In 2002, Congress codified the statute of limitations for securities fraud actions for the first time. As part of the Sarbanes-Oxley reforms, Congress declared that securities fraud claims “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.”
After nearly eight years of litigants fighting over the meaning of these words, the Supreme Court, on April 27, 2010, weighed in on the meaning of the phrase “after discovery of the facts constituting the violation” in Merck & Co. v. Reynolds. The Court’s interpretation of the statutory language will have immediate practical implications for securities litigators. Most notably, the common law concepts of “inquiry notice” and “storm warnings” are rendered obsolete for purposes of the statute of limitations analysis. The cause of action accrues only “(1) when the plaintiff did in fact discover, or (2) when a reasonably diligent plaintiff would have discovered, ‘the facts constituting the violation’ – whichever comes first.” Significantly, the Court also held that the “facts constituting the violation” include the fact of scienter.
The Court’s opinion includes a number of key holdings for litigants in securities fraud actions:
- The Court rejected Merck’s argument that Sarbanes-Oxley does not require “discovery” of scienter-related facts, holding that scienter is “assuredly a ‘fact,’” and that scienter is an important and necessary element of a Section 10(b) claim. This is arguably a game-changer: notice (actual or constructive) of facts showing a mere misstatement or omission will not start the running of the statute of limitations.
- The Court rejected Merck’s argument that facts that tend to show a materially false or misleading statement (or omission) are ordinarily sufficient to show scienter. The Court held that facts constituting a misstatement or omission and facts constituting scienter will often be different. Thus, the statute of limitations will not start running until actual or constructive knowledge of both is established.
- The Court held that “inquiry notice,” the concept that a statute of limitations begins to run when a reasonably diligent plaintiff learns of facts that would cause him or her to investigate further, finds no support in the statutory text.
Though only time will tell how the lower federal courts will interpret Merck, going forward, in securities fraud cases, it will no longer be sufficient for defense counsel to simply argue for the existence of “storm warnings” or to make common law-like “inquiry notice” arguments. Instead, defense counsel will need to prove at what point a reasonably diligent plaintiff would have discovered “the facts constituting the violation” – including scienter. In a Section 10(b) case, constructive knowledge of facts constituting a misstatement or omission, without more, may not be sufficient to begin the running of the statute.
What could this mean? In many cases, the accrual date of the statute of limitations could be pushed out. The days of merely arguing that a plaintiff could see the storm approaching and had a duty to investigate further are over. On the other hand, the objective constructive fraud analysis could, in certain circumstances, be used by the defense bar to its advantage. One thing is certain, when millions and sometimes billions of dollars are at stake, whether a plaintiff missed the deadline for filing will continue to be an important issue.