SEC Curtailed in Going After Long-Ago Fraud

WASHINGTON (CN) - Securities regulators waited too long to go after investment advisers it accused of defrauding clients, the U.S. Supreme Court ruled Wednesday.

Under the Investment Advisers Act, the Securities and Exchange Commission can seek civil penalties from investment advisers who defraud their clients. The statute of limitations, however, gives the SEC just five years to seek such penalties.

In 2008, the agency brought a civil enforcement action related to alleged market timing committed by an investor of Gabelli Global Growth Fund (GGGF), which was advised Gabelli Funds.

The SEC's complaint alleged that Gabelli Funds COO Bruce Alpert and the fund's portfolio manager, Marc Gabelli, let Headstart Advisers exploit time delay in the daily valuation system of GGGF from 1999 until 2002.

Market timing is not illegal but can harm long-term investors in a fund, the Supreme Court noted Wednesday.

The practice allegedly allowed Headstart to earn 185 percent returns during the relevant period, while other long-term GGGF investors earned a rate of no more than negative 24.1 percent.

A federal judge ultimately dismissed the case after finding that the complaint alleged market timing up until August 2002 but was not filed until April 2008, exceeding the statute of limitations.

The 2nd Circuit reversed, however, based on its conclusion that the five-year clock did not start until discovery of the fraud, rather than its completion.

On Wednesday, the unanimous Supreme Court found no reason to apply the discovery rule exception, which arose in 18th-century fraud cases.

"Despite the discovery rule's centuries-old roots, the government cites no lower court case before 2008 employing a fraud-based discovery rule in a government enforcement action for civil penalties," Chief Justice John Roberts wrote for the court. "When pressed at oral argument, the government conceded that it was aware of no such case. The govern­ment was also unable to point to any example from the first 160 years after enactment of this statute of limita­tions where it had even asserted that the fraud discovery rule applied in such a context."

The 14-page ruling then compares the SEC to the private parties whom the fraud discovery rule aims to protect.

"Most of us do not live in a state of constant in­vestigation; absent any reason to think we have been injured, we do not typically spend our days looking for evidence that we were lied to or defrauded," Roberts wrote.

The SEC, on the other hand, "is not like an individual victim who relies on apparent injury to learn of a wrong," according to the ruling.

"Rather, a central 'mission' of the commission is to 'investigat[e] potential violations of the federal securities laws,'" Roberts wrote. "Unlike the private party who has no reason to suspect fraud, the SEC's very pur­pose is to root it out, and it has many legal tools at hand to aid in that pursuit."

In addition to access to the detailed trading information and financial records of securities brokers and dealers, the agency has subpoena power and is authorized to compensate or otherwise protect whistle-blowers.

"Charged with this mission and armed with these weapons, the SEC as enforcer is a far cry from the defrauded victim the discovery rule evolved to protect," Roberts wrote.

"In a civil penalty action, the government is not only a different kind of plaintiff, it seeks a different kind of relief," he added. "The discovery rule helps to ensure that the injured receive recompense. But this case involves penalties, which go beyond compensation, are intended to punish, and label defendants wrongdoers."

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