SDNY Judge Adheres To Prior Ruling That Discovery Rule Applies To Securities Act Statute Of Limitations

by Shearman & Sterling LLP

On July 28, 2017, Judge Victor Marrero of the United States District Court of the Southern District of New York denied a motion for reconsideration of an earlier decision declining to dismiss as untimely a putative class action asserting claims under Sections 11, 12(a)(2), and 15 of the Securities Act of 1933 (the “Securities Act”).  Xiang v. Inovalon Holdings, Inc., No. 16 Civ. 4923 (S.D.N.Y. July 28, 2017).  In denying reconsideration, the Court held that the “discovery rule” adopted by the United States Supreme Court in Merck & Co. v. Reynolds, 559 U.S. 633 (2010) in the context of claims brought under the Securities Exchange Act of 1934 (the “Exchange Act”) also applies to claims brought under the Securities Act.  Under the “discovery rule” adopted in Merck, the statute of limitations begins to run when a reasonably diligent plaintiff would have discovered the facts constituting the securities law violation.  This is distinguished from “inquiry notice,” under which the statute of limitations begins to run when facts would lead a reasonably diligent plaintiff to investigate whether it has a claim.  The decision deepens a split in the Southern District of New York (and elsewhere) over the issue of whether Merck applies to claims under the Securities Act. 
Plaintiffs filed suit in June 2016, claiming that Inovalon Holdings, Inc. (“Inovalon” or the “Company”), its officers and directors, and the underwriters of its IPO failed to disclose the Company’s rising tax rates.  When the Company disclosed the impact of these increased tax rates in August 2015, the Company’s share price dropped 30 percent.  Defendants unsuccessfully moved to dismiss on the ground that the one-year statute of limitations had run based on disclosures of tax rate increases more than one year before the suit was filed.  In rejecting that argument, the Court found the “discovery rule” applied and that plaintiffs could not have discovered their claims until the Company disclosed the impact the tax rate increases would have on earnings and forecasts and the Company’s stock price fell significantly in August 2015.  According to the Court, this stock drop allowed plaintiffs to plead damages resulting from their claims in a manner they could not have based on the earlier disclosures of increased tax rates. 
In denying reconsideration, the Court rejected defendants’ argument that the traditional “inquiry notice” standard controlled the running of the statute of limitations in Securities Act cases.  After acknowledging “some confusion and dispute” among the courts on this issue, the Court determined that “the weight of authority” and “substantive analysis” favored extension of Merck to Securities Act claims.  In particular, the Court expressed the view that the statute of limitations under both the Securities Act and the Exchange Act are keyed to “discovery” of the facts constituting the alleged violation, a similarity on which at least some other district courts have also relied in extending Merck to Securities Act claims.  See 15 U.S.C. § 77m (actions under Securities Act cannot be brought “within one year after the discovery of the untrue statement or the omission, or after such discovery should have been made by the exercise of reasonable diligence”) with 28 U.S.C. § 1658 (Exchange Act bars actions “two years after the discovery of the facts constituting the violation.”).  According to the Court, because the analysis in Merck “speaks to how to decide what constitutes ‘discovery’ of the facts” giving rise to a securities claim, “it makes sense to also apply the Merck standard in interpreting another securities statute that employ the same term also in reference to prescribing the applicable statute of limitations.” 
The decision deepens the split among the district courts over whether or not the “discovery rule” announced in Merck applies to Securities Act claims and is unlikely to bring finality to the ongoing debate.  

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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