SEC Proceeding Regarding Bond Fund Disclosures

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The administrative law judge cited Cornerstone Research experts in her ruling related to issuer reporting and disclosure.

Retained by Mintz Levin Cohn Ferris Glovsky and Popeo and by McDermott Will & Emery

In a Securities and Exchange Commission (SEC) administrative proceeding against two former executives of State Street Corporation, Chief Administrative Law Judge Brenda P. Murray exonerated the defendants, finding that their investor communications regarding a fixed-income fund “did not contain materially false or misleading statements or material omissions.”

Defense counsel retained Cornerstone Research, Professor Erik Sirri of Babson College, and Professor John Peavy of Texas Christian University, to address the SEC’s allegation that the defendants failed to disclose the true riskiness of the Limited Duration Bond Fund (LDBF), which was invested heavily in securities backed by subprime mortgage loans in 2007.

In ruling for the defendants, the judge cited Professor Sirri’s opinion that sophisticated investors should have known that the fund came with increased risk.

Professor Sirri opined on the disruption in asset-backed and mortgage-backed securities markets in the spring and summer of 2007. He also addressed the market consensus at that time regarding the predictability and future course of the subprime crisis, the trade-off between risk and return and the implied risk of a fund that aimed to obtain high returns, and the extent to which fund holdings and performance were consistent with representations made to investors. Professor Peavy opined on the fund’s communication and disclosure model and the approach followed by sophisticated investors toward collecting information prior to and after investing in an unregistered fund.

In ruling for the defendants, Judge Murray cited Professor Sirri’s opinion that “sophisticated investors knew, or should have known, that a fund that aimed for returns 50 to 75 bps above LIBOR came with increased risk.” Further, she found that the alleged failure of the defendants to warn investors of “the vulnerability of AA and AAA-rated subprime bonds” was based entirely on hindsight, stating that “expert testimony [by Professor Sirri] established that it was reasonable to believe in August 2007, that highly-rated structured securities in the LDBF portfolio could eventually recover in value and become more liquid.”

Judge Murray was also persuaded by Professor Peavy’s opinion that “no sophisticated investor would rely on [a] single piece of information, but would consider a total mix of information such as discussions with fund managers, responses to questions, and requests for information before making an investment decision.”

Following the administrative law judge’s opinion, the SEC appealed to the five-member Commission, which voted 3-2 to impose sanctions on the defendants. The defendants then filed an appeal of the ruling with the First Circuit, which found that there was insufficient evidence to support the SEC’s penalties. The First Circuit affirmed the original decision in favor of the defendants, again citing testimony from Cornerstone Research’s experts.

Case Expert

Erik R. Sirri

Professor of Finance (Emeritus),
Babson College;
Former Director, SEC Division of Trading and Markets;
Senior Advisor, Cornerstone Research