In an opinion issued on March 10, 2010, an en banc panel of the U.S. Court of Appeals for the First Circuit (the “First Circuit”) held that certain executive officers of a mutual fund underwriter and distributor could not be primarily liable under Section 10(b) of the Securities Exchange Act of 1934 (“Section 10(b)”) and Rule 10b-5(b) promulgated thereunder, for alleged materially misleading statements in the funds’ prospectuses. SEC v. Tambone, United States Court of Appeals for the First Circuit, No. 07-1384 (March 10, 2010). The SEC’s cause of action under Section 10(b) and Rule 10b-5(b) related to allegations that certain fund investors had been allowed to “market-time” their trades, despite language in the funds’ prospectuses prohibiting such activity.
Procedural Posture. The U.S. District Court for the District of Massachusetts (the “District Court”) dismissed all causes of action against Defendants. A First Circuit panel reversed. Defendants filed petitions for en banc review, and the full First Circuit withdrew the panel opinion, though it ordered a rehearing only on the Rule 10b-5(b) issue.
The SEC’s Claim. Rule 10b-5(b) makes it “unlawful for any person . . . [t]o make any untrue statement of a material fact . . . in connection with the purchase or sale of any security.” The SEC argued that Defendants made misrepresentations by distributing prospectuses that contained allegedly material misrepresentations. Defendants, according to the SEC, had a “special duty” to investigate the truthfulness of the prospectuses that they distributed, and therefore Defendants impliedly vouched for the truthfulness of the prospectuses.
The Court’s Analysis. The Court rejected the SEC’s argument. First, the Court held that because Rule 10b-5 does not define “make,” the term must be interpreted according to its ordinary meaning, and, as commonly understood, to “make” a statement does not mean to adopt another person’s statement. Second, the Court noted that by proscribing only the “mak[ing]” of untrue statements of material fact, the drafters of Rule 10b-5(b) deliberately chose to narrow the scope of liability permitted under Section 10(b), which authorizes the SEC to prohibit all conduct that “use[s] or employ[s]” any “manipulative or deceptive device or contrivance.” Rule 10b-5’s language is largely parallel to that of Section 17(a) of the Securities Act of 1933, with the exception that Section 17(a)(2) prohibits “obtain[ing] money or property by means of any untrue statement of material fact (emphasis added).” The Court held that “[t]he drafters [of Rule 10b-5(b)] easily could have copied that language. They declined to do so.” Thus, the Court rejected the SEC’s “implied representation” theory of liability: that a securities professional that directs the offering and sale of securities on behalf of an underwriter “makes” a statement subject to liability under Rule 10b‑5 by implying that the securities professional has a reasonable basis to believe that the key representations in the prospectuses are truthful and complete.
Finally, the Court held that adopting the SEC’s proposed interpretation of Rule 10b-5(b) would vitiate the Supreme Court’s carefully crafted distinction between primary and secondary securities violations as laid out in Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994). While the government may bring suit under Rule 10b-5 against both primary and secondary violators, private plaintiffs may only pursue primary violators of the statute. “If Central Bank’s carefully drawn circumscription of the private right of action is not to be hollowed – and we do not think that it should be – courts must be vigilant to ensure that secondary violations are not shoehorned into the category reserved for primary violations.”Therefore, the Court affirmed the District Court’s dismissal of the SEC’s Rule 10b-5 claim. The Court concluded: “This is one of those happy occasions when the language and structure of a rule, the statutory framework that it implements, and the teachings of the Supreme Court coalesce to provide a well-lit decisional path.” The Court also reinstated the panel’s decision allowing the SEC to go forward with its claim under Section 17(a)(2) and an aiding and abetting claim under Rule 10b-5.