(Reuters) - Not all confidential witnesses are created equal – at least, not in the eyes of the 5th U.S. Circuit Court of Appeals.
Such is the message of the appellate court’s ruling on Wednesday, reviving a shareholder class action against theme park developer Six Flags Entertainment Corp that had been tossed because the trial judge said he was bound by precedent to discount detailed allegations from a well-placed confidential witness. The 5th Circuit, in an opinion by Judge Leslie Southwick for a panel that also included Judges Catharina Haynes and Stephen Higginson, said the discount in the Six Flags case was too steep.
“Discount does not mean unfettered discretion to discard,” Southwick wrote. “A court must consider the details in the description of the source and whether those details substantiate that the source has the necessary knowledge.”
In the Six Flags case, the 5th Circuit said, the complaint specified the informant’s job title and explained the depth of his oversight duties for the Six Flags Chinese expansion that led to shareholders’ fraud allegations. As a result, the 5th Circuit said, “his allegations should be discounted only minimally for his anonymity and lack of corroborating witnesses.”
And with a less skeptical consideration of the informant's information, the 5th Circuit said, the case is solid enough to move forward.
Six Flags counsel Daniel Cellucci of Kirkland & Ellis did not respond to my query. The company insisted in its 5th Circuit brief that it did not mislead investors about problems with its plan to expand in China. Shareholder lawyer John Rizio-Hamilton of Bernstein Litowitz Berger & Grossmann, who argued for investors at the 5th Circuit, also did not respond.
The shareholder case alleges that Six Flags misled investors in 2018 and 2019 about the company’s progress on an ambitious plan to expand its international footprint with the construction of as many as 20 new theme parks in China.
By early 2020, the plan was in tatters. Six Flags revealed in January that its Chinese real estate development partner, Riverside Investment Group, had defaulted on its obligations. In February, the company terminated its deal with Riverside. Both the CEO and CFO of Six Flags stepped down in the midst of the fiasco. Ultimately, Six Flags’ share price, which was more than $73 in June 2018, plummeted to less than $32 in February 2020, when the China expansion had run off track.
Those sorts of public facts are certainly tantalizing enough to pique the interest of the class action bar. But public facts are rarely sufficient for shareholder fraud cases. That’s the classic challenge, as you know. Plaintiffs' lawyers aren’t entitled to discovery from defendants until they’ve survived a defense motion to dismiss. But to meet the high pleading standard for securities fraud class actions, plaintiffs' lawyers have to provide detailed, specific allegations that defendants intentionally deceived investors.
Confidential witnesses – ideally, employees (or former employees) or contractors with first-hand knowledge of the alleged shenanigans -- can provide shareholder lawyers with enough evidence to round out the public record and adequately plead fraud.
But anonymous sources are walking caveats. You surely remember a series of cases from about 10 years ago, in which confidential informants who had been tracked down by plaintiffs’ investigators and quoted in shareholder complaints subsequently recanted their allegations or even denied talking to plaintiffs’ investigators at all. Judges in a handful of cases were compelled to conduct evidentiary hearings just to figure out whether recanting witness had been misled by plaintiffs' lawyers – or bullied by defendants into changing their stories.
That furor has died down, but courts continue to regard confidential witnesses warily. I wrote earlier this month, for instance, about a New York judge’s decision not to rely on second-hand confidential sources whose claims ended up in a shareholder class action complaint against DraftKings Inc by way of a report from the short seller Hindenburg Research. Short seller reports, the judge concluded, are not per se unreliable, but plaintiffs' lawyers have to figure out how to confirm accounts from anonymous short-seller informants.
In 5th Circuit precedent, skepticism prevails. Dating back at least to 2008’s Indiana Electrical Workers v. Shaw Group Inc the appeals court provided trial judges with a no-nonsense warning: “Courts must discount allegations from confidential sources.”
The trial judge in the Six Flags case heeded that warning. Shareholder lawyers from Bernstein Litowitz and McKool Smith had found an unusually well-informed confidential witness – a former Six Flags project manager who was on site in China beginning in May 2018. The informant met with Six Flags’ development partners from Riverside, toured prospective theme park sites, oversaw construction on the first project site and provided weekly presentations and reports to Six Flags executives about the Chinese park plans.
The informant alleged that he was present at a 2018 meeting at which two executives from Six Flags China said that Riverside was running out of money – an assertion that was backed by a photo showing almost no progress at what was supposed to be the lead construction site. He also alleged that he had reported his concerns to in a 2019 letter to human resources personnel at Six Flags in the U.S.
Despite all of the details about the informant’s role and the specificity of the allegations he recounted, U.S. District Judge Mark Pittman of Fort Worth said he was required under 5th Circuit precedent to consider the unnamed witness’ assertions “through a discounted lens.” Ultimately, Pittman concluded, allegations from the confidential informant were not solid enough to establish that Six Flags officials deliberately deceived investors when they made optimistic predictions about the expansion project in China.
The 5th Circuit disagreed. So now Six Flags investors can forge on with the fraud class action. And maybe the next time a well-placed, well-informed confidential witness emerges in a securities class action in Texas, Louisiana or Mississippi, trial judges will think harder about disregarding her assertions.
Six Flags raises possibility of canceling China theme parks, shares plunge
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