Chapter 11

• Jurisdiction: United States

Chapter 11 Section 10(b) of the Exchange Act and Rule 10b-5, Part Three; Section 14 and Section 18

Primary Liability

In Janus Capital Group v. First Derivative Traders, 131 S. Ct. 2296 (2011), the Supreme Court continued its efforts to restrict private actions under Section 10(b). "We must give 'narrow dimensions' to a right of action Congress did not authorize."

At issue was a misstatement in a prospectus issued by Janus Investment Fund (JIF), a mutual fund created by Janus Capital Group. JCG is a publicly traded company that created a family of mutual funds, organized in a family trust known as JIF. JCG also created Janus Capital Management (JCM), an investment adviser, which was retained by JIF to govern the "management and administrative services" necessary for JIF's operation. JIF and JCM maintained separate legal identities. JIF issued prospectuses for several of its funds that suggested that the funds were not suitable for "market timing," a statement that could be read to suggest that JCM would implement practices to curb the practice. Apparently, however, there were secret agreements that permitted several of the funds to engage in market timing. When the fraud was discovered, investors began to withdraw their investments from JIF. As a result, JCM, which received its compensation as a percentage of the assets under management, lost revenue. JCG also derived a large part of its income from JCM's management fees; the loss in JCM's revenues caused a sharp decline in the price of JCG's stock (approximately 25 percent).

The complaint alleged a violation of Rule 10b-5b, one of three subsections of Rule 10b-5, and the only subsection that prohibited the "making" of untrue statements of material fact. The other two subsections prohibited any person "to employ any device, scheme, or artifice to defraud" and "to engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person. "Making" is clearly different from "employing" and "engaging."

The question at issue was "who made the false statements?" The claim was that JCG failed to reveal a breach of fiduciary duty to JIF investors. Plaintiff First Derivative Traders represented a class of shareholders of JCG who suffered losses. They alleged that JCG and JCM had "caused" the false prospectuses to be issued by JIF for the benefit of its investors and were liable to the JCG shareholders for a violation of Rule 10b-5. The district court dismissed the complaint but the Fourth Circuit reversed, finding that the complaint adequately alleged that JCG and JCM, by participating in the writing and dissemination of the prospectuses, "made" the misleading statements. The Supreme Court reversed, holding that only the entity with "ultimate authority" over a statement can be its "maker." The maker must have ultimate authority over the statement's content and how to communicate it.

How does one "make" a statement? According to Justice Thomas' majority opinion in Janus, one makes a statement "by stating it." "To make any statement," the court said, is the approximate equivalent of "to state." It does not mean "to create."

Janus has far-reaching implications. Entities that are legally separate from issuers cannot be primarily liable under Section 10(b). "We will not expand liability beyond the person or entity that ultimately has authority over a false statement."

Let's look at the language of Section 10(b) and 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. Recall that under Section 10(b), there is no secondary liability unless all of the requirements for primary liability have been met. And there is no private right of action for aiding and abetting. So what does it mean "to make"? The Supreme Court said that Oxford English Dictionary rules of construction say that where the term is followed by the noun form of a verb, the statement is approximately equivalent to stating the verb. Thus, the phrase "to make" would be the functional equivalent of "to state." Therefore, whichever entity can be said to "state" the prospectus is the entity that made the misrepresentation.

Justice Thomas concluded therefore that only the entity with "ultimate authority" over the statement, including its content and whether and how to communicate it, is the "maker." Does that necessarily follow? Is control the same as attribution? A footnote in the opinion suggests that either explicit or implicit attribution is necessary to establish that an entity "made" a statement and that more than mere "authority" over the statement is required. But the Supreme Court said that "attribution within a statement or implicit from surrounding circumstances is strong evidence that the statement was made by—and only by—the party to whom it is attributed."

Counsel for defendants analogized this to the relationship between the U.S. president and a speechwriter. You wouldn't say that the speechwriter "made" the speech. The plaintiffs analogized it to a playwright and an actor. You wouldn't say that the actor wrote the play. There is a reason why certain corporate subsidiaries have separate legal entities. Was this the right instance to pierce the corporate veil? Was there any evidence that the corporation adopted this form in order to justify a wrong or protect a fraud? The dissent in Janus analogized it to a statement made by a cabinet member, over whom the U.S. president had ultimate authority.

What about Section 20(b)? This section provides that "[i]t is unlawful for any person, directly or indirectly, to do any act or thing which it would be unlawful for such a person to do under the provisions of this title or any rule or regulation thereunder through or by means of any other person." That section is ambiguous. The implied private right of action under Section 10(b) was intended to be and has been applied narrowly. The Supreme Court: "The inexorable broadening of the class of plaintiffs who may sue in this area of the law will ultimately result in more harm than good."

Congress did provide for liability for secondary actors who "control" primary actors, so Congress did intend to limit primary liability for secondary actors. But it has repeatedly refused to extend primary liability to those who "participate" in a statement or who "help to create" the statement.

What about the liability of a major corporate shareholder? In the Southern District of New York, two judges came to opposite conclusions. In City of Roseville Employees Retirement System v....