REVISED, January 11, 2001
IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
No. 99-50958
LONE STAR LADIES INVESTMENT CLUB, A Texas General Partnership, on
behalf of itself and all others similarly situated; MARK BALIUS;
JOSEPH CASANO; WILFORD A. GRIMES; FRANK A. QUIRICONI; RALPH
CASEY,
Plaintiffs-Appellants,
versus
SCHLOTZSKY’S INC.,
Defendants,
SCHLOTZSKY’S INC.; MONICA GILL; JOHN M. ROSILLO; JEFFREY J.
WOOLEY; JOHN C. WOOLEY,
Defendants-Appellees
_______________________________
RONALD TRAUB, on behalf of himself and all others similarly
situated,
Plaintiff-Appellant
versus
SCHLOTZSKY’S, INC.; JOHN C. WOOLEY; JEFFREY J. WOOLEY; JOHN M.
ROSILLO; MONICA GILL,
Defendants-Appellees.
Appeal from the United States District Court
For the Western District of Texas
January 9, 2001
Before GARWOOD, HIGGINBOTHAM, and STEWART, Circuit Judges.
HIGGINBOTHAM, Circuit Judge:
This appeal is from dismissal of a suit on behalf of a class
of purchasers of securities, charging that Schlotzsky’s and four
of its officers and directors violated the Securities Act of
19331 and the Securities and Exchange Act of 19342 in their
required financial filing, including a public offering of
securities. The district court, faulting the absence of pleading
particulars, dismissed the complaint and refused leave to file an
amended complaint deleting all claims under the Securities and
Exchange Act. We are persuaded that the proffered amended
complaint should have been allowed. We reverse and remand to the
district court with instructions to grant leave to file the
amended complaint and for further proceedings.
I
According to plaintiffs:
(a) Defendant Schlotzsky’s is a franchisor of quick
service restaurants that feature made-to-order
sandwiches with distinctive bread, baked daily at each
location. Schlotzsky’s was a privately held
corporation until December 1995 when, pursuant to a
Registration Statement and Prospectus filed with the
SEC, it issued and sold 2,250,000 shares of common
stock at a price of $11 per share to the investing
public in an initial public offering (the “IPO”).
(b) On September 4, 1997, Schlotzsky’s announced that
it had filed a Registration Statement and Prospectus
with the SEC for a secondary offering of common stock.
On September 24, 1997, the Registration Statement and
1
15 U.S.C. 77k and 77l.
2
15 U.S.C. 78j.
2
Prospectus for the sale of 2,300,000 shares of
Schlotzsky’s common stock at a price of $18.375 became
effective (the “Offering”). The Registration Statement
and Prospectus provided for an over-allotment option
pursuant to which the Company could sell an additional
231,825 shares and the selling shareholders could sell
an additional 113,175 shares. Pursuant to the
Registration Statement and Prospectus, the Company
issued and sold 1,731,825 shares of common stock in the
offering and certain selling shareholders sold 913,175
shares.
Schlotzsky’s developed a “Turnkey Program,” by which
Schlotzsky’s would completely prepare a franchise operation and a
purchaser need only turn the key to begin doing business. The
Turnkey Program was a success and accounted in 1997 for much of
Schlotzsky’s profit. In 1997, Schlotzsky’s issued a press
release reporting Turnkey revenues of $762,000 – an 849% increase
over the preceding year. By March 31 of 1998 it had grown to
703 stores from 463 stores in December 1995.
Schlotzsky’s fueled its sales of franchises by offering
financial assistance. This often included Schlotzsky’s
guaranteeing the loans made for a purchase of a franchise. This
suit attacks Schlotzsky’s reporting of profits from its Turnkey
Program. Schlotzsky’s would recognize the full revenue received
on a Turnkey Program sale, without any deduction for Schlotzsky’s
guarantee of the franchisee’s loan. Yet Generally Accepted
Accounting Practices require the reduction of income from sales
to account for a seller’s continuing obligations with respect to
3
the property.3 Schlotzsky’s made no such adjustments, with
resulting higher revenues and higher profit margins for the
Turnkey Program.
The prospectus for Schlotzsky’s SPO and other financial
filings contained these nonconforming profit calculations. They
also, however, made disclosures regarding the Turnkey Program,
including the use of guarantees of debt.
On April 6, 1998, on the advice of its auditors,
Schlotzsky’s issued a press release disclosing that Turnkey
revenues had been overstated by approximately $3.4 million
dollars. The market reacted by a 27% decline in the trading
price of Schlotzsky’s stock. According to the plaintiffs:
“An April 15, 1998 press release admitted that 1997
Turnkey revenue had been $1,139,000, rather than the
$4,538,000 that Schlotzsky’s had earlier reported.
Schlotzsky’s had overstated 1997 Turnkey revenues by
$3,399,000 or 298%. The company confirmed that actual
earnings per share for fiscal 1997 had been only $0.71
rather than $0.82. Based on improper accounting for
Turnkey revenues, Schlotzsky’s had overstated Fiscal
1997 earnings per share by 15%.
The complaint asserted violations under both the 1934
Exchange Act and the 1933 Securities Act on behalf of all
purchasers of Schlotzsky’s stock from April 29, 1997, through
April 5, 1998. Granting a 12(b)(6) motion, the district court
held that the plaintiffs had not pleaded facts sufficient to give
rise to a strong inference of scienter as required by the Private
3
Statement of Financial Accounting Standard No. 66,
Accounting for Sales of Real Estate.
4
Securities Litigation Reform Act.
The district court, invoking Melder v. Morris,4 applied Rule
9(b)’s heightened pleading requirements to the claims asserted
under the 1933 Act. It insisted that despite the strict
liability provision of the act plaintiffs had not adequately
pleaded scienter, required because plaintiffs had grounded all of
their claims in fraud such that they were “merely wholesale
adoptions of plaintiffs’ section 10(b) securities fraud claims.”
The district court also held that the defendants were not
“sellers” to the members of the class under section 12 of the
Securities Act because the SPO was a firm underwriting. Under
that method of selling, all stocks are sold to underwriters under
a firm commitment and the underwriters sell to the public, here
class members.
Plaintiffs then sought leave to file an amended complaint
that dropped all claims under the 1934 Exchange Act, relying only
on asserted violations of the 1933 Securities Act. The district
court denied leave to file the amended complaint and refused to
reconsider that decision.
This appeal followed.
II
A
Our inquiry is framed by the question of whether the
4
27 F.3d 1097, 1100 n.6 (5th Cir. 1994).
5
district court abused its discretion by denying plaintiffs’
requests for leave to amend, twice made.5 The proposed amended
complaint made no 1934 Act claims.6
We are persuaded that the district court erred in denying
plaintiffs leave to file their amended complaint, and do not
reach the question of whether the original 1934 Act claims were
pleaded with the specificity required by the Reform Act. The
district court’s discretion is here limited by Rule 15(a)’s
provision that leave “shall be freely given.”7 This standard
favors leave as a necessary companion to notice pleading and
discovery. Not surprisingly, denying leave to amend, absent
articulable reason, is “not an exercise of discretion” but rather
“abuse of . . . discretion.”8 This is not an insistence that a
district court engage in a formal recitation of reasons when the
5
They did so first in the conclusion to their memorandum
opposing the motion to dismiss and again after the motion to
dismiss had been granted. Plaintiffs moved for reconsideration
of the dismissal, requesting leave to amend, and attaching a
proposed amended complaint.
6
Only two of the plaintiffs, Lead Plaintiffs Ronald Traub
and Ralph Casey, moved to amend their complaint. The Motion,
however, asserts that the remaining named plaintiffs “are not
seeking to reassert their Exchange Act claims.” Further, the
proposed Amended Complaint is styled as a class action, on behalf
of all persons who purchased Schlotzsky’s stock during the
relevant period. That class would, presumably, include any named
plaintiffs who did not expressly sign on to the Motion to Amend.
7
Forman v. Davis, 371 U.S. 178, 182 (1962).
8
Id.
6
reasons for denying leave are facially obvious.9 The reason for
denial must be clear, however, either from the findings of the
district court or elsewhere in the record.10
The district court stated no reason, and we perceive no
obviously correct reason for denying leave to amend. This is not
a case where plaintiffs have already had multiple opportunities
to amend their pleadings.11 Nor is this a case in which leave to
amend would prejudice the defense. Rather, the proposed
amendment eliminated the pleading issues attending the claims
under the 1934 Act asserted in the complaint. And prejudice is
the “touchstone of the inquiry under rule 15(a).”12
B
Defendants urge that for two reasons an amendment would have
been futile. First, the revised complaint, it is said, still
relied so heavily on allegations of fraud as to invoke and fail
9
See, e.g., Martin’s Herend Imports, Inc. v. Diamond & Gem
Trading United States Co., 195 F.3d 765, 771 (5th Cir. 1999).
10
See, e.g., Rolf v. City of San Antonio, 77 F.3d 823, 828-
29 (5th Cir. 1996) (“The district court’s order does not state
its reasons for denying leave. Our review of the record reveals
no substantial reason to deny leave to amend. Appellants should
have been granted leave to file an amended complaint.”); Halbert
v. City of Sherman, 33 F.3d 526, 529-30 (5th Cir. 1994) (holding
that denial of leave to amend is error in the absence of
justifying reasons).
11
Compare Price v. Pinnacle Brands, Inc., 138 F.3d 602,
607-08 (5th Cir. 1998).
12
Lowrey v. Texas A&M Univ. Sys., 117 F.3d 242, 246 (5th
Cir. 1997).
7
Rule 9(b). Second, other disclosures cured the allegedly
misleading filings. We address each contention in turn, and find
neither persuasive.
1
Citing Melder v. Morris,13 the district court applied Rule
9(b) to plaintiff’s claims under the 1933 Securities Act and
dismissed them for failure to satisfy Rule 9(b). Melder applied
Rule 9(b) to claimed violations of the 1933 Securities Act claim,
asserting that “[w]hen 1933 Securities Act claims are grounded in
fraud rather than in negligence as they clearly are here, Rule
9(b) applies.”14
Rule 9(b) applies by its plain language to all averments of
fraud, whether they are part of a claim of fraud or not.15 It
does not follow, however, that Rule 9(b) or Melder justifies
dismissing a 1933 Act claim when, disregarding the deficient
allegation of fraud, a claim is stated. Rather, Rule 9(b)
insists that “all averments of fraud . . . shall be stated with
particularity.” The price of impermissible generality is that
13
27 F.3d 1097, 1100 n.6 (5th Cir. 1994).
14
Id.
15
See Fed. R. Civ. Pro. 9(b) (“In all averments of fraud or
mistake, the circumstances constituting fraud or mistake shall be
stated with particularity.”) (emphasis added).
8
the averments will be disregarded.16
Where averments of fraud are made in a claim in which fraud
is not an element, an inadequate averment of fraud does not mean
that no claim has been stated. The proper route is to disregard
averments of fraud not meeting Rule 9(b)’s standard and then ask
whether a claim has been stated. There is a qualification. A
district court need not rewrite such a deficient complaint. It
may dismiss, without prejudice, placing that responsibility upon
counsel.
Melder quite properly observes that “[w]hen 1933 Securities
Act claims are grounded in fraud rather than negligence . . .
Rule 9(b) applies.”17 In Melder, the application of Rule 9(b)
was fatal because of “the complaint’s wholesale adoption of the
allegations under the securities fraud claims for purposes of the
Securities Act claims.”18 In other words, as we have explained,
a district court is not required to sift through allegations of
fraud in search of some “lesser included” claim of strict
liability. It may dismiss. If it does so, it should ordinarily
accept a proffered amendment that either pleads with the
requisite particularity or drops the defective allegations and
16
We assume, without deciding, that the averments of fraud
were insufficient.
17
27 F.3d at 1100 n.6.
18
Id. (emphasis added). In Melder, plaintiffs were allowed
to replead twice and the district court held a hearing.
9
still states a claim.
The proposed amended complaint left no room for
misunderstanding. It expressly “do[es] not assert that
defendants are liable for fraudulent or intentional conduct and
disavow[s] and disclaim[s] any allegation of fraud.” It avers
that Schlotzsky’s made untrue statements of material facts and
omitted to state material facts, in violation of 15 U.S.C. § 77k.
Those claims do not “sound in fraud” and cannot be dismissed for
failure to satisfy Rule 9(b).
2
We do not read the district court’s ruling to be that no
claim under the 1933 Act was stated, given the disclosures in the
offering materials and other filings regarding defendants’
treatment of income. Such a declaration in ruling on a Rule
12(b)(6) motion would have been error. Rather, it properly noted
that defendants disclosed certain facts concerning the Turnkey
Program, including its revenue recognition practices. The
district court then concluded that such disclosures strengthened
the contention that defendants were neither recklessly nor
intentionally fraudulent and hence the complaint had failed to
sufficiently allege scienter under the 1934 Act violations.
Whatever the ultimate answer to the adequacy of the
disclosures under the 1933 Act, we are not persuaded that that
decision ought be made here in ruling on a motion to dismiss for
10
failure to state a claim.19 Viewing the interaction between
Schlotzsky’s revenue recognition and the disclosure of its
Turnkey Practices in the light most favorable to the plaintiff,
as we must, the amended complaint was not vulnerable to a Rule
12(b)(6) motion on this basis. The lower threshold of liability
under section 11 and 12 of the 1933 Act as compared to the 1934
Act here matters a great deal. This threshold and its relevance
to a Rule 12(b)(6) motion is illustrated by two hornbook
principles of securities law. The liability of an issuer to a
plaintiff who purchases a security issued pursuant to a
registration statement for a material misstatement or omission is
“virtually absolute.”20 “Defendants other than the issuer can
avoid liability by demonstrating due diligence.”21 And this is an
affirmative defense that must be pleaded and proved.22
In sum, we are persuaded that the amendment would not have
been futile and the district court ought to have granted leave to
file the amended complaint. One matter remains. The district
court rejected the section 12(a)(2) claims on the additional
19
An example of the disclosure made appears in the 1997
First Quarter 10-Q: “The Company guarantees certain leases of its
franchisees for limited periods of time, which may affect its
ability to obtain financing in the future.” (emphasis added)
20
Herman & MacLean v. Huddleston, 459 U.S. 375, 382 (1983).
21
Id.
22
See Fed. R. Civ. P. 8(c).
11
ground that defendants were not the sellers of the securities to
plaintiffs.
III
Defendants urge, and the district court accepted, that they
cannot be held liable as “sellers” under section 12 of the 1933
Act because the stock offering was by a firm commitment
underwriting, in which defendants sold stock to underwriters, who
then sold to the public.23
Defendants rely upon Shaw v. Digital Equipment Corp.,24
which held that since “the issuer in a firm commitment
underwriting does not pass title to the securities, [the issuer
and its officers] cannot be held liable as ‘sellers’ under
Section 12(2) unless they actively ‘solicited’ the plaintiffs’
purchase of securities to further their own financial motives.”25
As we see it, the pivot point here is not whether defendants
were “sellers”, because “Congress expressly intended to define
broadly” the concept of seller to “encompass the entire selling
23
Section 11 imposes liability on “every person who signed
the registration statement” and “every person who was a director
of . . . the issuer at the time of the filing.” 15 U.S.C. § 77k.
24
82 F.3d 1194 (1st Cir. 1996).
25
82 F.3d at 1215.
12
process, including the seller/agent transaction.”26 Rather, our
issue is controlled by section 12's provision that a seller is
only liable “to the person purchasing such security from him.”27
The argument is that in a firm commitment underwriting, the
public purchases from the underwriter, not from the issuer.
Pinter held that the purchase clause of section 12 does not
“exclude solicitation from the category of activities that may
render a person liable when a sale has taken place.”28 For
example, “a securities vendor’s agent who solicited the purchase
would commonly be said, and would be thought by the buyer, to be
among those ‘from’ whom the buyer ‘purchased,’ even though the
agent himself did not pass title,”29 for example a broker acting
for an issuer. Shaw found that under some circumstances, “an
issuer involved in a firmly underwritten public offering could be
a ‘seller’ for purposes of Section 12(2)” where the issuer
solicited the sale of the stock.30 This much is clear under
Pinter.
It is also true under Pinter that under some circumstances,
the issuer is immune from section 12 liability in a firm
26
Pinter v. Dahl, 486 U.S. 622, 643 (1988).
27
15 U.S.C. §77l(a).
28
486 U.S. at 644.
29
Id.
30
82 F.3d at 1216.
13
commitment underwriting. In footnote 21, the Pinter Court
explained that:
One important consequence of [the purchaser clause] is
that §12(1) imposes liability on only the buyer’s
immediate seller; remote purchasers are precluded from
bringing actions against remote sellers. Thus, a buyer
cannot recover against his seller’s seller.31
In sum, in a firm commitment underwriting, such as this one,
the public cannot ordinarily hold the issuers liable under
section 12, because the public does not purchase from the
issuers. Rather, the public purchases from the underwriters, and
suing the issuers is an attempt to “recover against [the]
seller’s seller.”32 It is true that there are unusual cases in
which the issuer is sufficiently active in promoting the
securities as to essentially become the vendor’s agent. But that
possibility does not weaken this basic principle. Virtually all
issuers routinely promote a new issue, if only in the form of
preparing a prospectus and conducting a road show. That said,
Pinter holds that a plaintiff invoking section 12 may show that
an issuer’s role was not the usual one; that it went farther and
became a vendor’s agent.
On remand, plaintiffs will bear the burden of demonstrating
that these issuers did solicit in a manner sufficient to satisfy
Pinter, if they wish to preserve their section 12 claims. We say
31
486 U.S. at 644 n.21 (emphasis added).
32
Id.
14
only that this claim cannot be decided in this case and on these
facts upon a Rule 12(b)(6) motion, although the parties may bring
the question again upon a properly developed record under Rule 56
of the Federal Rules of Civil Procedure.33 We decline to step
further onto this terrain by applying these principles to
possible facts that plaintiffs might adduce. The able district
court is better equipped to first address these issues, with
facts in hand.
We REVERSE the decision of the district court to deny leave
to file the amended complaint, REMAND the case with instructions
to grant leave and for further proceedings not inconsistent with
this opinion.
REVERSED and REMANDED.
33
The question of controlling person liability under
Section 15 of the 1933 Securities Act is derivative of liability
under Sections 11 and 12(2) and must abide that ultimate
resolution.
15