Whether, in a private right-of-action, primary liability applies to an investment adviser for alleged participation in the issue of material misstatements by the client funds that it advises despite the lack of aiding-and-abetting liability claims in private actions under Section 10(b) of the Securities Exchange Act of 1934 and Security Exchange Commission Rule 10b-5.
A 2003 investigation by the New York State Attorney General revealed that Janus Capital Management, an investment adviser, had secretly allowed several hedge funds to engage in market-timing trades using the assets of the Janus Investment Fund, which were publicly marketed toward long-term investors. Subsequently, First Derivative Traders, a stockholder in Janus Capital Management’s parent company, brought a private securities fraud action against the Janus companies, alleging that Janus Capital Management was responsible for misleading statements in the Janus Funds’ prospectuses. Though Janus Capital Management argued that its status as a mere outside service provider precluded liability, the Fourth Circuit allowed First Derivative Traders to move forward with its claim. In a decision that will affect the scope of secondary liability in private securities-fraud actions, the Supreme Court is now asked to decide whether an investment adviser can be held responsible for misstatements that appear in its client’s offering documents.
Questions as Framed for the Court by the Parties
There is no aiding-and-abetting liability in private actions brought under Section 10(b) of the Securities Exchange Act of 1934. Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). Thus, a service provider who provides assistance to a company that makes a public misstatement cannot be held liable in a private securities-fraud action. Stoneridge Inv. Partners, LLC v. Scientific- Atlanta, Inc., 128 S. Ct. 761 (2008). In the decision below, however, the Fourth Circuit held that an investment adviser who allegedly "helped draft the misleading prospectuses" of a different company, ''by participating in the writing and dissemination of [those] prospectuses," can be held liable in a private action "even if the statement on its face is not directly attributed to the [adviser]." App., infra, 17a- 18a, 24a (emphases added). The questions presented are:
1. Whether the Fourth Circuit erred in concluding-in direct conflict with decisions of the Fifth, Sixth, and Eighth Circuits-that a service provider can be held primarily liable in a private securities fraud action for "help[ing]" or "participating in" another company's misstatements.
2. Whether the Fourth Circuit erred in concluding-in direct conflict with decisions of the Second, Tenth, and Eleventh Circuits-that a service provider can be held primarily liable in a private securities-fraud action for statements that were not directly and contemporaneously attributed to the service provider.
On September 3, 2003, New York Attorney General Eliot Spitzer filed a complaint against a hedge fund for making secret arrangements with Janus Capital Management (“JCM”) to benefit from market-timing. See First Derivative Traders v. Janus Capital Group, Inc., 566 F.3d 111, 128 (4th Cir. 2009). JCM managed various mutual funds under the Janus name and the alleged arrangements violated policies expressed in prospectuses filed with the Securities Exchange Commission (“SEC”). See id. at 116–18. The public reacted by pulling $14 billion out of JCM-managed funds. See id. at 128. Because Janus Capital Group (“JCG”) owns and derives ninety-percent of its revenues from JCM, JCM’s decline triggered a drop in JCG’s share price as investors raced to cash out. See id. at 114, 128. In fact, one day after the announcement, JCG’s stock fell by 12.7%. See id. at 118, 129.
Plaintiffs, First Derivative Traders and other shareholders of JCG (“FDT”), claim that JCM and JCG violated Section 10(b) and Section 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 when JCM allegedly misrepresented its market-timing policies. See First Derivative Traders, 566 F.3d at 114, 127. Market-timers use time-zone arbitrage to exploit inefficiencies in how a mutual fund that invests in foreign securities values its shares. See id. at 116. As local markets close, funds calculate their net asset values. See id. However, because foreign markets are open during this calculation, funds may use stale numbers that do not reflect changes in foreign-market closing prices. See id. So, if a foreign security’s value increases, the market-timer can purchase fund shares at an artificially low price and sell when the market corrects itself. See id.
Market timing disadvantages long-term shareholders in several ways: it dilutes the value of fund shares, inflates transaction costs, has significant opportunity costs, and creates negative tax implications. See First Derivative Traders, 566 F.3d at 116. Language describing a policy against market-timing appeared in multiple prospectuses for various Janus investment funds, which were readily accessible on the website shared by Janus funds, JCG, and JCM. See id. at 125–27. Despite the message broadcast to the public, JCM admitted during the investigation that it had engaged in secret market-timing arrangements with hedge funds for years. See id. at 117–18.
Craig Wiggins, a JCG shareholder, filed a complaint against JCG in the District Court of Colorado. See First Derivative Traders, 566 F.3d at 115. The action was eventually transferred to the District of Maryland. See id. There, the court named FDT lead plaintiff and FDT amended its complaint to include JCM, alleging that JCM caused the fraudulent misrepresentations in the prospectuses and that the public revelation of the fraud caused losses borne by JCG investors. See id. The district court dismissed FDT’s claims. See id. at 118. In dismissing the Section 10(b) claims against both JCG and JCM, the court found that FDT failed to adequately plead the necessary elements against either party. See id. Furthermore, the district court found, without a valid claim against JCM, FDT could not argue a valid control-person liability claim against JCG. See id.
Reviewing de novo, the United States Court of Appeals for the Fourth Circuit held that FDT’s complaint satisfied pleading requirements because investors might infer that, as an investment adviser, JCM participated in the misrepresentations and reliance under a fraud-on-the-market rationale need only show the statement is public and attributable to the defendant. See id. at 119, 127. The Fourth Circuit affirmed the dismissal the Section 10(b) claim against JCG but held that FDT adequately implicated JCG for control person liability. See id. at 127–28, 131.
In this case, the Supreme Court will determine whether Janus Capital Group (“JCG”), a publicly traded financial services company, and its subsidiary, Janus Capital Management (“JCM”), can be held liable for misrepresentations appearing in the prospectuses of Janus Investment Fund (“Janus Funds”), a family of mutual funds managed by JCM. Respondent First Derivate Traders (“FDT”), a stockholder in JCG, commenced this private securities-fraud action under Section 10(b) of the Securities Exchange Act of 1934 (“the Act”), which prohibits buyers and sellers of securities from using manipulative or deceptive devices in the disposition of securities. See 15 U.S.C. § 78j(b). Securities and Exchange Commission (“SEC”) Rule 10b-5(b) further proscribes the issuing of untrue or misleading statements in connection with the purchase or sale of securities. See 17 C.F.R. § 240.10b-5(b). Here, JCG and JCM (collectively “Janus”) argue that, as a mere outside service provider, JCM cannot be held liable for unattributed statements made by a legally independent entity such as the Janus Funds. See Brief for Petitioners, Janus Capital Group and Janus Capital Management at 8. FDT, on the other hand, contends that because the operations and the profitability of all three Janus entities are closely intertwined, JCG and JCM are not mere secondary actors, but primary actors liable for the Janus Funds’ public misstatements. See Brief for Respondent, First Derivative Traders at 12.
Janus begins its argument by asserting that, under both the Private Securities Litigation Reform Act of 1995 (“PSLRA”) and the Supreme Court decision of Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), private plaintiffs cannot maintain aiding-and-abetting securities-fraud claims under Section 10(b) of the Act, but instead must target directly the primary actors who committed deceptive acts during the purchase or sale of securities. See Brief for Petitioners at 16. Indeed, Janus points out that the basic purpose of the PSLRA was to reduce meritless litigation involving outside service providers—such as accountants, lawyers, and underwriters—frequently pursued by plaintiffs for their “deep pockets” rather than for their culpability in the commission of a deceptive act. See id.
Janus contends that, from both functional and definitional standpoints, JCG and JCM must be considered mere secondary actors incapable of liability under the Act. See Brief for Petitioners at 18–20. First, Janus notes that, though JCM manages the Janus Funds’ daily operations, JCM and the Janus Funds are separate legal entities, and neither JCG nor JCM own, govern, or control the Funds. See id. at 3–4. Furthermore, despite a detailed contractual relationship, Janus observes that JCM holds no specified responsibility to produce or supervise any disclosures made in the Janus Funds’ prospectuses. See id. at 26. Second, with reference to Central Bank and Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008), Janus asserts that the Court has definitively characterized outside service providers in the securities business as secondary actors, implying that in private actions only the direct issuers of securities may be held liable for misstatements that diminish the value of those securities. See id. at 18–20. Finally, Janus objects to FDT’s description of JCM as a “corporate insider” that should be held liable for the misstatements of a client whose operations it closely manages. See id. at 21. Janus argues that creating an “investment adviser exception” as FDT suggests would demolish the careful structure Congress and the SEC have to put in place to regulate business relationships in the securities industry. See id. at 21–23.
In response, FDT contends that Janus’ preoccupation with secondary liability is irrelevant because FDT, a stockholder in JCG, is in fact suing a direct issuer of devalued securities—in this case, JCG itself. See Brief for Respondent at 35. In arguing in favor of liability, FDT observes that JCG’s revenues related directly to the value of the assets under management at the Janus Funds; indeed, JCG’s stock price fell by 24% within weeks of the revelations of the secret market-timing arrangements. See id. at 42. Furthermore, FDT argues that JCG and JCM are far from removed secondary actors, but are better seen as the beating heart driving the Janus Funds’ operation. See id. at 43. For instance, FDT points out that, in addition to carrying out the day-to-day management of the Janus Funds, JCM engaged with both JCG and the Janus Funds in a coordinated marketing strategy that presented investors with a unified Janus brand. See id. at 4. FDT further mentions that, during the period in question, all seventeen of Janus Funds’ officers served as vice presidents at JCM. See id. at 20. Finally, FDT notes that the SEC itself has recognized that, due to high involvement in the daily management of funds, investment advisers such as JCM tend to “dominate” the mutual-fund clients they advise. See id. at 39.
After acknowledging that even outside service providers can, under certain circumstances be held liable for the fraudulent misstatements of their clients, Janus asserts that such liability is precluded in this case because Janus did not “make” the statements that appear in the Janus Funds prospectuses. See Brief for Petitioners at 29–30. As used in SEC Rule 10b-5(b), Janus proposes that the term “make” be interpreted to mean “to put forth,” “to give out,” “to deliver,” as when the President “makes” or “delivers” a speech written by his speechwriters. See id. at 40–41. Thus, Janus argues that, even if JCM was the entity that created the content that eventually appeared in Janus Funds’ prospectuses, by adopting this content and presenting it in its own offering documents, Janus Funds was the only entity actually making any statement to the public. See id. at 32, 38. Janus then takes issue with the many words FDT and its amici use in describing Janus’s role with relation to the content in the Janus Funds’ prospectuses—“helping,” “participating,” “creating,” “causing,” “preparing,” “filing,” and “disseminating.” See id. at 43. Janus notes that the language of SEC Rule 10b-5b does not expressly outlaw any of these actions, and furthermore, that words such as “help” are classic signifiers of secondary liability, associated with “aid” and “assistance” rather than with direct conduct. See id. at 35, 43.
Countering Janus’s arguments, FDT contends that, since the term “make” is not defined in SEC Rule 10b-5, the term should be given its common meaning—“to cause to exist,” “to create,” “to compose.” See Brief for Respondent at 15. To this end, FDT notes that the SEC, the promulgator of Rule 10b-5, has long understood the term “make” in just this manner. See id. at 16–18. Here, FDT argues, there is little doubt that Janus “made” or “caused to exist” the statements that appeared in the Janus Fund prospectuses. See id. at 23–24. In fact, JCM admitted in interrogatory responses that members of its staff drafted, reviewed, and commented on the relevant prospectus language. See id. Finally, FDT argues that, even if JCM merely “helped” or “participated” in the drafting of the Janus Funds prospectuses, the Court has previously recognized that multiple entities can all “make” a single misstatement, and thus share concurrent liability for its consequences. See id. at 32.
Finally, Janus argues that FDT cannot hold JCG or JCM liable for securities fraud under Section 10(b) of the Act in the absence of any evidence that FDT actually relied on misstatements issued by JCG or JCM. See Brief for Petitioners at 44. However, because the Janus Funds prospectuses contained no direct attribution to either JCM or JCG, Janus asserts that FDT would be hard pressed to prove any kind of reliance in this case—actual or presumed. See id. at 49. Responding to FDT’s contention that reasonable investors would have realized, even without an explicit attribution, that JCM and JCG were responsible for the content in the Janus Funds prospectuses, Janus points out that the Court has declined to extend securities-fraud liability to defendants who did not themselves speak to the market. See id. Extending liability in this manner makes little sense, Janus contends, because without direct attribution, the role that secondary actors played in shaping a company’s offering documents would not be known to the market, and thus could not be incorporated into the company’s stock price. See id. at 49, 52.
FDT, however, responds by asserting that even without direct attribution to either JCG or JCM, a reasonable investor in JCG would still have an interest in the Janus Funds prospectuses because of the link between the Janus Funds assets and JCG’s revenues. See Brief for Respondent at 49. Furthermore, contrary to Janus’ suggestion, FDT notes that courts have imposed liability in the absence of direct attribution, for example, by holding corporate insiders liable for misrepresentations issued in a corporation’s name. See id. Finally, FDT contends that Janus’ proposal of a direct-attribution requirement would ultimately harm the purposes of federal securities laws, enabling unscrupulous persons to deceive the securities market without fear of liability so long as these persons could avoid direct attribution for their misstatements. See id. at 51.
The Supreme Court’s decision in this case will determine whether, in a private action, an investment adviser is liable for statements distributed by the client fund it advises. The Petitioners, Janus Capital Group (“JCG”) and Janus Capital Management (“JCM”) (collectively “Janus”), contend that they did not issue the misstatements in question but are simply service providers and that any exceptions made to the lack of aiding-and-abetting liability in private Section 10(b) claims would invite a damaging flood of litigation on similar service providers. See Brief for Petitioners, Janus Capital Group and Janus Capital Management at 22, 56. FDT responds that JCM cannot declare itself a service provider because investment advisers “dominate” the funds they advise and because a direct-attribution requirement would frustrate Congress’ purpose in fostering investor confidence. See Brief for Respondent, First Derivative Traders at 39, 51.
Potential for Increased Litigation
The United States Chamber of Commerce (“Chamber”) concurs with Janus, citing fears that, by incorporating a substantial-role element into the Section 10(b) analysis and making liability determinations on a case-by-case basis, the Fourth Circuit decision dangerously expands the potential for civil action. See Brief of Amicus Curiae The United States Chamber of Commerce in Support of Petitioners at 21–22. Moreover, the Securities Industry and Financial Markets Association (“SIFMA”) contends that such an expansion is unnecessary. See Brief of Amicus Curiae SIFMA in Support of Petitioners at 17–18. SIFMA argues that the limitations complained of apply only to private actions, and that Congress intended to limit the nuisance litigation companies face while still providing the SEC and the Justice Department with the tools necessary to fight fraud. See id.
In response, the AARP and the North American Securities Administrators Association (“NASAA”) complain that the SEC lacks the resources necessary to protect all securities fraud victims. See Brief of Amici Curiae AARP and North American Securities Administrators Association in Support of Respondent at 6–8. The Council for Institutional Investors (“CII”) argues that private actions are so important to policing fraud in the securities industry that narrowing private rights-of-action will discourage confident investment. See Brief of Amicus Curiae Council of Institutional Investors in Support of Respondent at 11. Moreover, the New York State Common Retirement Fund, joined by six other retirement groups, points out that the Private Securities Litigation Reform Act of 1995 already succeeds in limiting nuisance litigation, and that Congress intended to leave the door open for institutional participation in policing securities fraud. See Brief of Amici Curiae New York State Retirement Fund, et al. in Support of Respondent at 12.
Fairness to Investors
The Chamber argues that, without a bright-line attribution rule, the resulting uncertainty will increase the cost of capital in the U.S. because all participants in the securities industry will be potentially liable for misstatements when preparing public financial documents, and will therefore charge issuers higher fees for advice. See Brief of Chamber at 21–22. SIFMA adds that, in reality, both issuers and investors benefit from increased predictability in how rules governing the securities markets operate. See Brief of SIFMA at 9. SIFMA points out that the costs of compliance hurts U.S. companies’ ability to compete in the global market and that these costs are ultimately passed to investors. See id. at 18.
CII counters that a bright-line rule of express attribution will inadvertently create a “safe harbor” for fraud because actors could avoid liability by issuing misstatements through the separate entities that they control and making certain that those statements are not attributed to them. See Brief of CII at 9–10. The United States echoes these fears and suggests that a better distinction than attribution is the one between corporate “insiders” and true outside service providers. See Brief of Amicus Curiae The United States in Support of Respondent at 23, 31. Moreover, AARP and NASAA assert that, because mutual funds are shells without assets other than those the investors provide, defrauded investors need to be able to sue the investment advisers to recover damages. See Brief of AARP and NASAA at 29–30.
Potential Impact on Other Professions
In support of neither party, the Center for Audit Quality (“CAQ”) fears that the Fourth Circuit’s decision employed a vague “participation” standard that could be extended to “outsiders” such as auditors. See Brief of Amicus Curiae The Center for Audit Quality in Support of Neither Party at 16. In response to the Fourth Circuit’s stance, CAQ argues that auditors lack the control that insiders have over public statements and that this counsels against a vague participation standard. See id. at 7.
The Attorneys’ Liability Assurance Society (“ALAS”) argues that a rule without a direct-attribution element hurts client-attorney relationships and could compromise the ethical obligations lawyers owe their clients. See Brief of Amicus Curiae Attorneys’ Liability Assurance Society, Inc. in Support of Petitioners at 22. ALAS suggests that if lawyers are liable for any possible participation in a client’s public statements, clients may react by withholding information necessary to provide effective counsel, or attorneys may refuse to adequately investigate public disclosures to avoid scienter requirements. See id. at 24.
The Supreme Court will determine whether an investment adviser can be held liable for fraudulent misstatements appearing in its client’s publicly available offering documents. Petitioners Janus Capital Group and its subsidiary, Janus Capital Management, argue that allowing liability in this context would contravene Congressional intent and open the door to frivolous securities claims against outside service providers. Respondent First Derivative Traders, however, asserts that, without the threat of secondary liability, dishonest companies could continue to disseminate fraudulent statements at will so long as these statements were not directly attributed to their originators—the dishonest companies themselves.
The authors would like to thank Professor Charles Whitehead for his insights into this case.
· New York Times, Peter J. Henning: The Hurdles to Suing Outside Advisers for Fraud (Oct. 27, 2010).
· Wall Street Journal, Brent Kendall: High Court Requests White House Views on Janus Appeal (Jan. 11, 2010)
· American Economic Association Papers and Proceedings, Eric Zitzewitz: How Widespread is Late Trading in Mutual Funds?