The distinction between primary and secondary liability in securities fraud suits has been a key issue since the Supreme Court handed down its decision in Central Bank of Denver v. First Interstate, 511 U.S. 164 (1994). Although the SEC had its authority to bring Section 10(b) fraud actions based on an aiding and abetting theory restored the next year with the passage of Exchange Act Section 20(e) as part of the PSLRA, Congress has declined requests to extend such liability to private damage actions.

Despite the legislative fix, the distinction between primary and secondary liability remains critical to the SEC. The circuits are split over the appropriate standard with some following a version of the “bright line” test, while others opt for an approach based on the notion of “substantial participation” as discussed here. While these tests have largely been developed in private damage actions, the dispute is impacting SEC enforcement cases as discussed here.

Many observers hoped the First Circuit’s en banc decision in SEC v. Tambone, No. 07-1384 (March 10, 2010) would bring clarity to the area. In its opinion, however, the court declined the opportunity to consider the issue. At the same time, it did comment on the question, if only in dicta.

The facts to Tambone are straightforward. James Tambone and Robert Hussey were senior executives of a registered broker dealer, Columbia Funds Distributor, Inc. The SEC’s complaint against the executives contains allegations based on Securities Act Section 17(a), Exchange Act Section 10(b) and aiding and abetting. In essence, the Commission alleges that the two men engaged in fraud in connection with the sale of mutual fund shares tied to market timing claims. The prospectuses for the funds told investors that market timing was not permitted. A number of customers were, however, permitted to market time. According to the SEC, the two defendants were responsible for the false statements in the prospectuses, having commented on the market timing passages prior to their inclusion in the documents.

The prospectuses were not prepared by, or the responsibility of, the broker dealer which employed the two defendants. The broker-dealer is owned by Columbia Management Group, Inc. The broker served as the primary underwriter and distributor of over 140 mutual funds in the Columbia mutual fund complex. The prospectuses for those funds were the responsibility of another entity, Columbia Management Advisors, Inc. Like the broker dealer, Columbia Management was also a wholly owned subsidiary of Columbia Management.

The district court granted a motion to dismiss the complaint. On the Section 10(b) claims, the court applied the bright line test followed by the Second Circuit, as well as others. Under this test, mere participation in the drafting process is insufficient to establish primary liability. The court also dismissed each of the other claims.

The SEC appealed the dismissal of its Rule 10(b)-5(b), Section 17(a)(2) and aiding and abetting claims. The panel reversed. That decision was withdrawn, however, and en banc review was granted on the Rule 10(b)-5(b) claim only.

In its March 10 opinion, the court reversed the panel decision, affirming the district court’s dismissal. Since the court did not reconsider the other claims, the initial panel decision as to those was reinstated.

The court parsed the question for review in two parts: The first is whether a securities professional can be said to “make” a statement which can result in Rule 10(b)-5(b) liability as a result of statements used to sell securities which were prepared by others? The second is if selling securities on behalf of an underwriter is an implied statement by the person, does he have a reasonable basis for believing that the statements in the prospectus were truthful and complete? The court’s answer to each question is “no.”

The court’s conclusion is based largely on the literal language of Rule 10(b)-5(b) and the meaning of the word “make.” In the context of this subsection, the rule is based on phrases such as “to make a statement” and “statements made.” Since the Rule does not define the word, its plain dictionary meaning applies. That definition is inconsistent with the gloss proposed by the SEC which would include statements by others within the meaning of the word “made.” The court buttressed its conclusion by looking at the overall structure of the rule and its enabling section. There, words such as “use” or “employ” are written into the text which give other sections a different and broader reading. In subsection (b), however, the drafters selected the word “make” as in “to make a statement.” The court found this deliberate word choice revealing.

The court rejected the SEC’s argument that the reach of the subsection is coextensive with that of Section 10(b). While clearly the rule cannot be broader than the section, that does not mean that every subsection of Rule 10(b)-5 must be coextensive with Section 10(b). If that were true there would be no need for the subsections. Indeed, when Rule 10(b)-5 was crafted, the drafters had before them Section 17(a)(2) which employs the word “use,” which is broader. This again suggests a deliberate selection of words resulting in a different standard. The court also rejected the SEC’s argument that “it is self-evident” that the language of the subsection should include the implied statements here. The only point which is self-evident the court held is that the plain meaning of the words selected governs.

The SEC’s proposed reading of the Rule would also undermine the Supreme Court’s decision in Central Bank, the court concluded. That decision squarely held that aiding and abetting liability does not fall within the text of Section 10(b). Yet, adopting the SEC’s proposed theory of liability here would bring conduct within the reach of the statute, which is at most aiding and abetting. After Central Bank that cannot be done.

Finally, while there is a split in the circuits over the proper test of primary liability, that issue need not be resolved in this case, the court concluded. Rather, the decision in this case is straightforward and based on the literal reading of the text of the rule, according to the court.

In concluding that it need not resolve the question of what constitutes primary liability, the court did note, however, that “these tests [bright line and substantial participation] are designed for private litigation, and, thus, poorly suited to public enforcement actions . . .” In a footnote, the court elaborated on this thought, noting that the bright line test is based in part on the need to prove reliance in private actions. Nevertheless, some courts, such as the district court in this case, continue to apply the concepts in SEC enforcement actions. The question now is whether the SEC will appeal this decision to the Supreme Court to try and obtain clarity on that issue.