JANUS AND PRIMARY LIABILITY IN AN SEC ENFORCEMENT ACTION

The impact of Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011) was the critical issue in a recent decision in SEC v. Daifotis, No 3:11-cv-00137 (N.D. CA. Filed Jan. 11, 2011). Previously in this case the court concluded that a question regarding the retroactivity of the Dodd-Frank provision which provides that aiding and abetting liability can be premised on reckless conduct was moot in view of the Commission’s concession on the point (here).

The SEC’s action was brought against Kimon Daifotis, the former lead portfolio manager for Schwab YieldPlus Fund, and Randall Merk, an Executive Vice President at Charles Schwab & Co. The complaint focuses on events during the market crisis in 2007 and 2008 regarding YieldPlus Fund, an ultra-short bond fund that at its peak had $13.5 billion in assets and over 200,000 accounts. It was the largest ultra-short bond fund in the category.

The complaint alleges that the defendants made a series of misstatements in connection with the operation of the Fund and that Mr. Daifotis aided and abetted its deviation from the disclosed concentration policies. Specifically, the SEC claims that in connection with the marketing of the Fund Messrs. Merk and Daifotis misled investors concerning the risks involved. Investors were told that the Fund was only slightly more risky than a money market fund in marketing materials and other communications. Those statements were false, according to the Commission, because they failed to tell investors about the differences between YieldPlus and money funds.

Other false statements concerned redemptions as the market unraveled. By mid-2007 as the Fund’s NAV began to decline many investors sought to redeem their holdings. Few of the Fund’s assets were scheduled to mature within the coming months. The Fund had to sell assets and discounted prices. Mr. Daifotis told investors in conference calls and written materials that the redemptions were “minimal” when in fact they were in the billions of dollars.

Finally, the complaint alleges that Mr. Daifotis aided and abetted the Fund’s violation of its concentration policy. That policy limited investments in mortgage backed securities to 25%. In fact the concentration in those securities greatly exceeded that limitation under the direction of Mr. Daifotis.

Following a ruling on a motion to dismiss which was granted in part and denied in part, the Supreme Court handed down Janus, thus prompting reconsideration. That decision held that a mutual fund investment adviser did not “make” the statements in its client mutual funds’ prospectuses. The question of who made the statement is critical under Section 10(b) and Rule 10b-5 because the statute uses the phrase to “make any untrue statement . . .” That person, the Janus court concluded is the one who has the ultimate authority over the statement including its content and whether to communicate it. Attribution of the statement to the alleged primary violator is necessary the court held.

In this case the parties agreed that the defendants “made” several statements within the meaning of Janus. Those included a registration statement signed by Mr. Merk, a set of questions and answers that listed Mr. Merk as the author which were published on the Schwab website, an advertisement quoting Mr. Daifotis and containing his picuture and similar items where attribution was clear.

However, Mr. Daifotis could not be held primarily liable for an alleged misstatement just because it contained his picture. That is insufficient to establish that he made the statements the court ruled. Similarly, as to other alleged misstatements insufficient facts were pleaded to demonstrate that the defendants made them. However, the court permitted discovery to proceed on all issues including those statements, concluding it would be inappropriate to strike them.

Finally, the court held that Janus does not apply to Securities Act Section 17(a) or Investment Company Act Section 34(b). The former does not use the word “make” which is the lynchpin to Janus. Rather, the Section speaks in terms of “to employ any device . . . “ or “to obtain money . “ In addition, Janus is premised in part on the fact that the cause of action under Section 10(b) in the private damage action before the court was implied. Since there is no implied cause of action under Section 17(a) that rationale is inapplicable.

Janus also does not apply to Section 34(b). That Section, which precludes making material false statements in a registration statement does use the word “make.” However, Janus only involved the question of primary violations and is limited by the fact that it considered an implied cause of action. Neither point is applicable here. Thus it would be inappropriate to limit the language of the Section the court concluded.

Program: Current Trends in FCPA Enforcement, August 17, 2011, Live in Menlo Park, CA, and webcast nationally. The program link is here.