The Supreme Court and the Mission to Restrict Investor Protection: Merck v. Reynolds (Part 7: The Misguided Notion of Inquiry Notice)

The Supreme Court granted cert in Merck v. Reynolds to address the statute of limitations under Rule 10b-5.  To the extent any of the Justices want to shorten the statute of limitations by hastening the onset of the two year period, they will need to address unaccommodating language in the statute and the legislative history.

As we noticed, the concept of "inquiry notice" originated not from any statutory source applicable to Rule 10b-5 but from either the limitations period contained in the Securities Act (which specifically imposed an obligation to inquire, see Section 13 of the 1933 Act) or federal common law (without significant reasoning and in period predating the elimination of aiding/abetting liability and the requirements of the PSLRA).  The Supreme Court in Lampf seemed to dispense with the need for inquiry notice, allowing investors to merely wait for the facts supporting fraud to arise.  Lower courts, however, ignored the reasoning.

Congress finally stepped in and provided a statutory basis for the limitations period under Rule 10b-5.  Section 804 of SOX added subsection (b) to 28 USC §1658 to address the issue. The expanded statute was added by amendment sponsored by Senators Leahy and Hatch and passed 97 to 0.  The provision provides: 

• (b) Notwithstanding subsection (a), a private right of action that involves a claim of fraud, deceit, manipulation, or contrivance in contravention of a regulatory requirement concerning the securities laws, as defined in section 3(a)(47) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(47)), 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.

The language on its face tracks the statutory periods in Section 9 and 18 of the Exchange Act (not to mention the language in Lampf) but avoids the language from the 1933 Act that specifically requires plaintiffs to engage in due diligence.  In other words, the limitations period contained in the statute imposes no affirmative obligation to investigate.  Instead, it indicates that plaintiffs can wait until the facts constituting the violation become available, albeit not more than five years.

The language itself ought to resolve this case.  The statute imposes no duty to investigate or otherwise take affirmative steps to uncover the fraud.  It simply requires investors to bring a case within two years once the facts constituting a violation have become apparent.  There is no obligation to inquire.

The legislative history likewise belies any notion of a duty to investigate.  The adoption of a five year period was designed to limit the ability of those committing fraud to successfully hide the behavior until after expiration of the limitations period.  See Statement by Senator McCain, SENATE CONSIDERATION, AMENDMENT AND PASSAGE OF S. 2763, July 10, 2002, pp. S6524-6560 ("This situation essentially encourages offenders to attempt to cover up their misdeeds however they can, including by using questionable accounting procedures and financial shell games. Furthermore, in some cases, the facts of a case simply do not come to light until years after the fraud. If a person does not and cannot know they have been defrauded, it is unfair to bar them from the courthouse. We need to recognize the sophistication and complexity of modern-day schemes designed to defraud investors.").

The two year period, on the other hand, was designed to provide adequate time to put together a complex case once the facts had become apparent.  The discovery of facts supporting fraud didn't necessarily mean that plaintiffs were finished.  They still had to determine who was responsible and to put together an adequate case.  As the legislative history notes:

• The one year statute of limitations from the date the fraud is discovered is also particularly harsh on innocent defrauded investors. This short limitations period has the effect of placing true fraud victims on a "stop watch," from the moment they know that they have been cheated.  As most prosecutors and victims will confirm, however, the best cons are designed so that even after victims are cheated, they will not know who cheated them, or how.  Especially in securities fraud cases, the complexities of how the fraud was executed often take well over a year to unravel, even after the fraud is discovered."

SENATE REPORT 107-146, 107th CONGRESS, SECOND SESSION, May 6, 2002.  Certainly, there was nothing suggesting that the two year period was to be spent on investigations needed to "discover" facts sufficient to establish a violation.  This was directly contradicted by the language in the statute that began the limitations period only after "after the discovery of the facts constituting the violation."

In other words, the legislative history, consistent with the language in the statute, provides a grace period to put together a case once the facts of the fraud have been discovered.  There is nothing in the statute or legislative history that imposes a duty to investigate prior to discovery.  The incentive to investigate arises not from the two year period but from the the five year period of repose. 

Applying this to Merck v. Reynolds results in a clear outcome.  The storm warnings in that case were at most an alert about the possibility of fraud.  They did not contain the facts needed to constitute a violation.

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