Jonathan Macey is the Sam Harris Professor of Corporate Law, Securities Law and Corporate Finance at Yale Law School.
Reading the facts of Gabelli v. SEC, scheduled for oral argument tomorrow, is like watching a Civil War reenactment. Market timing cases such as this are from the Eliot Spitzer era – and I don’t mean Governor Spitzer, but Attorney General Spitzer. The real world has suffered many undetected frauds since market timing was rooted out root and branch, but the SEC likes fighting on familiar ground. The big issue in this case is how to interpret an important federal statute of limitations. The district court and court of appeals also disagreed on the adequacy of certain disclosures made by Gabelli to its investors, though this issue will not be addressed on appeal. This is no problem, though because the court of appeals got it wrong on the statute of limitations but right on the disclosure issue. The district court got it right on the statute of limitations but wrong on the disclosure issue. The defendants are not exactly wearing the white hats in this case. But the SEC and its staff are far from good guys here. This is a case where both sides richly deserve to lose.
Background
The case has its origins in some pretty lamentable shenanigans that occurred about a decade ago at Gabelli Global Growth Fund (“GGGF”). GGGF is a mutual fund within the Gabelli Funds mutual fund family. The SEC sued Marc Gabelli, the portfolio manager of GGGF, and Bruce Alpert, the Chief Operating Officer of Gabelli Funds, LLC (“Gabelli”), GGGF’s investment advisor. Gabelli makes investment and operating decisions for the Fund and owes strict fiduciary duties to the Fund and its investors. GGGF and Gabelli granted special secret favors to one particular hedge fund investor in GGGF, Headstart Advisors, Inc., in exchange for Headstart’s promise to invest in a hedge fund run by Marc Gabelli.
The secret favor that Gabelli gave the hedge fund was the right to engage in a trading practice known as market timing. Market timing is not illegal. But the SEC is not fond of it. Then again, it is not easy to find a trading strategy of which the SEC approves. Market timing is simply the good old investment strategy of trying to buy when prices are low and to sell when prices are high. Those who follow the alternative “buy and hold” strategy reject the premise that it is possible to time the market because traders cannot discern when prices have reached their troughs or peaks. The empirical literature in finance is firmly on the side of the buy-and-hold investors who content themselves with taking the gains generated by the market over long periods of time rather than buying and selling frequently, which is what market timers tend to do.
Oddly, the SEC never has had much interest in distinguishing among the various forms of market timing, which is unfortunate since some are quite harmless. The SEC also is quite vague about what harm, if any, is caused by market timing.
Certain market timing strategies work well for the market timers. Some are quite a bit like betting on horse races after the winner has crossed the finish line. One such strategy is time zone arbitrage. Take, for example, a U.S. mutual fund stock in a Japanese company traded on the Tokyo Stock Exchange (“TSE”), which usually closes at 2 a.m. New York time. Under standard operating procedures condoned by the SEC, the U.S. mutual fund will calculate the value of its shares — and thus the price at which it will buy and sell its shares from investors — at 4 p.m. New York time. But the fund will use the TSE’s old 2 a.m. closing price – which will be fourteen hours old by the time it is 4 p.m. in New York — to make the calculation. If good news for Japanese stocks comes out during this fourteen-hour period, the news will not be reflected in the 4 p.m. price calculation. Investors armed with news released after the Tokyo close who can buy shares in the mutual fund at the old “stale” price can profit by selling those shares at the new higher prices that are set the next day.
The SEC alleged that GGGF generally tried to prevent this sort of time zone arbitrage along with other sorts of late trading in its funds, but made a big exception for Headstart from 1999 until 2002. During that period, Headstart’s three accounts at GGGF realized massive rates of return — 185%, 160%, and 73% at a time when the fund itself was racking up huge losses
At least as of this writing, however, making profits is not illegal. Especially in situations like this one, where the profits do not necessarily come at the expense of the other mutual fund investors. In this case, for example, when the market timer buys on positive news about Japanese stocks that emerges after the Tokyo markets are closed but before the shares are priced, these profits benefit the market timer, but they don’t prevent the other investors who hold shares in the mutual fund from profiting from the price rise: their shares increase in value on the good news from the East just as much as they would have done if there was no market timer.
Market timing, however, may impose costs on other mutual fund investors. Because the mutual fund allowing market timing does not manage to buy new shares at the old price, the mutual fund must have excess cash in the fund that is not earning much in the way of returns to make these purchases. This extra cash dilutes the fund’s returns, which harms all of the other shareholders.
Sometimes this cost is offset by the benefits that market timers provide to the fund. Market timers increase the size of assets under management, which reduces costs for all investors. For this reason, some funds used to encourage market timers to invest. In this particular case, however, the market timer traded in one Gabelli fund and put its extra money in an entirely different fund. This is wildly inconsistent with the fiduciary duties that the fund managers and directors owe to the investors in the GGGF fund that was being market timed. The investors in that fund should have gotten the benefits of the timer’s extra investments. Also, the optics in this case are bad: In contrast to the market timer’s huge gains, the other shareholders in the mutual fund suffered losses of around 24.1%, Gabelli finally stopped the favored client from doing any more market timing until August 2002.
The SEC began investigating Gabelli in the fall of 2003, right after Eliot Spitzer showed how the SEC was asleep at the switch by preemptively launching his own campaign against mutual fund behavior. The SEC did not get around to filing its own lawsuit until April 24, 2008. The SEC sought civil damages and injunctive relief for fraudulently permitting market timing practices that had had ended more than five years ago.
28 U.S.C. § 2462 provides that any penalty action brought by the government must be “commenced within five years from the date when the claims first accrued.” A claim generally accrues when it comes into existence. Gabelli’s lawyers thus moved to dismiss the claim for civil penalties, arguing that the SEC’s claim “first accrued” as early as September 1999, when it first could have sued, and certainly not later than August 7, 2002, when the defendants stopped permitting the market timing. The SEC argues that the statute of limitations should not begin to run in fraud cases until the fraud is “discovered” – which occurred in September 2003. The district court sided with Gabelli, noting that Section 2462 does not contain a discovery rule, and pointing out that the SEC could not avail itself of the doctrine of fraudulent concealment because it had failed to allege any acts that taken by the defendants to conceal what they were doing.
There is a fascinating disclosure issue in this case. It’s fascinating because the district court’s reasoning about Gabelli’s disclosure obligation mars an otherwise impeccable decision by the lower court. The SEC clearly had a point that the Gabelli defendants made a material misrepresentation when, in the September 2003 disclosure to investors posted on the Gabelli Fund’s parent’s website, the fund indicated that “for more than two years, [market timers] have been identified and restricted or banned from making further trades.” The district court found that this statement was literally true because market timers were identified and restricted from making further trades. But the truth is that all market timers except one large hedge fund were excluded. I cannot imagine how the disclosure of this exception was not necessary to make the rest of the disclosure not misleading.
On appeal, the Second Circuit reversed the district court on all issues in an opinion by Judge Rakoff, a district court judge sitting on the Second Circuit by designation. The court of appeals agreed with the government that the action was not untimely; moreover, it added, at the motion-to-dismiss stage, neither Gabelli nor Alpert had demonstrated to its satisfaction that a reasonably diligent plaintiff would have discovered the fraud prior to September 2003 — within five years of when the SEC had commenced its suit. Accordingly, the Second Circuit held that in cases sounding in fraud, “the discovery rule defines when the claim accrues and, correlatively, that the SEC need not plead that the defendants took affirmative steps to conceal their fraud.” Gabelli and Alpert then filed a petition for certiorari, which the Court granted on September 25, 2012.
Merits briefing and analysis
In his brief on the merits, Cleary Gottlieb’s Lewis Liman responded that in this particular fraud case there had not even been any allegations of concealment, and certainly no finding of concealment on the part of his client, Gabelli. The brief builds well on the district court’s finding that the SEC did not “allege with particularity … what acts Defendants took, beyond the alleged acts of wrongdoing themselves, or what contrivance or scheme was designed to mask the SEC’s causes of action.”
The Justices are thus faced with a choice between the SEC’s argument that as a categorical matter, when a claim sounds in fraud it need not be brought until it is discovered or should have been discovered by the government, and the Gabelli argument that the discovery rule should apply only in cases in which the defendant has engaged in inequitable conduct that might impede the discovery of the fraud. The SEC’s approach would, as a practical matter, eliminate the applicability of the federal statute of limitations in fraud cases. This does not seem like a sensible result.
The SEC’s view is that the SEC can’t police everyone 24/7, so a “discovery” rule makes sense. That argument would be stronger if it were limited in some way. Should the SEC really be able to litigate this case fifty years from now because it didn’t get around to completing its investigation until then? Of course the SEC cannot police everybody. But giving the SEC extra time, with no apparent limit, does not seem to be the answer. Statutes of limitation have been around for centuries, and for good reason. The fact that they are inconvenient for the SEC is not a compelling argument against them.
The case has important implications. If the Court upholds the Second Circuit’s decision, the insurance industry fears “a vast expansion of the amount of time that the SEC might have in which to discover and pursue violations of the federal securities laws — and correspondingly greater potential exposure to defense costs for insurers who write D&O and E&O coverage.”
Giving the SEC a victory on the statute of limitations issue would certainly reward the SEC for its “Civil War reenactment” litigation strategy, a result that hardly appears consistent with the public interest: If the Second Circuit panel’s approach to the statute of limitations issue is upheld, the SEC and other administrative agencies will have few incentives to pursue claims in a timely manner.
The SEC also is pursuing injunctive relief. Obtaining this form of relief requires that there be “a reasonable likelihood that the wrong will be repeated.” Since the entire mutual fund industry has evolved since Eliot Spitzer sued it into oblivion over a decade ago, the SEC does not appear to have much of an argument here, but that didn’t stop the Second Circuit from agreeing with the SEC anyway, on the ground that that future fraud was reasonably likely because the SEC’s complaint alleged fraud, and “fraudulent past conduct gives rise to an inference of a reasonable expectation of continued violations,” On this reasoning, there would never be any injunctive relief ever, unless the defendants were dead or defunct when the suit was brought. This slow pitch is unlikely to get by the Court, but who knows?
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