The SEC Loses One: ALJ Rules for Adviser
You could almost hear the champagne corks popping.
It’s not so much that the SEC lost a case it brought against an adviser – it’s that the Commission lost it in its preferred venue, an administrative hearing.
The SEC’s increasing use of administrative hearings to try cases, rather than federal district courts, has become a lightning rod among a number of parties in recent months, including advisers, defense counsel, one federal judge and two SEC commissioners. Much of the objections center around the contention that the SEC wins far more of its cases in the administrative setting than it does in district court.
But that was not the case on June 4, when an SEC administrative law judge dismissed the agency’s charges against The Robare Group, a Houston-based adviser, and two of its executives, Mark Robare, the firm’s founder and majority owner; and Jack Jones, who owned 17 percent of the firm. The Commission, the judge wrote, "failed to carry its burden" to show that they intentionally violated the Advisers Act by accepting payments from clients that created a conflict of interest, and then failed to adequately disclose them.
"In listening to Mr. Robare and Mr. Jones testify and observing their demeanor under cross-examination, it is difficult to imagine them trying to defraud anyone, let alone their investment clients," wrote the ALJ, James Grimes. "They came across as honest and committed to meeting their disclosure requirements. Indeed, their belt-and-suspenders approach to compliance, through which they relied on multiple firms … belies any argument that Mr. Robare or Mr. Jones acted with intent to deceive, manipulate or defraud anyone."
ALJs and the SEC
It was perhaps only a matter of time before an ALJ ruling came out against the Commission. "I think that ALJs are sensitive to the criticisms that have been in the press, that they are a rubber stamp for the SEC," said Sidley Austin partner Hardy Callcott. "They are looking for opportunities to underscore that they are independent."
The ruling is not all bad news for the SEC. The agency can, and most likely will, use it to make its case that ALJs do not always side with the Commission, said Callcott. The ruling, which was an initial decision, can be appealed to the full Commission. Should no request for an appeal or a review be made, the decision will be final.
Ulmer Berne partner Alan Wolper, who represented Robare and the two executives in the case, described the ruling as "a very strong decision that may not be very subject to appeal," in large part because of the number of "credibility determinations" the ALJ made as to his clients and other witnesses. In addition, given the issues that have arisen about the SEC’s use of administrative hearings, now that the agency has a case it can point to where it lost, "this may not be the best time to appeal."
Advisers and defense counsel, meanwhile, should perhaps drink their celebratory champagne with a bit of caution. "It pays to take note that the SEC brought an enforcement action even though the judge (in this case one of the SEC’s own ALJs) thought the claims were unsupported," said Zaccaro Morgan partner Nicolas Morgan. "While advisers may take some comfort from this ALJ’s conclusions, the bigger concern is that the Enforcement Division and the SEC commissioners pursued this case in the first place."
Compliance firms and the regulatory environment
The ALJ’s opinion may be noteworthy for two other reasons: it appears to validate adviser reliance on professional compliance consultants, and acknowledges, at least for this case, the confusing nature of current disclosure requirements.
In regard to the firm’s use of compliance consultants to help determine its actions, Grimes wrote that "even assuming that the [SEC] had carried its threshold burden, which it has not, I find that the respondents relied in good faith on the advice of its compliance firms."
What this means, Callcott said, is that the ALJ found it "consistent with good faith to rely on compliance consultants" and this "defeated allegations of intentional misconduct and negligence. That’s a big deal."
The ruling also specifically states that, when it came to disclosure about potential conflicts in this case, "the standard was unclear," Callcott said. The ALJ made this point when he referenced an expert who testified that advisers "’struggle … to determine what is sufficient disclosure.’" The expert "believes that the reason for this struggle is a lack of clear and concise guidance," he said, specifically, "an irreconcilable conflict between guidance to both fully disclose and to be concise."
The SEC called no witnesses to rebut the expert’s testimony, as well as testimony from another individual who made a similar point, the ALJ noted. "Absent such testimony, I am compelled to conclude, for purposes of this matter [emphasis Grimes], that investment advisers operate in an uncertain regulatory environment in respect to disclosing potential conflicts of interest."
The agency issued its order instituting administrative proceedings against The Robare Group, Robare and Jones on September 2, 2014. "This matter involves an investment adviser’s failure to disclose compensation it received through agreements with a registered broker-dealer and conflicts arising from that compensation," it said in the administrative order. Specifically, the SEC alleged that in 2004, the broker agreed to pay The Robare Group "a specified amount for all client assets the firm invested in certain mutual funds."
The agreement also allegedly created incentives for the firm to favor particular mutual funds over other mutual funds or other investments, as well as to favor the broker’s platform when giving investment advice to clients, the agency claimed.
"Robare Group failed to disclose this agreement and the resulting conflicts of interest to its clients for years, and then only provided inadequate disclosure about it and a subsequent agreement with the broker," the SEC said.
The agency charged The Robare Group and Robare with willfully violating Sections 206(1) and (2) of the Advisers Act, both of which outlaw fraud. In addition, Jones was charged with willfully aiding and abetting, as well as causing, the firm’s and Robare’s violations of these sections. Finally, all three parties were charged with willfully violating Section 207 of the Advisers Act for making untrue statements on their registration forms.
The ALJ’s point of view
The issues in the case, as defined by Grimes, included:
Whether payments to the firm from the broker "created a material conflict of interest,"
Whether the firm, assuming there was a material conflict of interest, adequately disclosed it, and
Whether any failure to adequately disclose proved that the firm and its executives "acted with scienter," meaning with intent to deceive.
Grimes, in his ruling, agreed with the SEC that the payments from the broker to the firm were material. However, he then ruled that firm’s disclosure was not inadequate, as the agency claimed. He provided two reasons: 1) the brokerage agreement adequately discloses the conflict created by the program, something he said the SEC did not contest; and 2) the instructions for Form ADV make clear that advisers may disclose conflicts by other means.
It was important that the judge recognized that Form ADV is not the only place in which to disclose, said Wolper. "There are other documents," he said, such as, in this case, the brokerage agreement, in which the judge found proper disclosures were made.
Even if the disclosure was inadequate, the ALJ wrote, the SEC "cannot prevail on its claim under Section 206(1) because it cannot show scienter."
"Scienter," Grimes noted, refers to a mental state embracing intent to deceive, manipulate or defraud. "Here, the [SEC’s] evidence of scienter consists of nothing more than assertions that Mr. Robare was knowledgeable about the program and possessed ultimate authority over [the firm’s] Form ADV filings. These facts are not enough to show scienter."
In fact, Grimes said, "the evidence developed at the hearing demonstrates that The Robare Group and its principals did not act, at any time, with scienter or any intent to deceive, manipulate or defraud."