Appeals Court Strikes Down Adviser’s NSMIA Challenge
In late 2004, California Attorney General Bill Lockyer successfully brought a shelf space enforcement case against PIMCO, alleging that the fund group committed fraud by failing to disclose details of its shelf space arrangements. PIMCO settled the California case for $9 million.
A few months later, Lockyer set his sights on Capital Research and Management. However, Capital Research, which had gotten wind of the fact that Lockyer was planning a suit, decided that enough was enough. The firm filed a preemptive suit designed to block Lockyer, arguing that the National Securities Markets Improvements Act, or "NSMIA," preempted virtually all state law governing the regulation of SEC-registered investment advisers. Of course, as the firm acknowledged, NSMIA contains savings clauses allowing states to sue advisers for fraud. But Capital Research argued that the savings clause created only a "narrow exception" and would not allow a state "to regulate the contents of offering documents, even those actions based on allegations that the offering documents are deceptive and/or fraudulent."
Capital Research asserted that Lockyerís pending enforcement action was intended to regulate the contents of the fundsí prospectuses and SAIs through a judicial decree that would prohibit the sale of fund shares unless and until the funds amended their prospectuses and SAIs to disclose the shelf space payments "in the manner dictated by the Attorney General." It asserted that its fundsí prospectuses and SAIs disclosed "all of the information required to be disclosed under the federal securities law."
In contrast, alleged Capital Research, the Attorney General "believes that no amount of disclosure could ever be sufficient." Representatives of the Attorney Generalís office have publicly stated that shelf-space payments "should be strictly prohibited," said the adviser.
The lower court was sympathetic to Capital Researchís claims, and issued a ruling preventing Lockyer from proceeding with his case.
Lockyer, and his successor in office, Edmund Brown, appealed.
And won. On January 26, the California Court of Appeal ruled that NSMIA did not preempt the suit against Capital Research, and overturned the lower courtís decision. "The Attorney General contends his enforcement action is not preempted," said the court. "We agree."
Rather than focusing on the question of whether the conduct at issue (namely, the alleged lack of disclosure about shelf space payments) was fraudulent, the courtís opinion seemed to focus on whether the state action was intended to force the funds to add disclosure to their prospectus, or whether it was designed to address the advisory firmís and wholesalerís lack of disclosure about the shelf-space payments. "[T]he Attorney General cannot sue [the fund] to force it to change its disclosure documents," noted the court, "but it can sue [the adviser] and [the wholesaler] to force them to disclose their oral agreements with the shelf-space brokers."
In the courtís view, it was the conduct of the fund wholesaler that was at issue, not quality of the fundís disclosures. The court cited numerous instances of legislative history where Congress made clear that despite NSMIAís preemption provisions, it still intended for state regulators to be able to sue broker-dealers for fraudulent sales practices.
The court did touch on the issue of whether making undisclosed shelf space payments was fraudulent, albeit briefly. "We summarily reject the trial courtís finding that the savings clause preserved only common law fraud claims (which require an intent to deceive), not those arising under [the provisions of California law]," the court noted in a footnote.
The case presented a bit of a chicken-and-the-egg question: If conduct is fraudulent absent disclosure, can a state still sue a federally-registered adviser or fund to compel that disclosure?
From a policy perspective, the answer to that question is fraught with peril: Say an adviser does not make certain disclosures that a state securities regulator feels is necessary. Might an aggressive state securities regulator, miffed that it could not substantively control the business practices of an SEC-registered adviser, be tempted to label the firmís conduct "fraudulent," so as to allow it to pursue an enforcement action against the firm?
Capital Research spokesperson Chuck Freadhoff noted that the courtís ruling "addressed only whether the Attorney General could continue with the case" and "did not address the merits of the case in any fashion." He said that attorneys for Capital Research are currently studying the courtís opinion, and a final decision about whether to appeal has not been made.