The principal of a Franklin, Tenn.–based investment advisory firm is pushing back on the Securities and Exchange Commission, arguing in federal court to dismiss charges that his firm breached its fiduciary duty by failing to disclose conflicts of interest over mutual fund share classes. The $1.2 billion AUM CapWealth Advisors claims its use of funds that charged 12b-1 fees met SEC disclosure requirements, and furthermore no clients suffered financial shortfalls.
In an interview with WealthManagement.com, CapWealth co-founder Tim Pagliara (who is also named as a defendant in the SEC’s suit), said the commission’s argument is “riddled with holes” and that the firm had offset any 12b-1 fees by discounting its standard advisory fee for those clients, negating any conflict. The government had also erred in asking for an injunction on the practice, as CapWealth shut down its broker/dealer in 2018, according to Pagliara.
“It’s just an example of how heavy handed and uninformed the attorneys are for the government,” he said. “They might as well have asked for an injunction to keep me from doing brain surgery.”
The fact that the case may head to trial is unique, as many firms over the past several years opted into the SEC’s Division of Enforcement’s Share Class Selection Disclosure Initiative, which launched in February 2018 to encourage firms to self-report mutual fund share class violations in order to avoid being charged and possibly paying higher penalties. That initiative returned nearly $140 million to clients. While the last filings from firms who self-reported came in April of last year, the SEC has continued to file complaints against firms that allegedly failed to self-report.
Pagliara said he was not making that concession.
"They intimidated other firms into doing this,” he said. “Because we didn’t do this ‘amnesty’ program, they’re trying to make an example out of us."
Pagliara first worried there’d be trouble in September 2019, when the SEC’s Office of Compliance Inspections and Examinations (now the Division of Examinations) asked him why CapWealth had not self-reported the issue as part of the Self Disclosure Initiative. Pagliara told the office then he felt he had nothing to disclose.
Four days after the SEC closed an audit of CapWealth on Jan. 4, 2020, the firm received notice of an investigation into its share class practices.
The commission filed charges in Tennessee federal court in December, arguing that CapWealth’s affiliated broker/dealer (since closed) sold investments in share classes of mutual funds that can have higher costs than identical funds, including 12b-1 fees. Over time, CapWealth began selling share classes that did not charge these fees, according to the SEC, which meant the firm was offering options for clients to hold the same type of securities with a lower cost.
But the commission’s own advice for investment advisors leaves open the possibility that some disclosures can be done in person, CapWealth attorneys argued in their motion to dismiss the case, filed last month. The document cites SEC guidance that firms can meet the requirements “through a combination of Form ADV and other disclosure.”
In the motion to dismiss, CapWealth principals further allege the commission “harassed” numerous clients, encouraging them to support claims that the firm harmed them. One client told Pagliara the SEC had called numerous times to convince him to sign an affidavit substantiating the charge. The client ignored the SEC’s request and continued doing business with CapWealth.
Pagliara further claimed the commission approached the firm in September of last year with a deal to charge the firm but not any of the principals. Pagliara decided to move forward, insisting they had done nothing to warrant the charges. He said his firm had been preparing for trial since first learning of the SEC’s investigation, spending more than $1 million thus far on legal bills.
He said he viewed the case as an illustration of how the SEC was mistreating less-sizable RIAs.
“I’m using this as a platform to expose what they’ve done to private small businesses,” he said. “I’m putting them on trial.”
In their response to CapWealth’s dismissal motion, filed today, SEC attorneys held their ground.
“Defendants did not provide full disclosure in the written materials," according to the SEC, and "any oral disclosures made by defendants were not only insufficient, but in some instances, affirmatively misleading.”
The SEC stressed that the firm’s disclosures maintained that its principals “may” receive compensation from 12b-1 fees, while not disclosing that both Pagliara and Tim Murphy, an investment advisor representative and the firm’s managing director of wealth management, were “routinely receiving” such fees. The commission also argued Murphy was not technically a “principal” of the firm. And on at least two occasions, Murphy had “provided misleading explanations to advisory clients” about how mutual fund investments were converted to lower-cost share classes, according to the SEC's response, a charge Pagliara denies.
“Specifically, the complaint alleges that Pagliara admitted that he did not believe there was a conflict of interest arising from his share class selection decisions and thus, he would not have disclosed it,” the response read. “Obviously, a reasonable inference from this allegation is that Pagliara never disclosed the material conflict of interest arising from his recommendation to purchase or hold higher cost share classes of mutual funds for the client.”
In an initial case management order filed earlier this week, the court established a potential schedule for the case to proceed, with written discovery and deposition of witnesses completed by November 2, and for a jury trial date of no later than June 13 of next year.