete inventory was based on age of the inventory and which products were showing slower or

declining sales. The demand forecast was based on historical sales and anticipated demand provided

by the Company’s sales personnel. The MRP system then generated an estimate of obsolete and

excess inventory on hand at the end of the year. CW5 then had additional discussions with sales

personnel about whether the identified excess and obsolete inventory could be sold and at what

prices. If the price at which the excess and obsolete inventory could be sold was less than the book

value of the inventory, the difference would be included in the allowance.

101. CW5 tried to use the Manugistics software to estimate the allowance for excess and

obsolete inventory but stated the software was unreliable because it would produce radically

different estimates of excess and obsolete inventory. In a 1/05 meeting, CW5 told Kalinske that

there was $7-$9 million of potentially excess and obsolete inventory. Kalinske pressured CW5 to

reduce that estimate but the Company eventually added $9 million to the allowance in 4Q04.

102. After the Class Period, the Company admitted the lack of supply-chain software

prevented LeapFrog from reporting inventory in accordance with GAAP and the Company’s

publicly reported inventory policy. During the 10/18/04 conference call, Curley said the lack of

supply-chain software during the Class Period prevented LeapFrog from identifying obsolete and

excess inventory:

[A]s we started getting into our supply-chain system, we also identified, you know, inventory – excess component inventory that we never had visibility clearly on before, but now that we’ve, you know, have a system that’s not manual, it’s giving us long term visibility.

During the Company’s 10/27/04 conference call, Perez stated the $3.5 million added to the reserve

for excess and obsolete inventory in 3Q04 was only identified as a result of new supply-chain

software that was still not providing complete visibility into the Company’s inventories:

We booked during the quarter 3.5 million in excess and obsolete inventory, specifically you know, that really came as a benefit from our supply-chain initiatives and we’re starting to get visibility into the components that we use in the manufacturing process, and we went from a manual system now we’re rapidly going to a very, you know, comprehensive automated system that will help us control inventories, so that gave us insight into, you know, definitely slow-moving components that we viewed this quarter as the quarter once we became aware of the charge.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

c. Understatement of Expenses and Liabilities

103. Defendants also knew that LeapFrog was understating expenses because of material

internal control weaknesses related to the purchase of materials and components used to manufacture

and assemble the Company’s products. According to CW7, the former engineering procurement

analyst responsible for handling engineering purchases, engineering personnel verbally ordered

goods and services from the Company’s vendors without approval and without issuing a purchase

order.

104. CW7 regularly received invoices from the Company’s various vendors for monies

owed related to goods and services that were not recorded in LeapFrog’s financial statements as an

account payable because no purchase order had been issued. As a result, CW7 regularly created

purchase orders after the invoice was received. CW7 stated that purchase orders were not generated

when goods and services were ordered verbally because the engineering department was operating

under tight deadlines to develop and build new products. Therefore, engineers would disregard

creating a purchase order to expedite procurement of the goods or services which in turn would help

the engineering department meet its deadlines.

105. CW7 stated that before incurring an expense by ordering goods and services from the

Company’s vendors, a process was supposed to be followed. A purchase requisition was supposed

to be submitted to CW7 who would forward it for approval to a supervisor, department director or

Wood based on the dollar amount of the proposed purchase. Wood had to approve requisitions over

$5,000. After the requisition was approved, it would be sent to the purchasing department where a

purchase order was created and sent to CW7 and the vendor. CW7 then entered the purchase order

into the general ledger system.

106. Because engineers were verbally ordering goods and services from vendors without

first getting approval, CW7 would obtain approval, generate a purchase order and enter the order

into the general ledger after the invoice was received and after the expense and payable should have

been accrued. CW7 stated that everybody in the engineering department knew the department was

not complying with LeapFrog’s purchasing policy because the purchase of goods and services from

the Company’s vendors without an approved purchase order was a regular practice that occurred for



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

years until the end of 2004. At that time, CW7 stated the Company completed the Sarbanes-Oxley

audit which concluded there were material weaknesses in the Company’s internal controls related to,

among other things, (1) the creation of purchase orders, (2) inventory purchasing, (3) the purchase of

materials and components used to manufacture and assemble products, (4) the manufacture and

assembly of the products and (5) LeapFrog’s payments to its vendors. Those material weaknesses,

and numerous others, were publicly disclosed by LeapFrog after the Class Period, when the

Company filed its 2004 10-K on 3/28/05.

6. After the Class Period, Defendants Admitted There Were Numerous Material Weaknesses in LeapFrog’s Distribution and Supply-Chain Operations that Prevented the Company from Accurately Forecasting Results and from Reporting the Company’s Financial Results in Accordance with GAAP

107. After the Class Period, defendants disclosed in LeapFrog’s 2004 10-K that there were

numerous material weaknesses in internal controls over financial reporting which precluded them

from providing reasonable assurance that LeapFrog’s financial reporting was reliable or that the

Company’s financial statements were prepared in accordance with GAAP. LeapFrog admitted that

there were insufficient controls that constituted material weaknesses in the areas of (1) revenue and

accounts receivable, (2) cost of goods sold and inventory and (3) information technology controls

related to the manufacturing, distribution, invoicing and sale, and remittance of payments by the

Company’s vendors and customers. Ex. C.

108. In the area of revenue and accounts receivable, LeapFrog identified the following

insufficient controls that constituted material weaknesses in the aggregate:

• Lack of segregation of duties between accounts receivable and order entry staff and possession by those persons of broad access to the Company’s revenue and accounts receivable information technology systems, including access to system areas controlling revenue recordation, cash application, credit memo issuance, credit authorization, invoice pricing and collections.

• Lack of effective controls over receivables credit memo review and approval process to monitor compliance with existing policies and procedures related to authorization of credit memos to customers.

• Lack of consistent and timely reconciliation and review processes related to sales discounts and allowances, shipment and invoicing, and cash receipts.

• Inadequate staffing to determine that internal controls over reconciliations, review of account balances and closing procedures are performed consistently and on a timely basis.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

109. In the area of cost of goods sold and inventory, LeapFrog identified the following

insufficient controls that constituted material weaknesses in the aggregate:

• Lack of segregation of duties between inventory and purchasing staff and possession by those persons of broad access to information technology systems, including access to system areas controlling the set-up of new vendors, the creation of purchase orders, and inventory purchasing and receiving functions.

• Inadequate preparation and review of reconciliations of physical inventory results to inventory ledgers and related cost of goods sold accruals.

• Inconsistent use of standard recordkeeping systems and formats to record and report inventory transactions.

• Inadequate control procedures to determine that work-in-process inventories are correctly summarized, estimated and recorded.

• Insufficient communication procedures between accounts payable and operations staff regarding returns of inventory back to vendors.

• Inadequate input and review controls over changes to bills of materials and work orders.

• Inadequate review of purchase price and production variances included in inventories and cost of sales.

• Inadequate staffing to ensure that internal controls over reconciliations, review of account balances and closing procedures are performed consistently and on a timely basis.

110. In the area of information technology controls, LeapFrog identified the following

insufficient controls that constituted material weaknesses in the aggregate.

• Ineffective logical access and change management controls related to information technology systems, data and programs that are used to monitor, record and transfer information. These controls relate to the purchase of materials and components used to manufacture and assemble products, the manufacture and assembly of products, the distribution, invoicing and sale of products and the remittance of payments by vendors, customers and the Company related to these activities.

• Pervasive inadequacies in enterprise resource planning, or ERP, application controls related to appropriate assignment of functions and segregation of duties, which allowed employees to access system programs and data or initiate transactions inconsistent with their assigned duties. ERP systems contain design deficiencies that do not adequately segregate and control access, and lack sufficient human oversight over the assignment of system access and authorities.

• Lack of appropriate training of personnel throughout the organization causing system users to be less effective due to insufficient understanding of the systems they manage and depend upon.

111. The Company’s auditors agreed with LeapFrog’s conclusion that it did not maintain

effective internal control over financial reporting.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

The Board of Directors and Stockholders of LeapFrog Enterprises, Inc.

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that LeapFrog Enterprises, Inc. did not maintain effective internal control over financial reporting as of December 31, 2004, because of the effect of the three material weaknesses identified in management’s assessment and described below, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). LeapFrog Enterprises, Inc. management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.

* * *

In our opinion, management’s assessment that LeapFrog Enterprises, Inc. did not maintain effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO control criteria. Also, in our opinion, because of the effect of the material weaknesses described above on the achievement of the objectives of the control criteria, LeapFrog Enterprises, Inc has not maintained effective internal control over financial reporting as of December 31, 2004, based on the COSO control criteria.

C. Defendants Knew that Mattel’s Competing PowerTouch Product Had Caused LeapFrog to Lose Sales and Lower Prices while they Falsely Told Investors that Mattel’s PowerTouch Product Was Only a Potential Risk to LeapFrog’s Sales

112. As detailed herein, throughout the Class Period, defendants downplayed the impact of

Mattel’s competing PowerTouch product and represented that LeapFrog was not changing its

marketing strategy in any way and that sales of the PowerTouch would actually have a positive

impact on LeapFrog’s sales by drawing buyers into stores. In every 10-Q and 10-K filed by

LeapFrog during the Class Period, defendants represented that the Company’s sales and market

share could decline if LeapFrog was unable to compete effectively with existing or new competitors.

Ex. D. Moreover, defendants specifically listed Mattel’s PowerTouch product – which was

introduced by Mattel in 7/03 – as a potential, but not actual, threat to the Company’s sales and

market share. Id.

113. On 10/3/03, LeapFrog sued Fisher-Price (a subsidiary of Mattel) for patent

infringement claiming that the competing PowerTouch product sold by Fisher-Price infringed

LeapFrog’s 861 patent related to its LeapPad family of products. The complaint, other pleadings



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

filed in the suit and the testimony of Wood, Bender and Brett Reed (“Reed”), LeapFrog’s damage

expert, during the trial show that defendants misled investors by downplaying the impact of Mattel’s

competing PowerTouch product and by representing that a decline in sales and market share was

only a possibility because LeapFrog had already lost sales, drastically reduced prices and offered

additional books with its LeapPad products in response to the introduction of the PowerTouch.

114. In the 10/3/03 complaint, LeapFrog alleged that Fisher-Price’s selling of its

PowerTouch Learning System (1) infringed LeapFrog’s patent, (2) had damaged LeapFrog, and (3)

would irreparably injure LeapFrog unless such infringing activities were enjoined. In LeapFrog’s

proposed jury instructions and trial brief, the Company claimed damages of $84 million because

sales of the PowerTouch which began in 7/03 (1) “took away sales of LeapFrog products that

LeapFrog would have made had Fisher-Price and Mattel not sold the PowerTouch learning system”

and (2) “caused LeapFrog to lower the price at which it actually sold its competing LeapPad

products.” Ex. E at 1, 10-12. Specifically, defendants stated that (1) LeapFrog would have sold at

least 1 million more units of its product if Mattel did not sell the PowerTouch, and (2) the Company

took “significant competitive actions in response to [Mattel’s] entry into the market” including

“drastic reductions in price” and including an extra book with its LeapPad systems because Mattel

advertised and promoted that the PowerTouch system included an extra book. Id.

115. During his opening statement at the patent infringement trial, LeapFrog’s lawyer, Ron

Shulman (“Shulman”), told the jury that “[t]he evidence will show that LeapFrog’s sales and profits

went down when Fisher-Price began selling PowerTouch” in 7/03. Ex. A at 136. Indeed, Mr.

Shulman stated that LeapFrog lost $65 million due to lost sales (after 10/3/03) and reduced prices.

Id. at 135, 814. He told the jury that the release of the PowerTouch “hit LeapFrog where it really

hurts” and that “LeapFrog took it in the gut when Fisher-Price introduced their PowerTouch.” Id. at

135. During his closing statement, Mr. Shulman told the jury it was not possible to believe the

PowerTouch did not impact sales of LeapFrog’s products. Id. at 1699.

116. The testimony during the trial shows that the $65 million of lost profits understates

the impact of Mattel’s PowerTouch product because the damage estimate does not include lost

profits prior to 10/3/03. That is because the patent laws do not allow LeapFrog to claim damages



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

prior to the date they gave notice to Fisher-Price that LeapFrog believed Fisher-Price was infringing

the patent. LeapFrog admits that Fisher-Price also sold 450,000 units of the PowerTouch prior to

10/3/03 which caused the Company to lose a like amount of LeapPad sales. Ex. A at 12, 515, 525.

LeapFrog’s lost profits increase to approximately $85 million – 78% of all profits reported by

LeapFrog from 2002 through 2004 – if the lost sales between 7/03 and 10/3/03 are included.1

117. During the trial, Wood testified that the PowerTouch caused three problems for

LeapFrog:

Q: Now, did the PowerTouch have any impact on LeapFrog’s ability to sell LeapPad?

A: Yes, it did.

Q: Briefly, can you explain what that impact was ?

A: Well, it created three problems for us. The first was we learned that Fisher-Price was going to include two books with the PowerTouch. We didn’t know they were going to be real skinny books. But we knew that on the cover, it said two books. So we did some research and we found out that we needed to include two books with our LeapPad. And that created two problems for us. One, it was a little bit expensive for the second book. But secondly, it turned out lots of parents, when they bought a LeapPad, normally they would buy a second book. But when they learned there were two included, they didn’t buy a second book. That was the first problem.

The second problem was that, at least in my opinion, every family that bought a PowerTouch should have bought a LeapPad. So we lost a sale of the LeapPad for each one they sold.

Then finally, my recollection is at the end of the year going into 2004 we reduced our prices significantly, so we lost a lot of profitability on the LeapPad.

Ex. A at 199-200.

118. Bender testified that LeapFrog tracked the sales of the PowerTouch in 2003 and 2004,

and that LeapFrog lost sales immediately after the PowerTouch was introduced in 7/03:

Q: In 2003, did you track competitive sales of PowerTouches in the marketplace ?

1 The Company’s damage expert testified that LeapFrog lost $35.4 million in profits because LeapFrog lost 630,000 sales or 80% of the 780,000 PowerTouch units sold after 10/3/03. Ex. A at 834, 839. That equates to $56.19 per lost sale ($35.4 million divided by 630,000). Thus, LeapFrog lost additional profits of $20.2 million assuming the Company lost 360,000 sales or 80% of the 450,000 PowerTouch units sold before 10/3/03 (360,000 multiplied by $56.19 = $20.2 million).



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

A: Yes, we did.

Q: Did you track the sales of the LeapPads in the marketplace ?

A: Yes, we did.

Q: Did that information give you any sort of a basis to have any understanding as to what was happening with respect to PowerTouch sales and LeapPad sales ?

A: Yes

Q: What was that understanding ?

A: We had a pretty good trend line of sales increases on the LeapPad business through July. And once the PowerTouch was introduced, and it was merchandised right next to the LeapFrog products, we immediately saw a depress in our sales on the hardware of LeapPads and the My First LeapPads.

Ex. A at 720.

119. Bender also testified that sales lost to the PowerTouch caused retailer channel

inventories to increase which resulted in the retailers reducing their purchases of LeapPads:

Q: So what if anything specifically happened to the retail sales of the LeapPad and the My First LeapPad after the PowerTouch came out ?

A: They declined.

Q: And where did they decline?

A: Well, they declined at retail – in the U.S. market. We shipped a lot of product into the consumers, because the buyers had, you know, believed we were going to sell this product, and we of course were increasing advertising to make sure that we were going to get our message across to consumers. But the products didn’t sell through at the rate that we had estimated or the buyers.

Q: Do you have any understanding as to why it was the – was why it was the PowerTouch that significantly affected the sales of the LeapPad, the My First LeapPad ?

A: They are going after the same audience, the same messaging, it was a learn to read experience. Moms had another choice. So being merchandised right next to LeapFrog, with a great brand name of Fisher-Price, they definitely took sales from us.

* * *

[W]e have access to online, to look at inventory levels at any given time of the year. We can see it by store. We can see it by chain, for any item. So at the end of the year, particularly, we do audits that make sure that we know what the inventory levels are at retail. This spread sheet [PX-1123] here is a compilation of that data that comes directly out of the customers’ systems. It is the most accurate information for determining information at retail.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Q: Does this accurately reflect retailer inventory levels of LeapPads and My First LeapPads at the end of 2003?

A: Yes, it does.

Q: What does it show about that ?

A: Well, nobody can see that because you need a telescope. But if you could look at the detail here, you could see that our carryforward inventory, which means the ending inventory, on the LeapPads and the My First LeapPads, was pretty significant, meaning it was high. Much higher than at any previous years, and much higher than our plan, and far higher than what the retailers plan was.

* * *

Q: Is this consistent with your recollection that there was excess retail inventory ?

A: Yes, absolutely. The retailers, you know, were disappointed that the buyers have plans that they are supposed to have a certain amount of inventory. Everybody had expectations that LeapFrog trends were going to continue and they would be solid at inventory through. And the Fisher-Price product did not add to the market. It took LP sales, so the inventory we shipped sat in retail stores.

Ex. A at 727-39.

120. Moreover, Bender testified the retail channel inventory increased despite the fact that

LeapFrog’s distribution and supply-chain problems prevented the Company from shipping products

to the retailers:

Q: [DTX-97] Is it your understanding that LeapFrog lost 1.2 million in LeapPad Pink orders for the quarter, unable to ship? Is that your understanding, sir?

A: For that quarter, yes. But I believe those would have shipped in early October.

* * *

Q: And in the first bullet point there it says lost 2.8 million in LeapPad and LeapPad Paint orders for the quarter due to availability. Is that correct, sir?

A: That’s correct.

Ex. A at 791-92.

Our retail sales slowed down when the PowerTouch product was introduced. And retailers reorder based upon sales. So we definitely lost some shipments there. But a lot of the purchases are made far in advance by retailers for Christmas season. So they are importing it from China in large quantities.

So in the case of 2003, although we missed some shipments, we shipped in a lot more product than actually sold. So what happened was, we really felt the shipment decreased in 2004 more than we did in 2003, although we had falloff, because so much product was left over after Christmas on the shelves.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Ex. A at 813.

121. LeapFrog’s damage expert, Brett Reed, testified that the PowerTouch very quickly

took away 25% of LeapFrog’s market share:

PowerTouch quickly got very strong distribution at the major retailers in America. And it also had very strong sales through to end customers in 2003. There was a study by Fisher-Price personnel that showed in 2003, the PowerTouch in terms of sales to end customers achieved about 25 percent in the way Fisher-Price was measuring that market. So it was a very quick, very strong performance.

* * *

But PowerTouch was able to achieve 25 percent of the market. So this would show the products in the market were really the PowerTouch, My First LeapPad and LeapPad, and that PowerTouch was able to take away 25 percent of the share from these LeapPad products.

Ex. A at 822-825. He also testified there were 460,000 LeapPad units in the retail channel at the end

of 2003 due to the lost sales and that sales to retailers declined dramatically in 2004:

In fact, I show here, the inventories increased at retailers compared to the end of 2002 to the end of 2003. There was 190,000 additional My First LeapPad platforms and there was 270,000 additional LeapPad platforms. So these would have been available to sell to the customers, the actual consumers, at the end of 2003.

Ex. A at 833.

[I]n late 2003, sales of the LeapPad buttoned and in 2004 sales to retailers declined dramatically.

Ex. A at 827. Reed testified that LeapFrog lost a total of 630,000 LeapPad sales after 10/3/03 due to

the PowerTouch:

During the damage period, Fisher-Price sold about 780,000 PowerTouch units, in my view, approximately 80 percent of that would be associated with lost LeapPad products. That translates into 630,000 units, approximately. Also I concluded that approximately half of those would be My First LeapPad lost sales and the other half would be LeapPad.

Ex. A at 834.

122. Although defendants represented that LeapFrog’s book sales were increasing as

shown by an increase in the tie ratio, Bender testified LeapFrog lost 2.9 million book sales and that

the tie ratio declined significantly after LeapFrog added a second book to the LeapPad platform in

response to Mattel including two books with the PowerTouch:



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Q: Does LeapFrog track [the] amount of additional books the typical owner of a LeapPad platform purchases ?

* * *

A: Yes, we do.

Well, the average consumer in our research shows that they will purchase between six and seven additional LeapFrog books after they buy the LeapPad.

* * *

Q: Do you also track book purchases per platform but on an annual basis ?

A: Yes. We call that the tie ratio. That is the number of books the consumer is buying against the platform.

* * *

Q: Can you just take a look at this and let me know if this exhibit [PX-1876] accurately reflects the annual tie ratios for those years?

A: Correct. So you can see, in ’99, when we launched the LeapPad, it was seven for each LeapPad. And then it increased to 1.6 in 2000, 2.4 in 2001, and 3.9 in 2002.

My point is, we had more books in the library. Plus we had more consumers on the system. They were both buying more books. It fell off in ’03 and then you can see, a pretty significant drop in ’04.

* * *

For the LeapPad, the tie ratio goes from a high of 3.9 in 2002 and it falls in 2003 to 3.7 and falls again to 2.9 in 2004.

Q: Why did that happen?

A: In 2003, about July, we added a second book into the LeapPad. You buy the LeapPad, there was one book in there, it was a sampler. Consumers would immediately either at that time buy a book, soon after, once the child is through that book, they are going to buy more. There was a competitive product in the market, the PowerTouch, and they were going to have two books in theirs. So we added a second book in 2003 to meet that competitive force that was coming into the market.

Q: If you added the second book in 2003, why is the ratio so much different in 2004?

A: Well, because consumers will buy the LeapPad, a good part of them are the Christmas period, the holiday period, October and December is really the big selling season. But the content, they really start coming after the content and buying a lot more in the first quarter, which would be January through March.

So we really saw the falloff because the children were playing with the included two books longer than they did when they got one. So they didn’t come back to the store as quickly for the next book.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Q: If Fisher-Price had not included a second book with the PowerTouch, would LeapFrog have bundled a second book with its LeapPad bundles ?

A: No.

Q: What effect would the second book have on LeapFrog sales ?

A: We measured we lost between about 2.8 and 2.9 million books that normally would have been sold to consumers.

Ex. A at 714-720.

123. Although defendants represented that LeapFrog was not changing its marketing

strategy in any way despite Mattel’s marketing blitz, Bender testified that LeapFrog increased the

marketing budget following the launch of the PowerTouch in addition to adding a second book:

Q: Did LeapFrog’s marketing budget change when you learned that the PowerTouch was coming out in 2003?

A: Yes.

Q: How?

A: We generally do most of our advertising starting mid-October and it comes through the beginning of December, when consumers are deciding what’s the best gifts for their children and who they are going to give gifts to for Christmas or holiday. In the case of 2003, we knew Fisher-Price was coming out with a very aggressive ad campaign starting in September.

And we didn’t want to be late getting our share of message to the consumer, so we felt it was important that LeapFrog get additional advertising expenditures in the month of September and for the back half of that year, so that consumers could hear from LeapFrog, what our products were.

Q: Did the budget for your marketing expenditures go up or down ?

A: They went up.

Ex. A at 726-727.

124. Bender also testified that LeapFrog substantially reduced prices on all LeapPad

products in 1/04 and that it would not have done so if the PowerTouch was not an available

competing product:

[I]t appeared that Fisher-Price was helping push down the retail pricing of the PowerTouch to effectively undercut the LeapPad pricing.

Q: Did LeapFrog take any action with respect to LeapPad pricing because of this ?

A: Yes.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Q: What was that?

A: Well, in January of 2004, we reduced the price of the LeapPad and My First LeapPad, and the QuantumPad and LeapPad Plus Microphone.

Q: For all of those products – let me ask you this: Why did the prices of all those products go down then?

A: Well, there is like a value proposition or chain. So the LeapPad is the core reading item. And then the next item is the LeapPad Plus Writing. So they can’t be too much apart from each other. If the price of the LeapPad is coming down, then the price of the LeapPad Plus Writing needs to be no more than about $10, according to our consumer research.

Q: Prior to this price change, had LeapFrog ever dropped the price to the retailers of the LeapPad products ?

A: No.

Q: Prior to making that change, at the beginning of 2004, did LeapFrog conduct any analysis to determine whether it should change prices in response to the PowerTouch?

A: Yes. This was a, you know, a subject we are very passionate about because it is the most important part of our business, the LeapPad. We did a number of studies of various retail prices and what would happen with Leapfrog’s share versus competitors. And we must have had 20 to 30 meetings as an executive team to decide, you know, what should we do to address the pricing of the LeapPad.

* * *

Q: In the absence of the PowerTouch, would LeapFrog have reduced the prices of the LeapPad family of products?

A: No.

* * *

Q: How important to LeapFrog’s business was the LeapPad family platform in 2004?

A: Well, it’s the largest segment of our business.

Q: After LeapFrog took down the prices on the LeapPads in January, what if anything happened to LeapFrog’s profitability?

A: Well, 2004 was the first year since I was there in 1997 that the company didn’t make its plan. We had a bad year. We missed our profit plan by over $70 million dollars. And it was a tough year.

Q: Has LeapFrog had to take any actions because of missing the plan last year?

A: Yes. After the 2004 year ended, which we ended with a large loss, in the millions, we had to cut a large number of educational products, we were developing some new technologies and new content for educational products for kids, that was the first



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

thing. Then the second thing is we had to let go about 170 great people that helped build this company.

Ex. A at 728-33.

125. Although defendants represented that the sale of the PowerTouch could have a

positive impact on LeapFrog’s sales by drawing buyers into stores, Bender testified defendants knew

that would not occur:

Q: In your marketing research, did you come to have any understanding as to whether or not the Fisher-Price brand name helped Fisher-Price make sales of the PowerTouch ?

A: Yes, it was very important to consumers.

Q: In your understanding of the market, do you have any understanding as to whether or not the Fisher-Price brand name on the PowerTouch brought people onto the learning aisle that otherwise would never have been there?

A: I don’t believe so.

Q: Why not?

A: LeapFrog is the number one thought of educational background. Consumers have come to shop that aisle, looking for educational products. Fisher-Price is not known, like LeapFrog, as the number one educational brand.

Ex. A at 721-22.

126. LeapFrog’s damage expert, Reed, testified that LeapFrog’s damages totaled $65.34

million due to the lost sales and price reductions caused by the sale of the PowerTouch. Ex. A at

819. Specifically, he testified that LeapFrog lost $35.4 million of profits because the Company lost

630,000 LeapPad sales and 2,768,000 book sales after 10/3/03. Id. at 834-839. He also testified that

LeapFrog lost $28.36 million of profits by lowering the price of the LeapPad platforms by $8.69 in

1/04. Id. at 839-44. Reed also testified that LeapFrog lost royalties of $1.58 million for the 157,600

sales of the PowerTouch after 10/3/03 that did not result in lost sales of LeapPads. Id. at 844, 852.

D. Defendants Knew that LeapFrog’s Results Were Dependant on a Few Customers that Were Deferring Orders to Reduce Their Levels of LeapFrog Inventory and Reducing Their Purchases Due to the Problems with LeapFrog’s Distribution and Supply-Chain Operations

127. In LeapFrog’s SEC reports, defendants admitted that LeapFrog’s business depended

on three retailers (Wal-Mart, Toys R Us and Target) that together accounted for approximately 69%

of net sales in 2002, 68% in 2003 and 64% in 2004. Ex. F. In addition, defendants represented that



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

LeapFrog’s business and operating results could be harmed if any of the retailers reduced their

purchases, changed the terms on which LeapFrog conducted business with them or experienced a

future downturn in their business. LeapFrog also represented that its business and operating results

could be significantly harmed if any retailer (1) reduced its overall purchases of the Company’s

products, (2) reduced the number and variety of products that it carried and the shelf space allotted

for LeapFrog’s products, (3) decided not to incorporate versions of the Company’s Learning Center

shelf displays in its stores or (4) otherwise materially changed the terms of their current relationship.

Ex. G. Defendants misled investors by representing that a change in the terms of their current

relationships with retailers was only a potential risk to the Company’s business and operating results

because they knew that Wal-Mart, Toys R Us and Target were reducing their purchases of LeapFrog

product.

128. The Company’s SEC reports confirm that Wal-Mart and Toys R Us, LeapFrog’s two

largest retail customers, substantially reduced their purchases of LeapFrog product by more than $54

million from 2003 to 2004. According to Leapfrog’s 2004 10-K, sales to Wal-Mart declined by

$31.5 million from $210.8 million in 2003 to $179.3 million in 2004. Similarly, sales to Toys R Us

declined by $22.7 million from $170 million in 2003 to $147.3 million in 2004.

129. Defendants knew that the Company’s retailers planned to and did reduce or defer

their purchases of Leapfrog product beginning no later than 3Q03. In their SEC reports, defendants

admitted that the Company’s retail customers were deferring orders to reduce inventory levels which

shifted a significant portion of inventory risk and carrying costs to LeapFrog and required LeapFrog

to supply product within shorter time frames. Ex. H. As detailed in ¶¶44-111, several former

LeapFrog employees stated that LeapFrog’s retail customers cancelled existing orders and reduced

their purchases of LeapFrog product due to LeapFrog’s inability to ship the product at all or to ship

the product that was actually ordered.

130. In LeapFrog’s SEC reports, defendants admitted that LeapFrog worked closely with

its retail customers to forecast demand for its products:

Our sales team works in conjunction with store buyers from our key retailers to forecast demand for our products, develop the store footprint, secure retail shelf space for our products and agree upon pricing components, including cooperative



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

advertising allowances. The large retail chains generally provide us with a preliminary forecast of their expected purchases of our products early in the year. While these and subsequent forecasts are not contractually binding, they provide important feedback that we use in our planning process throughout the year. We work closely with our key retailers during the year to establish and revise our expected demand forecasts and plan our production and delivery needs accordingly. Most retailers issue purchase orders to us, as they need product. Based upon these orders, we prepare shipments for delivery through various methods.

Ex. D.

131. Bill Ganey, LeapFrog’s Vice President of U.S. sales, stated in a 5/14/03 LeapFrog

press release, the Company “work[ed] very closely with our retail partners to exceed our shared sales

goals and to provide the consumer with an excellent shopping experience and product value.” In an

8/04 article on inboundlogistics.com, John Casella, LeapFrog’s former Chief Information Officer,

stated the following:

We [LeapFrog] assign account teams to each retail customer. The teams work closely with the [retailer’s] buyers to make sure supply and demand are in alignment. As a result, LeapFrog has a tighter connection with buyers regarding forecasts. ... we put increasing emphasis on our sales forecasting process.

It was also reported in the article that LeapFrog’s executive team reviews the sales forecasts and

information from marketing and then develops a consensus forecast that the Company buys to.

132. Defendants also knew that Wal-Mart began providing substantial price discounts on

LeapFrog’s (and other toy manufacturer’s) products in 9/03 as part of a price war to capture market

share during the 2003 holiday season. Although toy price wars had always been part of the holiday

season, the financial press reported that it was even more brutal than expected in 2003 as shown by

Wal-Mart’s dramatic price reductions in 9/03 which was six weeks earlier than usual. In fact, the

financial press reported the price wars contributed to the bankruptcies of FAO, Inc. and KB Toys

Inc. Tom Pritchard, LeapFrog’s senior vice president of marketing, confirmed that Wal-Mart

reduced the prices of LeapFrog’s products to help establish Wal-Mart as a destination for those

products.

133. Bender’s trial testimony in LeapFrog’s patent infringement suit against Mattel shows

that defendants also knew that retailers were reducing their purchases of LeapFrog’s products

because of a significant increase in channel inventories caused by sales of the PowerTouch. Ex. A at

736-39, 813.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

E. Defendants Received Millions of Dollars in Proceeds from Their Sales of LeapFrog Stock While Making Material Misrepresentations and Concealing Material Adverse Information from Investors

134. As alleged herein, defendants acted with scienter because they had actual knowledge

that their public statements were materially false and misleading. Defendants’ insider sales,

therefore, are not necessary to establish their scienter in this case. But defendants’ insider sales are

clearly probative of their knowledge and strengthen the already strong inference of scienter. The

Individual Defendants sold substantial amounts of their LeapFrog stock during the Class Period that

were suspicious in timing and amount. As shown in Ex. I, defendants sold 4,346,547 shares of their

LeapFrog stock and received proceeds in excess of $103 million. The sales were at prices that were

two to four times higher than $11.99, the closing price of the stock on 10/19/04, after declining more

than 34% from the previous day’s closing price. LeapFrog’s stock price has not recovered and

continues to trade in the $11.00 range.

135. In addition, the sales represented a substantial percentage of the Individual

Defendants’ stock and vested options.

Defendant

Shares Sold Stock Holdings % of Sales to Stock Holdings

Vested Options

% Sales to Stock Holdings and Vested Options

Wood 3,475,588 3,476,588 100% 0 100%Curley 30,000 31,121 96.4% 96,250 23.6%Kalinske 122,777 463,953 26.5% 152,639 19.9%Bender 170,000 172,181 98.7% 48,249 77.1%Rioux 180,000 193,133 93.2% 152,000 52.2%Lally 153,750 219,285 70.1% 64,313 54.2%Flowers 145,000 238,699 60.7% 185,895 34.2%Marggraff 69,432 233,518 29.7% 224,084 15.2%

Total 4,346,547 5,028,478 86.4% 923,450 73.0%

136. The sales by Wood and Kalinske were also dramatically out of line with their sales

prior to the Class Period. Wood sold 3,475,588 shares during the Class Period, more than three

times the 1,026,084 shares he sold before the Class Period. Kalinske sold 122,777 shares during the

Class Period, more than four times the 30,000 shares he sold prior to the Class Period.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

137. The timing of the sales was also suspicious. Between 7/24/03 and 10/21/03 when

LeapFrog’s stock price was trading at its all time high and when defendants knew about the shipping

problems and that sales of the PowerTouch were causing a decline in sales of LeapPads, all of the

defendants sold 688,318 shares for $24,921,291. Between 10/22/03 and 2/10/04 when defendants

knew the shipping problems continued, that LeapFrog was losing additional sales to the

PowerTouch, LeapFrog had “drastically reduced” prices on all LeapPad platforms, and the tie ratio

was declining, defendants unloaded an additional 702,031 shares for $21,163,627.

138. Wood’s sale of 2.7 million shares in 9/04 for $51 million was particularly suspicious.

Wood sold the stock in a private transaction and did not file a Form 4. Wood filed Form 144 on

9/7/04 which indicated he intended to sell all of his remaining class A stock, 2,688,642 shares, for

$51 million. But Wood never filed a Form 4 disclosing he had actually sold the stock. LeapFrog’s

2004 and 2005 Proxies confirm the sale and show Wood owned 2,663,417 class A shares as of

4/8/04 and just 1000 shares as of 4/11/05. The undisclosed $51 million sale occurred when Wood

knew about the problems with CLI that were significantly and adversely impacting LeapFrog’s

operating and financial results, and just before the Company reported the 10/18/04

preannouncement.

139. The financial press noted the suspicious nature of Wood’s private sale. On 10/18/04,

after LeapFrog announced 3Q04 sales and earnings would be sharply below expectations, Herb

Greenberg wrote the following:

SAN DIEGO (CBS.MW) – The writing was on the wall for a blowup at LeapFrog Enterprises.

There are plenty of reasons, which I’ve detailed in multiple columns over the past year and a half or so.

But the biggest red flag came a little over a month ago. As I wrote in Herb Greenberg’s RealityCheck at the time, the buzz in my channel was that former LeapFrog . . . CEO and founder Michael Wood sold 2.5 million shares of stock in a private transaction.

The company wouldn’t confirm that Wood, was the seller and Wood – chief vision officer, chief creative officer and vice chairman of the board immediately prior to his departure – never returned my call. (But by the same token, he also never called to complain about the story!).



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

According to the company’s April proxy, Wood who left the company Sept. 1 after being demoted in February, had 2.6 million shares. As I wrote at the time, “If Wood indeed was the seller, the timing of the sale would definitely be an eyebrow raiser. Did he sell because he decided it’s time to get out while the getting is good, which would be a negative? Or did he sell because he’s miffed he was pushed out and wanted nothing more to do with the company, which would be less of a negative?”

Based On Monday’s warning that third quarter and 2004 sales and earnings will be sharply below expectations, it looks like it might have been both.

DEFENDANTS’ FALSE AND MISLEADING STATEMENTS ISSUED DURING THE CLASS PERIOD

A. False and Misleading Statements Between 7/24/03 and 10/20/03: Defendants Falsely Assure Investors There Are No Impediments to LeapFrog Meeting 3Q03 Guidance, Include Materially False and Misleading Risk Factors in the Company’s 2Q03 10-Q and Downplay the Impact of the PowerTouch

140. False Statement: On 7/24/03, defendants Wood, Curley and Bender participated in

LeapFrog’s 2Q03 earnings conference call attended by various analysts that followed the Company.

During the conference call, defendants made the following false statements:

(a) Defendant Wood stated that LeapFrog “experienced strong growth in all three

of [LeapFrog’s] divisions, U.S. consumer, international consumer and U.S. SchoolHouse,” that

LeapFrog was “optimistic about the second half of this year,” and that “[w]e believe we enter the

second half of 2003 with good momentum, exciting new products and expanded distribution in each

of our three business divisions.” Wood also stated, “[w]e believe our new product offerings, which

include three new platforms, 31 new software titles and 15 new stand-alone products in the U.S.

consumer division will help maintain LeapFrog momentum for the second half.” Wood also stated

that “[o]ur product offerings this fall have created considerable buyer enthusiasm. You can expect to

see increased shelf space for our products at our existing retail partners and new distribution in such

retail outlets as Radio Shack and Best Buy.”

(b) Defendant Curley reaffirmed the Company’s previous guidance for 3Q03,

4Q03 and FY03 as follows:

We are reaffirming our third and fourth quarter guidance. Note that the guidance for the third and fourth quarters is unchanged from that published in our fourth quarter press release on February 10th. So to reiterate it, it’s as follows: third quarter 2003 net sales in a range from 225 to 235 million. Operating income, a



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

range of 54 to 57 million. And diluted net income per share, a range of 55 to 58 cents. Fourth quarter 2003, net sales 277 to 297 million.

Operating income, 66 million to 71 million. And diluted net income per share of 68 cents to 74 cents. Now, for the full year, as we have exceeded expectations in the second quarter, our full-year guidance should be revised as follows: net sales for the full year will be in a range of 647 to 683 million. Gross profit margin, 52 to 53% of net sales. Operating expenses, a range of 37 to 38% of sales. Our effective tax rate is 37%. Net income, we estimate 71 to 76 million. And our fully diluted share count is 60.6 million shares, and this results in a diluted net income per share for the full year of $1.17 to $1.25. . . .

(c) In response to a question from Bank of America Securities analyst Howard

Block, Wood stated that LeapFrog was ready to keep the Company’s retail customers in stock as

LeapFrog moved into the peak selling season:

[A]s you know, we’re right in the middle of the fall recess in all of our retailers. And given the expanded space that we’ve got and the expanded disproportionate number of new items, this is a natural time for us to be building up inventory. Just want to characterize, we think this is the appropriate place to be with inventory. One, very little risk on a carrying cost of inventory at this time. And secondly, we’re ready to keep our customers in stock as we move forward in this critical third period. . . .

(d) In response to a question from Salomon Smith Barney analyst Jill Krutick

about the Company’s supply-chain initiatives, Wood stated the Company had successfully launched

improvements in the supply-chain operations:

We continue to make strong growth in supply-chain. As I mentioned, our director of IT has implemented a supply-chain strategy both here and in our Hong Kong office, and now increasingly throughout our international divisions. And we all feel good about the successful launch of that improvement for this fall. . . .

(e) In response to another question from Krutick about the Company’s guidance,

defendant Wood stated there were no impediments to reporting results in line with guidance.

We feel very positive. We’re going to stick with our guidance until we continue to eliminate those uncertainties that remain ahead of us throughout the year. And that would be true on net sales and on net income. But there’s no boogie man out there in either of those of which we’re aware.

Kutrick: No impediments in terms of retail inventory levels being a little bit higher heading into the holiday season?

Wood: No.

141. Facts showing why statements were materially false and misleading and that

defendants knew it: Defendants knew their statements were materially false and misleading for the

reasons set forth in ¶¶34-139. Specifically, defendants knew there were numerous impediments that



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

would preclude LeapFrog from reporting the financial results reiterated during the 7/24/03

conference call:

(a) On 10/21/03, LeapFrog reported 3Q03 sales of $203.9 million or 11% less

than the $225-$235 million defendants told investors there were no impediments to achieving.

Although defendants did not know the precise amount of the 3Q03 sales miss on 7/24/03, they knew

that the problems with the distribution and supply-chain operations, particularly the inability of DSS

to ship product to LeapFrog’s customers, were very real impediments to LeapFrog reporting sales in

line with the guidance reiterated during the 7/24/03 conference call. The witness accounts show that

by 7/24/03 defendants knew DSS was unable to ship product to the Company’s retail customers

within shorter time periods and that DSS was shipping product to Wal-Mart, Target and Toys R Us

that they had not ordered and would not pay for. In addition, defendants knew the Company’s retail

customers repeatedly complained about the inability to accurately fulfill orders and reduced their

purchases of LeapFrog product as a result. In fact, defendants had already decided to replace DSS

with another warehouse management company because of the problems.

(b) During LeapFrog’s 10/22/03 conference call, defendants admitted they knew

about the sales miss well before they disclosed it publicly on 10/21/03. During the conference call

Wood admitted the sales shortfall was due to the Company’s inability to ship product in response to

orders received in the last 10 days of the quarter. In addition, Wood stated that LeapFrog would

have needed more orders earlier in the quarter to have met guidance because DSS could not ship

orders received in the last 10 days of the quarter. In fact, Wood admitted that LeapFrog thought

about preannouncing 3Q03 results but decided not to.

(c) As detailed in ¶¶112-126, pleadings filed in the Company’s patent

infringement suit against Mattel and the testimony of Wood, Bender and Reed show that defendants

knew sales of Mattel’s competing PowerTouch product was another impediment to LeapFrog

reporting 3Q03 results in line with the reiterated guidance. In its trial brief, LeapFrog admitted that

(i) it would have sold at least 1 million more units of product if Mattel did not sell the PowerTouch

and (ii) LeapFrog took significant competitive actions in response to Mattel’s entry into the market

including “drastic reductions in price” and including an extra book with its LeapPad systems because



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Mattel advertised and promoted that the PowerTouch system included an extra book. Ex. E. The

testimony of Wood, Bender and Reed show that defendants knew LeapFrog lost 450,000 sales prior

to 10/3/03. Bender testified that LeapFrog tracked sales of the PowerTouch and LeapPads in 2003

and that “once the PowerTouch was introduced [in 7/03], and it was merchandised right next to the

LeapPad products, we immediately saw a depress in our sales on the hardware of LeapPads and

the My First LeapPads.”

(d) Defendants also knew that the Company was facing competition from

Publications International LLC (“PIL”), a company LeapFrog had just settled a lawsuit with on 2/03.

PIL introduced two new products, the ActivPad, a stylus driven electronic workbook system that

competed with the LeapPad and Story Reader, a portable electronic storybook reader that competed

with the Leapster – a product that LeapFrog did not introduce until 11/03. Further, defendants knew

as was reported in the financial press, that PIL’s competing products retailed for $30 which was

substantially less than the price of LeapFrog’s products.

(e) The distribution and supply-chain problems and the lost sales caused by

Mattel meant defendants could not accurately forecast LeapFrog’s future financial results. Thus,

defendants knew they had no reasonable basis for reiterating the guidance for 3Q03, 4Q03 and

FY03. CW7 said that Wood, Kalinske and Curley repeatedly told LeapFrog employees during

quarterly meetings that the Company was not doing well and would not meet its goals. After failing

to accurately forecast the Company’s 3Q03 financial results, LeapFrog substantially lowered

guidance for 1Q04 on 3/10/04, just one month after providing initial guidance. The Company

lowered guidance again on 4/21/04 and 10/18/04. On 12/16/04, LeapFrog not only withdrew

guidance but failed to provide any new guidance because as Kalinske stated, “we’ve been so

horrible at providing guidance I just don’t think there’s any benefit in continuing the practice for

the rest of this year.” The Company’s new CFO also conceded LeapFrog could not forecast its

results: “[W]e’re withdrawing our guidance for 2004 . . . it’s been difficult to provide useful

financial guidance. Specifically, we are faced with a number of factors that make this type of

analysis even more complicated . . . we have not had all the processes in place to give us adequate



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

visibility to provide more accurate information . . . therefore, we are not in a position to provide

guidance.”

(f) As detailed in ¶¶134-139, defendants’ sales of 688,318 shares for $24.9

million between 7/24/03 and 10/21/03 when LeapFrog’s class A stock traded at its all time high

indicate they knew there were impediments to LeapFrog meeting the 3Q03 results.

(g) In addition to the witness accounts, defendants’ admissions during the

10/22/03 conference call, defendants’ admissions in the suit against Mattel and defendants’

suspicious insider sales, defendants’ knowledge is also reasonably inferred from their positions in

the Company and the nature of the improprieties. Defendants were the senior most officers of the

Company and knew that competition from Mattel and the ability to ship product to LeapFrog’s retail

customers were material risks to the Company’s business and operating results.

142. Stock Price: After declining 17% in the two weeks leading up to the conference call,

defendants false positive statements about LeapFrog caused the price of the Company’s stock to

increase 8.5%, from a closing price of $28.30 on 7/23/03, to a closing price of $30.70 on 7/24/03.

That increase compared to a 0.7% decline in the S&P 500 and a 0.2% decline in the S&P Consumer

Discretionary Index (the “proxy peer group”) – the indices LeapFrog used in its Proxy Statements as

a comparative peer group. On 7/24/03, Reuters reported that LeapFrog’s shares jumped more than

8% after the conference call. LeapFrog’s stock price continued to increase, closing at $31.16 on

8/19/03, a 10.1% increase from 7/23/03, compared to a 1.3% increase in the S&P 500 and a 3.7%

increase in the proxy peer group.

143. False Statement: On 8/11/03, LeapFrog filed its 2Q03 Form 10-Q with the SEC

which was signed by defendants Wood and Curley. The 10-Q included false and misleading

statements regarding (a) the Company’s ability to ship product to its customers within shorter time

periods, (b) the Company’s ability to compete effectively with existing or new competitors, (c) the

dependence on Wal-Mart, Toys R Us and Target for a majority of the Company’s sales, and (d) the

Company’s internal controls over financial reporting.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

(a) Defendants represented that LeapFrog’s relationships with its retail customers

could be damaged, shipping costs could increase and sales opportunities could be delayed or lost if

the Company was unable to meet tight shipping schedules and fill retail orders:

Our business is seasonal, and therefore our annual operating results will depend, in large part, on sales relating to the brief holiday season.

Sales of consumer electronics and toy products in the retail channel are highly seasonal, causing the substantial majority of our sales to U.S. retailers to occur during the third and fourth quarters. In 2002, approximately 81% of our total net sales occurred during this period. This percentage of total sales may increase as retailers become more efficient in their control of inventory levels through just-in-time inventory management systems. Generally, retailers time their orders so that suppliers like us will fill the orders closer to the time of purchase by consumers, thereby reducing their need to maintain larger on-hand inventories throughout the year to meet demand. While these techniques reduce retailers’ investments in their inventory, they increase pressure on suppliers to fill orders promptly and shift a significant portion of inventory risk and carrying costs to suppliers like us. The logistics of supplying more product within shorter time periods will increase the risk that we fail to meet tight shipping schedules, which could damage our relationships with retailers, increase our shipping costs or cause sales opportunities to decline. . . .

Ex. H. Defendants further represented that LeapFrog’s operating results could suffer if it failed to

develop and maintain management systems and resources sufficient to manage the Company’s rapid

growth:

Our rapid growth has presented significant challenges to our management systems and resources, and we may experience difficulties managing our growth.

Since the introduction of our first platform, we have grown rapidly, both domestically and internationally. Our net sales have grown from $71.9 million in 1999 to $531.8 million in 2002. . . . This expansion has presented, and continues to present, significant challenges for our management systems and resources. If we fail to develop and maintain management systems and resources sufficient to keep pace with our planned growth, our operating results could suffer.

Ex. J.

(b) Defendants represented that sales and market share could decline if LeapFrog

was unable to compete effectively:

If we are unable to compete effectively with existing or new competitors, our sales and market share could decline.

We currently compete primarily in the infant and toddler and preschool categories and electronic learning aids category of the U.S. toy industry and, to some degree, in the overall U.S. and international toy industry. . . . Each of these markets is very competitive and we expect competition to increase in the future. For example, in July 2003, Mattel, Inc. introduced under its Fisher-Price brand a



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

product called “PowerTouch” having functionality similar to that of our LeapPad platform. . . . Many of our direct, indirect and potential competitors have significantly longer operating histories, greater brand recognition and substantially greater financial, technical and marketing resources than we do. These competitors may be able to respond more rapidly than we can to changes in consumer requirements or preferences or to new or emerging technologies. They may also devote greater resources to the development, promotion and sale of their products than we do. We cannot assure you that we will be able to compete effectively in our markets.

Ex. D. Defendants also represented that sales of platforms, the product that Mattel’s PowerTouch

competed with, were of particular importance to LeapFrog’s financial results:

We currently rely, and expect to continue to rely, on our LeapPad platform and related interactive books for a significant portion of our sales.

Our LeapPad platform and related interactive books accounted for approximately 48% of our net sales in 2002 No other product line, together with its related software, accounted for more than approximately 10% of our net sales [in] 2002. A significant portion or our future sales will depend on the continued commercial success of our LeapPad Platform and related interactive books. If the sales for our LeapPad platform are below expected sales or if sales of our LeapPad interactive books do not grow as we anticipate, sales of our other products may not be able to compensate for these shortfalls and our overall sales would suffer.

Ex. K.

(c) Defendants represented that LeapFrog’s business and operating results could

be harmed if Wal-Mart, Toys R Us or Target, the three retailers that accounted for 85% of the

Company’s U.S. Consumer sales in 2003 and 95% in 2004, reduced their purchases, changed the

terms on which they conducted business with LeapFrog or experienced a downturn in their business:

Our business depends on three retailers that together accounted for approximately 69% of our net sales in 2002, and our dependence upon a small group of retailers may increase.

Wal-Mart (including Sam’s Club), Toys “R” Us, and Target accounted in the aggregate for approximately 69% of our net sales in 2002. We expect that a small number of large retailers will continue to account for a significant majority of our sales and that our sales to these retailers may increase as a percentage of our total sales. At December 31, 2002, Wal-Mart (including Sam’s Club) accounted for approximately 33% of our accounts receivable and Toys “R” Us accounted for approximately 30% of our accounts receivable. If any of these retailers experience significant financial difficulty in the future or otherwise fail to satisfy their accounts payable, our allowance for doubtful accounts receivable could be insufficient. If any of these retailers reduce their purchases from us, change the terms on which we conduct business with them or experience a future downturn in their business, our business and operating results could be harmed.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

We do not have long-term agreements with our retailers and changes in our relationships with retailers could significantly harm our business and operating results.

We do not have long-term agreements with any our retailers. As a result, agreements with respect to pricing, shelf space, cooperative advertising or special promotions, among other things, are subject to periodic negotiation with each retailer. Retailers make no binding long-term commitments to us regarding purchase volumes and make all purchases by delivering one-time purchase orders. If the number of our products increases as we have planned or the roll out of versions of our Learning Center shelf displays in selected retail stores proceeds as we anticipate, we will require more retail shelf space to display our various products. Any retailer could reduce its overall purchases of our products, reduce the number and variety of our products that it carries and the shelf space allotted for our products, decide not to incorporate versions of our Learning Center shelf displays in its stores or otherwise materially change the terms of our current relationship at any time. Any such change could significantly harm our business and operating results.

Exs. F and G.

(d) Defendants represented that LeapFrog’s financial results were prepared in

accordance with GAAP and that the Company’s internal controls over financial reporting – a process

designed to provide reasonable assurance that the Company’s financial reporting was reliable and

that the Company’s financial statements were prepared in accordance with GAAP – were effective.

Ex. C.

(e) As required by §302 of Sarbanes-Oxley, Curley and Wood certified that (1)

the 10-Q did 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, (2) the financial statements included in the 10-Q fairly presented in all




Company’s internal controls over financial reporting which were reasonable or likely to adversely

affect LeapFrog’s ability to record, process, summarize and report financial information. Ex. L.


defendants knew it: Defendants knew their statements contained in the 2Q03 Form 10-Q were

materially false and misleading for the reasons detailed in ¶¶34-139. Specifically:



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

(a) As detailed in ¶¶44-111, the witness accounts and the Company’s admissions

during the 10/22/03 conference call and after the Class Period show that defendants knew

LeapFrog’s relationships with its retail customers had already been damaged, shipping costs had

already increased and sales had already declined because DSS was unable to ship product to the

Company’s retail customers within shorter periods and because DSS shipped product to the retailers

that they had not ordered and would not pay for.

(b) Defendants also knew that LeapFrog’s operating results were already

suffering because the Company had not developed and maintained sufficient management systems to

keep pace with planned growth. As admitted by defendants after the Class Period and as explained

by the witnesses, LeapFrog’s failure to implement supply-chain software caused a significant

adverse impact on the Company’s operating and financial results. Specifically, LeapFrog was

unable to assure it had sufficient levels of inventory to fill customer orders because the Company did

not upgrade existing or implement new operational information systems, including supply-chain

management systems.

(c) As detailed in ¶¶112-126, LeapFrog’s suit against Fisher-Price/Mattel shows

defendants knowingly deceived investors by representing that competition could cause sales and

market share to decline. Pleadings LeapFrog filed in that suit and the testimony of Wood, Bender

and Reed show defendants knew the Company was losing millions of dollars in sales and profits due

to the sale of PowerTouch including the loss of 450,000 LeapPad sales before 10/3/03. In short,

competition already had caused a reduction in sales and profitability at LeapFrog.

(d) Defendants knew their representations that LeapFrog’s business and operating

results could be harmed if Wal-Mart, Toys R Us or Target reduced their purchases, changed the

terms on which they conducted business with LeapFrog or experienced a downturn in their business,

were materially false and misleading. As defendants admitted during the 10/22/03 conference call,

they knew the revenue shortfall in 3Q03 was caused by retailers deferring orders due to their

conscious decision to defer inventory buildup. In addition, they knew that the retail customers had

reduced orders of the Company’s products and imposed millions of dollars of vendor violation

penalties because DSS was unable to ship product within shorter time periods and because DSS



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

shipped product that the retailers had not ordered and would not pay for. Bender’s testimony in the

Mattel suit shows that defendants knew they lost sales to retailers because sales of the PowerTouch

reduced sales of LeapPads which caused retail channel inventories to increase: “[T]he ending

inventory, on the LeapPads and the My First LeapPads, was pretty significant, meaning it was

high. Much higher than at any previous years, and much higher than our plan, and far higher

than what the retailers plan was . . . Fisher-Price product did not add to the market. It took LP

sales, so the inventory we shipped sat in retail stores.”

(e) As detailed in ¶¶87-111, the witness accounts and the admissions by

defendants in the 2004 10-K show that defendants knew the certifications that LeapFrog’s disclosure

controls and internal controls over financial reporting were not sufficient to ensure the reliability of

the Company’s financial reporting or that the Company’s financial statements were prepared in

accordance with GAAP. The witness accounts and post-Class Period admissions show defendants

knew there were numerous material weaknesses in the areas of revenues and accounts receivable,

costs of goods sold and inventory, and information technology controls related to the purchase of

materials and components used to manufacture and assemble products, the manufacture and

assembly of products, the distribution, invoicing and sale of products and the remittance of payments

by vendors, customers and LeapFrog.

145. False Statement: On 8/20/03 Bear Stearns issued a report entitled, “Takeaways from

Upbeat Meetings with Management” that was based on and repeated statements by defendants.

Our recent meetings with management of LeapFrog enhanced our conviction that the second half of the year will be a blow out and the company’s long term prospects remain bright.

Sales momentum remains strong, shelf space is increasing at retail, manufacturing costs are dropping and distribution channels continue to expand.

Management was nonchalant over Mattel’s launch of its competing product and the marketing blitz that will accompany it.

* * *

[Management] also believe[s] [Mattel’s PowerTouch] could have a positive impact. Mattel’s marketing spend will surely elevate consumer awareness and potentially draw buyers into stores which could, in fact, stir sales of the LeapPad or other LeapFrog products which tend to show better at retail. Furthermore, management



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

believes that Mattel’s PowerTouch will prove to have less staying power than LeapFrog’s products. . . .

Management indicated that it is not changing its marketing strategy in any way despite Mattel’s marketing blitz for its competing PowerTouch product. . . .

146. Facts showing why the statements repeated to the market by Bear Stearns were false

and misleading and that defendants knew it: The statements by defendants that were repeated to the

market in the 8/20/03 Bear Stearns report were false and misleading for the reasons set forth in

¶¶112-126. Defendants knew they were misleading Bear Stearns into serving as conduits for

distributing false information to investors. Specifically:

(a) Defendants knew that the second half of the year would not be a blowout and

that sales momentum was not strong because retailers were deferring orders and because LeapFrog

was losing millions of dollars in sales and profits as a result of Mattel’s competing PowerTouch

product. As admitted during the 10/22/03 conference call, defendants knew the shipping problems

would prevent LeapFrog from reporting 3Q03 revenues they previously told investors there were no

impediments to reporting.

(b) Contrary to their representations defendants were not nonchalant about

Mattel’s competing PowerTouch product and were changing marketing strategies. Wood or Bender

testified that LeapFrog immediately added another book to the LeapPad platforms, increased the

marketing budget, and started its holiday advertising campaign earlier than usual, in response to

Mattel including two books with the PowerTouch. They also testified that LeapFrog immediately

saw a decline in sales of LeapPad platforms and content books after the PowerTouch was launched

in 7/03. Bender’s testimony in the patent infringement suit shows that defendants knew that the

PowerTouch would not have a positive impact by drawing buyers into stores:

Q: In your understanding of the market, do you have any understanding as to whether or not the Fisher-Price brand name on the PowerTouch brought people onto the learning aisle that otherwise would never have been there?

A: I don’t believe so.

Q: Why not?

A: LeapFrog is the number one thought of educational background. Consumers have come to shop that aisle, looking for educational products. Fisher-Price is not known, like LeapFrog, as the number one educational brand.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Ex. A at 721-22.

147. Stock Price: As reported by The Wall Street Journal on 8/20/03, LeapFrog’s stock

price increased $2.40 or 7.6% from $31.61 on 8/19/03 to $34.01 on 8/20/03 after Bear Stearns issued

the report repeating defendants’ positive statements. The 7.6% increase in LeapFrog’s stock price

compared to a 0.2% decline in the S&P 500 and a 0.1% increase in the proxy peer group.

LeapFrog’s stock price continued to increase and closed at $37.95 on 9/16/03, a 20% increase from

the closing price of $31.61 on 8/19/03. During the same time period the S&P 500 increased 2.7%

and the proxy peer group increased 1.3%. In fact, on 9/8/03 Bear Stearns issued a report lowering its

rating on LeapFrog’s stock due to the 30% increase in the stock price over the past three weeks.

148. False Statement: On 9/17/03, defendants Kalinske and Curley made a presentation at

the Bank of America Securities 33rd Annual Investment Conference and the ThinkEquity Partners

Growth Conference. During both conferences, Kalinske and Curley gave what Citigroup Smith

Barney analyst Jill Krutick (“Krutick”) described in her 9/17/03 report as “very positive”

presentations. Kalinske and Curley touted LeapFrog’s historical growth and stated the introduction

of three new platforms in the second half of 2003 would result in continued growth and a very big

second half for LeapFrog. But neither would comment on the Company’s guidance for 3Q03 and

4Q03 which they knew LeapFrog would not meet.

This is going to be a very big second half for us with the launch of three new platforms. So that brings our platform family from six to nine. So we think that will drive a lot of new platform sales.

At the same time we’re selling – our library of software’s become bigger and bigger. So we’ll see continued success with that. We haven’t broken out guidance on what we estimate the mix to be. But having said that we expect growth in all three categories – you know software, hardware and stand-alone products.

* * *

Right now we’re in a black-out period. It’s the last month of the quarter. So we’re refraining from any kind of discussion even about previously published guidance.

Curley represented that LeapFrog was a financially disciplined company:

I’d like to demonstrate that we’re also a financially disciplined company. You may say, well, how do you get financial discipline in a creative, innovative environment? And I think you have to approach the product innovation with the strong ROI mentality, and that’s what we try to do. Here we have consistent sales growth over



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

the last three years, compound annual growth of 82%. The first half of this year a 43%, so it’s been consistently growing. . . .

In addition, Curley represented that LeapFrog was improving inventory management by purchasing

a supply-chain management system from Manugistics:

We do have our ways to improve, as far as inventory management, to be at least like our peers. So we bought Manugistics, a supply-chain management system. We thought we’d install it this year. It was getting too close to busy season so we really delayed it so we wouldn’t disrupt the business, and we’re on target for that for next year.

149. False Statement: On 9/17/03, Citigroup Smith Barney analyst Jill Krutick issued a

report that was based on and repeated the statements made by Kalinske and Curley during their

presentations. Krutick reiterated the positive statements made by Kalinske and Curley (although she

referred to them as “LeapFrog’s senior management” rather than identify them by name) and

reported that LeapFrog should report sales growth and margin improvements. Specifically, Krutick

reported

[o]verall, a very positive story and one that will likely continue to percolate.

Despite some risks of profit taking, rising competition in the interactive education niche, and concerns about the expiring lock-up stock overhang, we believe LeapFrog should at least continue to appreciate with its peer group. . . .

Sales growth this year should be aided by the introduction of three new platforms in the second half of 2003, as well as an array of new software titles and standalone products. . . .


defendants knew it: Kalinske and Curley knew they made false and misleading statements during

the 9/17/03 conferences that were repeated to investors in the Citibank Smith Barney report.

Specifically:

(a) Kalinske and Curley knew Kalinske misled by refusing to comment on the

Company’s previously issued guidance and by stating that it was going to be “a very big second

half” with “growth in all facets of LeapFrog’s business” because Kalinske and Curley knew

LeapFrog’s 3Q03 results would be significantly less than the guidance reiterated during the 7/24/03

conference call. The testimony in the patent infringement suit shows that defendants knew LeapFrog

lost 450,000 LeapPad sales prior to 10/3/03 due to sales of the PowerTouch. The testimony also



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

shows that defendants knew the decision to add a second book to LeapPad platforms caused a

substantial decline in sales of software (content books) because the Company tracked book

purchases per platform, i.e., the tie ratio, which showed the tie ratio was declining. Bender testified

that LeapFrog lost 2.9 million book sales due to the decision to include the second book.

(b) During the Company’s 10/22/03 conference call, Wood admitted that he and

the other defendants knew LeapFrog needed additional orders before 9/20/03 to meet guidance

because the Company did not have the ability to fulfill orders received in the last 10 days of the

quarter. Further, the witness accounts show that Kalinske and Curley knew sales to LeapFrog’s

retail customers were not sufficient to meet guidance because DSS was unable to ship product to the

Company’s retailers within the required shorter time periods and because DSS was shipping product

that the retailers had not ordered and would not pay for. Moreover, Curley knew that LeapFrog tried

to avoid reporting the sales miss by improperly recognizing revenues on product DSS shipped to an

empty warehouse.

(c) Kalinske and Curley also knew that LeapFrog was not a financially

disciplined company as Curley represented during the conferences because of the inability to ship

product in accordance with retail customers’ purchase orders and the unsuccessful attempt to report

revenues on the fabricated sales. After the Class Period, LeapFrog acknowledged it was not a

financially disciplined company by admitting there were numerous material weaknesses with the

Company’s internal controls that prevented LeapFrog from ensuring its financial reporting was

reliable and its financial statements prepared in accordance with GAAP.

(d) Kalinske and Curley also knew Curley’s representation that the purchase of

the Manugistics supply-chain software was delayed to avoid disruption of the business was false and

misleading because they failed to disclose to investors that the delayed implementation of the

software precluded LeapFrog from accurately forecasting and meeting customer demand and was

contributing to the disruption of the business that caused the 3Q03 sales miss.

151. Stock Price: Following Kalinske’s and Curley’s statements on 9/17/03, the price of

LeapFrog’s stock continued to increase. On 9/17/03, the stock price increased $1.40 or 3.7% to

$39.35, compared to a 0.3% decline in the S&P 500 and a 0.4% decline in the proxy peer group.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Between 9/16/03 and 10/21/03, LeapFrog’s stock price increased $8.60 or 22.6%, closing at a Class

Period high price of $46.54. During the same time period, the S&P 500 increased just 1.65% and the

proxy peer group increased just 1.75%.

152. On 10/3/03, LeapFrog filed its suit against Mattel alleging the PowerTouch infringed

the Company’s patent. On 10/7/03, Merrill Lynch analyst Fine issued a research note that reported

the suit could raise questions of whether Mattel’s competing PowerTouch product was having an

impact on current LeapPad sales but that she did not believe the lawsuit was a reflection of current

sales trends and was more a standard industry practice than anything else. On the same day, Pacific

Growth Equities analyst Natalie Walrond (“Walrond”) issued a report stating the lawsuit was

“unlikely to impact LeapFrog’s operations, financials or the competitive outcome of the ELA space

over the near term.” On 10/8/03, Bear Stearns analyst Childe reported that the suit “looks to us like

an admission that the PowerTouch is or could do some damage” because LeapFrog alleged that it

had “been damaged and will be ‘irreparably injured’ unless the court stopp[ed] Mattel from selling

the product.” As Bender testified during the trial on 5/18/05, defendants knew LeapFrog tracked

sales of the PowerTouch, the LeapPad and content books and had lost 450,000 LeapPad platform

sales and millions of book sales by 10/3/03 due to sales of the PowerTouch. Ex. A at 12, 515, 525,

714-720.

B. False and Misleading Statements Between 10/21/03 and 2/9/04: Defendants Cause LeapFrog to Report False and Misleading Financial Results in 3Q03, Falsely Assure Investors that the Distribution and Supply-Chain Problems that Caused the 3Q03 Revenue Shortfall Were Fixed, and Include False and Misleading Risk Factors in the Company’s 3Q03 10-Q

153. False Statement: On 10/21/03, LeapFrog disclosed that its sales in 3Q03 were

significantly less than defendants led investors to believe. LeapFrog reported sales of $203.9

million, 11% less then the $225-$235 million they told investors to expect previously.

LeapFrog Earns $0.55 per share in Third Quarter, Net Income up 25% Increases Sales and Earnings Guidance for Fourth Quarter and Reaffirms Full Year

Guidance

Emeryville, Calif – October 21, 2003 – LeapFrog Enterprises, Inc. (NYSE:LF), a leading developer of innovative technology-based educational products, today reported financial results for the third quarter ended September 30, 2003. The



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

company also increased its sales and earnings guidance for the fourth quarter and reaffirmed its guidance for the full year 2003.

Net Income Up 25% For 3rd Quarter and Up 102% YTD

The company recorded increased net income for the third quarter of 2003 of $33.4 million, or $0.55 per share, up 25% from net income of $26.7 million, or $0.50 per share over the same period in 2002. In the first nine months of 2003, net income was $28.5 million, or $0.47 per share, up 102% from net income of $14.1 million, or $0.30 per share, in the first nine months of 2002.

Net Sales Up 12% For 3rd Quarter and Up 23% YTD

Net sales for the third quarter of 2003 were $203.9 million, up 12% over the same period in 2002. For the first nine months of 2003, net sales were $348.7 million, up 23% over the same period in 2002.

Segment Results

Net sales from the U.S. Consumer segment were $167.1 million in the third quarter, up 4% over the same period in 2002. . . .

In the first nine months of 2003, net sales from the U.S. Consumer segment were $272.6 million, up 14% over the same period in 2002. . . .

“While we were satisfied with the sales growth in our International and Education and Training divisions, late building demand from our key retailers resulted in lower net sales growth for the third quarter in our U.S. Consumer business. This resulted in a shift of deliveries from the third quarter to the benefit of the fourth quarter,” said Mike Wood, President and Chief Executive Officer. “Our underlying sell-through at the retail level remained very strong throughout the third quarter. The strength of our U.S. retail sell-through across all of our product lines, coupled with the anticipated fourth quarter launch of our Leapster platform product, has led us to revise our fourth quarter guidance upward and to reiterate our full year guidance.”

“This demand for engaging learning products remains high among children, teachers and parents, and leads us to believe we will have a strong holiday season,” Wood concluded.

Guidance for the Fourth Quarter and 2003

The company is increasing its guidance for the final quarter and reaffirming its guidance for full year 2003 as follows:

Fourth Quarter 2003

Net sales $316 million to $334 million

Net income $42 million to $47 million

Diluted net income per share $0.69 to $0.76

Full Year 2003



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Net sales $665 million to $683 million

Gross profit margin 51% to 52% of net sales

Net income $70 million to $75 million

Fully diluted share count of 61 million shares

Diluted net income per share $1.17 to $1.25

154. False Statement: During the 10/22/03 conference call, defendants Wood and Curley

repeated the Company’s 3Q03 financial results and made additional false statements about the

reasons for the 3Q03 revenue miss and the Company’s business and operations:

(a) Wood and Curley stated that the sales shortfall in 3Q03 was primarily due to

timing and would be recognized in the fourth quarter and provided revised guidance:

[W]e believe that our shortfall in U.S. sales in the third quarter was primarily timing, and that those sales not recognized in the third quarter will be recognized in the fourth quarter. As a result we’ve increased our fourth quarter guidance and are reiterating our full year guidance. So I look forward to what we believe will be a very strong fourth quarter in both sell-through and sell-in.

* * *

We are raising our fourth quarter guidance as follows. Net sales, we’re guiding you towards $316 million to $334 million for the fourth quarter, net income in a range of $42 to $47 million, and diluted net income per share of 69 cents to 76 cents.

* * *

Our new fourth quarter guidance results in full year guidance of the following. Net sales in a range of $665 million to $683 million. Gross profit margin of 51% to 52% of net sales. Net income in a range of $70 million to $75 million. A fully diluted share count of 61 million shares, and a diluted net income per share range of $1.17 to $1.25.

(b) In response to analysts’ questions, Wood assured that the distribution and

supply-chain problems that contributed to the sales shortfall in 3Q03 had been fixed:

Krutick: Mike, I was hoping you could give us a flavor for your supply-chain, your distribution process, your logistics, how would you sort of describe where you are, where you expect to be, and your order fill rates, when did the orders come in for those sort of last sales that are being translated into the fourth quarter, when did those orders come in, how were they filled, and what kind of management systems you have in place to be monitoring this very closely. Thank you.

Wood: Well, as we mentioned last time, we work through, I believe it’s seven factories in China. We have four warehouses in Los Angeles, we use manugistics.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

We have an extensive and experienced operating team, many of whom have been with Tom Kalinske and Paul Rioux for over 20 years.

Having said all that, there are lots of areas of improvement within LeapFrog and operations is clearly one of them, which is why we hired Fred Forsyth as COO about two months ago and Fred spent the last two months in Asia and down in our warehouse and throughout the operations looking for ways to improve so that we can become best of breed in operations.

* * *

We’ve done some soul searching in terms of could we have done better in terms of shipping. The answer is yes, but I don’t want to use that as an excuse. Suffice it to say that we’re in position to take the orders that we have and the orders which we’re projecting in our guidance and to ship those efficiently in the fourth quarter.

Krutickfollowed up and asked Wood to share some of the changes made to avoid any sort of replay

of missed shipments in the fourth quarter. In response Wood stated the following:

[W]e’ve buttressed up the team and we’ve actually increased the warehousing and distribution capability for the fourth quarter.

(c) In response to questions from Piper Jaffray analyst Tony Gikas (“Gikas”),

Wood represented that pricing was not a challenge during the quarter and did not account for any of

the revenue miss. He also represented that competition, including Mattel’s PowerTouch product, did

not contribute to the revenue miss:

Your second question is was pricing a challenge and do we anticipate lowering prices on our hardware. The answer is no on both.

* * *

So do I think competition had an effect? Of course I did. But net-net of the effect I’ve just given you, the increase on the demand in our product in the third quarter.

Wood further downplayed the competitive effects of Mattel’s PowerTouch by saying that it was not

the reason Wood believed the fourth quarter would be a very competitive quarter:

No, just to calibrate something. PowerTouch is one item for one purchaser of one of our platforms. We’ve got substantial infant/toddler items, substantial preschool items, substantial ELA items, platforms for kids under 3. Quantum Pads for kids in the third, fourth and fifth grades, I-quest in the fifth, sixth, seventh and eighth grade, so certainly PowerTouch is one of our competitors but there is competition for parents and relatives’ dollars for every one of their kids in every category.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

155. The false and misleading statements made in the 10/21/03 press release and during

the 10/22/03 conference call were repeated in reports issued on 10/22/03 by CSFB, Deutsche Bank,

Bear Stearns, Pacific Growth Equities, U.S. Bancorp Piper Jaffray, Merrill Lynch and Citigroup

Smith Barney. The analysts also noted the importance of competition and LeapFrog’s ability to

manage growth, including distribution and supply-chain operations, to the Company’s future

success. For example:

• CSFB analyst Brandon Dobell (“Dobell”) maintained his outperform rating on LeapFrog’s stock and stated that the decline in the stock price presented a buying opportunity. In addition he stated that CSFB was comfortable that timing rather than structural deficiencies drove the revenue shortfall but also noted that management had not explained how their supply-chain worked in enough detail.

• Merrill Lynch analyst Fine maintained her neutral rating on the stock and wrote that half of the revenue miss was a non-issue and that the price decline was an overreaction to the 3Q03 revenue miss. On 10/23/03, Merrill Lynch analyst Fine issued a report that stated the revenue shortfall mystery would only make sense once the fourth quarter was completed. She stated that all would be forgiven if LeapFrog made its fourth quarter revenue target but that if there was a shortfall, serious questions regarding the Company’s growth prospects and management’s credibility would be expected.

• Citigroup Smith Barney analyst Krutick repeated Wood’s statements that the revenue shortfall was due to insufficient logistics and distribution controls but noted that Wood failed to identify critical factors and solutions that would avoid these problems in the future. She specifically identified competition and the Company’s ability to manage its growth, including logistics, distribution and inventory as Company-specific risks to LeapFrog’s success and noted these areas needed to be monitored closely and that LeapFrog’s ability to fix the problems and satisfy customer demand had been called into question.

• The next day, Pacific Growth Equities analyst Walrond issued a report upgrading its rating on LeapFrog’s stock and noting that steps were being taken to improve logistics management and that the outlook for the December quarter was strong. In addition, she wrote that management indicated better than expected product demand and suboptimal inventory levels at retailers could drive December revenues to higher than originally anticipated.


defendants knew it: Defendants knew the statements made in the press release and during the

conference call were false and misleading for the reasons described in ¶¶34-139. Specifically:

(a) As detailed in ¶¶87-94 and 107-111, defendants knew that LeapFrog’s 3Q03

financial results, particularly revenues, earnings and receivables, were materially false and

misleading and not prepared in conformance with GAAP because they knew LeapFrog was

recognizing revenues (and recording receivables) on sales where collection was not reasonably

assured. They knew collection was not reasonably assured because they knew DSS was shipping



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

product to its retail customers that they had not ordered and would not pay for. As a result, they

knew that revenues, earnings and receivables were overstated and that inventories were understated.

(b) As detailed in ¶¶87-89, 95-102 and 107-111, defendants also knew that

LeapFrog’s inventories were misstated because the Company did not have systems and procedures in

place – including the lack of supply-chain software caused by the cancelled implementation of the

Manugistics software - to reconcile reported inventory with actual inventory on hand or to assure the

Company had established sufficient allowances for excess and obsolete inventory. Notwithstanding

these deficiencies, defendants caused LeapFrog to reduce the allowances for excess and obsolete

inventory in 2003.

(c) As detailed in ¶¶87-89 and 103-111, defendants knew that LeapFrog’s

expenses and liabilities (accounts payable) were understated because LeapFrog was ordering

materials and components used to manufacture and assemble products without creating purchase

orders. As a result, the expenses and liabilities were not reflected in the Company’s financial

statements.

(d) As detailed in ¶¶107-111, after the Class Period, LeapFrog admitted that it

could not reasonably assure the reliability of its financial reporting or that its financial results were

reported in accordance with GAAP because there were numerous material weaknesses in the

Company’s internal controls over financial reporting in the areas of revenues and accounts

receivable, costs of goods sold and inventory, and information technology related to the manufacture

and distribution of the Company’s products.

(e) Defendants knew Wood’s representation that the reason for the 3Q03 sales

miss was “late building demand from our key retailers” was false and misleading because Wood

concealed from investors that the real reason was the inability of DSS to ship the correct product to

the Company’s retailers or to ship product within the shorter time periods required by LeapFrog’s

retail customers.

(f) Defendants knew that Wood’s assurances that the missed 3Q03 sales would be

recognized in 4Q03 and that LeapFrog was in a position to ship all orders – actual and projected –

efficiently in 4Q03 were false and misleading because the problems with DSS had not been resolved.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Indeed, the witness accounts show that the problems continued in 4Q03 and deteriorated to crisis

levels. Target threatened to stop doing business with LeapFrog and the Company was forced to send

reinforcements to the DSS managed warehouses to help address the problems. Further, CW8 stated

that most of the orders that were not shipped in 3Q03 were lost and not shipped at a later date.

(g) The testimony of Wood and Bender in the suit against Mattel that LeapFrog

lost millions of dollars of sales, and “drastically reduced prices” shows that defendants knew Wood’s

representation that LeapFrog did not anticipate lowering prices on hardware in response to Mattel’s

competing PowerTouch product was false and misleading. In fact, Bender testified there were 20-30

executive team meetings that preceded the price reductions made in 1/04.

(h) As admitted by defendants after the Class Period, defendants knew there was

no reasonable basis for the revised guidance included in the press release and repeated during the

conference call because the numerous problems with the distribution and supply-chain operations,

the lost sales caused by the PowerTouch and the numerous material weaknesses in the Company’s

internal controls over financial reporting prevented LeapFrog from accurately forecasting future

results.

157. Stock Price: On 10/22/03, following the issuance of the 10/21/03 press release and the

10/22/03 conference call, the price of the Company’s stock declined $11.65, or 25%, from $46.54 on

10/21/03, to $34.89 on 10/22/03, removing some, but not all of the inflation in the stock and causing

class members to suffer economic loss. The S&P 500 declined 1.6% and the proxy peer group

declined 1.1% from 10/21/03 to 10/22/03. Although the price of LeapFrog’s stock declined

substantially in response to the disappointing 3Q03 financial results causing class members to suffer

economic losses, it continued to trade at inflated prices due to the false and misleading statements

made by defendants in the 10/21/03 press release and during the 10/22/03 conference call.

158. False Statement: On 10/24/03, Citigroup Smith Barney analyst Krutick issued a report

based on and repeating statements made by Kalinske during her meeting with Kalinske earlier in the

day to further address the reasons for LeapFrog’s 3Q03 sales shortfall as well as the state of the retail

industry for toy products.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

At a management meeting this afternoon, LeapFrog Chairman Tom Kalinske addressed reasons for the company’s sales shortfall in the third quarter as well as the state of the retail industry for toy products and other initiatives the company is taking to pursue growth.

With respect to the shortfall, management highlighted 2 key sources of the shortfall: (1) poor forecasting of 3Q03 orders based on 3Q02 strength in the face of the dockworkers’ strike which brought orders earlier in 2002 than is typical, and (2) problems in managing distribution and logistics.

The company believes it is addressing this logistical issues, having moved distribution between locations and making progress in the implementation of its Manugistics system (an automated logistics system that optimizes the match between retail order flow and production/inventory decisions).

159. Facts showing why the statements repeated to the market in the Citigroup Smith

Barney report were false and misleading and that defendants knew it: Kalinske and the other

defendants knew Kalinske’s statements repeated to the market in Krutick’s 10/24/03 report were

materially false and misleading and that Kalinske misled Krutick into serving as a conduit for

distributing false information to investors. Specifically, Kalinske and the other defendants knew that

LeapFrog was not making progress in the implementation of the Manugistics supply-chain software

system. The witness accounts show that the implementation was delayed for months and that the

Manugistics software had still not been implemented by 7/04 when CLI took over management of

the Company’s Fontana warehouse. In addition, the Company admitted in its 2004 10-K that it was

still in the process of “upgrading existing and implementing new operational information systems,

including supply-chain management systems.”

160. False Statement: On 11/10/03, LeapFrog filed its 3Q03 Form 10-Q with the SEC

which was signed by defendants Wood and Curley. The 10-Q repeated the false and misleading

financial results reported on 10/21/03 and included the same false and misleading risk disclosures

contained in the 2Q03 10-Q regarding (1) the Company’s ability to ship product to its customers

within shorter time periods, (2) the Company’s ability to compete effectively with existing or new

competitors, (3) the dependence on Wal-Mart, Toys R Us and Target for a majority of the

Company’s sales, and (4) the Company’s disclosure controls and internal controls over financial

reporting.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28



the Company was unable to meet tight shipping schedules and fill retail orders. Ex. H.

(b) Defendants further represented that LeapFrog’s operating results could suffer

if it failed to develop and maintain management systems and resources sufficient to manage the

Company’s planned growth. Ex. J.

(c) Defendants represented that sales and market share could decline if LeapFrog

was unable to compete effectively. Ex. D.

(d) Defendants also represented that overall sales would suffer if sales of LeapPad

platforms and books, the products that Mattel’s PowerTouch competed with, declined. Ex. K.

(e) Defendants also represented that LeapFrog’s business and operating results

could be harmed if Wal-Mart, Toys R Us or Target, the three retailers that accounted for 85% of the


terms on which they conducted business with LeapFrog or experienced a downturn in their business.

Exs. F and G.

(f) Defendants represented that LeapFrog’s financial results were prepared in




Ex. C.

(g) As required by §302 of Sarbanes-Oxley, Curley and Wood certified that (1)









1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28




defendants knew it: Defendants knew the statements contained in the 3Q03 10-Q were false and

misleading for the reasons set forth in ¶¶34-139. Specifically:

(a) Defendants knew the financial results reported in the 10-Q were not reliable

and not prepared in accordance with GAAP as represented for the reasons set forth in ¶¶87-111.

(b) As detailed in ¶¶44-66, the witness accounts and the Company’s admissions

after the Class Period show that defendants knew LeapFrog’s relationships with its retail customers

had already been damaged, shipping costs had already increased and sales had already declined

because DSS was unable to ship product to the Company’s retail customers within shorter periods

and because DSS shipped product to the retailers that they had not ordered and would not pay for.

The witness accounts show that the problems continued in 4Q03 and became a crisis. Target

threatened to stop doing business with LeapFrog and the Company was forced to send

reinforcements to the DSS managed warehouses to help address the problems.

(c) Defendants also knew that LeapFrog’ operating results were already suffering

because the Company had not developed and maintained sufficient management systems to keep

pace with planned growth. As admitted by defendants after the Class Period and as explained by the

witnesses, LeapFrog’s failure to implement supply-chain software caused a significant adverse

impact on the Company’s operating and financial results. Specifically, LeapFrog was unable to

assure it had sufficient levels of inventory to fill customer orders because the Company did not

upgrade existing or implement new operational information systems, including supply-chain

management systems.

(d) As detailed in ¶¶112-126, LeapFrog’s suit against Fisher-Price/Mattel shows


market share to decline. Documents and pleadings LeapFrog filed in the suit, and testimony during

the trial shows that defendants knew LeapFrog was losing millions of dollars in sales and profits due



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

to the sale of PowerTouch that began in 7/03. In short, competition already had caused a reduction

in sales and profitability at LeapFrog.

(e) Defendants knew their representations that LeapFrog’s business and operating



were materially false and misleading. They knew that the retail customers had reduced orders of the

Company’s products and imposed millions of dollars of vendor violation penalties because DSS was

unable to ship product within shorter time periods and because DSS shipped product that the retailers

had not ordered and would not pay for. As Bender testified, defendants also knew LeapFrog lost

sales due to the PowerTouch.

(f) As detailed in ¶¶87-111, the witness accounts and the admissions by

defendants in the 2004 10-K show that defendants knew LeapFrog’s disclosure controls and internal

controls over financial reporting were not sufficient to ensure the reliability of the Company’s

financial reporting or that the Company’s financial statements were prepared in accordance with

GAAP. The witness accounts and post-Class Period admissions show defendants knew there were

numerous material weaknesses in the areas of revenues and accounts receivable, costs of goods sold

and inventory, and information technology controls related to the purchase of materials and

components used to manufacture and assemble products, the manufacture and assembly of products,

the distribution, invoicing and sale of products and the remittance of payments by vendors,

customers and LeapFrog.

162. Stock Price: The false and misleading statements and omissions included in the

10/24/04 Citigroup Smith Barney report and the 3Q03 10-Q filed on 11/10/03 caused LeapFrog’s

stock price to trade at inflated prices. On 11/13/03, Reuters reported that the price of the Company’s

stock increased 6% on 11/13/03 after Bear Stearns predicted a strong holiday season for LeapFrog.

The S&P 500 did not change and the proxy peer group declined 0.5%. The stock price, however,

declined 14% to $29.9 by 11/19/03. Analysts, including Krutick from CitiGroup Smith Barney and

Lauren Rich Fine from Merrill Lynch, reported the decline was due to steeper and earlier price

reductions on toys by Wal-Mart, insider selling by Michael Milken, and the closing of 182 specialty



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

stores by Toys R Us and retailers reducing inventories. The analysts noted that LeapFrog relied on

Wal-Mart for more of its sales than competitors Mattel and Hasbro and that there was concern about

whether LeapFrog would be able to meet retailer demand given the problems with its logistics

management system that caused the 3Q03 sales shortfall.

163. In December, the price of LeapFrog’s stock continued to decline to as low as $24 by

12/15/03. On 12/10/03, CitiGroup Smith Barney analyst Krutick raised her risk rating on the stock

to “speculative” due to concerns about retailers’ more conservative inventory builds and modest

holiday sales. On 12/15/03, CSFB analyst Dobell lowered his price target on LeapFrog’s stock to

$34 from $48 due to management credibility issues caused by the 3Q03 revenue miss, concerns

about channel inventory and the coming two-month lack of information from LeapFrog until it

would announce 4Q03 results in February. The price then rebounded following an upgrade by US

Bancorp Piper Jaffray analyst Gikas on 12/19/03.

C. False and Misleading Statements Between 2/10/04 and 3/9/04: Defendants Falsely Portray Management Changes, Cause LeapFrog to Report False and Misleading Financial Results for 4Q03 and FY03 and Provide Investors with Guidance for 2004 that They Knew LeapFrog Could Not Meet

164. False Statement: On 2/10/04, LeapFrog issued a press release announcing that Wood

had resigned as CEO and President and was appointed Chief Vision and Creative Officer by the

Company’s Board of Directors. In addition, the press release disclosed that Kalinske replaced Wood

as CEO and Jerome Perez replaced Wood as President:

LeapFrog Enterprises, Inc. Announces the Appointment of Mike Wood to Chief Vision and Creative Officer; Tom Kalinske Moves from Chairman to CEO; Jerry

Perez Joins as President; Director Steve Fink Appointed Chairman

Emeryville, Calif. – February 10, 2004 – LeapFrog Enterprises, Inc. (NYSE: LF), a leading developer of innovative, technology-based educational products, today reported the appointment of founder Mike Wood to Chief Vision and Creative Officer. The company also announced that Tom Kalinske would resume the role of CEO. Jerry Perez joins LeapFrog as President. Director Steve Fink has been appointed Chairman of the Board of Directors.

“LeapFrog has achieved extraordinary success over the past nine years, starting from a simple belief that learning can be effective and engaging for all ages, and transforming that commitment into a $680 million company,” said Mike Wood. “I believe that going forward I can maximize my contribution to the company and its shareholders by serving as LeapFrog’s Chief Vision and Creative Officer. This



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

new role will enable me to pursue my passion – helping children to learn – while allowing me to continue to develop new products that achieve that goal.”

* * *

“I welcome the opportunity to return to the role of CEO as LeapFrog continues to expand into new categories and geographies as a truly global education company,” said Kalinske. “This move will enable LeapFrog to continue to benefit from Mike’s genius in creative product development, his first love, and it allows me to focus on preparing the company for global education leadership in the consumer and school markets.”

165. Facts showing why the 2/10/04 press release was false and misleading and that

defendants knew it: Defendants misled investors by stating the appointment of Wood to Chief

Vision and Creative Officer would allow Wood to continue to develop new products and enable

LeapFrog to benefit from Wood’s genius in creative product development because they knew Wood

was actually demoted due to the continued problems with LeapFrog's distribution and supply-chain

operations and that his role with the Company was being greatly diminished with little to no

involvement in product development. The Company admitted as much several months later when

Wood was forced out of the Company. On 9/1/04, when Wood was forced to resign from LeapFrog,

Merrill Lynch analyst Fine reported that Wood “had no direct reports and was not as involved in

product development” as Chief Vision and Creative Officer. CSFB analyst Dobell reported Wood

had “not been actively involved since his transition from the CEO position in February ‘04” and

Merriman Curhan Ford analyst Sharma reported Wood’s “role in the company had been greatly

diminished in the last six months” and Wood “had only been working two and a half days a week

and had no one reporting to him.”

166. False Statement: On 2/10/04, LeapFrog issued a press release announcing its 4Q03

and FY03 results. LeapFrog reported 4Q03 sales in line with their revised guidance which suggested

the 3Q03 sales shortfall was made up in 4Q03 as defendants previously assured investors they would

be. The Company’s EPS came in $0.01 less than consensus estimates.

LeapFrog Enterprises, Inc. Reports 2003 Net Income up 67% on Sales Increase of 28%

LeapFrog becomes Market Leader in Entire US Preschool Category

in Critical Fourth Quarter



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Emeryville, Calif. – February 10, 2004 – LeapFrog Enterprises, Inc. (NYSE: LF), a leading developer of innovative technology-based educational products, today reported financial results for the fourth quarter and year ended December 31, 2003.

Net Income up 67% for Full Year, Up 50% in Fourth Quarter

Net income for 2003 increased 67% to $72.7 million compared with net income of $43.4 million for the year ended December 31, 2002. Net income per fully-diluted share increased to $1.20 compared with $0.86 per fully-diluted share in the prior year.

The company recorded net income for the fourth quarter ended December 31, 2003 of $44.2 million, up 50% compared with net income of $29.4 million for the fourth quarter of 2002. Net income per fully-diluted share was $0.72 in the fourth quarter of 2003, compared with $0.50 per fully-diluted share in the fourth quarter of 2002. . . .

* * *

Net Sales up 28% for Full Year, Up 33% in Fourth Quarter

Net sales for 2003 were $680.0 million, up 28% compared with $531.8 million for 2002. Net sales for the fourth quarter of 2003 were $331.3 million, up 33% compared with $248.4 million in the fourth quarter of 2002.

* * * Segment Results For 2003, net sales from the U.S. Consumer segment were $546.0 million, up 19% from 2002. . . .

For the fourth quarter of 2003, net sales from the U.S. Consumer segment were $273.4 million, up 25% from the fourth quarter of 2002. . . .

Gross Margin

For 2003, gross profit margin was 50.0%, down 80 basis points compared with 50.8% in 2002. For the fourth quarter of 2003, gross profit margin was 47.9%, down 310 basis points from 51.0% in the fourth quarter of 2002. The gross profit margin decrease for the fourth quarter and all of 2003 can be attributed primarily to the lower margin on the sales of the Leapster platform, which was introduced at the end of October 2003 and which included in its cost of sales the airfreight incurred in the holiday season.

* * *

“As we expected, strong holiday sales of our new platform and software learning products produced solid results and growth for LeapFrog in 2003,” said Mike Wood, President and Chief Executive Officer of LeapFrog. “We are very pleased that our fourth quarter results soundly verified what we said on our third quarter conference call. Namely, while the retail toy industry appears to be shifting its ordering practices more toward the back end of the year, consumer demand for our learning products is more vibrant than ever. . . .

* * *



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Outlook for 2004

* * *

LeapFrog’s full-year guidance for 2004 is as follows:

Net sales of $800 to $850 million

Effective tax rate of approximately 34% for all of 2004

Net income of $88 to $95 million

Fully diluted share count of approximately 63 million shares

Diluted net income per share of $1.39 to $1.51

In addition, the company provides the following discussion to assist in understanding the seasonality anticipated during the year:

Consistent with reported trends, the company expects that its 2004 sales growth will be lower in the first half and higher in the second half, as compared to 2003. The company expects 2004 sales seasonality to be about 20% of full year sales in the first half, spread equally between the first two quarters. Gross profit margin is expected to be approximately 50% in each quarter in 2004. Operating expenses are expected to grow approximately 20% to 25% for the full year, but the rate of growth of operating expenses in the first quarter of 2004 is expected to be 10% to 15% over the first quarter of 2003.

LeapFrog’s guidance is reflective of the company’s current expectations, which are based on information available at the time of this release, and are subject to changing conditions, many of which are outside the company’s control.

167. False Statement: On 2/11/04, defendants Wood, Curley and Kalinske participated in

LeapFrog’s earnings conference call attended by various analysts that followed the Company.

During the conference call, defendants repeated the Company’s 4Q03 and FY03 financial results and

the guidance for 2004 included in the 2/10/04 press release. In addition, defendants made the

following false statements. Curley represented that the decline in the gross profit margin was

entirely attributable to sales of the Company’s Leapster product:

Our gross profit margin was 47.9% in the quarter, down 310 basis points from 51% last year. We estimate that Leapster had a 330 basis point negative impact on consolidated fourth quarter gross profit margin which included the cost of air freight to expedite delivery of our new platform late in the quarter. . . .

Curley also misrepresented the reason for the increase in receivables and DSOs:

Our accounts receivable at December 31, 2003 were $281.8 million, an increase of $112.1 million from last year’s year end position. On a percentage basis accounts receivable increased 66% over last year. At quarter end we were 77 days sales outstanding compared to 61 days sales outstanding last year.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

The increase is primarily related to the timing of sales occurring later in the fourth quarter of 2003 versus last year’s fourth quarter of 2002. . . .

Curley made additional misrepresentations about the Company’s 4Q03 sales and receivables in

response to a question from Merrill Lynch analyst Fine:

FINE: [G]iven the surge in receivables at the end of the year, and the cash flow really not improving barring exercise of stock option proceeds, it has the feel that sales were very, very late in the quarter, and I am wondering if you could address whether this stole, potentially from the first quarter given your guidance of equal revenue first to second quarter which has not been the historic pattern . . . .

* * *

CURLEY: Yes. The increase in receivable, and specifically how it equates down to DSOs, really does relate solely to the timing of both sales shipped from the third quarter into the fourth quarter, so it made the fourth quarter much bigger. But then since our terms are less than 90 days of the fourth quarter, it really happened within the quarter. There was a shift in sales later in the quarter, especially Leapster product, that put a bigger shift year-over-year at the back end of the fourth quarter. That is just timing and it will be collected in the first quarter of next year. And so of the 15 days increase in days sales outstanding, I calculated about 12 days of the increase was just about related to that timing. We had another day related to K-B, which is still included in our receivables and obviously, that is not getting paid and at current. And we had about two days of shipping issues that are pretty normal at this time of year but we’re just working through and giving proof of deliveries to customers. Looking at it a different way from an aging standpoint we actually had a more current receivable balance this year at year end than we did last year when you look at any receivables over one day past due, and so I feel very good about our receivable balance and collectability. . . .

168. The false statements made by defendants in the 2/10/04 press releases and during the

2/11/04 conference call were repeated to the market in numerous articles and in reports issued by (1)

CSFB analyst Lobell on 2/10/04 and 2/11/04, (2) Citigroup Smith Barney analyst Jill Krutick on

2/10/04 and 2/11/04, (3) Piper Jaffray analyst Gikas on 2/11/04, (4) Merrill Lynch analyst Fine on

2/11/04, (5) Bear Stearns analyst Childe on 2/11/04, (6) Pacific Growth Equities analyst Walrond on

2/11/04 and 2/12/04, and (7) Deutsche Bank analyst Jeetil Patel (“Patel”) on 2/12/04.



conference call were materially false and misleading for the reasons described in ¶¶34-139.

Specifically,

(a) As detailed in ¶¶87-94 and 107-111, defendants knew that the Company’s

4Q03 and FY03 financial results were materially false and misleading and not prepared in



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

conformance with GAAP because they knew LeapFrog was recognizing revenue (and recording

receivables) on sales where collection was not reasonably assured because they knew the Company

was shipping product to its retailers that they had not ordered and would not pay for.



place – including the lack of supply-chain software caused by the cancelled implementation of the



these deficiencies, the defendants caused LeapFrog to reduce the allowances for excess and obsolete

inventory in 2003.





statements.







(e) In addition, defendants knew that LeapFrog’s 4Q03 and FY03 financial results

were materially false and misleading because the Company had stuffed the channel and stolen sales

from 1Q04 as suspected by Merrill Lynch analyst Fine who asked defendants about the suspicious

timing of the sales and subsequently issued a report in which she stated Merrill Lynch was

concerned that “Q4 sales stole from Q1’04.” Ms. Fine suspected LeapFrog had stolen sales from

1Q04 to meet guidance for 4Q03 based on the Company’s high accounts receivable position, the

increase in DSOs, the high inventory levels Merrill Lynch observed in early January in the retail



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

channel, the Company’s cash flow position, and the FY04 guidance that projected sales in 1Q04 that

were lower than historical patterns.

(f) LeapFrog’s receivables almost doubled during the quarter to $281.8 million

which represented 85% of 4Q03 revenues ($331.4 million), an all-time high for LeapFrog and

substantially higher than the percentage of receivables to revenues, 66%, reported in 4Q02. In

addition, DSOs increased from 61.5 days at 12/31/02 to 76.5 days at 12/31/03.

(g) LeapFrog’s 2004 guidance also indicated that LeapFrog stole sales from 1Q04

to meet guidance in 4Q03 because LeapFrog’s 2004 guidance indicated that 1Q04 revenues would

be equal to 2Q04 revenues when historically first quarter revenues were greater than second quarter

revenues. LeapFrog reported revenues of $57.8 million in 1Q02 compared to $43.1 million in 2Q02

and reported revenues of $76.7 million in 1Q03 compared to $68 million in 2Q03. Just one month

later LeapFrog disclosed that 1Q04 sales and earnings would be much lower further indicating

defendants knew LeapFrog stole sales from 1Q04 to meet 4Q03 and FY03 guidance.

(h) During the conference call defendants confirmed that many of the Company’s

4Q03 sales occurred late in the quarter, but denied LeapFrog stole sales from 1Q04 by stuffing the

channel. But just one month later defendants admitted they stole sales from 1Q04 by stuffing the

channel in 4Q03. On 3/10/04, LeapFrog announced that 1Q04 sales would be $66-$72 million, more

than $20 million less than expectations of $87.9 million. The Company also disclosed the net loss in

1Q04 would be $0.18-$0.22, more than three times expectations of $0.06. On 3/10/04, Ms. Fine

reported that her suspicions that LeapFrog had stolen from 1Q04 to meet 4Q03 guidance were

“borne out” by LeapFrog’s preannouncement notwithstanding defendants’ denials of channel

stuffing in 4Q03. After talking to the Company she issued a report on 3/11/04 that stated, “LF

acknowledged Leapster demand in early 2004 may have been fulfilled in 4Q03.” During the

Company’s 2/15/05 conference call, Perez admitted that LeapFrog “began the year with some

buildup of inventory at the beginning of the year at retail.” During the Mattel trial, Bender testified

that there were significant and high levels of inventory in the retail channel that were higher than any

previous year and Reed testified that there were 460,000 LeapPad units in the retail channel at the

end of 2003.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

(i) Defendants knew that they had no reasonable basis for the FY04 guidance

they provided given the 4Q03 channel stuffing, numerous problems with the distribution and supply-

chain operations and competition which they knew was causing the Company to lose sales and incur

additional expenses. They also knew that revenues would be negatively impacted by the Company’s

decision in 1/04 to substantially reduce prices on all LeapPad products, the bankruptcies of FAO

Schwartz and KB Toys, the closing of more than 182 specialty toy stores (Kids R Us and

Imaginarium) by Toys R Us and pressure from Wal-Mart to reduce prices. The Company’s warning

just one month later that 1Q04 sales and earnings would be substantially worse than analysts’

forecasts shows defendants had no reasonable basis for the guidance. So does the magnitude of the

revision. The 3/10/04 preannouncement indicated 1Q04 sales would be $66-$72 million, $20

million less than LeapFrog’s 2/10/04 guidance of $80-$85 million. After the Class Period the

Company admitted it did not have the ability to provide guidance.

(j) Curley and the other defendants knew that Curley misled investors when he

stated that the 310 basis point decline in the gross profit margin was entirely due to sales of the

Leapster which included the cost of air freight to expedite delivery of the new platform late in the

quarter. Defendants knew that the problems with the Company’s distribution and supply-chain

operations were the reason LeapFrog had to ship products by air rather than by the less expensive but

slower contract ocean carriers. Defendants also knew that the supply-chain problems required

LeapFrog to ship product other than the Leapster by air. In addition, they knew Wal-Mart’s

dramatic price discounting in its effort to increase market share also caused the gross margin to

decline.

(k) Curley and the other defendants knew Curley misled investors by stating the

increase in receivables and DSOs was “primarily related to the timing of sales occurring later in the

fourth quarter of 2003.” Defendants knew that receivables and DSOs had increased because

LeapFrog had stolen sales from 1Q04 to report sales and earnings in line with previously issued

guidance. They also knew the increase was caused by the Company’s retail customers refusing to

pay for product they had not received or received but did not order.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

(l) Defendants knew consumer demand for LeapFrog’s learning products was not

more vibrant than ever as represented in the 2/10/04 press release. Bender’s testimony in the Mattel

patent infringement suit shows that LeapFrog immediately lost sales after the introduction of the

PowerTouch in 7/03 and that retail channel inventories at the end of 2003 were higher than any

previous year and higher than LeapFrog’s plan due to the lost sales caused by the PowerTouch.

170. Stock Price: The price of LeapFrog’s stock declined $3.39, or 11%, from $30.4 on

2/10/04, to $27.01 on 2/11/04 compared to a 1.1% increase in the S&P 500 and a 1.2% increase in

the proxy peer group. Reuters reported that the stock declined due to concerns that sales growth

could slow in 2004. Analysts reported that the decline was due to the deterioration in the gross

margin in 4Q03, the 2004 guidance that projected sales growth but a flat 50% gross margin which

was the same as 2003, operating expenses growing 20%-25%, and concerns about the level of

receivables and DSOs. Although the price decline removed some of the inflation from the stock and

caused class members to suffer economic losses, the stock continued to trade at inflated prices due to

defendants’ false and misleading statements and omissions regarding the numerous problems with

the Company’s distribution and supply-chain operations, the numerous material weaknesses with the

Company’s internal controls and the lost sales and profits caused by competition from Mattel.

Following the price decline on 2/11/04, LeapFrog’s stock traded in the $26-$27 range through

3/10/04.

D. False and Misleading Statements Between 3/10/04 and 4/20/04: Defendants Lose All Credibility by Preannouncing 1Q04 Results Just One Month After Providing Initial Guidance but Assure Investors the Supply-Chain Operations Are Being Strengthened and Include Materially False and Misleading Financial Results and Risk Factors in the Company’s FY03 10-K

171. False Statement: On 3/10/04, LeapFrog issued a press release warning that

LeapFrog’s 1Q04 sales and net income would be substantially worse than the guidance provided by

the Company on 2/10/04 (1Q04 sales of $80-$85 million) and analysts’ forecasts:

LeapFrog Enterprises, Inc (NYSE: LF), a leading developer of innovative technology based educational products, today issued guidance for the first quarter of 2004. Despite positive sell-through data to date in the first quarter, LeapFrog expects net sales in the first quarter to be between $66 million and $72 million. This, coupled with reduced gross margin for the quarter and continued strong investment in research and development and supply-chain initiatives, results in an



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

expected net loss for the quarter of between $(0.18) per share and $(0.22) per share.

Despite the fact that LeapFrog’s initial guidance, provided just one month earlier, indicated 1Q04 net

sales would be less than investors expected, causing the price of the Company’s stock to decline

11%, Kalinske urged investors not to read too much into the revised and substantially lower

guidance and assured investors the problems with the distribution and supply-chain operations were

being strengthened:

“The first quarter is a very small portion of our overall year. In fact, we had expected the first quarter to represent just 10 percent of 2004 net sales,” said Thomas Kalinske, LeapFrog’s Chief Executive Officer. “However, the first quarter is particularly vulnerable to trends that impact our net sales, margin and net income, including the shifting of retail orders to later in the year, and the difficult financial position of certain retailers.”

“We believe that it is premature to draw conclusions with respect to the entire year based upon our sell-in results to date,” added Kalinske.

* * *

“We remain committed to innovation and improvements in operations that provide superior long term value to our stockholders,: said Kalinske. . . . We are also strengthening our operations group, supply-chain management system and warehousing and logistics functions.

The company believes all of these expenditures are in the best long-term interests of its stockholders and will result in a stronger business. While these investments in the business will result in significantly higher operating expenses in 2004, LeapFrog expects that they will lead to improved margins and reduced costs in the long run.

172. Following the Company’s preannouncement, analysts issued scathing reports

downgrading the stock and attacking defendants’ credibility. Reports were issued by (1) Merrill

Lynch analyst Fine on 3/10/04 and 3/11/04, (2) Citigroup Smith Barney analyst Krutick on 3/11/04,

(3) Piper Jaffray analyst Gikas on 3/11/04, (4) CSFB analyst Dobell on 3/11/04, (5) Deutsche Bank

analyst Patel, (6) Bear Stearns analyst Childe, and (7) Pacific Growth Equities analyst Walrond.

173. Piper Jaffray, CSFB, Bear Stearns, Deutsche Bank, and Pacific Growth Equities all

downgraded the stock and substantially reduced their price targets on the stock.

174. Analysts attacked defendants’ credibility. CSFB reported “the fact that this

announcement comes less than a month after the 4Q earnings report is discouraging and wipes

out any credibility management had left.” Bear Stearns stated management credibility was severely



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

damaged because preannouncement was just one month after initial guidance. Pacific Growth

Equities wrote that the preannouncement was yet another example of management’s inability to

accurately forecast its own business and manage street expectations, that Pacific Growth Equities

was fed up with management’s poor job of executing the operating and cash cycle, and that it was

unacceptable for LeapFrog as public company to conveniently move into the quiet period and

provide little to no information about the reason for the shortfall.


defendants knew it: Kalinske and the other defendants knew the statements contained in the 3/10/04

press release were materially false and misleading. Specifically:

(a) Kalinske and the other defendants knew that Kalinske misled investors by

telling investors it was premature to draw conclusions with respect to the entire year based on the

preannouncement and that gross margins and costs would improve in the long run. Defendants knew

that LeapFrog’s financial results during the remainder of 2004 would be adversely impacted by (1)

the numerous problems with the Company’s distribution and supply-chain operations which were

causing retail customers to reduce their purchases of LeapFrog product, (2) lost sales caused by

competition from Mattel and other competitors, (3) price reductions by the Company’s retail

customers, (4) lost sales from KB Toys and FAO, Inc. due to their bankruptcies, (5) lost sales from

Toys R Us due to its financial difficulties, (6) increased legal costs caused by the Company’s suit

against Mattel, and (7) increased operating expenses related to the attempts to fix the problems with

the distribution and supply-chain operations, and increased R&D costs. In fact, just a few weeks

later on 4/21/04, LeapFrog revised and lowered guidance for the remainder of 2004 confirming that

defendants knew Kalinske’s reassurances were false.

(b) Kalinske and the other defendants also knew that Kalinske misled investors by

stating that LeapFrog was strengthening its operations group, supply-chain management system and

warehousing and logistics function. That statement concealed the ongoing problems with the

Company’s distribution and supply-chain operations that were far from being fixed. By 3/10/04,

defendants knew that the anticipated changes to the Company’s distribution and supply-chain

operations would be delayed until the peak selling season in 2004. Defendants knew LeapFrog had



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

decided to replace DSS as the Company’s warehouse operator due to the problems with DSS but

would still have to retain their services due to the delays. They knew LeapFrog (1) had been

negotiating with CLI to replace DSS since 11/03 but still had not executed a contract (the contract

with CLI was not executed until 7/1/04), (2) was in the process of executing the lease for the Fontana

warehouse which would not be available until 7/04 at the earliest, and (3) LeapFrog still had not

implemented the supply-chain software that was necessary to accurately forecast and fulfill customer

demand and to accurately report the Company’s inventories. Indeed, after the Class Period,

defendants admitted in the 2004 10-K that there were still material weaknesses in the Company’s

distribution and supply-chain operations and that LeapFrog was still “upgrading existing and

implementing new operational information systems, including supply-chain management systems.”

176. Stock Price: Following the 3/10/04 preannouncement, LeapFrog’s stock price

declined $6.40, or 24.6%, from $26 on 3/10/04, to $19.6 on 3/11/04. Reports that Al Qaida had

taken responsibility for the recent Madrid bombings caused the S&P 500 to decline 1.5% and the

proxy peer group to decline 1.2%. But the 24.6% decline in LeapFrog’s stock price shows that the

Company’s preannouncement, not the general market decline caused by the Al Qaida report, was the

cause for the much steeper decline in the price of LeapFrog’s stock. Although the price decline

removed some of the inflation from the stock causing class members’ economic loss, the stock

continued to trade at inflated prices due to defendants’ materially false and misleading statements

and omissions regarding LeapFrog’s financial results, the numerous problems with the Company’s

distribution and supply-chain operations, the numerous material weaknesses with the Company’s

internal controls, and the lost sales and profits caused by competition from Mattel.

177. False Statement: On the same date LeapFrog preannounced 1Q04 results, it also

issued its Report on Form 10-K for the year ending 12/31/03. The 10-K was signed by defendants

Kalinske, Curley, Wood and Rioux, and reported the Company’s 2003 financial results, represented

those financial results conformed with GAAP and included the same false and misleading risk

disclosures contained in the 2Q03 10-Q and 3Q03 10-Q regarding (1) the Company’s ability to ship

product to its customers within shorter time periods, (2) the Company’s ability to compete

effectively with existing or new competitors, (3) the dependence on Wal-Mart, Toys R Us and



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Target for a majority of the Company’s sales, and (4) the Company’s disclosure controls and internal

controls over financial reporting.




(b) Defendants also represented that the Company might experience difficulties

managing growth and that LeapFrog’s operating results could suffer if it failed to develop and

maintain management systems and resources sufficient to keep pace with planned growth. Ex. J.



(d) Defendants represented that overall sales would suffer if sales of LeapPad


(e) Defendants represented that LeapFrog’s business and operating results could




Exs. F and G.





Ex. C.

(g) As required by §302 of Sarbanes-Oxley, Curley and Kalinske certified that (1)

the 10-K did not contain any untrue statement of a material fact or omit to state a material fact


were made, not misleading, (2) the financial statements included in the 10-K fairly presented in all





1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28





defendants knew it: Defendants knew the statements contained in the 2003 10-K were false and


(a) Defendants knew the financial results reported in the 10-K were not reliable


(b) The witness accounts and the Company’s admissions after the Class Period

show that defendants knew LeapFrog’s relationships with its retail customers had already been

damaged, shipping costs had already increased and sales had already declined because DSS was

unable to ship product to the Company’s retail customers within shorter periods and because DSS

shipped product to the retailers that they had not ordered and would not pay for. The witness

accounts show that the problems continued in 4Q03 and became a crisis. Target threatened to stop

doing business with LeapFrog and the Company was forced to send reinforcements to the DSS

managed warehouses to help address the problems.

(c) Defendants also knew that LeapFrog’s operating results were already

suffering because the Company had not developed and maintained sufficient management systems to

keep pace with planned growth. They knew the representations that LeapFrog upgrading existing

and implementing new supply-chain systems, and consolidating warehouse operations were false

and misleading because they concealed from investors the problems with DSS and the Company’s

decision to replace them with CLI. The representations were also false and misleading because

defendants knew that CLI would not replace DSS until the peak selling season in 2004 and that the

warehouse would not be available until 7/04. Defendants also knew the implementation of new

supply-chain software was being delayed and would not be completed before the peak selling season

in 2004. As admitted by defendants after the Class Period and as explained by the witnesses,

LeapFrog’s failure to implement supply-chain software caused a significant adverse impact on the

Company’s operating and financial results. Specifically, LeapFrog was unable to assure it had



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

sufficient levels of inventory to fill customer orders because the Company did not upgrade existing

or implement new operational information systems, including supply-chain management systems.



market share to decline. Documents and pleadings LeapFrog filed in that suit, and trial testimony

shows defendants knew LeapFrog had lost millions of dollars in sales and profits due to the sale of

PowerTouch that began in 7/03. In short, competition already had caused a reduction in sales and

profitability at LeapFrog.







had not ordered and would not pay for. They also knew Toys R Us was reducing its purchases of the

Company’s products due to its own financial difficulties. Bender’s testimony in the patent

infringement suit shows that defendants knew retailers were also reducing purchases of LeapFrog’s

products because sales of the PowerTouch caused channel inventories to be “much higher than at

any previous years, and much higher than our plan, and far higher than what the retailers plan was. . .

. So the inventory we shipped sat in retail stores.”











1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28



E. False and Misleading Statements Between 4/21/04 and 7/20/04: Defendants Cause LeapFrog to Report False and Misleading Financial Results for 1Q04 and Include Materially False and Misleading Risk Factors in the Company’s 1Q04 10-Q

179. False Statement: On 4/21/04, LeapFrog issued a press release announcing the

Company’s 1Q04 results which were in line with the revised guidance issued on 3/10/04:

Net sales for the first quarter of 2004 were $71.6 million, compared with $76.7 million in the first quarter of 2003, down 7%.

* * *

Gross margin was 44.6% in the first quarter of 2004, down from 53.0% in the first quarter of 2003. Gross margin declined largely due to a shift in the mix of products sold in the quarter from higher margin software to platforms and standalone products and a loss of sales leverage against fixed costs.

* * *

The company recorded a net loss for the first quarter of 2004 of $(11.8) million, or $(0.20) per share, compared with a net loss for the first quarter of 2003 of $(969,000), or $(0.02) per share.

* * *

“While we are disappointed in the low sales in the first quarter, we are very pleased that retail consumer sales for our top four retailers (representing over 80% of our U.S. Consumer net sales) are up over 20% year-to-date,” said Tom Kalinske, chief executive officer. “Clearly retailer orders in this quarter do not match our strong consumer over-the-counter sales. We also have new research that reports that the consumer ownership software-to-hardware tie ratio for our LeapPad family (My First LeapPad, LeapPad, Quantum Pad, and LeapPad Plus Writing) has increased from a year ago, indicating a healthy business.

“This year we are actively engaged in a number of projects that bode well for the long term success of the company. We are investing in increasing our installed base of platform products, expanding our software offering, increasing our software marketing efforts, and improving our operations and systems infrastructure. We believe these steps are important to our company’s market leadership in 2004 and beyond as we continue to provide enjoyable and effective learning products for all stages of a child’s life.”

The company is revising its published guidance to incorporate first quarter actual results and revised full year expectations based on more conservative expectations for the remainder of the year, as follows:

Outlook for 2004

• Net Sales of $770 to $800 million



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

• Gross Profit Margin of 48% to 49% of net sales

• Operating expenses of 33% to 35% of net sales

• Fully diluted share count of approximately 63 million

• Diluted net income per share of $1.18 to $1.28

180. False Statement: On 4/21/04, defendants Kalinske and Curley participated in

LeapFrog’s 1Q04 earnings conference call that various analysts reported had a very positive and in-

control tone to it. Kalinske and Curley repeated the financial results and guidance included in the

4/21/04 press release and also made the following false and misleading statements:

(a) Kalinske stated that increased sales of higher margin software would improve

the Company’s results:

We are committed to taking this company, which has come so far so fast, to the next level by focusing on the following four business initiatives. First, we are driving our high margin software business across platforms by continuing to expand our libraries and increasing our software marketing efforts. The software side of the business and our improving consumer tie ratio are the most direct tools we have for bolstering our gross margin. We expect that gross margin will improve in subsequent quarters as retailers sell through the current retail inventory, and as we more aggressively market software to customers and sell more in.

We have new propriety research that indicates that the software to hardware tie ratio improves the longer the LeapPad has been in the home. The same research revealed that consumer software tie ratios to the installed base of LeapPad platforms, and I’m including the classic LeapPad, the LeapPad Plus Writing, the My First LeapPad and the Quantum Pad, has increased from 5.1 to 1 to 6.5 to 1 over the last year.

(b) Kalinske also stated that all aspects of improving the Company’s supply-chain

and information technology systems were up and running or on track to be fully operational at the

end of 2Q04:

Our second initiative focuses on improving our internal systems in the areas of supply-chain and information technology. Specifically, we are implementing supply-chain information management systems in a new consolidated warehouse. All aspects of these initiatives are on track to be fully operational at the end of the second quarter, and our new supply-chain management system is up and running as we speak.

These improvements are essential to our long-term growth and will benefit the U.S. Consumer division in the second half of this year with increasing returns accruing in coming years. We believe our investment and achievement in these operational initiatives bodes well for our execution in the critical second half of this year.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

(c) Curley stated that the increase in DSOs was caused by slower paying retailers.

Our days sales outstanding increased about 19 days year-over-year.

We’ve seen a pattern of slower paying by the larger retailers.

(d) Curley also stated that the increase in inventory was caused by lower than

expected sales and increases in ordering lead times in the Company’s manufacturing process.

Our net inventory of March 31, 2004 was 115.1 million, up 41% from 81.9 million last year. About 7 million of the increase came from our lower than expected first quarter sales. The balance of the increase is due to increasing ordering lead times in our manufacturing process. Our operations group has see[n] increased ordering lead times for chips, ASIC and LCD touch-screens. This has caused [for] us to increase inventory earlier in the cycle as we ramp our manufacturing for the fall.

We feel that our earlier investment in inventory is prudent in light of the our supply-chain initiatives. We are insuring that inventory is in place earlier than last year to maximize customer fill rates and take the pressure off the automated supply-chain through the transition period.



conference call were materially false and misleading for the reasons set forth in ¶¶34-139.

Specifically:










place – including the lack of supply-chain software caused by the delayed implementation of the



these deficiencies, defendants caused LeapFrog to reduce the allowances for excess and obsolete



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

inventory in 2003. Moreover, as explained by CW5, no allowances were established in 1Q04 even

though the Company identified excess and obsolete inventory because a salesman claimed the excess

inventory could be sold by the end of 2Q04. When the inventory was not sold, the Company

established a $2 million reserve in 2Q04.





statements.







(e) Defendants knew Curley misled investors when he represented the increase in

DSOs was caused by slower paying retailers because Curley knew retailers would not pay at all for

product they received but had not ordered due to the problems with LeapFrog’s distribution and

supply-chain operations.

(f) Defendants knew they misled investors by representing that all aspects of the

Company’s supply-chain and information technology initiatives were up and running or on track to

be fully operational by the end of 2Q04. The witness accounts and post-Class Period admissions

show that defendants knew there were numerous problems that delayed the opening of the Fontana

warehouse, the transition from DSS to CLI and the upgrading and implementation of supply-chain

software. During the 10/18/04 conference call Kalinske stated that LeapFrog had “experienced

several challenges getting our new distribution center up and running smoothly” which negatively

impacted the Company’s financial results. That admission and the admissions in the 2004 10-K that

LeapFrog was still in the process of upgrading and implementing supply-chain software confirms



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

that defendants knew the supply-chain and information technology initiatives were not up and

running or on track to be fully operational by the end of 2Q04.

(g) Defendants knew they misled investors by representing that retail consumer

sales by LeapFrog’s top retailers were up over 20% because they concealed from investors that

retailers were reducing their purchases, delaying orders for purchases they planned to make in order

to reduce inventories, and reducing purchases due to the numerous problems with LeapFrog’s

distribution and supply-chain operations that prevented the Company from filling retailer orders.

(h) Defendants knew they misled investors by representing an increase in higher

margin software sales as shown by a purported increase in the tie ratio indicated a healthy business

for the Company and that the tie ratio increased from 5.1 to 1 to 6.5 to 1 over the last year. After the

Class Period, the Company admitted, and Merrill Lynch reported in a 11/4/04 report, that the

decision in 4Q03 to offer two books in response to the PowerTouch hurt the tie ratio, causing it to

decline to 3.5:1. Moreover, Bender testified during the Mattel trial that the tie ratio actually declined

to 3.7 in 2003 and that it declined significantly to 2.9 in 2004 after LeapFrog decided to include a

second book with each LeapPad platform.

(i) The defendants knew there was no reasonable basis for the guidance provided

for the remainder of 2004 given the numerous problems with the distribution and supply-chain

operations and the millions of dollars in lost sales and profits caused by the PowerTouch which

prevented the Company from accurately forecasting or meeting customer demand. Further, during

the Company’s 7/21/04 conference call defendants admitted they knew – and purposely did not

disclose – that gross margins would decline in 2Q04 because retailers were not going to purchase the

Company’s higher margin software due to large changes to software packaging being made by the

Company that would not be available until 8/04:

In terms of the software side, I would like to make one comment. We have been quiet about this, but we have been doing a large packaging change on software. So if you were a U.S. retailer in April, May and June, you did not have any incentive to purchase software from us because we are about to implement the change of new packaging which isn’t available until August to ship into the market.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

In fact, during the 7/21/04 conference call defendants said the packaging change was the reason

LeapFrog reported a decline in the gross margin to 45.1% which was less than the 48%-49% they

told investors to expect during the 4/21/04 conference call.

182. Stock Price: On 4/22/04, following the issuance of the 4/21/04 press release and the

very positive conference call, the price of LeapFrog’s stock increased as much as 9% and closed at

$23.19, up $1.40, or 6.4% from $21.79, the closing price on 4/21/04. By comparison, the S&P 500

increased 1.4% and the proxy peer group increased 1.7%.

183. False Statement: On 5/7/04, LeapFrog issued its 1Q04 10-Q that was signed by

Kalinske and Curley. The 10-Q repeated the financial results that were initially reported by the

Company on 4/21/04 and included the same false and misleading risk disclosures contained in the

2Q03 10-Q, the 3Q03 10-Q, and the 2003 10-K, regarding (1) the Company’s ability to ship product

to its customers within shorter time periods, (2) the Company’s ability to compete effectively with

existing or new competitors, (3) the dependence on Wal-Mart, Toys R Us and Target for a majority

of the Company’s sales, and (4) the Company’s disclosure controls:











(e) Defendants represented that LeapFrog’s business and operating results could





1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28


Exs. F and G.





Ex. C.

(g) As required by §302 of Sarbanes-Oxley, Kalinske and Wood certified that (1)


















shipped product to the retailers that they had not ordered and would not pay for. Defendants also

knew that LeapFrog’ operating results were already suffering because the Company had not

developed and maintained sufficient management systems to keep pace with planned growth. They



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

knew the representations that LeapFrog upgrading existing and implementing new supply-chain

systems, and consolidating warehouse operations were false and misleading because they concealed

from investors the problems with DSS and the Company’s decision to replace them with CLI. The

representations were also false and misleading because defendants knew that CLI would not replace

DSS until the peak selling season in 2004 and that the warehouse would not be available until 7/04.

Defendants also knew the implementation of new supply-chain software was being delayed and

would not be completed before the peak selling season in 2004. As admitted by defendants after the

Class Period and as explained by the witnesses, LeapFrog’s failure to implement supply-chain

software caused a significant adverse impact on the Company’s operating and financial results.

Specifically, LeapFrog was unable to assure it had sufficient levels of inventory to fill customer

orders because the Company did not upgrade existing or implement new operational information

systems, including supply-chain management systems.

(c) As detailed in ¶¶112-126, LeapFrog’s suit against Fisher-Price/Mattel shows


market share to decline. Documents and pleadings LeapFrog filed in that suit and trial testimony

show defendants knew LeapFrog was losing millions of dollars in sales and profits due to the sale of



(d) Defendants knew their representations that LeapFrog’s business and operating







Company’s products due to its own financial difficulties.

(e) As detailed in ¶¶87-111, the witness accounts and the admissions by




1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28









F. False and Misleading Statements Between 7/21/04 and 10/18/04: Defendants Cause LeapFrog to Report False and Misleading Financial Results for 2Q04 and Include Materially False and Misleading Risk Factors in the Company’s 2Q04 10-Q

185. False Statement: On 7/21/04, LeapFrog issued a press release announcing the

Company’s 2Q04 results:

LeapFrog Reports 2nd Quarter 2004 Results; Net Sales Up 19%

EMERYVILLE, Calif., July 21/PRNewswire-FirstCall/ – LeapFrog Enterprises, Inc. (NYSE:LF), a leading developer of innovative technology-based educational products, today reported financial results for the second quarter ended June 30, 2004.

Net Sales

Net sales for the second quarter of 2004 were $80.8 million, compared with $68.0 million in the second quarter of 2003, up 19%.

Segment Results

Net sales from the U.S. Consumer segment were $47.7 million, up 4% from $45.8 million in the second quarter of 2003. . . .

Gross Margin

Gross margin was 45.1% in the second quarter of 2004, compared with 52.7% in the second quarter of 2003. Gross margin declined largely due to lower gross profit margins in the U.S. Consumer segment, which saw a shift in the mix of products sold in the quarter from higher margin software to newer lower margin platforms. The company expects its gross margins to improve in the second half of the year as new software titles become increasingly available and software sales comprise a larger portion of the company’s total sales mix.

Net Loss



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

The company recorded a net loss for the second quarter of 2004 of $(7.4) million, or $(0.12) per share, compared with a net loss for the second quarter of 2003 of $(3.9) million, or $(0.07) per share.

“We are pleased with our progress in the second quarter and with about 80% of the sales year still ahead of us, we are prepared for the second half of 2004,” said Tom Kalinske, Chief Executive Officer. “We are excited about strategically expanding our product line within both our Consumer business and our Education and Training business. Our progress in penetrating the U.S. school market is particularly encouraging and, in a mature business model, will support a more even, year-round selling cycle for us over the long term. On the Consumer side, while the U.S. retail environment remains challenging, we are pleased that our POS data indicates that sell through at retail is up over 20% to date, which should bode well for the busy fall and holiday selling season. We believe that the work we are doing in 2004 to build our brand, company, infrastructure and product line will position LeapFrog to become a universally-recognized global leader in the future.”

The company’s published guidance for the full 2004 year remains unchanged as follows:

Outlook for 2004

- Net sales of $770 to $800 million - Gross profit margin of 48% to 49% of net sales - Operating expenses of 33% to 35% of net sales - Fully diluted share count of approximately 63 million - Diluted net income per share of $1.18 to $1.28

186. False Statement: On 7/21/04, defendants Kalinske, Curley and Lally participated in

LeapFrog’s 2Q04 earnings conference call attended by various analysts that followed the Company.

Kalinske and Curley repeated the 2Q04 financial results and guidance for the remainder of 2004

included on the 7/21/04 press release and made the additional materially false and misleading

statements:

(a) Kalinske reiterated the Company was prepared for the second half of the year

and that the gross margin would improve in 3Q04:

While our gross margin in the quarter improved slightly to 45.1 percent from 44.6 percent in the first quarter of 2004, we fully expect further improvement in the second half if this year as our new software titles are released, as retailers restock their software sections with our new packaging, and we begin to realize expected efficiencies in producing our new learning platform products.

* * *

We are committed to delivering solid second half with well-managed inventor, good cash flow and a strong balance sheet at the end of the year. We are pleased with our progress in the second quarter, and with about 80 percent of the sales here still ahead of us, we are prepared for the second half of the year.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

(b) Kalinske also stated that LeapFrog was improving the distribution and supply-

chain operations, including the completed implementation of supply-chain management software

programs:

In an update to our last call, I would like to report that we are making progress with improvements to our supply-chain management initiatives. Several of our new supply-chain management software programs are up and running. We are also continuing to consolidate our distribution centers and will complete our move into our new warehouse and begin shipping from it at the end of the month. We will maintain a level of redundancy with our warehouses until the new facility has been fully tested.

Last year we believed that too little available inventory resulted in lost opportunity with our retailers. Consequently, we have planned early and provided for contingencies, including redundant shipping capacity and a larger amount of inventory entering the third quarter. We are focused on improving our delivery and our fulfillment performance in the critical second half of this year. Next year we will shed this warehouse redundancy and the need for an inventory buffer and expect to reap additional operation performance benefits.

(c) Lally stated that pilot programs LeapFrog had conducted with school districts

over the past several years were generating large purchases, including a $1 million sale to the Prince

George County School District in Maryland:

The pilots that LeapFrog SchoolHouse has been conducting over the past several years with school districts throughout the country are beginning to pay off by generating larger purchases from both existing and new customers.

For example, earlier this month we announced a $1 million contract with Prince George’s County Maryland, where our LeapTrack system will be installed in every Title 1 kindergarten classroom together with a one-to-one ratio of LeapPad platforms to students.

187. The false and misleading statements made by defendants in the 7/21/04 press release

and during the 7/21/04 conference call were repeated to the market in analysts reports issued on

7/21/04 by Citigroup Smith Barney and on 7/22/04 by Piper Jaffray, CSFB, Merrill Lynch, Bear

Stearns, Deutsche Bank and Merriman Curhan Ford.


defendants knew it: Defendants knew the statements made in the press release and conference call

were materially false and misleading for the reasons detailed in ¶¶34-139. Specifically:





1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28








place – including the lack of supply-chain software caused by the delayed implementation of the


Company had established sufficient allowances for excess and obsolete inventory.





statements.







(e) Defendants knew Kalinske misled by representing (1) LeapFrog was making

progress with improvements to the Company’s distribution and supply-chain initiatives, (2) supply-

chain software was up and running, and (3) the Company had provided for redundant shipping

capacity by retaining DSS. The witness accounts show that LeapFrog had not completed the

implementation of necessary supply-chain software, including the Highjump warehouse

management software which did not go live until 8/04. Further, defendants admitted after the Class

Period (as reported by Merrill Lynch on 11/4/04) that there were numerous problems with the



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

initiatives, including delays in opening the warehouse and DSS requiring LeapFrog to quickly move

inventory in their warehouses to the Fontana warehouse. After the Class Period, the Company

reported in the 2004 10-K that it was still in the process of upgrading existing and implementing new

supply-chain software.

(f) Defendants knew there was no reasonable basis for reiterating the guidance

for 2004 and representing that LeapFrog was prepared for the second half of 2004 when 80% of the

Company’s sales were generated because they knew there were numerous problems that delayed the

transition from DSS to CLI and the upgrade and implementation of supply-chain software that would

cause the distribution and supply-chain problems to continue and that LeapFrog was losing millions

of dollars in LeapPad sales and profits due to the PowerTouch.

(g) Defendants knew there was no reasonable basis for representing gross margins

would improve in the second half of 2004 as higher margin software sales comprised a larger portion

of the Company’s sales mix because they knew the delays in transitioning to CLI, consolidating

warehouse operations and implementing supply-chain software until the peak selling season would

prevent the Company from fulfilling customer orders. Kalinske admitted during the Company’s

2/15/05 conference call that he knew CLI was unable to ship product to LeapFrog’s retailers

correctly by 8/04. Bender’s testimony in the patent infringement trial shows that defendants knew

software sales would not comprise a larger portion of the Company’s sales. Bender testified that the

decision to add a second book to LeapPad platforms caused a substantial decline in sales of software

which defendants knew about because the Company tracked book purchases per platform, i.e., the tie

ratio, which showed the tie ratio was declining. Bender testified that LeapFrog lost 2.9 million book

sales due to the decision to include the second book.

(h) Defendants also knew that Lally’s representation that the $1 million sale to the

Prince George County School District was a result of pilot programs conducted over the past several

years was false. In fact, the sale was the result of LeapFrog salesperson Sienna Owens’ (“Owens”)

personal relationship with Andre Hornsby (“Hornsby”), the head of the school district. The sale

violated LeapFrog’s internal code of conduct and is currently being investigated by the FBI and

other authorities. According to a 4/22/05 article in the Washington Post, the $1 million sale was for



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

216 “classroom kits” each of which included 22 LeapPads, headphones, software, teaching manuals,

programmable cartridges and interactive books. The Post also reported that the $1 million sale

ranked among the largest in LeapFrog history and helped fortify its educational division as the

Company’s total retail sales flagged.

(i) The sale was approved by Hornsby, the CEO of the Prince George County

School District without disclosing he lived with LeapFrog saleswoman Owens. Deborah Adam

(“Adam”), another LeapFrog salesperson, received a $40,000 commission on the sale, a portion of

which was apparently shared with Owens. Owens and the other salesperson left LeapFrog following

the internal ethics investigation. On 12/14/04, LeapFrog announced that Lally had also been forced

to resign for violating the Company’s ethics policy related to the sale. Nevertheless, as reported by

the Washington Post on 11/18/04, LeapFrog continued to provide Hornsby money by sponsoring a

speech at the National Alliance of Black School Educators convention.

189. Stock Price: LeapFrog’s stock price was artificially maintained at $18.55 by the false

and misleading statements made by defendants in the 7/21/04 press release and during the

conference call that were repeated to the market in several analyst reports. The stock price would

have declined (as it did on 10/19/04) if the market knew (as it did on 10/18/04) the truth about the

distribution and supply-chain operations, the lost sales caused by sales of the PowerTouch and the

distribution and supply-chain problems, the numerous internal control deficiencies and the inability

to forecast future results.

190. False Statement: On 8/6/04, LeapFrog issued its 2Q04 10-Q with the SEC which was

signed by defendants Kalinske and Curley. The 10-Q repeated the false and misleading financial

results disclosed on 7/21/04 and included the same false and misleading risk disclosures contained in

the 2Q03 10-Q, the 3Q03 10-Q, the 2003 10-K, and the 1Q04 10-Q regarding (1) the Company’s

ability to ship product to its customers within shorter time periods, (2) the Company’s ability to

compete effectively with existing or new competitors, (3) the dependence on Wal-Mart, Toys R Us

and Target for a majority of the Company’s sales, and (4) the Company’s disclosure controls



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28










platforms and books, the product that Mattel’s PowerTouch competed with, declined. Ex. K.

(e) Defendants also falsely represented that LeapFrog’s business and operating

results could be harmed if Wal-Mart, Toys R Us or Target, the three retailers that accounted for 85%

of the Company’s U.S. Consumer sales in 2003 and 95% in 2003, reduced their purchases, changed

the terms on which they conducted business with LeapFrog or experienced a downturn in their

business. Exs. F and G.





Ex. C.

(g) As required by §302 of Sarbanes-Oxley, Curley and Kalinske certified that (1)









1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28












shipped product to the retailers that they had not ordered and would not pay for. During LeapFrog’s

2/15/05 conference call, Kalinske admitted that he and the other defendants knew CLI was unable to

ship product to LeapFrog’s retail customers beginning in 8/04.

(c) Defendants also knew that LeapFrog’ operating results were already suffering

because the Company had not developed and maintained sufficient management systems to keep

pace with planned growth. They knew the representations that LeapFrog upgrading existing and

implementing new supply-chain systems, and consolidating warehouse operations were false and

misleading because they concealed from investors that the implementation of new supply-chain

software was being delayed and would not be completed. As admitted by defendants after the Class

Period and as explained by the witnesses, the Company is still in the process of upgrading existing

and implementing new supply-chain software and LeapFrog’s failure to implement supply-chain

software in 2004 caused a significant adverse impact on the Company’s operating and financial

results.



market share to decline. Documents and pleadings LeapFrog filed in that suit, and trial testimony

shows the Company was losing millions of dollars in LeapPad sales and profits due to the sale of



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28







Company’s products and imposed millions of dollars of vendor violation penalties because CLI was

unable to ship product within shorter time periods and because CLI shipped product that the retailers


Company’s products due to its own financial difficulties.











192. False Statement: On 8/11/04, Merriman Curhan Ford & Co. analyst Raj Sharma

issued a report after speaking at length with Kalinske and others who told her that they felt better

about the outlook for LeapFrog than they had in months as the Company was receiving excellent

responses from retailers and winning over the competition:

Management Visit Confirms Bullish Thesis; Better Q3 Visibility; Reiterate Buy

* We visited with management yesterday, and spoke at length on new products, retailer relationships, and outlook for the year. Management now feels far better about the outlook and the business than they did three months ago. The company has better visibility now that they are half-way through Q3, and is receiving an excellent response from retailers on new products.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28


defendants knew it: The statements made by defendants that were included in the 8/11/04 analyst

report were false and misleading for the reasons set forth in ¶¶34-139 and that they caused Merriman

Curhan Ford analyst Sharma to serve as a conduit for distributing false information to investors. In

fact, Kalinske admitted during the 2/15/05 conference call that he and the other defendants felt worse

about the outlook for the business because by 8/04 they knew that CLI was unable to ship product to

LeapFrog’s retailers correctly.

194. Stock Price: LeapFrog’s stock price was artificially maintained at $18.25 by

defendants’ misrepresentations and omissions, including the false representations included in

Sharma’s 8/11/04 report. The stock price would have declined, as it did on 10/19/04, if the market

knew (as it did on 10/18/04) the truth about the distribution and supply-chain operations, the lost

sales due to competition and the shipping problems, the numerous internal control deficiencies and

the Company’s inability to accurately forecast its results.

195. On 9/1/04, LeapFrog issued a press release announcing that Wood had resigned from

the Company. Just a few days later when Wood and the other defendants admitted they knew CLI

was unable to ship product correctly to LeapFrog’s retail customers, Wood sold all of his remaining

stock – 2.7 million shares – for $51 million. In a 9/7/04 article titled, “Did Leapfrog’s founder dump

shares?” Herb Greenberg noted the suspicious nature of the sale:

Leaping leapfrogs: Buzz in my channels today is that 2.5 million shares of Leapfrog stock was sold in a private transaction this morning through Merrill Lynch. The buyers were said to be existing holders, who no doubt would rather buy than see the impact of so many shares being dumped on the market at once.

And the seller? Word is it was none other than Leapfrog founder and former CEO Michael Wood, who resigned last week as chief vision and creative officer and vice chairman of the board. As of Leapfrog’s (LF: news, chart, profile) last proxy statement, on April 8, Wood had 2.6 million shares.

If Wood indeed was the seller, the timing of his sale would definitely be an eyebrow raiser. Did he sell because he decided it’s time to get out while the getting was good, which would be a negative? Or did he sell because he’s miffed he was pushed out and wanted nothing more to do with the company, which would be less of a negative? And if he wasn’t the seller, who was – and why sell now?

Interestingly, Leapfrog today issued an announcement about “a major contract” by its SchoolHouse division. (To counter any impact of chatter related to the stock sale?)



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

Leapfrog’s comment? Haven’t heard back yet, but will let you know when and if I do.

196. False Statement: On 9/24/04, Merriman Curhan Ford & Co. analyst Raj Sharma

issued a report that was based on and repeated positive statements made by Kalinske about the

Company’s sales and expected financial results in 3Q04 and 4Q04:

Management Update Positive; Improved Sell-ins and Dynamic Management Execution; Reiterate Buy

* Q3 sales indicate to be better than last year. Positive tone from management. We believe retailer product response has been positive and Q3 sell-ins have been good and that Q4 may look even better.


defendants knew it: The statements made by defendants that were included in the 9/24/04 analyst

report were false and misleading for the reasons set forth in ¶¶34-139. Defendants knew they were

misleading Merriman Curhan Ford analyst Sharma to serve as a conduit for distributing false

information to investors. With less than a week left in 3Q04 the defendants knew, as they admitted

during the 2/15/05 conference call, that LeapFrog’s 3Q04 results would be substantially less than

guidance because of the distribution and supply-chain problems. Kalinske admitted during the

2/15/05 conference call that defendants knew by 8/04 that CLI was unable to ship product to

LeapFrog’s retailers correctly.

198. Stock Price: LeapFrog’s stock price was artificially maintained at $20.76 by

defendants’ misrepresentations and omissions, including the false representations included in

Sharma’s 9/24/04 report. The stock price would have declined, as it did on 10/19/04, if the market

knew (as it did on 10/18/04) the truth about the distribution and supply-chain operations, the

additional lost sales due to competition and the shipping problems, the numerous internal control

deficiencies and the Company’s inability to accurately forecast its results.

199. On 10/15/04, Merrill Lynch analyst Lauren Rich Fine issued a report that showed

investors had been deceived into believing the distribution and supply-chain problems had been

fixed and would not cause a repeat of the 3Q03 sales miss one year ago:

We believe the company-specific issues related to fulfilling demand and inventory management are being addressed, although we hope to learn more about how the new warehouse and supply-chain management implementations are going when LF



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

reports Q3 results, as these systems are being tested for the first time this season. This is a risk, but a solid effort has been made and we are hopeful there isn’t a repeat of last year.

200. Three days later defendants admitted what they had known all along - that LeapPad

sales were declining and that there were numerous problems with the distribution and supply-chain

operations that prevented LeapFrog from fulfilling customer demand, managing inventory,

accurately forecasting the Company’s results and assuring the reliability of LeapFrog’s financial

reporting.

THE END OF THE CLASS PERIOD AND POST CLASS PERIOD EVENTS FURTHER DEMONSTRATING DEFENDANTS’ FRAUD

201. On 10/18/04, after repeatedly assuring investors that LeapFrog would report solid

financial results in 3Q04 and 4Q04 and that the distribution and supply-chain problems had been

fixed, defendants shocked investors yet again by preannouncing that 3Q04 results would be

significantly worse than the guidance previously provided by defendants. Moreover, they revealed

that the reasons for the shortfall included soft sales and problems with the Company’s distribution

and supply-chain operations:

LEAPFROG PROVIDES REVISED OUTLOOK FOR 2004

AND PRELIMINARY RESULTS FOR THIRD QUARTER

EMERYVILLE, Calif. – October 18, 2004 – LeapFrog Enterprises, Inc. (NYSE: LF), a leading developer of innovative technology-based educational products, today announced its revised full year financial outlook for 2004 and preliminary results for the third quarter of 2004.

“The operating climate in the United States is tougher than we anticipated, and we expect to see this continue through the Holiday season,” said LeapFrog Chief Executive Officer Tom Kalinske. “In addition, we are experiencing softness in our basic LeapPad business in the United States, and we have had several challenges getting our new distribution center and supply-chain systems up and running smoothly during this peak season.”

“As a result, we believe that it is prudent to adjust our outlook for 2004 accordingly,” continued Kalinske. “While we had a more optimistic view of the second half of the year three months ago, we believe that 2004 will be less profitable than we had previously expected. Clearly, this is not acceptable to us and we are taking immediate action to ensure a healthy company and a strong product line for 2005.”

Preliminary Results for Third Quarter of 2004

The company also announced that it expects to report net sales for the September quarter 2004 of approximately $225 to $230 million on gross margins of 40% to 41%



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

and operating expenses of 27% to 28%. Based on a fully diluted share count of approximately 61.5 million, the company also expects to report earnings per share on a fully diluted basis of approximately $0.32 to $0.34 per share. Complete financial results for the third quarter of 2004 will be released on October 27.

Outlook for 2004

The company’s published guidance for the full 2004 year is revised as follows:

Net sales of $680 to $710 million Gross profit margin of 42% to 43% of net sales Operating expenses of 36% to 37% of net sales Fully diluted share count of approximately 61.5 million Diluted net income per share of $0.40 to $0.60

202. During the Company’s conference call later that day, Kalinske admitted again that

there were problems with the Company’s distribution and supply-chain operations that the Company

needed help to correct. In addition, contrary to the risk disclosures contained in every 10-Q and 10-

K issued during the Class Period, Kalinske’s statements during the conference call showed that

LeapFrog had not made infrastructure investments sufficient to keep pace with the Company’s

astronomical growth:

[W]e have experienced several challenges getting our new distribution center up and running smoothly. As you will recall, we consolidated our distribution centers into one, newer, larger facility this past July. At the same time, we also launched a number of new information management systems to build out our supply-chain. In addition, we hired a new third-party logistics venture, Commodity Logistics, Inc., to implement these operations. However, getting all this up and running during this peak time has been challenging and we have experienced negative financial ramifications through this transition, ultimately impacting margin.

* * *

[W]e are working closely with our distribution partner, Commodity Logistics, Inc., to significantly improve and strengthen our supply-chain management at our new consolidated warehouse, using our new IT systems, so that we may effectively deliver and efficiently deliver our products to our U.S. retail partners. We have also brought in outside consultants, such as Accenture, to help us through these changes. All in all, we know that we are going to have to work very hard to restore faith with our key retail customers.

We’re working to improve and perfect our organization, processes, and infrastructure to properly support this new phase of our company’s growth. Leapfrog is a business that has grown astronomically over the last several years. During that time, the emphasis was on feeding that rapid growth with new products delivered to market as quickly as possible. As we enter a new phase of our company’s growth, this management team is focused on building the infrastructure necessary for future success, including developing an efficient, team-oriented organization implementing internal systems designed to give us better



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

visibility and control over our businesses and developing business planning processes to ensure consistent future growth and profitability.

203. Following the pre-announcement, LeapFrog’s stock price declined $6.21, or 34%

from $18.20 on 10/18/04, to $11.99 on 10/19/04, causing class members to suffer economic losses.

By comparison, the S&P 500 declined 1% and the proxy peer group declined by 0.7%.

204. Following the pre-announcement, incredulous analysts issued scathing reports that

stated management credibility had sunk to new lows because LeapFrog management had botched the

Company’s distribution and supply-chain operations for at least a year and a solution did not appear

at hand:

• Bear Stearns analyst Childe slashed EPS estimates and stated “[l]ooking forward, execution remains the biggest risk to the story, with management credibility hitting new lows. LF has now struggled with supply-chain issues for a full year now and we have limited confidence in the company’s ability to execute on 4Q plans.”

• In her report, Merriman Curhan Ford analyst Sharma stated that LeapFrog management “admits to botching up supply-chain and distribution execution in Q3. This should clearly affect management credibility and call for changes in the management structure.”

• Piper Jaffray analyst Gikas downgraded the stock and wrote “[f]or one year now LF has struggled with product sales and supply-chain problems – it’s unlikely a solution is at hand.”

• Merrill Lynch analyst Fine downgraded the stock and noted that LeapFrog management “cited . . . challenges with its distribution and supply-chain system during the peak season with LF unable to fill all of its orders...management credibility has taken an even bigger step down at this juncture.”

• Citigroup Smith Barney analyst Krutick noted that the distribution and supply-chain problems were far from fixed: “LeapFrog is working closely with distribution partners and consultants and implementing new IT systems to improve efficiency of distribution in order to better deliver product to retail.”

205. On 10/27/04, LeapFrog reported financial results in line with the revised guidance

provided two weeks earlier and reiterated the revised guidance for FY04 that was provided on

10/18/04. In addition, during the conference call Kalinske and Perez tried to convince investors,

again, that LeapFrog was taking steps to address the problems. Analysts, however, remained

skeptical:

• Citigroup Smith Barney analyst Jill Krutick issued a report that stated, “[o]ur cautious outlook for LeapFrog is unchanged at this time, as we note that the third quarter was the third of the last five quarters in which the company pre-announced disappointing results. On the company’s conference call, management tried to dispel concerns by outline [sic]



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

steps they are taking to address the issues, but as they itemized the issues, we did not gain a comfort level that everything has been pinpointed.”

• CSFB analyst Dobell issued a report that stated, “[w]e continue to remain cautious on Q4 and F05 numbers because we believe industry fundamentals and LeapPad issues have the potential to bring down numbers again.”

• Bear Stearns analyst Jennifer Childe issued a report that stated, “visibility remains unquestionably weak and management credibility both in its ability to execute and in its ability to accurately forecast the business has dropped to new lows.”

• In his 10/28/04 report, Piper Jaffary analyst Anthony N. Gikas stated, “[o]ur concerns remain and include: 1) Significant execution risk; 2) management credibility; 3) CY05 estimates not firm; 4) increasing materials and systems costs; 5) margin pressure during CY05; 6) cornerstone LeapPad product line at risk; 7) limited visibility; and 8) lack of near term catalyst.”

• In a 10/28/04 report, Merrill Lynch analyst Fine stated, “the dramatic misses of late and the lack of management credibility make it difficult to have conviction on the shares.”

206. On 12/16/04, the analysts and investors learned their skepticism about LeapFrog was

well founded. On 12/16/04, LeapFrog withdrew its FY04 guidance again and disclosed FY04

financial results would be “significantly below” the substantially reduced guidance provided on

10/18/04. Moreover, the Company failed to provide any new guidance for FY04 or 2005 because, as

LeapFrog’s new CFO admitted during the 12/16/04 conference call and as was reported by Merrill

Lynch analyst Fine in a 12/17/04 report, LeapFrog was unable to provide accurate forecasts in the

past and still did not have processes in place to provide more accurate information.

207. On 2/15/05, LeapFrog announced terrible 4Q04 and FY04 financial results that were

substantially worse than the revised guidance provided on 10/18/04 which was subsequently

withdrawn on 12/16/04. Net sales in 2004 were $640.3 million, $70 million less than the revised

guidance provided on 10/18/04. In addition, LeapFrog reported a net loss of $7.9 million, or $0.13

per share, compared to the guidance of $36 million or $0.60 EPS provided on 10/18/04.

208. In addition to the withdrawn guidance and terrible financial results, defendants’ fraud

has caused the Company to substantially reduce its workforce and make numerous management

changes. On 10/27/04, the Company announced it was eliminating 100 jobs, or 11% of the

workforce. On 2/15/05, the Company announced it was eliminating another 180 jobs, or 16% of the

workforce.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

209. There have also been numerous management changes at the Company. In addition to

the forced resignation of Wood, Curley’s forced resignation was announced on 11/11/04, just before

the Company withdrew its guidance for 2004 and as the Company was preparing to disclose that

there were numerous material weaknesses in the Company’s internal controls that precluded

reasonable assurance that LeapFrog’s financial statements had been prepared in accordance with

GAAP. Curley was replaced by William B. Chiasson (“Chiasson”) because, as Chiasson and Curley

reportedly told Merrill Lynch analyst Fine, it was time to transition from an early stage CFO to one

with more experience and interest in employing management processes as well as experience with

supply-chain management and financial modeling.

210. On 12/14/04, the Company announced the forced resignation of Lally in response to

the internal investigation under LeapFrog’s code of conduct relating to a $40,000 commission paid

to a sales representative on a $1 million sale to the Prince George County School District. As

detailed in ¶¶188(h) and (i), that transaction is under investigation by the FBI and other authorities

because the school district’s CEO, Hornsby, authorized the purchase in 6/04 without disclosing he

lived with LeapFrog saleswoman Sienna Owens. Owens and another LeapFrog salesperson who

apparently shared some of the $40,000 commission with Owens, left LeapFrog following the internal

ethics investigation.

211. On 2/2/05, LeapFrog announced the resignation of Forsyth, the COO hired in 8/03 to

fix the distribution and supply-chain problems. On 2/15/05, the Company announced it had hired a

new Chief Information Officer and on 4/1/05, the Company announced it had hired a new senior vice

president of supply chain and operations.

212. On 2/14/05, LeapFrog announced that Jeffrey Berg (“Berg”) resigned from the

Company’s Board of Directors and was therefore no longer a member of the audit, compensation,

and nominating and corporate governance committees. As a result, LeapFrog was not in compliance

with NYSE rules which required audit committees to have at least three members. The resignation

of Berg occurred just one month before defendants disclosed they could not reasonably assure

LeapFrog’s financial results were accurate or prepared in accordance with GAAP because of the

numerous material weaknesses in the Company’s internal controls in the areas of revenue and



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

accounts receivable, cost of goods sold and inventory and information technology including

distribution and supply-chain operations.

213. As detailed in ¶¶107-111 and in Ex. C, on 3/28/05, LeapFrog filed its 2004 10-K and

admitted that there were numerous material weaknesses with the Company’s distribution and supply-

chain operations that prevented the Company from reasonably assuring LeapFrog’s financial

reporting was reliable or that the Company’s financial statements were prepared in accordance with

GAAP.

LEAPFROG’S FALSE FINANCIAL REPORTING DURING THE CLASS PERIOD

214. LeapFrog’s financial results during the Class Period were materially false and

misleading. Defendants caused LeapFrog to report inflated financial results during the Class Period

by (1) improperly recognizing revenues upon shipment of products to its U.S. retail customers that

they did not order and would not pay for, (2) improperly recording receivables on those sales, (3)

failing to adequately reserve for obsolete, defective and excess inventory, and (4) failing to report

expenses related to the purchase of goods and services used to manufacture the Company’s products.

After the Class Period, LeapFrog admitted in its 2004 10-K that it could not reasonably assure the

reliability of its financial reporting or that its financial statements were prepared in accordance with

GAAP because there were numerous material weaknesses in the areas of (1) revenue and accounts

receivable, (2) costs of goods sold and inventory and (3) information technology controls, including

the Company’s distribution and supply-chain operations.

215. GAAP are those principles recognized by the accounting profession as the

conventions, rules and procedures necessary to define accepted accounting practice at a particular

time. SEC Regulation S-X (17 C.F.R. §210.4-01(a)(1)) states that financial statements filed with the

SEC which are not prepared in compliance with GAAP are presumed to be misleading and

inaccurate, despite footnote or other disclosure. Regulation S-X requires that interim financial

statements must also comply with GAAP, with the exception that interim financial statements need

not include disclosure which would be duplicative of disclosures accompanying annual financial

statements. 17 C.F.R. §210.10-01(a).



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

A. LeapFrog’s Improper Revenue Recognition and Failure to Adequately Reserve for Accounts Receivable with Doubtful Collectibility

216. Pursuant to GAAP, as set forth in Financial Accounting Standards Board (“FASB”)

Statement of Financial Accounting Concepts (“FASCON”) No. 5, SEC Staff Accounting Bulletin

No. 101 and LeapFrog’s publicly reported revenue recognition policy, revenues can not be

recognized upon shipment unless the following criteria are met: (1) persuasive evidence of an

arrangement exists, (2) delivery has occurred, (3) the fee is fixed and determinable, and (4)

collection is reasonably assured.

217. Further, pursuant to GAAP as set forth in FASB’s Statement of Financial Accounting

Standards (“SFAS”) No. 48, revenues can not be recognized at the time of sale where the buyer has

the right to return the product unless (1) the price is substantially fixed or determinable at the time of

sale, (2) the buyers payment obligation is not contingent on resale, and (3) the amount of future

returns can be reasonably estimated.

218. Defendants knew collection of the revenues recognized during the Class Period was

not probable because they knew DSS and CLI were delivering product to the Company’s U.S. retail

customers that they had not ordered, would not pay for and would return.

219. GAAP, as set forth in SFAS No. 5, Accounting for Contingencies, states that any loss

to be expected from an uncollectible receivable should be accrued when it is probable and when the

amount of such loss can be reasonably estimated. See SFAS No. 5, ¶8. According to SFAS No. 5,

¶22:

Losses from uncollectible receivables shall be accrued when both conditions in paragraph 8 are met [the loss is probable and the amount of loss can be reasonably estimated]. Those conditions may be considered in relation to individual receivables or in relation to groups of similar types of receivables. If the conditions are met, accrual shall be made even though the particular receivables that are uncollectible may not be identifiable.

220. Although receivables should not have been accrued at all on the sales of product to

LeapFrog’s retail customers that they had not ordered and would not pay for, defendants caused

LeapFrog to violate GAAP by failing to make timely and adequate accrual for these uncollectible



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

receivables despite knowing the Company’s U.S. retail customers would not pay for product they

were delivered but did not order.

221. After the Class Period the Company admitted that it could not reasonably assure the

reliability of its financial reporting or that the Company’s financial statements were prepared in

accordance with GAAP because there were numerous material weaknesses in the areas of revenue

and accounts receivable.

B. LeapFrog’s Improper Accounting for Inventory

222. GAAP, as set forth in ARB No. 43, Chapter 4, Inventory Pricing, and LeapFrog’s

publicly reported inventory policy required inventories to be recorded at the lower of cost or market.

ARB No. 43, Chapter 4, Statement 5, states:

A departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as its cost. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business, will be less than cost, whether due to physical deterioration, obsolescence, changes in price levels or other causes, the difference should be recognized as a loss in the current period. This is generally accomplished by stating such goods at a lower level commonly designated as market.

(Emphasis in original.)

223. During the Class Period, defendants knew that LeapFrog had not implemented

supply-chain software that was needed to evaluate and determine if additional allowances for

obsolete and excess inventory were needed. Pursuant to GAAP, the Company was required to

evaluate its inventory at each quarter-end and record losses for the excessive inventory. LeapFrog

actually reduced the allowance in 2003 and added just $2 million to the allowance in 2Q04. After

the Class Period, LeapFrog increased the allowance for excess and obsolete inventory by $14 million

from approximately $5 million as of 6/30/04, to $19.0 million as of 3/31/05.

224. After the Class Period the Company admitted that it could not reasonably assure the

reliability of its financial reporting or that the Company’s financial statements were prepared in

accordance with GAAP because there were numerous material weaknesses in the areas of costs of

goods sold and inventory.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

C. LeapFrog’s Failure to Report Expenses Related to Goods and Services Purchased from Its Vendors

225. GAAP, as set forth in ARB No. 43, Chapter 3, §A, Current Assets and Liabilities,

required LeapFrog to report a current liability for payables incurred in the acquisition of materials

and supplies to be used in the production of goods. ARB No. 43, Chapter 3, ¶7. During the Class

Period, defendants knew LeapFrog violated GAAP because the engineering department was ordering

goods and services from vendors without creating or submitting approved purchase orders. As a

result, LeapFrog did not report a liability for the payables incurred.

226. After the Class Period, LeapFrog admitted it could not reasonably assure the

reliability of its financial reporting or that its financial statements were prepared in accordance with

GAAP due to numerous material weaknesses related to (1) the creation of purchase orders, (2)

inventory purchasing, (3) the purchase of materials and components used to manufacture and

assemble products, (4) the manufacture and assembly of products and (5) LeapFrog’s payments to

vendors.

D. Defendants’ False Representations and Certifications that LeapFrog’s Financial Reporting Was Reliable, LeapFrog’s Financial Statements Were Prepared in Accordance with GAAP and that LeapFrog’s Disclosure Controls and Internal Controls over Financial Reporting Were Effective

227. As required by SEC rules and regulations, LeapFrog represented and Wood, Curley

and Kalinske (as the Company’s CEO and CFO) certified that (1) the Company’s 10-Qs and 10-Ks

did not contain any false or misleading statements, (2) the financial statements included in the 10-Qs

and 10-Ks fairly presented in all material respects the financial condition, results of operations and

cash flows of LeapFrog, and (3) based on their most recent evaluation of LeapFrog’s internal

controls over financial reporting, they had disclosed all significant deficiencies and material

weaknesses in the design or operation of LeapFrog’s internal controls over financial reporting which

were reasonably likely to adversely affect the Company’s ability to record, process, summarize and

report financial information. 17 C.F.R. §§240.13a-14, 240.13a-15, 240.15d-15.

228. Throughout the Class Period, defendants knew those representations and

certifications were materially false and misleading. They knew the inability of DSS and CLI to



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

fulfill customer orders accurately or within required shorter time periods caused the Company to

misreport revenues, receivables and earnings. They knew the failure to implement supply-chain

software systems prevented LeapFrog from accurately reporting inventory and from assuring there

was sufficient inventory on hand to fulfill customer orders. They knew LeapFrog was

underreporting expenses and liabilities because engineering was purchasing goods and services from

vendors without issuing a purchase order.

229. Defendants made the false representations and certifications and concealed the

internal control deficiencies until after the Class Period when the Company admitted there were

numerous material weaknesses in the Company’s internal controls over financial reporting which

prevented LeapFrog from reasonably assuring the reliability of its financial reporting or that the

Company’s financial statements were prepared in accordance with GAAP.

E. Additional Violations of GAAP and SEC Regulations

230. Due to the foregoing accounting improprieties, the Company presented its financial

results and statements in a manner which violated GAAP, including, the following fundamental

accounting principles:

(a) The principle that interim financial reporting should be based upon the same

accounting principles and practices used to prepare annual financial statements was violated (ARB

No. 28, ¶10);

(b) The principle that financial reporting should provide information that is useful

to present and potential investors and creditors and other users in making rational investment, credit

and similar decisions was violated (FASCON No. 1, ¶34);

(c) The principle that financial reporting should provide information about the

economic resources of an enterprise, the claims to those resources, and effects of transactions, events

and circumstances that change resources and claims to those resources was violated (FASCON No.

1, ¶40);

(d) The principle that financial reporting should provide information about how

management of an enterprise has discharged its stewardship responsibility to owners (stockholders)

for the use of enterprise resources entrusted to it was violated. To the extent that management offers



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

securities of the enterprise to the public, it voluntarily accepts wider responsibilities for

accountability to prospective investors and to the public in general (FASCON No. 1, ¶50);

(e) The principle that financial reporting should provide information about an

enterprise’s financial performance during a period was violated. Investors and creditors often use

information about the past to help in assessing the prospects of an enterprise. Thus, although

investment and credit decisions reflect investors’ expectations about future enterprise performance,

those expectations are commonly based at least partly on evaluations of past enterprise performance

(FASCON No. 1, ¶42);

(f) The principle that financial reporting should be reliable in that it represents

what it purports to represent was violated. That information should be reliable as well as relevant is

a notion that is central to accounting (FASCON No. 2, ¶¶58-59);

(g) The principle of completeness, which means that nothing is left out of the

information that may be necessary to insure that it validly represents underlying events and

conditions was violated (FASCON No. 2, ¶79); and

(h) The principle that conservatism be used as a prudent reaction to uncertainty to

try to ensure that uncertainties and risks inherent in business situations are adequately considered

was violated. The best way to avoid injury to investors is to try to ensure that what is reported

represents what it purports to represent (FASCON No. 2, ¶¶95, 97).

231. The failure of the Company to report its financial results also violated Regulation S-

X, which states that financial statements filed with the SEC that are not prepared in conformance

with GAAP will be presumed to be misleading. 17 C.F.R. §§210.4-01(a)(1), 210.10-01(a).

232. Further, the undisclosed adverse information concealed by defendants during the

Class Period is the type of information which, because of SEC regulations, regulations of the

national stock exchanges and customary business practice, is expected by investors and securities

analysts to be disclosed and is known by corporate officials and their legal and financial advisors to

be the type of information which is expected to be and must be disclosed.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

PROXIMATE LOSS CAUSATION

233. As alleged herein, during the Class Period defendants misled the public regarding (1)

the problems with the Company’s distribution and supply-chain operations, (2) the Company’s

financial results, (3) the effectiveness of the Company’s internal controls over financial reporting, (4)

declining sales due to the distribution and supply-chain problems and the sale of competing products

including Mattel’s PowerTouch, and (5) the Company’s ability to accurately forecast its future

results given the distribution and supply-chain problems, competition and the material weaknesses in

the Company’s internal controls over financial reporting.

234. Defendants’ scheme to deceive investors and the market through the issuance of

materially false and misleading statements and omissions caused LeapFrog’s class A common stock

to trade at artificially inflated prices and operated as a fraud and deceit on Class Period purchasers of

the stock. Lead plaintiffs and the class suffered actual economic loss and were damaged when the

problems with the distribution and supply-chain operations, the numerous material weaknesses with

the Company’s internal controls over financial reporting, the lost sales and the inability to accurately

forecast results were disclosed to the market causing the inflation to be removed from the

Company’s stock price.

235. Throughout the Class Period defendants issued partial disclosures of problems with

the Company’s distribution and supply-chain operations, declining LeapPad sales, and the

Company’s inability to accurately forecast its results. These announcements caused significant

declines in the price of LeapFrog’s class A common stock on 10/22/03 (disclosure of 3Q03 sales

shortfall due to distribution and supply-chain problems caused stock to drop 25%), 2/10/04

(disclosure of 4Q03 and FY03 results and guidance for 2004 that projected slower growth and flat

gross margins caused stock to drop 11.2%), and 3/10/04 (disclosure that 1Q04 results would be less

than guidance provided on 2/10/04 caused stock to drop 24.6%). Each of these partial disclosures,

however, was accompanied by numerous false and misleading statements concerning the Company’s

distribution and supply-chain operations, reported and future financial results, effects of competition,

and internal controls. None of the partial disclosures revealed the full extent of the problems.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

236. On 10/18/04, defendants admitted that the distribution and supply-chain problems and

soft LeapPad sales would cause LeapFrog to report 3Q04 results significantly less than the

Company’s prior guidance. LeapFrog’s stock collapsed, declining by 34%, removing the artificial

inflation from the price of the stock. The 34% decline in the stock price was a direct result of the

revelation to the market about the extent of the distribution and supply-chain problems and lost

LeapPad sales that had been concealed by defendants’ prior misstatements and fraudulent conduct.

As a result of their purchases of LeapFrog class A common stock at artificially inflated prices during

the Class Period and the disclosures that caused the stock price to decline, thereby removing the

artificial inflation from the price of the stock, lead plaintiffs and the class suffered economic loss,

i.e., damages under the federal securities laws.

CLASS ACTION ALLEGATIONS

237. Plaintiffs bring this action as a class action pursuant to Rule 23 of the Federal Rules

of Civil Procedure on behalf of all persons who purchased LeapFrog common stock (the “Class”) on

the open market during the Class Period. Excluded from the Class are defendants.

238. The members of the Class are so numerous that joinder of all members is

impracticable. The disposition of their claims in a class action will provide substantial benefits to

the parties and the Court. During the Class Period, LeapFrog reported there were between 26.3 and

32.2 million shares of LeapFrog’s class A common stock outstanding, owned by hundreds if not

thousands of persons.

239. LeapFrog’s stock traded on the New York Stock Exchange, the most developed and

efficient stock market in the United States. As alleged herein there was a cause and effect

relationship between unexpected information about LeapFrog released to the market and the price

movement in the Company’s stock. The average weekly trading volume in the Company’s stock

during the Class Period was approximately 4.8 million shares. The Company was followed by

numerous securities analysts who attended the Company’s conference calls and issued reports on the

Company throughout the Class Period. There was significant institutional ownership of the

Company’s stock and LeapFrog was eligible to register securities on SEC Form S-3.



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

240. There is a well-defined community of interest in the questions of law and fact

involved in this case. Questions of law and fact common to the members of the Class which

predominate over questions which may affect individual Class members include:

(a) Whether the 1934 Act was violated by defendants;

(b) Whether defendants omitted and/or misrepresented material facts;

(c) Whether defendants’ statements omitted material facts necessary to make the

statements made, in light of the circumstances under which they were made, not misleading;

(d) Whether defendants knew or deliberately disregarded that their statements

were false and misleading;

(e) Whether the price of LeapFrog common stock was artificially inflated; and

(f) The extent of damages sustained by Class members and the appropriate

measure of damages.

241. Plaintiffs’ claims are typical of those of the Class because plaintiffs and the Class

sustained damages from defendants’ wrongful conduct.

242. Plaintiffs will adequately protect the interests of the Class and have retained counsel

who are experienced in class action securities litigation. Plaintiffs have no interests which conflict

with those of the Class.

243. A class action is superior to other available methods for the fair and efficient

adjudication of this controversy.

FIRST CLAIM FOR RELIEF

For Violation of §10(b) of the 1934 Act and Rule 10b-5 Against All Defendants

244. Plaintiffs incorporate ¶¶1-243 by reference.

245. During the Class Period, defendants disseminated or approved the false statements

specified above, which they knew or deliberately disregarded were misleading in that they contained

misrepresentations and failed to disclose material facts necessary in order to make the statements

made, in light of the circumstances under which they were made, not misleading. Defendants also

failed to disclose material adverse information in connection with their sales of LeapFrog stock.

246. Defendants violated §10(b) of the 1934 Act and Rule 10b-5 in that they:



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

(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; or

(c) Engaged in acts, practices, and a course of business that operated as a fraud or

deceit upon plaintiffs and others similarly situated in connection with their purchases of LeapFrog

common stock during the Class Period.

247. Plaintiffs and the Class have suffered damages in that, in reliance on the integrity of

the market, they paid artificially inflated prices for LeapFrog common stock. Plaintiffs and the Class

would not have purchased LeapFrog common stock at the prices they paid, or at all, if they had been

aware that the market prices had been artificially and falsely inflated by defendants’ misleading

statements.

248. As a direct and proximate result of these defendants’ wrongful conduct, plaintiffs and

the other members of the Class suffered damages in connection with their purchases of LeapFrog

common stock during the Class Period.

SECOND CLAIM FOR RELIEF

For Violation of §20(a) of the 1934 Act Against All Defendants

249. Plaintiffs incorporate ¶¶1-248 by reference.

250. The Individual Defendants acted as controlling persons of LeapFrog within the

meaning of §20(a) of the 1934 Act. By reason of their positions as officers and/or directors of

LeapFrog, and their ownership of LeapFrog stock, the Individual Defendants had the power and

authority to cause LeapFrog to engage in the wrongful conduct complained of herein. LeapFrog

controlled each of the Individual Defendants and all of its employees. By reason of such conduct,

the Individual Defendants and LeapFrog are liable pursuant to §20(a) of the 1934 Act.

PRAYER FOR RELIEF

WHEREFORE, plaintiffs pray for judgment as follows:

A. Declaring this action to be a proper class action pursuant to Rule 23(a) and (b)(3) of

the Federal Rules of Civil Procedure on behalf of the Class defined herein;



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

B. Awarding plaintiffs and the members of the Class compensatory damages, interest

and costs;

C. Awarding plaintiffs and members of the Class pre-judgment and post-judgment

interest, as well as reasonable attorneys’ fees, expert witness fees, and other costs;

D. Awarding extraordinary, equitable or injunctive relief as permitted by law or equity;

and

E. Awarding such other relief as the Court may deem just and proper.

JURY DEMAND

Plaintiffs demand a trial by jury.

DATED: June 17, 2005 LERACH COUGHLIN STOIA GELLER RUDMAN & ROBBINS LLP PATRICK J. COUGHLIN CHRISTOPHER P. SEEFER

/s/ CHRISTOPHER P. SEEFER

100 Pine Street, Suite 2600 San Francisco, CA 94111 Telephone: 415/288-4545 415/288-4534 (fax)

LERACH COUGHLIN STOIA GELLER RUDMAN & ROBBINS LLP WILLIAM S. LERACH DARREN J. ROBBINS 401 B Street, Suite 1600 San Diego, CA 92101 Telephone: 619/231-1058 619/231-7423 (fax)

Lead Counsel for Plaintiffs T:\CasesSF\LeapFrog\CPT00021205.doc


1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

DECLARATION OF SERVICE BY MAIL

I, the undersigned, declare:

1. That declarant is and was, at all times herein mentioned, a citizen of the United States

and employed in the City and County of San Francisco, over the age of 18 years, and not a party to

or interested party in the within action; that declarant’s business address is 100 Pine Street,

Suite 2600, San Francisco, California 94111.

2. That on June 17, 2005, declarant served the CONSOLIDATED CLASS ACTION

COMPLAINT FOR VIOLATIONS OF THE FEDERAL SECURITIES LAWS by depositing a

true copy thereof in a United States mailbox at San Francisco, California in a sealed envelope with

postage thereon fully prepaid and addressed to the parties listed on the attached Service List.

3. That there is a regular communication by mail between the place of mailing and the

places so addressed.

I declare under penalty of perjury that the foregoing is true and correct. Executed this 17th

day of June, 2005, at San Francisco, California.

/s/ CAROLYN BURR


Service List - 6/17/2005Page 1 of 2

(03-0393)

LEAPFROG (LEAD)

Counsel For Defendant(s)

Boris FeldmanLeo P. CunninghamDaniel W. Turbow

650 Page Mill RoadPalo Alto, CA 94304-1050

650/493-9300650/493-6811(Fax)

Wilson Sonsini Goodrich & Rosati, P.C.

Counsel For Plaintiff(s)

Todd S. Collins

1622 Locust StreetPhiladelphia, PA 19103

215/875-3000215/875-4604(Fax)

Berger & Montague, P.C.Kurt B. Olsen

2121 K Street, N.W., Suite 800Washington, DC 20037

202/261-3553240/683-8349(Fax)

Klafter & Olsen LLP

Samuel H. RudmanDavid A. Rosenfeld

200 Broadhollow Road, Suite 406Melville, NY 11747

631/367-7100631/367-1173(Fax)

Lerach Coughlin Stoia Geller Rudman & Robbins LLP

Patrick J. CoughlinChristopher P. Seefer

100 Pine Street, Suite 2600San Francisco, CA 94111-5238

415/288-4545415/288-4534(Fax)



Service List - 6/17/2005Page 2 of 2

(03-0393)

LEAPFROG (LEAD)

William S. Lerach

401 B Street, Suite 1600San Diego, CA 92101-4297

619/231-1058619/231-7423(Fax)



07/02/200308/07/2003

09/12/200310/17/2003

11/21/200312/30/2003

02/05/200403/12/2004

04/19/200405/24/2004

06/30/200408/05/2004

09/10/200410/15/2004

11/19/200412/28/2004

02/02/200503/10/2005

04/15/2005

$5

$10

$15

$20

$25

$30

$35

$40

$45

$50

$55

Dol

lars

Per

Sha

re

LeapFrog Enterprises Inc.July 2, 2003 to April 20, 2005

7/24/03 - 10/21/03: Defendants sell 688,318 shares for $24,921,291.

10/22/03: LF reports false and misleading financial results including sales of $203.9 million that were 11% less than expectations. Stock price declines 24% or $11.65 to $34.89; defendants assure sales will be made up in 4Q03.

10/22/03 - 2/10/04: Defendants sell 702,031 shares for $21,163,627 while falsely assuring distribution and supply chain problems are fixed.

11/10/03: LF issues 3Q03 10-Q with false and misleading financial results, risk factors and certifications.

2/10/04: Stock price declines $3.39 or 11.2% to $27.01 after LF reports Wood demotion and disappointing initial 2004 guidance; but LF also reports false and misleading 4Q03 and FY03 results.

3/10/04: Stock price declines $6.40 or 24.6% after LF pre-announces 1Q04 results; but LF assures supply chain being strengthened and issues 2003 10-K with false and misleading financial results, risk factors and certifications.

4/21/04: LF reports false and misleading 1Q04 results and reduces guidance for 2004.

5/7/04: LeapFrog issues 1Q04 10-Q with false and misleading financial results, risk factors and certifications.

7/21/04: LeapFrog reports false and misleading 2Q04 results and reiterates guidance for 3Q04 and 4Q04.

8/6/04: LeapFrog issues 2Q04 10-Q with false and misleading financial results, risk factors and certifications.

8/11/04: Defendants state they feel better about outlook than they did 3 months ago.

Class Period: 7/24/03 - 10/18/04

7/24/03-10/21/03: Stock price increases 65% to $46.54 as defendants assure there are no impediments to reporting 3Q03 results in line with guidance and conceal distribution and supply chain problems and lost sales to Mattel’s PowerTouch.

9/7/04: Wood sells 2.7 million shares for $51 million; Bender sells 50,000 shares for $1,001,500.

9/24/04: Defendants state 3Q04 sell ins have been good and 4Q04 may look even better.

10/18/04: Stock price declines $6.21 or 34.1% to $11.99 after LF preannounces 3Q04 results due to soft LeapPad sales and distribution and supply chain problems.

12/16/04: LF withdraws guidance and admits it lacks the ability to forecast future results.

3/28/05: LeapFrog issues 2004 10-K that states distribution and supply chain problems continue and that LF cannot reasonably assure financial reporting is reliable or financial statements prepared in accordance with GAAP.9/1/04: Wood

resignation announced.

2/15/05: LeapFrog reports horrible FY04 results, 16% RIF and admits distribution and supply chain problems continue.

10/27/04: LF reports 3Q04 results and 11% RIF.

11/11/04: Curley resignation announced.


Exhibit A

Wilmington, DelawareMonday, May 16, 2005

8 :15 a .m .

BEFORE : HONORABLE GREGORY M. SLEET, U .S .D .C .J, and a Jury

APPEARANCES :

RICHARD H . MORSE, ESQ .

Young Conaway Stargatt & Taylor, LLP-and-

RON E . SHULMAN, ESQ .,

TERRY KEARNEY, ESQ .,

MICHAEL BERTA, ESQ ., and

STEPHEN HOLMES, ESQ .

Wilson S'onsini Goodrich & Rosati,

A Proffessiona.l .Corporation

(Palo. Alto, California)

Counsel for Plaintiff

FIRST DAY OF TRIAL

1 2

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

MR . SHULMAN : It was in our initial damage s

expert report .

THE COURT : Do we have that?

I think it 's an important issue . Somebody wrote

somewhere that 35 percent of LeapFrog's damages --

MR. SHULMAN : That goes to the -- the 35 percent

was in their brief they just submitted . That is just the

number of units that were sold pre-notice . 35 percent of

all the units that they have ever sold were sold pre-notice .

I don't know if we have it in the courtroom,

Your Honor . We didn't anticipate this coming up, the exper t

report . It may take us --

MR. BERTA: We can try to locate it on the

system . I can tell you the language .

THE COURT : What is your name?

MR. BERTA : Mike Berta .

What our damages expert said in his opening

report, pretty unequivocally, was that it's his belief that

the continued ability of Fisher-Price to sell component

books by themselves after notice to the extent they would

have been combined with pre-notice units, that that would --

that had Fisher-Price not been allowed to do that because of

the notice issue, and thus it was an infringement, that

people would have quickly switched to LeapFrog devices

because selling books was a part of the value proposition of

101

1 THE COURT: Yes .

2 MR . SHULMAN : Thank you, Your Honor . Once

3 again , my name is Ron Shulman . I am a lawyer . I represent

4 LeapFrog in .thiscase . .

5 Earlier today , I introduced you to the seven

.6 executives from LeapFrog who are here today . LeapFrog is a

7 Delaware company . But they are actually headquartered i n

-8 California . These seven executives that I introduced you to

.9 have felony across the country today to be here for th e

10 beginning . of this trial, because this case is a very

11 important case toLeapFrog , as I will explain in a few

12 minutes .

13 Again , some of the people weren't here when I

14 introduced them by name . Let me introduce you to some of

15 the lawyers that are going to be participating in the trial .

16 There is Mike Berta that , who is right here . Terry Kearney .

17 Richard Morse . And Sasha Pesic, who is from LeapFrog . And

18 the most important guy is that guy in the corner, who

19 runs -- Bill Smith, who will be running all the equipment

20 here in the courtroom .

21 So you have heard that this is a patent case . A

22 patent case sounds complicated . I admit, it sounds

23 complicated . But let me assure you that this particular

24 patent case is not very complicated at all . The reason the

25 case is.,not very complicated is that it boils down to just a

1

2

3

4 .

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

110

This is where wee will hit LeapFrog ..

Slide 3, please .

What did Fisher-Price do? They made a-decision .

As you can see-on the screen, theevidence . w ll show, they

decided to develop a product that directly competed with

LeapFrog ':s LeapPad . .

Now, the evidence will also show that beginning

in the year 2000, they began their effort to design the

directly competing product, the PowerTouch . And after three

years of effort, they cameup with their directly competing

product, and in the summer of 2003, slightly less than two

years ago , they launched the PowerTouch, which they promoted

with the largest advertising campaign in the history.'of

their company . .

So let me show you the PowerTouch .

As you can see , this is how it works . You open

it up . Again, it will be demonstrated during the trial, I

am not going to play it . It comes with a book . You open up

the book to whatever page you want, like this page . You can

touch a letter, like the letter B here . And when you touch

the letter B here , the device will play the sound of the

letter B as it 's made in the word Baker .

You touch the letter A ., you will hear the sound

of the letter A, as well as some other sounds . But you

always get the phonetic sound of .the letter that you touch .

.134

1 Fisher-Price went to another lawyer, named Mr . Wallace, and

2 they were thinking of hiring Mr . Wallace as their trial

3 . lawyer for this particular case . He is going to testify

4 . here, Mr. Wallace will .

5 The evidence will show that the first question

6 that Fisher-Price asked Mr-. Wallace was, are there any

7 problems with Mr . Jamieson ' s earlier . opinion, the one he

8 wrote without ever looking at the product? The evidenc e

9 will show that Mr . Wallace told Fisher -Price that there were

10 problems with Mr . Jamieson's opinion . And finally, the

11 evidence will show that after Wallace told Fisher-Pric e

12 about the problems, guess what ? - Fisher=Price decided not to

13 hire. him for this case .

14 Now, LeapFrog believes that this evidence will

15 establish that Fisher-Price did not reasonably rely upon Mr .

16 Jamieson's opinion . For that reason, LeapFrog believes that

17 the evidence will . show that Fisher-Price willfully infringe d

18 the patent .

19 Now , one last issue , I will be very brief, the

20 last topic is the issue of damages . The damages refers to

21 the amount - of damage that LeapFrog has suffered because of

22 Fisher-Price ' s infringement . I won't spend a lot of-time,

23 because it's a pretty simple issue . LeapFrog will call Mr .

24 Brett Reed as a witness . He is a recognized expert in

25 calculating damages in patent infringement cases . Sometimes

135

1 he; calculates : damages for the defendants , like Fisher-Price .

2 And sometimes he works for the plaintiff, like we are in

3 this case .

4 So Mr . Reed has calculated the damages Mn the

. 5 case . He will explain those calculations to you .

6 Now, as we saw earlier, the evidence will show

7 that Fisher-Price designed the PowerTouch product t o

8 directly compete with the LeapPad . The evidence will show

9 that the PowerTouch,was Fisher-Price's opportunity to hit

10 LeapFrog where it really hurts , saw that exhibit earlier .

11, The evidence . will show that is precisely what

12 happened when they released the PowerTouch . Mr . Reed will

13 explain how LeapFrogtook it in the gut when Fisher-Price

14 introduced their PowerTouch . And the evidence will show

15 that Fisher-Price planned for that to happen .

.16 Slide 27, please .

17 Let's look at one of the Fisher-Price planning

.18 documents . from 2002 , shortly before they released the

19 product .

20 The evidence will show that in this document,

21 Fisher-Price was planning for the launch of the PowerTouch .

22 And as you can- see on the screen , Fisher-Price said that the

23 only pro of launching the PowerTouch , the only advantage of

.24 launching thePowerTouch, was the competitive hit to

.25 LeapFrog .

136

1 : The evidence will show that LeapFrog's sales and :

2 profits went down when Fisher-Price began selling

3 PowerTouch. Why did that happen? Because there is only one

4 product on the market that competes with the LeapPad, and

.5 that' s the PowerTouch .

6 So when Fisher-Price sells an infringing

7 PowerTouch , LeapFrog loses a sale of its LeapPad . If you

8 want to buy this kind of product , you have two choices :

9 them or us . By infringing our patent, we say , we were

10 deprived of the right to sell our product .

11 As Mr. Reed will explain, because PowerTouch is

.12 the only product that directly competes with .the LeapPad,

13 the damages calculation in this case is not that .

14 complicated .

15 The evidence will show that when you do the

16 arithmetic and add up our lost sales and our lost profits,

17 the damages come to approximately 78 million dollars .- That

18 is the damage which LeapFrog has. suffered from

19 Fisher-Price ' s infringement .

20 With that , I amfinished talking about what the

21 evidence will show in-this case .

22 I want to thank you for listening closely . Good

23 luck during the trial and you will now have an opportunity

24 to hear from the Fisher-Price lawyer .

25 THE COURT: Ladies and gentlemen of the jury,

198 I

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

(indicating), so in this case, we go (,indicating), or gave .

Q . Thank you .

.Now, you mentioned that it doesn't have reader .

And you show that you have to touch that green circle, I

think it was, to tell. it what page it's on?

A . Yes .

Q . Apart from the reader, did LeapFrog design this

product to include all of the other elements of Claim 25 ?

A . LeapFrog and the predecessor, yes . And I believe that

it includes all of the elements of Claim 25, excluding, that

is except the'reader .

Q . Why did LeapFrog decide not to include a reader in

this particular product?

A . Well, we considered it . But we thought that the cost

of including it was . significant enough that the price that

we need to charge to make a reasonable profit would be too

high for some parents and kids to .afford .

Q . Now, how many LeapPads has LeapFrog sold since the

product was introduced?

A. I believe Wood - direct 20 million .

Q . And the product was introduced when, sir?

A. In 1999 .

Q . And since its introduction, have there been any

products that directly compete with the LeapPad ?

A. Yes, . there have been .

1

2

3

4

5

6

7

8

9

10

1.1

12

13

14

15

.16

17

18

19

20

21

22

23

24

25

199

Q . And were any-such.dir-ect competition in . existence in

1999?

A.- No, not to my knowledge .

Q. How about in 2000 ?

A. No.

Q . 2001?

A. No .

Q, 2002?

A. No .

.Q . When did the first competition come into the

marketplace?

A. The first direct competition came in the fall of 2003 .

Q. What was that, sir ?

A . There were two products, but the primary product was

the PowerTouch from Fisher-Price .

Q . And that's the product at issue here?

A . That's why we. are here .

Q . Now, did the PowerTouch have any impact on LeapFrog's

ability to sell LeapPad?

A . Yes, it did .

Q . Briefly, can you explain what that impact was ?

A. Well, it created three problems for us . The first was

we learned that Fisher-Price was going to include two books

with the PowerTouch . We didn't know they were going to be

real skinny books . But we knew that on the cover, it said

200

1 two books .

2 So we did some research and we found out that we

3 needed to include two books with our LeapPad . And that

4 created two problems for us . One, it was a little bi t

5 . expensive for the second book . But secondly , it turned out

6 lots of parents , when they bought a LeapPad, normally they

7 would buy a second book . But when they learned there were

8 two included , they didn 't buy a second book . That was the

9 first problem .

10 The second problem was that , at least in my opinion,

11 every family that bought a PowerTouch should have bought a

12 LeapPad. So we lost a sale of the LeapPad for each one they

13 sold .

14 Then finally , my recollection is at the end of

15 the year going into 2004 we reduced our price s

16 significantly , so we lost a lot of profitability on the

17 LeapPad .

18 Q. Now, I believe Mr. DeLucia suggested that there are no

19 patents on the LeapPad .

20 Can you pull up the LeapPad? .

21 A. Well , I think Mr . DeLucia said that the '861 patent

22 was not on the LeapPad .

23 Q. That' s correct, because of the reader , as you have

24 explained .

25 A. Right .

51 1

1

2

3

4

5

6

7

8

9

1 0

i t

1 2

1 3

1 4

1 5

1 6

1 7

1 8

1 9

2 0

2 1

2 2

2 3

2 4

25

IN THE UNITED STATES DISTRICT COURT

IN AND FOR THE DISTRICT OF DELAWARE

LEAPFROG ENTERPRISES, INC . :a Delaware corporation

Plaintiff,

v .

FISHER-PRICE, INC . ,a Delaware corporation,

Defendant .

Civil Action

No . 03-927 (GMS )

Wilmington, DelawareWednesday , May 18, 2005

8 :30 a .m .


APPEARANCES :

RICHARD H . MORSE, ESQ .Young Conaway Stargatt & Taylor, LLP

-and-RON E . SHULMAN, ESQ .,

TERRY KEARNEY, ESQ.,

MICHAEL BERTA, ESQ ., and

STEPHEN HOLMES, ESQ .Wilson Sonsini Goodrich & Rosati,

A Professional Corporation(Palo Alto, California )


THIRD DAY OF TRIAL

51 5

1 THE COURT: Let me ask you this, counsel : Does

2 this involve a mathematical calculus, a computation of-

3 addition and subtraction, is that what we are talking about

4 here, multiplication and some division possibly? Is tha t

5 what we are talking about ?

6 MR. HUTCHINS : Yes . But I have no idea how he

7 arrived at his new numbers . For instance, if you look on

8 the slide that says summary of LeapFrog's lost sales

9 damages, and he initially -- initially, if you look on the

10 top left, has 500,000 lost LeapPad and 500,000 lost My First

11 LeapPad . And you see those listings . Those are the los t

12 sales that LeapFrog says that they would --

13 THE COURT : I am looking at the wrong chart . I

14 have got you . Summary of LeapFrog's lost sales damages .

15 Right? 500,000 LeapPad?

16 MR. HUTCHINS: Exactly . As you heard before ,

17 there were roughly 450,000 PowerTouch units sold pre-notice .

18 About one-third of the 1 .2 million were pre-notice .

19 He didn't exclude damages based on thos e

20 pre-notice units in his expert report . Now they say they

21 are excluding damages for the pre-notice units . However, he

22 only takes off -- there is 400 some thousand PowerTouc h

23 units pre-notice . Yet he only reduces his lost sales by

24 30,000 LeapPad and 30,000 My First LeapPad . He takes off

25 60,000 .

525

1 calculations that were in his expert report . Now-we are

2 being blamed for not questioning him about things admittedly

3 not in his expert report .

4 More to the point , Your Honor , Fisher -Price did

5 not waive any objection to their claiming damages on

6 pre-notice units overall, under any theory . And the motion

7 in limine .No . 8, which you granted at least in part on the

8 morning , the conclusion , for the foregoing reasons ,

9 defendants move for an order that LeapFrog be precluded from

10 introducing arguments or evidence about or referring to any

11 sales or damages related to sales made prior to October 3rd,

12 2003 .

13 That ' s precisely what we are talking about : We

14 made 450,000 sales of profits before 2003 .

15 And we moved to have any reference to those

16 sales excluded . And we moved to have any reference abou t

17 damages related to those sales excluded , because we believed

18 that the marking statute and the notice requirement, ba r

1.9 none , precluded them .

20 Now, what we are talking about now is a sliver

21 of that argument .

22 THE COURT : That ' s a pretty significant sliver .

23 MR . HUTCHINS : It is .

24 My point is this , Your Honor . Had you granted

25 our motion in toto , which we were urging at the time --

525

1 calculations that were in his expert report . Now-we are

2 being blamed for not questioning him about things admittedly

3 not in his expert report .

4 More to the point , Your Honor , Fisher -Price did

5 not waive any objection to their claiming damages on

6 pre-notice units overall , under any theory . And themotion

7 in limine No . 8, which you granted at least in part on the

8 morning , the conclusion, for the foregoing reasons ,

9 defendants move for an order that LeapFrog be precluded from

10 introducing arguments or evidence about or referring to any

11 sales or damages related to sales made prior to October 3rd,

12 2003 .

13 That's precisely what we are talking about : We

14 made 450,000 sales of profits before 2003 .

15 And we moved to have any reference to those

16 -sales excluded . And we moved to have any reference abou t

17 damages related to those sales excluded , because we believed

18 --that the marking statute and the notice requirement, ba r

1.9 none , precluded them. -

20 Now, what we are talking about now is a sliver

21 of that argument .

22 THE COURT : That's a pretty significant sliver .

23 - MR . HUTCHINS : It is .

24 My point is this, Your Honor . Had you granted

25 our motion in toto, which we were urging at the time --

66 7Bender -.direct

.1 Q, . Mr. Bender, good morning, first .

2 A . Good afternoon.

3 Q . Good afternoon .

4 Can you go ahead and state your name for th e

5 record and introduce yourself to the jury ?

6 A . Yes . I am Tim Bender .

7 Q . Do you work at LeapFrog ?

8 A . Yes .

9 Q . What is your position at LeapFrog?

10 A . I am the president of the global consumer group .

11 Q . Can you just give us . a brief description of what

12 the. -- the general nature of your duties and

13 responsibilities as president of the global consumer group ?

14 A . I am responsible for worldwide sales for products that

15 go into retail, and for the international marketing o f

16 LeapFrog products .

17 Q . How long have you been at LeapFrog ?

18 A . This is my eighth year .

19 Q . Have you had responsibility for sales of the LeapPad

20 line of products at LeapFrog?

21 A . Yes .

22 Q . What level of responsibility?

23 A . Final authority for sales and sales programs .

24 Q . When did LeapFrog first introduce the LeapPad?

25 A . Well, we first introduced it to our customers in

71 4Bender - direct

1 books every year . We added more subject matter . The morel

.2 books we had on the shelf and the deeper the curriculum an d

3 the longer the child could a play with it, the mor e

4 consumers bought the LeapPads .

5 So household penetration was directly increasing

6 with the number of books that we offered .

7 Q. Does LeapFrog track amount of additional books th e

8 typical owner of aLeapPad platform purchases ?

9. A . Yes, we_do .

10 Q . What information have. you -- what was your

11 understanding of that amount ?

12 A. Well, the average consumer in our research shows tha t

13 they will purchase between six and seven additional LeapFrog

14 books after they buy the LeapPad .

15 Q. What about .for the My First LeapPad., do you track the

16 same type of information for the My First LeapPad?

17 . A . Yes, we do track that information, it is slightly

18 less . It is just about six .

19 Q . Do you also track book purchases per platform but o n

20 an annual basis ?

21 A . Yes . We call that the tie ratio . That is the number

22 of books the consumer is buying against the platform .

23 MR. BERTA: Can I have PX-1876, please .

24 BY MR . BERTA :

25 Q . Can you just take a look at this and let me know if

715Bender - direct

1 this exhibit accurately reflects the annual tie ratios for

2 those years?

3 A. Correct .

4 So you can see, in 1 99, when . we launched the LeapPad, .

5 it was seven for each LeapPad . And then it increased to 1 .6

.6 in 2000, 2 .4 in . 2001, and 3 .9 in 2002 .

.7 My point is, we had more books in the library . Plus

8 we had more consumers on the system . They were both buying

9 more books . It fell off in '03 and then you can see, a

10 pretty significant drop in '04 .

11 Q. Now , the previous, when we were previously discussing

12 book to platform purchases , you said that customers buy six

13 books per platform . Is that inconsistent with this here?

14 A. They don ' t buy them all in the same year . So they

15 might buy three the first year . Then they may buy two the

16 next year and three the next year. Some consumers are heavy

17 users, which buy a lot of books , and some buy less .

18 But there is a pattern where they continue to buy them

19 at the rate when the child is growing . Some children are

20 much more learners and they are moving through the content

21 quicker so they will tend to buy more books and some use it

22 less often so they will buy less books for those children .

23 For the LeapPad , the tie ratio goes from a high of 3 .9 in

24 2002 and it falls in 2003 to 3 . 7 and falls again to 2 .9 in

25 2004 .

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

Bender - direct71 6

Q . Why did that happen?

A. In 2003, about July, we added a second book into the

LeapPad .

You buy the LeapPad, there was one book in there, it

was a sampler . Consumers would immediately either at that

time buy a book, soon after, once the child is through that

book, they are going to buy more . ,

There was a competitive product in the market, the

PowerTouch, and they were going to have two books in theirs .

So we added a second book in 2003 to meet that competitive

force that was coming in the market .

Q. If you added the second book in 2003, why is the ratio

so much different in 2004 ?

A. Well, because consumers will buy the LeapPad, a good

part of them are the Christmas period, the holiday period,

October and December is really the big selling season . But

the content, they really start coming after the content and

buying a lot more in the first quarter, which would b e

January through March .

So we really saw the falloff because the

children were playing with the included two books longer

than they did when they got one . So they didn't come back

to the store as quickly for the next book .

Q . If Fisher-Price had not included a second book with

the PowerTouch, would LeapFrog have bundled a second book

71 7Bender - direc t

l with its LeapPad bundles ?

2 A . No .

3 Q . What effect would the second book have on LeapFro g

4 sales ?

5 A . We measured we lost between about 2 .8 and 2 . 9 million

6 books that normally would have been sold to the consumers .

7 Q . We talked about the Fisher-Price and the PowerTouch a

8 little bit .

9 When exactly did the PowerTouch launch ?

10 A . Well, it started showing up at retail in July of 2003 .

11 Q . Do you have any understanding of what the marketin g

12 premises of PowerTouch is?

13 A . Yes .

14 Q . What is it?

15 A . Very similar to LeapPad . If you looked at the box, i t

16 was a learn to read proposition , same as LeapPad , getting

17 kids engaged in a reading experience .

18 Q . What was the age range targeted of the PowerTouch ?

19 A . Three to eight , I believe .

20 Q . You mentioned where LeapPads are sold . Can you tell

21 me what stores , if you have an understanding as to at wha t

22 store s the PowerTouch was being sold ?

23 A . Well , generally, the Fisher-Price and LeapFro g

24 products are sold in similar channels . The Toys R Us ,

25 Wal-Marts, Targets .

720

Bender - direct

1 THE COURT : ..Well, you might want to get him to

2 say what that understanding is based upon .

3 BY MR . BERTA :

4. Q. Is part of your duties and responsibilities with

5 respect to marketing'and sales, do you track sales of

6 competitive products ?

7 A. Yes, we do ,

8 Q. In the marketplace?

9 A . Yes, we do .

10 Q. In 2003 , did you track competitive sales of

11 PowerTouches in the marketplace?

12 A. Yes, we did .

13 Q . Did . you track the sales of the LeapPads in the

14 marketplace?

15 A. Yes, we did .

.16 Q. Did that information give you any sort of a basis to

17 have any understanding as to what was happening with respect

18 to PowerTouch sales and LeapPad sales ?

19, A. Yes .

20 Q. What was that understanding ?

21 A. We had a pretty good trend line of sales increases on

.22 the LeapPad business through July . And once the PowerTouch

23 was introduced , and it was merchandised right next to the

24 LeapFrog products , we immediately saw a depress in our sales

25 on the hardware of LeapPads and the My First LeapPads .

72 1Bender direct -

1 Q . Did you have any understanding as to what customer s

2 perceived were the primary differences between the

3 PowerTouch and the LeapPad ?

4 A. Yes .

5 MR. CANADA : Objection .

6 . Hearsay .

7 THE COURT : Read the question , please .

8 (Question read . )

9 THE COURT : Do you have a basis for answering

10 it?

11 THE WITNESS : We have marketing research data ,

12 sir .

13 THE COURT : Overruled .

14 BY MR . BERTA :

15 Q . What was your understanding of what customer s

16 perceived to be the primary differences between the LeapPa d

17 and the PowerTouch?

18 . A. First and foremost , the Fisher-Price brand, it is a

19 well known and trusted brand . Moms have a great deal of

20 experience with the Fisher -Price products for infants an d

21 toddlers . They have a good brand awareness that mom would

22 know when she saw the product . And secondly, their position

23 was that you could read with your finger , versus the

24 LeapFrog stylus that we had on our product .

25 Q . In your marketing research , did you come to have any

72 2Bender - direct

1 understanding as to whether or not the Fisher-Price bran d

2 name helped Fisher-Price makes sales of the PowerTouch?

3 A . Yes, it was very important to consumers .

4 Q. In your understanding of the.market , .do you have any

5 understanding as to whether or not the Fisher-Price brand

6 name . on the PowerTouch brought people onto the learning

7 aisle that otherwise would never have been there ?

8 A. I don 't believe so .

9 Q. Why not?

10 A. LeapFrog is the number one thought of educational

11 background . Consumers have come to shop that aisle , looking

12 for educational products . Fisher-Price is not known, lik e

•13 LeapFrog , as the number one educational brand . Consumers

14 are generally shopping for those products in other aisles ,

15 such as infant , toddler, some preschool aisles . So the

16 consumers are coming into our aisle , looking for LeapFrog

17 products, and they happen to find, there is the Fisher-Price

18 PowerTouch in our same area .

19 Q. Do you have any understanding as to whether some

20 people bought the PowerTouch because of the finger touch

21 feature of the product ?

22 A. Yes .

.23 Q . What is that understanding?

24 A . Well, first and foremost , consumers are looking for a

25 reading product .

72 3Bender - direct

1 Q. I might have been unclear . I don't know if you were

2 saying yes, you have an understanding or yes, that was true .

3 Let me ask it differently . First, do you have an

4 understanding one way or the other about whether people buy

5 the PowerTouch because of the finger touch feature ?

6 A. The most important thing consumers are looking for is

7 a learn to read product. That's the first and foremos t

8 thing they are shopping for . So the goal would have been to

9 seek a product that's claiming learn to read . It's possible

10 that some consumers would be influenced to buy a produc t

11 that uses finger versus stylus .

12 Q . Do you have any understanding as to whether the finger

13 touch feature is why those people buy this as a learn to

14 read device?

15 A. No .

16 Q. Why not?

17 A . Well, the LeapFrog penetration was incredible . So the

18 number of households that were buying the LeapPad was- a s

19 strong as any product in the history of the toy industry .

20 That only happens when consumers are very happy

21 with the product . It's working for the child, they are

22 playing with it . They are engaged .

23 And that generally leads to great word-of-mouth .

24 An that's why LeapFrog continued to build sales every year,

25 because consumers were so happy . So here we have had a

72 6Bender -'direct

1 message , and' it worked effectively for them as well .

2 Q . What was the product called before phonics?

3 A. It was called the Alphabet Desk .

4 Q. What . was it called after the - -

5 A. It was called Phonics A to Z .

6 Q . Is that product still being sold ?

7 A. No, it's not . Not to my knowledge, at least not in

8 the U . S. market, I .haven't seen it in .-quite a while .

9 Q . Did LeapFrog's marketing budget change when you

10 learned that the PowerTouch was .coming out in 2003?

11 A. Yes .

12 Q . Bow?

13 A. We generally do most of our advertising starting

14 mid-October and it comes through the beginning of December ,

15 when consumers are deciding what ' s the best gift for their

16 children and who they are going to give gifts to for

17 Christmas or holiday . In the case of 2003, we knew

18 Fisher-Price was coming out with a very aggressive ad

19 campaign starting in September .

20 And we didn ' t want to be late getting our share

21 of message to the consumer , so we felt it was important tha t

22 LeapFrog get additional advertising expenditures in th e

23 month of September and for the back half of that year, s o

24 that consumers could hear from LeapFrog , what our products

25 were .

727Bender - direct

1 Q. Did the budget for your marketing expenditures go up

2 or 'down?

3 A. They went up .

4 Q. Before Fisher-Price was., on the market with the

5 PowerTouch , how many customers was LeapFrog reaching with

6 its advertisings?

7 A . We were reaching about 95 percent of consumers that

8 are our target market . That is generally moms that are 2 5

9 to 49 years old with . children , and they, purchase educational

10 products . And we were reaching them about 15 times . So

11 almost . everybody .

12 Q. So what if anything specifically happened to the

13 retail sales of the LeapPad and the My First LeapPad after

14 the PowerTouch came out?

15 A. They declined .

16 Q . And where did they decline?

17 A. Well, they declined at retail -- in the U .S . market .

18 We shipped a lot of product into the consumers , because the

19 buyers had, you know, believed we were going. to sell this

20 product , and we of course were increasing advertising to

21 make sure that we were going to get our message across t o

22 consumers . But the products didn't sell through at the rate

23 that we had estimated or the buyers . .

24 Q. Do you have any understanding as to why it. was the --

25 was why it was the PowerTouch that significantly affected

. . 728

1

2

3

4:

5

6

7

8

9

10

11

1 .2-

13

14

15

16

17

18

20

21-

22

23

24

25

Bender - direct

the sales of the LeapPad , the. . My First LeapPad?

A . They are going after the same audience , the .same

messaging , it was a learn to read experience . Moms .had

another choice . - So being merchandised right next to

LeapFrog , with a great brand name of Fisher-Price, they

definitely took. sales from us .

Q . When a PowerTouch was launched , do you have any

understanding as to .whether it was priced the same as the

LeapPad?

A. Well, there is suggested retail price . Is that what

you are referring to?

Q . Sure .

A. In the market . So the LeapPad .and Fisher-Price

PowerTouch both had suggested retail of 49 .99 .

Q . After launch of the PowerTouch , did you see. any

evidence that Fisher-Price was cutting the price of the

PowerTouch?

A. Well, I don 't know if Fisher-Price immediately was

cutting the price . But the retailers were taking the price

down , Target was immediately at about $45 . Then by the

beginning of October there was pricing in the market that

was below $.40 .

And then through the fall there was additional

retail activity which was below the Fisher -Price cost . And

so it appeared that Fisher-Price was helping push down the

7-2 9Bender - direct

retail pricing of the PowerTouch to effectively undercut th e

2 LeapPad pricing .

3 Q. Did LeapFrog take any action with respect to LeapPad

4 pricing because of this?

5 A . Yes .

f_ Q. What was that?

7 A. Well, in January of 2004, we reduced the price of th e

8 LeapPad and My First LeapPad, and the QuantumPad and LeapPad

9 Plus Microphone .

10 Q . For all of those products -- let me ask .you this :

11 Why did the prices of all of those products go down then ?

12 A. Well-, there is like a value proposition or chain . So

13 the LeapPad is the core reading item . And then the next

14 item is the.LeapPad plus writing . So they can't be too much

. 15 apart from each other. If the price of the LeapPad is

16 coming down, then the price of the LeapPad Plus Writing

17 needs to be no more than about $10, according to ou r

18 consumer research .

19 The My First LeapPad doesn't have as rich of a

20 curriculum as the LeapPad . It only has 167 books, so the

21 longevity of the product is less so consumers expect it t o

22 be less expensive . So we need to put those all in line .

23 But we didn't do that until 2004 .

24 Q . Prior to this price change, had LeapFrog ever droppe d

.25 the price to the retailers of the LeapPad products?

73 0Bender - direct

1 A. No .

2 Q. What was the price to retailers in 1999 ?

3 A. In 1 99 when we launched , the domestic price was $39. .

4 Then you could buy.-it out of China if you like, the

5 retailers were responsible for bringing it to the Unite d

6 States, that price was $34 . We raised it the next year . .

7.

Q. In 2000?

8 A . In 2000 we raised the price .-

9 Q . What was that change from 1999 to 2000 ?

10 A . We took the price up .50 . 34 .50 from China and 33 .50

11 in the U .S . The primary reason we did that was, again, we

12 are still a pretty small company , don't have a lot of

13 marketing funds . We wanted to get the LeapFrog message out .

14 So we took those additional funds to create more

15 advertising, to create more awareness for the LeapFrog brand

16 and spend more money on research and development for mor e

17 books .

1.8 Q . After 2000, from 2000 and 2001 , did the price of

19 LeapPad to retailers change?

20 A. No .

21 Q . 2001 and to 2002 ?

.22 A . No .

23 Q . 2002 to 2003?

24 A . No .

25 Q . Prior to making that change , at the beginning of 2004,

731Bender - direct

did LeapFrog conduct any analysis to determine whether it

should change prices in response to the PowerTouch ?

A. Yes . This was a , you know , a subject we are very

passionate about because it is the most important part of

.our business, the LeapPad . We did a .number of studies of

various retail prices and what would happen with .LeapFrog's

share versus competitors . And we must have had 20 to 30

meetings as an executive team to decide , you know, what

should we do to address the pricing of the LeapPad .

Q . Can you just take a look in your binder? There is two

documents in there, PX-427A and 427B . Do you see those?

-A. I think you have right got the right one here

Q . So I guess not .

MR . BERTA : Can I be up here, Your Honor?

THE COURT : Yes .

MR. BERTA : Thank you .

BY MR . BERTA:

. Q . How about this one , then tell me if you see them .

A . Okay, yes .

Q. What are 427A and 427B?

A. This is a research study that we undertook in the fall

of '03 to learn more about the market for LeapPad and its

competitive products that were in the market , or potential

competitive products in the market .

Q . In the absence of the PowerTouch, .would LeapFrog have

732Bender - direc t

1 reduced the prices of the LeapPad family of'products?

2 A. No .

3 Q. Why not?

4 A. It wouldn ' t have made any sense. The consumer was

5 . . happy with the product . It was selling well . You. saw

6 increasing sales every year . The retailers were happy

7 because they were selling more LeapPads .every year . Plus,

8 the attachment rate of the number of books they bought were

9 going up every year . So it would have made no sense for us

10 to reduce our costs . We would have .had less money to spend

11 on further development for books and other LeapFrog

12 products . So, no .

13 Q . How important to LeapFrog ' s business was the LeapPad

14 family platform in 2004 ?

15 A. Well ._ it's the largest segment of our business ..

16 Q . . After LeapFrog took down the prices on the LeapPads in

.17 January, what if anything happened to LeapFrog' s

18 profitability?

19 A. Well , 2004 was the . first year since I was there in

20 1997 that the company didn't make its . plan. We had a bad

21 year . We missed our profit plan by over 70 million dollars .

22 And it was a tough year .

23 Q . Has LeapFrog had to take any actions because of

24 missing the plan last year?

25 A. Yes . After the 2004 year ended , which we ended with a

73 3Bender - direc t

1 large loss , in the millions , we had to cut a large number of

2 educational products , we were developing some new

3 technologies and new content for educational products-for

4 kids , that was the first thing .

5 Then the second thing is we had to let go about

6 170 great people that helped build this company .

7 Q. Have you seen any evidence that Fisher -Price has

8 continued to cut prices on the PowerTouch in the year 2005?

9 A. Yes .

10 Q . What evidence have you seen?

11 A. Well, there has been retail marketing programs thi s

12 year where the PowerTouch is at $ 19 .99 and the books are at

13 half price .

14 Q. Has LeapFrog cut the prices of the LeapPad family to

15 match this new decrease?

16 A. No .

17 Q. Why not?

18 A.' Well, if we did that, we would soon be out of

19 business . We could never afford to match those prices .

20 Q. In 2003 , just before the PowerTouch launched , how many

21 learn to read book platforms were available in the market

22 besides LeapPad?

23 A. None .

24 Q. Have you ever heard of a product called the Story

25 Reader?

73 6Bender - direct

1 A. No .

2 Q. Did any new products in 2004 , to .your knowledge, have

3 any effect on LeapPad sales or pricing?

4 P . No .

5 Q. Do you have any understanding of whether, if th e

6 PowerTouch had not come out, would retailershave sold mor e

7 LeapPads and My •First LeapPads ?

8 A. Yes, sir .

9 Q. Why?

10 A . . Well, our research shows that the sales for the

11 PowerTouch came right from LeapFrog's sales and we-were --

` ..12 they had the same .marketing - message, the same positioning as

13 far as the learn to read system . Engaging for kids .

14 Powered by phonics and other activities .

15 So that wap directly taking sales from LeapFrog .

16 So had those not been there , there is no doubt, we would

17 have continued our trend in selling more LeapPads and books .

18 Q .. In 2003-and 2004 , did LeapFrog have the capacity to

19 manufacture more LeapPads and My First LeapPads ?

20 A . Yes .

21 Q . How do you know?

22 A . Well, we have capacity plans which allow us to make ,

23 you know , certain number of units . We did not manufacture

24 in 2003 at our full capacity . So we had some capacity in

.25 '03 . But in ' 04, we manufactured far less LeapPads than we

737Bender - direct

."". .. 1 did in '03 So we had a great deal of capacity'in 104 .

.2 Q . Canyou just give me an idea of how many extra LeapPad

3 and My First LeapPads you could have shipped - in 2004 ?

4. A . Cumulatively? One to two 'mil:lion .

5 Q . Does LeapFrog track its inventory level at the

.6 retailers?

7 A. Yes, we do .

8 Q . Can you take a look at PX-1123 .

9 A . Okay .

10" Q . What does this document . show? What is it a report of ?

11 A . This is information that we compiled that comes

12 directly from our customers' point of sale data, for

13 companies like Wal-Mart , we have access to online , to look

14 at inventory levels at any given time of . the year . We can

15 see ..it by store . We can see it by chain , for any item .

16 So at the end of the year , particularly, we do

17 audits that make sure that we know what the inventory level s

18 are at retail .

19 This spread sheet here is a compilation of that

20 data that comes directly out of the customers ' systems . I t

21 is the most accurate information for determining information

22 at retail .

23 Q . Does this accurately reflect retailer inventory level s

24 of LeapPads and My. First LeapPads at the end of 2003 ?

25 A. Yes, it does .

73 8Bender - direct

1 Q . What does it show about that?

2 A. Well , nobody can see that because you need a

3 telescope . But if you could look at . the detail here, you

4 . could see that our carryforward inventory , which means the

5 ending inventory , on the LeapPads and the Me First LeapPads ,

6 was pretty significant, meaning it was high . Much higher

7 than at any previous years, and much higher than our plan ,

8 and far higher than what the retailers plan was .

9 Q. There it is .

10 A . There you go .

11 Q . I believe you, if that' s what you said .

12 Let me ask you another question .

13 A. You would have to move over a little bit more . There ,

14 if you look at those beginning inventory levels for 200 4

15 beginning inventory , that column showed the quantities . I

16 think if you move down , you see the quantity of products o n

17 hand .

18i

Q . Is this consistent with your recollection that there

19 was excess retail inventory? .

20 A . Yes, absolutely. The retailers , you know, were

21 disappointed that the buyers have plans that they are

22 supposed to have a certain amount of inventory . Everybody

23 had expectations that LeapFrog trends were going to continue

24 and they would be solid at inventory through . And the

25 Fisher- Price product did not add to the market . It took LP

73 9

1

2

3

4

5

6

7

8

9

10

": 11

;12

1 3

i1 4

16

17.•

18

Bender - direct

sales, so the inventory we shipped sat in retail stores .

Q . Are LP and Fisher-Price competitors?

A. Yes .

Q . Has LeapFrog faced competition in the market before

Fisher-Price came out with the PowerTouch?

A. Absolutely . We are, we are a company that is still

pretty young . We started growing , in like ' 97, '98, slowly

and surely . We had a lot less resources , less money, less

people , less marketing resources . Through creativity and a

lot of passion , and good employees of our company , we worked

a lot harder . We cared a lot more .

So we were scrappers . We fought hard to build

the company that we built . So, yeah, we know what it's like

to compete . We do it every day . That's all we do, is

educational products . That ' s our passion , and it's the

business we know .

Q . Has LeapFrog ever licensed the '861 patent to any

competitors in the toy industry ?

A . No .

Q . Why not?

A . Well, actually, there is probably two reasons . One

is, we develop a lot of our intellectual property ourselves .

We spend a lot of money and time doing that . So we wouldn't

want to license it out, particularly since we don't feel

that a lot of the competitors in our marketplace are really

74 4

25

790

Bender - cros s

1 the Power.Touch product wasn ' t on the market . . Was that your

2 testimony?

3 A. Yes,

.4 Q . Isn't it true , sir, that LeapFrog was having some .

5 major supply chain problems in 2003 ?

6 A. We had some issues with supply chain in 2003 that were

7 in the third quarter, primarily September .

8 Q . That would have been right around, a couple month s

9 after the PowerTouch product came on the market . Correct?

10 A. The two are unrelated. But the timeline is correct .

11 Q . So around September of 2003, LeapFrog couldn't even

12 fulfill its own orders . Correct?

13 A. No . We were fulfilling orders . We were shipping

14 all-time record shipments . We didn ' t ship everything that

15 we had hoped to in the month of September . But we caught up .

16 with those shipments two weeks later, far early enough t o

17 get them in the retail chain for Christmas .-

18 Q. You didn't tell the jury that yesterday, did you, that

19 you had these difficulties in September?

20 A. If you would have asked me about those , I would tell

21 you . There is no secret there .

22 Q. Okay .

23 Can I-get.DTX-97, please?

24 I am going to hand you DTX-97, Mr . Bender .

25 If you turn to the second page of the document .

79 1Bender - cros s

1 If I can get the Target paragraph, please ,

2 Is it your understanding that LeapFrog lost 1 .2

3 million in LeapPad Pinkorders for the quarter, unable to

4 ship?

5 Is that your understanding, sir?

6 A. For that quarter, yes . But I believe those would have

7 shipped in early October .

8 Q. If I can get the last paragraph , the TRU , the TRU,

9 what does that stand for?

10 A. Toys R Us .

.11 Q. That is one of your major customers . Correct?

12 A. Correct .

13 Q. And in the first bullet point there it says lost 2 .8

14 million in LeapPad andLeapPad Paint orders for the quarter

15 due to availability .

16 Is that correct, sir?

17 A. That' s correct . Most of our --

18 Q. So in September of 2003, LeapFrog was unable to 'ship

19 to both Target and Toys R Us at that time . Correct?

20 A. 70 percent of our Christmas sales happen in the last

21 two months ..

22 It's irrelevant what we are shipping in

23 September , as long as the supply chain is full .

24 In this case our in-stock levels were at a high

25 rate in most customers . So if you are not losing . consumer

792Bender - cros s

1 sales, that's the most important part of it . But we did

2 have issues shipping quantities in September due to issues

3 in our supply chain , that's correct .

4 Q . And those issues continued for LeapFrog in 2004 .

5 Isn '_t that correct?

6 A. They were different issues .

7 Q. Mr . Bender, I am going to hand to you DTX -628, which

8 is a conference call transcript . I would like to turn your

9 attention, sir, to Page 3 of that document .

10 If we can blow up the last paragraph .

11 Let me ask the question first . You are aware

12 that this is a Q4, 2003 Enterprises -- or LeapFro g

} 13 Enterprises , Inc .'s earnings conference call document?

14 A. That's correct .

15 Q. On Page 3 of that document , down at the bottom i t

16 says , simply , our management processes such as planning, our

17 operating processes, such as supply chain , and our

18 information systems, have not been very effective .

19 Do you see that?

20 A. Yes .

21 Q. Is it your understanding that the operating processes,

22 such as supply chain , were not very effective for LeapFrog

23 as of the fourth quarter 2004 ?

24 A . There were particular items that we could have done a

25 much better job supplying .

81 3Bender - redirect

1 Q . Let me ask you this . question, in a retail store - -

2 THE COURT: Why don ' t you try LeapPad first?

3 THE WITNESS : Let me start ..

4 Our retail sales slowed down when the PowerTouch

5 product was introduced . And retailers reorder based upo n

6 sales . So we definitely lost some shipments there. But a

7 . lot of the purchases . are made far in advance by retailer s

8 for Christmas season . So they are importing it from Chin a

-9 in large quantities .

10 So in the . case of 2003, although we missed some.

11 shipments , we shipped in a lot more product than actually

12 sold . So what happened was, we really felt the shipment

13 decreased in 2004 more than we did in 2003, although we had

.14 falloff, because so much. product was left over after

15 Christmas on the shelves .

16 So we did lose shipments . But they went over a

17 longer period than 2003 .

18 MR . BERTA : I don ' t have any further questions ,

19 Your Honor .

20 THE COURT : Did'you want to ask any additiona l

21 questions, Mr . Canada?

22 MR . CANADA: No, Your Honor .

23 THE COURT : Thank you, sir .

24 THE WITNESS : Thank you .

25 (Witness excused .)

81 4

1 MR . SHUL ,N Your Honor, may I make that brie f

2 statement we spoke about yesterday?

3 THE COURT, Sure .

4 HR. SHULMAN : When I was before you in the

5 opening, I told you that -- you realize we are now in the

6 damages part of the case . When I was before you during the

7 opening .I told you that we would be seeking 78 .million

8 dollars in damages . I don't know . if you recall that or not ,

.9 but that is what I said .

10 As you recall yesterday, we adjourned earlier

11 because the Judge told you he had made some rulings and we

12 have to adjust certain things. of our presentation . And the

13 rulings that Judge Sleet made affect how much money we can

14 recover . '

15 So we have revised our claim for damages . It i s

16 no longer 78 million dollars . But only it's 65 million

.17 dollars, in light of what Judge Sleet has ruled . . I simply

18 wanted to alert you to that .

19 So our next witness is our damages expert, Mr .

20. Brett Reed, who will explain how damages are calculated .

21 . .BRETT REED, having been duly sworn as a

22 witness, was examined and testified as follows . . .

23 DIRECT EXAMINATION

24 BY MR . BERTA :

25 Q. Good morning, Mr . Reed .

81 9Reed - direct

1 Q. I am just asking , why would you be looking at 10-K s

2 for Mattel in this; case?

3 A. Because Fisher-Price is part of Mattel . So Mattel' s

4 10-Ks would talk about its various businesses .

5 Q. Thank you .

6 Can we . just get the,first slide up there .

7 . All right . So can we just lay out first of all

8 where it is where it is we are going with this analysis .

9 What is this ?

10 A. This is a summary chart that at a very high level

11 shows the elements of damages , . and of course the total

12 damage amount that I calculated, which is 65 . 34 million

13 dollars .

14 Q . On this chart , you have two types of damage, one i s

15 lost profits and one is reasonable royalty .. What is the

16 difference between those two?

17 A . Well, in patent damages , there can be different

18 circumstances that will give rise to different types o f

19 damages . For example , if I am an inventor and I have a

20 patent and another company uses that patent to make a

21 product, I can ' t claim that I lost sales to " them because I

22 am an inventor . I don ' t have a product to sell . In that

2.3 case , I am entitled to damages, I am entitled to what i s

24, called a reasonable royalty .

25 On the other hand , if I am a large company

822

Reed - direct

1 A. Yes .

2 Q. Why don ' t we start off with the first one, which is

3 demand for the patented product . What did you look at to

4 determine whether or not there . was demand for the patented

5 product?

. 6 A . I prepared . charts for the information I looked-at on

7 each of these .

8 Q. Why don ' t we go to the next chart , then .

9 A. So with . respect to the first Panduit factor , I looked

10 at information relating to the PowerTouch itself . The

11 PowerTouch was a very successful product . Again, in the

12 context of-damages, it would be found that the PowerTouch

13 infringes the patent , so I am assessing how did the

.14 PowerTouch do in the marketplace .

15 Of course, we will see, with those slides I will

16 address later , PowerTouch quickly got very stron g

17 distribution at the major retailers in America . And it also

18 had very strong sales through to end customers in 2003 .

19 There was a study by Fisher -Price personnel that showed in

20 . 2003 , the PowerTouch in terms of sales to end .customers

21 achieved about 25 percent in the way Fisher-Price was

22 measuring that market . So it was a very quick , very strong

23 performance .

24 Q . Are there some other things you looked at here in

25 determining whether or not there was demand for the patented

825 .

Reed - direct

1 the market that she was assessing .

2 Basically , she said the market was th e

3 PowerTouch, and My First LeapPad , and then preschool

4 LeapPads . And those were really the products in the market . .

5 She viewed that the market was . flat , according to the data

6, they were relying on , the market was flat from 2002 to 2003 .

7 But PowerTouch was able to achieve 25 percent of

8 the market . So this would show the products in the marke t

were really the PowerTouch , My First LeapPad and LeapPad,

10 and that PowerTouch was able to take away 25 percent of the

11 share from these LeapPad products .

12 Q . Were there any other appropriate products to be

13 considered -in this market, in your opinion?

14 A. Well, there were other products . I certainly looked

15 for information about other products and the success o f

16 those other products . My analysis suggested these other

17 products were not successful , and in fact , Mr . Bender

18 related the same information to me .

19 Q. What does that. third bullet address ?

20 A. There is also the sub-point . I also understand that

21 LeapFrog . viewed .these other products , such as the Active

22 Pad, the PIL , the. Active Pad would infringe LeapFrog

23 patents . That also raises a new question , whether it is a

24 noninfringing alternative .

25 1 am sorry , the third bullet addresses whether

82 7Reed = direct

1 A . Yes , it does . I looked at nformation,like-sales

2 patterns, customer surveys . I considered , also , the reviews

3 of the Amazon , reviews particularly of the PowerTouch, at

4 Amazon . com . The market share analysis by Fisher-Price tha t

5 .I just mentioned . I also considered statements that were

6 made by Fisher-Price or Mattel executives .

7 Q . Do you have some slides on each of these paints ?

8 A . Yes, I do .

9 Q . Why don't we flip to the next one .

10 What does this slide illustrate, help

11 illustrate?

12 A . This slide shows the shipment patterns to retailers .

13 Again , this is not what is called point of sale . This is

14 not sales to end customers like you and me , but rather

15 shipments to retailers . by LeapFrog . . It shows the LeapPad

.16 with the introduction in 1999 , with increasing sales . . These

17 are in thousands . So it reached 2 . 9 million in 2002 . My

18 First LeapPad came out in 2001 and also had very stron g

19 success through 2003 .

20 But in late 2003, sales of the LeapPad buttoned

21 . and in 2004 sales to retailers declined dramatically . I was

22 looking at this decline in sales in 2004 and considering, i s

23 it associated with the PowerTouch shipments that took place

24 largely in late 2003 and also 2004 .

25 Q . For the LeapPad line :, which product does that include?

83 2

4

5

6

7

8

9

1 0

11

1 2

1 3

14

15

16

1 7

22

23

24

25

Reed - direct

Similarly, with the My First LeapPad , there was a .much

stronger level of actual shipments of these products to

retailers .

In my view, this clearly demonstrates that there

was enough capacity to ship more in 2004 . It's seen perhaps

more clearly with the next slide .

This next slide adds in what I view to be the

lost sales of the LeapPad, sales that I believe, because of

the infringement in the case, the LeapPad would have lost to

PowerTouch. And that 630,000 units in total, I believe it

would.be roughly half and half between My First LeapPad and

LeapPad .

Again, if I add those additional units that

would be lost, it is very strong evidence that LeapFrog had

enough ability to manufacture and ship products to meet the

total units that would have been applicable in 2004 .

Q. Okay. And I think you mentioned you had another

slide .- What does this show?

A. Yes . This goes to, who are these companies selling

to . Mr . Bender addressed this . But it shows that very

large proportions of the products , both the PowerTouch and .

the LeapFrog products generally , are being sold to really

the four major retailers in the United States .

So it's a question. of, if PowerTouch wasn't

being sold to Wal-Mart, it would be quite possible that

Reed - direct

.5

6

7

8

9

10

11

12

1 3

14

15

1 6

17

18

19

20

21

22

23

24

25

833

LeapFrog would just sell additional to Wal-Mart . And

obviously, this shows a very strong correlation between the

customers .

Q . If we could go back to Slide 10 .

I think we have covered the first two bullets .

What .do the last three bullets all relate to?

A. They all relate to the ability to manufacture more

product in the event these lost sales would have been made

by LeapFrog . Also, it covers inventory . Mr . Bender

addressed the large inventories that occurred in late 2003 .

In fact, I show here, the inventories increased

at retailers compared to the end of 2002 to the end of 2003 .

There was 190,000 additional My First LeapPad platforms and

there was 270,000 additional LeapPad platforms . So these

would have been available to sell to the customers, the

actual consumers, at the end of 2003 .

Then in 2004, LeapPad would have the ability to

manufacture more units . to sell back to those retailers to

replenish the supply and get ready for the next selling

season .

Q. What is this evidence, or what does the information

that you looked at suggest about whether LeapFrog had the

capacity to make the sales that you claim are lost ?

A. I think it clearly shows that LeapFrog did have the

capacity .

83 4Reed - direct

1 Q . Okay . What is the next step of the analysis ?

2 A. The next step is really to put it all together, to -

3 quantify the amount of the lost sales and the lost profit s

4 associated with that .

5 Q . Does this lay out the different items that were los t

6 because of the_PowerTouch?

7 A. Yes, it does summarize it .

6 Q . Why don ' t we just walk through it . It says LeapFrog

9 would have sold more platforms , 315,000 LeapPads , 315,000 My

10°. First LeapPads . Why those numbers ?

11 A . During the damage period , Fisher-Price sold about

12 780,000 PowerTouch units, in my view, approximately 80

13 percent of that would be associated with lost LeapPad

14 products . . That translates into 630,000 units ,

15 approximately . Also I concluded that approximately half o f

16 those would be My First LeapPad lost sales and the .other

17 half would be LeapPad .

18 I assumed that would be the Classic LeapPad ,

19 because that is the lowest price of the LeapPad family . The

20 reason why roughly half and half has to do with the age

21 distribution , who was buying the PowerTouch . The PowerTouch

22 was directed towards younger children . In fact, the

23 Amazon.com review data suggested that 70 percent of th e

24 PowerTouch reviewers verse , their children , when they bought

25 the PowerTouch , were three years or less .

83 7Reed - direct

1 Q . How many did you determine -- how .many lost books did

2 you include in your analysis then?

3 A. I included only three books . . And I spread it out over

4 time . So-the damage analysis takes into account. the detail

5 that these books would be purchased by the consumers and

6 then ultimately cause LeapFrog to ship more books to

7 retailers over time .

8 . Q . Why did you only pick three books ?

9 A. Well , to be conservative , I applied only three books .

10 It could have been a larger number .

11 Q. Can we go back to Slide 14 ?

12 At the very bottom , it says -- there is a lost

13 profits reference .: What is that reference?

14 A . Well , this refers to what Mr . Wood and Mr . Bender

15 addressed in their testimony to the jury, that because o f

16 the PowerTouch , LeapFrog added an additional book to the

17 LeapPad platform . It was only the LeapPad books, such a s

18 the Writing , the Microphone , Classic, the Pink LeapPad, not

19 My First LeapPad .

20 But a second book was added . That resulted in a

21 decline in book sales, because consumers would then not be

22 purchasing as many books as they would otherwise . We saw a

23 slide in Mr . Bender ' s testimony about the decline .

24 Q . Now, after you have gone through and determined ho w

25 many of the sales were in fact, lost to the PowerTouch, what

838Reed - direct

1 is the next step here ?

2 . A. The next step would be to quantify and apply the

3 incremental profit rate for these losses .

4 Q . There it is . So you have lost platforms, lost books . .

5 Is this consistent with what you have been explaining about

6 what you have included in your analysis ?

7 A. Yes, it is .

8 Q. So you have a unit number , and are those the ones that

9 we were just talking about?

10 A. Yes . The books reflect the three books for each of

11 these platforms , including the LeapPad upgrade platforms,

12 then the- number with the LeapPad under lost books ,

13 2,768,000 . That is the number of platforms that were sold

14 from July 2003 through July 2004 .

15 Q. Okay . What is the dollars per unit figure there?

16 A. That reflects the incremental profit that LeapFrog

17 earns when it sells additional products .

18 . Q .. What did you look at to determine what that number

19 . should be ?

20 A. Well, I looked at the financial records of LeapFrog

21 that is associated with the TLP document . I considered all

22 the variable costs that would be associated , all the

23 incremental costs .

24 What that means is, for example , if additional

25 shipments have been made to Wal-Mart , what would be the

843Reed - direct

1 So if the higher pricing applies for the damages

2 analysis , then you would also apply the price erosion pe r

3 unit to the lost LeapPad and the lost My First LeapPad

4 units .

5 Q. The losses on the LeapPad and My First LeapPad on the

6 bottom row , those are losses that LeapFrog already ha d

7 suffered . Is that right? What I mean by that is , these are

8 not future losses of sales of platforms . Right?

9 A. No . It doesn ' t include 2005 through today . It is

10, based on 2004 .

11 Q. Can we flip back to Slide 1 .

12 So that -- does that number match the -- did we

13 sum this up?

14 I am sorry . I apologize . Can we go back to

15 Slide 19 .

16 Does this show the total with respect to the

17 present value of the lost profits that LeapFrog ha s

18 suffered?

19 A. Yes . It's all in 2004 . It is already in present

20 value . In fact , it's future . But it is 28 .36 million .

21 Q . Can we go back to Slide 1 . Is that number there for

22 price erosion?

23 A. Yes, that ' s the second element on this chart .

24 Q. Okay . So with the remaining units , then, you look at

25 the reasonable royalty . Is that correct?

839Reed direct

1 profit on those additional shipments . So you wouldn't take

2 into account overhead expenses, such as the Emory bil l

3 facility where LeapFrog is, located or the research an d

4 development on developing more content and developing new

5 products. . That. is not an incremental cost .

6 Is marketing expenses an incremental cost?

.7 A. I don't believe marketing is an incremental cost . In

8 fact, Mr . Bender addressed that in 2003 LeapFrog had t o

9 increase its marketing in part to clear up confusion about

10 different products in the marketplace .

11 Q . Putting these together, then, you come to a total

12 amount of -- what is the total amount of lost profits

13 damages that you were able to determine?

14 A . . Well, the total is 36 .75 . That includes some future

15 amounts, because some of these books would be sold in the

16 future . So I had to apply a discounting methodology . That

17 takes these future amounts and calculates it as of today .

18 And that figure is 35 .4 million dollars .

19 Q. Can we go back to Slide 1 for a second .

20 There is lost sales . Is that that number there,

21 35 .4 million?

22 A. Correct .

23 Q. You have an. entry for price erosion . Why don't we

24 walk through the price erosion . Can you explain what price

25 erosion is?

84 0Reed - direct

1 A. Yes .

2 In the previous calculation, when I was looking

3 - at the lost profit per unit , the incremental profit, it was

4 based on 2004 pricing . As we will see on the next slide ,

5 prices changed dramatically after the introduction of th e

6 PowerTouch . So this chart shows two different data sources .

7 One that goes back further in time . So I included that to

8 show the stability of pricing in the 1999 to 2002 time

9 period .

10 This is pricing for the LeapPad , the basic

11 LeapPad platforms , including the Pink product that came out

12 later . You can see, from 1999 to 2002 the price was very

13, stable . In late 2003, there was some discounting that was

14 occurring . And in 2004 , the LeapPad list price was reduced

15 to retailers . It was quite a large decline . The decline in

16 price reflected by the red pricing was $ 8 .69, from 2003 to

17 2004 .

18 Q . If LeapFrog had reduced its prices on its LeapPad

19 platforms in response to Fisher-Price coming into the

20 market , in your opinion, is that a rational move by

21 LeapFrog?

22 A. It can be a rational move when you are dealing with a

23 competitor like Fisher -Price that has a very large -- they

24 have the ability to introduce their product quickly, to a

25 large number of retailers . And they have the resources to

1

2

3

4

5

6

7

8

9

10

11

1 2

13

14

1 5

1 6

1 7

18

19

842Reed - direct

Also, information about Fisher-Price reducing

their prices of the Power-Touch, which I will'touch . on later,

is very consistent with that analysis .

Were: you able to quantify what the damages should be

for price erosion?

A . Yes,, I have .

Q. Does this lay that out?

A. Yes .

Q . What is the top row? What does that show?

A. The top two rows show the actual sales that were made

by LeapFrog to retailers in .-2004 . And my price erosion

analysis really focuses on 2004 and only 2004 .

So, the actual unitsshipped to retailers of

LeapPad in 2004 , including the writing , .with the various

flavors of the LeapPad, were 2,164,000 units . I applied

that to my calculation of the price erosion per unit .

Similarly , I do the same thing for My First LeapPad,

actual units shipped to retailers in 2004 .

If .you would like , I can move to the bottom two .

20 Q. Okay .

21 A. The bottom two is another aspect of the losses .

22 Remember , the lost profit analysis , LeapFrog would have had

23 additional sales associated with the sales it lost t o

24 PowerTouch . And so when I calculated the losses for those,

25 it was at the lower .2004 pricing .

84 3Reed - direct

1 So if the higher pricing applies for the damages

2 analysis , then you would also apply the price erosion per

3 unit to the lost LeapPad and the lost My First LeapPad

4 units .

5 Q. The losses on the LeapPad and My First LeapPad on the

6 bottom row , those are losses that LeapFrog already had

7 suffered . Is that right ? What I mean by that is, these are

8 not future losses of sales of platforms . Right?

9 A. No . It doesn ' t include 2005 through today. It is

10 . based on 2004 .

11 Q. Can we flip back to Slide 1 .

12 So that -- does that number match the -- did we

13 sum this up?

14 I am sorry . I apologize . Can we go back to

15 Slide 19 .

16 Does this show the total with respect to the

17 present value of the lost profits that LeapFrog ha s

18 suffered?

19 A. Yes . It's all in 2004 . It is already in present

20 value . In fact, it's future . But it is 28 .36 million .

21 Q . Can we go back to Slide 1 . Is that number there for

22 price erosion ?

23 A. Yes , that ' s the second element on this chart .

24 Q. Okay . So with the remaining units, then , you look at

25 the reasonable royalty . Is that correct?

84 4Reed - direct

1 A. Correct .

2 Q . So why don't we go through the reasonable royalty

3 analysis . Did you in fact do a reasonable royalty analysis

4 with respect to certain of the PowerTouch units ?

5 A. Yes, I did. In fact , this slide shows the units .

6 There were about 787 , 000 units shipped during the damage

7 period by Fisher -Price . 630,000 of which I view are lost

8 profit units , 'the remaining are 157,600 .

9 Q . How does one approach a reasonable royalty analysis

10 for the remaining units ?

11 A. Just like there was this Panduit case, and Pandui t

12 factors to address for lost profits, there is also guidance

13 on reasonable royalty . It is called the Georgia-Pacifi c

14 case and the Georgia-Pacific factors .

15 Q . Does this lay out the Georgia-Pacific factors ?

16 A. Yes . It lays out the 15 factors . These are economic

17 and financial and licensing factors that are typicall y

18 addressed by people like me in addressing the issue of what

19 would be a reasonable royalty for the use of the patent .

20 THE COURT: Before we continue on with

21 Georgia-Pacific , why don ' t we take our morning break .

22 (Jury leaves courtroom at 11 : 10 a .m . )

23 (Recess taken . )

24 THE COURT : Be seated .

25 Bring in the jury , please .

85 2Reed - direct

I fairly takes into account all the book . units .

2 Q. Why don't we just walk through it . If it is a $1 0

3 royalty per unit, can you explain why it .is 157,000 units

4 that you applied this to ?

5 A. Yes . Again, there were, during the. damage period ,

6 approximately 787,000 Fisher-Price PowerTouch units tha t

7 were shipped to retailers . And my lost profit analysis too k

8 630,000 of those units . That leaves a remainder of 157,000

9 units . That's what would apply to the $10 royalty per unit .

10 Q . Can we go back to slide l . .

11 That is that number on the bottom . . Is that

12 correct, the amount of damages for the reasonable royalty

13, addition ?

14 A . 1 .58 million .

15 Q. You come to a'sum total of ?

16 A . 65 .34 million in total damages .

17 Q . Can-you give me an idea on whether or not on the

18 spectrum' this . is an aggressive or conservative number ?

19 A . Well, there are additional aspects of damages that I

20 alluded to that have been included and some others I haven' t

21 discussed . There could be loss upgrades to the QuantumPa d

22 or LeapFrogster and other products that LeapFrog sells tha t

23 _ many customers of the LeapPad later on purchase . There

24 could be more books that would. be purchased by thes e

25 customers, the lost customers . All of these would give rise

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

844Reed - direct

A. Correct .

Q . So why don -I t we go through the reasonable royalty

analysis . Did you in fact do a reasonable royalty analysis

with respect to certain of the PowerTouch units`,

A. Yes , I did . In fact, this slide shows the units .

There were about 787 ,000 units shipped during the damage

period by Fisher-Price . -630,000 of which I view are lost

profit units,'the remaining are 157,600 .

Q. How does one approach _ a reasonable royalty analysis

for the remaining units ?

A. Just. like there was this Panduit case, and Panduit

factors to address for lost profits, there is also guidance

on reasonable royalty. It is called the Georgia-Pacific

case and the Georgia-Pacific factors .

Q . Does this lay out the,Georgia-Pacific factors?

A. Yes . It lays out the 15 factors . These are economic

and financial and licensing factors that are. typically

addressed by people like me in addressing the issue of what

would be a reasonable royalty for the use of the patent .

THE COURT : Before we continue on with

Georgia-Pacific , why don't we take our morning break .

(Jury leaves courtroom at 11 :10 a .m .)

(Recess taken . )

THE COURT : Be seated .

Bring in the jury , please .

152 5

IN THE UNITED STATES DISTRICT COURT

IN AND FOR THE DISTRICT OF DELAWARE

LEAPFROG ENTERPRISES, INC . :

a Delaware corporation

Plaintiff,

V .

FISHER-PRICE, INC . ,

a Delaware corporation,

Defendant .

Civil Action

No . 03-927 (GMS )

Wilmington, Delaware

Tuesday, May 24, 20059 :45 a .m .


APPEARANCES :

RICHARD H . MORSE, ESQ .

Young Conaway Stargatt & Taylor, LLP-and- ,

RON E . SHULMAN, ESQ .,TERRY KEARNEY, ESQ .,

MICHAEL BERTA, ESQ ., andSTEPHEN HOLMES, ESQ .

Wilson Sonsini Goodrich & Rosati,A Professional Corporation(Palo Alto, California )


SEVENTH DAY OF TRIAL

1699

1 ignore these documents . She said , ignore them because

2 Fisher -Price didn't really mean what it was saying .

3 Fisher-Price didn ' t mean it when they said they want to hit

4 LeapFrog . Fisher-Price didn ' t mean it, Ms . Mancuso didn't

5 mean it when she said we must blunt LeapFrog ' s unbelievable

6 momentum . They didn ' t really mean it when they said the

7 only advantage of introducing the PowerTouch was the

8 competitive hit it would have on LeapFrog .

9 You didn't hear anything about teaching kids how

10 to read . The advantage of introducing this was the

11 competitive hit on . LeapFrog .

12 What else 'did Ms . Mancuso ask you to believe?

13 She asked you to believe that sales of the

14 PowerTouch , see them right there, that sales of the

15 PowerTouch had no impact at all , she said, on the sales of

16 the LeapPad .

17 Well , try as you might, that isn't possible to

18 believe . Let's look at a 21-page market research report

19 written by Ms . Mancuso ' s own marketing department . As you

20 can see on the screen, Fisher-Price said that the PowerTouch

21 was introduced to directly compete with the LeapPad .

22 Now , is LeapFrog asking you to protect it from

23 fair competition? Absolutely not . You remember our

24 witness , Mr . Bender , he was the president of sales , the guy

25 who was dressed very nicely , he took the stand earlier . And

Ex. C

LEAPFROG: 10-Q & 10-K STATEMENTS Internal Controls Over Financial Reporting

8/11/03

2Q03 10-Q 11/10/03

3Q03 10-Q 3/10/04

FY03 10-K Item 4. Controls and Procedures. Evaluation of LeapFrog’s Disclosure Controls and Internal Controls As of the end of the period covered by this quarterly report on Form 10-Q, LeapFrog evaluated the effectiveness of the design and operation of its “disclosure controls and procedures,” or “Disclosure Controls.” This evaluation, or “Controls Evaluation,” was performed under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. CEO and CFO Certifications Attached as exhibits to this quarterly report, there are “Certifications” of the CEO and the CFO required by Rule 13a-14(a) of the Securities Exchange Act of 1934, or the Rule 13a-14(a) Certifications. This Controls and Procedures section of the quarterly report includes the information concerning the Controls Evaluation referred to in the Rule 13a-14(a) Certifications and it should be read in conjunction with the Rule 13a-14(a) Certifications for a more complete understanding of the topics presented. Disclosure Controls and Internal Control Over Financial Reporting Disclosure Controls are procedures designed to ensure that

Item 4. Controls and Procedures. Evaluation of LeapFrog’s Disclosure Controls and Internal Controls As of the end of the period covered by this quarterly report on Form 10-Q, LeapFrog evaluated the effectiveness of the design and operation of its “disclosure controls and procedures,” or “Disclosure Controls.” This evaluation, or “Controls Evaluation,” was performed under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. CEO and CFO Certifications Attached as exhibits to this quarterly report, there are “Certifications” of the CEO and the CFO required by Rule 13a-14(a) of the Securities Exchange Act of 1934, or the Rule 13a-14(a) Certifications. This Controls and Procedures section of the quarterly report includes the information concerning the Controls Evaluation referred to in the Rule 13a-14(a) Certifications and it should be read in conjunction with the Rule 13a-14(a) Certifications for a more complete understanding of the topics presented. Disclosure Controls and Internal Control Over Financial Reporting Disclosure Controls are procedures designed to ensure that

Item 9A. Controls and Procedures. Evaluation of LeapFrog’s Disclosure Controls and Internal Controls As of the end of the period covered by this annual report on Form 10-K, we evaluated the effectiveness of the design and operation of our “disclosure controls and procedures,” or “Disclosure Controls.” This evaluation, or “Controls Evaluation,” was performed under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. CEO and CFO Certifications Attached as exhibits to this annual report, there are “Certifications” of our CEO and the CFO required by Rule 13a-14(a) of the Securities Exchange Act of 1934, or the Rule 13a-14(a) Certifications. This Controls and Procedures section of the annual report includes the information concerning the Controls Evaluation referred to in the Rule 13a-14(a) Certifications and it should be read in conjunction with the Rule 13a-14(a) Certifications for a more complete understanding of the topics presented. Disclosure Controls and Internal Control Over Financial Reporting Disclosure Controls are procedures designed to ensure that information required to be disclosed in our reports filed

Case 5:03-cv-05421-RMW Document 121-3 Filed 06/17/2005 Page 34 of 77

8/11/03 2Q03 10-Q

11/10/03 3Q03 10-Q

3/10/04 FY03 10-K

information required to be disclosed in our reports filed under the Exchange Act, such as this quarterly report, is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms. Disclosure Controls are also designed to ensure that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Internal control over financial reporting is a process designed by, or under the supervision of, the issuer’s principal executive and principal financial officers, and effected by the issuer’s board of directors, management and other personnel, 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 and includes those policies and procedures that: • Pertain to the maintenance of records that in

reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the issuer;

• Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the issuer are being made only in accordance with authorizations of management and directors of the issuer; and

• Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the issuer’s assets that could have a

information required to be disclosed in our reports filed under the Exchange Act, such as this quarterly report, is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms. Disclosure Controls are also designed to ensure that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Internal control over financial reporting is a process designed by, or under the supervision of, the issuer’s principal executive and principal financial officers, and effected by the issuer’s board of directors, management and other personnel, 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 and includes those policies and procedures that: • Pertain to the maintenance of records that in



• Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the issuer’s assets that could have a material effect on the financial statements.

under the Exchange Act, such as this annual report, is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms. Disclosure Controls are also designed to ensure that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Internal control over financial reporting is a process designed by, or under the supervision of, an issuer’s principal executive and principal financial officers, and effected by the issuer’s board of directors, management and other personnel, 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 and includes those policies and procedures that: • Pertain to the maintenance of records that in





8/11/03 2Q03 10-Q

11/10/03 3Q03 10-Q

3/10/04 FY03 10-K

material effect on the financial statements.

Limitations on the Effectiveness of Controls Our management, including the CEO and CFO, does not expect that our Disclosure Controls or our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within LeapFrog have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with its policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Conclusions Based upon the Controls Evaluation, our CEO and CFO

Limitations on the Effectiveness of Controls Our management, including the CEO and CFO, does not expect that our Disclosure Controls or our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within LeapFrog have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with its policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Conclusions Based upon the Controls Evaluation, our CEO and CFO have concluded that, subject to the limitations noted above,

Limitations on the Effectiveness of Controls Our management, including our CEO and CFO, does not expect that our Disclosure Controls or our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with its policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Conclusions Based upon the Controls Evaluation, our CEO and CFO have concluded that, subject to the limitations noted above,


8/11/03 2Q03 10-Q

11/10/03 3Q03 10-Q

3/10/04 FY03 10-K

have concluded that, subject to the limitations noted above, our Disclosure Controls are effective to ensure that material information relating to LeapFrog is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared. There have been no changes in our internal control over financial reporting during the quarter ended June 30, 2003 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 10-Q at 27-28.

our Disclosure Controls are effective to ensure that material information relating to LeapFrog is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared. There have been no changes in our internal control over financial reporting during the quarter ended September 30, 2003 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 10-Q at 28-29.

our Disclosure Controls are effective to ensure that material information relating to our business is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared. There have been no changes in our internal control over financial reporting during the quarter ended December 31, 2003 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 10-Q at 44-45.


5/7/04 1Q04 10-Q

8/6/04 2Q04 10-Q

3/28/05 FY04 10-K

Item 4. Controls and Procedures. Evaluation of LeapFrog’s Disclosure Controls and Internal Controls As of the end of the period covered by this quarterly report on Form 10-Q, LeapFrog evaluated the effectiveness of the design and operation of its “disclosure controls and procedures,” or “Disclosure Controls.” This evaluation, or “Controls Evaluation,” was performed under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. CEO and CFO Certifications Attached as exhibits to this quarterly report, there are “Certifications” of the CEO and the CFO required by Rule 13a-14(a) of the Securities Exchange Act of 1934, or the Rule 13a-14(a) Certifications. This Controls and Procedures section of the quarterly report includes the information concerning the Controls Evaluation referred to in the Rule 13a-14(a) Certifications and it should be read in conjunction with the Rule 13a-14(a) Certifications for a more complete understanding of the topics presented. Disclosure Controls and Internal Control Over Financial Reporting Disclosure Controls are procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this quarterly report, is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms. Disclosure Controls are also

Item 4. Controls and Procedures. Evaluation of LeapFrog’s Disclosure Controls and Internal Controls As of the end of the period covered by this quarterly report on Form 10-Q, LeapFrog evaluated the effectiveness of the design and operation of its “disclosure controls and procedures,” or “Disclosure Controls.” This evaluation, or “Controls Evaluation,” was performed under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. CEO and CFO Certifications Attached as exhibits to this quarterly report, there are “Certifications” of the CEO and the CFO required by Rule 13a-14(a) of the Securities Exchange Act of 1934, or the Rule 13a-14(a) Certifications. This Controls and Procedures section of the quarterly report includes the information concerning the Controls Evaluation referred to in the Rule 13a-14(a) Certifications and it should be read in conjunction with the Rule 13a-14(a) Certifications for a more complete understanding of the topics presented. Disclosure Controls and Internal Control Over Financial Reporting Disclosure Controls are procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this quarterly report, is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities

LeapFrog’s 2004 10-K Internal Control Disclosures. Item 9A. Controls and Procedures. Attached as exhibits to this Form 10-K are certifications of LeapFrog’s Chief Executive Officer and Chief Financial Officer, which are required in accordance with Rule 13a-14 of the Securities Exchange Act of 1934, as amended. This “Controls and Procedures” section includes information concerning the controls and controls evaluation referred to in the certifications. Evaluation of Disclosure Controls and Procedures As of the end of the period covered by this annual report on Form 10-K, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures or disclosure controls. This controls evaluation was performed under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. Disclosure controls are controls and procedures designed to reasonably assure that information required to be disclosed in our reports filed under the Exchange Act, such as this report, is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms. Disclosure controls are also designed to reasonably assure that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. The evaluation of our disclosure controls included a review of the controls’ objectives and design, our implementation of the controls and the effect of the controls on the information


5/7/04 1Q04 10-Q

8/6/04 2Q04 10-Q

3/28/05 FY04 10-K

designed to ensure that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Internal control over financial reporting is a process designed by, or under the supervision of, the issuer’s principal executive and principal financial officers, and effected by the issuer’s board of directors, management and other personnel, 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 and includes those policies and procedures that: • Pertain to the maintenance of records that in




Limitations on the Effectiveness of Controls Our management, including the CEO and CFO, does not expect that our Disclosure Controls or our internal control over financial reporting will prevent all error and all fraud.

and Exchange Commission’s rules and forms. Disclosure Controls are also designed to ensure that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Internal control over financial reporting is a process designed by, or under the supervision of, the issuer’s principal executive and principal financial officers, and effected by the issuer’s board of directors, management and other personnel, 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 and includes those policies and procedures that: • Pertain to the maintenance of records that in




Limitations on the Effectiveness of Controls

generated for use in this report. In the course of the controls evaluation, we reviewed identified data errors and control problems and sought to confirm that appropriate corrective actions, including process improvements, were being undertaken. This type of evaluation is performed on a quarterly basis so that the conclusions of management, including the CEO and CFO, concerning the effectiveness of the disclosure controls can be reported in our periodic reports on Form 10-Q and Form 10-K. Based upon the controls evaluation, our CEO and CFO have concluded that, as a result of the matters discussed below with respect to our internal control over financial reporting, our disclosure controls as of December 31, 2004 were not effective. Management Report on Internal Control Over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is a process designed by, or under the supervision of, our principal executive and principal financial officers, and effected by our board of directors, management and other personnel, 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 and includes those policies and procedures that: • Pertain to the maintenance of records that in reasonable

detail accurately and fairly reflect the transactions and dispositions of the assets of our company.

• Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial


5/7/04 1Q04 10-Q

8/6/04 2Q04 10-Q

3/28/05 FY04 10-K

A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within LeapFrog have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with its policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Conclusions Based upon the Controls Evaluation, our CEO and CFO have concluded that, subject to the limitations noted above, our Disclosure Controls are effective to ensure that material information relating to LeapFrog is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared.

Our management, including the CEO and CFO, does not expect that our Disclosure Controls or our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within LeapFrog have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with its policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Conclusions Based upon the Controls Evaluation, our CEO and CFO have concluded that, subject to the limitations noted above, our Disclosure Controls are effective to ensure

statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors.

• Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.

Management assessed our internal control over financial reporting as of December 31, 2004, the end of our fiscal year. Management based its assessment on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO. Management’s assessment included evaluation of such elements as the design and operating effectiveness of key financial reporting controls, process documentation, accounting policies, and our overall control environment. An internal control material weakness is a deficiency, or combination of deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Based on management’s assessment of our internal control over financial reporting as of December 31, 2004, we have identified the following material weaknesses in our internal control over financial reporting. In the area of revenue and accounts receivable, we identified the following insufficient controls which we believe constitute a material weakness in the aggregate. • Lack of segregation of duties between our accounts

receivable and order entry staff and possession by those persons of broad access to our revenue and accounts


5/7/04 1Q04 10-Q

8/6/04 2Q04 10-Q

3/28/05 FY04 10-K

There have been no changes in our internal control over financial reporting during the quarter ended March 31, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 10-Q at 26-27.

that material information relating to LeapFrog is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared. There have been no changes in our internal control over financial reporting during the quarter ended June 30, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 10-Q at 33-34.

receivable information technology systems, including access to system areas controlling revenue recordation, cash application, credit memo issuance, credit authorization, invoice pricing and collections.

• Lack of effective controls over our receivables credit memo review and approval process to monitor compliance with existing policies and procedures related to authorization of credit memos to our customers.


• Inadequate staffing to determine that internal controls over reconciliations, review of account balances and closing procedures are performed consistently and on a timely basis.

In the area of cost of goods sold and inventory, we identified the following insufficient controls which we believe constitute a material weakness in the aggregate. • Lack of segregation of duties between our inventory and

purchasing staff and possession by those persons of broad access to our information technology systems, including access to system areas controlling the set-up of new vendors, the creation of purchase orders, and our inventory purchasing and receiving functions.

• Inadequate preparation and review of reconciliations of physical inventory results to inventory ledgers and related cost of goods sold accruals.



• Insufficient communication procedures between our accounts payable and operations staff regarding returns of inventory back to our vendors.


5/7/04 1Q04 10-Q

8/6/04 2Q04 10-Q

3/28/05 FY04 10-K




In the area of information technology controls, we identified the following insufficient controls which we believe constitute a material weakness in the aggregate. • Ineffective logical access and change management

controls related to information technology systems, data and programs that are used to monitor, record and transfer information. These controls relate to the purchase of materials and components used to manufacture and assemble our products, the manufacture and assembly of our products, the distribution, invoicing and sale of our products and the remittance of payments by our vendors, our customers and ourselves related to these activities.

• Pervasive inadequacies in enterprise resource planning, or ERP, application controls related to appropriate assignment of functions and segregation of duties, which allowed employees to access system programs and data or initiate transactions inconsistent with their assigned duties. Our ERP systems contain design deficiencies that do not adequately segregate and control access, and lack sufficient human oversight over the assignment of system access and authorities.


Because of the material weaknesses described in the preceding paragraphs, our management believes that, as of


5/7/04 1Q04 10-Q

8/6/04 2Q04 10-Q

3/28/05 FY04 10-K

December 31, 2004, our internal control over financial reporting was not effective based on the COSO criteria. Our independent registered public accounting firm, Ernst & Young LLP, has issued an attestation report on management’s assessment of the Company’s internal control over financial reporting, which is included below. Completed and Planned Remediation Actions to Address Internal Control Weaknesses Management believes that actions that we have taken since December 31, 2004 and actions that will be taken in 2005, along with other improvements yet to be formally identified, will address the material weaknesses in our internal control over financial reporting noted above. Some of these remediation actions are discussed below. In relation to the material weakness in the area of revenue and accounts receivable, we have taken or plan to take the following actions in 2005: • Manual detective controls have been put in place in

advance of systems controls to confirm the population of credit memos are appropriately authorized.

• Manual detective controls are being put in place in advance of systems controls to ensure all revenue transactions are valid and properly supported.

• Manual detective controls have been put in place to confirm that adjustments to prices reflected on invoices that we issue to our customers that have been properly approved.

• Duties will be segregated in the accounts receivable area between persons who have control over credit and persons who have control over billing, and systems will be implemented that will allow our personnel access only to


5/7/04 1Q04 10-Q

8/6/04 2Q04 10-Q

3/28/05 FY04 10-K

those system areas to which they require access in the normal execution of their duties.

• A layer of automated controls will be applied to existing and future information technology systems that will physically limit and restrict the ability of system users to enter, change, and view data within the system, and that will track and provide a detailed history of changes to key elements of the data.

In relation to the material weakness in the area of cost of goods sold and inventory, we plan to take the following actions in 2005: • Supply chain leadership will be upgraded through the

addition of a senior executive with overall responsibilities for the function. A formal search is underway.

• Accounting capabilities will be strengthened through improved additional staffing and training.

• Corporate ERP systems will be redesigned and implemented to confirm the proper, necessary and appropriate levels and breadth of access and control to functional areas of our systems.

• Quarterly test counts of physical inventories will be conducted and appropriately reviewed and documented.

• Reconciliations of physical inventory results to inventory ledgers and related cost of goods sold accruals will be properly reviewed and documented.

• Estimations of work-in-process inventories will be adequately supported and properly reviewed.

• Variances from standards will be separately tested and reviewed for reasonableness in relation to calculated amounts to ensure the general ledger balances are reasonable based on these calculations.

• A formal return-to-vendor policy will be put in place to confirm that systems appropriately reflect returns of inventory back to our vendors.

• Bill of material maintenance processes and work order


5/7/04 1Q04 10-Q

8/6/04 2Q04 10-Q

3/28/05 FY04 10-K

processes will be changed to ensure accurate relief of inventory.

• Duties will be segregated between our inventory and purchasing staff to prevent our personnel from having inappropriate access to system areas controlling the set-up of new vendors, the creation of purchase orders and access to our inventory purchasing and receiving functions. In addition, software controls will be applied to our existing and future ERP systems to adequately enforce this segregation.

In relation to the material weakness in the area of information technology controls, we plan to take the following actions in 2005: • Our new Chief Information Officer will develop a

comprehensive information technology system strategy that is in line with and supports our business strategy and our need for appropriate processes and policies related to internal controls.

• Corporate ERP systems will be re-designed and implemented to properly align these systems with corporate business objectives. The re-design will be intended to ensure that these systems properly enable and support our corporate business objectives and include appropriate levels of control and security.

• The number of different software vendors and information system architectures that constitute our current ERP systems will be reduced in order to decrease complexity and increase the uniformity, usability, reliability, efficiency, security and effectiveness of these systems.

• System end users will be formally identified and trained in the proper set-up, testing and use of the corporate ERP systems, in order to establish functional accountability and responsibility for corporate ERP systems within a core of educated and responsible end users across our company.

• Proper controls for our ERP systems will be implemented


5/7/04 1Q04 10-Q

8/6/04 2Q04 10-Q

3/28/05 FY04 10-K

and documented that limit access to system functions consistent with appropriately segregated duties of our financial and operation staff in the normal execution of their respective duties.

• Information technology functional capabilities will be upgraded or added to establish stronger communication and planning between the information technology department and the functional teams within the company that use the systems in order to provide decision makers with accurate, timely, and appropriate information required for them to make proper business decisions.

• Information technology department processes will be established, documented, and enforced to ensure that all information system initiatives, including upgrades, patches and bug fixes, are appropriately prioritized, approved, documented and reported.

Inherent Limitations on Effectiveness of Controls LeapFrog’s management, including our CEO and CFO, does not expect that our disclosure controls or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can


5/7/04 1Q04 10-Q

8/6/04 2Q04 10-Q

3/28/05 FY04 10-K

occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Changes in Internal Control Over Financial Reporting There have been no changes in our internal control over financial reporting during the quarter ended December 31, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. The discussion above under “Completed and Planned Remediation Actions to Address Internal Control Weaknesses” describes a number of changes we have made since December 31, 2004 that we believe have materially improved our internal control over financial reporting, as well as other improvements that we plan to make in 2005. Rport of Independent Registered Public Accounting Firm The Board of Directors and Stockholders of LeapFrog Enterprises, Inc. We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that LeapFrog Enterprises, Inc. did not maintain effective internal control over financial reporting


5/7/04 1Q04 10-Q

8/6/04 2Q04 10-Q

3/28/05 FY04 10-K

as of December 31, 2004, because of the effect of the three material weaknesses identified in management’s assessment and described below, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). LeapFrog Enterprises, Inc. management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed 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. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;


5/7/04 1Q04 10-Q

8/6/04 2Q04 10-Q

3/28/05 FY04 10-K

(2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following three material weaknesses have been identified and included in management’s assessment: 1. In the area of revenue and accounts receivable, the following insufficient controls were identified which management believes constitute a material weakness in the aggregate:

• Lack of segregation of duties between accounts receivable and order entry staff and possession by those persons of broad access to revenue and accounts receivable information technology systems, including access to system areas controlling revenue recordation, cash application, credit memo issuance, credit authorization,


5/7/04 1Q04 10-Q

8/6/04 2Q04 10-Q

3/28/05 FY04 10-K

invoice pricing and collections. • Lack of effective controls over receivables credit memo

review and approval process to monitor compliance with existing policies and procedures related to authorization of credit memos to customers.


• Inadequate staffing to determine that internal controls over reconciliations, review of account balances and closing procedures are performed consistently or on a timely basis.

2. In the area of cost of goods sold and inventory, the following insufficient controls were identified which management believes constitute a material weakness in the aggregate:

• Lack of segregation of duties between inventory and purchasing staff and possession by those persons of broad access to systems, including access to system areas controlling the set-up of new vendors, the creation of purchase orders, and inventory purchasing and receiving functions.

• Inadequate preparation and review of reconciliations of physical inventory results to inventory ledgers and related cost of goods sold related accruals.



• Insufficient communication procedures between accounts payable and operations staff regarding returns of inventory back to vendors.


5/7/04 1Q04 10-Q

8/6/04 2Q04 10-Q

3/28/05 FY04 10-K




3. In the area of information technology controls, the following insufficient controls were identified which management believes constitute a material weakness in the aggregate:

• Ineffective logical access and change management controls related to information technology systems, data and programs that are used to monitor, record and transfer information. These controls relate to the purchase of materials and components used to manufacture and assemble products, the manufacture and assembly of products, the distribution, invoicing and sale of products and the remittance of payments by vendors, customers and LeapFrog Enterprises, Inc. related to these activities.

• Pervasive inadequacies in enterprise resource planning, or ERP, application controls related to appropriate assignment of functions and segregation of duties, which allowed employees to access system programs and data or initiate transactions inconsistent with their assigned duties. The ERP systems contain design deficiencies that do not adequately segregate and control access, and lack sufficient human oversight over the assignment of system access and authorities.



5/7/04 1Q04 10-Q

8/6/04 2Q04 10-Q

3/28/05 FY04 10-K

These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2004 financial statements, and this report does not affect our report dated March 25, 2005 on those financial statements. In our opinion, management’s assessment that LeapFrog Enterprises, Inc. did not maintain effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO control criteria. Also, in our opinion, because of the effect of the material weaknesses described above on the achievement of the objectives of the control criteria, LeapFrog Enterprises, Inc has not maintained effective internal control over financial reporting as of December 31, 2004, based on the COSO control criteria. /s/ Ernst & Young LLP San Francisco, California March 25, 2005 10-Q at 57-64.

T:\CasesSF\LeapFrog\NonPldgs\Internal Controls chart.doc


Ex. D

LEAPFROG: 10-Q & 10-K STATEMENTS Competition

8/11/03

2Q03 10-Q 11/10/03

3Q03 10-Q 3/10/04

FY03 10-K If we are unable to compete effectively with existing or new competitors, our sales and market share could decline. We currently compete primarily in the infant and toddler and preschool categories and electronic learning aids category of the U.S. toy industry and, to some degree, in the overall U.S. and international toy industry. Our SchoolHouse division competes in the supplemental educational materials market. Each of these markets is very competitive and we expect competition to increase in the future. For example, in July 2003, Mattel, Inc. introduced under its Fisher-Price brand a product called “PowerTouch” having functionality similar to that of our LeapPad platform. We believe that we are beginning to compete, and will increasingly compete in the future, with makers of popular game platforms and smart mobile devices such as personal digital assistants. These companies are well situated to compete effectively in our primary markets. Additionally, we are beginning to cross over into their markets with products such as our iQuest handheld device and our Leapster platform, which is expected to be released by the end of 2003. Many of our direct, indirect and potential competitors have significantly longer operating histories, greater brand recognition and substantially greater financial, technical and marketing resources than we do. These competitors may be able to respond more rapidly than we can to changes in consumer requirements or preferences or to new or emerging technologies. They may also devote greater resources to the development, promotion and sale of their products than we do. We cannot assure you that we will be able to compete effectively in our markets. 10-Q at 20.

If we are unable to compete effectively with existing or new competitors, our sales and market share could decline. We currently compete primarily in the infant and toddler and preschool categories and electronic learning aids category of the U.S. toy industry and, to some degree, in the overall U.S. and international toy industry. Our SchoolHouse division competes in the supplemental educational materials market. Each of these markets is very competitive and we expect competition to increase in the future. For example, in July 2003, Mattel, Inc. introduced under its Fisher-Price brand a product called “PowerTouch” having functionality similar to that of our LeapPad platform. We believe that we are beginning to compete, and will increasingly compete in the future, with makers of popular game platforms and smart mobile devices such as personal digital assistants. These companies are well situated to compete effectively in our primary markets. Additionally, we are beginning to cross over into their markets with products such as our Leapster platform and iQuest handheld device. Many of our direct, indirect and potential competitors have significantly longer operating histories, greater brand recognition and substantially greater financial, technical and marketing resources than we do. These competitors may be able to respond more rapidly than we can to changes in consumer requirements or preferences or to new or emerging technologies. They may also devote greater resources to the development, promotion and sale of their products than we do. We cannot assure you that we will be able to compete effectively in our markets. 10-Q at 21.

If we are unable to compete effectively with existing or new competitors, our sales and market share could decline. We currently compete primarily in the infant and toddler and preschool categories and electronic learning aids category of the U.S. toy industry and, to some degree, in the overall U.S. and international toy industry. Our SchoolHouse division competes in the supplemental educational materials market. Each of these markets is very competitive and we expect competition to increase in the future. For example, in July 2003, Mattel, Inc. introduced under its Fisher-Price brand a product called “PowerTouch” having functionality similar to that of our LeapPad platform. We believe that we are beginning to compete, and will increasingly compete in the future, with makers of popular game platforms and smart mobile devices such as personal digital assistants. These companies are well situated to compete effectively in our primary markets. Additionally, we are beginning to cross over into their markets with products such as our Leapster platform and iQuest handheld device. Many of our direct, indirect and potential competitors have significantly longer operating histories, greater brand recognition and substantially greater financial, technical and marketing resources than we do. These competitors may be able to respond more rapidly than we can to changes in consumer requirements or preferences or to new or emerging technologies. They may also devote greater resources to the development, promotion and sale of their products than we do. We cannot assure you that we will be able to compete effectively in our markets. 10-K at 36.


5/7/04

1Q04 10-Q 8/6/04

2Q04 10-Q

3/28/05 FY05 10-K

If we are unable to compete effectively with existing or new competitors, our sales and market share could decline. We currently compete primarily in the infant and toddler and preschool categories and electronic learning aids category of the U.S. toy industry and, to some degree, in the overall U.S. and international toy industry. Our SchoolHouse division competes in the supplemental educational materials market. Each of these markets is very competitive and we expect competition to increase in the future. For example, in July 2003, Mattel, Inc. introduced under its Fisher-Price brand a product called “PowerTouch” having functionality similar to that of our LeapPad platform. We believe that we are beginning to compete, and will increasingly compete in the future, with makers of popular game platforms and smart mobile devices such as personal digital assistants. These companies are well situated to compete effectively in our primary markets. Additionally, we are beginning to cross over into their markets with products such as our Leapster platform and iQuest handheld device. Many of our direct, indirect and potential competitors have significantly longer operating histories, greater brand recognition and substantially greater financial, technical and marketing resources than we do. These competitors may be able to respond more rapidly than we can to changes in consumer requirements or preferences or to new or emerging technologies. They may also devote greater resources to the development, promotion and sale of their products than we do. We cannot assure you that we will be able to compete effectively in our markets. 10-Q at 19.

If we are unable to compete effectively with existing or new competitors, our sales and market share could decline. We currently compete primarily in the infant and toddler category, preschool category and electronic learning aids category of the U.S. toy industry and, to some degree, in the overall U.S. and international toy industry. Our SchoolHouse division competes in the U.S. supplemental educational materials market. Each of these markets is very competitive and we expect competition to increase in the future. For example, Mattel, Inc. sells under its Fisher-Price brand a product called “PowerTouch” having functionality similar to that of our LeapPad platform. We believe that we are beginning to compete, and will increasingly compete in the future, with makers of popular game platforms and smart mobile devices such as personal digital assistants. These companies are well situated to compete effectively in our primary markets. Additionally, we are beginning to cross over into their markets with products such as our Leapster platform and iQuest handheld device. Many of our direct, indirect and potential competitors have significantly longer operating histories, greater brand recognition and substantially greater financial, technical and marketing resources than we do. These competitors may be able to respond more rapidly than we can to changes in consumer requirements or preferences or to new or emerging technologies. They may also devote greater resources to the development, promotion and sale of their products than we do. We cannot assure you that we will be able to compete effectively in our markets. 10-Q at 26.

If we are unable to compete effectively with existing or new competitors, our sales and market share could decline. We currently compete primarily in the infant and toddler category, preschool category and electronic learning aids category of the U.S. toy industry and, to some degree, in the overall U.S. and international toy industry. Our SchoolHouse division competes in the U.S. supplemental educational materials market. Each of these markets is very competitive and we expect competition to increase in the future. For example, Mattel, Inc. sells under its Fisher-Price brand products called “PowerTouch” having functionality similar to that of our LeapPad and LittleTouch LeapPad platforms. Also, VTech Holdings Ltd. and Mattel under its Fisher-Price brand sell, V.Smile and InteracTV, respectively, which are television-based learning products that allow for video game-play similar to our Leapster learning system. We believe that we are beginning to compete, and will increasingly compete in the future, with makers of popular game platforms and smart mobile devices such as personal digital assistants. For example, we are beginning to cross over into their markets with products such as our Leapster handhelds, iQuest handheld and planned products, such as our Fly pentop computer. These companies are well situated to compete effectively in our primary markets. Many of our direct, indirect and potential competitors have significantly longer operating histories, greater brand recognition and substantially greater financial, technical and marketing resources than we do. These competitors may be able to respond more rapidly than we can to changes in consumer requirements or preferences or to new or emerging technologies. They may also devote greater resources to the development, promotion and sale of their products than we do. We cannot assure you that we will be able to compete effectively in our markets. 10-K at 49.

T:\CasesSF\LeapFrog\NonPldgs\LeapFrog Competition chart.doc


Ex. F

LEAPFROG: 10-Q & 10-K STATEMENTS Dependence on Three Retailers

8/11/03

2Q03 10-Q 11/10/03

3Q03 10-Q 3/10/04

FY03 10-K Our business depends on three retailers that together accounted for approximately 69% of our net sales in 2002, and our dependence upon a small group of retailers may increase. Wal-Mart (including Sam’s Club), Toys “R” Us, and Target accounted in the aggregate for approximately 69% of our net sales in 2002. We expect that a small number of large retailers will continue to account for a significant majority of our sales and that our sales to these retailers may increase as a percentage of our total sales. At December 31, 2002, Wal-Mart (including Sam’s Club) accounted for approximately 33% of our accounts receivable and Toys “R” Us accounted for approximately 30% of our accounts receivable. If any of these retailers experience significant financial difficulty in the future or otherwise fail to satisfy their accounts payable, our allowance for doubtful accounts receivable could be insufficient. If any of these retailers reduce their purchases from us, change the terms on which we conduct business with them or experience a future downturn in their business, our business and operating results could be harmed. 10-Q at 21.

Our business depends on three retailers that together accounted for approximately 69% of our net sales in 2002, and our dependence upon a small group of retailers may increase. Wal-Mart (including Sam’s Club), Toys “R” Us and Target accounted in the aggregate for approximately 69% of our net sales in 2002. We expect that a small number of large retailers will continue to account for a significant majority of our sales and that our sales to these retailers may increase as a percentage of our total sales. At December 31, 2002, Wal-Mart (including Sam’s Club) accounted for approximately 33% of our accounts receivable and Toys “R” Us accounted for approximately 30% of our accounts receivable. If any of these retailers experience significant financial difficulty in the future or otherwise fail to satisfy their accounts payable, our allowance for doubtful accounts receivable could be insufficient. If any of these retailers reduce their purchases from us, change the terms on which we conduct business with them or experience a future downturn in their business, our business and operating results could be harmed. 10-Q at 22.

Our business depends on three retailers that together accounted for approximately 68% of our net sales in 2003, and our dependence upon a small group of retailers may increase. Wal-Mart (including Sam’s Club), Toys “R” Us and Target accounted in the aggregate for approximately 68% of our net sales in 2003. We expect that a small number of large retailers will continue to account for a significant majority of our sales and that our sales to these retailers may increase as a percentage of our total sales. At December 31, 2002, Wal-Mart (including Sam’s Club) accounted for approximately 33% of our accounts receivable and Toys “R” Us accounted for approximately 30% of our accounts receivable. If any of these retailers experience significant financial difficulty in the future or otherwise fail to satisfy their accounts payable, our allowance for doubtful accounts receivable could be insufficient. If any of these retailers reduce their purchases from us, change the terms on which we conduct business with them or experience a future downturn in their business, our business and operating results could be harmed. 10-Q at 37.


5/7/04

1Q04 10-Q 8/6/04

2Q04 10-Q

3/28/05 FY04 10-K

Our business depends on three retailers that together accounted for approximately 68% of our net sales in 2003, and our dependence upon a small group of retailers may increase. Wal-Mart (including Sam’s Club), Toys “R” Us and Target accounted in the aggregate for approximately 68% of our net sales in 2003. We expect that a small number of large retailers will continue to account for a significant majority of our sales and that our sales to these retailers may increase as a percentage of our total sales. At December 31, 2002, Wal-Mart (including Sam’s Club) accounted for approximately 33% of our accounts receivable and Toys “R” Us accounted for approximately 30% of our accounts receivable. If any of these retailers experience significant financial difficulty in the future or otherwise fail to satisfy their accounts payable, our allowance for doubtful accounts receivable could be insufficient. If any of these retailers reduce their purchases from us, change the term on which we conduct business with them or experience a future downturn in their business, our business and operating results could be harmed. 10-Q at 20.

Our business depends on three retailers that together accounted for approximately 68% of our net sales in 2003, and our dependence upon a small group of retailers may increase. Wal-Mart (including Sam’s Club), Toys “R” Us and Target accounted in the aggregate for approximately 68% of our net sales in 2003. We expect that a small number of large retailers will continue to account for a significant majority of our sales and that our sales to these retailers may increase as a percentage of our total sales. At December 31, 2003, Wal-Mart (including Sam’s Club) accounted for approximately 35% of our accounts receivable, Toys “R” Us accounted for approximately 26% of our accounts receivable and Target accounted for approximately 12% of our accounts receivable. If any of these retailers experience significant financial difficulty in the future or otherwise fails to satisfy their accounts payable, our allowance for doubtful accounts receivable could be insufficient. If any of these retailers reduce their purchases from us, change the terms on which we conduct business with them or experience a future downturn in their business, our business and operating results could be harmed. 10-Q at 27.

Our business depends on three retailers that together accounted for approximately 64% of our net sales in 2004, and 86% of the U.S. Consumer segment sales, and our dependence upon a small group of retailers may increase. Wal-Mart (including Sam’s Club), Toys “R” Us and Target accounted in the aggregate for approximately 64% of our net sales in 2004. In 2004, sales to Wal-Mart (including Sam’s Club), Toys “R” Us and Target accounted for approximately 28%, 23% and 13%, respectively, of our consolidated net sales. We expect that a small number of large retailers will continue to account for a significant majority of our sales and that our sales to these retailers may increase as a percentage of our total sales. In addition, if any of these retailers experience significant financial difficulty in the future or otherwise fails to satisfy their accounts payable, our allowance for doubtful accounts receivable could be insufficient. For example, at December 31, 2004, Wal-Mart (including Sam’s Club) accounted for approximately 30% of our accounts receivable, Toys “R” Us accounted for approximately 32% of our accounts receivable and Target accounted for approximately 14% of our accounts receivable. If any of these retailers reduce their purchases from us, change the terms on which we conduct business with them or experience a future downturn in their business, our business and operating results could be harmed. 10-K at 50.

T:\CasesSF\LeapFrog\NonPldgs\LeapFrog Dep 3 Retailers chart.doc


Ex. G

LEAPFROG: 10-Q & 10-K STATEMENTS Agreements with Retailers

8/11/03

2Q03 10-Q 11/10/03

3Q03 10-Q 3/10/04

FY03 10-K We do not have long-term agreements with our retailers and changes in our relationships with retailers could significantly harm our business and operating results. We do not have long-term agreements with any our retailers. As a result, agreements with respect to pricing, shelf space, cooperative advertising or special promotions, among other things, are subject to periodic negotiation with each retailer. Retailers make no binding long-term commitments to us regarding purchase volumes and make all purchases by delivering one-time purchase orders. If the number of our products increases as we have planned or the roll out of versions of our Learning Center shelf displays in selected retail stores proceeds as we anticipate, we will require more retail shelf space to display our various products. Any retailer could reduce its overall purchases of our products, reduce the number and variety of our products that it carries and the shelf space allotted for our products, decide not to incorporate versions of our Learning Center shelf displays in its stores or otherwise materially change the terms of our current relationship at any time. Any such change could significantly harm our business and operating results. 10-Q at 21.

We do not have long-term agreements with our retailers and changes in our relationships with retailers could significantly harm our business and operating results. We do not have long-term agreements with any of our retailers. As a result, agreements with respect to pricing, shelf space, cooperative advertising or special promotions, among other things, are subject to periodic negotiation with each retailer. Retailers make no binding long-term commitments to us regarding purchase volumes and make all purchases by delivering one-time purchase orders. If the number of our products increases as we have planned or the roll out of versions of our Learning Center shelf displays in selected retail stores proceeds as we anticipate, we will require more retail shelf space to display our various products. Any retailer could reduce its overall purchases of our products, reduce the number and variety of our products that it carries and the shelf space allotted for our products, decide not to incorporate versions of our Learning Center shelf displays in its stores or otherwise materially change the terms of our current relationship at any time. Any such change could significantly harm our business and operating results. 10-Q at 22.

We do not have long-term agreements with our retailers and changes in our relationships with retailers could significantly harm our business and operating results. We do not have long-term agreements with any of our retailers. As a result, agreements with respect to pricing, shelf space, cooperative advertising or special promotions, among other things, are subject to periodic negotiation with each retailer. Retailers make no binding long-term commitments to us regarding purchase volumes and make all purchases by delivering one-time purchase orders. If the number of our products increases as we have planned or the roll out of versions of our Learning Center shelf displays in selected retail stores proceeds as we anticipate, we will require more retail shelf space to display our various products. Any retailer could reduce its overall purchases of our products, reduce the number and variety of our products that it carries and the shelf space allotted for our products, decide not to incorporate versions of our Learning Center shelf displays in its stores or otherwise materially change the terms of our current relationship at any time. Any such change could significantly harm our business and operating results. 10-K at 37-38.


5/7/04

1Q04 10-Q 8/6/04

2Q04 10-Q

3/28/05 FY04 10-K



We do not have long-term agreements with our retailers and changes in our relationships with retailers could significantly harm our business and operating results. We do not have long-term agreements with any of our retailers. As a result, agreements with respect to pricing, shelf space, cooperative advertising or special promotions, among other things, are subject to periodic negotiation with each retailer. Retailers make no binding long-term commitments to us regarding purchase volumes and make all purchases by delivering one-time purchase orders. If the number of our products increases as we have planned or the roll out of versions of our Learning Center shelf displays in selected retail stores proceeds as we anticipate, we will require more retail shelf space to display our various products. Any retailer could reduce its overall purchases of our products, reduce the number and variety of our products that it carries and the shelf space allotted for our products, decide not to incorporate versions of our Learning Center shelf displays in its stores or otherwise materially change the terms of our current relationship at any time. Any such change could significantly harm our business and operating results. 10-K at 50.

T:\CasesSF\LeapFrog\NonPldgs\LeapFrog Agt with Retailers chart.doc


Ex. H

LEAPFROG: 10-Q & 10-K STATEMENTS Seasonality

8/11/03

2Q03 10-Q 11/10/03

3Q03 10-Q 3/10/04

FY03 10-K Our business is seasonal, and therefore our annual operating results will depend, in large part, on sales relating to the brief holiday season. Sales of consumer electronics and toy products in the retail channel are highly seasonal, causing the substantial majority of our sales to U.S. retailers to occur during the third and fourth quarters. In 2002, approximately 81% of our total net sales occurred during this period. This percentage of total sales may increase as retailers become more efficient in their control of inventory levels through just-in-time inventory management systems. Generally, retailers time their orders so that suppliers like us will fill the orders closer to the time of purchase by consumers, thereby reducing their need to maintain larger on-hand inventories throughout the year to meet demand. While these techniques reduce retailers’ investments in their inventory, they increase pressure on suppliers to fill orders promptly and shift a significant portion of inventory risk and carrying costs to suppliers like us. The logistics of supplying more product within shorter time periods will increase the risk that we fail to meet tight shipping schedules, which could damage our relationships with retailers, increase our shipping costs or cause sales opportunities to be delayed or lost. The seasonal pattern of sales in the retail channel requires significant use of our working capital to manufacture and carry inventory in anticipation of the holiday season, as well as early and accurate forecasting of holiday sales. Failure to predict accurately and respond appropriately to consumer demand on a timely basis to meet seasonal fluctuations, or any disruption of consumer buying habits during this key period, would harm our business and operating results. 10-Q at 19-20.

Our business is seasonal, and therefore our annual operating results will depend, in large part, on sales relating to the brief holiday season. Sales of consumer electronics and toy products in the retail channel are highly seasonal, causing the substantial majority of our sales to U.S. retailers to occur during the third and fourth quarters. In 2002, approximately 81% of our total net sales occurred during this period. This percentage of total sales may increase as retailers become more efficient in their control of inventory levels through just-in-time inventory management systems. Generally, retailers time their orders so that suppliers like us will fill the orders closer to the time of purchase by consumers, thereby reducing their need to maintain larger on-hand inventories throughout the year to meet demand. While these techniques reduce retailers’ investments in their inventory, they increase pressure on suppliers to fill orders promptly and shift a significant portion of inventory risk and carrying costs to suppliers like us. The logistics of supplying more product within shorter time periods will increase the risk that we fail to meet tight shipping schedules, which could damage our relationships with retailers, increase our shipping costs or cause sales opportunities to be delayed or lost. The seasonal pattern of sales in the retail channel requires significant use of our working capital to manufacture and carry inventory in anticipation of the holiday season, as well as early and accurate forecasting of holiday sales. Failure to predict accurately and respond appropriately to consumer demand on a timely basis to meet seasonal fluctuations, or any disruption of consumer buying habits during this key period, would harm our business and operating results. 10-Q at 20.

Our business is seasonal, and therefore our annual operating results depend, in large part, on sales relating to the brief holiday season. Sales of consumer electronics and toy products in the retail channel are highly seasonal, causing the substantial majority of our sales to U.S. retailers to occur during the third and fourth quarters. In 2003, approximately 79% of our total net sales occurred during this period. This percentage of total sales may increase as retailers become more efficient in their control of inventory levels through just-in-time inventory management systems. Generally, retailers time their orders so that suppliers like us will fill the orders closer to the time of purchase by consumers, thereby reducing their need to maintain larger on-hand inventories throughout the year to meet demand. While these techniques reduce retailers’ investments in their inventory, they increase pressure on suppliers to fill orders promptly and shift a significant portion of inventory risk and carrying costs to suppliers like us. The logistics of supplying more product within shorter time periods will increase the risk that we fail to meet tight shipping schedules, which could damage our relationships with retailers, increase our shipping costs or cause sales opportunities to be delayed or lost. For example, in the second half of 2003, one of our largest retail customers changed its order pattern to occur later in the holiday season, which we believe delayed a significant portion of our net sales to this customer from the third quarter of 2003 to the fourth quarter of 2003. The seasonal pattern of sales in the retail channel requires significant use of our working capital to manufacture and carry inventory in anticipation of the holiday season, as well as early and accurate forecasting of holiday sales. Failure to predict accurately and respond appropriately to consumer demand on a timely basis to meet seasonal fluctuations, or any disruption of consumer buying habits during this key period, would harm our business and operating results. 10-K at 36.


5/7/04

1Q04 10-Q 8/6/04

2Q04 10-Q

3/28/05 FY0 4 10-K

Our business is seasonal, and therefore our annual operating results depend, in large part, on sales relating to the brief holiday season. Sales of consumer electronics and toy products in the retail channel are highly seasonal, causing the substantial majority of our sales to U.S. retailers to occur during the third and fourth quarters. In 2003, approximately 79% of our total net sales occurred during this period. This percentage of total sales may increase as retailers become more efficient in their control of inventory levels through just-in-time inventory management systems. Generally, retailers time their orders so that suppliers like us will fill the orders closer to the time of purchase by consumers, thereby reducing their need to maintain larger on-hand inventories throughout the year to meet demand. While these techniques reduce retailers’ investments in their inventory, they increase pressure on suppliers to fill orders promptly and shift a significant portion of inventory risk and carrying costs to suppliers like us. The logistics of supplying more product within shorter time periods will increase the risk that we fail to meet tight shipping schedules, which could damage our relationships with retailers, increase our shipping costs or cause sales opportunities to be delayed or lost. For example, in the second half of 2003, one of our largest retail customers changed its order pattern to occur later in the holiday season, which we believe delayed a significant portion of our net sales to this customer from the third quarter of 2003 to the fourth quarter of 2003. The seasonal pattern of sales in the retail channel requires significant use of our working capital to manufacture and carry inventory in anticipation of the holiday season, as well as early and accurate forecasting of holiday sales. Failure to predict accurately and respond appropriately to consumer demand on a timely basis to meet seasonal fluctuations, or any disruption of consumer buying habits during this key period, would harm our business and operating results. 10-Q at 18-19.

Our business is seasonal, and therefore our annual operating results depend, in large part, on sales relating to the brief holiday season. Sales of consumer electronics and toy products in the retail channel are highly seasonal, causing the substantial majority of our sales to U.S. retailers to occur during the third and fourth quarters. In 2003, approximately 79% of our total net sales occurred during this period. This percentage of total sales may increase as retailers become more efficient in their control of inventory levels through just-in-time inventory management systems. Generally, retailers time their orders so that suppliers like us will fill the orders closer to the time of purchase by consumers, thereby reducing their need to maintain larger on-hand inventories throughout the year to meet demand. While these techniques reduce retailers’ investments in their inventory, they increase pressure on suppliers to fill orders promptly and shift a significant portion of inventory risk and carrying costs to suppliers like us. The logistics of supplying more products within shorter time periods will increase the risk that we fail to meet tight shipping schedules, which could damage our relationships with retailers, increase our shipping costs or cause sales opportunities to be delayed or lost. In addition, in the second half of 2003, one of our largest retail customers changed its order pattern to occur later in the holiday season, which we believe delayed a significant portion of our net sales to this customer from the third quarter of 2003 to the fourth quarter of 2003. The seasonal pattern of sales in the retail channel requires significant use of our working capital to manufacture and carry inventory in anticipation of the holiday season, as well as early and accurate forecasting of holiday sales. Failure to predict accurately and respond appropriately to consumer demand on a timely basis to meet seasonal fluctuations, or any disruption of consumer buying habits during this key period, would harm our business and operating results. 10-Q at 25.

Our business is seasonal, and therefore our annual operating results depend, in large part, on sales relating to the brief holiday season. Sales of consumer electronics and toy products in the retail channel are highly seasonal, causing the substantial majority of our sales to retailers to occur during the third and fourth quarters. In 2004, approximately 76% of our total net sales occurred during this period. This percentage of total sales may increase as retailers become more efficient in their control of inventory levels through just-in-time inventory management systems. Generally, retailers time their orders so that suppliers like us will fill the orders closer to the time of purchase by consumers, thereby reducing their need to maintain larger on-hand inventories throughout the year to meet demand. While these techniques reduce retailers’ investments in their inventory, they increase pressure on suppliers to fill orders promptly and shift a significant portion of inventory risk and carrying costs to suppliers like us. The logistics of supplying more products within shorter time periods will increase the risk that we fail to meet tight shipping schedules, which could damage our relationships with retailers, increase our shipping costs or cause sales opportunities to be delayed or lost. For example, in the second half of 2004, we had operational difficulties related to our new U.S. distribution center, which had an adverse impact on our 2004 financial results. The seasonal pattern of sales in the retail channel requires significant use of our working capital to manufacture and carry inventory in anticipation of the holiday season, as well as early and accurate forecasting of holiday sales. Failure to predict accurately and respond appropriately to consumer demand on a timely basis to meet seasonal fluctuations, or any disruption of consumer buying habits during this key period, would harm our business and operating results. 10-K at 46-47.

T:\CasesSF\LeapFrog\NonPldgs\LeapFrog Seasonality chart.doc


Ex. J

LEAPFROG: 10-Q & 10-K STATEMENTS Rapid Growth

8/11/03

2Q03 10-Q 11/10/03

3Q03 10-Q 3/10/04

FY03 10-K Our rapid growth has presented significant challenges to our management systems and resources, and we may experience difficulties managing our growth. Since the introduction of our first platform, we have grown rapidly, both domestically and internationally. Our net sales have grown from $71.9 million in 1999 to $531.8 million in 2002. During this period, the number of different products we offered at retail also increased significantly. At December 31, 1999, we had 85 employees and at December 31, 2002 we had 690 employees. In addition, we plan to hire a significant number of new employees in 2003. This expansion has presented, and continues to present, significant challenges for our management systems and resources. If we fail to develop and maintain management systems and resources sufficient to keep pace with our planned growth, our operating results could suffer. 10-Q at 24.

Our rapid growth has presented significant challenges to our management systems and resources, and we may experience difficulties managing our growth. Since the introduction of our first platform, we have grown rapidly, both domestically and internationally. Our net sales have grown from $71.9 million in 1999 to $531.8 million in 2002. During this period, the number of different products we offered at retail also increased significantly. At December 31, 1999, we had 85 employees and at December 31, 2002 we had 690 employees. In addition, we plan to hire a significant number of new employees in 2004. This expansion has presented, and continues to present, significant challenges for our management systems and resources. If we fail to develop and maintain management systems and resources sufficient to keep pace with our planned growth, our operating results could suffer. 10-Q at 25.

Our rapid growth has presented significant challenges to our management systems and resources, and we may experience difficulties managing our growth. Since 2001, we have grown rapidly, both domestically and internationally. Our net sales have grown from $314.2 million in 2001 to $680.0 million in 2003. During this period, the number of different products we offered at retail also increased significantly, and we have opened offices in Canada, France, Macau and Mexico. At December 31, 2001, we had 438 full-time employees and at December 31, 2003, we had 869 full-time employees. In addition, we plan to hire a significant number of new employees in 2004. We are upgrading existing and implementing new operational software systems, including supply chain management systems. Further, we are planning on consolidating multiple third party distribution warehouses into a single distribution warehouse to handle our needs. This expansion has presented, and continues to present, significant challenges for our management systems and resources. If we fail to develop and maintain management systems and resources sufficient to keep pace with our planned growth, our operating results could suffer. 10-K at 41.


5/7/04

1Q04 10-Q 8/6/04

2Q04 10-Q

3/28/05 FY04 10-K

Our rapid growth has presented significant challenges to our management systems and resources, and we may experience difficulties managing our growth. Since 2001, we have grown rapidly, both domestically and internationally. Our net sales have grown from $314.2 million in 2001 to $680.0 million in 2003. During this period, the number of different products we offered at retail also increased significantly, and we have opened offices in Canada, France, Macau and Mexico. At December 31, 2001, we had 438 full-time employees and at December 31, 2003, we had 869 full-time employees. In addition, we plan to hire a significant number of new employees in our Asia-based offices in 2004. We are upgrading existing and implementing new operational software systems, including supply chain management systems. Further, in mid-2004, we are planning on consolidating multiple third party distribution warehouses into a single distribution warehouse to handle our needs. This warehouse will be operated by a new third party logistics service provider. This expansion has presented, and continues to present, significant challenges for our management systems and resources. If we fail to develop and maintain management systems and resources sufficient to keep pace with our planned growth, our operating results could suffer. 10-Q at 24.

Our rapid growth has presented significant challenges to our management systems and resources, and we may experience difficulties managing our growth. Since 2001, we have grown rapidly, both domestically and internationally. Our net sales have grown from $314.2 million in 2001 to $680.0 million in 2003. During this period, the number of different products we offered at retail also increased significantly, and we have opened offices in Canada, France, Macau and Mexico. At December 31, 2001, we had 438 full-time employees and at December 31, 2003, we had 869 full-time employees. In addition, we plan to hire a significant number of new employees in our Asia-based offices in 2004. We are upgrading existing and implementing new operational software systems, including supply chain management systems. Further, in July 2004, we began consolidating multiple third party distribution warehouses into a single distribution warehouse to handle our needs. This warehouse is being operated by a new third party logistics service provider. This expansion has presented, and continues to present, significant challenges for our management systems and resources. If we fail to develop and maintain management systems and resources sufficient to keep pace with our planned growth, our operating results could suffer. 10-Q at 30.

Our rapid growth has presented significant challenges to our management systems and resources, particularly in our supply chain and information systems, and as a result we may experience difficulties managing our growth. We have grown rapidly, both domestically and internationally. Our net sales were $314.2 million in 2001 and $640.3 million in 2004. During this period, the number of different products we offered at retail also increased significantly, and we have opened offices in Canada, France, Macau and Mexico. At December 31, 2001, we had 438 full-time employees and at March 9, 2005, we had 889 full-time employees. We are upgrading existing and implementing new operational information systems, including supply chain management systems. Further, in July 2004, we began consolidating multiple third-party distribution warehouses into a single distribution warehouse to handle our needs, and this warehouse is being operated by a new third-party logistics service provider. During the second half of 2004, we had significant difficulties operating our management systems and the new consolidated distribution center during our peak shipping season. This expansion has presented, and continues to present, significant challenges for our management systems and resources and has resulted in a significant adverse impact on our operating and financial results. If we fail to improve and maintain management systems and resources sufficient to keep pace with our business needs, our operating results could continue to suffer. 10-K at 48.

T:\CasesSF\LeapFrog\NonPldgs\LeapFrog RapidGrowth chart.doc


Exhibit K

Ex. K

LEAPFROG: 10-Q & 10-K STATEMENTS Platforms

8/11/03

2Q03 10-Q 11/10/03

3Q03 10-Q 3/10/04

FY03 10-K We currently rely, and expect to continue to rely, on our LeapPad platform and related interactive books for a significant portion of our sales. Our LeapPad platform and related interactive books accounted for approximately 48% of our net sales in 2002. No other product line, together with its related software, accounted for more than approximately 10% of our net sales [in] 2002. A significant portion of our future sales will depend on the continued commercial success of our LeapPad platform and related interactive books. If the sales for our LeapPad platform are below expected sales or if sales of our LeapPad interactive books do not grow as we anticipate, sales of our other products may not be able to compensate for these shortfalls and our overall sales would suffer. 10-Q at 21.

We currently rely, and expect to continue to rely, on our LeapPad platform and related interactive books for a significant portion of our sales. Our LeapPad platform and related interactive books accounted for approximately 48% of our net sales in 2002. No other product line, together with its related software, accounted for more than approximately 10% of our net sales in 2002. A significant portion of our future sales will depend on the continued commercial success of our LeapPad platform and related interactive books. If the sales for our LeapPad platform are below expected sales or if sales of our LeapPad interactive books do not grow as we anticipate, sales of our other products may not be able to compensate for these shortfalls and our overall sales would suffer. 10-Q at 22.

We currently rely, and expect to continue to rely, on our LeapPad family of platforms and related interactive books for a significant portion of our sales. Our LeapPad, LeapPad Plus Writing and Quantum Pad platforms, each of which is based on our NearTouch technology, together with interactive books related to those platforms that are generally compatible with any of those platforms, accounted for an aggregate of approximately 47% of our net sales in 2003. Our My First LeapPad platform and My First LeapPad interactive books accounted for an aggregate of approximately 12% of our net sales in 2003. No other product line, together with any related software, accounted for more than approximately 10% of our net sales in 2003. A significant portion of our future sales will depend on the continued commercial success of our LeapPad, LeapPad Plus Writing, Quantum Pad platforms and compatible interactive books, and our My First LeapPad platforms and related interactive books. If the sales for our LeapPad, LeapPad Plus Writing, Quantum Pad and My First LeapPad platforms are below expected sales or if sales of their related interactive books do not grow as we anticipate, sales of our other products may not be able to compensate for these shortfalls and our overall sales would suffer. 10-K at 37.


5/7/04

1Q04 10-Q 8/6/04

2Q04 10-Q

3/28/05 FY04 10-K

We currently rely, and expect to continue to rely, on our LeapPad family of platforms and related interactive books for a significant portion of our sales. Our LeapPad, LeapPad Plus Writing and Quantum Pad platforms, each of which is based on our NearTouch technology, together with interactive books related to those platforms that are generally compatible with any of those platforms, accounted for an aggregate of approximately 47% of our net sales in 2003. Our My First LeapPad platform and My First LeapPad interactive books accounted for an aggregate of approximately 12% of our net sales in 2003. No other product line, together with any related software, accounted for more than approximately 10% of our net sales in 2003. A significant portion of our future sales will depend on the continued commercial success of our LeapPad, LeapPad Plus Writing, Quantum Pad platforms and compatible interactive books, and our My First LeapPad platforms and related interactive books. If the sales for our LeapPad, LeapPad Plus Writing, Quantum Pad and My First LeapPad platforms are below expected sales or if sales of their related interactive books do not grow as we anticipate, sales of our other products may not be able to compensate for these shortfalls and our overall sales would suffer. 10-Q at 20.

We currently rely, and expect to continue to rely, on our LeapPad family of platforms and related interactive books for a significant portion of our sales. Our Classic LeapPad, LeapPad Plus Writing and Quantum Pad platforms, each of which is based on our NearTouch technology, together with interactive books related to those platforms that are generally compatible with any of those platforms, accounted for an aggregate of approximately 47% of our net sales in 2003. Our My First LeapPad platform and My First LeapPad interactive books accounted for an aggregate of approximately 12% of our net sales in 2003. No other product line, together with any related software, accounted for more than approximately 10% of our net sales in 2003. A significant portion of our future sales will depend on the continued commercial success of our Classic LeapPad, LeapPad Plus Writing, Quantum Pad platforms and compatible interactive books, and our My First LeapPad platforms and related interactive books. If the sales for our Classic LeapPad, LeapPad Plus Writing, Quantum Pad and My First LeapPad platforms are below expected sales or if sales of their related interactive books do not grow as we anticipate, sales of our other products may not be able to compensate for these shortfalls and our overall sales would suffer. 10-Q at 27.

We currently rely, and expect to continue to rely, on our LeapPad family of platforms and related interactive books for a significant portion of our sales. Our Classic LeapPad, LeapPad Plus Writing and Quantum LeapPad platforms, each of which is based on our NearTouch technology, together with interactive books related to those platforms that are generally compatible with any of those platforms, accounted for an aggregate of approximately 37% of our net sales in 2004. Our My First LeapPad platform and My First LeapPad interactive books accounted for an aggregate of approximately 9% of our net sales in 2004, and our Leapster learning system and its interactive software accounted for an aggregate of approximately 16% of our net sales in 2004. No other product line, together with any related software, accounted for more than approximately 10% of our net sales through 2004. A significant portion of our future sales will depend on the continued commercial success of our Classic LeapPad, LeapPad Plus Writing, Quantum LeapPad platforms and compatible interactive books, our My First LeapPad platforms and related interactive books, and our Leapster learning system and related interactive software. If the sales for our Classic LeapPad, LeapPad Plus Writing, Quantum LeapPad and My First LeapPad platforms and our Leapster learning system are below expected sales or if sales of their related interactive books do not grow as we anticipate, sales of our other products may not be able to compensate for these shortfalls and our overall sales would suffer. 10-K at 49.

T:\CasesSF\LeapFrog\NonPldgs\LeapFrog Platforms chart.doc
