Investment fund executives vindicated by First Circuit's reversing SEC on scienter and non-misleading statements



December 11, 2015

Securities Litigation Alert

Author(s): George J. Skelly, Eric Walz

Investment fund executives’ cherry-picked statements are not always misleading or material. The First Circuit vacated an SEC ruling and provided expanded options in the defense of SEC enforcement actions. This alert discusses the details of the action and key takeaways for executives, advisors and their attorneys.

Securities and Exchange Commission (“SEC”) Chief Administrative Law Judge Brenda Murray surprised securities litigators in 2010 when she dismissed an Enforcement Division’s proceeding against two former State Street executives accused of misleading investors. There, the SEC Enforcement Division had claimed that the two fund executives misled investors while respectively presenting a slideshow and sending two letters to institutional investors concerning a particular bond fund (the “Fund”) in May 2007. But then, in a controversial three-to-two decision handed down last year, the Commission reversed Judge Murray, fined the executives and suspended both from associating with an investment advisor for a period of one year. In its reversal, the Commission concluded that the first executive acted with scienter by presenting materially misleading information concerning the Fund’s “typical” asset composition that differed from its actual asset composition. The Commission further concluded that the second executive was twice negligent in approving letters containing materially misleading information and thus, as a matter of law, engaged in a “course of business” that deceived investors in violation of Section 17(a)(3) of the Securities Act of 1933.

On Tuesday, the First Circuit vacated that ruling and held that the Commission abused its discretion in finding that “substantial evidence” supported a finding that either executive made or approved materially misleading statements. As to the first executive, the First Circuit began by noting that materiality and scienter are intertwined. Observing that a person would not intentionally or with extreme recklessness hide immaterial or marginally material information, the First Circuit analyzed whether the allegedly undisclosed information was material. During a presentation, the first executive allegedly did not disclose a known change in the diversification of Fund assets from what had been presented as the “typical” percentage of asset-backed securities to the actual, much larger, percentage. To prove its case, the Commission called a single witness who testified that the diversification of assets presented was “important to him.” However, he drafted a report the following day in which he failed to mention the fund’s diversification.

Additionally, despite the Commission’s assertions that the presentation was material and misleading, readily available fact sheets showed the Fund’s actual diversification. Moreover, the executive’s experts testified that a fund’s advertised “typical” makeup is only a starting point for investors to perform their due diligence, and the executive testified that he did not believe the asset diversification was material. Concluding that there was not substantial evidence to support the Commission’s conclusion that asset diversification was material under the circumstances, the First Circuit held that the Commission abused its discretion in finding that the first executive acted with scienter.

As to the second executive, the Commission had found that he negligently approved two materially misleading letters that were sent to institutional investors. The first letter stated that the Fund’s sale of AAA-rated assets was one of many “steps to seek to reduce risk across” certain portfolios, and also that the sale “simultaneously reduced risk in other [funds].” According to the Commission, these statements downplayed the Fund’s risk and encouraged investors to hold their shares while other State Street funds were reducing holdings in the Fund.

But the First Circuit disagreed, first by noting that the Commission failed to present substantial evidence that the Fund was at a greater risk after the AAA-asset sale than it would have been if the sale had not occurred. Second, the First Circuit pointedly underscored that the Commission ignored the word “other” when it concluded that the second statement misled investors into believing that the sale reduced the particular Fund’s risks, as opposed to risks for “other” fund strategies. Finally, the court noted the second executive presented substantial evidence that State Street had acted consistently with an attempt to reduce the risk profile of the affected portfolios. Having concluded that the Commission did not present substantial evidence of a misleading statement, the court did not reach the question of materiality. Nor did the court reach the second letter. Instead, the court abided by the Commission’s own reading of Section 17(a)(3) that a single misrepresentation could not be a “practice” or “course of business” sufficient to violate the section. Having concluded that the first letter was not misleading, the First Circuit held that there was not substantial evidence to support a violation of Section 17(a)(3).

By vacating the Commission’s ruling on rarely seen abuse of discretion grounds, the First Circuit has presented defense attorneys with guideposts to be used when defending against enforcement actions. First, the court reasserted the important relationship that materiality plays in analyzing and proving scienter. Weak materiality arguments should lead defense counsel to strongly oppose a prosecutor’s or the SEC’s scienter argument. Second, defense counsel should note that the Commission’s interpretation of Section 17(a)(3) requires “repeated” misstatements. Thus, in certain fact patterns, it may be possible to avoid liability under Section 17(a)(3) by disproving some but not all alleged misstatements.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

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