First Circuit's Reversal Of Summary Judgment Clarifies Materiality Standard For Advisory Conflicts

• Published date: 21 May 2025
• Subject Matter: Corporate/Commercial Law, Litigation, Mediation & Arbitration, Corporate and Company Law, Trials & Appeals & Compensation, Securities
• Law Firm: Foley & Lardner
• Author: Ms Kathryn Marie Throo, William McCaughey and Margaret G. Nelson

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...