The First Circuit has ruled that senior executives of a mutual fund underwriter may be held liable for violating Section 17(a) of the Securities Act in the absence of any false statements directly attributable to them on a theory that they used false statements contained in fund prospectuses “to obtain money or property” in the sale of securities. By a 2-to-1 majority, the First Circuit panel also ruled that the same underwriting executives may be liable for making false statements in violation of Section 10(b) of the Securities and Exchange Act and Rule 10b-5 because their distribution of prospectuses containing false information constitutes “implied statements of their own” regarding the accuracy of those prospectuses.
Columbia Funds Distributor, Inc. (“the Underwriter”), is a registered broker-dealer which, between 1998 and 2003, was the principal underwriter and distributor for a group of approximately 140 mutual funds (“the Funds”) issued by Columbia Advisors, a registered investment adviser (“the Issuer”). During the relevant period, James Tambone was the Underwriter’s Co-President and Robert Hussey was its Senior Vice President. During its investigation of market timing practices in the mutual fund industry, the SEC became aware of irregularities in the Funds. The SEC eventually charged Tambone, Hussey and three former executives with primary acts of fraud in violation of securities laws and with aiding and abetting primary violations committed by the Underwriter and by the Issuer.
The SEC’s complaint was based on Fund prospectuses which prohibited market timing in those funds -- a practice which the Court of Appeals described as “‘a mutual fund trading strategy that exploit[s] brief discrepancies between the stock prices used to calculate the shares’ value once a day, and the prices at which those stocks are actually trading in the interim.” The SEC alleged that Tambone and Hussey knew, or should have known, that the market timing prohibition contained in the prospectuses was false since they had affirmatively approved or knowingly allowed frequent trading in particular mutual funds by favored investors in violation of this very prohibition. A district court judge in Massachusetts granted motions to dismiss filed by Tambone and Hussey on the grounds that, in the absence of any false statements directly attributable to them, they could not be held liable for misleading statements or omissions in the prospectuses or for failing to correct the false prospectuses.
The First Circuit reversed, ruling that the SEC’s complaint had stated viable claims against the defendants given the role they and their company played in the mutual fund market. The Court noted that Section 17(a) prohibits a seller of securities from “obtain[ing] money or property by means of any untrue statement,” but ruled that the statute does not require that the seller himself make the untrue statement. Liability attaches, the First Circuit reasoned, so long as an untrue statement is used “to obtain money or property,” regardless of the statement’s source. By contrast, the coverage of Rule 10b-5(b) extends to all segments of the securities industry, but its language requires that a violator “make an untrue statement of a material fact . . . in connection with the purchase or sale of any security” (emphasis added).
Applying the law to the individual defendants, the Court emphasized the Underwriter’s primary responsibility for the sale and distribution of the mutual funds in question and the defendants’ primary responsibility, as senior executives, for the distribution of prospectuses to potential investors and other broker-dealers. The SEC had alleged that, in the offering and selling of securities, Tambone and Hussey had obtained money by means of an untrue statement (the market timing prohibition) contained in the mutual fund prospectuses. Those allegations, if true, stated a viable claim for direct or primary liability under Section 17(a) of the Securities Act according to the unanimous opinion of the First Circuit panel.
The Court further ruled that the SEC had stated a viable claim under Section 10(b) of the Securities and Exchange Act and under Rule 10b-5. If, as the complaint alleged, Tambone and Hussey had used prospectuses containing false information to market mutual funds, “they made implied statements of their own regarding the accuracy and completeness of those prospectuses” in light of “their statutory duties and their central role [as underwriters] in the securities market.” The Court noted that, even though the Issuer of the mutual funds remained primarily responsible for the representations in the fund prospectuses, this did not preclude the primary liability of the individual defendants as well, since actors with different responsibilities could have parallel liability for the same misstatement. The majority also found the SEC allegations sufficient to support claims that Tambone and Hussey had aided and abetted the primary violations committed by the mutual fund Issuer.
One member of the panel dissented from the majority ruling on the Section 10(b) and Rule 10b-5 violation on the grounds that Rule 10b-5 clarifies and limits the scope of Section 10(b) by making it unlawful for any person to “make” any untrue statement of a material fact. According to the dissenter, the plain meaning of that verb cannot cover the passive conduct of Tambone and Hussey. Therefore, the majority’s interpretation impermissibly rewrites Rule 10b-5 and blurs the line between primary and secondary liability for securities law violations.
While the Supreme Court decision in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct. 761, 768 (2008) held plaintiffs to a high standard of proof in private securities lawsuits, the First Circuit’s decision highlights that the SEC “need not allege any of the elements required to establish a direct link between a defendant’s misrepresentation and an investor’s injury – including reliance by the investor on an explicit misstatement, economic loss, and loss causation.” The full text of the decision can be found at SEC v. Tambone, et al., 2008 U.S. App. LEXIS, 24457, No. 07-1384 (1st Cir. December 3, 2008).