Three Major Supreme Court Decisions on the 1934 Act During 2011

28 November 2011 Publication
Authors: Richard S. Davis

Legal News: Securities Enforcement & Litigation

During 2011, the U.S. Supreme Court issued three major opinions in cases presenting questions under the Securities Exchange Act of 1934. The decisions, summarized below, present no discernible pattern. In both of the first two decisions, the Supreme Court ruled unanimously in favor of the plaintiff investors, providing rulings consistent with Court precedent. In the third decision, rendered by a 5-4 vote, the conservative wing of the Court issued a ruling narrowly defining the term “maker” of a misrepresentation or omission for purposes of federal securities fraud claims. While that decision indicates that the Court, as presently constituted, may side with defendants to securities fraud actions when presented with close questions, the first two decisions demonstrate that the Court will not issue opinions adverse to plaintiff investors simply as a matter of practice, course, or philosophy.

Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011) — An alleged omission may be “material” and actionable, even if a plaintiff investor does not allege “a statistically significant increased risk of adverse events” from circumstances known by a defendant.

In a unanimous decision authored by Justice Sonia Sotomayor, the Court held that plaintiff investors could maintain a claim for securities fraud, even though the investors did not allege that the defendant — a cold remedy manufacturer — knew of “statistically significant evidence” of a causal link between use of the manufacturer’s product and the loss of smell. In critical language applicable to future securities litigation, the Court stated: “[T]he materiality of adverse event reports cannot be reduced to a bright-line rule.”

The defendant, Matrixx Initiatives, Inc., manufactured Zicam Cold Remedy, which accounted for approximately 70 percent of Matrixx’s sales. The investors alleged that between 1999 and February 2004, Matrixx had received reports from physicians and customers that individuals had experienced a loss of smell after using Zicam; that Matrixx was advised of studies linking a zinc compound similar to Zicam’s active ingredient to a loss of smell; and that four product liability lawsuits had been filed against Matrixx.

In October 2003 and January 2004, Matrixx provided strong revenue guidance to the public. On February 2, 2004, following news reports that the FDA was reviewing complaints that use of Zicam might cause the loss of smell, Matrixx stated that such statements “are completely unfounded and misleading.” On February 6, 2004, the end of the proposed class period, Good Morning America reported that a doctor had discovered more than a dozen patients suffering a loss of smell after using Zicam. The price of Matrixx stock then plummeted.

Matrixx urged dismissal of the plaintiff investors’ claims, arguing that the plaintiffs had failed to allege a “material” misrepresentation or omission of fact, by failing to allege that Matrixx knew of a “statistically significant correlation” between the use of Zicam and the loss of smell. Specifically, Matrixx argued that “adverse event reports that do not reveal a statistically significant increased risk of adverse events from product use are not material information” and, therefore, inactionable. In rejecting Matrixx’s position for the Court, Justice Sotomayor: i) recited the Supreme Court’s decades-old definition of “material” information as information that would be “viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available;” ii) stated that the Court had long rejected “bright-line rule” approaches that designate “a single fact or occurrence as always determinative” of materiality; iii) noted that “statistically significant” evidence of causation is not always available; and iv) concluded that “[g]iven that medical professionals and regulators act on the basis of evidence of causation that is not statistically significant, it stands to reason that in certain cases reasonable investors would as well.”

Erica P. John Fund, Inc. v. Halliburton Co., 131 S. Ct. 2179 (2011) — To obtain class certification at the intermediate stage of federal securities fraud litigation, a plaintiff need not prove “loss causation.”

In a unanimous decision authored by Chief Justice John Roberts, the Court held that to obtain class certification, plaintiff investors need not prove “loss causation” (i.e., “that the defendant’s deceptive conduct caused their claimed economic loss”).

The plaintiff investment fund alleged that defendant Halliburton Co. deliberately made misrepresentations, concerning various matters, designed to inflate Halliburton’s stock price. The fund further alleged that Halliburton subsequently made a number of corrective disclosures that caused Halliburton’s stock price to drop, and investors to lose money.

Justice Roberts began his analysis for the Court by noting that “reliance” on an alleged misrepresentation or omission is an “essential element” of a securities fraud claim, and that to obtain class certification, a plaintiff must show that the issue of reliance presents a question of law or fact common to class members. In 1988, the Supreme Court articulated a rebuttable presumption of reliance for investors in “fraud-on-the-market” cases, whereby the Court presumed that “the market price of shares traded on well-developed markets reflects all publicly available information, and, hence, any material misrepresentations.” In that decision, the Court further assumed that an investor relies on such representations when it “buys or sells stock at the price set by the market,” thereby presumptively satisfying the commonality requirement for class certification purposes.

The Fifth Circuit Court of Appeals had ruled that plaintiff investors are required to establish loss causation at the class certification stage of securities fraud litigation to “trigger the fraud-on-the-market presumption.” In reversing this decision, the Supreme Court held that such a requirement was not justified by precedent or logic. As Justice Roberts explained, the element of reliance relates to “transaction causation,” and “surround[s] the investor’s decision to engage in the transaction. . . . Loss causation, by contrast, requires a plaintiff to show that a misrepresentation that affected the integrity of the market price also caused a subsequent economic loss.” Accordingly, the Court ruled that “[t]he 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,” and has no bearing on the determination of class certification motions.

Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011) — The “maker” of a statement potentially liable for securities fraud is the person or entity with ultimate authority over the statement, and not others who merely had a hand in producing the statement.

In a 5-4 decision authored by Justice Clarence Thomas, the Court held that a defendant mutual fund adviser could not be held liable in a securities fraud action for false statements made in its client mutual funds’ prospectuses.

Defendant Janus Capital Management LLC (JCM) was the investment adviser to the Janus Investment Fund, a business trust owned by mutual fund investors. In September 2003, the New York Attorney General alleged that Janus Capital Group, Inc. (JCG), JCM’s parent company, had entered into secret arrangements to permit impermissible market timing in several funds run by JCM. Following these allegations, significant amounts of money were withdrawn from the funds, and the price of JCG stock fell significantly. A plaintiff investor then sued JCM and JCG, alleging that they were liable for misleading statements concerning market timing in fund prospectuses issued by the Janus Investment Fund, and that JCG also was liable as a “controlling person” of JCM.

Even though JCM and Janus Investment Fund were separate legal entities, the plaintiff investor contended that “an investment adviser should generally be understood to be the ‘maker’ of statements by its client mutual fund.” In rejecting this argument, and in holding that the plaintiff investor could not maintain a securities fraud claim against JCM or JCG for statements made in the prospectuses, the Court held: “the maker of a statement [for purposes of federal securities fraud claims] is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.” In writing for the Court, Justice Thomas: i) rejected the argument that by participating in the preparation and dissemination of the prospectuses, JCM “made” the misleading statements contained therein; and ii) stated that “[w]ithout control, a person or entity can merely suggest what to say, not ‘make’ a statement in its own right. One who prepares or publishes a statement on behalf of another is not its maker.” Justice Thomas added that the Court’s decision was consistent with prior Supreme Court rulings, which held that a federal securities fraud lawsuit cannot be maintained against alleged aiders and abettors, or against parties that committed acts which allowed a company to issue misleading financial statements.

In a dissenting opinion authored by Justice Stephen Breyer, and joined by Justices Ruth Bader Ginsburg, Sonia Sotomayor, and Elena Kagan, Justice Breyer reasoned that a court could find that JCM “made” the statements at issue, because each of the Janus Investment Fund’s officers was a JCM employee; JCM managed the purchase, sale, redemption, and distribution of the Janus Investment Fund’s investments; JCM prepared, modified, and implemented the Janus Investment Fund’s long-term strategies; JCM disseminated the fund prospectuses through the JCG web site; and JCM employees drafted and reviewed the fund prospectuses. Justice Breyer stated, “Nothing in the English language prevents one from saying that several different individuals, separately or together, ‘make’ a statement that each has a hand in producing . . . Unless we adopt a formal rule (as the majority here has done) that would arbitrarily exclude from the scope of the word ‘make’ those who manage a firm — even when those managers perpetrate a fraud through an unknowing intermediary — the management company at issue here falls within that scope.”

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