A sharply divided U.S. Supreme Court adopted a bright-line rule this week that individuals or entities that participate in drafting statements but do not have ultimate authority over such statements cannot be held liable under Securities Exchange Commission (SEC) Rule 10b-5.
In Janus Capital Group, Inc. v. First Derivative Traders, No. 09-525, (U.S. June 13, 2011), the Supreme Court held that an investment adviser, Janus Capital Management LLC (JCM), cannot be held liable under Rule 10b-5 for alleged false statements contained in its mutual fund client’s prospectuses. JCM, a wholly owned subsidiary of Janus Capital Group (JCG), served as the investment adviser and administrator for Janus Investment Fund (JIF). The Court reasoned that because JIF, a separate legal entity, “made” the statements in question, JCM could not be liable.
Plaintiff alleged that statements contained in JIF’s mutual fund prospectuses “created the misleading impression” that JCG and JCM would implement measures to “curb” market timing. Slip. Op. at 3-4. Plaintiff argued that JCM could be held liable for “making” the alleged false statements because it was significantly involved in preparing JIF’s prospectuses. Plaintiff also alleged that JCG was liable for JCM’s acts as a “controlling person” under Section 20 of the Securities Exchange Act.
Rule 10b-5 prohibits “mak[ing] any untrue statement of a material fact” in connection with the purchase or sale of a security. 17 C.F.R. § 240.10b-5 (2010). The Court began its analysis by looking to the English dictionary definition of “makes.” The Court held that “[o]ne ‘makes’ a statement by stating it.” Slip. Op. at 6. Thus, Rule 10b-5’s phrase “‘[t]o make any ... statement,’” is “the approximate equivalent of ‘to state.’” Id. In the Rule 10b-5 context, the “maker” of a statement is the entity “with ultimate authority over the statement, including its content and whether and how to communicate it.” Id. By way of example, the Court explained that, even if a speech writer drafted a speech, the content of the speech is entirely within the control of the speaker. Id. at 6-7.
The Court rejected the argument that “make” should be defined as “create” because such a definition would allow private plaintiffs to sue those who provide false or misleading information to another who ultimately puts it into a statement. Id. at 8-9. Similarly, in a footnote, the Court explained that JCM is not liable under Rule 10b-5 for providing access to JIF’s prospectus on JCM’s Web site because “[m]erely hosting a document on a Web site does not indicate that the hosting entity adopts the document as its own statement or exercises control over its content.” Id. at 12 n.12.
The Court also noted that its definition of “makes” is consistent with its holding in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), in which the Court held that Rule 10b-5’s private right of action does not encompass a claim against aiders and abettors. Rather, only the SEC can bring an action against an entity that contributes “substantial assistance” to a false statement.
Accordingly, the Court held that JIF, and not JCM, “made” the statements in JIF’s prospectus. This bright-line rule should provide comfort not only to investment advisers but also to other participants in the securities markets, including bankers, accountants, and lawyers, who routinely assist in preparing these public documents.
Pepper Point: An Alternative Theory in Support of the Same Result
On the ninth page of the majority opinion, the Court introduces a concept that, in our view, provides another compelling basis for the same result. The Court acknowledged an argument made by the Plaintiff, but declined to be swayed by it:
“For its part, [Plaintiff] suggest[s] that the ‘well-recognized and uniquely close relationship between a mutual fund and its investment adviser’ should inform our decision ... It suggests that an investment adviser should generally be understood to be the ‘maker’ of statements by its client mutual fund, like a playwright whose lines are delivered by an actor. We decline this invitation to disregard the corporate form. Although [Plaintiff] and its amici persuasively argue that investment advisers exercise significant influence over their client funds, ... it is undisputed that the corporate formalities were observed here. JCM and Janus Investment Fund remain legally separate entities, and Janus Investment Fund’s board of trustees was more independent that the statue requires. ... Any reapportionment of liability in the securities industry in light of the close relationship between investment advisers and mutual funds is properly the responsibility of Congress and not the courts.”
Slip Op. at 9-10 (emphasis added, citations omitted).
To fully understand the importance of the corporate form in the context of this case, it might be helpful to elaborate a bit on the structure and management of open-end investment companies, or mutual funds.
A mutual fund is a highly regulated entity. It is a separate corporation, frequently (as in this case) organized as a Massachusetts Business Trust. But the entity then must register with the SEC as an investment company under the Investment Company Act of 1940. The investment company (mutual fund) then issues shares, which can be purchased by investors.
Critical to an understanding of this case is the fact that mutual funds differ from other types of public companies in two important respects. First, mutual fund shares do not trade on an exchange. Instead, investors purchase shares directly from the fund, and redeem shares directly to the fund. Second, the value of mutual fund shares depends on the value of securities in the portfolio; the value of the shares is not influenced in any way by the perception of the investing public regarding the value of the company. Simply put, the value of a mutual fund’s shares (called net asset value, or NAV) is the product of a mathematical equation, nothing more.
As a practical matter, this means that a mutual fund shareholder cannot sue the fund under a “fraud on the market” theory because there is no public market. In this case, the statement that was alleged to be fraudulent – we take steps to “curb” market timing – was a statement of the fund, not a statement of the investment adviser, JCM, or the adviser’s parent company, JCG. But the shares that dropped in value were those of the public company, JCG, not the mutual fund that “made” the statement.
Plaintiff in this case, as in most cases of this type, was undoubtedly motivated by the drop in JCG’s stock price as the measure of potential damages. The problem was that Plaintiff owned shares in JCG, not the mutual fund, and the prospectus at issue was not JCG’s prospectus. Plaintiff’s challenge was connecting the drop in JCG’s stock price to the alleged misstatements in the mutual fund’s prospectus. To get there, Plaintiff argued that the Court ignore the corporate formalities and equate the statement of the mutual fund with that of its adviser. If the adviser were found liable, then Plaintiff could get to JCG under a control person theory. Thankfully for Janus, as well as other potential defendants, the Court did not take the bait.
The importance of the corporate formalities also helps to defeat one of the arguments put forth by the dissent – that the majority opinion would preclude an action against a corporation when its “management” caused the corporation to make a misstatement. Dissent at 9-10. The dissent fails to recognize that the “management” provided to a mutual fund by an adviser is not the same as the “management” of a public company by its officers. In a more familiar public company context, company managers are employees of a company, and those managers cause the company to act and, occasionally, to “make” statements. In this context, of course, the statements are statements of the issuer of shares the plaintiff owns.
Mutual funds, however, do not have any employees. Instead, they have a board and officers, and they have contracts with service providers. One of those contracts is with the investment adviser, and the adviser, as a factual matter, may have some influence over the contents of the mutual fund prospectus. But, as the Court aptly noted, the investment adviser does not have ultimate authority over the prospectus language. In theory, the mutual fund board could seek compensation from the adviser for losses the fund experiences as a result of misstatements in the prospectus that were made in reliance on information provided by the adviser. But a private investor has no claim against the mutual fund for “fraud on the market” and no claim against the parent company for statements it did not make.
The corporate form exists for a reason. The investment community can breathe a sigh of relief now that the Court has reaffirmed the importance of corporate formalities in the mutual fund context.