One day after announcing it was being acquired by LPL Financial, Commonwealth Financial Network won its appeal of a $93.2 million penalty in a SEC case over mutual fund recommendations.
A three judge panel of the First Circuit Court of Appeals sided with Commonwealth on Tuesday after finding that a lower district court had made “fundamental legal errors” when handing down the landmark judgment in April last year. Commonwealth was walloped with more than $72 million in disgorgement and civil penalties and $21.2 million in prejudgment interest over allegations that it had failed to properly disclose brokers’ conflicts of interest when recommending certain mutual fund products.
The SEC had contended that at least some clients would have gone for cheaper alternatives had they known they were available. Judge Indira Talwani of the U.S. District Court in Boston agreed in a ruling handed down in April last year.
“Had Commonwealth’s clients known they were invested in higher-cost shares of funds for which lower-cost shares existed, and that the higher cost resulted in greater profit for Commonwealth, there is reason to believe that at least some of those clients would have elected to move their money to the lower-cost funds,” Talwani wrote.
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Commonwealth filed its appeal of what it called a “draconian” judgment roughly three months later. In siding with the firm, judges on the federal First Circuit Court of Appeals faulted Judge Talwani for deciding on her own that conflict-of-interest information Commonwealth allegedly withheld from investors might have caused them to act differently and invest in cheaper products than they actually did. That question, according to the opinion written by appelate judge Sandra Lynch, should have been left to a jury.
And there’s no guarantee that jurors would have reached the same conclusion as Talwani, the appellate judges wrote. “There are material issues of fact as to the importance of price, Commonwealth’s influence over the funds selected, and about the significance of the allegedly deficient disclosures, themselves,” according to the decision. “It is the role of a jury to determine those questions.”
The ruling sends the dispute back to district court in Boston, where regulators can again try to pursue their claims against Commonwealth. The SEC, which originally filed its case in 2019, did not respond to a request for comment.
No impact on LPL’s acquisition decision
In its appeal, Commonwealth said that the $93 million penalty would strike a substantial blow to its finances. The amount, the firm wrote, was nearly double the profits it had reported for 2014.
But the judgment did not figure in the announcement this week that Commonwealth will be sold to LPL Financial for $2.7 billion in a deal expected to close in the second half of this year. In an interview on Tuesday, LPL CEO Rich Steinmeier said the pending $93 million judgment wasn’t viewed as an impediment to the negotiations.
“With the size and the scope of the transaction, that was not really a concern as we went through our due diligence,” Steinmeier said.
An LPL spokesperson declined to comment on Commonwealth’s successful appeal, and Commonwealth did not return a request for comment.
‘Negligent mistakes’ — but a substantial sanction
Commonwealth noted in court filings that the required disclosures weren’t entirely absent. Forms ADV filed with the SEC between 2014 and 2018, for instance, revealed that the firm had a possible conflict of interest through its arrangement with Fidelity’s National Financial Services clearing arm. Commonwealth also noted in its appeal that its advisors received no additional compensation for recommending certain mutual fund products over others.
“It is no flight of fancy to wonder if there has been another case in the annals of federal administrative regulation in which a greater civil sanction was imposed for only negligent mistakes made during attempted compliance with unwritten rules and without proven harm or complaining victims,” Commonwealth argued.
In its decision Tuesday, the court of appeals wrote that investors have many reasons for choosing investment products, and nothing guarantees that their needs will always be met by the cheapest option. The judges noted that various Commonwealth brokers testified to having researched and gone over various investing alternatives with clients before making any recommendations.
The appellate court said Commonwealth was working with roughly 319,000 investors in 2018.
“Those investors differed in many categories of ways, including as to the types of investors, types of investments, types of investment goals they set, and what advice they received from their representatives,” according to the court. “The SEC’s motion and supporting evidence in many ways assumed that these investors were identically situated. Yet a reasonable jury could find those assumptions questionable and not substantiated.”
Nor did the SEC, the court wrote, provide testimony from clients indicating they attributed any significance to information Commonwealth may have withheld.
A ‘wrongly influenced’ decision and a disgorgement disconnect
Bill Singer, a securities lawyer and retired author of the Broke and Broker blog, said there was a time not long ago when federal courts were inclined to give great deference to agencies like the SEC. But that willingness has been chipped away under a series of Supreme Court cases like SEC v. Jarkesy, in which the justices stripped the federal regulator of its authority to handle cases internally and instead said fraud charges have to be brought before juries.
Clearly, Singer said, the court of appeals viewed the lower court’s decision “as too quickly undertaken and wrongly influenced by inappropriate inferences.”
The appellate judges also faulted the lower court for the $65.6 million in disgorgement it ordered Commonwealth to pay as part of the $93 million penalty. Disgorgement is generally used to force violators to pay back any “ill-gotten gains” they may have realized from their misdeeds.
But the SEC, according to the court of appeals, failed to connect the disgorgement amount it was seeking with the money Commonwealth might have made by failing to disclose information about mutual fund transactions. Instead, the judges wrote, the SEC based its claim for disgorgement on Commonwealth’s profit figure for the entire year.
“The district court justified the use of the SEC’s entire sum as a disgorgement award by reasoning that causation was ‘self-evident’ because ‘at least some’ clients would have moved money to lower-cost funds had Commonwealth more fully disclosed its conflict of interest,” the judges wrote. “This is not the relevant standard and it is incompatible with the requirement that disgorgement represent ‘a reasonable approximation’ of Commonwealth’s unjust enrichment.”
The SEC’s case against Commonwealth came in many ways as the culmination of a series of SEC investigations into firms’ alleged failure to adequately disclose how they were making money from recommending mutual funds and similar investment vehicles.
In April 2023, for instance, the SEC hit the wealth management giant Merrill with a $9.5 million penalty over allegations that it had failed to notify clients of more than $4 million in undisclosed foreign exchange fees. The previous November, two subsidiaries of the large independent broker-dealer Cetera Financial Group were ordered to pay $8.6 million for not disclosing various fees and payments it received for the sale of mutual funds.
