How an RIA scored a rare win over SEC fraud charges

After more than 100 settlements of SEC cases accusing wealth managers of failing to disclose conflicts of interest, at least one registered investment advisor has beaten the regulator in court.

A jury acquitted CapWealth Advisors, founder Tim Pagliara and another representative of the RIA on Nov. 1 in federal court in Nashville, Tennessee of fraud charges. Wall Street's regulator had accused them of placing clients in higher-priced mutual fund share classes without adequately explaining their financial incentives, a move that caused investors to pay roughly $450,000 in "avoidable 12b-1 fees." The fees, for  marketing and distribution expenses, often result in mutual fund clients paying more for certain share classes compared to lower-cost identical products. But CapWealth Advisors, which is based in Franklin, Tennessee, successfully argued that its clients actually paid lower overall expenses through a tax strategy.

"Everything that I did was in the best interests of my clients," Pagliara said in an interview, noting that he was a 40-year industry veteran who has appeared frequently in industry rankings as the principal of a billion-dollar RIA. "That made the trophy even bigger, if they could get me convicted of something," he said. "There is a better way to run a regulatory system."

Representatives for the Securities and Exchange Commission didn't respond to requests for comment about the case. 

Regulation and compliance

SEC tells advisors to rein in conflicts of interest under Reg BI

August 3, 2022 5:56 PM

Pagliara's remarks echo a common complaint in the industry that the regulator is overreaching by making new rules through enforcement. It's not immediately clear how many RIAs out of the handful that are fighting SEC charges against them have won in court. Pagliara said he didn't know of any other RIAs that have beaten an SEC case of this type, although he said that many large wealth management firms settle their matters as a cost of doing business.

Client advocates view the SEC's raft of actions and restitution orders and fines totaling close to $200 million since 2019 as a legitimate exercise of the regulator's power to stamp out practices they say ran afoul of the fiduciary duty. That standard requires RIAs to place clients' interests ahead of their own and avoid conflicts of interest regarding 12b-1 fees or other payments flowing between advisory firms, clearing brokers and fund companies. 

For all of the industry's howls of protest, wealth management firms have lined up en masse to settle their cases. In the latest example, Cetera Financial Group agreed last month to pay $8.6 million rather than continuing its struggle against the SEC in Denver federal court. 

In its December 2020 case against CapWealth, the SEC said that the firm's "failure to disclose adequately these material conflicts of interests prevented their advisory clients from the opportunity to provide informed consent to these conflicts" from June 2015 until June 2018.

"As an investment adviser, CapWealth owed its advisory clients a fiduciary duty to act in their best interests and to fully disclose all material facts about the advisory relationship, including disclosing any conflicts of interest that might cause CapWealth to put its own interests before those of its clients," the regulator's filing said.

The SEC brings lawsuits against companies only when it alleges egregious violations of securities law. But jury trials "related to complicated regulatory issues" often pose challenges, according to regulatory expert Louis Straney of Arbitration Insight. For one, investors may not be familiar with the technical topic. For another, courtroom hearings add context to a case that can suggest there is subtlety around how the fiduciary duty "to demonstrate loyalty and trust" may apply in certain situations, Straney said in an email.   

"Regulators generally prevail in best interest and disclosure cases," he said. "That is consistent with the long respected principles of the various Securities Acts, which require full and balanced disclosures and the highest principles of commercial practices. I can only conclude that, based on the testimony and evidence, the jury determined that these standards were met."

Practice and client management

5 tips to strip stress out of your next SEC, FINRA or state regulatory audit

August 30, 2022 1:13 PM

The Nashville jury found that the SEC "did not prove by a preponderance of the evidence" that CapWealth or its representatives "engaged in conduct that operated as a fraud or deceit upon any client" in violation" of the Investment Advisers Act and "did not adopt and implement written policies and procedures reasonably designed to prevent violation" of the Act.

In the hearings, CapWealth benefitted from Judge Waverly Crenshaw taking the regulator's attorneys to task over procedural errors and from an expert testifying for the prosecution who wasn't able to answer basic questions, according to Pagliara. The parties engaged in mediation talks, but Pagliara said he rejected the SEC's offer of a settlement for $500,000. 

"As the Commission is well aware, CapWealth used 12b-1 fees as part of a tax strategy to provide lower overall fees to its clients. Cap Wealth absorbed the cost of the 12b-1 fees through lower advisory fees," the firm said in its formal August 2021 response to the case in court. "Despite having received evidence of CapWealth's strategy and the benefit it provided to its clients, the Commission continues to make the same boilerplate allegations here that it has made against other advisors who did not employ such a strategy."

Pagliara said that the regulator's case ignored the fact that mutual fund fees are tax deductible in certain cases. During the trial, CapWealth presented records of an SEC audit of the firm in 2011 and of the firm's subsequent full review by a compliance consultant who found it had followed the regulator's instructions about updating client disclosures.

"We did everything they told us to do," Pagliara said. "They waited eight years to come back and tell me I did something wrong in 2016 and 2017."

Regulation and compliance

Cetera to pay $8.6M as SEC disclosure cases leave lasting impact

November 2, 2022 4:18 PM

Pagliara said that some of the SEC share-class enforcement cases of recent years were solid, since many of them involved practices such as revenue sharing that weren't at issue in CapWealth's proceeding. The regulator could have simply put out guidance and given the industry time to comply rather than pursuing all of the cases, he said.

CapWealth needed to defend itself from the beginning against the allegation it "defrauded and deceived clients," Pagliara said, adding that he's closer to "the end of my career" than the beginning of it after 42 years in the field. "When we finally saw the jury verdict form, it sunk in as to what this meant to me."