Defending Against Confidential Witnesses In Securities Fraud Class Actions

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. PLEADING STANDARDS

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)

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. Scienter. Reliance. Economic loss. Loss causation. (Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398, 2407 (2014).)

THE PSLRA

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).)

SCIENTER

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...