Statutory Interpretation and Primary Liability: S.E.C. v. Tambone

In Securities and Exchange Comm’n v. Tambone, No. 07-1384, 2010 WL 796996 (1st Cir. Mar. 10, 2010), the First Circuit Court of Appeals in an en banc decision held the SEC failed to sufficiently allege that a registered broker-dealer’s senior executives made false statements of material facts under Rule 10b-5 of the Securities Exchange Act of 1934 where they allegedly distributed but did not otherwise "make" the false statements.

Defendants, James Tambone and Robert Hussey, were senior executives of a registered broker-dealer, Columbia Funds Distributor, Inc. (“Columbia”).  Tambone served as Columbia’s co-president and Hussey served as managing director.  The trading practice at issue is called “market timing.”  That is, the practice of frequent buying and selling of a singe mutual fund’s shares to exploit market inefficiencies.  The SEC claimed that, although not illegal, this practice can harm other fund investors; thus, mutual fund managers commonly bar this practice.

In 1998, Columbia began inserting language into its prospectuses restricting the number and frequency of market timing exchanges in which an investor could participate.  By 2003, language prohibiting this activity appeared in all of Columbia’s prospectuses.  The SEC alleged the defendants jointly and severally entered into, approved, or knowingly permitted arrangements allowing certain preferred customers to engage in market timing.  Furthermore, the SEC alleged the defendants used the prospectuses in sales efforts by allowing them to be disseminated and referring potential clients to them.

The SEC’s complaint alleged Tambone and Hussey violated Section 17(a) of the Securities Act of 1933 and Section 10(b) and Rule 10(b)-5 of the Exchange Act of 1934.  In addition, the complaint alleged the defendants aided and abetted primary violations of sections of the Exchange Act, and primary violations of the Investment Advisors Act of 1940. 

The court examined whether a securities professional could be charged with liability under Rule 10(b)-5(b) for distributing false statements.  The court also examined whether a securities professional could be liable by directing the offering and sale of securities on behalf of an underwriter, thus making an implied statement that he has a reasonable basis to believe that the key representations in the relevant prospectus are truthful and complete.  The court held that a securities professional cannot be held liable in either case.

Section 10(b) of the Exchange Act renders it unlawful for any person “to use or employ . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe.”  Rule 10(b)-5(b) states “it shall be unlawful for any person . . . to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made . . . not misleading.”  (emphasis added) The inquiry focuses on whether the defendants “made” untrue statements of material fact within the meaning of this rule.  The court looked at the structure of section 10(b) and Rule 10(b)-5(b) for guidance: the SEC deliberately chose the word “use” in section 10(b) and the word “make” in its subsection.  This, the court found, was meaningful.  Specifically, the court stated that the SEC’s declaration that one can “make” a statement when he merely uses a statement created entirely by others was incorrect.  The fact that the SEC created a different subparagraph of the rule and selected a more exclusive verb is significant, according to the court.

The SEC argued that “make” must include “use” because the statute prohibits “use,” and therefore, the rule must prohibit all that the statute prohibits.  The court rejected this reasoning, stating that even if the Rule is coextensive with the coverage of the section, it does not mean that each of the subparagraphs of the Rule is itself coextensive with the coverage of the section.  If this were true, the court reasoned, each subparagraph would proscribe exactly the same conduct.  If the SEC intended to prohibit more than just the actual making of a false statement in Rule 10(b)-5(b), it would not have employed the verb “make” in the rule’s text.

The SEC’s interpretation was also considered inconsistent with Supreme Court precedent.  In Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), the court did not address the precise issue in the case at bar.  In Central, the court held aiding and abetting, which is a secondary violation, does not fit within Rule 10(b)-5, which extends only to primary violations.  Adopting an implied liability theory would allow the SEC to impose primary liability on the defendants for conduct that constitutes, at most, aiding and abetting, which is a secondary violation.  Reading “make” to include the use of a false statement by one other than the maker would extend primary liability beyond the scope of conduct prohibited by Rule 10(b)-5(b).  If Central is to have any real meaning, a defendant must actually make a false or misleading statement in order to be liable under section 10(b).

Finding that the plaintiff failed to sufficiently allege that a registered broker-dealer’s senior executives made false statements of material facts under Rule 10(b)-5, the court affirmed the lower court’s dismissal of the 10(b)-5(b) claim.  Because the en banc review was limited to that claim, the court reinstated the Section 17(a)(2) claim and the aiding and abetting claims.  The case was remanded to the district court for further proceedings on those claims, consistent with the en banc opinion. 

Primary materials are available on the DU Corporate Governance website.