Securities Act Section 11 and 12 Claims Not Subject to Heightened CPLR 3016 Pleading Standards

On June 2, 2020, Justice Borrok of the New York Commercial Division issued a decision in Matter of Netshoes Sec. Litig. v. XXX, 2020 NY Slip Op. 20123, holding that Securities Act Section 11 and 12 claims are not subject to heightened CPLR 3016 pleading standards, explaining:

As they did in Netshoes I, the defendants again argue that the heightened pleading standard of CPLR § 3016(b) applies to the claims asserted in this action because the plaintiff claims that the offering documents contain misrepresentations and are therefore materially false and misleading.

Inasmuch as CPLR § 3016(b) provides that where a cause of action or defense is based upon misrepresentation, fraud, mistake, willful default, breach of trust or undue influence, the circumstances constituting the wrong shall be stated in detail, the defendants argue that dismissal is required where the plaintiff s fails to set forth their claim with the requisite particularity. The argument fails.

As the United States Supreme Court explained in Cyan, Inc. v Beaver County Empl. Retirement Fund, Congress enacted the 1933 Act and the Securities and Exchange Act of 1934 (the 1934 Act) to promote honest business practices in the securities market (138 S Ct 1061 [2018]). The 1933 Act created private rights of action in connection with the initial public offerings of securities and the 1934 Act regulates subsequent trading activity. Federal and state courts have concurrent jurisdiction over claims that are based on alleged violations of the 1933 Act and federal courts have exclusive jurisdiction over claims that are based on alleged violations of the 1934 Act. In Omnicare, Inc. v Laborers Dist. Council Const. Indus., the Court explained that the 1933 Act protects investors by ensuring that companies issuing securities make a full and fair disclosure of information relevant to a public offering.

The plaintiff's claims in this case are based on alleged violations of the 1933 Act. In interpreting this federal statute, the Second Circuit in Litwin v Blackstone (634 F3d 706, 715 [2d Cir 2011] held that claims based on violations of Sections 11 and 12(a) of the 1933 Act need not satisfy the heightened pleading requirements of Rule 9(b) of the Federal Rules of Civil Procedure. In so doing, the Litwin court, and quoting Rombach v Chang (355 F3d 164, 171 [2d Cir 2004]), a mixed claims case (i.e., a case involving claims based on alleged violations of both the 1933 Act and the 1934 Act), explained:

Fraud is not an element or a requisite to a claim under Section 11 or Section 12(a)(2). [A] plaintiff need allege no more than negligence to proceed under Section 11 and Section 12(a)(2).

In addition, in NECA-IBEW Health & Welfare Fund v Goldman Sachs & Co., 693 F3d 145 (2d Cir 2012), the Second Circuit further explained:

Neither scienter, reliance, nor loss causation is an element of § 11 or § 12(a)(2) claims which —unless they are premised on allegations of fraud—need not satisfy the heightened particularity requirements of Rule 9(b). Nor do the heightened pleading standards of the Private Securities Litigation Reform Act apply to such non-fraud claims. Thus, the provisions place a relatively minimal burden on a plaintiff.

Accordingly, the Second Circuit has held that under the 1933 Act, Section 11 and (12)(a) claims sound in negligence even as to an alleged misrepresentation" of fact where the duty is prescribed by the statute, causation is established if the securities were purchased in connection with or traceable to the offering documents at issue and damages are as provided for in the 1933 Act. For the avoidance of doubt, because the Second Circuit is interpreting the express terms of the 1933 Act, these holdings do not create or implicate any issue of federal common law under Erie v Tompkins, 304 US 64 (1938).

CPLR § 3016(b) does not apply to negligence actions, and the court should not re-characterize the nature of a federal statutory action (whether or not the pleadings allege knowledge or intent). At bottom, this remains a negligence action, and it does not matter whether plaintiffs often allege knowledge and intent either to support parallel claims under the 1934 Act (which does require scienter and which, under those circumstances, must meet the heightened pleading requirements of Federal Rule 9[b]), or to make clear to the court and defendants that particular 1933 Act claims may be particularly strong. Indeed, the Litwin court indicated that Section 11 and 12(a)(2) claims are subject to Rule 9(b) only insofar as they are premised on fraud.

As the court (Kaplan, J.) in In re AmTrust Financial Services, Inc. Sec. Litig, 2019 WL 4257110 (SDNY Sept 9, 2019) recently explained with respect to claims brought based on violations of both the 1933 Act and the 1934 Act:

To state a claim under Sections 11 and 12(a)(2), the plaintiff must allege that the registration statement or prospectus contained: (1) a material misrepresentation; (2) a material omission in contravention of an affirmative legal disclosure obligation; or (3) a material omission of information that is necessary to prevent existing disclosures from being misleading. If a plaintiff establishes one of these three things, then the general rule is that an issuer's liability is absolute. This general rule is subject to exception, of course.

The exception applies when the Section 11 and 12(a)(2) claims are premised on allegations of fraud. In these circumstances, a plaintiff must meet the additional pleading requirements of Rule 9(b). This is so because Rule 9(b) applies to all averments of fraud. And even though fraud is not an element or a requisite to a claim under Section 11 or Section 12(a)(2) claims under those sections may be — and often are — predicated on fraud. Accordingly, when the same course of conduct supports both a claim of fraud under the 1934 Act and a claim under Section 11 or 12(a)(2) of the 1933 Act, the latter claim must satisfy the requirements of Rule 9(b) unless the complaint identifies clearly an alternate basis, i.e., negligence, for the claim. Mere disavowal of any allegations that would make Rule 9(b) applicable will not suffice.

Put another way, when the claim arises under both the 1933 Act and the 1934 Act and where fraud is alleged, as it must be under the 1934 Act, the pleadings must comply with the heightened pleading requirement of Federal Rule 9(b). This reading of the pleading standard appears consistent with the 1933 Act, which only relates to the initial issuance of securities, and applies a lower negligence standard so as to encourage underwriters to do better due diligence (for which they face strict liability) — as opposed to secondary market transactions where fraud standards, along with their higher pleading standards, apply. Accordingly, CPLR § 3016(b) need not be applied to state court 1933 Act claims that are not paired with a securities fraud claim under the 1934 Act (which they cannot be as state courts do not have concurrent jurisdiction as to claims based on violations of the 1934 Act).

In addition, not requiring a higher pleading standard is consistent with New York law. On a motion to dismiss in New York state court, the court's inquiry is whether the alleged facts fit within any cognizable legal theory. Inasmuch as a cause of action based on negligence is sufficient for purposes of claims under Section 11 and 12(a)(2), a CPLR § 3211 analysis should not therefore require CPLR § 3016(b) pleading with particularity to survive a motion to dismiss.

Moreover, if the court were to apply a heightened pleading standard of CPLR § 3016(b), there would be a disparity in pleading standards with respect to a federal statute that creates concurrent state court jurisdiction based on whether the claim is brought at 60 or at 40 Centre Street (i.e., in state or in federal court). There simply is no evidence that Congress intended this disparity, which undoubtedly would create forum shopping.

Finally, the court acknowledges that recently in Hoffman v AT & T Inc. (2020 NY Slip Op 50517[U]) and in Matter of Sundial Growers Inc. Sec. Litig. (2020 NY Slip Op 50579 [U]), the court (Ostrager, J.) applied CPLR § 3016(b) to the claims asserted in those cases.

In Hoffman, the court wrote:

The first issue the Court must address is whether plaintiff's claims are subject to the notice pleading standard under CPLR §3013, as plaintiff argues, or the heightened pleading standard under CPLR §3016(b), as defendants argue. CPLR §3016(b) states: where a cause of action or defense is based upon misrepresentation, fraud, mistake, wilful default, breach of trust or undue influence, the circumstances constituting the wrong shall be stated in detail. Here, plaintiff alleges that the Offering Documents contain misrepresentations. Accordingly, CPLR §3016(b) applies and plaintiffs must state the circumstances constituting the misrepresentations in detail.

Notwithstanding the foregoing, the court in Hoffman held that, even if the notice pleading standard under CPLR § 3013 applied, the action must still be dismissed based on the documentary evidence that was submitted which the court held utterly refuted the plaintiff's claims.

In Sundial Growers, the court wrote:

here, plaintiff alleges that the Offering Documents are materially false and misleading, in other words, they contain misrepresentations. Accordingly, CPLR § 3016(b) applies and plaintiff must state the circumstances constituting the misrepresentations in detail.

In that case, the court denied the motion to dismiss and held that the plaintiff had stated all three of its causes of action in sufficient detail to meet the pleading requirements of CPLR § 3016(b).

For the reasons set forth above and discussed below, here, the SAC sets forth considerable detail that was not present in the Prior Complaint, which detail might satisfy the requirements of CPLR § 3016(b), to the extent it applied in this case. In any event, for the reasons set forth above, to the extent that Hoffman and Matter of Sundial Growers Inc. Sec. Litig. could be read to conflict with the holding set forth herein, this court respectfully disagrees with the analysis in those cases because, this is an ordinary notice pleading case and CPLR § 3016(b) does not apply.

(Internal quotations and citations omitted).

We have substantial experience in litigation regarding securities, both in state and federal court. Contact Schlam Stone & Dolan partner John Lundin at jlundin@schlamstone.com if you or a client need help regarding a claim related to stocks, bonds or other financial instruments.