Confidential witnesses in securities class actions. A Certified Legal Investigator white paper.

Confidential witnesses in securities class actions

Why securities fraud complaints rest on former employees, where the process fails them, and the verification practices that protect both the witness and the case.

By Lael Henterly, CLI

There are few areas of civil law in which investigators play a pivotal role as they do in securities fraud actions. The search for truth in modern securities swindles demands detailed information about events in the inner sanctums of corporate boardrooms and C-suite corner offices, far from the public eye. Investigators identify who will most likely have the information the legal team needs and collect insider accounts of corporate wrongdoing. These former employees, referred to as confidential witnesses, often determine whether a lawsuit moves beyond a motion to dismiss.

In securities fraud claims under the Securities Exchange Act of 1934, courts stay discovery until plaintiffs overcome a motion to dismiss by pleading "particular facts giving rise to a strong inference of fraud." Without the help of well-placed insiders, plaintiffs would be hard-pressed to gather facts sufficient to clear this unusually high pleading standard.

How we got here

It was not always this way. Plaintiff's firms could once file suit after a steep drop in stock price, then gather evidence once granted discovery. Following a raft of frivolous lawsuits, Congress stepped in to prevent abuse in 1995, passing the Private Securities Litigation Reform Act.¹ Under PSLRA, plaintiffs needed to plead specific, detailed allegations about what happened inside the company. Meanwhile, Section 21D(b)(3)(B) of the Securities Exchange Act of 1934 stripped the plaintiff's investigative powers, barring discovery until they overcame a motion to dismiss.²

John C. Coffee Jr. described the "'Catch-22' problem" created, which stays discovery during the pendency of any motion by a defendant challenging the adequacy of the pleadings. "The plaintiff cannot obtain discovery until the plaintiff has adequately pled a particularized complaint, but to plead such a complaint, plaintiffs traditionally rely on discovery."³

CWs filled the vacuum

This is where confidential witnesses come into play. Without access to company documents or data, plaintiffs turned to complex litigation investigators to find and gain the cooperation of witnesses in the boardrooms where executives made key decisions.

These whistleblowers are former employees of the defendant company who share their knowledge of corporate wrongdoing with the plaintiff's investigators. For a lawsuit to move beyond the motion to dismiss, the confidential witnesses' information must be sufficient to establish a "strong inference" of intent to deceive.⁴

Confidential witnesses safeguard financial markets by providing firsthand accounts of company wrongdoing, supplementing the efforts of regulatory agencies like the SEC. The government recognized their critical role and even included protections for whistleblowers in the Sarbanes-Oxley Act (SOX) of 2002.⁵

Today, cooperating insiders are indispensable in securities class action litigation, with most complaints resting on a tapestry of CW evidence. Confidential witnesses' primary role in securities suits is to show the court that there is a strong likelihood that the company acted with intent to deceive, helping plaintiffs survive a motion to dismiss and gain access to discovery. Only about half of securities class action suits make it to discovery. Of those, virtually all settle, making this the determinant stage in a case's trajectory.⁶

This paper explores the challenges, strategies, and legal implications of utilizing confidential witnesses in securities fraud investigations. We also suggest rigorous best practices for protecting the integrity of evidence obtained from confidential witnesses during an investigation and the confidential witnesses who provide it.

Proving scienter

Under Section 10(b) of the Securities Exchange Act, plaintiffs' firms typically bring securities fraud class actions against public companies when their stock prices drop after disclosing an adverse event. Plaintiffs claim that the company acted with scienter, "intent to deceive, manipulate, or defraud," in its earlier public statements to investors. Scienter is a lower standard than strict liability but, according to the Supreme Court, a higher standard than negligence.

The PSLRA's⁷ two key pleading requirements ushered in the ubiquitous use of CWs in securities class actions. Under the law, plaintiffs must:

1. specify each statement alleged to be misleading, the reason(s) why the statement is misleading, and all facts on which that belief is formed; and
2. state with particular facts giving rise to a strong inference that the specific defendant acted with the requisite scienter.

Confidential witnesses

Without access to corporate files, plaintiffs have little more than conjecture to support their complaints unless they can obtain insider accounts of wrongdoing. As a result, insider witnesses (CWs) have become essential for securities litigation plaintiffs.⁸ By providing firsthand factual accounts of corporate chicanery, CWs supplement the efforts of the SEC and serve as a check on companies that break the law.

That does not guarantee the court's respect, though. Courts have taken disparate positions on information from former employees who have blown the whistle on securities fraud. It is widely understood that whistleblowers experience negative blowback. Still, courts are slow to offer protection to CWs, sometimes even requiring them to appear in court to review their statements.

Attorney Ethan Wohl sorts informants into two groups: those who trade information for money or immunity and "citizen informants," who gain anonymity alone. Corporate employee informants, or whistleblowers, fall into the second group. Their work plays an important societal good and helps protect the integrity of the markets where securities trade, exposing wrongdoing that might otherwise remain hidden.⁹

While a criminal informant may have their life hanging in the balance of a prosecution, creating a strong incentive to provide the information sought by handlers, courts nevertheless treat them as credible, going to great lengths to protect their identities.¹⁰ Meanwhile, many courts question the motives of witnesses who hope to remain confidential in securities fraud cases.

With no incentive to offer prospective confidential witnesses to entice them to cooperate, investigators rely on witnesses' sense of civic duty or kindness to gain their cooperation. The justice system asks many former employees, who risk their reputation and livelihood, to assist with litigation in which they rarely have a stake.

Challenges

Federal courts have grudgingly allowed confidential witness evidence at the pleading stage in securities suits. However, its use has not been without hiccups, and some courts, like the Fifth and Seventh Circuits, remain wary of such testimony. When the court lifts the discovery stay, identities emerge. Often, the defense has already pieced together a witness's identity from their job description, dates of tenure, and reporting lines, which courts require.¹¹

As CWs became ubiquitous, companies began taking proactive measures to counteract securities lawsuits, requiring departing employees to sign non-disclosure agreements as a condition of their severance agreements. Defendants weaponize these confidentiality agreements to prevent interviews. Their tactics effectively discourage many employees from speaking with plaintiffs' counsel. Defense teams identify and intimidate witnesses upon filing an amended complaint; due to the power imbalance, it does not take much more than contact.

Defense perspective

In a system where defense attorneys must accept the CW information as true while their motion to dismiss is pending, defense attorneys worry that plaintiffs' counsel and their investigators are incentivized to distort witness information to strengthen a weak complaint. Disputes over both the truthfulness of the CWs and the conduct of plaintiffs' investigators are frequent, with defense attorneys questioning the often-inconsistent processes investigators use while obtaining and recounting evidence from these fact witnesses.¹²

Though overblown, their concerns are not without basis. Different firms take different approaches to investigating securities fraud claims, with many firms taking a hands-off approach to witness relations. An attorney may not speak with witnesses during fact-gathering. Follow-up interviews frequently occur long after the initial investigator contact.

Need for best practices

With over 3,000 interviews supporting upward of 250 securities fraud, antitrust, and qui tam matters, I've worked with numerous top firms gathering evidence. I have often been surprised at how firms handle witnesses and the information they provide. Establishing a rigorous, transparent process for evidence gathering in these cases could avoid the problems legal teams encounter while litigating securities class action matters. Such a process would also better protect the interests of the witnesses. The most diligent firms already perform rigorous checks before including CWs.

With no legal representation to stand up for their interests, witnesses are prone to change their minds about participating in litigation when contacted by defense counsel. When it becomes clear that participation will consume far more time and energy than initially anticipated or that they risk compromising a job reference, CWs sometimes recant. Other times, they go silent as the time burden associated with repeated calls and requests takes its toll. One can hardly blame them, given the demands of whistleblowing and the inadequate support offered by the current system.

Investigators and witnesses are often unaware that an amended complaint was filed, and both are occasionally surprised to see what was included. Even after judges have indicated that legal teams should inform witnesses before their statements are used as the basis for a federal lawsuit,¹³ not all firms do so for every case and witness.

Investigative process

Strategic framework. After a new securities class action is filed, the investigator studies the complaint and performs a media review, creating a fact sheet and timeline to refer to during interviews. Next, she crafts an interview template to guide the process of substantiating the allegations. Questions focus on the core allegations, channel stuffing, missing revenue, or fabricating clinical trials, for instance, and establishing scienter by demonstrating that the top executives were aware of the issues and did not tell investors.

Identifying potential witnesses. Next, investigators identify potential sources, carefully verifying that they no longer work for the defendant company and noting whether they left on bad terms. Investigators leverage job search platforms like LinkedIn to find people who worked for the defendant company during the relevant period.

Witness outreach. It is time to make calls after counsel verifies the questions and leads. In my experience, about half of the people who answer cooperate and provide relevant information.¹⁴ However, the level of cooperation and the value of the information provided vary widely based on company culture and which employees are most likely to have valuable information. Frequent objections include an aversion to lawyers or lawsuits, loyalty to the former employer, or a desire for compensation. Other former employees signed NDAs on their way out the door, often as a condition of severance.

Calls are frequently more rushed than ideal; witnesses are most likely to cooperate if you can gain their trust immediately. Each call begins with confirmation that the witness does not work for the defendant's company. Next, the investigator explains the case, who she is working for, that the law firm is adverse to the witness's former employer, and that, though their name won't appear in the complaint, the legal team can't guarantee their information will remain confidential. If counsel represents the witness, the investigator gets the attorney's contact information and passes it to her client.

Most individual witnesses possess fragments of the company's story, but the picture is clarified after as many as 30 interviews.

Lack of incentives to report fraud

Securing the cooperation of former corporate insiders under no mandate to answer questions and receive no benefit is among the more challenging feats for an investigator. Unlike relators in qui tam cases or whistleblowers who file TCRs with the SEC, no reward is available to the witnesses who blow the whistle on securities fraud to assist private litigants. An investigator can't promise witnesses confidentiality or offer compensation for the time a witness spends helping bolster plaintiffs' allegations. Meanwhile, the defendant company has various levers they can use to dissuade employees from cooperating. It's not unheard of for companies to launch a parallel effort to discourage people from speaking with investigators.

CWs often do not want to get involved in a court case, fearing the stress and inconvenience if they are called in for a deposition or expected to testify as a fact witness at trial. They often express concerns that their identity will be evident if their information is in the complaint. They often express concerns that their name will be placed on an informal blocklist and that they won't get a job anywhere in their industry. This belief is especially prevalent with former tech company employees, who are also among the least likely to cooperate.

Despite these concerns, many people who are contacted do cooperate. While their reasons for assisting vary, the typical CW does so out of a sense of civic responsibility, a desire for justice, or a desire to provide context they believe the investigative team lacks. Others had particularly terrible experiences and appreciate the opportunity to share the hardships they endured in a toxic workplace. Hearing witnesses' experiences, whether relevant to the case, is key to rapport-building and establishing trust during these interviews.

Since the False Claims Act of 1863, the U.S. has continued to pass legislation to protect whistleblowers. More than 137 federal statutes currently protect those who blow the whistle on corporate shenanigans. However, whether the laws are effective is another matter. Between half and two-thirds of whistleblowers lose their jobs, and most never work in the field again, possibly due to placement on "an informal blacklist."¹⁵

Evaluating reliability

It is crucial to carefully evaluate the credibility and reliability of CWs' information by talking to multiple witnesses and seeking additional sources from each. Biases or complicated motives do not necessarily make a witness unreliable, and certain motives may increase their commitment during a lengthy litigation process. Nonetheless, the investigator and legal team must be aware of factors that could impact the reliability of a witness's testimony.

The legal memos detailing each witness interview include context to help the legal team understand the witnesses' level of cooperation and attitude toward the former employer. This context helps counsel balance the value of the witness's firsthand knowledge of fraud against their reliability. Investigators also cross-reference witness statements with other evidence to assist the counsel in identifying recurring themes in the case.

Recanting CWs

One significant risk of relying on confidential witnesses is the possibility that they will recant when contacted by their former employer, retracting or contradicting their previous statements. Defense attorneys do not need to do much to intimidate witnesses. Attorneys often mention that it is illegal to use confidentiality agreements to cover up fraud evidence or retaliate against whistleblowers. Be that as it may, in reality, there is no way to stop companies from leveraging their power to scare witnesses out of cooperating: No one ever tells you you're on a blacklist; you never work in your industry again.¹⁶

Even one recanting witness can severely weaken a plaintiff's case and lead to its dismissal if there is not a robust fabric of evidence to fall back on. Yet it happens regularly, often due to the same shortcomings in the investigative process. The primary securities class action firms are familiar with witnesses who say one thing to plaintiffs' investigators and another when confronted by their former employers.¹⁷ There have been several high-profile cases where confidential witnesses have withdrawn or contradicted their initial statements.

Competing pressures

A 2013 case, City of Pontiac General Employees' Retirement System v. Lockheed Martin Corp., illustrated the competing pressures placed on confidential witnesses. Though Lockheed was dismissed, Judge Jed Rakoff issued his opinion as a memorandum to call out problems associated with using confidential witnesses in securities class actions, which he feared would become endemic. After the defense claimed four witnesses had recanted the statements attributed to them in the complaint, Judge Rakoff called the witnesses and the investigator into court in search of clarity.¹⁸

Rakoff concluded that the investigator's notes were largely accurate. However, "he did not ask any other member of his staff to be with him on his phone calls with the CWs, nor did he ask the CWs if he could tape-record the calls or meet with them in person, preferring to rely, instead, on his non-stenographic notes of the telephone conversations made even while the conversations were continuing."¹⁹

Rakoff's critique highlights the importance of careful investigation and accurate reporting. In the transcript, he delves into how the investigator posed questions, pointing out that the type of questions and method of documentation in that case are "far less rigorous" than those employed by federal law enforcement investigators. His interview memos indicated he had shared information with the witnesses and then asked them to verify it. He had interviewed the witnesses alone, which he told the court was a cost-saving practice.²⁰ The court indicated that cost efficiency was not a suitable reason to cut corners, suggesting two investigators would have been more appropriate.

Rakoff noted that the testimony "bore witness to the competing pressures this process has placed on the confidential witnesses and the impact such pressures had had on their ability to tell the truth."²¹

In other instances, a witness is surprised to learn that casual statements made during a call with an investigator one evening form the basis of a federal lawsuit against their former employer. Such was the case in the Millennial Media, Inc. Securities Litigation,²² where Judge Engelmayer's opinion highlighted the perils of sloppy witness work in securities fraud cases. Of the 11 confidential witnesses plaintiffs cited in their complaint, 44 percent later disputed the statements attributed to them, with several claiming they were unaware they would be quoted in a federal lawsuit.²³

Engelmayer dubbed these practices "unsettling" and "problematic,"²⁴ violating both basic decency and the duty of reasonable inquiry under Rule 11.²⁵ One CW, who was leaving a happy hour when the investigator called, attributed the strongly worded opinions he had previously expressed about his former employer to "the beers." Judge Engelmayer stressed that lawyers must confirm the witnesses' statements and notify them before filing an amended complaint²⁶ to ensure fair context and treat them with decency.

Lockheed and Millennial Media underscore the need for ethical considerations to play a more significant role in witness handling to ensure these individuals' rights are not overlooked or discounted in pursuit of shareholder recoveries. Still, many firms do not consistently confirm witness statements and ongoing cooperation before filing amended complaints.²⁷ Witnesses may learn that their statements form the basis for a federal lawsuit when they receive a call from defense counsel, who frequently identify witnesses while a motion to dismiss is still pending.

Some judges have questioned whether the witnesses even exist. In Higginbotham, the Seventh Circuit held that allegations from anonymous witnesses should be steeply discounted at the pleading stage, noting that such sources may be biased, dishonest, or fictitious. The court added that plaintiff lawyers, as advocates, cannot be expected to provide neutral accounts of what these witnesses say, further highlighting the essential role of investigators as fact finders. The court's opinion suggested a steep discount to the weight given to confidential witnesses, saying, "It's 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 are lying. Perhaps they don't even exist."²⁸

Best practices for verification and confirmation

To minimize problems with information gathered from confidential witnesses, investigators, litigators, and the federal judiciary should work together to establish a framework for evidence collection and verification in these cases. Implementing these steps before filing would protect the process and witnesses:

1. Investigator review of complaint. An astute investigator will be able to anticipate which witness statements used in the complaint may elicit strong reactions. The legal team's ethical responsibility is to ensure that the substance of the witnesses' words is conveyed in the complaint. Even small statements misconstrued risk harm to witnesses' careers and reputations.²⁹ Truly stand by the words attributed to them and the context in which they appear before proceeding with the amended complaint.
2. Verify information attributed to CWs. Verifying allegations would add a layer of credibility to witnesses' accounts, sending a clear message to adversaries that plaintiffs obtained explicit consent from witnesses before incorporating their statements into a complaint. As expected, some witnesses may retract their agreement to be part of a federal lawsuit once faced with the verification process. Influenced by outside forces such as family or friends, seeking new opportunities, or hoping to maintain their professional reputations, these individuals may distance themselves from the case. As time passes, memories may fade, and essential details may be lost. Others may want to move on from past events. It is the responsibility of the legal system to ensure that witnesses fully comprehend the ramifications of their involvement before proceeding.
3. Retain independent counsel for all interested confidential witnesses. This protects them from harassment by corporate lawyers and defense counsel and ensures they're protecting their interests.

Implementing these practices would protect the integrity of complaints and the interests of the witnesses we interview. Without confidential witnesses, lawyers representing plaintiffs would face a daunting challenge in bringing renowned corporations to justice for securities fraud under the PSLRA. Numerous class action lawsuits would wither and perish without this essential element.

Legal teams should establish a custom of keeping investigators informed about what they attribute to confidential witnesses. Similarly, regular updates to witnesses about ongoing litigation prevent shocking revelations from blindsiding them should the defense come knocking.

If implemented system-wide, these simple confirmation and verification practices, already employed by some firms, foster greater trust between opposing counsels. After all, if the defense is made aware that plaintiffs' counsel is diligent in keeping witnesses informed and ensuring their statements are accurately represented, there will be less incentive to dig up dirt on said witnesses and intimidate them. Most importantly, establishing standardized communication and notification protocols in these matters would offer much-needed protection to the brave individuals who put themselves at risk for truth and justice, shielding them from potential collateral consequences.

By adhering to a thorough, ethical approach, investigators can minimize the potential for unpleasant surprises arising during litigation while safeguarding their sources, who willingly give their time and risk their professional reputations to support lengthy legal battles.

Notes

1. U.S. Congress. 1995. Private Securities Litigation Reform Act of 1995, H.R. 1058, 104th Congress.
2. Coffee, John C., Jr. 2006. "Reforming the Securities Class Action: On Deterrence and Its Implementation." Columbia Law Review 106: 1534.
3. Ibid.
4. Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007).
5. Wohl, Ethan D. 2007. "Confidential Informants in Private Litigation: Balancing Interests in Anonymity and Disclosure." Fordham Journal of Corporate & Financial Law 12 (3).
6. Cornerstone Research and Stanford Law School Securities Class Action Clearinghouse. 2024. "Securities Class Action Filings: 2023 Year in Review," 19.
7. Private Securities Litigation Reform Act of 1995.
8. Hickok, Robert, Jay Dubow and Whitney Redding. 2022. "Confidential Witnesses in Securities Litigation: Handle With Care." The Legal Intelligencer, May 27.
9. Wohl 2007.
10. Ibid., 554.
11. "Securities Laws Need to Curb Misuse of Confidential Witnesses." 2023. US Law Week, August 1.
12. Ibid.
13. In re Millennial Media, Inc. Securities Litigation, No. 14 Civ. 7923 (PAE) (S.D.N.Y. May 29, 2015).
14. Based on the author's experience working on more than 250 confidential witness cases and interviewing more than 3,000 witnesses over the past decade.
15. Alford, C. Fred. 2001. Whistleblowers: Broken Lives and Organizational Power. Cornell University Press, 18–19.
16. Ibid.
17. Frankel, Alison. 2012. "The Confidential Witness Conundrum in Securities Class Actions." Reuters.
18. City of Pontiac General Employees' Retirement System v. Lockheed Martin Corp., Transcript of Proceedings, S.D.N.Y., November 18, 2013.
19. City of Pontiac Gen. Emps.' Ret. Sys. v. Lockheed Martin Corp., 952 F. Supp. 2d 633, 637 (S.D.N.Y. 2013).
20. Lockheed, Transcript of Proceedings, November 18, 2013.
21. Ibid.
22. In re Millennial Media, Inc. Securities Litigation (S.D.N.Y. May 29, 2015) (Engelmayer, J.).
23. Ibid., 22–39.
24. Ibid., 41.
25. Ibid., 44.
26. Ibid.
27. "Securities Laws Need to Curb Misuse of Confidential Witnesses," 2.
28. Association of the Bar of the City of New York, Securities Litigation Committee, Subcommittee on Use of Confidential Sources. Dialogue on the Current Law and Proposals for Reform on the Use of Information from and the Disclosure of the Identity of Informants, 21.
29. Alford 2001, 18–19.

Further reading: Eisenkraft, Michael B. 2017. "Dealing With Confidential Witness Recantation Statements," Law360; Higginbotham v. Baxter International, Inc., 495 F.3d 753 (7th Cir. 2007); Miller, Geoffrey P. 2009. "Pleading After Tellabs," Wisconsin Law Review 507; Smollar, Leigh Handelman. 2015. "The Importance of Conducting Thorough Investigations of Confidential Witnesses in Securities Fraud Litigation," Loyola University Chicago Law Journal 46 (3).

First published as a Certified Legal Investigator white paper in The Legal Investigator, the journal of the National Association of Legal Investigators, Spring 2025, pp. 29–33. Reproduced by the author.