US high court decision will hasten SEC enforcement actions

On Feb. 27, the U.S. Supreme Court issued an important ruling concerning the statute of limitations for enforcement actions in which the government seeks civil penalties. In Gabelli v. Securities and Exchange Commission, 2013 DJDAR 2538, the court unanimously ruled that the Securities and Exchange Commission must file enforcement actions seeking civil money penalties within five years after the underlying fraudulent conduct occurred rather than when it is discovered. The court's rejection of the so-called "discovery rule" will force the SEC and other government agencies with civil enforcement powers to bring enforcement actions sooner, particularly when the SEC does not discover the fraudulent conduct until years after it has occurred. Given the frequent collaboration between the SEC and Department of Justice, this ruling also may impact the timing and pace of parallel criminal investigations.

In Gabelli, the SEC brought a civil fraud action under Section 206 of the Investment Advisers Act against two officers of a Gabelli mutual fund for allegedly allowing a preferred investor to engage in market timing in the fund between 1999 and 2002. However, the SEC did not file its complaint, which requested injunctive relief, disgorgement and a civil money penalty, until April 2008. The defendants moved to dismiss the complaint on the ground that the SEC's claims were barred by 28 U.S.C. Section 2462, which provides, "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 district court agreed and dismissed the SEC's penalty claims, but not its claims for disgorgement and injunctive relief. (Claims for disgorgement and injunctive relief are equitable in nature, not punitive, and therefore are not subject to the five-year limitations period contained in Section 2462.) The 2nd U.S. Circuit Court of Appeals reversed, however, and applied the discovery rule, under which the claim accrues, and the statute of limitations starts to run, when the SEC discovers, or should have discovered with reasonable diligence, the alleged fraud.

In an opinion authored by Chief Justice John Roberts, the Supreme Court reversed the 2nd Circuit and refused to apply the discovery rule to government enforcement actions seeking civil penalties. The court articulated several compelling reasons for not applying the discovery rule in such actions. First, the discovery rule was designed to protect injured plaintiffs who may be unaware that they have been defrauded, not the government seeking civil penalties in an enforcement action. Second, the SEC does not require the protection of the discovery rule because, unlike a defrauded private party who may lack the resources to discover and investigate potential fraud, "the SEC's very purpose is to root [out fraud] ... and it has many legal tools at hand to aid in that pursuit." Third, the discovery rule aids an injured victim in obtaining compensation, which does not apply to government enforcement actions that are intended to punish alleged wrongdoers, not compensate victims.

The court also seemed to be troubled by the apparent unfairness to defendants who are accused by the SEC of wrongdoing and subjected to an enforcement action "not only for five years after their misdeeds, but for an additional uncertain time period in the future." Quoting Judge Marshall in Adams v. Woods, 2 Cranch 336, 352 (1805), Chief Justice Roberts emphasized that "it 'would be utterly repugnant to the genius of our laws' if actions for penalties could 'be brought at any distance of time.'" In addition, if the discovery rule were applied to government enforcement actions, courts would face "particular challenges" in trying to determine when the government knew or should have known of the alleged violation to trigger the running of the limitations period.

The court's decision contains several significant qualifications on its strict application of Section 2462's five-year statute of limitations. First, the decision applies only to penalty claims; the SEC's equitable remedies (injunctions and disgorgement) are unaffected by the decision. Second, the court left unaddressed whether equitable tolling would apply when the defendant actively conceals discovery of its conduct. Third, the discovery rule may still apply when the government is the victim of the fraud and is seeking both compensatory damages and penalties.

It is likely that Gabelli will have a significant impact on government investigations and resulting enforcement actions seeking civil penalties. Typically, the SEC is unaware of an alleged fraud until after it has occurred and then takes months - if not years - to conduct its investigation. Up against a hard deadline to file an enforcement action within five years, SEC enforcement attorneys will be required to complete their investigations more quickly to avoid dismissal of stale claims. Speedier investigations will also impose burdens on individuals or companies that are the subjects of such investigations who are likely to be refused even reasonable requests for additional time to respond to the SEC's investigative subpoenas or Wells notices. The SEC likely will also seek tolling agreements more frequently from potential defendants as the age of the conduct nears five years, which will require those potential defendants to engage in the frustrating exercise of trying to predict whether the SEC will promptly file suit if they decline the requested tolling agreement and before they have a full opportunity to persuade the SEC that an enforcement action is unwarranted.