As a result of the PSLRA’s heightened pleading standard and pre-dismissal motion discovery bar, as well as the requirements of cases such as Tellabs, plaintiffs in liability suits under the federal securities laws frequently rely on confidential witnesses. This practice has led to  the “confidential witness problem” in securities litigation. In a September 25, 2017 post on The CLS Blue Sky Blog entitled “Confidential Distortion: Dealing with Confidential Witnesses in Securities Litigation” (here), Columbia Law School Professor John Coffee takes a look at the problems that have arisen in connection with confidential witness practices and the ways court have tried to deal with the problems. He then explores some possible “best practices” for courts and parties to use to try to avoid the problems, which I discuss below.

Under the PLSRA and related case law, in order to survive a motion to dismiss, securities plaintiffs must plead facts sufficient to create a strong inference that the defendants acted with scienter. As a result of the PSLRA’s pre-dismissal motion discovery bar, plaintiffs at the initial pleading stage usually will not have access to documentary or deposition testimony relevant to the defendants’ state of mind. These restrictions have produced what Southern District of New York Judge Jed Rakoff has called “an unintended consequence” in that it forces plaintiffs’ counsel to “undertake surreptitious pre-pleading investigations designed to obtain ‘dirt’ from dissatisfied employees.”

Allegations based on confidential witness testimony may prove sufficient for the plaintiffs’ complaint to survive the dismissal motion. The problems arise when the confidential witnesses’ identities becomes know, as it will in post-dismissal motion discovery (although sometimes the identities are unearthed prior to the dismissal motion). What sometimes (often?) happens is that when the witnesses are questioned, the witnesses recant. Judge Rakoff noted that this can sometimes happened because the witnesses are “pressured into denying outright the statements they had actually made.”

As Professor Coffee notes in his recent blog post, one of the frequent sources of these problems is the way in which the witnesses’ testimony is gathered and then transferred into the pleadings. As he notes, several cases involving recanted confidential witness testimony “show substantial distortion in the information transmission, as the witness’ testimony is aggressively rephrased, as it passes from the initial investigator, to a junior associate, and finally to senior counsel.”

Because of these kinds of concerns, the Seventh Circuit has taken the position that the statements of confidential witnesses should be “substantially discounted”, 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.”

In order to address the question of what courts should try to do to manage confidential witness issues, Professor Coffee examines the approaches that several courts have taken in order to try to see if it might be possible to develop some “best practices standards.”

The problem in thinking about these issues is that in ruling on a motion to dismiss, a district court judge must accepted all well-pleaded facts as true. Questions about the veracity and reliability of confidential witnesses involved disputed facts of a kind ordinarily not to be resolved or even addressed at the dismissal motion stage.

As Professor Coffee discusses in his article, in order to address these issues, the district court in Campo v. Sears Holding Corp. denied the defendants’ motion to dismiss without prejudice and ordered deposition testimony of the confidential witnesses (for the background on this refer here, to footnote 54). Following the depositions, the defendants renewed their motion to dismiss, which was granted. The Second Circuit affirmed, saying that “the district court’s use of confidential witnesses’ [deposition] testimony to test the good faith basis of plaintiffs’ compliance with Tellabs was permissible.

Professor Coffee notes that this approach may “surprise orthodox proceduralists,” as under this approach the motion to dismiss could approach a mini-summary judgment motion.  Coffee suggests that Fed. R. Civ. Proc. 43 might provide a way to satisfy the proceduralists; Rule 43(c) provides that “When a motion relies on facts outside the record, the court may hear the matter on affidavits or may hear it in wholly or partly on oral testimony or on depositions.” (Professor Coffee’s article refers to Rule 43(b), but I believe he intended to refer to Rule 43(c)). He suggests that if a defendants’ motion to dismiss relies on the argument that confidential witnesses have denied or recanted the assertions attributed to them, the Court could rely on Rule 43(c).

The problem with this approach is that it depends on the defendants being able to challenge the confidential witnesses’ testimony at the dismissal motion stage. This approach doesn’t help defendants who only determine through post-motion to dismiss discovery that there are problems with the confidential witness testimony.

In looking at the cases in which confidential witness problems arise, one recurring theme has to do with the fact that the witnesses often are interviewed by investigators, while the witnesses’ testimony is reported in pleadings by attorneys who did not actually speak to the witnesses. Coffee refers to a May 2015 opinion by Judge Paul Engelmayer in In re Millennial Media Securities Litigation (here), in which Judge Englemayer notes that while there is nothing wrong with having an initial interview with a prospective witness “inquiry reasonable under the circumstances … demands more.” Specifically, Judge Engelmayer suggested that the Court expected before filing a complaint that counsel “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.”

Professor Coffee suggests confidential witness best practices standards might specify that 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 confidential witness confirmed the statements in the complaint attributed to the witness and that senior counsel affirms that the witness was shown the complaint or informed of how he or she was being quoted and did not object.

Coffee acknowledges in this article that in the face of this kind of affirmation requirement, plaintiffs’ counsel have expressed the view that they would be “exposed” because “defense counsel can pressure confidential witnesses to recant.” Coffee suggests that one approach to offset this concern is for plaintiffs’ counsel to hire independent counsel for confidential witnesses, which would preclude direct communications between defense counsel and the witness (other than in the presence of the independent counsel) which should “chill pressure and potential retaliation.”

Discussion

Reading Professor Coffee’s article and in particular reviewing his discussion of the various cases in which these kinds of issues have arisen is a reminder that the practices surrounding the involvement of confidential witnesses in securities litigation is a significant and recurring problem, as I have previously noted on this blog.

There have been prior proposals to try to address these issues, such as, for example, requiring confidential witnesses to provide a sworn declaration as to their testimony. Coffee acknowledges this proposal in his article, commenting that “I agree with plaintiffs’ counsel that witnesses would never sign such an affidavit and would disappear.”

Coffee’s suggestion of an affirmation from plaintiffs’ counsel that counsel (rather than just an investigator) has spoken to the witness and that witness had affirmed the statements attributed to him or her in the complaint seems like a more workable solution. Perhaps courts could adopt practices where in the absence of this type of affirmation that the court would permit the type of limited deposition testimony allowed by the court in the Sears Holding Corp. case. Alternatively, perhaps the Seventh Circuit’s “substantially discounted” standard could be matched up with an affirmation requirement, whereby the confidential witness statements would be discounted in the absence of an affirmation by counsel.

I suspect that plaintiffs’ counsel would resist these ideas, to which I would say, OK what is your idea for dealing with this issue? It is not sufficient for current practices simply to continue. As Judge Rakoff noted in his July 9, 2013 order in the Lockheed Martin securities class action lawsuit (here),

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 disgruntles 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 PLSRA and cases like Tellabs are likely to make such problems endemic.

For more about the problems arising from the involvement of confidential witnesses in securities litigation, please see Doug Greene’s post on his D&O Discourse blog entitled “Flawed Confidential Witness Allegations: A Crucial Issue in Securities Class Action Litigation” (here).