On April 30, 2019, the U.S. Court of Appeals for the D.C. Circuit held that an investment adviser (IA) cannot willfully make a negligent disclosure in its Forms ADV. The decision vacated a combined $150,000 in fines that the Securities and Exchange Commission (SEC) issued to IA The Robare Group (TRG) and its two principals.
In The Robare Group, LTD. v. SEC, No. 16-1453, 2019 WL 1907220 (D.C. Cir., Apr. 30, 2019), the IA failed to disclose in its Forms ADV a conflict of interest regarding compensation it received through a revenue-sharing agreement with Fidelity Investments. As part of the revenue-sharing agreement, Fidelity would pay TRG when TRG clients invested in certain funds Fidelity offered on its online platform. The D.C. Circuit held that TRG’s omission could not simultaneously violate both Section 206(2) of the Investment Advisers Act of 1940 (Advisers Act) for negligent failure to disclose a potential conflict of interest to clients and Section 207 of the Advisers Act for willful failure to disclose a potential conflict of interest to the SEC.
In September 2014, the SEC’s Enforcement Division initiated an administrative and cease-and-desist proceeding against TRG and its principals, alleging TRG failed to disclose to its clients and the SEC its revenue-sharing agreement with Fidelity. The SEC alleged that for almost a decade, TRG failed to disclose this agreement with Fidelity in its Forms ADV, which effectively created an incentive for TRG to advise its clients to invest in eligible funds using Fidelity’s services.
At issue here are Sections 206(2) and 207 of the Advisers Act. Section 206 governs disclosures to clients, while Section 207 governs disclosures to the SEC. Section 206(2) makes it unlawful for an IA, directly or indirectly, to engage in any practice that operates as a fraud upon any client or prospective client. Unlike Section 206(1) which requires proof of “scienter” – that is, proof of an “intent to deceive, manipulate, or defraud” – Section 206(2) only requires proof of simple negligence. Section 207, however, provides that it is unlawful for a person to willfully make an untrue statement of a material fact in any registration application or report filed with the SEC.
The administrative law judge dismissed the charges, finding that TRG did not act with scienter or any intent to deceive, manipulate or defraud its clients, and that the Enforcement Division failed to prove a negligent violation under Section 206(2) or a willful violation under Section 207.
However, upon de novo review, the SEC determined that TRG and its principals negligently failed to disclose the revenue-sharing agreement and potential conflict of interest to its clients and willfully omitted material facts from the Form ADV. As such, the SEC imposed a total of $150,000 in civil monetary penalties on TRG and its two principals for their negligent violations under Section 206(2) and willful violations under Section 207, adding that both principals reviewed the Forms ADV before filing, and therefore were responsible for their content.
The DC Circuit’s Decision
TRG appealed the SEC’s decision to the D.C. Circuit, arguing that the SEC’s findings of inadequate disclosure of financial conflicts of interest were not supported by substantial evidence.
First, TRG argued that its omission did not constitute negligence under Section 206(2) of the Advisers Act. However, the D.C. Circuit disagreed, holding that the disclosures were “plainly inadequate” over a period of “many years.” Adding that “a reasonable adviser with knowledge of the conflicts would not have committed such clear, repeated breaches of its fiduciary duty, TRG and its principals acted negligently.”
Second, TRG argued that the SEC could not find its disclosure was negligent but not intentionally reckless under Section 206(2), and then subsequently determine that the very same disclosure constituted a willful omission pursuant to Section 207 of the Advisers Act. As such, TRG contended there was not substantial evidence to support the SEC’s findings of willfulness. The D.C. Circuit agreed. Relying on Wonsover v. SEC, the D.C. Circuit held that “willfully in this context means intentionally committing the act which constitutes the violation,” and that the actor need not “be aware that he is violating one of the Rules or Acts.” The court stated that “[i]ntent and negligence are regarded as mutually exclusive grounds for liability.” Therefore, because the SEC “found the repeated failures to adequately disclose conflicts of interest on TRG’s Forms ADV were no more than negligent for purposes of Section 206(2), the [SEC] could not rely on the same failures as evidence of ‘willful[ ]’ conduct for purposes of Section 207.”
The court did, however, hold that TRG’s failure to disclose was negligent under Section 206(2). Accordingly, the court vacated the $150,000 in civil penalties and remanded the case to the SEC to impose appropriate sanctions for Section 206(2) violations.
The D.C. Circuit’s holding that conduct cannot be deemed both negligent and willful for the purposes of Section 207 of the Advisers Act may signal that courts plan on applying a stricter “willfulness” standard to other areas of federal securities laws. This is an important clarification of the definition of willful and confirms that merely negligent conduct falls short of the intentional acts required to demonstrate willfulness. Nonetheless, the D.C. Circuit was clear that negligent actions such as the repeated omission at issue here violates Section 206(2). Compliance officers should use the opportunity to vet their disclosures regarding conflicts to confirm that they are current and accurate.