Confidential Witnesses

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.


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