March 01, 2014

Gabelli v. SEC: Ramifications for EPA’s Enforcement Programs

Sheila D. Jones

In February 2013, the U.S. Supreme Court issued an opinion in a securities fraud case with significant implications for the U.S. Environmental Protection Agency’s (EPA) enforcement programs. Unless Congress has specified a statute of limitation elsewhere, the federal statute of limitations at 28 U.S.C. § 2462 (2012) is applicable to an action seeking a civil penalty, fine, or forfeiture irrespective of which a federal agency is the plaintiff. In Gabelli v. SEC, ___ U.S. __, 133 S. Ct. 1216 (2013), the Court addressed the following question: Does the five-year clock in the general statute of limitations for civil penalty actions start when the violation occurs or when the violation is discovered by the government?

In 2008, the Securities and Exchange Commission (SEC) began a civil enforcement action against two investment advisors alleging that they had violated the Investment Advisors Act of 1940 by aiding and abetting investment advisor fraud. The defendants moved to dismiss, in part, on the ground that the SEC’s complaint was not filed timely. All parties agreed that the general statute of limitations at 28 U.S.C. § 2462 applied. The statute, in relevant part, states:

Except as otherwise provided by Act of Congress, an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued. . . .

Messrs. Gabelli and Alpert argued that the statute of limitations began to run when the allegedly fraudulent conduct occurred, and, because the SEC alleged that the fraud occurred until August 2002, the April 2008 complaint was untimely. The SEC argued that the statute of limitations began to run when the fraud was discovered by the SEC or when the fraud reasonably could have been discovered by the SEC. The SEC argued that the “discovery rule” applied because the underlying violations sounded in fraud.

The SEC alleged that Messrs. Gabelli and Alpert allowed an investor to engage in “market timing” (a trading strategy that exploits time delay in a mutual fund’s daily valuation system) in a fund managed by Gabelli and Alpert in exchange for an investment by the investor in a hedge fund managed by Gabelli. Market timing, while not illegal, can harm long-term investors in a fund. The other investors in the fund were not notified by either defendant that one investor was permitted to engage in market timing. In addition, the defendants prohibited other investors in that fund from engaging in market timing.

The district court agreed with the defendants and dismissed the civil penalty claim. The Second Circuit reversed on the ground that the underlying violations sounded in fraud and, thus, the “discovery rule” applied. The Supreme Court, in a unanimous opinion, agreed with the defendants: the enforcement action for civil penalties was untimely.

As an initial matter, it is important to note what the Supreme Court did not address in the Gabelli case. In its arguments to the Supreme Court, the SEC did not rely upon the fraudulent concealment doctrine or any other equitable tolling doctrine that tolls the running of the limitations period when the defendant takes measures or actions beyond the alleged illegal conduct itself to conceal the illegal conduct from the plaintiff. Thus, the Court did not discuss the scope or application of the fraudulent concealment doctrine or any similar basis upon which a limitations period is tolled.

The Court begins its analysis by noting that the so-called discovery rule is an exception to the standard rule governing the applicability of the limitations period. With respect to the applicability of 28 U.S.C. § 2462, the Court observes that the “standard rule,” which has governed since the 1830s when the predecessor to 28 U.S.C. § 2462 was enacted, is that a claim accrues when the plaintiff has a complete and present cause of action. Gabelli, 133 S. Ct. at 1220. In 28 U.S.C. § 2462, Congress declares that an action, suit, or proceeding for a civil fine, penalty, or forfeiture is untimely “unless commenced within five years from the date when the claim first accrued.” In fraud cases, the “discovery rule” exception delays accrual of the claim until the fraud is discovered or could have been discovered with reasonable diligence by the plaintiff. The Court notes that the exception arose in eighteenth-century fraud cases to protect a plaintiff when the defendant’s deceptive conduct prevented the plaintiff from knowing he or she had been defrauded. Unlike some federal statutes of limitations, the exception is not set forth in 28 U.S.C. § 2462. Rather, it is federal common law.

The Court’s unwillingness to extend the discovery rule exception to the SEC enforcement action essentially turned on three facts: (1) the SEC had not been defrauded; (2) when it sued the defendants, it did so in its capacity as enforcer of the federal securities law; and (3) it did not seek the type of relief typically sought by a plaintiff in a fraud case.

Most importantly, the SEC was not a victim of the alleged fraud. As the Court observed, it had never applied the discovery rule exception to a case in which the plaintiff is not a defrauded victim. 133 S. Ct. at 1221. The Court noted that the discovery rule exception had been applied in Exploration Co. v. United States, 247 U.S. 435 (1918), where the defendant engaged in fraudulent conduct when purchasing land from the government. Because the discovery rule exception arose to protect a plaintiff when the defendant’s deceptive conduct prevented the plaintiff from knowing he or she had been defrauded, the Court concluded that the purpose of the discovery rule exception is to protect defrauded persons by providing an opportunity for the plaintiff to seek recompense for his injuries. 133 S. Ct. at 1223.

However, a close reading of the Court’s opinion suggests that even if the governmental agency has been defrauded while acting in its capacity as a law enforcement agency (for example, inspecting a regulated plant) and 28 U.S.C. § 2462 is the relevant statute of limitations, the discovery rule exception might not apply to a claim for civil penalties. Nothing in the opinion suggests that the SEC alleged that it had been the target of the fraud or a victim of the fraud. Seemingly, therefore, the Court could have noted that fact and moved on with its analysis. It did not. The Court catalogues the investigatory tools available to the SEC that allow it to discover securities law violations. Specifically, the Court observed that the SEC can require investment advisors to provide their books and records, require brokers and dealers to submit trading information, subpoena relevant documents and witnesses during its investigations, and pay monetary awards to whistle-blowers. The dissimilarity between the SEC and parties for whom the discovery rule exception was created is more than the fact that the SEC was not a victim of the fraud. Apparently, equally as important to the Court are the investigatory and prosecutorial powers possessed by the SEC. Because of the investigatory tools available to the SEC and the nature of its core mission, the Court concluded that “the SEC as enforcer is a far cry from the defrauded victim the discovery rule evolved to protect.” 133 S. Ct. at 1222.

What is the takeaway? If the governmental agency is acting in a nonenforcement capacity (e.g., procuring services) and is defrauded, the discovery rule exception might apply. The question to be resolved is: When should the plaintiff have known about the fraud? However, if the governmental agency is acting in its law enforcement capacity and a fraud occurred but the agency is not the target of the fraud, the discovery rule exception does not apply to an action for a civil penalty, fine, or forfeiture that is to subject to 28 U.S.C. § 2462.

Between those two ends of the spectrum is the case where the agency is operating in its law enforcement capacity and is defrauded. The Court does not indicate if the outcome in the Gabelli case might have been different if the SEC had been defrauded by the defendants in the course of its investigation. In addition, assuming 28 U.S.C. § 2462 applies, it is unclear from the Court’s analysis if a governmental agency seeking a civil penalty, civil fine, or forfeiture may rely on the discovery rule exception even if the regulated entity obtained a benefit (e.g., a permit) from the regulator by providing false and/or misleading information to the regulator.

Not only was the SEC a different kind of plaintiff, but also it sought a type of relief different from that sought by a defrauded party. It did not seek recompense or to restore the status quo. The purpose of the discovery rule exception is to protect a defrauded plaintiff by ensuring the plaintiff has an opportunity to receive recompense. The SEC sought penalties in order to punish the defendants for their alleged wrongdoing.

The Court’s analysis does not focus on those differences; rather it focuses on whether it will be more difficult for courts to determine when the government knew or should have known of the events that constitute the violation than for the courts to determine when a nongovernmental plaintiff knew or should have known of the actions that resulted in the plaintiff’s injury. For example, the Court asks: How does a court determine when the government knows of a violation when an agency may have hundreds of employees, dozens of offices, and several levels of leadership? 133 S. Ct. at 1223. The Court also expresses uncertainty as to if and how courts should consider agency priorities and resource constraints when attempting to determine when the government knew or should have known of the violation. 133 S. Ct. at 1223. Determining what a reasonably diligent plaintiff should have known prior to when the person actually knew the relevant facts is complicated irrespective of whom the plaintiff is. However, in the Court’s view, that task is significantly more complex when the plaintiff is a governmental agency acting in its capacity as an enforcer of the law.

What appears to be driving the Court’s analysis is its desire to limit the period of time during which a person or entity may be sued by the government in an enforcement action for a civil fine, penalty, or forfeiture. The Court observes that “grafting the discovery rule onto § 2462 . . . would leave defendants exposed to Government enforcement action not only five years after their misdeeds, but for an additional uncertain period in the future. Repose would hinge on speculation about what the Government knew, when it knew it, and when it should have known it.” 133 S. Ct. at 1223 (emphasis added). Repose, of course, would be determined by judicial findings of fact not speculation. However, depending on when the government discovers the alleged violation, considerably more than five years might pass after the occurrence of the alleged violation before the enforcement action is filed, by which time documents might have been misplaced or destroyed in the normal course of business, witnesses may have retired to unknown locations or died, and memories may have faded. The same can be said of cases filed by defrauded individuals and nongovernmental entities. However, it is the uncertainty as to when the government “discovers” the violation of law and when it should have known of the violation that troubles the Court. Quoting Chief Justice Marshall, the Court observes that it “would be repugnant to the genius of our laws” if actions for penalties could be brought at some considerable period after the alleged violation occurred. Id.

The language of 28 U.S.C. § 2462 clearly expresses Congress’ intention that actions for civil fines, penalties, or forfeiture should be initiated within five years of when the claim accrues. Congress adopted the common law “standard rule” without a discovery rule exception. Although the Supreme Court has been willing since the nineteenth century to apply the discovery rule in cases where the plaintiff alleges fraud, the Court concludes that there is no reason to alter 28 U.S.C. § 2462. Therefore, the Court reversed the Second Circuit.

Congress included a statute of limitations in many federal environmental statutes. However, in some instances, the Act-specific statute of limitations does not apply to the agency’s enforcement actions. For example, although there is a statute of limitations provision in the Federal Water Pollution Control Act (FWPCA), it does not apply to an enforcement action alleging the failure to obtain a discharge permit as required by FWPCA section 301 or to an action alleging that the permit-holder has violated the permit. 33 U.S.C. § 1342 (2012). There is no statute of limitation for civil penalty enforcement actions in the Emergency Planning and Community Right-to-Know Act (EPCRA), the Clean Air Act (CAA), or the Solid Waste Disposal Act (SWDA), as amended.

Will the Gabelli decision affect the USEPA enforcement program? Yes. It has the potential to change some aspects of its enforcement program. For example, EPA has taken the position that the failure to obtain a Prevention of Significant Deterioration (PSD) permit as required in CAA section 165, 42 U.S.C. § 7475, is a continuing violation because each day the plant operates without a PSD permit is a violation of CAA section 165. Thus, as part of its New Source Review (NSR) initiative, EPA has filed cases where the failure to obtain a PSD permit and the required best available control technology (BACT) emission limitations occurred more than five years prior to the initiation of the civil enforcement action. In some cases, the failure to obtain a PSD permit occurred more than ten years before the enforcement action was initiated.

The Third Circuit, Seventh Circuit, Eighth Circuit, and Eleventh Circuit each has ruled that the failure to obtain a PSD permit is not a continuing violation. In each case, the appellate court ruled that, while the failure to obtain a PSD permit before beginning construction or a major modification of a regulated source is a violation because there is no statutory obligation to obtain a PSD permit (with BACT emission limitations) before commencing the operation of a new or modified regulated source, it is not a continuing violation. There is some uncertainty as to whether the government’s claim accrues on the first day of construction/modification without a PSD permit, when the PSD permit is obtained, or when the construction /modification is finished, whichever occurs first. That is an issue for another article. What is clear, at least in those four Circuits, is that operating without a PSD permit is not a violation of the CAA. By contrast, the Sixth Circuit has interpreted the Tennessee air program as imposing an obligation to operate in compliance with the PSD permit issued to the facility and the BACT requirements specified in the permit. Nat’l Parks Conservation Ass’n, Inc. v. Tenn. Valley Auth., 480 F.3d 410 (6th Cir. 2007).

On September 3, 2013, the U.S. Department of Justice filed for en banc review of the Seventh Circuit’s ruling in United States v. Midwest Generation, LLC, 720 F.3d 644 (7th Cir. 2013) that failure to obtain a PSD permit is not a continuing violation. The government’s action is not surprising given EPA’s long-held view that every day a regulated plant is operated without a PSD permit is another day of violation. However, the Supreme Court’s Gabelli decision also may have provided an additional impetus for filing the petition. On September 20, 2013, the Seventh Circuit denied the petition for en banc review.

The appellate rulings regarding the obligation to obtain a PSD permit and the Gabelli decision create a perfect storm for EPA. Assume the former plant owner began operating its plants prior to August 7, 1977, modified its plants between 1994 and 1999, never obtained a PSD permit for any of the modifications, sold each plant to another company after the modifications were completed, and was sued by EPA in 2009. Parenthetically, these are the facts alleged in the Midwest Generation, LLC case. Also, assume the controlling law is that the failure to obtain a PSD permit is not a continuing violation. The former owner would not be a proper defendant for a claim for civil penalties. At best, from the government’s perspective, the statute of limitations on a civil penalty action began running sometime in 1999 for one or more of the plants. The enforcement action was filed in 2009. Even if EPA did not discover the alleged violations until after 2004, after Gabelli, EPA no longer has the option to argue that the discovery rule exception should apply.

If the action is filed in a Circuit where EPA still can argue that the failure to obtain a PSD permit is a continuing violation, the obligation of the prior owner ended when it sold the plants. Therefore, in terms of the prior owner, the continuing violation stopped sometime in 1999. In the post-Gabelli world, irrespective of when EPA discovered the violation, a civil penalty action is untimely if filed five years or more after the date the plants were sold.

The Gabelli decision also has an effect on EPA’s enforcement efforts against the current owner. If the failure to obtain a permit is not a continuing violation, EPA does not have a claim for civil penalties against the current owner for major modifications undertaken in the 1994 to 1999 time period unless EPA has a persuasive successor liability argument or one of the equitable tolling doctrines applies. The current owner, however, would have potential liability for any modifications undertaken without a PSD permit within the five-year period before commencement of the enforcement action in 2009. But a cause of action seeking a civil penalty for a violation that occurred more than five years before the lawsuit was filed in 2009 would be untimely no matter when EPA discovered any such earlier violations.

Similarly, if one assumes the alleged violation is a continuing violation, EPA can seek civil penalties against the current owner only for days of violation that occurred within five years of the commencement of the lawsuit. As a consequence of the Gabelli decision, it cannot “capture” any days of violation that occurred five years or more before the lawsuit was filed, irrespective of when it discovered those earlier days of violations, unless there is a basis for tolling the statute of limitations.

The Gabelli decision will require EPA to make some changes to the enforcement programs to which 28 U.S.C. § 2462 is applicable. It will have to assess how it can use its various enforcement tools and resources more efficiently to identify noncompliance and to convert its assessments of noncompliance into enforcement actions.

In its strategic planning, EPA has identified the following “Next Generation Compliance” goals: (1) designing regulations and permits for clear and effective implementation; (2) using advanced monitoring technologies to identify noncompliance and appropriate enforcement action; (3) shifting to electronic reporting; (4) expanding transparency of pollution and compliance information; and (5) using innovative enforcement strategies to improve compliance. The regulated community has seen a shift toward electronic reporting in several compliance programs. As part of its next-generation approach, the agency also intends to include electronic reporting in consent decrees when performance testing is required. Electronic reporting assists the agency and its enforcement partners in identifying compliance issues more efficiently and timely. Therefore, electronic reporting probably will become standard procedure in the compliance and enforcement programs. The agency also has expressed interest in requiring more self-reporting. Requiring the use of advanced monitoring technologies also probably will increase. Use of such technology, like the use of self-reporting and electronic reporting, enhances the agency’s ability to identify non-compliance. Faced with fewer resources, knows it must change how it operates its compliance and enforcement programs. The Gabelli decision likely will force change faster than it otherwise would occur.

Unless the USEPA ultimately persuades the Supreme Court that the failure to obtain a PSD permit is a continuing violation, the most immediate adverse impact of the Gabelli decision might be to the NSR enforcement program. However, other programs will be affected. For example, if 28 U.S.C. § 2462 is applicable and the alleged violation is a continuing violation, once a current owner or operator no longer owns or operates the facility or site, EPA has to commence its civil penalty action within five years of the last date when the person was an owner or operator, unless the facts support an argument that the statute of limitations should be tolled.

In order to surmount the obstacle presented by the Gabelli decision, EPA will have to collect information more frequently (e.g., via inspections or information requests), analyze the information it obtains from the various sources faster in order to determine if a violation has occurred or is occurring, and assemble and submit any referral to the U.S. Department of Justice expeditiously so the Department will have time to file the action within the limitations period. All of these activities are resource intensive. The agency also will have to rely more on its state partners for those programs where the state has a delegated or authorized program. The states also are resource-constrained, and, thus, ultimately many, if not most, states will not be able to accelerate their existing compliance/enforcement efforts or undertake additional inspections. Redesigning the federal-state partnership to accommodate the Gabelli decision will be necessary. In addition, EPA will need to reevaluate whom to target in its enforcement programs generally and in its enforcement initiatives. The Gabelli decision is yet another factor that will force EPA to reevaluate its enforcement program.

Sheila D. Jones

Ms. Jones is of counsel with Holland & Hart.