One Year Later: The Consequences of Janus Capital v. First Derivative Traders

In Janus Capital Group, Inc. v. First Derivative Traders, Inc., a case decided one year ago this month, the Supreme Court hampered the Securities and Exchange Commission (SEC) in its efforts to combat fraud, by deciding that white-collar criminals could devise complex structures of shell corporations to avoid accountability. The decision – part of a growing trend of corporation-friendly 5-4 rulings engineered by the conservative wing of the Court – was ostensibly intended to create a bright-line rule that would clarify the application of important corporate accountability regulations, but has instead confused and divided lower courts and stifled the effectiveness of those checks on corporate practices. This confusion makes it more likely that the issue decided in Janus could end up back before the Supreme Court one day soon. In the meantime, Congress or the SEC can act to repair the damage done to corporate accountability mechanisms by Janus.

According to its drafters, the story behind SEC Rule 10b-5 began with an anecdote that circulated around SEC offices in 1942. A wealthy Boston banker had made a fortune by fleecing his investors, telling them (falsely) that the bank was in dire trouble, purchasing their stock at a sharp discount, and reaping huge profits when, in fact, the bank’s stock quadrupled in value soon thereafter. At the time, the SEC had adopted rules penalizing fraud related to the sale of securities, but no rule existed to penalize securities purchasers who engaged in fraud. Rule 10b-5 changed that, authorizing the SEC, as well as the affected stockholders, to sue buyers or sellers who engaged in securities fraud. Since its adoption, Rule 10b-5 has been described as “the primary vehicle for class actions against public companies based upon allegations of false disclosure and the legal source for the prohibition of insider trading.” The Janus ruling, however, has brought the continued vitality of Rule 10b-5 into question.

Worst Decisions, #3: Janus Capital v. First Derivative

AFJ is counting down the 10 worst decisions of the Corporate Court's 2010-11 term. Yesterday at #4, we talked about American Free Enterprise v. Bennett, which makes it easier for wealthy special interests to buy elections.

Worst Decisions of the 2010-11 Corporate Court Term: #3: Janus Capital Group v. First Derivative Traders

In a 5-4 decision, the Corporate Court created a major new loophole that allows holding companies in the $12 trillion mutual-fund industry to escape liability for securities fraud.  The corporations may now create subsidiaries that can then make false and misleading statements on behalf of the parent company and that have no assets other than investors’ money.

Janus Capital Group is a huge financial investment corporation that has created numerous subsidiaries, including Janus Investment Fund, which deliberately misled investors in its mutual fund prospectus by telling the public that it did not allow hedge funds to engage in “market time” transactions. Behind the scenes, hedge funds were routinely engaging in just those sorts of timing transactions with Janus. When the truth came out, the Janus stock dropped precipitously, costing deceived investors millions.

Rule 10b-5 of the securities laws prohibits “mak[ing] any untrue statement of a material fact.” In this case, the deception about market timing certainly qualified as an untrue material statement. However, the pro-corporate majority decided Janus Capital could not be liable because it had not “made” the statement, only Janus Investment Fund had. It arrived at this fiction by concluding that only the party with “ultimate authority” over a statement can “make” it. A speechwriter does not a make a statement, only the speaker does, the majority reasoned.

The dissent attacked this conclusion as a distortion of the common use of the English language. “Every day, hosts of corporate officials make statements with content that more senior officials of the board of directors have ‘ultimate authority’ to control…. Nothing in the English language prevents one from saying that several different individuals, separately or together, ‘make’ a statement that each has a hand in producing.”

The tipping point between these competing visions should turn on whether one believes Congress, in drafting Rule 10b-5, intended to immunize corporate fraud or protect investors. The pro-corporate majority argues that Rule 10b-5 must be read narrowly, which in this instance would immunize corporate fraud. As Justice Breyer noted in dissent, the majority’s interpretation would often leave no one accountable under the securities laws, even for fraud committed through intentional lying, if the subsidiary’s board was as deceived as investors were by the original perpetrator’s lies.  It is difficult to imagine that Congress intended to open such a gaping loophole in the law.

Janus Capital Group v. First Derivative Traders is number three on AFJ’s Worst Decisions of the 2010-11 Corporate Court term because, as one article put it, “[t]he U.S. Supreme Court has shown mutual fund bosses an easy way to skirt class-action lawsuits.”

Senate Judiciary Committee Hears Testimony on Supreme Court’s Corporate Slant

Today, the Senate Judiciary Committee held a hearing on the Supreme Court’s ongoing pattern of putting the financial interests of corporate litigants above the rights of everyday Americans.

Chairman Leahy called the hearing to focus on three decisions from the recently-completed Court term: Wal-Mart v. Dukes, AT&T Mobility v. Concepción, and Janus Capital Group v. First Derivative Traders. These cases are representative of how, as Chairman Leahy described it, “the most business-friendly Supreme Court in the last 75 years” is eroding the legal protections American consumers and employees rely on, particularly in tough economic times.

Among the witnesses was Betty Dukes of Pittsburg, CA, a seventeen year veteran employee of Wal-Mart and lead plaintiff in the gender discrimination case broken up by the Court last week. Dukes remains upbeat in her hope that, even without the ability to fight Wal-Mart as a unified class, women subjected to the retail giant’s discriminatory culture and practices will one day obtain justice. However, she testified that many women will give up because it’s too hard to fight the company alone, and especially difficult to fight one’s own employer.

Professor Melissa Hart of the University of Colorado Law School testified to the common threads between the Wal-Mart and AT&T decisions. In both cases, the same five-vote majority of the Supreme Court interpreted procedural rules in ways completely different from their original meaning and with hostility to the class action device. As a result, no court has reached or will be likely to reach the substance of the claims made in those cases. Questioned by Senator Franken, Professor Hart stated that the Court’s interpretation of the Federal Arbitration Act of 1925 was inconsistent with its legislative history and purpose, and that allowing corporations to write class action bans into fine print contracts incentivizes small-dollar rip-offs of hundreds of thousands of hard working people. Franken has introduced the Arbitration Fairness Act in response to AT&T, which would amend the FAA and limit binding mandatory arbitration.

Senator Franken also took to task witness Andrew Pincus, the attorney who represented AT&T before the Supreme Court. Pincus, a partner at corporate defense giant Mayer Brown LLP, wrote in the New York Times and suggested in his opening statement that only plaintiffs’ attorneys looking to rack up huge fees would be hurt by the Court’s ruling. Franken noted that the average partner at Mayer Brown is paid over $1 million per year; Pincus, he said, is in no position to criticize others for a possible financial interest in the workings of the legal system.

Professor James Cox of Duke University School of Law testified on the likely fallout in the financial industry from the Court’s decision in Janus. The narrow and inapt definition adopted by the Court of who can “make” a false or misleading statement will greatly restrict the power of investors to recover damages and enforce anti-fraud laws. Only the Securities Exchange Commission will be able to go after many offenders, and even then there may now be loopholes. But the SEC, Cox explained, has only investigated, much less taken enforcement action, in 17% of resolved securities fraud cases, and it has been hesitant to take action against the biggest Wall Street firms. Connecting back to Wal-Mart, Senator Franken observed that the Equal Employment Opportunity Commission, the government body charged with pursuing workplace discrimination claims and to which many of Dukes’s colleagues may now have to turn, has a backlog of 80,000 claims to hear.

Senator Whitehouse observed that the procedural hurdles, arcane rules, and cramped statutory interpretations that characterize recent Supreme Court decisions might be summed up in two words: “corporation wins.” In closing, he extolled the role of jury in our constitutional design, and lamented the Court’s “steady addition of trouble, toils, and snares” between everyday Americans and their right to have their cases heard by their peers.

For complete analysis of how big business has fared before the Supreme Court, see AFJ's Corporate Court webpage.

Supreme Court Rules Wall Street Management Companies Can’t be Held Liable for False Statements

Today the Supreme Court decided Janus Capital Group v. First Derivative Traders. A 5-4 majority of the Court ruled in an opinion by Justice Thomas that a company can’t be held primarily liable in a private securities fraud action for false statements that are primarily attributed to a different entity even though the company took part in drafting and distributing those statements.

The conservative majority of the Supreme Court held that Janus Capital Group (JCG) could not be held liable in a lawsuit brought by individual or group investors for violations of federal securities laws. The Court ruled that Janus Capital Group (JCG) and its wholly owned subsidiary Janus Capital Management (JCM) could not be held to have “made” untrue statements in a Janus Investment Fund (JIF or “Fund”) prospectus because JCG had created the Fund as a legally separate entity, even though all of the JIF officers that drafted the prospectus were employees of a JCG subsidiary.

The JIF is a trust of mutual funds operated under the Janus name. First Derivative Traders, as well a class of other private investors, owned stock in JCG. JCM was hired to act as an advisor to the Fund. In practice, however, all of JIF’s officers were also JCM officers, and they carried out the day-to-day business of the Fund. JCM even hosted the Fund’s prospectuses on its website.

In 2002, JIF issued its annual prospectus, which stated that the Fund did not engage in and would resist any attempts at the use of a trading technique known as “market timing.” However, in 2003 the New York Attorney General’s office filed a case against JCG and JCM, alleging a secret agreement to use market timing in the Fund. JCG and JCM later settled for $100 million in fines and reimbursements to Fund investors. JCG’s stock dropped in price as a result, and First Derivative brought this suit against JCG and JCM to recover their losses.

For decades, courts have held that Securities and Exchange Commission (SEC) Rule 10b-5, published pursuant to Section 10 of the Securities Exchange Act of 1934, allows harmed investors to sue anyone who “makes any untrue statement of a material fact” in connection with the purchase or sale of securities. The Fourth Circuit Court of Appeals held that JCM’s participation in the writing and dissemination of the misleading prospectus was sufficient to say that they had “made” the statements as a matter of law, thereby allowing the case to go forward.

The defendants appealed to the Supreme Court, which under Chief Justice Roberts has developed a reputation for protecting corporate interests from the civil justice system. Justice Thomas’s opinion for the 5-vote majority explicitly gave “narrow dimensions” to the important right of action that Rule 10b-5 provides investors. Looking to dictionary definitions of “make,” Thomas wrote that the Rule should be read as “to state” rather than, as the Government urged in its amicus brief, “to create.” Since the Fund’s board was not controlled by JCM employees, only its officers who prepared and published the prospectus, the Court allowed the corporate form to trump practical responsibility.

“One who prepares or publishes a statement on behalf of another is not its maker,” Thomas wrote on behalf of the Court. Such a case would merely be one of “substantial assistance,” a violation of securities law which only the SEC itself may pursue in court. Somewhat ironically for the ultra-conservative justice, the investing public will now be more dependent on government regulators.

Justice Breyer, for the four dissenting Justices, pointed out that “every day, hosts of corporate officials make statements with content that more senior officials or the board of directors have the ultimate authority to control.” The majority’s cramped reading, if extended, could open up a whole new world of securities fraud. Further, Breyer noted, the SEC’s authority to pursue those “substantial assistance” or “aiding and abetting” cases only extends to instances where the Court’s ultimate “maker” of untrue statements (i.e., the corporate board) knew of the fraud; that is, if the officers deceived their board as well as the public, it seems no one could be held liable.

In siding with Janus, the Court has limited the power of private investors and the courts to hold Wall Street insiders accountable for securities fraud. Now, the deeper the deception runs, the more likely will be that investment managers can paper-over their wrongdoing.