April 29, 2010
In Actions Under Section 10(b) of Securities Exchange Act of 1934, Statute of Limitations Does Not Begin to Run Until Plaintiffs Have Discovered or Reasonably Could Have Discovered Facts Constituting Securities Fraud, Including Scienter
On April 27, 2010, the United States Supreme Court held that the statute of limitations for private actions claiming securities fraud under Section 10(b) of the Securities Exchange Act of 1934 does not begin to run until plaintiffs have discovered or, with reasonable diligence, could have discovered the facts constituting the fraud, including scienter. The decision in Merck & Co. v. Reynolds, No. 08-905—authored by Justice Breyer and joined in full by five Justices and in part by the remaining three—establishes a more plaintiff-friendly standard that will make it more difficult for defendants to challenge the timeliness of plaintiffs’ Section 10(b) claims.
The Sarbanes-Oxley Act of 2002 provides that a private action claiming fraud under Section 10(b) of the Exchange Act (and Rule 10b-5 promulgated thereunder) must be brought "not later than the earlier of—(1) 2 years after the discovery of the facts constituting the violation; or (2) 5 years after such violation." 28 U.S.C. § 1658(b). Every court of appeals to have addressed this provision had held that "discovery" means both constructive and actual discovery, and that constructive discovery turns at least in part on when a plaintiff is on "inquiry notice" of the alleged fraud. But the pre-Merck consensus ended there, with confusion in the circuits on both the narrow issue of what is necessary to establish inquiry notice and the broader question of when exactly the statute of limitations begins to run after inquiry notice has been established.
Until Merck, the rule in most circuits had been that a plaintiff is on inquiry notice for purposes of Section 10(b) when there existed sufficient "storm warnings" suggesting possible wrongdoing on the part of a defendant such that a reasonable investor would investigate further. The Third Circuit, which decided Merck below, held that, in order to establish inquiry notice, the storm warnings must also suggest to a reasonable investor that a defendant acted with scienter—they must suggest, in other words, not only some possible misrepresentation, but that a defendant might have been aware of that misrepresentation. Perhaps more significant, the circuits were also split three ways as to when the statute of limitations began to run once inquiry notice had been established: (1) immediately (the "pure inquiry notice" approach); (2) only after a reasonably diligent plaintiff could have discovered the facts underlying the fraud (the "reasonable diligence" approach); or (3) only after a reasonably diligent plaintiff could have done so, so long as that plaintiff actually initiates an investigation (the "hybrid" approach).
In Merck, the Supreme Court resolved the circuit splits. As to the issue of what triggers the statute of limitations, the Court rejected both the "pure inquiry notice" and "hybrid" approaches in favor of the "reasonable diligence" approach, holding that the limitations period "begins to run once the plaintiff did discover or a reasonably diligent plaintiff would have ‘discover[ed] the facts constituting the violation’—whichever comes first." Slip op. at 17 (quoting 28 U.S.C. § 1658(b)(1)). This new uniform standard, the Court made clear, applies "irrespective of whether the actual plaintiff undertook a reasonably diligent investigation." Id. As to the issue of when inquiry notice and ultimately "discovery" exists, the Court held that discovery of the "facts constituting the violation" includes discovery of both facts that would suggest to a reasonable investor some misrepresentation on the part of a defendant and facts that would suggest that the misrepresentation was made with scienter. The "’fact’ of scienter," the Court observed, is "an important and necessary element of a § 10(b) violation." Id. at 13 (quoting § 1658(b)(1)). The Court also cleared away some of the terminological underbrush that had grown up around the concept of constructive discovery. The Court pointedly stated that, while "terms such as ‘inquiry notice’ and ‘storm warnings’ may be useful to the extent that they identify a time when the facts would have prompted a reasonably diligent plaintiff to begin investigating," id. at 17, the "’inquiry notice’ . . . standard generally . . . cannot [be] reconcile[d] . . . with the statute," which speaks only in terms of "discovery." Id. at 16.
In establishing a more plaintiff-friendly standard for the statute of limitations, the Court addressed and counterbalanced what it perceived to be a course of steadily increasing burdens on plaintiffs seeking to bring securities fraud claims. Having construed the scienter requirement of the Private Securities Litigation Reform Act ("PSLRA"), 15 U.S.C. § 78u-4(b)(2), in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), to set a high mental-state bar, and having imposed more stringent notice pleading requirements on plaintiffs in Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007), the Court believed that it would be inconsistent to then embrace a rule that would time-bar plaintiffs who have not yet (or could not reasonably have) developed facts sufficient to meet those decisions’ more demanding pleading standards.
Indeed, this "Catch-22" appeared to figure prominently in the Court’s reasoning. The Twombly decision was a clear focus at the Merck oral argument, and the Merck opinion cited Tellabs in declaring that excluding scienter from the "facts constituting the violation" did not square with the PSLRA’s requirement that plaintiffs "’state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.‘" Slip op. at 13 (quoting § 78u-4(b)(2)). Thus, the same defendant-friendly rulings in Twombly and Tellabs now allow plaintiffs, under Merck, more time to develop their claims. In Merck, the Court has not only reiterated the importance of a uniform national statute of limitations for federal securities fraud claims, but also signaled that, of necessity in its view, courts must have more patience toward plaintiffs seeking to uncover such fraud.
Merck‘s inclusion of the element of scienter within the "facts constituting the violation" raises the question whether other elements of Section 10(b) claims—such as reliance, loss, and loss causation, all of which defendants routinely challenge as inadequately pled in dispositive motions practice—should also be considered "facts constituting the violation" for statute of limitations purposes. While the Court took no position on that issue in its opinion, litigation on that issue seems likely as plaintiffs seek to forestall the running of the limitations period for as long as possible.
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