Supreme Court Limits Securities Fraud Liability by Defining the “Maker” of a Misstatement.

On June 13, 2011, in Janus Capital Group, Inc. v. First Derivative Traders, a 5-4 Majority of the Supreme Court held that a mutual fund investment adviser cannot be held liable in a private action under Securities and Exchange Commission (SEC) Rule 10b-5 (17 CFR § 240.10b-5) for false statements included in its client mutual funds’ prospectuses, which it did not make.The issue was the meaning of the word, “make” – who makes a false statement when there is a complex constellation of related parties involved in writing it? Justice Thomas wrote the opinion in which Roberts, Scalia, Kennedy and Alito joined.

Janus Capital Group, Inc. (“JCG”) is a publicly traded company that formed the Janus family of mutual funds. The mutual funds are organized into a Massachusetts Business Trust, the Janus Investment Fund (the “Fund”). Janus Capital Management, LLC (“JCM”) is a wholly owned subsidiary of JCG, which the Fund retained to be its investment advisor and administrator.All of the officers of the Fund were also officers of JCM and the two entities also shared a board member.

First Derivative represented a class of plaintiffs who owned shares in JCG, and alleged that the market had been misled in the Fund’s prospectuses, which represented the Fund would implement measures to curb market timing, which is legal but harms other Fund investors.JCG’s shares dropped sharply when the New York Attorney general sued JCG and JCM for allegedly entering into secret agreements to permit market timing in the Fund.First Derivative asserted claims against both JCM and JCG.The allegedly misleading prospectuses, however, were filed by the Fund.See 15 U. S. C. §§ 77e(b)(2), 80a-8(b), 80a-29(a)-(b); see also 17 CFR § 230.497 (imposing requirements on “investment companies”).

The U.S. District Court for the District of Maryland dismissed the complaint for failure to state a claim.The U.S Court of Appeals for the Fourth Circuit reversed, holding that the plaintiffs had alleged that JCG and JCM participated in drafting the misleading prospectuses and therefore made the challenged statements.

According to the majority opinion, “[f]or purposes of Rule 10b-5, 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. Without control, a person or entity can merely suggest what to say, not “make” a statement in its own right. One who prepares or publishes a statement on behalf of another is not its maker. And in the ordinary case, attribution within a statement or implicit from surrounding circumstances is strong evidence that a statement was made by–and only by–the party to whom it is attributed.”(emphasis added).

The U.S. Government filed an amicus brief on behalf of the plaintiffs, but the Court rejected its contention that to “make” a statement should be synonymous with to “create” a statement.This would mean that providing false information to someone who makes the public statement would be a basis for liability.

The Court also rejected the more context dependent contention by the plaintiff that the Court should consider the special relationship between an investment adviser and a mutual fund – like a “playwright whose lines are delivered by an actor.”The majority opinion rejected this argument as an “invitation to disregard the corporate form.”The majority notes that Congress has elsewhere expressly provided in § 20(a) for “[e]very person who, directly or indirectly, controls any person liable” for violations of the securities laws.15 U. S. C. A. § 78t(a).

The Minority Opinion, written by Breyer and joined by Ginsburg, Sotomayor and Kagan, saw things quite differently.They would have ruled that “both language and case law indicate that, depending upon the circumstances, a management company, a board of trustees, individual company officers, or others, separately or together, might “make” statements contained in a firm’s prospectus–even if a board of directors has ultimate content-related responsibility.”

Indeed, the Minority Opinion is quite indignant:“But where can the majority find legal support for the rule that it enunciates? The English language does not impose upon the word ‘make’ boundaries of the kind the majority finds determinative. Every day, hosts of corporate officials make statements with content that more senior officials or the board of directors have “ultimate authority” to control. So do cabinet officials make statements about matters that the Constitution places within the ultimate authority of the President. So do thousands, perhaps millions, of other employees make statements that, as to content, form, or timing, are subject to the control of another.”

The Minority also rejects the contention that control person liability under Section 20(a) provides the appropriate potential remedy.Section 20(a) imposes liability on someone who “controls” another person who is primarily liable for a securities violation.Section 20(a), for example, cannot hold accountable a person who exploits an innocent person into making misstatements.“The possibility of guilty management and innocent board is the 13th stroke of the new rule’s clock. 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?”The Minority Opinion points out that the Majority decision might even prevent the SEC from enforcing aiding and abetting liability, if there is no liable primary statement maker.

The problem with bright-line rules rather than standards is that they can be both over inclusive and under inclusive – here, at least from a plaintiff’s point of view, the court has created a rule that is under inclusive – it excludes too many from potential liability as the “maker” of the statement.But as a practical matter, if a standard were applied here – opening up possible liability for a range of possible statement makers (e.g., attorneys and accountants working on the prospectus), the resulting uncertainty would likely lead to painful prospectuses, loaded down with even more disclaimers and caveats than they suffer from now.The spectrum of named defendants would expand in every lawsuit, the costs of securities litigation would rise, and the consequences would be far reaching.Although on the facts of the Janus case give the Minority real ammunition to fire at the Majority decision, if the Minority Opinion had held the day, the consequences would have been painful.