On April 1, 2021, the Texas State Securities Board (TSSB) announced the entry of a Consent Order against an SEC registered investment adviser named Independent Financial Group, LLC (“Independent”). The TSSB’s action may represent a large shift in investment adviser regulation and enforcement considerations for SEC-registered investment advisers. (Emphasis on “may.”)
The Investment Advisers Act of 1940 is commonly understood to significantly limit states’ application of their securities laws as to SEC registered investment advisers.
Specifically, Section 203A(b) of the Investment Advisers Act states that “No law of any State or political subdivision thereof requiring the registration, licensing, or qualification as an investment adviser…shall apply to any person” that is registered with the SEC. However, Section 203A(b) goes on to confirm that the preemption discussed in the subsection will not prohibit a state securities regulator “from investigating and bringing enforcement actions with respect to fraud or deceit against an investment adviser or person associated with an investment adviser.”
The collective language is the basis for the widely held belief (at least amongst securities counsel) that states are preempted from regulating SEC registered investment advisers as to anything except fraudulent or deceitful conduct.
So what makes the TSSB action against Independent truly remarkable is that there is no allegation of fraud or deceit by Independent. Instead, the only violation cited is the failure to maintain a reasonably designed supervisory system. Hardly sounds like traditional fraud or deceit.
How is the TSSB’s action possible if federal law largely preempts states from enforcing their securities laws against SEC registered investment advisers?
Possible Explanations
We note the Consent Order specifically cites a provision of the TSSB’s regulations that states, “The Agency has jurisdiction to investigate and bring enforcement actions to the full extent authorized in the Texas Securities Act with respect to fraud or deceit, or unlawful conduct by an investment adviser…” (emphasis added). Generally, that provision has not been referred to in actions the TSSB has taken against Texas registered investment advisers. So, the reference to that rule in this case must be noted.
A Narrow Reading of the Preemption
Perhaps the reference to the “unlawful” language suggests TSSB has taken the position that the preemption language in Section 203A of the Investment Advisers Act only applies to state laws “requiring the registration, licensing, or qualification” of an investment adviser. In other words, the agency has concluded it can enforce state securities laws against SEC registered investment advisers as long as those laws are not the ones requiring “registration, licensing or qualification.”
If such position were deemed valid, SEC registered advisers would face a monumental shift in potential exposure considerations. Not only would they become exposed to compliance burdens tied to disparities between state laws, but they would also be considerably exposed to the investigation and enforcement authority of state regulators. It is not an overstatement to view such an outcome as earth-shaking for SEC investment advisers. SEC investment advisers would have significantly more work to do and exponentially higher exposure to scrutiny from state regulators.
A Broad Reading of “Fraud or Deceit”
Another possibility is that the TSSB is reading “fraud or deceit” more broadly than what we traditionally think of as encompassing fraudulent or deceitful conduct. Here, too, the state’s reference to its rule involving “unlawful” conduct strikes a chord because it mirrors certain language under the very law that established the federal preemption – i.e., the Investment Adviser Act of 1940.
Section 206 of the Investment Advisers Act begins, “It shall be unlawful for an investment adviser…” before identifying certain prohibitions against fraudulent or deceptive conduct. Further, Rule 206(4)-7 under the Investment Advisers Act provides that “it shall be unlawful within the meaning of Section 206” for a SEC registered investment adviser to provide investment advice without having adopted and implemented reasonably designed written policies and procedures.
So, maybe, the TSSB is contending that a violation of any rule that indicates conduct thereunder is unlawful under Section 206 of the Investment Advisers Act is “fraud or deceit” for purposes of assessing the exclusion from federal preemption. While not as far reaching as the first possibility discussed above, this would certainly expose SEC registered investment advisers to varied interpretations of their written supervisory procedures.
For purposes of this post, it is suffice to say we believe there are many good arguments against such applications of the federal preemption. The possibilities above are simply some postulations as to how the TSSB may have supported its action. We would expect a different conclusion on the jurisdictional issue in a litigated matter, which leads us to why the Independent Consent Order likely does not represent a major tectonic shift, but still one that should trigger the alarms.
A Reading of the “Tea Leaves”
Certain details suggest the Independent Consent Order may have been a somewhat focused flexing of the TSSB’s muscle and not an effort to broaden its enforcement regime.
It is common for firms and individuals to reach settlements with regulators simply to avoid the initiation of litigation, much less actually litigating against them. On the other side, a key settlement tool for regulators is the ability to concede on the nature of the allegations if they can obtain the desired findings and/or sanctions. That is just “how the sausage is made.” Understanding the ingredients in this matter is useful in assessing risk for SEC investment advisers.
First, while the ultimate violation to which Independent consented is not fraud based, the facts appear to involve significant underlying violations by a former investment adviser representative. In December 2020, that Houston based investment adviser representative was denied a Texas license by the TSSB based on findings that the representative had over-concentrated clients at Independent in leveraged exchange-traded funds (ETFs). These allegations, theoretically, may have been sufficient for the TSSB to at least allege that Independent—through the representative—made unsuitable recommendations and breached its fiduciary duty to clients. This could explain why Independent may have consented to a state enforcement action based on supervisory violations despite the availability of federal preemption.
Also notable is the fact that Independent is not just a SEC investment adviser but is also a broker-dealer registered in Texas. To the extent the alleged violations involve a failure to develop adequate training and supervisory controls, it is possible—if not likely—that the TSSB could have made the same allegations against Independent as a broker-dealer. That would have avoided the jurisdictional issue entirely as states are not limited in their enforcement jurisdiction as to broker-dealers.[1] It seems that the TSSB saw an opportunity to send a message to the SEC investment adviser community.
The belief that the TSSB was interested in using the Independent Consent Order as a bellwether may be crystalized by the fact that the Order was done on “without [Independent] admitting or denying” the findings and conclusions. Many state securities regulators balk at allowing firms to settle on a “without admitting” basis despite the prevalence of that approach in SEC settlements. Texas has historically only sparingly allowed firms to settle on a “without admitting” basis. The use of that language in this case indicates the TSSB was motivated in utilizing one of its rarest settlement concessions in order to finalize a non-fraud enforcement action against a SEC registered investment adviser.
What does this mean for SEC Registered Investment Advisers?
The true message of the Independent Consent Order is that Texas sees a pathway to taking meaningful enforcement actions against SEC registered investment advisers in a reserved, targeted manner. We suspect other state regulators will have taken notice and will at least consider following suit.
Even if the use of the approach is limited, it is still very noteworthy that state securities regulators, to limit the preemptive effect of the Investment Advisers Act, might leverage an alleged breach of fiduciary duty (e.g., making unsuitable recommendations) or broadly interpret “fraud or deceit.”
Thus, there is a threshold takeaway for SEC registered investment advisers: state regulators appear to have in mind an approach to effect regulatory sanctions and change in matters that involve serious underlying conduct but still fall below the point where the SEC can justify its investigative resources. State securities regulators are proud to be seen as the “cops on the beat,” so the approach used in this case by the TSSB may be regarded as an addition to their ammunition. SEC registered investment advisers would be wise to incorporate this possibility into their risk management considerations.
Andrew Rosell | 817.420.8261 | arosell@winstead.com
Toby Galloway | 817.420.8262 | tgalloway@winstead.com
[1] Of course, according to the Consent Order, the subject activity took place in investment advisory (i.e., fee-based) accounts, which would have contributed to why the TSSB sought to address the issues under its investment adviser regulations.
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