First Circuit Vacates $93 Million Judgment for SEC, Including $65 Million Disgorgement Award

On April 1, the US Circuit Court of Appeals for the First Circuit vacated a $93 million judgment for the SEC against Commonwealth Financial, including a $65 million disgorgement award. The three-judge panel concluded that the question of whether Commonwealth was required to provide more detailed disclosures regarding the conflict—and whether those disclosures were material such that they would have changed the minds of its clients—was a question for a jury. Further, the First Circuit held that should a jury find liability, the district court must consider whether the SEC established a causal relationship between the profits earned by Commonwealth from the revenue-sharing arrangement with its clearing broker and the alleged securities law violations before calculating an appropriate disgorgement penalty.

The US Securities and Exchange Commission (SEC) alleged that Commonwealth breached its fiduciary duties by failing adequately to disclose conflicts of interest associated with a revenue-sharing arrangement that incentivized Commonwealth to direct client investments into mutual fund share classes that paid compensation to the firm over other share classes that may have been cheaper for Commonwealth’s clients.

The First Circuit reversed the district court’s order granting the SEC’s motion for summary judgment, vacated the decision and disgorgement order, and ordered the case to be returned to the district court for further proceedings. [1]

BACKGROUND

In 2019, the SEC brought an action in the US District Court for the District of Massachusetts against Commonwealth, a dually registered broker-dealer and investment adviser, alleging that the firm failed to fully disclose conflicts of interest associated with its receipt of compensation for client investments in “no-transaction fee” mutual funds offered by its clearing broker. [2] The SEC alleged that Commonwealth breached its fiduciary duties owed to its clients, in violation of Sections 206(2) and 206(4) of the Investment Advisers Act of 1940 (Advisers Act), and Rule 206(4)-7 thereunder, by not fully disclosing that the revenue-sharing arrangement with its clearing broker incentivized Commonwealth to select more expensive mutual fund share classes that would pay revenue to the firm where lower-cost share classes of the same funds were available to clients. The SEC moved for summary judgment on its claims. [3]

In April 2023, the district court granted partial summary judgment for the SEC, holding that Commonwealth’s disclosures omitted material facts that would have led clients to reconsider whether the mutual funds they were invested in were appropriate in light of the revenue sharing arrangement. This omission, the court held, was a breach of Commonwealth’s fiduciary duties under the Advisers Act. [4]

In addition to a $6.5 million civil penalty and $21 million in prejudgment interest, the district court ordered Commonwealth to disgorge $65 million in “revenue-sharing income”—the amount an SEC expert claimed to be the difference in revenue Commonwealth earned from the arrangement it had with its clearing broker and what it would have earned if those clients had invested in lower cost share classes of the same mutual funds. The court reasoned that the disgorgement was appropriate because causation was “self-evident.” It found that “at least some” of Commonwealth’s clients would have invested in lower-cost mutual funds had Commonwealth more fully disclosed the conflict of interest. [5]

FIRST CIRCUIT OPINION

Vacating the liability judgment and the $93 million judgment against Commonwealth, the First Circuit remanded the case back to the district court. If a jury finds liability in whole or in part, the First Circuit instructed the court to consider whether the SEC has adequately established a causal connection between Commonwealth's profits and its alleged violative conduct to warrant the $65 million disgorgement award. [6] The court’s opinion emphasizes two key aspects related to the adequacy of disclosures: the requirements for materiality, and the propriety of disgorgement, discussed below.

Materiality

In vacating the district court’s grant of partial summary judgment, the First Circuit emphasized that the materiality of the allegedly omitted information from Commonwealth’s conflict of interest disclosures regarding its revenue-sharing arrangement—i.e., whether the omitted information was significant enough to influence a reasonable investor's decision to invest in alternative or lower-cost mutual fund share classes—is an issue generally left for the trier of fact. [7] Accordingly, unless reasonable minds could not differ on the question of materiality, it should be decided by a jury, not on summary judgment. The First Circuit found that the trial court had neglected to conduct the required fact-specific materiality inquiry, instead erroneously presuming all potential conflicts of interest are material as a matter of law. [8] This ruling will be helpful for defendants facing securities fraud charges, particularly those seeking to challenge SEC allegations involving presumed materiality of statements and alleged omissions.

Disgorgement

With respect to the $65 million disgorgement award, the First Circuit explained that the SEC bears the burden to provide a reasonable approximation of profits that were causally connected to the alleged violations. [9] The court found the SEC’s reliance on expert calculations insufficient where the expert based his findings on sampling not representative of the share classes approved by Commonwealth and did not adequately account for transaction fees or consider the diverse goals and strategies of Commonwealth’s clients. [10] For these reasons, among others, the First Circuit held that the SEC did not sufficiently show the requisite clear, causal relationship between Commonwealth’s alleged securities law violations and its alleged ill-gotten gains. [11] The court effectively reaffirmed that mere calculation of profits earned is an insufficient basis for a disgorgement award.

KEY TAKEAWAYS

Some key lessons learned from the Commonwealth decision include:

Robust Conflict of Interest Disclosures Are Still Important

Firms should still maintain robust conflict of interest disclosures, particularly where there may be an incentive to offer certain products over others, in order to avoid unwanted scrutiny from the SEC.

Large Disgorgement Penalties May Be Scrutinized

In recent years, it was common for the SEC to seek large, seemingly punitive disgorgement awards. The First Circuit’s reasoning suggests the SEC will be put to its proof and must do the work to establish a causal link between the ill-gotten gains received (excluding any legitimate business expenses) and the federal securities law violations alleged.

Court Interpretations Will Vary

While the Commonwealth decision is viewed positively by firms who offer similar products with similar clearing broker relationships, not every court will be aligned with the First Circuit’s reasoning. Further interpretations of both violations of federal securities laws and corresponding disgorgement awards and penalties imposed by the SEC are subject to varying interpretations across the circuits, so firms must be ready to adapt their strategies to comply with such interpretations, particularly in their jurisdictions.