BORIS FELDMAN, State Bar # 128838
DOUGLAS J. CLARK, State Bar # 171499
CYNTHIA A. DY, State Bar # 172761
DAVID SLOSS, State Bar # 189954
WILSON SONSINI GOODRICH & ROSATI
Professional Corporation
650 Page Mill Road
Palo Alto, California 94304-1050
Telephone: (650) 493-9300

Attorneys for Defendants
RATIONAL SOFTWARE CORPORATION and
PAUL D. LEVY

INTRODUCTION

ARGUMENT

I. THE COURT MAY DISMISS THE COMPLAINT FOR FAILURE TO ALLEGE SCIENTER

II. THE COMPLAINT DOES NOT PLEAD SCIENTER

III. THE COMPLAINT DOES NOT ADEQUATELY PLEAD "PERSONAL BENEFIT"

IV. THE COMPLAINT FAILS TO STATE A CLAIM UNDER SECTION 20A OF THE EXCHANGE ACT

A. The Complaint Does Not Plead a Predicate Violation of the Exchange Act or the "Rules or Regulations Thereunder"

B. Plaintiffs Fail to State a Claim Under Section 20A(c)

V. THE CORPORATIONS CODE CLAIM MUST BE DISMISSED

CONCLUSION

Allison v. Brooktree Corp., 999 F. Supp. 1342 (S.D. Cal. 1998)

Application of Prudential Sec., Inc., 795 F. Supp. 657 (S.D.N.Y. 1992)

Burlington Indus., Inc. v. Edelman, 666 F. Supp. 799 (M.D.N.C. 1987)
     aff'd [1987 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 93,339 (4th Cir. June 22, 1987)

Chill v. General Elec. Co., 101 F.3d 263 (2d Cir. 1996)

Dirks v. SEC, 463 U.S. 646 (1983)

Elkind v. Liggett & Myers, Inc., 635 F.2d 156 (2d Cir. 1980)

Energy Factors Inc. v. Nuevo Energy Co., [1992 Tr. Binder] Fed. Sec. L. Rep.
     (CCH) ¶ 96,883 (S.D.N.Y. July 7, 1992)

Hawkins v. Nat'l Ass'n of Sec. Dealers, Inc., [Current Tr. Binder] Fed. Sec. L. Rep.
     (CCH) ¶ 90,234 (5th Cir. June 23, 1998)

Hockey v. Medhekar, et al., No. C-96-0815 (MHP), 1998 U.S. Dist. LEXIS
     4297 (N.D. Cal. Mar. 31, 1998)

In re Motel 6 Sec. Litig., No. 93 Civ. 2183 (JFK), 1996 WL 531819
     (S.D.N.Y. Sept. 18, 1996)

In re Silicon Graphics, Inc. Sec. Litig., 970 F. Supp. 746 (N.D. Cal. 1997)
     appeal docketed, No. 97-16240 (9th Cir. Nov. 19, 1997)

In re Trump Hotel Shareholder Derivative Litig., [1997 Tr. Binder] Fed. Sec. L. Rep.
     (CCH) ¶ 99,537 (S.D.N.Y. Aug. 5, 1997)

Lange v. H. Hentz & Co., 418 F. Supp. 1376 (N.D. Tex. 1976)

Medhekar v. United States Dist. Ct., 99 F.3d 325 (9th Cir. 1996)

Neubronner v. Milken, 6 F.3d 666 (9th Cir. 1993)

Novak v. Kasaks, et al., 997 F. Supp. 425 (S.D.N.Y. 1998)

Paracor Fin., Inc. v. General Elec. Capital Corp., 96 F.3d 1151 (9th Cir. 1996)

Rothberg v. Rosenbloom, 771 F.2d 818 (3d Cir. 1985);

SEC v. Downe, 969 F. Supp. 149 (S.D.N.Y. 1997), aff'd sub nom, SEC v. Warde,
     [Current Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 90,239 (2nd Cir. July 8, 1998)

SEC v. Ingram, 694 F. Supp. 1437 (C.D. Cal. 1988)

SEC v. Maio, 51 F.3d 623 (7th Cir. 1995)

SEC v. Tome, 638 F. Supp. 596 (S.D.N.Y. 1986)

Scheuer v. Rhodes, 416 U.S. 232 (1974)

Securities and Exch. Comm'n v. Rosenberg, No. 91-2403 (SSH),
     1991 WL 296668 (S.E.C.) (D.D.C. September 24, 1991)

State Teachers Retirement Bd. v. Fluor Corp., 654 F.2d 843 (2d Cir. 1981)

U.S. v. Smith, No. 97-50137, 1998 WL 527066 (9th Cir. Aug. 25, 1998)

United States v. City of Redwood City, 640 F.2d 963 (9th Cir. 1981)

Wenger v. Lumisys, Inc., 2 F. Supp. 2d 1231, (N.D. Cal. 1998)

Zeid v. Kimberley, 973 F. Supp. 910 (N.D. Cal. 1997)

Securities Exchange Act of 1934:

§ 21D(b)(2), 15 U.S.C. § 78u-4(b)(2)

§ 10(b), 15 U.S.C. §78j(b)

§ 20A

§ 20A(a)

§ 20A(c)

15 U.S.C. § 78f(b)(1)

15 U.S.C. § 78s(c)(4)(C)

15 U.S.C. § 78s(e)(1)(A)

15 U.S.C. § 78s(g)(1)

15 U.S.C. § 78s(h)(1)

15 U.S.C. § 78t-1(a)

15 U.S.C. § 78t-1(c)

Securities Exchange Act of 1934:

Rule 10b-5; 17 C.F.R. 240 10b-5

17 C.F.R. § 240.0-1 (1998)

H.R. Conf. Rep. No. 104-369, 104th Cong., 1st Sess. (1995)

Plaintiffs still decline to answer the critical question: why Rational Software Corporation or Paul D. Levy (the "Rational Defendants") would risk potential liability and professional reputation to selectively disclose information to a Cowen & Company ("Cowen") securities analyst. As shown in the Rational Defendants' opening brief, without this crucial allegation, the Complaint fails to plead the elements necessary to state a claim.

Plaintiffs' opposition, like the Complaint, assumes that mere speculation is sufficient to state a cause of action. Instead of building their argument on case law, plaintiffs depend on irrelevant articles about securities analysts and focus on exchange rules and industry guidelines which do not give rise to actionable claims. Nor do plaintiffs rebut the arguments in the Rational Defendants' opening brief which reveal the Complaint's fatal flaws.

First, the Complaint fails to allege particular facts creating a strong inference of scienter. While plaintiffs contend that materiality serves as a proxy for scienter, the cases they rely on refute that argument. To state a claim, the Complaint must allege scienter -- and it does not.

Second, the Complaint does not allege that the Rational Defendants received a personal benefit in exchange for the purported selective disclosure to Cowen. All the Complaint does is describe benefits any analyst could give to any company or corporate officer. Moreover, the Complaint does not attempt to explain why the Rational Defendants would choose Cowen, among all investment banks, to favor with this purported tip.

Third, plaintiffs do not adequately plead an insider trading claim. All plaintiffs do is allege that the Rational Defendants and Cowen tipped unidentified traders. That is not enough. In fact, plaintiffs do not cite a single case which held an insider liable without any specific allegation that someone traded despite knowing an insider had breached a duty by selectively disclosing material nonpublic information.

Finally, plaintiffs' state law claim must be dismissed for failure to allege the essential element of privity. They seek discovery; discovery is not permitted under the Reform Act.

The Complaint fails to state a claim. It should be dismissed.

I. THE COURT MAY DISMISS THE COMPLAINT FOR FAILURE TO ALLEGE SCIENTER.

Plaintiffs argue incorrectly that this Court may not dismiss the Complaint on scienter grounds. See Plaintiffs' Consolidated Opposition to Defendants' Motion to Dismiss ("Pl. Mem.") at 9. Plaintiffs insist that scienter is a "factual determination" which cannot be made at the pleading stage. Id. at 10, 12, 17. This argument flies in the face of the Private Securities Litigation Reform Act of 1995 (the "Reform Act") and numerous decisions dismissing securities class actions on scienter grounds.

In passing the Reform Act, Congress recognized that "[n]aming a party in a civil suit for fraud is a serious matter. Unwarranted fraud claims can lead to serious injury to reputation for which our legal system effectively offers no redress." H.R. Conf. Rep. No. 104-369, 104th Cong., 1st Sess. at 41 (1995) ("Conf. Rep.") (Clark Decl. Ex. A). To ensure that each person's reputation is protected from baseless fraud accusations, the Reform Act requires plaintiffs to plead, with particularity, facts that give rise to a strong inference that each defendant acted with scienter. Securities Exchange Act of 1934, § 21D(b)(2), 15 U.S.C. § 78u-4(b)(2). The Reform Act states unequivocally that "the court shall . . . dismiss the complaint" if scienter is not pled in accordance with the Reform Act's heightened standard. Id. at § 21D(b)(3)(A), 15 U.S.C. § 78u-4(b)(3)(A) (emphasis added).¹

Consistent with the Reform Act's directive, many courts have granted motions to dismiss on scienter grounds. See, e.g., Hockey v. Medhekar, et al., No. C-96-0815 (MHP), 1998 U.S. Dist. LEXIS 4297, at *45-*47 (N.D. Cal. Mar. 31, 1998) (allegations concerning defendants' failure to follow GAAP did not satisfy Reform Act's scienter requirements); Novak v. Kasaks, et al., 997 F. Supp. 425, 433 (S.D.N.Y. 1998) (dismissing complaint for failure to plead scienter); In re Silicon Graphics, Inc. Sec. Litig., 970 F. Supp. 746, 767 (N.D. Cal. 1997) appeal docketed, No. 97-16240 (9th Cir. Nov. 19, 1997) (dismissing complaint; holding that complaint failed to allege scienter as against certain defendants).

Accordingly, contrary to plaintiffs' contentions, this Court may dismiss the Complaint for failure to allege scienter.

II. THE COMPLAINT DOES NOT PLEAD SCIENTER

The Rational Defendants' opening brief ("Open. Mem.") demonstrated that the Complaint does not meet the heightened scienter pleading requirements of the Reform Act. See Open. Mem. at 3-6. The Rational Defendants established that (a) Mr. Levy's failure to sell his Rational stock, which exposed him to a substantial loss, rebuts an inference of scienter; (b) alleged violations of exchange rules or non-binding investor relations guidelines do not amount to sustainable allegations of scienter; and (c) plaintiffs' failure to make specific factual allegations that the Rational Defendants disclosed information to Cowen analyst Rehan Syed with the knowledge that Mr. Syed would improperly use that information to his advantage, is fatal to the Complaint. Id.

Plaintiffs' response to the Rational Defendants' scienter arguments fails to resuscitate the Complaint. Plaintiffs' response suffers from three shortcomings.

First, plaintiffs hopelessly confuse two elements of a Section 10(b) cause of action -- materiality and scienter.² Plaintiffs in their opposition argue that the scienter requirement is satisfied by the Complaint's allegations that Mr. Levy conveyed to Syed material, non-public information:

Here, as in Ingram and Elkind, there can be no question that all defendants acted with the requisite scienter because they all knew that the information Levy tipped to Syed (lower revenue and earnings estimates), was extraordinarily material and non-public.

Pl. Mem. at 13 (emphasis in original).

Plaintiffs are wrong. It is not enough to allege only that a defendant communicated material, non-public information to another. Even the authorities plaintiffs rely upon make this point clear. For example, in Elkind v. Liggett & Myers, Inc., 635 F.2d 156, 167 (2d Cir. 1980), the court held that scienter only exists for "[o]ne who deliberately tips information which he knows to be material and non-public to an outsider who may reasonably be expected to use it to his advantage[.]" Id. (emphasis added); see State Teachers Retirement Bd. v. Fluor Corp., 654 F.2d 843, 854-55 (2d Cir. 1981) (holding scienter is alleged only by pleading particularized facts creating strong inference that insider deliberately tipped outsider who may reasonably be expected to use it to his advantage). To plead fraud, there must be more than an allegation of disclosure to an analyst; plaintiffs must allege specific facts showing knowledge or expectation of the analyst's improper use of the information. Open. Mem. at 6; see Elkind, 635 F.2d at 168 ("Absent evidence from which it may be inferred that the tipper knows or should certainly appreciate that the disclosure could reasonably be expected to be used by the tippee to his advantage, the essential state of mind for 10b-5 liability is lacking."). The Complaint lacks any such allegation. See Complaint ¶¶ 32-36 ("scienter" allegations).³

The other case which plaintiffs count on to fashion their "materiality equals scienter" argument, SEC v. Ingram, 694 F. Supp. 1437, 1441 (C.D. Cal. 1988), also fails to support their position. Plaintiffs' opposition excerpts a footnote in which the Ingram court states that the degree of materiality "could" affect the scienter analysis. Ingram, 694 F. Supp. at 1441 n.5. However, the text of the Ingram decision shows that the court based its finding of the requisite scienter on a few factors, including the defendant's statement to a customer that "I really shouldn't be telling you this." Id. at 1441. Materiality alone did not carry the day in Ingram, as plaintiffs would have this Court believe. Merely alleging that Mr. Levy communicated non-public, material information to Mr. Syed is not enough to allege scienter.

Second, plaintiffs persist in arguing that a violation of SEC rules, exchange rules, or investor relations guidelines somehow creates an inference of scienter. See Pl. Mem. at 16. The Rational Defendants demonstrated in their opening brief that allegations of rule violations do not create a strong inference of scienter. See Open. Mem. at 5 (citing cases); Chill v. General Elec. Co., 101 F.3d 263, 270 (2d Cir. 1996) ("Allegations of a violation of GAAP provisions and SEC regulations, without corresponding fraudulent intent, are not sufficient to state a securities fraud claim.") (Citations omitted). Without citing any authority to support their position, plaintiffs argue in their response that "[w]hile the existence of National Investor Relations Institute guidelines and NASDAQ rules do not, standing alone, resolve the issue of scienter, they support the logical inference that Levy's conduct was knowing or, at a minimum, reckless[.]" Pl. Mem. at 16. (emphasis in original).

Plaintiffs' theory would eviscerate the scienter requirement for federal securities fraud cases. Securities class actions are brought against public companies and their officers. The rules and guidelines plaintiffs allude to apply with equal force to all public companies and their officers. All of these securities class actions allege disclosure issues of one kind or another. If the mere existence of disclosure rules is deemed to support an inference of knowing or reckless wrongful conduct, then the scienter requirement would be satisfied as a matter of course in every securities fraud case. This is not the rule. The Reform Act requires particularized facts creating a strong inference of scienter as to each defendant -- more than innocent, ordinary circumstances. See Zeid v. Kimberley, 973 F. Supp. 910, 923 (N.D. Cal. 1997) (holding that scienter cannot be pleaded by "broad allegations that apply to virtually any company").⁴

Third, the Complaint does not even plead "motive and opportunity," the scienter standard plaintiffs favor.⁵ See Pl. Mem. at 20. As an initial matter, the "scienter" section of the Complaint (¶¶ 32-36) makes no mention of the Rational Defendants' alleged motive to selectively disclose information to Cowen or Mr. Syed. Plaintiffs merely recycle the Complaint's "personal benefit" allegations for this purpose. The Rational Defendants address below why those allegations are insufficient. See pp. 7 - 9, infra.

One part of the "motive and opportunity" analysis does warrant discussion here: Mr. Levy's stock holdings. The Rational Defendants demonstrated in their opening brief that the fact that Mr. Levy held onto his Rational stock rebuts an inference of scienter. Open. Mem. at 4; see Allison v. Brooktree Corp., 999 F. Supp. 1342, 1352 (S.D. Cal. 1998) (plaintiffs alleged stock sales to show scienter; court held that purchase of stock "negate[d] an inference of motive to defraud" and dismissed complaint). Plaintiffs' opposition contends that this "factual" issue cannot be considered by the Court (Pl. Mem. at 11, 15), yet because the Complaint (¶ 27) describes Mr. Levy's Rational stock holdings, it is entirely appropriate for the Court to consider those holdings on this motion.⁶

Plaintiffs try to distort the Rational Defendants' discussion of the exculpatory impact of Mr. Levy's lack of stock sales. For the sake of clarity, here again is the reason why Mr. Levy's retention of his Rational stock rebuts an inference of scienter. Plaintiffs ask this Court to believe that, for no apparent reason, Mr. Levy would give Cowen, among all other investment banks, an opportunity to let its customers sell Rational stock prior to the release of adverse information. Meanwhile, Mr. Levy did not sell a single share of his own substantial holdings of Rational stock. In other words, the Complaint implausibly accuses Mr. Levy of engaging in a scheme to defraud the investing public while personally standing pat and enduring a $9 million paper loss.

For the foregoing reasons, and those set forth in the Rational Defendants' opening memorandum, the Complaint fails to allege scienter. Accordingly, the Complaint should be dismissed. See Dirks, 463 U.S. at 663 n.23 (noting that in insider trading case, "[s]cienter . . . is an independent element of a Rule 10b-5 violation").

III. THE COMPLAINT DOES NOT ADEQUATELY PLEAD "PERSONAL BENEFIT"

As shown in the Rational Defendants' opening brief, the Complaint fails to allege another essential element of a Rule 10b-5 claim: "personal benefit." See Open. Mem. at 6-9. Instead of addressing the Rational Defendants' motion as it was written, plaintiffs engage in sophistry.

Plaintiffs mischaracterize the Rational Defendants' argument regarding personal benefit: the opening brief does not say, as plaintiffs contend, that personal benefit must be pled by alleging that the Rational Defendants made a "pecuniary profit" (plaintiffs' words) in exchange for conveying information to Mr. Syed. See Pl. Mem. at 22-23. The Rational Defendants refer the Court to pages 6-7 of their opening brief for a thorough discussion of the Supreme Court's construction of the "personal benefit" standard in Dirks. See Dirks, 463 U.S. at 663. For the Court's convenience, Defendants will briefly summarize the Dirks personal benefit test again.

Trial courts should focus on objective criteria to determine whether:

the insider receives a direct or indirect personal benefit from the disclosure, such as pecuniary gain or a reputational benefit that will translate into future earnings

Id. (emphasis added). The Supreme Court identified two circumstances which could justify an inference that an insider received a direct or indirect personal benefit:

a relationship between the insider and the recipient that suggests a quid pro quo from the latter or an intention to benefit the particular recipient [or]

a gift of confidential information to a trading relative or friend

Id. at 664 (emphasis added). That is the Dirks standard; and it is the same one the Rational Defendants set forth in their opening brief. Open. Mem. at 6-7.

The simple question is whether the Complaint's personal benefit allegations meet any aspect of the Dirks standard.⁷ First, the parties apparently agree that the Complaint does not allege that the Rational Defendants sought a "pecuniary gain" in exchange for the allegedly disclosed information. See Pl. Mem. at 23; Open. Mem. at 7-8. In fact, this case stands in stark contrast to cases where such a "pecuniary gain" was alleged. See, e.g., Rothberg v. Rosenbloom, 771 F.2d 818, 826 (3d Cir. 1985) (Higginbotham, J., concurring) (insider received a personal benefit because his tip "almost certainly facilitated the sale of his own shares"); Burlington Indus., Inc. v. Edelman, 666 F. Supp. 799 (M.D.N.C. 1987) aff'd [1987 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 93,339 (4th Cir. June 22, 1987) (insider disclosed material inside information for purpose of obtaining management position and equity interest in company to be formed after hostile takeover); SEC v. Tome, 638 F. Supp. 596, 615, 622 (S.D.N.Y. 1986) (insider charged tippees $200,000 for material inside information).

Second, plaintiffs do not allege that the Rational Defendants engaged in selective disclosure to provide "a gift of confidential information to a trading relative or friend." Dirks, 463 U.S. at 664; See, e.g., SEC v. Maio, 51 F.3d 623 (7th Cir. 1995) (insider tipped close personal friend who in turn tipped another good friend; both tippees made a profit from trading the stock); SEC v. Downe, 969 F. Supp. 149 (S.D.N.Y. 1997), aff'd sub nom SEC v. Warde, [Current Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 90,239 (2nd Cir. July 8, 1998) (insider tipped close friend who profited from trading warrants).

Third, the Complaint does not allege that the Rational Defendants stood to gain a "reputational benefit that will translate into future earnings." Dirks, 463 U.S. at 663. The Complaint is silent on the point of how the vague benefits which would purportedly accrue to the Rational Defendants would translate into future earnings. See Neubronner v. Milken, 6 F.3d 666, 668 (9th Cir. 1993) (holding that allegations in insider trading complaint must be stated with particularity).⁸

Finally, the Complaint does not allege a "relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient." Dirks, 463 U.S. at 664. The Complaint fails notably on this front. Its personal benefit allegations are merely a recitation of acts that any analyst could take to benefit any public company or corporate officer. If this were sufficient, it would establish unfettered liability completely at odds with the Supreme Court's adoption of a "limiting principle" in Dirks. Id. Rather, to plead "personal benefit," the Complaint must answer this question: why would the Rational Defendants choose to benefit Cowen and Mr. Syed among all other investment banks and analysts?

Plaintiffs' opposition inadvertently calls attention to this fatal omission. See Pl. Mem. at 5 n.4. They state: "[w]hat the illegal tip did was to allow defendants Cowen and its privileged institutional clients to get out of Rational's stock before the ordinary investing public[.]" Id. Presumably, the alleged selective disclosure also allowed Cowen and its institutional customers to dispose of their Rational stock before all other investment banks and their institutional customers. However, the Complaint does not attempt to explain why Cowen should be the recipient of such largesse. The Complaint is silent as to why the Rational Defendants intended to benefit the particular recipients, Cowen and Mr. Syed.

Accordingly, the Complaint fails to satisfy, as it must, the "personal benefit" element of an insider trading claim. The Complaint should be dismissed.

IV. THE COMPLAINT FAILS TO STATE A CLAIM UNDER SECTION 20A OF THE EXCHANGE ACT

The Rational Defendants established in their opening brief that the Complaint fails to state a Section 20A claim for two reasons: (1) the Complaint does not plead the necessary predicate of an independent violation of the Securities Exchange Act; and (2) the Complaint does not identify anyone who engaged in illegal insider trading based on the alleged selective disclosure from the Rational Defendants. Open. Mem. at 9.

Plaintiffs argue in response that (1) the Complaint need not allege an independent violation of the Securities Exchange Act; it is enough to allege a violation of an NASD rule; and (2) plaintiffs are under no obligation to identify someone who actually traded on the basis of the purported tip. Pl. Mem. at 25-31. They are wrong.

A. The Complaint Does Not Plead a Predicate Violation of the Exchange Act or the "Rules or Regulations Thereunder."

Plaintiffs' opposition concedes that to state a claim under Section 20A of the Exchange Act, the Complaint must plead an independent, predicate violation of some other provision of the Exchange Act, or "the rules or regulations thereunder." 15 U.S.C. § 78t-1(a); Pl. Mem. at 25 - 26. Rational Defendants have already established that plaintiffs have failed in this regard because they have not stated a claim under Rule 10b-5. Open. Mem. at 3 - 6.

Plaintiffs incorrectly contend that a violation of NASD rules can serve as a basis for Section 20A liability because those rules are issued under the Exchange Act. Pl. Mem. at 27-30. The language of the Exchange Act itself, and of its implementing rules, contradicts that argument.

The Securities and Exchange Commission expressly defines the term "rules and regulations" to mean "rules and regulations adopted by the Commission . . . ." 17 C.F.R. § 240.0-1 (1998) (emphasis added). The Exchange Act also consistently distinguishes between: (a) the rules and regulations thereunder; and (b) the rules of self-regulatory organizations, such as the NASD. See, e.g., 15 U.S.C. § 78f(b)(1) (prohibiting registration as a national securities exchange unless able to enforce compliance with "this title, the rules and regulations thereunder, and the rules of the exchange"); 15 U.S.C. § 78s(e)(1)(A) (sanctions imposed by self-regulatory organizations should be affirmed if actions violate "this chapter, the rules or regulations thereunder, [or] the rules of the self-regulatory organization"); 15 U.S.C. § 78s(g)(1) (requiring self-regulatory organizations to comply with "this chapter, the rules and regulations thereunder, and its own rules"); 15 U.S.C. § 78s(h)(1) (imposing sanctions if self-regulatory organization violates "this chapter, the rules or regulations thereunder, or its own rules").

To emphasize the distinction between SEC rules and the rules of self-regulatory organizations, Congress stated explicitly that if the SEC amends the rules of a self-regulatory organization, the amendment "shall be considered for all purposes of this chapter to be part of the rules of such self-regulatory organization and shall not be considered to be a rule of the Commission." 15 U.S.C. § 78s(c)(4)(C) (emphasis added).

If Congress had intended for a violation of the rules of a self-regulatory organization, such as the NASD, to serve as a predicate violation for Section 20A, it would have said so. In light of the numerous statutory provisions cited above that refer explicitly to the rules of self-regulatory organizations, the absence of any such reference in Section 20A is dispositive.

Plaintiffs' reliance on Hawkins v. Nat'l Ass'n of Sec. Dealers, Inc., [Current Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 90,234 (5th Cir. June 23, 1998), is misplaced. Hawkins held only that allegations that the NASD violated federal securities laws give rise to federal subject matter jurisdiction. In contrast, it is well established that a violation of NASD rules does not give rise to federal subject matter jurisdiction. See, e.g., Application of Prudential Sec., Inc., 795 F. Supp. 657, 659 (S.D.N.Y. 1992) ("NASD rules . . . do not give rise to federal question jurisdiction."); Lange v. H. Hentz & Co., 418 F. Supp. 1376, 1380 (N.D. Tex. 1976) (breach of rules of NASD, a private association, did not trigger federal jurisdiction). This is precisely because NASD rules -- unlike SEC rules -- are not federal laws. Hence, a violation of NASD rules cannot serve as a basis for Section 20A liability.

B. Plaintiffs Fail to State a Claim Under Section 20A(c).

The Complaint's Section 20A claim should be dismissed for another, independent reason: the Complaint does not allege that any person violated Rule 10b-5 "by purchasing or selling a security". 15 U.S.C. § 78t-1(a). The Complaint alleges that the Rational Defendants and defendants Cowen and Mr. Syed violated Section 10(b) by selectively disclosing material, non-public information. In their opposition, plaintiffs contend that is enough -- they argue that they do not need to state a claim against anyone who actually sold Rational stock based on the alleged selectively disclosed information.⁹

To support their argument, plaintiffs selectively revise Section 20A(c) of the Exchange Act. Below, defendants quote Section 20A(c), including, in the underlined text, the portions of the statute which plaintiffs left out. See Pl. Mem. at 26.

Any person who violates any provision of this chapter or the rules or regulations thereunder by communicating material, nonpublic information shall be jointly and severally liable under subsection (a) of this section with, and to the same extent as, any person or persons liable under subsection (a) of this section to whom the communication was directed.

15 U.S.C. § 78t-1(c) (emphasis added). The statute is clear. Under Section 20A(c), an insider is liable only "to the same extent as" a trader who is liable under Section 20A(a) -- without such a trader, there is no selective disclosure liability. Id.

Thus, to state a claim, the Complaint must both identify persons who purportedly traded based on the supposed "tip" from the Rational Defendants or the Cowen defendant; and allege that those persons improperly sold Rational stock knowing or suspecting that an insider had breached his duty to Rational shareholders by selectively disclosing material information. See Dirks, 463 U.S. at 660; U.S. v. Smith, No. 97-50137, 1998 WL 527066, at *18 (9th Cir. Aug. 25, 1998) (Supplemental Declaration of Douglas J. Clark, Exhibit E) (Rule 10b-5 violation requires improper "use" of material nonpublic information, not just knowing possession).

Lastly, plaintiffs argue that they have alleged all they "can be expected to know without discovery and all they reasonably can be expected to plead." Pl. Mem. at 30. They cite In re Motel 6 Sec. Litig., No. 93 Civ. 2183 (JFK), 1996 WL 531819 (S.D.N.Y. Sept. 18, 1996), for the proposition that examination of trading allegations is premature prior to discovery. See Pl. Mem. at 30-31. Their reliance on Motel 6, a pre-Reform Act case, is misleading at best. In Motel 6, the court was addressing a class certification motion, not a motion to dismiss. Motions to dismiss had already been resolved; discovery would have been permitted in Motel 6, even under the Reform Act. Motel 6, 1996 WL 53819 at *1.

The Reform Act's mandatory discovery stay applies in this case. The Reform Act was designed in large part to prohibit the practice that plaintiffs encourage here: the use of discovery to cast about for evidence to support an insufficient allegation. See Conf. Rep. at 31 ("abusive practices committed in private securities litigation include: (1) the routine filing of lawsuits . . . with only faint hope that the discovery process might lead eventually to some plausible cause of action"); Medhekar v. United States Dist. Ct., 99 F.3d 325, 328 (9th Cir. 1996) ("Congress clearly intended that complaints in these securities actions should stand or fall based on the actual knowledge of the plaintiffs rather than information produced by the defendants after the action has been filed.").

V. THE CORPORATIONS CODE CLAIM MUST BE DISMISSED

Plaintiffs concede that they have failed to allege privity, a required element of their California Corporations Code claim. As indicated above, their assertion that discovery is not only allowed but required (Pl. Mem. at 32) is wrong and misses the point. Because this lawsuit is subject to the Reform Act, plaintiff is not entitled to take discovery until he has filed an adequate complaint. See In re Trump Hotel Shareholder Derivative Litig., [1997 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 99,537 at 97, 653 (S.D.N.Y. Aug. 5, 1997) ("[h]aving chosen to invoke Section 14 of the Exchange Act," plaintiff was not entitled to discovery on pendent state claim). Discovery should be denied and the Corporations Code claim should be dismissed.

For the reasons set forth above and in their opening brief, the Rational Defendants respectfully request that the Complaint be dismissed.

¹ To curb the onslaught of abusive lawsuits, Congress took the extraordinary step of defining a pleading standard and ordering courts to dismiss non-compliant complaints. The Reform Act=s pleading directives supplant prior case law discussing judicial review of complaints at the pleading stage, such as Scheuer v. Rhodes, 416 U.S. 232, (1974) and United States v. City of Redwood City, 640 F.2d 963 (9th Cir. 1981), upon which plaintiffs rely for their argument that this Court may not dismiss the Complaint on scienter grounds. See Pl. Mem. at 9.

² To state a claim under Section 10(b), a plaintiff must allege as to each defendant "(1) a misrepresentation or omission of a material fact, (2) reliance, (3) scienter, and (4) resulting damages." Paracor Fin., Inc. v. General Elec. Capital Corp., 96 F.3d 1151, 1157 (9th Cir. 1996).

³ Plaintiffs' opposition claims that the mere allegation that Syed was a securities analyst is sufficient to plead scienter because an analyst is "someone whom one can reasonably expect to use the information for his benefit." Pl. Mem. at 20. Not so. If that were enough, any conversation with a securities analyst could be grounds for liability. Plaintiffs' reasoning was rejected by the Supreme Court in Dirks v. SEC, 463 U.S. 646 (1983). The Supreme Court established a limiting principle on liability, acknowledging that analysts often obtain information by questioning corporate officers and that it "is the nature of this type of information, and indeed of the markets themselves, that such information cannot be made simultaneously available to all of the corporation's stockholders or the public generally." Id. at 658. Even the Securities and Exchange Commission ("SEC") has stated that securities analysts are "necessary to the preservation of a healthy market" and should be free to obtain information from corporate officers. Id. at 658 & n.17 (1983).

⁴ For example, Energy Factors Inc. v. Nuevo Energy Co., [1992 Tr. Binder] Fed. Sec. L. Rep. (CCH) ¶ 96,883 (S.D.N.Y. July 7, 1992) alleged far more than the disclosures in the course of a routine company-analyst conversation claimed here; in that case there were allegations of a very close relationship between the company and an investment bank which had provided financing help, a motive to repay a past favor, and disclosures outside the context of a normal company-investment bank relationship.

⁵ There has been much debate as to whether the Reform Act implements the scienter pleading standard of the Second Circuit Court of Appeals, or a stricter test. Again, the Rational Defendants believe this Court need not engage in the scienter debate, since plaintiffs have not satisfied either test.

⁶ It is somewhat ironic that securities class plaintiffs argue here that a defendants' stock holdings cannot appropriately form the basis for a scienter ruling, as plaintiffs typically proffer stock sales as a basis for a scienter finding. See, e.g., Hockey, 1998 U.S. Dist. LEXIS 4297 at *44-*45; Wenger v. Lumisys, Inc., 2 F. Supp. 2d 1231, 1251 (N.D. Cal. 1998) (plaintiffs' scienter argument based on defendants' stock sales); Silicon Graphics, 970 F. Supp. at 767-768 (stock sales alleged to plead scienter). Moreover, plaintiffs' protests that Mr. Levy's losses do not rebut an inference of scienter is misplaced (Pl. Mem. at 15-16), since plaintiffs have not even met their initial burden to create such an inference.

⁷ Plaintiffs claim that the Rational Defendants stood to receive "1) positive coverage and publicity for Rational, 2) access to information about the high-technology industry and 3) future reciprocal favors[.]" Pl. Mem. at 23; see Complaint ¶ 29.

⁸ Importantly, the cases plaintiffs rely on to argue that the Complaint satisfies this aspect of the Dirks standard are inapposite. Plaintiffs' suggestion that this case is analogous to SEC v. Downe is unpersuasive. As noted above, the insider and alleged tippee were close personal friends. See Downe, 969 F. Supp. at 152. Hence, Downe is a classic case of "a gift of confidential information to a trading relative or friend," Dirks, 463 U.S. at 664, sufficient to constitute a breach of fiduciary duty.

⁹ On September 8, 1998, plaintiffs submitted a Supplemental Declaration in opposition to this motion. The declaration annexed an irrelevant news article about a company called Zoltek and an SEC release in the matter of Securities and Exch. Comm'n v. Rosenberg, No. 91-2403 (SSH), 1991 WL 296668 (S.E.C.) (D.D.C. Sept. 24, 1991). The Rosenberg release is interesting because the S.E.C.'s complaint in that matter focused on one of the key elements missing in this case. In Rosenberg, a Cowen analyst received non-public information about Apollo Computer, Inc. and sold his Apollo stock based on that information. Id. at *1-*2. The Complaint in this case does not allege that any defendant sold stock based on inside information.