In a recent article prepared for the ABA’s National Institute on Class Actions, which is now posted on SSRN (available here), I and Professor Alexandra Lahav survey recent class action developments, and I focus particularly on the special case of securities litigation. Here, a unique and problematic feature of securities litigation is the frequent reliance placed by plaintiff’s counsel on confidential witnesses. Nowhere else does one regularly encounter detailed complaints that cite as many as 20 or more confidential witnesses (listed in order as CW-1, CW-2, CW-3, etc.), most describing damaging admissions allegedly made to these unnamed witnesses by individual defendants or senior executives at the principal corporate defendant. The origins of this anomaly are easy to understand: Necessity was the mother of invention. Plaintiff’s counsel had to find some means by which to satisfy the high pleading standards imposed by the Private Securities Litigation Reform Act (“PSLRA”), which requires (in a Rule 10b-5 case) that the plaintiff plead facts with particularity that give rise to a strong inference of fraud before the plaintiff can obtain discovery.[1] Some defense counsel regard confidential witnesses as generating more fiction than fact, in order to help the plaintiffs surmount the PSLRA’s high hurdle at the motion to dismiss stage and enter the subsequent stage where costly discovery induces defendants to settle. No case reveals anything quite this cynical, but several cases (discussed below) do show substantial distortion in the information transmission, as the witness’ testimony is aggressively rephrased, as it passes from an initial investigator, to a junior associate, and finally to senior counsel.

At present, the U.S. circuit courts of appeals are divided in their tolerance for unidentified confidential witnesses, with the Seventh Circuit holding that the statements of confidential witnesses should be “substantially discounted”^[2] while the Second and Third Circuits permit the use of confidential witnesses “provided they are described with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information.”^[3]

In this light, what can or should be done with respect to the use of confidential witnesses? One real possibility is the development of best practices standards. The Federal Rules Committee is interested in this possibility, and, in support thereof, Duke University Law School sponsored a program this summer in New York City to discuss possible such standards with a specially invited group of federal judges and prominent practitioners. I served as moderator for the panel dealing with confidential witnesses, but, because Gresham House rules applied, I cannot discuss the views of any specific participant. Still, it will surprise few to learn that plaintiff and defense counsel disagreed. The former thought that defense counsel “were inventing a solution for a problem that does not exist,” and defense counsel believed that the PSLRA was being outflanked by creative pleading that was only thinly grounded in fact. Equally significant, judges had a different problem: At the motion to dismiss stage, judges are not authorized to find facts, but must accept the well-pleaded allegations in the complaint. What then do they do when defendants produce affidavits from confidential witnesses asserting they have been misquoted? Some cases have found ways to permit some fact-finding at this stage, but the legitimacy of these decisions was questioned by some of the participants.

To evaluate what best practices are needed, it is useful to begin with the facts of several well-known cases. Probably the best known of these decisions is Judge Posner’s 2013 opinion in the Boeing litigation.[4] There, the issue was whether senior executives at Boeing were already aware of certain stress problems that had developed in the wings of Boeing’s new Dreamliner aircraft at the time they announced (incorrectly) that there would be no delay in its initial flight test. Initially, the U.S. district court dismissed the complaint for failure to plead facts giving rise to a strong inference of scienter, but it allowed plaintiffs to file an Amended Complaint. Then, it reversed its decision when this Amended Complaint pled that a confidential witness, described as a Boeing “chief engineer” who had worked on wing-stress tests on the Dreamliner, had seen “internal contemporaneous communications regarding the specific results of the tests and copies of internal communications to Boeing’s senior executives” informing them that “the tests had failed and a delay was likely.”[5]

Although these allegations looked like a smoking gun, they had no basis in fact. Ultimately, it turned out that the confidential witness had not worked for Boeing, but only for a contractor performing low-level engineering work on a different model airplane, and had never been shown the complaint. Nor did the witness have access to Boeing’s internal data. Finally, the witness denied most of the statements attributed to him. Based on evidence to this effect, defendants convinced the trial court to reconsider her earlier denial of the motion to dismiss, and the court dismissed the complaint with prejudice.

What had gone wrong? In a pattern that has occurred repeatedly, the confidential witness had been interviewed by two investigators, first in a phone call with one, and then in a two hour interview with the second. None of the plaintiffs’ attorneys had met the witness until after the second amended complaint had been filed; no tape recording was taken at the interview, and each investigator was alone with the witness and had no corroborating witness as to what was said.

On appeal to the Seventh Circuit, the plaintiffs challenged the ability of the trial court to make findings on disputed facts on a motion to dismiss, but Judge Posner outflanked this argument, finding that because the plaintiffs had “abandoned” “their sole confidential source”—without whom the case had earlier been dismissed—nothing remained in dispute.[6] The Seventh Circuit thus upheld the district court and also insisted that Rule 11 sanctions be imposed (and the district court complied).

This same procedural issue has arisen in other cases when defendants have been able to identify and interview a confidential witness for plaintiffs. At this point, defendants will file with their motion to dismiss the witness’s affidavit, which typically denies that the witness ever said anything resembling what the complaint alleges he said. This frames the key procedural issue: How is the district court to resolve disputed facts on a motion to dismiss when it is normally expected at this stage to accept all well-pleaded facts? The one decision that provides a clear answer is Campo v. Sears Holding Corp,^[7] but it is controversial. There, the district court noted that plaintiff’s complaint was thin and hinged on statements by confidential witnesses.^[8] Although it denied defendant’s motion to dismiss, it did so without prejudice and ordered a limited number of depositions of the confidential witnesses. Finding ultimately that these witnesses’ statements at these depositions did not corroborate the statements attributed to them in the complaint, the court dismissed the complaint. On appeal, the Second Circuit affirmed, noting that the “anonymity of these sources of plaintiff’s factual allegations concerning scienter frustrates Tellabs’ requirement that a court weigh competing inferences.”^[9] In Tellabs, the Supreme Court had ruled that the ultimate test on a motion to dismiss under the PSLRA was whether “a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.”[10] Accordingly, the Second Circuit said, “the district court’s use of the confidential witnesses’ [deposition] testimony to test the good faith basis of plaintiffs’ compliance with Tellabs was permissible.”^[11]

This decision may surprise orthodox proceduralists, but Tellabs arguably reframes the motion to dismiss in securities law cases, converting it into a comparison of competing inferences at which some discovery may be permitted to test the reliability of the allegations. Under Campo, the motion to dismiss could begin to approach a mini-summary judgment motion. Still, how other circuits will respond to Campo remains to be seen, and several judges at the Duke conference thought the decision went too far.

Probably the most important and revealing district court decision on confidential witnesses is Judge Engelmayer’s opinion in In re Millennial Media, Inc. Securities Litigation,^[12] because he there undertook to set forth ethical best practices that plaintiff’s attorneys should satisfy in connection with their use of confidential witnesses. In the Millennial Media case, plaintiffs’ complaint attributed information to some 11 confidential witnesses. Then, one confidential witness (CW-4) informed plaintiffs that he did not wish to be quoted, and plaintiffs sought permission from the court to file a “Supplemental Amended Complaint” that would delete all references to CW-4. Concerned as to whether CW-4 had also disputed the statements attributed to him and whether plaintiffs had followed appropriate practices in dealing with the other confidential witnesses, Judge Engelmayer directed that (1) a sworn affidavit be filed by plaintiffs, signed by a “personally knowledgeable attorney explaining with specificity” the circumstances by which CW-4’s statements were included in the complaint, and (2) a sworn affidavit from CW-4 recounting his version of these events. When these affidavits were filed, it appeared that CW-4 had only been interviewed once, telephonically, by an investigator, had never been told that he would be quoted, had not been shown the complaint before it was filed, and had disputed the accuracy of several of the statements in the complaint attributed to him. Defendants then filed documents indicating that CWs 5, 8, and 11 also objected to how they were quoted. Eventually, after further submissions mandated by the court, the court found that plaintiffs’ counsel had never personally spoken to 10 of the 11 persons identified as CWs; none of the 11 knew that they were to be quoted; four of the 11 (CWs 4, 5, 8, and 11) had asked to be removed from the complaint, and at least four claimed to have either been misquoted or misleadingly quoted.

At this point, plaintiffs filed a motion for voluntary dismissal of the action, to which defendants consented. Finding these practices “unsettling” and “problematic,” the court indicated that, even if these practices were industry-wide (as plaintiffs’ counsel confidently asserted), it found them unacceptable for two reasons: (1) the potential for inaccuracy, and (2) the unfairness to such witnesses. The court then added that plaintiffs’ counsel’s failure “to confirm the quotes of a witness on whom counsel purposes to rely in a public filing sits at best uneasily alongside Federal Rule of Civil Procedure 11.”[13]

Judge Engelmayer made clear that the use of an investigator to conduct the initial interview is appropriate, but, he added, Rule 11’s requirement of an “inquiry reasonable under the circumstances…demands more.” The court’s bottom line was that it expected “counsel before filing the Complaint, to attempt to confirm with the witness the statements that counsel proposes to attribute to him and to assure that the Complaint is presenting these statements in fair context.”[14] “Basic decency,” he added, requires the same. Finally, Judge Engelmayer concluded:

“[C]ounsel here treated these people shabbily. The Court’s hope and expectation is that, in future cases, counsel will aspire to do better.”[15]

How should we translate Judge Engelmayer’s strongly felt concerns into best practice standards? Among the obvious possibilities are: (1) a senior plaintiff’s counsel in the action should personally interview each confidential witness and affirm to the court in a written certification that each witness confirmed to this counsel the statements attributed to the witness in the complaint; and (2) such senior counsel also affirms that each confidential witness was either shown the complaint or informed how he or she was being quoted and did not object. Several experienced plaintiff’s counsel have advised me that they already do this. Fine, that is where a best practices standard should start: namely, with a practice already observed by the best counsel. Still, some defense counsel want more, arguing that plaintiff’s counsel should obtain an affidavit from any confidential witness it offered, summarizing its testimony. Here, I agree with plaintiff’s counsel that witnesses would never sign such an affidavit and would disappear.

If it is agreed that plaintiff’s counsel should confirm with the confidential witness through personal contacts the allegations reported by investigators, the next question is: How should this best practice be enforced? My preferred answer would be that a court, in conducting the Tellabs-mandated comparison of inferences, should ask for a certification by plaintiff’s counsel that a senior counsel on the case has contacted each confidential witness and heard the essential allegations confirmed by the witness. Absent such a certification, the court could find that it is unable to draw any reliable inferences from the allegations and hence find for defendants.

But what happens if this certification is given, and defense counsel obtains an affidavit from one or more witnesses claiming that the witness was seriously misquoted? Here, different answers are possible. The Campo decision suggests that the court could order depositions, but some judges at the Duke symposium expressed the view that this is beyond their power at the motion to dismiss stage. At least one judge felt that the only answer was an immediate Rule 11 hearing to determine if the plaintiff’s counsel took reasonable steps to verify the allegations it asserted. Still, most judges and practitioners were reluctant to turn to Rule 11 or sanctions as their first or best answer.

To satisfy the proceduralists, another possibility when there is such a dispute over the reliability of allegations based on confidential witnesses is to rely on Rule 43(b) of the Federal Rules of Civil Procedure. It states:

“When a motion relies on facts outside the record, the court may hear the matter on affidavits or may hear it wholly or partly on oral testimony or on depositions.”

Arguably, if defendant’s motion to dismiss relies on statements that confidential witnesses have denied or recanted the assertions attributed to them in the complaint, this should allow the court to turn to Rule 43(b) and order testimony or depositions. In short, Rule 43(b) could provide a stronger procedural foundation for the novel procedure used in Campo.

Nonetheless, as a practical matter, it may be enough simply for the district court to request a certification that one of the senior counsel for plaintiff’s interviewed the confidential witness, confirmed his testimony with him, and explained that counsel would be citing it in their complaints. Few counsel will be reckless enough to give such a certification without direct contact with the witness.

Plaintiff’s counsel feel that they are exposed in this context because defense counsel can pressure a confidential witness to recant, darkly hinting at professional repercussions if the witness does not recant. Certainly, a witness who is properly described in the complaint will often be easily identified by defense counsel. But one answer here would be for plaintiff’s counsel to hire an independent counsel for its confidential witnesses. This would preclude direct communication by defense counsel with the witness, except in the presence of independent counsel, and this should chill pressure and potential retaliation.

To sum up, the pattern shown by these cases—Boeing, Campo, and Millennial Media—is more one of optimistic distortion than bald-faced fabrication. To paraphrase Simon & Garfunkel, “a man hears what he wants to hear and disregards the rest”[16]—that is, in the transmission from investigator to counsel, the allegations become inflated and selectively edited. Here, best practices standards seem the better and more proportional response, and Rule 11 sanctions should be reserved for egregious cases. The better plaintiff’s counsel already recognize the need for direct communication between senior counsel and the witness, and the purpose of best practices standards is to pull the laggards up. Will such standards ever be adopted? This is hard to predict, because the Bar resists change. Still, it is time for other judges to follow Judge Engelmayer’s lead!

ENDNOTES

[1] See Section 21D(b)(2) of the Securities Exchange Act of 1934, 15 U.S.C. §78u-4.

[2] City of Livonia Emps. Ret. System & Local 295/Local 831 v. Boeing Co., 711 F. 3d 754 (7^th Cir. 2013).

[3] Novak v. Kasaks, 216 F. 3d 300, 314 (2d Cir. 2000); Cal. Pub. Employees’ Ret. Sys. v. Chubb Corp., 394 F. 3d 126 (3d Cir. 2004).

[4] See City of Livonia Emps. Ret. System v. Boeing Co., supra note 39.

[5] 711 F. 3d at 759-761.

[6] Id at 761.

[7] 635 F. Supp 2d 323 (S.D.N.Y. 2009), aff’d 371 F. App’x 212 (2d Cir. 2010).

[8] 635 F. Supp. 2d at 334-336

[9] See Tellabs, Inc. v. Makor Issues & Rights, Ltd.,  554 U.S. 308, 324 (2007)(“a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.”)

[10] 371 F. App’x 212, 216 n. 4 (2^d Cir. 2010)

[11] See 371 F. App’x 212, 216 n. 4. The court justified this investigation into “good faith” based on Rule 11’s requirement “that there be a good faith basis for the factual and legal contentions contained in a pleading…” Id.

[12] 2015 U.S. Dist. LEXIS 69534 (S.D.N.Y. May 29, 2015), 14 Civ. 7923 (PAE).

[13] 2015 U.S. Dist. LEXIS 69534 at *32-*33.

[14] Id at *34.

[15] Id at *44.

[16] For those of the Millennial Generation (and others grossly ignorant of the classics), this line is from Paul Simon’s “The Boxer” (1969).

This post comes to us from John C. Coffee, Jr,, the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance. It is based on his recent article, co-written with Alexandra Lahav, “Class Actions in the Era of Trump: Trends and Developments in Class Certification and Related Issues,” available here.