The Securities Exchange Act of 1934 was implemented to promote honest securities markets by affording investors a private cause of action for fraudulent market practices.[1] Section 10(b) of the Securities Exchange Act makes it unlawful to use or employ any manipulative or deceptive device “in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors,” while Rule 10b-5 makes it unlawful to make an untrue statement of material fact or omit a material fact necessary to make statements not misleading.[2] In practice, confidential witnesses serve as a practical tool to prosecute this type of corporate misconduct. Confidential witnesses provide first-hand information that connects a corporation’s public statements to the corporation’s internal reality. As such, confidential witnesses are not a loophole in securities litigation, and courts should not treat them as such—courts should avoid requiring confidential sources to be named at the pleading stage and instead apply a holistic approach that calibrates any discount based on the facts pled about the witness’s knowledge, job position, and other reliability criteria.
Though investors are afforded a private right of action, plaintiff-investors face a heightened pleading standard to pursue their claim. Investors must allege each element of a violation under Section 10(b) and Rule 10b-5, including that the corporate defendant acted with the requisite “scienter.”[3] The United States Supreme Court has defined “scienter” as a mental state of intent to deceive, manipulate, or defraud.[4] The Private Securities Litigation Reform Act of 1995 (“PSLRA”) created a heightened pleading standard for scienter by requiring plaintiffs to “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”[5] PSLRA’s heightened pleading standard was enacted for dual purposes: to curb frivolous, lawyer-driven litigation, while preserving a plaintiff-investor’s ability to recover on meritorious claims.[6]
The United States Supreme Court in Tellabs v. Makor Issues & Rights clarified how courts should determine whether a complaint sufficiently pleads a “strong inference” of scienter in securities litigation.[7] To qualify as “strong,” an inference of scienter must be “more than merely plausible or reasonable – it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent,” but need not be irrefutable.[8] As part of the court’s inquiry, scienter must be assessed holistically while weighing the plausible, nonculpable explanations for the defendant’s conduct as well as inferences favoring the plaintiff.[9]
To sufficiently plead scienter under PSLRA’s heightened pleading standard, plaintiffs must often uncover internal company information.[10] In turn, plaintiffs often receive information from former company employees. Former employees’ own recollections are especially useful to provide the particularized allegations needed in a securities complaint to survive a motion to dismiss.[11] For example, a former employee with a significant corporate title may be able to demonstrate the company knew its public statements were contradicted by the internal reality of the company or provide corroborating reports that its public statements were false.[12] Current or former employees often bridge the gap between vague allegations of a corporate defendant’s access to information and an inference of knowledge to demonstrate scienter.[13]
Considering the nature of current or former employees’ allegations against corporations, the individual who provides information is typically named anonymously in the plaintiff-investor’s complaint which gives rise to the term “confidential witness.”[14] How courts treat confidential witness allegations has become a debated topic within securities litigation, particularity in light of its heightened pleading requirements. Namely, some circuits apply an automatic discount against confidential witness allegations due to reliability concerns associated with confidentiality while other circuits apply a discount in proportion to the facts alleged about the confidential witness’s knowledge, job position, and other criteria supporting the reliability of their allegations.
Though PSLRA requires plaintiffs to “state with particularity facts giving rise to a strong inference of scienter,” it does not mention the source of these facts.[15] Without further guidance regarding confidential sources, courts have found that “the reading of the PSLRA rejects any notion that confidential sources must be named as a general matter.”[16] As such, courts have looked to the holistic review of securities complaints promoted in Tellabs for guidance. For example, the Second Circuit has determined that “a complaint may rely on information from confidential witnesses if they are described in the complaint with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged.”[17]
The intent behind enacting PLSRA reinforces this treatment. In enacting PSLRA, Congress demonstrated twin goals of preventing frivolous litigation yet allow meritorious securities fraud claims to proceed.[18] Though Congress heightened the pleading standards for securities complaints, it did not create an insurmountable bar for plaintiffs.[19] An automatic discount on confidential witness allegations or requiring the confidential witness to be named conflicts with these goals because it creates an additional barrier for plaintiffs to overcome. The inherent tension in balancing two goals cannot be evaded by adopting a categorical discount.[20]
Requiring plaintiffs to name confidential sources as a general matter also may deter plaintiffs from bringing meritorious claims. As the First Circuit has explained, employees or others in possession of important malfeasance may be discouraged from stepping forward if they must be identified at the earliest stage of the lawsuit.[21] The Second Circuit has further recognized this consideration in stating that requiring plaintiffs to name their confidential sources “serves no legitimate purpose while it could deter informants from providing critical information [. . .] or invite retaliation against them.”[22] Any deterrence against reporting fraudulent market practices directly contradicts the Security Exchange Act’s purpose of ensuring market honesty.
Information from confidential witnesses has proven to be particularly important in cases involving the corporate fraud that the Securities Exchange Act aims to prevent.[23] Corporate employee-informants, also known as whistleblowers, play an essential role in reporting wrongdoing that could be impossible to detect otherwise.[24] Studies have shown that whistleblowers are generally better at uncovering corporate fraud than government supervisory authorities acting alone.[25] For example, in 2016, Congress reported that over the span of four years, whistleblowers uncovered 54.1% of fraud in public companies versus the 4.1% of fraud detected by the Securities and Exchange Commission and external auditors.[26] Accordingly, any deterrence of whistleblower information will have detrimental implications on exposing corporate fraud.
Finally, the frequency of whistleblower retaliation helps demonstrate that maintaining confidentiality at the outset of litigation may improve judicial efficiency by avoiding whistleblower-retaliation litigation. A study has found that 82% of a whistle-blower population had been fired, quit their job due to duress, or had significantly altered responsibility due to their whistleblowing activity.[27] Retaliation is not limited to current employees either. Courts have noted that former employees may face retaliation as prospective employers often require references from prior employers.[28]
In total, the use of confidential witnesses in securities litigation is indispensable to promote an honest market. Considering the dual purposes of the heightened pleading standard in securities litigation, courts should not create an additional hurdle for plaintiffs to overcome by requiring confidential sources to be named. Instead, courts should utilize a holistic approach of applying a discount, if any, in proportion to the facts alleged about the confidential witness’s knowledge, job position, and other criteria supporting the reliability of their allegations.
[1] Sally J.T. Necheles, Cause of Action for Securities Fraud Under Section 10(b) of 1934 Securities Exchange Act and/or Rule 10b-5, 74 Causes of Action 2d 567, §2 (Updated March 2026), https://1.next.westlaw.com/Document/I2d1ab0e189a211e68f0ee788d95a4213/View/FullText.html?originationContext=typeAhead&transitionType=Default&contextData=(sc.Default)/.
[2] 17 C.F.R. § 240.10b-5(b).
[3] Ariel S. Lichterman, Confidential Witnesses: The Reform Act and the Battle at the Pleading Stage, 8 Cardozo Pub. L. Pol’y & Ethics J. 609, 617 (2010).
[4] See Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).
[5]15 U.S.C. § 78u–4(b)(2); Tellabs v. Makor Issues & Rights, Ltd., 551 U.S. 308, 311 (2007).
[6] Tellabs, 551 U.S. at 309.
[7] Id. at 314.
[8] Id. at 313–314.
[9] Id. at 323–324.
[10] Use of confidential witnesses in securities fraud pleading, 26A Sec. Lit. Damages § 24:53.
[11] Id.
[12] Oklahoma Firefighters Pension & Ret. Sys. v. Six Flags Ent. Corp., 58 F.4th 195, 215-216 (5th Cir. 2023).
[13] Use of confidential witnesses in securities fraud pleading, 26A Sec. Lit. Damages § 24:53.
[14] Id.
[15] 15 U.S.C. § 78u–4(b)(1)(2).
[16] Novak v. Kasaks, 216 F.3d 300, 313 (2nd Cir. 2000); Cal. Pub. Emps.’ Ret. Sys. v. Chubb Corp., 394 F.3d 126, 147 (3rd Cir. 2004) (the plain language of the PSLRA “is far from commanding that confidential sources must be named as a general matter”).
[17] Novak, 216 F.3d at 313.
[18] In re Cabletron Sys. Inc., 311 F.3d 11, 30 (1st Cir. 2002).
[19] Collier v. Moduslink Global Solutions, Inc. 9 F.Supp.3d 61, 69 (D. Mass. 2014).
[20] Cabletron, 311 F.3d at 30.
[21] Id.
[22] Novak, 216 F.3d at 314.
[23] Ethan D. Wohl, Confidential Informants in Private 17 Litigation: Balancing Interests in Anonymity and Disclosure, Fordham J. Corp. & Fin. L. 551, 555 (2007).
[24] Id.
[25] Christina P. Skinner, Whistleblowers and Financial Innovation, 94 N.C. L. Rev. 861, 892 (2016).
[26] Id. at 892.
[27] Gideon Mark, Recanting Confidential Witnesses in Securities Litigation, 45 Loy. U. Chi. L. J. 575, 597 (2014).
[28] Id.