The U.S. Court of Appeals for the Second Circuit, in disagreeing with the Courts of Appeals for the Third and Ninth Circuits, ruled on August 5, 2019 in Oxford University Bank v. Lansuppe Feeder, Inc.1 that a private right of action for rescission exists under Section 47(b) of the Investment Company Act of 1940. Although the Second Circuit’s decision has the potential to create uncertainty for mutual fund advisers and trustees in a number of important respects, the theoretical risks created by the decision are limited by a number of legal and practical considerations, as outlined below.
Background
Section 47(b) addresses the enforceability of contracts made in contravention of, or the performance of which contravenes, a provision of the 1940 Act or any rule, regulation or order thereunder. Under Section 47(b), a contract made in violation of, or the performance of which violates a provision of, the 1940 Act is unenforceable by either party to the contract. Section 47(b) also provides an equitable remedy of rescission for contracts that have been performed (or partially performed), though that remedy is in turn limited by equitable consideration, precluding a court from granting a request for rescission should it find enforcement of the contract to be the more equitable outcome.
Until the Second Circuit’s decision in Oxford University Bank, federal courts generally held that Section 47(b) “does not establish a private right of action” because “the structure of the [1940 Act] forecloses reading the statute as implying a private [right] of action ‘to enforce the individual provisions of the Act.’”2 Instead, taking into consideration the Supreme Court’s 2001 ruling in Alexander v. Sandoval, the 1940 Act had been interpreted not to create any implied private rights of action, but instead to empower only the SEC to enforce the provisions of the 1940 Act unless a provision of the 1940 Act expressly states otherwise.3 Thus, until recently, the only provision of the 1940 Act that had been interpreted to allow for a private right of action post-Sandoval was Section 36(b), which permits a fund shareholder to bring a claim against a mutual fund investment adviser and its affiliates for excessive advisory fees. Moreover, most courts have held that Section 47(b) does not create any cause of action, but instead is a remedial provision that may be invoked only when the predicate violation itself provides for a private right of action.4
The Oxford University Bank Decision
In Oxford University Bank, the Second Circuit departed from this post-Sandoval jurisprudence by concluding that Section 47(b) creates a private right of action for rescission. The case concerns a claim by a senior noteholder seeking to liquidate a trust (Trust) that had defaulted on its interest payments to noteholders. Liquidation of the Trust would have provided the senior noteholders with substantial compensation while not providing any payment to the junior noteholders. The Trust relied on Section 3(c)(7) of the 1940 Act to avoid registration as an investment company, and therefore could sell its interests only to persons that met the definition of “Qualified Purchasers”5 under the 1940 Act. The junior noteholders cross-claimed, alleging that the Trust violated the 1940 Act by selling notes to purchasers that were not “Qualified Purchasers,” meaning that the Trust could not rely on Section 3(c)(7), and therefore violated the 1940 Act by not registering as an investment company. According to the junior noteholders, the Trust’s failure to register as an investment company entitled the junior noteholders to rescission of their investment in notes issued by the Trust under Section 47(b). The district court concluded that summary judgment was warranted in favor of the senior noteholder in large part because no private right of action existed to allow for claims of rescission under Section 47(b).
On appeal, the Second Circuit concluded that although the district court erred in finding that Section 47(b) does not provide a private right of action, it ultimately agreed with the district court that the junior noteholders’ cross-claims failed on the merits. With regard to the Section 47(b) analysis, the Second Circuit held that the “text of [Section] 47(b) unambiguously evinces Congressional intent to authorize a private action” given that both of its subsections “indicate that a party to an illegal contract may seek relief in court on the basis of the illegality of the contract.” Section 47(b)(1) renders contracts that violate the 1940 Act “unenforceable by either party” to the violative contract, meaning at least that a party sued for failure to perform under such a contract may invoke the illegality of the contract as a defense. Similarly, Section 47(b)(2) provides that “a court may not deny rescission at the instance of any party (emphasis added)…” under certain circumstances. The Court concluded these provisions presuppose that a party may seek rescission in court by filing suit because the language Congress used is effectively equivalent to providing an express cause of action. Further, the Court explained that the most natural reading of Section 47(b)(2) is that “any party” refers to parties to a contract whose provisions violate the 1940 Act. In rejecting the plaintiff’s argument that only the SEC can seek rescission, the Court emphasized that it would be “highly unlikely” that Congress meant to allow a suit only by the SEC given its specific use of the phrase “any party,” a naturally more expansive phrase than one that limits the use of Section 47(b) to only the SEC, which would never be a party to a contract at issue. Further, the legislative history is arguably supportive of the view that Congress intended to confirm the availability of a private action for rescission.6
The fact that other circuits have reached the opposite conclusion was not lost on the Second Circuit, which recognized that the Third Circuit in Santomenno ex rel. John Hancock Trust v. John Hancock Life Ins. Co.7 found plaintiffs lacked a private right of action to seek rescission under Section 47(b), where plaintiffs alleged violations of Section 26(f) of the 1940 Act.8 The Second Circuit rejected the Santomenno court’s reliance on “interpretive canons that are intended to help resolve ambiguity” over focusing on the actual text of the statute. The Second Circuit also disagreed with previous district court rulings that interpreted Section 47(b) as providing a remedy over a substantive right, concluding that such approach would “effectively read [Section] 47(b)(2) out of the [1940 Act].”
Potential Implications
While an anomaly in its approach for now, the Second Circuit’s decision to expand the Section 47(b) private right of action under the 1940 Act may have a number of practical implications. For example, the decision raises a question as to whether transactions or agreements that rely on SEC staff no-action guidance allowing certain contracts to be approved or modified under certain circumstances, which otherwise may not technically comply with the standards established under the 1940 Act, could be subject to rescission under Section 47(b). While parties that avail themselves of the benefits of a no-action position are seemingly unlikely to switch gears and challenge the validity of contracts (and such reliance could be an equitable factor considered by a court under Section 47(b)(2)), it is not unheard of for parties to a contract to later challenge its validity.
Another possible implication arises from the potential interplay between Oxford University Bank and the Ninth Circuit’s decision in Northstar Financial Advisors v. Schwab Investments9 (Northstar). In Northstar, the Ninth Circuit held that a fund’s prospectus could be considered a contract between a fund and its shareholders, allowing shareholders to pursue state law contract claims against the fund for “breaches” of the prospectus.10 If a prospectus, by which shareholders invest in a fund, creates a contract between a fund and its shareholders, and if Section 47(b) is construed as providing a cause of action for any contractual party to rescind contracts that violate the 1940 Act, then funds theoretically could now be exposed to expanded claims for rescission by shareholders if a term of the prospectus is “breached” (e.g., if a fund violates a prospectus limit on illiquid holdings). However, this risk is substantially mitigated by three different considerations. First, Northstar’s aberrational contract ruling has not been adopted to date outside of the Ninth Circuit, where the case law does not currently recognize a private right of action under Section 47(b). Second, Northstar’s impact has been substantially curtailed by a subsequent holding by the Ninth Circuit that affirmed the preclusion of the claims in that case under the Securities Litigation Uniform Standards Act (SLUSA), which bars state law class actions alleging misrepresentations in connection with the sale of securities.11 There are therefore substantial hurdles facing class action lawyers trying to use the decision in Oxford University Bank to breathe new life into Northstar. Third, Section 47(b), by its terms, only attaches when the making and/or performance of the contract involves a violation the 1940 Act or a rule or order thereunder. Accordingly, it is unclear whether a court would read Section 47(b) literally to apply it only where a prospectus itself requires a fund to violate, or an adviser to cause a fund to violate, the 1940 Act or a rule or order thereunder.
For the foregoing reasons, it appears more likely that the plaintiffs’ bar will attempt to bring rescission claims on behalf of a fund, as the party to an allegedly unlawful contract, instead of attempting to resuscitate Northstar. However, this approach also would likely require any shareholder to meet the exacting standards for pursuing a derivative claim on behalf of a fund. Such claims are rarely successful, for the simple and sound reason that the decision whether to assert a claim on behalf of a fund is in the first instance committed to the sound business judgment of the trustees. And here, there remains the additional open question of whether the Oxford University Bank case would even extend to a derivative claim.
Finally, there remains substantial uncertainty surrounding the strength of the statutory equitable backstop. While the Second Circuit’s decision highlights the availability of such protection, it left unanswered how equitable principles might apply in practice to support a ruling that rescission would be less equitable than enforcement of the at-issue contract. Any future litigation will thus face open questions about what factors an assessing court will find persuasive in its determination to order, or reject, rescission. Mutual fund advisers and trustees (and their counsel) should therefore pay close attention to future developments that seek to apply – or expand – the Oxford University Bank ruling.
Footnotes
1) 16-cv-4061 (2d Cir.).
2) UFCW Local 1500 Pension Fund v. Mayer, 895 F.3d 695, 700 (9th Cir. 2018).
3) Alexander v. Sandoval, 532 U.S. 275, 288 n.7 (2001) (finding that in determining whether Congress has created a private right of action, “the interpretive inquiry begins with the text and structure of the statute.”).
4) See e.g., Smith v. Oppenheimer Funds Distributor, Inc., 824 F. Supp. 2d 511, 519 (S.D.N.Y. 2011) (“Section 47(b) contains a remedy, but not a substantive right.”); Smith v. Franklin/Templeton Distributors, Inc., 2010 WL 2348644 at *7 (N.D. Cal. June 8, 2010) (“By its terms, [Section] 47(b) provides a remedy ... rather than a distinct cause of action or basis for liability.”).
5) See 15 U.S.C. § 80a-2(a)(51).
6) The Second Circuit also noted that the making and performance of the Trust Indenture did not violate the 1940 Act, and therefore the junior noteholders' request for rescission of their investments, or the blocking of the liquidation, was misplaced. Rather, if any contract would be subject to Section 47(b), it would have been the purchase agreements to which the non-Qualified Purchasers were parties. This point, although not directly addressed by the court, re-emphasizes the importance of investment company status representations and warranties (and the underlying status opinions) that are often part of private fund and financing transactions. However, it remains unclear how Section 47(b) would operate in a circumstance where a transaction would, for example, cause a private fund relying on Section 3(c)(7) of the 1940 Act to no longer be able to rely on its exclusion and thereby cause the private fund to need to register as an investment company. The contract at issue in such a transaction would not necessarily be in violation of the 1940 Act; rather the private fund itself would be in violation of the 1940 Act for not being registered.
7) Santomenno ex rel. John Hancock Trust v. John Hancock Life Ins. Co., 677 F.3d 178 (3d Cir. 2012).
8) Section 26(f) makes it unlawful to pay fees or charges on certain insurance contracts, which payments exceed what is reasonable.
9) 779 F.3d 1036 (9th Cir. 2015).
10) Id.
11) See Northstar Fin. Advs. v. Schwab Invs., 904 F.3d 821 (9th Cir. 2018).
