Not Dead Yet: Second Circuit Revives Private Rights of Action Under Section 47(b) of the Investment Company Act of 1940

On August 5, 2019, the Second Circuit held in Oxford University Bank v. Lansuppe Feeder, LLC that “§ 47(b) provides an implied private right of action for rescission.” The case arose when the senior noteholder in a trust sought to have the trust’s assets distributed in accordance with the trust’s indenture. Junior noteholders, who would receive nothing under the indenture scheme, argued that the trust violated the ICA, thereby entitling them to rescind their investment notes under Section 47(b). The trust was a special-purpose vehicle that did not register as an investment company with the Securities and Exchange Commission (SEC) under the ICA, relying on an exemption for issuers whose securities are only owned by “qualified purchasers.” The junior noteholders contended that some of the trust’s investors were not qualified purchasers under the ICA and that the trust therefore violated the ICA’s registration requirements.

Section 47(b) does not expressly provide for a private right of action. It states that a contract that is made in, or whose performance involves a, violation of the ICA “is unenforceable by either party,” and that to the extent such a contract has been performed, “a court may not deny rescission at the instance of any party” unless the court finds that it would be inequitable to rescind.

The Second Circuit recognized that under U.S. Supreme Court precedent, “private rights of action to enforce federal law must be created by Congress.” The Second Circuit also acknowledged that since 2002 numerous federal courts have refused to find that implied private rights of action exist under the ICA, including two earlier decisions by the Second Circuit itself: Bellikoff v. Eaton Vance Corp., 481 F. 3d 110 (2d Cir. 2007) (no implied private right under Section 36(a) of the ICA) and Olmsted v. PruCo Life Ins. Co., 283 F. 3d 429 (2d Cir. 2002) (no implied private right under Sections 26 or 27 of the ICA). Nevertheless, the Second Circuit concluded that Section 47(b) contained “rights creating language” because, among other things, it provides that “a party to an illegal contract may seek relief in court on the basis of the illegality of the contract,” which “necessarily presupposes that a party may seek rescission in court by filing suit.” To the Second Circuit, this “unambiguously evinces Congressional intent to authorize a private action.”

The Second Circuit recognized that its decision conflicts with the Third Circuit’s decision in Santomenno v. John Hancock Trust, 677 F. 3d 178 (3rd Cir. 2012), but stated “we do not find the reasoning in Santomenno persuasive.” According to the Second Circuit, the Third Circuit ignored the “clear language” in Section 47(b) and improperly resorted to canons of statutory construction only intended to help interpret ambiguous statutory provisions. The Second Circuit also disagreed with other federal court decisions that concluded that Section 47(b) provides a remedy rather than a substantive right because, according to the Second Circuit, this would read the rescission provision of Section 47(b) out of the statute.

Despite the newly-created split between the Second and Third Circuits, the procedural posture of the case means that Supreme Court review of the Second Circuit’s decision is highly unlikely. Although the Second Circuit held that an implied private right of action exists under Section 47(b), the court nevertheless affirmed dismissal of the junior noteholders’ claim because it concluded that the contract the junior noteholders sought to rescind – the trust’s indenture – did not violate the ICA. As a result, despite having lost on the issue of whether Section 47(b) creates an implied private right of action, the senior noteholders won on an alternate ground and therefore have no basis to seek further appellate review. And the junior noteholders, should they seek to challenge in the Supreme Court the alternate ground on which they lost, will not seek review of a holding they won. So the circuit conflict may exist for some time, during which the Second Circuit decision will presumably govern federal trial courts within its jurisdiction.

Mutual fund investors previously have challenged a variety of conduct under Section 47(b), including Rule 12b-1 plans, failures to participate in class action settlements, market timing and late trading practices, excessive fees, and breaches of fiduciary duty under Section 36(a) of the ICA. For the past 20 years, none of these claims have succeeded because, inter alia, courts refused to find a private right of action under Section 47(b). Until the Supreme Court resolves the issue, however, investors may seek to bring these and other types of claims that a creative plaintiffs’ bar can come up with under Section 47(b), at least in federal district courts within the Second Circuit, without having to overcome the defense that no private right of action exists under that section.

A copy of the decision is here.