Seventh Circuit Issues an Important Opinion Regarding the Statute of Limitations for SEC Civil Fines

March 5, 2009

In recent years, Securities and Exchange Commission ("SEC") enforcement investigations have become extended and enforcement actions have often been commenced five years or more after the events that form the basis for the claim.  As a result, lawyers for persons who are involved in SEC investigations are frequently asked to sign agreements tolling the running of the statute of limitations.  On February 26, 2009, the United States Court of Appeals for the Seventh Circuit issued a significant decision in Securities and Exchange Commission v. Koenig (Docket No. 08-1373) holding that for the purpose of applying the general federal civil penalties statute of limitations provision, 28 U.S.C. § 2462, to an SEC fraud claim, the statute does not begin to run until the SEC discovers or reasonably could have discovered the fraud.  The decision also establishes important precedent on the amount of civil money penalties that may be imposed.

Background

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." 

In SEC v. Koenig, the Seventh Circuit reviewed a district court decision imposing a civil penalty and ordering disgorgement of bonuses upon a jury finding that the defendant engaged in accounting fraud.  The defendant’s actions allegedly occurred prior to January 1997.

The Court noted that Waste Management issued a press release in October 1997 declaring its financial statements to be unreliable.  The SEC filed its complaint in March 2002, more than five years after the defendant’s alleged misconduct.  However, the district court concluded that the SEC’s demand for civil penalties was timely because the statute did not begin to run until October 1997, when the SEC discovered the alleged fraud.

Under Koenig, the Limitations Period Under 28 U.S.C. § 2462 Begins when the Alleged Fraud is Reasonably Discoverable by the SEC, Not when Misconduct Occurs

The federal securities laws do not have an express statute of limitations for SEC enforcement actions other than a five year limitation for actions seeking a civil penalty for insider trading (which runs from the date of the purchase or sale of the security in question).  Section 2642 is a catch-all statute of limitations for federal civil penalties which applies to any "form of punishment imposed by the government for unlawful or proscribed conduct, which goes beyond remedying the damage caused to the harmed parties by the defendant’s action."  Johnson v. SEC, 87 F.3d 484, 488 (D.C. Cir. 1996). In that opinion, the United States Court of Appeals for the District of Columbia held that Section 2462 applied to relief sought in SEC actions that had a punitive effect – in that case, the suspension of a stock broker’s employment with a brokerage firm.  The Johnson holding has since been extended to other suspensions of professionals and to the imposition of civil money penalties generally.

While the SEC has accepted the Johnson holding, it has asserted that the statute does not run for allegedly fraudulent conduct from the date of the events.  In Koenig, the Seventh Circuit declined to evaluate when a claim accrues for the purpose of Section 2462 generally because of a "special rule for fraud."  The Court held that "a victim of fraud has the full time from the date that the wrong came to light, or would have done had diligence been employed." 

Thus, the Court determined that the October 1997 press release put the SEC on notice of the need for inquiry.  Even though the defendant did not contend that the SEC investigation should have begun earlier, the Court, in dictum, asserted that the lack of a qualified opinion by the outside auditors or the absence of an earlier and sharp decline in the company’s stock price supported this conclusion.

Prejudgment Interest May Be Included in Calculation of Pecuniary Gain as a Base for Imposition of Civil Money Penalties

The district court ordered the defendant to disgorge those portions of his performance based bonuses that were allegedly affected by the financial misstatements, plus prepayment interest on those bonuses, which totaled $2.1 million.  The district court then imposed a civil money penalty of $2.1 million, which equaled  the disgorgement of bonuses and prejudgment interest.  Under the SEC’s civil money penalty provisions, a district court may not impose a civil money penalty greater than $100,000 per violation or "the gross amount of pecuniary gain to [the] defendant as a result of the violation."  15 U.S.C. §§ 77t(d)(2)(A), 77u(d)(3)(B)(i).  In this instance, the district judge treated the prejudgment interest as part of the defendant’s "pecuniary gain" in determining the civil penalty.  The Seventh Circuit agreed that the defendant’s "’pecuniary gain’ is the amount he obtained by his fraudulent accounting, plus the economic return he made (or could have made) by investing that sum" and concluded that "prejudgment interest is the right way to estimate the second component" in order to adjust for the time-value of money.

Implications of the Seventh Circuit Opinion

The Seventh Circuit’s holding in Koenig sharply contrasts with SEC v. Jones, 476 F. Supp. 2d 374 (S.D.N.Y. 2007), in which the United States District Court for the Southern District of New York held that the SEC had failed to establish that the statute of limitations should be tolled as a result of defendants’ alleged concealment of their  activities.  The defendants in Jones were alleged to have engaged in fraudulent concealment in 1999.  In 2003, a whistleblower disclosed the alleged wrongdoing to the SEC.  In 2005, the SEC sued the defendants for aiding and abetting a violation of Section 206 of the Advisers Act.

The Court in Jones, however, held that the SEC’s action for civil penalties was time-barred under Section 2462.  The Court held that to toll the statute of limitations for fraudulent concealment, the SEC must prove:  "(1) that Defendants concealed the existence of the cause of action; (2) that it did not discover the alleged wrongdoing until some point within five years of commencing this action; and (3) that its continuing ignorance was not attributable to lack of  diligence on its part."  To demonstrate concealment, the SEC must show "either that Defendants took affirmative steps to prevent discovery of the fraud or that the wrong itself was of  such a nature as to be self-concealing."  Id. at 382 (quoting New York v. Hendrickson Bros., Inc., 840 F.2d 1065, 1083 (2d Cir. 1988)).  The Court rejected the premise that allegations of fraud suffice to demonstrate that conduct was self-concealing in the absence of "some misleading, deceptive, or otherwise contrived action or scheme."  Id. (quoting Hobson v. Wilson, 737 F.2d 1, 34 (D.C. Cir. 1984)).  Rather, the Jones court effectively put the burden of proof on the SEC to demonstrate concealment.  Because "the Commission has not met its burden to demonstrate that Defendants’ alleged deception was unknowable and hence self-concealing," the court granted summary judgment to the defendants.

Jones regarded the SEC’s ability to access information related to the misconduct to be sufficient to meet the standard of discoverability and start the five-year ticking clock of Section 2462.  The Koenig decision did not reach this issue.

Furthermore, the Court in Jones found persuasive that the misconduct was discoverable and that the SEC had access to information that put it on notice of potential claims:  "while defendants’ allegedly fraudulent acts of misrepresentation may not have been affirmatively disclosed to the Commission, the record does not support a finding that they were incapable of being known."  Specifically, the Court found that the profits were disclosed in the Board Memo and included in the funds’ prospectuses and registration statements.  Accordingly, the SEC’s claim for civil penalties was dismissed as time-barred.

Jones held that "the Commission’s conclusory assertion of self-concealing fraud is insufficient to sustain its claim for civil penalties."  Dictum in the Koenig opinion suggests a lower bar.

For practitioners, these cases have several important implications. 

First, courts outside the Seventh Circuit may not accept the Koenig holding.  It applies a general, federal statute of limitations in a manner that is inconsistent with the express securities law statute of limitations applicable for insider trading and appears to contradict the holdings in Jones and Johnson.

Second, facts regarding "discoverability" of the alleged fraud – such as the timing and content of newspaper articles and whistleblower complaints — may now be important to determining when the statute begins to run.  Further, the Koenig opinion does not address claims for violations other than fraud or discoverability of facts within firms that are subject to direct oversight by the SEC, creating the potential for different limitations periods for different alleged securities law violations. 

Third, the Seventh Circuit’s conclusion that prejudgment interest is a part of the "pecuniary gain" that may form the basis for a civil money penalty may raise the stakes for potential parties who face lengthy investigations whose conclusion they cannot control and potentially extended civil litigation while awaiting judgment by the district court. It would appear inequitable for defendants to be penalized for investigation and litigation delays that are beyond their control.  Thus, counsel may wish to consider making a record of delay that is not attributable to the defense.