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Dismissal of Securities Fraud Claim in Federal Court Has No Preclusive Effect on Common Law Fraud Claims Brought in State Court

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  • Posted on: Nov 14 2018

Dismissal of Securities Fraud Claim in Federal Court Has No Preclusive Effect on Common Law Fraud Claims Brought in State Court

Securities fraud and common law fraud have much in common. The core elements required to prevail on both claims are similar. Yet, dismissal of a federal securities fraud claim is not necessarily the death knell of a common law fraud claim. Recently, Justice O. Peter Sherwood of the Supreme Court, New York County, Commercial Division, reached this conclusion in Brown v. Cerebus Capital Management, LP, 2018 N.Y. Slip Op. 32782 (Sup. Ct., N.Y. County Oct. 30, 2018) (here).

Common Law Fraud vs. Securities Fraud

Common Law Fraud

The essential elements of a common law fraud cause of action include: a material misrepresentation or omission of fact, knowledge of its falsity, reasonable reliance upon such misrepresentation or omission, and resulting damages. See Eurycleia Partners, LP v. Seward & Kissel, LLP, 12 N.Y.3d 553, 559 (2009). Under CPLR 3016(b), each element must be pled with particularity. Id. CPLR 3016(b) is satisfied when the facts in the complaint “permit a reasonable inference of the alleged conduct.” Pludeman v. Northern Leasing Sys., Inc., 10 N.Y.3d 486, 491 (2008).

In Pludeman, the Court of Appeals explained that the purpose of CPLR 3016(b) is to inform a defendant of the complained-of conduct. For that reason, CPLR 3016(b) “should not be so strictly interpreted as to prevent an otherwise valid cause of action in situations where it may be impossible to state in detail the circumstances constituting a fraud.” 10 N.Y.3d at 491 (internal quotation marks and citation omitted). Therefore, at the pleading stage, a complaint need only “allege the basic facts to establish the elements of the cause of action.” Id. at 492. Thus, a plaintiff will satisfy CPLR 3016(b) when the facts permit a “reasonable inference” of the alleged misconduct. Id.

Securities Fraud

To bring a claim under Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”), and Rule 10b-5 promulgated thereunder, a plaintiff must allege sufficient facts to establish that a defendant: (1) made misstatements or omissions of material fact; (2) with scienter (i.e., intent to deceive); (3) in connection with the purchase or sale of securities; (4) upon which the plaintiff relied; and (5) that plaintiff’s reliance was the proximate cause of his/her injury. In re Puda Coal Sec. Inc., Litig., 30 F. Supp. 3d 261, 265-66 (S.D.N.Y. 2014) (quoting In re IBM Corp. Sec. Litig., 163 F.3d 102, 106 (2d Cir. 1998)).

In addition, a plaintiff alleging securities fraud must also satisfy the heightened pleading requirements of the Private Securities Litigation Reform Act of 1995 (“PSLRA”), 15 USC § 78u-4, and Rule 9(b) of the Federal Rules of Civil Procedure by stating with particularity the circumstances constituting the alleged fraud. ECA & Local 134 IBEW Joint Pension Trust of Chi. v. JP Morgan Chase Co., 553 F.3d 187, 196 (2d Cir. 2009). This pleading threshold is intended to give a defendant notice of the claim, like CPLR 3016(b), but also is designed to safeguard the defendant’s reputation from “improvident” charges in strike suits. ATSI Commc’ns, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 99 (2d Cir. 2007). Given the particularity requirement, a securities fraud complaint based on false and misleading statements “must (1) specify the statements that the plaintiff contends were fraudulent, (2) identify the speaker, (3) state where and when the statements were made, and (4) explain why the statements were fraudulent.” ATSI, 493 F.3d at 99.

The PSLRA “expanded on the Rule 9(b) standard, requiring that securities fraud complaints specify each misleading statement; that they set forth the facts on which [a] belief that a statement is misleading was formed; and that they state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” Anschutz Corp. v. Merrill Lynch & Co., 690 F.3d 98, 108 (2d Cir. 2012) (emphasis added). Thus, plaintiffs must “do more than say that the statements … were false and misleading; they must demonstrate with specificity why and how that is so.” Rombach v. Chang, 355 F.3d 164, 174 (2d Cir. 2004).

In short, unlike CPLR 3016(b), which only requires a “reasonable inference” of fraud, the PSLRA and Rule 9(b) require a “strong inference” that the defendant acted with the requisite state of mind.

Brown v. Cerebus Capital Management, LP


Plaintiffs, former mid-level managers of Covis Pharmaceuticals, Inc. (“CPI”), filed suit in connection with the grant of employment compensation they claimed to be part of a fraudulent scheme to deprive them of their compensation benefits.

Plaintiffs were each recruited to build the distribution network for the Covis Enterprise (a collection of various CPI related entities), a pharmaceutical start-up founded in 2011 by former employees of GlaxoSmithKline PLC as a vehicle to obtain interests in the commercial rights of certain pharmaceutical products (the “Rights”), rebrand them, and sell them to other healthcare companies. With regard to compensation, Plaintiffs allegedly were told that they would be paid below-market salaries, but in exchange, would receive interests in the appreciation of the Rights, which would be worth more than tens of millions of dollars. Plaintiffs further alleged that, in reliance on this understanding, they built and managed CPI.

Following their hire, Plaintiffs received an award of unvested profits interests (“Profit Interests”) through agreements with MIP I, which was created to provide profits incentives to Covis executives, directors, and managers (the “2012 Award Agreements”). The Profits Interests did not grant Plaintiffs any equity in the Covis Enterprise; instead, pursuant to contract, each received the potential to receive some of the profits of the Covis Enterprise, net of return of capital and repayment of debt. The 2012 Award Agreements allowed for 50% of the awarded Profits Interests to vest based upon continued employment over time, and the other 50% to vest if the company satisfied certain performance criteria. If and when fully vested, the Profits Interests afforded Plaintiffs a collective 1.25% stake in the Covis Enterprise’s profits.

The 2012 Award Agreements made clear that continued employment was a condition of vesting, and that any unvested Profits Interests would be forfeit if employment was terminated, for any reason, whether voluntarily or involuntarily.

In April 2013, the Covis Enterprise executed a corporate restructuring pursuant to a Master Restructuring Agreement. Pursuant to agreements with MIP II, which was also created to provide profits incentives to Covis executives, directors, and managers (the “2013 Award Agreements”), Plaintiffs surrendered their MIP I Profits Interests in exchange for equivalent Profits Interests in MIP II. The MIP I and MIP II Award Agreements and operating agreements are substantively identical. Plaintiffs signed the 2013 Award Agreements and received, as replacements for their interests under MIP I, Profits Interests under MIP II that granted equivalent interests in the profits of the Covis Enterprise.

In the summer of 2014, two plaintiffs were terminated as employees due to a corporate restructuring, and one plaintiff voluntarily resigned. In December 2014, the employment of two plaintiffs ended as a result of CPI’s decision to eliminate its cardiovascular sales team. Pursuant to the 2013 Award Agreements, all of Plaintiffs’ unvested Profits Interests automatically forfeited back to MIP II as of their respective termination dates. At December 31, 2014, MIP II exercised its call right for Plaintiffs’ vested Profits Interests.

Plaintiff’s Allegations Common to State and Federal Actions

Plaintiffs alleged that the 2013 restructuring was a fraudulent scheme to wipe out their share of the Profits Interests and replace them with illusory interests in empty shell companies. Plaintiffs further alleged that Defendants made several extra-contractual false misrepresentations that they relied upon in executing the 2013 Award Agreements. In that regard, Plaintiffs alleged that Defendants falsely represented that Plaintiffs were entitled to 3.5% of the Covis Enterprise’s profits, and that any payments would be increased by 31% to account for taxes. Defendants also allegedly represented that the investment would be worth tens of millions of dollars – a representation Plaintiffs alleged was false.

According to Plaintiffs, after they executed the 2013 Award Agreements, Defendants employed various schemes to “cancel” the Profits Interests, including setting impossible performance targets, and terminating Plaintiffs under false pretenses to prevent time-based vesting. Plaintiffs also claimed that Defendants failed to update certain disclosures to reveal merger negotiations that occurred in 2014, and the sale process in late 2013 that failed to receive any bids, which, if revealed, would have indicated to one Plaintiff that a sale of the Rights was imminent, and would have caused him not to resign.

On March 9, 2015, the Covis Enterprise announced that it was selling substantially all of its assets to Concordia Healthcare Corporation (“Concordia”) for $1.2 billion. Plaintiffs filed suit, claiming they were entitled to greater payments based on the ultimate Concordia transaction.

The Federal Litigation

Plaintiffs filed their original action in the United States District Court for the Southern District of New York, asserting federal and state-law claims under the federal securities laws and the common law. Among other things, Plaintiffs alleged that: (1) Defendants violated Rule 10b-5(b) of the Exchange Act by telling Plaintiffs at the time of the 2013 restructuring that CPI’s managers were entitled to 3.5% of the Covis Enterprise’s profits, and promising that any payments would be increased by 31% to account for taxes; (2) Defendants violated Rules 10b-5(a) and (c) of the Exchange Act by terminating Plaintiffs’ employment and setting impossible performance targets, all to keep Plaintiffs’ Profits Interests from vesting; and (3) Defendants violated Rule 10b-5(b) of the Exchange Act by failing to inform one of the Plaintiffs about discussions to sell the Covis Enterprise’s assets, in order to dissuade him from resigning from his employment in August 2014.

Defendants moved to dismiss the action, which Judge George B. Daniels granted with prejudice on December 12, 2016. In dismissing Plaintiffs’ federal claims, Judge Daniels declined to exercise supplemental jurisdiction over Plaintiffs’ state-law claims. In reaching that decision, Judge Daniels held that Plaintiffs failed to adequately plead scienter for their federal securities claims under the heightened pleading requirements of Rule 9(b) of the Federal Rules of Civil Procedure and the PSLRA. By summary order dated July 11, 2017, the United States Court of Appeals for the Second Circuit affirmed.

The State Court Action and the Court’s Decision

Thereafter, Plaintiffs filed suit in New York Supreme Court, asserting claims of common law fraud and violations of each Plaintiff’s state blue-sky laws, together with a variety of contract-based and quasi-contract claims.

Defendants moved to dismiss. With regard to the fraud claims, Defendants argued that the claims were barred by the doctrine of collateral estoppel because they require scienter, and the federal court dismissed Plaintiffs’ federal claims for lack of scienter. The Motion Court rejected the argument.

In denying the motion, the Motion Court observed that there was no preclusive effect resulting from the dismissal of Plaintiffs’ federal securities fraud claims because of the different standards for pleading scienter.

After examining the elements of collateral estoppel – i.e., (1) the issues in both proceedings are identical, (2) the issue in the prior proceeding was actually litigated and decided, (3) there was a full and fair opportunity to litigate in the prior proceeding, and (4) the issue previously litigated was necessary to support a valid and final judgment on the merits – the Motion Court concluded that “Defendants [could not] demonstrate that they [had] satisfied the elements of collateral estoppel because the federal court did not decide issues identical to those raised here.”

Defendants cannot demonstrate that they have satisfied the elements of collateral estoppel because the federal court did not decide issues identical to those raised here. The federal securities claims brought in the federal action were subject to Rule 9 (b) and the PSLRA, which require a plaintiff to allege “facts giving rise to a strong inference that the defendant acted with the required state of mind” (15 USC § 78u-4). In contrast, the complaint’s fraud claims are subject to the CPLR and “3016 (b) may be met when the facts are sufficient to permit a reasonable inference of the alleged conduct” (Pludeman v North Leasing Sys., Inc., 10 NY3d 486, 492 [2008]). New York courts have uniformly held that the federal strong inference standard is higher than New York’s reasonable inference standard.

Accordingly, because the federal court applied the strong inference standard to the federal action’s allegations of scienter, the federal dismissal is not preclusive of plaintiffs’ state law fraud claims.

Citations omitted.

Accordingly, the Court denied the motion to dismiss the fraud claims.


As discussed, federal securities claims are subject to the heightened pleading requirements of Rule 9(b) and the PSLRA. As such, a plaintiff must allege “facts giving rise to a strong inference that the defendant acted with the required state of mind.” 15 U.S.C. § 78u-4. By contrast, common law fraud claims brought in New York State courts are subject to CPLR 3016(b). To satisfy CPLR 3016(b), a plaintiff need only plead facts sufficient to permit “a reasonable inference of the alleged conduct.” Pludeman, 10 N.Y.3d at 491-92 (2008).

Given the different pleading standards, New York State courts have routinely held that the federal standard is more exacting than New York’s standard. E.g., Syncora Guar. Inc. v. Alinda Capital Partners, LLC, 2013 N.Y. Slip Op. 31489[U], *18 (Sup. Ct., N.Y. County 2013) (CPLR 3016 (b) “is a more lenient test than the Second Circuit’s ‘strong inference of fraud’ test, in that it requires only that the complaint include ‘facts from which it is possible to infer defendant’s knowledge of the falsity of its statements.’”) (citation omitted); see also PMC Aviation 2012-1 LLC v Jet Midwest Grp., LLC, 2016 N.Y. Slip Op. 30972[U], *14 (Sup. Ct., N.Y. County 2016) (“The particularity required by CPLR 3016 (b) is not as exacting as what is required under Rule 9 (b) in federal court”); NRAM PLC v. Societe Generale Corp., 2014 N.Y. Slip Op. 32155[U], *20 (Sup. Ct., N.Y. County 2014) (“The applicable New York standard requires only a ‘reasonable inference’ of scienter, while Rule 9(b) of the Federal Rules of Civil Procedure and its interpreting case law is far more demanding”). Brown adds its name to the list of cases that have recognized this difference.

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