Sunday, February 26, 2006

Third Circuit Clamps Down on Sound in Fraud Rule

If you’ve ever litigated 1933 Act and 1934 Act claims together, than you’ve no doubt made or defended the “sound in fraud” argument. If you’re a Plaintiff, you know the frustration of trying to draft the two claims together while alleging fraud on one hand -- and negligence on the other. And if you’re a Defendant, you know how fun it is to try to convince the Judge that Plaintiff should have done just that. Well Plaintiffs, you finally may have found a sympathetic ear in the Third Circuit.

You see, in the Suprema Specialties (the melted cheesemaker) securities class action, the Panel reversed most of Judge William H. Walls’ (D. N.J.) complete dismissal of both ’33 and ’34 Act claims, holding that “where, as here, individual defendants are accused in separate claims of the same complaint of having violated Section 11, Section 12(a)(2), and Section 10(b), the Securities Act claims do not sound in fraud if ordinary negligence is expressly pled in connection with those claims. In such a case, the fraud allegations cannot be said to ‘contaminate’ the Section 11 and Section 12(a)(2) claims if the allegations are pled separately.” “Here, ordinary negligence is alleged in the Section 11 and Section 12(a)(2) claims, and those claims are pled separately from the Section 10(b) fraud claims against the same defendants. That is enough to avoid triggering Rule 9(b). A contrary result would effectively preclude plaintiffs from filing suit under Section 11 and Section 12(a)(2) as well as Section 10(b)(5). There is no suggestion that Congress intended such an incongruous approach.”

"In short, the reputational concerns that animate Rule 9(b) with respect to a defendant accused of fraud are not implicated when a defendant stands accused of nothing more than negligence.” So, “because the Section 11 and Section 12(a)(2) claims of the plaintiffs here were expressly negligence-based and pled distinctly in the complaint from the fraud-based claims, it was error for the District Court to hold that they sound in fraud. Accordingly, we will vacate the dismissal of these claims.”

Be sure to also check out the decision for rulings on inside trading, accountants’ liability, and tracing issues.

You can read In re Suprema, issued February 23, 2006, here, or at 2006 U.S. App. LEXIS 4307.

Nugget: “To be sure, the ‘sounds in fraud’ determination for Securities Act claims will not always be clear cut in cases where the plaintiff simultaneously raises claims against the same defendants under a provision that requires a showing of scienter, like Section 10(b). But where the plaintiff has exercised care in differentiating asserted negligence claims from fraud claims and in delineating the allegations that support the negligence cause of action as distinct from the fraud, the determination is straightforward.”

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