The First Circuit's Flannery Decision Leaves Unresolved the Validity of the SEC's Attempt to Expand the Reach of Sections 10(b) AND 17(a)

Originally appeared in Bloomberg BNA's Securities Regulation & Law Report on February 15, 2016.

There has been genuine delight among the securities defense bar with the First Circuit's decision in Flannery v. SEC,1and its reversal of the decision of the Securities and Exchange Commission (the "SEC") on the ground that there was no factual basis to hold two employees of State Street Global Advisors liable for a violation of both the Securities Act of 1933 (the "1933 Act") and the Securities Exchange Act of 1934 (the "1934 Act"). Notwithstanding that positive result, the First Circuit failed to address the more troubling aspect of the SEC's December 2014 decision vacating the finding of the administrative law judge and imposing liability on the two individuals.

Specifically, in its decision, the SEC took an overbroad and expansive view of Section 10(b) of the 1934 Act and Section 17 of the 1933 Act. Yet, when rejecting the SEC's factual findings, the First Circuit did not address the SEC's holdings regarding those two provisions. So, while the First Circuit's decision underscores the burden of proof that the SEC bears in an in-house enforcement proceeding, it does not prevent the SEC (until checked by another appellate court) from disregarding contrary judicial holdings and asserting an overbroad interpretation of the anti-fraud provisions in both the 1933 and 1934 Acts.

As is well known, over the last several years, the United States Supreme Court has meaningfully circumscribed the scope of liability under the 1934 Act, rejecting the broad interpretation that the SEC had given to the antifraud provisions. The most recent decision among that group is Janus Capital Group v. First Derivative Traders,2 in which the Supreme Court restricted the definition of who is a maker of a false statement under Section 10(b) of the 1934 Act.

Not surprisingly, the SEC has chafed at the limitations put on its enforcement authority, and has attempted to construe the decisions of the Supreme Court and various Courts of Appeal narrowly. The SEC's decision in In re Flannery3 is the most forceful attempt at achieving that goal. In its Flannery decision, the SEC adopted a sweeping view of both Section 10(b) of the 1934 Act and Section 17(a) of the 1933 Act.

The two respondents, John Flannery and James Hopkins, appealed from that decision to the First Circuit, which granted review and vacated the SEC's order. The First Circuit rejected the SEC's attempt to follow its own path and to impose liability and sanctions, contrary to the findings and conclusions of its in-house administrative law judge. Specifically, the court subjected the SEC's ruling to a searching review of the record and rejected the flimsy basis for the SEC's findings of materiality and scienter. The court discussed the legal standards for materiality and scienter, but not the SEC's rulings regarding the scope of Section 10(b) of the 1934 Act or Section 17(a) of the 1933 Act.

Background

The two respondents, James Hopkins and John Flannery, worked for State Street Global Advisors ("State Street"). Among Hopkins' job responsibilities as a "product engineer" was communicating directly with investors in one of State Street's bond funds. Flannery was State Street's fixed income chief investment officer, and participated in the preparation and signing of letters to investors of that fund.

The SEC brought charges against each of them under Section 10(b) and Section 17(a) with respect to communications made in connection with the offer and sale of State Street's Limited Duration Bond Fund. In October 2011, after an 11-day hearing, the administrative law judge dismissed all of the claims against each individual. The administrative law judge specifically held that Supreme Court's ruling in Janus applied to each of the subparagraphs in Section 17(a) and Rule 10b-5 when the alleged violations were based solely on misstatements.4 Based on the evidence and its application of Janus, the administrative law judge held that the individuals were responsible for only one of the alleged misrepresentations.5 And as to that statement, the administrative law judge found that the statement was not a material misrepresentation.6 Accordingly, the administrative law judge dismissed all of the charges.7

The SEC's Decision

On review, the SEC overruled the administrative law judge's rulings in part and imposed liability. The SEC wrote, in effect, its own de novo opinion with respect to the alleged misrepresentations, and held that each individual violated Section 17(a) and Section 10(b).

The SEC rejected the administrative law judge's holding that Janus applied to claims of misrepresentations under all of the subparagraphs of Section 17(a) and Rule 10b-5. The SEC also rejected several of the administrative law judge's factual findings and held that certain statements were material misrepresentations, either made with scienter or as a result of negligence.

With respect to Janus, even though the alleged misconduct concerned only misrepresentations, the SEC specifically limited the Janus ruling to Rule 10b-5(b), and held that Janus did not apply to subparagraphs (a) and (c) of Rule 10b-5 because neither of those paragraphs contain the word "make," as does subparagraph (b).8 Similarly, the SEC held that Janus does not apply to any of the subparagraphs of Section 17(a), even with respect to subparagraph (2) (which courts have held prohibits the same conduct and activity as subparagraph (b) of Rule 10b-5 does).9

The SEC's interpretation of the elements of subparagraphs (a) and (c) of Rule 10b-5 has pushed the breadth of those two subparagraphs to the extreme. The SEC held that those two subparagraphs also embrace the making of misstatements, thereby permitting the SEC to charge an individual for violation of one of those two subparagraphs instead of subparagraph (b) and to evade the "maker" restriction set forth in the statute that the Supreme Court enforced in Janus. The SEC relied on a truncated and misleading quotation of snippets of the Supreme Court's analysis in Janus to justify its rejection of rulings of the federal courts to the contrary.10 Further, according to the SEC, the subparagraphs of Rule 10b-5 are to be read flexibly to effectuate the 1934 Act's remedial purposes.11

The SEC further concluded that it can impose liability under subparagraph (a) or (c) bound solely on a misrepresentation, and that such a result is not inconsistent with the Supreme Court's ruling in Central Bank of Denver, N.A. v. First Interstate Bank of Denver.12 The SEC asserted that the various federal courts that have readCentral Bank to the contrary have gotten it wrong and that the SEC, in its...