The opinion of the court was delivered by: GAGLIARDI
Plaintiff Edna Straus has commenced this action pursuant to § 11 of the Securities Act of 1933 ("Securities Act"), 15 U.S.C. § 77k, § 10(b) of the Securities Exchange Act of 1934, ("Exchange Act"), 15 U.S.C. § 78j(b), and principles of common law fraud. Jurisdiction is premised upon § 22(a) of the Securities Act, 15 U.S.C. § 77v, § 27 of the Exchange Act, 15 U.S.C. § 78aa and principles of pendent jurisdiction. This case involves allegedly misleading statements and omissions in a registration statement filed for the purpose of a public offering of common stock held by various controlling persons of defendant Holiday Inns, Inc. ("Holiday").
Plaintiff purports to sue on behalf of a class consisting of all persons who purchased shares in Holiday in the period from March 23, 1976, the effective date of the registration, until April 27, 1976 either pursuant to the prospectus or on the open market. Shortly after plaintiff moved for an order certifying the class pursuant to Rule 23(c)(1), Fed.R.Civ.P., defendants Holiday, Walkem Development Company, Inc. ("Walkem"), Kemmons Wilson, Wallace E. Johnson, and Ernest B. McCool moved for an order: 1) requiring plaintiff to furnish an undertaking in the amount of $ 100,000 as security for their costs of defending this action, pursuant to § 11(e) of the Securities Act, 15 U.S.C. § 77k(e); 2) staying all discovery in the action pending the determination of their motion for an undertaking pursuant to Rule 26(c), Fed.R.Civ.P.; and 3) staying any ruling on plaintiff's motion for class certification pending the determination of their undertaking motion pursuant to Rule 23(d), Fed.R.Civ.P. Defendants Smith Barney, Harris Upham & Co., Inc. and Merrill Lynch, Pierce, Fenner & Smith, Inc., underwriters for the public offering in question, joined the other defendants in requesting that a response to plaintiff's class certification motion be deferred pending the determination of the motion for an undertaking. Plaintiff then cross-moved for an order staying all discovery of plaintiff until her class action motion has been decided. For the reasons stated below, defendants' motion for an undertaking is granted. All defendants are directed to respond to plaintiff's class certification motion within 20 days of plaintiff's posting of the undertaking or her notice to all parties and this court of her intent to discontinue her § 11 claim. All discovery concerning matters other than class certification is stayed pending the resolution of the class certification motion.
Allegations of the Complaint
Defendant Holiday is a large multinational corporation of which the principal operations involve food and lodging, transportation, and the manufacture and sale of furnishings and equipment. In early March 1976, Holiday filed with the Securities and Exchange Commission ("SEC") a registration statement with respect to 1,130,000 shares of common stock to be offered to the public by defendants Walkem (1,000,000 shares) and Johnson (130,000 shares). Defendants Johnson, Wilson and McCool were directors and officers of Holiday and together owned virtually all of the stock of Walkem, a corporation which prior to the sales made pursuant to the March 1976 offering owned 1,672,976 shares of Holiday common.
Both the registration statement, and the prospectus contained Holiday's comparative statements of income for the five fiscal years ending January 2, 1976 and its balance sheets for the dates of January 3, 1975 and January 2, 1976. Plaintiff alleges that on or about March 23, 1976, in reliance upon the prospectus of that date, she purchased 100 shares of Holiday at a price of $ 16.75 per share.
Holiday's first fiscal quarter for 1976 ended on April 2. On April 27, Holiday made its first announcement of earnings for the first quarter showing net income after taxes of approximately $ 2 million, or $ .07 per share, as compared to approximately $ 6 million, or $ .20 per share, for the comparative quarterly period ending April 4, 1975. Plaintiff alleges that each of the defendants knew, or was on notice of and recklessly disregarded, facts indicating that the March 23, 1976 prospectus
was materially false and misleading in its failure to disclose that: a) earnings and earnings per share for the first quarter of 1976 would be only about one-third of those for the comparative quarter of 1975; b) operating costs and expenses for Holiday's "Hospitality Group" for the first quarter of 1976 would increase by.$ 1.2 million as compared to the first quarter of 1975, whereas that group's revenues would increase by only $ .5 million for those periods; c) operating costs and expenses for Holiday's "Products Group" would increase by about $ 3.9 million in the first quarter of 1976 as compared to the first quarter of 1975, whereas revenues for that group increased by only.$ 3.6 million for those periods; d) operating costs and expenses for Holiday's "Transportation Group" would increase by about $ 8.6 million for the first quarter of 1976 as compared to the first quarter of 1975; e) operating costs and expenses for the Transportation Group for the first quarter of 1976 would exceed revenues by.$ 1.2 million, whereas revenues exceeded cost and expenses by $ 6.7 million for that group in the first quarter of 1975; and f) in every major area of Holiday's operations, the results for the first quarter of 1976 were materially less favorable than for the first quarter of 1975.
Count I of the Complaint alleges that defendants' actions violated § 11 of the Securities Act and § 10(b) of the Exchange Act. Count II alleges that defendants' acts constituted common law fraud.
Defendants' Motion for an Undertaking
Section 11(a) of the Securities Act provides for civil liability for misstatements or omissions in a registration statement. 15 U.S.C. § 77k(a). Issuers, directors, underwriters, signatories to the registration statement and professionals whose reports or valuations are used in connection with it may all be found liable for these misstatements or omissions subject to the detailed affirmative defenses contained in § 11(b), 15 U.S.C. § 77k(b). See Feit v. Leasco Data Processing Equip. Corp., 332 F. Supp. 544, 575-83 (E.D.N.Y.1971); Escott v. BarChris Constr. Corp., 283 F. Supp. 643, 682-706 (S.D.N.Y.1968). In contrast to § 10(b) of the Exchange Act, liability for the violation of § 11 may lie for wholly negligent conduct. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 208, 96 S. Ct. 1375, 47 L. Ed. 2d 668 (1976).
Section 11(e) states in pertinent part:
In any suit under this or any other section of this subchapter the court may, in its discretion, require an undertaking for the payment of the costs of such suit, including reasonable attorney's fees, and if judgment shall be rendered against a party litigant, upon the motion of the other party litigant, such costs may be assessed in favor of such party litigant (whether or not such undertaking has been required) if the court believes the suit or the defense to have been without merit, in an amount sufficient to reimburse him for the reasonable expenses incurred by him, in connection with such suit, such costs to be taxed in the manner usually provided for taxing of costs in the court in which the suit was heard.
15 U.S.C. § 77k(e). This portion of § 11(e) was not part of the Securities Act as originally enacted, Act of May 27, 1933, c. 38, § 11(e), 48 Stat. 83, but was added to the section by amendments adopted as part of the Exchange Act. Act of June 6, 1934, c. 404, § 206(e), 48 Stat. 907. Although this provision permits the imposition of costs or the requirement of an undertaking of either plaintiffs or defendants, among Congress's principal purposes in enacting this section was to deter the bringing of meritless actions solely for the purposes of procuring a favorable settlement. Ernst & Ernst v. Hochfelder, supra, 425 U.S. at 211 n. 30, 96 S. Ct. 1375, Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 740-741, 95 S. Ct. 1917, 44 L. Ed. 2d 539 (1975); See 78 Cong.Rec. 8669 (1934) (remarks of Senator Fletcher).
Although § 11(e) speaks in terms of "discretion," the courts of this Circuit have consistently interpreted it to require a specific finding that the action is brought in "bad faith" or is so utterly lacking in merit as to "border on the frivolous." Klein v. Shields & Co., 470 F.2d 1344, 1347 (2d Cir. 1972); Katz v. Amos Treat & Co., 411 F.2d 1046, 1056 (2d Cir. 1969); Linchuck v. Cooper, 43 F.R.D. 382, 384 (S.D.N.Y.1967). An application for an undertaking generally "is not looked upon with favor." Lerner v. Ripley Co., (1961-1964) Fed.Sec.L.Rep. (CCH) P 91,249, at ...