The narrow focus of Janus Capital Group, Inc. v. First derivative Traders, 131 S.Ct. 2296 (2011) may have a significant impact in private damage actions and SEC enforcement cases. Focusing on the word “make” in the second clause of Rule 10b-5 the court concluded that primary liability only attaches where the person controls the statement which is alleged to be false. The High Court not discuss the other subsections of the Rule. Likewise, Justice Thomas, in his opinion for the Court, did not mention Section 10(b)’s analogue in the Securities Act, Section 17(a).

Now the courts are struggling with the application of Janus. In SEC v. Kelly, 2011 U.S. Dist. LEXIS 108805 (S.D.N.Y. 2011) the court held that the test applies to all of the subsections of Rule 10b-5 as well as Securities Act Section 17(a). In contrast, in SEC v. Daifotis, No. 3:11-c-00137 (N.D. CA. 2011) the court refused to expand Janus beyond the one subsection.

Now Chief Administrative Law Judge Brenda P. Murray has held that Janus applies to SEC actions under Section 10(b) as well as Section 17(a). The ruling was made in the Initial Decision handed down in In the Matter of John P. Flannery, Adm. Proc. File No. 3-14081 (Initial Decision Dated Oct. 28, 2011).

The Order for Proceedings named John P. Flannery and James D. Hopkins as Respondents. Both are employed by State Street Bank and Trust Company, a subsidiary of State Street Corporation. Both are involved in the management of funds advised by State Street.

The proceeding centered a series of claimed false statements made by the Respondents that supposedly mislead investors about the extent of subprime mortgage-backed securities held in certain unregistered funds under State Street’s management. As a result of those false and misleading statements investors continued to purchase shares in the funds or maintain their positions as the market crisis unfolded and the sub-prime market unraveled.

According to the Order, by 2007 the fund was almost entirely invested in or exposed to the subprime market. The Respondents however continued to describe it in various materials and statements as having better sector diversification than a typical money market fund. They failed to inform investors about the extent of its exposure to sub-prime investments. Offering materials for the fund such as quarterly fact sheets, presentations to current and prospective investors, and responses to investor requests for proposal were misleading because they omitted material about the exposure of the fund to the sub-prime market. Mr. Hopkins was responsible for these materials the Order alleges.

A series of shareholder communications were also false and misleading because the failed to inform investors about the fund’s concentration in subprime. Messrs. Hopkins and Flannery played an instrumental role in drafting the misrepresentation in these communications, according to the Order.

As the market crisis evolved State Street’s internal advisory groups decided to redeem or recommend redemption from the fund for their clients. State Street Corporation’s pension plan was one of those clients. Mr. Flannery and the investment committee sold the fund’s most liquid assets and use the cash to redeem shares for what the Order calls “better informed” investors. The fund was left with largely illiquid holdings. The Order alleged violations of Sections 17(a) and 10(b).

In the Initial Decision Judge Murray rejected each of the Division’s claims. Critical to the decisions is the ruling on the application of Janus. The Division argued that the Supreme Court’s decision “applies only for purposes of Rule 10b-5(b) implied private rights of action and does not affect its ‘scheme liability’ and ‘course of conduct’ claims pursuant to Rule 10b-5(a) and (c). . . “ or to its 17(a) claims. After considering Janus, Kelly and Daifotis, Judge Murray held: “ I find the Janus test to be the appropriate standard to apply in evaluating the extent of Respondents’ conduct. Therefore, with respect to allegations involving documentary evidence, the Division must establish that respondents’ had ultimate authority and control over such documents.”

Judge Murray then carefully reviewed each allegation and concluded either that the Respondents were not responsible for the statement within the meaning of Janus, that the statement was not false, or both. For example, the Initial Decision concludes that Mr. Hopkins was not responsible for the Fact Sheets, a kind of very summary document about the fund, furnished to investors. The Initial Decision concludes that those sheets were written by others. Although Mr. Hopkins reviewed them he was not ultimately responsible for their content. Likewise, the Initial Decision rejects the claim that Mr. Hopkins was responsible for a claimed power point presentation shown to potential investors which supposedly was false and misleading. While Mr. Hopkins could make corrections to the presentation, he was not ultimately responsible for it under Janus.

Similarly Judge Murray repeatedly rejected the Division’s claims that statements were false and misleading. Typical of those findings is one regarding a July 26 letter to investors which was an attempt to explain the under performance of the fund. In part the letter stated that management was trying to reduce risk where appropriate while seeking to avoid putting undue pressure on the assets. The Initial Decision concludes that at the time of the letter the management team believed that in the long term housing market fundamentals would prevail. It goes on to conclude that “it is with the benefit of hindsight that the Division believes it was incumbent on Flannery and Hopkins to warn investors of something that the evidence shows they were unaware of at the time – the vulnerability of AA and AAA rated subprime bonds.” Stated differently, fraud by hindsight is not fraud. And, under Janus there is no primary liability for documents used by a person when he does not control their content under Section 10(b) or Section 17(a), according to the ruling.