In re Diamond Foods, Inc., Securities Litigation 11-CV-05386

Case3:11-cv-05386-WHA Document124 Filed07/30/12 Page1 of 209

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John F. Harnes (admitted pro hac vice) Gregory E. Keller (admitted pro hac vice) 1350 Broadway, Suite 908 New York, New York 10018 Tel: (917) 595-4600 [email protected] [email protected]

Robert W. Killorin (admitted pro hac vice) Meryl W. Roper (admitted pro hac vice) Ze’eva Kushner Banks (admitted pro hac vice) CHITWOOD HARLEY HARNES LLP 2300 Promenade II 1230 Peachtree Street, N.E. Atlanta, Georgia 30309 Tel: (404) 873-3900 Fax: (404) 876-4476 [email protected] [email protected] [email protected]

Richard M. Heimann (State Bar No. 63607) Joy A. Kruse (State Bar No. 142799) LIEFF CABRASER HEIMANN & BERNSTEIN LLP 275 Battery Street, 29th Floor San Francisco, California 94111- 3339 Tel: (415) 956-1000 Fax: (415) 956-1008 [email protected] [email protected]

Attorneys for Lead Plaintiff Mississippi Public Local Counsel for Lead Plaintiff Employees’ Retirement System Mississippi Public Employees’ Retirement

System

UNITED STATES DISTRICT COURT

NORTHERN DISTRICT OF CALIFORNIA

SAN FRANCISCO DIVISION

Case No.: 11-cv-05386-WHA IN RE DIAMOND FOODS, INC., SECURITIES LITIGATION

CONSOLIDATED COMPLAINT

CLASS ACTION

This Document Relates to: DEMAND FOR JURY TRIAL

All Actions

Consolidated Complaint No. 11-CV-05386-WHA

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TABLE OF CONTENTS

I. NATURE OF THE ACTION .................................................................................... 1

II. JURISDICTION AND VENUE ................................................................................ 2

III. THE PARTIES .......................................................................................................... 3

A. THE LEAD PLAINTIFF ............................................................................... 3

B. THE DEFENDANTS .................................................................................... 3

IV. CLASS ACTION ALLEGATIONS ........................................................................... 6

V. SUBSTANTIVE ALLEGATIONS – OVERVIEW OF SCHEME .......................... 8

A. BACKGROUND...........................................................................................8

B. DIAMOND’S DEALINGS WITH ITS WALNUT GROWERS .................. 12

C. THE PROPOSED PRINGLES TRANSACTION ......................................... 13

D. DIAMOND ENGAGES IN FRAUD ............................................................ 16

1. The Fall 2009 Crop .............................................................................. 16

2. The Fall 2010 Crop .............................................................................. 20

VI. DEFENDANT DIAMOND AND THE INDIVIDUAL DEFENDANTS’ FALSE AND MISLEADING STATEMENTS ........................................................ 27

A. FISCAL YEAR 2010 YEAR END RESULTS ............................................ 28

1. Form 8-K for the Fourth Quarter and 2010 Fiscal YearResults ...................................................................................... 28

2. Earnings Conference Call for Fourth Quarter and 2010 Fiscal Year Results ............................................................................ 29

3. Fiscal Year 2010 Financial Results on Form 10-K ........................... 31

4. News Articles Relating to Diamond’s Financial Results .................. 32

B. FIRST QUARTER OF FISCAL YEAR 2011 (AUGUST 2010 – OCTOBER2010) .......................................................................................... 33

1. Form 8-K for the First Quarter of Fiscal Year 2011 ......................... 34

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2. Earnings Conference Call Regarding First Quarter of Fiscal Year 2011 Financial Results ................................................... 34

3. First Quarter Fiscal Year 2011 Financial Results onForm 10-Q .................................................................................... 35

C. SECOND FISCAL QUARTER OF 2011 (NOVEMBER 2010– JANUARY2011) .......................................................................................... 36

1. Form 8-K for the Second Quarter Fiscal Year 2011 ......................... 37

2. Earnings Conference Call for Second Quarter Fiscal Year2011 .......................................................................................... 38

3. Second Quarter 2011 Financial Results on Form 10-Q ..................... 40

D. FORM 8-K ATTACHING INVESTOR PRESENTATION ......................... 42

E. FORM 8-K REGARDING MERGER AGREEMENT ................................. 43

F. THIRD FISCAL QUARTER OF 2011 (FEBRUARY 2011 – APRIL2011) ................................................................................................. 46

1. Form 8-K for the Third Quarter Fiscal Year 2011 ............................ 46

2. Earnings Conference Call for the Third Quarter FiscalYear 2011 ................................................................................ 48

3. Third Quarter 2011 Financial Results on Form 10-Q ....................... 49

G. FORM 8-K ATTACHING JUNE 2011 INVESTOR PRESENTATION......................................................................................... 51

H. DIAMOND UPDATES INVESTORS CONCERNING THE PRINGLES MERGER DURING THIS PERIOD ................................ 52

I. FORM 8-K ATTACHING SEPTEMBER 2011 INVESTOR PRESENTATION ......................................................................................... 54

J. FISCAL YEAR 2011 YEAR END RESULTS ............................................. 56

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Form 8-K for the Fourth Quarter and 2011 Fiscal YearResults ....................................................................................... 56

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Earnings Conference Call for Fourth Quarter and 2011 Fiscal Year Results ................................................................... 57

3. Fiscal Year 2011 Financial Results on Form 10-K ........................... 58

ii Consolidated Complaint No. 11-CV-05386-WHA

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K. TRUTH BEGINS TO EMERGE, BUT DIAMOND DENIES ALLEGATIONS........................................................................................... 60

L. NOVEMBER 1, 2011 8-K AND VARIOUS NEWS ARTICLES FROM NOVEMBER 2011 ....................................................... 63

M. NOVEMBER 28, 2011 8-K AND NOVEMBER 29, 2011 NEWS ARTICLE...................................................................................................... 73

N. DECEMBER 9, 2011 NEWS ARTICLES .................................................... 77

O. DECEMBER 12, 2011 8-K AND NEWS ARTICLES FROM DECEMBER 12 AND 13, 2011 .................................................................... 78

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DECEMBER 15, 2011 8-K AND DECEMBER 18 NEWSARTICLE .......................................................................................... 83

Q COMMON STATEMENTS ISSUED THROUGHOUT THE CLASS PERIOD...................................................................................86

1. Sarbanes-Oxley Certifications ........................................................... 87

2. Statements Regarding Internal Controls ............................................ 89

R. THE TRUTH EMERGES ............................................................................. 94

VII. DIAMOND AND THE INDIVIDUAL DEFENDANTS’ VIOLATIONS OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (“GAAP”) .......... 100

A. DIAMOND’S RESPONSIBILITIES REGARDING FINANCIAL REPORTING AND INTERNAL CONTROLS OVER FINANCIAL REPORTING.........................................................................102

B. DIAMOND IMPROPERLY ACCOUNTED FOR THE FALL 2009 CROP........................................................................................................... 103

1. Timing of Delivery and Payment Schedule for Crops ....................... 103

2. The Method by Which Diamond Engaged in Accounting Manipulation During Fiscal Year 2010 ............................................. 107

C. THE ACCOUNTING MANIPULATIONS CONTINUE AND GROW DURING FISCAL YEAR 2011 .................................................................... 109

D. DIAMOND’S FINANCIAL STATEMENT DISCLOSURES WERE FALSE AND MISLEADING ....................................................................... 113

Consolidated Complaint No. 11-CV-05386-WHA iii

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E. DIAMOND’S ADDITIONAL GAAP AND SEC RULES VIOLATIONS INCLUDED IN ITS CLASS PERIOD FINANCIAL STATEMENTS............................................................................................. 116

F. DIAMOND’S STATEMENTS REGARDING INTERNAL CONTROLS OVER FINANCIAL REPORTING WERE MATERIALLY FALSE AND MISLEADING WHEN MADE ................... 117

VIII. DELOITTE VIOLATED GENERALLY ACCEPTED AUDITING STANDARDS AND THE FEDERAL SECURITIES LAWS .................................. 119

A. DELOITTE’S RESPONSIBILITIES AND FUNCTIONS AS AN INDEPENDENT AUDITOR ........................................................................ 122

B. DELOITTE WAS AWARE OF THE ACCOUNTING MANIPULATIONS IN FISCAL YEAR 2010 BUT FAILED TO FULFILL ITS RESPONSIBILITIES AS AN INDEPENDENT AUDITOR..................................................................................................... 127

1. Deloitte Knew, or was Deliberately Reckless in Disregarding, the Improper Valuation of Inventory and Payable to Growers During Fiscal Year 2010 ................................................................... 127

2. Deloitte’s Audit for Fiscal Year 2010 Identified $20 Million in Grower Payments Improperly Recorded in Fiscal Year 2011 ..... . 128

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Deloitte Improperly Issued an Unqualified Audit Opinion for FiscalYear 2010 ........................................................................... 131

C. DELOITTE WAS AWARE OF THE ACCOUNTING MANIPULATIONS IN FISCAL YEAR 2011 BUT FAILED TO FULFILL ITS RESPONSIBILITIES AS AN INDEPENDENT AUDITOR..................................................................................................... 133

1. First through Third Fiscal Quarterly Reviews ................................... 133

2. Fiscal Year 2011 Audit ...................................................................... 136

D. DELOITTE FAILED TO FULFILL ITS RESPONSIBILITIES AND FUNCTIONS AS DIAMOND’S INDEPENDENT AUDITOR ................... 138

1. Deloitte Failed to Exercise Due Professional Care and Skepticism......................................................................................... 138

2. Deloitte Intentionally Ignored Numerous Red Flags Establishing That Its Audits Violated GAAS and That Diamond’s Financial Statements Violated GAAP ............................ 139

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Consolidated Complaint No. 11-CV-05386-WHA iv

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3. Deloitte Properly Failed to Plan and Perform Adequate Audit Procedures on Diamond’s Financial Statements for Fiscal Years 2010 and 2011 .............................................................. 144

4. Deloitte Failed to Obtain Adequate Knowledge of Diamond’s Business as Required by GAAS ..................................... 145

5. Deloitte Failed Properly to Consider the Risk of Fraud at Diamond as Required by GAAS ....................................................... 146

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Deloitte Failed to Uncover or Investigate Possible Illegal Acts at Diamond as Required by GAAS ................................ 149

7. Deloitte Failed to Properly Consider Diamond’s Lack of Internal Controls as Required by GAAS ........................................... 150

8. Deloitte Failed to Obtain Sufficient Competent Evidential Matter to Support Its Unqualified Audit Opinions as Requiredby GAAS ............................................................................ 153

9. Deloitte Failed to Evaluate Appropriately the Adequacy of Diamond’s Financial Statement Disclosures as Required byGAAS ........................................................................................... 160

10. Deloitte Had Broad and Unfettered Access to Diamond’s Accounting Records and Information ............................................... 160

E. DELOITTE’S FALSE AND MISLEADING STATEMENTS DURING THE CLASS PERIOD .................................................................. 161

1. 2010 and 2011 Fiscal Years End ....................................................... 161

2. Deloitte Fraudulently Represented to Investors that It Conducted Its Audits and Issued Audit Opinions in Accordance with GAAS .................................................................... 165

3. Deloitte Failed to Modify its Previously Issued Unqualified Audit Opinions for Fiscal Years 2010 and 2011 ............................... 167

4. Deloitte’s Other Violations During the Class Period ........................ 168

F. DELOITTE’S MOTIVES TO COMMIT SECURITIES FRAUD ............... 170

IX. ADDITIONAL SCIENTER ALLEGATIONS ......................................................... 172

A. THE INDIVIDUAL DEFENDANTS MADE THE DECISIONS ATISSUE ...................................................................................................... 173

Consolidated Complaint No. 11-CV-05386-WHA v

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B. THE INDIVIDUAL DEFENDANTS RECEIVED REPORTS

ATTENDED MEETINGS, AND IMPROPERLY MANIPULATED THE COMPANY TO ATTEMPT A MULTI-BILLION DOLLAR MERGER WITH PRINGLES ....................... 173

C. THE INDIVIDUAL DEFENDANTS RECEIVED ENORMOUS BONUSES.....................................................................................................179

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DIAMOND’S INCONSISTENT AND CONTRADICTORY EFFORTS TO EXPLAIN THE FRAUD ESTABLISH SCIENTER ............ 181

E. DIAMOND’S REPEATED ATTEMPTS TO DENY AND COVER UP THE FRAUD ESTABLISH SCIENTER ................................................ 182

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THE MAGNITUDE AND LACK OF COMPLEXITY OF THE FRAUD EVIDENCES SCIENTER .............................................................. 183

G. CORPORATE SCIENTER ........................................................................... 183

X. PRESUMPTION OF RELIANCE: FRAUD ON THE MARKET DOCTRINE........................................................................................................... 183

XI. LOSS CAUSATION ................................................................................................. 185

XII. NO SAFE HARBOR ................................................................................................. 190

CLAIMS FOR RELIEF ......................................................................................................... 190

COUNT I (Violations of Section 10(b) of the Exchange Act and Rule 10b-5 Promulgated Thereunder Against Diamond and the Individual Defendants) ....................... 191

COUNT II (Violations of Section 10(b) of the Exchange Act and Rule 10b-5 Promulgated Thereunder Against Deloitte) ........................................................................... 194

COUNT III (Violations of Section 20(a) of the Exchange Act Against the IndividualDefendants) ..........................................................................................................198

PRAYER FOR RELIEF ........................................................................................................ 199

JURY TRIAL DEMANDED ................................................................................................ 199

Consolidated Complaint No. 11-CV-05386-WHA vi

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By and through their undersigned counsel, Lead Plaintiff Mississippi Public

2 Employees’ Retirement System (“Mississippi PERS” or “Lead Plaintiff”) alleges the

3 following against Defendants Diamond Foods, Inc. (“Diamond” or the “Company”), Michael

4 J. Mendes (“Mendes”), Steven M. Neil (“Neil”) (Mendes and Neil are collectively referred to

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6 herein as “Individual Defendants”), and Deloitte & Touche LLP (“Deloitte”) upon personal

7 knowledge of those allegations concerning Lead Plaintiff and, as to all other matters, upon

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the investigation of counsel, which included, without limitation: (a) review and analysis of

9 public filings made by Diamond and other related parties and non-parties with the Securities

10 and Exchange Commission (“SEC”); (b) review and analysis of press releases and other

11 publications disseminated by certain of the Defendants and other related non-parties; (c)

12 review of news articles and postings on Diamond’s website concerning the Company’s

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14 public statements; (d) review of other publicly available information concerning Diamond,

15 the other Defendants, and related non-parties; (e) consultation with experts; and (f)

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interviews with factual sources, including individuals formerly employed by Diamond.

17 I. NATURE OF THE ACTION

18 1. This is a securities class action brought on behalf of all persons and entities who

19 purchased publicly traded securities of Diamond during the period from October 5, 2010

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21 through and including February 8, 2012 (the “Class Period”) and were damaged thereby (the

22 “Class”).

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2. This action seeks to recover damages proximately caused by a fraud perpetrated

24 by all Defendants. During the relevant period, Diamond and the Individual Defendants

25 knowingly understated the costs of the walnuts it purchased in order to inflate artificially the

26 price of the Company’s common stock. Such common stock was the principal currency

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1 pursuant by which it sought to acquire a snack-foods manufacturer, an acquisition that was

2 essential to the growth of the Company and which would double its size.

3 3. Diamond and the Individual Defendants sought to conceal this understatement by

4 issuing two payments, one after the close of Fiscal Year 2010, and the other after the close of

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6 Fiscal Year 2011, which they falsely stated were not payment for the prior year’s crop, but

7 were for other purposes and chargeable to the following year.

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4. Notwithstanding the exceptional and extraordinary nature of these payments,

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Deloitte certified Diamond’s financial statements, which were materially misstated as a result

10 of the fraud at issue. As a result of the material and knowing misstatements, particularized

11 more fully below, investors during the Class Period were injured.

12 II. JURISDICTION AND VENUE

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14 5. The claims asserted herein arise under and pursuant to Sections 10(b) and 20(a) of

15 the Securities Exchange Act of 1934 (the “Exchange Act”), (15 U.S.C. §78j(b), 78n(a) and

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78t(a)), and Rules 10b-5 promulgated thereunder (17 C.F.R. §240.10b-5).

17 6. This Court has jurisdiction over the subject matter of this action pursuant to §27

18 of the Exchange Act (15 U.S.C. §78aa) and 28 U.S.C. §1331.

19 7. Venue is proper in this District pursuant to §27 of the Exchange Act, 15 U.S.C.

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21 §78aa and 28 U.S.C. §1391(b). Diamond’s principal place of business is the Northern

22 District of California, Individual Defendants Mendes and Neil reside in the Northern District

23 of California, and Deloitte’s audit took place in the District. Many of the acts and

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transactions alleged herein, including the preparation and dissemination of materially false

25 and misleading information, occurred in substantial part in this District.

26 8. In connection with the acts, conduct and other wrongs alleged in this complaint,

27 Diamond, the Individual Defendants and Deloitte, directly or indirectly, used the means and


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instrumentalities of interstate commerce, including but not limited to, the United States

2 mails, interstate telephone communications, and the facilities of the national securities

3 exchange.

4 III. THE PARTIES

5 A. THE LEAD PLAINTIFF

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7 9. Lead Plaintiff Mississippi PERS is a public retirement system that manages

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billions of dollars of assets for the benefit of the current and retired public employees of the

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State of Mississippi. Mississippi PERS provides benefits to more than 86,022 retirees and

10 beneficiaries, and future benefits to more than 162,392 current and former public employees.

11 As set forth in its certification previously filed herein, Mississippi PERS purchased Diamond

12 common shares on domestic stock exchanges during the Class Period at artificially inflated

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14 prices and suffered damages as a result of the violations of the federal securities laws alleged

15 herein.

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10. By Order dated March 20, 2012 [ECF No. 98], Mississippi PERS was appointed

17 to be Lead Plaintiff in this action.

18 B. THE DEFENDANTS

19 11. Defendant Diamond is a Delaware Corporation with its principal executive offices

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21 located at 600 Montgomery Street, 13th Floor, San Francisco, California 94111. According

22 to its public filings, Diamond engages in processing, marketing, and distributing snack

23 products, including roasted, glazed and flavored nuts, trail mixes, dried fruit, seeds,

24 microwave popcorn products, and potato and tortilla chips under the Emerald, Pop Secret,

25 and Kettle brands. The Company also offers culinary, in-shell, and ingredient nuts under the

26 Diamond of California brand name. It markets its culinary nuts to individuals who prepare

27 meals or baked goods at home, and ingredient nuts to food processors, restaurants, bakeries,

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1 and food service companies and their suppliers. The Company sells its products directly to

2 national grocery, mass merchandiser, clubs, convenience stores, and drug store chains in the

3 United States, the United Kingdom, Germany, the Netherlands, Spain, Canada, South Korea,

4 Turkey, China, and Japan. During the Class Period, the Company’s common stock traded on

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6 the NASDAQ under the ticker symbol “DMND.”

7 12. Defendant Mendes served as the President, Chief Executive Officer (“CEO”), and

8 Chairman of Diamond from January 2010 to February 8, 2012, when he was placed on

9 administrative leave. He resigned from the Board of Directors of the Company effective

10 March 7, 2012. Mendes joined Diamond in 1991 and served as the Company’s Vice

11 President of International Sales and Marketing prior to being appointed as Diamond’s

12 President and CEO in 1997, and had been on Diamond’s Board of Directors since 2005.

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14 13. Defendant Neil served as Executive Vice President, Chief Financial and

15 Administrative Officer of Diamond from March 2008 to February 8, 2012, when he was

16 placed on administrative leave. He resigned from the Board of Directors of the Company

17 effective March 7, 2012. Neil had served as a Director of Diamond since 2005.

18 14. Defendants Mendes and Neil will be collectively referred to herein as the

19 “Individual Defendants.”

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21 15. Defendant Deloitte is an independent registered public accounting firm that was

22 engaged to examine and report upon financial statements of Diamond during the Class

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Period. Deloitte served as Diamond’s independent auditor and principal accounting firm

24 prior to and during the Class Period. In fact, Deloitte has served as Diamond’s independent

25 auditor for every year since Diamond became a publicly traded company.

26 16. By virtue of their high level positions with Diamond, the Individual Defendants

27 directly participated in the management of the Company, were directly involved in the day-

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to-day operations of the Company at the highest levels, and were privy to confidential

2 proprietary information concerning the Company and its business, operations, growth,

3 financial statements, and financial condition. They were privy to such undisclosed

4 information from internal corporate documents, conversations and connections with other

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6 corporate officers and employees, attendance at management and Board of Directors

7 meetings and committees thereof and via reports and other information provided to them in

8 connection therewith.

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17. By reason of their positions as officers and/or directors of the Company, and

10 because of their ability to control the business and corporate affairs of the Company, the

11 Individual Defendants owed Diamond and its shareholders the fiduciary obligations of good

12 faith, trust, loyalty and due care. Additionally, the Individual Defendants were required to

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14 use their utmost ability to control and manage the Company in a fair, just, honest, and

15 equitable manner. The Individual Defendants, as officers and/or directors of the Company,

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had a duty to disseminate complete, accurate and truthful information about Diamond’s

17 financial condition, earnings and expenses, and promptly correct any public statements

18 issued by Diamond that had become false and misleading. The Individual Defendants were

19 also involved in the drafting, producing, reviewing and/or dissemination of the false and

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21 misleading statements alleged herein. Thus, the Individual Defendants knew or were

22 deliberately reckless in not knowing of the adverse material facts which rendered the

23 statements alleged herein false and misleading.

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18. Diamond’s public filings evidence the key roles played by the Individual

25 Defendants in the Company’s operations, public statements and financial reporting. As

26 indicated more specifically herein, Mendes and/or Neil signed all documents Diamond filed

27 with the SEC, including but not limited to annual reports on Form 10-K, quarterly reports on

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Form 10-Q and press releases appended to Forms 8-K. Additionally, the Individual

2 Defendants, as management of the Company were “responsible for establishing and

3 maintaining adequate internal control over financial reporting, as such term is defined in Rule

4 13a-15(f) under the Securities Exchange Act of 1934, as amended.” See Diamond FY 2011

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6 Form 10-K, Item 9(a).

7 19. The Individual Defendants were also controlling persons of Diamond within the

8 meaning of Section 20(a) of the Exchange Act. By virtue of their positions with the

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Company, the Individual Defendants possessed the power and ultimate authority to control,

10 and did control, the contents of Diamond’s quarterly reports, annual reports, press releases,

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

12 investors. Because of their positions with the Company, and their unrestricted access to

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14 material non-public information available to them but not to the public, the Individual

15 Defendants knew, or were deliberately reckless in not knowing, that the public statements by

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Diamond specified herein were materially false and misleading and had the ability and

17 opportunity to prevent their issuance or cause them to be corrected.

18 IV. CLASS ACTION ALLEGATIONS

19 20. Lead Plaintiff Mississippi PERS brings this action as a class action pursuant to

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21 Federal Rules of Civil Procedure 23(a) and 23(b)(3) on behalf of a class consisting of all

22 persons and entities who purchased Diamond securities from October 5, 2010 through and

23 including February 8, 2012 and who were damaged thereby. Excluded from the Class are

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Diamond, the Individual Defendants, Deloitte, the officers and directors of the Company and

25 Deloitte, at all relevant times, members of their immediate families and their legal

26 representatives, heirs, successors or assigns and any entity in which Diamond, the Individual

27 Defendants and/or Deloitte have or had a controlling interest.

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1 21

Because Diamond had millions of shares of securities outstanding during the

2 Class Period, and because the Company’s securities were actively traded, members of the

3 Class are so numerous that joinder of all members is impracticable. As of August 31 2011,

4 Diamond had 22,011,196 shares of common stock outstanding. Throughout the Class Period,

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6 Diamond’s securities were actively traded on the NASDAQ. While the exact number of

7 Class members can only be ascertained through appropriate discovery, Lead Plaintiff

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believes that Class members number at least in the thousands and that they are

9 geographically dispersed.

10 22. Lead Plaintiff’s claims are typical of the claims of the members of the Class as all

11 members of the Class are similarly affected by Diamond’s, the Individual Defendants’ and

12 Deloitte’s wrongful conduct in violation of federal law that is complained of herein.

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14 23. Lead Plaintiff will fairly and adequately represent and protect the interests of the

15 members of the Class. Lead Plaintiff has retained competent counsel experienced in class

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and securities litigation and intends to prosecute this action vigorously. Lead Plaintiff has no

17 interests antagonistic to, or in conflict with, those of the Class.

18 24. Common questions of law and fact exist to all members of the Class and

19 predominate over any questions solely affecting individual members of the Class. Among

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21 the questions of law and fact common to the Class are the following:

22 A. whether the federal securities laws were violated by Diamond, the Individual

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Defendants and Deloitte’s acts and omissions as alleged herein;

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B. whether statements made by Diamond, the Individual Defendants and Deloitte

25 to the investing public during the Class Period misrepresented material facts about the

26 business, financial performance, and management of Diamond; and

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C. to what extent the members of the Class have sustained damages and the

2 proper measure of damages.

3 25. A class action is superior to all other available methods for the fair and efficient

4 adjudication of this controversy since joinder of all members is impracticable. Furthermore,

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6 because damages suffered by the individual Class members may be relatively small, the

7 expense and burden of individual litigation makes it impracticable for the Class members

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individually to redress the wrongs done to them. There will be no difficulty in the

9 management of this action as a class action.

10 V. SUBSTANTIVE ALLEGATIONS – OVERVIEW OF SCHEME

11 A. BACKGROUND

12 26. According to its Form 10-K for the Fiscal Year 2011, filed with the Securities and

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14 Exchange Commission, Diamond was incorporated in 2005. Prior thereto, it had been a

15 member-owned California agricultural cooperative association, owned by the growers

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themselves. In 2005, Diamond converted from a cooperative association to a Delaware

17 corporation, completing a public offering that year (the “Conversion”). According to

18 Confidential Witness (“CW”) 1, whose family has been selling walnuts to Diamond since

19 1979, the impetus behind the conversion was Mendes, who persuaded the larger growers,

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21 who possessed the most voting power, to approve the proposed transaction.

22 27. The Form S-1 issued by Diamond in connection with the Conversion stated that,

23 at the time, Diamond was a company specializing in processing, marketing, and distributing

24 culinary, snack, in-shell, and ingredient nuts. Net revenue for fiscal 2004, the last full fiscal

25 year before the Conversion, was reported to be approximately $360 million, with net income

26 reported to be approximately $178 million. For the same year, Defendant Mendes’ total

27 compensation, excluding relocation costs, was approximately $1.1 million. Neil’s

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predecessor as chief financial officer was paid approximately $340,000. Diamond’s Annual

Bonus Incentives “were determined by both a corporate financial objective, representing 60%

of bonus potential, and individual objectives for each named executive officer, representing

40% of bonus potential.” See Amended FY2011 10-K. Consequently, the Annual Bonus

Incentive received by Mendes and Neil was directly related to the non-GAAP earnings per

share achieved by the Company. 1

28. Pursuant to the Conversion, over eight million shares were issued to the members

of the cooperative, i.e. , the growers, and six million shares were sold to the public. As a

consequence, Diamond’s management grew less accountable to the growers.

29. Almost immediately after the Conversion, at Mendes’ direction, the Company

began a series of acquisitions, leveraging the Company by borrowing cash to complete the

acquisitions. In May 2006, Diamond acquired certain assets of Harmony Foods Corporation

for $18 million in cash and the assumption of certain defined liabilities. In September 2008,

Diamond acquired Pop Secret, a brand of microwave popcorn products, from General Mills

for $190 million in cash. In 2010, Diamond acquired Kettle Foods, a premium potato chip

company in the United States and the United Kingdom, from Lion Capital LLP for $615

million in cash.

30. The money utilized to effect the acquisitions came from two sources. The initial

Pop Secret acquisition was financed by a $250 million line of credit; the Kettle Brand

acquisition was financed by a new $600 million line of credit. In five years, Diamond had

1 For Fiscal Year 2011, “the target level at which 100% of the target corporate financial objective portion of the bonus would be earned [was set] at $2.45 non-GAAP earnings per share,” while the threshold level was $2.30 non-GAAP earnings per share. Thus, when Diamond reported $2.61 in non-GAAP earnings per share for Fiscal Year 2011, the corporate financial performance objective element of the bonus incentives was paid at 164%.

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transformed from a relatively debt-free company specializing in nuts, to a highly leveraged,

2 diversified, snack food company.

3 31. By Fiscal Year 2010, Diamond reported a significant rise in revenue, but a

4 significant decrease in net income. For fiscal 2010, revenue was reported to be $680.162

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6 million, but net income was reported to be only $26.21 million, a fraction of what it had been

7 prior to the conversion. Nevertheless, Mendes’ salary grew exponentially. By Fiscal Year

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2009, Mendes’ total compensation had more than tripled, to $3.8 million. By Fiscal Year

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2011, it had nearly doubled again, and was reported to be approximately $7.3 million. The

10 compensation paid to Neil, who became CFO in March 2008, was approximately eight times

11 that of his predecessor chief financial officer at the time of the Conversion.

12 32. At all relevant times, Mendes was Chief Executive Officer of Diamond.

13

14 According to one former Diamond employee, a financial accountant with the Company from

15 2005 through November 2010 who attended weekly meetings with Mendes, CW 2, Mendes

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was a master of detail. Mendes possessed “an incredible knowledge of the business. You

17 could talk to Michael about anything” from nut sourcing, to the prices being paid by

18 Diamond’s international and retailer customers. Mendes’ knowledge of what was happening

19 at Diamond was “the best of anyone in the Company.” CW 2 further explained “[m]y

20

21 experiences with him [Mendes] were about excruciating detail.” CW 2 was surprised that

22 someone at Mendes’ position in the Company had “such a thirst for detail.” For example, for

23 most of the CW 2’s time at Diamond, Mendes interviewed every new employee hired at the

24 Company. “Michael gave you the impression he was involved in everything and he made

25 that known.” Mendes even knew when CW 2 went to lunch every day, even though he had

26 no reason to have that information. “Michael was not a delegator. About grower payments,

27 in my opinion, Michael knew every detail.” As another former employee CW 3, an assistant


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treasurer from March 1999 through May 2011, confirmed: “Mendes had to approve

2 everything at the end of the day.”

3 33. CW 4, who worked in the human resources department from May 2011 through

4 June 2012 and knew Mendes, stated that Mendes made every decision at Diamond, from

5

6 “what soda to stock in the vending machine to whom to hire.” “It was Michael’s company,

7 for good or bad.” CW 4 confirmed that information was kept within a tight circle. No one in

8 the Company beneath Mendes, Neil, or Senior Vice President of Supply Chain Steve

9

Zaffarano (“Zaffarano”) even obtained access to profit and loss statements broken out by

10 Diamond.

11 34. From 2008 onwards, Neil served as Chief Financial Officer of Diamond. Neil

12 was at all times involved in decisions affecting quarterly results. According to CW 3, he

13

14 personally was involved in several meetings with Neil (together with Senior Vice President

15 and Controller Jim Tropp (“Tropp”), and Vice President and Treasurer Bob Phillips) where

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accounting decisions were discussed in the context of the impact the decision would have on

17 the Diamond share price. On numerous occasions, they decided to delay recognizing an

18 expense or to accelerate a payment to make their earnings look better and improve their share

19 price.

20

21 35. Similarly, according to CW 5, a financial accountant from April 2008 through

22 May 2011, at the conclusion of each month, the Company prepared an Excel spreadsheet

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detailing the monthly financial results. Then Senior Director Debra Donaghy (“Donaghy”),

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Tropp and Neil reviewed those results and “scrubbed them.” This process was particularly

25 rigorous at quarter end, and Neil was involved in the quarter end review, also sometimes

26 known as the “pre-audit” review. Neil had meetings at quarter end, and instructed employees

27 “to be aggressive.” Those meetings were right before Diamond met with its auditors.

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Attendees included Neil, Tropp, the finance department, cost accounting, and sometimes

2 people from treasury. “Neil definitely knew what was going on. He was involved in pre-

3 audit reviews. He was in charge of treasury, too.”

4 B. DIAMOND’S DEALINGS WITH ITS WALNUT GROWERS

5

6 36. At all relevant times, Diamond purchased walnuts from its growers, pursuant to

7 exclusive long-term contracts, many of which dated from when the Company was still a

8 cooperative. Pursuant to such contracts, Diamond unilaterally set the price at which it would

9 purchase walnuts (although required to act in good faith), but agreed to purchase the entirety

10 of each grower’s crop. Growers recognized that Diamond historically paid slightly below the

11 going rate for walnuts, but the trade-off was the security and predictability of Diamond’s

12 commitment.

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14 37

Pursuant to payment schedules that were published at the beginning of each fiscal

15 year, Diamond made three payments to growers for their crop. The first payment was made

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shortly after the growers delivered their crop to Diamond, in late September or October of

17 each year. The second payment was made in February of the following year, at which time

18 Diamond determined, and announced, what it would pay for the year’s crop.

19 38. The final payment was made in August, after the close of the fiscal year which,

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21 for Diamond, occurred on July 31. Because Diamond took delivery of the walnut crop

22 before determining what price it ultimately would pay, the Company made an estimate of the

23 nuts’ cost in its interim financial statements, beginning with the first quarter 10-Q, and such

24 estimate is reflected in various balance sheet entries such as inventories and payable to

25 growers, as well as income entries for each quarter such as costs of sales, gross margin,

26 income from operations, income before income taxes, and net income.

27

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39. The determination what to pay growers was made by a close circle of senior

2 executives, including principally Mendes and Neil. Not only was this information not

3 disclosed publicly, but it was not even circulated internally. According to CW 3, information

4 about grower payments and accounting for those payments was maintained within a very

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6 small circle of people including Tropp, Neil, Mendes, and Senior Vice President of Grower

7 Accounting, Eric Heidman, Mendes’ brother-in-law. According to CW 2, who managed

8 every price list for every product: “[g]rower payments were held very close to the vest.” It

9 appeared strange to CW 2 that he was never informed what Diamond was paying growers

10 because he was responsible for setting prices in the price list. In order to perform that task, it

11 was helpful to know the input costs that went into the products. CW 2 “knew pricing for

12 everything but in-shell nut price for Diamond Foods.” That secrecy made it hard to run his

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14 business. “It felt weird when I could get everything on all other business.” CW 2 asked

15 Zaffarano for the grower payment or in-shell walnut pricing information, but Zaffarano

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refused to provide it to him.

17 C. THE PROPOSED PRINGLES TRANSACTION

18 40. According to a Form S-4, filed by Diamond with the SEC on June 20, 2011,

19 Diamond’s management had long viewed the Pringles brand as a potentially attractive

20

21 addition to the Diamond business and an excellent strategic fit within Diamond’s portfolio of

22 brands. Over the years prior thereto, Diamond’s management had discussed with the

23

Company’s Board of Directors an ongoing interest in the Pringles business.

24

41. In April 2009, a Diamond executive met with an executive of Procter & Gamble

25 (“P&G”), which owned Pringles, to discuss Diamond’s interest in that company and the

26 possibility of such acquisition. Subsequently, in October 2009, the Diamond executive sent

27 an e-mail message to his counterpart at P&G indicating that Diamond would be interested in

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1 evaluating a transaction involving the Pringles business if P&G were to decide to divest the

2 business. Diamond did not propose a specific transaction at this time, and the parties did not

3 have any substantive discussion concerning a potential transaction involving the Pringles

4 business.

5

6 42. From the outset, it was readily apparent to Diamond executives that the Company

7 did not possess the financial wherewithal to effect an acquisition utilizing cash, and that in

8 any transaction, Diamond stock would have to be a significant component of the

9 consideration to be paid to P&G. In December 2009, according to the S-4, representatives of

10 The Blackstone Group L.P. (“Blackstone”) visited Diamond to discuss, among other things, a

11 Reverse Morris Trust acquisition structure. Pursuant to a Reverse Morris Trust, a company

12 spins off all of the shares of a subsidiary to its shareholders. The subsidiary then merges with

13

14 a third party in a tax-free transaction whereby shareholders of the subsidiary own more than

15 50 percent of the combined entity. No specific transaction was discussed, but the specific

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structure for a potential Pringles acquisition was established. The principal consideration of

17 every offer made by Diamond to P&G to acquire Pringles was Diamond common stock. As

18 a consequence, at all relevant times, it was essential for Mendes and Neil to maintain the

19 market price of Diamond’s common stock.

20

21 43. According to Diamond’s Form S-1, in February 2010, P&G’s board authorized

22 that company’s management to explore a potential divestiture of the Pringles business. P&G

23 management retained financial advisors to assist in these efforts and initiated a non-exclusive

24 process designed to identify potential strategic alternatives for the Pringles business.

25 44. In March 2010, Mendes spoke with Diamond’s investment advisors, including

26 Blackstone, about a potential acquisition of Pringles using a Reverse Morris Trust structure.

27 Thereafter, in April, P&G contacted Neil, informing him that P&G would be commencing a


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1 non-exclusive process to explore possible strategic alternatives for the Pringles business.

2 Shortly thereafter, the parties executed a confidentiality agreement.

3 45. On May 12, 2010, Diamond submitted a non-binding indication of interest to

4 acquire the Pringles business for a total purchase price in the range of $1.96 billion to $2.18

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6 billion, consisting of a mix of Diamond common stock and a cash payment to P&G, which

7 would be funded by debt to be incurred by Pringles. The Diamond common stock to be

8

issued represented between 57.0% to 60.7% of the estimated outstanding equity of the

9 combined company based on the price of Diamond common stock at the time. The proposal

10 was structured as a Reverse Morris Trust business combination involving the spin- or split-

11 off of Pringles by P&G and its merger with Diamond.

12 46. Over the summer of 2010, Diamond submitted two higher bids to acquire

13

14 Pringles. Both offers were rejected by P&G; P&G’s advisors indicated that P&G was

15 seeking a higher value for the Pringles business and greater certainty with respect to the

16 value of Diamond common stock in the event the trading prices for such stock declined

17 between announcement of a transaction and closing. Finally, in August, P&G informed

18 Diamond’s investment advisors that it had elected to terminate the Pringles strategic

19 assessment process.

20

21 47. Nonetheless, Mendes continued to pursue a Pringles transaction. However, P&G

22 informed Diamond’s investment advisor that P&G would only be interested in considering a

23 transaction involving the Pringles business at a valuation of at least $2.35 billion and with

24 greater value protections than Diamond had indicated. Mendes made a fourth proposal on

25 behalf of Diamond; it too was rejected, and on September 24, 2010, during a meeting of the

26 Diamond Board, Mendes informed the Board that the Pringles discussions had terminated.

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48. According to Diamond’s S-4, however, in early February 2011, Diamond’s

2 management team and its investment advisor discussed the possibility of re-engaging with

3 P&G given that the trading price of Diamond common stock had appreciated since the

4 parties’ discussions in 2010. On February 14, 2011, a representative of Diamond’s

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6 investment advisor spoke with P&G about the possibility of reopening discussions between

7 Diamond and P&G.

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49. Negotiations resumed and continued over the next few months. Finally, on April

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5, 2011, the parties executed the transaction agreements and financing commitment papers,

10 and, on the same day, publicly announced the transaction, pursuant to which Diamond would

11 exchange 29.1 million shares of Diamond common stock, worth $1.5 billion, representing

12 57% of the combined company, and pay $850 million in cash, to be financed by loans to

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14 Pringles. There was a cash collar on the transaction, so that if the price of Diamond common

15 stock dropped, Diamond would to increase the cash component up to $1.05 billion, and if it

16 rose, Diamond could reduce the cash component to only $700 million. As a consequence,

17 the market price of Diamond common stock had a direct impact on the acquisition price, and

18 upon the financial wherewithal of Diamond.

19 50. From the moment the Pringles acquisition was announced, it materially impacted

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21 investors’ valuation of Diamond. Investors no longer valued Diamond as a stand-alone

22 company, but, looking forward, valued Diamond as a combined entity with Pringles.

23

51. As a consequence, the likelihood of the Pringles merger was material to

24 purchasers and sellers of Diamond securities and any information that materially affected the

25 likelihood of the Pringles merger occurring, or the price to be paid, was material.

26 D. DIAMOND ENGAGES IN FRAUD

27 1. The Fall 2009 Crop

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52. As reflected in the narrative set forth above, which is based entirely upon

2 admissions by the Company in public filings, from the outset of negotiations between

3 Diamond and P&G, the parties contemplated that the common stock of Diamond would

4 constitute the principal currency in any acquisition of Pringles by Diamond. Beginning as

5

6 early as October 2009, Mendes and Neil determined to manipulate the Company’s financial

7 statements, and, in particular, the recorded cost of walnuts, in order to meet analyst

8 expectations and boost the price of Diamond common stock to be utilized in the Pringles

9 merger.

10 53. According to CW 5, it was “common” for Diamond accounting to change its

11 “commodity costs” without any business justification for doing so. The explanations offered

12 by CW 5’s superiors, Donaghy or Tropp, were typically “‘Oh, we missed this expense’ or

13

14 ‘that expense is actually for next quarter.’” The “biggest was always walnut costs.” The cost

15 of buying walnuts from growers was also known internally as “commodity costs.” It was

16 common in preparing month end and quarter end financials for Donaghy or Tropp to ask CW

17 5 what the earnings looked like “if we dropped commodity prices half a penny or one penny”

18 per pound. CW 5 would make the change and run the numbers and then report back. If the

19 results did not yield earnings numbers that either met or exceeded analysts’ expectations, he

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21 was directed to drop the commodity costs by another small increment. Because Diamond

22 was buying a hundred million pounds of walnuts or more, it did not take a big drop in costs

23 per pound to result in big changes to earnings. When the changes to commodity costs

24 achieved the desired earnings numbers, Tropp or Donaghy told CW 5 “okay, we’ll do that.”

25 CW 5 or a co-worker then entered a journal entry for the commodity cost change. There was

26 never an explanation for why the reduced commodity costs were appropriate from a business

27 standpoint. It appeared to be all about achieving a desired earnings result.

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54. As CW 5 explained, Diamond may have projected at the start of the year that its

2 walnut costs were going to be 80 cents per pound in the coming year. But if Diamond was

3 running behind its earnings per share goals in the second quarter, then the price per pound

4 was reduced, for example to 78 cents, “to get to EPS goals.” It “seemed like every quarter

5

6 they dropped commodity costs. Jim [Tropp] and Debra [Donaghy] were aware of it.” CW 5

7 “ran the numbers over and over and the last thing was to lower commodity costs.” These

8 were accruals being made prior to the final payment to growers for walnuts. CW 5 said that

9 Donaghy and Heidman played a large role in determining how much Diamond paid its

10 growers for walnuts each year. CW 5 was not aware of any facts to suggest that the changes

11 he was directed to make to commodity cost accruals were related to changes in what

12 Diamond planned to actually pay its growers.

13

14 55. The result of changing the financials was significant to the Company’s bottom

15 line. In one quarter during Fiscal Year 2010, according to CW 5, that “took it from not being

16

profitable when I ran roll-ups first, and then all of a sudden we’re profitable.” Typically it

17 happened as follows: “Initially I ran profitability and we were losing money or not where we

18 want to be at. They [Donaghy, Tropp and Neil] looked through financials to see any big

19 ticket items they could shuffle into next quarter. Or if we were making too much money they

20

21 would push more costs in. Whenever we couldn’t hit our numbers, [or] if they needed extra

22 money, it was always commodity costs that got changed. It seemed like every quarter it was

23 the same dance. If it seemed like EPS (Earnings Per Share) was going to be a bit higher than

24 expected,” then Tropp, Donaghy and or Neil would tell him “this is a cost, this is a cost” to

25 increase expenses and lower profits to be closer to analysts’ expectations and leave more

26 room for profits the following quarter. Commodity costs w[ere] how they were able to beat


27

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their numbers.” The process was to look at all possible expenses and “scrub, scrub, scrub

through their numbers.” Were there “any accruals we could change?”

56. By the fourth quarter of Fiscal Year 2010, Diamond had materially understated its

commodity costs that it would be required to pay to its growers. If it paid them the required

amount, such payment would reveal the understatement of the prior quarters. Diamond came

up with a clumsy solution. It decided to designate part of its final payment for the Fall 2009

crop as something other than payment for the Fall 2009 walnut crop. The Company sent one

check to all Diamond growers, preceded by a letter, dated August 13, 2010, signed by

Mendes. The letter employed language that appears purposefully opaque. It did not suggest

that the payment was added payment for the prior year’s crop, nor did it suggest that it was

an advance payment for the following year’s crop. Instead, Mendes wrote:

The August payment will be sent by the end of the month and represents both the final payment on the 2009 crop and a continuity payment reflecting the value of the multi-year supply arrangement with our Diamond walnut growers.

See Ex. 1.

57. Although Mendes’ letter did not suggest that the “continuity” payment was an

advance for the Fall 2010 crop, it was treated as such by Diamond on its financial statements

and was reflected in the first quarter 10-Q for Fiscal Year 2011. Because the payment was

relatively small, it did not generate significant notice among growers.

58. According to one grower who provided walnuts to Diamond from 2007 until

2011, CW 6, although the 2008 crop price per pound received from Diamond was

competitive, for the 2009 crop, Diamond was paying less per pound than the market price

paid by other handlers. According to CW 6, “Diamond Foods was behind” for the 2009

crop. CW 6 believed at the time that the continuity payment was “a nice gesture” by

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Diamond to get them closer to market price. To CW 6, the continuity payment was for the

2 Fall 2009 crop, paid in August 2010. However, even with the continuity payment, Diamond

3 was “behind other handlers” in what it was paying per pound for the Fall 2009 crop.

4 According to another grower who provided walnuts from 2000 through the 2011 crop, CW 7,

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6 including the continuum payment, the price per pound CW 7 received from Diamond in 2010

7 for her 2009 walnuts was 79.95 cents per pound. The market price for 2009 walnuts was

8 about 85 cents.

9

59. Although the continuity payment was, in the words of CW 7, “subtle,” it was

10 sufficiently material to “catch the eye” of Deloitte. As discussed more fully below, Deloitte

11 determined to turn a blind eye to Diamond and the Individual Defendants’ misconduct.

12 2. The Fall 2010 Crop

13

14 60. With the negotiations over the Pringles merger breaking down in August 2010

15 over the value of Diamond stock offered as consideration for the merger, as well as over the

16

risk that Diamond stock might decline, the pressure upon Mendes and Neil to inflate

17 artificially the market price of Diamond common stock became even more acute.

18 61. Desperate to consummate the Pringles acquisition, Mendes and Neil caused

19 Diamond to understate its commodity costs throughout Fiscal Year 2011 to an even greater

20

21 degree than in Fiscal Year 2010. Making payments to growers at prices consistent with these

22 depressed estimates would have resulted in growers being paid prices well below the going

23 rate. Numerous growers recognized that the rates paid by Diamond for assorted varieties of

24 walnuts were significantly below the market price. One such grower, CW 1, had been doing

25 taxes for other growers who sold to buyers other than Diamond. In May 2011, he calculated

26 what growers were being paid, and recognized that “Diamond was $0.70 to $0.80 under

27 market” as of May 2011 for the Fall 2010 crop season. Diamond was “sitting at $0.60 [per

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1 pound] at that point.” CW 1 told all this to his grower representative Justin Bream. Bream

2 thanked CW 1 and told him “that its great information,” and he would relay it to his superiors

3 at Diamond.

4 62. In July 2011, CW 1 began talking with Bream’s boss, Heidman. Heidman told

5

6 CW 1 that Diamond “was not going to get to $1.50,” meaning that he knew Diamond would

7 pay growers, including CW 1, less than $1.50 per pound for the Fall 2010 crop. But

8 Heidman stated that Diamond had not yet settled on the price that would be paid. Heidman

9 said that he would have more information on what Diamond was going to pay per pound in

10 August 2011.

11 63. In prior years, Diamond had always announced at the time of its February

12 payment what the final payment would be. But in February 2010 and 2011, Diamond had

13

14 not determined the extent of its manipulations, and, as a consequence, could not inform

15 growers what the final payment would be.

16

64. Even as Mendes and Neil were desperate to show how financially strong

17 Diamond was, in reality it was having difficulty paying for its walnuts even at a reduced

18 price. According to CW 3, he learned from his daily forecasts in February or March 2011

19 that Diamond did not have sufficient cash to make its usual spring time payment to growers.

20

21 Heidman approached him to advise him how much money Diamond had to send to growers

22 for the February payment. CW 3 had a spreadsheet that calculated the cash cost to Diamond

23 based on the price per pound Diamond was paying for various varieties of walnuts. CW 3

24 plugged the payment information proposed by Heidman into his spreadsheet and the results

25 were clear. There was “no way we can make the grower payment.”

26

27

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1 65

CW 3 discussed with certain officers within Diamond, including Neil, Diamond’s

2 options. These officers told CW 3 that Diamond could not tap its line of credit, because they

3 believed, inter alia, doing so would attract negative attention from Wall Street.

4 66. Eventually, they determined to divide the February payment into two payments,

5

6 making an initial payment in February, and a subsequent payment in March, notwithstanding

7 that this was in violation of the contractually stipulated payment schedule. The

8

determination could not be implemented, however, without Mendes’ approval. Neil

9 informed CW 3 that he needed approval from Mendes first. After obtaining such approval,

10 the decision was then implemented.

11 67. At the end of Fiscal Year 2011, Diamond faced the same dilemma that it faced at

12 the end of Fiscal Year 2010. Having underestimated commodity costs throughout the year,

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14 Diamond could not pay a legitimate price for the Fall 2010 crop without revealing to what

15 degree its cost figures were understated. In this instance, however, the problem was even

16

more severe. Rather than being understated by $20 million, the cost figures for the Fall 2010

17 crop were understated by $60 million.

18 68. Diamond came up with a solution that was similar to that employed the prior year,

19 but which differed in several material respects. First, instead of sending just one check to

20

21 growers, and arbitrarily stating to the growers that the single check represented two distinct

22 payments, as it had done in 2010, Diamond sent two checks, one dated August 31, 2011, and

23 the other dated two days later, September 2, 2011, although the contractually stipulated

24 schedule called only for one payment. Even though Diamond informed growers that the

25 August 31 check represented the final payment for the Fall 2010 crop, tellingly, the receipt

26 that accompanied it, unlike the comparable receipts provided by Diamond every previous

27 year, did not bear the notation “Final Payment.”

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69. Second, Diamond came up with a new rationalization for the second payment. In

a letter to growers, Diamond labeled the payment a “momentum payment” rather than a

“continuity payment.” Making no effort to reconcile the purported purpose of the “continuity

payment” with that of the “momentum payment,” Diamond wrote on August 31, 2011:

Additionally, on September 2 nd we will mail a momentum payment designed to reflect the projected market environment prior to your delivery of the 2011. As you are aware, our branded walnut retail business spans two separate crop years. This payment conveys the anticipated value added by our branded walnut retail business during the transitional period prior to delivery and new crop availability. The momentum payment is independent of and incremental to your upcoming delivery payment

See Ex. 2.

70. As with the prior year’s “continuity” payment, the letter did not suggest that it

was added payment for the prior year’s crop, or an advance payment for the following year’s

crop, instead stating that the payment was for “the anticipated value added by our branded

walnut retail business.” Left unexplained was how the value of Diamond’s “branded retail

business” factored into a simple exchange of commodity for cash, why growers were being

compensated for value for which they had never been compensated previously or why, if the

value spanned more than one period, that particular period was selected in which to

compensate growers.

71. Diamond’s transparent attempt to disguise its final payment for the Fall 2010 crop

did not fool the growers. The August 31 check resulted in a payment that was so far below

market prices that it could not have been made in good faith. Indeed, even with the inclusion

of the “momentum” payment, the price paid to growers for the Fall 2010 crop was still

significantly below market. As one grower, whose family had been providing walnuts for

Diamond since the 1940s, CW 8 put it, it seemed like “accounting hocus pocus.” The

momentum payment was one lump payment amount with no breakout of what price he was

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1 getting for which varieties and grades. It was a “bunch of smoke and mirror business.” “It

2 was bad enough what they were doing already” with underpaying growers.

3 72. According to CW 7, the 2010 crop average payment was 59 cents a pound, not

4 counting the momentum payment. “That was about 38 or 40 cents less than market.” CW 7

5

6 grew both more valuable Huntley walnuts and less valuable Chico walnuts. CW 7 was

7 supposed to receive a final payment in August 2011, but instead “got a very small amount at

8 the end of August and then got the momentum payment in September 2011.” The August 31,

9

2011 payment was $10,000, but the receipt did not identify a price per pound for CW 7’s

10 varieties to arrive at the payment amount. Then on September 2, 2011, she received a lump

11 sum payment that, based on the pounds she harvested, amounted to about 20 cents a pound

12 on average. Even including the momentum payment in the Fall 2010 crop payment,

13

14 Diamond was still paying approximately 20 cents per pound less than market.

15 73. Another grower who provided walnuts to Diamond since 2005, CW 9, stated that

16 I when he first got this notice, he anticipated that the payment in August 2011 would be larger

17 than the momentum payment. At that time, the total of the payments from Diamond for the

18 2010 crop in the fall, February and March were far below what other growers had received

19 [$1.20 to $1.34 per pound] from other handlers. CW 9 anticipated that Diamond would make

20

21 a large payment in August to make up that difference. However, he only received a small

22 payment in August. The “momentum” payment was three times the amount of the so called

23

“final payment” that he received on August 31, 2011.

24

74. Another grower whose family had been providing walnuts to Diamond since

25 approximately the 1960s, CW 10, similarly stated that the price per pound Diamond paid to

26 CW 10 for his walnuts for the Fall 2010 crop was approximately $0.40 under market price,

27 even assuming that the momentum payment was included in the compensation paid in 2011.


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That year, CW 10 received $0.70 per pound for walnuts, when the market price was $1.10

per pound. CW 10 learned about the market prices based on conversations with his friends

who grew walnuts and sold to handlers other than Diamond. CW 10 received $20,000 for his

final 2010 crop payment in August 2011. The momentum payment he received in early

September 2011 was much larger, $68,000. There was no breakout attached to the

momentum payment, so there was no way for CW 10 to clearly calculate what that payment

equaled in terms of price per pound.

75. One grower, CW 1 noted that if the momentum payment applied to the Fall 2011

crop and not the Fall 2010 crop, he received $0.23 less per pound for the Fall 2010 crop, or

$0.67 per pound.

76. Disturbed by the disparity between what Diamond was purporting to pay its

growers for the Fall 2010 crop and what other companies were paying growers, several

Diamond growers contacted the Company to seek an explanation. CW 7 called a

representative at Grower Accounting at Diamond and spoke, upon information and belief, to

Diamond Grower Services Supervisor Jessica Dunlap. Dunlap said she had been receiving a

lot of calls from growers. She further said that the August 31, 2011 payment should have

been marked “Final Payment” but she could not explain why for the first time ever it was not.

77. In October 2011, CW 1 read an article quoting a Diamond stock analyst Thilo

Wrede who said the momentum payment was an advance against the Fall 2011 crop, and was

not attributable to the Fall 2010 crop. 2 CW 1 immediately called Heidman, who called CW 1

2 “Wrede said in a client note that concerns that Diamond’s September payment to nut growers might lower its 2012 earnings was unwarranted. Wrede said the September payment was not a one-time payment to quiet growers’ complaints about being underpaid for the 2010 harvest, but rather a prepayment for part of the 2011 harvest. The analyst said he expects the total cost for the 2011 crop to be the same as earlier expectations, leaving little reason for investors to worry.” http://www.businessweek.com/ap/financialnews/D9Q9ENBG0.htm

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1 back. Heidman was more forthcoming than Dunlap, telling CW 1 that the momentum

2 payment was for the Fall 2010 crop. CW 1 asked Heidman how the analyst got the

3 information that contradicted what Heidman was telling CW 1. Heidman said he was not

4 sure, but “it was just a numbers game, don’t worry about it.” Heidman told him that the

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6 money was just “budgeted” or “forecast” into 2011, even though it was applied to the 2010

7 crop. CW 1 asked Heidman three times whether the momentum payment was for the Fall

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2010 crop, in August, September and October 2011. Each time, Heidman confirmed that it

9 was for the Fall 2010 crop. “He was adamant that it was for the 2010 crop.” Heidman said

10 “don’t worry it is budgeted, don’t worry it is forecasted.”

11 78. Further belying Diamond’s public claim that the “momentum” payment was being

12 issued in connection with the Fall 2011 crop was the fact that Diamond made no attempt to

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14 recover the payments from growers who elected not to sell their Fall 2011 crop to the

15 Company. CW 1 refused to sell his whole Fall 2011 crop to Diamond. Despite the fact that

16 Diamond informed him that his refusal was in violation of his contract, the Company made

17 no attempt to recover the “momentum” payment purportedly made in connection with that

18 crop.

19 79. Similarly, CW 7 knew at least two growers who had already cancelled their

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21 contracts to sell walnuts to Diamond in Fall 2011, but still received the momentum payment.

22 A Diamond executive, Dan Newman, told those growers the payments were for 2010 and

23 that they could keep them even though they did not sell their 2011 crops to Diamond. No

24 one from Diamond has ever contacted these growers to request return of the momentum

25 payment.

26 80. On September 15, 2011, Diamond filed its Form 10-K for the Fiscal Year 2011.

27 The momentum payment was not reflected in the 2011 financial statements.


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1 81

As set forth in more detail below, the truth was revealed after the close of

2 business on February 8, 2012, when Diamond announced that the Company’s Audit

3 Committee “substantially completed its investigation of the Company’s accounting of certain

4 crop payments to walnut growers.” The Audit Committee concluded that $20 million of

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6 “continuity” payments made to growers in August 2010 and $60 million of “momentum”

7 payments made to growers in September 2011 were not properly accounted for in the correct

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fiscal years. The Audit Committee also identified at least one “material weakness in the

9

Company’s internal control over financial reporting.” As a result, Diamond announced that

10 its previously issued consolidated financial statements for the fiscal years ended July 31,

11 2010 and July 31, 2011, the accompanying reports of Diamond’s independent registered

12 public accounting firm, and the previously-issued unaudited condensed financial statements

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14 for the interim quarterly periods for the quarter ended July 31, 2010 and all quarterly

15 reporting periods within the fiscal year ended July 31, 2011 would have to be restated.

16 VI. DEFENDANT DIAMOND AND THE INDIVIDUAL DEFENDANTS’ FALSE AND MISLEADING STATEMENTS

17

18 82. From October 5, 2010 through and including February 8, 2012, in press releases,

19 conference calls, and in periodic filings with the SEC, the Company and Individual

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Defendants, as well as Deloitte, continuously made materially false and misleading

21 statements.

22 83. These materially false and misleading statements generally fall into four

23 categories: (a) false and misleading statements concerning Diamond’s financial condition,

24

25 including, but not limited to, inventory, payable to growers, cost of sales, gross margin

26 (profit), income from operations, income before income taxes, net income, diluted as well as

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basic earnings per share, earnings before interest, depreciation, taxes and amortization

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1

(“EBITDA”), and non-GAAP earnings per share; (b) false and misleading statements

2 concerning Diamond’s internal controls over financial reporting; (c) false and misleading

3 statements concerning the nature and purpose of the purported momentum and continuity

4 payments; and (d) false and misleading statements about the likelihood and timing of the

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6 Pringles merger.

7 A. FISCAL YEAR 2010 YEAR END RESULTS

8 84. On October 5, 2010, Diamond filed with the SEC a Form 8-K signed by Neil

9 containing financial results for the fourth fiscal quarter and Fiscal Year ending July 31, 2010

10 (the “FY2010 8-K”) and a Form 10-K signed by Mendes and Neil (the “FY2010 10-K”)

11 containing Diamond’s financial results for the Fiscal Year ended July 31, 2010 and the

12 interim quarters. Additionally, on October 5, 2010, the Company held a conference call,

13 which included Mendes and Neil, to report its fourth quarter and full-year fiscal 2010

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15 financial results.

16 1. Form 8-K for the Fourth Quarter and 2010 Fiscal Year Results

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85. The FY2010 8-K contained information concerning the Company’s financial

18 condition, including: (a) inventory for FY2010 of $143.405 million; (b) cost of sales for the

19 three months ended July 31, 2010 of $132.779 million and for FY2010 of $519.161 million;

20 (c) gross profit for the three months ended July 31, 2010 of $43.839 million, and for FY2010

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22 of $161.001 million; (d) income from operations for the three months ended July 31, 2010 of

23 $15.336 million, and for FY2010 of $52.23 million; (e) income before income taxes for the

24 three months ended July 31, 2010 of $9.228 million, and for FY2010 of $40.201 million; (f)

25 net income for the three months ended July 31, 2010 of $6.7 million and for FY2010 of

26 $26.2 million; (g) basic earnings per share for the three months ended July 31, 2010 of

27 $0.31, and for FY2010 of $1.40; (h) diluted earnings per share for the three months ended


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July 31, 2010 of $0.30 and for FY2010 of $1.36; (i) full year adjusted EBITDA of $84.91

million; and (j) non-GAAP EPS of $0.34.

86. The FY2010 8-K provided in pertinent part that:

For the quarter, gross profit as a percentage of net sales was 24.8 percent compared to 28.9 percent during the prior year’s quarter. The prior year’s quarter gross margin included a favorable 890 basis point estimate adjustment to commodity pricing and yield assumptions for prior quarters due to changes in the commodity markets last year that were not repeated in the current year’s quarter. On a sequence basis, gross margins improved from the third fiscal quarter to the fourth as a result of including a full three months of higher margin Kettle sales, along with the carryover benefit of culinary nut price increases taken late in the third fiscal quarter .

(Emphasis added).

87. When addressing the Company’s financial results, Mendes stated as follows: “We

successfully acquired and integrated Kettle Foods while driving strong organic growth in our

base business, delivering 52 percent earnings growth for the year . . .”

2. Earnings Conference Call for Fourth Quarter and 2010 Fiscal Year Results

88. On October 5, 2010, the Company, including Mendes and Neil, hosted an

earnings conference call with various securities analysts to discuss Diamond’s fourth fiscal

quarter and 2010 Fiscal Year results. During the opening remarks, Neil commented on the

Company’s financial results:

Looking at gross margins, fourth-quarter gross margin of 24.8% was a nice improvement over last year’s 20% on a comparable basis.

* * * *

For the year, we generated $85 million in EBITDA compared to $61 million during the prior year, and we anticipate $135 million to $140 million in 2011, so we continue our strong focus on cash generation from operations.

* * * *

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So overall, we reported non-GAAP EPS of $0.34 per share in the quarter with $0.03 generated by the lower effective tax rate for the year. On a full-year basis, non-GAAP earnings were $36.8 million, a 52% increase over 2009.

* * * *

It is important to note that although commodities account for a large portion of our cost structure, we have the ability to hedge and otherwise manage these input costs quite effectively, and if necessary pass on price increases due to the strong brand equity we have earned in the marketplace. As a result, when we look across the basket of input costs, including commodities and other packaging and ingredient materials, we think that cost inflation during fiscal 2011 will be very manageable and not nearly as severe as many of the other food companies who are exposed to grain-based price inflation.

89. Mendes also addressed the Company’s financial results:

So what we’re saying is that our gross margin, our operating margin has improved significantly.

Our operating margin year on year has improved 150 basis points from last year and has more than doubled since 2008. But that being said, our operating margin is still well below most of the CPG companies we would compare ourselves in terms of the quality of our branded product line. So we’ve got some room to go there to improve our intrinsic profitability. So we’re holding ourselves to a high standard that we need to grow and improve profitability, and we think we can do that without compromising our top line.

90. Also during the Q&A session, Mendes was asked directly about the walnut crop

and revenue:

Mitch Pinheiro, Janney Montgomery Scott: ... Typically your first quarter is larger than your second, at least in the last three years, and it’s going to be flipped this year. In terms of revenue, how does the later walnut crop affect those numbers and does it affect equally the earnings pattern?

Mendes: Yes, let me take a cut at that, Mitch. You’re right. There’s a later walnut crop this year, probably about two weeks later than normal. Last year was a little bit late but this year is quite a bit later. That’s one factor. The second thing is we're evaluating the optimal market mix for that non-retail walnut business.

We’re probably going to shift a little more away from some of the international bulk in-shell business to a higher proportion of shelled Walnut business to serve what I consider to be more the steady less commoditized market opportunity. Two things happen with that. One is, when you go more

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Consolidated Complaint No. 11-CV-05386-WHA - 30 -

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domestic versus international the product changes position at our Ford warehouse so that would be a Q2 sale versus Q1 sale. And then just the fundamental fact that the crop’s later and you can only process so much product per day, is just going to shift about 10 days worth of production to the next quarter. So I think that’s one factor.

I think there’s also the broad macro issue of Kettle is going to be a less seasonal business so that will have an influence. And then as far as on the earnings impact I would say that our basket of commodities going into the first quarter are going to be a little bit higher cost than our basket of commodities in the final three quarters, so that’s going to have a little factor influence on the earnings Q1 versus Q2.

91. In response to a further question about the delayed walnut crop, Mendes

responded in part: “I would say that we are pleased that our carry out inventory is lean going

out of last year because, obviously, with the crop being a record crop and then it being a little

bit later it’s going to put that much pressure on trying to effectively market that supply. It’s

going to be interesting.”

3. Fiscal Year 2010 Financial Results on Form 10-K

92. The FY2010 10-K contained materially false and misleading statements

concerning the Company’s financial condition, including the figures provided above in the

FY2010 8-K, with the exception of EBIDTA and non-GAAP EPS, as well as the liabilities

payable to growers of $35.755 million as of July 31, 2010.

93. The FY2010 10-K also contained the following quarterly financial information for

the year ended July 31, 2010: (a) gross profit for the first quarter of $45.491 million, for the

second quarter of $40.578 million, and for the third quarter of $31.093 million; (b) net

income for the first quarter of $14.93 million, for the second quarter of $8.814 million, and

for the third quarter of a loss of $4.273 million; (c) basic earnings per share for the first

quarter of $0.90, for the second quarter of $0.53, and for the third quarter of a loss of $0.22;

and (d) diluted earnings per share for the first quarter of $0.88, for the second quarter of

$0.52, and for the third quarter a loss of $0.22.

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94. The FY2010 10-K contained the following statements about the

Company’s accounting practices:

Critical Accounting Policies

* * * *

Inventories . All inventories are accounted for on a lower of cost (first-in, first-out) or market basis.

We have entered into long-term Walnut Purchase Agreements with growers, under which they deliver their entire walnut crop to us during the Fall harvest season and we determine the minimum price for this inventory by March 31, or later, of the following calendar year. This purchase price will be a price determined by us in good faith, taking into account market conditions, crop size, quality, and nut varieties, among other relevant factors. Since the ultimate price to be paid will be determined subsequent to receiving the walnut crop, we must make an estimate of price for interim financial statements. Those estimates may subsequently change and the effect of the change could be significant.

* * * *

Basis of Presentation

The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”). Certain prior period amounts have been reclassified to conform to the current period presentation.

4. News Articles Relating to Diamond’s Financial Results

95 On October 6, 2010, Just-Food issued an article entitled “US: Diamond lifts

earnings forecast for upcoming fiscal year” which discussed Diamond’s increase of its

forecast for the upcoming fiscal year following twelve months of record results. The article

I stated that Diamond’s net income had increased by 10% over the last year to $26.2 million.

The article quoted Mendes as explaining that “[w]e successfully acquired and integrated

Kettle Foods while driving strong organic growth in our base business, delivering 52%

earnings growth for the year ... For 2010, our snack sales grew 70% and are projected to

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1 exceed $540m this year, 25 times larger than when we went public in 2005.” However, the

2 article indicated that earnings per share were $1.36, down from $1.42 a year earlier.

3 96. On October 13, 2010, Investopedia Advisor issued an article entitled “Diamond

4 Foods Still Has Luster” by Greg Sushinsky which explained that the acquisition of Kettle

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6 Foods had helped smooth out the more seasonal California nut crop, which was still the heart

7 of Diamond’s business. Moreover, the article stated that “Diamond’s management has

8 navigated the company’s business journey expertly, and this should continue with the same

9

CEO in place. The stock has been noticed by the market in recent years, and the business

10 should be watched by long-term investors who want a good candidate for growth with

11 stability.”

12 97. Diamond and the Individual Defendants knew, or were deliberately reckless in

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14 disregarding, that the statements set forth above in Paragraphs 85 through 94 were materially

15 false and misleading when made because the financial statements failed to disclose and

16 properly account for the $20 million payments owed to growers and eventually made in

17 August 2010 that should have been recorded in Fiscal Year 2010 instead of Fiscal Year 2011

18 as the Company admitted on February 8, 2012. Thus, Diamond’s financial results relating to

19 costs of sales, inventory and payable to growers were understated, resulting in an

20

21 overstatement of gross profit, income and earnings. Further, all of these statements were

22 false because they did not disclose Diamond’s true financial condition. As a result of the

23

improper accounting, Diamond’s financial results will be restated.

24

B. FIRST QUARTER OF FISCAL YEAR 2011 (AUGUST 2010 –

25 OCTOBER 2010)

26 98. On December 8, 2010, Diamond filed with the SEC a Form 8-K signed by Neil

27 providing financial results for the first fiscal quarter ended October 31, 2010 (the “Q1

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1

FY2011 8-K”) and a Form 10-Q signed by Neil and certified as accurate by Neil and Mendes

2 containing Diamond’s financial results for the first fiscal quarter ended October 31, 2010

3 (the “Q1 FY2011 10-Q”). Additionally, on December 8, 2010, the Company, including

4 Mendes and Neil held a conference call to report its first quarter earnings for the 2011 Fiscal

5 Year.

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7 1. Form 8-K for the First Quarter of Fiscal Year 2011

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99. The Q1 FY2011 8-K contained information concerning the Company’s current

9

financial condition, including, for the three months ended October 31, 2010: (a) inventories

10 of $205.518 million; (b) cost of sales of $188.97 million; (c) gross profit of $63.596 million;

11 (d) income from operations of $27.525 million; (e) income before income taxes of $21.408

12 million; (f) non-GAAP EPS-diluted of $0.65; (g) basic earnings per share of $0.65; and (h)

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14 diluted earnings per share of $0.64.

15 100. The Q1 FY2011 8-K also provided that “[f]or the quarter, gross profit as a

16

percentage of net sales was 25.2 percent. ... Adjusted EBITDA grew 28 percent to $37.1

17 million.”

18 101. In addressing the Company’s financial results, Mendes stated as follows: “We

19 are pleased with the organic growth in our base retail business, which has been augmented

20

21 by the addition of Kettle . . . Our strong performance gives us the confidence to further

22 invest in our brands while increasing our sales and earnings guidance.”

23

2. Earnings Conference Call Regarding First Quarter of Fiscal Year 2011 Financial Results

24 102. On December 8, 2010, the Company, including Mendes and Neil, hosted an

25 earnings conference call with various securities analysts to discuss Diamond’s Q1 FY 2011

26 results. During the opening remarks, Mendes commented on the Company’s financial

27 results:


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We had strong revenue growth for the quarter and off to a good start for the 2011 fiscal year.

* * * *

Our EBITDA of $37 million for the quarter reflects strong cash flow generation of the business, even though we are making significant investments in new products and building a brand equity to position the company for future growth.

103. Neil also addressed the Company’s financial results in his prepared

remarks:

Gross margin in the quarter was 25.2%, in line with our expectations and approximating last year.

* * * *

We generated $37 million in EBITDA compared to $29 million during the prior year quarter, and we anticipate EBITDA to be $135-$140 million in 2011, so we continue our strong focus on cash generation from operations.

3. First Quarter Fiscal Year 2011 Financial Results on Form 10-Q

104. The Q1 FY2011 10-Q contained materially false and misleading statements

concerning the Company’s financial condition for the three months ended October 31, 2010,

including the figures provided above in the Q1 FY2011 8-K, with the exception of EBIDTA

and non-GAAP EPS, as well as the following: (a) liabilities payable to growers of $84.804

million; (b) net income of $14.214 million; and (c) gross profit as a percentage of net sales

amounting to 25.2%.

105. The Q1 FY2011 10-Q contained the following statements about the Company’s

accounting policies:


* * * *

Inventories. All inventories are accounted for on a lower of cost (first-in, first-out) or market basis.



We have entered into long-term Walnut Purchase Agreements with growers, under which they deliver their entire walnut crop to us during the Fall harvest season and we determine the minimum price for this inventory by March 31, or later, of the following year. This purchase price will be a price determined by us in good faith, taking into account market conditions, crop size, quality, and nut varieties, among other relevant factors. Since the ultimate price to be paid will be determined subsequent to receiving the walnut crop, we must make an estimate of this price for interim financial statements. Those estimates may subsequently change and the effect of the change could be significant.

106. Diamond and the Individual Defendants knew, or were deliberately reckless in

disregarding, that the statements set forth above in Paragraphs 99 through 105 were

materially false and misleading when made because the financial statements failed to

properly account for the $60 million payments owed to growers and eventually made in

September 2011 that should have been recorded throughout Fiscal Year 2011 instead of

Fiscal Year 2012 as the Company admitted on February 8, 2012. Moreover, the financial

statements for the first quarter of Fiscal Year 2011 improperly included the $20 million

payments made in August 2010 that should have been recorded in Fiscal Year 2010. Thus,

Diamond’s payable to growers was understated by the $60 million September 2011 payment.

Moreover, Diamond’s financial results relating to inventory, costs of sales and income

before taxes were both overstated by the $20 million August 2010 payments and understated

by the $60 million September 2011 payments and usage that occurred during the first quarter

of Fiscal Year 2011. Correspondingly, net income and earnings relating to the first quarter

of Fiscal Year 2011 were materially misstated as well. All of these statements were false

because they did not disclose Diamond’s true financial condition. As a result of the

improper accounting, Diamond’s financial results will be restated.

C. SECOND FISCAL QUARTER OF 2011 (NOVEMBER 2010– JANUARY 2011)

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107. On March 8, 2011, Diamond filed with the SEC a Form 8-K signed by Neil

2 regarding its financial results for the second fiscal quarter ended January 31, 2011 (the “Q2

3 FY2011 8-K”) as well as a Form 10-Q signed by Neil and certified as accurate by Neil and

4 Mendes announcing Diamond’s financial results for the fiscal quarter ended January 31,

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6 2011 (the “Q2 FY2011 10-Q”). Additionally, on March 8, 2011, the Company discussed its

7 second quarter fiscal results for 2011 during a conference call, which included Mendes and

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Neil.

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1. Form 8-K for the Second Quarter Fiscal Year 2011

10 108. The Q2 FY2011 8-K stated that “[f]or the three months ended January 31, 2011,

11 diluted EPS grew 67 percent to $0.87 compared to $0.52 for the prior year’s comparable

12 period. Excluding $0.9 million in integration costs related to the Kettle acquisition last

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14 March, non-GAAP EPS was up 90 percent to $0.91 compared to $0.48 for the prior year’s

15 quarter.” Additionally, “[f]or the quarter, gross profit as a percentage of net sales was 27.5

16 percent compared to 22 percent in the prior year period. The increase in gross margin was

17 mainly due to favorable product mix and the result of cost efficiency initiatives ....

18 EBITDA grew 81 percent to $83.4 million year to date.” (Emphasis added).

19 109. The Q2 FY2011 8-K also contained information concerning the Company’s

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21 current financial condition, including, for the three months ended January 31, 2011: (a) cost

22 of sales of $186.736 million; (b) gross profit of $70.856 million; (c) income from operations

23 of $35.94 million; (d) income before income taxes of $29.948 million; (e) net income of

24

$19.72 million; (f) basic earnings per share of $0.90; and (g) EBITDA of $46,319,000.

25 110. The Q2 FY2011 8-K contained information concerning the Company’s current

26 financial condition, including, for the six months ended January 31, 2011: (a) inventories of

27 $215.697 million; (b) cost of sales of $375.706 million; (c) gross profit of $134.452 million;

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(d) income from operations of $63.465 million; (e) income before income taxes of $51.356

million; (f) net income of $33.934 million; (g) non-GAAP EPS of $1.58; (h) basic earnings

per share of $1.55; and (i) diluted earnings per share of $1.51.

111

In addressing the Company’s financial results, Mendes stated as follows:

We achieved double-digit organic sales growth in our snack portfolio due to securing key new distribution in the club, mass and drug channels. ... To support these new distribution gains, we plan to increase our advertising investment during the remainder of the year, which we believe will position our portfolio for continued growth in the future.

2. Earnings Conference Call for Second Quarter Fiscal Year 2011

112. On March 8, 2011, the Company hosted an earnings conference call, in which

Mendes and Neil participated, with various securities analysts to discuss Diamond’s second

quarter Fiscal Year 2011 results. During the opening remarks, Mendes commented on the

Company’s financial results:

Earnings per share increased 90% over last year to $0.91, which is the top end of our guidance range. Cash flow was particularly attractive for the period, with EBITDA of $46 million, allowing us to continue to reduce leverage against the business.

113. Neil also addressed the Company’s financial results in prepared remarks:

Gross margin in the quarter was 27.5%, 550 basis points above the second quarter last year and 230 basis points above the first quarter. Significantly stronger retail sales drove the year-to-year comparison and more favorable product mix drove the quarter-to-quarter improvement.

We are experiencing increases in some of our input costs and are effectively managing these through hedging and long positions, as well as executing operational efficiencies within our supply chain and manufacturing operations.

114. During the conference call, Neil answered questions directly about the

Company’s reported gross profits:

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Bryan D. Spillane, Bank of America: Okay. And then just on gross profits, in the 10-Q, it disclosed that there was a $1.2 million – I’m assuming this is – I’m reading this right, that there was about a $1.2 million catch-up accrual on walnut costs. Is that correct? ...

Steven M. Neil: Yeah, that’s correct. Again, walnuts are a little bit unique in that we don’t finalize the price until the summer, until August. And so what we must do is we estimate what that cost is, so that $1 million represents the impact in the second quarter of a very small increase in estimated costs that we estimated for the walnuts. So that’s a little bit of a – and the reason we highlight it, it’s a little bit of out-of-period for the pure second quarter results; but a small amount.

Bryan D. Spillane: But you absorbed that extra first quarter in the second quarter as well. ...

Steven M. Neil: That’s correct.

Bryan D. Spillane: And then in terms of the gross margin guidance, you’re basically absorbing the higher costs by raising prices in favorable mix. Is that the way to interpret it?

Steven M. Neil: Yeah. We didn’t go specifically to walnut there, but yes. Correct. I mean the way that we’re - our input costs, or some of our input costs certainly have increased and we had for certain tree nuts, we did have a price increase. And we’re also fortunate in the way that we buy a lot of our input costs is we have some effective hedging and long positions, so we feel very comfortable. While it’s a little bit adverse and to the extent that we can’t do it internally, we will have some periodic price increases.

115. Neil and Mendes addressed a question about the Company’s reported catch-up

walnut payments:

Akshay Jagdale: .... One last one for you, Steve, on walnuts. The catch-up, how should we think of that relative to where the market is today, meaning just what is the risk of further catch-ups in the back half of the year as you sit here today?

Steve Neil: What we need to do from an accounting perspective is each quarter provide our best estimate of the cost associated with the sell-through of the entire crop. We endeavor to be as conservative as we can, but when you have a crop that’s grown 15%, and you have a dollar that’s fluctuating around, et cetera, et cetera, there’s quite a few parameters that we don’t necessary control. So that’s how we approach it - that’s how GAAP says to approach it.

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Michael Mendes: And we feel comfortable that we don’t have much risk in the back half.

(Emphasis added).

3. Second Quarter 2011 Financial Results on Form 10-Q

116. The Q2 FY2011 10-Q contained information concerning the Company’s current

financial condition for the three and six months ended January 31, 2011, including the

figures provided above in the Q2 FY2011 8-K, with the exception of EBIDTA and non-

GAAP EPS, as well as the figure for liabilities payable to growers of $83.553 million as of

January 31, 2011.

117. Additionally, the Q2 FY2011 10-Q provided the following information:

In the three months ended January 31, 2011, the Company revised its estimate for expected walnut costs which resulted in a pre-tax increase in cost of sales of approximately $1.2 million for walnut sales recognized in the first three months of fiscal year 2011.

118. The Q2 FY2011 10-Q also stated:

Gross profit. Gross profit as a percentage of net sales was 27.5% and 26.4% for the three and six months ended January 31, 2011 and was 22.0% and 23.6% for the three and six months ended January 31, 2010. Gross profit as a percentage of net sales increased mainly due to favorable product mix and the result of cost efficiency initiatives. In the three months ended January 31, 2011, we revised our estimate for expected walnut costs which resulted in a pre-tax increase in cost of sales of approximately $1.2 million for walnut sales recognized in the first three months of fiscal year 2011. In the three months ended January 31, 2010, we revised our estimate for expected walnut costs which resulted in a pre-tax decrease in cost of sales of approximately $2.6 million for walnut sales recognized in the first three months of fiscal year 2010.

119. The 2Q FY2011 10-Q included the following statements about the Company’s

accounting practices:


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We have entered into long-term Walnut Purchase Agreements with growers, under which they deliver their entire walnut crop to us during the Fall harvest season and we determine the purchase price for this inventory by March 31, or later, of the following year. This purchase price will be a price determined by us in good faith, taking into account market conditions, crop size, quality, and nut varieties, among other relevant factors. Since the ultimate price to be paid will be determined subsequent to receiving the walnut crop, we must make an estimate of price for interim financial statements. Those estimates may subsequently change and the effect of the change could be significant. In the three months ended January 31, 2011, we revised our estimate for expected walnut costs which resulted in a pre-tax increase in cost of sales of approximately $1.2 million for walnut sales recognized in the first three months of fiscal year 2011. In the three months ended January 31, 2010, we revised our estimate for expected walnut costs which resulted in a pre-tax decrease in cost of sales of approximately $2.6 million for walnut sales recognized in the first three months of fiscal year 2010.



materially false and misleading when made because the financial statements failed to

disclose and properly account for the $60 million payments owed to growers and eventually

made in September 2011 that should have been recorded throughout Fiscal Year 2011

instead of in Fiscal Year 2012 as the Company admitted on February 8, 2012. Moreover, the

financial statements for the second quarter of Fiscal Year 2011 contained the residual effects

of Diamond improperly including the $20 million payments made in August 2010 that

should have been recorded in Fiscal Year 2010. Thus, Diamond’s payable to growers was

understated by the $60 million September 2011 payment. Moreover, Diamond’s financial

results relating to inventory, costs of sales and income before taxes were both overstated by

the $20 million August 2010 payment and understated by the $60 million September 2011

payment and usage that occurred during the second quarter of Fiscal Year 2011.

Correspondingly, net income and earnings relating to the second quarter of Fiscal Year 2011

were materially misstated as well. Further, all of these statements were false because they

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1 misrepresented the likelihood of the Pringles merger occurring. They did not disclose the

2 true condition of Diamond’s financial health, or the truth that it would be difficult or

3 impossible for Diamond to complete any merger or acquisition utilizing its common stock

4 because of its poor financial performance, or that, even if Diamond were to complete the

5 merger, it would likely cost the Company an additional $200 million in cash. As a result of

6 the improper accounting, Diamond’s financial results will be restated, and the Pringles

7 merger has been cancelled.

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9

D. FORM 8-K ATTACHING INVESTOR PRESENTATION

10

121. On March 15, 2011, Diamond filed with the SEC a Form 8-K containing an

11 investor presentation (the “March 15, 2011 8-K Investor Presentation”), which contained

12 materially false and misleading statements concerning the Company’s historical financial

13

14 condition, including representations about the following items: (a) the Company’s current

15 gross margin of 26.4% and operating margin of 12.7%; (b) the Company’s ability to maintain

16 sustainable growth over 22 of 24 quarters with a Compound Annual Growth Rate (“CAGR”)

17 of 21%; (c) the Company’s current costs of goods sold of $186.736 million for Q2 FY2011;

18 (d) the Company’s historic EPS of $1.91 for 2010, non-GAAP EPS of $.91 for Q2 FY2011,

19 and projected EPS in 2011 of $2.45-$2.51; (e) historic revenue of $680 million for 2010 and

20 adjusted EBIDTA of $85 million for 2010, and projected revenue of $925-950 million for

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22 2011 and adjusted EBIDTA of $135-140 million for 2011; (f) track record of growth; and (g)

23 earnings per share growth of 15-20% CAGR.

24


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disregarding, that the statements set forth above in Paragraph 121 were materially false and

26 misleading when made because the investor presentation, which included Diamond’s

27 financial results, failed to disclose and properly account for the $60 million payments owed


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1

to growers and eventually made in September 2011 that should have been recorded

2 throughout Fiscal Year 2011 instead of Fiscal Year 2012 as the Company admitted on

3 February 8, 2012. Moreover, Diamond’s financial results for Fiscal Year 2011 contained the

4 residual effects of Diamond improperly including the $20 million payments made in August

5

6 2010 that should have been recorded in Fiscal Year 2010. Thus, Diamond’s payable to

7 growers was understated by the $60 million September 2011 payment. Moreover,

8

Diamond’s financial results relating to inventory, costs of sales and income before taxes were

9 both overstated by the $20 million August 2010 payment and understated by the $60 million

10 September 2011 payment and usage that occurred during Fiscal Year 2011.

11 Correspondingly, net income and earnings relating to Fiscal Year 2011 were materially

12 misstated as well. Further, all of these statements were false because they misrepresented the

13

14 likelihood of the Pringles merger. They did not disclose the true condition of Diamond’s

15 financial health, or the truth that it would be difficult or impossible for Diamond to complete

16

any merger or acquisition utilizing its common stock because of its poor financial

17 performance. As a result of the improper accounting, Diamond’s financial results will be

18 restated and the Pringles merger has been cancelled.

19 E. FORM 8-K REGARDING MERGER AGREEMENT

20 123. On April 5, 2011, Diamond filed with the SEC a Form 8-K signed by Neil (the

21

22 “April 5, 2011 Merger 8-K”) announcing that that the Company and P&G, the Wimble

23 Company, a wholly owned subsidiary of P&G (“Spinco”) and Wimbledon Acquisition LLC,

24 a wholly owned subsidiary of Diamond, had entered into an agreement to merge the Pringles

25 snack business into Diamond.

26 124. The April 5, 2011 Merger 8-K stated that Diamond would pay for the transaction

27 with Diamond common stock, which would result in 43% of Diamond’s outstanding shares

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1 of common stock being held by then-existing shareholders and 57% of outstanding shares of

2 common stock being held by shareholders of P&G following the merger. The April 5, 2011

3 Merger 8-K was filed with four exhibits: (1) the Transaction Agreement between P&G, The

4 Wimble Company, Diamond, and Wimbledon Acquisition LLC; (2) Separation Agreement

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6 between P&G, The Wimble Company and Diamond; (3) an April 5, 2011 Merger Investor

7 Presentation; and (4) a joint press release by P&G and Diamond.

8

125. On April 5, 2011, Diamond, including Mendes and Neil, hosted a conference call

9 with P&G. In response to a question regarding the timing of the agreement to merger,

10 Mendes stated:

11 On “why now?” I would say that generally you don’t get to pick your time

12 with good transactions. Our M&A calendar is not built on when’s the optimal

time and then buy the best thing that’s available then. ... And when we

13

deemed it was available now the timing worked for us.

14

126. The April 5, 2011 Merger Investor Presentation contained materially false and

15 misleading statements concerning the Company’s financial condition, including: (a)

16 Diamond’s estimated EBITDA in 2011 of $138-143 million without the merger and $398-

17

410 million with the merger; (b) Diamond’s projected gross margin in 2011 of $25.7%-

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26.7%; (c) Diamond’s gross margin of 23.7% and operating margin of 9.5% in 2010; (d)

19 Diamond’s 2010 EBIDTA of $85 million, EBIDTA 2010 margin of 13%; and (e) EPS of

20

$1.91 in 2010.

21 127. The April 5, 2011 announcement by Diamond of the signing of a definitive

22 agreement to merge with P&G’s Pringles was discussed in a myriad of articles. For example,

23 The New York Times issued an article entitled “Diamond Foods and Pringles to Merge,”

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25 which reiterated the details of Diamond’s announced merger, valued at $2.35 billion and

26 estimated to potentially triple Diamond’s snack business. The article noted that the

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transaction would include $1.5 billion of Diamond stock and the assumption of $850 million


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1 of Pringles debt, with Diamond shareholders owning approximately 43% of the combined

2 company. An April 5, 2011 article issued by Nashville Business Journal entitled “Proctor &

3 Gamble sells Pringles for $1.5B” noted that the sale of Pringles had been in the rumor mill

4 for a long time, but in September 2010, Bloomberg News had reported that P&G had backed

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6 out of negotiations with Diamond.

7 128. Another article of the same date issued by AP Online Regional – US entitled

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“Diamond Foods buying Pringles in $1.5B deal” noted Diamond’s pre-market stock gain.

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The article stated that the merger was expected to close by the end of 2011 and, if

10 successfully completed in that time frame, Diamond forecasted fiscal 2012 earnings per share

11 of between $3 and $3.10, without accounting for the costs of the transactions. The article

12 included an explanation of the collar mechanism aspect of the merger, which could result in

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14 the amount of debt assumed by Diamond increasing by up to $200 million or being reduced

15 by up to $150 million. Moreover, the article reiterated that the merger would help bring the

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Company’s annual revenue to approximately $2.4 billion, and Diamond forecasted around

17 $100 million in one-time costs associated with the deal.

18 129. Also on April 5, 2011, The Associated Press issued an article entitled “CA P&G

19 Diamond merger 04 05,” in which the merger as well as Diamond’s financial results were

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21 discussed. The article noted that Diamond’s total revenues have doubled and earnings per

22 share have grown more than four-fold in the past five years. The article went on to state that

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if the merger closed by the end of 2011, Diamond estimated fiscal 2012 net sales of $1.8

24 billion. Moreover, the article pointed out that the combined business would be managed by

25 Diamond’s executive team and board of directors, led by Mendes. The article quoted

26 Mendes as saying, “[t]his strategic combination will create an independent, global leader in

27 the snack industry with a focus on quality and innovative products. Not only is this

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1 combination immediately accretive, it also creates a platform that we believe will allow us to

2 build shareholder value for years to come.”

3 130. The April 5, 2011 article issued by Just-Food entitled “UPDATE: US: Diamond

4 looks to build on Pringles Reach” by Katy Humphries quoted Neil as expounding on the

5

6 merger, saying he anticipates additional “leverage” in gross margin and operating expenses

7 resulting from the “added scale” of “delivering multiple brands.” Moreover, the article

8 quoted Mendes as saying Pringles has “penetration where we don’t, where we perhaps should

9 or could be, so we are going to look to leverage that.”


11 disregarding, that the statements set forth above in Paragraphs 125 through 126 were

12 materially false and misleading when made because they misrepresented the likelihood of the

13

14 Pringles merger. They did not disclose the true condition of Diamond’s financial health, or

15 the truth that it would be difficult or impossible for Diamond to complete any merger or

16

acquisition utilizing its common stock because of its poor financial performance. As a result

17 of the improper accounting, Diamond’s financial results will be restated, and the Pringles

18 merger has been cancelled.

19 F. THIRD FISCAL QUARTER OF 2011 (FEBRUARY 2011 – APRIL 2011)

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21 132. On June 2, 2011, Diamond filed with the SEC a Form 8-K signed by Neil

22 regarding its financial results for the third fiscal quarter ended April 30, 2011 (the “Q3

23 FY2011 8-K”) as well as a Form 10-Q signed by Neil and certified by Neil and Mendes (the

24

“Q3 FY2011 10-Q”) announcing its financial results for the fiscal quarter ended April 30,

25 2011. Additionally, on June 2, 2011, the Company, including Mendes and Neil, discussed its

26 third quarter fiscal results for Fiscal Year 2011 during a conference call.

27 1. Form 8-K for the Third Quarter Fiscal Year 2011

28



133. The Q3 FY2011 8-K indicated that “[f]or the three months ended April 30, 2011

non-GAAP diluted earnings per share (EPS) was $0.52....” Additionally, the Company

stated:

For the quarter, gross profit as a percentage of net sales was 26.7 percent compared to the prior year quarter’s 22.4 percent, primarily as a result of the sales mix and productivity of improvements. For the first nine months of the fiscal year, gross profit as a percentage of net sales was 26.5 percent, 320 basis points above the prior year comparable period’s 23.3 percent. The beneficial effect of higher margin sales mix, greater scale in snacks and manufacturing efficiency initiatives outweighed the impact from the increase in non-retail sales, some commodity price pressure and increased slotting and promotion for Breakfast on the go!.

134. The Q3 FY2011 also contained information concerning the Company’s current

financial condition, including, for the three months ended April 30, 2011: (a) cost of sales of

$163.403 million; (b) $59.588 million in gross profit; (c) income from operations of $17.553

million; (d) income before income taxes of $11.612 million; (e) $7.733 million in net

income; (f) basic earnings per share of $0.35; (g) diluted earnings per share of $0.34; and (h)

EBITDA of $32.387 million.

135. The Q3 FY2011 also contained information concerning the Company’s current

financial condition, including, for the nine months ended April 30, 2011: (a) inventories of

$189.532 million; (b) cost of sales of $539.109 million; (c) $194.04 million in gross profits;

(d) income from operations of $81.018 million; (e) income before income taxes of $62.968

million; (f) $41.667 million in net income; (g) basic earnings per share of $1.90; (h) diluted

earnings per share of $1.85; (i) adjusted EBITDA of $115.782 million; and (j) non-GAAP

EPS of $2.09.

136. In addition, Mendes reported upon the effect that Diamond’s purported strong

performance had upon the likelihood of closing the Pringles acquisition and integrating the

two companies. Addressing the Company’s financial results, Mendes stated as follows:

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Our business performed well during the quarter, including double digit organic growth in our snack portfolio. ... Based on our strong overall performance and effective integration of Kettle, we have increased our financial guidance for the year. We’re off to a strong start in planning for the integration of Pringles, and are encouraged by the prospects for a new combined entity.

2. Earnings Conference Call for the Third Quarter Fiscal Year 2011

137. On June 2, 2011, the Company, including Mendes and Neil, hosted an earnings

conference call with various securities analysts to discuss Diamond’s third quarter Fiscal

Year 2011 results

During the opening remarks, Mendes commented on the Company’s

financial results:

Earnings per share for the third quarter increased 73% to 52 cents, exceeding the top end of our guidance range. Strong operating cash flow for the period helped fund a significant increase in new product and advertising investment as EBITDA of $31 million was more than double the same period last year.

138

Neil also addressed the Company’s financial results in prepared remarks:

Gross margin, as reported in the quarter was 26.7%. But excluding a favorable out-of-period adjusted to input costs, it would have been 26.0%.

* * * *

As we discussed last quarter, we are experiencing increases in some of our input costs and are effectively managing these through hedging and long positions as well as executing operating efficiencies within our supply chain and manufacturing operations.

* * * *

Overall, our non-GAAP EPS, excluding integration and transaction costs, was 52 cents for the quarter, an increase of 73% over the third quarter last year, while net income grew 91%, reflecting the greater share count from the equity offering associated with the Kettle acquisition.

We continue to realize strong EBITDA growth, generating $32 million in the quarter and $141 million in the four full quarters we have owned Kettle, compared to EBITDA generation of $73 million in the previous four quarters.

139

During the conference call, Neil was asked directly about walnut cost accrual:

Tim Ramey (D.A. Davidson): ... It sounded like there may be an adjustment to the walnut cost accrual in the quarter when you mentioned that gross

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margin might have been 26% without a favorable adjustment. Am I reading that correctly?

Steve Neil: Yes, we estimate some of our input costs, including walnuts, and there was a small adjustment. Year to date, I think it's around $300,000, so very small. But we did have a small adjustment impact going one way in the second quarter and offsetting it in the third quarter.

3. Third Quarter 2011 Financial Results on Form 10-Q

140. The Q3 FY2011 10-Q contained information concerning the Company’s current

financial condition for the three months and nine months ended April 30, 2011, including the

figures provided above in the Q3 FY2011 8-K, with the exception of EBIDTA and non-

GAAP EPS, as well as the figure for liabilities payable to growers of $15.702 million as of

April 30, 2011.

141. Additionally, the Q3 FY2011 10-Q stated:

Gross profit. Gross profit as a percentage of net sales was 26.7% and 26.5% for the three and nine months ended April 30, 2011 compared to 22.4% and 23.3% for the three and nine months ended April 30, 2010. Gross profit as a percentage of net sales increased mainly due to retail sales mix, greater scale in snacks and manufacturing efficiencies, which offset some commodity price pressure and increased slotting and promotion for Breakfast on the go!. In the three months ended April 30, 2011, the Company revised its estimate for expected commodity costs which resulted in a pre-tax decrease in cost of sales of approximately $1.5 million for sales recognized in the first six months of fiscal year 2011. In the three months ended April 30, 2010, the Company revised its estimate for expected commodity costs which resulted in a pre-tax decrease in cost of sales of approximately $1.1 million for sales recognized in the first six months of fiscal year 2010.

142. With respect to the Company’s accounting practices, the Q3 FY2011 10-Q stated:


* * * *


We have entered into long-term Walnut Purchase Agreements with growers, under which they deliver their entire walnut crop to us during the Fall harvest season and we determine the purchase price for this inventory by March 31, or later, of the following year. This purchase price will be a price determined by

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us in good faith, taking into account market conditions, crop size, quality, and nut varieties, among other relevant factors. Since the ultimate price to be paid will be determined subsequent to receiving the walnut crop, we must make an estimate of price for interim financial statements. Those estimates may subsequently change and the effect of the change could be significant. In the three months ended April 30, 2011, the Company revised its estimate for expected commodity costs which resulted in a pretax decrease in cost of sales of approximately $1.5 million for sales recognized in the first six months of fiscal year 2011. In the three months ended April 30, 2010, the Company revised its estimate for expected commodity costs which resulted in a pre-tax decrease in cost of sales of approximately $1.1 million for sales recognized in the first six months of fiscal year 2010.



materially false and misleading when made because the financial statements failed to disclose

and properly account for the $60 million payments owed to growers and eventually made in


Fiscal Year 2012 as the Company admitted on February 8, 2012. Moreover, the financial

statements for the third quarter of Fiscal Year 2011 contained the residual effects of Diamond

improperly including the $20 million payments made in August 2010 that should have been

recorded in Fiscal Year 2010. Thus, Diamond’s payable to growers was understated by the

$60 million September 2011 payment. Moreover, Diamond’s financial results relating to

inventory, costs of sales and income before taxes were both overstated by the $20 million

August 2010 payment and understated by the $60 million September 2011 payment and

usage that occurred during the third quarter of Fiscal Year 2011. Correspondingly, net

income and earnings relating to the third quarter of Fiscal Year 2011 were materially

misstated as well. Further, all of these statements were false because they misrepresented the

likelihood of the Pringles merger. They did not disclose the true condition of Diamond’s

financial health, or the truth that it would be difficult or impossible for Diamond to complete

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1 any merger or acquisition utilizing its common stock because of its poor financial



4 G. FORM 8-K ATTACHING JUNE 2011 INVESTOR PRESENTATION

5

6 144. On June 21, 2011, Diamond filed with the SEC a Form 8-K containing a June

7 2011 Investor Presentation (the “June 2011 Investor Presentation”), which included

8 materially false and misleading statements concerning the Company’s financial condition and

9 projected financial condition, including: (a) gross margin of 23.7% and operating margin of

10 9.5% for FY2010; (b) estimated gross margin of 25.7%-26.7% and estimated operating

11 margin of 11.0%-12.0% for FY2011; (c) estimated 2011 EBITDA of $142-145 million

12 without the Pringles merger and $400-410 million with the merger; and (d) financial targets,

13

14 with the merger, of $300-310 million in EBITDA, 16-17% for EBITDA Margin, and $3.00-

15 $3.10 for EPS.

16


17 disregarding, that the statements set forth above in Paragraph 144 were materially false and



20

21 to growers and eventually made in September 2011 that should have been recorded


23

February 8, 2012. Moreover, Diamond’s financial results for the third quarter of Fiscal Year

24

2011 contained the residual effects of Diamond improperly including the $20 million

25 payments made in August 2010 that should have been recorded in Fiscal Year 2010. Thus,

26 Diamond’s payable to growers was understated by the $60 million September 2011 payment.

27 Moreover, Diamond’s financial results relating to inventory, costs of sales and income before

28



taxes were both overstated by the $20 million August 2010 payment and understated by the

$60 million September 2011 payment and usage that occurred during Fiscal Year 2011.

Correspondingly, net income and earnings relating to Fiscal Year 2011 were materially

misstated as well. Further, all of these statements were false because they misrepresented the

likelihood of the Pringles merger. They did not disclose the true condition of Diamond’s

financial health, or the truth that it would be difficult or impossible for Diamond to complete

any merger or acquisition utilizing its common stock because of its poor financial

performance. As a result of the improper accounting, Diamond’s financial results will be

restated and the Pringles merger has been cancelled.

H. DIAMOND UPDATES INVESTORS CONCERNING THE PRINGLES MERGER DURING THIS PERIOD

146. On June 21, 2011, Diamond Foods issued a press release entitled, “Diamond

Foods Announces Expiration of Hart-Scott-Rodino Act Waiting Period for Acquisition of

Pringles.” Therein, the Company, in relevant part, stated:

SAN FRANCISCO, Jun 21, 2011 (GlobeNewswire via COMTEX) – Diamond Foods, Inc. (Nasdaq:DMND) today announced that the waiting period for U.S. antitrust review under the Hart-Scott Rodino Antitrust Improvements Act of 1976 for Diamond Foods’ pending acquisition of the Pringles business from The Procter & Gamble Company expired on June 20, 2011. The pending acquisition remains subject to regulatory approval by competition authorities in various jurisdictions outside the United States.

On April 5, 2011, Diamond Foods announced the signing of a definitive agreement to acquire the Pringles business from The Procter & Gamble Company in a Reverse Morris Trust transaction valued at $2.35 billion. The transaction, expected to close by the end of this calendar year, is also subject to satisfaction of other conditions including approval by Diamond's stockholders.

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147. On July 27, 2011, Diamond Foods issued a press release entitled, “Diamond

Foods Receives Clearance on Pringles Acquisition From UK. Office of Fair Trading.”

Therein, the Company, in relevant part, stated:

Diamond Foods, Inc. (Nasdaq:DMND) today announced that it has received clearance from the United Kingdom’s Office of Fair Trading (OFT) on its pending acquisition of the Pringles business from The Procter & Gamble Company.

The clearance by the OFT follows Diamond’s June announcement that the waiting period for U.S. antitrust review under the Hart-Scott Rodino Antitrust Improvements Act of 1976 for Diamond Foods’ pending acquisition of the Pringles business from The Procter & Gamble Company expired on June 20, 2011.

On April 5, 2011, Diamond Foods announced the signing of a definitive agreement to acquire the Pringles business from The Procter & Gamble Company in a Reverse Morris Trust transaction valued at $2.35 billion. The transaction, expected to close by the end of this calendar year, is also subject to satisfaction of other conditions, including approval by Diamond’s stockholders.

148. Additionally, the Company’s Form 1O-K filed on September 15, 2011, in relevant

I part, stated:

Pending Pringles Merger

On April 5, 2011, we entered into a definitive agreement with The Procter & Gamble Company (“P&G”) to merge P&G’s Pringles business into our Company. The value of the proposed transaction at April 5, 2011 was approximately $2.35 billion, consisting of $1.5 billion of our common stock and the assumption of $850 million of Pringles debt. The number of shares of our common stock to be issued in the transaction was based on $1.5 billion divided by the average of 60 days of daily volume weighted average prices, or 60-day VWAP, of our common stock for the period ended March 28, 2011 of $51.47, which amounted to approximately 29.1 million shares of our common stock to be issued to Pringles stockholders in connection with the transaction. As of September 14, 2011, the value of the approximately 29.1 million shares of our common stock to be issued in the transaction was $2.2 billion. The parties have also agreed to a collar mechanism that would adjust the amount of debt assumed by us based upon our price during a trading period prior to the commencement of the Exchange Offer. The amount of debt to be assumed by us could increase by up to $200 million or decrease by up to $150 million based on this

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adjustment mechanism. The equity portion of the purchase price is represented by approximately 29.1 million shares.

The transaction, which is expected to be completed by the end of calendar 2011, is subject to approval by our stockholders and satisfaction of customary closing conditions and regulatory approvals. We expect to incur one-time costs of approximately $150 million, net of income taxes, related to the transaction over the next two years. P&G will also provide us with transition services for up to 12 months after closing. The merger will be accounted for as a purchase business combination and for accounting purposes, we will be treated as the acquiring entity.

149. Further, in an amendment to its form S-4, filed on September 16, 2011 in

connection with the Pringles merger, Diamond revised its estimate with respect to acquisition

costs, increasing such estimate from $100 million to $150 million.

150. All of these statements were false because they misrepresented the likelihood of

the Pringles merger. They did not disclose the true condition of Diamond’s financial health,

or the truth that it would be difficult or impossible for Diamond to complete any merger or

acquisition utilizing its common stock because of its poor financial performance. As a result

of the improper accounting, Diamond’s financial results will be restated, and the Pringles

merger has been cancelled.

I. FORM 8-K ATTACHING SEPTEMBER 2011 INVESTOR PRESENTATION

151. On September 7, 2011, Diamond filed with the SEC a Form 8-K containing an

investor presentation (“September 7, 2011 Investor Presentation”). The presentation was

made by Mendes and Neil on September 7, 2011 in Boston, Massachusetts at the Barclays

Capital Back-to-School Consumer Conference.

152. The September 7, 2011 Investor Presentation contained false and misleading

statements concerning the Company’s historical financial condition, including: (a)

Diamond’s 2010 operating margin of 9.5% and Diamond’s projected 2011 operating margin

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1 of 11.0%-12.0%; (b) Diamond’s 2010 EBIDTA of $85 million and EBIDTA 2010 margin of

2 13%; (c) Diamond’s 2011 EBIDTA estimate of $142-145 million and EBIDTA margin

3 estimate of ~15%; (d) Diamond’s gross margin expansion of 26%-27% as of June 2, 2011

4 and Diamond’s EBIDTA margin expansion of ~15% as of June 2, 2011; and (e) Diamond’s

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6 estimated 2011 gross margin expansion of 31%-33%, and Diamond’s estimated 2011

7 EBIDTA margin expansion of approximately 17%.

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disregarding, that the statements set forth above in Paragraph 152 were materially false and



12 to growers and eventually made in September 2011 that should have been recorded

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15 February 8, 2012. Moreover, Diamond’s financial results for Fiscal Year 2011 contained the

16 residual effects of Diamond improperly including the $20 million payments made in August

17 2010 that should have been recorded in Fiscal Year 2010. Thus, Diamond’s payable to

18 growers was understated by the $60 million September 2011 payments. Moreover,

19 Diamond’s financial results relating to inventory, costs of sales and income before taxes were

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21 both overstated by the $20 million August 2010 payments and understated by the $60 million

22 September 2011 payments and usage that occurred during Fiscal Year 2011.

23

Correspondingly, net income and earnings relating to Fiscal Year 2011 were materially

24 misstated as well. Further, all of these statements were false because they misrepresented the

25 likelihood of the Pringles merger. They did not disclose the true condition of Diamond’s

26 financial health, or the truth that it would be difficult or impossible for Diamond to complete

27 any merger or acquisition utilizing its common stock because of its poor financial

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3

4 J. FISCAL YEAR 2011 YEAR END RESULTS

5

154. On September 15, 2011, Diamond filed with the SEC a Form 8-K signed by Neil

6 providing financial results for the Fiscal Year ended July 31, 2011 (the FY2011 8-K), and a

7 Form 10-K signed by Mendes and Neil (the FY2011 10-K) containing its financial results for

8 the Fiscal Year ended July 31, 2011 and the interim quarters contained therein. Additionally,

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10 on September 15, 2011, the Company held a conference call, which included Mendes and

11 Neil, to report its fourth quarter and full-year fiscal 2011 financial results.

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1. Form 8-K for the Fourth Quarter and 2011 Fiscal Year Results

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155. The FY2011 8-K contained information concerning the Company’s 2011

14 financial results, including: (a) inventories of $145.575 million; (b) cost of sales for the three

15 months ended July 31, 2011 of $175.666 million, and for the 2011 Fiscal Year of $714.775

16 million; (c) gross profit for the three months ended July 31, 2011 of $57.107 million, and for

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18 the 2011 Fiscal Year of $251.147 million; (d) income from operations for the three months

19 ended July 31, 2011 of $11.962 million, and for the 2011 Fiscal Year of $92.98 million; (e)

20

income before income taxes for the three months ended July 31, 2011 of $6.172 million, and

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for the 2011 Fiscal Year of $69.14 million; (f) net income for the three months ended July

22 31, 2011 of $8.544 million, and for the 2011 Fiscal Year of $50.211 million; (g) basic

23 earnings per share for the three months ended July 31, 2011 of $0.39, and for the 2011 Fiscal

24 Year of $2.28; (h) diluted earnings per share for the three months ended July 31, 2011 of

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26 $0.37 and for the 2011 Fiscal Year of $2.22. (i) EBITDA for the three months ended July 31,

27 2011 of $30.429 million and full year adjusted EBITDA of $146.211 million; and (j) non-


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- 56 -


GAAP EPS for the three months ended July 31, 2011 of $0.52 and for the 2011 Fiscal Year

of $2.61.

156. Additionally, the FY2011 8-K provided in pertinent part that:

Gross profit as a percentage of net sales was 24.5 percent for the quarter and 26 percent for the year. The lower gross margin in the quarter reflects the relatively large percentage of non-retail sales in the quarter .

157. In addressing the Company’s financial results, Mendes stated as follows: “Our

I base Diamond business delivered record financial results this quarter, with our snack

portfolio up a solid 16 percent on an organic basis . . . . We’re particularly pleased that we

could achieve such strong performance while effectively managing the Pringles integration.”

2. Earnings Conference Call for Fourth Quarter and 2011 Fiscal Year Results

158. On September 15, 2011, Diamond, including Mendes and Neil, hosted an

earnings conference call with various securities analysts to discuss Diamond’s fourth quarter

and 2011 Fiscal Year results. During the opening remarks, Mendes commented on the

Company’s financial results: “The company produced the strong improvement in operating

cash flow for the year, with EBITDA up 72% to $146 million.”

159. Neil also addressed the Company’s financial results in prepared comments:

Gross margin as reported in the quarter was 24.5%, and was 26.0% for the full year.

* * * *

Overall, our non-GAAP EPS, excluding integration and transaction costs, was $0.52 for the quarter, with approximately $0.05 generated by the lower-than-projected effective tax rate. This year’s EPS is an increase of 53% over the fourth quarter last year. For the full year, non-GAAP EPS was $2.61 per share, with $0.06 generated by the lower-than-projected effective tax rate. For the full year, EPS was up 37% over last year. We realized strong EBITDA growth for the year, generating $145 million compared to $85 million during the prior year. Our EBITDA margin increased 270 basis points over last year to 15%.

- 57 -

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Capital expenditures for the year were $28 million, slightly below our estimates.

3. Fiscal Year 2011 Financial Results on Form 10-K

160. The FY2011 10-K filed on September 15, 2011, signed by Mendes and Neil,

contained materially false and misleading statements concerning the Company’s 2011

financial results, including the figures provided above in the FY2011 8-K (absent the costs of

sales for the three months ended July 31, 2011) as well as payable to growers of $15.186

million as of July 31, 2011, and payable to growers of $35.755 million as of July 31, 2010.

161. The FY2011 10-K also contained the following quarterly financial information for

the year ended July 31, 2011: (a) gross profit for the first quarter of $63.596 million, for the

second quarter of $70.856 million, and for the third quarter of $59.588 million; (b) net

income for the first quarter of $14.214 million, for the second quarter of $19.72 million, and

for the third quarter of $7.733 million; (c) basic earnings per share for the first quarter of

$0.65, for the second quarter of $0.90, and for the third quarter of $0.35; and (d) diluted

earnings per share for the first quarter of $0.64, for the second quarter of $0.87, and for the

third quarter of $0.34.

162. Additionally, the FY2011 10-K stated:

Gross profit. Gross profit as a percentage of net sales was 26.0% and 23.7% for the years ended July 31, 2011 and 2010. Gross profit as a percentage of net sales increased mainly due to retail sales mix, greater scale in snacks and manufacturing efficiencies, which offset some commodity price pressure and increased slotting and promotion for Emerald Breakfast on the go!.

163. The FY2011 10-K also contained the following statements about the Company’s

accounting practices:


* * * *


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We have entered into long-term Walnut Purchase Agreements with growers, under which they deliver their entire walnut crop to us during the Fall harvest season and we determine the minimum price for this inventory by March 31, or later, of the following calendar year. The final price is determined no later than the end of the Company’s fiscal year. This purchase price will be a price determined by us in good faith, taking into account market conditions, crop size, quality, and nut varieties, among other relevant factors. Since the ultimate price to be paid will be determined subsequent to receiving the walnut crop, we must make an estimate of price for interim financial statements. Those estimates may subsequently change and the effect of the change could be significant.

* * * *


The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”). Certain prior period amounts have been reclassified to conform to the current period presentation.



materially false and misleading when made because the financial statements failed to disclose

and properly account for the $60 million payments owed to growers and eventually made in


Fiscal Year 2012 as the Company admitted on February 8, 2012. Moreover, Diamond’s

financial statements for Fiscal Year 2011 contained the residual effects of Diamond

improperly including the $20 million payments made in August 2010 that should have been

recorded in Fiscal Year 2010. Thus, Diamond’s payable to growers was understated by the

$60 million September 2011 payments. Moreover, Diamond’s financial results relating to

inventory, costs of sales and income before taxes were both overstated by the $20 million

August 2010 payments and understated by the $60 million September 2011 payments and

usage that occurred during the fourth quarter of Fiscal Year 2011. Correspondingly, net

income and earnings relating to Fiscal Year 2011 were materially misstated as well. Further,

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all of these statements were false because they misrepresented the likelihood of the Pringles

merger. They did not disclose the true condition of Diamond’s financial health, or the truth

that it would be difficult or impossible for Diamond to complete any merger or acquisition

utilizing its common stock because of its poor financial performance. As a result of the

improper accounting, Diamond’s financial results will be restated, and the Pringles merger

has been cancelled.

K. TRUTH BEGINS TO EMERGE, BUT DIAMOND DENIES ALLEGATIONS

165. On September 26, 2011, an article in Reuters Breakingviews entitled “P&G’s

Pringles partner warrants careful taste test,” discussed the issue of payments to walnut

growers and associated ramifications of Diamond’s acquisition of Pringles as follows:

Perhaps most significant is the matter of payments to walnut growers. Diamond’s long-term contracts give it great leeway to determine a final price at the end of the crop year. And while walnut prices have been rising thanks to Chinese demand, they are among the most opaque in the agricultural world and can vary widely.

But growers contacted by Breakingviews say Diamond’s rates, based on a closing payment on Aug. 31 for the previous year’s crop, undercut competitors by at least a third, a far bigger discount than is typical. Based on Diamond’s estimated market share, this makes the company’s costs around $60 million lower than they would be had Diamond paid something closer to rivals. Considering that Diamond’s adjusted operating income for the year ended July 31 was about $110 million, that kind of difference is potentially significant.

The company’s accounts also suggest its walnut costs have shrunk appreciably. Diamond doesn’t break out these costs at the end of the year, but it reports a liability to walnut growers in its first quarter, a gauge of what it expects to pay. In the most recent fiscal year, that figure was about 25 percent lower than the year before. Meanwhile Diamond’s sales of nuts, a line item that includes more than just walnuts, grew by 15 percent. The implication could be that the gross profit margin on walnuts has expanded significantly.

Stranger still was a substantial follow-up payment by Diamond to walnut growers just two days after its Aug. 31 outlay. Diamond called this a “momentum payment,” a term new to growers, who say they’re not sure whether the extra check means they’re getting a better price for last year’s

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crop or that cashing it obligates them to deliver walnuts for the coming year. Diamond’s IR chief says the period to which the September payment applies is “somewhat of a blur” because the company sees it in the context of its three, five and 10-year contracts with growers.

Diamond may not be too worried about confused growers. The one-time walnut collective has culled their ranks by as much as 40 percent since going public. The Pringles deal also shows Diamond is trying to diversify further away from its century-old nuts heritage. But how the company packages its “momentum payment” in financial reports surely matters to P&G shareholders as they consider switching into Diamond stock. Along with other financial wrinkles, they should subject the deal to a careful taste test.

166. Likewise, an article dated September 27, 2011 in the Wall Street Journal entitled

“Hidden Flaw in P&G’s Diamond Deal” discussed the issues of walnut prices and the

“momentum” payment. The article stated as follows:

[B]efore opting for shares in the merged company, which keeps the Diamond name, investors should take a closer look at its historical business: walnuts. Diamond uses multi-year contracts that allow it to set walnut prices unilaterally—a practice that is causing uproar among growers.

As walnut prices surged for the 2010 crop, Diamond paid growers much less than most buyers, according to several growers interviewed by The Wall Street Journal. And yet on September 2, Diamond made an extra “momentum” payment to growers they hadn't received in past years. The payment sizes varied, but averaged 25 cents a pound or more, growers say. By email, Diamond says: “In an effort to optimize cash flow for growers, particularly in light of the delayed harvest, we issued a momentum payment to growers that provides additional cash flow in the fall consistent with the current market environment as we enter the 2011 harvest.”

That payment is critical to investors because it would have made a big dent in Diamond’s earnings had it been made by July 31, when the company’s fiscal year ended. The company declined to specify the size of the payment, but it’s possible to make a decent estimate. According to the Department of Agriculture, one billion pounds of California walnuts were sold in the 2010 crop. Diamond disclosed that in 2005 it bought 283 million pounds of walnuts, or about 40% of California’s production. So conservatively assuming it bought 20% of 2010’s output, the momentum payments would total $50 million. That compares with $93 million in operating income for the entire fiscal year.

Even with the September payment, growers still look underpaid for the 2010 crop. Independent grower Ryan Palm, for example, says he received about 70 cents a pound before the momentum payment and less than $1 a pound if it's included. The Department of Agriculture says the average price per pound

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was $1.06 for all California walnuts in the 2010 crop. Some varieties sold for far more.

Pressure from growers could quickly become an issue for Diamond. After all, growers can go elsewhere when contracts expire and exports to places like China and Turkey have been surging.

That makes the Pringles deal all the more important for Diamond as a way to diversify away from walnuts, which account for nearly 30% of sales, estimates Ed Aaron of RBC Capital Markets. Apart from Walnuts, Diamond owns snack brands like Kettle Chips and Pop Secret. It says the combined company’s sales would have been $2.4 billion last fiscal year including Pringles, rather than its actual $966 million.

Diamond’s shares have surged 51% since the deal announcement, trading at 27.3 times earnings for the year ending next July. That valuation helps P&G get a big price for Pringles, whose shareholders will get a fixed number of Diamond shares. But with the walnut business looking strained, Diamond stock could soon begin to crack.

167. On October 4, 2011, Diamond filed with the SEC a Form 8-K containing a media

release stating that the Company was reaffirming its 2012 Fiscal Guidance (the “October 3,

2011 Media Release”).

168. The October 3, 2011 Media Release stated:

Media Statement – Diamond Foods, Inc., Reaffirms Fiscal 2012 Guidance San Francisco, CA (October 3, 2011) – Diamond Foods, Inc. (NASDAQ:DMND) Diamond made a pre-harvest momentum payment to walnut growers in early September, prior to the delivery of the fall walnut crop to reflect the fiscal 2012 projected market environment. The payment is accounted for in fiscal 2012 cost of goods sold and is reflected in the guidance provided by the company on September 15, 2011.

Diamond reaffirms the guidance provided in its press release dated September 15, 2011, which reflects not only higher commodity costs expected in fiscal 2012, but also recent retail price increases taken for its products. Diamond believes it has an ample walnut supply for both the retail and value-added, non-retail business .

(Emphasis added).

169. The October 3, 2011 Media Release was materially false and misleading because

Diamond and the Individual Defendants knew, or were deliberately reckless in disregarding,

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that the $60 million payments made to walnut growers in September 2011 should have been

recognized in the Company’s Fiscal Year 2011 financial statements. Thus, Diamond’s

payable to growers was understated by the $60 million September 2011 payment. Moreover,

Diamond’s financial results relating to inventory, costs of sales and income before taxes were

understated by the $60 million September 2011 payment. Correspondingly, net income and

earnings relating to Fiscal Year 2011 were materially misstated as well.

170. On October 4, 2011, an article entitled “Diamond Foods (DMND) Makes Pre-

Harvest Walnut Payment, Affirms FY12 Guidance” on StreetInsider.com stated as follows:

Diamond Foods, Inc. (Nasdaq: DMND) made a pre-harvest momentum payment to walnut growers in early September, prior to the delivery of the fall walnut crop to reflect the fiscal 2012 projected market environment. The payment is accounted for in fiscal 2012 cost of goods sold and is reflected in the guidance provided by the company on September 15, 2011.

Diamond reaffirms the guidance provided in its press release dated September 15, 2011, which reflects not only higher commodity costs expected in fiscal 2012, but also recent retail price increases taken for its products. Diamond believes it has an ample walnut supply for both the retail and value-added, non-retail business.

L. NOVEMBER 1, 2011 8-K AND VARIOUS NEWS ARTICLES FROM NOVEMBER 2011

171. On November 1, 2011, the Company filed with the SEC a Form 8-K containing a

press release:

Diamond Foods, Inc. (NASDAQ: DMND) today announced that its previously announced acquisition of the Pringles snack business from The Procter & Gamble Company (“P&G”) is now expected to close in the first half of calendar 2012. Diamond and P&G had previously expected the closing to occur in December of 2011.

Diamond and P&G have revised the expected closing date of the acquisition following the receipt by the Chairman of the Audit Committee of Diamond’s Board of Directors of an external communication regarding Diamond’s accounting for certain crop payments to walnut growers. In response to the communication, Diamond’s Audit Committee decided to perform an investigation of this matter. Management is fully committed to supporting the Audit Committee in this process.

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Closing of the Pringles transaction remains subject to customary closing conditions and completion of an exchange offer by P&G. Antitrust approvals required for the transaction have already been obtained.

172. On November 1, 2011 the Canadian Press issued an article entitled “Procter &

Gamble delays $1.5B Pringles sale until June after Diamond announces investigation,” which

stated that Procter & Gamble delayed the sale of its Pringles division to Diamond until the

end of June 2012 because of an internal investigation at Diamond into its accounting. Procter

& Gamble originally had expected the sale to close by the end of 2011. The article reiterated

Diamond’s statement that its Board of Directors was investigating external communication

regarding the Company’s accounting for crop payments to walnut growers. Procter &

Gamble said the sale would occur after the investigation was completed.

173. The Midnight Trader also issued an article on November 1, 2011 regarding the

delay of Diamond’s acquisition of Pringles entitled “Procter & Gamble Moves Back Pringles

Sale After Diamond Foods’ Accounting Review – DMND Off 6%, PG Just Firm.” The

article stated that “DMND reports receipt by the Chairman of the Audit Committee of

Diamond’s Board of Directors of an external communication regarding Diamond’s

accounting for certain crop payments to walnut growers. In response to the communication,

Diamond’s Audit Committee decided to perform an investigation of this matter.

Management is fully committed to supporting the Audit Committee in this process.”

174. On November 2, 2011, an article in Reuters News entitled “Diamond Foods sinks

as Pringles deal delayed,” relayed that shares in Diamond lost nearly a quarter of their value

the day after Diamond pushed back finalizing its $1.5 billion acquisition of the Pringles chips

brand to allow it to complete an accounting probe into its walnut business. The article also

stated as follows:

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On Tuesday, Diamond said it was looking into the accounting for certain crop payments to walnut growers, prompting it to delay closing its Pringles acquisition to the first half of next year from December 2011.

“While we are hopeful that this issue is resolved in short order, we simply do not have the transparency needed to maintain a high conviction long thesis ahead of this process,” RBC Capital Markets analyst Edward Aaron said in a client note.

Aaron, who cut his rating on the stock to “sector perform” from “outperform,” said the onus was now on the company to prove there have been no irregularities.

The analyst also trimmed his 2012 and 2013 earnings per share expectations for the company by 21 cents and 28 cents respectively and said limited information about the review process makes it difficult to properly assess risk.

“Even if numbers do get restated, it would not drastically change the story as long as Diamond could demonstrate that there was not a major profitability shortfall in snacks,” Aaron said.

SunTrust Robinson analyst William Chappell cut his price target on the stock to $75 from $90 but kept his “buy” rating saying he remained comfortable with the accounting for Diamond Foods’ walnut business.

“We expect the stock to be depressed until there is clarification but remain comfortable the stock is worth $75 even without Pringles,” the analyst said.

Diamond Foods was betting on gaining a bigger share of the potato chips market and doubling its sales in fiscal 2012 through its acquisition of Pringles from consumer goods giant Procter & Gamble Co.

Shares of the company -- which owns brands such as Emerald snack nuts, Pop Secret popcorn, and Diamond of California nuts -- were down 20 percent at $51.18 on Wednesday morning on Nasdaq. They touched a low of $49.22 earlier in the session.

175. On November 2, 2011, an article in Marketwatch entitled “Diamond Foods cracks

under audit probe,” also discussed the decline in Diamond’s share price following revelations

that the Company’s audit committee was reviewing an outside letter it received that appeared

to question how Diamond accounted for payments to walnut growers. “From our

perspective, the onus now lies on Diamond to prove there have been no irregularities,” wrote

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RBC Capital markets analyst Ed Aaron, one of at least three analysts who downgraded

Diamond shares Wednesday. The stock price decline on November 2 erased $1 billion in

shareholder value since September 21, when Diamond shares reached a record high of

$96.13. The decline also meant that Diamond would take on more debt from Procter &

Gamble when the deal closed if its stock traded at current prices.

176. Also on November 2, 2011, San Francisco Business Times issued an article

I regarding the delay in Diamond’s acquisition of Pringles and Diamond’s accounting

investigation entitled “Diamond Foods shares plummet with Pringles deal delay.” The article

stated that:

[T]he deal was thrown into disarray this week when Diamond, led by CEO Michael Mendes, disclosed that its audit committee is investigating an extra payment made to walnut farmers in September, which may be for walnuts purchased in the previous fiscal year. The Wall Street Journal estimates the payment was for $50 million, which would have cut Diamond’s operating income by more than half had it been included in results for the fiscal year that ended in July.

Diamond’s share price plays a key role in the deal terms. At the time the deal was announced, Diamond (NASDAQ: DMND) said it will get Pringles for $1.5 billion in stock and the assumption of $850 million in debt. The amount of debt Diamond takes on may rise by $200 million or fall by $150 million depending on how its shares trade ahead of the deal’s closing.

And Diamond’s shares have been flying high since the Pringles transaction was announced in April.

In the past 52 weeks the shares have traded as high as $96.13, after changing hands for just $43.14 in the months before the deal was announced.

177. The discussion regarding the delay in Diamond’s acquisition of Pringles due to

the accounting investigation continued on November 3, 2011, in an article in Reuters

Breakingviews entitled “P&G Deal Partner Probe Proves Shorts Aren’t Nuts.” The article

stated as follows:

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Skeptical investors who went nuts over Diamond Foods <DMND.O> may not be so crazy after all. More than a third of the snack food company’s shares were out on loan in late September in anticipation of the company’s planned December purchase of the Pringles brand from Procter & Gamble <PG.N>. That’s indicative of interest from short sellers, who questioned Diamond’s accounting. Now, the company is undertaking an internal investigation, putting the $2.6 billion deal on hold.

* * * *

. . . The company postponed the Pringles deal this week and news of its accounting probe has pushed the shares down under $52 apiece. Even if nothing untoward turns up, Diamond might still be inspired to improve its delivery of information. Either way, it calls attention to the value provided by the salty side of investing. At least the company is listening to the short-selling messengers, not shooting them.

178. On November 4, 2011, Just-Food issued an article entitled “In the Spotlight:

Walnuts Crack Diamond,” which discussed Diamond’s announcement that its acquisition of

Pringles was postponed in light of the accounting investigation. The article stated as follows:

The company also lowered its EPS estimate for its full-year. . . this week that deadline was put back six months after Diamond announced the launch of a probe into “accounting for certain crop payments to walnut growers” after the chairman of the audit committee of Diamond’s board of directors received an “external communication” about the matter.

* * * *

The market welcomed the deal and Diamond’s share price shot up on the day. Other glowing projections surfaced - the combined business would enjoy annual sales of $2.4bn, EBITDA of up to $410m and - crucially for Diamond’s investors - be “immediately accretive” to earnings.

Diamond also raised its expected annual net sales to between $1.85bn and $1.95bn, after having previously forecast net sales of approximately $1.8bn for fiscal 2012.

In a conference call last month, Steve Neil, the chief financial and administrative officer, spoke glowingly about the opportunities and leverages an iconic brand like Pringles represents, such as its 90% distribution in the convenience store sector, cost efficiencies and experienced staff.

* * * *

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. . . Erica Chase at Barclays Capital said that while the delay is “clearly disappointing”, she is heartened by the fact that P&G put out a release stating the company “remains committed to the transaction”.

She added: “We interpret this to mean that P&G is comfortable with the audit committee’s investigation and, while it may take some time to play out, it should not inhibit the prospects of a deal between the two companies going forward.”

* * * *

Analysts at BB&T Capital Markets Equity Research say the furor over crop payments to walnut growers is likely to be over “speculation” that Diamond paid its growers less than the average realized market price for the 2010 crop.

The company also lowered its EPS estimates for its full-year 2012 slightly to $3.14 from $3.15.

“Should the deal get pushed out further, there could be further downside risk to our estimates,” it added.

“Further, if the shares remain under pressure that could potentially result in greater-than-expected debt assumption with the Pringles deal and, thus, result in higher interest expense.”

179. On November 5, 2011, Barron’s issued an article entitled “Getting to the Nut of

the Problem,” discussing the issue of payments to walnut growers at length. The relevant

portions of the article are as follows:

The Wall Street Journal talked to some walnut growers and found serious issues with Diamond’s accounting—issues that had escaped the eagle-eyed advisors on the Pringles deal: Bank of America Merrill Lynch, Morgan Stanley and the Blackstone Group. On Tuesday, Diamond delayed the Pringles closing while the audit committee of its board of directors investigates how Diamond accounted for its walnut-crop payments. Diamond’s shares closed late Friday at $46.40, below their level when the Pringles plan was announced.

After Diamond’s walnut accounting gets scrutiny, the stock could get crushed again.

Diamond’s problems come from its legacy business as a walnut processor, which Chief Executive Michael Mendes has been hustling to push backstage via his purchases of snack brands. At the same time, walnut growers say that the company has underpaid them in recent years. Rio Oso, Calif., grower Pat

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Mecklenburg remembers when she realized that Diamond was turning its back on walnuts: She poured out one of the company’s Emerald brand pouches of trail mix, and there was one walnut in the whole package. “Ever since Diamond came public,” says Mecklenburg, “they’ve become less and less competitive with other handlers, until the point that it just got ridiculous.”

Even after the selloff, Diamond shares look pricey. The acquisitive outfit has no tangible book value. It reported earnings for the fiscal year ended July 2011 of $2.61 a share (including pesky noncash charges, like option expenses), so Diamond’s multiple on those trailing earnings is a generous 18 times. And 2011 earnings were likely overstated, says Mark Roberts, whose Off Wall Street Consulting Group rang the first alarm about Diamond’s nutty accounting on Sept. 25, when most of Wall Street was still cheering the company on. Had Diamond properly booked costs for fiscal 2011, Roberts estimates, it would’ve earned as little as $1.14 a share.

Diamond declined to talk about the walnut investigation, but a spokesman said that both Diamond and P&G remain committed to completing a Pringles deal next year, which would double the company’s sales. Yet if questions arise about Diamond’s “representations and warranties” as it offered its shares to P&G shareholders in exchange for the Pringles business, the deal could fall apart—or at least become much more expensive for Diamond.

Diamond’s co-op members got more than half the company’s stock in the IPO and signed contracts to sell their entire crop to Diamond for a term of three, five or 10 years. Happily for the farmer shareholders and all others, the stock rose steadily from its IPO price of 17. At the same time, however, many growers became unhappy with their multiyear contracts with Diamond.

Over its history, Diamond had paid growers around a third of the fall crop’s estimated value within two weeks of receiving delivery, typically in November. It made another small payment in February of the following year, and the final 65% in August. Diamond ought to have booked these payments, or estimates thereof, as costs against the matching revenues from the prior fall’s crop.

In good years, Diamond paid a little less than other handlers, says Jonathan Field, the general manager of the Walnut Bargaining Association, because Diamond committed to take a grower’s entire crop, and because in years of weak demand, it paid a little more than the market price. In 2008, prices tanked to about 60 cents a pound, recalls Field, but Diamond paid more than 70 cents.

With recent demand booming for walnuts as a protein-packed snack with healthy, omega-3 fatty acids, Diamond’s payments for the fall 2010 crop came short of market prices. “Woefully short,” says Field.

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Then, in early September, Diamond sent growers something it called “a momentum payment” of 30 to 40 cents a pound. The company said the payment was for the coming 2011 crop, but farmers believe it was really a way to bring Diamond’s price for their 2010 crop closer to market rates. Transaction records examined by Off Wall Street’s Roberts showed that, until 2009, Diamond had called its August check the “final payment” for the prior year’s crop.

This year, Diamond didn’t use the word “final” on its August payment to a grower Roberts spoke with, telling the grower to expect a September “momentum payment.” Believing himself underpaid, the farmer asked Diamond’s head of field operations if the September payment was for the 2010 crop. According to Roberts, the Diamond executive said yes. Most puzzling, the September payments went to farmers who’ve ended their sales contracts with Diamond and won’t be supplying it with their 2011 year crop. Barron’s spoke with one of those growers.

Had the September payments been counted as part of Diamond’s July 2011 fiscal year, Roberts thinks that the gross margin reported by the company would have shrunk to less than 20%, from about 25%—making the exchange of its shares for Pringles less appetizing for P&G shareholders.

180. On November 23, 2011, Benzinga issued an article entitled “Diamond Foods Falls

16%,” which stated that “[t]he stock is under pressure on Wednesday after it was reported

I that Joseph Silveira, a member of the company’s board of directors had committed suicide

last week. The company said there was no link between his death and the audit committee’s

investigation of Diamond’s accounting practices.” Another article in Benzinga on November

23, 2011 entitled “Diamond Foods, Procter & Gamble Committed to Completing Pringles

Deal,” stated that “[a] spokesperson for Procter & Gamble (NYSE: PG) said Wednesday that

both P&G and Diamond Foods (NASDAQ: DMND) remain committed to bringing

Diamond’s planned purchase of Pringles from P&G to a close. This despite the disastrous

[sic] month experienced by Diamond Foods, culminating with reports Tuesday that board

member Joseph Silveira’s death was a suicide.” There were also articles on November 23,

2011 in Reuters News, the San Francisco Business Times and Just-Food regarding Mr.

Silveira’s suicide.

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181. On November 25, 2011, an article entitled “Drama and Share Price Decline At

Diamond Foods” was issued in Seeking Alpha . The article quoted portions of the September

27, 2011 Wall Street Journal article, and then stated as follows:

At first glance, this might seem like a reasonable explanation. DMND exerts significant power in its relationship with its suppliers. Companies in this position must balance their short-term a nd long-term interests. In the short term, using this negotiating power to pummel suppliers and increase profits might be attractive, but this can lead to long-term instability as suppliers become financially weakened and any goodwill is destroyed, resulting in a precarious relationship that could collapse at any point. Here, DMND is saying that it wants to ensure that its suppliers are around (and willing to supply DMND rather than overseas buyers) for the 2011 harvest, and so it was helping out with a “momentum payment.”

While this sounds reasonable, it is important to recognize this as a big red flag. Anytime companies make extraordinary payments to suppliers, there is an increased likelihood of financial shenanigans being used to shift expenses and cash flows between periods to manipulate the appearance of the company’s financial statements. . . Moreover, according to this article the payments are even stranger than they first appear.

Some growers said the total payment for the prior year’s crop left them underpaid relative to market rates for walnuts, fueling speculation that Diamond tried to shift its payment to its current fiscal year and to make the prior year’s results look better. Some growers also apparently received the September payment even though they don’t plan to supply Diamond walnuts for the upcoming year.

The bizarre nature of these payments and the red flag for financial shenanigans calls into question the validity of previously presented financial statements. In my books, this makes the company unfit for investment. How can you ever get comfortable with an analysis based on financials that cannot be trusted? There is rarely one cockroach in the kitchen, and there is no price that would make me want to be exposed when others are uncovered. In case you thought these payments weren’t material to the company’s operations, the WSJ article clears this up:

That payment is critical to investors because it would have made a big dent in Diamond’s earnings had it been made by July 31, when the company’s fiscal year ended. The company declined to specify the size of the payment, but it’s possible to make a decent estimate. According to the Department of Agriculture, one billion pounds of California walnuts were sold in the 2010 crop. Diamond disclosed that in 2005 it bought 283 million pounds of walnuts, or about 40% of California’s production. So conservatively

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assuming it bought 20% of 2010’s output, the momentum payments would total $50 million. That compares with $93 million in operating income for the entire fiscal year.

On November 1, the company announced that the closing of the Pringles deal would be delayed until sometime in H1 2012 (rather than an original December 2011 close). The delay is the result of an internal investigation into the walnut payments:

Diamond and P&G have revised the expected closing date of the acquisition following the receipt by the Chairman of the Audit Committee of Diamond’s Board of Directors of an external communication regarding Diamond’s accounting for certain crop payments to walnut growers. In response to the communication, Diamond’s Audit Committee decided to perform an investigation of this matter. Management is fully committed to supporting the Audit Committee in this process.

The story then takes a turn for the tragic. On November 17, Joseph Silveira, a director of DMND, died. It wasn’t until November 23 that it was revealed that he died as a result of suicide and that he was a member of the company’s audit committee. The company says, as a walnut grower himself, he had recused himself from the investigation into the momentum payments. The market reacted poorly to the news, sending shares down another 20.5%.

This controversy has some important implications, including potentially killing the Pringles deal. This deal was set up such that DMND would issue 29.1 million shares and assume a level of debt that ranged from between $700-1050 million, depending on the (VWAP) average price of DMND leading up to the closing of the transaction (essentially creating a collar on the value of the deal for PG shareholders).

Any price less than $44.61 results in the high end of debt being assumed, so with a share price now in the $27.70 range PG shareholders are getting a much worse deal than originally contemplated (to the tune of approximately $490 million, of 21% of the announced transaction value).

According to the proxy statement, PG has the right to terminate the transaction if DMND breaches any of its representations and warranties or covenants, potentially giving PG an opportunity to exit or renegotiate the deal. This introduced a significant amount of uncertainly when attempting to get a handle on what DMND will look like a year from now.

The consequence is that in analyzing DMND, one must consider two scenarios: one for the Pringles deal occurring and one for it being scuttled. In the event that the deal is scuttled, I don’t think even the current depressed purchase price is attractive on a free cash flow basis, even when not adjusting for the delayed payments.

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1 Furthermore, the company maintains an unattractive level of debt and its historical returns are lackluster at best. If the deal does go through and the high range of debt is assumed, based on the historical combined financials found in the proxy statement (which again paint an overly attractive picture given the shenanigans), I am also less than impressed.

So despite a dramatic decline in the company’s share price, I don’t find DMND to be an attractive purchase, even if the apparent shenanigans can be explained satisfactorily (which I doubt). What do you think of DMND?

M. NOVEMBER 28, 2011 8-K AND NOVEMBER 29, 2011 NEWS ARTICLE

182. On November 28, 2011, the Company filed with the SEC a Form 8-K containing

a press release updating investors on the progress of the investigation:

Accounting Investigation Update

As previously announced, Diamond’s Audit Committee is performing an investigation of Diamond’s accounting for certain crop payments to walnut growers. The Audit Committee is committed to a thorough and expeditious process, and earlier this month, the Audit Committee retained Gibson, Dunn & Crutcher LLP and KPMG LLP to assist in the investigation. “While we understand that the investment community would like the company to be providing additional detail about the investigation, we support the Audit Committee in its process, which includes refraining from public comment regarding these matters until the investigation has been completed,” said Mr. Mendes.

Additional information about risk factors that could adversely affect Diamond can be found in the Current Report on Form 8-K filed with the SEC concurrently with the issuance of this press release.

183. This statement was materially false and misleading because Diamond and the

Individual Defendants knew, or were deliberately reckless in disregarding, that the $20

million payments made to walnut growers in August 2010 should have been recognized in

the Company’s Fiscal Year 2010 financial statements, and the $60 million payments made to

walnut growers in September 2011 should have been recognized in the Company’s Fiscal

Year 2011 financial statements. Thus, Diamond’s financial results for both Fiscal Years

2010 and 2011 relating to costs of sales, inventory and payable to growers were understated,

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resulting in an overstatement of gross profit, income and earnings. Correspondingly, net

income and earnings relating to Fiscal Years 2010 and 2011 were materially misstated as

well.

184. On November 29, 2011, an article entitled “At Diamond Foods, Accounting

Weighs on Pringles Deal” was issued in DealBook . The article stated as follows:

Short-sellers have challenged Diamond Foods’ accounting over a payment for walnuts. A subsequent drop in the company’s stock has cast a shadow over a deal to acquire Pringles from Procter & Gamble.

It appears that not even Diamond Foods knows what the future holds for its proposed acquisition of Procter & Gamble’s Pringles brand of chips. Behind the uncertainty of Diamond’s deal are competing narratives of a company that is either the victim of an attack by short-sellers or otherwise responsible for its own troubles.

Diamond’s problems surfaced in late September when Mark Roberts, an analyst with the Off Wall Street Consulting Group, a firm that specializes in providing short-sale research, raised issues with Diamond Foods’ accounting. Mr. Roberts wrote that Diamond’s earnings for 2011 were likely overstated.

According to a report in Barron’s, Mr. Roberts believes that Diamond’s accounting problems arose in the company’s walnut-processing business. In September, Diamond sent what was called a “momentum payment” to its growers. Mr. Roberts contends that this payment was for walnuts delivered for Diamond’s fiscal year 2011, which ended in July, and that Diamond’s payment actually shifted costs related to its 2011 crop into the 2012 accounting year. If true, the company’s margins for its 2011 fiscal year ending in July would be substantially lower. According to Barron’s, Mr. Roberts estimates that if these payments were included in Diamond’s 2011 earnings, they would drop to $1.14 a share, from $2.61 a share.

Diamond’s management has denied that these payments were compensation for last years’ crop. Instead, it said, the payments were made “[i]n an effort to optimize cash flow for growers.” Diamond asserts that it has made similar payments in three of the last four years and that, consistent with past practice, last year’s payment was accounted for in 2011.

In October, an analyst at RBC Capital Markets, who spoke with Diamond’s executives, wrote: “Management insists that this momentum payment is viewed and treated internally as a payment related to this year’s crop, not last year’s, and that attestations to the contrary are simply misinformed. We figure that the litmus test for this is whether growers who terminated

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relationships with Diamond Foods last spring would have received this year’s momentum statement. Management clearly stated that they would not.”

So what explains the strong conflicting views? Diamond claims that it is the victim of an attack by short-sellers who are feeding rumors of accounting irregularities in order to profit. The short position in Diamond’s shares is now more than 50 percent of its public float, according to Bloomberg News and people close to the company. Diamond contends that short-sellers, with an able assist by Mr. Roberts, have planted reports in the news media intended to raise questions about its accounting, including articles in Barron’s and The Wall Street Journal’s Heard on the Street column.

While it is uncertain whether the short-sellers are correct about Diamond’s accounting, there does appear to be opacity in the company’s business. Diamond does not break out the profitability of its walnut division or disclose payments to the walnut growers.

In the absence of clarity, the dispute was described by RBC Capital Markets as a “he-said/she-said one.”

Given the regulatory environment, any passably credible allegation of accounting fraud brings everything to a halt. The accountants must investigate, the lawyers take over, and shareholders grow skittish.

Diamond has found this out through experience.

Sure enough, Diamond announced on Nov. 1 that it and P&G had agreed to delay the completion of their transaction to the first half of 2012. The reason was that “the Chairman of the Audit Committee of Diamond’s Board of Directors [received] an external communication regarding Diamond’s accounting for certain crop payments to walnut growers.” The extra time was needed for a full investigation by Diamond’s audit committee.

P&G denied sending the communication, and Diamond has implied this communication did not come from the Securities and Exchange Commission. So, it likely came from either a grower or investor.

185. On November 29, 2011, Reuters Breakingviews issued an article entitled “P&G

may need to pop a plan B for Pringles,” which discussed the potential acquisition and

accounting investigation as follows:

Things aren’t sparkling for Diamond Foods <DMND.O>. A month ago, the snack food maker delayed its $2.4 billion plan to buy Pringles from Procter & Gamble <PG.N> to look into accounting concerns. Now, the company is burying news about the probe and increasing payments to walnut-growing

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directors. These and other inconsistencies don’t seem to augur well for the investigation -- or for P&G’s deal.

When the Pringles deal was hot, Diamond shares soared to over $90 apiece. They now trade at less than a third of that and value the transaction at less than P&G said it would accept during negotiations. Bringing in extra auditing and legal help, as Diamond has done, should help its internal committee move things along. But rather than disclose the hires when made earlier this month, Diamond waited until Monday and shoehorned them into a release underneath news about market share gains.

Diamond hasn’t been the model of clarity in other ways, either. The company published a condolence note for board and audit committee member Joseph Silveira on its website on Nov. 17. Only when news outlets later reported that Silveira had killed himself did the company say he had previously excluded himself from the investigation because of a conflict of interest.

Then there are Diamond’s walnut purchases. Some growers complained the company was severely undercutting rivals on price. That led to questions about the timing and accounting treatment of payments. Meanwhile, one Diamond director who is also a grower made more in just a few months of this fiscal year than he did in all of last and another is already 80 percent of the way there. Each also earned over 40 percent more last year than the year before. Diamond says they’re delivering more, but superficially the numbers don’t seem consistent with what other growers say.

The puzzlement extends back even further. When asked by Breakingviews in September about a so-called momentum payment to growers, the company said the period to which it applied was “somewhat of a blur.” Just a week later, it was able to tell regulators definitively the payment was for fiscal year 2012.

Diamond’s internal investigation may clear the fog, send the shares back up and restart the company’s global expansion. Just in case, though, P&G, which said on Nov. 1 it was committed to the deal with Diamond, may want to pop a plan B for Pringles.

This article was republished in the New York Times on November 30, 2011.

186. On November 30, 2011, an article entitled “US: Diamond Warns of Further Strife

Over Walnut Price Probe,” in Just-Foods talked about the delay in Diamond’s acquisition of

Pringles and the accounting investigation as follows:

Diamond Foods’ delayed US $2.35bn acquisition of Pringles from consumer goods giant Procter & Gamble has been dealt another blow.

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1 Earlier this month, Diamond announced its acquisition of the snack brand would be delayed for six months following the launch of an internal probe into prices paid to walnut growers, which was sparked by an “external communication” sent to Diamond’s board of directors.

Now Diamond Foods has issued a SEC filing warning that its audit committee’s investigation could have a raft of consequences that will “adversely impact” the company.

The filing said: “The time required or outcome of the audit committee investigation of Diamond’s accounting for certain crop payments to walnut growers could adversely affect Diamond.

“Among other things, the investigation could result in a determination that restatement of Diamond’s prior period financial statements is required, or a conclusion that there is a material weakness in Diamond’s internal control over financial reporting.

“In addition, the time required or outcome of the investigation could result in the inability of Diamond to timely file required periodic reports under the Securities Exchange Act of 1934, as amended, which could result in the commencement of NASDAQ delisting proceedings for Diamond’s common stock.”

The company also expects to incur substantial costs as a result of the conclusion of the investigation.

Earlier this month, the audit committee retained law firm Gibson, Dunn & Crutcher and audit, tax and advisory services firm KPMG LLP to assist in the investigation.

Last week Diamond announced that director Joseph Silveira had died on 15 November. CNBC reported that the death was a suicide and that Silveira, a member of the snack maker’s audit committee, had recused himself from the investigation. Diamond insisted the death of Silveira was not linked to the probe.

N. DECEMBER 9, 2011 NEWS ARTICLES

187. The impact of Diamond’s false and misleading statements continued to be evident

even as the internal investigation was ongoing. For instance, on December 9, 2011, Reuters

issued an article entitled “Diamond shares up on hope of quick end to probe” which stated, in

part:

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KeyBanc Capital Markets analyst Akshay Jagdale said in a research note that the chances of a restatement of the company’s costs related to the payment was low, and that Diamond would likely still be able to carry through its plan to acquire Pringles from Procter & Gamble <PG.N> even though the deal was delayed because of the probe.

“We believe the ongoing investigation will reveal that Diamond has properly accounted for the various payments it makes to growers,” Jagdale said.

188. Numerous other articles on the same date referred to this prediction. In the article

“Shares of Diamond Foods jump on analyst report,” the Cincinnati Business Courier

reported that the KeyBanc analyst referenced above stated he had interviewed “a few walnut

growers,” reviewed “‘numerous documents’ detailing the company’s relationship with

growers,” and KeyBanc “also hired a third-party consultant who concluded an earnings

restatement is ‘highly unlikely.’”

O. DECEMBER 12, 2011 8-K AND NEWS ARTICLES FROM DECEMBER 12 AND 13, 2011

189. On December 12, 2011, the Company filed with the SEC a Form 8-K signed by

Neil disclosing that the Board’s Audit Committee was starting an investigation into payments

made to walnut growers, and would miss its filing deadline:

On December 12, 2011, Diamond Foods, Inc. (“Diamond”) notified The NASDAQ Stock Market LLC (“Nasdaq”) that it is not in compliance with the requirements for continued listing under Nasdaq Listing Rule 5250(c)(1), which requires that Nasdaq-listed companies file their required periodic financial reports with the Securities and Exchange Commission on a timely basis. As previously disclosed, the Audit Committee of the Diamond Board of Directors is performing an investigation of Diamond’s accounting for certain crop payments to walnut growers (the “Investigation”). As a result of the Investigation, Diamond expects to file its Form 10-Q for the first fiscal quarter after the December 12, 2011 filing deadline. The Audit Committee and its advisors are working diligently to complete the Investigation. Diamond expects that it will receive a notice of deficiency from the Nasdaq Listing Qualifications Department in accordance with standard Nasdaq procedure indicating that Diamond should submit a plan to regain compliance. Diamond intends to submit a plan to regain compliance as quickly as possible. If necessary, Diamond will request a hearing before the Nasdaq Listing Qualifications Panel to review the plan. During this process, Diamond’s

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common stock will continue to be listed and traded on The NASDAQ Global Select Market.

190. This statement was materially false and misleading because Diamond and the

Individual Defendants knew, or were deliberately reckless in disregarding, that the $20

I million payments made to walnut growers in August 2010 should have been recognized in

the Company’s Fiscal Year 2010 financial statements, and the $60 million payments made to

walnut growers in September 2011 should have been recognized in the Company’s Fiscal

Year 2011 financial statements. Thus, Diamond’s financial results for both Fiscal Years

2010 and 2011 relating to costs of sales, inventory and payable to growers were understated,

resulting in an overstatement of gross profit, income and earnings. Correspondingly, net

income and earnings relating to Fiscal Years 2010 and 2011 were materially misstated as

well.

191. On December 12, 2011, an article in the Wall Street Journal entitled “Diamond

Payments Questioned by Growers” discussed the issue of payments to walnut growers, based

upon interviews with such growers, as follows:

Some walnut growers have challenged Diamond Foods Inc.’s explanation of mysterious payments to them, further tangling an accounting question that has delayed the snack maker’s planned $2.35 billion acquisition of Pringles from Procter & Gamble Co.

Diamond Foods has said a sizable payment to its walnut growers in September was an advance on their 2011 crop.

But three growers said they told the company that they didn’t intend to deliver their 2011 crops to Diamond, yet were assured by company representatives that they could cash the checks anyway. The three said they were told the checks were to top up payments for their 2010 crops.

* * * *

The checks to the growers, what the company called momentum payments, are the subject of an investigation by Diamond’s board and have become a sticking point in the company’s deal to buy the Pringles snack brand.


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Diamond plans to pay in part with its stock, which has dropped 56% since late September, shortly after the company reported fiscal-year results.

Diamond said its agreements with growers are confidential.

Many growers, who harvested their 2011 crops last month, said they had never seen momentum payments before. Some growers also had grumbled over what they said were insufficient payments from Diamond for their 2010 crops.

Mark Royer, who has grown walnuts for Diamond for the past 10 years, said he hadn’t decided whether to deliver his 2011 crop to the company when he received his momentum check in September. He said he called his Diamond field representative to explain “what the mysterious payment represented.”

“I made the assumption it would have to be 2010 compensation, because the delivery-to-date pricing was almost 40% under market,” Mr. Royer said.

He said the representative told him Diamond executives “were not committing” about which crop the payment was for. “He simply said that he knew that certain growers were cashing their momentum-payment check with the understanding that they didn't intend to deliver in 2011.”

Mr. Royer said he then decided it was safe to deposit his check.

He said he won’t deliver this year’s crop to Diamond. “I’ve kind of washed my hands of the matter,” he says.

A grower from Sacramento, Calif., said he was unsatisfied with his final official payment this summer for his 2010 crop. “It was grossly under what other growers had received,” he said.

He was pleased to get another check, for $90,000, several days later, he said.

But he said he had been concerned that accepting the payment would require him to deliver his fall harvest to Diamond. He said field-service representative Eric Heidman, in Stockton, Calif., assured him that the check was the last payment for the 2010 crop.

Mr. Heidman didn’t return calls seeking comment.

Another grower in Northern California said his field representative told him the momentum check was for 2010, and that he had told Diamond he wouldn’t deliver this year’s crop to the company. He said he had his lawyer send Diamond a letter, confirming that the grower wouldn’t deliver this year’s crop and would cash the check.

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Diamond began an investigation into its accounting practices last month after the chairman of the board’s audit committee, Edward Blechschmidt, received complaints about the payments from someone outside the company.

The investigation delayed Diamond’s cash-and-stock purchase of Pringles from P&G.

Mr. Blechschmidt didn’t return calls seeking comment.

Diamond’s shares jumped $14.01, or 53%, Friday to $40.56 on the Nasdaq Stock Market after KeyBanc analyst Akshay Jagdale told clients that the accounting investigation will be wrapped up quickly and will confirm that the momentum payments were properly booked. The analyst said he met with several walnut growers and got the view that the payment wasn’t unusual and was intended to help cover the 2011 crop.

192. Similar articles in Bloomberg , San Francisco Business Times , Midnight Trader,

Seeking Alpha , Benzinga , and Just-Food were issued on December 12, 2011, discussing

Diamond’s announcement of its inability to file the quarterly Form 10-Q with the SEC and

the Wall Street Journal article. The article in Benzinga , entitled “Extreme Volatility

Continues in Diamond Foods; Stock Down 20%,” provided the following relevant

I information:

On Monday, the stock has lost a chunk of Friday’s gains after the Wall Street Journal reported that some walnut farmers questioned the explanations of payments. The company also announced on Monday that it would be delaying its fiscal first quarter earnings filing until the accounting probe could be completed.

Diamond expects that its audit committee will be able to finish the probe by the middle of February and report earnings sometime thereafter.

The investigation into the mysterious payments made to walnut growers centers on whether the company potentially inflated its previous year’s earnings by as much as 100% by delaying the $50 million payment until September. The company has said that the payment was an advance for farmers’ 2011 walnut crop.

This explanation is being refuted by some farmers, however, who have said that they received checks despite the fact they were not planning on delivering their 2011 walnut crops to DMND. When these farmers questioned the company about the checks they were told that they were so called “momentum

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payments” for their 2010 crops. These farmers were told they could go ahead and cash the checks even if they weren’t planning on selling walnuts to DMND in 2011.

The potential implication is that the company used the September payments to shift its costs forward into fiscal 2011, thereby inflating fiscal 2010’s earnings. The investigation into these payments has not only significantly damaged the stock which has lost around two-thirds of its value since trading as high as $92 in September, it has also delayed the company’s acquisition of Pringles from Proctor & Gamble (NYSE: PG).

193. Likewise, an article dated December 12, 2011 in The Business Insider , entitled

“The Rise and Fall of Momentum Stock Diamond Foods,” discussed the accounting

investigation and payment to walnut growers as follows:

Diamond Foods first came under scrutiny over mysterious payments for walnuts in September, which suppliers and analysts questioned. In a report this morning by Hannah Karp of the Wall Street Journal, at least three growers said they received sizable checks for future deliveries, even though they had no plans on delivering crops to Diamond Foods.

The news casts statements made by the company earlier this year in doubt, when, according to Karp, it said a large September payment to walnut growers was for future deliverables.

Analysts have alleged that Diamond may have delayed payment to growers to offset costs during its fiscal 2011 year, inflating earnings as it entered negotiations with Proctor & Gamble. The stock transaction depends heavily on Diamond’s share price, which has fluctuated precipitously since the announcement of the deal.

Today, investors hold short positions on 52.6% of outstanding share, up two-fold since the beginning of the year, according to data compiled by Bloomberg.

Volatility in Diamond Foods spiked at the end of last week when Akshay Jagdale of KeyBanc Capital Markets reassured investors in a research note that the chance of a restatement of costs due to the audit was unlikely and that Diamond had conducted its accounting properly. His remarks sent the stock up 53%, the most during its history.

Jagdale noted that similar payments were made in August 2010 to suppliers, which were then included in 2011 costs. Diamond Foods had seen its stock appreciate some 81% since the bell rang on January 3 to its high set over the summer.

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1 “We believe the ongoing investigation will reveal that Diamond has properly accounted for the various payments it makes to growers,” he said according to Reuters.

However, allegations that the company underpaid suppliers to smooth out costs could violate generally accepted accounting principles, if they were not matched to the period revenue was recognized. Diamond had announced it would pay suppliers for the 2011 crop three times over the year, first in October, followed by payments in February and August.

In its announcement this morning, Diamond said that it expected to receive a notice of deficiency from the Nasdaq Listing Qualifications Department, because it was not compliant with rule 5250 (c)(1).

“Diamond intends to submit a plan to regain compliance as quickly as possible,” Diamond said. The company anticipates completing its audit probe in February 2012.

Attention to the once-momentum darling reached a pinnacle this November, when Joseph Silveira, a board member sitting on the audit committee, committed suicide in his California home. Silveira had recused himself from the investigation into the payments.

P. DECEMBER 15, 2011 8-K AND DECEMBER 18 NEWS ARTICLE

194. On December 15, 2011, the Company filed with the SEC a Form 8-K signed by

Neil disclosing that the SEC had begun a formal investigation into the Company’s payments

to walnut growers:

On December 14, 2011, Diamond Foods, Inc. (“Diamond”) received a formal order of investigation from the staff of the United States Securities and Exchange Commission (“SEC”). As previously disclosed, the Audit Committee of Diamond’s Board of Directors is conducting an investigation of Diamond’s accounting for certain crop payments to walnut growers. The SEC has informed Diamond that its investigation should not be construed as an indication by the SEC that any violations of law have occurred. Diamond intends to cooperate fully with the SEC. Diamond is unable to predict the timing or outcome of the SEC’s investigation.

195. On December 18, 2011, the San Francisco Chronicle issued an article entitled

“SEC inquiry casts shadow on takeover by Diamond,” relaying the series of events regarding

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the payments to walnut growers and accounting investigation. The article provided in

relevant part as follows:

On Thursday, Diamond Foods said it was the subject of a “formal order of investigation” of its accounting practices by the Securities and Exchange Commission. The Pringles deal, which was supposed to close this year, is on hold, and there is speculation Procter & Gamble might walk away. At Friday’s close, Diamond’s stock stood at $27.

What happened?

Earlier this year, questions were raised about what are called preharvest momentum payments Diamond made in early September to walnut growers, ostensibly for that season’s crop.

On Monday, the Wall Street Journal quoted three Northern California growers who had dealt with Diamond as saying they had never in previous years heard of such advance payments.

They also said they told the company they would not be delivering crops to Diamond this year, “yet were assured by company representatives that they could cash the checks anyway” - as extra payment for the 2010 crop.

The payments were counted as costs in Diamond’s fiscal 2012 books “to reflect the fiscal 2012 projected market environment,” the company said.

But questions were raised about the accounting, including by an analyst at a Boston equity research firm. The analyst said that the costs of the payments should not have been booked in the fiscal 2012 year. Had they been booked in 2011, he said Diamond would have recorded lower earnings per share for that fiscal year.

Such a change would probably have had an adverse effect on Diamond’s stock price, an important consideration seeing as Procter & Gamble shareholders are to be paid in Diamond stock for the Pringles acquisition.

Indeed, Diamond’s share price dropped substantially when the analyst’s concern was aired.

Investigations begin: Responding to “an external communication,” Diamond said on Nov. 1 that the board’s audit committee would conduct an internal investigation into the crop payments and that the scheduled closing of the Pringles acquisition had been postponed.

Two weeks later, a member of the audit committee, Joseph Silveira, who had recused himself from the investigation, committed suicide. Silveira’s death,

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not publicly disclosed until CNBC reported it a week later, was not related to the internal investigation, Diamond said.

“Any suggestion that his passing was somehow related to the accounting investigation by people seeking to profit by spreading such unfounded rumors is demeaning to his legacy,” a spokesman said at the time.

But Diamond’s stock price dropped in the wake of Silveira’s death and has continued to decline, as shareholder and class-action lawsuits have piled up and more questions have been raised about the crop payments.

On Monday, Diamond said it would miss its first-quarter filing deadline but “will take steps to file ... as soon as practicable after conclusion of the investigation” - which it said will be completed by the middle of February.

On Wednesday, the SEC notified Diamond of its formal investigation into the affair, a notification the company announced the next day.

“Diamond intends to cooperate fully with the SEC,” it said in a regulatory filing. “The SEC has informed Diamond that its investigation should not be construed as an indication by the SEC that any violations of law have occurred.”

A spokeswoman Friday said the company would not comment beyond what was stated in the filing.

Lengthening shadow: In its most recent earnings report, filed in mid-September, Diamond said it enjoyed “record financial results” for both the fourth quarter and fiscal 2011 year, with snack food sales up 72 percent over the previous year.

Two weeks later, it reaffirmed a sales forecast of $540 million to $560 million in the first half of the 2012 fiscal year. It also reaffirmed a projected increase in earnings per share, assuming, in part, “the Pringles transaction closes in the first half of December.”

The extent to which the investigations have put a crimp in Diamond’s expectations remains to be seen.

In a statement after the SEC announcement, Procter & Gamble said its “commitment to the transaction is predicated on the favorable resolution of all current investigations.”

Not quite the full-throated backing of the deal P&G had voiced earlier.

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The SEC’s intervention “is certainly not helpful for getting the deal done,” said Timothy Ramey, an analyst with D.A. Davidson & Co., an asset management firm in Great Falls, Mont.

Ramey, who covers Diamond Foods, said the Pringles acquisition is still “a good fit” for the company. When asked if he thought it would ultimately go through, he said, “I do.”

But a longer shadow has surely been cast over Diamond Foods now that the SEC, armed with subpoena powers, is involved.

“It’s another step in the investigative process and nothing more,” cautioned Jacob Frenkel, a former Justice Department prosecutor and SEC counsel who is now in private practice in Maryland. “But any investigation like this - civil or criminal, federal or state - must be taken seriously.”

196. Also on January 12, the Wall Street Journal reported that federal prosecutors have

also started an investigation into a financial practices, specifically how Diamond treated

payments to its walnut growers, and are coordinating with the SEC:

Prosecutors in the white-collar division of the U.S. Attorney’s Office in San Francisco are coordinating with the U.S. Securities and Exchange Commission in looking into how Diamond treated payments it made to walnut growers last summer.... The SEC told the company last month that it had opened a formal investigation into the payments.

At issue are what the company calls “momentum payments” that it sent to growers in September. Diamond maintains they were an advance on the 2011 walnut crop. But three growers contacted by The Wall Street Journal have said they were told by the company’s representatives to go ahead and cash the checks even though they didn’t intend to deliver walnuts this year.

197. As a result of both announcements, by January 13, shares had plummeted as much

as 11%, according to Reuters . Further, several news stories stated that the federal

investigation into Diamond’s accounting practices is “set to delay” the Company’s

acquisition of Pringles.

Q. COMMON STATEMENTS ISSUED THROUGHOUT THE CLASS PERIOD

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198. During the Class Period, Diamond and the Individual Defendants issued a series

of statements that were repeated in the Company’s various filings with the SEC. These

statements and the times when they were issued to the investing public are detailed below.

1. Sarbanes-Oxley Certifications

199. The Sarbanes-Oxley Act of 2002 (“SOX”) requires a public company to evaluate

and report on the effectiveness of its internal controls over financial reporting (§404)

annually and that the principal officers certify their responsibilities for financial reports in

each quarterly and annual filing. (§§302, 906).

200. The Individual Defendants completed certifications pursuant to Section 302 of

SOX, certifying that:

1. I have reviewed this annual report on Form 10-K of Diamond Foods, Inc. 3 ;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the

The date and type of report (Form 10-K or Form 10-Q) reflected the period set forth in the relevant SEC filing to which the certification was appended.

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registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d) disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

201

Pursuant to Section 906 of SOX, Defendant Mendes and Neil further certified

that:

the Annual Report on Form 10-K of the Company for the fiscal year ended July 31, 2010 (the “Report”) 4 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or

' The date and type of report (Form 10-K or Form 10-Q) reflected the period set forth in the relevant SEC filing to which the certification was appended .

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78o(d)); and that the information contained in that Report fairly presents, in all material respects, the financial condition and results of operations of the Diamond Foods, Inc. 5

202. Mendes and Neil issued these certifications in connection with the Company’s

SEC filings on October 5, 2010 (FY2010 10-K), December 8, 2010 (Q1 FY2011 10-Q),

March 8, 2011 (Q2 FY2011 10-Q), June 2, 2011 (Q3 FY2011 10-Q), and September 15,

2011 (FY2011 10-K).

2. Statements Regarding Internal Controls

203. In each filing with the SEC, Diamond issued statements regarding the

effectiveness of its internal controls over financial reporting, stating that its internal controls

were effective. The following is the relevant language included in Diamond’s SEC filings

regarding its internal controls:

204. On October 5, 2010:

Item 9A. Controls and Procedures

We have established and currently maintain disclosure controls and procedures designed to provide reasonable assurance that material information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission and that any material information relating to the Company is recorded, processed, summarized and reported to our principal officers to allow timely decisions regarding required disclosures.

In conjunction with the close of each fiscal quarter, we conduct a review and evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial and Administrative Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Our Chief Executive Officer and Chief Financial and Administrative Officer, based upon their evaluation as of July 31, 2010, the end of the fiscal quarter covered in this report, concluded that

5 There are minor, ministerial changes in this certification among the various periods, such as the inclusion of the various applicable statutory provisions. All of the Section 906 certifications are identical in substance.

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our disclosure controls and procedures were effective. Our assessment of and conclusion on the effectiveness of our disclosure controls and procedures did not include an assessment of and conclusion on the effectiveness of the internal control over financial reporting of Kettle Foods, acquired on March 31, 2010.

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The management of Diamond Foods, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended. Our internal control system is designed to provide reasonable assurance regarding the preparation and fair presentation of our financial statements in accordance with generally accepted accounting principles.

An internal control over financial reporting system has inherent limitations and may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

As of July 31, 2010, there has been no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. We acquired the Kettle Foods business on March 31, 2010, which represented less than 10% of our consolidated assets, and less than 15% of our consolidated net sales as of and for the year ended July 31, 2010. Since this acquisition occurred in March 2010, the scope of our assessment of the effectiveness of internal control over financial reporting does not include Kettle Foods, as permitted for recently acquired businesses. However, our assessment of internal control over financial reporting for fiscal year 2011 will include Kettle Foods.

We have used the framework set forth in the report entitled “Internal Control — Integrated Framework” published by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission to evaluate the effectiveness of our internal control over financial reporting as of July 31, 2010. Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of July 31, 2010 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America. We reviewed the results of management’s assessment with the Audit Committee of our Board of Directors.

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Deloitte & Touche LLP, an independent registered public accounting firm, has issued an audit report on the effectiveness of the Company’s internal control over financial reporting.

(Emphasis added).

205. On December 8, 2010, March 8, 2011, and June 2, 2011:

Item 4. Controls and Procedures


In conjunction with the close of each fiscal quarter, we conduct a review and evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial and Administrative Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Our Chief Executive Officer and Chief Financial and Administrative Officer, based upon their evaluation as of October 31, 20106, the end of the fiscal quarter covered in this report, concluded that our disclosure controls and procedures were effective.

As of October 31, 2010 7, there has been no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

(Emphasis added).

206. On September 15, 2011:

Item 9A. Controls and Procedures

We have established and currently maintain disclosure controls and procedures designed to provide reasonable assurance that material information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange

' The date reflected the period set forth in the relevant SEC filing. 7 The date reflected the period set forth in the relevant SEC filing.

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Commission and that any material information relating to the Company is recorded, processed, summarized and reported to our principal officers to allow timely decisions regarding required disclosures.

We acquired Kettle Foods on March 31, 2010, and as a result, we updated our internal control over financial reporting (as defined in Rule 13a-15(f) under the 1934 Act) during our fiscal year ended July 31, 2011, to include specific controls for Kettle Foods. Otherwise, there were no changes in our internal control over financial reporting during the year ended July 31, 2011 which have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

In conjunction with the close of each fiscal quarter, we conduct a review and evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial and Administrative Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Our Chief Executive Officer and Chief Financial and Administrative Officer, based upon their evaluation as of July 31, 2011, the end of the fiscal quarter covered in this report, concluded that our disclosure controls and procedures were effective.

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The management of Diamond Foods, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended. Our internal control system is designed to provide reasonable assurance regarding the preparation and fair presentation of our financial statements in accordance with generally accepted accounting principles.

An internal control over

financial reporting system has inherent limitations and may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

We have used the framework set forth in the report entitled “Internal Control — Integrated Framework” published by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission to evaluate the effectiveness of our internal control over financial reporting as of July 31, 2011. Based on that evaluation, our management concluded that our internal control over financial reporting was effective as of July 31, 2011 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America. We reviewed the results of management’s assessment with the Audit Committee of our Board of Directors.

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Deloitte & Touche LLP, an independent registered public accounting firm, has issued an audit report on the effectiveness of the Company’s internal control over financial reporting.

(Emphasis added).

207. As a publicly traded company, Diamond was required by the Exchange Act to

maintain books and records in sufficient detail to reflect the transactions of the Company and

prepare financial statements in accordance with GAAP. Specifically, the Exchange Act

requires that public companies:

1. make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer;

2. devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that –

i. transactions are executed in accordance with management’s general or specific authorization;

ii. transactions are recorded as necessary (I) to permit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements, and (II) to maintain accountability for assets. (15 U.S.C. §78m(b)(2)).

208. Furthermore, the SEC requires that issuers maintain, and regularly evaluate the

effectiveness of, disclosure controls and procedures designed to ensure that the information

required in reports under the Exchange Act is recorded, processed, summarized, and reported

on a timely basis. 8 Also, SOX requires a Company’s independent auditors to audit

management’s assessment of internal controls over financial reporting.

8 SEC Final Rule “Certification of Disclosure in Companies’ Quarterly and Annual Reports,” effective August 29, 2002.

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209. As stated above, the Individual Defendants completed the required certifications

stating that Diamond had established and maintained both disclosure controls and procedures

as well as internal controls over financial reporting.

210. Despite the wording in the certifications, Diamond’s disclosure controls and

procedures as well as its internal controls over financial reporting were not effective.

Moreover, despite publicly acknowledging its responsibility to maintain adequate disclosure

controls and procedures as well as internal control over financial reporting and certifying that

the controls were effective, in reality Diamond’s controls were non-existent, rendering its

financial statements false and misleading.

211. Diamond and the Individual Defendants knew or were deliberately reckless in not

knowing that every statement issued during the Class Period about the Company’s internal

controls and their effectiveness was false and misleading. Moreover, these statements were

false and misleading because the Company’s internal controls over financial reporting were

inadequate to prevent a material misstatement due to fraud and to ensure proper accounting

with respect to purchases made from and amounts owed to walnut growers.

R. THE TRUTH EMERGES

212. On February 8, 2012, Diamond admitted that it had made materially false and

misleading statements concerning its accounting of cost of goods sold, specifically payments

to walnut growers in August 2010 and September 2011. The Company filed with the SEC a

Form 8-K signed by Neil, which stated:

The Audit Committee of the Board of Directors (“ Audit Committee ”) of Diamond Foods, Inc. (“Diamond”) has substantially completed its previously announced investigation of Diamond’s accounting for certain crop payments to walnut growers. The investigation focused primarily on whether payments to growers in September 2011 in the amount of approximately $60 million and payments to growers in August 2010 of approximately $20 million were accounted for in the correct periods.

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On February 7, 2012, the Audit Committee concluded that such crop payments were not accounted for in the correct periods and that Diamond’s previously issued consolidated financial statements for the fiscal years ended July 31, 2011 and July 31, 2010, the accompanying reports of Diamond’s independent registered public accounting firm, and the previously issued unaudited condensed financial statements for the interim quarterly periods for the fiscal year ended July 31, 2011 and the quarter ended July 31, 2010, should no longer be relied upon. In addition, the Audit Committee determined that Diamond has one or more material weaknesses in its internal control over financial reporting. As a result of these internal control deficiencies, Diamond’s disclosure controls and procedures were not effective as of the fiscal years ended July 31, 2011 and 2010. The Audit Committee has discussed these matters with Diamond’s independent registered public accounting firm.

Although the Audit Committee has concluded that restatements of certain of Diamond’s previously issued financial statements will be required as described above, additional information could be discovered as part of the ongoing investigation or in connection with the preparation of the restated consolidated financial statements that could result in Diamond identifying additional accounting errors. Diamond is working diligently to address control deficiencies and to complete the restatement of Diamond’s financial statements, and to file all required periodic reports with the Securities and Exchange Commission as soon as practicable.

* * * *

On February 7, 2012, Michael J. Mendes and Steven M. Neil were placed on administrative leave from their positions as President and Chief Executive Officer of Diamond, and Executive Vice President, Chief Financial and Administrative Officer of Diamond, respectively.

On February 7, 2012, the Diamond Board of Directors (“ Board”) appointed director Richard G. Wolford to serve as Diamond’s Acting President and Chief Executive Officer. Mr. Wolford, 66, has served as a director of Diamond since April 2011. . . Mr. Wolford’s compensation arrangements have not yet been determined.

On February 8, 2012, the Board appointed Michael Murphy of Alix Partners, LLP as Diamond’s Acting Chief Financial Officer. . . Diamond will pay Alix Partners a monthly fee of $100,000 in connection with Mr. Murphy’s service as Diamond’s Acting Chief Financial Officer, and will pay Alix Partners additional fees based on hourly rates for other Alix Partners personnel.

In addition, on February 7, 2012, the Board appointed director Robert J. Zollars to serve as Chairman of the Board. Mr. Zollars has served as the Board’s Lead Independent Director since July 2011.

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1 213. Diamond also issued a press release on February 8, 2012, which stated:

SAN FRANCISCO, CA, February 8, 2012 – Diamond Foods, Inc. (NASDAQ: DMND) today announced that the Audit Committee of its Board of Directors has substantially completed its investigation of the Company’s accounting for certain crop payments to walnut growers. The Audit Committee has concluded that the Company’s financial statements for the fiscal years 2010 and 2011 will need to be restated. Over the course of the last three months, the Audit Committee has carefully reviewed the accounting treatment of certain payments to walnut growers. The Audit Committee has concluded that a “continuity” payment made to growers in August 2010 of approximately $20 million and a “momentum” payment made to growers in September 2011 of approximately $60 million were not accounted for in the correct periods, and the Audit Committee identified material weaknesses in the Company’s internal control over financial reporting.

The Board of Directors is taking a number of corrective actions including the appointment of a new Chief Executive Officer and Chief Financial Officer. Effective immediately, the Board has appointed Director Rick Wolford to serve as Acting President and Chief Executive Officer and Michael Murphy, of Alix Partners, LLP, to serve as Acting Chief Financial Officer. The Company is commencing searches for permanent replacements for the CEO and CFO positions. The Board has also appointed Robert J. Zollars, who previously served as Lead Independent Director, to the position of Chairman of the Board. Michael J. Mendes and Steven M. Neil have been placed on administrative leave from the Company.

“After an extensive and thorough investigation, the Audit Committee concluded that the Company’s internal controls were inadequate and that certain grower payments for the 2011 and 2010 crops were not accounted for in the correct periods. As a result, the Company will restate its fiscal years 2010 and 2011 financial statements,” said Robert Zollars, Diamond Foods’ Chairman. “The Board takes the Company’s control and the integrity of its financial statements very seriously, and we are moving aggressively to implement corrective measures, including changes to the Company’s leadership.”

“I look forward to working with the management team and the terrific employees at Diamond and will be focused on moving the business forward, further driving Diamond’s strong brands and helping to find a permanent chief executive,” said Rick Wolford, Acting President and Chief Executive Officer.

Diamond is working diligently to complete financial restatements for the affected periods and will file all required reports with the U.S Securities and Exchange Commission as soon as possible. While the timing of the restatement is difficult to predict at this time, the Company will endeavor to provide updates on timing and other material developments.

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214. As a result of this announcement, Diamond shares plummeted more than 40

percent in after-hours trading.

215. SunTrust Robinson Humphrey analyst William Chappell, who had previously

backed the Company’s accounting practices, cut the stock to “neutral” from “buy” admitting

that he had been wrong, stating:

This is the worst case scenario, not only creating uncertainty around the financial statements and removing a senior management team that directed the solid growth of the past few years, but also likely rendering dead the pending Pringles deal.

216. On February 9, 2012, many analysts cut their price targets on Diamond shares,

including those at Barclays Capital, who cut price targets from $75 to $25 in a report issued

that day. Further, P&G revealed that Diamond acquisition target Pringles was attracting

“considerable interest” in the wake of Diamond’s most recent announcement.

217. On February 10, 2012, according to reports on Bloomberg , P&G was trying to

“terminate the planned $1.5 billion sale of its Pringles snack line” to Diamond. Also on

February 10, several small walnut growers told Reuters that they would stop supplying

walnuts to Diamond when their contracts expire because they said the Company had been

underpaying farmers.

218. Within a week of its announcement, by February 13, 2012, Diamond was down

37.53%, with a short float of 52.40%.

219. On February 15, Diamond announced that it and P&G had mutually agreed to

terminate Diamond’s proposed acquisition of Pringles, and that the companies had released

each other from all liabilities related to the proposed acquisition. P&G CEO Bob McDonald

called the deal “no longer feasible.”

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220. The following day, it was announced that Kellogg Company agreed to buy

Pringles for $2.7 billion in cash.

221. Also on March 19, 2012, an article in Reuters News entitled “INSIGHT – Seeds

of trouble sown at Diamond Foods years ago” discussed Diamond’s history and the unusual

payment to walnut growers in September 2011. The article stated as follows:

The accounting scandal at snack maker Diamond Foods in recent months may have shocked shareholders and some California walnut farmers. But a number of accounting and industry experts spotted red flags some time before.

A close examination of business practices at Diamond Foods, the nation’s largest walnut processor and maker of Emerald nuts, points up a number of warning signs, including unusual timing of payments to growers, a leap in profit margins, and volatile inventories and cash flows.

The picture that emerges is of a company that for years seemed to push hard on every lever to meet increasingly ambitious earning targets and allowed top executives to pull in big bonuses, according to interviews with former Diamond employees and board members, rivals, suppliers and consultants, in addition to reviews of public and non-public Diamond records. ...

Nick Feakins was among those who early on noticed something strange going on at Diamond. He teaches forensic accounting at San Jose State University and does some work for Bevmark, a food and beverage consultant that was watching Diamond because it is a competitor to a Bevmark client, PepsiCo’s Frito Lay.

The head-turner for Feakins was the relentless climb in Diamond’s profit margins. Boosted in part by acquisitions of two high-margin snack brands, net income rose to more than 5 percent of net sales in fiscal 2011 from 1.5 percent in fiscal 2006.

No competitors were improving like that, even with rising Asian demand. “That just doesn’t make sense,” Feakins said.

* * * *

Questions accelerated after unusual payments to growers in September.

When Douglas Barnhill, an accountant who is also a farmer of 75 acres of California walnut groves, got a mysterious check for nearly $46,000 from Diamond, he started asking questions.

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Barnhill said he twice talked to Eric Heidman, Diamond’s director of field operations, on whether the check was a final payment for his 2010 crop or pre-payment for the 2011 harvest. ...

Not long after he got the check, he saw news stories quoting analysts and the company saying it was an advance payment for the next crop. But Heidman told Barnhill the opposite, that the payment was for the 2010 crop, part of fiscal 2011, but that it would be “budgeted into the next year,” as Barnhill recalled.

Barnhill remembered telling Heidman that, under accounting rules, you cannot legitimately pay in a future fiscal year for a prior year’s crop.

If Diamond was moving grower payments into different periods, “that really is a huge issue,” said Charles Mulford, an accounting professor at Georgia Institute of Technology.

222. Moreover, the March 19, 2012 Reuters article indicated that, according to former

Diamond Audit Committee member Dennis Mussell, the $20 million in payments to growers

in August 2010 had caught Deloitte’s eye. The article continued with a discussion of cash

flow trends and bonuses, as follows:

The company’s cash flow trends are among areas that may still raise questions. Net income growth is generally reflected in operating cash flow increases, but at Diamond, cash generation was sluggish in fiscal 2010 when earnings were strong. That raises questions about those earnings, said Mulford, who has written books on how to spot accounting issues through cash flow and other financial statements.

BONUSES

Maximizing earnings is crucial for any company, but for Diamond executives whose bonuses were largely tied to earnings per share, it was especially so. In September 2010, Mendes boldly promised EPS growth of 15 percent to 20 percent each year for the next five years. In fiscal 2009, 2010 and 2011, $2.6 million of Mendes’ $4.1 million in annual bonus was paid because Diamond beat its EPS goal, according to regulatory filings. ...

Outsiders question whether proper checks and balances were in place during this aggressive growth spurt. ...

Mussell said Diamond’s audit committee was “very proactive,” but governance experts questioned its close ties to the CFO’s office. Prior to becoming CFO in 2008, Neil was an independent director and chairman of

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Diamond’s audit committee. As CFO, Neil stayed on the board though he stepped off the audit committee.

“What we can say about the board is that it had a very unusual structure that raises all kinds of conflicts of interest questions,” said Robert Jackson, a governance expert at Columbia Law School. “Having members of the board who are receiving payments from the firm; not only is the CFO on the board, but the CFO came from the board; having a staggered board - you have much less than ideal corporate governance at Diamond.”

VII. DIAMOND AND THE INDIVIDUAL DEFENDANTS’ VIOLATIONS OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (“GAAP”)

223. As detailed herein, Diamond’s previously-filed, publicly-issued financial

statements during the Class Period 9 intentionally, or with deliberate recklessness, reported

materially understated inventory, payable to growers and cost of sales, which in turn inflated

Diamond’s reported gross profit, income from operations, income before income taxes, net

income, and earnings per share. Specifically, Diamond’s concessions set forth in its

announcement of an upcoming multi-year restatement evidence that the previously-filed

Class Period financial results were materially false, misleading, could no longer be relied

upon and violated GAAP 10 and SEC guidance and that at least one material weakness in

Diamond’s internal controls over financial reporting existed throughout the Class Period.

9 Diamond’s Class Period financial statements and earnings releases issued to the public and filed with the SEC include: SEC Form 10-Q’s for the periods October 31, 2010, January 31, 2011, and April 30, 2011; SEC Form 10-Ks for the periods ended July 31, 2010 and July 31, 2011; and SEC Form 8-Ks issued on October 5, 2010, December 8, 2010, March 8, 2011, June 2, 2011, and September 15, 2011. 10 GAAP are those principles recognized by the accounting profession as the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time. SEC Regulation S-X (17 C.F.R. §210.4-01(a)(1)) states that financial statements filed with the SEC that are not prepared in compliance with GAAP are presumed to be misleading and inaccurate, despite footnotes and 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 that would be duplicative of disclosures accompanying annual disclosures, per 17 C.F.R. §210.10- 01(a).

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224. As noted above, Diamond’s Form 8-K filed on February 8, 2012, explained that

its previously-filed financial statements were materially misstated and therefore should no

longer be relied upon, in relevant part, as follows:

The Audit Committee of the Board of Directors (“ Audit Committee ”) of Diamond Foods, Inc. (“Diamond”) has substantially completed its previously announced investigation of Diamond’s accounting for certain crop payments to walnut growers. The investigation focused primarily on whether payments to growers in September 2011 in the amount of approximately $60 million and payments to growers in August 2010 of approximately $20 million were accounted for in the correct periods .

(Emphasis added).

225. Thus, although the February 8, 2012 Form 8-K states that the investigation

“primarily focused on the two payments” at issue, the 8-K does not suggest that the

investigation is limited thereto. That Diamond’s restatement may go well beyond the two

payments initially identified in the 8-K is evidenced by the length of time it is taking the

Company to issue its restatement as well as the expected scope and breadth of the restated

results.

226. According to Accounting Standards Codification (“ASC”) 250, Accounting

Changes and Error Corrections (“ASC 250”), which incorporated Accounting Principles

Board Opinion (“APB”) No. 20, Accounting Changes, provided, in relevant part, that:

Restating financial statements of prior periods may dilute public confidence in financial statements and may confuse those who use them. Financial statements previously prepared on the basis of accounting principles generally accepted at the time the statements were issued should therefore be considered final except for changes in the reporting entity or corrections of errors . (Par. 14)

* * * * Errors in financial statements resulting from mathematical mistakes, mistakes in the application of accounting principles, or oversight or misuse of facts that existed at the time the financial statements were prepared.

* * * *

If a change or correction has a material effect on income before extraordinary items or on net income of the current period before the effect of the change, the treatments and disclosures described in this Opinion should be

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1

followed. Furthermore, if a change or correction has a material effect on the

2 trend of earnings, the same treatments and disclosures are required. (Par. 38).

3 (Emphasis added).

4

227. Moreover, Statement of Financial Accounting Standards (“SFAS”) No. 154,

5 Accounting Changes and Error Corrections (“SFAS 154”), which was also incorporated in

6 ASC 250, stated: “Any error in the financial statements of a prior period discovered

7 subsequent to their issuance shall be reported as a prior-period adjustment by restating the

8 prior-period financial statements.” (Par. 25). Thus, GAAP provides that financial statements

9

10 should be restated only to correct a material error in previously issued financial statements.

11 228. Because Diamond’s restatement is due to an “error,” the restatement is an

12 admission by Diamond and the Individual Defendants that the Company’s previously-issued

13

financial results were materially misstated and its public statements regarding those results

14 were false. Moreover, as alleged herein, Diamond’s financial statements issued during the

15 Class Period were incorrect based on information available to Diamond, the Individual

16

17 Defendants, and Deloitte contemporaneously to the financial results being disseminated to

18 the investing public.

19 A. DIAMOND’S RESPONSIBILITIES REGARDING FINANCIAL

REPORTING AND INTERNAL CONTROLS OVER FINANCIAL

20

REPORTING

21 229. At all relevant times, Diamond represented that Class Period financial statements

22 were prepared in conformity with GAAP. As set forth in Statement of Financial Accounting

23 Concepts (“SFAC”) No. 1, Objectives of Financial Reporting by Business Enterprises

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25 (“SFAC 1”), one of the fundamental objectives of financial reporting is to provide accurate

26 and reliable information concerning an entity’s financial performance for the period being

27 presented. Specifically, SFAC 1 states the following:


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- 102 -


Financial reporting should provide information about an enterprise’s financial performance during a period. Investors and creditors often use information about the past to help in assessing the prospects of an enterprise. Thus, although investment and credit decisions reflect investors’ and creditors’ expectations about future enterprise performance, those expectations are commonly based at least partly on evaluations of past enterprise performance. (Par. 42).

230. Moreover, “[m]anagement is responsible for adopting sound accounting policies

and for establishing and maintaining internal control,” and “[t]he fair presentation of

financial statements in conformity with generally accepted accounting principles is an

implicit and integral part of management’s responsibility.” (AU §110.03). As part of SOX,

a public company is required to evaluate and report on the effectiveness of its internal

controls over financial reporting (SOX §404) annually, and the principal officers are required

to certify their responsibilities for financial reports in each quarterly and annual filing. (SOX

§302 or SEC Rule 13a-14(a) / 15d-14(a), §404 and §906 or 18 U. S. C. § 1350). As stated in

more detail above, Defendants Mendes and Neil provided such certifications, attesting for the

accuracy of Diamond’s financial statements, the effectiveness of Diamond’s internal controls

over financial reporting, and their direct and personal involvement in ensuring that such

attestations were true.

B. DIAMOND IMPROPERLY ACCOUNTED FOR THE FALL 2009 CROP

1. Timing of Delivery and Payment Schedule for Crops

231. As required by GAAP, Diamond employed the accrual method of accounting

which mandated accounting for the cost of any given fiscal year’s crop in the period in which

raw materials were actually received and utilized for production as opposed to when cash

was actually paid to growers. Additionally, the accrual method of accounting required

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recording expenses associated with the generation of revenues, following the principle of

matching revenues with expenses.

232. In accordance with Statement of Financial Accounting Concepts (“SFAC”) No. 5,

Recognition and Measurement in Financial Statements of Business Enterprises (“CON 5”),

Diamond was required to record the appropriate level of cost of sales as it was generating

revenue associated with the processing and selling of the crop. Paragraph 86 of CON 5

states:

Consumption of economic benefits during a period may be recognized either directly or by relating it to revenues recognized during the period:

a. Some expenses, such as cost of goods sold (i.e., cost of sales), are matched with revenues — they are recognized upon recognition of revenues that result directly and jointly from the same transactions or other events as the expenses .

b. Many expenses, such as selling and administrative salaries, are recognized during the period in which cash is spent or liabilities are incurred for goods and services that are used up either simultaneously with acquisition or soon after.

c. Some expenses, such as depreciation and insurance, are allocated by systematic and rational procedures to the periods during which the related assets are expected to provide benefits. (Par. 86)

(footnote omitted and emphasis added).

233. This method required Diamond to record a liability on the balance sheet at the end

of the period in which the liability had been incurred. A liability is defined in paragraph 35

of SFAC No. 6, Elements of Financial Statements (“CON 6”), as follows:

probable 11 future sacrifices of economic benefits arising from present obligations 12 of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. (Par. 35).

11 “Probable is used with its usual general meaning, rather than in a specific accounting or technical sense (such as that in SFAS 5, par 3), and refers to that which can be reasonably expected or believed on the basis of available evidence or logic but is neither certain nor proved...” 12 “Obligations in the definition is broader than legal obligations. It is used with its usual general meaning to refer to duties imposed legally or socially; to that which one is bound to

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1 234. CON 6 also describes three essential characteristics of a liability:

a. It embodies a present duty or responsibility to one or more other entities that entails settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand.

b. The duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice.

c. The transaction or other event obligating the entity has already

happened. (Par. 36).

235

Finally, GAAP makes it clear via ASC 450, Contingencies that:

An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements... and

b. The amount of loss can be reasonably estimated.

236

According to Diamond’s Class Period Forms 10-K, raw materials or crops were

received during the first quarter of Diamond’s fiscal year, normally in or around September.

Diamond described the process of recording inventory at estimated cost and recording the

associated revenues and costs of sales throughout the fiscal year as follows:

We receive our walnut crop each Fall pursuant to walnut purchase agreements that we enter into directly with growers, and process and sell the crop over the next 12 to 15 months .

I (FY2009 10-K) (emphasis added).

We have entered into long-term Walnut Purchase Agreements with growers, under which they deliver their entire walnut crop to us during the Fall harvest season and we determine the minimum price for this inventory by March 31 , or later, of the following calendar year. The final price is determined no later than the end of the Company’s fiscal year . This purchase price will be a price determined by us in good faith, taking into

do by contract, promise, moral responsibility, and so forth ( Webster’s New World Dictionary, p. 981)...”

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account market conditions, crop size, quality, and nut varieties, among other relevant factors. Since the ultimate price to be paid will be determined subsequent to receiving the walnut crop, we must make an estimate of price for interim financial statements. Those estimates may subsequently change and the effect of the change could be significant.

(FY2011 10-K) (emphasis added).

237. The chart below shows the timing of the relevant walnut crops and the fiscal year

in which they should have been fully accounted.

Walnut Crop Delivery Accounting Year for Diamond

Fall 2009

FY 2010 (August 1, 2009 to July 31, 2010)

Fall 2010

FY 2011 (August 1, 2010 to July 31, 2011)

Fall 2011

FY 2012 (August 1, 2011 to July 31, 2012)

238. Because Diamond’s fiscal year begins on August 1 of each calendar year and ends

on July 31 of the following year, the Fall 2009 crop would be received in the Fall of 2009,

and the inventory, along with the associated payable to growers, would be recorded in the

first fiscal quarter 2010 financial statements. Following the delivery, the cost of sales related

to the inventory used to generate sales would be recorded throughout Diamond’s Fiscal Year

2010 as the crop was processed and subsequently sold.

239. Moreover, according to Diamond’s public disclosures and materials sent to

growers, 13 Diamond regularly entered into long-term walnut purchase agreements and

13 See Exs. 3 and 4. Section Payment Information located on page 2 of the Harvest 2009 Grower Guidelines for Delivery, Grading & Payment booklet, states “the first delivery payments for the 2009 crop [fiscal year 2010 crop] are planned for late September and projected as follows: delivery payments will be mailed 10 to 14 days after delivery; by February 15, 2010; by August 15, 2010 (final payment).” In addition, Section Payment Information located on page 2 of the Harvest 2010 Grower Guidelines for Delivery, Grading & Payment booklet, states “the first delivery payments for the 2010 crop [fiscal year 2011 crop] are planned for early October and projected as follows: delivery payments will be

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1 communicated to growers a pre-determined payment schedule for the year’s crop in or

2 around August of each year, more than a month before crop deliveries were expected and

3 approximately one year before final payments were due.

4 240. Based on grower guidelines, payments for the Fall 2009 and Fall 2010 crops were

5

6 scheduled as follows (with the initial payment to occur after receipt of the walnuts):

1st Payment

2nd Payment Final Payment

Fall 2009 Crop

Late September 2009

By February 15, 2010

By August 15, 2010

Fall 2010 Crop

Early October 2010

By February 15, 2011

In August 2011

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11 241 As a result, payments made in August 2010 would be associated with the Fiscal

12 Year 2010 crop and therefore associated with Diamond’s cost of sales for Fiscal Year 2010.

13 2. The Method by Which Diamond Engaged in Accounting

Manipulation During Fiscal Year 2010 14

242. To ensure that P&G would accept common stock as currency, Diamond and the 15

16 Individual Defendants deliberately understated the cost of the Fall 2009 crop as far back as

17 September 2009 when the crop was delivered, ensuring the Company’s financial results for

18

Fiscal Year 2010 would meet or exceed analysts’ expectations. Understating the cost of raw

19 materials enabled Diamond and the Individual Defendants to understate cost of sales which

20 in turn overstated gross profit, income from operations, income before income taxes, net

21 income and earnings per share as far back as the first quarter of Fiscal Year 2010.

22 243. Having devised a scheme to defer cost of sales from period to period starting in

23

24 the first quarter of Fiscal Year 2010, Diamond and the Individual Defendants continued

25 deferring the cost of sales by materially understating the cost of the Fall 2009 crop when

26 recording sales and associated costs of sales throughout the fiscal year. By doing this,

27 mailed 10 to 14 days after delivery; progress payment by February 15, 2011; final payment in

28 August 2011.”



1

Diamond was able to report financial results that met or exceeded analysts’ expectations for

2 the second and third fiscal quarters of Fiscal Year 2010.

3 244. As final payment for the Fall 2009 crop was due to growers by August 15, 2010,

4 Diamond and the Individual Defendants had to finalize the price of the crop by the end of its

5

6 fiscal year on July 31, 2010. Based on the supply agreements, Diamond and the Individual

7 Defendants must, in good faith, pay its walnut growers fair value for their crops. Thus,

8 Diamond and the Individual Defendants knew that they needed to make payments to the

9 growers for approximately $20 million to keep the price that it paid for the crops reasonably

10 in line with the price that the growers would have received from another company or in the

11 open market.

12 245. When faced with the obligation to pay growers, Diamond and the Individual

13

14 Defendants improperly included the $20 million August 2010 payments in its financial

15 results for the first quarter of Fiscal Year 2011. This $20 million payment would have

16

increased the outstanding “payable to growers” balance of $35.8 million as of July 31, 2010

17 by more than 55%, and increased Diamond’s recorded cost of sales of $519.2 million for the

18 full Fiscal Year 2010 by almost 4%. Because the pre-determined schedule mandated that

19 Diamond issue the final payment for the Fall 2009 crop in August 2010, Diamond’s initial

20

21 explanation that the $20 million payment represented an advance payment for the Fall 2010

22 crop was at odds with both GAAP and the already published payment schedule, pursuant to

23 which the first payment for the Fall 2010 crop was not scheduled for another 60 days, or until

24

October 2010.

25 246. Diamond and the Individual Defendants deferred such expenses as they knew, or

26 were deliberately reckless in not knowing, that $20 million in additional costs of sales would

27 have reduced net income for Fiscal Year 2010 from $26.2 million down to $6.2 million, a

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(in thousands)

Balance Sheet Payable to Growers

As Reported

Fiscal Year

2010

$ 35,755

August 2010

Grower Payment

$ 20,000

If Adjusted Fiscal Year Change

2010 (%)

$ 55,755 55.9%

Income Statement Cost of sales

$

519,161

Gross Profit

$

161,001

Income from Operations

$

52,230

Net Income

$

26,211

Earnings Per Share

Basic $ 1.40

Diluted $ 1.36

$ 20,000 $ 539,161

$ (20,000) $ 141,001

$ (20,000) $ 32,230

$ (20,000) $ 6,211

$ 0.34

$ 0.33

3.9%

- 12.4%

-38.3%

-76.3%

-75.8%

-75.8%


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decrease of more than 76%. Likewise, Diamond’s cost of sales would have been

dramatically affected as well. For Fiscal Year 2010, cost of sales was reported to be $519.2

million, and an additional $20 million would have increased cost of sales by 3.9%, to $539.2

million. 14

247. Diamond’s financial results for the Fiscal Year 2010 were misstated as follows:

C. THE ACCOUNTING MANIPULATIONS CONTINUE AND GROW DURING FISCAL YEAR 2011

248. Having already improperly deferred $20 million related to the Fall 2009 crop to

Diamond’s financial results for Fiscal Year 2011, Diamond and the Individual Defendants

continued the scheme of deferring expenses from period to period during Fiscal Year 2011.

As Diamond and the Individual Defendants had done during Fiscal Year 2010, Diamond and

the Individual Defendants deliberately understated the cost of the Fall 2010 crop as far back

14 Lead Plaintiff recognizes that the figures set forth throughout the Complaint regarding the change in net income in Fiscal Years 2010 and 2011 as a result of the August $20 million payments and September 2011 $60 million payments, respectively, do not account for any tax effect. However, Diamond has yet to issue its restated financial results. Therefore, Lead Plaintiff is using estimates based on the Company’s February 8, 2012 corrective disclosure.


28


1 as September 2010 when the crop was delivered, ensuring that its financial results would

2 meet or exceed analysts’ expectations for Fiscal Year 2011.

3 249. Understating the cost of raw materials in inventory, along with the associated

4 payable to growers, enabled Diamond to continue to understate cost of sales, which in turn

5 overstated gross profit, income from operations, income before income taxes, net income,

6 and earnings per share in each of first two quarterly reporting periods of Fiscal Year 2011.

7 250. On April 5, 2011, Diamond and P&G announced that transaction agreements and

8 financing commitment papers had been executed. Diamond and P&G also disclosed that

9 “closing [of the transaction was] anticipated by the end of calendar year 2011,” and

10 “Diamond expects to incur one-time costs of approximately $100 million related to the

11 transaction over the next two years.” These transaction costs, i .e. , $100 million acquisition

12 and integration related expenses associated with the Pringles merger, provided Diamond a

13 mechanism by which it could hide improperly deferred expenses related to the amounts paid

14 to growers for the Fall 2009 and Fall 2010 crops.

15 251. Diamond and the Individual Defendants were aware that since acquisition and

16 integration costs were considered one-time costs, investors mostly excluded these costs when

17 valuing Diamond’s stock price. As a result, Diamond and the Individual Defendants knew,

18 or were deliberately reckless in not knowing, that an increase in these costs in a particular

19 period, hiding the previously deferred cost of raw materials into that category, would not

20 affect Diamond’s stock price significantly. To the point, Diamond discussed “non-GAAP

21 earnings per share, excluding integration and transaction costs” on a quarterly basis, a metric

22 closely monitored by analysts and investors. 15 Thus, at or about the same time that Diamond

23 paid $60 million to growers pursuant to the momentum payment, it increased its estimate of

24 transaction and integration costs from $100 million to $150 million.

25 252. The Pringles merger was subject to antitrust clearance by three entities: 1) the

26 United States Hart-Scott Rodino Antitrust Improvements Act of 1976; 2) United Kingdom’s


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- 110 -


1 Office of Fair Trading (OFT); and 3) the Antimonopoly Committee of Ukraine. Diamond

was aware that significant acquisition and integration related expenses could not be

supported and explained to the market and investors before the merger was approved.

Therefore, it was imperative to obtain approval from all three authorities as early as possible

in order to hide the fraud within Fiscal Year 2011. At that point, Diamond would be able to

record as many expenses as needed to hide the fraud without risking detection. Although

Diamond’s proposed merger had already been approved by both the Hart-Scott Rodino

Antitrust Improvements Act of 1976 and the United Kingdom’s Office of Fair Trading

(OFT), the third and final approval from the Antimonopoly Committee of Ukraine arrived on

August 3, 2011, three days too late. As a result, it would have been difficult to hide the

improperly deferred expenses related to the amounts paid to growers that Diamond had

improperly deferred from period to period throughout Fiscal Years 2010 and 2011, as there

were not enough acquisition and integration expenses recorded. 16

253. By the end of Fiscal Year 2011, Diamond had understated the expenses

associated with the Fall 2010 crop by approximately $60 million. Diamond had deferred

these expenses to ensure that its financial results would meet or exceed analysts’ expectations

for all reporting periods in Fiscal Year 2011. At this point, Diamond was obligated, under

the pre-arranged payment scheduled referenced in more detail above, to provide the growers

with $60 million for the final payment associated with the Fall 2010 crop. The $60 million

grower payments would have increased the outstanding “payable to growers” balance of

$15.2 million as of July 31, 2011 by more than 395%, and increased Diamond’s recorded

cost of sales of $714.8 million for the full Fiscal Year 2011 by more than 8%.17 These

16 By the end of Fiscal Year 2011, Diamond had deferred $20 million and $60 million in costs related to the Fiscal Year 2010 and 2011 crops, respectively, for a total of $80 million in deferred expenses. As a result, for Diamond to be able to hide these expenses into that category, Diamond needed to record a lot more than $80 million in acquisition and integrations related expenses, a difficult task since the merger had not been approved before the end of Diamond’s fiscal year end. 17 See Diamond’s FY2011 10-K, page 29.

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payments would have erased most of the reported net income for Fiscal Year 2011 from

$50.2 million18 to a net loss of $9.8 million, a decrease of almost 120%.

254. Diamond’s financial results for the Fiscal Year 2011 were misstated as follows:

As Reported

Fiscal Year 2011

$ 15,186

$ 714,775

$ 251,147

$ 92,980

$ 50,211

$ 2.28

$ 2.22

If Adjusted

September 2010

Fiscal Year Grower Payment

2011

$ 60,000

$ 75,186

$ 60,000 $ 774,775

$ (60,000) $ 191,147

$ (60,000) $ 32,980

$ (60,000) $ (9,789)

$ (0.45)

$ (0.45)

Change (%)

395.1%

8.4%

-23.9%

-64.5% -119.5%

-119.9% -120.4%

(in thousands)

Balance Sheet Payable to Growers

Income Statement Cost of sales

Gross Profit

Income from Operations

Net Income

Earnings Per Share

Basic

Diluted

255. As a result of the foregoing, Diamond and the Individual Defendants determined

that it should, as it did with respect to the $20 million payments in the prior year, improperly

defer to Fiscal Year 2012 the $60 million it owed to growers as of July 31, 2011. Given that

the final payment for the Fall 2010 crop was due in August 2011 and the first payment for the

Fall 2011 crop was not due until October 2011, it defies both GAAP and common sense to

falsely claim, as Diamond initially attempted to do, that the $60 million payment was a pre-

payment for the Fall 2011 crop. Additionally, as reported in the Wall Street Journal on

December 12, 2011, some growers who were receiving payments in September 2011 were

not due to deliver their Fall 2011 crop to Diamond for Fiscal Year 2012. Moreover, at this

time, Diamond increased its guidance for the acquisition-related costs associated with the

Pringles merger from $100 million to $150 million.

18 See Diamond’s FY2011 10-K, page 29.


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1 D. DIAMOND’S FINANCIAL STATEMENT DISCLOSURES WERE FALSE AND MISLEADING

256

SEC regulations require that certain disclosures supplement a company’s

quarterly and annual financial statements to help investors better understand a company’s

financial condition. Specifically, SEC Regulation S-K, Item 303, requires that each quarterly

Form 10-Q and annual Form 10-K include a narrative explaining the financial statements and

the changes in financial condition of the company “through the eyes of management.” “The

presentation of financial statements in conformity with generally accepted accounting

principles includes adequate disclosure of material matters. These matters relate to the form,

arrangement, and content of the financial statements and their appended notes, including, for

example, the terminology used, the amount of detail given, the classification of items in the

statements, and the bases of amounts set forth.” 19

257. Interpretative guidance prepared by the SEC, Financial Reporting Release

(“FRR”) No. 36, Management’s Discussion and Analysis of Financial Condition and Results

of Operations (“FRR 36”), further discusses the disclosure requirements of Regulation S-K,

Item 303. SEC Staff Accounting Bulletin (“SAB”) Topic 13B requires disclosure of the

company’s policy for each material type of transaction. This provision requires the following

disclosures with respect to liquidity, known trends and results of operations in the

Management’s Discussion and Analysis (“MD&A”) section of the Form 10-K:

MD&A requires a discussion of liquidity, capital resources, results of operations and other information necessary to an understanding of a registrant’s financial condition, changes in financial condition and results of operations. 20 This includes unusual or infrequent transactions, known trends or uncertainties that have had, or might reasonably be expected to have, a favorable or unfavorable material effect on revenue, operating income or net

19 Auditing Standards, AU §431, Adequacy of Disclosure in Financial Statements , Paragraph 02. 20 See Regulation S-K, Article 303 and FRR 36.

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income and the relationship between revenue and the costs of the revenue... The Commission stated in FRR 36 that MD&A should ‘give investors an opportunity to look at the registrant through the eyes of management by providing a historical and prospective analysis of the registrant’s financial condition and results of operations, with a particular emphasis on the registrant’s prospects for the future .’ 21

(Emphasis added).

258. The specific disclosure requirement of Regulation S-K, Item 303 (a) (3) (ii) states:

Describe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations. If the registrant knows of events that will cause a material change in the relationship between costs and revenues (such as known future increases in costs of labor or materials or price increases or inventory adjustments), the change in the relationship shall be disclosed.

259

Diamond and the Individual Defendants were required by GAAP and SEC rules,

including Accounting Principles Board (“APB”) No. 22, Disclosure of Accounting Policies,

to disclose in detail its accounting policies relating to cost of sales, valuation of inventory and

payable to growers in the footnotes of its financial statements in each of its publicly-issued

Forms 10-K and 10-Q during the Class Period. The requirement set forth in SAB 104 states

as follows:

A registrant should disclose its accounting policy for the recognition of revenue pursuant to [APB] Opinion 22. Paragraph 12 thereof states that the disclosure should encompass important judgments as to appropriateness of principles relating to recognition of revenue . . . Because revenue recognition generally involves some level of judgment, the staff believes that a registrant should always disclose its revenue recognition policy. If a company has different policies for different types of revenue transactions, including barter sales, the policy for each material type of transaction should be disclosed. If sales transactions have multiple units of accounting, such as a product and service, the accounting policy should clearly state the accounting policy for each unit of accounting as well as how units of accounting are determined and valued. In addition, the staff believes that changes in estimated returns recognized in accordance with Statement 48 should be disclosed, if material (e.g., a change in estimate from two percent of sales to one percent of sales).

21 FRR 36, also In the matter of Matter Caterpillar Inc., AAER 363 (March 31, 1992).

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1 260. Diamond made the following financial statements disclosures during the Class

2 Period:

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The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”).

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Use of Estimates

On an ongoing basis, the Company evaluates its estimates, including those related to inventories , trade receivables, fair value of investments, useful lives of property, plant and equipment, intangible assets, goodwill and income taxes, among others. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable , the results of which form the basis for management’s judgments about the carrying values of assets and liabilities.

(Emphasis added).

261. These disclosures were materially false and misleading and in violation of the

disclosure requirements included in SAB 104 and APB No. 22 because, as alleged above:

(a) Diamond and the Individual Defendants knew or were deliberately reckless in not knowing that the financial statements issued during the Class Period were not prepared in accordance with GAAP;

(b) Diamond and the Individual Defendants knew or were deliberately reckless in not knowing that cost of inventories or crops were not properly evaluated on an ongoing basis and that Diamond was not properly estimating the cost of the crops based on assumptions that were reasonable; and

(c) Diamond and the Individual Defendants knew or were deliberately reckless in not knowing that inventories were not accounted for at the lower of cost or market.

262. Diamond and the Individual Defendants failed to disclose the aforementioned

required information about the amount payable to growers and related cost of sales in its

Forms 10-K and Forms 10-Q during the Class Period. The failure to report and disclose such

information enabled Diamond to understate the cost of raw materials and related cost of

I sales, which in turn overstated gross profit, income from operations, income before income



taxes, net income, non-GAAP EPS, and earnings per share throughout the Class Period.

Additionally, Diamond and the Individual Defendants failed to disclose that the internal

controls over financial reporting were not in place and functioning properly in order to avoid

a material misstatement in Diamond’s financial statements during the Class Period.

E. DIAMOND’S ADDITIONAL GAAP AND SEC RULES VIOLATIONS INCLUDED IN ITS CLASS PERIOD FINANCIAL STATEMENTS

263. In addition to the GAAP and SEC violations described above, Diamond and the

Individual Defendants violated the following fundamental GAAP principles because they

failed to disclose that the August 2010 $20 million payments and September 2011 $60

million payments were improperly recorded in the incorrect reporting period:

a. 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; (FASB Statement of Concepts No. 1, Par. 34)

b. 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; (FASB Statement of Concepts No. 1, Par. 40)

c. 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. To the extent that management offers securities of the enterprise to the public, it voluntarily accepts wider responsibility for accountability to prospective investors and to the public in general; (FASB Statement of Concepts No. 1, Par. 50)

d. The principle that financial reporting should be reliable in that it represents what it purports to represent. That information should be reliable as well as relevant is a notion that is central to accounting; (FASB Statement of Concepts No. 2, Par. 58 and 59)

e. The principle of completeness, which means that nothing is left out of the information that may be necessary to ensure that it

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validly represents underlying events and conditions; (FASB Statement of Concepts No. 2, Par. 79) and

f. 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. The best way to avoid injury to investors is to try to ensure that what is reported represents what it purports to represent. (FASB Statement of Concepts No. 2 Par. 95 and 97).

264. Furthermore, the undisclosed adverse information concealed by Diamond and the

Individual Defendants throughout the Class Period that materially affected Diamond’s

financial results and artificially inflated the stock price is the type of information that was

required to be disclosed by Diamond and the Individual Defendants based on SEC rules and

regulations, the regulations of the national stock exchanges and based on customary business

practices.

F. DIAMOND’S STATEMENTS REGARDING INTERNAL CONTROLS OVER FINANCIAL REPORTING WERE MATERIALLY FALSE AND MISLEADING WHEN MADE

265. The February 8, 2012 press release announcing the results of Diamond’s Audit

Committee’s internal investigation disclosed the following:

[T]he Audit Committee determined that Diamond has one or more material weaknesses in its internal control over financial reporting. As a result of these internal control deficiencies, Diamond’s disclosure controls and procedures were not effective as of the fiscal years ended July 31, 2011 and 2010.

266. A material weakness is defined by the Public Company Accounting Oversight

Board (“PCAOB”) as a “significant deficiency, or combination of significant 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.” (AU §325.03). Based on the

PCAOB, a material weakness in internal controls is the highest level possible of internal

control deficiency. The severity of a deficiency depends on:

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• Whether there is a reasonable possibility that the company’s controls will fail to prevent or detect a misstatement of an account balance or disclosure; and

• The magnitude of the potential misstatement resulting from the deficiency or deficiencies.

(AS No. 5, Par. 63).

267. Based on SEC regulations and Diamond’s certifications issued throughout the

Class Period, Diamond and the Individual Defendants were responsible for establishing and

maintaining disclosure controls and procedures and internal controls over financial reporting.

Moreover, as Diamond admitted in its February 8, 2012 Form 8-K, at least one material

weakness existed throughout the Class Period. Had Diamond and the Individual Defendants

created a proper and functioning system of internal controls over financial reporting, the

simple accounting manipulation of deferring expenses from period to period would have

been detected.

268. Diamond was also required by the SEC to maintain books and records in

sufficient detail to reflect the Company’s transactions and prepare financial statements in

accordance with GAAP. By not implementing a system of internal controls over financial

reporting that was functioning properly and would uncover a material misstatement of the

financial statements throughout the Class Period, Diamond and the Individual Defendants

violated Section 13(b)(2) and Section 15(d) of the Securities and Exchange Act of 1934

entitled Periodical and Other Reports, which states the following with respect to books and

records and internal controls:

Every issuer which has a class of securities registered pursuant to section 12 and every issuer which is required to file reports pursuant to section 15(d) shall:

A. Make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer; and

B. Devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that:

i. Transactions are executed in accordance with management's general or specific authorization;

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1 ii. Transactions are recorded as necessary:

(I) To permit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements, and

(II) To maintain accountability for assets;

iii. Access to assets is permitted only in accordance with management's general or specific authorization; and

iv. The recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate deed is taken with respect to any differences.

VIII. DELOITTE VIOLATED GENERALLY ACCEPTED AUDITING STANDARDS AND THE FEDERAL SECURITIES LAWS

269. Defendant Deloitte is one of the world’s largest certified public accounting firms

providing a range of services, including accounting and auditing, tax preparation and

planning, merger and acquisition, and security risk services. Deloitte’s relationship with

Diamond goes back to Diamond’s initial formation in 2005. From Diamond’s inception as a

public company in 2005, Deloitte served as its independent auditor. This relationship

continues up to the present. Prior to Diamond becoming a publicly-traded company, Deloitte

audited the prospectus for the initial public offering and the consolidated financial statements

of Diamond Walnut Growers, Inc. and its subsidiaries for the three years prior to July 31,

2004.

270. Deloitte was heavily involved in and familiar with the accounting practices of

Diamond and had access to the files and key employees of the Company at all relevant times.

Deloitte personnel had continual access to and knowledge of Diamond’s internal corporate,

financial, operating, and business information and had an opportunity to observe and review

the Company’s business and accounting practices and to test Diamond’s internal financial

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information, its publicly reported financial statements and the Company’s internal control

structure.

271. As Diamond’s independent auditor, Deloitte was charged, inter alia, with auditing

Diamond’s financial statements for the Fiscal Years ended July 31, 2010 and July 31, 2011,

in accordance with Generally Accepted Auditing Standards (“GAAS”). Deloitte failed to do

so and instead issued materially false and misleading unqualified audit opinions stating that

Diamond’s Class Period financial statements had been prepared in accordance with GAAP,

the internal controls over financial reporting were in place and effective, and that its audits

complied with GAAS. Additionally, Deloitte was engaged to perform quarterly reviews of

the financial statements included in Diamond’s Form’s 10-Q for the quarters within Fiscal

Years 2010 and 2011.

272. Instead, Deloitte failed in its responsibility as independent auditors and issued

unqualified audit opinions for all fiscal years during the Class Period, stating that

in our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Diamond Foods, Inc. and subsidiaries as of July 31, 2011 and 2010, and the results of their operations and their cash flows for each of the three years in the period ended July 31, 2011, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of July 31, 2011 [and as of July 31, 2010], based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

Such statements were known to be false and misleading when made and constituted a basis

for the artificial inflation of Diamond’s stock price.

273. As detailed in greater length below, Deloitte knowingly, or with deliberate

recklessness, participated in Diamond’s fraudulent accounting manipulations. When the Fall

2009 and Fall 2010 crops were delivered in substantial part during the first fiscal quarters of

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1

2010 and 2011, respectively, inventory and payable to growers were severely understated as

2 compared to the amounts of inventory and payable to growers recorded in prior fiscal years.

3 Thus, from the outset, Deloitte knew, or was deliberately reckless in not knowing, that

4 something was amiss requiring further investigation. Far more egregious was Deloitte’s

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6 treatment of Diamond’s final payment to growers for those fiscal years. As evidenced by the

7 March 19, 2012 Reuters article, Deloitte was aware of the unusual and exceptional nature of

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the $20 million “continuum” or “continuity” payment made in August 2010 relating to the

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Fall 2009 crop, but instead of insisting that Diamond record the payment in its Fiscal Year

10 2010 financial statements, Deloitte provided an unqualified audit opinion and let the fraud

11 continue. Given Deloitte’s knowledge of this improper payment in Fiscal Year 2010,

12 Deloitte knew, or was deliberately reckless in not knowing, that a similar such payment could

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14 occur again in Fiscal Year 2011. Instead, Deloitte perpetuated the fraud by knowing, or

15 being deliberately reckless in not knowing, that Diamond recorded a similar payment three

16

times larger and allowing the $60 million September 2011 payments to be deferred until

17 Fiscal Year 2012. Given the clear language in the grower contracts that the first payment to

18 growers would not be made until after the crop was delivered to Diamond, Deloitte knew, or

19 was deliberately reckless in not knowing, that Diamond had no business justification for

20

21 issuing the payments and its rationale that the payments constituted pre-payments was a

22 pretext for perpetuating a fraud. Deloitte continued its egregious refusal to see the obvious,

23 and to investigate the doubtful. It made accounting judgments which that no reasonable

24 accountant would have made if confronted with the same facts.

25 274. Moreover, as Diamond has admitted, the Class Period financial statements were

26 not prepared in accordance with GAAP, were materially misstated and misleading, could not

27 be relied upon by investors, and will result in a restatement covering at least the Fiscal Years


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- 121 -


2010 and 2011 financial statements as well as the quarterly periods therein and that at least

one material weakness existed throughout the Class Period.

A. DELOITTE’S RESPONSIBILITIES AND FUNCTIONS AS AN INDEPENDENT AUDITOR

275. The PCAOB, established by SOX, is responsible for the development of auditing

and related professional practice standards relating to SEC registrants that are required to be

followed by registered public accounting firms. 22 On April 16, 2003, the PCAOB adopted as

its interim standards, GAAS, as described by the American Institute of Certified Public

Accountants (“AICPA”) Auditing Standards Board’s (“ASB”) Statement on Auditing

Standards (“SAS No. 95”), Generally Accepted Auditing Standards , and related

interpretations in existence on that date. Accordingly, an auditor’s reference to “the

standards of the Public Accounting Oversight Board (United States)” includes a reference to

GAAS in existence as of April 16, 2003. For simplicity, all references to GAAS below

include the standards of the PCAOB.

276. As one of the largest audit firms in the world, Deloitte, a registered accounting

firm,23 was well aware of the strategies, methods, and procedures required by the standards

of the PCAOB and GAAS for conducting proper audits. In addition, Deloitte knew or was

deliberately reckless in not knowing of the audit risks inherent at Diamond and in the

22 PCAOB Release No. 2003-025 states that “for purposes of any engagement performed in accordance with the applicable auditing and related professional practice standards of the PCAOB, references in the interim standards to generally accepted auditing standards, U.S. generally accepted auditing standards, auditing standards generally accepted in the United States of America, and standards established by the AICPA, mean the standards of the PCAOB.” 23 Effective October 22, 2003, each public accounting firm that –

(a) prepares or issues any audit report with respect to any issuer; or (b) plays a substantial role in the preparation or furnishing of an audit report with

respect to any issuer must be registered with the PCAOB. Section 102 of SOX prohibits accounting firms that are not registered with the Board from preparing or issuing audit reports on U.S. public companies and from participating in such audits.

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industry in which Diamond operated because of the comprehensive services it provided to

Diamond over many years and because of its experience in the packaged and snack foods

industry.

277. The auditor’s duty to the investing public has been described as follows:

The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders as well as to [the] investing public. This public watchdog function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.

United States v. Arthur Young, 465 U.S. 805, 817-818 (1984).

278. This concept of public trust was reiterated most recently by the Commissioner of

the SEC, in relevant part, as follows:

Under federal securities laws, accountants act as gatekeepers to the public securities markets. These laws require, or permit the Commission [SEC] to require, that independent public accountants certify financial information filed with the commission. As we all know, without an opinion from an independent auditor, a company cannot satisfy the statutory and regulatory requirements for audited financial statements. 24

279. Moreover, the auditing standards state the following regarding the objective of an

audit and the responsibility of the auditor:

The objective of the ordinary audit of financial statements by an independent auditor is the expression of an opinion on the fairness with which they present in all material respects, financial position, results of operations, and its cash flows in conformity with generally accepted accounting principles. The auditor’s report is the medium through which he expresses his opinion or, if circumstances require, disclaims an opinion . In either case, he states whether his audit has been made in accordance with generally accepted auditing standards. These standards require him to state whether, in his opinion, the financial statements are presented in conformity with generally accepted accounting principles and to identify those circumstances in which such principles have not been consistently observed in the

24 Speech by SEC Commissioner: Remarks before the AICPA National Conference on Current SEC and PCAOB Developments by Commissioner Elisse B. Walter dated December 9, 2009.

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preparation of the financial statements of the current period in relation to those of the preceding period.

(AU 110.01) (emphasis added).

280. GAAS are the sets of standards by which audit quality can be assessed and audit

objectives are to be achieved. The following ten standards were developed by the AICPA in

1947 and have remained substantively intact since that time. There are three types of

standards under GAAS: 1) General Standards, 2) Standards of Fieldwork, and 3) Standards

of Reporting. In accordance with GAAS, 25 as an independent auditor, Deloitte was required

to plan, conduct, and report on the results of their audits based on these standards.

281. GAAS are as follows:

A. General Standards

1

The auditor must have adequate technical training and proficiency to perform the audit;

2

The auditor must maintain independence in mental attitude in all matters related to the audit; and

3

The auditor must use due professional care during the performance of the audit and the preparation of the report.

B. Standards of Field Work

1. The auditor must adequately plan the work and must properly supervise any assistants;

2. The auditor must obtain a sufficient understanding of the entity and its environment, including its internal control, to assess the risk of material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further audit procedures; and

25 GAAS includes SAS’ issued by the ASB of the AICPA, which are codified in AICPA Professional Standards under the prefix “AU.”

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3. The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion regarding the financial statements under audit.

C. Standards of Reporting

1. The auditor must state in the auditor’s report whether the financial statements are in accordance with generally accepted accounting principles (GAAP);

2. The auditor must identify in the auditor's report those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period;

3. When the auditor determines that informative disclosures are not reasonably adequate, the auditor must so state in the auditor's report.

4. The auditor must either express an opinion regarding the financial statements, taken as a whole, or state that such an opinion cannot be expressed in the auditor’s report. When the auditor cannot express an overall opinion, the auditor should state the reasons therefore in the auditor's report. In all cases where the auditor's name is associated with the financial statements, the auditor should clearly indicate the character of the auditor’s work, if any, and the degree of responsibility the auditor is taking, in the auditor’s report.

282

GAAS also requires:

The auditor should have sufficient knowledge of the SASs to identify those that are applicable to his or her audit. The nature of the 10 standards and the SASs requires the auditor to exercise professional judgment in applying them. Materiality and audit risk also underlie the application of the 10 standards and the SASs, particularly those related to field work and reporting. When, in rare circumstances, the auditor departs from a presumptively mandatory requirement, the auditor must document in the working papers his or her justification for the departure and how the alternative procedures performed in the circumstances were sufficient to achieve the objectives of the presumptively mandatory requirement.

(As amended, effective December 2005, by Statement on Auditing Standards No. 102) (AU

§150.04).

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1 283

Additionally, based on SOX, sufficient competent evidential matter must be

2 obtained by the auditor to support its opinion that the internal controls over financial

3 reporting are effective. AU §326, Evidential Matter, paragraph 25 states: “In developing his

4 or her opinion, the auditor should consider relevant evidential matter regardless of whether it

5

6 appears to corroborate or to contradict the assertions in the financial statements.” Thus,

7 during the conduct of an audit, the auditor should consider all relevant evidential matter even

8

though it might contradict or be inconsistent with other conclusions. Audit documentation

9 must contain information or data relating to significant findings or issues that are inconsistent

10 with the auditor's final conclusions on the relevant matter. (Par. A37).

11 284. Deloitte’s unqualified audit opinions were included in Diamond’s Class Period

12 SEC filings on Form 10-K (and in other public filings) that were disseminated to and relied

13

14 upon by the investing public. Even though Deloitte was aware that its audit reports would be

15 relied on by investors to make investment decisions and determine the adequacy of the value

16

of Diamond’s stock price, Deloitte failed to comply with GAAS in conducting its audit of

17 Diamond’s financial statements.

18 285. GAAS required Deloitte to act when it obtained sufficient competent evidential

19 matter indicating that Diamond was improperly accounting for payments to growers. After

20

21 receiving such information, Deloitte knew, or was deliberately reckless in not knowing, that

22 it should have forced Diamond to adjust the financial statements, issued qualified audit

23 opinions and/or resigned as Diamond’s independent auditor. Instead, as set forth more fully

24 below, it falsely affirmed that Diamond’s statements were prepared in conformity with

25 GAAP and that its audits were conducted in accordance with GAAS. The material

26 misstatements related to how the Company recorded and recognized the cost of raw

27 materials, improperly classified expenses, failed to adequately match revenues and expenses,

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and failed to properly value inventories and accounts payable to growers. These

misstatements resulted in the overstatement of gross profit, income from operations, income

before income taxes, and earnings per share throughout the Class Period and were the

proximate cause of the artificial inflation in Diamond’s stock price.

B. DELOITTE WAS AWARE OF THE ACCOUNTING MANIPULATIONS IN FISCAL YEAR 2010 BUT FAILED TO FULFILL ITS RESPONSIBILITIES AS AN INDEPENDENT AUDITOR

1. Deloitte Knew, or was Deliberately Reckless in Disregarding, the Improper Valuation of Inventory and Payable to Growers During Fiscal Year 2010

286. Deloitte was confronted with numerous and obvious red flags present at Diamond

as early as October 2009 (the first quarter of Fiscal Year 2010) regarding the payments to

walnut growers that put Deloitte on notice that fraud was occurring at the Company. Deloitte

was aware of the pre-determined payments whereby growers would be receiving payments

for the Fall 2009 crop in three installments: (1) late September 2009; (2) February 15, 2010;

and (3) August 2010.

287. California walnut prices were substantially greater for the Fall 2009 crop as

compared to the prior year. 26 As of October 31, 2009, the end of Diamond’s first quarter for

Fiscal Year 2010 when the harvest had been substantially completed, Diamond’s recorded

payable to growers was $114.6 million as compared to $135.7 million as of October 31,

2008. This balance was approximately $21.1 million or 16% lower than the prior fiscal year.

The large discrepancy put Deloitte on notice, as early as the first quarter of fiscal 2010, that

26 See Ex. 5 (showing that the average walnut prices rose from $.64/lb for the Fall 2008 crop to $.86/lb for the Fall 2009 crop).

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there was the potential for a large misstatement. 27 Moreover, in each of the first three

quarters during Fiscal Year 2010, Deloitte performed quarterly reviews. During these

quarterly reviews, any comparison to prior years would have alerted Deloitte that the amount

of inventory and payable to growers was understated. Because the understated inventory is

inextricably tied with costs of sales, Diamond would have necessarily understated costs of

sales throughout Fiscal Year 2010 as it sold the walnut crop. Thus, when Diamond recorded

revenue during Fiscal Year 2010, it improperly understated the costs of sales, which had the

effect of overstating gross profit, income from operations, income before income taxes, net

income and earnings per share on Diamond’s income statements.

2. Deloitte’s Audit for Fiscal Year 2010 Identified $20 Million in Grower Payments Improperly Recorded in Fiscal Year 2011

288. Even assuming arguendo that Deloitte did not learn of the improper recording of

the amount owed to walnut growers (and the corresponding inventory on Diamond’s books)

during the first three fiscal quarter 2010 reviews, Deloitte became aware of the $20 million

payment while performing its audit procedures related to Diamond’s financial statements for

Fiscal Year 2010.

289. Deloitte’s typical audit approach for accounts payable is to test the outstanding

balance as of the end of the year via subsequent disbursements. This type of procedure is

designed to ensure that the accounts payable are not understated as of the end of the fiscal

year. Deloitte’s audit workpapers typically contain a workpaper labeled “6x10 - audit

program,” which directs the auditor to test the accounts payable or liability at period end by

27 Moreover, a review of Diamond’s financial results for the second quarter of Fiscal Year 2010 after the harvest was entirely completed shows that Diamond’s recorded payable to growers was still substantially lower than the prior year. Specifically, the payable to growers recorded for the second quarter of Fiscal Year 2010 was $76.9 million as compared to $88 million as of October 31, 2009. This balance was approximately $11.1 million or 13% lower than the prior fiscal year.

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obtaining (1) checks that have either been cancelled or cleared from the Company’s bank

accounts, (2) a listing of written but not yet mailed checks, and (3) a listing of outstanding or

not yet paid invoices after the end of the reporting period. Given that Diamond’s fiscal year

ended on July 31, 2010, the likely subsequent disbursement testing population ranged from

August 1, 2010 to shortly before October 5, 2010 (Deloitte’s audit opinion date). 28

290. The audit program indicates that selections are to be made from the population

and analyzed. In the event that selected cancelled checks, written but not yet mailed checks,

or outstanding invoices relate to the period under audit, an assessment of the adequacy of the

accounts payable outstanding can be made to ensuring that the balance is not understated.

291. Following these procedures, Deloitte would have selected payments made

subsequent to Diamond’s fiscal year ending July 31, 2010. Audit Committee and Board

Committee member Dennis Mussell indicated in the March 19, 2012 Reuters article that the

$20 million payment made in mid-August 2010 “caught the eye” of Deloitte. Thus, it

appears that Deloitte selected payments made to growers in mid-August 2010. This is further

corroborated by the statements of CWs 1, 9 and 10, who indicated that the $20 million

payments were made in mid-August 2010 accompanied by a letter dated August 13, 2010

from Mendes explaining the reason for the payment.

28 In stark contrast, Diamond’s previous independent auditor used a more appropriate technique to ensure that the payable to growers balance as of year-end was not materially misstated. According to a March 19, 2012 Reuters article, Moss Adams, LLP acted as Diamond’s independent auditor prior to Diamond becoming a publicly-traded company. As part of their audit procedures, Moss Adams, LLP sent audit confirmations to growers in order to evaluate the outstanding balance as of year-end. This type of confirmation would not only ensure that Moss Adams, LLP had a basis for its audit opinion but resulted in testing the balance outstanding in a way that the selections were always traced to the outstanding balance, providing a much higher level of assurance that the balance was not materially understated or overstated at any point in time. Additionally, it was, and still is, typical for Deloitte to use such an auditing technique and send out confirmations to test outstanding debt balances, regardless of whether the indicated amount owed was zero or millions of dollars.

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292. The August 2010 payment should have been accrued at the end of Fiscal Year

2010 given Diamond’s pre-determined schedule that expressly contemplated paying the final

installment of that crop in August 2010 and did not contemplate paying for the Fall 2010

crop until October 2010.

293. Moreover, at the time that the August 2010 payment was made, Diamond’s

“payable to growers” was only $36 million. This $20 million payment would have increased

the outstanding “payable to growers” balance of $35.8 million as of July 31, 2010 by more

than 55%, and increased Diamond’s recorded cost of sales of $519.2 million for the full

Fiscal Year 2010 by almost 4%. The dramatically reduced payable on Diamond’s financial

statements, as well as the unprecedented and exceptional nature of the payment itself, put

Deloitte on notice that something was amiss and needed to be investigated further.

Moreover, there was little justification for Deloitte to believe that Diamond was paying, in

the very same payment that it made for the Fall 2009 crop, such a high amount for the Fall

2010 crop that Diamond was not set to receive (and the payment was not scheduled) for

another two months.

294. Deloitte knew, or was deliberately reckless in disregarding, that Diamond was

required under GAAP to accrue for the $20 million payment in Fiscal Year 2010. GAAP

makes it clear that such accrual was required by ASC 450, Contingencies :

An estimated loss from a loss contingency [ e.g. , payable to growers] shall be accrued by a charge to income if both of the following conditions are met:

a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements... and b. The amount of loss can be reasonably estimated.

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295. When faced with the fact that $20 million had not be accrued or included in the

2 payable to growers balance as of July 31, 2010 in accordance with GAAP, Deloitte discussed

3 this issue with Diamond’s management.

4 3 . Deloitte Improperly Issued an Unqualified Audit Opinion for

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Fiscal Year 2010

6 296. Shortly after discovering that $20 million grower payments made in August 2010

7 were improperly excluded from the outstanding accounts payable to growers as of July 31,

8 2010, Deloitte learned or was deliberately reckless in not learning the truth about the

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10 accounting fraud. Deloitte was aware, or was deliberately reckless in not being aware, that

11 adjusting Fiscal Year 2010 financial results by $20 million would have reduced net income

12

for the quarterly period ended July 31, 2010 from $6.7 million to a net loss of $13.3 million,

13 a decrease of almost 300%. Additionally, recording an expense of this magnitude would

14 have reduced net income for Fiscal Year 2010 from $26.2 million down to $6.2 million, a

15 decrease of almost 76%.

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17 297. As discussed in detail herein, one of the primary motivations for keeping

18 Diamond’s stock price artificially inflated was to ensure that the proposed merger of Pringles

19 was consummated. Because the consideration for the proposed merger was comprised

20 mostly of Diamond’s common stock, it was imperative to keep the cost of sales during fiscal

21 2010 as low as possible, and correspondingly, the net income as high as possible. Although

22 P&G had withdrawn from negotiations in 2010, Mendes continued to work to complete the

23 proposed transaction, and, as a consequence, maintaining the price of Diamond common

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25 stock was essential to rekindle negotiations.

26 298. Faced with the fraud occurring at Diamond, Deloitte had a choice. On one hand,

27

Deloitte could ensure that Diamond properly recorded $20 million in Fiscal Year 2010.


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1

Because accounting for the $20 million in grower payments during the fourth fiscal quarter

2 would have resulted in Diamond recording a second consecutive quarterly loss for Fiscal

3 Year 2010, this option would have exposed additional weaknesses in Diamond’s financial

4 position, which would have jeopardized Diamond’s stock price and merger plans.

5

6 Alternatively, Deloitte could turn a blind eye on Diamond’s improper deferral of $20 million

7 in cost of sales from Fiscal Year 2010 to Fiscal Year 2011. By allowing for the improper

8

deferral, Diamond would have recorded financial results consistent with or exceeding

9 analysts’ expectations, thus ensuring that the stock price remained artificially inflated.

10 299. As evidenced by the fact that the $20 million was improperly deferred to Fiscal

11 Year 2011, Deloitte apparently made the decision to ignore the ongoing fraud at Diamond.

12 300. As part of its audit procedures, Deloitte regularly obtains representations from

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14 management, orally and/or in writing, regardless of whether it is in the normal course of

15 business or where competent evidential matter is either difficult to assess or requires

16

significant subjectivity. For example, valuation allowances for income taxes or for doubtful

17 accounts receivable are items regularly included in management’s representation letters to

18 Deloitte. To resolve the $20 million payment in the audit workpapers, Deloitte necessarily

19 had to rely on management’s representation that the payments related to the Fall 2010 crop

20

21 and were properly recorded in Diamond’s Fiscal Year 2011 financial results.

22 301. Relying on this representation despite the clear and contravening evidence that

23 such a representation was false constituted a violation of GAAS. Additionally, just prior to

24 the period at hand, the PCAOB issued a report condemning Deloitte for improperly relying

25 on management representations and not performing adequate audit procedures, which

26 evidences Deloitte’s pattern of conduct. The October 2011 PCAOB report, which was dated

27 May 19, 2010 and related to a 2007 inspection, stated as follows:


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The engagement reviews provide cause for concern that the Firm’s system of quality control may not do enough to assure that the Firm performs appropriate procedures to audit significant estimates, including evaluating management’s assumptions and testing the data supporting the estimates.

302. The PCAOB gave Deloitte one year to address and remediate the quality controls

I in the PCAOB’s review:

The Board prepares a report on each inspection it conducts, and a portion of each report is made publicly available when issued. Many reports contain nonpublic content, which may include, among other things, discussion of potential defects in a firm's system of quality control. Any such quality control criticisms remain nonpublic if the firm addresses them to the Board's satisfaction within 12 months after the report date. If a firm fails to satisfactorily address any of the quality control criticisms within 12 months, the portion of the report discussing the particular criticism(s) is made publicly available.

(Emphasis added).

303. A year after the issuance of this report, Deloitte failed to address the criticisms

and had not remediated such quality controls deficiencies, including Deloitte’s deficiency

associated with the appropriateness of its audit procedures surrounding management’s

estimates and the testing of such, resulting in the PCAOB issuing the report to the public.

This further evidences the deliberately reckless manner in which Deloitte conducted its

audits, which it apparently did here given its knowledge and Diamond’s concessions of an

impending restatement.

C. DELOITTE WAS AWARE OF THE ACCOUNTING MANIPULATIONS IN FISCAL YEAR 2011 BUT FAILED TO FULFILL ITS RESPONSIBILITIES AS AN INDEPENDENT AUDITOR

1. First through Third Fiscal Quarterly Reviews

304. In addition to the multitude of times that Deloitte knew, or was deliberately

reckless in not knowing that the $20 million payments should have been recorded in Fiscal

Year 2010, Deloitte had another opportunity to take the necessary actions to prevent a

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1 continuation of the fraud, but it failed to do so. Assuming Deloitte performed adequate

2 review procedures for the first quarter of Fiscal Year 2011, the quarterly period ended

3 October 31, 2010, it would have inquired about the $20 million payments dated August 2010

4 included in this first fiscal quarter. Because Diamond had been consistently understating its

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6 costs of sales due to its failure to include the $20 million payments throughout Fiscal Year

7 2010, the cash payment of $20 million recorded in the first fiscal quarter of Fiscal Year 2011

8 alerted Deloitte that something was amiss. Moreover, Diamond and the Individual

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Defendants underestimated the costs of the Fall 2010 crop to an even greater extent than they

10 did for the Fall 2009 crop. Thus, Deloitte ignored yet another red flag when signing off on

11 the quarterly review and not retracting its previously-issued unqualified audit opinion for

12 Fiscal Year 2010.

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14 305. Moreover, during the first fiscal quarter of Fiscal Year 2011 when Deloitte

15 submitted an unqualified audit opinion and Diamond filed its Fiscal Year 2010 financial

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statements, due diligence efforts regarding the Pringles merger had been underway for

17 several months. Thus, Deloitte likely was contemplating that either 1) the $100 million that

18 was expected in acquisition and integration related expenses associated with the proposed

19 Pringles merger would be significant enough in Fiscal Year 2011 to hide the improperly

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21 deferred $20 million, or 2) the $20 million would not be significant enough, when divided

22 into four separate quarterly periods of Fiscal Year 2011’s costs of sales, to raise red flags.

23 Further, Deloitte knew that it would not have to opine on the adequacy of Diamond’s

24

financial statements and its internal controls over financial reporting before the end of the

25 fiscal year. Thus, Deloitte knew that this was the end of its involvement in the fraudulent

26 scheme as either the contemplated Pringles merger would hide the fraud forever or the


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incremental amount of cost of sales recorded in the fourth quarter of Fiscal Year 2011 would

not be noticed by investors.

306. Having already improperly shifted expenses from Fiscal Year 2010 to Fiscal Year

2011, Diamond needed to defer enough additional costs to ensure that gross profit, income

from operations, income before income taxes, net income and earnings per share would meet

or exceed analysts’ expectations and the stock price would remain artificially inflated. Thus,

when the Fall 2010 crop arrived in early October 2010, Diamond once again underestimated

the cost of the crop 29 by $60 million, which understated both inventory and accounts

payable. 30 Specifically, the payable to growers balance as of October 31, 2010, the period in

which the substantial portion of the Fall 2010 crop had been received, was reported to be

$84.8 million or $29.8 million lower than 2010 balance of $114.6 million. As a result, in just

three years, the payable to growers balance dropped $60 million 31 , or almost 40%, while

sales during the same period increased by 37%. By underestimating the cost of the Fall 2010

crop, Diamond was able to understate its cost of sales and, as result, overstate gross profits,

income from operations, income before income taxes, net income and earnings per share

throughout Fiscal Year 2011. As a result of the improper deferral, Diamond was able to

report financial results that met or exceeded analysts’ expectations for the first quarter of

Fiscal Year 2011. By allowing Diamond to continue perpetuating this fraudulent scheme that

understated inventory, accounts payable and costs of sales and overstated gross profit,

29 See Ex. 5 (showing that the average cost of walnuts increased from $.86/lb for the Fall 2009 crop to $1.02/lb for the Fall 2010 crop). 30 As a result of the accounting manipulations, Diamond’s inventory was overstated with respect to the $20 million August 2010 payments and understated with respect to the $60 million September 2011 payments. Diamond’s payable to growers was understated by the $60 million September 2011 payments. 31 The payable to growers balance was $143.9 million as of October 31, 2008 balance, and was reduced to $84.8 million as of October 31, 2010, amounting to a decrease of almost $60 million.

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income from operations, income before income taxes, net income and earnings per share,

Deloitte did not perform its responsibilities in its quarterly reviews of the October 31, 2010,

January 31, 2011 and April 30, 2011 financial statements.

307. Deloitte’s failure to perform properly its audit responsibilities was particularly

significant when viewed in the context of the ongoing negotiations regarding the Pringles

merger. As stated above, Diamond did not receive antitrust clearance by July 31, 2011, and

therefore was unable to hide the $20 million August 2010 payments, as there were

insufficient acquisition and integration expenses incurred to date to mask these payments.

2. Fiscal Year 2011 Audit

308. Given that Deloitte knew, or was deliberately reckless in not knowing, that

Diamond made a $20 million payment in August 2010 that was improperly recorded in Fiscal

Year 2011, Deloitte knew, or was deliberately reckless in not knowing, that the same type of

expense deferral might occur in August 2011. A number of other factors alerted Deloitte that

any similarly structured payment was improper. First, “payable to growers” on the July 31,

2011 balance sheet was only $15.2 million, 58% percent lower than Diamond’s July 31, 2010

balance of $35.8 million, and 48% lower than the July 31, 2009 balance of $29.1 million,

which constituted a red flag putting Deloitte on notice that the payable to growers account

required additional scrutiny. Additionally, Deloitte knew that Diamond’s pre-determined

payment schedule mandated the final payment associated with the Fall 2010 crop be made in

August 2011. Finally, Diamond elected to rush the audit process by filing its Fiscal Year

2011 financial results 15 days before the large accelerated filer deadline 32 and 10 days before

it had ever filed in its seven years of existence as a publicly-traded company. As a result of

32 As a result of Diamond’s artificially inflated stock price, the public float on Diamond’s stock was greater than $700 million, which required Diamond to file its Form 10-K under the large accelerated filers’ requirement of 60 days after year-end.

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the foregoing, Deloitte knew, or was deliberately reckless in not knowing, that it needed to

2 increase its professional skepticism and employ additional audit procedures, which would

3 have included such procedures as sending confirmations to growers on the amounts they

4 were owed and extending any deadline on Deloitte’s subsequent disbursement testing.

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6 309. It appears that Deloitte did not employ such auditing techniques, or any adequate

7 subsequent disbursement testing. Assuming subsequent disbursement testing was performed

8 as it was in prior years, one of two results necessarily occurred. First, the testing was so

9

deficient that it failed to reveal an extraordinarily large and unusual $60 million payment

10 made on September 2, 2011 constituting more than 395% of the outstanding “payable to

11 growers” balance as of July 31, 2011 and more than 8% of Diamond’s total cost of sales for

12 all of Fiscal Year 2011. More likely, particularly in light of the fact that Deloitte knew of the

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14 $20 million continuity payment, at the close of Fiscal Year 2011, Deloitte knew of the $60

15 million payment. If Deloitte knew of the $60 million payment, it once again improperly

16

relied upon an unsubstantiated management representation when it issued an unqualified

17 audit opinion instead of forcing Diamond to record the payment in the proper period.

18 Similarly to Fiscal Year 2010, there was no business justification to issue such a large

19 payment to growers for the subsequent fiscal year, in contravention of the clear grower

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21 contracts, when neither the crop nor the payment were due for over another month. Thus,

22 under either scenario, Deloitte’s actions constituted violations of GAAS and rendered its

23 unqualified audit opinion relating to Diamond’s Fiscal Year 2011 financial statements

24 materially false and misleading when made.

25 310. Additionally, when performing the Fiscal Year 2011 audit, Deloitte was aware, as

26 both Diamond and P&G’s independent auditor, that Diamond’s stock, used as consideration


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related to the proposed Pringles merger, had appreciated by more than $600 million, 33 and

therefore, any revelation of accounting manipulations at Diamond would have jeopardized

the Pringles merger, potentially causing both of Deloitte’s clients to lose valuable assets.

D. DELOITTE FAILED TO FULFILL ITS RESPONSIBILITIES AND FUNCTIONS AS DIAMOND’S INDEPENDENT AUDITOR

1. Deloitte Failed to Exercise Due Professional Care and Skepticism

311. Deloitte violated GAAS by failing to exercise due professional care in the

performance of the Diamond audits. “Due professional care imposes a responsibility upon

each professional within an independent auditor’s organization to observe the standards of

fieldwork and reporting.” (AU §230.02). In addition, due care requires the auditor to use

“the knowledge, skill, and ability called for by the profession of public accounting to

diligently perform, in good faith and with integrity, the gathering and objective valuation of

evidence.” (AU §230.07). The standard also states the following regarding due care and

professional skepticism:

The auditor neither assumes that management is dishonest nor assumes unquestioned honesty. In exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that management is honest. (AU §230.09)

312

Additionally, GAAS state the following regarding professional skepticism and

fraud:

33 Based on Diamond’s definitive proxy statement for Fiscal Year 2011, “The implied equity value of the transaction consideration was based on the product of the average of 60 days of daily volume weighted average prices, or 60-day VWAP, of Diamond common stock for the period ending March 28, 2011 of $51.47 multiplied by the approximately 29.1 million [29,143,190] shares of Diamond common stock to be issued in connection with the Transactions.” As the total common stock consideration was valued at $1.5 billion (29,143,190 X $51.47) as of the date of the agreement but had soared to almost $2.1 billion as of July 31, 2011 (closing Diamond’s stock price as of July 29, 2011 was $71.59), the consideration in Diamond’s common stock to be received by P&G had appreciated by more than $600 million based on the artificial inflation in the stock price.

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Because of the characteristics of fraud, the auditor's exercise of professional skepticism is important when considering the risk of material misstatement due to fraud. Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. The auditor should conduct the engagement with a mindset that recognizes the possibility that a material misstatement due to fraud could be present, regardless of any past experience with the entity and regardless of the auditor’s belief about management's honesty and integrity. Furthermore, professional skepticism requires an ongoing questioning of whether the information and evidence obtained suggests that a material misstatement due to fraud has occurred. In exercising professional skepticism in gathering and evaluating evidence, the auditor should not be satisfied with less-than-persuasive evidence because of a belief that management is honest.

(AU §316.13) (emphasis added).

2. Deloitte Intentionally Ignored Numerous Red Flags Establishing that its Audits Violated GAAS and that Diamond’s Financial Statements Violated GAAP

313. As one of the largest audit firms in the world, Deloitte was necessarily aware of

the required procedures dictated by GAAS to perform proper audits of Diamond’s financial

statements and internal controls over financial reporting. In addition, Deloitte had virtually

limitless and unfettered access to information concerning Diamond’s operations.

314. Under GAAS, “[t]he auditor has a responsibility to plan and perform the audit to

obtain reasonable assurance about whether the financial statements are free of material

misstatement, whether caused by error or fraud.” (AU §110.02). Even assuming arguendo

that Deloitte was not directly informed of the ongoing fraud at Diamond, Deloitte ignored

numerous, obvious and blatant “red flags” that alerted it to the massive fraud at Diamond and

to the material weaknesses in Diamond’s internal controls over financial reporting.

315. Pursuant to GAAS, AU §508, Reports on Audited Financial Statements , Deloitte

was required to issue qualified or adverse audit opinions when Diamond failed adequately to

accrue the $20 million August 2010 grower payments in costs of sales in Fiscal Year 2010

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and the $60 million September 2011 grower payments in costs of sales in Fiscal Year 2011 in

accordance with GAAP, or, ultimately withhold the issuance of such audit opinions.

316. During the Class Period, Deloitte ignored numerous obvious red flags indicating

that fraud was ongoing at Diamond including the following:

1. The timing of the $20 million August 2010 payments could only be associated with the Fall 2009 crop and alerted Deloitte that this amount required accrual as of July 31, 2010 as payments for the Fall 2010 crop were not scheduled for more than 2 months;

2. The outstanding balance relating to payable to growers as of July 31, 2010 amounted to $35.8 million but decreased 58% to $15.2 million as of July 31, 2011, which alerted Deloitte that the payable to growers as well as cost of sales were materially understated throughout Fiscal Year 2011;

3. The payable to growers outstanding balance as of July 31, 2010 represented less than 7% of the cost of sales for Fiscal Year 2010 as compared to 13% 34 for Fiscal Year 2008 alerted Deloitte to the fact that the payable to growers as well as cost of sales were materially understated throughout Fiscal Year 2010;

4. The timing of the $60 million September 2011 payment could only be associated with the Fall 2010 crop and alerted Deloitte that this amount be required accrual as of July 31, 2011 as payments for the Fall 2011 crop were not scheduled for more than a month;

5. The size of the $60 million September 2011 payment, which was three times the payment made the prior year, alerted Deloitte that the September 2011 payment related to the Fall 2010 crop and required accrual as of July 31, 2011;

6. The size of the payments made after year-end as compared to the outstanding payable to growers balance as of July 31 of each year. Specifically, the $20 million and $60 million payments made in August 2010 and September 2011, respectively, represented 56% and 395%35 of the payable to growers outstanding on July 31, 2010 and 2011, respectively, and alerted Deloitte that these payments related to the previous periods;

34 Diamond’s FY2009 10-K, pages 24-25. As the payable to growers as of July 31, 2008 was $56.9 million and the cost of sales for fiscal year 2008 was $443.5 million, the payable to growers represented almost 13% of the fiscal 2008 cost of sales. 35 Diamond’s FY2011 10-K, page 44. The payable to growers balance as of July 31, 2010 was $35.8 million and $15.2 million as of July 31, 2011. As a result, the $20 million payments in August 2010 represented 56% of the payable to growers as of July 31, 2010 and the $60 million payments in September 2011 represented 395% of the payable to growers as of July 31, 2011.

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7. Some of the growers receiving payment in September 2011 were not scheduled to deliver any walnuts for Fall 2011 crop, establishing that the $60 million payments alerted Deloitte to the fact that this amount could only relate to the Fall 2010 crop and should be accrued as of July 31, 2011;

8. The fact Diamond issued a press release dated October 3, 2011 in which Diamond disclosed, for the first time ever, that Diamond “made a pre-harvest momentum payment to walnut growers in early September, prior to the delivery of the fall walnut crop to reflect the fiscal 2012 projected market environment” when Deloitte knew or was deliberately reckless in not knowing that payments for the Fall 2011 crop were not due for at least another 30 days. Basic inquiries would have alerted Deloitte to the obvious: 1) the September 2011 payment required accrual as of July 31, 2011 as it related to the Fall 2010 final crop payment; 2) making a payment for “fiscal year 2012 projected market environment” was contrary to Diamond’s public disclosure that “we [Diamond] determine the minimum price for this inventory by March 31, or later, of the following calendar year.”; and (3) if an appropriate price had been paid to the growers during the regular fiscal year’s accounting, then an unscheduled, unannounced, gratuitous payment to growers would have no legitimate business justification;

9. The fact that Diamond announced, in its Form S-4 dated September 16, 2011, that one-time acquisition and integration related expenses for the Pringles merger were now expected to be approximately $150 million when it had been previously disclosed that these costs would amount to $100 million. The $50 million increase in these costs, about the amount of the unprecedented and exceptional “momentum” payments of $60 million, put Deloitte on notice that Diamond was manipulating the financial statements and planned to shift these expenses into that category;

10. The enormous pressure on executives to keep the stock price artificially inflated to ensure that the Pringles merger would be consummated put Deloitte on notice of the heightened risk of fraudulent accounting manipulations and prevented sole reliance on management’s representations as a basis for issuing unqualified audit opinions as previously communicated to Deloitte by the PCAOB almost three years earlier;

11. The enormous pressure on executives to keep the stock price artificially inflated since Diamond was already leveraged with no borrowing capacity to enable it to finance the Pringles merger causing Diamond to use its common stock as currency put Deloitte on notice of the heightened risk of fraudulent accounting manipulations intended to keep the stock price and financial results artificially inflated;

12. The fact that P&G had already indicated to Diamond that Diamond’s stock price was too volatile and risky and previously refused to sell its coveted Pringles brand to Diamond put Deloitte on notice of the heightened risk of

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fraudulent accounting manipulations intended to keep Diamond’s stock price and financial results artificially inflated 36 ;

13. The fact that a large component of Diamond executives’ compensation was associated with Diamond’s financial results put Deloitte on notice of the higher risk of fraud and prevented sole reliance on management’s representations for balances that were material in all respects, as previously communicated by the PCAOB to Deloitte almost three years earlier;

14. The fact that a large component of Diamond executives’ compensation was associated with Diamond’s financial results, which were anticipated to grow exponentially following the pending Pringles merger, put Deloitte on notice of the higher risk of fraud and prevented sole reliance on management’s representations for balances that were material in all respects to Diamond’s financial statements; and

15. The fact that Diamond’s financial statements had disclosed, on the face of the balance sheet37, the amount payable to growers at any given period end from the time it went public in 2005 to the third quarter of Fiscal Year 2011 but ceased to do so on Diamond’s balance sheet as of July 31, 2011. Instead, Diamond buried the amount outstanding in disclosure number 9 of the financial statements, putting Deloitte on notice of the heightened risk that this amount could be materially misstated.

317. Other obvious and blatant “red flags” ignored by Deloitte include: (16) growers’

increasing dissatisfaction with the price Diamond paid per pound for the crop as compared to

36 As stated in Diamond’s definitive proxy statement for Fiscal Year 2011: “[i]n those discussions, P&G’s advisors indicated that P&G was seeking a higher value for the Pringles Business and greater certainty on value in the event the trading prices for Diamond common stock declined between announcement of a transaction and closing. Additionally, “[i]n early February 2011, Diamond’s management team and representatives of BofA Merrill Lynch discussed the possibility of re-engaging with P&G given that the trading price of Diamond common stock had appreciated since the parties’ discussions in 2010.” 37 See Diamond’s FY2011 10-K, page 44. Diamond, from the time it went public in 2005 to the third quarter of 2011, reported the payable to growers’ balance outstanding as of the end of the reporting period on the face of Diamond’s balance sheet. However, beginning on July 31, 2011 ( i.e. , end of Fiscal Year 2011), Diamond included the payable to growers in footnote 9 of the financial statements disclosures. By not presenting the payable to growers on the face of the balance sheet as of July 31, 2011 included in Diamond’s Form 10-K for fiscal year 2011, Deloitte failed to enforce Diamond’s policy of presenting certain balances on the face of the balance sheet. Comparatively, Diamond presented as a separate line item on the balance sheet the much lower balance of other long-term assets of $8.5 million and $6.8 million as of July 31, 2010 and 2011, respectively.

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market prices, putting Deloitte on notice that that cost of raw materials was understated 38 ;

(17) fluctuations in cost of sales not in line with increases or decreases in price per pound

dictated by market conditions; (18) lack of consistency and tone at the top from senior

management in ensuring that GAAP was consistently applied; (19) excessive pressure on

management and operating personnel to meet sales and profitability goals established by

senior management, which were designed to meet or exceed analysts’ estimates of net

income and earnings per share, to ensure that the stock price remained artificially inflated

and/or ensure that the stock price did not fluctuate significantly; (20) excessive interest of

senior management in maintaining or increasing Diamond’s stock price at inflated levels to

ensure that P&G would be interested in divesting the Pringles brand in exchange for

Diamond’s common stock; (21) excessive interest of senior management in maintaining or

increasing Diamond’s stock price at inflated levels and report increasingly aggressive

financial results targets to boost personal gain and benefits; (22) improper accounting for,

and failure to document, payments made to growers throughout the year; and (23) Deloitte’s

personnel’s reliance on a system of quality controls that did not ensure appropriate

procedures to audit significant estimates, such as payable to growers, including evaluating

management’s assumptions and testing the data supporting the estimates that were still not

remediated even one year after being reprimanded by the PCAOB.

318. Moreover, in a speech given at the 2009 AICPA National Conference on Current

SEC and PCAOB Developments, Jason S. Flemmons, Associate Chief Accountant, Division

of Enforcement, US Securities and Exchange Commission explained that:

38 Diamond’s FY2010 10-K, page 16. “In March 2008, a former grower and an organization named Walnut Producers of California filed suit against us in San Joaquin County Superior Court claiming, among other things, breach of contract relating to alleged underpayment for walnut deliveries for the 2005 and 2006 crop years. The plaintiffs purport to represent a class of walnut growers who entered into contracts with us.”

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management fraud does not exempt an auditor from carrying out his or her professional responsibilities to investors. Due care and professional skepticism are not abstract or arcane concepts that are retained just long enough to pass the CPA exam. To the contrary, these are bedrock principles that must be exercised in everything that an auditor does. Due care and professional skepticism must be vigorously employed whether you are planning, performing or supervising an audit or review.

3. Deloitte Properly Failed to Plan and Perform Adequate Audit Procedures on Diamond’s Financial Statements for Fiscal Years 2010 and 2011

319. Deloitte’s audits violated the first standard of fieldwork that requires the auditor

to properly plan the engagement. AU §311, Planning and Supervision, provides guidance for

the planning of an audit and states, in part, as follows:

Audit planning involves developing an overall strategy for the expected conduct and scope of the audit (3)... the work to be performed and should prepare a written audit program (or set of written audit programs) for every audit. The audit program should set forth in reasonable detail the audit procedures that the auditor believes are necessary to accomplish the objectives of the audit. (J5)... The auditor should obtain a level of knowledge of the entity’s business that will enable him to plan and perform his audit in accordance with the generally accepted auditing standards. That level of knowledge should enable him to obtain an understanding of the events, transactions, and practices that, in his judgment, may have a significant effect on the financial statements. (J6)...[In the planning phase of the audit,] The auditor should obtain a knowledge of matters that relate to the nature of the entity’s business, its organization, and its operating characteristics. Such matters include, for example, the type of business, types of products and services, capital structure, related parties, locations, and production, distribution, and compensation methods. The auditor should also consider matters affecting the industry in which the entity operates, such as economic conditions, government regulations, and changes in technology, as they relate to his audit. Other matters, such as accounting practices common to the industry, competitive conditions and, if available, financial trends and ratios should also be considered by the auditor. (Par. 7)

(Emphasis added).

320. As detailed herein, Deloitte violated the “planning” standards in connection with

its audits by failing either to obtain the requisite level of knowledge or by disregarding, with

deliberate recklessness, significant information that would have enabled Deloitte to plan and

carry out appropriate audit procedures relating to the actual cost of raw materials, timing of

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grower payments, payable to growers, cost of sales, and inventory valuation as of the end of

each reporting period which in turn overstated gross profit, income from operations, income

before income taxes, net income and earnings per share throughout the Class Period.

4. Deloitte Failed to Obtain Adequate Knowledge of Diamond’s Business as Required by GAAS

321. To properly plan an audit in accordance with GAAS, an independent auditor must

obtain a sufficient understanding of the entity’s business and operating environment. In

accordance with planning standards, understanding the entity’s business, the environment,

and internal controls is essential to planning and performing an audit in accordance with

GAAS. (AU §311.03). Such an understanding establishes a frame of reference within which

the auditor plans the audit and exercises professional judgment about assessing risks of

material misstatement of the financial statements and responding to those risks throughout

the audit, for example, when:

• Establishing materiality for planning purposes and evaluating whether that judgment remains appropriate as the audit progresses;

• Considering the appropriateness of the selection and application of accounting policies and the adequacy of financial statement disclosures;

• Identifying areas where special audit consideration may be necessary, For example, related-party transactions, the appropriateness of management's use of the going-concern assumption, complex or unusual transactions, or considering the business purpose of transactions;

~ Developing expectations for use when performing analytical procedures;

• Designing and performing further audit procedures to reduce audit risk to an appropriately low level; or

• Evaluating the sufficiency and appropriateness of audit evidence obtained, such as evidence related to the reasonableness of management’s assumptions and of management’s oral and written representations.” (AU §314.03).

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322. Had Deloitte appropriately obtained an adequate level of understanding of

Diamond’s business, it would have tested the appropriateness of the amounts recorded for

raw materials, payable to growers, cost of sales, and inventory valuation as of the end of each

reporting periods. The improper recording of these amounts in turn overstated gross profit,

income from operations, income before income taxes, net income and earnings per share

throughout the Class Period.

5. Deloitte Failed Properly to Consider the Risk of Fraud at Diamond as Required by GAAS

323. “The auditor has a responsibility to plan and perform the audit to obtain

reasonable assurance about whether the financial statements are free of material

misstatement, whether caused by error or fraud...” (AU §316.02 and AU §110.02).

Therefore, to conduct an audit in accordance with GAAS, Deloitte was required to perform

certain audit procedures to fulfill this responsibility. Specifically, GAAS (AU §316) requires

auditors to:

. Exercise professional skepticism;

• Brainstorm with engagement personnel regarding the risks of material misstatement due to fraud;

• Obtain information needed to identify the risks of material misstatement due to fraud;

• Make inquiries of management and others within the entity about risks of fraud;

• Consider the results of analytical procedures performed in planning the audit;

• Consider fraud risk factors; and

• Consider other information that may be helpful in identifying risks of material misstatement due to fraud.

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324. GAAS guidance indicates that accounts with high degree of management’s

judgment are always presumed to be a fraud risk:

Certain accounts, classes of transactions, and assertions that have high inherent risk because they involve a high degree of management judgment and subjectivity also may present risks of material misstatement due to fraud because they are susceptible to manipulation by management. (AU §316.39).

325. Additionally, GAAS guidance specifically indicates that shifting expenses from

one period to another temporarily is a significant fraud risk:

Two types of misstatements are relevant to the auditor's consideration of fraud —misstatements arising from fraudulent financial reporting and misstatements arising from misappropriation of assets.

• Misstatements arising from fraudulent financial reporting are intentional misstatements or omissions of amounts or disclosures in financial statements designed to deceive financial statement users where the effect causes the financial statements not to be presented, in all material respects, in conformity with generally accepted accounting principles (GAAP). Fraudulent financial reporting may be accomplished by the following:

o Manipulation, falsification, or alteration of accounting records or supporting documents from which financial statements are prepared

o Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant information

o Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure.

Fraudulent financial reporting need not be the result of a grand plan or conspiracy. It may be that management representatives rationalize the appropriateness of a material misstatement, for example, as an aggressive rather than indefensible interpretation of complex accounting rules, or as a temporary misstatement of financial statements, including interim statements, expected to be corrected later when operational results improve .


326

Due to this risk, GAAS provides for the following types of audit procedures to be

performed:

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• Performing substantive analytical procedures relating to cost of sales, payable to growers and inventory using disaggregated data, for example, comparing balances reported by month and by product line or business segment during the current reporting period with comparable prior periods;

• Computer-assisted audit techniques may be useful in identifying unusual or unexpected relationships or transactions;

• Confirming with customers certain relevant contract terms and the absence of side agreements, because the appropriate accounting often is influenced by such terms or agreements. For example, acceptance criteria, delivery and payment terms , the absence of future or continuing vendor obligations, the right to return the product, guaranteed resale amounts, and cancellation or refund provisions often are relevant in such circumstances.

• Inquiring of the entity’s sales and marketing personnel or in-house legal counsel regarding sales or shipments near the end of the period and their knowledge of any unusual terms or conditions associated with these transactions; and

• Being physically present at one or more locations at period end to observe goods being shipped or being readied for shipment (or returns awaiting processing) and performing other appropriate sales and inventory cutoff procedures.


327. Also, GAAS requires an auditor to consider the risk of management override of

I controls. GAAS, in AU §316.42, states:

Even if specific risks of material misstatement due to fraud are not identified by the auditor, there is a possibility that management override of controls could occur, and accordingly, the auditor should address that risk ...apart from any conclusions regarding the existence of more specifically identifiable risks.

328. Deloitte’s audit procedures related to Diamond’s financial statements for Fiscal

Years 2010 and 2011 failed to address the risk of management override of controls and the

risk of fraud, or alternatively failed to appropriately perform procedures (enumerated in

GAAS AU §316) designed to reduce such risk. These failures, in combination with the facts

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surrounding Diamond’s material misstatement of its Fiscal Years 2010 and 2011 financial

statements in existence when Deloitte was performing audit procedures, evidence that

Deloitte violated GAAS and issued its own materially false and misleading statements when

providing unqualified audit opinions during the Class Period.

6. Deloitte Failed to Uncover or Investigate Possible Illegal Acts at Diamond as Required by GAAS

329. GAAS prescribe the nature and extent of the consideration an independent auditor

should give to the possibility of illegal acts by a client in an audit of financial statements.

The standard states the following regarding audit procedures to be performed even in the

absence of evidence concerning possible illegal acts:

Normally, an audit in accordance with generally accepted auditing standards does not include audit procedures specifically designed to detect illegal acts. However, procedures applied for the purpose of forming an opinion on the financial statements may bring possible illegal acts to the auditor’s attention. For example, such procedures include reading minutes; inquiring of the client’s management and legal counsel concerning litigation, claims, and assessments; performing substantive tests of details of transactions or balances. The auditor should make inquiries of management concerning the client's compliance with laws and regulations. Where applicable, the auditor should also inquire of management concerning —

. The client’s policies relative to the prevention of illegal acts;

• The use of directives issued by the client and periodic representations obtained by the client from management at appropriate levels of authority concerning compliance with laws and regulations;

• The auditor also obtains written representations from management concerning the absence of violations or possible violations of laws or regulations whose effects should be considered for disclosure in the financial statements or as a basis for recording a loss contingency. (See section 333, Management Representations .) The auditor need perform no further procedures in this area absent specific information concerning possible illegal acts (AU §317.08).

330. Deloitte either failed to perform such procedures or turned a blind eye to results of

audit procedures that indicated, among other things, that Diamond improperly recorded the

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actual cost of raw materials, timing of grower payments, payable to growers, cost of sales,

and inventory valuation as of the end of each reporting period, which in turn overstated gross

profit, income from operations, income before income taxes, net income and earnings per

share throughout the Class Period and caused the stock price to be and remain artificially

inflated.

7. Deloitte Failed to Properly Consider Diamond’s Lack of Internal Controls as Required by GAAS

331. GAAS require the independent auditor to obtain an understanding of the internal

control structure existing at the organization. Specifically, AU §319, Consideration of

Internal Control in a Financial Statement Audit, requires that “[a] sufficient understanding of

internal control is to be obtained plan the audit and to determine the nature, timing and extent

of the tests performed.” According to AU §319.34 “[t]he control environment sets the tone

of the organization, influencing the control consciousness of its people. It is the foundation

for all other components of internal control, providing discipline and structure.”

332. GAAS distinguish between the responsibilities of an independent auditor and the

company’s management in an audit of an entity’s financial statements. Although

management is responsible for establishing and maintaining internal controls, (AU §110.03),

the auditor is responsible for providing an opinion on them, including an opinion on

management’s assessment of the effectiveness of the company’s internal controls over

financial reporting.

333. According to PCAOB Auditing Standards (“AS”) No. 5, An Audit of Internal

Control Over Financial Reporting Performed in Conjunction with an Audit of the Financial

Statements (“AS No. 5”), “[m]aintaining effective internal control over financial reporting

means that no material weaknesses exist; therefore, the objective of the audit of internal

control over financial reporting is to obtain reasonable assurance that no material weaknesses

exist as of the date specified in management’s assessment.” (Par. 2).

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1 334. AS No. 5, Par. 7 and 62 describe components of internal controls and explain how

an independent auditor should obtain a sufficient understanding of the internal controls for

the purpose of assessing the risk of material misstatement and identifying deficiencies in

internal control. Specifically, AS No. 5, states:

In an audit of internal control over financial reporting, the auditor must obtain sufficient competent evidence about the design and operating effectiveness of controls over all relevant financial statement assertions related to all significant accounts and disclosures in the financial statements. The auditor must plan and perform the audit to obtain reasonable assurance that deficiencies that, individually or in the aggregate, would represent material weaknesses are identified.

335. The auditor’s objective in an audit of internal controls over financial reporting is

to express an opinion on the effectiveness of the company’s internal controls over financial

reporting. Because a company’s internal controls cannot be considered effective if one or

more material weaknesses exist, to form a basis for expressing an opinion, the auditor must

plan and perform the audit to obtain competent evidence that is sufficient to obtain

reasonable assurance about whether material weaknesses exist as of the date specified by

management’s assessment. A material weakness in internal controls over financial reporting

may exist even when financial statements are not materially misstated. (Par. 3).

336. The auditor should use a top down approach to the audit of internal controls over

financial reporting to select which controls to test. A top down approach begins at the

financial statement level and with the auditor’s understanding of the overall risks to internal

controls over financial reporting. The auditor then focuses on entity level controls and works

down to significant accounts and disclosures and their relevant assertions. This approach

directs the auditor’s attention to accounts, disclosures, and assertions that present a

reasonable possibility of material misstatement to the financial statements and related

disclosures. The auditor then verifies his or her understanding of the risks in the company’s

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processes and selects for testing those controls that sufficiently address the assessed risk of

misstatement to each relevant assertion. (Par. 21).

337. The standards state that a proper auditor evaluation of controls results in

increasing or decreasing the testing that the auditor otherwise would have performed on other

controls. Entity level controls include the company’s control environment and the period end

financial close process. A company’s control environment is the overall attitude, awareness,

and actions of directors and management regarding internal controls and their importance to

the company.

338. As part of evaluating the control environment, the auditor should assess:

• Whether management’s philosophy and operating style promote effective internal control over financial reporting;

• Whether sound integrity and ethical values, particularly of top management, are developed and understood; and

• Whether the Board or audit committee understands and exercises oversight responsibility over financial reporting and internal control. (Par. 25).

339. A company’s period end financial reporting process includes:

• Procedures used to enter transaction totals into the general ledger;

• Procedures related to the selection and application of accounting policies;

• Procedures used to initiate, authorize, record, and process journal entries in the general ledger;

• Procedures used to record recurring and nonrecurring adjustments to the annual and quarterly financial statements; and

• Procedures for preparing annual and quarterly financial statements and related disclosures. (Par. 26).

340. Moreover, as part of evaluating the period end financial reporting process, the

auditor should assess:

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1 • Inputs, procedures performed, and outputs of the processes the company

2 uses to produce its annual and quarterly financial statements;

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• The extent of information technology (“IT”) involvement in the period- end financial reporting process;

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~ Who participates from management;

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. The locations involved in the period-end financial reporting process;

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~ The types of adjusting and consolidating entries; and

8 • The nature and extent of the oversight of the process by management, the

9 board of directors, and the audit committee. (Par. 27).

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341. Given the critical and pervasive nature of the cost of sales, inventory and

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liabilities cycles, as well as Diamond’s continued preoccupation with maintaining its

12 artificially inflated stock price to ensure the consummation of the Pringles merger, if Deloitte

13 had performed the tests as described above in accordance with GAAS, the only reasonable

14 conclusion Deloitte could have drawn would have been that Diamond’s internal controls over

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16 financial reporting were so ineffective that Diamond’s financial statements and related

17 disclosures could not be fairly presented in accordance with GAAP. Deloitte failed to

18 properly consider or discover that Diamond had a significant lack of internal controls over

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financial reporting as required by GAAS. Moreover, Deloitte failed to perform the required

20 procedures as detailed in AS No. 5 and issued false and misleading unqualified audit

21 opinions during the Class Period related to the effectiveness of the internal controls over

22 financial reporting knowing, or being deliberately reckless in not knowing, that Diamond’s

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24 internal controls were grossly ineffective and Diamond’s financial statements and related

25 disclosures could not be fairly presented in accordance with GAAP.

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8. Deloitte Failed to Obtain Sufficient Competent Evidential Matter

27 to Support Its Unqualified Audit Opinions as Required by GAAS


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- 153 -


342. GAAS require auditors to “obtain sufficient appropriate audit evidence by

performing audit procedures to afford a reasonable basis for an opinion regarding the

financial statements under audit.” (AU §150.02). AU §326, Evidential Matter (Audit

Evidence) states that the majority of the auditor’s work, in forming an opinion, consists of

obtaining evidence through “inspection, observation, inquiries, and confirmations” and

evaluating that evidence. In evaluating the sufficiency of evidential matter, the standard

requires the following:

The independent auditor should be thorough in his or her search for evidential matter and unbiased in its evaluation. In designing audit procedures to obtain competent evidential matter, he or she should recognize the possibility that the financial statements may not be fairly presented in conformity with generally accepted accounting principles . . . . In developing his or her opinion, the auditor should consider relevant evidential matter regardless of whether it appears to corroborate or contradict the assertions in the financial statements. (AU §326.25).

343. Furthermore the standard states that an auditor is required to consider both the

quantity (sufficiency) and quality (appropriateness) of audit evidence. (AU §326.06).

GAAS state the following regarding sufficiency and appropriateness of audit evidence:

The auditor should consider the sufficiency and appropriateness of audit evidence to be obtained when assessing risks and designing further audit procedures. The quantity of audit evidence needed is affected by the risk of misstatement (the greater the risk, the more audit evidence is likely to be required) and also by the quality of such audit evidence (the higher the quality, the less the audit evidence that may be required). Accordingly, the sufficiency and appropriateness of audit evidence are interrelated. However, merely obtaining more audit evidence may not compensate if it is of a lower quality. (AU §326.06). 39

344. Additionally, pursuant to AU §342, Auditing Accounting Estimates , Deloitte was

required to evaluate the reasonableness of accounting estimates made in financial statements,

39 AU§ 326 incorporated SAS No. 106 (effective for audits of financial statements for periods beginning on or after December 15, 2006).

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including those estimates made for the valuation of inventory, accounts payable, and loss

reserves:

The auditor is responsible for evaluating the reasonableness of accounting estimates made by management in the context of the financial statements taken as a whole. As estimates are based on subjective as well as objective factors, it may be difficult for management to establish controls over them. Even when management’s estimation process involves competent personnel using relevant and reliable data, there is potential for bias in the subjective factors. Accordingly, when planning and performing procedures to evaluated accounting estimates, the auditor should consider, with an attitude of professional skepticism, both subjective and objective factors.

* * * *

In evaluating reasonableness, the auditor should obtain an understanding of how management developed the estimate. Based on that understanding, the auditor should use one or a combination of the following approaches:

a. Review and test the process used by management to develop the estimate;

b. Develop an independent expectation of the estimate to corroborate the reasonableness of management's estimate; or

c. Review subsequent events or transactions occurring prior to the date of the auditor's report.

Note: When performing an integrated audit of financial statements and internal control over financial reporting, the auditor may use any of the three approaches. However, the work that the auditor performs as part of the audit of internal control over financial reporting should necessarily inform the auditor's decisions about the approach he or she takes to auditing an estimate because, as part of the audit of internal control over financial reporting, the auditor would be required to obtain an understanding of the process management used to develop the estimate and to test controls over all relevant assertions related to the estimate.

I (AU §342.04 and 342.10) (footnote omitted).

345. AU §342 also requires the auditor “to obtain sufficient competent evidential

matter to provide reasonable assurance” that, inter alia, estimates are reasonable under the

circumstances and are presented in conformity with GAAP. (AU §342.07). Moreover,

GAAS acknowledge that an auditor may be able to develop independently an expectation of

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an estimate by using key factors or alternative assumptions about those factors. (AU

§342.12).

346. Deloitte failed to obtain the requisite competent evidential matter in support of its

unqualified audit opinions, due in part to at least the following audit failures:

• Failing to test appropriately and audit Diamond’s policies and procedures to estimate the cost of raw materials and related cost of sales throughout the reporting periods and the associated internal controls;

• Failing to appropriately test and audit Diamond’s policies and procedures to estimate amount due to growers at the end of each reporting periods and the associated internal controls;

• Failing to test appropriately and audit Diamond’s policies and procedures to estimate the value of inventory as of each reporting periods and the associated internal controls;

• Failing to modify and/or increase the nature, timing and extent of their testing to obtain reasonable assurance as required by GAAS that Diamond’s financial statements were not materially misstated and had been prepared in accordance with GAAP; and,

• Failing to apply the requisite professional skepticism to management’s representations regarding the accuracy of Diamond’s financial statements, specifically that the inventory and payable to growers’ balances as of the end of each reporting periods were properly stated in accordance with GAAP and that the associated internal controls were in place and functioning properly.

347. With respect to subsequent events, under GAAS an auditor is required to apply

[c]ertain specific procedures ... to transactions occurring after the balance-sheet date such as (a) the examination of data to assure that proper cutoffs [i.e. , recording of revenues and expenses in the right period] have been made and (b) the examination of data which provide information to aid the auditor in his evaluation of the assets and liabilities as of the balance-sheet date.

(AU §560.11).

348. GAAS state that most of the auditor’s work in forming an opinion on financial

statements consists of obtaining and evaluating evidential matter concerning elements of the

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financial statements. (AU §326.02) With respect to the evaluation of evidential matter,

GAAS impose the following requirements:

The independent auditor should be thorough in his or her search for evidential matter and unbiased in its evaluation. In designing audit procedures to obtain competent evidential matter, he or she should recognize the possibility that the financial statements may not be fairly presented in conformity with generally accepted accounting principles... In developing his or her opinion, the auditor should consider relevant evidential matter regardless of whether it appears to corroborate or to contradict the assertions in the financial statements. To the extent the auditor remains in substantial doubt about any assertion of material significance, he or she must refrain from forming an opinion until he or she has obtained sufficient competent evidential matter to remove such substantial doubt, or the auditor must express a qualified opinion or a disclaimer of opinion.

(AU §326.25) (footnotes omitted).

349. GAAS states that “subsequent events affecting... the settlement of estimated

liabilities ordinarily will require adjustment of the financial statements... because such

events typically represent the culmination of conditions that existed over a relatively long

period of time.” (AU §560.07).

350. Deloitte was required under GAAS to obtain an understanding of Diamond’s

process of estimating the amounts owed to growers and to evaluate the reasonableness of

Diamond’s payable to growers, inventory valuation, and recognition of cost of sales as of and

for the Fiscal Years ended July 31, 2010 and 2011, as well as for the quarterly reporting

periods therein. Deloitte also knew, or was deliberately reckless in not knowing, that

amounts payable to growers were calculated based on raw material ( i.e. , walnut) prices

during the year in accordance with the provisions of the contracts with growers. In

connection with making such a determination, Deloitte knew, or was deliberately reckless in

not knowing, that it was required to examine a sufficient number of contracts with growers

and taken steps to confirm the amount due -- an audit step that was previously performed by

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Diamond’s previous independent auditor and performed by Deloitte for other significant

2 liabilities (i.e. , debt).

3 351. Deloitte failed in its responsibilities by not obtaining sufficient competent

4 evidential matter readily available that could have been undertaken by one of the most simple

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6 steps that auditors, including Diamond’s former auditor, do on a regular basis, which was to

7 send confirmation letters to ascertain the amounts due by Diamond to growers at the end of

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the reporting periods, including at fiscal year ends. Sending confirmations to growers would

9 have confirmed the quantity of raw materials sold to Diamond during the year, expected total

10 cost of a particular year’s crop, and payments received as of a confirmation date by growers.

11 Had Deloitte undertaken this elementary procedure, one which Deloitte undertakes for other

12 accounts such as outstanding debt, it would have received information allowing it to

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14 reconcile the balance of the liability payable to growers at the end of each reporting period,

15 thus eliminating the risk of material misstatement ( i.e. , this procedure would have tested the

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payable to growers for understatement as well as overstatement).

17 352. Furthermore, due to the significant portion of the payments that were

18 contractually required to be made after the end of Diamond’s fiscal year, it was obvious that

19 Deloitte knew, or was deliberately reckless in not knowing, that it should have been looking

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21 for such payments and ensuring that they were recorded in the proper reporting period.

22 353. Another obvious red flag that Deloitte ignored when failing to obtain available

23 sufficient competent evidential matter relates to Diamond’s disclosure that “we [Diamond]

24 have entered into long-term Walnut Purchase Agreements with growers, under which they

25 deliver their entire walnut crop to us during the Fall harvest season and we determine the

26 minimum price for this inventory by March 31, or later, of the following calendar

27 year .” (Emphasis added).


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354. In fact, by March of each fiscal year, Diamond was aware of the total crop cost

that it owed to the walnut growers, as made clear in Diamond’s Q1 2009 Earnings

Conference call. Gary Ford, Diamond’s Chief Operating Officer and Executive VP,

explained that “from a GAAP cost perspective, we have to estimate what that cost is here in

the first two quarters when we finalize it in the third quarter, so we do our best estimate to

project out to the year and obviously when you get into March it becomes solidified. So it is

a little bit of an estimation here in the first two quarters as we worked through that process.”

355. As a result, this disclosure highlights Deloitte’s failure to perform minimal and

simple audit procedures using readily available information. Such procedures would include,

at a minimum, the following:

• In its search for unrecorded liabilities and in its subsequent event test-work, Deloitte knew, or was deliberately reckless in not knowing, that it should have examined specific support ( i.e. , a specific calculation of the amounts owed to the growers) relating to the August 2010 $20 million payments. As such amount was unquestionably material, Deloitte knew, or was deliberately reckless in not knowing, that it should have determined whether this payment was required to be recorded in Diamond’s fiscal year 2010 financial results. A simple audit procedure, one which is commonly used by independent auditors including Deloitte, would have been to contact a representative sample of growers either by phone or confirmation letter, in order to gather sufficient appropriate evidential matter supporting the classification of these disbursements;

• In its search for unrecorded liabilities and in its subsequent event test-work, Deloitte knew, or was deliberately reckless in not knowing, that it should have examined specific support ( i.e. , a specific calculation of the amounts owed to the growers) relating to the September 2011 $60 million payment. Since there can be no question about the material nature of such amount, Deloitte knew, or was deliberately reckless in not knowing, that it should have determined whether this payment was required to be recorded in Diamond’s fiscal year 2011 financial results. A simple audit procedure, one which is commonly used by independent auditors including Deloitte, would have been to contact a representative sample of growers either by phone or confirmation letter, in order to gather sufficient appropriate evidential matter supporting the classification of these disbursements; and

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• Deloitte knew, or was deliberately reckless in not knowing, that it should have obtained copies of significant grower contracts and verified that the payments made to the growers were determined in accordance with the provisions of the terms of the individual contracts.

356. Had Deloitte performed these simple and obvious auditing procedures, Deloitte

would have made the obvious determination that the August 2010 $20 million payments

related to Fiscal Year 2010 and required accrual as of July 31, 2010, and that the September

2011 $60 million payments related to Fiscal Year 2011 and required accrual as of July 31,

2011.

9. Deloitte Failed to Evaluate Appropriately the Adequacy of Diamond’s Financial Statement Disclosures as Required by GAAS

357. GAAS require the independent auditor to determine whether informative

disclosures are reasonably adequate, and if not, the auditor must state so in the auditor’s

report. (AU §431.01). The standard states as follows:

The presentation of financial statements in conformity with generally accepted accounting principles includes adequate disclosure of material matters. These matters relate to the form, arrangement, and content of the financial statements and their appended notes, including, for example, the terminology used, the amount of detail given, the classification of items in the statements, and the bases of amounts set forth. An independent auditor considers whether a particular matter should be disclosed in light of the circumstances and facts of which he is aware at the time. (AU §431.02)

358. As described in the GAAP section above, Diamond’s financial statement

disclosures were inadequate and materially false and misleading when made. Therefore,

Deloitte violated GAAS by not modifying its previously issued unqualified audit opinions for

the inadequacy of the information disclosed. As stated in more detail above, the inadequate

disclosures involved basic fundamental concepts such as matching of revenues and expenses,

expense recognition, inventory and accounts payable valuation.

10. Deloitte Had Broad and Unfettered Access to Diamond’s Accounting Records and Information

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2 359

By virtue of being both Diamond and P&G’s independent auditors, Deloitte was

3 in the position to have broad and unfettered access to Diamond’s accounting records and

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information from two different perspectives: 1) as an auditor, the purpose of which is to

5 express an opinion on Diamond’s financial statements and internal controls over financial

6 reporting and 2) from a due diligence standpoint, the purpose of which is to advise P&G on

7 the potential divestiture of the iconic Pringles brand.

8 360. Unlike the “normal” independent auditor / client relationship, Deloitte had two

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10 separate teams reviewing and analyzing Diamond’s accounting records, a luxury not afforded

11 under any other circumstances. As a result, there were an even greater number of

12 opportunities for Deloitte to take the necessary corrective action to ensure that Diamond was

13 recording the payments to growers in the proper fiscal year, as well as recording the proper

14 amount of inventory, payables and cost of sales throughout the Class Period financial

15 statements. Given the simple nature of the fraud and the discovery of $20 million in

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17 payments improperly shifted from Fiscal Year 2010 to 2011, Deloitte cannot credibility

18 claim that it was unaware of the accounting manipulations designed to keep Diamond’s stock

19 price artificially inflated.

20

E. DELOITTE’S FALSE AND MISLEADING STATEMENTS DURING THE CLASS PERIOD

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22 1. 2010 and 2011 Fiscal Years End

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361. Deloitte audited Diamond’s consolidated financial statements for the Fiscal Years

24 ended July 31, 2010 and 2011, respectively. Deloitte issued unqualified audit opinions

25 included in Diamond’s Form 10-K for FY 2010 and FY2011 in which it stated that the

26 financial statements were presented, in all material respects, in conformity with GAAP, that

27 the internal controls over financial reporting had been tested properly and, in all material

28



respects, were properly maintained and effective during Fiscal Year 2010 and 2011, and that

Deloitte’s audit was performed in accordance with GAAS and the standards of the PCAOB.

362. Deloitte represented that it conducted its audits in accordance with the standards

of the PCAOB:

Forms 10-K filed on October 5, 2010, page 25, and September 15, 2011, page 27:

We conducted our audits 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 the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

363. Deloitte issued unqualified opinions on these financial statements in both years

stating the following:

Form 10-K filed on October 5, 2010, page 25:

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Diamond Foods, Inc. and subsidiaries as of July 31, 2010 and 2009, and the results of their operations and their cash flows for each of the three years in the period ended July 31, 2010, in conformity with accounting principles generally accepted in the United States of America.

Form 10-K filed on September 15, 2011, page 27:

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Diamond Foods, Inc. and subsidiaries as of July 31, 2011 and 2010, and the results of their operations and their cash flows for each of the three years in the period ended

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July 31, 2011, in conformity with accounting principles generally accepted in the United States of America.

364. In connection with its audits of Diamond’s financial statements, Deloitte also

audited Diamond’s internal controls over financial reporting as of July 31, 2010 and July 31,

2010. Internal controls over financial reporting are described as:

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’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. 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; (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.

(Forms 10-K filed on October 5, 2010, page 25, and September 15, 2011, page 27).

365. Deloitte represented that it had audited the Company’s internal controls over

financial reporting as of July 31, 2010 and 2011, based on criteria established in the

Integrated Framework issued by the Committee of Sponsoring Organizations of the

Treadway Commission (“COSO”):


We also have audited the Company’s internal control over financial reporting as of July 31, 2010, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. As described in “Management’s Report on Internal Control over Financial Reporting”, management excluded from its assessment the internal control over financial reporting at Kettle Foods, which was acquired on March 31, 2010 and whose financial statements constitute

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less than 10% of consolidated assets, and less than 15% of consolidated net sales of the consolidated financial statement amounts as of and for the year ended July 31, 2010. Accordingly, our audit did not include the internal control over financial reporting at Kettle Foods. The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying “Management’s Report on Internal Control over Financial Reporting.” Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.


We also have audited the Company’s internal control over financial reporting as of July 31, 2011, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying “Management’s Report on Internal Control over Financial Reporting.” Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.

366. Deloitte expressed unqualified opinions on the Company’s internal controls over

financial reporting as of the end of each fiscal year:


Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of July 31, 2010, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.


Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of July 31, 2011, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

367. In issuing unqualified audit opinions related to Diamond’s financial statements for

Fiscal Years 2010 and 2011 and internal controls over financial reporting, Deloitte either

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knew, or was deliberately reckless in not knowing, of Diamond’s blatant and improper

2 accounting practices, as described herein. Such accounting manipulations resulted in the

3 following: (a) the consolidated balance sheet of Diamond and subsidiaries as of July 31, 2010

4 and July 31, 2011, and the related consolidated statements of operations, stockholders’

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6 equity, and cash flows for the periods ended July 31, 2010 and July 31, 2011 not having been

7 prepared in conformity with GAAP in numerous respects and not presenting fairly, in all

8 material respects, Diamond’s true financial position; and (b) Diamond not maintaining, in all

9 material respects and throughout the reporting period, effective internal controls over

10 financial reporting. In addition, Deloitte stated to the investing public that it had audited

11 Diamond’s financial statements or internal controls over financial reporting for the Fiscal

12 Years ended July 31, 2010 and July 31, 2011 in accordance with GAAS and the standards of

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14 the PCAOB although it knew, or was deliberately reckless in not knowing, that these

15 statements were false and misleading when made.

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2. Deloitte Fraudulently Represented to Investors that It Conducted

17 Its Audits and Issued Audit Opinions in Accordance with GAAS

18 368. GAAS Standard of Reporting No. 1 requires the independent auditor’s audit

19 report to state whether the financial statements are presented in accordance with GAAP.

20

(AU §508.04). The audit report must express an opinion on the financial statements taken as

21 a whole and must contain a clear indication of the character of the independent auditor’s

22 work. The independent auditor can determine that it is able to express an unqualified opinion

23 only if it has conducted its audit in accordance with GAAS. (AU §508.07).

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25 369. Deloitte’s conclusions as set forth in its unqualified audit opinions on Diamond’s

26 financial statements for the Fiscal Years 2010 and 2011 and internal controls over financial

27 reporting evidence Deloitte’s failure to properly, meaningfully, and effectively perform its


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1 audits in accordance with GAAS. This is evidenced, in part, by Diamond’s concessions on

2 February 8, 2012 that, inter alia: 1) Diamond’s previously issued financial statements for

3 Fiscal Years 2010 and 2011 would be restated because they improperly recorded crop

4 payments, which affected reported cost of sales, in the wrong reporting period; 2)

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6 Diamond’s previously issued financial statements should no longer be relied on; 3) Deloitte’s

7 unqualified audit opinions relating to the financial statements and internal controls over

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financial reporting for Fiscal Years 2010 and 2011 should no longer be relied on; 4)

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Diamond’s disclosure controls and procedures were not effective as of the Fiscal Years

10 ended July 31, 2010 and 2011; 5) Diamond’s internal controls over financial reporting were

11 not effective, in all material respects, for the Fiscal Years ended July 31, 2010 and 2011; and

12 6) material weaknesses in the internal controls over financial reporting were identified for

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14 both Fiscal Years 2010 and 2011. Thus, Deloitte’s unqualified audit opinions issued during

15 the Class Period were incorrect, false and misleading because Diamond’s financial

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statements were not prepared in accordance with GAAP, Diamond’s internal controls over

17 financial reporting were not effective, and Deloitte’s audits did not comply with GAAS.

18 370. As detailed herein, Deloitte knew of the August 2010 $20 million payments, as

19 evidenced by the March 19, 2012 Reuters article, and nonetheless issued an unqualified

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21 opinion on Diamond’s financial statements for Fiscal Year 2010. Moreover, Deloitte either

22 knew of the September 2011 $60 million payments that were not recorded in Diamond’s

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Fiscal Year 2011 financial statements and issued an unqualified audit opinion nonetheless, or

24 was deliberately reckless in not uncovering such large and unusual payments that its audit

25 amounted to no audit at all. At the very least, Deloitte ignored numerous “red flags” that

26 clearly evidenced that Diamond’s financial statements were not prepared in conformity with

27 GAAP, and that Diamond’s internal controls over financial reporting were not effective.


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Consequently, Deloitte’s audits violated both the standards of the PCAOB and GAAS

throughout the Class Period.

3. Deloitte Failed to Modify its Previously Issued Unqualified Audit Opinions for Fiscal Years 2010 and 2011

371. Standard of Reporting No. 4 requires an independent auditor to express an

opinion on the financial statements of a company taken as a whole, or an assertion to the

extent that an opinion cannot be expressed. (AU §150.02). When Deloitte violated GAAS

with respect to the General Standards, the Standards of Fieldwork, and the Standards of

Reporting No. 1-3 as demonstrated above, Deloitte also violated the Standard of Reporting

No. 4 because it had an insufficient basis for expressing unqualified audit opinions on

Diamond’s financial statements and internal controls over financial reporting for the Fiscal

Years ended July 31, 2010 and 2011. Had Deloitte performed audits of Diamond’s Class

Period financial statements taken as a whole in accordance with GAAS, as required, the only

conclusion Deloitte reasonably could have drawn was that Diamond’s financial statements

were not prepared in accordance with GAAP and were materially false and misleading. Such

a conclusion would have prevented Deloitte from issuing unqualified audit opinions on

Diamond’s Class Period financial statements.

372. Deloitte’s unqualified audit opinions of Diamond’s Class Period financial

statements were critical metrics for investors because they provided assurance that

Diamond’s financial statements were fairly presented, could be relied upon, and complied

with applicable laws. During the Class Period, as alleged herein, Deloitte violated GAAS

when performing its audits of Diamond since Deloitte, amongst other violations:

a. Failed to obtain an adequate level of knowledge of Diamond’s business;

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b. Failed to exercise due care or professional skepticism when performing audit procedures on Diamond’s financial statements;

c. Failed to properly consider the risk of fraud at Diamond;

d. Failed to uncover or investigate possible illegal acts at Diamond;

e. Failed to uncover Diamond’s obvious inability to prepare financial statements in accordance with GAAP;

f. Failed to consider Diamond’s obvious inability to maintain, in all material respects, effective internal controls over financial reporting;

g. Failed to identify or investigate areas of Diamond’s internal controls over financial reporting containing obvious material weaknesses;

h. Failed to obtain sufficient competent evidential matter to support its unqualified audit opinions; and

i. Failed to evaluate the adequacy of Diamond’s financial statements disclosures.

373. Deloitte failed to follow professional standards and/or failed to complete the

required audit procedures under GAAS, and therefore Deloitte either knew, or was

deliberately reckless in not knowing, that its unqualified audit opinions issued throughout the

Class Period relating to Diamond’s financial statements and internal controls over financial

reporting were false and misleading when made. Deloitte knew or was deliberately reckless

in not knowing that its actions caused the investing public to rely unknowingly on Diamond’s

materially misstated financial statements during the Class Period.

4. Deloitte’s Other Violations During the Class Period

374. As a result of Deloitte’s issuance of unqualified audit opinions related to

Diamond’s Fiscal Years 2010 and 2011 financial statements and internal controls over

financial reporting, Deloitte utterly failed in its role as independent auditor as defined by the

SEC. SEC Accounting Series Release No. 296, Relationships Between Registrants and

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Independent Accountants , Securities Act Release No. 6341, Exchange Act Release No.

18044, states in relevant part:

[T]he capital formation process depends in large part on the confidence of investors in financial reporting. An investor’s willingness to commit his capital to an impersonal market is dependent on the availability of accurate, material and timely information regarding the corporations in which he has invested or proposes to invest. The quality of information disseminated in the securities markets and the continuing conviction of individual investors that such information is reliable are thus key to the formation and effective allocation of capital. Accordingly, the audit function must be meaningfully performed and the accountants’ independence not compromised. The auditor must be free to decide questions against his client’s interests if his independent professional judgment compels that result.

375. Deloitte knew, or was deliberately reckless in not knowing, facts indicating that

Deloitte should have: (a) disclaimed or issued adverse opinions on Diamond’s financial

statements and internal controls over financial reporting for Fiscal Years ended July 31, 2010

and 2011 when the financial statements were initially issued; or (b) withdrawn as Diamond’s

independent auditor and corrected or modified its previously-issued unqualified audit

opinions for the Fiscal Years ended July 31, 2010 and 2011 after learning of the truth.

376. In addition, Deloitte violated the requirements of Section 10A of the Securities

Exchange Act, which requires independent auditors of public companies to design

procedures to provide reasonable assurance of detecting illegal acts that would have a direct

and material effect on the determination of financial statement amounts. Section 10A also

requires an auditor to design procedures to identify related party transactions that are material

to the financial statements or otherwise would require disclosure. Section 10A instructs

independent auditors on the required response to such discovery of potential illegal act, in

relevant part, as follows:

If, in the course of conducting an audit pursuant to this title to which subsection (a) applies, the registered public accounting firm detects or otherwise becomes aware of information indicating that an illegal act (whether

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or not perceived to have a material effect on the financial statements of the issuer) has or may have occurred, the firm shall, in accordance with generally accepted auditing standards, as may be modified or supplemented from time to time by the Commission –

(A) (i) determine whether it is likely that an illegal act has occurred; and

(ii) if so, determine and consider the possible effect of the illegal act on the financial statements of the issuer, including any contingent monetary effects, such as fines, penalties, and damages; and

(B) as soon as practicable, inform the appropriate level of the management of the issuer and assure that the audit committee of the issuer, or the board of directors of the issuer in the absence of such a committee, is adequately informed with respect to illegal acts that have been detected or have otherwise come to the attention of such firm in the course of the audit, unless the illegal act is clearly inconsequential.

377. Deloitte knew, or was deliberately reckless in not knowing, that it violated

Section 10A and GAAS in the performance of its audits of Diamond’s financial statements

and internal controls over financial reporting for the Fiscal Years ended July 31, 2010 and

I 2011.

F. DELOITTE’S MOTIVES TO COMMIT SECURITIES FRAUD

378

Deloitte’s motives for committing securities fraud involved two of its clients,

Diamond and P&G. As Deloitte worked on both side of the Pringles acquisition through its

audits of Diamond and P&G and its due diligence on behalf of P&G, it had access to the

merger agreements, was aware of the material adverse change clauses typically contained in

such agreements, and was aware of P&G’s concern about Diamond’s stock volatility given

that the majority of the consideration for the merger was Diamond common stock. Thus,

Deloitte knew, or was deliberately reckless in not knowing, that if the $60 million payments

in September 2011 were recorded in Diamond’s Fiscal Year 2011 financial statements, this

would have caused Diamond to record a net loss for both the fourth fiscal quarter and fiscal

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2011 year end results. This would have caused Diamond’s stock price to decline

dramatically and placed the acquisition in jeopardy. Deloitte had a strong motive to preserve

the artificial gain in Diamond’s stock price caused by the materially false and misleading

financial statements so that its other client P&G would be able to profit from the sale of

Pringles. Given that Deloitte’s audit and audit-related fees related to P&G’s Fiscal Year

2011 amounted to more than $33.2 million in addition to the more than $735,000 in tax

related and other fees, for total fees of $33.9 million, 40 Deloitte was motivated either to

knowingly, or with deliberate recklessness, provide unqualified audit opinions for Diamond’s

financial statements.

379. Although the payment in August 2010 might initially have appeared to Deloitte as

a “one-off” payment, which could be absorbed in anticipated merger costs, the scheme had to

be expanded both in terms of scope and length due to the execution of the Pringles merger

taking longer than originally anticipated. Faced with the prospect of disappointing and

suffering harsh consequences from Diamond as well as P&G, Deloitte found itself in a

position of continuing to participate in the fraud, or turn a blind eye to it.

380. In the beginning, Deloitte likely perceived the risk to be low of improperly

shifting to Fiscal Year 2011 $20 million in cost of sales, which should have been recorded in

Diamond’s financial results for Fiscal Year 2010, despite such payments being material to

the investing public, as Deloitte likely thought as the fraud would only be perpetrated for a

short period of time. In return for Deloitte’s perceived minimal risk and short-term

involvement in the fraudulent scheme, Deloitte was to gain Diamond’s trust and foreseeable

business and benefit from a windfall related to significantly increased audit fees. For Fiscal

° For fiscal year 2010, Deloitte’s audit and audit-related fees related to P&G’s fiscal year 2010 amounted to more than $29.8 million in addition to almost $750,000 in tax related fees, for total fees of $30.6 million.

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1

Year 2005, Deloitte’s audit and audit-related fees related to Diamond amounted to $671,000

2 and tax related fees were $12,000, for total fees of $683,000. However, by Fiscal Year 2010,

3 after the Pop Secret and Kettle Foods acquisitions in Fiscal Years 2008 and 2010,

4 respectively, Deloitte’s audit and audit-related fees related to Diamond’s Fiscal Year 2010

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6 skyrocketed to more than $1.3 million, representing an increase of approximately 94% and

7 tax related fees were more than $190,000, an increase of approximately 1,417%, or total fees

8 of more than $1.4 million. Thus, once Diamond was able to acquire Pringles from P&G, its

9 projected net sales were approximated to be more than $2.4 billion, an overnight increase of

10 more than 150% from its current sales of $950 million, and Deloitte would be able to receive

11 much higher fees.

12 IX. ADDITIONAL SCIENTER ALLEGATIONS

13

14 381. The Individual Defendants acted with scienter in that they knew or deliberately

15 recklessly disregarded that the Company’s public documents and statements were materially

16

false and misleading, and knowingly or deliberately recklessly substantially participated or

17 acquiesced in the issuance or dissemination of such statements or documents as primary

18 violators of the federal securities laws. The Individual Defendants also knew or deliberately

19 recklessly disregarded that the Company’s public statements and documents omitted material

20

21 information necessary to make the public statements and documents not false and

22 misleading.

23

382. The Individual Defendants, by virtue of their control over and/or receipt of

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Diamond’s materially misleading statements and/or their associations with the Company that

25 made them privy to confidential proprietary information concerning Diamond, were active

26 and culpable participants in the fraudulent scheme alleged herein. The Individual Defendants

27 knew and/or deliberately recklessly disregarded the falsity and misleading nature of the


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1

information that they caused to be disseminated to the investing public. The ongoing fraud

2 as described herein could not have been perpetrated over a substantial period of time without

3 the knowledge and/or deliberate recklessness and complicity of the personnel at the highest

4 level of the Company, including the Individual Defendants.

5

6 383. In addition to the numerous allegations throughout the Complaint, incorporated

7 herein by reference, demonstrating the Individual Defendants’ scienter, for the reasons

8

further detailed below, both of the Individual Defendants had knowledge of or deliberately

9 recklessly disregarded that the public statements and documents the Company issued or

10 disseminated were materially false and misleading.

11 384. The Individual Defendants also undertook the affirmative obligation to obtain

12 knowledge in order to ensure that the Company’s disclosures to the market were truthful by

13

14 executing SOX certifications. See Section VI.Q. above.

15 A. THE INDIVIDUAL DEFENDANTS MADE THE DECISIONS AT

ISSUE 16

17 385. The Individual Defendants’ scienter is evidenced by the fact that they made all

18 decisions concerning what price to pay growers. As alleged more particularly above, the

19 price paid to growers was a closely guarded secret within the Company, known only by a

20

handful of senior executives, including Mendes and Neil. Not only did they not consult other

21 executives when making such decisions, but they did not even inform others of their

22 decisions.

23 B. THE INDIVIDUAL DEFENDANTS RECEIVED REPORTS

24

ATTENDED MEETINGS, AND IMPROPERLY MANIPULATED THE COMPANY TO ATTEMPT A MULTI-BILLION DOLLAR MERGER

25 WITH PRINGLES

26 386. Even assuming that the challenged decisions were made by persons other than the

27 Individual Defendants, scienter of the Individual Defendants is evidenced by their receipt of


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1

internal reports, attendance at meetings and “hands on” manner of operating and

2 manipulating the business. For example, Defendant Neil portrays himself as a “hands-on”

3 type of CFO, who is “also responsible for operations, logistics, IT, treasury, grower relations,

4 and purchasing,” See May 25, 2010 article in Executive Briefing entitled “We fail fast, learn,

5

6 and move on.” Neil explained his opinion that “for the CFO to really understand his or her

7 business you need to be out in the field and close to the widgets.” He sees himself as “the

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type of finance guy that looks at a financial report and sees it as just numbers on a piece of

9 paper unless I’m out in the plant and can see how the product flows, how we can reduce our

10 unit costs, and how we can improve our logistics.” As evidence of his hands-on approach,

11 Neil stated that he “visit[s] the walnut growers out in the field at least twice a year, usually

12 once during harvest and once during some stage of the bloom, either at the beginning or

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14 during the middle of the summer,” in addition to visiting Diamond’s nut facilities multiple

15 times a quarter.

16

387. According to CW 3, a former assistant treasurer of Diamond, both Mendes and

17 Neil received the daily forecasts, which detailed all the money going out and coming in that

18 particular day as well as how much cash and borrowing capacity the Company had available

19 under its revolving line of credit. Additionally, Neil received the financial reports emailed

20

21 quarterly to all vice presidents by CW 5. According to CW 3, there were “some situations

22 where Diamond Foods could not meet its cash obligations to growers” starting after the

23 acquisition of Kettle. CW 3 remembers the daily forecasts in February or March 2011

24 showing that the Company did not have enough cash or borrowing capacity to make its usual

25 spring payment to growers. According to CW 3, Mendes and Neil knew about this problem.

26 388. Neil engaged in discussions about how Diamond could get enough cash to pay its

27 bills and the growers and asked CW 3 to alter the proposed grower payments in the grower


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1 cost worksheet. Additionally, according to CW 3, Defendant Neil participated in discussions

2 regarding requesting an expansion of Diamond’s line of credit and Wall Street’s potential

3 perception of such a move. Neil also dealt with Diamond’s compliance with bank covenants,

4 meeting with Head of Treasury Bob Phillips about it, as recalled by CW 5.

5

6 389. According to CW 5, Defendant Neil was intimately involved in the quarter end

7 review of Diamond’s financial results. CW 5 recalls that “Neil definitely knew what was

8 going on. He was involved in pre-audit reviews. He was in charge of treasury, too.” Neil

9

held meetings at quarter end, right before meeting with Defendant Deloitte, and instructed

10 attendees, including the finance department, cost accounting and CW 5, “to be aggressive.”

11 390. Defendant Mendes employed a hands-on approach as well. According to CW 2,

12 who, as a former Senior Director of Customer Marketing, met with Mendes frequently,

13

14 including nearly daily crop update meetings from mid-September to the week before

15 Thanksgiving, Mendes possessed “an incredible knowledge of the business.” CW 2 recalls

16 that Mendes was very hands-on and talked with employees directly. According to CW 2,

17 “Michael [Mendes] gave you the impression he was involved in everything and he made that

18 known.”

19 391. CW 4, stated that Mendes made every decision at Diamond, from “what soda to

20

21 stock in the vending machine to whom to hire.” “It was Michael [Mendes]’s company, for

22 good or bad.” CW 4 confirmed that information was kept within a tight circle.

23

392. Mendes signed letters to Diamond’s growers discussing topics such as crop

24 payments, industry and general business updates, and the walnut crop. See, e.g. , March 31,

25 2006 Letter, Ex. 6; September 22, 2006 Letter, Ex. 7.

26 393. According to CW 3, “Mendes had to approve everything at the end of the day.”

27 This included decisions regarding how to pay the walnut growers. For example, CW 3


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1 recalls Neil saying that he needed Mendes’ approval of the decision to break the spring

2 payment for the 2010 crop into two separate payments, which CW 1, CW 9 and CW 10

3 recalled receiving in February 2011 and March 2011. Additionally, CW 5 recalls Mendes

4 being involved in purchasing walnuts and attending meetings at which the subject of

5

6 incoming deliveries of walnuts was discussed. According to CW 2, Mendes attended weekly

7 meetings at which details such as trade payments and the color of labels for packaging was

8

discussed.

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394. The walnut growers had placed trust in Diamond by entering long-term contracts

10 whereby the growers turned over their harvest without first determining a price, and counted

11 on Diamond to use “good faith” in determining a fair price later.

12 395. Diamond disclosed that “we [Diamond] have entered into long-term Walnut

13

14 Purchase Agreements with growers, under which they deliver their entire walnut crop to us

15 during the Fall harvest season and we determine the minimum price for this inventory by

16

March 31, or later, of the following calendar year .” (emphasis added).

17 396. During the Class Period, the U.S. Department of Agriculture tracked walnut

18 prices, and showed substantial increases for both the Fall 2009 and the Fall 2010 crops. 41

19 397. The Individual Defendants would have been aware of this and would have

20

21 known that paying higher prices to growers could hurt Diamond’s reported financial results,

22 but if they severely underpaid growers, the Company’s supply of walnuts would dry up.

23

398. The Individual Defendants came up with a simple solution to this problem:

24 underpay the growers for the year in which the walnuts are delivered and the expense is

25 accrued, and then make uncalled for payments that are put on the books of the following year

26 in order to keep the growers from leaving.

27

28 41 See Ex. 5.



399. The only thing left to do to implement this simple scheme was to make up a name

for the additional payments. The additional payments would be odd on their face because

they were not called for in the publicly filed grower contacts, were not publicly disclosed

when made, were against the stated Company policy of making payments to growers only

after the receipt of the walnuts, and were unprecedented in the history of the Company. The

Individual Defendants’ newly coined words were “continuity” payments for the $20 million

in additional payments made in August, 2010 and “momentum” payments for the $60 million

in additional payments made in September, 2010.

400. Mendes signed a letter dated August 13, 2010 which discussed the Fall 2009 crop

and informed them for the first time of the new “continuity” payment. See August 13, 2010

Letter, Ex.1. Mendes in part wrote as follows:

Enclosed please find the 2009 crop final value statement and summary that provides payment information for each of your individual walnut deliveries and a summary at the account level. The August payment will be sent by the end of the month and represents both the final payment on the 2009 crop and a continuity payment reflecting the value of the multi-year supply arrangement with our Diamond walnut growers.

Id. (emphasis added).

401. Defendants Mendes and Neil were aware that Diamonds determined prices for the

2009 Fall crop and the 2010 Fall crop were below market value, and set not in “good faith,”

and were instead an effort to misrepresent the Company’s poor financial condition in order to

negotiate and then complete a merger with Pringles.

402. By underestimating the cost of the Fall 2010 crop, Diamond was able to

understate its cost of sales and, as result, overstate gross profits, income from operations, net

income and earnings per share throughout Fiscal Year 2011. As a result of the improper

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deferral of costs, Diamond was able to report financial results that met or exceeded analysts’

2 expectations for the first quarter of Fiscal Year 2011.

3 403. If Diamond had correctly recorded the $20 million “continuity” in the correct

4 Fiscal Year (2010), that would have reduced net income for Fiscal Year 2010 from $26.2

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6 million down to $6.2 million, a decrease of more than 76%. Such a low number would have

7 called into question the profitability of the Company, disappointed analysts, and ensured that

8 Diamond’s attempts to reach a merger agreement with Pringles would again be rebuffed.

9

404. Once the Individual Defendants and Diamond headed down this road, there was

10 no turning back. The additional $20 million in costs that had been improperly placed into the

11 2011 Fiscal Year then threatened to undo the Pringles deal that was announced in April of

12 2011. When it was time to make the final payment for the Fall 2010 crop in August of 2011,

13

14 Diamond, at the direction of the Individual Defendants, again severely underpaid the

15 growers, reported a strong financial year, and then gratuitously made a $60 million

16 “momentum” payment to the growers, to be carried on Diamond’s Fiscal Year 2012 financial

17 statements.


19 disregarding, that starting Fiscal Year 2012 with a $60 million deficit would not be hard to

20

21 cover up if the $2.35 billion Pringles merger went through, and in fact, increased their

22 estimate of transaction and integration amounts in an amount that almost mirrored the

23 “momentum” payment.

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406. The $60 million grower payments represented almost 395% of the reported

25 outstanding “payable to growers” balance of $15.2 million as of July 31, 2011. Had the $60

26 million “momentum” payment been properly accounted for in Fiscal Year 2010, net income


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for that year would have been reduced from $50.2 million a net loss of $9.8 million and the

2 Pringles deal would have collapsed.

3 C. THE INDIVIDUAL DEFENDANTS RECEIVED ENORMOUS

4

BONUSES

5

407. The Individual Defendants were motivated to misrepresent Diamond’s financial

6 results because of their large cash bonuses and stock option grants that were closely tied to

7 the Company’s financial performance. As reflected by CW 5, a main motivation for

8 changing expense accrual and assumptions without justification in an effort to achieve the

9

10 desired earnings per share number was that the executives “wanted to hit their bonuses. That

11 is why they did it. It was just greed.” According to the Amended 10-K for FY2011 filed on

12 November 28, 2011, “The objective of [Diamond’s] executive compensation program is to

13 attract, retain and motivate executives of exceptional ability who have the capability to

14 provide strong leadership for Diamond Foods and increase stockholder value.” The

15 executive compensation program consisted of salary, bonuses and equity incentives.

16

17 408. As detailed in the Amended 10-K for FY2011, under Diamond’s bonus program,

18 the fiscal 2011 target bonus was set at 100% of base salary for Mendes and 70% of base

19 salary for Neil. The bonuses “were determined by both a corporate financial objective,

20

representing 60% of bonus potential, and individual objectives for each named executive

21 officer, representing 40% of bonus potential. Corporate and individual components are

22 determined separately.” Non-GAAP earnings per share, calculated as done for earnings

23 release purposes, was selected as the corporate financial performance metric. “[T]he target

24

25 level at which 100% of the target corporate financial objective portion of the bonus would be

26 earned [was set] at $2.45 non-GAAP earnings per share,” while the threshold level was $2.30

27 non-GAAP earnings per share. Meanwhile, the individual objectives for executives other


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than Mendes, such as Neil, were based on the Board of Director’s annual plan outlining

business objectives and key initiatives. CEO Mendes’ individual performance was measured

by looking at the following categories of business goals and corporate objectives:

growth in earnings and sales; performance of snack brands relative to the categories in which we compete; successful completion of integration of the Kettle Foods acquisition and the announcement and integration planning related to entering into an agreement with The Procter & Gamble Company to merge the Pringles business into Diamond; distribution and market share gains; execution of brand equity building initiatives; margin improvements and cost-efficiency initiatives; organizational development and recruiting; and development of systems and infrastructure to support growth.

409. Due to the fraud detailed herein, the Company’s gross profit, EBITDA and non-

GAAP earnings per share, among other things, were materially overstated during the Class

Period, allowing the Individual Defendants to receive undeserved and exorbitant

compensation. Given that Diamond reported $2.61 in non-GAAP earnings per share for

Fiscal Year 2011, the corporate financial performance objection element of the bonuses was

paid at 164%. As for the individual objection component of the bonuses, the Pringles

acquisition was a factor that supported Mendes’ receiving 200% of his target amount and

Neil receiving 190% of his target amount. Specifically, in Fiscal Year 2011, Mendes’ an

annual salary was $721,985, his bonus tied to corporate financial objections was $713,400,

and his bonus tied to individual objectives was $580,000, with his total compensation coming

to $7,292,168. In Fiscal Year 2010, Mendes received an annual salary of $645,192 and a

bonus of $1,450,000, with his total compensation coming to $4,342,910. Likewise, in Fiscal

Year 2010, Neil received an annual salary of $428,000 and a bonus of $629,160, with his

total compensation coming to $1,795,228. In Fiscal Year 2011, Neil’s an annual salary was

$448,596, his bonus tied to corporate financial objectives was $309,547, and his bonus tied to

individual objectives was $239,081, with his total compensation coming to $2,429,059. The

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Individual Defendants also received incentive stock and options grants that allowed them to

enrich themselves at the expense of shareholders. Had Mendes and Neil reported Diamond’s

true financial results, they would not have received this compensation. Because the

Individual Defendants’ compensation was tied to the Company’s financial performance, they

were motivated to falsify key financial figures to obtain their incentive compensation.

D. DIAMOND’S INCONSISTENT AND CONTRADICTORY EFFORTS TO EXPLAIN THE FRAUD ESTABLISH SCIENTER

410. In every quarterly and annual filing with the SEC, Diamond issued a statement

regarding the evaluation of its internal controls and procedures. In these filings, the

Company stated the following:


411. Further detail regarding Diamond’s disclosures of its internal controls can be

found in Section VI.Q above.

412. As a result, it is clear that all relevant information regarding the fraudulently-

timed $20 million payment to walnut growers in August 2010 and the $60 million payment

in September 2011 were known by and communicated to Mendes and Neil or they were

deliberately reckless in not knowing of such accounting issues.

413. Clearly, Diamond and the Individual Defendants knew or were deliberately

reckless in not knowing that the Company had a problem with internal controls. The

pervasive nature of the accounting manipulations evidences that Diamond did not have an

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adequate system of internal controls, and Mendes and Neil knew or were deliberately

reckless in not knowing about it.

E. DIAMOND’S REPEATED ATTEMPTS TO DENY AND COVER UP THE FRAUD ESTABLISH SCIENTER

414. Diamond was intentionally vague in its communication with walnut growers

regarding the $20 million payment and the $60 million payment. As Mendes stated,

addressing the $20 million payment: “The August payment will be sent by the end of the

month and represents both the final payment on the 2009 crop and a continuity payment

reflecting the value of the multi-year supply arrangement with our Diamond walnut

growers.” See August 13, 2010 Letter, Ex. 1. Regarding the $60 million payment to walnut

growers, growers were told, “In early September, we provided a momentum payment to

growers, which was paid in addition to the 2010 finalized crop return, reflecting the strength

of our walnut marketing activities as we enter the Fall harvest.” See September 13, 2011

Letter, Ex. 8. A short time later, beginning around September 25, 2011, after the close of the

market, the investing public was made increasingly aware of Diamond’s shady accounting of

the two specific payments to walnut growers. However, until Diamond’s press release

admitting that the $20 million payment in August 2010 and the $60 million payment in

September 2011 were not accounted for in the correct periods, as well as the identification of

material weaknesses in the Company’s control over financial reporting, Diamond engaged in

a campaign of misinformation and outright denial.

415. For example, in the Media Release attached to the Form 8-K filed with SEC on

October 4, 2011, the Company stated in part:

Diamond made a pre-harvest momentum payment to walnut growers in early September, prior to the delivery of the fall walnut crop to reflect the fiscal 2012 projected market environment . The payment is accounted for in fiscal

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2012 cost of goods sold and is reflected in the guidance provided by the

2 company on September 15, 2011.

3 (Emphasis added).

4

416. In the November 1, 2011 press release, Diamond continued the pretense, although

5 admitting that it had received “an external communication regarding Diamond’s accounting

6 for certain crop payments to walnut growers.”

7 417. In an article dated January 12, 2012, the Wall Street Journal reported that the U.S.

8 Attorney’s Office in San Francisco opened an inquiry into the September 2011 “momentum

9

10 payments.” According to the article, “Diamond maintains they were an advance on the 2011

11 walnut crop.”

12

F. THE MAGNITUDE AND LACK OF COMPLEXITY OF THE FRAUD EVIDENCES SCIENTER

13

14 418. The Individual Defendants’ scienter is further demonstrated by the nature of the

15 fraud itself. The sums at issue were materially large. The payments themselves were

16

unprecedented, were not scheduled, and did not involve interpretation of complex accounting

17 rules. Instead, the fraud at issue in this case relates to the principle of matching revenue to

18 expenses, which is a basic, fundamental principle of accrual accounting.

19 G. CORPORATE SCIENTER

20

21 419. All of the allegations of scienter as to the Individual Defendants apply equally to

22 Diamond to establish its scienter, as the corporation acts through its employees.

23 X. PRESUMPTION OF RELIANCE: FRAUD ON THE MARKET DOCTRINE

24

420. The regard to Counts I and III arising under Sections 10(b) and 20(a) of the

25 Exchange Act and Rule 10b-5 promulgated thereunder, Lead Plaintiff will rely, in part, on

26 the presumption of reliance established by the fraud-on-the-market doctrine that, among

27 other things:


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1 1

2 2 3

4 3

Diamond and the Individual Defendants made public misrepresentations or failed to disclose facts during the Class Period;

The omissions and misrepresentations were material;

Diamond securities traded in an efficient market;

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4. The misrepresentations alleged would tend to induce a reasonable investor to misjudge the value of the Company’s securities; and

5. Lead Plaintiff and the other members of the Class purchased Diamond securities between the time Diamond and the Individual Defendants misrepresented or failed to disclose material facts and the time the true facts were disclosed, without knowledge of the misrepresented or omitted facts.

421. At all relevant times, the market for Diamond’s publicly traded securities was an

efficient market for the following reasons, among others:

1. The Company’s common stock met the requirements for public listing and was listed and actively traded on the NASDAQ, a highly efficient market. The average daily volume of Diamond’s common stock during the Class Period was 800,334.12 shares based on information from the Yahoo Finance website. The total number of shares traded during the Class Period was 272,113,600 shares.

2. As a regulated issuer, Diamond made public filings, including its Forms 10-K, Forms 10-Q and related press releases, with the SEC.

3. Diamond was followed by analysts from major brokerages including: SunTrust Robinson Humphreys, BB&T Capital Markets, Price Target Research, Keybanc Capital Markets, Sadif Investment Analytics, Craig Hallum Capital Group LLC, Redchip Companies, Janney Capital Markets, Global Data Financial Analysis, RBC Capital Markets, Jeffries Group, Inc., Deutsche Bank, Datamonitor, Disclosure Insight, ICD Research, New Constructs, LLC, Validea.com , ValuEngine, Inc., and Wright Investors Services. The reports of these analysts were redistributed to the brokerages’ sales force, their customers, and the public at large; and

4. Diamond regularly communicated with public investors via established market communication mechanisms, including the Company’s website, regular disseminations of press releases on the major news wire services, and other wide-ranging public disclosures, such as communications with the financial press and other similar reporting services.


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422. As a result, the market for Diamond’s publicly traded securities promptly digested

current information with respect to Diamond from all publicly available sources and reflected

such information in the price of the Company’s securities. Under these circumstances, all

purchasers of Diamond’s publicly traded securities during the Class Period suffered similar

injury through their purchase of the Company’s publicly traded securities at artificially

inflated prices, and a presumption of reliance applies.

XI. LOSS CAUSATION

423. The following chart shows three of the most precipitous stock price drops during

the Class Period as the truth of the fraud was revealed to the market .

$90

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$70

$60

$50

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sdzInitial coverage of i Precipitous Diamond Stock Price Drops “momentum” payments-

September 26, 2011 through February 9, 2012 S t b 26 2011

Announcement of postponement of Pringles acquisition -

Announcement of Restatement-

February 8, 2012

$20 I

424. During the Class Period, as detailed herein, Diamond, the Individual Defendants

and Deloitte engaged in a scheme to deceive the market and engaged in a course of conduct

that artificially inflated Diamond’s stock price and operated as a fraud or deceit on Class

Period purchasers of Diamond stock by grossly misrepresenting the Company’s financial

status, the true chances of acquiring Pringles, and the true nature of approximately $80



million in payments made to growers in 2010 and 2011. When more accurate information

concerning these issues began to enter the market on September 26, 2011, including the

events described below, Diamond’s stock price fell drastically from a closing price of $90.37

on September 23, 2011 to a closing price of 23.13 on February 9, 2012, as shown in the chart

above.

425. On Sunday, September 25, 2011, the research firm Off Wall Street Consulting

I Group issued a report questioning Diamond’s accounting practices with respect to walnut

purchases. On this news, shares of Diamond declined $5.11 per share, or about 5.7%, to

close on September 26, 2011, at $85.26 per share, on unusually heavy trading volume.

426. On, September 26, 2011, after market close, an article in Reuters Breakingviews

entitled “P&G’s Pringles partner warrants careful taste test” exposed mysterious

“momentum” payments that Diamond had made to growers, and quoted a member of

Diamond management as saying that the period for which the payments applied was

“somewhat of a blur”:

Stranger still was a substantial follow-up payment by Diamond to walnut growers just two days after its Aug. 31 outlay. Diamond called this a “momentum payment,” a term new to growers, who say they’re not sure whether the extra check means they’re getting a better price for last year’s crop or that cashing it obligates them to deliver walnuts for the coming year. Diamond’s IR chief says the period to which the September payment applies is “somewhat of a blur” because the company sees it in the context of its three, five and 10-year contracts with growers.

427. On September 27, 2011, the Wall Street Journal published an article noting that

as walnut prices surged for the 2010 crop, Diamond actually paid growers much less than

most buyers. Further, the article disclosed that on September 2, 2011, after the close of the

Company’s 2011 Fiscal Year (ending July 31, 2011), the Company made an unusual extra

“momentum” payment to growers that growers had not received in past years. The article

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1 estimates that the “momentum” payments could total as much as $50 million. The article

2 also stated that the “momentum” payment would have significantly impacted the Company’s

3 2011 Fiscal Year financial results had it been included in FY 2011, and would have

4 substantially reduced the Company’s $93 million in operating income that it had reported for

5 the entire 2011 Fiscal Year.

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7 428. On this news, shares of Diamond further declined $3.20 per share, or 3.7%, to

8 close September 27, 2011, at $82.06 per share, also on unusually heavy trading volume.

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429. On November 1, 2011, after market close, the Company filed with the SEC a

10 Form 8-K containing a press release announcing that the previously announced acquisition of

11 Pringles would be delayed. This was widely reported in news articles such as Reuters, which

12 issued an article on November 1, 2011 entitled (“UPDATE 2-Diamond Foods delays Pringles

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14 deal closing to H1 2012”), which stated that P&G delayed the sale of its Pringles division to

15 Diamond until the end of June 2012 because of an internal investigation at Diamond into its

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accounting.

17 430. On this news, the Company’s shares declined $11.33 per share, or 17.7%, to close

18 on November 2, 2011, at $52.79 per share, on unusually heavy trading volume.

19 431. On November 3, 2011, the Wall Street Journal reported, among other things, that

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21 the accounting investigation at Diamond “centers around the timing of a recent payment to

22 walnut growers for their 2011 crop,” and that at least one of the improper payments is

23 estimated at $50 million. Also on this day, BB&T in its Capital Markets publication lowered

24 its earnings estimates for Diamond, stating: “[Diamond] made a ‘momentum’ payment

25 rumored to be in the $0.20-$0.30/lb range (called ‘continuity’ payment in 2010) in

26 September that critics charge was a sort of make-whole payment to growers for the 2010

27 crop and, thus, should have been expensed in FY’11.” On this news, Diamond shares


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declined an additional $6.39 per share or 12.1% over two consecutive trading sessions, to

2 close at $46.40 per share on November 4, 2011.

3 432. On Saturday, November 5, 2011, Barron’s Online published an article entitled

4 “Getting to the Nut of the Problem.” The article discussed in detail the Company’s

5

6 September 2011 “momentum payment” to walnut growers and suggested that the Company

7 may have overstated its fiscal 2011 financial results. On November 7, 2011, following these

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disclosures, Diamond’s stock price continued to decline on substantial trading volume,

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falling to a close of $39.09 per share, a 15.8% decline from its Friday, November 4, 2011

10 close of $46.40 per share.

11 433. On November 28, 2011, after market close, Diamond revealed in a Form 8-K

12 filing that: “Among other things, the investigation could result in a determination that

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14 restatement of Diamond’s prior period financial statements is required, or a conclusion that

15 there is a material weakness in Diamond’s internal control over financial reporting, or a

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determination that its disclosure controls and procedures are not effective.” On November

17 29, 2011, following this disclosure, Diamond’s stock price continued to decline on

18 substantial trading volume, falling to a close of $27.60 per share, a 5.2% decline from its

19 November 28, 2011 close of $29.12 per share.

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21 434. The morning of December 12, 2011 Diamond revealed that it would miss its filing

22 deadline in a Form 8-K which stated: “As a result of the Investigation, Diamond expects to

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file its Form 10-Q for the first fiscal quarter after the December 12, 2011 filing deadline.”

24

Following this disclosure, Diamond’s stock price declined on extremely high trading volume,

25 falling to a close of $31.30 per share, a 22.8% decline from its Friday, December 9, 2011

26 close of $40.56 per share.

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435. The morning of December 15, 2011 Diamond revealed in a Form 8-K that the

SEC had launched a formal investigation: “On December 14, 2011, Diamond Foods, Inc.

(“Diamond”) received a formal order of investigation from the staff of the United States

Securities and Exchange Commission (“SEC”).” On this news, analysts at Jefferies

downgraded Diamond, stating: “In our view, the announced SEC investigation creates too

much of an overhang with uncertain timing and increases the risk that the Pringles deal will

be terminated.” Following these disclosures, Diamond’s stock price declined on extremely

high trading volume, falling to a close of $27.87 per share, a 5.6% decline from its previous

close of $29.51 per share.

436. On January 12, 2012, after market close, The Wall Street Journal reported that the

Department of Justice had opened an inquiry to determine if Diamond’s accounting practices

involved criminal fraud. Following this disclosure, on January 13, 2012 Diamond’s stock

price declined on extremely high trading volume, falling to a close of $29.73 per share, a

10.2% decline from its previous close of $33.13 per share.

437. On February 8, 2012, Diamond admitted that the Company had made materially

false and misleading statements concerning its accounting of cost of goods sold, specifically

payments to walnut growers in August 2010 and September 2011. The Company filed with

the SEC a Form 8-K, which stated:

The Audit Committee of the Board of Directors (“Audit Committee”) of Diamond Foods, Inc. (“Diamond”) has substantially completed its previously announced investigation of Diamond’s accounting for certain crop payments to walnut growers. The investigation focused primarily on whether payments to growers in September 2011 in the amount of approximately $60 million and payments to growers in August 2010 of approximately $20 million were accounted for in the correct periods.

438. On this news the price of Diamond stock fell $13.53 and closed on February 9,

2011 at $23.13. This was a drop of 36.9% on extremely high trading volume.

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439. It was reasonably foreseeable that disclosure of this information would cause the

2 price of Diamond’s stock to drop precipitously.

3 440. The decline in Diamond’s stock price from September 23, 2011 until the end of

4 the Class Period was a direct result of Diamond, the Individual Defendants and Deloitte’s

5

6 fraud being at least partially revealed to investors and the market. The timing and magnitude

7 of Diamond’s stock price declines negates any inference that the loss suffered by Class

8 members was caused by changed market conditions, macroeconomic or industry factors, or

9

Company specific facts unrelated to the fraudulent conduct of Diamond, the Individual

10 Defendants and Deloitte. The misrepresentations by Diamond, the Individual Defendants

11 and Deloitte during the Class Period were the proximate cause of Lead Plaintiff’s losses.

12 XII. NO SAFE HARBOR

13

14 441. The statutory safe harbor provided for forward-looking statements under certain

15 circumstances does not apply to any of the allegedly false statements pleaded in this

16

Consolidated Complaint. Many of the specific statements pleaded herein were not identified

17 as “forward-looking statements” when made. To the extent there were any forward-looking

18 statements, there were no meaningful cautionary statements identifying important factors that

19 could cause actual results to differ materially from those in the purportedly forward-looking

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21 statements. Alternatively, to the extent that the statutory safe harbor does apply to any

22 forward-looking statements pleaded herein, Diamond and the Individual Defendants are

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liable for those false forward-looking statements because at the time each of those forward-

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looking statements was made, the particular speaker knew that the particular forward-looking

25 statement was false, and/or the forward-looking statement was authorized and/or approved by

26 an executive officer of Diamond who knew that those statements were false when made

27 CLAIMS FOR RELIEF


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1

COUNT I

2 (Violations of Section 10(b) of the Exchange Act and Rule 10b-5 Promulgated

3 Thereunder Against Diamond and the Individual Defendants)

4 442. Lead Plaintiff repeats and realleges each and every allegation above as if fully set

5 forth herein, except for Section VIII, above.

6 443. During the Class Period, Diamond and the Individual Defendants carried out a

7 plan, scheme and course of conduct which was intended to and, throughout the Class Period,

8 did: (i) deceive the investing public, including Lead Plaintiff and other Class members, as

9 alleged herein regarding Diamond’s business, operations and management and the intrinsic

10 value of Diamond’s securities; (ii) artificially inflate and maintain the market price of

11 Diamond’s publicly traded securities; and (iii) cause Lead Plaintiff and other members of the

12 Class to purchase Diamond’s publicly traded securities at artificially inflated prices. In

13 furtherance of this unlawful scheme, plan and course of conduct, Diamond and the Individual

14 Defendants, and each of them, took the actions set forth herein.

15 444. Diamond and the Individual Defendants: (a) employed devices, schemes, and

16 artifices to defraud; (b) made untrue statements of material fact and/or omitted to state

17 material facts necessary to make the statements not misleading; and (c) engaged in acts,

18 practices and a course of business which operated as a fraud and deceit upon the purchasers

19 of the Company’s securities in an effort to maintain artificially high market prices for

20 Diamond’s securities in violation of Section 10(b) of the Exchange Act and Rule 10b-5.

21 Diamond and the Individual Defendants are sued as primary participants in the wrongful and

22 illegal conduct charged herein.

23 445. In addition to the duties of full disclosure imposed on Diamond and the Individual

24 Defendants as a result of making affirmative statements and reports, or participation in the

25 making of those statements and reports to the investing public, they had a duty to promptly

26 disseminate truthful information that would be material to investors in compliance with the

27 integrated disclosure provisions of SEC Regulation S-X (17 C.F.R. §210.01 et seq.) and S-K

28 (17 C.F.R. §229.10 et seq.) and other SEC regulations, including accurate and truthful



1 information about the Company’s operations, financial condition and performance so that the

2 market prices of the Company’s publicly traded securities would be truthful, complete and

3 accurate.

4 446. Diamond and the Individual Defendants, individually and in concert, directly and

5 indirectly, by the use, means or instrumentalities of interstate commerce and/or of the mails,

6 engaged and participated in a continuous course of conduct to conceal adverse material

7 information about the business, practices, performances and operations of Diamond as

8 specified herein.

9 447. Diamond and the Individual Defendants employed devices, schemes and artifices

10 to defraud, while in possession of material adverse non-public information and engaged in

11 acts, practices, and a course of conduct as alleged herein in an effort to assure investors of

12 Diamond’s value and performance and continued substantial growth, which included the

13 making of, or the participation in the making of, untrue statements of material facts and

14 omitting to state material facts necessary in order to make the statements made about

15 Diamond and its business operations in the light of the circumstances under which they were

16 made, not misleading, as set forth more particularly herein, and engaged in transactions,

17 practices and a course of business that operated as a fraud and deceit upon the purchasers of

18 Diamond’s securities during the Class Period.

19 448. Each of the Individual Defendants’ primary liability, and controlling person

20 liability, arises from the following facts: (i) the Individual Defendants were high-level

21 executives and/or directors at the Company during the Class Period and members of the

22 Company’s management team or had control thereof; (ii) each of these Individual

23 Defendants, by virtue of his responsibilities and activities as a senior officer and/or director

24 of the Company was privy to and participated in the creation, development and reporting of

25 the Company’s internal budgets, plans, projections and/or reports; (iii) the Individual

26 Defendants enjoyed significant personal contact and familiarity with Defendant Deloitte and

27 were advised of and had access to other members of the Company’s management team,


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1 internal reports and other data and information about the Company’s financial condition,

2 performance, and operations at all relevant times; and (iv) the Individual Defendants were

3 aware of the Company’s dissemination of information to the investing public that they knew

4 or deliberately recklessly disregarded was materially false and misleading.

5 449. Diamond and the Individual Defendants had actual knowledge of the

6 misrepresentations and omissions of material facts set forth herein, or acted with deliberate

7 reckless disregard for the truth in that they failed to ascertain and to disclose such facts, even

8 though such facts were available to them. Such material misrepresentations and/or omissions

9 were done knowingly or deliberately recklessly and for the purpose and effect of concealing

10 Diamond’s operating condition and business prospects from the investing public and

11 supporting the artificially inflated price of its securities. As demonstrated by Diamond’s and

12 the Individual Defendants’ overstatements and misstatements of the Company’s business,

13 operations and earnings throughout the Class Period, if they did not have actual knowledge

14 of the misrepresentations and omissions alleged, they were deliberately reckless in failing to

15 obtain such knowledge by deliberately refraining from taking those steps necessary to

16 discover whether those statements were false or misleading.

17 450. As a result of the dissemination of the materially false and misleading information

18 and failure to disclose material facts, as set forth above, the market prices of Diamond’s

19 securities were artificially inflated during the Class Period. Unaware that market prices of

20 Diamond’s publicly traded securities were artificially inflated, and relying directly or

21 indirectly on the false and misleading statements made by Diamond and the Individual

22 Defendants, or upon the integrity of the market in which the securities trade, and/or on the

23 absence of material adverse information that was known to or deliberately recklessly

24 disregarded by Diamond and the Individual Defendants but not disclosed in public statements

25 by them during the Class Period, Lead Plaintiff and the other members of the Class acquired

26 Diamond’s securities during the Class Period at artificially high prices and were damaged

27 thereby.


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1 451. At the time of said misrepresentations and omissions, Lead Plaintiff and other

2 members of the Class were ignorant of their falsity, and believed them to be true. Had Lead

3 Plaintiff and the other members of the Class and the marketplace known of the true

4 performance, business practices, prospects and intrinsic value of Diamond, which were not

5 disclosed by Diamond and the Individual Defendants, Lead Plaintiff and other members of

6 the Class would not have purchased or otherwise acquired their Diamond’s securities, or, if

7 they had acquired such securities during the Class Period, they would not have done so at the

8 artificially inflated prices that they paid.

9 452. By virtue of the foregoing, Diamond and Individual Defendants have violated

10 Section 10(b) of the Exchange Act, and Rule 10b-5 promulgated thereunder.

11 453. As a direct and proximate result of Diamond’s and the Individual Defendants’

12 wrongful conduct, Plaintiff and the other members of the Class suffered damages in

13 connection with their respective purchases and sales of the Company’s securities during the

14 Class Period.

15

COUNT II

16 (Violations of Section 10(b) of the Exchange Act and Rule 10b-5 Promulgated

17 Thereunder Against Deloitte)

18

454. Plaintiff repeats and realleges the allegations set forth in Sections I-V, VII-IX,

19 above.

20 455. During the Class Period, Deloitte carried out a plan, scheme and course of

21 conduct which was intended to and, throughout the Class Period, did: (i) deceive the

22 investing public, including Lead Plaintiff and other Class members, as alleged herein

23

24 regarding the veracity of Diamond’s financial statements and effectiveness of its internal

25 controls over financial reporting; (ii) artificially inflate and maintain the market price of

26

Diamond’s publicly traded securities; and (iii) cause Lead Plaintiff and other members of the

27 Class to purchase Diamond’s publicly traded securities at artificially inflated prices. In


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1

furtherance of this unlawful scheme, plan and course of conduct, Deloitte took the actions set

2 forth herein.

3 456. Deloitte: (a) employed devices, schemes, and artifices to defraud; (b) made untrue

4 statements of material fact and/or omitted to state material facts necessary to make the

5

6 statements not misleading; and (c) engaged in acts, practices and a course of business that

7 operated as a fraud and deceit upon the purchasers of the Company’s securities in an effort to

8 maintain artificially high market prices for Diamond’s securities in violation of Section 10(b)

9 of the Exchange Act and Rule 10b-5. Deloitte is sued as a primary participant in the

10 wrongful and illegal conduct charged herein.

11

457. In addition to the duties of full disclosure imposed on Deloitte as a result of 12

making affirmative statements and reports, or participation in the making of those statements 13

14 and reports to the investing public, it had a duty to promptly disseminate truthful information

15 that would be material to investors in compliance with the integrated disclosure provisions of

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SEC Regulation S-X (17 C.F.R. §210.01 et seq.) and S-K (17 C.F.R. §229.10 et seq.) and

17 other SEC regulations, including accurate and truthful information about the Company’s

18 financial condition and internal controls over financial reporting so that the market prices of

19 the Company’s publicly traded securities would be truthful, complete and accurate.

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21 458. Deloitte, directly and indirectly, by the use, means or instrumentalities of

22 interstate commerce and/or of the mails, engaged and participated in a continuous course of

23 conduct to conceal adverse material information about the financial condition of Diamond as

24 specified herein.

25 459. Deloitte employed devices, schemes and artifices to defraud, while in possession

26 of material adverse non-public information and engaged in acts, practices, and a course of

27 conduct as alleged herein in an effort to assure investors that Diamond’s financial statements

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1 were prepared in accordance with GAAP, it possessed effective internal controls over

2 financial reporting, and that its audits were conducted in accordance with GAAS as set forth

3 more particularly herein, and engaged in transactions, practices and a course of business that

4 operated as a fraud and deceit upon the purchasers of Diamond’s securities during the Class

5 Period.

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7 460. Deloitte’s liability arises from the following facts: (i) Deloitte was Diamond’s

8 I independent auditor since Diamond’s inception as a publicly traded company and was

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intimately familiar with the Company’s businesses and operations as well as its internal

10 controls over financial reporting; (ii) Deloitte, by virtue of its responsibilities and activities as

11 Diamond’s independent auditor was privy to the Company’s financial results and supporting

12 documentation as well as its internal controls over financial reporting; (iii) Deloitte was

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14 aware or was deliberately reckless in not being aware that Diamond’s financial statements

15 were not prepared in accordance with GAAP and that its internal controls over financial

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reporting were not effective; and (iv) Deloitte was aware or deliberately reckless in not being

17 aware that its independent audit was not prepared in accordance with GAAS.

18 461. Deloitte had actual knowledge of the misrepresentations and omissions of

19 material facts set forth herein, or acted with deliberate reckless disregard for the truth in that

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21 it failed to ascertain and to disclose such facts, even though such facts were available to it.

22 Such material misrepresentations and/or omissions were done knowingly or deliberately

23 recklessly and for the purpose and effect of concealing Diamond’s true financial condition

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from the investing public and supporting the artificially inflated price of its securities. As

25 demonstrated by Deloitte’s statements regarding the veracity of Diamond’s financial

26 statements, the effectiveness of Diamond’s internal controls over financial reporting, and the

27 manner in which it conducted its audits throughout the Class Period, if it did not have actual


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1

knowledge of the misrepresentations and omissions alleged, was deliberately reckless in

2 failing to obtain such knowledge by deliberately refraining from taking those steps necessary

3 to discover whether those statements were false or misleading.

4 462. As a result of the dissemination of the materially false and misleading information

5

6 and failure to disclose material facts, as set forth above, the market prices of Diamond’s

7 securities were artificially inflated during the Class Period. Unaware that market prices of

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Diamond’s publicly traded securities were artificially inflated, and relying directly or

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indirectly on the false and misleading statements made by Deloitte, or upon the integrity of

10 the market in which the securities trade, and/or on the absence of material adverse

11 information that was known to or deliberately recklessly disregarded by Deloitte but not

12 disclosed in public statements by it during the Class Period, Lead Plaintiff and the other

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14 members of the Class acquired Diamond’s securities during the Class Period at artificially

15 high prices and were damaged thereby.

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463. At the time of said misrepresentations and omissions, Lead Plaintiff and other

17 members of the Class were ignorant of their falsity, and believed them to be true. Had Lead

18 Plaintiff and the other members of the Class and the marketplace known of the true financial

19 condition of Diamond and ineffectiveness of the Company’s internal controls over financial

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21 reporting, which was not disclosed by Deloitte, Lead Plaintiff and other members of the

22 Class would not have purchased or otherwise acquired their Diamond’s securities, or, if they

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had acquired such securities during the Class Period, they would not have done so at the

24 artificially inflated prices that they paid.

25 464. By virtue of the foregoing, Deloitte has violated Section 10(b) of the Exchange

26 Act, and Rule 10b-5 promulgated thereunder.

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1 465

As a direct and proximate result of Deloitte’s wrongful conduct, Lead Plaintiff

2 and the other members of the Class suffered damages in connection with their respective

3 purchases and sales of the Company’s securities during the Class Period.

4 COUNT III

5

6 (Violations of Section 20(a) of the Exchange Act Against the Individual Defendants)

7 466. Lead Plaintiff repeats and realleges each and every allegation above as if fully set

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forth herein, except for Section VIII, above.

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467. The Individual Defendants acted as controlling persons of Diamond within the

10 meaning of Section 20(a) of the Exchange Act as alleged herein. By virtue of their high-

11 level positions, and their ownership and contractual rights, participation in and/or awareness

12 of the Company’s operations and/or intimate knowledge of the false financial statements

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14 filed by the Company with the SEC and disseminated to the investing public, the Individual

15 Defendants had the power to influence and control and did influence and control, directly or

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indirectly, the decision making of the Company, including the content and dissemination of

17 the various statements that Lead Plaintiff contends are false and misleading. The Individual

18 Defendants were provided with or had unlimited access to copies of the Company’s reports,

19 press releases, public filings and other statements alleged by Lead Plaintiff to be misleading

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21 prior to and/or shortly after these statements were issued and had the ability to prevent the

22 issuance of the statements or cause the statements to be corrected.

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468. In particular, the Individual Defendants had direct and supervisory involvement in

24 the day-to-day operations of the Company and, therefore, are presumed to have had the

25 power to control or influence the particular transactions giving rise to the securities violations

26 as alleged herein, and exercised the same.

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469. As set forth above, Diamond and the Individual Defendants each violated Section

2 10(b) and Rule 10b-5 by their acts and omissions as alleged in this complaint. By virtue of

3 their positions as controlling persons, the Individual Defendants are also liable pursuant to

4 Section 20(a) of the Exchange Act. As a direct and proximate result of all of Defendant

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6 Diamond, the Individual Defendants and Defendant Deloitte’s wrongful conduct, Lead

7 Plaintiff and other members of the Class suffered damages in connection with their purchases

8 of the Company’s securities during the Class Period.

9

PRAYER FOR RELIEF

10 WHEREFORE , Lead Plaintiff prays for relief and judgment as follows:

11 1. Determining that this action is a class action under Rule 23 of the Federal

12 Rules of Civil Procedure;

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14 2. Awarding compensatory damages in favor of Lead Plaintiff and other Class

15 members against all Defendants, jointly and severally, for all damages sustained as a result of

16 Defendant Diamond, the Individual Defendants and Defendant Deloitte’s wrongdoing, in an

17 amount to be proven at trial, including pre-judgment and post-judgment interest thereon;

18 3. Awarding Lead Plaintiff and the Class their reasonable costs and expenses

19 incurred in this action, including counsel fees and expert fees; and

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21 4. Awarding such other and further relief as the Court may deem just and proper.

22 JURY TRIAL DEMANDED

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Plaintiff demands a trial by jury.

24

Dated: July 30, 2012

Respectfully submitted,

25 By: /s/ John F. Harnes

26

John F. Harnes

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1

CHITWOOD HARLEY HARNES LLP John F. Harnes (admitted pro hac vice)

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Gregory E. Keller (admitted pro hac vice) 1350 Broadway, Suite 908

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New York, New York 10018 Tel.: (917) 595-4600

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[email protected] [email protected]

5 Robert W. Killorin (admitted pro hac vice)

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Meryl W. Roper (admitted pro hac vice) Ze’eva Kushner Banks (admitted pro hac vice)

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2300 Promenade II 1230 Peachtree Street, N.E.

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Atlanta, Georgia 30309 Tel: (404) 873-3900

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Fax: (404) 876-4476 [email protected]

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11 Class Counsel for Lead Plaintiff the Mississippi

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Public Employees’ Retirement System

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1 LIEFF CABRASER HEIMANN & BERNSTEIN

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LLP

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Richard M. Heimann Joy A. Kruse

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275 Battery Street, 29th Floor San Francisco, California 94111- 3339

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Telephone: (415) 956-1000 Facsimile: (415) 956-1008

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7 Local Counsel for Lead Plaintiff the Mississippi Public

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Employees’ Retirement System

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1

2 CERTIFICATE OF SERVICE

3 I am employed in the County of Fulton, State of Georgia. I am over the age of

4 eighteen (18) years and not a party to the within action; my business address is 1230

5 Peachtree Street NE, Suite 2300, Atlanta, Georgia 30309.

6 On July 30, 2012, I caused to be served via electronic transmission through the

7 website for the U.S. District Court, Northern District of California, a copy of the below-

8 referenced documents upon parties registered in the action for e-service:

9 1. Consolidated Class Action Complaint

10 with the Clerk of the Court using the CM/ECF system which will send notification of such

11 filing to the attorneys of record.

12 I also hereby certify that I am personally and readily familiar with the business

13 practice of Chitwood Harley Harnes LLP for collection and processing of correspondence for

14 mailing with the United States Postal Service, and on July 30, 2012, I caused a copy of the

15 foregoing document to be served via the United States Postal Service upon the following:

16 See attached list

17 I also hereby certify that I caused an electronic copy of the foregoing documents to be

18 forwarded via email to the following Designated Internet Site, in compliance with Civil L.R.

19 23-2(c)(2):

20 Securities Class Action Clearinghouse

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Stanford University School of Law Crown Quadrangle

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Stanford, CA 94305-8612 [email protected]

23 I declare under penalty of perjury that the foregoing is true and correct. Executed in

24 Atlanta, Georgia on July 30, 2012.

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26 By: /s/ Nora D. Hackett_______

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Nora D. Hackett

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Documents

In re Diamond Foods, Inc., Securities Litigation 11-CV-05386