First Circuit Authorizes "Primary" Anti-fraud Liability for "Implied" Statements

December 11, 2008
5 minutes

The United States Court of Appeals for the First Circuit issued an opinion on December 3, 2008 that has potentially broad-reaching consequences for mutual fund complex executives. The Court held that officers using fund prospectuses to sell shares may be liable under the securities laws as "primary" violators for misstatements or omissions in the sales documents. The decision extends the reach of the SEC’s enforcement power, authorizes "primary" liability for the conduct of "secondary" actors, and may arm private plaintiffs with a weapon they did not previously wield.

SEC v. Tambone arose from the "market timing" scandal that erupted in 2003. The Commission sued two senior executives of Columbia Funds Distributor, Inc., the principal underwriter for the Columbia Mutual Funds. In response to market timing activity, the funds inserted language into their prospectuses that the funds did not permit market timing of any kind. The SEC's complaint alleged that the executives subsequently made "sticky asset" arrangements that allowed certain investors to execute "round-trip" trades in some funds in exchange for long-term investments in other vehicles. The Commission alleged that the executives were liable for the false prospectus statements even though they had not drafted the documents. The District Court dismissed the complaint because the inaccurate statements in the prospectus were not attributable to either defendant.

The First Circuit reversed. It held that, as senior executives of the primary underwriter for the mutual funds, the defendants had a duty to confirm the accuracy and completeness of the prospectuses used by the distributor to sell the funds. In light of that duty, the Court concluded that the defendants "made" untrue statements when they disseminated and relied upon prospectuses they knew were materially wrong. Although Rule 10b-5(b) only renders it unlawful to "make" an untrue statement, the Court took refuge in the broader language of Section 10(b) of the Exchange Act, which makes it unlawful to "use or employ" a deceptive device.

Acknowledging that it was operating in uncharted territory, the Court held that the use of a prospectus to sell securities by an individual who knows that the document contains a misstatement is an "implied [mis]statement" that is actionable under Rule 10b-5(b). The defendants' personal knowledge of the falsehood and their role in distribution combined, in the Court’s view, to fit the "deceptive use" rubric.

The Court bolstered its ruling by concluding that the defendants’ conduct was also actionable under Section 17(a)(2) of the Securities Act, which prohibits individuals from "obtaining money or property by means of any untrue statement." The Court distinguished this text from the language of Rule 10b-5(b), which proscribes "mak[ing] any untrue statement of a material fact" in connection with securities transactions, and concluded the measures are not co-extensive. Section 17(a)(2) can access conduct not swept up by Rule 10b-5’s "catch-all" reach. It therefore extends to officers compensated by underwriters or distributors that earn fees from selling securities.

Judge Selya wrote a spirited dissent, criticizing the majority’s reasoning as a "radical departure" from precedent and text, and an "unwarranted usurpation of legislative and administrative authority." He particularly disapproved of the majority’s casual conflation of the word "make" in Rule 10b-5(b) with the word "use" as it appears in the statute. And the dissent rebuked the majority for authorizing "primary" liability against "secondary" actors in the mechanics for securities sales.

Section 17(a) of the Securities Act has long been an enforcement weapon of choice for the SEC against participants in the offer and sale of securities. The measure is only enforceable by the SEC, sweeps a broad range of conduct into its orbit, and generally does not require proof of a culpable state of mind such as scienter. Negligent misconduct is sufficient for the Commission to trigger key elements of the statute. Tambone extends the reach of SEC power by confirming that Section 17(a)(2) is broader than—and not co-extensive with—Rule 10b-5. And the decision adds to the SEC’s armaments by authorizing primary Section 17(a) liability on officers and employees of underwriters and broker-dealers for "using" in the course of their employment an issuer’s prospectus they either knew or should have known to contain misrepresentations.

Perhaps more importantly, Tambone has the potential to expand liability for defendants in private securities litigation. "Primary" liability under Rule 10b-5(b) had previously been limited to statements actually uttered or drafted by a defendant. Almost fifteen years ago in Central Bank,1 the Supreme Court rejected private enforcement of "secondary" liability theories under the antifraud rule, including "aiding and abetting," respondeat superior, or other forms of vicarious liability. And just last term, the Court refused to extend the reach of the Rule to "participants" in alleged "schemes."2 But in Tambone, the First Circuit rejected arguments that analogized the behavior of the defendant executives to secondary actors or scheme participants.

The effect of the Court’s ruling in Tambone is to allow officers, executives and employees previously thought to be "secondary" actors to be liable as "primary" violators under Rule 10b-5(b) for making "implied [mis]statements" through the "use" of other authors' falsehoods. Because secondary liability is not otherwise available to private plaintiffs—only the SEC can bring an "aiding and abetting" claim—that transformation of "secondary" conduct into "primary" violations expands the arsenal available to private plaintiffs and enlarges their field of targets.

The decision's reasoning, of course, is not limited to mutual funds. Unless reconsidered en banc3 or further reviewed, Tambone’s blurring of the fault line between "primary" liability and the conduct of "secondary" actors should give pause to any officer or executive involved in the issuance and sale of public securities.

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1 Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 173 (1994).
2 Stoneridge Investment Partners v. Scientific-Atlanta, Inc., 552 U.S. ___, 128 S. Ct. 761, 770 (2008).
3 The opinion was written by Circuit Judge Lipez, joined by a District Judge sitting by designation, over Judge Selya's dissent. In view of the split between the two active circuit judges, Tambone presents a plausible case for rehearing en banc by the First Circuit.