Opinion ID: 3160896
Heading Depth: 2
Heading Rank: 2

Heading: Flannery

Text: Section 17(a)(3) deems it unlawful for any person in the offer or sale of any securities . . . to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser. 15 U.S.C. § 77q(a)(3). [N]egligence is sufficient to establish liability under . . . § 17(a)(3). Ficken, 546 F.3d at 47. The Commission concluded that the August 2 and August 14 letters were materially misleading, particularly when their - 24 - cumulative effect is taken into account. It found that [w]hen considered together -- and as part of a larger effort to convince investors to remain in the poorly performing LDBF -- the letters misleadingly downplayed LDBF's risk and encouraged investors to hold onto their shares, even though SSgA's own funds and internal advisory group clients were fleeing the fund. We disagree. At the very least, the August 2 letter was not misleading -- even when considered with the August 14 letter -- and so there was not substantial evidence to support the Commission's finding that Flannery was liable for having engaged in a 'course of business' that operated as a fraud on LDBF investors.12 The Commission's primary reason for finding the August 2 letter misleading was its view that the LDBF's sale of the AAArated securities did not reduce risk in the fund. Rather, the sale ultimately increased both the fund's credit risk and its liquidity risk because the securities that remained in the fund had a lower credit rating and were less liquid than those that were sold. At the outset, we note that neither of the Commission's assertions -- that the sale increased the fund's credit risk and increased its liquidity risk -- are supported by substantial evidence. 12 In light of this conclusion, we do not reach Flannery's argument that the Commission's interpretation of Section 17(a)(3) as applying to misstatements is incorrect. - 25 - First, although credit rating alone does not necessarily measure a portfolio's risk, the Commission does not dispute the truth of the letter's statement that the LDBF maintained an average AA-credit quality. Second, expert testimony presented at the proceeding explained that the July 26 AAA-rated bond sale reduced risk because these bonds entailed credit and market risk that were substantially greater than those of cash positions. In addition, a portion of the sale proceeds was used to pay down [repurchase agreement] loans and reduce the portfolio leverage. Further, testimony throughout the proceeding indicated that the LDBF's bond sales in July and August reduced risk by decreasing exposure to the subprime residential market, by reducing leverage, and by increasing liquidity, part of which was used to repay loans. To be sure, the Commission maintained that the bond sale's potentially beneficial effects on the fund's liquidity risk were immediately undermined by the massive outflows of the sale proceeds . . . to early redeemers. But this reasoning falters for two reasons. First, the Commission acknowledged that between $175 and $195 million of the cash proceeds remained in the LDBF as of the time the letter was sent; it offered no reason, however, why this level of cash holdings provided an insufficient liquidity cushion. Second and more fundamentally, even if the Commission was correct that the liquidity risk in the LDBF was higher following the sale than it was prior to the sale, it does not - 26 - follow that the sale failed to reduce risk. Rather, to treat as misleading the statement in the August 2 letter that State Street had reduced risk, the Commission would need to demonstrate that the liquidity risk in the LDBF following the sale was higher than it would have been in the counterfactual world in which the financial crisis had continued to roil -- and in which large numbers of investors likely would have sought redemption -- and the LDBF had not sold its AAA holdings. But the Commission has not done this. Independently, the Commission has misread the letter. The August 2 letter did not claim to have reduced risk in the LDBF. The letter states that the downdraft in valuations has had a significant impact on the risk profile of our portfolios, prompting us to take steps to seek to reduce risk across the affected portfolios (emphasis added). Indeed, at oral argument, the Commission acknowledged that there was no particular sentence in the letter that was inaccurate. It contends that the statement, [t]he actions we have taken to date in the [LDBF] simultaneously reduced risk in other SSgA active fixed income and active derivative-based strategies, misled investors into thinking SSgA reduced the LDBF's risk profile. This argument ignores the word other. The letter was sent to clients in at least twenty-one other funds, and, if anything, speaks to having reduced risk in funds other than the LDBF. - 27 - Even beyond that, there is not substantial evidence that SSgA did not seek to reduce risk across the affected portfolios. As one expert testified, there are different types of risk associated with a fund like the LDBF, including market risk, liquidity risk, and credit or default risk. The LDBF was facing a liquidity problem, and at the July 25 meeting, Michael Wands, the Director of Active North American Fixed Income, explained that [i]t's hard to predict if the market will hold on or if there will be a large number of withdrawals by clients. We need to have liquidity should the clients decide to withdraw. Flannery noted that if [they didn't] raise liquidity [they] face[d] a greater unknown. Robert Pickett, the LDBF's lead portfolio manager, noted that selling only AAA-rated bonds would affect the LDBF's risk profile. After discussion of both of these concerns, the Investment Committee ultimately decided to increase liquidity, sell a pro-rata share to warrant withdrawals, and reduce AA exposure. And that is what it did. On July 26 and 27, 2007, LDBF's portfolio management team sold approximately $1.6 billion in AAA-rated bonds and about $200 million in AA-rated bonds; between approximately July 31 and August 24, 2007, it sold about $1.2 billion of AA-rated bonds; and on August 7 and 8, 2007, it sold about $100 million of A-rated bonds. The August 2 letter does not try to hide the sale of the AAA-rated bonds; it candidly acknowledges it. At the proceeding, Flannery testified that - 28 - selling AAA-rated bonds itself reduces risk, and here, in combination with the pro-rata sale, was intended to maintain a consistent risk profile for the LDBF. Pickett testified that the goal of the pro-rata sale was to treat all shareholders -- both those who exited the fund and those who remained -- as equally as possible and maintain the risk-characteristics of the portfolio to the extent possible. These actions are not inconsistent with trying to reduce the risk profile across the portfolios. Finally, we note that the Commission has failed to identify a single witness that supports a finding of materiality. Cf. SEC v. Phan, 500 F.3d 895, 910 (9th Cir. 2007) (The SEC, which both bears the burden of proof and is the party moving for summary judgment, submitted no evidence to the district court demonstrating the materiality of the misstatement about the payment terms.). We do not think the letter was misleading, and we find no substantial evidence supporting a conclusion otherwise. We need not reach the August 14 letter.13 In its opinion, the Commission stated that while Section 17(a)(1) and Rule 10b- 5(a) & (c) would proscribe even a single act of making or drafting a material misstatement to investors, Section 17(a)(3) is not 13 We also do not reach the defense of whether the last sentence of the relevant paragraph was no more than a nonactionable opinion, protected under Omnicare, Inc. v. Laborers Dist. Council Constr. Indus. Pension Fund, 135 S. Ct. 1318, 1327 (2015). - 29 - susceptible to a similar reading. Of course, one who repeatedly makes or drafts such misstatements over a period of time may well have engaged in a fraudulent 'practice' or 'course of business,' but not every isolated act will qualify. See also In re Anthony Fields, CPA, Securities Act Release No. 9727, Exchange Act Release No. 74,344, Investment Company Act Release No. 31,461, 2015 WL 728005, at  (Feb. 20, 2015) ([A]n isolated misstatement unaccompanied by other conduct does not give rise to liability under [Section 17(a)(3)].). Even were we to assume that the August 14 letter was misleading, in light of the SEC's interpretation of Section 17(a)(3) and our conclusion about the August 2 letter, we find there is not substantial evidence to support the Commission's finding that Flannery engaged in a fraudulent practice or course of business.