In the
United States Court of Appeals
For the Seventh Circuit
____________
No. 06-1312
DENNIS HIGGINBOTHAM, et al.,
Plaintiffs-Appellants,
v.
BAXTER INTERNATIONAL INC., et al.,
Defendants-Appellees.
____________
Appeal from the United States District Court
for the Northern District of Illinois, Eastern Division.
No. 04 C 4909—William T. Hart, Judge.
____________
ARGUED DECEMBER 8, 2006—DECIDED JULY 27, 2007
____________
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 preced-
ing 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
2 No. 06-1312
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. (Al-
though the PSLRA applies only to a “suit that is brought as
a plaintiff class action”, 15 U.S.C. §78u–4(a)(1), the stat-
ute’s rules apply whether or not the class is certified.)
The district court issued a series of opinions first
dismissing the action, 2005 U.S. Dist. LEXIS 12006 (May
25, 2005), then reinstating it, 2005 U.S. Dist. LEXIS 21349
(Sept. 23, 2005), and finally dismissing it again with
prejudice, 2005 U.S. Dist. LEXIS 38011 (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 giv-
ing rise to a strong inference that the defendant acted
with the required state of mind”. 15 U.S.C. §78u–4(b)(2).
No. 06-1312 3
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
(1976); SEC v. Jakubowski, 150 F.3d 675, 681 (7th Cir.
1998). The district court ultimately ruled that the com-
plaint 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 opin-
ion, Tellabs, Inc. v. Makor Issues & Rights, Ltd., No. 06-
484 (U.S. June 21, 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.” Slip op. 12–13, footnote omitted. Second,
in applying this standard, “the court must take into
account plausible opposing inferences.” Slip op. 11.
One upshot of the approach that Tellabs announced is
that we must discount allegations that the complaint
attributes to five “confidential witnesses”—one ex-em-
ployee 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. Per-
haps 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
4 No. 06-1312
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 Cableton 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 (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
No. 06-1312 5
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 demon-
strate 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 informa-
tion 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 “confi-
dential witnesses” must be “discounted” rather than
ignored. Usually that discount will be steep. It is unneces-
sary 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 plain-
tiffs 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 subsid-
iary.
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
6 No. 06-1312
10, 2004 (covering financial information for the first
quarter of 2004). These documents contain false informa-
tion 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 knowl-
edge (or reckless indifference) before March 12, 2004, and
very little reason to infer knowledge (or reckless indif-
ference) before May 10, 2004. Although the complaint
asserts that managers at Baxter’s headquarters knew
about the contracts reported by the Brazilian subsid-
iary—they appeared in a computerized database available
throughout the firm—there is a big difference between
knowing about the reports from Brazil and knowing that
the reports are false. The complaint documents the
former but not the latter.
Knowledge does not come until May at the earliest. One
of the “confidential sources” supposedly told defendant
Brian P. Anderson, Baxter’s Chief Financial Officer from
February 1998 through June 2004, about the Brazilian
deceit during the first half of May 2004. (We refer to this
allegation not because we think this “confidential source”
reliable but to show that even by plaintiffs’ lights the
evidence is slim.) And during a discussion with analysts
following the announcement on July 22, Robert Parkinson,
Jr., Baxter’s Chief Executive Officer, related that head-
quarters had been notified of the fraud by an employee
in Brazil “sometime in the May time frame.” These two
tidbits do not supply a “compelling” demonstration that
No. 06-1312 7
anyone who signed the 10-Q report filed on May 10 had
actual knowledge that the data from Brazil had been
tampered with. The most one can say is that, sometime
during May 2004, Baxter learned enough to lead a reason-
able person to conduct an investigation. That is exactly
what Baxter did during the next two months, demonstrat-
ing a pursuit of truth rather than reckless indifference to
the truth. Knowing enough to launch an investigation
(Baxter could not simply assume that the initial report of
bad news was accurate) is a very great distance from
convincing proof of intent to deceive.
On April 29, 2004, Brazil’s national government accused
Baxter’s subsidiary there of participating in a cartel to
raise the price of blood products. Plaintiffs say that this
should have alerted the parent to the fraud before the 10-Q
report of May 10. We don’t get it. Accusations differ from
proof; business executives are not charged with “knowing”
the truth of whatever any public official anywhere in the
world may assert. Anyway, antitrust offenses have no
apparent link to fraud. Cartels improve the profitability of
the participants; proof that managers in Brazil were
working hard to generate profits (if illegal ones) would not
imply that they were also reporting nonexistent sales.
What’s more, the charge of antitrust conspiracy was public
knowledge. If it were enough to demonstrate fraud, then
plaintiffs and other investors could have drawn that
inference themselves, and the price of Baxter’s stock would
have declined immediately. The securities laws do not
require firms to “disclose” information that is already in
the public domain. See Wielgos v. Commonwealth Edison
Co., 892 F.2d 509, 517 (7th Cir. 1989).
Plaintiffs insist that Baxter must have known of the
deceit in April, because during that month Anderson and
Carlos del Salto (one of Baxter’s senior vice presidents)
sold shares of the company’s stock. Anderson realized
about $1.5 million and del Salto $4.4 million. Surely they
8 No. 06-1312
knew that something was amiss, plaintiffs insist. That
inference is neither compelling nor cogent, given that
plaintiff ’s own complaint identifies May 2004 as the first
month in which the bad news reached Baxter’s headquar-
ters. Even if Anderson and del Salto had got wind of some
problem, why would that induce them to sell? The restated
financials showed that the fraud in Brazil had increased
Baxter’s reported net income by about $33 million over a
three-year period, or some 1.5% of Baxter’s operating
profits. Reasonable executives need not see a 1.5% change
as substantial; indeed, securities lawyers often use a
5% change as a rule-of-thumb approach to what is “mate-
rial,Ӡ and 1.5% is less than a third of that. Cf. Basic Inc.
v. Levinson, 485 U.S. 224 (1988); TSC Industries, Inc. v.
Northway, Inc., 426 U.S. 438 (1976).
The complaint did not allege (nor do plaintiffs argue on
appeal) that the sales by Baxter’s senior managers as a
whole were abnormally high during the period before
public disclosure of the Brazilian problem. Managers sell
stock all the time (Anderson’s sale was part of a planned
program, though del Salto’s was not); if two of Baxter’s
†
The genesis of this commonly used benchmark may be Finan-
cial Accounting Standards Board, Accounting Standards:
Statements of Financial Accounting Concepts No. 2 at 55 (1980)
(suggesting a range between 3% of “large” numbers and 10% of
smaller ones). See Arthur Acevedo, How Sarbanes-Oxley Should
be Used to Expose the Secrets of Discretion, Judgment, and
Materiality of the Auditor’s Report, 4 DePaul Bus. & Comm. L.J.
1, 32 & n.189 (2005) (tracing the genesis of this rule of thumb).
Both the SEC, see Staff Accounting Bulletin No. 99, 64 Fed. Reg.
45150, 45151 (Aug. 19, 1999), and the courts of appeals, e.g., In
re Westinghouse Securities Litigation, 90 F.3d 696, 714 & n.14 (3d
Cir. 1996), have recognized the potential utility of this yard-
stick—but they stress, as do we, only as a rule of thumb and
not as a rule of law.
No. 06-1312 9
senior managers sell blocs during the average month,
plaintiffs can’t get any mileage out of what happened in
April. One possible inference is that the absence of sales
by other managers who would have been in the know (had
news of the fraud reached HQ) implies that nothing was
thought to be out of the ordinary in April 2004. Because
Tellabs instructs us to consider all potential inferences,
and not just those that favor plaintiffs, the absence of
any demonstration that April 2004 was an unusual
period for managerial sales means that the complaint
lacks the required “strong” demonstration of scienter.
Plaintiffs’ remaining theories are even weaker. Take the
claim that Baxter “knew” the financial controls in Brazil to
be inadequate yet failed to disclose this to investors until
July 22. Hindsight is the only basis of the proposed
inference—and, as the Court observed in Tellabs, citing a
famous opinion by Judge Friendly, there is no “fraud by
hindsight.” Slip op. 8, quoting from Denny v. Barber, 576
F.2d 465, 470 (2d Cir. 1978). A report by Baxter’s
audit committee accompanying the restated financials in
August 2004 concluded that the reporting system used in
Brazil had not been up to the task of preventing the
fraud. That’s no news; by definition, all frauds demon-
strate the “inadequacy” of existing controls, just as all
bank robberies demonstrate the failure of bank security
and all burglaries demonstrate the failure of locks and
alarm systems. It does not follow from this that better
financial-tracking systems would help shareholders.
Spending $50 million to stop a $33 million fraud is no
bargain. Indeed, no system is so foolproof that it cannot
be evaded. Top managers at any firm can affect how
financial results are reported, and it was the top managers
in Brazil who engineered this deceit.
In September 2004 Baxter hired Deloitte & Touche to
beef up financial controls in Brazil, upgrading the subsid-
iary’s system to the level required in the United States by
10 No. 06-1312
the Sarbanes-Oxley Act. Drawing any inference from this
would be incompatible with Fed. R. Evid. 407, which
provides that subsequent remedial measures may not be
used as evidence of liability. Quite independent of Rule
407, changing the accounting protocols does not show that
earlier ones were recognized as deficient. For all the
complaint reveals, improving the financial controls in
Brazil is not cost-justified and has been undertaken only
as a public-relations measure, or to forestall future
litigation, the cost of which easily can exceed the losses
attributable to fraud. Overstating profits by $33 million
does not “cost” shareholders $33 million; bogus “paper
profits” differ from money out of pocket; the actual
loss—funds stolen by the dishonest managers plus unnec-
essary volatility in stock prices and the costs of diversifica-
tion designed to protect against surprises at a single
firm—may have been modest. See generally John C.
Coates IV, The Goals and Promise of the Sarbanes-Oxley
Act, 21 J. Econ. Perspectives 91, 101–08 (Winter 2007).
The judgment of Congress, reflected in the PSLRA, is that
it is better to curtail baseless litigation by dismissing
unfounded complaints than by hiring teams of accoun-
tants.
As for the contention that Baxter should have disclosed
the news in June 2004 or the first half of July, rather than
on July 22: what rule of law requires 10-Q reports to be
updated on any cycle other than quarterly? That’s what
the “Q” means. Firms regularly learn financial informa-
tion between quarterly reports, and they keep it under
their hats until the time arrives for disclosure. Silence is
not “fraud” without a duty to disclose. See Basic and, e.g.,
Dirks v. SEC, 463 U.S. 646 (1983). The securities laws
create a system of periodic rather than continual disclo-
sures. See Gallagher v. Abbott Laboratories, 269 F.3d 806,
810 (7th Cir. 2001); Grassi v. Information Resources, Inc.,
63 F.3d 596, 599 (7th Cir. 1995). See also Gregory S.
No. 06-1312 11
Porter, What Did You Know and When Did You Know It?:
Public Company Disclosure and the Mythical Duties to
Correct and Update, 68 Fordham L. Rev. 2199 (2000).
Gallagher distinguishes between a duty to update
disclosures by adding the latest information and a duty to
correct disclosures false when made. The Securities
Exchange Act of 1934 may require the latter, though not
the former, Gallagher holds. Plaintiffs maintain that their
claim falls on the correction side of this line; after all, the
information from Brazil was false, so the annual and
quarterly statements also were false when released. But
this does not mean that correction must occur as soon as
the statements have been questioned. Prudent managers
conduct inquiries rather than jump the gun with half-
formed stories as soon as a problem comes to their atten-
tion. Baxter might more plausibly have been accused of
deceiving investors had managers called a press conference
before completing the steps necessary to determine just
what had happened in Brazil.
Taking the time necessary to get things right is both
proper and lawful. Managers cannot tell lies but are
entitled to investigate for a reasonable time, until they
have a full story to reveal. See Stransky v. Cummins
Engine Co., 51 F.3d 1329 (7th Cir. 1995); In re Burlington
Coat Factory Securities Litigation, 114 F.3d 1410, 1430–31
(3d Cir. 1997) (Alito, J.). After all, delay in correcting a
misstatement does not cause the loss; the injury to inves-
tors comes from the fraud, not from a decision to take the
time necessary to ensure that the corrective statement
is accurate. Delay may affect which investors bear the
loss but does not change the need for some investors to
bear it, or increase its amount.
We have so far refrained from mentioning appellants’
opening argument: that the district judge, having recon-
sidered his initial order dismissing the complaint, should
not have re-reconsidered and dismissed it a second time.
12 No. 06-1312
The law of the case bars re-reconsideration, plaintiffs
maintain. We held this argument for last because it is
frivolous. No matter what the district judge should have
done as a matter of local procedure, the only question on
appeal is whether the complaint is adequate. See, e.g.,
Santamarina v. Sears, Roebuck & Co., 466 F.3d 570, 571–
72 (7th Cir. 2006). The law of the case never blocks a
higher court from inquiring into the subject and making
the right decision. It would be absurd for this court to
remand for further proceedings, only to reverse at the end
of the case because the complaint flunked the PSLRA. A
district court ought not be reversed for getting to a legally
required outcome by a needlessly roundabout means.
None of appellants’ other arguments requires comment.
AFFIRMED
A true Copy:
Teste:
________________________________
Clerk of the United States Court of
Appeals for the Seventh Circuit
USCA-02-C-0072—7-27-07