The United States Court of Appeals for the Third Circuit recently held, in Institutional Investors Group v. Avaya, Inc.,1 that the Supreme Court’s decision in Tellabs, Inc. v.Makor Issues & Rights, Ltd.2 did not change existing law on the use of confidential witnesses to meet the pleading requirements of the Private Securities Litigation Reform Act (“PSLRA”). The Court reaffirmed its holding in Cal. Pub. Employees’ Ret. Sys. v. Chubb Corp.3 that a complaint can rely on information from a confidential informant under the PSLRA so long as it “provid[es] sufficient documentary evidence and/or a sufficient description of the personal sources of the plaintiff’s beliefs.”4 On a related issue, the Avaya court also held that after Tellabs, allegations of a defendant’s motive and opportunity to commit fraud are no longer sufficient to give rise to the “strong inference” of scienter that the PSLRA requires.
Congress adopted the PSLRA in 1995 in an attempt to make it more difficult for meritless private actions under Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5 to survive motions to dismiss. The legislation consisted in part of heightened pleading standards, under which plaintiffs are required to allege with particularity both the defendant’s supposed false statements and facts giving rise to a strong inference of scienter. Plaintiffs frequently attempt to meet those pleading burdens by alleging statements attributed to purported “confidential informants.” The lower federal courts have divided on what weight should be given to such anonymous statements in evaluating whether a complaint sufficiently pleads the necessary “strong inference” of scienter.
In Tellabs, the Supreme Court construed the PSLRA’s scienter pleading requirements and directed courts to use a balancing test, weighing the “plausible nonculpable explanations for the defendant’s conduct” against the “inferences favoring the plaintiff.” A “strong inference” of scienter arises only where the facts properly before the court on a motion to dismiss, taken collectively, give rise to an inference of scienter that is “cogent and at least as compelling as any opposing inference of nonfraudulent intent.”5 But Tellabs did not speak directly to the issue of how courts should evaluate, under the PSLRA, allegations from anonymous sources, an issue over which the lower courts have differed. For example, in Chubb the Third Circuit had held, prior to Tellabs, that confidential sources need not be named, provided that they are “described in the complaint with sufficient particularity.”6 Shortly after the Tellabs decision, the Seventh Circuit held that allegations made by confidential witnesses “must be discounted rather than ignored.”7 The Sixth and Ninth Circuits have adopted rules similar to those of the Third Circuit.8 The Second Circuit has not ruled on this issue post-Tellabs, but a court in the Southern District of New York recently followed the Second Circuit’s ruling in Novak v. Kasaks9 that “even if personal sources must be identified, there is no requirement that they be named, provided they are described in the complaint with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged.”10 In Avaya, the Third Circuit concluded that its prior holding in Chubb was consistent with Tellabs, and that courts should evaluate the indicia of the sources’ reliability and, if sufficient, may consider the allegations, notwithstanding their anonymity.
District Court’s Decision
In Charatz v. Avaya, Inc.,11 plaintiffs accused Avaya, Inc., a corporation that sells communications products and services, its CEO and CFO of making misleading statements regarding Avaya’s acquisition of telecommunications companyTenovis GmbH&Co. KG, Avaya’s financial and operational results for the fourth quarter of fiscal year 2004, and financial predictions for fiscal year 2005.
The district court granted defendants’motion to dismiss, holding that some of the defendants’ statements fell within the PSLRA’s safe harbor for forward-looking statements, that the plaintiff shareholders had failed to demonstrate that all of the defendants’ statements were false or misleading when made, and that the plaintiffs had failed to plead the strong inference of scienter required by the PSLRA.
The Third Circuit’s Decision
TheThird Circuit separated the alleged misleading statements into two categories: 1) “pricing pressure” statements in which defendants were alleged to have falsely denied that Avaya was offering unusual discounts and facing significant pricing pressure from competitors, and 2) “forecast-related statements” in which the defendants projected financial results and made positive portrayals of them.
The panel affirmed the District Court’s ruling that, under the PSLRA safe harbor provision, the forecast-related statements could not give rise to liability, agreeing that the company’s cautionary statements were “substantive, extensive, and tailored to the future-looking statements they reference.”12
As to the “pricing pressure” statements, plaintiffs claimed that, while defendants repeatedly assured analysts and investors that there were no significant changes to the pricing environment, they knew or disregarded the fact that competition was forcing 20% to 40% price discounts that impaired profit margins.To support this allegation, the shareholders relied on allegations they attributed to confidential witnesses.13 The shareholders described the positions the confidential witnesses had held at Avaya, the approximate dates of their tenure with Avaya, and the basis for their knowledge of Avaya’s operations.
Before Tellabs, the Third Circuit held in Chubb that courts should evaluate allegations based on purported confidential witness statements in light of the “detail provided by the confidential sources, the sources’ basis of knowledge, the reliability of the sources, the corroborative nature of the facts alleged, . . .the coherence and plausibility of the allegations, and similar indicia.”14 If found wanting with respect to these criteria, the allegations were to be “discounted steeply,” but if the allegations were sufficient under the criteria, the court would not dismiss them simply on account of their anonymity.15
After surveying other circuits’ case law interpreting Tellabs, the Third Circuit concluded that Chubb was still good law.16 Applying the Chubb factors to the case before it, the Avaya panel affirmed the district court’s decision that the shareholders had sufficiently described the positions formerly held by each of the alleged confidential sources as well as the basis of their personal knowledge. Accordingly, the panel found that plaintiffs had sufficiently pleaded falsity as to one of the alleged misstatements, and thus reversed the dismissal of plaintiffs’ claim based on that statement.17
The shareholders also disputed the district court’s finding that they had failed to adequately plead scienter, arguing that the District Court failed to consider the “combination of specific facts from various sources ‘collectively.’”18
Before Tellabs, in theThird Circuit, a plaintiff could satisfy the PSLRA scienter pleading standard with detailed allegations that the defendants had “motive and opportunity” to commit fraud. Plaintiffs did not necessarily also have to allege facts from which to infer a defendant’s “knowing deceit or recklessness.”19 The Avaya court found that in light of the balancing analysis that Tellabs requires, allegations of motive and opportunity alone no longer suffice to establish a “strong inference” of scienter.20 The court noted that even persons who have a strong motive and ample opportunity to commit bad acts often do not.Moreover, the mere existence of motive and opportunity does not mean that the possible nonculpable explanations for a false or misleading statement are any less compelling than the culpable ones. However, consistent with pre-Tellabs jurisprudence, allegations of motive and opportunity may still buttress an inference of scienter: “motive must be supported by facts stated with particularity, and must give rise to a strong inference of scienter.”21
The court then found that with respect to certain of defendants’ pricing statements, the plaintiffs had adequately pleaded scienter.22
Given the strict pleading standards imposed by the PSLRA, plaintiffs will likely continue to rely on statements by confidential informants. Defendants will argue, in turn, that, under the Tellabs weighing analysis, courts should discount such statements and find that they cannot support the “cogent and compelling” inference in the absence of detailed allegations demonstrating the first-hand knowledge of the informants.