Almost every securities fraud complaint contains allegations supported by statements of confidential witnesses (CWs). CW statements may be inaccurate, but generally, on a motion to dismiss, the allegations of a complaint are taken as true. Recent cases involving false CW allegations have highlighted the potential for abuse as well as the procedural difficulties defendants face when seeking to attack the veracity of allegations based on CW statements. We review some of the recent cases addressing CW allegations and the procedural devices defendants have used to discredit CW allegations and obtain dismissals at an early stage.
The Private Securities Litigation Reform Act and Plaintiffs’ Use of CWs
In 1995, “prompted by significant evidence of abuse in private securities lawsuits,” Congress enacted the Private Securities Litigation Reform Act (PSLRA), Pub. L. No. 104-67, 109 Stat. 737. One such abuse was the filing of suits alleging fraud against issuers following a drop in stock price “without regard to any underlying culpability of the issuer, and with only faint hope that the discovery process might lead eventually to some plausible cause of action.” See H.R. Rep. No. 104-369, at 31 (1995) (Conf. Rep.). To combat these abuses, the PSLRA introduced a heightened standard for pleading, requiring that plaintiffs plead with particularity facts giving rise to a strong inference that defendants acted with scienter. 15 U.S.C. § 78u-4(b)(2). The PSLRA also imposed a discovery stay while a motion to dismiss is pending, effectively eliminating plaintiffs’ ability to use discovery to uncover the facts necessary to meet the heightened pleading requirements. 15 U.S.C. § 78u-4(b)(3)(B).
Those two aspects of the PSLRA have significantly changed how plaintiffs litigate securities fraud cases. Now plaintiffs’ counsel often conduct an investigation before filing their intended operative complaint, to try to uncover information supporting fraud allegations. The sources of this information are, primarily, current or former company employees or other company insiders. Because these insiders are, purportedly, concerned about retaliation or other consequences from their disclosure of internal company information, plaintiffs do not identify the sources by name. Instead, the sources are described as CWs.
In the use of allegations by CWs as anonymous sources, there is much room for misuse and abuse. A CW might have no foundation for the statements he or she makes, his or her statements might be misunderstood or misconstrued by the investigator or plaintiffs’ counsel, or the statements could be fabricated or misattributed altogether. Although defendants often have reason to doubt the veracity of allegations attributed to a CW, the general rule is that, on a motion to dismiss, allegations in a complaint are accepted as true. And the PSLRA bars discovery before a motion to dismiss. Therefore, there is no clear procedural means for a securities fraud defendant to attack the accuracy of CW allegations before the court rules on its motion to dismiss or, at least, before having to endure the expense of full-blown discovery.
Consequently, defendants have had to engineer their own procedures to bring evidence attacking the veracity of CW allegations before the courts. Defendants have sought pre-motion-to-dismiss discovery, have done their own independent investigations of CWs in connection with motions to dismiss, and have prioritized discovery relating to CWs following the denial of motions to dismiss for evidence supporting a motion for reconsideration. Below, we review how courts have responded to these defense efforts.
Available Protections Against Misuse
Limited discovery. At its discretion, a court can lift the PSLRA’s discovery stay “in order to prevent undue prejudice to a party.” 15 USC § 78u-4(b)(3)(B). The leading case granting pre-motion-to-dismiss discovery relating to CWs is Campo v. Sears Holding Corp., 635 F. Supp. 2d 323 (S.D.N.Y. 2009), in which the court ordered and then considered deposition testimony of CWs in ruling on the motion. The Campo court denied the defendants’ initial motion to dismiss, citing allegations of three CWs, but ordered the depositions of those CWs to test the allegations and determine whether dismissal should have been granted. In readdressing the motion after the CW depositions, the court stated that “[w]ith respect to allegations derived from confidential witnesses, the Court considers only those allegations that later were corroborated by those witnesses in depositions.” The court granted dismissal, finding that a “reasonable person could not infer from the statements these CWs acknowledged in their depositions that [the individual defendants] acted with the requisite recklessness or intent. Two of [the three cited CWs] left the company before the Class Period and none had any contact with either [individual defendant].” On appeal, the Second Circuit found no error because the district court relied on the testimony “for the limited purpose of determining whether the CWs acknowledged the statements attributed to them,” to test the good-faith basis of the plaintiffs’ complaint.
Other courts have been reluctant to follow Campo. For example, in In re Cell Therapeutics, Inc., 2010 U.S. Dist. LEXIS 125782, at *5 (W.D. Wash. Nov. 18, 2010), the defendants submitted declarations from three CWs claiming their statements were taken out of context, misrepresented, or fabricated. Based on those declarations, and citing Campo, the defendants sought to depose two remaining CWs. The court denied the motion, stating “neither the Federal Rules nor the Private Security Litigation Reform Act (PSLRA) supports the practice” of allowing discovery during the pleading stage, except in limited circumstances not present. The court noted that Campo had not been followed elsewhere, that it was not binding, and that the language regarding CW depositions was dictum.
Some defendants, rather than seeking an order allowing pre-motion-to-dismiss discovery, have done their own investigation regarding CWs, and attempted to use evidence regarding CW allegations in a motion to dismiss. In In re St. Jude Medical, Inc. Securities Litigation, 836 F. Supp. 2d 878 (D. Minn. 2011), the defendants located one of the CWs cited in the plaintiffs’ complaint and submitted, with their motion to dismiss, the CW’s affidavit asserting that the complaint misrepresented what she had told the plaintiffs. Although the courtdoubted “the propriety of addressing the factual accuracy of an affidavit” on a motion to dismiss, it did ignore the few allegations attributed solely to that witness. The court in Local 703, I.B. of T. Grocery & Food Employees Welfare Fund v. Regions Financial Corp., 2011 U.S. Dist. LEXIS 93873 (N.D. Ala. Aug. 23, 2011), also allowed the defendants to submit CW affidavits with a motion to dismiss. The complaint cited the CWs for having personal knowledge that the individual defendants were aware of improper changes in loan classifications. Although the court did not discuss why it allowed the defense to submit the affidavits, it cited Campo in explaining that the investigator’s notes were reviewed in camera to determine whether the CWs acknowledged statements attributed to them in the complaint.
Other courts have rejected evidentiary submissions on motions to dismiss. In Belmont Holdings Corp. v. SunTrust Banks, Inc., 2011 U.S. Dist. LEXIS 156309 (N.D. Ga. Sept. 7, 2011), the complaint alleged that the defendants knew their statements regarding SunTrust’s capital and reserves in 2007 were false. The complaint supported these allegations with statements from a CW described as the “Vice President of Risk Management” who “was employed by [SunTrust] from 2005 through 2007” and who, during his time at the company, told the defendants that reserves were inadequate. The defendants argued that the CW left SunTrust in August 2007 and therefore could not attest to matters after that date. The court declined to inquire into that factual assertion on the motion to dismiss, stating that it must view the allegations in the light most favorable to the plaintiffs and must therefore assume the CW did have personal knowledge. The court did say, however, that if it later surfaced that the CW did not have personal knowledge of events throughout 2007, it would consider whether the plaintiffs’ actions had violated Federal Rule of Civil Procedure 11(b). The subsequent proceedings in SunTrust are discussed below.
Motions for reconsideration. If a court is unwilling to consider evidence contradicting CW allegations at the motion-to-dismiss stage, or if the defendants do not have such evidence at the time of the motion but obtain it later, the defendants may be able to raise the issue at a relatively early stage, through a motion for reconsideration.
That is what occurred in SunTrust, where, following the court’s denial of their motion to dismiss, the defendants obtained several declarations from the CW who was the source of the allegations regarding the defendants’ knowledge of inadequate reserves. Belmont Holdings Corp. v. SunTrust Banks, Inc., 896 F. Supp. 2d 1210, 1221–23 (N.D. Ga. 2012). In those declarations, the CW confirmed that he left the company in August 2007 and knew nothing about the defendants’ knowledge after that time. In considering that evidence, the court noted:
In the securities litigation context, where there is a higher scienter pleading standard under the PSLRA, a district court may reconsider an order denying a motion to dismiss, even where the defendant relies upon extrinsic evidence outside the pleadings, when a manifest factual error was made by the court based on fraud [by the plaintiff], carelessness by [the plaintiff’s] counsel [in making its factual allegations], or by the court’s own misperception of the facts.” The court granted defendants’ motion for reconsideration and dismissed the case, noting that its initial denial was “based on its misperception of the facts due to Plaintiff’s carelessness.
A similar situation arose in City of Livonia Employees’ Retirement System v. Boeing Co., 711 F.3d 754 (7th Cir. 2013). There, the lower court had denied a motion to dismiss a second amended complaint after it had dismissed the prior complaint. The second amended complaint relied on a new CW allegation that certain officers made material misstatements, intentionally deceiving investors about tests of Boeing’s 787-8 Dreamliner aircraft. The defendants deposed the CW, described as “a high-ranking Boeing engineer,” and several other CWs during discovery. The alleged high-ranking engineer denied “virtually everything that the investigator had reported.” The CW was actually a temporary contractor—not an employee—and did not work with Boeing when the tests at issue were conducted. He denied having any personal knowledge of the tests and was not in a position to obtain the information he was alleged to possess. Based on that testimony, the court granted the defendants’ motion for reconsideration and dismissed the complaint. The Seventh Circuit affirmed the district court’s dismissal.
In City of Pontiac General Employees Retirement System v. Lockheed Martin Corp., 2013 U.S. Dist. LEXIS 96895 (S.D.N.Y. July 9, 2013), following an unsuccessful motion to dismiss, the defendants took depositions of CWs cited in the complaint, several of whom completely recanted or disputed the statements attributed to them. The defendants brought what they termed a “limited motion for summary judgment” based on the inconsistent CW testimony. The court directed five of the CWs implicated, as well as the investigator, to appear at a hearing to determine the veracity of the complaint. The hearing established that some of the CWs “had been lured by the investigator into stating as ‘facts’ what were often mere surmises, but then, when their indiscretions were revealed, felt pressured into denying outright statements they had actually made.” Although the parties settled the case before the court issued an opinion, the judge, Hon. Jed Rakoff, issued a memorandum anyway “in light of certain issues presented by that motion that are likely to recur in future cases.” The memorandum set out his views on the use of CWs in securities fraud cases, which he viewed as problematic for everyone involved—plaintiffs, defendants, and CWs themselves. But Judge Rakoff concluded that, because of the pleading requirements imposed on plaintiffs by the PSLRA and cases such as Tellabs, Inc. v. Makor Issues & Rights, 551 U.S. 308 (2007), the problems were likely “endemic” to securities fraud actions.
Sanctions. Faulty or outright false CW allegations naturally raise the question of sanctions. A plaintiff’s use of CWs in a complaint must comport with Rule 11, which requires certification that the claims are warranted and that the facts presented are supported by evidence. While Rule 11 applies to pleadings and motions in all cases, in enacting the PSLRA Congress unequivocally intended to “strengthen the application of Rule 11 in private securities actions.” Accordingly, the PSLRA was designed to “impose upon courts the affirmative duty to scrutinize filings closely,” mandating that the court make “specific findings regarding [each party’s and attorney’s] compliance” with Rule 11, and mandating sanctions for any violation thereof. See H.R. Rep. No. 104-369, at 39 (1995) (Conf. Rep.); 15 U.S.C. § 77z-1(c).
However, at least to date, even courts that have granted dismissals due to erroneous CW allegations have not imposed sanctions. The SunTrust court raised the potential for sanctions under Rule 11(b) in its initial denial of the defendants’ motion to dismiss finding plaintiffs’ counsel’s conduct “troubling,” but in a “close and reluctant call,” no sanctions were issued. The court stated that “Plaintiff’s counsel carelessly—or cleverly—led the Court to believe” that the CW had knowledge that was personal and current throughout 2007, when in fact it was not. The plaintiffs’ counsel never met with or interviewed the CW to evaluate his credibility, and their “laundry list of explanations and excuses [was] itself disturbing.” However, the court found that because the investigator had misleadingly reported the factual support the plaintiffs relied on for the complaint, the plaintiffs’ conduct was merely careless and did not warrant sanctions.
The Seventh Circuit addressed the issue of sanctions in Boeing, discussing the plaintiffs’ lack of diligence and noting that counsel’s failure to inquire into a “red flag” raised by their investigator was akin to “ostrich tactics,” “reveal[ing] stronger evidence of their scienter regarding the authenticity of the confidential source than the flimsy evidence of scienter they were able to marshal against Boeing.” It stated “[r]epresentations in a filing in a federal district court that are not grounded in an ‘inquiry reasonable under the circumstances’ or that are unlikely to ‘have evidentiary support after a reasonable opportunity for further investigation or discovery’ violate” Rule 11. The court also noted that plaintiffs’ counsel was the same law firm criticized for similar conduct in SunTrust and several other cases. Despite all this, the court found that whether to assess sanctions was more properly the province of the district court and thus remanded.
A securities fraud defendant fighting a complaint with potentially false CW allegations faces a difficult, but not impossible, path to resolution. For the most part, courts are reluctant to consider disputes regarding the accuracy of CW allegations in the context of a motion to dismiss, although they seem to be more receptive to such evidence in the context of a motion for reconsideration. And, while courts do not seem eager to impose sanctions, even in the case of repeat offenders, if more examples of such misconduct arise, courts will, presumably, become more receptive to defense arguments on the issue and more willing to punish offenders.