On April 27, 2010, the US Supreme Court issued a decision that effectively tolled the statute of limitations applicable to securities fraud litigation until plaintiffs discover or reasonably should have discovered sufficient evidence of scienter to plead a fraud claim in conformity with the Private Securities Litigation Reform Act (PSLRA), i.e., fraudulent intent.

Under the Securities and Exchange Act of 1934, the statute of limitations for securities fraud is two years after the “discovery” of facts constituting the violation (the “discovery rule”). There is also a repose period of five years after the occurrence of the violation itself. In Merck & Co., Merck moved to dismiss, based on the two-year statute of limitations, the plaintiffs’ claims alleging that Merck made false statements concerning the painkiller Vioxx’s cardiovascular risks. The district court rejected this statute of limitations defense and the circuit court affirmed. The Supreme Court has now affirmed the decisions of the lower courts.

Supreme Court Holding

The Supreme Court held, first, that while the statute referred to “discovery” of the violation, discovery meant actual discovery of facts giving rise to the cause of action or facts showing that plaintiffs with the exercise of reasonable diligence should have discovered. Second, that “facts constituting the violation” included facts giving rise to a strong inference of scienter — that the plaintiff knew or should have known that the defendant knew, or was reckless in not knowing, that there was a material false or misleading statement. On this point, the Court reasoned that because securities plaintiffs must plead with specificity facts giving rise to a strong inference of scienter in order to survive a motion to dismiss, to not extend the statute of limitations to discovery of evidence of scienter would bar claims simply because a defendant was able to conceal its fraudulent intent for more than two years. Finally, the Supreme Court rejected the concept of “inquiry notice,” to which some circuits previously subscribed. Inquiry notice provides that the statue of limitations begins to accrue when a securities plaintiff possessed enough information to suggest wrongdoing and indicate to the plaintiff that it should investigate. The Supreme Court found that inquiry notice was inconsistent with the statutory language requiring actual or constructive discovery of the facts giving rise to a securities violation.

Implications and Conclusions

While, prior to Merck & Co., there was a split among the circuits regarding inquiry notice, the Supreme Court’s decision on the law itself was not a surprise because the vast majority of circuits had reached this conclusion. However, extending the discovery rule to include facts showing scienter as to the particular defendant is a crystallization of the law that could have a significant impact on accounting firms since accounting firms historically have experienced success with statute of limitations defenses, including at the motion to dismiss stage.

Scienter Pleading Requirements. Under the PSLRA, a securities fraud plaintiff must plead scienter with specificity. Defendants frequently file and prevail on motions to dismiss based on lack of sufficiently pleaded scienter. The Supreme Court decision will better enable plaintiffs to delay the filing of a complaint by claiming that they were unaware of the facts surrounding scienter and, thus, unable to yet plead a sufficient complaint under the PSLRA, all within the statute of limitations.

Discovery of Scienter. A defendant asserting a statute of limitations defense will now have to show that a reasonably diligent plaintiff would have uncovered some evidence of scienter against that defendant to start the statute of limitations. This is a higher hurdle than prior standards, in which the discovery was related to the conduct of the violation rather than the intent and knowledge of the allegedly involved parties. The Supreme Court rejected the argument that actual knowledge of scienter alone would support a statute of limitations dismissal and, therefore, motions to dismiss may be litigated based on facts relating to scienter found in the public record, thus subject to judicial notice. There will likely be many facts that will be considered too preliminary and, thus, tenuous to demonstrate scienter. As an example, the Court agreed that a pharmaceutical company’s scientific debates about the potential harm of a product does not give rise to a strong inference of scienter.

No Inquiry Notice. By rejecting inquiry notice, the Supreme Court limited the circumstances in which defendants can assert a statute of limitations defense in cases involving misstatements made less than five years prior to the filing of the litigation. Previously, defendants may have been able to assert the defense in these situations upon a showing that plaintiffs had enough information to begin an investigation, such as evidence of a company’s financial distress. This opportunity will no longer be available.

Additional Defendants. Plaintiffs in securities fraud actions may be tempted to use discovery to create scienter allegations against parties that were not previously involved in the litigation. The risk for an accounting firm is that a plaintiff will claim that it had no knowledge or evidence of the accounting firm’s scienter until receiving the audit workpapers during discovery in the litigation filed against the accounting firm’s corporate client and that the statute of limitations did not start to run until the workpapers were produced. This risk is tempered by the fact that scienter allegations against the original parties will often support sufficient allegations against added parties. In fact, the New England Health Care Pension Fund case cited and ruled upon by the Court in Merck & Co. is precisely such a case. It suggests that allegations of the accounting firm’s scienter are connected to those of the corporation’s scienter and held that the filing of claims against the company supported dismissal of the claims against the subsequently-added accounting firm.

For more information about the Federated decision, or any other matter raised in this Alert, please contact Stanley J. Parzen or Dana S. Douglas.

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