Evaluating Confidential Informant Allegations Under 'Tellabs'

, New York Law Journal

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Sarah S. Gold and Richard Spinogatti
Sarah S. Gold and Richard Spinogatti

Since the U.S. Supreme Court's decision in Tellabs v. Maher Issues & Rights, 551 U.S. 308 (2007), federal courts have wrestled with its impact on the use of confidential informant allegations in federal securities complaints. There appears to be widely divergent views on this subject, partly mitigated by the differing facts of the cases in which the issue is raised. Most recently, the U.S. Court of Appeals for the Third Circuit addressed the issue in Rahman v. Kid Brands, discussed herein. No. 12-4257, 2013 WL 6038246 (3d Cir. Nov. 15, 2013).

Pre-'Tellabs'

Fed. R. Civ. P. 9(b) requires that circumstances constituting alleged fraud be stated with particularity. And, Section 21D(b) of the Private Securities Litigation Reform Act (PSLRA) also requires particularity, both in stating the facts upon which an alleged belief is based1 and in stating the facts giving rise to a "strong inference" that the defendant acted with the required state of mind,2 i.e., scienter in actions asserting claims under Section 10(b) and Rule 10b-5. To meet these particularity requirements, plaintiffs asserting such claims frequently rely upon factual allegations attributed to confidential informants, often the only or the principal information available to plaintiffs' counsel. In assessing such allegations, courts have considered the detail provided by the confidential sources, the sources' basis of knowledge, the reliability of the sources, the corroborative nature of other facts alleged, the coherence and plausibility of the allegations and similar indicia.3

Most courts have held that confidential informants need not be named. In Novak v. Kasaks, 216 F. 3d 300 (2d Cir. 2000), the U.S. Court of Appeals for the Second Circuit explained that "where plaintiffs rely on confidential personal sources but also on other facts, they need not name their sources as long as the latter facts provide an adequate basis for believing that the defendants' statements were false" and "even if personal sources must be identified, there is no requirement that they be named, provided they are described in the complaint with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged." 216 F.3d at 314.

The 'Tellabs' Decision

Novak, however, pre-dated the Supreme Court's decision in Tellabs, which held that, in determining whether the allegations give rise to a "strong" inference of scienter, the court must take into account plausible opposing inferences. 551 U.S. at 323. The court explained that "the inference of scienter must be more than merely 'reasonable' or 'permissible'—it must be cogent and compelling, thus strong in the light of other explanations" and held that a complaint will survive "only if 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." Id. at 324.

In addressing the particular allegations presented, the Supreme Court agreed "that omissions and ambiguities count against inferring scienter, for plaintiffs must 'state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.'" Id. at 326 (quoting §78u-4(b)(2)). It reiterated that "the court's job is not to scrutinize each allegation in isolation but to assess all the allegations holistically." Id. The court, however, made no mention of the fact that the Tellabs allegations were based on confidential informant information.4 Furthermore, the court did not apply its announced standard but instead remanded the case to the U.S. Court of Appeals for the Seventh Circuit. Thus, it is not crystal clear from Tellabs what the Supreme Court intended the federal courts to do about confidential informants.

The Seventh Circuit

Shortly after Tellabs, the Seventh Circuit observed, in Higginbotham v. Baxter International, 495 F.3d 753, 756-757 (7th Cir. 2007) that "[o]ne upshot of the approach that Tellabs announced is that we must discount allegations that the complaint attributes to five 'confidential witnesses'" because "it is hard to see how information from anonymous sources could be deemed 'compelling' or how we could take account of plausible opposing inferences." The court then explained that "[p]erhaps these confidential sources have axes to grind," or "are lying," or "don't even exist." Id.

Although cautioning that its holding did not mean "that plaintiffs must reveal all of their sources," the court stated that "[o]ur point, rather, is that anonymity conceals information that is essential to the sort of comparative evaluation required by Tellabs" and, "[t]o determine whether a 'strong' inference has been established, the judiciary must evaluate what the complaint reveals and disregard what it conceals." Id. at 757. Finally, the court explained that "[b]ecause it is impossible to anticipate all combinations of information that may be presented in the future, and because Tellabs instructs courts to evaluate the allegations in their entirety, we said above that allegations from 'confidential witnesses' must be 'discounted' rather than ignored. Usually that discount will be steep." Id.

Although Higginbotham appears to require that all allegations from confidential witnesses be "discounted," and suggests that it might no longer be possible to meet the Tellabs test using solely information from confidential informants, the Seventh Circuit's application of Higginbotham on the Tellabs remand suggests a slightly less stringent view. In Makor Issues & Rights v. Tellabs, 513 F.3d 702 (7th Cir. 2008), the Seventh Circuit addressed the argument frequently made by plaintiffs (and generally accepted by the federal courts and by Congress) that anonymity is required because plaintiff's lawyers "won't be able to get to first base without assuring confidentiality to the employees whom they interview."

The Seventh Circuit characterized this argument as flimsy, noting that retaliation is unlawful and informants are protected by whistleblower laws so they should have no fear of retaliation and noting further that, since informants have no evidentiary privilege, their identity will be revealed ultimately in pretrial discovery (unless the action is never filed or the matter is settled). The Seventh Circuit went on to explain that the trouble with the argument in favor of anonymity is that "allegations based on anonymous informants are very difficult to assess," which led to the "suggestion" in Higginbotham that such allegations be "steeply discounted."5Makor, 513 F.3d at 711.

However, the Seventh Circuit then contrasted Makor's complaint with the Higginbotham complaint, pointing out that the confidential sources listed in Makor "are numerous and consist of persons who from the description of their jobs were in a position to know at first hand the facts to which they are prepared to testify…." Id. at 712. The information was set forth in "convincing detail," some of it corroborated by multiple sources. Thus, while "[i]t would be better were the informants named in the complaint," the "absence of proper names does not invalidate the drawing of a strong inference from informants' assertions." Id. In sum, while the court may have "discounted" the confidential informant information, it did not prove insurmountable.

The Third Circuit

Recently, the Third Circuit wrestled with the confidential informant issue in Rahman v. Kid Brands. Pointing to the standard from Novak, Rahman held that "when dealing with confidential witnesses, courts should assess the '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.'"6 Importantly, the Third Circuit confirmed that "[i]f, after that assessment, 'anonymous source allegations are found wanting with respect to those criteria…[courts] must discount them steeply.'" Rahman, Id., (quoting Avaya, 564 F.3d at 263).

The Third Circuit explained that such a discount is consistent with Tellabs' teaching that "omissions and ambiguities count against inferring scienter under the PSLRA's particularity requirements, but if 'a complaint's confidential witness allegations are adequately particularized, we will not dismiss them simply on account of their anonymity.'" Rahman, Id., (quoting Avaya, 564 F.3d at 263). This analysis is notably different from the Seventh Circuit's Higginbotham requirement that confidential witness information be discounted in all instances.

The Second Circuit

The Second Circuit has issued two post-Tellabs summary orders addressing the issue of confidential informants in securities class action complaints. In its summary order in Campo v. Sears Holding, the court affirmed the district court's decision, in resolving the defendants' motion to dismiss, to require depositions of confidential witnesses for the limited purpose of determining whether they acknowledged the statements attributed to them in the complaint. 2010 U.S. App. Lexis 7043 at **6 n. 4 (2d Cir. 2010). In doing so, the Second Circuit appeared to cite favorably to Higginbotham, observing that "[t]he anonymity of the sources of plaintiffs' factual allegations concerning scienter frustrates the requirement, announced in Tellabs, that the court weigh competing inferences to determine whether a strong inference of scienter has been alleged." Id.

In its summary order in New Orleans Emples. Ret. Sys. Celestica, the Second Circuit reversed dismissal of a complaint, citing Novak to find that, although the informants were not identified by name, "plaintiff's descriptions of these persons are sufficiently particular to permit the strong inference of scienter required for plaintiffs to sustain their burden on a motion to dismiss." 455 Fed. Appx. 10, *14 (2d Cir. 2011). Celestica ignored Higginbotham and Campo, and thus provided no guidance as to any appropriate consideration of the level of detail required to avoid discounting allegations based upon confidential informants when determining if a strong inference of scienter has been pleaded.

With little meaningful guidance from the Second Circuit, a split has developed among the courts in the Southern District. Several courts read Higginbotham as holding that information in securities fraud pleadings from confidential witnesses "should always be discounted" and reject that approach. See City of Brocton Ret. Sys. v. Shaw Group, 540 F.Supp.2d 464, 474 (S.D.N.Y. 2008) (McMahon, J.), In re PXRE Group, 600 F.Supp.2d 510, 526 n. 18 (S.D.N.Y. 2009) (Sullivan, J.) and In re MBIA, 700 F.Supp.2d 566, 589 n. 16 (S.D.N.Y. 2010) (Karas, J.).

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