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.

OCIE Highlights the Top 5 Compliance Topics from Examinations of Investment Advisers

On February 7, 2017, the Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert discussing the five most frequent compliance topics identified in OCIE examinations of investment advisors. The Alert was compiled based on deficiency letters from over 1,000 investment adviser examinations completed during the past two years. The top five topics are: (1) the Compliance Rule; (2) Regulatory Filings; (3) the Custody Rule; (4) the Code of Ethics Rule; and (5) the Books and Records Rule.

The Compliance Rule

The Compliance Rule requires: (1) written and policies and procedures reasonably designed to prevent violations of the Advisers Act; (2) annual review of the policies and their implementation; and (3) a chief compliance officer who monitors the policies and procedures.  Examples of common Compliance Rule problems included:

  • Advisers did not follow their compliance policies and procedures;
  • Annual reviews were not performed or did not address the adequacy of the adviser’s policies and procedures;
  • Compliance manuals were not reasonably tailored to the adviser’s business practices; and
  • Compliance manuals were not current.

Regulatory Filings

OCIE frequently cited advisers for failing to make timely and complete regulatory filings, such as Form ADV (as required by Rule 204-1 under the Advisers Act), Form PF (as required by Rule 204(b)-1 under the Advisers Act), and Form D (as required by Rule 503 under Regulation D of the ’33 Act) on behalf of an adviser’s private fund clients. Timely, accurate, and appropriately amended regulatory filings, especially for these three forms, should be a priority for all advisers.

The Custody Rule

The Custody Rule, which applies to advisers who have custody of client cash or securities, is designed to safeguard client assets from unlawful activity or financial problems of the adviser.  OCIE identified the following common deficiencies or weaknesses with respect to the Custody Rule:

  • Advisers did not recognize they had “custody” due to: (1) having online access to client accounts, or (2) having other authority over client accounts (such as having power of attorney or serving as a trustee of client trusts); and
  • Surprise examinations by independent accountants were not actually a surprise, and advisers failed to fully disclose custody lists during surprise examinations.

The Code of Ethics Rule

The Code of Ethics Rule requires that advisers adopt and maintain a code of ethics that meets certain minimum requirements, and which is described in Form ADV and made available to clients or prospective clients. Deficiencies or weaknesses regarding the Code of Ethics Rule were often found because:

  • Advisers failed to identify all of their access persons;
  • Codes did not specify review of the holdings and transactions reports, and did not identify specific submission timeframes;
  • Submission of transactions and holdings were untimely; and
  • Advisers failed to describe their code of ethics in Form ADV.

The Books and Records Rule

The maintenance of books and records as dictated by SEC requirements is another frequent problem area according to OCIE. Some advisers had contradictory information within separate sets of records, while other advisers either maintained inaccurate records or failed to update their records in a timely fashion. Worse still, other advisers simply failed to maintain all of the records that the Books and Records Rule requires them to keep.