The “Tellabs Excuse” and Confidential Witnesses

When the Supreme Court decided Tellabs, Inc v. Makor Issues last June, holding that securities-fraud plaintiffs must plead facts giving rise to a “powerful or cogent” inference of scienter to survive a motion to dismiss under the Private Securities Litigation Reform Act, I argued on this Blog and at The Race to the Bottom that the case did little to change the law, characterizing it as a victory for shareholders.  I noted, however, that Tellabs would provide an excuse to judges predisposed to dismissing securities class actions, allowing courts to dispose of suits on the ground that the complaint did not give rise to an inference of scienter “powerful or cogent” enough for the judges’ tastes. 

The Seventh Circuit has now provided the first example of the “Tellabs Excuse” at work: Higginbotham v. Baxter International.  (Primary materials from the case can be found here.)  While I expected that the federal courts would rely on Tellabs as a frequent basis for securities-fraud dismissals, I didn’t expect judges to go so far as to invoke Tellabs to eliminate the use of confidential witnesses to meet the pleading standard for securities class actions.  Nonetheless, that is awfully close to what the Seventh Circuit has done.

Baxter is a fairly traditional securities-fraud suit, turning on whether the complaint adequately alleged scienter.  The case involved allegations of fraud in Baxter’s Brazilian subsidiary, including conduct that ultimately required the company to restate its financial results.  On the day the problem in Brazil was announced, Baxter’s shares fell by 4.6%. 

The Seventh Circuit panel included Chief Judge Easterbrook and Judges Posner and Ripple, and it was clear at oral argument that Chief Judge Easterbrook and Judge Posner were unimpressed by the complaint.  (You can listen to the oral argument here.) 

For example, Chief Judge Easterbrook commented to plaintiffs’ counsel: “You’ve got a case where there are, there’s demonstrable, lying.  You choose not to sue about the demonstrable lies but to sue about things that it’s almost impossible to show scienter about and no one had any reason to lie about.  It’s almost as if you set out to find the one kind of suit that would be blocked by the PSLRA and bring that.”  Judge Posner, too, was clearly unmoved by the complaint.  At one point he described one of the plaintiffs’ arguments as “ridiculous.”  And the panel opinion went even further, applying Tellabs virtually to exclude the use of confidential witnesses in securities suits.

In drafting their complaint, the plaintiffs made use of five such witnesses, including a “former Baxter executive . . . knowledgeable about the Brazilian situation,” one of Baxter’s “consultant[s] on the issue of financial controls,” “a former Brazilian Baxter executive,” someone “responsible for training Baxter’s financial executives,” and another “former Baxter executive.”  The plaintiffs filed an affidavit by an investigator confirming that he had spoken with these witnesses.

The Tellabs opinion makes no mention of confidential witnesses: it requires only that courts evaluate whether a plaintiff has alleged scienter “cogently.”  But at the Baxter oral argument, counsel for Baxter mentioned the confidential witnesses to note that Tellabs required an assessment of witness reliability when weighing allegations.  Baxter’s lawyer didn’t argue that Tellabs excludes the use of confidential witnesses; he simply urged the court to give their testimony less weight, because with confidential witnesses the source of the information is unknown.  (Baxter’s counsel acknowledged later in the argument that he was contesting “the adequacy,” and not “the propriety,” of the testimony.) 

Judge Posner was clearly caught off guard.  He expressed surprise that confidential witnesses were ever used in securities suits.  “What are they?” he wanted to know.  “Are they like police informants?”  Later, Chief Judge Easterbrook noted that the propriety of reliance on confidential witnesses had not been at issue in Tellabs or raised by Baxter on appeal.  But the fireworks really erupted when counsel for plaintiffs returned to the podium for rebuttal. 

Judge Posner pressed the plaintiffs’ attorney with a series of questions on the use of confidential witnesses, indicating that he had never seen a civil case involving unidentified witnesses.  “Are these people going to testify behind a screen with a voice alternation?”  When counsel responded that the witnesses might not actually testify, Judge Posner admonished:  “You put allegations in a complaint that you can’t substantiate because they are supplied by people you’re not going to call as witnesses”; the Judge was “baffled” by such behavior.  

Judge Posner pressed on, asking why the confidential witnesses’ allegations had even been mentioned in the complaint.  After all, he argued, it is obvious that “having a confidential witness doesn’t strengthen an allegation.”  Such a person could be “any kind of snitch, any kind of liar. .  [making] anonymous accusations against a company.”  The Judge went so far as to suggest that including such allegations in the complaint might run afoul of the attorney’s obligations to the court:  

“I would think a complaint based on [confidential witnesses] would flunk the requirement that a complaint is supposed to be based on a reasonable inquiry.  Look someone calls you up, disguises his voice and says oh, monkey business is going on in the Brazilian subsidiary.  That you regard as sufficient to file a complaint?”  

Commenting that in our legal system “we don’t have anonymous law suits,” Judge Posner was apparently unmoved by plaintiffs’ counsel’s urging that anonymity was necessary to persuade Baxter’s employees to provide information for the suit.

Thus, in a case in which the parties did not raise the propriety of using confidential witnesses in securities cases, the Seventh Circuit has announced that “[o]ne upshot of the approach that Tellabs announces is that we must discount allegations that the complaint attributes to five ‘confidential witnesses,'” essentially eliminating the use of such witnesses in securities complaints.  Although such witnesses could corroborate other evidence, the court noted, “we said above that allegations from ‘confidential witnesses’ would be discounted rather than ignored [under Tellabs].  Usually that discount will be steep.” 

Tellabs, however, compelled no such conclusion.  The case requires only that a securities complaint be considered “in its entirety” before deciding whether “all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard.”  To single out confidential-witness statements for discounting is the antithesis of this approach. 

Moreover, Judge Posner’s surprised reaction to the use of confidential informants is, well, itself surprising.  Justice Stevens’s Tellabs dissent specifically mentions the use of confidential witnesses; the Court is apparently aware of the practice, but chose not to give it special treatment for purposes of the PLSRA.  And even before Tellabs, the circuits had addressed at length the use of confidential sources; the Ninth Circuit, for example, generally discounts them unless the sources are described with “a large degree of specificity.” 

The judges on this panel didn’t like the use of “anonymous accusations against a company,” and were determined to put a stop to them; Tellabs simply provided the requisite excuse.  The Seventh Circuit’s approach reflects considerable hostility toward securities class actions, and the only consequence of this misguided holding is to force plaintiffs to name their confidential witnesses in the complaint, which in turn will make it harder to obtain information that can help bring securities fraud to light.  Tellabs is no excuse for making meritorious causes of action more difficult to bring.