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Since the enactment of The Private Securities Litigation Reform Act of 1995 (PSLRA), [FOOTNOTE 1]many decisions have interpreted the new pleading requirements as they apply to the antifraud provisions of the federal securities laws and regulations such as �10(b) [FOOTNOTE 2]and Rule 10b-5, [FOOTNOTE 3]focusing on the allegations necessary to give rise to “a strong inference that the defendant acted with a particular state of mind.” [FOOTNOTE 4] Several recent cases discuss the application of the PSLRA’s heightened pleading requirements to other types of federal securities claims such as those brought pursuant to �14(a) and Rule 14a-9, which prohibit the making of a false statement or the omission of a material fact in connection with proxy materials. This article will focus on how the courts have applied enhanced pleading requirements to federal securities claims that are not fraud-based, using �14(a) as the statutory paradigm. [FOOTNOTE 5] BACKGROUND Section 14(a) [FOOTNOTE 6]makes it unlawful for any person to use the instrumentalities of interstate commerce to solicit proxies or authorizations in contravention of any rules the Securities and Exchange Commission (SEC) may establish. Pursuant to this provision, the SEC promulgated Rule 14a-9 which states: No solicitation subject to this regulation shall be made by means of any proxy statement, form of proxy, notice of meeting or other communication, written or oral, containing any statement which, at the time and in light of the circumstances under which it is made, is false or misleading with respect to any material fact necessary in order to make the statements therein not false or misleading or necessary to correct any statement in any earlier communication with respect to the solicitation of a proxy for the same meeting or subject matter which has become false or misleading. [FOOTNOTE 7] Unlike �10(b) and Rule 10b-5 that require allegations and proof of scienter, no such showing is required under Rule 14a-9. As the 2nd U.S. Circuit Court of Appeals stated, Rule 14a-9 is “negligence based.” [FOOTNOTE 8] Ordinarily, a �14(a) plaintiff would not have to meet the particularity requirements of Rule 9(b). The exception to this rule arises when the allegations supporting a �14(a) claim “sound in fraud.” [FOOTNOTE 9]The rationale for this exception is that Rule 9(b) in referring to “all averments of fraud,” focuses on the substance of the allegations made, rather than whether proof of fraud is an essential element of the cause of action being pled. [FOOTNOTE 10]A claim based upon a negligent misrepresentation or omission or strict liability “sounds in fraud” if the plaintiff makes allegations of fraudulent or reckless conduct. Such allegations are sometimes made to emphasize or enhance the alleged impropriety of the defendant’s behavior. For example, in Anchor Gaming Securities Litigation, [FOOTNOTE 11]the plaintiffs asserted claims under ��11 and 12 of the Securities Act of 1933, which do not require the allegation or proof of fraud. In holding that the particularity requirements of Rule 9(b) nonetheless applied to these claims, the court noted that although the complaint did not use words such as “fraud” or “fraudulent conduct,” it contained allegations of intentional and reckless conduct. The court pointed to assertions that after the defendants’ false and misleading statements were made to the public, they “decided to take advantage of the rising price” of the stock at issue, selling it at a profit and, when this conduct was revealed the stock price dropped significantly. The complaint further stated that “the defendants acted quickly to stem the decline” by issuing positive press releases and the court found these allegations akin to fraud. [FOOTNOTE 12] In contrast, claims based on negligence or strict liability that do not contain allegations of intentional misconduct will generally not “sound in fraud.” THE IMPACT OF THE PSLRA The PSLRA’s pleading requirements create a higher hurdle for plaintiffs in many securities actions. Section 21D(b)(1) provides that in any private action arising under the securities laws based upon an allegation of untrue statement or omission of material fact, the plaintiff must specify each statement alleged to have been misleading and the reasons why the statement is misleading. [FOOTNOTE 13]Where the allegations are based on information and belief, the plaintiff must state with particularity all facts on which the belief is formed. [FOOTNOTE 14]A second provision, �21D(b)(2), imposes the following requirement: In any private action arising under this chapter in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. (Emphasis supplied.) [FOOTNOTE 15] The application of ��21D(b)(1) and (2) to claims requiring the allegation and proof of scienter has been well established. [FOOTNOTE 16]However, whether those pleading requirements apply to federal securities claims not predicated on fraud, such as claims under �14(a) has received far less judicial attention. Since the requirements of �21D(b)(1) are triggered when a federal securities action is based upon an untrue statement of material fact or omission of material fact, their application to �14(a) claims seems clear, although no 2nd Circuit case has so held. However, other courts have applied �21D(b)(1) to �14(a) claims. [FOOTNOTE 17]The application of �21D(b)(2) to securities claims which are not fraud based is far more questionable. Section 14(a) claims do not require proof of fraud or scienter. Therefore, the issue is whether negligence-based claims, such as claims under �14(a), are claims requiring “a particular state of mind” within the meaning of �21D(b)(2). To date, no court in the 2nd Circuit has directly addressed this issue. However, three district courts in other circuits have considered the question and the answers are conflicting. DIVERSE OPINIONS In Reliance Securities Litigation, [FOOTNOTE 18]the district court held, under established 3rd Circuit law, that negligence, not scienter, is the standard of liability under Rule 14a-9. [FOOTNOTE 19]The district court held that while �21D(b)(2) might be interpreted as raising the pleading requirements for violations of Rule 14a-9, it would await direction from the 3rd Circuit on this issue, [FOOTNOTE 20]and refused to apply �21D(b)(2) to the �14(a) claim. Although the opinion was not clear on this point, the court’s holding suggests its concern that the application of the PSLRA’s pleading requirements to Rule 14a-9 claims would, in effect, create a scienter requirement for 14a-9 claims. [FOOTNOTE 21]In BankAmerica Corp. Securities Litigation, [FOOTNOTE 22]the Eastern District of Missouri also considered the defendant’s argument that �21D(b)(2) applied to �14(a) claims. [FOOTNOTE 23]As that district court framed the issue, “the defendant’s request, without any authority, that the [state of mind requirement for �14(a) claims] be reconsidered in light of the PSLRA.” [FOOTNOTE 24]The court held that �21D(b)(2) cannot reasonably be read as changing the substantive state of mind required under �14(a) claims from negligence to scienter [FOOTNOTE 25]and refused to apply �21D(b)(2) to the �14(a) claim. The Northern District of California reached a different result in McKesson HBOC, Inc. Securities Litigation. [FOOTNOTE 26]There, the plaintiffs asserted a number of federal securities violations, including claims under �14(a). On the defendants’ motion to dismiss, the court considered whether �21D(b)(2) applied to �14(a) claims, i.e., whether recovery under �14(a) is predicated on proof that the defendant acted with a “particular state of mind.” [FOOTNOTE 27]The court first noted that the plaintiffs conceded that the “negligence” required for �14(a) claims is technically a “state of mind.” The court found that there is little relevant case law and focused on the language of the �21D(b)(2), stating that: the plain text of the statute provides a ready answer: any “required state of mind” is subject to a requirement of pleading particular facts giving rise to a strong inference of that state of mind. The text of the statute provides no exception for standards of culpability lower than scienter. [FOOTNOTE 28] ‘STATE OF MIND’ Is Negligence “A State of Mind” Under �21D(b)(2)? As with any statutory analysis, one must first look to the plain text of the statute. [FOOTNOTE 29]In �21D(b)(2), Congress chose to use the phrase “a particular state of mind,” rather than “scienter,” “intentional misconduct” or “reckless misconduct.” As the statute reads, one could certainly argue, as the Northern District of California accepted, that negligence is a “state of mind” within the meaning of �21D(b)(2). It may be argued that the PSLRA should be applicable to negligence or strict liability based federal securities claims. Many of the abuses and concerns that Congress addressed in enacting the PSLRA are as prevalent in �14(a) claims as in fraud-based claims. The PSLRA’s primary purpose was to “protect investors, issuers and all who are associated with our capital markets from abusive securities litigation.” [FOOTNOTE 30] Arguably, these same concerns are present in lawsuits brought pursuant to �14(a) or any of the other negligence based or strict liability provisions in the federal securities laws. But, the language of �21D(b)(2) may also be read to connote a volitional state of mind. When one is negligent, there may simply be an absence of such a “state of mind.” A POSSIBLE SOLUTION A possible solution to the issues discussed above, may have been articulated by Judge McMahon in the Southern District of New York. In American Bank Note Holographics, Inc. Securities Litigation, [FOOTNOTE 31]the plaintiffs alleged, among other things, violations of �11 which, like �14(a), does not require proof of fraud. In moving to dismiss, the defendants argued that the heightened pleading requirements of both Rule 9(b) and the PSLRA applied because the �11 claims “sounded in fraud.” [FOOTNOTE 32]The court held that the allegations supporting the �11 claim were the same as those upon which the plaintiffs’ �10(b) and Rule 10b-5 claims were based and, as such, the plaintiffs were required to meet the heightened pleading requirements of both Rule 9(b) and the PSLRA. [FOOTNOTE 33]Although the court found that the complaint met those requirements, [FOOTNOTE 34]its application of the PSLRA to the allegations sounding in fraud is consistent with the purpose and policies underlying the PSLRA and Rule 9(b) jurisprudence. Leon P. Gold is a partner and Richard L. Spinogatti is a senior counsel in the Litigation and Dispute Resolution Department at Proskauer Rose LLP. Jason A. Zweig, an associate in the Litigation and Dispute Resolution Department, assisted in the preparation of this article. ::::FOOTNOTES:::: FN1Pub. L. No. 104-67, 109 Stat. 737 (1995) (codified as amended in scattered sections of 15 U.S.C.). The express purpose of the PSLRA was “to reform Federal securities litigation, and for other purposes.” Id. FN215 U.S.C. �78j. FN317 C.F.R. �240.10b-5. FN415 U.S.C. �78u-4(b)(2). See, e.g., Vogel v. Sands Bros. & Co., Ltd., 126 F.Supp. 2d 730, 739 (S.D.N.Y. 2001). FN5Although we use �14(a) as the example here, the foregoing analysis may have application to other securities law provisions which do not require proof of scienter such as ��11 (15 U.S.C. �77k) and 12 (15 U.S.C. �77l) of the Securities Act of 1933. FN615 U.S.C. �78n(a). FN717 CFR �240.14a-9. FN8 Gerstle v. Gamble-Skogmo, Inc., 478 F.2d 1281 (2d Cir. 1973). See also The Zemel Family Trust v. Philips Int’l Realty, No. Civ. 7483, 2000 WL 1772608, at *3 (S.D.N.Y. Nov. 30, 2000). FN9 Goldman v. Lexington Ave. & 42nd St. Corp., No. 84 Civ. 5341, 1987 WL 8340, *3 (S.D.N.Y. Mar. 18, 1987); Am. Bank Note Holographics, Inc. Sec. Litig., 93 F.Supp. 2d 424, 439-440 (S.D.N.Y. 2000). FN10 Hershey v. MNC Fin., Inc., 774 F.Supp. 367, 376 (D. Md. 1991). FN1133 F.Supp. 2d 889 (D. Nev. 1999). FN12Id. at 892. FN1315 U.S.C. �78u-4(b)(1). FN14Id. FN1515 U.S.C. �78u-4(b)(2). FN16 Vogel v. Sands Bros. & Co. Ltd., 126 F.Supp. 2d 730, 737 (S.D.N.Y. 2001). FN17See Desaigoudar v. Meyercord, 223 F.3d 1020, 1022, 1023 (9th Cir. 2000); Giarraputo v. UnumProvident Corp., No. Civ. 99-301-PC, 2000 WL 1701294, at *9 (D. Me. Nov. 8, 2000). Two 2nd Circuit cases have suggested that 21D(b)(1) does apply to non-fraud based securities claims. See Minzer v. Keegan, 218 F.3d 144, 148 n.1 (2d Cir. 2000); Union of Needletrades, Indust. and Textile Employees v. May Dep’t Stores, Co., 26 F.Supp. 2d 577, 584 (S.D.N.Y. 1997). FN1891 F.Supp. 2d 706 (D. Del. 2000). FN19Id. at 729. FN20Id. The district court did not address the applicability of �21D(b)(1) of the PSLRA. FN21Id. FN2278 F.Supp. 2d 976 (E.D. Mo. 1999). FN23Id. at 989. FN24Id. FN25Id. The court did not specifically address the applicability of �21D(b)(1) of the PSLRA. FN26126 F.Supp. 2d 1248 (N.D. Cal. 2000). FN27The court did not specifically address whether 21D(b)(1) also applies to �14(a) claims. FN28Id. FN29Novak, 216 F.3d at 310. FN30Conference Report. FN3193 F.Supp. 2d 424 (S.D.N.Y. 2000). FN32Id. at 439. It was not clear from the opinion as to whether Judge McMahon applied either 21D(b)(1) or 21D(b)(2) or both. FN33Id. FN34Id.

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