Shearman & Sterling LLP | Government Regulatory Enforcement Blog | D.C. Circuit Clarifies “Willfulness” Requirement For Investment Advisers Act Violations, In Decision With Possible Ramifications For SEC Sanction Authority<br >  
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  • D.C. Circuit Clarifies “Willfulness” Requirement For Investment Advisers Act Violations, In Decision With Possible Ramifications For SEC Sanction Authority
     
    05/07/2019

    On April 30, 2019, the United States Court of Appeals for the District of Columbia Circuit vacated an aggregate $150,000 in fines that the U.S. Securities and Exchange Commission (“SEC”) had levied against an investment advisory firm (the “Firm”) and its three owners.  The fines were brought over alleged failures to disclose conflicts of interest to Firm clients related to its fee arrangements.  Although the D.C. Circuit agreed with the SEC that the Firm acted negligently in failing to properly disclose certain fee arrangements, it held that such negligent conduct could not as a matter of law constitute “willful” conduct within the meaning of the Investment Advisers Act of 1940 (“Advisers Act”).  See The Robare Group, Ltd., et al. v. SEC, No. 16-1453, (D.C. Cir. April 30, 2019).  Accordingly, the D.C. Circuit remanded the case for reconsideration of the appropriate sanctions in a decision that could prompt the SEC to alter charging language for certain cases given that so much of its sanction authority requires a finding of “willful” conduct.

    Section 206(2) of the Advisers Act imposes a fiduciary duty on investment advisers to act for their clients’ benefit, including an affirmative duty to act with the utmost good faith and fully disclose all material facts and all conflicts of interest.  See 15 U.S.C. § 80b-6(2); SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-92 (1963).  Because of the affirmative nature of the duty, simple negligence suffices to prove a violation of Section 206(2).  Meanwhile, under Section 207 of the Advisers Act, investment advisors are prohibited from “willfully” making any false statements of material fact or omitting any material facts in any applications or reports filed with the SEC.  15 U.S.C. § 80b-7.
     
    According to the SEC, the Firm entered into a revenue sharing arrangement with Fidelity whereby Fidelity provided fees to the Firm when the Firm’s clients invested in certain funds offered on Fidelity’s online platform, but failed to disclose the arrangement or any resulting conflicts of interest to its clients in the Forms ADV that it filed with the SEC or elsewhere.  The Administrative Law Judge who heard the case ruled in favor of the Firm, finding that there had been no scienter and also no proof of a negligent or willful violation.  But after an appeal by the Division of Enforcement, the SEC held that the Firm had acted negligently in failing to disclose its conflicts of interest.  

    The D.C. Circuit concluded that the SEC’s finding of negligence was supported by substantial evidence, but rejected the SEC’s supplemental conclusion that the Firm had also acted willfully in failing to disclose those conflicts on its Forms ADV, reasoning that the SEC “could not rely on the same failures” as evidence of willful conduct because willfulness and negligence “are regarded as mutually exclusive.”  The D.C. Circuit pointed to the SEC’s own finding that the Firm did not act with scienter—“an intent to deceive, manipulate, or defraud”—in failing to disclose its arrangement with Fidelity, as evidence that the Firm could not have acted willfully under Section 207. 

    The term “willful” has long been an important one for the SEC, as much of its sanction authority only kicks in when there is a finding of willful conduct.  For example, Section 203 of the Advisers Act allows for censure, suspension, and revocation of registration for any investment adviser that “willfully” violates the securities laws, 15 U.S.C. § 80b-3(e)(5), and Section 15 of the Securities Exchange Act of 1934 has similar limitations.  

    The SEC has traditionally relied on a definition of willfulness drawn from a prior D.C. Circuit case, Wonsover v. SEC, 205 F.3d 408 (D.C. Cir. 2000), which held that a person acts willfully when “the person charged with the duty knows what he is doing,” irrespective of any intent to violate the law.  While the D.C. Circuit’s decision in Robare did not overturn that definition—and accepted as undisputed that the Wonsover standard applied to the word “willfully” in Section 207—it clarified how that standard should be applied.  As the Court wrote, the SEC “misinterprets Section 207, which does not proscribe willfully completing or filing a Form ADV that turns out to contain a material omission but instead makes it unlawful ‘willfully to omit . . . any material fact’ from a Form ADV.”  

    Framed in that manner, “willfully” becomes much closer to a scienter-based requirement.  In the absence of an ability to establish willfulness, the SEC still has certain statutory provisions that allow it to seek penalties, such as Section 21B(a)(2) of the Exchange Act, which allows for a civil penalty in any case with a cease and desist order irrespective of a finding of willfulness.  But the opinion should at the very least serve as a practical reminder that the level of mens rea is critical in the ultimate setting of any penalties, and that when one is “negligently” violating the securities laws, one cannot simultaneously be “willfully” doing so.