The 10b-5 Daily

In the Merck case, a unanimous U.S. Supreme Court (with two concurrences) has found that the investors’ securities fraud claims are not barred by the statute of limitations. In making that determination, however, the Court has significantly changed the relevant legal landscape

The statute of limitations for private federal securities fraud claims provides that a case “may 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.” Under the “discovery” clause, courts frequently have found that the statute of limitations begins to run once a plaintiff is on “inquiry notice” of the possibility (or probability) that a fraud has occurred. At issue in the Merck case was whether, as held by the Third Circuit, a plaintiff needs evidence of scienter (i.e., fraudulent intent) before inquiry notice is triggered.

As a threshold matter, the Court found that the statutory words could be read “as referring to the time a plaintiff actually discovered the relevant facts.” Nevertheless, based on longstanding judicial precedent, “‘discovery’ as used in this statute encompasses not only those facts the plaintiff actually knew, but also those facts a reasonably diligent plaintiff would have known.” The facts that must be known to the plaintiff, however, are the “facts constituting the violation.” Scienter, as “an important and necessary element” of a securities fraud claim, clearly meets this definition. A plaintiff therefore must have discovered (or have been able to discover) scienter-related facts before the statute of limitations begins to run.

The Court rejected the “inquiry notice” standard, however, as inconsistent with the “discovery” rule. To the extent that the term “‘inquiry notice’ refers to the point where the facts would lead a reasonably diligent plaintiff to investigate further, that point is not necessarily the point at which the plaintiff would already have discovered facts showing scienter or ‘other facts constituting the violation.'” In sum, the “discovery” 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.” The Court concluded that whether the plaintiff was on “inquiry notice” or failed to undertake “a reasonably diligent investigation” is not relevant to the analysis.

Turning to the case at hand, the Court agreed with the Third Circuit that the publicly-available information related to Merck’s alleged fraud did not reveal facts indicating scienter. Therefore, the statute of limitations was not triggered more than two years before the filing of the complaint and the plaintiffs’ suit was timely.

Holding: Judgment affirmed.

Notes on the Decision

(1) The Court is vague – perhaps deliberately so – on the question of exactly what quantum of evidence concerning scienter is sufficient to constitute discovery of the necessary facts. In various spots, the decision refers to “facts showing scienter” and “facts indicating scienter,” but then also notes that the PSLRA requires a plaintiff to plead facts demonstrating a “strong inference” of scienter.

(2) The Court declined to decide whether there are other facts necessary to support a private securities fraud claim, beyond “facts showing scienter,” that a plaintiff must have discovered (or have been able to discover) to trigger the running of the statute of limitations. Are facts concerning a plaintiffs’ reliance or loss causation among the facts that constitute “the violation”?

(3) For defense counsel who are concerned about the Court’s rejection of the inquiry notice standard, there may be some cold comfort in the fact that the decision could have been even more aggressive. Justice Scalia’s concurrence (joined by Justice Thomas) argues that under a proper reading of the statute the limitations period should only start upon the plaintiffs’ “actual discovery” of the facts constituting the violation.

In In re Omnicom Group, Inc. Sec. Litig., 597 F.3d 501 (2d Cir. 2010), the company had announced in 2001 that it was placing certain investments into a separate holding company. There was no statistically significant movement in the company’s stock price following the disclosure. In June 2002, however, there was a flurry of negative news reports about Omnicom and the transaction, leading to a stock price decline. In particular, a June 12 article reported on the resignation of the Chair of Omnicom’s Audit Committee and noted concerns about the company’s aggressive accounting strategy.

The lower court granted summary judgment for the defendants based on the plaintiffs’ failure to proffer evidence sufficient to support a finding of loss causation. On appeal, the Second Circuit affirmed on two grounds. First, the June 2002 news reports were not a “corrective disclosure” of the fraud because they failed to provide the market with any new facts. Second, the resignation of the director (and the accompanying negative publicity) was not a “materialization of the risk” that was supposedly concealed by the fraudulent statements. A mere concern over the company’s accounting practices cannot satisfy that standard.

Holding: Grant of summary judgment affirmed.

Quote of note: “The securities laws require disclosure that is adequate to allow investors to make judgments about a company’s intrinsic value. Firms are not require by the securities laws to speculate about distant, ambiguous, and perhaps idiosyncratic reactions by the press or even by directors. To hold otherwise would expose companies and their shareholders to potentially expansive liabilities for events later alleged to be frauds, the facts of which were known to the investing public at the time but did not affect share price, and thus did no damage at that time to investors. A rule of liability leading to such losses would undermine the very investor confidence that the securities laws were intended to support.”

Oral argument in the National Australia Bank case took place this morning. By all accounts, it does not appear that the U.S. Supreme Court is likely to embrace the broad extraterritorial application of the antifraud provisions of the federal securities laws.

Already facing a tough battle, the petitioners could not have been happy to learn that in the Court’s audience were several justices of the Supreme Court of Canada. And whether it was out of deference to their foreign guests, or genuine concern about the policy ramifications of allowing foreign investors access to the U.S. courts, the Court’s questioning was hostile from the start.

A few highlights (based on the official transcript):

(1) The Court appeared uninterested in the petitioners’ suggestion that it might be appropriate to remand the case to the Second Circuit without rendering a decision. Justice Scalia’s verdict: “There is no reason to send it back.”

(2) Justice Ginsburg started out the substantive questioning with what would turn out to be the quote of the day – “[T]his case is Australian plaintiff, Australian defendant, shares purchased in Australia. It has ‘Australia’ written all over it.” The justices pressed this theme repeatedly, with questions about the existence of a United States interest, potential interference with the regulation of foreign securities markets, and the connection between the fraud and the United States.

(3) As for the respondents and the government (which received 10 minutes of argument time), the justices appeared interested in exploring the utility of a bright-line test – i.e., barring any claims based on transactions involving shares of foreign issuers purchased or sold on foreign exchanges. Counsel for the respondents was asked about the effect on Americans who purchased stock on foreign exchanges (J. Stevens) and given a hypothetical wherein the fraudulent conduct took place in the United States and the stock purchase took place overseas (J. Breyer). The government, which advocated a test focusing on whether “significant conduct material to the fraud’s success occured in the United States,” was asked about whether its test was simply too complicated to be workable (C.J. Roberts).

For coverage of the hearing, see SCOTUSblog, the New York Law Journal, and the Associated Press.

As the U.S. Supreme Court gets ready to hear oral arguments in the National Australia Bank case today, here is all the information necessary to set the stage.

The briefs can be found here. The 10b-5 Daily has previously summarized the arguments made by the petitioners (investors) and respondents (corporate defendants). A couple of additional notes:

(1) There has been late supplemental briefing on the issue of whether the Supreme Court should remand the case back to the Second Circuit. According to the petitioners, all of the parties agree that the Second Circuit should not have decided the case on the basis of subject matter jurisdiction. The Second Circuit therefore should have the opportunity to reconsider its decision based on recent relevant Supreme Court decisions. The respondents disagree, arguing that the “jurisdictional label used by the court of appeals made no difference to the outcome of this case” and the real question before the Court is the substantive extraterritoriality issue.

(2) If amicus filings are a contest, the win goes to the respondents. There are three amicus briefs filed in support of the petitioners and fourteen amicus briefs filed in support of the respondents (including three separate briefs from the governments of France, Australia, and the United Kingdom).

For pre-argument coverage, see The Times (London), National Law Journal, and (most comprehensively) SCOTUSblog.

Supreme Court Justice Sandra Day O’Connor may be retired, but she is not done creating securities law. Last year, she sat with the Fifth Circuit by designation and wrote an opinion on loss causation. In February, it was the Sixth Circuit and her opinion concerns the scope of the Securities Litigation Uniform Standards Act (“SLUSA”), which precludes certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities.
In Demings v. Nationwide Life Ins. Co., 2010 WL 364335 (6th Cir. Feb. 3, 2010), the Sheriff of Orange County Florida brought a class action on behalf of all public employers who sponsor � 457 deferred-compensation plans alleging that Nationwide implemented a scheme under which it improperly received revenue-sharing payments from mutual funds and mutual fund advisors that should have gone to the plan participants. The district court found that the case was precluded by SLUSA because the substance of the sheriff’s claim was a covered class action alleging that “Nationwide misrepresented a relationship with mutual fund advisors, or, at a minimum, failed to disclose material facts about the relationship.”
On appeal, the sheriff argued that his suit was subject to SLUSA’s “state actions” exception, which exempts certain suits brought by states, political subdivisions thereof, and state pensions plans from SLUSA’s preclusive effect. By its plain terms, however, the state actions exception only applies to a covered entity that brings an action “on its own behalf.” Although the sheriff might be a “political subdivision,” his complaint sought to bring an action on behalf of the deferred-compensation plan. In the absence of any allegation that the sheriff had the authority to bring an action as the plan, the district court was entitled not to consider that possibility. Moreover, the “state actions” exception requires the members of the proposed class to be “named plaintiffs . . . that have authorized participation, in such action.” The sheriff was attempting to bring a class action on behalf of a prospective class of unnamed sponsors of deferred-compensation plans.
Holding: Affirmed dismissal based on SLUSA preclusion.