DC Circuit Ruling May Limit SEC Ability to Bar or Suspend Registered Persons

The US Court of Appeals for the DC Circuit upended a longstanding Securities and Exchange Commission (SEC or Commission) position by ruling on April 30 that “willful” conduct—a frequent prerequisite in a broad range of sanctions for violations of federal securities law provisions—implies intentional or reckless but not negligent behavior.[1] The decision will likely affect the Commission’s ability to institute proceedings in the SEC’s administrative forum to suspend or bar individuals associated with broker-dealer and investment adviser firms for negligent violation of the federal securities laws. This is a likely effect because a specific type of proceeding in the SEC’s administrative forum that is often used to suspend or bar registered firms and individuals from the industry, by statute, requires a finding that an entity or individual “willfully” violated the federal securities laws.

The Robare Decision

The DC Circuit held that an investment advisory firm and its principals (collectively Robare) acted negligently in violation of one of the antifraud provisions of the federal securities laws. In Robare Group, Ltd., et al. v. Securities and Exchange Commission, Robare appealed an SEC opinion (Commission Opinion) finding that Robare had violated Sections 206(2) and 207 of the Investment Advisers Act of 1940 (the Advisers Act) by failing to disclose a material conflict of interest. Sections 206(1) and 206(2), along with Section 207, are the antifraud provisions of the Advisers Act. Section 206(1) requires a finding of scienter, that is, either intent or recklessness. Section 206(2) requires only a finding of negligence, thus providing the basis of a “negligent fraud” theory. The Commission Opinion partially overturned on appeal an earlier decision by an SEC Administrative Law Judge (ALJ decision) who had found that Robare did not violate Sections 206 or 207 because Robare did not act intentionally or negligently. The Commission Opinion ruled that Robare acted negligently in violation of Section 206(2) but not intentionally and thus not in violation of Section 206 (1). The DC Circuit affirmed this portion of the Commission Opinion.

‘Willfully’ May Not Mean ‘Negligently’

In its decision, the Commission had found that Robare violated Section 207 because of Robare’s omission of the material conflict of interest in its filing of a Form ADV with the Commission. Section 207 makes it unlawful for any person “willfully” to misstate or omit a material fact in applications or reports to the SEC. However, on appeal, the DC Circuit reversed this determination, holding that Robare did not “willfully” violate Section 207 of the Advisers Act because Robare had acted negligently but not intentionally or recklessly.

The SEC relies on a prior DC Circuit decision, Wonsover v. SEC, which held that “willfully” in the context of Section 15(b)(4) of the Securities Exchange Act of 1934 (Exchange Act) meant “intentionally committing the act which constitutes the violation.”[2] Section 15(b)(4) provides for the SEC to institute administrative proceedings and impose sanctions against broker-dealers in certain circumstances, including where a person willfully violated the federal securities laws. Wonsover rejected the argument that “willfully” meant that a person “[must] also be aware that he is violating” the federal securities laws. The SEC had argued that because Robare intended the language in the Form ADV and intended to file the form with the Commission, Robare thus acted willfully, within the meaning of Wonsover.

The court in Robare ruled that the SEC had misinterpreted Wonsover and held that “willfully” meant that Robare would have intended to omit material information. The court further stated that “[a]ny given act may be intentional or it may be negligent, but it cannot be both.” Because the Commission had found that Robare negligently failed to disclose the conflict of interest in the Form ADV, the DC Circuit Court found in its decision that Robare did not act willfully.

Impact on SEC Ability to Suspend or Bar

Since Robare may be interpreted to mean that “willfully” is not the same as “negligently,” the decision may impede the SEC’s ability, in connection with negligent misconduct, to institute a specific type of proceeding in the SEC’s administrative forum for suspending or barring broker-dealers, investment advisers, and their associated persons from working in the industry. The federal securities laws provide for a variety of such proceedings, presided over by SEC administrative law judges and subject to de novo review by the Commission. Two types of these proceedings are most frequently instituted by the SEC: (i) administrative proceedings, such as those under Section 15(b) of the Exchange Act and Section 203 of the Advisers Act; and (ii) cease-and-desist proceedings, such as those under Section 21C of the Exchange Act and Section 203(k) of the Advisers Act. Administrative proceedings only apply to registered entities and individuals such as broker-dealers and investment advisers. For example, the Wonsover matter involved interpretation of Section 15(b)4(E) of the Exchange Act that provides for administrative proceedings for broker-dealers. Cease-and-desist proceedings apply to any entity or individual charged with violating the federal securities laws.

A key difference between the two types of proceedings in the SEC’s forum is that administrative proceedings provide for suspensions and bars as a remedy, in addition to disgorgement and civil penalties. Cease-and-desist proceedings also provide for monetary sanctions, but do not explicitly provide for suspensions or bars of entities or individuals. Administrative proceedings are commonly used primarily for obtaining a bar or suspension, based on violations of any provisions of the federal securities laws, failure to supervise a person who violated the federal securities laws, or based on certain criminal convictions or civil federal district court injunctions involving a securities law violation by a registered person or entity. Unlike cease-and-desist proceedings, a prerequisite for instituting administrative proceedings based on violations of the federal securities laws is that the entity or individual “willfully” committed the violation. Based on its prior interpretation of Wonsover, the SEC could institute administrative proceedings to suspend or bar financial professionals for negligent violations of any provisions of the federal securities laws, including non-fraud, technical provisions that did not have scienter requirements. Now, under the Robare decision, the SEC may not be able to institute administrative proceedings to suspend or bar registered professionals for negligent conduct, as the SEC may not be able to meet the statutory prerequisite of willful conduct.[3]

Potential SEC Options

Given this circumstance, the SEC may appeal the Robare decision, seek en banc review by the DC Circuit, or try to find ways to narrowly interpret or distinguish Robare. Alternatively, it may find venues other than administrative proceedings to obtain suspensions or bars for negligent conduct. For instance, the SEC has obtained conduct-based injunctions in federal district court actions against public officials from participating in municipal bond offerings, even though there are not specific statutory provisions providing for such relief.[4] The SEC instead relied on the general equitable power of the court. However, these types of injunctions have been imposed in settled cases and have not been challenged in a litigated setting. Another possibility is that the SEC will first obtain a federal district court civil injunction against negligent conduct and then institute a “follow-on” administrative proceeding to obtain suspension or bar. However, before undertaking such a convoluted path, the SEC must consider whether it would be going against the apparent intent of Congress to allow suspension or bar for only intentional or reckless conduct. Finally, the SEC may be more aggressive in alleging intentional or reckless conduct in order to seek suspensions or bars.

Conclusion: Period of Uncertainty

It is likely that the SEC and its Staff are closely analyzing this unexpected Robare ruling and assessing potential options. In the immediate future, those dealing with the Staff in enforcement matters involving registered entities and individuals, including matters involving potential suspensions or bars, may go through a period of uncertainty. Finally, the SEC and its Staff may be evaluating whether current suspensions or bars imposed on financial professionals for alleged negligent conduct remain valid.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Boston
Michael D. Blanchard
David C. Boch
Timothy P. Burke
Jason D. Frank
Thomas J. Hennessey
Jordan D. Hershman
Jason S. Pinney
T. Peter R. Pound
Emily E. Renshaw

Chicago
Peter K.M. Chan

New York
Michele A. Coffey
Bernard J. Garbutt III
Mary Gail Gearns
Brian A. Herman
Ben A. Indek
Kenneth I. Schacter

Orange County
Robert E. Gooding, Jr.

Philadelphia
Marc J. Sonnenfeld

San Francisco
Joseph E. Floren
Susan D. Resley
Charlene S. Shimada
Lucy Wang

Washington, DC
Ivan P. Harris