The Janus Decision: Supreme Court limits liability for fraud
By H. Steven Vogel (Miami), with contributing assistance from Louis Castoria (San Francisco) and William J. Kelly (White Plains, N.Y.), Wilson Elser Moskowitz Edelman & Dicker LLP
The U.S. Supreme Court recently ruled in the Janus Capital Group case that the legal entity or person actually making an allegedly fraudulent statement in a public securities offering, and only that person, can be held liable under Securities and Exchange Commission (SEC) Rule 10b-5, in a private securities fraud action.
In declaring that only those entities that have “the ultimate authority” over a statement may be held liable in private action, the Supreme Court has created a bright-line test to determine who can (and cannot) be held liable for allegedly fraudulent statements under the federal securities laws.
Many believe that the Janus decision provides clear guidance to those in the securities industry and their attorneys, auditors and advisers as to how to avoid a private cause of action under SEC Rule 10b-5. Arguably, the Janus decision articulates a road map to avoid the multitude of potential fraud liability for those involved in the securities industry.
Critics assert that the court’s 5-4 split decision narrowly interprets the intent of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. Others argue that the decision sets a standard that future courts, arbitrators and regulators may apply liberally to circumscribe liability for misrepresentations to those who actually speak the words to the public.
The decision may prove to be beneficial to professionals who provide services to their clients in the securities industry. The court did not address the issue of whether professional advisers should be shielded from liability based on theories other than Rule 10b-5.
Facts of the Janus Case
The Janus Capital Group Inc. v. First Derivative Traders, 564 U.S,___ (decided June 13, 2011), originated in the 4th U.S. Circuit Court of Appeals, where the plaintiff alleged that misleading statements were made in the Janus Mutual Fund prospectuses. The case raised important questions about the ability of plaintiffs to bring fraud lawsuits under federal securities law against service providers for statements made by their clients.
The plaintiff, First Derivative Traders (FDT), sought to hold Janus Capital Group (JCG) and its wholly owned subsidiary, Janus Capital Management LLC (JCM), which was hired to act as investment adviser and fund administrator, liable for the alleged misstatement in the Janus Investment Fund prospectuses. JCG, a publicly traded financial services company, created Janus Investment Fund.
The Janus Funds offer securities to the public via offering documents and are governed by an independent board of trustees. FDT invested in the stock of JCG, but not in the Janus Funds. All of Janus Investment Fund’s officers were also officers of JCM. However, the legal distinctions between the two companies were properly maintained and noted by the high court.
The principal allegation in the underlying case is that misleading statements in the Janus Funds’ prospectuses artificially inflated the price of JCG’s stock. Specifically, the challenged statements relate to the policies for discouraging and deterring “market timing.” FDT claimed that these statements were misleading because JCM permitted discretionary frequent trading by a small number of investors.
The lower (district) court dismissed the complaint on the grounds that JCG did not make the statements in the Janus Funds’ prospectuses, and regardless of whether the statements were made, JCM cannot be liable to JCG shareholders who did not invest in the Janus Funds. The 4th Circuit reversed and recognized that the critical issue was whether FDT had adequately pleaded reliance on the alleged statements – an essential element of a private class action under the SEC’s Rule 10b-5.
The U.S. Supreme Court granted certiorari on June 28, 2010,
and heard oral arguments on Dec. 7, 2010.
Questions presented to the Supreme Court
JCG and JCM raised two key issues in their petition for writ of certiorari, wherein they argued that the 4th Circuit’s decision created or magnified conflicts among the circuits.
First, in holding that a service provider “made the misleading statements” contained in the prospectuses of a different company “by participating in the writing and dissemination of those prospectuses,” the 4th Circuit contradicted the Supreme Court’s rulings in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct 761 (2008) and Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. 511 U.S 164 (1994).
In Stoneridge, the Supreme Court curtailed the investing public’s right to bring a federal securities fraud action against secondary actors under both primary and other theories of liability. The court held that there is no implied private right of action against secondary actors under the federal securities laws even where the secondary actors engage (allegedly) in fraudulent conduct. Secondary actors in this case were those defendants that were not directly involved in the dissemination of the information relied on by the plaintiffs.
The court focused on the requirement that the allegedly injured investors directly relied on the alleged fraud and highlighted the decision by Congress in its 1995 legislation specifically limiting the authority to bring an action for aiding and abetting securities fraud to the SEC. The 4th Circuit also split with several circuits that have rejected liability against service providers for participating in other companies’ misstatements.
Second, in finding that a service provider can be held liable for a statement in another company’s prospectus, “even if the statement on its face is not directly attributed” to the service provider, the 4th Circuit exacerbated an existing circuit conflict.
The conflict was over whether a statement must be directly attributed to a nonspeaking defendant (such as a service provider to the issuer) for private liability to attach.
The questions presented by the petition for certiorari were:
1. Whether the 4th Circuit erred in concluding … that a service provider can be held primarily liable in a private securities-fraud action for “helping” or “participating in” another company’s misstatements and
2. Whether the 4th Circuit erred in concluding … 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.
Ruling by the Court
By way of background, Section 10(b) of the Securities Exchange Act of 1934 makes it “unlawful for any person, directly or indirectly, … [to] use or employ … any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may proscribe. …” Pursuant to this section, the SEC promulgated Rule 10b-5, which makes it unlawful, among other things, for “any person, directly or indirectly, … [t]o make any untrue statement of a material fact” in connection with the purchase or sale of securities.
This is the basis for almost all securities fraud claims, and it has long been held that this section of the act provides for a private cause of action against principal wrongdoers. The Janus opinion focuses on the issue of who should be considered the “maker” of the allegedly untrue statement.
At first blush, “who is the maker of a statement” may seem like an easy question to answer, but the complexities of modern securities offerings complicate the analysis. For example, if a law firm drafts a prospectus that contains a misleading statement, and the company ultimately issued the prospectus, is the law firm a “maker” of an untrue statement?
By further example, is an auditor whose statements are incorporated into an annual report considered the “maker” of at least a portion of the annual report? The lower courts have been inconsistent in answering this question.
The Supreme Court held in Janus that “the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.” The court went on to explain that, “without control, a person or entity can merely suggest what to say, not ‘make’ a statement in its own right.”
In creating this bright-line rule, the court examined the definition of “make” and analogized it to a speaker and speechwriter. Ultimately, it is the speaker who receives credit for, and is held responsible for, the speech, not the speechwriter.
The decision specifically rejects the plaintiffs’ and others’ proposed rationales for a more inclusive definition, including the government’s position that one who “creates” a statement should be held liable for the content of that statement. The Supreme Court also rejected the argument that the “well-recognized and uniquely close relationship between a mutual fund and its investment adviser” should suggest that “an investment adviser should generally be understood to be the ‘maker’ of statements by its client mutual fund.”
In rejecting this argument, the court noted that the fund and adviser maintained distinct corporate independence. While not directly addressing “primary” vs. “secondary” liability in the opinion, the Supreme Court stated that any further expansion of liability under Rule 10b-5 should be left to Congress, not the courts.
The dissent was written by Justice Breyer (with Justices Ginsburg, Sotomayor and Kagan joining) and argued that the majority’s definition of “make” is misguided because it is not common usage and is not supported by prior lower court and Supreme Court decisions. Although the dissent offers criticism and proposes its own interpretation, it is not precedent.
Lessons from Janus
Narrowly read, the Janus decision limits the targets of private securities fraud claims based on Section 10(b) and Rule 10b-5 to those who actually “make” the alleged representations. And it refrains from expanding the potential pool of defendants in such cases via judicial decree rather than an act of Congress. The decision is by no means a “free pass” for potential fraudulent conduct by those involved in the drafting of securities prospectuses.
The Janus decision, like Stoneridge and its progeny, limits the potential exposure against a private right of action under Rule 10b-5 for those in the securities field and professionals involved with promulgating securities prospectuses. The professionals that the Janus decision may affect include attorneys, accountants, bankers, financial advisers and consultants.
It appears that Janus provides protection for attorneys and other professionals who participate in drafting prospectus materials from direct liability to securities purchasers in fraud claims based on those offering materials. In particular, corporate lawyers should appreciate the consequence of this decision. Usually, the issuer’s outside corporate lawyers draft the prospectus, annual report and some other corporate disclosures.
Prior to the Janus decision, it was unsettled whether the lawyers could be liable for misstatements contained in these documents. The court’s decision forecloses this potential liability, at least under Rule 10b-5. Notwithstanding this, outside lawyers may not escape liability under state law theories.
On the other hand, auditors of an issuer do not appear to be protected from Rule 10b-5 liability for statements made in their own audit reports, knowing that the audited company in its public securities filings may quote those reports.
Critics of the decision, including plaintiffs’ lawyers, investor advocates and members of the SEC argue that the Janus decision makes it tougher to hold liable those allegedly responsible for fraudulent statements.
For example, the New York Common Retirement Fund and the North American Securities Administrators Association, Inc., as well as the United States (through the Department of Justice and the SEC), filed amici curiae briefs. They reveal fears that a strict interpretation, as ultimately rendered by the Supreme Court, would harm investors by creating an impenetrable shield for those involved in using or trading securities.
As with any decision by the Supreme Court, it will take years for the full impact of the ruling to be realized. For now, a large number of potential securities fraud defendants may rest a little easier. So long as they do not have the “ultimate authority” to actually “make” a statement, they know they are shielded from at least one form of exposure and sometimes cripplingly expensive litigation.
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