The Seventh Circuit several years ago questioned its ability to rely on confidential witness allegations in securities class actions governed by the Private Securities Litigation Reform Act. In the often cited Higginbotham v. Baxter Int'l Inc., 495 F.3d 753, 756-57 (7th Cir. 2007), the court said: "It is hard to see how information from anonymous sources could be deemed 'compelling' or how we could take account of plausible opposing inferences. Perhaps these confidential sources have axes to grind. Perhaps they are lying. Perhaps they don't even exist."
In City of Livonia Employees' Retirement Sys. v. The Boeing Company (7th Cir. Mar. 26, 2013), the Seventh Circuit affirmed the dismissal of a securities class action against Boeing in light of baseless confidential witness allegations and remanded for determination of whether plaintiffs' counsel should be sanctioned under Rule 11.
In Boeing, plaintiffs brought a class action against Boeing and two executives who were alleged to have deceived investors regarding the Company's 787 Dreamliner aircraft — specifically the testing of the aircraft, its delivery schedule and its planned "First Flight." After Boeing announced that the Dreamliner's First Flight had been canceled due to anomalies in certain wing tests and the aircraft's delivery would be delayed, Boeing's stock price dropped and litigation ensued.
The district court dismissed plaintiffs' amended complaint because there was no support for the allegation that Boeing's top executives had made optimistic statements regarding the First Flight at a time when they knew the optimism was unfounded. In other words, i.e., plaintiff had not shown a "strong inference" of scienter as required by Tellabs, Inc. v. Makor Issues and Rights Ltd., 551 U.S. 308, 324 (2007).
In a second amended complaint, plaintiffs added four paragraphs concerning a confidential witness described as "Boeing's senior structural analyst engineer and chief engineer." The new allegations stated that the witness had worked on the wing tests at issue and "had direct access to, as well as first hand knowledge of the contents of, Boeing's 787 stress test files that memorialized the results of the failed 787 [wing tests]." Expressly relying on these new allegations to establish scienter, the district court denied the defendants' motion to dismiss.
The witness, subsequently identified as Bishnujee Singh, then provided a declaration and deposition testimony in which he denied that he was the source of the information attributed to him. In fact, Singh had never been a Boeing employee; he had been employed by a contractor for Boeing. He began working at Boeing months after the events at issue, and he denied having any personal knowledge of the wing testing documents or their circulation to Boeing executives. Moreover, he never met plaintiffs' counsel until he was deposed by defendants' counsel. Agreeing with the defendants that there had been a "fraud on the court," the district court granted the defendants' motion for reconsideration and dismissed the case with prejudice. City of Livonia (N.D. Ill. Mar. 7, 2011).
On appeal, the Seventh Circuit noted that plaintiffs' counsel initially had vouched for the accuracy of its investigator's report on which the Singh allegations were based. At oral argument, however, plaintiffs' counsel said that Singh would not be a witness for the plaintiffs. With plaintiffs having abandoned their only source of allegations supporting scienter, the Seventh Circuit affirmed the dismissal of the action. Plaintiffs argued that the district court could not consider Singh's deposition and declaration without converting the defendants' motion to dismiss into a motion for summary judgment. The Seventh Circuit rejected this challenge because plaintiffs' abandonment of Singh, the only source of information that might have established fraud, meant that the original dismissal of the complaint should stand.
The Seventh Circuit next considered whether plaintiffs' counsel should be sanctioned under Rule 11. The court said the fact that counsel had not spoken to Singh and their investigator had expressed qualms about her ability to verify what Singh allegedly had told her was a "red flag" (and counsel's failure to inquire further suggested potential "ostrich tactics"). The Seventh Circuit remanded, however, because the district court was in a better position to consider whether to impose Rule 11 sanctions.
Defendants' efforts to challenge confidential witness allegations with declarations from those witnesses disavowing statements attributed to them are not new. Courts have been reluctant, however, to consider these declarations when deciding a motion to dismiss.
In In re Par Pharmaceutical Securities Litigation (D.N.J. Sept. 30, 2009), the defendants moved to strike paragraphs of plaintiffs' complaint and sought attorneys' fees based on a confidential witness's declaration that the plaintiffs' private investigator misquoted her, took information out of context and ignored other information she had provided.
Because the PSLRA requires a stay of discovery, the court felt constrained to deny the motion to strike the allegations in plaintiffs' pleading so as to avoid discovery and a motion to strike every time confidential witnesses are cited in a complaint. See also e.g., In re St. Jude Medical Inc. Sec. Litig., 836 F. Supp. 2d 878, 901 n.9 (D. Minn. 2011) ("This court doubts the propriety of addressing the factual accuracy of an affidavit on a Rule 12(b)(6) motion."); In re Proquest Sec. Litig., 527 F. Supp. 2d 728, 740 (E.D. Mich. 2007) (stating that defendants had engaged in "inappropriate discovery" in obtaining declaration of confidential witness during the discovery stay).
Campo v. Sears Holdings Corp., 635 F. Supp. 2d 323 (S.D.N.Y. 2009), gave defendants hope that flawed confidential witness allegations could be exposed promptly. There, the court ordered the deposition of three confidential witnesses to determine whether they supported the allegations attributed to them for purposes of the defendants' motion to dismiss. After considering "only those [confidential witness] allegations that later were corroborated by those witnesses in depositions," the court granted the defendants' motion to dismiss. 635 F. Supp. 2d at 330.
The Second Circuit found no error in the district court's order that the confidential witnesses be deposed or in its consideration of the deposition testimony in weighing the plaintiffs' allegations because the court "relied upon the deposition testimony for the limited purpose of determining whether the confidential witnesses acknowledged the statements attributed to them in the complaint." Campo, 371 Fed. App'x 212, at *3 n.4 (2d Cir. 2010).
While many commentators in the defense bar thought Campo would begin a trend, that optimism was unfounded. The few courts that since have considered the issue have rejected attempts to depose confidential witnesses in advance of a motion to dismiss ruling as unsupported by the PSLRA and the Federal Rules of Civil Procedure. See e.g., In re Cell Therapeutics Class Action Litigation (W.D. Wash. Nov. 18, 2010) (rejecting Campo and denying a motion to depose two confidential witnesses,); St. Jude Medical, 836 F. Supp. 2d at 912 n.15 (finding "no authority" for allowing depositions prior to ruling on motion to dismiss and citing PSLRA discovery stay).
Even after a motion to dismiss has been denied, however, defendants continue to challenge the confidential witness allegations that allowed plaintiffs' pleadings to survive. These efforts too have been largely unsuccessful. In In re Dynex Capital Inc. Securities Litigation, (S.D.N.Y. May 5, 2011) (Freeman, M. J.), adopted by 2011 U.S. Dist. LEXIS 67756 (S.D.N.Y. June 6, 2011), for example, the court denied defendants' motion to dismiss with prejudice as a sanction where six of nine confidential witnesses had denied in sworn declarations that they made the statements attributed to them.
Plaintiffs' counsel, of course, countered with their own declarations, and the court called the evidence "a collection of competing declarations" that was insufficient to establish a fraud on the court. The court also accepted as possible plaintiffs' suggestion that the witnesses were now denying their prior negative statements "to remain in the good graces of their former employer."
In other cases, courts have determined that witnesses' sworn statements did not necessarily conflict with the statements attributed to the witness in the prior pleading. See, e.g., Minneapolis Firefighters' Relief Association v. Medtronic, 278 F.R.D. 454 (D. Minn. 2011) (differences in what thirteen witnesses said in their declarations and allegations in the plaintiffs' amended complaint were "mostly innocuous" and, in many cases, witnesses simply challenged the "implication" that plaintiffs drew in the pleading); Local 703, I.B. of T. Grocery and Food Employees Welfare Fund v. Regions Fin. Corp. (N.D. Ala. Aug. 23, 2011) (review of witness affidavits and plaintiffs' investigators' notes did not suggest that the complaint's allegations were necessarily inconsistent with the witnesses' more recent averments).
Boeing, however, is not the only case to reconsider a motion to dismiss based on confidential witness allegations that were exposed as untenable. In Belmont Holdings v. SunTrust Banks (N.D. Ga. Sept. 7, 2011), the court dismissed plaintiff's complaint, which alleged that certain of the defendants' U.S. Securities and Exchange Commission filings were misleading. Plaintiff then filed an amended complaint adding key scienter allegations attributed to a former SunTrust vice president, and the court determined that those allegations allowed the complaint to survive defendants' motion to dismiss.
The defendants' counsel later submitted two declarations in which the witness said that: (1) he had left his position before the SEC filings were made; (2) he had no knowledge regarding SunTrust's operations or financials after he left his position; and (3) he never told plaintiff's investigators that he had knowledge relating to the time period at issue. After examining the witness's declarations and the declaration of the plaintiff's investigator, the court found insufficient support for the allegations in plaintiff's amended complaint. The court granted reconsideration to correct a "manifest factual error" and dismissed the claims with prejudice. Belmont Holdings v. SunTrust Banks (N.D. Ga. Aug. 28, 2012). While calling the conduct of plaintiff's counsel "troubling," the court's "close and reluctant call" was that the conduct did not violate Rule 11.
More recently, Judge Jed Rakoff wrestled with these issues after denying — largely based on information attributed to confidential witnesses — defendants' motion to dismiss in City of Pontiac General Employees Retirement System v. Lockheed Martin, 875 F. Supp. 2d 359 (S.D.N.Y. 2012). Lockheed Martin weeks later sought summary judgment when four of the six confidential witnesses disputed telling plaintiffs' investigators the information attributed to them.
In an attempt to determine "who the heck tried to pull a fraud on this court," on Oct. 1, 2012, Judge Rakoff heard seven hours of testimony from the witnesses and the plaintiffs' investigator and asked questions himself. When the hearing ended, Judge Rakoff opined that some of the witnesses were credible, others were not credible, and the plaintiffs' investigator was credible "on the whole." He questioned, however, whether "double" and "triple" hearsay could support an allegation in a complaint. Ultimately, Judge Rakoff summarily denied Lockheed Martin's motion for summary judgment. The parties settled the case a few weeks later.
Defense counsel no doubt will be emboldened by the Seventh Circuit's decision in Boeing. Simple themes emerge from these cases, however. First, the defendants' chances of obtaining dismissal of a complaint and/or sanctions are slim if there are multiple confidential witnesses purportedly supporting plaintiffs' version of events. Second, a witness must not only dispute what was attributed to him or her, but corroborating facts must support the conclusion that the witness either did not say what was attributed to him or her, or the witness was lying if he or she made such statements. The odds of obtaining the dismissal achieved in the Boeing case are long, but that case shows that a motion to dismiss may be only the beginning of the effort to undermine confidential witness allegations.
Originally published in Law360, New York (April 02, 2013, 12:02 PM ET)
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