This summer, individual defendants received a dose of good news, at least in the United States Court of Appeals for the Fifth Circuit, when the Fifth Circuit ruled that the injunctions against future securities law violations and officer and director bars that the U.S. Securities and Exchange Commission (SEC) sought constituted "penalties" subject to the five-year statute of limitations under 28 U.S.C. § 2462. In SEC v. Bartek,1 the Fifth Circuit considered Section 2462, which governs SEC actions seeking penalties for the enforcement of securities law violations, and held that the common law "discovery rule" did not apply to those actions, foreclosing the SEC's ability to take a potentially unlimited amount of time to discover and seek penalties for violations of securities laws. The Supreme Court will now decide whether the rule of Bartek will apply nationally the Court recently agreed to review a Second Circuit case, SEC v. Gabelli, in which the Second Circuit reached the opposite conclusion and applied the "discovery rule" to an SEC action arising from the market-timing scandal of the early 2000s.2 Thus, by June 2013, the Supreme Court will decide whether the Second Circuit or the Fifth Circuit's view will prevail.
Bartek comes on the heels of the SEC's well publicized efforts to enhance its pursuit of securities law violations, with a significant focus on individual accountability particularly as a result of alleged misconduct associated with the 2008 financial crisis. The SEC's arsenal of potential remedies against individuals includes disgorgement, monetary fines, bars against serving as officers and directors of publicly-traded companies, injunctions against future violations of securities laws, and, for individuals who are enjoined, permanently barring or suspending them for a period of time from the securities industry.
As we approach the five-year anniversary of the financial crisis, it will become increasingly difficult for the SEC to allege securities law violations that fall within Section 2462 leaving the SEC to argue that the penalties it seeks should be subject to exceptions or fall outside of Section 2462. In Bartek, the Fifth Circuit rejected two such arguments, distancing itself from the Second Circuit's Gabelli decision applying the "discovery rule" to Section 2462, but following a D.C. Circuit decision3 classifying certain sanctions as "penalties" and subject to Section 2462.
SEC v. Bartek
Bartek arose from an alleged stock option back-dating scheme at Microtune, Inc. that occurred between 2000 and 2003. The SEC alleged that two former Microtune officers had engaged in misconduct specifically, fraud and aiding and abetting records-keeping violations of their employer. Microtune settled the case shortly after the SEC filed suit in June 2008. The SEC sought equitable relief against the individual defendants in the form of injunctions and officer and director bars, as well as civil penalties. Section 2462, which governs securities fraud claims brought by the SEC, provides that when the SEC seeks to impose a "civil fine, penalty, or forfeiture" in an enforcement action, the action must be commenced "within five years from the date when the claim first accrued." The parties battled over two important statute of limitations issues: (1) when securities fraud claims subject to this limitation "accrue," and (2) which remedies constitute a "civil fine, penalty, or forfeiture" and, thus, are covered by the statute of limitations.
The district court granted the individual defendants' motion for summary judgment and dismissed the SEC's claims, holding that the statute of limitations had elapsed. The Fifth Circuit affirmed, holding that, for purposes of Section 2462, a securities fraud claim "accrue[s]" when the alleged violation occurs, and not, as the SEC argued, when the SEC alleges that it discovered the violation. The SEC had urged the Fifth Circuit to apply the "discovery rule," a doctrine that delays accrual of a claim until the plaintiff discovers the claim, or, in the exercise of due diligence, should have discovered it. In rejecting the SEC's argument, the Fifth Circuit noted that a plain reading of Section 2462 revealed no discovery rule exception.
Bartek conflicts with Second Circuit's Gabelli decision, now before the Supreme Court.
Bartek conflicts with the Second Circuit's 2011 Gabelli decision, where the Second Circuit held that, under Section 2462, the discovery rule applies to the SEC's securities fraud claims.4 The Gabelli defendants made the same argument adopted by the Fifth Circuit in Bartek i.e., because the "plain language" of Section 2462 contains no reference to the discovery rule, the SEC's claim for civil penalties accrued at the time of the defendants' alleged violation.5 The Second Circuit rejected the defendants' argument and held that, for claims that sound in fraud, the discovery rule is read into Section 2462.6 Because the SEC's claim in Gabelli was made under the anti-fraud provisions of the Investment Advisers Act of 1940, the Second Circuit applied the discovery rule and reversed the district court's ruling that the SEC's claim for civil penalties was time-barred.7 By contrast, Bartek rejected the SEC's argument that the Fifth Circuit should follow Gabelli, distinguishing Gabelli as a case that involved "an inherently self-concealing scheme."8
On September 25, 2012, the Supreme Court agreed to hear the Gabelli defendants' case seeking review of the Second Circuit's decision. The Gabelli defendants cited to Bartek for its reasoning regarding the application of the discovery rule to Section 2462. If the Supreme Court rules in favor of the Gabelli defendants and rules that the SEC's action was untimely, Bartek's reasoning could effectively become the law of the land i.e., the SEC would be forced to seek penalties within five years of defendants' alleged violations, without the flexibility afforded by the discovery rule.
The injunctions and officer and director bars sought by the SEC in Bartek were "penalties" and so were time-barred.
Bartek also rejected the SEC's argument that some of the relief it sought permanently enjoining the defendants from violating any securities laws and barring them from serving as officers and directors at any public company fell outside the scope of Section 2462, and thus was not subject to any statute of limitations. The SEC reasoned that this relief consisted of remedial sanctions rather than "penalties."
Prior to Bartek, the Fifth Circuit had not ruled on whether particular sanctions available to the SEC should be considered remedial sanctions or penalties; its willingness to closely consider the proper classification of those sanctions is an encouraging development for defendants. In determining whether a sanction is a "penalty" or a remedial sanction for the purposes of Section 2462, courts have focused on whether the effect of the SEC's action is to "impose a punishment" in which case it is a penalty or to "restore the status quo ante" or protect the public which is remedial.9 In most cases, it is difficult to show that a remedy such as disgorgement is punitive because it "merely requir[es] one to 'give back' wrongfully obtained proceeds."10 But other sanctions that arguably seek to protect the public from future harm often have punitive aspects that have caused courts to conclude that they are, in reality, penalties. For example, injunctions against future violations and officer and director bars can effectively bar defendants from their professional fields. And defendants have successfully argued that because some types of securities law violations are unlikely to be repeated, these sanctions are not necessary to protect the public and should be considered to be "penalties" subject to Section 2462.11
In determining that the Bartek injunctions and officer and director bars were penalties, the Fifth Circuit referenced the dictionary definition of "penalty," as well as several legal sources that define "penalty" as something punitive or involving punishment. The Fifth Circuit also rejected the SEC's argument that the term as used in Section 2462 is limited to sanctions that involve collecting money or property.12 The Fifth Circuit acknowledged that permanent injunctions and officer and director bars traditionally have been considered to be remedial, but explained that "determining whether an injunction here is a 'penalty' or simply remedial requires a look at the nature or characteristic of the injunction."13 In so doing, the Fifth Circuit applied the test from the D.C. Circuit's Johnson v. SEC decision, which took a pragmatic view of the consequences of SEC sanctions and held that "the degree and extent of the consequences to the subject of the sanction must be considered as a relevant factor in determining whether the sanction is a penalty."14 In Bartek, the district court and the Fifth Circuit held that the remedies were penalties and, therefore, subject to Section 2462's limitations period because they would have significant collateral consequences to the defendants, did not address the past harm allegedly caused by the defendants, and did not focus on preventing future harm. The Fifth Circuit stated that the SEC's sought-after remedies were "essentially seeking a lifetime ban against the Defendants," which could be construed as punitive.15 While other courts have reached similar conclusions,16 and this aspect of Bartek is far from a pro-defendant innovation, Bartek reinforces the need for courts to analyze the specific nature and characteristics of the injunction or bar requested.
The Supreme Court will soon consider whether the discovery rule applies to securities fraud claims under Section 2462, resolving whether, in seeking penalties, the SEC must bring claims within five years of alleged violations or within five years after discovery of those violations. Bartek is also important because it employed Johnson v. SEC's searching examination of whether a purportedly remedial sanction should be considered a penalty subject to Section 2462. Time will tell whether Bartek ultimately is part of a significant defendant-friendly trend regarding application of the discovery rule and definition of penalties subject to Section 2462. Meanwhile, Bartek clarifies arguments that individual defendants can make to characterize injunctions, bars, or suspensions as penalties, and therefore subject to Section 2462's five-year limitations period: (1) the consequences of the sanction on the defendant are harsh, with a stigmatizing effect and longlasting repercussions, making it punitive; (2) the sanction is not remedial because it does not address the past harm caused by the defendant; and (3) the sanction is not needed to protect the public because the defendant is not likely to repeat the violation. These sanctions can have serious consequences on individuals, and courts' willingness to meaningfully consider such consequences improves defendants' ability to argue that the SEC should not be permitted to obtain punitive sanctions based on alleged misconduct that took place outside of Section 2462's five-year limitation period.–
1 SEC v. Bartek, No. 11-10594, slip op. (5th Cir., Aug. 7, 2012) (per curiam, non-precedential).
2 SEC v. Gabelli, 653 F.3d 49 (2d Cir. 2011), cert. granted ___ U.S.L.W.___ (U.S. Sept. 25, 2012) (No. 11-1274).
3 Johnson v. SEC, 87 F.3d 484 (D.C. Cir. 1996)
4 653 F.3d 49 (2d Cir. 2011).
5 Id. at 59, 60.
6 Id. at 60 (citations omitted).
7 Id. at 60.
8 SEC v. Bartek at 7.
9 87 F.3d at 490-92 (citation omitted).
10 SEC v. Lorin, 869 F. Supp. 1117, 1123 (S.D.N.Y. 1994).
11 See, e.g., SEC v. Leslie, 2010 WL 2991038, No. C 07-3444 at *37-38 (N.D. Cal. July 29, 2010) (holding that director and officer bar was penalty subject to Section 2462); SEC v. Jones, 476 F. Supp. 2d 374, 383-85 (S.D.N.Y. 2007) (holding that permanent injunction was penalty subject to Section 2462).
12 SEC v. Bartek at 11.
13 Id. at 12 (emphasis added).
14 87 F.3d at 488.
15 SEC v. Bartek at 13.
16 See, e.g., SEC v. Leslie, 2010 WL 2991038, at *37-38; SEC v. Jones, 476 F. Supp. 2d at 383-85.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.