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SEC Urges Supreme Court to Hold that Investment Adviser Could Be Liable for Misstatements in the Prospectuses of Funds It Manages

By Jim Hamilton

An investment adviser to a family of funds could be primarily liable for alleged misleading statements in the funds? prospectuses, maintained an SEC amicus brief to the Supreme Court, 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 mis­statements contained therein. Unlike a typical second­ary actor such as a lawyer or accountant, reasoned the SEC, an investment adviser?s unique and close relationship with a mutual fund makes it essentially a corporate insider. The adviser was no run-of-the-­mill outside service provider to the funds, but rather a manager of the funds. Oral argument is set for December 7, 2010 and the government has asked for permission to participate in it. Janus Capital Group, Inc. v. First Derivatives Traders, US Supreme Court, Docket No. 09-525.

The Supreme Court agreed to review a Fourth Circuit panel ruling that fund shareholders adequately alleged that the investment adviser made misleading statements, and that the statements at issue were properly attributable to the adviser. Specifically, the shareholders alleged that the prospec­tuses of several of the funds created the mis­leading 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. The term ?market timing? refers to ?the practice of rapidly trading in and out of a mutual fund to take advantage of inefficiencies in the way the fund values its shares, which could potentially harm other fund investors by diluting the value of shares, increasing transaction costs, reducing investment opportunities for the fund, and producing negative tax consequences.

This was a securities fraud-on-the-market action in which the appeals panel held that the attribution element of the reliance inquiry could be established by proving that interested inves­tors would attribute the allegedly misleading statement to the adviser and that the shareholders satisfied that requirement by alleging that the adviser is responsible for day-to-day management and, as a practical matter, runs each of the funds, allowing investors to infer that the adviser played a role in preparing or approving the content of the fund prospectuses.

Urging the Supreme Court to affirm the panel?s ruling, the Commission said that under its reading of Rule 10b-5 the adviser wrote and represented and therefore made misleading statements in the funds? prospectuses. An investment adviser?s managerial role makes it essentially a corporate insider, said the SEC, and distinguishes it from a true secondary actor like an accountant, lawyer, or bank. Thus, the adviser can be held liable for its own state­ments to the market made directly or indirectly through the prospectuses of the Funds over which it exercised managerial control.

The SEC contended that the attribution requirement urged by the shareholders would have the per­verse effect of insulating a defendant from suit precisely because it was successful in concealing its identity as the maker of false statements. Further, the SEC asserted that the earlier Supreme Court ruling in Stoneridge does not suggest that attribution is a pre­requisite for the fraud-on-the-market presumption.

Even if the reliance element of a Rule 10b-5 action required contemporaneous public identifi­cation of the person who made a statement, continued the SEC, express attribution should not be required when the statement?s actual maker is so closely tied to the entity in whose name the statement is made that reasonable investors would have inferred the actual maker?s responsibility. In light of the close relationship between investment advisers and their mutual funds, investors would natu­rally infer that statements in a fund?s prospectus bear the imprimatur of the fund?s adviser. Requiring such statements to be formally attributed to the investment adviser, reasoned the SEC, would al­low advisers to avoid Section 10(b) liability simply by declining to state explicitly what the investing public already knows.

Even if the investment adviser is considered a secondary actor, posited the SEC, it would not be immune from liability here since even after the Court?s Stoneridge ruling the im­plied right of action under Rule 10b-5 continues to cover second­ary actors who commit primary violations. The allegations adequately state a claim of pri­mary liability based on the adviser?s own misrepresentations, and not a secondary-liability claim that the adviser merely aided a fraud spearheaded by the funds.

The adviser is alleged to have performed the insider func­tions that corporate officers would ordi­narily perform, noted the SEC, and not the advisory role typically associated with outside service providers. If the adviser created state­ments for the prospectuses that misled investors about how the funds combated market timing, said the SEC, it can be held liable for its own statements to the market. Courts have recognized in the context of conduits and publicly unidentified corporate employ­ees that such cases involve primary liability, not aiding-and­-abetting liability, because the defendant is being held liable for its own conduct and not for merely assisting someone else.

With regard to satisfying the reliance element of Rule 10b-5, the SEC said that reliance can be established through the fraud on the market presumption without showing that the relevant false statements were attributed to the defendant at the time they were made. But even if proof of attribution were necessary to establish reliance, continued the Commission, the allegations would be sufficient since the market would reasonably attribute statements about market timing in the funds? prospectuses to the adviser in light of its role as the funds? day-to-day manager.

Full post as published by Jim Hamilton's World of Securities Regulation on November 05, 2010 (boomark / email).