Supreme Court To SEC: No ‘Discovery Rule’ For You

The SEC doesn’t get the benefit of the “discovery rule” to toll the statute of limitations when suing for civil penalties from investment advisers accused of defrauding their clients, a unanimous Supreme Court ruled this week.

The ruling in Gabelli v. SEC, No. 11-1274 (Feb. 27, 2013), limits the government to five years to bring such cases.

In Gabelli, the SEC sought civil penalties against the chief operating officer and former portfolio manager of a mutual fund.  The government alleged that the defendants aided and abetted violations of the Investment Advisors Act of 1940, which bans investment advisors from defrauding clients or prospective clients.  The SEC filed the action in 2008, contending that the fraud took place between 1999 and 2002.

Citing the five-year statute of limitations for bringing actions for civil penalties, the defendants moved to dismiss the 6-to-9-year-old claims.  The government countered that because it alleged fraud by the defendants, the court should apply the “discovery rule,” a legal doctrine that keeps time from running on the statute of limitations until the point when the plaintiff knew or reasonably should have known it had been injured. 

The district court agreed with the defendants and dismissed the case; the Second Circuit sided with the government.

“Unlike the private party who has no reason to suspect fraud, the SEC’s very purpose is to root it out,” the Chief Justice wrote, “and it has many legal tools at hand to aid in that pursuit.”

The Supreme Court reversed.  Writing for a unanimous court, Chief Justice Roberts explained that the discovery rule is meant to protect plaintiffs who would have no reason and likely no ability to investigate frauds perpetrated against them.  But the SEC is a different beast.

“Unlike the private party who has no reason to suspect fraud, the SEC’s very purpose is to root it out,” the Chief Justice wrote, “and it has many legal tools at hand to aid in that pursuit.”

The Court also concluded that the discovery rule is ill-suited for penalty actions, which seek not to compensate a victim but to punish the wrongdoer. 

Finally, the Court noted the inherent difficulty in applying the discovery rule to government actions, given the “hundreds of employees, dozens of offices, and several levels of leadership” in most agencies and the complexities inherent in establishing investigative priorities.  How exactly would a court determine when a reasonable government agency would have known of the fraud?

“Applying a discovery rule to Government penalty actions is far more challenging than applying the rule to suits by defrauded victims,” the Chief Justice wrote, “and we have no mandate from Congress to undertake that challenge here.”