Conflicts of Interest | Disclosures | Form ADV

SEC Imposes Strict Liability Standard on Advisers, Dismissing Due Care Defense

weeping-girlThe first week of November was a time for surprises, but most surprising to me was the SEC’s decision in In re The Robare Group, Ltd.  Back in 2015, I was encouraged by the findings in the original case, where Administrative Law Judge James E. Grimes at long last provided investment advisers with direction on the appropriate standard of care for disclosing conflicts of interest in the Form ADV.   In the proceeding, the SEC alleged that The Robare Group, Ltd. (“TRG”), a registered investment adviser, failed to provide adequate disclosure regarding a compensation arrangement TRG had with Fidelity, its custodian, and Triad Advisers, a registered broker dealer.  ALJ Grimes dismissed the case, stating that the SEC had failed to meet its burden of showing that TRG acted negligently or with scienter (which, from a legal perspective, means knowing something was wrong and doing it anyway).

With respect to the negligence claim, the judge relied heavily on the testimony of a compliance expert, including her statement that “with respect to Form ADV disclosures, advisers operate in a difficult environment that presents challenges for even experienced compliance professionals.” As a result of this testimony, ALJ Grimes concluded that “employing a compliance professional and following his or her advice” met industry standards of due care. These comments indicated a willingness by at least one judge to require the SEC to demonstrate why an adviser’s compliance efforts were deficient, instead of simply stating that regulatory violations occurred and consequently the firm did not meet its standard of care.

The Division of Enforcement appealed this decision to the Commission, which promptly swept aside the concept of reasonableness, finding that TRG was negligent in failing to fully and fairly disclose the conflict of interest that arose from a compensation sharing arrangement.  The firm principals, Robare and Jones, were fined $50,000 each based on their failure to provide any disclosure of the arrangement before December 2011.   “Although we do not find that they acted with scienter, Respondents’ conduct involved fraud and constituted a fundamental breach of their fiduciary duties to their clients. Respondents’ conduct also harmed their clients by depriving them of conflict-free advice.”

One of the most troubling aspects of this case is the SEC’s statement that the conduct involved fraud, and that TRG’s clients were harmed because they did not receive conflict-free advice.  Based on the facts presented, there was no fraud.  Fraud involves the intentional use of deceit or other dishonest means to deprive another of money, property or a legal right.  Even the SEC admits throughout its opinion that there was no intent to defraud on the part of TRG.

Additionally, clients of an investment adviser are not entitled to receive conflict-free advice.  They are entitled to disclosure of all material conflicts so they can decide whether to take an investment adviser’s advice.   Testimony in the case indicates that even though TRG’s principals were compensated under the Program Agreement, their investment decisions were not influenced by those payments.  Their recommendations were made based on objective criteria, and the SEC did not provide any evidence to indicate that TRG was deliberately selecting funds that would entitle them to additional compensation. It is difficult to see in this situation how clients were harmed.

I also find it troubling that the SEC so summarily dismissed the TRG’s argument of reliance on expert advice.  Negligence is defined as the failure to exercise the care towards other which a reasonable or prudent person would do in the circumstances.  Given the complexity of the disclosures required in Form ADV, TRG’s principals sought out the advice from compliance experts (several times) and followed the advice they received.  But the SEC flat out rejects this evidence, and instead, imposes strict liability.  Here’s a direct quote:

In any case, TRG and Robare could not reasonably rely on any advice that the disclosures were adequate because they knew their obligations as investment advisers, that they were required to disclose potential conflicts of interest, and that the Arrangement presented such a conflict but was not disclosed. Because of the obvious inadequacy of TRG’s disclosure, we find that any reliance by TRG on advice that its disclosure was adequate was not reasonable and thus does not negate our finding of negligence.  [footnotes omitted].

Admittedly, I am a compliance professional who provides advice to clients on the appropriate disclosure for the Form ADV, so I have a bias in this situation.  But as anyone who has completed a Form ADV can attest, this is a complicated form and not easy to understand.

I also find it completely disingenuous for the SEC to so easily dismiss the defense of reliance on experts.  The SEC said that to rely on this defense that the defendant has to demonstrate that he made “complete disclosure to counsel, sought advice as to the legality of his conduct, received advice that his conduct was legal, and relied on that advice in good faith.”  The SEC went on to says that “no evidence exists that TRG specifically sought or received advice” from Triad, the broker dealer providing compliance assistance, about how to disclose the arrangement to its clients.  Triad was the entity initially receiving the payments so it seems highly improbable that it did not understand the nature of the arrangement sufficiently to give advice on disclosure.

It seems even more incredible that SEC could so easily assert that “Robare’s vague references to discussions with consultants do not establish that TRG received and followed advice about the disclosure of the Arrangement.”  As most compliance consultants will tell you, the firms asking for help do not always know what information is needed to complete Form ADV disclosure – that is why they are seeking advice.  It is the consultant’s job to ask questions about sources of compensation and potential conflicts of interest in order to draft the disclosure.

Commissioner Piwowar’s comment at the end of the opinion gives me some cause for hope.  Although he agreed with the opinion, he disagreed about the need to impose fines. He noted that in this case, there was no harm to others, and none of the principals of TRG were unjustly enriched.  Additionally, the principals had clean records, and there was no indication that penalties were required to deter them from future bad acts.

Lessons learned:

  • Advisers should look very closely at all sources of revenue and compensation, and make sure they identify and disclose any potential or actual conflicts associated with that revenue.
  • Advisers that receive compensation that could present a conflict of interest have to clearly disclose this. This requires identifying all sources of compensation the firm receives, and determining whether that compensation might provide an incentive to act in a way that enriches the firm at the expense of the client.
  • Disclosure that an adviser “may” receive compensation when the firm and/investment adviser representative DOES receive compensation is not going to cut it.
  • It may still be possible to use the defense of relying on an expert. To establish this defense, an adviser should be able to demonstrate that the firm made complete disclosure to the expert, asked for advice on the appropriate action to take, received the advice and acted on it in good faith.

This last point requires providing the consultant with a complete picture of the situation, access to any agreements or documentation relevant to the issue, and fully responding to any questions asked.  Experienced consultants will ask additional questions to ensure that all bases are covered.  As is true with any analysis, the principle of “garbage in, garbage out” applies.  The relevancy and usefulness of the advice is directly dependent on the information provided.