In a much-anticipated decision, on April 30, 2019, the US Court of Appeals for the District of Columbia Circuit issued its decision in Robare, a case that concerned an investment adviser’s (IA) disclosure of conflicts of interest regarding its receipt of payments from a custodian.1 The court held that the Commission’s findings of “negligent” violations under Section 206(2) were supported, but the Commission’s findings of “willful” violations under Section 207, based on the same negligent conduct, “are erroneous as a matter of law.” The court remanded the case for the Commission to determine the appropriate remedy for the Section 206(2) violations.
The case is significant because the US Securities and Exchange Commission (SEC) had previously settled more than 100 cases regarding similar issues where the SEC alleged that firms inadequately disclosed conflicts of interest regarding receipt of certain fees. Most recently, on March 11, 2019, the SEC announced that it settled cases against 79 firms that failed to adequately disclose the receipt of 12b-1 fees, leading to the firms returning more than $125 million to clients.
The question the industry has been asking is: Can a firm successfully litigate against the SEC on these issues? At this point, the DC Circuit’s opinion suggests that firms may have an uphill battle in litigating these types of disclosure issues. However, because each firm’s disclosures and underlying facts are unique, it is possible that another firm will litigate successfully.
The IA used a custodian for execution, custody, and clearing services for its advisory clients. The custodian made “revenue sharing” payments to the firm when its clients invested in certain funds offered on the firm’s platform. The SEC had alleged that the firm and its principals (the Respondents) failed to disclose the revenue-sharing arrangement and the conflicts of interest. However, in June 2015, an Administrative Law Judge (ALJ) dismissed all charges against the Respondents, determining that they sufficiently showed they complied with the applicable standards of care and industry standards. While the ALJ determined that the arrangement presented a potential conflict of interest, the ALJ found that the firm did not act negligently, relying on good faith advice from the compliance consultants.
In November 2016, the Commission, on appeal from the ALJ’s decision, disagreed with the ALJ and found that the Respondents negligently failed to adequately disclose the material conflict of interest to firm clients and willfully omitted material facts from the Form ADV. Thus, the Commission found negligent violations under Section 206(2) and willful violations under Section 207. The Commission imposed a $50,000 civil monetary penalty on the firm and the same sanction on each principal.
Issues on Appeal
During the January 23, 2019 oral argument, the parties and the court focused on three issues: (1) whether the use of the word “may” was adequate in light of the potential conflict of interest and the arrangement with the custodian; (2) the appropriate standard of care under Section 206(2) liability; (3) whether the firm acted willfully under Section 207. The court’s opinion, however, focused on Sections 206(2) and 207. The Petitioners were successful on the “willful” issue, resulting in the court remanding the case back to the Commission to determine appropriate sanctions.
- The Respondents failed to persuade the court that they did not act negligently under Section 206(2).
The Respondents argued that they did not violate Section 206(2) because they were not negligent; however, the court disagreed, finding the disclosures to be “plainly inadequate” and their conduct to be negligent. The court stated that:
[T]he Commission found, and the record supports, that the principals acknowledged the payment arrangement with [the custodian] created potential conflicts of interest and that they knew of their obligation to disclose this information to their clients. . . . Nevertheless, their disclosures were “plainly inadequate,” over a period of “many years.” Because a reasonable adviser with knowledge of the conflicts would not have committed such clear, repeated breaches of its fiduciary duty, [the firm] and its principals acted negligently. (Citations omitted.)
The court added:
[The firm] and its principals had a fiduciary duty to fully and fairly reveal conflicts of interest to their clients. Their statutory obligation and the administrative record here show that the question whether [the firm] and its principals negligently breached their duty was not so complex as to require expert testimony; for a decade their disclosures simply did not refer to the payment arrangement with [the custodian], much less its terms.
- The Respondents failed to persuade the court that expert testimony and the notion that “everybody else does it” exonerated them.
At the ALJ trial, the firm and the principals had put forward expert testimony that the disclosures they made “conformed to or exceeded the industry standards.” The court stated that, “even assuming” that their conduct was “like that of most other investment advisers at the time[, that] would not require the Commission to find that they acted reasonably.” The court stated, “They have acknowledged that as investment advisers they had a fiduciary duty to disclose the payment arrangement with [the custodian] to their clients, and yet the administrative record shows they resisted doing so for years.”
- The court was persuaded that the Respondents could not have acted both negligently (for Section 206(2) purposes) and intentionally (for Section 207 purposes).
The firm and the principals argued that, “the Commission erred in ruling that they violated Section 207 of the Advisers Act by willfully omitting material information about the payment arrangement” in the firm’s Forms ADV. In analyzing this argument, the court noted that the Commission was taking inconsistent positions. For purposes of Section 206, the Commission found that the Respondents “acted negligently but not ‘intentionally or recklessly’ by making disclosures that did not contain ‘the information [their clients] needed to assess the relevant conflicts of interest and did not even, at a minimum, satisfy the specific disclosure requirements of Form ADV.’” On the other hand, for purposes of Section 207, the Commission “found the same conduct to be willful.” The Respondents “contend there is not substantial evidence to support the Commission’s findings of willfulness, and we agree.”
The court noted that the parties agreed that the standard set forth in Wonsover v. SEC, 205 F.3d 408, 413–15 (DC Cir. 2000), applied. (The court assumed “without deciding” that the Wonsover standard governs.) In Wonsover, the court stated that “[i]t has been uniformly held that ‘willfully’ in this context means intentionally committing the act which constitutes the violation,” and rejected an interpretation that “the actor [must] also be aware that he is violating one of the Rules or Acts.” The court then examined how the Commission applied this standard. The Commission had found that the principals “acted willfully because they ‘both reviewed each of the Forms ADV before filing’ them with the Commission and they ‘were responsible’ for the forms’ content.” In addition, the court stated that it was the Commission’s “position that they ‘acted intentionally, as opposed to involuntarily’ because they ‘intentionally chose the language contained in the Forms ADV and intentionally filed those Forms.’” Furthermore, the Commission contended that, “neither the principals’ ‘alleged “good faith mindset’” nor their ‘subjective belief that their disclosures were proper . . . . is relevant to willfulness.’”
The court found that the Commission’s articulation “misinterprets Section 207, which does not proscribe willfully completing or filing a Form ADV that turns out to contain a material omission but instead makes it unlawful ‘willfully to omit . . . any material fact’ from a Form ADV.” Thus, according to the court, the statute “signals that the Commission had to find, based on substantial evidence, that at least one of [the firm’s] principals subjectively intended to omit material information from [the firm’s] Forms ADV.”
Citing other authorities, the court explained that “Intent and negligence are regarded as mutually exclusive grounds for liability” and that “[a]ny given act may be intentional or it may be negligent, but it cannot be both.” The court noted that the Commission found that the principals acted negligently, not “intentionally or recklessly.” The court then concluded:
Because the Commission found the repeated failures to adequately disclose conflicts of interest on [the firm’s] Forms ADV were no more than negligent for purposes of Section 206(2), the Commission could not rely on the same failures as evidence of “willful” conduct for purposes of Section 207. We are aware of no appellate case holding that negligent conduct can be “willful” within the meaning of Section 207, and we conclude that it cannot.
- Bottom line: the Respondents win some and lose some.
The court denied the petition on the Section 206(2) violations, but granted the petition on the Section 207 violations. Therefore, the court vacated the order imposing sanctions and remanded the case for the Commission to determine the appropriate sanction for the Section 206(2) violations.
Implications for Firms
The SEC is continuing to investigate firms for disclosures and conflicts regarding the receipt of payments and fees, including the receipt of 12b-1 payments and revenue sharing. So, the question becomes: After Robare, can a firm successfully litigate against the SEC on these issues?
- Section 206(2) charges for inadequate disclosures are alive and well, but facts and circumstances determine whether disclosures are adequate and whether parties acted negligently.
The Commission has brought well over 100 settlements against investment advisers for Section 206(2) violations related to disclosures of conflicts of interest about the receipt of payments from third parties. The SEC also has numerous related investigations currently underway. While the disclosures in the Robare case are somewhat different from the disclosures at issue in the 79 settlements referenced above, which dealt with 12b-1 fees, the theory of the Robare case and the basis for the Section 206(2) charge are very similar because both deal with the adequacy of the disclosures and whether firms acted negligently. The DC Circuit decision may make the Staff feel emboldened as they investigate other firms for disclosure issues. However, firms may be able to prove that their disclosures and their underlying facts are different from those in Robare.
- The future of Section 207 charges may be in question.
In the past (including, for example, the 12b-1 settlements), the SEC cited and quoted Wonsover for the proposition that a “willful” violation of the securities laws means “‘that the person charged with the duty knows what he is doing.’” Wonsover v. SEC, 205 F.3d 408, 414 (DC Cir. 2000) (quoting Hughes v. SEC, 174 F.2d 969, 977 (DC Cir. 1949)) and that there is no requirement that the actor “‘also be aware that he is violating one of the Rules or Acts.’” Id. (Citation omitted.) The DC Circuit decision will force the SEC to rethink how and whether to charge firms for willful violations of Section 207.
Moreover, this decision may reach beyond Section 207. The Adviser’s Act uses “willful” in a number of locations, including throughout Section 203(e) (administrative sanctions against advisers), as incorporated by reference into Section 203(f) (administrative sanctions against individuals associated with advisers), and throughout Section 203(i)(A) (penalties based on Sections 203(e) and (f)). The staff has always taken the position that willful in those contexts means, “not sleepwalking.” If the decision extends to other provisions where willful appears (and the SEC itself seems to have invited this by citing to Section 203(e), see opinion page 19), that could have a big impact on the SEC’s enforcement program, particularly in actions involving censures, suspensions, bars, or revocations of registration.
- The reliance on compliance consultants as a defense has been left for another day.
At the trial, the firm and the principals argued that their retention of compliance consultants to determine appropriate disclosures demonstrated their good faith efforts and beliefs. The ALJ agreed with this argument, finding that, “Respondents relied in good faith on the advice of its compliance firms” and such reliance presented “‘possible evidence of an absence of any intent to defraud.’” In reversing the decision of the ALJ, the Commission held that neither Respondents nor the ALJ cited any case recognizing reliance on compliance consultants as a defense. The Commission further noted that even if such a defense existed, Respondents had been unable to establish such reliance, given the evidence presented at the trial. The Commission concluded that the firm and one principal (the president and CEO) “could not reasonably rely on any advice that the disclosures were adequate because they knew their obligations as investments advisors, that they were required to disclose potential conflicts of interest, and that the Arrangement presented such a conflict but was not disclosed.” The court did not address this issue, so we will have to wait for another court decision to assess the merits of this argument.
- The use of the word “may” was ignored by the court.
In the past, many firms (including Robare) stated that they “may” receive payments from third parties or that such payments “may” give rise to conflicts of interest. During the oral argument, the court focused on the use of the word “may” because the firm agreed that the payments and the arrangement with the custodian presented a potential conflict of interest. One judge called the payment a “kickback” and questioned why the firm’s disclosure language was so “cryptic” since, according to the judge, kickbacks should be disclosed. Counsel for the firm argued that the firm believed the relationship with the custodian was disclosed and that the use of the word “may” was adequate because the firm did not know every instance in which it would receive the payment. The court’s decision did not address the word “may” or analyze other specific words used in the firm’s disclosures. Instead, the court found:
In sum, the evidence before the Commission demonstrated that [the firm] and its principals persistently failed to disclose known conflicts of interest arising from the payment arrangement with [the custodian] in a manner that would enable their clients to understand the source and nature of the conflicts. As the Commission emphasized, [the firm] and its principals had the burden under the Advisers Act of showing they provided “full and fair disclosure of all material facts,” Decision at 7 [citation omitted], and the evidentiary record permitted the Commission to find they did not carry this burden. Evidence that their clients suffered actual harm was not required. (Citation omitted.) [The firm] and its principals cannot, and do not, suggest their payment arrangement with [the custodian] was not a material fact of which their clients needed to be fully and fairly informed, nor do they explain how, during the period of years at issue, that material fact was conveyed through [the firm’s] Forms ADV or other means.
Thus, the court did not provide specific guidance on the use of the word “may.” It is possible that in other disclosures, a court may find that word to be accurate.
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Firms often seek guidance when they are trying to determine whether their disclosures are adequate. In the past, for the most part, they have had to rely on SEC settlements for guidance. However, as the SEC has “stressed many times,” settlements are not precedent.2 Therefore, it is helpful for the industry that the US Court of Appeals for the District of Columbia Circuit has weighed in. Of course, given that disclosures and underlying facts differ among firms and arrangements with third parties, each firm will need to assess how this case affects its particular circumstance.