Argument recap: We’re from the government and we’re here to win

Jonathan Macey is the Sam Harris Professor of Corporate Law, Securities Law and Corporate Finance at Yale Law School.

Since Justice Powell left the Court in June 1987, there has not been a real securities law maven among the Justices.  Most of the action in corporate and securities law has been in Delaware.  So it was fun to see the oral argument before the Court in Gabelli v. SEC, a case that involves the venerable practice of market timing in a disclosure context.  Although the statute at issue in the case is 28 U.S.C. § 2462, which establishes the statute of limitations for dozens of federal statutes and several important administrative agencies, from the Securities and Exchange Commission to the Social Security Administration, there was plenty of interesting discussion about the SEC and market timing issues.

For one thing the statute at issue provides that any penalty action brought by the government must be “commenced within five years from the date when the claims first accrued.”  This statute seems particularly unfair when applied to the SEC, an administrative agency that often does not get around to noticing market developments until they make the headlines or until a few ambitious state attorneys general start suing the companies that the SEC is supposed to be regulating.  Several Justices (indeed, virtually all of the Justices except Justices Sotomayor and Thomas) seemed concerned about the SEC’s argument that whenever the SEC alleges that its lawsuit sounds in fraud — which is almost always, because non-disclosure and incomplete disclosures are frauds – the statute of limitations should not begin to run until the SEC gets around to noticing (or “discovering”) the illegal activity, regardless of when it should have noticed it had it been a bit more attentive.

In a pre-oral argument post on this blog, I noted that it seemed odd that the Securities and Exchange Commission was still litigating market timing cases after all these years.  During the argument itself, Justice Ginsburg asked Jeffrey Wall, the Assistant to the Solicitor General arguing the case, whether he could “explain the SEC’s pursuit of this – of this case.  The alleged fraud went on from 1999 to 2002.  It was discovered in 2003.  The SEC waited until 2003 until 2008 to commence suit.  What was the reason for – for the delay from the time of discovery till the time suit is instituted?”

Mr. Wall’s response was stunning.  He explained that suit was not filed within the five-year statute of limitations period because

there was a lot of back and forth between the parties, document exchanges, they wanted to make additional submissions. The Government hoped that there would be a settlement that would encompass all the defendants. Ultimately, there was a settlement that only went to the fund and petitioners did not settle and then the Government put together and brought its case.

Wow.  The government’s argument is that it should prevail under a DISCOVERY exception to a statute of limitations notwithstanding that it continued to procrastinate about whether to bring suit even after it discovered the alleged fraud. Is it possible that this point can strengthen rather than weaken the government’s argument?  The policy justification for the exception is that fraudsters should not be able to avail themselves of a statute of limitations period where they have taken action that hides the discovery of their own wrongdoing.  The government wants to extend this argument to cover all cases sounding in fraud, regardless of when, where, or how the government “discovered” the fraud.

Following up on Justice Ginsburg’s question, Justice Kagan said that she wanted to “go even further than Justice Ginsburg.”  Justice Kagan, combining law with a bit of  political science, asked Mr. Wall the following question:

The Government had decided not to go after market timers. And it changed its decision when a State Attorney General decided to do it, and it embarrassed them that they had made that enforcement priority decision, and then the Government made a different enforcement priority decision. But that’s not the kind of situation that the discovery rule was intended to operate on, is it?

Mr. Wall’s response – “I don’t think that’s fair” – is hard to interpret.  He then added that perhaps Spitzer was not investigating market timing; he was investigating mutual funds that permitted market timing, “but misleading investors about it”?  Well, I have only been researching this issue for a decade or so, but I think Justice Kagan’s question was fair, not to mention right on target.  Mr. Wall then added that “I don’t think we can ignore the evidence here, because we shouldn’t decide the case based on feverish hypotheticals.”  It is not clear, however, to which “feverish hypotheticals” Mr. Wall was referring, since Justices Ginsburg and Kagan’s questions did not pose hypotheticals at all. The questions were based on the actual, undisputed facts of the case that was being argued before the Court at that moment.

Mr. Wall had begun his argument by asserting that there long has been, and should continue to be, a “specific principle for cases of fraud and concealment.”  One of the government’s core arguments is that “there is no basis in law or logic for petitioner saying that this statute meant to pick up one of those concepts and not the other concept.”  Later, Mr. Wall clearly acknowledged, however, that there is a difference between fraud and concealment .  In this context, a fraud case is one in which a defendant commits a fraud on a third party, like its customers.  A concealment case is one in which a defendant commits a fraud, and then tries to conceal it from the government.  There was no such concealment in this case.

A big problem that the Court had with the government’s argument was that nobody could figure out whether there was any difference between the rule that the government was arguing for and, as Justice Scalia succinctly put it, “a rule that there is no statute of limitations” at all.  Unfortunately the Justices did not pick up on Mr. Wall’s assertion that “in our view the justification (for concealment) is the same for concealment as fraud.” This does not seem right to me.  There can be fraud and concealment at the same time, but there also can be cases (and this case seems to be one of them) where there is (alleged) fraud but no concealment.  As Justice Scalia pointed out, for purposes of the argument before the Court, the petitioner only conceded that there was fraud; it did not concede that there was any “later concealment to cover up that fraud.”

One way to deal with this issue is to say that the statute of limitations does not begin to run until the government should have discovered the wrongdoing had it been reasonably diligent.  Not only, as the Chief Justice observed, is it “going to be almost impossible for somebody to prove that the government should have known about something,” but it’s going to be almost as difficult to determine which part of the government should be responsible for knowing whatever it is that should have been known.” The Chief Justice went on to add that what is reasonable for the SEC to have discovered “depends really on how many enforcement officers the SEC has, is it reasonable for them to have been aware of the particular item in some publication.  Maybe if they’ve got 1,000 people reviewing it, but maybe not if they have 10.”

The government was not without some strong arguments.  One particularly good point for the government is that the discovery rule applies in civil cases brought as private rights of action by non-government plaintiffs, so it should apply here as well.   The response to this argument from Mr. Liman, arguing on Gabelli’s behalf, was that this case involves a penalty that the government is trying to collect, so the rule should be stricter than in a suit involving an actual “recovery to victims.”

Those Justices who love the government, think that there can be no better allocation of government resources than suing private companies and their executives, and believe that such suits should be brought by the government at its leisure will side with the SEC in this case. But many of those who have watched one particular part of the litigation elephant, namely the part involving corporate and securities litigation brought by the SEC, who fervently wish that the Commission would pay some attention to allocating its admittedly scarce resources to relevant cases in a reasonably efficient way would see a reversal of the Second Circuit as a useful wake-up call for a federal agency that sorely needs one.  I do not know how this case will come out, but I think I know how Justice Powell, who gave great wake-up calls to the SEC on more than occasion, would have ruled.