Knowledge and notice in section 10(b) limitations law.

• Author: Ford, Christopher A.
• Position: Securities fraud

Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act")(1) makes it illegal "[t]o use or employ, in connection with the purchase or sale of any security ... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [Securities Exchange] Commission (SEC) may prescribe . . . ."(2) This provision, coupled with Rule 10b-5(3)--the primary SEC regulation promulgated under section 10(b)--prohibits an issuer of securities from tricking buyers into their purchase through any sort of fraudulent representation.

Originally only the SEC could enforce these antifraud provisions, but since 1971 the Supreme Court has permitted private parties to bring suit under section 10(b) and Rule 10b-5.(4) Since courts created this right of action, however, section 10(b) litigation has been bedeviled by questions about what limitations period applies. In 1991, with its holding in Lampf,(5) the Supreme Court articulated a uniform federal limitations rule for section 10(b) actions: they must be brought "within one year after the discovery of the facts constituting the violation and within three years after such violation."(6)

This Note argues that this judicially created limitations period remains in one respect ambiguous, specifically with respect to the one-year prong of its "two-tiered" limit. Lampf did not make clear, for example, whether the one-year limit runs only from a plaintiff's actual awareness of the relevant facts of fraud (actual knowledge) or whether it can run from when she ought to have known them (constructive knowledge). It is also unclear whether the limit runs from a plaintiff's knowledge of facts indicating merely the danger of fraud (inquiry notice), or only from knowledge of the fraud itself Several different interpretations of the one-year limit are possible, each having different implications for section 10(b) plaintiffs.

Under an "actual knowledge" standard, the one-year limit would not begin until a plaintiff actually discovers that she has been defrauded. The second interpretation, "constructive knowledge," allows a plaintiff's awareness of fraud to be inferred: the limit runs from the point at which fraud should have been discovered. The third possible view of the one-year limit, "inquiry notice," runs the one-year period from the plaintiff's receipt of information that would have made a reasonable investor suspicious of fraud, whether or not the plaintiff actually became suspicious. Alternatively, courts might apply both the constructive knowledge and inquiry notice standards at the same time, dismissing cases that fit either standard. Finally, a "constructive inquiry notice" interpretation would apply a constructive knowledge standard to the facts underlying inquiry notice, beginning the limitations period when the plaintiff should have been aware of fraud or should have received information that would have made a reasonable investor suspicious.

In light of the values served by limitations law--protecting defendants, the courts, and (in this context) the securities markets from suits brought by delinquent plaintiffs--this Note argues that the best of the above interpretations is the last, "constructive inquiry notice" or "CIN." Imposing on plaintiffs this duty of diligence is necessary, faithful to the values underlying the two-tiered one-year/three-year limitations scheme chosen by Congress, and entirely consistent with the equitable traditions of federal limitations law. Plaintiff negligence in bringing timely suit should preclude the equitable limitations remedy of tolling.

The idea of holding plaintiffs responsible for reasonable inquiry into facts which might raise suspicions of fraud might at first seem harsh, particularly with respect to unsophisticated and inexperienced investors. To avoid unfairness to plaintiffs, this Note argues, the standard of investor diligence should vary with the sophistication and experience of the investor. What is "reasonable" for an inexperienced, unsophisticated investor may not be so for a sophisticated market player. Finally, it should be remembered that the survival of equitable doctrines in the operation of the one-year period means that certain types of affirmative defendant misconduct occurring after the initial fraud may be relevant in an analysis of plaintiff "reasonableness."

1. Lampf and Its Aftermath

   Since Congress did not expressly provide a private cause of action under section 10(b), it is not surprising that Congress has never expressly provided a statutory limitation period for such an action. For many years, federal courts "borrowed" state law limitations periods,(7) leaving section 10(b) limitations law confusing and unpredictable.(8) Only in 1991, in Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson,(9) did the Supreme Court attempt to clarify this area of the law by adopting a uniform federal limitations period for private section 10(b) causes of action.

   1. The Decision: One-Year/Three-Year Limitations Period

      In Lampf, investors in a failed limited partnership venture sued the law firm that had prepared the venture's offering memoranda, accusing the firm of having violated Rule 10b-5 by misrepresenting, among other things, the purported tax benefits of the limited partnership scheme. In defense, the law firm argued that the claim, filed more than three years after the alleged violation, was untimely under the analogous two-year Oregon statute of limitations. Writing for the Court, Justice Blackmun concluded that although the Exchange Act did not provide a limitations period specifically for private section 10(b) actions, it did provide adequate guidance as to the proper limitations period.(10) The Court found that the Exchange Act's two-tiered, one-year/three-year scheme(11) was most appropriate for section 10(b) litigation and should be adopted as a uniform federal standard for such actions.(12) Under this new rule, the plaintiffs' claims were untimely: they had been filed more than three years after the date of the alleged violation.(13)

      Lampf settled the question of which limitations period to apply to private section 10(b) and Rule 10b-5 claims.(14) It did not, however, settle the question of precisely when the one-year prong of the period begins to run. This question must be resolved if the "basic purpose"(15) of certainty in limitations law is properly to be served.

   2. The Three-Year Prong

      The three-year prong of the Lampf limitations period is comparatively straightforward: no private suit for a violation of section 10(b) or Rule 10b-5 may be filed more than "three years after such violation."(16) Courts have had little trouble ascertaining this date, running the three-year prong from the date of the plaintiff's "commitment" to the allegedly fraudulent transaction.(17) This three-year bar provides an absolute period of repose:(18) even the most culpable of malefactors can sleep secure in the knowledge that after three years no injured plaintiff may bring suit. Under the one-year prong of the Lampf rule, an injured party is normally accorded a year after his "discovery" of the fraud in which to bring suit. Because of the three-year bar, however, if this "discovery" should take place more than two years after the date that fraud was committed, the full enjoyment of the one-year period will not be permitted.(19)

   3. The One-Year Prong

      The one-year prong of the Lampf limitations period is much more difficult to apply. Part of this difficulty stems from the specific limitations language the Supreme Court adopted. Noting that "the various 1-and-3-year periods contained in the [Exchange] and [Securities] Acts differ slightly in terminology," the Court expressly adopted the language of section 9(e) of the Exchange Act.(20) This choice has caused many disputes as to whether the limitations period for private claims under section 10(b) and Rule 10b-5 includes a constructivity standard--that is, whether the limitations period runs from when a plaintiff should have possessed the requisite sort of knowledge rather than when he actually did so.

      On its face, the language of section 9(e) does not appear likely to produce confusion: "No action shall be maintained to enforce any liability created under this section, unless brought within one year after the discovery of the facts constituting the violation and within three years after such violation."(21) It provides no textual basis for a constructive knowledge standard, and the choice of this provision over others containing clear constructive knowledge language (such as section 13 of the Securities Act)(22) might suggest the Court's intent to preclude constructivity.

      The Lampf Court did not seem to attach any significance to the difference between sections 9(e) and 13, however. Moreover, lower federal courts have often read a constructive knowledge standard into section 9(e).(23) In fact, the Lampf Court chose to adopt section 9(e) against a background of Third Circuit cases finding that an identically phrased limitations period implicitly contained a constructivity standard.(24) The Lampf Court also claimed to "agree" with the Seventh Circuit's adoption of section 13-with its express constructive knowledge provisions--for section 10(b) litigation.(25) Lampf thus leaves unclear whether or not the section 10(b) limitations period begins with the plaintiff's constructive knowledge.

      But there is another ambiguity as well, stemming not from discrepancies between section 9(e) and section 13 but from broader conceptual fuzziness in federal limitations law as to what sort of knowledge, whether actually or constructively obtained, will be required of a plaintiff. Does the one-year prong of the limitations period begin when the plaintiff (actually or constructively) had factual evidence of fraud, or does it begin when he (actually or constructively) knew only enough to put a reasonable investor on "inquiry notice," that is, to make him...