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SEC Fraud Suits Undercut by Supreme Court Ruling Shielding Execs

An AOL Inc. employee walks past signage at the company's headquarters in New York. Photographer: Jin Lee/Bloomberg
An AOL Inc. employee walks past signage at the company's headquarters in New York. Photographer: Jin Lee/Bloomberg

Aug. 9 (Bloomberg) -- For three years, former AOL Inc. executives Steven Rindner and Mark Wovsaniker have fought regulators’ claims that they helped their company artificially inflate advertising revenue just before its ill-fated 2001 merger with Time Warner Inc. In June, the U.S. Supreme Court gave them reason to hope.

The ruling, which effectively shrinks the universe of people who can be sued for making false statements in financial filings, has sent the Securities and Exchange Commission rushing to salvage lawsuits against the former AOL executives and at least eight other people, court filings show.

SEC lawyers also are reviewing a slate of open investigations to determine if they’re still viable, according to three people briefed on the matter, who spoke on condition of anonymity because they weren’t authorized to speak publicly.

The court’s June 13 decision, which held that only those ultimately responsible for corporate statements can be sued for fraud, halted a legal approach dating back to the 2001 Enron Corp. collapse that the SEC used to pursue behind-the-scenes lawyers and accountants.

The ruling may force the SEC to pursue more executives on claims of aiding and abetting, rather than fraud. That might shield them from private lawsuits and place a higher burden on the agency to detail all a scheme’s actors and their roles, said James Cox, a securities law professor at Duke University.

“The court really opened up a conundrum for the SEC,” Cox said. “Every case becomes a policy question because of the potential collateral consequences.”

Far-Reaching Effects

While the Janus ruling dealt with the responsibilities of corporate entities rather than individuals, it has far-reaching effects on the SEC’s Rule 10b-5, which says it’s illegal “to make any untrue statement” in the purchase or sale of a security. The SEC has built cases for years on the presumption that the rule can be applied to anyone who substantially participates in creating a false statement, not just those who sign a fraudulent document.

The statements at issue in the Janus case involved a practice known as market timing -- the short-term buying, selling and exchanging of securities to exploit pricing inefficiencies. While legal, it can disadvantage other investors in a mutual fund.

Janus Investment Fund, which offers mutual funds, said in its prospectuses that it was taking steps to deter the practice. Instead, the funds had entered into secret arrangements to let some preferred clients engage in market timing, then-New York Attorney General Eliot Spitzer claimed in September 2003. Shares of Janus Capital Group, which created the mutual funds as a separate legal entity and managed them through a subsidiary, plunged almost 25 percent. Janus paid about $225 million in 2004 to settle claims by Spitzer, Colorado regulators and the SEC, without admitting or denying wrongdoing.

‘Inflated’ Shares

First Derivative Traders sued Janus Capital, claiming the firm and a subsidiary that provided investment advisory services to the mutual funds were responsible for the misleading statements. The lawsuit said Janus’s share price was artificially inflated as a result.

In a 5-4 decision, the Supreme Court ruled for Janus Capital, finding that as a separate legal entity from the mutual funds it can’t be held responsible for “making” the statements. Justice Clarence Thomas wrote in the majority opinion that only the person or entity with “ultimate authority” over the statement can be considered its “maker” under the rule.

“Even when a speechwriter drafts a speech, the content is entirely within the control of the person who delivers it,” Thomas said in the opinion. “And it is the speaker who takes credit -- or blame -- for what is ultimately said.”

Narrowing Scope

The decision was a defeat for private litigants seeking deeper pockets by suing entities behind a fraud. Supreme Court decisions dating back to 1994 prohibit investors from suing anyone who wasn’t a so-called primary violator directly responsible for perpetrating a fraud. Thomas’s opinion further narrows the scope of private lawsuits.

While the extent of the decision’s impact on SEC enforcement is less clear, the agency is already changing tack.

The SEC sued Rindner and Wovsaniker in 2008, three years after the merged company, AOL Time Warner, agreed to pay $300 million to resolve SEC allegations that AOL improperly booked advertising sales to inflate the company’s revenue ahead of the merger. AOL settled without admitting or denying the claims, and four executives have paid $8 million to do the same.

Claiming a ‘Scheme’

The SEC said Wovsaniker, 55, the company’s former head of accounting policy, provided advice on how to structure and document improper transactions and Rindner, 43, who worked in AOL’s business affairs unit, helped carry them out.

Following the Janus decision, lawyers for Rindner and Wovsaniker said in court filings that their clients didn’t have control over the statements at the center of the SEC’s allegations. The SEC dropped certain claims, conceding that the Janus decision protected the two former AOL executives from some of the allegations. Still, the agency argues that other provisions of Rule 10b-5 allow it to sue people for participating in a “scheme” to defraud.

“The SEC cannot escape the inevitable consequences of the Supreme Court’s decision in Janus by attempting to recast its misrepresentation claims,” Wovsaniker said in a July 11 court filing. The “logic and broad sweep of the Supreme Court’s analysis in Janus fatally undermines” the SEC’s case, the filing said.

‘Big Premium’

That remains to be determined by U.S. judges, according to George Canellos, head of the SEC’s regional office in New York. There will be “a big premium on judicial scrutiny of what scheme liability means,” he said at a July 20 securities law event in New York.

In at least one decision, the SEC has gotten a favorable result. In San Francisco, U.S. District Judge William Alsup ruled Aug. 1 that Kimon Daifotis and Randall Merk, former Charles Schwab Corp. executives who were sued for making false statements in marketing the company’s YieldPlus funds, still had to face some of the claims that they had challenged based on Janus.

Other courts may decide differently, and the motions to throw out SEC cases based on the Janus decision are piling up.

Among the defendants making such filings are Matthew Tannin, the former Bear Stearns & Co. managing director who was acquitted in a 2009 criminal case after losing $1.6 billion of investors’ money; Lisa Berry, who was sued by the SEC for her role in allegedly backdating options while general counsel for two companies, Juniper Networks, Inc. and KLA-Tencor Corp.; and Susan Skaer, the former general counsel of Mercury Interactive LLC, who was also sued for backdating options.

Diebold and InfoGroup

Others include Sandra Miller, who was accused of making false statements as the former director of corporate accounting at Diebold Inc.; and Rajnish Das and Stormy Dean, two former chief financial officers of infoGroup, Inc. who were accused of making false financial statements that hid a fraud.

Lawyers for Wovsaniker, Rindner, Berry, Skaer, Daifotis, Merk, Miller and Tannin either declined to comment or didn’t reply to requests for comment.

To be sure, the SEC has other ways to pursue individuals who take part in making false statements even if they weren’t liable under Rule 10b-5 as primary violators.

Aiding and Abetting

The Private Securities Litigation Reform Act of 1995 authorized the agency to bring aiding and abetting claims against anyone who provides “substantial assistance” to others in a fraud. Last year, the Dodd-Frank financial regulatory expanded that power to permit the SEC to sue an individual who “recklessly” aids a fraud even if the person isn’t aware of the wrongdoing. Previously, regulators had the heavier burden of proving the person knowingly assisted the misconduct. Dodd-Frank also clarifies so-called control person liability, enabling the agency to hold senior officers, directors or other executives accountable for misconduct by people they manage.

Before Janus, those provisions “weren’t all that important because the scope of direct liability was pretty broad,” the SEC’s Canellos said at the New York event. Now, they’re more significant, he said.

In the wake of the Janus ruling, the agency is going to have to be a lot more precise about who did what, said James Meyers, an attorney at Orrick, Herrington & Sutcliffe LLP, who represents Berry and Skaer.

“Typically, companies either cooperate and aren’t charged or settle without admitting or denying the allegations,” Meyers said. “It’s harder for the SEC to argue to a jury that an individual aided and abetted a company’s fraud if the company itself was never charged.”

Breyer Dissent

The possibility that the Janus ruling might box in the SEC’s other powers was raised by Supreme Court Justice Stephen Breyer in his dissent. Breyer said that if management drafted a prospectus with false statements that was approved unknowingly by the directors, the managers wouldn’t be liable as principals, and “there would be no other primary violator they might have tried to ‘aid’ and ‘abet’.”

Adam Pritchard, a University of Michigan law professor who previously served in the SEC’s Office of the General Counsel, said such concerns may be overblown. He said SEC lawyers could proceed with fraud cases without invoking Rule 10b-5 and bet that they will hold up in the longer term.

“It wouldn’t get back to the Supreme Court for several years at a minimum,” Pritchard said. “So, they can read it narrowly and see if they can get away with it, and the court may be a different court by the time it gets there.”

To contact the reporter on this story: Joshua Gallu in Washington at

To contact the editor responsible for this story: Lawrence Roberts at

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