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Appellate Court Expands Scope of Liability in SEC Enforcement Actions

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In a recent 2-1 decision in SEC v. Tambone, the federal appeals court sitting in Boston dramatically expanded the scope of liability for securities fraud by holding that a defendant’s conduct may constitute an implied fraudulent statement even though the defendant did not actually make any false or misleading statements. In a separate opinion, Judge Bruce M. Seyla dissented from the court’s interpretation of Rule 10b-5, writing that the majority's view constituted "an unwarranted usurpation of legislative and administrative authority" and improperly blurred the line between primary liability and aiding and abetting claims.
On December 3, 2008, the United States Court of Appeals for the First Circuit issued a lengthy decision in a Securities and Exchange Commission enforcement action arising out of the market timing scandal. The Commission alleged that two executives of a mutual fund distributor violated the federal securities antifraud provisions by distributing fund prospectuses that contained a prohibition of market timing when they allegedly knew that some investors were permitted to engage in market timing trading. The district court dismissed the case, but the appellate court reversed. The court's key holdings are:

  • Under Section 17(a)(2) of the Securities Act, unlike the comparable antifraud provisions of the Exchange Act (Section 10(b) and Rule 10b-5), a defendant may be found liable for “using” a false or misleading statement as a means to obtain money. It does not matter whether the defendant or someone else actually “made” the statement.
  • Under Section 10(b) of the Exchange Act and Rule 10b-5, the role a particular defendant plays in the securities markets may give rise to a duty to investors such that a defendant’s conduct may be deemed to create “an implied statement” giving rise to fraud liability even though the defendant never actually uttered the words in question.
  • Mutual fund distributors (and their executives) that function as underwriters by selling fund shares to intermediaries and retail customers are subject to the same due diligence standards that apply to underwriters of other securities offerings. Namely, they have a duty to make an investigation that would provide them with a reasonable basis to believe that the information contained in offering documents is truthful and complete.
  • Under Section 10(b) and Rule 10b-5, the Commission does not need to show that allegedly false statements were publicly attributable to the defendants.
  • The heightened pleading standards applicable in private securities litigations do not apply in Commission enforcement actions. The Commission need allege scienter (i.e., that the defendant acted as least recklessly) only generally.
  • The limitations period for Commission enforcement actions (which applies only to penalty claims) is equitably tolled if a reasonable investor would not have been aware of the allegedly fraudulent conduct during the tolling period.

The Commission’s complaint involves the alleged roles of two former executives of a mutual fund distributor in allowing certain preferred customers to engage in market timing trading in funds. Specifically, the Commission alleged that:  (1) the mutual fund prospectuses restricted or prohibited market timing trading by shareholders; (2) the defendants reviewed and oversaw the process of drafting the market timing prohibitions contained in the prospectuses; (3) the defendants later “approved or knowingly allowed” certain investors to engage in market timing trading that violated the fund prospectuses and in some cases, blocked efforts to halt market timing trading by preferred investors; and (4) the defendants oversaw the distribution of fund prospectuses containing the market timing prohibition, which they knew to be false due to their role in approving or allowing some investors to engage in market timing trades.

Twice, the district court dismissed the Commission’s complaint on various grounds. Adopting the so-called “attribution test,” the district court held that to be liable under either Section 17(a) or Section 10(b) and Rule 10b-5, a defendant must have personally made the allegedly false statements or material omissions. According to the district court, neither “disseminating” the allegedly false prospectuses nor “participat[ing] in the process of revising the disclosures” was sufficient to satisfy the attribution test. The district court also held that even though the defendants distributed the prospectuses to investors, they had no duty to clarify allegedly misleading statements because those statements were not publicly attributable to them. Finally, the district court held that the Commission failed to satisfy the strict pleading standards that applied to securities fraud cases and aiding and abetting claims.

The Court of Appeals, however, disagreed with most of the district court’s reasoning and reversed its dismissal. First, the appellate court held that the scope of liability for sellers of securities under Section 17(a)(2) is more broad than under Section 10(b) and Rule 10b-5 because the plain language of Section 17(a)(2) expressly proscribes the “use” of a false statement rather than the “making” of a false statement. Because dissemination of the allegedly false prospectuses to investors was a “use,” the appellate court held that the Commission stated a claim under Section 17(a)(2).

Second, the appellate court held that a defendant’s conduct can constitute the “making” of a false statement under Section 10(b) and Rule 10b-5 even if the defendant did not draft, speak or sign the statement. In arriving at this conclusion, the court relied heavily on its understanding of the specific statutory and business obligations placed on mutual fund underwriters to be primarily responsible for the sale and distribution of fund shares by (1) entering into agreements with brokers, dealers, and other intermediaries or selling shares directly to the retail customers; (2) ensuring that all investors receive the fund prospectuses; (3) creating and distributing advertising materials and other disclosure documents; (4) ensuring compliance with state and federal offering requirements; (5) identifying potential investors and responding to inquiries; (6) executing purchase and redemption transactions; and (7) providing other services not provided by the fund administrator. According to the court, these statutory and business obligations create the same duty to investors that is traditionally associated with the underwriters of equity or debt offerings:  the legal duty to confirm the accuracy and completeness of the prospectus. Thus, when defendants distributed the prospectus, they were making an “implied statement” to investors that they had a reasonable basis to believe it was accurate and complete. Because defendants allegedly knew that it was not, that implied statement was actionable under Section 10(b) and Rule 10b-5.

Third, the appellate court held that the Commission does not need to demonstrate that a statement is attributable to a defendant to bring a claim under Section 10(b) and Rule 10b-5. A showing of attribution is unnecessary because the Commission, unlike a private litigant, does not need to demonstrate that any investor actually relied upon the allegedly fraudulent statement. However, the appellate court declined to take a position on the current split among the circuits as to whether Section 10(b) and Rule 10b-5 require that a defendant actually made the allegedly false statement (the “bright-line test” adopted by the Second Circuit) or merely played a significant role in making the statement (the “substantial participation test” adopted by the Ninth Circuit). Here, the court noted that the substantial participation test has been criticized as too broad by other courts, but it stated that the defendants’ implied statements would satisfy both tests.

Finally, the appellate court clarified certain standards for Commission enforcement actions that it had not previously had an opportunity to address. The court made clear that the heightened pleading standards of Private Securities Litigation Reform Act do not apply and that the Commission may allege scienter generally. But, following the reasoning of the Supreme Court in the recent Tell Labs case, the court held that it will assess the sufficiency of complaint “in its entirety” to determine “whether all of the facts alleged, taken collectively” meet the scienter standard. The court also held that Commission claims may be equitably tolled if a reasonable investor would not have been aware of the violative conduct. In this case, the court held that a reasonable investor would not have been aware of the alleged market timing trading by other shareholders in light of the prospectus statements that represented otherwise. Thus, the limitations period was tolled.

In a strongly worded dissent (although concurring in judgment), Judge Seyla wrote that the court’s interpretation of Section 10(b) and Rule 10b-5 is a “path-breaking step,” a “rewriting” of the rule, a “radical departure” and “an unwarranted usurpation of legislative and administrative authority.” In Judge Seyla’s view, the court’s holding stretches the meaning of the word “make” under Section 10(b) and 10b-5 to encompass more conduct than Congress intended. Judge Seyla, however, agreed with the court’s interpretation of Section 17(a) and its other holdings.

The full text of the court’s opinion and the dissent are available here.

This client advisory was prepared by Ian D. Roffman. Ian served as senior trial counsel in the SEC’s Boston office at the time SEC v. Tambone was originally filed, but he did not take part in the prosecution of that action. If you would like more information about Nutter’s Securities Enforcement and Litigation or Government Enforcement practices, please contact Jonathan L. Kotlier, Ian D. Roffman or your Nutter attorney at 617-439-2000.

Ian D. Roffman

This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising. 

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