First Circuit Reverses SEC In State Street Bank Case

The long ordeal of two former employees of State Street Bank and Trust Company appears to have come to an end. Initially charged by the SEC with making false statements in the mist of the market crisis, the Administrative Law Judge found against the Division and dismissed the charges based largely on an application of the Supreme Court’s decision in Janus.

The Commission reversed in a 3-2 decision, concluding that James Hopkins, formerly the vice president and head of North American Product Engineering, had made one false statement in one slide used for presentations and had thus violated Securities Act Section 17(a)(1) and Exchange Act Section 10(b). John Flannery, formerly the chief investment officer, was responsible for two misleading letters and thus violated Securities Act Section 17(a)(3). Those decisions were reversed by the First Circuit Court of Appeals. Flannery v. SEC, Nos. 15-1080 & 15-1117 (1st Cir. December 8, 2015).


The initial proceeding centered a series of claimed false statements made by the two men that supposedly mislead investors about the extent of subprime mortgage-backed securities held in certain unregistered funds under State Street’s management. As a result of those false and misleading statements investors continued to purchase shares in the funds or maintain their positions as the market crisis unfolded and the sub-prime market unraveled.

According to the Order, by 2007 the fund was almost entirely invested in, or exposed to, the subprime market. The Respondents, however, continued to describe it in various materials and statements as having better sector diversification than a typical money market fund. They failed to inform investors about the extent of its exposure to sub-prime investments. Offering materials for the fund such as quarterly fact sheets, presentations to current and prospective investors, and responses to investor requests for proposal were misleading because they omitted material about the exposure of the fund to the sub-prime market. Mr. Hopkins was responsible for these materials the Order alleged.

A series of shareholder communications were also false and misleading because they failed to inform investors about the fund’s concentration in subprime. Messrs. Hopkins and Flannery played an instrumental role in drafting the misrepresentation in these communications, according to the Order.

As the market crisis evolved State Street’s internal advisory groups decided to redeem or recommend redemption from the fund for their clients. State Street Corporation’s pension plan was one of those clients. Mr. Flannery and the investment committee sold the fund’s most liquid assets and use the cash to redeem shares for what the Order calls “better informed” investors. The fund was left with largely illiquid holdings. The Order alleged violations of Sections 17(a) and 10(b).

Circuit court

The circuit court decision turns the question of whether there was substantial evidence to support the findings of the Commission as well as questions of materiality. The slide was part of a presentation used by Mr. Hopkins for potential investors. It contained a number of statistic regarding assets classes and was labeled Typical Portfolio – it did not represent any one fund but provided a general overview. At the time of the presentation in question Mr. Hopkins had not updated the concentration numbers on the slide which would have shown an increase in ABS held.

In reviewing the Commission’s finding the court assumed that the Typical Portfolio slide was misleading. The court also assumed that Mr. Hopkins used the slide in his presentations. But in view of the totality of the facts which demonstrated that the slide was just one of 20, that update information was available and that the slide was actually a generic and not representative of any specific fund the court concluded that “This thin materiality showing cannot support a finding of scienter. . .” Indeed, Mr. Hopkins testified that in his experience investors did not focus on sector breakdown when making their investment decisions and there was no contrary evidence. Accordingly, the SEC’s determination was found not to be supported by substantial evidence.

The court reached a similar conclusion as to Mr. Flannery. The determination focused on two letters that the SEC found misleading when when considered together because they encouraged investors to hold their shares even though the firm’s own funds and internal advisory group clients were selling.

The court concluded that the first letter was not misleading even when considered with the second. The SEC focused on an assertion in the first letter that the sale of certain AAA rated securities did not reduce the risk of the fund. The Commission claimed this was false because it left lower grade securities thus increasing the risk. Expert testimony established otherwise based on the overall composition of the portfolio.

Perhaps more importantly, “the Commission has misread the letter,” according to the circuit court. And, at oral argument counsel for the SEC acknowledged that no specific sentence in the letter was inaccurate.” Since the first letter was not inaccurate, and one incorrect statement is not sufficient to violate Section 17(a)(3), the court did not analyze the second. Ultimately the court concluded that “We do not thin the letter was misleading and we find no substantial evidence supporting a conclusion otherwise.”


The reversal of the SEC’s conclusions here for a lack of evidence is a substantial set-back for the agency. Frequently the SEC defends these types of actions asserting that Chevron deference is due to its legal positions, effectively insulating them from review, and that its findings of fact are protected by the substantial evidence requirement of the Administrative Procedure Act. It is rare for a court to second-guess the determinations of the agency in view of these standards, particularly on the evidence. The loss here, coupled with the history of the action, more that suggests over-reaching by the SEC. Perhaps in the future more careful consideration will be given to be given to enforcement decisions before persons are forced to face the years long ordeal of an enforcement action.

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