RIA Compliance Blog
Mark Twain is alleged to have said, “When the end of the world comes, I want to be in Kentucky because everything happens there twenty years later than it happens anywhere else.”
That bit of “wisdom” is more than a bit unfair to Kentucky, but it has proven true in connection with investment adviser law. In an interesting judicial opinion earlier this year, the Kentucky Court of Appeals reached the same conclusion that the federal courts reached over thirty years ago on essentially the same issue. The Kentucky Court held that an investment manager who was paid to manage the brokerage accounts of two clients was “an Investment Adviser” under the Kentucky Securities Act (“KSA”), even though he never discussed with or recommended securities transactions to the clients.The case demonstrates how concepts that are taken for granted and seem to be well-settled and beyond dispute by financial professionals, regulators and seasoned professionals in the investment adviser arena can sometimes lead to protracted and uncertain litigation.
The case is Lawrence Rosen v. Commonwealth of Kentucky, Department of Financial Institutions, et al.. At issue were enforcement charges by Kentucky’s Department of Financial Institutions (“DFI”) against one Lawrence Rosen (“Rosen”) who operated a sole proprietorship under the name Larry Rosen Company out of his home in Louisville, Kentucky. Rosen had entered into contracts with two clients under which Rosen would be compensated by payment of 10% of the gross proceeds of option sales, dividends, and interest received for all transactions that he made in the course of managing the accounts of the two clients. The contracts gave Rosen complete discretion over all securities traded in the accounts, meaning that he was not required to obtain any approval prior to implementing a transaction. Rosen performed both contracts by purchasing and selling securities in both clients’ accounts and by receiving the compensation as set forth in a contract. He conducted all these activities without registering under the KSA.
In 2011, the DFI filed an administrative complaint against Rosen alleging that he was acting as an unregistered adviser and seeking a $5,000 fine and other costs and attorneys’ fees. DFI alleged that Rosen was acting as an investment adviser and was doing so without being registered as required by the KSA. Specifically, the KSA, as do almost all state securities acts, defines an investment adviser as “a person who, for compensation, directly or indirectly, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities . . . .” Rosen defended the enforcement case on the basis that he was not covered by this statutory definition because all he did was manage the clients’ funds and securities and did not at any time advise the clients, either directly or through publications or writings, as to the value or advisability of purchasing or selling of securities.
On its face, Rosen’s argument seems reasonable. However, registered advisers, investment managers, and securities professionals who have worked in the industry for any period of time will immediately recognize that investment management of the type Rosen was conducting has, for as long as memory serves, been considered by federal and state regulators to be providing “investment advice” under the definition contained in the KSA and the similar definition contained in the Investment Advisers Act of 1940 (the “Advisers Act”), and that the SEC and state regulators constantly issue rules and orders that affect only investment managers such as Rosen who never discuss or recommend anything to their clients, and that all this is all done without giving any second thought to the apparent distinction raised by Rosen.
The definition of “Investment Adviser” under the 1940 Act was similarly challenged in a few decisions in the 1970s, including most notably, Abrahamson v. Fleschner, a decision of the Second Court of Appeals out of New York. In that case, the Court held that the definition included those who merely managed the investments of their clients without specifically providing investment advice to those clients. In reaching this decision, the Court said that its conclusion was “born out by the plain language of [the definition] and its related provisions, by evidence of legislative intent and the broad remedial purposes of the [Advisers Act].”
With all due respect to the Abrahamson Court, the language in the definition and the “related provisions” is far from plain. In order to reach that conclusion, the Court strained to look at provisions in the 1940 Act that required an investment advisers to disclose the scope of its authority with respect to client funds and to another provision that establishes standards for investment advisers that include contracts “to act as an investment adviser or to manage the investment or trading account.” Because these provisions only applied to “investment advisers” in the first place, it is somewhat disingenuous to rely upon them to inform the definition of what an investment adviser is when the very act under consideration contains a definition. The better argument, based solely on the statute, is that those provisions imposed requirements on investment advisers as defined, and that those requirements reached management activity but did not expand the definition. In other words, the Advisers Act doesn’t mean what it says.
More persuasive was the Abrahamson’s Court reliance upon the 1940 Act’s legislative history and “broad remedial purposes.” The Court correctly referred to a 1939 study by the Securities and Exchange Report that was influential in the passage of the 1940 Act that specifically referred to the need to regulate “not only those who merely made recommendations to their clients” but also those “with management powers over their clients’ funds and the power to make purchases and sales for their clients.” Even so, with the distinction between types of advisers and their typical tasks so clearly defined in the report, one can’t help but conclude that the omission of the investment manager within the definition was an unintentional and fairly significant error.
In the Kentucky case, there was apparently no judicial precedent interpreting the similar Kentucky definition. Rosen lost round one before a hearing officer who ruled Rosen’s conduct fell within the definition of “investment adviser.” Interestingly, however, the hearing officer declined to impose a fine, costs or fees against Rosen because he “had good cause to believe that he was not covered by the statute when, in fact, he actually was covered.” Thus, the hearing officer apparently concluded, quite reasonably, that if Kentucky wanted to include investment management without advice or recommendations as conduct within its statutory definition, it should have said so. It should be noted that at this point the idea is so well accepted that even the drafters of the Uniform Securities Act of 2002, which has now been adopted in 17 states, carries forward the same basic definition from the IAA, as there is no need for clarification after Abrahamson and similar cases. Apparently, until this Kentucky case, the matter was thought to be beyond question.
After the hearing officer’s order, the Commissioner of DFI concurred in the hearing officer’s findings of facts but disagreed with the sanction, ordering Rosen to pay a $5,000 fine and the costs associated with the enforcement. Presumably, then, DFI thought Rosen should have known his conduct was covered. Rosen appealed to a circuit court within Kentucky that, similar to Abrahamson, looked at the broad purposes of KSA “to protect investors by preventing investment fraud and illegal conduct.” Interestingly, the court found that Rosen “circumvented” consulting with his clients by granting himself absolute discretion, finding that this “does not constitute management.” It also said that Rosen was “bypassing . . . a requirement to obtain prior approval” from his clients. In so holding the Circuit Court disregarded the plain realities of the investment management as a business that is understood in the United States.
Finally, having lost for a second time, Rosen appealed to the Kentucky Court of Appeals. That Court considered the issue de novo, meaning without deference to the Circuit Court’s opinion. The Court of Appeals did, however, note that, as is common in cases interpreting statutes administered by state agencies, the Court would defer to the agency’s own interpretation of this statute that it is charged with implementing. Having said that, the Court of Appeals affirmed the trial court on the grounds that the KDA itself contained a statement of its purposes, which included “protect[ing] investors by preventing investment fraud and related illegal conduct.” The Court simply concluded that Rosen’s clients “understood that [the] trades were based on his recommendations. To hold otherwise would be to leave investors unprotected, in disregard of [the statutes purpose].”
The Court reached the right result on the interpretation issue, but only because it is hard to turn a blind eye to decades of statutory gloss and legislative history. It is also hard, however, to argue with the hearing officer’s original conclusion that Rosen could reasonably have concluded just from reading the statute — in other words, without benefit of statutory gloss or legislative history — his conduct was not covered by the KSA.
Before embarking on an investment or financial-services related business venture, it is always wise to seek legal counsel regarding the implications of the securities laws. Parker MacIntyre’s attorneys regularly advise in the area of broker-dealer, investment adviser, and securities law compliance.