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.