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On Dec. 30, 2004, the 3rd U.S. Circuit Court of Appeals handed down a decision, California Public Employees’ Retirement System v. Chubb Corp., 394 F.3d 126 (3d Cir. 2004), which clarified the pleading requirements for securities fraud actions. In Chubb, the 3rd Circuit confronted, for the first time, the proper standard for pleadings based on confidential witnesses. In addition, the court addressed the appropriateness of applying the particularity requirements of Fed. R. Civ. P. 9(b) to securities claims for causes of action other than fraud when those claims sound in fraud. While the court in Chubb ultimately adopted the rationale employed by the 2nd Circuit for analyzing allegations based on confidential sources and appeared to confirm the viability of the sounds in fraud doctrine, the application of these two standards in future cases remains an open question. Chubb involved a securities class action brought on behalf of shareholders of the Chubb Corp. (Chubb) against Chubb, Executive Risk Inc. (Executive Risk), and several of their officers. The plaintiffs claimed that the defendants defrauded investors by artificially inflating the value of Chubb’s common stock through accounting manipulations and false statements designed to effectuate a stock-for-stock merger between Chubb and Executive Risk and to avoid an alleged hostile takeover attempt. Throughout their complaint, the plaintiffs alleged facts based on information from “confidential witnesses.” The district court granted the defendants’ motion to dismiss the plaintiffs’ second amended complaint pursuant to Fed. R. Civ. P. 12(b)(6), the Private Securities Litigation Reform Act and Fed. R. Civ. P. 9(b), and denied plaintiffs leave to file a third amended complaint. The 3rd Circuit affirmed. CONFIDENTIAL WITNESSES A plaintiff must explain how a confidential witness would possess the information alleged. In affirming the lower court’s dismissal of the complaint’s fraud claims, the 3rd Circuit adopted the 2nd Circuit standard for evaluating confidential witnesses that was promulgated in Novak v. Kasaks, 216 F.3d 300 (2d Cir. 2000). In Novak, the 2nd Circuit held that “where plaintiffs rely on confidential personal sources but also on other facts, they need not name their sources as long as the latter facts provide an adequate basis for believing that the defendants’ statements were false.” Id. at 314. The Chubb court held that this standard requires courts to examine: (i) the basis of the confidential witnesses’ knowledge, (ii) the reliability of the sources, (iii) the corroborative nature of other facts alleged, (iv) the coherence and plausibility of the allegations, and (v) “similar indicia.” Chubb, 394 F.3d at 147. In applying this standard, the court held that the complaint’s allegations based on unnamed, confidential witnesses failed to plead the falsity of the defendants’ statements with sufficient particularity because they did not adequately explain how “a person in the position occupied by the [confidential] source would possess the information alleged.” Id. at 155. Specifically, the court noted that the plaintiffs repeatedly attributed allegations about the purported fraud to former employees who worked in other business segments, or individuals who did not work for the company at all, without furnishing any explanation as to how such sources would possess the information alleged. Additionally, the 3rd Circuit reasoned that the sheer volume of confidential sources cited could not compensate for the complaint’s dearth of facts. The court thus held that “[c]obbling together a litany of inadequate allegations does not render those allegations particularized in accordance with Rule 9(b) or the PSLRA.” Id. at 155. Despite the result in Chubb, the court’s adoption of the 2nd Circuit’s Novak standard does not necessarily sound the death knell for pleadings based on confidential sources. Indeed, shortly after Chubb, the 9th Circuit, in In re Daou Systems, Inc., Sec. Litig., 397 F.3d 704 (9th Cir. 2005), applied the same Novak standard to reach the opposite conclusion, holding that the complaint in that case was sufficiently particularized. Unlike the complaint in Chubb, which principally relied on unspecified allegations about what the defendants “knew,” without detailing how the accounting irregularities occurred, Daou‘s confidential witnesses provided detailed information about how the defendants “cooked the books.” Furthermore, because these confidential witnesses by virtue of their titles were alleged to have dealt directly with the purported accounting matters at issue, the Daou court apparently found it unnecessary to delve any deeper into how they possessed the information alleged. SOUNDS IN FRAUD DOCTRINE In addition to dismissing the fraud claims, the 3rd Circuit also dispatched the complaint’s claims brought pursuant to Section 11 of the Securities Act of 1933. Generally, for a �11 claim to overcome a motion to dismiss, a plaintiff must plead only that it purchased securities in or traceable to a public offering and that the offering was pursuant to a registration statement that contained a misstatement or omission of material fact. 15 U.S.C. 77k. Despite this strict liability standard, courts have recently required that plaintiffs plead their Securities Act claims with particularity under what has become known as the sounds in fraud doctrine. Although courts have in the past applied the doctrine to dismiss claims not pled with particularity, litigants, commentators and even some courts have questioned the doctrine’s viability and scope. After Chubb, however, it appears that the sounds in fraud doctrine may well be viable in the 3rd Circuit. While acknowledging that neither proof of fraud nor negligence was required to maintain a �11 claim, the court relied upon Shapiro v. UJB Fin. Corp., 964 F.2d 272 (3d Cir. 1992), to hold that a complaint may be required to satisfy Rule 9(b)’s heightened pleading standard when it sounds in fraud. That is, if “a core theory of fraud permeates the entire [complaint] and underlies all of [p]laintiffs’ claims,” Rule 9(b)’s particularity requirement may apply to the nonfraud claims as well as the fraud claims. 394 F.3d at 160. Rule 9(b) requires a plaintiff to specify “the who, what, when, where and how [of the fraud]: the first paragraph of any newspaper story.” Id. at 144. Applying Rule 9(b)’s standard to the complaint in Chubb, the 3rd Circuit stated that the complaint was “completely devoid” of any allegation that the defendants acted negligently and that both the nonfraud and fraud claims hinged on the same facts. Id. at 161. Accordingly, the court affirmed the district court’s dismissal of the complaint’s �11 claims because the plaintiffs failed to plead fraud with particularity. In reaching this holding, the court rejected three arguments. First, the plaintiffs argued that had Congress intended to impose such a pleading standard, it could have required that plaintiffs particularize these claims, as it did with claims arising under the Securities Exchange Act of 1934. See 15 U.S.C. � 78u-4(b)(1). The court, however, avoided this argument by stating that “Plaintiffs’ argument disregards the fact that Rule 9(b) and the PSLRA impose distinct and independent pleading standards.” 394 F.3d at 161. Second, the Chubb plaintiffs contended that two Supreme Court cases, Leatherman v. Tarrant County Narcotics Intelligence & Coordination Unit, 507 U.S. 163 (1993) and Swierkiewicz v. Sorema N.A., 534 U.S. 506 (2002), precluded the application of Rule 9(b) to claims for which “fraud” or “mistake” were not an element. The Chubb court distinguished these cases by emphasizing the underlying facts of the case and opining that the high court’s cases involved “judicially created heightened pleading standards,” whereas the Chubb case represented a straightforward application of the Rule. 394 F.3d at 162 (emphasis in original). Lastly, the plaintiffs cited the now-familiar 5th Circuit case of Lone Star Ladies Investment Club v. Schlotzsky’s, Inc., 238 F.3d 363 (5th Cir. 2001), for the proposition that a court should “disregard averments of fraud not meeting Rule 9(b)’s standard and then ask whether a claim has been stated.” Id. at 368. The court found this argument unpersuasive largely because the plaintiffs based their Section 11 claim entirely on allegations of fraud. Accordingly, the court stated that a “district court is not required to sift through allegations of fraud in search of some ‘lesser included’ claim of strict liability.” 394 F.3d at 162 (quoting Lone Star Ladies, 238 F.3d at 368). The court further noted that, unlike the plaintiffs in Chubb, the Lone Star Ladies plaintiffs had previously amended their complaint to drop all of their Exchange Act claims and were thus solely advancing nonfraud claims under the Securities Act. PLEADING WITH PARTICULARITY Only time will reveal the contours of a properly pled claim based on unnamed sources. In the coming years, plaintiffs will no doubt explore the outer edges of what does and does not satisfy the recently established Chubb standard. As for the sounds in fraud doctrine, the 3rd Circuit has yet to address a — if not “the” — significant issue in this area of the law: the proper standard for analyzing a complaint that contains mixed allegations of both fraud and nonfraud. At present, the court, in Shapiro and Chubb, has dealt with cases in which the plaintiffs have not alleged ordinary negligence but instead have advanced claims based on a unified course of fraudulent conduct. In cases that plead mixed allegations of fraud and non-fraud, a growing number of circuits have adopted a standard that “strips” the fraud allegations from the complaint and then examines the remaining allegations to determine whether they state a claim under Rule 8′s more lenient standard. Although in distinguishing Lone Star Ladies the 3rd Circuit seems to have signaled its departure from this standard, it has nevertheless left the door open for future courts to adopt that standard. William M. Uptegrove is an associate and a member of the securities litigation and enforcement practice group at Lowenstein Sandler of Roseland.

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