Securities lawyers are closely monitoring the outcome of a motion for reconsideration in a 1st U.S. Circuit Court of Appeals fraud case that has many claiming the court has gone too far.
In SEC v. Tambone, the court radically expanded the scope of liability in securities fraud investigations by holding that the conduct of two mutual fund executives could constitute an “implied fraudulent statement” even though they did not actually make any false or misleading statements.
As word of the December decision was making its way through the business and legal communities, the 1st Circuit in Tambone announced in a Feb. 23 order that it was accepting briefs on a petition for rehearing en banc.
“Because the 1st Circuit doesn’t have many securities decisions, each new case that comes out gets closely scrutinized, and that certainly has happened here,” said Anthony D. Mirenda, a lawyer at Foley Hoag in Boston who was not involved in Tambone. “The majority opinion went out further than any other court has ever gone. That’s part of what prompted the 1st Circuit to consider reviewing the case en banc, which is something you rarely see them do.”
The controversial decision, which puts the 1st Circuit at odds with every other jurisdiction in the country, comes at a time when SEC enforcement activity is expected to continue to rise in light of the country’s ongoing financial difficulties.
“This ruling means that any officer who knows something [about a transaction] can be accused of making an implied misstatement,” said John D. Donovan Jr., of Ropes & Gray in Boston. “My first thought after reading this was, ‘Tell the clients,’ because this is a potential game-changer.”
Citing his pending motion before the 1st Circuit, Elliot H. Scherker, of Greenberg Traurig in Florida, who represented one of the defendants, declined to comment. An SEC spokesman could not be reached for comment prior to deadline.
Widening the net
After reviewing the decision, Ian D. Roffman, who practices at Nutter, McClennen & Fish in Boston, said he was not surprised to hear about a possible rehearing since the ruling provides a powerful expansion of liability standards in securities litigation.
“One of the things that caught everyone’s attention here is that this represents a significant broadening of the categories of people who could potentially be caught up in a securities fraud case,” he said. “Unlike almost every other court that’s looked at this issue, the 1st Circuit didn’t focus on who made the statement or the role they played in making the statement.”
Instead, Roffman — a former senior trial counsel at the SEC’s Boston office — said the majority looked at the status of the individuals involved and assessed what their obligations and responsibilities were within the securities industry.
“The reason that this is such a dramatic departure is because there are a lot of people in the securities industry who play very specific roles and have a specific status with respect to any particular transaction,” he said. “And so this decision could be interpreted to imply that any violation of those duties can be converted to a claim [under Rule 10b-5 of the Securities Exchange Act of 1934] if the person can be deemed to have made an implied statement that they fulfilled their duties.”
Judge Bruce M. Seyla echoed many of those concerns in a dissenting Tambone opinion. He wrote that the majority’s interpretation of Rule 10b-5 improperly “blurs the line” between primary and secondary (or aiding and abetting) liability. Rule 10b-5 states that it is unlawful for a person in connection with the purchase or sale of a security to make an untrue statement of a material fact “necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.”
“I have come to conclude that this path-breaking step, though taken in the guise of an interpretation of Rule 10b-5, involves nothing less than a rewriting of that rule,” Selya wrote of the majority decision. “In the bargain, it stretches the concept of primary liability beyond what I believe the Supreme Court would countenance and allows the SEC to cast a wider net than any court has ever thought possible.”
Unless Tambone is reversed, Donovan said the biggest fallout from the decision is that private plaintiffs will now be armed with a cause of action they did not previously enjoy. Under the 1994 Central Bank of Denver v. First Interstate Bank of Denver decision, he said the U.S. Supreme Court had held that private enforcement of anti-fraud laws were permitted for primary actors, but not aiders and abettors. But with Tambone now classifying officers, executives and other employees as primary actors under Rule 10b-5, Donovan said that all changes.
“These are people who have always been thought to be secondary actors,” he said. “But if you blur the line and say that what has always been thought to be secondary aiding and abetting really is primary conduct, you all of a sudden expand the scope of liability.” As a result, Donovan said the class of people a private plaintiff can now sue has likely expanded to officers of a mutual fund distributor, individual officers, executives and other players in the underwriting business.
“How about lawyers, accountants and others who are involved in the whole process of underwriting?” asked Donovan. “It’s one of those ‘who knows’ questions. Either way, this gives [plaintiffs’ counsel] a new set of arguments to make.”
Mirenda, who sent out a detailed alert to his Foley clients in the wake of the decision, added that the Supreme Court, in a series of recent cases, has sought to restrict the scope of private actions in securities investigations. In those decisions, he said the court has made clear it prefers the SEC to have exclusive enforcement authority over aiding and abetting complaints.
“But the majority has really opened the door to provide an end run around those efforts by the U.S. Supreme Court to reign in liability,” he said. “And I think the 1st Circuit is now concerned about that and is seriously considering what Judge Selya said in his dissent and trying to get a better understanding about the impact the ruling might have beyond the facts of this case.”
In 2005, the SEC filed a civil complaint against defendants James Tambone and Robert Hussey, former executives at Columbia Funds Distributor. Columbia was the principal underwriter and distributor for a group of approximately 140 mutual funds in a mutual fund complex. The SEC alleged they had violated Rule 10b-5 and §17(a) of the Securities Act of 1933 by participating in a fraudulent scheme with Columbia. From 1998 to 2003, the SEC claimed the defendants had secretly entered or approved arrangements with at least eight investors that allowed them to engage in frequent short-term trading.
According to the complaint, that arrangement violated the terms of a prospectus that did not permit such trading. Although the prospectus was primarily written by an entity the defendants did not work for, the SEC alleged the defendants had commented on drafts, which their employer then disseminated. In 2006, U.S. District Court Judge Nathaniel M. Gorton in Massachusetts dismissed the case on grounds that the defendants could not be held primarily liable for false statements in the prospectus because they did not make the statements at issue.
But 1st Circuit Judge Kermit V. Lipez, writing for the majority, disagreed, finding that underwriters in the defendants’ position play a unique role in the sale and distribution of mutual funds. Lipez wrote that the defendants had a legal duty to confirm the accuracy and completeness of the prospectus and other fund materials they distributed.
“As a result of this duty, [they] made implied statements to potential investors that they had a reasonable basis to believe that the statements in the prospectuses regarding market timing practices were accurate and complete,” he wrote. “Because certain statements in the prospectuses regarding market timing were allegedly false, defendants’ implied statements were also false. These implied statements fall within the purview of section 10(b) and Rule 10b-5(b).” The majority also concluded that the defendants’ conduct was actionable under §17(a), which prohibits individuals from “obtaining money or property by means of any untrue statement.”
Although he agreed with the majority ruling on the §17(a) issue, Selya said the court’s findings on the Rule 10b-5 claims amounted to nothing less than a rewriting of the rule. “In recent months, the securities industry has been wracked by a treacherous combination of market forces, overly optimistic risk-taking, and lapses in judgment,” he wrote. “The majority proposes to add to this perfect storm by judicial enlargement of the scope of primary liability for violations of the antifraud provisions of the securities laws.”