The opinion of the court was delivered by: KNAPP
This securities fraud action is presently before us on plaintiff's Rule 23 motion for class determination and defendants' cross-motion for summary judgment. For the reasons set forth below, plaintiff's Rule 23 motion is granted, but all of defendants' motions are denied, except for their motion to dismiss Count I of the complaint, which is granted.
On August 7, 1972, plaintiff -- a concededly experienced investor and an attorney in his own right -- purchased 1000 shares of defendant Dunkin Donuts, Inc. ("Dunkin") common stock through his broker, defendant Lehman Brothers Incorporated ("Lehman"). These shares were allegedly purchased as part of a public offering of Dunkin common stock shares issued pursuant to a Registration Statement and Prospectus effective July 27, 1972. It is this registration statement and prospectus -- specifically, the financial statements and accompanying auditor's opinion -- which are the subject of this lawsuit. A total of 350,000 common stock shares ("new" stock) were issued pursuant to this registration statement, while 600,000 previously issued shares ("old" stock) were already on the market. For the purposes of that part of the defendants' motion which is addressed to Count I, this distinction between "old" and "new" stock is crucial.
The alleged defect in the registration statement concerns the manner in which the accompanying audited financial statement treated the interest payments due on Dunkin's indebtedness. Dunkin conducts a fast foods business, and owns or franchises an extensive chain of "Dunkin Donut" shops and "Howdy Beefburger" drive-in restaurants. It financed itself almost exclusively by issuing notes payable over a period of years (usually seven). It was a peculiarity of these notes that they were payable in unchanging annual installments, no designation being made as between the payment of interest and the return of principal. Thus, by way of arbitrary example, if Dunkin had taken out a seven year loan in 1960, the total cost of repaying principal and interest on which would have come to $70,000, Dunkin would have discharged that indebtedness in seven annual payments of $10,000 each. In such a situation, the first year's payment would necessarily have been in considerable part attributable to interest charges, the interest component would lessen in each succeeding year, and the last year's payment would consist almost wholly of the return of principal. The accounting method used in Dunkin's financial statement did not, however, reflect this variation in interest charges. On the contrary, such statement reported interest on a so-called "straight line" method, whereby the same amount of interest would have been attributed to the first payment as to the last. Based on these facts, plaintiff makes a two-step contention: first, the accounting method used was improper, in that, because it failed to charge off enough interest in the early years of a loan, it artificially inflated Dunkin's report of net earnings and assets; and second, the huge amount of Dunkin loans outstanding caused this artificiality materially to inflate the market value of Dunkin stock.
Dunkin's auditor, defendant Price Waterhouse, presumably agreed as to the impropriety of the method, because it later compelled Dunkin to correct it by using an "effective interest" method of reporting, whereby the interest on the amount of principal actually outstanding would each year be reported. For purposes of these motions only, all defendants concede both impropriety and materiality.
With respect to the class action motion, plaintiff purports to sue both individually and on behalf of a proposed class consisting of all persons other than defendants who sustained damages by purchasing Dunkin common stock between July 27, 1972, the effective date of the subject Registration Statement, and February 15, 1973, the day on which the 1972 Annual Report informed the shareholders of the corrected accounting methods.
In addition to being the plaintiff in this action, Mr. Lorber, in his private capacity as an attorney, has rendered legal services to the class and expects to continue to do so if called upon by the firm of Milberg & Weiss, who appear as his attorneys in this action.
The defendants are: Dunkin, a Delaware corporation; five individuals who were Dunkin directors and/or officers during the relevant period; Price-Waterhouse & Co., Dunkin's auditors during that time; Goldman Sachs & Co., the managing underwriter of the 1972 offering; and 36 co-underwriters, including plaintiff's broker, Lehman Brothers. Plaintiff alleges that all defendants, directly or indirectly, "participated in or aided and abetted each other, or conspired with" each other to commit the acts or create the omissions complained of (Complaint, para. 24).
The Complaint alleges five causes of action. Count I asserts a claim under Section 11 of the 1933 Securities Act, 15 U.S.C. § 77k; Count II is based on Section 12(2) of the same Act, 15 U.S.C. § 77 l ; Count III invokes Section 10(b) of the 1934 Securities Exchange Act, 15 U.S.C. § 78j(b) and Rule 10b-5, 17 C.F.R. 240.10b-5; and Counts IV and V allege common law fraud and negligence claims. So far as relevant to this action, the various statutes mentioned provide as follows:
Section 11 of the 1933 Act, upon which Count I is based, imposes what amounts to liability without fault for any registration statement found to be false or misleading. However, to avail himself of this section, a plaintiff must be able to demonstrate that the stock he purchased was issued pursuant to the particular registration statement found to have been false or misleading. Defendants have moved to dismiss plaintiff's claim under this section on the ground either that the stock he purchased was "old" and not "new", and thus had not been issued pursuant to the registration statement now claimed to have been false and misleading, but had been issued in the course of a previous offering, or that plaintiff cannot establish whether his stock was "old" or "new".
Section 12(2), upon which Count II is predicated, differs from Section 11 in several respects: (1) it does not impose liability without fault, but allows a due diligence defense; (2) as a general rule, it limits recovery to a purchaser's immediate seller; on the other hand, (3) it does not require proof that the stock in question was issued pursuant to any particular prospectus but supports liability if the immediate seller used any false or misleading prospectus (or indeed any oral misrepresentation) in effectuating the sale. Defendants seek dismissal of this Count on the alternative grounds that: (1) plaintiff purchased his stock in an open market transaction and thus can establish no immediate seller, or (2) if the underwriter (defendant Blyth Eastman Dillon & Co., Inc.) from whom plaintiff's broker acquired the stock were deemed to be plaintiff's immediate seller, such underwriter did not supply plaintiff with any prospectus or otherwise communicate any information to him in effectuating the sale.
Liability under Section 10(b), upon which Count III rests, does not depend on whether a defendant was the immediate seller or whether the stock purchased by the plaintiff had been issued pursuant to any particular registration statement. The section does, however, as a general rule require proof that, among other things, the plaintiff relied on the particular misrepresentation alleged. Defendants' motion for summary judgment as to this Count is based on the contention that the record already before the court conclusively establishes that there was no such reliance.
As to the pendent claims asserted in Counts IV and V, defendants' position is that should plaintiff's federal claims be dismissed, the pendent claims must also fall.
DEFENDANTS' MOTIONS FOR SUMMARY JUDGMENT
Count I: Section 11 Claim
Section 11 provides, in relevant part:
". . . In case any part of the Registration Statement, when such part became effective, contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading, any person acquiring such security * * * may, * * * sue [the various categories of defendants named in this action] . . ." (emphasis supplied)
It is at once apparent that the foregoing language is ambiguous because of the lack of any antecedent to the words "such security". The courts in this Circuit have consistently resolved that ambiguity by limiting § 11 recovery to purchasers of shares issued pursuant to the particular registration statement claimed (or found) to be defective. Barnes v. Osofsky (2d Cir. 1967) 373 F.2d 269, Colonial Realty Corp. v. Brunswick Corp. (S.D.N.Y. 1966) 257 F. Supp. 875. Anyone who may have purchased identical securities already traded on the open market must look elsewhere for relief. Wolfson v. Solomon (S.D.N.Y. 1972) 54 F.R.D. 584, 588. It follows that a plaintiff, in order to have a valid § 11 cause of action, must plead and prove that his stock was issued pursuant to the particular registration statement alleged to be defective. Barnes v. Osofsky, supra, at 273. In the instant case, plaintiff must demonstrate that his 1,000 shares were "new" stock, as above defined; if he fails to do this, his § 11 claim must be dismissed.
A careful review of the pleadings and the papers submitted on the instant motions leads us to the inescapable conclusion that plaintiff cannot meet this test. He has neither pleaded nor could he prove that the stock he purchased was issued pursuant to the allegedly defective registration statement. In the first place, plaintiff makes no such allegation in that portion of the Complaint in which he sets forth Count I (paras. 25-28). Similarly in para. 4, under the heading "Parties", plaintiff describes himself as having purchased shares of Dunkin common stock "pursuant to a Registration Statement and Prospectus" (emphasis supplied). No attempt is made to specify the statement and prospectus pursuant to which his shares had been issued.
Without an allegation that it was the 1972 statement and prospectus, we have no reason for not assuming that it may not have been a previous statement and prospectus, and thus concluding that plaintiff may have purchased "old" stock rather than "new".
The reason for plaintiff's caution in pleading becomes clear when one examines the factual situation with which he was confronted. The defendants' papers (especially pp. 8-10, defendants' Joint Memorandum) go into great detail in establishing that plaintiff could not have purchased "new" but must have purchased "old" stock. As plaintiff does not claim to be able to dispute defendants' factual contentions, it would unduly burden this opinion to elaborate them. Suffice it to say that: (1) plaintiff's purchase of the stock was completed in 1972 when defendant Blyth Eastman Dillon & Co., Inc. (the seller from whom plaintiff's broker, defendant Lehman, had purchased the stock) delivered to a clearing house for defendant Lehman's account a certificate directly traceable to one which had been issued before the effective date of the 1972 registration statement (i.e., "old" stock); and (2) plaintiff did not take physical possession of his stock until about a year later, at which time he received a certificate which came out of a Lehman "house account" which held both "old" and "new" shares on a fungible basis and thus could not be identified as either "old" or "new".
Plaintiff urges, however, that the critical question is not the origin of the certificate delivered to the clearing house for his broker's account in 1972, but the origin of the one actually delivered to him a year later. Moreover, conceding his inability conclusively to identify the latter certificate as "new", he contends that the burden of identification should be on defendants and that he should qualify for § 11 relief by showing that the certificate might have been traceable to "new" stock. Neither contention can prevail.
As to the first, it seems clear that the transaction was completed in 1972 when delivery of "old" stock was made by defendant Blyth to the clearing house U.C.C. § 8-301(1); § 8-320. When that transaction cleared, plaintiff acquired the rights -- including the remedies [U.C.C. § 1-201(36), § 8-102(61)] -- in the shares which Blyth conveyed. U.C.C. § 8-301(1).
With respect to plaintiff's second contention, under the law in this Circuit it is insufficient that stock "might" have been issued pursuant to a defective statement. A plaintiff must show that it actually was so issued. Barnes v. Osofsky, supra, 373 F.2d at 273, n. 2.
The plaintiffs in Barnes -- who had purchased stock on the open market, and thus could not trace its origin -- attempted to invoke § 11 to sustain recovery on the basis of misleading financial information contained in a certain registration statement. Those plaintiffs -- much as does the one at bar -- strongly argued that in such a case the burden of tracing should be shifted to the defendants. Since misleading financial information would affect the price of already outstanding stock to the same extent as newly issued stock, they argued, it would be unreasonable to distinguish between the two. To read Section 11 as affording a cause of action only to those purchasers who could trace lineage of their shares to a particular offering, they contended, would make the result turn on "mere accident", since most trading is done through brokers who neither know nor care about the origin of the stock they are handling. Finally, they noted, it is often impossible to determine the lineage of particular shares in situations where stock is held in fungible accounts in street name. The court speaking through Chief Judge Friendly, rejected those arguments and concluded that they were "unpersuasive" (373 F.2d at 273), "inconsistent with the over-all statutory scheme . . . [and] contrary to the legislative history". (Id., at 272).
Count I is, accordingly, dismissed.
Count II: Section 12(2) Claim
The second count purports to state a claim under Section 12(2) of the 1933 Act, 15 U.S.C. § 77 l (2), which provides: