Failure to Provide Counsel with Key Information Likely Won’t Pass SEC Muster
When seeking legal advice, advisers should provide all relevant material facts to the attorney. Failure to do so may result in a legal opinion that won’t stand up to SEC scrutiny.
Take the SEC’s recent settlement with California-based advisory firm Sagent Wealth Management and its majority owner, Marshall Eichenauer, Jr. Both were charged with failing to obtain client consent and failing to disclose loan transactions involving the use of fund dollars to finance loans benefitting Eichenauer.
Eichenauer sought and received legal advice that, based on the operating agreements involved, client consent was not necessary, according to the agency’s administrative order that instituted the settlement. However, the SEC said, he "did not seek or receive legal advice on whether or how to disclose his conflict of interest."
The result was that the agency nonetheless found that both Sagent and Eichenauer "violated the Advisers Act’s anti-fraud provisions by failing to disclose Eichenauer’s conflict of interest or obtain investors’ consent in causing the fund to make these loans," the agency said.
"Generally speaking, advice of counsel is not a defense but rather a factor in assessing a party’s state of mind," said Ropes & Gray counsel Jeremiah Williams. "For example, if someone received legal advice that certain conduct was permissible, that advice could undercut a claim that the person acted with scienter (intent) or in bad faith. But in the context of non-scienter-based claims, advice of counsel will not necessarily prevent the SEC from charging someone."
"Second," he said, "The administrative order here mentions this legal advice to distinguish between two issues – the consent requirement and disclosure. The order is saying that even if one credits the legal advice with respect to consent (which the Commission ultimately didn’t), there was no legal advice regarding disclosure, and hence no justification for failing to disclose the purpose of the loans."
"The adviser should make sure that it discloses all material facts to the attorney and then follow the advice received," said Kelly Hart partner Toby Galloway.
"My clients look forward to putting this matter behind them and moving forward with their advisory business," said the attorney representing Sagent and Eichenauer.
Beyond the facts given to legal counsel, disclosure to clients must also be thorough.
"Complete disclosure is needed when there is a conflict of interest," said Williams. "Investors were told that the fund had made loans to the investment advisory firm, and investors knew about the terms of the loans. But, critically, investors were not told that the primary purpose of the loans was to finance payments to the owner of the advisory firm. This omission made the disclosures inadequate."
Proper disclosure may also make a difference in the face of inadequate legal advice. "Had the adviser fully and fairly disclosed the alleged conflict of interest to its clients but without getting consent for the loan because of erroneous legal advice, an enforcement action would have been far less likely and much easier to defend against," said Galloway.
Sagent was 80 percent owned by Eichenauer, who founded it in September 2010 as a replacement for a predecessor firm also owned by him. The other 20 percent was owned by Sagent Private Investment Fund I (SPIF), a private investment fund also formed by Eichenauer. In addition to being in charge of Sagent, Eichenauer was in charge of a management entity that controlled SPIF.
According to the SEC, Eichenauer’s compensation came in three parts: advisory management fees of 1.25 percent from SPIF, based on the amount of SPIF assets under management; an annual distribution of $450,000 quarterly installments; and, beginning in July 2012, an annual salary, paid by Sagent, of $100,000.
That arrangement may sound fine, but apparently it did not work out as planned. "In 2011 and 2012," the agency said, "Sagent did not generate enough revenue to make Eichenauer’s distribution payments for his 80 percent stake in Sagent." Eichenauer relied on those payments, particularly prior to July 2012, as his salary did not start until then.
So, beginning in March 2012, Eichenauer sold large portions of SPIF’s publicly-traded securities "and loaned the proceeds to Sagent so that Sagent could, in turn, pay at least a portion of Eichenauer’s distributions payments," the SEC said.
The loans were issued in five promissory notes that Eichenauer "personally executed" on both SPIF’s and Sagent’s behalf, the agency said. The first one was issued in March 2012 for $200,000. "Sagent initially borrowed $125,000 of that principal amount, and then borrowed the balance in four separate installments by September 2012," according to the order.
Subsequent to that, the SEC said that Eichenauer executed four promissory notes, as follows: $50,000 in September 2012, $50,000 in December 2012, $25,000 in December 2013, and $25,000 in January 2015. Sagent then allegedly borrowed an additional $126,650 against those four notes, which the agency said Eichenauer continued to finance by selling SPIF’s publicly-traded securities.
"In all, between March 2012 and January 2015, SPIF loaned Sagent a total of $326,650, eventually reducing SPIF’s [publicly-traded securities] to less than $1,000 by January 2015," the agency charged. "Eichenauer personally received approximately half of the loan proceeds, $166,400, during that period."
Consent and disclosure
The SEC alleged that Sagent and Eichenauer, in terms of consent or disclosure, failed to:
Disclose Eichenauer’s conflict of interest to SPIF investors in causing SPIF to use the fund’s publicly-traded securities to lend Sagent money, "the primary purpose of which was so Sagent could make distribution payments to Eichenauer."
Seek or obtain consent from the advisory clients who had invested in SPIF before causing the fund to make the loans to Sagent.
Provide written disclosure to other SPIF investors or give them the chance to consent to the loans.
Appoint an independent representative or independent board to act on behalf of SPIF before the fund made the loans to Sagent.
Seek or receive legal advice on whether or how to disclose Eichenauer’s conflict of interest. The only legal advice sought, the agency said, was whether the consent of SPIF’s investors was required before SPIF made the loans, given his conflict of interest.
Inform SPIF investors that the fund was making the loans until after SPIF’s March 2012 loan of $125,000 to Sagent. After that, according to the administrative order, SPIF investors were informed about the loans in quarterly updates, and the SEC said it found these inadequate.
Enter the examiners . . . and exit SPIF
Examiners from the SEC’s Office of Compliance Inspections and Examinations visited Sagent in May 2016. During the examination, the SEC said, Eichenauer and Sagent "liquidated and closed SPIF. Sagent repurchased SPIF’s 20 percent equity ownership in Sagent at the original purchase price of $900,000. Additionally, Sagent repaid the balance of SPIF’s loans to Sagent in the amount of $315,000. Afterwards, Eichenauer paid SPIF’s final expenses and closing audit, distributed the net proceeds to SPIF investors, and terminated SPIF."
These changes aside, the agency noted that "from March 2012 to SPIF’s closure in May 2016, SPIF paid Eichenauer or Sagent $15,380 in advisory management fees for managing the loans that Eichenauer and Sagent failed to disclose posed a conflict of interest."
Violations and punishment
The settlement found that Eichenauer and Sagent violated Adviser Act Section 206(2), which prohibits fraud; 206(3), which prohibits principal transactions without disclosure; and Section 206(4) and its Rule 206(4)-8(a)(1), which prohibit advisers from making untrue statements of material fact. Both were censured, and agreed to pay a civil money penalty of $165,000, as well as disgorgement of $15,380. ?