- Supreme Court Limits Rule 10b-5 Liability to Actual “Makers” of Allegedly Misleading Statements - Perhaps Not the Fraud Shield Predicted by Some
- July 21, 2011 | Authors: Sheena Jain; H. Steven Vogel
- Law Firms: Wilson Elser Moskowitz Edelman & Dicker LLP - San Francisco Office ; Wilson Elser Moskowitz Edelman & Dicker LLP - White Plains Office ; Wilson Elser Moskowitz Edelman & Dicker LLP - Miami Office
Many view the United States Supreme Court’s recent Janus Capital Group decision as drastically limiting the pool of potential defendants in federal securities fraud claims, but some of the champagne bottles should stay corked for now.
The Court held that the legal entity or person actually making an allegedly fraudulent statement in a public securities offering, and only that entity or 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 a private action, the Supreme Court created a bright line as to who can and cannot be held liable for fraudulent statements under the federal securities laws. 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. In essence, the Supreme Court’s decision articulates a roadmap to avoid the spectre of potential fraud liability for those involved in the securities industry.
The 5¿4 Janus decision, written by Justice Thomas and rendered along straight party lines, illustrates the pro-business tilt of a bare majority of the current Supreme Court. This decision may prove to be a tremendous help to professionals who provide services to clients in the securities industry.
Why leave some of the champagne on ice? Like the two-faced Roman god of doorways, gates and transitions for whom Janus Capital Group, Inc. was named, the Janus decision looks backward in time and narrowly interprets the intent of section 10(b) of the Securities Exchange Act of 1934 and the SEC’s Rule10b-5. However, according to some critics, the decision also looks forward by setting a standard that future courts, arbitrators and regulators may apply more broadly to circumscribe liability for misrepresentations to those who actually speak the words to the public.
Explicitly, Janus does not address whether professional advisers should be shielded from bases of liability other than Rule 10b-5. As we note below, that question is left for another day.
The Janus Capital Case
In Janus Capital Group, Inc., et al. v. First Derivative Traders, 564 U.S. (decided June 13, 2011), the plaintiffs alleged that misleading statements were made in the Janus Mutual Fund prospectus. The plaintiffs sought to hold Janus Capital Group (JCG), the creator of Janus Investment Fund, 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 Prospectus. All of Janus Investment Fund’s officers were also officers of JCM; however, the Court keenly noted that the legal distinctions between the two companies were properly maintained.
In 2003, the New York State Attorney General filed a complaint alleging various wrongdoings on the part of the Janus enterprises. When the allegations became public, many investors withdrew their deposits from the Janus funds. This caused a significant drop in value and led to a Rule 10b-5 class action securities fraud lawsuit. The plaintiffs alleged that JCG and JCM “caused mutual fund prospectuses” that contained misleading statements “to be issued for Janus mutual funds and made them available to the investing public.”.
Rule 10b-5, promulgated by the SEC under its authority granted by section 10 of the Securities Exchange Act of 1934, states in part: it is unlawful 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. The Court’s 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 prospectus is ultimately issued by the company, is the law firm a “maker” of an untrue statement? As another example, is an auditor whose statements are incorporated into an annual report considered the “maker” of at least that portion of the annual report? The lower courts have been inconsistent in answering these and similar questions. The Court’s decision in Janus has provided clarity on these points.
The Supreme Court held 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 Supreme Court examined the definition of “make” and analogized it to a speaker and a speechwriter. Ultimately, it is the speaker who receives credit for, and is held responsible for, the speech, not the speechwriter.
The decision specifically rejects 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. Ultimately, the Supreme Court stated that any further expansion of liability under Rule 10b-5 should be left to Congress, not the courts.
The dissent 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, the majority decision is now the law of the land.
Impact for Professionals
The Janus decision creates a broad shield against Rule 10b-5 liability for those in the securities field and the professionals they hire. Financial advisers and fund creators who maintain a distinct, independent corporate structure should be protected against consumer securities fraud liability under Rule 10b-5 for statements made by or on behalf of the fund. Although the Supreme Court did not articulate how to establish corporate independence, various state statutes and court decisions provide this guidance.
Similarly, attorneys or other professionals who participate in drafting prospectus materials should be shielded 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. More often than not, it is the issuer’s outside lawyers who 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. However, outside lawyers may not escape liability under state law theories. For example, a New York appellate court recently ruled that a lawyer who drafted a private placement memorandum with the knowledge it would be used by people who had been banned from the securities industry to solicit investor money, could be found to have aided and abetted fraud under a state law theory. The court stated that it could not countenance a “see no evil, hear no evil” approach. Oster v. Kirschner, 77 A.D.3d 51 (1st Dep’t 2010).
By the same reasoning, auditors appear unlikely to be shielded from Rule 10b-5 liability for statements made in their own audit reports, knowing that those reports may be quoted by the audited company in its public securities filings. Even after the Janus decision, auditors will probably be deemed to be the makers of their audit opinions. However, to the extent that the accountants or auditors contribute behind the scenes to a company’s report or statement, they should now be shielded from liability for statements originating from the security issuer.
The Court’s interpretation of Rule 10b-5 narrows the scope of primary liability for mutual fund managers and those who sell or recommend securities, such as broker-dealers and investment advisers. However, Janus’s limitation of liability to those with “ultimate authority” does not expressly shield such professionals from misrepresentation claims brought under state law; under other sections of the Securities Exchange Act of 1934, such as section 20(a) liability (insider trading); or under rules of self-regulatory bodies, such as the Financial Industry Regulatory Authority (FINRA). As is evident from its opinion, the Court considered the availability of these other forms of liability in concluding that Rule 10b-5 is not needed to create liability that is already available elsewhere through Congress’s creation of section 20(a) liability.
For professional advisers, the ultimate question my be whether the rationale of Janus will be more broadly applied to cases other than section 10(b) and Rule 10b-5 claims, and even beyond public securities offerings. Justice Breyer’s dissenting opinion in Janus makes the classic “slippery slope” argument, that the majority’s ruling will erode liability in other areas. It is not far-fetched for attorneys representing broker-dealers against purported misrepresentations made in placement memoranda (PPM) to analogize the passive involvement of JCM in Janus to the passive involvement of broker-dealers in the “making” of statements in PPMs drafted by offering sponsors. Broker-dealers and investment advisers will use the reasoning behind the Janus rule and the Court’s articulation of “ultimate authority” to bolster their position that they should not be held liable as intermediaries for statements made by sponsors. Once again, a proposition that seems simple may not be so, because liability under states’ securities laws and self-regulatory organizations’ rules can be worded quite differently than they are in section 10(b) and Rule 10b-5.
By no means is this decision, as some have criticized, a “get out of jail free” card for potential fraudsters. The Supreme Court may have reined in potential consumer claims relating to securities fraud in offering documents, but that does not eradicate all possible liability exposures. The SEC is still empowered to bring aiding and abetting fraud claims against secondary actors, and the Department of Justice (DOJ) may bring criminal charges under a variety of statutes for both primary and secondary actions. Narrowly read, Janus simply limits the targets of private securities fraud claims based on section 10(b) and Rule 10-b5 to those who actually “make” the alleged representations, and refrains from expanding the potential pool of defendants in such cases via judicial decree rather than act of Congress.
Not surprisingly, plaintiffs’ lawyers, investor advocates and some at the SEC are disappointed by the ruling and foresee a tougher time holding those allegedly responsible for fraudulent statements liable. Indeed, the briefs filed by amici curiae, such as the New York Common Retirement Fund (a large institutional investor), the North American Securities Administrators Association, Inc. (an association of state securities regulators) and the United States (through the DOJ and the SEC) 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 issuing or trading securities.
However, as articulated by another amicus writer, the Center for Audit Quality (an affiliate of the American Institute of Certified Public Accountants), the outside professionals who serve the securities industry desired a clear rule, one that would not be subject to expansion by zealous plaintiffs’ attorneys. The Janus ruling is almost directly in line with “limit on liability” argued for by the Center for Audit Quality.
As with any decision of this magnitude, it will take years for the full impact of this ruling to be appreciated. However, a large number of potential securities fraud defendants may now rest a little easier, knowing that so long as they do not have the “ultimate authority” to actually “make” a statement, they are shielded from at least one form of exposure and sometimes cripplingly expensive litigation.
In a broader context, the Supreme Court’s application of a “narrow construction” to Rule 10b-5 cases may be argued by analogy to a variety of other issues in securities litigation. This may prove to be the larger impact of the Janus decision.