Establishing scienter in private securities fraud litigation under the Private Securities Litigation Reform Act of 1995 (PSLRA) can be a daunting challenge to even the most skilled and seasoned practitioners. In enacting the PSLRA, Congress sought to raise the evidentiary bar by which claims of fraudulent conduct by corporations and executives must be pleaded. This has led to substantial litigation on various aspects of the PSLRA, including the heightened requirements for pleading scienter confronted by potential PSLRA plaintiffs.
These enhanced requirements have led PSLRA plaintiffs to employ many techniques to plead scienter with sufficient specificity, as required by the PSLRA, including the use of confidential witness statements in securities fraud complaints. This article analyzes the standards under which courts review such statements when considering a motion to dismiss, and provides securities litigators some thoughts to consider when drafting or attacking a securities fraud complaint containing confidential witness statements.
The PSLRA’s Heightened Pleading Requirement
The PSLRA, 15 U.S.C. § 78u-4(b)(2), requires that a plaintiff “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” The PSLRA, however, failed to provide a workable definition of either “strong inference” or “required state of mind,” requiring courts to develop their own standards under which to determine whether a given complaint satisfied the exacting standards of the PSLRA. Courts struggled to find the proper microscope under which to view PSLRA securities fraud claims, with different tests and standards emerging from different courts. This created disharmony among the U.S. circuit courts of appeal, with each circuit adopting its own standards for determining when scienter was pled with sufficient specificity and strength.
Confidential Witnesses in PSLRA Complaints
The elevated pleading standards in actions under the PSLRA, coupled with the institution of an automatic discovery stay upon a defendant’s filing of a motion to dismiss, require securities plaintiffs to employ all available resources when drafting a complaint. One of the most oft-employed techniques is reliance on the statements of confidential sources to substantiate claims asserted in the pleadings.
Because witnesses with information pertinent to plaintiffs’ causes of action may be current or former employees of the defendant corporation, or confidants of the corporation’s executives, the only way to secure their testimony about alleged corporate fraud or misappropriation is by ensuring their anonymity. This is especially true in the case of sources who remain employed by the defendant corporation, who may fear retaliation for their cooperation with plaintiffs, despite anti-retaliation protections of federal whistleblower laws. Thus, the utilization of confidential witness statements has become a common practice in pleading securities fraud actions under the PSLRA.
The Supreme Court Weighs In
The disparity among the circuit courts became so pronounced that in 2007 the U.S. Supreme Court sought to create uniformity with its decision in Tellabs Inc. v. Makor Issues & Rights Ltd. In Tellabs , the court held that in determining whether a plaintiff has established a “strong inference” of scienter, a court “must engage in a comparative evaluation; it must consider, not only inferences urged by the plaintiff … but also competing inferences rationally drawn from the facts alleged.” To qualify as “strong,” an inference of scienter “must be more than merely plausible or reasonable; it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent.”
Despite the Supreme Court’s efforts to articulate a uniform standard for courts to employ in evaluating scienter in securities fraud complaints, Tellabs generated additional confusion among the circuit courts, particularly when the courts were left to determine how much factual specificity is necessary for an evaluation of the cogency of competing inferences. What weight should be given to particular factual averments determining whether a plaintiff has alleged fraud with sufficient particularity has become a contested issue among the circuit courts. In particular, post- Tellabs courts have struggled to determine the appropriate deference and authority to afford statements of confidential sources in securities fraud complaints.
The Circuits Articulate Pleading Requirements
After Tellabs , courts were initially uncertain of the proper consideration to afford confidential witness statements when evaluating averments of scienter on a defendant’s motion to dismiss. The 7th Circuit, whose decision the Supreme Court vacated in Tellabs , initially discounted any information provided by confidential witnesses, concluding in Higginbotham v. Baxter International Inc. that Tellabs prohibits such consideration because anonymity of sources would permit plaintiffs to conceal information that a court should properly evaluate when considering a motion to dismiss.
The court quickly retreated from this position, however, when it considered Tellabs on remand from the Supreme Court. There the court determined that because the information presented by the confidential witnesses was set forth in “convincing detail,” and that some of the information was corroborated by multiple sources, “[t]he absence of proper names does not invalidate the drawing of a strong inference from informants’ assertions.”
Over the three years since the Supreme Court decided Tellabs , multiple circuit courts have had the opportunity to consider the appropriate role of confidential witnesses in PSLRA complaints, and the decisions rendered by those courts, with the singular exception of Higginbotham , have been remarkably consistent in their treatment of confidential witness statements.
In Zucco Partners LLC v. Digimarc Corp. , the 9th Circuit in 2009 proposed a two-part test for evaluating the veracity and weight attributable to statements made by confidential witnesses. First, the confidential witnesses “must be described with sufficient particularity to establish their reliability and personal knowledge.” Second, the confidential witness statements “must themselves be indicative of scienter.” To meet the requirements of the first part of the test, a confidential witness must be sufficiently identified in the complaint, not just by providing details about the witness’ job title and employment information, but also by describing how the witness was “in a position to be personally knowledgeable of the information alleged.”
The 5th Circuit, in its 2007 case, Central Laborers’ Pension Fund v. Integrated Electrical Services Inc. , declined to find a strong inference of scienter based on statements by confidential witnesses in the complaint because the witnesses’ statements lacked sufficient detail. The court questioned the validity of the witnesses’ statements because the statements “lack specific details, such as particular job descriptions, individual responsibilities, and specific employment dates for the witnesses, and that without such information there is an insufficient basis on which to evaluate the presented information.”
The 6th Circuit, in the 2008 case Ley v. Visteon Corp. , similarly discounted confidential witness statements in a complaint, concluding: “While we agree that anonymous sources are not altogether irrelevant to the scienter analysis, Plaintiffs’ allegations here are too vague and conclusory to be accorded much weight.” The court determined that because the statements failed to allege which individuals at Visteon knew about alleged accounting improprieties, and “what, when, where, and how they knew,” the statements were inherently suspect. Absent such context for guidance, the court was unable to determine that the statements gave rise to an inference of scienter.
More recently, in Konkol v. Diebold Inc. , the 6th Circuit in 2008 again discounted statements from confidential witnesses because of the statements’ lack of specificity about the identity of the witnesses and the bases for their assertions. Because the complaint did not contain any details about most of the confidential witnesses, such as dates of employment, job description, employment location, or which defendants interacted with the witnesses, the general nature of their statements about the corporation were insufficient to impute scienter to the defendants.
Finally, in the 2008 case Mizzaro v. Home Depot Inc. , the 11th Circuit, confronted with the question of the weight afforded confidential witnesses, embraced a position similar to that of the other circuit courts. The court stated that “the weight to be afforded to allegations based on statements proffered by a confidential source depends on the particularity of the allegations made in each case, and confidentiality is one factor that courts may consider.” The court concluded, however, that “[c]onfidentiality … should not eviscerate the weight given if the complaint otherwise fully describes the foundation or basis of the confidential witness’s knowledge, including the position(s) held, the proximity to the offending conduct, and the relevant time frame.”
The 3rd Circuit
In 2009, the 3rd Circuit examined the proper method for evaluating confidential witness statements in Institutional Investors Group v. Avaya . In Avaya , the court re-embraced the principles it had articulated in California Public Employees’ Retirement System v. Chubb Corp. , that “there is no requirement that [confidential witnesses] be named, provided they are described in the complaint with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged.” Although Chubb was decided pre- Tellabs , the court reviewed the principles it espoused in light of Tellabs and the opinions promulgated by the several circuit courts of appeal that had similarly revisited their perspectives on confidential witnesses after Tellabs .
In evaluating confidential witness statements and determining the appropriate amount of consideration to afford them, the court stated that it should “evaluat[e] the detail provided by the confidential sources, the sources’ basis of knowledge, the reliability of the sources, the corroborative nature of other facts alleged, including from other sources, the coherence and plausibility of the allegations, and similar indicia.” Taking up the concern addressed by other circuits about the appropriate amount of deference the witnesses’ statements should receive in the event the statements contain insufficient context or detail, the court resolved that “[i]f anonymous source allegations are found wanting with respect to these criteria, then we must discount them steeply. This is consistent with Tellabs’s teaching that ‘omissions and ambiguities count against inferring scienter’ under the PSLRA’s particularity requirements.”
Thus the 3rd Circuit joined the other circuit courts of appeal that permit consideration of confidential witness statements, so long as the statements are pled with sufficient specificity to enable a trial court to make an appropriate determination of the veracity of the informants’ information and the context in which they acquired such information.
Advice for Practitioners
Each circuit court that has evaluated the proper mechanism for examining confidential witness statements in PSLRA complaints has reached a similar conclusion: that such statements are not unworthy of consideration in assessing whether a complaint sufficiently alleges scienter on the part of the defendants merely because the statements are provided on an anonymous basis. Nevertheless, all reviewing courts have also determined that such statements must contain ample details about the witnesses’ backgrounds and basis for knowledge, and about the facts alleged, to be considered sufficiently trustworthy and deserving of consideration by a court in evaluating a motion to dismiss.
The post- Tellabs decisions addressing confidential witness statements have articulated clearly identifiable indicia of legitimacy, the absence of which will likely lead a court to question the veracity of the statements. To properly plead scienter by utilizing confidential witness statements, a securities fraud complaint should:
• Allege facts in the greatest detail possible, as the more detail a statement contains, the greater the likelihood the court will find it compelling.
• Provide sufficient information about the confidential witness, including the witness’ position within the company, approximate dates of employment, and basis for knowledge of the facts alleged.
• Explain how the witness came to possess knowledge of the facts alleged, whether by first-hand communications, observing documents in the course of the witness’s employment, or otherwise.
• Corroborate, as extensively as possible, the facts alleged by each confidential witness, to further assure the court of the witness’s legitimacy.
A securities litigator’s perspective on the circuit courts’ post- Tellabs approach to confidential witness statements will likely depend on whether the lawyer represents primarily plaintiffs or defendants, and on the frequency with which they employ or are confronted with confidential witness statements in complaints. Plaintiffs’ attorneys may consider these standards to be overly burdensome and risk inadvertent identification of witnesses who have provided information on the assurance that their identities will be protected. These attorneys should remember, however, that confidential witness statements were never intended to be taken as gospel, and should be amply corroborated by independent evidence to achieve the maximum impact. Defense attorneys may consider the standards to be overly relaxed because they fear that opportunistic counsel may take advantage of such standards by embellishing or misrepresenting the true identities and factual bases of confidential witnesses. These attorneys should remember that Congress intended the PSLRA to level the playing field in securities litigation, but not to fix the match in favor of the defense.
Courts appear to share some of the trepidation that may be foremost in some practitioners’ minds, at least those members of the defense bar concerned with the veracity of allegations attributed to confidential sources in PSLRA complaints. In a recent summary order, the 2nd Circuit took notice of the availability of court-ordered depositions of anonymous witnesses to verify their assertions in the complaint. In that case, Campo v. Sears Holding Corp. , the court noted with approval the district court’s order that the confidential witnesses whose statements were employed in the complaint be deposed.
Although the court concluded that the plaintiffs’ challenge to the district court’s consideration of the deposition testimony was waived on appeal, the court went on to state that “[t]he anonymity of the sources of plaintiffs’ factual allegations concerning scienter frustrates the requirement, announced in Tellabs , that a court weigh competing inferences to determine whether a complaint gives rise to an inference of scienter that is ‘cogent and at least as compelling as any opposing inference of nonfraudulent intent.’ Because Fed. R. Civ. P. 11 requires that there be a good faith basis for the factual and legal contentions contained in a pleading, the district court’s use of the confidential witnesses’ testimony to test the good faith basis of plaintiffs’ compliance with Tellabs was permissible.”
The court reiterated that the deposition testimony was relevant to verify the witnesses’ statements as articulated in the complaint, and that because the district court used the testimony for the “limited purpose of determining whether the confidential witnesses acknowledged the statements attributed to them in the complaint,” the district court had not erred. Thus the court was able to assuage defense counsel’s concerns about the accuracy of confidential witness statements while ensuring plaintiffs’ counsel flexibility in pleading scienter.
While both of these potential perspectives certainly possess legitimate concerns, courts have set forth the path for attorneys to follow in alleging scienter through confidential witness statements. Legitimate claims of fraud should be pursued, and courts have determined that it is proper to consider verifiable, supported statements by confidential witnesses in support of complaints seeking redress for such alleged wrongs. •
Robert L. Hickok is a partner in the commercial litigation practice group of Pepper Hamilton. He is a member of the firm’s management committee and past member of the executive committee. Hickok focuses his commercial litigation practice on matters involving corporate governance, the antitrust laws, federal securities laws and class action defense. He can be reached at 215-981-4583 or email@example.com.
James H.S. Levine is an associate in the commercial litigation practice group of Pepper Hamilton, resident in the firm’s Wilmington office. Levine concentrates his practice on complex commercial and corporate litigation, corporate governance and fiduciary disputes, as well as federal securities litigation. He can be reached at 302-777-6536 or firstname.lastname@example.org.