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Flannery v. Securities & Exchange Commission

United States Court of Appeals, First Circuit

December 8, 2015

JOHN P. FLANNERY, Petitioner,


Mark W. Pearlstein, with whom Laura McLane, Fredric D. Firestone, David H. Chen, and McDermott Will & Emery LLP were on brief, for petitioner John P. Flannery.

John F. Sylvia, with whom Andrew N. Nathanson, Jessica C. Sergi, and Mintz Levin Cohn Ferris Glovsky & Popeo PC were on brief, for petitioner James D. Hopkins.

Lisa K. Helvin, Senior Counsel, with whom Michael A. Conley, Deputy General Counsel, John W. Avery, Deputy Solicitor, and Benjamin L. Schiffrin, Senior Litigation Counsel, Securities and Exchange Commission, were on brief, for respondent.

Jonathan G. Cedarbaum, Christopher Davies, Daniel Aguilar, John Byrnes, Wilmer Cutler Pickering Hale and Dorr LLP, Kate Comerford Todd, Steven P. Lehotsky, and U.S. Chamber Litigation Center, Inc., on brief for the Chamber of Commerce of the United States of America, amicus curiae in support of petitioners.

Before Lynch, Stahl, and Kayatta, Circuit Judges.

LYNCH, Circuit Judge.

In 2010, the United States Securities and Exchange Commission ("SEC" or "Commission") issued an Order Instituting Proceedings against two former employees of State Street Bank and Trust Company ("State Street"): (1) James D. Hopkins, a former vice president and head of North American Product Engineering, and (2) John P. Flannery, a former chief investment officer ("CIO"). The Commission alleged that during the 2007 subprime mortgage crisis, Hopkins and Flannery "engaged in a course of business and made material misrepresentations and omissions that misled investors" about two substantially identical State Street–managed funds collectively known as the Limited Duration Bond Fund ("LDBF"). Hopkins and Flannery were charged with violating Section 17(a) of the Securities Act of 1933 (15 U.S.C. § 77q(a)), Section 10(b) of the Securities Exchange Act of 1934 (15 U.S.C. § 78j(b)), and Exchange Act Rule 10b-5 (17 C.F.R. § 240.10b-5). After an eleven-day hearing, involving nineteen witnesses and about five hundred exhibits, the SEC's Chief Administrative Law Judge ("ALJ") dismissed the proceeding, finding that neither Hopkins nor Flannery was responsible for, or had ultimate authority over, the documents at issue and that these documents did not contain materially false or misleading statements or omissions.

The SEC Division of Enforcement ("Division") appealed the ALJ's decision to the Commission. In 2014, the Commission, in a 3-2 decision, reversed the ALJ with regard to a slide that Hopkins used at a May 10, 2007, presentation to a group of investors, and two letters, dated August 2 and August 14, 2007, that Flannery wrote or had seen before they were sent to investors. See In re John P. Flannery & James D. Hopkins, Securities Act Release No. 9689, Exchange Act Release No. 73, 840, Investment Company Act Release No. 31, 374, 2014 WL 7145625 (Dec. 15, 2014). The Commission found Hopkins liable under Securities Act Section 17(a)(1) ("Section 17(a)(1)"), Securities Exchange Act Section 10(b) ("Section 10(b)"), and Exchange Act Rule 10b-5 ("Rule 10b-5"); it found Flannery liable under Securities Act Section 17(a)(3) ("Section 17(a)(3)"). The Commission imposed cease-and-desist orders on Hopkins and Flannery, suspended Hopkins and Flannery from association with any investment adviser or company for one year, imposed a $65, 000 civil monetary penalty on Hopkins, and imposed a $6, 500 civil monetary penalty on Flannery. These petitions for review followed.

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. We grant the petitions for review and vacate the Commission's order.


We take the underlying facts from the record before the Commission. See Rizek v. SEC, 215 F.3d 157, 159 (1st Cir. 2000).

State Street Global Advisors ("SSgA") is the investment management arm of State Street Corporation.[1] It advises and manages State Street–affiliated registered mutual funds and unregistered collective trust funds.[2] On March 1, 2002, SSgA created the LDBF, a combination of two unregistered fixed-income funds that were invested in various fixed-income products. The LDBF was offered and sold only to institutional investors. Investments in the LDBF came from three sources: first, other State Street funds invested directly in the LDBF; second, clients of internal advisory groups invested in the LDBF based on SSgA's recommendation to those groups; and third, independent institutional investors invested directly in the LDBF.

The LDBF was heavily invested in asset-backed securities ("ABS"), which included residential mortgage-backed securities ("RMBS"). Until 2007, the LDBF had outperformed its benchmark index. In January and February 2007, it underperformed its benchmark index because of its investment in certain lower-rated securities. April and May 2007, however, were two of the best months in the LDBF's history. Then, beginning in June 2007, during the subprime mortgage crisis, the LDBF experienced substantial underperformance. The Division's charges against Hopkins and Flannery involve communications about the LDBF that Hopkins and Flannery either made or were involved with in 2007.

A. Vice President Hopkins

Hopkins worked at State Street from 1998 until 2010, when he was offered retirement as a result of the SEC proceeding. From 2006 to 2007, he was a vice president and head of North American Product Engineering. During that time, Hopkins was the senior product engineer responsible for fixed-income funds, including the LDBF. He served as a liaison between the portfolio managers and the client-facing people, which included salespeople and consultant relations people. Hopkins was one of several people that would make presentations to potential clients. He was also responsible for correcting inaccuracies in LDBF "fact sheets, " two-page quarterly documents made available to clients and prospective clients that showed the LDBF's strategy and performance numbers. Apart from the SEC charges, Hopkins worked in the securities industry for thirty-five years with an unblemished record.

SSgA used a standard PowerPoint presentation when presenting information about the LDBF. In 2006 and 2007, this presentation included a slide titled "Typical Portfolio Exposures and Characteristics -- Limited Duration Bond Strategy" ("Typical Portfolio Slide"). We describe the slide:

Under the slide title, it read:
• Exposure to non-correlated fixed income asset classes
• High quality
• No interest rate risk

Below, it had a box containing the ...

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