With the arrival of the first Monday in October, the Supreme Court begins its new Term. On its docket are three cases involving important questions of securities law, an area that was not prominent on the Court’s docket in its previous Term. In fact, while the Court heard several cases last Term with important implications for businesses, the Court did not hear a single case where securities law issues predominated. This stands in stark contrast to landmark securities law decisions in previous terms,1 and to the upcoming Term. This GT Alert provides an overview of the securities law cases currently scheduled for argument this Term, and explains why they may be important.
Merck & Co. v. Reynolds2
The most significant securities law question on the Court’s docket is when the statute of limitations begins to run in a securities fraud action. Under the Sarbanes- Oxley Act of 2002, 28 U.S.C. § 1658(b), a private plaintiff in such an action must file suit within two years of “the discovery of the facts constituting the violation.” The term “discovery” encompasses both actual and constructive discovery, including “inquiry notice.”
At issue in Merck is what constitutes “inquiry notice,” and on this point the circuits disagree. In certain circuits, the statute begins to run as soon as the plaintiff has notice, or “storm warnings,” of the possibility of fraud. In others, notice of the possibility of fraud requires plaintiffs to begin investigating, but the two-year statute does not begin to run until their reasonable due diligence would have uncovered the fraud. And yet other circuits hold that plaintiffs are not on inquiry notice until there is publicly available evidence that a misrepresentation was made with scienter.
Having granted certiorari, the Supreme Court now has the opportunity to establish a uniform, nationwide standard defining at what point plaintiffs are placed on inquiry notice. This, in turn, may have a substantial impact on plaintiffs’ ability to survive motions to dismiss. If plaintiffs are put on inquiry notice as soon as they have “storm warnings,” rather than once they have evidence of scienter, plaintiffs may find it more difficult to satisfy the heightened pleading requirements established by the Private Securities Litigation Reform Act.3 Arguments will take place on November 30, 2009.
Jones v. Harris Associates L.P.4
On November 2, 2009, the Court will hear arguments in Jones v. Harris Associates L.P. In Jones, the plaintiffs, mutual fund investors, allege that the funds’ investment adviser, Harris Associates, charged fees that were excessive and thereby violated the fiduciary duties established by Section 36(b) of the Investment Company Act of 1940.5 At issue in the case is whether the standard applied by the court of appeals is consistent with the Act.
Before the Jones decision, the prevailing standard for determining Section 36(b) liability had come from the Second Circuit’s decision in Gartenberg v. Merrill Lynch Asset Management, Inc.6 Under the Gartenberg standard — which has been followed, if imperfectly, by every other circuit except the Seventh — an investment adviser violates its Section 36(b) duties when it charges a fee that exceeds what could be obtained in an arm’s-length transaction.7
The Seventh Circuit departed from the Gartenberg test. Under its standard, which rejected an ex post, judicial determination as to the reasonableness of fees, an adviser is not liable for breach of fiduciary duties under Section 36(b) unless the adviser also misled the fund’s board of directors in obtaining their approval of the fee charged. By imposing the “misleading disclosure” requirement, the Seventh Circuit established a stricter standard for establishing a violation of an adviser’s fiduciary duties. The Court is now called upon to resolve the disagreement over the proper standard for determining a Section 36(b) violation, and its decision will bear important consequences for mutual funds, fund investors, and investment advisers.
Free Enterprise Fund v. Public Company Accounting Oversight Board8
At issue in the case is whether the procedure used to appoint members of the Public Company Accounting Oversight Board (PCAOB) violates the Constitution.
Title I of the Sarbanes-Oxley Act of 2002 (the “Act”) established the PCAOB, whose purpose it is “to oversee the audit of public companies that are subject to the securities laws . . . in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports.”9 The five members of the PCAOB are appointed by the SEC after consultation with the Chairman of the Board of Governors of the Federal Reserve and the Secretary of the Treasury.10 The Act empowers the PCAOB, subject to the oversight of the Commission, to, among other things, register public accounting firms, establish auditing and ethics standards, conduct inspections and investigations of registered firms, impose sanctions, and set its own budget.11
In 2006, the Free Enterprise Fund, a nonprofit public interest organization, and Beckstead & Watts, an accounting firm, filed a complaint in the United States District Court for the District of Columbia. The complaint challenged the constitutionality of the PCAOB. In particular, Beckstead alleged that Title I violated the Appointments Clause,12 separation of powers, and non-delegation principles. The plaintiffs sought declaratory and injunctive relief prohibiting the PCAOB from carrying out its duties, which included a formal investigation of Beckstead. The United States intervened to defend the constitutionality of the Act. The district court granted summary judgment in favor of the PCAOB and the United States. The plaintiffs appealed.
The D.C. Circuit affirmed and efforts to rehear the case en banc failed after a 5-4 vote and over a vigorous dissent by Judge Kavanaugh. The panel held that the Title I appointments process was consistent with the President’s appointment and removal powers under the Constitution. On May 18, 2009, the Supreme Court granted the Fund’s petition for certiorari. Arguments will take place on December 7, 2009. The case is of special importance to accountants, auditors, and corporate insiders who deal with the regulation of financial practices. The case may also have more widespread implications affecting the corporate governance and reporting practices of all publicly traded companies. This is because the Act does not have a severability clause, and some have voiced concern that the entire Act, and the regulatory structure enacted thereunder, may be voided if any of its provisions — including those at issue in this case — are declared unconstitutional. Yet the prospects of such radical change are slim, given that courts generally assume that statutory provisions are severable from one another, and because Congress would likely step in to remedy any constitutional deficiencies through appropriate legislation.
This Alert discussed the three securities cases currently on the docket for the Supreme Court’s upcoming Term. Each of these cases is significant, and more securities cases may yet land on the docket. Directors, officers, and company counsel should pay close attention to these cases, as well as to the numerous legislative and administrative proposals related to federal securities regulation that are now pending.