Plaintiffs’ lawyers are facing intense judicial scrutiny of problems with their use of “confidential witnesses” (“CWs”) in the Lockheed Martin and SunTrust securities class actions. Courts have recently addressed similar CW problems in two other high-profile securities class actions, Sears Holdings (affirmed by the Second Circuit) and Boeing.
Courts need to scrutinize CWs more closely in deciding motions to dismiss – not just in post-denial motions for reconsideration or summary judgment following CW discovery. After discussing the two current cases, I propose two modest reforms.
Belmont Holdings v. SunTrust Banks
In SunTrust, the court denied defendants’ motions to dismiss the First Amended Complaint (“FAC”), based primarily on purported claims from a CW, Mr. Trapani, that the individual defendants knew that certain financial reporting at the end of 2007 was false.* Mr. Trapani left SunTrust in August 2007, but the FAC alleged that Mr. Trapani worked at SunTrust from “2005 through 2007” and contained several references to information he provided concerning knowledge “throughout 2007.” During the motion to dismiss process, SunTrust asserted that Mr. Trapani left SunTrust in August 2007. The court acknowledged the assertion but expressly left the issue for later, stating it “must assume Trapani had personal knowledge” and if he does not, “the Court will consider later whether these allegations support a violation of the pleading standards under the Federal Rules of Civil Procedure.”
Defendants moved for reconsideration based on declarations from Mr. Trapani that he left SunTrust in August 2007, knew nothing about the challenged financial reporting thereafter, and never told plaintiffs’ investigator that he discussed the individual defendants’ knowledge of SunTrust’s financial reporting thereafter. Based on Mr. Trapani’s declarations, the court reconsidered its motion to dismiss order and dismissed the action. The court “reluctantly” decided against sanctions because it appeared that notes from plaintiffs’ investigator, Ms. Torres, supported the FAC’s allegations based on Mr. Trapani.
So it appeared that plaintiffs’ counsel was off the hook. But they might not be. Ms. Torres contacted the court to say she was concerned about the accuracy of plaintiffs’ counsel’s arguments against sanctions. In particular, she “stated that she had information she wished to share with the Court, including that Plaintiff’s counsel were involved in the interviews of Mr. Trapani and that, in those interviews, Mr. Trapani made clear that he did not have any knowledge after August 2007 ….”
The court has set a hearing for November 9, 2012 to hear more from Ms. Torres, her firm, and the parties. “The Court will, after the proceeding, evaluate whether further inquiry or action is required.”
City of Pontiac General Employees’ Retirement System v. Lockheed Martin
In Lockheed, Judge Rakoff denied defendants’ motion to dismiss. Discovery commenced. Discovery of the CWs revealed two categories of problems: (1) several CWs disputed telling plaintiffs’ investigator the facts the complaint attributed to them; and (2) certain of the CW allegations were not based on the CWs’ personal knowledge because the information they provided was outside of their employment dates and/or job responsibilities. Defendants moved for summary judgment, pointing out the flaws with the CW allegations on which Judge Rakoff relied in denying defendants’ motion to dismiss.
On October 1, 2012, Judge Rakoff held a day-long evidentiary hearing to determine “who the heck tried to pull a fraud on this court.” The 218-page hearing transcript allows a rare look into the securities-class-action-complaint-preparation kitchen. Plaintiffs and defendants submitted post-hearing briefs that slice and dice the complaint’s allegations and evidence revealed during discovery and during the October 1 hearing. At the hearing’s conclusion, Judge Rakoff offered some tentative thoughts about the witnesses’ credibility. He remarked that some CWs were credible and others were not, and that plaintiffs’ investigator was credible “on the whole.”
For more background, see here.
The CW Hearings in SunTrust and Lockheed Martin Demonstrate Two Problems with CW Allegations
Problem One: The first problem is the “who in the heck tried to pull a fraud on this court” problem – CWs who claim not to have told plaintiffs’ investigators the information the complaint attributes to them.
Although it’s not unusual for there to be differences between the complaint’s allegations and what the CWs later say, allegations of fabrication are not common. But, based on the recent cases of potential fabrication, I anticipate that some people might suggest a partial lifting of the discovery stay for depositions of CWs during the motion to dismiss process. I would hesitate to favor such an approach in all cases because it could undermine the defendants’ discovery stay – e.g. it’s hard to strictly confine the CWs’ answers to what they told plaintiffs’ investigators – and thus could do more harm than good in some cases. However, in a case of potential fabrication, and where defense counsel can’t adequately deal with the allegation through motion to dismiss arguments, then I say go for it.
Some might suggest severely limiting the weight to be placed on CWs, or even doing away with their use. Following Tellabs, some courts, including the Seventh Circuit in Higginbotham v. Baxter International, found that an “upshot” of Tellabs is that allegations from anonymous sources must be heavily discounted, and “[u]sually that discount will be steep.” However, in the second Tellabs decision, the Seventh Circuit distinguished Higginbotham on the basis that the problem there was that plaintiffs’ complaint failed to describe the CWs sufficiently – a problem that didn’t exist with the Tellabs plaintiffs’ complaint. Since that decision, judicial focus has generally been on the adequacy of CW descriptions.
Problem Two: Inadequate description of CWs’ employment dates and job responsibilities is the root of the second problem raised by SunTrust and Lockheed. The CWs’ employment dates and job responsibilities are necessary to lay a foundation for the information attributed to a CW so that the court can determine that the information is reliable enough to be probative and, if it is, how probative.
If the complaint accurately describes employment dates and responsibilities, most CW allegations are tame: a lower-level employee with narrow responsibilities opines about company-wide problems; an employee switched to an irrelevant position before the events about which he provides information; an employee provides second- or third-hand information; or someone responsible for Division X opines about Division Y. Courts usually have no problem disregarding or discounting such allegations.
Problems occur, however, when the complaint’s CW descriptions are inaccurate or vague, or fail to plead how the CW knows the alleged information. Even with insufficient descriptions, it is often possible to figure out the CWs’ identities, but defendants are arguably unable on a motion to dismiss to introduce the real facts so that the court can appropriately disregard or discount the CW allegations. SunTrust is a good example of this problem. The defendants pointed out that Mr. Trapani left the company in August 2007. The court appreciated the possibility that the defendants were right, but deferred the issue because of its view that it didn’t have the ability to sort that out on the motion to dismiss.
Two Suggested Reforms
Suggestion One: To address Problem One, the “who the heck tried to pull a fraud on this court” problem, plaintiffs’ counsel should be required to obtain declarations from the CWs. Plaintiffs’ counsel’s likely objection to such a requirement would be that it would deter CWs from cooperating because some won’t want to be involved in the litigation in such a formal way. But a candid plaintiffs’ lawyer should inform CWs that courts increasingly require disclosure and discovery of CWs, so they will become formally involved in the litigation anyway if the defendants’ motion to dismiss is denied. Plaintiffs’ investigator in Lockheed testified that his practice is to tell CWs that he “can’t guarantee . . . that their names might not be revealed later as the litigation progresses” and that it is “possible that further involvement would be obliged of them as the case progresses in discovery.”
Declarations would significantly enhance the accuracy of CW information; what someone is willing to say “anonymously” over the phone can be much different than what he or she will say under penalty of perjury, and plaintiffs’ counsel’s description of CW information in the complaint would better hew to the facts the CWs actually provided. Plaintiffs’ counsel should welcome such a requirement, or only mildly protest it; declarations would protect them from disputes such as those that they are having with the CWs in SunTrust and Lockheed. Such disputes can arise quite innocently – for example, through a misunderstanding or miscommunication during the interview, an error in preparing the interview memo, or a misinterpretation of the interview memo by the lawyer drafting the complaint.
An alternative to a declaration requirement, though probably somewhat less effective, would be verifications from each CW that he or she has read the complaint and approves as true and fairly stated (1) the description of his or her employment dates and job descriptions and (2) the allegations attributed to him or her, and (3) that the complaint does not omit facts that the CW believes are important for a fair understanding of the information he or she provided. A third alternative, but less effective than the first two, would be certifications by plaintiffs’ counsel, as part of his or her Rule 11 obligations, that each CW has verified each of these three items to plaintiffs’ counsel. A fourth alternative would be for plaintiffs’ investigator to verify that the complaint accurately and fairly states the information obtained from the CWs and does not omit information that is important for a fair understanding of what they said.
These suggestions are consistent with the rationale of the Second Circuit’s decision in Sears Holdings, which upheld the district court’s use of deposition testimony to assist the district court in resolving defendants’ motion to dismiss:
The anonymity of the sources of plaintiffs’ factual allegations concerning scienter frustrates the requirement, announced in Tellabs, that a court weigh competing inferences to determine whether a complaint gives rise to an inference of scienter . . . . Because Fed.R.Civ.P. 11 requires that there be a good faith basis for the factual and legal contentions contained in a pleading, the district court’s use of the confidential witness’ testimony to test the good faith basis of plaintiffs’ compliance with Tellabs was permissible. The court made no credibility determinations, nor did it weigh competing testimony. To the contrary, it relied upon the deposition testimony for the limited purpose of determining whether the confidential witnesses acknowledged the statements attributed to them in the complaint. Under these circumstances, we identify no error.
Suggestion Two: To address Problem Two, poor CW descriptions, plaintiffs should be required to precisely describe, at a minimum, the following information for each CW: (1) employment dates – by day, month, and year; (2) employment responsibilities – including job title, job description, and a detailed list of job responsibilities, and the substance and exact date of any changes; and (3) how the CW knows the information the complaint alleges. There can be no reasonable objection to CWs providing these facts. With regard to employment information, CWs know it precisely and, if they don’t recall precisely, they have documents that reflect it. With regard to the basis of knowledge, if the CWs can’t recall the basis, there’s no good reason to credit the other information the complaint alleges. Indeed, under current law, vagueness in these three areas undermines the CW allegations.
If plaintiffs do not precisely plead employment information or if they plead inaccurate employment information, defendants should be entitled to submit targeted employment information that demonstrates that a CW lacks knowledge of the information the complaint pleads about him or her. For example, in SunTrust, imagine the resources the court and parties would have saved had the court simply considered a simple employment document demonstrating that Mr. Trapani left SunTrust in August 2007. That would have left plaintiffs only with the ability to ask the court to infer that Mr. Trapani had post-employment conversations with the individual defendants. At that point, I like defendants’ chances of convincing the court to disregard plaintiffs’ requested inference on the grounds that it isn’t supported by facts, is speculative, and implausible.
* Plaintiffs’ only claims were Securities Act claims, which do not require proof of scienter, but the individual defendants’ state of mind was relevant because the challenged statements concerned reserves, which are statements of opinion and thus false only if they are not genuinely believed. Rule 9(b) applied, the court ruled, because the allegations sounded in fraud.