Confidential Witnesses

The history of securities and corporate governance litigation is full of wishes about the law that we later regret (or will), or are happy were not granted.  Many of these are not obvious—and some will surprise people.  From certain case-by-case tactical decisions such as establishment of special litigation committees, to the (failed) attempt to abolish the fraud-on-the-market doctrine, to the very high standard for director liability for oversight failures, not everything that seems helpful to companies really is.

I will publish a series of blog posts on this topic over the coming months.  This month’s post discusses the Private Securities Litigation Reform Act, with a focus on two provisions: the safe harbor for forward-looking statements (“Safe Harbor”), and lead plaintiff procedures.

Overview of the Reform Act

The Reform Act was passed by the Contract-with-America Congress to address its perception that securities class actions were reflexive, lawyer-driven litigation that often asserted weak claims based on little more than a stock drop, and relied on post-litigation discovery, rather than pre-litigation investigation, to sort out the validity of the claims.  The Reform Act, among other things:

  • Imposed strict pleading standards for showing both falsity and scienter, to curtail frivolous claims by increasing the likelihood that they would be dismissed.
  • Created the Safe Harbor, to encourage companies to make forecasts and other predictions without undue fear of liability.
  • Imposed a stay of discovery until the motion-to-dismiss process is resolved, to prevent discovery fishing expeditions and to eliminate the burden of discovery for claims that do not meet the enhanced pleading standards.
  • Created procedures for selecting a lead plaintiff with a substantial financial stake in the litigation, to discourage lawyer-driven actions and the “race to the courthouse.”

Over my career as a securities litigator, I’ve seen both sides of the securities-litigation divide that the Reform Act created.  In the first part of my career, I witnessed the figurative skid marks in front of courthouses, as lawyers raced to the courthouse to file claims before knowing if there really was a claim to be filed—the emblem of the problems Congress sought to correct.  And in the 21 years since, I’ve seen the Reform Act both succeed and fail to achieve the results Congress intended.

Having lived the before and after, I would not argue that the Reform Act has not helped companies and their directors and officers.  It certainly has.  But it is a mixed bag.  Indeed, I can argue that even the heightened falsity and scienter pleading standards have caused harm.  For example, the pleading standards lead even the most prominent defense lawyers to rely heavily on the lack of words in a complaint—the securities litigation equivalent of “neener neener neener”—instead of using the complaint and judicially noticeable facts to cogently explain why the defendants didn’t say anything false, much less on purpose.

Over-reliance on the pleading standards is a strategic mistake.  The Reform Act’s standards give judges enormous discretion; they can dismiss most complaints, or not, with little room to challenge their decisions upon appeal.  Winning motions recognize the human element to this discretion.  Even if a complaint is technically deficient, judges are less likely to dismiss it (certainly less likely to dismiss it with prejudice) if they nevertheless get the feeling that the defendants committed fraud.  Effective motions use the leeway given to defendants by the Reform Act, and now the Supreme Court’s decisions in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015), and Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), to build a robust factual record that gives judges a sense of comfort that they are not only following the law, but that by strictly applying the Reform Act’s protections, they are also serving justice.  And even if the judge doesn’t dismiss the case, he or she will leave the motion to dismiss process with a better feeling about the case going forward.  But the pleading standards can be an attractive nuisance, distracting defense lawyers from the best way to defend their clients.

The pleading standards have also spawned a sideshow of “confidential witnesses,” primarily former employees who provide plaintiffs’ lawyers with internal corporate information to help them meet the pleading standards.  In addition to raising whistleblower issues, causing fights over misuse of confidential information, and airing dirty laundry, the use of confidential witnesses has resulted in fights between plaintiffs’ lawyers and recanting witnesses requiring judicial intervention.

In one especially contentious dispute, Judge Rakoff spent a day taking testimony from recanting witnesses and a plaintiffs’ investigator, and took additional time to write an opinion commenting on this issue after the parties had settled the litigation.  He concluded his nine-page opinion as follows:

The sole purpose of this Memorandum … is to focus attention on the way in which the PSLRA and decisions like Tellabs have led plaintiffs’ counsel to rely heavily on private inquiries of confidential witnesses, and the problems this approach tends to generate for both plaintiffs and defendants.   It seems highly unlikely that Congress or the Supreme Court, in demanding a fair amount of evidentiary detail in securities class action complaints, intended to turn plaintiffs’ counsel into corporate “private eyes” who would entice naïve or disgruntled employees into gossip sessions that might support a federal lawsuit.  Nor did they likely intend to place such employees in the unenviable position of having to account to their employers for such indiscretions, whether or not their statements were accurate.  But, as it is, the combined effect of the PSLRA and cases like Tellabs are likely to make such problems endemic.

We may well see this problem as one of the underpinnings of a legislative attempt to reform the Reform Act one day.

In any event, and regardless of one’s views of the pleading standards’ overall benefits, two other Reform Act provisions certainly have grown to be problematic for public companies: the Safe Harbor, and the lead plaintiff provisions.

The Safe Harbor for Forward-Looking Statements

The Safe Harbor was a centerpiece of the Reform Act.  Lawsuits prompted by announcements of missed earnings forecasts deterred companies from giving valuable earnings guidance.  Congress sought to encourage guidance and other forward-looking statements by precluding liability if the statements were accompanied by “meaningful cautionary statements” or made without “actual knowledge” that they were false.  15 U.S.C. § 77z-2(c)(1); 15 U.S.C. § 78u-5(c)(1).

Yet the Safe Harbor is anything but safe.  In the 21 years of the Reform Act, surprisingly few dismissals are based solely the Safe Harbor; instead, courts either use it as  fallback grounds for dismissal, or just sidestep it—which has resulted in some significant legal errors.  The most notorious erroneous Safe Harbor decision was written by one of the country’s most renowned judges, Judge Frank Easterbrook, in Asher v. Baxter, 377 F.3d 727 (7th Cir. 2004).  Judge Easterbrook read into the Safe Harbor the word “the” before “important” in the phrase “identifying important factors,” to then hold that discovery was required to determine whether the company’s cautionary language contained “the (or any of the) ‘important sources of variance’” between the forecast and the actual results.  Id. at 734.

The reason for this judicial antipathy was best articulated by Bill Lerach, who famously said that the Safe Harbor would give executives a “license to lie.”  Judges have tended to agree with his conclusion.  Some have been quite explicit about it.  For example, in In re Stone & Webster, Inc. Securities Litigation, the First Circuit called the Safe Harbor a “curious statute, which grants (within limits) a license to defraud.”  414 F.3d 187, 212 (1st Cir. 2005).  And the Second Circuit, in its first decision analyzing the Safe Harbor—15 years after the Reform Act was enacted, illustrating the degree of judicial avoidance—correctly interpreted “or” to mean “or,” but stated that “Congress may wish to give further direction on …. the reference point by which we should judge whether an issuer has identified the factors that realistically could cause results to differ from projections.  May an issuer be protected by the meaningful cautionary language prong of the Safe Harbor even where his cautionary statement omitted a major risk that he knew about at the time he made the statement?”  Slayton v. American Express Co., 604 F.3d 758, 772 (2d Cir. 2010).  Probably for this reason, the Safe Harbor has not deterred plaintiffs’ counsel from continuing to bring false forecast cases.  Twenty-one years later, a great many securities class actions still focus on earnings forecasts and other forward-looking statements.

Much of this problem is self-inflicted.  We defense lawyers have worsened the judicial antipathy and reluctance to issue rulings on Safe Harbor grounds by making hyper-technical arguments that are detached from any notion that the challenged forward-looking statements aren’t false in the first place.  Most challenged forward-looking statements are true statements of opinion—an especially strong argument under the Supreme Court’s Omnicare decision—and don’t even need the Safe Harbor’s protection.  But by bypassing the falsity argument, and falling back on the Safe Harbor, defense counsel plays right into plaintiffs’ hands.  Many defense lawyers try to overcome this problem by emphasizing that Congress intended to immunize even unfair forward-looking statements, if they are accompanied by appropriate warnings.  But judges don’t like caveat emptor, and they don’t like liars—regardless of Congressional intent.  A much better way to defend forward-looking statements is to show that they were true statements of opinion and then use the Safe Harbor as a fallback argument.  It makes the judge feel comfortable dismissing the claim in either or both ways.  But few defense lawyers take that approach.

Finally, companies and their outside corporate counsel have contributed to the Safe Harbor’s lack of safety by failing to describe their risks in a fresh and detailed way each quarter.  When I evaluate a securities class action complaint that challenges forward-looking statements and other statements of opinion (which comprise nearly all securities cases), one of the first things I look for is the progression of the risk factors each quarter.  Using a chart, I read them from start to finish, just as the judge will when we create the context for our arguments against falsity and to support the application of the Safe Harbor.  Are the risk factors specific or generic?  Do they change over time or are they static?  Do the changes in the risk factors track disclosed changes in business conditions?  Etc.  But companies and their outside corporate counsel frequently devolve to boilerplate, and fail to draft careful disclosures that make a judge feel comfortable that they were trying to disclose their real risks each quarter.

Lead Plaintiff Procedures

The symbol of the pre-Reform Act era is the race to the courthouse among plaintiffs’ lawyers to file a complaint first and thus win the lead counsel role.  Congress intended the heightened pleading standards and the Safe Harbor to play a role in fixing that problem, because they are meant to incentivize plaintiffs to do more pre-filing investigation.  However, the Reform Act’s lead plaintiff provisions—which require the court to choose a lead plaintiff and lead plaintiff’s counsel after a beauty contest—undermine that goal, since only the lead plaintiff has an economic incentive to invest much time and money in an investigation.  So although the initial filer no longer has a competitive advantage by being the first plaintiff to file, the initial complaint is still routinely filed without any real investigation or worry about satisfying the pleading standards.

The lead plaintiff procedures were also designed to prevent lawyer-driven litigation, by providing that the lead plaintiff is presumptively the plaintiff with the largest financial loss—i.e., a plaintiff with “skin in the game.”  While that goal is salutary, it has spawned complex and mixed results.  The Reform Act’s lead plaintiff process incentivized plaintiffs’ firms to recruit institutional investors to serve as plaintiffs.  For the most part, institutional investors, whether smaller unions or large funds, retained the more prominent plaintiffs’ firms, and smaller plaintiffs’ firms were left with individual retail investor clients who usually can’t beat out institutions for the lead plaintiff role.  At the same time, securities class action economics tightened in all but the largest cases.  Dismissal rates under the Reform Act are pretty high, and defeating a motion to dismiss often requires significant investigative costs and intensive legal work.  And the median settlement amount of cases that survive dismissal motions is fairly low.  These dynamics placed a premium on experience, efficiency, and scale.  Larger firms filed the lion’s share of the cases, and smaller plaintiffs’ firms were unable to compete effectively for the lead plaintiff role, or make much money on their litigation investments.

But nature abhors a vacuum—here, a securities litigation system that leaves out retail investors and smaller plaintiffs’ firms.  So, it was inevitable that these alienated groups would find a way to bring securities class actions. As I’ve chronicled previously, this void started to be filled with the wave of cases against Chinese issuers in 2010.  Smaller plaintiffs’ firms initiated the lion’s share of these cases, primarily on behalf of retail investors, as the larger firms were swamped with credit-crisis cases and likely were deterred by the relatively small damages, potentially high discovery costs, and uncertain insurance and company financial resources.  Moreover, these cases fit smaller firms’ capabilities well; nearly all of the cases had “lawsuit blueprints” such as auditor resignations and/or short-seller reports, thereby reducing the smaller firms’ investigative costs and increasing their likelihood of surviving a motion to dismiss.  The dismissal rate has indeed been low, and limited insurance and company resources have prompted early settlements in amounts that, while on the low side, appear to have yielded good outcomes for the smaller plaintiffs’ firms.

With these gains in efficiency, market share, and money, these smaller plaintiffs’ firms have continued to file a large number of securities class actions on behalf of retail investors.  Like the China cases, these tend to be against smaller companies.  Thus, smaller plaintiffs’ firms have discovered a class of cases—cases against smaller companies that have suffered well-publicized problems that reduce the plaintiffs’ firms’ investigative costs—for which they can win the lead plaintiff role and that they can prosecute at a sufficient profit margin.

We now have two classes of prominent plaintiffs and plaintiffs’ firms:  larger firms with institutional investor clients, as Congress intended, and smaller plaintiffs’ firms with smaller individual clients, which Congress sought to displace.   In a sense, we’re back to where we started, but now with more aggressive institutional investors to boot.

Smaller plaintiffs’ firms’ permanent arrival on the scene has led to two sets of additional problems.

First, smaller plaintiffs’ firms have ratcheted up the number of press releases by plaintiffs’ firms seeking plaintiffs to file a securities class action.  There have always been plaintiff law firm “investigations” to try to find plaintiffs to file lawsuits, but there has been nothing short of an avalanche in recent years.  This is so for a number of reasons. Unlike larger plaintiffs’ firms that have spent 21 years cultivating institutional investor clients as the Reform Act envisioned, smaller plaintiffs’ firms generally don’t have existing attorney-client relationships with potential plaintiffs who own a wide range of securities—so they need to recruit plaintiffs for particular cases. Smaller plaintiffs’ firm successes are drawing more smaller firms into the securities class action business.  This competition is resulting in an “investigation” following nearly every negative corporate announcement.  Increasingly, this is so even if the stock price drop is relatively small—indeed, I’ve seen more investigations and subsequent securities class actions follow single-digit stock drops than ever before, likely because the of the number of smaller-firm players and the reality that a small case is better than none.  The press release process is repeated after a lawsuit is filed.  As the Reform Act requires, the first filer publishes a press release announcing the filing. Other smaller plaintiffs’ firms then publish their own announcements that a lawsuit has been filed in order to find a good lead plaintiff contestant.  Each firm publishes their own notice, and the firms then publish reminders leading up to the lead plaintiff filing deadline 60 days later.

To put it mildly, this process is a real nuisance, especially for smaller companies. Investors, employees, and other stakeholders who don’t understand this process sometimes perceive that the company is falling apart.  Dealing with their concerns can cause officers and directors to become distracted.  The result can be further deterioration of the company’s business and financial condition, and an unwarranted sell-off of the company’s stock.  This can be about more than money—for example, development of life-saving drugs can be slowed or even derailed. Obviously, none of that is good.  I doubt the plaintiffs’ lawyers themselves would disagree, but instead would say that they’re simply working under the Reform Act’s lead plaintiff procedures.

Second, the fervent competition among smaller plaintiffs’ firms is affecting the types of cases filed and settlement dynamics.  Although the smaller plaintiffs’ firms’ bread-and-butter are “lawsuit blueprint” cases that often have difficult facts, they are also filing many low-merit cases, such as challenges to earnings guidance.  At the same time, the intense competition sometimes results in more difficult and protracted litigation, meritorious or not.  There are usually other smaller plaintiffs’ firms on the scene through tag-along derivative suits or as co-lead securities class action counsel, and none of the firms wants the others to see it as a pushover for wanting to settle for an amount they’d otherwise gladly take.  That said, it’s also true that smaller plaintiffs’ firms are defeating an increasing number of motions to dismiss and can be formidable adversaries—which of course gives them greater leverage and leads to more difficult litigation to defend and resolve.

Conclusion

Although these issues won’t make the legislative agenda anytime soon, we defense lawyers can make a difference.  We can:

  • Emphasize the truth of the challenged statements through the tools the Reform Act and Supreme Court have provided, and avoid over-reliance on the Safe Harbor and pleading standards.
  • Ask courts to impose clear leadership and coordination between and among securities class action and derivative plaintiffs’ counsel.
  • Educate companies about the reasons for the frustrating flurry of press releases.

This year will be remembered as the year of the Super Bowl of securities litigation, Halliburton Co. v. Erica P. John Fund, Inc. (“Halliburton II”), 134 S. Ct. 2398 (2014), the case that finally gave the Supreme Court the opportunity to overrule the fraud-on-the-market presumption of reliance, established in 1988 in Basic v. Levinson.

Yet, for all the pomp and circumstance surrounding the case, Halliburton II may well have the lowest impact-to-fanfare ratio of any Supreme Court securities decision, ever.  Indeed, it does not even make my list of the Top 5 most influential developments in 2014 – developments that foretell the types of securities and corporate-governance claims plaintiffs will bring in the future, how defendants will defend them, and the exposure they present.

Topping my Top 5 list is a forthcoming Supreme Court decision in a different, less-heralded case – Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund.  Despite the lack of fanfare, Omnicare likely will have the greatest practical impact of any Supreme Court securities decision since the Court’s 2007 decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308  (2007).  After discussing my Top 5, I explain why Halliburton II does not make the list.

5.         City of Providence v. First Citizens BancShares:  A Further Step Toward Greater Scrutiny of Meritless Merger Litigation

In City of Providence v. First Citizens BancShares, 99 A.3d 229 (Del. Ch. 2014), Chancellor Bouchard upheld the validity of a board-adopted bylaw that specified North Carolina as the exclusive forum for intra-corporate disputes of a Delaware corporation.  The ruling extended former Chancellor Strine’s ruling last year in Boilermakers Local 154 Retirement Fund v. Chevron, 73 A.3d 934 (Del Ch. 2013), which validated a Delaware exclusive-forum bylaw.  These types of bylaws largely are an attempt to bring some order to litigation of shareholder challenges to corporate mergers and other transactions.

Meritless merger litigation is a big problem.  Indiscriminate merger litigation is a slap in the face to careful directors who have worked hard to understand and approve a merger, or to CEOs who have spent many months or years working long hours to locate and negotiate a transaction in the shareholders’ best interest.  It is cold comfort to know that nearly all mergers draw shareholder litigation, and that nearly all of those cases will settle before the transaction closes without any payment by the directors or officers personally.  And we know the system is broken when it routinely allows meritless suits to result in significant recoveries for plaintiffs’ lawyers, with virtually nothing gained by companies or their shareholders.

Two years ago, I advocated for procedures requiring shareholder lawsuits to be brought in the company’s state of incorporation.  Exclusive state-of-incorporation litigation would attack the root cause of the merger-litigation problem: the inability to consolidate cases and subject them to a motion to dismiss early enough to obtain a ruling before negotiations to achieve settlement before the transaction closes must begin.  Although the problem is virtually always framed in terms of the oppressive cost and hassle of multi-forum litigation, good defense counsel can usually manage the cost and logistics.  Instead, the bigger problem, and the problem that causes meritless merger litigation to exist, is the inability to obtain dismissals.  This is primarily so because actions filed in multiple forums can’t all be subjected to a timely motion to dismiss, and a dismissal in one forum that can’t timely be used in another forum is a hollow victory.  If there were a plenary and meaningful motion-to-dismiss process, less-meritorious cases would be weeded out early, and plaintiffs’ lawyers would bring fewer meritless cases.  The solution is that simple.

Exclusive litigation in Delaware for Delaware corporations is preferable, because of Delaware’s greater experience with merger litigation and likely willingness to weed out meritless cases at a higher rate.  But the key to eradicating meritless merger litigation is consolidation in some single forum, and not every Delaware corporation wishes to litigate in Delaware.  So I regard First Citizens’ extension of Chevron to a non-Delaware exclusive forum as a key development.

4.         SEC v. Citigroup:  The Forgotten Important Case

On June 4, 2014, in SEC v. Citigroup, 752 F.3d 285 (2d Cir. 2014), the Second Circuit held that Judge Rakoff abused his discretion in refusing to approve a proposed settlement between the SEC and Citigroup that did not require Citigroup to admit the truth of the SEC’s allegations.  Judge Rakoff’s decision set off a series of events that culminated in the ruling on the appeal, about which people seemed to have forgotten because of the passage of time and intervening events.

Once upon a time, way back in 2012, the SEC and Citigroup settled the SEC’s investigation of Citigroup’s marketing of collateralized debt obligations.  In connection with the settlement, the SEC filed a complaint alleging non-scienter violations of the Securities Act.  The same day, the SEC also filed a proposed consent judgment, enjoining violations of the law, ordering business reforms, and requiring the company to pay $285 million. As part of the consent judgment, Citigroup did not admit or deny the complaint’s allegations.  Judge Rakoff held a hearing to determine “whether the proposed judgment is fair, reasonable, adequate, and in the public interest.”  In advance, the court posed nine questions, which the parties answered in detail.  Judge Rakoff rejected the consent judgment.

The rejection order rested, in part, on the court’s determination that any consent judgment that is not supported by “proven or acknowledged facts” would not serve the public interest because:

  • the public would not know the “truth in a matter of obvious public importance”, and
  • private litigants would not be able to use the consent judgment to pursue claims because it would have “no evidentiary value and      no collateral estoppel effect”.

The SEC and Citigroup appealed.  While the matter was on appeal, the SEC changed its policy to require admissions in settlements “in certain cases,” and other federal judges followed Judge Rakoff’s lead and required admissions in SEC settlements.  Because of the SEC’s change in policy, many people deemed the appeal unimportant.  I was not among them; the Second Circuit’s decision remained of critical importance, because the extent to which the SEC insists on admissions will depend on the amount of deference it receives from reviewing courts – which was the issue before the Second Circuit.  It stands to reason that the SEC would have insisted on more admissions if courts were at liberty to second-guess the SEC’s judgment to settle without them.  Greater use of admissions would have had extreme and far-reaching consequences for companies, their directors and officers, and their D&O insurers.

So it was quite important that the Second Circuit held that the SEC has the “exclusive right” to decide on the charges, and that the SEC’s decision about whether the settlement is in the public interest “merits significant deference.”

3.         Wal-Mart Stores, Inc. v. Indiana Elec. Workers Pension Trust Fund IBEW:  Delaware Supreme Court’s Adoption of the Garner v. Wolfinbarger “Fiduciary” Exception to the Attorney-Client Privilege Further Encourages Use of Section 220 Inspection Demands

On July 23, 2014, the Delaware Supreme Court adopted the fiduciary exception to the attorney-client privilege, which originated in Garner v. Wolfinbarger, 430 F.2d 1093 (5th Cir. 1970), and held that stockholders who make a showing of good cause can inspect certain privileged documents.  Although this is the first time the Delaware Supreme Court has expressly adopted Garner, it had previously tacitly adopted it, and the Court of Chancery had expressly adopted it in Grimes v. DSC Communications Corp., 724 A.2d 561 (Del. Ch. 1998).

In my view, the importance of Wal-Mart is not so much in its adoption of Garner – given its previous tacit adoption – but instead is in the further encouragement it gives stockholders to use Section 220.  Delaware courts for decades have encouraged stockholders to use Section 220 to obtain facts before filing a derivative action.  Yet the Delaware Supreme Court, in the Allergan derivative action, Pyott v. Louisiana Municipal Police Employees’ Retirement System  (“Allergan”), 74 A.3d 612 (Del. 2013), passed up the opportunity to effectively require pre-litigation use of Section 220.  In Allergan, the court did not adopt Vice Chancellor Laster’s ruling that the plaintiffs in the previously dismissed litigation, filed in California, provided “inadequate representation” to the corporation because, unlike the plaintiffs in the Delaware action, they did not utilize Section 220 to attempt to determine whether their claims were well-founded.  Upholding the Court of Chancery’s presumption against fast-filers would have strongly encouraged, if not effectively required, shareholders to make a Section 220 demand before filing a derivative action.

In Wal-Mart, however, the Delaware Supreme Court provided the push toward Section 220 that it passed up in Allergan.  Certainly, expressly adopting Garner will encourage plaintiffs to make more Section 220 demands.  That should cause plaintiffs to conduct more pre-filing investigations, which will decrease filings to some extent.  But increased use of 220 also means that the cases that are filed will be more virulent, because they are selected with more care, and are more fact-intensive – and thus tend to be more difficult to dispose of on a motion to dismiss.

2.         City of Livonia Employees’ Retirement System v. The Boeing Company:  Will Defendants Win the Battle but Lose the War?

On August 21, 2014, Judge Ruben Castillo of the Northern District of Illinois ordered plaintiffs’ firm Robbins Geller Rudman & Dowd to pay defendants’ costs of defending a securities class action, as Rule 11 sanctions for “reckless and unjustified” conduct related to reliance on a confidential witness (“CW”) whose testimony formed the basis for plaintiffs’ claims.  2014 U.S. Dist. LEXIS 118028 (N.D. Ill. Aug. 21, 2014).

I imagine that some readers may believe that, as a defense lawyer, I’m including this development because one of my adversaries suffered a black eye.  That’s not the case at all.  Although I’m not in a position to opine on the merits of the Boeing CW matter, I can say that I genuinely respect Robbins Geller and other top plaintiffs’ firms.  And beware those who delight in the firm’s difficulties: few lawyers who practice high-stakes litigation at a truly high level will escape similar scrutiny at some point in a long career.

But beyond that sentiment, I have worried about the Boeing CW problem, as well as similar problems in the SunTrust and Lockheed cases, because of their potential to cause unwarranted scrutiny of the protections of the Private Securities Litigation Reform Act.  I believe the greatest risk to the Reform Act’s protections has always been legislative backlash over a perception that the Reform Act is unfair to investors. The Reform Act’s heavy pleading burdens have caused plaintiffs’ counsel to seek out former employees and others to provide internal information.  The investigative process is often difficult and is ethically tricky, and the information it generates can be lousy.  This is so even if plaintiffs’ counsel and their investigators act in good faith – information can be misunderstood, misinterpreted, and/or misconstrued by the time it is conveyed from one person to the next to the next to the next.  And, to further complicate matters, CWs sometimes recant, or even deny, that they made the statements on which plaintiffs rely.  The result can be an unseemly game of he-said/she-said between CWs and plaintiffs’ counsel, in which the referee is ultimately an Article III judge.  At some point, Congress will step in to reform this process.

Judge Rakoff seemed to call for such reform in his post-dismissal order in the Lockheed matter:

The sole purpose of this memorandum … is to focus attention on the way in which the PSLRA and decisions like Tellabs have led plaintiffs’ counsel to rely heavily on private inquiries of confidential witnesses, and the problems this approach tends to generate for both plaintiffs and defendants.  It seems highly unlikely that Congress or the Supreme Court, in demanding a fair amount of evidentiary detail in securities class action complaints, intended to turn plaintiffs’ counsel into corporate ‘private eyes’ who would entice naïve or disgruntled employees into gossip sessions that might help support a federal lawsuit. Nor did they likely intend to place such employees in the unenviable position of having to account to their employers for such indiscretions, whether or not their statements were accurate. But as it is, the combined effect of the PSLRA and cases like Tellabs are likely to make such problems endemic.

Rather than tempt Congress to revisit the Reform Act’s protections (which defendants should want to avoid) and/or allow further unseemly showdowns (which plaintiffs and courts should want to avoid), plaintiffs, defendants, and courts can begin to reform the CW process through some basic measures, including requiring declarations from CWs, requiring them to read and verify the complaint’s allegations citing them, and requiring plaintiffs to plead certain information about their CWs.  As I’ve previously written, these reforms would have prevented the problems at issue in the Boeing, SunTrust, and Lockheed matters, and would result in more just outcomes in all cases.

1.         Omnicare:  In My Opinion, the Most Important Supreme Court Case Since Tellabs

Omnicare concerns what makes a statement of opinion false.  Opinions are ubiquitous in corporate communications.  Corporations and their officers routinely share subjective judgments on issues as diverse as asset valuations, strength of current performance, risk assessments, product quality, loss reserves, and progress toward corporate goals.  Many of these opinions are crucial to investors, providing them with unique information and insight.  If corporate actors fear liability for sharing their genuinely held beliefs, they will be reluctant to voice their opinions, and shareholders would be deprived of this vital information.

The standard that the federal securities laws use to determine whether an opinion is “false” is therefore of widespread importance. Although this case only involves Section 11, it poses a fundamental question: What causes an opinion or belief to be a “false statement of material fact”?  The Court’s answer will affect the standards of pleading and proof for statements of opinion under other liability provisions of the federal securities laws, including Section 10(b), which likewise prohibit “untrue” or “false” statements of “material fact.”

In the Sixth Circuit decision under review, the court held that a showing of so-called “objective falsity” alone was sufficient to demonstrate falsity in a claim filed under Section 11 of the Securities Act – in other words, that an opinion could be false even if was genuinely believed, if it was later concluded that the opinion was somehow “incorrect.”  On appeal, Omnicare contends, as did we in our amicus brief on behalf of the Washington Legal Foundation (“WLF”), that this ruling was contrary to the U.S. Supreme Court’s decision in Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083, 1095 (1991).  Virginia Bankshares held that a statement of opinion is a factual statement as to what the speaker believes – meaning a statement of opinion is “true” as long as the speaker honestly believes the opinion expressed, i.e., if it is “subjectively” true.

Other than a passing and unenthusiastic nod made by plaintiffs’ counsel in defense of the Sixth Circuit’s reasoning, the discussion at the oral argument assumed that some showing other than so-called “objective falsity” would be required to establish the falsity of an opinion. Most of the argument by Omnicare, the plaintiffs, and the Solicitor General revolved around what this additional showing should be, as did the extensive and pointed questions from Justices Breyer, Kagan, and Alito.

It thus seems unlikely from the tone of the argument that the Court will affirm the Sixth Circuit’s holding that an opinion is false if it is “objectively” untrue.  If the pointed opening question from Chief Justice Roberts is any indication, the Court also may not fully accept Omnicare’s position, which is that an opinion can only be false or misleading if it was not actually believed by the speaker.  It seems more probable that the Supreme Court will take one of two middle paths – one that was advocated by the Solicitor General at oral argument, essentially a “reasonable basis” standard, or one that was advanced in our brief for the WLF, under which a statement of opinion is subjected to the same sort of inquiry about whether it was misleading as for any other statement.  Under WLF’s proposed standard, plaintiffs would be required to demonstrate either that an opinion was false because it was not actually believed, or that omitted facts caused the opinion – when considered in the full context of the company’s other disclosures – to be misleading because it “affirmatively create[d] an impression of a state of affairs that differs in a material way from the one that actually exists.” Brody v. Transitional Hosps. Corp., 280 F.3d 997, 1006 (9th Cir. 2002).

Such a standard would be faithful to the text of the most frequently litigated provisions of the federal securities laws – Section 11, at issue in Omnicare, and Section 10(b) – which allow liability for statements that are either false or that omit material facts “required to be stated therein or necessary to make the statements therein not misleading . . . .”  At the same time, this standard would preserve the commonsense holding of Virginia Bankshares – that an opinion is “true” if it is genuinely believed – and prevent speakers from being held liable for truthfully expressed opinions simply because someone else later disagrees with them.

Why Halliburton II is Not a Top-5 Development

After refusing to overrule Basic, the Halliburton II decision focused on defendants’ fallback argument that plaintiffs must show that the alleged misrepresentations had an impact on the market price of the stock, as a prerequisite for the presumption of reliance.  The Court refused to place on plaintiffs the burden of proving price impact, but agreed that a defendant may rebut the presumption of reliance, at the class certification stage, with evidence of lack of price impact.

Halliburton II has a narrow reach.  The ruling only affects securities class actions that have survived a motion to dismiss – class certification is premature before then.  It wouldn’t be economical to adjudicate class certification while parties moved to dismiss under Rule 12(b)(6) and the Reform Act, and adjudicating class certification before rulings on motions to dismiss could result in defendants waiving their right to a discovery stay under the Reform Act.  Moreover, most securities class actions challenge many statements during the class period.  Although there could be strategic defense benefit to obtaining a ruling that a subset of the challenged statements did not impact the stock price – for example, shortening the class period or dismissing especially awkward statements – a finding that some statements had an impact would support certification of some class, and thus would allow the case to proceed.

Defendants face legal and economic hurdles as well.  For example, in McIntire v. China MediaExpress Holdings, Inc., 2014 U.S. Dist. LEXIS 113446, *40 (S.D.N.Y. Aug. 15, 2014), the court held that a “material misstatement can impact a stock’s value either by improperly causing the value to increase or by improperly maintaining the existing stock price.”  Under this type of analysis, even if a challenged statement does not cause the stock price to increase, it may have kept the stock price at the same artificially inflated level, and thus impacted the price.  Plaintiff-friendly results were predictable from experience in the Second and Third Circuits before the Supreme Court’s rulings in Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, 133 S. Ct. 1184 (2013), and Halliburton II.  Despite standards for class certification that allowed defendants to contest materiality and price impact, defendants seldom defeated class certification.

Halliburton II may also be unnecessary; it is debatable whether the decision even gives defendants a better tool with which to weed out cases that suffer from a price-impact problem.  For example, cases that suffer from a price-impact problem typically also suffer from some other fatal flaw, such as the absence of loss causation or materiality.  Indeed, the price-impact issue in Halliburton was based on evidence about the absence of loss causation.

Yet defendants no doubt will frequently oppose class certification under Halliburton II.  But they will do so at a cost beyond the economic cost of the legal and expert witness work:  they will lose the ability to make no-price-impact arguments in settlement discussions in the absence of a ruling about them.  Now, defendants will make and obtain rulings on class certification arguments that they previously could have asserted would be resolved in their favor at summary judgment or trial, if necessary. Plaintiffs will press harder for higher settlements in cases with certified classes.

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In addition to Halliburton II, there were many other important 2014 developments in or touching on the world of securities and corporate governance litigation, including: rare reversals of securities class action dismissals in the Fifth Circuit, Spitzberg v. Houston American Energy Corp., 758 F.3d 676 (5th Cir. 2014), and Public Employees’ Retirement System of Mississippi v. Amedisys, Inc., 769 F.3d 313 (5th Cir. 2014); the filing of cybersecurity shareholder derivative cases against Target (pending) and Wyndham (dismissed); a trial verdict against the former CFO of a Chinese company, Longtop Financial Technologies; the Second Circuit’s significant insider trading decision, United States v. Newman, — F.3d —, 2014 U.S. App. LEXIS 23190 (2d Cir. Dec. 10, 2014); increasingly large whistleblower bounties, including a $30 million award; the Supreme Court’s SLUSA decision in Chadbourne & Parke LLP v. Troice, 134 S. Ct. 1058 (2014); the Delaware Supreme Court’s ruling on a fee-shifting bylaw in ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), and the resulting legislative debate in Delaware and elsewhere; the Supreme Court’s ERISA decision in Fifth Third Bancorp v. Dudenhoeffer, 134 S. Ct. 2459 (2014); the Ninth Circuit’s holding that the announcement of an internal investigation, standing alone, is insufficient to establish loss causation, Loos v. Immersion Corp., 762 F.3d 880 (9th Cir. 2014); the Ninth Circuit’s rejection of Item 303 of Regulation S-K as the basis of a duty to disclose for purposes of a claim under Section 10(b), In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046 (9th Cir. 2014); and the Ninth Circuit’s holding that Rule 9(b) applies to loss-causation allegations, Oregon Public Employees Retirement Fund v. Apollo Group Inc., — F.3d —, 2014 U.S. App. LEXIS 23677 (9th Cir. Dec. 16, 2014).

In defending a securities class action, a motion to dismiss is almost automatic, and in virtually all cases, it makes good strategic sense.  In most cases, there are only four main arguments:

  • The complaint hasn’t pleaded a false or misleading statement
  • The challenged statements are protected by the Safe Harbor for forward-looking statements
  • The challenged statements weren’t made with scienter, even if the complaint has adequately pleaded their falsity
  • The complaint hasn’t adequately pleaded loss causation

For me, the core argument of virtually every brief is falsity – I think that standing up for a client’s statements provides the foundation for all of the other arguments.  For most clients, it is important to stand up and say “I didn’t lie.”   And an emphasis on challenging the falsity allegations encompasses clients’ most fundamental responses to the lawsuit:  they reported accurate facts; made forecasts that reflected their best judgment at the time; gave opinions about their business that they genuinely believed; issued financial statements that were the result of a robust financial-reporting process; etc.

The Reform Act, and the cases which have interpreted it, provide securities defense lawyers with broad latitude to attack falsity.  In my mind, a proper falsity analysis always starts by examining each challenged statement individually, and matching it up with the facts that plaintiffs allege illustrate its falsity.   Then, we can usually support the truth of what our clients said in numerous ways that are still within the proper scope of the motion to dismiss standard:  showing that the facts alleged do not actually undermine the challenged statements, because of mismatch of timing or substance; pointing out gaps, inconsistencies, and contradictions in plaintiffs’ allegations; showing that the facts that plaintiffs assert are insufficiently detailed under the Reform Act; attacking allegations that plaintiffs claim to be facts, but which are really opinions, speculation, and unsupported conclusions; putting defendants’ allegedly false or misleading statements in their full context to show that they were not misleading; and pointing to judicially noticeable facts that contradict plaintiffs’ theory.  These arguments must be supplemented by a robust understanding of the relevant factual background, which defines and frames the direction of any argument we ultimately make based on the complaint and judicially noticeable facts.

Yet many motions to dismiss do not make a forceful argument against falsity, supported with a specific challenge to the facts alleged by the plaintiffs.  Some motions superficially assert that the allegations are too vague to satisfy the pleading standard, and do not engage in a detailed defense of the statements with the available facts.  Others simply attack the credibility of the “confidential witnesses,” without addressing in sufficient detail the content of the information the complaint attributes to them.  And others fall back on the doctrine of “puffery,” which posits that even if false, the challenged statements were immaterial.*  By focusing on these and similar approaches, a brief may leave the judge  with the impression that defendants concede falsity, and that the real defense is that the false statements were not made with scienter.

That’s risky.

It’s risky for several reasons.  First, detailed, substantive arguments against falsity are some of the strongest arguments that defendants can make.  Second, those arguments provide the foundation for the rest of the motion.  The exclusion of a strong falsity argument weakens the argument against scienter, and fails to paint the best possible no-fraud picture for the judge – which is ultimately what helps a judge to be comfortable in granting a motion to dismiss.

Failing to emphasize the falsity argument weakens the scienter argument.

The element of scienter requires a plaintiff to demonstrate that the defendant said something knowingly or recklessly false – in order to do this, plaintiffs must tie their scienter allegations to each particular challenged statement.  It is not enough to generally allege, as plaintiffs often do, that defendants had a general “motive to lie.”  When I analyze scienter allegations, I ask myself, “scienter as to what?”  Asking this question often unlocks strong arguments against scienter, because complaints often make scienter allegations that are largely detached from their allegations of falsity.  Often, this is the case because the falsity allegations are insufficient to begin with.  But many motions to dismiss are unable to point out this lack of connection, because they don’t focus on falsity in a rigorous and thorough way.

Focusing on falsity also is necessary because of how courts analyze falsity and scienter.  Although falsity and scienter are separate elements – and should be analyzed separately – courts often analyze them together.   See, e.g., Ronconi v. Larkin, 253 F.3d 423, 429 (9th Cir. 2001) (“Because falsity and scienter in private securities fraud cases are generally strongly inferred from the same set of facts, we have incorporated the dual pleading requirements of 15 U.S.C. §§ 78u-4(b)(1) and (b)(2) into a single inquiry.”).  Arguing a lack of falsity thus provides essential ingredients for this combined analysis.  Even when courts analyze falsity and scienter separately,  a proper scienter analysis requires a foundational falsity analysis, because as noted above, scienter analysis asks whether the defendant knew that a particular statement was false.  Without an understanding of exactly why that challenged statement was false, and what facts allegedly demonstrate that falsity, the scienter analysis meanders, devolving into an analysis of knowledge of facts that may or may not be probative of the speaker’s state of mind related to that statement.

The tendency to lump scienter and falsity together is exemplified by the scienter doctrines that I call “scienter short-cuts:” (1) the corporate scienter doctrine (see, e.g., Teamsters Local 445 Freight Division Pension Fund v. Dynex Capital, Inc., 531 F.3d 190, 195-96 (2d Cir. 2008) and Makor Issues & Rights, Ltd. v. Tellabs Inc., 513 F.3d 702 (7th Cir. 2008)), and (2) the core operations inference of scienter (see, e.g., Glazer Capital Management LP v. Magistri, 549 F.3d 736 (9th Cir. 2008)).  Under these doctrines, courts draw inferences about what the defendants knew based upon the prominence of the falsity allegations.  The more blatant the falsity, the more likely courts are to infer scienter.  A superficial falsity argument weakens defendants’ ability to attack these scienter short-cuts, which plaintiffs are asserting more and more routinely.

Failing to emphasize the falsity argument fails to paint the best possible no-fraud picture for the judge.

I contend that it is a good strategy for a defendant to thoroughly argue lack of falsity, even if there are better alternative grounds for dismissal, and even if the challenge to falsity is unlikely to be successful as an independent grounds for dismissal.  This is for the simple reason that judges are humans – they will feel better about dismissing a case based on other grounds if you can make them feel comfortable that there was not a false statement to begin with.  For example, courts are often reluctant to dismiss a complaint solely on Safe Harbor grounds because it is seen as a “license to lie,” so it is strategically wise also to argue that forward-looking statements were not false in the first place.  Similarly, even if lack of scienter is the best basis for dismissal, it is good strategy to defend on the basis that no one said anything wrong, rather than appearing to concede falsity and being left to contend, “but they didn’t mean to.”

Judges have enough latitude under the pleading standards to dismiss or not, in most cases.  The pivotal “fact” is, in my opinion, whether the judge feels the case is really a fraud case, or not.  A motion to dismiss that vigorously defends the truth of what the defendants said is more likely to make the judge feel that there really is no fraud there.  Conversely, if defendants make an argument that essentially concedes falsity and relies solely on the argument that the falsity was immaterial, wasn’t intentional, or is not subject to challenge under the Safe Harbor, a judge may stretch to find a way to allow the case to continue.  Put simply, a judge is more likely to dismiss a case in which a defendant says “I didn’t lie,” than when defendants argue that “I may have lied, but I didn’t mean to,” or “I may have lied, but it doesn’t matter,” or “I may have lied, but the law protects me anyway.”  Even when a complaint might ultimately be dismissed on other grounds, I think that a strong challenge to falsity is essential to help the judge feel that he or she has reached a just result.

*Many statements that defense counsel argue are “puffery” are really statements of opinion that could and should be analyzed under the standard that originated in the U.S. Supreme Court’s Virginia Bankshares decision:  in order to adequately allege that a statement of opinion is false or misleading, a plaintiff must plead with particularity not only that the opinion was “objectively” false or misleading, but also that it was “subjectively” false or misleading, meaning that the opinion was not sincerely held by the speaker.  My partner Claire Davis recently posted a discussion of statements of opinion.

The recurring and pervasive problem of flawed confidential witness (“CW”) allegations tops my list of the key issues in securities class action litigation.*  I don’t mean just notorious situations such as those recently at issue in the Lockheed, SunTrust, and Boeing securities class actions – which I discussed in an earlier post and discuss further below.  I also mean the garden-variety inaccuracies that are present in a great many cases.

After catching readers up on what has happened in Lockheed, SunTrust, and Boeing since my prior CW post, I’ll discuss why fixing this problem is so crucial, and then propose a solution.  For a useful survey of CW decisions, see Bryan House, “The Fact Pattern Behind the Boeing Class Action Grounding,” Law360 (April 2, 2013).

Update on Lockheed, SunTrust, and Boeing

City of Pontiac General Employees’ Retirement System v. Lockheed Martin (S.D.N.Y. Case No. 11 CV 5026 (JSR)).  In Lockheed, Judge Jed Rakoff denied defendants’ motion to dismiss.  875 F. Supp. 2d 359 (S.D.N.Y. 2012).  During discovery, several CWs disputed telling the investigator for plaintiffs’ counsel (Robbins Geller) the facts the complaint attributed to them, and discovery revealed that certain of the CW allegations were not based on the CWs’ personal knowledge.  Defendants moved for summary judgment, pointing out the flaws in 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.”  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.”  He asked for briefing by the parties on the issues raised at the hearing.

Following the parties’ post-hearing submissions, Judge Rakoff issued a summary order denying defendants’ summary judgment motion, and promised a longer order.  The fact of the denial indicated that, to some extent, Judge Rakoff rejected defendants’ CW challenges, though we’ll never know his findings, because the case settled before he issued his longer order.

Belmont Holdings v. SunTrust Banks (N.D. Ga., Case No. 1:09-cv-01185-WSD).  In SunTrust, Judge William Duffey denied defendants’ motions to dismiss, primarily because of allegations based on information provided by a CW, Scott Trapani, indicating that defendants knew SunTrust’s reserves were understated throughout 2007.  During the motion-to-dismiss process, defendants pointed out that Mr. Trapani left SunTrust in August 2007, and therefore was not in a position to comment about the reserves throughout the year, but the court ruled it would leave that issue for discovery.

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 the investigator for plaintiffs’ counsel (again Robbins Geller) 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, Desiree Torres, supported the FAC’s allegations related to Mr. Trapani.

Ms. Torres later contacted the court and indicated that she was concerned with the accuracy of information plaintiffs’ counsel submitted in their argument against sanctions.  The court held a hearing to hear from Ms. Torres, her firm, and the parties, including Robbins Geller.  Ms. Torres indicated that she had quit her job over the situation.  She said her primary concerns were that, in her view, the submissions incorrectly suggested that plaintiffs’ counsel was not part of interviews of Mr. Trapani in which he indicated that he left SunTrust in August 2007, and that plaintiffs’ allegations inaccurately portrayed Mr. Trapani’s knowledge of matters after August 2007.

At the hearing, Robbins Geller examined Ms. Torres in detail about the interviews of Mr. Trapani and plaintiffs’ pleadings.  If you are a securities litigation geek, you’ll find the transcript fascinating.  In a nutshell, the problem seems to have been caused by a combination of vagueness in what Mr. Trapani said he knew after August 2007, which apparently was occasioned in part by his unwillingness to provide certain details to plaintiffs’ counsel and their investigators, and plaintiffs’ counsel’s interpretation, inferences, and extrapolation of the information he did provide – and then plaintiffs’ counsel’s failure to correct their prior allegations and argument once the scope of Mr. Trapani’s knowledge became clearer.

The court took the matter under advisement, and in a post-hearing order did not impose Rule 11 sanctions:

After hearing testimony and argument at the hearing, the Court concludes that, while not in keeping with the conduct expected of attorneys practicing before this Court, Plaintiff’s counsel’s actions in this matter did not constitute an actionable violation of the Federal Rules of Civil Procedure. The Court remains troubled by the conduct of Plaintiff’s counsel in failing to correct representations made in their pleadings or to notify the Court of them immediately after it became apparent that Trapani did not have knowledge after August 2007 of Defendants’ conduct or beliefs regarding the [reserves]. The decision not to correct the record after counsel became aware of the Court’s reliance on Plaintiff’s representations is perplexing and disappointing. Had Plaintiff’s counsel done so, Ms. Torres likely would not have felt compelled to contact the Court after reading the August 28th Order based on her understanding of the manner in which the Court interpreted the information that was provided to it by Plaintiff’s counsel.

City of Livonia v. Boeing (N.D. Ill., Case NO. 09 C 7143; 7th Cir. Case Nos. 12-1899, 12-2009).  On the basis of allegations based on information allegedly obtained from a CW, Bishnujee Singh, the court denied defendants’ motion to dismiss.  Boeing’s investigation revealed that plaintiffs’ allegations based on Mr. Singh were incorrect, including the allegations that he was employed by Boeing (he was not; he was employed by a contractor of Boeing), or highly improbable, including the allegation that he communicated with senior management.  Boeing took his deposition.  He denied almost everything the investigator for plaintiffs’ counsel (again Robbins Geller) had attributed to him.

Defendants filed a motion for reconsideration of the court’s order denying their motion to dismiss.  The district court granted the motion and dismissed the complaint.  Defendants didn’t file a motion for Rule 11 sanctions, and the court didn’t impose them on its own.

Plaintiffs moved for relief from that order on various grounds, including assertions that the documents Boeing produced confirmed the information Mr. Singh provided, and that Mr. Singh’s recantation was caused by his desire to work directly for Boeing.  In support of their recantation theory, plaintiffs cited an email from Mr. Singh to senior Boeing employees, which plaintiffs characterized as follows:

Singh’s communications with Boeing employees also demonstrate his motive to change his story. He actively sought work at Boeing. Pl. Br. at 9, 13. On the very day of his deposition, Singh wrote directly to Michael Denton, who he had identified in his meeting with the investigator as the Vice President of Engineering for the 787 Program, and Jim Albaugh, defendant Carson’s replacement at Boeing, noting that he was “following up” with them, and stating that he deserved “[a]t least” a “THANK YOU!” for “trying my best to help in all possible ways to Boeing group in this disposition [sic] case by denying knowledge of the facts.” Pl. Br. at 4; Dkt. No. 173, Ex. 1. Eight days later, Singh filed another application for work at Boeing.

The Seventh Circuit, in an opinion by Judge Richard Posner, affirmed the dismissal, and remanded the case to the district court to address plaintiffs’ counsel’s compliance with Rule 11, which Judge Posner noted the Reform Act requires even without a motion by defendants.  2013 WL 1197791 (7th Cir. March 26, 2013).  Judge Posner noted that the evidence suggested that plaintiffs’ counsel’s investigator had “qualms” about the information Mr. Singh provided, and that the failure of some of the evidence to check out “should have been a red flag.”  Judge Posner’s criticism of plaintiffs’ counsel was blistering:

Their failure to inquire further puts one in mind of ostrich tactics—of failing to inquire for fear that the inquiry might reveal stronger evidence of their scienter regarding the authenticity of the confidential source than the flimsy evidence of scienter they were able to marshal against Boeing. Representations in a filing in a federal district court that are not grounded in an “inquiry reasonable under the circumstances” or that are unlikely to “have evidentiary support after a reasonable opportunity for further investigation or discovery” violate Rules 11(b) and 11(b)(3).

The plaintiffs’ law firm–Robbins Geller Rudman & Dowd LLP–was criticized for misleading allegations, concerning confidential sources, made to stave off dismissal of a securities-fraud case much like this one, in Belmont Holdings Corp. v. SunTrust Banks, Inc., No. 1:09-cv1185-WSD, 2012 WL 4096146 at *16-18 (N.D.Ga. Aug. 28, 2012).  The firm is described in two other reported cases as having engaged in similar misconduct: Camp v. Sears Holdings Corp., 371 Fed. Appx. 212, 216-17 (2d Cir.2010); Applestein v. Medivation, Inc., 861 F.Supp.2d 1030, 1037-39 (N.D.Cal.2012). Recidivism is relevant in assessing sanctions.  Reed v. Great Lakes Cos., 330 F.3d 931, 936 (7th Cir. 2003).

 The Importance of Solving the Confidential-Witness Problem

 

Obviously, we can’t keep having problems like those at issue in these three cases.  Although these cases have received significant attention because of the prominence of the companies and judges, as well as some extreme facts (e.g. Ms. Torres contacting the court and quitting her job), problems with CW allegations – from disagreement about information attributed to them, to vagueness and ambiguity in the complaint’s descriptions and allegations – exist in many cases.  Finding a solution is important, for two main reasons.

First and foremost, CW allegations based on inaccurate information result in injustice; insufficient complaints aren’t dismissed.  Yet defendants are procedurally limited in their ability to present evidence demonstrating inaccuracies unless and until their motion to dismiss is denied.   This is so because the Reform Act’s stay of discovery during the motion to dismiss process applies to both plaintiffs’ and defendants’ discovery.  So, even if the defendants know that the plaintiffs have completely misstated what a CW told plaintiffs’ counsel/investigator – indeed, even if a purported CW claims not to have spoken with the plaintiffs at all – defendants cannot take discovery to establish such facts without court permission.  And a decision to seek court permission to conduct discovery can be tricky; there’s a risk that discovery will mushroom, and the defendants will lose the benefits of the stay.

Moreover, even if discovery demonstrates inaccuracies in the complaint, there is no completely satisfactory procedural mechanism for raising the issue before the court decides the motion to dismiss.  A Rule 11 motion is the most procedurally suitable procedure, but it is a very serious one, and the defendants rightly approach it with caution, since it can backfire in the form of an angry judge and/or an inefficiently unworkable relationship between the lawyers.  A Rule 12(f) motion to strike isn’t available in at least some courts, and is frowned upon by some others.  And defendants can submit factual information on a motion to dismiss only in limited circumstances.

So, defendants often make the best motion-to-dismiss arguments they can and then address the CW problems after the motion to dismiss is denied.  But, at that point, it’s too often late to effectively address the inaccurate CW allegations, because the case is in discovery, and the CW problems can fade into one of the myriad issues to be sorted out in discovery.

Second, I believe the greatest risk to the Reform Act’s protections has always been legislative backlash over a perception that the Reform Act is unfair to investors.  The Reform Act’s heavy pleading burdens have caused plaintiffs’ counsel to seek out former employees and others to provide internal information.  The investigative process is often difficult and is ethically tricky, and the information it generates can be lousy.  This is so even if plaintiffs’ counsel and their investigators act in good faith – information can be misunderstood, misinterpreted, and/or misconstrued by the time it is conveyed from one person to the next to the next to the next.  And, to further complicate matters, CWs sometimes recant, or even deny that they made their previous statements.

The result is an unseemly game of he-said/she-said between CWs and plaintiffs’ counsel, in which the referee is ultimately an Article III judge.

If Robbins Geller avoids sanctions in Boeing, it will be major, major news, especially given Judge Posner’s scathing criticism.  I don’t predict that there would be an outpouring of sympathy for Robbins Geller.  But I do believe that a decision not to impose sanctions, along with the outcomes of Lockheed and SunTrust, would prompt scrutiny by commentators and possibly legislators: how could there have been three cases in just the last year that turned from allegations of serious misconduct against plaintiffs’ counsel – accompanied by preliminary but harsh criticism from courts – to conduct the courts ultimately found did not violate Rule 11?

An examination of these CW hearings would necessarily involve a discussion of the Reform Act’s heightened pleading standards; they are the reason plaintiffs’ counsel turns to CWs.  Indeed, in Lockheed, Judge Rakoff’s concluding remarks noted that extreme pleading standards involve “dangers” – for example, the “difficulties plaintiffs have in getting information that they know they’re going to have to get to meet the very high standard that the Supreme Court has now imposed on plaintiffs in these cases.”

It would be highly unfortunate, however, if there were serious discussion about reforming the Reform Act’s pleading standards or other protections.  The CW problem can be solved through simpler means that do not undermine the Reform Act’s protections, which have created a system of securities litigation that is vastly superior to the one the Reform Act reformed.

Some Suggested Reforms to the CW Process

An effective solution to the CW problem could be achieved with three reforms:

First, plaintiffs’ counsel should be required to obtain from each confidential witness a declaration and/or a certification that he or she has read the complaint and agrees with the description of the information he or she provided.  This simple requirement would prevent most CW problems, and make the ones that do arise much easier to resolve.  Although some witnesses may balk at providing a declaration, few legitimate witnesses with accurate information to provide would hesitate to certify the accuracy of the relevant portions of the complaint – indeed, most would want to do so, to avoid the hassles that misunderstandings can cause.

Second, 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.

Third, defendants should be allowed to seek limited discovery, without risk to their discovery-stay rights, and to offer evidence to address significant inaccuracies before the motion to dismiss, through a motion to strike the inaccurate allegations – or, alternatively, during the motion-to-dismiss process itself, without converting the motion to a summary judgment motion.  Having a designated process for raising these concerns would help attorneys and the judge to navigate a moderate middle course between the two extremes that are pervasive today – either allowing inaccurate allegations to survive through a motion to dismiss, or taking the dramatic step of filing a Rule 11 motion against plaintiffs’ counsel.  Defendants should not be required to resort to Rule 11 to raise these issues, though they should be permitted to use Rule 11 if the conduct of plaintiffs’ counsel makes it the most appropriate course of action.

These three measures would have prevented the problems at issue in Lockheed, SunTrust, and Boeing.  For example:

  • If the CWs in Lockheed had provided declarations or certifications, Judge Rakoff would not have had to hold a day-long hearing to determine whether the CWs, in fact, told plaintiffs’ counsel’s investigator the information alleged in the complaint.
  • If plaintiffs’ counsel in SunTrust were required to more precisely allege Mr. Trapani’s employment dates, the court and parties could have avoided the hassle and spectacle of the hearing to settle this basic issue.
  • In all three cases, it would have been more efficient and less costly if defendants had an effective means of raising these concerns before the motion to dismiss, or, at the very least, during the motion-to-dismiss process.

These reforms would not only prevent unseemly showdowns – between defense counsel and plaintiffs’ counsel, or among plaintiffs’ counsel, their CWs and their investigators.  They would make all securities class action complaints more factually accurate and thus make the outcomes more just – and would help to avoid continued actions against plaintiffs’ counsel, which could eventually cause Congress to consider reforming the Reform Act.

 

* I do not include shareholder challenges to mergers in the category of “securities class actions.”  Merger cases present the biggest issue facing shareholder litigation in general:  a system that not only allows, but encourages, meritless shareholder challenges.  See here for my post on suggested reforms in that area.

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.

Continue Reading Confidential Witness Hearings in SunTrust and Lockheed Martin Demonstrate Need for Reforms