On April 27, 2010, the Supreme Court issued its much-anticipated decision in Merck & Co., Inc. v. Reynolds. The Supreme Court made two important rulings on Section 10(b) statute of limitations issues. Both rulings favor securities plaintiffs.
The Merck case arose out of events concerning Vioxx, a painkiller approved by the FDA in 1999. Beginning in 2000, reports began to circulate questioning the safety of Vioxx and linking the medicine to heart attacks. The company responded with the “naproxen hypothesis.” This theory posited that there was no connection between Vioxx and heart attacks, and that studies suggesting such a link reflected only the fact that the drug used as a control – naproxen – had beneficial cardiovascular effects.
By September 2001, several product liability class actions had been filed against Merck. The FDA had also sent Merck a warning letter stating that the company’s Vioxx marketing materials were “false, lacking in fair balance, or otherwise misleading.” The FDA acknowledged that the naproxen hypothesis was a “possible explanation” of the heart attack data but found that the company had presented the hypothesis without acknowledging “another reasonable explanation” – that is, that Vioxx might have adverse cardiovascular effects. Later, after further studies also suggested a link to increased heart attack risk, Merck withdrew Vioxx from the market.
Plaintiffs filed Section 10(b) claims in November 2003. Defendants argued on a motion to dismiss that the applicable two-year limitations period had run by that time, based on the events of September 2001. The district court granted the motion to dismiss. The Third Circuit reversed. The appellate court reasoned that none of the information available in September 2001 showed that Merck disbelieved the naproxen hypothesis. So long as the company believed what it said about Vioxx safety and the naproxen hypothesis, it was not making false statements with scienter. And until plaintiffs had access to facts suggesting that defendants did in fact act with scienter, plaintiffs were not on “inquiry notice” of their claims and the statute did not begin to run. In re Merck & Co., Inc. Sec., Deriv. & “ERISA” Litig., 543 F.3d 150, 172 (3d Cir. 2008).
The Supreme Court accepted the case to resolve a split among the circuits as to what triggers the limitations period for Section 10(b) claims.
Limitations Period Does Not Begin To Run Until Plaintiffs Have Information Pertaining To Defendants’ Scienter
The Supreme Court affirmed the Third Circuit’s decision. The Supreme Court’s analysis centers on the language of 28 U.S.C. § 1658, which requires that Section 10(b) claims be brought no more than “two years after the discovery of the facts constituting the violation.” (The statute also contains a five-year repose period, which was not at issue in Merck.) The Supreme Court stated that the “’fact’ of scienter ‘constitut[es]’ an important and necessary element of a §10(b) violation.” Consequently, until plaintiffs discover facts related to scienter, the two-year period does not begin to run. Facts suggesting that challenged statements were false are not enough. According to the Supreme Court, “[i]t would . . . frustrate the very purpose of the discovery rule in this provision . . . if the limitations period began to run regardless of whether a plaintiff had discovered any facts suggesting scienter.”
The Court’s analysis on this point appears straightforward but does not necessarily resolve all issues in the area. The Court did not hold that scienter must be “discovered” in order to trigger the statute simply because scienter is an element of a Section 10(b) claim. The Court singled out scienter as “an important and necessary element.” Perhaps more significantly, the Court noted that scienter is the very element of a Section 10(b) claim that causes it to come within Section 1658’s limitations provisions: Section 1658 extends to claims of “fraud, deceit, manipulation or contrivance.” The Court explicitly expressed no view on the question of whether other elements of a Section 10(b) claim – reliance, loss and loss causation – must also be “discovered” for the twoyear period to run. Merck thus provides little support for plaintiffs hoping to argue that limitations periods commence only when they have discovered all elements of their claims.
Limitations Period Does Not Begin To Run On “Inquiry Notice” Or “Storm Warnings”
The Supreme Court’s second holding may be the more significant one. The Merck defendants argued that even if the relevant discovery must include discovery of scienter-related facts, such discovery occurs as soon as plaintiffs are on “inquiry notice.” The Supreme Court squarely rejected the argument.
In analyzing the issue, the Court adopted defendants’ definition of inquiry notice: “the point ‘at which a plaintiff possesses a quantum of information sufficiently suggestive of wrongdoing that he should conduct a further inquiry.’” The Court then briefly reviewed the use of the inquiry notice concept in the Courts of Appeals, noting that it had given rise to several different rules:
- Inquiry notice is sufficient to start the two-year period running;
- Inquiry notice does not start the period running but confers a duty to investigate; the period begins to run once investigation leads or should have led to discovery;
- Inquiry notice confers a duty to investigate; if plaintiffs in fact investigate, the period begins to run on discovery; if plaintiffs do not investigate, the period begins to run on inquiry notice.
The Supreme Court rejected the first approach. The Court held that inquiry notice and discovery are simply not the same thing, and that inquiry notice generally precedes discovery. Thus, the point at which facts lead plaintiff to investigate is “not necessarily the point at which the plaintiff would already have discovered facts showing scienter or other ‘facts constituting the violation.’” Because discovery – and not inquiry notice – is the statutory trigger, inquiry notice alone does not cause the two-year period to commence.
The Supreme Court also rejected the third approach, finding it inconsistent with statute. The statute, the Court held, “simply provides that ‘discovery’ is the event that triggers the 2-year limitations period – for all plaintiffs.” Whether or not plaintiffs actually investigated does not matter.
The Court ultimately adopted a use of inquiry notice that closely mirrors the second of the three approaches outlined above: Inquiry notice will not trigger the statute, although it may be relevant in determining when discovery should have occurred.
We conclude that the limitations period in § 1658(b)(1) begins to run once the plaintiff did discover or a reasonably diligent plaintiff would have “discover[ed] the facts constituting the violation”—whichever comes first. In determining the time at which “discovery” of those “facts” occurred, terms such as “inquiry notice” and “storm warnings” may be useful to the extent that they identify a time when the facts would have prompted a reasonably diligent plaintiff to begin investigating. But the limitations period does not begin to run until the plaintiff thereafter discovers or a reasonably diligent plaintiff would have discovered “the facts constituting the violation,” including scienter – irrespective of whether the actual plaintiff undertook a reasonably diligent investigation.
In light of this passage, securities defendants’ approach to limitations issues can be expected to shift. Rather than centering their analysis on inquiry notice, defendants in many cases will likely skip straight to the argument that plaintiffs had access to facts constituting actual or constructive discovery itself. The alternative, under Merck, is to attempt to establish inquiry notice, and then, once that has been done, to further define the nature, length and likely course of the investigation that plaintiffs should have undertaken once they were on notice. As the Merck defendants suggested to the Court, “determining when a hypothetical reasonably diligent plaintiff would have ‘discover[ed]’ the necessary facts” is a task that in some cases may simply appear too speculative or complicated to take on. The Supreme Court expressed its confidence that the lower courts are equal to the job, but defendants may find that the easier path is simply to collapse inquiry notice and the investigation period into a single point at which “discovery” should be deemed to have occurred.
Justice Scalia’s Concurrence
Before reaching its two principal conclusions – that discovery of facts relating to scienter is necessary to trigger the limitations period, and that inquiry notice is not a sufficient trigger – the Supreme Court addressed an issue on which the parties had agreed. Section 1658 speaks only of “discovery” of facts constituting the violation. It does not state that the two-year period will also be triggered in cases where a reasonably diligent plaintiff should have discovered the relevant facts. The plaintiffs, defendants and the Solicitor General were nevertheless in accord that a “should have discovered” standard—constructive discovery—was appropriate.
The Supreme Court agreed. The Court reasoned that in using the term “discover” in Section 1658, Congress intended to incorporate the common-law discovery rule, pursuant to which statutes run on discovery rather than on accrual of an action – but plaintiffs are held to a standard of reasonable diligence in making the required discovery. The Court relied on both the longstanding use of the term “discovery” and on more recent history. In 1991, the Supreme Court adopted a uniform federal limitations period for Section 10(b) claims and modeled that period on other limitations provisions triggered by “the discovery of the facts constituting the violation.” Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350 (1991). Since Lampf was decided, the Merck Court explained, all Courts of Appeals to address the issue have adopted a constructive discovery standard. When Congress enacted Section 1658 as part of the Sarbanes-Oxley Act in 2002, Congress used the same formulation used in Lampf – “discovery of the facts constituting the violation.” Thus, according to the Merck majority, Congress incorporated the post-Lampf interpretation of “discovery” – under which discovery may be either actual or constructive – into Section 1658.
Justice Scalia disagreed. In a concurring opinion joined by Justice Thomas, Justice Scalia stated that the correct result would have been to affirm the Third Circuit on the ground that plaintiffs did not actually discover the facts constituting the violation within the relevant period. Constructive discovery, according to Justice Scalia, has no place in a Section 1658 analysis. Justice Scalia relied primarily on Section 13 of the 1933 Act (15 U.S.C. § 77m), which sets forth limitations periods for claims under Section 11 and 12 of that Act, and which explicitly incorporates a constructive discovery standard. Under Section 13, claims must be brought, as a matter of statute, within one year after “discovery” or “after such discovery should have been made by the exercise of reasonable diligence.” “Discovery,” in Section 13, thus means “actual discovery”; otherwise, according to Justice Scalia, there would be no need for the explicit adoption of a constructive discovery standard in the statute. And what “discovery” means in Section 13, Justice Scalia concluded, “discovery” must also mean in Section 1658 – actual discovery only. As to the argument that post-Lampf courts have all understood “discovery” to mean “constructive discovery,” Justice Scalia was unpersuaded. Drawing on an amicus brief filed by law professors, Justice Scalia concluded that the record among the Courts of Appeals was by no means uniform. “This motley assortment of approaches comes nowhere near establishing that the word ‘discovery’ in §78i(e) [the statute from which Lampf drew the limitations period for Section 10(b) claims] meant constructive rather than actual discovery.”
Justice Stevens also issued a short concurrence. In Justice Stevens’ view, the Court could have avoided deciding whether Section 1658 embraces a constructive discovery standard – the ruling with which Justice Scalia disagreed. There was no need to decide the question, Justice Stevens explained, because even if a constructive discovery standard were available, defendants could not meet it.
Justice Scalia’s concurrence provides an interesting view of post-Lampf developments in securities law. And of course the concurrence is one more arrow in the literalist quiver. As a practical matter, however, it is unlikely to change the approach to limitations issues in this area.