Logic Prevails as the D.C. Circuit Reverses the SEC: An Investment Adviser Cannot Be Negligent and Intentional at the Same Time
May 03, 2019
By Ivan B. Knauer and Mark Webb
In a triumph of reason over complexity, the D.C. Circuit has held that an investment adviser cannot negligently commit an intentional act. In so holding, the second highest court in the land has (once again) overturned a decision in which the SEC took an aggressive stance on a critical legal question in an apparent effort to further its enforcement program.
On April 30, 2019, the United States Court of Appeals for the District of Columbia Circuit (D.C. Circuit) issued a decision in Robare Group, Ltd. v. SEC, Case No. 16-1453 (D.C. Cir. 2019) that vacated fines imposed by the Securities and Exchange Commission (SEC or Commission) in the combined amount of $150,000. In Robare, the court held that an adviser and its principals cannot simultaneously violate Section 206(2) of the Investment Advisers Act of 1940 for negligent failure to disclose potential conflicts of interest to clients and Section 207 for willful failure to disclose potential conflicts of interest to the SEC.
Section 206(2) makes it unlawful for an investment adviser, directly or indirectly, to engage in any practice that operates as a fraud upon any client or prospective client. Fraud includes failure to disclose potential conflicts of interests to clients. Similarly, Section 207 of the Act makes it unlawful for a person to willfully make an untrue statement of a material fact in any application or report filed with the SEC.
The Robare Group (TRG) used a financial services corporation (custodian) for execution, custody, and clearing services for its advisory clients. In 2004, TRG entered into a revenue-sharing arrangement with the custodian whereby it paid TRG when its clients invested in certain funds offered on the custodian's online platform. Between September 2005 and September 2013, TRG received from the custodian approximately $400,000, which was approximately 2.5% of TRG’s gross revenue.
In September 2014, the SEC’s Division of Enforcement brought administrative proceedings against TRG and its principals, alleging that TRG failed to disclose to its clients and to the Commission the compensation TRG received from the custodian for using its services. The Administrative Law Judge (ALJ) found that TRG and its principals did not act with “scienter” to knowingly deceive their clients in violation of Section 206(1). The ALJ also found that the SEC did not prove a negligent violation under Section 206(2) or a willful violation under Section 207.
The Commission reviewed the case de novo and determined that TRG and its principals acted negligently by failing to adequately disclose the conflict of interest with the custodian. The SEC also found that, because TRG and its principals repeatedly breached their fiduciary duty to disclose material facts to the SEC in their FORMS ADV, they violated Section 207. The SEC fined TRG and its principals $150,000 for these violations.
TRG appealed the Commission’s decision, arguing there was not sufficient evidence to find that they failed to disclose known conflicts of interest, and that they did not willfully omit material information about the payments from the custodian to TRG.
The D.C. Circuit upheld the SEC’s finding that there was sufficient evidence to show that TRG and its principals negligently failed to disclose known conflicts of interest to clients, thereby violating Section 206(2).
The D.C. Circuit, however, overturned the SEC’s finding that TRG and its principals willfully failed to disclose material facts to the SEC on their FORMS ADV. Relying on Wonsover v. SEC, 205 F.3d 408, 413–15 (D.C. Cir. 2000) the D.C. Circuit stated that willful in the context of Section 207 means intentional. The court then found support for the proposition that intent and negligence are mutually exclusive grounds for liability. Thus, the D.C. Circuit concluded that, because TRG and its principals were found negligent in failing to disclose conflicts of interests to clients in violation of Section 206(2), TRG and its principals could not simultaneously be found to have willfully (i.e., intentionally) failed to disclose that conflict of interest to the SEC in violation of Section 207. The D.C. Circuit vacated the $150,000 fine and remanded the case to the SEC to impose appropriate sanctions for Section 206(2) violations.
There are three takeaways from this case: First, the current Commission is focused on protecting retail investors from conflicts of interest, and it seems willing to push the envelope on legal theories in furtherance of its enforcement program.
Second, the D.C. Circuit continues to be willing to overturn decisions by the SEC that are not well grounded in the law, thereby putting the brakes on the Commission’s occasional overreaching.
Third, although it is rare for a regulated entity to be willing to endure enforcement proceedings before an SEC ALJ and a review by the full Commission, and then exercise its right to appeal to the D.C. Circuit, this case shows that sometimes it is necessary to engage in principled pushback against your primary regulator.
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