Confronted with the heightened pleading standards that govern securities fraud claims, plaintiffs increasingly are relying on confidential witness statements to provide the high level of particularity required in their complaints. As case law on the appropriate use and reliability of confidential witnesses continues to develop, defendants and their counsel must determine how best to challenge the adequacy of these allegations.
Before the passage of the Private Securities Litigation Reform Act of 1995 (PSLRA), many companies routinely settled securities cases to avoid the expense of litigation, including massive discovery costs, even where the lawsuits were meritless. The main beneficiaries of these large settlements, which sometimes reached hundreds of millions of dollars, were plaintiffs' lawyers, who received a percentage of each settlement, even where a class, certified only for settlement purposes, received pennies on the dollar of their losses.
Congress enacted the PSLRA to curb this perceived exploitation in private securities litigation. In Congress's view, these nuisance settlements were an unjustified tax on corporate America that did not benefit taxpayers. To restrict the abuse of securities class actions, Congress structured the PSLRA to subject these lawsuits to heightened pleading standards that could weed out weak and implausible claims early and permit only strong claims to proceed to discovery.
The PSLRA's provisions impose a unique set of characteristics for securities fraud class actions, resulting in only slightly more than half of complaints surviving motions to dismiss and far fewer progressing to trial. Because so many securities fraud cases are either dismissed based on inadequacies in the complaint or settled, motions to dismiss in securities class actions take on even more importance than in other types of litigation.
To clear the motion to dismiss hurdle, plaintiffs increasingly have relied on confidential witness statements. Not only can "confidential" witnesses support factual allegations in plaintiffs' complaints, the anonymity of these witnesses makes it more difficult for defendants to evaluate and respond to the allegations. It also gives plaintiffs significant latitude to selectively present the purported statements in a way that is helpful to survive a motion to dismiss, but is not necessarily an accurate or unbiased representation of the witnesses' accounts. Indeed, courts have accused some plaintiffs' counsel of misusing confidential witnesses by mischaracterizing their statements or inserting inflammatory phrases into allegations that amount to lawyers exaggerating the witnesses' actual statements and taking them out of context.
Notably, because the PSLRA also imposes an automatic stay of discovery in securities cases while a motion to dismiss is pending, defendants in these cases are faced with the prospect of moving to dismiss a complaint before learning any information about their anonymous accusers. Defense counsel in securities fraud class actions must therefore understand:
- The pleading standards applicable to securities fraud claims and confidential witness allegations.
- How to assess the reliability of a confidential witness and his allegations at the pleading stage.
- The role of confidential witnesses past the pleading stage, including strategies to uncover the identity of a confidential witness and test his allegations.
- How to challenge confidential witness allegations through motion practice.
Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 10b-5, promulgated by the Securities and Exchange Commission under Section 10(b), provide an implied private right of action to recover damages, based on material misstatements or omissions, or manipulative and deceptive devices, in connection with the sale or purchase of a security (see Superintendent of Ins. v. Bankers Life & Cas. Co., 404 U.S. 6, 13 n.9 (1971)). Section 20(a) of the Exchange Act further imposes liability on any person who directly or indirectly controls any person liable under Section 10(b) or Rule 10b-5, to the same extent as the controlled person (15 U.S.C. § 78t(a)).
By contrast to the typical requirement that a complaint include "a short and plain statement of the claim" showing that the plaintiff is entitled to relief under Federal Rule of Civil Procedure (FRCP) 8(a), securities fraud claims are subject to stringent pleading requirements under FRCP 9(b) and the PSLRA.
FRCP 9(b) requires a party to state with particularity the circumstances constituting fraud or mistake. A defendant may challenge a claim by showing that the plaintiff failed to allege or prove with particularity any one of the following required elements:
- A material misrepresentation or omission.
- A connection with the purchase or sale of a security.
- Economic loss.
- Loss causation.
(Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398, 2407 (2014).)
The PSLRA further heightens the particularity required in a plaintiff's pleading in a securities fraud class action with respect to facts constituting both:
- The violation. For each alleged misrepresentation or omission, the plaintiff must describe why the statement or omission is misleading and, where an allegation regarding the statement or omission is made based on "information and belief," all facts on which that belief is formed (see FRCP 9(b); 15 U.S.C. § 78u-4(b)(1)).
- The requisite state of mind. The plaintiff must establish a strong inference that the defendant acted with scienter, that is, the intent to deceive, manipulate or defraud. The inference must be "more than merely plausible or reasonable — it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent." (Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 314 (2007); 15 U.S.C. § 78u-4(b)(1).)
Where the defendant is a corporate entity, "the pleaded facts must create a strong inference that someone whose intent could be imputed to the corporation acted with the requisite scienter" (In re Gentiva Sec. Litig., 971 F. Supp. 2d 305, 329 (E.D.N.Y. 2013) (internal quotations omitted)).
A complaint that fails to meet either of these standards must be dismissed (15 U.S.C. § 78u-4(b)(3)(A)-(B)).
Additionally, unlike the rules applicable to traditional litigation, the PSLRA imposes an automatic stay of discovery pending a court's decision on a motion to dismiss in a securities case. However, courts are afforded discretion to allow discovery during the pendency of a motion to dismiss "upon the motion of any party that particularized discovery is necessary to preserve evidence or to prevent undue prejudice to that party." (15 U.S.C. § 78u-4(b)(3)(B).)
Plaintiffs in securities fraud class actions increasingly rely on information provided by confidential witnesses to adequately allege scienter. Courts have noted the tension between alleging scienter based on anonymous sources and the requirement that the court weigh the plaintiff's favored inferences against the strength of other plausible inferences (see Higginbotham v. Baxter Int'l Inc., 495 F.3d 753, 757 (7th Cir. 2007)).
To satisfy the heightened pleading standards of FRCP 9(b) and the PSLRA, a complaint relying on confidential witnesses must describe:
- The witness's role and responsibilities with sufficient particularity to establish his reliability and personal knowledge.
- The specific circumstances of when and how the witness came to have the information pleaded that indicates the defendant's scienter.
(See Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981, 995 (9th Cir. 2009); In re Huntington Bancshares Inc. Sec. Litig., 674 F. Supp. 2d 951, 964 (S.D. Ohio 2009); see also Browning v. Amyris, Inc., 2014 WL 1285175, at *18 (N.D. Cal. Mar. 24, 2014).)
ASSESSING THE WITNESS AND HIS ALLEGATIONS DURING THE PLEADING STAGE
Confidential witnesses typically are former employees identified by private investigators hired by plaintiffs' law firms. The PSLRA and decisions such as Tellabs have had the unintended consequence of turning plaintiffs' counsel "into corporate 'private eyes' who would entice naive or disgruntled employees into gossip sessions that might help support a federal lawsuit" (City of Pontiac Gen. Employees' Ret. Sys. v. Lockheed Martin Corp., 952 F. Supp. 2d 633, 638 (S.D.N.Y. 2013)). As a result, many confidential witnesses have complained of pleadings that "inaccurately attributed facts and statements to them" (In re Millennial Media, Inc. Sec. Litig., 2015 WL 3443918, at *12 (S.D.N.Y. May 29, 2015) (collecting cases)). Indeed, the temptation to manipulate confidential witness statements is amplified because defendants have limited means of challenging these allegations while the automatic PSLRA discovery stay is in place.
Certain circumstances surrounding a confidential witness's relationship with the company may signal problems with the strength of the allegations. As courts have noted, anonymous sources may be "lying," "have axes to grind" or not "even exist" (Higginbotham, 495 F.3d at 757; see also City of Livonia Employees' Ret. Sys. & Local 295/Local 851 v. Boeing Co., 711 F.3d 754, 759 (7th Cir. 2013) ("sources may be ill-informed, may be acting from spite rather than knowledge, may be misrepresented, may even be nonexistent")).
RELIABILITY OF THE CONFIDENTIAL WITNESS
Courts have taken particular issue with the reliability of information from confidential witnesses who:
- Have left the company. Former employees who are dissatisfied with the circumstances of their departure from the company may present a negatively biased view of the company or have ulterior motives (see Higginbotham, 495 F.3d at 756-57; City of Livonia, 711 F.3d at 759; see also Millennial Media, 2015 WL 3443918, at *6-9).
- Are low-level personnel opining on management-level issues. Low-level employees often have limited or no access to decision-making discussions of top management and offer only "mere surmises" stated as fact to support allegations of the executives' scienter (see, for example, City of Pontiac, 952 F. Supp. 2d at 636-37; Sarafin v. BioMimetic Therapeutics, Inc., 2013 WL 139521, at *19 (M.D. Tenn. Jan. 10, 2013)). Courts have required these types of allegations to be sufficiently particular "to support the probability that a person in the position occupied by the source would possess the information alleged" (Novak v. Kasaks, 216 F.3d 300, 313-14 (2d Cir. 2000); Sorkin, LLC v. Fischer Imaging Corp., 2005 WL 1459735, at *7 (D. Colo. June 21, 2005) (discounting allegations where the witness's job title was inconsistent with the subject of the statements); but see, for example, In re Countrywide Fin. Corp. Deriv. Litig., 554 F. Supp. 2d 1044, 1058 n.10 (C.D. Cal. 2008) (declining to discount witnesses based solely on their low level)).
- Did not work in the relevant department or group. Courts are skeptical of confidential witness allegations concerning unrelated departments or groups (see, for example, Cal. Pub. Employees' Ret. Sys. v. Chubb Corp., 394 F.3d 126, 148-49 (3d Cir. 2004) (dismissing complaint that failed to explain "how or why such employees would have access to the information they purport to possess"); Millennial Media, 2015 WL 3443918, at *7-8 (former employee disavowed statements attributed to him about company departments with which he did not work)).
- Did not work at the company during the class period. Witnesses whose tenure does not coincide with the applicable period for the alleged fraud are viewed with suspicion (see, for example, In re Ceridian Corp. Sec. Litig., 542 F.3d 240, 247 (8th Cir. 2008); Local 295/Local 851 IBT Employer Group Pension Trust & Welfare Fund v. Fifth Third Bancorp, 731 F. Supp. 2d 689, 722 (S.D. Ohio 2010); Malin v. XL Capital Ltd., 499 F. Supp. 117, 141-42 (D. Conn. 2007)). However, courts acknowledge that statements by these witnesses may be relevant if the plaintiff can establish a connection to the class period (see, for example, Institutional Investors Grp. v. Avaya, Inc., 564 F.3d 242, 249 n.13 (3d Cir. 2009) (acknowledging that both post-class period data and pre-class period data can be used to confirm what a defendant should have known during the class period); In re Scholastic Corp. Sec. Litig., 252 F.3d 63, 72 (2d Cir. 2001)).
- Report only rumors or speculation. Many judges have shown little tolerance for the presentation of hearsay, rumors, innuendo or gossip as competent evidence of fraud (see, for example, Zucco Partners, 552 F.3d at 997-98; Horizon Asset Mgmt. Inc. v. H & R Block, Inc., 580 F.3d 755, 764-65 (8th Cir. 2009); Chubb, 394 F.3d at 155; In re Ferro Corp. Sec. Litig., 2007 WL 1691358, at *12 (N.D. Ohio June 11, 2007); In re ESS Tech., Inc. Sec. Litig., 2004 WL 3030058, at *10 (N.D. Cal. Dec. 1, 2004)).
RELIABILITY OF THE ALLEGATIONS
Besides the nature of the confidential witness's role in the company, courts have developed varying criteria for assessing the reliability of the underlying allegations, including review of:
- The level of detail provided by the witness.
- The corroborative nature of other facts alleged (including from other sources).
- The coherence and plausibility of the allegations.
(See Institutional Investors, 564 F.3d at 261-62.)
Where plaintiffs properly plead confidential witness statements and the basis for their knowledge, courts will assign considerable weight to their allegations (see, for example, Halford v. AtriCure, Inc., 2010 WL 8973625, at *7 (S.D. Ohio Mar. 29, 2010) (crediting confidential witness allegations where the complaint detailed actions by individual defendants that the witnesses personally observed)).
By contrast, most courts are skeptical of confidential witnesses who essentially are commenting on issues of which they have no personal knowledge. Moreover, even if a statement made by one confidential witness appears to be corroborated by other confidential witnesses, a court must evaluate the credibility of each statement in light of each witness's specific circumstances. For example, courts have refused to credit confidential witness allegations where a complaint:
- Does not clearly state the basis for the witness's knowledge, including where it:
- identifies a confidential witness only by his title (see Ind. State Dist. Council of Laborers & Hod Carriers Pension & Welfare Fund v. Omnicare, Inc., 583 F.3d 935, 946 (6th Cir. 2009)); or
- fails to identify "how or why" the confidential witnesses "would have access to the information they purport to possess" and whether "they are relaying information received first, second, or even third hand" (City of Austin Police Ret. Sys. v. ITT Educ. Servs., Inc., 388 F. Supp. 2d 932, 943 (S.D. Ind. 2005)).
- Relies on only vague or conclusory confidential witness allegations of generalized, company-wide knowledge or senior management's consciousness of wrongdoing, instead of specifying the defendants that knew about any misconduct "and what, when, where, and how they knew" (Ley v. Visteon Corp., 543 F.3d 801, 811 (6th Cir. 2008); see also Metzler Inv. GMBH v. Corinthian Colls., Inc., 540 F.3d 1049, 1068 (9th Cir. 2008); Sorkin, 2005 WL 1459735, at *7-8; In re Vertex Pharm. Inc. Sec. Litig., 357 F. Supp. 2d 343, 354 (D. Mass. 2005)).
- Includes statements from many anonymous witnesses that are not adequately pled, because it is "the quality of the allegations, rather than the quantity" that is most critical when pleading a securities fraud claim (In re Career Educ. Corp. Sec. Litig., 2006 WL 999988, at *11 n.14 (N.D. Ill. Mar. 28, 2006); see also Karpov v. Insight Enters., Inc., 2010 WL 4867634, at *6 (D. Ariz. Nov. 16, 2010) (dismissing complaint with 31 confidential witnesses); In re Huntington Bancshares, 674 F. Supp. 2d at 964 ("a shared opinion among confidential witnesses does not necessarily indicate falsity if the allegations themselves are not specific enough") (internal quotations and alterations omitted)).
IDENTIFYING AND TESTING THE WITNESS OUTSIDE THE PLEADINGS
In addition to challenging the facial sufficiency of confidential witness allegations as pled in the complaint, defendants must determine whether and how to pursue substantive defenses based on challenges to those allegations. If a confidential witness supports the plaintiff as an evidentiary witness beyond the pleading stage, the defendant should seek discovery to undermine the witness's credibility and substantive testimony. By contrast, a confidential witness who disclaims or recants the allegations attributed to him in the complaint may provide the defendant with compelling evidence for a court considering the merits of the plaintiff's claims.
Before responding to confidential witness allegations, defense counsel should try to:
- Identify the confidential witnesses.
- Test the plausibility and reliability of the confidential witness allegations.
IDENTIFYING CONFIDENTIAL WITNESSES
Uncovering the identities of confidential witnesses where possible is a critical step in evaluating the merit of the plaintiffs' case and anticipating the witnesses and other evidence that can support each element of every claim or defense. Counsel should not wait until the conclusion of motion practice challenging the facial sufficiency of the allegations to begin efforts to identify the witnesses. Rather, counsel's first step after receiving a complaint with confidential witness allegations should be to try to identify each witness through internal diligence. Identifying confidential witnesses also should be part of any threshold discovery requests, to be served as early as possible in the litigation.
Courts have declined to impose a per se rule requiring confidential witnesses to be identified before the discovery stay has been lifted and plaintiffs generally do not provide the names of their sources in the complaint. At most, plaintiffs provide basic identifying information for confidential witnesses, such as the period they worked at the company and their general positions and duties (see Box, The Other Side: Best Practices for Plaintiffs' Counsel). However, there are tools available to defense counsel for obtaining more information about the identity of confidential witnesses, even during the pendency of a stay of discovery under the PSLRA.
Where the witness is not alleged to be a current or former employee, counsel should use their best efforts to identify the person based on the information available. Because each case is different, there is no universal means to do this. Although it may not be possible to identify confidential witnesses in every case, especially where only sparing or generic information is available in the pleading, defense counsel should use their ingenuity to probe for the identity of these individuals, such as by:
- Discussing with business-side employees or outside transactional lawyers the third parties most likely to have access to the type of information alleged.
- Interviewing third parties outside the company.
- Conducting internet and social media research on possible candidates.
- Interviewing possible candidates.
If the confidential witnesses are identified as current or former employees of the company, counsel should coordinate with the company's human resources department to determine each person's identity, including by reviewing any employment or other information referenced in the complaint in conjunction with the respective statements made by each witness. The identifying information provided may be vague, so counsel may have to consider a number of individuals initially.
Where counsel is reasonably certain that a confidential witness is one of several current or former employees, counsel should:
- Perform due diligence on all possible candidates. This
diligence includes reviewing human resources files to determine:
- who worked with the confidential witness;
- the witness's job responsibilities;
- the likely knowledge base for the witness's information;
- any notable events that occurred during the witness's employment; and
- the circumstances surrounding the witness's departure from the company.
- Conduct interviews with current employees. These interviews can
help counsel assess the likelihood that the confidential witness
will be friendly to the company, and the extent to which the
allegations attributed to the witness are accurate and based on his
personal knowledge. In many cases, counsel should interview the
witness's supervisors and team members to fill in any gaps
identified during counsel's review of the witness's human
resources files, including to determine:
- the scope of his duties;
- information to which he had access;
- whether he had any interaction with top management;
- his general attitude toward the company; and
- why he left the company.
- Consult with executives and individual defendants. By meeting with top management, counsel can determine whether the executives knew the witness and, if so, learn about the extent and scope of their interaction with him.
- Run searches through the defendants' electronically stored information. A search intended to capture documents created or received by a confidential witness can help counsel assess the merits of the allegations attributed to that witness in the complaint.
Generally, courts do not make exceptions to a PSLRA stay except on a showing of good cause. For example, a need for discovery from a witness with a terminal illness is sufficient to justify an exception to the stay, while a desire for discovery to benefit a defendant's motion to dismiss rarely will constitute good cause.
If a court allows discovery to proceed, defendants should serve discovery geared toward identifying confidential witnesses as early as possible. Discovery tools that may allow defendants to identify confidential witnesses include:
- Initial disclosures. Plaintiffs may identify the confidential witnesses in their initial disclosures if the witnesses are "likely to have discoverable information" (FRCP 26) (for sample disclosures, with explanatory notes and drafting tips, search Initial Disclosures on Practical Law).
- Early interrogatories. Defendants should serve interrogatories
on plaintiffs as early as possible (for a collection of resources
to assist counsel with drafting and serving interrogatories, search
Interrogatories in Federal Court Toolkit on Practical Law). These
interrogatories should request that the plaintiffs identify any
confidential witnesses and provide additional relevant information
about the witnesses, such as:
- the dates and circumstances in which the plaintiffs or plaintiffs' counsel contacted the witnesses;
- the details of the witness interviews, including the length of the interviews, the attendees and whether any contemporaneous notes or recordings were taken;
- whether the plaintiffs provided any compensation to the witnesses;
- whether plaintiffs' counsel contacted any former employees or other individuals who refused to serve as a confidential witness; and
- the basis for the witnesses' statements.
TESTING CONFIDENTIAL WITNESS ALLEGATIONS
Once a confidential witness is identified, counsel should consider carefully the importance of the witness's alleged statements to the case and a potential motion to dismiss, and assess the likely risks and benefits in contacting the witness. Counsel should be mindful that the witness may be estranged from the company or otherwise have a hostile attitude that gives him a skewed view of the issues. Further, the witness may have had no first-hand information or only limited access to top management on the relevant issues.
If counsel decides to reach out to a confidential witness, counsel should aim to elicit the same relevant information sought in an early interrogatory, as described above, as well as to:
- Determine whether the witness is represented by counsel, in which case further inquiries should be directed to counsel.
- Corroborate that the witness recalls having contact with plaintiffs' counsel or its representative and, if so, with whom.
- Assess the witness's familiarity with the case and complaint.
- Determine whether the witness is aware of the allegations attributed to him in the complaint.
- Assess whether the witness believes that the allegations attributed to him in the complaint adequately capture his views on the topic.
- Gauge the witness's general attitude toward the company.
- Evaluate the witness's appetite for staying involved in the litigation.
- Establish a positive rapport with the witness.
Additionally, counsel may use discovery tools to test confidential witness allegations, including:
- Document requests. Defendants can request to see any materials the confidential witnesses may have provided to the plaintiffs, as well as transcripts or memoranda of meetings with the confidential witnesses prepared by plaintiffs' counsel or its investigator, and records of any compensation provided to the plaintiff. However, transcripts and memoranda prepared by lawyers may be protected from disclosure by the attorney-client privilege or work product doctrine. (For a collection of resources to assist counsel with navigating document discovery, search Document Discovery Toolkit on Practical Law.)
- Depositions. Counsel can depose the individuals identified as
confidential witnesses and confront these witnesses with the
allegations attributed to them, as well as expose any bias. Should
a witness disavow or otherwise undercut the manner in which his
allegations are used in the complaint, counsel can use this
testimony to support their efforts to challenge the allegations.
(For a collection of resources to assist counsel with preparing for
and taking depositions, search Deposition Toolkit on Practical
Law.) To prepare for these depositions, defense counsel should:
- review the witness's human resources file;
- interview his supervisors; and
- determine what interaction, if any, he had with individual defendants and the issues in dispute.
CHALLENGING WITNESS CLAIMS THROUGH MOTION PRACTICE
A confidential witness's position may be put before the court through motion practice, which may include motions:
- To strike before moving to dismiss.
- To reconsider a denial of a motion to dismiss.
- For summary judgment.
- For sanctions.
MOTIONS TO STRIKE
Particularly in connection with a motion to dismiss where a confidential witness has disavowed part or all of the allegations attributed to him in a complaint, defendants may consider moving to strike confidential witness allegations under FRCP 12(f) (see, for example, Porter v. Fairbanks Cap. Corp., 2003 WL 21210115, at *7 (N.D. Ill. May 21, 2003) (striking an exhibit to a complaint in a debt collection case because the information was attributed to anonymous sources and was not sufficiently reliable)). Motions to strike are entrusted to the sound discretion of the court, and are typically disfavored (see, for example, Cornerstone Staffing Solutions, Inc. v. James, 2013 WL 3568511, at *2 (N.D. Cal. July 12, 2013)).
Where a witness claims never to have either made the statements attributed to him or possessed the relevant knowledge, and agrees to provide the defense with an affidavit to that effect, a court may consider a motion to strike and provide some remedy before addressing a motion to dismiss (see, for example, Dep't of the Treasury of the State of New Jersey v. Cliffs Natural Res., Inc., No. 14-1031, slip op. at 6-7 (N.D. Ohio Mar. 5, 2015) (on a motion to strike, ordering the plaintiff to file an amended complaint and instructing the plaintiff to "reevaluate its confidential witnesses and their statements," and include only those allegations for which the witness had firsthand factual knowledge)). This is one possible way to avoid spending the time and expense of motion to dismiss briefing when the complaint contains obvious misstatements and mischaracterizations.
FRCP 12(f) permits a court to strike from a complaint any allegations that are redundant or:
- Immaterial or impertinent. Immaterial matters have no "essential or important relationship to any of the pleaded claims for relief." Similarly, an allegation is impertinent "if it does not pertain, and is not necessary, to the issues in question in the case." (Cornerstone Staffing Solutions, 2013 WL 3568511, at *1.) Where a confidential witness contradicts the plaintiff's characterizations of his alleged personal knowledge, defense counsel may argue that the allegations attributed to that witness should be struck as immaterial and impertinent. The same is true where a confidential witness fails to corroborate the allegations in his deposition testimony.
- Scandalous. Allegations that gratuitously reflect negatively on a person's moral character, like alleged criminal conduct unrelated to the issues in a case, are considered impermissibly scandalous, such as where plaintiffs accuse defendants of engaging in fraud, securities or otherwise (see, for example, Cornerstone Staffing Solutions, 2013 WL 3568511, at *1-2 (allegations of tax fraud placed an undue emphasis on the criminal nature of a defendant's conduct that were unrelated to the contractual claims at issue in the case); Beck v. Cantor, Fitzgerald & Co., 621 F. Supp. 1547, 1565 (N.D. Ill. 1985) (striking on "information and belief" allegations that company engaged in insider trading)). Although there are not yet reported decisions striking confidential witness allegations as scandalous, pleadings relying on anonymous sources may satisfy this standard.
Motions to strike generally are permitted only within 21 days of being served with a pleading. However, the unavailability of information during this time period may lead a court to find counsel has just cause to make a later filing. (FRCP 6(c), 12(f).)
MOTIONS TO DISMISS OR RECONSIDER
As discussed above, allegations based on confidential witness statements that do not satisfy the relevant pleading requirements may provide grounds for a motion to dismiss for failure to state a claim. In some cases, however, preliminary inquiries may show that a confidential witness is prepared to deny or recant allegations in the complaint. In these cases, defense counsel should consider memorializing the witness's position in a sworn declaration. This type of declaration may be attached to a motion to dismiss as a rebuttal declaration. In practice, however, this approach is unlikely to succeed.
Generally, a complaint's allegations are accepted as true on a motion to dismiss. Therefore, courts often refuse to consider a rebuttal declaration attached to a motion to dismiss because it presents facts outside the pleadings (see, for example, In re Proquest Sec. Litig., 527 F. Supp. 2d 728, 740 (E.D. Mich. 2007) (defendants that sought out and obtained a declaration from a confidential witness to accompany a motion to dismiss "engaged in discovery which was wholly improper"); Waterford Twp. Police & Fire Ret. Sys. v. Smithtown Bancorp., Inc., 2014 WL 3569338, at *4 (E.D.N.Y. July 18, 2014) (declining to consider an affidavit from a confidential witness because it was outside the pleadings)). When presented with rebuttal affidavits, courts may convert a motion to dismiss into a motion for summary judgment (FRCP 12(d)). However, most courts simply ignore allegations addressed in a rebuttal declaration (see, for example, In re St. Jude Med., Inc. Sec. Litig., 836 F. Supp. 2d 878, 901 n.9 (D. Minn. Dec. 23, 2011)).
A more common approach is to request that a court reconsider denial of a motion to dismiss under FRCP 54(b) once the PSLRA discovery stay has been lifted. Under FRCP 54(b), a court may reconsider interlocutory orders, such as orders denying motions to dismiss, where they were based on factual errors. As part of this analysis, a court may consider evidence of the factual errors detected during discovery "for the limited purpose of determining whether its dismissal orders were procured by fraud, carelessness by counsel, or by the court's own misperception of the facts." (City of Livonia Employees' Ret. Sys. v. Boeing Co., 2011 WL 824604, at *4 (N.D. Ill. Mar. 7, 2011).)
Under this approach, the defendant would argue in its motion to dismiss that the court should dismiss confidential witness allegations as unreliable. If the motion is denied, the defendant aggressively presses forward in discovery to promptly depose appropriate confidential witnesses. Once counsel has deposed the confidential witnesses, the defendant can return to the court to seek reconsideration of the motion to dismiss, supported by declarations from the confidential witnesses. To the extent possible, these declarations should not only contradict allegations in the complaint, but offer new information demonstrating that the plaintiffs mischaracterized the witnesses' bases for personal knowledge.
The obvious downside of this approach is that defendants must incur discovery expenses before challenging confidential witness allegations. However, the expense usually is justified given that several courts have granted motions to dismiss on reconsideration in this context, where confidential witness depositions revealed errors in the underlying complaint. For example, in Campo v. Sears Holding Corp., the court denied the defendants' motion to dismiss without prejudice, but ordered the depositions of three confidential witnesses to determine whether dismissal was appropriate. The court then relied on deposition testimony contradicting complaint allegations attributed to a confidential witness to grant dismissal of the complaint. (635 F. Supp. 2d 323, 329-30 & n.54, 334-36 (S.D.N.Y. 2009).)
Similarly, in City of Livonia Employees' Retirement System v. Boeing Co., the defendants deposed the confidential witnesses after their motion to dismiss was denied. Deposition testimony revealed that the primary confidential witness had no personal knowledge of the information he allegedly possessed. Based on this testimony, the court granted the defendants' motion for reconsideration and dismissed the complaint. (2011 WL 824604, at *3-5; see also Belmont Holdings Corp. v. SunTrust Banks, Inc., 896 F. Supp. 2d 1210, 1220-23 (N.D. Ga. 2012) (after considering new evidence from a confidential witness that he had no personal
knowledge of facts attributed to him in the complaint, granting motion for reconsideration and dismissing the case).)
Search Motion to Dismiss: Overview and Motion to Dismiss: Drafting and Filing a Motion to Dismiss, Opposition and Reply for more on motions to dismiss in federal court.
MOTIONS FOR SUMMARY JUDGMENT
If a securities fraud lawsuit is one of the minority of cases to reach the summary judgment stage, the party moving for summary judgment must take the position that there is no genuine issue of fact. In a case relying on confidential witnesses, defense counsel may use evidence from a recanting confidential witness to oppose the plaintiffs' motion for summary judgment to argue that:
- The plaintiffs have no factual basis for an essential element of the case.
- There are no remaining issues of fact and summary judgment should be awarded to the defendant.
MOTIONS FOR SANCTIONS
Defendants challenging inaccurate confidential witness allegations also may consider bringing a motion for sanctions under FRCP 11. This is a drastic tactic and some judges are reluctant to grant sanctions. Unlike motions to dismiss or strike, a motion for sanctions can be made at any time.
FRCP 11 requires a lawyer signing a pleading to certify that the allegations contained in the pleading have evidentiary support, or will have support after a reasonable opportunity for further investigation or discovery. FRCP 11 imposes an affirmative duty on the lawyer to conduct an objectively reasonable inquiry into the facts and law before signing papers that are filed with the court. (See FRCP 11(b)(3); Rentz v. Dynasty Apparel Indus., Inc., 556 F.3d 389, 401 (6th Cir. 2009).)
To support a motion for sanctions, a defendant must demonstrate that plaintiffs' counsel engaged in objectively unreasonable conduct in investigating facts alleged by confidential witnesses. The reasonableness of counsel's investigation is especially important in a securities fraud case because the PSLRA makes FRCP 11 sanctions mandatory if the rule is violated (see 15 U.S.C. § 77z-1(c)(2)). Sanctions may be warranted if:
- A pleading contains allegations that plaintiffs' counsel knew to be false (see, for example, Rentz, 556 F.3d at 394).
- Plaintiffs' counsel makes assurances about a confidential witness without independently speaking to the source or verifying the information the source gave (see, for example, City of Livonia Employees' Ret. Sys. v. Boeing Co., 306 F.R.D. 175, 181-82 (N.D. Ill. 2014); but see Belmont Holdings Corp., 896 F. Supp. 2d at 1220-23, 1231-33 ("reluctantly" declining to impose sanctions on plaintiffs' counsel for relying exclusively on information gained from investigators and falsely representing to the court that a confidential witness had personal knowledge to prove the defendants' scienter)).
- A confidential witness decides not to cooperate with plaintiffs' counsel and disavows his statements, while plaintiffs' counsel defends the allegations based on that witness's statements in court appearances (see, for example, City of Livonia, 306 F.R.D. at 182).
The authors would like to thank Anne Marie Bossart and Aaron Buchman of Cadwalader, Wickersham & Taft LLP for their assistance in preparing this article.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.