(Courtesy of the SEC)

In the wake of the financial crisis, government regulators have been widely criticized for failing to hold more individuals accountable, but a pending case by the U.S. Securities and Exchange Commission against two former executives at State Street Bank and Trust Co. shows how difficult in practice it can be to make charges stick.

On Friday, the SEC commissioners heard an appeal of an initial decision by chief administrative law judge Brenda Murray, who in 2011 ruled squarely against SEC enforcement division lawyers, dismissing the government’s case against John Flannery and James Hopkins for misleading investors.

“Chief Judge Murray simply got this wrong,” Kathleen Shields, a senior trial lawyer at the SEC, told the commissioners. She argued that investors in a limited duration bond fund “had the right to know what they were investing in.”

Mark Pearlstein, a McDermott Will & Emery partner who represents Flannery, countered that the enforcement division is “seeking a do-over.” After 11 days of trial, 500 exhibits and 19 witnesses, he said, “there is literally nothing in the record that would support substituting the commission’s judgment for that of an experienced administrative law judge.”

When the SEC first announced the charges in September 2010 against the duo, the case appeared straight-forward.

Flannery, a chief investment officer, and Hopkins, a product engineer, allegedly misled investors about the fund’s exposure to subprime residential mortgage-backed securities, in violation of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Exchange Act Rule 10b-5.

State Street—then the largest institutional investment fund manager in the world, with more than $1.5 trillion in assets under management—had already settled related charges for $300 million. In suing Flannery and Hopkins separately, the SEC said it was “committed to identifying and holding accountable those who violated the law and harmed investors through subprime investments,” as then-director of enforcement Robert Khuzami said publicly at the time.

According to the SEC, by 2007 the fund was almost entirely invested in subprime residential mortgage-backed securities and derivatives, but continued to be described as less risky than a typical money market fund, and the extent of its subprime investments was not disclosed to investors.

When Murray dug into the facts, it became harder to hold Flannery and Hopkins individually responsible for any faulty disclosures, especially in light of a 2011 U.S. Supreme Court decision, Janus Capital Group v. First Derivative Traders, that established what it means to “make a statement” for purposes of Rule 10b-5.

The high court focused on who had “ultimate control” over allegedly misleading statements, ruling it was the person with “ultimate authority.”

Murray ruled that Flannery and Hopkins did not have responsibility or ultimate authority over the disclosures, and further, that the disclosures were not false or misleading. She also concluded that most of the fund’s investors were sophisticated or had sophisticated consultants advising on their behalf, and that they had access to detailed information about the fund’s investments.

Murray also pointed a finger at Mark Duggan, then associate general counsel at State Street and now an investment management partner at K&L Gates. Duggan “was, or should have been, knowledgeable on the facts required for a legal opinion,” she found, ruling that Flannery “acted reasonably” in relying on the lawyer’s advice.

Duggan did not immediately respond to a request for comment.

In arguing before the commission, Shields said Flannery “told half-truths about how risks in the fund had been reduced” in three client letters.

In the midst of the financial meltdown, the fund sold virtually all of its most-liquid and highest-rated assets, a move that Flannery knew “significantly increased the risk of the fund,” she said.

“Not necessarily,” Commissioner Michael Piwowar responded.

In Flannery’s defense, Pearlstein said that “in no sense” did he preside over the client letters. Flannery “knew a lot of the information provided,” but ultimately relied on State Street’s client and consultant relations divisions and in-house counsel to “ensure the totality of information provided was correct,” Pearlstein said. “The law is very, very clear that involvement of counsel … while not necessarily dispositive, is strong evidence supporting a lack of scienter.”

In going after Hopkins, Shields said he “hid the ball and failed to do his job … to convey accurate information.”

Shields pointed to a slide used in at least five presentations to investors that listed “typical” sector breakdowns for the fund’s assets. The slide did not indicate that by 2007, almost all the investments were in subprime residential mortgage-backed securities. “Putting ‘typical’ in front of a lie does not make it OK,” she said. “He told a story about diversification to lull investors into not asking more probing questions.”

Hopkins’ lawyer, John Sylvia, cochair of the securities litigation practice at Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, responded that the SEC had “a total failure of proof” to support its allegations of wrongdoing. During trial, the agency “didn’t call any investors or potential investors to find out what [Hopkins] actually told them,” he said.

“Without knowing what Mr. Hopkins did and did not say to investors and clients, and without knowing what other information that clients were provided, the record simply does not support the conclusion that misrepresentations were made,” Sylvia said.

Commissioner Luis Aguilar asked Shields why the SEC didn’t put any investors on the stand. Shields said the agency did call David Hammerstein, a consultant to several investors, and felt his “testimony was clear and compelling.”

The five SEC commissioners will now determine whether to affirm, reverse, modify, set aside or remand Murray’s initial decision.

Contact Jenna Greene at jgreene@alm.com or on Twitter @JgreeneJenna