Lone Star Ladies Invest. v. Schlotzky's

• Decision Date: 09 January 2001
• Docket Number: No. 99-50958,99-50958
• Citation: 238 F.3d 363
• Parties: (5th Cir. 2001) 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, v. 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 v. SCHLOTZSKY'S, INC.; JOHN C. WOOLEY; JEFFREY J. WOOLEY; JOHN M. ROSILLO; MONICA GILL, Defendants-Appellees
• Court: U.S. Court of Appeals — Fifth Circuit

Page 363

238 F.3d 363 (5th Cir. 2001)

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, v. 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 v. SCHLOTZSKY'S, INC.; JOHN C. WOOLEY; JEFFREY J. WOOLEY; JOHN M. ROSILLO; MONICA GILL, Defendants-Appellees.

No. 99-50958

IN THE UNITED STATES COURT OF APPEALS, FIFTH CIRCUIT

January 9, 2001

REVISED, January 11, 2001

[Copyrighted Material Omitted] Appeal from the United States District Court For the Western District of Texas.

Before GARWOOD, HIGGINBOTHAM, and STEWART, Circuit Judges.

PATRICK E. 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 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 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 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 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 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 Rule 9(b). Second, other disclosures cured the allegedly misleading filings. We address each contention in turn, and find neither persuasive.

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 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...