On June 13, 2011, the Supreme Court of the United States held in a 5-4 decision that an investment adviser to a mutual fund does not “make” the statements contained in that fund’s prospectus for purposes of Rule 10b-5 under the Securities Exchange Act of 1934. Instead, the court ruled in Janus Capital Group, Inc. v. First Derivative Traders, that false statements in a mutual fund’s prospectus are made by the fund and not the adviser, and that the adviser and its parent company cannot be held primarily liable and subject to a private action by the parent’s shareholders under Rule 10b-5.

The ruling is widely viewed as providing additional insulation for the investment advisory industry from suits by the plaintiffs’ securities litigation bar and virtually eliminates liability in private suits for the investment adviser and other service providers who draft and often insist on the language contained in a fund’s prospectus.  

The case stemmed from a lawsuit filed by First Derivative Traders (First Derivative), a shareholder of Janus Capital Group (JCG), the parent company of Janus Capital Management (JCM), in connection with statements concerning market timing in the Janus Investment Fund series of mutual funds advised by JCM. The prospectuses stated that the funds were “not intended for market timing or excessive trading” and provided remedies the funds may use to prevent such practices. JCG and JCM were implicated in the 2003 market timing scandals, and the New York State Attorney General’s public allegations that JCG had entered into secret arrangements to permit market timing in funds advised by JCM resulted in significant withdrawals from the Janus Investment Fund mutual funds. Because JCM’s management fees for Janus Investment Fund were assetbased and constituted a significant proportion of JCG’s revenues, the drop in assets under management for JCM pulled down JCG’s revenue and stock price. First Derivative brought suit against JCG under Rule 10b-5 for the misleading prospectus disclosure, alleging that the false and misleading statements on market timing in the prospectuses had made the JCM-advised funds more attractive to investors than they should have been and had caused JCG to realize higher revenues and to trade at an inflated price. Although JCM was the investment adviser to the funds, JCG was the publicly-owned company that controlled JCM and was thus the subject of the shareholder suit.

The Court’s opinion, authored by Justice Clarence Thomas and joined by Chief Justice John Roberts as well as Justices Samuel Alito, Anthony Kennedy and Antonin Scalia, rejects First Derivative’s theory of liability on the grounds that JCM did not “make” the material misstatements in the Janus Investment Fund prospectuses. The opinion reasoned that the statements made in the prospectuses were those of the mutual funds and not their adviser, and that “[o]ne who prepares or publishes a statement on behalf of another is not its maker.” While acknowledging that the adviser to a mutual fund may contribute substantial assistance in the making of a statement in the fund’s prospectus, the opinion held that the fund as a separate legal entity operating with its own board of trustees would have ultimate authority and therefore be the “maker” of any prospectus statement. As such, the adviser’s liability would not be that of one who “make[s] any untrue statement of material fact” in connection with the purchase and sale of securities. The court’s opinion further stated that parties contributing substantial assistance to a prospectus statement could not be subject to liability in a private lawsuit for primary liability under Rule 10b-5 and could be subject only to secondary liability for aiding and abetting the making of the statements, which could be initiated by the Securities and Exchange Commission.

Writing in dissent, Justice Stephen Breyer was joined in the minority by Justices Ruth Bader Ginsburg, Elena Kagan and Sonia Sotomayor. He first took issue with the majority’s interpretation of “make,” stating that, depending on the circumstances, any one of a number of parties could be considered to “make” a statement in a prospectus. He added that neither common English nor the court’s earlier precedents limited the scope of the word “make” to persons with “ultimate authority” over a statement. Additionally, the dissent argued that the majority’s opinion extends the court’s previous decision on the line between primary and secondary liability under Rule 10b-5 to require plaintiffs to “show some kind of ‘attribution’ of a statement to a defendant” beyond simply making the statement. Justice Breyer’s dissent further states that, under the majority’s rule, “when the guilty management writes a prospectus (for the board) containing materially false statements and fools both board and public into believing they are true,” there is in fact no one who can be found to have made a materially false statement for purposes of a private Rule 10b-5 claim.  

As we mentioned earlier, the ruling is believed by many to further insulate the investment advisory industry from suits by the plaintiffs’ securities litigation bar.  

In light of the elimination of all other potential targets for plaintiffs’ lawyers in prospectus disclosure cases, funds and their boards of directors may face increased litigation threats. It is also possible that Congress could take action through legislation. The Dodd-Frank Act required a Government Accountability Office (GAO) study and report regarding “the impact of authorizing a private right of action against any person who aids or abets another person in violation of the securities laws.” The GAO report is due to be issued soon, and, depending on its conclusions, could cause Congress to take further action with respect to primary and secondary liability under federal securities laws.