Appeals Court Ruling in Case Involving Inadequate Disclosure by RIA May Have Significant Impact on Future SEC Enforcement Proceedings

A recent decision handed down by the DC Circuit Court of Appeals in a case involving SEC action against an adviser for failure to disclose material conflicts of interest provides potentially significant precedent for SEC enforcement proceedings going forward. See The Robare Group, Ltd., et al. v. SEC, No. 16-1453, (D.C. Cir. April 30, 2019). The Robare decision is a mixed bag for the SEC in that, while it affirmed the SEC’s findings of negligence against the adviser under one section of the Advisers Act, it threw out the SEC’s findings that the adviser “willfully” violated a second Advisers Act provision based on the same negligent conduct. Notably, the Court predicated its holding against the SEC on negligent behavior and willful behavior being “mutually exclusive.” The significance of this holding is that the SEC has traditionally applied a standard of willfulness in enforcement proceedings that falls short of the level of intent required by Robare. Accordingly, unless Robare is reversed or modified, the SEC will be forced to reconsider its prior practice of assuming that all voluntary conduct constitutes “willful” behavior going forward.

Robare involved an appeal by a Houston-based adviser, The Robare Group (“TRG”), of SEC administrative findings that TRG had violated Advisers Act Sections 206(2) and 207, and Rule 206(4)-7 under the Advisers Act, as a result of TRG’s inadequate disclosure of a “revenue sharing” arrangement with Fidelity Investments, whereby Fidelity compensated TRG in return for TRG clients investing in certain funds offered on Fidelity’s online platform. While TRG received approximately $400,000 over an eight year period from Fidelity under this arrangement, the SEC alleged that, during that same period, TRG failed (at first entirely and then inadequately) to disclose to its clients and to the SEC the compensation received from Fidelity and the conflicts of interest arising from that compensation.

Section 206 governs disclosures to clients, and has long been held to require advisers to act as fiduciaries and in the best interests of clients. Failure by an adviser to disclose potential conflicts of interest to its clients in turn constitutes fraud. While a violation of Section 206(1) requires proof of an intent to deceive, manipulate, or defraud, sometimes referred to as “scienter,” a violation of Section 206(2) only requires proof of negligence. In Robare, the SEC found that TRG’s conduct was merely negligent.

Section 207, on the other hand, governs disclosures to the SEC (such as in a Form ADV filing), and prohibits advisers from “willfully” making any untrue statement of a material fact or “willfully” omitting any material fact which is required to be made, all in applications or reports filed with the SEC.

The SEC found that TRG was negligent, and therefore violated Section 206(2), because of the “obvious inadequacy” of the firm’s disclosures to clients and “failure to exercise reasonable care.” The SEC also found that TRG and its principals violated Section 207 by willfully omitting material facts from TRG’s Forms ADV, explaining that TRG’s principals both reviewed each of the Forms ADV before filing them and were responsible for the content therein.

On appeal, the DC Circuit accepted the first of the SEC’s findings as to negligence, but rejected the second as to willful behavior. In analyzing the willfulness of TRG’s behavior, the DC Circuit relied on a definition of “willful” derived from a 2000 DC Circuit case—the same case that SEC enforcement actions traditionally rely on. Notably, in that earlier case, the court had held that “‘willfully’ in this context means intentionally committing the act which constitutes the violation,” but not that “the actor [must] also be aware that he is violating one of the Rules or Acts.” As noted above, in the SEC’s view, this standard was met merely by TRG intentionally choosing the language contained in the Forms ADV and intentionally filing those Forms.

However, the Robare decision rejects that approach, holding that the SEC “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.” (emphasis in original). According to the court, Section 207 “signals that the Commission had to find, based on substantial evidence, that at least one of TRG’s principals subjectively intended to omit material information from TRG’s Forms ADV.” Since the SEC had not done this, according to the court, TRG could not have violated Section 207.

In reaching its decision the court further explained that “[i]ntent 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.” Therefore, “[b]ecause the Commission 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 Commission could not rely on the same failures as evidence of ‘willful’ conduct for purposes of Section 207.”

Our take on the Robare decision is that it will significantly impact SEC enforcement actions under Section 207. Indeed, at least with respect to cases premised on omissions, the SEC will now need to prove intent to omit. This is akin to scienter, or intent to defraud. This impact may be felt in connection with enforcement actions under other sections of the Advisers Act as well to the extent that those provisions require “willful” conduct, and the SEC has attempted to satisfy this requirement with simple negligence.

On the flip side, we also observe that the court’s upholding of the SEC’s findings as to negligence under Section 206(2) bodes well for SEC enforcement actions resting on that provision. That is, the court was little moved by TRG’s arguments that its conduct was not negligent, observing that “[b]ecause 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.”

Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our regulatory practice group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our website for more information.

Contact Information