A License to Lie, Backdated

Steve Randy Waldman writes about finance and economics at the website Interfluidity.

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In a party-line, 5 to 4 split, the Supreme Court last week severely curtailed investors’ practical ability to hold financial intermediaries accountable for fraud. The case, Janus Capital Group, Inc. v. First Derivative Traders, seems arcane. But for perpetrators of fraudulent securitizations, it is a jubilee. The Supreme Court has eliminated the danger of their being investigated and sued by the people whom they fleeced.

The decision limits the reach of Rule 10b-5:

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,

• To employ any device, scheme, or artifice to defraud,
• 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
• 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.

The case concerned a mutual fund whose prospectus was alleged to contain misleading statements that harmed investors. The question before the Supreme Court was not whether the statements were in fact misleading, but who should be construed as having made the statements. The answer, the Court determined, is perhaps nobody at all. Misleading statements were made, but literally no one can be held accountable.

When an ordinary firm issues securities, the firm itself is the “person” who makes the statements that appear in prospectuses and other disclosures. But with dedicated investment vehicles, things are more complicated. Investment vehicles — mutual funds and ETFs, but also securitizations like RMBS and CDOs — segregate the management and operation of the fund from the legal entity whose securities investors hold. If you “own” a Janus mutual fund, the securities you hold are likely claims against an entity called Janus Investment Fund. But Janus Investment Fund exists mostly on paper. Another company, Janus Capital Management, actually does everything. The human beings who make day-to-day investment decisions, as well as the offices they work in and the equipment they work on, are provided by Janus Capital Management. Communications and legal formalities, including prospectuses, are drafted by employees of Janus Capital Management.

The Supreme Court held is that, even though employees of Janus Capital Management company actually wrote any misleading statements, even though they managed nearly every substantive aspect of the operation of the fund, they cannot be held responsible because they did not “make” the statements. The “person” under law who made the statements was the entity on whose behalf the offending prospectus was issued, the investment fund, which has no capital other than the money it invests for shareholders. Under Janus, the management company is beyond the reach of aggrieved investors.

Then can the fund be meaningfully held accountable? The fund does have an “independent” board of directors, who in theory work for shareholders and “negotiate” the terms of the management contract. In practice, the management company typically organizes the fund and selects its directors. Still, if the investment fund “made the statement”, then surely those directors would be accountable, right? No. The investment fund’s directors supervise the fund at a very high level. In a large “fund family”, the same directors may be responsible for tens or hundreds of different portfolios. They may not have understood that statements in some prospectus were misleading. A violation under Rule 10b-5 must be knowing or reckless to be actionable. So the fund’s directors may prove beyond reach. Outright lies may be told, yet investors may find they have no practical means of holding anyone accountable. Justice Breyer, who dissents from the Court’s decision, writes

The possibility of guilty management and innocent board is the 13th stroke of the new rule’s clock. What is to happen when guilty management writes a prospectus (for the board) containing materially false statements and fools both board and public into believing they are true?

Plausible deniability is the order of the day. Managers can be as nasty as they wanna be. As long as their misbehavior is obscure enough that fund directors can plead ignorance, nobody gets in trouble. (If directors could be held liable, then the management company might be in jeopardy as well, under Section 20(a) of the Securities Exchange Act. But if the directors are innocent, then so are the managers.)

The really high-stakes fraud lately has been in the securitization business. The Janus decision gives CDO arrangers a huge get-out-of-lawsuits-free card. Each asset-backed security or CDOs is its own little investment company, a “special purpose vehicle” with its own notional directors or trustees, often incorporated in the Cayman Islands. Under the reasoning of Janus, any misleading statements in the offering documents for a securitization were made by the SPV, not the investment bank that put together the documents or arranged the deal. The SEC relied in part on Rule 10b-5 in prosecuting Goldman Sachs for its failure to disclose material facts regarding the ABACUS deal. Under Janus, that would no longer be possible. Investors in securitizations can hold literally no one accountable for lies or misstatements in the offering documents. (The directors and trustees of an SPV have little substantive role in managing its operations or controlling its communications, so they would almost certainly be “innocent”.)

In theory, Rule 10b-5 is not investors’ only redress against securities fraud. Mutual fund operators and arrangers of securitizations are underwriters as well as managers. Underwriting is fraught with conflicts of interest, so Sections 11 and 12 of the Securities Act of 1933 give investors the right to sue when misleading statements come to light. These sections offer powerful tools to investors in public offerings of ordinary shares. But they are not so useful to buyers of mutual funds or securitization deals.

When material mistruths about an ordinary firm are exposed, its share price typically drops. This provides a measure of the loss “caused” by the misstatement. The value of mutual fund shares, however, is computed according to the NAV of the fund’s assets, and so is not usually affected by a revelation. Sections 11 and 12 of the Securities Act specify that investors are to recover losses “resulting from” the misstatement. Showing that any losses are due to some other cause is an affirmative defense. So mutual fund managers argue, often successfully, that the proximate cause of investor losses are declines in the value of portfolio assets, declines which are unrelated to any misstatement on their part. Rule 10b-5, on the other hand, doesn’t provide for such a defense. In Rule 10b-5 actions, courts can take into account “transaction causation” (“but for the lie, I wouldn’t have invested!”) and consider investor losses more flexibly.

Securitizations are often organized so as to avoid US registration requirements. For an unregistered security, Section 11, which creates liability for false registration statements, obviously doesn’t apply. According to Thomas Lee Hazen and David Ratner, a 1995 Supreme Court decision

…which surprised almost everyone [held that] 1933 Act §12(a)(2)…does not…apply…unless [offerings] are made publicly by means of a statutory prospectus… [I]t appears that there will be no liability under any provision of the 1933 Act for written or oral misstatements in offerings which are exempt from that Act’s registration requirements, and that persons making such misstatements can only be sued under 1934 Act Rule 10b-5

So, until last week, the only effective remedy that investors in both mutual funds and securitizations had against misleading statements in prospectuses was Rule 10b-5. Now investors have no practical remedy whatsoever. [*] The government can still hold these vehicles accountable, under Section 17 of the Securities Act. But investors are not permitted to sue under that section, and regulators may be reluctant to pursue powerful or politically favored firms.

The Supreme Court’s decision in Janus is a license to lie. And it is backdated. The statute of limitations on Rule 10b-5 actions is five years. Perhaps naively, I had hoped that some of the egregious fraud of the securitization boom would be punished by investors, despite the “let’s look forward”, see-no-evil attitude of the regulatory community. Thanks to Janus, lawsuits-in-progress may be disappearing as we speak. Lawsuits regarding the particularly rancid 2006 / 2007 vintage of securitizations may never be filed. Going forward, if you are considering an investment in a mutual fund or ETF, you should understand that you will have little recourse if information provided in the prospectus turns out to be misleading or incomplete, even outright fraudulent. Perhaps you are comfortable relying solely upon your fund managers’ reputation, perhaps not. If you have a say in how a pension fund or endowment or bank invests its money, I can’t imagine why you’d permit investment in any sort of securitization while you have no meaningful assurance that what is being sold to you is actually what you are buying, even or perhaps especially if the deal is being offered by a big, famous, “deep-pocketed” bank. Much of my own savings is invested in various ETFs. I am significantly more nervous about that than I was a week ago.

Update: Jennifer Taub, who wrote a wonderfully detailed eight-post series on the Janus case in January (1, 2, 3, 4, 5, 6, 7, 8, followup), points out that in the case just decided, it was not mutual fund investors who were suing, but shareholders in the parent of the management company, Janus Capital Group, whose stock lost value when when the misstatements and related misconduct were exposed. This was the mutual fund “market timing” scandal, which received a great deal of press when it broke in 2003. In this very prominent instance, the SEC pursued and reached a settlement with the management company on behalf of fund investors, so no private action was necessary. However, the reasoning of the Janus decision creates a very large barrier for investors in general when, for whatever reason, the SEC declines to act as their champion.

[*] Justice Breyer, in his dissent, notes another potential remedy, to which he suggests the majority opinion hints obliquely. But pursuit of that remedy — liability based on the provisions of Section 20(b) of the Securities Exchange Act — would be at best a speculative enterprise. Justice Breyer points out, “‘There is a dearth of authority construing Section 20(b),’ which has been thought largely ’superfluous in 10b–5 cases.’ 5B A. Jacobs, Disclosure and Remedies Under the Securities Law §11–8, p. 11–72 (2011)”