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.