The First Circuit’s decision underscores the limits of court deference to Commission decisions, gives teeth to the “substantial evidence” standard of review, and provides a valuable roadmap for evaluating and defending allegations of material misstatements.

On December 8, the US Court of Appeals for the First Circuit vacated a US Securities and Exchange Commission (Commission) order imposing sanctions against two former employees of State Street Bank and Trust Company: James D. Hopkins (a former vice president) and John P. Flannery (a former chief investment officer). The Commission had found Hopkins liable under Section 17(a)(1) of the Securities Act of 1933, as well as Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. Flannery was found liable under Section 17(a)(3) of the Securities Act. The First Circuit disagreed with the Commission’s interpretation of the facts, held that the Commission had abused its discretion, and vacated the findings of liability.

The First Circuit’s decision underscores the limits of court deference to Commission decisions and gives teeth to the “substantial evidence” standard of review—particularly in cases where the Commission’s conclusions differ from those reached by the administrative law judge (ALJ) who conducted the trial and heard witnesses in person. The decision also provides a valuable roadmap for evaluating and defending allegations of material misstatements, particularly in cases involving investments sold to institutional investors.

The Commission’s divided opinion had set out its own legal interpretation to resolve the impact of Janus Capital Group v. First Derivative Traders, in which the US Supreme Court limited primary liability for false and misleading statements under Rule 10b-5 of the Exchange Act to those who had the “ultimate authority” to make a statement—typically, the speaker of the statement. Citing the “agency’s experience and expertise in administering securities law,” the Commission held that the limits Janus placed on private claims did not apply to the SEC, and that Janus did not apply to Section 17 of the Securities Act. Although the First Circuit does not address this aspect of the case, its reversal is significant for that reason as well.

Background

The SEC brought charges against Hopkins and Flannery in 2010 based on allegedly misleading communications to investors in a State Street-managed fund known as the Limited Duration Bond Fund (LDBF or the Fund), an unregistered fund offered only to institutional investors. The Fund was composed largely of asset-backed securities (ABS) and experienced substantial underperformance beginning in June 2007 during the subprime mortgage crisis. 
Following an eleven-day hearing with nineteen witnesses, an ALJ dismissed the proceeding, finding that neither Hopkins nor Flannery was responsible for the documents at issue, and that the documents did not contain materially false or misleading statements or omissions.

The SEC Enforcement Division appealed to the Commission. In a 3-2 decision, the Commission reversed the ALJ. The Commission’s decision imposed cease-and-desist orders, suspended both men from association with any investment adviser or company for one year, and fined Hopkins $65,000 and Flannery $6,500.[1] Hopkins and Flannery appealed the decision to the First Circuit.

The Court’s Stringent Review of the SEC’s Factual Findings

The court noted that where, as here, the Commission reached the opposite conclusion of the agency’s own ALJ, its review is “slightly less deferential than it would be otherwise.”[2] Even with that, the case appears to reflect a pronounced lack of deference to the Commission, with the court rejecting a number of the key factual findings upon which the Commission (in a split decision) relied, and pointing out that the Commission had “misread” one of the communications at issue. Also of note is the court’s emphasis on the absence of testimony from investors in the Fund to support the Commission’s conclusions that certain statements were misleading or material to investors.

“Context Makes a Difference” when Evaluating Materiality and Scienter

The Commission’s findings against Hopkins were based on a presentation that Hopkins made to an investor in the Fund (Investor) in May 2007. During the presentation, Hopkins used a slide deck that included a slide titled “Typical Portfolio Exposures and Characteristics—Limited Duration Bond Strategy” (Typical Portfolio Slide). This slide depicted an allocation of 55% in ABS, when in fact the Fund’s investment in ABS had reached nearly 100%.[3] 

The First Circuit assumed that the slide was misleading, but, noting that “context makes a difference,” found that the SEC’s materiality showing was “marginal.” The slide was one in a deck of at least twenty, and accurate allocation information was available to investors upon request, as well as through various fact sheets, a password-protected website, and annual audited financial statements. The court also relied on expert testimony that “a typical investor” in an unregistered fund would not rely solely on a slide presentation, but would perform additional due diligence, and would know that it could specifically request additional information.[4]

Although the Investor’s investment consultant testified that he was misled by the Typical Portfolio Slide, the investment consultant had never before asked for the sector breakdown or the Fund’s financial statements. The court also pointed out that there was no testimony from “actual investors” to support a finding of materiality, and no evidence to suggest that the credit risks posed by ABS were materially different from those of Commercial Mortgage-Backed Securities (CMBS) or Mortgage-Backed Securities (MBS).[5] 

According to the court, these facts undermined any conclusion that the Typical Portfolio Slide had “significantly altered the ‘total mix’ of information made available.” [6] Noting that “questions of materiality and scienter are connected,” the court also found that the “thin materiality showing cannot support a finding of scienter” (a high degree of recklessness) to support the findings under Section 17(a)(1) and Rule 10b-5.[7]   

Language Matters when Considering Misleading Statements

The Commission’s decision against Flannery rested on its conclusion that two letters sent to Fund investors—one that Flannery helped edit and one that he drafted—were misleading, in violation of Section 17(a)(3), which creates liability for intentionally or negligently engaging in a “course of business which operates or would operate as a fraud or deceit upon the purchaser.”  According to the Commission, the two letters were part of a “larger effort to convince” investors to stay in the Fund by “misleadingly downplay[ing]’ the Fund’s risks.”[8]

Focusing on the first of the letters in question, the court rejected the Commission’s analysis, particularly in view of the Commission’s acknowledgement that no particular sentence of the letter was inaccurate. In the Commission’s view, the letter misled investors because it suggested that the Fund had taken actions to reduce risks. According to the Commission, however, these actions—selling AAA-rated bonds in order to increase the Fund’s liquidity—had actually increased risk, because the remaining Fund holdings were less liquid and had lower credit quality.

The court disagreed, citing expert testimony that selling the AAA bonds had reduced risk in several respects. Furthermore, the court found that the Commission had simply “misread the letter,”[9] which did not actually claim to have reduced risk in the Fund itself. Specifically, the letter stated that risk had been reduced in “other” funds (emphasis added). The letter also used the phrase “seek to reduce risk” when referring to the Fund itself. The court also addressed materiality, emphasizing that the SEC, which had the burden of proof, had “failed to identify a single witness that supports a finding of materiality.”[10}

Because the court rejected the Commission’s conclusions as to the first letter, it did not attempt to resolve the question of whether the second letter was misleading. As the Commission’s prior opinion had recognized, a single misleading statement would not support a claim under Section 17(a)(3), which requires a course of dealing. Since the first letter was not misleading, consideration of the second letter was unnecessary.