Since the Supreme Court eliminated aiding and abetting liability for private securities actions under Rule 10b-5 in Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 173 (1994), the question of who “makes” a statement for purposes of liability under the federal anti-fraud rules has been a key question in securities litigation. Certain federal courts have given a narrow response to this query, limiting liability to those to whom the statements in question are attributed at the time of dissemination. See, e.g., Wright v. Ernst & Young LLP, 152 F.3d 169, 175 (2d Cir. N.Y. 1998) (“defendant must actually make a false or misleading statement . . .to be [ ] liable under Section 10(b). Anything short of such conduct is merely aiding and abetting, and . . . not enough to trigger liability”) (internal citation omitted). In SEC v. Tambone, No. 07-1384, 2008 U.S. App. LEXIS 24457 (1st Cir. Dec. 3, 2008), the First Circuit arguably took a step pointing in the other direction and held employees of an underwriter liable under Rule 10b-5 for false statements made by the issuer in a prospectus.
The First Circuit’s decision depended on the Court’s view of the unique role of underwriters. Because underwriters under the Securities Act of 1933 typically exercise due diligence in determining that a prospective is materially true, the Court found that, by utilizing the prospectuses in their sale of securities, the underwriter-defendants made the “implied statement” that they had a “reasonable basis” to believe that the statements in the prospectuses were “accurate and complete.” Id. at *120. The First Circuit found a duty by underwriters under the 1933 Act to “investigate and confirm the accuracy of the prospectuses and other fund materials that they distribute,” id. at *76, and transformed that duty into an “implied” affirmative statement (covered by Rule 10b-5) by the underwriters that they believed, and had a reasonable basis for their belief, that the statements in the prospectus were accurate. In a vigorous dissent, Judge Selya criticized this decision as embarking on “judicial adventurism” — namely the “judicial enlargement of the scope of primary liability for violations of the antifraud provisions of the securities laws” via the “rewriting” of Rule 10b-5. Id. at *133-34 (Selya, J. dissenting in part).
In addition, the majority in Tambone1 decided that section 17(a)(2) of the 1933 Act, which forbids an individual from “obtain[ing] money or property by means of any untrue statement,” extends liability beyond people who make the statement to anyone who uses the statement “to obtain money or property,” “regardless of its source.” Id. at *53. In doing so, the Court rejected the argument, supported by Second Circuit case-law, that the prohibitions of section 17(a) were coterminous with Rule 10b-5, and explicitly held that section 17(a) covered conduct not forbidden by Rule 10b-5. See id. at *54.
The case focused on allegedly false and misleading statements contained in Columbia Funds’ prospectuses. Defendants Tambone and Hussey were both senior executives2 of Columbia Funds Distributor, Inc. (formerly known as Liberty Funds Distributor, Inc.), a broker-dealer registered with the SEC which underwrote and distributed the Columbia Funds. The SEC contended that the underwriter defendants were liable for allegedly false representations in fund prospectuses that the funds did not “permit short-term or excessive trading in its shares,” (a practice known as markettiming), while simultaneously permitting such practices. Id. at *10-12. The district court dismissed the SEC case, holding that neither defendants’ roles in “disseminating the allegedly misleading prospectuses nor their participation in the process of revising the disclosures” sufficed to establish liability since “a defendant must have personally made either an allegedly untrue statement or a material omission.” Id. at *24 (internal citations omitted). Among other things, the district court concluded that, without statements attributable to them, the defendants could not be liable for misleading statements in the prospectuses or their failure to correct these false statements. Id. at 24-25.
The First Circuit’s Decision
The First Circuit, in a two to one decision, reversed the district court. After finding a duty by underwriters to “investigate and confirm the accuracy of the prospectuses and other fund materials that they distribute,” the Court held that in “light of this duty to review and confirm the accuracy of the material in the documentation that it distributes, an underwriter impliedly makes a statement of its own to potential investors that it has a reasonable basis to believe that the information contained in the prospectus it uses to offer or sell securities is truthful and complete.” Id. at *76. Thus, since the SEC alleged that Tambone and Hussey made such implied statements to investors about timing practices in the Columbia Funds when “they knew, or were reckless in not knowing, that the representations in the prospectuses about timing practices were false . . . these implied statements were a violation of Rule 10b-5(b).” Id. Judge Selya, in his dissent, asserted that this holding “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.” Id. at 121-22.
In another important part of the opinion, the Court adopted an expansive view of the coverage of section 17(a)(2) of the 1933 Act. Section 17(a)(2) declares in part that it “shall be unlawful for any person in the offer or sale of any securities . . . (2) to obtain money or property by means of any untrue statement of a material fact. . . .” This provision can be enforced only by the SEC and to prove a claim under 17(a)(2) the SEC “need show only that the defendants acted negligently.” Id. at 46. The First Circuit rejected the argument (adopted by the district court) that the language of Section 17(a)(2) and Rule 10b-5 was coterminous, declaring that liability under Section 17(a)(2) is broader than under Rule 10b-5. The First Circuit held that, unlike Rule 10b-5, which requires that a person make3 the statement for liability to attach, “it is irrelevant for purposes of liability whether the seller uses his own false statement or one made by another individual. Liability attaches so long as the statement is used to ‘obtain money or property,’ regardless of its source.” Id. at 53. Since the SEC claimed that Defendants “used” the false and misleading prospectuses in order to sell shares of the Columbia Funds, the Court held this adequately alleged liability and reversed the district court’s decision to dismiss the claims. Judge Selya concurred with the majority’s conclusion on this point, but felt its language was “overly broad.” Id. at 122.
Tambone is a reminder to underwriters that they can face liability under Rule 10b-5 as well as under the 1933 Act for misstatements in a prospectus. Under the 1933 Act, an underwriter’s due diligence is a defense against strict liability for misstatements in the prospectus in civil claims bought by purchasers. Tambone characterized this due diligence defense to liability under the 1933 Act as an affirmative “duty to investigate and confirm the accuracy of the prospectuses and other fund materials that they distribute.” Tambone then found, based on this duty, “implied” affirmative statement by the underwriter as to the prospectus’ truth, such that the underwriter could be liable under Rule 10b-5 to persons who trade in the market when a prospectus contains misstatements.While Tambone’s holding should be limited to underwriters, private plaintiffs may seek to extend the holding in an attempt to make an end-run around Central Bank’s prohibition on aiding and abetting liability.