RULE 10b-5

LOSS CAUSATION

Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc.

Rule of Law: An investor may not prove reliance pursuant to 10(b) of the Exchange Act
using evidence of a public misstatement caused by the business operations of a third party.

Facts: Scientific-Atlanta, Inc. and Motorola (defendants) engaged in several transactions with
Charter Communications, Inc., a cable operator. These transactions consisted of Charter
overpaying Scientific-Atlanta for equipment related to its cable business, with the agreement that
Scientific-Atlanta would then use the funds from the overpayment to purchase television
advertisements from Charter. Charter then used this arrangement to inflate its revenue figures
and manipulate its financial documents distributed to investors. When this was discovered,
Charters investors (Stoneridge) (plaintiffs) began a class-action suit against Scientific-Atlanta
and Motorola for a violation of 10(b) of the Exchange Act. The district court ruled in favor of
Scientific-Atlanta and Motorola. The court of appeals affirmed. Stoneridge then petitioned for
certiorari to the United States Supreme Court.

Issue: May an investor prove reliance pursuant to 10(b) of the Exchange Act using
evidence of a public misstatement caused by the business operations of a third party?

Holding and Reasoning (Kennedy, J.)

No. Stoneridge may not prevail against Scientific-America and Motorola because the
requirement of reliance on a public misstatement has not been met in this case. An investor
may not prove reliance pursuant to 10(b) of the Exchange Act, with evidence of a public
misstatement caused by the business operations of a third party. It is apparent from the legislative
history of 10(b) that this reliance must be in relation to deceptive acts in dealing securities, not
in business operations. In this case, Stoneridges 10(b) claim against Scientific-Atlanta and
Motorola must be dismissed because it merely complains that their business operations
contributed to misrepresentations of Charters financial documents. Although Scientific-Atlanta
and Motorola may have been engaged in deceptive business operations, neither was involved
with the misrepresentations associated with Charters securities filings. Thus, the judgment of the
court below is affirmed.

Dissent (Stevens, J.)

The majority in this case is mistaken in its analysis, in that Motorola and Scientific-Atlanta
engaged in deceptive activity and will not be held civilly liable. Furthermore, Motorola and
Scientific-Atlanta proximately caused the misstatement in Charters financials through its
deceptive activity. Thus the ruling of the court below should be reversed.

- Notes from class: Scheme Liability Do you think this is convincing under 10b5?
 - One of the larger questions at stake related to these statutory reference.
o What are the worries related to liability?
Everything has a transaction. Are you going to hold everyone liable for
each and every transaction?
As long as they are not negligent and reckless about it.
But what really happens to these lawsuits? You are just trying to
get to discovery. And as such, they want to allege it enough to go
past motion to dismissand thereby hold the companies hostage
to make a settlement.
o Reliance is one way of drawing that line whether the case
should be dismissed or pursued further to discovery.
Then what would be necessary then to show reliance in this case?
o Agreements between the two partiesif there might have
been some public disclosure
In all events we conclude suppliers deceptives acts,
which were not disclosed to the investing public,
are too remote to satisfy the requirement of reliance.
It was Charter, not supplier, that mislead its auditor
and filed fraudulent financial statements; nothing
suppliers did made it necessary or inevitable for
Charter to record the transactions as it did. Pg. 295

Janus Capital Group, Inc. v. First Derivative Traders

Rule of Law: A mutual fund investment adviser cannot be held liable for false statements
included in its client mutual funds prospectuses where the adviser lacks ultimate authority
over the statement.

Facts: Janus Capital Group, Inc. (JCG) (defendant) created the Janus Investment Fund (JIF), a
family of mutual funds legally distinct from JCG. Janus Capital Management LLC (JCM)
(defendant) provided investment advisory services to JIF. All officers of JIF were officers of
JCM. In accordance with legal requirements, JIF issued prospectuses for several of its funds.
These prospectuses stated that market timing was not a proper practice for the funds, and implied
that JCM would seek to restrict it. In September 2003, the New York State Attorney General filed
a complaint alleging that JCG had made secret arrangements to allow market timing for several
of the funds managed by JCM. Consequently, investors withdrew money from JIF mutual funds,
causing JCG a significant loss of income. First Derivative Traders (First Derivative) (plaintiff)
brought suit against JCG and JCM on behalf of other owners of JCG stock. The complaint
alleged that JCG and JCM violated Securities and Exchange Commission Rule 10b-5 by issuing
mutual fund prospectuses containing misleading statements. The District Court found that First
Derivative failed to state a claim that JCM made the misleading statements and dismissed the
complaint. The Court of Appeals for the Fourth Circuit reversed. This Court granted certiorari.
Issue: Can a mutual fund investment adviser be liable for false statements included in its
client mutual funds prospectuses where the adviser lacks ultimate authority over the
statement?

Holding and Reasoning (Thomas, J.)

No. A mutual fund investment adviser cannot be held liable for false statements included in
its client mutual funds prospectuses where the adviser lacks ultimate authority over the
statement. Under Rule 10b-5, only the person or entity with ultimate authority over a statement
can be considered the maker of the statement. An entity that merely prepares or publishes a
statement for another cannot be considered the maker of the statement. Here, the statements in
the prospectuses were issued by JIF. Any assistance provided in preparing the prospectuses by
JCM was subject to the control of JIF. Consequently, JCM cannot be considered the maker of
the misleading statements. Therefore, First Derivative has failed to state a claim against JCM.
The judgment of the Fourth Circuit is reversed.

Dissent (Breyer, J.)

The majority has improperly determined that the term make only applies to those with ultimate
authority over a statement. This interpretation does not comport with a common understanding of
the English language. It is also contrary to case law, which suggests that management, boards, or
other individual company officers can make statements for the purposes of 10b-5 liability even
where those statements appear in documents over which they lack ultimate control. Here, as an
investment advisor that shared many of the same officers with JIF, JCM had significant
involvement in the preparation of the prospectuses. Consequently, JCM should be considered to
have made the statements at issue in the prospectuses.

CONTROL PERSON LIABILITY

- Who can be subject to liability as a control person under Section 20(a)?

Lustgraaf v. Behrens

Rule of Law: To state a claim for control-person liability, a plaintiff must demonstrate that
a person violated securities laws, that the defendant controlled that person, and that the
defendant had the power to dictate the acts or omissions that produced the violation.

Facts: Bryan Behrens (defendant) was a registered representative of Sunset Financial Services,
Inc. (Sunset) (defendant), a broker-dealer that provided Behrens access to the stock market.
Behrens was also a general agent of Sunsets parent company, Kansas City Life Insurance
Company (KCL) (defendant). Behrens operated a Ponzi scheme. The plaintiffs were victims of
this scheme. The plaintiffs brought a securities fraud suit against Sunset and KCL, alleging that
Sunset and KCL had control of Behrens under Section 20(a) of the Securities Act of 1934 and
thus were liable for Behrenss fraud. The district court granted Sunsets and KCLs motion to
dismiss for failure to state a claim on the ground that Sunset and KCL did not have sufficient
control over Behrens to render them liable. The plaintiffs appealed.

Issue: To state a claim for control-person liability, must a plaintiff demonstrate that a
person violated securities laws, that the defendant controlled that person, and that the
defendant had the power to dictate the acts or omissions that produced the violation?

Holding and Reasoning (Melloy, J.): Yes. To state a claim for control-person liability, a
plaintiff must demonstrate (1) that a person violated securities laws, (2) that the defendant
actually exercised control over that person's general operations, and (3) that the defendant
possessed the power to dictate the specific acts or omissions that resulted in the violation.
The plaintiff need not prove that the defendant actually exercised the power to determine those
specific acts or omissions, only that it possessed the power to do so. Nor is it necessary for the
plaintiff to prove the defendants culpable participation in the conduct. Once a plaintiff meets the
initial burden outlined above, the burden shifts to the defendant to demonstrate that it acted in
good faith and did not induce the violators conduct. In this case, the district court correctly
dismissed the complaint against KCL but erred in dismissing the complaint against Sunset.
Broker-dealers such as Sunset maintain significant control over their registered representatives.
Broker-dealers give their representatives access to securities markets and are required to
implement oversight mechanisms. Given this relationship, Behrenss status as Sunsets registered
representative establishes a presumption that Sunset had the requisite control over Behrenss
general operations and possessed the power to order the specific conduct upon which the Ponzi
scheme was predicated. This presumption is sufficient to withstand a motion to dismiss on the
issue of control. KCL, however, did not exert enough control over Behrens for the plaintiffs to
maintain their claim against KCL. KCL was Sunsets parent company but did not actually
exercise control over Behrens or his conduct. Although KCL had the ability to exercise that
control, it did in fact not do so. As KCL is not a broker-dealer, the presumption applied to Sunset
does not apply to KCL; evidence of actual control is necessary. Because the plaintiffs did not
demonstrate that KCL actually exercised control over Behrenss general operations, they have
not stated a claim against KCL on which relief can be granted. The judgment of the district court
is affirmed in part, reversed in part, and the case is remanded.

DAMAGES

RULE 10b-5 Damages:

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Garnatz v. Stifel, Nicolaus & Co., Inc.

Rule of Law: Rescissory damages are appropriate in a Rule 10b-5 claim when the
defendant fraudulently induced the plaintiff to purchase the securities in question.

Facts: Milton Garnatz (plaintiff) was an average investor, without expertise in the securities
market. Garnatz attended investment seminars held by Stifel, Nicolaus & Company, Inc. (Stifel)
(defendant). He also met personally with Stifel vice president Kingsley Wright (defendant).
Based on those seminars and meetings, Garnatz enrolled in a special bond margin account
program, under which Stifel purchased bonds on Garnatzs behalf. Stifel told Garnatz that the
program had no risk and made other assurances that turned out to be incorrect. Garnatz told
Stifel he did not wish to invest in speculative markets. Despite this, most of the bonds that Stifel
bought on Garnatzs behalf were either low- or non-rated, and thus highly speculative. Garnatzs
bonds declined in value after purchase. Garnatz brought a private action against Stifel and
Wright, based on Rule 10b-5 of the SECs regulations. The trial jury awarded Garnatz $45,000.
The defendants appealed, arguing for calculation of damages based on the out-of-pocket rule.

Issue: Are rescissory damages appropriate in a Rule 10b-5 claim when the defendant fraudulently
induced the plaintiff to purchase the securities in question?

Holding and Reasoning (Matthes, J.): Yes. Rescissory damages are appropriate in a Rule 10b-5
claim when the defendant fraudulently induced the plaintiff to purchase the securities in
question. In other words, if the plaintiff would not have made the purchase at all without the
defendants fraud, rescissory damagesas opposed to out-of-pocket damagesmay be
appropriate. Out-of-pocket damages are not mandatory in a Rule 10b-5 claim. In awarding
rescissory damages, a court seeks to return the parties to the position they were in before the sale,
effectively refunding the investor the total amount of the purchase price, minus any value the
investor accrued as a result of the purchase. In this case, the trial court did not err in awarding
Garnatz rescissory damages. Under the out-of-pocket rule, Garnatz would not be entitled to any
damages because, at the time of the purchase, the value of the bonds equaled Garnatzs purchase
price. The out-of-pocket rule is appropriate when the fraud is related to the value of the
securities, but that is not the case here. The fraud perpetrated on Garnatz was not related to the
value of the bonds, but rather the fact that Garnatz purchased the bonds at all. Garnatz did not
want to make any speculative investments. Without Stifels fraudulent assurances that the bonds
were not speculative and involved no risk, Garnatz would not have agreed to buy the bonds.
Rescissory damages are thus appropriate to cover the bonds loss in value, and were
appropriately awarded by the trial court. The judgment of the trial court is affirmed.