Client Update: SEC v. Commonwealth Equity Services (Disgorgement)

The case of SEC v. Commonwealth Equity Services, LLC is an important First Circuit decision concerning: 1) the standard for summary judgment in a securities fraud case, and 2) disgorgement sought by the SEC. In this case, Commonwealth Equity Services, LLC (Commonwealth) appealed a district court decision granting summary judgment and financial penalties (disgorgement) in favor of the Securities and Exchange Commission (SEC).  The appeal focused on whether the district court erred in doing so, particularly on the issues of materiality and causation related to the alleged conflicts of interest.  Commonwealth argued that these issues should have been decided by a jury, not through summary judgment. The First Circuit agreed. White-collar leader Eric Rosen, a prominent securities fraud attorney, discusses the decision below:

Background of the Case

The case, United States Court of Appeals For the First Circuit No. 24-1427 involved allegations that Commonwealth did not adequately disclose potential conflicts of interest in violation of Sections 206(2) and (4) of the Investment Advisers Act of 1940, 15 U.S.C. § 80b-6(2), (4), and SEC Rule 206(4)-7, 17 C.F.R. § 275.206(4)-7(a). The SEC claimed that Commonwealth's revenue-sharing agreement with National Financial Services, LLC (NFS) incentivized Commonwealth to direct its clients' investments to mutual fund share classes that produced revenue-sharing income for Commonwealth over other share classes that could be cheaper for Commonwealth's clients. Commonwealth's representatives, who were responsible for managing clients' accounts, were not aware of which share classes were part of the revenue-sharing agreement between NFS and Commonwealth. 

The district court granted the SEC's motion for summary judgment as to Commonwealth's liability and denied Commonwealth's cross-motion for summary judgment and its later motion to reconsider the grant of summary judgment to the SEC.  The district court then entered final judgment against Commonwealth, ordering disgorgement of $65,588,906 in revenue-sharing income plus $21,185,162 in prejudgment interest and imposing on Commonwealth a civil penalty of $6,500,000. 

Commonwealth appealed from these orders, and the Court of Appeals vacated the grant of summary judgment and the disgorgement order, remanding for further proceedings consistent with its opinion.

Materiality and Jury Determination

The First Circuit Court of Appeals vacated the district court's summary judgment, emphasizing that the question of materiality—whether the omitted information about conflicts of interest was significant enough to influence a reasonable investor's decision—was an issue typically be decided by a jury.  In doing so, the Court cited cases such as Basic Inc. v. Levinson, 485 U.S. 224 (1988), which establishes that materiality requires a fact-specific inquiry into whether there is a substantial likelihood that a reasonable investor would consider the omitted information important. The court also referenced SEC v. Navellier & Associates, Inc., 108 F.4th 19 (1st Cir. 2024), which reaffirmed that materiality is typically a question for the jury. The First Circuit ruled that the district court had improperly applied a per se rule, assuming all potential conflicts of interest are material as a matter of law, rather than conducting the necessary fact-specific inquiry.  This approach was inconsistent with the principles outlined in Navellier, which emphasized the need for a jury to determine materiality based on the specific facts of each case.  The First Circuit also cited TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976), which cautions that materiality determinations require delicate assessments of the inferences a reasonable investor would draw from a given set of facts and the significance of those inferences.  The First Circuit highlighted that these assessments are ones for the trier of fact, meaning they should be left to a jury unless the omissions are so obviously important that reasonable minds cannot differ on the question of materiality. 

Disgorgement and Causation

The court also vacated the disgorgement order, which required Commonwealth to pay back $65,588,906 in profits deemed to be ill-gotten gains. 

The First Circuit explained that the SEC must provide a reasonable approximation of profits causally connected to the alleged violations.  The district court's reliance on the SEC's expert calculations was insufficient for multiple reasons.

First, the SEC's expert, Eugene Orlov, used a sample of the ten highest revenue-sharing fund families to estimate the number of share classes with lower-cost alternatives.  This sample as unrepresentative of the approximately 17,000 share classes approved by Commonwealth. 

Second, Orlov's analysis did not adequately account for the impact of transaction fees, which could make higher-expense ratio funds more cost-effective for clients who actively trade. 

Third, the SEC's assumptions did not consider the diverse investment strategies and goals of Commonwealth's clients, who were advised by independent representatives.  These representatives often conducted their own research and did not solely rely on Commonwealth's recommendations. 

The Circuit court emphasized that the SEC must establish a clear causal relationship between the alleged violations and the profits to be disgorged, which was not sufficiently proven in this case.  The First Circuit cited SEC v. Happ, 392 F.3d 12 (1st Cir. 2004), which requires that disgorgement be a reasonable approximation of profits causally connected to the violation, and Liu v. SEC, 591 U.S. 71 (2020), which mandates that courts must deduct legitimate expenses unless the entire profit results from wrongdoing. Additionally, the court's decision in SEC v. Jarkesy, 603 U.S. 109 (2024), reinforces the importance of a jury trial in determining the appropriateness of disgorgement amounts in SEC enforcement actions.

Implications and Conclusions

This case is a boon for defendants facing securities fraud charges in the District of Massachusetts and elsewhere. First, it confirms that materiality is a question of fact for the jury, and not one typically for courts on summary judgment motions. This will likely help defendants defeat the SEC’s summary judgment motions. Second, with respect to disgorgement, the First Circuit reaffirmed that calculating profits earned is insufficient. The SEC must trace those profits to the violation, which the SEC failed to do here. A win for the defense!

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