You own any mutual funds? Better pay attention, then.
As we learned yesterday, the Supreme Court of the United States (SCOTUS) ruled in Janus Capital Group, Inc. v. First Derivative Traders (hereafter the “Janus Case”) that a mutual fund investment adviser and administrator can not be held liable for Rule 10-b5 violations if the document that contained those false statements was signed by the mutual fund itself.
Known Knowns (i.e. Facts) about the Janus Funds
Janus Investment Fund (the “Janus Fund”) was a trust that held all of the Janus family of mutual funds. It put its name on the prospectus containing the false statements, not the investment adviser and administrator of the Janus Capital Management LLC (the “Janus Manager”). Janus Manager called all the shots on which stocks the Janus Fund would buy or sell. It also likely wrote the Janus Fund’s prospectuses along with the assistance of its parent company, Janus Capital Group, Inc. (“Big Janus”) the parent company that wholly owned and controlled Janus Manager, and, by the way, created all the Janus mutual funds held in the Janus Fund trust.
So, what’s the big deal? It’s all just a matter of arcane securities laws with no real effect on you and me, especially if we don’t own any Janus funds, right? It doesn’t effect the plaintiffs’ ability to pursue state securities or common law fraud claims against Janus Manager and Big Janus, right?
Well –Not exactly. Let me explain why it matters a great deal and what some of the potential consequences and ramifications for our economy and our financial markets that may result from this decision by SCOTUS. I’ll discuss the following likely outcomes of the Janus case:
- The Decision in the Janus Case
- The Absence of Viable State Remedies for defraud investors
- Incentives created by the Janus Case to Foster Securities Fraud
- Lack of Confidence in Our Financial Markets
The Janus Case Decision
First let’s look at the ruling itself. On its face it dealt only with an interpretation of the private right of action granted to investors under the SEC’s Rule 10-b5. What is Rule 10-b5? Well, it is a rule by the SEC that states as follows:
“Rule 10b-5: Employment of Manipulative and Deceptive Practices”:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,in connection with the purchase or sale of any security.”
I’ll let Justice Thomas, who wrote the majority opinion in the Janus Case explain what a private right of action under 10b-5 action requires:
The elements of a private action under Rule 10b–5 are “(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the pur-chase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.” Stoneridge Invest-ment Partners, LLC v. Scientific-Atlanta, Inc., 552 U. S. 148, 157 (2008).
Ok, so that’s not very helpful. Let me explain it in layperson’s terms. First, any publicly traded company whose securities are sold to the public (and shares in a mutual fund are securities) must provide investors wit a document called a prospectus and also file regular reports with the SEC that discloses all the relevant information a reasonable investor would need to make an informed decision about whether to buy or sell that security.
“Material information” includes things like financial statements, past performance in the market (especially important regarding mutual funds), who controls the company or fund whose securities are being offered, lawsuits against the company or any of its affiliates, and so on and so forth. Lying about stuff like that, or failing to include relevant information in a prospectus or in any of the the other reports required to be filed with the SEC, is a violation of Rule 10-b5.
“Scienter” is a fancy legal term for a person knowing he’s doing something wrong. In other words you have to show that the person making the false statement or omitting relevant information knew it was a bad thing to do. Generally, one can infer this “intent to deceive or defraud” by showing that the defendant had relevant information and either refused to disclose it or reported false information instead. In general, corporate defendants are imputed to have the same intent as the employees or other agents (outside accountants, lawyers, bankers, consultants) who they hired to act for them.
The law also can also impute liability to persons (corporate or real individuals) who essentially so dominate, through ownership or otherwise, the actions of other persons that the controlled party is in effect the “alter ego” of the entity which acts to control that party’s actions even if their is no direct ownership involved. For example, in many cases, a parent company of a wholly owned subsidiary corporation can be found liable for the actions of its subsidiary under the doctrine of piercing the corporate veil. Why? Because usually the board of directors and managers of the subsidiary are generally not independent of the parent organization and act on its behalf according to directions and policies established by the parent company.
However, you can also establish liability by a separate entity with no direct ownership interest, if you can demonstrate that that entity exercised authority over the other to such an extent that the two are virtually indistinguishable. That was the argument made by plaintiffs in the Janus case. Both the Janus Manager and Big Janus, did not own shares in the Fund. However, through contracts established at the time Big Janus created the Fund, the Janus Manager had for all intents and purposes complete control over the Janus Fund’s day to day operations.
As the dissenting opinion of Justice Breyer pointed out:
Each of the Fund’s officers is a Janus Management employee. Janus Management, acting through those employees (and other of its employees), manages the purchase, sale, redemption, and distribution of the Fund’s investments. Janus Management prepares, modifies, and implements the Janus Fund’s long-term strategies. And Janus Management, acting through those employees,carries out the Fund’s daily activities.
Janus Manager was paid a significant management fee, which represented almost all of its profits, profits that were then transferred to Big Janus’ bottom line.
Furthermore, both Janus Manager and Big Janus had previously employed practices to time the market regarding the Janus Fund for their own gain and the gain of other investors, practices they did not disclose to the Fund’s shareholders.
Market timing activity within Janus funds was uncovered during Attorney General Spitzer’s investigation of Canary Capital Partners in the summer of 2003. Since that time, coordinated investigations by the regulators revealed that Janus entered into a series of agreements with select investors which permitted these preferred investors to engage in improper, frequent short-term trading of Janus mutual funds while diluting the returns of other fund shareholders. Attorney General Salazar began his own inquiry of market timing abuses at Janus in October.
The agreements Janus made with timers were not disclosed to long term investors. On the contrary, statements contained in prospectuses sent to investors stated that “the Funds are not intended for market timing or excessive trading,” and outlined a series of measures to “deter these [market timing] activities.”
In effect, Big Janus used its knowledge of and control over the Janus Manager and Janus Fund to time the market and make profits from its advance knowledge for itself and its “friends.” As a result a case was brought by New York Attorney General’s Eliot Spitzer against Big Janus and Janus Manager (later joined by then Colorado AG Ken Salazar) for this market timing scheme in 2003. In 2004, Janus settled that lawsuit by agreeing to pay the following:
New York Attorney General Spitzer and Colorado Attorney General Ken Salazar today announced a $225 million settlement with Janus Capital Management, LLC (Janus) to resolve allegations that it permitted excessive market timing activity in a number of its mutual funds, including those trading in international and foreign securities. The agreement was reached in cooperation with the Securities and Exchange Commission and the Colorado Division of Securities…
Janus, a mutual fund adviser headquartered in Denver, Colorado is the ninth largest mutual fund company in the nation.
Under terms of the settlement, Janus has agreed to pay $50 million in restitution and disgorgement to injured investors, $50 million in civil penalties, and $125 million in a reduction of fees charged to investors over a five-year period. In addition, Janus has agreed to pay $1 million to be held in trust by the Colorado Attorney General to be used for consumer and investor education and future enforcement activities.
As a result of these lies and fraudulent statements in the Janus Fund’s prospectuses, and the settlement of the market timing cases, shares of Big Janus declined approximately 25%.
First Derivative Traders filed a class action on behalf of all shareholders who in 2003 owned shares in Big Janus. The Janus case plaintiffs alleged that the false statements in the Janus Fund prospectuses that the funds would not be used for any market timing or excessive trading schemes misled investors and directly caused the stock of Big Janus shares to fall, once the market timing complaint by Spitzer was made public. This share devaluation of Big Janus occurred because many fund investors withdrew their money from the Janus Funds after learning they had been the victims of a Big Janus’ market timing scheme.
This class action lawsuit was dismissed by the US District Court, but was reinstated by the Fourth Circuit Court of Appeals, who stated in their opinion that (per Justice Thomas’ SCOTUS opinion):
… First Derivative had sufficiently alleged that “[Big Janus] and [Janus Administrator], by participating in the writing and dissemination of the prospectuses, made the misleading statements contained in the documents.” In re Mutual Funds Inv. Litigation, 566 F. 3d 111, 121 (2009) (emphasis in original). With respect to the element of reliance, the court found that investors would infer that JCM “played a role in preparing or approving the content of the Janus fund prospectuses,” id., at 127, but that investors would not infer the same about JCG, which could be liable only as a “control person” of JCMunder §20(a). Id., at 128, 129–130.
Well, as we all know, Justice Thomas and the other four conservative members of the Court essentially ignored the wrongdoing by Big Janus and Janus Administrator in preparing the misleading Janus Fund prospectuses. Ignoring the evidence of wrongdoing, the SCOTUS majority hung their hat on the fact that the “corporate formalities were observed” and so despite any “alleged” control of the Janus Fund by Big Janus and Janus Administrator, since they didn’t sign the prospectuses, they couldn’t be held liable for the false statements they caused to be placed there.
What corporate formalities were observed you might ask? Well, Justice Thomas relied on the fact that only one if the trustees of the Janus Fund was also “associated” with Janus Administrator. On that basis, he and his four conservative brethren determined that there was no need to hold a factual hearing on the amount of control exerted by Janus Manager and Big Janus over the Janus Fund.
In effect, the majority in the Janus Case decided to ignore the past wrongdoing of Big Janus and Janus Manager and the managers they put in place to control the Janus Fund. They used their knowledge and control to manipulate the market and exploit the Janus Fund for their benefit and the benefit of others. The majority also ignored the allegations of actual control by Janus Manager and Big Janus, ignored the allegation that they had prepared the misleading language in the prospectuses (while more or less accepting that they were in all likelihood responsible for preparing the false statements), and did not allow the plaintiffs to show at trial that Janus Fund was a mere shell used and plundered by Big Janus as it saw fit.
The Thomas majority, in coming to its ridiculous decision, reads the statute and Rule as narrowly as possible to say that only the entity that actually signs the prospectus is the speaker or “maker” of the false statements. Anyone who “assists” the ultimate signer of the prospectus, even if that person wrote the entire fraudulent document, cannot be held not liable under these circumstances. Justice Thomas said that unless the false statements in the fund prospectuses were directly attributable to the Janus Manager in the language of each prospectus, no suit could be filed against the two Janus companies that assuredly controlled the Janus Fund (as evidenced by the market timing scheme they perpetrated).
In essence, the Thomas majority played word games over who actually “made” the false statements in the Janice Fund prospectuses as opposed to who “created” them. Furthermore, they determined, without any evidentiary hearing, that the Janus Fund was an entity independent as a matter of law from the corporations, Janus Manager and Big Janus, even though, as the dissent rightly points out they actually made all the decisions.
The Thomas opinion in the Janus Case effectively eviscerates the holdings of a myriad of prior federal cases where controlling persons could be held liable for Rule 10b-5 false statements of entities they dominated if sufficient facts could be established to show that the subordinate entity was indistinguishable from the person or company who exercised all the control over the subordinate’s actions.
As the dissent by Justice Breyer states, the majority simply ignored the plain language of the rule which clearly states that it applies to any statement made by any person “directly or indirectly” in a prospectus:
[T]he majority has incorrectly interpreted the Rule’s word “make.” Neither common English nor this Court’s earlier cases limit the scope of that word to those with “ultimate authority” over a statement’s content. To the contrary, both language and case law indicate that, depending upon the circumstances, a management company, a board of trustees, individual company officers, or others, separately or together, might “make”statements contained in a firm’s prospectus—even if aboard of directors has ultimate content-related responsibility. And the circumstances here are such that a court could find that Janus Management made the statements in question. […]
The majority finds the complaint fatally flawed, however, because (1) Rule 10b–5 says that no “person”shall “directly or indirectly . . . make any untrue statement of a material fact,” (2) the statements at issue appeared in the Janus Fund’s prospectuses, and (3) only “the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it”can “make” a false statement. […]
But where can the majority find legal support for the rule that it enunciates? The English language does not impose upon the word “make” boundaries of the kind the majority finds determinative. […]
[T]he present case is about primary liability—about individuals who allegedly themselves “make” materially false statements, not about those who help others to do so. The question is whether Janus Management is primarily liable for violating the Act, not whether it simply helped others violate the Act. […]
The possibility of guilty management and innocent board is the 13th stroke of the new rule’s clock. What is to happen when guilty management writes a prospectus (for the board) containing materially false statements and fools both board and public into believing they are true? Apparently under the majority’s rule, in such circumstances no one could be found to have “ma[d]e” a materially false statement—even though under the common law the managers would likely have been guilty or liable (in analogous circumstances) for doing so as principals (and not as aiders and abettors).
Indeed, under the majority’s rule it seems unlikely that the SEC itself in such circumstances could exercise the authority Congress has granted it to pursue primary violators who “make” false statements or the authority that Congress has specifically provided to prosecute aiders and abettors to securities violations.
So, a terribly reasoned decision that benefits Wall Street, but hurts everyone else, whether they are large institutional investors or people who merely own a few mutual funds in the retirement plans or IRAs. What consequences are likely to result from this travesty of Justice?
No Viable State Remedies for Defrauded Mutual Fund Investors
Plaintiffs seeking relief for misleading or false statements in federal disclosure documents used to be able to pursue their claims in state court. Unfortunately, in 1998, Congress passed a law, the Securities Litigation Uniform Standards Act (“SLUSA”), that severely limited the right to bring a class action in state court to recover damages for securities fraud. From the Amicus brief filed in the Janus Case by AARP and the North American Securities Administrators Association, Inc. (“NASAA”):
Securities fraud litigation initiated by private parties is an essential means of enforcing the securities laws and protecting the integrity of the securities markets for investors and maintaining investor confidence in the markets. The limited resources of the Securities and Exchange Commission are selectively employed and are seldom directed at making securities fraud victims whole. Nowhere is this dynamic more pronounced and more important than in the mutual fund arena. […]
In this case, state law offers limited recourse for investors in the Respondent’s position. Congress has expressly limited the use of class action suits seeking recovery for securities fraud under state law. In 1998, Congress enacted the Securities Litigation Uniform Standards Act (“SLUSA”) to address the concern that “securities class action lawsuits [had] shifted from Federal to state courts” as a means of circumventing the Reform Act. See 15 U.S.C.A. § 78a (findings set forth in Pub. L. 105-353, § 2, Nov. 3, 1998). With certain exceptions, SLUSA provides that no class action based upon state law may be maintained in any state court on behalf of more than 50 class members.
Know of any mutual funds with only 50 investors? Me neither. SLUSA effectively guts small investors from large class actions against Wall Street Firms in state court. Now, The Janus case effectively limits the ability of those small investors to seek recovery from the administrators of mutual funds and their parent companies (i.e., the entities with the money) so long as the funds themselves share no more than one director with fund administrators. So that door is locked as well. Worse yet, most states have ignored civil remedies for securities fraud, relying upon the federal securities laws to provide investors with recourse to the courts. Few states have any laws that provide the type of protection that the federal laws do. Mutual Funds just became a whole lot riskier.
Janus Case Fosters Securities Fraud
The majority’s opinion in the Janus case reads like a blueprint on how to get away with the perfect crime. It lays out all the steps Wall Street firms need to take to insure that no lawsuit for false information can ever be brought by mutual fund investors against them. As long as they structure their funds to be held by a trust with no more than one insider on the Board of Trustees, and abide by all the formal legal niceties (hold regular board meetings of the trust, document the minutes, etc.) they are insulated from private liability even if they lie their asses off in the mutual fund prospectuses.
The Janus Case allows the managers in charge of mutual funds to get away with anything they want. Churn the accounts? No problem. Use information you as the fund manager are privy to time the market? Feel free. Say anything in the fund’s prospectus, no matter how false or misleading? As long as you aren’t the entity technically responsible for signing that disclosure document, you only need to worry about the SEC. And as noted by many observers, the SEC can only catch so many grifters. Even when it does,the SEC can only fine them for violations — it can’t recover all the losses by those investors, losses that usually far exceed the fines levied.
Of course, that assumes that the Janus Case opinion doesn’t apply to the SEC, an assumption that Justice Breyer (and I) can not with certainty make. The Janus decision is a loophole that will permit a massive wave of fraudulent practices to occur. I doubt its restrictive and arbitrary reasoning in favor of Wall Street forms will be reserved only for cases in which false or fraudulent information is contained in prospectuses. The conservative majority on SCOTUS is sending a clear message to Wall Street that regardless of the laws and regulations, we will find a way for you to avoid liability for your misdeeds.
Janus Case Will Harm Confidence in the Integrity of the US Markets
Let me again refer to the Amicus brief by the AARP and the NASAA to make the point that the destruction of private enforcement mechanisms of our securities laws the Janus Case permits will destroy investor confidence in our markets, particularly among those who hold mutual funds:
[E]specially important in our current financial downturn, private securities litigation performs a significant role in maintaining investor confidence by enforcing the mandatory disclosure system. As this Court recently noted, “The magnitude of the federal interest in protecting the integrity and efficient operation of the market for nationally traded securities cannot be overstated.” Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. 71, 78 (2006). Investor confidence in the integrity of the securities markets is crucial to helping businesses raise the capital they need to
expand and keep the lights on. See Basic v. Levinson, 485 U.S. 224, 235 n.12 (1988). If investors are prevented from holding corporate actors accountable for their frauds, investors will be far less willing to participate in our securities markets. See Hearings, supra, at 145.Investor confidence takes on particular importance in the mutual fund industry. Speaking of the market timing allegations at the core of this case, an industry analyst stated that “[i]f these charges are proven true, there has been a breach of law that cuts close to the heart of what protects all mutual-fund shareholders.” BUSINESSWEEK, supra (quoting Russel Kinnel, Director of Fund Analysis, Morningstar). “One of the reasons that funds are so popular is the perception that they’re very ethical – they supposedly treat the little guy like the big guy. But clearly, they haven’t done that here.” Id. (quoting Russel Kinnel, Director of Fund Analysis at Morningstar). Adds a hedge fund manager, “Hardly anyone has a clue about all the games mutual funds play.” The exodus of investors from the Janus Funds upon learning of the secret market timing deals speaks volumes.
Hardly anyone has a clue about all the games mutual funds play. That statement speaks volumes, and you can bet that after the Janus case, we will have even less opportunity to know. If the “safest investment” the US stock market supposedly offers is rife with manipulation and fraud, and investors have no way to seek remedies for their losses when fraud is discovered, what will happen? We’re about to find out.
