Last year, the U.S. Supreme Court issued a ruling that, on its face, appeared to be based so squarely in common sense that one may wonder why a writ of certiorari was needed to confirm it.
Boiled down, the ruling is simple: one should not be liable for statements made by another party.
In a vacuum, it’s hard to disagree, right? Before you answer, let’s exit the vacuum and enter into the complex world of securities regulation.
In Janus Capital Group, Inc. v. First Derivative Traders (June 13, 2011), the U.S. Supreme Court was asked to determine whether Janus Capital Management, LLC (“JCM”), a mutual fund administrator and investment advisor, could be held liable under SEC Rule 10b-5 for false statements of material fact included in the investment prospectus of its client, Janus Investment Fund (the “JIF Mutual Fund”), a separate legal entity owned entirely by mutual fund investors. To complicate matters, JCM is a wholly-owned subsidiary of Janus Capital Group, Inc. (“Janus”), a publically traded company that created a series of mutual funds, including the mutual fund at issue here, the JIF Mutual Fund.
Under Rule 10b-5, it is unlawful for any person, directly or indirectly, to make any untrue statement of material fact in connection with the purchase or sale of securities.[1. A 10b-5 claim requires 6 elements: (1) material misrepresentation or omission; (2) scienter; (3) a connection between the material misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the material misrepresentation or omission; (5) economic loss; and (6) loss causation. See Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. 552 U.S. 148, 157 (2008).] In Janus, it is hardly in dispute that false statements of material fact were made in the investment prospectus issued to JIF Mutual Fund Investors. The question is, who made them?
The Supreme Court found that neither JCM nor Janus were liable under 10b-5 for making those false statements of material fact despite the following overwhelming facts:
(1) Janus owned JCM as a wholly owned subsidiary;
(2) Janus formed the JIF Mutual Fund;
(3) JCM was the Mutual Fund Administrator and Investment Advisor for the JIF Mutual Fund;
(4) Janus participated in, and JCM was significantly involved in, the writing and dissemination of the prospectus in which the false statements of material fact were made;
(5) All the officers of the JIF Mutual Fund were also officers of JCM;
(6) A September 2003 New York Attorney General Complaint alleged that Janus and JCM, not the JIF Mutual Fund “entered into secret arrangements to permit” [the very activity that was the basis of the false statements of material fact.]
All indications were that Janus and JCM were not only involved in putting the false statements of material fact in the JIF Mutual Fund prospectus, but perhaps responsible for the very activity that made the statements false in the first place. Still, the U.S. Supreme Court ruled that Janus and JCM were not liable, because neither Janus nor JCM were the “maker” of the false statements of material fact. To reiterate the tortured metaphor adopted by the Court, Janus and JCM may have written the speech, but they didn’t give the speech – and that made all the difference.
The determination of the Court rested primarily on the premise that the implied[2. 10b-5 provides no express private cause of action. However, one has been implied. Superintendent of Ins. of NY v. Bankers Life & Casualty Co., 404 US 6.] right of action for 10b-5 claims must be given narrow dimensions.[3. Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. 552 U.S. 148, 157 (2008)] The court reasoned that the “maker” of a statement is “the person or entity with the ultimate authority over the statement, including its content and whether and how to communicate it.” The Court relied on jurisprudence that did not extend 10b-5 liability to aiders and abettors who contribute “substantial assistance” in making statements, but do not actually make it. [4. Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 500 US 164. ] While the tangle of Janus-based entities may seem a bit incestuous, the Court noted that corporate formalities were observed, and each entity maintained a separate legal identity. [5. Ironically, First Derivative Traders, the plaintiff (respondent) in the action, represents a class of Janus shareholders, not JIF Mutual Fund Investors, who filed a lawsuit against Janus based on how the fallout from the false statements of material fact in the JIF Mutual Fund prospectus caused the Janus stock to drop in price by 25% over September of 2004.] At the end of the day, the Court could not overcome the simple fact that, technically, the JIF Mutual Fund issued the relevant investment prospectuses, and technically, the JIF Mutual Fund made the false statements of material fact contained therein.
Now let’s go back to our common sense principle that one should not be held liable for statements made by another party. Still agree?
On one hand, the Janus ruling feels a little bit like saying the ventriloquist cannot be liable for what the puppet says. On the other hand, it creates a clear bright line rule for where the buck stops with respect to 10b-5 liability: The “maker,” or person or entity with ultimate control over the statement bears the risk of liability for false statements of material fact. [6. This article does not address the separate question of liability of “control persons” under 15 USC 78t(a), Section 20(a) of the Securities Exchange Act of 1934.] With the final authority, the maker of the statements makes the final determination of whether it contains any falsehood.
So what does Janus mean for my clients who are conducting securities offerings?
When any of my clients are conducting an offering or otherwise issuing securities, the statements made in their offering documents are going to be attributed to the clients as the issuers, and as the makers of the statements in the offering materials relied upon by their investors. Often times, the reality is that the offering materials provided to prospective investors are a complex compilation of contributions from clients, lawyers, tax consultants, business advisors, and any number of other affiliated parties. Intellectual property connotations aside, an offering prospectus is most commonly somewhat of a work of joint authorship.
However, only those with the final say, the final control, and the ultimate authority, will face 10b-5 liability for false statements of material fact. That last chance moment of dominion over the statements is in the hands of the maker of the statements, the issuer – the client. This is why it becomes so very important for both clients and their legal and tax professionals to give offering materials careful review and a heightened level of scrutiny.
Janus represents a bit of a gloomy reality for my issuer-clients, and admittedly allows my investment advisor clients to breathe a small sigh of relief. Only time will tell if the Courts, Congress and the SEC believe that the Janus ruling really makes sense in the context of securities fraud cases.
The notion that Janus and JCM are not liable even though they were involved in making the statements, and responsible for making those statements false, doesn’t seem to make sense. Though it’s common sense that one shouldn’t be held liable for the statements of a third party, right? At least that makes sense in a vacuum.
For more information on Janus, 10b-5 claims, conducting securities offerings, or securities regulation, please contact the Corporate Securities Law Group at Ashbaugh Beal.