In Janus Capital Group, Inc. v. First Derivative Traders, Inc., a case decided one year ago this month, the Supreme Court hampered the Securities and Exchange Commission (SEC) in its efforts to combat fraud, by deciding that white-collar criminals could devise complex structures of shell corporations to avoid accountability. The decision – part of a growing trend of corporation-friendly 5-4 rulings engineered by the conservative wing of the Court – was ostensibly intended to create a bright-line rule that would clarify the application of important corporate accountability regulations, but has instead confused and divided lower courts and stifled the effectiveness of those checks on corporate practices. This confusion makes it more likely that the issue decided in Janus could end up back before the Supreme Court one day soon. In the meantime, Congress or the SEC can act to repair the damage done to corporate accountability mechanisms by Janus.
According to its drafters, the story behind SEC Rule 10b-5 began with an anecdote that circulated around SEC offices in 1942. A wealthy Boston banker had made a fortune by fleecing his investors, telling them (falsely) that the bank was in dire trouble, purchasing their stock at a sharp discount, and reaping huge profits when, in fact, the bank’s stock quadrupled in value soon thereafter. At the time, the SEC had adopted rules penalizing fraud related to the sale of securities, but no rule existed to penalize securities purchasers who engaged in fraud. Rule 10b-5 changed that, authorizing the SEC, as well as the affected stockholders, to sue buyers or sellers who engaged in securities fraud. Since its adoption, Rule 10b-5 has been described as “the primary vehicle for class actions against public companies based upon allegations of false disclosure and the legal source for the prohibition of insider trading.” The Janus ruling, however, has brought the continued vitality of Rule 10b-5 into question.
The Janus case began with fraudulent allegations in a series of prospectus documents issued by Janus Capital Group (JCG) to its investors, including First Derivative Traders, Inc. (FDT). Specifically, JCG claimed in the prospectus documents that it did not participate in the controversial market manipulation practice known as “market timing.” When it was subsequently revealed that JCG had in fact been secretly engaging in marking timing for the benefit of a select group of well-connected hedge fund managers, its stock plummeted and shareholders, including FDT, lost a fortune.
JCG’s false claims were a clear violation of Rule 10b-5, and FDT, along with several other shareholders, decided to sue. In addition to JCG, they also sued Janus Capital Management (JMT), a JCG subsidiary that managed the mutual funds and to which JCG channeled the profit in the form of management fees. This meant that if FDT sued JCG alone, FDT would not be able to recover its lost profits because virtually all of JCG’s assets were funneled to JCM. This divided corporate structure is a common one for the management of mutual funds, and most view it as a formality alone. The same individuals who issue the mutual funds under the auspices of one corporate entity typically also manage them under another. The New York Times has called this structure “one of the great legal fictions of Wall Street” and “legal ventriloquism,” and has referred to asset-less entities like JCG as “dummy corporations.”
As it turns out, the mutual funds’ divided management structure ended up being the key to the case. The Court’s ruling stated that JMT could not be liable for the fraudulent prospectus statements, because it was technically the asset-less parent company, JCG, that issued them and bore ultimate responsibility for their contents. Therefore, the Court said, JMT did not “make” the fraudulent statements within the meaning of Rule 10b-5. It didn’t matter that JCG and JMT were directed by largely the same group of people, that the sole reason for JMT’s existence was to shield JCG’s assets from liability, or that, by exempting JMT from liability, the Court was effectively ensuring that that the people behind the Janus family of mutual funds would not have to compensate the investors they had defrauded. In short, the Court allowed JCM to manipulate the legal fictions of the corporate form in order to get away with fraud.
In the year since Janus was decided, lower courts have split on their application of its holding to other cases. Some lower courts have come down on the side of minimizing the impact of Janus, usually by finding ways to distinguish its facts from those of cases before them. For example, three months after Janus was decided, a federal district court in Alaska held that Janus’ limitation on liability couldn’t protect other corporate officers who had signed fraudulent SEC disclosure forms. Going even further, a federal district court in New York held that Janus did not prevent a parent company from being held liable under Rule 10b-5 for fraudulent statements issued by a subsidiary corporate entity, where the parent company owned the subsidiary and exercised a degree of control that ensured that the parent company had “control over the content of the message, the underlying subject matter of the message, and the ultimate decision of whether to communicate the message.”
On the other hand, some courts have taken up Janus’ invitation to isolate Rule 10b-5 liability to a single corporate entity. For example, in Hawaii Ironworkers Annuity Trust Fund v. Cole, a federal district court in Ohio took the Janus ruling and ran with it, holding that Janus not only limited Rule 10b-5 liability between corporate entities, but also within a single corporate entity, effectively adopting a “just following orders” defense to securities fraud. Perhaps most alarmingly, a district court in Nebraska has held that the Janus holding narrows the scope not only of private actions for securities fraud, but of SEC-initiated actions, as well. That interpretation ties the hands of watchdog agencies, going even further to ensure that white-collar criminals can avoid both public and private accountability for fraud. The district court’s reasoning runs counter to the reasoning of the Supreme Court in Janus, which was based in part on judicial restraint concerns about expanding the right of individuals to sue under Rule 10b-5, as had been implied by the courts.
During the year since Janus, legal scholars and Court watchers have reacted strongly to the decision. Scholars have commented on the irony that the “bright-line” rule announced in Janus – which was intended to clear up confusion about the application of Rule 10b-5 among the lower courts – has only added to the confusion. They have also noted that the different applications of Janus have created divided authority, with courts of some circuits reading Janus broadly and others reading it narrowly. This creates a risk that corporate defendants will attempt to engage in “forum shopping,” the practice of manipulating procedural technicalities to get cases moved to jurisdictions with law that is more favorable to them.
In the meantime, scholars have also noted ways that Congress and even the SEC itself can limit, or altogether eliminate, the impact of the Janus ruling. For example, the SEC could promulgate new regulations requiring investment advisors, such as the executives at JCM, to sign statements issued by the funds, thus becoming “makers” of the statements within the meaning of Rule 10b-5. The SEC could even just tweak the language of Rule 10b-5, such as by replacing the word “make” with “create.”
It is easy to get lost in the technical complexity of cases like Janus. It is also easy to dismiss the case as insignificant because it seems to affect such a small group of litigants: private plaintiffs filing fraud claims under Rule 10b-5 (although, as we have seen, lower courts have not always confined the holding in this way). But it is important to keep in mind that this case is representative of a larger pattern of corporation-friendly rulings from the conservative wing of the Court.
The ostensible concerns that underlie the majority’s reasoning in Janus—judicial restraint and establishing a clearly defined rule regarding the reach of Rule 10b-5 liability—have been poorly served by the ruling itself, which has only further muddled the judicial understanding of Rule 10b-5 and, on some courts, has set off a fresh wave of conservative judicial activism. Should the issue appear back before the Court, as some scholars believe it is likely to, unwillingness to reconsider its holding would be a sure signal that the Court is interested primarily in stifling the effectiveness of important regulatory checks on fraud, ensuring that white-collar criminals have the opportunity to manipulate the legal fictions of the corporate form to shield their malfeasance from the reach of both federal regulators and their own shareholders.