[by Larry Goldfarb]

The emphasis on enforcement actions against directors and officers related to bank failures has brought a critical legal provision front and center.  Banks and their executives may be wondering how the SEC can continue to bring enforcement actions so many years after the events of the financial crisis.  With respect to civil enforcement actions, generally speaking, courts have held that the SEC has five years from the challenged acts to bring an action.  See, e.g., SEC v. Johnson, 87 F.3d 484 (D.C. Cir. 1996).  However, the Supreme Court may change that in the coming term, and banking executives should be aware of the potential impact of this case. 

In Gabelli et al. v. SEC, 653 F.3d 49 (2d Cir. 2011), the SEC brought a civil enforcement action in April 2008 alleging that two individuals who worked for the portfolio manager of a mutual fund secretly allowed an investor to engage in non-disclosed market-timing transactions in violation the Investment Advisers Act of 1940.  Id. at 52. 

• The transactions at issue occurred between 1999 and 2002; the SEC claimed it discovered the misconduct in September 2003 shortly after the New York Attorney General began an investigation into the fund for market-timing and the company responded to the announcement with a public memorandum.  Id. at 55. 
• The defendants argued that the claims were barred by 28 U.S.C § 2642¹ because their actions occurred—and therefore “accrued”—more than five years before the SEC’s Complaint, and that the text of the statute did not provide for a “discovery” rule.  Id. at 59. 
• The SEC argued that its action was not time-barred because the “discovery rule”—the doctrine that holds that a cause of action cannot begin to accrue until the discovery of the alleged misconduct — applies to the five-year statutory limitation on agency actions to enforce securities fraud.  Id.  The 2nd Circuit agreed with the SEC and held that the claims did not accrue, and the limitations period did not begin to run, until after the SEC discovered facts regarding the alleged misconduct.   Id. at 59-60. 
• The Supreme Court has now agreed to hear this appeal and will decide whether the “discovery rule” applies to civil enforcement actions.  Gabelli et al. v. SEC, U.S. Supreme Court, No. 11-1274.  If the Supreme Court endorses the SEC’s view, the ruling could breathe new life into possible civil enforcement actions related to banks or other financial institutions that collapsed or severely declined during the financial crisis that might otherwise have been barred with the passage of time, including actions against executives and directors. 
• Even for events that took place in 2007-8 during the credit crisis, for example, the SEC could possibly bring a claim if the agency didn’t “discover” the alleged wrongdoing until banking regulators brought the facts to light — similar to how the SEC claims it discovered misconduct by virtue of actions prompted by the New York Attorney General’s investigation in Gabelli — or referred the case to the SEC.² Consequently, if Gabelli is upheld, there may be aggressive efforts by the SEC to continue to file actions like the recently-filed TierOne Bank action.  

Thus, five years after the beginning of this global crisis, bank executives may still not be out of the woods for liability under the federal securities laws, given the possible expansion and use of the “discovery rule.” Any strategy of hoping to “run out the limitations clock” on these kinds of claims because of the SEC’s limited resources to quickly investigate potential claims may become less reliable. 

Moreover, if Gabelli is upheld, purchasers of failed banks in the past five years may find themselves inheriting liability that they thought expired or fighting D & O carriers over whether these are covered claims. 

For further information, please read [Reuters, 10/15/12]