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U.S. Supreme Court: Discovery Rule Doesn’t Apply To SEC

WASHINGTON, D.C. - (Mealey's) The U.S. Supreme Court on Feb. 27 reversed a Second Circuit U.S. Court of Appeals ruling allowing the Securities and Exchange Commission to seek securities fraud penalties for conduct that had ceased more than five years before the SEC brought the lawsuit, saying that applying the discov­ery rule to government penalty actions "is far more challenging than applying the rule to suits by defrauded victims, and the Court de­clines to do so" (Marc J. Gabelli, et al. v. Securities and Exchange Commission, No. 11-1274, U.S. Sup.). ( subscribers may access Supreme Court briefs and the opinion for this case)

The SEC filed a complaint in the U.S. District Court for the Southern District of New York, naming Marc J. Gabelli, who is Gabelli Global Growth Fund's portfolio manager, and Bruce Alpert, the chief operating officer of funds adviser Gabelli Funds LLC, as defendants. The SEC alleged that the defendants violated Section 10(b) of the Securities Exchange Act of 1934, Section 17(a) of the Securities Act of 1933 and SEC Rule 10b-5 by failing to disclose certain favorable treatment provided to one of the fund's investors in preference to others.

Additional claims for violation of Sections 206(1) and 206(2) of the Investment Advisers Act also were made, and the SEC sought injunctive relief, disgorgement and civil monetary penalties.

In particular, the SEC contended that although the defendants prohibited other investors from engaging in a form of short-term trading called "market timing," it allowed one investor, Headstart Advisers Ltd., to market time the fund in exchange for an investment in a hedge fund managed by Gabelli.

2nd Circuit Reverses

The District Court dismissed the Section 10(b) and Section 17(a) claims; denied dismissal of the Advisers Act claims but ruled that the SEC may not seek civil penalties for the claims because it was not brought within the statute of limitations period for such claims and the SEC is not authorized to seek monetary penalties for claims for aiding and abetting violations of the Advisers Act; and dismissed the SEC's prayer for injunctive relief because the SEC "has not plausibly alleged that Defendants are reasonably likely to engage in future violations."

The SEC appealed the District Court's dismissal of the Exchange Act and Securities Act claims to the Second Circuit, and the defendants cross-appealed, arguing that the District Court erred in denying their motions to dismiss the SEC's prayer for disgorgement under the Advisers Act and, more generally, in denying their motions to dismiss with prejudice the SEC's claim for aiding and abetting violations of the Advisers Act.

The Second Circuit reversed and remanded, granting the SEC's appeal in all respects and dismissing the cross-appeals "for want of appellate jurisdiction."

'In This Context'

The defendants filed their petition for writ of certiorari in the Supreme Court on April 20, and the Supreme Court granted review on Sept. 25. The Investment Advisers Act makes it illegal for investment advisers to defraud their clients and authorizes the SEC to seek civil penalties from advisers who do so. Under the general statute of limitations for civil penalty actions, the SEC has five years to seek such penalties. The question presented to the Supreme Court was whether the five-year clock begins to tick when the fraud is com­plete or when the fraud is discovered. Oral arguments were held Jan. 8.

The government argued that the discovery rule, under which accrual is delayed "until the plaintiff has 'discovered'" his cause of action, should apply, pursuant to Merck & Co. v. Reynolds (559 U.S. ___, ___ [2010] [slip op., at 8]).

"But we have never applied the discovery rule in this context, where the plaintiff is not a defrauded victim seeking recompense, but is instead the Government bring­ing an enforcement action for civil penalties," the panel held. "Despite the discovery rule's centuries-old roots, the Government cites no lower court case before 2008 employing a fraud-based discovery rule in a Government enforcement action for civil penalties."

No Extension To Government

The government "was also unable to point to any example from the first 160 years after enactment of [the] statute of limita­tions where it had even asserted that the fraud discovery rule applied in such a context," the panel continued.

"There are good reasons why the fraud discovery rule has not been extended to Government enforcement actions for civil penalties," the panel said. "The discovery rule exists in part to pre­serve the claims of victims who do not know they are injured and who reasonably do not inquire as to any injury. Usually when a private party is injured, he is imme­diately aware of that injury and put on notice that his time to sue is running. But when the injury is self-concealing, private parties may be unaware that they have been harmed. Most of us do not live in a state of constant investigation; 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. And the law does not require that we do so. Instead, courts have de­veloped the discovery rule, providing that the statute of limitations in fraud cases should typically begin to run only when the injury is or reasonably could have been discovered.

"The same conclusion does not follow for the Government in the context of enforcement actions for civil penalties. The SEC, for example, is not like an individual victim who relies on apparent injury to learn of a wrong. Rather, a central 'mission' of the Commission is to 'investigat[e] potential violations of the federal securities laws.' SEC, Enforcement Manual 1 (2012). Unlike the private party who has no reason to suspect fraud, the SEC's very pur­pose is to root it out, and it has many legal tools at hand to aid in that pursuit."

Chief Justice John G. Roberts Jr. wrote the Supreme Court's opinion and was joined by Justices Antonin Scalia, Anthony M. Kennedy, Clarence Thomas, Ruth Bader Ginsburg, Stephen G. Breyer, Samuel A. Alito Jr., Sonia Sotomayor and Elena Kagan.


The SEC is represented by Solicitor General Donald B. Verrilli Jr. of the U.S. Department of Justice in Washington.

The defendants are represented by Liman of Cleary Gottlieb Steen & Hamilton in New York.

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