Commonwealth appeals $93M fine, says there's no evidence of client harm

Commonwealth Financial Network is fighting what it calls a "draconian" landmark judgment, arguing the SEC never established a causal link between client harm and its allegedly inadequate investment disclosures.

Waltham, Massachusetts-based Commonwealth, an independent RIA and broker-dealer firm with 2,300 independent advisor representatives, filed a brief last month in its appeal seeking the overturn of the more than $93 million judgment the firm was hit with in late March over allegations that it had failed to adequately disclose how it makes money from its recommendations of certain mutual fund products. The amount — consisting of $72 million in disgorgement and civil penalties, as well $21.2 million in prejudgment interest — was handed down by Judge Indira Talwani of the U.S. District Court in Boston in a legal action brought by the Securities and Exchange Commission in 2019. 

The appeal notes the $93.5 million penalty was nearly double the profits that Commonwealth, which has the No. 7 spot on Financial Planning's IBD Elite list of the largest independent brokerages, reported for 2014.

The case 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. Commonwealth, for instance, was accused of not doing enough to let investors know how much it was being compensated for selling certain mutual fund products through an arrangement with National Financial Services, a trade-clearing arm of Fidelity Investments. The SEC contended at least some clients would have gone for cheaper alternatives had they known they were on the market.

The only trouble, according to Commonwealth's appeal, is that the SEC never furnished any evidence to support the idea that investors would have actually made that choice. In handing down its judgment, the district court accepted at face value regulators' contention that some clients were harmed, according to the appeal.

"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," states the brief, filed in the federal First Appellate Circuit. "The district court's freewheeling approach was more an unauthorized civil forfeiture than an equitable remedy."

The term "civil forfeiture" refers to the use of civil proceedings to seize property and assets from people who are suspected of crimes but haven't been formally charged. A spokesperson for the SEC, whose brief in the case is due on Sept. 23, declined to comment "beyond the public filings for this matter."

Peggy Ho, Commonwealth general counsel and chief risk officer, said in a statement, "Commonwealth continues to vigorously pursue all available legal avenues to ensure a fair and just outcome. Meanwhile, we remain focused on our mission to offer independent advisors the services and solutions they need to grow their businesses and enhance the experience for their clients."

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Questionable judgment?
The appeal also questions the district court's decision to determine on its own that Commonwealth's supposed disclosure omissions were "material" — meaning they were significant enough to influence clients' behavior. That call on materiality, according to the appeal, was one that a jury should have made.

The appeal also accuses the SEC of "cherry-picking" the mutual fund share classes it cited in arguments in order to bolster the penalty amount faced by Commonwealth. While denying regulators' accusations, Commonwealth conducted its own analysis of how much it could be liable for and argued for $40 million less in disgorgement and no prejudgment interest. 

Commonwealth also contends that the $93 million judgment ignores the Supreme Court's decision in 2020 in Liu v. SEC, which held in part that firms' "legitimate expenses" should be deducted from disgorgement amounts. Commonwealth argues it had $10.8 million in such expenses related to maintaining accounts at Fidelity's National Financial Services arm.

Commonwealth notes that it did disclose in Form ADVs filed with the SEC between 2014 and 2018 that the firm had a possible conflict of interest through its arrangement with Fidelity's National Financial Services clearing arm. It also points out that its advisors received no additional compensation for recommending certain mutual fund products over others.

"There was no evidence that any [independent advisor representative] steered any client to purchase any mutual fund because it was a source of revenue sharing," according to the appeal.

Turning scrutiny on the regulators
Commonwealth's appeal comes amid heightened judicial scrutiny of regulatory agencies and the SEC's use of its enforcement powers. On June 27, in SEC v. Jarkesy the U.S. Supreme Court rejected the regulator's authority to bring fraud cases seeking civil penalties before internal tribunals known as administrative law judges. Defendants in such cases, the court found, were being denied their Seventh Amendment right to a jury trial.

Louis Straney, a regulatory expert at Arbitration Insight, said it's too early to know what the Jarkesy decision and other rulings rolling back regulatory authority will mean for a case like Commonwealth's. In large part, he said, Commonwealth's outcome will depend on the individual judge or judges hearing its appeal.

"Every one of these is a one-off because the fact pattern is unique to each case and company policies and testimony," Straney said. "I don't think you can make a blanket judgment about how these are likely to turn out." 

But a friend of the court brief filed on Aug. 1 by the Financial Services Institute, a trade group representing independent advisory practices and broker-dealers, contends the SEC is overstepping to assume clients suffer harm from allegedly inadequate disclosures. The brief, written by Joseph Toner of Wilmer Cutler Picker Hale and Dorr of Washington, D.C., notes that the district court in Commonwealth's case found that such harm was "self-evident" before handing down the $93 million judgment. 

That's hardly sufficient, the brief argues. Clients aren't always better off buying supposedly cheaper mutual funds, according to the brief. Investors who plan to trade frequently, for instance, might want a fund that comes at an ostensibly higher cost but without fees tacked on for each individual transaction.

"In this case, the court's 'self-evident' causation theory significantly oversimplifies complex market and investment dynamics," according to the brief. "Even if Commonwealth's disclosures had included more specific conflicts disclosures, there are a host of reasons why Commonwealth clients might have opted for and/or kept their investments in what the district court styled as 'higher-cost' shares rather than invest in or shift their investments to what the court styled as 'lower cost' shares."