On November 7, 2016, the Securities and Exchange Commission (SEC), on appeal by the Division of Enforcement, overturned an administrative law judge’s (ALJ) dismissal of an enforcement proceeding and voted to impose civil money penalties against The Robare Group Ltd. (the Firm), a registered investment adviser, and two of its principals (collectively with the Firm, the Respondents) for failing to adequately disclose material conflicts of interest associated with an arrangement whereby the Firm received compensation from Fidelity Investments (Fidelity), the custodian of its client accounts, for maintaining client assets in certain mutual funds offered on the Fidelity platform. Although the SEC agreed with the ALJ that the Respondents did not act with scienter, the SEC reached a different conclusion on the Respondents’ alleged negligence, finding that because the Respondents negligently failed to fully and fairly disclose a material conflict of interest, their conduct “operate[d] as a fraud or deceit upon [their] client[s]” and violated Section 206(2) of the Advisers Act. The SEC also found that the Respondents made material misrepresentations and omissions on Form ADV, thus violating Section 207 of the Advisers Act. 

The SEC’s opinion states that the Firm offers its clients a number of model portfolios consisting almost entirely of nontransaction fee (NTF) mutual funds offered on Fidelity’s online platform. According to the opinion, in early 2004, the Firm entered into a revenue sharing arrangement with Fidelity (the Arrangement), pursuant to which Fidelity paid the Firm “shareholder servicing fees” between two and twelve basis points, based on the value of eligible assets under management, when its clients invested in certain eligible non-Fidelity, NTF mutual funds. The opinion states that under the terms of the agreement with Fidelity, the Firm was responsible for reviewing and determining whether additional disclosure regarding the Arrangement was necessary in the Firm’s Form ADV. However, the SEC found that the Firm’s Form ADV did not adequately disclose the Arrangement until at least April 2014. In this regard, the SEC cited the form requirement that an adviser “describe the arrangements” whereby the firm or related persons were given “cash…or…some economic benefit…from a non-client in connection with giving advice to clients,” and found, for instance, the Firm’s March 2005 ADV disclosure that its representatives “may sell securities…for sales commissions” to be inadequate. The SEC stated that the foregoing “boilerplate” disclosure about possible sales commissions and selling compensation did not constitute the “full and fair” disclosure that the law requires; specifically, the disclosure was inaccurate since the compensation that the Firm received under the Arrangement was not a sales commission and was not paid per transaction. Consequently, the SEC alleged the disclosure about possible compensation based on sales in the Form ADV could not alert clients to the actual source of the conflict of interest – that the Firm had a financial incentive to maintain client assets in certain mutual funds. Notably, the SEC asserted that, regardless of the nature and/or type of compensation received, the Firm’s disclosure that it may receive selling compensation in the form of 12b-1 fees “in no way revealed” that the Firm actually had an arrangement with Fidelity, that it received compensation thereunder and that the arrangement presented at least a potential conflict of interest.

Subsequent Form ADV disclosure by the Firm was also found to be insufficient, even though it identified Fidelity as the source of compensation and provided “an abbreviated description of the basis for the payments.” In this connection, the SEC asserted that the disclosure failed to explain that the Firm received compensation based on its selection of certain NTF mutual funds over others. The SEC also rejected the Respondents’ contention that they adequately disclosed the Arrangement to its clients by means other than its Form ADV, including the Fidelity custody agreement (the Agreement) which the Firm gave clients when they opened their accounts. The SEC raised two objections: first, that a large proportion of the Firm’s clients never received the relevant version of the Agreement and second, that the Agreement did not provide adequate disclosure even for those clients that received it. As to the latter point, the opinion cites a statement by Fidelity in the Agreement that Fidelity “may pay your advisor for performing certain back-office, administrative, custodial support, and clerical services for [Fidelity] in connection with client accounts for which [Fidelity] act[s] as custodian,” and that “[t]hese payments may create an incentive for your adviser to favor certain types of investments over others.” The foregoing disclosure was inadequate, according to the SEC, because it failed to state that the Firm had, in fact, entered into an agreement with Fidelity to receive these payments.

In finding that the Respondents failed to exercise reasonable care and thus, acted negligently in failing to adequately disclose the Arrangement, the SEC rejected the Respondents’ contention that they relied on others, including compliance consultants, about how to disclose the Arrangement. Contrary to the ALJ, which was persuaded that the Respondents sought advice from “experienced and competent compliance consultants” and relied in good faith on such advice, the SEC asserted that neither the Respondents nor the ALJ cited any case recognizing a defense of reliance on compliance consultants and that, in any event, no evidence exists that the Firm specifically sought or received advice about how to disclose the Arrangement to its clients.

Given the findings that the Respondents violated Sections 206(2) and 207 of the Advisers Act and in light of the factors considered, the SEC imposed a cease-and-desist order and a total of $150,000 in civil money penalties against the Respondents.

Commissioner Piwowar concurred with the opinion but dissented on the imposition of civil penalties, believing that five of the six statutory factors relevant to determining whether a penalty should be assessed weighed against imposing any penalty.

The Opinion is available at: https://www.sec.gov/litigation/opinions/2016/ia-4566.pdf.