The Supreme Court on Wednesday delivered a swift and decisive rejection of the Securities and Exchange Commission’s argument that it should operate under a more forgiving statute of limitations in pursuing penalties in fraud cases.
As a result of the decision, the agency will have to find a long-term solution to give itself more time to investigate cases.
In Gabelli v. Securities and Exchange Commission, Chief Justice John G. Roberts Jr. wrote in the unanimous decision rejecting the S.E.C.’s argument that a federal statute that limits the government’s authority to pursue civil penalties should commence when a fraud is discovered, not when it occurred.
The S.E.C. was hoping that the court would apply what is known as the “discovery rule.” In 2010, the Supreme Court endorsed this rule in a private securities fraud class-action suit, Merck & Co. v. Reynolds, stating “that something different was needed in the case of fraud, where a defendant’s deceptive conduct may prevent a plaintiff from even knowing that he or she has been defrauded.”
The discovery rule is an exception to the protection afforded by a statute of limitations, which puts an endpoint on potential legal liability for conduct. Unlike most cases, when fraud is involved, it may not be apparent to the victims that they were harmed because the primary goal of deceptive conduct is to keep it from being exposed.
In the Gabelli case, the S.E.C. filed fraud charges in 2008 against the mutual fund manager Marc Gabelli and a colleague, Bruce Alpert, saying they had violated the Investment Advisers Act of 1940 for permitting an investor to engage in market timing. Ten years ago, a major scandal erupted when it came to light that some advisers had permitted select investors to buy shares at favorable prices to take advantage of pricing disparities in the securities held by mutual funds.
In its complaint, the S.E.C. sought civil monetary penalties based on market timing that it claimed had taken place from 1999 to 2002, and resulted in the preferred investor purportedly reaping significant profits while ordinary investors suffered large losses. The defendants denied the charges and filed a motion to dismiss the case because it was not brought in time.
A federal statute, 28 U.S.C. § 2462, provides that “an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued.” The provision dates to 1839, and applies to any government agency.
A decision by the United States Court of Appeals for the Second Circuit in Manhattan allowed the case to proceed by applying the discovery rule to a governmental action. Coincidentally, that decision was written by Judge Jed S. Rakoff, who despite being an occasional thorn in the S.E.C.’s side, accepted the agency’s argument to avoid a strict application of the five-year statute of limitations.
The Supreme Court, however, saw things differently. This week, it issued its opinion less than two months after it heard oral argument in the case in January, a clear sign the justices found no merit in the S.E.C.’s contention that the agency should be treated the same as private plaintiffs in trying to get around the statute of limitations.
According to the Supreme Court, victims in securities fraud cases should have a longer period to file a claim – from when the fraud was discovered. “Most of us do not live in a state of constant investigation,” the court wrote. “Absent any reason to think we have been injured, we do not typically spend our days looking for evidence that we were lied to or defrauded.”
Chief Justice Roberts explained that “the S.E.C. as enforcer is a far cry from the defrauded victim the discovery rule evolved to protect.” One of the reasons the agency exists is to detect and penalize violations, with tools that the ordinary investor simply does not have, like the authority to compel testimony and the production of documents. The message is simple. When it’s your job to investigate fraud, you cannot argue that your failure to do so is a justification for not meeting a statute of limitations.
The Supreme Court’s decision puts increased pressure on the S.E.C. to pursue its investigations with greater alacrity and not let them gather dust, which can occur as a result of staff turnover or other pressing issues. The market timing case is a good example of how an investigation might get lost in the shuffle as corporate accounting frauds at large companies like Enron and WorldCom, which also came to light in 2002, strained the S.E.C.’s investigative resources.
There are a couple of options to deal with this issue in the long run, apart from a substantial increase in the agency’s budget – an unlikely prospect in the face of the looming federal budget sequestration deadline.
The S.E.C. can obtain an agreement to stop the statute of limitations, known as tolling, from those it is investigating, something it has done in the past. For example, in its insider trading and securities fraud case against Samuel E. Wyly, his now deceased brother, Charles J. Wyly Jr., and two other defendants, the S.E.C. got an agreement that let it pursue claims beyond the normal five-year limitations period.
A permanent solution would be to seek legislation from Congress that would give the S.E.C. a longer window to complete its investigations. The statute of limitations is not a constitutional protection, so Congress can amend it as it sees fit, which it has done in other areas involving fraud.
The limitations period for banking crimes, for example, was extended to 10 years during the savings and loan crisis because of the crush of cases that made it difficult to finish investigations in the five-year window to initiate criminal prosecutions. The Fraud Enforcement and Recovery Act of 2009 added mail and wire fraud affecting a financial institution to the list of crimes that get the benefit of the 10-year limitations period, again because of fear that cases would be lost because of the number of investigations taking place after the financial crisis.
The issue of the statute of limitations may even come up at the confirmation hearings of Mary Jo White, who has been nominated to be chairwoman of the S.E.C. That could be an early indicator of whether she would be willing to push for relief from the effect of the Gabelli opinion to help out the enforcement division.
In the short run, the Supreme Court’s decision will cause defendants in government enforcement actions to examine whether they might be able to take advantage of the five-year limitations period. Given how slowly the government has been known to move on occasion, it may be that some cases will fall by the wayside because of the Gabelli decision.
