The new leadership team at the U.S. Securities & Exchange Commission (SEC) has pledged to bring about positive change to the way it approaches its important regulatory enforcement duties. It remains to be seen in exactly what form this change will take. Some of the most significant changes to the way the SEC approaches its work, however, are likely to come from the outside — specifically, as a result of what has been described as the “mildly technical decision” issued in February 2013 by the U.S. Supreme Court in Gabelli v. Securities & Exchange Commission.
The case began in 2008, when the SEC sued a mutual fund investment advisor, Gabelli Funds LLC, in New York federal district court for alleged violations of the Investment Advisors Act of 1940. According the SEC, between 1999 and 2002, senior officers at Gabelli aided and abetted an important client in fraudulent “market timing” activity that allowed the client to profit from differences in the closing times for U.S. and foreign financial exchanges. Among other things, the SEC sought to impose civil monetary penalties against Gabelli. Gabelli moved to dismiss, arguing, in part, that the claim for civil penalties was time-barred by the five-year statute of limitations set out in 28 U.S.C. § 2462. The district court agreed and dismissed that claim.
On appeal to the 2nd Circuit, the SEC argued that it was entitled to the protections afforded by the discovery rule. In the SEC’s view, the limitations period on its claims against Gabelli began to run only after the SEC discovered the fraud, not when it occurred. The 2nd Circuit agreed, holding that such fraud-related claims do not accrue until a plaintiff knows or should have known of the fraud.
In a decision authored by Chief Justice John Roberts, the Supreme Court unanimously rejected the 2nd Circuit’s holding. According to the Court, under the “most natural reading” of Section 2462, a fraud claim accrues when it occurs and not when the SEC discovers the fraud. Noting that the discovery rule historically has not been applied in civil enforcement proceedings brought by the government, the Court also found fault with the notion that the SEC can or should be equated with a typical plaintiff in a civil case. Rather, the two are distinct, and the Court stressed that there are important reasons for the distinction: “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.”
The “primary mission” of the SEC, on the other hand, is to investigate and “root out” fraud. And it has many legal tools at its disposal to do so, including: demanding that brokers and dealers submit detailed information, even before a suit is filed; offering and paying monetary awards to whistleblowers; and issuing subpoenas for documents and witnesses it deems relevant to an investigation. As Chief Justice Roberts explained, “[c]harged with this mission and armed with these weapons, the SEC as enforcer is a far cry from the defrauded victim the discovery rule evolved to protect,” and does not need protections afforded by that rule.
The Court went on to observe that, even if that were not the case, there is a practical limit on the ability of courts to allow the government to rely on the discovery rule. The federal government is composed of multiple, overlapping bureaucracies staffed by thousands of employees. Consequently, determining what the government knew and when would be an unrealistic, virtually impossible exercise.
The decision is significant and likely to have a lasting impact. Indeed, for those companies who are or were concerned about possible SEC enforcement proceedings related to their conduct during the 2007-2009 financial credit crisis, the Gabelli decision makes clear just how long they need to hold their breath. For the SEC, there is new and powerful pressure for greater vigilance and efficiency in the identification and prosecution of cases. Increased use of tolling agreements with parties under investigation can be expected as well. Finally, given that the Supreme Court’s holding in Gabelli was limited to actions in which the SEC seeks a civil monetary penalty, one should look for the SEC to take greater advantage of the many other enforcement remedies available to it, including disgorgement, injunctive relief and suspensions from the industry.