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NASAA Supports Private Actions Against Fund Advisers

By Jim Hamilton

The North American Securities Administrators Association (NASAA) has filed a joint amicus brief with AARP in the case of Janus Capital Partners v. First Derivative Traders, urging the U.S. Supreme Court to affirm a Fourth Circuit decision that permitted mutual fund investors to go forward with a private action against the funds' adviser for allegedly fraudulent statements contained in the funds' prospectuses. The complaint had alleged that the investment adviser and its parent violated federal securities laws by falsely representing in several fund prospectuses that the funds' managers did not permit, and took active measures to prevent, "market timing" of the funds. Noting that mutual funds themselves serve as mere shells for the transaction of the investment activity of innocent investors, the organizations argued that the funds' adviser participated in the making of the fraudulent statements concerning market timing to a greater extent than any other party. Accordingly, the investment adviser's involvement in the fraudulent conduct was sufficient to sweep the adviser into the circle of primary actors liable for false statements to the complaining shareholders under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, the organizations contended.

The organizations reminded the high court of the importance of private securities litigation in deterring and redressing securities fraud. The organizations observed that the Congressional mandate and funding for the U.S. Securities and Exchange Commission (SEC) has only allowed the agency the reach to prosecute the most flagrant abuses of securities laws. Moreover, probing violations in the mutual fund industry has not been a top priority for the SEC. Additionally, private actions afford victims of fraud the best and often only hope of recovering their losses, something for which government enforcement actions are ill-quipped, the organizations stated. Finally, the organizations emphasized the importance of private securities litigation in maintaining investor confidence by enforcing the mandatory disclosure system. Investor confidence is particularly important in the mutual fund industry, the organizations stated, as evidenced by the exodus of the funds' investors upon learning of the secret market timing deals.

The organizations urged the high court to reject the defendants' argument that liability under Section 10(b) and Rule 10b-5 requires "direct attribution" of an allegedly misleading statement to a defendant. In the organizations' view, such a standard would severely restrict the ability of investors to seek redress for their injuries while simultaneously creating perverse incentives for corporate actors to engage in fraud. Without recourse against the funds' adviser, the organizations contended, the investors would have no other adequate remedies available to them. The funds may not be sued directly, the organizations observed, because they do not carry on operating activities of their own while recovery for the plaintiffs would simply impose liability on other, innocent shareholders. At the same time, the investment adviser would be able to escape liability by simply keeping its name off the prospectuses. Applying Section 10(b) to the deceptive conduct described in the complaint would impose no other duties or uncertainties on advisers other than the universal and fitting obligation to refrain from making misrepresentations and engaging in securities fraud, the organizations argued.

The organizations also stressed to the high court the importance of providing investors with meaningful remedies under federal law, given the lack of available remedies under state law. The organizations noted that the federal Securities Litigation Uniform Standards Act of 1998 generally precludes the use of class action suits that seek recovery for securities fraud under state law. Moreover, state courts generally have not recognized the doctrine of fraud-on-the-market in cases seeking relief under state common law. As a result of the massive corporate frauds that have surfaced in recent years, however, some courts have recognized the need to re-evaluate barriers to civil actions alleging securities fraud, the organizations observed. As an example, the organizations referenced recent statements by the California Supreme Court, which has cited the increase in corporate fraud as a reason to recalibrate the balance of interests between investors and corporations in favor of providing greater judicial recourse to victims of fraud.

Finally, the organizations argued that the uniquely close relationship between the investment adviser and the funds mandated that the adviser be held accountable as a primary actor for the misrepresentations in the prospectuses. In the organizations' view, the Fourth Circuit properly emphasized the special relationship between the adviser and its family of funds because the adviser was so central to the funds' operation and continued existence that the two were practically indistinguishable. Accordingly, a claim for primary securities fraud liability properly lay against the adviser because the adviser exerted virtually unrestrained control over the funds' policies and core operations. Moreover, the allegations in the complaint strongly supported the notion that the adviser did not interact with the funds at arm's length, the organizations argued. Rather, the funds were actually launched by the investment adviser by and through its parent corporation, which sponsored the funds and provided the initial seed capital. It was practically impossible, therefore, that the funds' board would exercise the "nuclear option" and fire the investment adviser. The adviser and its parent should also not be allowed to navigate the legal relationship between the adviser and the funds in order to work an injustice on investors, the organizations contended, as the adviser and its parent were the sole beneficiaries of the fruits of the fraud, which took the form of increased advisory fees from "sticky assets" pledged to the funds by hedge funds that wished to engage in market timing.

(As noted by Keith Bishop of Allen Matkins on his California Corporate & Securities Law blog, the Supreme Court will hear oral arguments on the case today.)

Full post as published by Jim Hamilton's World of Securities Regulation on December 07, 2010 (boomark / email).