A federal court recently ruled a Texas investment advisory firm failed to disclose conflicts related to the sale of mutual funds, but it also said it didn't do so willfully — vacating the civil penalties and sending the case back to the Securities and Exchange Commission.
Despite an April 30 decision by the U.S. Court of Appeals for the D.C. Circuit that
gave both sides a partial victory, the message to registered investment advisers is to beef up disclosure language in their Form ADVs, according to a compliance lawyer.
The case involved Robare & Jones Wealth Management in Houston. The
SEC alleged the firm inadequately disclosed conflicts of interest from 2005 to 2013 related to a revenue-sharing agreement with
Fidelity Investments that gave the firm a payment when it recommended certain funds on the Fidelity platform. The advisory firm received approximately $400,000 from Fidelity.
The SEC said the arrangement wasn't disclosed at all until 2011, and after that point, the disclosure fell short of full transparency because it said the firm "may" receive revenue-sharing when, in fact, it did.
The firm's principals, Mark Robare and Jack Jones, appealed the SEC enforcement case to an in-house SEC administrative law judge and won. But the full commission overturned the ALJ decision and imposed $50,000 in penalties on Mr. Robare, Mr. Jones and the firm.
Mr. Robare and Mr. Jones then appealed to the D.C. Circuit, which found they were negligent in disclosing conflicts of interest but did not hide them willfully. The court vacated the civil penalties. Now, it's back in the SEC's hands to decide what kind of punishment to mete out.
Mr. Robare and Mr. Jones created model portfolios for their clients comprised of no-transaction-fee mutual funds,
according to a blog post by the firm's lawyer, Alan Wolper, partner at Ulmer & Berne. He said Fidelity told them they would receive a "small fee if they happened to select 'eligible'" funds, but that they could choose funds based on objective criteria.
The two entered the agreement and then hired consultants to write their Form ADV disclosure.
"Having surrounded themselves with experts and advisers, they firmly believed that any conflict of interest, whether actual or potential, that was created by the deal with Fidelity was adequately disclosed to the world on their Form ADV," Mr. Wolper wrote in his blog post.
But the D.C. Circuit still found they committed fraud.
"I think we're strangled with a strange legal standard here," Mr. Wolper said in an interview. "I don't know what else they could have done. And then for them to be held liable notwithstanding [the hiring of consultants] is frustrating to say the least."
The case has direct implications for the recent
share-class disclosure initiative the SEC conducted. In that program, the agency encouraged investment advisers to report themselves if they failed to disclose they received 12b-1 fees for selling the funds. The firms that stepped forward had to repay their clients but avoided fines.
It now appears the SEC is starting enforcement investigations into firms that didn't self-report. Those probes are extending into revenue-sharing. The D.C. Circuit's decision strengthens the SEC Enforcement Division's hand, according to Jim Lundy, partner at Drinker Biddle & Reath.
"This is a precedent that may embolden the asset management unit to be aggressive regarding the disclosure requirements of RIAs," Mr. Lundy said.
Investment advisers should review their Form ADV disclosures and sharpen language about possible conflicts of interest based on financial incentives, according to Mr. Lundy.
"If you want to stop the disgorgement clock from ticking, you need to go in and make your disclosures as specific and detailed as possible," he said.
Mr. Wolper is hopeful the SEC will lighten up on Mr. Robare and Mr. Jones when determining whether civil penalties are still appropriate following the D.C. Circuit opinion. The advisers will not appeal the appeals court decision to the Supreme Court.
