The currently mandated myopia of Rule 10b-5: pay no attention to that manager behind the mutual fund curtain.

• Author: Kibble, Kelly S.
• Position: I. Introduction into III. The Turnabout Trilogy C. Janus 2. The Decision, p. 171-204

1. INTRODUCTION

   This Article examines the current state of the Rule 10b-5 (1) right of action following a constricting trilogy of Supreme Court cases that have rendered it a myopic remnant of the right previously endorsed by the United States Securities and Exchange Commission (the "SEC") and hundreds of courts over a span of numerous decades. (2) The Roberts Court's pronouncement in Janus Capital Group, Inc. v. First Derivative Traders (3) has generated an immense amount of criticism (4) and a slew of conflicting lower court decisions. (5) By effectively abolishing most private Rule 10b-5 claims against secondary actors, (6) including lawyers, accountants, credit rating agencies, underwriters and securities analysts, and by mistakenly including mutual fund investment managers in the class of ordinary secondary actors, (7) the Court has chosen a short-sighted, ill-reasoned standard that ignores the doctrinal foundations of the Securities Exchange Act of 1934 (the "1934 Act"), (8) as well as the practical realities and traditional bases of mutual fund law and practice. (9)

   Specifically, despite the fact that a typical mutual fund (10) has no employees, no office space, no assets other than those it holds for its investors, no officers that are not also officers of its investment manager, and no involvement in its own day-to-day management (having delegated such management and investment decisions to its investment manager), the Roberts Court has mandated that aggrieved investors pursuing private Rule 10b-5 claims must ignore fraudulent managers and other "mutual fund malefactors," (11) even where they have deceived their fund boards. (12) In sum, Janus does real harm: it potentially allows a deceitful manager to "coordinate all major aspects of a mutual fund" (13) for fraudulent purposes, while it reaps increased fees, hides its deceit and avoids private Rule 10b-5 liability. This "pay no attention to the manager behind the mutual fund curtain" (14) dictate is untenable and should be remedied by legislative action.

   Janus' absolution of all but those with "ultimate authority" in private Rule 10b-5(b) actions is particularly concerning in light of the high volume of financial frauds during the last decade involving complicit "gatekeepers," (15) who prioritized their own economic interests over their ethical obligations: Enron, WorldCom, Tyco, and Global Crossing only begin the long list of complicit gatekeeper scandals. (16) Janus is especially perplexing in light of the numerous front-page stories of mutual fund adviser misconduct over the last decade, including scandals involving market timing, late trading, valuation misconduct and soft-dollar practices. (17) Concurrent with these high-profile frauds, recent years have also witnessed highly-publicized failures of the SEC, including its failure to discover Bernie Madoff's estimated $13.2 billion to $65 billion Ponzi scheme, despite "credible and specific allegations ... repeatedly brought to the attention of SEC staff...." (18) Without doubt, gatekeepers have also shouldered a significant amount of blame for the recent financial crisis. (19) The Supreme Court's constriction of the Rule 10b-5 right, despite this troubling confluence of events, will most surely disadvantage U.S. investors, (20) as further set forth herein, unless remedied by legislative and administrative action.

   This Article discusses the potentially harmful consequences of the above-referenced trilogy of Supreme Court cases with respect to private investor suits and agency-driven actions, with a particular focus on the effect on aggrieved mutual fund investors. In light of drastically reduced regulatory budgets that compromise today's securities fraud enforcement efforts, this issue is particularly timely, given that over forty percent of American households own mutual fund shares, generally assuming such investments to be relatively safe retirement vehicles. (21)

   Part II of this Article provides an overview of Section 10(b) of the 1934 Act (22) and describes Rule 10b-5 (23) as promulgated under Section 10(b). Part III discusses the above-referenced trilogy of Supreme Court cases: Central Bank of Denver v. First Interstate Bank of Denver, N.A., (24) Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., (25) and Janus. (26) Part IV explores the unique relationship between an investment adviser and a mutual fund, with a focus on important doctrinal foundations of the Investment Company Act of 1940 (27) (the "1940 Act") ignored by the Janus Court. Part V examines the confusion among lower courts in adjudicating post-Janus cases and defines certain ambiguities and open questions in current Rule 10b-5 law. Part VI proposes legislative and regulatory fixes in line with the doctrinal underpinnings of the 1934 Act and the 1940 Act.

2. STATUTORY LIABILITY FOR SECURITIES FRAUD AND THE ROBERTS COURT

   This Part provides a brief overview of the securities laws involved in the subject trilogy of cases. Although [section] 10(b) and Rule 10b-5 liability is the focus of the Court's analyses, an understanding of [section] 20 liability is also important to the discussion. Additionally, a brief summary of the Roberts Court's approach to securities-related matters provides a necessary background to Part III's trilogy analysis.

   1. Overview of [section] 10(b) and Rule 10b-5

      To address widespread financial abuses after the 1929 stock market crash, the seventy-third Congress enacted the Securities Act of 1933 (the "1933 Act"), (28) governing initial securities distributions, and the Securities Exchange Act of 1934 (the "1934 Act"), (29) governing secondary market distributions. (30) The 1933 Act and the 1934 Act (collectively, the "Acts") "embrace a fundamental purpose ... to substitute a philosophy of full disclosure for the philosophy of caveat emptor." (31) To effectuate this purpose, the Acts establish an "extensive scheme of civil liability." (32) The SEC and the Department of Justice are authorized to institute proceedings and assert penalties against violators of various provisions. (33) Further, private litigants may sue violators of certain provisions that expressly provide for private rights of action. (34) Private litigants may also sue violators of certain statutes pursuant to judicially-created private rights of action found to be implied by such provisions. (35) The Supreme Court has historically stressed the importance of private antifraud securities actions in supplementing government criminal and civil enforcement proceedings. (36) Further, the Supreme Court has admonished "that the statute should be construed not technically and restrictively, but flexibly to effectuate its remedial purposes." (37)

      Section 10(b) (38) embodies the "general antifraud provision of the 1934 Act." (39) In 1942, pursuant to authority granted under [section] 10(b), the Securities and Exchange Commission ("SEC") promulgated Rule 10b-5, (40) which further delineates prohibited fraudulent activities.

      The judicially-recognized Rule 10b-5 private right of action, "a judicial oak which has grown from little more than a legislative acorn," (41) was established long ago and has been consistently recognized by the courts. (42) Because Congress has not provided any guidance regarding a Rule 10b-5 private right of action, (43) the courts "have had 'to infer how the 1934 Congress would have addressed the issue[s] had the 10b-5 action been included as an express provision in the 1934 Act.'" (44) Without doubt, a private litigant may not sue under Rule 10b-5 for acts that are not prohibited by [section] 10(b). (45) As the Supreme Court explained, "our cases considering the scope of conduct prohibited by [section] 10(b) in private suits have emphasized adherence to the statutory language, '[t]he starting point in every case involving construction of a statute.'" (46)

      To prevail on a Rule 10b-5 claim, a private plaintiff must prove the following elements: "(1) a material misrepresentation or omission by the defendant; (2)...