On June 13, 2011, the Supreme Court in a 5-4 decision in Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. ___ (2011), held that only the maker of an allegedly false statement may be held primarily liable in a private action under Rule 10b-5. According to the Court, the maker of a misleading statement is “the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.”
For the mutual fund industry in particular, this decision means investment advisers do not have primary liability under Rule 10b-5 for misleading statements in the mutual fund prospectuses of the funds they advise so long as the legal separateness of the funds from their investment advisers is maintained and the funds comply with the requirements of the Investment Company Act of 1940 regarding disinterested directors. This decision is also an important reminder that mutual funds themselves have primary liability for registration statements that include the funds’ prospectuses and statements of additional information, and their directors and officers who sign the registration statements also have certain responsibilities for those registration statements. In light of the decision, fund advisers, directors and officers may wish to review their procedures and processes for the preparation and review of fund registration statements.
This decision has important implications not only for the mutual fund industry and investment advisers, but also more generally for public companies and their advisers, accountants and others who provide services to issuers or participate in the writing and preparation of prospectuses and other documents but who, unlike the issuers, do not in the ordinary course have ultimate authority over the issuers’ statements.
First Derivative Traders (First Derivative) alleged in a class action on behalf of shareholders of Janus Capital Group, Inc. (JCG) that JCG and its wholly owed subsidiary, Janus Capital Management LLC (JCM), the investment adviser to the Janus funds, violated Rule 10b-5 and §10(b) of the Securities and Exchange Act of 1934 by causing the Janus funds to issue misleading prospectuses. In May 2007, the United States District Court, District of Maryland, dismissed the complaint for failure to state a claim. The Fourth Circuit reversed, finding that First Derivative had sufficiently alleged that “JCG and JCM, by participating in the writing and dissemination of the prospectuses, made the misleading statements contained in the documents.” This decision was at odds with decisions out of the Fifth, Sixth and Eighth Circuits.
Supreme Court Decision
The Supreme Court granted certiorari to address whether JCM could be liable in a private action under Rule 10b-5 for false statements included in the Janus Investment Fund’s prospectuses.1 The Court held that for JCM to be liable, it “must have ‘made’ the material misstatements in the prospectuses.” Relying on the Oxford English Dictionary, the Court held “[o]ne ‘makes’ a statement by stating it” and therefore “[t]he phrase at issue in Rule 10b-5, ‘[t]o make any . . . statement,’ is thus the approximate equivalent of ‘to state.’” Consequently, for the purposes of Rule 10b-5, the “maker of a statement is the person or entity with ultimate control over the statement, including its content and whether and how to communicate it.”
The Court relied in significant part on its holding in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994)‚ that Rule 10b-5’s private right of action does not include suits against aider and abettors. “Such suits — against entities that contribute ‘substantial assistance’ to the making of a statement but do not actually make it — may be brought by the SEC . . . , but not by private parties.” Rejecting a broader reading of “make,” the Court noted “for Central Bank to have any meaning, there must be some distinction between those who are primarily liable (and thus may be pursued in private suits) and those who are secondarily liable (and thus may not be pursued in private suits).” The Court was satisfied that its holding “draw[s] a clean line between the two — the maker is the person or entity with ultimate authority over a statement and others are not.”
The Court found further support in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008), where it rejected a private action under Rule 10b-5 against companies involved in deceptive transactions, even when information about those transactions was later incorporated into false public statements. “We see no reason to treat participating in the drafting of a false statement differently from engaging in deceptive transactions, when each is merely an undisclosed act preceding the decision of an independent entity to make a public statement.” “[T]he maker of a statement is the entity with authority over the content of the statement and whether and how to communicate it.” Based on this reasoning, the Court rejected the government’s contention that “make” should be defined as “create.”
The Court additionally rejected an argument that the close relationship between a mutual fund and its investment adviser mandates the conclusion that the investment adviser “should generally be understood to be the ‘maker’ of statements by its client mutual fund.” Declining “this invitation to disregard the corporate form,” the Court noted that it was undisputed that JCM and Janus Investment Fund were legally separate entities, the funds’ board of trustees had more than the required number of independent trustees, and corporate formalities had been observed. The Court also warned that this argument would read into Rule 10b-5 a theory of liability similar to‚ but broader than‚ the control person liability Congress has already created under Section 20(a) of the Exchange Act. “Any reapportionment of liability in the securities industry in light of the close relationship between investment advisers and mutual funds is properly the responsibility of Congress and not the courts.” The Court expressly reserved, however, the question of whether Congress created liability under Section 20(b) of the Exchange Act for entities that act through innocent intermediaries.
The Court held on the facts that “JCM did not ‘make’ any of the statements in the Janus Investment Fund prospectuses; Janus Investment Fund did.” The Fund had the statutory obligation to file the prospectuses with the SEC, the SEC recorded that the Fund did in fact file the prospectuses, and nothing on the face of the prospectuses indicated that statements in the prospectuses were made by JCM. “[B]ecause none of the statements in the Janus Investment Fund prospectuses were attributed, explicitly or implicitly, to JCM,” the Court declined to interpret the word “indirectly” in Rule 10b-5 to expand the meaning of “make” to cover JCM, but also declined to “define precisely what it means to communicate a ‘made’ statement indirectly . . . .” “More may be required to find that a person or entity made a statement indirectly, but attribution is necessary.” Of additional note in the information age, it is not a basis for liability that JCM hosted the prospectuses at issue on its website — hosting a document “does not indicate that the hosting entity adopts the document as its own statement or exercises control over its content.”
In a sharply worded dissent, Justice Breyer disagreed with the majority’s reasoning, including with the majority’s interpretation of “make” in Rule 10b-5, and expressed concern that the majority decision will result in situations in which shareholders are left with no recourse: “What is to happen when guilty management writes a prospectus (for the board) containing materially false statements and fools both board and public into believing they are true? Apparently under the majority’s rule, in such circumstances no one could be found to have ‘ma[d]e’ a materially false statement . . . .” Justice Thomas, writing for the majority, dismissed these concerns.
After Central Bank eliminated private rights of action under Rule 10b-5 against aiders and abettors, the debate focused on exactly what a private plaintiff must show to hold a defendant primarily liable under Rule 10b-5 as the “maker” of an allegedly false statement. The Court’s decision now draws a clean line between those who ultimately control, and therefore “make,” statements and those who do not. The decision thus imposes significant restrictions on private rights of action against advisers, accountants and others who provide services to issuers or participate in the writing and preparation of prospectuses and other documents‚ but who in the ordinary course do not have ultimate authority over the issuers’ statements.
The decision provides some important guidance for the mutual fund industry. Failures to maintain legally separate entities, to observe corporate formalities or to comply with the requirements of the Investment Company Act of 1940 regarding disinterested directors could expose investment advisers to primary liability under Rule 10b-5. Mutual funds themselves have primary liability for their registration statements, and directors and officers who sign registration statements also have certain responsibilities for those registration statements. Fund advisers, directors and officers may now wish to review their procedures and processes for preparation of fund registration statements in light of this decision.
For assistance, please contact the following lawyers in the Financial Services Area:
Michael Blanchard, Partner, Securities and Financial Institutions Litigation
Jordan D. Hershman, Co-chair, Securities and Financial Institutions Litigation
This article was originally published by Bingham McCutchen LLP.