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Congressional hearings, subpoenaed documents, leaked e-mails — securities lawyers need only open the newspaper to find evidence upon which to base a class action against Enron Corp. But the case against the Houston-based energy firm remains a spectacular anomaly, especially in the securities litigation arena. Under the Private Securities Litigation Reform Act (PSLRA), lawyers are often forced to hire private investigators to find enough evidence to survive a motion to dismiss. Until then, the reform act places discovery out of their reach. Now, the 5th U.S. Circuit Court of Appeals is poised to decide a threshold issue for those lawyers: When must they reveal the identities of the confidential sources they increasingly rely on for evidence of fraud? Plaintiffs’ lawyers argue that employees of defendant companies will be unwilling to come forward if they know their identities will be quickly revealed. Defense lawyers counter that the cloak of anonymity provides a dangerous platform to employees with an agenda. The 2nd and 9th U.S. Circuit Courts of Appeal have split on the issue, one which securities lawyers on both sides of the aisle agree is a crucial, unanswered question about the reform act. “The statute says ‘all facts,’ it doesn’t say ‘some facts,’” says securities defense lawyer Robert J. Giuffra Jr., a partner at New York’s Sullivan & Cromwell who, when he was chief counsel to the U.S. Senate Banking Committee, was instrumental in the drafting of the 1995 act. “If you rested a complaint solely on the allegations of some confidential informant,” they should be identified in case “they have a nondisclosure agreement or an axe to grind.” REFORM MANTRA “Show, don’t tell,” is the mantra of the reform act, passed as part of the Republican Congress’ “Contract with America.” Critical of trial lawyers and the increasing number of “stock-drop” lawsuits brought against corporations, Congress passed the law to protect corporate America from frivolous lawsuits. No longer would plaintiffs’ lawyers be able to extract settlements out of companies with the threat of voluminous, time-consuming and exorbitant discovery demands. “Congress’ intention was to stem the race to the courthouse — that plaintiffs’ lawyers would instead conduct thorough investigations of the facts,” says Giuffra, who represents David Duncan, chief auditor of the Enron account for Arthur Andersen and a central figure in both the criminal investigation and securities class actions involving both companies. Congress did this by strengthening the normal, “notice-pleading” standards, which does not require plaintiffs to plead all of the facts that support their allegations. The reform act requires lawyers to find “all” evidence that shows a “strong inference” of wrongdoing before discovery. “If an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed,” the law states. The complaint must also “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” To obtain such information without the benefit of discovery, plaintiffs’ lawyers have used investigators to interview current and former employees of defendant companies. On July 2, 1999, Senior Judge Joseph T. Sneed III, writing in the 9th Circuit’s 2-1 ruling in In Re Silicon Graphics, 183 F.3d970, sided with defense lawyers, saying that such informants must be identified early in any class action litigation. He noted that Congress had considered and rejected attempts by some members to water down the language of the statute’s pleading requirements. But on June 21, 2000, the 2nd Circuit lined up behind plaintiffs’ lawyers, bluntly dismissing Sneed’s reasoning. Judge John M. Walker, writing for a unanimous 2nd Circuit panel in Novak v. Kasaks, 216 F.3d 300, held that plaintiffs did not have to reveal the sources of their information when making their initial allegations. “Plaintiffs who rely on confidential sources are not always required to name those sources, even when they make allegations on information and belief concerning false or misleading statements, as here,” Walker wrote. “The court in Silicon Graphics relied primarily on the hyperbolic statements of legislators attempting (unsuccessfully) to amend the proposed act to lighten plaintiffs’ pleading burden. Our reading of the PSLRA rejects any notion that confidential sources must be named as a general matter. Rather, plaintiffs need only plead with particularity sufficient facts to support those beliefs.” Securities law expert John Coffee Jr., a professor at Columbia University School of Law, says the divide between the circuits isn’t as wide as some litigators have been saying. “ Silicon Graphics can be read to say that sometimes you maybe have to identify confidential informants,” he says. “But Novaks is very clear, although later on discovery may force you to divulge their identity.” Coffee contends that the statute’s “language doesn’t say to state with particularity the provenance of all facts — the witnesses. It means state the facts.” SOURCE CREDIBILITY Robert E, Zimet, a partner at New York’s Skadden, Arps, Slate, Meagher & Flom, says he agrees with Judge Walker’s standard, but only in circumstances where other information has been presented to establish the credibility of a plaintiff’s allegations of securities fraud. Zimet argued on behalf of French telecommunication giant Alcatel on March 4 in New Orleans before the 5th U.S. Circuit Court of Appeals. He claims that in that securities class action, no such connection was made. Alcatel Plaintiffs Group v. Tchuruk, 01-40645. “It is an overstatement of Alcatel’s position to say that we think the district court was requiring the disclosure of confidential sources,” Zimet says. “The literal meaning of the statute is that it could require disclosure of all sources. It doesn’t necessarily follow that you have to put the finger on the witness, but you have to have some credible articulation of sources or basis.” In a brief to the 5th Circuit, plaintiffs cited allegedly misleading statements by Alcatel officers during the class period as grounds for the class action. In their complaint, they allege that Alcatel was trying to drive up the value of its American Depository Shares, currency to be used in a planned $4.4 billion stock-for-stock purchase of Texas-based DSC Communications. The plaintiffs note that the purchase was concluded Sept. 8, just nine days before the company announced that its 1998 earnings would not meet expectations, causing Alcatel’s stock to drop sharply. On Nov. 18, 1999, the U.S. District Court dismissed the case on the grounds that the plaintiffs had failed to show that Alcatel’s public statements were false, or that Alcatel’s officers knew they were false. On June 23, 2000, the court dismissed a second amended complaint because it didn’t address the court’s demand for the confidential sources of plaintiff allegations of securities fraud. “Because disclosure of confidential informants would be an open invitation to retaliation, courts have persuasively concluded that such a disclosure requirement would frustrate rather than further the policies of the securities laws,” countered Samuel Issacharoff, a professor at Columbia University School of Law, in his brief to the 5th Circuit. “The complaint reports specific meetings in Paris and specific reports of cancellation of massive contracts in Thailand, Switzerland and elsewhere.” The specificity of the allegations, he concludes, “more than remedies any deficiencies identified by the district court.” Since the securities litigation act was enacted, law firms have been hiring private investigators to find current and former employees of target companies to disclose book-cooking or other wrongdoing that could support a case. “What we’re doing is going out into the field and hiring investigators, talking with former employees and customers that can point to specific practices and instances of what we are complaining about,” says plaintiffs’ securities lawyer I. Stephen Rabin, of New York’s Rabin & Peckel. “An ex-employee might say ‘Yeah, they shipped it out at the end of the month to someone’s garage and they holed it up there and said it was a customer when in effect it was a company warehouse,’” a classic tactic in accounting fraud cases. Nicholas G. Himonidis, an attorney and president of the Roslyn Heights, N.Y., investigative firm NGH Associates Ltd., says many of his clients are law firms but that the use of private investigators in securities class actions is relatively new. But he notes that, without a guarantee of at least confidentiality, current employees are unlikely to come forward. Plaintiffs’ securities lawyers agree, warning that such reluctance will take the reform act beyond congressional intent and expose shareholders to more fraud. “It would be impossible if whistleblowers wouldn’t blow the whistle,” says Coffee. “If you’re interested in destruction of documents at Enron, you are going to have to have witnesses telling you that. You’re still going to need a firsthand witness.” But Zimet warns that the act’s mandate will go unfulfilled unless federal courts hold to strict interpretation of the threshold pleading requirements. “As a lawyer that defends scores of these cases, and who knows of the coercive impact of the expense of discovery, the damage of exposure is so great, the pressure oftentimes is inexorable to settle cases rather than try them,” he says. “The promise of the PSLRA is that the price of admission to the litigation arena is that a plaintiff has to demonstrate that there is a reasonable prospect their allegations are grounded in hard fact.” Some 478 securities class actions were filed last year, more than double that of 2000 and more than any year since 1991, says Stanford Law School’s Securities Class Action Clearing House. Sixty-two have been filed in 2002. Plaintiffs’ lawyers claim that Zimet’s argument simply rationalizes a standard that will encourage fraud. “Anybody who says anything bad about the company is always labeled as disgruntled,” says Rabin. “The evidence is all in the hands of the corporations — you don’t have access to the books and records. They’re in effect closing the courthouse doors.”

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