In 1995, Congress passed the Private Securities Litigation Reform Act to eliminate abusive practices in federal securities litigation.1 Among other things, the act raised plaintiffs’ burden in pleading federal securities fraud actions. First, the Reform Act heightened the standard to plead scienter (i.e., a fraudulent state of mind), requiring a federal securities fraud complaint to plead facts “giving rise to a strong inference that the defendants acted with the required state of mind.”2 Second, the Reform Act instituted an automatic discovery stay in securities cases until resolution of the defendant’s motion to dismiss.3 As a result, a federal securities plaintiff can no longer simply file a bare bones complaint and then serve pre-motion-to-dismiss discovery requests, hoping to obtain information to support a subsequent well-pleaded amended complaint. Instead, he must at the outset plead facts giving rise to a strong inference of scienter, without the benefit of formal discovery.

In many cases, plaintiffs attempt to meet this burden by relying on statements attributed to anonymous current or former company insiders, usually referred to as confidential witnesses or CWs. (For obvious reasons, many current and former employees of defendant corporations are reluctant to be identified by name in class action securities complaints). Since Congress passed the Reform Act, the courts have struggled with the proper treatment of such confidential witness statements under the act’s pleading standard.

While most courts have concluded that confidential witness allegations may be sufficient in some cases to support a strong inference of scienter, developments in recent cases cast serious doubts on the reliability of such statements. As discussed below, those recent decisions counsel greater skepticism of statements attributed to confidential witnesses and employment of additional procedural safeguards to ensure their reliability.

Inference of Scienter

After Congress passed the Reform Act, the U.S. Court of Appeals for the Second Circuit (and most other courts to consider the question) held that confidential witness statements could support a strong inference of scienter if the complaint alleged facts indicating that the statements were reliable, including describing the witnesses’ basis of knowledge.4 But the Supreme Court subsequently clarified the Reform Act’s pleading requirement, explaining that “[t]o qualify as ‘strong’…an inference of scienter must be…cogent and at least as compelling as any opposing inference of nonfraudulent intent.”5

Several courts applying this standard determined that confidential witness statements should be treated with skepticism.6 Most notably, in Higginbotham v. Baxter International, the U.S. Court of Appeals for the Seventh Circuit held that confidential witness statements should be “steeply discounted.”7 Judge Frank Easterbrook, writing for the court, concluded that “[i]t is hard to see how information from an anonymous source could be deemed ‘compelling’ or how we could take account of plausible opposing inferences.”8 Most district courts in the Second Circuit, however, have continued to hold that properly pleaded allegations based on statements attributed to confidential witnesses may be sufficient to survive a motion to dismiss if they are accompanied by sufficient indicia of reliability.9

Skeptical Treatment

Once a case proceeds to discovery, however, defendants are typically able to learn the identities of confidential witnesses and probe the accuracy of their statements. And in several recent cases, discovery from these witnesses has raised serious concerns about the reliability of information attributed to them in complaints. And when courts have had a basis to evaluate the substance of confidential witness statements on motions to dismiss, similar concerns have arisen. In particular, these cases cast doubt on the methods some lawyers and investigators use to obtain and verify information from confidential witnesses.

First, in Applestein v. Medivation, a district court in the Northern District of California dismissed with prejudice a securities fraud complaint based largely on information purportedly obtained from three confidential witnesses.10 The Applestein court considered a motion to dismiss the third amended complaint in that action. In determining that the confidential witness statements were not reliable, the court noted that statements attributed to some confidential witnesses contradicted those of others and even contradicted statements attributed to the same confidential witnesses in a previous complaint.11 And at a hearing on the motion, plaintiffs’ counsel acknowledged that neither they nor their investigators had actually spoken to two of the purported confidential witnesses, relying instead on hearsay accounts from the third confidential witness. This defect had not been previously disclosed.12

Similarly, in Belmont Holdings v. Suntrust Banks, a district court in the Northern District of Georgia granted a motion for reconsideration and dismissed a securities fraud complaint based on declarations from the confidential witness relied on in the complaint.13 In his declarations, the confidential witness contradicted several of the statements attributed to him in the complaint and denied ever having made such statements to the plaintiffs’ investigators. In particular, he stated the he had left the defendant company months before many of the events about which the plaintiffs attributed statements to him. The witness also revealed that while he had several telephone conversations with the plaintiffs’ investigators, he never met them in person and never communicated at all with the plaintiffs’ attorneys. In dismissing the complaint, the court found that, based on the confidential witnesses declarations, “the positions Plaintiff took in its Amended Complaint were misleading or, at least, unsupported.”14

And finally, in a recent decision in City of Livonia Employees’ Retirement System and Local 295/Local 851 v. Boeing, the Seventh Circuit affirmed dismissal of a securities fraud complaint against Boeing and remanded to the district court to determine whether Rule 11 sanctions should be imposed on the plaintiffs’ lawyers for relying on statements attributed to (and later disavowed by) a confidential witness without taking appropriate steps to verify the statements despite indications that the complaint inaccurately reported the witnesses’ statements.15 Discovery in the case revealed that a confidential witness referred to in the complaint as a Boeing “senior engineer” had never actually worked for the company and did not have access to the information attributed to him in the complaint.16 In Boeing, the Seventh Circuit found that the plaintiffs’ lawyers “made confident assurances in their complaints about a confidential source—their only barrier to dismissal of their suit—even though none of the lawyers had spoken to the source and their investigator had acknowledged that she couldn’t verify what (according to her) he had told her.”17

‘City of Pontiac’

Most recently in City of Pontiac General Employees’ Ret. Sys. v. Lockheed Martin, Judge Jed S. Rakoff in the Southern District of New York commented thoughtfully on the problems raised by widespread reliance on confidential witnesses.18 In City of Pontiac, the court, relying on confidential witness statements in the complaint, had previously denied the defendants’ motion to dismiss. In subsequent discovery, however, those witnesses either recanted statements attributed to them or denied ever making the statements in the first place. The defendants then moved for summary judgment, arguing that there was no longer any competent evidence supporting the plaintiffs’ claims. The court directed five of the confidential witnesses and the plaintiffs’ investigator to appear and testify in court at the hearing on the defendants’ summary judgment motion.19

After that hearing, the court denied the defendants’ summary judgment motion in a summary order with an opinion to follow. In the interim, the parties settled the case. The court issued an opinion, nonetheless, to comment on the problems associated with the widespread use of confidential witness statements in securities fraud complaints.

Rakoff determined that some of the confidential witnesses had been “lured by the investigator into stating as ‘facts’ what were often mere surmises, but then, when their indiscretions were revealed, felt pressured to denying outright statements that they had actually made.”20 Other confidential witnesses “confirmed the substance of the statements attributed to them in the amended complaint, while noting that such snippets did not always convey the nuances of what they told” the investigator.21 The court also noted that the investigator “did not ask any other member of his staff to be with him on his phone calls with the [witnesses], nor did he ask the [witnesses] if he could tape-record the calls or meet with them in-person, preferring to rely, instead, on his non-stenographic notes of their telephone conversations made even while the conversations were continuing.”22 Nonetheless, the court ultimately determined that the record did not support a finding of misconduct by the investigator or plaintiffs’ counsel.

City of Pontiac shows that confidential witness statements may be unreliable even absent misconduct. A thorough investigator will ask a witness about many aspects of a company’s operations, including areas about which the witness lacks first-hand knowledge. The witness, in turn, may speculate or provide opinions rather than facts. And the investigator may mistake a witness’ conjecture for fact. Even when investigators accurately report facts as stated by the witness, there will be a natural tendency for plaintiffs’ representatives to characterize or shade those facts in the way most suggestive of fraud. These practices will almost inevitably lead to complaints that do not accurately reflect the factual knowledge of the underlying witnesses.

Potential Responses

These recent decisions suggest that, in many instances, the actual statements of confidential witnesses are not accurately reported in complaints. As a result, courts should and often do view confidential witness statements with skepticism and apply the federal rules and pleading standards accordingly.

First, many problems raised by the use of confidential witnesses could be solved simply by requiring plaintiffs’ counsel to take a more active role in assuring the reliability of pre-complaint factual investigations. The courts should make clear that Rule 11 requires counsel to take reasonable steps to ensure that statements attributed to confidential witnesses accurately reflect the witnesses’ actual statements. At a minimum, lawyers should confirm that their investigators follow appropriate professional investigative practices.

Second, courts should require that securities fraud complaints plead facts buttressing the reliability of any confidential witness statements. These allegations should certainly include facts showing the confidential witness would have had access to the relevant information at the relevant time. But given the problems discussed above, courts should also consider going further, requiring factual allegations about investigators’ experience and reliability or about the pre-case investigation itself.

Third, while plaintiffs often argue that the confidential witnesses’ identities are protected attorney work product, the courts should make clear that defendants are entitled to discover confidential witnesses’ identities.23 As the Higginbotham court noted, “there is no ‘informer’s privilege’ in civil litigation.”24 Witnesses with legitimate concerns about safety or security can be protected by appropriate protective orders.

Finally, when defendants can identify with particularity potential inaccuracies or discrepancies in confidential witness statements, courts should permit pre-motion-to-dismiss discovery into the identity and reliability of confidential witnesses. While discovery on a motion to dismiss is rare, at least one court in the Southern District of New York, in Campo v. Sears Holdings, has granted limited discovery into the reliability of statements attributed to confidential witnesses and relied on the fruits of that discovery to grant a motion to dismiss.25 The Second Circuit affirmed.26 Given the circuit court’s approval, district courts should be open to limited motion-to-dismiss discovery of confidential witnesses in appropriate cases.

Conclusion

Well-pleaded securities complaints stating fraud claims (including facts supporting a strong inference of scienter) should, of course, be permitted to proceed to discovery. But plaintiffs should not be permitted to pass the significant threshold of a motion to dismiss based on dubious confidential witness allegations. Trial courts should maintain an appropriate level of skepticism for anonymous statements when applying the federal rules and the Reform Act’s heightened pleading standards to complaints relying heavily on confidential witness statements. In doing so, the courts should require strong indicia of reliability before accepting such statements as true and should allow defendants discovery to test those statements, including at an early stage in the case where appropriate.

Carl H. Loewenson, Jr. is a partner at Morrison & Foerster and cochair of the firm’s securities litigation, enforcement, and white-collar defense group. James J. Beha II is a litigation associate at the firm.

Endnotes:

1. Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, 109 Stat. 737 (codified as amended in scattered section of 15 and 18 U.S.C.); see also Senate Report No. 104-98 at 10 (identifying “[e]limination of abusive practices in securities litigation” as a purpose of the Reform Act).

2. 15 U.S.C. §78u-4(b)(1) (2006).

3. 15 U.S.C. §78u-4(b)(2) (2006).

4. Novak v. Kasaks, 216 F.3d 300, 314 (2d Cir. 2000) (courts may credit confidential witness statements if witnesses “are described with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged”).

5. Tellabs, 551 U.S. at 314.

6. See, e.g., Higginbotham v. Baxter Intern, 495 F.3d 753, 757 (7th Cir. 2007).

7. Higginbotham, 495 F.3d at 757.

8. Id.

9. See, e.g., In re MBIA Sec. Litig., 700 F.Supp.2d 566, 589 n.16 (S.D.N.Y. 2010) (“Absent guidance to the contrary [from the Second Circuit], the Court will consider Lead Plaintiff’s allegations that are based on the CW’s information without discounting those allegations solely due to the anonymity of the CW” (internal quotation marks omitted)).

10. 861 F.Supp.2d 1030 (N.D. Cal. 2012).

11. Id. at 1038 (“the confidential witness statements in the [third amended complaint] are unreliable because they contradict statements made by the same group of witnesses in the [second amended complaint]“).

12. Id. at 1038-39 (noting that “the fact that Plaintiffs rely on hearsay statements passed onto CW-2 further underscores the unreliability of the confidential witnesses’ statements in this case”).

13. 896 F.Supp.2d 1210 (N.D. Ga. 2012).

14. Id. at 1233.

15. City of Livonia Employees’ Ret. Sys. and Local 295/Local 851 v. Boeing, 711 F.3d 754 (7th Cir. 2013).

16. City of Livonia Employees’ Ret. Sys. and Local 295/Local 851 v. Boeing, C.A. No 09 C 7143, 2011 WL 824604, at *4 (N.D. Ill. March 7, 2011).

17. Boeing, 711 F.3d at 762.

18. City of Pontiac General Employees’ Ret. Sys. v. Lockheed Martin, No 11 Civ. 5026 (JSR), 2013 WL 3389473 (S.D.N.Y. July 9, 2013).

19. Id. at *2.

20. Id. at *3.

21. Id.

22. Id.

23. See Plumbers and Pipefitters Local Union No. 630 Pension-Annuity Trust Fund v. Arbitron, 278 F.R.D. 335, 339 (S.D.N.Y. 2011).

24. Higginbotham, 495 F.3d at 757.

25. Campo v. Sears Holdings, 635 F.Supp.2d 323 (S.D.N.Y. 2009).

26. Campo v. Sears Holdings, No. 09-3589-cv, 371 Fed. Appx. 212, 217 n.4 (2d Cir. April 6, 2010).