Higginbotham v. Baxter Intern., Inc.

• Decision Date: 27 July 2007
• Docket Number: No. 06-1312.,06-1312.
• Citation: 495 F.3d 753
• Parties: Dennis HIGGINBOTHAM, et al., Plaintiffs-Appellants, v. BAXTER INTERNATIONAL INC., et al., Defendants-Appellees.
• Court: U.S. Court of Appeals — Seventh Circuit

495 F.3d 753

Dennis HIGGINBOTHAM, et al., Plaintiffs-Appellants, v. BAXTER INTERNATIONAL INC., et al., Defendants-Appellees.

No. 06-1312.

United States Court of Appeals, Seventh Circuit.

Argued December 8, 2006.

Decided July 27, 2007.

Christopher B. Sanchez, Miller, Faucher & Cafferty, Chicago, IL, for Plaintiffs-Appellants.

Matthew R. Kipp (argued), Skadden, Arps, Slate, Meagher & Flom, Chicago, IL, for Defendants-Appellees.

Russell D. Paul (argued), Berger & Montague, Philadelphia, PA, Patrick V. Dahlstrom, Pomerantz, Haudek, Block, Grossman & Gross, Chicago, IL, for Appellant.

Before EASTERBROOK, Chief Judge, and POSNER and RIPPLE, Circuit Judges.

EASTERBROOK, Chief Judge.

On July 22, 2004, Baxter International announced that it would restate the preceding three years' earnings in order to correct errors created by fraud at its subsidiary in Brazil. Managers there had conveyed the illusion of growth by reporting sales as having been made earlier than their actual dates; when it was no longer possible to accelerate revenue this way, the managers reported fictitious sales. Brazilian managers also failed to create appropriate reserves for bad debts. On the day the problem was announced, Baxter's common stock fell $1.48 per share, or 4.6% of its market price. (The parties have not used econometric methods to separate firm-specific changes from movements of the market as a whole, so we give raw numbers.) A few weeks later, when the formal restatement showed that the overstatement of profits was less serious than many investors initially feared, the price edged up. This is consistent with the pattern at other firms: a plan to restate earnings creates uncertainty that may be dispelled by the concrete results, but revelation that the firm's internal controls allowed the problem in the first place usually causes a persistent loss. See Zoe-Vonna Palmrose, Vernon J. Richardson & Susan Scholz, Determinants of market reactions to restatement announcements, 37 J. Accounting & Econ. 59 (2004).

Any restatement of a public company's financial results is likely to be followed by litigation. Multiple suits were filed in the wake of this one. These claims, which invoke § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and the SEC's Rule 10b-5, 17 C.F.R. § 240.10b-5, were consolidated, and a lead plaintiff was selected under the Private Securities Litigation Reform Act of 1995. Oddly, the district court never decided whether the litigation could proceed as a class action, though this subject has not been raised as an issue on appeal. (Although the PSLRA applies only to a "suit that is brought as a plaintiff class action", 15 U.S.C. § 78u-4(a)(1), the statute's rules apply whether or not the class is certified.)

The district court issued a series of opinions first dismissing the action, 2005 WL 1272271, 2005 U.S. Dist. LEXIS 12006 (N.D.Ill. May 25, 2005), then reinstating it, 2005 WL 2368795, 2005 U.S. Dist. LEXIS 21349 (N.D.Ill. Sept. 23, 2005), and finally dismissing it again with prejudice, 2005 WL 3542521, 2005 U.S. Dist. LEXIS 38011 (N.D.Ill. Dec. 22, 2005). The PSLRA provides that the complaint in a securities-fraud action must, "with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind". 15 U.S.C. § 78u-4(b)(2). That "required state of mind" is an intent to deceive, demonstrated by knowledge of the statement's falsity or reckless disregard of a substantial risk that the statement is false. See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976); SEC v. Jakubowski, 150 F.3d 675, 681 (7th Cir.1998). The district court ultimately ruled that the complaint fails to establish the required "strong inference" of scienter.

At the time this appeal was briefed and argued, Makor Issues & Rights, Ltd. v. Tellabs, Inc., 437 F.3d 588 (7th Cir.2006), supplied this circuit's understanding of § 78u-4(b)(2). Shortly after argument, however, the Supreme Court granted certiorari in Tellabs, and we deferred action pending the Court's decision. The Supreme Court's opinion, Tellabs, Inc. v. Makor Issues & Rights, Ltd., ___ U.S. ___, 127 S.Ct. 2499, 168 L.Ed.2d 179 (2007), establishes two propositions that govern this appeal. First, "[a] complaint will survive [a motion to dismiss] only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged." 127 S.Ct. at 2510, footnote omitted. Second, in applying this standard, "the court must take into account plausible opposing inferences." 127 S.Ct. at 2502.

One upshot of the approach that Tellabs announced is that we must discount allegations that the complaint attributes to five "confidential witnesses"—one ex-employee of the Brazilian subsidiary, two ex-employees of Baxter's headquarters and two consultants. 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.

At oral argument, we asked when the identity of these five persons would be revealed and how their stories could be tested. The answer we received was that the sources' identity would never be revealed, which means that their stories can't be checked. Yet Tellabs requires judges to weigh the strength of plaintiffs' favored inference in comparison to other possible inferences; anonymity frustrates that process.

Not that anonymity is possible in the long run. There is no "informer's privilege" in civil litigation. Defendants are entitled to learn in discovery who has relevant evidence, and to obtain that evidence. Indeed, plaintiffs are obliged by Fed. R.Civ.P. 26(a)(1)(A) to provide defendants with the names and addresses of all persons "likely to have discoverable information that the disclosing party may use to support its claims or defenses". Concealing names at the complaint stage thus does not protect informers from disclosure (and the risk of retaliation); it does nothing but obstruct the judiciary's ability to implement the PSLRA.

This does not mean that plaintiffs must reveal all of their sources, as one circuit has required. See In re Silicon Graphics Inc. Securities Litigation, 183 F.3d 970, 985 (9th Cir.1999). A complaint is not a discovery device. Our point, rather, is that anonymity conceals information that is essential to the sort of comparative evaluation required by Tellabs. To determine whether a "strong" inference of scienter has been established, the judiciary must evaluate what the complaint reveals and disregard what it conceals.

Decisions such as In re Cabletron Systems, Inc., 311 F.3d 11, 24 n. 6, 28-31 (1st Cir.2002), which countenance the use of confidential sources to satisfy the PSLRA, analogize to unnamed informants in affidavits for search warrants. See Illinois v. Gates, 462 U.S. 213, 103 S.Ct. 2317, 76 L.Ed.2d 527 (1983). That analogy shows the problem. A complaint passes muster under Tellabs "only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged." That is a higher standard than "probable cause," which (the court stressed in Gates) does not entail a more-likely-than-not threshold. 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 could draw from the facts alleged."

It is possible to imagine situations in which statements by anonymous sources may corroborate or disambiguate evidence from disclosed sources. 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. It is unnecessary to say more today.

Plaintiffs do not proffer concrete evidence that anyone at Baxter's headquarters in the United States knew of the shenanigans in Brazil until May 2004. Nor do plaintiffs contend that the knowledge of the senior managers in Brazil should be imputed either to Baxter or any of its managers in the United States. Perhaps they omit this line of argument because Baxter Brazil was a subsidiary rather than a division of Baxter International, but it does not matter why the argument has been omitted. It is enough to say that we need evaluate only arguments concerning managers at the firm's headquarters, none of whom participated in the scheme at the Brazilian subsidiary.

Plaintiffs describe, as the fraudulent statements, the income and earnings figures in Baxter's 2004 10-K report filed on March 12, 2004 (covering financial information through the end of 2003), and its 10-Q report filed on May 10, 2004 (covering financial information for the first quarter of 2004). These documents contain false information that the Brazilian subsidiary reported to Baxter's headquarters. Plaintiffs assert that by March 12 or May 10 Baxter's senior managers (the ones who signed the reports) knew the Brazilian data to be false, or were recklessly indifferent to its accuracy. Plaintiffs also maintain that Baxter's senior managers knew (and failed to disclose) that the Brazilian subsidiary had inadequate financial controls, and that even if Baxter did not learn of the Brazilian fraud until after May 10 it should not have waited until July 22 to disclose the problem.

Yet the complaint offers no reason at all to infer knowledge (or reckless indifference) before March 12, 2004, and very little reason...