In the aftermath of the Supreme Court's opinion in Tellabs (which construed the "strong inference" language in the PSLRA), the Seventh Circuit has issued two, arguably conflicting, opinions, both addressing the right to use confidential sources to overcome the scienter standard. 

The two cases are Higginbotham v. Baxter International, 495 F.3d 753 (7th Cir. 2007)(written by Judge Easterbrook but with Judge Posner on the panel and very involved at oral argument with the confidential witness issue); and Makor Issues & Rights Ltd. v. Tellabs Inc. (Tellabs II), No. 04-1687, 2008 WL 121180 (7th Cir. 2008)(written by Judge Posner).

In Baxter, shareholders brought a class action suit against Baxter Inc., a global healthcare company, alleging violations of §10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. In an opinion by Chief Judge Easterbrook, the Seventh Circuit affirmed the district court’s holding and dismissed the complaint because it failed to demonstrate a “strong inference” of scienter.  In the course of the opinion, the court strongly criticized the use of confidential informants to establish scienter. 

The §10(b) claim arose from Baxter Inc.’s announcement that it would restate the previous three years earnings because its Brazilian based subsidiary fraudulently reported growth and sales. This announcement resulted in Baxter Inc.’s stock price falling by 4.6%. Plaintiffs claimed that Baxter Inc.’s senior managers knew the Brazilian information either was false or were “recklessly indifferent to its accuracy.” Plaintiffs also alleged that management knew of the inadequate financial controls in Brazil; or alternatively, having learned of the fraud on May 10th, should not have waited until July 22nd to disclose the problem. To support these claims the plaintiffs’ complaint contained allegations from five confidential informants, an issue not taken lightly by the Seventh Circuit.

In Baxter the court referred to the recent Supreme Court decision Tellabs, Inc. v. Makor Issues & Rights Ltd. (Tellabs I), 127 S.Ct. 2499 (2007). In Tellabs I, the Supreme Court remanded the Seventh Circuit decision and held that when evaluating a motion to dismiss a §10(b) action a court must, inter alia, “determine whether the pleaded facts give rise to a ‘strong’ inference of scienter . . . [by] tak[ing] into account plausible opposing inferences.” In addition, the Supreme Court held a §10(b) complaint will survive only if the inference of scienter is “at least as compelling as any opposing inference one could draw form the facts alleged.”

With this standard in mind, the court in Baxter found it difficult for information from confidential informants to allow the “sort of comparison” required by the Supreme Court in Tellabs I. According to the court, “it is hard to see how information from anonymous sources could be deemed ‘compelling’ or how we could take account of plausible opposing inferences.” The court opined that the “upshot” of the approach the Supreme Court announced in Tellabs I is that “we must discount allegations that the complaint attributes to . . . ‘confidential’ witnesses.”

Less than six months later, the court decided Tellabs II, the remanded case from the Supreme Court, and distinguished its approach in Baxter with respect to confidential witnesses.  In an opinion written by Judge Posner, the Seventh Circuit reversed the previous ruling and allowed the suit to continue because the plaintiffs’ pleading created a “strong inference” of scienter as required by the Supreme Court.

In Tellabs II, the complaint alleged that Tellabs Inc., a manufacturer of fiber optic network equipment, violated Rule 10b-5 in a series of announcements concerning its primary product line. The plaintiffs’ complaint in Tellabs II referred to 26 confidential informants. Judge Posner reiterated the Seventh Circuit’s position from Baxter where “allegations based on anonymous informants are very difficult to assess . . . [and] that such allegations must be steeply discounted.” However, here, unlike Baxter, the “discount” was not enough to prevent finding scienter.

Comparing the court's decisions in Tellabs II and Baxter the Seventh Circuit gives mixed signals on the ability to demonstrate scienter through confidential informants. The court in Tellabs II found the use of confidential informants did “not invalidate the drawing of a strong inference from informants’ assertions.” While the court in Baxter found that, “no decision of which we are aware concludes that anonymous accusers can demonstrate that scienter is ‘at least as [likely] as any opposing inference.”

One difference between the confidential informants in Tellabs II and Baxter is the relationship between the informants’ job and the informants’ information. The court in Tellabs II found the description of confidential informants indicated they were “in a position to know at first hand the facts to which they are prepared to testify.” However, in Baxter, the plaintiffs’ confidential informants consisted of a

• “former Baxter executive employed in the Brazil office throughout the Class Period, . . . a consultant [retained by Baxter Inc.] on the issue of financial controls” whose information was “based upon observations and conversations with Baxter’s internal audit personnel,” and “a consultant hired to train Baxter’s executives on issues related to financial reporting.”

Given this information, the court in Baxter found that the complaint based on five confidential informants, “described merely as three ex-employees . . . and two consultants” is not enough to support a strong inference of scienter.

These two cases indicate that the discount given to confidential is not always insurmountable, but rather the discount is a function of whether the informants’ information is “set forth in convincing detail” and whether the informants’ information is “corroborated by multiple sources.”

The primary materials for this case may be found on the DU Corporate Governance .