U.S. Supreme Court to Decide When a Plaintiff “Discovers” Securities Fraud for Purposes of Triggering Statute of Limitations in Actions Under Section 10(b) of Securities Exchange Act of 1934

May 27, 2009

On May 26, 2009, the United States Supreme Court granted certiorari in Merck & Co. v. Reynolds, No. 08-905, agreeing to resolve disagreements among the circuit courts of appeals on when constructive discovery of fraud occurs for the purpose of triggering the running of the statute of limitations in federal securities actions brought under section 10(b) of the Securities Exchange Act of 1934.  The Court’s decision next Term in Merck will clarify, first, when a plaintiff is considered to be on notice of the possibility of fraud, and, second and related, when the statute of limitations is actually triggered.

The Circuit Splits

Section 804(a) of the Sarbanes-Oxley Act of 2002 provides that a private action claiming fraud under section 10(b) of the Exchange Act (and Securities and Exchange Commission 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 has held that the statute of limitations may be triggered by constructive as well as 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 consensus ends there, with growing 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. 

Whether Evidence of Scienter Is Necessary for Inquiry Notice

As typically understood, a plaintiff is on inquiry notice in a securities fraud action under section 10(b) where there exist sufficient “storm warnings” suggesting possible wrongdoing on the part of a defendant such that a reasonable investor would investigate further.  The courts of appeals were in general agreement on this most basic standard until last year, when the Ninth Circuit broke with the others in Trainer Wortham & Co. v. Betz, 519 F.3d 863 (9th Cir. 2008).  The court there held that a plaintiff is not on inquiry notice until he has been alerted to facts suggesting that a defendant acted with scienter in committing possible wrongdoing: the storm warnings, in other words, must alert a reasonable investor not only of some possible misrepresentation, but also that the defendant might have been aware of that misrepresentation.  This additional requirement can make a meaningful difference in many cases because a plaintiff’s suspicion that something is wrong does not necessarily translate into suspicion that a defendant knowingly committed that wrong.

In In re Merck & Co. Securities, Derivative & “ERISA” Litigation, 543 F.3d 150, 172 (3d Cir. 2008), the Third Circuit joined the Ninth Circuit in requiring storm warnings indicating that defendants acted with scienter in order to establish inquiry notice for section 10(b) claims.  No other circuit has imposed such a requirement, and at least the Tenth and Eleventh Circuits appear to reject it outright.

When the Statute of Limitations Is Actually Triggered

Merck’s scienter requirement for inquiry notice implicates a broader and deeper split among the circuits as to when the statute of limitations for section 10(b) actions begins to run in cases involving constructive discovery.  The Seventh and Eleventh Circuits are the most pro-defendant on that question, embracing a pure inquiry notice approach and holding that the two-year clock starts once a plaintiff is on inquiry notice–that is, once a plaintiff has sufficient storm warnings of possible wrongdoing that should cause him to investigate further.  The majority of the circuits to have addressed the issue (the D.C. and Federal Circuits have not) are more plaintiff-friendly and add a second step: once inquiry notice is established, the clock still does not begin to run until a plaintiff, in the exercise of reasonable diligence, could have discovered the facts underlying the alleged fraud.  The Second and Third Circuits adopt a hybrid approach, holding that, once inquiry notice is established, the statute of limitations does not begin to run until a plaintiff could have discovered the facts underlying the alleged fraud, so long as the plaintiff actually initiates an investigation.  Because storm warnings often cause plaintiffs to investigate further, this and the majority approach frequently converge in practice.

The Third Circuit’s Decision in Merck

Merck illustrates the difference these divergent tests can make to defendants challenging the timeliness of plaintiffs’ claims.  A large group of investors filed several class actions against Merck for allegedly misrepresenting the safety and commercial viability of its popular Vioxx pain reliever, misrepresentations that eventually caused Merck’s stock price to plummet.  A number of potential storm warnings existed that would have alerted reasonable investors to possible wrongdoing on the company’s part, including postings on the Food and Drug Administration’s website, a New York Times article, and several consumer fraud, product liability, and personal injury lawsuits, all of which discussed Merck’s alleged misrepresentations.  Even so, the plaintiffs failed to conduct any investigation into possible fraud by Merck.  They also waited more than two years from the date of the storm warnings before filing their suit.

Had a pure inquiry notice or a hybrid approach applied, the plaintiffs’ claims would have been time-barred.  The Third Circuit allowed the claims to go forward anyway, holding that inquiry notice could not be established–and thus the statute of limitations did not begin to run–unless and until a reasonable investor would have been aware of warnings suggesting that Merck had acted with scienter.  Echoing the Ninth Circuit in Trainer Wortham, the court concluded that, because the storm warnings provided “no reason to suspect that Merck did not believe” its earlier optimistic studies on the safety and viability of Vioxx, those warnings did not put plaintiffs on inquiry notice.  543 F.3d at 172 (emphasis added).  The Trainer Wortham court had held that storm warnings must contain “evidence that the defendants had intentionally or deliberately and recklessly misled” a plaintiff before they would result in inquiry notice, 519 F.3d at 878, in a case involving an individual who sued a personal investment company for a decrease in the principal in her account after the company told her that it would never decrease.  The Supreme Court considered a petition for certiorari in Trainer Wortham simultaneously with the petition in Merck, and appears to be holding the petition pending its eventual decision on the merits in Merck

Implications of The Supreme Court’s Certiorari Grant in Merck

In granting certiorari in Merck, the Supreme Court has once again indicated the importance of a uniform national statute of limitations for federal securities fraud claims.  See Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350, 357 (1991).  There are, of course, a number of ways in which the Court could resolve the issue when it decides the case next Term, with important implications for plaintiffs and defendants.  Hewing closely to a pure inquiry notice approach would put a halt to the incremental judicial loosening of the constructive discovery doctrine in favor of plaintiffs as exemplified by the Third and Ninth Circuit decisions.  Alternatively, the Court might adopt a more pro-plaintiff position, such as that urged by the Solicitor General in which “discovery of the facts constituting the violation” under § 1658(b) contemplates facts sufficient (on a motion to dismiss) to establish each and every element of fraud, including scienter.  Whatever the Court’s ultimate disposition, it almost certainly will have to grapple directly with the intertwining issues implicated by the different splits among the circuits.  The case thus presents an important opportunity for the Court to provide plaintiffs and defendants alike with more predictability and less circuit-by-circuit variance in an area of federal securities law that has been a source of increasing confusion among the lower courts in recent years.

Gibson, Dunn & Crutcher LLP

Gibson, Dunn & Crutcher’s Securities Litigation Practice Group is a recognized leader in the defense of securities class actions, derivative litigation, and SEC and government enforcement actions. The firm’s Appellate and Constitutional Law Practice Group has played a leading role in a number of recent significant cases in the Supreme Court, and also handles a range of appellate and strategic counseling matters in the areas of securities and corporate governance.

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