Rejecting a widely-held consensus, on August 5, 2019, the United States Court of Appeals for the Second Circuit held that Section 47(b)(2) of the Investment Company Act (“ICA”) creates an implied private right of action for rescission in favor of a party to a contract that allegedly violates the ICA (or whose performance allegedly violates the ICA). Oxford University Bank v. Lansuppe Feeder, Inc., No. 16-4061 (2d Cir. Aug. 5, 2019).
The action concerned a dispute between plaintiff, which held the majority of senior notes issued pursuant to an indenture for a special purpose vehicle, and junior noteholders for the same trust. Plaintiff brought an action to direct the trustee to liquidate the trust and distribute its remaining assets pursuant to the indenture’s waterfall provision. The junior noteholders moved to intervene and to bring claims for rescission, objecting that the trust had violated the ICA by not preventing the transfer of notes to a purchaser who was not a “Qualified Purchaser” within the meaning of the ICA. The district court rejected the intervenors’ claims on the grounds that the ICA did not create a private right of action, and also determined that the claims failed on the merits. The Second Circuit held that the ICA did create a private right of action, but affirmed the grant of summary judgment for the senior noteholders because the junior noteholders’ claims failed on the merits.
In holding that the ICA did, in fact, create a private right of action, the Second Circuit determined that the text of the ICA “unambiguously evinces Congressional intent to authorize a private action.” Slip Op. at 13. In particular, Section 47(b)(1) of the ICA provides that a contract that violates the ICA “is unenforceable by either party,” and Section 47(b)(2) then provides, in pertinent part, that “a court may not deny rescission [of such a contract] at the instance of any party.” Pointing to that language of Section 47(b)(2), the Second Circuit emphasized that while “Congress did not expressly state that a party to an illegal contract may sue to rescind it,” the clause’s language “necessarily presupposes that a party may seek rescission in court by filing suit.” Id. at 14. Furthermore, the Second Circuit highlighted that Section 47(b)(2) identifies a “class of persons” who benefit from the availability of the right of action. Id. (citing Bellikoff v. Eaton Vance Corp., 481 F.3d 110, 116 (2d Cir. 2007) (per curiam)). Specifically, the Court held that Section 47(b)(2) provides “parties to a contract whose provisions violate the ICA” with a remedy that benefits them. Id. at 15.
The Second Circuit rejected the argument that the provision should be interpreted to provide an enforcement right to the SEC alone. The Court determined that the reference to rescission sought by “any party” could not reasonably be interpreted to mean that rescission could only be sought by the SEC. Id. at 16-17. Moreover, while the provision of specific enforcement mechanisms could “suggest” that Congress intended to preclude a private right of action, the Court held that the text here was clear and unambiguous that a private right to rescission exists. Id. at 17. In addition, the Court pointed to a Supreme Court decision, Transamerica Mortgage Advisors (TAMA) v. Lewis, 444 U.S. 11 (1979), which interpreted a similar provision of the Investment Advisors Act to provide a private right of action, and legislative history in the form of a Congressional committee report from the ICA’s amendment in 1980 which stated that the committee “wishes to make plain that it expects the courts to imply private rights of action under this legislation.” Id. at 19-20.
However, the Court affirmed the district court’s determination that intervenors failed to state a claim under the ICA. The Court emphasized that the indenture was the only contract at issue, and neither its terms nor its performance allegedly violated the ICA (indeed, the Court commented that the indenture’s terms specifically prohibit ownership of notes by non-Qualified Purchasers so were drafted to reflect good faith compliance with the ICA). While noting that the intervenors “may well be correct” that the sale of unregistered notes to non-Qualified Purchasers violated the ICA, this could only provide a basis to rescind the contracts of sale for those purchases—not to rescind or modify the terms of the indenture, as intervenors sought. Id. at 24-25.
The Second Circuit’s holding that Section 47(b)(2) creates an implied private right of action for rescission conflicts with the decision of the Third Circuit in Santomenno ex rel. John Hancock Trust v. John Hancock Life Ins. Co., 677 F.3d 178 (3d Cir. 2012), which held that the same provision of the ICA did not permit a private right of action. The Second Circuit found the reasoning of the Third Circuit “unpersuasive,” because it “relied on interpretive canons that are intended to help resolve ambiguity” and did not address the language, which the Second Circuit found to be clear and unambiguous. Id. at 21. The Second Circuit also rejected the reasoning of various district courts that had declined to find an implied private right of action under Section 47(b)(2) as “effectively read[ing] § 47(b)(2) out of the ICA.” Id. at 23.
The holding of the Second Circuit is limited to parties to a contract allegedly violative of the ICA; it thus does not address many potential follow-on questions, such as whether that holding might be extended to allow investors to pursue claims with respect to fund-related contracts to which investors are not parties. As the law under Section 47(b) was considered settled for many years, with no prospect for individual claims, development of the law in this area will be important to monitor going forward. It also will be important to watch for a case that may present an opportunity for the Supreme Court to resolve the conflict between the Second and Third Circuits, as the Oxford case itself is unlikely to present such an opportunity, given the affirmance of summary judgment on the alternative ground that the junior noteholders failed to state a claim under Section 47(b)(2).
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