Using Confidential Sources To Plead Scienter After Tellabs

Following the Supreme Court’s decision last June in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007), one key question in pleading a “strong inference” of scienter is whether plaintiffs can rely on facts supplied by confidential sources. Specifically, the question is whether the use of confidential sources is consistent with the holding in Tellabs. That ruling requires that to be strong, an inference of scienter must be “cogent” and at least equal to the opposing inference. In making, its ruling the Court noted without comment that the complaint was based in part on confidential sources.

Since the Supreme Court handed down its decision last June, five circuit courts have considered the impact of Tellabs on pleading a strong inference of scienter. Three of those cases examined the question of confidential informants.

Shortly after the Supreme Court’s decision, the Seventh Circuit, which had been reversed in Tellabs, handed down its decision in Higginbotham v. Baxter International, No. 06-1312 (7th Cir. July 27, 2007). There, the court affirmed the dismissal of a financial fraud case by the district court. In an opinion written by Judge Easterbrook, and joined by Judges Posner and Ripple, the court held:

One upshot of the approach that Tellabs announced is that we must discount allegations that the complaint attributes to five “confidential witnesses” – one ex-employee of the Brazilian subsidiary, two ex-employees of Baxter’s headquarters, and two consultants. It is hard to see how information from anonymous sources could be deemed ‘compelling’ or how we could take account of plausible opposing inferences. Perhaps these confidential sources have axes to grind. Perhaps they don’t even exist.

Slip op. at 3

The next month, the Fifth Circuit concluded that confidential sources could be used, but then declined to accept evidence proffered from these sources because it lacked sufficient detail. Central Laborers’ Pension Fund v. Integrated Electrical Services Inc., No. 06-20135 (5th Cir. August 21, 2007). In reversing the dismissal of a financial fraud complaint, the Fifth Circuit, citing a pre-Tellabs case, held that “confidential source statements are a permissible basis on which to make an inference of scienter.” Slip op. at 7. The court went on to discount the statements from these sources in this case, however because the complaint lacked details which would permit evaluation of the witnesses and their facts such as job descriptions, the identification of individual responsibilities, employment dates and similar items.

Finally, the Seventh Circuit, in permitting the Tellabs complaint to go forward on remand, adopted the Fifth Circuit approach. Distinguishing its earlier decision in Higginbotham, the Court, in an opinion written by Judge Posner, held that

The confidential sources listed in the complaint in this case, in contrast, 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. … The information that the confidential informants are reported to have obtained is set forth in convincing detail, with some of the information, moreover, corroborated by multiple sources. It would be better were the informants named in the complaint, because it would be easier to determine whether they had been in a good position to know the facts that the complaint says they learned. But the absence of proper names does not invalidate the drawing of a strong inference from informants’ assertions.

Slip op. at 17-18.

Read together, the three circuit court rulings suggest that when sufficient detail is pled so that the statements can be sufficiently evaluated, evidence from confidential sources can be used to support a strong inference of scienter. The key is the adequacy of the detail about the witness and the statements.

The FCPA: The New SEC and DOJ Enforcement Priority – Part VI, Large Penalties

2007 was the year of the record settlement. Vetco International and Baker Hughes both paid record fines to resolve FCPA cases. Indeed, Baker Hughes set two records, one for the largest combined DOJ/SEC FCPA settlement and a second for penalty paid for violating an SEC cease and desist order. DOJ prosecutors claim to be guided by the sentencing guidelines in deciding on fines. The SEC notes that it follows its statement on corporate penalties. Nevertheless, in view of the emphasis in this area and the increasing number of investigations and prosecutions, these records may not last long. At the same time, it is important to note that both of these cases involved entities with prior FCPA violations.

In February 2007, Vetco International paid DOJ a record fine of $26 million to resolve an FCPA case. In this action, three wholly owned subsidiaries of Vetco pled guilty to FCPA bribery charges, while a fourth entered into a non-prosecution agreement. U.S. v. Vetco Gray Controls, Inc., No. 07-004 (S.D. Tex. Filed Feb. 6, 2007); U.S. v. Aibel Group Ltd., No. 07-005 (S.D. Tex. Filed Feb. 6, 2007).

The government alleged that Vetco Gray UK provided services and construction equipment to Nigeria’s first deep water oil drilling project. It did so in conjunction with Aibel Group, Vetco Gray Controls, Inc., and Vetco Controls Ltd. Vetco Gray Controls, Inc. is a domestic concern based in Huston.

From 2002 to 2005, the companies authorized a freight forwarding agent to make at least 378 corrupt payments totaling $2.1 million to Nigerian Customs officials. The payments were made to obtain preferential treatment.

Previously, in 2004 Vetco Gray UK, then named ABB Vetco Gray UK, pled guilty to FCPA bribery charges relating to a Nigerian government agency. Before this entity was acquired, DOJ issued an opinion to Vetco International, noting that the subsidiary must implement an FCPA compliance program.

The plea agreements require the payment of a record $26 million fine and that the company undertake a complete investigation of the conduct in various countries. In addition, the agreement requires that if any of the companies are sold, the agreement must provide that it binds the acquirer to the monitoring and investigation obligations.

Two months later, two more FCPA records were set in the Baker Hughes combined DOJ and SEC settlement. In those settlements, the company agreed to pay over $44 million in the combined settlements, a record. As part of the settlement the company agreed to pay a $10 million civil penalty for violating a 2001 SEC cease and desist order, which is also the first of its kind.

The SEC complaint alleges that Baker Hughes paid two agents about $5.2 million, knowing that some or all of the money was intended to bribe officials of state-owned companies in Kazakhstan. Subsequently, the company was awarded a contract in the oil fields in Kazakhstan. This contract generated over $210 million in gross revenue. The agents paid were hired at the behest of defendant Roy Fearnley, who claimed that the company would not get future business absent payment.

A second contract was obtained with KazTranOil, the national oil transportation operator of Kazakhstan. A fee of $1 million was paid to the agent, who represented a high raking executive of KazTranOil.

Baker Hughes also made payments in Nigeria, Angola, Indonesia, Russia, Uzbekistan and Kazakhstan. Those payments were made under circumstances which reflect a failure of sufficient controls to determine the nature of the payments and whether they were for legitimate services.

To resolve this matter with the SEC, Baker Hughes consented to the entry of an injunction based on the anti-bribery, books, records and internal control provisions. In addition, the company agreed to the entry of an order requiring the payment of over $19.9 million in disgorgement, over $3 million in prejudgment interest and the payment of a $10 million civil penalty. The company also agreed to retain an independent consultant to review its FCPA compliance procedures. SEC v. Baker Hughes, Inc., Civil Action No. 07-01408 (S.D. Tex. Filed April 26, 2007).

To settle with the Department of Justice Baker Hughes entered into a deferred prosecution agreement. That agreement requires the company to hire an independent monitor for three years to oversee the creation of a robust compliance program and to make a series of reports to DOJ. BHS, a subsidiary, pled guilty to FCPA violations. The charging documents alleged that in connection with a bid to develop and oil field the subsidiary agreed to pay 2% of the revenue on the current project and 3% on future projects and a commission of $4.1 million. U.S. v. Baker Hughes, Inc., No. 07-130 (S.D. Tex. Filed April 11, 2007).