SEC Reversed ALJ But Federal Court Reverses SEC

December 21, 2015

As we travel back to the ominous days leading up to the financial crisis known as the Great Recession,  we come to 2007, when things are beginning to shake, rattle, roll, and crumble: It's the onset of the subprime mortgage crisis. It's a time of denial. Cover-ups. Whistling past the graveyard.

By 2010, all the regulators who had missed the warning signs of the historic marketplace meltdown were engaging in belated finger-pointing. Smack dab within the crosshairs of the Securities and Exchange Commission's Division of Enforcement were two mutual fund executives charged with having fraudulently persuaded investors that all was not so dire, and, gee, maybe you should stay the course or, hmmm, maybe even dollar-cost-average. Some called those two executives fraudsters but others called them scapegoats. Regardless of where on the continuum you might have found yourself, one thing was for sure, the two respondents were "toast" because Enforcement just didn't lose those types of cases -- or, at least, that's how it seemed five years ago. By 2015, however, federal appellate courts weren't affording the SEC the same deference as in the old days. As the song explains: There ain't no good guy. There ain't no bad guy. There's only you and me and we just disagree.

Case In Point

On September 30, 2010, the Securities and Exchange Commission ("SEC") filed an Order Instituting Administrative and Cease-And-Desist Proceedings ("OIP") alleging that John P. Flannery and James D. Hopkins had engaged in fraud. In the Matter of John P. Flannery and James D. Hopkins, Respondents (OIP, '33 Act Rel 9147; '34 Act Rel. 63018; Inv. Adv. Act Rel. 3094; Invst. Co. Act Rel 29451; and Admin. Proc. File 3-14081 / September 30, 2010).
  • Respondent Flannery had joined State Street Corporation in 1996 and by January 2006 had become the firm's Chief Investment Officer (Americas). In November 2007, State Street terminated Flannery as part of its purported restructuring of its investment groups.
  • Respondent Hopkins joined State Street in 1998, where he served from 2004 to 2007 as the "product engineer" for the firm's Limited Duration Bond Fund; in 2008, he was promoted to Head of Product Engineering (North America).
As set forth in the "Summary" section of the OIP:

1. During the subprime mortgage crisis in 2007, State Street Bank and Trust Company ("State Street") and two of its employees, Hopkins and Flannery, engaged in a course of business and made material misrepresentations and omissions that misled investors about the extent of subprime mortgage-backed securities held in certain unregistered funds under State Street's management. The effect of this course of business and these misrepresentations was to cause the misled investors to continue to purchase or continue to hold their investments in these funds. As a result of State Street's and the Respondents' conduct, investors in State Street's funds lost hundreds of millions of dollars during the subprime market meltdown in mid-2007.
2. State Street offered investments in certain collective trust funds to institutional investors that were customers of State Street, including pension funds, employee retirement plans, and charities. These funds included two substantially identical funds - referred to together as the Limited Duration Bond Fund (the "Fund") - made available to different categories of investors. Other actively-managed bond funds and a commodity futures index fund managed by State Street ("the related funds") also invested in the Fund. State Street established the Fund in 2002 and State Street and Hopkins marketed the Fund by saying it utilized an "enhanced cash" investment strategy that was an alternative to a money market fund for certain types of investors. By 2007, however, the Fund was almost entirely invested in or exposed to subprime residential mortgage-backed securities and other subprime investments ("subprime investments"). Nonetheless, State Street and Hopkins continued to describe the Fund to prospective and current investors as having better sector diversification than a typical money market fund, while failing to disclose the extent of its exposure to subprime investments.

3. When the subprime market collapsed in mid-2007, many investors in the Fund and the related funds were unaware that the Fund had such significant exposure to subprime investments. In fact, the Fund's offering materials, such as quarterly fact sheets, presentations to current and prospective investors, and responses to investors' requests for proposal, all of which Hopkins was responsible for drafting or updating, contained misleading statements and/or omitted material information about the Fund's exposure to subprime investments and use of leverage. As a result, many investors either had no idea that the Fund held subprime investments and used leverage, or believed that the Fund had very modest exposure to subprime investments and used little or no leverage.

4. Beginning on July 26, State Street sent a series of shareholder communications concerning the effect of the turmoil in the subprime market on the Fund and the related funds that misled investors and continued State Street's and the Respondents' failure to disclose the Fund's concentration in subprime investments. Hopkins and Flannery played an instrumental role in drafting the misrepresentations in these investor communications. At the same time, State Street provided certain investors with accurate and more complete information about the Fund's subprime concentration. These other investors included clients of State Street's internal advisory groups, which provided advisory services to some of the investors in the Fund and the related funds. During 2007, State Street's advisory groups became aware, based on internal discussions and internally available information, that the Fund was concentrated in subprime investments. Prior to July 26, 2007, at least one internal advisory group also learned that State Street was going to sell a significant amount of the Fund's distressed assets to meet significant anticipated redemptions. State Street's internal advisory groups, one of which reported directly to Flannery, subsequently decided to redeem or recommend redemption from the Fund and the related funds for their clients. State Street Corporation's pension plan was one of those clients. At the direction of Flannery and State Street's Investment Committee, State Street sold the Fund's most liquid holdings and used the cash it received from these sales to meet the redemption demands of these better informed investors, leaving the Fund with largely illiquid holdings.

5. By virtue of their conduct, the Respondents violated Section 17(a) of the Securities Act [15 U.S.C. §77(q)(a)], Section 10(b) of the Exchangee

As to Respondent Flannery's alleged fraud, the OIP asserts, in part, that:

37. On August 2, 2007, State Street asked its client service personnel to send another form letter to all affected investors concerning the subprime situation and preliminary July performance returns. That letter did not disclose the information that State Street had provided to its internal advisory groups and certain other investors who requested the information. Also, in the August 2 letter, State Street again stated it had taken actions to reduce risk, including the sale of certain subprime bonds, while maintaining the Fund's average credit quality. However, State Street had sold almost all of the Fund's highest rated subprime bonds, and, upon meeting anticipated investor redemptions in late July and early August, the Fund's bonds were increasingly lower credit quality. Those investors who remained in the dark concerning the Fund's risks invested in or continued to hold their investment as the Fund became concentrated in lower-rated and largely illiquid subprime investments.

38. Flannery revised the August 2 letter to make it even more misleading concerning actions State Street had taken to reduce risk in the Fund. On August 1, Flannery revised the letter's risk reduction statements to reflect what State Street had already done (e.g., reduced exposure to certain swaps) to reduce risk as opposed to what State Street intended to do to reduce risk. When making the statement concerning what State Street had already done to reduce certain exposures (and omitting that those same actions increased the Fund's risks), Flannery was aware that these decisions were motivated to meet significant investor redemption demands, including advisory groups' clients' redemptions.

39. When he revised the August 2 letter, Flannery also knew that those investors who remained in the Fund held a fund with bonds of lower average credit quality because State Street sold the Fund's AAA rated bonds to meet redemption demands. .

As to Respondent Hopkins alleged fraud, the OIP asserts, in part, that:

13. In 2006 and 2007, as the product engineer responsible for the Fund and certain of the related funds, Hopkins was responsible for drafting and updating offering documents and other communications about the Fund and related funds for investors and prospective investors. These offering documents and other communications stated that the Fund was sector-diversified and was an enhanced cash portfolio (or slightly more aggressive than a money market fund). In fact, the Fund was concentrated in subprime bond investments and derivatives tied to subprime investments. For example, in 2006 and 2007, the Fund's quarterly fact sheet for prospective and current investors stated:

The Limited Duration Bond Strategy utilizes an expanded universe of securities that goes beyond typical money markets including: Treasuries, agencies, collateralized mortgage obligations, adjustable rate mortgages, fixed rate mortgages, corporate bonds, asset backed securities, futures, options, and swaps… When compared to a typical 2 A-7 regulated money market portfolio, the Strategy has better sector diversification, higher average credit quality, and higher expected returns. The tradeoff is this fund purchases issues that are less liquid 4 than money market instruments and these instruments will have more price volatility. This Strategy should not be used for daily liquidity. Returns to the Strategy are more volatile over short horizons than traditional cash alternatives and may not benefit the short-term investor.

In 2006 and 2007, this language misled investors into believing that the Fund had better sector diversification than a typical money market portfolio, when in reality by that time the Fund held primarily subprime investments.
ALJ Initial Decision

Respondents defended against the charges through an SEC administrative hearing. The SEC Division of Enforcement sought orders imposing upon both Respondents a Cease-And-Desist and civil monetary penalties, and a Bar from association with any investment adviser or registered investment company.

Following an 11-day hearing before SEC Chief Administrative Law Judge Brenda P. Murray ("ALJ Murray"), she dismissed the proceeding and did not impose any remedial action. In the Matter of John P. Flannery and James D. Hopkins, Respondents (ALJ Initial Decision, Admin. Proc. File 3-14081 / October 28, 2011). In summarizing her findings in a 58-page Initial Decision, ALJ Murray explained [Ed: footnotes omitted]:

For the reasons stated above, I find that neither Flannery nor Hopkins was responsible for, or had ultimate authority over, the allegedly false and materially misleading documents at issue in this proceeding. Those documents include the LDBF Fact Sheets, Typical Portfolio Slide, the "reduction in ABX holdings" slide, and several 2007 letters sent to LDBF investors (March 2007, July 26, and August 2). Moreover, I find that these documents, as well as Hopkins' representation to Hammerstein on April 9, 2007, and Flannery's August 14 letter, did not contain materially false or misleading statements or material omissions. Because I find there were no materially false or misleading statements or omissions, there can also be no fraudulent "course of conduct" or "scheme liability."

Page 57 of the ALJ Initial Decision

SEC Opinion

The SEC Division of Enforcement appealed the ALJ Initial Decision. Although the SEC's Chair and Commissioners review of a proposed Initial Decision overwhelmingly results in approval, ALJ Murray's Initial Decision did not meet that typical fate. In the Matter of John P. Flannery and James D. Hopkins, Respondents (SEC Opinion, '33 Act Rel 9689; /34 Act Rel. 673840; Inv. Adv. Act Rel. 3981; Invst. Co. Act Rel 31374; and Admin. Proc. File 3-14081 / December 15, 2014).

In a split opinion (Chair White and Commissioner Aguilar and Stein constituting the Majority; Commissioners Gallagher and Piwowar the Dissent), the SEC rejected the ALJ Initial Decision and found that:

  • Respondent Flannery: willfully violated Section 17(a)(3) of the Securities Act of 1933 by defrauding Fund investors. The SEC suspended him for one year from association with any investment adviser or investment company. The SEC further imposed a Cease-And-Desist and a $6,500 civil money penalty;
  • Respondent Hopkins: willfully violated Section 17(a)(1) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Exchange Act Rule 10b-5 thereunder by misrepresenting material facts concerning the Fund. The SEC suspended him for one year from association with any investment adviser or investment company. The SEC further imposed a Cease-And-Desist and a $65,000 civil money penalty

In deciding to impose suspension, the SEC Majority offered, in part, this rationale [Ed: footnotes omitted]:

We find that it is in the public interest to suspend Hopkins and Flannery from associating with investment advisers or investment companies for one year. As to Hopkins, his conduct in violation of Section 17(a)(1) and Rule 10b-5 was an abuse of his responsibilities as a securities professional. He has refused to acknowledge the wrongful nature of that conduct; indeed, he has consistently insisted that he acted in the best interests of LDBF investors. He also has made no assurances against future violations. Thus, we are concerned that Hopkins will commit future violations of the securities laws and present a danger to investors if not subjected to a suspension.

As to Flannery, although he did not act with scienter, his misconduct spanned more than one communication and thus cannot be seen as a single lapse in judgment. He was a senior SSgA official responsible for client investments who, like Hopkins, abused his professional responsibilities. Moreover, Flannery too has never acknowledged the wrongful nature of his conduct or made assurances against future violations. Thus, we are similarly concerned about protecting investors from future violations and impose a one-year suspension.

In reaching this determination, we have considered factors that Respondents contend are mitigating. They argue, for instance, that the Division failed to show how many, or to what extent, investors were harmed by their actions. But the Division is not required to establish reliance or loss by any investor, and our decision that suspensions are warranted is not premised on investors having suffered financial losses. Respondents also note that they were not shown to have benefited personally from the fraud. But that is not a requirement for imposing a suspension and, in any event, we find that their misconduct was (at the very least) in furtherance of their lucrative careers as securities professionals. Finally, Respondents emphasize that they have had long careers as securities professionals without any prior disciplinary history. We have considered that fact in finding that it is in the public interest to impose the relatively lenient sanction of a one-year suspension as to both Hopkins and Flannery

Page 53 of the SEC Opinion

1Cir Opinion

Having seen the SEC Chair and two Commissioners snatch defeat from the jaws of the apparent ALJ Initial Decision victory, Flannery and Hopkins petitioned the United States Court of Appeals for the First Circuit ("1Cir") to review the SEC's Opinion. NOTE: The United States Chamber of Commerce file an amicus curiae brief in support of the Petitioners. John P. Flannery, Petitioner, v. Securities and Exchange Commission, Respondent (1Cir Opinion, No. 15-1080, December 8, 2015) -AND- James D. Hopkins, Petitioner, v. Securities and Exchange Commission, Respondent (1Cir Opinion, No. 15-1117, December 8, 2015).

In granting the petitions and vacating the SEC's Order, 1Cir preliminarily summarized its rationale as follows:

We conclude that the Commission's findings are not supported by substantial evidence. With regard to Hopkins, we find that the Division's materiality showing was marginal, and that there was not substantial evidence supporting scienter in the form of recklessness. With regard to Flannery, we conclude that at least the August 2 letter was not misleading, and therefore, as we explain, we need not reach the issue of whether the August 14 letter was misleading.

Pages 4 - 5 of the 1Cir Opinion

1Cir recognized the unusual circumstance in the appeals before it; namely, the SEC rejection by the SEC of the recommendations of its trier-of-fact:

When the Commission and the ALJ "reach different conclusions, . . . the [ALJ]'s findings and written decision are simply part of the record that the reviewing court must consider in determining whether the [SEC]'s decision is supported by substantial evidence." NLRB v. Int'l Bhd. of Teamsters, Local 251, 691 F.3d 49, 55 (1st Cir. 2012) (citing Universal Camera, 340 U.S. at 493). Because "evidence supporting a conclusion may be less substantial when an impartial, experienced examiner who has observed the witnesses and lived with the case has drawn conclusions different from the [Commission]'s than when [the ALJ] has reached the same conclusion," id. at 55 (quoting Universal Camera, 340 U.S. at 496), "where the [Commission] has reached a conclusion opposite of that of the ALJ, our review is slightly less deferential than it would be otherwise," id. (quoting Haas Elec., Inc. v. NLRB, 299 F.3d 23, 28-29 (1st Cir. 2002)).

Pages 16  17 of the 1Cir Opinion

SIDE BAR: 1Cir is making a critical point here; namely, that on review of a matter where there is a split between the trier-of-fact (the ALJ) and the body charged with confirming/rejecting/revising the trier-of-fact's recommended findings, the federal court does not necessarily exalt the ALJ's Initial Decision. To the contrary, 1Cir makes it clear that it respects the integrity of a commission process wherein ALJs conduct hearing, make recommendations, but the actual administrative decision is rendered by Commissioners. To that extent, 1Cir views the Initial Decision and the ALJ's findings as "simply part of the record." The focus for the appellate court is whether the SEC Chair and SEC Commissioners' Opinion was supported by "substantial evidence." 1Cir properly admonishes that when there is a split between the SEC and one of its ALJs, the appellate court will continue to respect the commission process but the legal and factual review is "slightly less deferential" to the SEC than would otherwise be the case.

Having reviewed the record, 1Cir demonstrates that it was, in fact, less deferential to the SEC Majority. As to Flannery's role with the August 2nd letter. 1Cir noted:

The Commission's primary reason for finding the August 2 letter misleading was its view that the "LDBF'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.

Page 25 of 1Cir Opinion

In further analysis of the August 2nd letter, 1Cir pointedly explains that:

Independently, the Commission has misread the letter. The August 2 letter did not claim to have reduced risk in the LDBF. 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 [LDBF] simultaneously reduced risk in other SSgA active fixed income and active derivative-based strategies," misled investors into thinking SSgA reduced the LDBF'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 LDBF.

Page 27 of the 1Cir Opinion

In addition to clearly noting that it was declining to address the August 14th letter, 1Cir offers yet one more fillip concerning the August 2nd letter:

Finally, we note that the Commission has failed to identify a single witness that supports a finding of materiality. Cf. SEC v. Phan, 500 F.3d 895, 910 (9th Cir. 2007) ("The SEC, which both bears the burden of proof and is the party moving for summary judgment, submitted no evidence to the district court demonstrating the materiality of the misstatement about the payment terms."). We do not think the letter was misleading, and we find no substantial evidence supporting a conclusion otherwise.

Page 29 of the 1Cir Opinion

As to the SEC Opinion's findings of fraud by Hopkins, 1Cir found that:

Given the evidence weighing against the materiality of the portion of the slide to which the SEC objects, we cannot say there is substantial evidence that Hopkins's presentation of a slide containing sector breakdowns labeled "typical," with notes of the actual sector breakdown ready at hand, constitutes "a highly unreasonable [action], involving not merely simple, or even inexcusable[] negligence, but an extreme departure from the standards of ordinary care . . . that is either known to [Hopkins] or is so obvious [Hopkins] must have been aware of it." Ficken, 546 F.3d at 47-48 (second alteration in original) (quoting SEC v. Fife, 311 F.3d 1, 9-10 (1st Cir. 2002)). We conclude that the Commission abused its discretion in holding Hopkins liable under Section 17(a)(1), Section 10(b), and Rule 10b-5.

Page 24 of the 1Cir Opinion


And what better song to end all this disagreement among the Respondents, Division of Enforcement, the ALJ, the Majority, the Dissent, and the First Circuit: