A recent ruling may raise the bar forthe Securities and Exchange Commission (SEC) in charging registered investment advisers for omissions of potential conflicts and seeking disgorgement, giving the defense bar additional ammunition to fight SEC investigations. This ruling is especially significant in that it casts doubt on the basis for the SEC's Share Class Selection Disclosure Initiative under Chairman Jay Clayton, which resulted in substantial settlements with a large number of investment adviser firms.
A U.S. Court of Appeals for the First Circuit panel, which included former Supreme Court Justice Stephen G. Breyer sitting by designation, recently vacated a summary judgmentorder in favor of the SEC and $93 million in disgorgement, prejudgment interest, and civil penaltiesagainst registered broker-dealer and investment adviser Commonwealth Equity Services, also known as Commonwealth Financial Network (Commonwealth). The case focused on Commonwealth's allegedly inadequate disclosure of potential conflicts of interest arising from its revenue sharing arrangements with a clearing broker related to certain transactions advertised as "no fee" mutual funds, in violation of Section 206(2) of the Investment Advisers Act of 1940 (Advisers Act). The First Circuit's April opinion rejected the District Court's holding that all conflicts of interest are per se material to a reasonable investor, stating that the question of materiality should be decided by a jury. The Appellate Court also reversed the disgorgement order due to (1) insufficient proof of a causal connection between Commonwealth's allegedly inadequate disclosures and purported unlawful profits and (2) the lower court's failure to deduct legitimate expenses as required by the Supreme Court's Liu v. SEC.1 The case has been remanded for further proceedings.
Procedural Background
On August 1, 2019, the SEC filed suit against Commonwealth, an SEC-registered broker-dealer and investment adviser, for violations of Sections 206(2) and (4) of the Advisers Act. According to the SEC, between 2014 and 2018, Commonwealth failed to adequately disclose potential conflicts of interest related to its receipt of revenue sharing payments for certain client mutual fund investments.
Commonwealth used a clearing broker (the "Clearing Broker") to buy and sell mutual funds for clients. Certain mutual fund companies paid fees to that Clearing Broker, to make their funds or share classes available on the Clearing Broker's platform. In 2014, the Clearing Broker agreed to pay Commonwealth 80% of the gross revenue it received from those mutual fund companies. Commonwealth's investment advisory representatives (IARs) were not aware of which share classes were part of Commonwealth's revenue sharing agreement, and the IARs' compensation did not change based on if the selected funds provided Commonwealth with revenue sharing income.
Commonwealth disclosed the existence of its revenue sharing agreement with the Clearing Broker. Specifically, Commonwealth's Form ADV stated that it "may receive service fees and other compensation from investment product sponsors . . . ."2 Further, the Form ADV stated that Commonwealth's receipt of revenue sharing fees "may present a potential conflict of interest because Commonwealth or your advisor may have an incentive to recommend those products or programs . . . ."3
In 2018, Commonwealth updated its Form ADV disclosure to state that Commonwealth "will receive" revenue sharing payments rather than that it "may receive" those payments. It further disclosed that "a conflict of interest exists because Commonwealth or your advisor have a financial incentive to recommend or select NTF funds that do not assess transaction charges but cost you more in internal expenses than funds that do assess transaction charges but cost you less in internal expenses."4
The SEC alleged that from July 2014 through December 2018, Commonwealth failed to adequately disclose that its revenue sharing agreement with the Clearing Broker created a conflict of interest by incentivizing Commonwealth to direct client investments to those mutual fund share classes that produce revenue sharing income. According to the SEC, Commonwealth's failure to disclose this conflict violated Section 206(2) of the Advisers Act, a negligence-based claim. The SEC further asserted that Commonwealth's failure "to adopt and to implement written policies and procedures reasonably designed to ensure that Commonwealth identified and disclosed these conflicts of interest" violated Section 206(4) of the Advisers Act.5
On April 7, 2023, the United States District Court for District of Massachusetts granted the SEC's motion for summary judgment on its Sections 206(2) and (4) claims. The District Court found Commonwealth's disclosures were inadequate as a matter of law because Commonwealth "present[ed] the payments [Commonwealth] receive[d] from the revenue sharing arrangement as a hypothetical rather than disclosing it as a matter of fact."6 Further, the District Court found Commonwealth's revenue sharing arrangement was a material fact that required disclosure, because "potential conflicts of interest are material facts that investors would consider important in making investment decisions."7
On March 29, 2024, the District Court entered a final judgment, ordering Commonwealth to pay just over $65 million in disgorgement, $21 million in prejudgment interest, and a $6.5 million civil penalty. According to the lower court, this amount represented the difference between the amount Commonwealth received from its revenue sharing payments and what Commonwealth would have received if clients' assets had been invested in lower-cost share classes of those same funds. The District Court reasoned that "at least some" of Commonwealth's clients would have moved to lower-cost shares if they knew they were invested in higher-cost shares. The District Court also declined to deduct Commonwealth's expenses from the amount disgorged.
A Jury Must Determine the Materiality of Conflicts of Interests and Omissions
The First Circuit found that whether an omitted fact is material is a mixed question of law and fact that should be determined by a jury, considering the total mix of information available to investors. Thus, assessing materiality requires a detailed consideration of the inferences that a reasonable investor would draw from a given set of facts. The First Circuit faulted the District Court for failing to engage in any fact-specific inquiry and its erroneous conclusion that all potential conflicts are per se material, and therefore the omissions at issue were material as a matter of law.
Among other disclosures, the panel considered Commonwealth's Form ADV brochures from 2014 to 2018 in detail. The panel recognized that SEC regulations require that the brochures fully disclose all material conflicts of interest between an investment adviser and its clients that could affect the advisory relationship.8 The disclosures also must provide sufficiently specific facts to allow the client to understand the conflicts of interest and describe any arrangements where entities other than clients provide an economic benefit to the adviser for providing advisory services so as to provide informed consent.9
The First Circuit noted that the SEC failed to put forward any testimony from Commonwealth clients supporting the asserted significance of the omitted evidence.10 Relatedly, it acknowledged unresolved questions of fact for the jury, including whether adding disclosures with more precise descriptions "to the already-disclosed conflicts of interest"11 would have been viewed by a reasonable investor as significantly altering the "total mix" of information Commonwealth made available. On this basis, the court overturned the prior finding that Commonwealth's disclosures were inadequate as a matter of law, due in part to the 2014–2018 disclosures presenting the payments from the revenue sharing agreement "as a hypothetical rather than disclosing it as a matter of fact."12 Applying the "usual rule" that materiality is to be decided by the jury,13 the First Circuit held a reasonable jury could conclude that more precise descriptions in Commonwealth's disclosures during the period would not have significantly altered the "total mix" of information available.14
The Appellate Court also identified several other factual issues potentially precluding summary judgment, including evidence that clients made investment decisions through sophisticated and independent representatives that sometimes conducted independent research in connection with their recommendations, as opposed to solely relying on Commonwealth's recommendations or product structures. Additionally, the First Circuit criticized the District Court's assumption that a lower cost or no fee fund was important to each of Commonwealth's diversely situated clients.
Only Net Profits Casually Connected to Violations May Be Disgorged
In vacating the liability judgment, the First Circuit acknowledged that the disgorgement award also needed to be vacated. Nevertheless, the First Circuit also found the District Court erred in calculating disgorgement. First, it determined that the SEC did not adequately show "either reasonable approximation or causal connection sufficient to support the court's disgorgement award." In calculating its disgorgement award, the District Court reasoned that "at least some" clients would have moved to lower-cost funds. However, this standard encompassed "too wide a range of possibilities." The First Circuit found that the lower court failed to address shortcomings raised by Commonwealth to the SEC's causation evidence.
Second, and equally important, the First Circuit found that the lower court failed to determine whether any legitimate expenses existed in ruling the entire profit was attributable to the wrongdoing. Thus, it found that the District Court must assess whether Commonwealth was entitled to deduct expenses from the disgorgement amount in accordance with Liu.15
Practical Implications
A Higher Bar for SEC Enforcement May Chill Retail Investment Adviser Cases
- The First Circuit's decision in Commonwealth comes on the heels of the SEC's 2018 Share Class Selection Disclosure Initiative ("Disclosure Initiative"), which targeted the adequacy of investment advisers' disclosures relating to the selection of mutual fund share classes that paid the adviser or its related entities or individuals a fee pursuant to Rule 12b-1 of the Investment Company Act of 1940 (12b-1 fee), when a lower-cost share class for the same fund was available to clients.16 Although not a 12b-1 case, the SEC's investigation of Commonwealth began around the same time and is based on the same share class selection concepts.
- The SEC set forth its view of the law in the Disclosure Initiative announcement stating "it is usually in the client's best interest to invest in the lower-cost share class rather than the 12b-1 fee paying share class because the client's returns would not be reduced by the 12b-1 fees" and offering self-reporting options to "[i]nvestment advisers that did not explicitly disclose in applicable Forms ADV (i.e., brochure(s) and brochure supplements) the conflict of interest associated with the 12b-1 fees the firm, its affiliates, or its supervised persons received for investing advisory clients in a fund's 12b-1 fee paying share class when a lower-cost share class was available.17 The announcement further stated that "[a] conflict of interest is a material fact that an investment adviser must disclose to its clients."18
- Prior to Commonwealth, several courts also adopted rulings consistent with the SEC's interpretation, including findings that all undisclosed fees earned by a registered investment adviser represented a material conflict of interest as a matter of law in assessing the sufficiency of disclosures regarding revenue sharing issues.19
- Thus, the Commonwealth decision represents a departure from materiality determinations and a significant scaling back of concepts that the SEC viewed as clear violations. Paired with the increased evidence and resources that may be needed for further enforcement actions against retail investment advisers, this decision may have a chilling effect on SEC enforcement in this area.
Further Scrutiny of Disgorgement Orders
- The First Circuit's ruling also lays groundwork for scrutinizing future disgorgement rulings' causation analysis. Specifically, the SEC is required to present evidence that any disgorgement sought is causally connected to the alleged wrongdoing and thus represents a reasonable approximation of ill-gotten gains.
- Additionally, in followingLiu, the First Circuit's decision provides further basis for challenging the amount of disgorgement ordered where legitimate expenses were not appropriately deducted.
Footnotes
1. SEC v. Commonwealth Equity Serv. LLC, 133 F.4th 152, 173 (1st Cir. 2025) (citing Liu v. SEC, 591 U.S. 71, 91-92 (2020)).
2. Id. at 158.
3. Id. at 159.
4. Id. at 160.
5. Id. at 165.
6. Id.
7. Id.
8. Id. at 158 (citingAmendments to Form ADV, Investment Advisers Act of 1940, Release No. 3060 (2010), 2010 WL 2957506, at *74).
9. Id. at 158.
10. Id. at 170.
11. Id.
12. Id. at 165.
13. Id. at 168.
14. Id.at 170 (citing Basic Inc. v. Levinson, 485 U.S. 224, 232 (1988)).
15. https://www.foley.com/insights/publications/2020/06/supreme-court-recognizes-secs-disgorgement-power/.
16. SEC Launches Share Class Selection Disclosure Initiative to Encourage Self-Reporting and the Prompt Return of Funds to Investors, SEC Press Release No. 2018-15 (Feb. 12, 2018).
17. Share Class Selection Disclosure Initiative, SEC (May 1, 2018), https://www.sec.gov/newsroom/whats-new/scsd-initiative.
18. Id. (citing SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-92 (1963)).
19. See, e.g., SEC v. Westport Capital Markets LLC, 408 F. Supp. 3d 93, 104 (D. Conn. 2019) (holding that vague disclosures that an adviser "might be deriving additional compensation from their trading activities" were inadequate when the adviser is "actually doing so" and failed to apprise clients of the same); SEC v. Ambassador Advisors, LLC, 576 F. Supp. 3d 286 (E.D. Pa. 2021) (conflict disclosure under the Investment Advisers Act required full and frank disclosure of any practice that presents conflict of interest).
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