The Ninth Circuit On Tellabs And Confidential Witnesses

In Zucco Partners, LLC v. Digmarc Corporations, Case No. 06-35758 (9th Cir. Jan. 12, 2009) the court ruled on two key PSLRA pleading issues for securities class actions. First, the court harmonized the Supreme Court’s teachings in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007) regarding pleading a strong inference of scienter with its prior precedents on the subject. Second, the court ruled on the requirements for using information from confidential informants to support a strong inference of scienter.

Digmarc Corporation, a provider of secure personal identification documents, and two of its officers were named as defendants in a securities fraud case. The complaint alleged that defendants purposefully manipulated the financial results of the company by capitalizing internal software development expenditures that should have been expensed. These improper practices resulted in a restatement of Digmarc’s financial statements. The district court dismissed the second amended complaint. The circuit court affirmed.

The Court began by considering the application of Tellabs in the context of its prior jurisprudence, a question that it had not previously considered. In Tellabs, the court concluded that a strong inference of scienter is pled if a reasonable person would deem the inference “cogent and at least as compelling” as any opposing inference. The Supreme Court’s test is based, the circuit court noted, on a holistic approach which requires that all of the allegations and inferences be considered. The Tellabs analysis is inherently comparative because it requires consideration of both those inferences which support a strong inference and opposing inferences.

The Supreme Court’s formulation of the PSLRA strong inference requirement is not inconsistent with the prior holdings of the circuit court, according to the opinion. Previously, the circuit court held that a securities law plaintiff must allege that the defendant made false or misleading statements “either intentionally or with deliberate recklessness.” This standard was adopted by the court in In re Silicon Graphics Inc. Securities Litigation, 183 F.3d 970 (9th Cir. 1999). To evaluate whether inferences based from allegations which met this pleading standard establish a PSLRA “strong inference” of scienter, the circuit court used what it called a “segmented” analysis. Under this approach each inference was individually.

The Ninth Circuit concluded that its “segmented” approach is not sufficient under Tellabs. Rather, the Supreme Court requires that the allegations be considered collectively. To harmonize its approach with Tellabs, the circuit court concluded that both its prior segmented approach and the Supreme Court’s holistic approach should be employed. Under this approach the allegations must meet the Silicon Graphics pleading standard and the strong inference of scienter will be gauged by Tellabs.

No other circuit had adopted the “deliberate recklessness” standard of Silicon Graphics. While Tellabs did not discuss the definition of scienter, the Ninth Circuit’s requirement here seems at odds with the overall approach of the Supreme Court. The Ninth Circuit did not discuss this question, however. Rather, it simply assumed that the Silicon Graphics standard should be used.

Second, the court addressed the issue of using inferences from information supplied by confidential witnesses to meet the Tellabs standard. Information from these witnesses must meet a two-prong test to support a strong inference of scienter. In the first instance, the allegations “must be described with sufficient particularity to establish their reliability and personal knowledge.” This requires not just an identification of the witnesses’ job title and employment information, but also facts pled with particularity demonstrating that the “confidential witnesses were in a position to be personally knowledgeable of the information alleged.” In addition, the statements themselves must “be indicative of scienter.”

Here, the totality of the allegations from a series of confidential witnesses failed this test largely because the statements were vague and lacking in detail. The court’s ruling on this issue is consistent with that of other courts which have considered this issue. See, e.g., Western Pa. Electrical Employees Benefits Fund v. Ceridian Corp., No. 07-2707 (8th Cir. Sept. 11, 2008), discussed here.

Prosecution Motion To Jail Madoff Denied

Bernard Madoff remains out on bail following the denial by the court of the government’s motion to have him detained pending trial. In denying the motion of the government, the Court imposed additional conditions on Mr. Madoff’s pretrial release suggested by the defense. U.S. v. Madoff, No. 08 Mag. 2735 (S.D.N.Y. Ruling: Jan. 19, 2009).

Last week, the government requested that the court revoke Mr. Madoff’s bail and order him detained pending trial. The motion argued: (1) that there was a clear risk of flight and obstruction of justice; and (2) the current conditions of release are not sufficient to protect the safety of the community. The motion was based on claims by the government that on or about December 24, 2008, Mr. Madoff and his wife mailed packages to family and friends as “gifts” which contained jewelry and other personal property that may have a value of up to $1 million. Most of these items have been returned.

At the time the gifts were sent, Mr. Madoff had been released on a $10 million personal recognizance secured bond. The bond was secured by his apartment and properties owned by his wife and brother. The conditions of release also required Mr. Madoff to file confessions of judgment with respect to these properties, be subject to home detention 24 hours per day with electronic monitoring and have a security firm monitor the apartment on a continuous basis. Although not a condition of his bail, at the time of the actions in question Mr. Madoff was subject to a consent decree in the SEC’s civil action against him which essentially precluded the dissipation of assets.

In ruling on the government’s motion, the court began by noting that the accused is to be released on personal recognizance or an unsecured appearance bond unless that will not reasonably assure the appearance of the person or will endanger the safety of others or the community. The government can seek detention if there is a serious risk that the defendant will either flee or obstruct or attempt to obstruct justice. To support detention based on danger, the government’s proof must be clear and convincing.

Here, the government admitted during the hearing that the prior bail orders substantially diminished the risk of flight. The Court rejected the government’s claim that because those restrictions did not diminish the risk to zero that they were insufficient.

The Court also rejected the government’s claim that there was a risk of obstruction. The question in this regard is not whether Mr. Madoff’s actions can be considered obstruction “but whether there is a serious risk of obstruction in the future.” The Court found it unnecessary to address this issue because the government failed to demonstrate “that no conditions can be set to reasonably protect the community from this form of obstruction.”

In this regard, Mr. Madoff offered to add specific restrictions into the terms of his bail to satisfy the concerns raised by the government. These include an offer to incorporate the terms of the SEC injunction into the bail requirements. In addition, he offered to compile an inventory of all valuable portable items in the apartment where he is confined and to have an inventory taken every two weeks. These requirements, coupled with the earlier bail restrictions, were sufficient, the Court concluded. This is particularly true since the government failed to even address their adequacy. Accordingly, Mr. Madoff, whose counsel postponed the preliminary hearing that had been scheduled, will remain out of jail on bond pending trial.