Largely as a result of the pre-dismissal motion discovery bar and the heighted pleading standard Congress and the courts have imposed, the plaintiffs in these cases increasingly have come to rely on the statements of confidential witnesses in attempting to plead securities fraud cases, a development that has become the target of extensive criticism.


In an unusual July 9, 2013 post-settlement order in the Lockheed Martin securities class action lawsuit, Southern District of New York Jed Rakoff examines the role of confidential witness-based allegations, both in the Lockheed case itself and in securities cases in general. As is clear from Judge Rakoff’s memorandum, the plaintiffs’ reliance on confidential witness testimony to try to meet heightened pleading standards presents a problem for both plaintiffs and for defendants, as well as for the courts. A copy of Judge Rakoff’s July 9 opinion can be found here.



As discussed here, in July 2011, shareholder plaintiffs filed a securities class action lawsuit against Lockheed Martin and certain of its directors and officers. Among other things, the plaintiffs alleged that the defendants had misrepresented the company’s prospects and financial results. In support of their allegations, the plaintiffs’ complaint relied in part on the supposed testimony of certain confidential witnesses, who were current or former company employees and who provided testimony substantiating that the individual defendants were aware of certain facts or had knowledge of certain issues. The defendants moved to dismiss the plaintiffs’ complaint.


In a February 14, 2012 ruling explained in a July 13, 2012 order, Judge Rakoff denied the defendants’ motion to dismiss – as he later noted, the dismissal denial was “partly in reliance on the statements attributable to the [confidential witnesses].” After the dismissal motion was denied, the parties commenced discovery. Defense counsel used discovery processes to obtain the names of the confidential witnesses and then took their depositions.


The defendants then filed a motion for partial summary judgment, arguing that in their depositions, the confidential witnesses had recanted their testimony or denied having made the statements attributed to them. The plaintiffs countered that the witnesses had changed their stories because of financial or other pressure Lockheed had brought to bear on them but that their investigator’s notes largely confirmed what had been attributed to the witnesses in the complaint.


As Judge Rakoff later explained in his recent memorandum, because “the parties competing assertions raise serious questions” that “implicated the integrity of the adversary process itself, he ordered five of the confidential witnesses to appear in court, along with the plaintiffs’ investigator. The transcript of the October 2012 hearing, which can be found here, makes for some interesting reading


On December 14, 2012, Judge Rakoff issued an order denying the defendants’ motion for summary judgment, with an opinion to follow. That same day, the parties informed the court that they had settled the case. Judge Rakoff preliminarily approved the settlement in March 2013. Even though the case has settled and it was, as Rakoff noted in his recent memorandum opinion, “no longer necessary to issue a full opinion” explaining his reasons for denying the defendants’ motion for summary judgment, Judge Rakoff nevertheless issued his July 9 memorandum because, he noted, “a few comments may be helpful in light of certain issues presented by [the summary judgment] motion that are likely to recur in future cases.”


The July 9 Memorandum

Judge Rakoff opened his July 9 memorandum by noting that “the recent attempts by Congress and the Supreme Court to curtail what they perceive as vexatious, even extortionate class action filings have spawned innovative but problematic reactions—as this case illustrates.” He added that the procedural hurdles that Congress and the courts had created, while designed to give the courts a “gatekeeper” function to weed out “dubious class action lawsuits at the outset,” have produced “an unintended consequence” – that is, that plaintiffs’ counsel “undertake surreptitious pre-pleading investigations designed to obtain ‘dirt’ from dissatisfied employees.” The amended complaint in this case, “as in many others,” relied on information attributed to confidential witnesses.


After reviewing the cases’ procedural history and the reasons why he convened the unusual October 2012 hearing at which he heard the live testimony of the previously confidential witnesses and the plaintiffs’ investigator, he summarized his conclusions about the testimony. Judge Rakoff stated that the testimony


bore witness to the competing pressures this process has placed on the confidential witnesses and the impact such pressures had had on their ability to tell the truth. In a nutshell, it appeared to the Court that some, though not all of the [confidential witnesses] had been lured by the investigator into stating as ‘facts’ what often were mere surmises, but then, when their indiscretions were revealed, felt pressured into denying outright statements they had actually made.


With respect to three of the witnesses who had backpedaled rather too far from what they had told the plaintiffs’ investigator, Rakoff said that “while the court was not unsympathetic to the difficult position in which these witnesses found themselves, their disrespect for their obligation to tell the truth hardly redounded to their credit.” Rakoff contrasted these witnesses from two others who “provided welcome evidence that some witnesses can still place the value of truth above their self-interest.”


Judge Rakoff found with respect to the plaintiffs’ investigator that “his report of his findings to plaintiff’s counsel was accurate in all material respects.” The only statement attributed to a confidential witness that was not accurately stated in the amended complaint was not the result of mis-reporting by the investigator “but of mis-drafting by counsel.” The amended complaint, in a misstament Judge Rakoff described as “improper,” characterized a witness’s surmise as actual knowledge, “an error made more egregious by the fact that the Court had relied, in part, on the statement” in denying the motion to dismiss. However he noted that had had relied on other evidence as well, and the plaintiff’s counsel had subsequently amended the complaint to correct the error.


Strictly speaking, there was no reason for Judge Rakoff to have issued his July 9 memorandum. With the case settled, no issues remained before him except as pertains to procedures surrounding the pending settlement. In his concluding paragraph, Judge Rakoff explained why he nevertheless released the Memorandum:


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. Bat as it is, the combined effect of the PSLRA and cases like Tellabs are likely to make such problems endemic



Judge Rakoff is far from the first observer to note the problems involved with plaintiffs’ reliance on confidential witnesses and the abuses that can sometimes result. Indeed he is far from the first member of the judiciary to raise a red flag about the problems associated with confidential witness testimony in securities cases.


For example, in a February 5, 2013 order in the SunTrust Banks securities suit, in which Northern District of Georgia Judge William S. Duffey, Jr.,   in a post-dismissal proceeding in which he denied the defendants’ motion for sanctions, noted that the plaintiffs’ conduct with respect to a confidential witness was “not in keeping with the conduct expected of attorneys practicing before the Court.” While counsel’s actions “did not constitute an actionable violation,” the Court “remains troubled by the conduct of Plaintiffs’ counsel.”


By the same token, in a March 26, 2013 decision of the Seventh Circuit in an opinion by Judge Richard Posner in the Boeing securities class action lawsuit, the appellate court remanded a case to the district court to address the plaintiffs’ counsel’s compliance with Fed. R. Civ. Proc. 11, noting that the plaintiff’s counsel’s failure to inquire about apparent concerns with a confidential witness’s testimony “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 that the flimsy evidence of scienter they were able to marshal against Boeing.” The Court noted that the law firm involved had been criticized in other cases for “misleading allegations concerning confidential witnesses” and added that “recidivism is relevant in assessing sanctions.”


What makes Judge Rakoff’s observations about the ills associated with the plaintiffs’ reliance on confidential witnesses noteworthy (other than the fact that he went way out of his way to issue an entirely non-required statement) is that he emphasized that the problem is an issue for both plaintiffs and for defendants and, more importantly, he focused on the cause of the problem. Rakoff sees the problem as the unintended result of the pleading constraints that Congress and the Supreme Court have put on plaintiff shareholders in securities class action lawsuits. In his view, the problem appears almost unavoidable, or at least highly likely to recur, making these kinds of problems “endemic.”


Judge Rakoff stated that he was issuing his memorandum, despite the absence any case-specific reason to do so, because he wanted to “focus attention” on the problem. He does not specify whose attention he wants to focus. Certainly, he got my attention, as well as that of other bloggers. But although I am sure Judge Rakoff is quite attentive to opinion in the blogosphere, I recognize that his primary motivation was trying to attract the attention of Congress and appellate courts, to show them how the unintended consequences of their actions were producing a serious problem of all concerned.


Though Judge Rakoff can try to focus attention on the problem, that effort alone does not address the obvious next question, which is – what can be done about it?


In an April 4, 2013 post on his D&O Discourse blog (here), securities litigator Doug Greene of the Lane Powell lays out his proposal of what to do about the confidential witness problem. Among other things, Greene suggests requiring plaintiffs’ lawyers to include sworn declaration from confidential witnesses and to provide employment related information to substantiate that their employment provided them the actual opportunity to observe the events about which they were testifying. Greene also proposes allowing defense counsel limited discovery of confidential witnesses prior to the motion to dismiss, to avoid situations where dismissal motions are granted based on the testimony of witnesses that later recant. (I should emphasize that I am summarizing Greene’s proposals ; his analysis and discussion of these issues is extensive and warrants a full reading, rather than my mere summary description here).


Certainly, one of the issues causing the confidential witness problem is that they are, well, confidential. The pattern recurs often that after the dismissal motion is denied, and the witnesses’ identities are known and their testimony is questioned, the witnesses recant. In that respect, Greene’s suggestion that plaintiffs must provide greater corroborating and identifying information appears to have a substantial basis.


On the other hand, as Judge Rakoff noted, once the identities of confidential witnesses are known, they are then “pressured into denying outright the statements they had actually made.” As one leading plaintiffs’ lawyer has said to me, confidential witnesses always recant, because of the financial and other pressure their employer can bring to bear on them, regardless of how precise, specific and detailed their prior testimony had been. The introduction of procedural steps that would accelerate the process of forcing witnesses to recant their testimony – even where, as Judge Rakoff noted, they had actually made the statements they were now denying – will not necessarily and in every case represent a guarantee of greater integrity in the process.


The one thing that is clear is that we have a problem. Judge Rakoff is right to try to draw attention to this problem. Whether or not the problem is, as Judge Rakoff state, “endemic,” it clearly is a recurring problem. While greater scrutiny of plaintiffs’ use of confidential witness testimony is one step to try to address this problem, that alone will not be sufficient. As Judge Rakoff’s memorandum highlights, the focus should be on the cause of the problem, which he regards as the unintended result of the specific steps taking by Congress and the courts to rein in abusive securities litigation.


I have no brilliant proposals to address this problem, but I think Judge Rakoff is on the right track. It is more important to look at causes, rather than effects. The focus should be on the causes. More importantly, there must be a focus. This is a problem that is not going away.


More About the Supreme Court: When the founding fathers in their ageless wisdom set up our tripartite system of government, they virtually guaranteed that there would be tension between the three branches. A recent essay in the Lexington column in the Economist magazine taking a look at the just-completed Supreme Court term comments on how this tension – particularly the tension between the Court and Congress – characterizes much of the Court’s late term activities.


In the essay, entitled “Above the Fray, but Part of It,” the column’s author notes that


A single instinct binds together several big and seemingly incompatible rulings handed down by the Supreme Court at the end of its term. That instinct touches on traditional arguments about the competing rights of the federal government versus the 50 states, but is larger than a discussion of states’ rights. Put simply, the court showed a deep suspicion of attempts to use the law to place a particular group or institution on a pedestal, granting it special privileges to shield it from attack or competition. To give the instinct a single label, the court rejected paternalism as a way of organizing American society.


After noting that the court had rejected one kind of paternalism in the Voting Rights Act and affirmative action cases, “in striking down the Defense of Marriage Act, the majority was – in effect — taking issue with a paternalism of the right.” The Supreme Court’s suspicion of paternalism “belongs to a long national tradition, to be sure: America was born of revolution and built around self-government.”


Just the same, the court’s end-of-term rulings “defy easy partisan labeling.” Both from the right and the left there is a distinct sense of “what is at stake, politically.” As the column’s author notes, “This is a Supreme Court which does not hide its disdain for Congress.” It is a “supremely confident court.” As a result, “this has been a term of unusual confrontation and drama. Expect more to follow.”