Third Circuit Holds Rule 10b-5 Violations May Be Imputed to Investment Management Company on Basis of Apparent Agency

by BakerHostetler

The United States Court of Appeals for the Third Circuit recently issued a decision that highlights the importance of investment management companies using extreme caution when promoting investment products to their clients, as well as maintaining appropriate supervisory practices over hedge fund managers operating separate businesses while working for the company.

In Belmont v. MB Investment Partners, Inc., No. 12-1580, 2013 WL 646344 (3d Cir. Feb. 22, 2013), the plaintiff investors filed suit against investment management company MB Investment Partners, Inc. (MB) and others to recover monies lost in a Ponzi scheme. The defendant Mark Bloom perpetrated the fraudulent scheme while he was an employee, officer and co-managing partner of MB through a hedge fund called North Hills, L.P. (North Hills).[1] Bloom formed North Hills in 1997 and was its sole principal and managing member. However, after joining MB in 2004, Bloom, along with other MB employees, continued to administer investments through North Hills using MB's offices, computers, filing facilities and office equipment. Bloom and other MB employees met with investors, distributed MB business cards and affirmatively marketed North Hills as a fund option available to customers through the MB platform. Bloom and the MB employees allegedly also used MB's access to North Hills as a selling point for MB's advisory services.

The plaintiffs argued, inter alia, that Bloom's violations of Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 10b-5 promulgated thereunder should be "imputed" to MB because Bloom and other MB employees marketed North Hills and led investors to believe North Hills was an MB approved product. The fraud of an officer will be imputed to a corporation when the officer's conduct was (1) within the scope of his employment and (2) for the benefit of the corporation. However, the "adverse interest" exception to this rule negates that. The exception provides that when "an agent acts in his own interest and to the corporation's detriment, imputation generally will not apply."[2] The District Court for the Eastern District of Pennsylvania granted MB summary judgment, relying on the adverse interest exception to find that Bloom's violations could not be imputed as a matter of law. It was reasoned that he committed the fraud solely for his own benefit through a separate entity and that the fraud ultimately devastated MB.

The Third Circuit vacated this portion of the judgment and remanded the Rule 10b-5 claim for trial, holding that the district court erred when applying the adverse interest exception. The court ruled that a proper application of the exception would have considered whether there was a sufficient lack of benefit or apparent detriment to MB, such that it would be fair to charge the plaintiffs with notice that Bloom was not acting with MB's authority. While the scheme was ongoing, what the plaintiffs knew or should have known regarding Bloom's scope of authority as an officer of MB were, the court held, heavily contested questions of fact. A jury should therefore determine whether the manner in which Bloom marketed North Hills to the plaintiffs while working for MB, and the apparent benefit to MB, made it appear to the plaintiffs that Bloom marketed North Hills within the scope of his authority at MB. The court found that if the plaintiffs succeed at trial in proving that Bloom marketed North Hills with apparent authority, then his Rule 10b-5 violations could be imputed to MB.

The court also considered and decided other interesting issues, including those involving "control person" liability under Section 20(a) of the Exchange Act. The court's decision suggests that under the Exchange Act, and in particular the "control person" provisions of Section 20(a), the standard of intent for secondary actors as opposed to primary actors is a higher one and, in this case, akin to actual knowledge of the primary actors' fraudulent conduct.[3] The court affirmed summary judgment in favor of the defendants on the Section 20(a) claim, because the plaintiffs failed to set forth any evidence that the defendants had knowledge of Bloom's fraud.[4]

The Belmont decision is significant in that the Third Circuit reinforced application of the imputation doctrine to acts committed with apparent, rather than actual, authority -- even in the context of an officer committing securities fraud in an outside entity. Further, the court found that imputation of Bloom's Rule 10b-5 violations could be proper, even where the plaintiffs had failed to establish their claims for "control person" liability under Section 20(a) of the Exchange Act, negligent supervision and breach of fiduciary. While "sloppy compliance practices" were insufficient to impose Section 20(a) "control person" liability in Belmont, the Third Circuit found that public policy supported imputation where MB accepted inadequate compliance reports from Bloom that did not disclose details of North Hills' operation.[5]

Post-Belmont, it appears to the court that investment management companies and hedge funds should take extra precautions to clearly distinguish the company's investment products from those being offered by one of its managers or employees for another legal entity or business. Otherwise, investors and clients might believe that the other entity's products have the imprimatur of your own management company. The Third Circuit seems to endorse the idea that care should be taken to learn about any of the outside business activities of company personnel. In addition, there should be some supervision or monitoring over the marketing and other disclosure materials. In the broker-dealer industry, these practices are already required by FINRA regulation and are standard practices.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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