Securities Laws Need to Curb Misuse of Confidential Witnesses

Congress should amend the federal securities laws to regulate the abusive use of confidential witnesses in securities litigation. Meanwhile, courts have the inherent authority to implement some of the reforms below on their own.

The (Big) Problem

In 1995, Congress amended the Securities Act of 1933 and Securities Exchange Act of 1934. These reforms came after years of abusive litigation seeking to weaponize discovery and extort settlements. They limited discovery in securities actions until after a motion to dismiss, and elevated the pleading standard required to survive dismissal.

To overcome these obstacles, plaintiffs’ lawyers turned to a pernicious practice. To shore up weak complaints, they canvass former employees for quotes that lend a semblance of verisimilitude to deficient claims. These “confidential witnesses” are promised anonymity in exchange for quotes. Plaintiff firms hire purported “investigators,” who cold-call former employees, introducing themselves as former government agents.

In rushed conversations, investigators purport to conduct a legal inquiry and suggest that cooperation is expected or required. The former employee, sometimes caught between two jobs, stressed about their career, perhaps resentful, agrees to speak to the “agent.” Recordings are rarely made—investigators prefer not to have a discoverable record.

A purportedly privileged memo is produced instead. The former employee is never given an opportunity to check their quotes and almost never sees the complaint. Their identity is suppressed in the complaint in favor of the more prosaic moniker of “CW-5” or “FE-3.” But their job responsibilities and performance are described so precisely that defendants readily identify them.

This is where you’d expect a reckoning, right? But defendants aren’t allowed to challenge these anonymized allegations. Courts credit CW allegations, which in any other context would raise even Leonid Brezhnev’s eyebrows.

Defendants may later depose confidential witnesses. Sometimes they uncover questionable practices, misinformation, and quotes plucked out of context. The former employee is sometimes shocked to read their words twisted to demean former colleagues. Sometimes outright fabrications are uncovered.

And again, nothing happens. The lawsuit is past the pleading stage and the next exit opportunity isn’t until summary judgment. Discovery unfolds, millions of dollars in expenses mount, and, in extremis, the company settles, with a full release of liability for the plaintiffs’ lawyers tucked into the settlement agreement.

Congress and the courts can end this abusive practice. Here’s how.

The Legislative Fix

Congress can curb this practice by amending the two statutes as follows.

All confidential witnesses shall be named in a sealed certification accompanying the complaint, attesting under penalty of perjury the accuracy of the statements attributed to them.

No allegations attributed to a confidential witness shall be credited unless the court conducts a hearing at which the witness must appear, confirm, or deny the statements attributed to them, and be questioned under penalty of perjury. The hearing may be closed to the public. The witness shall be afforded an opportunity, prior to the hearing, to review the complaint.

All pre-filing interviews of confidential witnesses shall be recorded and the witness informed of such recording. Such recording shall be produced to the court and parties before the hearing.

At the hearing, the court shall make a written determination whether the witness adopted the statements attributed to them, agreed to be quoted in the complaint, and has been quoted consistent with Rule 11. If the court determines these conditions aren’t met, it shall strike from the complaint the confidential witness allegations.

The weight afforded such confidential witnesses, after the necessary hearing, shall be that provided in the existing case law.

This proposal doesn’t eliminate confidential witnesses. Whistleblowers serve a purpose. Such individuals may wish to come forward without fear of professional repercussions from other potential employers. The old employer will know their identity anyway, so revealing the name to the defendant doesn’t prejudice the witness. Besides, knowing the identity of one’s accuser is fair and grounded in centuries of jurisprudence.

What the proposal does do is ensure that the witnesses are real, that they said what plaintiffs say they said, and that they meant it.

The (Imperfect) Judicial Fix

Even if Congress doesn’t act, courts can implement some of these reforms under their existing powers.

They have the inherent authority to conduct proceedings to verify whether the allegations of the complaint are independently corroborated, as required by Rule 11. In fact, under the 1995 amendments, the federal securities statutes already require that, before any securities class action is terminated, the court determines that all sides complied with Rule 11. The court has the authority to strike allegations that fall short of Rule 11. Congress intended courts to exercise these powers.

Puzzlingly, few courts ever conduct the Rule 11 determination required by the securities laws. Courts likely don’t know about the statutory requirement. By the end of the lawsuit, if the parties have settled, defendants are bound by the settlement agreement not to challenge the conduct of plaintiffs’ lawyers. Deprived of the adversarial system, the busy judge is happy to let sleeping Rule 11 determinations lie, statutory letter notwithstanding.

A judicial fix need not be adopted on a massive scale to be effective. All it takes is a few federal judges implementing a version of this protocol. In time, an appellate precedent can be created. And a semblance of fairness and justice restored.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Doru Gavril is a securities litigation partner at Freshfields Bruckhaus Deringer. He routinely represents technology and life sciences public companies in securities disputes. This article represents his own views.