Securities Law | Expert Legal Commentary

April 26, 2010

SEC v. Tambone: SEC’s Effort to Expand Primary Liability Rejected

SEC v. Tambone

By Josh Lawler of Zuber Lawler & Del Duca and Joel Ginsberg

SEC v. Tambone: SEC’s Effort to Expand Primary Liability Rejected

Sitting en banc, the First Circuit has rejected the SEC’s argument that Rule 10b-5(b) allows for primary liability for defendants’ “implied misrepresentations” to their customers. In SEC v. Tambone, 597 F.3d 436 (2010), the First Circuit focused on the meaning of the word “make” as used in Rule 10b-5(b), finding that merely “using” a statement that was originated by another party is not the same thing as “making” that statement. At most, such use could only subject a defendant to secondary liability for aiding and abetting, not primary liability.

FACTUAL BACKGROUND

James Tambone and Robert Hussey were senior executives at Columbia Funds Distributor, Inc., a registered broker dealer. The SEC filed a complaint against the executives, alleging that they engaged in fraud in connection with the sales of mutual fund shares in violation of Securities Act Section 17(a), Exchange Act Section 10(b). The prospectuses for the funds told investors that marketing timing was not permitted, but many customers were allowed to market time.

The prospectuses were not prepared by either the defendants or the broker dealer that employed them. Rather, the defendants’ broker dealer was owned by Columbia Management Group, Inc., which also owned Columbia Management Advisors Inc. – the latter was the entity responsible for the prospectuses. The parent company served as the primary underwriter and distributor for more than 104 mutual funds.

The SEC alleged that the two defendants were primarily liable for the false statements in the prospectuses because they commented on the market timing passages prior to the inclusion of those passages in the documents. Moreover, the SEC claimed the defendants had made an “implied representation”  to their customers that the prospectuses were accurate to the best of their knowledge.  Because the defendants knew that the prospectuses contained false or misleading information, this “implied representation” was actionable under Section 10(b) and Rule 10b-5(b).

PRIMARY v. SECONDARY LIABILITY

Rule 10b-5(b) of the Securities Exchange Act of 1934 makes it unlawful “[t]o make any untrue statement of a material fact… in connection with the purchase or sale of any security.” 17 C.F.R. section 240.10b-5(b). Courts have delineated two different levels of liability relating to these false statements – primary and secondary liability. Primary liability attaches to those directly make material untrue statements or omissions while offering or selling securities.

Secondary liability – aiding and abetting – may be imposed on one “who directly or indirectly with intent to deceive or defraud or with reckless disregard for the truth or the law materially aids a seller, buyer, or issuer of a security.” See, e.g. In re Enron Corporation Securities, Derivative & “ERISA” litigation, 540 F. Supp. 2d 759, 769 (S.D. Tex. 2007). Typically, secondary actors are lawyers, accountants, investment bankers, etc., while the primary actors is most often the issuer.

In 1994, the United States Supreme Court held that civil liability could not attach to aiding and abetting under 10b-5. Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994). In 1995, the Private Securities Litigation Reform Act restored the SEC’s authority to bring section 10(b) fraud actions for aiding & abetting, but Congress declined to extend secondary liability to private damage actions. Since Central Bank of Denver, private actions can only be brought against primary violators of securities laws.

To determine whether someone is a primary or secondary actor, the federal courts have developed two different tests and there is a split among circuits as to which test applies. The Ninth Circuit has developed the broad “substantial participation” test, under which a defendant may be primarily liable if he or she substantially participates in, or is intricately involved in, the preparation of the financial statements at issue. The participation need not result in the person actually making a false statement or the actor’s identity becoming known in the market place. See, e.g. Howard v. Everex Sys. Inc., 228 F.3d 1057 (9th Cir. 2000); In re Software Toolworks Inc., 50 F.3d 615 (9th Cir. 1994).

In contrast, a majority of other circuits apply the “bright line” test, which simply holds that in order to be considered a primary violator, the actor must actually make a material misstatement or omission. See, e.g., Wright v. Ernst & Young LLP, 152 F.3d 169, 175 (2nd Cir. 1998) (“[A] secondary actor cannot incur primarily liability … for a statement not attributed to that actor at the time of its dissemination.”).

In SEC v. Tambone, the District Court granted a motion to dismiss the complaint, applying the bright line test to the section 10b claims. The SEC appealed to the First Circuit Court and the panel reversed the District Court decision, agreeing with the SEC that even though the defendants had not authored, signed, or otherwise attributed to the statements in question, the defendants could still be held primarily liable for their “implied representations.” SEC v. Tambone, 550 F.3d 106, 135 (1st Cir. 2008).

The First Circuit granted a rehearing en banc, and the en banc Court reversed the panel, agreeing with the District Court.

The statutory language requires rejection of the SEC’s expanded liability theory

The en banc First Circuit adamantly rejected the SEC’s implied representation theory of primary liability. The Court broke the issue into two questions, answering both in the negative: 1) Whether a securities professional “makes” a statement that can result in Rule 10b-5(b) primary liability by using statements prepared by others to sell securities?; and 2) whether that professional, when directing the offering and sale of securities on behalf of an underwriter, makes an implied statement that he has a reasonable basis to believe that the key representations in prospectus are truthful and complete, thus subjecting himself to Rule 10b-5(b) primary liability? 597 F.3d at 442.

The Court noted the specific language of Rule 10b-5(b), which makes it unlawful “to make an untrue statement of a material fact” and stated, “(i)n light of this deliberate word choice (‘make’), the SEC’s asseveration that one can ‘make’ a statement when he merely uses a statement created entirely by others cannot follow.” Id. at 443. The Court, which referred to the SEC’s assertions as an “abstract, decontextualized approach to the interpretation of a statute or regulation,” determined that the bright line test is the only one that comports with both the rule and the Supreme Court’s decision in Central Bank of Denver. Id. at 445.

“[T]he definition of ‘make’ that we propose is compatible with Central Bank as it holds the line between primary and secondary liability in a manner that is faithful to Central Bank… 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.” Id. at 445 – 446.

The en banc Court decided that the SEC was trying to impose primary liability on conduct that would constitute, at most, secondary violations. Id. at 446.

The Court acknowledged the split among the courts as to the test for primary liability, but the Court did not believe that it needed to resolve that dispute in this case. The Court stated that the bright line and substantial participation tests “are designed for private litigation,” since only primary violations are actionable in private litigation, and thus the discussion is “poorly suited to public enforcement actions.” Id. at 447.

CONCLUSION

The SEC may still appeal the en banc First Circuit decision to the Supreme Court, which at some point may also have to resolve the question of which test courts should use to identify primary violators for Rule 10b actions. In the meantime, the split over the appropriate standard remains.

Notably, in the last year, three U.S. Senators have attempted to introduce legislation that would allow private plaintiffs to sue for aiding and abetting violations. Most recently, Senator Chris Dodd incorporated an aiding and abetting section into his “Restoring American Financial Stability” banking reform and consumer protection legislation. However, on March 15, 2010, a week before the legislation was slated to proceed to full markup, Senator Dodd introduced a new version that did not include the aiding and abetting language.

If legislation is adopted that will allow private causes of action for secondary violations, the bright line- substantial participation split becomes moot and Central Bank and its progeny will be virtually meaningless. Moreover, such legislation could significantly expand the liability for anyone working with issuers and underwriters of securities.

About the Authors

Joel Ginsberg is Deputy General Counsel at Guidance Software, an industry leader in digital investigative solutions.

Image Credit: ©iStockphoto.com/ adam36

View a PDF of the judicial opinion

Connect on Linkedin®

Josh Lawler
Joel Ginsberg

Companies Mentioned

Securities and Exchange Commission

Also See:

Amgen Inc. v. Connecticut Retirement Plans & Trust Funds: Supreme Court Sides with Investors in Securities Fraud Class Action

Gabelli v. SEC: Unanimous Supreme Court Rejects Extending Statute of Limitations in SEC Enforcement Actions

In re Rigel Pharmaceuticals, Inc.: Ninth Circuit Increases Difficulty for Investors to Sue Drug Companies Based on Clinical Trial Results

Mastick v. TD Ameritrade, Inc.: Court Upholds Use of California Arbitration Act in Contracts Governed by California Law

Lawson et al. v. FMR LLC: Sarbanes-Oxley’s Whistleblower Protection Is Limited to Employees of Publicly Traded Companies

The most advanced document                
         management system in the world.

Only $59 / person / month
FeaturesLawLoop Demo
FeaturesWelcome to the Future
Play LawLoop Demo

Companies Mentioned

Securities Law

The following companies are mentioned in Securities Law Updates:

Securities and Exchange Commission

Harris Associates, L.P.

Banc of America Securities LLC

Citicorp USA, Inc.

The Public Employees’ Retirement System of Mississippi

Morgan Stanley & Co., Inc.

Jan Charles Finance S.A.

Park East, Inc.

CIBC World Markets Corp.

Citigroup Inc.

Barclays Capital Inc.

Citigroup Global Markets, Inc.

Torchmark Corp.

Beckstead and Watts, LLP

Barclays Bank PLC

KPMG Peat Marwick, LLP

Deloitte & Touche LLP

Public Company Accounting Oversight Board

BNY Capital Markets, Inc.

Florida State Board of Administration

Credit Suisse Securities (USA) LLC

Credit Lyonnais Securities (USA) Inc.

The Cleaners & Caulkers Local 1 Pension Fund

Credit Suisse, New York Branch

Ameriprise Financial, Inc. f.k.a. American Express Financial Corp.

Deutsche Bank AG

Harris Nesbitt Corp.

California Department of Corporations

The Royal Bank of Scotland plc

RiverSource Investments, LLC

Asset Management Holding AG

Deutsche Bank

Consolidated Management Group, LLC

The Bank of Nova Scotia

Alex Brown, Inc.

Toronto Dominion Texas, LLC f.k.a. Toronto Dominion Texas, Inc.

SG Cowen Securities Corp.

Tellabs, Inc.

Deutsche Bank Securities, Inc.

Mizuho International PLC

Lydia Capital, LLC

Suntrust Capital Markets, Inc.

Makor Issues & Rights, Ltd.

ABN AMRO Inc.

Tribune Company

Fleet Securities, Inc. n.k.a. Bank of America, N.A.

City of Philadelphia Board of Pensions and Retirement

Staples, Inc.

The Bank of New York Company, Inc.

CIBC, Inc.

Additional Resources

Securities Law

Further Reading in Securities Law

Other Recent Expert Legal Commentaries

More Securities Law Expert Legal Commentaries

Recent Summaries

More Securities Law Summaries