Corporate Governance

The Supreme Court and the Mission to Restrict Investor Protection: Merck v. Reynolds (Part 6: The Misguided Concept of Inquiry Notice)

By J. Robert Brown

We are discussing Merck v. Reynolds, a case in which the Supreme Court recently accepted cert.  This case will likely turn on when "storm warnings" put plaintiffs on notice of the possibility of fraud.

The broader issue in the case, however, is the entire storm warnings standard.  Storm warnings contemplate that investors will learn something that suggests the possibility of fraud.  Thereafter, they have an obligation to investigate and inquire.  It is the process of investigation that is expected to uncover the facts that establish a fraud claim. As defendants describe in their brief:

• Other Courts of Appeals, in contrast, held that the statute of limitations begins to run on what might be a significantly later date: when a reasonable investor, alerted to the possibility of fraud and under a duty to investigate, would have discovered facts sufficient to bring suit.

As we will show, this standard is inconsistent with the language of the statute governing the limitations period for securities fraud actions.  The standard instead is a holdover from the days when courts interpreted the statute of limitations under Rule 10b-5 in the absence of any governing statute.  Indeed, the language quoted above is functionally the same standard contained in Section 13 of the Securities Act, a standard inapplicable to the limitations period in the Exchange Act. 

The term "storm warnings" was apparently used for the first time in a securities fraud context by Judge Lasker in University Hill Foundation v. Goldman, Sachs & Co., 422 F. Supp. 879 (SD NY 1976).  The phrase had nothing to do with the test for the statute of limitations but was used to demonstrate that a defendant had adequate notice of financial problems at Penn Central at the time it conducted a credit investigation of the failed financial institution.  See Id. at 902 ("The question, however, is not whether Goldman, Sachs conducted a reasonable credit investigation in May or June, 1970, but whether by March 13, 1970, the date of the Foundation's purchase, there were sufficient storm warnings as to the Company's insecure condition to render Goldman, Sachs' normal procedures inadequate and to require more concrete verification of management representations and projections.").  

The term, however, made a jump to the statute of limitations in Cook v. Avien, Inc., 573 F.2d 685 (1st Cir. 1978).  In that case, plaintiffs brought suit under Section 12 of the Securities Act and Rule 10b-5 under the Exchange Act.  At the time, there was no statutory limitations period for actions under 10b-5.  Instead, courts looked to state law to determine the applicable limitations period. 

Section 12 in the 1933 Act, however, was subject to an explicit statute of limitations.  Section 13 of the same Act provided a one year statute of limitations from the date of discovery of the fraud or "after such discovery should have been made by the exercise of reasonable diligence."  15 USC 77m In other words, the Section imposed an affirmative obligation on the part of putative plaintiffs to investigate.

Unsurprisingly, the court reiterated the inquire but inexplicably extended it to actions under Rule 10b-5.  There was no basis for this approach.  The imposition of an obligation to inquire in the absence of an explicit statutory requirement was never discussed.  Moreover, because the court affirmed the dismissal of the 1933 Act claim but reversed the dismissal of the Exchange Act claim, the application of the approach to actions under Rule 10b-5 was arguably dicta.       

Nonetheless, Avien became a commonly cited case for the proposition that, for purposes of the statute of limitations, plaintiffs had a duty to inquire under Rule 10b-5.  See General Builders Supply Co. v. River Hill Coal Venture, 796 F.2d 8, 11 (1st Cir. 1986)(relying on Avien and concluding that "It is well established in this circuit that the statute of limitation applicable to claims under Section 10(b) and Rule 10b-5 begins to run when an investor, in the exercise of reasonable diligence, discovered or should have discovered the alleged fraud."). 

Other cases found the need for inquiry notice under Rule 10b-5 in federal common law.  Thus, as the Fifth Circuit explained:

• Although we borrow the applicable limitations period from state law, the determination of when that limitations period begins to run is governed by federal law. Under federal law, the limitations period commences when "the aggrieved party has either knowledge of the violation or notice of facts which, in the exercise of due diligence, would have led to actual knowledge" thereof.  Thus, the limitations period applicable to a cause of action for fraud, including one brought under § 10(b) or Rule 10b-5, which proscribe the use of fraudulent or deceptive representations or practices in the sale of securities, does not begin to run until the plaintiff discovers, or in the exercise of reasonable diligence should discover, the alleged fraudulent conduct. The requisite knowledge that a plaintiff must have to begin the running of the limitations period "is merely that of 'the facts forming the basis of his cause of action,' . . . not that of the existence of the cause of action itself."

Jensen v. Snellings, 841 F.2d 600, 606-607 (5th Cir. 1988). The analysis was not compelled by statutory language.  Moreover, it again mimicked the standard contained in Section 13 of the Securities Act.  Instead, it was largely based on a poorly defended policy of encouraging rapid resolution of securities cases.  The analysis also occurred at a time when aiding and abetting liability still existed and Congress had not yet imposed the onerous pleading standards contained in the PSLRA.

Whether finding inquiry notice in Section 13 of the Securities Act or federal common law, the approach ought to have changed with the Supreme Court's decision in Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350 (1991).  There, the Court created a federal statute of limitations for fraud actions, abandoning state law as the source.

While the statute was a judicial creation, the Court was guided by the express limitations period in the Exchange Act, particularly Sections 9 (15 USCS § 78i) and 18 (15 USCS § 78r) of the Exchange Act.  Unlike Section 13 of the Securities Act, these provisions did not impose a duty to inquire or engage in due diligence.  Instead, the provisions started the statute within one year "after the discovery of the facts constituting the cause of action."  The Court itself picked up on this language and noted that the statutory period began "after discovery of the facts constituting the violation, making tolling unnecessary."

The statute of limitations wasn't statutory but it was based on statutes.  And the statutes forming its basis did not require any investigation.  Thus, there was nothing in the requirement that supported the standard cited at the top of this post.  The provision did not require reasonable investors, after merely being "alerted to the possibility of fraud" to investigate in order to "discover[] facts sufficient to bring suit."  Instead, investors could wait until "discovery of the facts constituting the cause of action" without any affirmative action on their part.  The three year period of repose provided the incentive to move quickly, not the one year statute imposed in Lampf. 

Despite the absence of any inquiry duties on plaintiffs, the law changed little.  The statute of limitations for cases under Rule 10b-5 was triggered by storm warnings and a duty to investigate.  In the next post, we will examine the implications of the amendment to the limitations period contained in SOX.

The cert petition and other primary materials can be found on the DU Corporate Governance web site.

Full post as published by The Race to the Bottom on June 22, 2009 (boomark / email).