Janus Capital Group v. First Derivative Traders: Only the Supreme Court can “Make” a Tree

The Supreme Court decision in Janus Capital Group v. First Derivative Traders is one of those cases that takes your breath away. The case astonishingly holds that an investment advisor is not liable for fraud in the prospectus of a sponsored mutual fund because the investment advisor is not the “maker” of those statements – even though the fund’s officers are all employees of the advisor (and paid for that service by the advisor) and the advisor prepares, files, and distributes the prospectus. Nevertheless, says the Supreme Court majority, the advisor did not “make” the fraudulent statement, because the fund, a legally separate entity, had “ultimate authority over the statement, including its content and whether and how to communicate it.”

Okay, we get that the Supreme Court is hostile to the implied private right of action under Rule 10b-5 yet seems to regard its existence as a “super-precedent.” But Janus Capital Group does real damage. First, the Court seems willfully to deny what it should have learned about the functioning of mutual funds in last term’s advisory fee case, Jones v. Harris Associates. A mutual fund is hardly a free-standing entity bargaining at arm’s length with a supplier of advisory services, notwithstanding the “independence” of the fund’s directors. At a time when an increasingly large share of investment activity occurs through large pools of capital, the decision exacerbates the problem of “agency capitalism” – the tendency of the managing agents to pursue their own objectives at the expense of the ultimate beneficiaries. Why strain to find ways to insulate wrong-doers from accountability systems?

Second, one of the deep lessons of the 2000s, beginning with Enron and culminating with the financial crisis, is that purported gatekeepers to the financial system – accountants, lawyers, credit rating agencies, underwriters – often pursued their immediate economic interests at the expense of their critical gate-keeping function. Why encourage the creation of formal boundaries and the reallocation of “ultimate authority” so as to shift responsibility and accountability from actual wrong-doers?

Some commentators on Janus have praised the decision for “clarity” it brings to the issues of agent liability. Are they serious? If an attorney inadvertently announces to his Twitter followers that he has falsified risk factors in an IPO prospectus, won’t some court strain to find liability under Rule 10b-5 even though the issuer has “ultimate authority” over the filing? Less dramatic hypotheticals also suggest themselves in which culpability is also clear and the case for sanction also strong.

Janus also opens the way to extensive litigation over the scope of “control person” liability under section 20(b) of the 1934 Act. Presumably the fund’s officers had knowledge of the fraud; shouldn’t knowledge of such agents be imputed to the fund, satisfying scienter, even though the board itself had no knowledge? On this analysis Janus, which has control (through the officer-employees) over the fund, the primary violator, is secondarily liable as a control person.

Hopefully the case will trigger another round of SEC rule-making in the mutual fund governance area to address the policy implications that seemed to escape the Court’s attentions. My colleague Jack Coffee is formulating a proposal in which the investment advisor is required to join the fund on its filings, so that the advisor becomes a “maker” of the funds statements. One good formal turn deserves another.

One irony here is that the actual litigation is not a particularly appealing case for liability. The plaintiff was not a shareholder of the fund claiming damage from the fraud, but rather a shareholder in the investment advisor, asserting that as the fraud was uncovered, investors in the fund redeemed their shares, the pool of managed assets shrank, advisory fees declined, and thus the stock price of the investment advisor fell. The defendant had been given no opportunity to demonstrate other factors at work in the stock price. A Supreme Court concerned about the potential reach of an implied right of action could have disposed of the case on loss causation grounds long established in the Court’s prior cases without creating the collateral damage entailed by Janus Capital Group v. First Derivative Traders.