Lone Star Ladies Investment Club v. Schlotzsky's Inc.

                     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