ARTICLE III - INVESTMENT ADVISER SANCTIONS

The Three Tier Sanction Scheme

In view of the severity of SEC monetary and time suspension and bar sanctions and the impact that these sanctions have on the investment adviser’s reputation, not only do the prescriptions and proscriptions of the statute and rules have to be clearly drafted but the sanctions have to fit the gradiations of the adviser’s conduct and thereby serve the fundamental and remedial purpose of the securities laws. These goals will not be accomplished if ill defined "constructive fraud" and breach of fiduciary duty are mixed in a confusing fashion.

The 1940 Act, 15USCS § 80b-9 (e), provides for a three tier monetary penalty framework for violations of the anti-fraud statutory and SEC Rules. In respect to the first tier for each violation of the 1940 Act, SEC Rules and Regulations, or a Cease-And-Desist Order the Commission can bring an action in a United States District Court, upon a proper showing to impose a civil monetary penalty. The first tier penalty is to "be determined by the Court in light of the facts and circumstances," thus covering every kind of violation of the 1940 Act and its applicable rules. The penalty shall not exceed the greater amount of $5,000 for a natural person or $50,000 for a juridical person or the gross amount of pecuniary gain to the defendant as a result of the pecuniary gain. In respect to the second tier, the amount of the penalty shall not exceed the greater of $50,000 for a natural person or $250,000 for a juridical person or "the gross amount of pecuniary gain to such defendant as a result of the violation if the violation was a Section 206(1) and (4) one involving "fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement." The third tier penalties are not to exceed the amount of $100,000 for a natural person, $500,000 for a juridical person or the gross amount of pecuniary gain to the defendant if the violation is a Section 206(1) or (4) one involving fraud, deceit, manipulation, or deliberate or reckless disregard or a regulatory requirement and "such violation directly or indirectly resulted in substantial losses or created a significant risk of substantial losses to other persons." It is manifest from the language of Section 206(1) and (4) that such conduct comes within the second and third provided that the conduct involved "fraud, deceit, manipulation or deliberate or reckless disregard of a regulatory requirement," all of which denote and connote scienter.

It further appears from the language of Section 206 (3) that scienter is also an element and the conduct comes within the second and third tier penalty provisions. The text of the statute with clarity provides it is unlawful for any investment adviser "acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as a broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction ..." (emphasis added). The prohibitions do not apply if the broker or dealer is not acting as an investment adviser "in relation to such transaction." In view of the word "knowingly" used twice and the subparagraph’s precision in describing the transactions to which it applies and where it does not apply, there can be no doubt as to the sanction exposure if there is a violation.

Subparagraphs (2) and (4) of Section 206 presents some puzzlement. A question arises whether the "operative fraud" language fits only within the first tier monetary penalty provision or can a valid argument be made that a violation of subparagraph (2) fits within those categories imposing more severe sanctions. Intent or recklessness is not an element of a violation of subparagraph (2) and therefore it appears since the conduct in issue only operates as a fraud and does not have to be a fraud, the Second and Third sanctions are excluded. This leaves open the issue whether there is any conduct that violates Section 206(4) that is a violation without the scienter as a necessary element, that can be subject to Second or Third tier monetary penalties. What did Congress intend? What is fair as well as in the public interest? Here is the minefield for investment advisors and their counsel, and from the authors’ perspective, that which deserves reconsideration and reform.

The interplay between Section 206(4) and Rule 206(4)-1(a) and the three tier penalty provisions can create difficulties in that the Second and Third Tier penalty provisions appear to require scienter as does Sections 206(1) and (4). Section 206(4) uses the same language as 206(1) but applies to any act, practice or course of business, not a scheme or artifice. This is nonetheless fraudulent conduct, at least by the subparagraphs’ language, requiring scienter. In respect to the language in Section 206(4), i.e., "(t)he Commission shall, for the purposes of this paragraph (4) by rules and regulations define, and prescribe means reasonably designed to prevent such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative," there is an open question whether the Commission can dispense with scienter or non-specific rules. Rule-making in the context of Section 206(4) is appropriate provided the rules provide educative notice to investment advisers as to what they can and cannot do since, such specific notice is mandated if the rule is deemed violated and sanctions imposed. This is the functional equivalent of scienter. Ignorance of the law is no excuse clearly in situations where the law is specific. However, where the law is unclear in a regulatory context, scienter should be required.

The problem becomes apparent in dealing with the advertising rule, Rule 206(4)-1(a). Rules 206(4)-1(a) 1 to 4 are quite specific prohibitions satisfying the basic fairness test since the rule in these contexts gives educative notice. Rule 206(4)-1(a)5, however, is artistic ambiguity and cognitive nonsense. The rule can be applied unfairly and subject an advisor to a severe Second or Third Tier monetary penalty where the advisor only acted negligently and without intent or recklessness. Subparagraph (5) prohibits an advertisement that "contains any untrue statement of a material fact" which is certainly not objectionable by itself. However, the subparagraph crosses the line with the language" which is otherwise false or misleading." The dictionary defines "otherwise" to mean "in another manner," "differently," "in all other points or respects," and "in other circumstances." To "mislead" is "to lead in a wrong direction," "lead astray," to "lead into error" and to "deceive or delude." If an advertisement contains materially accurate statements, it defies logic to suggest that it can be "otherwise misleading. Otherwise misleading" is a non-specific "catch all" phrase that is not what Congress meant when it required the Commission by its rule making authority to essentially define the conduct investment advisors should and should not engage in with respect to their clients and prospective clients. Contrast the first four subparagraphs, i.e., subparagraph (1) that proscribes testimonials; subparagraph (2) that proscribes unqualified references to past specific recommendations, which were or would have been profitable; subparagraph (3) that proscribes the use of graphs, charts, and formulas that supposedly assist in making investment decisions "without prominently disclosing in such advertisement the limitations ... and the difficulties with respect to its use;" and subparagraph (4) prohibits statements that any investment advisory service will be furnished free of charge when that is not the case; with the non-specific and "otherwise misleading" language of subparagraph five. It is obvious that in this respect the Commission is not meeting its responsibilities to use its expertise and authority to educate advisers as to what is and is not permissible.

Contrast also the "otherwise misleading" language to the basic language of Section 10(b) and Rule 10b-5, to wit, "to make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made in the light of the circumstances under which they were made, not misleading ..." and it is apparent that "otherwise misleading" is out of place in the federal securities laws. The advertising rule which has broad applicability from the dissemination of publications to face to face client - adviser meetings covers the vital flow of information to public investors and there should not be any guessing either by advisers, or the government in respect to its meaning or proper application.

In SEC v. Wall Street Publishing Institute Inc, the Court articulated the well established materiality standard in the Section 206 context, as follows:

The general standard applied to establish materiality of a false or misleading statement under Section 206 is that set forth by the Supreme Court ... ‘An omitted fact is material if there is a substantial likelihood that a reasonable ,,, [investor would consider it important in deciding the matter before him, i.e., in making and investment decision" (Emphasis added).

How then could either a non-material accurate statement or a non-material inaccurate statement be "otherwise misleading"? Is there a substantial likelihood that a reasonable investor would consider it important in making the investment decision? The difference between Section 206(1) and 206(4) violations and the non-intentional, non-reckless fraud of Section 206(2) is significant in terms of what tier penalty provision is to apply. Any ambiguity such as "otherwise misleading" should be erased from the statute and rules. In fact, the statute and rules, especially because of the professional and fiduciary status of investment advisers, and the implication a fraud charge or case resolution has to their reputation and business, should make the statute and rules models of clarity.

In SEC v. Blavin, a United States District Judge tried to fathom the meaning of "otherwise misleading" and the level of materiality required. The Court observed:

"Rule 206(4)-1(a)(5) further forbids the distribution of any advertisement which contains any untrue statement of a material fact or which is ‘otherwise misleading’ ... [T]his Rule prohibits statements that are not only materially misleading ... but also statements that fall short of the materiality standard." (Emphasis added).

How important or unimportant must the misstatement be and is it an affirmative misstatement or an omission? The opaque language in the rule violates lawyer Lincoln’s rule that in stating legal propositions "one should not run with the hares and hunt with the hounds.

In SEC v. Slocum Gordon & Getal, the Court addresses the distinctions between the three tiers as follows:
".... Civil penalties under the Advisers Act are divided into three possible tiers, each with a higher penalty attached to it. In the First Tier, the amount imposed for each violation "shall not exceed the great of (i) $5,000 for a natural person or $50,000 for any other person, or (ii) the gross amount of pecuniary gain to such defendant as a result of violation.’ 15 U.S.C. 80b-9(e)(2)(A). The Second Tier imposes higher penalties per violation, but may only be invoked if the violation ‘involved fraud, deceit, manipulation, or a deliberate or reckless disregard of a regulatory requirement.’ The Third Tier imposes significantly higher penalties, but only applies if the violation satisfies all the requirements for the second tier and, in addition, the Court concludes that the ‘violation directly or indirectly resulted in substantial losses or created a significant risk of substantial losses to other persons.’

The Commission argues that the Court should apply the third tier to Defendants’ respective violations, arguing that their actions were both deliberate and resulted in substantial losses to their clients. However, because no losses were demonstrated, and because this Court concludes that Defendants’ actions were not intentional or deliberate, second and third tier penalties are inappropriate. Rather, the Court will impose a civil penalty under the first tier only. (Emphasis added.)

In the case the Court imposed a monetary penalty of $1,000 per violation and it was significant to note that it did so because the acts and omissions violated only Section 206(4) and specifically Rule 206(4)-2(a)(2) which addresses the specific prohibitions involving custody or possession of client funds and securities, and not the undefined and "otherwise misleading" provision of Rule 206(4)-1(a)(5). The functional equivalent of scienter or a reckless disregard of a regulatory requirements was present so a stiffer sanction could be imposed.

In imposing severe monetary sanctions, i.e., second and third tier penalties, consideration should be given that the criminal act provision of the 1940 Act, 15 USCS §80b-17 (2005), only imposes in addition to possible imprisonment, a fine of not more than $10,000. This illustrates why monetary penalties are, more often than not, punitive and not remedial and that when, and if imposed, should be done carefully only against those who violate clear statutory provisions and rules.

Other Sanction Consequences
In the mind of the layman fraud is fraud and there is not any distinction between actual fraud and what is essentially constructive fraud, i.e., conduct without intent or recklessness that might cause an effect similar to that which is caused by actual fraud. The staff often seeks, and the Commission and Courts grant by way of prophalytic relief that the sanctioned adviser distribute the Order resolving the administrative or injunctive proceeding to present and prospective clients. In Valicenti Advisory Services Inc. v. SEC, the Second Circuit described the type of conduct and attendant public interest risk that an order distribution requirement has to involve for a fair imposition of such a sanction. The Second Circuit observed:

"[T]he SEC has provided at least two reasonable explanations justifyingthe imposition of the distribution requirement as a reasonable limitation on petitioners’ investment adviser activities. First, the distribution requirement will apprise present and prospective clients of the Commission’s findings so that these investors may be fully informed in deciding whether they wish to do business with petitioners. Second, the distribution requirement may discourage petitioners from committing further violations. Given the serious nature of the petitioners’ violations, we cannot deny that the distribution requirement is a rational means to alert actual and prospective clients of petitioners’ misconduct and to discourage any further such conduct ... [and] ‘[s]o long as an agency has articulated a satisfactory explanation for its action including a rational connection between the facts found and the choice made, we will uphold its choice of sanctions." (Emphasis added.)

In the context of a statute and rules that do not draw a clear line between actual and constructive fraud, a distribution order can be an injustice.

The March 2006 US Chamber of Commerce’s Report on the Current Enforcement Program of the Securities Exchange Commission suggests a more palatable alternative, especially in respect to investment advisers who are governed more significantly by fiduciary responsibilities than by the anti-fraud provisions. Both more effective "fix it" solutions and better guidance to investment advisers can be achieved if the Chamber’s recommendations are followed. Among the recommendations, which will avoid harsh measures such as a distribution requirement that do not advance the public interest, is the following:
"The Commission should consider the use in appropriate cases of formal reprimands, as suggested by the Wells Committee in 1972, and of Memoranda of Understanding, as utilized by banking regulations, to remedy situations short of enforcement actions. In addition, the wider use of Reports of Investigation under Exchange Act Section 21(a) can help provide meaningful guidance on difficult disclosure and accounting issues and on the Commission’s emerging views on appropriate standards of conduct."

Implementing this recommendation will certainly be more congruent with the remedial as opposed to the punitive purposes of the federal securities laws. It will also give better definition to the investment adviser’s fiduciary duties and the standards that govern the adviser’s conduct. The recommendation coupled with the relatively new chief Compliance Officer Rule 206(4)-7 certainly also will enhance the efficacy of the statutes and rules, provided there is a sharper focus on educative notice.

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