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Confidential evidence discounted in lawsuit


CHICAGO—Attorneys expect that securities fraud plaintiffs nationwide will pay close attention to a federal appeals court's dismissal of a case that relied heavily on statements of confidential witnesses.

After interpreting a recent U.S. Supreme Court ruling on case dismissals, a three-judge panel of the 7th U.S. Circuit Court of Appeals decided unanimously to heavily discount the importance of confidential witness statements because they never could be verified.

With the statements no longer of significant value to plaintiffs' allegations that the defendants intended to deceive shareholders, the panel affirmed a lower court's dismissal of the lawsuit against Deerfield, Il.-based Baxter International Inc. in Dennis Higginbotham et al. vs. Baxter International Inc.

"A ruling like this does give a court the flexibility to dismiss cases it didn't think it had before," said policyholder attorney William Passannante, a partner with Anderson Kill & Olick P.C. of New York. "I would think it lessens the exposure" of directors and officers liability insurers.

The ruling was the fourth federal court decision since a June 21 U.S. Supreme Court ruling that outlined how courts should analyze the strength of plaintiffs' cases at the early motion-to-dismiss stage. In that case, Tellabs Inc. et al. vs. Makor Issues & Rights Ltd. et al., the Supreme Court ruled plaintiffs' allegations should survive only if--after considering all plausible inferences of defendants' fraudulent and innocent activity--a reasonable person would find the plaintiffs' arguments "at least as compelling" as any opposing inferences that person could draw (BI, July 2).

But the 7th Circuit ruling is significant because the appeals panel had to extensively interpret the Supreme Court's guidelines in weighing how much value to give to confidential witness statements in the court's analysis of whether to dismiss a securities fraud lawsuit, attorneys said.

The Baxter case stems from the May 2004 disclosure that executives at a Brazilian subsidiary of the medical equipment manufacturer and pharmaceutical concern misrepresented the timing of sales and fabricated some sales to drive up profits.

Baxter began investigating the claims shortly after it issued its first-quarter 2004 financial statements in early May that year. When Baxter announced the problem, its stock price dropped 4.6% but rebounded somewhat a few weeks later when the company determined the profit impact would not be as severe as shareholders had anticipated, according to court papers.

Shareholders sued, but a lower court dismissed the consolidated litigation before reinstating it and then dismissing it again in 2005.

The 7th Circuit panel earlier this year deferred action on the case while awaiting a decision in the Tellabs case, in which the Supreme Court overturned the 7th Circuit's previous case evaluation process, which did not take into account inferences that the court could draw on potentially innocent behavior by defendants.

Court expresses frustration

In light of the Tellabs decision, the 7th Circuit panel said it felt frustrated with the confidential witness statements in the Baxter case because the plaintiffs' attorney told the court the witnesses would never be identified.

"It is 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," the panel wrote.

But the panel also said it would not ignore evidence from confidential witnesses. "It is possible to imagine situations in which statements by anonymous sources may corroborate or disambiguate evidence from disclosed sources," the panel noted. "Informants sometimes play this role in applications for search warrants. Because it is impossible to anticipate all combinations of information that may be presented in the future, and because Tellabs instructs courts to evaluate the allegations in their entirety, we said above that allegations from 'confidential witnesses' must be 'discounted' rather than ignored. Usually that discount will be steep."

Insurer attorney Arthur Washington, a partner at Mendes & Mount L.L.P. in New York, and Mr. Passannante said they expect the ruling to be influential among other courts because of reputation of the judges on the 7th Circuit panel.

Plaintiffs' attorney Carol Gilden, president of the Washington-based National Assn. of Shareholder & Consumer Attorneys, predicted that some courts would follow the 7th Circuit's reasoning but that others would not.

The attorneys agreed that plaintiffs nationwide, who often rely on confidential witness statements to establish defendants' intent, will pay attention to the decision.

The attorneys also agreed that the 7th Circuit followed the guidelines that the Supreme Court established in its Tellabs decision.

But, Mr. Washington said the panel had to balance the high court's direction to consider all factors that could give rise to opposing inferences of culpability and innocence against the panel's discomfort with allegations that could never be verified. "Personally, I think this 7th Circuit decision probably gets it right," Mr. Washington said.

Ms. Gilden did not expect other courts would be troubled by the 7th Circuit panel's interpretation of Tellabs. "The application of a standard always necessitates involving some interpretation by the court," said Ms. Gilden, a partner at Cohen Milstein Hausfeld & Toll P.L.L.C. in Chicago.

The panel also "poked holes" in arguments in which the plaintiffs' tried to demonstrate that the defendants acted with the intent to commit fraud, noted insurer attorney Dan A. Bailey, a partner with Bailey Cavalieri L.L.C. of Columbus, Ohio.

Among those arguments was the time Baxter executives took to investigate the problem before announcing it publicly. The panel ruled: "Managers cannot tell lies but are entitled to investigate for a reasonable time, until they have a full story to reveal."

Dennis Higginbotham et al. vs. Baxter International Inc., 7th U.S. Circuit Court of Appeals, July 27; 2007; No. 06-1312.