Author: Enforcement Highlights

Federal Prosecutor Faces Accusations that it Used the SEC to Collect Evidence for its Criminal Investigation

In a ruling handed down on Tuesday, a Southern District of New York judge ordered the U.S. Attorney’s Office for the Southern District of New York (“USAO”) to submit a full account of their communications with the SEC after defendant Jason Rhodes accused the USAO of using the SEC to develop its criminal case against him.

Rhodes was charged with four counts, including conspiracy to commit securities fraud and wire fraud, securities fraud, wire fraud, and investment advisor fraud, in what the government alleges was an elaborate $19.6 million scheme to defraud investors. Notably, the charges against Rhodes were brought almost two years after the government charged all other co-conspirators. During that time, the SEC initiated an investigation involving Rhodes.

In a motion filed back in March of this year, Rhodes argued that the USAO may have violated his due process rights by using the SEC civil process to further its criminal investigation against him. During the SEC’s investigation, it used its investigatory authority to obtain documents from Rhodes, including communications and data from his cellphone. These documents were then turned over to the USAO and the substance of certain of those documents was subsequently included in the criminal complaint against him. Rhodes asserted in his motion, as soon he was arrested, the SEC stopped investigating him.

Given that timeline, the court insisted the USAO submit an affidavit outlining its relationship with the SEC regarding its civil investigation and its criminal charges against Rhodes. After one AUSA submitted an affidavit, the court held that as of now, Rhodes had not shown the government acted in bad faith. The court went on to say, however, that the submitted affidavit “d[id] nothing to advance the ball.” While the AUSA insisted that he did not request the issuance of the SEC subpoena, the affidavit was silent regarding the involvement of others in the USAO. As a result, the court ordered that the USAO submit a new affidavit “detailing, with specificity, the nature and extent of any and all communications between the SEC and those involved in the criminal investigation of Rhodes.” Only then will the court determine whether the materials should be turned over to Rhodes.

The SEC and U.S. Attorney’s Office across the country often conduct parallel investigations and the SEC regularly shares the information it gathers with those offices. While there is nothing to prevent the government from conducting parallel investigations, the government must act “in good faith and with the proper procedures.” See United States v. Kordel, 397 U.S. 1, 6(1970). Indeed, the SEC warns in its “Form 1662” that it may share the information and documents produced pursuant to a subpoena (or voluntarily) to a host of other agencies, including, but not limited to, state and federal criminal authorities. It is, however, well-settled law at this point that the criminal authorities cannot direct the SEC’s investigation and that any action taken by the SEC, including subpoenas for documents, testimony and other evidence, must be supported by the SEC’s independent decision making and must be in furtherance of its investigation; not the criminal authority’s investigation. See, e.g., United States of America v. Stringer, 408 F. Supp. 2d 1083 (Dist. Or. 2006); United States of America v. Scrushy, 366 F. Supp. 2d 1134, 1140 (N.D. Ala. 2005.

The Final Reg BI Package: What to Know and What’s Next

To nobody’s great surprise, on June 5, the SEC approved the “Reg BI Package,” which includes a series of new standards governing the fiduciary responsibilities of broker-dealers and investment advisers. The approved items consisted of the Regulation Best Interest – Standard of Conduct for Broker-Dealers; Form CRS Relationship Summary; Standard of Conduct for Investment Advisers; and Interpretation of “Solely Incidental,” all of which seem likely to have considerable impact on the industry going forward.

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The SEC’s Reg BI Package Time to Vote

On June 5, the SEC will hold an Open Meeting to consider whether to adopt certain measures to reform retail investment standards. In this alert, the Best Interest Compliance Team provides a brief preview of the key topics and potential concerns about the proposed standards.

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The Robare Ruling Regarding “May” Disclosures and “Willfulness”

Over the last year, the SEC has continued to intensify its focus on disclosures from investment advisers on Forms ADV regarding several issues, including—but not limited to—revenue sharing arrangements. Last week, the D.C. Court of Appeals handed down a decision that will likely have significant ramifications for investment advisers and the SEC’s Division of Enforcement (“Enforcement”). In Robare Group, Ltd., v. SEC, the D.C. Circuit upheld the SEC Commission’s decision that the use of the word “may” in a disclosure regarding an investment adviser’s conflicts of interest pertaining to revenue sharing violated the negligence-based fraud provision of Section 206(2) of the Investment Advisers Act of 1940 (“Advisers Act”).
On appeal, The Robare Group, Ltd., a Texas-based investment adviser, argued that the evidence presented by Enforcement in an administrative proceeding did not support the Commission’s ruling, upon review, that their disclosures regarding conflicts of interest relating to a revenue sharing agreement were inadequate. Sections 206(2) and 207 of the Advisers Act were at issue on appeal.

Robare used Fidelity Investments for execution, custody, and clearing services for its advisory clients. Robare entered into a revenue sharing arrangement with Fidelity Investments in 2004. Through that arrangement, Fidelity paid Robare when its clients invested in certain mutual funds offered on Fidelity’s platform. Robare received nearly $400,000 from Fidelity from 2005 to 2013 as a result of the arrangement.

Robare had modified its Form ADV disclosures in December 2011, after Fidelity advised Robare that it would cease making payments if the arrangements were not disclosed. Robare’s disclosures then stated that certain investment advisers “may receive selling compensation” due to “the facilitation of certain securities transactions on Client’s behalf” through certain broker-dealers, or “may also receive compensation resulting from the sale of insurance products to clients.” Robare further revised its disclosures to state, “Additionally, we may receive additional compensation in the form of custodial support services from Fidelity based on revenue from the sale of funds through Fidelity. Fidelity has agreed to pay us a fee on specified assets, namely no transaction fee mutual fund assets in custody with Fidelity. This additional compensation does not represent additional fees from your accounts to us.”

In 2014, Enforcement filed charges against Robare and its principals alleging that Robare had failed for years to disclose to clients and the SEC that it received shared revenue from Fidelity and the conflicts of interest that consequently arise therefrom. Enforcement alleged that Robare’s conduct violated Sections 206(2) and 207 of the Advisers Act. In 2015, an administrative law judge dismissed the charges. Enforcement appealed, and the Commission saw the situation differently. In the Commission’s opinion, it found that Robare negligently failed to adequately disclose said conflicts and willfully failed to provide enough information in its Form ADV filings.

In last week’s ruling, the D.C. Circuit agreed with the Commission and Enforcement that Robare’s disclosures “did not disclose that [Robare] had entered into an arrangement under which it received payments from Fidelity for maintaining client investments in certain funds Fidelity offered.” It further found that the Form ADV “in no way alerted its clients to the potential conflicts of interest presented by the undisclosed arrangement.” The D.C. Circuit agreed with Enforcement that Robare and its principals should have known that their disclosures were inadequate and, therefore, acted negligently in violation of Section 206(2).

The Section 207 charge as alleged, however, requires willful conduct. The SEC has steadfastly maintained over the years that “willful” under the federal securities laws simply means “intentionally committing the act which constitutes the violation” and not that “the actor [must] also be aware he is violating one of the Rules or Acts.” See Wonsover v. SEC, 205 F.3d, 408, 414 (D.C. Cir. 2000). The DC Circuit rejected Enforcement’s arguments that the challenged Section 207 negligent conduct constituted “willful” conduct and explained that “[t]he statutory text signals that the Commission had to find, based on substantial evidence, that at least one of [Robare’s] principals subjectively intended to omit material information from [Robare’s] Form ADV” to prove a violation of Section 207. It was established that Robare’s conduct was negligent, not willful, and the two are mutually exclusive. As a result, Robare was not found to be in violation of Section 207.

To be sure, the Robare decision bolsters the SEC’s longstanding position that disclosures using “may” are not sufficient when the adviser “is” receiving fees or “is” engaging in other practices that create a conflict of interest.

On the other hand, the Robare opinion and ruling with respect to “willfulness” is likely to significantly impact the SEC’s charging decisions with respect to Section 207 and certain other provisions of the federal securities laws, and the SEC’s ability to obtain certain remedies for which willfulness is required.

SEC Issues Risk Alert Regarding Reg S-P, Privacy, Safeguarding, and Registrant Compliance

The SEC’s OCIE recently issued a Risk Alert focusing on compliance issues related to Regulation S-P, the primary SEC rule governing compliance practices for privacy notices and safeguard policies for investment advisers and broker-dealers. The Risk Alert summarizes the OCIE’s findings from two-year’s worth of issues identified in deficiency letters to assist investment advisers and broker-dealers in adopting and implementing effective policies and procedures for safeguarding customer records and information pursuant to Regulation S-P.

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The SEC Speaks . . . and Cooperation is Key

SEC Speaks, the SEC’s annual conference in Washington, D.C., often provides valuable insight into developments at the agency, as well as pronouncements about policy evolution and enforcement priorities. At this year’s conference, “cooperation” emerged as one of the themes that the SEC has been prioritizing over the past year – and is committed to prioritizing in the future. Indeed, the co-directors of the SEC’s Division of Enforcement remarked that, “cooperation is as important now as it has ever been,” and that the “full range” of remedies are available to entities that provide meaningful cooperation to the SEC. Interestingly, the staff emphasized that the SEC is making a concerted effort to use its press releases and orders to highlight the importance, components, and benefits of cooperation – all in an effort to promote earlier, more meaningful, and more widespread cooperation.

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The First SEC Share Class Selection Disclosure Settlements: What We Learned & What’s Next?

Jim Lundy and Ben McCulloch authored an article entitled “The First SEC Share Class Selection Disclosure Settlements: What We Learned & What’s Next?” for the Investment Adviser Association’s IAA Newsletter Compliance Corner. In the article, Jim and Ben discuss the first wave of settlements under the SEC’s SCSD Initiative as well as lessons learned. They also explore the agency’s ongoing efforts regarding the remaining participants, consequences for firms who opted not to self-report, and the Division of Enforcement’s continued scrutiny of revenue sharing arrangements, disclosures, and conflicts.

Read the full article.*

*Originally published in the IAA Newsletter, April 2019.

SEC Releases SCSD Self-Reporting Initiative Settlements

On March 11, 2019, the SEC announced and released settlements against 79 self-reporting registered investment advisers (RIAs), touting $125 million being returned to investors. The actions stem from the SEC’s Share Class Selection Disclosure Initiative (SCSD Initiative). The SCSD Initiative incentivized RIAs to self-report violations resulting from undisclosed conflicts of interest, to promptly compensate investors, and to review and correct fee disclosures. Specifically regarding Rule 12b-1 fees, the SEC’s orders found that the RIAs failed to adequately disclose conflicts of interest related to the sale of higher-cost mutual fund share classes when a lower-cost share class was available.

SEC Chairman Jay Clayton commented: “I am pleased that so many investment advisers chose to participate in this initiative and, more importantly, that their clients will be reimbursed. This initiative will have immediate and lasting benefits for Main Street investors, including through improved disclosure. Also, I am once again proud of our Division of Enforcement for their vigorous and effective pursuit of matters that substantially benefit our long-term, retail investors.”

While the SEC and its Division of Enforcement may be pleased, the various industry reactions during the course of the SCSD Initiative included frustration–and at times reasonably so. Tempering that frustration, is that the SEC’s focus on RIA conflicts of interest and disclosures continues. First, there is an expectation that the SEC will announce more settlements in the future for additional SCSD Initiative participants and that this may involve a grouping of a “second wave” of settlements. Second, Enforcement’s Asset Management Unit has already opened investigations into RIAs who did not self-report. Lastly, these investigations included requests for documents and information regarding revenue sharing practices and disclosures.

In conclusion, it is expected that the SEC’s aggressive enforcement efforts regarding RIA conflicts of interest and disclosures to Main Street investors will continue and has already expanded to include revenue sharing.     

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