On May 7, 2009, the U.S. Court of Appeals for the Fourth Circuit (the “Fourth Circuit”) reversed a decision by the U.S. District Court for the District of Maryland (the “District Court”) in which the District Court dismissed plaintiffs’ shareholder suit brought against the adviser to a family of mutual funds (the “Adviser”) and its publicly traded parent (the “Parent”) for failing to state a claim under Section 10(b) of, and Rule 10b-5 under, the Securities Exchange Act of 1934 (the “1934 Act”) against either defendant or a claim under Section 20(a) of the 1934 Act against the Parent. The plaintiffs, who were stockholders of the Parent, alleged that the Adviser and the Parent were responsible for certain false disclosures regarding restrictions on frequent trading appearing in prospectuses for a number of individual funds. The plaintiffs alleged that they had bought shares of the Parent at inflated prices, which fell when the market timing practices actually allowed by the Adviser were publicly disclosed. (The Adviser settled SEC enforcement proceedings in 2004 related to market timing in certain of the funds.)
Section 10(b) Primary Liability. The Fourth Circuit held that the plaintiffs sufficiently pled all six elements of a private Section 10(b) securities fraud claim against the Adviser, but failed to sufficiently plead a Section 10(b) claim against the Parent. The Fourth Circuit focused most of its attention on whether the plaintiffs had met their burden of proving that they had relied on the defendants’ alleged misrepresentation, and in particular, on the sole issue under the fraud‑on‑the‑market doctrine disputed by the parties: whether the statements regarding frequent trading restriction in the funds’ prospectuses were sufficiently attributable to the defendants to be treated as public statements by them. Noting that the courts of appeal “have diverged over the degree of attribution required to plead reliance,” the Fourth Circuit held that a plaintiff seeking to avail itself of the presumption of reliance under the fraud‑on‑the‑market doctrine “must ultimately prove that interested investors (and therefore the market at large) would attribute the allegedly misleading statement to the defendant. At the complaint stage a plaintiff can plead fraud-on-the-market reliance by alleging facts from which a court could plausibly infer that interested investors would have known that the defendant was responsible for the statement at the time it was made, even if the statement on its face is not directly attributable to the defendant.” Noting (a) statements in fund prospectuses and statements of additional information regarding the Adviser’s day‑to‑day role in managing fund affairs, (b) the fact that the funds, the Adviser and the Parent held themselves out to the public as a single entity, and (c) the fact that the defendants and the funds maintained a single website that was used to disseminate fund prospectuses, the Fourth Circuit concluded that interested investors would have inferred that if the Adviser had not itself written the frequent trading disclosure in fund prospectuses, it must at least have approved the disclosure.
As to the Parent, however, the Fourth Circuit observed that while an investment adviser “is well known to be intimately involved in the day-to-day operations of the mutual funds it manages,” it is not necessarily “apparent to the investing public that the investment advisor’s parent company, which sponsors a family of funds, participates in the drafting or approving of prospectuses issued by the individual funds.” In a concurring opinion, one member of the three-judge panel argued that since the Parent was alleged to have made the fund prospectuses available on its website, the prospectus disclosures should be attributed to the Parent; therefore, a claim of primary liability under Section 10(b) and Rule 10b-5 had been properly pled against the Parent.
Section 20 Control Liability. Although it found that the plaintiffs failed to allege a Section 10(b) claim of primary liability against the Parent, the Fourth Circuit nevertheless held that plaintiffs had sufficiently pled a claim of control person liability against the Parent under Section 20(a) of the 1934 Act. In general terms, Section 20(a) provides for joint and several liability of any person with any persons it directly or indirectly controls for the controlled persons’ violations of the 1934 Act and its rules. The Fourth Circuit held that the plaintiffs’ allegations adequately pled the Parent’s control of the Adviser because the plaintiffs alleged that (a) the Parent wholly owns the Adviser, (b) the Parent and Adviser shared a common director who was also a portfolio manager at the Adviser during the class period; (c) the CEO and President of the Parent during part of the class period, who had previously served as a senior officer of the Adviser, spearheaded publicly discussed efforts by the Parent to combat market timing; and (d) employees of the Parent had publicly discussed market timing policies and actions taken to prevent timing in a manner indicating presumptive control over those efforts.The Fourth Circuit reversed the motion to dismiss as to both defendants and remanded the case to the District Court.