The U.S. government suffered a setback in its investigation of subprime fraud when a judge dismissed a case against two former State Street Corp executives accused of misleading investors in the summer of 2007 about a $2.9 billion fund loaded with exposure to risky mortgages.

Chief Administrative Law Judge Brenda Murray dismissed the U.S. Securities and Exchange Commission's case against John P. Flannery and James D. Hopkins, according to her initial decision on October 28.

Flannery was a chief investment officer of the Americas for State Street Global Advisors until November 2007. SSgA is the investment management arm for Boston-based State Street, which has agreed to pay more than $600 million to investors who lost money during the subprime market meltdown in 2007. The company has neither admitted or denied allegations made by regulators, including the SEC.

Flannery's attorney on Monday declared total victory against the SEC, which sought fines and to bar Flannery from the industry.

This really represents complete exoneration, Mark Pearlstein, a lawyer for Flannery, told Reuters in a telephone interview.

Flannery left State Street in November 2007 after his position was eliminated, according to documents in the case. Hopkins left the company last year after State Street offered him retirement, a move he had not planned to make.

In a 59-page decision, Judge Murray said Flannery and Hopkins testified with candor, conviction and sometimes frustration. An 11-day hearing produced more than 3,000 pages of transcript. Flannery's witnesses included a Catholic priest from Boston, who praised his charitable work.

As subprime worries began to roil Wall Street in the summer of 2007, SSgA had to quickly unwind the Limited Duration Bond Fund to avoid big losses. During a one-month stretch, the fund sold more than $1.2 billion in assets to raise liquidity.

The SEC accused Flannery and Hopkins, a former head of product engineering for SSgA North America, of misleading investors about the extent of subprime mortgage-related investments in the fund. Investors included Emory Investment Management, General Motors, Xerox Corp, the Monetary Authority of Macao and the Houston Police Officers Pension System, case documents show.

Investors also included clients advised by SSgA internal advisory groups. These funds cut their exposure to the troubled bond fund, but not because of any confidential information, the judge said.

Judge Murray said in her decision that Flannery and Hopkins did not have ultimate authority over fact sheets distributed to investors. The judge also said the evidence in the case did not show that the fact sheets contained material misrepresentations or omissions about the fund's assets.

In addition, Flannery did not have ultimate authority over letters sent to investors, but rather they were a joint effort by a number of people, the judge said in her ruling. She also said letters State Street sent to investors were not misleading.

David Bergers, director of the SEC's Boston Regional Office, said, We are reviewing the decision.

State Street shares were down 1.4 percent at $41.44 on Monday afternoon on the New York Stock Exchange.

(Reporting by Tim McLaughlin in Boston; Editing by Gerald E. McCormick, Matthew Lewis and Steve Orlofsky)