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U.S. Supreme Court to review an important securities case that may open the door to fraud suits against service providers

August 2010

Overview

The U.S. Supreme Court will hear a case that may expose service providers to lawsuits over alleged misstatements in securities prospectuses.  The decision's impact could extend beyond the investment management business to others who advise public companies concerning securities offering documents.  That group likely would include accountants, attorneys, bankers, financial advisors and consultants.

Background

On June 28, 2010, the U.S. Supreme Court granted certiorari in Janus Capital Group Inc. v. First Derivative Traders, No. 09-525.  This case originated in the U.S. Court of Appeals for the 4th Circuit and raises important questions about the ability of plaintiffs to bring fraud lawsuits under federal securities law against service providers for statements made by their clients.

The petitioners are Janus Capital Group, Inc. (JCG), a publicly traded financial services company, and its subsidiary, Janus Capital Management, LLC (JCM), a registered investment advisor that advises the Janus Family of mutual funds.  The Janus Funds offer securities to the public via offering documents, are governed by an independent board of trustees, and are not controlled or owned by JCM or JCG.

First Derivative Traders (FDT) is the court-appointed lead plaintiff and proposed representative of a class of persons who invested in the equity stock of JCG, but not in the Janus Funds themselves.  The principal allegation is that the price of JCG's stock was artificially inflated as a result of misleading statements in the Janus Funds' prospectuses.  Specifically, the statements being challenged relate to the policies for discouraging and deterring "market timing."  FDT claims that these statements were misleading because JCM did allow discretionary frequent trading by a small number of investors.

The district court dismissed the complaint on the grounds that JCG did not make the statements in the Janus Funds' prospectuses, and, regardless of whether the statements were made, JCM cannot be liable to JCG shareholders who did not invest in the Janus Funds.  The 4th Circuit reversed, and recognized that the critical issue was whether FDT had adequately pled reliance on the alleged statements – an essential element of a private class action under the Securities and Exchange Commission's Rule 10b-5.

Questions presented to the Supreme Court

JCG and JCM raised two issues in their petition to the Supreme Court for writ of certiorari, wherein they argue that the 4th Circuit's decision created or intensified conflicts among the circuits.  First, in holding that a service provider "made the misleading statements" contained in the prospectuses of a different company "by participating in the writing and dissemination of those prospectuses," the 4th Circuit contravened the high court's holdings in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct 761 (2008) and Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. 511 U.S 164 (1994).  In those cases, the Supreme Court held that Rule 10-b5 does not authorize a private right of action for aiding and abetting securities fraud.  The 4th Circuit also split with several circuits that have rejected liability against service providers for participating in other companies' misstatements.  Second, in finding that a service provider can be held liable for a statement in another company's prospectus "even if the statement on its face is not directly attributed" to the service provider, the 4th Circuit inflamed an existing circuit conflict on whether a statement must be directly attributed to a nonspeaking defendant (such as a service provider to the issuer) in order for private liability to attach.

The questions presented by the petition for certiorari are: (i) whether the 4th Circuit erred in concluding  that a service provider can be held primarily liable in a private securities-fraud action for "helping" or "participating in" another company's misstatements and (ii) whether the 4th Circuit erred in concluding that a service provider can be held primarily liable in a private securities-fraud action for statements that were not directly and contemporaneously attributed to the service provider.

It is anticipated that the Supreme Court will clarify the distinction between "primary" and "secondary" liability in such private class actions, and this will be of interest to accountants, attorneys, bankers, consultants, financial advisors and others who provide services to public companies, as well as the public companies themselves.  This is the result of a provision contained in Rule 10-b5 that costs incurred by professionals, because of litigation, may be passed on to their client companies, who in turn may pass those costs on to investors.  See Central Bank at 511 U.S. 189.

Conclusion

If the 4th Circuit's decision is affirmed, investment advisors could face additional lawsuits alleging misstatements in the prospectuses (and other offering documents) of the mutual funds they advise.  With more than 7,600 American mutual funds managing in excess of $10 trillion in assets, the importance of this case and the issues it raises are critical to a spectrum of service providers.

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