The First Circuit Court of Appeals has recently addressed the assessment of the materiality of a misrepresentation and the connection between the statement’s materiality and scienter. In Flannery v. Securities & Exchange Commission, 2015 U.S. App. LEXIS 21244 (1st Cir. Dec. 8, 2015), the First Circuit concluded that the materiality of an alleged misrepresentation made by the petitioner in the form of a slide that was part of a presentation to a portfolio strategist for an institutional investor regarding an unregistered fixed income fund was at best marginal when viewed in the context of other information that was available to the portfolio strategist. The First Circuit held that the marginal materiality of the allegedly misleading slide was insufficient to show that petitioner had acted with scienter, reversing the determination by the Securities and Exchange Commission that petitioner violated Section 17(a)(1) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5.

In Flannery, Petitioner James Hopkins made a presentation regarding the Limited Duration Bond Fund (“LDBF”) on May 10, 2007 to David Hammerstein, the chief strategist for Yanni Partners, an institutional investment consulting firm. During the presentation, Hopkins used a slide labeled “Typical Portfolio Slide” which inter alia stated that a typical sector allocation for the LDBF was (i) 55% invested in asset backed securities (including residential mortgage backed securities) (“ABS”); (ii) 25% invested in commercial mortgage backed securities; and (iii) 10% invested in mortgage backed securities. Flannery, 2015 U.S. App. LEXIS 21244 at **6-7. At the time this presentation was made, however, the LDBF’s actual sector allocation for ABS was close to 100%. Id. at **7 and 19-20.

On appeal from the Commission’s determination that Hopkins had misled investors with the Typical Portfolio Slide, the First Circuit concluded that the Division of Enforcement’s “thin materiality showing cannot support a finding of scienter here.” Flannery, 2015 U.S. App. LEXIS 21244 at *24. The First Circuit observed initially that “questions of materiality and scienter are connected” and that “[i]f it is questionable whether a fact is material or its materiality is marginal, that tends to undercut the argument that defendants acted with the requisite intent or extreme recklessness in not disclosing the fact.” Id. at *18 (quoting City of Dearborn Heights Act 345 Police & Fire Ret. Sys. v. Waters Corp., 632 F. 3d 751, 757 (lst Cir. 2011)). The First Circuit concluded that assuming the Typical Portfolio Slide was in fact misleading, the evidence supporting the Commission’s determination of materiality “was marginal.” That evidence was the testimony of Hammerstein that (i) the information on the Typical Portfolio Slide was important to him because “[i]t lead to the impression that the fund was well diversified, and therefore that State Street took steps to reduce the risks or control the risks;” and (ii) when he subsequently learned that the LDBF’s ABS exposure actually approached 100%, Yanni Partners advised its clients to liquidate their LDBF positions because they “felt that State Street did not adequately inform [them] of the risks in the portfolio.” Flannery, 2015 U.S. App. LEXIS 21244 at **18-20. The First Circuit cautioned, however, that in assessing the materiality of an alleged misrepresentation, “context makes a difference.” Id. at *22. That context here included (i) a report by Hammerstein explaining why the LDBF had underperformed in the first part of 2007 which did not mention the Typical Portfolio Slide; (ii) expert testimony presented by Hopkins that “[p]re-prepared documents such as…presentations…are not intended to present a complete picture of the fund,” that they serve as “starting points” after which due diligence is performed and that “a typical investor in an unregistered fund would understand that it could specifically request additional information regarding the fund;” and (iii) evidence that not only were clients given specific information about asset allocation upon request, information about the LDBF’s actual percentage sector allocation was available through fact sheets and annual audited financial statements that were issued prior to the May 10, 2007 presentation, including that the LDBF was 100% allocated to ABS. Id. at **22-23. The First Circuit concluded that “these facts weigh against any conclusion that the Typical Portfolio Slide had ‘significantly altered the total mix of information made available.’” Id. at *23. The Court held further that this “thin materiality showing cannot support a finding of scienter here,” concluding that “[g]iven the evidence weighing against the materiality of the portion of the slide to which the SEC objects, we cannot say there is substantial evidence that Hopkins’ presentation of a slide containing sector breakdowns labeled ‘typical’ .. constitutes ‘a highly unreasonable [action], involving … an extreme departure from the standards of ordinary care…that is either known to [Hopkins] or is so obvious [Hopkins] must have been aware of it.’” Id. at *25.

Flannery makes the point that the materiality of an alleged misrepresentation cannot be viewed in isolation and must be assessed in the context of other information available to the investor. In other words, the availability to the investor of sufficient other information to negate the significance of the alleged misrepresentation reduces the materiality of the misrepresentation to the point that it cannot support a finding that the defendant acted with scienter.


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