(Article from Registered Funds Alert, September 2015)
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As discussed in a prior Alert, on September 2, 2014, the SEC initiated administrative proceedings against the Robare Group (“Robare”), a Houston-based investment advisory firm, seemingly related to its widely reported “distribution in guise” sweep examination. The SEC alleged that Robare violated Sections 206(1), 206(2) and 207 of the Advisers Act, by failing to disclose in its Form ADV an alleged hidden fee arrangement with a broker that compensated Robare for investing client assets in certain mutual funds through the broker’s platform. Notably, some of the language at issue in Robare’s Form ADV stated that it “may” receive compensation from the broker, which the SEC argued was misleading because it was in fact receiving compensation.
In June 2015, an administrative law judge (the “ALJ”) dismissed the SEC’s case against Robare by finding that the Division of Enforcement failed to carry its burden of proof (the “Initial Decision”). Specifically, the ALJ separated the time period in question into two segments, pre-2005 and post-2005. During the post-2005 period, Robare’s clients received the participating broker’s agreement, which the SEC conceded sufficiently disclosed the potential conflicts under the commission program. Emphasizing that the overriding goal of the Advisers Act was full disclosure by advisers, the ALJ concluded that disclosure through an adviser’s Form ADV was not the only means to disclose adequately conflicts to clients. The ALJ also specifically pointed to Form ADV’s instructions, which provide that conflicts may be disclosed “to clients in [the firm’s] brochure or by some other means.” Thus, the only timeframe in question as to whether Robare adequately disclosed the program’s conflicts was pre-2005, during which Robare accepted approximately 150 clients who were not provided the broker’s agreement. Additionally, the ALJ disagreed with the SEC’s assertion that use of the term “may” was misleading with respect to Robare’s receipt of payments from the broker, as the parties were free to terminate the payments (with notice) after an initial period.
Scienter and intent are required elements of any violation based on Section 206(1) and 207, respectively; however, scienter can be shown through both intent as well as an extreme departure from the ordinary standard of care. Significantly, the ALJ’s decision acknowledged, “for purposes of this matter, … investment advisers operate in an uncertain regulatory environment in respect to disclosing potential conflicts of interest.” Noting that many firms, especially small to mid-sized firms, consult third-party compliance professionals, a practice the SEC itself has acknowledged as acceptable, the court concluded that the relevant standard of care entails the consultation and application of the professional’s advice regarding a firm’s disclosure obligations. Additionally, the ALJ acknowledged that reliance on compliance professionals as well as counsel demonstrates good faith and shows an absence of the intent to defraud required for a Section 206(1) violation. In the same vein, the court found that Robare’s good faith reliance on compliance professionals as well as its own diligence demonstrated a lack of willfulness as required for any Section 207 violation.
Even though a Section 206(2) violation requires only a demonstration of negligence, or a failure to exercise reasonable care, the ALJ found that Robare’s diligence and use of compliance professionals demonstrated that Robare did use reasonable care. Accordingly, the court found that the SEC provided no evidence of Robare breaching the standard of care, an essential element to the SEC’s Section 206(2) violation.
The SEC staff appealed the Initial Decision to the full Commission on June 26, 2015, asserting that the decision “shifts the burden of fully disclosing a conflict of interest from an investment adviser, who has a fiduciary duty to and a relationship with its clients, to a compliance consultant (who has no such connection).” Robare’s motion for summary affirmance of the Initial Decision was also recently denied on August 12, 2015. The SEC staff’s brief in support of the petition for review is scheduled to be filed by September 11, 2015, and Robare’s brief in opposition is scheduled to be filed by October 12, 2015. Arguments will commence shortly thereafter.
If the Initial Decision is upheld, it may discourage the SEC from pursuing enforcement actions based on scienter where an adviser consulted a third-party compliance professional and followed their advice in connection with the conduct giving rise to an alleged violation. Furthermore, the comments from the ALJ regarding the meaning of the word “may” is in direct contrast to positions that we are aware have been taken by the SEC staff in communications with registrants in several contexts. Specifically, it calls into question whether saying that a practice “may” occur when in fact that practice actually occurs is a sufficient cause for an enforcement action (although we continue to believe that it is a good practice to affirmatively disclose the occurrence of a practice if it is actually taking place).