Confidential witnesses in securities litigation.

Author:Mark, Gideon
 
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  1. INTRODUCTION II. CONFIDENTIAL WITNESSES IN SECURITIES FRAUD LITIGATION PRIOR TO TELLABS III. TELLABS AND HIGGINBOTHAM A. The Supreme Court Decision in Tellabs B. Application of Tellabs by the Federal Courts 1. Higginbotham and Tellabs II 2. Higginbotham's Influence IV. HIGGINBOTHAM IS INDEFENSIBLE A. Tellabs Provides No Support for Higginbotham's Conclusion That Information From Confidential Sources Cannot Be Deemed Compelling B. Higginbotham Is Undercut By Rule 11 and the PSLRA 's Sanctions Provision C. Disclosure of Confidential Witnesses Is Not Inevitable Under Rule 26 1. Initial Disclosures Under Rule 26(a)(1) 2. Work Product Protection 3. Public Policy D. The Informant's Privilege Justifies Non-Disclosure of Confidential Witnesses E. The Reporter's Privilege Justifies Non-Disclosure of Confidential Witnesses F. Whistleblower Statutes Fail to Adequately Protect Confidential Witnesses V. CONCLUSION I. INTRODUCTION

    The use of confidential witnesses in class action securities litigation has become ubiquitous in the years since Congress enacted the Private Securities Litigation Reform Act of 1995 (PSLRA or Act) (1) in an effort to curb perceived abuses by plaintiffs' lawyers in securities litigation. (2) Two specific aspects of the PSLRA have driven this trend to use anonymous sources for facts alleged in securities fraud complaints. First, Congress raised the bar for pleading securities fraud. Second, Congress mandated a stay of discovery in all private securities litigation during the pendency of a motion to dismiss, subject to two limited exceptions.

    In particular, the PSLRA imposed two distinct pleading requirements, both of which must be met in order for a complaint to survive a motion to dismiss. When plaintiff's claim is based on alleged misrepresentations or omissions of a material fact, the complaint must specify each allegedly misleading statement, the reason(s) why the statement is misleading, and, if an allegation is made on information and belief, "all facts" supporting that belief with particularity. (3) In addition, the complaint must, with respect to each act or omission alleged to constitute a securities violation, "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." (4)

    Congress coupled the PSLRA's strict pleading standard with a mandatory stay of discovery during the pendency of a motion to dismiss, (5) absent application of one of two statutory exceptions. (6) Thus, so long as a motion to dismiss by any defendant is pending, or even contemplated, (7) discovery (expedited or otherwise) is stayed for the entire case--even if there are multiple defendants, some of whom have had both their motions to dismiss denied and have answered. (8) Because the stay includes motions to dismiss amended complaints (9) and motions for reconsideration of orders on motions to dismiss, (10) it is of great practical significance. Given the frequency with which original complaints are amended in securities litigation, the net result can be that many months or even years pass before discovery begins in earnest. (11) This is the typical pattern, because plaintiffs have generally failed in their efforts to have the PSLRA's mandatory discovery stay lifted, under either the first (12) or second (13) statutory exceptions.

    The combination of the PSLRA's strict pleading requirements and discovery stay explains why the use of confidential witnesses has become so common. Plaintiffs must plead their cases with particularity, but they are generally barred from obtaining discovery to bolster their allegations until after all motions to dismiss have been decided. (14) The result has been almost universal reliance by plaintiffs in class action securities complaints on information provided by confidential witnesses. (15) Allegations based on such information often are the only specific allegations in a complaint supporting a claim of securities fraud. (16)

    The use of confidential witnesses, who typically are current or former employees, customers, or suppliers (17) fearful of retaliation if their identities are disclosed, (18) has raised significant issues concerning pleading and discovery in securities cases. The primary pleading issue is whether and to what extent the information provided by confidential witness must be discounted in the aftermath of the 2007 decision by the United States Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd. (19) In that case the Court resolved a circuit split concerning interpretation of the "strong inference" standard. The Court did not address the use of confidential witnesses, but nevertheless numerous federal courts have applied Tellabs to assess the use of such witnesses. Many courts, following the lead of the Seventh Circuit in Higginbotham v. Baxter Int'l, Inc. (20) have concluded that the information supplied by confidential witnesses in securities fraud complaints must be steeply discounted when deciding motions to dismiss. Other courts have rejected Higginbotham and eschewed automatic discounting.

    The key discovery issue is whether plaintiffs must disclose the identities of confidential witnesses in advance of trial. Federal district courts that have considered this latter issue are split into two camps. Post-PSLRA, a majority has held that the identities of confidential witnesses who provide information set forth in a securities fraud complaint are generally discoverable, and a minority has held that the identities are protected from disclosure as attorney work product or on public policy grounds. No federal appellate court had resolved the issue by early 2011.

    This Article provides a framework for analyzing and resolving both the pleading and discovery issues. Part I considers the use of confidential witnesses prior to Tellabs. Part II examines Tellabs and its application by the lower federal courts. Part III critiques those decisions that have applied Tellabs to automatically discount information provided by confidential witnesses. Each reason given by Higginbotham and similar decisions to support automatic discounting is reviewed and rejected. Particular attention is paid to Higginbotham's erroneous conclusion that discounting is justified because discovery of the identities of confidential witnesses is inevitable.

    The Article concludes that (1) courts should not discount information provided by confidential witnesses for use in securities fraud complaints if the witnesses are described with sufficient particularity to support the probability that persons in the positions occupied by the witnesses would possess the information alleged; and (2) in general, the identities of confidential witnesses should not be discoverable unless the witnesses will testify at trial. A central theme is that imposing a general requirement of disclosure of confidential sources is likely to invite retaliation against them, or have a significant chilling effect that deters informants from providing critical information to plaintiffs' investigators in meritorious cases, thereby undermining the federal securities laws and the public policy rationale for such laws.

  2. CONFIDENTIAL WITNESSES IN SECURITIES FRAUD LITIGATION PRIOR TO TELLABS

    More than 2800 securities class actions were filed in federal court from 1996 to 2010 (21) and confidential witnesses were used in many, if not most, of them. (22) Such witnesses have been commonly used to bolster claims asserted under the securities law provisions most frequently utilized in class action securities litigation, which are section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) (23) and companion Rule 10b-5. (24) In 2010, 66% of the 176 securities class actions filed in federal court included 10b-5 claims. (25) Confidential witnesses also have been used to support claims asserted under section 11 of the Securities Act of 1933 (Securities Act), (26) which creates a private remedy for purchasers of a security if any part of the registration statement contained an untrue statement of a material fact or omitted to state a material fact required to be stated or necessary to make the statements not misleading. (27)

    The use of confidential witnesses in class action securities litigation has been of greatest significance in connection with the motion to dismiss, which is the single most important procedural step in virtually all such litigation. (28) The motion to dismiss acquired its importance in securities litigation primarily by virtue of the PSLRA's strict pleading requirements. The Act requires, inter alia, that a securities complaint specify each allegedly misleading statement, why the statement was misleading, and, if an allegation is made on information and belief, "all facts" supporting that belief with particularity. (29) During the period 1997 to 2001, several federal district courts interpreted the phrase "all facts" literally, to require plaintiffs to specifically name their confidential sources. This was the conclusion of at least one district court each in California, (30) New Jersey, (31) and Florida. (32)

    All federal appellate courts to consider the issue by 2011 rejected the foregoing approach. Beginning in 2000, the First, (33) Second, (34) Third, (35) Fourth, (36) Fifth, (37) Sixth, (38) Seventh, (39) Eighth, (40) Ninth, (41) Tenth, (42) and Eleventh (43) Circuits all rejected the notion that confidential witnesses who provide information used in securities fraud complaints must be identified by name in the complaint, as a general rule. (44) However, the appellate courts have disagreed about how such witnesses should be identified.

    The first circuit to specifically consider the subject of confidential witnesses in class action securities litigation was the Second, in 2000. In Novak v. Kasaks, the Second Circuit concluded that reading "all" literally would tend to produce illogical results that Congress could not have intended, because...

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