Supreme Court Limits Liability Of Mutual Fund Advisor For Fund Prospectus Misstatements

The Supreme Court continues to limit private rights of action under the Securities Exchange Act of 1934 (Exchange Act) Section 10(b) and Rule 10b-5. In Janus Capital Group, Inc. v. First Derivative Traders, a significant victory for mutual fund sponsors, the Court ruled that shareholders can seek Rule 10b-5 redress only against parties with "ultimate authority"1 over a statement in controversy. Although the Court's opinion intimates that fund advisors may be liable under other theories of liability, a legally separate advisor entity cannot be viewed as having "made" the false statements in the fund entity's prospectus and, therefore, cannot be held directly liable under Rule 10b-5 where the fund entity has the ultimate authority over the false statements. This is a bright line test that should limit mutual fund advisor liability in Rule 10b-5 private actions—but not necessarily actions by the Securities and Exchange Commission.

Background

Janus Capital Group, Inc. (JCG), a publicly traded company, wholly owns Janus Capital Management LLC (JCM), which serves as the investment advisor of mutual funds that were separate series of Janus Investment Fund, a Massachusetts business trust (Janus Funds). First Derivative Traders (First Derivative), representing a class of shareholders of JCG, claimed that false statements concerning the Janus Funds' policies prohibiting market timing in Janus Fund shares were made in the Janus Funds' prospectuses by JCM. Revelations arising from a September 2003 complaint filed by the New York State Attorney General against JCG and JCM indicated that market timing activities occurred in Janus Fund shares, causing Janus Fund investors to redeem a significant quantity of their fund shares. This redemption activity caused the mutual fund fees of JCM, which were a significant portion of JCG revenues, to decline, and thereby negatively affected the price of JCG stock held by the First Derivative class of shareholders.

Although JCG created the Janus Funds and JCM was retained as the funds' advisor and administrator, the Janus Funds was found to be a separate legal entity owned in its entirety by mutual fund investors. In addition, corporate formalities maintained the legal independence of the Janus Funds from JCM and JCG. Only one member of the Janus Funds board of trustees was associated with JCM (indicating greater independence of the board than is required by the Investment Company Act of 1940) even though all of the...