IS THE THIRD TIME THE CHARM? JANUS AND THE PROPER BALANCE BETWEEN PRIMARY AND SECONDARY ACTOR LIABILITY UNDER SECTION 10(B)

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1 IS THE THIRD TIME THE CHARM? JANUS AND THE PROPER BALANCE BETWEEN PRIMARY AND SECONDARY ACTOR LIABILITY UNDER SECTION 10(B) Elizabeth Cosenza ABSTRACT On June 13, 2011, in a 5 4 ruling that has generated much criticism, the Supreme Court decided Janus Capital Group, Inc. v. First Derivative Traders, a landmark case establishing the limits of secondary actor liability under section 10(b) of the Securities Exchange Act of 1934 (Exchange Act). Following Janus, investment managers who deceive and manipulate their shareholders no longer face the prospect of liability under section 10(b) as long as those managers perpetrate their fraud through the mutual fund itself, which is, in essence, a business trust. More importantly, the decision holds that liability under section 10(b) may only be imposed upon issuers or any person or entity that ultimately has control over a false statement that is issued to the market. Janus will thus act as a bar to private lawsuits brought by investors under section 10(b) against secondary actors (such as attorneys, accountants, investment bankers, and counterparties). In effect, the blurry line between primary and secondary misconduct that investors had attempted to invoke in the aftermath of the Supreme Court s decisions in Central Bank and Stoneridge to seek broader redress for securities fraud has now been clarified to eviscerate secondary actor liability. In an editorial entitled So No One s Responsible?, the New York Times commented that the decision was wrong because [t]here is no doubt that [the fund adviser] is responsible given that [i]t used legal ventriloquism to speak through the business trust and [the] funds. Days later, Senate Judiciary Committee Chairman Patrick Leahy la- Assistant Professor of Law and Ethics, Fordham Schools of Business, Fordham University. B.A., 1998, Fordham University; J.D., 2001, Harvard Law School. I wish to express my gratitude for the invaluable advice offered by Mark A. Conrad, Kenneth R. Davis, and Brent J. Horton; and for the generous support of the Fordham Schools of Business. 1019

2 1020 CARDOZO LAW REVIEW [Vol. 33:3 mented that the decision allows Wall Street companies to design new ways to evade accountability from the harm inflicted on hardworking Americans who have seen their life savings ravaged over the past few years by fraudulent investment schemes and corporate misconduct. Not surprisingly, as the Supreme Court has limited the scope of private securities fraud liability since its decision over fifteen years ago in Central Bank, fraud in the financial markets has become increasingly prevalent. In light of this inverse relationship, this Article proposes that Congress amend section 20 of the Exchange Act (the control person provision) to include a private right of action against any person [who] knowingly provides substantial assistance to another person in violation of the Exchange Act. The proposed substantial participation standard would effectuate the remedial purpose of the federal securities laws, restore investor confidence in the United States s financial markets, and promote outside advisers traditional role as gatekeepers of the securities market. In rejecting the formalistic approach adopted by the Supreme Court in Janus, the proposed standard also properly balances the need to permit investors to recover against outside advisers for securities fraud, and to limit frivolous claims at an early stage of the litigation. Furthermore, the SEC should enact a regulation mandating that investment advisers sign their funds filings to ensure that investment advisers are treated as primary violators under section 10(b). Whatever the merits of creating categorical restrictions on primary liability for secondary actors, such restrictions should not apply to those who play a substantial role in assisting fraud, regardless of the legal ventriloquism involved in making false statements to the market. Private securities litigation is a valuable and necessary part of the overall anti-fraud enforcement regime that compensates defrauded investors, deters fraud, promotes investor confidence in the financial markets, and facilitates the fair and efficient functioning of our capital markets. To restrict it in the manner the Supreme Court did in Janus is improvident and provides a blueprint for widespread immunity from securities violations.

3 2012] JANUS AND ACTOR LIABILITY BALANCE 1021 TABLE OF CONTENTS INTRODUCTION I. SECTION 10(B) OF THE SECURITIES EXCHANGE ACT OF A. Section 10(b), Rule 10b-5, and the Elements of a Cause of Action Thereunder B. The Elements of a Private Right of Action C. Pre Central Bank Jurisprudence II. CENTRAL BANK A. Factual Background B. The Supreme Court s Decision III. JUDICIAL STANDARDS FOR SECONDARY ACTOR LIABILITY UNDER RULE 10B A. The Bright-Line Standard Advantages and Disadvantages of a Bright-Line Standard for Liability B. The Substantial Participation Standard Advantages and Disadvantages of the Substantial Participation Standard C. The Creator Standard Advantages and Disadvantages of the Creator Standard IV. STONERIDGE A. Factual and Procedural Background B. Supreme Court s Decision C. The Aftermath of the Decision Pacific Investment Management Co. v. Mayer Brown LLP SEC v. Tambone Pugh v. Tribune Co V. JANUS A. Factual Background B. The Lower-Court Decisions C. The Supreme Court s Majority Decision D. Justice Breyer s Dissent VI. JANUS AND THE MEANING OF MAKE VII. A LEGISLATIVE SOLUTION CONCLUSION

4 1022 CARDOZO LAW REVIEW [Vol. 33:3 INTRODUCTION The most common, and in some instances the most destructive, vehicle for financial harm so far in the twenty-first century has been securities fraud. From Enron and WorldCom to Bear Stearns and Lehman, Fannie Mae and Freddie Mac, and Bernard Madoff s massive Ponzi scheme, the events of the last decade demonstrate that securities fraud is repeatedly perpetrated against unsuspecting investors. The antifraud provisions of the federal securities laws are an essential tool used to combat this systemic problem, providing investors with the ability to initiate civil litigation against those responsible for the fraud. In fact, private civil litigants typically bring a wide array of claims against not only the company and its insiders, but also so-called secondary actors (such as attorneys, accountants, investment bankers, and counterparties) who have some relationship with the primary wrongdoer. 1 There is, however, a nagging question regarding the precise scope of liability for secondary actors under section 10(b) of the Securities Exchange Act of and SEC Rule 10b-5. 3 With limited success, the Supreme Court has attempted to provide guidance on this issue three different times over the past two decades. The Supreme Court s first decision addressing the issue, Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., was in There, the Supreme Court declined to recognize a private right of action under section 10(b) against secondary actors who aid and abet a primary wrongdoer s violation of the securities laws. 5 The extent to which Central Bank immunized secondary actors from liability, particularly those who assist in drafting public disclosures issued to investors, was unclear. As a result, after Central Bank, the line between holding secondary actors liable for securities fraud without running afoul of the Supreme Court s prohibition against aiding and abetting liability remained murky. In 2008, the Supreme Court revisited the issue of secondary actor liability in Stoneridge Investment Partners v. Scientific-Atlanta, Inc. 6 In Stoneridge, the Court addressed scheme liability as a basis for an ac- 1 Daniel R. Fischel, Secondary Liability Under Section 10(b) of the Securities Act of 1934, 69 CAL. L. REV. 80, 80 n.4 (1981). This is in contrast to enforcement actions brought by the Securities and Exchange Commission (SEC) which are typically brought against a more limited set of defendants, namely companies and their directors and officers U.S.C. 78j(b) (2006) C.F.R b-5 (2011) U.S. 164 (1994). 5 Id. at U.S. 148 (2008).

5 2012] JANUS AND ACTOR LIABILITY BALANCE 1023 tion against secondary actors who participate in a scheme to defraud. 7 Noting that scheme liability bore a striking resemblance to aiding and abetting, (which, in the aftermath of Central Bank, was no longer a cognizable cause of action), the Court rejected scheme liability and held that secondary actors are not liable under section 10(b) in the absence of a public statement or other conduct on which investors could have relied. 8 Although Stoneridge put to rest the notion of scheme liability, it, like Central Bank, failed to define the precise limits on the liability of secondary actors who assist in making or drafting disclosures issued to investors. This failure left open significant liability questions in the wake of the mutual fund market timing scandals, the subprime mortgage crisis of 2008 and the ensuing economic meltdown, the host of recent financial scandals, and the securities-fraud lawsuits filed in their aftermath. Following subsequent rulings in which lower courts continued to struggle to interpret Central Bank and Stoneridge, the Supreme Court decided to review the Fourth Circuit s decision in In re Mutual Funds Investment Litigation, 9 in which the court found that a mutual fund investment adviser violated section 10(b) by making misrepresentations that were contained in the mutual fund s prospectuses. 10 Even though those misrepresentations were directly and contemporaneously attributed to the funds (and not the investment adviser), the Circuit concluded that any reasonable investor would attribute the misstatements in the prospectuses to the adviser in light of the publicly disclosed facts confirming the investment adviser s day-to-day control of the mutual funds. 11 In a controversial 5 4 decision, the Supreme Court reversed the Fourth Circuit s ruling, holding that section 10(b) claims can be brought only against parties with ultimate authority over an alleged misstatement. 12 As a result, the Court dismissed the claims brought against the mutual fund adviser on the basis that the adviser did not have ultimate authority over the statements contained in the prospectuses of the mutual funds it advised and managed. 13 The Janus decision sparked a firestorm. In an editorial entitled So No One s Responsible?, the New York Times commented that the major- 7 Id. at Id. at 158 ( The conduct of a secondary actor must satisfy each of the elements or preconditions for liability.... ) F.3d 111 (4th Cir. 2009), rev d sub nom. Janus Capital Grp., Inc. v. First Derivative Traders, 131 S. Ct (2011). 10 Id. at Id. at 127 ( [I]nterested investors would have inferred that if [the investment adviser] had not itself written the policies in the Janus fund prospectuses regarding market timing, it must at least have approved these statements. ). 12 Janus, 131 S. Ct. at Id. at 2305.

6 1024 CARDOZO LAW REVIEW [Vol. 33:3 ity s decision was wrong. 14 It stated that [t]here is no doubt that [the fund adviser] is responsible given that [i]t used legal ventriloquism to speak through the business trust and [the] funds. 15 Senate Judiciary Committee Chairman Patrick Leahy lamented that the decision allows Wall Street companies to design new ways to evade accountability from the harm inflicted on hardworking Americans who have seen their life savings ravaged over the past few years by fraudulent investment schemes and corporate misconduct. 16 Many in the media also cited with approval Justice Breyer s vigorous dissent in Janus. 17 Noting that the relationship between the investment adviser and the fund could hardly have been closer, Justice Breyer criticized the majority opinion because it leads to a situation in which there would be no liability under section 10(b) if guilty management writes a prospectus (for the board) containing materially false statements and fools both board and public into believing they are true. 18 Under that scenario, management would not be liable because it did not make the alleged misstatements and the board would not be liable because it did not have the requisite wrongful state of mind. 19 According to Justice Breyer, the majority s reading of section 10(b) leads to that unacceptable (and widely criticized) result. 20 Against the backdrop of the Janus decision, this Article considers where, in the vague borders between primary and secondary liability, an investment adviser to a mutual fund falls for purposes of section 10(b) liability. Part I of this Article sets forth the provisions of section 10(b) and Rule 10b-5, emphasizing their important role in U.S. securities regulation. Part I then discusses the early pro-plaintiff trajectory of securities fraud jurisprudence, including the extension of civil liability to aid- 14 Editorial, So No One s Responsible?, N.Y. TIMES, June 15, 2011, at A Id. 16 S. Comm. on the Judiciary, Hearing on Barriers to Justice and Accountability: How the Supreme Court s Recent Rulings Will Affect Corporate Behavior, June 29, 2011, judiciary.senate.gov/hearings/index.cfm?t=congress&p=hearings (click on the hearing title, then click on link under Member Statements in the right pane) (statement of Sen. Patrick Leahy, Chairman, S. Comm. on the Judiciary) [hereinafter Leahy Statement]. 17 See id.; see also Larry Doyle, Supreme Court Ruling on Janus Funds Smells, SENSE ON CENTS (June 16, 2011, 9:43 AM), ( Management can avoid liability, has no liability, and is considered bulletproof. All watchwords which mean as an investor you are getting bent over. I do not own any Janus funds but if I did I would sell them. I would then ask my brokers and/or financial planners for a position statement by other mutual fund families on their position on this case. As one highly respected Wall Street executive whom I hold in high regard told me, this ruling does not pass the smell test. I concur. The stench of this ruling combined with the smell of the vomit beneath my desk is truly overpowering. ). 18 Janus Capital Grp., Inc. v. First Derivative Traders, 131 S. Ct. 2296, 2310 (2011) (Breyer, J., dissenting). 19 Id. 20 Id.

7 2012] JANUS AND ACTOR LIABILITY BALANCE 1025 ers and abettors. Part II of this Article analyzes the Supreme Court s decision in Central Bank. By eliminating the private cause of action against aiders and abettors, Central Bank raised serious questions concerning the continued liability exposure of secondary actors, who traditionally had been found liable as aiders and abettors. Part III outlines three arguably conflicting judicial standards of secondary actor liability that emerged following Central Bank and the uncertainty created by its failure to clarify the precise scope of section 10(b) liability. Part IV of this Article examines the Supreme Court s decision in Stoneridge and explores scheme liability as a new analytical framework for the imposition of section 10(b) liability. Part IV also analyzes a trilogy of post- Stoneridge lower-court decisions that highlight the ongoing doctrinal ambiguities surrounding the proper application of section 10(b) liability to secondary actors. Part V of this Article analyzes Janus, the most recent Supreme Court decision to address secondary actor liability, in which the Court handed down a controversial 5 4 decision in which it declined to extend primary liability under section 10(b) to an investment adviser for allegedly misleading statements contained in the prospectuses of the mutual funds it managed. Part VI discusses the impact of Janus. Finally, Part VII proposes a legislative solution to address the glaring gap in the post-janus scope of section 10(b) liability. I. SECTION 10(B) OF THE SECURITIES EXCHANGE ACT OF 1934 A. Section 10(b), Rule 10b-5, and the Elements of a Cause of Action Thereunder Following the Stock Market Crash of 1929 and the resulting Great Depression, Congress enacted two landmark pieces of legislation to instill public confidence in the financial markets: the Securities Act of 1933 (1933 Act) 21 and the Securities Exchange Act of 1934 (1934 Act) 22 (together, the Acts). 23 Representing a significant departure from the merit-based approach to securities regulation that state governments previously had taken, the Acts required mandatory disclosures designed to remedy the informational asymmetries that existed between ordinary shareholders and company insiders, and other market professionals Pub. L. No , 48 Stat. 74 (codified as amended at 15 U.S.C. 77a 77aa (2006)). 22 Pub. L. No , 48 Stat. 881 (codified as amended at 15 U.S.C. 78a 78mm (2006)). 23 See Steve Thel, The Original Conception of Section 10(b) of the Securities Exchange Act, 42 STAN. L. REV. 385, (1990). 24 See id.; see also André Douglas Pond Cummings, Ain t No Glory in Pain : How the 1994 Republican Revolution and the Private Securities Litigation Reform Act Contributed to the Collapse of the United States Capital Markets, 83 NEB. L. REV. 979, 996 (2005) ( The 1933 Securi-

8 1026 CARDOZO LAW REVIEW [Vol. 33:3 To meet this objective, the 1933 Act requires adequate disclosure during the initial distribution of a security 25 and the 1934 Act mandates accurate and timely disclosure during post-distribution trading. 26 One of the essential tools used to promote the informational integrity of the capital markets is section 10(b) of the 1934 Act, the key antifraud provision of the federal securities laws. It provides that [i]t shall be unlawful for any person, directly or indirectly (b) To use or employ, in connection with the purchase or sale of any security... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [Securities and Exchange] Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors. 27 Pursuant to the statute, the SEC promulgated Rule 10b-5, which sets forth the range of conduct subject to prohibition under section 10(b). 28 Its language broadly seeks to prevent any fraud or deceit in connection with the purchase or sale of any security. 29 The text of Rule 10b-5 provides in its entirety as follows: It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, ties Act, 1934 Securities Exchange Act, and the battery of federal regulations that were put into place by President Roosevelt and the New Deal Congress for the express purpose of protecting U.S. investors sought to strike a delicate balance between investor protection and enhancement of capital formation by U.S. corporations. ). More generally, as the Supreme Court has noted, Congress sought to substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry. SEC v. Zandford, 535 U.S. 813, 819 (2002) (internal quotation marks omitted) (quoting Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 151 (1972)). The Court explained that that the securities laws embrace a philosophy of full and accurate disclosure seeking to protect investors against fraud and promote standards of the highest standards of honesty and fair dealing. Id. 25 See Ronald J. Colombo, Cooperation with Securities Fraud, 61 ALA. L. REV. 61, 65 (2009) ( [T]he federal approach was built around mandatory disclosure, rather than merit regulation. ); James C. Spindler, IPO Liability and Entrepreneurial Response, 155 U. PA. L. REV. 1187, 1188 (2007) ( Sellers of securities such as founding entrepreneurs are required under the Securities Act of 1933 to make full and complete disclosure to purchasing investors (the public shareholders) in public offerings. ). 26 See Robert M. Lawless et al., The Influence of Legal Liability on Corporate Financial Signaling, 23 J. CORP. L. 209, 218 (1998) ( [T]he 1934 Act governs the trading of securities in the secondary markets, such as the New York Stock Exchange or the NASDAQ. ) U.S.C. 78j(b) (2006). 28 See 17 C.F.R b-5 (2011). 29 See id.; see also Ronald J. Colombo, Buy, Sell, or Hold? Analyst Fraud from Economic and Natural Law Perspectives, 73 BROOK. L. REV. 91, 123 (2007) ( Congress did require that investors be provided with certain key pieces of information, and that all the information furnished to investors (whether required or not) in connection with the purchase or sale of security be complete and accurate. ).

9 2012] JANUS AND ACTOR LIABILITY BALANCE 1027 (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security. 30 Although the Rule is silent on whether there exists a private right of action against those who violate section 10(b), it is now well settled that there is an implied private right of action. 31 Courts have found that a private right of action is critical to the effective enforcement of the federal anti-fraud regime. 32 In particular, the implied private right of action assists in furthering the three fundamental goals of the federal securities laws: (1) the deterrence of fraud; (2) the compensation of victims; and (3) the promotion of investor confidence in the financial markets. First, private securities actions are necessary to deter violations of section 10(b). 33 Even though the SEC has broad authority to bring enforcement actions, its limited resources prevent it from detecting and or prosecuting even the most flagrant abuses of the securities laws. 34 Nowhere have the constraints on the SEC s ability to prevent and or detect fraud been made more obvious than in 30 Id. Section 10(b) and Rule 10b-5 are coextensive. See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 214 (1976) (explaining that the scope of Rule 10b-5 cannot exceed the power Congress granted to the Commission under section 10(b)); see also Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 173 (1994) ( We have refused to allow [private] 10b-5 challenges to conduct not prohibited by the text of the statute. ). If section 10(b) does not give rise to liability a fortiori, neither does Rule 10b-5. See Jeanne Schroeder, Envy and Outsider Trading: The Case of Martha Stewart, 25 CARDOZO L. REV. 2023, 2046 (2005) ( Although the language of Rule 10b-5 is broader than that of 10(b), under the basic principles of administrative rulemaking, the rule should not be read more expansively than the statute under which it is promulgated. ). 31 See Ernst & Ernst, 425 U.S. at 196; In re Parmalat Sec. Litig., 376 F. Supp. 2d 472, 494 (S.D.N.Y. 2005) (noting that the implied private right of action under Rule 10b-5 has been recognized in the lower courts since 1946 and was acknowledged by the Supreme Court in 1971). 32 See, e.g., Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 730 (1975). 33 See Private Litigation of the Federal Securities Laws: Hearings Before the Subcomm. on Secs. of the S. Comm. on Banking, Hous. & Urban Affairs, 103d Cong. 113 (1994) (testimony of William R. McLucas); see also Securities Litigation Uniform Standards Act of 1997:Hearing on S Before the Subcomm. on Secs. of the S. Comm. on Banking, Hous. & Urban Affairs, 105th Cong. 5 6 (1998) (statements of Arthur Levitt and Isaac C. Hunt) ( Private actions are an especially important supplement to the Commission s enforcement program today because of the phenomenal growth of the securities industry during a time when the Commission s staff and budget levels have remained relatively constant. ). 34 As courts have noted, the SEC s resources are adequate to prosecute only the most flagrant abuses. Berner v. Lazzaro, 730 F.2d 1319, (9th Cir. 1984).

10 1028 CARDOZO LAW REVIEW [Vol. 33:3 the Bernie Madoff fiasco. 35 Madoff succeeded in operating a Ponzi scheme for decades despite continuous SEC oversight. 36 Second, victims of securities fraud are more fully compensated for their losses through private civil actions. Although the SEC may pursue monetary relief in an enforcement action, the Supreme Court has commented that meritorious private actions... enforce federal antifraud securities laws [and] are an essential supplement to criminal prosecutions and civil enforcement actions. 37 Because private enforcement is entrepreneurially motivated, private plaintiffs will pursue monetary remedies from securities-fraud defendants with predictable ardor. 38 Lastly, private securities actions help promote investor confidence in the informational integrity of the securities markets by enforcing compliance with the disclosure requirements of the Acts. 39 If investors can hold corporate actors accountable for failing to comply with the Acts, they will be more willing to invest capital in the securities markets. 40 B. The Elements of a Private Right of Action Given that Congress did not expressly create a private right of action under section 10(b), courts have had to determine the elements and the precise scope of a private liability scheme. In Stoneridge, the Supreme Court articulated the six elements of a private cause of action under section 10(b): (1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon 35 The SEC s Office of Inspector General released a 477-page report on August 31, 2009 detailing the SEC s failures to detect the Madoff fraud. See OFFICE OF INVESTIGATIONS, SEC. & EXCH. COMM N, INVESTIGATION OF FAILURE OF THE SEC TO UNCOVER BERNARD MADOFF S PONZI SCHEME (2009), available at 36 See id.; see also id. at 21 ( The OIG found that between June 1992 and December 2008 when Madoff confessed, the SEC received six substantive complaints that raised significant red flags concerning Madoff s hedge fund operations and should have led to questions about whether Madoff was actually engaged in trading. Finally, the SEC was also aware of two articles regarding Madoff s investment operations that appeared in reputable publications in 2001 and questioned Madoff s unusually consistent returns. ). 37 See Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 313 (2007). 38 See Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 310 (1985) (observing that implied private actions are a most effective weapon in the enforcement of the securities laws (citations omitted)). 39 See SEC v. Zandford, 535 U.S. 813, 813 (2002) (stating that the securities laws embrace a philosophy of full and accurate disclosure to protect investors against fraud and promote standards of the highest standards of honesty and fair dealing). 40 See Dura Pharm., Inc. v. Broudo, 544 U.S. 336, 345 (2005) ( The securities statutes seek to maintain public confidence in the marketplace... by deterring fraud, in part, through the availability of private securities fraud actions. ).

11 2012] JANUS AND ACTOR LIABILITY BALANCE 1029 the misrepresentation or omission; (5) economic loss; and (6) loss causation. 41 Materiality is a threshold question for the viability of all section 10(b) claims. 42 An untrue statement (or omission) is actionable only if it is material. 43 In TSC Industries v. Northway, Inc., the Supreme Court held that an omitted fact is material when there is substantial likelihood that a reasonable shareholder would consider [a fact or omission] important when making an investment decision. 44 The Court explained that the materiality standard is satisfied if the untrue statement (or omission) has a significant impact on the total mix of information available to a reasonable investor. 45 The Court recently reaffirmed the total mix standard for assessing materiality in Matrixx Initiatives, Inc. v. Siracusano. 46 There, the Court held that a drug company had an obligation under the federal securities laws to reveal details of the observed side effects of a drug to investors even though the information did not rise to the level of statistically significant data. 47 Matrixx reiterated that that there is no clear litmus test for materiality. 48 Instead, materiality involves a fact-specific inquiry that requires consideration of the source, content, and context of any alleged misstatement or omission. 49 The second element of a claim under section 10(b) is scienter, defined as the intent to deceive, manipulate, or defraud. 50 Enacted, in part, to deter strike suits wherein opportunistic private plaintiffs file securities fraud claims of dubious merit in order to exact large settlement recoveries 51 from deep-pocketed defendants, the Private Securities Litigation Reform Act (PSLRA) of 1995 includes, among other things, a heightened pleading standard for allegations of scienter in section 10(b) cases. 52 Pursuant to section 21D(b)(2) of the PSLRA, plaintiffs must state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. 53 Specifically, 41 Stoneridge Inv. Partners v. Scientific-Atlanta, Inc., 552 U.S. 148, 157 (2008). 42 See Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1318 (2011). 43 Id U.S. 438, 449 (1976) (defining materiality in the context of proxy statements and Rule 14a-9); see also Basic Inc. v. Levinson, 485 U.S. 224, 232 (1988) ( [E]xpressly adopting the TSC Industries standard of materiality for the 10(b) and Rule 10b-5 context. ). 45 TSC Indus., 426 U.S. at S. Ct Id. at Id. at Id. 50 Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976). A showing of severe recklessness is sufficient to establish the necessary state of mind. See Matrixx Initiatives, 131 S. Ct. at Novak v. Kasaks, 216 F.3d 300, 306 (2d Cir. 2000). 52 See 15 U.S.C. 78u-4(b)(1)(2) (2006). 53 Id. 78u-4(b)(2)(A). The PSLRA was enacted in the aftermath of the Supreme Court s abolition of aiding and abetting liability in Central Bank. See H.R. REP. No , at 37 (1995), reprinted in 1995 U.S.C.C.A.N. 730, 736. The PSLRA was intended, in part, to address

12 1030 CARDOZO LAW REVIEW [Vol. 33:3 a plaintiff must plead with particularity each statement alleged to have been misleading and the reason(s) why the plaintiff believes the alleged statement to have been misleading. 54 In a securities fraud lawsuit, investors must also show the requisite causal link between their claimed injury and defendant s misrepresentation by establishing that they relied on the information that defendant provided to them when making the investment decision at issue. To state it another way, a plaintiff must demonstrate that defendants conduct caused [the plaintiff(s)] to engage in the transaction in questhe concern that the application of joint and several liability in securities class actions resulted in less culpable defendants having to pay disproportionately high damage awards for harm predominately caused by other defendants. See id. at 37. The PSLRA thus amended the 1934 Act including section 10(b) so that a defendant faces joint and several liability for a jury s entire damage award only if the jury finds that the defendant had knowingly violated the securities laws. For all other violators (i.e., those who did not knowingly violate the securities laws), a proportionate liability scheme for the allocation of damages replaced the then-existing joint and several liability regime. See 15 U.S.C. 78u-4(f)(2)(B)(i) ( Except as provided in subparagraph (A), a covered person against whom a final judgment is entered in a private action shall be liable solely for the portion of the judgment that corresponds to the percentage of responsibility of that covered person, as determined [by the fact finder]. ). As to the issues raised by Central Bank, the PSLRA amended the 1934 Act to emphasize that the SEC had the ability to file suit against aiders and abettors of a section 10(b) violation. See 15 U.S.C. 78t(e). For SEC enforcement actions, the PSLRA codified the pre Central Bank standard in assessing whether a defendant committed an aiding and abetting violation. See id. However, the PSLRA did not disturb the Supreme Court s decision in Central Bank and provided a private litigant with the right to bring aiding and abetting causes of action. 54 See 15 U.S.C. 78u-4(b)(2)(A). If an investor fails to satisfy these requirements, the PSLRA provides that the court shall, on the motion of any defendant, dismiss the complaint. 15 U.S.C. 78u-4(b)(3)(A). The Supreme Court examined the pleading standards for scienter in Tellabs, in which shareholders of Tellabs filed a class action lawsuit against the corporation and its chief executive officer, Notebaert, alleging securities fraud in violation of section 10(b). Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, (2007). Plaintiffs claimed that, during the class period extending from December 2000 until June 2001, Notebaert: (1) made statements indicating that demand for Tellabs s flagship networking device, the TITAN 5500, was growing, when, in fact, demand for the product was declining; (2) made statements indicating that Tellabs s next-generation networking device, the TITAN 6500, was available for delivery and that demand for that product was growing, when in fact the product was not ready for delivery and demand was waning; (3) falsely represented Tellabs s financial results for the fourth quarter of 2000, and, in connection with those results, condoned the practice of channel stuffing, under which Tellabs flooded its customers with unwanted products; and (4) overstated revenue projections while knowing that demand for the TITAN 5500 was weak and that production of the TITAN 6500 was behind schedule. See id. at 315. On June 19, 2001, Tellabs disclosed that demand for the TITAN 5500 had dropped significantly and simultaneously lowered its revenue projections for the second quarter of See id. at 316. The following day, the price of Tellabs s stock plunged to a low of $15.87 after having reached a high of $67 during the class period. See id. Evaluating the plaintiffs claim of intentional misrepresentations, the Tellabs Court considered what it means to create a strong inference of scienter within the meaning of section 21(D)(b)(2) of the PSLRA. The Court held that an inference of scienter must be more than merely plausible or reasonable it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent. Id. at 314. The Court cautioned that, if not adequately contained, [private securities class actions] can be employed abusively to impose substantial costs on companies and individuals whose conduct conforms to the law. Id. at 313.

13 2012] JANUS AND ACTOR LIABILITY BALANCE 1031 tion. 55 Reliance is typically a threshold issue for a court when it is determining whether a securities action should be certified as a class action, and the court will generally not certify it as such if proof of individual reliance by each investor would be required. 56 However, in two instances, there is a rebuttable presumption of class-wide reliance that eliminates the need for individualized proof of reliance. First, under the Supreme Court s decision in Affiliated Ute, investors are afforded a presumption of reliance if their claims are primarily based on allegations of the fraudulent omission of information that a defendant had a duty to disclose. 57 Second, under the fraud-on-the-market doctrine (or Basic presumption, articulated by the Supreme Court in Basic Inc. v. Levinson), reliance is presumed for the entire class when the allegedly false statement is disclosed to the public. 58 In addition to the foregoing elements, investors must sustain the burden of establishing loss causation. Following the Court s decision in Dura Pharmaceuticals v. Broudo, 59 plaintiffs are required to show that their losses resulted from the alleged fraud and not from other factors such as market conditions, investor expectations, or other miscellaneous developments within the company. 60 The Court has noted that although a misrepresentation could play some role in future losses or the company s performance, [t]o touch upon a loss is not to cause a loss, and it is the latter that the law requires. 61 Recently, in Erica P. John Fund, Inc. v. Halliburton Co., the Court unanimously held that a securities 55 Newton v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 259 F.3d 154, 174 (3d Cir. 2001) (quoting Robbins v. Koger Props., Inc., 116 F.3d 1441, 1447 (11th Cir. 1997)) (internal quotation marks omitted); see also Basic Inc. v. Levinson, 485 U.S. 224, 243 (1988) ( Reliance provides the requisite causal connection between a defendant s misrepresentation and a plaintiff s injury. ). It is often difficult to prove reliance in the context of secondary actor liability. Unlike issuers whose actions can be directly tied to the losses suffered by the plaintiff, secondary actors are usually one step removed from the specific misrepresentation (or omission) on which the plaintiff relied and which caused the plaintiff s injury. 56 See In re Initial Pub. Offerings Secs. Litig., 471 F.3d 24, 42 (2d Cir. 2006); Castano v. Am. Tobacco Co., 84 F.3d 734, 745 (5th Cir. 1996). Basic involved an efficient market the market in securities traded on the New York Stock Exchange that quickly incorporated public information into stock prices. The Basic (or fraud-on-the market ) presumption is based on the theory that in an open and developed securities market, the price of a company s stock is determined by the available material information regarding the company and its business... [and that] [m]isleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements. Peil v. Speiser, 806 F.2d 1154, (3d Cir. 1986) (citation omitted) (citing Note, The Fraud-on-the-Market Theory, 96 HARV. L. REV. 1143, (1982), quoted in Basic, 485 U.S. at As stated in In re Initial Public Offerings Securities Litigation, [w]ithout the Basic presumption, individual questions of reliance would predominate over common questions. 471 F.3d at See Affiliated Ute Citizens v. United States, 406 U.S. 128, (1972). 58 Basic, 485 U.S. at U.S. 336 (2005). 60 See id. at Id.

14 1032 CARDOZO LAW REVIEW [Vol. 33:3 fraud plaintiff is not required to prove loss causation in order for the court to certify a plaintiff class. 62 The Court again explained how plaintiffs can satisfy the element of loss causation in securities class actions: Loss causation... requires a plaintiff to show that a misrepresentation that affected the integrity of the market price also caused a subsequent economic loss. As we made clear in Dura Pharmaceuticals, the fact that a stock s price on the date of purchase was inflated because of [a] misrepresentation does not necessarily mean that the misstatement is the cause of a later decline in value. We observed that the drop could instead be the result of other intervening causes, such as changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions, or other events. If one of those factors were responsible for the loss or part of it, a plaintiff would not be able to prove loss causation to that extent. This is true even if the investor purchased the stock at a distorted price, and thereby presumptively relied on the misrepresentation reflected in that price. 63 The Court s recent decision in Halliburton thus affirmed Dura s approach to loss causation S. Ct. 2179, 2186 (2011). By focusing only on the loss causation issue, Halliburton avoided the disagreement among the lower courts concerning whether a defendant may attack the presumption of reliance at the class certification stage by introducing evidence that the alleged misrepresentations had no impact on the price of the relevant security. Some courts (including the Second and Third Circuits) permit a defendant to attempt to rebut the Basic presumption of reliance by introducing evidence that the alleged misrepresentation did not affect the market price of the security at issue. See, e.g., In re DVI, Inc. Secs. Litig., 639 F.3d 623, (3d Cir. 2011); In re Salomon Analyst Metromedia Litig., 544 F.3d 474, 485 (2d Cir. 2008). The Seventh Circuit appears to have rejected placing the initial burden of proving price impact on the plaintiff at the class certification stage. See Schleicher v. Wendt, 618 F.3d 679, 685 (7th Cir. 2010). According to the Fifth Circuit, on the other hand, the plaintiff must prove at the class certification stage that the defendant s misrepresentation affected the market price of the underlying security. See Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton Co., 597 F.3d 330, 335 (5th Cir. 2010), vacated sub nom. Erica P. John Fund, Inc. v. Halliburton Co., 131 S. Ct (2011). 63 Halliburton, 131 S. Ct. at 2186 (alteration in original) (citations omitted). The Fifth Circuit had previously affirmed the district court s denial of class certification for failure to establish loss causation. See Archdiocese of Milwaukee Supporting Fund, Inc., 597 F.3d at 334 ( In order to obtain class certification on its claims, Plaintiff was required to prove loss causation, i.e., that the corrected truth of the former falsehoods actually caused [Halliburton s] stock price to fall and resulted in [Plaintiff s alleged] losses. ). 64 See 131 S. Ct. at In doing so, Halliburton expressly left undecided whether defendants in a securities class action could rebut the fraud-on-the-market presumption at the class certification stage by pointing to evidence that the alleged misrepresentations had no impact on the price of the securities, which Halliburton had argued should be sufficient to rebut the presumption and deny certification to the plaintiff class. See id. ( According to the Court of Appeals, however, an inability to prove loss causation would prevent a plaintiff from invoking the rebuttable presumption of reliance. Such a rule contravenes Basic s fundamental premise that an investor presumptively relies on a misrepresentation so long as it was reflected in the market price at the time of his transaction. The fact that a subsequent loss may have been caused by factors other than the revelation of a misrepresentation has nothing to do with whether an investor relied on the misrepresentation in the first place, either directly, or presumptively through the fraud-on-

15 2012] JANUS AND ACTOR LIABILITY BALANCE 1033 C. Pre Central Bank Jurisprudence Until the Supreme Court drew a jurisprudential line in the sand in Central Bank, the federal judiciary also recognized a private right of action against aiders and abettors of section 10(b) violations. 65 Prior to Central Bank, section 10(b) and Rule 10b-5 had afforded significant advantages to plaintiffs who asserted sweeping claims against issuers and their executives, and against those who assisted the issuers in perpetrating fraud. Brennan v. Midwestern United Life Insurance Co. is particularly illustrative in this regard. 66 In Brennan, plaintiffs alleged that Dobich Securities Corporation (Dobich), a brokerage firm that sold stock in Midwestern Life Insurance Company (Midwestern), used investors money as working capital for speculation and other improper purposes and made fraudulent misrepresentations in explaining to purchasers the reason for delays in delivery of the purchased shares of stock. 67 Plaintiffs further maintained that Midwestern knew of Dobich s activities and permitted the activities to continue by failing to report Dobich... to the Securities and Exchange Commission. 68 Plaintiffs asserted that Midwestern should be held liable for the fraud. In moving to dismiss the complaint, Midwestern argued that there is nothing in the statute indicating a Congressional intent to impose civil liability on persons aiding and abetting violations of Section 10(b) and Rule 10b The district court, however, rejected Midwestern s argument, noting that likewise, one can search the statute in vain for language indicating that a [primary] violator of Section 10(b) and Rule 10b-5 should be liable in a civil action for damages. 70 Relying on the broad and remedial purpose of the statute, the court found that civil liability under section 10(b) extends to aiders and abettors. 71 Post-Brennan, claims for aiding and abetting liability pursuant to section 10(b) became prevalent in securities fraud actions. Aiding and abetting violations involved three elements: (1) a primary violation of section 10(b); (2) the aider and abettor s knowledge of (or recklessness the-market theory. Loss causation has no logical connection to the facts necessary to establish the efficient market predicate to the fraud-on-the-market theory. ). 65 See, e.g., Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 194 (1994) (Stevens, J., dissenting); In re Parmalat Secs. Litig., 376 F. Supp. 2d 472, 494 (S.D.N.Y. 2005) (stating that civil liability for aiding and abetting violations was recognized in the 1960s and subsequently became a common feature of private section 10(b) lawsuits) F. Supp. 673 (N.D. Ind. 1966). 67 Id. at Id. 69 Id. at Id. 71 Id. at

16 1034 CARDOZO LAW REVIEW [Vol. 33:3 as to) the primary violation; and (3) the aider and abettor s substantial assistance in furthering the primary violation. 72 In 1994, the Supreme Court had its first opportunity to review aiding and abetting liability in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. Reversing three decades of lower court jurisprudence, the Court held that no private right of action exists for aiding and abetting a section 10(b) Rule 10b-5 violation. Instead, the only properly named defendants in such an action, the Court said, are those actors concerning whom all of the requirements for primary liability under Rule 10b-5 are met. 73 II. CENTRAL BANK A. Factual Background The underlying facts in Central Bank are as follows: A bond issuer hired Central Bank of Denver to serve as indenture trustee for $26 million in secured bonds. 74 The bonds were to be used to finance public improvements at a planned residential and commercial development. 75 The bonds contained covenants requiring that: (1) the land subject to the liens be worth, at a minimum, 160% of the bonds outstanding principal and interest; and (2) the land s developer provide Central Bank with evidence that the 160% requirement was satisfied. 76 Although the land did not meet the 160% test, Central Bank failed to get an updated land appraisal before the closing of the bond issue. 77 This delay proved significant. Had the appraisal been done before the completion of the bond offering, the bond purchasers would have known that the bonds were not properly secured. 78 After the issuers later defaulted on the bonds, the bond purchasers sued Central Bank, alleging that it was secondarily liable under section 10(b) for its conduct in aiding and abetting the fraudulent sale of the bonds See, e.g., Landy v. FDIC, 486 F.2d 139, (3d Cir. 1973); see also David J. Baum, The Aftermath of Central Bank of Denver: Private Aiding and Abetting Liability Under Section 10(b) and Rule 10b-5, 44 AM. U. L. REV. 1817, (1995) (setting forth the elements of an aiding and abetting section 10b-5 claim pre Central Bank) U.S. at Id. at Id. 76 Id. at Id. at Id. at Id. at 168.

17 2012] JANUS AND ACTOR LIABILITY BALANCE 1035 B. The Supreme Court s Decision Relying on both a literal reading of the statutory text and its interpretation of congressional intent, the Supreme Court held that a private right of action for aiding and abetting does not exist under section 10(b). 80 The Court maintained that the statutory text controls the definition of conduct covered by 10(b) and that the statutory language does not itself reach those who aid and abet a 10(b) violation. 81 [S]tatutory silence, the Court explained, cannot be interpreted as tantamount to an explicit congressional intent to impose 10(b) aiding and abetting liability. 82 The Court dismissed the bond purchasers argument that the statute s prohibition on direct[] or indirect[] violations of the securities laws reached all persons who engage, even if indirectly, in a proscribed activity. 83 According to the Court, that proffered reading of the text would impermissibly impose liability on those who do not engage in the proscribed activities at all, but who give a degree of aid to those who do. 84 The Court found that the statute prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act. The proscription does not include giving aid to a person [who makes a material misstatement or] commits a manipulative or deceptive act. 85 Furthermore, the Court noted that because a defendant would be liable as an aider-and-abetter without the plaintiff having to show that he relied on the defendant s statements or actions, such a scheme would impermissibly circumvent one of the required elements of a section 10(b) cause of action. 86 The Court went on to explain that the federal securities laws establish a comprehensive scheme of liability. In that overall scheme, the SEC has the authority to initiate administrative actions and injunctive proceedings against those who aid and abet violations of the federal securities laws. Thus, even though there is no private right of action for 80 Id. at Id. at Id. at Id. at (emphasis added) (internal quotation marks omitted). 84 Id. at Id. at 177 (emphasis added) (citations omitted). 86 Id. at 180 (arguing that [a]llowing plaintiffs to circumvent the reliance requirement would disregard the careful limits on 10b-5 recovery mandated by our earlier cases ); see also Wright v. Ernst & Young LLP, 152 F.3d 169, 175 (2d Cir. 1998) (interpreting Central Bank to require that a misrepresentation be attributed to that specific actor at the time of public dissemination, that is, in advance of the investment decision ).