Part VII: Securities Class Actions: Current And Emerging Trends

Prior installments of this series have considered various pleading requirements for securities class actions. Another key pleading issue involves the use of confidential witnesses. Following the passage of the PSLRA, and prior to the Supreme Court’s decision in Tellabs, the question was whether facts pled in a complaint based on confidential sources complied with the “all facts” pleading requirement of the Reform Act.

Some early cases concluded that the “all facts” provision required that the sources be identified. See, e.g., In re Nice Sys. Lid. Sec. Litig., 135 F. Supp. 551 (N.N.J. 2001).

In what became the leading case on the question, the Second Circuit in Novak v. Kasaks, 216 F.3d 3000 (2nd Cir.) cert. denied, 531 U.S. 1012 (2000) concluded that “our reading of the PSLRA rejects any notion that confidential sources must be named as a general matter.” The court reasoned that naming informants could have a chilling effect. The First, Third, Fifth, Seventh, Eighth, Ninth and Tenth Circuits subsequently agreed. See, e.g., In re Cabletron Sys., Inc., 311 F.3d 11 (1st Cir. 2002); Cal Pub. Employees’ Ret. Sys. v. Chubb Corp., 394 F.3d 126 (3d Cir. 204); ABC Arbitrage Plaintiffs Group v. Tchruk, 291 F.3d 336 (5th Cir. 2002). As the Seventh Circuit held: the “bright line rule obligating the plaintiffs to reveal their sources has the potential to deter informants from exposing malfeasance. Such a rule might also invite retaliation.” Makor Issues & Rights, 437 F.3d. 588 (7th Cir. 2005) reversed on other grounds, 127 S.Ct. 2499 (2007).

Under Novak, the key question became what must be pled to permit the court to evaluate the allegations from confidential witnesses. The Second Circuit concluded that the sources must be “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.” Novak, 216 F.3d at 314. While the Fifth and Seventh Circuits agreed with this approach, the First developed an alternative approach. In Cabletron Sys., Inc., 311 F.3d 11 (2002) the court held that the test should be an “evaluation … of the level of detail provided by the confidential sources, the cooberative nature of the other facts alleged (including from other sources), the coherence and plausibility of the allegations, the number of sources, the reliability of the sources, and similar indicia.” The Third and Ninth Circuits adopted a similar approach.

The Tenth Circuit crafted a third approach. In Adams v. Kinder-Morgan, Inc., 340 F.3d 1083 (2003), the Circuit Court concluded that “source information is more important for allegations that are difficult to confirm than for claims that ‘many be objectively verifiable’ such as contract terms, financial results and similar information.”

In Tellabs, the Supreme Court did not consider the issue of confidential witnesses. Prior to review by the Supreme Court, the Seventh Circuit considered the question and followed Novak. However, the question was not presented for review by the High Court.

Following Tellabs, the Seventh Circuit initially seemed to reverse its position. In Higginbotham v Baxter International, Inc., the court concluded that “One upshot of the approach that Tellabs announced is that we must discount allegations that the complaint attributes to five ‘confidential witnesses’ … It is hard to see how information from anonymous sources could be deemed ‘compelling’ or how we could take account of plausible opposing inference. Perhaps these confidential sources have axes to grind. Perhaps they are lying. Perhaps they don’t even exist.” 495 F.3d 753, 756-757 (7th Cir. 2007). Interestingly, the decision was based on Section 21D(b)(2) rather than the “all facts” requirement.

Subsequently, however, the Seventh Circuit reverted to its prior position. When the court considered the question in Tellabs on remand, it explained Higginbotham as being devoid of facts about the confidential sources, other than the fact that they were three ex-employees of the company. The court then went on to credit allegations from confidential sources in applying the Tellabs test noting that they “are numerous and consist of persons who from the description of their jobs were in a position to know first hand the facts…” In addition, the material from the confidential informants “is set forth in convincing detail” and in some cases “corroborated by multiple sources.” Makor Issues & Rights, Ltd. v. Tellabs, Inc., 513 F.3d 702 (7th Cir. 2008).

Next: Dura and loss causation

Suggestions To Improve The Enforcement Program From Commissioner Atkins

SEC Commissioner Paul Atkins recently published an article tracing the history of the enforcement division, calling for a new Wells Committee and making recommendations for items to be considered by the Committee. Paul S. Atkins and Bradley J. Bondi, Evaluating the Mission: A Critical Review of the History and Evolution of the SEC Enforcement Program, 13 Fordham Journal of Corporate & Financial Law 367 (2008).

This is not the first time Commissioner Atkins has raised the issue of a new Wells Committee or raised some of the points contained in the article. Some of the suggestions have been raised by the Commissioner in speeches discussed here and here. Nevertheless, the article does contain a number of thoughtful suggestions regarding the enforcement program.

According to Commissioner Atkins, a new Wells or advisory committee should be formed with the “mission … to conduct an independent review of the Commission’s enforcement program from multiple, diverse perspectives, and to recommend to the Commission, if warranted, any needed changes.” In the article, Commissioner Atkins then suggests several topics for consideration by the new committee including:

1) The implementation of mechanisms to provide more efficacy, predictability and transparency to the enforcement program. In this regard, the overall management and approach of the enforcement program would be examined in view of its mission and goals.

2) The implementation of an “open jacket” policy, such as that used by criminal prosecutors. Under this policy, which Commissioner Atkins as recommended before, the enforcement staff would disclose to defense counsel the evidence supporting its claims.

3) A review of the closing process. As noted the article, a prior GAO report harshly criticized the Enforcement Division for failing to promptly close investigations.

4) An examination of enforcement practices from a due process stand point and consideration of ways to improve the current Wells process.

5) A review and analysis of the costs and burdens imposed by the investigative process. This would include consideration of the necessary scope of requests for documents and consideration of ways to ease the burdens and costs of electronic data production.

6) An examination of the use, effects, amount and appropriateness of issuer penalties.

7) Consideration of the minority recommendation from the Senate Finance Committee regarding the Pequot Capital Management inquiry suggesting that Enforcement adopt a manual of procedures which would be similar to the U.S. Attorney Manual.

These are thoughtful and serious recommendations which deserve careful consideration. Hopefully, the Commission will act on the suggestion of Commissioner Atkins and convene an appropriate committee to consider these and other issues.