The SEC suffered a stunning loss in the First Circuit in a December 8, 2015 decision ruling that the SEC’s findings of securities law violations by two executives in connection with the operation of a State Street Bank bond fund lacked substantial supporting evidence. The Commission had, by a 3-2 divided vote, overturned a decision by one of its administrative law judges that no violations had occurred, and in doing so wrote a highly controversial opinion in which it staked out aggressive positions on a variety of securities law issues. See SEC Majority Argues for Negating Janus Decision with Broad Interpretation of Rule 10b-5; New, Thorough Academic Analysis of In re Flannery Shows Many Flaws in the Far-Reaching SEC Majority Opinion; and SEC not entitled to deference in State Street fraud appeal – law prof.
The First Circuit panel found, however, that the underlying evidence simply failed to support the finding of any violation on any theory, even the aggressive interpretations set forth by the Commission in its opinion. As a result, the First Circuit never ruled on the validity or invalidity of several important legal issues raised by the Commission in its overreaching opinion. Therefore, the key issue whether the SEC’s attempt at aggressive revisions of the scope of the law are entitled to deference or acceptance was not reached. The end result, however, which vacates the SEC Order, leaves no SEC precedent in place to support those aggressive opinions.
The First Circuit’s opinion is available here: 1st Circuit Decision in Flannery v. SEC. The now-vacated SEC opinion is available here: In re Flannery Majority Opinion.
Perhaps the most stunning aspect of the First Circuit opinion is the way in which the court schooled the SEC — the supposed experts on securities — by explaining why the evidence the SEC found compelling (despite a contrary ruling by its ALJ) was in fact deeply flawed. Where the Commission majority found evidence of material intentional and negligent misrepresentations, the appellate court found no substance whatever. What does this say about the competence of the SEC and its staff to consider such issues? If you read the opinion, you will see that the SEC’s willingness to stretch minimal evidence into supposed violations of law, and to disregard the lack of real evidence of materiality and state of mind proffered during the trial, seems a lot like the strained efforts of plaintiffs’ lawyers to find securities fraud everywhere. And that is the reality faced by those being investigated and prosecuted by the SEC: the investigation and prosecution proceeds on the basis of a distorted view of what constitutes important information, and intentional or negligent behavior, that puts almost every decision in the SEC’s cross-hairs based largely on backward-looking, “fraud by hindsight” reasoning.
The First Circuit opinion is based on an analysis of the specific evidence in the record, and therefore is not easily summarized. The case turned on two sets of events.
The case against Mr. Hopkins turned on a short presentation to investors in which he participated, and, indeed, a single power-point slide in that presentation. That slide set forth various parameters of the bond fund at issue (State Street’s Limited Duration Bond Fund, hereafter “the Fund”) under the heading “Typical Portfolio Exposures and Characteristics.” It never purported to lay out the exact characteristics of the Fund at the time of the presentation, although Mr. Hopkins had that information available if any investor asked about them. The SEC charged Mr. Hopkins with fraud for discussing this power-point slide without providing the exact information about the Fund at that time, which in some respects differed from the “typical” slide, and in others did not. In particular, the percentage of holdings of different types of asset-backed securities — ABS (asset-backed securities, included residential mortgage-backed securities), CBS (commercial-backed securities), MBS (mortgage-backed securities), and other designations — at the time varied from the “typical” slide by having heavier ABS holdings.
The case against Mr. Flannery focused on two letters sent by State Street to investors regarding the impact of the 2007 financial crisis on the Fund and steps being taken to respond to that. Mr. Flannery signed one of those letters, but not the other. Many State Street officials participated in the drafting of these letters, including its General Counsel. The SEC contended that Mr. Flannery negligently participated in a “course of business” that “operated as a fraud” in his role in connection with these letters. The alleged misrepresentations in the letters related to whether steps taken to divest the Fund of certain bonds were properly described as lessening its exposure to risk.
As you can see, these are “in the weeds” issues to which the SEC should be able to bring sophistication and expertise. Instead, they pursued a blunderbuss case that ignored the context of the disclosures, the realities of these types of communications (what they are intended to communicate and what not), and the actual language used. The SEC essentially waved its hands around and said “this is bad; this is bad” and “look how badly the funds did when the mortgage-backed securities market tanked.” But it failed to present evidence that what was said was wrong, or that the aspect that it contended was wrong was even important to investors, and ignored substantial evidence to the contrary.
Here is some of what the court said with respect to the case against Mr. Hopkins:
Questions of materiality and scienter are connected. . . . “If it is questionable whether a fact is material or its materiality is marginal, that tends to undercut the argument that defendants acted with the requisite intent or extreme recklessness in not disclosing the fact.” . . .
Here, assuming the Typical Portfolio Slide was misleading, evidence supporting the Commission’s finding of materiality was marginal. The Commission’s opinion states that “reasonable investors would have viewed disclosure of the fact that, during the relevant period, [the Fund’s] exposure to ABS was substantially higher than was stated in the slide as having significantly altered the total mix of information available to them.” Yet the Commission identifies only one witness other than Hopkins relevant to this conclusion. . . .
[T]he slide was clearly labeled “Typical.” [The witness and his firm] never asked … for a breakdown of the [Fund’s] actual investment…. Further, the Commission has not identified any evidence in the record that the credit risks posed by ABS, CMBS, or MBS were materially different from each other, arguing instead that the percent of investment in ABS and diversification as such are important to investors. Context makes a difference. According to a report [the witness] authored the day after the meeting, the meeting’s purpose was to explain why the [Fund] had underperformed in the first quarter of 2007 and to discuss its investment in a specific index that had contributed to the underperformance. The Typical Portfolio Slide was one slide of a presentation of at least twenty. Perhaps unsurprisingly, the slide was not mentioned in [the witness’s] report.
Hopkins presented expert testimony . . . that “[p]re-prepared documents such as . . . presentations . . . are not intended to present a complete picture of the fund,” but rather serve as “starting points,” after which due diligence is performed. [The expert] explained that “a typical investor in an unregistered fund would understand that it could specifically request additional information regarding the fund.” And not only were clients given specific information upon request, information about the [Fund’s] actual percent of sector investment was available through the fact sheets and annual audited financial statements. The … fact sheet … six weeks prior to the … presentation [said] the [Fund] was 100% invested in ABS. The [fact sheet one-month after the presentation said] the [Fund] was 81.3% invested in ABS. These facts weigh against any conclusion that the Typical Portfolio Slide had “significantly altered the ‘total mix’ of information made available.” …
This thin materiality showing cannot support a finding of scienter here…. Hopkins testified that in his experience investors did not focus on sector breakdown when making their investment decisions and that [Fund] investors did not focus on how much of the [Fund] investment was in ABS versus MBS…. He did not update the Typical Portfolio Slide’s sector breakdowns because he did not think the typical sector breakdowns were important to investors. To the extent that an investor would want to know the actual sector breakdowns, Hopkins would bring notes with “the accurate information” so that he could answer any questions that arose. We cannot say that these handwritten notes provide substantial evidence of recklessness, much less intentionality to mislead — particularly in light of Hopkins’s belief that this information was not important to investors….
We conclude that the Commission abused its discretion in holding Hopkins liable under Section 17(a)(1), Section 10(b), and Rule 10b-5.
Slip op. at 21-24 (footnotes omitted).
The court said in a footnote: “… We do not suggest that the mere availability of accurate information negates an inaccurate statement. Rather, when a slide is labeled ‘typical,’ and where a reasonable investor would not rely on one slide but instead would conduct due diligence when making an investment decision, the availability of actual and accurate information is relevant.” Slip op. at 22 n.8.
And here is some of the discussion about the case against Mr. Flannery:
… At the very least, the August 2 letter was not misleading — even when considered with the August 14 letter — and so there was not substantial evidence to support the Commission’s finding that Flannery was “liable for having engaged in a ‘course of business’ that operated as a fraud on [Fund] investors.”
The Commission’s primary reason for finding the August 2 letter misleading was its view that the “[The Fund’s] sale of the AAA-rated securities did not reduce risk in the fund. Rather, the sale ultimately increased both the fund’s credit risk and its liquidity risk because the securities that remained in the fund had a lower credit rating and were less liquid than those that were sold.” At the outset, we note that neither of the Commission’s assertions — that the sale increased the fund’s credit risk and increased its liquidity risk — are supported by substantial evidence.
First, although credit rating alone does not necessarily measure a portfolio’s risk, the Commission does not dispute the truth of the letter’s statement that the [Fund] maintained an average AA-credit quality. Second, expert testimony presented at the proceeding explained that the July 26 AAA-rated bond sale reduced risk because these bonds “entailed credit and market risk that were substantially greater than those of cash positions. In addition, a portion of the sale proceeds was used to pay down [repurchase agreement] loans and reduce the portfolio leverage.”
Further, testimony throughout the proceeding indicated that the [Fund’s] bond sales in July and August reduced risk by decreasing exposure to the subprime residential market, by reducing leverage, and by increasing liquidity, part of which was used to repay loans.
To be sure, the Commission maintained that the bond sale’s potentially beneficial effects on the fund’s liquidity risk were immediately undermined by the “massive outflows of the sale proceeds . . . to early redeemers.” But this reasoning falters for two reasons. First, the Commission acknowledged that between $175 and $195 million of the cash proceeds remained in the LDBF as of the time the letter was sent; it offered no reason, however, why this level of cash holdings provided an insufficient liquidity cushion. Second and more fundamentally, even if the Commission was correct that the liquidity risk in the [Fund] was higher following the sale than it was prior to the sale, it does not follow that the sale failed to reduce risk. Rather, to treat as misleading the statement in the August 2 letter that State Street had “reduced risk,” the Commission would need to demonstrate that the liquidity risk in the LDBF following the sale was higher than it would have been in the counterfactual world in which the financial crisis had continued to roil — and in which large numbers of investors likely would have sought redemption — and the [Fund] had not sold its AAA holdings. But the Commission has not done this.
Independently, the Commission has misread the letter. The August 2 letter did not claim to have reduced risk in the [Fund]. The letter states that “the downdraft in valuations has had a significant impact on the risk profile of our portfolios, prompting us to take steps to seek to reduce risk across the affected portfolios” (emphasis added). Indeed, at oral argument, the Commission acknowledged that there was no particular sentence in the letter that was inaccurate. It contends that the statement, “[t]he actions we have taken to date in the [Fund] simultaneously reduced risk in other [State Street] active fixed income and active derivative-based strategies,” misled investors into thinking [State Street] reduced the [Fund’s] risk profile. This argument ignores the word “other.” The letter was sent to clients in at least twenty-one other funds, and, if anything, speaks to having reduced risk in funds other than the [Fund].
Even beyond that, there is not substantial evidence that [State Street] did not “seek to reduce risk across the affected portfolios.” As one expert testified, there are different types of risk associated with a fund like the [Fund], including market risk, liquidity risk, and credit or default risk. The [Fund] was facing a liquidity problem, and … the Director of Active North American Fixed Income, explained that “[i]t’s hard to predict if the market will hold on or if there will be a large number of withdrawals by clients. We need to have liquidity should the clients decide to withdraw.” Flannery noted that “if [they didn’t] raise liquidity [they] face[d] a greater unknown.” … [The Fund’s] lead portfolio manager, noted that selling only AAA-rated bonds would affect the [Fund’s] risk profile. After discussion of both of these concerns, the Investment Committee ultimately decided to increase liquidity, sell a pro-rata share to warrant withdrawals, and reduce AA exposure. And that is what it did.… The August 2 letter does not try to hide the sale of the AAA-rated bonds; it candidly acknowledges it. At the proceeding, Flannery testified that selling AAA-rated bonds itself reduces risk, and here, in combination with the pro-rata sale, was intended to maintain a consistent risk profile for the [Fund]. [Another witness] testified that the goal of the pro-rata sale was to treat all shareholders — both those who exited the fund and those who remained — as equally as possible and maintain the risk-characteristics of the portfolio to the extent possible. These actions are not inconsistent with trying to reduce the risk profile across the portfolios.
Finally, we note that the Commission has failed to identify a single witness that supports a finding of materiality…. We do not think the letter was misleading, and we find no substantial evidence supporting a conclusion otherwise.
We need not reach the August 14 letter…. Even were we to assume that the August 14 letter was misleading, in light of the SEC’s interpretation of Section 17(a)(3) and our conclusion about the August 2 letter, we find there is not substantial evidence to support the Commission’s finding that Flannery engaged in a fraudulent “practice” or “course of business.”
Slip op. at 25-30 (footnotes omitted).
As noted above, it is obvious that the court’s decision turned on a close examination of the evidence, and an understanding of what the statements made by Hopkins and Flannery really meant, within their context. The generalized power-point slide used by Mr. Hopkins, in the context of a broader presentation, and the availability of specific information on request, was so close to immaterial that Mr. Hopkins’ understanding that investors would not place significant weight on the “typical” data could not be reckless. And the State Street letters to investors in which Mr. Flannery participated were not inaccurate because the SEC did not understand that the transaction described was, in fact, a means of reducing risk exposure. That last point is a killer: the SEC could not even understand how to evaluate the risk exposures of these types of portfolios! How good does that make you feel about the Commissioners that are responsible for understanding and protecting our capital markets?
This is a huge loss for the Commission because so much effort was made to make this case a showpiece for enforcement against individuals for supposed securities violations in the sale of the mortgage-backed securities that were devastated in the financial crisis. The SEC was loaded for bear to hold some individuals responsible, regardless of the evidence. Thank goodness a court was ultimately available to return us to the true rule of law.
Straight Arrow
December 9, 2015
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