For more than 50 years, the Securities and Exchange Commission (SEC) has relied primarily on two circuit court decisions to apply a surprisingly low standard of what constitutes a “willful” violation to a broad range of securities laws.
Over time, the SEC’s interpretation of willfulness has evolved to fall even below negligence, and the SEC has generally applied this standard in the context of settled orders where there is typically no judicial review. But in challenging an unfavorable decision in an SEC administrative proceeding, one litigant has upended this approach to willful violations.
In Robare Group Ltd. v. SEC, the D.C. Circuit held April 30 that there must be evidence of an individual’s or entity’s knowledge or “extreme recklessness” in order to find a “willful” violation. This could be difficult for the SEC to prove.
History of Willful Conduct
In Tager v. SEC, the SEC revoked the registration of a broker-dealer for willfully violating the anti-fraud and anti-manipulation provisions of Section 17(a) of the Securities Act of 1933 (the Securities Act). Tager had told investors that there was a market for stock underwritten by his company when in fact there was not.
In arguing on appeal that his conduct was not “willful” for purposes of the charged violation, Tager contended that willfulness for purposes of Section 17(a) requires a showing that he understood that his conduct was manipulative. The Second Circuit found this argument “wholly lacking in merit” as willful conduct merely requires “intentionally committing the act which constitutes the violation.”
The D.C. Circuit later went further, holding that a party commits a willful violation even where that party some, albeit insufficient, efforts to claim a statutory exemption from generally prohibited activity.
In Wonsover v. SEC, the SEC sanctioned a former registered representative of a broker-dealer for selling unregistered securities in violation of Section 5(a) of the Securities Act, which does not require scienter. Although Wonsover knew that the shares he sold were restricted, he asserted that he believed they qualified for an exemption from Section 5(a)’s general prohibition of sales of restricted shares.
Indeed, Wonsover took certain steps—including directing the sales through his employer broker-dealer’s Restricted Shares Department—that he argued demonstrated his efforts to determine whether such an exemption applied.
Nevertheless, the SEC found that Wonsover had ignored several “red flags” associated with the stock sales that should have alerted him to such stock not being covered by any registration exemption. After concluding that substantial evidence supported this finding, the D.C. Circuit held that Wonsover acted “willfully” for purposes of Section 5 of the Securities Act by proceeding with stock sales without conducting a “searching inquiry” of such “red flags” before relying on such an exemption.
In reaching this conclusion, the panel in Wonsover quoted its precedent interpreting the very statutory provision at issue. In these prior decisions, the D.C. Circuit had rejected arguments that either knowledge or reckless disregard were required; all that is required is that “that the person charged with the duty knows what he is doing.” Furthermore, there is no requirement that the actor “also be aware that he is violating one of the Rules or Acts.”
SEC Sets Low Bar
In numerous settled orders spanning a broad range of securities violations well beyond Section 5 of the Securities Act, the SEC has relied on the above quoted language from Wonsover to set a relatively low bar to demonstrate a respondent’s “willfulness.”
For example, in one decision in an administrative proceeding, the commission noted that it needed “to find only that [the respondent] voluntarily committed the acts that constituted the violation, not that [the respondent] was aware of the rule he violated or that he acted with a culpable state of mind.”
The D.C. Circuit, however, recently undermined the SEC’s reliance on Wonsover. While purporting to apply Wonsover to its interpretation of “willful” violations under Section 207 of the Investment Advisers Act of 1940, the D.C. Circuit interpreted “willfulness” to set a higher bar than the SEC has historically read the decision.
In Robare Group, the respondent had failed to disclose certain potential conflicts of interest in a Form ADV that registered investment advisers are required to file with the SEC. Based on the evidence presented, the SEC found that the respondent had failed to do so negligently, but not intentionally or recklessly.
Applying Wonsover, the SEC concluded that such negligent conduct was “willful” to support a finding of a Section 207 violation. The D.C. Circuit disagreed, holding that merely negligent conduct does not constitute the “willful” making of an untrue statement for purposes of Section 207.
The Future Is Unclear
It is unclear what standard the D.C. Circuit will apply to these and other “willful” violations going forward, but the panel appeared to embrace the view that such violations require a respondent to have knowledge or, at a minimum, to have acted with “extreme recklessness.”
This holding in Robare Group is in tension with Wonsover’s instruction—as interpreted and applied by the SEC—that all a “willful” violation of the securities laws requires is “that the person charged with the duty knows what he is doing.”
There seems little doubt that the respondent in Robare Group knew what he was doing when he was completing the Form ADV and failed to disclose the relevant potential conflicts of interest. And given the SEC’s reliance on Wonsover for a broad range of willful securities violations, this calls into question whether the SEC may continue to apply its favorable interpretation of willfulness in the future.
Based on Robare Group, the D.C. Circuit appears to have adopted the view that willful securities violations require intentional or extremely reckless conduct. To charge a willful violation after Robare Group, the SEC now has the difficult, if not sometimes impossible, task of obtaining evidence that an individual or entity acted or failed to act intentionally or extremely recklessly.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Bill Martin, a white collar defense & corporate investigations counsel in the New York office of O’Melveny & Myers, is a former senior counsel with the Market Abuse Unit in the Securities and Exchange Commission’s Enforcement Division. He is grateful to the research assistance of Reuben Goetzl, an associate in the Washington office of O’Melveny & Myers, in connection with this article.