SEC Loses Controversial Flannery Appeal

Ruling Shows a Federal Court Appeal is an Important Check Against SEC Overreach, but also that a Politicized SEC Can PushInnocent Professionals Out of the Business

The SEC lost the appeal of its controversial Flannery decision, which had been widely criticized as politicized SEC overreach because the Commission rejected the decision of its own Chief Administrative Law Judge - and two Republican SEC commissioners - in finding two State Street executives liable for securities fraud.

The U.S. Court of Appeals for the First Circuit handed the SEC a major loss in a controversial case, Flannery v. S.E.C.,[1] in which the SEC had previously reversed a decision by its own in-house Chief Administrative Law Judge ("ALJ") that rejected liability for two State Street executives. The First Circuit found that the SEC's case failed the "substantial evidence" test for upholding SEC factual findings of liability. This is a stinging rebuke to the SEC, because the substantial evidence test is "highly deferential to the agency fact-finder"[2] and decisions are rarely overturned on this ground.

In Flannery, the SEC charged a Chief Investment Officer (CIO) and Vice President of State Street Global Advisers ("SSGA") with materially misrepresenting the extent of subprime mortgage back securities exposure in the State Street Limited Duration Bond Fund (the "Fund"). But the SEC's own Chief Administrative Law Judge, Brenda Murray, rejected the SEC's charges on two grounds. First, Chief Judge Murray held that the statements were not materially misleading, largely because the challenged statements were subjective or technically true statements that the SEC was attacking for omitting warnings about subprime risk. Second, she held the two executives were not liable for the statements - primarily Fund fact sheets and Powerpoint slides - because they did not have ultimate authority over the content of those documents. Instead, other employees made the final decision on the content of statements.[3]

At first, the Flannery Initial Decision was lauded as proof that SEC in-house administrative proceedings were fair. But all that changed when the SEC appealed the decision to the five-member Commission itself. In a shocking turn of events, the Commission reversed its own Chief ALJ over three years later, ruling both that (i) the statements at issue were materially misleading, and (ii) the two executives could be held liable for the statements because they substantially participated in drafting them.[4] The Commission's decision was as partisan as it was shocking, with the two Republican Commissioners (Gallagher and Piwowar) dissenting from the decision of the three Democratic Commissioners (Chair White, Aguilar and Stein). It also was devastating for the executives: It suspended each of them from the investment advisory business for a year, and imposed a total of $70,000 in civil penalties.

The First Circuit vacated the SEC's politicized decision, holding that it failed to meet even a highly deferential standard of review. The Court criticized the SEC's evidence as "thin" and "marginal" as to one executive.[5] As to the other, the Court ruled that his main statement at issue was not misleading. In short, the Court rejected the factual premise of the SEC's entire case.

Sadly, the First Circuit's decision was cold comfort to the two State Street executives, both of whom suffered the "loss of their careers" as a result of their SEC legal battle.[6] Both executives were "effectively locked out of the industry," while their case was pending, apparently because firms did not want to risk of employing a person with a pending SEC case. It took the executives over five years and two months from the time the SEC filed charges to get a federal court to rule in their favor. Given the Court's ruling, it is fair to wonder whether America's securities professionals deserve better than the risk of losing their careers due to a politicized and controversial regulator.

Key Takeways: The Flannery Case illustrates five important points • Federal Courts Are An Important Check Against SEC Overreach: The First Circuit's decision proves that defendants are more likely to get a fair hearing in federal court. Clients should not overlook using federal courts to appeal SEC decisions or to challenge the constitutionality of SEC in-house proceedings before they even start. • Politicized Justice is Bad Justice: The highly partisan and fractured SEC decision led to a bad ruling. The SEC's refusal to reach a consensus with its Republican Commissioners (and Chief ALJ) made its decision more controversial, and thus made it more likely to get reversed on appeal. Invoking politics may be a successful negotiating tool in the future. • The SEC's In-House Courts are Perilous for Securities Professionals: SEC in-house decisions are both more likely to rule in the SEC's favor and easier for the SEC to successfully appeal in the rare cases where it loses. And it can take many years to get federal court review. Clients facing an SEC in-house action should strongly consider raising constitutional claims to enjoin in-house cases, and early settlement options. • Sometimes Winning is Really Losing: The State Street executives might have gotten a better result if they settled with the SEC. The SEC's ruling imposing only $70,000 in fines and a one-year suspension, suggesting that it might have required less to settle - and certainly less than the five-plus years during which the executives were effectively locked out of the industry. Often, the SEC makes a favorable - and palatable - settlement offer right before trial, which does not require admitting any allegations. • SEC Investigations Have Higher Stakes Than Ever: That the State Street Executives were effectively forced out of the industry even though they were innocent proves that more is at stake than ever in SEC investigations. It is thus critical for clients to retain counsel for any SEC interaction, no matter how innocent you think you are. The SEC might still bring a case - and where will your career be when the dust setlles? If you have questions about this Alert, please contact Sam Lieberman at 212.573.8164 or ----

[1] 2015 WL 8121647, --- F.3d ---- (1st Cir., Dec. 8, 2015), [2] Koch v. S.E.C., 793 F.3d 147, 156 (D.C. Cir. 2015) [3] In the Matter of Flannery et ano., Adv. Pro. No. 3-14081, Init. Rel. No. 438 (Oct. 28, 2011), available at [4] In the Matter of Flannery et ano., Adv. Pro. No. 3-14081, Sec. Rel. No. 9689 (Dec. 15, 2014), [5] 2015 WL 8121647, at *7-*8. [6] J. Eaglesham, "SEC Appeals Process on the Slow Track," (Wall St. J., Dec. 21, 2015)
Cheryl Spratt