Following up on Steven Bradford’s post regarding the Fourth Circuit’s interpretation of Janus Capital Group v. First Derivative Traders (2011):

The SEC recently announced  that it intends to pursue more cases under Section 20(b) of the Exchange Act, which prohibits people from violating the Exchange Act “through or by means of any other person.”  I suspect this move will have serious implications for private cases under Section 10(b).

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Section 10(b) prohibits manipulative and deceptive devices used in connection with securities transactions.  It does not explicitly provide a private right of action, but one has been implied in the statute since 1946.

The Supreme Court has long expressed its suspicion of Section 10(b) actions, offering the view that they are unusually “vexatious” and potentially frivolous.  Nonetheless, in Blue Chip Stamps v. Manor Drug Stores (1975), it acquiesced to the private right of action.

At the same time, the Court has long sought to narrow its scope. 

In light of its suspicion of private actions under 10(b), the Blue Chip Court said it would interpret 10(b) differently for private investors than for the SEC.  Private investors, the Court said, would have to show that they either purchased or sold a security in reliance on the fraudulent conduct; they would not be permitted to bring claims alleging that they were manipulated into holding, or not buying, shares.  The Court acknowledged, however, both in Blue Chip and later decisions, that this “purchase or sale” limitation did not extend to actions brought by the SEC, and was not commanded by the statutory text.

Regardless of the merits of Blue Chip, the line it drew between private actions and government actions was relatively straightforward – Section 10(b) would be interpreted to prohibit certain forms of conduct, but for a private investor to bring a claim based on that conduct, she would have to demonstrate that she was personally injured by it – and, after Blue Chip, this could only be accomplished in a relatively narrow way.  Similarly, for private investors to bring actions under Section 10(b), they must prove both that they relied on the misconduct, and that their losses were caused by the misconduct – requirements that do not apply to government actions.  These rules follow the same logic:  10(b) proscribes certain activities, but private investors have to pass what is often a high bar to show they were personally injured by those activities before they can state a claim.

Eventually, the Court began to narrow the scope of the substantive conduct prohibited by Section 10(b) – but that was awkward, because its interpretations necessarily impacted the scope of conduct that could be pursued by the SEC as well, which was not the subject of the Court’s ire.  For example, in Central Bank v. First Interstate Bank of Denver (1994), the Court read Section 10(b) not to prohibit “aiding and abetting” fraud.  The Court’s reasoning appeared to be based solely on the statutory language, and thus to impact even SEC actions, but one sentence – its claim that private investors do not “rely” on the conduct of aider and abetters, and therefore cannot meet all of the elements of a private cause of action – suggested the Court might be searching for ways to distinguish private actions from government actions.

Lower courts had little time to explore the implications for the SEC, however, because a year later, Congress passed the PSLRA, which explicitly gave the SEC the right to pursue aiding and abetting actions.  Thus, courts were not forced to interpret Section 10(b) differently for the SEC relative to private investors; instead, Section 10(b) was interpreted to prohibit the same conduct for both, with the additions of the PSLRA granting the SEC special authority to bring cases against aiders and abettors. 

In subsequent cases, lower courts grew increasingly restrictive in their interpretation of the Section 10(b) cause of action as they tried to distinguish what constituted “primary” misconduct from “aiding and abetting.”  The same rules were routinely applied to both SEC actions and private actions – for example, prior to Janus, several district court decisions adopted very narrow definitions of what it means to “make” a misstatement, and applied them equally to SEC as well as private actions.  See, e.g., SEC v. Lucent Techs., Inc., 610 F. Supp. 2d 342 (D.N.J. 2009); SEC v. KPMG, LLP, 412 F. Supp. 2d 349 (S.D.N.Y. 2006).

In 2011, the Supreme Court decided Janus, where it adopted the rule that the only person who “makes” a misstatement, and thus can be liable under Section 10(b), is the person with “ultimate authority” over that statement – a narrow interpretation that, for example, means that midlevel corporate executives who supply false information to higher level authorities for public distribution may not have “made” a statement, and thus may not be liable, under Section 10(b).  Once again, the Court’s reasoning appeared focused squarely on private actions – for example, the Court stated it would not defer to the SEC’s interpretation because the SEC has no authority to define the scope of the private right of action. 

Nonetheless – until the Fourth Circuit case that Steven discussed – lower courts uniformly agreed that Janus would apply to government actions as well as private lawsuits.

But now, as described above, the SEC is apparently going to pursue an alternate strategy, one suggested by the Supreme Court in Janus.  Section 20(b) of the Exchange Act prohibits persons from doing “any act or thing which it would be unlawful for such person to do under the provisions of this chapter or any rule or regulation thereunder through or by means of any other person.”  Up until now, it’s essentially been a dead statute – no one ever used it, because until recently, any conduct that violated Section 20(b) was presumed to be encompassed by Section 10(b) itself.

Section 20(b), I believe, will give courts the opportunity to finally adopt what they’ve been searching for – a way to treat 10(b) cases differently for private actors than for the SEC.  Section 20(b), unlike 10(b), has never been interpreted to permit a private right of action – and given the Supreme Court’s modern hostility to implying private rights of action, and its antipathy for the Section 10(b) right of action in particular, I think it’s inevitable that courts will reject any argument that Section 20(b) should be interpreted to allow private investors to sue.  Once that’s been established, courts suspicious of private 10(b) actions will, I believe, be tempted to adopt even narrower interpretations of 10(b), while shunting ever-growing forms of misconduct into the 20(b) category, thus functionally accomplishing what the Supreme Court has sought to do for ages – narrowing the private 10(b) cause of action without limiting the SEC’s ability to bring its own cases.

My prediction is that we may see essentially two tiers of cases – private cases, based on increasingly narrow ranges of misconduct – and government cases, that gradually restore to the SEC the flexibility that has eroded in recent years due to narrowing interpretations of 10(b) that were aimed at private plaintiffs.