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Since the passage of the Private Securities Litigation Reform Act of 1995, with its heightened pleading standards for shareholder plaintiffs, it has become routine for plaintiffs’ lawyers to load their federal securities class action complaints with allegations purportedly obtained from “confidential witnesses” (or “CWs”). Plaintiffs frequently use these anonymous sources, alleged to be witnesses from “inside” the defendant corporation, in an effort to bolster their allegations that officers and directors acted with the required scienter, or state of mind. The weight that courts should place on these allegations has been repeatedly contested. Defendants have sought to peel away the “confidential” label attached to the CWs and to discover the identity of these individuals in order to assess – and challenge – the veracity and reliability of these allegations. See, e.g., Ryan v. Flowserve, 2006 U.S. Dist. LEXIS 51211, at *6 (N.D. Tex. May 1, 2006 (rejecting plaintiffs’ request for a protective order restricting disclosure of names of “confidential witnesses” referenced in pleading). Last year, the United States Court of Appeals for the Second Circuit, in affirming the dismissal of a federal securities fraud class action, endorsed the deposition of CWs at the motion to dismiss stage. Campo v. Sears Holdings Corp., 2010 WL 1292329 (2d Cir. Apr. 6, 2010).

Despite skepticism, courts have generally agreed that plaintiffs may rely on CW allegations if the complaint includes “detail provided by the confidential sources, the sources’ basis of knowledge, the reliability of the sources, the corroborative nature of other facts alleged, including from other sources, the coherence and plausibility of the allegations, and similar indicia.” Institutional Investors Group v. Avaya, Inc., 564 F.3d 242, 263 (3d Cir. 2009). Specificity is required because courts recognize that “these confidential sources [may] have axes to grind. Perhaps they are lying. Perhaps they don’t even exist.” Higginbotham v. Baxter Int’l Inc., 495 F.3d 753, 757 (7th Cir. 2007).

The latest decision on CWs, from the United States District Court for the Northern District of Illinois, graphically illustrates this concern. Last week, in City of Livonia Employees Retirement System v. The Boeing Company, the district court granted a motion for reconsideration pursuant to Rule 54(b) of the Federal Rules of Civil Procedure on the grounds that the court’s previous denials of Boeing’s motion to dismiss were premised upon false information in the complaint concerning a CW’s position and personal knowledge of the alleged fraud.

In Boeing, shareholder plaintiffs asserted that the company had made misrepresentations about the testing and delivery schedule for the 787 Dreamliner commercial aircraft. Plaintiffs relied on allegations by an unnamed CW who was said to be a Boeing “chief engineer” with personal knowledge that adverse test results were circulated to – and concealed by – senior Boeing executives. After dismissal was denied in August 2010, in part based upon the scienter allegations attributed to this CW, defendants learned the CW’s identity. They ultimately determined that he was in fact not a Boeing employee, had no personal knowledge of the Dreamliner test results, had never met plaintiffs’ counsel prior to being deposed, and had never been shown the allegations attributed to him in the complaint. Defendants again filed a motion to dismiss, arguing that they had learned that plaintiffs’ CW allegations were false. The judge initially denied defendants’ motion to dismiss in October 2010.

While plaintiffs’ lead counsel Robbins Geller Rudman & Dowd was in the process of attempting to certify the case as a class action, the defense subpoenaed the CW. The individual denied that he was the source of the allegations attributed to him. The CW also testified that he was never a Boeing engineer but rather an employee of a Boeing contractor. Also, the CW was not employed at the contractor when the 2009 Dreamliner tests occurred and had no personal knowledge of the adverse test results or their circulation to Boeing executives. Indeed, plaintiffs’ lawyers never met with the CW before filing the complaint relying upon him. Rather, they merely incorporated information derived from notes purportedly taken by their investigators who attempted communications with the CW.

On the basis of this testimony, the defendants returned to the district court with a motion seeking reconsideration of prior denials of their motions to dismiss. Plaintiffs’ counsel asserted in response that, although they had never met the CW prior to his deposition, he had told the truth to their investigators and was now lying for ulterior motives. The court granted the defendants’ motion to reconsider and dismissed the complaint with prejudice. City of Livonia Employees’ Ret. Sys. v. The Boeing Co., C.A. No. 09 C 7143 (N.D. Il. Mar. 7, 2011). The court concluded that “[t]he reality is that the informational basis for [the complaint] is at best unreliable and at worst fraudulent.” “More significantly, this unseemly conflict between plaintiffs’ confidential source and plaintiffs’ investigators could have been avoided by reasonable inquiry on the part of plaintiffs’ counsel before filing the. . .complaint, and, later, by making flawed representations directly to the court about the confidential source’s position and firsthand knowledge of Boeing’s internal testing documents.” The court was troubled by plaintiffs’ counsels’ reliance on investigators’ unverified interview reports, particularly when one such report had described portions of the CW’s information as unreliable.

The similarities between the denials and repudiations of CW allegations in the Boeing and Campo cases and other recent federal securities fraud suits cannot be ignored. Faced with the these recent decisions, plaintiffs’ counsel should abandon all expectations that they may “protect” the identity of CWs, as they have attempted to do in the past. Moreover, as the costs of federal securities actions continue to rise, public companies and their counsel should reassess every means of unmasking alleged “confidential witnesses.” Armed with the growing record of purported unnamed “insiders” cited in securities fraud pleadings who ultimately disavow facts attributed to them as inaccurate or outright false, defense counsel should seek to challenge the underlying basis for CW allegations as early as possible in these cases.

To read the Boeing decision, please click here.

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