The U.S. Court of Appeals for the First Circuit, sitting en banc, issued a major blow to the U.S. Securities and Exchange Commission (SEC) on March 10, 2010, when it rejected the SEC's claims that an underwriter makes implied statements when it disseminates prospectuses. In the opinion, SEC v. Tambone1, which was authored by Judge Selya, the court held that one cannot "make" a statement within the purview of Rule 10b-5(b) of the Securities Exchange Act of 1934 ("Exchange Act") by merely using or disseminating a statement without regard to the authorship of that statement, nor do securities professionals who direct the offering and sale of shares on behalf of an underwriter impliedly "make" a statement, covered by Rule 10b-5(b), to the effect that the disclosures in a prospectus are truthful and complete. The decision divided the Court 4-2.
Background
The defendants, James Tambone and Robert Hussey, were senior executives of a registered broker-dealer, which underwrites and markets mutual funds. As the underwriter, the broker-dealer sold shares in the mutual funds and disseminated their prospectuses to investors; however, the broker-dealer was not directly responsible for the representations contained in the prospectuses.
The prospectuses disseminated by the broker-dealer prohibited short-term trading.2 The SEC alleged that despite this prohibition, the defendants entered into, approved and/or knowingly permitted arrangements allowing certain preferred customers to engage in market timing forays in at least 16 different funds, and by so doing, were liable for material misrepresentations under Rule 10b-5(b).
Procedural History
The SEC filed its civil complaint against the defendants in the U.S. District Court for the District of Massachusetts on May 19, 2006, alleging violations of Section 17(a) of the Securities Act of 1933 (Securities Act"), Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Additionally, the SEC alleged that the defendants aided and abetted various primary violations of federal securities laws.
Each defendant moved to dismiss the claims against him for failure to properly plead any actionable misstatements on their behalf. The District Court granted the motions to dismiss and the SEC appealed certain of its claims. A divided panel of the First Circuit reversed the dismissals and the defendants filed petitions for en banc review. Rehearing en banc was ordered for the Rule 10b-5(b) issues only.
Section 10(b) And Rule 10b-5(b)
Section 10(b) of the Exchange Act makes it unlawful for a person "to use or employ...any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe..." Rule 10b-5(b) provides, in pertinent part, that "it shall be unlawful for any person, directly or indirectly....to make any untrue statement of material fact or to omit to state a material fact necessary in order to make the statement made, in light of the circumstances under which they are made, not misleading." (Emphasis added.)
First Circuit's Analysis
The issue before the court was whether defendants "made" any untrue statements of material fact within the meaning of Rule 10b-5(b). More specifically, the court was presented with a two-part question - whether a securities professional can be said to "make" a statement, such that liability under Rule 10b-5(b) may attach either by (i) using statements to sell securities regardless of whether those statements were crafted entirely by others, or (ii) directing the offering and sale of securities on behalf of an underwriter, thus making an implied statement that he has a reasonable basis to believe that the key representations in the relevant prospectus are truthful and complete. The court held that the answer to both parts of this question is no.
Meaning Of "Make" As Used In Rule 10b-5(b)
The court first looked at the meaning of the word "make" as used in Rule 10b-5(b) and found that both the ordinary meaning and the accepted dictionary definitions of the word are inconsistent with the SEC's interpretation of "make," which would allow one to "make" a statement when he merely uses a statement created entirely by another. The court then looked at the word in terms of statutory construction. First, the court found significant the obvious distinction between the verbs contained in Section 10(b) (i.e., "use" and "employ") and the significantly different and narrower verb contained in Rule 10b-5(b) (i.e., "make"). Second, the court noted that the drafters of Rule 10b-5 chose to draft subsection (a) of the rule to make it unlawful to "employ" a device, scheme or artifice to defraud, which is notably broader than the word "make" used in subsection (b). Finally, the court observed that the drafters of Rule 10b-5 faithfully tracked the language of Section 17(a) of the Securities Act, but deliberately eschewed the expansive language of Section 17(a)(2) when drafting subsection (b) of Rule 10b-5. The court concluded that in light of the deliberate choice of the word "make" by the drafters of Rule 10b-5(b), the SEC's assertion that one can "make" a statement when he merely uses a statement cannot follow.
Supreme Court Precedent
Primary v. Secondary Liability
The court found that the SEC's interpretation of Rule 10b-5(b) also conflicted with Supreme Court precedent, namely Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), which distinguished between primary and secondary violators of Rule 10b-5. Central Bank provides that private plaintiffs are permitted to bring suit under Rule 10b-5 against only primary violators. The court in Tambone characterized the defendants' actions as conduct that constituted, at most, aiding and abetting (i.e., a secondary violation), and thus, imposing liability for such actions under Rule 10b-5(b) would threaten the dichotomy between primary and secondary liability. The court stated that secondary violations of liability should not be permitted to be shoehorned into those rules, such as Rule 10b-5, that are reserved for primary violations.
Duty Of Underwriters
According to the court, another problem with the SEC's implied statement theory is that it effectively imposes upon securities professionals who work for underwriters an unprecedented duty. Securities professionals working for underwriters have a duty to investigate the nature and circumstances of an offering. The SEC alleges that based on this duty securities professionals impliedly "make" a representation to investors that the statements in a prospectus are truthful and complete. Thus, under the SEC theory, securities professionals would have an unconditional duty to disclose. The court found the imposition of such a duty to be in direct conflict with Supreme Court precedent.
In Chiarella v. United States, 445 U.S. 222, 228 (1980), the Supreme Court held that a party's nondisclosure of information to another is actionable under Rule 10b-5 only when there is an independent duty to disclose the information arising from a fiduciary relationship or a similar relationship of trust and confidence between the parties. Therefore, the court explained, it could not adopt the SEC's implied statement theory, as doing so would require it to impose liability in a situation in which there was no independent duty on the part of the defendants to disclose information.
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For each of the foregoing reasons the court affirmed the district court's dismissal of the SEC's Rule 10b-5(b) claims.3
Dissent
The two dissenting judges believed that the majority overstated the significance of Central Bank, failed to account for an underwriter's unique statutory duty to provide investors with accurate information, and mistakenly allowed concerns about excessive private litigation influence its judgment. In the view of the dissent, if an underwriter knows or should have known, that statements contained in a prospectus are false or misleading, the underwriter likewise makes an implied false or misleading statement when it uses such a prospectus, and therefore, has violated Rule 10b-5(b).
Implications
This decision is important for securities professionals in that it limits such individuals from liability under Rule 10b-5(b) to private plaintiffs for material omissions or misrepresentations in prospectuses they disseminate. Had the court ruled in favor of the SEC's theory of an implied statement, underwriters and other market participants would face potential liability under Rule 10b-5(b) to private parties for disseminating prospectuses containing material misrepresentations or omissions, and consequently, a duty to disclose would be imposed on such securities professionals. The court refused to expand both the duty of underwriters in connection with the dissemination of prospectuses and the SEC's basis for liability under Rule 10b-5(b). Thus, the decision merely upholds the status quo.
Footnotes
1. No. 07-1384, 2010 WL 796996 (1st Cir. Mar. 10, 2010).
2. Short-term trading is also known as "market timing," a practice that involves the frequent buying and selling of shares of a single mutual fund in order to exploit inefficiencies in mutual fund pricing. Market timing is not illegal, but in as much as it has the potential to harm fund investors, it is generally barred or restricted by mutual funds.
3. The First Circuit panel decisions that related to the SEC claims not reviewed en banc, namely the Section 17(a)(2) and aiding and abetting claims were reinstated and such claims were remanded to the district court for further proceedings.
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