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.