WASHINGTON (Dow Jones)--A federal appeals court has rejected for the first time a legal theory put forth by the U.S. Securities and Exchange Commission that underwriters can violate the law simply by referencing false or misleading materials about investment products such as mutual funds.

The decision could curtail the SEC's enforcement avenues by limiting legal liability to cases in which securities professionals actually make misstatements, rather than giving their clients prospectuses or other secondary documents that they didn't prepare.

The U.S. Court of Appeals for the First Circuit issued an en banc decision late Wednesday saying the SEC's "expansive interpretation" of the law governing intentional securities fraud is inconsistent with "the ordinary meanings of the phrase 'to make a statement.'"

The ruling stems from 2005, when federal regulators filed civil fraud charges against two former employees of FleetBoston Financial Corp., which was subsequently acquired by Bank of America Corp. (BAC).

The SEC alleged that James Tambone and Robert Hussey, both former employees of a FleetBoston mutual-fund unit, entered into or approved undisclosed market- timing agreements with investors. Market timing is the practice of frequent buying and selling of shares of a single mutual fund in order to exploit inefficiencies in mutual fund pricing.

The company had made efforts to deter frequent short-term trading within each of its mutual funds. By 2003, all mutual fund prospectuses contained language stating that the practice was prohibited, according to the court.

The SEC argued that the defendants made implied false representations to investors by using those prospectuses, which were written by another entity, to sell the mutual funds.

According to the SEC's theory, securities professionals can be liable for an implied representation to investors that a prospectus is truthful and complete when they engage in an offering.

The court said that theory is wrong. SEC rules say it is unlawful "to make any untrue statement of a material fact."

But the defendants in this case used statements created by others to sell mutual funds, which isn't the same thing, the court said. Had the SEC intended to include implied statements in its rules, it could have used broader verbs such as "use" or "employ."

"Word choices have consequences, and this word choice virtually leaps off the page," the court said in an opinion written by Judge Bruce Selya.

Chief Judge Sandra Lynch and Judge Michael Boudin concurred with the circuit's majority opinion, noting that the SEC's theory could encompass "virtually anyone involved in the underwriting process."

Had the appeals court ruled in SEC's favor, "it would have expanded the market participants that could be included" in lawsuits alleging intentional securities fraud, said Susan DiCicco, a partner at Bingham McCutchen LLP, who has been watching the case. "It would have given quite a tool to civil plaintiffs."

In a partial dissent, Judges Kermit Lipez and Juan Torruella said underwriters should be held liable for referencing misleading documents because of their unique role in the securities industry.

"If the underwriter knows, or is reckless in not knowing, that the statements contained within the prospectus are in fact false, the underwriter's implied statement is likewise false," the dissenting judges said.

The SEC is reviewing the decision, a spokesman said.

"We believe the decision is an important, and correct, clarification" of the SEC's rules, said Paula DeGiacomo of Greenberg Traurig LLP, who argued the case on behalf of Tambone.

Christopher Joralemon of Gibson, Dunn & Crutcher LLP, one of the attorneys representing Hussey, said they "greatly appreciate" the court's decision, and they believe it is "correct and well-reasoned."

The Securities Industry and Financial Markets Association, or Sifma, likewise applauded the decision. Sifma had argued in briefs to the court that the SEC's implied statement theory should be rejected.

- By Fawn Johnson, Dow Jones Newswires; 202-862-9263; fawn.johnson@ dowjones.com

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  03-11-10 1542ET
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