Yesterday, in a 5-4 split decision, the United States Supreme Court ruled that for purposes of SEC Rule 10b-5, a mutual fund investment advisor cannot be held liable for material misstatements in its client’s prospectus because those statements are ultimately controlled by the client.  Janus Capital Group, Inc. v. First Derivative Traders, No. 09-525, slip op. (U.S. June 13, 2011).  Under Rule 10b-5, it is unlawful for “any person, directly or indirectly, …[t]o make any untrue statement of a material fact” in connection with the sale or purchase of securities.  17 C.F.R. § 240.10b-5 (2010). 

Justice Thomas, writing for the majority, began the opinion by interpreting “to make”:

[f]or purposes of Rule 10b-5, the maker of the statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.  Without control, a person or entity can merely suggest what to say, not “make” a statement in its own right.  One who prepares or publishes a statement on behalf of another is not its maker. 

Slip op. at 6. 

The Court rejected the argument that in light of the “‘well-recognized and uniquely close relationship between a mutual fund and its investment adviser,’” the adviser “should generally be understood to be the ‘maker’ of statements by its client mutual fund.”  Slip op. at 9.  The Court noted that its ruling followed from its earlier holding in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 180 (1994), where the Court held that Rule 10b-5’s private right of action does not include suits against aiders and abettors who contribute “substantial assistance” to the making of a statement.  Slip op. at 7. 

The plaintiffs, shareholders of Janus Capital Group (JCG), brought securities fraud claims against Janus Investment Fund’s investment advisor, Janus Capital Management (JCM), and also JCG.  The JCG shareholders contended that the Fund’s disclosure documents misrepresented that JCG and JCM would implement policies to curb strategies based on delays in fund valuations.  The plaintiffs alleged that in 2003, when the market learned that the Fund permitted “market timing,” after JCG was sued by New York’s Attorney General, investors withdrew their money from the Fund to the detriment of JCG’s stock price.  Importantly, the complaint did not allege that JCG or JCM issued the inaccurate prospectuses.     

Justice Breyer, in his dissent, worries that the new rule creates a gap in the law and may immunize “guilty management” from liability under Rule 10b-5: “Every day, hosts of corporate officials make statements with content that more senior officials or the board of directors have ‘ultimate authority’ to control.”  Slip op., dissent, at 3.  He asks, “what is to happen when guilty management writes a prospectus (for the board) containing materially false statements and fools both the 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….”  Slip op., dissent, at 9-10.

The court’s clarification of primary liability under the securities laws will potentially impact all investment advisers, lawyers, accountants, and others who help prepare financial disclosures for issuers but do not control the ultimate statement, and may impact other litigation brought under Rule 10b-5. 

On June 6, 2011, the U.S. Supreme Court held in Erica P. John Fund, Inc. v. Halliburton Co., 563 U.S. ____ (2011) that plaintiffs accusing Halliburton Co. of securities laws violations do not have to prove loss causation in order to obtain class certification.   

The Halliburton plaintiffs sought class certification for shareholders who allege that Halliburton made misrepresentations designed to inflate its stock price in violation of §10(b) and Rule 10b-5 of the Securities Exchange Act.  The 5th Circuit held that to satisfy Federal Rule of Civil Procedure 23(b)(3) (which requires plaintiffs to show that common questions of law or fact predominate before obtaining class certification), the plaintiffs must show reliance, which may be done through the fraud-on-the-market theory.  The fraud-on-the-market theory gives a rebuttable presumption of reliance to plaintiffs in securities fraud actions, based on the premise that investors rely on any misstatements in the marketplace at the time they buy or sell stock.

The Halliburton plaintiffs were denied class certification by the 5th Circuit, which held that plaintiffs had to prove loss causation to trigger the fraud on the market presumption.  This meant that the plaintiffs had to prove that a causal connection existed between a material misrepresentation made by defendant and the economic loss suffered by plaintiffs at the class certification stage.

A unanimous Supreme Court vacated the 5^th Circuit’s decision.  Loss causation, the Court ruled, is different from whether an investor relied on a misrepresentation when buying or selling a stock.  Loss causation requires a plaintiff to show that a misrepresentation that affected the integrity of the market price also caused a subsequent economic loss.  But whether economic loss is caused by a misrepresentation or other factors “has nothing to do with whether an investor relied on that misrepresentation in the first place, either directly or through fraud-on-the-market.”  Thus, the Court held that the Halliburton plaintiffs do not have to prove loss causation for class certification.

Writing for the Wall Street Journal blog, Nathan Koppel calls the decision a "big win" for those who bring shareholder class actions.  Without a doubt, the decision will have an impact on securities class actions currently working their way through the courts. 

In the securities enforcement world, it is widely understood that the Southern District of New York is the veritable home of securities fraud litigation.  Due in part to its proximity to Wall Street, the  Southern District’s jurisdiction is far-reaching, leading some to joke that the “Sovereign District” (as it is affectionately known by many) will take exclusive jurisdiction over securities fraud perpetrated anywhere within the sweeping shadow of the Manhattan skyline.

Enter: Neil H. MacBride, U.S. Attorney for the Eastern District of Virginia.  As Thomas Catan reported in the Wall Street Journal, this year MacBride unveiled a new Financial and Securities Fraud Task Force aimed at enhancing the Eastern District’s ability to prosecute major national securities fraud cases.  MacBride’s efforts signal to the Wall Street Journal’s Ashby Jones, among others, that the Eastern District is “making a bid to give the [Southern District] a run for its money.”  

But how do MacBride and the Eastern District plan to wrest securities matters from the Southern District?  According to MacBride, the answer lies in the Eastern District’s “unique venue options.”  On October 26th, at a program hosted by the American Bar Association White Collar Crime Committee, MacBride outlined four unique bases for jurisdiction in the Eastern District. 

The media darling:

1.  EDGAR.  This one has received a lot of media attention.  If your company makes mandatory filings to the SEC via EDGAR, it is amenable to jurisdiction in the Eastern District.  Earlier this year, McGuireWoods’ own Richard Cullen and Chuck McIntyre explained that “the Eastern District is able to claim jurisdiction over almost all securities fraud and other financial fraud cases involving public companies because the reports those companies are required to file with the SEC are sent to the EDGAR computer server located in Alexandria, Va.” 

Three new grounds:  

2.  TARP (Wire) Fraud.  If your company received funds from the Troubled Asset Relief Fund, it is amenable to jurisdiction in the Eastern District.  The Eastern District has jurisdiction over TARP-related fraud because TARP funds are wired from the Federal Reserve’s eastern regional clearing house, located in Richmond, Va.

3.  Recovery Act Fraud.  As with TARP fraud, American Recovery and Reinvestment Act of 2009 funds are wired from Virginia.  If your company received stimulus funds, it is amenable to jurisdiction in the Eastern District. 

4.  Home Mortgage Fraud.  Based in Fairfax County, Va., Freddie Mac and Fannie Mae are big players in the mortgage-backed securities market.  If your company purchased from, sold to, or otherwise works with Freddie Mac and Fannie Mae in the home mortgage market, it may be amenable to jurisdiction in the Eastern District.  Also, fraud related to mortgages registered with the Reston, Va. based Mortgage Electronic Registration System (“MERS”) – of “robo-signer” fame – present a separate basis for the Eastern District to take jurisdiction.

The bottom line:  MacBride’s four “unique venue options” give the Eastern District claim to a vast array of securities enforcement matters that surely rivals the Southern District.  If you’re used to securities fraud cases requiring frequent journeys through LaGuardia and Penn Station, you might want to check the schedule for roundtrips to Richmond International Airport or Reagan National.

Special thanks to McGuireWoods’ Toby Vick, who posted a useful blog related to the Fraud Task Force on Subject to Inquiry in May 2010. 

In 2002, Congress codified the statute of limitations for securities fraud actions for the first time.  As part of the Sarbanes-Oxley reforms, Congress declared that securities fraud claims “may be brought not later than the earlier of – (1) 2 years after the discovery of the facts constituting the violation; or (2) 5 years after such violation.” 

After nearly eight years of litigants fighting over the meaning of these words, the Supreme Court, on April 27, 2010, weighed in on the meaning of the phrase “after discovery of the facts constituting the violation” in Merck & Co. v. Reynolds.  The Court’s interpretation of the statutory language will have immediate practical implications for securities litigators.  Most notably, the common law concepts of “inquiry notice” and “storm warnings” are rendered obsolete for purposes of the statute of limitations analysis.  The cause of action accrues only “(1) when the plaintiff did in fact discover, or (2) when a reasonably diligent plaintiff would have discovered, ‘the facts constituting the violation’ – whichever comes first.”  Significantly, the Court also held that the “facts constituting the violation” include the fact of scienter. 

The Court’s opinion includes a number of key holdings for litigants in securities fraud actions:

• The Court rejected Merck’s argument that Sarbanes-Oxley does not require “discovery” of scienter-related facts, holding that scienter is “assuredly a ‘fact,’” and that scienter is an important and necessary element of a Section 10(b) claim.  This is arguably a game-changer: notice (actual or constructive) of facts showing a mere misstatement or omission will not start the running of the statute of limitations.
• The Court rejected Merck’s argument that facts that tend to show a materially false or misleading statement (or omission) are ordinarily sufficient to show scienter.  The Court held that facts constituting a misstatement or omission and facts constituting scienter will often be different.  Thus, the statute of limitations will not start running until actual or constructive knowledge of both is established.
• The Court held that “inquiry notice,” the concept that a statute of limitations begins to run when a reasonably diligent plaintiff learns of facts that would cause him or her to investigate further, finds no support in the statutory text.

Though only time will tell how the lower federal courts will interpret Merck, going forward, in securities fraud cases, it will no longer be sufficient for defense counsel to simply argue for the existence of “storm warnings” or to make common law-like “inquiry notice” arguments.  Instead, defense counsel will need to prove at what point a reasonably diligent plaintiff would have discovered “the facts constituting the violation” – including scienter.  In a Section 10(b) case, constructive knowledge of facts constituting a misstatement or omission, without more, may not be sufficient to begin the running of the statute.

What could this mean?  In many cases, the accrual date of the statute of limitations could be pushed out.  The days of merely arguing that a plaintiff could see the storm approaching and had a duty to investigate further are over.  On the other hand, the objective constructive fraud analysis could, in certain circumstances, be used by the defense bar to its advantage.  One thing is certain, when millions and sometimes billions of dollars are at stake, whether a plaintiff missed the deadline for filing will continue to be an important issue.