SEC v. Commonwealth: a win for the securities industry

The SEC brought suit against Commonwealth Financial Network, a dual registrant, for alleged deficiencies in Commonwealth’s disclosures of its receipt of revenue sharing from its clearing broker. The SEC alleged that Commonwealth violated Sections 206(2) and 206(4) of the Advisers Act and Rule 206(4)-7 thereunder. The district court granted summary judgment in favor of the SEC, finding that as a matter of law, Commonwealth’s disclosures were deficient. The district court also largely adopted the SEC’s proposed disgorgement figure, even though Commonwealth argued that the SEC had not shown any causal connection between the alleged violations and the disgorgement figure, that the SEC’s calculations were severely flawed and not a reasonable approximation of the firm’s profits causally connected to the purported violation, and that the SEC failed to deduct reasonable expenses as directed by the Supreme Court.

Commonwealth appealed both the trial court’s grant of summary judgment and disgorgement order to the First Circuit. The First Circuit vacated the summary judgment order and disgorgement order, finding for Commonwealth on every issue. The opinion contains four main takeaways that investment advisers, broker-dealers, and practitioners should consider going forward:

• The Issue of Materiality Belongs with a Jury. The First Circuit held that the question of whether Commonwealth’s alleged omissions of certain statements were “material” was a question of fact that should have been decided by a jury. Noting that it is the “usual rule” that materiality is a jury issue, the First Circuit rejected the district court’s conclusion that an investment adviser’s potential conflicts of interest are “per se” material facts that should have been disclosed. The First Circuit reversed summary judgment because, among other things, the SEC failed to introduce evidence showing how “clients themselves” considered the alleged conflicts at issue and because a fact question exists as to whether additional disclosure by Commonwealth would have “significantly altered the total mix of information made available” to investors. 

The decision is likely to alter the state of play in future SEC investigations alleging insufficient disclosure of conflicts of interest. The SEC staff may place greater emphasis on gathering evidence from investors and developing a factual record sufficient to prove omitted information would have had an impact on their investment decision, rather than argue that all conflicts of interest related to compensation are per se material. Going forward, the SEC will need to demonstrate that the undisclosed information it claims is material would have altered the total mix of information available such that there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision. 

• The SEC must provide evidence of a causal connection between the alleged violations and any disgorgement. The First Circuit ruled that the SEC's disgorgement calculation was not causally connected to Commonwealth's alleged disclosure violation. The SEC did not present any testimony by clients related to Commonwealth’s alleged failure to disclose additional information related to revenue-sharing. Specifically, there was no testimony indicating that any additional disclosure by Commonwealth would have caused the clients to move into lower-cost share classes. Despite the lack of evidence, the district court found that some clients would have moved money to lower-cost funds if Commonwealth had made additional disclosures. The First Circuit was not persuaded by the district court’s reasoning that causation was “self-evident” because “at least some” clients would have moved money to lower-cost funds had Commonwealth fully disclosed its alleged conflicts of interest. The First Circuit rejected the district court’s “at least some” standard for disgorgement, stating that it encompassed “too wide a range of possibilities.” 

The SEC may place greater focus on gathering evidence from investors during investigations to demonstrate that the lack of disclosure led to actual harm. The SEC will likely focus on client statements and testimony that the lack of disclosure caused them to make a more expensive investment choice. Along with the implications above regarding materiality, the Staff’s investigations will require more time and resources to gather evidence than before, thereby increasing the scope and length of investigations. However, such evidence will likely be the basis for the staff’s recommendation whether the Commission should pursue a formal action against a Respondent, possibly leading to more favorable resolutions for the industry. 

• Any disgorgement calculation must be thorough and use justifiable methodologies. To establish a disgorgement award, the SEC has the burden to prove a “reasonable approximation” of profits causally connected to the alleged violation. The district court adopted in full the $65.5 million sum the SEC alleged was representative of Commonwealth’s profits. But both the SEC and the district court ignored, the First Circuit found, “inadequately supported assumptions made by the SEC” and the criticisms raised by Commonwealth’s expert as to the representativeness of the sample used by the SEC’s expert to identify alternative share classes. The First Circuit stressed that although exactness is not required, more analysis and connection between an alleged violation and the disgorgement calculation are required than the SEC conducted. 

The decision offers valuable guidance on the criteria for determining what constitutes a “reasonable approximation.” Under the First Circuit's standard, the SEC must conduct a thorough analysis of data rather than extrapolate from a data sample. Like the points made above, this could also prolong the length of investigations as the Staff seeks to obtain, synthesize and review large volumes of trading data to reach a reasonable approximation of the profits causally connected to the alleged disclosure violation. This will provide an opportunity for Respondents to attack the SEC’s damages calculations early on and to propose alternative theories on disgorgement.

• Courts must deduct legitimate expenses from any disgorgement figure. Citing to the pivotal United States Supreme Court case Liu v. SEC, 591 U.S. 71 (2020), the First Circuit found that the district court failed to assess whether Commonwealth was entitled to deduct any of its expenses from the disgorgement award. The First Circuit correctly noted that courts awarding disgorgement must analyze whether a defendant’s claimed expenses were “legitimate” and had “value independent of fueling a fraudulent scheme” and, therefore, subject to deduction. 

Despite Liu, some lower courts have been hesitant to deduct legitimate expenses from disgorgement amounts. The First Circuit’s explicit instruction to deduct expenses may lead to more lower courts doing so. The decision highlights that a trial court cannot simply ignore a defendant’s legitimate expenses when conducting a disgorgement analysis. This may provide an avenue for defendants in future SEC enforcement actions to push for a detailed review of expenses by the SEC and the court.