1st Circuit Hands SEC Major Reversal While SEC Doubles Down on In-House Courts

As we reported last year, the SEC has substantially increased its use of in-house administrative proceedings before SEC-employed Administrative Law Judges (“ALJs”). Appeals from the ALJs’ decisions are then reviewed by the SEC’s own commissioners. But the SEC cannot entirely remove itself from the jurisdiction of the federal courts—and the 1st Circuit recently handed the SEC a significant reversal, reminding the SEC it has to play by the rules, even in its own in-house courts.

In Flannery v. SEC, Nos. 15-1080, 15-1117 (1st Cir. Dec. 8, 2015), the 1st Circuit reversed the SEC’s order imposing sanctions against James Hopkins and John Flannery of State Street Global Advisors (“State Street”) for securities violations during the 2007 subprime mortgage crisis. The 1st Circuit’s decision explores the limits of court deference to Commission decisions, gives teeth to the “substantial evidence” standard of review, and provides a useful roadmap for evaluating and defending allegations of material misstatements in securities cases.

In 2010, the SEC instituted proceedings against Hopkins (a former State Street vice president) and Flannery (a former chief investment officer) based on allegedly misleading communications to investors in a State Street-managed fund. Following an 11-day hearing, involving testimony from 19 witnesses, the ALJ issued a 58-page decision finding neither Hopkins nor Flannery made any false or misleading statements. The decision was a rare defeat for the SEC in its in-house courts (in which it has a 90% success rate).

The SEC’s Division of Enforcement appealed the ALJ’s decision to the five-member Commission. Three years later, the commissioners issued a 3-2 decision reversing the ALJ. As to Hopkins, the Commission determined that a single slide in a presentation he had given to a group of investors was materially misleading regarding the percent of the fund invested in asset-backed securities. As to Flannery, the Commission found he was liable to misstatements in two letters. Both men were suspended for one year from association with any investment adviser or company and assessed a civil monetary penalty.

Hopkins and Flannery appealed to the 1st Circuit, which reversed. The Court found the SEC’s showing of materiality related to the single slide in Hopkins’ presentation was “marginal” and the SEC failed to demonstrate he acted with scienter. As to Flannery, the Court concluded one of the two letters cited by the Commission was not misleading, and even assuming the other letter might have been, the single alleged misstatement was not sufficient to hold Flannery liable under the relevant law (which required a course of dealing).

Two aspects of the Court’s decision were of particular interest to observers of the SEC’s increased use of in-house courts. First, the Court’s stringent review gave the Commission less deference than we have come to expect of a “substantial evidence” standard of review. The Court rejected a number of key factual findings by the Commission and explained how the Commission “misread” one of the communications at issue. Second, the Court focused on context when evaluating materiality and scienter. Although the Court acknowledged a single misleading statement could be actionable under certain securities laws, it reminded the SEC that materiality and scienter must be considered in the context of the presentation or statement at issue and the other information readily available to investors.

While this loss gives hope to individuals and companies facing the SEC’s in-house courts, we will have to wait and see if other courts follow the 1st Circuit and engage in a searching inquiry of decisions coming out of the SEC. Meanwhile, the SEC continues to bring civil enforcement actions in its in-house courts despite the continuing constitutional challenges the system faces. The 4th Circuit recently refused to block the SEC’s administrative action pending an appeal challenging the constitutionality of the process. See Bennett v. SEC, No. 15-2584 (4th Cir. Jan. 22, 2016). The 4th Circuit may be foreshadowing that it will join the 7th and D.C. Circuits in refusing to consider challenges to the SEC in-house court’s constitutionality while an administrative claim is underway. In contrast, the 2nd Circuit in September froze a contested administrative proceeding so that it could consider the issues surrounding the SEC’s in-house court. A district court judge in Georgia has likewise stayed several SEC administrative proceedings, finding that the agency’s in-house court is likely unconstitutional. See Ironridge Global IV v. SEC, No. 15-cv-2512 (N.D. Ga. Nov. 17, 2015); Gray Fin. Grp. Inc. v. SEC, No. 15-cv-492 (N.D. Ga. Aug. 4, 2015); Hill v. SEC, 15-cv-1801 (N.D. Ga. June 8, 2015). The SEC has appealed the judge’s rulings to the 11th Circuit.