The United States Court of Appeals for the First Circuit, sitting en banc, ruled Wednesday that one may not be held liable as a primary violator for “implied” statements, closing an avenue of liability the Securities and Exchange Commission (“SEC”) sought to open based on its broad construction of the term “make” in Rule 10b-5(b), promulgated by the SEC pursuant to Section 10(b) of the Securities Exchange Act of 1934 (the “1934 Act”). In an opinion drafted by Judge Bruce M. Selya, the Court held in SEC v. Tambone that the SEC’s “expansive interpretation” of Rule 10b-5(b) is inconsistent with the text and structure of the rule and relevant statutes, and in tension with Supreme Court precedent. No. 07-1384, 2010 WL 796996 (1st Cir. Mar. 10, 2010).
Defendants, employees at an underwriter, were not alleged to have uttered or written direct misstatements, but the SEC brought suit based on an “implied representation” theory. Under this theory, Rule 10b-5 liability could attach to one who was not the actual speaker of an alleged misstatement but used the alleged misstatement to sell securities. In Tambone, the SEC argued that the individuals “made” misrepresentations in two ways: (1) by using prospectuses drafted by others to sell mutual funds that allegedly contained misrepresentations, and (2) by acting on behalf of the underwriter, thus implying they must have had a reasonable basis to believe the statements in the prospectuses were accurate and complete. The SEC based its implied statement theory on the premise that underwriters have a “special duty” to undertake an investigation that would provide them with a reasonable basis for believing the representations in the prospectus are truthful and complete. The Court sat en banc to determine whether primary liability under Rule 10b-5 could extend to Defendants on the basis of these theories and determined that it could not. As described more fully below, this decision maintains the current boundaries of the SEC’s enforcement tools, and it does not create a new avenue for private civil suits under Rule 10b-5.
The SEC Advances its Implied Representation Theory
In filing suit against James Tambone and Robert Hussey, the SEC challenged the legacy of Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), which held that defendants must actually make a false or misleading statement in order to be primary violators under Section 10(b) of the 1934 Act and Rule 10b-5 promulgated thereunder. Tambone and Hussey were senior executives of broker-dealer Columbia Funds Distributor, Inc., which served as the principal underwriter and distributor of over 140 mutual funds. The SEC accused the Defendants of engaging in federal securities fraud based on allegations that the Defendants allowed certain preferred customers to engage in excessive trading in at least 16 different funds while offering those funds to other investors using prospectuses representing that “market timing” was discouraged or prohibited.
The SEC’s arguments that Defendants should be held liable as “primary” violators for misstatements or omissions in fund offering documents that Defendants did not draft were rejected by the District Court of Massachusetts. However, on December 3, 2008, a panel opinion of the United States Court of Appeals for the First Circuit reversed the decision, holding that the Defendants had a duty to confirm the accuracy of the prospectuses they used to sell the funds, and therefore impliedly had “made” untrue statements by distributing the inaccurate materials.1 Upon petition by the Defendants, the First Circuit granted an en banc review, limiting it to Rule 10b-5(b) issues, and oral argument was heard on Oct. 6, 2009.
On rehearing, the SEC argued Tambone and Hussey made implied statements to investors: as senior executives, Defendants allegedly implied that they had a reasonable basis to believe the statements in the prospectuses regarding market timing were accurate and complete. The Commission further asserted that Tambone and Hussey made false statements within the purview of Rule 10b-5(b) by impliedly adopting the statements of the drafters when they distributed the prospectuses containing false statements on market timing practices. The SEC also emphasized the distinction between its enforcement actions under Section 10(b) and private civil litigation, asserting that policy concerns about the latter should not narrow the scope of primary liability in an SEC enforcement action.
The Defendants disputed the SEC’s theory of liability, arguing it did not fit within the statutory language of Rule 10b-5 and blurred the distinction between primary and secondary liability. Defendants asserted that the “bright line” test routinely applied in Rule 10b-5 cases is applicable to their conduct, which would require the SEC to allege that the Defendants personally made statements in order to establish their primary liability claims. Defendants also noted that a theory of implied representation could extend liability to auditors, underwriters, investment bankers and others who “impliedly bless” other’s alleged misstatements by virtue of their role in the securities markets.The First Circuit Rejects Attempt to Shoehorn Alleged Secondary Violations Into Categories of Liability Reserved for Primary Actors
In rejecting both dimensions of implied liability asserted by the SEC, the Court rested its fundamental analysis on a detailed examination of the language and construction of Section 10(b) and Rule 10b-5. Based on the ordinary meaning of the word “make,” and the absence of any suggestion by the drafters that they intended to imbue the word with “exotic meaning,” the Court concluded that the SEC’s proposed reading was inconsistent with the text of both the statute and the rule. The Court buttressed this conclusion with a contextual analysis of other statutory provisions, recognizing the drafters’ apparently intentional use of narrower verbs in Rule 10b-5(b) than in other provisions (e.g., Section 17(a)(2); Rule 10b-5(a)).
The Tambone decision also addresses the relevance of Central Bank and its progeny. “Under modern Supreme Court precedent dealing with Rule 10b-5, much turns on the distinction between primary and secondary violators.” Tambone, slip op. at 20. According to the Court, this distinction must be vigilantly maintained in order to remain faithful to Central Bank and its “carefully drawn circumscription of the private right of action.” Id. at 21. “Allowing courts to imply that ‘X’ has made a false statement with only a factual allegation that he passed along what someone else wrote would flout a core principle that underpins the Central Bank decision.” Id. at 23.
Describing the SEC’s position as “alarmingly ambitious,” Judges Boudin and Lynch amplify in their concurring opinion some of the themes addressed in the majority opinion. Id. at 34. The concurring judges expressed great concern that adopting the SEC’s “making a statement” theory would result in broad liability for “virtually anyone involved in the underwriting process,” and would expand the universe of private civil actions as well. Id. at 38. Noting that the SEC already has enforcement tools necessary to address the conduct at issue in Tambone — a claim for aiding and abetting violations of Section 10(b) — the opinion concludes by emphasizing: “More than enough is too much.” Id. at 39. They note that increasing the potential liability under Section 10(b) of underwriters, auditors or others who provide services in connection with securities offerings would inevitably increase costs that would be borne by the public.
Implications of the Decision
The Tambone decision is most important for what it does not do: it does not extend primary liability under Rule 10b-5(b) to securities professionals whenever they use a prospectus drafted by others that fails to disclose material information. Most significantly, it rejects the concept that use of an offering document means the underwriter impliedly vouches for the accuracy and completeness of such document. By resisting the SEC’s invitation to depart from what most observers believed was the status quo, the Court recognizes that the SEC’s theories would have been “tantamount to imposing a free-standing and unconditional duty to disclose.” Id. at 26. Had the Tambone Court adopted the SEC’s interpretation of primary liability under Section 10(b) and Rule 10b-5, however, private litigants would have had a basis for asserting class action claims against underwriters and other market participants based on the argument that such service providers allegedly breached representations that they impliedly made in securities offering documents. Tambone squarely rejects that expansion of liability under federal securities law.
Acknowledging that post-Central Bank case law has attempted to define the boundaries between primary violations and mere aiding and abetting, the Court declines to choose between the two branches of analysis that have evolved to define that distinction (the “bright line” test and the “substantial participation” test). The Court also declines to define “make” for the purposes of Rule 10b-5 liability, explaining that resolution of the Tambone matter did not require the explication of a comprehensive test for determining when a speaker may be said to have made a statement. However, the Court’s thorough analysis of the relevant statutory framework provides some guidance on this issue that will likely inform future matters.
As the concurring opinion emphasizes, the SEC still maintains its traditional arsenal of enforcement methods. Thus, the Tambone decision is again more noteworthy for its restraint than for its introduction of new opportunities (for the SEC) or imposition of new obligations (for underwriters and other market participants).
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This article was originally published by Bingham McCutchen LLP.