Fordham University School of Law

Securities Law Enforcement

Professor John Peloso

Fall 2012

Research Paper

Secondary liability in Securities Law: evolution and new

guidelines after Dodd Frank Act and Janus Capital Group v.

First Derivative Trader

Student: Davide Carretta, LL.M.

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ABSTRACT

Fraud is one of the major challenges for sustainable development of financial markets.

The issues of fraud become especially apparent and painful during the crisis times. Fraud

scandals frighten away investors. Secondary liability for fraudulent action serves as a certain

guarantee for investors. Thus, the presence of secondary liability rules ensures investors a

better chance to recover their damages induced by fraudulent conduct. Federal securities laws

contain certain secondary liability provisions which aim to address the participation of

secondary actors (auditors, lawyers, investment bankers) in fraudulent conduct. The

presented paper is dedicated to development in secondary liability issues.

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Introduction

The one major element that adversely affects financial and security market especially in

the 21st century is securities fraud. Several unsuspecting hard working investors have suffered

in the hands of unscrupulous security market agents. Fraud in financial markets is not a new

phenomenon. In fact, during 1920s financial markets were permeated by a “casino” spirit –

everyone expected to earn a good fortune by investing in the stock market1. However, many

financial statements were full of misleading or even false information, and investment

decisions were largely grounded on rumors and allusions2. Accounting records were used in

order to generate as much profit as was possible, often at the expense of misleading investors.

Misleading and false impressions of the market activity triggered price manipulation in

securities trading and these impressions artificially drove security prices upwards3. As a

result, some profiteers managed to gain before prices dropped to more reasonable market

values4. Fraud became a contributing factor to the severe financial crisis of 1930s know as the

Great Depression. Thus, it has been reported that fraud was an important factor contributing

to the failure of the Bank of the United States5.

In order to address the fraud concerns and other issues related to financial markets,

during the early days of the New Deal era, Congress passed two statutes: the Securities Act of

1933 and the Securities Exchange Act of 1934. In Blue Chip Stamps v. Manor Drug Stores6,

Justice Rehnquist observed that the Securities Act was enacted to “provide full and fair

1 Bloom, R., The schism in accounting, Greenwood Publishing Group, (1994)2 Ibidem3 Ibidem4 Ibidem5 Hamilton, J. D. Monetary factors in the Great Depression. Journal of Monetary Economics, 19(2), 145-169,(1987).6 421 U.S. 723 (1975)

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disclosure of the character of securities sold in interstate and foreign commerce and through

the mails, and to prevent frauds in the sale thereof, and for other purposes”. The purpose of

the Securities Exchange Act was to “to provide for the regulation of securities exchanges and

of over-the-counter markets operating in interstate and foreign commerce and through the

mails, to prevent inequitable and unfair practices on such exchanges and markets, and for

other purposes” (Justice Rehnquist in Blue Chip Stamps v. Manor Drug Stores7). Thus, one

may observe that one of the reasons behind the aforementioned Acts was the aspiration to

prevent fraud.

The provisions of Security Act of 1933 and Security Exchange Act of 1934 made

great stride to restore the rule of law against the backdrop of an increasing number of

individuals, which were embroiled in corporate scandals. Therefore, these Acts were meant to

act as regulator to provide checks for the malpractice that had become a norm in the stock

market prior to the crisis. The antifraud provisions of these Federal Securities Statutes are

essential tools that have the capacity to address the issue of fraud in the security market.

These laws provide investors with the ability to bring action against those responsible for the

fraud. In fact, private civil litigants typically bring a wide array of claims not only against the

company and its insiders, but also against the so-called secondary actors such as attorneys,

accountants, investment bankers, and counterparties, who have some degree of relationship

with the primary wrongdoer.

The presented paper is devoted to the issues of secondary liability of parties that are in

some way are related to a wrongdoer. The paper consists of four major parts. The first part

discusses the provisions of the Securities Act of 1933 and the Securities Exchange Act of

1934 that deal with secondary liability both as control person and/or an aider or abettor. The

7 Ibidem

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second part provides the analysis the court cases and cases considered through SEC

Administrative Proceedings regarding the elements needed to be proven to impose secondary

liability in enforcement cases both as control person and/or aider and/or abettor prior to the

Dodd Frank Reform Act of 2010. The third part discusses the provisions of the Dodd Frank

Reform Act of 2010 that address the secondary liability issues. Finally, the fourth part

provides the analysis of Janus Capital Group v. First Derivative Trader8 and its implications

for SEC enforcement cases.

Part I: Securities Act and Securities Exchange Act

1.1. Secondary Liability Provisions in the Securities Act of 1933

1.1.1 Section 15

Section 15 provides that “control persons” or “persons who control” the violators of

sections 11 and 12 of the act, by owning stock or under agency principals, jointly and

severally liable. The section is essentially similar to the section 20 (a) of the Securities

Exchange Act of 1934. The concepts embodied in the section are discussed in the following

paragraphs covering section 20 (a) of the Securities Exchange Act of 1934. Section 15 helps

investors to recover damages if the defendant is insolvent, or does not have enough resources

to repay the investor9.

8 131 S.Ct. 2296 (2011)9 1. Sarkar, D. (n.d.) “Securities Exchange Act of 1934”. Retrieved fromhttp://www.law.cornell.edu/wex/securities_exchange_act_of_1934

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1.1.2 Section 17 (a)

Section 17 (a) constitutes a key anti-fraud provision of the Securities Act. It imposes

liability for fraudulent sales of securities. The section prohibits using any scheme, device or

artifice in order to defraud. Also, the section prohibits obtaining property or money by

material omissions or misstatements. Finally the section prohibits engaging in any practices,

course of business or transactions, which operate or would operate as a deceit or fraud upon

the purchaser. Section 17 (a) is essentially similar to section 10 (a) and Rule 10b-5 of the

Securities Exchange Act of 1934. The concepts embodied in section 17 (a) are discussed in

more details in one of the following paragraphs, covering section 10 (a) of the Securities

Exchange Act of 1934.

1.2 Secondary Liability Provisions in the Securities Exchange Act of 1934

1.2.1 Section 9

Section 9 (a) prohibits market manipulation. The prohibition covers any person. In other

words, section 9 covers a broad circle of actors, including secondary actors. In the run up to

security market collapse in 1929, most stakeholders in this market fabricated financial

performance of their company to cast good results that attracted investors who thought they

could make a kill from such investments yet this was never the case. Section 9 empowers the

investors to sue for trade activities and patterns that falsely give an impression of strong stock

performance, which makes the investors to trade in the securities. In particular, section 9 (e)

provides investors with right to bring action against sellers or buyers, who trade on a stock

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exchange, provided that the stock was registered on the exchange10. The investors must

however prove that the impression of a stable price or security performance was because of

manipulation by stock traders11. Also, an investor should prove that the defendant acted

willfully. Finally, the investor must demonstrate the damage suffered by proving actual value.

If an investor proves actual value, he may then successfully claim the difference between the

price paid and the actual value.

1.2.2 Section 10 (b)

Section 10 (b) imposes private civil liability on those who commit a deceptive act in

relation to the purchase or sale of a security. In particular section 10 (b) prohibits, 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 use manipulative or deceptive devices in connection with

the purchase and sale of any security registered on a national securities exchange or any

security not so registered, or any securities-based swap agreement. Under this provision SEC

promulgated the Rule 10b-5. This rule prohibits, in connection with the purchase or sale of

any security to: (1) employ any device, scheme, or artifice to defraud; (2) 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; (3) engage in any act, practice, or course of business which operates or would

operate as a fraud or deceit upon any person (17 C.F.R. 240.10b-5). Both, section 10 (b) and

the Rule 10b-5, are referred as to “the principal statutory weapons against fraud”12.

10 Sarkar, ibidem11 Sawtelle D., Securities fraud liability of secondary actors. DIANE publishing, (2004)12 Sarkar, Ibidem

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Keller13 reveals that 30 per cent of all securities actions brought under section 10 (b) of

the Securities Exchange Act and Rule10 b-5 promulgated by SEC. Such circumstance

demonstrates that plaintiffs focus not only on primary violators, but also for persons who aid

and abet in the illegal acts or omissions.

1.2.3 Section 18

Section 18 of the Act is equally relevant in dealing with secondary liability. It is

almost similar to section 10 (b) but it is more specific in that it provides a narrower cause of

action against perpetrators as opposed to section 10 (b). Under this section investors who

actually purchased or sold security have legal grounds to institute suit for damages against

companies which have material fraud in their financial statement that duped investors to trade

in securities14. This provision is very effective as it provides the right of action against a wide

range of defendants, including those who actually made the act of a fraudulent statement

(control persons) as well as those well as the aiders and abettors. The only drawback of this –

otherwise effective – provision, lies in the burden of proof. This provision clearly stipulates

that the burden of proof of fraudulent acts on the financial statement committed by the

defendant lies with the plaintiff. The plaintiff, who is the investor, in this case must prove that

he was actually prompted to trade in the security of a certain company because such a

company had falsely represented its financial statements to show that the securities were

fairing on well in the market, when in reality, this was not the case and, as a result, the

investor has incurred financial losses for which he is seeking redress from the law.

13 Keller, J. F., Aiding and abetting liability under securities exchange act Section 10 (b) and SEC rule 10b-5:The infusion of a sliding-scale, flexible-factor analysis. Loyola of Los Angeles Law Review, 22 (4), 1189 –1225, (1989)14 Galbraith K., The Great Crash of 1929. Houghton Mifflin Harcourt, (2009).

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1.2.4 Section 20 (a)

Section 20(a) of the Securities Exchange Act of 1934 stipulates in part, that every

person that directly or indirectly have control of any person who is liable under any

provisions of the Act or any other rule or regulation shall also be liable jointly and severally

to the extent as such controlled person is liable, unless the controlling person performed the

alleged acts in good faith and therefore, never directly or indirectly influenced act

constituting the violation of cause of action. Lowenfels & Bromberg (1997)15 explain that the

term “control” here means “the possession, direct or indirect, of the power to direct or cause

the direction of the management and policies of a person, whether through the ownership of

voting securities, by contract, or otherwise”. It means that, for instance, a holding company

potentially can be held liable for the wrongdoings of the subsidiary company.

Also, one should pay attention to the scope of liability embodied in section 20 (a). Thus,

section 20 (a) speaks about the liability “under any provision of this title or of any rule or

regulation thereunder”. In other words, section 20 (a) imposes secondary liability for

infringements of 10(b)(17) and Rule 10b-516. Moreover, under section 20 (a) persons can be

held vicariously liable for violation of any provision of the Security Exchange Act or rule

promulgated under any provision of the Act17. Thus, controlling persons can be held liable

under the express prohibition of manipulation provisions (section 9 (19)), proxy regulation

provisions (section 14 (20)), or for misleading statements in reports filed with the SEC

(section 18 (21)).

15 Lowenfels, L. D., & Bromberg, A. R. (1997). Controlling person liability under section 20 (a) of theSecurities Exchange Act and Section 15 of the Securities Act. Business Lawyer, 53, 116 Ibidem17 Ibidem

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Furthermore, section 20 (a) determines a kind of liability that can be imposed on

controlling persons – joint and several liability. In connection with this provision, Lowenfels

& Bromberg (1997)18 raise an important question: “whether, and to what extent, the

proportionate liability provisions of section 21D (g) [now section 21D (f)] enacted as part of

the Private Securities Litigation Reform Act of 1995 supersede the joint and several liability

provisions of section 20(a)”. At this point it is important to note that Lowenfels & Bromberg

(1997)19 specify that proportionate liability provisions do not appear to extend to section 15.

While section 21 D (f) (A) restates that covered persons can bear joint and several liability, if

the trier finds that a covered person knowingly committed a violation, section 21 D (f) (B)

stipulates that “[e]xcept 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”. The

phrase “except as provided in subparagraph (A)” allows suggesting that if covered person

was found as committed a violation unknowingly (which is otherwise than foreseen in section

21 D(g)(B)) it can bear a proportionate liability. Lowenfels & Bromberg20 suggest that there

are two possibilities: controlling persons may be held jointly or severally liable, or

proportionately liable by virtue of section 21 D (f). They point out that if section 20 (a) joint

and several liability prevails, the controlling person can be held liable only to the same extent

as the controlled violator. However, if the section 21 (D) (g) liability prevails, “a controlling

person's knowing or no knowing conduct and percent of responsibility win be determined

separately from the controlled person's.”

18 Ibidem19 Ibidem20 Ibidem

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Section 20 (a) contains the important reservation: “unless the controlling person acted

in good faith and did not directly or indirectly induce the act or acts constituting the violation

or cause of action”. In other words, acting in good faith, and non-inducing the violation

constitute a defense to section 20 (a) liability. Lowenfels & Bromberg (1997)21 regard such a

defense as broad and explain it by the broad scope of liability (liable for violation of any of

the act provisions and rule promulgated under them). Thus, the authors believe that the broad

defense corresponds to the broad scope of liability.

1.2.5. Section 20 (e)

Section 20 (e) allows SEC to bring an action against persons who knowingly or

recklessly provided substantial assistance to another person in violation of any provision of

the Securities Exchange Act. One may observe that this section provides enforcement

mechanism for SEC. Furthermore, this section provides an extended scope of secondary

liability – SEC may bring an action against any secondary actor who knowingly or recklessly

provided assistance to persons who violated any of provisions of the Security Exchange Act.

21 Ibidem

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Part II: Elements of Secondary Liability

2.1. Material misrepresentation

One of the elements that should be proven in order to establish secondary liability is

material misrepresentation. For a plaintiff, in order to succeed in his claim under section 10

(b) of the Securities Exchange Act, it is necessary to prove that the defendant committed

fraud or deceit warranting material misrepresentation or omission. Material misrepresentation

should be one that affects a reasonable investor’s purchase decision and as such, a company

can be held liable for statement considered half-truth that is literally themselves true but

omits any other material facts that would be necessary to make the statement as a whole not

misleading.

The analysis of existing case law allows suggesting that once material misrepresentation

had not been proven, the investor would not succeed in his claims. In Santa Fe Industries,

Inc. v. Green22, the Supreme Court rejected that the purchase of stock of the company had

deceptive or manipulative character because no material misrepresentation has been proven.

Also, in this case the Supreme Court held that when a party does not trade on inside

information, failure to disclose does not constitute a material misrepresentation. At the same

time, there is no clear provision as to whom the material representation should be attached.

It is important to bear in mind that misrepresentation always should be material (Gilbert

v. Nixon23). The test of materiality under section 10 (b) of the Securities Exchange Act is

well elaborated by the courts. Thus, in Kardon v National Gypsum Co24, the court pointed out

22 430 U.S. 462 (1977)23 429 F.2d 348 (1970)24 73 F.Supp. 798 (1947)

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that materiality occurs when misrepresentation “would materially affect the judgment of the

other party to the transaction”. Furthermore, in Gilbert v. Nixon25, the court quoting from

Coates & Kline v. SEC indicates that material fact includes any fact “which in reasonable and

objective contemplation might affect the value of the corporation's stock or securities”. SEC,

citing Basic, Inc. v. Levinson26, points out that:

“The materiality element is satisfied by showing that there is a substantiallikelihood that, under all the circumstances, the omitted fact would haveassumed actual significance in the deliberations of a reasonable investor”(Re Calvin Shenkir).

At the same time, some courts disregard the materiality requirement. Thus, in Re ZZZZ

Best Securities Litigation27 the District Court of California rejected the notion that liability

attaches for material misrepresentations only if those misrepresentations are linked to the

defendant. In this case dissatisfied investors brought suit against Z Best Co. (Z Best) and its

accounting firm, Ernst & Young (E&Y). The plaintiffs asserted that there were securities

fraud violations in relation to the public offering and trading of Z Best stock. Plaintiffs

alleged that a number of Z Best’s public disclosure documents had misstatements about Z

Best’s finances, its management, and its future business prospects. E&Y allegedly had

substantially participated in the process of drafting, issuance, and review of Z Best’s public

disclosures even though none of the disclosures at issue were publicly attributed to E&Y.

E&Y argued that there was no material misleading since statement released by Z Best could

not be attributed to E&Y by the investing public. However, the court the securities marked

still relied on the public statements released by Z Best and anyone, who was involved in their

25 Ibidem26 485 U.S. 224 (1988)27 864 F. Supp. 960 - Dist. Court, CD California 1994

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creation. The court, thus, found that due it its participation in drafting financial statements,

which caused deception, E&Y should be held liable under section 10 (b) and Rule 10b-5.

Misrepresentation can take various forms. Thus, in Re Michael H. Novick28, the SEC

held the president and owner of Novick & Co., a company, which was a broker-dealer and an

investment adviser registered with the Commission, liable under Section 17(a) of the

Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder for

fraudulently inducing one of his customers to engage in series of option trades. Novick

engaged his clients in purchase by misrepresenting that options trades had been profitable,

when, if fact, they were not. In Re Calvin Shenkir29, the CEO of Littlefield, Adams &

Company (LAC), misrepresented the company’s income by making it appear that the

company obtained a consulting fee, $ 250.000, for consulting services delivered to Shenkir

& Associates. However, in fact, no such services were performed and the company never

earned any of the income in question. Calvin Shenkir, who operated under Shenkir &

Associates furnished a letter to LAC auditors that the company earned $ 250.000 for

consulting his company. Calvin Shenkir was held liable for violation of section 10 (b) of the

Securities Exchange Act and Rule 10b-5. The SEC found that was a cause of material

understatement of the company’s net loss.

2.2. Scienter

For a successful suit, the burden of proof rests with the plaintiff. The plaintiff has the

responsibility to prove that the defendant has scienter. This implies that the defendant must

28 Re Michael H. Novick, (1995). SEC. Retrieved from http://www.sec.gov/litigation/admin/3436408.txt29 Re Calvin Shenkir, (1995). SEC. Retrieved from http://www.sec.gov/litigation/admin/3436446.txt

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have performed the conduct at issue with deliberate malice. As such, the defendant must have

intended to deceit, manipulate or fraud. The conduct of the defendant must be more than just

negligence, that is, such conduct should explicitly show failure on the defendant part to

exercise care that a reasonable person in his caliber is expected to exercise. Under this

element, the defendant must have disregarded a known risk that misleads investors duping

them into trading in securities.

The scienter requirement was upheld by the Supreme Court in a landmark case Ernst

& Ernst v. Hochfelder30. The main issue before the court was whether the civil damages

action can be brought under section 10 (b) of the Securities Exchange Act, if there is not an

allegation of intent to deceive, manipulate, or defraud on the part of the defendant. The

Supreme Court ruled that such action cannot be brought. The decision in Ernst & Ernst v.

Hochfelder31 was landmark is that it ended up the long lasting debate between courts and

scholars on whether scienter was a necessary element for a cause of action under section 10

(b). Furthermore, in Aaron v. SEC32, the Supreme Court ruled that the scienter element was

also necessary to establish liability under section 17 (a) of the Securities Act of 1933.

Moreover, the Court ruled that SEC should establish the scienter element in its enforcement

actions under section 17 (a).

On many occasions courts considered what may or may not constitute a scienter. In

Abrams v. Baker Hughes Inc33, the investors sued Baker Hughes, claiming the company

deceived the investing public as to the company’s financial discipline and the adequacy of

financial control. The Fifth Circuit held Baker Hughes not liable because of the absence of

scienter. The court pointed out that “the mere publication of inaccurate accounting figures or

30 425 U.S. 185 (1976)31 Ibidem32 446 U.S. 680 (1980)33 292 F.3d 424 (2002)

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failure to follow GAAP, without more, does not establish scienter”34. In Central Bank of

Denver, N.A. v. First Interstate Bank of Denver, N.A35 the Supreme Court rejected the SEC’s

argument that “recklessness is a sufficient scienter for aiding and abetting liability”. The

Court pointed out that in order to establish criminal aiding and abetting liability that the

defendant, who associated himself with the venture, participated as in something he wish to

bring about and sought the action to succeed. However, there are cases, when recklessness

was admitted as a scienter. In Nathenson v. Zonagen Inc.36 the investors sued Zonagen and

some of it officers, claiming, among others, that it fraudulently misrepresented its patent

statements. Zonagen’s officers stated that the patent covered the use of certain technology,

when in fact it did not. The Fifth Circuit found no deliberate intention to misrepresent.

However, the court held that the “severe recklessness” which is reflected in “highly

unreasonable omissions” or misrepresentations that involve “an extreme departure from the

standard of ordinary care” and pose a threat of misleading sellers and buyers was enough to

satisfy the scienter requirement.

SEC also contributed to the development of the scienter doctrine. In Re Revalee et

al37, three persons Revalee, Molton and Dworschak agreed to offer for sale non-existing

prime bank securities, including promissory bank guarantees, letters of credit, prime bank

notes, and bank guarantees. The respondents offered non-existing securities under roll or

“tranche” programs, thus, encouraging investors to make recurring investments. SEC pointed

out that each of respondents knew or were reckless in not knowing that prime banks security

did not exist. On this basis SEC concluded the respondents acted with scienter. Furthermore,

34 Abrams v. Baker Hughes Inc. Ibidem35 511 U.S. 164 (1994)36 267 F.3d 400 (2001)37 In Re Revalee et al, (1995). SEC. Retrieved from http://www.sec.gov/litigation/admin/3436519.txt

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in Re First Fidelity Securities Group38, SEC found that FFSG acted with scienter by

arranging various kickback schemes to secure its underwriting business, thus, defrauding

issuers and investors. In particular, SEC pointed out that a senior investment banker with

FFSG agreed to pay kickbacks to secure underwriting business. Also, SEC drew attention

that the senior investment banker knew that kickback agreements were not disclosed to

investors and issuers.

2.3. Nexus

The defendant’s fraudulent conduct must level the nexus requirement, namely that the

conduct must have been related with relation to the purchase or sale of stock in interstate

commerce. For this reason, only those who have an implied private right of action under rule

10(b) of the Security Act 1933 can sustain a successful suit. Therefore, it is important to note

that there is no remedy whatsoever for those who decided not to purchase security based on

the fraudulent act. This element only offers a remedy to those who fell prey to the fraudulent

action of the stakeholders in the security market and traded in securities resulting in economic

loss.

In Blue Chip Stamps v. Manor Drug Stores39 the Supreme Court ruled that only

investors who suffered damage upon purchase of securities which were offered in violation of

the securities statutes has a cause of action. In this case, the plaintiff did not purchase the

securities, however he claimed that the securities were offered with the violation of Rule 10b-

5. The Supreme Court held that, since the plaintiff did not purchase securities, and thus, did

38 In Re First Fidelity Securities Group, (1996). SEC. Retrieved from http://www.sec.gov/litigation/admin/3-8917.txt39 421 U.S. 723 (1975)

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not suffer damage, he was not entitled to cause an action. The Court pointed out that it is

necessary to show “a logical nexus between the alleged fraud and the sale or purchase of a

security”. If there is no sale or purchase, there is no nexus.

At the same time, there is a precedent when the nexus was found despite the actual

purchase of securities was not conducted. Thus, in Griggs v. Pace American Group, Inc40 the

Ninth Circuit held that a former shareholder who exchanges his stock for contingent rights to

receive stock, has standing to sue as a purchaser of stock for purposes of § 10(b) of the

Securities Exchange Act of 1934 and Rule 10b-5.

SEC in Re First Fidelity Securities Group41, a case discussed in paragraph 2.2, found

that the frauds committed by FFSG were made to offer or sale, and in connection with the

purchase and sale of securities. SEC explained that FFSG was awarded contracts to purchase

securities from issuers, who were advised by consultants, who received kickbacks from

FFSG. Therefore, SEC saw the connection between fraud (kickback arrangement) and the

fact that FFSG obtained a role of the purchaser. In addition, SEC pointed out that the burden

of kickbacks was in part imposed on issuers, thus, increasing the cost of issuance and

decreasing consideration obtained by issuers for their securities.

2.4 Reliance

For a successful suit, the plaintiff must have relied upon the defendant fraudulent

conduct when entering into the transaction at issue. This infers that the defendant fraudulent

misrepresentation must have influenced the plaintiff’s decision to purchase or enter into a

40 170 F.3d 877 (1999)41 Re First Fidelity Securities Group, (1996). SEC. Retrieved from http://www.sec.gov/litigation/admin/3-8917.txt

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transaction. This element of reliance in certain cases qualifies rebuttable presumption of

reliance, which reverses the burden of proof and shifts it to the defendant. In this case, it is

upon the defendant to disapprove the presumption. The plaintiff is always entitled to a

rebuttable presumption of reliance in situations where the defendants had a duty to disclose to

the plaintiff but made a material omission. Another instance in which the plaintiff is entitled

to a rebuttable presumption of reliance is the fraud on market doctrine. The doctrine implies

that proof of actual reliance is not necessary in bringing actions against public companies.

The fraud on market applies in the situation where information at issue is material in nature,

the market is reasonably active, and the fraudulent information was made publicly. By

stakeholders assuring an accurate price accurate share price, the shareholders rely on this

misstatement to trade. In this scenario, therefore, it is not necessary to prove actual individual

reliance.

In Basic Inc. v. Levinson42, the Supreme Court defined the role of reliance – provision

of “the requisite causal connection between a defendant's misrepresentation and a plaintiff's

injury”. In establishing the standard of reliance, the Supreme Court departed from the

understanding that modern security markets involve “millions of shares changing hands

daily”. The Court believed that the standard of reliance should take into account the

difference between the way the modern securities market operates and face-to-face

transactions. The Court, thus, held that the courts may ground their judgments on the

presumption of reliance. Justice Blackmun noted that the presumption of reliance is justified

since most publicly available information is reproduced in market price, and thus, it is logical

to presume that investor relied on public misrepresentation.

42 485 U.S. 224 (1988)

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Furthermore, in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A43

the Supreme Court views reliance as very essential to any Rule 10b-5 action and as such

could not fall prey to plaintiff's claim to recover in a situation in which the plaintiff never

directly relied on any misstatement for omissions by the defendant. The plaintiff therefore

could not recover damages on the grounds that the defendant's conduct failed to satisfy all the

elements relating to primary liability in a private Rule 10b-5 action and in these

circumstances could not recover whatsoever under an aiding and abetting aspect as such a

theory was not provided by section 10(b).

2.5 Economic Loss

The plaintiff should have suffered measureable monetary damages under which the

plaintiff seeks recovery. If he did not suffer any loss in monetary terms, the law lacks remedy

for this situation. Just like common law of tort of fraud, such damages must result to actual

economic loss and not just a nominal damage. The plaintiff must have already suffered the

actual economic loss and he should not just bring up a suit on expected economic loss in the

future.

2.6. Loss Causation

There must be a causal relationship between defendant’s material misrepresentation

and the plaintiff’s economic loss. This is to say that the plaintiff’s economic loss must not

43 511 U.S. 164 (1994)

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only be related to the defendant’s fraudulent material misrepresentation or omission but also

actually be caused by it.

As far as actions under section 10 (a) are concerned, courts considered the causes of

economic loss. One of the well-established principles is that “inflated purchase price will not

itself constitute or proximately cause the relevant economic loss”44. This principle was

adopted by the Second Circuit in Emergent Capital Inv. v. Stonepath Group, Inc.45, by the

Eleventh Circuit in Robbins v. Koger Properties46, Inc and by the Third Circuit in Semerenko

v. Cendant Corp47. Moreover, the principle was upheld by the Supreme Court in Dura

Pharmaceuticals, Inc. v. Broudo48. The Supreme Court observed that private securities fraud

actions for recovery are permissible “where, but only where, plaintiffs adequately allege and

prove the traditional elements of causation and loss”. Also, the Supreme Court pointed out

that in order to prove economic loss the plaintiff should provide the defendant with “notice of

what the relevant economic loss might be or of what the causal connection might be between

that loss and the misrepresentation”.

Part III: Dodd Frank Reform Act of 2010

3.1. General Overview

Barack Obama signed the Dodd Frank Wall Street Reform into law in 2010. The

Dodd-Frank Act is viewed as a response to “anger and cries for retribution against Wall

44 Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005)45 343 F.3d 189 (2003)46 116 F.3d 1441 (1997)47 223 F.3d 165 (2000)48 Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005)

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Street” 49. In more formal language, the act represents an attempt to address numerous

failures of the US financial system, which became apparent during the financial crisis.

Needless to say, that every new piece of legislation, introducing dramatic changes, comes in

times of crisis. That was the case with the Securities Act of 1933 and the Securities Exchange

Act of 1934, and that is the case with the Dodd-Frank Act. The Act is indeed an impressive

law: it contains 2.319 pages and requires 11 regulatory agencies to promulgate 243 new

formal rules50. The Dodd-Frank Act is described as “the most ambitious and far-reaching

overhaul of financial regulation” since the Great Depression era51. There is no doubt that the

Act will significantly modify the structure of financial markets.

The spirit of the Dodd-Frank Act is permeated by the economic theory of regulation.

According to this theory markets need regulations. The lack of regulations triggers many

failures and frauds. The need for regulation becomes apparent in times of severe crises.

Indeed, the first wave of strict regulation came in the 1930s in the times of the Great

Depression. As far as securities are concerned, the regulation was directed, among others, at

the prevention of frauds, which constituted a significant contributing factor in the crisis of the

1930s. The same situation is today. One may observe that modern Wall Street is involved in

numerous fraud investigations and proceedings. The need for regulation became apparent

again.

While the advantages and drawbacks of the act are yet to be seen, it is possible to state

that act has several potent and effective provisions, which can help restore decorum in the

financial sector especially the security market. The most formidable task that awaits Dodd

Frank Wall Street Reform and Protection Act is implementation. This act aims to protect

49 Cooley & Richardson, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of GlobalFinance, John Wiley & Sons, (2010)50 Ibidem51 Ibidem

23

consumers under lending as well as increase government scrutiny of providers of consumer

financial services.

3.2. Expanding the Scope and Definition of Secondary Liability

SEC has always relied on theories of secondary liability to enforce the federal

securities laws, especially those provisions, such as the reporting and internal controls

requirements applicable to public companies, and the rules governing brokerage firms and

investment advisers that were not directly applicable to individuals. To apply these provisions

to individuals, the Commission commonly filed complaints alleging that an individual "aided

and abetted" the violation by a company. In 1995, Congress restored the SEC's aiding and

abetting claims as a part of the Private Securities Litigation Reform Act by adding Section

20(e) of the Securities Exchange Act which extended liability to “any person who knowingly

provides substantial assistance to another in violation. . . .” Sections 929M through O of the

Dodd-Frank Act attempt to end this division by amending Section 15 of the Securities Act

and Section 20(e) of the Securities Exchange Act and adding Section 209(f) to the Investment

Advisers Act to allow liability to any individual or entity that aids or abets in fraudulent

undertakings52.

In particular, section 929 M of the Dodd-Frank Act amends section 15 of the

Securities Act of 1933 by adding the following provision:

“any person that knowingly or recklessly provides substantial assistance toanother person in violation of a provision of this Act, or of any rule orregulation issued under this Act, shall be deemed to be in violation of such

52 Ho, Missed Opportunity for Wall Street Reform: Secondary Liability for Securities Fraud after the Dodd-Frank Act, A. Harvard Journal on Legislation 49, 175-191 (2012)

24

provision to the same extent as the person to whom such assistance isprovided”

Here, one should draw attention to the words “knowingly or recklessly”. To recall, the

courts held that recklessness except severe recklessness does not constitute the scienter

element. If there is no scienter, there is no liability. However, the fact that the Dodd-Frank

Act now expressly states that recklessness also induces liability means that courts will have

to change their position. In simple terms, recklessness is no longer an excuse. Therefore,

investors now have a cause of action under section 15 of the Securities Act of 1933 even if

controlling person was acting not with intent but recklessness. In other words, one may

observe that the introduced amendments are to bring dramatic change into the scienter

doctrine. While considering the amendment of section 15 of the Securities Act, one should

look at two aspects. On the one hand, the amendment can be interpreted as such helping

investors. Indeed, the amendment, in fact, guarantees to SEC the cause of action even if a

controlling person acted recklessly. SEC’s authority to institute actions even in cases of

recklessness is a signal of enhanced guarantees for investors, which is good for maintaining a

sustainable investment climate. With a guaranteed cause of action investors now are more

secure. Such a security can become of driver for increased investment, not only from the US

investors but also from the overseas investors. On the other hand, tightened liability puts

many professionals, such as auditors, lawyers, investment bankers and many others in a very

difficult position. Now they are liable even if they acted recklessly. In other words, their

professional risks increased dramatically. There are always two sides of this issue. One may

argue that now CEOs, lawyers, auditors, investment bankers will act in a more responsible

way. However, genuine mistakes cannot be excluded and the price of a mistake of the

aforementioned professionals became too high. Normally, when the risks of profession are

25

too high, the cost of employing became high too. In other words, one may expect that the

cost of services provided by auditors, lawyers, investment bankers, CEOs and many other

professional will significantly increase. It means that the transaction costs will be higher.

Overall, one may observe that extended cause of action against controlling persons brings

opportunities (enhanced conditions for investments) and risks (increased transaction costs).

Furthermore, section 762 (c) (2) of the Dodd-Frank Act amends section 17 (a) of the

Securities Act. In particular, the amendment foresees liability not only for the fraudulent

conduct in the course of the offer and sale of any securities but also in the course of security-

based swaps. There is already a post-Dodd-Frank precedent when the company’s employee

was held liable for fraudulent conduct in the course of the securities-based swap agreements.

Thus, in SEC v. Goldman Sachs & Co53, a case heard by the District Court of New York,

SEC claimed that one of the Goldman’s traders, Fabrice Tourre violated section 17 (a) by,

inter alia, misrepresenting in security-based swap agreements. The court held Tourre liable.

In this case, the District Court did not consider whether transactions entered by Tourre, in

fact, were security-based swaps. Therefore, it remains unclear when a fraudulent transaction

involving swaps can be considered as security-based swaps, and thus, gives a rise to liability

under section 17 (a) as amended by the Dodd-Frank Act.

The Dodd-Frank Act also makes significant changes to secondary liability provisions

contained in the Securities Exchange Act of 1934. In particular section 929L (2) amends

section 9. In pre-Dodd-Frank version the section 9 liability was limited to transactions,

involving securities registered on a national securities exchange. The Dodd-Frank

amendment strikes the phrase “registered on a national security exchange”. In result, the

section 9 liability covers transactions involving any security other than a government

53 790 F.Supp.2d 147 (2011)

26

security, instead of any security registered on a national exchange. Thus, one may observe

that the base for liability has been enlarged substantially. If before the Dodd-Frank Act a

person was liable under section 9 only if transactions involved exclusively securities

registered on a national exchange, now a person can be held liable under section 9 for

transactions involving any security other than a government one. In simple terms the concept

of “any security other than government security” is broader than the concept of “any security

registered on a national exchange”.

In addition, section 984 of the Dodd-Frank Act introduces changes to section 10 of the

Securities Exchange Act of 1934. The amendment introduces liability for additional kind of

conduct. Thus, it stipulates that it outlaws effecting, accepting, or facilitating a transaction

involving the loan or borrowing of securities, by the use of instrumentality or any means “of

interstate commerce or of the mails, or of any facility of any national securities exchange”, in

violation of rules promulgated by SEC.

Section 929O of the Dodd-Frank Act amends section 20 (e) so as to specify that

controlling person on which liability by virtue of section 20 (a) is imposed, are the persons

that “knowingly or recklessly” provide substantial assistance to the violator. Thus, one may

observe that the Dodd-Frank Act introduces the concept of “knowingly or recklessly” not

only section 15 of the Securities Act of 1933, but also section 20 of the Securities Exchange

Act of 1934. In other words, as well as in case of article 15 of the Securities Act, the Dodd-

Frank Act makes cause of action against a controlling person more available.

27

3.3. Reasons behind Extended Liability Provisions

One of the most notable cases that provide a good basis for understanding contribution

of The Dodd-Frank Act is Central Bank where the bondholders accused a bank of aiding and

abetting a bond issuer in securities fraud by agreeing to delay its review of the appraisal of

land, underlying the value of the bonds until the bond issue had completed. The Court in their

opinion deemed it pointless to look beyond the provision of Exchange Act 1934, which fails

to address the liability on those who aid and abet in Section 10(b) violation. The court held

that in their interpretation the provisions do not permit the application of aiding and abetting

liability to actions brought by private litigants. However, the Court was quick to note that

section 10 (b) does not completely bar the possibility of securities fraud liability for

secondary actors in the securities markets. Such actors include lawyers, accountants, and

investment bankers and the securities laws can reach any actor who meets the requirements

for primary liability, regardless of the nature of the actor’s relationship to the harmed

investor.

Another notorious case, which demonstrated the powerlessness of section 10 (b) claims

when it comes to secondary liability, is Stoneridge Investment Partners v. Scientific-

Atlanta54. In this case the investors sued the suppliers and later customers of the company,

who agreed to the arrangements that allowed the investor’s company to its auditor and

publish a misleading financial statement. The Supreme Court ruled that plaintiff did not have

a cause of action. In particular, the Court held that section 10 (b) of the Securities Exchange

Act does not reach customers and suppliers of a violator.

54 128 S.Ct. 761 (2008)

28

Both case underlined the weakness of secondary liability provisions. The Supreme

Court adopted very restrictive interpretation of the secondary liability provisions. Under the

principles of Central and Stoneridge investors had few chances to succeed in their claims.

The Dodd-Frank Act, although does not extend the civil liability of aiders and abettors in

private actions, but at least makes it easier for SEC to establish the scienter element, it

includes recklessness into the concept of scienter. Ho55 reveals that Congress considered the

possibility to extend the aider and abettors’ liability in private action but rejected this idea

despite there was a testimony before the Senate Committee on Banking, Housing and Urban

Affairs that there was a need to “address the glaring hole in the fabric of investor protection

created by the [Central Bank] and Stoneridge cases”56. Ho believes that the Dodd-Frank Act

ought to provide a private right of action against aiders and abettors, and in this sense,

considers that the statute failed to address concerns raised by Central Bank and Stoneridge57.

However, it seems that, in declining the private right of action against aiders and abettors,

Congress attempted to make a balanced decision – not to endanger to the extreme such

professionals as investment bankers, lawyers, auditors, but also leave it SEC to deal with

secondary actors.

55 Ho, Missed Opportunity for Wall Street Reform: Secondary Liability for Securities Fraud after the Dodd-Frank Act, A. Harvard Journal on Legislation 49, 175-191 (2012)56 Ibidem57 Ibidem

29

Part IV: Janus Capital Group V. First Derivative Traders58

4.1. Facts of and Procedural History

Janus Capital Group, Inc. (JCG) operated as the Janus family of mutual funds, which

existed in a Massachusetts business trust called The Janus Investment Fund. The Fund

operated as a separate legal entity in the ownership of mutual-fund investors and as such, it

operated independently. The Fund retained JCG's wholly owned subsidiary, Janus Capital

Management, LLC, which was its investment adviser and administrator of the Fund. The

Investment Adviser existed as separate legal entity from the Fund. This Fund, known as the

Janus Investment Fund, issued prospectuses, which contained the description of its

investment strategy and operations. Some prospectuses showed that the Fund was unsuitable

for market timing and asserted that the Fund would act to curb the practice if detected and

compensate against loses to investors.

In 2003, the Attorney General of the State of New York accused JCG of entering into

secret arrangements to allow market timing in many of the Janus funds managed by the

Investment Adviser. These allegations reached the public domain, thereby prompting

investors to withdraw significant amounts of money from the Fund. This move adversely

affected JCG because it led to a significant decrease in the management fees paid to the

Investment Adviser. This led to plummet in JCG's income since the Investment Adviser

existed as JCG’s wholly-owned subsidiary. Against such a background, JCG's stock price fall

was inevitable59.

58 131 S.Ct. 2296 (2011)59 U.S. Government, Securities Fraud Liability of Secondary Actors. General Books LLC, (2011)

30

In the midst of this allegation against JCG, First Derivative Traders, an investment

firm which had stock in JCG felt that JCG had contravened their agreement and pressed

charges against JCG and the Investment Adviser pursuant to Section 10(b) of the Securities

Exchange Act of 1934. According to First Derivative Traders, JCG and the Investment

Adviser occasioned the issuance of prospectuses that contained misleading statements

concerning market timing. Consequently such a misleading led to the decline in JCG's stock

price. First Derivative Traders claimed that JCG was liable for actions of the Investment

Adviser's as a controlling person under Section 20(a) of the Act.

The trial court dismissed the First Derivative's complaint on the grounds that First

Derivative had failed to state a claim. First Derivative Traders appealed. The Fourth Circuit

ruled that First Derivative had satisfactorily stated their allegations that JCG and the

Investment Adviser, through their participation in the writing and dissemination of the

prospectuses, which contained misleading statements, committed fraud. Also, the Fourth

Circuit held that investors would deduce that the Investment Adviser had played a role in

making the content of the prospectuses, but that investors would not deduce the same thing

about JCG, which is liable as control person of the Investment Adviser under Section 20(a).

Finally, the case was brought before the Supreme Court.

4.3. The Supreme Court Ruling

The Supreme Court reversed the earlier ruling on the grounds that the Investment

Adviser did not “make” the misstatements contained in the prospectuses. The private right of

action, which is present in Rule 10b-5 according to the Supreme Court, has narrow

dimensions. The ordinary meaning of a “maker” of a statement, as established under Rule

31

10b-5, refers to the person or entity with whom the ultimate authority over the statement

rests. This aspect includes the content of the statement and whether and how such statement

is communicated. According to the Supreme Court, other parties might give their input

through giving suggestion on what to say, prepare or publish on a statement on behalf of

another.

However, one should bear in mind that these parties cannot be regarded as having

made the statement because the content of the statement rests in the control of the person who

delivers it. Following this logic, the Court rejected the notion, which presumes the

relationship existing between a mutual fund and its investment adviser, dictates that an

investment adviser should be viewed as having made the statements present in mutual fund's

prospectuses60.

The Supreme Court was of the opinion that the notion failed to consider the corporate

form, in the context of this case. The court pointed out that the Fund and the Investment

Adviser existed separately, and each acted independently in performing their duties. The

Supreme Court reiterated that ruling on the contrary would have dire consequences because it

would mean that the courts overrule Central Bank.

4.3 Debates over the Supreme Court Ruling

The Janus Capital Group decision sparked numerous and endless debates. Many

experts raised their concerns via various media channels, claiming that the Janus Capital

Group decision allows the Wall Street companies come up with new ways to escape liability

for the loss inflicted on hardworking people who have witnessed their life savings destroyed

60 Kates, The Global Financial Crisis: What Have We Learnt?, Edward Elgar Publishing, (2011)

32

by fraudulent investment schemes. 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 a wake of such

developments, legal experts have been piling pressure on the Congress to amend section 20

of the Securities Exchange Act, especially the control person provision. The experts are of the

view that the concept of control person needs to be expanded so as to include a private right

of action against any person who knowingly provides substantial aid to another person in

violation of the Securities Exchange Act61.

Some experts believe that the proposed substantial participation standard would offer

and serve remedial purpose of the federal securities laws, restore investor confidence in the

United States’ financial markets, and promote outside advisers’ traditional role as gatekeepers

of the securities market62. According to them, by rejecting the approach taken by the Supreme

Court in Janus Capital Group, the proposed standard can properly balance the need to give

investors the opportunity to recover against outside advisers for securities fraud, and to limit

frivolous claims at an early stage of the litigation63. There are also suggestions that 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)64. Also,

there is an opinion, that whatever the merits and grounds of creating categorical restrictions

on primary liability for secondary actors are, such restrictions should not apply to those who

play a substantial role in assisting fraud65.

61 Galbraith, The Great Crash of 1929. Houghton Mifflin Harcourt, (2009)62 Copeland C., Dodd-Frank Wall Street Reform and Consumer Protection Act: Regulations to be Issued by theConsumer Financial Protection Bureau. DIANE publishing, (2004)63 Ibidem64 Ibidem65 Ibidem

33

4.5. Impact of Janus on subsequent court litigation and SEC Administrative

Proceedings

4.5.1 Court cases

While it is widely claimed that the Janus decision has detrimental impact on private

actions against secondary actors, the impact on SEC actions remains unclear. There is no

agreement among the courts as to how Janus affects SEC’s ability to bring actions against

secondary actors. In particular there are considerable difference between the positions of the

District Court of California for the Northern District and the District Court of New York for

the Southern District.

Thus, in SEC v. Daifotis66 the District Court for the Northern District of California

ruled that Janus does not apply to section 17 (a) of the Securities Act of 1933, and to section

34 (B) of the Investment Company Act. In this case, defendants sought to strike the SEC’s

allegations in violation of section 10 (b) of the Securities Exchange Act, to section 17 (a) of

the Securities Act of 1933 and to section 34 (B) of the Investment Company Act. They

succeeded only in part. However, the SEC’s claims under secondary liability provisions were

upheld despite Janus. In a word, in Daifotis the District Court did not find that Janus limited

SEC’s ability to embrace secondary liability claims. Also, in SEC v. Sells, the District Court

of California rejected the defendant’s claim that Janus forecloses his liability under Rule 10b-

5(b). The court explained that since Janus did not address these sections, it does not apply to

66 District Court, N.D. California (2011) Not reported. 2011 WL 3295139. Only the Westlaw citation iscurrently available

34

them. Thus, one may observe that the District Court for Northern District of California

interprets Janus in strict and narrow terms.

There is no unanimity among judges of the District Court for Southern District of

New York. In SEC v. Kelly67, the District Court took an approach opposite to that one

adopted by the District Court in California. In this case the Commission, realizing that it will

not succeed with its section 10 (b) and Rule 10b-5 claim instituted for “scheme liability”

under subsections (a) and (c) of Rule 10b-5. To recall, these subsections make it “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, (a) To

employ any device, scheme, or artifice to defraud, [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.” 17 C.F.R. § 240.10b-5(a), (c).

However, the District Court denied that SEC can establish its claim under subsections (a) and

(c) of Rule 10b-5. Judge McMahon pointed out that the SEC’s scheme liability claim is

grounded on misrepresentation but neither defendant “made” a misstatement in terms of

Janus. At the same time, in SEC v. Pentagon Capital Management PLC68 the District Court

of New York for Southern District rejected the notion that Janus has impact on actions

brought by SEC. In particular, Judge Sweet drew attention that the Janus doctrine is limited

to private actions and does not cover SEC’s actions. The District Court concluded that Janus

does not apply to SEC enforcement actions under section 10 (b) of the Securities Exchange

Act, and under section 17 (a) of the Securities Act.

67 817 F.Supp.2d 340 (2011)68 844 F.Supp.2d 377 (2012)

35

The position of the District Court in Illinois is largely consistent with the position of the

District Court in California. Thus, in SEC v. Sentinel Management Group69, the District

Court pointed out that “the policy underlying the Janus decision is inapplicable to a claim

brought by the SEC under Section 17(a)”.

4.5.2. SEC Administrative Proceedings

The decision in Janus affected SEC Administrative Proceedings. Thus, in Re

Flannery70, SEC Chief Administrative Law Judge Brenda Murray, in an initial decision

applied the reasoning of SEC v. Kelly71 and applied Janus. In particular, Judge Murray

dismissed SEC claims finding that neither respondent was had ultimate authority over the

alleged misstatements72. In general, it is reported that up to date SEC Administrative Law

Judges apply the Janus’s “make” requirement in enforcement cases under Rule 10b-573. Also,

SEC Administrative Law Judges find that Janus rule is applicable to statements under section

17 (a). Thus, in Re Flannery concluded that Janus test is appropriate to assess the defendant’s

conduct under section 17 (a). By applying Janus, Judge Murray in Re Flannery found that

defendants did not have ultimate authority over or responsibility for documents, which

contained misstatement74. Although there is a precedent of the Janus test application by SEC

Administrative Law Judges, it is still premature to state that SEC in its proceedings applies

and observe the Janus “maker” standard.

69 District Court, N.D. Illinois, Eastern Division (2012). Not reported. Retrieved from scholar.google.com70 SEC News Digest 2011-210, Enforcement Proceedings71 817 F.Supp.2d 340 (2011)72 Dorfman, M., & Wheeler, E. Top Ten SEC Enforcement Developments of 2011. Securities Regulation LawJournal, 40(1), 5, (2012).73 Bartholomew, C. & Nilson, S. (2012) Top SEC Enforcement Issues for Public Companies. Retrieved fromhttp://www.weil.com/files/upload/Top_Enforcement_Issues.pdf, (2012)74 Ibidem

36

Conclusion

The Securities Act of 1933 and the Securities Exchange Act of 1934 contain a range of

secondary liability provisions which aim to provide investors to bring an action against

persons, other than a primary violator. These provisions allow different scope and degree of

secondary actor’s liability. In the course of time, the courts elaborated various tests for

secondary liability claims. Thus, in order to succeed in a private action against the secondary

actor, a plaintiff must establish five main elements: material misrepresentation, scienter (state

of mind), nexus (logical connection between the alleged fraud and purchase or sale of

securities), reliance (e.g. Investor’s reliance on misrepresented facts or statements), economic

loss, and loss causation (connection between the alleged fraud and economic loss). The

Supreme Court adopted a very restrictive interpretation of secondary liability provisions.

Many experts point out that such a narrow interpretation leads to a situation when many

participants in fraudulent schemes can escape liability. The Dodd-Frank Act of 2010

extended the scope of liability. Specifically, it introduced new kinds of conduct for which

secondary actors can be held liable. Also the act introduced the “knowingly or recklessly”

concept which allows holding a person liable for reckless misconduct. At the same time, the

Dodd-Frank Act did not bring any dramatic change in enhancing the cause of action for

private litigants. In fact, the Act is often criticized for that. One of the recent cases that have a

dramatic impact on narrowing the scope of secondary liability is Janus. In this case the

Supreme Court basically ruled that under Rule 10b-5 investors have a cause of action only

against an individual or entity with final authority over the alleged false or deceitful statement

in a prospectus. While it is rational that Janus ruling will have a profound impact on private

actions, at this point, it seems that actions brought by SEC seem largely unaffected.

37

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