Securities Regulation Daily Adviser’s failure to disclose conflicts was negligent, but not willful
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Tuesday, April 30, 2019

Adviser’s failure to disclose conflicts was negligent, but not willful

By Anne Sherry, J.D.

Because intent and negligence are mutually exclusive, the SEC could not rely on the same conduct as evidence of both negligent and willful conduct under the Advisers Act.

The District of Columbia Circuit invalidated part of an SEC order that held an investment adviser and its principals liable for failures to disclose conflicts of interest. Although there was ample evidence that the advisers were negligent to support a violation of Advisers Act Section 206(2), the SEC could not rely on the same conduct to satisfy the willfulness standard of Section 207 (The Robare Group, Ltd. v. SEC, April 30, 2019, Rogers, J.).

Disagreements on state of mind. In 2014 the SEC charged The Robare Group Ltd. (TRG) and its co-owners with fraud for failing to disclose to clients a servicing fee agreement with Fidelity under which TRG received a percentage of investments in certain mutual funds. The Commission alleged that the respondents violated (or aided and abetted violations of) Investment Advisers Act Sections 206(1), 206(2), and 207 by failing to disclose the arrangement and the resulting conflicts of interest. Section 206 concerns disclosures to customers, while 207 concerns the Form ADV filed with the SEC. To find a violation of 206(1) requires proof of scienter, 206(2) requires negligence, and 207 requires willfulness. The administrative law judge found none of the above and dismissed the charges.

The SEC reversed the ALJ, however, in 2016. Although the then-three-member Commission agreed that the record did not support a finding of scienter, it found that TRG and its cofounders acted negligently to support a finding that they violated Section 206(2) and willfully for purposes of Section 207. The Commission imposed a $50,000 penalty on each respondent. Commissioner Piwowar concurred in the opinion, other than the imposition of civil penalties, which were supported by only one of the six factors the SEC considered in determining whether and in what amount to impose a penalty.

Negligence, yes. On appeal, the D.C. Circuit registered yet another disagreement with the preceding tribunals. The appeals court agreed with the SEC only so far as its finding of negligence relevant to the Section 206(2) claim. There was substantial evidence to support the SEC’s finding that TRG’s Forms ADV, along with its disclosures to customers, did not fully and fairly disclose the conflicts of interest arising from its arrangement with Fidelity. Regardless of the standard of care for Form ADV, TRG and its principals had a fiduciary duty to disclose conflicts to their clients. The question whether they negligently breached this duty was not complex: their disclosures did not disclose the existence of the Fidelity arrangement, much less its terms.

The court also found that the Commission did not violate its own standard of deference to its ALJs. While the SEC gave significant weight to the ALJ’s credibility determinations, its review of the record was de novo, so it owed no deference on the factual questions of whether the TRG principals sought or received disclosure advice from their consultants. Substantial evidence also supported the SEC’s finding that any reliance on such advice would be objectively unreasonable because the respondents knew of their fiduciary duty to disclose conflicts yet repeatedly failed to do so.

Willfulness, no. TRG and its cofounders did successfully argue that the Commission erred in ruling that they violated Section 207. For purposes of this section, the SEC found that the same conduct underlying the Section 206 violation was willful. On appeal, the parties agreed that the standard for willfulness set forth in Wonsover v. SEC (D.C. Cir. 2000) applied to the Section 207 claim: "willfully" means "intentionally committing the act which constitutes the violation." The SEC contended that the advisers acted intentionally because they intentionally chose the language contained in the Forms ADV and intentionally filed the forms.

The court reasoned that this position misinterprets Section 207, which does not center around the completion or filing of the Form ADV but instead makes it unlawful "willfully to omit … any material fact." This text indicates that the Commission had to find that at least one of TRG’s principals subjectively intended to omit material information from the Forms ADV. The court also cited case law and treatises for the proposition that intent and negligence are mutually exclusive grounds for liability. Because the SEC found that the disclosure failures were no more than negligent for purposes of Section 206(2), it could not rely on the same failures as evidence of willful conduct for purposes of Section 207.

The court accordingly granted the TRG parties’ petition to dismiss the Section 207 violations and vacated the SEC’s order imposing sanctions. The matter is remanded to the SEC to determine the appropriate sanction for the 206(2) violations.

The case is No. 16-1453.

Attorneys: Heidi E. Vonderheide (Ulmer & Berne LLP) for The Robare Group, Ltd. Daniel E. Matro, U.S. Securities and Exchange Commission, for the SEC.

Companies: The Robare Group, Ltd.

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