Legal

Back when former Goldman Sachs director Rajat Gupta's most pressing problem was the Securities and Exchange Commission's civil case against him, his defense scored a small victory when the SEC agreed to drop an administrative proceeding against him and brought civil charges in federal court instead. Gupta's lawyer, Gary Naftalis of Kramer Levin Naftalis & Frankel, had fought to have Gupta's case heard by a federal judge, rather than an SEC administrative law judge, because the rules of evidence in administrative proceedings favor the agency. Among other things, the SEC can admit hearsay evidence, and defendants don't have the same rights to depose opposing witnesses. Although the SEC can't seek the same penalties in administrative proceedings as it can in federal court, they can be an effective way for the agency to make a statement about improper conduct.

Except when the defendants win.

On Friday, the SEC's chief administrative law judge, Brenda Murray, entered a painstaking 58-page decision that cleared former State Street executives John Flannery and James Hopkins on all of the SEC's sprawling allegations that they misled investors about the mortgage-backed securities holdings in State Street bond funds. Murray found that the agency failed to show at trial that Flannery and Hopkins violated any securities laws in communicating with investors about the funds' subprime MBS holdings. She went out of her way to describe the former State Street execs as candid, believable witnesses who were frustrated to be on trial.

Murray's ruling is yet another courtroom rebuke to the SEC, which in the last few years has seen several high-profile trials end in victory for defendants. Most notably, in 2009 a San Francisco federal judge dismissed stock options backdating charges against Broadcom executives; and in 2010 a Manhattan federal judge exonerated two traders in a landmark SEC case alleging insider trading in credit default swaps. The State Street loss is perhaps an even bigger black eye for the SEC, given that the loss came in an administrative proceeding, the agency's home turf.

"This is a case where the SEC should never have proceeded against my client," said Mark Pearlstein of McDermott Will & Emery, who represented former State Street Americas chief investment officer Flannery. "We felt all along that if we received a fair hearing we would prevail. Chief judge Murray gave us a very fair hearing."

Hopkins, who was a former head of project engineering for State Street, was represented by John Sylvia of Mintz Levin. "We and our client are thrilled," Sylvia said. "We've maintained from the outset that this is a case that never should have been brought."

The ruling may be a setback for the SEC in another way as well. Agency lawyers urged the chief ALJ to adopt a narrow interpretation of the U.S. Supreme Court's June 2011 ruling in Janus Capital v. First Derivative Traders. In Janus, the court ruled that a mutual fund adviser isn't liable for the fund's allegedly false statements in a prospectus because the adviser did not make the statements at issue. The SEC argued that the Janus decision should apply only to private securities fraud cases, and not to its causes of action. The administrative law judge, citing a ruling by U.S. district judge Colleen McMahon in Securities and Exchange Commission v. Kelly, said Janus extends to the SEC's allegations.

In the end that didn't matter in the case against Flannery and Hopkins, because Murray found that the SEC's allegations of misstatements fell short. But the agency may want to think twice about asking the full commission to review the chief ALJ's reasoning on Janus. The SEC, which told Reuters that it is reviewing the ruling, has three weeks to decide whether to appeal Murray's initial determination to the full commission.