The oral argument before the US Supreme Court in a case involving the attribution to a fund manager of allegedly fraudulent statements in the fund’s prospectus intensively explored the relationship between a fund and the investment adviser that created it. The Supreme Court is reviewing a Fourth Circuit panel ruling that fund shareholders in a family of funds adequately alleged under Rule 10b-5 that the fund’s investment adviser made misleading statements and that the statements at issue were properly attributable to the adviser. Specifically, the shareholders alleged that the prospec¬tuses of several of the funds created the mis¬leading impression that the adviser would implement measures to curb market timing in the funds when in fact secret arrangements with several hedge funds permitted market timing transactions. Janus Capital Group, Inc. v. First Derivatives Traders, US Supreme Court, Docket No. 09-525.
The Solicitor General and the SEC filed an amicus brief contending that an investment adviser to a family of funds could be primarily liable for alleged misleading statements in the funds’ prospectuses, since an investment adviser exercising day-to-day management over a mutual fund cannot be considered a secondary actor for Rule 10b-5 purposes like an accountant or attorney could be. Thus, the investment adviser’s alleged role in the drafting of the funds’ prospectuses was a sufficient basis for concluding that it made the alleged mis¬statements contained therein.
At oral argument, Curtis Gannon of the Solicitor General’s office said that the SEC’s position is that somebody who makes a statement, if they write the statement or provide the false information that is used to construct the statement or allows the statement to be attributed to them can be primarily liable, and the government thinks that that is a reasonable construction of the term "make," because the statute and the rule both apply to persons who make the statement directly or indirectly. And, so, they could be using a conduit, whether the conduit is witting or unwitting, and would be a primary violator if they had. In addition, he acknowledge that somebody needs to be sufficiently involved in the creation or dissemination of the statement in order to be deemed its maker or its author.
Seizing on the phrase "sufficiently involved," Justice Breyer said that it takes us back to what is sufficient to make the person the principal rather than the aider and the abettor, and apparently creating or writing the statement is not clear whether it is or is not sufficient.
Mr. Gannon said that in this instance there is no doubt that the manager of the funds was not a mere advisor. The truth is that reasonable investors, and that's the test for purposes of reliance, can rely on anonymous and falsely attributed statements. In this instance there is no reason to doubt that an investor would have relied on statements in the prospectus about the fund's purported anti-market timing and excessive trading policies.
Justice Kagan asked counsel to suppose that the Court thinks that the SEC’s test is ``pretty broad’’ and that it might apply to a range of factual situations that are not before the Court. The Justice asked if there was a way the Court could confine its holding just to the mutual fund situation, and if there is, how would you do that. Mr. Gannon replied that the easiest way would be to analogize it to the cases involving corporate employees. There are cases where a corporate employee drafts a statement that's issued in the company's name. In the instant case, the investment advisor is management for the company, and the fact that they happen to be management by virtue of contract rather than just the internal arrangements of the corporation shouldn't change that arrangement. It is also the case that if the Court were looking for a way to narrow its holding it could do so by talking about the elements of the Rule 10b-5 cause of action, said counsel, which would apply only to private suits and not to enforcement actions brought by the SEC or the Department of Justice.
Mark Perry, arguing for the fund manager, said that the statements in the prospectus should be attributed to the fund, which had its own trustees who were in charge. There is no misdirection here about who is in charge, he said, the trustees are in charge. But Justice Ginsburg pointed out that the whole arrangement was made possible by the investment adviser, which wants long-term investors so it put this provision in the prospectus. The board of directors had no reason to believe that the fund manager was dissembling and was going to go out and seek hedge funds. Mr. Perry replied that if it is a dupe case, it's dealt with by Exchange Act section 20(b).
He cautioned that affirming the Fourth Circuit ruling would authorize private securities fraud class actions against every service provider that participates in the drafting of a public company's prospectus and would constitute a frontal assault on the Court's decisions in Central Bank and Stoneridge, where the Court held that service providers may not be sued primarily in private class actions and left that matter for Congress to resolve. In the Private Securities Litigation Reform Act, Congress authorized an SEC enforcement action only against aiders and abettors, leaving the question of private class actions for the Court's resolution.
This is an area that needs bright lines, said Mr. Perry, it needs to be resolved on motions to dismiss. And Congress, in the Dodd-Frank Act,referred this issue to the General Accounting Office, to the Controller General, and said take a year and study the problem of the distinction between companies that issue securities on the one hand and those who provide services on the other hand, like the advisor here, and come back to the Congress and tell us whether we need to solve the problem.
In colloquys with Justice Kagan and Justice Ginsburg, counsel for the fund manager acknowledged that the statements in the prospectus were drafted by lawyers paid by the manager. So Justice Kagan concluded that, while they were ostensibly working for the fund at the time of the drafting, the statements in the prospectus were written by the adviser’s lawyers. But counsel contended that the draft materials become the client's statement when adopted by the client. The board of trustees of the funds has to review every policy and is responsible for every policy drafted. Counsel said that the SEC has specifically recognized in the context of investment companies that where an adviser counsel is representing the Funds, his or her client for those purposes, is the funds. And here, these lawyers are very careful to separate who their clients are for various purposes.
Counsel said to Justice Kennedy that when the statement is adopted by the issuer it becomes the issuer's statement. Only an issuer can make the statement. While noting that the statement is not publicly attributable to the adviser, Justice Kennedy noted that an alternate theory would be that the adviser is really the day-to-day manager in day-to-day active control of the Fund, and therefore, it should be chargeable as if it and the fund are the same for purposes of making the statement.
Justice Scalia said that the representation was made in the prospectus issued by the fund, not by the adviser. While the fund may have a cause of action against the fund manager, he continued, what is crucial in this case is whether the investor can establish that it is fund manager who made the representation to the public, and the Justice did not ``see how you can get there.’’ You might proceed under the control person provision, he offered, but not by saying that they made the representation.
David Frederick, counsel for the investors, responded that the adviser wrote the prospectus and created the fund. That is how mutual funds work, said Mr. Frederick, managers create them, they lure investors to them, and they get money by having a percentage of assets under management. Chief Justice Roberts noted that the SEC has recognized that the fund and its manager remain two separate entities, despite the interconnected relationship. Conceding that the SEC has so recognized them as separate entities, Mr. Frederick said that federal courts have recognized that a company can outsource its management function and those outsourced managers can make misstatements on behalf of the company. But the Chief Justice countered that the one activity that we know the funds did not outsource was review of the prospectus materials submitted by the fund manager. The fund trustees had independent counsel who conducted a review of the materials.
The Chief Justice then queried if it would have been a breach of the fund trustees' fiduciary obligations to the fund investors under common law to rubberstamp what they get from somebody on the outside, not to have independent counsel review what they're going to say in their prospectus. Mr. Frederick said that this is a very difficult question under fiduciary duty law, because here, the fiduciaries have been duped themselves. When they got the wording of the prospectus and the policy that the adviser was purporting to implement, the adviser did not tell the fund board that there were 12 secret deals with hedge funds which were going to make money by attracting long-term investors and make money with short-term market climbers.
Justice Scalia asked how counsel could say that the fund did not have control when it could have stopped the alleged misstatement from being placed in its prospectus and had outside lawyers who advised it whether it should allow this statement to be included in its prospectus. Counsel replied that the fund board did not have knowledge of the falsity.
That may mean that they were duped, said Justice Scalia, but it doesn't mean that they did not have control. They had control, he emphasized, being duped is quite a different theory from saying that they had control. Counsel said that the fund board did not have substantive control over the content of the message, because if they did, they would not have allowed the false statements to have been issued. And that's the whole point, said counsel for the investors, that's the theory here, that the adviser was luring long-term investors with the promise, if you park your money with the Janus Funds, it will be safe from market timing problems. They were then secretly going out and luring money from the hedge funds.
Justice Kennedy noted that there was nothing to indicate that that statement was attributed to the adviser. To which counsel responded that the public understood it that way. You can play with the words, "make" as you choose, said Justice Kennedy, but there is nothing in the record that would justify an assumption that t was attributed to the adviser.
Justice Kagan noted that a substantial part of the power of counsel for the investor’s argument comes from the notion that the fund manager was in the driver's seat and controlled the fund, that the fund was at most an alter ego of the adviser and maybe something more, that it was just a creature of the adviser. But the securities legislation seems to deal with that in section 20, she noted, and the case was not brought under section 20, and because of the relationship between mutual funds and their investment advisors, presumably could not be brought under section 20.
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