Second Circuit Affirms Dismissal Of Securities Fraud Suit Based On Statute of Limitations

In a summary order issued on Wednesday, the Second Circuit Court of Appeals affirmed the dismissal of a securities class action based on the application of the statute of limitations. The Court left open the possibility that plaintiffs would amend their complaint, since the district court order was not with prejudice. City of Pontiac General Employees’ Retirement System v. Capone, Case No. 07-1117-cv (2nd Cir. Nov. 12, 2008).

The complaint in this action, brought against MBIA and six current and former officers, claimed that the company violated Sections 10(b) and 20(a) of the Exchange Act by falsifying the financial statements of the company to avoid a huge loss. Specifically, the complaint alleges that in 1998, MBIA improperly booked a series of transactions as reinsurance agreements and the associated proceeds as income to avoid recording a huge loss. At the time, the company issued press releases about the transactions.

Subsequently, in December 2002, a research report about the company discussed the incorrect accounting treatment and its impact. The company issued a press release stating that the company which issued the report was not independent and intended to profit from it. The release went on to state that MBIA stood by its accounting.

The district court dismissed the action as time barred. The court began by noting that Section 804 the Sarbanes Oxley Act extended the statute of limitations for non-time barred securities fraud cases to two years from discovery and five years from the violation. Discovery for purposes of the two-year period takes place when the plaintiff obtains actual knowledge of facts giving rise to the action or notice of the facts which, in the exercise of reasonable diligence, would have led to actual knowledge. The circumstances which give rise to the duty of inquiry are referred to as “storm warnings.”

Under this standard, the date the statute commences begins depends on how the plaintiff responds to the duty of inquiry. “If the investor begins to investigate when the duty arises, knowledge of the fraud will not be imputed, and the limitations period will not begin to run, until that investor ‘in the exercise of reasonable diligence, should have discovered’ the fraud. … On the other hand, ‘If the investor makes no inquiry once the duty arises, knowledge will be imputed as of the date the duty arose.” (citations omitted).

Here, the court concluded that the plaintiff was put on notice and had a duty of inquiry when the December 2002 research report was issued, because that report directly addressed the financial accounting issues on which the case is based. Although the company issued a press release denying any impropriety after the report was issued, it “did not even specify the 1998 transactions, let alone address the particular concerns raised by” the research report or “identify any steps to relieve those concerns.” A blanket denial is not sufficient to relieve investors of their obligation. In reaching its conclusion, the court distinguished cases where the company issued denials that were “designed to specifically address the concerns raised in'” the report.

Since the complaint was filed more than two years after the research report, it was properly dismissed as time barred, the Circuit Court concluded. Since the district court did not state that the dismissal was with prejudice, the Court of Appeals remanded the case to the district court.

The decision in this case is based on one of the tests used by the circuit courts in applying the two-year prong of the statute of limitations in securities fraud cases. The Supreme Court has been asked to resolve a split among the circuits on this issue as discussed here.

SEC Enforcement Cases: Focus On Individuals, Declining Corporate Penalties

NERA Economic Consulting has developed a proprietary database of post-SOX SEC enforcement statistics which provides interesting comparative data.

First, the statistics demonstrate that most enforcement cases are brought against individuals. Since the passage of Sarbanes Oxley, the SEC has filed over 4,700 enforcement actions. About three times as many of those actions named individuals as defendants compared to corporations.

By far, the largest category of cases involves microcap fraud, which includes boiler room operations, pump and dump schemes, fraudulent offerings and similar matters. The next largest category involves misstatements and omissions. That category includes option backdating. Insider trading is number five on the list (misappropriation of investor funds in ponzi schemes and misrepresentations to investors are, respectively three and four). While misstatements and omissions would appear to be a type of case which focuses on issuers, 700 individuals were charged in these cases while only 197 companies were named as defendants in the post-SOX time period.

For 2008, NERA projects that the number of settled cases based on misstatements will increase. The report projects that there will be 157 settled cases in this category for 2008, up slightly from 151 in 2007. If the projection is correct, it will be the highest post-SOX number in this category. The dollar value of those settlements is projected to fall, however. The high was in 2006 at about $50 million, while for 2008 the value it projected to be only $12 million. The projected 2008 amount is less than half that of 2007, but exceeds the amounts for 2002 through 2005.

The report also projects a record number of settlements for 2008. Following three years of decline (from 898 in 2003 to 663 in 2006), the report projects that the SEC should settle 739 cases in 2008. That increase however, is being driven by settlements with individuals, not issuers. The projection suggests that the SEC will have 568 settlements with individuals compared 171 with business organization. If that projection is correct, it would be the lowest number of company settlements since the passage of SOX.

The potential decrease in company settlements also appears to be reflected in the amount of penalties being imposed on issuers in SEC enforcement actions. From 2002, when SOX was passed, through 2006, the mean amount of those penalties rose from $0.01 to $1.5 million. While the projected mean settlement for 2008 of $1 million exceeds the 2007 mean by about $0.3 million, it is the lowest since 2003. This may reflect the impact of the new procedure instituted by Chairman Cox for the consideration of corporate penalties, discussed here. This also seems to track the mean value of corporate SEC settlements, which peaked in 2003 and for 2008 is projected to decline to its lowest value since 2002. Similarly, the monetary component of corporate settlements with the SEC is predominately composed of penalties rather than disgorgement, while the opposite is true for individuals.

Overall, while SEC enforcement actions seem to focus on individuals and the number of settled cases may be increasing overall in the post-SOX era, the percentage of those brought against issuers is declining, as is the dollar value of corporate settlement, which is, in large part, penalties rather than disgorgement.