In City of Livonia Employee Retirement System v. Boeing Co., Nos. 12-1899, 12-2009 2013 WL 1197791 (7th Cir. Mar. 26, 2013), the United States Court of Appeals for the Seventh Circuit (Posner, J.) affirmed the dismissal of a securities fraud class action against the Boeing Company (“Boeing”) and remanded the question of whether sanctions under Rule 11 of the Federal Rules of Civil Procedure should be levied against plaintiffs’ counsel after allegations attributed to a confidential witness, which initially saved the case from dismissal, were later denied by the witness. The Court’s ruling provides a strong reminder that plaintiffs’ counsel in securities cases must exercise great care when using allegations of confidential witnesses to satisfy the heightened pleading standards of the Private Securities Litigation Reform Act of 1995, 15 U.S.C. § 78u-4 (“Reform Act”).

This class action was brought purportedly on behalf of purchasers of Boeing common stock. Plaintiffs alleged that despite failure of two stress tests on the Boeing 787-8 Dreamliner in April and May 2009, Boeing executives made representations that the Dreamliner would have its first flight on June 30, 2009. On June 23, 2009, Boeing announced the cancellation of the first flight due to an anomaly revealed by the stress tests that Boeing had hoped (but was unable) to resolve in time for the June 30, 2009 flight. Boeing also announced that the cancellation would cause delay in delivery of the Dreamliner, which many airlines had already ordered. In response, Boeing’s stock price dropped by more than ten percent. Plaintiffs alleged that Boeing’s representations regarding the planned first flight of the Dreamliner were false or misleading in violation of Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b).

The United States District Court for the Northern District of Illinois dismissed the initial complaint for failure to plead particularized facts giving rise to a strong inference that defendants made the alleged misrepresentations with scienter. The district court, however, granted leave to amend.

In the amended complaint, plaintiffs attempted to bolster their scienter allegations with facts supposedly supplied by a confidential witness. Plaintiffs described him in the amended complaint as a “Boeing Senior Structural Analyst Engineer” who allegedly had worked on wing-stress tests of the 787-8 Dreamliner and who, as part of his job, supposedly had direct access to and first-hand knowledge of the results of the stress tests, as well as internal, contemporaneous communications regarding those tests. On the basis of these new allegations, the district court denied defendants’ motion to dismiss and allowed the case to proceed to discovery.

Defendants promptly took the deposition of the confidential witness, who by this time had been identified. At his deposition, the formerly confidential witness denied virtually everything plaintiffs’ counsel had alleged in the amended complaint. For example, he did not work on the Dreamliner 787-8, but rather a different model, the 787-9; he did not have knowledge of or access to internal Boeing communications regarding tests on the 787-8; and he was not a Boeing employee when the 787-8 tests were conducted, but rather was an outside contractor. When plaintiffs’ counsel conceded that this individual, because of his testimony, would not be a trial witness for plaintiffs, defendants moved for reconsideration of the district court’s denial of their motion to dismiss. The district court reconsidered, and dismissed the complaint, but this time with prejudice. Plaintiffs appealed, challenging the dismissal, while defendants cross-appealed, challenging the failure of the district court to impose sanctions on plaintiffs’ counsel pursuant to Rule 11.

The Seventh Circuit affirmed the dismissal and remanded for a determination of sanctions. Judge Posner first reviewed the language of Section 10(b) and the Reform Act, which he explained altered the landscape of federal securities fraud litigation in four significant ways: (1) for “forward-looking” statements, plaintiff must prove actual knowledge of falsity; (2) the complaint must create a “strong inference” that defendant acted with the requisite state of mind; (3) the heavy pleading burden induces plaintiffs’ lawyers to seek out confidential sources of information about the defendant in advance of filing a complaint; and (4) even if neither side files a Rule 11 motion, the district judge must determine each party’s compliance with the Rule 11 and impose appropriate sanctions for violations.

The Court had little trouble holding that in the absence of the allegations attributed to the confidential witness the complaint failed to provide sufficient particularized facts giving rise to a strong inference that defendants made false statements regarding the first flight of the Dreamliner with scienter.

The Seventh Circuit then analyzed defendants’ cross-appeal for imposition of sanctions. The district court had noted that plaintiffs’ counsel did not speak with the confidential witness until six months after they filed the amended complaint, and that such failure by plaintiffs’ counsel to verify the allegations in their investigator’s notes amounted to a fraud on the court. Judge Posner seemed to agree, noting that the plaintiffs’ law firm was alleged to have made similarly misleading confidential witness allegations in at least three other cases. Judge Posner reiterated that under the Reform Act, defendants need not move for the imposition of sanctions; instead, the statute imposes on the district court the affirmative duty to determine sua sponte whether sanctions are appropriate upon final adjudication of the action. The Court thus remanded to the district court for such determination, making clear his view that sanctions likely were warranted.

This decision illustrates the consequences of careless use of confidential witnesses in securities fraud complaints, and provides a cogent reminder that the Reform Act mandates that the district court consider the imposition of sanctions in every case where the complaint fails to pass muster under its heightened pleading standards.