Second Circuit Decision Finds Implied Private Right of Action Under the Investment Company Act

September 18, 2019

In a recent decision, Oxford University Bank v. Lansuppe Feeder, LLC, the United States Court of Appeals for the Second Circuit held that parties that enter into contracts that violate the Investment Company Act of 1940 (the “Act”) have a private right of action under § 47(b) of the Act to sue for rescission of those contracts.

The Second Circuit’s holding departs from prior decisions by two other Circuit courts and several district court decisions, amplifying potential contractual and litigation risks for funds and “inadvertent investment companies,” as well as such entities’ investors, lenders and contractual counterparties.

In Oxford University Bank[1], a private fund issuer, which otherwise would have been required to register as an investment company, relied on the § 3(c)(7) exemption from the definition of “investment company” in the Act. The § 3(c)(7) exemption requires, among other things, that owners of the issuer’s outstanding securities be, at the time of acquisition of such securities, “qualified purchasers” (“QPs”) or “knowledgeable employees.” Holders of a class of junior notes of the issuer alleged a violation of the exemption and sued for rescission of the indenture under which the notes were issued.

In contrast to previous decisions by the Third and Ninth Circuits,[2] the decision in Oxford University Bank held that § 47(b) creates an implied private right of action that allows such a security holder suit for rescission. The Second Circuit identified parties to contracts violating the Act as the “class of persons” § 47(b) “unambiguously” aims to protect through the creation of a private right of action.  The court emphasized, however, that this implied private right of action belongs only to a party to the contract violating the Act and not third parties, such as holders of a different class of securities.

The scope of § 47(b) is extremely broad – applying to any contract “that is made, or whose performance involves, a violation of the Act, or any rule, regulation or order thereunder.” The Second Circuit’s decision potentially impacts registered investment companies (“RICs”), unregistered investment companies organized outside the United States and unregistered investment companies organized in the United States in different ways. Unregistered investment companies organized outside the United States are only prohibited from issuing securities to the public in the United States; as a result, the Second Circuit’s decision highlights the importance of assessing the status of foreign entities under the Act at the time of offerings to U.S. investors. The impact is most dramatic on unregistered investment companies organized in the United States – because the Act prohibits such companies from engaging in interstate commerce, almost every contract such an entity enters into (including any issuances of securities) could be subject to rescission, highlighting the need to continually assess the status of U.S. companies under the Act.  Therefore as interpreted in Oxford University Bank, § 47(b) could impact every contract, commercial activity and securities issuance by an alleged unregistered investment company organized in the United States (as the Ninth Circuit cautioned in UFCW Local 1500, “every other contract Yahoo! has entered into for the better part of a decade”) and any contractual counterparty could seek to invoke the right to rescission.

Accordingly, if the Oxford University Bank opinion stands (absent a Supreme Court decision reconciling the conflict among the three Circuits), it will create another risk beyond enforcement actions by the Securities and Exchange Commission for companies violating the Act, their investors and counterparties, and will underscore the importance of law firms considering status under the Act when giving legal opinions as to the enforceability of contracts.[3]

This article was republished by the Harvard Law School Forum on Corporate Governance and Financial Regulation

[1]           Oxford University Bank v. Lansuppe Feeder, Inc., No. 16-4061 (2d Cir. 2019).

[2]           Santomenno ex rel. John Hancock Trust v. John Hancock Life Ins. Co., 677 F.3d 178 (3d Cir. 2012); UFCW Local 1500 Pension Fund v. Mayer, No. 17-15435 (9th Cir. 2018).
[3] This issue has previously been highlighted by the TriBar report on Third-Party “Closing” Opinions, but it is of renewed importance in light of the Second Circuit’s recent opinion. TriBar Opinion Committee, Third-Party “Closing” Opinions, 53 Bus. Law. 592, 628 (“Similarly, the opinion preparers should consider the effect of the Investment Company Act of 1940 when preparing an opinion on the binding effect of an agreement on a registered investment company. … The opinion preparers should also consider the application of the Act if they recognize that the Company’s activities may make it an inadvertent investment company.”)