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March 15, 2017 Articles

Confidential Witness Allegations in Securities Fraud Litigation

A recanting confidential witness may result in a complete dismissal of the complaint, as well as sanctions against counsel.

By Heather Speers – March 15, 2017

Confidential witness (CW) allegations are a byproduct of the Private Securities Litigation Reform Act (PSLRA).

Two aspects of the PSLRA are particularly relevant to the emergence of CW allegations: the heightened pleading standard for falsity and scienter, and the automatic discovery stay in effect while a motion to dismiss is pending. 15 U.S.C. § 78u-4(b)(1), (b)(2)(A), (b)(3)(B).

To meet the heightened pleading standard, plaintiffs must allege particularized facts to support their belief (1) that each of the challenged statements is misleading and (2) that defendants made each misleading statement with the requisite mental state (scienter). Id. § 78u-4(b)(1), (b)(2)(A). In light of the automatic discovery stay, plaintiffs must satisfy this heightened pleading burden without legally mandated access to relevant information, such as internal company documents, emails, deposition testimony, interrogatory responses, or admissions.

This is where CWs come into play. When the fraud allegations concern the conduct of a corporation and/or its officers and directors, the individuals most likely to have relevant information are current and former employees of the company. These individuals, however, may be reluctant to provide information and be named in a complaint out of fear of retaliation by current or future employers. Accordingly, to balance the specificity requirements for pleading securities fraud with the potential unwillingness of individuals to be identified by name in the complaint, plaintiffs customarily rely on CW allegations. In fact, CW allegations “often are the only specific allegations in a complaint supporting a claim of securities fraud.” Gideon Mark, Confidential Witnesses in Securities Litigation, 36 J. Corp. L. 551 (2011).

As a lawyer—whether you represent plaintiffs or defendants—you should be aware of certain case law concerning CWs.

Cautions to Plaintiffs’ Counsel

Counsel should check the private investigator’s work. Case law warns against plaintiffs’ attorneys blindly relying on a private investigator’s work with a CW.

In re Millennial Media, Inc. Securities Litigation is particularly instructive in this regard. 2015 WL 3443918 (S.D.N.Y. May 29, 2015). There, plaintiffs voluntarily dismissed their case after further investigation and the court’s own prodding showed that CWs objected to being quoted in the complaint and disputed the accuracy of the statements attributed to them. Plaintiffs’ counsel admitted that they had never spoken to ten of the eleven CWs identified in the complaint. And when plaintiffs’ counsel finally did contact the other ten CWs, five asked to be removed from the complaint, and three stated that statements attributed to them were inaccurate or presented in a misleading context. Id. at *3–4.

The court noted that in light of plaintiffs’ voluntary dismissal, it “has no occasion to rule on the propriety of counsel’s practices with respect to quoting persons designated as CWs.” Id. at *5. However, for edification of Federal Rule of Civil Procedure 11’s requirement that counsel conduct “an inquiry reasonable under the circumstances,” the court opined thus:

[W]here a Complaint proposes to rely on quotes drawn from an investigator’s memo recounting an unrecorded witness interview, it is reasonable to expect counsel, before filing the Complaint, to attempt to confirm with the witness the statements that counsel proposes to attribute to him and to assure that the Complaint is presenting these statements in fair context.

Id. at *11. Other recent cases are in accord. See, e.g., Lopez v. Ctpartners Exec. Search Inc., 173 F. Supp. 3d 12, 31 n.7 (S.D.N.Y. 2016) (noting that “best practices for counsel who propose to rely on confidential sources” include “attempting to confirm with the witness the statements that counsel proposes to attribute to him so as to assure that the Complaint is presenting these statements in fair context”); Bolling v. Gold, No. C13-0872JLR, 2015 WL 6870617, at *6–7 (W.D. Wash. Nov. 9, 2015) (citing with approval cases criticizing counsel’s failure to personally interview witnesses relied upon in complaint).

Counsel should warn the CW of the risks involved. Additionally, plaintiffs’ counsel should ensure that each interviewee is notified of counsel’s intent to designate him or her as a CW and that such designation may result in the public disclosure of the witness’s name.

Again, In re Millennial Media is informative. There, plaintiffs’ counsel admitted that none of the eleven CWs had been “affirmatively notified” that they would be quoted in the complaint or designated as a CW. In re Millennial Media, 2015 WL 3443918,at *4. Recognizing the pressures that create this situation, the court stated thus:

The PSLRA’s high pleading hurdles no doubt may tempt plaintiffs’ counsel not to alert a helpful witness of the risks to him of being quoted as a CW in a Complaint, lest the witness back away. The issue presented by a law firm’s practice of not notifying an interviewee—unless he asks—that he will be designated as a Confidential Witness is therefore, predominantly, not one of law. It is one of basic decency. When counsel designates an interviewee as a CW, counsel exposes the interviewee to the risk of public disclosure of his name and, potentially, professional or personal tumult.

Id. at *13–14.

Nevertheless, the court stated, CWs have the right to expect more of counsel: they “have a right to expect counsel to treat [them] with decency”; the “right to expect counsel, before designating a person as a CW, to take into account how that person might be affected were this designation to lead to his identification”; and the “right to expect counsel to consider thoughtfully, for each person who submits to an interview, whether the consequences of potentially outing that person are justified—genuinely justified—by counsel’s duty of zealous representation of their clients.” Id. at *14.

Mishandling CWs can result in the dismissal of the complaint and sanctions. In the event that counsel ignores these best practices, they run the risk of confronting the consequences of a recanting CW, which can have varying impacts on counsel and plaintiffs.

Where plaintiffs do not voluntarily dismiss and defense counsel introduces declarations from a recanting CW, courts have taken varied approaches. Some courts have simply ignored declarations of recanting CWs at the motion to dismiss. See, e.g., Dep’t of the Treasury of the State of N.J. & Its Div. of Inv. v. Cliffs Natural Res., Inc., No. 1:14 CV 1031, 2015 WL 6870110, at *4 (N.D. Ohio Nov. 6, 2015) (finding that “issues of fact and credibility raised by Defendants’ witness declarations cannot be determined at the pleading stage”). Others have considered such declarations and disregarded allegations that contradict the CWs’ later statements. See, e.g., Campo v. Sears Holdings Corp., 635 F. Supp. 2d 323, 330 (S.D.N.Y. 2009), aff’d, 371 F. App’x 212 (2d Cir. 2010) (noting that “the Court considers only those allegations that later were corroborated by those witnesses in depositions”). Where such an approach is taken and the complaint relies solely on the CW allegations, a recanting CW may result in a complete dismissal of the complaint, as well as sanctions against counsel. See, e.g., City of Livonia Emps.’ Ret. Sys. v. Boeing Co., 306 F.R.D. 175, 183 (N.D. Ill. 2014).

In City of Livonia, the court ordered sanctions against plaintiffs’ counsel where

[c]ounsel failed to conduct a proper investigation before filing the original complaint; counsel blindly relied on their investigators and failed to verify the truth of the confidential source’s allegations before including them in the second amended complaint; and counsel made repeated misrepresentations to the court as to the strength and truth of the confidential source’s allegations.

306 F.R.D. at 183. While this case may be considered extreme, the court, in finding sanctions appropriate, noted the “history of similar misconduct” of the plaintiffs’ counsel.

In Blasco v. Keurig, Case No. 15cv02766 (N.D. Cal. 2016), defendants moved for sanctions after learning that four of the six CWs cited in the complaint rejected as false the statements attributed to them. Dkt. No. 119. Plaintiffs opposed the motion for sanctions but dismissed the case before the court ruled on the motion for sanctions. Despite the absence of any ruling, the transcript from the hearing on the motion for sanctions evidences the court’s extreme displeasure with the conduct of plaintiffs’ counsel:

I would think that if I were a lawyer and I filed a lawsuit that rested largely on the allegations of confidential witnesses, and then I received declarations from those confidential witnesses saying that significant portions of what . . . I said are not true, then my reaction would not be to simply oppose the sanctions motion and sort of shrug my shoulders and say, well, they said one thing to us and now they’re saying something different; they might be recanting because they’re scared of the defendants, but we stand by what we did. . . .

. . . [T]hat seems inadequate, like an inadequate response, and kind of a troubling response, and potentially an ethically challenged response. . . .

. . . That reaction seems troubling to me, and I wonder if you should be sanctioned for that, because that seems inconsistent with rule 11.

Blasco, Case No. 15cv02766, Dkt. No. 133, at 5–7.

Cautions to Defense Counsel

Counsel should be honest when contacting the CW. Defense counsel often attempt to contact CWs to investigate allegations in the complaint. When doing so, it is imperative that defense counsel act with professional care to avoid any actual or perceived intimidation of witnesses. For example, defense counsel should take care not to mislead CWs into thinking that they have been identified by name in a complaint when they have not.

In In re BofI Holding, defendants’ counsel left messages for certain individuals claiming that the individuals had been “named as a witness” or that “your name’s come up because of the complaint.” 2016 WL 6995482, at *1 (S.D. Cal. Nov. 30, 2016). Arguing that the messages were not “harassing,” defendants tried to shift the blame, arguing that it was “Lead Plaintiff and their counsel who were at fault for falsely assuring CWs that their identities would be kept secret.” Houston Mun. Emps. Pension Sys. v. BofI Holding, Inc., No. 15CV2324 GPC (KSC), 2016 WL 4521656, at *2 (S.D. Cal. Aug. 26, 2016), rev’d in part sub nom., In re BofI Holding, Inc. Sec. Litig., 2016 WL 6995482.

This argument misses the point. As the district court noted,

[d]efendants’ language in communicating with the confidential witnesses, suggesting that they had been “named” in the complaint, had and has the potential to mar the credibility of Lead Plaintiff’s counsel in the eyes of the witnesses, to influence them so as to not cooperate with Lead Plaintiff moving forward, or even to pressure confidential witnesses to give untruthful statements.

In re BofI Holding, Inc., 2016 WL 6995482, at *6.

The magistrate found defense counsel’s conduct so unacceptable that it granted plaintiff’s request for a protective order prohibiting defense counsel from “contacting or attempting to contact . . . any former BofI employees for any purpose related to this litigation.” Houston Mun. Emps. Pension Sys., 2016 WL 4521656, at *3. On appeal, the district court agreed that a protective order was necessary, but with a more narrowed scope. In re BofI Holding, Inc., 2016 WL 6995482, at *7.

Counsel should not question CWs about their interactions with plaintiffs’ counsel. Asking about interactions with plaintiffs’ counsel is unnecessary and can lead to disputes regarding work product privilege. Courts take different views on work product, but one court reasoned thus: “Although the identity and location of witnesses that may have knowledge of any discoverable matter is not protected, the identity of witnesses interviewed by opposing counsel is protected.” Ferruza v. MTI Tech. Corp., No. SACV 00-0745 DOC, 2002 WL 32344347, at *3 (C.D. Cal. June 13, 2002).

In In re BofI Holding, the court warned that “if Defendants were to interview confidential witnesses relied upon by Lead Plaintiff in the complaint, and to ask questions regarding the witnesses’ interactions or communications with Lead Plaintiff, that conduct would raise serious concerns about the exposure of Lead Plaintiff’s attorney work product.” 2016 WL 6995482, at *6. Accordingly, the protective order also prohibited defense counsel from “seeking to obtain Lead Plaintiff’s attorney work product from such former employees.” Id. at *7.

The court further warned that if the protective order was intentionally violated, the court would consider sanctions.

In light of the PSLRA, current and former employees play a crucial role in the vast majority of securities fraud class action complaints. However, both plaintiffs’ counsel and defense counsel are cautioned that involvement of these individuals may come at a cost—both to the witness and to counsel. To avoid any negative repercussions, counsel should act with professionalism, courtesy, and decency, ensuring that each witness understands his or her involvement in the case and the potential repercussions that may follow from such involvement.

Heather Speers is an associate at Cooley LLP in San Diego, California.